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TrendTradingforaLiving

LearntheSkillsandGainthe

ConfidencetoTradeforaLiving

Dr.ThomasK.

Copyright©2008byThomasK. Carr. All rights reserved.Manufactured in the UnitedStates ofAmerica. Except aspermitted under the UnitedStatesCopyrightActof1976,no part of this publicationmay be reproduced ordistributed inany formorbyany means, or stored in adatabase or retrieval system,

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Thisbookisdedicatedto:...myfather,whoisamuchbetter pastor than investor,but is supportive ofmyworknonetheless;. . . my late mother, whoalways encouraged her sonstofollowtheirdreams;. . . my lovely wife, Ina, forlooking after our toddlerwithout complaint while Iwrote (and for directing meback to the computerwhen Iwasn'twriting!);

. . . and my two lovelydaughters, Natasha andNadia, who are my bestinvestments; therisksmaybegreat,butthereturnonequityispriceless!

CONTENTS

FOREWORD BY ALANFARLEYACKNOWLEDGMENTSINTRODUCTION FromPassiontoProfession

PARTONEPreliminaries

CHAPTER 1 What YouNeedtoGetStartedCHAPTER 2 Becoming aChartReaderCHAPTER 3 Developing aTrader'sMindCHAPTER4The10Habitsof Highly Successful

Traders

PARTTWOTrend-TradingBasics

CHAPTER 5 What IsTrendTrading?CHAPTER 6 Setting UpYourWatchListsCHAPTER 7 DeterminingGeneralMarketDirection

CHAPTER 8 Put YourMarket-Reading Skills totheTest

PARTTHREEGetStartedinTrendTrading

CHAPTER 9 SelectingBullish Stocks to Trend-TradeCHAPTER 10 SelectingBearish Stocks to Trend-Trade

CHAPTER 11 Entries andExits

PARTFOURTrendTradingwithOptions

CHAPTER 12 OptionsBasicsCHAPTER 13 OptionsStrategies:BullishTrendsCHAPTER 14 Options

Strategies:BearishTrendsCHAPTER 15 OptionsStrategies:Neutral

PARTFIVETradingforaLiving

CHAPTER 16 The BiggerVision: Where TrendTradingCanTakeYouFINALTHOUGHTS

INDEXABOUTTHEAUTHOR

FOREWORD

andearna living through thetrading game. After all, noone but the mint is printingmoney, nor does it grow ontrees.So here's the bottom line

for anyone wanting to tradestocks, currencies,or futures.You'll either earn yoursuccessthroughhardworkorloseyourstakeandmoveon.Tradinghasamathematical

advantageoverinvesting,andgood traderswillmakemore

money over less time thangood investors.But the devilis in the details. It's thetrader'sjobtocapturevolatileprice swings that flatten outover the holding period of abuy-and-hold investor. As aresult,theyneedtomasterthechallenging skill of timemanagement.Takethispursuitseriously,

and find a strategy thatcapitalizes on marketmovement. Indeed, your

successorfailuredependsonthe path you choose. Themost dangerous road chasesprofits without anunderstanding of downsiderisk.The safest coursebuildsskills one step at a time andacts defensively when thingsgowrong.Fortunately, you've found

your way to Thomas Carr'sexcellent book on trendtrading.This informative textopensthemarketvaulttonew

and experienced traders,welcoming them into ourdiscipline with open arms.Indeed,you'llfindeverythingyouneedtogetstartedontheroadtotradingprofitsintheseenlighteningpages.But don't stop your

education there. Developingsuperior trading skills is alifetime pursuit, in whichwe're constantly on the huntfor new ideas, methods, andstrategies. This active

learning process keeps ourgame fresh in a predatorymarket world that takes noprisoners.Make sure your trading

matches your lifestyle. Youcanlosealotofmoneywhenyour reach exceeds yourgrasp. Don't trade every tickifyoucan'tfollowthemarketin real time. Don't day-tradeyour investments or buy andhold your trades. Never usethemarketasyourtherapyfor

personalproblems.Itmakesaterriblecellmate.Watch the clock, and

becomeasurvivor.Developasense of how stocks react todifferent cycles. Learn theunique traits of the marketday,week,andmonth.Theserepetitive tendencies affecthow prices move and howtraderstrade.Andtheyrevealtelling quirks that producehigh-probabilitytrades.Catalog strange market

behavior, and apply simpletechniques to trade it.Mastera few setups, and let thesepayyourwaywhileyoulearntoplaythegame.Realizethatchasing hot stocks is a badwaytomakemoney.Giveuptheexcitementandfollowtheprecision of classic marketmechanics. They'll produceconsistent profits, with farlessstress.Manage risk before

worrying about profits. The

most important rule of riskmanagement requires littleinterpretation: Don't enter atrade without knowing theexit. Understand the risk ofyour positions, and get outwhen the price action saysyou're wrong. Trading smallis the best way for newplayers to control risk untilthey learn how to makemoney. Remember that themarkets will be theretomorrow, next week, and

nextyear.Focusonpreciseentryand

exit.Pickyourprice,andstayon the sidelines when themarketdoesn'tgiveit toyou.Reduce position size whenyourbuyingorsellingsignalsdon't line up.Use discretion,execute wisely, andremember: good entries onbad stocks produce greaterreturns over time than badentriesongoodstocks.Thebesttradescomewhen

the information flow sendsthesamemessageindifferentways. A moving average,newsreport,andcross-marketsurgecanallsuddenlylineupand tell you to buy or sell.But avoid seeking out dataand opinions just to supportyour bias.Themarketswon'tcarewho'sonyourbuddylistwhenthey'rereadytomove.Finally, commit many

hours of study andobservation to the market.

Develop a predatory instinct,avoid greed, and view thishobbyasalifelongobsession.Work hard to complete youranalysis, and don't cutcorners. Develop your owntrading style and don't runwiththeherd.Be patient, and the doors

will eventually open toconsistenttradingprofits.

AlanS.Farley

Author

ofTheMasterSwingTrader

ACKNOWLEDGMENTS

perpetual student of themarkets and of tradingsystems, I am privileged tohave had many fine teachersand mentors whosecontributions to this volumeare evident on every page.Letmetakeamomentheretoacknowledge the mostimportantofthose.I owe a huge debt to the

writings of the late NicholasDarvis, my first and greatestmarket inspiration, whose

storyItellintheIntroduction.It was his box system thatfirstgotmestartedinsystemsdevelopment, and it was hisbreathless story of wealthcreation in the stock marketwhile pursuing a full-timecareerthatfirstinspiredmetobelievethatIcoulddoit,too.Even more, I am indebted

to Alexander Elder, masterteacher and marketpsychologist, also mentionedin detail in these pages. Dr.

Elderfirstrevealedtometheelegance and logic oftechnical analysis as appliedto price charts. Many of thekeyconceptsembeddedinthesystemsexplainedinthistextcomefromhisseminalwork,Trading for a Living, nowconsideredaclassicintradingliterature.I also wish to recognize a

family friend, the late GeneBrowning. Gene was asuccessful options trader as

well as a man of deep faith;heistrulyanexemplarofthelife well lived. Throughseveral phone conversations,Gene taughtme that a careerwatching numbers and chartsneed not necessarily excludea life of devotion to higherprinciples.Genewasfirstandforemost a disciple of JesusChrist. He always saw histrading skills as subservienttothatcalling.This bookwould not exist

were it not for Alan Farley,whose commitment toteaching the art of trading toothers is second to none.Many years ago Alanembarked on a career as atrader educator through hisWebsite,Hardrightedge.com,and it was his example andencouragement (at a timewhen trading was mostly aprofessional'sgamewithrulesunknown to the masses) thatinspired me to launch

Befriendthetrend.com, nowone of the leading onlinesources of trading education.IamdeeplyindebtedtoAlanfor volunteering to write theforeword to this book, and Iconsideritagreathonor.Other important members

in the cast of this dramainclude Jamie Caputo, vicepresident at RBC/CarlinEquities, whose passion andenthusiasm for supportingtraders is as rare as it is

contagious; Ken Adams,trading systems developer,superb encourager, and long-term Silicon Investor friend;and Dianne Wheeler, editorextraordinaire, and all hercolleagues at McGraw-Hill,fortheirtirelessconfidenceinthis publication and theirdedication to publishingprofessionalism.Aspecialthanksisowedto

allourfriendsandpartnersatBefriendthetrend.com: God

blessyouall!

TrendTradingforaLiving

INTRODUCTIONFROMPASSIONTOPROFESSION

minute: what does the stockmarket represent to you?What images come tomind?What feelings do youassociate with trading, withWall Street, with the globalmarkets? When I reflect onwhatthemarketsmeantome,thisiswhatIcomeupwith:

Afree-flowingstreamofnumbers, numbers,numbersGreensandreds,upsand

downs, peaks andtroughs,ebbsandflowsA melting pot ofproducts, services,technologies,commodities, andinformationManhattan high culture,soot-stained buildings,suspenders andpinstripesA barometer of theeconomic andpsychological state of

the nation, and of theworldPower,greed,discipline,corruption, intelligence,ecstasy,andagonyThe playground of veryenergetic people wholovemakingmoneyIcon of free-marketcapitalism, ofdemocracy,ofAmericaAn efficient, highlyaccessible vehicle forcreating wealth,

freedom,opportunity

Obviously, my impressionof the stock market is anamalgam of a variety ofthings.Themarketrepresentsto me the most challengingandmoststimulatingarenainall of human culture. I loveart, literature, architecture,science, film, and fashion. Iam a religiously committedperson and am conversantwith many of the world's

majorphilosophies.Butofallproducts of human making,no other so totally engagesmy intellect, my will, mypassion as does the stockmarket.My introduction to the

stockmarket came through arecurring image in the pagesof my favorite serial comicbook character: Richie Rich.There stood the "poor littlerich boy" in front of a glass-enclosed machine, slender

tape in hand, scrutinizing theever-growingRichfortunehewas destined to inherit. Theneural network this imagehardwired into my six-year-old brain must have beenpermanent, for I have beenstriving ever since tounderstandwhatMasterRichmust have understood as hestared at that long stream ofpaper.IfIwantedtolivelikehelived(andwhatyoungboywouldn't?), I knew I would

one day have to unlock thesecrets of that mysterioustickertape.On my eighth birthday I

asked for, and received, theoriginal,1968deluxeversionoftheWhitmanStockMarketGame. This classic game isplayed just like Monopoly,only instead of buyingfamous streets, youaccumulatesharesinsomeofthe world's biggest andfastest-growing companies.

At the time, thosecompaniesincludedMaytag,Woolworth,American Motors,International Shoe, andGeneral Mills (how timeshave changed!). Playersbarter and bid for shares andare forced to pay dividendswhen they landona stock insomeone else's portfolio.Unfortunately,Icouldnotgetany ofmy playmates excitedenough about the stockmarket to play with me. So

for the most part I playedalone, often for hours at astretch, bidding againstmyself as I amassed a smallfortune. Funny thing, Ialwayswon!Asanaside,the1968WhitmanDeluxe StockMarket Game is no longermanufactured, but you canoccasionallyfindoneforsaleoneBayforabout$20.My next childhood

association with the stockmarket came when I turned

12 and was old enough towalk on my own to thedowntownpubliclibraryafterschool. The first book Iremember checking out withmy new library card was abiography of HowardHughes. I devoured everypage,seeinginHughesareal-life, grown-up version ofRichie Rich. While Iremembernot liking themanverymuch,Irecallwantingtodowithmy lifewhat hewas

able to do with his. Iremember making theconnection in my mindbetween the ideas of risk,speculation, and passionateinvestment on the one hand,and on the other, the kind offreedomandpowerbothRichandHughesenjoyed.On my next visit to the

library I walked up to thelibrarian and asked, "Do youhave any books on the stockmarket?"Managing tohidea

smile, the woman escortedme quite courteously to ashelflocatedupstairsinafar,dark corner. After lookingovertheneatlystackedbooks,she pulled one down andhanded it tome. "Here," shesaid, "you might like thisone."Thebook'stitlecouldn'thavebeenmoreperfect:HowI Made $2,000,000 in theStock Market. It describedhow a young professionaldancernamedNicolasDarvas

amassed a fortune by tradingstocks on only three bits ofinformation: the high of theday, the low of the day, andthe close.Darvas invested infundamentally sound,growing companies breakingoutofconsolidationbasesonstrongvolume.Oncehemadea purchase, Darvas wouldsimply record the boxes thestockpricemadeasitmovedabove the base. A box waswhat Darvas called the

tradingrangethestocktendedto trade within, based on itsdaily highs and lows. If itbroke above the upper edgeof the box, he would movethe box up to a higher level,butifitbroketheloweredgeof thebox,hewould sell thestockandcuthislosses.AlthoughIdidn'tknowitat

the time, Darvas's book wasmy first introduction tosystems trading—and I washooked.But I alsoknew that

the kind of fundamentalanalysisDarvasappliedtothecompanies he traded wasbeyond the competencies ofmy 12-year-old brain. So acouple years passed before Ipicked up another stockmarket book. When I did, Ifounda realwinner, one thattaught me how a profitablesystem can turn the stockmarket into a virtual moneymachine. It was RobertLichello's 1977 best-seller,

How to Make $1,000,000 inthe Stock MarketAutomatically! Written inresponse to the 1970s bearmarket,Lichello developed asystemthatexploitedthetypeof volatility that typicallyappears at market tops andbottoms. Like Darvas's boxmethod, Lichello's systemwas simple and mechanical:after buying an initialposition in a stock, you buymore shares if thepricegoes

down and you sell shares ifthe price goes up. Amathematical formula wasappliedtotheclosingpriceatthe end of each week todetermine what to do withyourposition:buyalittle,sella little, or hold. In this way,Lichello claimed, a stockcould move up and downwithin a range—netting thebuy-and-holder very little—and still yield a handsomeprofit to the one using his

automatic investmentmanagement(AIM)system.After I finished Lichello's

bookIdecidedtoexperimentwith his system to seewhether it worked. I askedmyfather toexplain thatoddsectionofthepaperwithtinyprint that listed all the NewYork Stock Exchange(NYSE) companies and howthey fared in that day'strading. He showed me howto read the numbers and

suggested I focus on acompanyIwasfamiliarwith.I chose McDonald's. We atetheirhamburgersatleastoncea week, and though I didn'tknow that it was the fastest-growing franchise in theUnited States, I was wellaware from the big sign outfront that the number ofhamburgers served at ourlocal restaurant kept goinghigher. So I put the AIMmethod to work with an

imaginary 500 shares ofMcDonald's.Lichello's AIM method

requiresonlyaweeklyglanceattheclosingpriceofastockinordertoworkthesystem.Idecided that was tooinfrequent, so I checked theprice every day. I stillremember feeling absolutelyelated that first day aftermyimaginary purchase uponlearningthatMCDhadclosed+¼point,nettingmeapaper

profitof$100.By theendofthat first week, as I recall,MCDwasupawholedollar.A$500returninoneweek!The problem with

Lichello's method is that itonly works with stocksmaking large up and downswings. However impressivea $1 move might be, it didnothing to trigger AIM'ssignal to sell shares. Thatwouldhaverequiredatleasta$3move.SoIwatchedagain

the next week. Each day Icheckedthepapertoseehowmy shares did on the bigboard battlefield, and eachdaymyhopeswouldriseandfall with each quarter-pointadvanceordecline.ThiswentonforabouttwomoreweeksbeforeIfinallygaveupoutofsheerboredom.I decided to give Darvas's

box method another read. Idog-eared the library's copyofHowIMade$2,000,000in

the Stock Market, carefullytakingnotesonhowtoapplyevery aspect of the system.Again, I took an imaginaryinvestment in my favoritecompany, McDonald's. Itcertainly fit the Darvasprofile: strong earningsgrowth, hot prospects, andtrading in a long-range base.So early in the summer of1974I"bought"500sharesofMCD in my make-believetradingaccountandexcitedly

set about putting Darvas'ssystemtothetest.Idrewupakind of primitive spreadsheetforkeepingtrackof thedailyhighs and lows in order todetermine the boxesnecessarytomanagetheopenposition. At that time, MCDwastradinginthelow40s.Ithad recently broken out of amonths-long trading rangewith a lower edge in theupper20s andanupper edgein the mid-30s. I already

knew MCD was afundamentally soundcompany, and this basebreakout qualified as aDarvasentrypoint.SoIwentlongthestockaround$42pershare and set my stop-lossjust under the lower edge ofthenewtradingrange,around$37.Aboutthreeweekslater,the stock rallied to near $48before closing the month at$44,soIdutifullymovedtheDarvas box up two points.

My stop-loss now stood at$39, and I was comfortablyaheadnearly$1,000.Lifewasgood!For a while things looked

promising.Thepositioncameclose to getting stopped outfollowing a stern earningswarning,butmyboxwasnottouchedandIremainedinthetrade. Then disaster struck.MCD declared earnings thatfellbeloweventheir loweredprediction, and this was

followedpromptlybyseveralhigh-level downgrades. In aswiftNewYorkminuteIwastaken out of the trade for animaginary, but no lesspainful, loss of $1,500.Suddenly, and decidedly,mycareer as a teenage WallStreet tycoonhadcometoanend.Igrewupabitafterthat.I

got interested in sports,girls,parties—the usual adolescentdistractions.At18 Iwentoff

to university to studymedicine,untilIdiscoveredIhated being in hospitals andfelt nauseated at the sight ofblood. So I switched toreligious studies andphilosophy, and 10 years ofgraduate study later foundmyselfwithadoctorateinthesubject, teaching therudiments of Plato andAquinastoundergraduates.Having weathered a very

frugal decade as a starving

graduate student, and with amountainofstudentloansandcredit card debt to pay off,not even a full-timeprofessor'ssalarycouldtemptme back into the tradinggame.ButwhenItookupanoffertoteachsummerschool,the $5,000 bonus broughtwithit,ratherunexpectedly,areturnoftheoldtradingbug.The year was 1996 and a

new trading tool was all therage: 24-hour financial

television. First came theCNN-FinancialNetwork,andthen CNBC and BloombergTelevision. When this inputcoupledwith Internet tradingchat rooms, online discountbrokers, and cheap chartingWeb sites, Wall Streetquickly became Main Street.Themarket had just put in ahuge year in what was thenthe middle of the great bullmarket of the 1990s. Cabdrivers shared stock tips, bus

boys traded between shifts—theageof theday traderhaddawned. The smell of quickprofits was in the air, and Iwantedtoinhaleasdeeplyaspossible. So I opened anonlinebrokerageaccountthatsummer and put the entire$5,000 into it. In those days,there were no pattern daytrader rules, so with $5,000youcouldbuyup to$10,000worthofstockonmarginandtradeitrepeatedlythroughout

theday.I decided that with such a

small amount of capital towork with I had better stickwithlower-pricedstocks.SoIscanned the chat rooms andinvestor threads for ideas. Isoon found one. On all themajor sites, traders werebuzzing with talk about asmall public company thatwas developing a process bywhich to turn sewage intosafe drinking water. There

were rumors that the CEOwas going to be interviewedon a network news showsometime thatweek,and thathewoulddrinkafullglassofformersewageinfrontofthecameras to prove hisconfidence in his company'ssystem. Speculation ran wildthat thisexposure tomillionsof viewers would driveinstitutional investors to buyupsharesindroves.Thisseemedaboutasclose

toasurethingasIcouldfind.SoIdecidedtomakemyfirstreal-money stockpurchase inthis wastewater treatmentcompany. This small-capNasdaq issue was tradingaround$2.00atthetime,soIbought a starter position of1,000 shares. I anxiouslywatched the news that night,but there was no mention ofthe company. The rumorspersisted,andonthenextdaythe stock opened around

$2.50. In my euphoria, Ibought 1,000 more shares.When just before the closethestockhitahighof$3.00,Ibought 1,000 more shares,bringingmypositionto3,000sharesatatotalinvestmentof$7,500, one-third of whichwas borrowed from mybrokeronmargin.That night my heart raced

asthenewspromomentionedafeaturestoryona"miracle"waterpurificationsystemthat

could revolutionize the waywater is used and suppliedaround the world. Thispurification process washeralded as having thepotential to save the lives ofmillions of children aroundthe world who wouldotherwise have no access toclean drinkingwater.At thatmoment I clicked onto thediscussion thread monitoringthe stock and shared in thepreannouncement revelry

along with dozens of otherinvestors who, like me, hadboughtthousandsofsharesinanticipationofthismoment.Ihad never imagined tradingstocks could be this easy, orthisfun.Wewereallgoingto"clean up" on this one, punintended!I waited restlessly through

the other stories of theevening until Tom Brokawfinally announced the featurewewere allwaiting for. The

previewclipevenshowedtheCEOofan"innovativewatertreatment company" beingchallenged by Brokaw todrink a glass of what wasformerly sewage, purified byhis system. The CEOannounced, "Sure, I'll drinkthat!" With those words, IbeganamentalprocessthatIhave repeated numeroustimes since: I begancalculating what I would dowithmysuddenwindfall.My

conservative estimate wasthat the stock would doubleovernight, givingme a paperreturn of at least +125percent.Iplannedtosellhalfmysharesandholdtherestasa free trade as the stockrampedupintodoubledigits.With a fresh account of$7,500 in cash, Iwould thenbegin stalking my nextconquest and do the samething over again—and againand again—until, like so

manyoftheotherdaytradersI had been hearing about, Iwould retire young to aseaside mansion and spendmydaysloungingpoolside.The commercials ended,

and Brokaw stood again onscreen,readytointroducethefinal story of the night. Hebeganbyoutliningtheglobalproblem of polluted water,whichaccountsforamassivenumber of deaths indevelopingnations.Withthat

segue, he ushered in theconcept of using ultravioletradiation along withmicrofilters to sanitizewastewater. At that moment,there flashed over Brokaw'sright shoulder a companylogo and name, a companythat held the patent on andexclusivemarketing rights toa machine that is capable oftransformingrawsewageintosomething that even Eviancould bottle. There, plainly

visible to millions oftelevisionviewers—includinghundreds of hedge fundmanagers, mutual fundanalysts, brokers, and daytraders—was the logo andname, not of the companywhosesharesIowned,butofitsprimarycompetitor!Oncetheinitialshockwore

off, I immediately plungedintodenial.Surelytheremusthave been some mistake.NBCmiscuedthenameofthe

company, and tomorrow apublic relations campaignwould swing into action tocorrect the misinformation.Or perhaps, I quicklyreasoned,thisis,infact,verygood for our company.Peoplewillnowinvest in thewhole sector, and our littlecompanywillgetsweptupinwhatwouldbecomethegreatwater purification bubble of1996!As I tuned back in to

Brokaw's interview, Iwatched intently as the CEOdrank a full glass of watertaken from his machine. Wewere told that the water hadbeen reclaimed runoff fromthecity'sdrainagesystem.Nodoubt this display ofconfidence in the capacity ofthe process to producepotableproductwouldgo farwith industry analysts. Iimagined thousands of callsbeing placed the next day to

brokersaskingaboutanyandallcompaniesworkinginthisniche market. Again, myeuphoriareturned.All was well and good—

untilBrokaw asked one finalquestion: "So just when willyourmachine be available tothe market?" It was areasonable question, the kindofquestiononewouldexpecta top-notch journalist likeBrokaw to ask. And to thisday every bit of the CEO's

answer—the tonality, themeter, the syllabification—remains embedded in mybrain."Oh, theprocess is tooexpensive right now tomakeit marketable." "So . . ."Brokaw pressed, "just howlong will it take to get thecosts down?" "Well, we are15, maybe 20 years out,"repliedtheCEO.Andthatwasit.Therewas

nothingtobedoneaboutit.Inthose days there was no

postmarket trading availableto make a quick exit. All Icould do was wait it out. Iknew that throughout thenight, traders would startpiling up the sell orders, andinthemorningatthemarket'sopen the price of the stockwould plummet—and alongwithit,allmyhopesforearlyretirement! Sure enough, thestock opened the next day at$1.75 per share, well belowmyaveragecostbasisfor the

position. There were far toomanyordersaheadofminetogetsomanysharesouteasily,and by the time my orderfilled, I received $1.38 pershare, for a loss of over$3,500 if you include thecommissions. My tradingaccount was devastated. In afit of shame and self-disgust,Iwired themoneyoutof theaccountandcloseditthenextday.Well, even after that

embarrassing experience Isimply could not shake thetradingbug.ThenextsummerItaughtsummerschoolagain,and again I opened a smalltradingaccountwithmyextra$5,000.Thistime,IdecidedIwould do things the rightway. I would transformmyself into a long-term buy-and-holder, a value investor,a champion of soundfundamentals and fiscalresponsibility. I read just

enough Lynch, Buffett,Zweig, and O'Neil to knowthat what I was looking forwas a company with thatmagic combination ofregularly increasingearnings,increasingpricingpower,lotsof cash on hand with littledebt, a hot new set ofproducts, and solid growthprospects.IbelievedtheroadtomarketricheslayinfindingthenextMicrosoft,Wal-Mart,orStarbucksbeforetherestof

the investingworld.Youbuybeforethegrowthphasehypehits thestreetsand thenhangon until, after a dozen splits,you sell your nest egg for asmallfortune.Bolstered by this hope, I

went searching for the nextbigthing.WhatIfoundwasaseries of stocks destined,throughnofaultoftheirown,toseparatemefrommyhard-earned money. There is nowayIcouldhaveknownitat

the time, but that summer of1997 was not the mostopportunetimetoinitiatenewlong positions. Despite aragingbullmarketintechandInternet stocks, the broadermarkets were overdue for aconsolidation, and they suregot one: the S&P choppedsidewaysforfourmonthsandthenmidyearbeganadeclinethat took it 13percentbelowits high. It was in thatenvironment that I had

determinedIwouldbeginmycareer as a successful long-terminvestor.So after several days of

research, I bought a smallcompany that provideddiagnostic equipment to theairline industry. The stock'spress releases referred to thecompanyasholdingexclusivecontracts with several largecarriers.Newmanagementonboardhadbeenweanedawayfrom successful careers

elsewhere. There was littledebt and plenty of cash onhand to begin buying up thecompetition. This companyhadthesmellofBuffettologyall over it. It had the rightproducts, under the rightmanagement, and with therightbusinessplantotakemeandmynesteggtothezenithof financial security;unfortunately, it was in thewrong sector. As profits forthe airlines began to dry up,

my little company and itsexclusive contracts werequickly shown the door. Thestockwentfrom$5persharetounderabuckandwasthendelisted from the Nasdaq,before the companyeventuallywentbankrupt.Next I bought a boutique

electronics dealer with anabsurdly low price/earnings(P/E) ratio, no debt, and lotsof great press. It hadweathered the market

pullback well and hadrecently hired a new CEO.Moreover, the company hadjustfinishedaseriesofsmallacquisitions, which wouldensuretheirstrongholdintheindustry. But, as luck wouldhave it,Wal-Mart,BestBuy,and Circuit City were justbeginning to expand theiroperations,andmylittle firmjust couldn't compete.Again,Ilostmoney.I decided to give the buy-

and-hold strategy one moretry. With what little cash Ihad left (about $1,000), Ibought into a company that,after DELL and CSCO, wassupposed tobe themust-ownstockof1997.Thestockwasinacompanythatwentbytheunusually Latinate name ofQualcomm.InlateOctober,thebroader

stock indexes had rallied offtheir lows and looked to bebreakingouttonewhighs.So

with what was left of mytrading stake, I bet it all onQCOM.Within three weeks,it dropped 40 percent. Butthiswasa long-termhold, soI dutifully held on to myshares.Iheldthestockforsixmore months. It went up; itwent down. It went up anddown again. And again.Finally, at just slightlyworsethan a break-even price, Isoldmyshares just toget ridof the nausea. Imagine how

heartbroken I felt when lessthan a year later the stockramped up by 2,500 percent!Had I held on to those fewshares worth around athousandbucks,Iwouldhavehad the opportunity to cashout within the year with aquarter-million-dollar nestegg.Arrggh!It was at this point that I

decided to formulate threerules that Ihaveheld to eversince:

