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THE BEAI HOIY GRAIT

Money Management Techniques


of Top Traders
THE BEAL HOIY GBAIT
Money Management Techniques
of Top Traders

Contributors:

Mark Boucher
Jeff Cooper
Daniel P Delaney
Loren Fleckenstein
Kevin Haggerty
Duke Heberlein
Dave Landry
Kevin N. Marder
Brice Wightman

Edited by
Eddie Kwong

PI. GI"'D"IJ GI'1'UID


'DUI'LISilISG
los Angeles, California
Copyright O 2001, TradingMarkets.com

ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a re-
hieval system, or transmitted, in any form or by any means, electronic, mechanical, pho-
tocopying, recordingr or otherwise, without the prior written permission of the
publisher and the authors.
This publication is designed to provide accurate and authoritative information in regard
to the subject matter covered. It is sold with the understanding that the authors and the
publisher are not engaged in rendering legal, accounting, or other professional service.
Authorization to photocopy items for internal or personal use, or for the internal or per-
sonal use of specific clients, is granted by M. Gordon Publishing Group, Inc., provided
that the U.S. $Z.OO per page fee is paid directly to M. Gordon Publishing Group, Inc.,
1.-213-955-5777.

ISBN: 1,-893756-10-6

Printed in the United States of America


Disclaimer

It should not be assumed that the methods, techniques, or indicators presented in this
book will be profitable or that they will not result in losses. Past results are not necessar-
ily indicative of future results. Examples in this book are for educational purposes only.
The author, publishing firm, and any affiliates assume no responsibility for your trading
results. This is not a solicitation of any order to buy or sell.

The NFA requires us to state that "HYPOTHETICAL OR SIMULATED PERFORMANCE


RESUIJTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PER-
FORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL
TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED,
THE RESULTS MAY HAVE TINDER- OR OVERCOMPENSATED FOR THE IMPACT, IF
ANY OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMU-
LATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBIECT TO THE FACT
THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESEN-
TATION IS BEING MADE THAT ANY ACCOUNT IArILL OR IS LIKELY TO ACHIEVE
PROFITS OF LOSSES SIMILAR TO THOSE SHOWN.'
To my wrfe loy and to my two daughters, Melinda and Rosemarie.
GONTENTS

INTBODUCTION

CHAPTEE ONE
Money Management: The Beal 'Holy Grail' 5
WHAT EVERY TRADER SHOULD KNOW
ABOUT MONEY MANAGEMENT
By Daniel P. Delaney and Dufu Heberlein 6

CONTROLLING RISK AND CAPTURING PROFITS


By Daoe Landry 12

THREE RULES THAT WILL HELP YOU BECOME


A MASTER TRADER
By Mark Boucher 20
CHAPTEB TWO
Stop-Losses Stop Losses 29
INITIAL STOP PLACEMENT
By Daae Landry 30

TRAILING STOP TECHNIQUES


By Mark Boucher 46

CHAPTER THBEE
Protecting Yourself in Different Time Frames 53

DAYTRADING TIME FRAME:


Learning to Lose is Crucial for Winning in Daytrading
lnteroiew With lff Cooper (From Hit and Run Trading II) 54

DAYTRADING TIME FRAME


TradingMarlcets.com lnteraiew u:ith lff Cooper 61.

DAYTRADING TIME FRAME


lnteruiew with Keoin Haggerty 57

SWING-TRADING TIME FRAME:


Ten Tenets of Swing Trading
By Daoe Landry 69

INTERMEDIATE-TERM TIME FRAME:


Marder on Money Management 76

INTERMEDIATE-TERM TIME FRAME:


The Discipline No Intermediate-Term
Trader Can Do Without
By Loren Fleckenstein 81
CHAPTER FOUB
Special Topics in Money Management 89
THE POWER OF PUTTING THE PIECES TOGETHER
By lff Cooper 90

SETTING TIME STOPS:


Knowing When to Exit Drifting Positions
By Brice Wightman 91

THE ART OF PROTECTING LONG-TERM PROFITS


By Daniel P. Delaney 97

CHAPTEB FIUE
The Mental Side of Money Management 115
FIVE WAYS TO PREVENT YOURSELF FROM
LOSING YOUR MIND WHILE TRADING
By Eddie l(wong 115

APPENDIX
lntroduction to Uolatility 127
INTRODUCTION

Tnir may be one of the most important books about hading that you'll ever read.

Not because I-or the other contributors to this book-have magical formulas for indica-
tors or chart patterns to reveal to you. Not because you'Il leam a trading strategy or sys-
tem that gives 1.00% accurate buy or sell signals.

Yet I can assure you that the principles described in precise detail in this book have con-
tributed more to the success of professional traders than anything else.
This is a book about the number one obsession that every trader must have in order to
succeed. This is one thing to which most traders fail to pay enough heed at the begin-
ning of their careers: MONEY MANAGEMENT!
Let me explain why money management-and not making money-should be your
main focus as a trader.
Trading is about taking risks with money in order to make more money. While you
stand a chance of making money with every trade you make, you could also lose it.

. As you lose money, you have less money to bet. You weaken your ability to make
money.

. If you lose all your money, you have no money to bet. You can no longer trade. lt's all
ooer.
It's important for you to understand that it is easier to lose money trading than it is to
make money. It is not just a passive pool of cash from which you just shovel money into
your trading account. Rather, there are forces at work which act to shovel money out of
your trading account. When you trade, it will often seem as though the market actively
does whatever it can to take money away from you.

The consequence of losing is not mere disappointment, but also the potential loss of a
Iot of money.
Every survey that has ever been conducted about the relative performance of neophyte
traders shows that most blow themselves out of the game by losing all their money
within the first year. Many times, they save or borrow enough money to try again, only
to repeat the pattern of failure again.
I've had the good fortune, as Editor-in-Chief of TradingMarkets.com, to become well-ac-
quainted with many of the best haders in the world. Most of those that I've spoken to
say that a! the beginning of their careers, they either lost a substantial amount of money
or came close to losing all of it. In some cases, this happened more than once.
But at some point they pulled themselves together and halted the bleeding by ceasing
their trading activities and taking a hard look at what they were doing *ro.rg. They re--
evaluated their trading strategies and the rationale they had for entering and
trades. IAlhat it all boiled down to in every single one of these cases was that the "*iting
central
problem that needed to be fixed was not in their system or methodology. Rather it was
it was this:
They had no working system of money management in place.

Basically, while they had a strategy for finding good trading opportunities in exchange
for taking on a certain amount of risk, they had no methodical approach for controlling
losses.

Likely, they committed one or more of the familiar mistakes that beginners make, such
as putting too much money into a single trade, or letting a small loss turn into a big one.
In their initial attempts at trading, they aliowed their losses to spin out of control.
Somehow, however, these traders managed to muster the determination to not only di-
agnose their mistakes, but also to learn sound money-management principles and apply
them in an unwaveringly disciplined fashion.

At kadingMarkets2O00 before an audience of nearly 600 people, I asked 16 of the coun-


try's best traders the following question:
If there was only one thing that the people attending our conference could do to
dramatically improae their trader results, what would it be?

Without exception, every one of them gave an answer that was directly related to money
management.

This book contains the money-management techniques of some of the best traders in the
business. These are individuals who paid their dues and endured the pain that their
mistakes caused early in their careers.

They leamed. They fought their way back. They triumphed. This is your chance to learn
what they leamed about money management. They learned the hard way Will you nou)
take this opportunity to learn the easy wayT

This book is divided into five chapters:

1. Chapter One deals with money-management basics. It will introduce to you in


specific detail why it's important to have a loss-control strategy and what the
consequences are for not having one. You'll also learn every basic approach to
money management there is. While there have been many books written about
trading psychology, there are very few books written on money management.
You will find that this one chapter contains more information about money
management than you're likely to find in all the books available on the topic.

2. Chapter Two deals with the loss-control principles that are critical to all
traders'success whether past, present or future. You'll learn about the two most
important tools for any trader's survival: stop-losses and trailing stops.
3. Chapter Three will take you through concepts that are unique to different
trading styles. Practically all traders have a preferred time frame they like to
focus on. We've got you covered. In this section, we'll take a look at risk-control
techniques from the perspective of daytraders, swing traders, and
intermediate-term traders.

4, Chapter Four will delve into some of the deeper specialized issues of money
management. These are the answers to some of the most commoniy asked
questions. This section will cover pyramiding, the proper use of margin, the use
of time stops, and how money management factors into buy-and-hold investors.
5. Chapter Five extends some of the maior themes of trading psychology. Trading
psychology has become one of the most popular focal points of books, seminars
and magazine articles. But so much of it is pure psychobabble. This section will
give you a real understanding of your mind and how to use to take your trading
to the next level.

One thing further: This book is a compilation of ideas from some of the best traders in
the business. You'll get the benefit of many different viewpoints for developing the basis
for formulating your own money-management strategy. So, in addition to some minor
differences in their styles of money management, you'll find many recurring themes that
are conunon to all these traders. The repetition of familiar ideas from slightly different
viewpoints serves to reinforce the importance of the classic money-management princi-
ples.

Make no mistake about it-money management is a dfficult discipline to execute consistently.


The repetitiott of these classic money-management principles is pwely intentional.
CHAPTER ONE

Money Management:
The Beal 'Holy Gnail'

While l'm assuming that readers of this bookhaae some knowledge and experience of
trading, it doesn't hurt to proaide some basic dfinitions and oueraiews of tuhat money
management is all about and why it's so important. These three articlesfrom experienced
traders take you through these basics. Eaen if you're a more adoanced trader, you should
still spend some quality time here because in this section you'll learn more than just
definitions and the bare-bones mechanics of money management. You'll gain an
understanding of the quantitatiae reasoning behind money management . That is, the cold,
hard numbers that proae beyond a shadow of a doubt that money management deseraes to
be at the aery top of your priority list, ertery time you place a trade.
WHAT EVERY TRADER SHOULD KNOW ABOUT
MONEY MANAGEMENT
By Daniel P. Delaney and Duke Heberlein

Daniel P . Delaney has been working in the financial markets for L4 years as a
financial
consultant and writer. He is currently Senior Market Analystfor TradingMarkets.com
and writes pre-market opening and recap columns as utell as the widely
followed
"Ooerheard on the Street" column.

Duke Heberlein is a former golf pro turned trading pro. He is Director of News
for
TradingMarkets.com. Asideftom oaerseeing TradersWire, the premier source of actionable
intraday news content, Duke's ongoing analysis of the markets appears throughout each
trading day on the site. Duke speaks at numerous trading conferences and is the producer
of cont ent fo r T r a din gMarke t s. com' s Eo ent s D iaision.

In this article, Delaney and Heberlein will giue you an oaeraiew af money,management
principles.

The main goal of trading or investing is obviously to make money. But most people
spend more time poring over charts or researching complicated trading systemi tlian
they do thinking about what to do if a trade goes bad.

By establishing a well-thought-out plan to minimize losses, you will have accomplished one
of the most important aspects of trading: Preserving Your Capital!
This aspect of trading or investing is known as Money Management. The main goal of
money management is to minimize your losses.

\Atrhetheryou are a long-term investor or a short-term trader, you should have some sort
of disciplined strategy that you adhere to before you enter any position. Without a plan,
you may find yourself facing big losses, or worse, find yourself panicking ovei tig
losses and making bad trading decisions. All too often, emotions cai cause tlou to stay
in a stock too long and take much bigger losses than you anticipated
EMOTIONS
\Mhen there is money on the line, and a trade moves against you, there will undoubtedly
be a variety of emotions unleashed. It has been said that fear and greed drive the stock
market, and that is definitely true. \Mhat also kicks in if you are losing money are feelings
of denial, self-doubt, or even panic. It's hard to admit to yourself that you Taere TDrong on a
trade, so what happens is you just keep watching a stockfall, and all of a sudden a small loss gets
bigger and bigger and bigger.

Many traders have said that in any losing position, the minute you start hoping for the
price to come back, you're dead. Hope adds to losses, so it makes sense to have an exit
strategy in place before you ever enter a trade.

YOUR LEVEL OF RISK TOLERANGE


Once you decide to launch your trading career, you should sit down and figure out a
leuel of risk that will suit you best.

Some daytraders refuse to lose more than 3/8of a point, while some intermediate-term
traders refuse to take losses of more than 7To on any position. The key is to never trap
yourself by having too much of your capital in any one position. This Process is known
as Diversification.

For example, if you have all of your money in one position, and it deciines by 50%, then
you are in a very difficult position. Not only have you lost half of your trading capital,
but also the remaining balance has to gain1,00% just for you to get back to breakeven.
If you never trade more ttrar. 10% of your capital in any one position, even if you did
Iose 50% on a trade, you still would only be down 5% n your total trading capital lf
you used a protective stop to limit your loss on that trade to 1.0Vo, then the hit to your
overall trading capital would be a mere 1%!

So, it makes put all of your eggs in any one basket. If you are a new trader,
sense to not
you have to be even more careful with your capital.

CAPITALIZATION
Trading is a business just like any other business. If you haven't already thought of it
as such, think again. A11 new businesses require start-up capital, and a trading business
is no exception. An undercapitalized business can face serious obstacles; an un-
der-funded trading account is no different. Many traders believe they'llbe profitable im-
mediately, and while this may be true for you, in most cases there's a learning curve,
during which losses could wipe out your new business rapidly. Sure, you've been pa-
per-trading for a while and have established a decent record, but now you're commit-
ting real funds to your trading; you'll soon see it feels much different.
Let's say you start your trading account with $3000, and your cost-per-trade is $15 (in
and out $30). Assuming you break even on every trade (unlikely), this means you'il be
in business for 100 trades. Assuming two trades per day ($60), this means your capital
will be totally depleted in 50 trading days (about two-and-a-half months), and you'll be
asking your ex-boss for your job back. Again, this is assuming you simply break even on
every trade. If you lose, or trade more frequently, you'll be out of the game even
quicker. Yes, there's always the possibility (even probability) of some winning trades
during this time, but don't count on them. The point is, to give your new business the
best possible chance of succeeding, begin with adequate capitalization.

One more thing: Don't expect to pay your living expenses out of your trading ac-
count!

PROTEGTIUE STOPS
A protective stop is an open order to exit a position at a specified price if the trade
moves against you. Think of a protective stop as insurance against large losses.

Keep in mind that once the stop is hit, your order becomes a market order, and your ac-
tual fill price may be less favorable in a fast-moving market.
By placing a protective stop immediately after you enter a position, you take your emo-
tions out of the equation, and most importantly, you have taken action to preserve your
capital, which is the main goal of money management.
Remember, small losses can grow into huge losses, even if the companies are
high-profile market darlings.

Question: So how do I know where to place the stop order once I enter a trade?
The answer depends upon your level of risk tolerance, but there are basically three
schoois of thought on protective stops.
THREE SCHOOLS OF THOUGHT
There are basically three different ways to look at protective stops and how to place
them once you have entered a trade. Remember that as a trade moves up in your favor,
you would manually raise your stop prices in order to lock in your profits should the
trade move against you. This Process is known as setting trailing stops.

Approach One
You set your stop based upon a percentage of price pulling back from your original en-
try point. Some traders might choose 3% while others might choose as much as 107o.
This would again depend on what level of risk you are comfortable with as well as
whether you are a short-term trader of a few hours or days or whether you are more
comfortable with intermediate-term setups that you hold for up to several weeks.

Say you buy a stock at $L00 and you had decided that you would not lose more than 57o
on the trade. You would immediately enter a sell stop at $95, so if your trade moved
against you, you would be sold out at the 5% Ioss.

If your trade moved higher, you would adjust your stop upward to always keep your
loss limited to SVo. So if your stock jumped to $110, you would adjust your stop upward
to 9104.50. That way, you not only lock in your profit, but you also are staying disci-
plined in your sell strategy by trailing your stop higher'

Approach Two
Approach two is similar to the percentage-based system, but instead of percentage loss,
you woutd choose a number of points. For instance, some traders are not willing to risk
more than L point to the downside as they attempt to make at least 3 points to the up-
side.

Many daytraders will set a stop as little as 1/4 or'L/2 of a point below their entry point.
WittL stops set so close to the entry points, these trades often cause the trader to be
stopped out. This is part of the "risk-and-reward" equation where you feel most com-
fortable.
There are many times with highiy volatile Nasdaq stocks that a good trade entry can
lead to large point gains. Keep in mind, however, that attempting larger point gains on
more volatile stocks involves more risk, so you can expect to be stopped out more often.
Keep in mind that choosing a specific percentage or number of points is an important
part of your trading business, and it is there to keep you from holding a stock as it rap-
idly falls 50% and wipes out your trading career.

Approach Three
With this approach, rather than just choosing the percentage or number of points you
are willing to risk, you would choose your stop based upon where the stock had the
nearest term support or resistance.

Recall that support and resistance points are those battleground areas of a chart where a
stock consolidates and trades in a flag, triangle or narrow trading range. Those areas of
congestion are what some traders would focus on in choosing their stop. For instance, if
you were "long" a stock (thinting it would go up), you would place your sell stop
slightly below the nearest support level. That way, if the trade went against you, the
stock would find a natural support level that it might bounce off ot, but if it failed, your
stop would kick in and sell you out before you experienced any more downside dam-
a8e.

Have a look at the Figure L.1, and notice how the stop is placed slightly below the re-
cent support level.
FIGURE 1.1

Dnily Chart of
Oracle IORCL]

., , J['
Entry Pcirt ls rtlttilt''
Breakorn From
TradingRanp [[r'
I[ilr
Stops Could Be
Prior I
Support
Larel
r[il
PlacedllAt
Place, At
rat Lr
Ernry Day Or *][r
Loru of
Lqn
C Leuel
1

or.t, lnsuringi
Breakor.t,
Brealr ln lu:ingA
lnsu
aren ITra
Breake,ren
Break erren rde O
Trade OrA

[[' rr[tt tr SmallLossll


Small
-he
T St
Loss lf The
Turns AEinr
Agrin* You
Stod<

t10
Jul
11 24 51118
Sep

This approach plays into what type of pattern had set up in the first place, so many
traders will look for flags or triangles and buy on the breakout and minimize risk be-
cause the support level prevents a stock from being prematurely triggered.
GONTROLLING RISK AND GAPTURING PROFITS
By Dave Landry

As director of research and one of thefounders of TradingMarkets.com, Daae Landry has


played a key role in the deaelopment of the proprietary market indicators that traders use
eaery day on the site. His daily stock andfutures outlooks are among the most popular
columns on the site. Landry's extensiae programming background giaes him an edge in
deaeloping useful tools and systemsfor traders. This in combination with his trading skills
has made him a much sought-ffier commodity trading adaisor and money manager. He is
the author of the highly regarded Dave Landry on Swing Trading.

MONEY MANAGEMENT
Money management is the process of analyzing trades for risk and potential profits, de-
termining how much risk, if any, is acceptable and managing a trade position (if taken)
to control risk and maximize profitability.
M*y traders pay lip service to money management while spending the bulk of their time
and energy trying to find the perfect (read: imaginary) trading system or entry method.
But traders ignore money management at their own peril.

The Story of Three Not-So-Wise Men


I know of one gentleman who invested about $5,000 on options on a hot stock. Each
time the stock rose and the options neared expiration, he would pyramid his position,
plowing his profits back into more options. His stake continued to grow so large that he
quit his day job.
As he approached the million-dollar mark, I asked him, "Why don't you diversify to
protect some of that capital?" He answered that he was going to keep pyramiding his
money into the same stock options until he reached three to four million dollars, at
which point he would retire and buy a sailboat.
I recently met a second gentleman at a dinner party. He told me that six months ago he
began daytrading hot stocks. It was so profitable, he said, that he quit a flourishing law
Practice to trade full time. Amazed at his success, I asked him, "How much do you risk
per trade? A half point? One point?" He replied, "Oh no, I don't like to take a loss.,'
A third gentleman was making his fortune buying the stocks that had the greatest mo-
mentum. These stocks had superb relative strength both in the short- and long-term. He,
too, was on the verge of quitting a successful business. When asked about his exit strat-
egy, he replied, "I just wait for them to go up." When asked, "\Mhat if they go down?"
his reply was, "Oh, they always come back."
What ever happened to these "traders?" Gentleman number one is now homeless, and
the other two are about to be. They are on the verge of financial devastation and the
emotional devastation that goes along with it. This is the cold, hard reality of ignoring
risk. How do we avoid following in the footsteps of these foolhardy traders?

Three thingswill prevent this from happening: 1) money management, 2) money


management, and 3) money management.

The importance of money management can best be shown through drawdown analysis.

DBAWDOWN
Drawdown is simply the amount of money you lose trading, expressed as a percentage
of your total trading equity. If all of your trades were profitable, you would never expe-
rience a drawdown. Drawdown does not measure overall performance, only the money
lost while achieving that performance. Its calculation begins only with a losing trade
and continues as long as the account hits new equity lows.

Suppose you begin with an account of $10,000 and lose $2,000. Your drawdown would
be 20%. Of the $8,000 that remains, if you subsequently make $1,000, then lose $2,000,
you now have a drawdown of 30% ($8,000 + $1,000 - $2,000 = $7,OOO, a 307o loss on the
original equity stake of $10,000). But, if you made $4,000 after the initial $2,000 loss (in-
creasing your account equity to $12,000) then lost another $3,000, your drawdown
would be 25% ($12,000 - $3,000 = $9,000, a 25% drop from the new equity high of
$12,000).

Maximum drautdown is the largest percentage drop in your account between equity
peaks. In other words, it's how much money you lose until you get back to breakeven. If
you began with $10,000 and lost $4,000 before getting back to breakeven, your maxi-
mum drawdown would be 40%. Keep in mind that no matter how much you are up in
your account at any given time-100%,200Ta, 300%-a 700Vo drawdown wiil wipe out
your trading account. This leads us to my next topic: the difficulty of recovering from
drawdown.

Dnawdown Recovery
The best illustration of the importance of money management is the percent gain neces-
sary to recover from a drawdown. Many think that if you lose 10% of your money all
you have to do is make a 10Vo gain to recoup your loss. Unfortunately, this is not true.
Suppose you start with $10,000 and lose L0% ($1,000), which leaves you with $9,000. To
get back to breakeven, you would need to make a return of 77.77% on this new account
balance, not 10Vo 00% of $9,000 is only $900-you have to make 11.11% on the $9,000 to
recoup the $1,000 lost).
Even worse is that as the drawdowns deepen, the recovery percentage begins to grow
geometrically. For example, a 50% loss requires a 100% return just to get back to
breakeven (see Table 1.1 and Figure 'I.,.2 for details).

TABLE 1.1

o/o loss of Capital o/o of Eain Bequircd to Becoup loss

100/o 11.110/o

20o/o 25.000/o

300/o 42.850/o

400/o 66.660/o

500/o 1000/o

600/o 150%
700/o 2330/o

800/o 4000/o

900/o 9000/o

1000/o broke

NoEice that as losses [drawdown] increase, the percent gain necessary to necoven Lo
bneakeven incneases aE a much fasten rate.
FIGURE 1.2

000
s
800
t
o
600
R
E 400
t
o 200
u
E
0
f 10 20 30 40 50 60 70 80 90
S of Loss

PencenE loss [drawdown) vs, percent to recoven Notice that the percent to necoven
(top line) grows at a geomeEric nate as the pencent loss incneases. This illustrates the
difficulty of necovening from a loss and why money managemenL is so important.

