A successful trader is like a fish swimming upstream, against the current. Commissions, slippage, and expenses keep pushing you back. You must make enough money to overshoot these three barriers before
making a dime. There is no shame in deciding trading is too hard and walking away, just as there is no shame in being unable to dance or play the piano. Many beginners jump in without thinking and get financially and emotionally hurt. It is a great game, but if you leave, better do it early.
If you decide to trade, read on, because in the following sections we will look into psychology, trading tactics, and money management. But first, we must talk about the practical aspects of trading—how to open an account, choose a computer, and start collecting data.

Size Matters

Size Matters

Making or losing money in the market depends in part on how much you put into your account. Two people can take identical trades, but one will grow equity, while the other will bust out. How could this be if they buy and sell the same quantity of the same stock at the same time? Suppose we meet and decide to pass an hour tossing a coin, playing heads-or-tails—heads you win, tails you lose. Each of us will bring $5 to the game and bet 25 cents on each flip. As long as we use a fair coin, by the end of the hour we will be about even, each with about $5.
What happens if we play the same game and use the same coin, only now you start with $5, while I bring only $1? You’ll probably end up taking my money. You are likely to win because your capital provides greater staying power. It would take a string of 20 losses to bankrupt you, while for me a string of just 4 losses would be fatal. Four losses in a row are much more likely than 20. The trouble with a small account is that it has no reserves to survive even a short run of losing trades. Winning trades are always interlaced with losers, and a short losing streak wipes out small traders. Most beginners start out with too little money. There is plenty of noise in the markets—random moves that defy trading systems. A small trader who runs into a noisy period has no safety cushion. His longterm analysis may be brilliant, but the market will do him in, because he does not have the staying power to ride out a losing streak.
Back in 1980, as a greenhorn amateur, I walked into a Chase bank around the corner and drew a $5,000 cash advance against my credit card. I needed that princely sum to meet a margin call in my depleted trading account. A beady-eyed cashier called the manager, who demanded my thumbprint on the receipt. The transaction felt dirty, but I got the money—which I proceeded to lose within a few months. My system was correct, but the market noise was killing me. It wasn’t until I got my trading account into a comfortable high five figures that I started making money. I wish someone had explained the concept of size to me in those days. Trading a small account is like flying an airplane at treetop level. You have no room to maneuver, no time to think. The slightest slip of attention, a piece of bad luck, a freaky branch sticking out into the air—you crash and burn. The higher you fly, the more time you have to find your way out of trouble. Flying at a low altitude is tough enough for experts, but deadly for beginners. A trader needs to gain altitude, get more equity, and buy some space for maneuvers. A person with a large account who bets a small fraction on any given trade can stay calm. A person with a small account grows tense knowing that any single trade can either boost or damage his account. As the stress rises, the capacity to reason goes down. I saw the best example of how money can twist a player’s mind while teaching my oldest daughter to play backgammon. She was about eight at the time but very determined and bright. After a few months of practice she began beating me. Then I suggested we play for money—a penny a point, which in our scoring meant a maximum of 32 cents per game. She kept beating me, and I kept raising the stakes. By the time we reached 10 cents a point she started losing and soon gave back every last penny. Why could she beat me playing for little or no money but lost when the stakes increased? Because for me $3.20 was pocket change, but for the kid it was real money. Thinking about it made her a little more tense and she played slightly below her peak level—enough to fall behind. A trader with a small account is so preoccupied with money that it impairs his ability to think, play, and win.
Other beginners bring too much money to the game, and that is not good either. A beginner with too much capital goes chasing after too many rabbits, becomes careless, loses track of his positions, and ends up losing money. How much should you have in your trading account when you start? Remember, we are talking about trading capital. It doesn’t include your savings, long-term investments, retirement funds, house equity, or Christmas club. We only count the money that you want to spin in the markets, aiming to achieve a higher rate of return than you can get from Treasury bills.
Do not even dream of starting with less than $20,000. That is the barest minimum, but $50,000 provides a much safer flying altitude. It allows you to diversify and practice sensible money management. At the same time, I do not suggest starting with more than $100,000. Too much money in a trading account makes a beginner lose focus and leads to sloppy trading. Professionals can use a lot more, but beginners should stay below $100,000 while learning to trade. Learn to fly a single-engine plane before moving up to a twin-engine model. A successful trader needs to get into the habit of being careful with money. Beginners sometimes ask me what to do if they have only $10,000 or $5,000. I urge them to study the markets and paper-trade, while getting a second job to accumulate capital. Start trading with a decentsized account. You’re going into battle, your capital is your sword, and you need a weapon that’s long enough to give you a chance in combat with well-armed opponents.


