market skill

7/31/2019 Market Skill

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This discussion was described in the "Investor's Chronicle" as "The most lucid explanation of how the financial

markets work that I have seen: a worthwhile read for investors at all levels of expertise".

Technical Analysis is, in essence, the observation of the market itself with a view to deducing its next move

from its past and current behaviour- as opposed to Fundamental Analysis, which is the study of the external factors

likely to push the market higher or lower. Disciplined, straighforward analysis & trading techniques work the best, as

explained in these pages.

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

This general discussion of how the dynamics of the financial markets - how they really work - is an expansion of an

article originally published in the Belgian business magazine of April 14, 1994.

Centuries ago it was thought that inspection of the entrails of dead animals provided the data necessary for the

prediction of future events. Astrological techniques were an improvement - at least in terms of hygiene. The British, a

nation with many curious habits, took to interpreting the patterns of dead leaves left in the bottom of their tea-cups.

This was, of course, before the invention of the tea-bag.

More recently, with the aid of telecommunications and computers, more sophisticated methods of arriving at future

projections have been applied, particularly to the financial markets:
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2/21

build complex econometric models and study the correlations between money supply, inflation,interest-rates, industrial capacity utilisation, wage settlements, taxation policy and many other variables.

Forecasts are made based on the results of these studies.

study balance-sheets, income statements, product markets, quality of management,manufacturing costs and many other variables in order to determine whether the shares of a particular

company or sector "ought" to go up or down.

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

So, based on the results of the application of all of this awesome intellectual and electronic power, where will the yen,

or the London stock market, or shares in Siemens, or US treasury bonds be next week - or next month - or next year

?

Not only does nobody know any of these instruments will go up or down: it is impossible to predict the

of the next move in any market in any time-frame. The only exceptions to this rule are:

1. ahead of the publication of important news, this is illegal in most jurisdictions (which does notseem to act as much of a deterrent). In order to get away with it you need (a) to have access to inside

information in the first place, (b) to distance yourself from the execution of the transactions (not that easy),

and - possibly - (c) have a very good and expensive lawyer and/or be highly placed politically. I advise

against insider-trading.

2. against irrational market manipulators, usually governments or cartels. The spectacle ofgovernments vainly attempting to maintain indefensible exchange-rates is always pathetic, and would be

laughable were it not so expensive. The fact that, after they have failed, subsequent events usually

demonstrate that they were wrong even to have made the attempt adds irony to these sad events (witnessthe improved performance of the British economy following the most recent EMS debacle, and the relative

absence of the expected surge in inflation).

The academic consensus used to be that it was impossible to "beat" freely fluctuating markets on a regular basis

because they were inherently unpredictable. Two theories were advanced in support of this proposition:

The " " postulated that everything now known which is relevant to a particular market has

already been taken into account by market participants in determining the current price. It followed that only unknown

future events could influence the price up or down. This argument:

failed to explain the wide fluctuations which occur in the absence of any significant news, and did not take into account the fact that different people and organisations react at different speeds and in

different ways to the same information - even if they learn of it simultaneously.

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

serious error.


3/21

Mr. Soros' Quantum fund is reputed to have made a billion dollar profit speculating against Sterling during the most

recent EMS crisis. The Malaysian national bank, whose then governor is now otherwise occupied, lost more than that

betting the other way (ironically, Mr. Soros himself admitted to losing $600 Mn. in speculation, notably in the Yen,

early in 1994).

The " " is a development of the same line of thought, postulating that "Price action is random, andtherefore unpredictable, since the markets are continually reacting to a random stream of positive and negative news

of randomly varying intensity". Prices do not, however, behave randomly (or at least not randomly).

The really significant difference between random and real price-series is that in real markets the variations in

are much wider: markets go through long periods of relative calm punctuated by dramatic moves with much wider

period-to-period variations.

The bar-chart shown below (with "RSI" underneath it) was generated using Excel's random-number generator. The

program used to generate is available for free down-loadhere. Every time the worksheet is recalculated a new chart

will be generated.

The above randomly-generated "time-series" shows surprisingly persistent "trends", interrupted by "corrections", as

will the others you generate if you run the program.