1. Don't trade on chat roomtips.2. Don't trade on newsreports.3.Don'ttradeoneconomicorbusinessforecasts.I decided that I needed, in

all humility, to admit theshortcomings in mypreparation as a trader.Although I possess anembarrassing amount offormal education, I amtrained in neither economics

nor business management. Iremember the supply-and-demandcurvefrommybone-head economics class incollege, but the finerintricacies of micro- andmacro-economicrelationshipsescapeme.Thus,Idecidedtoleavefundamentalanalysistothe professionals. As for hotstock tips or trading newsflashes, there is already ahealthy crowd moving in onthatactionandI'veneverhad

muchofalikingforcrowds.No, if I was going to

succeed in the trading game—and by now this was amatter of resolutedetermination—Iwould haveto come up with a tradingmethodology that was wellsuited tomyexperiences,mytemperament, and theconstraints on my time andenergy as a full-timeprofessor. Following severalweeks of research, I decided

that what I needed to learnmore about was technicalanalysis, a methodology thatreliesonsimplemathematicalrelationships along withintuitive price patternrecognition.Think about this for a

moment: fundamentalanalysis relies on an almostinfinite array of inputs, frombalance sheets and earningsprojections to changes inmanagement, sector cycles,

product development, and awholehostofotherthingstoonumerous to mention. Howcan any single human mind,however well trained inbusinesstheory,keeptrackofit all? And not only do youhave to know everythingabout the company youwantto invest in,youalsohave toknow everything about itscompetitors, its sector, itsindustry . . . and then youhavetoweighthisknowledge

against a background ofnational, and indeed global,economic analysis. Frankly,whohasthetimeforallthat?Now consider this idea:

what if everything youneeded to know about acompany's future prospectswere already there in thepriceofitsshares?Thisisthekey assumption of technicalanalysis. If the price of yoursharesisgoingup,themarketlikes your company's

prospects.Ifthesharepriceisgoingdown,itdoesn't. It'sassimple as that. Technicalanalysis saves a ton of time,is accessible to anyoneregardless of education, and,if rightly applied, worksprettydarnwell.SoIdecidedthenandthere

thatIwouldfocusexclusivelyon technical analysis totrigger my buy and sellsignals. The combination ofdisciplines inherent to

technical analysis seemed tomeshwellwithmyacademictraining: as a scholar ofancient texts, I hadexperience both in theobjective discernment oflinguistic relationshipsand inthe more subjective art ofinterpretation. Technicalanalysis seemed to me to bethe closest thing to puttingthese two skills to work onthemarkets.Instead of income

statements and balancesheets, technical analystsworkwith price charts. Pricechartsgraphicallyportray thehistorical movements of astock's price and tradingvolume. They are fixedpicturesofastock'spastpricebehavior over time. Theanalyst who works withcharts is thus part historian,part psychologist, partphilosopher: with anexperienced eye, she reads

the chart to understand itspast price patterns, whichthenallowsher togenerate apsychological profile of thestock's current state, as wellas project a conceptualframework within which thestock is most likely to movegoing forward. In otherwords, technical analysts areto the financial world whatliberal arts professors are totheworldofacademia:highlyexperienced in the arts of

evaluation,interpretation,andapplication.So with my newfound

commitment to learning thefiner points of technicalanalysis, I went in search ofmentors.The first thing Ididwasenrollinaseminartaughtby a fellow whose name Iwon't mention here, since hewas later convicted of fraudby the Securities andExchange Commission(SEC). Nevertheless, while

this trader'smarketing tacticswere suspect, he did, in fact,teach a valid, if basic,technical methodology, theskeleton of which forms thebasis of several of thesystemsoutlinedinthisbook.In the seminar I was taughthow to use moving averagesto determine trend directionand strength, and thestochastics indicator to timeentriesandexits.Tothisday,I use both to advantage and

consider this particular setupthe most reliable of allpossible setups. To thisfellow I truly owe thefoundation of my entire"befriendthetrend"system.An Amazon.com search

led me to a second mentor,Alexander Elder. His 1993best-seller, Trading for aLiving,nowdeemedaclassicin the field, is a highlyreadable introduction to boththe mathematics and the

meaning of the various toolsused by technical analysts.Elder is himself aprofessional psychologist, soI immediately felt at homewith someone who, like me,came to theworld of tradingwithout a Wall Street or B-schoolbackground.FromElder I learnedmost

ofwhatInowknowaboutthemost common technicalindicators. I learned whattechnicaloscillatorsandprice

patterns tell us about thepsychological state of equitymarkets. I learned abouttrend-lines and how to usethem to apply patterns ofcontainment to futuremovements in price. Mostimportant, perhaps, I learnedto recognize and evaluatedivergences between priceandoscillatorbehavior.Thesedisjunctions between pricetrends and the visuallyportrayed mathematics of

those trends provideimportantpsychologicalcluesto the current health andlikely forward projection oftrends.Other seminars were to

follow. I spent time withWellesWilder, learning howtocombinevariousindicatorswith projection trendlines. Ilearned the finer points ofJapanese candlesticks fromSteve Nison. In addition toreading all the best-selling

books about day trading, Iread widely about the stockmarket itself, the history ofWall Street, and thebiographies of several of itsbiggest players. With theseresources under my belt Ibegan to put together andexperiment with varioustechnical systems that couldbe used to recognizeprofitable marketprobabilities. It is this set ofsystemsthatIamreferringto

inthisbookwhenItalkabouttrend trading. I use thetechnical systems I havepersonally developed todetermine the nature andstrength of a stock's trend,and then use those systemsagain to alert me to short-term buying and sellingopportunities.There are four different

sourcesofinputusedinthesesystems (in no particularorder):

Price patterns (asdeterminedbytheuseoftrendlines and channellines)MovingaveragesTechnical oscillators(the exact mix I usechanges with themarkets, but the corefive are MACD,stochastics, RSI, CCI,andOBV)Japanesecandlesticks

Essentially, successfultechnicalreadsofstockchartsare all about two things:present price and past price.Price patterns supply thehistorical context portrayedby past price that in turngives meaning to presentprice. Moving averages giveus a visual smoothing of thechanging temporalrelationshipbetween the two.The various technicaloscillators render a visual

account of the mathematicalrelationships between thetwo. Japanese candlesticksgraphically mark therelationship between thecurrent closing price and therangewithinwhich the stocktradedonanintradaybasis.Definition:Apricetrendreferstothegeneraldirectionastockpricedisplaysonapricechartwhenitismovingeither

up(bullishtrend)ordown(bearishtrend).Whenastockisnotinatrendbutismerelymovingupanddownwithinatradingrange,wecallthatatrendlessorrange-boundmarket.Together, these four

vectors map out therelationshipbetweenastock'spast and its present statemuch in the same way the

tools of the philosopher(logic,theoriesofknowledge,metaphysics, etc.) allow himor her to apply ancientwisdom to the issues of theday.So I set to work

hammeringoutmysystemsinreal-time trading. In order todothisright,IknewIneededthesupportofanexperiencedcommunity. To that end, Ijoined an online tradingforumcalledSiliconInvestor.

In July of 1998, I started adiscussionthreadtherenamed"BefriendtheTrendTrading,"anditsoonbecameoneofthemost popular threads on thesite.Indozensofdailyposts,I thoughtout loudabouthowto best combine theseelements into a series ofworkable, profitable systems.Ipostedmypicksforthedayandfollowedupwitharecordof profits and losses. Soonother, more experienced

traders joined me, offeringtheir advice and contributingto the overall methodology.We became a tight,mutuallysupportive network. Andwithin a year, we wereconsistently, even at timesradically,profitable.Though no one knew it at

thetime,1999willalwaysberemembered—by traders atleast—as the year of theinfamous tech bubble. TheNasdaq market was ramping

up in parabolic fashion.Waiters and barbers wereretiring on their investmentsinQualcomm,Cisco,Yahoo,and Amazon. Everyone wastradingstocks,talkingstocks,hyping stocks. Traders weretrendy, sexy, and (soeveryone thought) rich.Theyweretreatedbythemedialikerock stars, makingappearances on GoodMorning America and TheTonight Show. Bankers,

doctors,dentists,and lawyerswere leaving their six-figuresalariestostayathome,sitinfront of computers in theirbathrobes, and day-trade. Ayear and a half later, themarketswouldcrashanddaytradingwouldbecomeadirtyword. Until that time,however, the party was onand therewasno shortageofrevelers.A few made an amazing

amount of money in those

heady days.Onewell-knownexample was Dan Zwanger.In 1999 he turned $11,000rescued from his greedy butincompetentbrokerintoa$14million fortune. Anotherfellowwhogoesbythenameof "Waxie" sold his tradingcard collection for $150,000,andafterhisbrokerreduceditto$30,000,hetookcontrolofhisportfolioandturneditinto$7million.We did okay, too. The

Silicon Investor threadnarrates my experimentalventure into the world ofhigh-turnover trading.Because my capacity tostomach market fluctuationsis not that strong, I mostlystuck with well-known,larger-cap issues as Icontinued to refine mysystems.Wedid not yield asmuch return as the Nasdaqdid that year (+86 percent),butwemanagedtoturninour

first full year of profitabletrading.Thencametheyear2000,a

year of reckoning. Once alltheY2Kfusshaddieddown,severalwordsthathadn'tbeenheardmuchthepreviousyearbegan to be tossed about onthe financial shows: wordslike valuation, sustainability,and that dreaded "b" word,bubble. The intradayvolatility increased fivefoldas prescient profit takers

clashed with bullishlatecomers. The get-rich-quickgoldrushwasover,butit took about six monthsbefore most traders andinvestors realized it. Duringthat time there were regularintradayswingsonascaleofwildness that would havemade even the late SteveIrwin, the Crocodile Hunter,recoilinfear.It was in that environment

that I began to experiment

withatradingsystemIcalledBTTT-MAX.BTTTstoodforBefriend the Trend Trading(ourcompanyname),andtheMAX part of the acronymstood for Moving AverageCrossover.Inthissystemyouwere fully invested 100percent of the time in oneormore of the most volatilestocks trading. You watchedtheintradayhourlychart,andon bullish crossovers, youwent long; as soon as a

bearish crossover wasspotted, you sold the sharesand immediately went short.Since in that environmentsignalscameeveryfewhours,and given the violent natureoftheintradayswingsduringthat period, BTTT-MAXquicklypileduphugereturns.I'll never forget my first

real-money experiment withBTTT-MAX.Iwasonspringbreak from the college andspent the week glued to my

computer, trading stocks. Inmy first experiment withMAX, I traded NOVL, thenpriced in the 30s but headedto single digits before theyear was out. I started with100 shares per side, takingevery signal on an hourlybasis. After three days oftradingIwasupnearly$800.Easy money! Encouraged, Iaddedsizeandbegantotradeabasketoffourstocksperthesystem.TwodayslaterIwas

upanother$2,200.Whilemycolleagues were outfertilizing their lawns, I hadbanked a cool three grandsimplybyclickingmymouseevery couple of hours. Nordid the fun stop there. Threemonths of extreme marketvolatility managed to exploitthe MAX system to such adegree that by the end myaccount had increased over500percent!Word soon got out about

the simple system with thecatchy moniker put togetherby a religious studiesprofessor who was turning amessy market into a pot ofgold. The Silicon Investorthread shot to the top of thehot list and stayed there forweeks, and I soon foundmyphone ringing with requestsfor interviews. The WallStreet Journal wanted toknow whether I thought themarkets would come back

and takeout theMarch2000highs. I don't remember nowwhat I said, but I'm sure itwas something like this: "Itreally doesn't matter. Whatmatters is having a greatsystem (like BTT-MAX),which can make money inanykindofmarket!"ThenU.S.NewsandWorld

Report did a feature storyonpart-time day traders, usingme as their poster child. Thestory included a full-page

color spread of "Dr Stoxx"sittinginhiscrampedcollegeoffice. Unbeknownst to me,thestoryintendedtofocusonlosingtraders,andsinceIwascoming off a hard week myonly quote after a three-hourinterview was about losing$1,500 on a JNPR trade.After that, I wised up to thefact that themediawished toportray traders negatively (asgreedy, irresponsible,sociopathicdropouts), and so

I declined all furtherinterviews.As seasoned traders know

well, a system likeBTTTMAX, which exploitsparticular market conditions,works well only until thoseconditions change. Sureenough, they did, and ourprofitsbegantodryup.Ihavesince refined the system tokeep us out of the marketswhenconditionsarenotright,but I doubt wewill ever see

returns with the system likewe saw in that magicalsummerof2000.In the years since the

market's bubble burst, sincethoseecstaticdaysofBTTT-MAX,I'vebeenhardatworkexpanding the universe ofBefriend the Trend Tradingsystems.In2002welaunchedour Web site,Befriendthetrend.com, alongwithafreeweeklynewsletterdesignedtohighlightonenew

stockpickeachweekderivedfrom whatever system wasworking best at the time.Today, five years on,we arestill going strong, with over7,000 subscribers to thatoriginal newsletter. Over theyearswehavelaunchedthreeadditional newsletters forpaying subscribers and haveseen brisk sales on the sixtrading manuals we havepublished and two seminarswe'veheld.Ourlatestventure

began in March of 2005,whenI incorporatedacapitalmanagement company andpartnered with RBC CarlinEquities and Goldman Sachsto oversee the Befriend theTrend Fund for accreditedinvestors. Yes, I still teach(and enjoy teaching)undergraduate students at thecollege the finer points ofphilosophyandreligion.Nothing has been easy

since the nearly vertical

market ramp-up of the late1990s. The broader indexeshave been trading withintighter and tighter ranges, astheSECandFederalReservearequickertoclampdownonexcesses.Currently,asIwritethis, various markers formarket volatility (the VIX,BollingerBandWidth,optionpremiums, etc.) are justbeginning to rise off historiclows. Global and localeconomies have had to

discountthingsliketerrorism,rising oil prices, and naturaldisasters. The currentbuzzword among marketprognosticators is notvaluation or bubble butgeopolitics. Day traders areout,andhedgefundmanagers—a far more powerfulinfluenceonmarketvolatility—are in. Recently, bothMerrill Lynch and GoldmanSachs fired dozens of tradersbecause they were not

making any money. Themarketsarejustthattough!The good news is that in

any market condition, withthe right systems at hand,tradingcannicelysupplementyourincome,andifyouhavethe patience to stick with itforawhile,itcanevenmakeyou very wealthy. It takessome work getting up tospeed on the terminology.Learning to read a chart is alittle bit like learning a

foreign language. But thehard part has been done foryou.Youhold in your handsthe culmination of years ofintensive labor,doneonyourbehalf.Hereyouhaveall theinformation you need to findstockspoisedtomove,totakepositions in thosestocks,andto exit those positions withthegreatestexposuretoprofitandtheleastexposuretorisk.The trading systems outlinedherehavebeendesignedtobe

as close to 100 percentmechanical as possible. Andeachsystemiscomplete.Youare not taught here a fewfundamental principles andthen left on your own toapply them to the markets.I've done all the necessaryapplicational steps for you.Allyouhavetodoiscopymywork.Allofthisistosay:ifIcan

do it, socanyou!Regardlessof your education, your

trading experience, yourfluency with numbers, you,too, can trade for a living.Canyoutellwhetheralineismovingupordown?Canyouclickamouse?Thenyou,too,can trade for a living.We atBefriendthetrend.com wishyou all the best as you startthis wonderful adventure oftrendtrading.

PARTONEPRELIMINARIES

CHAPTER1WHATYOUNEEDTOGETSTARTED

home-based business. Thereis no inventory to store inwarehouses, nothing to ship,nobothersomecustomers,nocold calling, no gimmickymarketing.Youdon'thave tohaunt garage sales and fleamarkets looking for items tosell on eBay. Unlike realestate investing, traders don'thave to worry about doingany maintenance work ortracking down renters whoare late with their payments.

There is no Wal-Mart downthe road to undercut yourprices.Therearenofranchisefees, no staff to employ, nolawyerstokeeponretainer.Yes, there is a certain

amount of starting capitalrequired, and yes, there aresomemonthly costs thatwillmake a small dent in yourprofits. Compared to mostother home businesses,however, trendtradinghasaslow a set of barriers to entry

as any business couldpossiblyhave.Profitmarginsrunwell over 90 percent. It'shardtobeatthat!Allyoureallyneedtotrade

profitably and comfortablyare a good chair, a newercomputer with a wide-screenmonitor, a high-speedInternet connection, somesoftware, a calculator, andpaper and pen. That's it. I'mguessing that many of youreadingthiswillalreadyhave

mostifnotalloftheseitems,but if you do not yet havethem, let me offer someguidance on the moreimportantones.

HARDWARE

I recommend using a recent-model desktop PC orMacintosh computer.

Between these two formats,theWindows-based option isthe better choice, since mostof the software useful fortrading is available only inthat format. With the recentsuccess of newer and fasterMac computers, this maychange in coming years, butfor now the widest selectionof trading software can befound only for theWindowsplatform.Regarding the computer,

processor speed is not asimportant as memorycapacity. To be sure, thefastertheprocessorspeed,thebetter. The fact is, though,that even the cheapest newPC today is plenty fastenough to handle what youwill need for trading.Memory,however,shouldnotbe skimped on.With a largeamount of random-accessmemory (RAM), youwill beable to run your trading

platform, charting software,news feed, and a couple ofWeb browsers all at oncewithout running the risk offreezingyourmachineduetooverload. RAM capacity of500MB is sufficient to runmost trading platforms andcharting packagessimultaneously, but adoublingofthatwouldnearlyguarantee a flawless tradingexperience.The monitor is also an

important piece of yourtradingarsenal.Asarule,thelargerthemonitor, thebetter.For this reason, laptops arenot the best choice fortrading. They are fine forthose days you are on theroadandneedtokeeptabsonyour portfolio. I find myselffrequently trading from thelocal Starbucks on a laptopwith wireless broadbandconnection. But try openingyour trading workstation,

yourreal-timecharts,aquotestreamer, your watch lists,and your Befriend the Trendnewsletters all at once, andyou will soon realize hownecessary it is to have asmuch desktop space aspossible. Some traders usemore than one monitor totrade from, and if you canafforditthisisnotabadidea.You may need to install adual video card to handlemorethanonescreen,butthe

small investment will beworthit.There are alsomultiscreen

and tiling screen monitorsnow that are designedespecially for traders. Thesecan give you up to 100diagonal inches of desktopspace:agenuineluxury.Theyare expensive, however,runningover$5,000each forthebettermodels.Asforme,I use a single, 24-inch flat-panel,high-definitionmonitor

anddonotconsiderthisatallhazardous tomy trading.Buttry to trade every day on atiny14-inchscreen?Noway!If you are interested in

multiple monitors and canafford it, take a look at acompany called DigitalTigers (assuming they arestill in business). Theyproducemulti-panelmonitorswith as many as sevenseparate panels, including atelevision display. Imagine

having CNBC on one paneland Bloomberg on anotherpanel, with additional panelsdevoted to your tradingplatform, a variety of yourfavorite charts, and browsersopen to trading chat rooms,discussion threads, and yourBefriend the TrendNewsletters. Now that istrading heaven! They alsomanufacture a product calleda sidebar, which allows youto plug a multiple monitor

intoyourlaptop(thoughthenitisnolongeralaptop,isit?).

SOFTWARE

Where you go with softwarewill depend greatly on whatkind of capital you arestarting with in your tradingaccount. If you are tradingunder $10,000, thenyouwill

needtofindwaystogetyourstreamingdataandcharts foras little cost as possible(remember, Istartedoutwithonly $5,000). If, however,you can fund your accountwithup to$25,000, thenyoucan afford to step up to thenext level, and I'll show youhow. If you are fortunateenoughtoplunkover$50,000of risk capital into youraccount, then let me showyou the sort of premium

services that will serve yourtradingwell.The truth is, you really do

notneedtospendanymoneyat all on software to have allthe tools you need to tradesafely and profitably. Therearefreeservicesgaloreinthetradingworld.Andamongthefee-based providers, manywill let you download theirbasicserviceswithoutpaying.Ofcourse,theyhopeyouwilllike their entry format so

muchthatyouwillbewillingtopayfortheupgrade.Butinmost cases you will have allthe information you need totrade the markets profitablywithout much in the way ofoverheadcosts.Among the free services,

your first stop should beStockcharts.com.Stockcharts.com offers afantasticWeb-basedtechnicalcharting service that you canuse for free. Simply by

signing up you will haveaccess to 20-minute delayedchartswith awide variety oftechnical indicators, limitedstock scans you can use tofindsetups,sectorandmarketbreadth analysis, and muchmore. Their candle-glancefeature allows you to createand save an infinite numberof small charts that you canuse as your primary watchlists (explained later). Withlow-cost upgrades,

Stockcharts.com will allowyoutoaccessreal-timechartsand scan for an unlimitednumberofsetups.Real-timequotesshouldbe

available from your broker,but if, like me, you like afreestanding quote streamer,you should download a copyof Jerry Medved's award-winning Quotetrackersoftware. It is free andcompatible with dozens ofdata sources, including most

online brokerages and real-time charting packages.Quotetracker includes LevelII quotes, real-time intradaycharts, price alerts, and anews feed—all for free! Thesoftware is ad-supported, soyouwill have to put upwithperiodic banners and pop-upads, but for a very smallmonthly fee (about the priceofonetradecommission)youcanuseaversionwithout theads. For further information

andtodownloadthesoftware,justgotoQuotetracker.com.If you wish to take your

trading to the next level andwant that extra measure ofcontrol over your entries andexits, then you will need areal-time charting package.While Quotetracker offersreal-time charts for free,manydonotfindthechartingformatveryuserfriendly.Thesame can be said for thechartsofferedbymostonline

brokers. Instead, I wouldrecommend moving up toIQCharts. As a midpricedservice, IQCharts offers areal-time, stand-alonecharting package thatincludesalltheindicatorsyouwillneed,intradaychartsthatautomatically update in realtime, the ability to storedozens of watch lists withslide-show capabilities, andboth prepackaged andconstruct-your-own scans

with technical andfundamental parameters.IQCharts is also one of theonly real-time chartingpackages currently availablefortheMacintoshplatform.Another midpriced option

is TC2000. In addition to areal-time charting system,TC2000offersstockadvisoryguidancefromthecompany'sfounders, the Wordenbrothers. They also have acommunity feature where

stock traders can chat witheach other in real time aboutwhattheyaretrading,andtheWorden brothers themselvesoffer free daily marketcommentary to all payingsubscribers.Thehighestleveloftrading

sophistication comes with aprice tag. If you can affordabout $125 per month foryourreal-timecharts(moreifyou want futures data), thentherearethreepackagesIcan

recommend: Quote.com,eSignal, and RealTick. I'veused all three services, andwhile there are a few minordifferences between them, Idon't have a clear favorite.Theseserviceswilltakesometime to get used to if youhave been trading on amorescaled-down format. Onceyou get used to it, though,you'll wonder how you evertraded on anything less. Ifyou plan on day trading any

of our trend-trading systems,then I strongly recommendgoingwitheitherofthesetwopremiumservices.There are many other

formsoftradingsoftwareyoucan purchase, but I'mconvinced that other thanyour broker's tradingplatform,abasicmembershipwith Stockcharts.com, and areal-time charting package,thereisnothingelseyouneedfor trading profitably.

However,therearetradersforwhomresearchishalfthefunof trading. For them there isno shortage of software andWeb-based services one canpurchase or subscribe to thatwill seemingly enhance theirability to investigate everypossible technical, economic,cyclical, and fundamentalangleofthemarkets.Two such services I can

recommend are MetaStock,which is a high-end package

that,amongotherthings,willallow you to backtest yourtechnicaltradingsystems,andVectorVest, which analyzesand ranks the universe ofstockseverydayaccordingtocertain fundamental andtechnical parameters. Again,however,totradewellallyoureally need to spend isbetween $10 and $50 permonth for the few basicserviceslistedhere.