Hardware and Software

Computer

Thinking about my first purchases of trading technology is pure nostalgia. I walked into a drugstore in Florida and bought a pocket calculator. A year later I acquired a programmable calculator with a tiny engine that pulled magnetic memory cards through its slot. Then I bought my first computer. It had two floppy drives—one for the program, the other for the data diskette. I upgraded it from 48K to 64K RAM (that’s kilobytes, not megabytes!), and it was a rocket. My first modem collected data at a brisk 300 baud, later upgraded to a sizzling 1,200. When hard drives became available, I bought myself a 10-MB unit (they also had a 20-MB model, but who needed such a monster?). There was only one good program for technical analysis, and it cost $1,900. Today, I can buy a hundred times more powerful software for a tenth of that price.
Does every trader need a computer? My friend Lou Taylor did all his research on scraps of paper. I used to offer him computers, but to no avail. Most traders, including myself, would be lost without a computer. It expands our reach and speeds up research. Just keep in mind that computers do not guarantee profits. Technology helps, but does not guarantee victory. A poor driver will crash the best car. To become a computerized trader, you must choose a computer, trading software, and a source of data. Trading programs tend to be undemanding and run well on older, slower machines. A good program for technical analysis must download the data, plot daily, weekly, and possibly intraday charts, and offer a multitude of indicators. A good program should allow you to add your own indicators to the system and let you scan lists of securities according to your parameters.
The list of programs for traders keeps growing, so that by the time you read this book any review will be out of date. My company keeps updating our brief software guide, which we send out as a public service. To request a current copy, please contact us at the address that appears in the back of this book. A striking development in recent years is the wealth of resources for traders available on the Internet. Today you can analyze markets without buying any software—just go to a website, key in your stocks or futures, select the indicators, and click your mouse. Some websites are free, while others are subscription-based. With all those websites, why buy technical analysis software? For the same reason that in a city like New York, with its good public transportation system, some of us own cars. Clients often ask me how to add some new indicator to their favorite website. When you travel by bus, you cannot ask the driver to take your favorite route.
Can you program your own indicator into a website and scan charts with it, posting green dots for buy signals and red dots for sell signals? When you find a website that can do it, you may no longer need software. Until that time, those of us who are serious about research will continue to buy technical analysis software. You can get a top-notch program for a few hundred dollars. A historical database with a year’s worth of updates will cost a couple of hundred more. If you have a tiny account, however, use free websites. Always try to push your expenses down to the smallest possible percentage of your account.