Professional traders and money managers are well aware of how difficult it is to recover
from drawdowns. Those who succeed long term have the utmost respect for risk. They
get on top and stay on top, not by being gunslingers and taking huge risks, but by con-
trolling risk through proper money management. Sure, we all like to read about famous
traders who parlay small sums into fortunes, but what these stories fail to mention is
that many such traders, through lack of respect for risk, are eventually wiped out.
SUMMARY
Money management involves analyzing the risk/reward of trades on an individual and
portfolio basis. Drawdown refers to how much money you've lost between hitting new
equity peaks in your account. As drawdowns increase in size, it becomes increasingly
difficult, if not impossible, to recover the equity. Traders may have phenomenal
short-term success by taking undue risk, but sooner or later these risks will catch up
with them and destroy their accounts. Professional traders with long-term track records
fully understand this and control risk through proper money management.

GENERAL GUIDELINES FOR LONG.TERM SUCCESS


The good news is that for most traders, money management can be a matter of common
sense rather than rocket science. Below are some general guidelines that should help
your long-term trading success.
l. Risk only a small percentage of total equity on each trade, preferably no more
than ZVo of your portfolio value. I know of two traders who have been actively
trading for over 15 years, both of whom have amassed small fortunes during this
time. In fact, both have paid for their dream homes with cash out of their trading
accounts. I was amazed to find out that one rarely trades over 1,000 shares of
stock and the other rarely trades more than two or three futures contracts at a
time. Both use extremely tight stops and risk less than 17o per trade.

2. Limit your total portfolio risk to 20%.In other words, if you were stopped out
on every open position in your account at the same time, you would still retain
807o ol your original trading capital.

3. Keep your reward-to-risk ratio at a minimum of 2:7, and preferably 3:L or


higher. In other words, if you are risking 1 point on each trade, you should be
making, on average, at least 2 points. An S&P futures system I recently saw did
just the opposite: It risked 3 points to make only 1. That is, for every losing trade,
it took three winners make up for it. The first drawdown (string of losses) would
wipe out all of the trader's money.
4. Be realistic about the amount of risk required to properly trade a given
market. For instance, don't kid yourself into thinking you are only risking a
small amount if you are position trading (holding overnight) in a highflying
technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust position
size accordingly. That is, take smaller positions in more volatile stocks and
futures. Also, be aware that volatility is constantly changing as markets heat up
and cool off.

5. Understand position correlation. If you are long heating oil, crude oil and
unleaded gas, in reality you do not have three positions. Because these markets
are so highly correlated (meaning their price moves are very similar), you really
have one position in energy with three times the risk of a single position. It
would essentially be the same as trading three crude, three heating oil, or three
unleaded gas contracts.

Lock in at least a portion of windfall profits. If you are fortunate enough to


catch a substantial move in a short amount of time, Iiquidate at least part of your
position. This is especially true for short-term trading, for which large gains are
few and far between.
8. The more active a trader you are, the less you should risk per trade. Obviously,
if you are making dozens of trades a day, you can't afford to risk even ZVo per
trade-one really bad day could virtually wipe you out. Longer-term traders
who may make three to four trades per year could risk more, say 3Vo-SVo per
trade. Regardless of how active you are, just limit total portfolio risk to 20Vo (ruJe
#2).

9. Make sure you are adequately capitalized. If there was one "Holy Grail" in
trading, I think it would be having enough money to trade and taking small
risks. These principles help you survive long enough to prosper. I know of many
successful traders who wiped out small accounts early in their careers. It wasn't
until they became adequately capitalized and took reasonable risks that they
survived as long-term traders.
This point can best be illustrated by analyzing mechanical systems
(computer-generated signals that are 700% objective). Suppose the system has a
historical drawdown of $10,000. You save up the bare minimum and begin
trading the system. Almost immediately, you encounter a string of losses that
wipes out your account. The system then starts working again as you watch in
frustration on the sidelines. You then save up the bare minimum and begin
trading the system again. It then goes through another drawdown and once
again wipes out your account.
Your "failure" had nothing to do with you or your system. It was solely the
result of not being adequately capitalized. In reality, you should prepare for a
"real-life" drawdown at least twice the size indicated in historical testing (and
profits to be about half the amount indicated in testing). In the example above,
you would want to have at least $20,000 in your trading account, and most likely
more. If you had started with three to five times the historical drawdown,
($30,000 to $50,000) you would have been able to weather the drawdowns and
actually make money.

L0. Never add to or "average down" a losing position. If you are wrong, admit it
and get out. TWo wrongs do not make a right.

LL. Avoid pyramiding altogether or only pyramid properly. By "properly," I mean


only adding to profitable positions and establishing the largest position first. In
other words the position should look like an actual pyramid. For example, if
your typical total position size in a stock is L000 shares, then you might initially
buy 600 shares, add 300 (if the initial position is profitable), then 100 more as the
position moves in your direction. Ln addition, if you do pyramid, make sure the
total position risk is within the guidelines outlined earlier (i.e.,2Vo on the entire
position, total portfolio risk no more that20Vo, etc.).
L2. Always have an actual stop in the matket. "Mental" stops do not work.

13. Be willing to take money off the table as a position moves in your favor;
"2-fo,r-L money management" is a good start. Essentially, once your profits
exceed your initial risk, exit half of your position and move your stop to
breakeven on the remainder of your position. This way, barring overnight Baps,
you are ensured, at worst, a breakeven trade, and you still have the potential for
gains on the remainder of the position.

14. Understand the market you are trading. This is especially true in derivative
trading (i.e., options, futures). I know a trader who was making quite a bit of
money by selling put options until someone exercised their options and "put"
the shares to him. He lost thousands of dollars a day and wasn't even aware this
was happening until he received a margin call from his broker.

15. Strive to keep maximum drawdowns between 207o and 25Vo. Once drawdowns
exceed this amount it becomes increasingly difficult, if not impossible, to
completely recover. The importance of keeping drawdowns within reason was
illustrated earlier (see p. L4).
16. Bewilling to stop trading and re-evaluate the markets and your methodology
when you encounter a string of losses. The markets will always be there. Gann
said it best in his book, Hout to Make Profits in Commodities, published over 50
years ago: "When you make one to three trades that show losses, whether they
be large or small, something is wrong with you and not the market. Your trend
may have changed. My rule is to get out and wait. Study the reason for your
Iosses. Remember, you will never lose any money by being out of the market."

17. Consider the psychological impact of losing money. Unlike most of the other
techniques discussed here, this one can't be quantified. Obviously, no one likes to
lose money. However, each individual reacts differently. You must honestly ask
yourself, "What would happen if I lose X%? Would it have a material effect on
my lifestyle, my family or my mental well being?" You should be willing to
accept the consequences of being stopped out on any or all of your trades.
Emotionally, you should be completely comfortable with the risks you are taking.

The main point is that money management doesn't have to be rocket science. It aII boils
down to understanding the risk of the investment, risking only a small percentage on
any one trade (or trading approach) and keeping total exposure within reason. While
the list above is not exhaustive, I believe it will help keep you out of the majority of
trouble spots. Those who survive to become successful traders not only study methodol-
ogies for trading, but they also study the risks associated with them. I"strongly urge you
to do the same.
THREE RULES THAT WILL HELP YOU BECOME
A MASTER TBADER
By Mark Boucher

Ifirstmet hedgefund ffianager MarkBoucher during the summer of L999 when I helped
him put together his l}-Week Short-Term Trading Course. At that time, I had had about
20 years of trading experience under my belt and I thought I knew something. ,4fier
working with Markfor a while,lfound out that I knew absolutely nothing-next to Mark
Boucher. Mark has a unique approach to tying together fundamental and technical
analysis. Mark'sformidable understanding of the markets has enabled him to earn
consistent returns with minimal drawdowns for his hedge fund clients. lt' s no small
wonder that Mark's fund was recently ranked number one in the world by Nelson's
World's Best Money Managersfor itsfiae-year compounded rate of return.

But you want to know something interesting? Through all the accoladesfor his
performance as a trader, there is one aspect of his trading strategy that comes ahead of all
the analysis he does: the disciplined use of money management principles.

A key component to successful trading is proper money management.


Traders, in general, spend far too much time and effort trying to find magical systems or
methodologies that produce high returns, rather than increasing their understanding of
the markets and using astute money management to apply what they learn.
I agree with Stanley Kroll who once said:

"It is better to have a mediocre system and good money management than an
excellent system and poor money management."

I'm going to teach you what I've learned about the discipline of money management in
the past 17 years of trading and fund management. You'll not only review some familiar
rulei, but also learn about some powerful principles that go way beyond just cutting
your losses short and letting your profits run. Even though these principles can make
you a lot of money, I doubt that you'll hear very many fund managers or system ven-
dors talking about them in their ads because they know that the public is drawn toward
glitzy performance numbers-not risk control.
But, if you want know the real truth about what it takes to be a successful trader, be as-
sured that I won't pull any punches.

Now let's get started. The first three rules are what I consider to be the most impor-
tant. Without them, everything falls apart. I consider them to be the very foundation
of my success as a trader.

RULE 1: MINIMIZE LOSSES!


As simple as it sounds, failure to keep losses small is the #L reason why most traders
blow out early in the game. That almost happened to me, in fact.
When I first started trading, I bought call options on gold stocks right before the big ex-
plosion in gold prices lr.1979.In less than a year I made 500% on my money. I thought I
knew everything. But then my real education started.
In L981, I got caught short orange juice during a series of limit-up moves that lasted
more than a week. By the time I exited, I had lost nearly half of my account. It was at
this point that I realized the importance of limiting my losses.

Very few traders understand the mathematics of losses and risk. But I believe that just
understanding the following concept can turn a losing trader into a winning one be-
cause it can help you to focus on doing the right things and turn you away from the
wrong things.
Here is the concept that I strongly suggest you chew on for a while:

. When you lose money in trading, you wind up having less capital to work with.
Therefore, to make back what you lost, you have to earn a substantially higher per-
centage return than what you lost.

Example: If you make a series of bad trades and your account drops 70% in value, you
will not get back to your break-even point until you have made over 230Vo on your re-
maining money!
That doesn't sound fair does it? You'd think that if your account dropped 70Vo, you'dbe
at the break-even point again when you've made 70Vo. Sorry, but this is not reality. A
trader who loses 20Vo or more must show a return of 30Vo to make up for the loss. It can
take a year or more for even the best traders I know to produce such a return.
This is one of principles that keeps many losing traders from digging themselves out of
the hole they've dug for themselves. Thuy lose a big chunk of money and, even if their
skill improves, they are not able to recover unless they add more money to their trading
account-usually from their hard-earned paychecks or credit cards.
As I studied the qualities of successful traders, the concept of weighing risk and reward
hit home. Trading performance meant more to me than just shooting for big gains; it
meant looking closely at the risks I was willing to take to make those gains.

Indeed, as I studied the qualities that the most successful traders have in common, I no-
ticed that most strive to keep their drawdowns to around 20Vo to 307o or less.
When you trade, you always have to be conscious of the dangers of suffering big losses.
You not only lose the money, but you also have the potential to be knocked out of the
game permanently. Realizing this will produce a fear in you that I assure you will be
quite healthy. That fear will help you to remember to keep your position sizes small and
to apply trailing stops religiously.

Winning traders minimize losses.

BULE 2: GONSISTENCY lS THE KEY


For most individual traders and investors, the single most important criterion for judg-
ing the performance of a trading methodology is total return. Consequently, when you
look at ads selling trading systems and methodologies, you see a lot of wild claims of
80Vo,700Vo, or even 3007o average annual rate of return.

It's ironic that in talking to the vast majority of traders who've made their millions
through trading, total return is the very last number they look at when judging the via-
bility of a trading strategy. \Alhat matters more to this elite class of trader is risk, maxi-
mum drawdown, the duration of drawdowns, volatility, and a wide assortment of other
risk-oriented benchmarks. Only when all their risk criteria is met do they consider total
refurn.
The typical trader might wonder if these traders are just overly cautious and conserva-
tive. But that is simply not the case. As a whole, they are just as fanatical about the accu-
mulation of wealth and financial freedom as anyone else who trades.
What has caused these traders to shift their focus to this winning strategy is that they've
worked through the numbers. Doing so, they find:
. Total return is only a valid measure of performance when risk is taken into consid-
eration.

I credit my success as a money manager to my voracious study and practice of this con-
cept. Let me show you a simple example that you may find surprising. Even though I use
investment funds i. *y example, this concept I'm illustrating is directly applicable to all
traders no matter how short-term their orientation is:

1. Over the past 30 years, investment Fund A has returned l2Vo annaally on
average, has a strategy that is not dependent on any particular market doing
well, and has had a 5To worst-case historical drawdown.
2. Over the past 30 years, investment Fund B has returned lTTo annually on
average, has had performance highly correlated with U.S. stock indexes, and has
had a lSVo worst-case histotical drawdown (both investments are vastly superior
totheS&P).
Which fund would you invest in?
Most traders and investors wouid be most attracted to Fund B, which showed greater
total returns over the 30-year period. In justifying this they'd say: "I have no problem
accepting a worst-case 15Vo hit because I'll come out ahead in the end. The extra protec-
tion in the Fund A doesn't help me that much.
Now-check this out. Most professional traders who understand the math would select
Fund A. With the lower maximum drawdown, they would simply concentrate more fire
power in Fund A by buying it on margin (putting 50% down). Doing this they would
earn a 19Vo artual refurn after margin costs and sustain only a 10% expected drawdown
risk, compared with a 17% return on Fund B with a 15% expected risk.
But there's even more to it.

THE SMOKE AND MIBNORS BEHIND AUERAGE


ANNUAL RETURNS
Whenever any trader, trading-system vendor, or money manager brags about their per-
formance in terms of Annual Average Return, they are-whether or not they know
it-engaging in smoke and mirrors.
What is concealed in this statistic is the harm that is wreaked upon capital growth by
drawdowns and losing streaks. In Rule #L, "Minimize Losses," we talked about how the
difficulty of making up for a large trading loss is seemingly disproportionate to the
magnitude of the error that caused the loss in the first place. That factors greatly into
how much money you wind up making.
The real truth behind how much money you make is to be found in "Compounded An-
nual Return." That is, calculate your annual refurn by adding every gain and subtract-
ing every loss that occurs during the course of a year.
Let's consider the Table 1.2:

TABLE 1.2

Uolatile Betums 0ependable Gains


Year lnnualBetums [o/ol Principal AnnualBetunr (o/ol Principal

1 21 1,210,000 18 1 ,180,000
2 35 1,633,500 18 1,392,400
3 20 1,960,200 18 1,643,030
4 -26 1,450,500 18 1,938,790
5 32 1,914,720 18 2,287,760
6 12 1,347 ,450 18 2,699,560
7 42 3,045,170 18 3,185,480
I -16 2,557,950 18 3,750,887
g 31 3,350,910 18 4,435,460
10 56 5,233,000 18 5,233,850

Average Annual Return = 20.7olo Average Annual Return = 18olo


Compound Annual Return = 17.98% Compound Annual Rate = 18%

As you can see, the fund that makes a steady 1,8% per year actually makes you more
money than the one that posts spectacular gains eight out of ten years. The damage
caused by the two losing years is quite evident.

Again, this example is applicable whether you are a daytrader or a long-term investor.
The vast majority of trading strategies that boast spectacular gains, also take great risks.
This means greater drawdowns and more volatile performance. To be successful as a
trader, you must ignore the flashy statistics and work through the numbers. Evaluate
your strate gy by calculating on paper where your total trading equity would hypotheti-
cally be for every trade over a period of several years'
You will find that it is far, far better to use strategies that earn steady and consistent re-
turns year after year after year. You will inevitably find that the annual returns of these
strate[ies are fai less spectacular than those that are widely advertised', but the math
makeJ it clear that you are far more likely to be laughing your way to the bank this way.

Oh yes, you'll sleep better at night now. For successful traders, consistency is the key.

EULE 3: UNDERSTANDING THE MARKETS lS MUCH MORE


IMPORTANT THAN METHODOLOGY
Many traders are fixated on finding the "Holy Grail"-that is, a mechanical trading sys-
tem or methodology that generates large and consistent profits with no discretionary
iudgment on the part of the trader'
Most traders who read this will deny they are looking for the Holy Grail, stating that
they'd be happy with a mechanical system offering only a 60% win-to-loss ratio as op-
posed to the bOn to 90% that is claimed in many ads-as long as the system makes
them a millionaire within ayefi to two.

I would, without hesitation, say that anybody in search of an enduringly profitable trad-
ing system that makes all your trading decisions for you is in search of the HoIy Grail.
In other words, such a money-making machine simply does not exist.
But wait, you may say-'aren't all the highly successful traders in the world using some
kind of unique methodology or system? Why can't I simply use the same exact ap-
proach they are and become just as successful?"

The answer is this: The markets are always changing. All trading strategies go through
seasons of winning and losing. The key to long-term success is to understand the mar-
kets well enough so that you know how to adjust or switch strategies or even develop
new ones in reiponse to changing market conditions. Focus on systems and you may
make money for a while, but eventually you'll give it all back (and more). Focus on true
understanding and you will be well on the way to consistent trading success.
WHAT "UNDEBSTANDING" IS
You may wonder what I mean by "understanding." "Understanding" is the pot of gold
that comes through your skills as a trader and on your ability to consistently find ways
to limit your risks while participating in opportunities that have much more reward
than the risk you are taking. It is the ability to see a strategy as nothing more than a tool
and see when it's applicable and when it's not.
In short, the pot of gold does not lie in some system outside of yourself; it lies in the
set of skills and degree of understanding and insight that you build within.

A TRUE STOBY TO ILLUSTPATE MY POINT


The Master Tlader strives for understanding. The Novice Tiader searches in vain for
magical systems.

In closing this section, Iet me share a true story with you that will graphically illustrate
my point:
In the mid-80s, I met fwo traders who had attended a seminar by a very well-known
and reputable trader. These two traders did not know each other, but coincidentally,
they both learned and applied the same system.

The first trader was the Novice Trader.

He began to trade the system in 1985 and was shocked at how much money he made.
He was anxious to commit more capital to it, but wanted my opinion first. I back-tested
the system and found that it had an identical performance to what was claimed in the
seminar. However, I explained to this trader that I had three serious reservations. First,
there was no stop-loss protection. Secondly, even though the system showed phenome-
nal gains in its four years of testing, that was not a sufficient time frame in which to
evaluate the system properly. Third, the system was tested during a bull market. I didn't
think it would perform well during a bear market.
To address these concerns, I suggested that the trader employ stop-losses and trend fil-
ters. This would have cut the total hypothetical profits during the four-year testing pe-
riod and hence, likely reduce future profits. The trader, however, did not heed my
advice and left my office intending to continue trading the system, "as is."

This trader's confidence in the system continued to build over the next several months
as he made a fortune by racking up steady and consistent profits month after month. On
October 77, 7987, the day of the great market uash, this ttader was completely zoiped.
out,

A few months later after the crash, I was talking to another trader. This trader was one
I'd call a Master Tiader.
I found out that he had attended the same seminar spoken about above and that he had
been exploiting the same strategy as the Novice Trader, but in contrast, he'd been suc-
cessful using it, despite the 1987 crash.

I noticed that this trader had not taken the system's signals on October 27, nor during
the entire October-November 1987 peiod. He explained to me anyone with a true un-
derstanding of the markets would not be applying the system during that period. He
thought the system was good at identifying opportunities, but he'd only exploit them if
he could limit risk with a stop-loss and in upward-trending market. That was not the
case during that period.

The Novice Trader focused on the "system" and not "understanding the markets." In
so doing, he assumed that system was infallible and he was not able to anticipate the
market environment that would usher in the system's inevitable season of loss. The Noa-
ice Trader wanted to find a fishing hole where the fish were always biting.

The Master Tiader was simply looking for ideas that help him increase his under-
standing. He didn't consider what he learned at the seminar to be a "system," b17t
rather, it was knowledge that he could use to find more low-risk, high-reward opportu-
nities. There was no way he would use it without fully understanding it so that he'd
know the conditions under which it applied best and when it might not apply. The Mas-
ter Trader was looking for another way to find a fishing hole where the fish might be
biting for a while.
Winning traders seek to understand the markets and not to find magical systems.
GHAPTEB TWO

Stop-Losses Stop Losses

One of the most important tools for any trader to become proficient in using is the
stop-loss order. Yet,for many, this is afrustrating and widely misunderstood strategy that
many traders would just as soon ignore. When traders congregate at trading conferences,
they're there to learn the latest hot system or strategy and not how they're going to keep
the profits they malce. lt's no wonder thnt such a small percentage of traders are able to
stay in the game and thriue month afier month and year after year. Would you like to be
one of them? Become an expert on the use of stop-losses because they do indeed stop losses!
INITIAL STOP PLACEMENT
By Dave Landry

One af the most challenging aspects of stop-losses and trailing stops is how you determine
the price leael at which they'rc placed. Part of the reason is that the trading masses aren't
well informed about the zuide range of stop-placement strategies that are aaailable. Daae
Landry nowfills the gaps.

Most traders love to search for and discover chart patterns. Finding the next volatility
setup, breakout or a pullback variation that's going to give you a nice explosive run is a
fun and potentially rewarding challenge.
But finding such entry points is only one piece of the puzzle. Position management is as
important, if not more so, than entry techniques. I will now show you some methods for
placing initial protectiae sfops (IPS).
Most neophyte traders I have met have no method whatsoever for determine where
they place their stop. They just place their stops at an arbitrary price level. This is the
chief source of the almost universal frustration that traders have when they watch a
stock blast off to new highs after their stop gets triggered.

\iVhile I can't guarantee that I have the key to making this frustration a thing of the past,
I believe that for every style of trading, there's a systematic stop placement approach
that will maximize your profits while limiting your losses.
There are various ways to determine where to place your IPS. You could use a technical
pattern, risk a fixed dollar amount or set the initial stop based on the volatility of the
market. Below we will look at the pros and cons of these methods.

Editor's Note: Thefollowing discussion gets into some important, but deeper mathematical con-
cepts. If you find yourself getting a little glassy-eyed but want to understand aolatility, refer to
the Appendix on page L27.
UOLATILITY BASED STOPS
Volatility based stop methods measure the current volatility of the market and place the
IPS outside of the price range determined by that volatility. While the math jargon may
be a little unfamiliar, the principle is straightforward corunon sense.

The theory is simply that you will avoid getting stopped out by the normal "noise" of
the market, which is reflected by the volatility measurement. It's sort of like the way a
boxer might spend an entire round stepping in close enough to taunt and tire out his
opponent, but far enough away that he won't get hit.

For example, if a particular market typically fluctuated 3 points per day, you would be
foolish to place a protective stop (for a position trade) only 1 point away, because the
chances are high the normal fluctuations of the market would quickly trigger your stop.

There are various ways of predicting where the stops should be placed based on the vol-
atility. Below we will look at using historical aolatility (HV) and aaerage true range (ATR).

AUEBAGE TRUE RANGE TATRI STOPS


The average true range of a market is just that: an average of the price range (including
ovemight gaps) of a market. Once you find the ATR of a market, you then take some
multiple of it and add it to the closing price to determine where your stop should be
placed. Shorter-term traders can use a small period (say, several days) for the average
and a low multiple (say 1 to 1.5) of the AIR. Longer-term-trend followers may use sev-
eral weeks for the ATR and a multiple of 2 or more.