INTERNETSERVICEPROVIDERS

When it comes to Internetservice providers these days,you have a lot of choices.There is dial-up, high-speeddial-up,HSDN,DSL,satellitebroadband, cable broadband,and T-1 lines. I've always

used a cable ISP and wouldnotwanttotradeonanythingslower. But then, I do a fairamount of day tradingwherespeed and a constant flowofdataareessential.Many subscribers to our

BTTTNewsletters tradewithdial-up and do just fine. Toenter your trade orders andmonitor your open positions,dial-upisnormallysufficient.Fortunately,tradinghoursformostU.S. timezonesat least

do not coincide with thosedreaded "porn hours" (lateevening) when the phonelines get jammed and dataruns slowly. If you are asubscriber to one of ournewsletters(oranynewsletterservice, for that matter), youwon't need the surfing speedrequired to do all the stockresearch. However, if youplan on doing your ownresearch—running yourmarket scans and checking

your watch lists each day—you will save yourselfcountless hours of surf timeby switching to a broadbandproviderofsomekind.I am on the road a lot

during the year and nearlyalways stay in hotels thathave high-speed Internetaccess, but occasionally Ihave to resort to using dial-up. Itworks just fineas longas you don't need to belightning fast when entering

and exiting trades. I alsorecommendkeepingadial-upservice installed and paid foras a backup during thoseinevitable times when yourcable or other higher-speedservicegoeson theblink.Tothis end, I can recommendusing NetZero's high-speeddial-up service. For $15 permonth you have the securityofknowing thatyouareonlyaphonelineawayfrombeingable to put on and take off

trades.One final option to look

into is a satellite service thatruns through your wirelessphone connected by modemtoyour laptop.Thiscanbeabit expensive, with monthlycosts running up to near$100, and in the recent pasttheyweretooslowtobecosteffective. However, thecurrent versions are muchfaster,andwiththissetupyoucan take your laptop nearly

anywhereintheworldandsetupyourtradingworkstation.

ONLINEBROKERS

Justafewquickwordsaboutyouronlinebroker:youneeda good one, an inexpensiveone, and one whose systemfor inputting trades you arecomfortablewith.Inmyyears

of trading, I've used most ofthe popular onlinebrokerages: Schwab, Datek,E*Trade, Suretrade,Scottrade, Investrade,Interactive Brokers, and MBTrading(someofthesearenolongerinoperation).Allofferdiscount pricing—thoughsome are more discountedthan others—and user-friendly trading and accountmanagementinterfaces.CurrentlyIhaveapersonal

account with InteractiveBrokers (IB) and trade theBefriend the Trend Fundthrough a prime broker(Goldman Sachs, which usesthe REDIPlus platform). Irecommend IB to anyone. Ihave found them to bereliable and inexpensive ($1orlessper100sharestraded),and their accountmanagement system is userfriendly. Some people,however, find their Trader

Workstation, which is whereyou input your trades,cumbersomeandconfusing.A recommended

alternative is MB Trading.They offer the same pricestructure as InteractiveBrokers,buttheyalsooffera$9.95-per-trade option forunlimited shares. This is anattractive option for largeraccounts or those tradingpennystocks.GenerallyIfindtheir MBT Navigator, where

trades are inputted, to beslightly more user friendlythanIB'sTraderWorkstation,though IB's recent upgradesto their system make thedifferences between the twoformatsminimal.

CHAPTER2BECOMINGA

CHARTREADER

am going to reveal exactlywhat I lookforwhenIselectnew trades to be included inthe various Befriend theTrend Trading newsletters.An important point toremember:selectingstockstotrade is the easy part.Knowing when to enter andexit is the hardest part, andthe most important part, oftrading. Both how to enterand how to exit yourpositionswillbediscussedin

detailhere.Before we get to the nuts

and bolts of how you canactually begin to put yourmoney to work in themarkets, however, we firstneed to discuss the mostimportant element of alltrading that is based ontechnical analysis: the pricechart.InthissectionIwilltellyouexactlyhowIsetupandread the charts I use forselecting new trades and

monitoringopenpositions.

THEINDICATORS

Thefirst thingyoushoulddois set up your default chartwith all the indicators andparameters you will need tomake technically soundtrading selections. Formyself, I use two sets of

charts: I make frequentreference to a delayedcharting service offered byStockcharts.comandconsidertheir charts to be the bestWeb-based service available.With their basic subscription(about $10 per month), youcansetupyourchartswithalltheparameters and indicatorsIteachhereaswellasscreenfor the setups taught later inthe book. Their charts arealso easy to read and can be

formatted to suit a variety ofaesthetic tastes. Recently,Stockcharts.com added real-timedatatotheirsubscriptionservice fora small additionalmonthly charge. While thechartsdonotupdateinstantlyas they do in the premiumservices listed previously,you can set the charts toupdateautomaticallyevery15seconds.The second package I use

iseSignal'spremiumcharting

servicewith real-time stocks,options, and futures data.With eSignal you can inputan infinite number of watchlists, andwith a simple clickof the mouse you can scrollthrough these easily in realtime. While the package Isubscribe to is fairlyexpensive and constitutes aconsiderable overhead cost,the advantages it affords areworth it. With the eSignalpremium package, you can

get automatically updatingcharts with real time in alltime frames, andwithwhat Iconsider to be the mostreadableformatavailable.If you use eSignal or a

similar service, likeQuote.com or RealTick, foryourchartingneeds,youhavethe opportunity to set upseveral charts that willsimultaneously displaydifferent time periods for thesame stock symbol. At the

click of the mouse, you canchangefromstocktostockasyou view weekly, daily, andvarious intraday charts foreach stock sideby side.Lesssophisticated chartingpackages such as IQChartsand TC2000 also allow formultiple charts in differenttime frames, but the linkagesbetween them are not asintuitive and are often buggyand unstable. For mosttrading purposes this is

sufficient, but where youneed theedgeofsplit-seconddecision making, there is nosubstituteforhigherquality.Whatever charting service

you use, you should add thefollowing indicators to yourdefaultchart:

Simplemovingaverages(SMAs): 20 MA, 50MA,200MAMoving averageconvergence-divergence

(MACD): 12–26–9periodicityStochastics: 5–3 (or 5–3–3)periodicityOn balance volume(OBV)Relative strength index(RSI):5periodicityCommodity channelindex (CCI): 20periodicity

If you are confused at thispoint, don't worry. Here is a

simple primer on what theseindicatorsmeanandhowtheytendtobeused.

Simple Moving Averages(SMAs):20,50,and200Settings

Theory: An MAmeasures the consensus,oraverage,closingpriceof a stock over a given

period of time. A 20setting shows theaverage price over 20days, and so on. Asimple MA is one thattakes an equallyweighted average ofprice.Reading the indicator:SMAs represent priceconsensus over a givenperiod of time. Whenprice gets too far awayfrom the consensus, it

tends to revert to thatconsensuslikeamagnet.In turn, SMAs tend toact as barriers to price,putting a stop to anytrend that runs into it.SMAs also indicatetrend: if they are slopedup, the price trend is up(bullish). If they aresloped down, the pricetrend is down (bearish).If the slope is sharp, thetrendisstrong,andifthe

slope is shallow, thetrend is weak. A flat orchoppySMAindicatesarange-boundmarket.Uses:

1. To show areas of supportandresistance

2.Todetermine thedirectionand strength of the currenttrend

Chart example: Figure2.1 shows the S&P 500

proxy (SPY) with boththe 20 (dotted line) andthe50(solidline)SMAsoverlaid.Notehowthe

Figure 2.1 Dow Jones

IndustrialAveragewith20/50SMAs.upward slope on the left ofthechartconfirmstheuptrendin price and acts as supportfor that uptrend, while theright of the chart shows theSMAs confirming abreakdown in price. The flat50SMA in the right third ofthe chart indicates a choppy,range-boundmarket.

Moving AverageConvergence/Divergence(MACD): 12–26–9 PeriodicitywithHistogram(aBarGraphofDailyMACDReadings)Overlay

Theory: MACDmeasures the differencebetween a shorter-termconsensusofpriceandalonger-term consensus,and works on the

assumption that whenthese diverge, thecurrent price trend isincreasing in strength,andwhentheyconverge,thetrendisdecreasinginstrength.Theperiodicitysettings represent thefollowing: a 12-daymovingaverageofprice(short-term), a 26-daymovingaverage(longer-term), and a 9-dayaverageofthedifference

between the twoaverages.Reading the indicator:Positive MACDreadings (above the 0-line) indicate that bullsare in charge of themarket, while readingsbelowthe0-lineindicatethat bears are in charge.The length of thehistogram bars can beused to determine thestrength of trends: the

longer the bars, thestronger the trend (andvice versa). Also, boththe MACD signal linesand the MACDhistogramcanbeusedtoshow bullish or bearishdivergence from price,which can give tradablesignals (the termdivergence will beexplained later).Crossoversfrompositiveto negative MACD

readings,andviceversa,do not offer reliabletrading signals, sincethey tend to lag themarket.Uses:

1. As a contrarian indicatorwhenitdivergesfromprice

2. To determine the strengthorweaknessofpricetrends

3. To determine whether amarket is currently bullishorbearish

Chart example: InFigure 2.2, the SPY hasthe MACD below it,showing an interestingrelationship betweenindicatorandprice.Notehowas

Figure2.2SPYwithMACDindicator.the uptrend matures, MACDfailstoputinnewhighsevenas price does so. This

indicates relative weakness,or bearish divergence. Alsonote the moves above andbelow the0-linewith respecttopricemoves.Clearly theseshifts cannot be used astrading signals since theycome too late to catch themove, but they are valuableinindicatingtheoverallmood(bullish or bearish) of thestock'sprice.

Stochastics: 5 (%K), 3 (%D)Settings

Theory: Stochasticsmeasures therelationship between themostrecentclosingpriceand the totalprice range(highs to lows) over agiven period of time. Adeclining stochasticsindicates that price is

tendingtoclosenearthelower end of its recenttrading range (bearish),whilearisingstochasticsindicates that price istendingtocloseneartheupper end of its recenttrading range (bullish).%Disamovingaverageof %K values over agivenperiod.Reading the indicator:Stochasticsgives a clearbuysignalonceitpasses

below the 20-line(oversold) and then%Kcrosses over %D. Itgives a clear sell signalonce itpassesabove the80-line(overbought)andthen %K crosses under%D.Uses:

1.Toregisteroverboughtandoversoldlevelsinprice

2. To register entry and exitsignalsfortrendtrades

Figure 2.3 SPY withstochasticsindicator.3. As a contrarian indicatorwhenitdivergesfromprice

Chart example: InFigure 2.3, the SPY hasthe stochastics (5–3)below it.Note howdipsto or below the 20-line(oversold) often precedesharp upward thrusts inprice.Thesignalstosellover the 80-line(overbought) are lessreliable during theuptrend, but offerprofitable tradingopportunities once the

index shows someweakness in the overalltrend.

OnBalanceVolume(OBV)

Theory: Since OBV ismeasured by adding thevolumeofanupdaytoarunning total of volume

and subtracting thevolume of a down dayfrom that total, it givesus a pictorial image ofwhetherastock isbeingaccumulated (moresharesbeingboughtthansold) or distributed(more shares sold thanbought) over time. Arising OBV indicatesaccumulation, while afalling OBV indicatesdistribution.

Readingtheindicator:Ifa price trend isconfirmedby supportivevolume,OBVwillmovein concert with price,making new highs orlows along with newprice highs or lows.When it does so, OBVconfirms the currenttrend.When itdoesnot,OBVactsasacontrarianindicator. OBVsometimes acts as a

leading indicator: if itrises ahead of price,price tends to follow;and vice versa if it fallsaheadofprice.Uses:

1. To confirm the validity ofcurrenttrendsandbreakoutmoves

2. As a contrarian indictorsignaling false breakoutsandweakeningtrends

3. As a leading indicator

useful to taking positionsin breakouts prior to thebreakoutmove

Chart example: InFigure 2.4, the SPY hasOBV below it. OBV isused to confirm pricetrends, so as long asOBV is making newhighs, the bullish pricetrend should be bought.ButnotehowOBVgavea divergencewarning in

late February when itfailedtoprintanewhighaspricewashittingnewhighs. The market soldoff sharply right afterthat.TheOBVwasright—traders weredistributingtheirshares.

Figure 2.4 SPY with theOBVindicator.

RelativeStrengthIndex(RSI):5-

PeriodSetting

Theory:RSIismeasuredby dividing an averageof net positive changesin closing prices over agiven period of time byan average of netnegative changes inprice. As this numberincreases over time, abullish trend is

confirmed. When thenumber decreases, abearish trend isconfirmed.Reading the indicator:RSI should move inconcertwithpriceduringmajor trends.WhenRSIdiverges fromprice, thisrepresents a tradablesituation and mayindicate a top or bottomto the current trend. Areading above 70

indicates overboughtlevels in price, while areading below 30indicates oversold levelsinprice.Uses:

1. As a contrarian indicator,foreshadowing potentialreversalsoftrend

2. To confirm the validity ofthe current trend or pricebreakout

3.Toregisteroverboughtand

oversoldlevelsinprice

Chart example: InFigure 2.5, the SPY hasRSIbelowit.Likeotheroversold-overboughtindicators, RSI can beused profitably to alertus to buy and sellsignals, but only whenother

Figure2.5SPYwiththeRSIindicator.factors are in place. As a

stand-alone indicator, it isbestusedtoshowdivergence.OnthechartinFigure2.5,wecan see clear bearishdivergence to price in lateFebruary and bullishdivergence in the middle ofMarch.

Commodity Channel Index(CCI):20-PeriodSetting

Theory: CCI iscalculated by dividingprice increases ordecreases over a periodof time by a meanstandard deviation of aconsensus or average ofprice over time. Theresulting plotted line ofthiscalculationwillgivevisual readings of thestrengthofcurrenttrendsas well as indicate"hidden" strength or

weakness duringrelatively flat marketperiods.Reading the indicator:Extreme high and lowreadings in the CCIindicator (+200/−200)areusedbysometradersto signal pricewaves orcycles.Theindicatorcanalso be used, like othersingle line indicators(RSI, OBV), to signalbuys and sellswhen the

indicator diverges fromprice. Like otherindicators,CCIcanbealeadingindicatorwhenitdiverges from price. Arelatively flat marketwith a rising or fallingCCI can signal futuredirectioninprice.Uses:

1. As a contrarian indicator,foreshadowing potentialreversalsoftrend

2. To confirm the validity ofthecurrenttrend

3. To indicate the beginningand end of price waves orcycleswithinalargertrend

Chart example: InFigure 2.6, SPY has theCCI indicator below it.Again like the RSIindicator,weseebearishdivergence in lateFebruary and bullishdivergence in mid-

March. What is uniqueaboutCCIisitsabilitytopinpoint cycle changes.The extreme bearishreadingweseeattheendof February andbeginning of Marchsignals a change ofcycle. The short-livedbearish cycle is likelyover, and a new bullishcyclehasbegun.

Figure2.6SPYwiththeCCIindicator.So that's it. These "sexy

six" are the only indicators I

use consistently in all mytrend-trading systems. Thereare other indicators Ioccasionally use, such as afive-period exponential MAcoupled with an eight-periodSMA, Bollinger Bands,ADX, and Money Flow, butthese are used mostly inspecial-casetradingsituationsthat fall outside theparameters of ordinary,everyday trend-tradingstrategies. For most trend-

trading purposes, theprecedinglistissufficient.

SETTINGUPYOURCHART

Nowit is timetosetupyourchart. The foregoing givesyoualistofalltheindicatorsyou should put on yourprimarychart, alongwith the

specific settings. Theseindicators and settings willremainthesamewhetheryouare looking at weekly, daily,or intradaycharts.The trend-tradingsystemsyouwilllearninthisbookcanbeappliedtoalltimeframes,dependingonyour trading preferences andgoals.Butforthepurposesofsimplicity, we will limit ourexamplestothedailychart.Some of these indicator

settingsareconfigured to the

standard default setting youget with most chartingapplications. But several(stochastics, RSI, CCI) havebeen set to a more sensitivereading, which bettersupports what we are tryingtodowithtrendtrading.Youcan fiddle around with thesenumbersifyouwantto,butIrecommendatleasttryingthesettingsIusefirst.Figure2.7 isachartof the

S&P 500 proxy SPY

(Spyders) with all theaforementioned indicators.Takenoteofseveralthings.

Figure 2.7 SPY with all theindicators.1.First,lookathowtheMAs(20,50,and200)wentfromaperiod of up and downconfusion,crossingovereachotherandnotgivingmuchofan indication of trend, to aperiod where all three aresharply rising, with the 20(dotted line) over the 50(thick solid line) and the 50overthe200(thinsolidline).

This change of condition wecall a change from a range-bound to a stronglyuptrending market. Boththesetermswillbedefinedingreater detail in the nextsection.2. Note the oversold andoverbought conditions of theRSI, stochastics, and CCIindicators and compare thesevalues towhatpricedid.Noteveryoversoldoroverboughtcondition marks a valid buy

orsellsignal.Indicatorsneedto be taken together withother triggers on the pricechart itself. Oversold andoverbought conditions cansimplybecomeveryoversoldor very overbought beforetheyresolvethemselves.Asaclear example of this,compare the consistentlyoverbought action ofstochastics during the monthofNovemberwithwhatpricewasdoing(i.e.,goingupand

up).3. Note how the OBVindicator can be played withtrendlines—just like price.Abreakout of the downtrendline in early Novembersignaledthestartofahealthybull run, while the break ofthe uptrend line in mid-January may signal a newdowntrendinprice.4. Note how CCI markedsignificant cycle changeswheneverithitextremesof+/

−200. Except for theNovember high, the otherthree signals circled on thechart proved profitable. CCIcanalsobeplayedlikeOBV,with trendlines overlaid. Thetrendline break to the upsidein mid-October signaled abuyingopportunity.5. Finally, note the bearishdivergence thatcrept into thelast two months of trading.Note how even though theSPY price was making new

near-term highs, theRSI andMACD indicators weremaking lower highs. This isbearish divergence andflashes a caution sign tomarket bulls. Indeed, severalweekslaterSPYtradeddownto near 120.00 beforerecovering.Figure2.8 is another chart

of the S&P 500 proxy, SPY,from a year earlier than thechart that preceded it.Here Ihavehighlightedanumberof

divergences between priceandthevariousindicatorsweuse. Whenever price sets ahigher high or lower lowwithout the indicatorsfollowing suit, we have asetup that often foreshadowslarge market moves. Whendivergence is seen betweenprice and one or moreindicators, trend traders willfadethepriceandtradeinthedirection of the indicators.Also note again the use of

trendlines on the OBVindicator andhowabreakofthose lines can signal achange in price direction.And finally, take a look athowtheindicators,especiallystochastics, register oversoldand overbought conditions ator near major marketreversals.

Figure 2.8 SPY with all theindicators.

TRENDLINES ANDCHANNELLINES

It is extremely important intrend trading to determinewhether the market ingeneral,andthestocksonour

watch lists in particular, arein a trend, and if so, whatkindoftrenditis.Trendlinesand channel lines are amongthetoolsweusetodothis.Trendlines and channel

lines are lines drawn over atleast two tops and under atleast two bottoms of majorprice movements. The moretops and bottoms you canintersect with the trendline,themorevalidthetrend.Asageneral rule, we recommend

only drawing in a trendlinethatcanintersectatleastthreeprice points. Note that theseprice points need not bepivots in price (that is, highsand lows in price), merelytouches of the trendline byindividualpricebars.Trendlines help traders

identify the dominant trendsthatpricehas tended to tradewithin, while channel linesdemarcate trendless channelsortradingrangeswithsupport

and resistance points. Inshort, these lines give us asimple,visual referenceas towhether the stock is in anuptrendoradowntrend,or isstuck in a trading range.Furthermore, if we extendthose lines beyond the rightedge of the chart, we willhave a visual map of wherethe stock is likely to tradeinto the near future. Thus,trendlines are an invaluabletool in helping us to make

profitabletradingdecisions.Trendlines are used to

measureuptrendsbydrawingthe lines under the lows,while downtrends aremeasured by drawing thelinesover thehighs.Aseriesof higher lows indicates thatthe bears are getting lessaggressiveandthebullsmoreconfident.Thatisallweneedto know to call suchmovement an uptrend. Thereverse is true for a down-

trend. An uptrending linedrawn below the lowscombinedwithaflatlineoverthehighsisstillanuptrend.Adown-trending line over thehighs combined with a flatline under the lows is still adowntrend. Again: In anuptrend,only the lowscount.In a downtrend, only thehighscount.The following are

theoretical examples of bothan uptrend and a downtrend.

Note that the trend isdetermined by only one sideoftheformation:thelowsfortheuptrendand thehighs forthe downtrend. Figure 2.9 isan example of an uptrend.Figure2.10 is an example ofadowntrend.Ifboth trendlines—theone

over the highs and the oneunder the lows—are flat, thestock is in what we call atrading channel or tradingrange. The stock's price is

likelytobounceupanddownbetween these channel linesuntil either the upper or thelower line is broken. If theupper

Figure 2.9 An uptrenddefined by higher lows, nothigherhighs.

Figure 2.10 A downtrend,defined by lower highs, notlowerlows.lineisbroken,wecanexpecttoseeanewuptrenddevelop.If the lower channel line isbroken,wecanexpect to seea new downtrend develop.

The same principles applywhenwe have an uptrendinglineunderthelowscombinedwithadowntrendinglineoverthe highs. This is still achannel, but it is now whatwe call anarrowing channelor a triangle formation. Anybreakout from that formationisatradableevent.Figures 2.11 and 2.12 are

theoretical examples of thetwo most common types oftradingrangesorchannels.

Both trendlines andchannel lines are used infollowingways:

To determine the statusof a price trend:up,down,orrange-boundTo project future pointsof price resistance andsupportTo calculate where toputstop-lossesTo note areas of pricecontainment in order to

predictbreakoutmoves

Figure 2.11 A sidewaystradingchannelorrange.

Figure 2.12 A tighteningtradingrangeortriangle.

Figure 2.13 BRCM showingtrendlines.Figure 2.13, the BRCM

chart, demonstrates a tradingchannel or range in Augustthat broke out to the upside.Thisledtochoppytradewithshort-term up- and down-trends, which then led to amoreprolongeddowntrendinOctober, followed by aprolonged uptrend intoDecember. Note that if aposition had been takenduring either the channel orany of the trending patterns,thestop-lossforshortsshould

havebeenplacedjustovertheupper trend-line (dotted line)anda stop-loss for longs justunder the lower trendline(solidline)oncethetrendlinewas established with at leastthreepointsofintersection.Figure 2.14 is a classic

trading range or channelbreakoutexhibitedbyBEAS.The stock bounced up anddownwithina2.00rangeforfive months before finallybreaking out to the upside.

This kind of long-term pricecontainment with breakoutsends the bullish signal thatthe stock is now ready totrade within a higher pricerange.

Figure 2.14 BEAS showingpricechannelbreakout.Note also that once the pricechannel was established bysufficientpricetouchesinlateJuly, the lower trendline,once extended out to theright, would have been areasonableplaceofsupporttoputabidinforthestock(andthe same would be true forputting an offer at the uppertrend-line). Note finally thatthe break of the second

established trading range'slower trendline in earlyNovember signaled that itwastimetoexitthetradeandbank the profit. This chartthus represents a potentialtrendtradereturnofover+40percent in about nine weeks:buying BEAS at trend-linesupport (near 11.00) andselling on a trendline breaknear15.50.Two warnings need to be

issued regarding the use of

trend and channel lines. Thefirst is that these lines arealways subjectively drawn.Even when software is usedto draw trendlines, there issubjectivity at work in theway the programmer codedthe software. This is to saythat you must always bereadytoalteryourtrend-linesin response to new marketdata.Itisalltooeasytodrawinatrendchannelwherenonereallyexistsbecausewehave

a predisposed bias to thestock moving in a certaindirection. Trendlines andwishful thinking are adangerous combination. Forthis reason, always apply thefollowing rule toyouruseoftrendandchannellines:

No trend or tradingchannel exists until alinecanbeplacedonthechart that intersects atleast three price points.Two price points can

yield a trendline, but notrading decision shouldbe made until a thirdtouch of the line isrecorded.

There is much debateamong market techniciansand traders whether oneshouldrunatrendorchannelline over/under intradayprices (the "tails" or"shadows" on thecandlesticks)oronlytheend-of-daypricepoints.Thereare

various answers to thisquestion. It has been mygeneral experience thatclosing prices trump intradayswings. Thus, if you draw atrend or channel line acrossthetopsorunderthebottomsof several runs in price, andthen find that at numerouspoints there are intradayswingsinpricethatcannotbecontainedbythoselines, it isokay.Aslongasyoucontainwithin the lines the majority

consensus represented by theclosing price (or the edge ofthe candle body if you areusing candlestick charts), Ibelieve you canmore or lessignore the extreme opinionsrepresented by a fewwayward intraday runs (ortails). Some do prefer,however, to use lines tocontain all points in price,includingintraday

Figure 2.15 RIMM withtrendlines.swings. Hence, a soundcompromise position ondrawing trendlines can beheard in the teaching ofAlexander Elder, who states,

". . . It is better to draw [theline] through the edges ofcongestion areas. Thoseedges show where themajority of traders havereverseddirection."(Elder,p.88)InFigure2.15,thechartof

RIMM demonstrates Elder'strendline technique in action.Hereweseeadowntrendlineand subsequent uptrend linepassingthroughareasofpricecongestion rather than at

either intraday or end-of-daypricepoints.A second warning with

respect to trend and channellinesisthattradersoftenhavethe tendency to draw toomany of them. Ifwe keep inmind that such lines aremerely accidental tools weuse togiveus averygeneralsense of price containmentand are not nearly asmathematically elegant andpreciseastheotherindicators

mentioned previously, wewill then have a betterattitude toward their use. If,however, we use them tomake definitive or exclusivetrading decisions, we can betempted to draw in linesunder and over every littlezigzag in price movement,projecting ahead onto therightedgeofthechartmyriadcompeting and conflictinglines.Acharttoofulloftrendand channel lines will only

leadtoindecision.The following one-year

chartofQQQQ(Figure2.16)demonstrates well how youcangettoocarriedawaywithtrend and channel lines. Justhow are you supposed to getasolidreadofthischart?It is best, therefore, to use

trendlinesonly togiveus thebig picture. When in doubt,remember KISS (Keep ItSimple, Stupid!). In otherwords, try to incorporate as

many highs and lows (pricepoint touches) as possible asyoudrawyourlinesandtrytocontain asmuch price actionas possible. Use trendlinesonlytofocusonmajortrendsandchannels,and,aswewillseeingreaterdetaillater,theywillbecomeveryusefultoolsindeed.