Data

Chart Data

Signing up with a data service appears simple, but raises several questions that go to the heart of trading. How many markets should you follow? How far back should you go in your research? Do you need real-time data? Answering these questions takes you deep into the trading enterprise and forces you to review your decision-making process. How Many Markets Should You Follow? Beginners make the common mistake of trying to follow too many markets at once. Some look for software to scan thousands of stocks and quickly bog down. Serious beginners should pick no more than two or three dozen stocks and track them day in and day out. You need to get to know them, develop a feel for how they move. Do you know when your companies release their earnings? Do you know their highest and lowest prices for the past year? The more you know about a stock, the more confidence you have and the fewer surprises can jump out at you.
Many professionals focus on just a few stocks, or even on a single one. Which stocks should you track? Begin by choosing two or three currently hot industries. Technology, Internet, telecommunications, and biotechnology industries are in the forefront of the market at the time of this writing, but the list is likely to change. It always does. Pick half a dozen leading stocks in each of those industries and follow them daily. That’s where you’ll find the highest volumes, the steadiest trends, the crispest reversals. Several months later, after you get to know your stocks and make some money, you may be ready to add another industry group and pick its top six stocks. Remember, the depth of your research is much more important than its breadth. You can make more money from a handful of familiar stocks.
The choice is easier for futures traders—there are only about three dozen futures, in six or seven groups. Beginners should stay away from the most volatile markets. Take grains, for instance. You should analyze corn, wheat, and soybeans, but trade only corn because it tends to be the slowest and quietest of the group. Learn to ride a bicycle with training wheels before starting to race. When it comes to tropicals, analyze all, but trade only sugar—a big, liquid, and reasonably volatile market, leaving aside coffee and cocoa, which can move as fast as the S&P. Needless to say, a beginner has no business with stock index futures, whose nickname on the floor is “rockets.” You may graduate to them in a couple of years, but at this stage, if you have an opinion on the stock market, trade SPDRs or QQQs, exchange-traded market indexes.
How Far Back Should You Go in Your Research? A daily chart on a computer screen will comfortably show five or six months of history. You’ll see less with candlesticks, which take up more space. Daily charts alone aren’t enough, and you need weekly charts with at least two years worth of history. Learning history prepares you for the future, and it could be helpful to glance at a 10-year chart and see whether that market is high or low in the long-term scheme of things.
Charts spanning 20 or more years are especially useful for futures traders. Futures, unlike stocks, have natural floors and ceilings. Those levels are not rigid, but before you buy or sell, try to find out whether you’re closer to the floor or the ceiling. The floor price of futures is their cost of production. When a market falls below that level, producers start quitting, supply falls, and prices rise. If there is a glut of sugar and its price on the world markets falls below what it costs to grow the stuff, major producers are going to start shutting down their operations. There are exceptions, such as when a desperately poor country sells commodities on the world markets to earn hard currency, while paying domestic workers with devalued local money. The price can dip below the cost of production, but it cannot stay there for long. The ceiling for most commodities is the cost of substitution. One commodity can replace another if the price is right. For example, with a rise in the price of corn, a major animal feed, it may be cheaper to feed animals wheat. As more farmers switch and reduce corn purchases, they take away the fuel that raised corn prices. A market in the grip of hysteria may briefly rise above its ceiling, but cannot stay there for long. Its return to the normal range provides profit opportunities for savvy traders. Learning from history can help you keep calm when others are losing their heads.
Futures contracts expire every few months, making long-term charts difficult to analyze. When it comes to dailies, we look at the currently active month, but what about the weeklies? Here we have to use continuous contracts, mathematical devices that splice several contract months. It pays to download two data series—the currently active contract, going back about six months, and the continuous contract going back at least two years. Analyze weekly charts using continuous data, and switch to the front month to study daily charts.
Do You Need Real-Time Data? Real-time data flows to your screen tick by tick, as prices change in the markets. A live screen is one of the most captivating sights on Earth, right up there with nude co-ed volleyball or a chain collision on an expressway. Watching your stock dance in front of your face can help you find the best spots for buying and selling—or make you forget reality and swim in adrenaline. Will live data improve your trading? The answer is “yes” for a few, “maybe” for some, and “no” for most. Having a live screen on your desk, says a trader friend, is like sitting in front of a one-armed bandit.
You invariably end up feeding it quarters. Trading with live charts looks deceptively easy, while in fact it is one of the fastest games on the planet. Buy at 10:05 A.M., watch the price rise a few ticks, and take a couple of hundred dollars off the table by 10:15. Repeat several times a day, and go home at 4 with thousands of dollars and no open positions. Sleep like a baby and return in the morning. Trouble is, you need perfect reflexes to do that. If you pause to think, delay taking a profit, or quibble accepting a loss, you’re dead. Most successful day-traders are men in their early 20s. I’ve met very few successful day-traders over 30. There are exceptions, of course—a friend in her 70s is a fantastic day-trader, but she is an exception who confirms the rule. This game requires lightning-fast reflexes, as well as a certain thoughtless capacity to jump, that few of us preserve past the age of 30.
Beginners do not need live data because they have to put all their attention into learning to trade with daily and weekly charts. Once you start pulling money out of the markets, it might be a good idea to apply your new skills to intraday charts. When longer-term charts give you a buy or a sell signal, use live data not to day-trade but to dance into or out of positions.
Once you decide to use live data, make sure it’s real and not delayed. Most exchanges charge monthly fees for real-time data, while the Internet is full of websites offering free data, delayed by 20 minutes. That delay does not interfere with the entertainment value, but trading with it is suicidal. If you need real-time data, be sure to get the best.


ANALYSIS AND TRADING


Markets generate vast volumes of information: annual and quarterly reports, earnings estimates, corporate insiders’ reports, industry group studies, technology forecasts, weekly, daily, and intraday charts, technical indicators, trading volume, opinions in chat rooms, the neverending discussion circles on the Internet. With so much data, you soon realize your analysis can never be complete. Some traders who have lost money fall into paralysis from analysis.
They develop a quaint notion that if they analyze more data, they’ll stop losing and become winners. You can recognize them by their beautiful charts and shelves crammed with stock reports. They will show you indicator signals in the middle of any chart, but when you ask them what they will do at the right edge, they only mumble because they do not trade. Analysts are paid to be right; traders are paid to be profitable. Those are two different goals, calling for different temperaments. Institutions tend to separate traders and analysts into different departments. Private traders have no such luxury.
Analysis quickly reaches the point of diminishing returns. The goal is not to be complete but to develop a decision-making process and back it up with money management. You need to develop several analytic screens to reduce a huge volume of market information to a manageable size.


