Active Traders - Active Trader Magazine 2003 April Issue

2 E d i t o r ’s Note3 C o n t r i b u t o r s4 Chat Room

Inside the Market: By Jeff Ponczak6 Finding the best definition of best execution

The SEC has many things to consider when deciding its best execution policy — particularly since it’s so difficult to define best execution.

9 What’s a commission really worth?Is the price a broker charges for commission reflective of the service they provide?

10 Quick Scalps

1 2 Web Watch: Best of the WebBy Active Trader Staff

1 4 New Products

1 5 Tra d e r ’s BookshelfA review of Gerald M. Loeb’s The Battle for Investment SurvivalBy David Bukey

1 6 Technology for Tra d e r sSoftware Screening: Ensign Windows Reviewed by David Bukey

Trading Stra t e g y1 9 How to trade broadening tops

It’s not one of the best-known reversal patterns, but the broadeningtop has the ability to identify major turning points.By Thomas A. Bierovic

23 Opening shotsTwo types of narrow-range bars set up short-term trades in stocks and futures.By Thom Hartle

26 Outside bars: From concept to strategy The outside bar is one of the simplest price patterns around.Here’s a look at the process of attempting to use it as the basis for a trading system.By Timothy Andrews

29 Trading System Lab: Trend with pattern entry

Futures and Options Watch :By Jeff Ponzcak31 The Merc speaks out

After a mandatory quiet period, the Chicago Mercantile Exchange discusses becoming the first U.S. exchange to go public.

32 Euro(N)ext for CBOTThe Chicago Board of Trade chooses EuronextLIFFE to be its new electronic-trading platform provider.

32 “Down” year for options still very busyAlthough yearly options volume was down from its 2001 totals,it was still quite a busy year for the options exchanges.

33 Eurex comes to the U.S.European exchange Eurex announced its plans to begin trading U.S.-based products.

3 3 Fast Fills

34 Futures and Options Trading Stra t e g i e sThe RSI trendline methodLooking for a simple way to enter trades? Using trendline analysis on the relative strength index (RSI) can provide solid trend-following signals.By Thom Hartle

37 Futures Trading System LabTrend with pattern entry

39 Futures Snapshot

40 Active Trader Intervi e wRelatively speaking: John BollingerA conversation with analyst, commentator and money manager John Bollinger about the current market and the opportunities and challenges facing traders in the years to come.By Mark Etzkorn

46 The Face of Trading: From pennies to patternsBy Kira McCaffrey Brecht

47 Risk Control and Money ManagementRoad to ruin Probabilities can tell you a lot about your trading strategy,but they have a limit. Case in point: The probabilities of losing your trading stake using risk-of-ruin calculations. By Active Trader Staff

Trading Basics49 Taking a different route

New to stock trading? Learn how Electronic Communication Networks (ECNs) function and the benefits they provide traders.By Jeff Ponczak

52 Indicator Insight: TSI/Ergodic oscillatorBy Active Trader Staff

5 5 Technical Tool Insight: GapsBy Kira McCafffrey Brecht

58 Trading and Investing: Give me land, lots of land…What’s really important when assessing housing stocks? Hint: It’s not what you might think.By Peter Navarro

61 The Business of Trading: The proof is in the returnA comparison of tax forms shows the benefits traders have over investors.By Robert A. Green, CPA

65 After Hours66 Trade Diary

ACTIVE TRADER • April 2003 • www.activetradermag.com 1

APRIL 2003 ISSUE

2 www.activetradermag.com • April 2003 • ACTIVE TRADER

E verything’s relative in the markets. Today mightbring a two-week high, but that high might also bethe latest in a series of five lower swing highs overthe past few months. Tomorrow’s horrendous sell-

off may be its biggest losing day in six months, but does thatovershadow the fact a market just con-cluded its best three-month upswingin the past two years? It’s all a matterof perspective.

Of course, perspective can be diffi-cult to come by when a generation oftraders raised on bull are suddenlyf o rce-fed a steady diet of bear.Disappointment with recent marketperformance is just one part of the lim-iting “Up good, down bad” mentalitythat dominates the public investmentpsyche.

This is not to argue that bear mar-kets in stocks are simply interchange-able with –— or just as desirable as —bull markets, when it comes to trad-ing. It’s just that there might be moreopportunity to make lemonade withthe current market lemon than we’veled ourselves to believe.

At least John Bollinger thinks so. The subject of this month’sActive Trader Interview, Bollinger has been around longenough to see the market hit more than a few highs and lows.And while the market has blindsided millions of investorsover the past three years, Bollinger thinks things are prettymuch unfolding according to historical script, and he seesplenty of juicy scenes for traders in the future.

In “Relatively speaking: John Bollinger” (p. 60), the analyst,commentator and developer of the trading bands that bear hisname explains why he thinks the market may be stuck in arange (a very, very big one, that is) for quite some time — andwhy this environment might offer great opportunities fortraders with the ability to accept and trade the market for whatit is. After all, today’s conditions are similar to those Bollingerfirst experienced when he started his career in the late 1970s.At the time, traders who recognized the market’s oscillating

nature and capitalized on its intermediate-term swings wereable to continue taking profits out of a market investors hadgiven up for dead years before.

Relativity also rears its head in the Trading Strategies sec-tion. Relative low-volatility and high-volatility patterns pro-vide the background for two articles this month. “Openingshots” (p. 36) analyzes different techniques for trading narrow-range bars (including inside bars), while “Outside bars: Fromconcept to strategy” (p. 40) uses outside bars to illustrate the

process of developing a trading strat-egy, starting with an observation andbuilding up to strategy rules and testprocedures. The Futures Strategy sec-tion shows how the relative strengthindex can be used as a trend tool(rather than a momentum oscillator)and the basis for a T-bond futures sys-tem.

No solution to any trading problemis perfect. Each involves trade-offs.Making a choice about how to use aparticular strategy is a matter ofdetermining if the rewards are worth-while relative to the risks.

Finally, if you haven’t been to ourWeb site in a while, you should take alook. In addition to our expandingmenu of market commentary, we’veopened message boards wheretraders can exchange ideas about

everything from strategies and software to the economy andtrader tax issues, a trading Web site directory, a trading dic-tionary and resource center, and — most importantly — anonline store where you can purchase articles from past issuesof Active Trader and download them immediately to your com-puter. See what’s new at www.activetradermag.com.

Mark Etzkorn, Editor-in-chief

EDITOR’SNote

There might be moreopportunity to makelemonade with the

current market lemonthan we’ve led

ourselves to believe.

T H E O RY of relativity


q Thom Hartle is a private trader and president of Market A n a l y t i c sInc. (www.thomhartle.com). In a career spanning more than 20 years,Hartle has been a commodity account executive for Merrill Lynch, vicep resident of financial futures for Drexel Burnham Lambert, trader forthe Federal Home Loan Bank of Seattle and editor for nine years ofTechnical Analysis of Stocks & Commodities magazine.

q Peter Navarro ( w w w. p e t e r n a v a r ro.com) holds a Ph.D. in economicsf rom Harvard University. He is an associate professor of economics atthe Graduate School of Management, University of California-Irvine,and the author of If it’s Raining in Brazil, Buy Starbucks: The Investor’sGuide to News and Other Market-Moving Events (McGraw-Hill, 2001).

q Thomas A. Bierovic ( t b i e [email protected]), p resident of the Synerg yTrading Group, has been successfully trading his own account since1971. He has presented technical analysis and trading seminars at con-f e rences in the United States and more than 40 other countries. He is theauthor of Playing for Keeps in Stocks & Futures: Three Top Trading StrategiesThat Consistently Beat the Markets. His daily stock recommendations (anda free copy of his new e-book, Synergetic Trading) are available at www. s y n e rg y t r a d-e r.com.

qKira McCaffrey Brecht, a Chicago-based financial writer and technicalanalyst, has been writing about the markets for 12 years. Posts duringher career include Chicago bureau chief at Futures World News, techni-cal analyst at Bridge News and market analyst at MMS International.

q Tim Andrews ([email protected]) is a Chicago-based trader,analyst and system designer active in both the stock and futures markets.

q Robert A. Green ( i n f o @ g re e n c o m p a n y.com) is a CPA and his firm,GreenTraderTax.com, consults traders on tax solutions, reviews orprepares their tax returns, and sets up business entities and retirementplans. GreenTraderTax.com also specializes in hedge-fund creationand management, and offers trader tax guides and trade-accountingsoftware. For more information, visit www.greentradertax.com or call(212) 658-9502.

q Dion Kurczek ([email protected]) is a private trader, software engineer andtrading system researcher. In 2000 he founded Wealth-Lab Inc. and launched aninteractive trading system development laboratory on the World Wide We b(www.wealth-lab.com). His firm produces trading system development and back-testing software for traders.

q Volker Knapp has been a trading system researcher for more than 15 years. He ispresident of the VTAD (the German branch of the International Federation ofTechnical Analysts) and co-founder of Wealth-Lab Inc. He was also a professionalhockey player and coach.

THIS MONTH’S Contributors


Breaking news

I’ve been doing my trading research for quite a while now and I’mgetting close to going online with real money. (With little or no edu-cation or skills, I had tried day trading in 2000 during a three-week

vacation from work.) My question begins with a recent observation: On Dec. 24, 2002,

AGN opened at 52.64. At 10:01 a.m., BusinessWire announced AGNreceived an FDAapproval (stock rallies to 53.90). At 10:16, www.brief-ing.com posted the story (stock rallies to 56.00). At 11:18, Reuters post-ed the story (stock rallies to 57.15).

What newswire service is going to offer me the quickest news direct-ly to my monitor (not e-mail or fax, and not from a list of stocks that Ipre-select)? From the above example, BusinessWire would be the one,but I don’t believe they offer individuals the service that I’m lookingfor. If I had www.briefing.com or Reuters I would not have had theopportunity to make money on this news. I would appreciate any helpthat you could give in this matter.

—Patrick

Hey, how did that three-week day-trading stint in 2000 work out? Nevermind. Don’t ask, don’t tell — that’s our policy.

And now, on to the news: Having spoken to several traders (and from per -sonal experience), the bottom line is no single news service will always be firstin line. One service will be first one day, a different one will be quickest thenext day. Some of the traders we spoke to feel some services are quick in cer -tain areas — e.g., economic releases, earnings numbers, and so on. One thingyou can do is ask a particular source or site if they are buying their news fromsomeone else; if you really need space, there’s no point in using a service that’sredistributing news.

Some trading or analysis platforms will include several news services, orthe option to subscribe to more than one. Head-to-head comparison is reallythe only way to find one that gives you the most “scoop” for your buck. Onepiece of stand-alone news-tracking software, NewsWa re (www. n e w sware.com), combines multiple news and analysis services and allows you toset up various filters and alerts.

A commitment to trading

I actively trade both the S&P E-Mini andNasdaq E-Mini. I was reading your interviewwith Larry Williams in your December 2002

issue and he mentions two indicators, theCommitment of Traders (COT) and the AdvisorySentiment Index. How I can get these indicators?Any help you can provide would be greatlyappreciated.

— Jan A. Verleur

Besides the CFTC site (www.cftc.gov), LarryWilliams says Genesis data (www.gfds.com) hasthis information. CSI Data (www.csidata.com)also provides COT data. A quick Web search pro -duced a few other possibilities for COT analy -sis: Trading Systems Analysis Group (www.tsagroup.com), which offers COT data and analysistools, and MarketPit (www. m a r k e t p i t . c o m ) ,which has COT charts.

The first thing you may want to do, though,is ask your broker (and software vendor, if theyaren’t the same) if they have that information.

Six of one, 2000i of the other

Iam an Active Trader subscriber and I useTradeStation 6 (TS6). It seems that most ofthe code on your Web site is for TS 2000i.

Why? I am a novice when it comes to EasyLanguage

and one of the most attractive parts of yourmagazine is the fact that the ideas are coded for

CHATRoom


New York, New York

I have been a proprietary trader trading New York StockExchange stocks for the last three months. I trade with a firm inCanada. Because I was the first group of trainees with this com-

pany, they didn’t really have much of a strategy for us to follow. Iwas just wondering if there were any tips (i.e., dealing with a spe-cialist, technical analysis, differences between the NYSE and theNasdaq) for day trading the NYSE. Most of the material out thereseems to be Nasdaq-oriented.

— Dan Roch

Strategically, there’s no real difference. Technical analysis is technicalanalysis, whether it’s applied to NYSE or Nasdaq stocks on an intradaybasis, or the crude oil market on a long-term basis.

Tactically, the primary difference between trading NYSE and Nasdaqstocks are their respective specialist and market-maker systems and theirslightly different uptick rules. Because order flow always goes through adesignated specialist on the NYSE, and because specialists are required tofill customer orders before their own (ifthose orders are at the same price),some traders look for situations inwhich the specialist may be alone onthe bid or offer, and then trade“with” the specialist.

Active Tr a d e rhas pre v i o u s l ypublished articlesdealing specificallywith trading NYSEstocks. Check out“Playing the special -ist’s game” in the May2000 issue; “Bullish onthe Big Board” in theJan. 2002 issue; and“NYSE short selling:Bear raid warning” in theJuly 2002 issue. All threearticles are written byChristopher A. Farrell.

These articles, as well as all other pastarticles, can now be purchased from theActive Trader Web site (www.activetradermag.com). Click on the “down -load articles” link at the top of thepage.

Questions about an article or trading issue? Send them to [email protected]. Active Tr a d e rreserves the right to edit letters for clarity and length.

easy use — that is, unless the code won't “veri-fy” because it’s written for an outdated (at leastin my humble opinion) system. Please add TS6code!

— Scott Miller

We began publishing code for indicators andstrategies before TradeStation updated to TS6—hence the 2000i code. However, more recentadditions to the code page have been writtenon the TS6 platform. Yes, some older code willtake some tweaking to make it usable in newprogram iterations, but that’s unavoidable.TradeStation has a new version of its softwarein the wings, and it may render some TS6 code“unverifiable,” too!

Connecting the connections

I read in a previous Active Trader article thatthere is a router on the market that candynamically switch Internet connections if

one (such as cable or DSL) should fail. I cannotremember what month the article was in, but Ibelieve you would just plug in a Cable modem,DSL line, and even a 56k backup line. The routerwould use the primary line unless it was notfunctional, and in that event it would shift tothe next line. Can you help?

— Bob Byrne

The product you’re referring to is the NexlandPro800 Turbo router. Our article on the product,written by David Bukey, appeared in theJanuary 2003 issue. As you mentioned, it allowsyou to plug your broadband and dial-up connec -tions into one central port, and it switches con -nections if one fails.


I t wasn’t all that long ago that bestexecution in the stock market wasa concept more than an actualrule. Sure, there was legislation on

the books that required it, but nobody(from the brokers to the regulators) paidmuch attention to it. The trading publicwas essentially at the mercy of brokers,who may or may not have filled theircustomers’ orders in a timely manner,and may or may not have done it at thebest price available.

H o w e v e r, advanced technologieshave changed all that. ECNs allowtraders to execute trades in fractions of asecond, and there are myriad placestraders can find the best bid/offer for aparticular stock.

As a result, there is more emphasis onbest execution than ever before. TheSecurities and Exchange Commission(SEC) has mandated all execution ven-ues provide data on how fast they exe-cute an order and at what price. This hasallowed for a direct comparison betweenexecution firms.

Still, best execution means differentthings to different traders — scalperswant an order filled at the price showingon their screen; institutional investorswith a one-million share order are moreconcerned about their order gettingfilled quickly than they are about price.

In the third of a three-part seriesexamining challenges facing the SEC,we’ll look at the issues surrounding bestexecution and the difficulty of keepingall market participants happy.

What does it mean?With the exception of trades executedthrough ECNs, all orders are first sent toa broker, who then sends the order to beexecuted. Although the bro k e r / d e a l e rdoes not necessarily oversee the execu-

tion of the trade, SEC rules say it is theb roker/dealer who is responsible forensuring the customer receives best exe-cution.

In theory, this puts the onus on theb roker/dealer to find an executionvenue that consistently provides the bestexecution. The problem, though, is find-ing a comprehensive, objective defini-tion of best execution.

“Best execution is a combination ofthings including speed, effective spread,price improvement, liquidity and cost ofexecution,” says David Herron, CEO ofthe Chicago Stock Exchange. “As eachbroker/dealer builds a business modeland chooses which markets to go to, theyare able to compete for customer busi-ness. The customer will vote with theircommission dollars.

“The exchanges are also required toprovide for best execution in makingsure the specialist and floor brokers are

looking out for the bestinterests of their customers,” he says. “Ifthey don’t, the system breaks down.”

When execution data is reported bymarket participants, all price data iscompared to the national best bid/offer(NBBO). The NBBO has long beenaccepted as the “best” price available inthe marketplace. However, even that isnot as cut and dried as it seems.

“The simplicity of the NBBO is not assimple as it seems,” says Matt DeSalvo,managing director of Morgan Stanley’sequity division. “When we have anunequal playing field with re g a rd toaccess standards and access speeds, youcannot determine price as the standardfor best execution. If we don’t addressequal access standards, we cannot getgood determination of price as best exe-cution.”

From an access speed standpoint, theinequality is apparent when both an

INSIDE THE Market BY JEFF PONCZAK

Good, better, best?

Finding the best definition of best execution


ECN and a floor-based exchange areshowing the best price. An order sent toan ECN can be executed immediately; anorder sent to the floor may be held by thespecialist, and price may change beforethe order is filled.

On the other hand, the price shown onECNs does not take into account accessfees. In the case of floor-based ex-changes, no fees apply.

“At a minimum, a price in one marketshould be equal to another market,”DeSalvo says. “When I access a $10 bid,it should be 10 to me, not 10 plus anaccess fee. In addition, there should be aminimum level of access standard sbetween markets. At that point, you atleast have a skeleton to work with.”

The missing link?One plan that has been suggested morethan once is connecting all market partic-ipants via high-speed linkages and giv-ing all execution venues auto-executioncapabilities.

Not surprisingly, the floor- b a s e dexchanges are reluctant to support anyplan that would diametrically change abusiness model that has been successfulfor decades.

“There are a lot of ways to access theNYSE,” says Chris Quick of FleetTrading, an NYSE specialist. “Linkage isnot a problem.”

One of those ways is the IntermarketTrading System (ITS), an electronic plat-form that gives other exchanges access toNYSE quotes. For years, ECNs had noaccess to the ITS and therefore no abilityto post NYSE quotes.

Some ECNs have since joined the ITSthrough Nasdaq, albeit reluctantly. TheITS allows a three-second delay from thetime an order is received to the time itmust be acted on. For an ECN, three sec-onds is a lifetime, and even Quick admitsthe ITS has its flaws.

“In 1975, it probably accomplished theobligation of best execution,” he says.“I’m not sure today that it’s the vehicle tocontinue on to the future.”

Additionally, ITS rules prohibit a mar-ket from trading through the quotes ofany other. So, if a specialist is sitting onthe best bid or offer, it may be a whileb e f o re anything can be done in thatstock.

“[No trade-throughs] would makesense if all quotes were electronically,instantaneously reachable, but they arenot,” says Thomas Peterff y, chairmanand CEO of direct-access firm InteractiveBrokers. “These rules provide traditionalexchanges somewhere between 30 and90 seconds to decide if they want to tradewith an order or not.

“The SEC should examine whetherexchanges and ECNs with electronicallyaccessible limit order books could be cutf ree from ITS participant quotes,” hesays. “If the answer is yes, these elec-tronic venues could form their own ITSrules. There are a sufficient number ofthem, so you could certainly come upwith a fair price.”

The members of the ITS are consider-ing changing the rules to allow trade-throughs.

DeSalvo thinks any discussion of link-

age is moot unless equal access and feestandards are first addressed. Obviously,those from the electronic-trading arenadisagree.

“How do you have equal access whenyou have floor-based models and elec-t ronic models?” says Janet A n g s t a d t ,associate general counsel of Archipelago.“When you’re an electronic market andyou’re trying to access a manual market,what does that mean for you? Linkage isa good next step, and then we can decidewhat access is for each individual mar-ket.”

Another idea floating around is that ofletting the customer decide what bestexecution is. If the customer desire sspeed, then his broker will be judged onhow fast he fills an order. If he desiresprice, that will be the benchmark.

However, Peterffy thinks drawing dis-tinctions between the two is silly.

“The only reason people want speed isbecause they worry price will moveaway from them,” he says. “So it’s onlyprice we are into. Best execution certain-ly means the best aggregate price for theorder.”

Fee, fi, fo, fumM o rgan Stanley’s DeSalvo is by nomeans alone in his displeasure of ECNfees. For firms such as Morgan Stanleyand others that operate as both tradersand market makers, the system has itsinequities.

If A rchipelago routes an order toMorgan Stanley for execution, there is noaccess fee involved (in fact, it is forbid-den by SEC law). However, if MorganStanley goes to the Archipelago book toexecute a trade, that trade comes with anaccess fee.

“We have the same business model,”DeSalvo says. “But we can’t charge anaccess fee.”

In defending the ECNs, Angstadt saysevery participant should be able toc h a rge an access fee. And, Nasdaq’sSuperMontage trading platform givesusers a choice of viewing prices with orwithout access fees being considere d .Moreover, she says, other market partici-pants charge transaction fees.

“Why are we making a distinctionbetween transaction fees and accessfees?” Angstadt asks. “If, as a service, I

“The simplicity of the

NBBO is not as simple as

it seems. When we have

an unequal playing field

with regards to access

standards and access

speeds, you cannot

determine price as

the standard for best

execution. If we don’t

address equal access

standards, we cannot get

good determination of

price as best execution.”

—Matt DeSalvo, Morgan Stanley


am providing liquidity and I am able tocharge a transaction fee, why should Ihave to give that product away?”

Complicating matters even further isthe fact that ECNs and the Nasdaq pro-vide rebates to traders who add liquidityby placing limit orders. Some see thispractice as no different from payment foro rder flow, a controversial activityinvolving execution venues paying bro-ker/dealers for the right to execute theirorder flow.

Critics of payment for order flow claimb roker/dealers send their orders to theparticipant who pays them the most, notnecessarily the one who will provide thebest execution. Likewise, critics of marketrebates believe it will give certain partici-pants a disproportionate amount ofo rders, even if they are not the best venuefor executing them.

H o w e v e r, Angstadt says there is aclear distinction between rebates andpayment for order flow.

“When people pay for order flow, it’sbecause they believe they can make a lotof money on that order flow,” she says.“On a rebate, we’re glad to give someback because we have saved money bybeing able to cross order internally. Wewant to pass those savings along.”

The system makes perfect sense toPeterffy.

“Liquidity takers must pay liquidityproviders,” he says. “That’s either donevia paying the spread or by rebates forlimit orders. If you look at what is hap-pening at the ECNs, spreads areextremely tight, so that’s a good deal forthe customer.

“When we route a limit order to anECN, we get two-tenths of a penny. Wealso route to ECNs because they provide

the quickest way to cancel an ord e r,which is part of best execution.”

Besides, not everybody is convincedthat payment for order flow is necessari -ly a bad thing.

“There is no reason why payment foro rder flow itself has to come at theexpense of best execution,” says BernieMadoff, principal of Madoff InvestmentSecurities, a Nasdaq market maker. “Inthe equities market, I could prove thatthe venues paying for order flow are get-ting better execution than those thataren’t. The problem is that most compet-ing markets use payment for order flowas a way of disparaging other markets.”

Madoff says the mandatory publiciz-ing of execution data has taken the nega-tive perception away from payment fororder flow.

“Payment for order flow is not a prob-lem because it’s very easy for a firm tolook at the execution stats and clearlymake a determination as to where toroute their order,” he says. “It’s impor-tant we don’t characterize payment fororder flow as an evil child, because that’snot the case.”

Still, some market participants are dis-pleased with rebates of any kind. Theypay millions of dollars in access feesannually, and they believe if rebates areeliminated either by mutual agreementor legislation, the need for access feeswill be eliminated and the entire systemwill run much smoother.

Angstadt, though, says access fees arenot designed to offset rebates.

“Routing out and having peopleaccess us costs money,” she says. “Plus,consider the ITS. It’s free, but it’s slow.You should be able to charge for thevalue you provide.”

Additionally, Instinet CEO Ed Nicollbelieves there is a need to create anincentive for placing limit orders.

“When somebody places a limit order,they are putting themselves at a disad-vantage to someone who doesn’t place alimit order,” Nicoll says.

Joel Hasbrouck, professor of finance atNew York University, believes therebates provided by ECNs have helpednarrow Nasdaq spreads.

“We need to make sure that we notonly have incentives for limit orders, wedon’t present disincentives –— i.e.,charges for changing and canceling limitorders,” he says. “In listed markets, spe-cialists having the ability to delay post-ing of limit orders and delay executing ofmarket orders are disincentives. The rea-sons spreads have not narrowed are adirect result of that.”

What’s next?Although a central limit order book hasbeen proposed more than once over thepast few years, it enjoys only moderatesupport today. The SEC has long favore dinnovation and technology, as is appare n tin allowing ECNs to charge access feeswhen other market participants don’t.

Many think the next logical step is acomplete linkage, similar to the onerecently enacted among optionsexchanges. However, this would certainlymeet with great opposition, and is yearso ff even with complete participation.

The SEC is often hesitant to make rad-ical changes to any aspect of the marketunless situations get completely out ofhand. While this patience often makes itthe brunt of criticism, it also suggests theSEC will continue to have a wait-and-seeattitude toward best execution.Ý

INSIDE THE Market

©2003, Active Trader Magazine

TRADING ROOM ANGELI'm installing your

new operating system.

Darn, I hate whenthat happens.

Allow me.

It's not safe aroundhere. Let's go over

to “On the Job.”

But the oldone's working

just fine.

Does she doservers?

Race you topage 98!

Must be that new System Restore feature I heard about.


W hile improvements to atrading platform aresometimes announcedwith nothing more than

a press release, it’s not unusual for firmsto roll out reduced commissions with afull-blown marketing blitz, includingprint and media advertising, and newsignup specials.

This no doubt due in part to the factthat while more experienced traders alsoconsider a bro k e r’s trading platform,execution quality, customer support, etc.,commissions are often the only point ofreference for traders just entering thebusiness.

“The newer entries into the industryare price shoppers,” says MB TradingCEO Ross Ditlove. “As they mature intothe industry, they begin to educate them-selves as to the benefits beyond price,and often times the lowest price provideris not going to give you the highest levelof service.”

Indeed, commissions are just one partof the overall package a firm brings to itscustomers. And finding the right balancebetween price and service isn’t alwaysthe easiest thing to do.

“It’s important to have low costs,”says Chris Doubek, president of TerraNova Trading “But there is not enoughfocus being placed with the customer onbeing profitable because firms thinkprofitability is something subjective thatthey can’t address. And that is absolute-ly not true. Being concerned about yourrisk is much more important than beingconcerned about whether you have a $7,$8, $10 or $20 commission.”

It should be noted that non-direct-access firms, where less active tradersand investors typically trade, routinelyhave cheaper commissions because theyoften have lower-end platforms andslower execution speeds.

Most trades at Terra Nova cost $15,although there are incentives available toreduce the costs.

Doubek isn’t convinced a firm that con-

sistently offers cheap commissions canadequately provide the services necessaryto ensure an active trader’s success.

“You’re going to give up somethingwhen your commissions are as low asyou would like them to be,” he says.

However, Andy Gill, vice president ofmarketing for CyberTrader, believes it ispossible to offer low commissions andstill provide a complete range of servic-es. CyberTrader has commissions as lowas $9.95, with $12.95 as a top tier.

“We look at commissions as one of thelevers we use to provide the best value toour clients,” he says. “And we look atvalue as the combination of low commis-sions with high-quality executions,knowledgeable and available client serv-ice, and services such as education tohelp the trader.

“I think we compare favorably [tofirms that charge more money],” Gillsays. “When we launched our newstreaming Web platform, we made surewe were committed to providing a valueto that client, recognizing that theirneeds were going to be different than theneeds of somebody who has traded for20 years at a very high volume.Consequently, our clients services aretrained to handle those sorts of ques-tions, and we want to help those peoplebe successful in their trading style,whether it’s 10 or 100 trades a month or100 trades a day.”

However, Gill knows that traders whochoose CyberTrader won’t stay justbecause of low commissions.

“We have to provide the best value,”he says. “You have to take things thataren’t a direct cost of the trade — clientservices, technical analysis, trader edu-cation — and understand what yourclients think the value of those are indetermining that price.”

According to Steve Sanders, executivevice president of Interactive Bro k e r s ,“The key to whatever you’re going tocharge is your infrastructure.”