The methods used to generate the charts are detailed on the spread-sheet.
http://www.marketskillbuilder.com/datadown.htmhttp://www.marketskillbuilder.com/datadown.htmhttp://www.marketskillbuilder.com/datadown.htmhttp://www.marketskillbuilder.com/datadown.htm


4/21

The following two charts compare the "Frequency Distributions" of a randomly generated series with 5-minute moves

in the Standard & Poors stock-index futures over three months, excluding the first and last half-hours of each day to

ensure that the results are not skewed by the influence of the overnight gap:

The chart on the left shows a typical bell-shaped random distribution. On the right the "real-market" distribution is

taller and thinner, with broad, relatively flat extremities. It confirms what experienced market observers already know:

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

Every now and then a major (and unexpected) move occurs, of a size to knock the unwary flat.Note that while the "body" of the S&P chart is shifted to the right (more positive than negative moves in an up-trend)

the move is on the left (a vicious correction).

In the simplest possible terms, the reason that neither of the above theories holds true is that while, over the long

term, market prices will always adjust to changes in the underlying fundamentals, it is also true that

.

A simple example: if share prices are under-valued in relation to net company assets (as they are in the depths of a

bear-market), alert financiers can make large profits by buying companies and selling-off their assets. This has a

number of effects including the triggering of a general rise in equity prices, which has the effect of increasing


5/21

everyone's wealth, and in particular the collateral value of shares against which money can be raised to carry out

additional leveraged deals, which then accelerate the process. At the same time "real-world" activity is stimulated.

Increasing asset-valuations encourage investment. The economy and consumption expand. These processes

become self-feeding and continue until levels of excess are reached, deals start to fail, and the process reverses.

These observations are not original, of course. This was the story of the 1980's and the processes are well

understood. The key points are:

The process is "self-feeding" - until it auto-destructs through excess. "Self-feeding" market moves are theresult of the "mode-locked" inter-action of real-world events and market-price evolution (not of technical

traders following trends, or of market conspirators acting in concert to de-stabilise virtuous policies, as

ignorant by-standers and politicians frequently suppose. Mr. Harold Wilson, a British prime minister in the

1960s famously blamed one of the Pound Sterlings numerous devaluations on the "Gnomes of Zurich").

Once one of these processes is under-way, it is easy to see (and predict) that a reversal will eventuallyoccur. It is impossible, however to predict when and from what level. This point is worthy of emphasis : it is

absolutely and utterly impossible to predict major (or minor) turning points in any freely-traded market. .

This does not, of course, stop people from trying. Market and economic cycles are accompanied by Guru-Cycles. The process here is that someone makes a few good market turning-point calls, gathers a following,

becomes a celebrity, makes a spectacularly inaccurate prediction at the height of his or her fame, and retires

to obscurity.

Since even powerful trends are interrupted by corrections (counter-trend moves), it is not necessarily evidentat any given time whether a reversal has occurred. Distinguishing between corrections and major reversals

as they are occurring is the main problem faced by all market analysts. In simplistic terms: if a market is

running up strongly, potential supply is withdrawn (sellers abstain). At some point profit-taking starts, sellers

appear, holders perceive their profits to be eroding and accentuate the counter-trend move. Market

commentators are split as to whether a correction or reversal is occurring, and erratic trading ensues as

bargain-hunters buy dips and profit-takers sell rallies. All of this can occur without any significant change tothe fundamental dynamics governing the longer-term move. The main trend then resumes once all the

"weak holders" have been shaken-out.

Whether or not these processes are " " in the mathematical sense is open to debate. Chaos theory postulates

that dynamical systems, where the future values of the variables involved (such as market prices, the weather,

population sizes or gross national product) depend both on each other , evolve in

series of persistent cyclical trends. The cycles are never however identical, and are extremely sensitive to tiny

changes in the initial conditions. In other words, even if the markets are governed by deterministic forces (which

would imply that they can be predicted by accurate modeling of the current situation and the forces which apply to

each variable including the price), it would paradoxically still be impossible to predict them because tiny and

unavoidable errors in the definition of the initial conditions would cause major errors to appear in the results after a

very few iterations. Of course if they are not deterministic, then any attempt to build forecasting models is futile. Either

way, forecasters and econometric modelers are doomed to failure.

