RISING MARKETS ARE ALWAYS GOOD?

Traders who choose to follow our contrarian ripple trading method will be
beneficiaries of a fringe benefit that they are freed from the tyranny of the
“markets going up are good—markets going down are bad” syndrome. It is
typical in the financial press and TV business news to hear talk of a good
day on the market when stocks are up and, in solemn tones, a bad day on
the market when the Dow is down. This view of the markets is shared by
most of the investing public and by professionals as well. It comes about
because most investors and traders are firmly on the long side and, having
bought into their stock positions, they now only feel smart if these go up.

Conversely, they can feel dumb if the stock they bought at $50 goes down
to $48. This view of up equals good and down equals bad is irrational. The

only people who should feel good about a market going up are those who
are fully invested and waiting to sell their positions. For anyone who has
cash and wishes to invest it, a falling market should be a welcome sight.
For most people, however, this is an alien mindset.

By the very nature of our trading strategy and philosophy, we tend only
to be fully invested in stocks following a fairly long period of market weakness
and we are absolutely never fully in cash. As a result, a market moving
up makes us feel good about the fact that we can take profits on some of
the stocks we have bought in recent days. However, a market moving down
also makes us feel good about the purchases that the downward movement
opens up under our method. This even holds true when the market takes
a major tumble, such as that of February 27, 2007. On that day, the Dow
dropped 413 points or over 3 percent, but intraday was showing a loss of
543 points owing to trading-volume-related technical glitches that affected
the computers that calculate and feed the Dow index numbers to market
participants. We are content in such a market pull-back to let our riding
of the ripples pull us back into stock positions where buy signals flash as
those stocks that we have previously sold drop back to the last purchase
price. In the case of the February 27, 2007, market drop, we did exactly this,
ripple trading back into eight stock positions on that day that we had previously
sold in the preceding days or weeks, including one, Weatherford
International (WFT) that we bought, sold and bought back that day. The
one stock we bought that day that was not a ripple trade was Texas Instruments
(TXN). (See the appendixes for details.) Meanwhile, it was positive
news for us that the market was finally making a significant move downwards,
allowing us to ripple trade back into these stocks.

One market scenario that can give us the blahs is the listless one where
the market moves sideways for long periods and stocks in general are going
nowhere, neither up nor down. Luckily this happens only quite rarely. Even
in a year such as 2005, when the market did indeed go mostly sideways,
there were fluctuations within that narrow trading range that provided
good ripple trading opportunities. A good fluctuating market is always the
one that best suits our trading method. A market that goes up or down
strongly for a long period—such as the bullish market of the last half of
2006 and the beginning of 2007 that topped out February 20—is also not a
favorite of ours, as the opportunities to trade the ripples are much reduced
as a result. However, no market is ever completely without short-term fluctuations,
and you will find us buying to some extent in every market phase.
Read More : RISING MARKETS ARE ALWAYS GOOD?

Major Participants Of Trading Market

Participants in the foreign exchange market are many and varied and the individual involvement
of each participant can vary dramatically. Surveys over recent years tend to indicate
that participants can broadly be divided into three main groups: banks, brokers and clients.

Commercial banks are by far the most active, while brokers act as intermediaries. Clients can
be classed as anything from multinational corporations to individual investors to speculators.

Who then are the active participants in this global market?

GOVERNMENTS
Governments sometimes have requirements for foreign currency. This may be for paying staff
salaries and local bills of an embassy abroad, or for a foreign currency credit line, most often
in dollars, to a third world national government for industrial or agricultural development. In
its turn, the third world nation’s government will periodically have to pay interest due on any
foreign loans, with the capital sum eventually having to be repaid. It is more than likely that
the government would approach the market via its own central bank or a commercial bank.

Foreign exchange rates are of particular concern to governments because changes in foreign
exchange rates affect the value of products and financial instruments. As a result, unexpected
or large changes can affect the health of a nation’s markets and financial systems. Exchange
rate changes also impact a nation’s international investment flow, as well as export and import
prices. These factors, in turn, can influence inflation and economic growth.

For example, suppose the price of the Japanese yen moves from 120 yen per dollar to 110
yen per dollar over the course of a few weeks. In market jargon, the yen is ‘strengthening’, or
becoming more expensive against the dollar. If the new exchange rate persists, it will lead to
several related effects:
1. Japanese exports to America will become more expensive. Over time, this might cause
export volumes to America to decline, which, in turn, might lead to job losses in Japan.
2. The higher American import prices might be an inflationary influence in America.
3. American exports to Japan will become less expensive, which might lead to an increase in
American exports and a boost to American employment.

BANKS

Central banks
Central banks are the traditional moderators of excess. The Bank of England, the European
Central Bank, the Swiss National Bank, the Bank of Japan and, to a lesser extent, the Federal
Reserve Bank will enter the market to correct what are felt to be unnecessarily largemovements,
often in conjunction with one another. By their actions, however, they can sometimes create
the excesses they are specifically trying to prevent.


Intervention, in general, does not shift the balance of supply and demand immediately.
Instead, intervention affects the present and future behaviour of investors. In this regard,
intervention is used as a device to signal a desired exchange rate movement.

The second group of banks can best be described as aggressive managers of their reserves.
Some of the Middle Eastern and Far Eastern central banks fall into this category. They are
major speculative risk takers and their activities often disturb market equilibrium. Along side
this activity, the central banks have clients in their own right and they will have commercial
transactions to undertake. In certain countries, central banks are involved in local fixing sessions
between commercial banks, often acting as an adjudicator to the correct fixing of the daily
rates, or to ensure that the supply and demand for foreign currency is balanced at a rate that is
in line with its current monetary policy.

Trading banks
Banks (trading banks) deal with each other in the ‘interbank market’, where they are obliged
to make a ‘two-way price’, i.e. to quote a bid and an offer (a buy and a sell price). This
category is perhaps the largest and includes international, commercial and trade banks. The
bulk of today’s trading activity is concentrated between 100 and 200 banks world wide, out of
a possible 2000 dealer participants. These banks also deal with their clients, some of the more
important of which also qualify for two-way prices. In the vast majority of cases, however,
most corporations will only be quoted according to their particular requirement. These banks
rely on the knowledge of the market and their expertise in assessing trends in order to take
advantage of them for speculative gain.

Commercial banks
Commercial banks (clearing banks in the UK) operate as international banks in the foreign
exchange market, as do many retail banks in other major dealing centres. Many banks in
the UK have specialized regional branches to cater for all their clients’ foreign business,
including foreign exchange. All this retail business will eventually be channelled through
to the bank’s City of London foreign exchange dealing room for consolidation with other
foreign currency positions either for market cover or continued monitoring by the specialist
dealing-room personnel.

The situation in America is slightly different, where legislation prohibits banks in certain
states from maintaining branch networks, but all banks have their affiliates or preferred agents
in the main dealing centres of New York, Chicago and Los Angles.

Other commercial banks have large amounts of foreign exchange business to transact on
behalf of their clients, and although they will have their own dealing rooms, for one reason or
another they have not developed their operations to become involved in the interbank foreign
exchange markets.

Regional or correspondent banks
Regional or correspondent banks do not make a market or carry positions and, in fact, turn to
the larger money centre banks to offset their risk. Such relationships have been built up over
many years of reciprocal service, and in many instances are mutual, whereby the correspondent
bank abroad acts as the clearing agent in its own currency for the other bank involved.


Investment and merchant banks
The strength of investment and merchant banks lies in their corporate finance and capital
markets activities, which have been developed over many years’ servicing the financial needs
of large corporations, rather than retail clients. With the multi-currency sophistication of the
capital markets and the wide international spread of corporations and other market participants,
they are frequently required to transact foreign exchange business, which they effect either by
dealing direct or through the brokers’ market.

BROKERING HOUSES
Brokering houses exist primarily to bring buyer and seller together at a mutually agreed price.
The broker is not allowed to take a position in a currency and must act purely as a liaison.
For this service, they receive a commission from both sides of the transaction, which will vary
according to currency handled and from centre to centre.
However, the use of live brokers has decreased in recent years, due mostly to the rise of the
various interbank electronic brokerage systems.