Figure2.16 QQQQwith toomanytrendlines.

EYEBALLING THECHARTS

Now that you have yourcharts set up, input each ofthe stocks on your primarywatch list so that you caneyeball, or take a quickglance at, their daily charts.Don'tworryifyoudonotyethaveawatchlistofstockssetuptomonitor.InChapter9,Iwill showyou how to set upanawesomewatch listof thebeststocksavailablefortrendtrading,andhowtokeepthis

listupdatedover timeso thatyoualwayshaveonlythebestmarkets available to you.Here,Ijustwanttointroduceyoutowhatwillsoonbecomea daily discipline for you:eyeballing the charts forcurrentordevelopingsetups.Depending on which

charting package you use,you can go through yourwatchlists,10atatime,pageby page, or you can scrollthroughadrop-downmenuof

your watch list stocks andwith the click of the mousecall up the daily chart foreach one. Some chartingpackageswillevenletyousetupa slide-showfunction thatwill scroll automaticallythrough your lists for you.You simply sit back, watch,and take notes. It should besaid that one advantage tosaving your watch lists in aWeb-based service ratherthanyourchartingpackageis

thatthenifyou,likeme,tradefromdifferentcomputers,youwill always have instantaccess to your watch liststhrough the Web. If yourwatch lists are saved only toyour charting software, youwill only be able to accessyour lists from the computertheyare savedonunlessyoutake the time to export andimport the lists (a lot moreeasilysaidthandone!).Sometimes it is helpful to

take your primary watch listand divide it into smallerlists. There are several waysto do this. You can, forexample,dividebysector,byprice, by index affiliation, orby some other scheme. Iprefer to divide by sector,since I regularly monitorsector charts and like to keymy trades off them. If, forexample, I see thesemiconductorsectorflashinga fresh buy signal, I'll go to

my semiconductor watch listand focus only on thosestocks. The same is true forsteel stocks, financials,Internets, China stocks,alternative energy plays, andso on. You can also makesaved watch lists of thosestocks that turn up on yourspecial screens, as outlinedlater, but that have not yetgiven buy or sell signals. Inany case, you will runthrough these watch lists at

the end of each trading day,lookingfornewsetups.The eyeballing process is

the bread and butter of trendtraders.Astechnicalanalysts,ourprimarysourceofinputisthepricechart.Theonlywayto receive that input is to layyour eyes on a number ofthem, day in and day out.Tune out the news, tune outCNBC, tune out the spam e-mail for "Hot stocksmovingnow!,"tuneoutyourbuddyat

thegymwhohasahot stocktip.Yourcompleteandentireinvestmentdisciplinerequiresonly that you eyeball thecharts.It is also important that

before you begin eyeballingthe charts on your primarywatch list, you first askyourself, "What do I expectthe broader markets to doover the next few days?" Ifyou expect a bullish period,then you will be eyeballing

primarilyforbullishsetups.Ifyou expect a bearish period,then you will be eyeballingprimarily for bearish setups.If you are unsure about thegeneralmarketdirection,thenyou will be eyeballing forboth bullish and bearishsetups. (Don't worry if youdon't yet know how todetermine the general trendexpectations of the broadermarkets.Wewillbecoveringthatlater.)

THEHERMENEUTICALPROBLEM

I wrote my doctoraldissertation at Oxford onhermeneutics, the study ofhow the mind understandsand applies the content of

written texts. One of thethingswecanlearnfromthisstudy is that no one readstexts in a vacuum. Whetherwe are reading the Bible orthe nightly newspaper, weeach bring our ownexperiences, biases, andpersonal preferences to whatwe are reading, and these inturn can influence how weunderstand and apply whatweread.A stock chart functions

verymuch likea text.Likeatext, a stock chart speaks tous about something we needto understand, but instead ofusing ordinary language, ituses price bars, candlesticks,moving averages, volume,andothertechnicalindicators.Together, these are trying totellusa story—astoryaboutthe underlying company'ssuccessesandfailuresand(ifwe listen very carefully) thefuture prospects of its

publicly traded shares. Butthere is a problem in ourability to hear clearly whatthe chart wants to say to us,and it is a hermeneuticalproblem. The problem,simply put, is this: ourprejudices (or our"prejudgments") get in theway.Let'ssay,forexample,that

you plug into anApple iPodat the gym, and you use anApple Macintosh at the

office, and you do yourcreative writing at Starbuckson an Apple MacBook. Youare a big fan of Apple'sproducts. Steve Jobs is yourhero. You genuflect everytime you pass the Cupertinoexit on Highway 101. Okay,that'sabitmuch . . .butyouget thepoint.You really likethe company, think they cando no wrong, and believetheir stock price is going togo"todamoon,"astheysay.

These are prejudices, andtheymight prevent you fromhearing what the stock chartwantstotellyou.Back in January of 2006,

Apple (AAPL) could do nowrong. It was the darling ofthe street. Its stockpricewashittingnewall-timehighs,upnear $90 per share. Itsproducts, especially the iPod,were seen everywhere.Rumors were flying aboutnew products: an iPhone, an

i-TV, and so on. However,the daily chart was trying tosaysomethingthatonlyafewtraders were willing to hear:notallwasrightwiththewaythe shares were behaving.Thereweresubtlesellsignalsforming in key indicators,like the MACD andstochastics. Sure enough, thenextmonth the stockoptionsbackdating scandal hit thecompany and sharesplummetedoverthenexttwo

quartersto$50(sincethen,ofcourse, the iPhone did comeoutandAAPLsharesrampeduptonearly$150!).The moral of that story:

ignore the hype, ignore thenews, ignore your ownprejudices, and just listen towhat the chart is telling you.Asmuchaspossible,"bracketyour prejudgments" (to usephilosopher EdmundHusserl's phrase) and justtunein to thechart.AsI like

to tell my trading clients:priceandvolume—that is allyou need to know to tradewell.Here is another example,

but of a different kind.Broadwing (BWNG) is acompanywith amultifacetedfootprint in the Internetsector. Through itssubsidiaries, the companyprovides data and Internet,broadband transport, andvoice communications

services to several largecommunications serviceproviders. In late spring of2006, the company was hitwith a string of events thatsentitsearningsanditssharesinto a tailspin. EarningsannouncementsfailedtomeetStreet expectations. Therewere unexpected changes inmanagement. With reallypoor timing, the companypriced a large convertibledebenture offering, which

further diluted shares. Priceplummeted from a high of$16.44 toa lowof$8.26, fora loss of nearly 50 percent.Former hedge fund managerJimCramer,onhishitCNBCshow Mad Money, calledBroadwing a "dog" and toldhisaudiencetosellit.However, the chart of

BWNGtoldusotherwise.Asprice skidded to lows below$10 per share—a point thatnormallytakesastockoffthe

radar screen of professionaltraders—certain indicatorswerepointing to the fact thatthe stock was underaccumulation. Momentum inthe latest sell-offs waswaning, and the stock wasripefora turnaround.Bullishdivergence was seen inseveralkey indicators, tellingusitwastimetobuy,notsell,shares. Sure enough, threemonths later, shares hadclimbed to $13 per share

before they announced theywerebeingboughtoutbyoneof their competitors at a 20percentpremium.Again, the moral of the

story is this: just check thechart. If you don't like thechart,don'tplaythesharesnomatter what the talking-headexpertssay.IftheStreetsayssellbutthechartsaysbuy,gowith the chart. Always gowiththechart.To read, understand, and

applywhatthechartistryingto tell you, you will have toface up to the hermeneuticalproblem.Again, thisproblemstates that you haveprejudices, biases, andpersonalpreferencesthatmayinhibit your hearing clearlywhat the chart has to say.Bracket them. Ignore them.Tell themtoshutup! Just letthechartspeak.

CHAPTER3DEVELOPINGATRADER'SMIND

traders who will buy thisbook, read it, and put one ormore of its systems intopractice in the markets. Thefirst type will be successful,makingmoneyregularlyfromthemarkets,whilethesecondtype will consistently losemoneyuntilheor she finallygives up on tradingaltogether.Thesadfactisthatmost traderswill fall into thesecond category, and only asmall percentage of those

who buy this book will fallintothefirstcategory.What is the difference

between these two camps—between the successful traderandthelosingtrader?Believeit or not, the determiningfactorhasnothing todowitheducation,nothingtodowithinnateintelligence,nothingtodowitheconomicorbusinesssmarts. The difference isstrictlypsychological.Noonecan deduce a universal

personality profile from theset of winning traders.Among successful traders,you will find introverts andextroverts, feeling types andthinking types, levelheadedautomatons and passionateimpulsives. But there arecertain traits of characterthey hold in common. Thetrader who successfully putsthese trading systems intopracticeisonewhopossessesallofthefollowing:

Self-disciplineThe ability to takeresponsibilityA positive attitudetowardsuccessAkeenunderstandingofriskThe ability to maintainanopenmind

The trader whounsuccessfully puts thesetrading systems into practiceismorethanlikelylackingin

one or more of the thesequalities of character. Notethat these are qualities ofcharacter, not personality.Attend any one of the threeannual U.S. Trader's Exposymposia at which gatherhundredsofwildlysuccessfulstock, options, and futurestraders, and you will findevery possible personalitytype represented (includingsomethatprobablyshouldbeonmedication).But youwill

also find a narrow range ofcharacter traits—those listedhere—that serve the tradingcareerwell.In short, one's character or

state ofmind has a lotmoreto do with trading successthanone'spersonality.Iwon'tbesayingtoomuchaboutthistopic, since there are manyexcellent resources availablethat can give you a muchmore detailed education. ButwhatIhavetosayheremight,

infact,bethemostimportantpartofthisbook.Asthelong-term successful trader youlong tobe, it isessential thatyou pay attention to thepsychological side of yourtrading. You may have theworld's most robust, mostprofitable trend-tradingsystem at hand, but if fear,anxiety, panic, laziness,greed, or some otherunhelpful mental statedominates your frame of

thinking, you are much lesslikely to make that systemwork for you. Even 100percent mechanical systemsrequireahumanhand topullthetriggerateachnewsignal.Like it or not, that hand isconnected to a brain thatmakesitwork.

CONTROLLINGEMOTION

Contrary to popular opinion,there is not a specificemotional archetype that isidealforthesuccessfultrader.Someportray the ideal traderasanemotionless robot,withice forbloodandacomputerfor a brain. But the truth is,highlyprofitabletraderscomein all sorts of emotionalvarieties. Think of JimCramer, the screaming,saliva-spewing host of

CNBC's popularMadMoneyshow.Cramerisanythingbutemotionless, and by mostaccounts (including his own)his turn as a hedge fundmanagerwasverysuccessful.No, it'sreallynotessential totrading that you curb youremotional enthusiasm andtrade like amachine. Indeed,I believe that a passionatefeelingforthemarkets,a"fireinthebelly,"isarealplusforthetrader.Whatelseisgoing

tokeepyoucomingbackdayafterdaytothetedious,oftenboring research that needs tobe done? What else will getyouback in thegame after alosingstreak?What is essential is not

rootingoutallemotionwhileyou are trading—animpossible task, in any case—but managing youremotionsastheyarise.Whenemotions cause impulsivetrading, trading against the

plan,tradingagainstyourbestinstincts, experience, andeducation, they areproblematic. Any emotionalstate that underminesconfidence in your edge as atrader will pose seriousobstacles to your success.With the trading systemsoutlined in this book, younow have your edge on themarkets. But that edge isworthlessifitisnotmanagedappropriately.AsEdSeykota,

the great futures trader, likesto say (and I paraphrase),trading is mostly aboutnumbers, but once you'vemastered thenumbers, it's allaboutpsychology.The primary cause of

failure in tradingisnotabadtrading system but badtrading psychology. Goodtrading psychology can bestbe defined as any mentalcondition that allows youenough confidence in your

trading and moneymanagement strategies tohangon to yourwinners andcutshortyourlosers.Thefirstact, hanging on to winners,requires the trader to possessa state of mind that iscomfortablewithsuccessandthatavoidsself-sabotage.Thelatter act, keeping lossessmall, requires a hard-nosedrealism, an appreciation forrisk, a mind open to thepossibility that you are

wrong,andtheself-disciplineto stick with predeterminedexitrules.Developing this kind of

winningtradingattitudeisnosmall task. Fortunately, thereare several excellentresources available that havehelped thousands of tradersdo just that. The first book Irecommend is MarkDouglas's best-sellingTradingintheZone.Ibelievethis to be the best resource

currently available forhelping traders develop theright attitude toward themarkets they are trading.Douglas is president ofTrading Behavior Dynamics,Inc.,whichdevelopsseminarson trading psychology forbrokerages, banks, andmoney managers. Douglasemphasizes that having ahealthy respect for risk, awillingness to think in termsof probabilities instead of

certainties,andanopenmindtoward whatever marketexpectations you may haveare essential ingredients inthewinner'smindset.Douglas has conveniently

includedatrader'spersonalityinventory test (it is bettertermed a "characterinventory" test) in his book.Oncethistestisassessed,youwill have a clear idea whereyou might be stuckemotionally and in terms of

yourcorebeliefs—thatis,thetest uncovers those specificmental attitudes that are thecause of so much tradingfailure.Douglas is convincedthat as you align your corebeliefs as a trader with whatcan rightly be expected fromthe markets over time, youwill have the mentalapparatusinplacetotakejustabout any trading system totheheightsofsuccess.Here is how Douglas

himselfdescribes the essenceofhisworkinTradingintheZone:

As long as you aresusceptible to the kindsof errors that are theresult of rationalizing,justifying, hesitating,hoping,and jumping thegun,youwillnotbeableto trust yourself. If youcan't trustyourself tobeobjective and to alwaysact in your own best

interests, achievingconsistentresultswillbenext to impossible . . . .The irony is that, whenyouhavetheappropriateattitude, when you haveacquired a "trader'smind-set" and canremain confident in theface of constantuncertainty, trading willbeaseasyandsimpleasyou probably thought itwas when you first

started out. So, what isthe solution? You willneed to learn how toadjustyourattitudesandbeliefs about trading insuchaway thatyoucantrade without theslightest bit of fear, butat the same time keep aframework in place thatdoes not allow you tobecome reckless. That'sexactlywhatthisbookisdesigned to teach you

(Douglas,p.15).A second resource I can

recommend is the longer,more complex work of VanK.Tharp,entitledTradeYourWay to Financial Freedom.Despitethetitle,Tharp'sbookdoesnotoutlineaspecificsetof trading systems you canuse to trade for a living.Instead, Tharp focuses onwhat it takes—mentally,emotionally, philosophically—todevelop,trade,andstick

with your own tradingmethodology. His essentialpoint is that trading systemsneedtobematchedtotradingtemperaments, so the betteryoucanunderstandwhatkindof person you are, the betterthetraderyouwillbe.In a chapter Tharp admits

to be "the most difficult tounderstand," the authoroutlines six variables thatmustbetakenintoaccountinany winning trading system:

reliability,profit-to-lossratio,transaction costs, tradefrequency, initial accountsize, and position sizing.Tharp carefully outlines theimportance of each of thesevariables,thenrelatesthemtotheconceptofexpectancy,orwhat sort of returns you canreasonably expect a tradingsystem toproduceover time.As these variables changewithin a particular tradingstrategy, sowillwhat can be

expected of the strategy interms of its returns.Consequently, with a simpletweaking of these variables,you can work toward acustomized optimization ofyourtradingsystembasedonyour particular tradingpsychologyandobjectives.Tharp has over 20 years'

experience working withindividual and institutionaltradersasaconsultantforthedevelopment of trading

systems. He also manages acompany, the InternationalInstitute of TradingMastery,Inc., that produces homeseminars on systemsdevelopment and testing.Tharp's Web site(www.iitm.com) contains awealth of resources fortraders, including a freetrading personality test andsimulated trading game.Tharp nicely summarizes histrading philosophy in these

words taken from theconclusion to Trade YourWaytoFinancialFreedom:

First, you cannot tradethe markets—you canonly trade your beliefsabout the market. As aresult, it is importantforyoutodetermineexactlywhat those beliefs are.Second, certain keybeliefs, which havenothing to do with themarket, will determine

your success in themarkets.Those are yourbeliefs about yourself.What do you think youare capable of doing? Istrading for successimportant to you? Howworthy of success doyou believe yourself tobe? Weak beliefs aboutyourself can underminetrading with a greatsystem (Tharp,pp.322–323).

VALUES-BASEDTRADING

The last resource I'd like tomentionisabookthatmakesnomentionoftradingbuthastremendous application tocultivating a healthy tradingpsychology. The book madeits appearance in late 2005

andquicklyrosetothetopofthe New York Times best-seller list. Early in 2006 theauthor was interviewed byTimemagazine.*Needless tosay, the impact of the bookhas been tremendous. Notonly have the author'steachings been taken up bythegeneral* John Cloud, "HappinessIsn't Normal," Time,February 13, 2006. Muchof the description of

Acceptance andCommitment Therapy inwhatfollowsis takenfromthisarticle.

public, theyhavealsocausedan important reassessment—though not without debate—of traditional psychologicaltherapies.The book is provocatively

titledGet Out of Your MindandIntoYourLife.Itsauthor,Steven Hayes, is a professorof psychology at the

UniversityofNevada—Reno.After suffering from a seriesofunexpectedpanicattacks—so severe that he couldn'tproperly teach his classes—Hayes pursued research intovarious models of therapydesigned to overcomedepression and anxiety. ItseemednaturalthatHayes,asformer president of theAssociation of Behavioraland Cognitive Therapies,wouldturntothesedominant

schoolsofpsychologytotreathimself. But he soon foundthat neither behavioral norcognitive modification couldeffectively treathisparticularillness. Hayes then began toincorporate the Easternpractice of mindfulness intohis therapy, with positiveresults.Tothishealsoaddedthe discipline of consciouslycommitting himself, not towhat his emotions dictated,but to the values that matter

most to him, to his personalconvictions and beliefs. Andwith this amalgam came hishealing—and a new form ofpsychological therapy aswell.What Hayes had

discovered during hisexperiments in self-healingcametobecalledAcceptanceand Commitment Therapy(ACT). Today ACT standsalongside thepsychoanalytical, behavioral,

and cognitive schools oftherapy as the next bigwaveinpsychotherapeuticpractice.ACT has generated animpressive pedigree ofclinical support,with healingclaims for everything fromaddictions to schizophrenia.Skeptics dismiss it as apassing fad, but there is agrowing contingent ofprofessional counselors whoare embracing its primarymantra: Accept who you are

and commit yourself to whoyouwanttobecome.So how does ACT work,

and of what use is it totrading? In short—you willhavetoreadGetOutofYourMind for the full version—ACTproposes thatwheneverwe have a negative thought,instead of deprogramming itascognitivetherapysuggests,weshouldembraceit.Weareto acknowledge the thoughtwith attention and

mindfulness,foraswedoso,Hayes insists, we distanceourselves from the thoughtand therefore negate itspower. So, for example,instead of saying, "I amdepressed,"we are to say, "Iam having the thought thatI'm depressed." In this waythe thought becomessomething Ihave rather thansomethingIam.Assuch,itismuchmoreeasilydiscarded.The second step in ACT,

then,istocommityourselftowhatyoumostvalue.Havingmindfully defused the powerof the negative thought, youmust then just step out infaith intowhat is believed tobe the right course of action,evenifyouremotionsarenotsupportive. To facilitate thiscommitment, Hayesrecommendsspendingqualitytime outlining your personalphilosophy (or philosophies)of life, what you value most

highly, what you want toaccomplishbeforedying,andso on. This then gives you akind of road map to followduringthedarkertimes.I am incredibly excited

about the possibility ofapplying this new therapy totrading. Here is how Ienvision ACT being used bytheactivetrader:imaginethatevery time you have anegative thought about yourtrading,youwerealsoableto

detach yourself from, andthus defuse, the thoughtbeforeitaffectedyourtradingdecisions. I know hownegativethetrader'smindcanbeattimes.Ihavepersonallyexperienced the waves ofregret, fear, anxiety, andanger that come with everytick of the tapewhen it goesagainst your position. Howhelpful would it be if youcould find a way to negatethese emotional waves, and

thus free yourself to followyour system strictly andprofitably!Nowimaginethatyouhave

writtendownsomewherenearyour trading station a list ofyour commitments as atrader. As for me, I have anumber of bright yellowsticky notes pasted to mymonitorwithpithy,bold, all-caps statements on them.Theseinclude:

Trade only your ownpicks!Neveraveragedown!Letwinnersrun!Cutlossesshort!No impulse buys orsells!

You can probably guessthat behind each of thesestatements lies a terriblyembarrassing, losing tradethatmotivatedmeinabsolutehorror to write out a maxim

and slap it to the monitor.You can also likely imaginethat behind each of thesecommitmentstatementsliesaparticular value, somethingthatIhighlyhonoranddesireas a trader. My own list oftrading values lookssomethinglikethis:

Yourtradingsystemsaresoundandprofitable.You are in control ofyourimpulses.

Trade with integrity atalltimes.Trade responsibly foryour family's financialfuture.Trading isonlyameanstoanend.Profits come with thesystem, not withhunches.

Now imagine that theseandothertradingvalueswereto govern my every trading

decision—howmuchbetter atrader I would be! Thus,regardless of what I amfeeling emotionally, as Idetach myself from thoseimpulsive feelings that sooften foul up my tradingdecisions I am free to followa structured roadmap ofmyowndesign,hammeredoutbythe hard-won experience ofyears of trading. This is thepromise of ACT whenapplied to trading: its tools

helpmetoclearandfocusmymind so that I can commitmyself to following mysystem despite how I'mfeeling about a particulartrade.Sowhatifyoudon'thavea

set of trading rules or valuesforyourself?What ifyouarenot sure what personalpsychological frame ofthinking is most suited toactive trading?This iswheretheDouglasandTharpbooks

are helpful. Together, theywill provide for you thatemotionalblueprintyouneedto follow as you constructyourtrader'smind.

CHAPTER4THE10HABITSOF

HIGHLYSUCCESSFULTRADERS

ofuse.BACK in thewinterof2003Iheld an online seminar forseveral hundred of ourclients, most of whom wererelatively new to trading. Intwo grueling four-hoursessions we covered thebasics of chart reading,candlesticks, and trendtrading. I also includeda fullexplanation of two never-before-taught trend trading

setups that I had beenworkingonthepreviousyear.During the question-and-answer period, however, Iwas surprised to find thatmost of the concerns of theaudiencehadlittle todowiththe logistics of trend tradingand more to do with thespecificdetailsofmy tradingapproach. In order to answerthose questions as preciselyas possible, I promised myclients that I would write up

my trading rules and sendthemeachacopy.The following list is a

replica of that original set ofrules I sentmy clients.Noneof the rules have changedsince then, though some oftheirapplicationshavegottena bit more sophisticated. Asalwayswithtrading,thereareexceptions allowed, asdictated by current marketconditions.

THE10HABITSOFHIGHLYSUCCESSFULTRADERS

1. Follow the Rule of

Three. There are manyindicators a technical analystuses to determinewhether ornot to take aparticular trade.There are patterns the price

barsmakeon thechart; therearemovingaveragesofprice;there are various momentumand overbought/oversoldindicators as well. Together,these form a pictorialdescriptionofwhereastock'scurrentpriceis,relativetoitsprice history. My Rule ofThree says that I will notenter any trade unless I cancarefully articulate threereasons from among my listof technical indicators for

doing so. Three is theminimum,andmoreisbetter.Sooftenyoungtraderstakeatrade for only one reason: adouble bottom, for example,or overbought stochastics.These indicators need to beconfirmed by othersworkingin tandem. Conflictingindicators signal a confusedmarket. We don't want that.We want to enter onconviction,not confusion.Soalways wait until you can

satisfy the Rule of Three (atleast).Remember,tradingisagame of probabilities, andyou should always stack theoddsinyourfavor.2. Keep losses small.

Bernard Baruch, the greatWall Street speculator fromthe turn of the last century,once said, "Even being rightthreeor four timesoutof tenshould yield a person afortune ifhehas thesense tocut his losses quickly."

Baruch was right. It isimportant to keep losses to aminimum, as most largelosses started out as smallones,andlargelossescanendyour trading permanently.Normally,wekeepourlossessmall by setting stop-lossesonallopentrades.Wedothison all trades that we are notmonitoring on a minute-by-minute basis; otherwise, wewill keep a mental stop inplace and exit the position

once that price level isviolated. Remember WarrenBuffett'sRule#1:"Don'tLoseMoney!"Buffett alsomadeasecond rule: "Don't forgetRule #1!" So take a tip fromthe world's greatest investorand always strive to keepyourlossessmall.3.Adjuststopsandtargets

at theendof theday.At theendofeachtradingday,onahigh-watermark basis, adjustyour stop-loss or target price

as needed. Here "high watermark" means you adjusteither the stop or target onlyiftheclosingpricesetsanewhighorlowfromthepointofentry. This is how it works:raise your stop-loss price ateach new closing high sinceentry(ornewlowifthetradeis a short). And if you areusingatargetpriceasanexit,lower your target price ateach new low if the tradegoes against you (or raise at

eachnewhighifshort).Don'tget complacent with yourtrades. Monitor them eachday at least once near theclose, and adjust your stopsand targets accordingly. It isalso a good idea to take offyourstopsovernighttoavoidthewidefluctuationsofafter-hours trading. But do keepyour target orders in place. Ilike tobreakdownmy targetlimit order into smaller bitsandsetthemonepennyapart.

