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Slippage rises with market volatility. Floor traders can get away with more in fast-moving markets. When the market begins to run, slippage goes through the roof. The third kind of slippage is caused by criminal activities of floor traders.
THE ODDS AGAINST YOU 9 They have many ways of stealing money from customers. Some put their bad trades into your account and keep good trades for themselves. This kind of activity and other criminal games were recently described in a book, Brokers, Bagmen and Moles, by David Greising and Laurie Morse. When a hundred men spend day after day standing shoulder to shoulder in a small pit, they develop a camaraderie-an "us against them" mentality.
Floor traders have a nickname for outsiders which shows that they consider us less than human. They call us "paper" as in "Is paper coming in today? That is why you have to take steps to protect yourself. To reduce slippage, trade liquid markets and avoid thin and fast-moving markets. Go long or short when the market is quiet. Use limit orders. Buy or sell at a specified price. Keep a record of prices at the time when you placed your order and have your broker fight the floor on your behalf when necessary.
Total Damage Slippage and commissions make trading similar to swimming in a shark- infested lagoon. Let us compare an example from a broker's sales pitch to what happens in the real world. The "party line" goes like this: A contract of gold futures covers ounces of gold. Five individuals buy a contract each from someone who sells five contracts short.
The lion's share was pocketed by floor traders and brokers who took a much bigger cut than any casino or a racetrack would dare! The cost of computers and data, fees for advisory services and books- including the one you are reading now - all come out of your trading funds. Look for a broker with the cheapest commissions and watch him like a hawk. Design a trading system that gives signals relatively infrequently and allows you to enter markets during quiet times.
Individual Psychology 4. WHY TRADE? Trading appears deceptively easy. When a beginner wins, he feels brilliant and invincible. Then he takes wild risks and loses everything. People trade for many reasons- some rational and many irrational.
Trading offers an opportunity to make a lot of money in a hurry. Money symbolizes freedom to many people, even though they often do not know what to do with their freedom. If you know how to trade, you can make your own hours, live and work wherever you please, and never answer to a boss. Trading is a fascinating intellectual pursuit: chess, poker, and a crossword rolled in one.
Trading attracts people who love puzzles and brainteasers. Trading attracts risk-takers and repels those who avoid risk. An average person gets up in the morning, goes to work, has a lunch break, returns home, has a beer and dinner, watches TV,and goes to sleep. If he makes a few extra dollars, he puts them into a savings account. A trader keeps odd hours and puts his capital at risk. Many traders are loners who abandon the certainty of the present and take a leap into the unknown.
Self-Fulfillment Most people have an innate drive to achieve their personal best, to develop their abilities to the fullest. This drive, along with the pleasure of the game and the lure of money, propels traders to challenge the markets.
They are open to new ideas. The goal of a good trader, paradoxically, is not to make money. His goal is to trade well. If he trades right, money follows almost as an afterthought. Successful traders keep honing their skills. Trying to reach their personal best is more important to them than making money. A successful New York trader said to me: "If I become half a percent smarter each year, I'll be a genius by the time I die.
He is so focused on trading right and improving his skills that money no longer influences his emotions. The trouble with self-fulfillment is that many people have a self-destruc- tive streak. Accident-prone drivers keep destroying their cars, and self- destructive traders keep destroying their accounts see Section 7. Markets offer unlimited opportunities for self-sabotage, as well as for self-fulfillment.
Acting out your internal conflicts in the marketplace is a very expensive proposition. Traders who are not at peace with themselves often try to fulfill their con- tradictory wishes in the market. If you do not know where you are going, you will wind up somewhere you never wanted to be.
FANTASY VERSUS REALITY If you hear from a friend with little farming experience that he plans to feed himself with food grown on a quarter-acre plot, you will expect him to go hungry.
We all know that one can squeeze only so much blood from a turnip. The one field in which grown-ups let their fantasies soar is trading. When I tried to show him the futility of his plan, he quickly changed our topic of conversation.
He is a bright analyst, but he refuses to see that his "intensive farming" plan is suicidal. In his desperate effort to succeed, he must take on large positions-and the slightest wiggle of the market is sure to put him out of business. A successful trader is a realist. He knows his abilities and limitations. He sees what is happening in the markets and knows how to react to them.
FANTASY VERSUS REALITY 13 I analyzes the markets without cutting comers, observes his own reactions, and makes realistic plans. A professional trader cannot afford illusions. Once an amateur takes a few hits and gets a few margin calls, he becomes fearful instead of cocky and starts developing strange ideas about the mar- kets. Losers buy, sell, or miss trades thanks to their fantastic ideas. They act like children who are afraid to pass a cemetery or look under their bed at night because they are afraid of ghosts.
The unstructured environment of the market makes it is easy to develop fantasies. Most people who have grown up in Western civilization have several sim- ilar fantasies. They are so widespread that when I studied at the New York Psychoanalytic Institute, there was a course called "Universal Fantasies.
A fantasy seems to explain the unfriendly and impersonal world. It consoles a child but prevents him from seeing reality. Our fantasies influence our behavior, even if we are not con- sciously aware of them. In talking to hundreds of traders, I keep hearing them express several uni- versal fantasies. They distort reality and stand in the way of trading success. A successful trader must identify his fantasies and get rid of them.
The Brain Myth Losers who suffer from the "brain myth" will tell you, "I lost because I didn't know trading secrets. This fantasy helps support a lively mar- ket in advisory services and ready-made trading systems. A demoralized trader often whips out his checkbook and goes shopping for "trading secrets. When that self-destructs, he sends another check for a "scientific manual" that explains how he can stop being a loser and become a true insider and a winner by contetnplating the Moon, Saturn, or even Uranus.
The losers do not know that trading is intellectually fairly simple. It is less demanding than taking out an appendix, building a bridge, or trying a case in court. Good traders are often shrewd, but few of them are intellectuals. Many have not been to college, and some have even dropped out of high school. Intelligent and hardworking people who have succeeded in their careers often feel drawn to trading. Many have postgraduate degrees or own their businesses.
The two largest professional groups among traders are engineers and farmers. Why do these intelligent and hardworking people fail in trading? What separates winners from losers is neither intelligence nor secrets, and cer- tainly not education.
The Undercapitalization Myth Many losers think that they would be successful if they could trade a bigger account. All losers get knocked out of the game by a string of losses or a sin- gle abysmally bad trade.
Often, after the amateur is sold out, the market reverses and moves in the direction he expected. The loser is ready to kick either himself or his broker: Had he survived another week, he might have made a small fortune!
Losers take this reversal as a confirmation of their methods. They earn, save, or borrow enough money to open another small account. The story repeats: The loser gets wiped out, the market reverses and "proves" the loser right, but only too late - he has been sold out again. That's when the fantasy is born: "If only I had a bigger account, I could have stayed in the market a little longer and won.
It seems to prove that they would have won big, if only they had had more money to work with. But if they raise more money, they lose that, too - it is as if the market were laughing at them! A loser is not undercapitalized - his mind is underdeveloped.
A loser can destroy a big account almost as quickly as a small one. He overtrades, and his money management is sloppy. He takes risks that are too big, whatever the size of his account. No matter how good his system is, a streak of bad trades is sure to put him out of business. Traders often ask me how much money they need to begin trading.
They want to be able to withstand a drawdown, a temporary drop in the account equity. They expect to lose a large amount of money before making any! They sound like an engineer who plans to build several bridges that collapse before erecting his masterpiece.
Would a surgeon plan on killing several patients while becoming an expert at taking out an appendix? A trader who wants to survive and prosper must control his losses. FANTASY VERSUS REALITY 15 that by risking only a tiny fraction of your equity on any single trade see Chapter 10, "Risk Management". Give yourself several years to learn how to trade.
Learn from cheap mistakes in a small account. Amateurs neither expect to lose nor are in any way prepared for it. The notion of being undercapitalized is a cop-out that helps them avoid two painful truths: their lack of trading discipline, and their lack of a realistic money management plan. The one advantage of a large trading account is that the price of equip- ment and services represents a smaller percentage of your money.
