Practical Technical Analysis

Relative Strength Investing

2010-06-08T21:05:00.000+05:30

(source: http://systematicrelativestrength.com/2010/06/07/buy-and-really-hold-will-suck-your-portfolio-dry/)

Summary:

It’s a little-known and depressing fact, but the majority of individual securities tend to post negative returns over the long run.

In fact, researchers at the investment management firm Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago’s CRSP total equity market database.

As for the bottom 75% of stocks in the U.S. market, they collectively generated annual losses … over the past 29 years.
If you miss the best 25% of stocks, you will end up losing more than 2% per year.
The answer to getting the best stocks is Index Investing.
There is evidence on the futility of stock picking and the triumph of index investing. What it really reveals is this: index investing would be an abject failure if it weren’t for two things: 1) active management and/or 2) relative strength weighting. First, if indexes didn’t replace companies that went out of business or were no longer “representative,” they’d have a buy-and-hold portfolio that, by their own calculations, would lose money. Replacing losers (dead companies) with winners (live companies) is, in fact, an efficient casting out process used for active portfolio management. Second, index returns are helped immensely by increasing the weighting of the stocks that go up the most. This is actually a form of relative strength weighting, more commonly referred to by index providers as “capitalization weighting.” Emphasizing the winners at the expense of the losers also tends to help returns over time.

When Genius Failed

2009-09-09T19:00:00.002+05:30

WHEN GENIUS FAILED: The Rise and Fall of Long-Term Capital Management
Author: Roger Lowenstein, Publisher: Random House

(Summary of book based on book reviews)

Nobel prizes and billions of dollars don't always equal success

Long-Term's basic strategy was to bet on the eventual convergence between the prices of extremely similar assets.

As an example, if Nifty futures offered a long term contract, say 1 year, then the arbitrage will be between the 3 month and the 1 year futures contract. Sometimes, the difference between the two will be Rs 10/-, and sometimes it may be Rs 12/-. The idea was to use computer based analysis to buy when the difference was perceived to be less and sell when it increased.
Now, making Rs 2/- on two contracts is no fun. There is margin required on two contracts, and, transaction charges, so where is the money? The return is going to be marginally higher than the interest.
In principle, it was a low-risk strategy, with tiny returns on each trade.
LTCM started with $4 billion. Then they took on loans for $100 billion. On the 100 billion, they will make a small amount after payment of interest, but that amount will become large enough on their own investment of 4 billion. LTCM was earning 50% per year on its capital. The 104 billion was used as margin to take on derivatives trades as explained above. LTCM exposure in derivatives was $1.2 trillion.
Now, all of this was working because the trades were almost risk free. Note my use of the word 'almost'.
With this kind of financial leverage even the most minute market move against you can wipe you out several times over. Talk about financial weapons of mass destruction! This risk did not deter Long-Term, though.
Finally in 1998, Russia defaulted on its bonds- many of which Long-Term owned. This default stirred up the world’s financial markets in a way that caused many additional losing trades for Long-Term.
[As an example, a sudden event in India causes the near month futures to fall much more than the far month. If you are short the near month and long the far month, you are in trouble!]
By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.
That's true, bcause convergence between two similar products was bound to happen at some point. But, if one instrument suddenly went against LTCM while the other one did not go in favor, LTCM was saddled with markt o market losses, increased margin - all on the 1.2 trillion dollars of positions. Where was the money?
By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.
With $1.2 trillion dollars at risk, the economy could have been devastated if LTCM’s losses continued to run its course. After much discussion, the Federal Reserve and Wall Street’s largest investment banks decided to rescue Long-Term. The banks ended up losing several hundred million dollars each.
What became of Long-Terms founders? Were they jailed or banned from the financial world? No. They went on to start another hedge fund!

Reviews used to write this post:
http://www.stock-market-crash.net/book/genius.htm
http://findarticles.com/p/articles/mi_m1316/is_9_32/ai_65160621/

Meaningful Position Sizing

2009-08-31T18:54:00.002+05:30

The blog tischendorf letter has some sensible ideas on trading appropriate volume (position size). While all of us warn traders on overtrading and on carrying large positions which they cannot afford, the reverse is also true. I am quoting from the blog:

Ed Seykota says: ‘Risk no more than you can afford to lose and also risk enough so that a win is meaningful.’ My experience tells me lots of traders have difficulties applying this rule because they probably don’t fully understand the implications.
It is obvious you shouldn’t put all your eggs in one basket unless you are watching the basket very closely. Personally I like to diversify a bit but as a general rule I pay attention not to diversify too much and I keep my position sizes meaningful. The reasons why I do this are the following:

You don’t lose focus.
Fewer positions force you to be disciplined and do your DD.
You are forced to focus on the best technical setups.
No excuses. If there are two stocks you could choose from go with the better one.

Sticking to fewer stocks and spending more time on the selection process will increase your discipline and your focus. That alone is worth it as you are more likely to reach a ‘flow state’ where you only trade the best stocks with the best setups offering the best odds. Then you are able to trade at peak performance

Lessons in Technical Trading

2009-07-11T21:36:00.003+05:30

thekirkreport.com talks about mistakes in trading.
The report asked a question from its subscribers: "So far in 2009, what is the most important thing you've learned about investing, trading, and/or the markets?"

Some of the lessons learned were:

Success takes longer than expected
That you must learn to trade and trust yourself and not to become so dependent on the opinions of others, which ultimately keeps you from becoming the best you can be
The very best profit opportunities occur in the midst of extreme emotional sentiment
Persistence and dedication to a daily routine is key
Developing an edge is the first step for trading successfully. Without that, disciplined trading will only make sure you gradually losing money
You have to respect the market even if you think it is under some kind of manipulation
Anything can happen. Trading is all about probabilities

There is more in the report which was mentioned earlier.

Dennis Gartman gives a set of trading rules. The basic themes are:

Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.
In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.
Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect “gaps” in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.
Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In “good times,” even errors are profitable; in “bad times” even the most well researched trades go awry. This is the nature of trading; accept it.
Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

The Day Trader's preparation

2009-05-25T22:26:00.002+05:30

Brett Steenbarger is an excellent traders coach. He writes a blog where he shares his trading ideas. This post consists of a selection of his trading suggestions relevant to day trading. Given at the end of the post are the links from which this selection is derived.

Preparation for the Trading Day

The trader’s daily preparation begins before markets open. By observing how markets trade overnight, evaluating the behavior of correlated asset classes prior to the open, and by assimilating economic data, news, and earnings releases (and market responses to these), the trader gains a feel for the market day before the opening bell rings.

Key to the trader’s reasoning is an elaboration of “what-if”scenarios that review hypotheses regarding likely market action. What if we open with low volume, near the previous day’s pivot level on a day with no scheduled economic releases? What if we open weak in the S&P 500 Index, but see firmness among the small cap stocks and a mixed open among the major stock sectors? What if the market breaks above a key price level, with bullish behavior in bonds, the dollar, commodities, and the more speculative stock sectors? What if the market breaks below support, but breadth remains mixed?

Each of these scenarios calls for a specific trader response. Each offers potential trading opportunity. By mentally reviewing the scenarios in advance, the trader becomes more prepared to act upon them. The trader also becomes more sensitive to their unfolding, so that trading opportunities can be properly anticipated and mapped out.

Three Questions for the start of the trading day

Here are three questions to ask at the start of the trading day:
1) Am I bringing baggage to the day's trade? Am I carrying over frustrations from losing money or missing opportunity? Am I feeling particular pressure to make winning trades? Am I locked into a view of markets because those views haven't been paying me?
2) Am I prepared? Have I identified significant price levels for the day? Have I gained a feel for how various markets have been trading overnight? Do I know if economic reports are scheduled for the day and what the expectations are?
3) What am I working on? Do I have goals for the day? What have been the mistakes I've been making that need to be corrected? What improvements have I made that I want to cement? What kinds of trades have been working best for me, and am I prepared to actively look for those.

