THE TRADING BOOK

McGraw-Hill

Contents

Chapter One

"You cannot step twice into the same rivers; for other waters are ever flowing onto you." —HERACLITUS

As long as we keep conscious of the fact that the markets are a living enterprise, run by fickle, changeable beings, we'll grip the notion that they are never the same place twice. As Mark Twain once said, "History does not repeat itself, it merely rhymes." The same is true of markets. The general "introduction to the markets" chapter normally describes the basic structure of the markets with equities, futures, forex, or some other trading instrument. Although that is important, and the structures are a good thing to understand, I will leave that to other authors. The nature of this work suggests we take an alternate view of the market at the outset in the not-so-typical way—not the overview of the forest, but a look through the trees while keeping very aware of the fact that we are in a forest.

This view is even more unusual when we consider that our approach to trading will be largely technical in nature. Our ability to grasp this view, however, will assist us in observing the market as an entity, not just an amalgam of technical pieces, and that, in turn, will transform you into a trader who thinks on a grand and, at the same time, granular scale.

By accepting that the market is an entity in constant flux, we cannot approach trading in a cookie-cutter manner, no matter how much we would like to. Instead, to trade at maximum efficiency, we must set that cookie cutter aside to make real tracks toward our end goal of superior, consistent returns. The same actions will not always be required in response to occurrences of the same type all the time. Did the full impact of that sentence seep through? The markets are never exactly in the same place twice, and each time we witness a technical event, the meaning of that event may not be the same as the last time we saw it. The markets require that we remain in a thinking and analytic state in order to perform well within it.

Here's what I mean: if the general rule is "short below the moving average break or crossover," that might not be the specific action you need to implement due to another extraneous event also unfolding. The day is never as simple as the "if-then" statement. If you are looking for that kind of road map in trading, your search will be exhausting, never ending, and oh, by the way, an exercise in futility. It is never as simple as "tell me when to buy and sell." Trading well means we are always discerning and appraising. We will need the power of discretionary thought to move through our trades. Only then will we achieve excellence in performance. This notion unnerves many newer traders because we all realize that there are things we don't know. The problem is that we just don't know that we don't know these things until we realize we didn't know them in the first place, and that comes only after we know them, no? By then, the market has usually charged us dearly for the access to the knowledge. Right? Yes, the road most traveled, indeed. So how do we navigate the markets as a technician? In order to answer that question, we must ask ourselves the following question.

WHAT IS TECHNICAL TRADING?

Technical trading uses charting methods and analyses to determine market movement. Completely different to fundamental analysis, all technical analysis uses are the formations that the charts develop as the stocks move through particular price points. It is a method that assumes there is a way to discover patterns that accurately predict future events based on prior market formations. Technical trading attempts to identify areas of entry and exit that skew our chances of being correct to greater than a coin toss (fifty-fifty). The use of technical indicators does not imply causality; that is, one event does not cause the other. Instead, we approach the technicals in the framework that they have a likelihood of appearing together. This can also be called probability bias.

In case the following thought has not occurred prior to this moment, we actually use probability bias in every aspect of our lives. Some of the most common events utilize the bias, such as knowing that if you see the mailman driving down the street, it is likely that your mailbox will have something in it shortly. Will it happen every single time? Maybe not, but it sure does happen a lot. Does our mailman cause us to have mail? No, he does not. What causes us to have mail is the person or persons who mailed us. He just happened to be the conduit of transport. What about the caller ID on our phone showing the chattiest friend we have calling? We are quite aware that if we answer it, it is most likely that we'll be on the phone for a while. Will our friend talk ad nauseam every time? Perhaps, and perhaps not. Again, it is the possibility of the event that we are considering that causes us to contemplate a decision. So it is with technical trading.

We work on identifying patterns that seem to happen in clusters, and we choose to make decisions based on what we assume is highly probable of occurring. We make the choices simple, but decisions to execute and act will always be less than completely straightforward. Our ability to discern the minor shifts in the market action that might require us to take the extra step, waiting for further confirmation (another signal) before our decision to enter or exit the trade, will be the delineator between success and failure.

