Trading Manual

JOE ROSS

Trading Manual – Tips, Tricks, Strategies, and Tactics for Traders  Copyright 2002 by Ross Trading, Inc. ALL RIGHTS RESERVED

Printed in the United States of America NO PART OF THIS PUBLICATION MAY BE REPRODUCED, STORED IN A RETRIEVAL SYSTEM, OR TRANSMITTED IN ANY FORM OR BY ANY MEANS, ELECTRONIC, MECHANICAL, PHOTOCOPYING, RECORDING OR OTHERWISE, WITHOUT THE PRIOR WRITTEN PERMISSION OF THE PUBLISHER AND THE COPYRIGHT HOLDER EXCEPT IN THE CASE OF BRIEF QUOTATIONS EMBODIED IN CRITICAL ARTICLES AND REVIEWS. ANY PERSON OR ENTITY VIOLATING COPYRIGHT LAWS OR COPYING ANY PART OF THIS BOOK WITHOUT EXPRESS PERMISSION OF THE AUTHORS WILL BE PROSECUTED TO THE FULL EXTENT OF THE LAW. ROSS HOOK AND THE LAW OF CHARTS ARE PROPERTIES OF ROSS TRADING INC. TRADERS UNIVERSITY AND TRADING MANUAL - TIPS, TRICKS, STRATEGIES, AND TACTICS FOR TRADERS ARE PROPERTIES OF ROSS TRADING, INC. Distributed by Ross Trading, Inc., 1509 Jackson, Cedar Park, TX 78613, U.S.A. E mail: [email protected] Telephone: 512-249-6930 Fax: 512-249-6931 Order: 800-476-7796 Office hours: 9:00 A.M - 5:00 P.M. CST Visit our Web site: www.rosstrading.com

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DEDICATION

We dedicate this manual to anyone who has never before had anything dedicated to them

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Table of Contents THE AUTHOR.....................................................................................11 INTRODUCTION.................................................................................12 PART I..................................................................................................14 CHAPTER 1 .........................................................................................16 DISGRUNTLED....................................................................................... 16

CHAPTER 2 .........................................................................................19 ACHIEVING PERFECTION ........................................................................ 19

CHAPTER 3 .........................................................................................23 THOUGHTS ON MANAGING MONEY.......................................................... 23

CHAPTER 4 .........................................................................................27 ADMIT WHEN YOU 'RE WRONG................................................................. 27

CHAPTER 5 .........................................................................................36 WHAT' S YOUR EQ?................................................................................ 36 CHAPTER 6 .........................................................................................45 MONEY MANAGEMENT........................................................................... 45

CHAPTER 7 .........................................................................................57 TRADING IS AN ART ............................................................................... 57

CHAPTER 8 .........................................................................................71 BRAIN VS MACHINE ............................................................................... 71

CHAPTER 9 .........................................................................................79 EXPERIENCE ......................................................................................... 79

CHAPTER 10 .......................................................................................85 ARE YOU A LOSER?................................................................................ 85

CHAPTER 11 .......................................................................................90 COMMON SENSE TRADING ...................................................................... 90

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CHAPTER 12 .......................................................................................97 THE ULTIMATE STOP LOSS ................................................................... 97

PART II .............................................................................................. 103 CHAPTER 13 ..................................................................................... 105 RHYTHM TRADING............................................................................... 105

CHAPTER 14 ..................................................................................... 110 GIMMEES ............................................................................................ 110

CHAPTER 15 ..................................................................................... 116 THE CONCEPT OF SECOND TIME THROUGH ............................................. 116

CHAPTER 16 ..................................................................................... 121 THE SWEET CHARIOT........................................................................... 121 CHAPTER 17 ..................................................................................... 125 CHAPTER 17 ..................................................................................... 127 DAY TRADE VS POSITION TRADE ........................................................... 127

CHAPTER 18 ..................................................................................... 135 STAYING WITH A TREND ...................................................................... 135 CHAPTER 19 ..................................................................................... 147 WEAK HANDS VS STRONG HANDS.......................................................... 147

CHAPTER 20 ..................................................................................... 159 LEARNING BY INSPECTION ................................................................ 159

CHAPTER 21 ..................................................................................... 169 BABY STEPS – GIANT STEPS ................................................................ 169

CHAPTER 22 ..................................................................................... 180 A TRUE STORY ................................................................................... 180

CHAPTER 23 ..................................................................................... 193 THE CAMELBACK TECHNIQUE............................................................... 193

CHAPTER 24 ..................................................................................... 204 DIVERGENCE DECISIONS ...................................................................... 204

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CHAPTER 25 ..................................................................................... 217 KELTNER CHANNEL ............................................................................. 217

CHAPTER 26 ..................................................................................... 228 THRUST BARS ..................................................................................... 228

CHAPTER 27 ..................................................................................... 234 MARKET MANIPULATION...................................................................... 234

CHAPTER 28 ..................................................................................... 243 LIQUIDATION................................................................................. 243 CHAPTER 29 ..................................................................................... 253 SOME INTRADAY FAVORITES ................................................................ 253

CHAPTER 30 ..................................................................................... 259 1-2-3’ S AND BOLLINGER BANDS ........................................................... 259

APPENDIX A ..................................................................................... 269 THE LAW OF CHARTS ........................................................................... 269

APPENDIX B...................................................................................... 295 THE TRADER' S TRICK ONE MORE TIME.................................................. 295 APPENDIX C ..................................................................................... 307 IDENTIFYING CONGESTION .................................................................. 307 READING LIST:................................................................................ 319

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Caution CAUTION: THIS IS A COURSE INTENDED TO HELP TEACH YOU HOW TO TRADE STOCKS, IMPROVE YOUR TRADING SKILLS, OR BOTH. THERE ARE SECTIONS OF THIS COURSE WHICH ARE DIFFICULT TO UNDERSTAND UPON FIRST READING. IT IS A MANUAL MEAN T TO BE STUDIED . THE CONCEPTS CONTAINED IN THIS COURSE TOOK MAN Y YEARS TO DEVELOP. MOST TRADERS WILL NOT BE ABLE TO GRASP THESE WITH JUST A CURSORY READING OF THE TEXT . IN THE PAST , MUCH OF THIS MATERIAL WAS RESERVED EXCLUSIVELY FOR PRIVATE SEMINAR S WHICH COST $10,000 PER STUDENT .

To the Ladies who are taking this course: We tried to write the manuals in a way that is gender neutral. Ladies, it just didn’t work. So please forgive the fact that we used the masculine gender throughout. It is not our intent to offend you in any way.

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DISCLAIMER NO CLAIM IS MADE BY JOE ROSS OR BY ROSS TRADING INCORPORATED THAT THE TRADING METHODS SHOWN HERE WILL RESULT IN PROFITS AND WILL NOT RESULT IN LOSSES. TRADING STOCKS MAY NOT BE SUITABLE FOR ALL RECIPIENTS OF THIS PUBLICATION. ALL COMMENTS, TECHNIQUES, METHODS, SYSTEMS, AND CONCEPTS SHOWN WITHIN THIS MANUAL ARE NOT AND SHOULD NOT BE CONSTRUED AS AN OFFER TO BUY OR SELL ANY OF THE TRADING VEHICLES NAMED HEREIN. THE THOUGHTS EXPRESSED ARE NOT GUARANTEED TO PRODUCE PROFITS. ALL OPINIONS ARE SUBJECT TO CHANGE WITHOUT NOTICE. EACH TRADER IS RESPONSIBLE FOR HIS/HER OWN ACTIONS, IF ANY. PURCHASE OF THIS MANUAL CONSTITUTES YOUR AGREEMENT TO THIS DISCLAIMER AND EXEMPTS THE CREATORS, PUBLISHERS, AND DISTRIBUTORS FROM ANY LIABILITY OR LITIGATION.

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The Author JOE ROSS

Joe Ross, trader, author, and educator, has been an active trader since 1957, when he began his trading career in the commodity futures markets. In 1982, when it became possible to day trade the S&P 500 stock index futures via a live data feed, he successfully made the transition from full-time position trader to full-time day trader. In 1988 he formed Trading Educators for the purpose of training aspiring traders in the futures, bonds, and currency markets. Since 1988, Joe has written seven major texts on futures trading. All have become classics. An eighth text is distributed only to students who take his private day trading course. In 1991, in addition to private tutoring, Joe began to give seminars and to write Trader’s Notebook, a teaching newsletter. He did this in order to keep his students apprised of new trading techniques, and global situations which can affect all markets. Joe teaches that a trader should be able to live anywhere in the world where he can obtain trading facilities, and be able to trade any market at any time whether it be stocks, futures, currencies on the Forex, or interest rate contracts. To prove that he meant it, Joe moved to the Bahamas. “The phones are lousy, and I can barely get data,” Joe says. But he successfully trades from there. Although Joe’s career has centered mostly on the trading of futures, and in recent years more particularly on day trading the S&P 500 futures, he has also been a successful trader in the stock market. In fact, many active and successful stock market traders have read Joe’s books on their way to becoming profitable. As Joe likes to say, “A market is a market, and a chart is a chart. Given those two and a way to enter an order, a trader should be able to earn his money.” Joe holds a Bachelor of Science degree in Business Administration from the University of California at Los Angeles. He did his Masters work in Computer Sciences at the George Washington University extension in Norfolk, Virginia. Joe has now added four stockmarket books to his authoring repertoire. A fifth book is distributed privately.

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Introduction What we present in this manual are tips, tricks, and various insights into profitable futures trading. In this volume you are going to see more charts, unusual uses of indicators, ways to use the news and government reports, ways to use fundamentals, and trading ideas that have taken years of experience to discover, be made workable, and finally, to implement. Some of the ideas presented here we learned from very successful traders. Others were derived from our years of trading experience. We know that you are anxious to get started  to dig in and begin filling your plate with the goodies offered at this buffet table. With that in mind, let's get started. Joe Ross

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PART I

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Chapter 1 DISGRUNTLED The following situation happens quite often to many traders. Look it over and see if it has been happening to you: You have been faithfully following your trading plan and the rules you've set for trading. By following them you are now in a trade that doesn't look so good. At the same time, by following your trading plan, you see that you've missed a beautiful move in a different market, one that could have made you a lot of money. You are in a bad trade and you've missed out on a great trade. You become disgruntled. You think to yourself that your trading plan must not be so great. You think there must be a better methodology that you should use that will prevent this from happening. You think to yourself, “Yes! That's it, I'll change the way I do things.” So you create a new rule or modify an old one so that such a rule would have let you capture the trade you missed and avoid the one you took. Have you been making this mistake? Here's another way it can happen: You are in a trade, and your rules cause you to be stopped out with little or no profit. Shortly after you exit the trade according to plan, prices take off and move to where, had you stayed in, you would have made substantial profits. The move leaves you sitting there thinking you are stupid. You reason that there must be something wrong with the way you do things. Your rules, your plan, or both must not be right. So you change what you are doing, or make a new rule so that the next time this happens, you won't be left behind. You have just abandoned all of the hard work you've previously done that enabled you to successfully trade futures. You've abandoned your education and learning. You've abandoned the wisdom that will enable you to be consistently successful as a trader. You've just started trading history, and you are supposed to be trading on the

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future movement of prices. You are trading what happened, not what will happen. By not being willing to be left behind, you are setting yourself up for being left out. If you've been having thoughts, or have been acting as we've just described, you have a terrible problem with greed. Why? Because greed can never get enough. You can't satisfy greed. Greed wants more, and yet more. Not every trade is your trade. Not every trade has to work out for you. You have to be satisfied with getting a reasonable share of trades that fit your description of a good trade. Some of those trades will turn out to be great trades, others are good trades, and a certain percentage of your trades will be bad. There's no way around it. Not every good trade will turn into a great trade. When you enter a trade according to your rules and trading plan, you have no idea whether or not it will turn out to be a good trade, much less a great trade. The reality of trading is that, try as you might, you cannot know the future. Whenever we miss a big move and then try to find some pattern, indicator, rationale, or modification to make to what we are doing so that the next time we will not miss the “big” move, it is a part of the hunt for something magic  a continuation of our quest for the holy grail of trading. What a terrible mistake to allow yourself to make. Winning as a trader consists of making some small profits and some larger profits on a regular basis. Obviously, there will be some losses. We regularly want to keep losses small, but there are times when a loss will get away from us and turn out to be bigger than desired. If adversity causes you to become disgruntled, then you really need to examine your thinking and your approach to trading. Your trading plan must allow for disappointment and loss. You've got to believe in what you are doing and be able to trade from the knowledge that when you follow your rules and your plan, you will make money from your trading. 17

When you become disgruntled and begin to change your plan, your rules, or both, you are setting yourself up for almost certain failure and the worst thing that can happen to a trader  you will lose the courage of your convictions. Without it you cannot trade with any level of confidence. This is why we encourage you to write out the reasons and rationale for every trade you make, even if you have to do it after you have completed the trade. You must develop a keen recognition of the trades that are your trades. Write out your trading plan every day and for every trade you intend to make. If you did not have time to plan every trade, be sure to review those you did make without preplanning. Then you can go back over your trading and be able to see why and when you are successful. Reminder: Here are some steps to take before the market opens. • View major formations on the charts of those futures you intend to trade. View potential congestion areas, get the big picture from the longer term charts. • Write down all potential entries as you see them on the chart. You need to go through this exercise every day that you trade. This takes discipline. However, doing so will help you develop the kinds of habits that will mold you into a great trader. If you are too busy to be disciplined, then you are too busy to trade. If you don't discipline yourself, you will soon disappear from the trading scene.

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Chapter 2 ACHIEVING PERFECTION Trade quality, not quantity. Take the best of the best. Get the big picture. If you haven't previously come across such advice, or if you have and are not following it, it is time that you take these words to heart. But how? Trade selection and adequate planning go hand in hand. This is where most would-be professional traders miss the boat. Much more money is made as a result of proper planning than from sitting and trading everything that comes along or “looks” good. It's difficult to fully understand why people think they have to trade so much. It's difficult to truly grasp why people think that they have to take as many trades as they do. Just the opposite is true. There is a correct approach to each and every trade. That is what achieving perfection is all about. It all starts with proper management: planning, organizing, delegating, directing, and controlling. These facets of management must be woven together into your trading; they do overlap. Although planning is the major management function involved in achieving perfection, you can't possibly plan well unless you are organized to do so. You must have your tools at hand: your trading software, your data, the proper equipment. All of the rudiments for planning must be in place, which in itself is a part of organizing.

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You must be physically fit when you plan: well nourished, properly exercised, well rested and mentally alert — all part of having your life organized, all part of achieving perfection as a trader. To be a winning trader, you have to be among the best. There can be no middle ground. There are only winners and losers, and to be a winner you have to be a champion. And, just like any champion, you must have discipline, self-control, and a willingness to train, train, train. There are no runners-up in trading, you either get the gold or you give the gold. Often, while others are busy going to parties or watching sports events, you are busy poring over charts, studying, thinking, planning. When others are listening to music or watching TV, you are busy practicing your trading, practicing trade selection, working hard to become a more astute trader. Part of achieving perfection involves the diligent study of charts. The data, as presented on your screen and preserved as charts, are, for the most part, all you have for making trading decisions. They are a picture, a visualization of what is taking place in the reality of the market. Your job in achieving perfection and becoming an adequate trader is to picture and imagine in your mind what makes prices move and form the way they do. Ask yourself, “How does what I see in front of me relate to the supply and demand for this market?” Ask yourself, “Is what I am seeing on the chart even related to supply and demand, or is what I am seeing related to an engineered move by some insider or market mover?” Supply and demand are not what makes prices move or fail to move most of the time. The sooner you realize that fact, the better off you will be. Markets are engineered, manipulated  you need to know that. But there's more to a chart than merely price patterns. Reflected in the chart are the emotional reactions of human beings. Reactions to rumors and news; to national and world events; to government reports — these, too, are on the charts.

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You might say that price movement, or the lack thereof, is the net effect of all the perceptions of all the traders who are participating in the market for a particular commodity. There is something else on the charts, something that too few take into account. That something is the manipulations from and by the insiders, the market movers, and by brokers holding large inventories of the underlying commodity you are attempting to trade. In achieving perfection as a trader, you must train yourself to look for evidence of any and all of these things as you study your charts. It is the cumulative action of all perceptions which causes patterns to form on a price chart. You must learn to look for the truths in the markets. There are certain truths which are self-evident; they are always true. For instance, take the phenomenon of a breakout. When prices break out, no one can change the fact that they did break out. It is a fact and it is true. The breakout may turn out to be a “false” breakout, but nevertheless it is a breakout. As part of achieving perfection in your trade selection skills, you have to learn to tell which breakouts are most likely true breakouts, and which ones are most likely false. How can you know? By the price patterns on the chart. And what about trend? Your job in achieving perfection as a trader is to master how to trade a trend. A trend is a trend, is a trend. It is a trend until the end, and part of your job is to know when a market is not trending. The trend is the trend while it lasts. While a market is trending it is telling the truth. The trend can change, but the truth is the truth. If prices are rising, the trend is up. If prices are falling, the trend is down. The truth can be found in the trend. It is an immutable fact. You are to learn to make my money by trading with the trend. You are to learn what constitutes a trend. You have to learn to spot trends early so that you can make the most out of the market while it is trending. Your job in achieving perfection as a trader is to learn to recognize when a trend will most likely begin, and just as important, to learn to be even more adept at deciphering when a trend is ending.

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In achieving perfection, you must learn to recognize “your” trade(s), and to take only “your” trades. Trade the formations and patterns that you can easily recognize and identify. You must learn to trade using tips and tricks that you are shown and to accumulate and keep a collection of techniques that result in the selection of high probability trades. How are you to do all this? Practice, practice, PRACTICE. Practice recognition of congestion areas. Practice recognition of high probability breakouts. Practice trend recognition. Practice and more practice. Just like anyone who wants to achieve perfection at anything, there must be total dedication, study, practice and more practice. You are to become a trading virtuoso. You are to practice, yet always realizing that you will never attain true perfection, that there is always room for improvement. There is usually a way to refine: ways that you can do things better, more efficiently, and with greater speed and finesse.

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Chapter 3 THOUGHTS ON MANAGING MONEY We often hear from students by letter, telephone, and in person at seminars, that they greatly desire to trade managed money. At the opposite end of the spectrum, we also hear from students who want money managed for them. In either case, the experience can be gut wrenching. This chapter should serve as a warning and a caution to both. Since your author has at one time or another engaged in managing money for others, I base what I have to say here on my own experiences and, if it please the reader, this may be entitled “Confessions of a Trader.” The psychological basis for successful trading is indeed a delicate subject. No one we have ever heard of has been able to pinpoint exactly what it is that gives one trader success while another trader fails. Although some claim to have done this, coming up with an attribute profile of the “average” winner, no one we know of has identified a set of common denominators among professional winning traders. Besides, which of us is “average?” Is it you? Winning in the markets seems to involve a fine balance of traits that differ among winning traders. To make the identification of winning traders even more complicated, there seems to be a distinction between those traders who can successfully trade their own money and those traders who can successfully trade the money of others. I have met both. Two of the most successful money managers I know personally began by trading managed money. They began trading other people's money for lack of sufficient money of their own with which to trade. Later in their careers, when they did have sufficient money with which to trade their own account, they found that they failed miserably. They were not able to trade their own money with any degree of success. More than that, when they traded their own 23

money simultaneously with trading managed money, they failed at both. Upon further investigation, and after speaking with a number of traders who have tried both, I discovered that there are many traders who are successful at trading managed money, but who can't trade their way out of their hat when trying to trade their own money. Invariably, upon further probing, some admitted that they were much more daring and courageous with other people's money than they were when the money was their own. Also in this group of those who trade better for others than themselves, I have been able to identify traders who said they were much more careful and conservative with the money of others than they were with money of their own. So within this group of traders, all of them students of ours who can successfully trade managed money, some are successful because they are more daring with other people’s money, and some are successful because they are more careful with money not their own. Next, we come to those traders who successfully manage their own money and who have attempted to manage money for others, but failed. I have heard from quite a few traders who attempted to manage money for others. In this group I include those who have failed miserably. I have spoken with a number of students who have had the experience of losing at least half of the money under their management prior to returning the balance to those who invested with them. Amazingly, the answers are the same as with the group who successfully manage money. Managed money seems to be a “monkey” on their backs. They find that they trade too carefully, too conservatively when the money is not their own. Worse than that, when things go wrong with a trade, they do not act rationally and with the same cool determination as with their own money. When they trade their own account, they do not think of it as money. When they trade someone else's account, all they can think of is that it is money. And, because it is not their own, they try their hardest not to lose it.

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Unfortunately, experience shows that what they fear the most happens – they do lose the money. I have spoken with students who successfully manage their own money because they are more careful with their own than with the money of others. They, too, have failed with managed money, and have resigned themselves to trading only their own accounts. Among the students and acquaintances, I have identified at least four categories of traders who attempt to manage money. I’m sure there are other categories, but these are the ones I've found: 1. Those who successfully manage money for others but cannot manage their own account with any great degree of success because they are too careful with their own money, while they are more daring with the money of others. 2. Those who successfully manage money for others but cannot manage their own account with any great degree of success because they are too daring with their own money, while they are more careful with the money of others. 3. Those who successfully manage their own money but fail with managed money because they are too careful when managing money for others. 4. Those who successfully manage their own money but fail with managed money because they are too daring when managing money for others. Conclusions: Among these students I found none who successfully traded both managed accounts and their own accounts. The size of the population for this study was too small to come up with any meaningful statistics, but there are some warnings and cautions that can be concluded. To those of you who want to have your money managed, be aware that the individual success of any trader trading his/her own money is 25

no guarantee that that person can successfully manage the money of others. It would seem to bear out the reality of placing managed money with a proven successful trader of managed money. To those of you who want to manage money for others, be aware that successfully trading your own account is no guarantee that you will be able to successfully trade the account of other persons. Failure in either of these situations is painful for all concerned! In fact, the pain can be so great as to prematurely end the trading hopes of either party. Be very careful, because in both of these situations the result can be great personal pain. The pain may be both physical and mental, and can cause you to abort your trading career. I feel it is my duty to caution you about getting involved with managed money, whether you try to manage the money of others, or whether you want someone else to manage yours. The costs can be horrendous. The responsibility of trading managed money can really wear you down. You may have to go for years without a vacation. You find yourself working late into the night, and working a significant portion of the weekends. All work and no play is not a good thing for your trading career. Interestingly, most of my students come to me relating that the reason they want to learn how to trade is so they can become independent and not have to work at a regular job. However, trading managed money is one of the most grueling jobs you can ever undertake.

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Chapter 4 ADMIT WHEN YOU'RE WRONG CASE HISTORY In Trading Is a Business I showed how several characters refused to admit when they were wrong about a trade. Here is a true story of a greatly disgruntled trader. It is another tale of woe involving the failure to admit being wrong. As an electronic day trader, he first contacted us to tell us that he was unhappy with the data he was receiving. He wanted to know if we could recommend a good trading book for him. We mentioned a couple of our own to him, and he decided on one. An interval of time went by, and he called again. This time it was because he was dissatisfied with his computer. His hardware just wasn't fast enough. Could we recommend a good computer for him? If he had a good computer like other people had, he would be able to turn his current losers into winners – or so he thought. A month or two went by and he called to tell us that he liked the book, but he was still losing. He wanted to know if we could recommend a few trading techniques for him. He was sure that if he changed his technique, his luck(?) would change. We complied with his wishes and gave him a few trading hints he might like to try. There was another period of time before we heard from him again. When we did, he complained that there were too many distractions at his house. He said he was looking for office space. He asked if we had any students in his area that might be willing to share office facilities with him. We hope those of you reading this will appreciate the fact that we do not sic characters like him on any of you. 27

The next time we heard from him was when he called to ask for assistance with a trade. He was told him that we do not mind answering questions about the content of our books. Nor do we mind answering questions about brokerage, equipment, software, data feeds, etc. But in answering questions directly related to a trade, to a trading strategy, or to the management of an account, we feel we are entitled to a consulting fee. He agreed to pay it. A month later we heard from him again. This time it was by fax. He sent us a chart indicating a trade he was contemplating. He wanted us to fax him back an answer. The only answer we faxed back was that he would be charged a fee if we were to spend time to analyze his position and give him an answer. He called to tell us that by faxing a chart he thought he would not incur a fee. He said that by not faxing him back an immediate answer, we had caused him lose on the trade. We'd like to be able to say he lost because we did not fax him back an answer. The truth of the matter is that we weren't even in the office when the fax came. Even if we had chosen to answer, it would have been hours after he'd already lost. As we viewed the chart he faxed, we saw that he had gone long at just the time he should have been going short. The chart he faxed is shown below. Examine it closely. Sometimes you simply have to know when to trade. How would you have handled this situation?

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Disgruntled bought at the arrow. He had bought into a buying climax. But how was he to know? There are a number of visual clues on the chart that gave a strong indication of a climax situation. Let's look at those now!

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The first item was the two explosive gaps.

Gaps of the size seen on the chart above often precede a buying climax. Prices have moved too far, too fast! Over the years we have taught that traders should be very aware of gaps. They often predict an imminent end to any move, whether it be up or down.

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The second item was the size of the individual price bars leading up to and including the top.

Widening price ranges on the individual price bars are often caused by news or fundamental information. In this instance, there were rumors involved. When they failed to come to pass, the blow-off was a sure thing. By widening price range on individual bars, we are referring to the height of those bars with the arrows. Volatility is measured by the height of those bars. When you add in the size of the gaps to the height of the price bars, you can see that on at least two of those days, volatility was exceedingly great.

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Sharply accelerating trend or explosion. In fact, such sharp acceleration as we see on this price chart constitutes an explosion in prices and in volatility. From a visual point of view, we can see that the market has “arched its back.” It has become “parabolic.” From a psychological point of view, the herd instinct is at work.

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Let’s look at the blow-off reversal bar at the top. If the low of this bar had been only slightly higher, we would have been looking at an island reversal (see inset).

When a bull market enters its final stage, the rise in price increasingly attracts the attention of traders who fear they will miss the boat, as well as the attention of those who shorted the market prematurely. Eventually some news or rumor triggers an emotional response that results in a stampede of panic driven buying. The mad rush to buy drives prices to overvaluation. Overvaluation in turn gives rise to selling by well informed, professional interests. The “pros” contribute to the climactic price action by selling into the increasing demand. They do this to fatten 33

their profits. This selling into ever increasing prices drives the market to a point where there is no one left to buy – prices are simply too high. The result is that the weak hands in the market (usually the public and traders who are afraid they will miss the move) are being met by a superior force, the selling by the strong hands, the professionals. At the pinnacle of the move, both buying and selling, supply and demand, are at their greatest level. The stepped up trading from both sources produces another characteristic of climactic action which shows up as an expansion of volume. Once the buying frenzy ends and is turned back by massive selling, we see the that prices change direction. We have a price reversal. In the case of the chart we've been viewing it is manifest in a price bar that gaps open, rushes to its high, and then, as the selling overpowers the buying, closes on its low – a true key reversal (buying climax below). You can see what happened to prices in the days and weeks following the climax:

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Of course, the opposite is true in the case of a “selling climax.” The herd instinct is triggered when losing longs, who had been riding the market down, reach their psychological and financial breaking point. This releases a flood of panicky selling which drives price to undervaluation. When the market is depressed by heavy supply, large funds and insiders begin the process of accumulation by covering shorts from higher levels. Who is it that is liquidating near the bottom of a selling climax and buying near the top of a buying climax? You guessed it! The less informed, less expert, non-professional, thinly financed sap, er, trader. They are the weak hands in the market. They trade too often. They trade greatly undercapitalized. They trade emotionally out of fear and greed. They trade a size “too big for their britches.” They trade the wrong markets. They trade at the wrong time. They don't know when to trade and they don't know which way is up (or down, as the case may be). The more experienced we become, the more we realize that waiting for the right trade is the wisest of strategies. Across a broad range of futures, one can usually find markets that are in the throes a buying or selling climax. We would rather “load up” on the trades that are the most likely to be winners. Buying and selling climaxes present just such an opportunity, if you are trading them in the right direction. Buying climaxes are wonderful for writing Call options above the climax high or simply for selling futures. Selling climaxes are wonderful for selling Put options below the climax low, or simply buying futures. While you are waiting for the great opportunities, enjoy a day at the beach, a round of golf, go fishing, or just relax and enjoy the money you've made from trading market climaxes.

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Chapter 5 WHAT'S YOUR EQ? In my book “Trading is a Business, I talked about trading being the world's most perfect business. At the end of this chapter I will be showing you that I am not alone in believing that trading is an excellent way to make a living. What is your emotional quotient (EQ)? Do you know? Are you aware that you have one? Your EQ involves some of the factors that determine whether or not you will be successful as a trader. We're going to cover a few of them in this chapter. We’ll be talking about some of the major qualities that go into making up your EQ. You need to know about them if you are to be successful in this world's most perfect business. SELF-MOTIVATION One of the primary factors of paramount importance if you are going to achieve success as a trader is that of positive motivation. You might say it is the ability to marshal feelings of enthusiasm, zeal, and confidence. Being able to motivate yourself to pursue relentless training routines is a must in the long run. It is a trait common to world-class performers of every kind. From chess-masters to Olympic athletes, the ability to be self-motivated is evident. To accomplish self-motivation requires that you believe in yourself, that you have a can-do, must-do, will-do attitude. In addition, you must have clearly defined goals, and be optimistic about achieving them. The flip-side of being self-motivated is one of being pessimistic. The pessimist tends to see things in catastrophic terms because he doesn’t really believe in his ability to succeed. A pessimist is likely to interpret a trading loss as meaning I’ve failed, I’ll never make it as a trader. He inculcates the loss into his own personal psyche. Conversely, the self-motivated optimist will blame the fact that he’s had a trading loss on the situation that brought it about rather than on himself. Because of that, he is motivated to make the next trade.

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Your predisposition to a positive or negative outlook may or may not be inborn. By trying and with practice, a pessimist can learn to think more positively. It has been documented that if you can learn to catch negative, self-defeating thoughts as they occur, you can restructure the situation in less disastrous terms and see things in a more hopeful light. SELF-AWARENESS Self-awareness is the ability to recognize a feeling while it is happening. Learning to recognize feelings and separating them from opinion is the basis for being able to trade intuitively. People who are more sure of their feelings are better guides of their trading lives. Developing self-awareness requires that you learn to recognize and use what are called “gut-feelings.” Gut feelings can occur without a person’s being aware of them. All too often, people tend to suppress these feelings rather than to cultivate them and bring them to the forefront. It takes deliberate effort to become more aware of your gut feelings. You have to tune in on them and learn to evaluate them. Trading from the gut is one of the best ways you can possibly trade. Becoming more astute in emotional awareness is a fundamental building block of your EQ. EMPATHIC SKILLS The ability to put yourself in the other person’s shoes is important to successful trading. You have to be able to work with the people with whom you have to deal in the market. The capacity to know how the other person feels is essential to your ability to communicate your own desires. Even over the telephone we transmit to and catch moods from the person at the other end of the line. This is done in such subtle ways that unless you pay careful attention, they are almost imperceptible. Simply the way you give an order in a verbal ordering situation, or the way you say please or thank you, can leave the other person feeling that you are rude, that you feel superior to that person, or that you basically reject that person. On the other 37

hand, your tone of voice, your inflection, the expression on your face when you give a verbal order can be upbeat. It can make the person taking your order feel important and appreciated. You can make that person want to help you and to give you the best possible service. The more clever we are at discerning the feelings of others, the better the quality of signals we can send to them. In case you are saying to yourself, “but I never give verbal orders, I'm an electronic trader,” think again. You never know when your electronic ordering system is going to break down and you find yourself having to call a broker and tell him/her verbally what it is you want to accomplish. Through years of trading, I have learned to refrain from entering a verbal order to trade when detecting that the person taking the order was angry, frustrated, or in some way not feeling well; refusing to increase risk if that link in the organizational chain was in a state of “disrepair” and unable to function well. I have remembered to always praise and thank those people who handle my trades well. I have let them know I care and that I appreciate even the smallest of favors and cooperation. HANDLING MOODS We all have our moods, both good and bad. That’s part of being human. Moods are part of our character building, and the key to handling moods is balance. In general, we have little control over when an emotional wave will sweep over us. Moods are entirely emotional regardless of the cause. But we do have some control over how long the mood will last, and how we will handle it. Psychologists say that the most difficult mood to escape is that of anger. When you miss a trade because someone else goofed, or you get a terrible fill for unexplained reasons, you can become filled with rage. Outbursts of anger stimulate the arousal system of the brain leaving you more outraged, not less. An effective technique for dealing with this powerful emotion is that of restructuring. When you get no fill or an unexplained outrageously bad fill, tell yourself that perhaps the market was fast, or maybe the person taking your order was having a bad day.