Trading by Themes

One of the most important calls an active trader can make is the dominant theme of the day's trade. Sometimes a news or earnings report will set the theme of the day. Other times, we will see themes carry over from trade in Asia and/or Europe. I find that tracking the market before the open provides a feel for some of the themes that may move markets--or shift on us--during the trading session.

Importance of the Opening Price

A trending market will stay above or below the opening price for the majority of the session, as we reject that early estimate and probe value higher or lower. A range market will tend to accept the early estimate of value, and we will oscillate around the open for much of the session.
Knowing how we're trading relative to the open--but also seeing how individual stocks and sectors are trading relative to their opening prices--is useful in gauging evolving market strength and weakness.

Three Questions for the End of the Trading Day

1) Did I trade well today? - Did I make good use of my preparation? Did I follow rules about position sizing and execution? Did I adapt well to shifts during the trading day? Was I patient in finding trades with good risk/reward characteristics?
2) What did I learn about myself today? - What about today's trading can I bring to the next day to make myself better? How can I learn from what I did right and wrong today? What goals can I set for tomorrow to make sure that I carry over that learning?
3) What did I learn about markets today? - Did markets do what I expected? Are my views on markets any different based on today's trade? What levels did I observe in today's trade that can inform decision making tomorrow? What themes from today will I be tracking tomorrow?

http://traderfeed.blogspot.com/2009/05/importance-of-opening-price.html
http://traderfeed.blogspot.com/2009/05/three-questions-for-start-of-trading.html
http://traderfeed.blogspot.com/2009/04/trading-by-themes.html
http://traderfeed.blogspot.com/2009/05/three-questions-for-end-of-trading-day.html
http://traderfeed.blogspot.com/2009/05/reasoning-preparation-and-trading.html

Buying Pullbacks

2009-05-13T20:19:00.004+05:30

As part of your futures trading strategies, or as an online day trading method, buying on pullbacks is a skill that every trader needs to learn. Like any other skill, the more you do it, the better you get at it. Here are guidelines to follow when searching for buying on pullbacks (or selling on rallies):

1. The stock or futures instrument must be in a trending market. ie Market is bullish or bearish. There are no pullbacks in sideways markets.

2. Identify sectors that are outperforming the market (in an uptrend).

3. Make a list of market leaders and leaders in the sectors that are leading the market trend. 4. This point is key: Such stocks should pullback to support levels on LOWER VOLUME. Sometimes the pullback is pretty intense, especially in higher priced stocks. But, as long as the volume is average or, better yet, below average, this is still a pullback and not a reversal.

4. Preferably, leading stocks should pullback to support or key levels. This can mean different things to different traders depending on their time frame and risk tolerance. To figure out what those levels might be consider a few ideas:
-Past resistance as support.-Price action at certain levels. This can happen anywhere, but it means some kind of unusual activity where prices cluster for a few bars suggesting that a fight occurred between buyers and sellers where the buyers won-The stock pulls back to a moving average. Use the 8 day, 20 day, 50 day and 200 day simple moving averages, depending on my time frame.

5. Another key point: After entering into the trade, see the stock go up on VOLUME. LOW VOLUME ON THE PULLBACK, HIGH VOLUME as the stock advances higher. This is a sign of strength.

6. Lastly, and this goes with out saying, WHEN WRONG, GET OUT OF YOUR POSITION!! NO IF, AND’S, BUTS or MAYBE’S about it. Do not be in the business of averaging down. There is a difference between averaging down and buying into a pullback. One makes you money and the other ends careers.

These are guidelines to follow, but keep in mind not much in the world of trading is black and white. Be aware that pullbacks can be messy and uncomfortable, especially for newer traders. But, your ability to recognize good entry points for strong stocks pulling back in an upward trending market will make you more money and help you become a consistent trader.

The posts in Practical Technical Analysis are like futures trading courses. Please take advantage of this education.
(Post adapted from Trading Notes)

Recognizing strong up trend days

2009-05-07T08:02:00.002+05:30

Adapted from a post by Brett Steenbarger

Strong trend days offer excellent trading opportunities, as pullbacks generally occur at higher lows, offering entry points for short-term trades through the day (as well as opportunities to hold positions through the day).

First, if there is a gap open it should not be too large. 'Too large' is rather subjective, but 30-40 points is fine, I suppose.

Second, Lopsided ratio of advancing to declining stocks, suggesting broad market strength.

Third, Average or above average trading volume, with volume expanding on moves higher.

Fourth, Lows of the day hold. Either a pattern of higher lows is evident, or a breakout after an initial consolidation.

Fifth, An early thrust above upside price targets: previous day's high, R1/R2, so that these targets are hit early in the trading session.

Sixth, Dominance of bullish trading themes, such as sector strength among growth-oriented stocks, or gains in Asian markets.

How to test a trading system

2009-05-04T07:45:00.000+05:30

The DOJI as a reversal Signal

2009-04-11T20:43:00.001+05:30

Candlestick patterns are used by traders and investors to identify trading setups.
The DOJI is a significant pattern which is a possible reversal signal. This post will examine how the DOJI may act as a leading indicator and warn of impending reversal.

What is a DOJI ?

A DOJI is a candlestick pattern where the open and close are almost equal. (Note that 'almost' is good enough, there is no need for an exact match. The trader has to determine what is 'almost'.)
The DOJI represents an equilibrium in price where the buyers and sellers are equally matched - neither side being strong enough to move the opening price.

Why is the DOJI a reversal signal ?

If the DOJI represents equilibrium in price, why is it not a neutral signal ? After all, buyers and sellers are equally matched so the DOJI should mean neutral!

Well, the DOJI is a neutral signal! Just consider what happens in an uptrend. Prices are moving up, mainly driven by white candles where the close is higher than the open. This tells us that the bulls are in control with bullish candles appearing one after the other. Now, after a sustained advance, a neutral candle appears. Why should there be a neutral candle when the bulls were in control ?Maybe the bulls are losing control ? It is also possible that the bulls were taking some rest, or even deliberately selling to catch the short sellers later. Thus, the DOJI tells us that 'the bullish candle after bullish candle' scenario may be changing. If the market resumes its advance, closing above the Highs of the DOJI candle, then we know that the bulls remain in control. The DOJI was made for some reason or the other which is no longer relevant. But, if prices start slipping, closing below the low of the DOJI candle, then we get a sign that the bulls may be actually losing control. This is a signal to close long positions and take a short position if you wish.
The DOJI is relevant only when it appears after a sustained trend. If the DOJI appears inside a trading range, the pattern has no relevance. Because the DOJI tells us that the market is neutral, which is what the trading range tells us. So there is nothing to reverse!

A lot of technical analysis is common sense applied to charts.

It is Experience

2009-04-05T20:16:00.002+05:30

(from SMB Capital Blog)

There is no substitute for experience. As you gain experience you will leave poor risk/reward trades alone. In the past you may have been tempted to jump into certain poor risk/reward set ups but with experience you will not. You will also understand your strengths better. You will learn how you make your money. You will learn what set ups are best for you. You will identify when to sink your teeth into a position. And you will search for more of these set ups.

Trading is just a game of math. There are set ups that work best for you. There are set ups that should be avoided based upon your trading style. And experience teaches you what will work. The good trader exploits these set ups and leaves the others alone. So if in the past twenty percent of your trades were made in poor risk/reward setups then when you gain experience only one percent will include poor risk/reward opportunities. This completely changes your trading results.

Be Like a Tiger

Tiger Woods is the world's best Golfer, probably.

Many talk about wanting to be great traders. And many wish to be a great golfer like Tiger. Wouldn’t that be cool? You would have a private jet, a supermodel wife, all the money in the world, and access to anything you desired. But seriously, how many are willing to pay the price that Tiger does for success?

