Category: blog

• Trade with the trend.  Make sure stock has resumed its trend before entering again

• Debit spreads
  • are medium to long term trades
  • you want to use options with expiration months that allow enough time for this move to occur
• Credit Spreads
  • typically short term where you want to capture the credit as soon as reasonable possibly
  • Conditions of a good credit spread
    • Extra premium has been pumped into the side being sold
    • Underlying stock needs little or no movement to achieve maximum profit
    • both of the above achieved with front month options
  • Look for 1 time events but wait until dust settles and premium still higher than before,  then initiate spread with short leg near the price extreme => look for roughly equal reward to max risk
    • early Feb, RMBS, royalty fees, big drop, price stabilized at support, sell mar 22.5 / buy mar 25, for 1.25 credit and 1.25 risk
    • early Feb DIS, hostile takeover by comcast for $27, price shot up to $28, then stabilized at $27 2 days later, it would be rejected unless comcast raised offer.  Sell Mar 27.5 / buy 30, 1.3 credit  / 1.20 max loss
    • Mid apr, fell after good eps on high volume to $34 before stabilizing.  May Sell 35 / buy 32.50, credit 1.2 / 1.2 max loss
  • avoid situations where it will be a continuing saga, as in accounting irregularities or possible restatement of earnings
  • Put IV is higher lower in the chain, so makes bull put spreads less lucrative
• Calendar Spreads
  • good for stable stocks that will move less than 15% over a month
  • primary feature of calendars is to roll a new option every month for the front month short leg
  • at least 1 month expiration difference so you can roll once
  • use calls for expected upward drift, puts for expected downward drift
  • exit the trade if you’re taking a 50% loss, roll or close if you’ve achieved 50% of the gain
  • IV is the most important characteristic of calendar spreads
    • volatility skew – short option IV is larger than long option IV
      • % increase in IV of short option compared to that of the long option
      • 10% – 25% is ideal range, avoid IV skews > 30% esp when both have high IV
    • early may XYZ is $17.  $17.50 Jun IV is 49, Jan IV is 41 = (49/41)  = 19.5% skew.  Buy Jan 17.5 for $2.10, sell Jun 17.5 for $1.15,$125 max gain /  max risk is $95
  • Deep ITM Put Calendars – Expect stock to rise over time
    • Buy 1 Leap (21 – 24months) w/ strike well above current price and sell nearer term Leap(9 to 12months) with same strike
    • Both will be nearly the same price, thus making the cost low and offer substantial leverage.  As near month expires worthless, you can close immediately for max profit
    • if all time values disappears and open interest is low, you might get assigned.
    • sell the stock assigned to you and resell the same put option simultaneously, as 1 transaction.
• Diagonal Spreads
  • works best when the 2 strikes are no more than $2.50 apart because it keeps the maximum risk on the trade at a reasonable level, which restricts this trade to low / medium priced stocks, or indices
• Covered Call
  • Focus on the stock price, and to a much lesser extent the option price.  Decide on an appropriate stop loss for the stock, and protect if it goes below by closing the option and stock
  • Decide on the strike price at  a level where you are actually willing to sell the stock
  • Choose 1 or 2 months out, do not go too far
  • If you’re going to get assigned, just accept the loss, don’t buy back the call for a loss
• Straddles/Strangle – long call / long put
  • Price between $20 – $50, if cheaper than $20, might not be enough room to fall, if above $50 options may be too expensive to create a straddle with good profit potential
  • Identify an event.  EPS, court decision, FDA rulings
  • Event is 30 to 60 days away.  Options do not expire until at least 30 days after the event.  So you’re looking at least 60 to 90 days until expiration
  • Upcoming event should not have already generated interest, open interest / trading volume should be normal.  IV vs HV should also be normal
  • Look for a stock within a narrow trading range.  When it does breakout the option price will gain extra time value
  • Exiting:
    • Sometimes better to exit 1 side before the event.
    • Don’t stay in the straddle much longer after the event, sell the profitable option before time value decreases
    • Never hold both sides of straddle until expiration.  Exit with 3 to 4 weeks before expiration
• Stock Repair
  • buy 1 ATM call for each 100 shares, then sell 2 OTM calls
  • only works if stock price rebounds
  • example: stock declines from $35 to $23 by March
    • L Jun 25 C for $3.30 / S 2 Jun 30 C for 1.75 => credit of $.20
    • this creates a covered call w/ a bull call spread
    • if stock closes at $30 by expiration you will have made $35
  • to open for a credit, you need about 2 months until expiration
• Stock enhancement
  • buy 100 shares at $58, holding for $75 target, starting in Mar
    • L Jan 70 C for $3.70, S 2 Jan 75 C for $2.50 => credit of $1.30
    • if stock is above $75, you will have generated equivalent of $81
  • you can do also replace stock above w/ 1 Jan 40 call, for $19.70
• Collar
  • stocks you intend to hold minimum 10 months
  • example: nov 2004, you buy XYZ at $19 and plan to hold at least 1 year
    • Buy 1 Jan 20 put for $2.90, Sell 1 Jan 25 call for $1
    • max loss is $90(-4.3%), max gain is 17%
  • enhanced if stock pays dividend
  • if at a loss, it is possible to close early, however max gain you must wait until expiration
  • used on conservative, non-volatile stocks
• Synthetic
  • Long Stock – L 1 ATM Call, and S 1 ATM Put
  • S Deep ITM Put will have delta close to +1, and substitute as L stock
    • slightly higher probability of early assignment than call, because less time value
  • S Deep ITM Call will have delta close to -1, and substitute as S stock
• BackSpreads
  • only used when stock will move big, a small move generates a maximum loss
  • example: in Feb XYZ is at $19, and you think it can go to $35 in the next year
    • L 2 Jan 22.5 C $1.70, sell 1 Jan 20 call at $2.80.  Cost $60, max risk $310
• Butterfly
  • focuses on a narrow range of profitability, but used when price is trending towards a target
  • Ex: July, XYZ trading for $30, setup butterfly at $35 w/ 1 L Nov 30 P .80 / 2 S Nov 35 P $4.60, max profit at $35
  • Adjustments can be made to take off the profitable S middle leg and leave on the L outer legs for a subsequent move in the opposite direction
    • if price went up to $38 by late sept, you could sell the Nov 35 puts for $1, and collect $3.60 then hold the puts for a move down
• Iron Condor
  • Use options that expire in 1 – 2 months
  • No need to let trade get to worst case scenario
  • Ex: Late December stock trading for $56, open 60 / 65, 40 / 45 iron condor, for $185, max loss $500
    • if stock falls below 48 or above 62, close the trade for $100 loss.
• Double Diagonal
  • You can roll the short legs once in this set to create additional profit
  • No need to let trade get to worst case scenario
  • Ex:Late December stock trading for $56, open Feb 60 / March 65, 40March  / 45 Feb double diagonal, for $150 profit, max loss $400
    • if stock is below $48 or above $63 close for a $100 loss
    • if price moves up to $60 or down to $50, the short feb options can be rolled to march options
    • or feb 60 calls can be rolled up to 65, or feb 50 puts can be rolled down to feb 45 puts to create calendar spreads
• Vertical Spreads – used mainly for directional trades
  • A vertical spread will always maintain its delta position, any time you buy the lower strike and sell the higher strike, you create a bullish (positive delta position).
  • The greater the distance, the greater the delta
  • If IV is too low, vertical spreads should focus on purchasing the at the money option
  • if IV is too high, vertical spreads should focus on selling the at the money option
  • The focus is mainly on the at the money option to buy / sell when the volatility is mispriced.  You can trade the OTM or ITM first, and then leg into the ATM portion (closest to 50 delta)
• Conversions / Reversals
  • create syntheic long or short, and then go short or long the underlying
• Boxes
  • Synthetic L lower and Synthetic S higher, at expiration it will be worth the difference of strike prices.  This entire box will be discounted according to the interest rate

• Neutral w/ Bearish Volatility
  • Covered call
  • Butterfly
  • Condor
  • Double Diagonal
  • Collar
• Neutral w/ Bullish Volatility
  • Straddle / Strangle
  • Calendar
• Bearish
  • Bear Call Spread (credit)
  • Put Backspread
• Bullish
  • Bull Put Spread(credit)
  • Call Backspread