Dynamical systems can remain in a trend much longer than expected (as when stocks remain in a bull market long

after most commentators consider them to be over-valued). At other times they break down unexpectedly, the 1994

collapse in bond prices world-wide being a case in point. When this happens scapegoats are quickly identified. In

1987 it was "program trading", in 1994 it was "hedge funds".


6/21

Notwithstanding all of the above, there are numerous different strategies, both "fundamental" and "technical" which

can be successfully deployed to obtain above-average returns from the markets. All of them involve the disciplined

assumption of risk, and the willingness to get out as soon as it becomes apparent either that the initial analysis was

wrong or that conditions have changed.

My own preferred approach is technical because everything which is relevant to a particular market is reflected in the

evolution of its price. Alert interpretation of the manner in which a price is acting, as revealed by price-charts, gives

clues as to its future movement which are at least as likely to be correct as the attempted analysis of all of the many

outside factors which are thought likely to influence it: and it is much easier to do. Equally importantly, the market tells

me directly (and brutally) when I am wrong, and I can act accordingly.

The type of trading advocated here is designed to permit rapid capital expansion while guarding against the risk of

ruin.

To be successful in the markets over the long-term a trader must have a winning strategy, and apply it consistently. A

winning strategy :

: The simpler the better. Remember, you can't forecast the market's next move, andneither can anyone else. Simple trading rules make for clear-cut and effective decisions (while most other

participants are still trying to compute and weigh the implications of dozens of factors and indicators - and

generally wallowing in a state of catatonic confusion, particularly if the market is not going their way - you willhave acted, and will be calmly observing and waiting for a new signal).

:o definition of the conditions which will trigger the opening and closing of positions (both to take

profits and to cut losses).

o rules governing the size of position to be taken.That much seems obvious (at least to me), but a very large proportion of traders and investors fail to make these

definitions. They buy things they think (or are advised) are likely to go up; watch them start to go down; then think "Oh

(supply your own preferred expression of disgust) - what shall I do now ?". This is not the way to succeed.

I recall a converstaion with a very well known and respected market commentator: he was very taken aback by my

observation that trading should be extremely boring. "How can that be!? - all of life's rich tapestry is reflected in

market action etc. etc.". Very true, but if you want to make money in the markets all you do is look for a few simple

repetitive patterns and act on them when they appear. Very tedious, but then excited traders do not win over the long

term (any more than excited poker players do).
http://www.marketskillbuilder.com/tradstrat.htm


7/21

The classic response to dealing with market uncertainty is, of course, to diversify. An un-leveraged diversified

portfolio will never disappear altogether (unless either the financial intermediary with whom it is placed disappears or

the entire financial system collapses). It is, however very unlikely to expand faster than (or even as fast as) the

underlying market averages. If the objective is capital expansion (as well as conservation), it seems to me that rather

than diversifying, it is more rational to place the bulk of capital in ultra-safe relatively short-term government paper,

thus guaranteeing capital conservation, and using the balance to finance a small numberof "at risk" positions with aview to capital expansion.

A portfolio containing 90% zero-risk and 10% high-risk components is safer than one containing 100% diversified

medium-risk investments if only because all one's attention can then be concentrated on managing the 10% high-risk

element.

A brief word about corporate market exposures: Most corporations with currency and commodity market exposures

have policies regarding the resulting market activity which are designed to limit the attendant risk of loss. Many do not

(or do but fail to police them adequately) - which is why spectacular, sometimes crippling, losses are announced and

widely reported by one company or another at approximately 6-monthly intervals.

In general terms, selective hedging is usually thought to be "OK", trading for profit is frequently forbidden. A more

rational approach is to:

a) : This is not as simple as it sounds since while the balance-sheet exposuresrelating to completed but unsettled transactions are easily identified, quantification of the exposures relating

to forward business can depend on numerous factors including terms of contracts, pricing flexibility,

matching of purchases and inventory to sales commitments etc. etc. Although it can be complex, the

problem is essentially accounting / budgeting / administrative in nature.

b) "Trading for profit" as a completely separate profit-centre activity operating underclearly defined constraints. Provided that all trading counter-parties are instructed to send transaction

confirmations to a separate department this activity can be controlled and monitored without the risk of

catastrophic loss.