The Autopilot Myth Imagine that a stranger walks into your driveway and tries to sell you an automatic system for driving your car. Just pay a few hundred dollars for a computer chip, install it in your car, and stop wasting energy on driving, he says. You can take a nap in the driver's seat while the "Easy Swing System" whisks you to work. You would probably laugh the salesman out of your driveway.
But would you laugh if he tried to sell you an automatic trading system? Traders who believe in the autopilot myth think that the pursuit of wealth can be automated. Some try to develop an automatic trading system, while others buy one from the experts. Men who have spent years honing their skills as lawyers, doctors, or businessmen plunk down thousands of dollars for canned competence.
They are driven by greed, laziness, and mathemati- cal illiteracy. Systems used to be written on sheets of paper, but now they usually come on copy-protected diskettes. Some are primitive; others are elaborate, with built-in optimization and money management rules.
Many traders spend thousands of dollars searching for magic that will turn a few pages of com- puter code into an endless stream of money. People who pay for automatic trading systems are like medieval knights who paid alchemists for the secret of turning base metals into gold.
Computerized learning systems have not replaced teachers, and programs for doing taxes have not created unemployment among accountants. Most human activities call for an exercise of judgment; machines and systems can help but not replace humans. So many system buyers have been burned that they have formed an organization, Club , named after the price of many systems. If you could buy a successful automatic trading system, you could move to Tahiti and spend the rest of your life in leisure, supported by a stream of checks from your broker.
So far, the only people who have made money from trading systems are the system sellers. They form a small but colorful cottage industry. If their systems worked, why would they sell them? They could move to Tahiti themselves and cash checks from their brokers! Meanwhile, every system seller has a line. Some say they like programming better than trading. Others claim that they sell their systems only to raise trading capital.
Markets always change and defeat automatic trading systems. Yesterday's rigid rules work poorly today and will probably stop working tomorrow. A competent trader can adjust his methods when he detects trouble.
An auto- matic system is less adaptable and self-destructs. Airlines pay high salaries to pilots despite having autopilots. They do it because humans can handle unforeseen events. When a roof blows off an air- liner over the Pacific or when a plane runs out of gas over the Canadian wilderness, only a human can handle such a crisis. These emergencies have been reported in the press, and in each of them experienced pilots managed to land their airliners by improvising.
No autopilot can do that. Betting your money on an automatic system is like betting your life on an autopilot. The first unexpected event will destroy your account.
There are good trading systems out there, but they have to be monitored and adjusted using individual judgment. You have to stay on the ball-you cannot abdicate your responsibility for your success to a trading system.
Traders who have the autopilot fantasy try to repeat what they felt as infants. Their mothers used to fulfill their needs for food, warmth, and com- fort. Now they try to re-create the experience of passively lying on their backs and having profits flow to them like an endless stream of free, warm milk. The market is not your mother. It consists of tough men and women who look for ways to take money away from you instead of pouring milk into your mouth. MARKET GURUS 17 The Personality Cult Most people give lip service to their wish for freedom and independence.
When they come under pressure, they change their tune and start looking for "strong leadership. When I was growing up in the former Soviet Union, children were taught that Stalin was our great leader. Later we found out what a monster he had been, but while he was alive, most people enjoyed following the leader.
He freed them from the need to think for themselves. When I came to the United States and began to trade, I was amazed to see how many traders were looking for a guru- their "little Stalin" in the market. The fantasy that someone else can make you rich deserves its own discussion later in this chapter.
Trade with Your Eyes Open Every winner needs to master three essential components of trading: a sound individual psychology, a logical trading system, and a good money manage- ment plan. These essentials are like three legs of a stool-remove one and the stool will fall,.
together with the person who sits on it. Losers try to build a stool with only one leg, or two at the most. They usually focus exclusively on trading systems. Your trades must be based on clearly defined rules. You have to analyze your feelings as you trade, to make sure that your decisions are intellectually sound.
You have to structure your money management so that no string of losses can kick you out of the game. In , the classic book on market manias, Extraordinary Popular Delusions and the Madness of Crowds, was published in England. It is still in print today. Its author, Charles Mackay, described the Dutch Tulip Mania, the South Seas Bubble in England, and other mass manias.
Human nature changes slowly, 'This section originally appeared as an article, "Market Gurus," in the September issue of Fumres and Options World London, U. Gum manias spring up faster now than they did centuries ago, thanks to modern telecommunications. Even educated and intelligent investors and traders follow market gums, like the devotees of the false Messiahs in the Middle Ages. There are three types of gurus in the financial markets: market cycle gums, magic method gums, and dead gums.
Some gums call important mar- 9 ket turns. Others promote "unique methods '-new highways to riches. Still others have escaped criticism and invited cult following through the simple mechanism of departing this world. Market Cycle Gurus For many decades, the U. stock market has generally followed a four-year cycle. Significant bear market lows occurred in , , , , , and The broad stock market has normally spent 2.
A new market cycle gum emerges in almost every major stock market cycle, once every 4 years. A gum's fame tends to last for 2 to 3 years. The reigning period of each guru coincides with a major bull market in the United States. A market cycle gum forecasts all major rallies and declines. Each correct forecast increases his fame and prompts even more people to buy or sell when he issues his next forecast. As more and more people take notice of the gum, his advice becomes a self-fulfilling prophecy.
When you recognize a hot new guru, it pays to follow his advice. There are thousands of analysts, some of whom are certain to be on a hot streak at any given time. Most analysts become hot at some point in their careers for the same reason a broken clock shows the right time twice a day. Those who have tasted the joy of being on a hot streak sometimes feel crushed when it ends and they wash out of the market.
But there are enough old foxes who enjoy their occasional hot streaks, yet continue working as usual after their hot streak ends. The success of a market cycle gum depends on more than short-term luck. He has a pet theory about the market. That theory-cycles, volume, Elliott Wave, whatever- is usually developed several years prior to reaching star- dom. At first, the market refuses to follow an aspiring gum's pet theory.
MARKET GURUS 19 the market changes and for several years comes in gear with theory. That is when the star of the market guru rises high and bright above the marketplace. Compare this to what happens to fashion models as public tastes change. One year, blondes are popular, another year, redheads. Suddenly, last year's blonde star is no longer wanted for the front cover of a major women's mag- azine.
Everybody wants a dark model, or a woman with a birthmark on her face. A model does not change - public tastes do. Gurus always come from the fringes of market analysis. They are never establishment analysts. Institutional employees play it safe and never achieve spectacular results because each uses similar methods. A market cycle guru is an outsider with a unique theory.
A guru usually earns a living publishing a newsletter and can grow rich selling his advice. Subscriptions can soar from a few hundred annually to tens of thousands. A recent market cycle guru was reported to have hired three people just to open the envelopes with money pouring into his firm.
At investment conferences, a guru is surrounded by a mob of admirers. If you ever find yourself in such a crowd, notice that a guru is seldom asked questions about his theory. His admirers are content to drink in the sound of his voice. They brag to their friends about having met him. A guru remains famous for as long as the market behaves according to his theory-usually for less than the duration of one 4-year market cycle.
At some point the market changes and starts marching to a different tune. A guru continues to use old methods that worked spectacularly well in the past and rapidly loses his following. When the guru's forecasts stop working, public admiration turns to hatred. It is impossible for a discredited market cycle guru to return to stardom. The reigning guru in the early s was Edson Gould.
He based his fore- casts on policy changes of the Federal Reserve, as reflected in the discount rate. His famous rule of "three steps and a stumble" stated that if the Federal Reserve raised the discount rate three times, that showed tightening and led to a bear market.