• Come up with graphs using a computer
• Use the risk of greatest concern
  • if volatility is the greatest concern choose vega
    • position vega / theoretical price (price i believe options are worth) and compare the different strategies
  • large move? look at delta
    • if gamma is positive, don’t need to include

Adjustments

• new traders should avoid adjustments which increase the size of their position
• if you want to remain risk neutral, buy or sell the underlying contract to adjust the delta of the position
• if you use options, the remaining greeks will all also be adjusted, use them to get risk back to where you believe it should be while increasing your theoretical edge

• Our interpretation of situations turn normal stress into distress.  Trading is always stressful, but should not turn into distress
• How to prevent distress
  • Position sizing guidelines, per trade loss limits, per trade price targets, and daily loss limits
  • risk per trade should be meaningfully smaller than potential reward of profit targets
  • amount of money of daily loss should be a fraction of the money you make on your best days
  • no single daily loss should be so large to prevent you from making money for the week
• Journal
  • Every time you experience a distinctly negative emotional reaction to a market event, ask yourself, “How am I perceiving the current market as a threat”
  • Identify the perceived threat and turn it into an opportunity.  Write it down in a journal
  • Journal has 3 columns, it must be detailed enough to understand what is going on in your mind at that time:
    • Specific situation in the market,
    • transcribe your exact thoughts / feelings / actions taken in response to the situation,
    • consequences of the particular cognitive, emotional, or action patterns taken in column 2. => goal is to become aware, not change, do for 30 days
    • You can add a 4th column, with what a friend might say to you that was positive about your thinking / trade idea
  • It is an emotional exercise, not logical.  It needs to have the power of emotional force, and vigorously reject the negative thought patterns.  These thought patterns have sabotaged your trading, cost you money, and threatened your success
• Trading rules – to create repetition
  • rules for risk management; taking breaks after large or multiple losses, entering at defined signal points, preparation for the day.
  • review rules before trading and visualize yourself in different trading situations following the rules
  • review rules during the day
  • grade your rule following at the end of the day, if you get less than a B, it is an explicit goal for next days trading
• Fear
  • Fear is a cue to examine your trade more deeply, not make changes.
  • Make a checklist of things you look for to make sure your trade is working, and whether it makes sense to be in it.
• Performance Anxiety
  • Thinking about the outcome of a your performance will interfere with the process of performing.  Focus on the doing, and the outcome takes care of itself
  • Know your niche and only trade that product, time frame, and setup.  Most of the time bad trades come from trading out side your performance zone
  • Label trades as A,B,C.  A are home runs, B are good setups, and C are marginal setups.  When you lose your edge or start a slump, only take the A trades are reassess the market
  • Volatility will cause anxiety if you are not aligned w/ the market.  If you expect high volatility, but market is low, you will expect moves that never occur.  If it is high and you expect low, you will get stopped out too easily.  You will also not size your positions correctly
  • You need many fulfilling activities in your life, so if trading isn’t working out particularly well, you have other things you are being successful at
    • Rate yourself on spiritual interests, artistic activities, athletic pursuits, social life, intellectual life, family, community and hobbies.  Select 1 area for cultivation to improve emotional diversification
• Maximize Confidence
  • It’s easier to stay in a trade if you have a defined profit target because you get less caught up in the up and down ticks of the market
  • You must know the historical odds of the market acting in your favor.  Without this it is hard to have confidence in the ideas.  Markets experience normal retracements on the way to to a profit target, and those adverse excursions will be difficult to weather
    • these pullbacks can be viewed as threats to paper profits or opportunities to add at favorable prices
  • It takes more confidence to sit through a trade than to enter it
    • Most people will choose a 100% chance of making $1000 vs 75% chance of making $1500, even though on avg you get $1125
  • Processing retracements
    • a lost paper profit is not a threat to your account
    • most criticize themselves for missed opportunities or lapse into a state of frustration
    • it is the self blame and discomfort of second guessing you are avoiding  when  you take a profit before your profit target
  • Confidence is trust
    • you must act on your trade ideas and see through to their planned conclusion to develop trust in your ideas.
    • Leave on a small portion of your position to your intended target to help you build trust in your ideas

ch 4 – How to Journal

• How to review your trading journal to self diagnose
  • divide entries into 2 clusters, successful trading and trading at your worst
  • look for things such as trade frequency, trade size, coping with market challenges
  • Compare best trades vs worst trades w/:
    • emotional patterns – distinct differences in how you feel before and during trades
    • behavior – differences in how you prepare trades, manage them
    • cognitive patterns – thought process or concentration level
    • physical patterns – energy level, tension, relaxation, posture
    • trading – sizing, times of the day, mode of entering (scale vs all in), instruments traded
  • Watch for:
    • impulsive of frustrated trades after losing ones
    • risk averse / failing to take good trades after a losing period
    • overconfident during a winning period w/ marginal and unplanned trades
    • anxious about performance and cutting winning trades short
    • oversizing to make up for losses
    • ignoring stop-loss levels to avoid taking losses
    • working on trading when you’re losing money, but not when you’re making it
    • caught up in moment to moment action vs actively managing a trade, preparing for the next trade
    • beating yourself up after losing trades / losing motivation for trading
    • trading for excitement / activity rather than making money
    • trading because you’re afraid of missing market move, rather than favorable risk / reward
• Best traders continue to compete against themselves long after they have made enough to retire.  They are constantly trying to improve rather than make money
• Journaling is an emotional exercise, not a cognitive one.  You must learn to hate your worst trading habits so you do not repeat them because they disgust you.
• Keep yourself solution focused:
  • What did I do well today/this week? What did I do right about this trade?
• Usually many trading problems come from 1 core problem: ie: negative self talk causes missing good trades, sizing position too conservatively, cutting winning trades too quickly
• Imagery
  • Mentally summoning stressful market scenarios and imagining in detail how  we want to respond to these, we inoculate ourselves against those stresses by priming our coping mechanisms
    • Visualize specific market / situation, levels, and PA.  the realism enables the exercises to substitute for real experience
    • Visualize like a movie, playing out real time
    • Imagine from beginning to end, until the entire situation no longer evokes emotion
    • Slightly vary the scenario
    • Repeat the visualization daily
  • Imagine how FT or Lak would trade the same market

• Past relationships are the basis for your identity.  How you reacted to past relationships will affect how react to current relationships. Relationships can be with anything people or markets.
• One trader defended against loss by never getting too close.  He lost a sibling when he was young and his parents tried not to dwell on the tragedy.  He never committed to anyone, to keep his from experiencing his pain of loss, but never had a fulfilling emotional life.  He traded with ludicrously small size, and was distracted by chat rooms / reading web sites.  He avoided loss in relationships, dabbled at the edges of markets, and never achieved anything close to his potential.
• To crystallize your pattern you need to understand the underlying need.  The trader above had an overwhelming need for safety and took the safest path in relationships and trading.  He is guarding against the vulnerability of investing in oneself and losing that emotional investment.
• Patterns can be broken down:
  • Need – what we are missing, what we crave
  • Feeling State – distress associated with not having that need met
  • Defense – what we do to cope and avoid the painful feeling state
  • repetitions – how we replay defenses in current situations
  • consequences – negative outcomes from our current defensive efforts
• Schemas are habits of negative thought patterns that hijack your mind and the way your process information.  You need to feel the horror of losing control of your mind / behavior
  • justice – i put in my work, i should make money
  • catastrophe – it would be terrible if my trade didn’t work out
  • safety – i can’t act the market is too dangerous
  • self-worth – i’m a total failure, i can’t make money
  • rejection – i’ll look like a fool if i can’t succeed at this
• Market is not about you
  • When you start using “I” and “me” your attention is becoming self-directed.
  • Need to break this thought process
• Worry
  • visualize worst case scenario and how you would handle it constructively.
    • What are you really fearful of?  what unresolved situation is looming?
    • until you face it, it will intrude in your work and affect your mood
  • worry reinforces a sense of hopelessness and helplessness in the face of those scenarios
  • worry masks larger concerns
    • once you anticipate the worst case scenario, you can take catastrophe out of the situation
• you don’t drive on the opposite side of the road because it is dangerous, you don’t have to think about it, you just do it.  You should have the same rules with trading.  Internalize the rules so you it doesn’t even occur to you to do dangerous things
• make sure you are emotionally connected to the rule, ie: remember the times you violated the rule and what happened
• Common rules:
• • Position sizing
  • limiting losses – per trade, day, week
  • adding to position
  • when you stop trading or limit size / risk
  • when you increase size / risk, per trade / per day
  • entering and exiting
  • preparing for the day / week
  • diversification among position
• during every change process you will relapse to your old ways, this is common and expected, until they become automatic
• Imagine situations where you feel fear, greed, frustration, and boredom.  Imagine yourself tempted to react in your normal patterns, and the vividly envision keeping those negative patterns in check

