scienceofstatisticaltrading

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221017 News

1.  Odd Lots: How One Trader Won Big While Everyone Else Panicked on Black Monday

2.  Robots Are Winning as AI-Powered ETF Beats the Market, BofA Says 3. Growth Mindset

4. Stocks rally

5. Credit Research

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News 211017

1. Hedgefund Stars are losing their sway. 2. Family offices

3. Returns are hard to come by

4. IBM’s Rally

5. Neutralising the market

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News 20/10/17

1. SEC is looking to regulate cryptocurrencies to prevent people from losing money as they invest and the companies fold up. 2. There are lending schemes in which cryptocurrencies are being used as collateral.

3.  Poking Holes in the Market Bubble Hypothesis Long story short: Just using P/E is an incomplete metric. 4.  What Could Send Bitcoin Into the Stratosphere?

5.  Lessons From Over a Decade of Managing Money Using Quant Strategies

6.  Automation on Wall Street Is Coming Sooner Than You Think

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News Reflection 191017

1.  How to Invest At All-Time Highs Not particularly insightful. Talks about: a. Rebalancing b. Overbalancing c. Keep in cash d. Invest in momentum e. Diversifying f. Buy and hold 2.  Analysts Really, Really Want to Be Liked Talks about the implications of MiFid II. Analysts seem to be struggling to get votes for a ranking among clients who use their services. This is because as MiFid II separates the research coverage from the brokerage services, many asset management firms are likely to slash costs in their equity research department, as more firms who rely on these researches will be much more picky and selective in cost controlling when paying for these services. “A revised version of the European Union’s Markets in Financial Instruments Directive, known as MiFID, aims to root out conflicts of interest and make prices for financial services more transparent. Instead of the cost of research being buried inside trading commissions and other revenue sources, fund managers who want investment ideas will have to pay a separate fee for it. They may become more picky about how much research they subscribe to. Although the rules apply only in Europe, they’re likely to influence how global banks and money managers do business everywhere.” 3.  China’s Giant Ball of Money May Be Headed Back to Stocks Speculation. No powerful insights except what the title suggests. 4.  3 Reasons Why The 'FANG' Phenomenon Will End Badly Saying FANG is overvalued at a PE ratio of >120.

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News Reflection 181017

1. J.P. Morgan buying fintech startup WePay “The banking giant plans to roll out WePay’s technology to J.P. Morgan’s JPM, -0.22%   4 million small-business customers, said Matt Kane, CEO of Chase Merchant Services. WePay, which has roughly 200 employees, helps online marketplaces and crowdfunding websites like GoFundMe process payments.” “The growing popularity of e-commerce and mobile shopping has fueled deal making in the payments sector of late. There have been 166 deals involving payments companies in 2017 for a total of at least $29.3 billion, the most in any segment of fintech, according to investment bank Financial Technology Partners LP.” Thoughts: Fintech companies dealing with e-payment and mobile shopping seems to be on the rise, as there have been many deals totaling almost 30 billion in acquisition of payment companies.  2.  Why China Is Leading the Fintech Race “But there are actually seven tech firms in the global top 10 now — the other two are Chinese: Alibaba and Tencent. In China, everyone knows “BAT” (Baidu, the Chinese Google, along with Alibaba and Tencent). There is much less BAT buzz outside China, for two reasons.First, the Chinese government’s “great firewall” around the internet not only restricts the flow of information in China, it also helps protect Chinese firms from international competition. Second, the Chinese tech companies have tended to be rapid adopters and adapters of innovations generated elsewhere rather than breakthrough inventors themselves.” “ Rather, I am most struck by China’s massive lead (literally 50 times the U.S.) in the world of mobile payments — an area where most people expect dynamic if not revolutionary change (towards a cash-free society) the world over in the coming decade. The title of the graph below from the Financial Times says it all.” “Four hundred and sixty-nine million people made online payments in China in 2016. A larger number used phones to pay in offline retail stores. I am now used to seeing people in China paying for everything from taxis and coffee to clothes and meals with either WeChat (Weixin) Pay or Alipay (Zhifubao) — another world from the China of the early 2000s when you had to pay hotel bills with a series of 100 RMB notes.This new world was brought home to me at a breakfast I attended a few months ago in Shanghai. It was the birthday of someone at the table. To celebrate, someone wanted to send “red packets” (hongbao) to everyone at the breakfast. This is an age-old Chinese tradition — stuffing different amounts of cash into red envelopes to celebrate a special occasion, with the surprise of seeing what you got.Of course, there were no (physical) red packets on the breakfast table. Only a lot of smartphones, all with the red packets app on WeChat. Apparently, my breakfast companions were not alone. Last Chinese New Year, 14 billion digital red packets were gifted through WeChat — 10 packets for every one of the 1.4 billion people living in China.” “And then someone at the table turned the red packet into gold — by using their red packet bounty to buy gold (probably no more than .01 of an ounce), on another WeChat app. I really don’t know how the gold transaction worked, but if there is a way to trade gold on your phone in the U.S. I certainly haven’t been able to find it.Then there is the rise of quasi-banking in China — all based on the fact that people deposit money on their phones to pay for stuff. Here the leader is Alibaba’s Yu’e Bao (“leftover treasure”), a money market fund with 370 million account holders and $211 billion in assets, with 100% growth in the past year. It is now the largest money market fund in the world according to Morningstar. By contrast, J.P. Morgan Asset Management, a bank founded in 1895, is number two.” Thoughts: China is almost 50x bigger than the US in terms of contactless payments(mobile), to the point where people are sending red packets to each other via their mobile phones. That’s pretty cool. There’s also a quasi-banking in China, as people make deposits in their phones to pay for the things they buy. It is the largest money market fund in the world, with 370million account holders and $211billion in assets. 3. Risk Perception vs. Risk Profile Not particularly insightful, just few people are worried about the economy now compared to 2009, where it peaked on the number of people saying the economy is the most worrying thing.   “This is why understanding yourself is the most important part of the investment process. If you don’t understand yourself — your reactions, your personality traits, your biases, your limitations — it doesn’t matter which type of investor you’re supposed to be. It matters which type of investor you are.Some investors are constantly plagued by the fear of missing out on huge gains. Others will be haunted by the fear of being fully invested when markets take a dive. Panic selling or buying is the mistake attached to each of these fears but panicked investment decisions tend to come from a misunderstanding of the current risks rather than a change in risk profile.There’s no perfect equilibrium between your willingness, ability, and need to take risk but the goal is to balance out your future goals with your desire to sleep soundly at night. You just have to approach the investment process with the understanding that you will never be able to completely hedge out every risk, fear, or market event.This is why true risk management is about creating behaviorally aware portfolios, not fancy mathematical risk measurement techniques. The biggest risk for investors is never a black swan or even a market-moving geopolitical event. The biggest risk for investors is themselves.” Build a portfolio based on your own needs. 4.  Intel Proclaims Machine Learning Nervana “In a blog post today, Intel (NASDAQ:INTC) CEO Brian Krzanich announced the Nervana Neural Network Processor (NNP). He wrote:The Intel Nervana NNP promises to revolutionize AI computing across myriad industries. Using Intel Nervana technology, companies will be able to develop entirely new classes of AI applications that maximize the amount of data processed and enable customers to find greater insights – transforming their businesses... We have multiple generations of Intel Nervana NNP products in the pipeline that will deliver higher performance and enable new levels of scalability for AI models. This puts us on track to exceed the goal we set last year of achieving 100 times greater AI performance by 2020.The NNP is the brainchild of Nervana Systems, a startup that Intel acquired for about $400 million in 2016. At the time, Nervana had developed an open source deep learning framework called neon. From neon, Nervana developed Nervana Cloud, which was optimized to run on Nvidia (NASDAQ:NVDA) Titan X GPUs.” Nvidia is invested in AI and aims to improve it by 100x by 2020. Their acquisition, Nervana, is aiming to develop processors that promises to maximise the amount of data processed.

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News Reflections 171017

1. Small Endowments May Get to Invest in Bridgewater Associates Bridgewater associates is getting Cambridge Associates, a consultancy firm, to pool together funds from its clients in order to meet Bridgewater’s investment threshold, which is  “requires that clients have at least $7.5 billion of investable assets in order to put money into the hedge fund. Many investors pay at least $500,000 — and sometimes as much as $4 million — a year in fees to Bridgewater.” This may be due to Bridgewater trying to start a new fund, which will invest primarily in China securities. “The possible arrangement with Cambridge is part of a broader effort by Bridgewater to rake in more assets.The firm is working on a new China-focused portfolio that will invest mainly in Chinese bonds, stocks and commodities. The fund will be open only to investors who do not live in China.” Another interesting facet of this news is a. Bridgewater’s AUM -  “ Bridgewater Associates, a hedge fund firm with $160 billion in assets under management” b. Performance of Bridgewater’s main funds “Bridgewater’s two main hedge fund portfolios — Pure Alpha and All Weather — both posted big market-beating returns in 2010 and 2011. But in recent years the performances of those funds have been far more modest.This year the Pure Alpha fund is down about 2 percent, and All Weather is up more than 8 percent through the end of September. The average hedge fund, as measured by Hedge Fund Research’s broadest index, is up 5.7 percent this year.” Reflections:  Hedgefunds have only been up 5.7% this year? That’s pretty bad isn’t it. It seems that maybe Hedgefund’s are doing bad now because the stock market as a whole has been rising. Is it due to index investing? 7.5billion in order to invest. Holly molly that’s alot. I guess that’s what happens when you go institutional.  There’s something interesting going on in China if Bridgewater wants to have a China fund. 2.  China's Outlook and the Case for Quality Credit in Asia “China’s macro environment has remained supportive of capital markets, with an improvement in growth momentum in the first half of the year (beating expectations at 6.9% year-on-year). In addition, capital outflows, which placed downward pressure on the yuan last year, have slowed and foreign exchange (FX) reserves have stabilized.” China’s economy seems to be growing while the Government is trying to keep yuan’s price stable? And the article suggests that this may be due to “This year's calm was initially driven by macroprudential measures and higher money market rates.” Investors are confident about China’s future and the Asian economy has been doing well. “According to our estimates, in the first three quarters of 2017, emerging Asia has seen inflows of around U.S. $90 billion. Fixed income inflows have outweighed equity inflows by about 2 to 1.” Does this mean that more people are investing in Fixed Income from China, at a 2:1 ratio to investment in stocks? Preference for investment grade credit Local investors have led to strong performance in Asian credit, despite higher than expected issuance.  “We favor IG credit over HY in Asia given more attractive relative value opportunities and the fundamental improvement in IG. Local demand for IG credit is also more reliable, whereas the demand for HY is not as uniform and holds more idiosyncratic risk. This results in stronger technicals for IG relative to HY. Within IG in Asia, we favor the A-rated sector, which provides approximately 55 basis points (bps) in pickup over similarly rated U.S. IG. For BBB-rated credits, the spread is around 40 bps, while Asian HY trades almost flat to U.S. HY, further reducing its attractiveness.” Three key risks for China’s economic outlook a. North Korea b. U.S. Trade policies c. China’s policy errors. “Any rise in U.S. protectionism would affect export-oriented segments of Asian credit, and a geopolitical crisis on the Korean Peninsula could lead to broader contagion in the region.” Reflections: Growth a in GDP growth? What kind of growth? Ans: Yes, I think it’s  GDP growth target. What are capital outflows? Ans: Capital outflow is the movement of assets out of a country. Capital outflow is considered undesirable and results from political or economic instability. The flight of assets occurs when foreign and domestic investors sell off their holdings in a particular country because of perceived weakness in the nation's economy and the sense that better opportunities exist abroad. Effect of capital outflows on Exchange Rates? Ans: As capital exits, a nation's currency supply increases as individuals, as in the case of China, sell yuan to acquire U.S. dollars. The resultant increase in the supply of yuan decreases the value of that currency, decreasing the cost of exports and increasing the cost of imports. The subsequent depreciation of the yuan triggers inflation as export demand rises and import demand falls. What are macroprudential measures and higher money market rates? Ans:  Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole (or "systemic risk"). A large number of instruments have been proposed; however, there is no agreement about which one should play the primary role in the implementation of macroprudential policy. Most of these instruments are aimed to prevent the procyclicality of the financial system on the asset and liability sides, such as: Cap on loan-to-value ratio and loan loss provisions Cap on debt-to-income ratio The following tools serve the same purpose, but additional specific functions have been attributed to them, as noted below: Countercyclical capital requirement - to avoid excessive balance-sheet shrinkage from banks in trouble. Cap on leverage - to limit asset growth by tying banks' assets to their equity. Levy on non-core liabilities - to mitigate pricing distorsions that cause excessive asset growth. Time-varying reserve requirement - as a means to control capital flows with prudential purposes, especially for emerging economies. To prevent the accumulation of excessive short-term debt: Liquidity coverage ratio Liquidity risk charges that penalize short-term funding Capital requirement surcharges proportional to size of maturity mismatch Minimum haircut requirements on asset-backed securities In addition, different types of contingent capital instruments (e.g., "contingent convertibles" and "capital insurance") have been proposed to facilitate bank's recapitalization in a crisis event. A money market account is an interest-bearing account that typically pays a higher interest rate than a savings account. What is idiosyncratic risk?   Ans:  Idiosyncratic risk, also referred to as unsystematic risk, is the risk that is endemic to a particular asset such as a stock and not a whole investment portfolio. Being the opposite of systematic risk (the overall risk that affects all assets like fluctuations in the stock market or interest rates), Idiosyncratic risk can be mitigated through diversification in an investment portfolio. 3.  The Money-Losing Volatility Trade That Hedge Funds Can't Resist A few hedgefund managers are betting on Volatility spiking. They believe that volatility is the most mispriced asset class right now. That we should be investing in volatility because the world seems to be in turmoil and the stock market seems to be “ignoring” it. “While the funds surged 46 percent as a group during the crisis in 2008, they’ve lost 9.1 percent this year and are down 17 percent over the last five years, according to Eurekahedge Pte. The five-year drop is the second worst among 20 categories after tail risk, a supercharged cousin of long volatility that bets on extreme market swings.The past few years “have created a whole graveyard of long-volatility funds,” said David Frank, the New York-based chief executive officer of Stonehaven LLC, which helps connect investors with alternative money managers.” There are many funds attempting to start a volatility fund soon. “That should be music to the ears of hedge fund managers like Brevan Howard. The firm is expected to start a long volatility fund soon, people with knowledge of the matter said. Funds planning similar launches this year include Astrid Hill, founded by Millennium Management alumnus Arun Singhal in Singapore, and One River Asset Management, a manager of $700 million led by Eric Peters in Greenwich, Connecticut, according to Singhal and One River marketing materials obtained by Bloomberg News.” Some people are unconvinced that the true pricing of volatility is priced in. “The low volatility environment just doesn’t make sense when you step out of markets and look at the real world,” said Steve Jacobs, BTG Pactual’s London-based head of asset management.” The three biggest arguments for rising volatility is a. Trump and North Korea b. Tighter Fiscal Policy c. China’s rising debt The argument against the flipside is stable global economic growth and controlled inflation in most parts of the world. Selling options has become attractive to investors who care more about earning extra income than protect themselves against market turmoil that may never materialize.  “And in a lot of ways, that made sense: global economic growth has been stable and inflation has remained under control in most parts of the world. With bond yields hovering near historic lows, selling options (the contracts that underlie volatility gauges like the VIX Index) has become attractive for investors who care more about earning extra income than protecting themselves against market turmoil that may never materialize.”