REALITY AND PERCEPTION

Many of us think of the market as a logical mechanism. People who are not acutely aware of markets and how they operate will argue this fact without ceasing. In fact, there are scores of intellectual economic studies that try to reassure us that Adam Smith's notion of the free hand of the market (the natural order and market laws of supply and demand will drive market efficiencies to maximum output and fairness) operates well, and hence it is sufficient for markets to function without intervention. There are also scores of other books that suggest that Keynesian economics (a theory that states that government intervention is not only favorable but highly necessary for markets to run well) is necessary for order in markets to continue.

Markets aren't really orderly though, and they are never in balance for more than an instant—if ever. The market is a giant pendulum that swings from one extreme to the other, forced there by a variety of reasons that numerous pundits pontificate (inaccurately many times) daily. If we know the market operates as a giant swing, then as traders we must work at being keenly aware of the direction of the oscillations and signals that accompany tipping points, which often lead to reversal. There are no markets that operate efficiently on a consistent basis; instead, the ebb and flow caused by sentiment shift, panic, euphoria, greed, and disbelief drives us through the peaks and valleys. If we can firmly cement this simple concept, we will avoid one of the worst mistakes an inexperienced trader will make: trading what we think and not what we see.

Sometimes It Is Best Not to Trade What You Think

Sounds like an oxymoron, doesn't it? Yes, this statement does need some qualifiers, so here they are. First, if we think something seems logical, we need to wait for the market to prove us out before we go "all in on margin" because we are sure of what the market will do next. Second, simply because something makes sense doesn't mean the market will respond in the way we think it will or at the time we think it will. Here's an example: Every Thursday, initial jobless claims are reported at 8:30 A.M. Let's say we've been watching the news, and we've seen long lines at the unemployment office on television, or we've been talking to people all over who reveal the same information: the job market is soft. So we know that the number is going to be bad, and when the number is bad, the market usually takes a dip.

So the night before, stepping in front of the trade, we decide we are going to take a short position to capitalize on the market dip—we load up on the SDS, or go short SPY, or short ES_F (the e-mini futures), or simply go long the SPX puts before the close of the day. We are very keen and excited about trading this piece of news giving us the "edge" and the jump on catching the dip.

Thursday morning, as we suspect, the numbers are dreadful, but amazingly, the market moves upward (does this story sound familiar to anyone?). Why? We were correct in our anticipation of the poor numbers release. Did we look to see what the projected number was going to be? Did we notice if the market was pulling back days before and thus pricing the number in? These are market nuances that the new retail trader spends little time reviewing and, because of it, she ends up on the wrong side of the trade. One of many news flashes: trading the news can be hit or miss, and, mostly, it is miss.

So why is it that we don't need to trade what seems logical? Because we are not privy to all the moving parts often, and making decisions with a lack of proper information leads to poor choices in the trading realm. Now, as we develop skill, market knowledge, and understanding of basic market rhythms, what seems logical will come closer to what we expect, but no matter how much we think we understand, it is always the best discretion to let the market show us where it is going and just simply follow (this would be prudent), rather than predict where the market is going and place a position (this would be gambling).

Markets Are Not for Gambling

As I try to introduce people to the mechanics of technical trading, I am often hit with the statement "you're just gambling," or "it's just gambling, trading in the market." Many people think of and approach the market as a large casino. We come in with five thousand and expect to leave with a million at the end of the month. OK, I'm exaggerating—we expect to leave with, say, ten thousand. (Realize that we expose ourselves to this same "gambling" element if we opt to participate in a 401(k), or anything that uses our liquid capital to multiply itself.)

In my experience, many traders from the retail side who come into trading fall into it—they lose their primary source of income and decide that they will trade their 401(k) to generate copious amounts of cash and quickly move to basking in the Tahitian sunshine. Or they enter with a small account, lured by the promise of extraordinary success (usually through outrageous advertising), and trade with completely unrealistic expectations and, by default, an extremely high level of risk.

It is highly likely that if we entered the market as an average retail trader, our hopes were most likely unrealistic due to a large gap in our knowledge of how and when markets move, and why. Also possible is that we don't understand just how much risk it takes to magnify our accounts to such extremes. So many traders come in expecting to make 10, 20, 50 times the returns of the greatest investors and traders of our time. Why is that? A lack of knowledge, understanding, and perspective.