• trade management – the market generates information once you are in the trade, use this to your advantage
  • he has 6 units, and only enters trades w/ 1 or 2.  If his ideas are confirmed, he adds units on pullback
• you must cultivate an aggressive mindset when you know you have the market nailed.
  • add to your position on paper after you’ve entered and track how well these ‘nailed’ positions perform
• Experienced traders know when they are right and wrong.  Beginners try to avoid being wrong.  Experienced traders know they’ll be wrong on a significant portion of their trades.  Their coaching is designed to help them anticipate and manage losses

• The underlying attraction of trading is the unlimited freedom of creative expression.  This is something that has been denied for most of us
• Emotional Pain is caused by an imbalance between your mental state and the exterior world
  • When these are not balanced we experience it as dissatisfaction, anger, frustration
• As a child we are constantly denied creative expression
  • Don’t touch, ect…by the time we are adults we have heard several thousand denials, and thus have had several thousand denied impulses
  • As a child, we reconcile these denied impulses by crying.  As an adult the denied impulses accumulate and manifest themselves in addictive / compulsive behavior habits
    • ie: children who didn’t feel they had enough attention, will have unresolved emotional energy that compels them to crave attention.  As adults the draw attention to themselves to satisfy the addiction
  • These unreconciled denied impulses affect our ability to stay focused and disciplined while trading
• Safeguards – rules / boundaries while trading
  • Trading is in constant motion with no beginning or end.  It is unlike any other activity because you are the only one who decides when it starts, how long it lasts, and when to end
    • Regardless of what you have planned, psychological factors come into play.  if you become distracted, scared, or overconfident you will act in erratic and unintended ways
  • Since there are no boundaries, we must act with some self control
• Problems
  • Rules – Most people are resistant to rules in trading because it is a completely boundless environment
  • Responsibility – We want the freedom to make choices, but that doesn’t mean we are willing to accept the responsibility of the outcome
    • When we act on our own ideas, we put our creative ability on the line and get instant feedback on how well our ideas worked.  It’s difficult to rationalize away any unsatisfactory results.  If we enter into unplanned, random trades, it’s much easier to shift the responsibility by blaming other things
  • Random rewards – monkeys will keep doing a task if the reward is given randomly, however if it is given on a consistent basis, and then it is stopped, they will stop as soon as the rewards are stopped.
    • Chemicals in our brain our released when we receive an unexpected, pleasant surprise.  If we trade randomly and get a good result, it will always be an unexpected, pleasant surprise
  • External vs Internal Control
    • One reason many professionals fail in the market is that they have the ability to control and manipulate their environment to fulfill their needs and desires.  As traders we have no ability to control the market externally

• Taking Responsibility – sounds simple but is not easy to grasp or put in practice.  You must understand the ways in which you are and are not responsible for your success as a trader.
  • Complete responsibility – All of your results are self generated, based on your interpretations of market information, the decisions you make and the actions you take
  • Without complete responsibility you
    • establish an adversarial relationship with the market that takes you out of the constant flow of opportunity.
    • mislead yourself into believing that your trading problems can be rectified through market analysis
• Shaping Your Mental Environment – your ultimate goal is consistency.
  • Your goal has to to learn to think like a consistently successful trader.  They have eliminated the effects of fear and recklessness from their trading
  • Fear based errors come from rationalizing, subconsciously distorting info, hesitating, jumping the gun, or hoping.  Once the fear is gone, there won’t be a reason to make these errors and they will disappear from your trading
  • Euphoria from a string of winners is also as dangerous as fear
• The Zone
  • It is a carefree state of mind where there is absolutely no fear and you react instinctively.  You don’t weigh alternatives or consider consequences or 2nd guess.
  • You cannot force yourself into the zone, but you can develop a positive winning attitude
    • Positive winning attitude is expecting a positive result from your efforts, with the acceptance that whatever results you get are a perfect reflection of your level of development and what you need to learn to do better
    • Others get bogged down in negative self-criticism, regret, and self-pity
• Expectations are our mental representations of how some future moment in the environment is going to look, sound, feel, smell or taste.  Depending on how much energy is behind the expectation, it can hurt a lot when it isn’t fulfilled.
• Blaming the market
  • As children most of the time we were forced out of a state of joy or happiness by someone with more power or authority.  We had no choice (or believed to have no choice) or responsibility for what put us into emotional pain.  Thus the outside force was to blame.
  • We feel betrayed because these situations were unexpected or unanticipated and we were unprepared for how some people in our lives had the potential to behave.
  • If we haven’t accepted and prepared for the inherent risks of trading and don’t know how to guard against these natural connections between our past and present, we will end up blaming the market for our results instead of taking responsibility for them.
• The market
  • The purpose of the market is to facilitate people taking money from each other.  It is trying to separate you from your money just as much as the opposite.
  • If you blame / feel betrayed by the market you are expecting the collective actions of everyone participating in the market to make the market act in a way that gives you what you want.
• Consequences of avoiding pain
  • Conscious level – We shield painful information by rationalizing, justifying, or making a case for staying in a losing trade.  Some typical ways we do this are to call our trading buddies, talk to our brokers, look at indicators we never use, all for the purpose of gathering unpainful information in order to deny the validity of painful information
  • Subconscious – will automatically distort, alter, specifically exclude information from our conscious awareness
• Euphoria
  • if losses are the result of euphoria, it doesn’t matter form the streak takes, it can be any number of wins in a row.  But the overconfidence means you cannot perceive any risk because it makes you believe that nothing can go wrong.  If nothing can go wrong, there are no need for boundaries or rules to govern your behavior
• Winning Attitude
  • Is leaving money on table more painful than taking a loss?  When we lose there are a number of ways to shift the blame and not accept responsibility, but we are completely responsible for leaving money on the table.
  • The most efficient path to discovering what you need to be successful is a winning attitude.  It produces the kind of mindset that is most conducive to discovering something no one else has experienced
  • Many traders think they have a winning attitude, when they don’t or expect the market to develop the attitude for them by giving them winning trades.  No amount of market analysis will give you a winning attitude
  • Stop expecting the market to give you anything or do anything for you.  If you stop fighting the market, and yourself, the market will not be your opponent.  You will quickly recognize exactly what you need to learn, and how quickly you will learn it

Ch 4 – Consistency – a state of mind

• What separates traders is not what they and when they do it, it is how they think about what they do and how they’re thinking when they do it
• People who are truly happy don’t need to do anything in order to be happy.  Traders who are consistent don’t have to try to be consistent, they are consistent.  There is no struggle, they see exactly what they need to see and act on it in the moment.
  • Nothing is being blocked from your awareness, so it is effortless
  • Having to try indicates that there is some degree of struggle or resistance.  The best traders don’t try to get anything from the market, they take advantage of whatever the market is offering.
• Understanding Risk
  • accepting the risk means accepting the consequences of your trades without emotional discomfort or fear
  • possibility of being wrong, losing, missing out, leaving money doesn’t cause defense mechanisms to kick in and take you out of the opportunity flow
  • you make yourself available to take advantage of an opportunity, you don’t impose any limitations or expectations on the market’s behavior, and you are satisfied to let the market do whatever it is going to do
  • Pros don’t not perceive anything that the market does as threatening because of the way they view risk

• Most traders experience the market through their last couple trades.  Pro’s are not negatively / positively impacted by their last few trades
• Secret of the Nature of trading – at the core of one’s ability
  • trade w/o fear or overconfidence
  • perceive what the market is offering from its perspective
  • stay completely focused on the ‘ now moment opportunity flow’
  • spontaneously enter the’zone’ – a strong belief in an uncertain outcome with an edge in your favor.  You believe without a doubt that anything can happen regardless of what has just happened.
• The fear of being/admitting wrong causes us to place an inordinate amount of significance on the info that tells us we’re right
• Not pre-defining your risk, not cutting your losses, or not systematically taking profits are the 3 most common trading errors you can make
  • The reason typical traders do this is because they believe it is not necessary.  It is only not necessary if he believes that he knows what is going to happen next, based on what he perceives is happening in any given moment now
  • Believing, assuming, or thinking he knows will be the cause of virtually every trading error.