“If you’re a high-cost broker with old

mainframe systems and you use otherpeople to do things, obviously you’re notgoing to be able to charge a very lowprice,” he says.

“At Interactive, we have our ownclearing system and our own executionsystem. We have never gone outside fora consultant. We link into the exchangesdirectly and we view that as a competi-tive advantage. We can offer the lowestcommissions, and anybody else who istrying to offer the same low commissionwithout a system like ours won’t be ableto sustain that in the long ru n . ”Interactive has one of the lowest com-missions plans available, with certaintrades costing as little as a penny a share.

Sanders says Interactive often turns

Is the price right?

What’s a commission really worth?


away less-experienced traders, suggest-ing they trade with a broker that pro-vides more services.

“We aim at more of the professionaltype,” he says. “If someone wants helpand advice, we’re not going to do that.We offer the lowest commissions andprofessional customer service. We’ll helpyou with problems or issues, but wewon’t provide the hand-holding thatother brokers will provide.”

Added importance Cyber (Charles Schwab) and InteractiveBrokers (Timber Hill) are both owned bylarger organizations, and Terra Nova is

the largest “independent” direct-accessbroker. As a result, their financial situa-tions and infrastructures are more stablethan those of many other firms.

For smaller firms such as MB Trading,commissions take on even greater signif-icance.

“ We are constantly balancing thre ethings with the company — price, serviceand quality,” says Ditlove. “We attempt topick two at all times, because you can’tpick three. Those priorities sometimeschange. It’s always service first, and whenquality is below price (i.e., we don’t off e rall features as our competitors), we bumpup the quality. Once we catch up or

exceed the industry, we can emphasizekeeping price in line. But our goal is notnecessarily to be the cheapest.”

MB offers traders the option of payingper trade or per share. As a result, sometrades are less than $10, and Ditlove saysit’s difficult to make a profit on an individ-ual trade when commissions are that low.

“As you go through various economicgrowth cycles, you have supernaturalgrowth, normal growth and then youplateau out and profits go toward zero,”he says. “Once you start getting to thepoint where profits are zero, you have tocontinuously watch the bottom line asfar as expenses are concerned. And this

INSIDE THE Market

• • • • • • • • QUICK SCALPS • • • • • • • • QUICK SCALPS

YOU SCRATCH MY BACK…q Brokerage firm Robertson Stephens was censured and fined $28 million in early January after the NASD found it receivedinflated commissions from clients in exchange for IPO shares in 1999 and 2000. Half the fine goes to the NASD, the other$14 million to the SEC. In some instances, customers were paying more than $1 a share for orders — well above the typicalcharge of six cents. Robertson Stephens was the lead manager of more than 75 IPOs in 1999 and 2000.

IT’S EVEN MORE SUPERq In early February, the SEC approved a change that allows non-registered Nasdaq participants to post limit orders inSuperMontage. The SEC approval is for a 90-day pilot program. Under the rule change, broker/dealers and other order-entryfirms that do not have direct access to SuperMontage will be able to enter limit orders into the system. Plus, market mak-ers will be allowed to display orders in SuperMontage for stocks in which they do not make markets. The Nasdaq made thechange in an effort to increase SuperMontage liquidity.

TAKE YOUR TIMEq With the index still mired in a slump, and prices of many of its stocks trading near or below a dollar, the Nasdaq hasdecided to continue a pilot program that gives issuers additional time to avoid delisting for failing to meet minimum bidrequirements. The rule has been extended until Jan. 31, 2004. According to the rules of the program, all Nasdaq issues thatfail to meet certain listing requirements would have 180 calendar days to demonstrate compliance with minimum bidrequirements and another 180 days if they comply with other listing criteria. For SmallCap stocks failing to meet bidrequirements, the grace period is also 180 days. However, it increases to 540 days (about 18 months) for stocks that meetother listing criteria.

LEGAL MATTERSq U.S. lawyers enjoyed a victory of sorts in late January when the SEC decided to extend its comment period on the “noisywithdrawal” provisions of the Sarbanes-Oxley Act. The rule would have, in certain circumstances, required lawyers repre-senting publicly traded companies to blow the whistle on their clients if they found evidence of wrongdoing. Attorneysclaimed this would be a violation of attorney-client privilege. The SEC did pass provisions that require lawyers to reportviolations to upper management or, if that fails, to the board of directors. And, companies will be allowed to form “quali-fied legal compliance committees” to recommend appropriate response to a material violation. The rules will not apply tolawyers of foreign-based, U.S.-listed companies, as long as those lawyers are not advising their clients on U.S. law.

DON’T BLAME ME…BLAME MY BOSSq The NASD’s ongoing investigation of Wall Street analysts could be expanded to include the analysts supervisors, publishedreports said. The NASD is considering a case against former Merrill Lynch Internet analyst Henry Blodgett, who becamefamous for his outlandishly bullish reports on stocks such as Qualcomm and Amazon.com. However, the NASD is also inves-tigating the supervisory structure of Merrill Lynch to see if it did enough to prevent analysts from making unwarrantedclaims.


is why you have seen such tremendousconsolidation within the industry. Youhave to grow as far as trades or sharestraded per day, because if you don’t,you’re going to get eaten alive. That’swhat you see happening.”

Ditlove admits MB Trading watchesthe competition closely to ensure it iscompetitively priced, although he saysp revious price changes have been adirect result of customer feedback.

Share the blameWhile Doubek thinks some firms need tobe less concerned with commissions, healso thinks some responsibility has to

fall on the customers.“When the question is asked of the

firm, “What are your commissions,”somewhere in that conversation shouldbe a question about how profitable theperson is on those trades,” he says.“Ultimately, if you’re not profitable, itdoesn’t matter what the commissionsare. You should be looking first at riskmanagement. Then you look at makingsome money on the trade. Once you’reprofitable and you don’t have to thinkabout each trade being profitable, thenyou can start working on your expenses,such as commissions.”

“If a group of customers continue to

put downward pressure on broker/deal-ers for lower prices, broker/dealers real-ly have nowhere else to go but to contin-ue to eliminate services and eliminatei n f r a s t ru c t u re,” Doubek says. “It’s adownward spiral.

“I think it’s important for us as pro-fessionals in the industry to dictate someof the pricing and the focus,” he says. “Idon’t think there’s a successful traderwho will tell you that a $20 commissionvs. a $10 commission on each trademade the difference in their success. Ifyou have so little profit that you becomeunprofitable after a difference of $10,you’ve got some problems.”Ý

SPEND IT WISELYq It appears the SEC will have more money to play with in the next fiscal year. The federal budget, submitted in earlyFebruary, calls for an SEC budget of around $650 million. That represents about a $100 million increase from the last fis-cal year, which ends Sept. 30. The total SEC budget is less than Democrats wanted, but it’s an increase on the initial fig-ure proposed by Republicans last summer.

NEW, POSSIBLY IMPROVEDq The New York Stock Exchange recently introduced a revised composite index that will serve as the basis for anexchange-traded fund. The index will represent nearly every stock that trades on the NYSE. While the old NYSEComposite Index took into account every issue on the NYSE, the new index would eliminate closed-end funds, preferredstocks, derivatives and limited partnerships. All told, 2,077 stocks will comprise the new index.

HEY, DIDN’T I SEE YOU ON TV?q Todd Eberhard, a stockbroker who was also a frequent guest on financial TV, was arrested in early February on chargeshe cheated his clients for his own personal profit.

The 39-year-old Eberhard, a guest on CNN’s Moneyline and other shows, is charged with making excessive trades in hiscustomer’s accounts (known as churning) for the purposes of creating excessive commissions. The actions caused one cus-tomer to lose more than $10 million. The charges allege Eberhard began the scheme in 1999. If convicted, he could faceup to 25 years in jail. Eberhard was previously named in numerous complaints that caused him to pay more than $4 millionin settlements.

THAT IS SO(ES) ILLEGALq In concluding an investigation that began in 1993, the SEC in mid-January charged four individuals and day-trading firmHeartland Securities with fraud related to Nasdaq’s Small Order Execution System (SOES). Total penalties in the case totalmore than $70 million, with two individuals — Sheldon Maschler ($29.2 million) and Jeffrey Citron ($22.5 million) — payingtwo of the largest individual fines the SEC has ever handed down. The group is charged with using SOES to execute tradesfor their own accounts — a violation of NASD rules. The group created fictitious records and filed false reports with theSEC.

THE FEELING IS MUTUALq After months of discussion, the SEC in early February proposed new rules for mutual funds. The rules will mandate that inter-nal controls need to be tightened and will consider creating a self-policing organization for the mutual fund industry. Theserules follow on the heels of an SEC vote weeks earlier that forces fund managers to tell their investors how the managers votedon shareholder questions asked by the companies that comprise the fund. The proposed rules are subject to a 60-day publiccomment period, after which they are expected to be approved.

BY ACTIVE TRADER STAFF

O ver the past three years, Active Trader has writtenabout dozens of trading Web sites. Some havebeen mainstays of the online trading community;others have been consigned to the dustbin of digi-

tal history since we wrote about them.Now that the field has been pared down a bit, we revisited

some of the sites and looked at new ones to develop a list of toptrading and investment sites that have stood the test of time,however modest that time period may be.

We focused on sites offering useful free content to visitors, aswell as pay sites providing a service or product not readilyavailable anywhere else.

Trader tax and business siteGainskeeper.com (www.gainskeeper.com): This site waslaunched in the late 1990s as a way to help traders automate thep rocess of reporting trades for tax purposes. Gainskeeper has con-tinuously made changes and additions to the site, and it re m a i n shelpful for traders trying to make sense of their tax situation.

Gainskeeper’s best feature is its ability to download individ-ual trade data from a brokerage (more than 30 brokers havepartnered with Gainskeeper). The data can be transferreddirectly into an individual’s account; in some cases, it must bedownloaded into an Excel file then transferred to the Web site.Gainskeeper then compiles all the trades and prints them outon a Schedule D (the tax form required by the IRS). For anactive trader, this will save hours, if not days, of paperwork.

Gainskeeper handles wash sales (the repurchase of a prod-

uct you sold at a loss less than 30 days ago), which can causetax losses if not properly reported. It also has an education cen-ter that answers many tax questions.

Gainskeeper’s subscriptions can cost as much as $149/year— even more if you have in excess of 1,000 transactions.However, a 30-day free trial is available, which should be ade-quate time to determine if the product is right for you.

ECN sitesIsland.com and Archipelago.com (www. i s l a n d . c o m ,www.archipelago.com): These two popular ECNs have plentyof helpful data on their Web sites, including their respectiveorder books, which can help traders get an idea of the liquidi-ty of a particular stock at Island or Archipelago.

A d d i t i o n a l l y, Island.com has other data tools such as price-volume charts and time and sales for individual stocks, and top-5, 10 and 20 lists that show Island’s most-traded stocks. Whilethe information provided is only for trades entered and execut-ed on Island.com (and not for all of the Nasdaq), it is fre e .Considering how popular Island is (on certain days, the ECNdoes 20 percent of total Nasdaq volume), the price showing onIsland.com is often the best bid/offer on the Nasdaq. Thati n c reases the quality of the information Island.com is pro v i d i n g .

Archipelago also provides lists and updates, but the bestpart of its Web page is its program allowing traders to makesense of the execution data provided by market centers. SECrules mandate all execution venues (i.e., ECNs, market makers,exchanges) must disclose where they are routing their ordersto, at what price orders are getting executed, etc.

This data is released in spreadsheet form, with dozens ofcolumns and thousands of rows. It’s vir-tually impossible to make any sense of theraw data. Archipelago, though, has takenthe raw data and presented it in a waythat everybody can understand. Forexample, you could compare executiontime between Island and SuperSOES onall Oracle orders between 2,000-4,999shares.

Twenty-three different market partici-pants can be compared on speed, priceand price-to-speed. The three most recentmonths of data can be viewed.

Online system testingWealth-Lab.com (www.wealth-lab.com):There are several software programs thatlet you design and test trading systems.Wealth-Lab.com provides free access tosophisticated testing tools through itsWeb site.

Wealth-Lab.com offers access to itslibrary of trading systems and allowsusers to create their own using the pro-gram’s “WealthScript” language (a moresophisticated version of Wealth-Lab isavailable as stand-alone software). Users

WEBWatchBest of the We b

FIGURE 1: GAINSKEEPER.COM

Active traders with hundreds of transactions to report may find Gainskeeper. c o mto be a great timesaver.


can also create detailed charts and examine volumes oftrade and systems statistics and performance charac-teristics. Wealth-Lab.com can back-test trading sys-tems on individual equities or stock portfolios.

There are dozens of systems to experiment with,and a forum through which to share thoughts withother traders and systems designers.

Market research M a r k e t H i s t o r y.com (w w w. m a r k e t h i s t o r y.com): I fyou’re looking for probabilities and statistics about dif-ferent price moves and market relationships, Mar-ketHistory.com is one of your best bets on the Web.

With re s e a rch and number crunching powered byMarket Information Machine (previously software soldby the firm Logical Information Machines),MarketHistory foregoes vague re f e rences to what usuallyhappens when indicator x c rosses threshold y, and insteadanswers questions such as, “How has the Dow performedin the past during the month of December when it hasbeen down more than 10 percent going into the month?” and “TheDow on Tuesday declined 172.98 points, or -2 percent. What’s hap-pened in the past when the Dow has made a one-day decline ofm o re than 2 percent two days before Thanksgiving?”

The answers blend written summary with tables and chartsthat break down the results, usually over several years, so youcan get a handle on the probabilities. Covering the stock,futures and Forex markets, MarketHistory puts the numbers atyour fingertips, allowing you to factor historical market ten-dencies into your trading plan. Subscriptions range fro m$24.95 to $200 per month.

E c o n o m i c sThe Dismal Scientist (www.economy.com/dismal): Even if itwas a shoddy Web site, The Dismal Scientist would be worthyof praise for its name and URL.

F o r t u n a t e l y, Dismal, an affiliate of Economy.com, is a gre a tonline re s o u rce for all things economic. If you weren’t payingattention in Econ 101 (and re a l l y, who could blame you?), Dismalhas educational re f e rences and numbers galore.

Commentary, forecasts and analysis of various economicdata (domestic and overseas) abound, and the site has neattools, including a CPI calculator that gives you an idea of howmoney changes value over time as inflation ebbs and flows.There’s also a section devoted to the Federal Reserve for thosewho like to read the minutes of FOMC meetings. Subscriptionsstart at $19.91 per month ($189.95 annually) and the site offersa free two-week trial.

Options/volatility analysisIvolatility.com (www.ivolatility.com): When we first looked atIvolatility.com in September 2000, the site was just starting out.More than two years later it has mushroomed into a multifac-eted research center for traders who want the inside scoop onoption value and volatility. Better yet, it still has a lot of freeinformation and tools, including general stock and optionprice, volume and open interest data, option chains with

implied volatility, delta and theoretical option values, historicalvolatility, current 30-day implied volatility index for calls andputs, and price and volatility charts.

Also free is the basic options calculator, which allows you tocalculate theoretical option prices and Greeks by entering theparameters (option style, price of the underlying instrument,strike price, expiration date, implied volatility, interest rate anddividends) of your choice.

Various subscription packages allow you to add option andvolatility scanners, rankers, and advanced worksheets and cal-culators.

Online research/browsing toolSpeedResearch.com (www.speedresearch.com): If you’re aninformation junkie, this is the site for you. SpeedResearch is adownloadable browser with links to dozens of market-relatedWeb sites. Switching from, say, BigCharts to Yahoo Finance toTheStreet.com can be done with a single click of the mouse.

The best part is that if you’re looking for information on aspecific stock, you need only enter the stock symbol at the topof the browser and all subsequent sites you visit will have thedata for that stock. For example, if you’re analyzing a chart ofDell on Prophet.net and you want to see how Dell is trading inthe Island book, a click of the Island link will send you direct-ly to the Island order book for Dell.

SpeedResearch also links to various lists — i.e., 10 mostactive, biggest percentage gainers/losers, etc. You can enterand track entire portfolios, and any stock or stocks you find ona Web site can be instantly transferred into a portfolio (e.g., ifyou find a list of the 10 stocks that did the most volume in thefirst hour of trading, with one click you can move them all intoa portfolio and track them the remainder of the day).

There is a one-time payment of $37.99 for SpeedResearch.All upgrades are free, and the site comes with a 30-day freetrial.Ý

Next month: more Best of the Web.

FIGURE 2: ARCHIPELAGO.COM

The Archipelago Web site can help make sense of the executiondata provided by market centers.



q FutureSource has released ProNET 4.2, an upgrade to itsreal-time charts, quotes and news application. New featuresinclude chartable expressions, which allow users to performany mathematical operation on one or more contracts;redesigned price pages; and the ability to e-mail charts andweather maps. Also, six additional indicators (Moving AverageConvergence Divergence, Spread Absolute, Spread Relative,Stochastic Fast, Stochastic Slow, and Volume and OpenInterest) are available through ProNet Express , and users willfind support for Delta, Gamma, Theta, Vega and ImpliedVolatility. There is also a new user authentication service,among other enhancements. For more information on theupdated ProNET 4.2 or for a 14-day free trial visithttp://pronet.futuresource.com.

q The Options Industry Council has added Options University(OU) to its Web site, www.888options.com. OU offers a varietyof interactive options classes based on experience level —beginner, intermediate and advanced — including BuyingCalls, Buying Puts, Introduction to Spreading, Options in aBearish Market and Options in a Bullish Market. Once regis-tered, students have free access to: phone and e-mail support;options strategy overviews and articles; options calculatorsand glossary; and Online Options Investigator software .Quizzes are also part of the offering. For more information orto register, visit the Web site.

q The Trader Bulletin, a weekly magazine focused on profes-sional equity trading, has launched at www. t r a d e rbulletin.com. Membership at the Trader Bulletin is free and

includes a weekly e-mail bulletin with the latest trading indus-try headlines. New editions are released every Thursday morn-ing at the Web site after the market opens. Recent topics haveincluded trading innovations on the NYSE, the evolution ofECNs, new buy and sell-side technology, day-trading scandalsand market data controversies.

q GreenTrader Tax.com, a tax site for traders, has a brand-newlook. The new Web site is easier to navigate and has animproved Education Center. There is additional content onhedge funds and trader retirement plans, plus updated infor-mation on key issues such as trader tax status and mark-to-market accounting. Available on the site are the 2003 versionsof the Trader Tax Guides, written by GTT CEO Robert A.Green. The new guides are completely updated to reflect 2002tax law changes, and can be downloaded directly from the site.For more information, go to www.greentradertax.com.

q Global Forex Trading DealBookFX customers now haveaccess to MMS International’s Market Pulse, Central Banks andFX Fundamentals sections. As a result of a partnership betweenthe two companies, users will have access to market news andanalysis, intraday commentary, interday highs and lows in theUSD pairs and non-dollar crosses, central bank policy outlookand intervention tracker, as well as an FX forecast matrix, dailyFX commentary and special FX reports. In addition, coverageof MMS Market Movers, Foreign Exchange, Viewpoint, MajorMarkets, Emerging Markets and financial calendars are alsoincluded. For more information visit www.gftforex.com.

NEW Productsq E S i g n a l recently released eSignal 7.2, thelatest version of its real-time quote service andcharting software application. Among its fea-t u res, eSignal 7.2 includes a Learning/ ReplayMode, with which users can replay data afterhours into a chart to see how indicators andstrategies worked out, and Market Depth,which provides detailed exchange informa-tion including Nasdaq SuperMontage andIsland’s ECN Book data. Version 7.2 alsoincludes Formula Wi z a rd, through whichusers can back test, build studies, apply alertsand initiate trades automatically; single-stockf u t u res data from OneChicago; and the abilityto mix real-time and delayed services from themarkets. Anew chat function is also availablet h rough the recently unveiled eSignal CentralWeb site (www.esignalcentral.com), whichsupports file sharing and instant messaging,and features a learning center and pro d u c ttraining. Monthly subscriptions of eSignal 7.2start at $49 for active traders and $175 for pro-fessionals. For information, visit www. e s i g -n a l . c o m / f e a t u res.


TRADER’SBookshelf

REVIEWED BY DAVID BUKEY

Gerald M. Loeb’s The Battle for Investment Survival isa great book for active traders because it focuseson practical, short-term trading ideas rather thanlong-term investing concepts.

Loeb began his career as a stockbroker and financial journal-ist in 1921 and published this book in 1935 — about the sametime Benjamin Graham advocated long-term investing in hisinfluential book, Security Analysis. John Rothchild notes in hisf o re w o rd to Loeb’s book that many investors interpre t e dGraham’s ideas to mean buy and hold indefinitely — regard-less of what the market does.

Loeb, however, sees long-term investing based on hoperather than judgment, which leads to complacency and, ulti-mately, serious losses. By contrast, the author argues, getting inand out of the market in short bursts is a safer method. Hebelieves short-term trading provides flexibility long-terminvesting doesn’t: Having your assets fully invested can leaveyou vulnerable to unexpected risk, while leaving your portfo-lio in cash limits risk and allows you to take advantage offuture trading opportunities.

Loeb does not focus on specific trading rules, which will dis-appoint some readers. However, the real value of the book liesin its general principles for executing and managing trades.Not surprisingly, Loeb’s most relevant piece of advice is tolimit losses: Sell positions that have declined 10 percent andsell the bottom 10 percent of your portfolio each year.

Cutting losses allows you to preserve capital and view themarket with fresh eyes. Instead of waiting for a weak stock torebound, you can reassess your opportunities after taking theloss. This approach helps take emotion out of trading andforces you to stay focused on trades with the most profit poten-tial at any given moment.

Loeb describes his pyramid trading technique while explain-ing the “Ever-Liquid Account.” First, identify and enter apromising trade. Cut your loss if the trade goes against youand buy more shares as it becomes profitable. Loeb sees thisstrategy as more successful than dollar-cost averaging or diver-sification. While Loeb admits diversification is the best

approach for inexperienced traders, he believes in concentrat-ing one’s holdings: “The greatest safety lies in putting all youreggs in one basket and watching the basket.”

Context is another key issue for Loeb. Traders must have a

sense of general market conditions before committing to anypositions. For example, Loeb warns readers that increasingprice action and volume may mean different things dependingon market conditions. Individual stock movement must alwaysbe put into the context of the underlying market.

The Battle for Investment Survival contains Loeb’s original,short text, as well as additional chapters that reiterate thebook’s main themes. Loeb’s advice may seem simplistic andunoriginal to experienced traders, but his ideas are powerfulbecause they are much easier to dismiss than to act on with dis-cipline.

However, readers shouldn’t expect his advice to automati-cally lead to profits. In fact, Loeb’s goal is to remind his readersjust how risky the markets can be.Ý

The Battle for Investment SurvivalBy Gerald M. Loeb (Foreword by John Rothchild)John Wiley & Sons, 1996 (originally published in 1935)Hardcover, 320 pages$29.95

“[T]here is no cheaper insurance than accepting a loss quickly.

That is the tactic of retreat rather than capitulation. I think it

would be very difficult for an investor losing, say, five to 10 percent

each time on a succession of ventures, to continue to lose time and

time again without checking his errors or stopping altogether.

On the other hand, a buyer who holds regardless of unfavorable

news or action can become involuntarily locked in his ‘investment’

for years… It is important to regard the situation with an open

mind, unbiased by a bad stale position, and it is important to be

able to act each time convictions are very strong.”

— From page 104

BY DAVID BUKEY

E nsign Windows is a real-time chartanalysis program with features similarto higher-end trading software, butwithout the high-end price tag.

Ensign’s design interface may seem less pol-ished than its peers, but the software is quitec o m p rehensive and flexible. Its pro g r a m m i n glanguage — Ensign Software Pro g r a m m i n gLanguage (ESPL) — allows advanced users tocreate chart studies and indicators, trading sys-tems and market scans. However, the language’scomplexities may frustrate beginning and inter-mediate users.

Data sourcesEnsign Windows is compatible with real-time datafeeds from eSignal, BMI and DTN Satellite (at pre s stime DTN.IQFeed compatibility was scheduled forF e b ruary). Ensign Internet is an end-of-day pro-gram that costs the same as Ensign Windows anddownloads delayed intraday, daily, weekly ormonthly chart data directly from Ensign, bypassingthe need to subscribe to a separate end-of-day datas o u rce. Both versions can handle intraday future sdata and offer the same feature s .

F e a t u r e sC h a r t i n g . Ensign’s charts are user-friendly —they have many options and are easy to modify.Charts can be displayed over a variety of timeframes (tick and intraday to daily, weekly and monthly), andyou can choose from four chart types (bar, candlestick, line andclose ticks) and display them in either regular or logarithmicscale. You can choose how much historical data to view, but youcannot customize the range of the data. For example, there is noway to view a chart just for the first week of December 2002.

You can overlay more than 30 predefined chart studies andindicators on a price series, or plot them in one of nine sub-windows. The Color Bars function scans a chart for variouspredefined criteria and identifies 25 types of bullish and bear-ish characteristics on both price and volume bars. For instance,selecting the “Close Outer 10%” color bar scan changes barswith closing prices in the top 10 percent of the bar to green andchanges bars with closing prices in the bottom 10 percent of thebar to red. Similarly, the “Close vs. Open” scan distinguishesbars that closed higher than they opened from those thatclosed lower than they opened.

In addition to standard trendlines, Ensign includes more

than 20 line studies, including Fibonacci levels, Gann Fans andAndrew’s Pitchfork. It also includes more unique tools such asPyraPoint, a Gann-based line study that shows support andresistance levels and projects price turning points.

Like other chart elements, these tools are all easy to applyand modify. Right-clicking anywhere on a chart allows you toadd, delete and change its objects and properties. You canchange a chart’s background, gridlines and bars to any imagi-nable color. Toolbars allow you to edit the time frame and charttype, apply studies, indicators and color bars, and draw trend-lines with a couple of mouse clicks.

After tweaking a chart to your liking, you can save it as atemplate that will add your analysis settings to any chart youopen. Once you open multiple charts and quote screens, youcan save the layout as a workspace.

Quotes. Ensign’s real-time quote screens are comprehensiveand clearly organized. Pre-formatted quote pages are dividedinto categories such as NYSE, Nasdaq, indices, futures, corpo-rate and municipal bonds, and foreign stocks. You can create

Technology for TRADERS

S O F T WARE SUMMARY

P r o g ra m : Ensign Windows: version date 12/20/02What it is: Real-time chart analysis software that includes

customizable charts, quotes, news, paper-trading, scanning, system design and back-testing capabilities.

Who it’s for: Stock, option and futures tradersSkill level: Intermediate to advanced usersC o m p a n y : Ensign Software,

2641 Shannon Court, Idaho Falls, ID 83404 Tel: (801) 328-1382 Fax: (208) 525-8781

Web site: www.ensignsoftware.com; www.ensignsupport.comP r i c e : $39.95 per month for both real-time and end-of-day

versions. Additional data feed subscription needed for real-time Ensign Windows. Seven-day free trial can be downloaded from Web site.

U p s i d e : Flexible, powerful ESPL programming language. Comprehensive quote screens. New Play Back and Sim-Broker features make simulated trading easier.Various training and customer support resources.

D o w n s i d e : The programming language is difficult to understand for non-programmers and the manual is not as user-friendly as it could be.

M i n i m u m IBM compatible computer; Windows 98, Windows ME, s y s t e m Windows 2000, Windows NT or Windows XP;

r e q u i r e m e n t s : 300 MHz Pentium PC; 100 MB of available hard disk space; 256 MB of RAM memory; 800 x 600 Video resolution (higher resolutions preferred); Mouse (or equivalent pointing device); Internet connection for downloading data, upgrading software and receiving Internet data feeds.


Software S C R E E N I N G: Ensign Wi n d o w s

custom quote pages to keep track of hundreds of stocks, bondsand futures.

Quote page entries can be modified and sorted based on asmany as 51 price, volume and fundamental categories(depending on your data feed). Saving quote screens to Excel,MetaStock or AIQ formats, or establishing a Dynamic DataExchange (DDE) link to an Excel or Quattro Pro spreadsheet, isa snap. Loading a chart is as simple as double-clicking on theappropriate symbol.

Ensign includes Level II and time and sales windows thatare similar to other mid- to upper-echelon platforms. In addi-tion, you can overlay market maker bid and ask prices onto anunderlying stock chart to compare changes in both.

Paper trading. Ensign has developed three unique ways forusers to develop their trading skills via “paper trading”: usingDEMO, a simulated stock; replaying the price action of previ-ous days; or placing orders through Sim-Broker.