Occasionally,oneormoreofthese get filled overnight inthe sort of erratic, widelyranging trading thatcharacterizes the after-hoursmarket.4.Keep commissions low.

Useadiscountbrokerofyourchoice that charges amaximum of $10 per trade.There are several onlinebrokers(OLBs)thatchargeaslittle as, or even less than,$0.01 per share per trade.

You should not be payingmore than this. Thequalitative differencesbetween an OLB charging$30 per trade and onecharging $1 per trade areminimal at best. Both willofferyoufastfills,occasionalprice improvement betweenthe spread, frills likeautomatically trailing stops,boxingandbasketorders,andthe ability to trade funds,options,andfutures.Whypay

apremiumforabrandname?Remember, commissions arepartofyouroverheadcosts—and when running anybusiness, the lower you cankeepyouroverheadcosts,themore profits you get to taketothebank!5. Amateurs at the open,

pros at the close. What thisfamiliar trading adagemeansis that, in general, the well-funded institutional tradersoften fade (or trade against)

the morning momentum,happily handing shares toanxious amateurs, beforegoingofftogorgethemselveson a high-fat lunch. Whenthey get back to their desksaround 2:30 p.m. EST, theyfullyexpecttobeabletopickupthesamesharesatabetterprice. They are usually right.That's why they areprofessionals. They get paidto be right about things likethat. So if youmust trade in

the morning, be sure to easeinto your trades in smallerportions.Yes,youmightmissout on somenicemoves, butin the long runyouwill saveyourselfmoney. Even better:look to enter your tradeswithin the last two hours oftrading. In that way you aremorelikelytobeinsyncwiththe larger and moredeterminative moves causedbyprofessionaltrading.6. Know the general

market trend, and tradeaccordingly. This is moreeasilysaidthandone,butitisabsolutely essential tosuccessful trend trading.Youneed to know each daywhatkind of market you arecurrently trading in.Wewillsay more about this inChapter 5. Here the generalrule can be stated that thetypeofmarketweare inwilldetermine the type of tradeyou put on. There are five

general types of markettrends: weak uptrend, stronguptrend, weak downtrend,strongdowntrend,andrange-bound. Inweakuptrends anddowntrends,youshouldfocuson continuation plays; instrong uptrends anddowntrends,youshouldfocuson breakout plays; and inrange-bound markets, youshould look for reversalsetups. Again, these termswill be discussed in the next

chapter.You should also ask

whether the current trend orrange-bound condition isrelatively new or relativelyold. The longer a marketpersists in its currentcondition (uptrend,downtrend, or range-bound),the shorter your time frameshould be for new positions.Forexample, ifweare in theearly weeks of a new bullmarket, you should feel

comfortable setting a highertargetonyourlongpositions.Butifyouarelongduringanoverbought market (an olderbullmarket), you should aimto take quick profits whengiven. One quick and easyway todetermine thekindofmarket we are in is to applythe 50–day moving averageofclosingpricestoachartofthe S&P 500. Then simplylookat the slope. Is its slopeupward (weakly or strongly),

downward (weakly orstrongly), or flat (range-bound)?Hasitbeenthiswayfor a while (prolonged), ordiditjustturn(new)?Andsoon.7.Writedowneverytrade.

We keep track of so manyother things in life—thecheckswewrite,thegrocerieswe need, the donations tocharity we make, our golfscores, the last time wechanged the oil in the car—

but how many of us writedown the details of everytradewemake?InreadingtheMarket Wizards books byJack Schwager (which Ihighly recommend, by theway),youlearnthatnearlyallof the wizards keep tradingjournals.Isuggestyoudothesame. Make a spreadsheetthat records the date of eachtrade entry and exit, thesymbol of themarket traded,the price of your entry and

exit, thesizeof thetrade, theprofit or loss, a running totalof profits/losses, and acomment section where youdescribe as specifically aspossiblewhyyouenteredandexited the trade. If you areadept at working withspreadsheets, you can evenprogram columns to keeptrack of your stop-losses,target prices, and positionsize.Analyzethesetradesat the

end of each month. Are youconsistently losing with oneparticular setup? Are yourbreakoutplaysworkingbetterthanyourreversalplays?Areyour stops set too tight?Usethis journal to learn aboutyour weaknesses as a trader.Awareness of thoseweaknesses should soon leadto overcoming them. If youhave any trouble setting upyour spreadsheet, e-mail meat

support@befriendthetrend.com,andmystaffwillbehappytosendyoutheoneIuse.8.Neveraveragedownon

a losing position. Let's sayyoubuya stock, expecting itto take off like a rocket, andinstead it drops like a rock.What do you do? Answer:you do nothing. You stickwith your plan. You keepyourstop-lossinplace,loweryour target at the end of theday, and wait patiently. Do

not buy more shares at alower price to make youraverage cost lower.That is aloser's game. You alreadyownsharesatthatprice;whybuy more? Why throw goodmoney after bad? Just sit onyourhandsandletthemarketdo what it wants. Now theone exception to this rule iswhen you are positioningyourself into a trade and onyour entry day you takeadvantage of a small dip in

share price. But in this caseyou must still be favorabletoward the chart, far awayfrom your stop price, andprice is showing signs ofrecoveringfromitsslightdip.9. Never overtrade. You

know the feeling: you'veclosed out all your overnighttrades for a tidy profit andyou say to yourself, hey, I'monawinningstreak,let'stakeadvantageofit.Soyouputona fewmore trades.But these

don't go well, and now youare back to breakeven. Youwant those morning profitsback, so you put on a fewmoretrades,onlynowyougowith the e-minis or a few,deep in-the-moneyoptions toleverageyourposition.Thesedon't gowell either, and youclose the daywith a loss.Orperhaps you start the day byclosing out losing positions,and you overtrade to try toget the money back, only to

deepen your losses on theday. This is the obsessive-compulsive disorder knownas overtrading. It is aproblemfamiliartoalltradersand is rooted in deep-seatedfeelingsoffearandgreed.The bestway to overcome

this behavior is to set limitsonyourself:whenyoureachacertainprofitpointduringtheday, either reduce yourposition size or just quit.Better yet,when you reach a

certain number of tradesduring the day, just quit.Reward yourself then foryourdisciplinedbehavior:gosit by the pool, read a goodbook, take a bike ride in thewoods—just do somethingnice to reinforce thisdiscipline until it becomes ahabit.10. Give at least 10

percent of all tradingearnings to charity. Thechildren of John D.

Rockefeller were taught fivebasic rules regardingmoney:(a) work for all you get, (b)give away the first 10percent,(c)investthenext10percent, (d) live on the rest,(e) and account for everypenny. The Rockefellersbelieved that giving awaytheir money was essential totheir wealth. And so shouldyou.Thesecretisthatmoneymultiplies fastest when it'sdivided. It'sallGod'smoney,

in any case. We are merelytemporarystewardsofasmallportion of God's abundance.And when this portion isshared freely with those lessfortunate, we prime theeconomic pump of theuniverse.I encourage you to

establish a legacy that willoutlive you. Plant moneytrees from which others willharvest the fruit. Ultimately,the only purpose for having

wealth is to help others lessfortunate. Wealth shared istruewealthindeed.ThewayIseeit,GodinHisgracegaveme the undeserved talent tomake money by simplysitting in frontofacomputerand clicking a mouse everynow and then.As a result ofthatgift,weasafamilyhavebeenabletotraveltheworld,buildalargehome,andenjoysome of the finer things inlife.TheleastIcandoisgive

ahealthyportionofthefruitsof that gift back to God'sworkintheworld.

PARTTWOTREND-TRADING

BASICS

CHAPTER5WHATISTREND

TRADING?

trading that seeks tomaximize trading profits andminimizeriskbyenteringandexiting strategic price chartsetups. While the trend-trading systemsoutlinedherecan be applied to any timeframe—from multimonthpositiontradestomultiminutedaytrades—mosttrendtradesareheldfrom3 to30 tradingdays.Itiscalledtrendtradingbecause it seeks to enteralreadyestablishedtrends(for

themost part) and ride themas they swing up or down tonewhighsorlows.Butbeforewe further define what trendtrading is, let's first separatetheideafromwhatitisnot.

WHAT TRENDTRADINGISNOT

Trend Trading Is Not Buy-and-HoldInvesting

Buy-and-hold investinginvolves the fundamental oreconomic analysis of marketcycles, business sectors, andindividualcompanieswiththeintent of buying solidcompanies, or funds of suchcompanies, when valuationsareattractiveorwhengrowthprospects are strong, or,

ideally,both.Theaimof thisstrategy is to realize long-term capital gains with aminimum of portfolioturnover. Buy-and-holdinvestors are not traders.They normally pay littleattentiontoeventhebasicsoftechnical analysis. A pricechart trendeitherupordownmatters little to them. Whatmatters instead is, inWarrenBuffett's terms, "buying agreat company at a fair

price."Theholding timeofabuy-and-hold position isusuallymeasured inyears. Insome cases buy-and-holdinvestments can last alifetime.

Trend Trading Is Not PositionTrading

Position traders are indeedtraders inasmuch as they

normallyrelyonthetechnicalanalysisofpricechartsratherthanthefundamentalanalysisof companies. Rather thanpositioningthemselveswithinalready established trends,however,theiraimistogetinon the beginning of newtrends,oreveninanticipationof a trend prior to itsbeginning. In other words,position traders like to buybottoms and sell tops, twothings that trend traders are

forbidden to do except in avery limited sense (e.g.,buyingthebottomofadiptosupport in an establisheduptrend). Compared to trendtrading, position tradingrequires quite a bit morepatience. Position trades arenormallymeasuredinmonthsandcanlastayearor longer.The primary chart of theposition trader is the weeklychart, with the daily chartbeingusedtotimeentriesand

exits. If a position trade isenteredtoosoon,thetraderisforced to sit throughsometimes lengthydrawdowns.

TrendTradingIsNotOvernightTrading

The overnight trader issomeone who relies ontechnical analysis and tape-

reading skills, along with(sometimes) intraday newsbreaks, to take a quick two-day position in a stock. Theovernight trader normallyenters theposition late in thetrading day and sells beforethe close of the dayfollowing. The overnighttrader'saimistocapturethreephases of movement: theafternoon run, the overnightgap, and the next-daycontinuation. This is a very

profitable formof tradingforsomeone with sound tradingstrategies and a keenunderstanding of whatpromptsastock'smomentum,but it can be very timeconsuming, and trading theexitrequiresasmuchfocusedattention as day trading.Whiletrend-tradingskillscanbe used in overnight trading,it is amultifaceted disciplineand thus goes beyond thenormalrangeoftrendtrading.

TrendTradingIsNotScalping

Scalping is a form of daytradinginasmuchaspositionsare held for only one tradingday and all positions areexitedprior toorat thecloseof the trading day. As a daytrader, a scalper always goeshome flat (completely incash) at the end of each

tradingsession,withnoopenpositions held overnight. Butscalpingdiffersfromordinaryday trading (which can be asubspecies of trend trading)inthatpositionsarenormallyheld for only a few seconds,oratmostafewminutes.Andwhiledaytradersusuallyrelyon their chart-reading skills,scalpers play only on thetape. They isolate the stocksthat are moving sharply thatday— usually in response to

unexpectednews,anearningsannouncement,anupgradeordowngrade, or the like—andscrutinize the tape (Level Iand II quotes) foropportunistic, quick-turn in-and-out trades. Scalpers puton lots of trades each day,sometimes in the hundreds,with the aim tomake only asmallprofitoneach(ascalp).These small profits areleveraged into larger profitsby increasing both the

volume of trades and theposition size. Becausescalpersmake little referenceto price charts, they aretechnicallynottrendtraders.

WHAT TRENDTRADINGIS

In termsof time frame, trendtradingoccupies the rangeof

holding periods between themultimonth position trader atthe one extreme and themultisecond scalper at theother.Theprimaryaimofthetrend trader is to capture thebulk of major moves intrendingstocks,enteringafterthe trend has begun andnormally exiting before thetrend concludes. Trendtradersusethepricechartinatimeframe thatbest fits theirintended holding period. If

the trend-trading system isapplied to swing trading (seelaterdiscussion),forexample,then the trade will likely beheld from 5 to 30 tradingdays. In swing trading, thedaily chart is used primarily.But the trend-tradingsystemsoutlinedherecanalsobeusedfor day-trading purposes, inwhich case an intraday chartlike the five-minuteperiod ismostcommonlyusedandthepositionheldforonlyminutes

orafewhoursatmost.Thus, it is important to

thinkoftrendtradingasasetof trading systems and not atrading style.Your particulartrading style (position trader,swingtrader,daytrader,etc.)has to be determined by,among other things, yourtrading objectives, the limitsof your time, yourtemperament and skills (e.g.,unless you have quickreflexes, don't even think

about scalping), and yourincome expectations. Furtherclarification of the differenttypesof tradingstylescanbefound later in this chapter.(Notethatonlyswingtradingand day trading, as definedhere, are forms of trendtrading.)

Buy-and-HoldInvesting

Aim: Long-term capital

gainsStyle: Fundamentalanalysis of sectors andcompaniesHolding time: One yearorlongerTime investment: A fewhourseachmonthTurnover rate: One tofivetradesperyearCommission costs:MinimalExpected annual return:A gain of 15 percent or

PositionTrading

Aim:QuarterlyincomeStyle:Technicalanalysisofweekly/dailychartsHolding time: Three tosixmonthsTime investment: A fewhourseachweekTurnover rate: One to

fivetradesperquarterCommission costs:ModeratelylowExpected annual return:A gain of 25 percent ormore

SwingTrading–(CanBeaFormofTrendTrading)

Aim:MonthlyincomeStyle:Technicalanalysis

ofdaily/hourlychartsHolding time: Five tothirtytradingdaysTime investment:One tothreehourseachdayTurnover rate: Five tofifteentradespermonthCommission costs:ModeratelyhighExpected annual return:A gain of 40 percent ormore

OvernightTrading

Aim:WeeklyincomeStyle:Technicalanalysisofdaily/hourlychartsHolding time: Two daysmaximumTime investment: Six toeighthourseachdayTurnover rate: Two tofivetradesperdayCommission costs:Moderatelyhigh

Expected annual return:A gain of 50 percent ormore

Day Trading (Can Be aFormofTrendTrading)

Aim:DailyincomeStyle:TechnicalanalysisofintradaychartsHoldingtime:Minutestohours, one day

maximumTime investment: EighttotwelvehourseachdayTurnover rate: Five ormoretradesperdayCommission costs: VeryhighExpected annual return:A gain of 60 percent ormore

Scalping

Aim:DailyincomeStyle: Chasingmomentum,tapereadingHolding time: SecondstominutesTime investment: EighttotwelvehourseachdayTurnover rate: TwentyormoretradesperdayCommission costs:ExtremelyhighExpected annual return:A gain of 70 percent ormore

ADVANTAGES OFTRENDTRADING

The advantages of trendtrading over other forms oftrading are numerous.Obviously, the anticipatedreturnstendtobehigherthanwhat abuy-and-hold investorwouldexpect,evenoverwhat

position traders expect,makingtrendtradingineitherits longer-term (swingtrading)orshorter-term(day-trading)formsanidealwaytotrade for a living. If you donotholdadayjobandhave8to10hoursof free timeeachday—not to mention theinclination tospend that timesitting in frontofacomputerscreen clicking a mouse—then day trading may be theideal way to transform the

trend-trading techniquesoutlined in this book into avery profitable business. Ifyou don't have that muchsparetimeorwouldratherbedoing other things thansquinting at pixels all day,then swing trading using thetrend-trading strategies weoutlineheremaybe the idealwaytotradeforaliving.Perhaps more important,

trendtradingdoesnotrequirethe same level of expertise

that sound buy-and-holdersneed to turn a reasonableprofit year after year. Nodoubt about it, phenomenalwealth can be attainedthrough long-term investing—but it takes a lot of hardwork,a lotof time,andabitof luck as well. One of theworld's wealthiest men,Warren Buffett, is theepitome of the intelligent,successfullong-terminvestor,buying sound companies at

steeplydiscountedprices.ButBuffett works very hard atwhat he does. He knows thebusinesseshebuysinsideandout. He lunches with thecompany's executives; heinterviews middlemanagement; he visits thecompany's manufacturingplants and supply chains; hepores night and day overoodles of bottom-lineinformation—all beforecommitting one dime of his

hard-earned cash to a newinvestment. Even then, thereis little guarantee of success.While Buffett is truly aninvesting genius, his returnsover the past 10 years haveaveraged only a little over 6percentannually.As a trend trader, do you

have to work as hard asWarren Buffett? No! Yousimply take one of thesystemstaughtinthesepages,go over a few charts each

night, click themouse a fewtimesinthemorning,andyouare all set to make a decentliving.Moreover, buy-and-hold

investors, and to a lesserextent position traders, musthaveagreatdealofpatience.Theyhave towaitmonths, ifnot years, for the fruits oftheirlabortobecomeevident.Not so with trend trading.This is what makes trendtradingsoidealforthosewho

want to trade for a living.Stockmarkettrendsarefairlyshort-livedphenomena.Upto80percentofthetime,stocksmove sideways; they run intrends only about 20 percentof the time.To follow trend-tradingtechniquesistomovein and out of stocks on aweekly(forswing traders)orhourly(fordaytraders)basis.Thus, the payoff for yourefforts is more immediatelyseen.

This makes trend-tradingtechniquesidealforsettinguptradingasaprimarysourceofyour income. If you applytrend-trading systems toswing trading, say, yourincomecanbemadeavailableonamonthlybasisduetotherelatively high turnover rate.Thisallowsthetrendtradertotrade two weeks for incometo pay the monthly bills andthen two more weeks tocompound the trading

account. With day trading,the income is available evenmorefrequently.WhatIdoasmanager of our Befriend theTrend Fund is combine thetwo: swing trading for largermoves with day trading toexploitintradaymoves.It needs to be said, of

course, that like all forms oftrading, trend trading issusceptible to marketfluctuations and cycles.Whileyoucantrend-tradefor

a living,youneed tobeverycareful to set aside fundsduring the good periods inorder to have moneyavailable to pay the billsduring the lean periods. Likeany form of trading orinvesting, there certainlywillbeleanperiods.Anotheradvantagetotrend

trading is thatwhen properlyexecuted, trend-tradingstrategies of the type taughtherewillyieldmuchlessrisk

than longer-term strategies.Long-term investors areforced to ride bear marketsinto the ground, anxiouslywatching their networth slipaway as the indexes grinddowndayafterday.Buttrendtraders have the freedom tosimply exit losing tradesquickly and step aside. Orthey can use one of thestrategies outlined here thatare designed especially forbear markets to play on the

short side and thus makemoney while the investingworldsuffersadrawdown.Finally,totrend-tradewell,

youneedn'tworryabout...

Poring over financialstatements likebuy-and-holdinvestorsCatching precise markettops and bottoms likepositiontradersSeeing the bulk of yourprofits evaporate on

overnight gaps that goagainst you likeovernighttradersLearning thesophisticated nuances ofLevel II and other tape-reading devices likescalpers

In short, trend tradingprovides the greatest amountofreturnfortheleastamountofwork of any trading style.So, let's get started trend

tradingforaliving!

CHAPTER6SETTINGUPYOURWATCHLISTS

and over-the-counter stocksavailable for trading daily—and the list grows everyweek. It is impossible tomonitorthewholeuniverseoftrading vehicles on a dailybasis. So the logical thing todo, and what trend tradersmust do before they doanything else, is create andregularly update watch listsof stocks that meet certaincriteria.Itisfromthesewatchlists that wewill selectmost

ofthestocksweusefortrendtrading.In order to create a watch

list, we will need to screenout those stocks that areunsuitable for trend trading.Some charting services willoffer special screening toolsfor subscribers, but for ourpurposes the free stockscreeners offered by Yahoo!Finance are sufficient. Notethat Yahoo! Finance offerstwo free screening tools: a

basic service and a moreadvanced one. You shoulduse the more advanced tool,since the basic screener doesnot allow for screening byvolume. Fee-based screeningcan be found atStockcharts.com and atIQCharts; a subscription toeither service includesscreening and scanning toolsas part of the package. I canalso recommend thescreeningtoolinOmniTrader

fromNirvanaSystems.Itrunsvery slowly and thus is notsuitable for frequent use, butit otherwise is a verypowerfulresource.

YOUR PRIMARYWATCHLIST

Irecommendsettingupa listof possible trend-trading

candidates by screening forthe following three criteria:price, average volume, andbeta (a function of stockvolatility relative to thebroader market). There areusually lots of other optionsavailable in screeningpackages—things such asprice/earnings ratios,quarterly growth trends,debt/equity ratios, and often,too, a variety of technicalvariables. Just ignore them

fornow.Subsequentchaptersoutline ways to harness thefull power of your screeningtool to find great trend-tradingsetups.Tosetupyourprimary watch lists all youneed are the three variablesmentioned.In screening for price, we

want toweed out stocks thatare either too low in price(i.e.,wewanttoavoid"pennystocks") or too high in price.In screening for volume, we

want to avoid thinly tradedstocks. In screening forbeta,we want to eliminate slow-moving and nontrendingstocks. Specifically, Irecommendscreeningper thefollowingsettings:

Price: between $10 and$100Average daily volume:greaterthan500,000Beta:greaterthan2.0(atleast twiceasvolatileas

theS&P500)

This screen should returnatleast50stocks,andmostofthe time it will yield wellover that. But in certainmarket conditions you maygetlessthan50hits,inwhichcase it may be necessary tofiddleabitwiththenumbers.Inabreakawaybullmarketofthe kind we saw in the late1990s, for example, we mayneed to raise our maximum

stock price to capture thehigher-priced big movers. Incertain markets you areforced to pay up for quality,andwhen it comes to stocks,that is nearly always a wisething to do. Sometimes themarket goes into a quietperiod without muchmovement, inwhich casewemaynotbeabletofindmanystockstradingata2.0beta.Inthatcase,thefiguremayneedtobeloweredabit.

Traders with smalleraccounts may want to focusonly on lower-priced stocks.In this case, you can changethepricescreentosomethinglike$5to$50,orwhateverismost suitable. Traders withlarger accounts and optionstraders who are looking fordaily multipoint swings maywant to raise the price rangeaccordingly. AtBefriendthetrend.com wekeep twoseparatewatch lists

toserveourtwomostpopularnewsletters: one designed forsmaller account traders(stockspriced$5to$15)andoneforlargeraccounttraders(stocks priced $15 and up).Keeping two separate listslike this gives me a veryinteresting bit of marketinformation:IknowweareinabullmarketwhenIhavetoomany stocks showing up inthe higher-priced screen andtoo few in the lower-priced

screen—and vice versa forbearmarkets.Regarding volume, it is

important to note that wewant to screen for averagedaily volume, not single-dayvolume. This avoids stocksthat have a one-day high-volume event but which onaverage are too thinly tradedto suit our purposes. It bearsrepeating that in no caseshould the average volumefigure be lowered below

500,000 daily shares.Liquidity means stability,stability means lowered risk,and lowered risk meansgreaterprofitsinthelongrun;thus, liquidity is an essentialelement in building a long-termtradingcareer.Once this screen returns a

list of stocks, sort the list byorder of decreasing beta. Tomakeyourprimarywatchlist,takethefirst50stocksonthatlist, that is, the top50 stocks

rankedbyorderofdecreasingbeta.Thesearethestocksyouaregoingtomonitordailyfortrading setups. Don't selectmore than 50, because incertainmarketconditionsyouwill register toomany setupstotrade.Norshouldyoulimityour list to less than 50,because in nontrendingmarkets you may not haveanysetupsatall.Onceyouhaveyourlistof

50 stocks, write these into

your charting software andsave them as a focus list.Asan alternative, you can inputthe list into theCandleglancefeature on Stockscharts.com.This feature gives you 10thumbnail charts per Webpage, and includes the 20-and 50-period movingaverages and one technicalindicator of your choice oneach chart. Figures 6.1through 6.6 represent the sixtop high-beta, liquid stocks

pricedbetween$10and$100asscreenedonSeptember21,2007 (note:my initial screenreturned247stocks,which istypical of bull markets likethe one we are in now). I'veadded the CCI indicator andset the charts at the two-month time period (this alsois variable). This is whatCandleglancechartslooklikeonceyouhavesetthemup.Another site I like for

keeping watch lists is Clear

station.com, which allowsyou to keep an infinitenumber of lists for free. Ifyou input your list of stocksinto Clearstation—to do thisyouwillhavetoregisterwiththe

Figure 6.1 CRM two-monthchart with CCI and 20/50MAs.

Figure 6.2 AKS two-monthchart with CCI and 20/50MAs.

Figure 6.3 LMC two-monthchart with CCI and 20/50MAs.

Figure6.4RMBStwo-monthchart with CCI and 20/50MAs.

Figure6.5 JOYGtwo-monthchart with CCI and 20/50MAs.

Figure 6.6 BZH two-monthchart with CCI and 20/50MAs.site—not only will you getthumbnailchartswithmoving

averages, stochastics, andMACD, you will also getdaily updates on which ofyour stocks have hadupgrades or downgrades, areexpecting earnings, and havejust triggered certaintechnicalbuyandsellsignals.An advantage of theClearstationwatchlistsisthatyou only need to bookmarkone page to access all yourcharts; with Stockcharts'Candleglance feature you

have to bookmark one pagefor each 10 stocks on yourlist. A disadvantage is thatClearstation only offers barcharts, whereas Stockchartsuses the more informativecandlestick chart as itsdefault.I use both these services

becauseeachoffersaslightlydifferent set of tools. I doprefer thewatch list capacityat Stockcharts to that ofClearstation, since, as a

subscriber, I have access toupdates in real time (versusdelayed time forClearstation). In truth, bothare ideal for sorting throughdozens of stocks to find ashortlist of the charts youwant to do further researchon.