Ch 7

• Thinking in probabilities
  • Like a casino, you only needs odds in your favor and a large sample size.  At the micro level you don’t know which hands you will win or lose (based on variables like how the individual players act, ect), only that over time you will take in the rake (game has an expected outcome)
  • Trading is the same, you may have the same model that has an edge, but you don’t know at the micro level how the other traders will act.
    • So you must act on every edge because you will never know which edge will lead to a positive or negative outcome
  • Most traders crave certainty that analysis appears to give them.  Every trader wants to be right on every single trade.   You can only be certain that certainty does not exist.
  • If each moment in the market is unique, anything is possible, then any expectation that does not reflect these boundary-less characteristics is unrealistic
• Managing expectations
  • protecting ourselves from mental pain is the same way we protect ourselves from physical pain.  We try to avoid physical pain by moving away or deflecting it.  We avoid mental pain by ignoring, rationalizing, justifying, excusing, getting angry, or gathering information that will neutralize the conflicting information.
  • if we have an expectation, we expect it to be right.  If it comes an unfulfilled expectation we become unhappy.  If something causes us to be unhappy we use our pain avoidance mechanisms to exclude, distort, diminish our awareness to protect us
  • To avoid pain, we narrow or focus and concentrate on information that keeps us out of pain, regardless of how insignificant or minute
    • If we are trading counter trend, we ignore any trend continuation signals until the pressure of losing too much money becomes unbearable
  • Goal is to be rigid in your rules, and flexible in your expectations
    • Rules are there for self trust and protect us in an environment with few boundaries
    • Flexible in expectations so you can perceive, with clarity and objectivity, what the market is communication from its perspective
• Eliminating emotional risk
  • Thinking in a probabilistic environment
    • Anything Can happen
    • You dont need to know what is going to happen next to make money
    • There is a random distribution between wins and losses for any given set of variables that define an edge
    • An edge is nothing more than an indication of a higher probability of one thing happening over another
    • Every moment is unique in the market
  • The potential to experience emotional pain comes from the way you define and interpret the information you’re exposed to.  With appropriate expectations, you will eliminate the potential to define and interpret market information as either painful or threatening
  • As a trader when you are expecting a random outcome, you will always be a little surprised at whatever the market does, even if it conforms exactly to your definition of an edge and u win.  However expecting a random outcome doesn’t mean that you can’t use your full reasoning and analytically abilities to project and outcome.  You just can’t expect to be right.  If you are right you can’t expect that whatever you did last time will work next time even if the situations appear identical.  If you approach trading from the perspective that you don’t know what will happen next, you will circumvent your mind’s natural inclination to make the ‘now moment’ identical to some earlier experience.
    • When I put on a trade, all I expect is that something will happen.  Regardless of how good the edge is, I expect nothing more than for the market to move or to express itself in some way.  I know from past market behavior the odds of it moving in my direction are acceptable, in relationship to how much I am willing to spend to find out if it does.  I also know how much I am willing to let the market move against my position.  There is always a point where the odds of success are greatly diminished in relation to the profit potential.  At that point it’s not worth spending any more money to find out if the trade is going to work.  If the market reaches that point, I know without any doubt, hesitation, or internal conflict I will exit the trade.
    • The loss does not create any emotional damage because I don’t interpret the experience negatively.  Losses are simply the cost of doing business to make myself available for the winning trades.  If the trade does turn out to be a winner, I know at what point I am going to take my profits.
    • The best traders are in the now moment because there is no stress.  There is nothing at risk other than the amount of money they’re willing to spend on a trade.   They are not trying to be right or trying to avoid being wrong, nor prove anything.  If and when the market tells them their edges aren’t working or it’s time to take profits, their minds do nothing to block this information.  They completely accept what the market is offering them, and they wait for their next edge.

• Working with your beliefs
  • Consistency is the goal, it is the result of a carefree, objective state of mind, where we are able to perceive and act upon anything the market is offering us
  • carefree means confident but not euphoric.  You don’t feel fear, hesitation, compulsion because you’ve eliminated the potential to interpret market information as threatening
  • objectivity means you have conscious access to everything you have learned about the nature of the market.  nothing is being blocked by your pain avoidance mechanisms
  • making yourself available = means trading from the perspective you have nothing to prove.  You aren’t trying to win or avoid losing.  You aren’t trying to get your money back or take revenge.  You come to the market with no agenda other than to let it unfold and be in the best state of mind to recognize opportunities it makes available
  • “now moment” – there is no potential to associate an opportunity to get into, get out of, add to, detract from a trade with a paste experience that already exists in your mental environment
  • Fundamental Truths
    • Anything can happen – there are always unknown forces in every market at every moment
    • You dont need to know what is going to happen next in order to make money – There is a random distribution between wins and losses for any given set of variables that defines an edge.  Trading is a simply a probability and numbers game.  All you need to know is:
      • the odds are in your favor before you put on a trade
      • how much it’s going to cost you to find out if its is going to work
    • The only variables you need to know is whether the variables you use to define an edge are present at any given moment.
    • Every moment in the market is unique – it has never existed nor will ever exist again

• Nature of beliefs
  • Just because you understand something is different than using it at a functional level.  Understanding is just the first step.
  • Conflicting beliefs will sabotage your best intentions, and you will not be in the ‘now moment’
    • Now that you understand you don’t have to know what’s going to happen next, and that even trying to know will detract from your ability to stay objective in the moment you will have a conflict between your old and this new belief.
    • It takes a considerable amount of mental work to integrate this new understanding into your mental trading environment
• Origins of Belief
  • Pure memory – is only sensory information that is not organized or attached to words or concepts
  • Belief – is a concept about the way the external environment expresses itself
    • concepts combines sensory information with language
    • They are a very important part of defining our quality of life, yet they are rarely thought about
    • None of us are born with beliefs, they are acquired in many ways, usually instilled by other people.  The ones we struggle with the most are the usually the ones acquired from others without our conscious consent
    • How beliefs shape our lives
      • they manage our perception and interpretation of environmental information in a way that is consistent with what we believe
      • they create our expectations (what we know projected onto some future moment)
      • anything we do, or express, will be consistent with what we believe
      • they shape how we feel about the results of our actions
    • Our truth will determine:
      • the possibilities we perceive in relation to what is available from the environment’s perspective
      • how we interpret what we receive
      • the decisions we make
      • our expectations of the outcome
      • the action we take
      • how we feel about the result of our efforts
    • If we are in a good state, we can say what we perceived was consistent with our objective and what was available from the environment’s perspective.  If we are unhappy we can say relative to the environmental situation, the beliefs we are operating from dont work well and are not useful.