DEMO’s simulated prices are updated every second. Theprogram can generate up to four days of intraday data. DEMObehaves just like any other security, except it trades wheneveryou want it to — just pick a start price and market phase (ran-dom, trending or correction) and the program generates data,starting at the beginning of the trading day, and then scrolls

intraday price bars on a chart. Also, DEMO is useful for train-ing or practicing with other people because it can be synchro-nized among different computers.

Play Back works like a tape recorder and downloads intra-day price data from a previous trading session for any securi-ty. The program then plays it back, tick-by-tick on a chart, inreal time or up to 10 times the normal speed. The ability tospecify start times is convenient if you are interested in a par-ticular period of a past day.

Sim-Broker places simulated trades and keeps track of prof-it and loss on real data and DEMO, and works well with PlayBack. You can enter market, limit, stop or stop-and-reverseorders while choosing quantity and commission fees. Sim-Broker includes a transaction log that displays pending andfilled trades. It also places arrows on charts to mark entries andexits and summarizes each trade’s profit and loss.

Programming. The most powerful — but least accessible fornon-programmers — element of Ensign is its ESPL program-ming language. ESPL is similar to the Delphi or Pascal pro-gramming languages.

Unlike some system-design program languages, ESPL isgeared toward serious programmers; it cannot be learned in anafternoon.


Setting up multiple chart and quote windows as a workspace enables Ensign Windows users to track market changes.Here, an S&P E-Mini daily futures chart and Microsoft daily chart are shown with a standard quote screen and Level IIwindow.

FIGURE 1 ENSIGN CHART S

Source: Ensign Windows


However, those with programming skills will be able to takeadvantage of ESPL’s ability to design original chart studies,indicators, trading systems and market scans. There is virtual-ly no limit to what you can create. The language is flexible —E S P L functions can automate the operation of many ofEnsign’s features and can access, modify and close any chart,quote screen, trading system or scan within a program.

With ESPL, experienced users can design and test trading sys-tems on any individual security and view the performanceresults. You can also use ESPLto create market and chart scans tofind stocks, bonds and futures with user-specified criteria. Forexample, ESPL will scan all stocks on the Nasdaq and displayonly those with the volume and price characteristics that you indi-cate. However, while these two tools are useful, again, theirreliance on ESPLmakes them less accessible to non-pro g r a m m e r s .

Learning ESPL can be particularly frustrating because itsdocumentation is also somewhat complex, and seems to bewritten for a programming-literate audience. Although theESPL manual does contain sample code to experiment with,beginning and intermediate users could probably use moretutorials, examples, and pre-coded functions and systems tohelp them learn the basics of the language.

A programming drawback of Ensign is that it does not havea library of pre-defined trading or analysis functions or vari-ables you can link together when designing technical studiesor systems. This means you must declare all variables and pro-cedures — there are no short cuts.

For example, you can plot a simple, custom indicator inMetaStock with one line of its formula language (i.e., a 10-dayAverage True Range divided by its 60-day Average True Range:ATR(10)/ATR(60)). Plotting the same indicator with ESPLrequires at least 30 lines of code.

News. Ensign’s news options are extensive. Headlines areorganized by vendor and subject, and can be saved or searched

by keyword. News alerts will also notify you of articles con-taining keywords. Double-clicking a headline will display thefull article at the vendor’s Web site.

Options analysis. Ensign has basic option analysis tools.The options spreadsheet uses the Black-Scholes model to esti-mate an option’s value. In addition to listing values at differentstrikes, the program also calculates values such as impliedvolatility and delta.

Tr a d i n g . Ensign Windows now offers online tradingthrough Preferred Trade. Double-clicking on the bid or askprice in a quote screen will initiate a trade. Ensign allows youto track up to 500 trading accounts (more than enough for youraverage trader these days, we’re guessing).

Customer supportEnsign offers a free customer support line and its Web site pro-vides chart and line study examples, downloadable templates,newsletter archives, ESPL programming lessons and samplecode. In addition, Ensign programmers host tutorials andanswer questions each week in the Ensign chat ro o m(www.paltalk.com).

Bottom lineEnsign Windows’ charts, quotes, back-testing and scanning abil-ity are of the level normally found in more expensive software .The program’s reliance on its ESPL p rogramming language isboth its greatest asset and biggest drawback: Programmers canuse ESPL to customize Ensign’s features and create sophisticat-ed analysis tools and trading systems, but the language’s learn-ing curve and inadequate manual may prevent new users fro mtaking advantage of all Ensign has to offer (at least initially).

Ensign Windows is a compelling program with many pow-erful and clever features. Traders who are comfortable writingcode will appreciate its value.Ý

ESPL programming is at the heart of Ensign Windows’ capabilities. The code here backtests trading rules on IBM’shistorical price data and shows the profit and loss results.

FIGURE 2 ENSIGN TRADING SYSTEM PROGRAMMING SCRIPT

Source: Ensign Windows


TRADING Strategies

In previous articles, Tom Bierovic has discussed several classic chart patterns,

including flags, head-and-shoulders, inside days, rectangles, triangles

and wedges. He completes his series with a lesson on broadening tops —

perhaps the least appreciated and most misunderstood of major patterns.

How to trade BROADENING TO P S

BY THOMAS A. BIEROVIC

S ome technical analysisbooks that feature chartpatterns ignore bro a d e n-ing tops entire l y. Others

claim broadening tops are so hard toidentify and trade, it’s lucky theyoccur so infre q u e n t l y.

In reality, broadening tops are nomore difficult to find and trade thanmost other patterns. They occuroften enough to be worth looking forand, most importantly, they are as accu-rate and profitable as other major chartformations.

Why no broadening bottoms?E d w a rds and Magee addressed thisquestion in 1948 in their book, TechnicalAnalysis of Stock Trends:

“It has been assumed in the past thatBroadening Bottoms must exist, butthis writer has never found a good onein his examination of the charts ofthousands of individual stocks overmany years, and only one or two pat -terns which bore a resemblance to it inthe charts of the averages. Apparently,the circumstances which cre a t eBroadening Formations do not existafter a prolonged decline in prices. Thiswould seem to bear out our earliercharacterization of this sort of pattern

as suggesting active, excited tradingwith much public (and, hence, not toowell informed or managed) participa -tion. Such conditions are naturallyassociated with the final phases of aBull Market.”

Symmetrical broadening topsT h e re are three kinds of bro a d e n i n gtops: symmetrical, ascending anddescending. Figure 1 shows a symmetri-cal broadening top, the most common ofthe three types.

The salient feature distinguishingbroadening tops from many other chartpatterns is that price swings within abroadening top increase in size, whereasthe swings within other patterns stay thesame size (as in rectangles) or decreasein size (as in triangles and wedges).

Note the rising top line in Figure 1that connects a series of higher swinghighs and the declining bottom line that

connects a series of lower swinglows. (Aswing high has a lower highto its immediate left and right; aswing low has higher lows to itsimmediate left and right.) In a prop-er broadening top, the swing highsand lows alternate on the horizontalaxis: Point A is a high, point B a lowto the right of A, point C a high to theright of B, point D a low to the rightof C, and so on.

Trading the patternA broadening top is a reversal pattern —i.e., it usually signals a trend changefrom up to down. In Figure 2, an up-trend precedes the beginning of the pat-tern at point A, while a downtrend fol-lows the breakout from the pattern atpoint F. The following examples illus-trate an effective way to trade broaden-ing tops: Sell short when price dropsbelow the bottom line of the pattern,place a conservative protective stop andtake profits at a pre-defined price objec-tive.

In Figure 2, sell short below the bot-tom line (58.51) of the pattern at point F(58.50) and set a protective stop at thehigh of the day before entry (59.53), risk-ing 1.03 on the trade.

Next, determine two price objectives:Goal 1, a signal to lower the stop to

A

BD

F

EC

In a symmetrical broadening top, the upperline connects rising swing highs and thelower line connects declining swing lows. A sell signal occurs when price penetratesthe pattern’s bottom line.

FIGURE 1 SYMMETRICAL BROADENING TOP


breakeven, and Goal 2, a signalto take profits. Goal 1 is a multi-ple of the trade’s initial risk sub-tracted from the entry price.Any multiple between 1.15 and1.55 is reasonable — the objec-tive is for Goal 1 to be a little far-ther below the entry price thanthe initial protective stop isabove it. The following exam-ples use a multiple of 1.25. Goal2, the price target, is the heightof the pattern subtracted fromits bottom line on the day of thebreakout.

To calculate Goal 1 for thetrade in Figure 2, multiply thetrade’s risk by 1.25 (1.03*1.25 =1.29) and subtract the re s u l tfrom the entry price (58.50 - 1.29= 57.21). To determine Goal 2,first measure the height of thebroadening top by subtractingthe price level of the bottom lineon the breakout day (bar F) fromthe price level of the top linedirectly above it (62.60 - 58.51 =4.09). Then, subtract the pat-tern’s height from the bottomline at F (58.51 - 4.09 = 54.42).After a close below Goal 1(57.21), lower the protective stopto breakeven (58.50, the entryprice).

Some broadening top tradeshave an additional trade-man-agement step between movingthe stop to breakeven (at Goal 1)and taking profits (at Goal 2).After a stock posts its lowestclose since the trade entry, lookto the left on the chart betweenthe lowest close and the entryfor a swing high below thebreakeven stop. If you find one,lower the stop to that swinghigh. (If you find more than oneswing high, lower the stop to themost recent one.)

For example, in Figure 2, priceposts a new low close at point I,so lower your stop to 58, theswing high at point H, which isthe most recent swing high tothe left of I. (Although technical-ly a swing high, the high at H isbetter described as a “tweezertop,” candlestick terminology

William Wrigley Jr (WWY), daily

A

B

C

D

E

F

G

H

Protective stop

Sell short

Goal 1

Goal 2

13 20 June 10 17 24 July 8 15 22 29 Aug.5

60

58

56

54

52

50

48

46

44

In this example, the price swing that began at D failed to reach the broadening top’supper line, ending instead with a swing high at E. Such a partial rise is usually a bearish sign. Also, the stop was placed at the midpoint of the candle before entrybecause placing it above the high of the candle would represent too large a risk.

FIGURE 3 A SLIGHT TWIST

Source: TradeStation Platform by TradeStation Group

Loews (LTR), daily

A

B

C

D

E

F

G

H

I J

K

L

Protective stop

Breakeven stopSell short

Goal 1

Goal 2

25 April 8 15 22 29 May 6 13 20 June 10 17

63

62

61

60

59

58

57

56

55

54

Goal 1 was reached in two days and the protective stop was lowered to breakeven.Goal 2, the price objective, was reached 16 days later.

FIGURE 2 SETTING STOPS AND PRICE OBJECTIVES



for consecutive highs at thesame, or nearly the same,price.) At point K, pricemakes another new low close,so lower your stop to theswing high at J (56.10). Takep rofits of 4.10 when pricedeclines to Goal 2 (54.42).

Figure 3 shows a commonvariation in bro a d e n i n g - t o pformations. Note that theprice swing that began at thepattern’s bottom line at pointD failed to reach the top line,ending instead at the swinghigh at E. This partial rise is abearish sign: Price wasn’tstrong enough to rally all theway to the top of the pattern.Sell short at candle F at 54.70,on the open below the pat-tern’s bottom line.

The high of candle F is too far from theentry price to provide a reasonable pointfor a protective stop, so set the stop justabove the midpoint of the candle’s realbody instead. To determine the stop,subtract the bottom of the can-dle’s real body from its top,divide the diff e rence by two,and add that number to the bot-tom of the real body (56.60 -55.00 = 1.6, 1.6 divided by 2 =.80, and .80 + 55.00 = 55.80). Setthe stop at 55.85, a little abovethe midpoint, for a risk of 1.15.

To calculate Goal 1, multiplythe risk by 1.25 and subtract thedifference from the entry price(1.15 x 1.25 = 1.44, and 54.70 –1.44 = 53.26). To determine Goal2, subtract the height of the pat-tern at F (59.66 - 54.90 = 4.76)from the bottom line at F (54.90 -4.76 = 50.14). After price closesbelow 53.26 at G, lower yourstop to breakeven (54.70, theentry price). Take profits (4.76)at H when price falls to 50.14.Ascending and descending broadening topsThe final examples consist ofascending and descendingbroadening tops. An ascendingbroadening top has a rising topline and a flat bottom line(Figure 4a, above); a descendingbroadening top has a flat top

line and a falling bottom line (Figure 4b.Figure 5 shows a market example of

an ascending broadening top. Note therising line connecting the swing highs atpoints A and C, and the flat line connect-ing the swing lows at B and D. Sell short

at candle F at 20.92, below the pattern’sbottom line, and set a protective stop at21.61, a little above the midpoint of thetall, black candle before F.

Calculate Goal 1 by multiplying thetrade’s risk by 1.25 and subtracting the

Ceridian Corp (CEN), daily

A

B

C

D

E

F

G

H

Protective stop

Sell short

Goal 1

Goal 2

April May June July

23.5

23.0

22.5

22.0

21.5

21.0

20.5

20.0

19.5

19.0

18.5

18.0

17.5

17.0

Ascending and descending broadening tops are traded the same as the symmetricalversion of the pattern. Note in this example that seven days after entry, price pulled back to the pattern’s bottom line. Pullbacks after breakouts are a commonoccurrence.

FIGURE 5 TRADING AN ASCENDING TOP


A

B

C

D

E A

B

C

D

E

F F

In an ascending broadening top, the pattern’s upper line connects rising swinghighs and its lower line connects horizontal swing lows.

In a descending broadening top, theupper line is flat, and the lower line isdeclining.

FIGURE 4A ASCENDING BROADENING TO P FIGURE 4B DESCENDING BROADENING TO P


result from the entry price (.69 x1.25 = .86, and 20.92 - .86 =20.06). Determine Goal 2 by sub-tracting the bottom of the pat-tern at F from its top at F andsubtracting the difference fromthe bottom (23.02 - 20.93 = 2.09,and 20.93 - 2.09 = 18.84). Afterthe close below Goal 1 (20.06) atcandle G, lower the stop tobreakeven. Take profits (2.09) atcandle H at 18.84.

In Figure 6 (above), priceforms a descending bro a d e n i n gtop. The line connecting theswing highs at Aand C is flat; theline connecting the swing lows atB and D is declining. Sell short atF (at 38.89), just below the bottomline. The open of candle F (41.00),the top of the real body, pro v i d e sa reasonable place to set a pro t e c-tive stop (the high at F is too faraway from the entry price for ap rudent stop). The risk is 2.11(41.00 - 38.89 = 2.11 ) .

Calculate Goal 1 by multiply-ing the risk by 1.25 and subtract-ing the result from the entry price (2.11 x1.25 = 2.64, and 38.89 – 2.64 = 36.25).Determine Goal 2 by subtracting the bot-tom of the pattern at F from its top at Fand subtracting the difference from thebottom (44.76 – 38.90 = 5.86, and 38.90 –5.86 = 33.04).

Price closes below Goal 1 at candle G,so lower your stop to breakeven. Priceposts its lowest close since entry at pointI, so lower the stop to the swing high atH. After the next new low close (at K),lower the stop to the swing high at J.Take profits (5.86) at candle Lat 33.04.

Wrapping things upAll the patterns in this series (ActiveTrader, August 2002 to April 2003) onclassic chart patterns were described byRichard Schabacker in 1932 in TechnicalAnalysis and Stock Market Profits and byRobert Edwards and John Magee in 1948in Technical Analysis of Stock Trends.

Although technical analysts today canemploy new, advanced tools such as arti-ficial intelligence, chaos theory, fuzzylogic, genetic algorithms and neural net-

works, it has not yet been shown thesesophisticated techniques produce betterresults (i.e., bigger profits) than the sim-ple chart patterns that have been testedand proven in the markets by thousandsof traders over the last 70 years.

A 1948 quote from Edwards andMagee still rings true today:

“…Prices move in trends and trendstend to continue until something hap -pens to change the supply-demand bal -ance. Such changes are usuallydetectable in the action of the marketitself. Certain patterns or formations,levels or areas, appear on the charts,which have a meaning and which canbe interpreted in terms of pro b a b l efuture trend development. They are notinfallible, it must be noted, but the oddsare definitely in their favor. Time aftertime, as experience has amply proved,they are far more prescient than the bestinformed and most shrewd of statisti -cians.” Ý

For information on the author see p. 3.

ACE Limited (ACE), daily

A

B

C

D

E

F

G

I

J

K

L

H

Protective stop

Sell short

Goal 1

Goal 2

February March April May June

45

44

43

42

41

40

39

38

37

36

35

34

33

32

Note that after Goal 1 was reached, the stop was lowered two times before the exit — first, to the swing high at H after the new low close at I and, second, to theswing high at J after the new low close at K.

FIGURE 6 TRADING A DESCENDING TOP


Additional reading

Playing for Keeps in Stocks &Futures: Three Top TradingStrategies That Consistently Beatthe Marketsby Thomas A. Bierovic(John Wiley & Sons, New York,2001)

Technical Analysis of Stock Trendsby Robert D. Edwards and John Magee(Originally published in 1948, Seventh Edition, CRC Press, Boca Raton, Florida, 1997)

Technical Analysis and Stock Market Profitsby Richard Schabacker(Originally published in 1932, reissued by Pitman Publishing, London, 1997)

BY THOM HARTLE

I n the late 1980s, Tobey Crabelpublished a series of articlesdetailing various short-termprice patterns for futures trading.

The patterns were designed to detectshort-term volatility changes — that is,a market would move into a short-termconsolidation, and then break out of it.

Two of Crabel’s patterns will be cov-ered here. The first is an inside day thatis smaller than the previous four days(IDnr4) and the second is a day whoserange is less than that of the previoussix days (NR7). An NR7 day does nothave to be an inside day.

F i g u re 1 contains examples of theseprice patterns (in a stock rather than af u t u res contract). Bar A is an IDnr4: It isan inside day and its range is smaller thanthe ranges of the previous four days. BarB is an NR7 day. In this case, the day’srange is smaller than the previous sixdays’ ranges. Finally, bar C qualifies asboth an IDnr4 and an NR7 day.

Analyzing IBM daily bar data fro mOct. 1, 2001, to Nov. 15, 2002, revealed that15 IDnr4 and 44 NR7 days occurred overthis 286-trading day period. This meansthese patterns are somewhat rare .H o w e v e r, many trading opportunitiesp resent themselves if you look for thesepatterns across a number of stocks.

Trading the patternsCrabel recommended trading these pat-terns the next day using an entry strate-gy based on the opening price and a pre-set value called the “stretch.” He hadtwo versions of the strategy — onecalled the opening range breakout (ORB)and the second the opening range break-out preference (ORBP).


TRADING Strategies

IBM (IBM), daily

A

B

C

29 1 5 12 19 26 August

82.50

80.00

77.50

75.00

72.50

70.00

67.50

The bars at A, B and C are all relatively narrow-range bars that representshort-term consolidations. Applying specific entry rules allows you to takeadvantage of moves out of the consolidation when volatility increases.

FIGURE 1 IDENTIFYING SHORT-TERM VOLATILITY CHANGES

Source: CQGNet

Opening s h o t s

Narrow-range bars and inside

bars represent short-term

volatility lows out of which

price can move sharply. This

strategy uses a simple volatility

measurement to determine

where to enter trades to

capitalize on this behavior.


The stretch value is the 10-day aver-age of the difference between the openand the low or high, whichever is small-er. For example, if the open was 79.50,the high was 80.33 and the low was77.98, you would use the diff e re n c ebetween the open and the high (0.83) vs.the open and the low (1.52). Figure 2shows the stretch range for IBM overthe last year: from an extreme of justunder $1 to just over $0.20, with theaverage just over $0.50.

The entry strategy using ORB is toplace a buy stop just above the openingprice plus the stretch amount, and placea sell stop just below the opening priceminus the stretch amount. The first stopt r i g g e red is the trade, and the otherautomatically becomes the pro t e c t i v estop.

If other technical indicators provideevidence of a strong trend, then use theORBP: Place the entry stop in anticipa-tion of the trend continuing. For exam-ple, if the stock is in an uptrend, enteronly a buy stop above the opening priceplus the stretch amount. If filled, placethe protective stop below the stretchsubtracted from the open.

Time is of the essenceAccording to Crabel, the earlier in thetrading session the entry stop is hit themore likely the trade will be profitableat the close. A trend triggered quickly inthe session could rack up a substantialprofit by the close and should be heldfor a possible two- to three-day run.

Once filled (and if the market isexhibiting a strong trend early), thenmove the protective stop to breakeven.If you are not filled early in the session,reduce the size of the position as timepasses through the day. Any positionsfilled near the close are suspect. In thiscase, you may have only a small unreal-ized profit, and probably should nothold the trade overnight.

Rules in actionFigure 3 is Figure 1 with the addition ofa 30-day exponential moving average(EMA). Bar A is the IDnr4 day.Considering the market moved abovethe previous resistance level at 72.50 in

Day

$1.20

$1.00

$0.80

$0.60

$0.40

$0.20

$0.00

The “stretch” is an amount added to a bar’s opening price to determine theentry point and stop level, respectively.

FIGURE 2 TAKING A STRETCH

IBM (IBM), daily

A

B

C

29 1 5 12 19 26 August

30-day EMA

82.50

80.00

77.50

75.00

72.50

70.00

67.50

Whether a market is in a trend (defined here by a 30-day EMA) dictates thetrade entry technique that is used.

FIGURE 3 FACTORING IN THE TREND

Source: CQGNet


the act of confirming a double bottompattern, and the 30-day EMA was risingand provided a support level, it’s logicalto conclude the stock is in an uptrend.Accordingly, we want to use the ORBPguidelines.

At this time, the stretch was 0.49. Thenext day IBM opened at 71.55, so theentry stop price was 72.04 (71.55 + 0.49)and the stop loss was 71.06 (71.55 – 0.49).That day IBM climbed as high as 73.78,fell as low as 71.19, and closed at 71.90. Inthis situation, when there is no profit atthe close, you should take the loss (in thiscase, 14 cents plus any slippage).

Bar B is the NR7 bar. The market is

clearly in an uptrend, and the prudentthing to do is trade with the trend, againfollowing the ORBPguidelines. After theNR7 day, the stock opened at 76.50; thestretch was 0.48. In this case, the stockmade a low of 75.98 (0.52 below theopen) in the first few minutes, whichwould have triggered a short sale if wedid not use the ORBP rule to trade withthe trend.

The long-entry stop was 76.98, whichwas hit later in the morning. The stock

closed at 79.35 for a profit of 2.37 thatday, not including slippage. This openp rofit warranted holding the positionovernight.

The next day, the stretch is used as atrailing stop, based on the opening price(79.35). The stretch had increased to 0.53,making the stop level 78.82 (79.35-.53),which was not hit. The next day, thestock opened at 81.56. Subtracting thestretch (0.53) sets a new stop at 81.03, theapproximate level at which the tradewould have been stopped out.

Bar C is the combination IDnr4 andNR7 bar. Still trading from the long side,the market opened the next day at 81.90.

Adding the current stretch of 0.53 creat-ed an entry stop of 82.43. But because thehigh was 82.00 on this day, no long tradewas executed.

As an example of what would happentaking the trade against the trend, sub-tracting 0.53 from the opening of 81.90would have put you short at 81.37. Thestock closed at 81.00, which would haveresulted in a small profit if you exited atthe close. If you stayed short, however,expecting some follow-through pro f i t

taking, you would have been stoppedout at 81.48 (using the stretch the follow-ing day to determine the stop-loss).

Profit targetsOne way to take partial profits is to use apercentage of the 10-day moving averageof the daily ranges as a target. Figure 4compares the 10-day average of the dailyranges compared to the stretch amounts.The average daily range is 2.55, but itranges from just above 1.50 to just over3.50. A reasonable target is 66-percent ofthe current 10-day moving average, justto be sure to put away some partial prof-its when you have the chance.

For example, at the bar after A inF i g u re 3, the current 10-day movingaverage of the range was 2.78. Assumingthat once you are stopped into the longposition you are confident the low at71.19 is in place for the day, add 66 per-cent of 2.78 (1.85) to 71.19 for a target of73.04. This would have given you partialprofits of 0.98 on this day before slip-page, which offsets the loss taken hadyou held the position at the close.

In addition, had you traded againstthe trend after the bar C trigger, youwould have been short at 81.37. The 10-day moving average of the daily rangeshad increased to 3.06, so the targ e twould have been the high of 82.33 – 2.04= 80.31 (3.06 * 0.666 = 2.04), which wouldhave been reached.

Finally, once in a trade, consider mov-ing your stop to breakeven if the markethas reached a point that represents 50percent of the 10-day average of the dailyrange.

Be a specialistAvery important aspect of applying thiskind of pattern-based technique is yourability to execute trades with as littleslippage as possible. Identifying thesetypes of price patterns, and combiningthem with rules for entering, managingrisk and taking profits in various mar-kets amounts to specializing. And spe-cialization is as popular and pro f i t a b l ean endeavor in trading as it is in otherd i s c i p l i n e s .Ý


10-day MA of the daily ra n g e s

S t r e t c h

Day

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0

To increase the odds of profitability, you can take partial profits when pricemoves in your direction by 66 percent of the 10-day average daily range.

FIGURE 4 DETERMINING LOGICAL TARGETS


BY TIMOTHY ANDREWS

A nyone who has attempted to design a technicaltrading system knows how difficult it can be todevelop rules that consistently and mechanicallycapitalize on price patterns.

Because we tend to naturally focus on the potential profit(instead of the risk) in a trade scenario, our eyes sometimesdeceive us by seeing chart formations that, though obviousand easy to trade in hindsight, are much more ambiguous anddifficult to define when unfolding in real-time trading.

Also, we tend to focus on patterns and signals that seem toput us in the market at advantageous times, without regard tohow we will get out of trades or howmuch risk we will be exposed to alongthe way.

Walking through the process of devel-oping a rule-based trading strategybased on a simple, “visual” price patternhighlights these challenges, but alsohones the skills necessary for developingbetter trading systems in the future aswell as reinforcing trading habits thatbenefit both discretionary and systemat-ic traders.

The outsidersThe pattern that will form the basis of thestrategy is the outside bar, which is aprice bar with a higher high and lowerlow than the preceding bar (see Figure 1).

Because they probe both higher andlower than the bars that precede them,outside bars are sometimes viewed asambiguous price events — they send outmixed signals about market direction bymoving above and below the precedingbar, or bars. As a result, traders oftenignore them and look for more obviousprice patterns.

For example, a price bar with a higher

low and a higher high than the previous bar reflects upwardmomentum, especially if it closes near the top of the bar’srange and higher than the previous bar’s close. Several suchbars in a row would constitute a clear short-term uptrend.

Although they do not provide quite as decisive a picture ofmomentum as this, outside bars have certain characteristicsthat, when placed in the context of the surrounding marketconditions, can signal which direction a market is likely tomove in the near future. In short, outside bars can providepotential entry signals, if you know what to look for — andwhat to look out for.

TRADING Strategies

OUTSIDE BARS: From concept to strategyA trading strategy usually begins with a simple observation about market

b e h a v i o r. In the first of two articles, we explore the “meaning” of outside bars

and illustrate the process of designing a trading strategy around our conclusions.

Natural Gas (NG), daily

28 3 10 17 24 1 8 15 22 29 5 12 19 26 3 9June July August September

3.600

3.400

3.200

3.000

2.800

An outside bar has a higher high and a lower low than the previous bar.Depending on market conditions, outside bars can signal reversals or contin -uations of the existing price trend.

FIGURE 1 OUTSIDE BARS

Source: QCharts Quote.com


The challenge is developing ru l e sbased on these characteristics. A quickreview of the general price characteris-tics of outside bars will lay the ground-work for the strategy.

What outside bars representThe most obvious characteristic of anoutside bar is that it represents a volatili-ty increase — an expansion of the pricerange — from the previous bar.

Volatility, however, is non-directional— it doesn’t tell you anything about thedirection a market is moving, or is likelyto move. A high-volatility market couldbe moving up dramatically, down dra-matically, or thrashing back and forth ina wide trading range. Or, if the highvolatility conditions have existed for awhile, it could mean the market is readyto “quiet down,” after exhausting itself.

Viewed in isolation, outside bars aretypically considered non-dir e c t i o n a l .However, looking at any market event inisolation rarely gives an accurate impres-sion of its meaning. Similar to the trending bars (higher highs,higher lows and higher closes) described earlier, we can lookfor clues in outside bars themselves — how they close and howtheir highs and lows compare to previous bars — as well as inthe surrounding price action to find tradable price moves.