The advantages of separating these activities are obvious. "Selective hedging" is ridiculous (a) because it is trading

with one hand tied behind the trader's back (selective hedgers play only one side of the market) and (b) because it

tends to generate internal conflict and unclear reporting (a hedge which cost money was someone else's stupid

mistake, one which made money a master-stroke for which everyone seeks to take the credit).

"I don't know where to start". said Alice

"Start at the beginning. Go on to the end, then stop," said the Red Queen.

So let's start by stating the obvious:

The of the technical trader is "To accumulate capital by maximising profits gained from favourable market

moves while minimising losses suffered on unfavourable moves and transaction costs".

In other words, profits must more than equal the sum of losses plus costs.


8/21

The above may seem blindingly obvious, but it is at this simplest-possible level that most participants in the game fail,

because they expend too great a proportion of their efforts on attempting to perfect forecasting techniques with a view

to maximising the probability of profit, and pay insufficient attention to the strategies required to minimise losses.

The first point to note is that the analytical technique(s) used by the trader must " " on the market, in

other words produce better than random results: "Monte-Carlo" systems, where stakes are doubled on even bets until

a win is gained require enormous initial capital to avoid the risk of ruin. Suppose you bet $1000 on the toss of a coin,

doubling the bet each time you lose, and reverting to $1000 when a win in gained. How much will you have won after

2500 throws, and what will your maximum bet have been ? This can be easily simulated using any spreadsheet

program with a random function. I ran this simulation 25 times while writing this. Profits varied between $1,164,000

and 1,293,000, On two occasions consecutive runs of 15 occurred. Bets of $16,384,000 would then have been

required to keep the sequence going (with no guarantee of success on the next try). No amount of mathematical

tinkering can change the basic brutality of these numbers: You gotta have an edge.

A note on : The shorter the time-frame traded, the more important aggressive control of transaction

costs becomes. An intra-day trader may be capturing 50-point moves, while a position-trader who holds positions for

days / weeks might be looking for 500 points. a few extra points of slippage (bid/offer spread) or dollars of

commission may not matter too much to the latter, but intra-day trading performance can be seriously hurt by

inefficient order execution and excessive commissions. Additionally, the intra-day tradermusthave on-line non-

delayed quotes and charts (which cost money) whereas the position-trader can update charts manually. Basically, all

technical traders should use discount brokers, negotiate commissions aggressively (on the basis of trading volume),

and challenge execution prices which are out-of-line.

In developing a , two ratios need to be optimised:

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

These two ratios tend to be negatively correlated: for example, the trader who consistently aims to take 100-point

profits while cutting losses as soon as they reach 10 points will obviously tend to be "stopped-out" frequently (causing

a low profit to loss frequency ratio) but his average profit to average loss ratio will be high. Conversely, the trader who

maximises P/L frequency by placing 200 point stops and 100 point targets will suffer fewer losses each of which will

hurt more. Either or both of them may make or lose money over time depending on the quality of their underlying

analysis and the consistency and discipline with which they apply their respective strategies.

As a general "Rule of Thumb" : The trader should aim for three profits for every two losses, and a 3 to 1 average

profit to average loss ratio. These targets leave room for considerable under-performance before the trading

becomes unprofitable overall. (anyone who can achieve both objectives consistently will become very rich indeed).

Note that a free program down-load to model trading results resulting from random sequences of profits / losses withdefined probabilities will be posted to this site in June 1998.

Before considering how to determine the size of positions to be taken, let's take a look at the basics of the technical

analysis of market action necessary to determine whether to buy, sell or stand aside; and when to take action.


9/21

During any given time-frame a market can do one of three things : go up, go down, move sideways. Persistent movesin the same direction are generally referred-to as "Trends".