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Primal Learning

Key Takeaways: 1. The more you reuse something, the stronger the neural pathways. We have to revise, use it or lose it. 2. Spaced Practise is more effect than massed practise. Learn more per hour if we space out our learning. This is because we need time for memory consolidation. 3. Distractions destroy productivity. 70% of working time is wasted on distractions. 4. To Improve working memory a. Meditations b. Turn off notifications c. Do important things first d. Keep a distraction log 5. We should attach personal and emotional meaning to work. 6. Break up long term goals into smaller tasks. Baby step big goals. 7. Music to listen to when working Familiar but not too familiar music. 8. Cold showers -> Increase Noradrenaline -> Increase dopamine 9. To achieve flow (Flow triggers) a. Intense focus - Single tasking b. Tough deadlines c. Clear goals - Mastery goals (long lasting) - Attach emotion for mastery - Repeat & review goals - Small chunk goals (about 3 a day) - A day without goals is a day you’re not operating at your best. d. Immediate feedback e. High challenge to skill ratio - about 4 percent outside of our comfort zones. f. High consequences - Take small social risk - Take responsibility g. Creative Trigger - Have some time to just think about the subject - Creating creates a positive feedback flow h. Music - Instrumental music is good because it does not trigger associations - Music you enjoy 10. Flow cycle Struggle - Ingrained habits will surface when you try to struggle - Believe in the process - Just start Release - Concentrate deeply - Avoid and stop all distractions - Meditations Flow - Do what you love, believe in what you’re doing Recovery - Replenish neurotransmitters - Give yourself time to let go - Have fun - Talk about what you accomplished in flow - Have human interaction - Sleep

11. Flow cycle - Embrace the struggle - Maximise flow triggers(About 3) to achieve higher chance of entering a state of flow. - Set up learning to incorporate flow - Reduce all distractions a. Phone b. Email c. Facebook - Recover with fun - Single task with all your attention 12. Optimal Learning Strategies - Create time-efficient strategies - Master skills & subjects 13. Bloom’s level of thinking Try to achieve highest level of thinking to accelerate learning. - Ask yourself questions such as what’s the purpose behind the information, how does this information fit into the process and find out the specifics of the information. - Ask yourself how you can do it better. - Try to link ideas in new ways and design, construct, produce or invent something. 14. Surround yourself with talented and knowledgeable people. 15. Begin work with complex problems to coax higher level thinking. 16. Keep learning, reading and creating. 17. Create tough deadlines to meet miniature goals to fulfil the high level, clear, mastery-based goal. 18. As more learning is done, subsequent learning is easier. 19. Optimal learning techniques -Retrieval Practise a. Practise something by retrieving it from memory. b. This is better when done with something unfamiliar. c. Forgive forgetting, as it helps us retrieve the memory in order to solidify knowledge -Distributed Practisse a. Spacing effect b. We learn better when our studies are spaced over a longer period of time. c. Point is to let time pass by so we can use retrieval practise. d. Solidifies neural pathways. -Practise Testing a. Getting quizzed on material. b. Creating own questions and answer. c. Much more effective than studying. d. Actively engage by creating questions at the end of the chapter. e. Can test yourself before chapters (Counter intuitive but causes active thinking) f. Based on e, can start with exam papers/test papers. -Interleaved Practise a. Mixing in between different elements of practise b. Mix in different types of problems from different topics. -Elaborative Interrogation a. Asking why? b. Why does this happen? c. Helps us understand better. d. The deeper your questions, the more you understand. e. Better for knowledge that has already been acquired and is not unfamiliar. -Self explaination a. Explain what you know to yourself b. Linking new & old knowledge c. Better for abstract problem solving d. What does this sentence mean to me? What is the mean idea here? What is new to me here? How would I best describe it? How does this relate to what I already know? 20. Optimal Learning experiences - Exercise (at least 3 times a week) Reduces stress Improves brain functions Literally grows our gray matter Increases creativity Exercising before breakfast most effective to burn fats - Meditations (minimum 12 minutes a day) Resisting distractions better & regain focus Taking control of stress & have good feelings instead Better at handling stress Increase amount of gray matter Improves creativity - Sleep Quality > Duration Blue light results in sleep deprivation Short naps from 40-60 produces 5x improvement in information retrieval from memory. Aim to exercise 5-6 hours before sleep

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Margin Of Safety - Seth Klarman

These Ideas and learning points are not mine, I’ve ripped them off a website: here so that I may refer back to it at another day.

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The Art of Short Selling - Kathryn F. Staley

All ideas belong to Kathryn F. Staley, and I do recommend reading them for yourself.  Some ideas represented here are from various other blogs and websites. Short sale candidates are in three categories     1. When management lies to investors and obscure events that affect earnings 2. Companies with inflated stock prices     3. Companies that will be affected in significant ways from external events Signs that a company might be a good candidate for a short     1. Accounting gimmickry     2. Insider problems: insiders using the company as a personal bank or are selling the stock     3. Company has a consumes too much cash     4. Assets are overvalued or balance is in terrible condition Three sins of short selling: sloth, pride and timing Sloth: Doing too little work is always a problem for investing -- without proper doing the proper work (spreadsheets, notes, readings) you'll lose conviction when the position runs against you and you'll inevitably take a loss. "Shorting's easy. You short a stock, watch it double, cover in panic, then wait for the inevitable bankruptcy" Pride: The pride problems comes out in two different areas (1) using formulaic analysis to short companies. An example of that would be seeing six great savings & loan shorts and shorting the seventh without deeper analysis. The real estate or economic environment might be different for the seventh bank causing your thesis to be proven wrong. (2) shorting good companies. Julian Robertson and Jim Chanos have both identified this error. This is another way of saying don't short just based on valuation. Good management is tends to fix problems, which when solved cause already overvalued stocks to shoot higher. Timing: There is no solution for this. You find a great short selling candidate only only to see it turn into a 2% annualized rate of return because you were too early. First reason for bad timing is underestimating the insanity of the public market. Horrible companies can continue to exist on the promise of great products. Drug companies tend to have this problem. The second reason for bad timing is the investment bankers ability to raise money to keep bad companies on life support. Sometimes companies end up resolving their problems before the market realizes the fatal flaw. Sometimes the macroeconomic environment changes and lifts the company out of its problems, such as a change in interest rates. Short sellers might also underestimate a company's ability to grow out of their debt load. When the business environment is good -- business might survive a surprisingly long time with a crushing debt load. Short sellers have several techniques to try to remedy the timing problem. Michael Murphy covers automatically after a 25% price run-up and waits to short again. Other managers wait until the stock cracks, after the first drop when earnings and price momentum have slowed. Joe DiMenna never shorts a stock with great relative strength.     Other small problems with short selling: 1. Don't short commodities through a stock. It is easier to short companies based on their financials than it is based on their commodity production. If you do short a company that is highly influenced by the commodity, make sure you understand the commodity cycle of that product, for example if you are a short a chicken stock make sure you understand how weather and corn feed prices will affect chickens. Sometimes you'll find companies that are growing their inventories faster than revenue, but if that is the case your thesis should be built on bad financials but not the underlying commodity of the inventories. 2. Many short sellers avoid technology stocks. Normal signs of a good short do not apply to these companies. Often inventories will rise when a new products is coming. Insiders will own and sell stock without regard to the company's condition. Margins can fluctuate based on product cycles and pricing curves. Tech stocks have infamously caused problems with short portfolios -- American Online, US Robotics and Iomega. 3. Squeezes tend to be a self-inflicted wound for short sellers when they don't recognize the importance of float. Since short sells are based on getting loans for stock, when shares are no longer available for a lend it is inevitable you'll have a buy-in. Companies who want to be aggressive toward short sellers may ask their shareholders to take theirs take their shares out of a margin account (therefore hard to borrow) and into a cash account. They could also issue cash dividends or preferred shares that could make short selling more expensive. These tactics don't work well for companies with large float but might work well for companies with a small float. The books gives examples of infamous short squeezes such as Total Systems, General Development and Chase Medical. 4. Leveraged buy-outs s can cause stocks to be bought out at ridiculous valuations. Especially be worried during a flurry of deals -- private equity groups can start paying outrageous prices. 5. Fear causes short sellers to buy back their positions after a large run up. Generally if it scares you to death to short more of a company, the better move is to short more. 6. Be able to change your outlook if the facts change. Don't stick with the same thesis if the facts change. 7. It is easy to fall in love with your own analysis if the problem is highly complex. If you spent loads of time in the analysis it is easy to say you must have an opinion on the stock, when one might not be recommended. 8. Crowded short positions are also a problem. Amateur short sellers might buy a position when one might not be recommended. 10. Last but not least, shorting a company that is going through a "hiccup", instead of shorting a company that's having it's core business being overwhelmed. When a company is growing you can hide bad accounting practices for a while. Never short a good company. Six Pillars of Fundamental Short Selling 1. The Pessimist's Guide to Financial Statements. Short sellers attempt to discover the meaning behind the numbers and what drives the business. Books to read to increase your understanding of financial statements include: Leopold Bernstein's Financial Statement Analysis, anything written by Abraham Briloff, and Thornton O'Glove's Quality of Earnings. Short sellers should research the company's last six 10Qs; the last two 10Ks, proxies and annuals, and any 8Ks.  After studying these documents a short seller might need to go back farther chronologically. The most useful part of the financials will be the footnotes. Start with the last dated balance sheet and look for assets of suspicious value: i) Securities not marked to market. ii) Inflated real estate values, iii) Obsolete inventories iv) Aggressively booked receivables v) Receivables with low loss provisions vi) Bad loans vii) Fuzzy or empty assets Accounts receivables and inventories should be tested by looking at the growth in receivables and inventories versus previous year and comparing that to the growth in sales and cost of goods. If receivable growth is substantially greater than growth in revenues, problems with earnings will be likely. Growth in inventory versus growth in cost of goods is the single most reliable sign that a manufacturer or retail company will stumble. Goodwill and other intangible costs might be signs a company has overpaid for acquisitions, failing to expense drilling costs or software development. Check footnotes for the schedule of expenses for policy manuals which might have capitalized over too long of a period. If accumulated depreciation drops when gross PP&E rises, the company might have changed average life assumption and run a reversal through in the income statement. On the liability side of the balance sheet, look for odd descriptions or uncommon types of liabilities. Be especially suspicious of liabilities approximated or the present valued with assumptions made by management. Check footnotes for and notes on financial conditions to see if the company has any off-balance-sheet liabilities, any debt guarantees, or recourse-factored receivables. Check for growth in short term and long term debt. Note all lines of revenue that appear to be nonrecurring: i) Sale of equipment, land, and real estate ii) Sale of securities iii) Interest on securities or cash equivalents iv) Tax credits v) Currency gains as a reduction in cost of goods sold vi) One-time credits from manufacturers vii) Reduction in provision for doubtful accounts viii) One-time license agreements viv) Change in account Check the assumptions the company makes to book revenue and read the notes that explaining earnings in the current period. Check for any odd sources of revenue. Readjusted earning per share for fully diluted shares. Adjusting for the fully diluted shares can be a bit tricky, add in all convertible shares if they close to conversion or likely to be converted and any options and warrants. Important Ratios Check to see if company is trying to appease the street by giving a nice trend for earnings per share growth, and if so, see if they are trying to massage the numbers. Look at capitalization: long-term debt to equity, total debt to total capital, long-term debt to capital. Compare several years of balance sheets to see the trend in these ratios. Check ROE, ROA and ROIA. ROIA (Return on invested assets) is calculated by income before interest and taxes divided by equity plus all interest-paying debt. Look for trends and volatility of returns over time. It also tells, by comparison how the company does relative to other companies in the same industry, whether the company returns more than its average and marginal cost of debt, currently and historically. Key valuation ratios are Price to Earnings, price to book, price to revenue and price to cash flow. If a takeover occurs in a similar company, these ratios calculate quick comparables. Certain ratios are better for comparison in different industries. Price to revenue is higher for retail than for manufacturing. Price to earnings reflect growth potential. Price to cash flow is a buy-out indicator. Minimum list of ratios include the following: i) Checklist of Ratios ii) Capital Structure iii) Return Ratios iv) Valuation Ratios v) Long-term debt to equity vi) Return on equity vii) Price to earnings viii) Total debt to total capital viv) Return on assets x) Price to revenues xi) Total debt to equity xii) Return on invested assets xiii) Price to operating cash flow Go to the income statement to common size the statement: put everything in percentage of revenues to see if the percentage relationships are changing. R&D or Advertising as a percentage of revenue declining? Compare anomalies to the balance sheet. If SG&A is declining as a percent, are prepaid expenses or other assets rising? Is depreciation flat while fixed assets increase? Compare pretax operating profits. What is the sequential trend, as well as the annual one? Does it make sense for the business? Look for deviations and trends. Cash Flow is King It is often difficult to determine what the necessary cost from a business point of view is.  The quickest check is to look at the "Cash Flows from Financing." See if the company is constantly going to the markets to keep afloat. Is short and long term debt escalating? Is there a stock or convertible issue every year? Find out what the companies spends to do business. This can be calculated in different ways but here is one. Net income + depreciation, amortization, deferred taxes - non-recurring items (tax-adjusted, if possible) +/- changes in current assets (without cash, but broke out by lines to see what specifics are causing the cash drain)  +/- changes in other items  perceived to be relevant (like some portions of capital expenditures). Check how cash flows and capital expenditures change year of year. Check up on any anomaly. If the company able to meet their debt repayments? Check the PIK (payment in kind), zero-coupon bonds and other odd instruments. Reading the Sleep-Inducing Verbiage Read the 10K description of the business and the competition. Try to understand the financials in relation to that business plan. Try to drive the company, what the two or three most relevant numbers are. What is the most important number to watch to identify a developing problem? If it is a low-margin business, the key is probably revenues and inventory-turnover ratios. If it's a franchisor, it might be system sales or same-store sales. Does the financial structure make sense for the business? (do not leverage a cyclical company too much, do not build inventories too high if there is potential product obsolescence.) Think About It Think of the three financial statements as a 3-D chess game, see how they interact and see what tugs and pulls on what.  Determining the key variable in the health of a company is the most complex part of analysis. If this skill could be mastered, finding great ideas in the long and short side will come easier. Read Qs and Ks from first to last to see how things change over time.  Read the annual report and see if the executives say what you saw in the 10Ks and Qs.  Watch out for near meaningless buzzwords like synergism. Look for any oddities in the annual report like pictures of babies in a defense or drilling company -- suggesting the executives are a bit clueless. Watch for auditor turnover which can truly be indicative of trouble. What was not in the financials but you did not understand? Look for the lack of: i) description of nonrecurring revenues ii) information on explicit valuation iii) procedures of odd assets iv) clear disclosure of revenue-booking procedures v) fuzzy liabilities vi) comprehensible breakout of divisions: revenues, income, assets vii) description of effect of an acquisition on inventories and receivables Determining what the relevant piece of information is the most part of analyzing a company.  What runs or ruins the business.  2. In Search for Greed and Sleaze Useful forms provided by the Securities and Exchange Commission (SEC)Form 144. Key officers of a company are required to file this form when placing a sell order of their company stock. Barron' and the Wall Street journal report some insider sales. Vickers and the Insider's Report, also publish a list. [www.dataroma.com is a good source for this material now] Form 4. Insiders of the company must file this form if purchasing or selling shares. The list needs to be published 10 days after the last day of the month in which positions are increased or decreased. 13-D When an entity purchases 5% or more of a stock, they must file with the SEC in 10 days. These publicized in the news Barron's, Vickers, and the Insider Report, as well as the proxy. Proxies: The annual meeting is the trigger for this publication. The publication tells the stockholders what they can vote on during the annual meeting. It also reveals how much stock is owned by management, what their salaries and employment contracts are (including options, bonuses, and some perks) and the stockholders who own over 5 percent. The proxy tells who the accounts are, if there are any pending lawsuits, and other relationships and related transactions are pertinent. It is a great source for information about management philosophy. Look under "certain transactions" for some possible hidden information about creative management contracts Benchmark Proxies: Pantheon of Stars or Pigs at the Trough? Watch out for companies with excessive executive compensation relative to net income. Plenty of good short candidates come from executives who pilfer the shareholder's coffers with excessive compensation, benefits or related party transactions.If you need to read a proxy three times to understand it, chances are you have hit a likely short candidate.  

Checklist of Proxy Questions 1. Lookout for exorbitant executive salaries. Look at cash compensation relative to company earnings.     2. Does the company pay out large bonuses? Why do they pay out large bonuses, was it for doing an abnormally good job or that was just a normal bonus. Is the bonus based on increased sales, return on equity, or some measure or combination of measures?       3. Does the company pay a percentage of pretax profits to the primary offers in the form of bonuses? Are executives paid a percentage of revenues? Is the bonus calculated on a quick stock price appreciation.