Figure 2.1 shows a two-period ATR and uses a multiple of 1..5 times the ATR. Notice
that as the average true range increases, the suggested stop placement bands can get
quite large (a). Also notice that these bands self-adjust to the market: They begin to nar-
row as the volatilitl (in this case, the average true range) begins to drop off. As you can
see, even with a low-multiple and short-period average true range, the bands can get
quite large during volatile markets.
FIGURE 2.1

F50

40
t ti
30

Ereated with SuperCharts by 0meqa Flesearch e l ggE

Possible initial stop placement bands are created by using a multiple of the average
true nange, ln Ehis case, we Eook a two-period ATFI and multiplied iE by 1.5. We rhen
added it Eo Ehe closing price [fon potential IPS fon shorts] and subEnacted it from Ehe
close (fon potenEial IPS fon longs). Notice that Ehey expand (al as the volaEility of the
markeE increases and contnacE tbl as the volatility of the mankeE decneases.
Source: Amega Research

HISTORIGAL VOLATILITY IHVI BASED STOPS


With HV based stops, historical volatility is used to predict where the market has the
potential to trade over the holding period (the forecasted length of the trade). That is,
the longer-term HV (where the market has traded over a longer period) is reduced
down to the holding period. The longer the desired holding period, the more likely the
market will trade at its normal volatility. Therefore, where the market is likely to trade
over the next five trading days based on volatility will be much less than where the
market will likely trade over the next six months.
hr Figure 2.2, we have reduced the HV of the market down to a potential holding period
of three days. To show the volatility of the market increasing and decreasing, we have
plotted a short-term (six-day) HV reading. Like Figure 2.L, notice that as the volatility
increases, the bands also increase (a) and vice versa (b).

FIGURE 2.2

meqa Flesearch @ 199E

HV-based sEops adjust Ehe volatility of Ehe markeE to the peniod you intend Eo hold the
posiEion. When markets become more volatile, the bands expand [aJ and convensely, as
volatility drops off, Ehe bands contract (b).
Source: Omega Research

The advantage of volatility based stops is that they take into account the noise of a mar-
ket and determine stop placement outside of that noise, thereby reducing the chances of
being stopped out. The disadvantage is that such stops can often be quite wide (far from
your entry point), especially in volatile markets.
In addition, there is no guarantee the market will maintain its current voiatility. There-
fore, there is always the chance that even loose stops will be hit. Whether you use vola-
tility based stops or not, you cannot ignore the fact that the market has the potential to
trade within these ranges.

DOLLAR.BASED STOPS
With dollar-based stops, you determine how much you want to risk in a market and
place your stop accordingly. The advantage is that you only risk what you are comfort-
able with. The disadvantage is that the market doesn't care what risk you are comfort-
able with-it will trade wherever the volatility of that market dictates.

For example, in 1999, at mid-October volatility, the S&P futures could easily have swung
10 or even 20 or more points on any given day. This equates to a $2,500 to $5,000 move
(or more) per contract (1 point = $250). Overnight moves could be even more exagger-
ated. Theref.ore, if you were position trading and trying to risk only a few hundred dol-
lars per contract, you would more than likely be stopped out (and with slippage, lose
even more than you intended with potential overnight gaps).

This can be exemplified in a mechanical system (computer-based, 1,OO% objective):


Adding dollar-based stops that are too tight will decrease performance, and drawdown
(losses) will actually increase as trades that eventually become winners are removed due
to being stopped out.

Daytraders who take numerous trades and whose profits are limited to how much a mar-
ket can move in one day are forced to keep losses to a bare minimum on (numerous) indi-
vidual trades. Therefore, they may have to risk a fixed amount (dollar stop) when trading.
On the other hand, longer-term kaders who take fewer trades with the hopes of much
larger profits per trade would probably be better off determining the volatility of the mar-
ket and placing stops accordingly, to avoid being stopped out by the noise of the market.

PATTEPN-BASED STOPS
With pattern-based stops, you use technical analysis of the market to help determine a
logical place for the IPS. Below recent support, resistance, or the bottoms of pullbacks
are logical places for an IPS.

For instance, if you are trading breakouts, the theory is that the market should keep go-
ing after making a new high or low. It should not reverse: If it does, it's no longer a
FIGUBE 2.3

Aug
freated with bv 0meqa Hesearch o 19gE

PatEern-based stops. After a consolidation, AAPL breaks ouE. Placing a stop nighE be-
low the breakouE day ta) is a good place for the IPS'
Source: Omega Besearch

breakout. Referring to Figure 2.3 of Apple Computer (AAPL), notice that after a consoli-
dation, the stock breaks out. Logically, the stock should keep going; therefore, placing a
stop right beiow the breakout day (a) is a good place for the IPS'

Pattern-based stops have the advantage of additional technical forces: Buyers may come
in at support levels, sellers at resistance levels, and so on. The disadvantage is that be-
cause they inherently adjust to the volatility of the market (i.e., the bottom of a
wide-range breakout), losses triggered off pattern-based stops can become quite large.
DETEBMINING THE BEST IPS METHOD TO USE
Volatility based stops have the advantage of reducing the chances of getting stopped out
with the added cost of risk. Dollar-based stops have the disadvantage of frequently
stopping you out of a position but at a lower risk per trade. Pattern-based stocks incor-
porate technical analysis to help determine where IPS should logically be placed. Be-
cause to some extent pattern-based stops incorporate market volatility, they can often be
large, like standard volatility based stops.

So which should you use? It depends on your trading style. If you are a daytrader, you
may often be forced into using dollar-based stops to keep losses to a minimum. The idea
here is to withstand numerous small losses as you take "stabs" at a market while wait-
ing for the occasional large winner. Longer-term traders whose profits come from catch-
ing one to several moves a year may consider volatility based stops to help reduce the
risk of being stopped out by noise alone on the next potential big winner.
One last point, in trading there are no "exacts." Therefore, you can use a combination of
methods. For instance, if you aren't comfortable with the amount of risk associated with
technical/pattern-based methodsr /or1 can reduce your position size to decrease the
amount of money at risk. As a trader who uses pattern-based stops, you can also choose
to trade patterns in which your stop would not be very far below your entry point. A
breakout from a narrow consolidation might be one such pattern. Also, if you are a
daytrader who's forced to limit risk, you might still be able to apply the volatility or pat-
tern-based methods, but on a smaller intraday scale.

\Atrhenyou're choosing a method for setting IPS, you have to take your trading style into
consideration. Shorter-term traders are often forced into using tighter stops and will
likely get stopped out more often, whereas longer-term traders will likely want to use
methods that will help them avoid being stopped out by noise alone.

POSITION.MANAGEMENT TECHNIOUES
Let's look more closely at position-management techniques-what to do after you've
entered a position and set your initial protective stop. The techniques that come into
play here-deciding how to use trailing stops and take profits-are critical to controlling
risk.
As I mentioned earlier, getting in a trade is the easy part. Exiting positions, on the other
hand, is probably the biggest dilemma for any trader. Exit too soon, and you may miss
out on a substantial move. Stay in too long, and you can give back some or all of your
open profits. The methods we'll outline in the following sections are designed to help
you to manage your trades most effectively, in terms of both risk and reward.

Trailing Stops
A trailing stop follows your position as it progresses, rising with the market (when you
are long) and falling with the market (when you are short). For example, if you bought a
stock at 50 and used a two-point trailing stop, you would move your stop order pro-
gressively higher, say, from 48, to 49 to 50, and so on, as time passed and the market ral-
lied from 50, to 5'L to 52, respectively.
A basic principle is to tighten your trailing stop as the position becomes profitable, lock-
ing in a larger percentage of your gains as time passes. There are several methods of do-
ing this; the ones we will look at are based on recent highs and lows, chart patterns and
volatility.

Volatility Based
To use volatility based trailing stops, you simply take the volatility formula used to set
the IPS discussed earlier in this article and update it daily (or whatever time frame you
are trading on). Keep in mind that you should only tighten the stop as time Passes.

For example, referring to Figure 2.4, suppose you were lucky enough to go shortat a mi-
nor top in the bond market (a). Also suppose you decided to :use 1.-'1./2 times the
two-period ATR as your initial protective stop level (IPS on chart). To trail your stop,
you iimpty update the ATR figure every day. As time passes, the ATR line varies both
with and against the direction of the trend. However, we only tighten or "trarl" the stop
(TS). In other words, we ne'oer loosen the stop even though the volatility based method
may dictate that the market has the potential to trade there'
Although we have used the ATR in this example, another volatility calculation (i.e., his-
torical volatility) could be used just as easily.
FIGURE 2.4

117

115

113
TS

111

Dec. 99 T-bonds (USZ9), daily. ATR-based Er.ailing sEop.


Source: Omega Besearch.
Becent Highs and Lows
Recent highs and lows provide a simple but quite often effective method for trailing
stops. In Figure 2.5, we used a three-day high as our trailing stop (placing the stop
above the highest high of the most recent three days). The logic in this case is that if a
market is truly trending, it should not give back more than a few days' gains.

FIGURE 2.5

irrtlttttv d5 30 Yr 12tre-tr+ilu t0l2


118

rl
:=-
,:!,

l4_=-
:"" ,'1., 115
l,
r1
tl

: itt
I I' il-rFI-l= 114

1".. 'i,. 11ts

,,,
:: "': "' :" "- 112
a

tl
:.:
...-,..,'i I 111

20 zr g4

Dec. 99 T-bonds tUSZgl, daily. Three-bar high tnailing stop.


Source: Omega Research.
Pattern-Based
To place a pattern-based trailing stop, you look for a logical technical level to place your
stops. For instance, support (for long positions) or resistance (for short positions) are
good choices for trailing stops. The theory is that the market should not trade back
through these levels. If it does, it is possible the market dynamics have changed. Re-
ferring to Figure 2.6, notice that each time a new resistance level is established, you trail
your stop (TS) to just above that level.

FIGURE 2.6

f!:talury Egpds 30 If liJss;palty 116


IF5

115

- " Besistanee 114

+tl { -^:,^.
113
T5
112

111

Dec. 99 T-bonds tUSZ9l, daily. PaEEern-based tnailing stop.


Source: Omega Research.
TIME STOPS
Many traders view being in a nonproductive trade an opportunity cost. Even though
there may not be any losses, capital and mental energy (worrying about the position) are
being tied up, In addition, the longer that you are in a trade, the higher the probability
that something will go wrong with it. Because of these reasons, many traders simply exit
a market (regardless of price action) after a certain amount of time has elapsed. System
traders and short-term traders commonly use this method. Logically, the approach
makes sense because the original reason for entering the trade (say, momentum or a par-
ticular chart pattem) may no longer be valid.

Taking Profits
As we've mentioned, taking profits is always a dilemma. Ironically, the old Wall Street
adage, "You'll never go broke taking a profit" is exactly how many people do go broke
trading.

For example, suppose you risk on average $300 per trade but take profits when you are
$100 ahead. Simple math tells us that you must be right three times as often as you are
wrong. This is quite a hurdle to have to jump, considering that many professionals are
only right about half of the time. You actually can go broke taking a profit-if the profits
are too small relative to the risk you are taking.

So what's a trader to do? Whatever your trading methodology, you should aim to make,
on average, at least twice as much on your winning trades as on your losing trades. This
brings us to the next Wall Street adage: "Let your profits ride." To an extent, this bit of
wisdom is true. Howeve{, by letting profits ride, you run the risk of watching them
quickty evaporate if the market moves against you. Therefore, in addition to trailing
stops, you can achieve the best of both worlds by scaling out of positions as they move
in your favor. This way you are at least locking in small profits, and you still have a
chance for much larger profits on the remaining shares or contracts in your position

Here are two simple methods, in addition to trailing stops, you can add to your trading
repertoire that will improve your chances of success: 2-for-7 money management and
taking profits on parabolic moves.
2-for-1 Money Management
With 2-for-1 money management, you simply sell half your position when you've made
at least twice your initial risk; you then move the stop on your remaining position to the
breakeven level. For example, suppose you buy 200 shares of a stock at $50 with an ini-
tial protective stop (IPS) at $48, for a risk of $2 per share. If the stock subsequently
climbed to $52, you would sell 100 shares at a profit of $2 per share (the same as your
initial risk) and move your stop to breakeven ($50) on the remaining 100 shares. This
way, barring overnight gaps, the worst you can do on the remaining shares is break
even-and hopefully, the trend will continue and you will capture a much larger profit
on your remaining shares through trailing stops.

Taking Profits On Parabolic Moves


A parabolic move is a strong move (up or down) in a market that takes the shape of a
parabola (Figure 2.7). Euphoric, frenzied buying typically causes such moves. The buy-

FIGURE 2.7 Panabola

Panabola
ing builds into a panic and the price movement accelerates. In commodities, this kind of
activity can be triggered by a crop freeze, a war that could disrupt free trade (e.g., the
Gulf War), and so on.
In stocks these moves can result from buy-out rumors, enthusiasm over a company's
prospects (a new drug, a great product), and so on. Take December '99 coffee, for exam-
ple. As you can see, the futures took off, gaining over 40Vo in a few days (see Figure 2.8).

FIGUBE 2.8

120

115

110

105

100

90

1B

December '99 coffee, daily, Coffee makes a panabolic move, running up 400/o in a few
days. lt's advisable to take at leasE parEial pnofiEs on such Erades, since they fne-
quently give back much of thein gains very quickly, as was the case in this example.
Source: TradeStation by Omega Besearch,
If you are lucky enough to catch a parabolic move, you should lock in at least part of
your profits and tighten your stops on the remaining position because these moves are
often ihort-Iived. Reality eventually sets in. At these junctures, you have to ask yourself,
"Who's left to buy?" In Figure 2.8, notice that nearly all of the gains were wiped out
over the next few days.

PUTTING THE PIECES TOGETHEB


In trading, there are no "exacts" or precise methods. You can use any method or combi-
nation of methods for trailing stops as long as they tighten (decreasing your risk) as the
market moves in your direction.

Figure 2.9 is an example of using a pattern-based initial protective stop, a two-bar trail-
ing stop, 2-for-'!, money management, and a parabolic move. Let's walk through it.
On 6/28/99, Microsoft (MSFT) formed a cup-and-handle pattern. We go long above that
high at 87 (a) as it begins to rally out of its handle. We place our initial protective stop
(pittern-based) below the lowest low of the handle b) at 83 7/8 for a risk of 3 7/8
points. The stock continues to rally, and at point (c) we sell half the position, capturing
our initial risk (3 1/8 points), and then move the stop on the remainder of the position
to breakeven (d).

We then trail the stop on the remaining shares just beneath the two-bar low (e). At point
(f), the stock makes a parabolic move-its biggest one-day gain in months. This is a
good time to take more shares off the table to lock in an extraordinary gain. Finally, at
point (g) we are stopped out of any remaining shares as the stock trades below its prior
two-bar low.
FIGURE 2.9

MSFT-Daily gIlzgFB C=9! .03! '3.fit8 :0=94.343_. i


|.i';l'|)!ll[g$:],.--l[l
: :
, :
::::::::.: : : : i : Ll .t
:i.i ,j,i ldl{|i-
--[SJ
txppe..d

'F ;;il; iffiu'r"rjJul


.ll " ' . : i i tfr'.\rl' :ilelTo*itstop
B2

7B
it \L : ': lll rr'l i : : :. :

'May
1Apr

Microsoft, daily. Combining several stop and pnofit-taking techniques


Source: Omega Besearch.

this is admittedly a well-chosen example, it illustrates the possibilities of captur-


\Atrhile
ing profits and controiling risk through use of initial protective stops, money manage-
ment, trailing stops and by taking profits on parabolic moves.
TRAILING STOP TEGHNIOUES
By Mark Boucher

At TradingMarkets.com, we get a lot of questions about trailing stops and how to use
them. So this is one topic that certainly deseraes further explanation. There is probably no
person better suitedfor this task than hedgefund manager Mark Boucher. Mark proaides a
good follow-up to Daae Landry's piece because you'll see that Mark has his own unique
way of "putting the pieces together," as Daae des*ibed it in the preaious article. Mark's
approach is to use chart patterns in conjunction with changes in a stock's fundamentals to
dictate where he places his stops.

Most investors and traders spend far too much time focusing on how to enter a stock,
and far too little time focusing on how to best exit a profitable position. What is particu-
larly interesting regarding this neglect is that most traders make the vast majority of
their profits in a year from just one to five trades that move substantially in their favor.
Thus most traders would actually do better to focus in on how to better exit heavily
profitable trades than they would to further refine their entry techniques. In this article I
will go over some of our best "trailing stop" techniques to help traders learn how to exit
profitable trades much more profitably. We use a number of trailing-stop techniques, but
the simple rules of thumb we present here should greatly enhance the trading of most
investors.

We wait for a breakout of a three- to four-week or longer consolidation.

We place stops below the low of that consolidation after we've just entered the stock
(as long as it is not becoming overpriced on a price/earnings basis).

This requires patience as we watch the stock move higher after we've entered it (first
50 or so bars after a trade on any time frame).

However, when a stock starts to get a PE ratio that is both higher than its historical
high PE and above its forward one-to-three year growthrate projectedbyWall Street
analysts, then it is potentiallybecoming overvalued, and investors should tighten up
trailing stops much more aggressively.
. Once a stock becomes overvalued, it is generally in a blow-off stage. A blow-off can
lastfromweeks tomonths, and occasionallyyears-so the trickis to stickwith a stock
for as long as it is likelyto continue runningup,nomatterhowhigh theprice and PE.

When a stock rises to a PE ratio that is both higher than its historical high PE and above
its projected (by consensus analysts) growth rate for the next one to three years, we use
a different technique than the one we used before the stock became overvalued.

When a stock becomes overvalued:

We watch for any decline in the close for two days in a row.

Once we have a two-day-in-a-row decline in the close, we consider that stock to be in


a "reaction."

. Once a stock is in a reaction, we wait for it to recover to new highs.

. On any new high following a reaction, we will then move our trailing stop to the low
of that reaction-and we'll keep moving it up in this manner on every reaction and
subsequent new high.

In this way we are still waiting for a fairly significant support point to be broken on the
downside before exiting a stock, but we are moving our stops up much more aggres-
sively than is the case prior to the stock becoming overvalued.
BEAL.WOBLD EXAMPLES

FIGUNE 2.1O

Daily chart of Adobe )oRRed


out

rultlu,,,
/- -- Tighterstops;
Each time stock
makes new high
after. two-day
decline move stop
to low of the decline

Potentially overvduled
(possible blow-ofl)

Jan
Created with Qcharts

Let's take a brief look at how this works in the real world using actual trades we made
from 1999. The stocks in these examples also appeared in my daily indicator lists on
TradingMarkets.com during that time.
Adobe (ADBE) broke out to new S2-week highs in March 1999, and then developed a
nice tight trading range from late-March to mid-April, creating just the type of flag pat-
tern we like to watch for an entry signal. It was exhibiting strong relative strength,
strong EPS rank, strong quarterly earnings growth, had very strong earnings growth es-
timates for the next year, was the leader in its field, and was being re-accumulated by
funds-meaning that it met most of our criteria for a runaway stock with fuel to go
much higher.
\tVhen the four-week consolidation was broken to the upside in April (near the 30level):
. We started buying ADBE for clients

. It started appearing on our TradingMarkets.com list of new highs


The first trading range of three to four weeks following our entry occurred in May when
ADBE declined from 40.53 to 331./2, a fairly large dip. In June, ADBE broke out of this
consolidation to new highs, and we instigated our first trailing-stop rule, using a trailing
stop at 33, and we were finally able to "lock in" a profit by having our stop above our
entry price. Other three-to-four-week-plus consolidations developed in July-August and
in August-Septembel, allowing us to again raise our stops via the three-to-four-week-
plus consolidation and new high rule.
Then in October ADBE took off and began to trade above a P /E of 40. Forty had been a
high P/E for the last three years and was above earnings growth estimates for the next
two years after the one-year spike in eamings expected tn 1999. This meant ADBE was
potentially becoming overvalued and was potentially undergoing a blow-off in price.
Thus in October we began to use our tighter trailing stop method on ADBE. Every time
ADBE made a two-day-in-a-row decline and then later broke to new highs, we would
move our stop below the low of that reaction.
On Nov. 1 and 2, ADBE made a two-day-in-a-row decline. On Nov. 4, ADBE bottomed
at 67 1./8 and then made a new high on 11/8. This was nothing close to a three-week-
plus consolidation, but since we were in potentially overvalued territory, we used an
open protective stop (OPS) at 66 3 /4 (just below 67 7 / 8). The stock continued to explode
to 79 bef.ore collapsing, and we were stopped out via our 65 3/4 OPS in early-December
as ADBE began a decline to the 50s.

While we didn't catch the top perfectly, we caught the lion's share of this nice move,
and we caught more of the move by using a trailing stop than we would have had we
just began selling the position in October, when it first began to look overvalued.

Our final example is a foreign stock traded on the NASDAQ, Business Objects GOBJ).
In mid-June, BOBJ broke out of a two-month consolidation on the upside on a high-vol-
ume thrust and lap. It showed strong RS, exploding earnings growth, increasing-but-low
ownership by funds, and other elements of our runaway criteria.
We began buying BOBI near the 30 level, and put it into our PSL model portfolio in
June.
FIGUBE 2.11

Daily chart of Business Objects

ildt
WI /
' - -
Tighter stops;
Eachtime stock
makes new high
after two-day
decline move stop
to low of the decline

Created with Qcharc

BOBJ made a new high in July, corrected to the 37 level, and then consolidated for two
months before making a new 52-week high again. This allowed us to move our trailing
stops to just below 37 where we locked in a profit via our trailing stops.

BOBJ took off on a runaway up-move, and in November it moved above aP /E of 90 (its
projected earnings growth for the next year and a historic PE high). Thus, in November
we switched to our tighter trailing-stop technique. On 1/5/00, BOBI hit our stop at 1L5,
below the Dec. 74,7999,lows, and we took some very healthy profits.
CONCLUSION
Remember no trailing-stop technique is perfect. Trailing stops will often take you out of
a stock that ends up moving further in the desired direction. But even more often, the
trailing stop will prevent you from letting your open profits erode substantially in a
stock that has peaked for a considerable period of time. You can always re-enter a stock
if it meets your criteria on a new breakout. Tiailing stops therefore not only help you to
let your profits run and prevent you from giving back huge portions of open pioiit, brrt
they also help you to focus your trading capital on vehicles that aie rnoving up
strongly, right now, and exit those that are in protonged corrections.
GHAPTEP THREE

Protecting Yourself in
Different Time Frames
Okay-so now we'ae gioen you the basic techniques for loss protection. Now let's take a
look at money management from the perspectiae of traders who spend their time working
in different timeframes. ln this section, our contributors will speak to issues that are
unique to daytrading, swing trading, and intermediate-term trading. You'll see some
important dffirences in how certain parameters of loss-cutting procedures work, but the
main principle of " cut your losses and let your profits run" still applies uniaersally-
whateaer kind of trading you're doing.
DAYTBADING TIME FRAME:
Learning to Lose is Grucial for Winning in Daytrading
lnterview With Jeff Cooper (From Hit and Flun Trading ll/

Nowhere is the disciplined use of money-management techniques more critical than tn


daytrading. Many people u)ho'lse achieaed great success in a traditional profession come to
daytrading with starry-eyed hope belieaing in the adaertisements making outlandish
claims about instant wealth that can be attained using mechanical trading systems and
computerized techniques-only to be crushed because of their ignorance of the importance
of money management. lff Cooper is one highly successful and renowned daytrader whose
ability to instantly spot and take adaantage of powerful daytrading opportunities is
unparalleled. Yet hefully acknowledges that it's all useless without thefanatical
application of money-management rules eaery moment of ettery trading day.

Q, Vou often talk about the importance of being prepared each day. Can you ex-
pand upon this?
A: I believe daily preparation is key. You must have the names you are going to
trade, you must be aware of their trigger points, and you must have a plan of
attack weII before the morning bell rings. Many people are lazy and try to
wing it. Sorry, but this doesn't work. Daily preparation is tedious, but it is
also a necessity.

Q, neyond preparation, what role do money management and entry techniques


play?

A: Entry technique is important, but money management is more important. It


will sustain you through choppy markets and dry periods. I teII people they
should pat themselves on the back for scratching a trade or taking a small
loss. When I learned to scratch a trade or take an1/8 or L/4 point loss, I be-
came a more profitable trader. It leaves me with a fresh opportunity to take
another trade with more potential.