Lowering the discount rate in three steps revealed a loosen- ing of the monetary policy and led to a bull market. Gould also developed an original charting technique called speedlines-shallow trendlines whose angles depended on the velocity of a trend and the depth of market reactions. Gould became very hot during the bear market of He vaulted to prominence after correctly calling the December bottom, when the Dow Jones Industrials fell to near The market rocketed higher, Gould presciently identified its important turning points using speedlines, and his fame grew.
By , he had lost most of his following, and few people today even remember his name. The new market cycle guru emerged in Joseph Granville stated that changes in stock market volume preceded changes in prices. He expressed it colorfully: "Volume is the steam that makes the choo-choo go.
He wrote in his autobiography that the idea came to him while sitting on a toilet contemplating the design of floor tiles. Granville took his idea from the bathroom to the chartroom, but the market refused to follow his forecasts.
He went broke, got divorced, and slept on the floor of his friend's office. the late s, the market started to follow Granville's scripts as never before or since, and people began to take notice. Granville toured the United States speaking to overflow crowds.
He arrived on stage in a camage, issued forecasts, and chided "bagholders" who would not recognize his theory.
He played piano, sang, and, on occasion, even dropped his pants to make a point. His forecasts were spectacularly cor- rect; he drew attention to himself and became widely quoted in the mass media.
Granville became big enough to move the stock market. When he announced that he was bearish, the Dow dropped over 40 points in a day - a huge decline by the standards of that time. Granville became intoxicated with his success.
The market surged higher in , but he remained very bearish and kept advising his dwindling band of followers to continue to sell short. The market rocketed higher into Granville finally gave up and recommended buying when the Dow doubled in value.
He continued to pub- lish a market newsletter, a shadow of his former successful self. A new guru entered the spotlight in Robert Prechter has made a name for himself as an Elliott Wave theorist.
Elliott was an impecunious accountant who developed his market theory in the s. He believed that the stock market rallied in 5 waves and fell in 3 waves, which in turn could be subdivided into lesser waves. Like other market cycle gurus before him, Prechter had been writing an advisory letter for many years with modest success.
When the bull market penetrated the level on the Dow, people began to pay attention to the young analyst who kept calling for the Dow to reach The bull market 7 went from strength to strength, and Prechter s fame grew by leaps and bounds.
In the roaring bull market of the s, Prechter's fame swept outside the narrow world of investment newsletters and conferences. Prechter appeared on national television and was interviewed by popular magazines. MARKET GURUS 21 , he appeared to vacillate, first issuing a sell signal, then telling his fol- lowers to get ready to buy.
As the Dow crashed points, mass adulation of Prechter gave way to scorn and hatred. Some blamed him for the decline, others were angry that the market never reached his stated target of Prechter's advisory business shrank, and he largely retired from it. All market cycle gurus have several traits in common. They become active in the forecasting business several years prior to reaching stardom.
Each has a unique theory, a few followers, and some credibility, conferred by sheer survival in the advisory business. The fact that each gum's theory did not work for a number of years is ignored by his followers. When the theory becomes correct, the mass media take notice. When a theory stops working, mass adulation of a gum turns to hatred.
When you recognize that a successful new gum is emerging, it is prof- itable to jump on his bandwagon. It is even more important to recognize when a guru has reached his peak.
All gurus crash- and by definition, they crash from the height of their fame. When a gum becomes accepted by the mass media, it is a sign that he has reached his crest.
The mainstream media is wary of outsiders. When several mass magazines devote space to a hot market guru, you know that his end is near. Another warning sign that a market guru has reached his peak occurs when he is interviewed by Barron's-America's largest business weekly. Every January, Barron's invites a panel of prominent analysts to dispense wisdom and issue forecasts for the year ahead.
The panel is usually made up of "safe" analysts who focus on pricelearnings ratios, emerging growth industries, and so on. It is highly atypical of Barron's to invite a hot gum with an offbeat theory to its January panel. A gum gets invited only when the public clamors for him, and to exclude him would diminish the prestige of the magazine. Both Granville and Prechter were invited to the January panel when each man was at the crest of his fame.
Each guru fell within a few months of appearing on that panel. The next time a market guru is on Barron's January panel, do not renew your subscription to his newsletter. Mass psychology being what it is, new gums will certainly emerge. An old cycle gum never fully comes back.
Once he stumbles, the adulation turns to derision and hatred. An expensive vase, once shattered, can never be fully restored. Magic Method Gurus Market cycle gurus are creatures of the stock market, but "method gurus" are more prominent in the derivative markets, especially in the futures markets. Traders always look for an edge, an advantage over fellow traders. Like knights shopping for swords, they are willing to pay handsomely for their trading tools.
No price is too high if it lets them tap into a money pipeline. A magic method gum sells a new set of keys to market profits. As soon as enough people become familiar with a new method and test it in the markets, it inevitably deteriorates and starts losing popularity. Markets are forever changing, and the methods that worked yesterday are not likely to work today and even less likely to work a year from now. In the early s, Chicago market letter writer Jake Bemstein became hot by using market cycles to call tops and bottoms.
His methods worked well and his fame spread. Bernstein charged high fees for his newsletters, ran conferences, managed funds, and produced an endless flow of books. As usual, the markets changed, becoming less and less cyclical in the s. Peter Steidlmayer was another method gum whose star rose high above Chicago. He urged his followers to discard old trading methods in favor of his Market Profile.
That method promised to reveal the secrets of supply and demand and give true believers an ability to buy at the bottoms and sell at the tops. There appeared to be no conspicuous examples of success among Market Profile devotees, and the founders had a nasty falling out.
Steidlmayer got a job with a brokerage firm, and both he and Koy continued to give occasional seminars. Oddly enough, even in this era of fast global links, reputations change slowly. A guru whose image has been destroyed in his own country can make money peddling his theory overseas. That point has been made to me by a guru who compared his continued popularity in Asia to what happens to faded American singers and movie stars.
They are unable to attract an audience in the United States, but they can still make a living singing abroad. Dead Gurus The third type of a market gum is a dead gum. MARKET G U R U S 23 legend of the dear-departed analyst's prowess and personal wealth grows posthumously. The dead guru is no longer among us and cannot capitalize on his fame. Other promoters profit from his reputation and from expired copy- rights. One dear-departed guru is R.
Elliott, but the best example of such a legend is W. Various opportunists sell "Gann courses" and "Gann software. I interviewed W. Gann's son, an analyst for a Boston bank. He told me that his famous father could not support his family by trading but earned his living by writing and selling instructional courses.
When W. The legend of W. Gann, the giant of trad- ing, is perpetuated by those who sell courses and other paraphernalia to gullible customers.
The Followers of Gurus The personalities of market gums differ. Some are dead, but those who are alive range from serious academic types to great showmen. A guru has to produce original research for several years, then get lucky when the market turns his way. To read about the scandals that surrounded many gurus, try Winner Takes All by William Gallacher and The Dow Jones Guide to Trading Systems by Bruce Babcock. The purpose of this section is simply analysis of the guru phenomenon.
When we pay a guru, we expect to get back more than we spend. We act like a man who bets a few dollars against a three-card monte dealer on a street comer. He hopes to win more than he put down on an overturned crate. Only the ignorant or greedy take the bait. Some people turn to gurus in search of a strong leader. They look for a parent-like omniscient provider. As a friend once said, "They walk with their umbilical cords in hand, looking for a place to plug them in. The public wants gurus, and new gurus will come.
As an intelligent tradel; you must realize that in the long run, no guru is going to make you rich. You have to work on that yourself.
A trader who wants to be successful in the long run has to be very serious about what he does. He cannot afford to be naive or to trade because of some hidden psychological agenda.
Unfortunately, trading often appeals to impulsive people, to gamblers, and to those who feel that the world owes them a living. If you trade for the excitement, you are liable to take trades with bad odds and accept unneces- sary risks. The markets are unforgiving, and emotional trading always results in losses. Gambling Gambling means betting on games of chance or skill.
It exists in all societies, and most people have gambled at some point in their lives. Freud believed that gambling was universally attractive because it was a substitute for masturbation.