Up and down-moves can be fast ("impulsive") or slow ("corrective" or "drifting") in nature (or in between). The

most important aspect of "Momentum" is not any absolute measurement of its value, but whether it is constant or

changing. the key questions (to be answered from direct observation of the price-charts) are:

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

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

Can be low, with almost no price-swings away from and back to the underlying trend; high, with wide and erratic

price-swings in both directions, or anywhere in between. Changes in volatility often signal changes in trend, often

either in the form of either:

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

Can be high, with thousands of transactions being carried out on a continuous basis; or low, with only intermittent

price-quote updates and transactions. In general terms technical-trading is best suited to highly liquid markets

because effective transaction-costs (bid-offer spreads and commissions) are lower, and large orders can be placed

without adversely affecting the market.

are directly dependant on the actions taken (or not taken) by the participants in the market :

Technical Analysis is simply the observation of those actions, as shown on price-charts.

As stated above, technical trading is predicated on the proposition that the action of the market, which is the reflection

of the sum of the actions of all participants, provides clues as to the most likely future evolution of prices. The cluesare, however, frequently misleading (or mis-interpreted). This leads to the necessity for any successful trading

strategy to provide in advance for the "avoiding action" to be taken to minimise the damage caused by bad positions.

Technical traders/investors take important decisions (risk their own and other people's capital) on the basis of very

flimsy evidence: the direction prices are moving and the type of price-action. Successful trading is based on the

following

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


10/21

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

last two.

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

Major supports / resistances are more likely to turn the market back than break. Trend reversals are usually signalled by a clearly observable change in volatility (either a sharp break

against the trend or its continuation at reduced momentum).

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

levels.

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

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

emphasised:

An attempts to profit from major market swings which last many weeks / months (or even years).In monitoring his investments, and the general population of other investments into which he might switch,

he should review monthly ("long-term"), weekly ("medium-term") and daily ("short-term") charts.

A attempts to profit from major market swings which last several days or weeks. Inmonitoring their trades, they also generally review monthly ("long-term"), weeky ("medium-term") and daily

("short-term") charts every day and with greater emphasis on the daily charts.

An attempts to profit from major market swings which last from minutes to hours, andalways closes his positions overnight (or hands them on to a colleague in the next time-zone). In monitoring

his trades, he should review hourly ("long-term"), 5-minute ("medium-term") and 1-minute ("short-term")

charts.

That said, since price-charts are fractal in nature (ie self-similar irrespective of the time-frame being observed), thereis absolutely no difference in the methods of analysis and decision-making to be applied. It is absolutely critical to

success that which of these activities is being pursued is clearly understood and the appropriate actions consistently

taken. Disaster frequently overtakes those who fail to take this simple but critical decision. The cynical definition of a

"Long-Term Investment" is "A trade gone sour" ! (as when a trader buys a stock at 100, watches it go to 80, and then

says "That's OK, it's a .........")
http://www.marketskillbuilder.com/trends.htm


11/21

Now let's try to clarify the above statements by defining the terms:

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

The trend shown on this bar chart is (the strength of the current bounce indicates that

it might be turning up, but in the absence of a higher low, and as no major resistances have

been broken, the trend is down).

Highs and lows are defined below. The trend is judged by reviewing the medium-term chart

(the objective being to "catch" medium-term price-swings).

A "High" occurs when the top of a price-bar is higherthan the tops of the two preceding and two following

price-bars (or three or more equal price-bar tops are

higher than the two on either side)

A "low" occurs when the bottom of a price-bar is lowerthan the bottoms of the two preceding and two

following price-bars (or three or more equal price-bar

bottoms are lower than the two on either side)

Isolated highs and lows are referred to as "Minor resistance"

(above the market) and " Minor support" (below the market). As

noted above, minor resistance to an up-trend and minor support

below the price in a down-trend are expected to break

In the above example it can be seen that the trend is up (because successive lows are higher) and the secondcorrection held at the support provided by the first high.

So far so easy: the market moves in trends interspersed with counter-trend moves called corrections (which are often

referred to as "Rallies" where the trend is down and the counter-trend move up). Minor support and resistance-levels

are formed at the extremities of the sub-moves within the trend. Minor supports and resistances are expected to hold

and break respectively in an up-trend, and vice-versa in a down-trend.