Q: Vou have at least two dozen strategies. Do you trade them all?
A: k is impossible to trade them all at the same time. I do trade them all over
time.

Q, How often are you wrong?


A: More than most people think. I am wrong at least 40% of the time, if not
higher. This is where the protective stops come in and get me out with only a
small loss.

Q: Why do you think most people eventually get chewed up trading?


A: Two reasons. First, they are in the wrong stocks. You must be in the stocks
that are strongly trending and have some volatility.

second, they don't know how to take a loss. They let small losses turn into
large losses, and this paralyzes them both emotionally and financially. I can't
tell you how many faxes and letters I receive from people who have read my
book and still don't use protective stops! They call my office asking for my
help. I tell them to re-read my book and make darn sure they have stops in
on every trade.

Q, on most days, there are too many stocks with your setup patterns. How do you
pick the ones to ttade?
A: I work four to six hours after the close on Friday identifying the best trending
stocks (up and down). From this, I create my "hit list." Each day I spend up
to three hours focusing on the action that occurred. I am first looking for
multiple setups on my list, then the best setups from my list and then any
other setups from my universe of stocks that look interesting. Obviously, this
process is quite subjective, and my names won't be the same names someone
else will come up with.

Q: Then does gut and intuition play a role in your trading?

A: I have a sense of how certain stocks trade and their personaiity. My intuition
began to blossom as I created my methodology and had fewer things to focus
on. Someone trading the Hit and Run methodologies for years will be much
better than someone trading it for the first time.
Q: Let's talk about taking positions home overnight.

A: ff a stock closes strongly in my favor, I will often carry at least half the posi-
tion into the next day. I almost never carry a losing position overnight. The
few times I have, I paid for it dearly.

Q: Oo you take overall market activity into consideration?

A, Yes, the market tone guides me to how aggressive I want to get. No matter
how strong a setup is, if the overall market is moving in the opposite direc-
tion, I know the setup is less likely to succeed.

Q, Your methodology is to hit a lot of singles. Ever get the urge to hit a home run
with your trading?
A: Of course. The temptation is always there. Fortunately, I have learned to con-
trol it. I get very angry at myself when I allow a profit to evaporate because I
thought this was the big one.

Q: no you ever add to a position intraday?


A: Sometimes, but not often. It wilt happen when, for example, a setup trig-
gers at S5 1,/4 and I buy L,000 shares. If it's a thinly traded stock and
someone bids 10,000 shares at85 3/4,I will step in front of him and buy
another 500 shares. The buyer is protecting me, and the odds favor this as
a low-risk entry.

Q: ,O.re all signals created equal?


A' No. A signal is much stronger at new highs or new lows than if it occurs in
congestion. Also, multiple signals are better than one signal.

Q, ,Lre you absolutely rigid to the rules?

A: Yes and no. Yes, in that I need structure, and no because flexibility is impor-
tant. Let me explain this further. The rules state for Expansion Breakouts that
today must be a 60-day high or low. If it's a 58-day high or low, I'11 take the
trade. The concept is the same, and two days aren't going to make a differ-
ence in the setup's performance.
Qt Do you focus on the bigger picture?
A: I am aware of it. Obviously, it's been easier to focus and trade on the long
side over the past few years than the short side. When we start trending
down, my focus will be to the short side.

Q: What outside sources do you rely on?


A: CNBC. It helps me gather a general framework on what's going on.

Qt Do you ever trade off of their advice?


A: My father told me never to say never. In this case, I'll make an exception:
Never!

Q: You're expressing a tinge of cynicism.

A: As a kid, I would watch my father trade. Whenever I said, "Look at that stock
move," his reply was always, "Stocks don't move, they are moved!" Time
and time again,I see market manipulation. You have to get a little cynical
and ask who's moving this stock? Also, time and time again,I see brokerage
houses upgrade stocks only to see the stock gap higher and seIl off. You don't
have to think real hard as to who is doing the selling.

Q: Vou are sometimes buying a stock one day and shorting it the next. Isn't this
difficult?
A: You can't personalize a stock. If you think it's going higher, you buy it, if you
think it's going lower, you short it. The toughest part is to go long, be wrong,
and then stop yourself out with a loss and go short. The human mind is
wired to avoid pain. Once a stock bites you, it is against human nature to
turn around and trade the same stock again, but that's where some of my
largest profits have come from. My best trades have come when I was wrong
about direction, took the loss, and turned around to trade the opposite direc-
tion.

Q: no you surf?
A: (Laughing)I thought we were talking about trading, but I know where you're
coming from. You'd be surprised at the number of people who ask me that
question. Many think because the markets close at one o'clock on the West
Coast, I take off and go play. My day runs from e.u. into the early eve-
5:00
ning. I do not know many successful people whose day is much different.
There is a price to pay, and unfortunately long hours are part of it.

Q: Then you're obsessed?


A: You're not far off, but again I'm not much different from other people in this
respect.

Q, ffow do you handle rumors and tips?

A: Like most people, I used to pounce on most of them. I now only have to re-
view my tax returns to remind me of the consequences. It's a bad habit which
I broke years ago.

Q: Anything more on this?


A: market opinions. The Street is cluttered with market bears who refused to
Yes,
acknowledge the bull market of the '90s. These people had their self worth so
wrapped up in their opinion that they. not only missed one of the greatest
market moves in history, they also got wiped out in the process.

Ihave been bearish since late 7995, yet I have had some of my most profit-
able years trading.

Q, ffow did you do that being bearish?


A, By going with the overall trend. Wali Street doesn't give a damn if ]eff Cooper
is bearish. The market is going where the market wants to go no matter what
I think. My livelihood is dependent upon predicting prices for a few hours to
a few days. If I allowed my bearish opinion to overwhelm me, I would have
missed literally thousands of profitable trades over the past few years.

Qr Do you have the urge to pick tops and bottoms in the market?

A: I gave that game up years ago. It's a losing proposition.


Q: Why then is Wall Street and the public so obsessed with trying to do this?
A:Ego. There's an emotional reward by calling tops and bottoms. It's far easier
and financially more rewarding to trade short term in the direction of the
trend.
Qr Do you have losing streaks?

A: As time passes, they become fewer and fewer. I often have bad days but
rarely bad months.

Let's go back to trading specifics. You once said that you are impatient with
stocks. What did you mean?

A: It a stock doesn't move immediately in my favor, I am quickly moving up my


stops. My strategies are such that a stock should immediately become profit-
able. If it doesn't, I get very antsy.

So you move your stop closer, get stopped out, and then the market explodes
the way it should!

A: Itsometimes happens. It's unfortunately part of the game.

Ever get used to it?

A:Itused to piss me off to no end. Now I just scream and move on.

You earlier used the phrase "getting to know the personality of a stock." What
do you mean?

A: Stocks don't all trade the same way. Specialists move them around differently;
some fluctuate around a commodity price such as the oil service and oil
stocks, and some trend smoother than others.

How does one learn a stock's personality?


A, By trading it over and over. It is no different than spending time with a
friend. Over a long period, you get to know him or her very well. Their be-
havior becomes more and more predictable.

Q: ere there stocks that don't fall into this category?


A: Yes. There are certain stocksI absolutely can't make money in. Guidant (GDT)
is an example. No matter how great a setup is on this stock, it does the oppo-
site of what it should. There are many others, and over time I just give uP on
them. Luckily, there are many that do what they are supposed to do.
Q, Uow many trades do you make a d,ay?
A: Six to ten on average.

Q: That's healthy. Your broker must love you. And how many positions at a time?
A: Obviously, the fewer the better. Once I get up to five or six, I begin to lose the
needed focus.

Q: So you're in front of the screen all day?


A:Yes,pretty much.
Qr Vou work out of your home. Are there distractions?

A: Not really. My wife is terrific and knows not to acknowledge my existence un-
til after market hours.
Q: What about the outside day-to-day distractions? You're building a home in
Malibu as we speak.
A:Vy contractor is under strict orders not to call before 1:00 p.rra. unless there's
an emergency. I pretty much try to drown out most of the world until the
market closes. Focus for me is important.

Q: no you trade every day into the close?


A:IfI have a big morning I calt it a day. Otherwise, yes.

Q: Vacations?

A: fwo to three weeks off at the end of the year. No markets, no quotes, nothing.
I don't care if they blow WaIl Street up. I'm on vacation.

Q: Oo you talk with other traders during the day?


A: Only two. Both are excellent traders. We share ideas, and none of us imposes
our beliefs on the others.

Q: Last question. If you could only give one piece of advice to an aspiring trader,
what would it be?
A: Learn to take small losses. It's the difference between professional traders and
everyone else.
DAYTRADING TIME FRAME
Trad i n gMarkets. com lntervi ew with J eff Cooper

This next interuiew of lff


Cooper, which appeared online in TradingMarkets.com, picks
up where the preaious one left ff. As you read this, remember that lff
makes his liaing
trading. Look at how central his money-management philosophy has been to his suraiaal
and, ultimately, his spectacular performance as a trader-month after month, year after
year. Most traders aiew money management as an afterthought-something they add to
their methodology as afinishing touch. Ieff on the other hand, doesn't distinguish money
management from his methodology-it's an integral part of it. ln addition, he recognizes
that markets are dynamic and constantly adjusts his money-management style to current
market conditions.

MONEY MANAGEMENT: PRO TRADERS


SHARE THEIR LESSONS
Maybe we should fill readers in about some of your history. L:r your first book, Hit and
Run kading, you wrote that your father built and sold a very successful textile business
and retired to Beverly Hills, California. Based on his broker's advice, he began investing
in stocks. Not only did they sell him on the buy-and-hold mantra, but they also intro-
duced him to buying stocks on margin to increase his fortune through leverage.

Unfortunately, the first bear swing in the market wiped out your father's account. To
add insult to injury, the brokers who originally had convinced your father to part with
his money were now liquidating his portfolios on the day your mother was being oper-
ated on for cancer. Now forced into bankruptcy, your family had no choice but to move
back east. If this wasn't enough pain and suffering, the moving van caught fire en route
destroying what few possessions that were left.

Your father started yet another textile business from scratch and within five years sold it
for millions and retired. Instead of enjoying the good life, he decided once again to re-
turn to the markets. This time, however, it was on his terms. He began investing in
IPOs, but on a short-term basis. Not only did he make back his entire original stake, but
he made millions on top of that.
Q: Did you automatically become a short-term and risk-averse trader based on
your family's painful experience with buy-and-hold?

A: No. I fell into the footsteps of my father's initial tragedy. I was nearly wiped
out in the late 1980s making the same mistakes that he made over 20 years
earlier.

Q: Why is it that you didn't learn from your father's initial tragedy?
A: I suppose it's the Cooper family nature. We're hardheaded. Look at my father.
After being devastated in the markets, he started another textile business
from scratch and made back enough money to retire. Instead of living the
good live in retirement, he returned to the markets. Now, with those genetics,
I couldn't help but to go out and do it my way. I suppose as human beings
it's not enough to experience other's pain. You have to feel it for yourself.
The lessons that stick are ones that are learned first hand. And those have to
be learned and re-learned often. That's just the way most of us are built. Ber-
nard Baruch, one of the great investor/traders, went broke five or six times, I
believe, before asking his mother for some more of the family's funds. At this
point he was told that this is the last of it. He was able to make that his
grubstake, and turn it to his fortune.

Bernard Baruch was humbled by the markets before he was able to master
them. And I would have to say that this is one corunon thread that runs
through almost every great trader that I have ever met. They have all been
humbled by the market early on in their careers. This creates a definite re-
spect for Mr. Market. Until one has this respect indelibly engraved in their
makeup, the concept of money management and discipline will never be
treated seriously.

Qt So you were trading longer-term and taking excessive risk?

A: Yes.

Q: why?
A: The market has a way of soft-pedaling risk, making the masses happy and
comfortable. When that belief system is universal, that is when it (the market)
is to be feared the most. Hello! (referring to the masses who are currently plung-
ing into the market) Does this give anyone the idea I'm more of a daytrader as
opposed to a position trader?

Q,Wfty do you think people hold on to stocks and refuse to sell?

A: It's very easy to buy a story on a company you hear about at a cocktail party.
In addition/ many people are paid to promote stocks. Furthermore, people
are generally hopeful and optimist-dreamers by nature.

Q, Recently, a friend approached me at a cocktail party. The guy is a brilliant or-


ganic chemist, probably the most intelligent person I know. He took out a stack
of charts and began asking me for trading advice. On many of the charts it was
the same story: "I've doubled my money on this one but now it's selling off.
I'm still ap 50% but it keeps dropping." When asked, so why not take a SOTo
profit? His reply was that he couldn't do that because at one point he was up
700%. He felt like a failure. Yet, here's guy who had made some nice profits in
the market-profits I envied.

A: Many people think the object is to get out close to the top. They buy Amazon
at L50 and ride it up to 280 points. It then sells off to 240 and they think
they've made a bad decision. They forget that the real object is to make
money.

The hardest thing, though, whether it's investing or short-term trading is to


learn how to extricate oneself from a situation, whether it be positive or nega-
tive.

Q: Ves. It seems like each stock had a story behind it as to why it shoutd go back
uP.

A: It's human nature to be optimistic. Any fool can enter; it takes talent to exit
consistently and profitably.

Q: What do you think is the secret of your success?


A: I look to take money out of the market, to create income and build wealth. I
do this by consistently hitting singles not home runs. I never try to capture a
huge move and I never do.
Q, ffo* do you view money management?

A: Regardless of what we think we know and should happen the reality is that a
Iot of stock action is random. Therefore, money management is crucial if you
want to be successful as a trader. To me, it's the cornerstone of both making a
living at trading and building wealth.

Q: What percentage of equity do you generally risk per trade?

A: I risk very little. I don't really think of it in terms of percentages. I suppose if I


did, I'm probably not risking more than 1,/4 to 1/2% per trade. In addition, I
haven't changed my trading size in years. Nor do I intend to. Therefore, by
keeping my position sizes relatively small, my risk continues to decrease as
my capital base grows.

Qt Wt V not keep your risk consistent to the amount of your equity to strive for
even larger returns?

A: I see things on a monetary basis. For instance, I think $L,000-$2,000 is a lot of


money to lose on an individual trade. Think about it. Not many people make
$1,000 an hour, yet an active daytrader can loose that in a matter of minutes.

I suppose at some point in time, I might consider managed funds. At that


point, I'd be forced to adjust risk to equity. However, as long as it's my per-
sonal account, I'm comfortable knowing that as my equity grows, my risk
continues to decrease.

Q: Would you share with us your techniques for money management and dealing
with risk?
A: Sure. Depending on the situation, I use price stops, time stops, pivot stops
and size stops.

Q: Ot the fou+ price stops seem obvious-is that points risked per trade?
A: Yes.As a rule of thumb I never permit a stock to go more than L point against
me. I've learned that your first loss is the best and it only gets worse from
there. Almost all big losses start with small losses.

Q: ls your l-point rule rigid?


A, No. Markets are constantly changing. Also, obviously on a carry-over trade,
there's no way to prevent a gap from making it worse. However, in those
cases I reduce the risk by not taking the entire position home.

Q: What about thinner stocks, higher-priced stocks, or those that are more volatile?

A: On those I'm willing to go to 11,/2 points or so. However, I reduce my posi-


tion size accordingly.

Q: What are pivot stops?

A, \atrhenI see a stock break out of an intraday congestion or consolidation as a


momentum player, I'm looking for immediate continuation. That's the nor-
mal expectation. My many years in the market have taught me to be cynical:
Stocks don't move, they are moved. Often stocks don't go uP/ they are put
up. So typically, I will place a stop immediately below a consolidation. If the
stock simply is stutter-stepping after the breakout, that is, if the stock goes
one to three bars (on a five-minute chart) and then has a shallow pullback,
then, OK. However, if a stock comes in below the breakout point, I'm usually
gone. Most traders wait for a base to be violated. I won't wait that long. If the
stock reasserts itself, then I'll re-enter. That's the way I like to trade'

Q: What about time stops?


A: As a momentum/short-term player there's an opportunity cost to be in a
stock-especially with today's volatility.

Qt So by being in a stock that's not moving you miss opportunities in other stocks?
A, Yes. Depending on the stock, I find it difficult to manage five to six positions
at one time, and if we are talking about Lnternet stocks, managing more than
two or three on an intraday basis can be a real feat. So if I enter a stock based
on momentum, I expect continuation. If the stock just sits, I may simply
scratch the trade and look for greener pastures.

Q: What about exiting?


A: h all depends on the market. I recognize that markets are constantly changing
and require different approaches at different times. Although this should
sound patently obvious on the surface, it's been a real key to my profit-mak-
ing potential.
Let's say that the overall stock market or a sector is in a solid monolithic
move. I'm pretty comfortable with a one-point stop rule. I'm also more prone
to let things ride a bit. When markets are choppy, I'm going to be less forgiv-
ing, both with my stops and in taking profits. I'm much more apt to take a
piece off as a soon as a stock runs up a point or so and bring my stop up to
breakeven on the remaining piece. I don't overstay my welcome in choppy
markets.

Q: are there any times when you take larger positions or pyramid?
A: You can take the same two people and sit them at a blackiack table in Las Ve-
gas. The cards are coming out randomly but it's the player who bets properly
and uses a disciplined approach and knows how to recognize a streak when
it occurs and go for the throat who will live to survive and play another day.
The market is very similar. There are few times where the market has a
strong run and you want to do the same with your positions. This may hap-
pen as often as a few times a month or as seldom as a few times a year. The
key is to recognize when this is occurring and bend the rules and press a bit.

Q, Any closing thoughts?


A: Yes. Many people think they want to pursue one particular form of trading.
For me, it's daytrading and short-term momentum trading. This is not to say
it's for everyone. It all depends on your makeup. I admire traders like Mark
Boucher who occasionally catch much larger moves. Also, you have to be
willing to change. At some point in time, I might be willing to commit a
small portion of my capital to trading this style. However, for now, I know
my niche and stick to it.
DAYTRADING TIME FRAME
lnterview with Kevin Haggerty

Keoin Haggerty's long career in the institutional side of the trading business has gioen
him a unique perspectiaefrom tphich to pursue short-term stock trading. As theformer
senior aice presidentfor Equity Trading at Fidelity Capital Markets in Boston, Keain
understands the way large institutions moae in and out of the market. The huge lnoaes
that ariseftom the way they shift their weight is all the more reason that Ket:in always
keeps risk on a short leash.

Q: Do you always wait for your stop to be hit, or will you get out of a trade for
other reasons?
A: When you take your initial position, assume you are wrong until the market
proves your position correct. You don't have to wait until your stop is hit to
get out. If the dynamics of your specific trade change, just exit the trade and
immediately you will save some money that can be applied to other trades.
You can always re-enter the trade again if it sets up'

Q, How tight do you keep your stoPs?

A: Intraday trading requires tight stops to be profitable. You are limited by the
clock and the daily range of your selected stock. Remember, a Pure daytrader
goes home flat every day.

With tight stops of 7/4to3/8 of a point


and accuracy of 50Vo, a trader that
can lose 1./4 and make 1./2 can be very successful. With tight stops accuracy
is lower, So you must learn to manage the trades to make multi-point gains.

For example, on a 1,000-share position, a daytrader is not going to risk more


than'1,/4 to 3/8 of a point, including commissions. If you decide to adjust for
votatility and take a 500-share position in a stock with an implied volatility of
80 vs. one with 40, then you could risk, say, 3/4 of a point, or $375.

With tight stops of 1./4 to 3/8 you are often stopped out by normal market
noise, such as programs and news blurbs. You can't let this bother you emo-
tionally. Every trade you make is a probe and you will soon catch a
multi-point move. However, you can't make up a multi-point loss in a day.
Another key point is that beginning traders are better off trading smaller size
with wider stops, especially if they are not connected by direct-access execu-
tion and have to rely on a standard ISP hookup and possible phone call. I
highly suggest you don't attempt to daytrade with an online brokerage firm
where you don't have direct communication.

I have seen traders correct on 40Vo of their trades and stopped out on 60Vo of.
them who are among the most profitable in the firm because they are excel-
lent at managing their profitable trades and adamant about taking only small
losses.

Q, Can you expand on this in practical terms?

A: Consider catching a one-point move, and losing 1,/4pont on three trades.


Suppose your commissions are $25 per round trip and you are trading L,000
shares. If you lose a quarter point plus commissions (-$ZSO - $25 = -$275)
three times in a row (-$275*3 = -$825), then make 1 point ($1,000 - $25 =
$975), your net result is a profit of $150 even though you were wrong 75% of
the time-because you managed the winners properly.

But traders who lose'1./4 and take a profit of 7/4 and pay commissions go
out of business. Learn to manage your wirurers and keep tight stops. Py.u-
miding positions in stocks for a daytrade is difficult at best, and should not
be attempted by novice traders. It is probably better for all traders to put on
their maximum positions initially-that's your best entry, assuming you have
enough daily range to provide you ample profit opportunity.
SWING.TRADING TIME FRAME:
Ten Tenets of Swing Trading
By Dave Landry

Can it come as any surprise that an article titled "Ten Tenets of Swing Trading" is
comprised mostly of money-management rules? I meln, the article could aery well haoe
been a list of patterns and strategies that help you identfu entry points. But
no-swing-trader Daae Landry, as Ltsltal, puts the horse before the cart.

Swing trading is a method of trading which seeks to capture short-term gains in mar-
kets. It involves identifying markets that have the potential to make an immediate
move/ entering those markets and using strict money management to help protect
against major losses and lock in profits. Trades are normally held for one to five days.
Below we will look at ten general guidelines which are by no means are exhaustive, but
should help to keep you out of 90% of the trouble spots when swing trading.

1. LrMtT LOSSES
As soon as position is initiated, you should have a protective stop right below the recent
support (for longs), or above recent resistance (for shorts). Swing trading often produces
many small gains with only an occasional home run. Therefore, protective stops must be
used on all trades. Getting careless on just one trade can erase many winners.
FIGURE 3.1

Longs Shorts

Resistance

2. NO TIGKIE, NO TRADIE
Swing trading involves identifying short-term support and resistance and where a mar-
ket will likely re-assert itself. It is not about fading the market by picking tops and bot-
toms. Therefore, wait for follow through before attempting to enter a trade.

For instance, suppose a market is in rally mode and begins to sell off, chances are the
next move will be a resumption of the original uptrend. However, until that uptrend be-
gins to resume/ positions should not be initiated. For longs, this means waiting for the
market to turn back up, and for shorts, it means waiting for the market to turn back
down.
FIGURE 3.2

Wrong Correct

t Entry

- fu0nort

3. TAKE PABTIAL PBOFITS OUICKLY

On most swing trades, the profits will be small and have the potential to quickly erode.
Therefore, as soon as your profits (a) are equal to or greater than your initial risk (b),
you should lock in half of your profits and move your protective stop on your remain-
ing shares to breakeven (c) (near your original entry).
FIGUBE 3.3

IcI
Yfr:-ProF,t(a)
rnitior Riek (h!
l-

Locking in half of your profits and moving your stop to breakeven when your profits
are greater than or equal to your initial risk, will help to generate income for your ac-
count. This income will help to pay for the inevitable small losses associated with swing
trading. Further, barring overnight gaps, this gives you, at worst, a breakeven trade and
a chance at a home run on the remaining position.
4. TAKE WINDFALL PBOFITS
As a swing trader, windfatl profits are often few and far between. Therefore, you should
Iock in all or a significant piece of your profits when parabolic moves occur. After all,
large moves occur as players dog pile onto a market as it becomes obvious to the
masses. You've got to ask yourself, once it's obvious and the last players are entering the
market, who's left to buy?
As an example, notice below that Agilent Technologies (AGIL) had a tremendous
one-day gain (a), but all of those gains were eroded over the next few days (b).