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Try to see the situation in a different light. Restructuring can be applied to any bad mood. The sooner you place what happened to cause it into a more positive light, the sooner you will be able to put the negative emotion to rest. Another way to defuse anger is distraction. Turn off your computer screen and go somewhere else to cool off. It’s a good idea to do this when you are feeling despair over a serious loss, or you are frustrated with the way you’ve been trading. You need to get away and stay away until you can think clearly. Traders who have gotten into a seemingly impossible situation actually experience brain-lock. The best thing you can do is get away. Make yourself think about something else. Occupy your hands, or get involved in some sort of physical exercise. Take a walk. Do something to force your brain out of its locked state. Your aim should be to distract yourself. Distraction and restructuring can alleviate depression and anxiety as well as anger and frustration. Add to these deep breathing, meditation and other relaxation techniques, and you will find that you have a fair measure of control over negative moods. CONTROLLING IMPULSES Let’s say you’re in a trade and it begins to go against you. You experience an impulse to get out now! But you also have a goal of staying with this trade in order to give it a fair chance. In such a situation, following your impulse sacrifices your goal. Perhaps the essence of emotional control is the ability to delay impulses that get in the way of your meeting your goals. Controlling impulses is an important part of you EQ and ability to achieve success. The ability to resist impulses can be developed with practice. When you are faced with an impulse, remind yourself of your long-term goals. We're reminded of a time when a trader friend of ours wanted to purchase some far-distant out-of-the-money options. He wanted to pay the minimum possible for them, which in this case was $6 apiece. 39

He waited three weeks for those options to come down to that price, but they steadfastly remained at $10 each. Finally, on impulse, because he felt he couldn’t wait any longer, he bid the $10 and was filled. Two days later, and for the next few weeks, he could have been filled at $5. What he did was to allow the impulse to get in the way of his goal which was to buy those options at the lowest possible price. Later on, when those options went up by 30 times the $5 he could have paid for them, his options went up only 15 times because he had paid twice what they were selling for two days later. Instead of making $150 apiece, he made only $75 for each one he had purchased. THE WORLD’S MOST PERFECT BUSINESS Richard Russell of the Dow Theory Letters once wrote a piece on the “Ideal Business.” We thought it might be interesting to show you how what we think about trading matches up with Richard Russell’s concept of the ideal business. Our own comments are in bold print. “(1) The ideal business sells the world, rather than a single neighborhood or even a single city or state. In other words, it has an unlimited global market (and today this is more important than ever, since world markets have now opened up to an extent unparalleled in my lifetime). By the way, how many times have you seen a retail store that has been doing well for years – then another bigger and better retail store move nearby, and it’s kaput for the first store.” When you are a trader, the whole world and all of the exchanges are your market place to buy or to sell! “(2) The ideal business offers a product which enjoys an ‘inelastic’ demand. Inelastic refers to a product that people need or desire – almost regardless of price.” As a trader, you can choose to buy or sell any one of a number of commodities. If there is a shortage of crude oil, you can buy crude oil futures lower and sell them higher. If there is a shortage of gold, you can buy the gold futures. Let’s face it, inelasticity is the basis for every bull market there ever was, and elasticity, its opposite, is the basis for every bear market. 40

“(3) The ideal business sells a product which cannot be easily substituted or copied. This means that the product is an original or at least it’s something that can be copyrighted or patented.” With futures, you as the trader are the main product and you are unique. “(4) The ideal business has a minimal labor requirements (the fewer personnel, the better). Today’s example of this is the much-talked about ‘virtual corporation.’ The virtual corporation may consist of an office with three executives, where literally all manufacturing and services are farmed out to other companies.” Can you think of fewer labor requirements than a single person? You are the only executive and the only employee needed to run your trading business. “(5) The ideal business enjoys low overhead. It does not need an expensive location; it does not need large amounts of electricity, advertising, legal advice, high priced employees, large inventory, etc.” A trading business, while it has some overhead, mostly avoids the kind of overhead mentioned here. Probably the largest single item of expense is commissions including fees followed by the costs of data should you happen to require a live data feed. Believe it, some traders actually trade from newspaper prices, subscription chart services, and even delayed data feeds. “(6) The ideal business does not require big cash outlays or major investments in equipment. In other words, it does not tie up your capital (incidentally, one of the major reasons for new-business failure is under-capitalization).” Amen to the under-capitalization part. Most small traders attempting to “make a living” trading are woefully short on capital. However, trading futures, because of the leverage involved, requires relatively little capital investment commensurate with expected returns. “(7) The ideal business enjoys cash billings. In other words, it does not tie up your capital with lengthy or complex credit terms.” 41

Trading futures is one of the most liquid occupations there is. Cash is generally available within 24-48 hours. No credit involved here. “(8) The ideal business is relatively free of all kinds of government and industry regulations and strictures (and if you’re in your own business, you most definitely know what I mean with this one).” As an individual trader trading your own account, you are virtually free of government regulations except wherein they affect the entire industry. You are subject to exchange regulations, however. These are generally minimal and exist only to keep order in the market place. You don’t know what it’s like to have OSHA, the EPA, the SEC, or the FTC and a few others like them on your back unless you’ve actually experienced the horror in person. “(9) The ideal business is portable or easily moveable. This means you can take your business (and yourself) anywhere you want – Nevada, Florida, Texas, Washington, S. Dakota (none have state income taxes) or hey, maybe even Monte Carlo or Switzerland or the south of France.” This is where an individual trader can really shine. You can port your trading business to many parts of the world. The less you day trade and require a live data feed, the more places you can travel to and live in. As long as you can make a phone connection, and obtain prices within a reasonable length of time, you are in business. And now with access via electronic trading and the Internet, the entire world is your market. “(10) Here’s a crucial one that’s often overlooked: the ideal business satisfies your intellectual (and often emotional) needs. There’s nothing like being fascinated with what you’re doing. When that happens, you’re not working, you’re having fun. Here is another situation in which trading really glows. Most individuals trading their own account really and truly enjoy the never ending challenge of the markets. 42

“(11) The ideal business leaves you with free time. In other words, it doesn’t require your labor and attention 12, 16, or 18 hours a day (my lawyer wife, who leaves the house at 6:30 AM and comes home at 6:30 PM and often later, has been well aware of this one).” Even an addicted day trader does not have to trade all day long or every day of the week. Trading can be tremendously relaxed and leisurely if you allow it to be. “(12) Super-important: the ideal business is one in which your income is not limited by your personal output (lawyers and doctors have this problem). No, in the ideal business you can sell 10,000 customers as easily as you sell one (publishing is and example). Okay, so we only got 11 out of 12 right. Sad but true, when you are a trader, you are IT! You can’t hire a substitute. But you can sell 100 contracts with the same effort it takes to sell 10 contracts. “That’s it. If you use this list it may help you cut through a lot of nonsense and hypocrisy and wishes and dreams regarding what you are looking for in life and in your work. None of us own or work at the ideal business. But it’s helpful knowing what we’re looking for and dealing with. As a buddy of ours once put it, ‘I can’t lay an egg and I can’t cook, but I know what a great omelet looks and tastes like.’ “ ‘Work is love made visible. And if you cannot work with love, but only with distaste, it is better that you leave your work and sit at the gate of the temple and take alms from those who work with joy.’

“Albert Einstein’s three rules of work: (1) Out of clutter find simplicity. (2) From discord find harmony. (3) In the middle of difficulty find opportunity.” 43

Einstein’s three rules of work are the heart and core of what we try to teach in our books, seminars, and private tutoring sessions! Please read Einstein's rules and memorize them. They are the basis of all successful trading.

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Chapter 6 MONEY MANAGEMENT There are some common mistakes I’ve seen traders make in the area of money management. First, let’s understand what money management is all about. Money management overlaps with risk, trade, business, and personal management, yet it has many aspects that make it unique, distinctly different from all of the other areas of management. In this chapter we want to examine some areas of money management that seem to involve mental quirks leading to costly mistakes. LISTENING TO OPINION Kim has entered a long position in crude oil after carefully studying as many factors as she could reasonably include while making her decision to trade. She has entered the trade because her study of the underlying fundamentals has her convinced that crude oil prices must soon begin to rise. Then Kim turns on her television set Kim can't make up her mind. and begins to watch one of the financial news stations. An “expert” in crude oil is being interviewed. He begins to talk about how crude oil inventories are almost certain to drop this year because oil companies are not doing as much exploration as they have in previous years. Kim listens intently to what he has to say and then begins to doubt her decision about the trade she has entered. The more she thinks about it, the more panicky she becomes. She considers abandoning her position even though she will end up with a

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loss. The fact that an “expert” has decided something else completely shakes her confidence. She exits the trade intraday and takes a $400 loss. Prices have not come near her protective stop, which was $700 away from her entry. The market never moves sufficiently far to have taken out her stop. By the end of the day, her crude oil futures have made a new high, and in the following days explodes into a genuine bull market. Instead of a magnificent win, Kim has a loss. The loss is more than money, she has lost confidence in herself. What should be done? You should set your own trading guidelines and trade what you see. Forget about opinion, your own and especially that of others. Unless you are one of a very rare breed whose opinions are sufficiently good for trading, do not trade on them. Make an evaluation based on the facts you have and then go with the trade. Just be sure you have a strategy for extricating yourself before losses become big. Had Kim stayed with her original strategy and stop placement, she would have ended up a happy winner instead of a regretful loser. TAKING TOO BIG A BITE Biting off more than can be chewed is a weakness of many traders. This form of over trading derives from greed and failing to have clearly defined trading Will Pete end up like this guy? objectives. Trading only to “make money” is not sufficient. Pete has sold short T-Bonds and is now ahead by a full point. He notes that he is making money on his trade. Feeling very confident and thinking it would be smart to be diversified, he enters a long position in silver futures, and also sells short 46

Call options of wheat which he is sure is headed down. Almost as soon he is in the market, wheat prices explode upward and his Calls are in trouble. Pete buys back the losing short Calls and sells additional Calls on a two-for-one basis at a higher strike price. At the end of the day he looks at other positions. Silver had an intraday reversal leaving a spiked bottom as they close at the high of the day. The T-Bonds have made an inside day, but to Pete they suddenly look weak, he is down a few ticks. At the end of the day, he finds that most of the money he had made on his short T-Bonds was used to buy back the short wheat Call options. He covered those and now has additional premium in his account, but he also has additional risk, and is short Calls in a rising market – not an enviable position. Moreover, he is now worried about his long silver futures based on the fact that silver closed at its highs on what seems to be a genuine reversal. To further aggravate the situation, he has lost confidence in himself. What was once a happy, simple, winning silver short, has now become an ugly, confusing mess, and Pete has a good chance of ending up a loser on all three trades. If Pete keeps over-trading in this fashion, he could end up like the poor fellow in the picture. What should be done? Break every trade into definitive goals. Make sure you achieve those goals before adding other positions. Even with a single short sale of the T-Bonds, Pete could have set himself a goal for the trade. One or two full points might have been all he needed to satisfactorily retire that trade as a winner. Then he could have made his trading decision for an additional position. There are very few traders who can successfully manage multiple positions in a variety of markets. OVERCONFIDENCE Overconfidence is a particular kind of trap that springs shut when people have or think they have special information or personal experience, no matter how limited. That's why small traders get hurt trading on no more information than “hot-tips.” Tim is a farmer. He raises hogs and purchases huge amounts of feed to provide for his hogs. Tim has a large farming operation which is quite profitable. He takes 250 hogs a week to market. Because of 47

a steady flow of hogs from his operation to the market, Tim has no need to hedge his hog business because he is able to dollar average the prices he gets for them. But Tim does want to indirectly reduce the cost of the feed he has to buy, so he purchases soy meal futures. Tim listens to weather and farm reports all day long. He attends meetings of other farmers, and tries to gather all the information he can that might help him be more profitable. But Tim has a major problem, called tunnel vision. When he looks out at the grain fields in the area where he lives, whatever he sees there he extrapolates to the whole world. In other words, if Tim sees that the surrounding fields are dry, he suspects that all fields everywhere must also be dry. One year Tim witnessed a local drought. He checked with all the local farmers and they said they were truly experiencing drought conditions. He looked at the news on his data feed, and sure enough it said that there was a drought in his area. In fact, the entire state where Tim raises his hogs was undergoing drought. Tim wasn’t too concerned about his own feed bins. He had plenty of it in his silos from previous bumper crop years. Tim decided to be piggish and speculate on what he considered to be inside information. He called his broker and bought heavily into soy meal futures. Tim was confident. He was sure that soy meal prices would explode upward some time Is this Tim or one of his herd? soon, and that he was going to make himself a small fortune. Tim's greed may have turned him into a hog. However, the futures he purchased started moving down and the value of his investment began to shrink markedly. What Tim failed to do was to have a broader perspective. Everywhere else that grains were grown, farmers were experiencing rain in due season. The drought was localized almost entirely within the state in which Tim did his hog raising. Tim lost because he was confident in the limited knowledge he had.

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What should be done? We all need to broaden our horizons. We need a humble attitude relative to the markets. We can never afford to wallow in overconfidence in what we perceive as special knowledge. A trader can never afford to let his guard down. Tim thought he knew something that others hadn’t yet caught onto. In so doing, Tim made another mistake as well. He heard only what he wanted to hear. HEARING WHAT YOU WANT TO HEAR – SEEING WHAT YOU WANT TO SEE Marketers call this preferential bias. Preferential bias exists among traders. Once they develop a preference for a trade, they often distort additional information to support their view. This is why an otherwise conscientious trader may choose to ignore what the market is really doing. We've seen traders convince themselves that a market was going up when, in fact, Seeing what they want to see is a common problem among traders. When that it was in an established happens, they usually hear only what they downtrend. We’ve seen want to hear! traders poll their friends and brokers until they obtained an opinion that agreed with their own, and then enter a trade based upon that opinion. A student of ours, Fran and her husband, John, decided they wanted to go to live in the Missouri Ozarks. Everyone told them that there was no way for them to make a living there. Everyone they asked advised them not to do it.

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Finally, a minister in the Church they proposed to attend told them that they were to serve there. Out of twenty or thirty people they asked, that minister was the only one who told them to come. Of course, it was exactly what they wanted to hear. They sold their home and most of their possessions accumulated over a lifetime. They moved to the Ozarks and went broke within a year. They had to leave and begin all over again. John, who had been semi-retired, now had to find a job. So did Fran. She had to give up a promising start as a trader to go out to put food on the table. What should be done? Look at each trade objectively. Do not allow yourself to become married to your opinion. Learn to recognize the difference between what you see, what you feel, and what you think. Then, throw out what you think. Lock out the input of others once you have made up your mind. Don't let your broker tell you what you want to hear. Never ask your broker, your friends, or your relatives for an opinion. Turn off your TV or radio, you don't need to see or hear what they have to say. Take all indicators off your chart and just look at the price bars. If you still see a trade there, then go for it. FEARING LOSSES There is a huge difference between being risk averse and fearing losses. You must hate to lose. In fact, you can program your brain to find ways to not lose. But not losing is a logical thought-out process, rather than an emotion-based reaction. Two human-based tendencies come into play. The first is the sunk-cost fallacy and the second is the exaggerated-loss syndrome. Sunk-cost fallacy: You are in a trade that begins to go against you. You reason that you have already spent a commission, so you have costs 50

to make up for. Moreover, you have spent time and effort researching and planning this trade. You reckon that time and effort as cost. You have waited for just such an opportunity and you are afraid that now that it has come you will have to miss this trade. The time spent waiting for opportunity is something you also count as cost. You don't want to waste all these costs, so you decide to give the trade a little more room. By the time you realize what you’ve done, the pain is almost overwhelming. Finally, you have to take your loss which is now much larger than it might have been. The size of the loss adds to your fear of ever losing again. The end result is brain lock and inability to pull the trigger on a trade. Exaggerated-loss syndrome: You give the importance of losing on a trade two to three times the weight of winning on a trade. In your mind, losses have greater significance than wins. In reality, neither is more or less important than the other. In fact, wins do not have to be as numerous as losses as long as the wins are significantly larger in size than the losses. Of course, best is to have more wins than losses with the wins greater in size than the losses. What should be done? Evaluate your trades solely on their potential for future loss or gain. Ask yourself, “what do I stand to gain from this trade, and what do I stand to lose from this trade?” Think the matter through. “What is the worst thing that can happen to me if I take this trade, and do I have a plan and a strategy for extricating myself long before it happens?” “If I begin to lose, is there a way I can turn things around and come out a winner?” Learn to look at the costs of a trade as part of your business overhead. Try to have a mind set that you will not throw good money after bad. When you give a trade more room, you are doing just that – often throwing away money. VALUING INVESTED MONEY MORE THAN WON MONEY Traders have a tendency to be more careless with money they’ve won than with money they’ve invested. Just because you won 51

money on good trades doesn’t mean you should gamble with that money. People are more willing to take chances with money they perceive as winnings as though it were found money. They forget that money is money. Valuing money depending on where it comes from can lead to unfortunate consequences for a trader. The tendency to take greater risk with money made from trades than with money invested as capital makes no sense. Yet traders will take risks with money won in the markets that they would never dream about with money from their savings account. What should be done? Wait awhile before placing at risk money won on trades. Keep your trading account at a constant level. Strip your winnings from your account and put them in a safe conservative place. The longer you hold on to money, the more likely you are to consider it your own. FORGETTING ABOUT MARGIN INFLATION Before the crash of 1987, S&P 500 stock index futures carried an exchange minimum margin of about $12,000 . Immediately after the crash, margins required by some brokers rose to $36,000 and higher. A trader we know, called Willie, figured that if prices on an index he was short went down, he would continually add to his position whenever prices first pulled back and then broke out to new lows. The index he was trading became very volatile, and his broker raised margins to by 1/3rd. Willie was trading a small account, and when he tried to sell short additional contracts onto his already short position, his broker would not allow him to do so. Willie complained bitterly, but the broker was adamant in his refusal. The broker would not allow Willie to use unrealized paper profits to cover the additional margin required for adding on. He explained to Willie that to do so would in effect allow Willie to build a pyramid position and that was not going to be allowed by the broker's firm. The mistake Willie was making was what some call the “money illusion.” Willie assumed that because his position was moving in his favor that he had more selling power and more margin. His broker quickly brought Willie face to face with reality. While some brokers 52

may allow it, unrealized paper profits do not truly constitute additional funds that may be used for margin. Willie’s dream of fabulous profits from this trade were just that, a dream. Willie should be thankful that his broker did not allow him to get in trouble. Pyramiding with unearned paper profits is not the way to succeed as a futures trader. What should be done? You should realize that each so-called “add-on” to an open position is really a whole new position. Each add-on carries all new risk, and each add-on brings you closer to the add-on trade which will fail and become a loser. When planning a trade, be aware that if the market becomes volatile, margin requirements may go up, thereby defeating any strategy for adding on to your position. There is nothing wrong with building a position one leg at time as prices ascend or descend, but when volatility dictates an increase in margin requirements, beware of trying to add on and be aware that you may not be able to add on. Option sellers can quickly get into similarly difficult positions. As they roll out to new strikes to defend a threatened short options position, they can find themselves not only facing the need for a larger position, but also facing increased margins in creating that larger position. They may discover that they no longer have sufficient margin to defend a particular position and thus have to eat a sizable loss. MORE KEY MISTAKES Throughout our courses we mention some key mistakes commonly made by traders. Here are a few more: Error: Confusing trading with investing. Many traders justify taking trades because they think they have to keep their money working. While this may be true of money with which you invest, it is not at all true concerning money with which you speculate. Unless you own the underlying commodity, for instance, selling short is speculation, and speculation is not investment. Although it is possible, you generally do not invest in futures. A trader does not have to be concerned with making his money work for him. A trader’s 53

concern is making a wise and timely speculation, keeping his losses small by being quick to get out, and maximizing profits by not staying in too long, i.e., to a point where he is giving back more than a small percent of what he has already gained. Error: Copying other people’s trading strategies. A floor trader I know tells about the time he tried to copy the actions of one of the bigger, more experienced floor traders. While the floor trader won, my friend lost. Trading copycats rarely come out ahead. You may have a different set of goals than the person you are copying. You may not be able to mentally or emotionally tolerate the losses his strategy will encounter. You may not have the depth of trading capital the person you are copying has. This is why following a futures trading (not investing) advisory while at the same time not using your own good judgment seldom works in the long run. Some of the best traders have had advisories, but their subscribers usually fail. Trading futures is so personalized that it is almost impossible for two people to trade the same way. Error: Ignoring the downside of a trade. Most traders, when entering a trade, look only at the money they think they will make by taking the trade. They rarely consider that the trade may go against them and that they could lose. The reality is that whenever someone buys a futures contract, someone else is selling that same futures contract. The buyer is convinced that the market will go up. The seller is convinced that the market has finished going up. If you look at your trades that way, you will become a more conservative and realistic trader. Error: Expecting each trade to be the one that will make you rich. When we tell people that trading is speculative, they argue that they must trade because the next trade they take may be the one that will make them a ton of money. What people forget is that to be a winner, you can't wait for the big trade that comes along every now and then to make you rich. Even when it does come along, there is no guarantee that you will be in that particular trade. You will earn more and be able to keep more if you trade with objectives and are satisfied with regular small to medium size wins. A trader makes his money by getting his share of the day-to-day price action of the markets. That doesn't mean you have to trade every day. It means 54

that when you do trade, be quick to get out if the trade doesn’t go your way within a period of time that you set beforehand. If the trade does go your way, protect it with a stop and hang on for the ride. Error: Having profit expectations that are too high. The greatest disappointments come when expectations are unrealistically high. Many traders get into trouble by anticipating greater than reasonable profits from their trading. They will often get into a trade and, when it goes their way and they are winning, they will mentally start spending their winnings, and may even borrow against their anticipated winnings to take on additional risk. Reality is that you seldom make all of the money available in a trade. I cannot count the times that I had for the taking hundreds or thousands of dollars in unrealized paper profits only to see most of those profits melt away before I was able to or had the good sense to get out. One trader I know had $700 per contract profits in a short eurodollar trade. The next day his position literally imploded on news of a 50 basis point cut in interest rates. He was lucky to get out with $350 per contract. The money from trading often doesn’t come in as fast or as plentifully as you have expected or been led to believe, but the overhead costs of trading arrive right on schedule. False profit expectations have caused aspiring traders to leave their job before they were really successful. The same false hope causes them to lose the money of friends and family. False hope causes them to borrow against their home and other fixed assets. Too high expectations are dangerous to the well-being of every trader and those around him. Error: Not reviewing your financial goals. Before you make a position trading decision, or before you begin a day of day trading, review your motives and your goals. • Why are you trading today? • Why are you taking this trade? • How will it move your closer to your goals and objectives? Error: Taking a trade because it seems like the right thing to do now. Some of the saddest calls we get come from traders who do not know how to manage a trade. By the time they call, they are deep in 55

trouble. They have entered a trade because, in their opinion or someone else’s opinion, it was the right thing to do. They thought that following the dictates of opinion was shrewd. They haven’t planned the trade, and worse, they haven’t planned their actions in the event the trade went against them. Just because a market is hot and making a major move is no reason for you to enter a trade. Sometimes, when you don’t fully understand what is happening, the wisest choice is to do nothing at all. There will always be another trading opportunity. You do not have to trade. Error: Taking too much risk. With all the warnings about risk contained in the forms with which you open your account, and with all the required warnings in books, magazines, and many other forms of literature you receive as a trader, why is it so hard to believe that trading carries with it a tremendous amount of risk? It’s as though you know on an intellectual basis that trading futures is risky, but you don’t really take it to heart and live it until you find yourself caught up in the sheer terror of a major losing trade. Greed drives traders to accept too much risk. They get into too many trades. They put their stop too far away. They trade with too little capital. We’re not advising you to avoid trading futures. What we’re saying is that you should embark on a sound, disciplined trading plan based on knowledge of the futures markets in which you trade, coupled with good common sense.

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Chapter 7 TRADING IS AN ART One concept that every trader must master is that of knowing which elements of analysis are telling him the truth at any given time. The overriding factors of trading are those of common sense and trading what you see. However, there may be a time to use technical indicators, knowledge of cyclicals, perhaps even your own theories to help you in trading what you see. There is also a time to virtually discard all of these and trade only what you see without regard to confirmation. You might call that “intuitive” trading. At other times, confirmation can be achieved from the fundamentals in the market place. It is best to have confirmation of some sort before trading. Although an individual trader, without the benefit and support of a research staff, can hardly afford to delve deeply into the underlying fundamentals, almost any individual trader can easily ascertain from the news and various reports and advisories some of the basic fundamentals needed for confirmation. In this way a technical trader differs from a fundamentals trader, who may spend hours and days researching the fundamentals of a market in which he wishes to trade. Technical traders can satisfactorily use the research of others to know which futures to watch, and can outperform fundamentals traders by correctly timing his trades through both chart and technical analysis. In a demand driven market, only an appreciation of the fact that prices are rising should suffice. All the technical and fundamental analysis in the world goes out the window in such a market. Only trading what you see on a chart makes any sense. A demand driven bubble in stocks, which resulted in a corresponding bubble in the stock indexes such as seen in the latter part of the twentieth century, defies every type of analysis other than an admission that if you see prices rising, you should be long, albeit with protective stops to make sure you lock in profits.

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The demand driven bubble situation in the U.S. stock markets left many analysts shaking their heads in confusion. Avoiding confusion is one reason why we maintain that you should trade what you see. For safety’s sake and a feeling of reassurance in non-bubble markets, what you see usually should be backed up and confirmed by some other method of analysis. There are situations in which there is no time for confirmation. Choosing that “other” area is an individual choice based upon experience and success. You learn to use what works for you. Avoiding confusion is why you should never marry a market, a certain way of trading, or a particular method of analysis. The most successful traders I’ve seen learn to trade from a toolbox of analytical methods. They learn to use the appropriate tool for a particular market condition. To avoid confusion, you must not marry a philosophy. When asking yourself or asked by others which way you think a market will go, you should be able to answer, “I don’t know, but by following the market’s own action and my own analysis, then more often than not, I will be positioned appropriately – even if that position is one of standing aside.” As a trader, you must learn to dance with the market. You, also, must learn that if a market you are trading decides to do the “Cha-cha,” you do it too. But before you can dance with the market you have to learn how. You have to get to know and understand the basic forces that drive prices (Hint: Fear and Greed). You have to develop pattern recognition skills, and it can be helpful to include indicators that tell you things about the market you cannot readily see. The indicators are there to enhance your analysis, not to be your analysis. Indicators are no substitute for your own perception based upon what you see and know. What was it that was driving the stock markets throughout the latter part of the decade of the 1990's? It was demand! People were pouring money into mutual funds at a fantastic rate. Those funds could not just sit on that money, they had to invest it where the people want it placed – in the U.S. stock market. Anyone paying attention to their constantly rising price charts could have seen that. 58

A TURNKEY BUSINESS? There are far too many traders who enter this profession looking for a turnkey business. An accountant can buy an existing practice. So can a doctor and, to some extent, an attorney. An engineer can usually buy into an existing firm. Entrepreneurial-minded individuals can buy a franchise. If you have enough money, you can get a high-profile big-name franchise. A good one comes with training for you and for your hired help. It comes fully equipped with everything you’re supposed to need to run the business. Your advertising is laid out for you. You have an employee manual and an operations manual. You are shown how to set up your books, and trained in how to do it all on a computer using the software provided by the franchiser. Unless you are at the level of a functional idiot, you can pretty well be certain that you are going to succeed. However, trading is far from being a turnkey business. You simply cannot go out and buy a mechanical trading system that is going to guarantee you any viable degree of success. Oh, I know they are advertised that way – so are some franchises in other areas of business. But there are fakes and frauds the world over. Caveat emptor!! When you are a trader, no one gives you an employee manual. No one offers you an operations manual. There is no school to which traders can go to be trained specifically in this business. (We are hoping to correct that somewhat with our manuals, seminars, and tutoring sessions.) No one can truly sit down with you to show you which futures markets you should trade and in which time frame to trade them. Trading is something that cannot be packaged. There are too many aspects of trading that derive from the individual personality and mind set of the trader him/herself. Trading is not the only occupation that is that way. Anything truly creative cannot be packaged as a business.

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THE ART OF TRADING People talk about trading as though it were scientific. With varying degrees of success (failure??), they try to apply mathematics and scientific theories to markets, and consequently to the trading of futures. But if you allow trading to define itself, it is quickly seen that it is an art form and not a science. Trading is more nearly compared with art and music than it is with science. Great traders are individuals, and almost always creative ones at that. Could anyone package and franchise the ingredients that created a Salvador Dali, or a Picasso? Would it have been possible to package and franchise the make up of an Arthur Rubenstein, Elvis Presley, or Whitney Houston? Trading is an art based on an artist’s perception of what is happening in the markets. If it weren’t, there would be many more traders.

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Notice the head and shoulders pattern on the preceding chart. If prices followed some sort of law, or if chart analysis were a science, why didn’t that result in the market moving down instead of up? If something is scientifically provable, then it ought to be able to be reproduced repeatedly with the same results. If markets and trading were scientific, you ought to be able to obtain the same results every time you see a particular market pattern. But it just isn’t so! If it were, you could enter the trading profession and memorize all the major price patterns made by markets. You would then know exactly what to do in every case. You would have learned how to do a job, and the pay for trading would be like most other paying jobs – low. A similar observation can be made about theories. A theory is a theory until it becomes a fact. A fact is a fact because it is a result

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that can be proven repeatedly. A fact becomes fact when the result of something is always the same. If you jump out of an airplane, you’re going to fall – fact. If you slide down a forty foot razor blade...well you know! So why have we never seen an Elliott Wave fact? Because seemingly, no two people can agree on which wave they are in until after the fact!! Many artists train and study with and under great artists, but to become successful on their own, they have to develop their own style based on their own perception of the world around them. Musicians study under musicians having greater knowledge, experience, and maturity than themselves. But before they, too, can become proficient or achieve a level of greatness, they have to interpret music from their own perception of what they see and hear. Not every trader is destined to be a great one. You should be the last one to ever consider yourself to be a great trader. Your success in trading will be derived from becoming proficient in the discipline of perceiving markets for what they really are and how they really work. CLASSICAL TRADING PATTERNS We would have to guess that one of the first attempts at a scientific approach to the markets was that of pattern recognition. Pattern recognition has come full circle. It went out of vogue many years ago and now is back via the route of computer generated pattern recognition. The old-timers did a lot of their trading from these patterns, and maybe some still do: heads and shoulders, ascending and descending triangles, flags, pennants, coils etc. Do they work? Yes and no! You see, it is all a matter of perception. There were rules about how to trade these patterns. We can tell you this, they will work for you if you know when they are telling you the truth, and when to discard them as worthless. The same is true of technical indicators. Remember the heads and shoulders pattern we showed you on the previous page? The fact of real demand removed any semblance of reality for the heads and shoulders pattern – heads and shoulders tops are supposed to go down! 62

Nevertheless, an understanding of what is behind classic chart patterns will help to make you a better trader. CLASSIC PRICE PATTERNS

Assume prices trade within a relatively narrow Trading Range (between points “A” and “B” on the chart).