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Now we arrive at the critical question: how do we identify the conditions which indicate that the trend is likely to

change (or is in the process of changing) ? In other words, how do we distinguish trend from ?

The answer is that we watch for and act upon two separate types of event: :

We watch the action of the market (concentrating on the short-term price-chart) for signs of significant changes in

and .

: always trade in line with the impulsive move and against the direction of the drift.. In the example on the left, the second up-move is what is expected when the first is interrupted by the brief

period of down-drift. This is because down-drift indicates that, on balance, the pressure is on the sell-side

(probably due to profit-taking by short-term traders who were in the move early and now consider the market

to be "overbought"). There is, however no real pressure or conviction in the selling (or the price would be

falling faster). This process "frees-up" future buying-power as it means that there is a declining total of long

positions in the market, some of which will be re-established by trend-following operators when and if the

market accelerates up. Note that this type of pattern often occurs half-way through the larger move.

In the example on the right, the trend has remained the same, but momentum and volatility have declinedsignificantly. This is a warning that the trend is likely to change at any time. This is because while, on

balance, the market is still buying and few profit-takers are supplying the demand, "buying energy" is clearly

less strong than it was. This indicates that most participants who want to be long already are, and very few

of them have already taken their profits. There is therefore a lot of potential supply and few potential new

buyers available to support the price when the balance turns. The down-move, when it develops, is likely to

be sharp as everyone heads simultaneously for the exit. This is therefore an excellent opportunity to reverse

from long to short close to the "top of the drift" (which is likely to be the extremity of the move, thus

maximising profit on the both long position being closed and the new short position as well as minimising the

size of the loss to be taken if the up-trend re-asserts itself rather than reversing as expected).

Note that "Drifting" action can take more complex forms, as on the left where two brief periods of down-drift

are separated by a sharp up-period. The principle remains the same and this pattern is bullish.

(In market parlance "Bullish" = likely to go up, "Bearish" = likely to go down)

Positions taken "against the drift" (in either direction) should be protected by stops at a level above or below

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


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A sharp break against the trend with greatly expanded single-period range. This type of action may

(but will not neccessarily) follow-through with a succession of similar periods. Often caused by

unexpected news which is perceived as being significant by the market.

This type of action is "tough-to-trade" because it can be followed by further volatile periods in eitherdirection.

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

Place a limit order to exit the balance of any long position and establish a relatively small short position 2/3of the way back to the top.

Place a "stop" order to exit the balance of any long position (without entering a new short position) if theimmediate down-move extends by a further 1/3.

The odds that the limit price will be reached before the stop is hit are probably worse than even, but the

potential recovered-profit to potential additional-loss ratio is two-to-one. This makes it the rational decision to takethat the additional loss would not be excessive: hence the necessity to cut back immediately if the position

being carried is unusually large (the basic rules on the determination of position-sizing are discussed below).

A sudden acceleration of the existing trend with greatly expanded single-period range. This type of

action may also (but will not neccessarily) follow-through with a succession of similar periods. This

is usually the final bull-market buying-panic during the course of which the "last fool" finally gets

into the market. This type of move can provide spectacular profits to those who stay with it

frequently reverses as brutally as it proceeds. Generally referred to as a "blow-offor "spike" top

(or bottom if the chart is reversed).

If carrying a position against the trend: . It is very occasionallyappropriate to panic. this is one of those times. For survival it is very important to be amongst the

first ( last) so to do.


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carrying a position in line with the trend:place an " " just below the start of the

acceleration (above if the move is down), and follow the move up with a trailing stop (see below). You may

be stopped-out well before the final top: but that is much better than watching a massive profit wiped-out by

staying with the move to the top, and then staying with the following collapse. There is absolutely no way to

judge in advance where a "mass hysteria" move will end. When people start confidently to predict that a

price which has already tripled is going to re-double might be a good time to sell.

If not already carrying a position: (watch and weep).

If long or aside: reverse to / sell short on a test of . If short or aside: reverse to / buy long on

a test of .

Obviously " " needs to be defined, see below.

Incidentally you are "Long" something (a stock, currency or whatever) if you have either bought and paid for

it (entirely or partially) or have promised to buy it at a future date at a specified price. You are "short" something which

you have promised to deliver at a specified future date in exchange for a specified price.