Outside bars occur on all time frames, but they are less sig-nificant (although not completely meaningless) on intradaytime frames because the position of the close within the bar —and how the high and low relate to the previous high and low— are more arbitrary on five-minute or 10-minute (or 60-minute, etc.) bars than on daily or weekly bars. As a result, thestrategy is based on daily bars.

First impressionsFigure 2 shows a daily chart of the S&P Depository Receipts(SPY) with all outside days marked with dashed blue lines.There are 13 outside days among the roughly 112 days shownon this chart.

The price action that follows them is mixed: The secondSeptember outside day, second October day, first Decemberday and mid-January outside day were followed by significantprice moves; others, including the first September outside day,first October day and second December day, were followed bysmaller moves.

H o w e v e r, few of these bars were followed by much sidewaysmovement; for the most part, s o m e t h i n g usually happenedshortly after most of the outside bars. Closer examinationreveals several of the outside bars that are followed quickly bynotable up moves or down moves share a few characteristics.

First, many of the outside days tended to close in the dire c-tion of the short-term trend, which is re p resented in Figure 2 bya 10-day exponential moving average (EMA). The days withhigh closes were more often than not above the EMA, while theopposite was true of the days with low closes. These bars wereoften followed at least by a brief continuation of the trend.

From one perspective, this kind of continuation behaviorimplies the “indecision” often attributed to outside bars isactually a sign of trend strength, up or down. For example, if astock forms an outside bar on a day when a piece of bearishnews hit the market — e.g., a poor earnings announcement oran increase in unemployment — it could be evidence the mar-ket has the strength to absorb the sell-off that followed thenews and still rally to a new high.

However, the most conspicuous outside days in Figure 2were those that accompanied the October swing low and theDecember and January swing highs. These bars closed in theopposite direction of the short-term trend — at the upper endof the bar during a downtrend and the lower end of the barduring an uptrend. However, the October low outside barclosed below the EMA and the December and January highoutside bars closed above the EMA.

The first impression this chart gives is that outside barsmight be useful tools for identifying intermediate-term rever-sals, and to a lesser extent, momentum “thrusts” in the direc-tion of the short-term trend.

Distinguishing characteristicsThe next task is to translate these observations about outsidebars into logical statements that can be incorporated in a strat-egy and tested objectively.

Let’s first address the characteristics of those outside barsthat appear to offer the most favorable trade opportunities —the reversal bars. In terms of a bullish outside reversal bar thatoccurs at the bottom of a downtrend, the bar should closestrongly (in the opposite direction of the short-term trend, asnoted earlier). That could be defined as a close that is in theupper half of the bar’s range, above the open, and above theclose of the close two days ago (instead of just above yester-day’s close). These criteria are summarized in the followinglogical statement:

S&P Depository Receipts (SPY), daily

September October November December January 2003

96

94

92

90

88

86

84

82

80

78

The vertical lines identify outside bars. Some of these bars — includingthose at the more significant tops and bottoms — seem to provide potential -ly good entry signals, but defining them objectively is more difficult thanfinding them on a chart. (Note: The October low bar is an outside bar; itsdashed line is not visible.)

FIGURE 2 SOME GOOD, SOME BAD, SOME SO-SO



(high - close)/(high - low) < .50 andclose > open andclose > close[2] where[1], [2], etc., represent “one day ago,”

“two days ago,” etc.

To make sure this bar is occurring in adowntrend, we can add the conditionsthat its 10-day EMA value be less thanyesterday’s and that at least some of thebar is below the 10-day EMA:

10-day EMA< 10-day EMA[1] andlow < 10-day EMA.

Finally, adding the definition of theoutside bar results in the following defi-nition of the bars we are trying to identi-fy:

high > high[1] andlow < low[1] and(high - close)/(high - low) < .50 andclose > open andclose > close[2] and 10-day EMA< 10-day EMA[1] andlow < 10-day EMA.

The definition would be inverted (low replacing high, highreplacing low, “greater than” replacing “less than” and “lessthan” replacing “greater than”) for bearish outside reversal bars.

F i g u re 3 shows the same time period as Figure 2, with bull-ish and bearish outside reversal bars colored green and re d ,re s p e c t i v e l y. Only five of the 14 outside bars fulfilled the crite-ria, but with the exception of the first andlast outside bars, these criteria identifiedseveral of the important intermediate-term turning points on this chart (and asof press time, the jury was still out on thelast bar on the chart).

Hold your horsesIt’s too soon to have even the slightestidea whether these rules are the begin-ning of a good trading strategy. First,we’ve constructed these rules based onthe observation of one chart — a limiteddata sample, to say the least.

Second, we have not even determineda specific entry rule yet, let alone rules forc o n t rolling risk, taking profits or deter-mining how much capital to risk pertrade. All we know so far is that the ru l e shave identified some bars that occur inthe vicinity of some of the importantswing highs and lows on this chart.

Figure 4 shows the five months lead-ing up to the period in Figures 2 and 3,

with the outside days again highlighted with dashed lines. Ofthe nine outside days shown here, only one (highlighted green)fulfilled the outside reversal bar criteria we’ve developed.

One signal over five months constitutes a technical drought,but the time period was dominated by a major downtrend.This is a reminder that we need to revisit the other type of out-side bar we identified — those that close in the direction of thetrend and which can lead to short-term momentum moves —to see if we can make more use of outside bars.

In the follow-up to this article, we will develop trading rulesbased on the information we’ve put together about outsidebars, and test the strategy to see what kind of results we mightget in real trading.Ý




96

94

92

90

88

86

84

82

80

78

The green and red bars are the outside bars from Figure 2 that met the cri -teria we developed to identify reversal points. Only a handful of the outsidebars met the requirements.

FIGURE 3 OUTSIDE REVERSAL BARS



April May June July August

115

110

105

100

95

90

85

80

A look at the period preceding the time window shown in Figures 2 and 3reveals there were far fewer outside bars in general, and only one outsidereversal bar (in July).

FIGURE 4 EXPANDING THE HORIZON



Markets: Stocks.

System concept: The Trend with Pattern Entry(TPE) system combines a trend-following tech-nique with a simple pattern to pinpointentries. If the system determines a stock is inan uptrend, it looks for a brief pullback andenters long on the assumption the trend willresume.

The stop-loss level is based on current mar-ket volatility (expanding as volatility increas-es, and vice versa), which gives a trade suffi-cient breathing room to reach a profitable exitlevel.

This test is for the long-only version of thesystem. The Futures Trading System Lab ver-sion (see p. 54) includes both short and longtrades.

Rules:1. Trend-detection rule: The closing pricemust be above the 100-bar moving average.

2. Pullback entry rule: When two consec-utive bars close below the previous bar’sclose, enter long on the next bar’s open.3. Stop rule: The stop-loss level is equal tothe closing price minus four times the 10-bar average true range (ATR). Keep thisstop-loss order active for the duration ofthe trade.4. Exit rule: Exit at the market open whenthe trade closes with a 5-percent profit.

Money management: Risk 2 percent ofcurrent account equity per position. This isdone by calculating the difference betweenthe position’s “basis price” (the closingprice when the signal was triggered) andthe stop-loss level. Buy the number ofshares that results in a 2-percent loss ofaccount equity when the stop-loss is hit.

For example, given a current equitylevel of $120,000, a basis price of $20.55,and a stop-loss price of $17.40, the trade’smaximum point loss is $3.15. Two percentof the current equity is $2,400; dividingthis amount by the maximum point lossgives the number of shares to buy ($2400 /3.15 = 762).

Starting equity: $100,000. $10 slippage/commission deducted per trade.

1 , 0 5 0 , 0 0 0

1 , 0 0 0 , 0 0 0

9 5 0 , 0 0 0

9 0 0 , 0 0 0

8 5 0 , 0 0 0

8 0 0 , 0 0 0

7 5 0 , 0 0 0

7 0 0 , 0 0 0

6 5 0 , 0 0 0

6 0 0 , 0 0 0

5 5 0 , 0 0 0

5 0 0 , 0 0 0

4 5 0 , 0 0 0

4 0 0 , 0 0 0

3 5 0 , 0 0 0

3 0 0 , 0 0 0

2 5 0 , 0 0 0

2 0 0 , 0 0 0

1 5 0 , 0 0 0

1 0 0 , 0 0 0

5 0 , 0 0 0

0

E q u i t y Cash Linear reg Buy & hold

FIGURE 1 EQUITY CURVE

12/1/92 11/2/93 11/2/94 11/2/95 11/1/96 11/4/98 11/5/99 11/6/00 12/2/0212/3/01

Trend with pattern entry (TPE)

FIGURE 2 SAMPLE TRADES

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

Cisco Systems (CSCO), daily

Sell

Sell

Sell

Volume

Sell

Buy

Buy

Buy

Buy

January 1999 February

2 8 . 0 0

2 7 . 0 0

2 6 . 0 0

2 5 . 0 0

2 4 . 0 0

2 3 . 0 0

2 2 . 0 0

2 1 . 0 0

2 0 . 0 0

1 9 . 0 0

1 8 . 0 0

1 7 . 0 0

1 6 . 0 0

2 0 M

This chart of Cisco Systems (CSCO) shows entry and exit points during an uptrend,along with the 100-bar moving average that defines the long-term trend.

The light green area shows how much account capital is invested at anygiven time. The dark green area shows how much cash is available.


Test data: The system was tested on the ActiveTrader Standard Stock Portfolio, which contains thefollowing 18 stocks: Apple Computer (AAPL),Boeing (BA), Citibank (C), Caterpillar (CAT), Cisco(CSCO), Disney (DIS), General Motors (GM),Hewlett Packard (HPQ), International BusinessMachines (IBM), Intel (INTC), International Paper(IP), J.P. Morgan Chase (JPM), Coke (KO), Microsoft(MSFT), Sears (S), Starbucks (SBUX), AT&T (T) andWal-Mart (WMT).

Test period: December 1992 through December2002.

Test results: The system produced a 295-percent total net prof-it, compared to 328 percent for buying and holding over thesame period. Total market exposure was 72 percent, whichmeans on a risk-adjusted basis the system was slightly less effi-cient than buy and hold.

The system experienced a substantial drawdown of 31 per-cent near the end of the test period. However, buy and holdhad a 67-percent maximum drawdown during the test period.The system protects the portfolio from a more substantialdrawdown by avoiding the market when prices are below the100-bar moving average. The equity curve (Figure 1) shows thesystem is mostly in cash after prolonged down moves.

System parameters: The system parameters for the test wereselected subjectively, not as a result of optimization. A 100-bar

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

LEGEND: Net profit — profit at end of test period, less commission •Exposure — the area of the equity curve exposed to long or short positions, asopposed to cash • Profit factor — gross profit divided by gross loss • Payoffratio — average profit of winning trades divided by average loss of losingtrades • Recovery factor — net profit divided by max. drawdown • MaxDD% — largest percentage decline in equity • Longest flat days — longestperiod, in days, the system is between two equity highs • No. trades — num -ber of trades generated by the system • Win/Loss% — the percentage oftrades that were profitable • Avg. profit — the average profit for all trades •Avg. hold time — the average holding period for all trades • Avg. profit(winners) — the average profit for winning trades • Avg. hold time (win-ners) — the average holding time for winning trades •Avg. loss (losers) —the average loss for losing trades • Avg. hold time (losers) — the averageholding time for losing trades • Max. consec. win/loss — the maximumnumber of consecutive winning and losing trades

LEGEND: Avg. return — the average percentage for the period • Sharpe ratio— average return divided by standard deviation of returns (annualized) •Best return — best return for the period • Worst return — worst return forthe period • % Profitable periods — the percentage of periods that were prof -itable • Max. consec. profitable — the largest number of consecutive prof -itable periods • Max. consec. unprofitable — the largest number of consec -utive unprofitable periods

Trading System Lab strategies are tested on a portfolio basis (unlessotherwise noted) using Wealth-Lab Inc.’s testing platform.

If you have a system you’d like to see tested, please send the trad-ing and money-management rules to [email protected].

moving average (MA) captures the long-term trend whilebeing more responsive to price changes than the more com-monly used 200-bar MA. A 5-percent profit target is a reason-able goal. The ATR stop level gives the trade plenty of space,and should prevent the position from being stopped outbecause of random market noise.

You can tweak or optimize these parameters to see the effecton the system’s dynamics. For example, by decreasing the ATRlevel, we’d expect to see the average loss decrease, but we’dalso expect to see a larger number of losing trades (because ofwhipsaws). Adjusting system parameters usually involvestrade-offs such as this.

Bottom line: These simple rules yielded a moderately prof-itable trading system. It did not beat buy and hold in terms ofprofit on our test portfolio, but its drawdown was significant-ly smaller.

In addition to the filter that limits trades to uptrends only,the position-sizing rule ensures a maximum total loss of 2 per-cent per trade. This combination is an effective defense againstcapital deterioration.Ý

— Compiled by Dion Kurczek of Wealth-Lab Inc.

FIGURE 3 DRAWDOWN CURVE

0%-2%-4%-6%-8%

-10%-12%-14%-16%-18%-20%-22%-24%-26%-28%-30%

Profitability Trade statisticsNet profit ($): 212,926 No. trades: 656

Net profit (%): 212.93 Win/loss (%): 72.87

Exposure (%): 72.09 Avg. gain/loss (%): 1.36

Profit factor: 1.22 Avg. holding time: 17.79

Payoff ratio: 0.52 Avg. profit (winners): 6.55

Recovery factor: 1.56 Avg. hold time (winners): 15.13

Drawdown Avg. loss (losers): 12.57

Max. DD (%): 30.52 Avg. hold time (losers): 24.91

Longest flat days: 600 Max. consec. win/loss: 23/7

STRATEGY SUMMARY

PERIODIC RETURNS

A fairly long drawdown started in mid 2000, coinciding with thebroad market’s decline.

12/1/92 11/1/93 11/1/94 11/1/95 11/1/96 11/2/98 11/1/99 11/1/00 11/1/0211/1/01

Avg. Sharpe Best Worst % Max. Max.return ratio return return Profitable consec. consec.

periods profitable unprofitable

Weekly 0.24% 0.78 7.72% -8.63% 56.08% 8 7

Monthly 1.05% 0.79 13.50% -13.67% 56.20% 8 6

Quarterly 3.13% 0.78 18.95% -15.35% 68.29% 10 3

Annually 13.11% 0.76 35.49% -16.50% 80.00% 8 2


WatchWatch&FUTURES OPTIONS

Lend me your ear

The Merc speaks out

T he Chicago Merc a n t i l eExchange certainly had plen-ty to say about becoming thefirst U.S. exchange to go pub-

lic, but the SEC-mandated “quiet peri-od” kept Merc officials mum in theweeks before and after the Dec. 6 IPO.

Once the proverbial muzzle came off ,the Merc wasted no time in telling thefinancial world about its long-term plansas a publicly traded company.

“There are three key reasons we wentpublic,” says Merc chairman Te r r yDuffy. “Being public will facilitate futureaccess to capital markets, provide a stockcurrency for mergers and acquisitions,and create liquidity for our existingshareholders.”

And, at least from a volume stand-point, the CME has never been more indemand. Trading volume in 2002 was arecord 558 million contracts. That was 36percent higher than the record set in2001. Globex, the Merc’s electronic trad-ing system, had record volume of 198million contracts in 2002.

Total open interest at the Merc is themost for any options or future sexchange in the world, and the Dec. 12single-day re c o rd of 24.8 million opencontracts re p resented appro x i m a t e l y$16 trillion in notional value.

Volume in the E-Mini Nasdaq exceed-ed its old record by 67 percent; volumein the S&P E-Mini bested the formerhigh by 194 percent. The Merc alsoopened a remote data facility in 2002 andreported record revenue and earnings.

If stock value is any indication, theIPO has been a moderate success so far.The stock, which trades on the New YorkStock Exchange under the ticker symbolCME, opened at 35 and had not tradedbelow that level as of Feb. 12, when itwas trading around 42.70.

“As risk management continues tobecome an increasingly important com-ponent in the portfolios of institutionsand individual investors around theworld, we believe we have great potentialto attract more customers,” Duffy says.

The Merc’s recent success is tied to anumber of factors. For starters, the E-

Mini contracts on the S&Phave been an enormous suc-cess, as they have allowedsmall retail traders to partakein index futures trading.Overall, Globex has proven tobe a nice complement to theMerc’s floor-based business.

Not surprisingly, the Merc isi n t e rested in expanding itsp roduct line. The exchangewon’t specifically say whatnew products might be on the way, butP resident James McNulty admits they arealways looking in the interest rate are a .

The Merc also wants to expandGlobex’s ability to trade its own prod-ucts as well as increase its reach interna-t i o n a l l y. The Merc recently added aGlobex hub in London, and ChairmanEmeritus Leo Melamed sees China,South America and Eastern Europe asgood places for future growth.

H o w e v e r, it’s that expansion ofGlobex that creates a catch-22: To com-pete in today’s market environment, asignificant electronic presence isrequired. However, the more reliant theMerc is on Globex, the greater the per-ception the exchange is trying to phaseout the open-outcry part of its business.

In 2002, about half of the Merc’s vol-ume was electronic, up from only 12 per-cent in 1996.

But McNulty denies the Merc wantsto reduce or eliminate pit trading. In fact,he says the administration has no inputon closing trading pits. Rather, the Mercgauges volume and open interest todetermine whether a pit remains open.

This is not to say the Merc plans tostand in the way of future progress.

“We have put money into technology,and we will continue to do that and letcustomers make the decision as to whichplatform they want to choose,” saysDuffy.

Melamed points to currency tradingas proof that the Merc’s strategy in bal-ancing floor and electronic trading isworking.

“A few years back, everyone thoughtwe had lost the FX market, and we cer-

tainly were losing mar-ket share,” Melamedsays. “But it needed theelectronics to move, andwe provided that whenwe raised the level ofe fficiency in Globex.Almost the moment thathappened, the FX mar-ket started to come backto us.

“Our strategy is top rovide both venues in the best fashionpossible,” he says. “We spend all themoney we need to build the best elec-t ronic system in the world, and we spendall the money we need to maintain thefloor and keep it efficient and viable, andwe let the market dictate which way itwants to go. It has worked extre m e l yw e l l . ”

The Euro d o l l a r, the Merc’s mostactively traded contract, does most of itsvolume in the open-outcry market. Oneof the Merc’s big initiatives for 2003 isthe launch of EAGLE — an electronicway to trade Eurodollar spreads throughGlobex.

“The Eurodollar pit is an incrediblyefficient open-outcry mechanism for avery complex product,” McNulty says.“It’s that value added that has kept it aslively as it has. We also need to be able toprovide that on a 23-hour-a-day basis(the pit only trades during market hours;Globex virtually around-the-clock), soit’s extremely important for us to haveour Eagle release.”

However, while many outsiders arecurious to see how the increased relianceon electronic trading will eventuallyplay out, Duffy says it’s not a concern tothe people who matter most — themembers of the Merc.

“I talk to them all the time,” Duffysays. “And what’s not on their agendaare questions about how long the floorwill be open. The members are moreabout innovation and products. I alwayshave members come up to me with dif-ferent ideas on products and innovationand what they think will be successful intrading.”Ý

FUTURES OPTIONScontinuedWatchWatch&

T he Chicago Board of Trade issaying good-bye to one Euro-pean exchange and hello tothat exchange’s main com-

p e t i t o r.The CBOT dumped Eurex as its elec-

t ronic platform provider and agreed to adeal with EuronextLIFFE. Under theterms of the existing contract, Eure x ’ sa/c/e platform will be used by the Boardof Trade until Dec. 31, 2003. When trad-ing begins in 2004, LIFFE CONNECT

will be the CBOT’s new electronic trad-ing platform.

“Our selection will bring enormousbenefits to our customers and will allowthe Board of Trade to continue to off e rmarkets of the highest integrity, re l i a b i l i t y,liquidity and flexibility for years tocome,” says CBOT chairman NickN e u b a u e r. “Our board reached a decisionthat reflects our long-term business objec-tive of continued independence andg ro w t h . ”

The CBOT’s decision came a day afterEurex announced plans to launch a U.S.-based exchange (see “Eurex comes to theU.S.,” p. 48). CBOT president BernardDan says Eurex’s decision had nothingto do with the selection of Euronext, andhe expects the remaining months withEurex to go smoothly.

The original agreement between theCBOT and Eurex called for Eurex to pro-vide electronic trading capability untilOctober 2003, with the Board of Traderetaining exclusive rights to trade certainfutures contracts. The agreement wasmodified in July 2002 to shorten thelength of the technology agreement andallow Eurex to offer contracts similar tothose trading on the CBOT.

Dan doesn’t expect any difficulty inswitching over to the new platform.

“We anticipate a seamless transition,particularly as the majority of our cur-rent electronic trading volume comesfrom customers and members who arealready established users of the LIFFECONNECT system and are familiar withthe functionality and benefits offered bythat platform,” he says.

Neubauer says that he expects CBOTvolume — which set a record with morethan 343 million contracts traded in 2002— to increase even more in 2003 becauseof Euronext’s distribution range.

Dan adds, “We’re looking forward tosignificant enhancements to our inter-product and intraproduct spread tradingand to considerably more flexibility inthe matching algorithms. We’ll haveenhanced product development andproduct maintenance capability, whichwill translate into uniquely attractivenew product offerings.”

Dan says there is nothing specific onthe new product front, but the focus willbe on fixed-income products. And, hemaintains the selection of LIFFE CON-NECT in no way endangers the CBOT’sfloor-based business.

“ A significant portion of financialfutures are already traded electronical-ly,” he says. “LIFFE will increase capa-bility and functionality to ensure weremain competitive, not increase ourelectronic presence. It will enhance ourability to align our floor and electronictrading.”Ý


Making the CONNECTion

Euro(N)ext for CBOT

And here comes linkage!

“Down” year foroptions still very busy

F or the firsttime in 11years, total

and equity optionsvolume failed toset a new record.H o w e v e r, there’sno reason to shedtears for the op-tions industry.

Equity optionvolume for 2002was just less than710 million con-tracts — about 13 million less than therecord set in 2001, and the second-high-est total ever. Equity option volume alsowas the second highest ever; at 780.5million it missed breaking anotherrecord by less than 1 million contracts.

I n d i v i d u a l l y, the International Se-curities Exchange continued to be thestory. Total volume at the ISE increased133 percent from the year before to 152million contracts.

The Chicago Board Options Exchangecontinues to be the volume leaderamong the five U.S.-based optionsexchanges. Total volume at the CBOEwas more than 267 million, the third-highest total in exchange history.However, that represented a 13-percentdrop from 2001.

Equity options volume at the CBOEwas down 26 percent to 173 million — anumber directly attributable to the ISE,as the ISE trades only equity options.

In other options news, the long-await-ed linkage between the five U.S. optionexchanges (ISE, CBOE, American StockExchange, Pacific Coast Exchange,Philadelphia Stock Exchange) officiallybegan Jan. 31. The linkage, which hasbeen more than three years in the mak-ing, will begin with a batch of 14 active-ly traded options. At press time, alloptions were scheduled to be linked byMarch 4.

The options linkage is designed toprevent “trade-throughs” — an optiontrade executed on one exchange eventhough a better price can be found onanother exchange. Without linkage, thishas been a common occurrence. Withlinkage, option market makers will havethe ability to access quotes from theother exchanges and execute trades atthe best price.Ý

FUTURES OPTIONScontinuedWatchWatch&


F u t u res exchanges in the U.S. willbe getting a new competitorsoon — and one that comes witha long track re c o rd of success.

E u rex, the German derivativesexchange that leads the world in futuresvolume, announced its intentions tobegin trading derivatives on U.S. interest

rates, indices and equitiesin early 2004.

Although trading in U.S.bonds has long been theexclusive domain of theChicago Board of Tr a d e ,Eurex gained the right to offer thoseproducts by forming an alliance with the

CBOT. Although the alliance will end atthe end of 2003 (see “Euro(N)ext forCBOT,”p. 46), Eurex swapped its elec-tronic trading platform (a/c/e) for theright to list products already traded bythe CBOT.

Leaders of the top U.S. future sexchanges were quick to downplay thesignificance of the Eurex announcement.

“We are aware of the competition,”says Chicago Board of Trade presidentBernard Dan. “Eurex has several stepsthey need to make to get established inthe U.S. We don’t view them as a partic-ular threat.”

BrokerTec, an all-electronic exchangethat traded fixed-income products, wascreated as an alternative to the CBOT.Although BrokerTec traded more than 2million contracts its first full year in busi-ness, it failed to steal substantial busi-ness from the CBOT and was recentlybought by London-based bro k e r a g eICAP.

“We have seen competition before,”says CBOT chairman Nick Neubauer.“We have seen how difficult it is to com-pete with an established exchange. It’seven more difficult when that exchangeis not local and is based in another coun-try. As long as we do our business prop-erly and provide the best value we can toour customers, we’ll be successful.”

Because of Eurex’s familiarity with theCBOT (the a/c/e platform handles morethan 70 percent of the global bond trade),it’s likely CBOT products will be Eurex’sinitial focus. However, the ChicagoMercantile Exchange, a big provider ofinterest-rate products, will also see somedirect competition from Eurex.

“We have many excellent competitorsaround the world,” says Merc presidentJames McNulty. “We live with that on adaily basis and we’re happy to continueto.”Ý

HAVING MORE OPTIONSq The International Securities Exchange signed a licensingagreement with Standard & Poors in mid-January, allowingthe ISE to list options on nine Select Sector SPDR exchange-traded funds. Select Sector SPDRs are comprised of thestocks that make up various S&P sectors. The options willbe on the Consumer Discretionary Select Sector SPDR fund(XLY), Consumer Staples Select Sector SPDR fund (XLP),Energy Select Sector SPDR fund (XLE), Financial SelectSector SPDR fund (XLF), Health Care Select Sector SPDRfund (XLV), Industrial Select Sector SPDR fund (XLI),Materials Select Sector SPDR fund (XLB), Technology SelectSector SPDR fund (XLK) and Utilities Select Sector SPDRfund (XLU). Earlier in the month, the ISE began tradingoptions on the Financial Select SPDR fund (XLF),Technology Select Sector SPDR Fund (XLK) and UtilitiesSelect Sector SPDR Fund (XLU).

WELL FEDq The Chicago Board of Trade began trading options on FedFunds in mid-March. The Fed Funds futures contract oftenreaches record volume on days of Federal Open MarketCommittee meetings, prompting the CBOT to introduce anoption on the contract. Fed Funds options will be traded inan open-outcry pit.

TAKE A DIP IN THE INCENTIVE POOLq Eurodollars are already the most traded contract at theChicago Mercantile Exchange, but the Merc has launched anew incentive program to promote liquidity in the backmonths of the contract. The back months are contractmonths that trade three to 10 years into the future, andthe Merc will create an incentive pool that providesrebates to those accounts that meet minimum volumethresholds in the contracts. Additionally, the Merc isincreasing the size of the pit that trades back-monthEurodollar contracts.

• • • • • • • • FAST F I L L S• • • • • • • • F A S T F I L L S

Won’t they need a name change?

Eurex comes to the U.S.


StrategiesStrategies&FUTURES OPTIONS

T h e RSI TRENDLINE m e t h o dAlthough it is most commonly used as an overbought-oversold indicator,

the relative strength index (RSI) also functions as an accurate trend indicator.

Applying trendlines to the RSI and trading in the direction

of the trend results in many favorable entry points.

BY THOM HARTLE T raders who have used a cer-tain technical indicator for along time tend to become socomfortable with a particu-

lar interpretation of the tool they havet rouble conceiving diff e rent uses for it.

For example, the relative stre n g t hindex (RSI) is almost always discussed interms of signaling short-term over-bought or oversold conditions.H o w e v e r, “The Trend-Following RSI”(Active Trader January 2003, p. 44) illus-trated how the 14-day relative strengthindex (RSI) can be used as a de facto trendindicator: RSI readings greater than 50were shown to be equivalent to the mar-ket being above a 28-day exponentialmoving average, while RSI re a d i n g sbelow 50 were the same as the marketbeing below a 28-day exponential mov-ing average. In addition, uptrends wereshown to be characterized by persistentoverbought RSI readings, and down-trends by persistent oversold readings.

Because of its trend-following aspect,a simple trendline technique can beapplied to the RSI to generate entry sig-nals in the direction of the trend. To dothis, it is necessary to plot the indicatoras a histogram (a series of vertical bars)with the baseline set to 50, as shown inFigure 1). For an explanation of the RSI,see “The relative strength index” (oppo-site page).

RSI trendline rulesThe following rules describe how to usea trendline technique on the 14-bar RSI(daily charts):

Long tradesSetup:1. Find markets where the RSI is

greater than 50 and forms two pivothighs, the first higher than the second.