INTERNATIONAL MONETARY MARKET
The International Monetary Market (IMM) in Chicago trades currencies for contract amounts,
which are relatively small in size and for only four specific maturities a year. Originally designed
for the small investor, the IMM has grown apace since the early 1970s, and the major banks,
whose original attitude was somewhat jaundiced, now find that it pays to keep in touch with
developments on the IMM, which is often a market leader.


MONEY MANAGERS
Money managers tend to be large New York commission houses and are frequently very
aggressive players in the foreign exchange market. They act on behalf of their clients, but often
deal on their own account. They are not limited to one time zone, but deal around the world
through their agents as each centre becomes operational.

CORPORATIONS
Corporations are, in the final analysis, the real end users of the foreign exchange market.With
the exception only of the central banks that alter liquidity by means of their intervention, it
is the corporate players by and large who affect supply and demand. When the other major
players enter the market to buy and sell currencies, they do so not because they have a need,
but in the hope of a quick and profitable return. The corporates, however, by coming to the
market to offset currency exposure, permanently change the liquidity of the currencies being
dealt with.

RETAIL CLIENTS
Alongside these corporates, there is a non-too-significant volume from retail clients. This
category includes many smaller companies, hedge funds, companies specializing in investment
services linked to foreign currency funds or equities, fixed income brokers, the financing of
aid programmes by registered worldwide charities and private individuals. With the rise in
popularity of online equity investing, and a corresponding rise in online fixed income investing,
it was only a matter of time before the average retail investor began to see opportunities in
the foreign exchange market. Retail investors have been able to trade foreign exchange using

highly leveraged margin accounts. The amount of trading, both in total volume and in individual
trade amounts, remains low and is certainly dwarfed by the corporate and interbank markets.

OTHERS
Other financial institutions involved in the foreign exchange market include:

• Stockbrokers
• Commodity firms
• Insurance companies
• Charities and private institutions
• Private individuals.

SPECULATORS
All the above tend to have some sort of underlying exposure that has to be covered. Speculators,
however, have no underlying exposure to hedge, rather they attempt to fulfil the adage ‘buy
low, sell high’ by trading for trading profit alone. Foreign exchange is an ideal speculative tool,
offering volatility, liquidity and easy margin or leverage. This activity is vital to the stability of
the markets. Without speculation, hedgers would find the market too illiquid to accommodate
their needs.

While speculators seek excess profits as a reward for their activities, the process of speculat-
ing itself drives the markets towards lower volatility and price stability. No modern commodity,

equity or debt market could operate without the speculators. It is estimated that up to 90% of
the daily volume of trading activity in the foreign exchange markets is a result of speculator
activity, with the balance primarily made up of commercial hedging transactions.
Source: A Foreign Exchange Primer

A Brief History of the Market

Foreign exchange is the medium through which international debt is both valued and settled.
It is also a means of evaluating one country’s worth in terms of another’s and, depending on
circumstances, can therefore exist as a store of value.

Between 9000 and 6000 BC cattle (cows, sheep, camels) were used as the first and
oldest form of money.

THE BARTER SYSTEM
Throughout history, people have traded for various reasons: sometimes to obtain desired raw
materials by barter; sometimes to sell finished products for money; and sometimes to buy and
sell commodities or other goods for no other reason than to try to profit from the transaction
involved. For example, a farmer might need grain to make bread while another farmer might
have a need for meat. They would, therefore, have the opportunity to agree terms, whereby
one farmer could exchange his grain for the cow on offer from the other farmer. The barter
system, in fact, provided a means for people to obtain the goods they needed as long as they
had goods or services that were required by other people.

This system worked quite well and, even today, barter, as a system of exchange, remains
in use throughout the world and sometimes in quite a sophisticated way. For example, during
the cold war when the Russian rouble was not an exchangeable currency, the only way that
Russia could obtain a much-needed commodity, such as wheat, was to arrange to obtain it
from another country in exchange for a different commodity. Due to bad harvests in Russia,
wheat was in short supply, while America had a surplus. America also had a shortage of
oil, which was in excess in Russia. Thus Russia delivered oil to America in exchange for
wheat.


Although the barter system worked quiet well, it was not perfect. For instance it lacked:

• Convertibility – What is the value of a cow? In other words, what could a cow convert into?
• Portability – How easy is it to carry a cow around?
• Divisibility – If a cow is deemed to be worth three pigs, how much of a cow would one pig be worth?

It was the introduction of paper money – which had the three characteristics lacking in the
barter system – that allowed the development of international commerce as we know it today.

THE INTRODUCTION OF COINAGE
Approximately 4000 years ago, pre-historic bartering of goods or similar objects of value
as payment eventually gave way to the use of coins struck in precious metals. An important

concept of early money was that it was fully backed by a reserve of gold and was convertible
to gold (or silver) at the holder’s request.

Even in those days, therewas international trade and payments were settled in such coinage as
was acceptable to both parties. Early Greek coins were almost universally accepted in the then
knownworld; in fact, many Athenian designs were frequently mimicked, proving the coinage’s
popularity in design as well as acceptability.
Cowries (shells) were viewed as money in 1200 BC.

The first metal money and coins appeared in China in 1000 BC. The coins were made
of base metals, often containing holes so that they could be put together like a chain.
The first paper bank notes appeared in China in 800 AD and, as a result, currency
exchange started between some countries.

THE EXPANDING BRITISH EMPIRE
Skipping through time, some banking and financial markets nearer to those we know today
began in the coffee houses of European financial centres. In the seventeenth century these
coffee houses became the meeting places of merchants wishing to trade their finished products
and of the entrepreneurs of the day. Soon after the Battle of Waterloo, during the nineteenth
century, foreign trade from the expanding British Empire – and the finance required to fuel the
industrial revolution – increased the size and frequency of international monetary transfers.

For various reasons, a substitute for the large-scale transfer of coins or bullion had to be found
(the ‘Dick Turpin’ era) and the bill of exchange for commercial purposes and its personal
account equivalent, the cheque, were both born. At this time, London was building itself a
reputation as the world’s capital for trade and finance, and the City became a natural centre for
the negotiation of all such instruments, including foreign-drawn bills of exchange.

THE GOLD STANDARD
Gold was officially made the standard value in England in the nineteenth century.
The value of paper money was tied directly to gold reserves in America.
Foreign exchange, as we know it today, has its roots in the Gold Standard, which was introduced
in 1880. The main features were a system of fixed exchange rates in relation to gold
and the absence of any exchange controls. Under the Gold Standard, a country with a balance
of payments deficit had to surrender gold, thus reducing the volume of currency in the
country, leading to deflation. The opposite occurred to a country with a balance of payments
surplus.

Thus the Gold Standard ensured the soundness of each country’s paper money and, ultimately,
controlled inflation as well. For example, when holders of paper money in America
found the value of their dollar holdings falling in terms of gold, they could exchange dollars
for gold. This had the effect of reducing the amount of dollars in circulation. Inevitably, as the
supply of dollars fell, its value stabilized and then rose. Thus, the exchange of dollars for gold

reserves was reversed. As long as the discipline of linking each currency’s value to the value
of gold was maintained, the simple laws of supply and demand would dictate both currency
valuation and the economics of the country.

The Gold Standard of exchange sounded ideal:

• inflation was low;
• currency values were linked to a universally recognized store of value;
• interest rates were low, meaning that inflation was virtually non-existent.

The Gold Standard survived until the outbreak ofWorldWar I, after which foreign exchange,
as we know it today, really began. Currencies were convertible into either gold or silver, but
the main currencies for trading purposes were the British pound and, to a lesser extent, the
American dollar. The amounts were relatively small by today’s transactions, and the trading
centres tended to exist in isolation.
The early twentieth century saw the end of the Gold Standard.

THE BRETTON WOODS SYSTEM
Convertibility ended with the Great Depression, and the major powers left the Gold Standard
and fostered protectionism. As the political climate deteriorated and the world headed for
war, the foreign exchange markets all but ceased to exist. With the end of World War II,
reconstruction for Europe and the Far East had as its base the Bretton Woods system.