If you buy a house and take out a mortgage you are long property and short cash. (This is usually but not

necessarily a good position to be in).

" " supports and resistances are previous market turning-points separated from the current price-action

by at least two intervening reversals.


15/21

a test of major

resistance of the type shown

above, with a "re-reverse stop"

just over a "normal" period's

range above the old high. (if the

chart were inverted it would besupport to be bought, naturally).

Not infrequently, the

market will go straight through the resistance, and you will be "Stopped-out" within a very few time periods. This is

extremely irritating and expensive. On the other hand, it is astonishing how often markets will test and reverse from

"Major" levels of this type, in which case you are positioned to profit from the entire ensuing down-move.

The really critical point, however, is this: If you do not sell the test of the resistance but stay long and "wait to

see" whether the market goes through the resistance where do you place your stop ? (to get out of your current long

position if any and to join the move on the short side). Casual inspection of the chart shows that, since a new down-

trend will not have been "confirmed" until either at least one level of support has been taken out or a new (lower) high

has been formed, at least one-third, more likely a half, of the previous up-move will have been re-traced before you

enter your short position. At this point a significant proportion (possibly all) the unrealised profit on the up-move will

have been eroded, and a significant proportion of the new down-move missed and the logical place for the protective

stop on the new short position will be a long way from the entry-price.

Selling the above market short can be a gut-wrenching thing to do: particularly if you are watching the news

and all the commentators are explaining why the market is going through the roof (which they invariably are at

extremities). It becomes even more difficult if you have done the same thing before and been stopped-out for a

significant loss almost before putting down the 'phone. It is nevertheless the right thing to do because buying and

selling at probable extremities maximises the ratio of average profit to average loss.

It is noticeable that most analysts concentrate their attention on attempting to identify the direction of thenext move correctly (intending to maximise the frequency of profits compared to the frequency of losses). It is,

however, at least as important to maximise the ratio of average profit to average loss. If that means taking occasional

additional (relatively small) losses (and possibly feeling like a fool in the process), then so be it.

To repeat the definition of what constitutes " " support and resistance:

" supports and resistances are previous market turning-points separated from the current price-action

by at least two intervening reversals."

The example given above was obvious in that there were numerous minor reversals between the major

resistance and its current re-test. It is less obvious, however, when there are only two:

Answer: The three-wave move down from the top (ie two down-moves with one intervening upward

correction) may simply be a now-complete correction of the preceding up-move, in which case the market is destined

to reverse up from here and go straight through to new highs. This type of three-wave correction is extremely

common.


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But: it is at least as likely that it is either the start of a more extended and complex (and tradeable) form of

correction or the start of a new down-move which is destined to continue without a significant rally for some time.

First, place a sell-stop below the next low which, if hit, will exit any existing longposition and enter a small short position (small because the initial stop on the new

position would be above the recent high - ie a significant distance away from the entry

price). This initial stop protects against serious loss in the event that the market

continues straight down, and turns a profit if it goes far enough.

If the market you will have a (small) short position. Place

an initial stop above the recent high and await developments: If the market turns back

up towards the high (a) you will be glad that the short position is only small and (b) you

will watch the market action carefully in accordance with the notes below the next

horizontal line to determine whether to add to the short position as the market

approaches the high. On the other hand
http://www.marketskillbuilder.com/resist.htmhttp://www.marketskillbuilder.com/resist.htmhttp://www.marketskillbuilder.com/resist.htm


17/21

If the market the market (making you money on your new

short position (a) lower the buy-stop to just above the second minor-resistance level(the two levels of resistance are indicated here by jagged horizontal lines) and (b) -

optionally - plan to increase the short position on any rally towards the first resistance.

If the market "impulsively" to re-test the high without

forming a clearly identifiable intermediate high: stay long and raise the sell-stop to just

below the most recent low.

If the market moves back up towards the high, but in a " ":

reverse to short and place a buy-stop to cancel the new short position and reverse to

long above the high.


18/21

Similarly, if the move back towards the top is by a correction as

shown here, reverse to short and place a buy-stop to cancel the new short position and

reverse to long above the high.