When the RSI closes above the descending trendline drawn between twopivot highs, a long trade is entered. This trade was exited on the fourth dayafter entry, when price traded below the low of the previous day.

30-year T-bond futures (US), daily

RSI

1

4

2

3

A B C

Exit

Long

28 3 10 17June

101-00

100-00

99-00

98-00

97-00

7065605550

Source: CQGNet

FIGURE 1 TRADING IN AN UPTREND


(Apivot high is a high with a lower highpreceding and following it; a pivot lowis a low with a higher low precedingand following it.)

2. Draw a downward-sloping trend-line connecting the two pivot highs.

3. The RSI must close above thetrendline.

Entry:1. If price closes in the upper 50 per-

cent of the range for the day (which con-firms rising momentum), go long on theclose.

Stop-loss and exit:1. Set an initial stop two ticks below

the low of the entry bar. Then trail a stopbelow the low of the previous day forthe remainder of the trade’s life.

Reverse the rules for short trades

Trade examplesFigure 1 is a classic long trade in T-bondf u t u res (US). The market is in anuptrend, as indicated by the RSI read-ings above 50. Point A of the RSI his-togram is the first pivot high — the RSIvalue on that day is higher than the pre-vious and following day. Point B is alower pivot high, so a downward trend-line is drawn to connect points A and B.

The RSI closes above the trendline atpoint C, and price closes at its high forthe day, so a long trade is entered on theclose at 99 12⁄32. For the first full day of thetrade, the stop-loss is placed under thelow of the entry bar. On the second day,the stop was moved to under the low ofthe first day, and so on. The trade wasexited on day 4, when the trailing stop(set under the low of day 3) was hit at100 20⁄32.

The relative strength index (RSI)

The relative strength index (RSI) is an oscillator that ranges from 0 to 100.The formula is:

RSI = 100 - (100/[1+RS])

where

RS = relative strength = the average of the up closes over the calculationperiod (e.g., 10 bars, 14 bars) divided by the average of the down closesover the calculation period.

For example, when calculating a 10-day RSI, if six days closed higher thanthe previous closes, you would subtract the previous close from the currentclose for these days, sum the differences, and divide the result by 10 to getthe up-close average. (The sum is divided by the total number of days in thelookback period and not the number of up-closing days.)

For the four days that closed lower than the previous day’s close, youwould subtract the current close from the previous close, sum these differ-ences, and divide by 10 to get the down-close average. If the up-close aver-age was .8 and the down-close average was .4, the relative strength over thisperiod would be 2. The resulting RSI would be 100 - (100/[1+2]) = 100 - 33.3= 66.67.

With the market in a downtrend, a trendline is drawn between two ascend -ing RSI pivot lows. The trade is entered when the RSI penetrates the trend -line to the downside.

Nasdaq 100 E-Mini futures (NQ), daily

RSI

1

4

2

3

7

5

6

A

B C

Exit

Short

1 8 15 22 29July

1050.00

1000.00

950.00

900.00

50

45

40

35

30

Source: CQGNet

FIGURE 2 SELLING SHORT


Figure 2 is an example of a short salein the Nasdaq 100 E-Mini (NQ) futurescontract. The market is in a downtrend— the RSI readings are all below 50. Thebars preceding and following point Ahave higher RSI readings, establishing itas a pivot low.

Point B is a higher pivot low, so wedraw an upward trendline connecting thetwo points. At point C, the RSI closesbelow the trendline, and price closes rightat the low of the day, so a short position isestablished at the close at a price of 1005.After setting the initial stop, the trailingstop is implemented for the re m a i n i n gdays of the trade. The position is stoppedout at 929 on day 7, when the market trad-ed above the high of day 6.

Drawing appropriate trendlinesFigures 1 and 2 show fairly straightfor-ward trade examples. However, in someinstances it might be less clear which RSIpivot highs or lows should be connectedto form the correct trendline for a trade.

When a market is trending upward,the RSI will peak, and then edge its wayback to 50 — forming declining pivothighs — in a consolidation period. Theobject is to identify when a trend is justabout to begin; we look for a move abovethe RSI down trendline to signal upwardmomentum is reasserting itself. The con-cept is the same for a downtrending mar-ket, except we look for signs downwardmomentum is returning by virtue of a

downside penetration of the RSI uptrendline.

That being the case, the goal is to drawtrendlines on the RSI that signal momen-tum is returning sooner rather than later.Figure 3 illustrates a situation in whichmore than one trendline could be drawn.The trendline drawn along points A andB on the RSI histogram generated a buysignal on bar 1. This turned out to be alosing trade, stopped out two bars later.

Another pivot high formed at point C,allowing a trendline to points B and C.The RSI is above this trendline at bar 2,but price closes below the 50 percentpoint of the day’s range on this bar, so noentry signal occurs.

However, a down trendline connect-ing pivot highs A and C creates an entrysignal on bar 3 (two bars after RSI bar C).A long trade entered here would turnout to be very profitable. Although barsB and C were pivot highs, the fact theyw e re nearly horizontal indicates theywere part of the sideways trading action.

Because we are trying to enter tradesas soon as there is an indication momen-tum is returning, the RSI pivot highs orlows that should be connected are theones that result in the steepest possibletrendline. A steep trendline will be pene-trated earlier than one connecting twosimilar pivot points.

From momentum to trendThe RSI is a momentum indicator basedon calculating the difference betweenclosing prices over a given period. If amarket is moving from a trending phaseto a congestion phase, the RSI levels willmove closer to 50, which is the indica-t o r’s midpoint. This is a sign thatmomentum is decreasing.

The RSI trendline method alerts you toexpanding momentum — exactly what atrader wants, because it defines anemerging trend. Ideas to improve thisapproach include back-testing to see if abetter stop-loss point or preset profit tar-get becomes apparent.Ý


The trendlines drawn between points A and B and B and C resulted in a lossand no signal, respectively. However, the trendline connecting points A and Cbest reflected the renewed momentum and provided the basis for a success -ful trade.

30-year T-bond futures (US), daily

RSI

1 2

3

A

B C

Exit

Long

19 26 3 9September

111-00

110-00

109-00

108-00

107-00

106-00

75

70

65

60

55

Source: CQGNet

FIGURE 3 CONNECTING THE PROPER POINTS

Uptrends are characterized by persistent overbought RSI readings,and downtrends are reflected by persistent oversold readings.

FUTURES OPTIONScontinuedStrategiesStrategies&

Markets: Futures.

System concept: System designers must confront two tradingrealities: Complex or “innovative” strategy ideas often soundgood but fail to stand the test of time; and, most strategies thatare effective on stocks do not work on futures.

This test shows the performance of the Trend with PatternEntry (TPE) system, a straightforward strategy that combines atrend-following rule with a simple pattern to pinpoint tradeentries.

If a market is in an uptrend, the system waits for a brief pull-back and enters long. The system gives trades plenty of breath-ing room and the chance to reach the profit target (see the stockTrading System Lab on p. 44 for more details). Unlike the stockversion of the system, the futures system goes short as well aslong.

Rules:For long trades

1. Trend detection rule: The closing price must be above the100-bar moving average.

2. Pullback entry rule: When two consecutive bars closebelow the previous bar’s close, enter long on the next bar’sopen.

3. Stop rule: The stop-loss level is equal to the closing priceminus four times the 10-bar average true range (ATR). Keep thisstop-loss order active for the duration of the trade.

4. Exit rule: Exit at the market open when the trade closes with a5-percent profit.

Invert the rules to execute short trades.

Money management: Risk 2 percent of current account equity perposition. This is done by calculating the difference between theposition’s “basis price” (the closing price when the signal was trig-

gered) and the stop-loss level. Buy the number of contracts thatresults in a maximum loss of 2 percent of account equity whenthe stop-loss is hit.

For example, given a current equity level of $1.2 million, abasis price of $.008750 in the Japanese yen (JY) futures, and astop-loss price of $.008450, the trade’s maximum point loss is$.000300. The dollar risk is the point risk times the contract size($.000300*[12,500,000] = $3,750). Two percent of the current equi-

ty is $24,000; dividing this amount by the dol-lar risk gives the number of contracts to buy:$24,000/$3,750 = 6 (rounded).

Starting equity: $100,000. Deduct $10 slip-page/commission per contract (entry and exit).

Test data: The system was tested on the ActiveTrader Standard Futures Portfolio, which con-tains the following 20 futures contracts: DAX30(AX), corn (C), crude oil (CL), German Bund(DT), Euro dollar (ED), Euro Forex (FX), gold(GC), copper (HG), Japanese yen (JY), coffee(KC), live cattle (LC), lean hogs (LH), Nasdaq100 (ND), natural gas (NG), soybeans (S), sugar(SB), silver (SI), S&P 500 (SP) and T-notes 10year (TA). For this article we used ratio-adjust-ed data from Pinnacle Data Corp.

Test period: August 1993 until November 2002.

Test results: The system produced a total netprofit of 572 percent with a total market expo-sure of only 38 percent, which gives you thefinancial leeway to use the system on othermarkets, or to diversify with other systems.The system’s biggest drawdown was 17 per-cent (on June 6, 2000).

Most futures systems have a low perc e n t a g eof winning trades, which makes it difficult tostick to the system over time. The TPE future s

FIGURE 2 SAMPLE TRADES

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

Nasdaq 100 index futures (ND), daily

Volume

Cover

CoverCover

Cover

Cover

Cover

Short Short

Short

Short

Short

Short

November 2000 December 2000

4 , 0 0 0

3 , 9 0 0

3 , 8 0 0

3 , 7 0 0

3 , 6 0 0

3 , 5 0 0

3 , 4 0 0

3 , 3 0 0

3 , 2 0 0

3 , 1 0 0

3 , 0 0 0

2 , 9 0 0

2 , 8 0 0

2 , 7 0 0

2 , 6 0 0

2 , 5 0 0

2 , 4 0 0

4 0 , 0 0 0

2 0 , 0 0 0

7 0 0 , 0 0 0

6 5 0 , 0 0 0

6 0 0 , 0 0 0

5 5 0 , 0 0 0

5 0 0 , 0 0 0

4 5 0 , 0 0 0

4 0 0 , 0 0 0

3 5 0 , 0 0 0

3 0 0 , 0 0 0

2 5 0 , 0 0 0

2 0 0 , 0 0 0

1 5 0 , 0 0 0

1 0 0 , 0 0 0

5 0 , 0 0 0

0

Equity Cash Linear reg Short L o n g

FIGURE 1 PORTFOLIO EQUITY CURVE

8/16/93 7/1/94 6/1/95 5/1/96 4/1/97 3/2/98 1/3/00 12/5/00 12/4/01 12/3/02

Trading System LabTrading System LabFUTURES

Trend with pattern entry (TPE)

The system improved its entry points in the Nasdaq downtrend. Also note that thestop levels (green dots) on the chart stay constant until a new position is entered.

The light green area shows how much capital is invested at anygiven time. The dark green area shows how much cash is available.The top border of the light green area is the combined equitycurve of the short and long trades.



LEGEND: Avg. return — the average percentage for the period • Sharperatio — average return divided by standard deviation of returns (annualized)• Best return — best return for the period • Worst return — worst returnfor the period • % Profitable periods — the percentage of periods that wereprofitable • Max. consec. profitable — the largest number of consecutiveprofitable periods • Max. consec. unprofitable — the largest number ofconsecutive unprofitable periods

system has a very high winning percentage, combined with alow drawdown. Figure 1 shows the equity curves for both thelong trades (black line) and the short trades (red line) that areresponsible for the smooth overall equity curve. Although theshort trades experienced a hefty drawdown of over 47 perc e n tin recent months, the long trades were able to offset this.

Practical trading issues: Moving-average-based systemsvery often wipe out a large amount of trading capital in side-ways markets. If you wait until a market has crossed aboveor below a moving average (either by a certain percentagemove or for a certain number of days) before acting on atrade signal, you end up buying the highs and selling thelows. The TPE system avoids this problem and improves theentry point by taking a position when the market retracesafter a move above or below the moving average.

Because the original stop level is not a trailing stop, thesystem uses a profit target to lock in some profits and waitsfor the pattern to trigger a new signal before establishing anew trade. Also, with each new position you adjust the posi-tion size based on the recent market volatility and the result-ing ATR calculation. This happens only if the trend definedby the moving average is still moving in the same directionit was before.

The tested parameters were not the result of optimization.To verify the results, you can test the system on differentmarkets and see whether the results are consistently prof-itable across different parameter values. Table 1 shows theresults of a quick optimization of the moving average peri-od from 25 to 100 in steps of 25, using the same profit target,stop-loss and money management rules.

The system performs much better on commodity futuresthan it does on stocks because commodities generally havelonger trends and less volatility than equity markets. As aresult, trend-following systems such as this one can usually catch

Trading System Lab strategies are tested on a portfolio basis (unlessotherwise noted) using Wealth-Lab Inc.’s testing platform.

If you have a system you’d like to see tested, please send the trad-ing and money-management rules to [email protected].

PERIODIC RETURNSAvg. Sharpe Best Worst % Max. Max.

return ratio return return Profitable consec. consec.periods profitable unprofitable

Weekly 0.42% 1.29 9.53% -9.42% 60.70% 10 5

Monthly 1.80% 1.37 19.43% -7.83% 68.14% 10 3

Quarterly 5.47% 1.40 26.88% -10.53% 73.68% 6 2

Annually 22.19% 1.22 57.66% -1.53% 90.00% 7 1

Profitability Trade statisticsNet profit ($): 572,634 No. trades: 834Net profit (%): 572.63 Win/loss (%): 64.75Exposure (%): 38.34 Avg. gain/loss (%): 0.98Profit factor: 1.34 Avg. holding time: 29.39Payoff ratio: 0.73 Avg. gain (winners) 6.00%Recovery factor: 6.85 Avg. hold time (winners): 27.20

Drawdown Avg. loss (losers): -8.25%

Max. DD (%): 16.57 Avg. hold time (losers): 33.39Longest flat days: 341 Max. consec. win/loss: 12/5

STRATEGY SUMMARY

LEGEND: Net profit — profit at end of test period, less commission •Exposure — the area of the equity curve exposed to long or short positions, asopposed to cash • Profit factor — gross profit divided by gross loss • Payoffratio — average profit of winning trades divided by average loss of losingtrades • Recovery factor — net profit divided by max. drawdown • MaxDD% — largest percentage decline in equity • Longest flat days — longestperiod, in days, the system is between two equity highs • No. trades — num -ber of trades generated by the system • Win/Loss% — the percentage oftrades that were profitable • Avg. gain — the average profit for all trades •Avg. hold time — the average holding period for all trades • Avg. gain(winners) — the average profit for winning trades •Avg. hold time (win-ners) — the average holding time for winning trades •Avg. loss (losers) —the average loss for losing trades • Avg. hold time (losers) — the averageholding time for losing trades • Max. consec. win/loss — the maximumnumber of consecutive winning and losing trades

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

0 . 0 0 %

- 2 . 0 0 %

- 4 . 0 0 %

- 6 . 0 0 %

- 8 . 0 0 %

- 1 0 . 0 0 %

- 1 2 . 0 0 %

- 1 4 . 0 0 %

- 1 6 . 0 0 %

FIGURE 3 DRAWDOWN CURVE

8/16/93 7/1/94 6/1/95 5/1/96 4/1/97 3/2/98 1/3/00 12/8/00 12/7/01

A fairly long drawdown (more than one year) occurred at the beginningof the test period. However, the depth of the system’s drawdownswere modest.

TABLE 1 PARAMETER STABILITY

This table compares system results using different moving average lengths. The system results are stable across the range of parameters, even when comparing long and short trades (not shown).

SMA 100 SMA 75 SMA 50 SMA 25Starting capital $100,000 $100,000 $100,000 $100,000 Ending capital $672,634.81 $601,189.69 $559,724.00 $470,290.13Net profit % 572.63 501.19 459.72 370.29Exposure % 38.34 38.41 39.61 37.98All trades 834 823 787 807Winning trades 540 (64.75%) 527 (64.03%) 500 (63.53%) 499 (61.83%)Max. consecutive 12 13 13 12Losing trades 294 (35.25%) 296 (35.97%) 287 (36.47%) 308 (38.17%)Max. consecutive 5 6 7 7Max. drawdown -16.57% -15.79% -21.46% -28.69%

and ride more profitable trends in futures markets. Another factoris the futures version uses long and short signals, while the stocksversion uses long signals only.

Bottom line: All traders need to imprint their own personalitiesand styles to a trading method. For traders who like to diversifyamong markets, the TPE strategy provides a good starting point.Managing your risk at the portfolio level offers exciting opportu-nities for futures traders.— Compiled by Dion Kurczek and Volker Knapp of Wealth-Lab Inc.


SnapshotSnapshotFUTURES

Date: Feb. 11, 2003

The following table summarizes the trading activity in the most actively traded futures contracts.The indicator readings are NOT trade signals. They are intended only to provide a brief synopsis ofeach market’s liquidity, direction, and levels of momentum and volatility. See the legend (right) forexplanations of the different fields.

L e g e n d :

Sym: Ticker symbol.

Exch: Exchange on which the contract is traded.

Vol: 30-day average daily volume,in thousands.

OI: Open interest, in thousands.

S T T: Short-term trend direction,determined by whether a short-termmoving average (MA) is above/belowits value one month ago.

ITT: Intermediate-term trend direction, determined by whetheran intermediate-term MA isabove/below its value threemonths ago.

LTT: Long-term trend direction,determined by whether a long-termMA is above or below its value ninemonths ago.

Trend%: The first number in thisfield is a measure of relative trendstrength (NOT direction) expressedas the current short-term trendstrength divided by the intermedi -ate-term trend strength. The high-er the number, the higher the cur-rent short-term relative trendstrength (up or down). The secondnumber shows the percentile rankof the current reading compared tothe readings of the past twomonths. (In other words, a readingof .09, or 9%, means only 9 percentof the readings over this periodwere lower than the current read-ing.)

Vlty%: The first number in thisfield measures relative volatility bydividing the current short-termvolatility by the intermediate-termvolatility. The higher the number,the higher the current short-termrelative volatility. The second num-ber shows the percentile rank ofthe current reading compared tothe readings of the past twomonths. (In other words, a readingof .75, or 75%, means 75 percent ofthe readings over this period werelower than the current reading.)

OB/OS: Whether a 10-day momen-tum indicator registers the marketas overbought (OB), oversold (OS)or neutral (N). Note: Overboughtand oversold signals are NOT tradesignals. They are warnings thatupside momentum is high or low(compared to the market’s recentactivity) AND MAY REMAIN SO FORAN UNDETERMINED AMOUNT OFTIME.

M a r k e t S y m E x c h Vo l O I S T T I T T LT T Tr e n d % V l t l y % OB/OS

S&P 500 E-Mini E S C M E 6 2 2 . 3 0 0 . 8 9 q p q 3 . 5 0 / 1 . 0 0 0 . 9 1 / 0 . 9 2 N

Nasdaq 100 E-Mini N Q C M E 2 3 1 . 3 0 2 0 5 . 3 1 q p q 6 . 0 0 / 0 . 7 5 0 . 8 5 / 0 . 3 7 N

E u r o d o l l a r E D C M E 9 4 . 9 0 7 2 9 . 4 7 q p p 1 . 1 3 / 0 . 0 0 0 . 7 0 / 0 . 5 6 N

Crude oil C L N Y M E X 8 8 . 7 0 1 4 9 . 8 5 p p p 1 . 4 5 / 0 . 3 2 1 . 0 8 / 0 . 4 4 O B

1 0 - y r. T- n o t e T Y C B O T 6 8 . 1 0 7 5 3 . 4 7 p p p 1 . 8 6 / 0 . 1 4 0 . 9 2 / 0 . 2 4 N

S&P 500 index S P C M E 6 5 . 0 0 5 7 5 . 1 2 q p q 3 . 1 9 / 1 . 0 0 0 . 9 0 / 0 . 8 8 N

3 0 - y r. T- b o n d U S C B O T 4 0 . 1 0 4 0 3 . 0 0 p p p 1 . 1 1 / 0 . 2 5 0 . 9 6 / 0 . 3 2 N

Natural Gas N G N Y M E X 4 0 . 0 0 5 7 . 1 9 p p p 1 . 8 5 / 0 . 4 4 1 . 0 9 / 0 . 3 6 N

G o l d G C N Y M E X 3 6 . 1 0 1 0 8 . 1 5 p p p 2 . 1 8 / 0 . 0 0 1 . 4 4 / 0 . 8 8 O S

5 - y r. T- n o t e F V C B O T 3 4 . 1 0 6 6 8 . 0 0 p p p 2 . 3 3 / 0 . 2 2 0 . 8 9 / 0 . 3 2 N

C o r n C C B O T 3 3 . 7 0 2 0 6 . 2 0 q q p 2 . 0 0 / 0 . 1 2 0 . 8 0 / 0 . 3 9 N

E u r o c u r r e n c y E C C M E 2 9 . 3 0 1 0 1 . 0 0 p p p 2 . 0 7 / 0 . 2 2 1 . 1 7 / 0 . 9 8 N

Heating oil H O N Y M E X 2 7 . 7 0 4 2 . 2 8 p p p 2 . 2 0 / 0 . 3 6 1 . 5 9 / 1 . 0 0 N

S o y b e a n s S C B O T 2 7 . 3 0 7 0 . 4 9 q p p 0 . 7 4 / 0 . 3 6 0 . 9 7 / 0 . 8 6 N

Mini Dow Y M C B O T 2 4 . 7 0 1 5 . 5 3 q p q 2 . 0 8 / 1 . 0 0 0 . 9 0 / 0 . 8 6 N

Unleaded gasoline H U N Y M E X 2 3 . 8 0 3 6 . 8 9 p p p 2 . 4 7 / 0 . 7 8 1 . 1 5 / 0 . 8 3 N

Japanese yen J Y C M E 1 9 . 5 0 8 7 . 5 6 p p p 1 . 3 0 / 0 . 4 6 0 . 9 3 / 0 . 3 1 N

Dow Jones Ind. Avg. D J C B O T 1 8 . 4 0 2 7 . 8 4 q p q 3 . 2 7 / 1 . 0 0 0 . 8 9 / 0 . 8 6 N

Nasdaq 100 index N D C M E 1 5 . 8 0 7 2 . 7 3 q p q 5 . 0 0 / 0 . 6 9 0 . 8 4 / 0 . 3 6 N

S u g a r S B N Y B T 1 5 . 2 0 1 2 4 . 9 9 p p p 4 . 0 0 / 1 . 0 0 1 . 1 7 / 0 . 8 6 N

W h e a t W C B O T 1 2 . 8 0 5 3 . 6 0 q q p 2 . 4 3 / 0 . 5 3 0 . 8 1 / 0 . 3 2 N

S i l v e r S I N Y M E X 1 2 . 6 0 6 4 . 6 8 p p p 2 . 2 0 / 0 . 1 9 1 . 2 9 / 0 . 9 5 O S

Canadian dollar C D C M E 1 2 . 3 0 8 8 . 0 9 p p p 2 . 2 5 / 0 . 5 1 1 . 0 9 / 0 . 9 8 N

Soybean meal S M C B O T 1 1 . 7 0 3 7 . 6 6 p q p 2 . 0 9 / 0 . 4 4 1 . 0 5 / 0 . 9 7 O B

Swiss franc S F C M E 1 1 . 5 0 5 7 . 6 2 p p p 3 . 1 7 / 0 . 4 7 1 . 1 5 / 0 . 9 8 N

Soybean oil B O C B O T 1 0 . 3 0 5 4 . 2 7 q p p 2 . 3 5 / 0 . 4 7 0 . 9 6 / 0 . 5 9 N

C o p p e r H G N Y M E X 8 . 7 0 5 0 . 7 3 p p p 1 . 5 2 / 0 . 4 7 1 . 1 7 / 0 . 9 8 N

Russell 2000 E-Mini M R C M E 7 . 7 0 1 7 . 9 3 q p q 1 . 9 0 / 1 . 0 0 0 . 9 2 / 0 . 8 3 N

Live cattle L C C M E 7 . 5 0 4 6 . 7 3 p p p 2 . 0 8 / 0 . 0 5 1 . 1 0 / 0 . 5 8 N

British pound B P C M E 6 . 8 0 3 6 . 5 0 p p p 2 . 2 7 / 0 . 6 6 1 . 0 5 / 0 . 6 9 N

2 - y r. T- n o t e T U C B O T 6 . 3 0 1 0 8 . 1 5 p p p 2 . 1 7 / 0 . 1 0 0 . 8 4 / 0 . 3 6 N

C o ff e e K C N Y B T 6 . 3 0 3 2 . 8 2 p p q 1 . 3 6 / 0 . 2 5 0 . 9 3 / 0 . 8 1 N

Mexican peso Z G C M E 5 . 7 0 3 0 . 6 9 q q q 5 . 0 0 / 0 . 8 3 1 . 0 8 / 0 . 7 8 N

C o t t o n C T N Y B T 5 . 6 0 4 2 . 2 3 p p p 2 . 2 3 / 0 . 8 1 1 . 1 4 / 0 . 8 0 N

Cocoa C C N Y B T 5 . 5 0 3 2 . 5 9 p p p 1 . 6 8 / 0 . 7 5 1 . 1 5 / 0 . 5 8 O S

Lean hogs L H C M E 3 . 7 0 1 5 . 4 4 q p q 1 . 6 9 / 0 . 7 5 0 . 7 9 / 0 . 9 2 N

Aussie dollar A D C M E 3 . 5 0 4 5 . 0 3 p p p 2 . 8 2 / 0 . 4 4 1 . 0 0 / 0 . 6 1 N

L I B O R E M C M E 3 . 0 0 1 2 . 9 0 p p p 0 . 7 9 / 0 . 0 0 0 . 5 9 / 0 . 0 7 O S

Russell 2000 index R L C M E 2 . 2 0 2 4 . 6 5 q p q 4 . 6 4 / 1 . 0 0 0 . 8 8 / 0 . 8 1 N

Fed Funds F F C B O T 1 . 9 0 5 3 . 7 0 q p p 1 . 3 2 / 0 . 5 8 2 . 0 9 / 0 . 8 1 N

Nikkei 225 index N K C M E 1 . 4 0 1 5 . 6 0 q q q 2 . 4 0 / 0 . 0 7 0 . 8 2 / 0 . 2 2 N

Orange juice O J N Y B T 1 . 3 0 1 6 . 0 2 q q p 1 . 1 0 / 0 . 7 1 1 . 0 4 / 0 . 5 3 N

This information is for educational purposes only. Active Trader provides this data in good faith, but it cannotguarantee its accuracy or timeliness. Active Trader assumes no responsibility for the use of this information.Active Trader does not recommend buying or selling any market, nor does it solicit orders to buy or sell anymarket. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes allresponsibility for his or her actions in the market.


John Bollinger on market

cycles, overlooked

opportunities and why

a “consolidating” market

may be just what the

doctor ordered for a new

breed of swing trader.

BY MARK ETZKORN

Active TRADER Interview

I n the markets, what goes around comes around. You justhave to wait a while sometimes.

When Active Trader last spoke with analyst and moneymanager John Bollinger in late 2000, there was still livelydebate in the financial community as to whether the sell-off themarket had suffered that year was simply a nasty correction oran actual bear market. Given U.S. traders and investors hadrecently surfed the seemingly endless wave of an historic bullmarket, it’s not surprising many people were loathe to acceptthe idea the tsunami had finally reached the beach. Even manyof those brave enough to call a bear a bear when they saw itwere prone to positive spin, arguing a market turnaround wasprobably two or three quarters away.

More than two years later, the market has long since deliv-ered the coup de grace to the last of the big-picture bulls. Forthe most part, public speculation is now focused on signs ofgeneral economic strength and reassurance the worst is over inthe market — not hope that a new, sustained surge in equitieswill occur any time soon.

The market has indeed changed over the past three or so years,but as Bollinger, 52, points out, from a broader perspective, it hasmorphed back to what it was before the bull move started. (Andfor the younger readers out there, we’re talking 1982, not 1995.)

He’s not just making an academic observation. Bollinger’stake on the current market is especially interesting because hestarted in the trading industry right around the time the lastprolonged bear-market consolidation was ending and the mar-ket was gearing up for the 1980s bull move.

At the time, Bollinger says, long-term investors had essen-tially given up on the stock market after years of frustratingnon-returns, while traders, who had adjusted to the up anddown character of the market, were still in the fray — and mak-ing money.