UPKEEP OF YOURWATCHLIST

Now,withyourwatch list ofthe 50 most liquid and mostvolatile stocks set up, youhavethesetofchartsyouwillmonitor at the end of eachtrading day (or as a daytrader, throughout the day).Totrend-tradeeffectivelyyouwill need to become veryfamiliar with these pricecharts. Forget the companiesthemselves, what they make,what service theyoffer,what

their growth prospects are,andsoon.Allof that isnowirrelevanttoyourpurposesasatrendtrader.Everythingyouneed to know to trend-tradefor a living is right there inthepricechart;therestisjustnoise.After looking at their

chartsdayafterday,youwillbegin to develop a feel forhow these stocks trade. Asyou train yourself in thetrend-trading systems

outlinedinthisbook,youwilllearn to recognize points ofsupport and resistance. Youwillbeable tomakenotesofspecial trading opportunitiesas they set up on the charts(breakouts, breakdowns,consolidations, movementstoward or away from majormoving averages, etc.). Youwill be able to distinguishthose that look like easytraders—that is, ones thatmake smooth turns, rarely

gap up or down, and have asteady volume flow—fromthosethatlookmoredifficult.The more difficult stocks totrade tend to have sloppy,choppy price movements,wide overnight gaps, andhuge intraday ranges. Theseyou should delete from yourwatch list. You can replacethem with stocks fartherdownthelistofyouroriginalscreening.Remember,tradingis a business and these price

chartsareyouremployees.Asagoodboss,youshouldkeepclose tabs on them: fire theunproductive ones andreplacethemwithmoreeagerworkers.Your primary watch list

will need tobeupdatedoncea month. To do this, simplyrepeat the same process:screenforprice,volume,andbeta; select the 50 highestbeta stocks; then input theseinto your charting software.

As you do your monthlyupdatesyouwillfindthatthelist does not change all thatmuch over time. The samegreat trading vehicles keepgetting screened out fromamong the masses. But inmost market conditions youshould be replacing abouthalf a dozen stocks at eachnewscreening.Keep trackofthese new additions, becauseyouwillnowneedtobecomejust as familiar with them as

you were with those theyreplaced. Also, whenever acompanyisboughtoutorhasa horrible news event, it isbest to delete it from yourwatch list. Large, multipointgaps either up or down tendtomake formessy trading inthe weeks and months goingforward.In addition to this primary

list of trading stocks, youshouldadd,onadailybasis,afew stocks that are screened

for special trading setups.These setups are describedlater. You can add thesestocks to those you havechosen from your primarywatchlist,oryoucandowhatI do: make separate watchlists for each special setupscreen.One lastwordonupdating

your watch lists: if youchoose to useStockcharts.com for keepingyourwatchlists,youhavethe

advantage of moving theresults of your special setupscreens directly into yourwatchlistswithasingleclickof themouse. Since youwilleventually be screening forup to 10 setups—whichmeans potentially having 10different watch lists inaddition to your primary list—this can prove to be avaluabletimesavingoption.

CHAPTER7DETERMINING

GENERALMARKET

DIRECTION

ofuse.THE artof applying technicalanalysis to your watch listsand then selecting whichstocks to trade is a chart-specific exercise. This is tosay, your primary point ofreference is the stock's pricechart itself. All you need toknow to make profitablepredictions about a stock'sfuturepricemovementarethepatterns of its past price

movements as recorded onthe stock's daily chart. Thismeans that, with the tools oftechnical analysis in yourtrading arsenal, you do notneedto:

Watch every minute ofCNBC or BloombergTelevisionPore through hundredsof profit and lossstatements—boring!Track prior quarters for

earnings and revenuegrowthWorry about things likeprice/earnings ratios anddebt/equityratiosMonitor every newsdispatch onBriefing.comorReutersKeep track of grossdomesticproduct(GDP),theconsumerpriceindex(CPI),theproducerpriceindex (PPI), housingstarts, and employment

dataHang on every syllableof the latest FederalReserveannouncementAnticipate mergers,buyouts, publicofferings, splits, FDAapprovals,andsoon

Instead,allyouneedtodototrend-trade profitably withtechnical analysis is tocheckthe chart, find trends, enterthemaftertheystart,andexit

themwhentheyend.Having said that, there is

one further bit of analysisbeyondthestock'spricechartthatyoucando toadd to thelikelihoodthatyourtradewillgo in the intended direction.It also involves applyingtechnical analysis to a pricechart,butinsteadofthechartof the stock you intend totrade, you will now belooking at the chart of thebroader market. If you can

correlate your trade as muchas possible with the generalmarket's directionality andmomentum,thenyouwilladdsignificant percentage pointsto the probability that yourtradewillturnoutawinner.In his best-selling book

How to Make Money inStocks, William O'Neilincludes market direction asanimportantpartofhisCAN-SLIM trading strategy (it isthe "M" in SLIM). O'Neil's

strategy combines basicprinciples of fundamentalanalysis with an assessmentof thepricechartof theDowJones Industrial Average.O'Neil rightly concludes thatto give your trades everychance of success, wheneverpossible you should avoidtwo fundamental mistakes:going long in a bear marketand buying into the top of amarketrun.But O'Neil overstates the

casewhenhesays,"Ifyouarewrong about the direction ofthe broad general market,three out of four of yourstocks will slump with themarketaveragesandyouwilllose money" (O'Neil, p. 44).If you follow the systems Ioutlinehere,youwillbeabletomakegoodmoney long ina bearmarket and short in abullmarket.The key to trend-trading

successinanytypeofmarket

is finding good charts. Andthere are always great chartsthat shine brightly duringbearmarkets,justastherearemany laggards that stink uptheplaceduringbullmarkets.Again, any robust technicalsystem must be chart-specific: if directionalmovement is not happeninginthedailychartofthestock,it doesn't matter what thegeneralmarketisdoing,yourstockposition isnot likely to

move.Still,itisimportanttohave

a general sense of what typeof market we are in: bull,bear, or range-bound. Onereasonthisisimportantisnotbecause our success isdependent on it, but becauseitmakes our job a lot easier.Itismucheasiertofindgoodlong setups in a bull marketthan in a bear market. Andyou will have many moreshorts to choose from in a

bear market than in a bullmarket.Sounderstanding thecurrent market dynamic andplaying it accordingly isreally an exercise inefficiency. More important,perhaps,knowingandtradingwith the general marketdirection can put a fewpercentage points ofprobabilityonourside.Werewe infallible chart readers,thiswouldnotmatter.Butthefact that bullmarkets tend to

cause more stocks to go upthan down, and bearmarketscausemorestockstogodownthanup,meansthatgettingonthesideofthegeneralmarketdirection can help cover amultitude of chart-readingsins.

GENERALMARKET

Before we look morecarefully at types of generalmarkets, let's talk a bit aboutwhatwemeanbythegeneralmarket. The truth is, there isnothing "general" about thestockmarket.Itisacollectiveof very specialized marketniches,eachoneofwhichhasthe capacity to sway thewhole. Still, we are able toget a day-by-day picture ofthe market's consensus by

looking at the various stockindexes. For the purposes oftrendtrading,wewillneedtolook at only two primaryindexes:theS&P500andtheNasdaq 100. Tomake thingsassimpleaspossible,Iliketouse charts of the exchange-tradedfund(ETF)proxiesforthese indexes: SPY for theS&P 500 andQQQQ for theNasdaq 100. You can alsorefer to the Dow JonesIndustrial Average (whose

ETF is DIA). It is a much-revered benchmark, and itdoes represent the country's30largestcompaniesworkingthe world's most productiveindustries. But it so closelyshadows the S&P 500 that itneedn't be a requisite part ofourgeneralmarketanalysis.More experienced traders

can also add special marketcap indexes and sectorindexes to their analysis. Ifyou want to do that, let me

suggest thatyoualsoadd thefollowing charts to yourgeneral market watch list(again, put these in yourStockcharts.com orClearstation.com watch listsforaddedconvenience):

GeneralMarkets

SPY (S&P 500)—tracksthe 500 largest publiclytradedcompanies

QQQQ (Nasdaq 100)—tracks the 100 largesttech, biotech, andtelecomcompanies

MarketCapIndexes

MDY(S&PMidcaps)—tracks400representativemidcapcompaniesIWM (Russell 2000)—tracks 2,000

representative small-capcompanies

SectorIndexes

SMH—semiconductorcompaniesIBB—biotechcompaniesOIH—oil servicescompaniesHHH—Internet

companiesRTH—retailcompaniesXLF—financial servicescompaniesXHB—home buildingcompanies

This is not an exhaustivelist by anymeans, but it is agood start. These ETFs alsomake great trading vehicles,by the way. AtBefriendthetrend.com, weoffer The Index Newsletter,

which trades these and otherETFs exclusively, includingthe brand-new ultra funds,whichmove in syncwith thebroader indexes but areleveraged at 2:1. I useseveral.Manysubscribersusethis letter to determine theirsense of general marketdirection as well as profitfrom the trend-trade pickslistedthere.Butifyouwouldrather determine generalmarket direction on your

own, we give you here therulesfordoingso.Assume, for the sake of

convenience, that you aregoingtouseSPYandQQQQasyourprimary indicatorsofgeneral market direction.Over the course of severalyearsofwatchingandtradingthese broader indexes, wehave come to note fivedifferent types of marketconditions.Theyare:

BullishstronglytrendingBullishweaklytrendingBearish stronglytrendingBearishweaklytrendingRange-bound (ornontrending)

In general, wewant to focuson longplays in thefirst twotypes of market, short playsin the next two types, and amixoflongsandshortsinthelasttypeofmarket.Let'sfirst

definetheparametersofthesedifferentmarkettypes.

BULLISH:STRONGLYTRENDING

The Focus It should be onlong setups, particularlybreakout plays (to be

explainedlater).Characteristics This iseveryone's favorite kind ofmarket—except, of course,those "permabears" whoalways think the U.S.economyisgoing tocollapseat any moment. This is thesort of market that sparkedthe day-trading frenzy in thelate 1990s: everything goesup,andupalot,nearlyevery

day.Thebullsarecompletelyin control and win everybattlewith thebears.Makingmoney is easy in a bullishstrongly trending market, aslong as you have the rightentry system. But thedrawback is that when thiskindofmarket reachesa top,the sell-off can be quick andharsh and can wipe outmonths of hard-won gains ina matter of days. So in astrong bull market you must

always be careful to playdefensivelyagainstapossiblereversalofmomentum.What to Look For Bullishstrongly trendingmarkets areeasytospot.Herearethekeyindicators:

The20MAisabovethe50MA.Boththe20MAandthe

50MAarerising.The distance betweenthe 20 MA and the 50MA is large and/orgettinglarger.Pullbacks in price reachonlytothe20MA,oratthemostbetweenthe20MAand50MA;theydonot reach all theway tothe50MA.

How to Play It Use one of

our systemsasoutlined later.Herewecansaythatabullishstrongly trendingmarket is agreat market to be in if youare already long. But if youare coming late to the party(and hopefully not too late),your best play is to look forstocksthatarebreakingouttonew highs from periods ofconsolidation. You mustmake sure these breakoutplays are confirmed by thevarious technical indicators

we use. If price is making anew high but the indicatorsare not making new highs,then you have bearishdivergence and you shouldmoveontoanotherchart.ChartExampleThechartofSPY in Figure 7.1 shows aclassic bullish stronglytrendingmarket.Notethatthe20

Figure 7.1 SPY—bullish:stronglytrending.MA(dottedline)isabovethe50MA (solid line), and thatboth MAs are in a risinguptrend. Further, the 20 MA

isquitefarawayfromthe50MA, and the distancebetween is getting largerrather than smaller. Finally,note that the mid-Augustpullback and the twopullbacks in Septembertraveledonlyas faras the20MA before the trend upwardresumedagain.

BULLISH:

WEAKLYTRENDING

The Focus It should be onlongsetups,particularlypull-back plays (to be explainedlater).Characteristics This is atoughermarkettotrade,since

thepullbackstendtobemorefrequent, steeper, and longer-lived. In a weakly trendingmarket,correctionscan lastacoupleofweeks.Thiscanbefrustrating if you are sittingon open long positions.Ultimately, the bulls are incontrol, but it can seem fordays on end that the bearshave moved in and madethemselves right at home.However, this is one of thebestmarkets inwhichtofind

great risk/rewardscenarios inour setups. Those lengthierpull-backs serve to take a lotof the risk out of a trade, soourstop-losscanbecloser toentry,andourexittargetscanbethatmuchfurtheraway.What to Look For Bullishweakly trending markets arenot quite as obvious as theirstrong counterparts, but withsome experience you should

be able to recognize them.Herearethekeyindicators:

The 20 MA is mostly(though not always)abovethe50MA.The50MAisrising,butthe20MAisfluctuating(thoughmostlyrising).The distance betweenthe 20 MA and the 50MAchangesfrequently.Pullbacks reach all the

way to the 50 MA(sometimes beyond butonlybriefly).

How to Play It Use one ofour systems outlined later.Herewecansaythatabullishweakly trendingmarket is anidealmarketfortrendtrading.You should find stocks thatare showing strong trendingaction (normally strongerthanthegeneralmarketitself)

but have pulled back to anareaofsupport.Thispullbackshould be confirmed byoversold indicators, and thecurrent daily candlestickshouldputinareversalbarofsome kind before youconsideranentry.

Figure 7.2 SPY—bullish:weaklytrending.ChartExampleThechartofSPY in Figure 7.2 shows aclassic bullish weaklytrendingmarket.Notethatthe

20MAremainsabovethe50MA, and that the 50 MA isclearly in a rising uptrend.But also note that there arefluctuations in the 20 MA,indicatingthatsell-offsintheindex are quite sharp anddeep. You should also notethat the various pullbacksseen in every month of thischartperiodtraveledasfarasthe 50 MA, and sometimesbeyond, before the trendupwardresumed.

BEARISH:STRONGLYTRENDING

The Focus It should be onshort setups, particularlybreakdown plays (to beexplainedlater).

Characteristics This isperhaps the most difficultmarkettotrade.Therearetworeasons for this. First, bearmarkets always fight thelong-term trend of the stockmarket (which is up) and, assuch, tend to be short-lived.The second reason has to dowith the extremely volatilenature of short-covering.Strong downtrends can cause

amarkettogetsooversoldsoquickly that automated buyprogramskickintoscoopupcheap shares. This causestradersand fundmanagers tocover their short positions inorder to lock in profits. Astheydoso,theyareforcedtobuy back shares they haveborrowed, and the result is asharp and quick short-covering rally (what traderscall a dead cat bounce). Butthe advantage of bearish

strongly trending markets isthat they tend to go downfaster than bullish stronglytrending markets go up.Whenthebearsareincontrolofamarket,astheyareinthistype of market, they tend togo wild and overdo things.Can you blame them? Forover200years,theyhavehadto play second fiddle to theflashierbulls,andfinally thisis their chance in thespotlight. But you can take

advantage of this. If you arewilling to play the short side—to trend-trade for a livingyoumust be willing to short—youcanpotentiallymakealot more money in less timeinabearishstronglytrendingmarketthaninanyothertypeofmarket.Andit isalwaysathrilltomakemoneywhile90percentoftheinvestingworldislosingtheirs.

WhattoLookForAbearishstronglytrendingmarketisaseasy to spot as its bullishcousin. Here are the keyindicators:

The20MAisbelowthe50MA.Boththe20MAandthe50MAarefalling.The distance betweenthe 20 MA and the 50MA is large and/or

gettinglarger.Ralliesreachonlytothe20 MA or, at the mostbetween the20MAandthe50MA.

How to Play It Use one ofour systems outlined later.Here we can say that abearish strongly trendingmarketisagreatmarkettobein if you are already short.But ifyouarecoming late to

the party (and hopefully nottoo late),yourbestplay is tolook for stocks that arebreaking down to new lowsfrom periods ofconsolidation. You mustmake sure these breakdownplays are confirmed by thevarious technical indicatorswe use. If price is making anew low, but the indicatorsare not making new lows,then you have bullishdivergence and you should

moveontoanotherchart.ChartExampleThechartofSPY in Figure 7.3 shows aclassic bearish stronglytrending market. Note thatonce the bear market beginsinearnestinlateApril,the20MA

Figure 7.3 SPY—bearish:stronglytrending.

Figure 7.4 SPY—a quickrallyendsthebearishtrend.crossesbelowthe50MAandremains there throughout theperiod. Also note that bothMAsare falling, and that the20 MA is falling at a faster

pace than the 50 MA. Youshould also note that thevarious rallies seen in thischart,oncethestrongtrendisestablished, travelonlyas faras the 20 MA before thedominant trend downwardresumes.As a follow-up, keep in

mind our previous warning:bearish strongly trendingmarkets can end veryabruptly if a short-coveringfrenzy sets in. Check out

what happened just twoweeksafterSPYtestedthe20MA in a bearish stronglytrending market: instead ofresuming thedominant trend,itreversedandkilledit.

BEARISH:WEAKLYTRENDING

The Focus It should be onshort setups, particularlyrallies into resistance (to beexplainedlater).Characteristics This is aneasier bear market to tradethan the strongly trendingversion, since the rallies intoresistance that trigger oursetups take a lot of the risk

out of the trade. But it stillsuffers from the twoproblemsassociatedwithbearmarkets we mentionedpreviously. In a weaklytrending market, corrections(rallies) can last a couple ofweeks, which can befrustrating if you are sittingon open short positions.Ultimately, the bears are incontrol, but it can seem fordays on end that the bullshave moved in and made

themselves right at home.However, just like its bullishcousin,thisisoneofthebestmarketsinwhichtofindgreatrisk/reward setups. Thoselengthier corrections to thedominanttrendservetotakealot of the risk out of a trade,soourstop-losscanbecloserto entry, and our exit targetscan be that much fartheraway.

What to Look For Bearishweakly trending markets arealsoeasytospot.Herearethekeyindicators:

The 20 MA is mostly(though not always)belowthe50MA.The 50 MA is falling,but the 20 MA isfluctuating (thoughmostlyfalling).The distance between

the 20 MA and the 50MAchangesfrequently.Ralliesreachallthewayto the 50 MA(sometimes beyond butonlybriefly).

How to Play It Use one ofour systems outlined later.Here we can say that abearish weakly trendingmarket is a good market fortrend trading. You should

find stocks that are showingstrong downwardly trendingaction (normally strongerthanthegeneralmarketitself)but have rallied up into anarea of resistance. This rallyshould be confirmed byoverbought indicators. Thedaily candlestick should putinareversalbarofsomekindbeforeyouconsideranentry.Chart The chart of SPY in

Figure 7.5 shows a classicbearish weakly trendingmarket.Note that the20MAremains for the most partbelowthe50MA.There isaperiod inFebruarywhere the20 MA rises above the 50MA—a sign that the indexmight be moving into arange-bound condition. Butthen the trend resumes withanother bearish crossover.Note that the 50 MA isclearly in a falling trend

throughout the period. Alsonote that there arefluctuations

Figure 7.5 SPY—bearish:weaklytrending.

in the20MA,indicatingthatthe rallies in the index arequite sharp and prolonged.Thesevarious rallies traveledas far as the 50 MA, andsometimesbeyond,beforethetrend downward resumedagain.

RANGE-BOUND(NONTRENDING)

The Focus It should be onboth long and short setups,particularly trendlinebreakout/breakdownplays(tobeexplainedlater).Characteristics Range-boundmarketsarethebaneofa buy-and-holder's existence,but for the technical traderthey are a godsend. This is

because the technicalindicators we use(stochastics, CCI, RSI)registeroverboughtandover-sold signals that work mostrobustly in range-boundmarkets.Moreover,ifyouarewilling to trade morefrequently, you can make alot of money in a range-bound market. It is essentialtherefore to learn how toidentifyrange-boundmarkets,because the general market

spends amajority of its timein such a condition. In arange-bound market, pricebounces up and downbetween roughly parallelpivot points of support (onthe low side) and resistance(on the high side). Such amarketsuggeststhatbullsandbears are waging a war witheachother,butnoonesideisclearly winning. Tradingrangesbetweenparallelpivotpoints can be either wide or

narrow, and it is a generalrulethatthewiderthetradingrange, the longer price stayswithin it. Narrower rangestend to be broken to theupside or downside moreeasily.What to Look For Range-boundmarketsarenotalwayseasy to spot, but there arerules to follow. Here are thekeyindicators:

The 20 MA spendsabout as much timeabove as below the 50MA.The 50 MA is mostlyflat, while the 20 MAvaries from rising tofalling.The distance betweenthe 20 MA and the 50MAvariesgreatly.Rallies and sell-offs

easily pass through bothmovingaverages.

How to Play It Use one ofour systems outlined later.Here it can be said that it isfrustratingfor traderswhenarange-bound market firstappears, especially when itfollows a strong up- ordowntrend. Traders can bereluctant to transition from afast-money, momentum

environment (strong trend) tothe more strategic, labor-intensive environment of therange-bound condition. Butonce the trading range isestablished,itcanbeanidealtrading environment. In atrading range, we usetrendlines to highlight anddelimit theminitrendswithinthe range and our technicalindicators to spot oversoldandoverboughtlevelsaswellas bullish and bearish

divergence.Wearelookingtoplay reversals right off thepivot points of support andresistance, confirmed by abreak of the intrarangetrendline. Indicatordivergence is often a key tolocating the best reversaltrades and will often let uspinpoint with extremeaccuracy the tops andbottomsofmovementswithintherange.

Chart The chart of SPY inFigure 7.6 shows a ratherwide trading range or range-bound condition. Note thatthe50MAremainsrelativelyflat throughout this period,while the20MAbouncesupand down following price.Alsonote thatpricedoesnotpausemuch at eithermovingaveragebut for themostpartcontinues up and down as ifthey were not even there (in

trending markets the MAstend to act as support andresistance). That snake-ishlook to the 20 MA, up anddownlikearollercoaster,isatell-tale sign thatwe are in arange-boundmarket.Once you understand the

type of market you arecurrently trading in, youwillhaveabettersenseofthetypeof trade to look for: long orshort,breakoutorbreakdown,

pullback to support or rallyintoresistance,andsoon.Asindicated at the beginning ofthissection,thispieceofyourtrading strategy is far frombeingthemostimportant.The

Figure 7.6 SPY—tradingrange.vitalkeytoyoursuccessasatrend trader is finding thebest-looking chart, regardlessofwhattherestofthemarketis doing. But if you canconsistently get yourself onthesamesideas themarket'snetmoneyflow,youwillgiveyour trading an extra edge.Sometimesthatcanmakethedifferencebetween long-termsuccess and a short-term

wipeout.

CHAPTER8PUTYOURMARKET-

READINGSKILLSTOTHETEST

ofuse.IN the following pages I amgoing todisplayanumberofcharts from the ETF proxiesthat represent the threeprimary stock averages: SPY(S&P500),DIA (Dow JonesIndustrial Average), andQQQQ(Nasdaq100).Takeapiece of paper and jot downwhat market type you thinkeach chart displays. It mightbe helpful first to review the

rules for each of the markettypes.

Bullish: StronglyTrending

The20MAisabovethe50MA.Boththe20MAandthe50MAarerising.The distance betweenthe 20 MA and the 50MA is large and/or

gettinglarger.Pullbacks reach only tothe 20 MA or, at themost, between the 20MAand50MA.

Bullish: WeaklyTrending

The 20 MA is mostly(though not always)abovethe50MA.

The50MAisrising,butthe20MAisfluctuating(thoughmostlyrising).The distance betweenthe 20 MA and the 50MAchangesfrequently.Pullbacks reach all theway to the 50 MA(sometimes beyond butonlybriefly).

Bearish: Strongly

Trending

The20MAisbelowthe50MA.Boththe20MAandthe50MAarefalling.The distance betweenthe 20 MA and the 50MA is large and/orgettinglarger.Ralliesreachonlytothe20 MA or, at the most,between the20MAand50MA.

Bearish: WeaklyTrending

The 20 MA is mostly(though not always)belowthe50MA.The 50 MA is falling,but the 20 MA isfluctuating (thoughmostlyfalling).The distance betweenthe 20 MA and the 50

MAchangesfrequently.Ralliesreachallthewayto the 50 MA(sometimes beyond butonlybriefly).

Range-Bound

The 20 MA spendsabout as much timeabove as below the 50MA.

The 50 MA is mostlyflat, while the 20 MAvaries from rising tofalling.The distance betweenthe 20 MA and the 50MAvariesgreatly.Rallies and sell-offseasily pass through bothmovingaverages.

Now,seehowmanyofthefollowing charts (Figures8.1–8.20) you can correctly

identify.The correct answersare located after the charts,alongwithcommentary.Notethatsomeofthesechartswillshow transitional periodsbetween one type andanother. To answer correctlyin these cases you will needto identify bothmarket typeson either side of thetransition. There may be afew charts that clearly showmore than two types ofmarket. So think carefully

about your answers. Reviewtherulesandstayfocused!

1. Dow Jones Industrials,2006

Figure 8.1 Trend Test Chart1.

2.S&P500,1998

Figure 8.2 Trend Test Chart

3.S&P500,2000

4.S&P500,2006

6.Nasdaq100,2006

Figure8.6TrendTest6.

9.Nasdaq100,2004

Figure8.9TrendChart9.

10.S&P500,2005

Figure8.10TrendTestChart10.

11.Nasdaq100,2001

Figure8.11TrendTest11.