• Impact of beliefs on trading
  • Beliefs take a life of their own, and resist any force that would alter their present form
  • All beliefs demand expression
    • You must train your mind believe in the uniqueness of each moment, and deactivate any other belief that argues something different.
  • Beliefs keep on working regardless of whether or not we are consciously aware of their existence in our mental environment

• 3 stages of trader development
  • Mechanical
    • Build self trust necessary to operate in an unlimited environment
    • Learn to flawlessly execute a trading system
    • Train your mind to think in probabilities
    • Create a strong, unshakable belief in your consistency as a trader
      • What separates the ‘consistently great’ athletes from everyone else is their distinct lack of fear of making a mistake.  They don’t have a reservoir of negatively charged energy waiting to well up and pounce on their conscious thought process and kill them. Your mistakes help point you in the right direction, accept them as simply your current level of expertise.
  • Subjective – you use anything you have ever learned about the nature of market movement to do whatever it is you want to do
  • Intuitive
• If you’re going to become a consistent winner, mistakes can’t exist in the kind of negatively charged context in which they are held by most people
  • Work on acquiring a new set of positively charged beliefs about what it means to make a mistake, along with de-activating any negatively charged beliefs that would argue otherwise or cause you to think less of yourself for making a mistake
  • How to develop self discipline
    • Find a clear purpose why you want to monitor yourself
    • Direct your attention to what you think, say, or do
    • If you’re not focused on your objective, choose to redirect your words, thoughts, or actions in a way that is consistent with what you are trying to accomplish.
    • The more willfully you engage in this process, the faster you will create a mental framework that functions in a way consistent with your objectives
• Self discipline is a mental technique to redirect our focus of attention to the object or goal of our desire, when that goal or desire conflicts with some other component of our mental environment
  • I am a consistent winner because:
    • I objectively identify my edges –
      • objective means there’s no potential to define, interpret and perceive any market information form either a painful or euphoric perspective.
      • stay objective by keeping expectations neutral, always take unknown forces into consideration.  Unknown forces are other traders waiting to act on price movement
    • I Pre-define the risk of every trade
    • I completely accept risk or I am willing to let go of the trade
    • I act on my edges without reservation or hesitation
    • I pay myself as the market makes money available to me
    • I continually monitor my susceptibility for making errors
    • I understand the absolute necessity of these principles of consistent success and there I never violate them
• Exercise: trading like a casino
  • Find a any set of mechanical market variables that defines an edge
  • Find mechanical profit and stop loss targets based on this edge
  • Stick with one time from to enter and exit, you can only use the others to help define the edge
  • Take 1/3 profits on the scalp (1.5 – 2 pts emini or 4 ticks bonds)
    • Take 1/3 profits on the profit target, Move stop to break even
    • Use the carefree state to experience the ‘now opportunity flow’ and trade last 1/3 when it indicates to get out
  • Look for 3:1 risk to reward edges
  • Trade in samples sizes of 20 to determine if an edge is working or not
    • Accept the risk that you can be wrong in all 20 trades.  For SPY 3 pts at 150 shares = $900
  • This exercise will create a head-on collision between your desire to think objectively in probabilities and all the forces inside you that conflict with this desire.  The amount of difficulty will be in direct proportion to the degree to which these conflicts exist.  When you have a hard time, use self-discipline to refocus on your objective.  Write down the 5 fundamental truths / 7 principles of consistency so you can see while trading.  Acknowledge the conflict, and refocus on what you’re trying to accomplish.

• 95% of big winners had a major new product / service, new management, or important change in their industry
• Buy on the breakout.  The stock should be close to or actually making a new high after undergoing a price correction and consolidation.  Consolidation can last from 7 – 8 weeks (normal) to 15 months.  As it emerges from this base, it should be bought just as it is starting to breakout.
• Avoid buying more than 5 – 10% off the base

• Low float is better than big float
• Large % ownership by top mangement
• Today’s hot product will find sales slipping in 3 years, so management must be an entrepreneurial style
  • Not many layers between CEO and customer
  • small medium companies
• More than 95% of companies had fewer than 25M shares during their greatest period of eps improvement.  Avg was 11.8M and median was 4.6M between 1970 and 1982
• 3 to 1 and 5 to 1 stock splits after huge run ups make institutions sell (this doesn’t seem relevant)
• Comapanies buying their stock in the open market
• Reducing debt to equity over last 2 to 3 years
• Small cap with less liquidity and no institutional sponsorship / ownership should be avoided.
• Trading volume should be light on corrections and increase significantly on rallies (50% to 100% more)

Ch 5 ‘L’ Leader or Laggard

• Most people buy stocks they are familiar and comfortable with, like an old friend.  These will be the slowpokes rather than the leaders in the stock market.
• Buy the leading security in the industry you want to get in among the 2 or 3 best in a group
• Relative strength > 70 mean it outperformed 70% of the stocks in a comparison group over the last 6 – 12 months
  • Avg for best performing equitites between 1953 and 1993 rated 87 before major increase began.
  • Investors Business Daily has these numbers
• Look for charts in a bull flag or trading range and buy near the top of the range, but not more than 5 – 10% out of the range
  • …this doesn’t seem like a good idea
• Once a general market decline is over, the stocks that bounce back to new highs first will generally be the leaders.

• At least 3 – 10 mutual fund sponsors, corporate pension funds, insurance companies, large investment counselors, hedge funds, bank trust dept, education institutions.
• Certain mutual funds are better than others, so these will help define your quality of sponsorship
• Over owned by institutions may mean the largest moves are over

• Learn to interpret daily price and volume chart of general market averages.  You want to be on the correct side of the trend of the market, or 3 of your 4 positions will lose money.
• Market top
  • General market tops are later than individual stock tops
  • poor market rallies and rally failures in the SPX will occur
• Discount Rate
  • When it is successively raised 3 times usually marks beginning of recession, when it is lowered usually signal end of bear market
• Wait for adam eve bottom
• Stages of stock market
  • Economic indicators bottom AFTER the stock market, thus are a poor choice for stock market returns
  • Big money is in the 1st 2 years.  After this expect occasionally 8% to 15% drops
  • Railroad equipment, machinery, and other capital good industries are late moves in the business / stock market cycle
  • Bull markets begin when institutional cash positions are higher than normal and end when cash positions are lower than normal

• After each qtr focus on the relative returns of each investment in your portfolio, not the price you paid for it.
• When you buy a stock if it is down 7 – 8% from your purchase price you should cut your loss.  However dont sell your winners if they are down 7 to 8% from their highs.  You must give your winners room to run.
• Don’t avg down, don’t worry about how many potential “turkey’s” you had.  Your “red dress” has now turned into a “yellow one”.  Get rid of that “yellow dress” and go find the “red dress”
• Self confidence
  • holding losers makes you less confident.  If you cut your losses quickly and with discipline, you make the hardest decisions without wavering.
  • There are no good stocks, they are all bad – unless they go up

Ch. 10 When to sell and take your profit

• Most good investors / hedge fund managers sell on the way up.  They dont buy at the low and sell at the top
• Jesse Livermore
  • Pyramid and buy more as it goes up.  You want to make a lot of money when you’re right, and cut your loss quickly when wrong
• Revised profit plan
  • sell 20% profits (except with the most power of all stocks.  If it goes up 20% in < 8 weeks, then hold at least 8 weeks.  If it is still very strong, you will want to hold for 6 months)…Take your 8% loss
  • buy exactly at the breakout pivot buy point, do not pyramid 5% beyond the buy point
• Selling pointers
  • Buy at the right time.  This will solve half your problems
    • Buy off a proper base structure, do not chase or pyramid when the price is too extended past your buy point.  You will be able to sit through most corrections
  • Beware of big block selling.  The best stocks can have sharp selloffs for a few days or a week.  You shouldn’t get shaken out in a normal pullback
  • If the price is extended from a proper base, its price closes for a larger increase than on any previous up days, watch out! this climax is at or very close to the peak
  • Ultimate top may occur on the heaviest volume day
  • Big investors like to sell on big run ups when there is liquidity
  • new highs on low volume means there is temporarily no demand for that level and selling may soon overcome
  • after and advance, heavy volume w/o further upside price movement means distribution
  • Look for clear reversal days (low at the previous days low after an up day on several days.)
  • Sell if a stock breaks badly
  • Consider selling  a stock if it takes off for a good advance for several weeks and then completely retraces the advance
  • When qtrly eps increase slowly or decline for 2 consecutive qtrs, in most cases sell
  • Consider selling if there is no confirming strength by another important member of the same group
  • If a stock declines 8% from its peak, check if it is just a normal pullback.  If it declines 12% to 15%, you may want to sell
  • If a stock has made an extended advance, and suddenly makes its greatest 1 day drop since the beginning of the move, consider selling if confirmed by other signals
  • When you see heavy selling near the top, the next recovery will either follow through on weak volume, show poor price recovery, or last a short number of days.  Sell on the 2nd or 3rd day of the poor rally.  It will be the last good chance to sell
  • Sell a stock if it closes the end of the week below major lon term uptrend line or breaks key support on overwhelming volume
  • Number of up days vs down will change will change after stock starts down
  • Wait for 2nd confirmation of major changes to market avgs.  Don’t buy back stocks you just sold because they are cheaper
  • Learn you mistakes by plotting past trades on charts
  • Sell quickly before it becomes completely clear a stock should be sold.  Selling after an obvious support level break could be a poor decision.
  • In a few cases you should sell a the trend channel line overshoot
  • Sell when your stock makes a new high in price of it’s 3rd of 4th stage
  • Sell on new highs off a wide and loose erratic chart price formation
• When to be patient
  • Have a line on ur chart below your buy point where you must sell if price is touched.  Raise this as the prices move below the low of the 1st normal correction.  Don’t move too close because any weakness will stop you out.  If your stock increases 15% after purchase, move the sell line up to less than 5% below pivot purchase
  • Objective is to buy the best stock with the best eps at exactly the right time and hold until you’ve been proven right or wrong.  Give 13 weeks after your first purchase before you conclude that it was a faulty selection (if not stopped out first)
  • Any stock up 20% should not be allowed to drop into a loss.
  • Always pay attention to the general market.  If the markets are topping, most breakouts will fail
  • Major advances take time to complete.  Dont take profits during the 1st 8 weeks unless there is serious trouble or there is a rapid run up on a split.  If the stock shows 20% gain in 4 or 5 weeks, it is capable of a 100% to 200% move.  Only go for these long term moves after you are up for the year
  • Try to hold through the 1st correction if you already have a profit
  • Investors who can be right and sit tight are uncommon.  It takes time for a stock to make a  large gain