In 1944 the BrettonWoods agreement devised a system of convertible currencies,
fixed rates and free trade.
In 1944, the post-war system of international monetary exchange was established at Bretton
Woods in New Hampshire, USA. The intent was to create a gold-based value of the American
dollar and the British pound and link other major currencies to the dollar. This system allowed
for small fluctuations in a 1% band.

THE INTERNATIONAL MONETARY FUND
AND THE WORLD BANK
The conference, in fact, rejected a suggestion by Keynes for a new world reserve currency
in favour of a system built on the dollar. To help to accomplish its objectives, the Bretton
Woods conference instigated the creation of the International Monetary Fund (IMF) and the
World Bank. The function of the IMF was to lend foreign currency to members who required
assistance, funded by each member according to size and resources. Gold was pegged at $35
an ounce. Other currencies were pegged to the dollar and under this system, inflation would
be precluded among the member nations.

In the years following the Bretton Woods agreement, recovery was soon evident, trade
expanded and foreign exchange dealings, while primitive by today’s standards, returned. While
the amount of gold held in the American central reserves remained constant, the supply of

dollar currency grew. In fact, the increased supply of dollars in Europe funded the post-war
reconstruction of Europe in the 1950s. It seemed that the Bretton Woods accord had achieved
its purpose. However, events in the 1960s once again bought turmoil to the currency markets
and threatened to unravel the agreement.

THE DOLLAR RULES OK
By 1960, the dollar was supreme and the American economy was thought to be immune to
adverse international developments, and the growing balance of payments deficits in America
did not appear to alarm the authorities. The first cracks started to appear in November 1967.

The British pound was devalued as a result of high inflation, low productivity and a worsening
balance of payments. Not even massive selling by the Bank of England could avert
the inevitable. President Johnson was trying to finance ‘the great society’ and fight the
Vietnam War at the same time. This caused a drain on the gold reserves and led to capital
controls.

In 1967, succumbing to the pressure of the diverging economic policies of the members of
the IMF, Britain devalued the pound from $2.80 to $2.40. This not only increased demand for
the dollar but it also increased the pressure on the dollar price of gold, which remained at $35
an ounce. Under this system free market forces were unable to find an equilibrium value.


Source: A Foreign Exchange Primer

Are Markets Efficient?

Not surprisingly, the efficient market hypothesis is not enthusiastically hailed by professional portfolio managers. It implies that a great deal of the activity of portfolio managers—the search for undervalued securities—is at best wasted effort and possibly harmful to clients because it costs money and leads to imperfectly diversified portfolios. Consequently, the EMH has never been widely accepted on Wall Street, and debate continues today on the degree to which security analysis can improve investment performance. Before discussing empirical tests of the hypothesis, we want to note three factors that together imply the debate probably never will be settled: the magnitude issue, the selection bias issue, and the lucky event issue.

The magnitude issue 
We noted that an investment manager overseeing a $5 billion portfolio who can improve performance by only one-tenth of 1% per year will increase investment earnings by .001 $5 billion $5 million annually. This manager clearly would be worth her salary! Yet we, as observers, probably cannot statistically measure her contribution. A one tenth of 1% contribution would be swamped by the yearly volatility of the market. Remember, the annual standard deviation of the well-diversified S&P 500 index has been approximately 20% per year. Against these fluctuations, a small increase in performance would be hard to detect.

Nevertheless, $5 million remains an extremely valuable improvement in performance. All might agree that stock prices are very close to fair values, and that only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort. According to this view, the actions of intelligent investment managers are the driving force behind the constant evolution of market prices to fair levels. Rather than ask the qualitative question, Are markets efficient? we ought instead to ask the quantitative question,

How efficient are markets?
The selection bias issue Suppose you discover an investment scheme that could really make money. You have two choices: Either publish your technique in The Wall Street Journal to win fleeting fame or keep your technique secret and use it to earn millions of dollars.

Most investors would choose the latter option, which presents us with a conundrum. Only investors who find that an investment scheme cannot generate abnormal returns will be willing to report their findings to the whole world. Hence, opponents of the efficient market’s view of the world always can use evidence that various techniques do not provide investment rewards as proof that the techniques that do work simply are not being reported to the public.

This is a problem in selection bias; the outcomes we are able to observe have been preselected in favor of failed attempts. Therefore, we cannot fairly evaluate the true ability of portfolio managers to generate winning stock market strategies.

The lucky event issue 
In virtually any month, it seems we read an article in The Wall Street Journal about some investor or investment company with a fantastic investment performance over the recent past. Surely the superior records of such investors disprove the efficient market hypothesis.

This conclusion is far from obvious, however. As an analogy to the “contest” among portfolio managers, consider a contest to flip the most heads out of 50 trials using a fair coin. The expected outcome for any person is 50% heads and 50% tails. If 10,000 people, however, compete in this contest, it would not be surprising if at least one or two contestants flipped more than 75% heads. In fact, elementary statistics tells us that the expected number of contestants flipping 75% or more heads would be two. It would be silly, though, to crown these people the head-flipping champions of the world. They are simply the contestants who happened to get lucky on the day of the event (see the nearby box).

The analogy to efficient markets is clear. Under the hypothesis that any stock is fairly priced given all available information, any bet on a stock is simply a coin toss. There is equal likelihood of winning or losing the bet. Yet, if many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of bets. For every big winner, there may be many big losers, but we never hear of these managers.

The winners, though, turn up in The Wall Street Journal as the latest stock market gurus;
then they can make a fortune publishing market newsletters. Our point is that after the fact there will have been at least one successful investment scheme. Adoubter will call the results luck; the successful investor will call it skill. The proper test would be to see whether the successful investors can repeat their performance in another period, yet this approach is rarely taken.
With these caveats in mind, we now turn to some of the empirical tests of the efficient market hypothesis.
Read More: Are Markets Efficient?

BALANCE AND MARKET EQUILIBRIUM

In a perfectly balanced market, supply and demand of a particular commodity would be in equilibrium. Commercial producers’ output of a particular commodity would be just enough to meet commercial consumers’ demand. Prices would be stable. In the real world, however, the market gets out of balance due to disruptions in supply or demand, and prices become unstable, rising or falling depending on market conditions.

As this price action begins to unfold, speculators come into the market, buying or selling depending on the perceived imbalance, which may cause prices to rise or fall further. Eventually, this activity will help bring the market back into balance, because prices will either rise high enough to generate additional production (thus easing supply shortages), or they will fall far enough to generate additional demand or curtail production.

This ebb and flow in the fundamentals can be seen with careful study of the COT data as it relates the activity over time. Because it reveals what large commercial players—the key producers and consumers in the underlying physical commodity—are doing, it is essential to understanding the dynamics of a particular market.
Read More :BALANCE AND MARKET EQUILIBRIUM

Market-Generated In Information

The premise of this book is that market-generated information, when combined with fundamental information, can provide that elusive advantage. Market-generated information is information gained from observing the actual flow of orders within the market’s present-tense context. Making sense of this source of information begins by recognizing that markets are constantly moving from low to high and high to low.

This two-way auction process enables all market participants to express their opinions—no matter how those opinions were obtained—with real money; the auctions effectively establish a fair price where business can be conducted at any given time. This expression of the market’s collective will results in a constant flow of objective market-generated information.

In order to manage this information, as we mentioned in the preface to this book, we employ the Chicago Board of Exchange’s trader support tool called Market Profile. Market Profile is not a trading system, nor is it predictive. Market Profile simply allows you to observe the structure of the market as it unfolds, enabling a more accurate interpretation of which timeframe is in control of market movement. This concept of timeframe control will be a recurring theme throughout Markets in Profile.

The market, as we have said, is the manifestation of all possible influences, all news sources, all global and political events, and all market participants. As the market’s continuous auctions unfold, a market profile enables us to experience a composite of all available information (and opinions), because it is solely based on real order flow. Market-generated information, when properly organized and understood, can greatly demystify the endless complexity of the market. Such data can uncover vital information about what is driving change by providing clues that help unravel the strength or weakness of market momentum.