The repetitive and exciting activity of the hands, the irresistible urge, the resolutions to stop, the intoxicating quality of plea- sure, and the feelings of guilt link gambling and masturbation. Ralph Greenson, a prominent California psychoanalyst, has divided gamblers into three groups: the normal person who gambles for diversion and who can stop when he wishes; the professional gambler, who selects gambling as his means of earning a livelihood; and the neurotic gambler, who gambles because he is driven by unconscious needs and is unable to stop.
A neurotic gambler either feels lucky or wants to test his luck. Winning gives him a sense of power. He feels pleased, like a baby feeding at a breast. A neurotic gambler always loses because he tries to re-create that omnipotent feeling of bliss instead of concentrating on a realistic long-term game plan.
Sheila Blume, director of the compulsive gambling program at South Oaks Hospital in New York, calls gambling "an addiction without a drug. Women tend to gamble as a means of escape. Losers usually hide their losses and try to look and act like winners, but they are plagued by self-doubt.
Trading stocks, futures, and options gives a gambler a high but it does appear more respectable than betting on the ponies, Moreover, gambling in the financial markets has an aura of sophistication and offers a better intel- lectual diversion than playing numbers with a bookie. They feel terribly low when they lose. They differ from successful professionals who focus on long- term plans and do not get particularly upset or excited in the process of trading.
Brokers are well aware that many of their clients are gamblers. They often try to avoid leaving messages for traders with their wives, even when they call to confirm a trade. Amateurs are not the only ones involved in gam- bling-quite a bit of it goes on among professionals. Sonny Kleinfield describes in his book, The Traders, the endemic betting on sports events on the floors of financial exchanges.
The key sign of gambling is the inability to resist the urge to bet. If you feel that you are trading too much and the results are poor, stop trading for a month. This will give you a chance to re-evaluate your trading. If the urge to trade is so strong that you cannot stay away fiom the action for a month, then it is time to visit your local chapter of Gamblers Anonymous or start using the principles of Alcoholics Anonymous, outlined later in this chapter. Self-sabotage After practicing psychiatry for many years, I became convinced that most failures in life are due to self-sabotage.
We fail in our professional, personal, and business affairs not because of stupidity or incompetence, but to fulfill an unconscious wish to fail. A brilliant and witty friend of mine has a lifelong history of demolishing his success. As a young man, he was a successful industrial salesman and was sacked; he entered training as a broker and rose near the top of his firm but was sued; he became a well-known trader but busted out while disentan- gling himself from previous disasters.
He blamed all his failures on envious bosses, incompetent regulators, and an unsupportive wife. Finally, he hit bottom. He had no job and no money. He borrowed a quote terminal from another busted-out trader and raised capital from a few people who had heard that he had traded well in the past.
He knew how to trade and made money for his pool. As the word spread, more people brought in money. My friend was on a roll. At that point, he went on a speaking tour of Asia but continued to trade from the road. He took a side trip into a country famous for its prostitutes, leaving a very large open position with no protec- tive stop. By the time he returned to civilization, the markets had staged a major move and his pool was wiped out. Did he try to figure out his prob- lem?
Did he try to change? No- he blamed his broker! When traders get in trouble, they tend to blame others, bad luck, or anything else. A prominent trader came to me for a consultation. His equity was being demolished by a rally in the U. dollar, in which he was heavily short.
He had grown up fighting a nasty and arrogant father. He had made a name for himself by betting large positions on reversals of established trends. This trader kept adding to his short position because he could not admit that the market, which represented his father, was bigger and stronger than he was.
These are just two examples of how people act out self-destructive ten- dencies. We sabotage ourselves by acting like impulsive children rather than intelligent adults. We cling to our self-defeating patterns even though they can be treated - failure is a curable disease. The mental baggage from childhood can prevent you from succeeding in the markets. You have to find your weaknesses in order to change.
Keep a trading diary - write down your reasons for entering and exiting every trade. Look for repetitive patterns of success and failure. The Demolition Derby Almost every profession and business provides a safety net for its members. Your bosses, colleagues, and clients can warn you when you behave danger- ously or self-destructively.
There is no such support in trading, which makes it more dangerous than most human endeavors. The markets offer many opportunities to self-destruct without a safety net. All members of society make small allowances to protect one another from the consequences of our mistakes.
When you drive, you try to avoid hitting other cars and they try to avoid hitting you. If someone swings open the door of a parked car, you swerve. If someone cuts in front of you on a highway, you may curse, but you will slow down. You avoid collisions because they are too costly for both parties. Markets operate without normal human helpfulness. Every trader tries to hit others. Every trader gets hit by others. The trading highway is littered with wrecks. Trading is the most dangerous human endeavor, short of war.
Buying at the high point of the day is like swinging your car door open into the traffic. When your buy order reaches the floor, traders rush to sell to you - to rip your door off along with your arm. Other traders want you to fail because they get the money you lose. Others structure their lives to succeed in one area while act- ing out internal conflicts in another.
Very few people grow out of their prob- lems. You need to be aware of your tendency to sabotage yourself: Stop blaming your losses on bad luck or on others and take responsibility for the results. Start keeping a diary-a record of all your trades, with reasons for entering and exiting them. Those who do not learn from the past are condemned to repeat it.
You need a psychological safety net the way mountain climbers need their survival gear. I found the principles of Alcoholics Anonymous, outlined later in this chapter, to be of great help.
Strict money management rules also pro- vide a safety net. If you seek therapy for your trading problems, choose a competent thera- pist who knows what trading is about. You are ultimately responsible for your own therapy and must monitor its progress. I usually tell my patients that if a month goes by without clear signs of improvement, then therapy is in trouble.
When therapy shows no progress for two months, it is time to seek a consultation with another therapist. You may have a brilliant trading system, but if you feel frightened, arrogant, or upset, your account is sure to suffer. When you recognize that a gambler's high or fear is clouding your mind, stop trading.
Your success or failure as a trader depends on controlling your emotions. When you trade, you compete against the sharpest minds in the world. The field on which you compete has been slanted to ensure your failure. If you allow your emotions to interfere with your trading, the battle is over. You are responsible for every trade that you make. A trade begins when you decide to enter the market and grids only when you decide to take your- self out. Having a good trading system is not enough.
Most traders with good systems wash out of the markets because psychologically they are not pre- pared to win. Markets evoke powerful greed for more gains and a great fear of losing what we've got. Those feelings cloud our perceptions of opportunities and dangers.
Most amateurs feel like geniuses after a winning streak. It is exciting to believe that you are so good you can bend your own rules and succeed. That's when traders deviate from their rules and go into a self-destruct mode. Traders gain some knowledge, they win, their emotions kick in, and they self-destruct. Most traders promptly give their "killings" back to the markets. The markets are full of rags to riches to rags stories. The hallmark of a suc- cessful trader is his ability to accumulate equity.
You need to make trading as objective as possible. Keep a diary of all your trades with "before and after" charts, keep a spreadsheet listing all your trades, including commissions and slippage, and maintain very strict money management rules.
You may have to devote as much energy to analyzing yourself as you do to analyzing the markets. When I was learning how to trade, I read every book on trading psychol- ogy I could find. Many writers offered sensible advice. Some stressed disci- pline: "You cannot let the markets sway you. Do not make decisions during trading hours. Plan a trade, and trade a plan. Change your plans when markets change.
Others advised being open-minded, keeping in touch with other traders and soaking up fresh ideas. Each piece of advice seemed to make sense but contradicted other equally sensible advice. I kept reading, trading, and focusing on system development. I also con- tinued to practice psychiatry. I never thought the two fields were con- nected-until I had a sudden insight.
The idea that changed how I trade came from psychiatry. The Insight That Changed My Trading Like most psychiatrists, I always had some patients with alcohol problems. I also served as a consultant to a major drug rehabilitation program. TRADING LESSONS FROM AA take me long to realize that alcoholics and addicts were more likely to recover in self-help groups than in classical psychiatric settings.