Ch 11 – Diversify, Invest for Long Pull, Margin, Short

• Portfolio > 3M should have 6 to 7 stocks.  Most people should have 4 to 5.
• No well run portfolio should have losses carried for more than 6 months
• Use margin after you have experience and you’re young and still working.
  • Margin should never be 100% all the time, you must carefully choose when to use margin
  • Never add cash to meet margin call.  Sell the position
• Real Estate – buy it at the right time
  • Dont buy in:
    • Area that is not growing or deteriorating
    • At inflated prices after several boom  years and just before a severe economic setback in the economy or geographic area where the real estate is (major industry layoffs or closing of a plant).
    • Mortgage is greater than the rent
    • Frequent natural disasters

• Cup and Handle
  • 7 to 65 weeks, peak to low point is 12% – 33%
  • Shouldn’t correct more than 2.5x the general market
  • Handle is 1 to 2 weeks and has a price shakeout, volume should be very low on the pullback phase of the handle
  • Should consolidate above 200dMA
  • Handles that don’t properly shakeout (10% – 15%) are prone to failure
• Pivot Point
  • Line of least resistance should be broken with volume at least 50% > normal.
  • If you try to buy before this point, the stock will never get to the buy point.  If you buy 5 – 10% after you are too late
  • Objective is to buy a the right time before the move, not the cheapest price
  • Not necessarily the old high, could be a trendline from the old high
• Double Bottoms
  • Likes when 2nd bottom is lower than 1st to get a shakeout
• Flat Base
  • Usually after a run up from cup w/ handle, saucer, or double bottom.  Moves sideways for 6 – 7 weeks and does not correct more than 10% – 15%.
• Tight Flag
  • Occurs after 100% move in a short period of time
  • Corrects sideways w/ no more than 10% – 20% decline.
  • Only occurs a couple times / year
• Overhead supply
  • After a run up and significant pullback there is now overhead supply.  When the stock moves up again, you have to be able to tell where the overhead supply is using the charts

• Investors Business Daily ‘New America’ Articles show new companies
• Find stocks in the top 80% of all performers
• Look for large volume flowing into stocks
• Review leading industries.  S&P classificiations of industries is not correct, you should use revere

• There are many more industry sub groups that are actually related than those categorized by S&P.  You should use these sub groups to find the performance rather than the industry group.
• Only pick industries of the future
• A stock’s weakness can spill over to the rest of the group, so be aware
  • especially the best stock in the sector
  • avoid buying stocks unless there is one other important stock in the same group that shows strength and attractiveness
  • this doesn’t apply to companies that are completely unique (he gives Disney as an example)
• Follow on stocks
  • If oil prices rise, oil stocks go up, but so do oil service stocks.
  • When new efficient jet aircraft took off, airline stocks did well.  So did hotel stocks.
• Cousin Theory
  • Suppliers of the main group will do well
  • Boeing sold new jet lines, and its Monogram (sold toilets for airplanes) did well
  • Fleetwood (RVs) helped Textone because it supplied vinyl clad paneling and cabinets
• Defensive stock cues
  • If you see increased buying of defensive stocks after a couple years of bull market, it may indicate a near top.
    • Gold, Silver, Tobacco, Foods, Grocery, Electric / Telephone Utilities
  • Prolonged weakness in the Utility Average could also forecast increasing interest rates and bear market ahead
  • Look at $spx, $util, $tran in stock charts
• Stocks require a wall of worry, doubt, and disbelief to climb
  • Generally masses are wrong, so are investment managers
  • Stock market is about 8 to 9 months ahead of economic indicators
  • Fed, Tax Policy, and Interest rates are most important

• Most investors do not use a good selection criteria
• Miserable results will follow buying on the way down in price
  • Even Worse is to avg down your buying than average up
• Low priced stocks (< $10)are low because they are inferior in the past or something wrong happened recently
• 1st time speculators want to make a killing too fast without doing the necessary study and preparation
• Don’t buy on tips, rumors, stories, or advisory service recommendations.  People are willing to risk their money on what someone else says instead of knowing for sure what they are doing themselves.
• Investors buy 2nd rate stocks because of dividends or low P/E ratios.  Dividends are not as important as EPS.  Low P/E is most likely because it is inferior
• People buy company names they are familiar with.  Many of the best stocks will be newer names you won’t know well but could and should know if you do a little studying / research
• Most people don’t know anything about the market, so their advice is probably worthless
• 98% of people are afraid to buy a stock that is beginning to go into new high ground, pricewise.  It just seems too high to them.
• The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable.  They could get out cheaply, but being emotionally involved and human, they keep waiting hoping until their loss gets much bigger and costs them dearly.
• Investors take profits too easily and hold their losers, they exact opposite of correct investment procedure
• Investors worry too much about taxes and commissions.  Key objective is to make a profit.
• Dont focus on short term options.  Don’t sell naked options.  Focus on longer-term options
• Just use market orders, you are going for large gains not 1/8 and 1/4 of a point
• Most investors who are unable to buy or sell have no plan because they do not know what they are doing.  You need a plan, a set of principles
• Most investors cannot look at stocks objectively.  They have favorites, are always hoping, have personal opinions rather than paying attention to the opinion of the marketplace
• Investors are influenced by things that are not crucial – splits, increased dividends, news announcements, advisory recommendations

• preparing for the market day
  • The closing bell signifies the start preparation for the next day.  Adjust watchlists, add / remove opportunities, review your trading day with complete honesty
  • Review economic calendar for important economic reports.  Exercise great caution on fridays that release unemployment report
  • Avoid information overload
• Support / Resistance
  • Can be a price that cannot be crossed, or elasticity that can be stretched but not broken.
  • Swing traders earn their livelihoods as they find and execute setups along S/R lines
  • cup and handle, triple top / bottom breakouts
  • consider the benefit of contrary entry on classic S/R moves
  • a trend line break only means the current trend is over, most likely leading to a range bound market
• The Charting Landscape
  • Use 3D chartings (look at charts one period higher and lower than current chart to confirm)
  • Trading indicators/oscillators are only useful after identifying price / volume bars patterns.  They serve as a confirmation that your price observation was correct.  If the oscillator does not confirm, then do not take the trade, unless you’re very experienced
• MA Ribbons
  • Use MA’s for intraday, and EMA for daily or higher.
  • expect choppy actions when the MA’s criss cross out of order.  Use the standard 20, 50, 200 for daily, use 5, 8, 13 SMA for 1min, 5min, and 60min charts
• Candles – Most reliable when near the outside of BB
• Chart Polarity – Identify the current environment bull, bear, neutral on every chart time frame
  • Expansion / contraction -bars tend to expand rapidly into a climax through rallies and selloffs.  then congestion sets in and volatility drops as bar ranges contract along w/ ROC.  Often an impending price move is signaled by this, and many math indicators will be in neutral zones.
    • These are high-reward, low-risk entry points and entry permits a fast stop loss
  • Short covering – Consider closing positions when the market prints a wide range bar that departs substantially from routine price action, but does not occur at a breakout point.
• Building Watchlists
  • Keep a core group of 50 to 100 stocks, and follow them on a tick by tick basis.  Also review their charts on a nightly basis.  Put them in different groups.  If this is too big, cut it down to 20 to 30.
  • Out of the 2000 liquid, moderately priced stocks, use a scan to filter your trade setups.
  • Setups that look good the day before, must also look good as the market opens.
  • Don’t trade the most liquid stocks (INTC, MSFT, DELL, CSCO) .  They’re notoriously hard to trade