Stock Options     4. Stock grants, stock options and stock appreciation rights (SARs). SARs are the most generous because they guarantee cash money and are bankable immediately with no stock price appreciation necessary.     5. Does the company pay for stock options?     6. Does the company pay a bonus for taxes on options?     7. Do executives get special deals if there stock/rights offering of company or a sub's stock?     8. What percentage of the stock is owned by the primary officers? Parachutes     9. Does the company have an unusual severance pay contract, especially in case of merger or buy-out?     10. What are the terms of retirement contracts?     11. Are there extra perks such as large insurance policies, apartments, automobiles use, plane us? "Certain Transactions" 12. Does the company allow primary officers to do business with the company by owning other businesses? Does the company give those officers favorable terms in those contracts?     13. Are many of the officers related to each other?     14. Does the company deal with any relatives of the officers?     15. Does the company loan money to the officers? Does the company charge interest?     16. If the company engages with limited partnerships does it pay the officers to become general partners or limited partners? Does it grant bonuses for the participation in those partnerships? Does it give those partners the tax loss? Miscellaneous 17. Are there many lawsuits, what is the liability?     18. What is the age range of the officers? Are they all young or all old?     19. Who else owns the stock?     20. Check the board biographies? Is it a "good ol' boy" club? Is it an independent board? (Quaker Oats used to pay their board members $1,000 for each action taken by unanimous written consent) Make sure officers are getting paid for doing things before the stockholders. See what the top employee's total packages are relative to income. Check proxies over the year see how many executives have left the company. Attrition is not always free available data and requires research. 3. The Bigger Puzzle Research Review the industry -- the 10K should give you a good overview of the competitors, customers and suppliers.  Check value line and Stand & Poor's Industry Survey's for the industry fundamentals. Check trade publications and if see if any government office tracks data relevant to that industry. Services like Washington Researchers can provide comprehensive information on any topic. Read other publicly traded company's financial is a useful source of information. You can check a competitor's financials to compare margins, return on invested assets, growth rates, and inventory and receivable turns can give an analyst what is out of line and what looks different. Store Checks After you have decided what the business of the company is and what were the important/relevant metrics.  Use this information for checking out the market place. "If the key is store volume, visit a store and count customers, check average ticket size, talk to the store manager. If it is a hot new company with a to-die-for product, see if competitors have heard of the product yet. If it is an oil & change franchise, count cars at peak hours to see if franchisees are hitting break-even assumptions" Do not make conclusions on one store alone. Outliers due (possibly to do geographic area) might be an outliers on volume. Observing will give you an idea on the company's execution. 4. Who Owns It? High institutional ownership and high Wall Street coverage can make for quick collapse if something unexpected happens. Always follow short-sale numbers to tell you when a squeeze might develop so that the relative impact on a portfolio can be monitored. Watch option volume and relative pricing to note takeover speculation. Pay attention to 13Ds and 144s. 5. Check the Water Temperature Accumulate brokerage reports to provide the company-think and Wall Street's attitude. Brokerage reports can provide pertinent industry data. Often companies will send brokerage reports if you ask. Brokerage reports sent from the company bound to be positive. "As you read Wall Street reports, remember the job description of analysts: They are not paid to make waves or disagree or to be on the cutting edge of stock analysis. Analysts are relative: They are supposed to do a little better than their peers and charm the institutional clients who vote on the Institutional Investor all-star list. The problem is that some misinformed clients expect analysts to read the financials, even their bosses do not. Use analysts for indications of Street-think and as conduits of management information. It is not good guys versus bad guys, shorts versus analysts; the point is how effectively you use the information presented to you. Forbes and Barron's do good, strong, analytical fact-finding. Nobody fires them if they make waves. Many indexes carry only two or three years of references, but make sure you have at least five because ancient history is relevant to corporate hanky panky or to the firm's cultural tradition of hanky panky" 6. Pay Attention If you decide not to short a stock based on your preliminary analysis, it might be a good idea next year. if you short now, watch it. Events move slowly in the financial world, it can be hard to maintain concentration. First watch for earnings releases. Note when they are expected to be published and what Street expectations are. The date of the earnings release is also statistically relevant: the later they are, the worse the numbers. Many companies will fax the PR release, together with the income statements and balance sheet. Quick information is important. If it is a large, Street-covered stock small investors are at a disadvantage because Street analysts get the faxes and phone calls first, little players sometimes not until days later. Next, know when financials are expected out. The 10Qs and 10Ks are read slowly by Wall Street, so quick attention can yield important data -- little players can make up for the delay on receipt of earnings-release information. Waiting for new financials is like waiting for Christmas. It is fun to see if you were right and how things are developing. Go first to the key numbers, then the cash flow statement, finally the verbiage. Read the Qs carefully. Keep watching -- once a potential target, always a possibility. If you know a company well, you might recognize trigger, like the Zises' selling their Integrate stock, or HBJ selling Shamu, or J. Billder's closing stores or running over expected costs and out of money. Be quick to admit defeat. If you are shorted the stock because the investors were too high and the 10Q shows the company has corrected the problem, cover--NOW. Do not cover just because of price movements; wait until the resolution of the scenario. If Integrated looks like death, wait till it is buried. Short selling can be much like a cat waiting outside a mouse hole - the level of persistence, patience, and attentiveness is not for everyone, especially over sustained periods of time. Concept Recap The short seller's credo can be summarized into several points: 1. Dissent is Okay. 2. The facts are somewhere, free for the digging. 3. Hard work is old fashioned, so if you do a little, you will be far ahead. Analyst look at company PR rather than fundamentals and financials, and that provides opportunities and longer periods of market inefficiencies. 4. Computers confuse and build false confidence in portfolio managers, and that also provides opportunities. 5. Some accountants sanction everything, and that helps a lot, too. 6. Finally, Wall Street ices the inefficient cake with compulsive conformity. Everyone gets on the bandwagon and stays until the evidence is too compelling, then they all fall off with a jolt. Conclusion The key points to remember about selling, short selling or simply not buying are several. Never assume that a certain investment theme applies to all stocks. Each company and industry is different, so it is lazy to measure by the same scale if the yardstick is not relevant. If a company owns land at 1932 prices, do not worry about earnings or price/earnings. Think about the business and decide what the market wants you to pay for (cash flow, assets, earning). Then, after thoughtful consideration of the prospects, value the company according to your own analysis.Do not genuflect in front of a business, an executive, or an analyst. Keep your distance and you objectivity. The stock market is about people disagreeing over stock prices. Short sellers are entitled to their opinions, as are executives and analysts. And so are you. Do not take it seriously; it is only money. A short seller is a skeptic with a constructive, optimistic bent. If you are appalled when an executive lies about earnings prospects, do not just sell the stock, consider shorting it. When the short interest peaks at a staggering percentage of total volume and the marked has embraced pessimism.  This might be a good time to go long and cover short positions.

[scienceofstatisticaltrading]

One Up On Wall Street

The book attempts to explain that the best stock for long term investing possesses the following attributes:

(1) IT SOUNDS DULL—OR, EVEN BETTER, RIDICULOUS Who wants to put money into a company that sounds like the Three Stooges? What Wall Street analyst or portfolio manager in his right mind would recommend a stock called Pep Boys—Manny, Moe, and Jack—unless of course the Street already realizes how profitable it is, and by then it’s up tenfold already. If you discover an opportunity early enough, you probably get a few dollars off the price just for the dull or odd name.

(2) IT DOES SOMETHING DULL A company that does boring things is almost as good as a company that has a boring name, and both together is terrific. Both together is guaranteed to keep the oxymorons away until finally the good news compels them to buy in, thus sending the stock price even higher. If a company with terrific earnings and a strong balance sheet also does dull things, it gives you a lot of time to purchase the stock at a discount. Then when it becomes trendy and overpriced, you can sell your shares to the trend-followers.

(3) IT DOES SOMETHING DISAGREEABLE Better than boring alone is a stock that’s boring and disgusting at the same time. Something that makes people shrug, retch, or turn away in disgust is ideal. 

(4) IT’S A SPINOFF Spinoffs of divisions or parts of companies into separate, freestanding entities. Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents. Therefore, the spinoffs normally have strong balance sheets and are well-prepared to succeed as independent entities. And once these companies are granted their independence, the new management, free to run its own show, can cut costs and take creative measures that improve the near-term and long-term earnings.

(5) THE INSTITUTIONS DON’T OWN IT, AND THE ANALYSTS DON’T FOLLOW IT If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner. 

(6) THE RUMORS ABOUND: IT’S INVOLVED WITH TOXIC WASTE AND/OR THE MAFIA It’s hard to think of a more perfect industry than waste management. If there’s anything that disturbs people more than animal casings, grease and dirty oil, it’s sewage and toxic waste dumps. 

(7) THERE’S SOMETHING DEPRESSING ABOUT IT Now, if there’s anything Wall Street would rather ignore besides toxic waste, it’s mortality. 