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Recognizing the sideways price movement, the ‘longs’ might buy additional contracts if the price advances above the recent consolidation. They may even enter orders to buy at “B,” to “add” to their position if they should get some confirmation the trend is higher. But by the same token, recognizing prices might decline below the recent Trading Range and move lower, they might also enter sell orders below the market at “A” to limit their loss. The ‘shorts’ have exactly the opposite reaction to prices. If the price advances above the recent Trading Range, many of them might enter orders to buy above point “B” to limit losses. But they, too, may “add” to their position if the price should decline below point “A” with orders to sell short at some point below point “A.” Keep in mind that socalled “adding” to a position is a misnomer. You can not “add” to a 64

position, you can only create an additional position, which essentially “adds” risk. A third group is not in the market, but they are watching it for a signal either to go long or short. This group may have orders to buy above point “B,” because presumably the price trend would begin to indicate an upward bias if point “B” were penetrated. They may also enter orders to sell below point “A” for converse reasons. Assume the market advances to point “C.” If the Trading Range between points “A” and “B” has been relatively narrow and the time period of the lateral movement relatively long, the accumulated buy orders above the market could be quite numerous. Also, as the market breaks above point “B,” the result is a stream of market orders to buy. As this flurry of buyers becomes satisfied and profit-taking from previous long positions causes the market to dip from the high point of “C” to point “D,” another distinct attitude begins working in the market. Part of the first group that went long between points “A” and “B” did not buy additional contracts as the market rallied to point “C.” Now they may be willing to add to their position ‘on a dip.’ Consequently, buy orders trickle in from these traders as prices drift down. The second group of traders with short positions established in the original Trading Range have now seen prices advance to point C, then decline to move back closer to the price at which they originally sold short. If they did not cover their short positions with a buy order above point “B,” they may be more than willing to cover on any further dip to minimize the loss. Those not yet in the market will place price orders just below the market with the idea of ‘getting in on a dip.’ The net effect of the rally from “A” to “C” is a psychological change in all three groups. The result is a different tone to the market, where some support could be expected from all three groups on dips. (Support on a chart is defined as the place where buying brings sufficient demand to halt a decline in prices.) As this support is strengthened by an increase in market orders and a raising of buy 65

orders, the market once again advances toward point “C.” Then, as the market gathers momentum and rallies above point “C” toward point “E,” the psychology again changes subtly.

The first group of long traders may now have enough profit to pyramid additional contracts with their profits. In any case, as the market advances, their enthusiasm grows and they set their sights on higher price objectives. Psychologically, they have the market advantage. The original group who sold short between “A” and “B” and who have not yet covered are all carrying increasing losses. Their general attitude is negative because they are losing money and confidence. Their hopes fade as their losses mount. Some of this

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group begin liquidating their short positions either with stops or market orders. Some reverse their position and go long. The group which has still not entered the market – either because their orders to buy the market were never reached or because they had hesitated to see whether the market was actually moving higher – begins to ‘buy at the market.’ Remember that even if a number of traders have not entered the market because of hesitation, their attitude is still bullish. And perhaps they are even kicking themselves for not getting in earlier. As for those who sold out previously-established long positions at a profit only to see the market move still higher, their attitude still favors the long side. They may also be among those who are looking to buy on any further dip. So, with each dip the market should find the support of: 1) traders with long positions who are adding to their positions; 2) traders who are short the market and want to buy back their shorts if the market will only “back down some;” and 3) new traders without a position in the market who want to get aboard what they consider a full-fledged bull market. This rationale results in price action that features one prominent high after another, and each prominent reactionary low is higher than the previous low. In a broad sense, it should appear as an upward series of waves of successively higher highs and higher lows. But at some point the psychology again subtly shifts. The first group with long positions and fat profits is no longer willing to add to its positions. In fact, they are looking for a place to “take profits.” The second group of battered traders with short positions has really been worn down to a nub of die-hard shorts who absolutely refuse to cover their short positions. They are no longer a supporting element, eagerly waiting to buy the market on dips. The third group of those who never quite get aboard the up-move become unwilling to buy because they feel the greatest part of the upside move has been missed. They consider the risk on the downside too great when compared to the now-limited upside 67

potential. In fact, they may be looking for a place to “short the market and ride it back down.”

When the market demonstrates a noticeable lack of support on a dip that “carries too far to be bullish,” this is the first signal of a reversal in psychology. The decline from point “I” to point “J” is the classic example of such a dip. This decline signals a new tone to the market. The support on dips becomes resistance on rallies, and a more twosided market action develops. (Resistance is the opposite of support. Resistance on a chart is the price level where selling pressure is expected to stop advances and possibly turn prices lower.)

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THE DOWNTURN

Now the picture has changed. As prices begin to advance from point “J” to point “K,” traders with previously-established long positions take profits by selling out. Most of the hard-nosed traders with short positions have covered their shorts, so they add no significant new buying impetus to the market. In fact, having witnessed the recent long(er) decline, they may be adding to their short positions. If the rally back toward the highs fails to establish new highs, this failure is quickly noticed by professional traders as a signal the bull market has run its course. This is even more true if the rally carries only up to the approximate level of the rally top at point “G.” As profit-taking and new short-selling forces the market to decline from point “K,” the next critical point is the reactionary low point at “J.” A major bear signal is flashed if the market penetrates this prominent low (support) following an abortive attempt to establish new highs in prices. In the vernacular of chartists, a head-and-shoulders reversal pattern has been completed. But rather than simply explaining away price patterns with names, it is important to understand how the psychology of the market action at different points causes the market to respond as it does. It also explains why certain points are quite significant. In a bear market, the attitudes of the traders would be reversed. Each decline would find the bears more confident and prosperous and the bulls more depressed and threadbare. With the psychology diametrically opposite, the pattern completely reverses itself to form a series of lower highs and lower lows. But at some point, the bears become unwilling to add to their previously-established short positions. Those who were already long the market and had refused to sell higher would eventually be reduced to a hard core of traders who had their jaws set and refused to sell out. Traders not in the market who were perhaps unsuccessfully attempting to short the market at higher levels will begin to find the long side of the market more attractive. The first rally that “carries too high to be bearish” signals another possible trend reversal. 69

With this basic understanding of market psychology through three phases of a market, a trader is better equipped to appreciate the significance of all chart price patterns. No one expects to establish short positions at the high or long positions at the low, but development of a feel for market psychology is the beginning of the quest for trades that even hindsight could not improve upon. When you analyze charts, approach them with the idea that they reflect human ideas about prices that are the result and the struggle between supply and demand forces. Your attitude and ability to judge market psychology will determine your success at chart analysis. Unexpected occurrences can change price trends abruptly, and without warning. Also, some of the chart formations may be hard to visualize, you’ll sometimes need a good imagination as well. MEMORIZE THIS THREE PHASE SCENARIO – EVERY TRADER SHOULD BE ABLE TO RECITE IT FROM MEMORY!!

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Chapter 8 BRAIN VS MACHINE In this chapter we will examine the current state of the art insofar as we can compare the electronic computer with the human brain. Our conclusion, as you will see, is that with the current state of the art being such as it is, the field of artificial intelligence has a long way to go before it can produce a trading program that can match what a human being is able to do. I’m sure you all recognize the content of the picture on the left. Yes, it’s a snowflake, and it is said that no two of them are the same. HOT, HOT, HOT Over the years I’ve seen a lot of hot new ways to trade. It was only a few years ago that the only indicator around was the simple moving average. Following in time was Stochastics and similar indicators. Then along came a plethora of technical indicators. Subsequent to that were a rash of even more sophisticated indicators. Unfortunately, none of these indicators, from the first to the last, produced a plethora of successful traders. In fact, many of the authors and creators of the various indicators have since repudiated them. The hot new thing in trading these days is computer generated pattern recognition. While it may prove to be a useful tool for some (even indicators work for some), most who will use computer generated pattern recognition techniques will fail. They will fail because they will forget to take into account a number of things I’m going to discuss in this chapter. PATTERNS The human brain is a wonderful thing. It was created by a power far beyond the understanding of man. In fact, the human brain alone should be proof to any thinking person that there is a God and that all 71

things were created by Him. The most sophisticated concepts of which man is capable cannot compare with the intricacies of the human brain, and to entertain the idea that it came into being through a series of cosmic accidents, or that it evolved, strains the bounds of credibility. The brain is purported to be the residence of the mind. I’m not sure this is so. The mind may very well be a spiritual thing, in which case it couldn’t possibly be contained in the brain. Spirit is not physical and therefore not subject to the physical laws of time and space. But for lack of a better term, I will use the term human brain. The human brain is capable of accumulating an abundance of minutiae and somehow sorting and classifying these details in subtle ways that we do not even begin to understand. It is capable of organizing this mass of trivia and recalling it as something we refer to as “intuition” or “a hunch.” Applied to the art of trading, some traders call this “trading from the gut.” You get a gut feeling that you ought to go long or short. You have a hunch that prices for a commodity are about to crash. There is no concrete proof. You can’t truly tell why or how you know. You just know. Learning to trade hunches is an art form all its own. Researchers have determined that hunches or intuition are output from the right side of the brain. That doesn’t mean that intuition originates there, it means the phenomenon known as a hunch enters our thoughts from there. In truth, intuition is essentially pattern recognition. In some unexplained subtle way, the brain recognizes that it has encountered this before, or that what the eyes are seeing has had certain meaning in the past and therefore this may be a similar situation. It also may be aware of the probable outcome if such is appropriate to the situation. Computer generated pattern recognition works in the same way. The computer program recognizes that this pattern is similar to one it has encountered before. It also is able to keep track of the probable results derived from such pattern encounters.

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So what is the difference between what the brain can do and the computer can do with regard to pattern recognition? The difference is enormous, and when you fully grasp it you will see the glaring weaknesses in computer pattern recognition as it stands today compared with pattern recognition derived from human thought processes. As usual, we can best demonstrate this with a picture. The computer accurately assessed the pattern on the chart below as a 1-2-3 followed by a Ross Hook. What can be derived from the computer’s analysis is that you have the potential to short a breakout of that hook.

However, the pattern is completely out of context. You might very well hesitate to sell short if you saw it in the context shown on the chart on the following page. Human pattern recognition sees a pattern in context. It is able to compare a pattern occurring in one place with the a similar pattern 73

occurring in another place on a relational basis. The human brain is able to make a judgment call, the computer cannot come close to anything on the order of human judgment.

The human brain recognizes and considers the relationship among the open, high, low, and close. If there were volume shown on the chart, it would be capable of taking that into consideration as well. Viewing the pattern itself, the brain can see that, yes, this is a 1-2-3 high followed by a Ross Hook, which could indicate a sell signal, but it also recognizes that doing so would result in a sale right into the middle of a Trading Range.

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Your human brain is capable of relating all that you see to what it has subconsciously taken in and remembered from past similar situations. The brain is aware of the time of day, the date and the time of year, in the event that seasonal or even cyclical factors come into play. The brain can place into context the current price relative to an entire scale of prices, and can remember historically under-value and overvalue for a particular market. It can also recall whether or not there was a recent event, which might explain the huge gap that is sometimes seen on price charts. Can a computer tell whether or not a gap is caused by a news event? The human brain can also take into consideration some of the following items: • The nature of the particular market in which the pattern previously occurred. The brain is capable of recognizing that the pattern is occurring in one market as opposed to another. It therefore is able to give a subconscious validity rating to what it is seeing. The computer cannot do this. It only knows about the particular pattern. It doesn’t see the pattern as having occurred in the context of the one market versus the other. • The human brain can take into consideration the fact that the pattern is occurring on a government report day, or the day before a holiday, or that it is Triple or Double Witching day. The computer is ignorant of these facts, but even if had them, it would take an incredible amount of programming to teach a computer exactly what it is you wanted done under every conceivable situation. • The human brain sees a pattern relative to liquidity. It can conceptualize that the market for one reason or another is illiquid and therefore the pattern doesn’t mean what it seems to be showing.

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• The human brain views a pattern in the context of market volatility. It can recognize whether a pattern is occurring in a trend or in a congestion. It can recognize the relative size of the bars inherent in the make up of the pattern. It not only can comprehend the relationships between opens and closes, and highs and lows, but it has a sense that price bars are closing in the upper or lower half of the bars making up the pattern. The computer comprehends nothing. Computers simply do not understand. • The brain has a sense of the conditions attendant to a particular chart pattern. Without your even realizing it, it may be aware that this pattern is taking place under conditions of relatively large tick size. The computer is completely unaware of such details.

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• The human brain is capable of making relative comparisons. It can ascertain whether or not it saw a particular pattern in a fast market, a “normal” market, or a slow market. The computer doesn’t take such things into consideration. • The human brain is able to ascertain and assign a value to the composition of the market as to participants by looking at bid-offer identifiers on a screen where available, or through an inspection of insider trading reports, the Position of Large Traders report, market sentiment reports, or news items. • Through the eyes, the human brain is able to view, in context, an entire market consisting of hundreds of price bars. Computer pattern recognition programs are restricted to a view of only the last x number of bars – seldom over 30. In other words, the brain can correlate thousands of seemingly unrelated bits and pieces of information and present them to the trader in the form of a sense of probability for success. The computer is unable to do that. It seems that far too many traders will do almost anything to avoid using the wonderful device that resides between their ears. Instead, they choose to use indicators, phases of the moon, astrological positioning, all sorts of theories, and now computer generated pattern recognition. The problem is that they choose to use these first. Instead of using their brain, and then moving on to see how these synthetic brain substitutes might enhance their perception, they choose first to use these artificial stand-ins. They have put the cart before the horse. They then find that they are so confused that their brain has become befuddled. Is it any wonder that so many traders never realize their objectives? Such confusion leads to fear. You don’t know which way to turn or what the synthetic alternative really represents. You simply don’t understand the big picture or grasp the condition of the underlying market.

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When the human brain finally grasps a concept, it can cause the mouth to utter “I see!” We know of no computer that can do that. Computer comprehension at this time does not really exist. If I’m mistaken, and perhaps computers can comprehend, then the gulf between degrees of comprehension as seen in the brain compared with that of a computer is so vast that it is seemingly a gap that cannot, at present, be bridged. You, the human, may not even be aware of the details the brain is organizing into what is described as a gut feeling. Is there any value to computer pattern recognition? Yes, if you take it with a salt-grain of reality. It can call your attention to a pattern you might otherwise not have noticed. Pattern recognition, as with indicators, can show you something you might not have picked up with just a cursory glance at a market. It may even show you a larger picture than the one on which you are now focused. Of course, whether or not to use such software is a matter of human judgment – yours!

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Chapter 9 EXPERIENCE Throughout our course on futures trading, we have tried to point out to you that there is a great difference between having an investor attitude and being a trader. There are also many similarities. In one sense, a trader is someone who invests in his own trading ability. Therefore, in that sense trading is investing. Trading and investing are interrelated. You come to realize this through experience. For the most part, the trading approach comes from a much shorterterm mindset than the mindset of an investor. It can also be much more based on technical information than on fundamental information. But here again we find a dilemma. What exactly is technical information? What exactly is fundamental information? Where do the two overlap, or do they? Are they interrelated? Sure they are. But again, it is through experience that you learn about and develop an appreciation for these concepts. TECHNICAL VS FUNDAMENTAL?? As futures traders, we get to hear some pretty weird things, and also as writers, and teachers in the business of educating people about futures trading . One of the strangest things we get to hear is when people try to separate trading into either technical or fundamental. Why, oh why, does everything have to be put into a box? Would someone please explain how to separate one from the other? Is it possible, or is there some middle ground that cannot be classified as either technical or fundamental? For example, how do you classify trading from news stories? Surely you would not call news stories fundamental information, would you? A friend of ours tells about a time in January when he heard a commentator on CNBC explain that the price of coffee had gone up because of a freeze in Brazil. The only thing wrong with the story was that January is the middle of summer in that country. Was the news worthy of the name fundamentals?

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What about seasonal trades? Are they technical or fundamental? Certainly they are not based upon hard facts. Who knows if tomorrow will bring a season like the last? Who knows that the weather will be the same this summer as it was the last? They say enter on rumor, exit on fact. Is that technical or fundamental? Or is it just plain good old common sense? This chapter is about experience, but here’s the catch: You must survive as a trader long enough to gain experience. Experience will show you that trading cannot be placed into a box. Experience will bring you to the realization that some of the best trades you will ever make come from experience, gut feelings, and good old common sense. Experience will demonstrate to you that many great trades are derived by paying attention and learning to be an opportunist. Experience will bring you to the point where you will take a smattering of what others may call “fundamentals” along with a pinch of what some call “technical analysis,” and combine them with a spoonful of know-how to succeed in making your living in the markets. FUNDAMENTALS Our understanding is that fundamentals deal with known facts and published or unpublished information about the underlying commodity or instrument you wish to trade. Because statistics lie, governments knowingly lie with statistics, or at times do so unwittingly, those who can afford it and also have a need, spend tons of money doing their own research in order to come up with their own body of fundamental knowledge. This includes gathering information and statistics on anything imaginable that might affect the underlying. They research production, marketing, crop conditions, financial conditions, etc.; everything they can find out about the underlying. They may even make in-person visits to farms, mines, or financial institutions for discussions about the underlying. They then combine this knowledge with what they find believable as handed down by various reporting agencies. Even with live data, it is not economic to compete with these behemoths with regard to the amount of fundamental knowledge they can afford and are able to gather. 80

TECHNICALS Technical analysis in its purest form assumes that everything known about the markets that affect the markets can be seen on a price chart. We believe that to be true. But that’s where reality and the kind of technical analysis we see today part company. What we mean is, in general what do technical indicators show you that you can't normally see with your two eyes via pure chart reading and analysis? Admittedly there are a few things. We have never denied that an indicator like Bollinger Bands can show you the location of 2 standard deviations. We cannot visually know where that amount of deviation from price would be without the bands. But most technical indicators wipe away the very things we do want to see. They take your focus away from what is truly happening to price. By smoothing, they purport to remove “noise.” But it is the noise that we, as traders, and especially as day traders, most want to see. The noise is what tells us the reality of what is going on. REALITIES Fundamentals, in the purest sense, are beyond what the individual trader can deal with. Most individual traders simply don’t have the time to conduct the required research. But that doesn’t mean they cannot use this information should the happen to stumble across it. Technicals in the purest sense are fine, but the way they have been bastardized into virtually meaningless indicators makes no sense. The ultimate foolishness of technical indicators is that of rendering them as mechanical trading systems. Employing mechanical systems represents the height of the undisciplined mind. It is tantamount to conceding that because you do not have the discipline to exercise self-control, you will undergo the harsh discipline enforced on you by an uncaring, unfeeling machine. While you try to escape from self disciplined trading, mechanical systems force an even more horrible discipline upon you in that you now have to sit and grit your teeth due to the pain brought on yourself because of the mechanical aspect of the system. Mechanical trading is not without discipline, rather it places the discipline onto the wrong part of the trade. Instead of placing the emphasis on planning, organizing, directing, and controlling the trade, it gets the trader in via a mechanical signal and 81

then forces him to suffer through the trade in order to exercise discipline — quite often a discipline he does not understand based upon a system he does not understand, and that may have been derived entirely outside the realm of reality. The realities of the market are many. Markets are affected by a lot of things that are not measurable by either fundamental or technical analysis. In addition to seasonality, news, rumor, weather, and common sense observation, one has to take into account the market conditions at the time at which a trade is to be entered. Is the market fast? Is the market thin? Is the tick size abnormal? Are market makers moving the market? Is it options expiration day? Is it the day before a holiday? Is an important dignitary going to make a speech? Has the market gone into a state of hysteria, or even euphoria? Are you going to buy or are you going to sell? It is the summation, organization, and perception of these and even other criteria that constitute the realities of trading. REALITY TRADING We are convinced that the best way to trade should be termed “Reality Trading™.” In fact, we are so convinced that we have trade marked the name for future use. Reality Trading views the market as an entire entity, a living, throbbing reality that includes fundamentals, technicals, and realities such as news, rumors, seasonal tendencies, common sense observations, and market conditions. Let’s look at a possible trade that is based upon realities. Let’s say that this is a trade that has been good most years in the last 15 years. Let’s say that the trade is to buy March wheat between September and December of the current year. First we look to see if March wheat futures are behaving normally. What does the March wheat futures chart need to look like if this trade is going to work? We begin watching March wheat futures in the first week of September, for possible entry between that time and the last week in November. We’re not particularly interested in what the March wheat futures look like prior to September, but according to past seasonal 82

patterns, they should not end September in a down trend. The normal pattern for wheat futures at that time of year is that wheat prices begin to rise or at the very least remain flat. Falling prices would indicate an over supply of wheat. The rising or flatness may have begun earlier, or it may begin later, but not by the end of September. The main thing we don’t want to see is wheat prices falling after September. If wheat prices are falling in the time period mentioned above, then we do not have a normal year for these futures and we want to avoid this trade. No one knows for sure what weather conditions will be between the first week in September and the time the that wheat inventory figures are known. No one knows if exports will be up, down, or flat compared with the previous year. It is the seasonal anticipation that should prop up the price of the wheat futures. Obviously, this same sort of technique could be applied to any purchasable commodity that can be expected to experience increased activity seasonally. So, lets look at a wheat chart. We want to select the best the best possible time to enter. Experience has shown that the two best times are as follows: • An announcement by the government between September and October that it export sales of wheat have increased materially – a buying situation • A report showing a greater than expected inventory of wheat in September through November – a selling short situation.

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At “A” we see announcements coming from government reports that demand for wheat for export is great. It is the middle of September. People rush in to purchase wheat futures. However, from the look of this chart, overall demand for wheat was not very good. Actually, the year shown was poor for wheat most of the time. Later, beyond the time frame in which we are interested, at “B” we see that the government crop report for January was really bad for wheat. There was simply too much of it. Wheat prices began to plunge. What stopped the plunge? Anticipation of planting problems due to unusually cold weather.

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Chapter 10 ARE YOU A LOSER? Are you cutting off your nose to spite your face? Do you remember the life of Vincent Van Gogh? Good old Vincent discovered his girlfriend didn't like him, so he cut off his ear. Some of you don't like having money, so you cut yourself off from it by losing it in the market. You’ll never convince us you really like money when you’re so eager and quick to lose it. We’re going to give you a real life example of how to mismanage your money and turn a winning trade into a loser. The trade took place earlier this year, when we witnessed a professional trader (PT) making a self-defeating move like the one we will show you. First we’ll show you how the chart looked. Then we’ll talk about what the trader did, what he would have done had we not been there, and what he should have done that he didn't do, despite the fact that he came to us to have us coach him in day trading. PT was day trading from a fifteen minute chart. He also looked at hourly charts for perspective. Five minute charts gave him a more minute vision of what was happening in the markets, and a way to optimize his entries. Let's have a look at his method of entry, his reasons for entry, and where he made his mistake. By the way, this man is an excellent trader. He came to us because he was experiencing a severe equity draw down.

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60 Minute

The arrow shows the sixty minute period in question. opening hour of stock index trading in the U.S.

It is the

(First arrow): Viewing the sixty minute chart gave PT an overview of the market. The price bar shows that prices had been in and remained in an uptrend. (First arrow): The same price bar shows that prices opened on a gap up from the previous day’s close. A gap opening usually means the insiders may initially attempt to trade to the short side. PT’s plan was to use the momentum of the insiders to fade (take the opposite side from the direction of) the open, figuring that the insiders might actually double their shorts based upon the gap.

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PT then went to his fifteen minute chart for verification of what he was seeing.

15 Minute

(15 minute chart): According to what he told us, PT was looking for a pull back of at least 3/8ths of the last up upswing that had started the previous day. Although he doesn’t use the 1-2-3 low formation per se, we took the liberty of marking the chart so you could see the beginning of the upswing (arrow on the chart). We also marked the high of the opening fifteen minute bar as a Ross Hook (Rh), which came into effect as the second fifteen minute bar opened lower than the opening fifteen minute bar, and went no higher. PT’s plan was to short a breakout of the low of the opening fifteen minute bar.

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In order to optimize his entry, he went to the five minute bar chart looking for an entry formation that might get him short ahead of the actual breakout of the fifteen minute low. It was interesting to watch him because what he was looking for was the equivalent of a Trader’s Trick entry, or the breakout of a congestion prior to the actual taking out of the low.

5 Minute

(5 minute chart): As it turned out, there was no Trader’s Trick entry available prior to the taking out of the opening bar low. Nor was there a congestion breakout to assist his entry. The opening bar low (left arrow) was taken out (right arrow) in the time between twenty-five and thirty minutes after the open. You can see by the extra length of the bar that the insiders caught some stops resting just under the opening bar low. Those sell stops placed there as protective stops by those who had gotten long after the opening five minute bar high was 88

violated, as well as those who wanted to short a breakout of the opening bar low, caused an extra long “thrust” type bar to occur as the opening bar low was taken out. Earlier we noted that PT had made a mistake. He had turned a winning trade into a loser. How did he do that? Good fortune actually got him in his short position two ticks better than a breakout of the low of the opening bar. Prices then moved down to a point where he was $250 to the good in the trade. Because he was trading lightly during the coaching session, he entered the market with only a five lot. He failed to take off some of his contracts, even though his commissions and costs are only $9/round turn . When the bar subsequent to his entry bar (35 minutes after the open) threatened his entry point and then closed in the lower half of the bar, we breathed a sigh of relief and encouraged him to take off the entire position. He would have had over $325 of profit on a five lot. But he didn't cash in the trade. Instead, he wanted to discuss it. When the next bar (40 minutes after the open) failed to go any lower, and in fact was an inside bar that closed on its high, he finally set his stop at break even. Finally, he was stopped out above breakeven for a $150 loss plus costs. What could have been a nice profit had turned into a loss. This error turned out to be what was wrong with PT’s trading. He had gotten off track. He was failing to take the money while it was there. We hope many of you can learn from his mistake. PT’s goal was to take at least two full points out of the trade. But he was being stubborn. Stock index prices were not going to give him that many points on that day. The market was telling him that the only thing that happened at the opening low was that the insiders had run the stops. When he saw that prices were not plummeting down from there, he should have had an alternative plan to take what he could get from the market while he could get it. There was nothing wrong with PT’s plan to fade the open. In fact, it was a sound plan, one anyone one of us might frequently follow. It was his management that was faulty as well as his discipline.

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Chapter 11 COMMON SENSE TRADING This trader is ready to go. Yes, he has all his tools in place. Just look at all those charts. What's more, he may have found the secret of trading by the moon. If not that, surely he has worked out something using the stars. Just look at the magical data symbols on his hat and the fringes of his coat. From the look of it, he has been at it all night. The charts stacked in the back may be part of a black box system. In fact, as you can see, the box is at least partially black, isn't it? Here’s a quote from Trading Wizard an issue of a well known Wall Street periodical: “Black box trading systems are dead. Oldfashioned human brain-work and intuition are the keys to success.” This is a direct quote from the manager of one of the most successful hedge funds. Now ask yourself, “If the smart money knows that mechanical systems don't work, why don't I?” Many managed commodity pools which trade mechanical systems get the stuffing beat out of them every year. Conclusion: mechanical systems, trading models, even neural nets may not work when the trading gets rough. Neural nets, which have had some degree of success, can be lethal when given too little or too much training. It is difficult to find a correct balance. Even then, human intervention is the only way these nets can be optimized. Left to themselves, they make too many mistakes. They will, when left alone, fail to time trades correctly, and also compute incorrect valuations.

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We recently received a call from a broker who is also a system developer. He said, “I really like your stuff. You are right about systems, they don't work. I think you have something to offer that no one else teaches, common sense.” MORE COMMON SENSE We have said and written many times that during the last two weeks of the year one should avoid trading futures, especially one or two days before Christmas, and again one or two days before New Year’s day. While long options may be okay to trade with great caution, futures become far too dangerous. One year we determined to watch for and capture an example of why we avoid trading futures during the holiday season, or the day before any holiday throughout the year. In the example that follows and the chart below, you will see what can happen when a market gets thin, i.e., illiquid.

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On December 23, this normally very liquid market did a very strange thing. With no economic justification, and rather suddenly, the price of the underlying leaped upward, traveling in a matter of a few minutes to the high you see marked "A." Almost immediately, the market turned and plunged downward from "A" to "B" in less than 15 minutes. Now for the rest of the story. The only traders around at the time were the public trading from their computers, and a few of the market movers and insiders. The latter decided it was time for them to take home a nice Christmas present for their families. In what was no doubt a coordinated collusion, they ran prices up to the high at "A" taking out any and all stops between

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the beginning of the move and the high made at "A," and then they guaranteed themselves even greater profits by running everyone out of the market on the way down from "A" to "B." Now you may think that you would have been clever enough to have placed a buy stop just above the area of the Ross Hook (Rh) and once long, have taken profits and gotten out when you saw the market failing to go higher. Here's the sad news: Other than stops already in the market, the locals were not filling outsider orders. You would have gotten an "unable" on your exit stop. The market was said to have been “fast,” and the market movers would never have let you out until prices reached close to or at the level of "B." This kind of stop running and "market fun" can happen in any market when it is thin. Oh yes, the daily chart (not shown) looks just like it would on many other days, but the intraday action was murder. A lot of people were going to have a dark Christmas. Plenty of money was lost to the market movers on the maneuver that took place that day. That was true seasonal trading by the insiders. It was open season on any outsider who was foolish enough to be trading that day. One other item that comes up from time to time is the alertness one needs to have towards report days and other events which can and often do affect certain markets. One such event occurred in the realm of presidential speeches and it had an immediate and definite impact on the financial markets. The stock index futures in particular had a strong reaction to a speech declaring that there would be a middle class tax cut. War and rumors of war also greatly affect markets. During periods of great tension, virtually any report can greatly move a market. You must ask for and obtain a calendar from your broker or from any exchange on which you trade. These calendars contain important notice dates for futures and futures options traded at the various exchanges. You must also realize that these calendars are not always accurate. Quite often report notices are missing from them. We use two different calendars at Trading Educators, but at times they are not in agreement. More often than not, the calendar we obtain FREE from the exchange is more complete than the cheap piece of junk put out by many brokers. 93

However, either or both can be missing certain supposedly recurring reports that appear one month and fail to appear in the next. Certainly, speeches by presidents, chairmen of the Federal Reserve, Federal reserve governors, foreign dignitaries, loose-mouthed congressmen, and other events which may rupture or explode sector stock prices, do not appear in the event calendar. You must always look out for your own affairs. Even though it was not noted on a calendar, the fact that a president was giving a much publicized speech about a tax cut should have put on guard anyone who trades in financial markets. The President's topic and words were sufficient for his speech to have been treated as a report. The markets had a strong reaction to what he said. An easy way for you to tell whether or not something may have happened that would affect the stock index markets is to look at both the currency and interest rate markets ten to fifteen minutes after they have opened. If you see that the currencies have made a significant move prior to the opening of the stock index markets, then take that as your cue. In other words, use common sense. It is, after all, your money. Also look at T-Bonds and Eurodollars. If either have had a significant move prior to the opening of the stock index markets, trade with caution. On report days certain stock indexes often undergo wild gyrations. On a day when a report causes a large move in one of the other markets, some stock prices may also reflect such a report. But what about other markets? Is there a way to tell what is going to be in the various reports? Is there a way to be forewarned? At times, yes! And at times, there is even something you can do about it! Quite a few years ago, when the bonds commenced having an evening trading session, we began to notice that there was often an unexpected amount of direction, activity, or both, in the bond market the evening prior to a report day. It was not always the case, but it was sufficiently often for us to suspect something none of us would like to believe. But as much as we don't enjoy thinking of the crookedness and deception extant in governments and markets, one would have to be

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truly naive to not realize that there exists a great deal of corruption and dishonesty in today's markets. It became obvious that there were persons with foreknowledge of the content of major reports, and those persons were trading on that knowledge during the evening trading session of the bond market. The evening session provided them with a wonderful way to sneak in during the night when most traders are not watching. What we noticed in the evening session of the bond markets is also true and can often be seen if one charts the price action of financials traded in the Globex session of the Chicago Mercantile Exchange. You can sometimes see the corruption taking place during the night in the S&P 500 E-mini futures contract. But then isn't that the traditional time frame within which most thieves do their work? If you see that a lot of action has taken place during the night session and early morning trading, be alert. Be on guard to protect yourself. You have a responsibility to look out for yourself. This is hardly a stable world and anything can happen to cause the markets to go berserk at the open. Those of you who have access to such data should learn to watch the early stock index trading that takes place prior to the opening of the stock markets. You must surely check that every day that you trade. If a major move is going to take place in the S&P 500 stocks, you may see it in the trades that occur prior to the opening of the day session of the stock index futures markets. We want to interject a cautionary note: A lot of books and seminars are touting the value of using the full-size S&P 500 futures as a trigger point for engaging in short-term intraday trades in any of the mini contracts. This is an extremely amateurish approach to trading. The correlation between the mini index you are seeking to trade and the movements in the full-size S&P 500 may be very slight. There are many days when the minis go their own way. We have seen and experienced a great number of traders, who because they really don’t understand how to trade, attempt to use movements in the full-size S&P 500, and who ultimately lose a great deal of money. The 95

movements in the S&P 500 can experience a far greater magnitude of fakery than do the movements in the minis. Nor does it pay to watch movements in an individual stock or stock sector, which have at the very least the governor of supply and demand which keep their price movements somewhat in check. This is not true of the S&P 500 futures. We have been told that in one particular book there is an account about a strategy of following the full-size S&P 500 to day trade. The author bases one of his winning examples on trading that took place in mid August of 1997. Apparently the author was ignorant of the fact that volume during that month and the next had dried up to a point never before experienced in the S&P 500 futures, and that a move of the magnitude of well over 800 ticks ($4,000) had occurred much to the dismay of the principals in the S&P 500 trading pit. This excessive large single move was followed within days by a single move of well over 500 ticks ($2,500). An 800 tick move in the S&P at the time these trades took place was valued at $50 x 800 or $4,000 per contract traded. In other words, a trader buying a 10 lot in the S&P suddenly found himself $40,000 dollars poorer when the market ticked lower by 800 tick points literally in a fraction of a second. Amazingly, within a short time most of the loss was recovered. But pity the poor futures traders who bought just prior to that one 800+ tick meltdown. If you are willing to key your mini trades from the S&P 500, you may be in for a shock. There are much better ways to trade. Mainly, learn how to read a chart, and in particular, pay attention to the chart of the mini index you are trading.