13.Nasdaq100,2006

15.Nasdaq100,2004

16.Nasdaq100,2001

19.Nasdaq100,2005

20.Nasdaq100,1999

Figure8.20TrendTestChart20.Remember, these answers

and their supportivecommentary are the productsof my own subjectivereadings of the charts based

on many years of activetrading experience. Asmentioned, chart reading isnot an exact science.Subjectivity is involved nomatter how many rules areapplied. Nevertheless, aconscientious application ofthe rules we laid out shouldkeepusmoreorlessontrack.Intradingwearenot lookingfor exactitude. Precision isnot an available commodityon the trading floor. All that

is needed to be hugelyprofitableinthetradinggameistoberightmoreoftenthanwrong.Here are the answers as I

see them (feel free to argue,but you better have somegood reasons for doing so!).Giveyourselfpointsforeverymarkettypeyougetright:1. This is clearly a bullishstrong trending market, noquestionsasked.[1point]2.Thisone is a bit harder to

decipher.The left sideof thechart shows a straightfowardbullish strong trend. Thenthingsgetfuzzier.Themarketgoesintoatightconsolidationthat could be called range-bound, but because there isnot much snake-ish actionfrom the 20 MA it is reallymore a period of transition.From there we have twopossibilities. Either themarketgoesintoashort-livedbullishstrongtrend,followed

quickly by a bearish strongtrend, or the markettransitioned into the initialphaseofawiderange-boundcondition. More time isneeded to confirm whichpossibility is correct. Giveyourself credit if you gaveeither answer (in fact, themarket went into a widetradingrangeinlate1998).[2points]3.Hereweseearange-boundmarket. While the general

trendismodestlyupward,weseeenoughvariationinthe50MA to hesitate in calling ittrending. The 50 MA is thekeytothetrendingmarket: itshould show no hesitation inmoving up or down (a bit offlatnessisokay,butitshouldnever move countertrend).Certainly the 20 MA is"snakey" enough to allow usto get in some trendlinebreakout and breakdownplays.[1point]

4. Clearly a bullish strongtrend. What a beauty of achart![1point]5. Another range-boundmarket. Note the up anddowntwistsofthe20MA.[1point]6. Another clear bullishstrong trend. It tookabit forthis one to get started, butwhen price pulled back onSeptember11totouchthe20MA, then pushed off again,we got the confirmation that

thiswasindeedamarketwiththebullsincontrol.[1point]7. Again, a range-boundmarket, as shown by the 50MA, which just refuses toconfirm an uptrend. ThingsdidgetstronglybullishinlateSeptember for a week or so,but once price pulled backandclosedbelowthe50MA,that possibility was negated.[1point]8. Range-bound, very clear.Look at that 20 MA: snake-

city![1point]9. There is a lot going on inthis chart.Herewehave fivedistinct market types: howmanydidyouname?Clearly,on the left side of the chartwe are in range-boundterritory.Thatiseasyenough.But then a sharp drop in theindex in July and Augusttempts us to saywe are in abearish strong trend. Thisgets confirmed when pricekisses the 20MAon a relief

rally and then plunges lowerand the 50 MA shows adownwardslope.Sothat'sthesecond market type. But thetrend gets negated prettyquickly once price shoots upabove the 50 MA in earlySeptember. At this point wewould have to say we areback to a range-boundmarket,onlytherangeisnowwider. But then the indexkeeps going up, and the firstpullback in late September

bounces cleanly off the 50MAwithoutgoingthroughit.This gives us our fourthmarket type: a bullish weaktrend. We hold to this viewuntil mid-October, whensomeconsolidationbringstheindex down to the 20 MAarea. Here it holds beforepushing strongly higher. Thefact that itneverwentall thewaytothe50MAmeansthatnow, on the right side of thechart, we are in a bullish

strongtrend.Thisclearlygetsconfirmed as the indexcontinues to climb higher,andthe20MAmovesfurtherand further away from arising 50MA. Give yourselfone point for each markettype you recognized (in therightorder).[5points]10. Range-bound. No

questions asked. [1point]

11.Bearish strong trend. Nodoubtaboutit.[1point]

12. This chart is a bit moreinteresting. It startswithan obviousbullishweaktrend. Note the frequentpullbacks to the50MA,which is in a consistentuptrend. But then thechart morphs into arange-bound conditionasitconsolidatesallthatupward movement andthe 50 flattens out. Bymid-July we might betempted tocall theearly

part of that transition abearish weak trend,since the 50 MA areacameclosetoholdingasresistance and it isstarting to roll over tothe downside. But thefact that on its secondrelief rally later thatmonth the index waseasily able to passthroughthe50MAleadsustoconfirmthatwearestill within a trading

rangeratherthanstartinganewtrend.[2points]

13. We see a range-boundinitially, then the chartfalls off quickly into abearish strong trend asthattightrangebreakstothe downside. Thetrading range seen hereisverytight,andassuchit is one of the worstkinds of marketenvironmentstotradein.Range-bound conditions

are great for trendtrading, as long as therange iswide enough topermit both longs andshorts sufficient time tobring our trailing stop-losses into profitterritory.Butthekindoftight range seen here isnext to impossible toprofit from unless youare a day trader. Whenwe are in a tight range-bound market, we

therefore need to findcharts on our watch listthatarenot range-boundbut which are showingsizeablemoveseitherupordown.[2points]

14. This chart starts with abullish weak trend thatthen morphs into abullish strong trend.Either way, it is a nicemarket for longs. [2points]

15. A bullish weak trend is

clearly seen here. [1point]

16. Here we have a bearishstrong trend that thenreverses sharply andbecomesabullishstrongtrend. The fulcrum onwhich this strongreversal pivots is, ofcourse, the terroristattacks on the UnitedStatesthattookplaceonSeptember 11, 2001.You can see clearly the

gapdownthattookplaceafter the marketsreopened (they wereclosedforfourdaysafterthe attacks) andsubsequent sellingpressure that led theindextomakeadeepcutlow. From there, theindex rallied over 50percent in a few shortweeks.Wewere able toposition ourselves forthisramp-up,bytheway

—evenbeforethestrongtrend was confirmed—by looking at bullishdivergence in theindicators.[2points]

17. A bullish strong trend,which then consolidatesin a range-boundcondition.[2points]

18. A bullish strong trendthatthenflattensoutandmorphs into a bullishweak trend. Note thetransition that takes

place between the twomarkets. In July we seesomepriceconsolidationafter the sharp upwardramp.The20MAbeginsto flatten out, and theindexmovesall thewayinto the 50 MA, evenslightly beyond. Butonce the50MAheldassupport and the indexrallied, we knew wewere still in an uptrend;only now it would not

likely be as strong as ithadbeeninpriorweeks.Again, strong trendsplay off the 20 MA,weak trends off the 50MA.[2points]

19. A bearish weak trend isclearly seen here. Notethat this trend got a bigkick start with a gapdown in January. Alsonotehowthe50MAactsas resistanceall thewaythrough.[1point]

20. Easy enough: a range-boundmarket(duetothefact that pricemoves soeasily through the 50MA) that by mid-August, with the firstsuccessfulholdofthe50MAassupport,becomesa bullish weak trend. [2points]

So, howdid youdo?Giveyourself a point for everymarket type you correctlyrecognized. There are 32

market types represented inthese 20 charts. Write me ifyouwant to argue otherwise,but for now I am stickingwith the assessments listedhere.Here is how you should

scoreyourself:30:Excellent!Write me, I may have a jobforyou.

25–30:Verygood!With a bit more experience,youshouldbecomeagreat

chartreader.20–25:Notbad,but...I would suggest rereadingthis chapter and spendingsome time lookingatmorechartsbeforemovingon.

15–20:Havingabadday?Try drinking a strong cup ofcoffee and taking the testagain.

<15:Don'tquityourdayjob!Blametheauthorofthisbookfornotbeingclearenough!

PARTTHREEGETSTARTEDINTRENDTRADING

CHAPTER9SELECTING

BULLISHSTOCKSTOTREND-TRADE

IN thissection,Iamgoingtointroduce you to my top 10technical setups. These arethe setups we at Befriendthetrend.comhavefoundoverthe years to be the bestpossible setups for trendtrading. Each of these setupsis proprietary. This doesn'tmean that we have acopyright to them, or thatthey use any secret "blackbox" formula that we will

reveal to you only at ourreally, really expensiveseminars. Rather, it simplymeans that they have beenuniquely designed by me("Dr. Stoxx") and theBefriend thetrend.com teamthrough long periods ofrigorous back-testing andreal-moneytrading.Thesearethe setups we use daily tofind the trades werecommend to our variousnewsletter subscribers, and

that we also trade with realmoney in our Befriend theTrend Fund. While they usecommon technical elements—so common that anypopular charting system canaccommodate them—there isnothing common about theirperformance.A setup here refers to a

combination of price pattern—the way price paints acertainpictureonthechart—and technical indicators that,

together, give us the rightconditionsforpredictingwithreasonable confidence thefuture direction of a stock'sprice. Now just because youhaveagreat-lookingsetupona chart does not in any wayguarantee that price willmove in our predicteddirection. But the followingsetups have been selectedbecause they have, in thepast, contributed to a healthypercentage of highly

profitable trades. They arethushigh-probabilitysetups.Foreachofthesesetupswe

are going to tell you severalthings. We will indicatewhich market type, of thetypes we studied in Chapter8, each setup is best suitedfor. This doesn't mean thatthereisonlyonemarket typeyou should play the setup in—it only means that themarket type indicated willgive your trade the best

possible edge. We will alsogiveyoutherulesyouneedtoidentify the setup on yourwatch list (see Chapter 6 onsetting up a watch list),including the rules needed toconfirm your entry into thetrade.Wewillalsoshowyouhow to use a stock-screeningtool to search for thesesetups. You will have toresort to this tool wheneveryour watch list fails toproduceanyexamplesofthat

particular setup.Wewill tellyou in very specific termsexactly how and when toenterthesetupasyouinitiatea new stock position. Foreach setup we will give youtwo or three charts toexamine that illustrate whateach of the setups looks likeinlivetrading.For the sake of

conveniencewehaveputourfive bullish setups in thischapter and our five bearish

setups in Chapter 10. InChapter 11, we will betreating the all-importanttopicofhowtoproperlyenterand exit your positions inorder to maximize yourprofits and minimize yourrisks.Before beginning, if you

arenotfamiliarwithJapanesecandlestick terms, please goto one of the several freeWeb-based tutorials on thesubject. Three that I can

recommend are supplied bytheseWebsites:

www.altavest.comwww.stockcharts.comwww.incrediblecharts.com

Candlestick formationsfactor quite prominently inseveralofour systems, sobesure thatbeforeyoucontinueyou are familiar with theirbasic terminology. There aredozens of candlestick

formations that you couldstudy,butIfocusonlyonthefollowing high-percentageformations:

DojiHammerPiercingMorning/eveningstarEngulfing

Once you have had yourcandlestick tutorial, you arereadytobeginlookingforour

top 10 setups. We havedividedtheseintotwogeneraltypes: fivebullish setupsandfivebearishsetups.Ifyouarelookingfortradesonthelongside,withtheexpectationthatpricewillriseforseveraldaysafter entry, then you will belookingforoneofourbullishsetups.Ifyouarelookingfortradeson the short side,withtheexpectationthatpricewillfall for several days afterentry, then you will be

lookingforoneofourbearishsetups.In certain market

conditions you will not findmany setups, and sometimesnone at all. In other marketconditions, you will finddozens of tradable setups. Itisbestalwaystomaintainthemindset that you will takewhatever the markets giveyou. Following are the topfivebullishsetups.

THEPULLBACK

Market Type This setup isbestusedin:

Bullish: stronglytrendingmarketsBullish:weakly trendingmarkets

Characteristics This is oneofmyall-timefavoritesetups.Its origins lie in a seminar Itook back in 1996 under thetutelage of a nowdiscreditedstockmarket guru. Ifwe canbracket out the fact that theman was convicted by theSEC of making fraudulentclaims on hisWeb site, it isfair to say that he put on avery helpful seminar backthen, at a very reasonableprice. The essential tools I

learned there form the basisfor this bullish setup. Itsfocus isonuptrendingstocksthat have experienced aperiod of minor weakness.Thisweaknessmay just be aspate of profit taking, or itmay be in response to newsoranearningsannouncement.Regardless,ourassumptionisthat the weakness istemporary and thus a buyingopportunity.Normallyafteraperiod of minor weakness—

as measured here by thestochastics indicator reachingan oversold level—thedominant uptrend willreassert itself as traders whomissedoutonthepriormoveusethediptogetonboard.Key Indicators In thepullbacksetup,therearethreekeyindicators:

First, you shouldidentify an uptrendingstock (see definition)that has pulled backeither into an upsloping20MA, between the 20MA and the 50MA, orall the way to the 50MA. If this pullbackpoint coincides with, orlies near, an upslopingtrendline drawn underthe lows of the uptrend,somuchthebetter.

Definition:Anuptrendingstockisastockthatismakinghigherlows(andpreferablyhigherhighs,but,strictlyspeaking,thisisnotnecessary)overatleastthepastthreemonths.Aweaklyuptrendingstockisanuptrendingstockwhose20MAismostlyrisingandmostlyaboveaconsistentlyrising50

MA.Astronglyuptrendingstockisanuptrendingstockwhose20MAisalwaysrisingandalwaysaboveaconsistentlyrising50MA.Thefurtherthesetwomovingaveragesarefromeachother,thestrongertheuptrend.

Second, along with theprice pullback there

must be a sharp dip inthe stochastics indicator(5,3 period) to or belowthe oversold 20 line.This confirms that thestock is in an oversoldcondition.Third, the currentcandlestickmustregistera bullish reversal candleof some kind (hammer,engulfing, piercing, ordoji). If the currentcandlestick shows a

bearish candle, or a redor black candle of anykind (close lower thanthe open), then this is await-and-see condition.Youshouldmakeanotetocheckthatstockagainthenexttradingday.Buy signal: These threefactors register a buysignal, and the stock isready to be short-listedasavalidpullbackplay.

The Screening Tool Thepullback setup occurs mostoften in bullish weaklytrending markets that havesuffered a short period ofprice consolidation or profittaking.Theycanalsooccurinstrongly uptrending marketsinvolatile stocks that tend topull back further than thegeneral market. There areoccasions in the naturalcourseofmarketcycleswhen

pullbacksetupsdonotappearveryoften. Ifyoufail to findanydecentpullbacksonyourprimary watch list, you cantry using a special screen tosearch the universe of stocksfor them. To screen forpullback plays, input thefollowing criteria intoStockcharts.com's screeningtool:

For the last market

close:Allstockswith...

60-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simplemoving average ofclose for today isgreaterthan15.The chart has abullish engulfingpattern for today

(you can also runthis with piercing,hammer, or dojiselectedaswell).20-day simplemoving average ofclose for today isgreater than 50-daysimple movingaverageofclosefortoday.Daily close fortoday is less thandaily close for five

days ago times1.15.

Thiswillnormallygiveyoualist of between two andtwenty stocks, depending onmarket conditions. If the listis large, I will increase the60-day moving average ofvolume to 1,000,000 and thedaily close five days agomultiplierto1.20.Ifthelististoo small, Iwill decrease themultiplierto1.10orless.Itis

notwisetogoanylowerthan500,000 on the movingaverageofvolume.Ifthatscanfailstoproduce

any viable pullbackcandidates, you can try thisalternatescan:

For the last marketclose:U.S.stockswith...

20-day simplemoving average ofvolumefortodayis

greater than1,000,000.60-day simplemoving average ofclose for today isgreaterthan5.20-day simplemoving average ofclose for today isgreater than 50-daysimple movingaverageofclosefortoday.50-day simple

moving average ofclose for today isgreater than 200-day simple movingaverageofclosefortoday.50-day simplemoving average ofclose for today isgreater than 50-daysimple movingaverageofclosefor10daysago.200-day simple

moving average ofclose for today isgreater than 200-day simple movingaverageofclosefor20daysago.Daily close fortoday is less thandaily close for fivedaysago.Daily close for 7days ago is greaterthan daily close for20daysago.

Daily close fortodayislessthanorequal to 20-daysimple movingaverageofclosefortoday.Daily close fortoday is greaterthanorequalto50-day simple movingaverageofclosefortoday.Daily open fortodayislessthanor

equal todaily closefortoday.Daily slow stoch%K(5,3)fortodayisgreaterthandailyslow stoch %D (5,3)fortoday.

Figure 9.1 BRCM showingpullbacksetups.Figure9.1isanexampleof

a strongly uptrending stock,BRCM, which gave two

pullback buy signals. Notethatthestockiseasilyseentobe uptrending, and indeed isin a strong uptrend, with therising 20 MA well above arising 50 MA. We can seethat on two occasions thestock pulled back to the 20MA area and then put in abullish candle: in the firstsignal there is a bullishengulfing candle, and in thesecond instance a doji. Atboth signals the stochastics

droppeddowntoorbelow20,signaling an oversoldconditionripeforareversal.Figure 9.2 is another

example of a stronglyuptrending stock, QCOM,which gave onewait-and-seesignal (first arrow) and twopullback buy signals. Notethat the first of the two buysignals (second arrow)occurredina

Figure 9.2 QCOM showingpullbacksetups.strong uptrend butnevertheless got us in a bitprematurely, but a well-

placed stop-loss (seeChapter11)wouldhavekeptusinthetrade. With a little patience,the trade eventually turnedprofitable. The second buysignal occurred during aweaker moment in theuptrend but still yielded asolidprofitopportunity.

THE COILEDSPRING

Bullish: stronglytrendingmarketsBullish:weakly trendingmarketsRange-boundmarkets

Characteristics This issometimes known as a bull

flagorbullpennantsetupandsometimes as a symmetricaltriangle pattern, dependingon the shape of the coiledspring. For our purposes, wewill lump all these togetherunder a single setup. Thepremiseofthecoiledspringisthat after a strong runup, astrong stock likes to take abreatherasitconsolidatestheramp-up in price. A weakstock will sell off, givingbackmuchofitsgains.Buta

strongstocklikestocoilupina sideways movement. As itdoes so, price tends to trendinsideanevertighterrange—thespringcoilsuptighterandtighter—until shares areready to climb again. Whenthe coil finally springs open,it usually does so with adelightfully profitable burstofupwardmomentum.Key Indicators The patternrelies on a precise definition

of what we mean by coiledspring. Here are theparameters:

In the coiled springsetup, you are lookingfor a weakly uptrendingto strongly uptrendingstock(seeprevioussetupfor definition) that hasrecently put in a newhigh. By recently wemeanwithin the past 20

trading days. This newhigh must be at least anewthree-monthhigh.Since setting that newhigh, the stock hasconsolidated inside acoiled spring (seedefinition). The coiledspring can be short andtight or drawn out andchoppy, but the patternrequires the coil to betightening up (thetrading range is getting

smaller) as it movesfurthertotheright.

Definition:Thecoiledspringgetsitsnamefromthenarrowingrangethestocktradesinoverthelastseventotwentytradingdaysassharesconsolidateatornearitsnewhigh.Thisrangecantradesidewaysoritcandowntrendslightly,butit

shouldnotbetradingatanupwardangle.Thekeytothepatternisthatthetradingrange,ingeneral,isgettingtighterandtighter.

Note that in this setupwe pay no attention toindicators.Thisisapurepatternplay.Allweneedare the two movingaverages,the20MAand

the 50 MA, and sometrendlines.

Use the movingaverages todetermine that thestock is weakly orstrongly uptrending(see precedingdefinition).Draw in trendlinesover the top andbottomofthecoiledspring. It shouldform a triangular

shapeof somekinddue to thenarrowing tradingrangeofthecoilbutshould not beangledupward.It is essential thatthe coiled springlast at least sevenbutnomorethan20trading days. It isalso essential thatno part of the coilextendtoorbeyond

the 50 MA. It canpass over the 20MA,butnot the50MA.Buy signal: Thecoiled spring itselfputs the stock onthe shortlist. Abreak of thetrendline drawnoverthetopsofthiscoil marks the buysignal. A closebelow the lower

trendline negatesthe coiled spring,and so we delete itfromourwatchlist.

The Screening Tool Thecoiled spring setup is notoften seen among high-betaor volatile stocks, so it willnot show up much on yourprimary watch list. But youcanscreenforsuchstocksbyinputting the following

parameters intoStockcharts.com'sscreener:

For the last marketclose:Allstockswith...

60-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simplemoving average of

close for today isgreaterthan10.Daily close fortoday is greaterthan or equal todaily open fortoday.Daily high fortodayislessthanorequal to daily highforfivedaysago.Dailylowfortodayis greater than orequal to daily low

forfivedaysago.20-day simplemoving average ofclose for today isgreater than 50-daysimple movingaverageofclosefortodaytimes1.08.

Here is an alternate screenthat also can turn up somenicecoiledspringsetups:

For the last market

60-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simplemoving average ofclose for today isgreaterthan10.50-day simplemoving average ofclose for today is

less than 20-daysimple movingaverageofclosefortoday.Daily AverageDirectional Index(ADX)line(14)fortoday is less thandailyADXline(14)for 20 days agotimes0.41.

Inamarketmovingmostlysideways, youmay return 10

to 15 stocks per day withthese screens. But in mostmarket conditions, your listwill be a short one, and notall the stocks that turnuponthis screen are really coiledsprings. Give each chart thatturnsuponthescreenagoodeyeballing, and use theaforelisted rules to eliminateall but the most coiled ofsprings.One thing towatchout for

is that the trading range

within the coil is generallygetting smaller (less intradaymovement). The intradaylows should be getting a bithigher, and/or thehighs abitlower. You can have a widerangebarortwointhisrange,but that should be theexception, not the rule.Generally speaking, thelonger the coiled spring isstrung out, the higher it willrise after the spring hassprung. But coiled springs

longer than 20 days induration tend to indicateindecision on the part ofinvestors and are bestavoided.Figure9.3isanexampleof

a stock, ALVR, showing acoiled spring setup thattriggered a successful buysignaloncepricebrokeabovethe trendline drawn over thetopsofthecoil.Notethatthecoil is a consolidation of arecent price high in an

uptrend, is getting tighter,does not violate the 50MA,and in this case is trendingslightly downward. Whilethisruntoover10.50yieldeda+16percentreturn

Figure 9.3 ALVR showingcoiledspringsetup.in less than two weeks, thestockcontinuedhigherandiscurrently trading+55 percenthigherthantheentryprice.FORD (Figure 9.4) shows

another coiled springexample. Note that the 20MA is rising and is nicelyabove a rising 50 MA,showing the stock to be in astronguptrend.Alsonotethatcandlesticktailscanpokeout

ofthecoilaslongastheopenandcloseofeachcandlestayswithinit.Again,abuysignalis triggered once price tradesabove the upper trendline. Inthis case the trade yieldedover+50percentinaboutonemonth.Figure9.5isanexampleof

another stock, CME, thatshows two coiled springs.Note the sideways to slightlydowntrendingmovement thatmarks the coiled spring, and

howmanyof the candles aregetting smaller relative toprevious candles seen in theuptrend. Note also the buysignals as they print justabovetheresistancelines.

Figure 9.4 FORD showingcoiledspringsetup.

Figure 9.5 CME showingtwocoiledspringsetups.

THE BULLISHDIVERGENCE

Range-boundmarketsBullish:weakly trendingmarketsBearish:weaklytrending

markets

CharacteristicsThissetup isreallyaworkhorseforus.Wecan use it in all sorts ofmarkets, even bearish ones.The markets spend most oftheir time in range-bound orweakly trending conditions,and thissetupworks in thoseconditions very well. Asswing traders, we use thebullish divergence setup to

pinpoint the bottoms of deeppullbacks (beyond the 50MA) within long-rangeuptrends (see followingdefinition).Wewillalsouseaversionof it in another setupdiscussed later. Truly, thedivergence tool is a veryhandyoneindeed.Thebullishdivergence setup looks at astock that is tradingwithin along-range uptrend, butwhich is currently in asubstantial sell-off and has

just put in a series of lowerlows. This downtrendingseriesneedstobeatleasttwolows long so that there is abasis for comparison. Ofcourse, toomany lower lowswill eventually negate thelong-range uptrend, and thusnullifythissetup.Key Indicators This setuprelies on both price patternsand a variety of technical

indicators. Here are thespecifics:

First,weneedtoidentifythe stock as being in along-range uptrend (seedefinition). Thissupportstheideathatthedeep pullback we enteron is only a temporaryaberration.

Definition:Theeasiestway

toidentifyalong-rangeuptrendistonoteonthedailychartthatthe50MA(eitherrisingorfalling)istradingabovearising200MA.Note:Itiskeythatthe200MAisrising;thissignalstheuptrend.Oncethe50MAcrossesunderthe200MA,evenifthe200MAisrising,thelong-rangeuptrendisnegated.

Next, the bullishdivergencesetupisvalidwhen price does threethings:

1.Ittradesbelowthe50MA.2.Itputsinatleasttwoclearprice lows during thatpullback,with at least fivetrading days between thelows.

3. The last price lowcorresponds with a higherlow in two ormore of the

following technicalindicators:MACD,MACDhistogram, stochastics,RSI,OBV,andCCI(atthesettings we specifiedearlier).

Note that if the last(lower) price lowcorrespondswiththe200MA, trendline support,orpriorpricesupport,somuchthebetter.Buy signal: When the

aforementionedconditions have beenmet, a buy signal istriggeredwhen a bullishcandle of some kind(doji, hammer,engulfing, morning star,etc.) is printed on thedailychart.

The Screening Tool ThefollowingscreeninputtedintoStockcharts.com's stock

screener will identifypotential bullish divergencecandidates:

60-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simple

moving average ofclose for today isgreaterthan10.Daily low foryesterday is lessthan daily low for20daysago.Daily low foryesterday is lessthan daily low forthreedaysago.Daily MACDhistogram (12,26,9)for today is greater

than daily MACDhistogram (12,26,9)for15daysago.Daily CCI (20) fortoday is greaterthandailyCCI(20)for15daysago.Daily RSI (5) fortoday is greaterthan daily RSI (5)for15daysago.50-day simplemoving average ofclose for today is

greater than 200-day simple movingaverageofclosefortoday.Daily open fortoday is less thandaily close fortoday.