To establish the significance of an objective means of interpreting market activity, let’s revisit the potential pitfalls inherent in relying solely on fundamental information. Suppose that an analyst performs methodical, well-informed research on a company and comes to the conclusion that the company is well positioned for strong growth in the next quarter. But what this fundamental information may not reveal is whether the price of that company’s stock has already moved to reflect that fact. Or perhaps the industry within which the company operates is on the verge of collapse, and nobody is interested in the sector as a whole.

The positive report may be meaningless unless viewed in the proper context. Think of the numerous factors that must all line up to make fundamental information relevant. Even the slightest miscalculation can result over time in serious investment consequences. Of course, investors and money managers must be aware of fundamental indicators, but wouldn’t it make sense to employ an objective means of ensuring those indicators are actually resulting in the expected market activity?

Let’s say you bought shares of a good company that had an underpriced stock—you bought value—but the price has remained basically flat for an extended period of time. This is not uncommon, and is why many investors wait to invest until price momentum validates their buy decision.

By using the Market Profile tool, one can often discover confirming information (positive or negative) in the market structure before it is reflected in significant price movement. Securing good trade location—or being able to exit a bad trade earlier—is the advantage we were discussing earlier.

Before we provide a mechanical description of market profile construction, let’s first define “trading,” which in the context of this discussion is no different than “investing.” Trading is the anticipation, timing, and placement of orders to capitalize on change—no matter how short- or longterm the underlying investments.
Read More : Market-Generated In Information

ATTITUDE TOWARD THE MARKET AND RISK CONTROL

Before I mention a few details of stop orders and short selling, I’ll first discuss risk. You may wonder why an introductory book on technical analysis first talks about your trading philosophy and strategy as it relates to losing money. You probably got this book to find out how to make money. The reason why I go over the topic of risk and always having an exit strategy is that not controlling losses is a killer of consistent profits in the market, regardless of how skillful you become in your use of technical analysis. My goal in using technical analysis is not only to be right in the market, but also to profit from being right. And then to keep the lion’s share or as much as possible of any prior realized, or current unrealized, gains and not give them back due to market fluctuations.

If your attitude is that the market is a gamble and you are just rolling the dice, you begin at a major disadvantage to the multitude of market professionals who are in the market every day. It is true that the market is more speculative than, say, the fixed income market and certainly more so than money market instruments like U.S. Treasury bills. Market professionals do a better job of getting out of losing trades and investments or they won’t last long in the profession—they, by necessity, have to minimize the chance that their most precious commodity will be wiped out, which is their trading or investing capital. There is an old market saying that the small loss is the easy one. Here are seven trading rules related to how you manage your trading strategy, capital, and risk.

1. Right entry—Buy early in a trend when a stock or index has initial technical signals suggesting a trend is beginning, and don’t wait. Or buy or sell short after a setback (reaction) to the trend that is underway, for example, when a stock comes back to natural technical support or resistance points. Waiting and patience are the greatest virtues in the market.
2. Determine an objective when you are thinking of buying or shorting a stock. This is important because (and it may seem strange) it’s necessary to change your focus from how much you can make to how much you are willing to lose. Set profit objectives—how much we’re willing to risk or lose is defined in relation to how much we think the item could move in our favor, based on technical analysis criteria, of course!
3. Do the math—If you set a stop (your risk point) equal to one-half or one-third of what you hope to make, here is the calculation: On a 2:1 reward to risk—we calculate entry only when we could make $2 for every $1 risked—you could be stopped out or exited on one half of your trades and still make a substantial gain, minus commissions, as long as the other transactions achieve your profit objectives on average. In 10 transactions on a 2:1 risk/reward basis and where a loss is taken 5 times and a gain 5 times, but the average profit is double the average loss, the net result is that total profits are double total losses. However, then also assume that 1 or 2 losses get away from us. We decide to watch and see what happens—it’s not apparent why the stock, for example, is not performing. We hope the setback is temporary—but the stock ends up losing more than several earlier  winning transactions. This then upsets the profit equation and we quickly are at break even or down substantially from where we started.
4. Physically place the stop—Many investors don’t actually enter stops, preferring to take a wait and see attitude. After all, they are in this for the long haul. But think of all the surprises that occur in companies and their competitive positions in the marketplace. Traders are afraid of stops being hit or activated, only to see the stock go back up. The underlying problem with both of these attitudes is related to stock trading tip number 1: Select an entry at an optimal point, where there is an effective place (either under support or above resistance) to place a liquidating stop order that is both not likely to get hit and is relatively small in relation to your entry price. With mutual funds, it’s suggested you set mental stops, however wide, and adhere to them by liquidation when the loss point is exceeded.
5. Use trailing stops—Sell stops protect a long position or initial purchase and buy stop orders protect a short position. Canceling and re-establishing stop orders as needed so that they trail along with the ongoing price trend requires some work and diligence as you need to periodically raise or lower your stop orders. This insures that your stops can reflect what is a moving target—the point at which a trend reversal has begun. As things move in your favor, this process first gets your liquidating stop order to a break-even point, where you would have no loss if you exit. Assuming a further favorable trend, you can next begin to lock in some of that profit you had projected. For example, when you are in a stock that reaches your price target, the question arises whether to sell at your preset objective—a question without a set answer. If a price objective is based on the fulfillment of an objective implied by a chart pattern, then completion of the objective may remove the reason you had to take the trade. In other instances, I view initial projections as minimum hoped-for objectives within a trend. I also like to stay with, and in, a favorable trend. Once the price has passed a hoped-for objective, simply be vigilant to the trend reversing and protect as much profit, by use of a stop, as is warranted by technical considerations, as we are going to study in the chapters ahead.
6. Be willing to get out or get back in—As soon as the reasons for being in a position or in a trade are no longer present, it is best to exit. You may have bought a stock because it was in a strong uptrend. You purchased it right, the stock went up, and now you have a probable break-even situation due to moving a stop up to your entry point. However, the stock then goes into a sideways trend and basically moves laterally for many weeks. If you got into the stock because of its having a strong uptrend or the expectation of one, now may be the time to exit. The reasons you bought the stock are no longer present, particularly if the overall market continues to trend higher. Let’s examine further the case of a stock that goes against you. The object is to never let a loss get out of control, not to forget about or get negative on the stock(s) in which you were and may still be, interested in. If you get stopped out of such a stock and the countertrend runs its course, with the stock then resuming its prior trend, a repurchase may be warranted. But again, use favorable risk-to-reward criteria: If you risk to a point where liquidation would result in losing 10 percent of the money invested, but upside potential is calculated for at least 20 percent or more, and enough of these transactions average out this way over time, the result is a substantial overall profit.
7. Stick to your game plan or strategy and to sound money management rules—If you are successful in business or whatever profession you are in, you have probably had a particular plan or methodology you adhered to. You didn’t change the plan when it didn’t produce results right away or even for a prolonged period, assuming you were following time-tested practices. Setbacks are part of this and of stock market investing. Time and patience are required. You can’t force a business, or the market, to do what you want it to. You have to be sufficiently capitalized also. In investing or trading, just like in business, you need to have sufficient reserves to stay in business. In the same way, don’t commit all of your investment or trading money to the market. I suggest keeping one third to one-half in reserve, the larger figure when you’re in more speculative markets or stocks. If your losses are more than you  anticipate as you gain experience, that experience you gain will be of no use to you if you are out of the market due to lack of money to invest. As well, some people will get very aggressive and not only be 100 percent invested but buy on margin or borrowed money. I have seen many people lose considerable amounts in the end, even after having substantial profits at one time, because they were on margin and didn’t having staying power because of it—this is the well-known forced margin selling situation. The market might come back in your favor, but you can no longer profit from it. I also suggest reducing the size of your position if the market turns difficult and gets into turmoil. It would be best to not be in only one or two sectors of the market. I love tech stocks myself, but also find a lot to like in health care and drug stocks, for example, as they reflect another dominant and earnings-favorable investment theme, that of an aging population. If you like a stock, you don’t have to buy all that you would hope to buy initially. See how it behaves. If it looks good, buy some more after the first setback, and see how it behaves after that. If the item resists going down further, an eventual rally may develop.