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Chapter 12 THE ULTIMATE STOP LOSS “Only fools refuse to be taught. Wisdom shouts in the streets for a hearing. Wisdom calls out to the crowds at the exchanges, and to the judges in their courts, and to everyone in all the land: “‘You simpletons!’ she cries. ‘How long will you go on being fools? How long will you scoff at wisdom and fight the facts? Come and listen to me! I’ll pour out my spirit of wisdom upon you, and make you wise. I have called you so often but still you won’t come. I have pleaded, but all in vain, for you have spurned my counsel and reproof. I told you, some day you’ll be in trouble, and I’ll laugh! Mock me, will you? – I’ll mock you! When a storm of terror surrounds you, and when you are engulfed by anguish and distress, then I will not answer your cry for help. It will be too late though you search for me ever so anxiously.’ “For you closed your eyes to the facts and did not choose to reverence and trust in wisdom, and you turned your back on me and spurned my advice. That is why you must eat the bitter fruit of having your own way, and experience the full terrors of the pathway you have chosen. For you turned away from me – to death; your own complacency will kill you. Fools! But all who listen to me – wisdom – shall live in peace and safety, unafraid.’” These heavy paragraphs are a paraphrase from the book of Proverbs. You can read it non-paraphrased in the first chapter of that book. We decided to include them here, because what one always hopes will never happen to any trader has happened. A fellow trader and student committed suicide in his despondency over the losses he had taken in the market. This handsome and talented gentleman had become a millionaire before he lost his money. He made a fortune in real estate, buying, repairing, and then marketing various properties. Then he took up 97

trading. It looked so easy! How many of you view the markets the same way? In an earlier part of the first chapter of Proverbs, it says, “When a bird sees a trap being set, it stays away, but not foolish men; they trap themselves! They lay a booby trap for their own lives.” This man trapped himself. Did the markets kill him? No, he did it to himself. He poured good money after bad. In an almost maniacal frenzy, he desperately tried to recoup his ever mounting losses. In an intensity of panic, he day traded like a man possessed. As his fortune dwindled and his dreams of easy money went out the window, he blamed every one and everything for his troubles. In a meeting we had with him, he blamed his computer. He blamed his live data feed. He blamed his broker. He blamed the market insiders. There was no talking to this man – no way to help him. No matter what advice was offered by his trading friends, he refused to admit there was anything wrong with his trading or his attitude. To meet with him was uncomfortable. His gaunt, wild-eyed look immediately made uneasy all who met him. Where was his ultimate stop loss? Apparently, for this man, it was the grave. He placed a loaded gun in his mouth and pulled the trigger. Where is your ultimate stop loss? Is it at the same place as his? Is trading worth your very life? What of this man’s family? Who will comfort his wife in her old age? Who will be there for his children and grandchildren? It certainly will not be him! There must be a time and a place where you are willing to call it quits. For most people that point comes before the desire to save their fortune overwhelms their desire to save their own life. For years we have tried to understand why people threw themselves out of windows and plunged to their death as a result of the market crash of 1929. We hope none of us ever has to find that understanding in our own lives.

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We never cease to be amazed at the attitude of people who contact us because of our books and seminars. We shudder when we think of the frantic need to trade that some seem to have. TRADING BEFORE HOLIDAYS It was just prior to a three day holiday weekend. The market was to be closed Friday. We anticipated very thin trading on Thursday. Coincidentally, Thursday was to have one of the major governmental reports. On Friday, when the market would be closed, there was to be another major governmental report. These reports are known to have considerable effect on interest sensitive markets. To make matters even worse, on the afternoon of the Monday following this three-day weekend, a major policy making speech was to be made by the chairman of the Central Bank. In our estimation, the markets would be much too thin and volatile for trading on Thursday. An appropriate thought would have been “I am not considering a single trade today. The markets will be thin ahead of the holiday.” To our utter amazement, we began getting phone calls asking about various trades that individuals were seeing. Some were dismayed that we mentioned to them that we thought that it was totally inappropriate to trade at such a time in view of the holiday, the reports, and the upcoming speech. It was almost as if the callers were insulted by our caution and care for their safety. Were these traders or thrill seekers? Do people trade because they get an emotional high from this activity? Apparently some do! Apparently, trading is an addiction for some. Why not take up parachuting, auto racing, or some daredevil activity like diving into two feet of water from a fifty foot cliff? Some traders are so impatient. They have a compulsion to trade. Even worse, some feel they have to day trade all day long – as long as trading hours are open.

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Before you ever day trade with real money, you need trading experience. Your discipline should be fairly well set, your good trading habits pretty well formed. You should have developed an attitude of patience and reasonable satisfaction. You should be learning to tune in on your instincts and intuitive abilities. Even then, you will have some harrowing experiences. What on Earth makes so many think they can hear about trading from a friend, read a few books giving only a cursory treatment to the profession of trading, take a one or two day seminar, and then successfully step out and become an instantly marvelous trader? You may have to spend years learning the art and craft of trading, certainly it will take many months. It takes great stamina, skill, and discipline, especially when it comes to day trading. The mortality rate is extremely high among day traders. It might very well be that with the wrong approach, you have a better chance at a gambling casino or the race track, if all you want to do is gamble. There are no commissions at casinos, no exchange fees. There are not nearly as many books that you need to read, and there are probably no seminars for you to attend. Probably the biggest advantage at the casinos is that the gaming tables are, for the most part, fairly run. The house knows it doesn’t have to cheat you to get your money. The house’s edge is built into the system. This is not true on the trading platforms of the exchanges. The insiders will regularly try anything in order to gain an edge over you. They’ll steal your profits with bad fills. They’ll front-run your trades. They fake going long only to go short and vice-versa. They will beat you out of your money every chance they get. If you just want to throw away your money, you can do it at the gambling tables and have a lot more fun as well. At least there they feed you, offer you drinks, and entertain you while they take your money. The futures markets are one of the worst possible places in which to be a gambler. The scriptures say, “There is a time to mourn.” This chapter has been a time to take up a lament.

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Scripture also says there is a time to rejoice and to be happy. The same day that brought news of the suicide also brought news of three traders who are happily making lots of money in the markets. One in particular has done what we hope and pray you all will do. He has found himself and his way to trade. He does not use our methods per se, he has built his way of trading around what we taught him, a way more to his liking. He has found methods and techniques that fit his comfort level and his personality. He has found a way to trade that melds with his own temperament. He called to tell us this. What did he get from us? He grabbed onto the idea that trading was really involved with personality. He realized that you can do almost anything and make it work in the markets if only you believe in yourself and what you are doing. He began to treat his trading in a businesslike manner. He got control of himself and then his trading began to work. He satisfied himself that he had come up with a viable way to trade. He then studied and tested it for over two years, until he was satisfied that if he pursued it he would succeed. Has he found some magic way to trade? No! Has he found the holy grail of trading? Certainly not! What he has found is himself. He has found a discipline he can follow, and a method that works – for him. For bringing him to that realization he gives us the credit. But all we did was to show him the way. He still had to traverse the path to success. We’re really proud of him. He is a very special person to us. Our paths have crossed and our lives have touched and we each have gained from these happenings. The single most important thing you can have in trading is full confidence and belief in what you are doing. You must believe in yourself. Unfortunately, by the time many of you find the truth, you are already jaded. You are unsure of yourself. You have listened to, read, and absorbed tons of misinformation. You must set all that aside and go on from here. In trading you are your own worst enemy. Resolve in your mind to acquire the discipline you need to trade. You can do it. One of our 101

students, well up into his seventies, has done it. He has finally learned to control his emotions and trade successfully. It has been like pulling teeth for him (if he still has any), but he is now trading consistently well. His desire for success has been so great that it is monumental. We knew he would make it long before he did. How did we know? We knew because this man was willing to admit over and over again his mistakes in trading. He was willing to confront every error, admit it and deal with it. That takes courage, and we salute his immense determination and boldness in coming to terms with his trading problems. Fortunately, the calls telling us of success far outnumber those telling us of any failures. We are very grateful for that. Please call or write to let us know of your successes so we can pass them on. There is a tremendous need for encouragement in the field of trading. After that mini-sermon, were you beginning to wonder if we would ever get around to teaching you additional techniques? We will so that you won’t disown us. However, in order to give you time to think about what we said here, we won’t give you anything just yet. You’ll have to wait until next time.

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PART II

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Chapter 13 RHYTHM TRADING We’re going to show you an old-time technique that still works and is excellent in largely chopping, sideways markets. We call it “Rhythm Trading.” What we will do is show you a way to know when and how to scalp a market from the chart so that you will be going in the right direction. It’s a way to catch the rhythm of the price action. And by the way, you can do this in any time frame except one in which the price movement will not offer sufficient volatility for profitable trading. It does take a bit of your time.

Once you have determined, by looking back, that prices are chopping sideways, you look for a convenient low. You are looking for a 1-2-3 105

low formation that has 5-10 bars total width. The 1-2-3 formation on the previous contains seven [7] bars inclusive of the #1 and the #3 points. You then draw a line from the #1 point to the top of the highest bar in a sequence of the next 7 bars. We begin with the first bar subsequent to the #3 point to count our next sequence of seven bars. That produces a line from the #1 point to the top of the third bar in the second sequence of seven.

Now we must wait for the next low in prices prior to a price bar making both a higher low and a higher high. In the case above, that event occurs on the 17 th price bar since we began at #1. The actual “next low” came on the 16th price bar since we began at #1. We now draw a line from the bottom of the 16 th bar that is parallel to the first line we drew. It doesn’t matter where it falls, as long as it is parallel. Its purpose is to enable us to measure the distance between the rhythmic lows.

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We now have a complete rhythm cycle of sixteen [16] bars. We might say that prices, insofar as we can tell at this point, are marching to a 16 beat rhythm. The rhythm cycle may be thought of as consisting of the seven bars from the #1 to the #3 point, and the nine bars (total 16) that comprise the series of bars beginning with the first bar after the #3 point and ending with bar #16. Since we know the distance between rhythmic lows, we now project the plane along which the next low is expected to fall, and draw it in as a parallel line.

Once we have established the rhythm cycle at sixteen bars, we will then buy a breakout of the high of the bar that falls on the next expected rhythm cycle low. If the low comes early or late, by no more than one bar, we will buy a breakout of the high of the early or late bar.

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On the chart below, we would have attempted to buy a breakout of the high of the bar just ahead of the one labeled “16,” the bar labeled “16”, and had that not been the low, a breakout of the high of the bar just after the one labeled “16.” Since we now know where the rhythm cycle low is, we draw our next parallel line. We continue this pattern until or unless we find that we have lost the rhythm. The rhythm will almost always be lost once prices begin to trend.

With rhythm analysis and sideways prices, we let the price action determine its own cycle rather than trying to impose some theoretical cycle on it. If the market has a rhythm, it calls its own tune. That rhythm can and does change. No sacred cows here.

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Your job as a trader is to get in tune with the price action. Prices are going to go where they want when they want. If the price action is kind enough to set up a rhythm you can catch, then dance with the rhythm of the prices while you can. You never know when a market is going to change partners.

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Chapter 14 GIMMEES The Gimmee bar comes from one of the oldest formations known to traders, the reversal bar at the end of rising or falling prices when a market is seen overall to be going sideways. Although the recognition of reversal bars is ancient, using them in combination with Bollinger Bands is not ancient. Until the advent of computers, it was much too difficult and time consuming to calculate the bands. Virtually all software worth anything these days can put the bands on a chart for you, so we'll not waste time here with the mathematics. Suffice it to say that the bands are so constructed that when set with a 20 bar moving average of the close at two standard deviations, approximately 96.5% of all closes will be contained within the bands. Here's how the bands look. How to trade the Gimmees will follow:

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GIMMEE BARS ARE NOTHING MORE THAN REVERSAL BAR S THAT TAKE PLACE ONCE PRICES HAVE REACHED THE UPPER OR LOWER BANDS IN A SIDEWAYS MOVING MARKET .

HOW TO TRADE GIMMEES Gimmee bars are bars that reverse price direction once prices have touched the upper or lower bands. However, please note that this must happen in conjunction with prices being overall in consolidation (Trading Range).

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GIMMEE BARS AT THE UPPER BAND

Once prices touch the upper band, the bar touching the upper band or the very next bar may become designated as the Gimmee bar. All that is required is the occurrence of a price bar which closes lower than it opens. Should such a price bar occur, a sell short order is to be executed one tick below the low of the Gimmee bar. Here are some examples: The Gimmee bar in this example is the one that touched the upper band. What makes it the Gimmee bar is: 1. Prices were rising. 2. Prices touched the upper band. 3. The price bar closed lower than it opened when prices were previously rising. A sell order should be placed one tick below the low of the Gimmee bar. The Gimmee bar in this example is the price bar after the bar that touched the upper band. What makes it the Gimmee bar is: 1. Prices were rising. 2. Prices had touched the upper band. 3. The price bar closed lower than it opened when prices were previously rising. A sell order should be placed one tick below the low of the Gimmee bar. 112

GIMMEE BARS AT THE LOWER BAND

Once prices touch the lower band, the bar touching the lower band or the very next bar may become designated as the Gimmee bar. All that is required is the occurrence of a price bar which closes higher than it opens. Should such a price bar occur, a buy order is to be executed one tick above the high of the Gimmee bar. The Gimmee bar in this example is the one that touched the lower band. What makes it the Gimmee bar is: 1. Prices were falling. 2. Prices touched the lower band. 3. The price bar closed higher than it opened when prices were previously falling. A buy order should be placed one tick above the high of the Gimmee bar. The Gimmee bar in this example is the price bar after the bar that touched the lower band. What makes it the Gimmee bar is: 1. Prices were falling. 2. Prices had touched the lower band. 3. The price bar closed higher than it opened when prices were previously falling. A buy order should be placed one tick above the high of the Gimmee bar.

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PERTINENT POINTS

We would refrain from entering a trade if the extreme of the Gimmee bar has touched or is very close (a matter of judgment) to the moving average (the middle line between the two bands). Quite often prices stall out or experience minor congestions when they reach the level of the moving average. See Figure A below. We would refrain from entering a trade if the Gimmee bar is excessively long in length relative to the size of the preceding price bars. Often, when there has been a very large size bar, the next few bars will display a reaction to the move made by the large size bar. See Figure B below. We would refrain from entering a trade if the opening of the bar following the Gimmee bar is a gap open beyond the price range of the Gimmee bar. Gap openings outside the price range of one bar will often see prices move back toward the previous bar's close. See Figure C below.

Figure A

Figure B

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Figure C

Chapter 15 THE CONCEPT OF SECOND TIME THROUGH Quite often, prices will enter a congestive phase and begin to move sideways. The following chart is an example.

When this happens, it is often better to take a second-time through breakout of the congestion in the direction of the previous trend. It makes no difference as to the time period involved. The above chart happens to be a five minute chart. However, the same principle would apply to any time frame. Here are the conditions that set up the trade: 1. There must have been a prior trend. 2. There must be a clearly visible congestion area, the flatter it is in appearance, the better.

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3. There must be a breakout of that congestion area in the direction opposite to the prior trend. In other words, if the previous trend was downward, there must first be a breakout from the congestion to the upside. 4. The upside breakout must be followed by a first-time through breakout in the direction of the prior trend. 5. The first-time breakout of the congestion must be followed by a reaction back towards or even into the price level of the congestion. A second-time through breakout of the bottom of the boxed off congestion area on the chart below would be in keeping with the direction (down) of the previous trend. As prices pass through the lows of the congestion area, you would sell short because the direction of the previous trend had been down. The trade would look like this:

You may wonder why anyone would want to do this. The reason is that in the first time through congestion, often the only reason prices

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breakout is because the market movers see an easy opportunity to scalp a few profits by running the orders. Orders tend to accumulate just above and below congestion areas. However, the second time through the congestion, the previous orders are no longer there. The second time prices move through the congestion, the move is usually real. PERTINENT POINTS

1. Be sure you can clearly identify the direction of the previous trend.

Anticipate a very short term scalp on the fade side of the trade, i.e., once the first time through occurs, don't expect the reaction to last more than a few bars. Consider passing up the short term scalp, opting for the second-timethrough trade only.

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2. Be sure you can identify an opposite side breakout. In the example below, the breakout above the congestion is less pronounced than it is in the previous example.

3. Try to find a congestion area that has a flat bottom if the secondtime through breakout is to be through the lows. Try to find a congestion area with relatively flat tops if the second-time through breakout is to be through the highs. 4.

NOTE CONGESTION AREAS THAT BREAKOUT TO THE UPSIDE GENERALLY DO NOT PRESENT THEMSELVES WITH AS FLAT A CONGESTION AS DO THOSE THAT BREAKOUT TO THE DOWN SIDE.

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We had to look long and hard to find this example of an upside second-time through trade with fairly flat tops to the congestion, but we wanted to give you an example of what one looks like. Most of the time, flat top congestions are more difficult to find than congestions with flat bottoms. However, the above chart presents all of the criteria we've been discussing for second-time through trading.

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Chapter 16 THE SWEET CHARIOT One of the more difficult types of price action to trade is when prices are gradually rising, but making wide swings as they move higher. The Sweet Chariot trading technique is used to take advantage of these types of swings in a gradually rising market. It is a very simple yet effective way to trade prices which are moving sideways, but which have an upward trend bias. The Sweet Chariot will usually have you in a trade well before it begins trending more strongly.

The Sweet Chariot uses a simple 40 bar moving average of the close, and it looks like the above:

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We prefer to use it on weekly charts when trading for the longer term, but it works just as well on daily and intraday charts. The rules for trading are straightforward and easy to follow. 1.

When prices are above the moving average, long positions are initiated.

2.

No short positions are allowed with this technique.

3.

When prices are flat (not swinging) and are straddling the moving average, no new positions may be entered.

4.

On the first price bar that is completely above the moving average with a close in the upper half of its price range • Enter long on the first price bar to have at least 80% of its daily price range entirely above the moving average with a close in the upper 1/3 rd of its price range • Enter long on a breakout of the high of the bar meeting those qualifications. This is the entry bar for this trade.

The following chart shows some “go long” entries.

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Viewing from left to right, let's notice a few points: • We've assumed that prior to the first entry bar, that prices had been swinging well above and below the moving average. Based on that assumption and the price you can see, we've shown you the first time you might have attempted a long entry following a dip by prices below the moving average line. • The price bar prior to the first “go long” bar is clearly above the moving average. Its close is in the upper 1/2 of its price range. It qualifies as an entry bar, therefore you would go long on a breakout of its high. The same set of rules apply to the next “go long” bar, the one you might have “missed.” 123

• The price bar prior to the next “go long bar” has its low on the short side of the moving average, however, 80% of its price range is above the moving average and the close is in the upper 1/3 rd of its price range. The price bar prior to the next “possible entry” qualifies as an entry bar for the same reason.

• The price bar prior to the next to the last “go long” bars has 1/2 of its price range above the moving average, and closes in the top 1/3rd of its price range. It qualifies as an entry bar. • The price bar prior to the last “go long” bar has all of its price range clearly above the moving average, and closes in the top 1/2 of its price range. It qualifies as an entry bar.

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PERTINENT POINTS

• Be sure that prices are swinging well above and at times below the moving average. The wider the swings the better. • Be sure that prices are in a trend, but not too steep (no greater than a 45 degree angle). Steep trends will see prices almost always above the moving average. • You will need some crossing of the moving average by prices, but beware of prices constantly hugging the moving average. If they are, you are not in the right kind of situation for this technique to work properly. If a market is moving sideways, and the moving average is largely flat, the following chart indicates the nature of the problems you will face:

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Chapter 17 DAY TRADE VS POSITION TRADE For years, the arguments have gone up and back: which is better, day trading or position trading? We have heard many day traders say they prefer day trading because that way they leave less money lying on the table. They bemoan the plight of the poor position trader who is unable to extricate himself from a bad trade as quickly as can the day trader. They are of the opinion that they are able to extract profits quickly, while they are available. They enjoy the thrill of daily combat in the market place. Day traders also are of the opinion that they have more opportunities than do position traders. Finally, and importantly, day traders feel comfortable in not holding any positions overnight, and therefore are able to sleep without fear that they will awaken to some horrible unexpected gap in prices that will wipe out any profits that may have accrued, and which could result in a huge loss. Of course, position traders hold just the opposite view. They feel that it is the day trader who is leaving the most money lying on the table. They feel that day trading erodes their capital base with excessive transaction costs. They pity the day trader who has to fight his way into a trending market numerous times throughout the day, often getting badly beaten up for his trouble, whereas they, the position traders, get to take advantage of the longer term trend. Position traders are not burdened with sitting in front of a screen throughout the day. They would rather be free to enjoy other aspects of life, and avoid the frantic trading often required of day traders. Position traders contend that with so many choices from which to choose, there is no lack of opportunity for entering well-thought out, wellplanned trades. Finally, position traders take great comfort in knowing that when a market truly begins to trend and yields huge rewards relative to risk, that they will be in the market and will not miss the move. Who is right? They are both right, or they are both wrong. It depends upon your point of view and where you are most comfortable. 127

The choice of time interval in which to trade is a function of comfort level: economic comfort level, emotional comfort level, or psychological comfort level, maybe all three. It is also a function of financial capability and trading acumen. It is the knowledgeable trader who makes the most money. The trader who knows himself, knows how to read a chart, and is knowledgeable about the inner workings of the markets makes the most money, but even then, only if his knowledge is accompanied by disciplined action, disciplined decision making, and sufficient capital to comfortably support his style of trading and the time frame in which he attempts to trade. Sometimes a combination of both day trading and position trading is in order. Combining the two may be a good strategy for the position trader attempting to optimize his entries to and exits from the market by day trading an intraday chart at the specific times of entry and exit. Combining the two may be a good strategy for the day trader who determines to hold a winning position overnight in those situations where a protective stop loss is able to be moved to where it is a profit protecting position. Each trader will have to give up something in order to gain a feature enjoyed by the other. For example, the day trader will have to give up not holding overnight and miss being able to enjoy the benefits of the longer term trend. The position trader, provided he has the time and ability to monitor the market during the day, will have to acquiesce to being tied to a screen for whatever amount of time it takes to day trade his entries and exits in an attempt to optimize them. If unable to watch during the day, it will be rather difficult to optimize entries and exits. Let's take a look at each of these propositions to see how such a trading philosophy might work out.

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IMPLICATIONS OF DAY TRADING FOR THE POSITION TRADER If a position trader has access to live data, and the free time to monitor the price action at such times as he wishes to enter or exit the market, he can often optimize the results of those events by engaging in a bit of day trading. Let's look at one situation in which this might be done. Let's assume that the position trader is seeking either entry or exit on a day where prices open with a huge gap within or immediately outside of a congestion area. The percentages favor a reaction of some sort back towards the previous day's close. Usually, such a reaction will take place on the day of the gap. Occasionally the reaction will be delayed by a day.

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On the chart above, we have taken the liberty of marking gap openings. There are a lot of lessons we can learn from this chart and we will use it again later. The first lesson to be learned provides the proof that gap openings within or immediately outside of congestion areas will usually result in a reaction wherein prices move back towards the previous day's close. This one piece of knowledge is worth many times the price of most books and manuscripts you are likely to have to pay for. Now, let's look at the chart with respect to some probable positions held by a position trader. By day trading, the position trader can take advantage of that knowledge in light of the following scenarios:

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SCENARIO: THE GAP IS FAVORAB LE AT “A” OR “B”

Knowing that most gap openings within or immediately outside of congestion result in a reaction with prices moving back towards the previous day's close, the position trader willing to day trade and desiring to reap the profits available from the reality of the gap, can exit immediately upon seeing the gap. SCENARIO: THE GAP IS UNFAVORABLE AT “A” OR “B”

Knowing that most gap openings within or immediately outside of congestion result in a reaction with prices moving back towards the previous day's close, the position trader desiring to extract the most profits possible will wait for the reaction to the gap, and attempt to exit at a more favorable price than he might have otherwise obtained. 131

PERTINENT POINTS

• Notice that only at “C” and “D” is there a failure for prices to materially trade back toward the previous day's close. In the case of “C”, prices reacted strongly on the following day. • There are twenty-two gap openings marked on the chart. Only two of twenty-two failed to react strongly to the gap opening. One can say that 90.9% of the time, based on the price action shown, prices will demonstrate a strong reaction to a gap opening. Implications of position trading for the day trader: If a day trader is willing to hold overnight when his trade has accumulated acceptable profits, the day trader can often benefit by doing so when prices are strongly trending. 132

The trader must have seen sufficient profits in the trade by the time of the close to be able to place a profit protecting stop in the market. The percentages of a trend continuing once it is strongly trending are very high, and definitely favor holding overnight. Viewing the same chart of daily prices, we see that once prices began to trend at “D,” it would have been quite profitable to have held a winning position overnight as long as that position was protected by a stop.

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PERTINENT POINTS

• Be sure that prices are truly trending. An acceptable trend is one that is moving at an angle of 45 degree or greater. Quite often, falling prices will exhibit a greater than 45 degree angle, especially at the beginning. Overall, prices tend to fall 1/3 rd faster than they rise. • Realize that there will be some sort of reaction to every gap opening. Do not let that panic you out of a trade. Decide beforehand exactly how much of your profits you want to protect, and stick with your plan. • Occasionally, prices may jump over your protective stop, possibly resulting in a losing trade from what was once a winning trade. • When a trend becomes too steep, and the trend line becomes parabolic, you are near the end of the trend. Tighten stops considerably, or consider exiting entirely.

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Chapter 18 STAYING WITH A TREND While we are on the subject of the possibility of a day trader holding overnight, let’s also see a way to stay with the trend allowing price volatility to dictate an exit point. To do that, we first have to review some material we presented in Trading The Ross Hook. USING THE COMMODITY CHANNEL (CCI) INDEX TO STAY WITH THE TREND We will see together how you can use the CCI study in a way that few have seen before. We’ll take it a step at a time. Pay close attention to what is being taught here. (The CCI study is available in most charting software packages.) The CCI measures the mean deviation of a bar’s Typical Price relative to a moving average of N bars’ Typical Price. Typical Price may be computed as the high plus the low plus the close, divided by three. This gives a close-weighted Typical Price. The CCI study is generally displayed with three horizontal lines: +100, 0, and -100. However, CCI is theoretically, if not practically, infinitely expandable. There is one great advantage to the scale. It is increasingly difficult for CCI to make ever greater extremes in its readings. It takes increasingly more momentum to push the CCI plot increasingly further out on its scale. Experience has shown that a 30-bar CCI works best. We tested it all the way to 50 bars, and agreed that 30 bars was best. However, it may work better at other values in other markets, as we didn’t test every market available. Any software which will allow you to insert a fictitious price bar can be used to emulate the manner in which we use the CCI. To insert a 135

price, you need to be able to create a hypothetical price bar for what will be the next price bar. How to know what the next price bar will be will be shown just ahead. This is easily done on a daily chart with most software. On anything less than a 15 minute chart, you will really have to scramble to get the job done. The truth is, the calculation works best on an hourly, daily or weekly chart. Once you have placed the hypothetical bar on the chart, simply run the CCI study with the hypothetical bar in place, and see what the reading will be. The hypothetical bar need have only one price for all fields. The open, high, low, and close can all be a Typical Price, but if your software will allow, you can also insert a high and a low if you want to do the extra work. How do you know what the next bar’s Typical Price might be? We’ll show you two ways to do it. Then, we’ll show you how to use CCI as a trend following tool that will keep you in a well established trend. Figuring the next bar’s Typical Price in congestion has been done essentially this way since the inception of exchange trading. Each day many specialists and market makers come to the exchange with these figures in hand. They tend to sell at or near the typical high and buy at or near the typical low. If either the high or the low are violated by more than a few ticks, you will see them bail out and run for their lives. This shows up on a chart as an extra long intraday bar.

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FIGURING THE NEXT BAR’S TYPICAL PRICE IN CONGESTION (Open + High + Low + 2(Close)) / 5 = X 2X minus The High = Next Bar’s Projected Low 2X minus The Low = Next Bar’s Projected High O

H

L

C

Example: (24 + 25 + 23 + 2(23.5 )) / 5 = 23.8 2(23.8) - 25 = 22.6 = Next Bar’s Projected Low 2(23.8) - 23 = 24.6 = Next Bar’s Projected High

Next Bar’s Typical Price = (Next Bar’s Projected Low + Next Bar’s Projected High) / 2 (22.6 + 24.6) / 2 = 23.6

FIGURING THE NEXT BAR’S TYPICAL PRICE IN A TREND TYPICAL PRICE IN AN UPTREND.

To compute the next bar’s Typical Price in an uptrend, we need to find the average rate of ascent. It’s important to use 4 bars for this computation. What we want to know is, on average, how much prices are moving in the direction of the uptrend. To find out, we measure from low to high. Here are the steps to follow: We measure from one bar’s low to the next bar’s high, to see how far prices move over a two bar period. We do this for three overlapping two bar periods.

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Let’s take an example:

We then add those measurements together and divide by three. 2+ 3.75+ 3.25 = 9 , 9/ 3 = 3 on average. Adding 3 to the last known low (29.25), we obtain a number of 32.25, which is the next bar’s projected high. Next we need to determine tomorrow’s projected low. We measure the average volatility for the last three bars. Average volatility equals the sum of the differences between high and low, divided by three.

We have: 31.00 - 29.25 = 1.75 30.25 - 27.75 = 2.50 28.00 - 26.50 = 1.50 The three differences are 1.75, 2.50, and 1.50.

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Summing these and dividing by 3 = 5.75/3 = 1.92 (rounded). Subtracting 1.92 from the projected high (32.25), we obtain a number of 30.33 for the next bar’s projected low. The final step is to add the projected high to the projected low and divide by two to come up with a Typical Price. In this case, (32.25 + 30.33) / 2 = 31.29. It’s important to realize that this is not an exact science, but you might be surprised how often we can come within a tick or two of being right. We can also compute the Typical Price differently by measuring from high to high to get the projected high. To obtain the projected low, we would then do as we’ve just done and subtract average volatility for three days from the projected high. A third idea is to also measure from close to close to come up with a projected close. Then we can add the projected high + the projected low + the projected close, and then divide by three to come up with a close weighted Typical Price. The ultimate situation would be to project an open and throw that in there as well. Then we could substitute the four prices into the formula I gave for finding Typical Price in a congestion. It’s a matter of choice, yours. With today’s software in many instances being programmable by the user, we can figure all the different ways and then make our choice.

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Tomorrow’s Typical Price in a Downtrend To compute tomorrow’s Typical Price in a downtrend, we need to find the average rate of descent. It’s important to use 4 bars for this computation. What we want to know is, on average, how much prices are moving in the direction of the downtrend. To find out, we measure from high to low. Here are the steps to follow: We measure from today’s low to the previous day’s low, to see how far prices move over a two day period. We do this for three overlapping two day periods.