(8) IT’S A NO-GROWTH INDUSTRY Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry like plastic knives and forks, but only if I can’t find a no-growth industry like funerals. That’s where the biggest winners are developed. In a no-growth industry, especially one that’s boring and upsets people, there’s no problem with competition. You don’t have to protect your flanks from potential rivals because nobody else is going to be interested. This gives you the leeway to continue to grow, to gain market share. (9) IT’S GOT A NICHE I’d much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rock pit has a niche. Twentieth Century-Fox understood that when it bought up Pebble Beach, and the rock pit with it. What makes a rock pit valuable is that nobody else can compete with it. There’s no way to overstate the value of exclusive franchises to a company or its shareholders. Once you’ve got an exclusive franchise in anything, you can raise prices. I always look for niches. The perfect company would have to have one.  (10) PEOPLE HAVE TO KEEP BUYING IT I’d rather invest in a company that makes drugs, soft drinks, razor blades, or cigarettes than in a company that makes toys. Why take chances on fickle purchases when there’s so much steady business around? (11) IT’S A USER OF TECHNOLOGY Instead of investing in computer companies that struggle to survive in an endless price war, why not invest in a company that benefits from the price war—such as Automatic Data Processing? As computers get cheaper, Automatic Data can do its job cheaper and thus increase its own profits. Or instead of investing in a company that makes automatic scanners, why not invest in the supermarkets that install the scanners? If a scanner helps a supermarket company cut costs just three percent, that alone might double the company’s earnings. (12) THE INSIDERS ARE BUYERS There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it. In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy.  Long term, there’s another important benefit. When management owns stock, then rewarding the shareholders becomes a first priority, whereas when management simply collects a paycheck, then increasing salaries becomes a first priority. Since bigger companies tend to pay bigger salaries to executives, there’s a natural tendency for corporate wage-earners to expand the business at any cost, often to the detriment of shareholders. This happens less often when management is heavily invested in shares. But there’s only one reason that insiders buy: They think the stock price is undervalued and will eventually go up. (13) THE COMPANY IS BUYING BACK SHARES Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldn’t it invest in itself, just as the shareholders do? When stock is bought in by the company, it is taken out of circulation, therefore shrinking the number of outstanding shares. This can have a magical effect on earnings per share, which in turn has a magical effect on the stock price. If a company buys back half its shares and its overall earnings stay the same, the earnings per share have just doubled.  The common alternatives to buying back shares are (1) raising the dividend, (2) developing new products, (3) starting new operations, and (4) making acquisitions.  The book also then goes to talk about some ratios we should be wary of when selecting a stock: PERCENT OF SALES When I’m interested in a company because of a particular product—such as L’eggs, Pampers, Bufferin, or Lexan plastic—the first thing I want to know is what that product means to the company in question. What percent of sales does it represent?  THE PRICE/EARNINGS RATIO We’ve gone on about this already, but here’s a useful refinement: The p/e ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here. How do you find that out? Ask your broker what’s the growth rate, as compared to the p/e ratio. If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year (also known as a “12-percent grower”) and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown. In general, a p/e ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds. If your broker can’t give you a company’s growth rate, you can figure it out for yourself by taking the annual earnings from Value Line or an S&P report and calculating the percent increase in earnings from one year to the next. That way, you’ll end up with another measure of whether a stock is or is not too pricey. As to the all-important future growth rate, your guess is as good as mine. A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5. Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3. THE CASH POSITION We just went over Ford’s $8.35 billion in cash net of long-term debt. When a company is sitting on billions in cash, it’s definitely something you want to know about. Here’s why: Ford’s stock had moved from $4 a share in 1982 to $38 a share in early 1988 (adjusted for splits). Along the way I’d bought my 5 million shares. As cash piles up in a company, speculation about what will become of it can tug at the stock price. Ford’s been raising the dividend and buying back shares at a furious pace, but it has still amassed excess billions over and above that. Some investors wonder if Ford will blow the money on a you-know-what, but so far, Ford has been prudent in its acquisitions. THE DEBT FACTOR How much does the company owe, and how much does it own? Debt versus equity. It��s just the kind of thing a loan officer would want to know about you in deciding if you are a good credit risk. A normal corporate balance sheet has two sides. On the left side are the assets (inventories, receivables, plant and equipment, etc.). The right side shows how the assets are financed. One quick way to determine the financial strength of a company is to compare the equity to the debt on the right side of the balance sheet. This debt-to-equity ratio is easy to determine. Looking at Ford’s balance sheet from the 1987 annual report, you see that the total stockholder’s equity is $18.492 billion. A few lines above that, you see that the long-term debt is $1.7 billion. (There’s also short-term debt, but in these thumbnail evaluations I ignore that, as I’ve said. If there’s enough cash—see line 2—to cover short-term debt, then you don’t have to worry about short-term debt.) A normal corporate balance sheet has 75 percent equity and 25 percent debt. An even stronger balance sheet might have 1 percent debt and 99 percent equity. A weak balance sheet, on the other hand, might have 80 percent debt and 20 percent equity. Among turnarounds and troubled companies, I pay special attention to the debt factor. More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk. The debt burden was the difference. It’s the kind of debt, as much as the actual amount, that separates the winners from the losers in a crisis. There’s bank debt and there’s funded debt. Bank debt (the worst kind, and the kind that GCA had) is due on demand. It doesn’t have to come from a bank. It can also take the form of commercial paper, which is loaned from one company to another for short periods of time. The important thing is that it’s due very soon, and sometimes even “due on call.” That means that the lender can ask for his money back at the first sign of trouble. Creditors strip the company, and there’s nothing left for the shareholders after they get through with it. Funded debt (the best kind, from the shareholder’s point of view) can never be called in no matter how bleak the situation, as long as the borrower continues to pay the interest. The principal may not be due for 15, 20, or 30 years. Funded debt usually takes the form of regular corporate bonds with long maturities. Corporate bonds may be upgraded or downgraded by the rating agencies depending on the financial health of the company, but whatever happens, the bondholders cannot demand immediate repayment of principal the way a bank can. Sometimes even the interest payments can be deferred. Funded debt gives companies time to wiggle out of trouble. (In one of the footnotes of a typical annual report, the company gives a breakdown of its long-term debt, the interest that is being paid, and the dates that the debt is due.) DIVIDENDS Stocks that pay dividends are often favored over stocks that don’t pay dividends by investors who desire the extra income. There’s nothing wrong with that. The real issue, as I see it, is how the dividend, or the lack of a dividend, affects the value of a company and the price of its stock over time. The basic conflict between corporate directors and shareholders over dividends is similar to the conflict between children and their parents over trust funds. The children prefer a quick distribution, and the parents prefer to control the money for the children’s greater benefit. One strong argument in favor of companies that pay dividends is that companies that don’t pay dividends have a sorry history of blowing the money on a string of stupid diworseifications. This is one reason I like to keep some stalwarts and even slow growers in my portfolio. When a stock sells for $20, a $2 per share dividend results in a 10 percent yield, but drop the stock price to $10, and suddenly you’ve got a 20 percent yield. If investors are sure that the high yield will hold up, they’ll buy the stock just for that. This will put a floor under the stock price. Blue chips with long records of paying and raising dividends are the stocks people flock to in any sort of crisis. Then again, the smaller companies that don’t pay dividends are likely to grow much faster because of it. They’re plowing the money into expansion. The reason that companies issue stock in the first place is so they can finance their expansion without having to burden themselves with debt from the bank. I’ll take an aggressive grower over a stodgy old dividend-payer any day. DOES IT PAY? If you do plan to buy a stock for its dividend, find out if the company is going to be able to pay it during recessions and bad times.  BOOK VALUE Book value gets a lot of attention these days—perhaps because it’s such an easy number to find. You see it reported everywhere. Popular computer programs can tell you instantly how many stocks are selling for less than the stated book value. People invest in these on the theory that if the book value is $20 a share and the stock sells for $10, they’re getting something for half price. The flaw is that the stated book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin. When you buy a stock for its book value, you have to have a detailed understanding of what those values really are. At Penn Central, tunnels through mountains and useless rail cars counted as assets. MORE HIDDEN ASSETS Just as often as book value overstates true worth, it can understate true worth. This is where you get the greatest asset plays. Companies that own natural resources—such as land, timber, oil, or precious metals—carry those assets on their book at a fraction of the true value.  The accounting methods for “goodwill” were changed after the 1960s, when many companies vastly overstated their assets. Now it’s the other way around. For instance, Coca-Cola Enterprises, the new company that Coca-Cola created for its bottling operations, now carries $2.7 billion worth of goodwill on its books. That $2.7 billion represents the amount that was paid for the bottling franchises above and beyond the cost of the plants, inventory, and equipment. It’s the intangible value of the franchises. Under the current rules of accounting, Coca-Cola Enterprises has to “write” this goodwill down to zero over the next four decades, while in reality the value of the franchises is rising by the year.  There’s also hidden value in owning a drug that nobody else can make for seventeen years, and if the owner can improve the drug slightly, then he gets to keep the patent for another seventeen years. There can be hidden assets in the subsidiary businesses owned wholly or in part by a large parent company. There are hidden assets when one company owns shares of a separate company. Dedicated asset buyers look for this situation: a mundane company going nowhere, a lot of free cash flow, and owners who aren’t trying to build up the business. INVENTORIES There’s a detailed note on inventories in the section called “management’s discussion of earnings” in the annual report. I always check to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, it’s a red flag. There are two basic accounting methods to compute the value of inventories, LIFO and FIFO. As much as this sounds like a pair of poodles, LIFO actually stands for “last in, first out,” and FIFO stands for “first in, and first out.”  Whichever method is used, it’s possible to compare this year’s LIFO or FIFO value to last year’s LIFO or FIFO value to determine whether or not there’s been an increase or a decrease in the size of the inventory. PENSION PLANS As more companies reward their employees with stock options and pension benefits, investors are well-advised to consider the consequences. Companies don’t have to have pension plans, but if they do, the plans must comply with federal regulations. These plans are absolute obligations to pay—like bonds. (In profit-sharing plans there’s no such obligation: no profits, no sharing.) Even if a company goes bankrupt and ceases normal operations, it must continue to support the pension plan. Before I invest in a turnaround, I always check to make sure the company doesn’t have an overwhelming pension obligation that it can’t meet. I specifically look to see if pension fund assets exceed the vested benefit liabilities. This used to be a guessing game, but now the pension situation is laid out in the annual report. GROWTH RATE That “growth” is synonymous with “expansion” is one of the most popular misconceptions on Wall Street, leading people to overlook the really great growth companies such as Philip Morris. You wouldn’t see it from the industry—cigarette consumption in the U.S. is growing at about a minus two percent a year. The key to it is that Philip Morris can increase earnings by lowering costs and especially by raising prices. That’s the only growth rate that really counts: earnings. Then, they marketed the smaller roll as a “squeezable” improvement. This was the cleverest maneuver in the annals of short sheeting.) If you find a business that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fills the bill), you’ve got a terrific investment. That level of growth is very difficult to sustain for three years, much less ten. This in a nutshell is the key to the bigbaggers, and why stocks of 20-percent growers produce huge gains in the market, especially over a number of years. It’s no accident that the Wal-Marts and The Limiteds can go up so much in a decade. It’s all based on the arithmetic of compounded earnings. THE BOTTOM LINE Everywhere you turn these days you hear some reference to the “bottom line.” “What’s the bottom line?” is a common refrain in sports, business deals, and even courtship. So what is the real bottom line? It’s the final number at the end of an income statement: profit after taxes. What you want, then, is a relatively high profit-margin in a long-term stock that you plan to hold through good times and bad, and a relatively low profit-margin in a successful turnaround. What follows is a summary of the things you’d like to learn about stocks in each of the six categories: What follows is a summary of the things you’d like to learn about stocks in each of the six categories: STOCKS IN GENERAL • The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry. • The percentage of institutional ownership. The lower the better. • Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs. • The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.) • Whether the company has a strong balance sheet or a weak balance sheet (debt-to-equity ratio) and how it’s rated for financial strength. • The cash position. With $16 in net cash, I know Ford is unlikely to drop below $16 a share. That’s the floor on the stock. SLOW GROWERS • Since you buy these for the dividends (why else would you own them?) you want to check to see if dividends have always been paid, and whether they are routinely raised. • When possible, find out what percentage of the earnings are being paid out as dividends. If it’s a low percentage, then the company has a cushion in hard times. It can earn less money and still retain the dividend. If it’s a high percentage, then the dividend is riskier. STALWARTS• These are big companies that aren’t likely to go out of business. The key issue is price, and the p/e ratio will tell you whether you are paying too much. • Check for possible diworseifications that may reduce earnings in the future. • Check the company’s long-term growth rate, and whether it has kept up the same momentum in recent years. • If you plan to hold the stock forever, see how the company has fared during previous recessions and market drops. (McDonald’s did well in the 1977 break, and in the 1984 break it went sideways. In the big Sneeze of 1987, it got blown away with the rest. Overall it’s been a good defensive stock. Bristol-Myers got clobbered in the 1973–74 break, primarily because it was so overpriced. It did well in 1982, 1984, and 1987. Kellogg has survived all the recent debacles, except for ’73–’74, in relatively healthy fashion.) CYCLICALS • Keep a close watch on inventories, and the supply-demand relationship. Watch for new entrants into the market, which is usually a dangerous development. • Anticipate a shrinking p/e multiple over time as business recovers and investors look ahead to the end of the cycle, when peak earnings are achieved. • If you know your cyclical, you have an advantage in figuring out the cycles. (For instance, everyone knows there are cycles in the auto industry. Eventually there are going to be three or four up years to follow three or four down years. There always are. Cars get older and they have to be replaced. People can put off replacing cars for a year or two longer than expected, but sooner or later they are back in the dealerships. The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside. Lately we’ve had five years of good car sales, so I know we are in the middle, and perhaps somewhere close to the end, of a prosperous cycle. But it’s much easier to predict an upturn in a cyclical industry than it is to predict a downturn.) FAST GROWERS • Investigate whether the product that’s supposed to enrich the company is a major part of the company’s business. • What the growth rate in earnings has been in recent years. (My favorites are the ones in the 20 to 25 percent range. I’m wary of companies that seem to be growing faster than 25 percent. Those 50 percenters usually are found in hot industries, and you know what that means.) • That the company has duplicated its successes in more than one city or town, to prove that expansion will work. • That the company still has room to grow. When I first visited Pic ’N’ Save, they were established in southern California and were just beginning to talk about expanding into northern California. There were forty-nine other states to go. Sears, on the other hand, is everywhere. • Whether the stock is selling at a p/e ratio at or near the growth rate. • Whether the expansion is speeding up.  • That few institutions own the stock and only a handful of analysts have ever heard of it. With fast growers on the rise this is a big plus. TURNAROUNDS • Most important, can the company survive a raid by its creditors? How much cash does the company have? How much debt? (Apple Computer had $200 million in cash and no debt at the time of its crisis, so once again you knew it wasn’t going out of business.) What is the debt structure, and how long can it operate in the red while working out its problems without going bankrupt? (International Harvester—now Navistar—was a potential turnaround that has disappointed investors, because the company printed and sold millions of new shares to raise capital. This dilution resulted in the company’s having turned around, but not the stock.) • If it’s bankrupt already, then what’s left for the shareholders? • How is the company supposed to be turning around? Has it rid itself of unprofitable divisions? This can make a big difference in earnings.  • Is business coming back? (This is what’s happening at Eastman Kodak, which has benefited from the new boom in film sales.) • Are costs being cut? If so, what will the effect be? (Chrysler cut costs drastically by closing plants. It also began to farm out the making of a lot of the parts it used to make itself, saving hundreds of millions in the process. It went from being one of the highest-cost producers of automobiles to one of the lowest. ASSET PLAYS • What’s the value of the assets? Are there any hidden assets? • How much debt is there to detract from these assets? (Creditors are first in line.) • Is the company taking on new debt, making the assets less valuable? • Is there a raider in the wings to help shareholders reap the benefits of the assets? Here are some pointers from this section: • Understand the nature of the companies you own and the specific reasons for holding the stock. (“It is really going up!” doesn’t count.) • By putting your stocks into categories you’ll have a better idea of what to expect from them. • Big companies have small moves, small companies have big moves. • Consider the size of a company if you expect it to profit from a specific product. • Look for small companies that are already profitable and have proven that their concept can be replicated. • Be suspicious of companies with growth rates of 50 to 100 percent a year. • Avoid hot stocks in hot industries. • Distrust diversifications, which usually turn out to be diworseifications. • Long shots almost never pay off. • It’s better to miss the first move in a stock and wait to see if a company’s plans are working out. • People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years. • Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up. • Some stock tips, especially from an expert in the field, may turn out to be quite valuable. However, people in the paper industry normally give out tips on drug stocks, and people in the health care field never run out of tips on the coming takeovers in the paper industry. • Invest in simple companies that appear dull, mundane, out of favor, and haven’t caught the fancy of Wall Street. • Moderately fast growers (20 to 25 percent) in nongrowth industries are ideal investments. • Look for companies with niches. • When purchasing depressed stocks in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt. • Companies that have no debt can’t go bankrupt. • Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the president’s resume or speaking ability. • A lot of money can be made when a troubled company turns around. • Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money. • Find a story line to follow as a way of monitoring a company’s progress. • Look for companies that consistently buy back their own shares. • Study the dividend record of a company over the years and also how its earnings have fared in past recessions. • Look for companies with little or no institutional ownership. • All else being equal, favor companies in which management has a significant personal investment over companies run by people that benefit only from their salaries. • Insider buying is a positive sign, especially when several individuals are buying at once. • Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn’t count. • Be patient. Watched stock never boils. • Buying stocks based on stated book value alone is dangerous and illusory. It’s real value that counts. • When in doubt, tune in later. • Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.

[scienceofstatisticaltrading]

A Random Walk Down Wall Street - Burton G.Malkiel

The book is very focused on proving and detailing with evidence the random walks of the market, and how often Fund Managers under-perform a wide market index. The book does admit that there are a very small and select bunch of extremely astute fund managers that are able to beat the market, albeit inconsistently, and is quite adamant on attributing that victory to luck, or... Random walks of luck. The book also goes on to say that a monkey blindfolded and given darts would be able to outperform some portfolios, since it believes that it is quite difficult to outperform a wide market index.

The book however, does admit that there are benefits of diversification, which reduces the draw down of a portfolio from the collapse of a particular sector or country.  The book however, raises an interesting point, that the return of a stock markets does not rise with its inherent risk, as any risk that can be diversified away will not raise its intrinsic rewards,  and the return due to higher risk of a portfolio is largely due to the Beta, or correlation of a security to the market. Hence, one should aim to have a portfolio with varying Betas, such that when the market moves, we have a portfolio of securities that may reduce the overall momentum of the move and hence reduce risk. A security with high beta may also promise higher returns as it carries higher risk. The book also advocates diversifying in wide market indexes, bonds and REITs, as it believes that they have a low correlation to each other. The book also advocates that if the investment horizon is long, one should have a majority of holdings in stocks.  Also, the book argues that one should have a portfolio with beta that one is most comfortable with, and not lost sleep over draw downs. The book finishes off with advises on picking securities for oneself:

1) Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years. As difficult as the job may be, picking stocks whose earnings grow is the name of the game. Consistent growth not only increases the earnings and dividends of the company but may also increase the multiple that the market is willing to pay for those earnings. This would further boost your gains. Thus, the purchaser of a stock whose earnings begin to grow rapidly has a potential double benefit—both the earnings and the multiple may increase. 2) The book argues that you can roughly gauge when a stock seems to be reasonably priced. The market price-earnings multiple is a good place to start: You should buy stocks selling at multiples in line with, or not very much above, this ratio. The strategy is to look for growth situations that the market has not already recognized by bidding the stock's multiple to a large premium. As has been pointed out, if the growth actually takes place, you will often get a double bonus—both the earnings and the price-earnings multiple can rise, producing large gains. By the same token, beware of the stock with a very high multiple and many years of growth already discounted in the price. If earnings decline rather than grow, you will usually get double trouble—the multiple will drop along with the earnings, and heavy losses will result. 3) It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air. The book stressed in Chapter Two the importance of psychological elements in stock price determination. Individual and institutional investors are not computers that calculate warranted price earnings multiples and then print out buy and sell decisions. They are emotional human beings—driven by greed, gambling instinct, hope, and fear in their stock-market decisions. This is why successful investing demands both intellectual and psychological acuteness. Of course, the market is not totally subjective either; if a positive growth rate appears to be established, the stock is almost certain to develop some type of following. But stocks are like people—some have more attractive personalities than others, and the improvement in a stock's multiple may be smaller and slower to be realized if its story never catches on. The key to success is being where other investors will be, several months before they get there. So my advice is to ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd. Is it a story from which contagious dreams can be generated? Is it a story on which investors can build castles in the air—but castles in the air that really rest on a firm foundation? 4) Trade as little as possible.

[scienceofstatisticaltrading]

The Art & Science Of Technical Analysis - Adam Grimes

Practical Trading Templates

All material is from Grimes, Adam. The Art and Science of Technical Analysis: Market Structure, Price Action and Trading Strategies (Wiley Trading) (Kindle Locations 3136-3139). Wiley. Kindle Edition. 1) FAILURE TEST

Trade Type: Support/resistance holding or trend termination.

Concept: Markets probe for stop orders and activity beyond significant price levels. Many times, there is no real conviction behind these moves, and the moves fail and reverse quickly once the stop orders are triggered. Entering after such a move allows for excellent reward/risk potential with a clearly defined risk point. Setup: The market must be overextended or in some way primed for reversal. The best examples of this trade occur in mature, extended trends, and will usually be accompanied by momentum divergence on the trading time frame. Another common variation occurs in an extended consolidation just under resistance. This type of consolidation would normally have a high expectation of producing another trend leg above that resistance, so many traders are monitoring the area and will enter on a potential breakout. If this breakout occurs and fails, there will be many trapped traders, which can add momentum to a downside trade off that level. 

Trigger: For a short entry, the market trades above a clearly defined resistance area, but immediately reverses on the same or the following bar and closes back under the resistance. There can be significant volatility, volume, and activity on the breakout, but there should be no real conviction beyond the level. Enter short on the close of the bar that closes back below resistance. The buy setup is exactly symmetrical. Point B marks a brief probe below support, but the same day immediately closed back above the support level. At A, the stock attempted to break to new highs, but there was not enough buying pressure to hold it above the resistance level and it failed on the same day. A long entry would have been justified on the close of B, and a short on the close of A.

Stop: The stop for this trade is clearly defined: a hard stop must be entered just beyond the extreme of the test beyond the level. For instance, the stops on the two trades above would have been placed below the low of the bar marked B and above the high of A. In all cases, the stop goes just outside the most extreme test beyond the triggering support or resistance level. Because this is an aggressive countertrend trade, it is important to not add to losing trades. Respect the stop level without question. In addition, there is significant gap risk with trades held overnight. On losing trades, there is sometimes enough pent-up pressure to cause gap opens beyond the stop, so it may make sense to trade these on smaller size and risk compared to other setups.

Profit Target:  Most traders find best success with a plan that allows for taking partial profits as the market makes them available. For instance, one plan would be to take profit on the first part when the profit equals the initial risk on the trade. The profit target on the second portion is discretionary, but consider the possibility of a longer, complex correction that leads to continuation of the original trend. Some of these trades will turn into dramatic trend reversals, but this should not be your baseline expectation. In general, consolidation near the level, particularly if the first profit target is not reached, is a bad sign. For instance, if you enter short on A in Figure 6.1 and the market spends two to three days trading above the breakout, this is most likely a precursor of a losing trade. Reduce exposure or close out these trades if they do not work quickly in your favor.