There was the story told by Jesse Livermore of a great stock tip he gave to a veteran stock investor. Instead of doing what Livermore expected, this man promptly sold some of the stock and Livermore protested that this was hardly what he expected from this gift of information. The potential investor calmly watched the stock tape for a time. Finally, he began buying a substantial amount of the stock, saying to the young Jesse Livermore that he had first wanted to see how the stock behaved when he sold some. If it was being accumulated by a well-funded group of investors, any selling would be absorbed easily, and it was. His test was how the stock did when there was some selling against it. This is a good lesson, and also reflects going against the obvious and expected behavior.

Jack Schwager, in the Wizard Lessons summary chapter from his book, Stock Market Wizards, found many common traits in his group of supersuccessful money mangers and speculators. I’ll mention some of these lessons that reinforce what my own experience has shown. A universal trait, regardless of the method used to select stocks, was that individuals in this group had effective trading strategies and stuck to a game plan that accounted for all possibilities. They would assume that everything that could go wrong would go wrong—it’s all downhill after that. Great traders and money managers are marked by their flexibility. They were willing to see their pet ideas and theories proven wrong and change accordingly. This includes never falling in love with a stock. Save that for your spouse. It also takes time to become successful. Don’t give up.

Something I’ve discussed and Jack puts very well about his supersuccessful market professionals, is the role of hard work. Ironically, many people are drawn to the markets because it seems like an easy way to make a lot of money. Wrong! This group is, as was my own market wizard mentor, Mark Weinstein, extremely hard working—he, like most other big market winners, has a major passion for the market. Have a little passion and carve out a few hours a week from your busy lives, if you want a moderate success potential!

Last, all the very successful market participants that I’ve known are constantly, and I do mean constantly, concerned with avoiding loss and with how they manage their trading capital. The professionals believe that one of the most common mistakes made by novices is to expend great energy on finding the big potential winning stocks and a good entry price.

They spend comparatively little time on preventing and controlling losses as time goes on. This point also goes back to the work ethic that is required, to frequently assess and reassess your strategy and assumptions you may have made that could be wrong. Think about when to get out and keep thinking about it until you are out.

I have congratulated myself many times on getting in at the right time on a stock, for example, only to go to sleep, so to speak, and miss seeing the point at which upward or downward momentum slowed and then stopped. By the time the reversal was well underway, I was still hanging on because of having suspended my ongoing evaluation. I then missed the profit potential that was to be had. I expended good effort to research and find the trade but then wanted the work part to be over. This is a common fallacy and situation. I can only suggest that you remember when this happens to you so that you can correct it once experience has shown you this lesson.

All the above lessons and points have the common ground of being led astray by the great dual enemies of fear and greed. Greed is what drives many of the initial mistakes. We don’t expect to get rich quickly in most businesses and professions. Yet somehow when we see a stock make a huge move, we start to imagine finding just that kind of stock next. This tends to lead to haste in selection, or bad timing because we don’t wait for those special situations, as well as overcommitment of capital to the big hopedfor winner. Fear comes mostly from letting losses get out of control and overtrading. There used to be a saying among traders to “sell down to a sleeping level.” If you are so worried about your losses, actual or imagined, then reduce the size of your holding. I have sold stocks that I was sitting with at a loss, thinking I had no choice but to hope for the stock price to rebound. But by taking the loss and then being careful to select and closely monitor some other stock or stocks that looked promising, I started increasing the value of my portfolio again. And perhaps as important, I found a renewed interest in the market. And renewed commitment to not make the same mistake or mistakes I made before.
Read More : ATTITUDE TOWARD THE MARKET AND RISK CONTROL

Bull Markets

A bull market, named for the animal that charges ahead, comes after a lengthy and substantial decline in stock values that comes about due to a downturn in the economy or a recession. Major market advances are usually, but not always, divided into three phases. These phases are marked by who participates in them and what they are doing in each phase.

1. Accumulation Phase. In the first phase of a bull market, there is accumulation of stocks or buying over a period of time, during which very knowledgeable investors with good foresight about a coming business upturn, begin buying stocks offered by pessimistic sellers who want out. This group of knowledgeable buyers will also start to pay higher prices as the willing sellers exit. The economy and business conditions are still often quite negative. The public, and this is mirrored by the financial press, is quite disinterested in the market, to the point of where owning stocks is very unattractive to them and they are out of the market. The people who lost money in the last bear market are actively disgusted with the market. Market activity is modest at best but is picking up a bit on rallies, but this is mostly only noticed, if at all, by professional market participants.
2. A Steady Climb. The second phase is one of a fairly steady advance, but one that is not dramatic. There is a pickup in business and encouraging economic reports as an improving economy leads to a pickup in corporate earnings. This phase is also a period where money can be made relatively safely, as technical indicators turn positive and there is an absence of volatile trading swings.
3. Main Street Adopts Wall Street. The third phase, which at one and the same time can be both highly profitable and ultimately risky, is marked by heavy public interest and participation in the market. The economic news is good during this period, and suddenly, front pages of magazines have articles heralding the new bull market. The new stock issue market gets going as the public now has an appetite for new companies. This is the phase where you will hear banter at parties about the stock market, how well so-and-so is doing in stocks and where, today, market-related Internet chat rooms are quite active. Price advances can be huge and volume is equally large. The more speculative stocks continue to advance but it is here that the blue chip stocks of the most established big-name companies start to lag the overall market. Some sharp downswings occur among stocks that fall out of favor. Speculation is intense as seen in increased option activity, the first-day closes of hot new issues and in the level of buying stocks on margin. The end of this phase is always the same, varying degrees of collapse. This can come after a year or two or even after several years have passed from the beginning phase.

Read More : Bull Markets

Mr. Market's Bipolar Disorder

The patient exhibits classic manic depression—or bipolar disorder— combining episodes of euphoria with irritation. He goes on wild spending sprees for months on end, using money he does not have to buy things he does not need. In the buoyant periods he is talkative and full of ideas, but only in distracted, zigzaggy ways. He can charm you into buying the Brooklyn Bridge. Then, suddenly and swiftly, he shifts moods, falling into a months-long spell of darkdepression, often provoked by the tiniest annoyances, such as minor bad news and modestly disappointing results.

Experts observe that the condition might be inherited, caused by innate chemistry affecting mood, appetite, and the perception of pain, which in turn could lead to dramatic weight gains followed by abrupt weight losses. There are safety nets to fall backon, such as government support, and government-approved treatments, such as mood stabilizers. But the patient lives in denial and can become angry and suspicious, sometimes not taking the medicine and precipitating more intense bouts of ups and downs.

The patient I am describing, of course, is the stockmark et. It mixes episodes of irrational fear with episodes of irrational greed. It rises with massive infusions of funds—often borrowed—then falls after the withdrawal of those funds. It bounces around like a circus clown on a pogo stick, weaving wild tales of untold riches to be made without effort. Then it pouts, plummets, and corrects, often on news that this or that company failed to meet earnings estimates by mere pennies per share.

Clear thinkers about market behavior rightly believe that this condition is incurable, with the market being prone to fat gains followed by fat losses without a nexus to business or economic reality. Nevertheless, government engines such as the Securities and Exchange Commission and private ones such as the New YorkStock Exchange monitor the extremes, imposing “circuit breakers” that shut the market down when it threatens to slip into a bout of depression (a sell-off) or raising the requirements for margin accounts, particularly those of day traders.

Yet no cure is in sight. Mr. Market, in Ben Graham’s terms, denies its manic depression. It does this in numerous studies extolling how “rational” it is. It does it in countless conversations and publications referring to its “efficiency.” Reams of “beta books” are compiled in the belief that its gyrations simply and accurately reflect precisely the measurable riskthat stocks pose for investors. Abstract advice to diversify portfolios is sold as the only way to minimize the rational riskthat this efficient system manageably presents. Denial prevents cure.

Take Ben Graham’s Mr. Market a diagnostic step deeper. Malicious microorganisms called rickettsia (named for Dr. Howard T. Ricketts, 1871–1910) cause diseases such as typhus. From the Greek word for “stupor,” signifying a state of insensibility and mental confusion, typhus is characterized by bouts of depression and delirium. It is transmitted by bloodsucking parasites called ticks. These parasites transmit a similar disease called Q fever.