Do not make the mistake that good golf comes easily, He has practiced the winning shots a few hundred times a week. And that is how he does it.
“Tiger Day”
6 a.m. - lift weights for 90 minutes
7:30 a.m. - breakfast
9-11 a.m. - hit balls on practice range
11-11:30 a.m. - golf practice
11:30 a.m.-12:30 p.m. - play 9 holes
12:30-1 p.m. - lunch
1-3 p.m. - hit balls on practice range
3-4 p.m. - work on short game
4-5 p.m. - play 9 holes
5-5:30 p.m. - hit balls on practice range
5:30-6 p.m. - golf practice

Price leads Momentum

2009-03-30T20:48:00.002+05:30

A small slide show.

HDFC : A Case study

2009-03-29T17:50:00.004+05:30

Karthik writes:
Quote
Dear Sudarshan ji,I have learnt a lot of TA from your posts.Based on this,I looked at the HDFC charts and it seems that the stock has formed a bearish engulfing pattern,at the top of the rally and has closed below the trendline of the rally.The F&O data seems to suggest fresh short positions.Can we safely assume that this is a shorting opportunity?Please do answer this,as this will be of great help in furthering my knowledge of TA,of which I am a humble student.
UnQuote

Given below is my analysis for HDFC.

1. The trend has been up, in fact a steep uptrend. Such up moves tell us the bulls are strong.

2. There is a resistance zone between 1600 - 1700 where earlier tops were made. The same zone has acted as resistance, at least now.

3. A 17 period Slow stochastics suggests topping out. (Why 17 ?) Because my software suggests that HDFC is currently going through two cycles, 34 and 60 periods. The stochastic period shoul be half of the cycle length. I found 17 better than 30.

4. Now, we have a bearish engulfing candle on Friday, after a big up move, at previous resistance. This pattern could esaily signal a down move. Stop for any short position will be a close above the high of the up move (1672)

5. Just below Friday's close (1585) there is support. This is around 1550.

6. Then, a decline could find support in this area, giving a rather poor risk reward.

7. A close below 1550 will be a better signal to sell. The stop can then be moved down to the midpoint of Friday's bar.

Should you sell now or wait for a close below 1550, maybe then sell into a rally ? That's a question you have to answer. Sometime, one method will work better, sometimes the other. Then, you have to choose. That's what good trading is about.

Swing Trading Presentation - March 7, 2009

2009-03-07T20:58:00.000+05:30

Let me see if this works.

Day Trading Selection - March 6' 09

2009-03-06T21:38:00.002+05:30

The Day Trader has a question : What instruments to trade ?
Before seeking an answer to this question, we must understand that the day trader does not have the luxury of time. All trades are closed at end of day. Thus, a stock that may develop a trend in the next few days becomes useless for the day trader since she does not have the time to see it develop.
The Intra day trader then has to select instruments to trade within the constraints of time. The instruments should be:
Volatile, but not chaotic
Liquid.
Large Volumes
Capable of being short sold.
Followed by the 'public'
On this basis, equities should not be considred for day trading since they cannot be short sold. (Actually, for intra day, they can be, but there are no short sellers with carry forward positions in the equity market. Thus, many benefits of short seller presence are not available. Better to avoid.)
Now, instruments available for trading are :
Index Futures
Stock Futures
Index Options
Stock Options
Of these, Stock options do not have the liquidity so they can be ignored. As I write this, nifty options are liquid but option price calculations can upset their relationship with the underlying, so again, nifty options are not a good idea for day trading.
This leaves us with stock futures & index futures. A day trader should consider trading in liquid index and stock futures. A simple measure of liquidity is to examine the five minute chart. If the chart is not full, it is scanty then the instrument is not liquid.
At this point, we undertsand that traders should focus only on liquid index & stock futures.
How many instruments to trade ?
The asnwer to this question lies elsewhere. The day trader needs focus. She also needs to become ane xpert in day trading. An expert has to specialize. Now, day trading requires two different areas of expertise - knowledge of the instrument, and knowledge of the trading setup.
So, specialize in any one.
If you wish to trade in One insutrument then specialize in the behavior of that instrument. If you want to trade the Nifty, for example, then trade the Nifty. Trade its support / resistance breaks, trade chart patterns on the Nifty, trade momentum on the Nifty, trade mean reversion. Everything on the Nifty.
On the other hand, you can specialize in trading setups. Maybe, you enjoy trading breakouts from consolidation. Then, the basis of your trading is breakouts. You will trade breakouts wherever you find them. Maybe you scan 100 futures every hour to search for breakouts. Here, the specialization is the trading method.
In general, you have to specialize in one instrument or one pattern. The choice is yours.
When you wish to choose an instrument, you are confronted by higher gains possible in stocks and the advantage of more stable moves in Indices. Again,the choice is yours. But, whatever you decide, be consistent. Stock with your decisions for at least a few months. It is my understanding that the Nifty provides excellent opportunities for day trading, but this is just my preference, any liquid instrument will do.

Buying on DIps

2009-03-01T20:23:00.000+05:30

Buying weakness is the art of buying pullbacks. Stocks that are in up trends will pull back offering a low risk buying opportunity. (A pullback is a move against the main trend. Thus, for stocks in an uptrend, a pullback is a price decline).
The idea behind a dip-buying trade is to find stocks that are in relatively strong long-term trends but which also, at the same time, find themselves in quite sharp short-term pullbacks. The trader takes advantage of these overreactions and anticipates that the long-term trend will assert itself to bring the stock back to its previous highs.

Step 1. Be sure that the stock is in an uptrend.
An uptrend should be quickly and easily visible on a chart. This should be a series of higher highs and higher lows. Many traders will visually see a chart and identify the trend. Some others may use a trend indicator like the MACD, Mving Average or the CCI to identify an uptrend. But, in all cases, the price chart should have higher highs and higher lows.

Step 2. Identify the buy point in a dip or pullback.
There can be many way of doing this. Some trading setups are given here.
A. Look for support. This could be in the form of actual price support on the chart when a stock pulls back to a prior trading range or previous low, or it might mean a pullback to a key moving average within an uptrend.
B. Consecutive Price Patterns. Often, you will notice that a pullback in an uptrend consists of three consecutive down days with lower highs and lower lows. (or two down days and one inside day). That is what you want to look for in a pullback. You can buy the stock the first time it trades above the previous bar high.
C. The New-High-Dip. This setup consists of buying the first pullback or "dip" after a stock makes a new high. What makes this setup work so well is the consistency of human nature, which is the driving force behind all market behavior.
Here's how it works. After the initial flurry of buying that occurs when a stock breaks out to a new high, prices will usually pull back for a short breather. This retreat is almost always a buy and provides a safe entry on a stock that has obviously shown strength already.

EXITS

Ok, now that we know how to get into a trade, how do we get out? We need an exit strategy.
Your exit strategy consists of two parts: Where will you get out of the trade if the stock does not go in your favor? Where will you take profits if the stock does go in your favor? You have to be able to answer these questions before you can place the trade!
Part One – Your Stop Loss Order
You need a stop that makes sense and you need it to be out of the “noise” of the current activity in the stock.
Look at the average true range (ATR) of the stock over the past 10 days. If the average true range of the stock is, say, Rs 11, then your stop needs to be at least that far away from your entry price. The stop should be more than the ATR, probably 1.5 or 2 times.
Based on charts, your stop should go under a support area and a swing point low.
Part Two – Taking Profits
Use trailing stops! This is an easy and unemotional way of exiting a trade. If this trade is going to be a typical swing trade with a holding time of 2-5 days, then you can trail your stops a few rupees under the two day low. (This is the low of the last two days). Once you have spent 2 or 2 days in the trade, tighten the stop to just the previous day’s low.
Note: Initially, on the day of entry, your stop should be based on your stop loss order. the trailing stops come in, on the day your trade becomes profitable.
Please understand that success in trading comes with practice and experience.