We then add those measurements together and divide by three. 2.25 + 2.00 + 1.50 = 5.75 / 3 = 1.92 (rounded) on average. Subtracting 1.92 from the last known high (61.50), we obtain a number 59.58 for tomorrow’s projected low. Next we need to determine tomorrow’s projected high. We measure the average volatility for the last three bars. Average volatility equals the sum of the differences between high and low, divided by three.

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We have: 61.50 - 59.25 = 2.25 62.75 - 60.00 = 2.75 63.50 - 60.75 = 2.75 The three differences are, 2.25, 2.75, and 2.75. Summing these and dividing by 3 = 7.75 / 3 = 2.58 Adding 2.58 to the projected low, we obtain a number of 62.16 for tomorrow’s projected high. 59.58 + 2.58 = 62.16. The final step is to add the projected low and the projected high and divide by two to come up with a Typical Price. In this case, (62.16 + 59.58) / 2 = 60.87 = tomorrow’s Typical Price. One last thing. For those of you who might want to know the formula for the CCI, it’s shown on the following page.

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FOUR STEPS TO CALCULATE CCI

1.

COMPUTE TODAY’S “TYPICAL” PRICE, USING HIGH, LOW AND CLOSE: X1 = 1/3 (H + L+C)

2.

COMPUTE A MOVING AVERAGE OF THE N MOST RECENT TYPICAL PRICES:

3.

COMPUTE THE MEAN DEVIATION OF THE N MOST RECENT TYPICAL PRICES :

4.

COMPUTE THE COMMODITY CHANNEL INDEX :

WHERE: N = NUMBER OF DAYS IN THE DATA BASE X1 = CURRENT BAR’S TYPICAL PRICE X2 = PREVIOUS BAR’S TYPICAL PRICE X3 = BAR BEFORE PREVIOUS BAR’S TYPICAL PRICE XN = OLDEST TYPICAL PRICE IN THE DATA BASE

SIGNIFIES “ ABSOLUTE VALUE”; DIFFERENCE SHOULD BE ADDED AS IF ALL WERE POSITIVE NUMBERS.

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We had to take that to a mathematician to have it translated. To the best of our knowledge, CCI shows you the relationship (expressed as the mean deviation) of today’s Typical Price to a moving average of Typical Prices. By measuring today's Typical Price against a moving average of typical prices, we are in effect taking a measurement of volatility. Now it’s time to we look at how to use this concept to stay with a trend. The rules are similar to what we showed in Trading The Ross Hook, yet this set of rules are a little different, so pay attention. Rules 1.

LOOKING BACK FROM WHERE THE PRICE ACTION IS NOW, THE CCI MUST HAVE PASSED THROUGH THREE OF THE “ VISIBLE HORIZONTAL ” (VH) LINES (+100, 0, -100) IN A DOWNTREND OR LINES (-100, 0, +100) IN AN UPTREND. PRIOR TO DECIDING THAT THIS IS A TREND WORTH STICKING WITH.

2.

WHEN PRICES HAVE PAS SED THROUGH ALL THREE LINES, YOU USUALLY WILL DISCOVER THAT YOU HAVE A STRONG AND CONTNUOUS TREND IN EFFECT . THIS IS THE TIME TO SERIOUSLY CONSIDER HOLDING A POSITION UNTIL IT ONCE AGAIN REACHES 0:

Keep in mind that CCI varies from one software program to another, but then, of course, so does data vary somewhat from one supplier to another. However: AS LONG AS CCI IS CONSISTENT WITH THE CHARTS CREATED BY YOUR OWN SOFTWARE, IT IS ACCEPTABLE TO TAKE THE SIGNALS GENERATED. Following are some illustrations to help clarify the concept.

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The chart above is 5 minute chart spanning a time period of 3 days. (We were able at the time this was written to use a 5 minute chart only because the software were using [no longer available], allowed us to quickly plug in a price and the software instantly came up with a CCI value. Conversely, we could hand the software a CCI value and it would tell us at what price that value would occur.) Let me also add that the ability to make such a projection is not necessary to the technique I’m describing. At “A” CCI is below the -100 line. Notice that the CCI curve rises above -100, then above 0, and finally, above the +100 horizontal lines. When you see such action by CCI, you should suspect a trend in the making. If you have other indications of a trend such as a technical study, or a 1-2-3 formation followed by a Ross Hook, you should consider using CCI for your trailing stop.

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Once CCI rises above the +100 (in the case above), you would resolve to hold your position until CCI once again touches the 0 line, or could be projected to touch 0 through the use of typical price calculations. A projection would indicate to you exactly at which price the value of CCI would touch 0 and you would plan to exit at that price. In this particular instance, CCI never again touched 0.

The chart above is a 5 minute chart spanning a time period of 3 days. At “A” we see CCI crossing below the +100 line. Subsequently, it crosses through “0” and then -100 at “B.” This, combined with any other filters we may have, should alert us that a trend is in progress. Shortly after “B,” CCI touches “0,” but after that, the trend begins in earnest. CCI never again touches “0” until “C.”

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PERTINENT POINTS

• CCI in and of itself is not a great indicator of the start of a trend. However, it offers an excellent alert that a trend may be forming once you see CCI crossing three horizontal lines. • CCI should be filtered with at least one other method for confirmation of the trend. • If you choose to not compute typical prices for purposes of CCI projection, simply exit the trade on the first bar after CCI touches “0.” Statistically, the results will be about the same as with the projection. For day traders, this may mean waiting an extra few minutes depending upon the time frame in which the trading is done. However, for position traders this can mean an extra day or an extra week. Therefore, position traders, because they have the time to compute the projection, are probably better off doing so.

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Chapter 19 WEAK HANDS VS STRONG HANDS What is trading? Have you ever wondered about that? Is it picking out an entry signal that is so good that the market literally has to hand you a fat profit? Actually trading is in many respects a battle between “weak hands” and “strong hands.” Although with a bit of thought few would say that trading is simply finding excellent entry points, the majority of people who trade in the markets behave as though finding entry points is all that is involved in trading. They act in such a way as to convince me that most have never given much thought to trading beyond a method, system, or technique that gives good entry signals. THE MAJORITY OF TRADERS ACT AS THOUGH ALL THERE IS TO TRADING REVOLVES AROUND MARKET ENTRY! It’s as though if they could somehow find the method of coming up with entry signals, the rest of the trade would automatically turn out to be profitable. In fact, to prove that I’m correct in my assessment of how most traders conduct themselves, I submit as evidence the volumes of material concerned with technical studies, cycles, seasonals, astrology, mathematical indicators, oscillators, pattern recognition, volume, and open interest. Additionally, there are Gann time and price studies, Elliot Wave studies, and Fibonacci studies. If you don’t want to make a career of any of those, then you can try Fractals, 5VBTP’s, Japanese Candlesticks, Tonal Vibrations, Market Sentiment, Neural Networks and a host of others. Do any of those mentioned have any value at all? Surprisingly, the answer is a resounding YES ! Any, and perhaps all, are good for entry signals and therefore, by default, exit signals - especially if you know how to use one or more of them, believe in them, have confidence in them, and have mastered them.

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It is not my purpose to condemn entry signals or entry techniques. What I want you to come to see is the relatively small role they play in your actual trading, despite the fact that virtually all the available literature seems to dwell solely upon market entry. My own many years of trading experience indicate to me that the various elements of a trade are made up of the following categories and approximate percentages: Signal Identification 10% Trade Management 20% Risk Management 10% Money Management 10% Personal Management 50% I wish to admit here and now that there is nothing scientific in the way that I have assessed and allocated these activities and percentages. Others may have equally good guesses or have performed a more precise study of how much time a successful trader should spend with each of the listed activities. My own trading history tells me the above are at least close to being correct. What puzzles me most, is how few traders actually recognize that trading involves the activities I have listed. In light of the percentages given above, my question is, “Why do traders spend ninety percent or more of their time with entry signals?” Why do they continue to chase a phantom, the so called “holy grail” of trading? My contention is, that the holy grail of trading, if it were found, would be nothing more than entry signal recognition or an entry identification technique. How do I know that? Because of the many thousands of traders with whom I have come in contact, I have never encountered one who was looking for a holy grail of management. I have never met a trader who was exclusively seeking the perfect way to manage self with the object of becoming a winning trader. I have never encountered a trader who stated, “I am looking for a wondrous way to handle trade management so I can be a winning trader.” Nor have I encountered one who, in order to succeed, sought to be a prodigious manager of risk or miraculous manager of money. What I have encountered are hundreds of traders, who through countless hours of backtesting and simulation, seek only to 148

find perfect trading conditions, entry signals, or identification methods that guarantee that every trade, or even most trades will turn out to be winners. What I have also encountered are dozens of books, and seminars that enforce the search for a guaranteed perfect way to gain market entry. In addition, through the media of literature and presentation, those who produce them feed upon the quest for the perfect entry technique. The quest is invariably that of ‘entry.’ What is the magic way to enter a trade? What is the perfect entry signal and how do I recognize it? What combination of events will render a guaranteed profit and how do I distinguish them from all others. If I am correct in my assessment of the amount of time a trader should devote to the various elements of trading, and if it is true that most traders spend ninety percent of their time performing ten percent of the job of trading, is it any wonder that the number of losing traders approaches, and by some estimates exceeds ninety percent? When a newcomer to trading endeavors to find out how to make money as a trader he or she is immediately beset by a plethora of books, methods, and systems revolving around the concept of entry into the market. The bulk of advertising confronting a new trader involves itself with market entry. The exchanges themselves produce excesses of material on market entry. Can you blame them? They want to bring the individual to the point of market entry as quickly as possible. The sooner you trade, the sooner they make their profits from you. Brokers, too, want to cause you to quickly enter the markets. The sooner the better, as far as their commissions are concerned. The shortsightedness of the trading industry has always amazed me. They continually opt for the fast commissions and fees, totally ignoring the fact that if they nurtured traders with information and facts about how to trade profitably, they could considerably lengthen the time over which a trader would be profitable to them.

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According to one list vendor, there are approximately five thousand new, would-be traders per month making entry into the field of trading futures. There are many more who try their hand at trading stocks. What becomes of those five thousand new names? My estimate is that most of them lose their trading capital within a matter of months. Brokers have told me that the average life of an aspiring trader is less than six months. Most of the time during those few months is spent in trying to find out something about how to trade. The losses come quickly and hard. The recently opened account is closed and the attempt to trade is given up as a lost cause. A few traders or should I say wannabe traders do a rather strange and inane thing at the point where they have lost much, but not all, of their trading capital. Rather than admit defeat, they leave the balance of their trading capital with their broker. This money is at times completely forgotten and in some cases becomes forfeit. Usually the broker, if he is still around, will try to get the individual to trade that money so a commission can be earned. However, the clearing firms will allow that money to sit there as a part of their float. They can earn interest on that money in the overnight markets. A few die-hards of the original five thousand novices last as many as a few years before giving up. Now and then, mostly through the good fortune of finding a mentor, or even more rarely figuring out for themselves how to trade, a would-be trader actually becomes a profitable and successful trader. What is it that profitable and successful traders learn that makes them so? They learn to manage themselves, acquiring discipline and self-control. They learn, not a mechanical trading system, but rather a systematic approach to their trading. They learn to how structure reasonable objectives. They learn how to properly calculate where to place stops. They learn how to trade less and make profit more. They acquire the knowledge of which markets and trades are best for them as individuals. They come to appreciate that trading is not a one-size-fits-all, situation. Many of the things a successful trader learns are not easily or even probably able to be placed in a book. That is why at Trading 150

Educators we encourage our readers to pursue and advance their trading careers through mentoring—mentoring via group seminars, private tutoring, online chats, and lifetime support which go beyond the limits of what can be placed in a book. We are ready for you whenever you are ready for us. I thought you might find it interesting at this, the “half-way point” during your adventure through this trading manual to view the Mission Statement we hold to here at Trading Educators. Mission Statement • To show aspiring futures traders the truth in trading by teaching them how to read a chart so that they can successfully trade what they see and by revealing to them all of the insider knowledge they need in order to understand the markets. • To enable them to trade profitably by training them to properly manage their trades as well as their mind set and self-control. To accomplish our mission for our students we will educate them so that they know and understand: • Where prices are likely to move next • Why prices will move there • Who and what causes prices to move • How far prices are likely to move when they do move • Their own role in the movement of prices • How to take advantage of the knowledge they receive • How to properly manage a trade which they have entered

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• How to manage themselves and acquire the discipline needed to become successful traders Benefits for our Clients • Independence from complicated trading methods, magic indicators, and black-box systems • Independence from opinion, anyone’s opinion, including their own • Independence achieved through knowing how to read a chart • Independence through having knowledge of insider actions • Independence achieved by taking a holistic approach • Independence coming from knowing how to manage both the trade and themselves • Independence because they understand and trade what they see • Independence because they have learned the truth in trading Students learn only proven methods and techniques, which helps them to preserve capital and create consistent profits They learn to work effectively and smart. They learn to treat trading as a business: we offer no holy grail or magic systems They learn to adapt to changing market conditions They learn a systematic approach to trading rather than a mechanical system for trading.

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Chapter 20 LEARNING BY INSPECTION What is a volatility blow-off? A volatility blow-off comes when prices which have been strongly moving in one direction suddenly discontinue moving in that direction and begin to congest. In a moment we'll be showing you charts depicting this situation. During a blow-off, the range from top to bottom of the price bars diminish in size and trading quiets down considerably, leaving the market much less volatile than it previously was. Can you make money from a blow-off? If so, how? Volatility blow-offs are not created by the strong hands, but at times are used by them because they frighten the weak hands out of the market. By so doing, the strong players get to pick up the marbles the weak players leave behind. This often happens in thinly traded markets, and in all markets around holiday times. Blow-offs can be made more pronounced by those having control of a market. Volatility blow-offs are the reason you must learn to avoid trading just before a holiday. It is during those periods of time that the market movers can give themselves a holiday present at the expense of the foolish weak players who do not have enough sense to avoid trading then. There are actually cases where market movers make most of their entire year's profits just before holidays, when the markets are sufficiently thin and they can run prices first one way and then another, virtually to their hearts' content. To the casual trader, the price chart of a thinly traded futures looks no different from that of a heavily traded one. At the end of the day an open, high, low, and close are all in place regardless of liquidity. But during the trading day of the thinly traded futures, the insiders have had a picnic. They have cleaned the stops both above and below the market. That money is in their pocket and out of your account. 153

A close examination of some charts will show you how the insiders do it, and what you must look for. It may be that you, too, will want to play this game. The astute trader/business person will stand aside during these low liquidity times, but will seek to take advantage of the same action during times when liquidity is high. Let's take a look at some charts to see what we mean. We'll start with a market which is usually thinly traded, and like many markets can become even more thin when Christmas and the New Year roll around. What you will be seeing is a minor volatility blow-off, otherwise known as a melt-down or sudden collapse.

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First the market movers took the market higher. They made it look as though prices were going to breakout to the upside. Indeed, it did momentarily break the top of the Trading Range one day, and then broke out once more two days before a holiday. This was done in order to create a bull trap and pick off any buy stops lurking above the Trading Range. The intent of the market movers was to lure as many as possible into thinking they were truly taking the market up. Their real intent, however, was to take the market up so that they could take it down from a higher level, thereby snatching victory for themselves and handing unwary traders a defeat. If you don't think that such antics in the market are intentional and purposeful, then you have no business trading. You need to attend one of our seminars where we teach you about such things. Now, let's look at another sucker play, and then we'll look at some true volatility blow-offs, ones in which even the outside traders can make money. This next one happened in another thinly traded market. You must always be aware of thin markets and the ever present danger of bad fills, sudden reversals, and treachery designed to part you from your hard-earned cash.

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How about that? They ran the market and filled the orders above socalled resistance, and below so-called support. What a nice day these folks had for themselves. It goes back to the old saying, “When the cat’s away, the mice will play.” Unless there are lots of orders (liquidity) and stronger hands (perhaps in the form of large trading funds) to stop these kinds of shenanigans, the market movers can have a field day running stops in the market. They can see them, they know where they are. Many of them are open orders they’re holding in their hands, or which can be seen on their trading screens. Sometimes it is the strongest players in the market who run the market for their own purposes.

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They often do this just prior to running a market one way or the other. For instance, if they want to take a market up, they may squeeze it down first, scale buying into it just before they make their real move, which is to take the market up. At other times they will take a market up strongly so they can sell at higher prices, dumping parts of their position steadily as they go, buying back at lower prices than what they originally sold for. Such action may be seen as an upward explosion or a downward collapse. Is there a way for us to play these situations and make money? Yes, there is! It can be done, and to a certain extent you can control the amount of risk you are willing to take when doing it. Let's look at how to do it. First we'll show it as a pure futures play. Then we'll look at it as a pure options play, and finally how to do it combining futures and options. Then you can make your choice as to how you would like to attempt such a trade, should you care to try one at all. What's that, you don't do options? If you don't, then you may want to look into them. If your desire is to become a complete trader you will need to some day. Although options are for the most part beyond the scope of this book, perhaps we can tickle your imagination a bit and get you to look into them as a way to greatly improve your futures trading. Our purpose is not to encourage you to trade the options just yet, but to show you how it might be done should you care to try. A volatility blow-off occurs just after a sudden explosion or collapse in prices. Prices may explode upward and appear to be running away, or they may collapse into what appears to be a melt-down. In either case, volatility will be very high and the volatility deemed to be quite dangerous, to say the least. Such price action is best left alone by most traders. But the situation may be one of great opportunity to those traders who have a plan in mind for this very situation. We'll now look at a volatility blow-off.

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Notice carefully that prior to the big drop, prices had been volatile as they moved up. The price action even included closes outside the upper band (Bollinger Bands using 20 bar simple moving average and set at 2 Standard Deviations) on a few of the days before making the highest high on the chart “A”. As prices rose, a great many profit protecting stops would have been accumulating at various places that traders holding long positions might have considered as support. Call premiums would have been quite high as investors not willing to be long the futures themselves would have placed a high level of demand in the market for Call options. Two days after the highest high was made, there was an inside doji day. Such price action would have caused a flurry of orders in the market as traders were now seeing two days in a row in which prices failed to make higher highs. The day following the doji day, the market movers happily obliged those traders who had stops just under the double low created by the bar that made the highest high, “A,” and the reversal bar immediately following it. The next day, the big down day, “B,” the market makers took care of the rest of the stops, partly catching those traders who

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had stops at the top, bottom, and in the middle of the upward gap made a couple of weeks earlier. They did it without mercy. They opened the market with a gap down, and then ran a ton of stops that were in the market. Was this because suddenly no one wanted this market, or was it because the market movers were manipulating the market? The answer lies in the fact that once they had the bulk of the stops, which they did get in the next few days, most of the volatility in prices for this market disappeared and prices congested as pointed out by “C.” We'll look at the chart again to see ways in which this market could have been traded.

Notice that the day after “A”, the price action resulted in a reversal bar at the upper band. There had been a similar reversal bar 12 days prior to “A” that yielded a small win or breakeven trade, depending on

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how the trade was protected (if entered at all). When prices are drastically volatile, and become almost vertical (parabolic) in their ascent, it is definitely worthwhile to enter on reversal bars at the upper band using a tight stop. The reversal bar following “A” was an excellent pure-futures sell short situation.

Pure-options traders could have written Calls above the market one or two days after “A” if they were aware of the price action being extremely volatile. That prices were extremely volatile is seen by the fact that on numerous occasions dating back several weeks, prices had repeatedly violated the upper band. Even if Calls were not written until after “B,” exceptionally high Call premium would have been available, and Calls far out of the money would have brought extremely high prices.

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But once prices began to congest as they did at “C,” Call premiums would have shrunk dramatically, leaving the Call seller with some fat premiums in his account and prices far away from the Call's Strike Price. Call prices would have fallen apart when it became obvious that there was practically no chance of an immediate recovery back to the previous highs. You could literally bank any premium received for those Calls. The volatility blow-off occurs by virtue of the fact that a Trading Range will typically reduce the market's perception of volatility, and thereby the price of options themselves. Volatility blowoff literally means that volatility has collapsed. Writing Calls above a melt down or writing Puts below an explosion is virtually a sure-thing options trade. Please recall that writing naked options may require a sizable margin account and many brokers will advise you to not write them at all. The concept behind this kind of trade and many others are taught at our private tutoring sessions to those having a desire to learn about them. Y'all come! Of course, it was also possible to have the best of both worlds by combining the sale of Calls with the selling short of the futures while the meltdown was occurring. By doing that, you would have taken a wonderful opportunity to dramatically increase profits from the volatility blow-off situation. PERTINENT POINTS

• The trader who knows what to do with high volatility is in a better position to make money than the trader who does not know what to do. • Beware of thinly traded futures. The volatility in those markets may be entirely caused by market mover manipulations. • Beware of trading any market the day before a holiday • Protect yourself against fake moves by market movers and other strong hands who deal in the market you are trading.

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• Be very cautious of price movement as prices approach areas of so-called support and resistance. Tighten stops, take profits, or simply exit. • Be aware that most of the time the intraday price action has virtually nothing to do with supply and demand. True supply and demand are seen in trending prices on longer term charts. A monthly uptrend is much more indicative of short supply than is a weekly uptrend, and a weekly uptrend is more indicative than a daily chart uptrend. A monthly downtrend is much more indicative of over supply than is a weekly downtrend, and a weekly downtrend is more indicative than a daily chart downtrend.

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Chapter 21 BABY STEPS – GIANT STEPS What we call “baby steps” and “giant steps,” will explain to you one of the most fascinating defensive techniques any trader can use. Baby steps and giant steps represents a detailed explanation of the rationale behind the Trader’s Trick, which has been mentioned in virtually everything about which we have written, and is available as a free resource on our website. To see the deployment of Trader’s Trick, we refer you to Appendix B at the end of this course. What follows is a complete explanation of the “wherefore” of the Trader’s Trick. STEPS It has been said that the best offense is a good defense. Since most traders and aspiring traders are hardly in a position to move a market, or materially affect the movement of prices in any great way, it is incumbent upon such traders to learn to trade defensively. By trading defensively we don’t mean cowardly, or non-assertively. What we are saying here is that the individual trader, not having the wherewithal to move prices, must avoid being trampled by those traders who are able to manipulate and engineer price moves. The average trader reading this course must defend himself from becoming the victim of engineered market moves, whether they be small (baby steps) or large (giant steps). When prices begin to move, it is virtually impossible for the trader to know if the move is genuine, or merely a fake out. We suppose that every move in prices is genuine for someone, but whereas the insiders in the market, paying little or no commissions, can be profitable on a move of a fraction of a point, the “outsider” trader, i.e., the public, usually needs much more than that to be profitable. No one, other than the originator of a manipulated move, knows whether or not such a move is capable of being profitable. No one other than the originator of a manipulated move knows the true intentions behind the move. Is the originator taking the market up 163

because he wants to end up with higher prices? Or is the market being taken up because the originator actually wants to begin a sales campaign from a much higher price? Does the originator move prices down because he is a true short seller in the market, or are prices being driven down only so that a huge long position can be put on at significantly lower prices? The problem is even more acute than the lack of knowing the intentions of the originator. We are also unaware of the true size of the originator. If we see a series of bids that drive the market up, is the size of what we are seeing really the true size of what the originator is trying to buy, or is a massive position being put on that is far beyond the size we are now seeing in the market? Consider: We see the prices at 272.25. The next bid is 272.50 for 50 contracts. The very next bid is 272.75 for another 50 contracts. Does that truly mean that someone very much wants to own the underlying? Or is it a large short seller who wants to bring in a bunch of buying so that he can begin to sell from perhaps 274.50 ? Consider: We see prices at 339.50 the next offer is 50 contracts 339.25, quickly followed by 100 contracts at 339 even. Does this mean someone is dumping the underlying? Does it mean a short seller is trying to drive the market down? Or does it mean that a buyer, trying to put on a very large position, is now flooding the market with sell orders so that he can actually buy at much lower prices? Since we are unable to ascertain the true size or intention of any move, and especially engineered moves, we must find a way to defend ourselves against such moves, and to actually “go with the flow” so to speak. But before we do so, let’s continue to explore the problem faced by the average individual trader. Human nature being what it is, traders are always and forever trying to outwit the market. There seems to be no end of fools who enter the markets with some theory, system, or method that is going to 164

make him/her wealthy overnight. It is the same type of fool who regularly appears at the casinos of this world to serve up as cannon fodder for the owners of these gambling houses who are more than happy to take their money from them in return for allowing them to wallow in their foolishness for the period of time between their arrival and the time they leave, having lost all of their money and perhaps that of their friends, neighbors, and relatives. P.T. Barnum had it right when he said that there is a sucker born every minute. Eventually, some of these suckers find their way into the markets to serve as lambs for the slaughter. They are the proverbial patsies, there to have their feathers plucked so they can go home naked and ashamed, but seldom none the wiser. Invariably, they come back with a new twist, a novel change, or some adjustment, only to be taken to the cleaners once again. Be that as it may, these would-be winners, by their sheer numbers, have an effect on the markets. They do such foolish things as trading Fibonacci* retracements, buy or sell at the “golden ratio,” trade breakout systems, trade mathematical systems, blindly use indicators instead of their brains, etc. None of these ways of trading make any sense, yet they do make “noise” in the markets, especially when it comes to day trading markets. The more of these fools there are in a market, the louder the noise. Insiders have learned to welcome this noise in the same way as the casinos have learned to welcome system playing gamblers. It is just a matter of time until they have lost all of their stake and have to make room for the next sucker. The problem for us traders is that when we see buying at a retracement, we cannot be sure that the buying is such that we are able to make a profit from it, or that such buying is that from which only an insider can make a profit. Conversely, when we see selling at a retracement, we are not sure that such selling is real and can be profitable for us, or that the selling is such that only the insiders will be able to profit from the move. A further problem comes when we see buying or selling at breakout points in the market. Is the buying at a breakout real, or is it merely stop running? Similarly, is the selling at a breakout point real, or is it simply stop running?

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*FIBONACCI

TRADERS BUY/SELL AT .382, .50, AND .619 RETRACEMENTS. THE INSIDERS USE THEIR BUYING/SELLING AS PART OF THE MOMENTUM THEY NEED TO MOVE PRICES TO THEIR OWN OBJECTIVES.

By now you might be thoroughly discouraged and ready to throw your hands up in the air and give up. Don’t do it. Hang on a bit longer while we show you how the Trader’s Trick solves most of those problems most of the time. Since there is no way to know who is doing what, their size, their intentions, or anything else, all we can do is to trade defensively and attempt to catch the moves that occur in the market in some manner that will minimize our losses while we let our profits run. Since the public are the constant and steady losers in the market, we must learn to trade along with those who are able to move the market. Believe it or not, we can win while a market mover is winning, and even when he is losing!! How about that? We’ll explain the various players and how it all works, and then we will provide some examples and charts to help you get a lock on the rationale of the Trader’s Trick. BABY STEPS Baby steps are those created by the lesser market movers, and for the most part, they affect only day traders. These moves are basically small market manipulations good for picking up a few ticks or fractions of a point. When a market is dull, with little order flow, and insiders are bored, they will bump prices around trying to pick up a bit here and there. This is nothing more than spread trading where the market makers are “picking each others pockets,” and those of any outsiders foolish enough to trade when there is nothing really there worth trading. Somewhat larger baby steps, or intermediate steps, take place when the market is moved a short distance in order to pick off the stops that may have entered the market via the buy and sell orders of breakout and retracement traders, as well as those traders who are haphazardly following various indicators and moving average 166

crossovers. Sometimes this takes place as a slow sneaking-up on those stops, and such a situation is very difficult for us to trade. However, when a market is trading in baby steps, it will generally move sideways, and often look like a spider or centipede, with legs sticking out all over the place. We can rarely make money when a market is making a spider or centipede. The reward will rarely be worthy of the risk. However, the price action on the chart may look like a slow climbing caterpillar sort of inching its way upward or downward. We can make money in such a market, and very often need to make the attempt. However, the attempt must be made using the Trader’s Trick. GIANT STEPS Giant steps are large strong moves during intraday trading, seen on the daily charts in much the same way as they occur on intraday charts. For the most part, giant steps are manipulations by very large traders who run the stops on the daily charts in much the same way that baby-steppers run them on the intraday charts. Once again, we want to stay away from sideways spidery-looking price action. We’re ready now to implement the Trader’s Trick in order to demonstrate how it solves the various problems we have presented.

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As long as there is room for us to make a profit between where we anticipate entering the market and the point of the breakout, we can take a ride along with the market movers when they go for the buy stops place there by the breakout traders. If prices were to dip (correct) to the point where the magic number retracement traders have their buy stops, and then prices began to move upward in order to fill the breakout traders, we would then catch the momentum of not only the market movers going for the breakouttrader orders, but also the momentum of buying pressure created by the retracement traders. Where we placed our buy stop is the location of the Trader’s Trick. Now let’s see how the trading evolved. But note: The only difference between an intraday move and the same move on a daily chart is that of magnitude. Obviously, if the chart were a daily chart, the anticipated move would be greater than if the chart was a 15 minute chart. A chart is a chart, is a chart!!

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As you can see, in this particular instance, retracement traders would not have been filled at all. “Trader’s Tricksters” are filled and have to sweat out the next price bar after the fill. We took the liberty of moving our protective stop after the first reversal bar (close lower than the open) took place. Why? Two reasons: 1. Seventy-five percent of the time when a reversal bar takes place, the next bar sees prices move lower (higher) in the direction of the reversal bar. 2. For all we know, the only thing taking place here was stop running at the breakout point. Since good traders take profits while they are on the table for the grabbing, we want to lock in as much of the available profit as we can while still leaving ourselves open for a more substantial upward move if it is to take place. We are playing the percentages, pretty much in the same way the casinos do. If prices continue up strongly, we will be there. If all that was happening was stop running, then we will give back a modicum of the profits that were on the table, take the rest of our money, and wait to see what the market does next. We are trading what we see, not what we think, and that is the only way we know of to consistently win money as a trader. Let’s see what happened next. By the way, the price action we are showing you is taken exactly the way it happened on the very first chart we grabbed literally at random from our computer screen.

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Here we see the pattern repeating itself. If there is room between the Trader’s Trick entry level and the breakout point to make a profit, then an entry attempt is justified. As usual, we maintain a tight protective stop, whether mental or physical. The retracement trader’s entry point is anywhere from 38.2% of the last move down to 61.8% of the last move, with 50%, the “golden ratio” being the most common. These are Fibonacci ratio numbers. Gann traders also use the 50% ratio for retracements, but they seek lesser retracements at 1/3 rd and greater retracements at 2/3 rds of the last upward move. All of this foolishness makes about as much sense as awarding a doctorate degree to a dog who has learned to shake hands. However, the insiders are very much aware of the mind set of retracement and breakout traders, and they gain much of their momentum by feeding on the orders they place in the markets. 170

Those orders are simply grist for the mill to be ground into profits for the insiders. Actually, professional traders are very grateful for the neophyte traders and their foolishness. After all, in they have been supporting our respective life-styles for many years. Now let’s continue with our chart.

As we did previously, we moved our protective stop just underneath the last bar shown because it reversed by closing lower than it had opened. And once again, it appears that the retracement traders were left out of this move. We may get stopped out with little or no profit here, but at least we had our low risk shot at the move. Let’s see!

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The first protective stop is placed below the low of the bar that is the Trader’s Trick bar. The stop is moved to just below the low of the first bar to make a reversal by closing lower than it opens at a time that prices are rising. In this case, if we are stopped out, we will make more than the couple of ticks that were made on the previous trade. Once again, retracement traders are not getting in on the trade. When prices move at a 45 degree or steeper angle, retracement traders seldom get very much of the available price action. If you have noticed, breakout traders, unless they are using large stops and taking more risk, are the ones being hammered repeatedly in this series of price moves. Let’s continue with the trading.

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The Trader’s Trick is good for up to three bars of correction. Beyond three bars, the percentages are against success. Yes, you will miss some good trades where the correction last for more than three bars. The most we have seen is two bars of correction in this entire series. Does it matter whether or not anyone was deliberately moving this market? No! Does it matter whether or not we know the intent of the market mover? No! Does it matter whether or not the moves were genuine? No! Does it matter about the number of contracts (size) that hit the market? No! Do we care that the breakout traders put dinner on our table? No! Do we care that the retracement traders had no dinner at all? No! Did we have to use an indicator? No! Did we use any sort of “magic” number series? No! Do we stand to lose something on that very last trade? Yes! Did we control the possible loss with that last stop? Yes! Enough said? We hope so!