Markets Take Years to Master

I'd like you to ask yourself, "What do I expect out of my performance?" I had a very inexperienced person ask me, "I have a $20K account, and I would like to replace my current income of $120,000 a year. Can you help me do that?" Let's look at that question phrased another way: "I am a novice trader with little technical skill. I have an account limited by day-trading rules that allow me only three day trades in every five trading days, and with that, I would like to generate $10K a month consistently all year—that's 50% returns a month, or 600% a year." Yeah, sure, that sounds reasonable—not!

Here's another one: "I was hoping you could teach me everything you know. I have a $2K account, and I would like to generate 1% a day. Is that feasible?" Well, if you think about the fact that there are approximately 260 trading days in a year, you're asking for 260% return, and you are unskilled and trading a very small account. Is that even a rational thought?

I'm not here to quash personal aspirations, but we all need to be reasonable in our expectations and begin to think like professionals, not amateurs. In order for us to be successful, we must come to terms with what we have at our disposal, realize our limitations, build on our weaknesses, and position ourselves to be winners. Returns of 200%–600% each year are possible, but not probable, for the average, and even above-average, trader. Returns like that carry enormous amounts of risk and usually take accounts to ruin. Some of the greatest traders and investors of our time lost sight of risk, began to gamble, and ended up destroyed and penniless. If we can agree that gains like the ones just mentioned are less than common, what can we expect from a perspective of practicality working in the market? That answer solely depends on what it is we know and how well we are able to use what we know.

WHAT DO WE ACTUALLY KNOW ABOUT THE MARKET?

What we know about the market is impossibly difficult to identify if we are novice traders. There are two types of information in the market:

1. Actionable information

2. Everything else

Certainly, I write that a bit tongue in cheek, but becoming successful is not about amassing vast quantities of information based on economic theory and general market relationships. There are a lot of brilliant, highly informed, and intelligent people in the financial space who have no trading ability whatsoever. Lots of knowledge or understanding of what are thought to be general market dynamics does not necessarily make for a good trader. Only the application of very specific knowledge at a very specific time will make for good trades. Everything else is noise.

The Importance of Filtering Noise

We filter noise every moment of our waking lives. We filter overhead music and the din of the crowd to hear our dinner guests' chatter. We lose focus of the music in our car so that we can pick up the sound of the fire engine closing ground behind us. We filter our senses by lack of attention to the sensory input. This is a necessary element of our existence, and in fact, our ability to thrive as human beings. When it comes to trading, however, we forget how important this mechanism is to our survival. We lose our ability to filter the necessary from the unnecessary. Maybe because we believe more is always better, we choose to go after as much information as possible. I am not saying this is incorrect. What I am saying is that if your answer to the question "Why am I collecting this information?" is "So that I can trade better," and you still do not trade more successfully with the accumulation of information, there is a problem to be addressed.

Filtering garbage from usable data will be one of the most difficult things we will ever have to do as a short-term swing or day trader. What does this garbage look like? Simply, it is wrapped in a package of opinion, not based purely on verifiable data; it is conjecture without evidence. If we can avoid most of this, our trading will become less clouded by what the latest "smartest guy in the room" says. Problem is, most of the things we hear on television and the radio, and much of what we read, is pure conjecture. Here's a fact: just because someone is on television and being touted doesn't make him or her right.

I have a tendency to focus a lot on the importance of focus. Focus is everything and will make or break your trading day. I've heard from several senior partners at different trading firms that they do not allow their traders to watch any news television during their trading day solely so they stay concentrated on their task at hand. With every student I have ever coached, they all begin with a lack of focus on the charts and too much focus on what they are reading, or hearing, or watching outside of the charts. Charts will tell you the outcome of any truth before any average person will. Granted, there are those few in the market who seem to have outstanding fundamentals calls. They get in front of the trade and are right, but even they are looking at charts, though not the ones we, day traders, concentrate on.

(Continues...)

Excerpted from THE TRADING BOOKby ANNE-MARIE BAIYND Copyright © 2011 by Anne-Marie Baiynd. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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