Trend or Counter-Trend ?

2009-02-21T15:51:00.002+05:30

Who makes the most money - the trader who follows the trend or the trader who anticipates a trend reversal ?

Trend Traders are always late in entering the market. A trend needs to start before a trader can enter. Part of the trend is always over before the trader can plan an entry. Moreover, there is risk of the trend becoming mature just after a trader has entered. After all, no one can say how much more steam may be left in the trend.

The counter trend trader anticipates a trend reversal and enters almost at the point of the perceived reversal. He may often sell at the top or buy at the very lows. This is the stuff traders dreams are made of.

Charles Darwin said "It's is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change"

The Trend Trader is most responsive to change. He buys after the trend is up, therefore responding to the new circumstances. He sells after the trend turns down, again following the market.

The counter trend trader is probably the most intelligent. He forecasts what the market is likely to do. But this style of trading is fraught with risk. What happens if the market refuses to follow him ?

If a trend trader finds he is on the wrong side of the market, he takes a loss, in fact, often a series of losses. If a counter trend trader finds that the market is not obeying him, he waits for the market to respond. This can result in large profits, but often in large unacceptable losses.

There are very few counter trend traders but a large number of profitable trend traders. Ask yourself, how does a counter trend trader make money. By getting into a trend before it starts. So, it does come down to catching the trend, doesn't it ? The trend trader is humble and modest. He says the market is wise and "I will try to follow what the market does".

Blessed are the Meek for they shall inherit the earth.

Bob Farrells's Ten rules of Investing

2009-02-12T17:11:00.002+05:30

Bob Farrell is an acknowledged technical analyst. From his many writings, ten rules of market wisdom have been collected. I picked up these rules from The Big Picture. You can refer to it Here.
Bob Farrell's 10 Rules for Investing

1. Markets tend to return to the mean over time
When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people's heads. It's easy to get caught up in the heat of the moment and lose perspective.

2. Excesses in one direction will lead to an opposite excess in the other direction
Think of the market baseline as attached to a rubber string. Any action to far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.

3. There are no new eras -- excesses are never permanent
Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots. Look at how far the emerging markets and BRIC nations ran over the past 6 years, only to get cut in half.
As the fever builds, a chorus of "this time it's different" will be heard, even if those exact words are never used. And of course, it -- Human Nature -- never is different.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
Regardless of how hot a sector is, don't expect a plateau to work off the excesses. Profits are locked in by selling, and that invariably leads to a significant correction -- eventually. comes.

5. The public buys the most at the top and the least at the bottom
That's why contrarian-minded investors can make good money if they follow the sentiment indicators and have good timing.

6. Fear and greed are stronger than long-term resolve
Investors can be their own worst enemy, particularly when emotions take hold. Gains "make us exuberant; they enhance well-being and promote optimism," says Santa Clara University finance professor Meir Statman. His studies of investor behavior show that "Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks."

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
Hence, why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Watch for when momentum channels into a small number of stocks ("Nifty 50" stocks).

8. Bear markets have three stages -- sharp down, reflexive rebound and a drawn-out fundamental downtrend
Even with these sporadic rallies end, we have yet to see the long drawn out fundamental portion of the Bear Market.

9. When all the experts and forecasts agree -- something else is going to happen
As Stovall, the S&P investment strategist, puts it: "If everybody's optimistic, who is left to buy? If everybody's pessimistic, who's left to sell?" Going against the herd as Farrell repeatedly suggests can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest.

10. Bull markets are more fun than bear markets
Especially if you are long only or mandated to be full invested. Those with more flexible charters might squeek out a smile or two here and there.

Using Stop Losses, Janaury 16.09

2009-01-16T20:36:00.005+05:30

I received a comment about stop losses. I had mentioned that all my positions have stops. Srinivasgp wrote:
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....I just want to know how do you go about it? I am talking specifically for the overnight positions you hold. A big opening gap down/gap up can easily go beyond your stop losses. So are you suggesting that we should not be holding any naked positions (long/short) for positional trades and they should be hedged accordingly?
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A stop loss is maintained for every position that I hold. This can be a day trade or a position that is carried overnight. Now, there is always the possibility that the market can gap open against my position. In the current volatile environment this happens quite often. When this is so, I get out immediately. There is no hedging. An example: Nifty futures close at 2815. I am long in Nifty futures with a stop below 2740. The next day, Nifty fuures open at 2725. Since the market has opened below the stop, my stop is triggered (mentally) and I exit immediately.

I hold positions without any hedging. The reason is simple. I am prepared to take the overnight gap losses because I also get the benefit of the gaps in my favor. Moreover, the hedges cost money. Trading is a business of probabilities. If the trade is not working, get out. Why hedge ? This concept (of not hedging) may not be valid for investing, for the holding of positions for reasons other than trading.

I think of my stops as catastrophic stops. This is the point at which I have to accept that my trade is going against market momentum. Once I accept this fact, why should I hold on to the position ? The correct option is to exit immediately.

RSI2 Examples

2009-01-14T23:16:00.004+05:30

Here are live, real time examples for using the RSI2 method. Only the entries are discussed here. The complete strategy must include catastrophic stops, trailing stops, profitable exits, trading filters. The purpose of these examples is to stimulate your thinking.

NIFTY

The Nifty is in a down trend. We have a pattern of lower lows. The Index has also broken down from a trading range. In a dontrend, we are looking to go short. The RSI2 line is rising & has crossed 50. A short signal comes when the line turns down & starts falling. When the RSI turns down, sell below the low of the day on which it turns down. (Professional traders can check up the RSI values around 3:20 PM, before the close. If the line is turning down, the market is closing at its lows, they can anticipate the signal and go short. More risk. )

INFOSYS

The share is in an uptrend. The RSI2 is coming close to the 95 area. In an uptrend, this area is used to take profits. Exit any long positions once the RSI2 turns down. Sell below the low of the previous day.

Review of Short Term Trading Strategies that Work

2009-01-05T20:55:00.005+05:30

Larry Connors new book is reviewed Here. I strongly suggest that traders should buy this book. But, for starters, I am giving below the review by Damien.

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In this review, I’ll go over each chapter in brief, but I won’t discuss the specific strategy rules as I think that would be unfair to the author. I will also be starting to confirm the tests outlined in the book, and post some follow-up on the systems and whether I was able to reproduce the results, and how as the strategy done recently.

Chapter Overview:

Chapter 1 - Introduction: Not much to say here.

Chapter 2 - Think Differently - Rule 1 - Buy Pullbacks, Not Breakouts: This chapter makes the convincing argument that buying pullbacks has, statistically, worked far better than buying breakouts. While this is not news to me, the chapter presents some compelling information.

Chapter 3 - Rule 2 - Buy the Market after it’s Dropped; Not after it’s Risen: Basically a reverse of the prior chapter that continues the mean reversion as a strategy argument.

Chapter 4 - Buy Stocks above their 200-day Moving Average, not Below: This chapter shows how buying stocks/ETFs above their 200dma has a significant advantage over buying stocks below their 200dma.

Chapter 5 - Rule 4 - Use the VIX to your Advantage…Buy the Fear, Sell the Greed: Presents a basic VIX system in outline form (covered more in later chapters). The basic idea is to buy when the VIX is stretched.

Chapter 6 - Rule 5 - Stops Hurt: This chapter presents compelling stats on how much stops of different kinds (time stops, % loss, trailing) hurt trading systems. And this is without a doubt true. One issue I have with this approach is that I’m not sure most people could survive the drawdowns caused by this approach. A second issue is that not having stops takes away some pretty attractive position sizing techniques such a percent at risk or an ATR-based stop. His argument would no doubt be that those hurt the overall performance of the system, but in my limited experience I’ve found you can get more return out a system using position sizing. You can also translate that into options position sizing as well.