In January, Bollinger spoke with us about market cycles andwhat they portend for the future of U.S. stocks, and how tradersmay actually be more in the cat-bird’s seat than they think — ifthey understand the nature of the market and apply the appro-priate trading techniques.

AT: Things have changed a lot since the last time we talked.What can traders learn from what’s happened since 2000?JB: I think it’s important to understand that all stock markets— not only ours — go through cycles of expansion and consol-idation. And these are fairly long-term cycles we’re talkingabout.

In our market the cycle is typically 16 years. The expansion


after World War II, whichstarted in 1950 and contin-ued into 1966, was followedby a consolidation phasethat ran from 1966 to 1982(see Figure 1). Then therewas another big expansionphase from 1982 to summer1998, which is when theb road market topped out.So, we’re now four- a n d - a -half years into a consolida-tion phase.

AT: Only 12 years or so leftto go! Well, you’ve justdepressed everybody,John. JB: (Laughs.) I don’t thinkthat should be the case!When I came into the mar-ket in 1980 there were nolong-term investors left —they had all departed themarket in frustration. Thepeople still active were the ones we called swing traders.

The definition of a swing trader then was a little diff e re n tthan it is now. Back then, it meant something a bit longer term.Swing traders then used daily and weekly charts and werei n t e rested in taking intermediate swings out of the big stocksthat lasted anywhere from 10 or 20 days to six months or evena year. These were the people making money, and they weredoing quite well.

AT: Can you give the broad strokes of how you perceive therotation of expansion and consolidation cycles in the market?What are their earmarks?JB: At the beginning of a consolidation phase everybodybelieves in buy and hold because they’ve just enjoyed a verylong bullish period, during which the market was very hard tobeat and you did really well if you simply bought the broad listof stocks and held on to them.

At the end of a consolidation phase, all the buy-and-holdershave been totally frustrated. They’ve made no money for yearsand years, so they’ve gone elsewhere. At this point, the swingtraders are the kings of the market — the only ones making anymoney.

Market timing, which did not pay at all during the expan-sion phase, pays tremendously well during the consolidationphase. Frankly, for the technical investor or trader, this is thebest of all possible worlds because there are big, fat, interme-diate swings to trade. Also, classic indicators such as theadvance-decline line, new highs/new lows, the MACD, mov-ing averages, and overbought-oversold indicators work verywell in this type of environment.

AT: The “swings” you’re talking about are very large, though,a r e n ’t they? If you look at, say, that 1966 to 1982 period, themarket was essentially in a trading range, but it was a very widerange and the major moves sometimes lasted more than a year.

JB: Yes, there are huge moves. And that spells opportunity. Justto use round numbers, the stock market topped out at roughlyDow 10,000 in summer of 1998. Just counting swings of 10 per-cent or more, the stock market has traveled 20,000 points sincethen.

Of course, it’s virtually impossible to pick the very bottomor top of a move. That means traders trying to take advantageof these swings will be late getting in and late getting out. Forargument’s sake, let’s assume you’re 25 percent late — that is,it takes one quarter of a price move to occur before you recog-nize the direction of the market has changed. But that meansyou can still capture half the move, or 10,000 of the 20,000points that occurred over the last four and a half years — aperiod in which most people lost money.

The important thing to understand right now is that we’renot in a buy-and-hold environment, we’re in a trader’s envi-ronment. The keys to success in a trader’s environment aremarket timing and industry group and market sector ro t a t i o n— which is simply to say, market timing on both a macro andm i c ro level.

AT: In contrast to when you started in the business, tradersnow have access to different index and sector instruments —ETFs and HOLDRS, not to mention different stock indexfutures and options. Does that make trading this kind of envi -ronment that much easier?JB: I think the growth of these instruments has been a fantas-tic development. I remember when the Value Line futures werethe first index futures product launched in Kansas City (theKansas City Board of Trade), and the S&P 500 futures cameshortly thereafter, followed by OEX options. In a very shortperiod of time we went from having no vehicles for markettiming to having several great vehicles for market timing.

However, the interesting thing is that this was happeningjust when market timing was going to stop paying. The market

Dow Jones Industrial Average ($INDU), monthly

1940 1950 1960 1970 1980 1990 2000

9,059

6,069

4,066

2,724

1,825

1,223

819

549

368

246

165

111

A long-term chart of the Dow Jones Industrial Average (INDU) shows a pattern of alternating trend and consolidation/bear phases roughly 16 years in length. However,the intermediate-term swings within the consolidation periods are often quite substantial.

FIGURE 1 AROUND AND AROUND WE GO



was just finishing a consoli-dation phase and entering awild bull market, in whichmarket timing offered verylittle added value.

To d a y, by contrast, Ithink it’s a case of havingthe right instruments avail-able at the right time. Wehave a plethora of tools totrade the markets: stockindex futures of every type,stock and index options,and exchange-traded funds,which I think are a fantasticopportunity for investorsand traders. Not only canyou invest in the index ofyour choice, many indicesa re now even being bro k e nup into their growth com-ponents and value compo-nents, which allows you tomake “style” bets withinthe indices.

AT: With all these tools, doyou see any advantage totrading individual equitiesin this kind of market? Ifyou want to trade a sectoror group, why botherbuilding a portfolio ofindividual stocks and deal -ing with things like short-selling restrictions? Sectorand index derivativeswould seem to simplifythings.JB: They do and they don’t,because traders are individ-uals. Some people are nevergoing to be comfortabletrading index and sectora g g regate pro d u c t s .T h e y ’ re cre a t u res of thestock market, they’re inter-ested in individual stocks,and they’re never going tochange.

Then there are the peopleon the other side of theequation who, frankly, will

never trade an individual stock again. They’re going to tradethese tools exclusively over the coming years. It’s really a mat-ter of psychology — a matter of what you like, what suits you.

AT: On a semi-related subject, do you think single-stockfutures have a role to play in all this?JB: I’ve done quite a bit of research on them and I’m curious to

see how they’ll do. Europe has effectively had single-stockfutures for a long time. In France, all stock transactions are con-ducted as forward transactions that are settled, I believe, in 30days.

Single-stock futures have worked in other situations, andother types of investors have found them viable. The questionI have is whether U.S. investors are going to be interested inthem. To work, they’re going to have to attract a large follow-ing and really develop volume and liquidity.

American investors are very fickle, and you never knowwhat they’ll take to. For instance, for years there were productscalled the Americus Trusts, which were traded on the AMEX.They were a form of exchange-traded fund — the predecessorsof today’s iShares — and they languished. They were a littletoo complex for most people, and they just didn’t work.

But on the other hand, iShares have gone great guns. Single-stock futures have the potential to be an important part of thepuzzle, but we’ll have to wait and see. It’s very hard to figureout what the public will go for.

AT: Let’s go over some specific ideas for trading the kind ofconsolidation environment you were describing before.Where do you suggest a trader conditioned to trade in a long-term bull trend get started?JB: In this type of market, the tools that work the best are rel-ative tools — those that let you get a grip on what’s happeningin relation to immediately prior history.

Of course, different traders will have different ideas aboutwhat “immediately prior” means. For some it will mean what’shappened this morning, for others it will mean the past 20 daysor the past six months or year. But the advantage of relativetools is that you can adapt them to your purposes.

Bollinger Bands, for instance, provide a definition whetherprices are high or low on a relative basis (see “Indicator re-f e rence,”). At the upper band prices are high, and at the lowerband prices are low. If price tags the upper band, you knowprices are high, so you can consult another tool to determinewhether you believe that “highness” is sustainable or whetherit’s a potential reversal to be sold.

One of the problems I’ve seen is that people treat BollingerBands in the simplest way possible. They automatically thinka tag of the upper band is a sell and a tag of the lower band isa buy. Nothing could be further from the truth. Some tags ofthe upper and lower bands are sells and buys, respectively, butnot all tags are action points. Price can, and does, walk up theupper band or walk down the lower band, and often when thishappens you get some of the most profitable trades.

With rare exceptions, it’s not enough to use Bollinger Bandsalone. You have to combine them with something else that tellsyou about sustainability. For me, that something else is volumei n d i c a t o r s .

AT: Just indicators? Do you ever look at raw volume numbers?JB: Both can work. Some people are able to look at volume,relate it to the price bars and intuitively understand the sup-ply-demand relationship. Other people need to parse volumeinto an indicator to clarify the picture.

Older traders who grew up keeping charts by hand wouldprobably be more comfortable with raw volume numbers.Traders who grew up with technology that could easily calcu-

Indicator reference

Advance-Decline line:A day-to-day running totalof the number of stocksthat have gained on the dayminus the number of stocksthat have fallen on the day.A version using the week-to-week figures can also beused as a longer-term indi-cator. The most commonlyreferenced A-D line is theone calculated on New YorkStock Exchange (NYSE)stocks.

Bollinger Bands:Price bands that are placedtwo standard deviationsabove and below a 20-barmoving average (see Figure2 in main story).

Moving average conver-gence-divergence (MACD)indicator:A hybrid trend-momentumindicator consisting of twolines: the first (the MACDline) is the differencebetween a 12- and 26-dayexponential moving average(EMA); the second is a nine-day EMA of the MACD line.

On Balance Volume (OBV):A running sum of daily mar-ket volume weighted bywhether the market closesup or down for the day. Iftoday closed higher thanyesterday, the OBV value isyesterday’s OBV + today’svolume; if today closedlower than yesterday, theOBV is yesterday’s OBV -today’s volume; if todayclosed unchanged from yes-terday, the OBV is the sameas yesterday’s.


late and plot complex indicators willlikely be happier with volume indicators.

AT: C a n ’t volume be misleading,though? High volume can accompanyreversal points or support trends, but itseems like many volume-watchingtraders conveniently overlook the fre -quent occasions when volume gives“classic” signals and price does theopposite of what it’s supposed to. Andyou can also find plenty of turningpoints where volume wasn’t unusualone way or the other.JB: Well, first of all, I’m working with therelative definition of high and low pricelevels, so that lets me know when to con-sult volume.

For example, if price has just taggedthe upper band, I know this is a point atwhich to see if volume is adding any-thing to the picture. I don’t scan volumecontinuously, trying to make an ongoingstream of decisions based on the relation-ship between it and price. I only look atcritical junctures.

What I’ve found, in this regard, is thatit pays to wait. In other words, after I geta buy or sell signal, I wait for price actionto confirm that signal. If price tags theupper band and a volume indicator —say, 20-day on balance volume (OBV) —is in negative territory, you can treat that as a warning or alertbecause the combination suggests this is a potentially unsus-tainable situation. Then, if there’s evidence of a decline, youcan act, because you have the knowledge a proper setup was inplace.

The other thing you have going for you in this kind of tradesituation is knowing whether there’s a good risk-reward rela-tionship. If price tags the upper band and turns down, you canplace a stop just above the entry point, knowing if price goesback up and violates the stop, your setup is broken. And thatstop will be fairly close by, so the amount you’re risking is rel-atively small, whereas the immediate target for the move is forprice to get back to the lower band, which is much fartheraway.

AT: What kind of risk-reward numbers do you operate with?JB: Here’s one way to look at it: There are only two ways toimprove your trading performance. First, you can increaseyour number of winning trades vs. your number of losingtrades. If you’re batting around .500, you can try to add differ-ent timing information and indicators, and so on, and maybeget your batting average up to around .600 or .650. I thinkyou’re doing pretty well if you have 65 percent winners.

Second, you can increase the size of your winners vs. the sizeof your losers. Say your winners are twice the size of your los-ers — that’s pretty good. If you get up to three times the size, Ithink you’ll find the mathematics work very much in yourfavor. If you have 60 to 65 percent winning trades and your

winners are two to three times the size of your losers, you’llfind you’re making money pretty quickly.

By using this relative trading approach, you can addressboth those risk-reward dimensions. You address the size of thewinners vs. losers by having entry points with logical [stop]points nearby that let you know your trade was wrong. Youaddress the number of winners by finding the right volumeindicators to assess the type of trade and the vehicles you’reusing.

AT: What about a trend component that’s independent fromwhat you’re discussing now — independent in that it wouldprobably be on a longer time frame? JB: I think the idea of biasing your trading in the direction ofthe greatest probability of success is very important. In a side-ways market, you’ll get fairly important intermediate-term buysignals near the bottom of the range and sell signals near thetop. Those should absolutely dictate the direction of your trad-ing. Clearly, if you can bias your trading in favor of the inter-mediate swing direction of the market, you’ll go a long waytoward improving the two key components of success.

In terms of time frame, if you’re using Bollinger Bands, forexample, rather than trying to adjust the time frame by chang-ing the periods and width of the bands — 20 and 2 seem towork very well for most applications and are certainly a goodplace to start — try using a different bar length.

If you’re using daily bars and you want a shorter-term view,you might switch to hourly bars. If you want a longer-term view,try switching to weekly bars. That’s a good way to get an idea of

Microsoft (MSFT), daily

10/30/02 11/11/02 11/21/02 12/4/02 12/16/02 12/27/02 1/9/03

57

55

53

51

49

47

45

160

110

70

In early and mid-January, Microsoft was “walking” up the upper BollingerBand after bouncing off the lower band when it formed a “W” bottom. Belowprice is normalized volume, which is the 50-day average volume multipliedby 100 (the black horizontal line).

FIGURE 2 THE RELATIVE PICTURE

Source: www.equitytrader.com (Acme Analytics)


what’s happening in diff e rent time frames.

AT: Can we pick out a chart and kick around a few of theseideas we’ve been discussing?JB: What’s interesting about this market right now is that somany instruments have established interesting trading pat-terns.

If you look at Microsoft (MSFT), you see a fairly classic pic-ture (see Figure 2). The stock made a “W” bottom recently: Theright side of the W was a bit lower than the left side. Both sidestagged the lower band, as you might expect, and then volumecame in as the stock started rallying away from the right sideof the W. The buy came on Jan. 2, the expansion day.

Now (mid-January) the stock is making a nice little walk upthe upper band. From my perspective, Microsoft has behavedexactly the way an intermediate-term swing trader would like:

It established a well-defined, easy-to-diagnose turning point,and then confirmation came in the form of volume expansionin the direction of the new rally.

AT: The volume is increasing there, but if you compare it tothe last six months or so, it might be a little below average.Is that cause for concern?JB: No, I don’t look at volume that way. I look at volume on arelative basis, as I do everything else. I divide volume by its 50-day average and multiply by 100 to get “normalized volume.”Relative to that, the current volume is behaving very wellindeed.

When the market is up on the day, the volume bars are col-ored green; when it’s down, they’re red. Since that bottom, vol-ume has tended to expand on up days and contract on downdays.

AT: Some people tend to throw everything but the kitchensink onto a price chart. What do you think provides a solidfoundation for effective chart analysis?JB: Start with how you scale your chart. It’s very important touse logarithmic (percentage) scaling if you’re trading stocks. Ifyou’re trading futures, it’s very important to use arithmetic(regular) scaling.

AT: Why?JB: You want the depiction of the security to reflect its propereconomic value within your portfolio.

Futures margin is generally the same regardless of the price

level of the market. Aone-point move in a futures contract willhave the same value whether that move is from 100 to 101 or200 to 201. The gain-loss is always going to be the same for agiven distance on the chart.

But with stocks, you have to put up the value of your trade— or at least 50 percent of it — so a one-point move from 10 to11 is quite different from a move from 100 to 101. The first is a10-percent gain, the second is a 1-percent gain. Logarithmiccharting shows those moves occupying the same physicalspace on the chart.

Of course, I’d recommend using Bollinger Bands, whichgive you a relative definition of high and low price levels.Then, you can compare this to the action of a volume indicator,which I think you should also include. Use a volume “clip” —normalized volume, or at least a moving average of volume soyou have some idea of whether volume is high or low on a rel-ative basis.

And this may sound less important, but it’s something thatdrives me nuts: Make the chart (pause) pretty — make it some-thing you can look at. I hate charts with black backgroundsand garish price-bar and indicator colors — they give me aheadache. You’re going to spend a lot of time looking at achart, so you want to make it as comfortable as possible to lookat.

You obviously don’t want to burn out your eyes or get aheadache, but the more important aspect of this is that a chartis simply a tool to inform that fabulous pattern-recognitionengine you were born with. You want to give it the best possi-ble presentation to work with — the easiest to understand, theeasiest to utilize.

I’ve seen guys in their trading offices using nine monitors,with one garish display after another. I like a two-monitorsetup. One for charts and the second for numerical things —portfolio information, spreadsheets and what not. After all,you can only look at one chart at a time.

AT: Working on the assumption the current market may be ina consolidation environment for an extended period, whattime frame would you begin your analysis on? JB: It depends upon what you’re trying to do. If you’re tryingto get a handle on the market’s intermediate-term activity asbackground information, I think you can estimate the swingswill be three to six months at a minimum and six months to ayear maximum — that’s a typical pattern that’s occurred in thepast. Weekly bars seem to be the appropriate way to visualizethat information.

When you get down to the shorter-term — actually execut-ing trades in individual stocks or indices — I recommend dailybars. That’s my bias. I’ve looked at charts for years and I’mcomfortable in that time frame. For even shorter-term trades,hourly bars are quite useful.

There’s obviously that subset of traders who are going totrade within much tighter parameters — people who are usingfive-minute bars and tick charts. But the concepts really remainthe same, regardless of the time frame: knowing what’s hap-pening on the longer-term time frame so you can correctly biasyour operations in the shorter time frame.

If you get a nice entry signal for a long trade and the marketis in an upswing, you probably want to take that a little moreseriously than you would a nice entry signal for a short. The

principles we’re talking about are fractal in nature — theyexhibit the same kinds of patterns and characteristics at differ-ent levels of magnification, whether it’s 10 minutes and hourly,hourly and daily or daily and weekly. The same types of setupsand trading patterns are evident.

AT: It’s kind of surprising how many people don’t buy intothat, because it seems pretty apparent if you just look atcharts for a while. JB: I remember there was a fellow by the name of SamKachigan who designed a trading system called the Lennoxsystem. One of the basic elements of the system was that tradeshad to be confirmed in three time frames. There was the long-term setup, then you looked for a similar setup on the interme-diate time frame and, finally, the same thing on the shorter timeframe, which is where you executed the trade. It’s the same oldidea — having all the parts and pieces pulling in the samedirection.

AT: What about the different areas of the market being insync?J B : I really believe in the importance of industry groups andsectors, especially in a trading range market. It’s like a ro w b o a t :If you have four people rowing, one rower can be thought of asthe stock, one as the industry group, one as the sector, and thelast one as the overall market.

When all four are pulling their oars in the same direction, theodds of success increase dramatically. But if two are paddling inone direction the other two in the opposite direction, they’ll gon o w h e re. It’s the same thing in the market: If you’re trying toshort a stock in a weak group when the sector and the marketa re strong, the odds are against you.

In this type of market, I’ve found that getting the group andthe sector right is much more important than in a bull phase.During the bull market, getting the group and sector right mayhave added a couple of points to your performance. In thistype of market environment, it’s the difference between nega-tive and positive performance.

When I started in 1980, certain things were clear. First, buyand hold didn’t work — it hadn’t worked for a very long time.If you bought a stock and prayed for the long-term trend to bailyou out, you were dead. Second, relative strength worked, andworked well — you could buy strong stocks in a flat, choppymarket and do well, no question about it.

Nobody proved that more brilliantly at the time than GeorgeChestnut at American Investors. It was his work that really gotme focused. He understood relative strength wasn’t enough,and fully two-thirds of every issue of his [investment timing]service was devoted to analyzing industry groups and sectors.The final piece to the puzzle was market timing. You had to getyour market timing right — period.

Of course, though, after a 16-year bull market, everybody says,“No, no, no, market timing is terrible, you’re not supposed to doit — just buy and hold.” But now we’re back in market-timingmode again.

It’s interesting. If you think about the environment that pre-vailed from 1966 to 1982, what was the big thing in terms of theinvestment advisory business? Newsletters. There were a tonof newsletters and investors subscribed to them. Why? Becausethey dispensed an invaluable service — market timing.

Almost all those newsletters died out between 1982 and1998. People say, “Oh, it’s the Internet — nobody wants to buya paper newsletter anymore.” That’s simply wrong. Thenewsletter business dried up the way it did because there wasa huge bull market and investors, correctly, realized markettiming wasn’t doing them any good!

AT: Do you think this cycle is going to be any different frompast cycles, like the 1970s, when many people abandoned themarket altogether?JB: That’s not going to be any different whatsoever. Some peo-ple will leave the market shrieking in frustration. It’s part of thepuzzle, part of the development of a particular cycle.

You can already see some of the other mechanisms startfalling into place: The Bush administration proposes to endthe double taxation of dividends, which makes dividendsm o re attractive. Gradually, payout ratios will rise again andinvestors will get more interested in investing in stocks thata re paying dividends, and over the years that will play intoother aspects of the market that get long-term investors backinto stocks.

Eventually, we’ll have served our time in this consolidationand the base will be built for the next great bull market. Whenit starts running, there will be a bunch of naysayers shouting,“No, this isn’t for real, watch out!” and meanwhile the marketwill continue to go up and up and up. And when the lastdoubter is finally convinced, it will be time for the next consol-idation!

The three keys to success here are going to be relativestrength — positive or negative; market timing, so you knowwhich type of environment you’re operating in; and being rightabout groups and sectors, so you have the odds in your favor.That’s pretty much the agenda that prevailed in the ’70s andearly ’80s, and it’s the agenda that’s going to prevail now.Ý


Bollinger resources

John Bollinger, CFA, CMT, is the president and founder ofBollinger Capital Management. His book Bollinger onBollinger Bands was published in 2002 by McGraw Hill.

He has developed a new Web site devoted to industry-group analytics, www.GroupPower.com, and is also thefounder of the following sites:

www.EquityTrader.comwww.FundsTrader.comwww.BollingerBands.comw w w. B o l l i n g e r O n B o l l i n g e r B a n d s . c o mwww.PatternPower.com

Additional reading:“Volume indicators revisited,” by John Bollinger,Active Trader, March 2002, p. 32.

“John Bollinger: Focus on the markets,” by Mark Etzkorn, Active Trader, January 2001, p. 74.


D aryn Collier has always had an independentstreak. Over the last decade, he’s tried his hand atvarious forms of self-employment, includingstints in the restaurant, landscaping and dry-

cleaning businesses.After eventually tiring of those endeavors, Collier borrowed

some money from a relative and turned his hobby of tradingpenny stocks into full-time trading.

In his teens, Collier read One Up on Wall Street, written byFidelity mutual fund legend Peter Lynch. He has been interest-ed in the markets even since.

“I got started in highly speculative penny stocks and basi-cally just gave my money away,” Collier says. “I’d be at workat the dry cleaners and on the phone with the automated bro-ker.”

Living in Canada, Collier faced challenges in merely openingan account. Until recently, government regulations made it dif-ficult for Canadians to open up an account with a U.S. discountbrokerage firm. Collier was using a Canadian broker and pay-ing prohibitively high commission rates for NYSE stock trades.

However, a U.S.-based proprietary trading firm — BrightTrading — opened an office in Vancouver. Collier put up$25,000 and began trading full-time in May 2001.

Trading method: When he first began, Collier traded thespread between two NYSE companies that were merging.

“If you knew GE was acquiring Honeywell, offering 1.05shares for each share of Honeywell, you’d take the last pricetraded on GE and multiply it by 1.05,” Collier says. “Subtractthe last price of Honeywell and you have the spread. You couldeither be long or short.”

At first, this method was successful for Collier, and itenabled him to build up his trading account.

“There was good movement in the spreads,” Collier says. “Itwas easy to put them on and take them off — it was almost likefree money.”

However, the spreads eventually became tighter, and mak-ing money became more difficult. Undaunted, Collier switchedto pair trading — buying one stock and selling a different stock

in the same sector (i.e., buying Citibank and selling J.P. MorganChase).

That well also ran dry after pairs ceased trading in pre-dictable ranges, causing Collier to search for yet another trad-ing method.

“You have to know when to cut your losses and get out,” hesays. “You have to be willing to look at what’s working andwhat’s not.”

Collier currently trades stocks that are in short-term consoli-dation or flag patterns. He primarily uses intraday charts —one-, five- and 15-minute charts of big-cap, liquid NYSE stockssuch as Dupont, Citigroup, J.P. Morgan Chase, Boeing, Johnson& Johnson, Home Depot and Wal-Mart. He uses three monitorsjust for charts, and he scans them for short-term bull or bearflags that are just forming.

However, he doesn’t have specific rules for entry, noting, “Ithas to be done by feel.”

“I’ll try to wait for a flag to [form] on the 15-minute chart andthen look for an entry point on the five- or one-minute chart tokeep my risk down,” Collier says.

Collier enters the trade while the flag is forming, hoping tocatch a breakout in the direction of the longer-term trend. Hetrades roughly 500 to 1,000 shares at a time.

As far as exiting is concerned, he will take partial or full prof-its on a retest of the breakout point of the flag. If he keeps a por-tion of the position on, he moves his stop to breakeven. Hecompletes six to eight trades a day, none lasting more than 20minutes.

Worst trading experience: Collier experienced his worst tradewhen he used his merger arbitrage strategy to trade GE andHoneywell.

“It was the day bad news came out from European regula-tors and the completion of the merger was in question,” hesays.

At the worst point, Collier lost 20 percent of his tradingaccount, although he cut his losses to 10 percent by the finalbell.

When not trading: Collier enjoys running and spending timewith his family.

The best thing about trading: “Trading is the only thing I’vefound that has a constant supply of challenges,” he says.“Every day is different.”

Recommended reading: S t reet Smarts by Linda BradfordRaschke and Laurence Connors; Pit Bull by Marty Schwartz;Market Wizards by Jack Schwager; Linda Bradford Raschke’sWeb site (www.lbrcapital.com). Ý

Trading setup

Hardware: PC with 1.3 MHz processor and 512 MB RAM. Five monitors: three 17-inch for charts, two 21-inch for executions.

Software: TradeStation.

Internet connection: Cable modem.

Brokerage: RediPlus and DirectFutures.

The Face of TRADING

From pennies to patternsBY KIRA McCAFFREY BRECHT

Name: Daryn CollierAge: 30Lives and works in: Vancouver, British Columbia


O bjectively, trading can be thought of in terms ofprobabilities: the probability a price move of acertain magnitude will follow a particular tradesignal, the percentage of winning trades a strate-

gy generates over time, and so on.Although it is human nature to think almost exclusively

about the chances of making money, a more practical mindsetis to appreciate the odds of losing your money by using a par-ticular trading strategy or money management technique.“Take care of the losses first,” the trading axiom says, “and thewinners will take care of themselves.”

“Risk of ruin” is a concept sometimes used to determine theprobability you will “blow out” using a particular tradingapproach (or alternately, the odds you will reach an equitygoal before losing a certain percentage of your equity).However, risk-of-ruin calculations typically are based on sim-plifications and assumptions not possible or practical in realtrading. It should come as no surprise that many of these con-cepts have been applied more commonly to blackjack andother games of chance. There are, though, important differ-ences between a hand of blackjack and the infinitely morecomplex “game” of trading.

We’ll look at what a few simple calculations can tell usabout the probabilities of trading.

More than one roadThere are several ways to calculate risk of ruin, but you needto have at least three pieces of information to start: 1) theaccount size; 2) the financial goal, or target, for that account;and 3) the “ruin point.”

“Ruin” in this context does not have to mean losing all yourmoney. It could mean losing half your current account, 75 per-cent of it, 90 percent of it — whatever point would cause youto shut down your trading account or consider your tradingplan a complete failure.

The financial goal is similarly expressed in terms of theaccount size — two times the account size, three times theaccount size, etc. From this perspective, risk of ruin is the like-lihood you will reach your ruin point before reaching yourfinancial goal, or vice versa — e.g., what are the odds you’lldouble your money before losing half of it.

The following calculations illustrate the basic mathematicsof estimating risk of ruin. Unless otherwise noted, they arebased on the assumption the strategy in question is risking apredefined percentage of equity — e.g., 2 percent, 5 percent,etc. — on a trade.

Simple risk of ruin formulaThis formula is the most basic — and the most limited. It cal-

culates the odds of hitting a ruin point before a financialgoal when betting 100 percent of the predetermined optimal

Risk of ruin is a mathematical

estimate of the odds you will lose

your money using a tra d i n g

approach.

But is this concept really helpful, or

does it give traders a false impres-

sion of a trading system’s risk profile?


RISK Control and MONEY Management

R o a d t o R U I N


equity risk amount. The formula assumes an equal likelihood ofa winning bet and a losing bet, and that wins and losses are thesame size.