Failure Patterns: While it is certainly important to know what the pattern should look like if it’s working, from a pedagogical standpoint it probably makes more sense to focus energy and attention on what should not happen. If these early signs of failure can be recognized, it is often possible to reduce position sizes and to reduce the size of the ultimate loss. In addition, careful study of the typical patterns associated with failure can lead to a deeper understanding of the dynamics behind the trade. The key to most failure patterns is to understand what should not happen if the trade is good—to look for price action and emerging market structure that contradict the reasons for being in the trade. In this case, what we do not want to see after trade entry is simple: the market should not be able to consolidate near the level, nor should it exceed the stop-loss point. Consolidation near the level is more consistent with an impending breakout and continuation of the existing trend. If the failure test trade is successful, price should move sharply away from the level, and the trade should be immediately profitable (within one to three bars on the trading time frame). This is another expression of the classic price rejection, a further confirmation of the validity of the failure beyond the level. One last point to consider is that some of these trades will hit the stop point and, on the same or the next bar following the stop-out bar, will once again fall back inside the level. Though it can be psychologically challenging to reenter immediately after a loss, this second trade, taken on the second failure, is also an excellent entry. This is another reason for trading both entries on smaller risk—this second entry sets up often enough (and is virtually obligatory) that the sum of the risk on both trades should not be significantly larger than the maximum risk taken on other types of trades.

Comments: This is the simplest and most clearly defined of all the patterns. There is no subjectivity in stop location and little subjectivity in managing losing trades—if the market makes a new extreme, then you are wrong and must exit the trade. There are only two potential complications with this trade. The first is the reentry following a stop-out, which is usually a simple failure on the higher time frame. Traders must be aware of this possibility and must plan for this in their risk management and position sizing. The second potential issue deals with managing winning trades; it is important to consider the trade-off between high probability of a smaller profit and the lesser probability of a large payout. Some percentage of these trades will evolve into major trend reversals; however gratifying that is, it is not the most common outcome and should not be your expectation when trading this pattern. Many winning trades will give the trader the opportunity to take some profits around the first profit target, at which point the market begins consolidating or turns around and hits the stop. It is important to strike a balance between taking sufficient early profits that the entire set of trades will be profitable, while maintaining enough exposure that the much less common home runs make a significant contribution to the bottom line. There is no easy answer to this, and the choice will depend on a large degree on the personality and inclination of the individual trader.

2) PULLBACK, BUYING SUPPORT OR SHORTING RESISTANCE

Trade Type: Trend continuation. Concept : Pullbacks are probably the most important structural feature of trends. For many traders, pullbacks are the quintessential with-trend trade, using the countertrend pullback to position in the larger trend at an advantageous price. The broad term pullback encompasses a large number of specific patterns: flags, pennants, wedges, continuation triangles, and many others, but the exact shape of the pattern is not that important. In reality, these are all functionally the same—they are continuation patterns in trends. It is not necessary, nor is it constructive, to have separate trading plans for each of these patterns. Understand what the pattern is and what it does, and trade it accordingly. Setup: The most important condition for this trade is that the market must be trending. Though it is not always possible to separate trending from nontrending environments with precision, many losing trades are the result of attempting pullbacks in nontrending environments. Objective tools to identify trends have been discussed in Chapter 3, but the problem can be reduced to whether the setup leg preceding the pullback shows good momentum—it must be a move that should see continuation after consolidation. At the risk of oversimplifying, if the market is in an established trend, the preceding setup leg should be at least as strong as previous trend legs in the same direction. In other words, it should not break the pattern of the trend and should not show momentum divergence. Pullback trades are also possible on trend changes or following breakouts of trading ranges, though this more properly falls under the Anti trade category. In these cases, there will be no established trend, but the setup leg should show a distinct change of character compared to the preceding environment. Whether in an established trend or at the beginning of a new potential trend, the same condition applies: the setup leg should suggest momentum in the market that must be resolved through an attempted third leg (impulse-retracement-impulse) continuation. One useful way to approach trend trades is to consider conditions that would contradict this trade, which are the standard preconditions for countertrend trades. In the absence of any of these (e.g., momentum divergence, overextension on higher time frames, etc.), with-trend trades are fully justified. Different markets have different characters with respect to the integrity, length, and strength of trends—some markets trend better than others. For instance, it is somewhat unusual for most intraday index products to have trends that extend more than three legs, but individual equities, especially if they have had unusual news that day, may trend much further. Some commodities, such as meat products, do not tend to trend well, but petroleum products and grains are capable of significant, extended trends with many clean trend legs. On longer time frames, interest rate products, and currency rates often show multiyear trends. In general, there is an old rule of thumb that says that larger markets (in terms of nominal value) trend better; though this is difficult to prove quantitatively, it is a useful guideline to keep in mind. Certainly, extraordinary conditions do occur where a market makes a move that is out of all proportion to historical precedents. Your trading plan should allow you to participate in those moves with at least partial positions, but these unusual moves should not be the main focus of your plan. Once the main prerequisites of a trending market with no contradictory conditions are satisfied, we turn to the geometry of the pullback pattern itself. Good pullbacks almost always show reduced activity (smaller ranges for individual bars) and the absence of strong countertrend momentum. This is why traditional technical analysis suggests that volume should be lighter in pullbacks—they are zeroing in on the (valid) fact that trading activity should be less on the pullbacks. In many cases, pullbacks will have lighter volume, but this is not the distinguishing feature. In all cases the best pullbacks have reduced activity, which is visible on the lower time frame, in price action, and in the lack of strong countertrend momentum on the trading time frame—but necessarily lower volume per se. Last, it also makes sense to be responsive to developing market structure, even after the trade is initiated. A pullback may emerge at a spot where the trade was justified, but developing price action may suggest that the trend is losing integrity. If this happens, it is not necessary to hold the trade to the original stop-loss level. It is often advisable to scratch the trade, exiting for a small win or loss, and to wait for better opportunities. A good trading plan will allow flexibility and will encourage the trader to be responsive to developing market conditions. 

Trigger: The actual entry for this trade is buying against the support level near the bottom or selling short against the resistance near the top of the pullback. There is an important trade management issue to consider, as support and resistance levels usually slope in these patterns. One of the advantages of buying against support is that, usually, your risk is fairly clearly defined, but, in the case of buying into pullbacks, price can decline (or rally, in a pullback against a downtrend) much further than expected while the pattern remains valid. It can be difficult to define the risk on a position entered against a sloping support or resistance level, but it does not make sense to exit a trade that is still within the sloping level. Having the level itself is not enough; it is also important to have a clear trigger against that level to support the actual entry. There are two ideal triggers. In the first, the market has defined a clean pullback. Sometimes it is possible to draw a trendline on both sides of the pullback, but, barring that, a parallel trend channel can be used. The entry trigger is a failure of this trend line or channel, followed by an immediate reversal; that is, the line is penetrated, but prices recover back above the trend line within a few bars. Conceptually, what has happened is that traders buying into the pullback against the support level have been washed out of the market by the drop below that support. Note that this will often coincide with a lower time frame climax, though this is usually clear from the trading time frame and it is not necessary to explicitly examine lower time frames in most cases. This entry has the advantage of excellent trade location; some of these will actually be very near the low tick of the pullback. The only real disadvantage of this entry is that considerable experience may be required to read the market correctly at these spots, and, even on relatively long time frames, you have to pay attention because the exhaustion below support will happen on a single bar. This is a skilled trader’s tool, not a buy-and-forget entry. The second entry trigger is actually buying against the support at the bottom of the pullback. It is always possible to find examples of this entry on historical charts, but it can be considerably more difficult to make this trade in real time. Stop placement is problematic because the support can drop, washing weak-hand longs out of the market; the recovery from this fakeout is actually the previously discussed entry. Why put yourself in the position of being the weak trader who is washed out of the market? However, if you are executing some variation of this buying against support plan (or shorting against resistance), it is essential to limit your loss and your risk on these trades; some of them will drop support and trade lower with a vengeance. Note also that this entry has much in common with the tools and techniques for simply trading against any support and resistance level—the same ideas, risks, and caveats apply. One pattern to avoid is buying against multiple (three or more) tests of support in a pullback, as this pattern is often more indicative of an impending failure. The operative concept here is usually lower highs into support, as successive bounces find fewer willing buyers. This is not to say that retracement patterns that show this characteristic never work out, but, on balance, they are lower-probability plays. Most traders will have the most success if they restrict their operations to the best possible trades. The best pullbacks are pauses in strong trends; there should be enough interest in the market that the pullback does not languish too long near support or resistance.

Stop: There are basically two schools of thought on stop placement in general. Many traders want to put the stop as close to the pattern as possible, with the idea that doing so minimizes the size of losing trades. This is correct as far as the magnitude of the losses goes, but there are two other points to consider: First, trades should be sized so that every loss is equivalent; there is no such thing as a “low risk” trade. (Some types of trades may be traded with different levels of risk, but, even then, risk levels should be consistent for all trades of that type.) Second, and more importantly, very close stops have a higher probability of being hit. When the probability of the loss is considered, a very tight stop often is a much larger loss in terms of expected value than a farther stop. My preference is to put stops farther away from the pattern, and to introduce a small random “jitter” element to stop placement. One common mistake is to put your stop where everyone else puts theirs, because markets tend to seek out those stop levels. If you put yours a few ticks or cents beyond the obvious levels, you may still be swept out if there is extra volatility beyond the level, but this is an unavoidable risk of trading. The best we can do is to minimize it with intelligent stop placement.

Profit Target: The most conservative profit target is at the previous pivot high of the setup leg for long traders, or at the low of the setup leg for shorts. Many traders who focus on pullbacks will bid or offer (for short or long trades) part of their positions at the level, and are prepared to exit more of the position if the market runs into trouble there. These levels are often cleared easily, but there can be considerable volatility as some traders exit positions and others look to enter on breakouts beyond the level. The difference of opinion and two-sided trading in these spots can lead to unusual activity, but the strongest trends will continue past this level, extending into another leg. A good exit plan will allow for the possibility of taking partial profits while holding on to part of the position for a possible extension into further trend legs. Another common target is the measured move objective (MMO), which is calculated by taking the length of the setup leg (AB), adding that number to the pivot point marked C, and expecting the CD leg to be approximately the same length as the AB leg. There is no magic to this method. There is no mystical force at work here; the operative concept is that markets tend to trade with a fairly consistent level of volatility, and the MMO simply targets the approximate level at which we could expect the next swing to terminate based on the prevailing volatility levels and the average swing sizes of the market. Rather than treating this as an exact level, consider it a zone and give some consideration to what the correct course of action would be if the market stalls somewhere near this area. In general, the correct plan would be to take partial or complete profits even though the trade had not quite reached the target. Last, it is also possible to manage pullback trades using risk multiples as profit targets, for instance, taking partial profits at one or two times (1× or 2×) the initial risk on the trade. This is a solid plan, but it probably also makes sense to incorporate information from the conservative and MMO profit targets, as they are based on the reality of market structure and volatility-driven relationships. For instance, if the first 1× risk profit target is a little beyond the conservative previous swing target, it might be a good idea to move the target to the conservative target. However, if you are trading the 1× plan and find that your first target is significantly beyond the conservative target, an adjustment might skew the reward/risk ratio significantly. These are the types of issues that must be considered within a comprehensive trading plan. Comments: We will look at several variations of this trade, but the concept of using pullbacks in trending markets is one of the most robust discretionary trading techniques. It uses the normal pattern of a trending market (impulse-retracement-impulse) to position at attractive prices in the trend. Trading these patterns successfully is not as easy as might be expected. One challenge is assessing the strength of the trend while looking for that fine line between a very strong market and one that is overextended, perhaps primed for reversal. Trades in the latter market are much more likely to fail and result in losses, so being able to discriminate between the two environments is an essential trading skill. All of the information in the sections on trend structure must eventually be considered in trading these patterns and incorporated into your trading plan. Much of this can be quantified, but some traders will be more comfortable using much of this information on a subjective, almost subconscious, level. Another potential challenge is in the timing of the entry. Because pullbacks often have many of the characteristics of small trading ranges, price action within pullbacks tends to be more random and it can be difficult to time the entry point with confidence. In addition, pullbacks are actually contratrend lower time frame trends, so early entries can result in losses if the lower time frame trend is still in control. The third challenge is stop placement. The general idea with stop placement is to avoid the noise and to place stops at a level that would prove the trade incorrect. Finding this point in pullbacks can be a little more difficult; the lower time frame trends sometimes continue further than expected, and conservative stops can be hit at exactly the wrong point. In fact, one of these failures is so common that it deserves separate consideration under the category of complex pullbacks. Despite all of these potential issues, many traders will find that pullbacks offer some of the most attractive and consistent trading opportunities. A profitable trading plan can be built around this one trade, though an awareness of trend termination patterns will inform your perspective and help you manage losing trades. The next setup looks at an entry that combines the power of the pullback with the direction of momentum on the shortest time frames.

3) PULLBACK, ENTERING LOWER TIME FRAME BREAKOUT

Trade Type: Trend continuation and breakout blend.

Concept: This trade setup times the entry into the pullback by using the momentum of a lower time frame breakout so that the trade will be entered when the market is moving in the intended direction of the trade. This entry has the advantage of offering the confirmation of momentum with the trade-off that trade location will not be as good. This entry will require larger initial stops compared to entering near support or resistance, and have correspondingly lower reward/risk ratios.   Setup: This is another variation on the pullback concept; the same setup conditions as in the previous trade apply here. Trigger: The difference is the actual entry trigger, which, in this case, is on a breakout of some structure within the pullback itself, usually visible most clearly on a lower time frame. Over a large set of trades, this approach is hit or miss because the high of the trading time frame bar may or may not actually be an important point in the market or on the lower time frame. There is no magic to a breakout of the bar on any time frame, because the chart is simply a representation of the underlying market. In most cases, paying attention to lower time frame price action will allow for cleaner entries, but it is sometimes possible to identify clear support and resistance on the trading time frame. For instance, if a series of two to three bars all have the same high and all of the other conditions for a good pullback are fulfilled, paying a breakout through those highs is often a good entry. This is perhaps more common intraday, but it also occurs on higher time frames, particularly in liquid markets. It is not, however, common enough to be a bread-and-butter trade; it is more properly understood as a variation of a common pattern. One other issue to consider on higher time frames is that markets will frequently gap open beyond intended entry points. This happens in all setups, but is particularly common and the gaps may be unusually large in these pullback breakouts. Consider this carefully in your trading plan. Will you skip these entries altogether, wait for a better entry, or enter at whatever price you have to? If you do enter on the gap, will you enter your entire position or perhaps only a partial and look to add the rest at a later point? If you do enter on the opening, will you enter right on the opening print, or will you wait for a few minutes’ price action to define the opening range? There may not be one right or wrong answer to each question, but some are surely better than others. Stop: There are basically two schools of thought on stop placement in these trades. In the case of the lower time frame breakout trigger, many traders will want to use a very tight stop, operating under the assumption that if the breakout is truly a critical tipping point, they can simply exit the market for a very small loss if the anticipated move fails to develop. Furthermore, after booking this very small loss, they will have the freedom to reenter the market multiple times until they finally catch the move they were looking for all along. Traders taking this approach will argue that they are trading a higher time frame pattern with potential reward proportional to the swings on that time frame while using much smaller risk levels from the lower time frame.Though this is potentially a valid approach in some contexts, it is not usually the best practice. The small losses do add up, and these very tight stops do not respect the reality of the noise level in the market. My preference is to use a larger stop that is true to the geometry of the trading time frame pattern. Yes, there is motivation to have the stop as tight as reasonably possible (because the trade will then support a larger position size, not because it is a lower-risk trade), but there is an unavoidable trade-off between reward/risk ratio and probability. Assuming both traders trade consistently, the trader using a tight stop and the trader using the wider stop will have approximately the same expected payoff over a large number of trades. (There is an important lesson there.) In addition, the trader using the very tight stop with the plan to reenter will incur multiple transaction costs (including paying the spread, which is not trivial in some markets or time frames) and runs the ultimate risk of not having the position on when the market finally does make the move. For traders using very tight stops, position sizing is a serious problem. How many entries will it take until they finally catch the trade? Two? Five? More? Each one of these attempts will incur a loss. If they trade small enough that the losses are insignificant, the winning trades will also be insignificant. If they trade with meaningful size, they will not be able to enter the same trade very many times. Why play these games when a proper stop can be set that involves less work, lower transaction costs, and better payout? Profit Target: The same profit targets apply to all pullback trades. Comments: This trade setup addresses the key issue of precisely timing the entry into the pullback pattern. In the best cases, the market will never return to the entry price and the trade will be easy and painless from that point. These cases where the trade works perfectly are a minority, but, even in other cases, the character of the move after the pullback often gives good information about the balance of buying and selling pressure in the market. This combination of a breakout trade nested within a pullback is a powerful tool for discretionary traders on all time frames.