• Bottoms –
  • Double bottom, but with 2nd bottom >= to current bottom.  Usually 2nd bottom will be higher than first, but will occur more slowly.  Often resistance occurs where the center top is, and price consolidates before breaking out.
  • Rounded Bottom – Wait until momentum clearly shifts toward positive.  Best used to identify break markets that wash out and gear up for a bull leg.
  • Big W pattern – double bottom, and price retraces between 62 and 38 fibs before completely retracing.   Often congestion develops once pattern has fully retraced.
  • Stop set at first bottom.
  • Very hard to time bottoms.
  • H&S bottom must be perfect – neckline must line up, shoulders must be same price, breakout must pierce known resistance(MA / gap) on high volume
• Breakouts –
  • Sharp breakout gap on heavy volume.  If not high enough volume, gap will quickly fill.  Non-gapping, high volume surges provide a comfortable  breakout floor but support is less dependable.
  • Dip Setups – Moderate strength often setup good pullback trades.  Uptrend faces considerable obstacles and should force frequent dips that mark good buying opportunities.  Identify profitable resistance zones in advance.  Look for price to shoot past the top BB and this should provide a turning point to natural support.  Enter at support.
  • Price surge on MACD / ADX, and vertical rallies erupt.  Dip setups won’t work.  Shift to a lower time frame to find small support pockets.  Volume peaks as a smooth wave of increasing volume which draws to a climax often culminating with a price spike.
• Rallies –
  • Elliot Wave Theory.  Target the 3rd wave, it is the most powerful.  Use 3D charting to find multiple overlapping waves (ideally two 3rd waves)
  • Price will reach into broad resistance and it should gap over resistance.  RSI and other strength indicators should be in the middle of their ranges
  • 4th wave corrections setup the final 5th wave.  Both aborted waves and parabolic rallies occur in this wave and brings in a sense of invulnerability.
• New Highs –
  • Let accumulation – distribution guide.  When it is lagging, price will move up in stepped ranges before surging upwards.  Other issues will go up vertically immediately on breakout if acc-dist confirms
  • Use bottoms to congestion, for the measured move after a breakout.  Low to breakout to expected move is about 1.38.
  • Use MACD histogram rising on price pull backs to enter long
  • Avoid short sales until price and momentum peak.  Picking a top is a loser’s game.  Short after momentum drops but prices stays high in a rangebound market (SPX rangebound?)
  • Parabolic moves cannot sustain themselves, slow steady rallies last longer
  • First major break of a trendline signifies end of the trend.  This just means it is possibly rangebound.  Exit positions until conditions favor rapid price gains again.
• Tops –
  • H/S patterns and double tops occur when crowds slowly lose their faith.  Volume should decrease in the 2nd shoulder, this increases odds of neckline break;
    • Stay away from ascending H&S neckline breaks, descending is fine
  • Healthy trends find support at 62% fib before continuing.  100% retracement violates the primary price direction.  Allow for whipsaws at all fib levels since they are well known.
  • Shock events can kill enthusiasm
• Reversals –
  • Descending Triangle
    • BB contract, scalpers are pushing around the stock, momentum is fading
    • Use upticks to enter short sales and counter any weak bull response.  As horizontal support fails, sell stops trigger below support and price declines rapidly
  • Double Tops – Often this is the exactly opposite of the Adam / Eve bottom pattern
    • The more violent the sell off at the first top, the more likely it is the top cannot pass the support of the last high
    • Buying interest wanes as price does not support new highs
    • Swing traders can sell short into the 2nd rise of the double top if the exit when price violates first high
    • triple tops should rarely be sold short because accumulation has built up (daily MFI 30)
• Declines
  • Volume repeatedly surges through waves of selling pressure while false bottoms print and quickly fail.  Violent covering rallies erupt to shake out poorly time short sales and offer hope to wounded longs.  Price carries past rational targets, panic builds, and then a bottom is formed.
• Price Breaks
  • All time high is different than retracing old numbers.  No built-in supply of losers exists within tha time frame.  During these momentum markets, swing traders, may need to enter near highs rather than pullbacks and manage risk without close support under positions
    • 5min and weekly pattern – tight flag a the top of an expanding price right after a breakout (reverse wedge?).   Congestion at the top of the range generates strong demand that attracts the needed greed.
  • Breakouts / breakdown attract dumb money.  Insiders initiate whipsaws after each volume surge to shake out weak hands.
• Trends –
  • Volatility, bar width, and volume all decline as a range bound market nears its conclusion.  This empty zone(EZ) allow for a low risk entry where a small move against the position signals a violation

• Got Wall Street research and a broker and tried following their tips but it didn’t work either.

• Mortgages his house to invest in a stock he thinks is going up, and it goes down about 20%.  He almost goes broke.  Then he slowly starts developing his theory.

• Stocks trending up move in trading ranges (boxes).  Once they move from one range to the next they shouldn’t fall back into the previous trading range.  If that happens you should sell.  The range he uses is based on the daily chart hi and low.  Ranges appear to be 5 – 10 day, and every stock has their own characteristics.  Time frames were not necessarily important.
• The boxes on the chart should stack up to form a pyramid in time.
• It is normal and beneficial for stocks to have swing lows because it shakes out weak hands and enables the next jump upwards.
• Lessons:
  • You will only be right about 50% of the time
  • must look at stocks w/o emotions or attachment
  • must reduce risk as much as possible
  • He would buy on breakouts with stops in the previous range
  • Look for high volume on the breakouts that hold (large % of the float)
  • Keep stop below the box (it looks like he kept it about $1 below)

• He travels around the world for his career and he can only get Barron’s weekly articles and a few stock quotes from his broker.  This teaches him that he can ignore most of what is going on and still pick decent stocks.
• He makes ‘Cause of Error’ tables that show the stock, price bought / sold and the cause of error.  These tables became one his most important tools.  He describes this like driving a car.  You may have knowledge how it works, but you need to develop a feel for how hard to press the accelerator / brakes, and what a is a safe distance to trail the preceding car.
  • Errors: bought too late, stop – loss to close, overlooked weak market conditions, bought on decline, wrong timing

• Technofundametalist view – He would select stocks based on technical action, but only buy when he could give improving earning power as the fundamental reason for doing so.
• Takes a 20 year view of industries for those whose future he could expect revolutionary new products that would sharply improve the company’s earnings.
  • At this time the industries were electronics, missiles, rocket fuels (which were very small cap stocks)
  • stocks go in and out of fashion ever couple years, just like women’s styles
  • Find stocks that would be hoisted up because they stirred people’s imaginations of the future
    • Not interested in the company’s products, and didn’t want to know in case the extra info would inhibit him.  Only care about whether the company belong to a new vigorous infant industry and whether it behaved in the market according to his requirements.
    • Watch these stocks weekly
• During this bear market he noticed that most companies who didn’t fall as much had earnings trends that pointed sharply upwards.  The capital was still following the eps improvements.  He would only look for improving earnings power or anticipation of it.
• That was the position for which I had now trained myself for five years.  My Canadian period taught me not to gamble; my fundamentalist period taught me about industry groups and their earning trends; my technical period taught me how to interpret price-action and the technical position of stocks – and now I reinforced myself by piecing them all together.