Probability [A reaches G*A before reaching R*A] =G*(R-1)/(R-G)

whereA = the Account sizeG = the multiple of the initial account size that results in

the financial Goal.R = the multiple of the initial account size that results in

the Ruin point.

For example, the probability of tripling the account size (G= 3) before losing half of it (R = .5) when betting an optimalamount is:

3*(.5 - 1)/(.5 - 3) = .6, or 60 percent.

The probability of doubling the account size (G = 2) beforelosing half of it (R = .5) is:

2*(.5 - 1)/(.5 - 2) = .666, or 67 percent.

Despite its limitations, this formula shows that the moremodest a financial goal is, the higher the chances of reaching it— no surprise there.

Fractional risk of ruin This formula estimates the odds of reaching a financial goalbefore a ruin point when betting a certain fraction of the pre-determined risk amount. Like before, the odds of winning orlosing are assumed to be equal, and the winning trades areassumed to be the same size as losing trades.

Probability [A reaches G*A before R*A] =

[R((2/f) -1) - 1]/[(R/G)((2/f) -1) -1]

whereA = the Account sizeG = the multiple of the initial account size that results in

the financial Goalf = Fraction of the predetermined risk percentageR = the multiple of the initial account size that results

in the Ruin point

If risking 50 percent of the risk percentage, the probability ofdoubling the account before losing half of it is:

[ . 5((2/.5) -1) – 1]/[(.5/2)((2/.5) -1) – 1] = (.53 – 1)/(.253 – 1) =(.125 – 1)/(.015625 – 1) = -.875/-.984375 = .89, or 89 percent.

If risking 80 percent, the probability of doubling the accountbefore losing half of it is:

[.5((2/.80) -1) – 1]/[(.5/2)((2/.80) -1) – 1] = (.51.5 – 1)/(.251.5 – 1) = .74, or 74 percent.

If risking 10 percent, the probability of doubling the accountbefore losing half of it is:

[.5((2/.10) -1) – 1]/[(.5/2)((2/.10) -1) – 1] = (.519 – 1)/(.2519 – 1) = 99 percent.

However, neither of the two formulas we’ve reviewed so faruses a strategy’s winning percentage as an input.

Using winning percentageThis formula, adapated from Robert P. Rotella’s The Elements ofSuccessful Tr a d i n g (New York Institute of Finance, 1992),demonstrates how risk of ruin depends on a strategy’s per-centage of winning trades and the fraction of account equityrisked.

Risk of ruin = [(1 - PD) / (1 + PD)]f

wherePD = Percentage Difference, or the winning percentage

minus the losing percentage ( e.g., .40 for a winning percentageof .70).

f = Fraction of account equity risked on a trade, expressed in“units.” If you have a $50,000 trading account and you risk$1,000 per trade, you have 50 trade units. Units can be alsodetermined by dividing one (1) by the percentage of accountequity risked per trade. For example, if you risk 5 percent ofequity per trade, you have 1/.05 = 20 units.

Table 1 shows the risk of ruin across several PD andaccount equity risk levels.

Practical valueBecause of their inherent limitations, these formulas can givetraders only a rough feel for how risky a strategy might be. Theassumptions on which they are based (neglecting to factor inwinning percentage, and/or requiring wins and losses alwaysto be the same size, etc.) are too rigid for the complexities of thetrading world.

The most beneficial aspect of the risk-of-ruin concept isa rguably its clarification of the dangers of risking too muchmoney on a trade. All the math in the world cannot predict thef u t u re. But you don’t need to know the future to understand thetwo simple rules that are the foundation of conservative trad-ing: The less you risk, the less likely you are to get wiped out.And the more (and larger) winning trades you have, the morelikely you are to make money.

Pretty simple stuff, when you think about it.Ý

Some of the formulas in this article were adapted from those atwww.bjmath.com.

TABLE 1 RISK OF RUIN

Win % PD Risk %5% 10% 20% 33% 50%

55 0.1 1.81% 13.44% 36.66% 54.77% 66.94%

60 0.2 0.03% 1.73% 13.17% 29.63% 44.44%

70 0.4 — 0.02% 1.45% 7.87% 18.37%

80 0.6 — — 0.10% 1.56% 6.25%

90 0.8 — — 0.00% 0.14% 1.23%


TRADING Basics

BY JEFF PONCZAK

A lthough they didn’t exist justa few years ago, Electro n i cCommunications Networks(ECNs) have become an inte-

gral part of the equity-trading landscape.While swing traders and those with al o n g e r-term time frame may not be over-

ly reliant on them, they are the lifebloodof day traders and scalpers. Wi t h o u tECNs, short-term trading would bemuch diff e rent, and likely much mored i fficult, than it is today.

The trading opportunities providedby ECNs are so important that brokeragefirms (especially direct-access firms) touttheir connectivity to various ECNs; theNasdaq recently revamped its entiretrading platform in an effort to regainvolume lost to ECNs. However, it’s like-ly that while many new traders (andpossibly even some veteran traders)appreciate the importance of ECNs, theyhave no idea how they actually function.

Back in the last century…In late 1996, the Securities and ExchangeCommission (SEC) found that Nasdaqmarket makers were illegally inflatingspreads to increase their profits. Amongseveral rule changes put in place wasone that allowed the creation of alterna-tive trading systems — non-exchangeorganizations that matched buy and sellorders in stocks. In early 1997, four alter-native trading systems — the first mod-ern ECNs – opened their virtual doorsand began matching stock trades.

Instinet, which today is still one of theleading ECNs, has been around since the1960s. Up until very recently, Instinetserved only institutional customers, pro-viding a non-exchange venue for execu-tion of stock trades. So, while Instinet

was truly the “first” ECN in terms of theservices it provided, the term ECN wasnot created until 1997.

Since 1997, several other ECNs havelaunched operations. At the peak of thelate ’90s bull market, there were 11 ECNsand more being planned. Although con-solidation has changed the look of theECN landscape over the last six years( t h e re are currently nine ECNs), onething hasn’t changed: ECNs deal almostexclusively with Nasdaq stocks (about95 percent of total ECN volume is on theNasdaq). When ECNs first came intoexistence, the New York Stock Exchange(NYSE) had a rule prohibiting trading ofmany of its listed stocks anywhereexcept on the floor of the exchange.

Although that rule has since beenrepealed, very little NYSE volume hasmoved to ECNs. Although the ECNshope to change that, it will likely be awhile before significant non-exchangeNYSE volume develops.

So, what do they do?All ECNs have an “order book” no diff e r-ent than the order book kept by Nasdaqmarket makers or NYSE specialists. Therea re two kinds of ECNs: “execution”ECNs and “routing” ECNs. Both typestry to match buyers and sellers, but if arouting ECN can’t make an immediatematch within its own order book, it wills e a rch for another match (i.e., with anoth-er ECN, a market maker, etc.) and send

Taking a D I F F E R E N T R O U T EECNs have changed the face of short-term trading.

H e r e ’s a look at what they do and why they’ve become so popular.

Glossary: Market makers: Professionaltraders who provide liquidity andexecute orders in Nasdaq listedstocks.

Spreads: The difference between astock’s bid and ask price.

Order book: A list of open buy andsell orders.

Slippage: The difference betweenthe price you expect to get and theprice at which you actually getfilled.

Specialists: The NYSE equivalent of market makers. They provide liquidity and execute orders in NYSEstocks.


the order there. Most importantly, ECNshave the ability to perform these func-tions in less than a second.

In terms of volume, the No. 1 execu-tion ECN is Island and the No. 1 routingECN is A rchipelago, which last yeara c q u i red REDIBook, another ro u t i n gECN. Archipelago recently became anexchange, although its ECN businessremains the same.

Traders do not set up accounts withECNs. Instead, traders gain access toECNs through a broker. All brokers thatuse direct-access technology have theability to trade with ECNs, and ani n c reasing (but still relatively small)

number of non-direct-access platformscatering to active traders are making useof ECNs.

To fully understand the benefits ofusing ECNs, we’ll look at the same trademade by two traders — one who usesECNs, and one who doesn’t.

The need for speedLet’s assume both traders have access tothe Nasdaq Level II screen (which showsmultiple levels of bids and offers) andcan see the best bid and best offer in aparticular stock. Figure 1 shows a LevelII screen for Microsoft (MSFT).

Both traders want to buy 100 shares

and both can see the lowest current askprice is 49.33.

After the non-ECN trader enters thetrade information and clicks the “buy”button, the trade gets sent to the orderdesk at the trader’s brokerage firm.(When trading through a standard“Web-based” broker, hitting the buy but-ton is generally no different than send-ing an e-mail.) The order desk thensends the order to a market maker, whofills the order if a match is available.

Of course, the market maker has fiveseconds to decide what to do with thetrade, and in that time he may take theother side of it, send it elsewhere orreject it outright.

If an order is filled, the entire processoften takes less than 30 seconds.However, in a fast-moving or illiquidmarket, 30 seconds is enough to changethe price of a stock dramatically. Marketorders may get filled at a price muchworse than where the stock was tradingwhen the trade was entered, and limitorders might not get filled at all.

On the other hand, the trader usingECNs has many options. The Level IIscreen shows that four ECNs — Brut(shown on the Level II screen as BRUT),Instinet (INCA), Island (CINN — Islandposts all its quotes through theCincinnati Stock Exchange), and Track(TRAC) — are sellers at 49.33. Direct-access software allows traders to choosea specific ECN to send an order to, and alimit order of 49.33 sent to any of thesefour ECNs will arrive in their ord e rbooks almost instantaneously andstands a good chance of being immedi-ately executed.

In any event, the large majority ofECN trades are executed without thattrade ever going into the Nasdaq orderbook, where it can be manipulated bymarket makers.

To put things in perspective, oneshould consider what trading was like inthe pre-ECN era. Market makers werevery poorly regulated, and if youentered an order (especially in the pre-Internet days, when orders were placedover the phone), you could only hopethat it got filled (and if it did, you couldonly hope that someone would call youback and confirm it).

A trader with ECN connectivity could look at a Level II screen, see which market participant has the best price and send the order there. Traders with -out access to ECNs are at the mercy of their brokerage.

FIGURE 1 LEVEL II SCREEN

Source: eSignal


Because time is of the essence, dire c t -access brokerages typically allow tradersto use preset “one-click” trading buttonsto execute trades a certain way. In otherw o rds, a trader can designate a “hotkey”(e.g., the F4 button, or CTRL+ I) that willautomatically send an order to Island orany other ECN. This eliminates the need tomanually enter an ECN to send an ord e rto, which would cost precious seconds.

Some traders only look at best bid andoffer prices and do not concern them-selves with the depth of the Level IIscreen. These traders often designate all trades to go through Archipelago.

In the previous example, if a tradersent a limit order of 49.33 to Archipelago( A R C A on the Level II scre e n ) ,Archipelago would “scan” the marketand send the order to one of the fourECNs for automatic execution. Marketmakers on the best bid/offer could alsohave trades sent to them thro u g hArchipelago.

Nobody’s perfectOf course, while automatic execution isthe ideal, it doesn’t happen all the time.Limit orders can sometimes linger, andslippage does occur.

While a routing ECN may seem to bethe ideal situation (i.e., if a trade isn’tmatched in the order book, it’s sent out),that’s not always the case. A l t h o u g hsome traders are content to send all theiro rders through A rchipelago, otherstrade exclusively (or at least primarily)on Island just because of the sheer depthof the Island order book.

In some stocks, Island accounts foralmost one out of every five trades. Andsince Island merged with Instinet, theleading institutional ECN, in 2002, itsliquidity pool has become even bigger.

Say the ECN trader mentioned previ-ously wanted to exit a trade rather thanenter one. Three firms — Archipelago,Instinet and market-maker J.P. Morgan(JPHQ) — are showing the best bid.Island is a penny below them.

However, a look at the Island orderbook (Figure 2) shows numerous ordersat many price levels (some just .001away from the next level). Some tradersfind Island to be the most reliable ECNsimply because of the huge amount ofvolume it does, and they choose to route

all orders there.

The big twoT h e re are nine ECNs — Island,A rchipelago, Instinet, BloombergTradebook, Brut, MarketXT, A t t a i n ,NexTrade and Track — but the reality isthat Island, Archipelago and Instinet areresponsible for a dispro p o r t i o n a t eamount — more than 85 percent — of allECN volume.

While most direct-access trading plat-forms allow traders to route an order toany ECN, many successful traders neveruse anything other than Island orArchipelago. And since liquidity begetsl i q u i d i t y, it’s rather unlikely that thepecking order among ECNs will changein the foreseeable future.

Keep in mind, there are other executionvenues besides ECNs. High-end tradingplatforms also give you the choice to sendo rders to the Nasdaq, and non-ECN alter-native trading systems also are an option.And, orders executed through an ECNhave additional fees (no more than apenny a share, usually less) not associatedwith other market participants.

There’s more to trading than ECNs.In many ways, an ECN is a short-termt r a d e r’s best friend. However, usingthem won’t make up for a flawed trad-ing strategy, poor money managementor lack of discipline. Plus, configuringyour trading software to route orders inthe most efficient manner re q u i res amore thorough understanding of eachECN than is presented here.

ECNs may be the fastest car on thehighway, but if you don’t have a driver’slicense you’re doomed to wind up skid-ding off the side of the road.Ý

The Island’s order book in Microsoft(MSFT) shows bids far below thehighest bid price and far above thelowest offer price. This depthmakes Island a popular choice fortraders using ECNs.

FIGURE 2 ISLAND ORDER BOOK

Source: The Island ECN

Keep in mind, there are other executionvenues besides ECNs. High-end tradingplatforms also give you the choice to send orders to the Nasdaq, and non-ECN alternative trading systems alsoare an option.


T he True Strength Index (TSI) is an indicator that con-tains elements of both trend-defining and oscillatortools (an oscillator is a momentum indicator that

highlights shorter-term overbought and oversold levels). Theindicator was developed by William Blau and explained in hisbook, Momentum, Direction and Divergence (John Wiley & Sons,1995).

The TSI is based on a concept called “double smoothing,” bywhich Blau applied two exponential moving averages (EMAs;see sidebar, opposite page) to a one-day momentum calcula-tion (defined as the difference between yesterday’s closingprice and today’s closing price).

CalculationThe TSI is defined as:

TSI = 100*[{EMA2(EMA1(mtm))}/{EMA2(EMA1(|mtm|))}]

wheremtm = the one-day momentum (today’s close – yesterday’s

close)|mtm| = absolute value of one-day momentum.EMA1 = a longer-term exponential moving average (e.g., 60

bars).EMA2 = a shorter-term exponential moving average (e.g.,

five bars).

Note the numerator and denomi-nator of the indicator calculation dif-fer in only one respect: the numeratoruses one-day momentum, which canbe positive or negative; the denomi-nator uses the absolute value of one-day momentum, which is alwayspositive. This results in a figure that isalways between –1 and +1.Multiplying by 100 sets the indica-tor’s range between –100 and +100.

The addition of a moving averageof the TSI (a “signal line”), whichBlau originally designated as a five-day EMA, created an indicator calledthe Ergodic oscillator. Figure 1 showsthe TSI/Ergodic oscillator on a dailychart. The thick blue line is the TSIline, which is the double-smoothedmomentum calculation; the thin redline is the signal line. In this example,the longer-term average is a 60-dayEMA and the shorter-term average isa 20-day EMA. The signal line is a 10-day EMAof the TSI line.

Interpretation and useAs a trend indicator, the Ergodic oscil-lator signals an uptrend when the TSIline is above the signal line, as it was

Oracle Corp. (ORCL), daily

True strength index (TSI)/Ergodic oscillator


TSI line

Signal line

Divergence between rising price peaks and flat TSI peaks

13

12

11

10

9

8

14

6

2

The TSI line (blue) is a simple momentum calculation “double-smoothed” by twoexponential moving averages (EMAs). The addition of a “signal line” (red), whichin this case is a 10-day EMA of the TSI line, results in the Ergodic oscillator,which ranges from +100 to -100 and indicates both trend direction (when the TSIcrosses above and below the signal line) and momentum strength (whether theindicator is at a relative high level or low level).

FIGURE 1 THE TRUE STRENGTH INDEX/ERGODIC OSCILLATOR


Indicator Insight:True Strength Index and Ergodic oscillator


TRADING Basics


f rom early October to early Decemberin Figure 1; it signals a downtre n dwhen the TSI line is below the signalline, as it was in September. This appli-cation will be recognizable to anyonefamiliar with the equivalent interpre-tation of the moving average conver-g e n c e - d i v e rgence (MACD) indicator.

Because the TSI is bound within afixed range between -100 to +100, it ispossible to use the indicator to deter-mine when price is potentiallyoverextended — i.e., overbought oroversold. Higher TSI values reflectincreasingly overbought prices andlower values reflect the opposite con-dition. In Blau’s writings, over-bought and oversold levels for theindicator are typically set equidistantfrom the midpoint — for example,+25 and -25, respectively, althoughthese levels will vary depending onthe length of the moving averagesused to calculate the indicator.

An interesting aspect of theseparameters is that the indicator canmove much higher and lower thanthese representative overbought andoversold levels, which highlights thefact that markets with strong momen-tum can remain, technically, “over-bought” or “oversold” for extendedperiods of time.

A t rend reversal signal occurswhen the indicator is at a relativelyhigh or low extreme. In Figure 2,which applies the TSI/Ergodic to a10-minute chart, note the buy and sellsignals that occurred when the indi-cator was at a low level (near thebeginning of the chart) and at a highlevel (near the end of the chart).

Key pointsBlau’s double-smoothing techniquewas based on his observation that avery long-term moving average ofmomentum was an accurate — andsmooth — approximation of pricemovement. Further, applying a sec-

Oracle Corp. (ORCL), 10-minute

True strength index (TSI)/Ergodic oscillator

13:00 1/21 10:50 13:00 1/22 10:50 13:00 1/23 10:50 13:00 1/24 10:50

12.6

12.4

12.2

12.0

11.8

11.6

20

0

-20

Here the TSI/Ergodic oscillator highlights a choppy uptrend on an intraday chart.Notice the indicator reflects the price trend but removes most of the choppiness,or “noise.” At the beginning of the chart, the TSI crossed above its signal linewhen the indicator was at a relatively low level, indicating an uptrend. Near theend of the chart, the TSI crossed below its signal line when the indicator was ata relatively high level, indicating a downside reversal.

FIGURE 2 INTRADAY TREND


Exponential moving average (EMA)

The simple moving average (SMA) is the standard moving average calculation thatgives every price point in the average equal emphasis, or weight. For example, afive-day SMA is the sum of the most recent five closing prices divided by five.

Weighted moving averages give extra emphasis to more recent price action.The exponential moving average (EMA) weights prices using the following for-mula:

EMA = SC * Price + (1 - SC) * EMA(yesterday)

whereSC = a “smoothing constant” between 0 and 1, and EMA(yesterday) = the previous day’s EMA value.

You can approximate a particular SMA length for an EMA by using the follow-ing formula to calculate the equivalent smoothing constant:

SC = 2/(n + 1)

wheren = the number of days in a simple moving average of approximately

equivalent length.

For example, a smoothing constant of .095 creates an exponential movingaverage equivalent to a 20-day SMA (2/(20 + 1) = .095). The larger n is, thesmaller the constant, and the smaller the constant, the less impact the mostrecent price action will have on the EMA. In practice, most software programsallow you to simply choose how many days you want in your moving average andselect either simple, weighted or exponential calculations.

Crossover at low indicator level

Crossover at high indicator level


ond, shorter moving average to this first calculation resulted inan indicator that removed most market “noise” while laggingvery little. (Moving averages of price, by contrast, lag the priceaction relative to the number of days used to calculate the aver-age; the longer the average, the greater the lag.) The MACD andthe stochastic oscillator are two common indicators also basedon calculating moving averages of moving averages.

The TSI reflects longer and shorter price action, or trends,depending on whether longer or shorter EMAs are used. In hisbook, Blau illustrated a number of different EMA lengths.Figure 3 shows the same TSI/Ergodic oscillator from Figure 1along with the standard MACD and a longer-term stochastic

o s c i l l a t o r. The similarities betweenthe indicators are obvious. One dis-tinguishing characteristic of theTSI/Ergodic is that the primary indi-cator line (the TSI) is slightlysmoother than the other indicators,and its signal line “whipsaws” aboveand below the main indicator lineless than those of the other indica-tors.

Besides identifying price dire c t i o nand overbought and oversold levels,d i v e rgence between TSI peaks andbottoms and price peaks and bottomscan also signal potential reversals. Forexample, in Figure 1, the stock madeconsecutive higher price peaks inDecember and January. TheT S I / E rgodic’s January peak, howev-e r, failed to exceed its December peak,suggesting the January price highwas established on weakening

momentum. The TSI line subsequently dropped below the sig-nal line, indicating a downtre n d .

Bottom lineThe True Strength Index is similar to other indicators that haveboth trend-following and momentum characteristics, such asthe MACD. The unique aspect of the TSI is the concept of dou-ble-smoothed momentum used to create it. This concept — thatdouble-smoothed momentum creates an indicator with mini-mum noise and lag — can be used in a variety of situations todetermine both trend direction and overbought and oversoldconditions.Ý

Oracle Corp (ORCL), 10-minute

True strength index (TSI)

MACD

Stochastic Slow


12.0

9.5

14

2

0.5

0

100

50

The TSI/Ergodic oscillator from Figure 1 is shown along with the MACD and sto -chastic oscillator. All three of the indicators use double smoothing, but the TSIdouble smoothes a one-day momentum calculation rather than price. This exam -ple shows the TSI and its signal line are a little smoother than their MACD andstochastic counterparts.

FIGURE 3 SIMILAR INDICATORS



TRADING Basics

Technical Tool Insight: G a p sBY KIRA MCCAFFREY BRECHT

A price gap occurs when a price bar’s low is above theprevious bar’s high (an “up gap” or “gap higher”) orits high is below the previous bar’s low (a “downgap” or “gap lower”). Figure 1, shows examples of

both.Gaps reveal a quick shift in supply-demand dynamics. They

appear when there is a sudden change in market sentiment oroutlook, which causes buyers or sellers to quickly acceleratetheir buying or selling. Generally, up gaps in uptrending mar-kets are considered signs of strength, while down gaps indowntrending markets are viewed as evidence of weakness.

Gaps are often referred to by specific names — e.g., commongap, breakaway gap, running or measuring gap, and exhaus-tion gap — depending on the market context in which theyappear. On candlestick charts, gaps are called “windows.”

A variation of the basic gap is the “opening gap,” whichoccurs when price opens outside the range (above the high orbelow the low) of the previous bar. However, opening gaps canclose very quickly, after which no true bar-to-bar gap will exist.

Gaps definedThe relationship between price bars thatform a gap is simple to define:

Up gap = today’s low > yesterday’shigh

orDown gap = today’s high < yester-

day’s low.

Although gaps can occur on all timeframes, the longer the time frame, them o re significant the gap. Price gapsoccur frequently on intraday timeframes (see Figure 2), especially in thin-ly traded markets. Such gaps are eithersimply part of the natural intradayvolatility in a market or evidence of alack of liquidity — not meaningfulreflections of supply and demanddynamics. The remainder of the discus-sion addresses gaps on the daily (orlonger) time frame.

Interpretation and usesA gap reveals a dramatic shift in theperceived value of a market from oneday (or week, etc.) to the next. For exam-

ple, an up gap sug-gests highly moti-vated buyers arewilling to paymore for a securitythan they were thep revious tradingsession. On the flipside, a down gapmeans sellers areeager to exit longpositions or goshort below thelowest price of theprevious session.

Gaps often occur when surprising news hits a market — e.g.,an unexpected earnings drop for a stock, or an unforeseen frostor disease that decimates an agricultural crop.

Gaps are more meaningful (reflecting greater buying or sell-ing pressure) when they occur within trends rather than trad-ing ranges. Of the four types of gaps mentioned in the preced-

Chicago Mercantile Exchange (CME), one-minute

14:23 14:28 14:32 14:36 14:40 14:44 14:48 14:52 14:56

43.20

43.10

43.00

42.90

42.80

42.70

42.60

42.50

42.40

Intraday price gaps, such as those on this one-minute chart, are usually natural reflections of random short-term volatility (“noise”) or a sign of a thinly traded market.

FIGURE 2 INTRADAY GAPS


A gap occurs when a price bar’s low ishigher than the preceding bar’s high(up gap) or its high is lower than thepreceding bar’s low (down gap).

FIGURE 1 PRICE GAPS

up gap

down gap


ing section, common gaps (also known as “pattern” gaps),which occur within trading ranges or other trendless periods,

are the least significant and are often filled quickly — general-ly within the next few days.

Figure 3, left, shows how “common”common gaps can be. Throughout springand much of summer 2002, heating oilf u t u res traded in a sideways range.Many price gaps — both to the upsideand the downside — occurred duringthis period. However, they were general-ly filled within a week or so, andrevealed little about price behavior.

“Breakaway” gaps are more signifi-cant. This type of gap occurs when pricemoves forcefully out of a consolidationpattern (such as a trading range or a tri-angle) or some other low-volatility envi-ronment; such gaps can initiate signifi-cant price moves, as shown in Figure 4,.Throughout the month of August, themarket traded sideways. On Sept. 4,2002, it gapped higher and closed abovethe top of the August trading range (andalso gapped completely above a narrow-er trading range that formed within thelarger range). This breakaway gap ush-ered in a strong new uptrend.

The third type of gap is a running (or“runaway”) gap, which generally occursin the midst of an established trend andis considered a sign of acceleration of

bullish or bearish momentum (see Figure 5).Sometimes, several running gaps will appear aroundthe midpoint of a trend.

The final type of gap is the exhaustion gap, which asthe name implies, occurs toward the end of a trendwhen the buyers or sellers are running out of steam.The gap represents a last gasp of momentum and isfollowed by a trend reversal. For example, at the endof an uptrend, prices will leap higher, but the buyerswill fail to sustain the move. A quick retreat below thegap confirms a negative turn in the market.

Figure 6, shows an example of an exhaustion gap atthe top of an uptrend. A long uptrend accelerates in thefinal three bars, the last of which gaps higher. The nextbar reverses dramatically, filling the exhaustion gapand beginning a downtrend.

Key pointsT h e re is an old market adage that “gaps are meant to befilled.” This is not always the case, but gaps do typical-ly re p resent support or resistance levels (floors or ceil-ings that repel price movement in that direction). Theselevels have more significance in trending markets thann o n - t rending ones.

Heavy volume on breakaway gap days helps con-firm the buying or selling power behind the new direc-

February porkbellies (PBG03), daily

Breakaway gap outof a narrow tradingrange

Breakout bar closesabove the wider trading range

September

76.000

74.000

72.000

70.000

68.000

66.000

64.000

62.000

60.000

A breakaway gap occurs when price gaps higher or lower out ofa market consolidation, such as the trading range(s) shown here.Such gaps indicate the breakout occurred on strong momentum,and so might be a sign of a healthy new trend.

FIGURE 4 BREAKAWAY GAP


January heating oil (HOF03), daily

April May June July

0.7500

0.7400

0.7300

0.7200

0.7100

0.7000

0.6900

0.6800

0.6700

0.6600

Common gaps, which are also called pattern gaps, are those that appear innon-trending, sideways markets. They generally reveal little about pricemomentum or supply and demand.

FIGURE 3 COMMON GAPS



tional move. In the case of upside break-away and running gaps, price will oftenretreat to test and possibly fill the gap. Aslong as the far side of the gap range is notpenetrated significantly, the gap is con-sidered a valid support level.

Notice in Figure 5, price pulled back tothe gap five days later — penetrating butnot filling it — before turning back to theupside. However, it also is not uncom-mon for price to return to a gap after afew days, fill it (penetrating its farboundary only slightly), and thenreverse in the direction of the precedingtrend.

The longer a gap remains unfilled, thehigher the likelihood it re p resents ameaningful support or resistance level.Conversely, gaps that are filled quicklyand/or are penetrated significantlyshould be interpreted as reversal signals(as was the case of the exhaustion gap inFigure 6).

One “problem” with exhaustion gapsis that there is no way to diff e re n t i a t ethem from running gaps until after thefact. If the market in Figure 6 had contin-ued to rally higher instead of reverse, theexhaustion gap would have been a running gap. However, agap that occurs after a long-term trend, and especially after a

series of running gaps, is more likely to be an exhaustion gap.The important development to look for is whether or not price

violates the gap level. Gaps are continuation pat-terns that imply momentum strength in the dire c-tion they occur — until they are filled.

Bottom lineIn trending situations, price gaps can representaccelerated buying or selling strength that canestablish important support and resistance levels,but in non-trending conditions (or in thinly trad-ed markets), they are generally not meaningful,other than as a sign of illiquidity or choppiness.Also, intraday gaps are very common and reveallittle about price action.