Look at the Long-Term Charts to identify major support and resistance-levels. Look at the Medium-Term Chart to determine the current trend, trade in line with it so long as a reversal is

not indicated by the pattern of highs and lows, and / or direction of "drift", and / or changes in momentum /

volatility.

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

Always sell tests of Major Resistance buy tests of Major support. Expect the current trend to continue unless a counter-trend move is stronger than the previous "with-trend"

move (in which case, place orders to reverse on a re-test of support / resistance with a stop beyond the next

level of resistance to the presumed new trend)

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

of a fast market ten minutes late.

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

which can be taken.


19/21

I recommend that no more than 1% of capital be risked on an individual trade (entry-price to initial stop). This

relatively conservative policy ensures survival in the face of either a sudden massive adverse move or an extended

series of "Nickel & Dime" losses. This limit can be increased (say to 2.5%) if only one position is carried at a time.

Aggressive traders (many of whom fail to survive) risk much more: remember that if a draw-down of 50% is suffered

the trader then has to gain 100% on his remaining capital to get back to where he started. Minimising losses is much

more important than maximising profits.

The position-size to take (assuming a policy which precludes adding to positions) is therefore: 1% - 2.5% of capital / $

per single-contract point / no of points to stop.

With commission and slippage realistically costing +/- $50 / trade, how can someone with a limited starting capital of

say $5,000 enter this game since $100 - $250 stops are not realistic ?

Stop trading (fire your money-manager) if somewhere between 33 and 50% (decide in advance) of your risk capital is

lost - you/he are incompetent !

The answer is to approach the problem slightly differently, but still in a disciplined and business-like fashion, as

follows:

Don't start trading until you have saved a minimum of $10,000. Yes, I know that an account can be openedwith $5,000 and that people have gone from less than that to millions in the past - but don't count on it (many

are called but few are chosen) . . . so step 1 - .

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

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


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

the regular investment until the equity in the account reaches at least . Plan to start (say) 10% of net new equity every month after the account has reached .

A person who implements this type of strategy may spend a long time with capital fluctuating between $5,000 and

$15,000, but has an excellent chance of long-term success because:

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

techniques.

The discipline of regarding the enterprise as a business into which a regular investment is being made until itis successful enough to start paying dividends is conducive to development of the type of

approach which is vital to success.

Obviously the above numbers are not "cast in stone", but the general idea is sound. As in many other areas of life,

one starts by paying for education and experience, and then one profits from it. The more structured and disciplined

the approach, the quicker the pay-back is likely to be.

Am I seriously proposing that the financial markets can really be beaten by the application of this simplistic analysis ?

In a word :

But what about Moving averages, Kalman filters, RSI, Stochastics, Cycles (Astro & other), Dow Theory, Elliott waves,

Fibbonnacci, Fuzzy logic, Artificial intelligence, Chaos Theory, Delta theory, Trend-lines etc., etc. ? The use of some

of the above tools and techniques / application of the theories may increase the proportion of profits tolosses, but this will almost certainly be at the cost of a deterioration of the of average profit to average loss.

Note, however, that discussion of many of these indicators and techniques will be added progressively to this site - let

me know if you would like to be kept informed of developments

Remember, the point about the trading-style advocated above is that transactions only take place in

proximity to support and resistance levels beyond which stops can be placed - so that losses, when experienced, are
mailto:[email protected]


21/21

small. If you rely on one or several indicators or other techniques separate from the direct observation of the price

and its behaviour to tell you when to trade, this will inevitably be less true. In real-estate it is said that there are three

important elements : location, , and .

In trading and investing there are also three important elements : price, and

Nobody has to take my word for any of the above. The whole point of the package is that the

program gives the user the opportunity to effective realistic experience risk-free.

- clickhere
http://www.marketskillbuilder.com/orderinf.htmhttp://www.marketskillbuilder.com/orderinf.htmhttp://www.marketskillbuilder.com/orderinf.htmmailto:[email protected]://www.marketskillbuilder.com/orderinf.htmmailto:[email protected]://www.marketskillbuilder.com/orderinf.htmhttp://www.marketskillbuilder.com/orderinf.htm

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