FIGUBE 3.4

0 C=114
I

l{*
110

:14
5. TRADE IN LIOUID AND ACTIVE MARKETS
As swing traders, we are looking for an immediate short-term move. We don't have the
luxury of waiting around until a large price-move takes place. Therefore, the markets we
trade in must be liquid and active so we can move in and out with ease and, hopefully,
capture short-term fluctuations. Trading in thin and dull markets can be costly and will
likely chew you up, as most short-term trading profits are small.

6. STAGK THE ODDS IN YOUR FAUOR

In trading, the more pieces of the puzzle that fit together, the better. Although in swing
trading, we are looking for short-term setups, it helps to have longer-term factors in
place. This can be in the form of momentum or big-picture technical patterns such as
cups and handles, head-and-shoulders bottoms (or tops), double bottoms (or tops) and
so on and so forth. These can be on daily, weekly or even monthly charts. Some of the
best swing traders find markets that have the potential to double or triple (over time)
and look for short-term setups to capture a piece of that move. Also, for stock traders,
the above should be combined with an overall market bias.

7. ENTEB THE ENTIBE POSITION AT ONCE


In swing trading, we are in the market for a short period of time and looking for a swift
move. Unlike the longer-term player who has the luxury of building positions over time
and at an average price while waiting for the market to move, the swing trader is look-
ing for an immediate move. In most cases, you should be looking to lock in profits and
tighten stops as the market moves in your favor-not add to positions.
If you must pyramid, then do it quickly as the position moves in your favor, and make
sure it looks like an actual pyramid. In other words, only add to profitable positions and
establish your largest position first. A 3-2-1. ralio is a good ratio for establishing posi-
tions. For instance, if your position size is 500 shares, then enter 300, then 200, then 100,
provided of course, the market is moving in your favor while adding to the position.

8. KEEP POSITION SIZE WITHIN REASON


Swing trading is a game of probabilities. You win some, you lose some/ and hopefully,
through a consistent approach, you make money overall. Swing trading is not about try-
ing to hit "home runs" by taking excessive risk on any one position. In fact, you should
level take a position large enough to have a material impact on your trading account
should-or more likely, when-a price shock occurs.

9. BEMAIN CONSISTENT
Successful traders find a formula and stick to it. Swing trading is no different. you
must
fT9 u" approach that works for you and apply it in i consistent methodical manner. In
addition to being consistent in your appioiifr, you must also be consistent in your
money-management techniques. This involves keeping position size within reason,
us-
ing initial protective stops, taking profits and trailing siopr.

10. WHEN IN DOUBT, GET OUT


In swing trading, we are looking for an immediate short-term move. If the market doesn,t
move immediately, then there's no need to remain in the market-even if you,re
not
stopped out. The longer you are in a market that is not moving in your favor, the
more
you are exposing yourself to a potentially adverse move. In mist.ar"r, you,re better
off
exiting the position_ and waiting for the market to set up again. a good rule-of-thumb
here is to only take home profitable positions.
INTERMEDIATE-TEBM TIME FRAME:
Marder on Money Management

One day recently, I was standing in line to sign my 3-year-old daughter up for swimming
lessons. I couldn't help but oaerhear snippets of banter between soccer moms and softball
coach dads about high-momentum tech stocks, breakouts to new highs, and basing
patterns. Yes, the public has become a little more sophisticated these days and their focus
largely seems to be in the intermediate timeframe, where they can establish positionsfor
longer-term holds without interfering (or haoing the appearance thereofl utith their regular
jobs andfamily life. But alittleknowledge canbe dangerous. The intermediate timeframe
is especially dangerousfor inexperienced traders during a runaway bull market because so
many of them get used to outrageous gains offhigh-momentum trends that seem
neaer-ending. This conditions them into complacency as they automatically think that a
stock will resume its trend on any pullback. The net result? Many of these people (some of
whom I personally knout) ran their accounts to spectacular gains on margin only to get
completely wiped out and in debt in the Nasdaq crash of March-April 2000.

If you desire a more pleasant fatefor yourself, you'll want to study the ideas of this one
man who is aggressiae about being in the market when conditions arefaoorable and is just
as aggressiae about staying on the sidelines when they're not. l'm speaking of Keoin N.
Marder. Keain was a co-founder of CBS MarketWatch. As its editor, he deaeloped a solid
reputationfocusing on the stocks that were poised to make big,long-lasting mooes. In
1999, Online Investor magazine named "Marder On The Market' one of the Web's Top
25 Sources for Great Stock ldeas. ln 2000, Forbes magazine mentioned "Marder on the
Market" in its Best of the Web issue, calling it "smart commentary." Marder continues
that tradition at TradingMarkets.com. He co-edited The Best Conversations With Top
Traders.

Without a doubt, the aspect of trading given the shortest shrift by traders is money
management. The reason is simple: Money management is anything but glamorous.
Most traders would prefer to educate themselves on something more exciting like entry
techniques, believing that a good offense is most of the game. Either that or they spend
copioui amounts of time searching for the elusive "HoIy Grail," that magical indicator
or system that pledges to automatically deliver fat profits to their doorstep.
The way I see it, money management can be broken down into four types of decisions:

7. How much you allow a position to go against you before you cut a loss
2. How much money you allocate to a position
3. How much you allow a position to rise before you add to it (if at all)
4. How much of your position is borrowed through the use of margin
I am an intermediate-term trader. As such, my goal is to hold onto a winner for roughly
a few weeks to a few months. Therefore, what applies to my trading style surely doesn't
apply to that of a daytrader or swing trader. Beyond that, I have a certain tolerance for
risk that won't necessarily correspond to that of other intermediate-term traders.
With those two caveats aside, here is how I approach money management:

GUTTING LOSSES
Rule No. L of any intermediate-term trading strategy, is to admit when you're wrong,
sell a losing position, and step aside. Yet the very failure to abide by this rule is easily
the biggest reason why traders fail. It's kind of like your physical health: If you don't
have that, everything else is a moot point. And if you can't preserve your capital to play
the game again, a great strategy is worth nothing.

Selling to cut a loss involves tossing our own ego into the trashcan. For some of us,
this is very difficult. I've seen a number of people who have been quite successful in
other careers attempt to duplicate their success in trading, but to no avail. The prob-
Iem in every situation? These traders thought they were smarter than the market.
What they didn't fully comprehend is that what a trader thinks about a stock doesn't
matter. The market doesn't know who we are, or how educated we are, or how smart
we are/ or what a success we've been in another career.
The bottom line here is that I'oe neoer met a successful trader that zpasn't religious
about cutting losses,

The mathematics are simply against you when you let a small loss grow into a big loss.
For example, a 33Vo loss requires a 507o gain just to break even on a trade, while a 50Vo
loss requires a 100% gain. And that's just to break even. Too, if we're in a bull market,
the opportunity cost of having money tied up in a loser can be major.
The good news is that selling to cut a loss removes quite a bit of the stress associated
with trading. As well, it is, by factors, an easier decision than that of nailing down a
profit. Most of the time, I use a stop loss level that equates to 5%-7% below my entry
point. This level does not necessarily correspond with some area of support, though at
times I do set my stop just below a "shelf," or support level.

Of course, there are exceptions to every rule. Situations in which I deviate from the
5%-7% level, and instead set my risk at 3%-5%:

. In the case of stocks that sell for more than $150. With a $150 stock, I usually don't
need more than a 7-point cushion (4.7% below the entry point) to prove myself
wrong.

. When a stock breaks out of a brief consolidation area of less than four weeks. This es-
pecially applies to stocks that I buy that pull back for just a couple of days. For those
just starting out with this strategy,I strongly urge you to concentrate your buys on
those stocks formingbases of at least five to six weeks. AII other things being equal, a
breakout from a proper six-week base has substantially higher odds of succeeding
than a stock emerging from a consolidation of less than four weeks. Prove to yourself
that this strategy works with proper bases before you start taking on higher-risk
trades. The danger is that you'Il buy stocks coming out of brief, two-week pullbacks,
they'llfail, andyou'll end up chucking the whole gameplanbeforeyou giveit a legit-
imate chance to work. Of course, paper trading for a while is one way to build your
confidence.

. When I pyramid a position. I will usually set a stop of about3%-3.5% on any add-on
bry.
. When the general market's health is marginal.

The last three exceptions listed above involve higher risk, hence the tighter stop level.

For newcomers to trading, there will be many times in which you'll sell to cut a loss,
only to have the stock come right back in your face and break to the upside. You may
even develop an inferiority complex as you sell at the bottom tick of the day. Nonsense!
This happens to all traders. If you look on this business of cutting a loss as merely an in-
surance policy, you'll better appreciate its importance-not to mention the reduction in
stress that it brings.
POSTTION SIZING
I manage more than one account. h *y personal account, I start out with an 8% posi-
tion and then quickly add on to it if the trade moves my way in convincing fashion. I
would strongly recommend that someone just learning an intermediate-term trading
strategy begin by paper-trading that strategy before committing any hard-earned capital.
If the results make sense from a profitability standpoint, a small portion of one's capital
can then be committed. Finally, if this abbreviated exposure proves successful, a trader
can then commit his or her entire account to a particular strategy.

ADDING TO WINNEBS
With high-probability trades, I often add to a wiruner as it moves up, as long as the
add-on buy doesn't occur as the stock is extended above its most recent base. By "ex-
tended," I refer to a stock that's more than SVo or 7Vo above its base. Most of the time, I
do this by making a secondary buy of one-haif to two-thirds the size of my original pur-
chase. If the stock continues to act well, I will then follow up with a third buy equal to
one-half of the second purchase. As an example, I pttt 10% of my account in a stock. It
breaks out on robust volume, ises 2Vo, and I then add a second position of 5% of my ac-
count. I might then add on a third position equal to 2Vo or 3Vo of my account.

The second and/ or third buys might be put on shortly after a stock breaks out from a
base, but before it becomes extended. Another place they might be put on would be af-
ter a stock runs up 20Vo or 30Vr, forms another base, and then breaks out anew.

If I enter an add-on position, I wili treat that position


separate from the initial position.
Example: A stock breaks out of a nine-week base on roaring volume and I enter a posi-
tion equal to 10%o of my account at 100. My sell stop is 93, or TVobelow entry. The stock
moves up and I add a second position equal to 5%o of my account at L03. My sell stop on
this add-on position is 99.88, or 3Vo below my entry on this position. If I add a third po-
sition equal to 3Vo of my account that same day or at a point in the future, I will place a
37o sell stop below entry on that third position.

MARGIN
I make tiberal use of margin when the general market aPPears ripe for continued gains.
The combination of concentrated positions, pyramiding, and margin can take this strat-
egy to a whole different level in terms of performance. But like any other weapon, these
three can easily be misused. Use caution with these, and only use them once you've got
some experience under your belt with this strategy and can show a good profit. As well,
everyone has his or her own comfort level when it comes to risk. Some traders never
feei comfortable using concentrated positions, pyramiding, and margin, just as I would
never feel comfortable using this strategy with just four stocks in a fully margined ac-
count, as some traders do with phenomenal success.

Use of concentrated position sizes and margin will bring tlrre succes{u/ intermediate
trader's results to a new level. Notice that I emphasized the word "successful." Do
NOT-I repeat, do not-attempt to use concentrated position sizes and margin until you
have demonstrated that you can make money consistently with an intermediate strategy.
In particular, using margin when you have not proven to yourself that you can consis-
tently make money can have dangerous consequences when you run into an inevitable
losing streak that happens to every trader.
INTERMEDIATE.TEEM TIME FBAME:
The Discipline No lntermediate-Term
Trader Gan Do Without
By Loren Fleckenstein

Loren Fleckenstein is the Stocks Editor af TradingMarkets.com. His money-management


approach is rooted in thefact that high-momentum stocks are as rislcy as they are
rewarding. I got a taste of this myself during a talk that Loren gaae on intermediate-term
trading at the TradingMarkets2))} conference in Las Vegas. The room wasfilled to the
rafters, and oaerflow people were sitting on thefloor. And wouldn't you know it? When I
walked into the room, he just happened to be discussing placement of protectiae stops once
a stockbreaks out of abase. Prior to joiningTradingMarkets.com, Loren was a staff writer

for Investor's Business Daily where he coaered the stock market and tprote about trading
tactics. He currently writes the "Trading the News" and "Follouting the Money" columns
at T r a dingMarket s. com.

No trader will survive for long without a disciplined approach to money management,
one that affords sufficient exposure to profit materially from winning trades while
guarding against downside risk.
This holds as true for intermediate-term momentum stock traders as it does for
daytraders or swing traders. By definition, the intermediate-term momentum trader
buys stocks that are in strong uptrends and that have outperformed the market by a
wide margin over the past 6 to 12 months. When high-momentum stocks break out of
sound chart patterns, they have explosive upside potential. However, these highflyers
have vicious downside potential as well. Embedded in the highflyer's share price are
high expectations of future corporate performance. If an earnings disappointment or
other negative news hits such a stock, the resulting punishment will come swift and
hard. Consider every position in your account a potential time bomb.

To help you defend your account, I will describe four essential elements of money man-
agement attitude, initial protective price stops, position sizing and maximum portfo-
lio risk. Sound money management will never eliminate all risk, but it wili substantially
reduce your odds of suffering a catastrophic loss.
1. ATTITUDE
By "attitude," I mean self-discipline. The best-laid plan will surely failif the practitioner
lacks the resolve to carry it out. As in any other asPect of your trading strategy, you
must practice money management with ironclad discipline. Over your trading career,
yo, *itt encounter iemptations to deviate from your money-management plan. If the
market turns against yol, and your pian dictates the time has come to cut your losses
by selling stock, carry out your plan. Don't stall in hopes that the market will reverse
and turn your losing position into a winner. Act immediateiy on your protective stops.
Don't ,"rrir" them after the fact. Sell your losers and get out of harm's way. Likewise,
don't allow excitement over a particularly bullish-looking stock or market cause you to
take larger positions than permitted under proper position-sizing and portfolio-risk
Iimits.

By "attitude," I mean a willingness to accept small losses to avoid big losses. This means
r"tti.,g stocks that violate your risk rules. When the time comes, don't Srouse over tak-
ing thu loss. Don't hold on in hopes the market will reverse and prove you right. If you
let"vanity guide your decisions, you will set yourself up for far greater humiliation and
financiaipiin. Don't regret taking the small loss, even if that stock you just sold reverses
and ralliei for a monster-sized giin. Sooner or later, your loss-cutting regimen will save
you from a severe loss.
By "attitude," I mean vigilance. A stop will not work if you are napping when it is vio-
lated. You must continuously monitor your positions throughout the trading day. So you
must have a source of real-time streaming quotes and instant alerts to help notify you
when a trade gets into trouble.
By "attitude," I mean respect for the odds. Don't delude yourself. Tr1d9 iong enough in
high-momentum stocks, ind it's virtually inevitable that you will wind up-with a time
Uo"mO ticking away in your account. Without proper management, you will eventually
suffer the full forte of a detonation. Correct money management significantly raises
your chances of defusing an explosive position ahead of time, or deflecting most of the
blast.

I cannot belabor this final point enough. Consider a sobering bit of probability math.
Imagine that you have discovered the Hoty Grail: a simple, mechanical system that pro-
ducis winning trades with exceptional consistency. All you have to do is commit every
dollar in youiaccount whenevei your system identifies a worthy stock and sends an en-
try signai. You sell only when the system indicates a new trade. You have supreme con-
fiience in your Holy Grail. Even if a newly purchased stock falls sharply in price, you
will hold on. After all, you have calculated that the probability of a Holy Grail trade
ending in ruin is only one in 100.

Sound like a remote hazard? A1,To risk of ruin may seem trivial, but the odds of disaster
mount over a career of trading. An event with a lVo probability of occurrence in one trial
has a 22% likelihood in 25 trials.'In other words, you face a one-in-five chance of losing
your shirt if you bet the farm 25 times without a method of cutting short your losses. In
50 trades, that danger runs to 39To; n 75 trades, 53%; tn 100 trades, to 63Vo; in 200
trades, to 87%.

The chance of disaster striking any given high-momentum stock runs much higher than
1%. Asobering thought. That's why disciplined traders never allow a loss to compound.
They use price stops. It's also why disciplined traders never commit too much equity to
any single position. They use position sizing.

2. INITIAL PROTECTIVE PBIGE STOPS


An initial protective stop is simply a price beyond which you will liquidate a new trade
if the market moves against you. \Atrhenever you buy a stock, you immediately set a
price at some point below your cost where you will sell in case the stock falls in price.
Whenever you short. a stock, you immediately set a price above your cost where you
will buy back the shares and cover your short in case the stock rises in price. Most of
my examples will focus on long trades (buys).
Intermediate-term traders commonly set their initial stops as a percentage below their
cost for long trades, above cost for short trades. I have seen successful intermediate-term
traders use percentage stops between SVo and 8%. Others may adjust their stops to ac-
count for each target stock's volatility, recent support levels or other considerations.
Let's say you use a fixed SVo stop.If you buy a stock at 50 a share, you would sell if the
stock falls to 471/2.If you short a stock, you would cover if the stock rises to 521,/2.

Which percentage stop works best for you? That depends on your trading performance.
TWo factors govern stop placement:

L. The stop must be set wide enough to account for normal volatility and thus
avoid stopping you out of too many winning trades.
2. The stop must be set tight enough to protect you against a severe loss.
If you have traded for less than a couple of years, I suggest you start out with an initial
stop of 7Vo to 9Vo, a stop recommended, notably, by Inaestor's Business Daily fotnder Wil-
Iiam J. O'Neil as part of his successful CANSLIM strategy.

As you become more adept and experienced in your trading, you might tighten or
widen your stop in an attempt to squeeze higher risk-adjusted returns out of your trad-
ing. But be wary of the temptation to tinker. It takes a track record of many trades be-
fore you can draw conclusions about your risk-reward profile. New traders should keep
things simple. Use a fixed stop and focus on executing your stock selection, timing and
money-management strategies with as much discipline as possible.

This concludes our discussion of the initial protective stop. The aim of this stop is to
force you out of a new position at a small loss in the event the market moves against
you. But how do you handle a position that has run up a substantial profit? At some
point, you should switch to a trailing stop. A trailing stop follows your position in price
and, if violated, will force you out at breakeven or at a profit, depending on the size of
your profit. This subject deserves a chapter all its own, which you will find elsewhere in
this book.'

Another word of advice for new traders: Stay off margin, which is borrowing from your
broker to take larger positions than allowed by the cash balance in your account. Margin
can boost returns, but it also raises risk.'

MATHEMATICAL OUTGOME
Your initial protective stop defines your maximum loss before you pull the plug on a
position. How much money you are willing to lose on an individual trade depends on
the amount of money you expect to gain from a trade. At bare minimum, your win-loss
ratio shouldbe 2:'!., or 2. In other words, Iet's say your average gain over the course of a
hundred trades was 25Vo and your average loss was 9Vo. That yields a win-loss ratio of
about2.78.

The win-loss ratio, however, tells only part of the story. To fully calculate your trading
performance with a given stop, you also must factor in the percentage of trades that end
in a positive return. By combining your winning percentage with your win-loss ratio,
you can derive your mathematical outcome. Here's the formula for mathematical out-
come:

(1 + Win-Loss Ratio) x Winning percentage - L= Mathematical outcome


Assume that you had a 2.78 win-loss ratio, artd 40Vo of your trades resulted in gains (so
50% ended in losses). Your historic mathematical outcome would be about 0.5. The
higher the number, the better your overall performance. The lower the number, the
weaker your performance. A negative number means you are losing money.

After you have enough trades under the belt to calculate this figure, you can run hypo-
thetical results assuming a tighter or looser stop (or different rules for holding and sell-
ing your winners). This self-evaluation will help you spot problems in your trading. For
instance, you might discover you are holding losers too long or selling winners too
soon, or letting big winners turn into losers, etc., etc.

ASYMMETRIGAL LEUERAGE
Even if your stock selection is highly accurate, tempting you to loosen your stop to stay
in more eventual winners, I recommend against widening your stop to more than 10%
per trade. The greater you widen your stop, the more you suffer from asymmetrical [e-
verage.n In this case, asFrunetrical leverage means that as a trade declines in price, its
ability to recover from that loss deteriorates even more rapidly. For example, let's say a
stock falls L0% below your cost. That stock must increase about 11..7% in price to break
even. A20% decline requires a25% recovery. A50% decline requires a100% recovery.
As you allow a position to deteriorate, the percent to iecover increases at an exponential
rate.u

There's no recovery, of course, from a 100% decline in price. And if you fail to cut your
Ioss on a margined position, you could conceivably wipe out more than your account
balance. You could end up owing the brokerage money to boot!

3. POSITION SIZING
Stops limit your risk per trade. The risk-minded trader also takes steps to limit the risk
any trade poses to his or her total account equity. This is the heart of position sizing.
There are a variety of forms of position sizing. I will discuss a form of fixed fractional
money management. The approach is easy to understand and combine with your initial
protective stop regime.

The principle behind fixed fractional money management is simple. Never allow the
loss on an individual trade to exceed a fixed fraction (fixed percentage) of the total value
of your account at the time you initiated the trade. I recommend that you fix your maxi-
mum loss per trade at no more than 2To of the total value of your account. New traders
probably should limit their maximum loss per trade to l% of initial equity balance, a
level that suffices for many successful veterans.

This discipline sets an upper limit on your position size once you combine it with your
protective stop regime. Imagine that a hot-Iooking stock has caught your eye. How
much stock should you buy? Assume you start out with an equity balance of $100,000 in
your account. Under your money-management regimen, you hold losses on individual
trades to lVo of account equity. So your maximum loss per trade comes to $1,000
($100,000 x .01).

You also happen to use a SVo inltral protective stop. In other words, you will let the mar-
ket move no more than SVo against your position before you will sell your new buy (or
cover your short).

To determine your position size, divide your maximum loss per trade by your percent-
age stop. So $1,000/.05 = $20,000. Your position size is $20,000. So if you bought your
target stock at, say, 40 a share, you would buy 500 shares. Under your 1Vo initial protec-
tive stop, you would sell if the share price dropped to 38 a share, which would corre-
spond with a lVo drawdown on your total equity balance as well as a SVo price decline
in the individual stock.
To reprise, here are the position-sizing formulas:

Account Balance x Percentage Loss (.01 to .02) =


Maximum Loss Per Trade (in dollars)

Maximum Loss Per Trade/Initial Protective Stop


= Position Size (in dollars)

A combination of position sizing and protective stops will reduce, though not com-
pletely eliminate, the risk of a severe lbss. Anyone who holds a stock overnight still
faces the danger that a buy could gap down or a short could gap up in price, breaching
the protective stop. Position sizing limits the damage such an event will inflict on your
account.

4. MAXIMUM POBTFOLIO RISK AND BECAPITALIZATION


Trade long enough and a time may come when the market turns against you, stopping
you out of every position in your portfolio. Under the most bullish conditions, limit
your maximum portfolio risk to 20%. In other words, under your mix of initial and
trailing stops, your maximum drawdown would be 20Vo of total equity if the market
stopped you out of every outstanding position. If you are trading in a dicey market (for
example, leading stocks look extended or are selling off on good news), pull in your
horns. Throttle back your maximum portfolio risk to around 10% to 15%.