4) TRADING COMPLEX PULLBACKS Trade Type: Trend continuation. Concept: Complex pullbacks, which are pullbacks composed of two distinct countertrend legs, are very common, especially in mature trends. A good understanding of these structures is important, because they will often result in losses for traders who are trading simple pullbacks. Furthermore, many of the best pullbacks—those followed by the strongest, cleanest moves—are complex pullbacks, so a comprehensive trading plan must embrace this pattern. To actually trade these patterns, traders need to be aware of two distinct forms: one that shows the three legs clearly and one that hides them, buried within the lower time frame structure. The lower time frame will usually show the distinct trend legs, but they may not be visible on the trading time frame. For experienced traders, it is usually not necessary to explicitly examine the lower time frame, as the structure can usually be inferred from the trading time frame. At first, it may be easiest to recognize this structure on candlestick charts because they better highlight the open-to-close direction within each period. Most candles in pullbacks will be colored against the trend that set up the pullback; that is, pullbacks in uptrends will consist of full candles (red on modern charting packages) and pullbacks in downtrends will usually be empty (green) candles. This second complex pullback pattern is one or two with-trend candles in the middle of what otherwise looks like a simple pullback. The with-trend candle or candles usually represent(s) an aborted attempt to resume the primary trend, and this usually hints at a complex pullback hiding under the trading time frame structure. Since some traders will treat moves out of complex pullbacks differently than those out of simple pullbacks, it is important to be able to discern this subtle cue. In a sense, complex pullbacks are nothing more than a category of pullbacks, so all of the conditions for other pullback trades apply here, with one modification. It is usually a good idea to avoid pullbacks after conditions that could indicate a buying or selling climax. We have looked at these parabolic expansions and have seen that they frequently cap trends, so it does not make sense to enter with-trend pullbacks after such a move. Confirmation of the end of the trend is very strong countertrend momentum following such a condition, but market structure can unfold in another way: Rather than shifting into an immediate change of trend, the market can also consolidate and work off the overextension through a more extended consolidation. Normal (simple) pullbacks do this, as they give the market time to pause and digest each trend leg. In the case of a more serious overextension, a larger consolidation is usually required if the trend is going to continue, and these longer consolidations often take the form of complex consolidations. If you see a condition that would normally eliminate the possibility of a pullback (e.g., a buying or selling climax), a with-trend trade may still be possible following a complex consolidation in that same area. It is often easier to evaluate the integrity of the trend on the higher time frame, as the trading time frame complex consolidation will usually be a simple consolidation on the higher time frame. Trigger: Either of the two triggers already discussed for pullbacks—entering at support or on a breakout—are valid for complex consolidations. The support play, especially if backed up by a momentum shift on the lower time frame, is easier in complex consolidations than in simple consolidations because the stop is more clearly established due to the termination of the second pullback leg. In addition, both countertrend legs of the pullback tend to be similar lengths, so it is often possible to predict the general area where the second leg will stop using a measured move objective (AB = CD). (This is a guideline for trends in general, but the market tends to respect this principle even more strongly in pullbacks.) Stop: Another advantage of complex consolidations is that the stop level is more clearly defined. In simple consolidations, it is usually a bad idea to set a stop just underneath (for a long position) the consolidation area, but in complex pullbacks this is often an excellent risk point. There certainly are variations of complex pullbacks that have three or more pullbacks, each of which would result in another stop-out, but they are uncommon. The movements out of those also tend to be less reliable, so it does not make sense to make these a focus in the trading plan. Profit Target: The same profit targets apply to complex as to simple pullbacks, perhaps with the expectation that a stronger move could develop from a complex consolidation. You might be justified in taking less of your position off at your first profit target, and trying to press more size for a larger move compared to a simple pullback. If you decide to do this, weigh the benefits of having simple rules (e.g., take one-third of your position off at the previous swing) that enforce discipline and consistency against any incremental gains from a more complex approach. Comments: One important issue not yet considered is that these complex pullbacks often come following losing trades in simple pullbacks. This creates a risk management question that must be considered. Assume you want to risk $10,000 on each trade, and you just booked a $10,000 loss on a simple pullback, which, a few days later, is clearly developing into a complex pullback. What now? There are many possible answers, but it is important to have a clear plan before this situation is encountered. Risk management scenarios deserve careful consideration, planning, and maybe even quantitative modeling—these are not decisions to be made on the fly.

5) THE ANTI Trade Type: Trend termination. Concept: This trade is a very specific pullback variation that attempts to enter the first pullback after a potential trend change. Setup: There are two setup conditions for this trade. The first is that the market must have made a pattern that suggests the current trend could be terminating. Many of these patterns were discussed in Chapters 3 and 5: loss of momentum on successive thrusts, an extremely overextended market on the higher time frame, some type of double top or bottom formation where the market is unable to make a continuation, or perhaps a failure test. The second requirement is that the market then makes a move that shows a distinct change of character, such as a shift of momentum against the old trend. In the case of an uptrend, a downswing would emerge that was much stronger than previous downswings. This move would likely register a new momentum low on momentum indicators, suggesting further that the integrity of the uptrend had been challenged. This is the setup sequence, and both parts are important: the initial market structure that provides justification for potential countertrend trades, followed by a shift of momentum that shows that the dominant trend players have lost control of the market. Trigger: The actual entry for this trade is in the first pullback following the strong countertrend price movement. For example, imagine a market that has been in an uptrend and then puts in a sharp downward spike (countertrend to the uptrend). The next bounce following that spike is potentially the first pullback in a new downtrend; this trade represents an attempt to reverse, or at least to create a significant pause in the preexisting uptrend. Price action and evolving market structure must be carefully monitored in the pullback for warning signs that the pullback could fail and that the original trend may still be intact. This structure is a pullback and, to a great extent, can be traded like any other pullback. What distinguishes this pullback is its position in the evolving market structure as the first pullback following a potential trend change; normal pullbacks are continuation patterns in established trends. The Anti pullback may be entered via either of the two pullback entries already explored. The breakout entry may actually have a slightly better edge in this context than in a normal pullback, but it is also possible to position within the pullback using the support/resistance of the pattern itself. This is also a good example of how trading skills can be modular; the skills of trading pullbacks are applied here in another context. The third entry for this trade is probably not ideal. Because this is a countertrend trade, your risk point is clearly defined so you can simply enter anywhere into that first pullback with a stop outside the existing trend extreme (i.e., shorting into the first bounce following a strong down spike with a stop above recent highs). This is a sloppy entry in most cases, but there are times and time frames when we may not want to micromanage and fight over every tick. Stop: The general rule of stops in countertrend trades applies here: these stops must be respected without exception. There are two reasonable stops for this pattern. One choice is to simply put the stop beyond the trend extreme. Any price action inside that level (below it for an uptrend, above it for a downtrend) is consolidation and may still be supportive of trend change. If the level is violated, we know the countertrend attempt has failed and the probabilities favor trend continuation. This is the most conservative stop: farthest away from the market and at a level where the trend reversal has decisively failed. More aggressive stops, corresponding to larger position sizes, can be placed closer to the market, using any of the guidelines for stops in pullbacks. As usual, there are at least two arguments to consider: One, these areas tend to be more volatile, so closer stops may be more likely to get hit in the noise. Two, there can be a lot of pent-up countertrend pressure at these inflections, and the move, once it starts to develop, is often very clean. The most important thing is to have a plan and to execute it consistently so you are not making emotionally driven decisions in the heat of battle. Profit Target: The question of where to take profits is tied in to the expectations for countertrend trades in general. In some sense, the term countertrend is a misnomer, because the ideal outcome is for a new trend to begin from the point the trade was initiated; the trade would then be a with-trend trade in this new trend. Countertrend trades demand closer profit targets and tighter risk management than with-trend trades because of the danger of exceptional volatility if the trend change fails and the old trend reasserts itself. One good profit-taking plan splits the difference, taking off a significant amount of the exposure (33 to 66 percent) at the first profit target and holding the rest for a possible extension into a new trend. The MMO is an important factor in this trade. It is very common to see the first thrust after the initial pullback exhaust itself at the MMO, and then to see the market turn back down and eventually violate the previous trend extreme. Why? Because, at this point, the pattern has evolved into a complex consolidation, and trend continuation (of the original trend) is more likely. Monitor the market carefully for action in the neighborhood of the MMO. If it breaks, there is the possibility that you have just caught a major trend reversal. If, however, it holds and there is no continued countertrend momentum (and the pattern suggests a complex consolidation), be very protective of any remaining profits in the position. Once those profits are booked, it also makes sense to tighten the stop so that the worst possible outcome is a breakeven trade.  Comments: This is a powerful trade, and the sequence should be internalized: there must be, first, a reason for even contemplating the possibility of a countertrend trade; second, an initial impulse to confirm that the trend pattern is broken, that the dominant group has lost control of the market; and third, the actual entry in the pullback. This is a reliable pattern on all time frames, and is especially powerful for intraday traders when combined with time-of-day influences. 6) BREAKOUTS, ENTERING IN THE PRECEDING BASE Trade Type: Support/resistance breaking. Concept: Breakouts are an important class of trades and can give rise to strong price moves beyond the breakout point. Schematically, there are three places to enter breakout trades: before, after, or on the breakout. Trades entered on the breakout can incur high slippage and poor trade location due to the high volatility and low liquidity that accompany many of these trades; many traders find better success with executing either before or after the actual breakout. We will first look at some characteristic patterns preceding good breakouts in which the market tips its hand and shows that energy is being built up to support the breakout. (Think classic accumulation.) It is possible to enter in these formations preceding the breakout in order to have better trade location and to sidestep the potential slippage. Setup: Unfolding price action creates many potential support and resistance levels in the market. Most of these are insignificant—most support and resistance levels are nothing more than mirages. However, a very small set of these levels become extremely important, and, when violated, the pressure gives rise to a strong move beyond the level. For breakout trades, this is the first and most important condition: you must identify one of these significant levels that is likely to give good action when broken. If you are working with these levels and their accompanying formations, entering the trades properly, and managing them appropriately, breakout trades can be relatively easy. If you attempt breakout trades at insignificant levels and without a good plan, consistent losses will erode your trading account. Good breakout levels are usually levels that are clearly visible to all market participants. For instance, there are levels that have been tested cleanly multiple times, and it is obvious to even a casual chart reader that price has been unable to penetrate the level. This creates trading opportunities because some traders will make decisions when price eventually does get through the level. Whether they are stopping out of existing positions, taking profits, or entering on the breakouts does not matter; what does matter is that there will be additional volume and order flow when this important price level is violated. As a rule of thumb, entries in consolidations are usually less precise than entries in trends. Conceptually, we would like to buy as close to the bottom of the base as possible, but the most important thing is to get the position on. There are at least three logical entry triggers, each with some potential drawbacks. (These examples are for long trades, but apply, reversed, to shorts as well.) Once the base establishes itself, bid near the bottom of the smaller range. One potential drawback is that this order will be filled only in a declining market, meaning that you are buying against the short-term momentum. Another drawback is that the order may not be filled at all, so it may not be possible to get the position. Sometimes you will identify the range, bid near the bottom, and then watch the breakout as the market never returns to the bottom of the base. In these cases, you will miss the trade. However, the times that the order is filled will result in the best possible trade location, at or very near the bottom of the range. Once the base establishes itself, wait for springs (i.e., drops below the support at the bottom of the base that immediately recover back above the support level) and enter on the close of those bars. Though you will now probably be entering with the short-term momentum due to the recovery back above support, not every range features springs or upthrusts. In addition, this is a high-maintenance execution technique that requires good focus on subtle details of price action. Just get the position on, anywhere in the range. This one isn’t pretty, but the reality of trading is that our executions are not always at perfect, ideal points. Imagine we identify a breakout trade that has 10 points of upside potential out of a 5-point large range, with a 1.5-point base near the top of the larger range. If we can buy in that base and give it a 2-point stop, then maybe it doesn’t make sense to try to squeeze an extra half point out by bidding near the low of the range. There is no right or wrong here, and each trader will have to make the decision based on his personality and on how he intends to manage the trade. A trader who takes the proverbial 30,000-foot view and wants to manage things from a big-picture perspective might establish anywhere in the range and just not care about pennies. Another trader might intend to actively trade around and manage the position on the actual breakout; for this trader, pennies might be very significant indeed. This is also a good place to consider the adverse selection effect of entering on limit orders. Assume that trader A and trader B both identify the same set of 10 potential breakout trades and are buying bases before those breakouts. Also assume, though they would not know it in advance, that five of the trades will be losers. Trader A indiscriminately buys in the base and manages the trades, exiting his losers if they drop decisively below the bottom of the range. Trader B is much more precise with his entries and always bids at the bottom of the range. He is also disciplined about his exits from losing trades, and exits at the same points trader A exits his losing trades. Trader A and B both book their disciplined losers, though trader B’s total loss is slightly smaller because of his consistently better trade location. Of the five winning trades, perhaps three went to the bottom of the range where trader B was filled on his position before the breakout. Trader A and B both booked winners, though, again, trader B’s winners were slightly bigger, due to better trade location. Assume that the two remaining winning trades never went to the bottom of the base, so trader B was not filled on his entries, while trader A participated fully. This is a truism of using limit orders, and one that most people choose to ignore: if you enter on limit orders, you will price yourself out of some set of winning trades that never trade to (or, more realistically, through) your limit price while you will always participate fully in all losing trades. This is important—traders entering on limits will not be filled on some winners but will be filled on every losing trade. In our hypothetical example, we know trader B will miss some of trader A’s winning trades. We also know that he will have a small advantage, compared to trader A, on every trade because of better trade location, and the key question is whether that incremental gain is enough to more than compensate for the missed profits from the remaining two trades. This trade-off between market order and limit order entry styles is an important issue to consider, and one that is sorely neglected in the trading literature. Stop: There are two separate parts in the life cycle of this trade, requiring two separate approaches to trade management. The trade entry, by definition, is early. We are anticipating a breakout that may or may not happen, so when do we exit if the planned-for breakout does not develop? One simple strategy might be to put a stop below the lowest point reached while the market was in the base, with the plan that if you are stopped out on a temporary drop you probably must reenter the trade. Another approach is to set a much wider stop for the purposes of position sizing and risk management, with the idea to stop out before the level is reached if developing price action contradicts the trade. The second issue to consider is how you will manage the trade after the breakout occurs. Here, knowledge of the pullback patterns that occur after breakouts is essential. There are many possible choices, but the plan must be consistent with the realities of market action. If watching $50.00 as a potential breakout level, many traders would move their stop up to $50.00 or right under that level once the breakout actually happens. Their logic is that, if the breakout was actually valid, price should not come back below $50.00. This would seem to make sense, but the market does not work like this. Many excellent breakouts come back to retest or to exceed the breakout level in an effort to shake out weak-hand players; a good trading plan will not put you in this position of weakness. My approach to stops is so consistent that it is boring—I always set stops at places where the market should not go if my trade is correct. If I set a stop there and the market reaches the stop, the trade is wrong and I must exit. Setting a stop somewhere that it can be hit without my trade thesis being violated is anathema to me—why incur additional risk and transaction costs in the normal volatility of the market? Furthermore, it also usually does not make sense to dramatically tighten the stops once the breakout actually occurs, though it is also important to be sensitive to the patterns that suggest a breakout is failing. Distinguishing between these failures and the standard pullbacks of successful breakouts is a key skill for breakout traders to develop. Profit Target: Some traders will set ratio-based targets for breakout trades. Common examples use, for instance, measured move objectives based on the width of the preceding range or the base. These make sense for the same reason that all measured move objectives do—they simply define the magnitude of swings that are average for any given market, though it is important to realize that prebreakout conditions often feature abnormally contracted volatility. Ratio-based targets are apt to be unnecessarily conservative in these cases. In general, I do not favor setting profit targets for breakout trades, because, in the best cases, you just entered a new trend at its inception, and it does not make sense to give up that trade location as long as the trade is working well. Consider all of the possibilities, ranging from outright failure to a single extension above the level to a completely new trend. Just like with all my trades, I will take partial profits at a level approximately equal to my initial risk in the trade, and then will usually hold the remainder as long as the new trend appears to be intact, perhaps taking partial profits at other inflection points as the trade develops. Once you have a breakout trade that has gone through one successful, confirming pullback, it is simply a trend trade and can be treated as such, managing the pullbacks as in any other trend. Comments: We should also take a minute to consider simple channel breakout systems. It is well known by now that the core entry technique of the system the Turtles were taught was a breakout of a 20-day or 55-day channel. If you examine these levels carefully, you will see that most of them violate the rule I gave that good breakout levels have to be very real, visible levels in the market. In fact, most of these 20-day or 55-day highs/lows are not points that your eye would be drawn to on a chart. The success of some of the Turtles has grown into the stuff of legend and myth, but the breakouts were not the important part of that system. The general trading public has the idea that the Turtles traded breakouts of 20-day highs, but, in reality, much of their success was due to systematic approaches that were designed to capture every trend in markets that trended well at the time. The trade-off was that they had to accept many small losses on entries that did not develop into good trends, but, for their system to work, they had to be involved at the start of every potential trend. Our work in this book is focused on shorter-term swing trades around breakout levels, which is a completely different kind of trading. 7) BREAKOUTS, ENTERING ON FIRST PULLBACK FOLLOWING Trade Type: Support/resistance breaking. Concept: The first pullback after a breakout offers a spot to initiate a position in the direction of the new trend supported by the confirmation of a successful breakout. This entry also avoids the volatility of the actual breakout area, and the uncertainty inherent in positions established in the prebreakout base. Setup: The market has made a successful breakout of an important level. Furthermore, there is good activity (volume, volatility, and price action) beyond the level, proving that it was a valid breakout. The initial upthrust exhausts itself, the market rolls over, and a pullback begins. Trigger: This pullback can be treated as a standard pullback, with any of the standard pullback trigger entries. Stop: If the pullback is treated like any other pullback, the logical choice is to use the same stops you would apply to any pullback trade. There are two other levels worth considering here: the actual breakout level itself and any prebreakout reference level (e.g., support in the base, or the highest low preceding the breakout). Many traders will work with the idea that the breakout level should be a good price for stops, but it is not. Some of the strongest continuations will drop back below the level, stopping out naive weak-hand short-term traders, and then turn to trade much higher. These traders, now trapped out of the market, will have to chase it higher, adding additional impetus to the move. However, a good prebreakout level usually is a serviceable reference, and it is usually possible to tighten stops enough that a loss does not have to be taken to this level. (This level may still serve a useful purpose as a last-ditch exit and as a reference for position sizing.) It is very hard to justify holding a simple breakout pullback that drops below the pivot low of the prebreakout base, as this type of action is much more indicative of a failed breakout. However, it is not uncommon to see failed breakouts spend more time consolidating before breaking out and working on a second breakout attempt. These are certainly not the cleanest and easiest trades, and most traders will find that they enjoy the best success restricting their involvement to first breakout attempts. It is easy to overcomplicate these trades and to try to factor too many additional levels and patterns into the trading plan. At the end of the day, the first pullback following a breakout is nothing more than a pullback; there is no need for a complicated trade management plan if you already have the skills to trade pullbacks on other contexts. Profit Target: These are standard pullbacks, so standard pullback profit targets apply with one caveat: trends from good breakout levels tend to be exceptional trends. There is a better than average chance that any ensuing trend will extend for several legs with strong impulse moves. It still makes sense to maintain the discipline of taking partial profits, but it also makes sense to allow yourself the opportunity to participate in the potentially outsized trend run. This is another place where as a trader you will need to tailor the plan to fit your personality, but, of course, the key is to actually have a plan. Do not put yourself in a situation in which you have to make reactive decisions on the fly. Comments: In some sense, this is a hybrid trade, combining characteristics of both breakout and pullback trades, but it can be simplified further: it is really nothing more than a simple pullback trade. One last thought on breakout trades: we have not considered the higher time frame in these trade setups, and it often does not matter. A clear breakout level on the trading time frame will usually be an even clearer resistance level on the higher time frame, but there are cases where the breakout is further supported by the higher time frame structure. For instance, if an upside breakout on the trading time frame comes near the bottom of a higher time frame pullback in an uptrend, then the trading time frame breakout is essentially a breakout entry into the higher time frame pattern. Time frames often have complex interactions with influences flowing in both directions, but these considerations can sometimes add significant support to individual trade setups. 8) FAILED BREAKOUTS Trade Type: Support/resistance holding. Concept: Most breakouts fail. Setup: When most traders think of breakout trades, they think of big, dramatic winning trades, and it is not hard to find examples like this. However, the trader actually trading breakouts quickly comes face-to-face with a harsh reality: failed breakouts are more common than winning breakouts. This is not an indictment of the breakout trading concept, because exceptional reward/risk ratios can compensate for lower probability. Furthermore, good breakout traders know how to prequalify their trades by focusing on the patterns that tend to support successful breakouts and may have a higher winning percentage than might be expected. There certainly is money to be made trading breakouts, but it is also worthwhile to spend some time thinking about the patterns associated with breakout failures. It is difficult to nail these patterns down because it is not uncommon for good breakouts to have reactions that violate the breakout level. Imagine the frustration of the trader working with this flawed plan: pay into the actual breakout, and flip the position short if the breakout level does not hold. In the very common case of a volatile breakout with a pullback that violates the breakout level, this trader will first take a loss on the long position, and will now be positioned short as the pullback in the new uptrend begins its advance. This is a futile plan, but many developing traders fall into this trap because they attach too much importance to the retest of the actual breakout level. It is important to understand how the market really moves, rather than clinging to some idea of how the market logically should work. There are two setup conditions to consider: the strength of the move beyond the breakout level, and the character of the first reaction after the breakout. Good breakouts should have strong momentum, volume, and interest beyond the level. If this does not happen, it is more likely that the breakout will fail, perhaps painting a spring or upthrust outside the previous support or resistance level. In successful breakouts, the first reaction should be controlled and in proportion to this breakout thrust. It should look like a good pullback in the new trend, for that is exactly what it is. If the breakout fails, it will be through a failure of this first pullback; this is a critical point in breakout trading. If the first reaction is very strong (i.e., the first downswing after an upside breakout or vice versa for a breakdown through support), it suggests a failure of the break interest and greatly increased probability of trade failure. In terms of actual execution, the breakout failure is nothing more than a failed pullback. Breakout traders need to understand that the pullback pattern is a critical building block for these trades, and it is important to understand the patterns that suggest pullbacks failing and continuing. Stop: Saying most breakouts fail trivializes many of the issues we face trading these patterns because of the extreme volatility associated with breakouts and their failures. Being caught on the wrong side of a breakout trade (whether a successful or a failed breakout) is bad news. Stop placement is fairly simple, as the ultimate stop is above the extreme of the initial pullback thrust, but in this trade you must respect your stop fully and without question. If the stop is hit, get out of the trade. Do not try to trade around it; do not try to average your price. Just get out. You may play these games and get away with it 30 times in a row, but the 31st trade could wipe out many months’ profits. There is danger here—real tail risk—that is hard to comprehend and impossible to quantify. Profit Target: There are two likely resolutions to these trades. In some markets (for instance, longer-term commodities) failed breakouts can be absorbed into a large-scale consolidation. After spending some time working off the failure, the market may make another breakout attempt and continue to grind higher. The second possibility is that the market may truly melt down and collapse after a failed breakout. This outcome is slightly more likely in shorter time frames, but what we are looking for here is a violation of the base before the breakout and wholesale panic as trapped traders scramble to adjust positions. A good trading plan will consider both possibilities, with a provision to take partial profits at a relatively close target while holding a portion for a larger swing. From a practical standpoint, it probably makes sense to use the same profit targets on all trades, taking first partial profits at a point equal to the risk on the trade. In my own trading plan, I tend to be be aggressive in taking those profits on failed breakout trades, perhaps even exiting more than half of my position at the first target. As in all other trades, I will adjust that target to respect the geometry of the pattern. If a target is beyond a clear and significant level, adjust it by moving it slightly inside the level. This is nothing more than trading common sense. Comments: This is the most complex and least well defined of the major trade setups. Newer traders are probably best advised to not focus on this trade until some success is achieved with the other setups, but it is important to study these failure patterns even if you only intend to trade breakouts in the direction of the initial breakout. Awareness of how patterns fail and how trades fail can help you limit your losses and manage losing trades with equanimity. After you have traded many breakouts and internalized many variations of these patterns, you will begin to develop some intuition about them. Until then, the guidelines in this chapter will help you avoid some of the more serious and more obvious mistakes in trading these patterns. SUMMARY:  This has been a fairly long list of potential trading patterns, presented in the order in which I believe most traders should learn them. We started with the simplicity of the failure test, progressing to more complex pullbacks, then to the special situation of pullbacks after trend changes. Last, the volatile set of breakouts were added, and failed breakouts, which can be touchy, subjective, and dangerous, bring up the rear, so the progression is from simple and well-defined to complex and potentially confusing. There are only three core concepts here, which express the tendency of the trend to continue and the tendency of support and resistance to both hold and break. The other trade setups are derived from combinations of these core trading concepts. If this chapter has been confusing, consider this alternate classification. Primary Trades Pullback: The sine qua non of trend trading patterns (trend continuation). Failure test: A quick-and-dirty countertrend entry with a well-defined risk point (support/resistance holding). Breakout: The ultimate expression of support/resistance failing. Derived Trades Anti: A trend termination pattern that uses the pullback pattern as an entry and for confirmation. Buying support in a pullback: Basically a failure test entry into the pullback pattern. Paying a breakout of a pullback: A combination of a lower time frame breakout with a trading time frame pullback. Breakout, entering in base before: Anticipatory entry into a breakout trade; may use support at the bottom of the base as an entry trigger, so the trade is actually a support holding trade. Breakout, entering on first pullback following: Puts a simple pullback entry and probability in the context of a breakout trade. Breakouts, failed: A more complex version of the failure test; many of these are simple higher time frame failure test trades, but the motivating patterns are the failure patterns of pullbacks.