To avoid Q fever, those venturing into tick-infested forests prepare themselves. Hats, gloves, long sleeves, and pants are the dress code. If bitten, prudent forest denizens remove the parasite with tweezers, wash the bite, and apply rubbing alcohol, ice, and calamine lotion. They survive to enjoy the woods.

Fools in the tick-ridden forest go bare, leaving exposed their skin and, most daringly, their heads. After they find a tick, fear drives them to irrational action, such as burning the tickinstead of tweezing it out. The kings and queens of fooldom then venture gleefully on their forest expedition, giddily unaware that they are infected with Q fever—until depression and delirium set in.

In the stock market forest, the ticks of price quotes infect the unprepared fools in the same way and with similar results. Trader obsession with price quotations spreads the Q fever epidemic, adding gas to the fire of Mr. Market’s manic depression.

When venturing into the stockmark et, defend yourself just as you would when hiking in the forest: armed to fight the wealthsucking parasite of the Q fever price tick. Ben Graham and Warren Buffett prescribe the same course for dealing with Mr. Market. They advise that just as it is foolish not to recognize his symptoms or diagnose his disease, it is equally foolish to play into them or ex pose oneself to the contagion. Instead, use Mr. Market to your advantage.

Neither Graham’s Mr. Market nor this Q fever metaphor implies anything about the psychology of market participants. Rational people acting independently can produce irrational market results. Many investors simply defer to experts or majority opinion. Following the herd may seem rational and intelligent—until it stampedes straight off the cliff.
Read More : Mr. Market's Bipolar Disorder

Market Opportunity: The Other Half Of The Equation

Thus far we’ve been focusing on your talents and interests and their fit with what and how you trade. There is another factor in the equation, and it is tricky: the amount of opportunity that is in your market at your time frame. It’s tricky because opportunity changes—and requires that we change with it.

I recently wrote an article for the Trading Markets web site that described why so many short-term traders were struggling in the S&P 500 E-mini market. Going back 40 years, I investigated the proportion of twoday periods during a moving 250-day window that were either both up in price or both down in price. In other words, I was looking at the number of times a one-day move in the market carried over to a second day. This was a very simple measure of trending behavior.

If we assume that the market has a 50 percent probability of rising and a 50 percent probability of declining, then we should see approximately 125 occasions out of 250 in which the market is either up or down for two consecutive days. In the late 1960s and early 1970s, however, the number of trending occasions out of 250 was consistently above 140. This proportion steadily declined into 2006, where it has been hovering in the low 100s as I write. In other words, we have gone from market conditions in which markets were more likely to follow rises with rises and declines with declines to a situation in which rises are more likely to be followed by declines, and vice versa.

Moreover, I found evidence that this was occurring over multiple time frames. The Barchart.com web site has an interesting feature for subscribers that tracks the performance of each stock vis-à-vis a number of technical trading systems. These are trend following in nature, assuming, for example, purchase at moves above a moving average and sales below the average. Some of the systems are short term, covering trades and patterns lasting a few days on average, and some are longer term: up to 60 days. Looking back over a three-year performance period, Google (GOOG), a stock that had been strong during that period, was profitable on each of the systems. The S&P 500 exchange-traded fund SPY, however, was a loser on every system. In other words, Google was trending across multiple time frames and the broad market was not.

With the rise of automated trading and the increased program trading and arbitrage that it facilitates, trending movements in the broad market have become less common. Because this is occurring in very short time frames (intraday) as well as longer-term, it affects scalpers as well as active investors. Momentum trading (buying short-term market strength; selling short-term market weakness) and longer-term trend following have simply not worked in the S&P 500 market—and the proof is in the many proprietary stock index traders who used to make a living scalping that market and found dwindling opportunity.

It is interesting that some traders gravitate toward being momentum traders, while others are patient trend followers, and still others trade in a countertrend style, fading market movements. I’ve also noticed that many traders have a persistent bias, either to the long or to the short side. No doubt personality plays a role in such preferences. While I strongly suspect that flexibility of trading styles has advantages over such biases, I’ve seen traders succeed with a variety of idiosyncratic preferences. When that success has been present, however, it is always because market opportunity has lined up with those biases. Trend followers make money in trending markets; momentum traders profit when short-term moves continue into the next time period. Once market opportunity shifts, as I found, those biases leave traders at risk.

At that point, either they need to move to new markets (that accommodate their biases) or they need to cultivate a new trading style. Neither is an easy adjustment, and yet they are the kinds of adjustments required by markets that regularly shift their trending patterns. While it is important to match one’s cognitive and emotional styles to one’s style of trading, none of that will be helpful if there is not objective opportunity in the marketplace. Simple analyses like the ones I performed, such as looking across time frames and determining how often rises are followed by rises and declines by declines, will tell you quite a bit about a market’s personality—and whether it matches your trading style.

Another facet of the market’s personality is volatility. Some markets offer more movement than others, and this translates into greater potential risk and reward. I recently completed an analysis for my TraderFeed blog that looked at five-day periods of weakness in the market. The market forecast for the following five days was significantly bullish for both the S&P 500 Index (SPY) and the Russell 2000 Index (IWM) of small-cap issues.

While the number of historical winning and losing trades was similar across the two indices, the Russell offered a 50 percent greater return on average. This was because of the greater volatility of the small stocks during the period covered by the study. One’s profitability, in this case—as in most cases I’ve studied—was thus just as much a function of the market they traded as the pattern being traded. Once again, we can see that matching trading style to markets becomes key to trading performance.

Markets, like people, have their personalities; our relationships with markets will profit to the extent that there is compatibility.

One of the trickiest aspects of trading is that volatility varies on an intraday basis, as well as longer-term. Just as bear markets tend to be more volatile than rising markets, we typically see greater volatility when markets open and close than during their midday hours. Currencies, for instance, will trade greater volume and display enhanced volatility around the London and New York opens than during the period in between or during the New York afternoon. A short-term trading style that makes money in the morning can struggle mightily at midday. The fit between trading style and market personality that was there at one time period is no longer present later on. Opportunity thus becomes a moving target for the active trader.

These are the three legs of the performance stool: (1) your talents and interests, (2) your trading style, and (3) markets and their personalities. The meshing of your qualities with your trading style will help determine your ability to trade that style with consistency and discipline. The meshing of your trading style and the features of markets will determine the degree to which you have a performance edge in the marketplace. The ever-shifting features of markets ensure that traders who are adaptable will be most likely to sustain expert performance over the course of a trading career.
Read More : Market Opportunity: The Other Half Of The Equation

The Efficient Market Theory

A trader strains his mind, his soul, his entire being trying to take profits out of the market when an unsettling piece of news comes down the pike—the efficient market theory. Its main adherents are academics, who are fond of pointing out that prices reflect all available market information. People buy and sell on the basis of their knowledge, and the latest price represents everything known about that market.

This is a valid observation, from which the efficient market gang draws the curious conclusion that no one can beat the market. Markets know everything, they say, and trading is like playing chess against someone who knows more than you. Don’t waste your time and money—simply index your portfolio and select stocks based on volatility.

What about traders who make money? The efficient market theorists say that winners are plain lucky. Most people make money at some point, before bleeding it back into the markets. What about those who keep outperforming markets year after year? Warren Buffett, one of the twentieth century’s great investors, says that investing in a market in which people believe in efficiency is like playing poker against those who believe it does not pay to look at cards.

I think that the efficient market theory offers one of the truest views of the markets. I also believe it is one of the largest pieces of theoretical garbage. The theory correctly observes that markets reflect the intelligence of all crowd members; it is fatally flawed in assuming that investors and traders are rational human beings who always strive to maximize gains and minimize losses. That is a very idealized view of human nature.

Most traders can be rational on a fine weekend when the markets are closed. They calmly study their charts and decide what to buy and sell, where to take profits, and when to cut losses. When the markets open on Monday, the best laid plans of mice and men get ripped up in the sweaty palms of traders.

Trading and investing are partly rational and partly emotional. People often act on an impulse even if they harm themselves in the process of doing so. A winning gambler brags about his positions and misses sell signals. A fearful trader beaten up by the market becomes cautious beyond measure. As soon as his stock ticks down a bit, he sells, violating his own rules. When that stock rises, overshooting his original profit target, he can no longer stand the pain of missing the rally and buys way above his planned entry point. The stock stalls and slides, and he watches, first with hope and later frozen in horror, as it sinks like a rock.