The 20% maximum portfolio risk also sets a speed limit on how quickly you size up
your bets after your portfolio has risen in value. This is called recapitalization, using
profits to increase the equity baseline from which you calculate your maximum loss and
position size.
Imagine that you have an account balance of $L00,000, and you use a maximum loss per
trade of lVo of total equity, or $1,000. Thanks to successful trading, your account equity
appreciates above the initial value of $100,000. At what point do you raise your maxi-
mum loss per trade to reflect 1% of. the larger account balance?
A good rule-of-thumb is to recapitalize after you have grown the account value by 1.5
times your initial portfolio risk. So if you started with $L00,000 and set your maximum
portfolio risk at $20,000 (20% of $100,000), you would recapitalize once you had booked
$30,000 or more in net profits (L.5 x $20,000).
Let's say your new total equity reached $1.30,000; your new risk parameters would run
thus:

Assuming 1% maximum loss per trade, dollar value of maximum loss per trade: $1,300.
Assuming 5% initial protective stop, maximum position size: $26,000.
Assuming 20To ntle, maximum portfolio risk: $26,000.

ENDNOTES
1. Probability formula:

E=1.-(1-P)^n
6 = probability of an event occurring in a given number trials (e.g. trades); n =
number of trials (trades); p = probability of the event occurring in a single trial
(trade); ^ denotes an exponent. Assume the risk of ruin in one trade is 1,% (0.01),
and you trade 25 times. The formula runs thus:
E=t_(1_0.01)^25
E = 0.222778641., or about a 22To risk of ruin in 25 trades.
A complete strategy also requires a system for taking profits on your successful
trades. For a discussion of this topic, see the discussion of trailing stops in
Chapter 2, page 46by Mark Boucher. Intermediate-term traders also may find
illuminating Dave Landry's treatment of position management in Chapter 2,
page 30. Be aware, though, that Dave is a su.ting trader and operates over a
shorter time frame. Depending on your risk tolerance, you may need to widen
his stops to accommodate the greater volatility encountered in intermediate-term
trading.

3. SeeKevin Marder's "Intermediate-Term Time Frame," in Chapter 3,page76 for


money management with margin.

11/(L - percentage loss)] - L = Percentage gain to recover loss

For example, a loss of 20% requires a gain of 25% to recover: tl / (1 - .25)l - L=


.25

The relationship between percentage loss and percent to recover is illustrated in


"Controlling Risk and Capturing Profits" by Dave Landry, Figure 1..L, page L0.
CHAPTER FOUR

Special Topics in
Money Management

So. now staying aliae in the markets. If you put it all into
rue'Tte couered the basics of
practice along with a oiable strategy for identfuing setups, you haae the basis for
suruiaing and thriaing as a trader in these crazy markets. But still, we'oe only scratched
the surface of the wisdom that is aaailablefrom the top traders on money management. In
this section, we'll open up thefield on money management concepts that traders need to
grasp in order to stay in business and thriae oaer the long haul.
THE POWER OF PUTTING THE PIECES TOGETHEB
By Jeff Cooper

Preparation is an essential component of successful trading. When you prepare properly,


you will haae your escape plans in place and not be ooerwhelmed by the tremendous flow
lff
of information that streams in eoery day. So sayeth master trader Cooper in this short
gem.

One of the most frequently asked questions I hear is, "As a short-term trader, how do
you select setups to trade from the hundreds of possibilities that present themselves
each night?"

Let's start with the assumption that we all agree on the importance of focusing on a
handful of potential setups prior to each trading session. If we don't focus, we run the
risk of becoming overwhelmed and confused; by ttying to see too much, we often end
up seeing nothing.
1. You can only stalk so many trading candidates successfully.

2. You must adhere to the "Holy Grail," which means sticking to a routine screen of
a universe of stocks each evening. Being prepared is critical. Someone once said,
"aLot of work creates luck," and I believe this is very true for short-term trading.
[n trading, the risk of becoming overwhelmed is huge. There are so many potential trad-
ing choices, so many indicators and so much noise. That's why I concentrate on a dozen
or so stocks that meet certain price-based criteria.
More importantly, when multiple pieces come together-that is, when different signals
point to the same trade-a greater-than-average likelihood of follow-through exists.
As important as controlling your losses when a stock moves against you, is controlling
the amount of time you're willing to wait for something favorable to happen, when a
stock doesn't immediately do what you expect.
SETTING TIME STOPS:
Knowing When to Exit Drifting Positions
By Brice Wightman

During thefirstfew years that I traded,l was uery actiae in options. Options present a
aery formidable challenge in that their aalue will decay as they get closer to expiration. So
not only do you haoe to find stocks that are moaing in a particular direction, but you also
haue to make sure they're going to moae at aery high aelocity in that direction. After afew
years, I migrated to stocks, ETFs, and sector funds, but I truly belieue that my experience
in options trained me to be a better oaerall trader because it's giaen me a powerfal
awareness that when I'm in a trade, the clock is ticking. Brice Wightman has been inaolaed
in thefinancial marketsfor 1.4 years both as a trader and as a consultant on the brokerage
side. He's just as nware as I am about the importance of watching the clock when you're in
a trade. Here's his take on the subject.

You've entered a position on the basis of a good-looking setup. You know that most of
your past winning trades have tended to move right away. You watch, but this one stays
flat, not just for a few bars, but for hours. You end up holding the position overnight be-
cause you believe in it so much. TWo weeks later, with the position still drifting, you're
wondering what to do.
Sound familiar?

Suppose you bought Robert Half International (RHD on the gap breakout, and watched
the stock drift.
FIGUBE 4.1

1'.
Daily chaft of Robert Half lrrternational (RHII

hreakout

r|'
t1 *r[[r,[[t
/

,000,000

19 26 10 17 24 31Auq 7 14 21 28
@2000 Quste.com,

Originally designed to be a daytrade, the position has gone nowhere for two weeks, and
all of a sudden you're a swing trader.
How do you decide when to pull the plug?
Whenever you enter a trade, you should anticipate and have a Plan B, Plan C, Plan D,
etc. for all possible outcomes. Where is the trade going? What are your expectations?

Think in terms of your upside, as well as downside potential. Many traders use a mini-
mum risk/reward ratio of 2:'1, as a guideline, i.e., willing to risk $L to make $2. (This ob-
viously doesn't mean you have to exit with a $2 gain, it is simply used as a rationale for
taking a trade or not).
Risk/reward profiles vary with each setup. Consider the head-and-shoulders pattern in
Genentech (DNA). Calculating twice the distance from the top of the head to the neck-
line, you'd look for a target price of between $60-65; in fact, this setup worked beauti-
fuI1y, making a low of 64. A rally above the neckline would have been a clear warning
to get out.

FIGUBE 4.2

trally chart sf Genentech lnc, {ENA}


i
;

head ', riq!t shpul!er

t# i
1

,000,000

5 11
28 Sep 2g 16 23 30
@ 2000 Suute.com, lnc. Oct

Or look at the breakout from a pultback in Figure 4.3. On the pivot from the pullback,
you could reasonably expect a swing move several points above the previous highs. On
any failure, however, you would want to get out quickly'
FIGURE 4.3

of Boein g

1[tr[1,]rr,
1

-1
l

,*"rll l
:

,'

10,000,000

,000,000

21 28
Guote.com,lnc.

IT'S ABOUT TIME


Life would be rosy if aII you had to think about was the upside, but trading requires
you to think more deeply than that. Obviously, when you enter a position, you tempo-
iarily tie up capital that could be used for other trades. The opportunity cost of entering
one irade G tnat you can't simultaneously enter another. In this case, you have a drifting
position tying up precious trading capital that could be used to make money.
Keep in mind, any time you enter a position, several factors determine your risk in any
trade:
L. size of position
2. volatility of underlying security
3. pre-determined stop orders
4. time in market
One of the main premises behind daytrading is minimizing time in a given position and
avoiding day-to-day price gaps. When you hold a position ovemight, you're ignoring
this corrcept. By increasing the time in a position, you're automatically increasing the
probabitity
-only the trade will blow up through bad news, overall market action, etc. Not
this,-but the mental energy expended worrying about a drifting position is a real
drainer and can temporarily hurt your trading.
A good way to put yourself in a more time-critical state of mind is to consider the plight
of itre options buyer. He must not only be correct on price movement, but within a spec-
ified time. Time value is constantly decaying, making the position increasingly risky.
During the last two weeks before expiration, time value erodes very quickly. Option
buyers must look for especially explosive setuPs to overcome this disadvantage.
Thinking in these terms, a position held a couple of weeks seems pretty risky.
On stock trades, Ilike to imagine that every trade I put on has an expiration to it.
Usually the expiration is tied to some pattern that has given me an entry. I look at the
pattern and, sublectively, estimate how much time would need to pass before the pat-
iern is invalidated. This expiration varies from pattern to pattern and also is adjusted on
the basis of market technicals. Sorry that I used the word "subjective." Many people in
this business hate it. But I have spoken to a number of professional traders about this
and they, like me, do not have any specific parameters they use because there are many
variables involved in determining the length of time they'll sPend in a trade and it's
simply not as cut and dried as setting price stops. But I have accomplished my Purpose
in tirii article if I get you to become conscious of the risk exposure that comes along
with the amount of time you spend in any given trade'
Of course, if you're getting antsy about the length of time you're spending in a trade,
you can tighten your stop-Ioss instead of exiting the position outright. This will allow
you to hang on to the opportunity in case the Cavalry rides in to save the day'
Picked correctly, your setup should become profitable soon after entry. If it isn't, try rais-
ing your protective stop; move it up to force a trade on a downtick. Or try a sell stop
orr" o. two ticks aboue tie ask. (Be careful the stock suddenly doesn't swing and you end
up selling twicel)
Some ideas:

. If it doesn't feel right, get out.

. Pretend it's an expiring option.

. Adjust your stops to force a trade.

In general, you should immediately get out of a position that's not moving. Many times
it just doesn't feel right and the decision is easy. It usually means there is something
*io.,g with the stock, and you don't want to be in it when it breaks down. That doesn't
mean, however, that the sefup won't work out later.

Sometimes stocks do a "head fake" before following through with the anticipated move.
Many times, the second trigger is the real thing and you're back for a second-entry.
Being a good trader is not just about trading-it's about watching, waiting and patience.
Keep in mind, though, that there are two kinds of patience: smart and stupid.

Smart patience is waiting for just the right setup; stupid patience is wishing and hoping
a position will move.
THE ART OF PROTECTING LONG.TERM PROFITS
By Daniel P. Delaney

One group of people you' d think might not haae any use for rnoney-management
strategies are inaestors who buyfor long-term gains. Thisfallacy may be taught at major
unksersities and perpetuated by self-proclaimed emerging-technologies gurus, but I doubt
that this philosophy will get many endorsements during a prolonged bear market. Dan
Delaney explains how "buy-and-hold" inoestors can use some simple tools to protect
themselaes while maintaining their long-term outlook.

\rVhether you are a daytrader or a long-term investor, the last thing you want to have
happen is to lose your hard-won stock gains. IA[hile protecting profits is paramount to
any short-term trading strategy, many long-term buy-and-hold investors often assume
that they should avoid any technique that smacks of "trading" in their long-term ac-
counts. Unfortunately, this often includes taking advantage of basic money-management
techniques.

But by just looking at the increased volatility in the past few years, a long-term investor
might be able to protect gains by adopting more of a trader's mentality when it comes
to his or her portfolio. In fact, using some trading basics and common sense, a
buy-and-holder will not only protect himself from some gut-wrenching plunges, but
also enhance his returns.

All of this while still maintaining the buy-and-hold philosophy.

BACKGROUND
Following nearly two decades of a booming stock market, the "buy-and-hold" mentality
has served many traders and investors quite well. [r fact, many market strategists be-
lieve that such a resilient market has spoiled most market participants to the extent that
they have forgotten that "risk" accompanies all of the "rewards" that the market has
generated in recent years. Average annual returns over the past 10 years have averaged
an annual 1,8.2% in the S&P 500, and that is nearly double the historical11.3Vo average
annual return for the period from 1925 to 1999.
The Crash of 1987, the pre-Gulf War plunge of. 1990, and the quick and painful market
meltdowns of Octobers 1997 and 1998 all bounced back rapidly enough to prove that
quite often, the best strategy during those sell-offs was to "buy and hold" or even to
"buy the dips." But while the old adage about how trees don't grow to the sky reminds
us that markets do not rise forever, the past twenty years has shown that while those
trees may occasionally fall, they usually bounce right back.

As Figure 4.4 demonstrates, the last five years have been particularly rewarding for
long-term Nasdaq investors as returns have greatly exceeded historical performance.
FIGUBE 4.4

Monthly Chart of the


Nasdaq Com posite [COM P{

|tq

000.00

The difficulty of market timing has also reinforced the buy-and-hold mentality since it is
tough, if noi impossible, to call market highs and lows with precision. The market has
had a built-in upside bias that has almost guaranteed that if you wait long enough, the
averages will rise and grow exponentially as returns compound over time.
Buy-and-holders have the power and magic of compounding on their side._ So, patience
,r,d doirrg nothing other than adding money when the market dips has often been the
wisest thing for a trader or investor to do.
WHY CHANGE STRATEGIES?
So if buy-and-hold works so well, why should anyone with a longer-term focus consider
operating in the markets differently? After all, this philosophy is the trademark of leg-
endary investment geniuses like Warren Buffett, so if it isn't broken, why try to fix it? To
answer this question of why a buy-and-holder might alter his or her strategy, we just
need to look back at what occurred in the bear market of 7973-74 as well as the painful
plunge the Nasdaq took in 2000 following its March 10 peak of that year. Simply put,
large, year-afteryear gains bring about a complacency that can pose huge risks for any
trader or investor that ignores the inherent dangers in overextended markets. Sometimes
it's just plain smart to sell.
The 1973-74 bear market lasted an agonizing22 months as the S&P 500 lost 48Vo. Many
of the "go-go" stocks that led the bull market preceding the bear market never came
back and their painful legacy was enough to keep the market miserable for the follow-
ing eight years. It wasn't until the inflation of the late 1970s ended with the 1981-82 re-
cession that stocks managed to resume their upward trend.

Obviously, the second, more recent event that might make you reconsider a strategy
shift was the market meltdown of 2000. Fueled by a dot.com-driven, technology and
Internet mania, the Nasdaq finished 1999 up a scorching 85% and then charged into the
new millennium adding another 26% by the time it peaked intraday on March 10, 2000
at 5132.52. What followed was a painful, 40% collapse that took the Nasdaq down to
3042.66 on May 24,2000.

Another problem with 2000 was that stocks failed to bounce right back like most people
had expected. By the end of October, nearly eight months after its peak, the Nasdaq was
still hovering underwater just above 3000. Two summer rallies had fizzled, and for the
first time since 1.973-74, fhe buy-and-hold crowd was hurting.

..BUT STOCKS ALWAYS BOUNCE BACK''

Traders and investors throughout the 1980s and 1990s could count on stocks to always
bounce back from frightening sell-offs, and they grew accustomed to seeing this usually
within a short amount of time ranging from one to three or four months, The free fall of
October 1998 demonstrates the type of resiliency traders and investors had come to ex-
pect. From its July 21.,1998 peak of 2028.1.8, the Nasdaq plunged a harrowing 49Vo to its
intraday low on October 8,1998.
The dramatic faII followed a wave of collapsing Asian and Russian currencies, a threat
of global deflation, and the demise of Long Term Capital, a giant, highly leveraged
hedge fund. Despite being run by Nobel laureates, Long Term Capital had to be bailed
out by the Federal Reserve and most of the largest Wall Street Brokerages. It seemed for
a couple of days that "The End" had arrived for the capital markets.

The Federal Reserve immediately set in motion three interest rate cuts that flooded the
financial system with liquidity and helped calm the world-wide financial panic to the
degree that by November 30, just seven weeks latet the Nasdaq had bounced back to
2023.66.It was almost as if nothing had ever happened. The only losers from the near
meltdown were the egos of the principal from Long Term Capital and anyone who sold
out stocks at the bottom.

BOUNGES: NO GUARANTEES
The buy-and-holders strategy worked tn 1998, as well as in countless other plunges
through the 1990s, but the painful market of 2000 suggested that "buy-and-ho1d" could
instead have been be called "wait-and-lose." You have to wonder whether there are
strategies to follow that could protect your long-term holding from some of the vicious
sell offs that we so often see. Likewise, any investor. with a soiid, long-term portfolio
would probably like to have a strategy that would allow him to survive a prolonged
bear market like 1973-74, especially if years of accumulated gains are at stake.
Looking below at the weekly chart for the Nasdaq, you can see the bounce back from
the 1998 lows as well as the brutal sell off in April of 2000. In the first case, stocks
bounced right back, but in 2000, anyone waiting for the quick bounce got a sense of
what 1973-74 was like.

FIGUPE 4.5

Weekly Chart of the


Nasdaq Com posite [$COI''4 P)(I

Z0GWeek l'14

Jul Oct Apr Jul Oct Arr Jul

While I am not discouraging the buy-and-hold philosophy, I think it is worth suggesting


that a longer-term investor can enhance his or her returns by adopting a more aggres-
sive trading mentality in order to profit from the extreme swings in market volatility
that seem to blow through the financial markets once or fwice a year. What follows are a
few trading techniques that might help you to sleep soundiy through the inevitable mar-
ket firestorms that will come your way.
HANDLING UOLATILE MARKETS
Let's face it. Volatility is here to stay. Back in 1990,It was rare for the Dow, Nasdaq or
S&P 500 to ever move more than lTo or 2% n any given day. By 2000,2% or 3Vo swings
are typical on any given day and 47o or 5To intraday swings have become "normal" for a
volatile day. IAIhile the Nasdaq Composite may exhibit these big price swings, many of
the individual issues within the average might experience intraday moves of 10To or
20Vo on any given day.

Over the course of a year, even the leading Nasdaq stocks like Microsoft, Cisco, latel or
Sun Microsystems might go through extreme short-term downdrafts of once or twice a
year. Despite being the leading blue-chip techs, they still get caught up in the increas-
ingly volatile market swings. So, if the top-quality names get tossed around in a
multi-year bull market, what happens to them in a multi-year bear market? Or worse,
what happens to the second-tier companies? Even a buy-and-holder looking to hold
"the leaders" over the long term, probably should re-think the strategy that has worked
so well over the past decade.
LOVE 'EM . . . AND LEAUE 'EM?
It's easy to love the long-term buy-and-hold performance of a company like Cisco Sys-
tems (CSCO). A $10,000 investment in Cisco in mid 1995 would have grown to more
than $100,000 by early 2000 as the company, quarter after quartet, crushed earnings esti-
mates and either bought up or buried its competitors. If any stock could be the poster
child for the buy-and-holders, it was Cisco.

FIGURE 4.6

Weekfi Chart of
Cisco Systems ICSCO]

Apr Jul Oct Apr Jul Oct 1000


Jan Apr Jul Oct

While Cisco might have been a great buy-and-ho1d, there's no question that there were
many occasions when Cisco presented tradable opportunities over the years, and had a
buy-and-holder recognized those times, he may have been able to increase his Cisco
holdings near the lows or even sell Cisco and buy it back much cheaper later. With this
strategy, then, there are times when it might be best to leave one of your long-term stock
favorites, lock in some profits, and move on to a new opportunity, at least until one of
your favorites looks attractive again. The problem for the typical buy-and-holder is that
knowing when to sell is often one of the most difficult decisions to make.

MACBOECONOMIC SELL SIGNALS


With your longer-term winners, you can base a sell strategy on both experience and
common sense. Year after year, it seems there are periods of market euphoria, which are
followed by periods of fear. Each period usually moves to the extreme before the next
period assumes control and takes sentiment to the opposite extreme. These moves tend
to result from changes in the business cycle and interest rates, which act as the catalysts
for market shifts.
So pay homage to that old saying about not fighting the Fed. Regardless of how great
one of your companies is, or how bright its earnings prospects, it will never be com-
pletely immune to Fed interest rate hikes or an overall bad market. Since bad markets
often occur during times of rising interest rates and subsequent decreasing corporate
earnings, it makes sense to base your profit protecting strategies on macroeconomic
changes. Historically, whenever the Fed sees an overheated economy and raises interest
rates several times, stocks usually run into trouble. In the past 70 years whenever the
discount rate has moved above 6T0, it has usually triggered declines in the stock market
that preceded sharp slowdowns in the economy. Keep this in mind because regardless of
how great a stock is, it can be vulnerable in this kind of environment.

Always Remember: Don't Fight The Fed.

Seasonality also seems to play a ro11 in this equation, with stocks often having trouble in
the late-summer or early fall. The thing to remember is that when the overall market or
a specific sector turns sour, you rarely can avoid being dragged into the troubles. Lr both
L998 and 2000, as the Nasdaq sold off sharply, it was often the market leaders that caved
in or capitulated last.
To show you how the best of them are vulnerable and how long-term investors may be
subject to getting faked out, let me show you the case of Intel. The Fed started raising
interest rates in early 1999 and this series of rate hikes extended into 2000. As Inte1
shows in Figure 4.7, it held up relatively well in the April 2000 sell-off and actually
moved to new highs late in the summer.
FIGUBE 4.7

Weekly Chart of
lntel Corp. [NTC]

1998
Oct Jan Apr Jul Oct Anr Jul Oct 2000
Jan Apr Jul

But even Intel could not hold up when the summer rally fizzled out. Long-term
buy-and-holders of Lrtel thought they were exempt from the market turmoil of 2000. But
nature eventually ran its course. During a market sell-off the leaders like Intel fall, but
they are often the last ones to do so. Keep in mind the Fed was raising rates and that
should have been the red flag for long-term investors. No matter where you are/ you
can't hide from the Fed.

In the Fed's quest to cool the economy, higher interest rates lead to a higher cost of capi-
tal and a higher cost of capital prevents many companies from expanding. If companies
can't expand then they tend not to buy as many new computer systems. And if they're
not buying new computer systems, then Intel's earnings get whacked. So even a com-
pany as great as Intel is not immune to interest rate hikes.
FIGURE 4.8

Gap Dor,vn
And Weak
Close Are
70
hd-'"*=
Break 0f Trendline 60
At End Of Base ls First lntel Repcl-ts An
SigpalOf Top Earninp *rcrtfall
And Getsltftrad<e
Daily Chart of 50
,lntel [NTq Five Qr $x Big
Analyss Do,vng'ade
The Stodr The Dry
2for1 fftgThe 40
Volume Nme: Volume ls *a,ved DueTo
The H up Arrpunt On Day Of The
Anno-rned EarninpWaming

1 8 15 22 30 5 121928 3 2
MaT Jun Ju Aufl Oct
Crc*cd whh Odrartr

BREAKING LONG.TEBM TRENDS


Another way to protect profits of your winners is to track the long-term trends of your
top stocks. Yes, you may be in them for the long haul, but there are times when they
lose their attractiveness on a technical basis. Say for example your long-term position is
performing well, but there are earnings warnings from competitors or it looks like the
Fed will continue to raise interest rates. These factors might weaken your stock on a
technical basis, and it's that weakness that might signal you that there are potential
problems on the horizon.
If a stock breaks a long-term trend, it should alert you that something may be wrong
with your stock or its sector. As Figure 4.9 demonstrates, JDS Uniphase began showing
signs of a broken trendline in December 1999. \tVhile it did bounce back, it eventually
broke back below its trendline in late March and early April.
If you had ridden the stock from 40 to nearly160, the second trendline break should
have suggested that perhaps it was time to take some profits. In addition, the stock
breaking below its 50-day moving average might also have helped you realize that the
stock had entered a vulnerable realm.