Psychotherapy, medications, and expensive hospitals and clinics can sober up a drunk but seldom succeed in keeping him sober. Most addicts quickly relapse. They have a much better chance to recover if they become active in Alcoholics Anonymous AA or other self-help groups. Once I realized that AA members were likely to stay sober and rebuild their lives, I became a big fan of Alcoholics Anonymous. I began sending patients with drinking problems to AA and related groups, such as ACOA Adult Children of Alcoholics.
Now, if an alcoholic comes to me for treat- ment, I insist that he also go to AA. I tell him that to do otherwise would mean wasting our time and his money. One night, many years ago, I stopped by a friend's office on the way to a party at our department of psychiatry.
We had two hours before the party, and my friend, who was a recovering alcoholic, said: "Do you want to take in a movie or go to an AA meeting? I jumped at a chance to attend an AA meeting- it was a new experience. The meeting was held at a local YMCA. A dozen men and a few women sat on folding chairs in a plain room.
The meeting lasted an hour. I was amazed by what I heard - these people seemed to talk about my trading! They talked about alcohol, but as long as I substituted the word "loss" for "alcohol," most of what they said applied to me! My account equity was still swinging up and down in those days. I left that YMCA room knowing that I had to handle my losses the way AA handles alcoholism. TRADING LESSONS FROM AA Almost any drunk can stay sober for a few days. Soon, the urge to drink overwhelms him again and he returns to the bottle.
He cannot resist his urge because he continues to feel and think like an alcoholic. Sobriety begins and ends inside a person's mind. Alcoholics Anonymous AA has a system for changing the way people think and feel about drinking.
AA members use a step program for changing their minds. These 12 steps, described in the book Twelve Steps and Twelve Traditions, refer to 12 stages of personal growth. Any member can get a sponsor - another AA member whom he can call for support when he feels the urge to drink.
AA was founded in the s by two alcoholics - a doctor and a traveling salesman. They began meeting and helping each other stay sober. They developed a system that worked so well, others began to join them. AA has only one goal - to help its members stay sober.
It does no fund-raising, takes no political positions, and runs no promotional campaigns. AA keeps grow- ing thanks only to word of mouth. It owes its success only to its effective- ness. The step program of AA is so effective that people with other prob- lems now use it. There are step groups for children of alcoholics, smok- ers, gamblers, and others. I have become convinced that traders can stop los- ing money in the markets if they apply the key principles of Alcoholics Anonymous to their trading.
It might actually be worse than that. The most common form of forex trading is spot forex through a retail forex broker such as FXCM or Sterling Gent.
Brokers take an additional profit from the roll every day. We are now up to a 15 percent headwind to make any money. Stock investors tend to make money but that is largely because the stock market drifts higher over any decent, long period of time, not because stock investors are better investors. In addition, there is no time limit when you invest with stocks. Futures and options expire. Investors will often hang on to losing positions in stocks for years waiting for them to return to profitability.
The high leverage creates a mentality toward trading that works against traders. Contrast this mentality with the normal stock investing mentality that looks to buy and hold. The pressures of dealing with high leverage cause the usual forex trader to make a lot of mistakes.
And those mistakes cost more than in the unleveraged stock world. The high leverage puts a lot of mental pres- sure on the forex trader that is simply not there in as high a degree for a stock trader. The sum of all these differences is that the forex trader has a much harder time making money than a stock trader. The subtitle of this book is A Guaranteed Income for Life. This title was inspired by an infamous poker book from 20 years ago.
I truly believe that the material in that book can create a guaranteed income for life. This is not BS. You must not deviate. You must execute flawlessly. Only after you have mastered this material should you start to be creative. This self-discipline is critical to your success. A lackadaisical attitude will put you back in the category of a losing trader. You will live a life that few can even comprehend.
I wrote much of this book while hanging out near the beach in Belize. How can I do this? Internet access. I do all my analysis and trading online.
My first stop after the Singapore speech is a week in Bali. Guess what? I really only need Internet access for about 15 minutes a day. I prefer more than that because I post a lot of instructional videos on my educational Web sites and that takes more time and bandwidth. But how about just a few minutes at an Internet cafe´ in China or London or wherever?
The true goal for me, and most people trading forex, is not to make a lot of money but to gain freedom. I know that I presented a rather dismal picture about how hard it is to make money in the forex world. This is a very strong statement. How do I know that this is true? How can I be so sure? I have spent many years training traders. I have been teaching these techniques for over 25 years. More important, I have been training retail investors with no experience at all trading let alone trading forex.
It has been a very gratifying experience. I have really enjoyed watching people create a new life for themselves. Every single one of my retail educational clients has made money trading forex, except one. And he is down just a little.
At one point, I foolishly offered a mentoring program called Extreme Profits. What an idiot I am! All but one student doubled their money. These were normal retail in- vestors; no trading pros in the group. By the way, she was up 70 percent for the year. So I know that it can be done. I know that you can do it! you must execute flawlessly. Now go through this book. Execute the plan. Make money. Live the life you dream about. This book explains all the basics that a novice needs to know to get going.
At the same time, experienced traders will find the systems and methods, particularly my enhancements of classic methods, to be of signif- icant value. Every trader will find the sections on the psychology of trading and risk management will sharply enhance their profitability. Chapter 1 outlines the basic information you need to get started in trad- ing forex. But I assume that you know nothing about trading forex.
Even if you have some experience trading forex, this chapter is worth reading for the examples. Chapter 2 is where we really start the methods of making money in the forex market. This chapter introduces trend analysis. This technique is similar to what have been called s.
However, I add in a unique method to truly define which trends to jump onto and which ones to sidestep. In addition, I introduce to the public for the first time the Bishop tech- nique. This unique indicator has a tremendous track record of getting out of trades at major highs or lows.
I will exit all my open posi- tions on any technique whenever I see a Bishop buy or sell signal. This fil- ter eliminates about half of my losing trades while only eliminating about 5 percent of my winning trades.
What a great tradeoff! It dramatically enhances the profit of the trend analysis and other techniques. Chapter 3 is all about channel breakouts. This classic technique has been around since the s.
How- ever, I introduce several major enhancements to the classic technique that turbo-charge the profitability. The first enhancement is the principle of instant gratification, which is an underlying principle that will show you how to greatly enhance your understanding of the market, how to profitably trade, and how to boost your profits.
I also introduce the rejection rule. This powerful enhancement cuts the risk of trading channel breakouts by at least half, yet it retains all the profit potential.
It basically monitors the health of a breakout and leaps out of the position if there is no follow-through. In addition, it cuts down on the psychological stress of trading channel breakouts. I then add in another exit strategy called the last bar. I got this idea from ace trader Peter Brandt. It sharply reduces the risk in any given trade to a trivial amount.
As you can imagine, cutting risk to small amounts dramatically enhances your profits at the end of the year. I introduce the Conqueror in Chapter 4. Another unique feature of this method is that it uses different exit techniques than the entry techniques.
This is the only method I know that uses different exit and entry techniques. The Conqueror is a technique that has a very hard time entering the market.
It wants all the conditions to be perfect before entering a trade but jumps out of the position at the slightest intimation of weakness in the trade. I love this system and I think you will, too!
Chapter 5 introduces how to use stochastics profitably. It seems like everybody uses stochastics; they are perhaps the most popular indicator in chart services. Yet everyone is using them wrong. This chapter shows you how to profitably use stochastics while sidestepping the usual traps that drain money from your account. I show you how I use stochastics to iden- tify short-term turning points and, more important, how to identify major turning points.
As a bonus, I have included an amazing interview with the inventor of stochastics, George Lane. I had the privilege of interviewing him before he passed away. This hard-hitting interview reveals how he invented stochastics, where they got their name, and, most important, how George himself used stochastics to make money in his trading.
This interview is priceless. Another unique feature of this book is that I show you different profitable techniques to use over different time horizons. The techniques discussed here are techniques that look at the market from the perspective of days to weeks.