Fundamental Analysis


Fundamental analysts predict price movements on the basis of supply and demand. In stocks, they study supply and demand for company products. In futures they research supply and demand for commodities. Has a company announced a new technological breakthrough? An expansion abroad? A new strategic partnership? A new chief executive? Anything that happens to the business can influence the supply of its products and their costs. Almost everything that happens in society can influence the demand.
Fundamental analysis is hard because the importance of different factors changes with the passage of time. For example, during an economic expansion, fundamental analysts are likely to focus on growth rates, but during a recession, on the safety of dividends. A dividend may seem like a quaint relic in a go-go bull market, but when the chips are down the ultimate test of a stock is how much income it generates. A fundamental analyst must keep an eye on the crowd, as it shifts its attention from market share to technological innovation to whatever else preoccupies it at the moment. Fundamental analysts study values, but the relationship between values and prices is not direct. It’s that mile-long rubber band all over again.
The job of a fundamental analyst in the futures markets isn’t much easier. How do you read the actions of the Federal Reserve, with its great power over interest rates and the economy? How do you analyze weather reports during the critical growing seasons in the grain markets? How do you estimate carryover stocks and weather prospects in the Southern versus the Northern Hemispheres which are six months apart in their weather cycles? You can spend a lifetime learning the fundamentals, or you can look for capable people who sell their research.
Fundamental analysis is much more narrow than technical. A moving average works similarly in soybeans and IBM, on weekly, daily, and intraday charts. MACD-Histogram flashes similar messages in Treasury bonds and Intel. Should we forget about the fundamentals and concentrate on technicals? Many traders take the path of least resistance, but I think this is a mistake. Fundamental factors are very important to a long-term trader who wants to ride major trends for several months or years. If the fundamentals are bullish, we should favor the long side of the market, and if bearish, the short side. Fundamental analysis is less relevant to a short-term trader or a day-trader.
You do not have to become an expert in the fundamental analysis of every stock and commodity. There are very intelligent people who specialize in that, and they publish their research. Many of them also bang their heads against the walls, unable to understand why, if they know so much about their markets, they cannot make money trading.
If we can take our ideas from fundamental analysts but filter them through technical screens, we’ll be miles of head of those who analyze only fundamentals or technicals. Bullish fundamentals must be confirmed by rising technical indicators; otherwise they are suspect. Bearish fundamentals must be confirmed by falling technical indicators. When fundamentals and technicals are in gear, a savvy trader can have a field day.


WHERE DO I GO FROM HERE? The main book on the fundamental analysis of stocks is Security Analysis by Graham and Dodd. Both authors are long dead, but the book is being kept up-to-date by their disciples. If you decide to study it, make sure to get the latest edition. Warren Buffett, a student of Graham, became one of the richest men in the world. There is an easy-to-read book that explains his approach to fundamental analysis— The Buffett Way by Robert G. Hagstrom.
The best review of futures fundamentals is in The Futures Game by Teweles and Jones. This classic volume is being revised and updated every 10 years or so (be sure to get the latest edition). It has a section on the fundamentals of every futures market. Whether you trade soybeans or Swiss francs, you can quickly read up on the key factors driving that market.