FIGURE 4.9

Break Beto,v Trendl ine and {60


Daily Chart of SGdry MA ls SignalThat
JDS-Uniphase [fDSU] Trend ls Posibly

120
,,nflq4,

rll,il

80
SGdayMA 200-d4y l'14

line Break; 40
Fosible Exit Foint
(Sock Recqvers).. 2for1

If you have unrealized gains on your stock, it might be worth locking in some of those
profits if the stock breaks a long-term trend. Remember, it's the small losses that can
turn into bigger losses, so keep an eye on trends. Even monitoring weekly or monthly
charts can help you more clearly see if a stock breaks a one- or two-year trend and
threatens to evaporate your gains.
MOVING AUEBAGES
Another area to look for key levels of support are moving averages. Many traders and
fund managers closely follow the 200-day moving average. It is an average that allows
you to clearly see a stock's overall trend, and it can also serve as a signal of when you
might want to lock in and protect profits on some of your longer-term gains.
The attention that institutions pay to the 200-day moving average makes it one of the
key technical indicators that any long-term investor should be monitoring. Mutual funds
will often unload large blocks of shares when a stock dips below its 200-day moving av-
erage. Once the average is breached you will often see accelerated plunges. The techni-
cal damage is such that it can take a long time for a stock to recover. Do you really want
to be sitting on the Titanic as it is sinking all for the sake of sticking with your
buy-and-hold philosophy?
So this is why you will often find support or resistance at the 200-day. So many big
players are watching that average. Likewise, a rising stock might find resistance at that
same 200-day average and would attract buyers once it moved above it.

Thke a look at Figure 4.10 f.or an example of how to use the 200-day moving average.
Notice how Cisco bounced back after touching its 200-day moving average in late May
and in early August. That said Cisco remained intact for the time being, but it still
looked somewhat weak.
FIGUPE 4.1O

Daily Chart of
Cisco Systems ICSCO]

?fw 1
IrPr

What a decline to a 200-day moving average tells you is that a stock is under pressure
and once it penetrates the average, it's kind of like the stock has broken into new
ground. In other words, the stock is vulnerable. If a stock crosses below a 200-day aver-
age, and that move is in conjunction with other warning signs like a broken trendline or
even a deteriorating broader market, then you could consider locking in some profits.
As Figure 4.11 shows, the stock broke below its 50- and 200-day averages but then man-
aged to bounce back up to as high as 115 on March 24. But since Microsoft had spent a
few days below its 200-day moving average, it was obviously a stock having problems.

FIGURE 4.11

Daily Chart of
Hicrocoft [1'4SFT]
il

I[[

ZBdry l'1A

SGdayl'1A

27 1024
Jan
7 22G 20 3
2000r
17 {
Mar Apr Mav Jun
1530{226{024 72
Jul Auq

The Microsoft late March bounce weakened and failed to reverse the stock's downward
trend. The stock gapped down below its 200-day moving average on April 3 following a
negative antitrust ruling from the Department of Justice, and the stock subsequently col-
lapsed.

Microsoft is a great company and will likely regain its old highs, but for the long-term
holder, it can be an agonizing process. For this reason, it might be worth using a more
proactive approach to protecting gains. After all, as the chart shows, by October,
Microsoft had given back two years' worth of gains as it languished at its iowest levels
since October 1998.

BLOW-OFF TOPS
Another example of a time to possibly lock in profits would occur if you are ever fortu-
nate enough to own a "must own" stock that launches into a parabolic or nearly vertical
rise in price because the company made some magical new technology breakthrough or
because an overzealous analyst slapped a sky-high price target on the stock.

Remember, once everybody owns a stock, the stock has nowhere to go but down. This
isn't because anything really changed in the company, but rather, it's because every mo-
mentum trader, mutual fund manger, and mom-and-pop in the world is in the stock'
There is simply no one left to buy it, so it falls. This happened in late 1999 with wireless
giant Qualcofiun.
Thke a look at Figure 4.12. Several factors came together in late 1999, that launched
Qualcomm into outer orbit. It was in the red-hot wireless sector, the overall stock market
was booming, technology gurus were praising the Qualcomm, and finalty, a Wall Street
analyst gave the company a pre-split target price of $1000 per share ($250 per share post
split). A massive buying frenzy ensued, and the stock shot to the moon.

FIGUBE 4.12

Daily Chart of 200


Parabdic l'1ore is Qualcomm [QCOI',|]
Unsu*ainable; AJI
Good Thinp l'lust
ComeToAn End
5Gdqy I'1A

I
-&q
,llyil'-,,,,'[
,f -t' 2Bdry l'14

4for1
Itl is dedin:ing asQCOt l'goes into"hl61a:sffl' pealr
---llr ,000,000
7204181{
Sep Oct Nov Dec
t17 1 15 3012 2610
Apr Mav Jun Jul

Anyone holding Qualcomm for an extended period of time, or even from those
post-split $50 levels was ecstatic. For anyone with a longer-term outlook, the red lights
should have been flashing. \AIhiIe the company continued to have great prospects, it was
caught up in an unsustainable vertical ascent, and the smartest thing to do was to im-
mediately prepare to lock in a least some profits.
What you should look for on these rocketing stocks are signs that the upward momen-
tum is stalling out. Volume is the key here because as long as volume is surging highea
it tikely means the demand for the stock is still intact. If the stock continues higher on
decreasing volume, then look out below. Once the stock closes lower on surging volume,
then that usually means the blow-off top is in place. This suggests that the stock has lost
its upward momentum and is vubrerable to the downside.

Again, while Qualcomm is likely a great long-term company, it also shows that there are
times when even the best companies sometimes make moves that suggest that some
profit-taking might be in order. Notice also that Qualcomm further collapsed in May af-
ter it broke below its 200-day moving average.

PROTECTING PROFITS
It's hard enough to just identify the leading stocks that might become the solid,
long-term, profitable candidates in a portfolio. For that reason, if you do find one of
those Cisco-like gems, keep in mind that no company is a long-term, sure thing any-
more. ]ust look at the wreckage from some "sure things" of years past.

The bull market that preceded the 1973-74 bear market was led by "Nifty-fifty"
standouts like Polaroid and Xerox, which were the Ciscos and Intels of their day. Each
now trades in single digits today at their lowest levels in nearly 10 years.
IBM is another example of a "must-have" buy-and-hold that was a star performer for
decades. Once it peaked in August of.1987, however, the Crash followed and IBM didn't
see those 1987 levels again for nearly L0 years.

More recentiy, the year 2000 troubles at Microsoft, Dell, AI&T, WorldCom and Lucent
show that no matter how big or how powerful, no company is invincible to the con-
stantly changing technology, market forces, and investor sentiment. For this reason/ now
more than ever, traders and investors must remain vigilant and protective of their prof-
its. After all, protecting profits is an art that any serious participant should attempt to
master.
GHAPTEB FIUE

The Mental Side of


Money Management

FIUE WAYS TO PBEVENT YOURSELF FROM


LOSING YOUR MIND WHILE TRADING
By Eddie Kwong

Money management is notfun. But it is necessary. Now that this bookhas guided you
though the basics,'ue can turn our attention inward and ask: Okoy,how do I get the
discipline to stick to my money management plan? Here's my approach.

The fact is, taking small losses and letting profits run is hard to do psychologically. We
all get good feelings from winning and bad feelings from losing. So it requires mental
discipline to inflict short-term pain on ourselves even when it's what we have to do in
order to stay in business. It requires mental discipline to delay the good feelings you'll
get when you sell a position right now, and allow a stock to rise, enduring some volatil-
ity along the way in order to let the position become as profitable as possible.
To me the solutions are pretty simple.
I'm no expert on psychology but I have been a trader for about 20 years. I know how
my mood can affect my judgment, so I don't trade when I'm in a bad mood-instead I
play video games. I know what it is to trade in a disciplined fashion and I've also felt
the pain of doing incredibly dumb things because I let my guard down. So, these days, I
trade with a small enough amount of money that I don't care whether I win or lose.
That helps me stick with my plan.
These five basic ideas anchor my discipline:

1. Don't get lulled into complacency when you have a string of winning trades.
(Beware of beginner's luck.)

2. Take full responsibility.


3. Focus on the present, not the fufure.

4. Gain your composure by reducing your position size.

5. Be prepared for "the perfect storm."


I don't believe in that "positive thinking" approach that has permeated discussions
about trading psychology. I believe that successful traders are realists. You can a have
"positive mental attitude" taking small losses, but if you don't pay heed to the harsh re-
alities of trading, you will simply laugh your way out of business.

The following section is pretty much what I feel about this whole topic.

1. Beware of Beginner's Luck: lt Gan Be a Dangerous Thing


The worst thing that can happen to any person who's just getting his feet wet as a
trader is to get lucky and have an initial string of winning trades. This tends to happen
in bull markets when the market is moving relentlessly higher day after day and certain
groups of stocks seem to follow suit. So a beginner who has barely opened up a brand
new trading account with an online broker could buy a stock during such a period. And
find within weeks-
"Easy money, just like I pictured it!"
Juiced up with confidence after his initial success, this fledgling trader goes hog wild
and buys more stock. This time, he goes on margin in the hottest, fastest-rising specula-
tive stocks.
This is exactly what happened to a lot of people during the course of the massive bull
market that took place 1998 through March 2000. During that time, relative newcomers
to trading bought stocks in the hot technology sector. They followed the advice of the
technology gurus-the visionaries who prophesied about the industry trends that were
changing the world.

The public saw these stocks go higher and continue to go higher.

As a result, these new traders had no motivation to educate themselves on how to ana-
lyze the market technically so that they'd be able to spot potential problems and-much
worse-they had no motivation to learn money-management principles. During that
glorious period they saw many pullbacks. Every time, the market would snap back into
its uptrend, stronger than ever. Week after week, month after month, as they saw the
market do this and the value of their portfolios skyrocket, they were brainwished and
the strength of the imprint on their brains grew so strong that when they witnessed
gally 2000's nearly 40% phnge in the Nasdaq they were immobilized-clinging to the
belief that the market would come back just as it always did in the past. the margin
calls came and their stocks got sold off with huge losses. Lr many cases, these people
lost far more than their original investment because they had traded on margin.

The lesson from this is that it's important to heed the warnings of veteran traders who
manage to survive and profit over the course of many years. Without exception, they
have a healthy respect for the mysterious and unknowable nature of the mirket. This
makes trading one of the most difficult and stressful professions there is. Therefore,
whether the market environment seems easy or hard, they always maintain a healthy
paranoia about what the market will do next. When things look the easiest, they are es-
pecially on the alert with the defensive strategies that are discussed in this book, such as
stops and trailing stops. They keep a lid on their risk exposure. They keep one foot on
first as they steal second.

2. Take Full Responsibility


Many traders these days are looking for the perfect trading system, the perfect trader's
Web site, or the perfect advisory service. Those who never break out of their obsession
with these sorts of things are, in my opinion, going to be lifetime members of the losers'
club. Here is my creed:

Being a successful trader is like being at the top of any competitive profession
such as sports, business, or the arts-it all depends on getting educated with
top-quality knowledge, acquiring the skills to apply that knowledge correctly,
and having the drive to execute your daily plan over and over again, every day.

How you could possibty think that trading is an exception to this? Let me explain my
own theory in the hopes that it'll have a familiar-enough ring that you'I1 know it's time
to exorcize your own demons.

When you go to the shopping mall and see all the computerized gadgets that are now
available, it's easy to think that machines can do much of our thinking for us. The world
of advanced technology has led many traders, now more than ever before, down the
path of seeking the Holy Grail. That is, they want to find some computerized or mecha-
nized software program or system that spits out buy and sell signals. In mechanical
fashion, you just obey clicking the "buy" and "sell" buttons of your friendly online bro-
keli This kind of money machine has nwer existed in the past. lt doesn't exist today. I doubt it
will exist in thefuture.
Every successful trader I know uses computerized tools. But what they all have in com-
mon is that they fully understand that these tools, in themselves, do not understand the
markets. Rather, their function is to help them understand the markets.

Understanding the markets well enough to make a living buying and selling stocks, fu-
tures or options is a very complicated thing. It is too complicated a task for a computer.
You may have trouble accepting this especially if you have an engineering or medical
background because you've devoted your career to understanding complicated things.
But consider this:

. Think about how easy it is to drive a car to the supermarket. Now-ask yourself why
itis thatDetroithasnotdesigned a computer that does all the drivingforyou? Under-
standingthe markets is certainlymore complicated than driving a car. Seemypoint?

. Or how about if you ask yourself this: Would you consider yourself smarter or
dumber than a computer? Most people would say that they know for sure that
they're smarter than a computer. So why would you let something that is dumber
than you make your trading decisions for you?

It is a mistake to think that you can be out of the loop in decisions that must be made
when you trade. In fact, not only must you be in the loop, you must be at the center of
it. You must make your own decisions in the markets and take full responsibility for the
profits and losses of your trading.
If you don't, every time you have a string of losing trades, you'll put the blame on your
trading tools. You'll go right back into the cycle of flipping through the trading maga-
zines to find the better mousetrap. But I guarantee that you'll never find one smart
enough to drive you to the supermarket-much less make all your trading decisions for
you.

You must sit in the driver's seat and take responsibility for what you see on your
monthly profit-and-loss statement. When you do, you will automatically be dedicated to
taking advantage of every possible opportunity to continually improve your under-
standing of the markets. You will read the good books, attend the good seminars, and
hang out with the successful traders in your town.

When you can look at a price chart and see patterns in the price and volume ac-
tion . . . when you can look at technical indicators, corporate earnings, sentiment, etc.,
make sense out of it all, and decide your plan of attack every day, then you're the one
who's in control. AII successful traders think this way. It's not easy, but it's really the
only way.

3. Focus on the Present-Not the Future


One of the most difficult things for less experienced traders to accept is that the markets
are for the most part unpredictable. Oh, the window of opportunity may open a sliver
and occasionally throw you a no-brainer trade; but this is rare. Most popularly followed
technical indicators and patterns tell you next to nothing about future market action.
Then there are a small handful that give you a slight edge. But there is no tool that is so
reliable that you could bet your entire trading account on it repeatedly and survive for
very long.
Many traders will give good lip service to this and say, "Yeah, you don't have to remind
me. I already know the market can't be predicted." But get a room full of traders to-
gether or eavesdrop on some popular message boards or chatrooms on the Net, and
you'll see that traders are totally absorbed in concocting predictions about what they
think the markets and individual stocks will precisely do in the weeks and months
ahead. The predictions are often in full living color down to the specifics of price levels
and time.
But if you ask veteran professional traders-the very people who know the most about
the markets-what they think the market will do the future, they will typicatly admit
that they don't know. Maybe they'Il talk about what their indicators and patterns are
suggesting for the immediate future and have a grasp upon the possible scenarios. But
you will find that they will not commit to any particular point of view of the future.
They know better than that.

It's human nature to be tense and uncomfortable when the future is uncertain. Con-
versely, it's human nafure to feel good when you know what to expect in the future. So
traders naturally gravitate toward taking the minor directional biases that indicators and
patterns may have and then using imagination to fill in the blanks. They project their
hopes into the future and construct an imaginary, but erudite-sounding scenario of what
the market will do in the future.
The allure is powerful. So predictions sell real well in the news media and with consum-
ers. That's why advisory services have developed a talent for using the right jargon and
phrases to make their off-the-wall prophecies sound credible.

Professional traders know that when they fall into this trap of fixating on a given future
outcome in the markets, this cripples their ability to make good, sound decisions about
current market action. They know that if they allow themselves to become convinced
thatXYZ stock is going to go to the moon three months from now, they in all likelihood
will be lackadaisical in cutting their losses if KYZ plunged today.
In a nutshell, here's how belief in a prediction can mess your trading up:
. You'll feel a sense of relief and comfort that is unwarranted. This will cause you to be
sloppy with your loss-protection strategies if the market contradicts your preferred
outcome.

. You'll tend to hear only what you want to hear and see what you want to see. When
you perform your market analysis or hear the opinions of other people, you'll hear
only that which supports your preferred outcome. Everything else will get filtered
out. The mistakes and resultant misery will multiply.

So accept it. Making predictions is dangerous. When you dabble in this, you can easily
wind up thinking of a highly alluring and plausible version of what will happen. You
can get emotionally attached to it. Once you do, you're locked in. If the market does
something that suggests that your prediction is wrong, you're likely to ignore it. Do this
once and you'll get hurt. Do this repeatedly and it'll cost you your trading career.
The funny and yet sad irony of this is that the trading public is often angered by the in-
tentionally noncommittal comments that professional traders make in the financial me-
dia. That's how uncomfortable they are with uncertainty about the future.

4. Gain Your Gomposure By Beducing Your Position Size


Does the following describe you? You're smart. Your academic record and success in
your chosen profession proves it. You have a great trading strategy that has made other
traders very successful. You have a perfect understanding of money-management tech-
niques and you know what you need to do in order to keep your losses to a minimum
and profits growing steadily.

Yet . . . in spite of all of this, you still lose your composure at the most crucial times and
make mistakes that keep you from succeeding.

What's wrong?

Believe or not, even though I probably haven't met you personally, there's a good
chance that I know your problem and I know the solution to your problem. This is the
case as long as the above description fits you.

The problem and the solution is:

Position size.

Position size is the amount of capital that you're risking in any given trade.

The rational thinking trader usually will adjust his position size in terms of how it plays
into risk exposure. Most strategies of position sizing set limits on it based on the total
amount of available trading capital. That is something that has been discussed by the
great traders in this book.

But there is a very important psychological aspect of position sizing that often doesn't
receive as much attention as it deserves. I would go so far as to say that, for many trad-
ers, the psychological effect of position size is an overlooked, but easily adjustable vari-
able that can make the difference between long-term success and failure.

I have no doubt that this is one of the most powerful but simple things you can address
as a trader to dramatically improve your performance very quickly.
In order to convince yourself of this, I invite you to think back over all the time you've
been trading and consider the number of times you've made incredibly stupid mistakes.

That is, you were in the heat of battle. You had a critical decision to make. You knew
exactly what the right course of action was-but you did something else instead that you
knew was wrong and later on regretted.

You can reflect on the reason and I'11bet it happened because you couldn't resist some
powerful emotion that welled up at that strategic moment. Perhaps it was the fear of
missing out on an opportunity or the pain of taking a loss.

Whatever the case . . . I invite you to consider this for a moment:

Would you haae been able to stick to your guns and do the right thing at that moment had
therebeen no ffioney whatsoeoer at stake? I would aenture to guess that no matter how
many times you'ae made emotionally based blunders in the past, in most cases you could
trutltfully say that you would haae done the right thing.

Have you ever paper traded before and done so well that you felt omnipotent? But then
you start trading with real money and you nosedive before you barely have a chance to
get off the ground?

Or what about those average who make millions in simulated trading or invest-
Joes
ment competitions that have no money involved? Where are they now? Why aren't they
running hedge funds or quitting their day jobs?
Hello? Am I making my point? Do you see that you can have an incredibly wonderful
grasp on all that it takes to become a successful trader and you can play the game well
*itt imaginary money? But once you go to bat with real money and it's the World Se-
ries every day, powerful emotions can wreak havoc on your every decision.
because we love
I don't have to write a doctoral dissertation to explain it. We all trade
money and what money can do for us. Feelings of intense pain and pleasure are associ-
ated with the losses and gains we experience as traders. These are the emotions that
make us do dumb things even when we know better.
There is a solution, however. And it's one of the few times in this book in which I can
say, it's a solution that's easy to implement and see immediate benefit from'

Here it is:
Adjust your position size to a leoel that enables you to think clearly and rationally.

Probably no one has put this concept in a nutshell better than Lewis Borsellino in his
"Gas Tank Rule." Here it is:

How large you can trade depends upon many factors, including your experience leael and,
of course, your oaerall capitalization. Eoen if you haae a large amount of capital at your
disposal, you can't just start throwing around 5 or 10 S&P major contracts (at $250,
times the r:alue of the index, or roughly $375,000 each) as if were just "paper."

As a rule of thumb, l'd suggest the "gas tank" rule. When you trade, you shouldn't think
about the money on the line any more than you'd consider how much money you just
spent tofill up your gas tank. After all, znhen you pull up to the pump andfill up the gas
tank, you'll spend $20 or $30. You mightfeel that pinch when you pay, but after you driae
away, you don't think about that money any longer. lt's simply a necessary cost to driae
your car.

When you place a trade, you should not worry about the money on the line. If you're
thinking about that $500 or $5,000 or $50,000 that you've risked, you're trading too
largefor your risk tolerance and your capitalization.lt talces money to trade. When you
trade, you're putting money on the line, and sometimes the trades you make will be losers.
If the risk-per-trade that you're taking fficts you more thanfilling your gas tank, then
you should re-eaaluate your trade size in light of your capitalization and risk tolerance.

The concept is to find a risk for yourself that does not eoolce emotions and, therefore,
leael
allows you to stay as objectioe as possible so you canfullow your game plan. Of course,
there are others who belieae you need a higher sense of risk and aggressioeness to be alert
and achieae higher returns. While that may workfor some, the most important thing is to
find the ideal leael af risk that will allow you to perform at your best potential, while
keeping your emotions out of it. This balance, I belieoe, will help you become a better trader
faster-without the wear-and-tear on your stomach and personality.

I have a feeling that traders will have to cut back so dramatically on position size that
they may wonder, "Why bother trading?" But I have to respond by asking, "Why bother
trading if all you've got to show for it are persistent losses?" Doing this at least gives you
the opportunity to build your confidence using real money. That's just what you want
because ultimately, this is the very thing that will enable you to execute your trading
plan without flinching, even at times when your emotions are telling you to do other-
wise.

Over time, it may be possible for you to increase your position gradually and get to the
point where it's worth your while.

5. Always Be Prepared For The "Perfect Storm"-


Ir Will Happen
In addition to reading and studying the insights in this book, I strongly recommend that
you take the next step and make money managemelt yqrr number one priority-just as
|t as for every trader who contributed to this book. Most traders spend an excessive
amount of time searching for new and more powerful trading strategies, without tealiz-
ing that it's the risk control they add to their trading that will really enable them to
build wealth over time.
Don't make that mistake.
The markets are complicated. All trading strategies, software and methodologies-no
matter how good, no matter how wonderful the claims, no matter how expensive-ex-
pose you to the risk of ruin.

Maybe you have kouble believing this. Or you insist that a better mousetrap is right
around ihe .o*er. Or it could be that you believe that you already have it because your
trading account has been up six months in a row in spite of the fact you never use
stop-losses.

In the late-90s there were some hedge funds managed by the most brilliant minds in the
world who believed they had developed the perfect trading strategy.
These were the so-called "quant funds" that used sophisticated arbitrage strategies de-
veloped by Nobe1 laureateJ and top physics Ph.D.s. At the time, many Wall Street in-
vestment fi.ms were placing huge bets on them because these were the elite intellects of
the world who, with their-supircomputers, pitted themselves against the same stock
market that their grandfatherJ t aded by reading old-fashioned tickers. They believed
and convinced many others that they had the perfect trading strategy. The strategy was
based on many deiades' worth of accumulated data on the historical relationship be-
tween related issets. When these relationships went out of whack, the computers gener-
ated trades based on the assumption that these relationships would snap back in line
with the historical norm.
The risk was perceived to be minimal because in order for there to be real trouble, a
highly improbable event that had never before occurred in history would have to hap-
pen. Everything would have to go wrong simultaneously.

This perfect storm happened in 1998. It had all the makings of a Hollywood thriller. Ex-
cept that no one would understand the macroeconomics involved. So I won't explain
them here.

But the important point is that these hedge funds were annihilated by a highly improba-
ble alignment of events in the economy. What happened was akin to Goldie Hawn beat-
ing Tiger Woods at golf.
You and I do not have access to the brains or the computing firepower that these hedge
funds had. Yet, we tend to get cocky with our occasional wirming streaks and let our
guard down. Or worse yet, we don't set up adequate defenses in the first place.

It's important to make a habit of thinking realistically about each trade you make. What
do you expect to happen? If things don't go right, what defensive measures will you
take in order to escape alive and well? Trading is one of the most difficult activities to
succeed at. Constantly monitoring and controlling downside risk of every trade from the
moment of execution to your exit is essential for your survival and, ultimately, your suc-
cess.