In the end, he can’t take any more pain and sells out at a loss—right near the bottom. What’s so rational about this process? The original plan to buy may have been rational, but implementing it created an emotional storm.

Emotional traders do not pursue their best long-term interests. They are too busy savoring the adrenaline rush or too twisted in fear, des- perate to extract their fingers from a mousetrap. Prices reflect intelligent behavior of rational investors and traders, but they also reflect screaming mass hysteria. The more active the market, the more traders are emotional. Rational individuals can become a minority, surrounded by those with sweaty palms, pounding hearts, and clouded minds.

Markets are more efficient during flat trading ranges, when people are apt to use their heads. They grow less efficient during trends, when people become more emotional. It is hard to make money in flat markets because your opponents are relatively calm. Rational people make dangerous enemies. It is easier to take money from traders who are excited by a fast-moving trend because emotional behavior is more primitive and easier to predict. To be a successful trader you must keep your cool at all times and take money from aroused amateurs.

People are more likely to be rational when alone, and grow more impulsive when they join crowds. A trader’s intense focus on the price of a stock, a currency, or a future pulls him into the crowd of all who trade that vehicle. As the price ticks up and down, the eyes, the heads, and the bodies of traders across the continents start moving up and down in unison. The market hypnotizes traders like a magician hypnotizes a snake, by moving his flute rhythmically up and down. The faster the price moves, the stronger the emotions. The more emotional a market, the less efficient it is, and inefficiency creates profit opportunities for calm, disciplined traders.

A rational trader can make money by remaining calm and following his rules. Around him, the crowd chases rallies, hard with greed. It sells into falling markets, squealing from pain and fear. All the while, the intelligent trader follows his rules. He may use a mechanical system or act as a discretionary trader, reading his markets and putting on trades.

Either way, he follows his rules rather than his gut—that is his great advantage. A mature trader pulls money through the big hole in the efficient market theory, its presumption that investors and traders are rational human beings. Most people aren’t; only winners are.



Read More : The Efficient Market Theory

Derivatives and commodities markets

If equity markets are diverse, derivatives markets are even more so.
Innovative risk management tools, a speculator’s dream, is one of
many expressions used to describe derivatives and for a long time in
the late twentieth century many were not particularly complimentary!

Strange that this should be the case given that the purpose of a
derivative product is to transfer risk from a party wishing to remove
a risk to a party willing to take on the risk with a view to making a
profit. Derivatives bring stability to all types of markets, reducing the
need to sell assets and commodities in falling markets by preventing
losses when such a fall occurs. As long ago as the Middle Ages
derivative-type transactions took place so the product is not new. In
1848 the derivative markets we see today really began when the
Chicago Board of Trade was established and standardized contracts,
called futures, for commodities were created.

The standardization of the terms of a transaction into a contract
enabled that contract to be freely traded. If a farmer purchased a
grain contract he could subsequently sell this to someone else and
remove the obligation created by the trades by having an offsetting
long and short position, which could be closed out. As contracts were
for the delivery of grain and were a legally binding obligation to do so
on both the buyer and the seller this was an important feature. So too
was the guarantee offered by the clearing house of the exchange
which ensured that delivery would be honoured and that the grade of

commodity delivered would meet the required specification. Coupled
with the ability to discover the true price of the commodity as buyers
and sellers gathered to trade on the market floor generating liquidity,
it was of little surprise that success came quickly and within years
other similar markets trading a range of commodities opened in the
USA.

The scene remained much the same until the mid-1970s when
financial futures contracts were introduced. From then on volumes of
contracts traded on exchanges, which now numbered hundreds and
were worldwide, grew at a fantastic rate. By the end of 2001 volumes
were over 3 billion and rising. It is important to recognize that
derivatives are not just traded on exchanges. In fact prior to 1848
‘derivatives’ were traded in the form of forward contracts and
options. They were deals made between two parties and were
transacted off-exchange, in other words there were no rules or
regulations governing the deal and the terms were simply negotiated
to suit both parties. While this type of trade was common there were
large, and growing problems, with one or other party defaulting on
their obligations and also with establishing the ‘true’ price for the
deal. The Chicago Board of Trade was established to remove these
problems and did so with the introduction of the standardized futures
contract, which we recognize today.

The problem, if that is the right word, with derivatives is that when
use of them is made without understanding what they are designed to
do, or when their use is unauthorized or uncontrolled, then losses can
and do occur. However, we should focus on the positive side of
derivatives while respecting the need to understand the characteristics
and potential risk associated with the product.

Derivatives transfer risk from those who wish to avoid or disperse the
risk to those who wish to assume the risk with a view to profiting from
the characteristics. With that basic concept we need to understand
why the product is attractive to both hedgers (those who wish to get
rid of risk) and speculators who wish to profit from their use.
Read More : Derivatives and commodities markets

Bear Market

The general, but not universal, consensus is that a bear market occurs
when the broad market is down by 20 percent or more from
the previous month for a “sustained period of time”—usually two
or more consecutive months. Some folks place the decline at 15 percent
or more; however, the 20 percent number is more common.

That’s the technical definition. What matters to you is that
the broad markets, and most likely your portfolio, are dropping like
rocks and “investor confidence” is right behind them.


MARKET CORRECTIONS
You have to understand the definition of a bear market in order to understand
the underlying causes. Bear markets and “market corrections”
are not the same. Market corrections are declines of short duration, although
they can be severe.

The Standard & Poor’s 500 Index (S&P 500) lost some 10 percent
of its value in just a few days in October 1997. Investors in that month
had to decide if this was a market correction or the beginning of a bear
market. Investors who panicked and dumped stocks for “safer” havens
like bonds and cash instruments watched the market roar back, which put
them in the unenviable position of selling low, then buying high to get
back in the market. Investors who rode it out saw continued increases
until things began to unravel in the spring of 2000. Of course, they then
faced the same question again. This time it was a bear market.

THE PSYCHOLOGY OF BEARS
Bear markets are not just movements of stock prices in a downward direction.
They also represent a state of mind in the investing community.
During the roaring bull market of the 1990s, the general mood of
investors was that stock prices were going to continue to rise. Your entry
point didn’t really matter because prices were going up. No rational investor
will admit to this mindset, but investor confidence was very strong.
No one wanted to be sitting on the sidelines while the markets, particularly
the Internet/tech stocks, were flying high.

In a bear market, the reverse is true. Investors expect prices will keep
falling and take measures to protect their portfolios. Part of this protection
usually means dumping higher risk investments for more stable ones.
This pressure to sell only adds to the momentum of a declining market.


It usually takes time and sustained good news for a bear market to reverse
itself. As we said, this is one difference between a bear market and a market
correction.

THE RECEDING BEAR
A bear market and an economic recession are not the same things. Although
many of the same factors cause both, the stock markets do not always
move with the economy, nor does the economy always move with
the markets.

For example, analysts usually consider low unemployment good for
the economy because more people are working and they are buying more
goods and services. However, the stock market may view low unemployment
quite differently. Low unemployment means employers must compete
for workers, causing wages to rise. Rising wage rates may drive down
profits.

Investors purchase a stock based on the expectation of future profits.
If those future profits are threatened, the stock’s price may drop as
buyers look elsewhere for growth. Of course, it’s not quite that simple.
Rising wages can bring on inflation, which is one of the major causes of
bear markets.


This is not to suggest there is no connection between recessions and bear
markets. Sometimes a bear market will lead the economy into a recession
(after all, investors are betting on the future). Other times a bull market
can appear to lead the economy out of a recession: The 1990s bull market
began in the middle of a recession.
The point is that investors should look closely at the factors pushing
the markets toward a bear state of mind.
Read More : Bear Market

The Market Forms Its Trading Range Daily

The third postulate is as logical and natural for the market as both previous
postulates, and it is very important to a trader. It states that, during
one trading day (i.e., 24 hours), the market should start and finish a cer-

tain trading range. This range can be simply calculated based on an analysis
of each currency rate’s behavior on the preceding day even for a relatively
short period. In other words, for any currency rate, there is the
so-called daily operational task to fluctuate with amplitude of a certain
value. This minimum to average fluctuation amplitude is not the same for
different currency pairs. Also, from time to time, it deviates for the same
currency pair, depending upon market activity due to cyclic oscillations.