Technical Analysis


Financial markets run on a two-party system—bulls and bears. Bulls push prices up, bears push them down, while charts show us their footprints. Technical analysts study charts to find where one group overpowers the other. They look for repetitive price patterns, trying to recognize uptrends or downtrends in their early stages and generate buy or sell signals. The role of technical analysis on Wall Street has changed over the years. It was very popular in the early part of the twentieth century, ushered in by Charles Dow, the founder of The Wall Street Journal and the originator of the Dow averages. Several prominent analysts, such as Roger Babson, predicted and identified the 1929 top. Then came a quarter century of exile, when institutional analysts had to hide their charts if they wanted to keep their jobs. Technical analysis has become hugely popular since the 1980s. Easy access to personal computers has put technical software within easy reach of traders.
The stock market has become increasingly short-term oriented in recent years. Gone are the days of “buy-and-hold” when people bought “good stocks” for the long run, put them away, and collected dividends. The pace of economic change is increasing, and stocks are moving faster and faster. New industries emerge, old ones sink, and many stocks have become more volatile than commodities. Technical analysis is well suited for those fast-paced changes. There are two main types of technical analysis: classical and computerized. Classical analysis is based solely on the study of charts, without using anything more complex than a pencil and ruler. Classical technicians look for uptrends and downtrends, support and resistance zones, as well as repetitive patterns, such as triangles and rectangles. It is an easy field to enter, but its main drawback is subjectivity. When a classical technician feels bullish, his ruler tends to inch up, and when he feels bearish, that ruler tends to slide down.
Modern technical analysis relies on computerized indicators whose signals are much more objective. The two main types are trendfollowing indicators and oscillators. Trend-following indicators, such as moving averages, Directional System, and MACD (moving average convergence-divergence), help identify trends. Oscillators, such as Stochastic, Force Index, and Relative Strength Index (RSI) help identify reversals. It is important to select several indicators from both groups, set their parameters, and stay with them. Amateurs often misuse technical analysis by looking for indicators that show them what they want to see. The main tool of technical analysis is neither the pencil nor the computer, but the organ that every analyst is supposed to have between his ears—the brain. Still, if two technicians are at the same level of development, the one with a computer has an advantage.
Technical analysis is partly a science and partly an art—partly objective and partly subjective. It relies on computerized methods, but it tracks crowd psychology, which can never be fully objective. The best model for technical analysis is a public opinion poll. Pollsters use scientific methods but need psychological flair to design questions and select polling techniques. Price patterns on our computer screens reveal crowd behavior. Technical analysis is applied social psychology, the craft of analyzing mass behavior for profit. Many beginners, overwhelmed by the sheer volume of data, fall into the trap of automatic trading systems. Their vendors claim to have backtested the best technical tools and put them together into winning systems. Whenever an excited beginner tells me he is planning to buy an automatic system, I ask him what he does for a living and what would happen if I came to compete with him after buying an automatic decision-making system in his field. People want to believe in magic, and if that magic can also save them from working and thinking, they gladly pay good money for it.
Successful trading is based on the 3 M’s—Mind, Method, Money. Technical analysis, no matter how clever, is responsible for only onethird of your success. You also need to have sound trading psychology and proper money management, as you’ll see later in this book.



WHERE DO I GO FROM HERE? Technical Analysis of Stock Trends by Edwards and Magee, written in the first half of the twentieth century, is considered the definitive book on classical charting. Get any edition after 1955, because that was the last major revision of the book. Technical Analysis of the Financial Markets by John Murphy offers the most thorough review of modern as well as classical technical analysis.


When to Buy and Sell


The secret of trading is that there is no secret. There is no magic password to profits. Beginners keep looking for a gimmick, and plenty of crafty vendors sell them. In truth, trading is about work—and a bit of flair. It is no different from any other field of human endeavor. Whether you do surgery, teach calculus, or fly an airplane, it all boils down to knowing the rules, having the discipline, putting in the work, and having a bit of flair. An intelligent trader pays attention to fundamentals. He is aware of the key forces in the economy. He spends most of his analytic time on technical analysis, working to identify trends and reversals. Later in this book we will review key technical tools and put together a trading plan.
Markets keep changing, and flexibility is the name of the game. A brilliant programmer told me recently that he kept losing money but whoever was buying off of his stops must have been profitable because his stops kept nailing the bottoms of declines. I asked why he didn’t start placing his buy orders where he now placed stops. He wouldn’t do it because he was too rigid, and for him buy orders were buy orders and stops were stops. A high level of education can be a handicap in trading. Brian Monieson, a noted Chicago trader, once said in an interview, “I have a Ph.D. in mathematics and a background in cybernetics, but I was able to overcome those disadvantages and make money.”
Many professional people are preoccupied with being right. Engineers believe that everything can be calculated, and doctors believe that if they run enough tests, they’ll come up with the right diagnosis and treatment. Curing a patient involves a lot more than precision. It is a running joke how many doctors and lawyers lose money in the markets. Why? Certainly not for lack of intelligence, but for lack of humility and flexibility.
Markets operate in an atmosphere of uncertainty. Trading signals are clear in the middle of the chart, but as you get closer to the right edge, you find yourself in what John Keegan, the great military historian, called “the fog of war.” There is no certainty, only odds. Here you have two goals—to make money and to learn. Win or lose, you have to gain knowledge from a trade in order to be a better trader tomorrow. Scan your fundamental information, read technical signals, implement your rules of money management and risk control. Now you are ready to pull the trigger. Go!

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