Chapter 6 introduces several techniques that trade over a much shorter term. These techniques hold positions for less than one day. These pattern-recognition techniques are great for those traders who want to make money during the day rather than over the next week or month.
I like to think about these trades as just churning out some nice profits day after day. But making a nice chunk of money during the day is a very nice thing. This chapter also introduces the multiunit tactic. This technique uses multiple contract positions to give you more flexibility in your exits.
xvi PREFACE This technique has a lot of positive psychological benefits while also giving a kick to your profits. You cannot control the profit you make unless you control the risk in your account. Ninety percent of forex traders lose money while only about 5 percent make money.
I argue that one of the critical differences between the winners and the losers is that the winners know how to control the risk in their account. Chapter 7 drills down on this important subject and gives you clear instructions on how to control the risk in your account to ensure that you will be a profitable trader. I even take risk management one step further and show you how to use it as an offensive weapon, not just a defensive one. The concept of using risk management as a method for enhancing profits is rarely talked about in the markets.
This chapter is critical because you need to be able to survive the inevitable losing streaks without losing any significant money and to also be able to maintain the proper mental state. You must never get to a situation that is both financially and mentally debilitating. The next chapter, Chapter 8, shows a new technique called the Sling- shot as well as the mini-Slingshot.
I also use this chapter to extend the discussion of risk management. The Slingshot is a very interesting chapter due to the unique concepts embedded in it. It builds on the risk manage- ment concepts from the previous chapter. I believe that risk management is actually the second-most important factor for investment success.
Chapter 9 looks at the biggest block against making money in the markets: you. It is your psychology. You are the biggest problem.
Intellectual skills are trivial. You will rarely have prob- lems with the methods that I present in this book. The basic risk manage- ment rules are also easy to apply. But the psychology of trading is intense and few can master it.
I want you to be a huge success; it is the real key to making money in the market. Please do not disregard it or push it to the side. I am laying out a lot of profitable techniques in this book.
You will fail. You need to be able to execute the techniques or the techniques are useless. I am a big believer in stress-free trading. Why should I trade if I get all wound up in stress while doing it? Life is too short.
Once again, we need to deal with the psychology of trading. This chapter goes into the reasons people trade. I also go into all the reasons that people lose money and show specifically how to overcome those reasons. Chapter 10 shows you how all these techniques fit together. By this point, I will have shown you a collection of powerful techniques for making money trading forex. This chapter shows how they all fit together into a coordinated program for profits.
Each technique has a different purpose from the other techniques. So the totality of the techniques is truly greater than each technique separately. Once again, this is a very unique approach. Most books will present techniques but no framework. You should come away from reading this book with a concrete and comprehensive approach to making money trading forex. You will have a toolbox full of profitable techniques. You will understand how to man- age your risk.
You will understand how to have a stress-free psychology of trading. Good luck! This volume completely swamps the global stock market. It is not hard to understand why forex is traded the most. Nobody needs to buy stocks but we must all deal directly or indirectly with the foreign exchange forex world.
Global trade is huge. Every time a barrel of oil is bought, dollars must also be bought by everybody but Americans. Japanese must change their yen into dollars to buy oil since oil is priced in dollars.
Every time an American buys a Japanese car, dollars are swapped for yen to buy the car. Every time a kid watches a Disney movie in Poland, dollars are demanded. Cross-border capital flows for investment contribute another massive quantity of foreign exchange transactions. Perhaps the largest component of daily volume is speculation. This is mainly done by banks and other financial institutions around the world. Every day, banks trade among themselves looking for speculative profit.
In addition, major banks try other strategies to make money. Perhaps a large order had come into a bank that was large enough to change the price of the currency. This piece of knowledge could create additional profit opportunities for the bank that knew about the order.
This will be discussed later in this chapter. Let me assume that you know something about investing in general, perhaps in stocks, and focus on how the forex market is different from other markets. We had a client who was a cotton merchant from Turkey. He speculated in forex as a paying hobby. What he wanted to do was to sell 1 billion British Pounds.
The only currency that is capitalized is the Pound; all others are lowercase. Forex trivia! We were shocked at the size of the order. That would be a huge order for any major financial institution, let alone for a single individual. We were the counterparty on all orders from our customers so we were expected to take the other side of his trade.
No way. All foreign exchange trading, except for a small amount on the Inter- national Monetary Market, is over the counter. There is no exchange. All transactions are done over the phone, with a broker, or via some electronic means between two entities. Entities are usually financial institutions but are often corporations and sometimes individuals.
That means that when a retail investor, such as myself, puts in an order through an online broker, the counterparty is practically unknown. It could very well be the broker.
However, the broker could be aggregating prices from different brokers or institutions. The source of the prices are unknown, which is very dif- ferent from the stock market because a stock is generally traded only at one place, such as the New York Stock Exchange NYSE. Technically, the NASDAQ is an over-the-counter market that is centralized in one place so it is, effectively, an exchange. Forex is completely diversified. Back to the yard of cable. The size of his order meant that we had to lay off the risk to other dealers.
But there was no way that we could find a dealer to take the whole billion Pounds. Even million Pounds was a large order. It was very late in the afternoon and I only had a few forex dealers on the desk.
My main trading desk was in the form of a large T with me at the top of the T. I could see and hear everything on the desk this way. I started grabbing dealers from other desks. It took a few minutes but I soon assembled a cast of ten forex, bond, and cash dealers arrayed in front of me, five on each side of the bottom of the T.
We knew that the pressure of selling 1 million cable was going to cause a sharp drop in the price of the Pound Sterling. It was a huge order. This is called front running and is legal in forex and bond trading but illegal in stock trading. I told each trader to call a different bank and get a price for million Pounds. In the interbank world, you ask for a price from the other bank. The other bank must offer you a two-sided market.
The Basics of Foreign Exchange Trading 3 This means that they must give you a quoted price for both buying and sell- ing. Notice that 43 and 45 are not complete prices.
The complete price might have been 1. But dealers only speak about the last two figures of the price. In fact, the price of 43—45 was likely barked into the phone with the implication that we better quickly tell them whether we were buy- ers or sellers.
I told my dealers to raise their hand when they had a price. I gave them the sign to sell as soon as I saw my tenth dealer raise his hand. We were able to sell all billion Pounds that our client wanted us to sell. We sold them all at the current market price. But then all hell broke loose. The pressure from our order caused a vacuum to open up under the price. We may have sold a billion cable at 43 but the price was pips lower in a fraction of the second. A pip is the smallest normal increment that a currency trades in even though some brokers quote in tenths of a pip.
A general rule of thumb is to start with the far-left digit in a price and count to the right five places and that is a pip. The yen under In that case, only count four places. Always ignore decimal places. Our phone board lit up like Times Square. All ten of those dealers we had just sold to were screaming into the phone some variation of how we had stuffed them and how our parentage was suspect.
They were scream- ing about how they were now holding a big position in Pounds and had nowhere to lay off the risk since we had basically forced the market to go long.
They now owned 1 billion cable and had no one to lay off the risk to since we had just swamped the market. We let the other dealers vent for a minute or two and then explained that we had no choice in how we handled the order.
They all stopped venting and agreed that they would have done exactly the same thing and there were no hard feelings. Indeed, we found ourselves on the other side of such a trade over and over again. This is financial Darwin in action. Now, remember, we sold short 20 million Pounds before we stuffed the market. We had a huge profit in that posi- tion now. I remember one of my traders saying to me that we just had a good year in the last minute.
Yes, we made a lot of money on that trade. It was now time to mend some bridges. We would dole out our 20 million to the dealers that had com- plained the least to reward their attitude. On this trade, we were not trying to get the best price. But for ourselves, we wanted to get out at a reasonable price and, at the same time, give back a little love to the market after we had decimated it.
In this case, we called a few brokers and, after letting them rant a little more, told them that we were buyers of cable. That was a signal to them that they could move the price up a pip or two and make a little money on our order. Did I mention that trading forex is the most cutthroat of all the major markets to trade in? The Deutsche mark was still being traded when I was a dealer.