Going forward, I encourage you to make money management a part of your continuing
education. Consider this book only the beginning of your journey.

Good luck and profitable trading,


Eddie Kwong
APPENDIX

lntroduction to Uolatility
Tlraders are never far from the concept of volatility-either in the markets or on the
news. We hear about it all the time: Daytraders are advised that volatility is their best
friend when it comes to intraday trading opportunities, while long-term investors are
forever warned to hold tight and weather the most recent period of volatility until
things settle down again. It's no wonder many kaders have trouble understanding what
volatility really means and how it affects their trading.
To better understand this crucial aspect of trading, first we will look at what volatility
represents, its inherent features and a simple way of measuring it. We'll also look at gen-
eral ways of applying these concepts to the markets.

A SIMPLE CONCEPT
From a mathematical standpoint, volatility is one of the more complex market con-
cepts-but that doesn't mean it has to be difficult to understand in practical trading
terms. Volatility is simply how much prices change over a given period of time. For in-
stance, if the Dow Jones Industrial Average goes up 10 points one day and down 10
points the next, you would probably say volatility is low. However, if it goes up 200
points one day and down 200 points the next, then you'd probably say the market is
volatile.
In the most basic sense, that's really all there is to it. The more complex stuff has to do
with measuring volatility consistently, tracking its behavior, and taking advantage of its
characteristics.

UOLATI LITY CHARACTERISTIGS


Volatility has certain inherent features: cyclicity, persistency and mean reversion. Al-
though they might initially sound intimidating, again, the concepts are actually quite
simple.
Volatility is cyclical: Volatility tends to run in cycles, increasing and peaking out, then
decreasing until it bottoms out and begins the process all over again. Many traders be-
lieve volatility is more predictable than price (because of this cyclical characteristic) and
have developed models to capitalize on this phenomenon.

Volatility is persistezf: Persistency is simply the ability of volatility to follow through


from one day to the next, suggesting the volatility that exists today will likely exist to-
morrow. That is, if the market is highly volatile today, it will most likely be volatile to-
morrow; conversely, if the market is not volatile today it will likely not be volatile
tomorrow. By the same token, if volatility is increasing today, it will likely continue to
increase tomorrow, and if volatility is decreasing today, it will likely continue to de-
crease tomorrow.

Volatility tends to reoert fu the trcan: Someone once asked me to describe reversion to
the mean (average) in as simple terms as possible. My reply was if you know someone
who's normally "mean" and then they're nice to you for a few days, chances are they'll
revert back to being mean.

Seriously, this concept simply means that volatility has a tendency to revert back to
more average or normal levels when it reaches a high or low extreme. Once a market
hits an extreme high in volatility, it will likely revert back to the mean-that is, volatility
will fall back to more normal or average levels. Conversely, once volatility hits an ex-
tremely low level, it will likely rise to more normal (or average) levels. It's like a rubber
band: when stretched so fat it tends to snap back.

The above concepts are illustrated in Figure A.1. Notice the cyclical characteristic of vola-
tility. It tends to oscillate back and forth between periods of low volatility and periods of
high volatility. It tends to persist (follow through). Days of increasing volatility (a) tend to
be followed by days of increasing volatility (b). Conversely, days of decreasing volatility
(c) tend to be followed by days of decreasing volatility (d). Finally, it tends to revert back
FIGUBE A,1 Uolatility Gharacteristics

Hypothetical Volatility

high volatility

low volatility

to its mean-that is, periods of extremely high volatility (e) tend to be followed by moves
to more normal or average levels (0. Conversely, periods of extremely low volatility (g)
tend to be followed by periods of more normal or average volatility (h).

MEASUBING VOLATILITY
Because this is an introductory article on volatiliry we'll show a simple way to measure
it. One of the easiest ways is to take the average range (high - low) over a given period.
The number of days (or hours, or weeks, etc.) you use in your calculation will give you
a picture of the volatility over that time period. A five-day average range calculation
will give you an idea of how volatile the market has been the past week, but it won't tell
you anything about the past six months. A 100-day average range calculation would re-
flect volatility over a much longer period.
FIGURE 4.2 True Range

True Hange
[conriders gapsl

Eap
f
I
Ye*terday

Because more volatile markets often gap higher or lower overnight, the true range, de-
veloped by Welles Wilder, provides a more accurate measurement of volatility because it
accounts for overnight gaps in its calculation. This concept is illustrated in Figure A.2.
Because the range for only one day doesn't provide much information, the true range
can be averaged over a period of time (say two weeks). This average true range gives
you a better feel for volatility over time.
True range is the largest value (in absolute terms) of:

. today's high and today's low

. today's high and yesterday's close

. today's low and yesterday's ciose


Figure A.3, Global Telesystems Group (GTSG), provides a good real-world example of
these concepts.

FIGURE A.3 Global Telesystems Group

jcrsc-oaily o?l2lEg C=3B.OOO +.4ST O=37.875


:

'**h"t,;rtlrrf +rrr

,ltrtrrl,lrrhrril+t*lrr,lf

high volatility
.5

1.5

; 10 day ATH low volatility

Jun

Source: Omega Research.

Here we measured volatility by taking the L0-day average true range (ATR). Again, no-
tice the cyclical nature of volatility. It tends to cycle from periods of higtr volatility to pe-
riods of iow volatility. It tends to persist; periods of increasing volatility (a) tend to be
followed by periods of increasing volatitity (b). Conversely, periods of decreasing vola-
tilify (c) tend to be followed by periods of decreasing volatility (d). 4ltot notice that it
tends to revert back to its mean. That is, periods of extremely low volatility (e) tend to
be followed by higher or more normal (average) levels of volatility (f). Conversely, peri-
ods of high volatiiity tgl tend to be followed by periods of lower or more normal or av-
erage (h) levels of volatilitY.
GENEBAL TRADING APPLICATIONS
Higher-volatility markets offer potentially larger profits accompanied by increased risk.
Short-term traders, whose profits are limited by how much a stock or futures contract
can move in a given amount of time, may seek more volatile markets. Longer-term or
more conservative investors may seek markets that are less volatile.

If the volatility of a market is extremely low (compared to average or normal levels), then
chances are a larger move is imminent as volatility reverts to its mean. Conversely, if vola-
tility is extremely high (compared to normal levels) then the large price move which cre-
ated the jump in volatility may be over as volatility reverts back to more normal levels.

HISTORIGAL VOLATILITY
Now we will look at historical volatility, a more mathematically complex but useful way of
measuring volatility. We'lI show how you can use it to find (or avoid) volatile stocks, deter-
mine risk, set practical stops and forecast where the market has the potential to trade.

Historical Uolatility Defined


Historical Volatility (HV) is the standard deviation of day-to-day price change expressed
as an arurual percentage.'Whew! Essentially, all that means is that historical volatility is
a measurement of how much prices fluctuate over time. Suppose a stock or commodity
is trading at $L00 and its historical volatility is 10%. At the end of the year the market
wlll likely' (statistically a 66% chance) be trading somewhere between $90 ($100 - 70%)
and $110 ($100 + 70%). Markets with a high HV tend to offer more opportunity yet are
more risky than those with a low HV and vice versa. By the way, as with all indicators, I
strongly urge you have the computer do the work for you. Also, it's more important to
understand how to read and use the indicator than it is to understand the formula itself.

A TALE OF TWO MARKETS


Let's look at two completely different markets in terms of their volatility. Orange Juice is
a volatile market due to its nature (and Mother Nature). It's a crop that is strongly af-
fected by weather conditions (i.e., freezes) and reports (note: the movie Trading Places
does a good job of describing why orange juice is volatile).

On the other hand, the Canadian dollar is fairly stable. Obviously, the currency does
fluctuate over time, but much less than a market like orange juice. Therefore, the volatil-
ity (HV) of orange juice futures tends to run between 30% and 40% (or higher) whereas
the volatility on the Canadian dollar tends to run around 6Vo to 8Vo. So, you could ex-
pect the Canadian Dollar to fluctuate around 6Vo to 8% annually and orante juice to
fluctuate around 30% to 40Vo anmally. The same analogy can be applied to a govern-
ment-regulated utility stock which tends to fluctuate 10Vo'or less duiing a year versus a
high-flying technology stock than can move as much as307o or more in one day.

FINDING IOB AUOIDINGI VO1ATILE MARKETS


HV is one of the best indicators for determining volatility. If you are a daytrader whose
profits are limited to the amount a stock can move during the trading day, then you
probably want to seek out more volatile markets. On the other hand, if you take a lon-
ger-term view, you might want to avoid the more volatile markets because of their addi-
tional risk. At TradingMarkets.com we have found that a 50-Day HV reading is useful
for gauging the volatility of a market. (This is what is used on the "Trading lAtrhere The
Action Is List" and the "Futures Volatility Ranking" lists. These lists rank the most vola-
tile markets, from highest to lowest based on their 50-day FIV readings.)

WHY JOHNNY GETS STOPPED OUT


Johnny has carefully studied all the entry techniques and momentum trading. With all
this knowledge, he finds the hottest stocks in the hottest sectors and buys precisely
where his studies indicate. He plans to hold on for a few days and dreams of the large
moves he'll capfure. He puts in a tight stop and waits. However, to his dismay, he's con-
stantly stopped out,losing time after time.

\AIhy? Because Johnny failed to study the volatility of the stocks that he was trading. The
"noise" alone on his stocks is far greater than his stop-placement points, thereby almost
guaranteeing him a loss.

KNOW THY UOLAIILITY: USING HU TO SET STOPS


To help ensure (but not guarantee, of course) that you do not get stopped out when po-
sition trading, FfV can be used to determine where they should be practically placed.
Connors has shown' that by taking the HV and factoring in the number of days you in-
tend on holding a position, a realistic placement of stops can be achieved. Let's apply
this method of stop placement to a volatile stock.
FIGURE 4.4 Metricom (MCOMI Daily

Metriconl lnc-Daily
..,...1 .:,......
07*21 /Eg
:

I
::

::I f+
rT
Ft5

Using histonical volatility Eo define likely Erading nanges and stop levels.

Suppose you wanted to trade Metricom (MCOM), a stock with an extremely high histor-
ical volatility rating of 1,45% on 7 /21,/99. Also, suppose you intend to hold the position
for at least five days. If we reduce the volatility down to the holding period (five days),
it suggests that the stock has the potential (a two-thirds chance) to trade as high as 42
5/8 and as low as 28 3/8. Therefore, in order to reduce the likelihood of getting stopped
out, you would have to set your stops oufside of. 28 3 /8 for longs (a) and 42 5 /8 (b) for
shorts.

In trading, there's always the flip side. Some may argue for tighter stops even on vola-
tile stocks, knowing that the majority of the time they will be stopped out but the occa-
sional winner will make up for the losses. However, regardless of your trading style or
beliefs, you can't ignore the fact that more volatile markets have the potential for larger
swings and increased risk.
FORECASTING PBIGE BANGES USING HV
The same method used to set stops can also be used when planning options trades. For
instance, according to the above method of setting stops (and referring to the chart), the
stock has the potential (a 65% chance) that it could trade to (a) or O). One could then
analyze the premium of the option to determine if the option has the chance to be worth
more than the current cost based on the potential of the market. Obviously, there's a lot
more to option trading than the above, and I would strongly urge you not to make deci-
sions on trading options purely on FfV. The point here is to show where the stock has
the potential to go, based on volatility.

CALGULATING HISTORICAL VOLATILITY


As with any indicator, I strongly urge you to purchase software with the indicators al-
ready programmed and would never suggest anyone attempt this by hand. With that
said:

Let Length = Iength of volatility to be calculated and ln = natural logarithm

Historical Volatility(length) = standard deviation(ln(c1ose/yesterday's close),


length) * 100 * square root (255).

In English:
Divide today's close by yesterday's close.
Thke the natural log of #1..

Take the standard deviation of #2 for length desired (the number of trading days,
i.e., 50)

Multiply #3 by 100.

Multiply #4 by the square root of the number of trading days in 1 year (around
25O.

HV is based on a one-standard deviation move


For those familiar with the bell curve and standard deviations, statistically, this suggests
that approximately 66Vo the market should trade within these ranges. If you double the
HV which gives you two standard deviations, then this gives you a statistical probabil-
ity that 95% of the time the market will trade within this range. A three standard devia-
tion (3 * HV) would suggest that the market would trade within that range 99.7% of the
time.

Keep in mind, however, that these calculations assume a normal distribution and are
based on present volatility (volatility is constantly changing). Natenberg said it best in
Option Volatility and Pricing, "(You) shouldn't confuse unlikely with impossible."

USING HU TO SET PROTECTIVE STOPS


ln Connors on Adaanced Trading Strategies, Larry Connors shows that historical volatility
can be used to determine where stops should be placed. Calculation of these stop points
are as follows:

Divide 260 tradtng days by the number of days you intend to hold the position.
Take the square root of #1.

Divide the historical volatility by #2.

Take the stock price and add (for shorts) and subtract (for longs) #3 from it.

ENDNOTES
L. Laurence A. Connors, Connors on Adaanced kading Strategies.
2. Sheldon Natenberg, Option Volatility and Pricing.
3. Laurence A. Conrtors, Connors on Adaanced kading Strategies.

REFERENCES
1. Laurence Connors: Connors on Advanced Trading Strategies and Inaestment Secrets
of a Hedge Fund Manager (M. Gordon Publishing).

Z. Sheldon Natenberg: OptionVolatility and Pricing (Probus Publishing).


ADDITIONAL READING
7. Connors and Hayward: lnaestment Secrets of a Hedge Fund Manager.

2. "A Volatility Trade in Gold," Dave Landry, Technical Analysis of Stocks and
Commodities, July 1998 issue.
Othen Elooks fnorn
M. GicIFItrIcIN
PUETLISiHING GiFIGIUP
l rlrvr r. lTrgondonpub. corn
DAVE TAIUDBY O'U SWIIUG TBADIIUG;
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thing the beginner and intermediate trader needs to get started trading quickly.
Dave Landry helps you improve your trading results by exploring and explaining:

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M. Gordon Publishing Group, 445 S, Figueroa Street, Suite 2930,
Los Angeles, CA 90071
www.mgordonpub.com
All orders please add $6 plus $2 per each additional item;
for shipping and handling.
California residents include B0/o sales tax,
. Trend Qualifiers-Learn how to precisely identify strongly trending stocks.
. Stock Selection-Landry will show you how to narrow down your universe
to pick the right stocks to trade.
. Swing-Trading Strategies-More than a dozen strategies presented in an easy-to-read,
easy-to-understand format, providing you with the specific rules for entry and exit to
start identifying the best trading opportunities immediately.
Landry also goes into great detail covering:
Tiading Master Section
Stock Market Timing
Money Management
Trader's Psychology

Finish off your swing-trading education with Landry's thoughts on the winning trading
methodology, and so much more!
220 PAGES HARDCOVER $1.OO.OO

STPEET SMANTS
High Pmbabirity Sft orc-Term Trading Stnategies
LAUHENCE A. CONNOHS AND LINDA BRADFOHD HASCHKE

Published trL 7996 and written by Larry Connors and Nez, Market Wizard Linda Raschke, this
245-page manual is considered by many to be one of the best books written on trading futures.
Twenty-five years of combined trading experience is divulged as you will learn 20 of their best
strategies. Among the methods you will be taught are:

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Los Angeles, CA 90071
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California residents include B0lo sales tax.
. Swing Trading-The backbone of Linda's success. Not only will you leam exactly how
to swing trade, you will also learn specific advanced techniques never before made
public.

. News-Among the strategies revealed is an intraday news strategy they use to exploit
the herd when the 8:30 a.v. economic reports are released. This strategy will be
especially appreciated by bond traders and currency traders.

. Pattern Recognition-You will learn some of the best short-term setup pattems
available. Larry and Linda will also teach you how they combine these patterns with
other strategies to identify explosive moves.

. ADX-In our opiniory ADX is one of the most powerful and misunderstood indicators
available to traders. Now, for the first time, they reveal a handful of short-term trading
strategies they use in conjunction with this terrific indicator.

. Volatility-You will learn how to identify markets that are about to explode and how to
trade these exciting situations.

. Also, included are chapters on trading the smart money index, trading Crabel, trading
gap reversals, a special chapter on professional money management, and many other
trading strategies!

245 PAGE' HARDcovER $175.00

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Los Angeles, CA 90071
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HIT ANO BUIU TRADI'UG
The Short-Term Stock Traders' Bible
JEFF CooPER
Written by professional equities trader, ]eff Cooper, this best-selling manual teaches traders ho
to day-trade and short-term trade stocks. Jeff's strategies identify daily the ideal stocks to tra
and point out the exact entry and protective exit point. Most trades risk 1 point or less and la
from a few hours to a few days.
Among the strategies taught are:
. Stepping In Front Of Size-You will be taught how to identify when a large institution
is desperately attempting to buy or sell a large block of stock. You will then be taught
how to step in front of this institution before the stock explodes or implodes. This
strategy many times leads to gains from 1./4point to 4 points within minutes.
o 1.-2-3-4s-Rapidly moving stocks tend to pause for a few days before they explode
again. You will be taught the three-day setup that consistently triggers solid gains
within days.
. Expansion Breakouts-Most breakouts are false! You will learn the one breakout patte
that consistently leads to further gains. This pattem alone is worth the price of the
manual.
r Also, you will learn how to trade market explosions (Boomers), how to trade seconda
offerings, how to trade Slingshots, and you will learn a number of other profitable
strategies that will make you a stronger trader.
1.60 PAGES HARDCOVER $1.OO

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Los Angeles, CA 90071
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Califonnia residents include 80/o sales tax.
TT AND BUN' TEAD'IUG I'
APTUBING EXPLOS'VE SHOBT-rEBIil MOVES STOCKS
FF CooPER
'il
2 fact-filled pages of new trading strategies from Jeff Cooper. You will learn the best momen-
m continuation and reversal strategies to trade. You will also be taught the best day-trading
ategies that have allowed Jeff to make his living trading for the past decade. Also included is a
ecial five-chapter bonus section entitled, "Techniques of a Professional Trader" where Jeff
aches you the most important aspects of trading, including money management, stop place-
ent, daily preparatiory and profit-taking strategies.
you aspire to become a full-time professional trader, this is the book for you.
212 PAGE9 HARDcovER $100.00

HE s.DAY MOTilENTUM MEIHOD


FF CooPER
rongly trending stocks always pause before they resume their move. The S-Day Momentum
ethod identifies three- to seven-day explosive moves on strongly trending momentum stocks.
ghly recommended for traders w\o are looking for larger than normal short-term gains and
ho do not want to sit in front of the screen during the day. The S-Day Momentum Method
orks as well shorting declining stocks as it does buying rising stocks. Also, there is a special
ction written for option traders.
SPIRAL BoUND $5O,OO

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wut w.mgordonpub.com
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INVESTMEilT SECBETS OF A HEDGE FUIUD MAIUAGEP
Exploiting the Her'ld Mentality oJ the Financial Markets
LAURENCE A, CoruruONS AND BLAKE E. HAWVABD

Released tn this top-selling trading book reveals strategies that give you the tools to stand
1995,
apart from the crowd.
Among the strategies you will learn from this book are:

. Connors-Hayward Historical Volatility System-The most powerful chapter in the


book, this revolutionary method utilizes historical volatility to pinpoint markets that are
ready to explode.

. News Reversals-A rule-based strategy to exploit the irrational crowd psychology


caused by news events.

. NDX-SPX-An early warning signal that uses the NASDAQ 100 Lrdex to anticipate
moves in the S&P 500.

. Globex-Cutting edge techniques that identify mispricings that regularly occur on the
Globex markets.

225 PAGES CLOTH COVER $49.95

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Los Angeles, CA 90071
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COil'UOPS OIU ADVANCED TNADIIUG STBATEGIES
31 Ghapters on Beating tha Markets
LAUBENCE A. COITIruONS

Written by Larry Connors, this new book is broken into seven sections; S&P and stock market
timing, volatility, new patterns, equities, day-trading, options, and more advanced trading strate-
gies and concepts. Thirty-one chapters of in-depth knowledge to bring you up to the same level
of trading as the professionals.
Among the strategies you will learn are:

. Connors VIX Reversals I, II and III (Chapter 2)-Three of the most powerful strategies
ever revealed. You will learn how the CBOE OEX Volatility Index (VIX) pinpoints
short-term highs and lows in the S&Ps and the stock market. The average profit/trade
for this method is among the highest Larry has ever released'

. The 15 Minute ADX Breakout Method (Chapter 20)- Especially for day-traders! This
. dynamic method teaches you how to specifically trade the most explosive futures and
stocks everyday! This strategy alone is worth the price of the book.

. Options (Section S)-Four chapters and numerous in-depth strategies for trading
options. You will learn the strategies used by the best Market Makers and a small
handful of professionals to consistently capture options gains!

IO I|BIITB GAI.I:
1-800-797-2584 or 1-213-955-5777 toutside the U,S,l
OB ]AI( YOUB OBOER IO:
1-213-955-4242
OB MAII. YOUB ORIIEB Tll:
M, Gordon Publishing Gnoup, 445 S. Figuenoa Street, Suite 2930,
Los Angeles, CA 90071
Ul,wuu.m gordonpub.com
All ordens please add $6 plus $2 per each additional item;
for shipPing and handling'
California residents include 80/o sales tax.
. Crash, Burn, and Profit (Chapter ll)-Huge profits occur when stocks implode. During
a recent 12-month period, the Crash, Burn and Profit strategy shorted Centennial
Technologie s at 49 1 /8; six weeks later it was at 2 1, / 2! It shorted Diana Corp. at 67 3 / 8;
a few months later it collapsed to 4 3 /81 It recently shorted Fine Host at 35; eight weeks
later the stock was halted from trading at 10! This strategy will be an even bigger
bonanza for you in a bear market.

. Advanced Volatility Strategies (Section 2)-Numerous, never-before revealed strategies


and concepts using volatility to identify markets immediately before they explode.

t and much, much more!

259 PAGE' HARDcovER $150.00

METHOD DEAL'ilG IIU STOCKS


Eeading the'IU
Mind oJ the Market on a Daily Basis
JoSEPH H. KEnB, JB.

This gem was originally published in 1931 by foseph Kerr has been expanded and updated to re-
flect today's markets. This book is considered to be the bible of interpreting both daily market ac-
tion and daily news events.
1.50 PAGES PAPERBACK $35.00

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llR M[It
YllUB IIRIIEB IO:
M. Gordon Publishing Group, 445 S. Figuenoa Street, Suite 2930,
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THE BEST OF THE PNAFESSIO'UAL TRADEBS
JOUBIUAL SERIES
Best lnading Pattennst Volume I
Eest Trading Pattefns: Volume ll
Market Timing
Options Trading and Volatility Tnading
Day trading
EACH V)LUME $39.95

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M, Gondon Publishing Group, 445 S. Figueroa Street, Suite 2930,
Los Angeles, CA 90071
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AII orders please add $6 plus $2 per each additional item;
for shipping and handling.
California nesidents include 80/o sales tax.
About the Editor
Eaai" Kwong is the Editor-in-Chief for TradingMarkets.com. Mr. Kwong's involvement
in the financial markets began when he and a high school friend became fascinated with
the stock market during the late '70s.

Reading numerous books and attending many seminars, Mr. Kwong merged his educa-
tion with his trading experience and found that the key for his success in the markets
boiled down to the basics. Basic technical analysis. Basic chart reading. And basic money
management. Over the past 25 years of trading, Mr. Kwong's experience in the markets
has also extended into software development and teaching. He has spoken numerous
times to the American Association of Individual Investors and Omega Tiadestation
Users Groups and continues to speak at seminars nationwide.