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Chapter 22 A TRUE STORY Recently, the following quote appeared in a financial publication: “Try to find something that works and stay with it.” Is this sound advice for trading in the markets?” Although on the surface this statement may seem correct and wise, a deeper look will show that it may be inappropriate advice for a trader. We're going to give you an example based on a true story. We've changed it only enough to protect the identity of the individual involved. Once upon a time there was a young man who came to the commodity markets with only $500. Through patient endurance, persistence, and intelligent observation, this young man traded his $500 into a fortune amounting to hundreds of millions of dollars. So great was his success that he was admired around the world for his accomplishment. Indeed, he had become a very famous and much sought after trader. Then one year, on a series of trades in a crashing market, he suffered a loss in his account amounting to 10% of all the money he had ever made in the markets. Money he had made both for himself and others. In his case, such an amount represented a sum in the tens of millions of dollars. This major loss was quite sobering to the man, and he thought to himself, “I need a rest from the markets.” With that thought mulling about in his head, he decided to end his trading career and enter into a totally unrelated field of endeavor. Not knowing much about any other way to make a living, he failed miserably in his attempt to undertake a new career, and after several frustrating and unproductive years of trying, he decided to go back to trading. His ego and his confidence level were quite low from his failed attempt at another occupation, but he had kept all his notes covering his many years of trading, and he decided that he would 175

begin trading shortly after he had reviewed his notes, and then paper trade for awhile. He followed through on his plan. He carefully and deliberately brought himself up to speed in trading. He read and studied all his notes. He went over and over countless charts that were the backup for the trades he had done – the very trades that had made him rich. He then bought historical data covering the years in which his trading had reached glorious heights. Very carefully and thoroughly he backtested that data, until he was sure he would have taken the same trades in the same way. On paper, with only minor variances, he recreated his original fortune. At that point he felt he was up to his former level of trading. There remained only to test himself with real trading. He began to enter trades. He followed all the things he knew how to do. His discipline was magnificent. He was glowing with confidence that he would create yet another fortune from his trading. He began to lose! As was his habit and discipline from years of trading, he began to examine himself. He checked and double checked to see if he had traded the way he was supposed to trade. He checked every trading decision. He checked his order entries. He checked his reactions to crises that had arisen. He could find no error in his trading, so he pushed on. By mid year, his losses amounted to almost twice what they had been in the year he had suffered his greatest loss. What in the world was wrong? Everything seemed to be in place. Had he lost the skill that previously lifted him to lofty heights? The answer turned out to be that he was trying to do something that had worked splendidly at one time, but now no longer worked. The one area he hadn’t thought to check was that of the market itself. This great trader hadn’t changed. He still had discipline. He still could trade the way he always did. He still had his systematic method of trading. What was wrong was that he failed to perceive that the market had changed. It had changed drastically by the addition of a whole new set of participants. It was not that his system 176

or method in and of itself was no good. It was not that he lacked discipline in following what had usually worked before. No! What used to work was no longer working, and he had failed to realize the situation and adapt. His mistake cost him tens of millions of dollars. It took him five more years of consistently losing money before he finally came to the realization that what he needed to was to adapt his methodology to the changes that had taken place in the market. This story has a happy ending. The great trader is once again back on course and reaping a harvest of money. He has learned a great lesson. You might call it a lesson on how to survive through adaptation. On a smaller scale we knew a trader who borrowed $10,000 from a friend so he could start daytrading the stock indexes (never borrow money to start trading). He had never day traded a stock index before, but he had traded commodities for a few years (obviously not too successfully since he needed $10,000 to start trading again.) He started daytrading electronically, and for the next 12 months had profits of between $50,000 and $80,000 a month. He repaid his friend, purchased a red convertible Jaguar, wore a $7,000, watch and got married. Things were definitely going his way. But he traded using a certain method, that due to various rule changes, stopped working. He was determined to keep trading this strategy that gained him great success. We had numerous conversations with him. We explained the rule changes and told him why his trading strategy would no longer work. Finally he purchased a book which described a mechanical trading system. The book cost $100, and the trader was diligent in following the advice offered in the book. All he had to do was to purchase some software for an additional $200 that would enable him to use the mechanical trading system by merely pushing a few buttons on the computer. As it turned out, the combined cost for the book and software was approximately one-thousand times its real value. After only three months, our trading friend had lost over $40,000. By the way, he also tried trading other peoples’ money with the same disastrous results. This story does not have a happy ending. We recently spoke with the trader. He has moved at least twice during the last year, has spent or lost most of his money, and is fully 177

acquainted with most of the characters on the daily soap operas. Hopefully he will get back on track soon. We have included this story so you do not think that all our trading stories end the way we would like them. Speaking of stories, here is another interesting one. It teaches a lesson from which you are well advised to learn. We know two traders, one trading for about 10 months and the other about 2 1/2 years. Neither was a very large daytrader but both were quite consistent in their daily and monthly profits. Unfortunately, they both had bad tempers and were both quite lazy. They were both trading in the same daytrading office, and they both purchased a large number of contracts at a price of $4.00. Even though they were day traders, they did hold some positions longer term; this was one of those times. Over the next 6 months the market soared, and the market they were in quickly became quite visible through news releases from the secretary of agriculture. The market had risen to a high of $6.90. Both traders were really making money, in fact so much so that they both had stopped trading and decided to start living the high life — spending more time with their families, playing golf, and anything else they felt like doing. They acted as if their lottery ticket had just come in. However, they never cashed the ticket because they believed that the market was going to rise forever. So they felt there was no reason to cover costs, or sell any to take any profits. Sadly, in the seventh month that they were holding the contracts, there was some really bad news. The next day the market opened down 1 point from the previous day’s close of $7.00, and the next day down 2 more bringing them back to where they had gone long. They found themselves having not traded in seven months, and having never cashed in on a potential fortune. They had to start all over. This can be a really humbling business. KISS We're going to show you a technique that, if you will diligently follow it, will practically guarantee that you will be a winner in the market. It follows the U.S. Army KISS (Keep It Simple, Stupid) principle. This technique works well in trending but somewhat choppy markets. We want to take advantage of the probabilities. Statistics show that once 178

a trend has begun, the percentages favor a continuation. When prices are in a chopping trend, it may be difficult to see an overall trend line.

However, it may be possible to delineate the trend by creating a channel using a trend line for the highs and lows.

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We are assuming that you have read the Appendix but if you haven't, for understanding what follows, please review “THE LAW OF CHARTS.” We have included an expanded version of TLOC in the Appendix, with more detail than has been previously presented. The first step is to identify the trend as being established. This we have done, and marked a 1-2-3 low which defines the trend. A breakout of the Ross Hook following the defined trend establishes the trend. Originally, we drew a trend line between points 1 and 3. However, such a line is merely tentative because until the trend is established, we have only a defined trend in effect.

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Once we had an established trend, we re-drew the trend line to include “A,” and then added the channel line so that it paralleled the trend line. The upper channel line is of little importance other than to assist in the visual delineation of the trend. As has been mentioned in many places in our courses, the object of trading is to win. This is done by keeping losses small and maximizing gains. This in turn is done by keeping loss potential at a minimum while keeping the propensity for a win at a maximum. A trending channel offers just such an opportunity when prices reach the channel line. In a trending channel, the momentum and direction of the trend are likely to continue once the channel boundaries are tested. To further enhance the probability that any loss will be small compared with what can be attained with a win, we want to see not only a touch of the channel line by prices, but also the completion of a reversal bar which is evidenced in this case by the close being higher than the open on a price bar in which prices touch or violate the up trend line (A,B and C).

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Let's take the possible trades one at a time: • At “A,” we have a price bar that touches the uptrend line. Following that there is a bar that not only touches the uptrend line, but also reverses price direction by closing higher than it opens. We buy a breakout of the high of the reversal bar. • At “B,” we have a price bar that violates the uptrend line. Preceding “B” there were two price bars that also violated the uptrend line, but neither one of them gave any indication of a price reversal. Therefore, our entry point is a violation by price of the high of price bar “B.” That violation comes two bars later. • At “C,” we have a price bar that has most of its action well below the uptrend line, but which closes above the uptrend line. Because of the close being higher than the open, “C” is a reversal 182

bar. We purchase a breakout of the high of bar “C,” and are stopped out on the following price bar “D.” Bar “D” violates the uptrend line as explained in the following paragraph.

The stop for these trades initially goes below the trend line. Once the trend makes new highs on bars totally within the channel, any catastrophic stop is trailed at the channel line. That doesn't mean you always sit and wait until prices reach the channel line to be stopped out. Profit taking exit stops should be placed so that you take some profits, as with any trade where profits are possible. Profits should be taken via any method that is more immediate to the price action than is the trend line. Just be sure to take profits while they are available. Notice that another buying opportunity occurred two bars after bar “D” when prices violated the high of yet another reversal bar at the trend line.

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Let's look at another chart:

Once again we see prices trending, but it may be helpful to delineate the trend by drawing some channel lines. The questions are: “Where exactly did the trend start and when, if ever, did it become tradable using the channel technique?” Was it after we see prices breaking below the lower horizontal congestion line at “A”? Was it sooner? Was it tradable at all? Until prices broke below the lower horizontal line, which we drew to mark off what we perceived as chopping sideways prices, would it have been fair to say that prices were trending?

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Besides delineating the congestion, would it have helped to also delineate a possible trending channel? Let's see. The answer may surprise you.

As you can see, although by definition we had both a defined and established trend, and we drew the channel lines by the same rules as we did for the uptrending chart shown earlier, there were no trades available using this technique, because prices went outside the channel and remained there. Not once did we see a reversal bar subsequent to a violation of the Ross Hook that would have enabled us to enter a trade by selling short within the channel.

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Should we have redrawn the downtrend line and also the channel line. No! We don't want to change the method unless we discover that it hardly ever works. In that event, the market may have changed and we have to come up with a new method or adapt this one in order to compensate. We hope you can see the simplicity of this strategy and understand the tactics needed to carry it out. In a market that is clearly and less erratically trending, you won't need to draw channel lines. In a clearly trending market, one consistently making higher highs and higher lows, or lower highs and lower lows, a simple trend line or moving average line may be a better way to show containment of a move. The strategy and management for trading a normal trend is somewhat different as well. We have shown some of these strategies and tactics in our manuals TRADING BY THE MINUTE© and TRADING THE ROSS HOOK©. Remember, you don't necessarily want to find something that works and then stick with it. Such a strategy will be good for awhile, but you will end up the fool. It has happened to the best of traders. Your goal as a trader must always be to have a toolbox from which you can draw the appropriate tool for each market condition you encounter. Keep in mind: what works today for one market may not work today for another. What works today for one market may not work in the same market tomorrow. Markets trend, and they move sideways. The congestions can be short term, such as Ledges within a trend, or they can be long term, such as Trading Ranges. Trends can be gradual, with progressively higher highs and lows in an uptrend, and progressively lower highs and lows in a downtrend. But that description is an over simplification of market price action. There is an old saying that a market can trend up, trend down, or not trend at all (sideways market). Don't you believe that for a moment. A market can move up in a gradual trend, a stair stepping trend, a chopping trend, or an explosion. It can move down gradually, it can stair step down, it can chop its way down, or it can collapse (melt186

down). Each situation requires a different set of tools. It is a folly of mechanical trading systems that they attempt to trade all the ways a market can move using a single tool. It's like the repairman who tries to fix everything with a hammer. Sideways markets, too, have differences. There are tight Trading Ranges and there are large chopping Trading Ranges. There are Trading Ranges that continually narrow over time. People have termed these “coils.” There are Trading Ranges that continually widen over time. People have termed these “megaphones.” The underlying reasons for each of these different formations are themselves different. Different circumstances call for different sets of tools to properly enter and manage them. Would you want to trade all of the different formations with an 18 bar Relative Strength Indicator (RSI)? What if you changed the RSI to 15, or 14? Would you still get the same set of signals? If not, which would be right? Using different time spans for indicators, or any oscillator for that matter, is like using different hammer sizes. A hammer is still a hammer. Sometimes you need a wrench! You have heard it said, “If it works, don't fix it.” People have misunderstood the full meaning of what is being stated. It is true that when something works in the market, you shouldn't fool with it by trying to make it better. Doing that is the downfall of many traders. But you should be prepared at all times for what has been working to stop working. Then it's not a matter of fixing anything. It then becomes a matter of adaptation subsequent to the realization that what you have been doing is no longer working because the markets have changed. Our famous and great trading friend, after five years of frustration and agony, finally learned that lesson. We can all learn from his experience.

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Chapter 23 THE CAMELBACK TECHNIQUE At times, prices can be pretty wild. Sometimes we see large choppy Trading Ranges, abbreviated trends that fail to continue for more than a short duration. Lots of explosions and collapses make markets difficult to trade, even for the very best traders. It seems that at times only the innovative and adaptive traders can consistently take money out of their trading. Sometimes all that is needed is a simple set of tools. Let's look at just such a set of tools, that from a technical point of view are proving themselves successful in trading the kinds of charts we encounter from time to time. In the illustrations that follow, we will be using a fifteen bar exponential moving average of the close, along with a simple forty bar moving average of the highs and lows. With the forty bar simple moving average of the highs and lows we will attempt to create a channel. When prices move beyond the bounds of the channel, we will attempt to trade pointy places. We will never attempt a trade when prices are within the channel. The exponential moving average will be a filter used to keep us from trading when the moving average is flat. So, even though prices are out of the channel, as long as the fifteen bar moving average is flat or relatively flat, we will not attempt to trade. A trade will come when the moving average is trending and prices are out of the channel. If prices are above the channel, we will attempt trades only from the long side. If prices are below the channel, we will attempt trades only from the short side. Let's look at a chart so that you can get the picture of how the Camelback technique works with any time interval. You can use the Camelback for intraday or longer term position trading. More details follow.

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On the chart above, we see three moving averages. The most active (dotted line), is a 15 bar exponential moving average of the Close. It is used to filter out flat spots in the price action. When the 15 bar average is flat, we do not attempt to enter any trades. The smoother moving average lines are: 1) a 40 bar simple moving average of the Highs, and 2) a 40 bar simple moving average of the lows. These two form a channel which serves to delineate the price bars in such a way that we know when it is alright to attempt to enter trades. If prices are outside the channel, as long as the 15 bar average is not flat, we may attempt to enter trades, as will be explained in the material that follows.

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The idea behind the Camelback technique is to keep us on the correct side of the market at all times. This is accomplished via the channel created by the forty bar simple moving average of the Highs and Lows. WHENEVER PRICES ARE IN THE CHANNEL WE DO NOT TRADE. WHENEVER PRICES ARE ABOVE THE CHANNEL, THE APPROPRIAT E POSITION IS TO BE LONG . WHENEVER PRICES AR E BELOW THE CHANNEL, THE APPROPRIATE POSITION IS TO BE SHORT .

The only thing that will prevent us from attempting to get short below the channel or long above the channel is if the fifteen bar exponential moving average is flat or near flat. Our purpose for using the exponential moving average is to weight the more recent price action more prominently than the longer term averages for purposes of more quickly discovering when prices are flattening out. With the Camelback technique, we are attempting a three filter method for being on the correct side of the price action. We are pursuing the age-old concept of trading with the longer term trend by entering on a short term high/low breakout signal when the intermediate term trend moves counter to the long term trend. Let's look at a couple of charts to see how the concept works, and while we're at it, let's set some rules. • When prices are above the 40 bar moving average of the Highs, we go long on a violation of the high of the bar making the local low. • When prices are below the 40 bar moving average of the Lows, we sell short on a violation of the low of the bar making the local high. • We do not enter on a gap opening violation of either the high or low. • We do not enter a trade if the 15 bar moving average is flat or has turned away from the direction of the trade we want to take.

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At 'A' prices are inside the channel. Price bars must be entirely out of the channel before we can use the Camelback. When prices are above the channel, we attempt to purchase a breakout of the high of the bar that makes the local low. 'B' is a local low. An entry 1 tick above 'B' would have enabled the covering of costs and possibly a small profit. A trailing stop beneath the low of each bar would have seen profits maximized 4 bars after 'B'. 'C' was the next local low. An entry 1 tick above the high of 'C' would have done little more than allow cost covering and a breakeven exit some time in the next two time intervals. The next local low was 'D'. Entry 1 tick above the high of 'D' would have resulted a profitable trade. Entry above the next local low, 'E', might have only covered costs and broken even. Entry

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above local low 'F' would have given some nice profits, as would entry above local low 'G'.

'H' was a local low whose high was never violated, so there could not have been an entry. At 'I', the exponential moving average is turning and is flat. In addition, there was no possible entry on a violation of 'I.' Subsequently prices move to the other side of the channel. We are then looking to be short. Once we are operating on price bars that are entirely out of the channel, we then try to sell a breakout (violation) of the low of the bar that makes the local high.

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'J' is a local high. It is the top of a medium term downtrend. Shorting would have resulted in a profitable Shorting a breakout of the low of 'K', also resulted in a profitable trade.

minor correction to the recent the breakout of the low of 'J' move. 'K' was a local high. when it happened 3 days later,

Prices subsequently moved back into and through the channel. 'L' is a local low. It took 3 bars to violate its high. When it happened, costs and possibly a small profit were recoverable. Entry based on a breakout of the high of 'M' easily made a profit. A breakout of the high of bar 'N' would not be taken, because of the gap opening. The same is true of a breakout of bar 'P'. A breakout of the high of 'O' would have resulted in a profit. What we are doing here may be termed scalping. Scalping the longer term chart using short term trading techniques is a great way to trade the kind of action we see on these charts.

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Now let's look at another chart to help you lock in the idea of what we are trying to do. Please pay attention. The next chart is of a market that was trading amidst rumors of trouble in the Middle East by the time we see the latter portion of the price action. The problem was that the situation was an on-again, offagain proposition. Prior to the takeover rumors, prices had broken out of congestion and had begun trending down. Let's notice how the Camelback method kept us out of trouble.

We'll begin at 'a', where we have a local low fully outside the channel from which to trade. At best, 'a' would have resulted in no more than covering costs and then breaking even. 195

At 'b', we would have tried to go short below the low of a local high, but the trade was nullified due to a gap opening. At 'c' the 15 bar average was rising, and so a fill above the high of 'c' would have resulted in covering costs and being stopped out at breakeven. 'd', 'e', 'f', 'g', and 'h', were all profitable trades based upon selling short a breakout of the low of a bar making the local high. 'i' was unfulfilled because of the gap opening. The best trade was made with a fill one tick above 'j'. 'j' was a local low. 196

Now let's look a bit at the management of a Camelback trade. We always cover costs as soon as possible after entry, using 1/3 of our position. We set some sort of short term objective for a profit taking stop using 1/3 of our position. We then allow the final 1/3 to ride. From time to time, when the 15 bar moving average is flat, we will miss out on large moves that would have been in our favor. These will be offset by avoiding large moves that would have wiped us out. We will be content to make steady and regular profits. Now let's look at another chart using the Camelback technique. As far as we can see, there were only six trades on this next chart. It would have been rather difficult to trade on its own merits without some sort of filtration. The Camelback technique provided that filter. Obviously, the Camelback technique may at times not give a whole lot of trades, but wherever tested, it results in relatively small losses compared with relatively large wins. It seems to fulfill the requirement of keeping your losses small while you let your profits run. Let's look at the six trades.

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At 'a', 'b', 'd', and 'e' we sell short a breakout of the low of a local high. At 'c' and 'f,' we buy a breakout of the high of a local low. Here's one last chart using the Camelback.

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Once prices broke below the channel, the selling short of a breakout of the low of almost every price bar that made a local high would have resulted in a nice profit, or at the very least, have covered costs. We've placed an 'x' by every point at which we think this could have happened. The very last 'x' would almost surely have resulted in a loss.

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Chapter 24 DIVERGENCE DECISIONS The subject of divergence is one that we will approach with the utmost caution. We hope we have made ourselves clear in the other volumes of this course that we have little regard for oscillators and indicators when such “tools” are used indiscriminately, or used as a mechanical way to trade. However, when used intelligently, with full understanding of what and how they are constructed, and with knowledge as to when they will be accurate and when they will be misleading, we are not against the use of such tools. Divergence is a topic that has been hotly debated over the years. An indicator can be divergent from prices for much longer than proponents of its use may care to admit. Yet if used intelligently, divergence can be a useful tool. Our advice is to learn to use it at appropriate times, and perhaps with a few other measurements that will tend to confirm its validity. In this chapter, we are going to combine the delicate matter of divergence with an indicator that you may find useful. YOUR JOB AS A TRADER The job of a trader is that of decision making. A trader uses available practical tools to perform this job. An interesting trading tool a person can use to help in making a trading decision involves finding divergence in the MACD Histogram (MACDH) oscillator in conjunction with a seasonal entry signal. MACD stands for Moving Average Convergence and Divergence. MACDH is a histogram display of the difference between two moving averages.

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PUTTING IT ALL TOGETHER WITH MACDH

We want to show you a method that you might use in your approach to making a trading decision using a couple of sample trades in which we were involved. This method and approach is valuable for analyzing trades in any time frame. For the two trades we have chosen we used MACDH to assist in making our trading decision as to the validity of the divergence we were seeing on the shorter term chart. We are going to look at several tools which may be used to filter these trades. A couple of these tools are historic in nature. For purposes of the MACDH study analysis we used a short-term moving average of 9 bars and a longer term moving average of 19 bars. Although there is nothing magic about them, the 9 bar and 19 bar moving averages are fairly standard when employing MACDH for trade entry signals.

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Years of study by the originator of MACDH, Gerald Appel, has shown that divergence such as you see on the following chart offers a very strong confirmation of a trend change. The divergence we are referring to is that while prices are moving higher and making new highs, MACDH is moving lower and not making new highs. As you view this first chart, ask, “Could it be that prices were about to rollover into a downtrend? In that case, you might want to sell short. Or you might think, “Perhaps prices will not go down and perhaps they will enter into a congestion phase!”

THE SHORT-TERM CHART The chart we are showing you for this particular trade allows you to see prices before you know the final outcome of the divergence shown on the chart. However, entry into this trade, as with any trade, should always be decided on a risk-versus-reward-versus-probability basis. This kind of decision making is the job of a trader. Prior to a proposed long entry, prices had been in an established uptrend. 202

One has to consider that the price action as shown on the chart may very well lead to prices moving into congestion, as opposed to a genuine down-move in prices. The amount of risk is of course dependent upon where you place your protective stop or your trade exit strategy. We must now look at the risk/reward possibilities. In order to arrive at a sensible answer, we must assume a protective stop. What percentage of our money are we willing to risk on an outright short position? Another factor in our decision is the probability of prices entering into a prolonged congestion at this point. History shows that futures prices seldom make Vee-bottoms, but in this case we are concerned with whether or not prices will make a Vee-top. A look at the monthly chart just ahead reveals that prices have entered an area of previous congestion and may move higher before moving back toward the base of a long term congestion. We will combine two studies in different time frames for help in analyzing whether or not, from a technical standpoint, we might expect prices to move down at this point in time. The first is MACDH. The second will be the Bollinger Bands. We will use three different time frames: short, intermediate, and long term to make our trading decision. The ratio of the time frames will be five to one as follows: • The intermediate time frame will be five times as long as the shortterm time frame. • The long-term time frame will be five times as long as the intermediate time frame. Because we will be looking first at the long-term chart, we’re going to shorten the moving averages on MACDH to 5 months and 11 months respectively. The smoothing factor will be 11 months. The smoothing factor can be used to more accurately place the peaks and troughs of the histogram in line with the peaks and troughs of the price action. We shortened the moving average lengths because we want to cause 203

MACDH to show us on a more dynamically current basis what is taking place in prices. The long-term price chart follows:

LONG-TERM CHART We’ll also look at a chart showing the Bollinger Bands before we tell you how it was that we rendered our decision to refrain from selling short. Whether we were correct or incorrect you will be able to judge based on the chart that follows the intermediate-term chart. Keep in mind also, that of the three things price action can do, two of them are against taking this trade. Prices can move up, down, or sideways. For prices to move down significantly, we will need some indication of strong downside action. The most likely price action, if this trade is to be successful, would be for prices to fail to make a 204

new high, thus bearing out the truth of the divergence shown on the short-term MACDH. If prices are not to develop into a congestion, we can expect prices to continue in the direction of the uptrend. The likelihood of a trend continuation is equal to that of a Trading Range top. Was there any clue as to a potential down move on the basis of the intermediate term chart?

THE INTERMEDIATE-TERM CHART Not really. We find nothing to indicate such a move. In fact, prices have broken to the upside on the intermediate-term chart . 205

The Bollinger Bands are flat and parallel to one another. This typically occurs when prices are in a Trading Range. Bollinger Bands are extremely reliable for showing us likely price containment areas. Looking at them on the previous page indicates containment. The Bands are relatively flat, as is the 20 bar moving average in the center. The Bollinger Bands indicate a Trading Range continuation as the most probable outcome for prices based on the weekly chart. Prices are moving steadily towards the top of the Trading Range. Experience with Bollinger Bands has shown that when the Bollinger Bands are roughly parallel, the likelihood is for an immediate continuation of the present price action. The flatness of the bands indicates steady volatility and prices that, for the time being, are basically at equilibrium. There are also fundamental factors that should be taken into consideration provided we can find out anything through the news or from appropriate reports. Based on what we have already seen, and quite apart from any fundamental considerations, it is quite possible to make an intelligent trading decision. Favoring a Short Position: • Daily chart divergence of MACDH Against a Short Position: • Two out of three chart probabilities indicate a Trading Range or upward trend continuation. • MACDH on the long-term chart shows no divergence and a Trading Range market. • Bollinger Bands on the intermediate-term chart show steady volatility and upward continuation on a weekly basis. 206

Our decision: There are more factors against a short position than there are for a short position. Do not take this trade. The near-term result is shown below.

THE NEAR-TERM RESULT The arrow on the chart above points to the last bar we saw on the short-term chart. Had we made a decision to sell short, we would have been wrong. We would have failed to look at the entire picture prior to making a trading decision. Now, let’s take a look at a proposed long trading situation mentioned earlier.

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On the short-term price chart, we see that prices have broken out of a Trading Range and are now forming what some call a “flag.” According to some technicians, an upside breakout of the flag will lead to a rise in prices to an amount approximately equal to the height of the flagpole. Notice that prices moved up rather quickly from what had previously been a downtrend. The sudden move has resulted in a minor price consolidation. Experience shows that, unless there is a continuing strong demand, prices will retreat to test the top of the former Trading Range. Notice that any stops that might have accumulated above the top of the flagpole were recently taken out. A second-time through breakout of the top of the flagpole (not the flag itself) may signify a further real move in prices.

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THE SHORT-TERM CHART The relationships of opens to closes is of no help on the daily chart. Since the correction from the top of the flagpole, there have been an equal number of high and low closes relative to the opens. Prices have been flip-flopping in the minor price consolidation Bollinger Bands on the short-term chart are showing a rising market, but that is because the reality of the minor price consolidation has not yet registered. MACDH is showing divergence from the Bollinger Bands. What else might be there to help make a trading decision?

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Reviewing the intermediate-term chart below, gives a few additional clues.

THE INTERMEDIATE-TERM CHART 1.) MACDH had been divergent to the price action prior to prices leveling off and then moving higher. The divergence proved to be an excellent indication of what was to come. 2.) Bollinger Bands: The lower Bollinger Band has turned in and is now flat. This indicates an end to the downtrend, and the beginning of either an uptrend or a Trading Range action. When both Bollinger 210

Bands are flat, prices tend to move from one Band to the other. A move by price to the level of the upper band would bring prices exactly to the area of the projection on the short-term chart. 3.) That prices may go into a Trading Range is indicated by the fact that there is a previous matching congestion at a price level similar to the current price level. It is now time to make a decision. Favoring a Long Position: • Prices on the intermediate-term and short-tem chart are rising. • The shorter term chart favors a move up to the top of the flagpole. • The intermediate-term chart is supportive of a move to the upper band. Taken together, the chances are prices will pause briefly and then rise further. Against a Long Position: • Prices may have moved up too fast and prices are now ready to consolidate. Our decision: There are more factors in favor of a long position than there are against it. We will enter a long position at the first opportunity. The near term result is shown on the following page.

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THE NEAR-TERM RESULT The arrow points to the last bar we saw on the short-term chart. So it wasn't such a great trade! We're not perfect. But prices did break out and go up to the top of the flag pole. The only problem was we barely had time to get in before we had to get out (gulp).

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Chapter 25 KELTNER CHANNEL In dealing with memory, something that is an aid to memory is called a mnemonic. A mnemonic is something you see that acts as a triggers to help you remember an entire word, sentence, or even a concept or idea. Is there a name for something that is an aid to visualization? For a trader, perhaps it is the Keltner Channel. At various times we have used Keltner Channel as an aid to vision. As with other band studies, Keltner Channel bands were designed to bring out certain aspects of the price action. An excellent way to learn to trade by what you see can be via the creation of various channels utilizing “bands” to delineate the channel structure. Channels give a visualization of market phenomena that might otherwise go unnoticed. Probably the simplest form of band utilization is to draw a trend line using a ruler and connecting the major price lows in a market to create the bottom of the channel. To visualize the top of the channel, draw a trend line connecting the major price highs. Bands tend to show whether prices are high or low relative to where they have previously been. The history of bands has been progressive. By plotting lines around the structure created by the price action, a trader is able to create a visual envelope to aid his perception of what is taking place in a particular market. For example, Bollinger Bands are an outcome of a history of channel creating techniques. They were designed, among other things, to show the location of a specific number of standard deviations from a moving average of typical prices. Since markets tend to fluctuate rather than move in a straight line, various techniques have been introduced to better capture the overall market action. The simple moving average has been used to create 213

bands that are shifted up and down by a fixed percentage. J.M. Hurst, an early pioneer in creating bands using, such a technique. This technique has been expanded upon to include the use of geometric or exponential moving averages, as well as various sorts of weighted moving averages. Band studies have also been set up so that they contain a certain percentage of the data available from the price action. With this method, the market itself sets the band width. We believe the technique was first developed by Marc Chaikin at Bomar Securities. Any of the band techniques are both helpful and useful for trading, and each has its own strengths and weaknesses. TRADING THE KELTNER CHANNEL As with other band studies, Keltner bands were designed to bring out certain aspects of the market. Keltner bands are quite different from Bollinger bands and they must be traded in an entirely different manner. Do not make the mistake of trying to substitute one for the other simply because they look similar at times. There is nothing magic about the Keltner Channel, no special feature to make it outstanding over and above other band creation techniques. We have used it because the band distance is calculated based on the volatility of a bar’s true range from high to low. At Trading Educators we tend to favor studies that are based on volatility, because volatility is a very real factor in the price action, which is often overlooked by many traders who give a chart nothing more than a casual glance. More importantly, to use Keltner Channel, you must learn to understand its various idiosyncrasies. The bands are created by employing a moving average of each bar’s volatility from high to low, and then multiplying that moving average by a constant number to adjust the band distances from the moving average line. It is sort of a combination of other band techniques, 214

having some of the features of Hurst’s bands, Chaikin’s bands, and Bollinger’s bands. Its principal weaknesses are twofold. 1. The constant is determined by the user. 2. Volatility is expressed as the difference between the high and the low of each individual price bar. A better way to measure volatility is to measure the movement from yesterday’s low to today’s high when today’s high is higher than yesterday’s high, and to measure the movement from yesterday’s high to today’s low when today’s low is lower than yesterday’s low. Such a measurement would most certainly take care of all gaps and be a truer measure of volatility. (Note: Volatility figures are available on a number of websites. www.mrci.com is one of them). We have no idea who Keltner was, and we have no idea of how he (she?) used those bands. We found them in the software we use, and experimented with them until we achieved satisfactory results. To accomplish this technique we use a 9 bar exponential moving average of the closes, with a multiplier constant of 1.9. Why 9 and 1.9? Because that moving average and that multiplier have worked for us and for others. The moving average may be simple or exponential. It won’t make much of a difference which moving average is used. Exponential moving averages weight the most recent price action more heavily. Rest assured there is nothing miraculous or supernatural about those numbers. Other combinations of numbers would probably work equally well. The trick is in learning how to use Keltner Channel at one setting and stick with it until it eventually proves to be of no value. What are the characteristics of the Keltner Channel? In sideways markets, the band distance narrows due to falling volatility. In trending markets, the band distance increases, at least until volatility reaches some sort of equilibrium. From there on, the bands remain relatively the same distance apart. There is not much more to it than that in the way we use the Keltner Channel bands. In fact, there are times when you may find that you pretty much ignore the bands and stick mostly with the moving average. The bands are as stated 215

earlier, primarily a visual aid. We have found that not everyone is readily able to see (or notice) increases and decreases in volatility. Although the moving average is created by the price action, the number of days (9), and the band width (1.9) are from our own imaginations. It is we who have chosen to use 9 and 1.9. There is nothing of the market in those choices, and we’re not about to bow down and worship something created by our own hand. Because of that, we regularly break any rules we may have associated with the Keltner Channel study in favor of common sense and safety. Why then are we including the bands? Because they are a good visual aid. When you see the results of trading with them, and have tested them yourself, you will be able to decide whether or not they are worth using. As always, you must experiment with the bands, and you must be comfortable with them. You can try the bands at different widths, and you can change the moving average. This can be done in accordance with the price activity you encounter for each market. Keep in mind that we are dealing with a channel as opposed to an envelope. By its very nature, a channel implies that a market is trending. That means you have to know how to define a trend. You have to know what a trend looks like. The trend is your filter for the Keltner Channel. Of course, the sooner you are able to detect a trend, the sooner you can effectively use the Keltner Channel study as we will present it in this chapter. The Keltner Channel study works equally well in any time frame. The more trending the market, the better chance for success using the Keltner Channel. KELTNER CHANNEL METHODOLOGY Seasonality and Cyclicality: Where possible, we want to enter trades during those periods when a market is known to trend. Some futures have seasonal tendencies, so it is appropriate to use seasonality and cyclicality (are these words?) whenever and wherever possible as a filter for your trade. Since seasonality and cyclicality are really involved with timeliness, if there is a particular

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time of day when a market tends to trend, you should apply that knowledge to any day trading efforts. Bands: The upper and lower Bands must be clearly trending in the same direction at the time of entry into the trade. Moving Average: The moving average must be trending in the same direction as the bands at the time of the trade. The tradable channel is found between the moving average and the upper band in an uptrend and the moving average and the lower band in a downtrend. We are looking for general containment of retracements to the moving average line. Price Bars: Price bars must retrace in the following manner: 1. Touching, or if you choose, very close to and almost touching, the moving average. If you elect the very close method, it will be strictly a matter of perception on your part. 2. Penetrating the moving average, but by less than 1/2 the distance of the width of the channel opposite to the trend. 3. Price bars must conclude with an intraday reversal in the direction of the trend before an entry can be considered. Exit Rules: We’ve shown you various exit techniques throughout the course. We cannot tell you where to place your exit stop, or even whether you should use a stop in the conventional sense. However, you should use common sense. You should never risk more than you can afford with your stop. You should have a plan for extracting reasonable profits from a trade. Trade with objectives whenever possible. NOTE: How to trade without using stops; how to trade with objectives; when and how to add-on to a trade; how to maximize your wins and keep your losses small; how to manage money, risk, the

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mechanics of a trade, yourself, and much, much more, are all taught at Trading Educators seminars. WARNING: This methodology is not meant to be mechanized. There is a degree of human intervention and perception involved. Using this method of trading is subject to judgment. The application of the methodology will become more clear as we go through a series of charts. In the rest of this chapter we are going to present a single trade. However, the trade was what we consider to be long term. It was definitely not a day trade. Following is the chart:

You can see that, in terms of the Keltner Channel method, there is no buy signal. The bands and the moving average are all turned down. Next, let’s look at the situation five days later.