The euro came later. Deutsche Bank was the premier bank trading the mark. They were the big dog in the mark and really made the market for the mark.
They had all the big clients so they saw most of the flow into the market. I mentioned before that we would generally quote a market with both sides. If we quoted a price of 65—67, that meant that we would sell it to whoever called us for a price at 67 and buy it from them at That meant that they wanted a price for me to both buy or sell the D-mark.
They could be buyers or sellers. This process keeps the system fair. Otherwise, consider if I knew that they wanted to be buyers. I could then shade the price a little higher so they would have to bid up to my price to buy. That way, I would make a little more money.
The two-sided quote keeps the market fair and also keeps the dealers on the ball. The same situation applies to the online forex world. Two prices are always on the screen. The lower price is the bid and is the price that we will get when we sell a contract of forex. The higher price is the ask, or offer and is the price you will pay when you buy a contract of forex. I was always very afraid when Deutsche Bank would call me looking for a price on the mark.
They were the largest dealer in the currency. They knew what the price was and had a huge inventory of marks. They wanted to see if I was quoting the price of the mark correctly. However, they would do a trade with me if I was quoting the price incorrectly. But they would sell to me if I quoted them 64— They would sell to me at 64 knowing that they could buy at 63 from their clients, thus making a pip on the trade.
That meant that I had quoted the market correctly. I would have most certainly lost money if they had done a trade with me. They knew that market far better than I did. There are a lot of different currencies in the world to trade but the volume is concentrated in just a few. You are always long one side of the pair versus being short the other side of the pair.
You can be long or short either side. That is the convention. First, what does CHF stand for? It stands for Confederation Helvetia franc. The currency unit is called the Swissy even though the pair starts out with a USD. Foreign exchange in the interbank world is usually traded in units of a million dollars. The normal futures contract calls for delivery of , of whatever is being traded. So the Swiss franc contract calls for delivery of , Swiss francs.
The usual minimum unit that a pair can trade is called a pip. You can find out the value of a pip by multiplying the pip by the contract size that you are trad- ing. For example, suppose that you are trading a standard online contract of euro. The euro is quoted like 1. One figure to the left of the decimal place and four to the right although there are now online brokers who quote in tenths of pips. So take the rule of thumb that the pip is the fifth figure from the left the ex- ception being yen when it is quoted under The value of a pip for a standard online contract would be 0.
The value of a pip actually changes during the day as the value of the underlying in- strument changes. In addition, some brokers may change the contract size less often. It is always best to double-check with each broker. This is because the futures contracts are standardized at , francs, euros, or whatever.
Thankfully, no. There is no margin or good-faith deposit in the interbank market. Instead, banks do deals with each other simply on credit. A bank will have its credit officers examine the credit of the other potential trading banks.
The risk in the forex world is not strictly a credit risk since there is no credit being extended. There is just a delivery risk. The risk in this transaction is called delivery risk because the other side of the trade may fail to deliver, in this case 5 million euro. Forex trades are settled within one day so the delivery risk is a one-day risk. In the interbank world, the initial trade gets rolled over every day as if it were a new trade. The delivery risk is eliminated from the previous day but the very same delivery risk comes into play until the very last day when everything is reversed and there is no risk.
It is very dif- ferent in the online forex and futures worlds. Here, we must post a margin deposit every time we do a trade. Although it is termed margin, it is differ- ent from margin in the stock world. Interest must be paid on the balance owed to the broker.
Margin in the forex world is simply a good-faith deposit. You can even sometimes earn interest on it. The broker will freeze a certain amount of money for each contract you enter into. They will not allow you to put on a trade if there is not enough margin in the account.
The broker will allow us to enter no more than two contracts. If the position starts to lose money, the broker has the right to liquidate the position. They do that to make sure that you always have enough money in your account in case a position goes against you. And, yes, they will liquidate your open positions in an instant if you go below the margin position in your account. The situation is similar in futures. For example, suppose that the market is 63 bid and 66 offered or asked.
You will have to buy at 66 if you want to buy or sell at 63 if you want to sell. For the interbank and futures trader, the price on the screen will show 66 and it will appear that you have a break-even trade. However, if you were to instantaneously try to sell it, you would sell it at 63 for a three-pip loss. Online brokers will immediately show that you have a three-pip loss because they will show the bid price as the last price not the last price.
No matter how it is presented, you will have an instant loss of three pips when you enter a trade with a three-pip spread. But, obviously, it can also go the other direction. That compen- sates them for providing us with the ability to trade whenever we want to. Futures traders and sometimes interbank players must pay a commission. Futures traders must always pay a commission to their broker to execute their trade.
Interbank traders will sometimes execute a trade through an interbank broker and will have to pay a pip or a half pip to the broker to execute that trade.
Transaction costs become more important the shorter the time hori- zon of the trader. A three-pip spread over months is irrelevant. But three pips is highly important for a trader who is doing many trades throughout the day. Their profit objective may only be 20 pips; three pips is a significant hit on profitability.
Remember, the trader has to implicitly pay the three pips when you both enter and exit a trade. Effectively, the day trader is paying six pips to make IT NEVER STOPS Technically, forex trading begins Sunday morning in Tel Aviv and goes to Friday afternoon in New York. However, the Tel Aviv session is so small that it is usually ignored and trading starts on Monday morning in Welling- ton, New Zealand. Traditionally, the trading day begins in Wellington because it is the first trading center that opens.
However, Wellington is a small trading center so there is little trading. Trading really becomes more active when Sydney and Tokyo open.
The London forex center is the center with the highest volume, so trading really takes off when it opens. New York opens when London is at lunch and is the center with the second-highest volume of trad- ing.
The period with the highest volume is during the afternoon in London and the morning of New York. London then closes, leaving New York as the final trading center open for the day. There is decent volume in the New York afternoon except, perhaps, on Friday afternoon.
The slowest time of the day is between the time New York closes and Wellington opens. The cycle never ends. MY BIGGEST LOSING TRADE There are three main orders you can place in the forex market though on- line brokers can be more creative.
The first order is the market order. As mentioned earlier, the market always has a bid price and an ask, or offer, price. A market order to buy is always filled at the ask and a market order to sell is always filled at the bid.
The only exception is when the quantity to buy or sell is larger than the quantity on the bid or ask. For example, you want to sell eight contracts at the market. The bid is 79 but there are only five bids at that price. There are three bids just below that at So you would sell five at 79 and three at A market order must be filled by the broker at the best bid or ask immediately.
A limit order is an order to buy when the market goes lower or to sell the market when it rallies. A limit order would be to buy the pair when it dips to a level below the current market. So, for example, you would put in an order to buy two contracts at 33 limit. Your order will be filled when the market trades or is offered at You will use the limit order whenever you want to buy a dip in the market or sell a rally. The stop order is the order I use more than any other.
A stop order is used when you want to buy something at a price higher than the current market or wish to sell a pair at a price below the current market price. Consider this: The market is 38 bid and 39 ask. A stop order would be used to buy the pair when it rallies up to So, for example, an order to buy two contracts at 45 stop would be placed.
It becomes a market order when the market trades or is bid at The order will be filled at whatever the best offer is at that time. Use a stop order when you want to buy a pair at a price higher than the current price. A stop order is often called a stop loss order because the most common use of a stop order is to exit a position.
To exit the trade, you should it trade down to You would enter an order to sell at This would become a market order to sell if the market trades or is offered at However, I use stop orders almost exclusively. Buy low, sell high, they say to me.
The first problem with limit orders is that you almost always have a losing trade immediately. For example, you have an order to buy a pair at 85 limit. You can only be filled if the market trades at 85 or is offered at In the real world, the price will drop below the 85 limit price in order to get filled.