Chapter 7 - Rule 6 - It Pays to Hold Positions Overnight: Here Mr. Connor points out, again, using statistics, that most gains are made overnight rather than intraday. Thus, he argues that one should hold overnight to maximize profits.

Chapter 8 - Trading with Intra-Day Drops - Making Edges Even Bigger: This chapter shows how buying on a limit price below the open price can significantly improve the edge of a system. Obviously, there will be fewer trades as the percentage below the open increases, but Mr. Connors shows how both the percent correct and average gain per trade goes up. Definitely interesting stuff that I will be using.

Chapter 9 - The 2-period RSI - The Trader’s Holy Grail of Indicators?: I hate the title of this chapter - whenever I see the phrase “Holy Grail” I immediately think to myself that it is about to fail. But regardless, this chapter provides a comprehensive look at the power of the RSI(2) indicator. I’ve covered this a fair amount on this blog, so I don’t think much more needs to be said. This chapter also includes the Cumulative RSI strategy that I’m going to be testing myself over the next day or so.

Chapter 10 - Double 7’s Strategy: Not much I can say about this chapter without revealing the strategy - it presents a good simple trading strategy for the SPY when it over its 200dma.

Chapter 11 - The End of the Month Strategy: Michael over at Marketsci has been covering similar territory - Mr. Connors presents a strategy for focusing on the end of the month as a system.

Chapter 12 - 5 Strategies to Time the Market: This chapter covers, not surprisingly, 5 strategies. It builds out the VIX Stretch strategy, and then showcases another VIX strategy, a TRIN strategy, another Cumulative RSI strategy, and finally a short strategy for the SPY. All are interesting.

Chapter 13 - Exit Strategies: Here Mr. Connors reviews different exit strategies and their qualities. These include: time-based exit, first-up close exit, new-high exit, close above a moving average exit and the RSI(2) exit. The author provides detailed analysis of each exit. One criticism of the book here: he does not include stats on the first-up close exit and the new-high exit.

Chapter 14 - The Mind: I thought this chapter would bore me, but I found it surprisingly interesting. Rather than going on with the classic “trading in the zone” approach that has been covered numerous times, the author structures the chapter as a series of questions related to systems trading. Example: “You lose money for eight consecutive days and you’re long multiple positions as the market is imploding. What do you do? Get out?” My reaction to many of the questions (not that one because I have an answer) was “hmmm….I don’t have a good answer”. So more food for thought. There is also a long interview with Richard J. Machowicz, a former Navy SEAL, that may be of interest to some people but not me.

Positives:
Well written and easy to understand - even for someone without a lot of trading experience.
Very interesting strategy ideas - gave me lots of areas to explore. Favorites: Cumulative RSI and Double 7’s Strategy. Also interesting: the chapter on Exit Strategies.

Negatives:
The systems are a little lacking in detail. Are we entering on the close of the day the signal is generated, or on the open of the next day? While this may be somewhat obvious when looking at the charts showing entries and exits, I think beginning systems designers may find it confusing. The charts showing the sample trades don’t show dates - so if you’ve programmed the system and want to double-check the results, you have to do some guessing such as “When was the QQQQ between 52.50 and 52 on or around the 22nd of a given month?”
I actually find this a problem, in general, when people describe trading strategies in general. I’d love there to be some standard such as:
Entry:
- Indicator calculation (if appropriate): n/a
- Buy on: Open of the day following a signal.
- Position Size: Current Equity divided by number of positions
Exit:
- Indicator calculation: n/a
- Sell on: Open of the day following a signal.
Etc..
Much of the work in the book revolved around stocks/ETFs being above a 200DMA - and thus, there aren’t a huge number of strategies that will currently work.
As mentioned above, the systems don’t use stops. This may be unrealistic for many people, and limits your position sizing options. Simply saying “take your equity and divide it by the number of positions” keeps it simple but also gives no idea, for the trader, as to how much to risk.
Most of these negatives are pretty small - and I would strong recommend the book. For the beginning system designer, this book would be indespenible. For the experienced designer, you’ll probably find a gem or two that will spark some ideas of your own.

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The End of a Trend

2008-12-23T16:37:00.001+05:30

How does a trend come to an end ? This interesting question must be answered. After all, traders and investors are advised to exit when they perceive that the trend is facing a reversal. But what qualifies as a reversal ? Are reversal signals different for day traders, swing traders, position traders & investors ? This note will try to answer these questions.

How does the trend end ?

Trend is defined as a move of prices in any one direction. Prices keep on moving in one direction (up or down) offering opportunities for gains to people who participate in the move with the trend. At some point, sooner or later, all good things must come to an end. So also with a trending move. Technical Analysis provides many ways of identifying the exhaustion of a trend. Some of the methods are difficult, almost impossible to understand, leave alone follow. The simplest, easiest to understand methods are also the ones that are will survive different types of markets. The basic rules were defined by Charles Dow, then elaborated by Hamilton, Rhea, Edwards and Maggie, and, finally by David Fuller (fullermoney.com). My own ideas on trend exhaustion have been formed over a period of time based mainly on my perception of the markets and work of the masters.

Markets are dynamic, therefore signs of trend exhaustion will be different, every time a trend comes to an end. But, the broad patterns will be the same. After all, crowd psychology does not change.

Different Ways for the end of an up-trend

1. Distribution. After a sustained up move, momentum starts falling. Prices still go up, but at a slower pace. There are visible signs of a consolidation at current levels. Since the trend is up, it is assumed that the market will resume its up move after the consolidation is over. But, either through a large down day, or through a series of narrow range bars, prices eventually break down from the consolidation. This is a sign that the trend has reversed.

2. Trend Reversal. The up trend is defined as a series of higher highs and higher lows. After every upthrust, there is a brief corrective dip and prices then move up crossing the previous high. Usually, the dip will stop above the previous low. Eventually, after a dip, prices move up (as before) but fail to cross the previous high. Then a subsequent dip pushes prices lower than the previous low. A pattern of lower highs and lower lows is established thus reversing the uptrend.

3. Inverted V: While everyone is enjoying the upmove, prices suddenly fall, almost like a crash. If the price fall goes below a significant support level, then it is assumed that the up trend has come to an end. The difficult part is to define the 'significant support level'.

Different Ways for the end of a down trend

1. Accumulation. After a sustained down move, momentum starts falling. Prices still go down, but at a slower pace. There are visible signs of a consolidation at current levels. Since the trend is down, it is assumed that the market will resume its down move after the consolidation is over. But, either through a large up day, or through a series of narrow range bars, prices eventually break up from the consolidation. This is a sign that the trend has reversed.

2. Trend Reversal. The down trend is defined as a series of lower highs and lower lows. After every down move, there is a brief corrective rally and prices then move down below the previous low. Usually, the rally will stop below the previous low. Eventually, after a rally, prices move down (as before) but fail to cross the previous low. Then a subsequent rally pushes prices higher than the previous high. A pattern of higher highs and highs lows is established thus reversing the down trend.

3. The V: While everyone is staying away from the market which seems to be in a bear grip, prices suddenly rise, almost like a sudden thunderbolt on a sunny day. If the price rise goes above a significant resistance level, then it is assumed that the down trend has come to an end. The difficult part is to define the 'significant resistance level'.

These simple, easy to understand ideas are valid on all time frames for all types of trading & investing.

Inside Bars

2008-11-24T11:06:00.003+05:30

An Inside Bar is a sign of falling volatility. The current bar's range is within the previous bar's range. Another way of saying the same thing - an inside bar has a low greater than the previous bar's low and a high less than the previous bar's high.