[scienceofstatisticaltrading]

The Art & Science Of Technical Analysis - Adam Grimes

First Principles 1. Markets are highly random and are very close to being efficient.

2. It is impossible to make money trading without an edge.

3. Every edge we have is driven by an imbalance of buying and selling pressure.

4. The job of traders is to identify those points of imbalance and to restrict their activities in the market to those times.

5. There are two competing forces at work in the market: i) Mean Reversion ii) Range Expansion These two express themselves through the alternation of trends and trading ranges.

The Four Trades

1. Charts are tools, just tools.

2. Trades fall broadly into two 2 categories: Trend following and Counter Trend trading. These two categories require significantly different mindsets.

3. The four technical trades are: i) Trend Continuation ii) Trend Termination iii) Support and Resistance holding iv) Support and resistance failing

4. Each of these trades is more appropriate at one market cycle than another. You lose if you apply the trades in wrong conditions. Market Structure and Price Action 1. Market structure refers to the pattern of relative highs and lows and the momentum behind the moves that created that pattern. Market structure is more or less a static element.

2. Price action refers to the actual movements of price within market structure. Price action is dynamic and ephemeral and must sometimes be inferred from market structure.

3. There are three critical areas of market structure to consider: trends, trading ranges, and the interfaces between the two.

Trends and Retracements 1. Trends move in a series of with-trend impulse moves separated by retracements. 2. Retracements often contain lower time frame trends that run counter to the trading time frame trend.

3. Trends that run counter to the higher time frame tends to reverse.

4. Complex consolidations in trends are reflections of the lower time frame trend structure and are common.

Trend Terminations into Trading Ranges or Reversals

1. Trend terminations are usually set up by momentum divergences, and are confirmed by market structure. Do not attempt trend termination trades without clear evidence of a change of character. 2. Trends may terminate either into trading ranges or into trend reversals.

3. Trends end in one of two ways: by rolling over as the trend loses momentum, or in parabolic climaxes.

Trading Ranges

1. Trading ranges are defined by support and resistance zones, which may or may not be clean, exact levels.

2. Classic accumulation/distribution patterns are recognizable at the extreme of ranges.

3. Violation of support and resistance does not necessarily invalidate the trading range. It is possible that the new range has simply expanded or moved to a new level.

4. Trading ranges serve a structural function in the higher time frame; higher time frame market structure can give a bias to the direction of the break from a trading range. In the absence of contradictory information, assume that any trading range is a continuation pattern.

Breakouts

1. Breakouts from trading ranges are volatile and are driven by disagreement over price.

2. The first pullback after a breakout is critical for assessing the strength of the nascent trend.

3. Breakout failures are far more common than successful breakouts.

[scienceofstatisticaltrading]

Elliot Wave Principle - Elliot Theory: Detailed Analytics

Credit: Elliot Wave Principle - Frost & Pretcher Hello Readers, starting from today I will attempt to break down and dissect one of the more detailed books on Elliot Wave Principle. Due to its complexity as well as length, and in an attempt to preserve its original content, I will be splitting the book into different sections. Part 1a: Elliot Theory: Basic Tenets Part 1b: Elliot Theory: Detailed Analytics Part 2: Guidelines of Wave Formation Part 3: Historical and Mathematical Background Part 4: Ratio Analysis and Fibonacci Time Sequences Part 5: Miscellaneous I hope to cover one part each week in its full comprehensive glory. I will copy and paste the initial message (this section), every week, and bold the portion that I will be going through. Motive Waves Basic rules: i) Subdivide into five waves. ii) Always move in the same direction as the trend of one larger degree. iii) Wave 2 of a motive wave always retraces less than 100 percent of wave 1. iv) Wave 4 retraces less than 100% of wave 3. v) Wave 3 always travels beyond the end of wave 1. vi) Wave 3 is often the longest and never the shortest among the three actionary waves (1,3 and 5) of a motive wave.

The function of a motive wave is to make progress, and these rules of formation assure it will. Impulse Waves The Impulse Wave is the kind we have been using so far to illustrate how the structure of Elliott Wave is put together. It is the most common motive wave and the easiest to spot in a market. Like all motive waves, it consists of 5 sub-waves; three of them are also motive waves, and two corrective waves. This is labeled as a 5-3-5-3-5 structure, which was shown above. However, it has three rules that define its formation. These rules are unbreakable. If one of these rules is violated, then the structure is not an impulse wave and one would need to re-label the suspected impulse wave. The three rules are: i) Wave 2 cannot retrace more than 100% of Wave 1. ii) Wave 3 can never be the shortest of waves 1, 3, and 5. iii) Wave 4 can never overlap Wave 1. This rule holds especially true for all non-leveraged cash markets. The actionary subwaves (1,3 and 5) of an impulse are themselves motive, and subwave 3 is always an impulse. Extensions Most impulses contain what Elliot called an extension. An extension is an elongated impulse with exaggerated subdivisions.  The majority of impulses contain an extension in one and only one of their three actionary subwaves. The rest either has no extension or an extension in both subwaves three and five.  The fact that an extension typically occurs in only one actionary subwave provides a useful guide to the expected lengths of the upcoming wave. Wave 3 is typically the wave that extends as it cannot be the shortest wave.  Extensions can occur within extensions.

Truncation / Failure This describes a situation where the fifth wave does not move beyond the end of the third. A truncation can be verified by noting that the presumed fifth wave contains the necessary five sub waves.

Diagonal A diagonal is a motive pattern and yet not an impulse, as it has two corrective characteristics. As with an impulse wave, the diagonal has no reactionary subwave fully retraces the preceding actionary subwave, and the third subwave is never the shortest. However, a diagonal is the only five-wave structure in the direction of the main trend within which wave four almost always moves into the price territory of wave one. Within which all the waves are “threes”, producing an overall count of 3-3-3-3-3. Diagonals are substitutes for an impulse at two specific locations in the wave structure- the first or the last wave of the motive wave. Ending Diagonal An ending diagonal occurs primarily in the fifth wave position at times when the preceding move has gone too far too fast. A very small percentage of diagonals do appear in the C-wave position of A-B-C formations. In double or triple threes, they appear only as the final C wave. In all cases, ending diagonals are found at the termination points of larger patterns, indicating exhaustion of the larger movement. 

Leading Diagonal Diagonals have been shown to be able to appear in the wave 1 position of impulses as well. The subdivision appears to be the same: 3-3-3-3-3, however, the authors warn that in two cases, a 5-3-5-3-5 labelling is possible as well. 