Gaps that are not filled quickly (say, two to 10bars) tend to represent more significant supportand resistance levels. Ý

Neither Technical Tool Insight nor Indicator Insight isintended to recommend (or disavow) any indicator,trading tool, methodology or school of thought. Thegoal of each is simply to explain the background andmechanics of well-known trading concepts and theirmost common uses, and to give the reader the basis forfurther research, through which he or she should deter -mine the value of the concept.


Rambus (RMBS), daily

Running gap

Test of support attop of gap

October November December

9.50

8.50

7.50

6.50

5.50

4.50

Like breakaway gaps, running gaps reflect strong bullish or bearish momen -tum. Running gaps, however, occur in markets that are already trending, andso reflect accelerated trend momentum. Gaps represent support and resist -ance levels until they are penetrated significantly. Here, price soon pulledback to the gap (“testing” the support level) before reversing to continue the uptrend.

FIGURE 5 RUNNING GAP


Continuous coffee (KC), daily

Exhaustion gap

May June

300.00

280.00

260.00

240.00

220.00

200.00

180.00

The exhaustion gap represents a final outburst of momentum beforea trend loses its final strength and reverses. The fact that this gapoccurred after an extended uptrend and the quick — and significant— downside reversal of the gap on the next bar were indications theuptrend had ended.

FIGURE 6 EXHAUSTION GAP


BY PETER NAVARRO

A n important question hungin the air as 2002 rolled into2003: Is the housing market a“bubble” about to burst?

On the one hand, a gaggle of experts— from academics and homebuilder lob-byists to the Fed Chairman himself —repeatedly insisted at the turn of the newyear that there would be no repeat of thehousing market collapse that occurred inthe late 1980s.

The argument was straightforward:The builders had learned their lessonfrom the last bubble and were not flood-ing the market with “spec homes” andoversupply. Interest rates and mortgagerates would likely remain low for theforeseeable future, helping fuel demand.The demographics of an aging popula-tion likewise favored a continuedstrength in demand, as a bulge of 30-

somethings finally began to nest inearnest while a horde of recent retireeswere now buying “second homes.”

That’s all well and good. However,even if all this were true, does it stillmean that housing s t o c k s a re good instru-ments to buy? Answering this question isp recisely where a deeper understandingof economics comes in to play.

The media perspectiveThe first level of analysis is the one youwill likely have encountered in the popu-lar media. As frequently quoted in thep ress, bubble advocates were quick topoint out several ominous factors as 2002came to a close.

The interest rate cycle was at a bot-

tom. With soaring budget deficits and aneconomic recovery on the horizon, itwould not be long before mortgage andinterest rates spiked.

If the recovery did not arrive as fore-cast, it would still be true that consumershad become exhausted — at least whenit came to both the auto and housing sec-tors. Indeed, with their credit extendedand geo-political uncertainties casting alonger-term pall over their confidence, itwouldn’t be long before consumersstopped splurging on big-ticket items.

Perhaps worst of all, housing pricesa p p e a red to have already peaked inmany major markets. Their fall wouldeat right into the bottom line of housingsector stocks.


TRADING & Investing

Give me land, LOTS OF LAND…If you think booms or busts in the housing market provide an

accurate indication of how housing stocks will perform, you

may be in for a surprise. A smart trader with a keen

understanding of macroeconomics

knows where to look to find

the real story.


So much for the first level of bubbleanalysis. Where the active trader plotreally thickens, however, is with the sec-ond level — an economic analysis of theunderlying structure of the industry.

The macrowave perspectiveTable 1 illustrates the four major stages

of the development process of a house,prior to the actual sale. The major play-ers are listed, as is the profit potential foreach.

Let’s work backwards and start withthe last stage — home construction by thebuilding contractor. Here we see the pro f-it potential in this stage is very low. Why?

Simply because building contractorsoperate in a highly competitive industryand are generally forced to bid on proj-ects for construction. Because projectstypically go to the low bid, there is littlemoney to be earned in this segment ofthe business — in the language of eco-nomics, contractors merely earn a “nor-mal” rate of return. That’s why most ofthe big housing developers tend to putout the actual construction of theirhomes to bid rather than try to makemoney in this segment of the business.Instead, they focus on the more prof-itable second and third stages of theprocess — designing the homes and sub-divisions and then obtaining the variousbuilding permits.

In this area, it is not in the actual designof a sub-division where much of the pro f-its are made. For the most part, this iscookie-cutter stuff where plans are contin-ually recycled. Instead, the big money gets

When it comes to housing development, the real money is in owning theland, not building the house.

TABLE 1 THE FOUR STAGES OF DEVELOPMENT

Stages of development Major player Profit potential

Acquiring the raw land Land owner Very high

Sub-division and home design Developer Low

Obtaining the various building permits Developer Medium

Construction of the house Contractors Very low

Beazer Homes (BZH), daily

Single-family homes sales

12/31/02

Volume

Source: BigCharts.com

2,000

1,075

1,050

1,025

1,000

975

950

925

900

875

850

60%

50%

40%

30%

20%

10%

0%

-10%

-20%

-30%

-40%

3

2

1

0

While single-family home sales have risen steadily since the beginning of 2002, the same cannot be said of three bighousing stocks. This is an indication rising sales are making vacant land harder to come by, and builders are losingprofits because of the need to “restock” their land supply.

FIGURE 1 HOUSES GO UP, STOCK PRICES GO DOWN

2002 Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. 2003

made in the securing of developmentrights and building permits.

Because of this, in most urban are a sw h e re potential traffic congestion andschool overc rowding may be generatingsignificant anti-development sentiment,developers can face severe political oppo-sition to gaining approval for new subdi-visions. That’s why virtually every majorhomebuilder has a powerful lobbyingf o rce to push projects through local (andsometimes state) jurisdictions.

Of course, in this politicalbattle, the game is always toincrease the number of housesone can pack on to a parcel ofland while minimizing anyfees or costs associated witht r a ffic mitigation and otherforms of public services suchas parks and schools. Indeed,every extra house becomespure profit.

Now here’s the bro a d e rpoint: The developer who isable to swiftly obtainapprovals for his projects hasbasically been given thedevelopment rights to signifi-cantly boost his bottom line.And the profits will be all theg reater if these rights areobtained early in the boomcycle b e f o re housing priceshave started to rise signifi-cantly.

For example, a typical developer inCalifornia might get approval for a2,000-home subdivision. His businessplan may have originally projected anaverage price of $250,000 for each home.However, by the time the homes actuallyhit the market, he winds up with anaverage price of $350,000 per house.That’s a difference of $100,000 and a $2

hundred million windfall.Note, however, these kinds of wind-

falls are always one-time deals. That’swhy what ultimately constrains the prof-its and stock prices of homebuilders isthe first stage in the developmentprocess — namely, the acquisition of theraw land.

This first stage is the most importantto understand from a macrowave per-spective because it is here where home-

builders at the end of a boom are likelyto see their bubble burst. Here’s theproblem:

During a prolonged housing boom,housing prices do indeed rise substantial-l y, adding to the current profits of thedevelopers. During such a period, howev-e r, most homebuilders are forced to drawdown heavily on their own purc h a s e dstocks of available raw land. Meanwhile,

as housing prices rise, so, too, does theprice of the available raw land necessaryto continue to fuel the boom.

It follows that in every housing boom,developers inevitably reach a point wheremost of their potential profits for futurep rojects will not be realized. Instead, theywill have to dissipate these profits upfro n tt h rough payments to the owners of rawland.

Perhaps the best way to understandthis basic economic principle isto think about a shack — oreven a nice 2,000 square foothome — sitting on a covetedpiece of oceanfront property.The property might go for $5million with the shack andmaybe $5.25 million with thenice home. But the land isw h e re all the value — andprofits — ultimately reside.

For this reason, the biggestlong-term beneficiary of thehousing boom in the develop-ment sector tends to belandowners — n o t the actualhousing companies. More o v e r,if a developer winds up buyingland at exorbitant prices at amarket peak and then the mar-ket softens, he’s just doomedhis company to heavy losses.

It follows that if you come tocompletely understand the

economics of the housing market, youquickly realize the point illustrated inTable 2: Unlike the technology sector,where new innovations can make the skythe limit for stock prices, housing sectorstocks are forever captives of the ownersof raw land. They are eternally doomedto earning merely a decent level of prof-its in boom times and just as eternallydamned to facing huge risks every timetheir markets collapse with rising inter-est rates and geo-political uncertainty.

That’s precisely why the price-earn-ings ratios of the homebuilders in Table 2are laughably low compared to the lead-ers in technology. It’s also why home-building stocks can be highly risky totrade on the long side if you get caughtup in the boom rhetoric.Ý



Source: www.finance.yahoo.com

While tech stocks use the promise of new innovation to justify high P/E ratios, housing stocks are destined to have P/E ratios in the single digits.

TABLE 2 PRICE/EARNINGS RATIOS OF SELECTED HOMEBUILDERS AND TECHNOLOGY COMPA N I E S

Homebuilders Price/earnings ratios

Beazer Homes (BZH) 5.60

Centex (CTX) 7.70

Ryland (RYL) 5.86

Technology companies

Dell (DELL) 36.14

IBM (IBM) 23.98

Microsoft (MSFT) 30.77

During a prolonged housing boom, housing prices do indeed rise s u b s t a n t i a l l y, adding to the current profits of the developers.


The Business of TRADING

The P R O O F is in the R E T U R NTraders have distinct tax advantages over non-traders.

By comparing tax returns, you’ll see exactly

how much those advantages are worth.

And, you’ll see how much extra money you can save

by forming a single-member LLC and contributing

to a Mini 401(k) plan.

The numbers don’t lie: A trader who forms a single-member LLC enjoys greater taxsavings than a sole proprietor trader, who enjoys greater tax savings than an investorlacking trader tax status.

TABLE 1 COMPARING TAX RETURNS

Tax returns for 2002Investor Sole Single

(no trader Proprietor MemberIncome (expense) tax status) Trader LLC Trader

Trading gains $248,558 $248,558 $248,558 Schedule C - Trading business $0 ($43,900) ($197,020)

Net trading gains reported Form 4797 $204,658 $51,538Net trading gains reported on Schedule D $248,558

Schedule C - Administration $152,320 Interest & dividend income $894 $894 $894

Gross income $249,452 $205,552 $204,752

Adjusted gross income deductions:One-half of self-employment tax $0 $0 ($7,304)Self-employed health insurance deduction $0 $0 ($2,415)Mini 401k plan retirement plan - maximum $0 $0 ($40,000)

Total adjusted gross income deductions $0 $0 ($49,719)Adjusted gross income $249,452 $205,552 $155,033

Itemized or standard deductions ($21,789) ($4,700) ($4,700)Exemptions ($300) ($1,320) ($2,520)Taxable income $227,363 $199,532 $147,813Federal income tax $66,830 $57,089 $38,987Federal self-employment tax $0 $0 $14,607California total tax $19,636 $16,962 $12,312California single-member LLC tax $0 $0 $800

Total tax $86,466 $74,051 $66,706Tax savings $0 $12,415 $7,345Total tax savings $19,760

BY ROBERT A. GREEN, CPA

W hile there are avariety of ways toreduce your taxl i a b i l i t y, there is

one underlying truth that is essen-tial come tax time: Those who qual-ify for trader tax status enjoy signif-icant tax benefits over those whodon’t qualify (i.e., investors).

This month, we’ll use sample taxreturns to show just how much bet-ter off the trader is. And, we’ll alsoshow how a trader who forms a sin-gle-member Limited LiabilityCompany (LLC) in conjunction witha Mini 401(k) plan can save evenmore.

Before we get into details, let’sfirst review the re q u i rements fortrader tax status. The IRS Web site(www.irs.gov) details this informa-tion in Chapter 4 (Special Rules forTraders) of Publication 550. If youtrade all day, every day, you shouldnot have a problem attaining tradertax status.

However, if you don’t, the IRSrules are vague and subjective. Ifyou have less than 1,000 round-turntrades, you should seek the furtherhelp of a trader tax professional.

If you qualify as a trader, the IRSconsiders your trading a “businessactivity.” This allows you to file a“sole proprietor” tax return andreport trading business expenses as“ordinary” on Schedule C, wherethey are deducted in full against


gross income.If you fail to qualify as a trader, you must file

as an investor, which means your tradingexpenses are considered investment expensesreported on Schedule A. These expenses may belimited, and some of them (e.g., home-off i c eexpenses and seminars) are not deductible at all.

Trader status is not something you need toelect. You need to do nothing more than indi-cate it on your tax return, providing you quali-fy (and the IRS agrees). Many traders confusetrader tax status with “mark-to-marketaccounting” (MTM). MTM does need to beelected (via a statement filed with the IRS) byApril 15 of the tax year you wish to have MTM.For more information on MTM, see “Take con-trol of your taxes,” Active Trader, February 2002,p. 96.

MTM has no effect on the examples that fol-low, because the trader is profitable and did nothold any open positions at year-end. If thetrader had lost money, MTM would be a hugetax benefit, as it would convert capital loss lim-itations and carryovers into ordinary lossdeductions, generating immediate tax relief.

Our scenarios involve Mike, a trader fromCalifornia. The first example shows how hesaved $12,415 by filing as a sole proprietor asopposed to an investor. The second shows howhe could have saved an additional $7,345 hadhe formed a single-member LLC and funded aMini 401(k) retirement plan.

Each sample tax return has the same incomeand expenses for the taxpayer. For comparisonpurposes, it’s apples to apples. Table 1 (oppo-site page) breaks down the differences betweenthe three returns.

Sole proprietor vs. investorMike is a single 26-year-old resident ofCalifornia. He trades securities (no commodi-ties) every day, all day from his one-bedroomoffice (located in his two-bedroom apartment).He qualifies for trader tax status.

Mike has typical business expenses for mar-gin interest ($15,752), depreciation on equip-ment ($6,413), amortization on software ($646),supplies, travel, meals and entertainment,postage, telephone, tax and accounting servic-es, chat rooms, Internet service pro v i d e r s ,online information services, publications andbooks, and seminars.

Because investors get minimal tax breaks, their adjustedgross income (line 35) is their standard income. Deductions(line 38) are limited.

FIGURE 1 INVESTOR TAX RETURN


Mike has a trading account at a direct-accessbrokerage, and in 2002 his realized tradinggains on securities were $248,558. He did notkeep any open positions at year-end. Mike hadpreviously elected MTM, so he reports his trad-ing gains on Form 4797, Part II (ordinary gainor loss). His trading account had intere s tincome of $795 and dividend income of $99.

Taking a look at the Form 1040, we see somebig differences between the investor tax return( F i g u re 1) and the sole proprietor re t u r n(Figure 2). The investor must report his fullincome on Line 13, Capital gain or (loss).However, because the trader qualifies as a busi-ness owner, he is able to deduct $43,900 in busi-ness expenses on Schedule C and transfer thesame amount of trading gains from Form 4797.The overall effect is zero net business incomeon Schedule C (line 12) and lower Form 4797trading gain income (line 14).

On Line 38 (Itemized or standard deduc-tions), the investor is entitled to limited busi-ness expenses and produces a taxable income(Line 41) of $227,363. The trader has alreadydeducted (in full) these expenses elsewhere,and because he does not need to itemizedeductions, he is also entitled to the standarddeduction of $4,700. His taxable income is$199,532.

The trader also has lower taxable income onhis California state tax return. All told, the trad-er will pay $12,415 less than the investor.

Even more savingsHad Mike formed a single-member LLC(SMLLC) in his home state in 2002, he couldhave saved an additional $7,345 if he followedthrough on the main reason to form a businessentity — funding a retirement plan.

Forming a single-member LLC (SMLLC) inCalifornia costs around $210 and is simple todo. The only entity level tax is a fixed state taxof $800 and a fee depending on the individual’slevel of income. In many states, there are noentity level taxes. In any event, these taxes areusually deductible.

An SMLLC trader and a sole proprietor haveidentical tax treatment in many ways: all trad-ing business expenses are reported on aSchedule C; all trading gains are reported on aForm 4797; and all interest and dividendincome is reported on Schedule B.

Sole proprietors have less adjusted gross income thaninvestors (line 35), and they are able to claim a standarddeduction (line 38).

FIGURE 2 SOLE PROPRIETOR TAX RETURN


Providing the retirement plan strategy isproperly executed, the SMLLC trader enjoysseveral tax benefits over the sole proprietor.Figure 3 shows the SMLLC trader Form 1040.

In an LLC, the entity pays a “fee” to the indi-vidual for administration. The fee — in thisinstance, $152,320 (the minimum amount nec-essary for the maximum Mini 401(k) deduc-tion) — is reported on Line 12. This fee, alongwith $44,700 of trading business expenses istransferred from Form 4797 to the SMLLCSchedule C (both the entity and the individualmust file a Schedule C), leaving just $51,538 onform 4797 (line 14), and gross income (line 22)of $204,752.

While that’s about the same gross income asthe sole proprietor trader (the only difference isthe $800 California SMLLC tax deduction), thereal savings occur when determining adjustedgross income. While an SMLLC trader is sub-ject to self-employment taxes (on the individ-ual Schedule C), half those taxes can be deduct-ed from gross income (Line 29). Plus, theSMLLC trader can deduct health-insurancecosts (Line 30) and — this is the big one — upto $40,000 from forming a Mini 401(k). Whenthese three items are deducted, total adjustedgross income is $155,033. These deductions arenot available to sole proprietor traders.

Taxable income winds up at $147,813, andthe SMLLC trader pays $7,345 less in taxes thanthe sole proprietor — $19,760 less than theinvestor.

Furthermore, those with a Mini 401(k) canactively trade up to 25 percent of the plan’sassets, and all gains are tax-free until the traderretires. Mini 401(k) traders can also borrowmoney from the plan. For more on Mini 401(k)plans, see “A special ‘K’,” Active Tr a d e r,February 2003, p. 96.

The bottom lineTrader tax status will save you big money. Ifyou qualify, consider whether an SMLLC andMini 401(k) plan are wise for your tax andfinancial planning. Ý

Note that the sample tax returns in this article areincomplete. Full examples are available atw w w. g re e n t r a d e r t a x . c o m .


Deductions on adjusted gross income are critical to taxsavings for SMLLC traders is the . Deductions for self-employment tax (line 29), health insurance (line 30) and aMini 401(k) (line 31) provide significant tax savings.

FIGURE 3 SINGLE-MEMBER LLC TAX RETURN

AFTERHours

A way to — B O O M ! — improve financial TV

W hile CNBC, Bloomberg and other trading-re l a t-ed networks still have a significant audiencebase, it’s possible the broadcasts have lost a little“zing.” After all, reporting on the latest new low

set by the Nasdaq, or another batch of disappointing corporateearnings has a tendency to take the pep out of your step.

So what’s the solution? Well, these programs need a person-ality — someone with instant name recognition, someone who’snot afraid to express his opinions, someone who can provide thekind of daily analysis that’s often lacking.

Someone like John Madden.OK, so America’s most famous football analyst may not know

that much about the markets. But he’s comfortable in front of acamera, and people will tune in just to watch him. Besides,when has knowing anything about the markets been a prereq-uisite for being on financial TV?

We can almost picture it now….

Generic TV Host: John, as we ready for the opening bell, whatshould we look for today?John Madden: There’s no question that Alan Greenspan is theman to watch. Greenspan is a veteran economist out ofWashington, D.C., and he’ll face a tough Senate panel today thatwill be looking for a little payback. Last time these two met,Greenspan had the Senators scrambling for their economic text-books. This time around, you’ve got to think the Senators will bemore prepared.

GTH: What makes Greenspan so dangerous?JM: He’s really a triple threat. His testimony has the ability tomake the market go higher, make the market go lower or justconfuse most people with esoteric ramblings. Plus, what he saysaffects short-term traders as well as people with a longer timeframe, so he demands double coverage.

Plus, he’s 76 years old. He’s played this game a long time.He’s had to work under a few different bosses, but he’s alwaysstuck to his gameplan.

GTH: But hasn’t time caught up to him, John? Isn’t it fair to sayhe can’t single-handedly dominate like he did a few years ago?JM: That’s a good point. A superstar’s time is limited, and I

don’t think Alan Greenspan can becalled a superstar anymore. But he’sstill a student of the game and can def-initely make a big impact.

GTH: OK, now let’s turn our attention to the Nasdaq. John, thismarket has been struggling to get back on track recently. Whatcan the Nasdaq do to turn things around?JM: The Nasdaq has had no success in its battles with resistance.That resistance line has slowed Nasdaq’s progress more thanonce. (Achart of the Nasdaq is shown, and Madden grabs the telestra -tor). See, right here is what I’m talking about (Madden draws aresistance line.) Here’s what the Nasdaq needs: The technologysector has to avoid any more bankruptcies, and the telecomstocks need a favorable report on new cell phone sales. If boththose happen, BOOM! (Madden draws a line through the resistanceline, then draws price bars above it.) The Nasdaq will begin to tradeup here and might even be able to string some winning daystogether.

Madden continues his analysis throughout the day. We joinhim again after the closing bell.

GTH: Wow, what a performance by the Nasdaq, John! A gain ofmore than 3 percent. Who could have seen that coming?J M : And what a spectacular performance by ABC Dru gCompany! These guys have been practically unknown, butwhen it had that cancer drug approved by the FDA, BOOM!ABC performed so well it lifted the performance of the entireindex!

That just goes to show — you never know where your bigcontributions are going to come from. The Dells and Microsoftsand Oracles get all the attention, but it’s often a little-known per-former like ABC that comes through when it matters most.

GTH: Any thoughts about tomorrow, John?JM: You’re only as good as your last performance, so it’s impor-tant that Nasdaq keep this momentum going. And it can’texpect to get unexpected help like it did today — everybody hasto keep their earnings up and their noses clean. That’s whatmakes a winning index.

Mad(den) TV

ON THE JOB What does he thinkhe’s doing?

He doesn’t like to sell short, so whenhe looks at his screen upside-down, it

looks like a long trade.

That doesn’tmake sense

— his tradeswould be

going back int i m e .

Wait a minute — aren’twe in the wrong cartoon?


Trade

Date: Jan. 16, 2003

Entry: Short the S&P 500 index trust (SPY)at 92.47.

Reasons for trade/setup: The idea behindthis trade is related to concepts about out-side bars explored in “Outside bars: Fromconcept to strategy,” p. 40. After rallying inearly January, SPY moved sideways. OnJan. 15, it sold off intraday after opening atwhat would be the day’s high price (andabove the prior day’s high); and closingbelow the previous two days’ closes (andmaking the lowest low in three days). Thisindicated the consolidation was resolvingto the downside. A short sale was made thenext day on the open.

Initial stop: 93.82, 25 cents above the high of the outside bar(entry day).

Target: 87.11, the Dec. 31 swing low. We will take partial prof-its at this level and then trail a stop no farther than above theprevious day’s high for the remainder of the trade.

Pluses: The long-term trend is down and the market has lostupside momentum over the last week or so.

Minuses: The short-term trend is still up and the stop level isrelatively far away (1.35 points), compared to the typical TradeDiary position. The market is in its bullish new-year phase; thecurrent consolidation could be a pause before a continuation ofthe uptrend.

Update (Jan. 24): Took profits on half the position at 87.12; stoplowered to 89.58, 20 cents above the Jan. 23 high.

Result

Exit: 86.65 (second half oftrade).

Reason for exit: The trailingstop was hit.

Profit/loss: +5.95 (first half); +5.82 (second half).

Trade executed according to plan? Yes.

Lesson(s): This trade illustrates an important point: Any tradeplan or strategy is ultimately subject to the conditions in placeat the time of a given trade. The entry, stop and profit targetapproach used here, which is designed primarily to captureshort-term price moves, is very similar to the method used inthe many Trade Diary trades.

However, in this case, the market moved immediately —and significantly — in the trade’s direction, which allowed theposition to become much more profitable than others executedin a similar fashion. There was no way to predict that such asell-off would occur; the trade rules, however, were able to cap-italize on it when it came to pass.

This trade could have been slightly unprofitable or moder-ately profitable, depending on circumstances. Most tradesoccur in that unspectacular middle ground. Trades such as thisare the exception, but it’s still necessary to structure your strat-egy to capture them effectively when they occur.Ý

For a second installment of the Trade Diary, turn to next page.

TRADEDiaryA timely entry makes the most of market conditions.

Trade summary

D a t e S t o c k E n t r y I n i t i a l I n i t i a l Initial E x i t D a t e P / L A c t u a ls t o p t a r g e t r e w a r d / r e w a r d /

r i s k r i s k

1/16/03 SPY 92.47 93.82 87.11 3.97 87.12 (1/2 pos.) 1/24/03 +5.35 (1/2) 3.9686.65 (1/2 pos.) 1/29/03 +5.82 (1/2) 4.31

+5.58 total

S&P 500 index trust (SPY), daily

3 0 2 0 0 3 6 1 3 2 7 F e b r u a r y

Take profits onhalf the position

Exit second half

Short at 92.47

94.00

93.00

92.00

91.00

90.00

89.00

88.00

87.00

86.00

85.00


T r a d e

Date: Feb. 10, 2003

Entry: Long the Nasdaq 100 index-trackingstock (QQQ) at 24.00.

Reasons for trade/setup: The marketopened up this morning after havingapproached a 62-percent retracement of theOctober-December 2002 rally. This tradewill try to catch a short-term countertrendbounce. We will wait for an intraday pull-back and go long if the stock rallies abovethe early-morning high of 23.99.

Initial stop: 23.42, 20 cents below the day’slow. However, the position must quicklydemonstrate the potential to followthrough; it will be exited at the end of theentry day if the closing price is below theentry price.

Target: 24.86, the Feb. 5 high, which hap-pens to be the highest high of the precedingseven trading days. We will take partialprofits at this level and move the stop tobreakeven. After that, we will trail a stopbelow the low of the previous day. Thisplan will guarantee a winning trade if theanticipated short-term up move material-izes, while leaving room for additionalprofits if a more substantial rally develops.

Pluses: The risk is very low (although the initial reward/riskratio is not that great) and the trade was in the money (barely)on the close of the entry day, which indicates a potential forfurther gains. There aren’t any huge economic numbers dueout that could rattle the market until later in the week.

Minuses: This is a countertrend trade — the trend is still down,so this kind of trade is, by definition, an exercise in catching theproverbial falling knife.

Update (Feb. 11, 3:30 p.m. ET): The trade came close to the ini-tial profit target on Jan. 11, but a news release about Osama binLaden allegedly exhorting the Iraqis to defy the U.S. knockedthe wind out of the market.

Given the dicey conditions, wewill continue to apply (along withthe trailing stop) the secondarystop rule we used on the entry day:If QQQ doesn’t close above theentry price — on any day — we

will exit the trade. It remainsto be seen whether this con-servative move will help orhinder the trade.

R e s u l t

Exit: 23.82

Reason for exit: Price closedbelow the entry price.

Profit/loss: -0.18

Trade executed according to plan? Yes.

Lesson(s): Countertrend trades always need to be accompa-nied by very stringent risk control. This position cost very lit-tle: The trade approach got us out of the market with virtuallyno damage and the ability to enter again if a new signalappears. However, it could be argued the plan was flawedbecause it entered the position before the retracement level hadactually been reached. Ý

Trade summary

D a t e S t o c k E n t r y I n i t i a l I n i t i a l Initial E x i t D a t e P / L A c t u a ls t o p t a r g e t r e w a r d / r e w a r d /

r i s k r i s k2 / 1 0 / 0 3 Q Q Q 2 4 . 0 0 2 3 . 4 2 2 4 . 8 6 1 . 4 8 2 3 . 8 2 2 / 1 2 / 0 3 - 0 . 1 8 - 0 . 3 1

TRADEDiary

Nasdaq 100 index-tracking (QQQ), 10-minute2 4 . 6 0

2 4 . 5 0

2 4 . 4 0

2 4 . 3 0

2 4 . 2 0

2 4 . 1 0

2 4 . 0 0

2 3 . 9 0

2 3 . 8 0

2 3 . 7 0

We take a countertrend position in anticipation of a short-term bounce.

Close-threshold stop level

Stopped out

Long at24.00

2/10 10:50 12:30 2/11 10:40 12:20 2/12 10:30 12:10 13:50

2 9 . 0 0

2 7 . 0 0

2 5 . 0 0

2 3 . 0 0

2 1 . 0 0

Nasdaq 100 index-tracking (QQQ), daily

62% retracement

Nov. Dec. Jan. 2003 Feb.

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