The next pip after you have been filled will be 84 and, most likely, the price will move even lower before finding support. That means that you will be sitting on a losing trade right away. The market is telling you that the situation is bearish because it is dropping in price. I never want to go against the market. It is bigger, faster, smarter, and better looking than I am. We will always lose the battle if we fight the market.
Entering on a stop order creates a very different dynamic. You are nearly always in a profit position immediately. After all, you can be filled on a stop order until the market is trading at or higher than your stop or- der. The short-term momentum of the market will nearly always push the price beyond your entry price by at least a little bit.
More important, using entry stop orders ensures that we are in tune with the market. We are only buying when the market is bullish and only selling when the market is bearish. This means that we have the wind to our back, not to our face.
We are in sync with the market and, there- fore, have the power of the market behind us. It may not stay there long but it is always better to at least be in tune with the market for at least the beginning of any trade.
The only time to use limit orders is when there is a liquidity problem with buying on a stop. I would have to use limit orders to buy when I traded for institutions because the size of my stop order would cause the market to go sky high.
I was heading up a derivatives trading desk in the late s. One of the derivatives we dealt and traded was options on forex. We had a book of derivatives and then used a large quantity of forex to hedge the risk. There was a big economic release coming up that day. I was using forex futures to hedge my position. In particular, I was short the Swiss franc in large quantity and other currencies in lesser quantities.
I was short hundreds of contracts. The number was released and the market skyrocketed. I ended up having my protective stop filled about ticks or pips above where my stop had been placed! There was a complete vacuum of orders above the market. The other interesting thing is that the cash market peaked about pips under the futures market.
In other words, there was much more liquidity in the cash market than in the futures market. I got hammered. It seemed like the longest walk in my life as I trudged through the trading room to report my loss to my boss, the treasurer of the bank. In this case, the price jumped over the stop order leaving me with a fill pips beyond the stop order.
That can happen with stop orders. It is fairly common to have a stop order filled a pip or two away from the stop level in your order. Just get used to it. I like that imbalance. I want to get out at my price when I use a stop to protect an open position. On the other hand, I feel fortunate to get out, even with a bad fill, when the market gaps down beyond my stop because that means that there is so much pressure that there is no buying in the market. Note that this kind of situation never occurs with a limit order.
You will always be filled at your limit price. Of course, you may be in deep trouble if that happens. A big news item comes out and the market drops precipitously. You will be filled at 50 but the next print of the price may not be until Basically, you were filled at a price that was way above the market. A market order will always be filled when the market is moving dramatically. However, it may be far away from the price on the screen when you entered the order and you may be left chasing the market to get filled.
THE BOTTOM LINE Knowing the nitty-gritty of forex trading is important when you want to make money in the market which is always! Learn how to enter orders correctly and enhance your profits through understanding which orders will optimize your order. CHAPTER 2 Trend Analysis The Basis for All Technical Analysis n the late s, I used to trade a lot of mechanical technical systems. I I had fundamental regression models of just about every market you could think of.
I worked all day just feeding my computer with data and then putting in orders based on the output. But I had an epiphany. Why was I working so hard? I went through all my systems and real- ized that many of them were so highly correlated that there was no point to them.
I also applied the Pareto Principle, which states that 80 percent of the profits will come from 20 percent of the methods. And, in fact, that was basically the truth. I could cut out 80 percent of my work but still make 80 percent of the profits. In the mids I had the opportunity to interview Peter Brandt.
He was a purist in using classical chart anal- ysis. One of the things he said to me was that there are only about eight to twelve mega markets in the futures world each year. I looked at futures charts going back many years and he was basically right. He then went on to say that his job as a position trader was to capture only those mega moves. His ideal trading year was if he caught only those trades.
He felt the ideal year would only have eight to twelve trades. Every other trade was not worth the risk. So I decided to strip my trading down to the bare essentials. I wanted to really get to the heart of trading. No BS, just rock-bottom truth. The basic truth of trading is that we must be long when the market is bullish, be short when it is bearish, and stand aside when it is neutral.
Simple, yes? Let me say it again. Be long when bullish, be short when bearish, and stand aside the rest of the time. Easy to say, but is it easy to do? WHAT IS A TREND? Turns out that there is a classic definition of a bull or bear market. A bull market is any market that is making higher highs and higher lows.
A bear market is any market that is making lower highs and lower lows. A neutral market is any other condition. Once again, this is very simple. However, it is simple only if we agree on what a high or low is. And that has traditionally been a subjective decision. The highs and lows that we are looking for will be called swing highs and swing lows. That will clear up some confusion with the highs and lows on each daily bar.
In this chart, you and I likely agreed on where the swing highs and lows were. We intuitively agreed. But what if we disagree? What about the high five bars before the end of August?
We skipped over those because we agreed that they were not important or significant. So the real key is to understand which swing highs are significant. We intuitively skipped over the insignificant highs and lows.
But there may come a time when we may disagree on the significance of a given high or low. It would be better to have an objective way to determine the significance.
My friend Tom DeMark is perhaps the most innovative technical ana- lyst in history. He has probably added more and better technical indicators than anyone in history.
One of his innovations is the idea of creating ob- jective standards for what was traditionally considered subjective. For ex- ample, how do you label Elliott Waves? His ob- jective criteria eliminates the subjectivity that is often found in such types of technical analysis as Elliott Wave and classical chart analysis. No longer will you and I disagree about the proper slope of a trendline or the Wave count.
First, let me clarify some terms. The words high and low have two meanings. So the highs and lows on the chart that I circled are swing high and swing lows. Basically, DeMark showed that certain swing highs and swing lows are significant and other swing highs and swing lows are insignificant. The way he did it was ingenious. I think we can agree that the high in the middle of April is more impor- tant than the highs in the middle of October. We can see that very clearly on the chart.
DeMark created a method for determining how significant a swing high or swing low is. The following is my interpretation of what I learned from him. The basic idea is to identify every swing high with an objective rating system. The high in mid-August is the most important high on the chart because it is the highest high on the chart.
The lows made in December and January are the two most important lows because they are the lowest lows on the chart. Major highs and lows show up as major highs and lows because they are the most extreme. Choose a swing high or swing low in Figure 2. Now, look at the bar after this one and all the bars to the left of it. To be defined as a swing high there must be one bar to the right that has a lower high than the day we are looking at and at least one bar to the left of it with a high lower than the high on the day we are looking at.
That simple test defines a swing high reverse everything for a swing low. We have objectively defined every swing high. The circled bar at the high in August is a swing high but the bar to the left is not. So it is not a swing high. The bar to the right of the circled bar is also not a swing high because it has a lower bar to the right but the circled bar has a higher high than the bar that we are looking at. The next step in the analysis is to rank the swing highs and lows.
We do this by simply counting the number of bars to the left of the bar in question. We know that it is a swing high because it has at least one bar on either side of it with a lower high. Trend Analysis 17 However, there are 41 bars to the left of it with a high on the bar that is lower than the high on the circled bar.
I would call that a bar swing high because there are 41 lower highs to the left of it. There might be even more than that but we got to the edge of the chart. That would be a low four days after that major bar high.
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Now all I need to get short is to wait for a break of the first swing low to confirm that we will be making a lower low, again confirming a bear market. They brag to their friends about having met him. There is no pressure to speak, and nobody asks for your last name. Nothing will ever change, even if he gets a new job, a new wife, and a new landlord. There are three types of gurus in the financial markets: market cycle gums, magic method gums, and dead gums. I want to get out right away. It took me a couple of years to get rid of that notion.A sailor whose boat is being battered by ocean winds battens his sails—reduces sail area. WINNERS AND LOSERS 27 money. I found it one of the hardest things to learn. An average person gets up in the morning, goes to work, has a lunch break, returns home, has a beer and dinner, watches TV, and goes to sleep. Most traders who leave institutions get caught up in the emotions of fear, greed, elation, and panic when they start risking their own money. Do you want to learn how to invest in the stock market while managing risk? That friend, incidentally, had a trading forex for a living pdf reverse golden touch—any investment he touched went under water.