Go with the Trend

Inside bars are a sign of indecision with the current trend ... we assume that the indecision will be resolved in favor of continuing the current trend. Therefore, if the current trend is up, traders should use the Inside Bar as a setup to buy. If the trend is down, use the inside bar setiup for a sell. If no trend is visible, then the inside bar has no technical significance, and, should be ignored.

How to Trade:

For entry and initial stop placement: buy as the stock trades above the Inside bar, sell as the stock trades below the Inside bar. A stop loss is placed on the opposite side.

What makes this pattern so successful?

For one, an inside bar means that there was just not enough interest in the stock to move it decisively one way or another. As sure as day follows night, so does an increase in volatility follow the restricted trading of an inside day. The stock becomes like a race horse ready to hit the ground running out of the gate.
You understand that inside bars are the perfect setup for a low risk entry into a stock. Start to spot this little pattern on a stock chart. It's the secret key to picking tomorrow's winner's - today!

Two Inside Bars

If one inside bar is profitable, then two inside bars (one after the other) should be even better! And they are. Two inside bars are like a coiled spring. A sort of Jack in the Box. The second inside bar (by definition) is inside the first inside bar.

Added Filtering

Make sure that the 5 period ema is in very close proximity to the the second inside bar. When this happens, a breakout from the inside bar will also see a breakout from the ema.

The Inside Bars should have relatively narrow range. If a wide range bar has been made, the enxt day's price action can easily be enclosed inside the first day (wide range) but this may not be a good example of an inside day because the inside dayw as ceareated only due to the earlier wide range bar. A good example of an inside day is a 'normal bar' and then an inside day. This inside ady will have a smaller price range, thus actually becoming a sign of falling volatility.

The Fifteen Minute Rule

2008-11-03T20:43:00.002+05:30

Intra day traders / Swing Traders often face difficulties in entering the market when there is a gap open. But the gap need not destroy your trading plan. You can do a quick analysis, adjust your trading strategy and get into a good position well after the crowd pulls the trigger on a gap play. Here is how.

Let the index/stock trade for the first fifteen minutes and then use the high and low of this "fifteen minute range" as support and resistance levels. A buy signal is given when price exceeds the high of the 15 minute range after an up gap. A sell signal is given when price moves below the low of the 15 minute range after a down gap. It's a simple technique that works like a charm in many cases.

If you use this technique, though, a few caveats are in order to avoid whipsaws and other market traps. The most common whipsaw is a trading range that lasts longer than 15 minutes. If an obvious range builds in 20, 25 or even 30 minutes , use those to define your support and resistance levels. Also consider the higher noise level in the morning. A breakout that extends only a tick or two can be easily reversed and trap you in a sudden loss. So let others take the bait at these levels, while you find pullbacks and narrow range bars for trade execution.

Difference between Loss and Risk

2008-10-28T23:14:00.001+05:30

Can you trade without a loss ? Suppose I say that yes, this should be the objective for every trader. Surely, the reader will finsd fault with this statement. No one can assure that every trade will be profitable. Again, you are correct. In fact, I usually say that trading losses are the cost of doing business.

So, what's the catch ?

I wanted to make a distinction between a loss that causes damage to your capital, and risk that is part and parcel of trading.

A loss occurs because of careless money management. The trader is fully responsible for such careless behavior. You must trade with the objective of zero losses.

Alexander Elder, in his book - Come Into my Trading Room, gives an example:

Imagine you’re not trading but running a fruit and vegetable stand.You take a risk each time you buy a crate of tomatoes. If your customersdo not buy them, that crate will rot on you. That’s a normalbusiness risk—you expect to sell most of your inventory, but some fruitand vegetables will spoil. As long as you buy carefully, keeping theunsold spoiled fruit to a small percentage of your daily volume, yourbusiness stays profitable.

Imagine that a wholesaler brings a tractor-trailer full of exotic fruit toyour stand and tries to sell you the entire load. He says that you canearn more in the next two days than you made in the previous sixmonths. It sounds great—but what if your customers don’t buy thatexotic fruit? A rotting tractor-trailer load can hurt your business andendanger its survival. It’s no longer a businessman’s risk—it’s a loss.

The Successful trader respects his money. She will never allow losses to overwhelm her capital. Many trades will not work out, and there will be small losses. Sometimes, there is a run of losses when several trades do not work out. That's trading.
The amateur trader will throw his money at wild ideas. As beginners luck, he is likely to make money initially, then lose his entire capital when the market refuses to give him money for his stupidity.
Understand the difference between loss and risk. trading is about management of risk, and zero allowance for losses.

Hedging your Bets

2008-10-22T20:20:00.002+05:30

An excellent write up on 'Coping with Challenging Markets by hedging your Bets - financial and personal' appears in the traderfeed blog Here .
Brett Steenbarger writes:
It really has been an amazing time; I've traded the equity markets since late 1977, and I've never seen market and economic conditions like these.
.....
Traditional logic says that such pervasive bearishness should lead to favorable market returns going forward. After all, who's left to sell when everyone is bearish? In normal times, that logic holds.
.....
Valuations from a leveraged world are transitioning to deleveraged valuations. In my personal financial planning, I'm assuming that such a transition will not occur in weeks or months. I am prepared for the possibility of subnormal stock market returns for years to come .
.....
Financial planning--even among supposed professional financial planners--becomes simplistic: either hold on and wait for the turnaround or bail out of everything and rescue what capital you can. Little wonder that so many investors are frozen, not knowing whether to stay the course or jump ship.
.....
Prudent investment planning, however, suggests that neither extreme is necessary. The important consideration is identifying which assets (stocks, bonds, etc.) are likely to outperform the general markets during any period of extended weakness and ground investment in those. Then, hedge your bets. If you think that some companies that offer value to consumers--or that offer necessities--will outperform those that do not, you can be long the attractive names and short the unattractive ones. Or you can be long the attractive names and short the broad stock market. You hedge your bet by reducing your exposure to overall market risk. Your investment becomes a relative value play, rather than an outright directional one.
.....
In difficult markets, there are always areas of relative opportunity.

My Notes: You should read the entire post. Thank you, Dr Steenbarger for this actionable set of ideas.

Trading Big News Events

2008-10-05T12:25:00.002+05:30

Trading in big news events is a long term strategy ( as opposed to day trading).
The trader needs patience to watch the trade develop. Once a trade is visible, it may often last for many weeks.

News Events can create two different trading opportunities - reversals, and, thrust.

Reversals

The news causes a sharp price move. The price movement is a short term reaction to the news. Once the euphoria / fear on the news is dissipated, prices will return to their original trend. After the news, the price movement reverses in a short while.
StreetSmarts, a book by Connors and Raschke discusses such trades in detail. Here is a summary of their suggestions.
1. We are looking for an unusual event which causes the market to move strongly.
2. Identify the closing price before the news driven move started.
3. Enter the Market at this closing price. "If the market can digest the radical event and come back to this closing price level, we want to participate in the reversing move".
4. "Risk with a stop up to the lowest level the stock reached after the sell off. For example, if a stock was trading at 20 before the event and it then sold off to 17, we will buy the stock if it comes back to 20 and risk, down to 17. "

Thrust

This is a news driven strategy which I call "The thrust". Prices react to News, then go through a reversal as discussed in Reversals above, then return back to break down below the low recorded in the first reaction. The Market is telling us that the News is really changing the environment for the stock. The effects of the news will be prolonged.

Here are the rules to trade such Thrusts:
1. Markets react to news.
2. Identify the lowest point in the reaction.
3. Wait for a correction to the intial reaction. The correction should generally be 50% of the decline from the pre news level to the lows in (2) above.
4. If prices begin their decline, go short below the lowest point in (2). Place a stop above the correction high in (3).

An example will make this easier. (1) Stock A falls from 450 to 410 on news. (2) A bounce to 435 takes the price above the 50% correction of the decline from 450 to 410. (3) We will go short below 410 with a stop above 435. Prices fall below 410, finally touching 350 in a few weeks.