Ch 9 – My 2nd Crisis

• Gets a office on wall street at a brokerage and then loses his touch because he is too close to the quotes.  Loses 100k in 1 month from the 500k he made
• He moves to France and instructs his broker to just give him the daily quotes, and he will read his weekly financial paper to get new ideas
  • Also, my brokers must never quote any stock to me, except the ones I asked for. They must not tell me about any new stock because that would immediately come into the rumor class. I would pick new stocks myself, as I had always done, by reading my weekly financial paper. When I saw one that interested me and seemed to be preparing for a rise, I would ask for quotations. I would only ask for one new quotation at a time. Then, as I did before, I would study it carefully before deciding if it was worth going into.
  • After a month he starts to get his ‘feel’ for the market back

• If pre-select investment areas that put you ahead of the game before you start, the most important work is already done.  You’ll be picking and choosing from an already outstanding menu, and your choices are less likely to result in indigestion
• Spinoffs:
  • Stocks of spinoff companies, and shares of the parent companies significantly and consistently outperform market averages
  • Spinoffs in SP500 companies often will be subject to a huge amount of indiscriminate selling because the funds that own the new companies are too large to be concerned with the new smaller company
  • The largest stock gains occurred in the 2nd year after the spinoff
  • Reasons to own a spinoff:
  1. Institutions don’t want it (and the reasons don’t involve investment merits)
     • Host Mariott would be spun off with huge debt and unpopular real-estate assets(hotel market was terrible at the time).  Because the situation looked terrible, most people would be discouraged from additional research on the new stock
     • Host Mariott would be 15% of the 2B market cap of its parent company, which would make it too small for most of the original shareholders to want to own
  2. Insiders want it
     • Are the managers of the new spinoff incentivized along the same lines as shareholders
     • Will they receive a large part of their potential compensation in stock, restricted stock, or options?  Is there a plan for them to acquire more?  When all public documents have been filed, look in this area first
     • Host Mariott new CEO would be Stephen Bollenbach, who was the architect of the spinoff and had successfully helped Donald Trump turn around his failng hotel / gambling businesses
  3. A previously Hidden investment opportunity is created or revealed
     • Typically a great business or statistically cheap stock is uncovered as a result of of the spinoff.  In the Host case, tremendous leverage was the result.
     • The tremendous leverage would magnify returns on equity if it turned out to be more attractive than it initially appeared.
• • Digging for research involves reading multi-hundred page corporate documents and mountains of SEC filings, like Form 10
    1. Identify where you think you will find opportunity in the documents
    2. After you’ve identified a spot that has opportunity, then start digging
    3. It takes between 6 – 9 months after the initial disclosure of a spinoff to occur.  In the Host case it took over 1 year
  • • Form 10
      • Look through table of contents to identify areas you actually want to review
      • Pro forma statements – show what the company would be making if it was a separate entity
      • Economic interests of insiders
      • ‘Business of the company’ – Strattec 10F ‘based upon current product commitments, the company believes ford will become its second-largest customer during fiscal 1996’  The companies statements did not include any business related to Ford.  Since the current 2nd largest customer did about 16% of business, Ford would be responsible for about 16% more.
  • A spinoff that involves a parent company divesting a highly regulated industry may provide a prelude to a takeover because it makes the target a more attractive takeover
• Partial Spinoff
  • Only sell a partial amount of a division
    • If shares are distributed to current parent company shareholders, it is generally better than an public offering
    • By knowing the parent company market cap, and after the spinoff is complete, the child company market cap, you can figure out what the rest of the businesses in the parent company are worth
  • After analyzing the parent company there may be opportunities to purchase the existing business cheaply.
    • Sears needed to spinoff AllState and Dean Witter.  After their spinoff, Sears $27B in sales was worth only $1.5B in market cap
• Right’s offering
  • Gives you the right to buy shares in a newly spun off company, usually when the parent company needs additional capital
  • Look for oversubscription privileges and the motives of the insiders

Ch. 5 – Bankruptcy

• Common stock is almost always a terrible investment in bankrupt companies
• Bonds
  • All types of bonds
  • Bank Debt
  • Trade claims – claims from the companies suppliers who didn’t get paid for goods, materials, or services provided before the bankruptcy
  • Typically these holders get securities in the new company after it emerges from bankruptcy, bonds or common stock
• The opportunity comes from analyzing the new common stock by reading the disclosure statement.  This filing is made with the bankruptcy court and can be obtained directly from the company or SEC filing ‘registration statement’.  Disclosure statement is better because it provides management’s future projections and past complications.
  • A study showed that these new distributed stocks outperformed the market by 20% during the 1st 200 days of trading.  However, it was the stocks with the lowest market value that performed the best
  • Only buy good businesses – strong market niche, brand name, franchise or industry position
  • Buy companies that were overleveraged due to a takeover or LBO
    • Product liability lawsuits from a discontinued or isolated product line
  • Slumming – cheap compared to similar companies because analyst dont’ cover it, nobody knows about it, or bad stigma
    • Ex: Charter Medical still pretty leveraged after bankruptcy but management were trying new things to make up for lost revenue.  It ended up working and stock tripled, but then didn’t go any higher.
• Knowing when to sell:
  • Trade the bad ones, invest in the good ones.
  • If you bought because of a corporate event, once it is widely known, it is time to sell.
  • If the business is still difficult, but lots of analysts start speaking positively of the stock, sell it.
• Corporate Restructuring: Selling or shutting an entire division that is materially relevant to the entire company
  • Companies close or sell major division to stanch losses, pay off debt, or focus on more promising business lines
  • Often times, the division being sold was masking the company’s other businesses.
  • Two ways to profit, 1. after it is announced, often there is time to see what will happen.  2. Finding a company ripe for restructering

• Recapitalization
  • company repurchases a large portion of common stock in exchange for cash and/or securities
  • The left over stock is called a stub stock and many have returned 5x to 10x
  • Ex: $36 dollar stock, company recaps by giving $30 in bonds to common stock holders that carry 10% interest.  Earnings before were $3.  Pre-tax earnings were $5.  After recap, earnings are still $5, but $3 is paid out as interest.  Remaining $2 is taxed at 40% = .80c and remaining $1.20 is distributed to shareholders.  Stock was trading at P/E of 12 pre recap, and will trade at about 8 after.
    • Assumed growth of 20% before recap.  Growth of 20% in eps = $6.  EPS = $1.80 * P/E 8 = $14 from about $9.60
  • Recaps rarely happen now, they were more popular in the 80s.  However, you can emulate the leverage by buying LEAPS and warrants
• Options market tends to be undervalued during these special situation events.
  • During a spinoff, a call option can be split into 1 share of each of the two companies.  Since after a spinoff shares generally rise, this is not always taken into account with options models.

• Look in the WSJ, IBD, Outsanding Investors Digest(LEAPS candidates), Turnaround LEtter(orphan stocks from bankruptcy and restructuring stocks), value oriented funds (look up their picks that are related to special situations)
• SEC filings for the most interesting stocks from above: 10K, 10Q, Schedule 14A (executive stock ownership, sock options, overall compensation)
  • Extraordinary Events filings:
    • 8K – acquisition, asset sale, bankruptcy or change in control
    • S1, S2, S3, S4 – S1 -> S3 are registration statements for companies issuing new securities, S4 is for securities being distributed through merger or bother business combinations, exchange offer, recapitalization, or restructuring.  S4 sometimes combined w/ a proxy statement where shareholder vote is required
  • Form 10 – spinoff distribution
  • Form 13D – owner of 5% or more must disclose holdings and their intentions regarding the stake is for investment purposes.  If the purpose is for exerting control or influence, this filing may be a sign of an extraordinary corporate change
    • 13G is if institutional holder only is holding for investment purposes
  • Schedule 14D-1 – tender offer statement.  provides useful background info on a proposed acquisition.  You can get these from the information agent listed on the ad announcing the offer.
  • Schedule 13E-3, 13E-4 -E-3 is a going private transaction, E-4 is the tender offer statement when a company is buying back its own shares and disclosures are more extensive than usual, so read these carefully.