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Five days later the situation has changed. The bands and the moving average are rising. Prices have retraced to and made a minor penetration of the moving average, and then reversed by closing higher than they opened. This is our signal to get long. If we were watching intraday, we could have gotten long before the close. If we are end-of-day traders, we enter the market no sooner than 15 minutes after the open. In either case, we'll assume an entry at 22.50. Our stop is at our comfort level, we were willing to risk at least $1,000 on a trade taken from a daily chart. The stop is at $21.50. Looking back at what we labeled “the first possible entry day,” we can see that the close in the upper part of the day’s price range was significant. Prices had reversed intraday sufficient to come off their lows and close high. We enter long and, as prices move up, we take some profits out of the market, and move our remaining stop to break even. 219

We’re stopped out of our remaining contract(s) at breakeven the day before prices come crashing through the moving average. Do we now have a sell signal? Not according to the rules. Prices have reversed themselves and penetrated the moving average, but before we could be interested in them again, this time for a possible downward move, we would need to see a retracement by prices back to the moving average line.

Let’s see what happened next!!

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Wow! What's going on here? Can’t these prices make up their mind which way they want to go? Actually, that close was mighty weak for such a large day. Will we get a retracement to the moving average so that we can try again to go long?

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Taking it a day at a time after the “big” day: A: We cannot use day “A” because it violates our second rule for the retracement: “Penetrating the moving average, but by less than 1/2 the distance of the width of the channel opposite to the trend.” “A” is more than half way across the upper channel. B: Inside day. Prices touch the moving average line and close just 1 tick less than half way across the width of the channel. That is good. Day “B” is the bar that gives us our entry signal for day “C.” We enter 15 minutes after the open on Day “C.” We risk $1,000 on this position. The next chart will show you how it all came out. 222

After entering the trade: • As soon as possible, cash some contracts in order to take profits and be paid for trading. Place a stop at breakeven. • As soon as there is a low that is higher than breakeven, trail a stop just beneath the low of each day, until stopped out.

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Chapter 26 THRUST BARS One of the strongest signals that can be obtained on any chart, regardless of time frame, is what we call a thrust bar. Although thrust bars occur in both directions, the best and most trustworthy are those that occur in an upward direction. You will have to observe them for awhile before you can come to appreciate what we've written here. Your attention to thrust bars will be well worth the time you spend in learning to identify them. You must also learn how to manage trades that are the result of thrust bar actions. In general, we buy a break out of the high of an upward thrust bar. We'll show you some so you can get a better idea of what we're writing about. The thrust bar below is at the point of the arrow.

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Thrust bars close at or very near their highs. They are usually close to double or greater than the size of those bars immediately preceding them, although this is not necessarily the case. As you study them, you will learn to recognize them when they are not much larger than those bars preceding them. They invariably come out of clusters of congestion. We buy the high, or the breakout of the high, of the thrust bar once we see it close at or near its high. Sometimes it is all we can do to get in one tick above the thrust bar high.

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Other times, the following bar will dip a bit lower than the thrust bar high, thus giving us a chance to get in at a slightly lower price using the Trader’s Trick. On the chart above, the lower arrow points to the thrust bar. The upper arrow points to the buy point. A “price or better” order is good to use with thrust bars if it is possible for you to enter such an order. Thrust bars can also occur in trending markets. You wait for a 1-2-3 low followed by a Ross Hook. Then you look for a thrust bar on up to four bars of correction. Once again, you will have to work out the trade, money, and risk management. There is no miraculous way to do it that applies to everyone equally. You will have to take into consideration your own trading style,

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amount of acceptable risk, and the size of your account. We'll show you an example of a thrust bar occurring in a trending market. If however, you were trading 1-2-3’s and Ross Hooks, you would have already been in this trade.

Just in case you think this always works, let’s bring you down to earth with the chart on the following page. Because you never know for sure how much further the market will go after a thrust bar, the trade must be treated as a scalp. You must cover costs as soon as possible. You must have a definite objective for the next part of your total position. If, after meeting the first objective, you still have a part of your position remaining, you can then attempt to let the trade ride as far as it will go.

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The fill can come several bars later, but not more than four bars should be between the thrust bar and the fill bar. Surely if you search through your charts, you will find other examples of thrust bars that didn't make much money. Remember, just because a bar is large doesn't make it a thrust bar. It also has to close at, or very near, the top of the bar. If you need a number for that, let's just say it has to be in the top 10% of the bar’s range. You may wish to make it even tighter by saying the top 5%. Often you will do it, just making a judgment call based on what you see.

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There are a number of “not-so-hot” thrust bars on this chart. We pointed out the most obvious one with the lower arrow, and the entry with the upper arrow. Take a look and see if you don’t see the others. That way you’ll get a reality check. But it is important to know about these and learn to use them in your trading. There are numerous times when thrust bars render excellent trades. At least they give you some clue that something real is, for the moment, happening.

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Chapter 27 MARKET MANIPULATION “Please, Lord get me out of this trade and I swear I’ll never trade again.” Have you ever found yourself in the position of the noble trader on the left? “Why, oh why did I ever get into this trade?? I should have quit while I was still ahead!!? Perhaps, like this poor soul, you haven’t been properly planning your trades. If you’re like many traders we know, you’re in a hurry. You rush to trade while exhibiting very little in the way of patience. You probably have no idea of how to plan a trading campaign, and you’ll probably lose most of your money before you ever find out. That’s too bad, because as with any endeavor, preparation is the biggest part of the job. If something is worth doing, it’s worth doing well. So, in this chapter let’s show you a few more things you need to know to get things done right. Some of you need some lessons in how to do some long-term trading and planning. It’s not all that difficult. We’ll start out with a few of the basics of trading. RANDOM WALK? For years we have denied any notion of the theory of Random Walk in futures prices. The more time goes by the more strong that conviction becomes. It is as we’ve explained elsewhere, the market is a situation of “weak hands” vs “strong hands.” Prices are engineered by the strong hands to take advantage of the weak 231

hands. It’s always been that way, and it always will be that way, unless, somehow, human nature can find a way to change without the help of divine intervention. Let’s look at some pictures of engineering by the strong hands. In order to show you some major moves, we are going to move out to daily, weekly, and monthly charts. Even if you are a day trader, you can take advantage of these moves when they occur, provided you know what it is you are looking for. There are ample futures which you can trade, so these situations can be found in many places. All you have to do is look.

MONTHLY PRICE CHART

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Here’s what to look for: • “A” – Prices start dropping down into a major low area. • “B” – Prices consolidate for an extended period of time. (Remember, this is a monthly chart.) • “C” – Prices are squeezed even lower by the strong hands, sufficiently lower to drive out all of the weak hands. Anyone bullish on this market is now ready to or has already capitulated. During and following the squeeze, the strong hands accumulate everything available at low, low prices. The strong hands now own this market.

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• “D” – Since there is no one left to sell, the only thing that can happen is for demand to take hold and prices to rise. The strong hands sell into rising demand. The transfer of wealth eventually changes from the strong hands to the weak. You can see this same scenario time after time on quarterly, monthly, weekly and daily charts. It also takes place intraday. Only the players and the magnitude of what takes place are different. The driving force, however, is always the same – greed. The strong players in the market are patient. They can afford to be. They know they need only a few large well-planned moves to make their fortunes even fatter than they already are.

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How can you take advantage of a situation such as the one we just saw? You can learn to recognize the pattern of: a. descending prices, followed by a leveling off into congestion that appears to be as low as prices are going to go. b. a surprise further descent by prices (the squeeze), followed by another period of congestion prior to the start of a rise in prices. c. a steady rise in prices that eventually penetrates the former congestion It is in this period of steadily rising prices that you can take excellent trades in a market. You can count on the rise continuing for quite a long time. Let’s look at another chart. This time we’ll see it on daily prices.

DAILY PRICE CHART

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• “A” – Prices begin a drop to what, at the time, were major lows. • “B” – Prices consolidate at the major lows in what appears to be a bottom. It looks as if prices will not go any lower. • “C” – To the dismay of anyone bullish, prices do drop lower. The squeeze is on. All weak hands are driven out of the market. It is a complete bullish capitulation. • “D” – A period of consolidation forms once again. At this point and during the squeeze, we have had accumulation by the strong hands. • “E” – Prices begin to rise on demand • “F” – Prices rise higher than the former consolidation.

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We’ve been looking at bull squeezes. Sometimes the squeeze can be a bear squeeze. Here’s a bearish squeeze. This time we’ll use a weekly chart.

• “A” – Prices climb to new all-time highs • “B” – Prices consolidate, looks like perhaps the end of the bull rise. • “C” – Prices rise again in an attempt to squeeze out the weak bears.

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• “D” – Prices consolidate once again. distribution and prices will start down.

Perhaps this is now

• “E” – Wrong! Prices make on final squeeze to even higher highs. You now have a complete bear capitulation. The strong hands have driven out the bears. There is only one way prices can now go. • “F” – That’s right! Down!! Past the prior congestion. We figure you won’t rest until we show you that this also happens on intraday charts. So here comes one now.

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15 MINUTE CHART • “A” – Prices dropped to the lowest low in quite a few days. • “B” – Prices have flattened out compared with the angle of the prior downtrend. • “C” – The bulls are squeezed hard by a sharp drop in prices. • “D” – Prices congest once more. • “E” – Prices rise steadily until they move above the former congestion.

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Chapter 28 LIQUIDATION Knowing when to liquidate a trade is at least as important as knowing when to enter a trade. Since most traders are on the right side of a trade going in, then the problem would seem to be knowing when to get out. Too often traders are on the wrong side of a trade when exiting the market. We are constantly amazed that traders will stay long when the market is giving a clear-cut sell signal. The opposite of that is true as well. Traders who would normally go long on a buy signal will try to stay short through that very same signal once they have taken a short position. If you are short and are looking at the breakout of the number 2 point of 1-2-3 low formation, then surely it is time to think about getting out of your short whether you have won or lost. Large pattern signals such as 1-2-3's are a good way to exit trades. But there are finer points of market action which can indicate that it's time to exit. There are tell-tale signs that inform us that it's time, win or lose, to take our money and run. In this chapter we will share with you some thoughts about liquidation and exiting. WHO HAS CONTROL One way to determine when it is time to exit is to ascertain who has control of the market, buyers or sellers?

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Regardless of time frame, if you are long, and you begin to see a number of bars that tell you the sellers are in control of the market, you should be quite anxious to exit. More than that, you should begin to get nervous the moment the buyers lose control of a market. That means that as soon as you see price bars no longer closing in the upper 1/3 of the price bars, begin thinking about protecting yourself – win or lose! The opposite is true when you’re short. Regardless of time frame, if you no longer see prices closing in the lower 1/3 of the price bars, you should strongly consider exiting the trade. Usually a number of bars is required to notice that the trend is no longer intact. Sometimes a single bar is sufficient. A very large bar can be quite convincing. In an uptrend, a large bar with a very low close may be the blow-off bar, a complete reversal of the way prices have been trending. The momentum is clearly down on that bar. Exit as soon as possible. A very large bar in a downtrend with a very high close may be the very bottom. Prices will usually rally. Exit all shorts. See the example on the following page.

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A gap may be sufficient to cause you to notice that a trend is no longer intact. A large outside gap, with a very low close in an uptrend or with a very high close in a downtrend may be a signal that prices are now ready to move in the opposite direction – the direction that will go against your position. (See the example on the following page.) This type of very close analysis is much more important at the beginning of a trade, before you've made a profit, than it is after the trade has become profitable.

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A TIME RULE If you’re able to watch the price action, and prices have not enabled you to cover costs within a certain number of minutes, then exit, win or lose. It is important to have either or both a time constraint or number constraint. It is vital to encode in your mind that, "I will be out of this trade win or lose within such and such a time period." The period chosen should be selected so that it suits your temperament, trading style, and personality. You must choose your own time parameter. We want to make it clear that we did not do extensive statistical testing that would have proved that any particular number of minutes is the ideal time. You have to find your time by trial and error and by experience. Once you’ve discovered it, use it regardless of the time frame in which you trade. This includes taking

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an intraday trade from a weekly or daily chart signal. If you have not covered costs in your selected time period, exit. Here’s another rule you might like to try. We call it a 3 bar rule. It states that if you have not at least covered costs by the time three bars appear on the chart, you get out of there. Which rule you apply must depend on both the price action and what you see. You might favor the time rule because you are looking for almost immediate confirmation that you are correct. Perhaps in your own case, you would do better with a 4 or 5 bar rule. That is your decision to make. We’ve been asked, “Does it make sense to use a time rule for all markets?” The answer to that is, “perhaps.” Certainly “yes,” if your trading style and entry techniques presume an explosive move upon entry. If you don't get it, you know you’re wrong, at least for the time being. Therefore, you exit. You can take many small hits and still survive. One of the great differences noticeable among successful traders, and which separates them from unsuccessful traders, is that successful traders are not afraid of losses. They may not like them, but they consider them to be the cost of doing business. They don't get emotionally involved, and they don't take losses personally as though losing reflected on them and their abilities as a trader or as a human being. Unsuccessful traders do take losses personally. They feel as though they've failed. They feel losses are a reflection upon themselves. Truly, losses are only a cost of doing business. Your job is to keep those costs as low as possible.

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COMBINING THE TIME RULE WITH WHO'S IN CONTROL In the early stages of a trade, before having covered costs, even before the set number of minutes for your time rule have transpired, if you see two bars in a row that open and close in opposition to your trade, you should exit.

If you are short, and you see two consecutive bars that close higher than they open, you should begin your exit procedure. If you are long, and you see two consecutive bars that close lower than they open, get out. You no longer want to be in the trade. When you are using a three bar rule, regardless of time frame, if you see two consecutive opposite-side closes as just described, exit without waiting for three bars to register on your chart.

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MARKET BREAKS Market breaks can be a signal. They are a minor signal intraday, but they are a major pattern signal on daily charts, and on very active five minute or greater time interval charts. Here's what a Market Break looks like: When you see the lowest close, followed by two higher closes, then a lower close, and then a break, unload your short positions, you have a buy signal. The important thing is the pattern of the closes. Obviously, this pattern could have taken place with an infinite variety of highlow-open relationships. The opposite pattern is also true. If you are long when this happens, you must immediately exit your long position. It wouldn’t hurt at that point to sell short as well. The pattern is: the highest close, followed by two lower closes, then a higher close, and then a break. Remember, it is the pattern of the closes that is important. The relationship of the opens, highs, and lows is meaningless when looking for this pattern. That is not to say that the relationships of open-high-low are not also important, but with Market Breaks we are interested only in the relationship between closes and the fact that the market then breaks on the open. PRICE VERSUS VOLUME What can be done with volume? What does it show? The most important thing to know is whether or not price increases or 247

decreases relative to volume. The level of volume, other than for the way it affects getting decent fills, is meaningless if prices do not move. In fact, volume relative to price movement or non-movement can tell you a great deal about what is happening among inside traders. If prices are not moving, no matter how great the amount of volume, you can be pretty sure that nothing more is going on than the insiders trading among themselves. Insiders are quite content for the market to stay within tight trading ranges. They can safely scalp out their money within those price ranges wherein you dare not tread. They have the benefit of low, or no commissions, and the benefit of their insider status. The time delay on their trades is minuscule as long as the market is not too thin. The same is true of the slippage they incur. As long as there are sufficient traders, the insider's slippage will be little if any. In general, trend is not caused by insiders. Real trend movement is brought about by the outsiders who come into the trading arena to intentionally move or engineer the market to their own liking. Therefore, when you see volume drying up, you can expect little price movement. If it happens apart from a major report of some kind and after price has been trending, you can safely assume the move is over and it's time to get out of the trade. Volume is not an absolute indicator, because of the engineering that can take place in a market, and because price may not move on increased volume when position squaring ahead of an earnings report or other important announcement is taking place. But it can act as a tie-breaker when you are not sure. It can be a filter that says, "get in" or "get out." Remember, very often the signal to enter a trade can be your signal to exit a trade. MENTAL VERSUS PHYSICAL STOPS One of the most frequent questions we are asked is, “Where do I put my stop?” Equally important but rarely asked is, “When do I put in a stop?” We will now raise another question in your mind, “Why put the stop where you do, or why put it there at all?”

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Let's look at these together. We will give you something to consider in your trading from now on. The insiders want to see your stop loss. It is in their best interests. When your stop is in the market it becomes part of the market. It is an additional order in the market. This is good for business. The exchange likes it. The insiders love it. It gives them something to fish for. When your stop loss is in the market they can see and take your money. Therefore, we submit that whenever possible, your stop loss should be mental, but only until you decide to hold beyond a day trade and replace it with a profit protecting stop. NEVER CARRY A LOSING POSITION OVERNIGHT! There are different types of stop loss that center around your mental perception and thoughts about what is happening: a stop loss that says, “I'm not completely wrong yet, I’m going to give this trade more room,” one that says, “I'm totally wrong, and I ought to either be out or going the other way,” and one that says, “Wow, what if I have a heart attack while I’m trading and I get wiped out before anyone realizes I’m in?” • “I’m not completely wrong yet.” This thought, of course, is like saying to yourself, “I’m only half pregnant.” If you are wrong, you are completely wrong. Get out! Do it now! • “I’m totally wrong and I ought to either be out or going the other way.” Isn’t it amazing how our minds can play tricks on us. The above thought is really illogical. When you are wrong, you are automatically “totally wrong.” However, the second part of the thought falls into the area of a hunch whose lead you should learn to follow. “I ought to be going the other way” calls for a reversing stop – a double order. One part to take you out of being wrong, and the other part to enter you into a position that is hopefully right. Intentionally waiting to take a loss doesn't make much sense. You should never allow prices to come that far against you. If you are that wrong, and you have structured the trade properly, then you should reverse – the market is going the other way.

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• “Wow, what if I have a heart attack while I’m trading and I get wiped out before anyone realizes I’m in?” This situation calls for a catastrophic stop. The catastrophic stop should be just as it says, the one you have in the market in case you have a heart attack or a stroke while in the midst of trading, or are called away, or are in some way prevented from exiting a trade at the appropriate time. Normally, you will have exited long before prices hit your catastrophic stop. ADDITIONAL LOSSES Ask yourself how many times have you been right about a trade only to see yourself stopped out of the market before the trade materialized. You wanted to get back in. You knew you ought to get back in. But because you were so demoralized by the loss you took, you do not go back in. At that point you have lost a lot more than your money. You have lost your self-esteem. You have lost your confidence. You have lost the courage of your convictions, and you have lost your nerve. Many times, having been stopped out of a trade, you will find it virtually impossible to get back in. The price action will not give you an entry point. You will be waiting for prices to correct so you can reenter. It never happens. Apart from throwing yourself to the wolves with a market order in a fast market, there will be no opening for you to get back in. In that case, you must learn to live with your loss. In this case, you have lost opportunity.

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Chapter 29 SOME INTRADAY FAVORITES Intraday congestion areas are quite common and occur frequently. There are certain chart patterns that simply have to be recognized so that they can be traded. Some of our students swear by these patterns and trade them regularly. Some of the best intraday trades we can make are shown in the formations that follow:

Note: The “sell” in the upper part of the chart is for a second time through.

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What follows throughout the remainder of this chapter is a summary of the patterns with which we have enjoyed great success. You might want to memorize them, it will be time well spent on your part. We would also refer you to Appendix C of this manual as well as TRADING THE ROSS HOOK, where you will find more in depth discussions about congestions.

Note: On Day 4 prices traced back to the middle or through the prior congestion area.

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The next chart shows a gap down from Day 3 to Day 4, a retracement through the congestion nearest the low of Day 3, and a breakout of the congestion formed on Day 4. You can sell a breakout of the congestion of Day 3. Or, an entry could be made on a breakout of the low of Day 3, following the breakout of the congestion nearest the low of Day 3.

With regard to the four days on the lower half of the chart, we see a gap, and a retracement to the highs of the congestion nearest the high of Day 3. We then see a congestion on Day 4, and a breakout of the congestion of Day 4, which is closer to the high of Day 3 than it is to the congestion of Day 3. Trade the breakout of the higher congestion if the two congestions are equal in size from top to bottom. Otherwise, trade the breakout of the tighter congestion.

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Here’s what to do when prices open at a new high above the highest high of the last three days:

Do the reverse of all those above when going short.

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When a congestion area falls right at a previous high or low, there must be a retracement to at least the middle of the congestion before trading the breakout of the previous high or low. Note: The vertical lines on pictographs 3-6 below indicate day breaks.

BASE ON BASE When there are two congestions of approximately equal size from top to bottom, we want to trade a breakout of the higher one when going long, and a breakout of the lower one when going short. This will allow us to avoid trading into an overhead resistance or underlying support area. However, if there are sufficient ticks separating the two

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congestion areas, it is okay to enter buy or sell orders with the anticipation of exiting when prices reach the second congestion area.

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Chapter 30 1-2-3’S AND BOLLINGER BANDS We’ve mentioned previously that Bollinger Bands perform a very important function relative to ones ability to read price charts. Bollinger Bands offer a visual presentation of the location of two standard deviations by the price action. Statistically speaking, two standard deviations will encompass 96.5% of all price action based on a simple or exponential moving average of prices. If those prices are the close, for example, then we can expect that 96.5% of all closes will fall within the limits of the Bollinger Bands. Of all the methods for finding market turning points, the Bollinger Bands have proved to be the most successful, in that they are statistically reliable in showing a trader where so-called overbought and oversold are located. In fact, any software that will do separate Bollinger Bands, one based upon a moving average of the lows and the other based upon a moving average of the highs, will indeed provide an excellent indicator of relative overbought and oversold. In the examples that follow, we will be using the conventional Bollinger Bands set at 2 standard deviations based on a 20 bar simple moving average of the closes. However, indicators are seldom enough in and of themselves for really good trading. Something else is needed to convict a trader of the fact that a market turn has taken place and that prices are now set to move in another direction, or at the very least cease moving in the direction in which they have been unfolding. That something else is the 1-2-3 formation. 1-2-3 highs that originate at the upper Bollinger Band or the moving average line, and 1-2-3 lows that originate at the lower Bollinger Band or the moving average line, provide some very excellent change-of-direction signals to the alert trader. Let’s look at some examples of this type of trading. It works well for any time interval and in any market that is sufficiently dynamic to swing from side to side while trending, or swing with sufficient volatility within a Trading Range to cause there to be profitable 257

trading opportunities. In fact, if prices are not moving much within a chosen time frame, then it is probably not worthwhile trading it at all. In general, this occurs when the Bollinger Bands become relatively flat.

Notice on the chart above: • 1-2-3 = Sell short formations. • 1-2-3 = Go long formations. • Arrows = Entry points Rules: In a down trending market, prices must touch or exceed the upper Bollinger Band, or prices must touch or exceed the moving average line before a 1-2-3 formation becomes a legitimate formation from which to trade. In an up trending market, prices must touch or exceed the lower Bollinger Band, or prices must touch or exceed the moving average line before a

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1-2-3 formation becomes a legitimate formation from which to trade. 1-2-3 Formations are further explained in Appendix A of this manual. Let’s look at a few more charts

Where do we place our exits? Exit points are placed one tick below the number 3 point in an up move, and one tick above the number 3 point in a down move. If you cannot afford to plan an exit according to that method, then you should avoid trading in your chosen time frame and perhaps drop down to a lesser time frame. There is always the option to not trade at all when you can’t afford the appropriate exit point. We also trail a stop or mental exit alert at natural support in an up move or natural resistance in a down move. We do that only after we have taken some profits out of the trade and are in position to do no less than breakeven. 259

Here’s another chart showing wildly swinging prices.

How’s this one for fun time? Sometimes we can pick some really volatile markets to trade. This one looks like Mr. Toad’s wild ride. If you find a market that displays a chart like this one, you might want to pass on it. It’s better to find something like the chart on the next page.

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This is the kind of price action that we like to see on a chart. Notice that the 1-2-3 formations are clear cut and crisp. In all cases, exits behind the number 3 points were easily maintained. Subsequent to the last 1-2-3, prices began to flatten out. There was almost a 1-2-3 high formation, but the #3 point failed to materialize. Beyond that, prices became quite flat. In other words, they quit swinging and the volatility went out of the market. At that time, look at what happened to the Bollinger Bands. They became relatively narrow. With so many markets to choose from, we are almost always able to find liquid markets that are trending nicely either up or down, or making reasonably volatile swings which enable us to reap a profit.

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The chart above has some excellent entries. Once again, the #3 points are never really challenged. Notice that the last 1-2-3 Low takes place in an area that is very flat. There were probably better entries available. Once the Bollinger Bands begin to severely narrow, it is often better to look elsewhere for a trade. Also notice the next to the last 1-2-3 formation. Prices dipped well below the moving average line. But as long as the price bar making the #1 point does not lose contact with the moving average line, it remains acceptable to take the breakout of the #2 point as an entry signal. We have been trying to show you these trades in the least favorable light so that you can appreciate how good they really are. We could

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have used the Trader’s Trick as our entry, and considerably improved the results on those trades which had 1-2-3 highs and lows which originated at the moving average line. Let’s look at one more price chart. This time, we will use our arrows to point out those entries in which we could have used the Trader’s Trick rather than a breakout of a #2 point. The Trader’s Trick is explained in detail in Appendix B.

On the chart above, we’ve marked only those trades which had 1-2-3 formations originating at the moving average line. Obviously, there were also trades which had 1-2-3 formations originating at the Bollinger Band lines, but those trades use only a breakout of the #2 point as their entry. What we wanted to show you here is how much improved the entries are using the Trader’s Trick on those formations in which the 1-2-3’s originate at the moving average.

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Also, notice that quite often 1-2-3’s originating at the moving average are followed by a very pronounced trend. We think that by now you should have this concept well in hand. What we suggest is that you go back over these charts, and review them while looking for the following: • How many times does a strong trend follow a 1-2-3 formation which forms at the moving average line? • How often does taking the Trader’s Trick entry improve the results of entering a trade that is the result of a 1-2-3 formation which began at the moving average line? • Is it really better to wait for the breakout of the #2 point when a 12-3 formation originates at one of the band lines?

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• How many times does not taking the Trader’s Trick keep you from entering a bad trade when a 1-2-3 formation forms at one of the band lines? PERTINENT POINTS The Trader’s Trick may be used at either the bands or the moving average 1-2-3 formations. However, our experience has shown that at the bands, the #2 point needs to be taken out before entry. The Trader’s Trick shows better results when used with the 1-2-3’s which form from the moving average. When prices reach one of the bands, we tighten stops or move our mental exit closer to the price action based upon the statistical probability that the move may be nearly over. If a move has begun based upon a 1-2-3 which formed at one of the bands, we attempt to take some profits when prices reach the moving average. If our entry began based on a 1-2-3 which formed at the moving average, we attempt to take some profits when prices reach one of the bands. However, quite often 1-2-3 formations which form at the moving average ultimately result in a strongly trending market, and when that happens, we want to ride the trend as far as is possible before exiting our entire position.

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Appendix A THE LAW OF CHARTS WITH INFORMATION NOT SHOWN IN OUR PREVIOUS COURSE MANUALS

1-2-3 HIGHS AND LOWS A typical 1-2-3 high is formed at the end of an uptrending market. Typically, prices will make a final high (1), proceed downward to point (2) where an upward correction begins; then proceed upward to a point where they resume a downward movement, thereby creating the pivot (3). There can be more than one bar in the movement from point 1 to point 2, and again from point 2 to point 3. There must be a full correction before points 2 or 3 can be defined. A number 1 high is created when a previous up-move has ended and prices have begun to move down. The number 1 point is identified as the last bar to have made a new high in the most recent up-leg of the latest swing.

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The number 2 point of a 1-2-3 high is created when a full correction takes place. Full correction means that as prices move up from the potential number 2 point, there must be a single bar that makes both a higher high and a higher low than the preceding bar or a combination of up to three bars creating both the higher high and the higher low. The higher high and the higher low may occur in any order. Subsequent to three bars we have congestion. Congestion will be explained in depth later on in the course. It is possible for both the number 1 and number 2 points to occur on the same bar.

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The number 3 point of a 1-2-3 high is created when a full correction takes place. A full correction means that as prices move down from the potential number 3 point, there must be at least a single bar, but not more than two bars that form a lower low and a lower high than the preceding bar. It is possible for both the number 2 and number 3 points to occur on the same bar.

Now, let’s look at a 1-2-3 low. A typical 1-2-3 low is formed at the end of an downtrending market. Typically, prices will make a final low (1); proceed upward to point (2) where an downward correction begins; then proceed downward to a point where they resume an upward movement, thereby creating the pivot (3). There can be more than one bar in the movement from point 1 to point 2, and again from point 2 to point 3. There must be a full correction before points 2 or 3 can be defined.

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A number 1 low is created when a previous down-move has ended and prices have begun to move up. The number 1 point is identified as the last bar to have made a new low in the most recent down-leg of the latest swing.