Corrective Waves The most important rule from studying corrective waves are that it never moves in fives. Only motive waves moves in fives. For this reason, an initial five-wave movement against the larger trend is never the end of a correction, only part of it. Corrective processes come in two styles. Sharp corrections angle steeply against the main trend while side ways corrections produce an overall sideways appearance. Specific corrective patterns fall into three main categories: 1. Zigzag (5-3-5; includes three types: single, double and triple) 2. Flat (3-3-5; includes three types: regular, expanded and running) 3. Triangle (3-3-3-3-3; three types: contracting, barrier and expanding and one variation: running) A combination of the above comes in two types: double three and triple three. Zigzags A single zigzag is of a three wave pattern labelled A-B-C. The subwave sequence is 5-3-5. Occasionally zigzags will occur twice, or thrice, especially when the first zigzag falls short of the normal target. In these cases, each zigzag is separated by an intervening three. Within impulses, second waves frequently spot zigzags, while fourth waves rarely do. Double zigzags are labelled as W-X-Y. The letter W now denotes the first corrective pattern in a double or triple correction, Y the second and Z the third (in a triple zigzag). Each subwave is now properly seen as two degrees smaller than the entire correction. Each wave X is a reactionary wave and thus always a corrective wave, typically another zigzag.  I’m unable to find a good example of a double zigzag in the DJIA. Hence if you need a more specific example, feel free to google for examples or email or leave a question on my tumblr. 

Flats A flat correction differs from a zigzag in that the subwave sequence is 3-3-5. Since the first actionary wave lacks sufficient downward force to unfold into a full five waves as it does in a zigzag, the B wave reaction seems to inherit this lack of counter trend pressure and terminates near the start of wave A. Wave C, in turn, generally terminates just slightly beyond the end of wave A rather than significantly beyond as in zigzags. A flat correction usually retraces less of the preceding impulse wave than does a zigzag. It tends to occur when the larger trend is strong. So it virtually always precedes an extension. Out of all the flat sub-types, the most common flat is called the expanded flat. In expanded flats, wave B terminates beyond the starting level of wave A, and wave C ends up substantially beyond the ending level of wave A. A very rare occurrence is the running flat, where wave B terminates beyond the start of wave A, and wave C does not reach the end of wave A.

Triangles Reflect a balance of forces, causing a sideways movement. Typically contains five overlapping waves that subdivide 3-3-3-3-3 and are labeled as A-B-C-D-E.  Wave E can undershoot or overshoot the A-C line. Wave B can penetrate the start of wave A (Running triangles). In rare cases, one of the sub-waves (usually wave E) is itself a triangle, so the entire pattern protracts into 9 waves. All triangles should effect a net retracement of the preceding wave at wave E’s end.

Additional notes from the authors regarding triangles: i) A triangle always occurs in a position prior to the final actionary wave in the pattern of one larger degree, i,e., as wave four in an impulse, wave B in an A-B-C, or the final wave X in a double or triple zigzag. ii) Often the time at which the boundary lines of a contracting triangle reach an apex coincides with the turning point of the market. Combination (Double and Triple Three) A double three or triple three are a combination of corrective patterns. There are a few guidelines the authors point out: i) The triangle is an allowable final component of such combinations. ii) A combination is composed of simpler types of corrections, including zigzags, flats and triangles. Their occurrence is to promote an extension of sideways movement. iii) As with double and triple zigzags, the simple corrective patterns are labeled W, Y and Z. Each reactionary wave is labelled X, and can take the shape of any corrective pattern, but is most commonly the zigzag. iv) Combinations appear to recognise and respect the character of triangles as the final wave. v) It is rare to have more than one zigzag or triangle. It typically starts with a flat and rarely repeats patterns in succession (Component patterns more commonly alternate in form, example, flat followed by a triangle).

Orthodox Tops and Bottoms A patterns’ end may differ from the associated price extreme. The actual price high or low may not be the end of the pattern, and this concept is important because proper labeling of the patterns is essential. Assuming falsely that a particular price extreme is the correct starting point for wave labeling can throw analysis off. Reconciling Function and Mode Labels for actionary waves are 1,3,5,A,C,E,W,Y and Z Labels for reactionary waves are 2,4,B,D and X. Actionary waves that develop in corrective mode: i) Waves 1,3 and 5 in an ending diagonal. ii) Wave A in a flat correction iii) Waves A, C and E in a triangle iv) Waves W and Y in a double zig-zag and a double three. v) Wave Z in a triple zigzag and triple three.

[scienceofstatisticaltrading]

Elliot Wave Principle - Elliot Theory: Basic Tenets

Credit: Elliot Wave Principle - Frost & Pretcher Hello Readers, starting from today I will attempt to break down and dissect one of the more detailed books on Elliot Wave Principle. Due to its complexity as well as length, and in an attempt to preserve its original content, I will be splitting the book into different sections. Part 1a: Elliot Theory: Basic Tenets Part 1b: Elliot Theory: Detailed Analytics Part 2: Guidelines of Wave Formation Part 3: Historical and Mathematical Background  Part 4: Ratio Analysis and Fibonacci Time Sequences Part 5: Miscellaneous  I hope to cover one part each week in its full comprehensive glory. I will copy and paste the initial message (this section), every week, and bold the portion that I will be going through. Elliot Theory The wave principle  is governed by man’s social nature, and since man does have a nature, its expression generates form. As the forms are repetitive, they have predictive value. Progress in the market takes the form of five waves of a specific structure. Three of the waves, labelled 1,3 and 5, effect the directional movement. The other two waves, labelled as 2 and 4, serve as counter trend interruptions.

There are 3 consistent aspects of the five-wave form: 1. Wave 2 never moves beyond the start of wave 1. (No 100% retracement) 2. Wave 3 is never the shortest wave. 3. Wave 4 never enters the price territory of wave 1. (Wave 4 will respect the support of the end of wave 1) Wave Mode There are two modes of wave development: motive and corrective.  Motive waves - Five wave structure, powerfully impel the market. As shown by wave 1,3,5 as well as the basic pattern itself. Corrective waves - Employed by all counter trend interruptions, which include wave 2 and 4. They are called corrective because they appear as a response to the preceding motive wave yet accomplishes only a partial retracement.  The Complete Cycle One complete cycle consists of eight waves, and is made out of two distinct phases, the five-wave motive phase (Denoted by numbers 12345), and the three wave corrective phrase (Denoted by letters, ABC).

The Essential Design When an initial eight-wave cycle ends, a similar cycle ensures, followed by another five wave pattern. This entire development produces a five-wave pattern of one degree larger than the waves of which it is composed.  This pattern is repeated to form one of a higher degree and so on, so forth.

Observe that within the corrective pattern illustrated above that waves A and C, which point downwards, are each composed of five waves, and within each of these 5 waves, wave 1,3 and 5 also contain five waves.  This construction discloses a crucial point:  1. Motive waves do not always point upwards 2. Corrective waves do not always point downwards 3. The mode of its wave is not determined by its absolute direction, but relative direction.    4. Waves divide in motive mode (five waves) when trending in the same direction as the wave of one larger degree of which it is a part of. Waves divide in corrective mode (three waves of a variation) when trending in the opposite direction as the wave of one larger degree of which it is a part of. (Aside from five specific exceptions). Why 5 - 3? I found this part to be one of the most revolutionary parts of the book. It was a simple revelation but nevertheless an important one. Think about why the waves are in a five - three sequence and you will realise that it is the minimum requirement for fluctuation and progress in linear movement.  One wave does not allow fluctuation. Three waves in both directions would not allow progress. To progress in one direction despite periods of regress, movement in that direction must be at least five waves to cover more ground than the intervening three waves.  Though there could be more waves than that, the most efficient (and of least resistance) path of punctuated progress is 5-3. Wave Degree and Nomenclature. 

Virtues of these form of nomenclature and labeling: 1. Progression in infinite in both directions. Based upon on easily memorised repetition. 2.  Motive waves are labeled with alternating sets of three Roman numerals followed by three Arabic numerals.  3. Corrective wave labels similarly between three upper case letters and three lower case letters.  4. Roman numerals always go with lower case letters. Arabic numbers always go with upper case letters. 5. All roman numerals are lower case below Minor degree and upper case above primary degree, so a quick glance at a chart reveals perspective on its time scale. Wave Function Waves serve one of two functions: Action or Reaction. An actionary wave trends in the same direction as the wave of one larger degree of which it is part. A reactionary wave is any wave that trends in the direction opposite to that of the wave of one larger degree of which it is part.  Reactionary waves are labelled with even numbers and letters. (wave 2,4 or b) All reactionary waves develop in corrective mode. However, not all actionary waves develop in motive mode. Most actionary waves do subdivide into five waves, however, a few actionary waves develop in corrective mode (they subdivide into three waves or a variation thereof). Summary of Technical Aspects These are the aspects of wave motion we will discuss in detail below. 1. Most motive waves take the form of an impulse (five wave pattern) which follows the three consistent aspects of the five wave motion. 2. These motive waves that take the form of an impulse are typically bounded by parallel lines (channels). 3. There is a rare motive variation called a diagonal, which is a wedge shaped pattern that appears at the start or the end of a larger wave (Wave 1 or A; Wave 5 or C). 4. Corrective waves have numerous variations: i) Zigzags ii) Flats iii) Triangles iv) A combination of above 5. In Impulses, wave 2 and 4 always alternate in form, where one correction is typically of the zigzag family and the other is not.    

[scienceofstatisticaltrading]

The Wave Principle - R.N. Elliot

The Wave Principle - R.N. Elliot The study of Elliot waves is the recognition that the human mental model, with all our emotions and psychology, are rhythmical in nature. A movement of an elliot wave occurs in 5 waves. 3 waves upwards (Impulse), and 2 waves downwards (corrective)

Wave 2 serves to correct wave 1. Wave 4 serves to correct wave 3. Every wave can be further divided into waves of lesser degrees. Every impulse wave will be further split into 5 waves, and every corrective wave will be further split into 3 waves. This is true for all waves in every degree.

Wave 4 should not carry to a level any lower than the peak of wave 1. This is a rule verified by experience according to the authors. There are 9 orders of wave cycles, arranging from the lowest to highest degree, are as follows: Sub-Minuette Minuette Minute Minor Intermediate Primary Cycle Super Cycle Grand Super Cycle Five waves of one degree will go up to make the first wave of the next higher degree. WAVE CHARACTERISTICS  1. A termination of one impulse wave indicates there has been five waves of the next lesser degree of movement, that the fifth wave of such next lesser degree will also require five waves of a still next lesser degree and so on.

2. The fifth wave of a movement, particularly the larger such as the Intermediate and above, generally will penetrate (throw over) the upper parallel line formed by channeling the the termination points of the second, third and fourth waves. Volume tends to climb on a throw-over. When the fifth wave of any degree fails to penetrate its upper channel line and decline occurs, this is a warning of weakness. The extent of weakness indicated is according to the degree of the wave.

3. A logarithmic scale is highly recommended to determine penetrations.

CORRECTIONS 

1.   Corrections always have three waves (less triangles, double threes, triple threes and double zigzags) which fall into these general types. Once the correction has been completed, the pattern indicates the strength of the ensuing move. In formation, it is sometimes difficult to forecast the exact pattern and extent.  The general outlines of patterns are the same in all degrees.

2. Strong corrections can prove useful as warnings of strong movements. Irregular corrections might have the second wave (B) exceed the orthodox top of the previous movement (5).

3. Strong corrections can prove useful as warnings of strong movements. A flat correction may indicate strong subsequent movement. 

4. Triangles are wave movements that taper off to a point or broaden out from a point in the form of a triangle. The triangular formations indicate the direction the market will take at the conclusion or apex of the triangle. Triangles are of two classes - horizontal and diagonal. Horizontal triangles represent hesitation. At the conclusion of a horizontal triangle, the market will assume the same trend which it was pursuing previous to triangular hesitation. Triangles, whether horizontal or diagonal, contain five waves. The fifth wave of all triangles (except reverse triangles) frequently falls short of its channel or triangle line (but it is possible for a penetration of the triangle line).  A diagonal triangle occurs only as a fifth wave, and usually signifies a significant reversal. 

EXTENSIONS

1. Extensions may appear in any one of the three impulses, wave 1,3 or 5, rarely in more than one, and usually in wave 5. The same rules apply to both extensions and extensions of extensions. 2. There are several rules of extensions: i. Extensions occur in new territory of the current cycle. ii. Extensions are retraced twice. (First retracement will occur in three waves to approximately the beginning of the extension (wave 2 of extension) and the second retracement will occur in the usual progress of the market and travel beyond the extension. iii. When an extension occurs in the fifth primary where a major reversal is due, the first and second retracements become waves A and B of an irregular correction. 

MISCELLANEOUS 

1. Different groups of stocks tend to establish lows simultaneously. One example is during July 1932, where many major spheres of human activity bottomed together.

2. In channeling, on an advance, the base line is below, on a decline, above.

3. Use weekly and daily charts to be able to judge several degrees of waves, and always keep the count of all degree on one chart so as not to arouse confusion.

[scienceofstatisticaltrading]

Correlation Check

Added a few pairs to my analysis table so decided to check all my currency pairs’ correlations to make sure I’m not over extending. Most of my majors are good to go, but the commodity pairs are highly related and I shouldn't be too invested in all of them at the same time. MAJORS USDJPY GBPSEK (89%) XAGUSD (-88.6%) GBPNOK (84.7%) XAUUSD  (-84.4%) CHFJPY  (83.4%) SGDJPY  (79.2%) EURGBP  (76.5%) USDCZK  (76.1%) EURUSD

USDX (-99.5%) USDHUF (-98.8%) USDSEK (-98.3%) USDCZK (-98.0%) USDPLN (-97.8%) USDNOK (-96.5%) EURSGD (96.1%) XTIUSD (94.8%) USDSGD (-94.2%) EURCHF (94.1%) GBPUSD SEKJPY (92.6%) USDMXN (-91.1%) GBPCHF (90.7%) USDCNH (-90.3%) EURJPY (87.5%) GBPSGD (87.4%) NOKJPY (87.3%) USDTRY (-85.2%) XAUEUR (-84.3%) USDPLN (-83.1%) USDCHF USDPLN (90.3%) USDX (87.1%) XPTUSD (-86.5%) EURUSD (-86.2%) USDSGD (86.1%) USDHUF (85.1%) USDNOK (84.9%) USDSEK (83.9%) XTIUSD (-82.2%) USDCZK (81.4%) USDCAD USDNOK (98.3%) USDHUF (95.9%) XPTUSD (-95.9%) USDSGD (95.8%) AUDUSD (-95.6%) USDSEK (95.4%) USDX (95.4%) XTIUSD (-94.3%) USDCZK (94.0%) USDPLN (93.9% AUDUSD AUDSGD (97.6%) USDNOK (-96.6%) USDCAD (-95.6%) USDSGD (-94.9%) XPTUSD (94.6%) USDHUF (-94.0%) AUDCHF (93.9%) USDX (-93.4%) NZDUSD (93.3%) XTIUSD (93.0%) NZDUSD  AUDUSD (93.3%) XPTUSD (91.8%) USDNOK (-91.2%) USDSGD (-90.7%) NZDCHF (90.5%) AUDSGD (90.1%) EURUSD (89.8%) USDHUF (-89.4%) USDPLN (-89.3%) USDX (-89.1%) EXOTICS EURAUD  EURCAD (68.6%) GBPAUD (63.1%) NOKSEK (-62.9%) EURZAR (61.6%) EURNZD (60.8%) AUDCHF (-57.1%) GBPCAD (53.9%) NZDCHF (-51.9%) XAGEUR (-51.5%) GBPNZD (51.5%) EURGBP GBPSEK (-90.4%) GBPAUD (-90.4%) GBPCAD (-89.3%) GBPJPY (-85.3%) GBPNZD (-85.2%) CHFJPY (-84.0%)  SGDJPY (-83.6%) GBPNOK (-81.9%)  USDJPY (-76.5%) EURCAD EURAUD (68.6%) EURZAR (66.3%) CADCHF (-47.8%) NOKSEK (-47.3%) EURNOK (46.8%) ZARJPY (-46.3%) CADJPY (-44.4%) CHFSGD (44.4%) USDTHB (43.4%) NZDCAD (43.1%) EURNZD NZDCAD (-73.2%) GBPNZD (61.8%) EURAUD (60.8%) AUDNZD (56.0%) USDHKD

EURTRY (43.0%) CADJPY (-41.9%) USDCNH (41.5%) GBPSGD (-40.8%) GBPUSD (-39.7%) GBPJPY (-39.0%) XAUAUD (38.7%) GBPCHF (-37.2%) ZARJPY (-36.7%) NZDJPY (-36.6%)