Nevertheless, the intraday fluctuations mean amplitude is more or less
stable for each cycle. The duration of each cycle is measured in months,
optimally providing the base for the approximate calculations of the minimum
to average fluctuation amplitude. This calculation allows a trader to
conduct an approximate advance forecast for the current day.

After creation of a philosophical basis of the method, formulating the
basics strategy and tactics of a speculative trade was an easy job for me. It
involves six steps:
1. The fundamental nature of the exchange rates’ fluctuations is not denied
by the method, but in practice it is not taken into consideration
because it does not directly affect the trader’s one and only goal,
which is to gain speculative profit on the basis of these fluctuations.
2. The basis of the method is the trader’s reaction to trading signals generated
by the market itself. The application of substitute and artificial
derivatives such as indicators, oscillators, and other man-made instruments
is essentially limited in this method. (In reality, for the market
analysis, I use only two or three indicators, which have no independent
significance and serve only to confirm basic signals in accordance
with the principles of my trade methods.)
3. The signal’s identification on a buy and sell is based on a set of market
behavioral models. The trade takes place when one of the trading
templates corresponds with a current market situation.
4. The templates represent a set of standard variants of a trader’s actions
executed in a certain sequence.
5. The basis of all templates used in the method is the estimation of a market
movement probability in one or the other direction. The estimation
of probability is made with the use of some rules of technical analysis
combined with money management elements in each of the templates.
6. Sometimes there is a possibility of using several different templates in
the same specific market situation. In this case, a final choice depends
on the trader’s will, his individual desire to undertake an increased
risk in exchange for an opportunity to gain an essential profit.


It is clear that the trader’s basic task is to be on the right side of the market
at the right moment. Basically, it is supposed to be his only concern.
My trade method is based on probability evaluation of the market future
behavior, which, as stated earlier, represents a set of templates that
are formulated in advance and then tested. The trade does not occur until
one of the templates corresponds with a current market situation. If and
when a template corresponds with the real market situation, the decision
to open or to liquidate a position will be taken by trader almost automatically.

In addition to some elements taken from technical analysis, I also
apply some issues concerning money management. They are an important
part of a trade strategy and serve as the additional insurance in the
event that the signal subsequently appears false and the market changes
its direction.

Therefore, it is possible to tell that different templates represent
combinations of trade signals received on the basis of the technical
analysis, estimation of probability of common statistical laws, and money
management.
Read More : The Market Forms Its Trading Range Daily

Eurozone Market

The European System of Central Banks (ESCB) was established in 1998 and has many
features in common with the US model. It is a system composed of the European
countries. The Governing Council comprises the members of the Executive Board and
the governors of the NCBs adopting the euro. The Executive Broads comprises:

• the President;
• the Vice-President;
• four other members appointed by common accord of the governments of the member states.

The main responsibility of the Executive Board is to implement monetary policy in
accordance with the guidelines laid down by the Governing Council, working through
the NCBs.

ESCB Goals
The goal of the system was explicitly defined at its outset as the maintenance of price
stability, that is, the control of inflation across the eurozone. It was established as a fully
independent central bank. Members of the ECB and of NCBs are forbidden from
taking instructions from any external body and member states may not seek to influence
members of the ECB or NCBs in the performance of their duties. Indeed since the system
was established by international treaty in one sense it is more independent than the
central bank of a sovereign state— the system can only be changed by common
agreement of all the member countries rather than by a single national legislature.

ESCB Regulations
Like the Fed , the ESCB imposes regulatory constraints on banks operating in its
territory, which are required to maintain funds on reserve with the NCBs in proportion

to their deposit base. The system of minimum reserve requirements is designed to
prevent excessive lending by the banks and also to stabilize money market interest rates.
Compliance with the requirement is based on average reserves over a period of one
month.

The ESCB has taken the decision to pay interest on reserves, perhaps to ensure that
money market activities in the euro do not move offshore where reserve requirements
would not apply. The ESCB provides short-term borrowing and lending facilities to
banks in the system and these rates establish minimum levels of interest rates
throughout the eurozone. Finally, the ESCB conducts regular open market operations
through the NCBs through which it provides funds to the markets, taking in return
securities such as government bills and bonds as collateral.
Read More : Eurozone Market

Being Right Versus Being Right About the Market

There's something very reductive about the stock market. You
can be right for the wrong reasons or wrong for the right reasons,
but to the market you're just plain right or wrong.

Compare this to the story of the teacher who asks if anyone
in the class can name two pronouns. When no one volunteers,
the teacher calls on Tommy who responds, "Who, me?" To
the market, Tommy is right and therefore, despite being unlikely
to get an A in English, he's rich.

Guessing right about the market usually leads to chortling.
While waiting to give a radio interview at a studio in Philadelphia
in June 2002, I mentioned to the security guard that I
was writing this book. This set him off on a long disquisition
on the market and how a couple of years before he had received
two consecutive statements from his 401(k) administrator
indicating that his retirement funds had declined. (He
took this to be what in chapter 3 is called a technical sell signal.)
"The first one I might think was an accident, but two in

a row, no. Do you know I had to argue with that pension person
there about getting out of stocks and into those treasury
bills? She told me not to worry because I wasn't going to retire
for years, but I insisted 'No, I want out now.' And I'm
sure glad I did get out." He went on to tell me about "all the
big shots at the station who cry like babies every day about
how much money they lost. I warned them that two down
statements and you get out, but they didn't listen to me."

I didn't tell the guard about my ill-starred WorldCom experience,
but later I did say to the producer and sound man that
the guard had told me about his financial foresight in response
to my mentioning my book on the stock market. They
both assured me that he would have told me no matter what.

"He tells everyone," they said, with the glum humor of big
shots who didn't take his advice and now cry like babies.
Such anecdotes bring up the question: "If you're so smart,
why ain't you rich?" Anyone with a modicum of intelligence
and an unpaid bill or two is asked this question repeatedly.
But just as there is a distinction between being smart and being
rich, there is a parallel distinction between being right and
being right about the market.

Consider a situation in which the individuals in a group
must simultaneously choose a number between 0 and 100.
They are further directed to pick the number that they think
will be closest to 80 percent of the average number chosen by
the group. The one who comes closest will receive $100 for his
efforts. Stop for a bit and think what number you would pick.
Some in the group might reason that the average number
chosen is likely to be 50 and so these people would guess 40,
which is 80 percent of this. Others might anticipate that
people will guess 40 for this reason and so they would guess
32, which is 80 percent of 40. Still others might anticipate
that people will guess 32 for this reason and so they would
guess 25.6, which is 80 percent of 32.


If the group continues to play this game, they will gradually
learn to engage in ever more iterations of this metareasoning
about others' reasoning until they all reach the
optimal response, which is 0. Since they all want to choose a
number equal to 80 percent of the average, the only way they
can all do this is by choosing 0, the only number equal to 80
percent of itself. (Choosing 0 leads to what is called the Nash
equilibrium of this game. It results when individuals modify
their actions until they can no longer benefit from changing
them given what the others' actions are.)

The problem of guessing 80 percent of the average guess is a
bit like Keynes's description of the investors' task. What makes
it tricky is that anyone bright enough to cut to the heart of the
problem and guess 0 right away is almost certain to be wrong,
since different individuals will engage in different degrees of
meta-reasoning about others' reasoning. Some, to increase their
chances, will choose numbers a little above or a little below the
natural guesses of 40 or 32 or 25.6 or 20.48. There will be some
random guesses as well and some guesses of 50 or more. Unless
the group is very unusual, few will guess 0 initially.

If a group plays this game only once or twice, guessing the
average of all the guesses is as much a matter of reading
the others' intelligence and psychology as it is of following an
idea to its logical conclusion. By the same token, gauging investors
is often as important as gauging investments. And it's
likely to be more difficult.
Read More : Being Right Versus Being Right About the Market