The number 2 point of a 1-2-3 low is created when a full correction takes place. Full correction means that as prices move down from the potential number 2 point, there must be a single bar that makes both a lower high and a lower low than the preceding bar, or a combination of up to three bars creating both the lower high and the lower low. The lower high and the lower low may occur in any order. Subsequent to three bars we have congestion. It is possible for both the number 1 and number 2 points to occur on the same bar.

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The number 3 point of a 1-2-3 low exists when a full correction takes place. A full correction means that as prices move up from the potential number 3 point, there must be at least a single bar, but not more than two bars, that form a higher low and a higher high than the preceding bar. It is possible for both the number 2 and number 3 points to occur on the same bar.

The entire 1-2-3 high or low is nullified when any price bar moves prices equal to or beyond the number 1 point.

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Ledges A LEDGE CONSISTS OF A MINIMUM OF FOUR PRICE BARS. IT MUST HAVE TWO MATCHING LOWS AND TWO MATCHING HIGHS. THE MATCHING HIGHS MUST BE SEPARATED BY AT LEAST ONE PRICE BAR, AND THE MATCHING LOWS MUST BE SEPARATED BY AT LEAST ONE PRICE BAR .

The matches need not be exact, but should not differ by more than three minimum tick fluctuations. If there are more than two matching highs and two matching lows, then it is optional whether to take an entry signal from either the latest price matches in the series (Match ‘A’) or those that represent the highest and lowest prices of the series (Match ‘B’). [See below] A LEDGE CANNOT CONTAIN MORE THAN 10 PRICE BARS. A LEDGE MUST EXIST WITHIN A TREND. The market must have trended up to the Ledge

or down to the Ledge. The Ledge represents a resting point for prices, therefore you would expect the trend to continue subsequent to a Ledge breakout.

TRADING RANGES A Trading Range (See below) is similar to a Ledge, but must consist of more than ten price bars. The bars between ten and twenty are of little consequence. Usually, between bars 20 and 30, i.e., bars 2129, there will be a breakout to the high or low of the Trading Range established by those bars prior to the breakout.

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ROSS HOOKS A Ross Hook is created by: 1. The first correction following the breakout of a 1-2-3 high or low. 2. The first correction following the breakout of a Ledge. 3. The first correction following the breakout of a Trading Range. In an up-trending market, after the breakout of a 1-2-3 low, the first instance of the failure of a price bar to make a new high creates a Ross Hook. (A double high/double top also creates a Ross Hook).

In a down-trending market, after the breakout of a 1-2-3 high, the first instance of the failure of a price bar to make a new low creates a Ross Hook. (A double low/double bottom also equals a Ross Hook).

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If prices breakout to the upside of a Ledge or a Trading Range formation, the first instance of the failure by a price bar to make a new high creates a Ross Hook. If prices breakout to the downside of a Ledge or Trading Range formation, the first instance of the failure by a price bar to make a new low creates a Ross Hook (A double high or low also creates a Ross Hook).

We’ve defined the patterns that make up the Law of Charts. Study them carefully. What makes these formations unique is that they can be specifically defined. The ability to formulate a precise definition sets these formations apart from such vague generalities as “head and shoulders,” “coils,” “flags,” “pennants,” “megaphones,” and other such supposed price patterns that are frequently attached as labels to the action of prices.

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TRADING IN CONGESTION Sideways price movement may be broken into three distinct and definable areas: 1. Ledges  consisting of no more than 10 price bars 2. Congestions  11-20 price bars inclusive 3. Trading Ranges  21 bars or more with a breakout usually occurring on price bars 21-29 inclusive. Trading Ranges consisting of more than 29 price bars tend to weaken beyond 29 price bars and breakouts beyond 29 price bars will be: • Relatively strong if the Trading Range has been growing narrower from top to bottom (coiling). • Relatively weak if the Trading Range has been growing wider from top to bottom (megaphone). We have written considerable material about breakouts from Ledges, primarily that since by definition, Ledges must occur in trending markets, the breakout is best traded in the direction of the prior trend, once two matching highs and two matching lows have taken place. The next discussion deals primarily with Congestions and Trading Ranges: Under the topic of the Law of Charts, we have defined the first correction following the breakout of a Trading Range or Ledge as being a Ross Hook.

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The same is true after a breakout from Congestion, i.e., the first retracement (correction) following a breakout from Congestion also constitutes a Ross Hook.

A problem most traders have in dealing with sideways markets is determining when prices are no longer moving sideways and have indeed begun to trend. Apart from an outright breakout and correction which defines a Ross Hook, how is it possible to detect when a market is no longer moving sideways, and has begun to trend? In other writings, we have stated that the breakout of the number 2 point of a 1-2-3 high or low formation ‘defines’ a trend, and that the breakout of the point of a subsequent Ross Hook ‘establishes’ the trend previously defined.

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1-2-3 high and low formations may be satisfactorily traded using the Trader’s Trick entry. All Ross Hooks may be satisfactorily traded using the Trader’s Trick entry. However, while a 1-2-3 formation occurring in a sideways market still defines a trend, the 1-2-3 formation, when it occurs in a sideways market, is not satisfactorily traded using the Trader’s Trick. This is because Congestions and Trading Ranges are usually composed of opposing 1-2-3 high and low formations. If a sideways market has assumed an /\/\ formation, or is seen as a \/\/ formation, these formations will more often than not consist of a definable 1-2-3 low followed by a 1-2-3 high, or a 1-2-3 high followed by a 1-2-3 low. In any event, the breakout of the number 2 point is usually not a spectacular event, certainly not one worth trading. What is needed is a tie-breaker. The tie-breaker will not only increase the likelihood of a successful trade, but will also be a strong indicator of the direction the breakout will most probably take. That tie-breaker is the Ross Hook. When a market is moving sideways, the trader must see a 1-2-3 formation, followed by a Ross Hook, all occurring within the sideways price action. The entry is then best attempted by using the Trader’s Trick ahead of a breakout of the point of the Ross Hook. Of course, nothing works every time. There will be false breakouts. However, on a statistical basis, a violation of a Ross Hook occurring when price action is sideways, consistently results in a low risk entry with a heightened probability for success. Since the violation of a Ross Hook occurring in a sideways market is an acceptable trade, then an entry based upon a Trader’s Trick entry ahead of the point of the Ross Hook being violated offers an even better entry. POINTS OF CLARIFICAT ION FOR 1-2-3 FORMATIONS We have had a number of people ask about the trading of the 1-2-3 high or low formation. They ask, “When do you buy and when do you sell?” 279

Although we prefer to use the Trader’s Trick entry whenever possible (See Appendix B), the illustration should be of help when not using the Trader’s Trick. The Breakout of a 1-2-3 High Or Low Let's illustrate what a 1-2-3 is: Sell a breakout of the # 2 point of a 1-2-3 high

Sell a breakout of the # 2 point. =============================================== Buy a breakout of the #2 point.

Buy a breakout of the # 2 point of a 1-2-3 low

Note: The #3 point does not come down as low as the #1 point in a uptrend, or as high as the #1 point in a down trend. We set a mental or computer alert, or both, to warn us of an impending breakout of these key points. We will not enter a trade if prices gap over our entry point. We will enter it only if the market trades through our entry point. 1-2-3 Highs and Lows come only at market turning points that are in effect major or intermediate high or lows. We look for 1-2-3 lows 280

when a market seems to be making a bottom, or has reached a 50% or greater retracement. We look for 1-2-3 highs when a market appears to be making a top, or has reached a 50% or greater retracement. Exact entry will always be at or prior to the actual breakout taking place. POINTS OF CLARIFICAT ION FOR ROSS HOOKS We are asked the same question with regard to the Ross Hook as we are about 1-2-3 formations: “When do I buy, and when do I sell?” Our answer is essentially the same as for the 1-2-3 formation. Although we prefer entry via the Trader’s Trick (See Appendix B), such entry is not always available. When the Trader’s Trick entry is not available, enter on a breakout of the point of the Ross Hook itself. Buy on a breakout of the point of the Ross Hook. But keep in mind this warning: When the point of a Ross Hook is taken out, it very often is nothing more than stop running, and the breakout will be a false one.

Sell on a breakout of the point of the Ross Hook.

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Some comments about the series of graphs that follow might clear up a few questions: This is important! Prices make a double top at the last Ross Hook shown, and then retreat. Many professional traders would go short as soon as they felt the double top was in place. Notice that we are able to connect a True Trend line from the point of the lower Ross Hook to the correction low that gave us the #3 point, and then to the correction low that created the double top Ross hook. That leaves us with a 1-2-3 low and a Ross Hook in the event of a breakout to the upside. It also leaves us with a 1-2-3 high and a Ross hook in the event of a breakout to the downside. A breakout of the double top (Rh) will set us up for any subsequent upside Ross Hooks if prices take out the double resistance area and then later correct. The double top Ross Hook represents a low risk entry for a short position. However, in this example we will wait for an entry at the violation of the Ross Hook itself. A more advanced trader might wish to go short as prices move away from the double top. This is a low risk trade because a stop can temporarily be placed above the high. Notice we are saying temporarily. The double top could be a terrible place to have a stop should the insiders engineer a move up to run the stops they know are there.

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The Trader’s Trick Entry (See Appendix B) would enable us to enter by going long earlier than waiting for the double top Ross Hook to be taken out. The more conservative trade is to use the Trader’s Trick entry, figuring that prices will at least test the high as prices move up. The Trader’s Trick Entry in this case is just above the third bar of correction. All or part of the position can be put on at the Trader’s Trick Entry point. It’s simply a matter of choice. If you want to know what our choice is, it is to place the entire position on at the Trader’s Trick Entry. However, prices continue down and take out the lower Ross Hook. We should have had a resting sell stop below that Ross Hook as well. We can sell short all or part of our position as the lower Ross Hook itself is violated.

We see that prices are plunging. However, we should not be jumping in front of the market at each lower bar, because by the time prices take out the Ross Hook, the market will have already been moving down for four consecutive bars. If you will recall the lessons learned from our section in ELECTRONIC TRADING ‘TNT’ I on finding the trend while it is still in the birth canal, you know that the market may be getting ready to correct.

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Note the intraday correction at the arrow on the right of the chart. An important event has taken place. The intraday correction makes it okay to jump in front of the market. The fact that the market opened, traded above the previous bar’s high, and then took out the previous day’s low, signifies at least one more good day to be short. If trading intraday, jump in front of the Ross Hook created by the intraday correction. In fact, if trading intraday, and it becomes available, use a Trader’s Trick Entry to enter ahead of prices taking out the previous day’s low. We now have an intraday correction followed by a reversal bar. The market is talking! Note the gap open beyond the previous bar’s low. Then notice the price action for the remainder of the day. Professional traders will go long on a gap open like that, some of them as soon as possible after the open, and others when prices trade through the open to the upside. When you see a gap open like that in a strongly trending market, take profits. If your guts are under control, take profits and reverse. Most of the time you will be glad you did. In fact, many professionals, if they think the market is beginning to congest, will double up on a gap opening and trade twice as many contracts against the trend as they would with the trend.

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The market was telling us to expect a correction. Were you listening? When prices are correcting and prices open in the upper part of the previous bar’s range, and then move above the previous bar’s high, chances are you haven’t seen an end to the correction.

This latest price bar places the chart into a 5 bar consolidation area. We’ll place a box around that area. This area is considered to be congestion by alternation and is described in Electronic Trading ‘TNT’ III – Technical Trading Stuff, and in Appendix C of this manual.

Although not shown, you can picture that a 3x3 moving average of the close, is running through the middle of the 5 bar congestion. You may recall from ELECTRONIC TRADING ‘TNT’ III that the 3x3 moving average is a filter for Reverse Ross Hooks. It is also a filter here for the same reasons – we are in a defined congestion by reason of alternation. Since the trade doesn’t pass our filter because of a “gap opening beyond the low of the Rh,” we must remove any order to sell a breakout of the Rh. The gap opening below the previous bar’s range has brought in a double load of orders from the insiders.

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Prices move up on a reversal day. Remember, when the insiders feel that a market is congesting or correcting, they will double their orders on openings that gap beyond the price range of the previous day. This doubling can serve as a filter for our trades, because we can expect the insiders to try to fill the gap. Day traders can use this to trade right along with the insiders who know to expect this type of price action. As prices gap past the Rh, and then correct, we can place a sell order below the new Rh. The following day, we get a gap opening to the upside. This time it is above the high of the previous day. It, too, will bring a double load of sell short orders. This is a correction day and so we can connect some segment lines.

Prices hit our sell stop below the Rh. Our sell stop has been placed one tick below the point of the Rh. We want a violation of the Hook before we will accept entry. There are many problems with getting filled on a gap opening below our sell stop, the least of which is slippage. Therefore, if at all possible, we do not enter orders until we see where the open occurs. Brokers can be instructed in that manner if you have to use one for the actual placement of your order. On the chart to the left, prices opened exactly one tick below the Rh.

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The next price bar makes an unusual close. We must do all we can to protect profits. There is apt to be further correction on the next price bar. We protect profits by moving our stop one tick above the high of any bar that closes very close to the high when we feel that prices should be continuing to move down.

The correction comes intraday, creating an intraday hook situation. Day traders may have been able to scalp a few ticks of profit here. Day traders may have been able to profit by selling under the low of the previous day. Any day trader at any time should consider a breakout of the low of the previous day a strong reason to sell short. The correction by prices on the last bar shown gives us another Rh.

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As prices correct, we try to sell a breakout of the low of the correcting bar.

The following comments apply to the chart above and the one below. We may want to put on our entire position but we have only two opportunities. It may be best to put on 2/3 of the position at the higher of the two entry points, and only 1/3 at the hook, if we are given the choice. Once prices start back down, we try for 2/3 immediately. If we still cannot get our position on, then we will have to place the entire position on at the hook. You may recall in a similar situation we looked at the 3x3 moving average of the close and considered it a filter for the trade because the 3x3 was running through a five bar consolidation. In this instance, the 3x3 moving average was still displaying containment of the downtrend. A trade at the low is missed because of the gap opening. We then try to sell a breakout of the next low, as well as the Rh. Our position is filled at both entry points.

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The following comments apply to the chart above and the chart below: As we take profits out of the market, we come to a point where we have accumulated sufficient profits that if we wish to risk those profits, we can begin to keep our stop further away from the price action. If we don’t want to take additional risk, then it’s best to trail a 50% stop as the market moves down, and pull stops even tighter on reversal bars, or any indication that something is amiss. Because of the reversal bar, we tighten stops. We don’t want a win to turn into a loss.

Another intraday correction gives day traders an opportunity to sell short.

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All traders can jump in front of the market and get filled as the low is taken out.

Prices break nicely to the downside.

The downtrend is fully intact. If we are willing to take more risk, we can allow our stop to lag further back.

Here we see the value in keeping our trailing stop a bit further away, once we have established acceptable profits.

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In any case, we would place a sell stop below the Rh and the next correction bar, in effect opting for the Trader’s Trick.

We now have three possible selling points. Whenever we get 3 bars of correction, we move our lagging stop (if we have one) to one tick above the high of the third correction bar. This is because, if we were to get more than three correcting bars, we would have to assume that the trend is at least temporarily over, and prices may now move higher, or at the very least move into a congestion phase. The gap open misses our highest entry point. Because it does, it would cause us to try to fill 2/3 rds of our position on a breakout of the low of the gap down bar.

Once again the entry point was missed on the gap opening. We will try again for entry on the next price bar.

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This bar brings a fill near the close.

At this point our entire position should be in place.

We do not need a sell order below the Rh if our entire position is in place. Note with regard to the last four charts: An adequate trailing stop would have kept us in the market throughout the four days show on these charts. We would have been able to build a position by adding contracts. But keep in mind that adding contracts also adds all new risk. Furthermore, the risk which is incurred may be greater in nature than the risk originally accepted. Why? Because each time we add to our position, we are closer in time to the end of the move being made. The method of trade management that we have been showing you in this entire series of charts is here is to demonstrate to you an alternative method of trade management. It is up to the trader to 292

decide how to manage his/her own positions. In our minds there are two basic approaches, both of which may be acceptable to some. The first is that of putting on the entire position upon the initial entry and then liquidating portions of that position to cover costs, take a small profit, and finally to ride the trade as far as it will go with what remains of the position after partial liquidation. The converse of this method is to build the position by entering a portion of it to test the waters. If the initial portion becomes profitable, you then add to the position by adding contractss in stages until you have put on the entire position. Much of any acceptability depends upon your personal comfort level in handling risk, and your financial capacity for handling risk. We’ll look at two more charts now. In actuality, the market continued downward for quite some time after the last chart below. Here we see a reversal day. By now you should know that it usually means some sort of correction is due

Sure enough, prices correct. We would start by trying to sell a breakout of the correction low. We would also place a sell stop below the Rh for part of our position. Remember, it is up to you to decide how much of your position you want to place at any given level. It is a matter of comfort and style. Where do you feel best about placing your entry orders?

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Appendix B THE TRADER'S TRICK ONE MORE TIME The purpose of the Trader's Trick entry (TTE) is to get us into a trade prior to entry by other traders. Let's be realistic. Trading is a business in which the more knowledgeable have the advantage over the less knowledgeable. It's a shame that most traders end up spending countless hours and dollars searching for and acquiring the wrong kind of knowledge. Unfortunately, there is a ton of misinformation out there and it is heavily promoted. What we are trying to avoid here is the damage that can be done by a false breakout. Typically, there will be many orders bunched just beyond the point of a Ross Hook. This is also true of the number two point of a 1-2-3 formation. The insiders are very much aware of the bunching of orders at those points, and if they can make it happen, they will move prices to where they see the orders bunched together, and then a little past that point in order to liquidate as much of their own position as possible. This action by the insiders is called “stop running.” Unless the pressure from the outsiders (us) is sufficient to carry the market to a new level, the breakout will prove to be false. The Trader's Trick is designed to beat the insiders at their own game, or at the very least to create a level playing field on which we can trade. WHEN TRADING HOOKS, WE WANT TO GET IN AHEAD OF THE ACTUAL BREAKOUT OF THE POINT OF THE HOOK. IF THE BREAKOUT IS NOT FALSE, THE RESULT WILL BE SIGNIFICANT PROFITS. IF THE BREAKOUT IS FALSE, WE WILL HAVE AT LEAST COVERED OUR COSTS AND TAKEN SOME PROFIT FOR OUR EFFORT .

Insiders will often engineer moves aimed at precisely those points where they realize orders are bunched. It is exactly that kind of engineering that makes the Trader's Trick possible.

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The best way to explain the engineering by the insiders is to give an example. Ask the following question: If we were large operators down on the floor, and we wanted to make the market move sufficiently for us to take a fat profit out of the market, and know that we could liquidate easily at a higher level than where the market now is because of the orders bunched there, how would we engineer such a move?

We would begin by bidding slightly above the market.

By bidding a large number of contracts above the market, prices would quickly move up to our price level. 296

Once again by bidding a large number of contracts at a higher level, prices would move up to that next level.

The sudden movement up by prices, to meet our large-order overpriced-bid, will cause others to take notice. The others are day traders trading from a screen, and even insiders. Their buy orders will help in moving the market upward towards where the stops are bunched. It doesn't matter whether this is a daily chart or a five minute chart, the principle is the same. 297

In order to maintain the momentum, we may have to place a few more buy orders above the market, but we don't mind. We know there are plenty of orders bunched above the high point. These buy orders will help us fill our liquidating sell orders when it's time for us to make a hasty exit. Who has placed the buy orders above the market? The outsiders, of course. They are made up of two groups. One group are those who went short sometime after the high was made, and feel that above the high point is all they are willing to risk. The other group are those outsiders who feel that if the market takes out that high, they want to be long. Because of the action of our above-the-market bidding, accompanied by the action of other inside traders and day traders, the market begins to make a strong move up. The move up attracts the attention of others, and the market begins to move up even more because of new buying coming into the market.

This kind of move has nothing whatsoever to do with supply and demand. It is purely contrived and engineered.

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Once the market nears the high, practically everyone wants in on this “miraculous” move in the market. Unless there is strong buying by the outsiders, the market will fail at or shortly after reaching the high. This is known as a buying climax.

What will cause this failure? Selling. By whom? By us as big operators, and all the other insiders who are anxious to take profits. At the very least, the market will make some sort of intraday hesitation shortly after the high is reached.

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If there is enough buying to overcome all the selling, the market will continue up. If not, the insiders will have a wonderful time selling the market short, especially those who know this was an engineered move. NOTE: DON’T THINK FOR ONE MOMENT THAT THERE IS NOT COLLUSION BY INSIDERS TO MANIPULATE PRICES. What will happen is that not only will selling be done for purposes of liquidation, but also for purposes of reversing position and going short. This means the selling at the buying climax may be close to triple the amount it would normally be if there were only profit taking. Why triple? Because if prices were engineered upward by a large operator whose real intention is to sell, he will need to sell one set of contracts to liquidate all of his buying, and perhaps double that number in order to get short the amount of contracts he originally intended to sell. The buying from the outsiders will have to overcome that additional selling. Because of that fact, the charts will attest to a false breakout. Of course, the reverse scenario is true of a downside engineered move resulting in a false breakout to the downside.

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WARNING: MOVING THE MARKET AS SHOWN IN THE PREVIOUS EXAMPLE IS NOT SOMETHING THE AVERAGE TRADER SHOULD ATTEMPT !

It is very important to realize what may be happening when a market approaches a Ross Hook after having been in a congestion area for awhile. The prior pages have illustrated this concept. With the preceding information in mind, let's see how to accomplish the Trader's Trick.

On the chart above the Rh is the high. There were two price bars following the high: one is the bar whose failure to move higher created the Hook, and the other is one that simply furthered the depth of the correction. Let’s look at that again by breaking it down in detail in an example.

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Following the high is a bar that fails to have a higher high. This failure creates the Ross Hook, and is the first bar of correction. If there is sufficient room to cover costs and take a small profit in the distance between the high of the correcting bar and the point of the Hook, we attempt to buy a breakout of the high of the bar that created the Hook, i.e., the first bar of correction. If the high of the first bar of correction is not taken out, i.e., violated, we wait for a second bar of correction. Once the second bar of correction is in place, we attempt to buy a violation of its high, again provided that there is sufficient room to cover costs and take a profit based on the distance prices have to travel between our entry point and the point of the Hook. If the high of the second bar of correction is not violated, we will attempt to buy a violation the high of a third bar of correction provided there is sufficient room to cover costs and take a profit based on the distance prices have to move between our entry point and the point of the Hook. Beyond three bars in the correction, we will cease in our attempt to buy a breakout of the correction highs. What if the fourth bar did as pictured on the left? As long as prices are moving back up in the direction of the trend that created the Ross Hook, and as long as there is sufficient room for us to cover costs and take a profit, we will buy a breakout of the high of any of the three previous correction bars. In the example, if we were able to enter before prices violated the high of the second bar of correction, we would enter on a violation of the high of the second correcting price bar. If not, and there is still room to cover and profit from a violation of the first correcting price bar, we would enter there. Additionally, we could choose to enter on a takeout of the high of the latest price bar as shown by the double arrow, even if it gaps past one of the correction bar highs. 302

REMINDER: ONCE THERE ARE MORE THAN THREE BARS OF CORRECTION, WE NO LONGER ATTEMPT TO ENTER A TRADE. THE MARKET MUST BEGIN TO MOVE TOWARD THE HOOK AT THE TIME OF OR BEFORE A FOURTH BAR IS MADE.

Although not shown, the exact same concept applies to Ross Hooks formed at the end of a down move. Risk management is based upon the expectation that prices will go up to at least test the point of the Hook. At that time, we will take, or already have taken some profit and have covered costs. We are now prepared to exit at breakeven, at the very worst, on the remaining contracts. Barring any horrible slippage, the worst we can do is having to exit the trade with some sort of profit for our efforts. We usually limit the Trader's Trick to no more than three bars of correction following the high of the bar that is the point of the Hook. However, there is an important exception to this rule. The next chart shows the use of double or triple support and resistance areas for implementing the Trader's Trick. Please realize that “support” and “resistance” on an intraday chart does not have the usual meaning of those terms when applied to the overall supply and demand in the market place. What is referred to here is given in the following four examples:

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Any time a business can consistently make profits, that business is going to prosper. Add to that profit the huge amount of money made on the trades that take off and never look back, and it’s readily apparent that enormous profits are available from trading. The management method we use shows why it is so important to be properly capitalized. Size in trading helps enormously. The method also shows why, if we are undercapitalized (most traders are), we must be patient and gradually build our account by taking profits quickly when they are there.

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If you are not able to tend to your own orders intraday electronically or on the Internet, it may be well worth your while to negotiate with a broker who will execute your trading plan for you. There are brokers who will do this, and you may be surprised to find that there are some who will perform such service at reasonable prices if you trade regularly. When we are trading using the Trader’s Trick, we don’t want to be filled on a gap opening beyond our desired entry price unless there is sufficient room for us to still cover costs and take a profit. Can you grasp the logic of that? The reason is that we have no way of knowing whether a move toward a breakout is real or not. If it is engineered, the market will move forward to the point of taking out the order accumulations and perhaps a few ticks more. Then the market will reverse with no follow through in the direction of the breakout. As long as we have left enough room between our entry point and the point where orders are accumulated to take care of costs and a profit, we will do no worse than breakeven. Usually, we will also have a profit to show for any remaining contracts, however small. If the move proves to be real (not engineered), then the market will give us a huge reward relative to our risk and costs. Remember, commission and time are our only real investment in the trade if it goes our way. The important understanding that we need to have about the Trader’s Trick is that by taking entry into a market at the correct point, we can neutralize the action by the insiders. We can be right and earn something for our efforts should the breakout prove to be false. Some breakouts will be real. The fundamentals of the market ensure that. When those breakouts happen, we will be happy, richer traders. With proper money management, we can earn something for our efforts even if the breakout proves to be false.

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Appendix C IDENTIFYING CONGESTION One of the concepts every trader must learn is how to know when prices are in congestion. There are a few rules for the early discovery of this ever important price action, and they are explained in detail in this chapter. RULE: ANY TIME PRICES OPEN OR CLOSE ON FOUR CONSECUTIVE BARS, WITHIN THE CONFINES OF THE RANGE OF A “ MEASURING BAR ,” YOU HAVE CONGESTION. THIS IS REGARDLESS OF WHERE THE HIGHS AND LOWS MAY BE LOCATED. A “ MEASURING BAR ” BECOMES SUCH BY VIRTUE OF ITS PRICE RANGE CONTAINING THE OPENS OR CLOSES OF AT LEAST 3 OF 4 SUBSEQUENT PRICE BAR S.

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Closely and carefully study this chart again. Congestion can be very subtle in appearance. Often the difference between congestion or trend is the positioning of a single open or close.

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To further demonstrate this concept, let’s first look at the combination of points “K” through “M” on the chart below. Even though “M” closed below the range of the measuring bar “J,” the fact that “L” made a new high and then closed, dropping back into the Trading Range of “J”, tells us that prices are still in congestion. This will be explained on the following pages. In addition, we now have congestion by virtue of alternating bars, which will also be discussed next.

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ANY TIME PRICES ARE NOT MAKING HIGHER HIGHS AN D HIGHER LOWS , OR LOWER HIGHS AND LOWER LOWS, AND WE CAN SEE FOUR ALTERNATING BARS, AT TIMES COUPLED WITH INSIDE BARS AND AT TIMES COUPLED WITH DOJIS, WE HAVE CONGESTION. ALTERNATING BARS ARE ONES WHERE PRICES OPEN LOWER AND CLOSE HIGHER ON ONE BAR , AND OPEN HIGHER AND CLOSE LOWER ON THE NEXT .

Inside bars look like this:

Doji Bars look like this:

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Below are more Doji bars. The open and close are at the same price or very near to the same price, yielding a bar that looks like this:

A combination of alternate close-high-open-low, close-low-open-high pairs is congestion. “Pointy” places made when the market is in congestion are not Ross Hooks. If a trend has been defined within congestion, you now have a trend, and any subsequent pointy place is a Ross Hook. The first bar of the congestion may very well be the last bar of what had been a trend. A congestion may look similar to any of the following, as long as it consists of four or more bars. Study these formations carefully:

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CONGESTIONS:

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Frequently congestion will start or end with a doji. Frequently congestion will begin or end with a long bar move, or a gap. Another way to identify congestion is when you see /\/\ or \/\/ on the chart. The smallest possible number of bars that can make up this formation is four. Let’s see how this can be done.

In reality, we may get something that looks more like the following:

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If we were to get a formation that looked like the following, the Ross Hook would be as marked. If that Hook is taken out, we would want to be long prior to the violation. Notice that the bar that created the Ross Hook was the last bar of the trend and the first bar of the congestion.

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Now, let’s see if you’re really getting this. Assume that an established trend is in effect, with prices having trended up from much lower. We’ve changed the chart a bit, so pay attention. The Ross Hook is as marked below.

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Note:

A 1-2-3 FOLLOWED BY A BREAK OUT OF THE #2 POINT THAT SUBSEQUENTLY RESULTS IN A ROSS HOOK , SUPERCEDES ANY CONGESTION OR PREVIOUS ROSS HOOK. QUITE OFTEN, SUCH A SERIES OF PRICE BAR OCCURRENCES WILL BE THE WAY PRICES EXIT A CONGESTION AREA, I.E, A 1-2-3 FORMATION WITHIN A CONGESTION AREA, A BREAKOUT OF THE #2 POINT , FOLLOWED BY A ROSS HOOK .

The price bar labeled “b” made a new local low. The take out by prices of the local double resistance, “a” and “b,” is a significant event. “a” and “b”, together, constitute the number two point of a 1-23 low occurring in congestion. The low of bar “b” is also a #3 point, and two bars later we get the highest high of the congestion, which is also an Rh.

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The new Ross Hook represents an even more significant breakout point. Combined with the old Rh, there is significant resistance. Within a few ticks of each other, the two constitute a double top. If prices take them both out, we would normally expect a relatively longer term, strong move up. We use the term “relatively” here, because the intensity and the duration of the move would be relative to the time frame in which the price bars were made. Obviously such a move on a one minute chart would hardly compare with an equivalent move on a daily chart. While we are looking at the chart, there is something else of importance to notice. Prices retreated from the resistance point, thereby creating the second Ross Hook. This represented a failure to break out. This failure is why Reverse Ross hooks are important. When prices retreat from a resistance point and move towards a RRh, it may indicate that the only reason the resistance point was challenged or even violated was because prices were “engineered” in that direction by some party or parties capable of moving prices for their own benefit. The anticipation is that prices next may move in the opposite direction toward a violation of the RRh. Now, go through a brief review of the various congestions. All of the three following conditions that define congestion must occur without consistently making higher highs or lower lows. Congestion by Opens/Closes: Four consecutive closes or opens within the range of a measuring bar. If opens are used, there can be no correcting bars before or coincident with the bar in which the open is used. Congestion by Combination: A series of four consecutive dojis, or at least one doji and any three alternating bars. The doji is a wild card and can be used to alternate with any other bar. If there are three non-doji bars, one of them must alternate high-to-low with the other two non-doji bars. Congestion by Alternation: A series of four consecutive alternating open high - close low, open low - close high bars in any sequence. This definition includes Congestion by High/Low pairs.

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READING LIST: BOOKS AND COURSES

ELECTRONIC TRADING 'TNT' I  GORILLA TRADING STUFF Joe Ross and Mark Cherlin ELECTRONIC TRADING 'TNT' II  HOW-TO-WIN TRADING STUFF Joe Ross and Mark Cherlin ELECTRONIC TRADING 'TNT' III  TECHNICAL TRADING STUFF Joe Ross and Mark Cherlin ELECTRONIC TRADING 'TNT' IV  TIPS –TRICKS AND OTHER TRADING STUFF Joe Ross and Mark Cherlin WHAT I LEARNED LOSING A MILLION DOLLARS Jim Paul and Brendan Moynihan REMINISCENCES OF A STOCK OPERATOR Edwin Lefevre HOW TO MAKE MONEY IN STOCKS William J. O’Neil THE DISCIPLINED TRADER Mark Douglas THE INNER GAME OF TRADING Robert Koppel and Howard Abell THE WINNING EDGE

Adrienne Laris Toghraie THE WINNING EDGE II

Adrienne Laris Toghraie

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