Why we need rules to trade ? Because rules provide us with discipline. The rules tell us when we should be trading, and, how.

Five Mantras for Traders

2008-09-11T08:25:00.002+05:30

This is from Trading Success , a site by Ray Barros: I am repeating the words as it is. Many thanks to the website.

Your Daily Mantra:

1. The market pays you to be disciplined.
The constant truth is discipline equals increased profits. Without discipline, you will put less money in your pocket.

2. Be disciplined 100 per cent of the time.
If you trade with discipline nine out of ten trades, you cannot claim to be 100 per cent disciplined. This 10 per cent undisciplined trade will really hurt your overall performance. So discipline must be practised on every trade.

3. Love to lose money.
Traders ask: What do you mean, love to lose money?
What the rule means is that you are going to lose throughout your trading sessions. So, get out of your bad trade as soon as you realise you have made a wrong choice. This will save you a lot of trading capital and make you a better trader.

4. If your trade is not going anywhere in a given timeframe, it is time to exit.
This rule relates to the theory of capital flow. When there is price stagnation which happens often throughout a trading session, the market is telling us that they are happy with the prevailing bid and offer. You do not want to be in the market then and best to exit. It is a waste of time, capital and emotional energy. The market will heat up again and then you can re-enter the market with a new trade.

5. Never take a big loss, only a big loss can hurt you.
Never put yourself in a position of losing more money than you can afford. You are not a ‘loser’ unless you do not get out of the losing trade once you know the trade is no longer good.
Big losses wipe out too many small winners you have worked hard for. It is also psychologically devastating when you lose big as it may take a long time to build up your confidence again. Then you are a loser.

My Notes: I again acknowledge Mr Barros as the writer of these excellent mantras. I follow all five of these, although I could not have summed up my rules so well.
When I say that I follow all five of these mantras, it is not to go on any ego trip. It is to share with you the fact that traders can implement these rules in their trading plan, with a little bit of discipline. If I can do it, everyone can.

The Success Rate

2008-09-10T22:06:00.004+05:30

Honesty is the best policy.
My business follows this principle. as we believe that being fair makes more money in the long run. We offer a service called Day Vinayak which provides day trading setups for Nifty, Bank Nifty and a few stocks. Today, I picked up the phone as other people in the office were busy. This is how the conversation went:

Speaker: Tell me about the Nifty services you provide.
Me: Brief explaination.
Speaker: What is the success rate of these signals ?
Me: About 45% to 50%
Speaker: (Laughs) : Tab to baat nahin banegi. (Then things will not work out).
Me: (Thinking for an appropriate response. - Problem - I told him the truth, but the person wanted to hear something like this: we offer 95% accuracy. I cannot say this, since this will be a false statement).
Speaker: Okay. I wil think about the service. (Leaves the phone).

As I write this post, I checked up the correct percentage (of the sucess rate) - 52%. This means that 1 out of 2 trades loses money. This, to my mind is an excellent rate, since for the Bank Nifty the success rate is 39.58%. About 40% winners is about average for most trading methods that we use. The 'Turtles' - the world famous group of technical traders probably get 25% winners- and they are an extremely profitable group.

Why are newcomers obsessed with the success rate ? If I say - 95% success, then my signals make Rs 1/- for each successful trade. For 95 trades, we make Rs 95. Now the five losing trades lose Rs 20/- each. The losses are Rs 100/-. After 95% 'hit' rate, the trading signals will lose money - Rs 5/- losses for every 100 trades.
That's not all. The order in which the trades will come is never known in advance. Suppose the first two trades are losing trades. The surprised trader loses Rs 40/-. Do you think he will have the patience to go through 40 more trades, earning Rs 1/- from each one ?
The Success rate is the most irrelevant ratio in the entire trading methods universe. What is more important:

Consistency. The trading system should make its profits spread over a large number of trades. This ensures that just one or two trades did not contribute to its performance. The Nifty system had 138 trades from Feb 1, 2008 to Sept 10, 2008. Every month had a minimum of 12 trades, and at least 5 trades every month were profitable. Every month was profitable. The system has earned 2734 points from Feb 1.

Why Feb 1? Because the month of January was an exceptionally profitable month for most trading systems. Now, such a remarkable month may not come again (at least in the near future). Therefore, our test results start from February, ignoring January completely.

Tighten your Stops

2008-09-04T21:11:00.004+05:30

Often, this term is used to advise traders: The markets are volatile OR The market may reverse OR The market is looking overbought, So, 'Tighten Your Stop'.
How should the trader implement this advice to 'Tighten the stop' ?
The objective of 'Tighten your Stop' is to reduce the risk and/or lock-in profits. As we hold a position over time and the paper profits begin to build, we periodically adjust the Stops to lock a larger percentage of our gains as time passes by. By tightening the Stops, we reduce the risk of incurring losses - reduce the risk of allowing profits to slip away.
Process:
If you have a Buy (long) position, then:
1. Identify the nearest support level. This can be a Pivot Low, or a consolidation. Put your stop just below the support.
2. Calculate the 8 or 13 period moving average. Your stop should be moved just below the average. If you really want to tighten, then use a 5 period average.
3. Locate a Fibonacci retracement of the nearest up swing. Keep a stop at 50% retracement of this up move. If the 50% is far away, then use the 38% retracement, or even 23% if neccessary.
If you have a Sell (short) position, then:
1. Identify the nearest resistance level. This can be a Pivot High, or a consolidation. Put your stop just above the resistance.
2. Calculate the 8 or 13 period moving average. Your stop should be moved just above the average. If you really want to tighten, then use a 5 period average.
3. Locate a Fibonacci retracement of the nearest down swing. Keep a stop at 50% retracement of this down move. If the 50% is far away, then use the 38% retracement, or even 23% if neccessary.
Discipline
Once a stop is installed, it cannot be moved lower for a buy and higher for a sell. Stops for buy positions can only be moved higher, while stops for short positions can only be moved lower.

Signs of Strength and Weakness

2008-09-01T18:24:00.004+05:30

A common phrase used by Analysts is to watch for 'Strength' or "Weakness' and take action accordingly. I must confess that I have been guilty of using these phrases myself.
In my blogs, I repeat the point that all trading notes must converge in actionable ideas. Before action can be taken on the presence of strength or weakness, it is fair to ask: What is Strength and Weakness ? How can it be identified ?
Strength and Weakness are associated with Support and Resistance. Markets will reach support, then hold it. Often, prices will touch resistance, then fail to cross it. The reverse can also happen, as the Market touches support, then breaks down to move lower, as also touches resistance then breaks out to move higher.

But the basic concept is:

Strength is Support holding out, not getting broken on the downside.
Weakness is Resistance holding out., not getting broken on the upside.

Let me take an example. An intra day trader is waiting to buy on signs of strength. The Market is falling. He waits patiently. At some point, the decline stops, a trading range develops. The trading range is support. If prices move up from the range, this will be a sign of strength. The range also allows the trader to execute a low risk trade since a breakdown from the range is a clear signal that the trade is not working out.
How do you identify a support in the making ? The answer is 'momentum'. As prices decline, momentum is on the side of the bears. At some point, the decline stops. Now, the bears do not have the benefit of momentum. This fall in downside momentum is the first sign that there may be support coming in. It could easily be just a pause before a new down move begins. That's not easy to predict. But then, it could also slowly lead to a trading range, then an upside breakout from the range. When this happens, the message is: there is support. This is a sign of strength.

Support does not come from Numbers. This should be clearly understood. When, for example, I write that support comes in at 4200, it does not mean that the market will, as if by magic, stop falling when it reaches 4200. What this means is: As the market reaches 4200, look for signs of support to emerge. These signs are the ones explained above. The focus should still be on the patterns discussed here, decline in momentum, trading range, eventual breakout. The number 4200 is a likely place for this pattern to emerge.

Resistance follows the same methods as Support, just on the reverse. If resistance holds, then we say there are signs of weakness.

Formal Learning in Technical Analysis

2008-08-30T21:41:00.003+05:30

A Technical Analysis certification is provided by International Federation of Technical Analysts. This is called the Certified Financial Technician (CFTe) Program. Traders as well as Analysts should aim to get this certification.
The program is designed for self-study.

The Other Side of a Futures Trade

2008-08-28T21:00:00.003+05:30

In a futures trade, there is a buyer for every seller, or vice versa. If buyers and sellers are matched, then what is this issue about open interest ? Yes, buyers and sellers match, but the important factor to know for price discovery is which side is initiating the trade.
In recent weeks it was the short side: Funds selling. The longs and shorts matched, but the impetus for the trades was selling. Thus, prices fell. At other times, if the impetus is from heavy buying, the buyers initiate the trade.
Open Interest (OI) is then related to the price of the security. if OI went up while the price went down, it is assumed that fresh trades were intiiated by the sellers. If OI went up when prices went up too, fresh trades were initiated by buyers.

Probability is the cornerstone of Trading

2008-08-24T21:37:00.009+05:30

No one can predict the future with certainty.
Meither I, nor you, nor the top traders in the world can tell you what the market will do in the next minute, hour, day or week. Traders have to operate in an environment of uncertainty.
How then do traders make money in the market ?
The asnwer is: probability.
Consider a trader who trades only head and shoulder patterns. His research tells him that 5 out of 10 patterns will be profitable. He makes 100 points on each profitable pattern, while he restricts his loss to 50 points on each failed pattern. In the long run, he will make 250 points for every 10 patterns he trades in.
Based on the past research, the trader has a strong probability of making profits if he consistently trades these head and shoulder patterns.
Will the trader make money on each trade ? NO. He will make money on a series of trades because in the long run, probability is in his favor.
Suppose you ask the trader to tell you what his next trade will be. Then you take that trade. Will you make money ? Not neccessary. What the trader is doing is to take 10 trades by which time probability should ensure that he makes a net profit. Thus, asking a successful trader for 'Tips' may still cause you to lose money while the trader remains successful.
Success in trading is far more dependent upon the understanding, acceptance and application of probability principles than any other factor.

Three books to read over the weekend

2008-08-23T18:52:00.004+05:30

Here are three books to start reading. They are available as low priced Indian Editions of American originals from http://www.visionbooksindia.com/ .
Technical Analysis of Stock Trends by Edwards & Magee
Timing the Market - How to Profit in Bull and Bear Markets With Technical Analysis
by Curtis M. Arnold
Swing Trading - A Guide to Profitable Short-Term Investing by Marc Rivalland
What you should gain from reading them -
Ta of stock trends: Bible of chart analysis. Use as a reference to understand how a pattern is identified and traded. The second section on tactics, written 60 years ago is applicable to traders even now.
Timing the market: Develops your mental strength, provides an explaination of why TA works and how.
Swing Trading: Introduces you to the nuts & bolts of swing trading.

Using Cycles in your Analysis

2008-08-20T22:24:00.004+05:30

Here is a contrarian reason to use cycles: most traders do not use them, so there is probably some advantage to use a method not frequently used.

There are cycles of optimism and pessimism in humans. Since the market consists of human emotions it is fair to expect the market to also have some kind of cyclical patterns. But, the market will not move in fixed patterns.

Using cycles can some times ensure buying near the lows and selling near the highs. This will not happen always, but it does provide low risk opportunities.

You should get started on cycle analysis by reading on J M Hurst. He was an aerospace engineer and a pioneer in the use of computers in cycles. His book: the profit magic of Stock market timing is a classic on the subject. Do a google search for "Hurst Cycles".

Hurst explained the concept of channels around centered moving averages. Buy when prices go below the lower channel, then come back in the channel. Sell when prices go above the upper channel then come back inside the channel. The problem is that centered averages are created by moving back in time, thus today's value will be available after many days.

This problem is solved in the chart given here. Here is a chart with the Hurst centered moving averages. But, these averages have been extended to the last bar giving current trading signals.

There are two channels - for the long term trend and the current trend. The moving average period is calculated by identifying cycles on the security - in this case the Nifty. Here we have a 136 period long term cycle and a 39 period short term cycle. looks good ?

Risk Management: The rationale behind Stop Losses

2008-08-16T22:49:00.001+05:30

Stop losses are essential for the profitable trader. If you do not use stops, then your risk becomes unlimited. When this happens, your risk to reward ratio is no longer in your favor.
Traders make money by having more profits than losses. This requires that profits should continue to move up, but losses should be kept small. To keep losses within limits, stop losses have to be used. Also, to keep profits higher than losses, the profits have to be actually realised, requiring a strategy for profit targets or trailing stops.
I am often asked the question: Where should I place my stop ? 1% below or Rs 50/- below the entry price ? My feeling is that the trader is asking the wrong question. A stop loss represents a point at which the trader accepts that the trade is working against him. He then takes the loss and exits the trade.
Now come two important issues: First, If the stop loss is likely to be beyond the acceptable loss limits then the trader does not take the trade. Here, the 1% or Rs 50/- or similar number comes into play. You may decide that a 1% stop is the maximum that is acceptable based on the trading plan that you create. Then, a stop loss that requires you accept more than 1% is not acceptable. In such cases, you do not take the trade. First, the stop loss point is determined when the trade is taken, not later.
Now, the entire discussion of stop losses requires that you have a basis for your trade. If there is no basis, then you will never know that the trade is not working out.

Indicators, Patterns, Signals, & Systems

2008-08-16T19:12:00.001+05:30

Market Technicians should understand the different uses of Technical Analysis in the form of Indicators, Patterns, Methods & Systems. All of the four have seperate purposes while also having many common elements.

1. Indicators

In the context of technical analysis, an indicator is a mathematical calculation based on a securities price and/or volume. The result is used to identify current trend and predict future prices. Common technical analysis indicators are the moving average convergence-divergence (MACD) indicator and the relative strength index (RSI).

2. Patterns

In some instances chart analysis indicators such as head and shoulders formations, trendline support and resistance, etc. are difficult to quantify, but they are still considered useful tools to determine trend and future price action. These are called patterns.

3. Signals

A signal is a higher level of analysis, above Indicators and Patterns. Signals add focus to the Technician's efforts. A signal tells the trader when to buy, sell or liquidate a position. A signal can be an individual indicator, or it can consist of a collection of indicators, which when combined, yield to a decision to buy, sell or hold. While the MACD is an Indicator, it becomes a signal when the trader says: I will buy when the fast line crosses above the slow line below zero, with the MACD having a value of 12,26,9. This is a signal.

4. Systems

A trading system consists of specific signals, clearly defined, combined with a set of risk management rules, all designed to make trading objective and mechanical. A signal may consist of objective rules for entering the market. Then what ? How should the trader take profits, what is the stop loss to be put in, what volumes to trade, is the market conducive for trading the signals. these questions need to be asnwered before the trade can be put in. The Trading System provides rules to examine and answer all questions relating to the trading plan.

What should a trader use : Indicators, Patterns, Methods or Systems ?

Simply stated, if it works, use it!

Systems are the best methods for trading the markets. The development of systems requires professional knowledge & hard work. That's not all. The actual trading of the signals generated by these systems requires tremendous amounts of discipline. Therefore, while systems make the most money in the long run, very few traders will be able to stay with the system develoment and trading process.

Traders should start with the use of signals as part of a basic trading plan. They should use an indicator or a pattern or both, with clearly laid out rules for entries and exits. This is fairly easy to achieve. The end result will be a disciplined approach to trading the market. You can asdd value to this approach by keeping a trading journal. The Journal will become your guide to identifying what works and when.