In Figure 9.6, FWLTregisters a nice bullishdivergence setup following ablow-off double bottomwitha lower price low coupled

with three cases of bullishdivergence in the indicators:MACD, RSI, and CCI. Notethatonthedayofentrythe50MA (dotted line), thoughfalling, is still above a rising200MA(solidline),andthaton the day prior to entrywehave a bullish candlestickmarking the second low(hammer candle). The shareswent on to gain +25 percentinonly20tradingdays.In Figure 9.7, see BRCM,

which gave two nice bullishdivergencebuysignals in thecourse of this choppy runup.Thetriggercandleforthefirstsetup was a doji and for thesecond a hammer. Note thatyou need divergence on onlytwo indicators tovalidate theplay. It is also interesting tonote that the buy-and-holderwithsharesheldfromtheleftside to the right side of thischart would have seen herposition increase by +24

percent, a nice run. Butconsider what you wouldhave gotten on two trendtrades:+40percentwithalotlesstimeexposedtotherisksofthemarket.

Figure9.6FWLTshowingabullishdivergencesetup.

Figure 9.7 BRCM showingbullishdivergencesetups.

THE BLUE SKYBREAKOUT

Bullish: stronglytrendingmarkets

CharacteristicsAlsocalledacup-and-handle formation,this setup is sometimes youronly play during prolongedbull markets when there justdoesn't seem to be any pull-back.Someswingtradersareforcedbyastrongbullmarketto sit on the sidelines dayafter day, waiting for a

pullback or priceconsolidation to give themsetups.Howfrustratingisthatwhen all those buy-and-holdersaregloatingovertheirgains!But trend traders haveakeyweaponintheirarsenalduring such times: the bluesky breakout setup. Blue skyhere refers to the new highterritory the stock trades upinto as it clears at least threemonths of prior price highs.We confirm the breakout by

looking at an indicator thatgivesusavisualreferenceofrecenttrendsinvolume.Key Indicators This setupreliesonfivepriceparameterscombined with one technicalindicator: on balance volume(OBV).Herearetherules:

First,theclosingpriceofthe stock (not just the

intraday move) mustregister a new highfollowing a previousnewpivothighsetwithinthepast20tradingdays.A pivot high is a newpricehighfollowedbyasell-off or sidewaysconsolidation of at leastfive bars (but not morethan 20) in length. Weset these limits becauseit is important that thenewhighbetheresultof

a recent and short-livedmoveinpriceratherthanaprolongedrunup.Second, the current newclosing price high mustbeasignificanthigh;nohigherclosingpricehighshouldbe recorded inatleast the past threemonthsoftrading.Third, the new closingprice high cannot haveruntoofarabovethe52-week low for the stock.

We don't want stocksthat are toooverextended. Toprevent this, wecalculate a multiple bytaking the new highclosing price anddividing it by the 52-week low price. Thismultiple should not bemore than 3.0. In otherwords, if a stock's 52-week low is 10.00, wewant to buy a blue sky

breakoutonlyifthenewclosinghigh is less than30.00.Fourth, the currentbreakout into blue skyterritory (no priceresistance within theprevious three months)should be accompaniedby the highest OBVreading seen in at leastthe past three months(seedefinition).

Definition:OBVstandsforonbalancevolume.Itmeasurestheaccumulationordistributionofshares:sharevolumeiseitheraddedto(onupdays)orsubtractedfrom(ondowndays)arunningbalanceofvolume.OBVconfirmspricemoveswhenitrunswithprice,andshowsdivergencewhenitrunsagainstprice.Ittendsto

bealeadingratherthanalaggingindicatorandassuchisusefulinpredictingfuturepricemoves.

Fifth, the candle on thedayof thebreakout to anew high must be agreen or white candle(close higher than theopen).

Buy signal: When allfive of these parametershave been met on thesameday,wehaveabuysignal.

TheScreeningToolInabullmarket, the following scanshould turn up severalpossible blue sky candidates—but since that first priceparametercannotbescreenedfor,afurthereyeballingofthe

charts is usually required toweedoutinvalidsetups:

New52-weekhigh.20-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simple

moving average ofclose for today isgreaterthan10.Daily close fortodayislessthanorequal to minimumlow over 260 daysstarting today times3.Daily OBV fortoday is greaterthandailyOBVfor60daysago.

InFigure9.8,AAPLshowsthree blue sky breakoutsignals. This kind of stair-stepping or repetitive cup-and-handle pattern iscommon in strong, healthyuptrendsandoftenprecedesalengthy and extended bullishrun. Note that the new pricehighsweresetwithin20daysof a previous new high withat least three down days inbetween.

Figure 9.8 AAPL showingblueskybreakoutsetups.Also note the new high seeninOBVineachcase.Further

note that by new high wemeanonaclosingbasisratherthan an intraday basis. Thuswhen drawing your lines onthepricechart,putthemoverthe topsof the closingpricesrather than the upper "tails"of the candles. So healthywas this trend, in fact, thatAAPLmade itall theway to86.40 before succumbing toprofittaking.Our second example,

CREE, (Figure 9.9) shows a

very profitable blue skybreakout.InlateApril,CREEset a new five-month pivothigh at the 20.00 price level.After 16 days ofconsolidation, the bullsstepped up again to drivepricehigher.OnApril22wegot our price breakoutcoupled with a new high inOBV.Weactuallycalledthisone

Figure 9.9 CREE showing ablueskybreakoutsetup.in our Trend TradeNewsletter, netting

subscribers a quick +22percent gain in 12 days. Alonger hold could havebanked something closer to+50percent.The blue sky breakout is

truly a befriend-the-trendkind of setup, and certainlyone of the most excitingsetups to trade. But manytraders are afraid toplay thiskindofbreakoutbecausetheyworry the shares are toooverbought and extended.

Theyneedn'tbe.Inastronglyuptrending market, your bestbet is to "buy high and sellhigher". Trends once beguntend to keep trending: this isthe essence of trend trading.But to keep theodds in yourfavor,stickcloselytothefiverulesweoutlinedabove.

THE BULLISHBASEBREAKOUT

Bullish:weakly trendingmarketsBearish: stronglytrendingmarketsBearish:weaklytrendingmarketsRange-boundmarkets

Characteristics This isanotherveryusefulsetupthatcan be traded in a variety ofmarkets. It nicely rounds outour series of bullish setupssince it is not strictly abefriend-the-trend kind ofsetup.Rather,inthissetupweare going to be contrarian,bucking the trend. Here wearelookingforastockthatisinadowntrendbuthasputinanextendedsidewaysbaseof

some kind. The fact that thestock is now movingsideways instead of downmakesthisbaseabullishone.Torenderthesetupvalid,weneed the indicators to tell ustwo things about pricebehavior within the base: ithas to be gaining inmomentum, and there mustbe evidence that shares areunder accumulation. Whilelongerholdsofthissetupcanreturnspectaculargains,there

is often a quick burst ofbuyingactivityatthepointofbreakout that canbringgainsof+10percentormorewithina few days, making this anideal short-term, trend tradesetup.Moreover,thissetupismost often seen in lower-pricedstocks,soitisanidealsetup for smaller accounttraders.Key Indicators This setup

relies on a price pattern(bullish base) combinedwithtwo technical indicators:MACD and on balancevolume (OBV). Here are thespecifics:

First, the stock must beclearly seen to be in adowntrendofsomekind,strong or weak (seedefinition).

Definition:Adowntrendingstockisastockthatismakinglowerhighs(andpreferablylowerlows,but,strictlyspeaking,thisisnotnecessary)overatleastthepastthreemonths.Astronglydown-trendingstockisadowntrendingstockwhose20MAisconsistentlyfallingandbelowaconsistentlyfalling50MA.Aweakly

downtrendingstockisadowntrendingstockwhose20MAmayberisingandfalling,butitisatleastmostlybelowaconsistentlyfalling50MA.

Second, for at least thepast30tradingdays(sixweeks), price must bemoving within aconsolidation base of

some kind. There aretwo types ofconsolidation bases:triangles and rectangles.Thesebasescanoccurinuptrends as well asdowntrends. In thissetup, we want to seethese at the bottom of adowntrend.Figures 9.10 and 9.11are two types ofrectangle

Figure 9.10 Flat rectanglebase.

Figure9.11Fallingrectanglebase.

Figure 9.12 Symmetricaltrianglebase.

Figure 9.13 Ascendingtrianglebase.

Figure 9.14 Descendingtrianglebase.bases seen in downtrendingmarkets(flatandfalling).

Figures 9.12 through9.14 are three types oftriangle bases seen indowntrending markets(symmetrical,ascending,anddescending.)The one type ofconsolidationpatternwewant to avoid is the

rising wedge, a type oftriangle consolidationthat occurs indowntrendingstocks,butwhichusuallyprecedesacontinuation of thedowntrend. A risingwedge does not form avalidbaseforthissetup.Risingwedges look likeFigure 9.15, where bothtrendlinesslopeupward.

Figure 9.15 Rising wedge:invalidbase.

Oncewehave identifiedaconsolidationbaseinadowntrending stock, weneedtoconfirmthatitisa bullish base. We do

this by referring to twotechnical indicators:MACDandOBV.

MACD must bemaking a series ofhigher lows whileprice is within thebase may or maynot be makinghigherlows.OBV must riseabove a trendlineplacedoverthetopsoftheindicator.

Buysignal:Abuysignalis triggered in a bullishbaseat thefirstgreenorwhite candle (closehigher than the open)after the candlestick onwhichtheOBVtrendlinebroketotheupside.Youcanalsoenteronthedayof anOBVbreak if thatcandleisgreenorwhite.

TheScreeningTool It isnot

possible to screen fortriangular or rectangularbases using what iscommonlyavailable.Mostofyour trades in this setupwillhave to come from yourwatchlistsasyoueyeballthecharts. But the followingscreen will turn up a fewdecent candidates amongmany false hits that can beshort-listed for furtherresearch. Readers who aremore adept at this sort of

thingthanIammightwanttofiddle around with theseparameters to make themmorerobust.

20-day simplemoving average ofvolumefortodayisgreater than500,000.

60-day simplemoving average ofclose for today isgreaterthan10.50-day simplemoving average ofclose for today isgreater than 20-daysimple movingaverageofclosefortoday.50-day simplemoving average ofclose for today is

less than 50-daysimple movingaverageofclosefor40daysago.Maximum rangeover 30 daysstarting today isgreater thanmaximum rangeover 15 daysstartingtoday.Maximum rangeover 15 daysstarting today is

greater thanmaximum rangeover5daysstartingtoday.Daily OBV fortoday is greaterthandailyOBVfor40daysago.Daily MACD line(12,26,9) for todayisgreaterthandailyMACD line(12,26,9) for 40daysago.

50-day simplemoving average ofclose for today isless than 200-daysimple movingaverageofclosefortoday.

Intheabsenceofareliablescreen, you will have tocheck the charts on yourwatch list on a regular basis.Infact,thisisabetterwaytogo because it allows you to

watch a base develop overseveraldaysandweeks.ThatOBV trigger signal is reallythe key to this setup: if youcan get in on the day thathappens,youoftenwillbeinat the start of a significantrally. But the stocks thatshow up on the precedingscreen most often havealready triggered their OBVsignal.InFigure9.16,AKSshows

aweakdowntrendcoilingup

within a bullish triangular(symmetrical) base. We canseethatMACDshowshigherlows (bullish confirmation)andthatOBVtriggeredabuysignalafterpricebrokeupoutof the base. From there thestock quickly climbed nearly20percentoverseventradingdays.

Figure 9.16 AKS showing abullishbasebreakoutsetup.

In Figure 9.17, KLACconsolidates a strongdowntrendcappedbyanastygap down within a bullishrectangularbase.Weknowitis bullish because MACD,which measures pricemomentum, is risingthroughout the base. OBVthen gives a buy signal justpriortothebasebreakout.Anentry around 42.00 wouldhave returned a healthy +19percent with the trade still

open on a trailing stop.Notehere how the upper trendlineofbullishbase(ata

Figure 9.17 KLAC shows abullishbasebreakoutsetup.

Figure9.18 JNPRshowingabullishbasebreakoutsetup.

price of 42.00), which actedas resistance while priceremained within the base,now acts as support for thenewuptrend.Figure9.18showsabullish

base beakout setup that weoffered subscribers to ourCheap Stocks Newsletter.JNPR's shares nicely formeda falling rectangular basewithin a clear downtrend(weak,becomingstrong).Thebase shows bullish

divergence in the MACDindicator, confirming that thebase is a bullish one. WhenOBV triggered a breakout ofits trendline, we hadconfirmation that shares ofJNPR were beingaccumulated. Price oftenfollows an OBV breakout,and, sure enough, shares ofJNPR did just that. Shortlyafter the falling rectanglegave way, JNPR sharesrocketedquicklyupwardfora

return of nearly +30 percentinjustsixweeks.

CHAPTER10SELECTING

BEARISHSTOCKSTOTREND-TRADE

SHORTSELLING

Short selling, or shorting, isan essential skill for trendtraders. Technically, it is notmuch different from buyingshares of a stock to open aposition and then sellingthose shares back to the

market to close the position.Only in short selling, youreverse that order: first yousellsharestothemarket,thentoclose thepositionyoubuythem back. If your openposition trades down belowyour entry price, moneywillbe credited to your accounton the purchase of stock. Ifyour open position trades upabove your entry price,money will be taken out ofyour account to cover the

loss.Since you can only sell

shares to themarket thatyoualready own, you must firstborrow from your broker thesharesneededtoopenashortposition. Thus, whether yourbroker has the shares toborrowinthefirstplaceisanessential part of the short-selling equation: if yourbroker has no shares to lend,youhavenosharestoborrowin order to sell short.

Generally, most good onlinebrokerskeepahealthysupplyofsharestolendonallmajor,liquid stocks. The stocks wenormally trade atBefriendthetrend.com arealmost always available toshort.Occasionally,however,youwill find yourself in thefrustrating predicament ofhavingdonea lotof researchon a chart only to discoverthat you cannot open theposition because your broker

doesn'thavesharestoborrow.Even more frustrating isseeingthatstocktankhardfordaysonend—withoutyouonboard. An alternative toselling the stock short, then,is buying put options on thestock. As explained in PartFour, buying puts on a stockis a way to profit from aselloff in the stock; and it issometimes your onlyalternative when your brokerisoutofsharestoborrow.

Somesaythatshortsellingis un-American or that itsomehow hurts the generaleconomy.Otherssaythatitisbeneficial to the overallhealthofthemarketinthatitsupplies much-neededliquidity to the buyers ofstock, especially duringprolongedbullmarkets.ButIdon't think you can make astrong case either way. Forevery buyer there must be aseller, and it makes little

difference whether you sellyour own shares or yourbroker'sshares. In fact,whenyousellyourownshares,thatterminates your relationshipwith the company and itspublic offerings. When youshort using borrowed shares,youhave,infact,enteredintoa promissory agreementwiththat company to make apurchaseofitssharesatsomepoint in the future (onbehalfofyourbroker,ofcourse,not

yourownaccount).Thereisalsotheperception

that short selling is a higher-risk activity than simplybuying stock. The rationalebehindthisisthat,whileyourlongpositionscango tozeroand wipe out your entireinvestment, a short positioncan rally to infinity (intheory), thus wiping out notonly your investment but allyour cash reserves as well,not to mention every other

asset you own. And thenthere is thenumbers game: astock that goes from $50 to$25takesa50percenthaircutoff your investment;however, if that same stocksold shortwere to rally from$25 to $50, you are out 100percent of your originalinvestment.Several things need to be

said here in defense of shortselling. First, there are easywaysofmanagingyourshort

positions in order to playthem defensively, which wewilldiscusslater.Thesekeepyour losses to a minimumwhen a trade goes againstyou. Second, long beforeyour entire account is wipedout, your broker is going togiveyouamargincall in theevent that your shortpositionsget tothepoint thattheyjeopardizeyourabilitytotrade (it is in your broker'sbest interests to keep you

trading). In most margincalls,yourbrokerwillsimplyexit yourpositions foryou ifyoudon'tdoityourselfwithinagiventimeperiod.Third,farmore companies go bankruptand trade to penny stockstatusthansoartoinfinity,sotheoveralltrendisonthesideof relative safety.Fourth, theshort-selling systemsdescribedherehaveatleasta70percentsuccessrate.Theyare oriented toward making

money,not losing it. Inshort(pardon the pun), with theright trading and positionmanagement systems inplace, the risks of shortsellingare faroutweighedbytherewards.

TOP FIVEBEARISHSETUPS

If you are looking for trendtradeson the short side,withtheexpectationthatpricewillfall after entry, thenyouwillbelookingforoneormoreofthe following setups. Whenyou come across a stock onyourwatch list fitting one ormore of these setups, jot itdown on a piece of paper.Once you have finishedeyeballing your primarywatchlist,youshouldhaveashort set of stocks you will

then do further research on.Youmayalsoadd to this liststocks that turn up on yourspecialscreens.

TheReliefRally

Bearish: stronglytrendingmarketsBearish:weaklytrendingmarkets

CharacteristicsThissetup isreally the inverse of thepullback setup mentionedpreviously. Here we arelooking for a stock that isstrongly or weaklydowntrending but has ralliedup off its lows to reach a

majormovingaverage,whichshould act as resistance. Wealwayswait toenteruntilweget confirmation of anoverbought condition—asseen in the stochasticsindicator—and a confirmingbearish candlestick of somekind. The relief rally itselfmay just be a spate of short-term profit taking or a shortsqueeze (where shorts areforcedtocovertheirpositionsandbuybacksharesdue toa

surprisingreversal),oritmaybe in response to newsor anearnings announcement.Regardless, once thereevaluation of shares playsitself out, thedominant trendusually emerges again. Theodds of this happening areheightened when this play isputonwhenabearishtrendisseeninthebroadermarket.Key Indicators In this setup

there are three keyingredients:

First, identify a stronglyorweakly downtrendingstock that has rallied upinto a downsloping 20MA (stronglydowntrending)or50MA(weakly downtrending).If this moving averagecoincides with, or isplaced near, a

downsloping trendlineplacedover thehighsofthe downtrend, somuchthebetter.

Definition:Adowntrendingstockisdefinedasastockthatisconsistentlymakinglowerhighs(andpreferablylowerlows,but,strictlyspeaking,thisisnotnecessary).Astronglydowntrending

stockisadowntrendingstockwhose20MAisalwaysfallingandbelowafalling50MA.ThefurtherthesetwoMAsareseparated,thestrongerthedowntrend.Aweaklydowntrendingstockisadown-trendingstockwhose20MAismostlyfallingandisbelowafalling50MA.

Second, theremust be asharp rise in stochastics(five-period)toorabovetheoverbought80line.Third, the price on therally to that movingaveragemusthaveputinabearishcandleofsomekind (doji, engulfing,gravestone, hangingman, evening star, etc.).Ifithasputinagreenorwhite candle (closeabove the open), then

this is a wait-and-seecondition. You shouldmake a note to checkthatstockagainthenexttradingday.Sell short signal: Thesethree factors register asell short signal and thestock is ready to beshort-listed as a validreliefrallysetup.

The Screening Tool There

are occasions in the naturalcourseofmarketcycleswhenrelief rally setups do notappearveryoften. If you failto find any decent reliefralliesonyourprimarywatchlist, you can try using aspecial screen to search theuniverse of stocks for them.When I do this, I input thefollowing criteria intoStockcharts.com's screeningtool:

60-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simplemoving average ofclose for today isgreaterthan10.The chart has abearish engulfing

patternfortoday.20-day simplemoving average ofclose for today isless than 50-daysimple movingaverageofclosefortoday.Daily close fortoday is greaterthan daily close forfivedaysago times1.15.

Normally, half a dozenstocks appear from thisscreen, depending on marketconditions. If the list is toolarge, I will increase thevolume to 1,000,000 and thedaily close five days agomultiplierto1.20.Ifthelististoo small, Iwill decrease themultiplierto1.10orless.Figure 10.1 is an example

of a downtrending stock,NVDA, that gave two reliefrally sell short signals: the

firstduringaweakdowntrendwith a rally into the 50MA,andthesecondafterthetrendgotstrongerwithareliefrallyonly into the 20 MA. Alsonotethatwehavetwobearishcandle

Figure 10.1 NVDA showingtworeliefrallysetups.formations in both cases: abearish engulfing at the firstsignalandashootingstardoji

atthesecondsignal.Youwillalsonote thatonJuly9 therewas an additional signal thatfailed to yield the desiredresult,unlessyouusedawidestop-loss.Figure 10.2 shows another

example of a weaklybecoming stronglydowntrending stock, QLGC,which gave four relief rallysell short signals within fourmonths. It is rare to get somany short signals in such a

short time period, but whenthey happen like this, it is atrader's dream come true.Notethattightlytrailingstopswouldhavedonewelltolockin substantial profits on atleast three of the trades. Areasonable return on thissequence of trades is in the+50 to +60 percent range,while thebuy-and-holderhadto sit through a veryuncomfortable 55 percentdrawdown.

Figure 10.2 QLGC showingfourreliefrallysetups.

TheBearishDivergence

Range-boundmarketsBearish:weaklytrendingmarketsBullish:weakly trendingmarkets

CharacteristicsThissetup is

the flip side of its bullishcousin noted previously, andas such is also a greatworkhorseforus.Wecanuseitinallsortsofmarkets,bothbearish and bullish.As trendtraders, we use the bearishdivergence setup to pinpointthe tops of sharp rallies(beyond the 50 MA) withinlong-range downtrends. Wewillalsouseaversionofitinanothersetupdiscussedlater.

Truly,thedivergencetoolisavery handy one indeed. Thebearish divergence setuplooksatastockthatistradingwithin a long-rangedowntrend, but which iscurrently in a substantialrally, and has just put in aseries of higher highs. Thisuptrending seriesneeds tobeatleasttwohighslongsothatthere is a basis forcomparison. Of course, toomany higher highs will

eventually negate the long-range downtrend and thusnullifythissetup.Key Indicators This setuprelies on both a price patternand a variety of technicalindicators. Here are thespecifics:

First,weneedtoidentifythe stock as being in along-range downtrend

(see definition). Thissupportstheideathatthesharprallyweenteronisonly a temporaryaberration.

Definition:Theeasiestwaytoidentifyalong-rangedowntrendistonoteonthedailychartthatthe50MA,eitherrisingorfalling,istradingbelowafalling200MA.Note:It

isessentialthatthe200MAisfalling;thissignalsthedown-trend.

Next, the bearishdivergencesetupisvalidwhen price does threethings:

It trades above the50MA.It puts in at leasttwo clear pricehighs during that

rally, with at leastfive trading daysbetweenthehighs.The last price highcorresponds with alower high in twoor more of thefollowing technicalindicators: MACD,MACD histogram,stochastics, OBV,CCI,orRSI.

Note that if the last(higher) price high

correspondswiththe200MA, trendlineresistance,orpriorpriceresistance, so much thebetter.Sell Short Signal:Whenthepreceding conditionshave been met, a sellshort signal is triggeredwhenabearishcandleofsome kind (doji,gravestone, engulfing,evening star, etc.) isprinted on the daily

chart.

The Screening Tool Wheneyeballing your watch listfailstoturnupanyreliefrallysetups, the following screeninputted intoStockcharts.com's stockscreener should identifyseveralpossiblecandidates:

For the last market

60-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simplemoving average ofclose for today isgreaterthan10.Daily high foryesterday is greaterthan daily high for

20daysago.Daily high foryesterday is greaterthan daily high forthreedaysago.Daily MACDhistogram (12,26,9)for today is lessthan daily MACDhistogram (12,26,9)for15daysago.DailyROC(12)fortoday is less thandaily ROC (12) for

15daysago.Daily RSI (14) fortoday is less thandaily RSI (14) for15daysago.50-day simplemoving average ofclose for today isless than 200-daysimple movingaverageofclosefortoday.Daily open fortoday is greater

than daily close fortoday.

In Figure 10.3, KLACregistersabearishdivergencesetup for a successful swingtrade.Notethatthe50MAissignificantly below the 200MA,signalingastrong

Figure 10.3 KLAC showingabearishdivergencesetup.

downtrend, and that bearishdivergence is seen betweenthe two price highs and twokey indicators (RSI andMACDhistogram).Alsonotethe bearish candle formation(eveningdojireversal),whichconfirmed the sell shortsignal.InFigure10.4,Agilent(A)

registersabearishdivergencesetup for a successful swingtrade,withbearishdivergenceseen between the two price

highs (higher) and both theRSI and CCI indicators(lower). Note that this setuphad the added attraction ofpricerunningupintoa

Figure 10.4 A showing abearishdivergencesetup.downsloping 200 MA along

with an area of former priceresistance(20.00area).

TheGapDown

Bullish strong trendingmarkets

Bullish weakly trendingmarketsRange-boundmarkets

Characteristics The gapdown setup employs acontrarian trading style. Thissetuptradesstocksthatareinstronguptrendsbut have justprintedanunfilledgapdown;thatis,theygapdownsharplyattheopenandfailduringtheday to close the gap. This

setup requires that the gapdown occur only after asignificant new high (highestprice for at least threemonths)hasbeenestablished.This is the reason theyworkbest in bull markets. Anystock climbing to new highsin a bear market is a safe-haven stock and should beavoided by short sellers.Frequently this setup signalsa strong reversal of trend, asinvestors panic and rush to

the exits in order to lock inprofits in the wake of badnews,disappointingearnings,profit taking,andsoon.Thissetuphasatendencytotakeafew days to get started asbears fendoff thedip-buyingcrowd. But once they wincontrol, and they usually doafter a gap down, the dropcanbesharpandfast.KeyIndicatorsThissetup is

very easy to spot and trade.Herearethespecifics:

First,weneedtoidentifythe stock as being in asteady uptrend. For thepurposes of this setup,we define a steadyuptrendasfollows:

The 50 MA isrising steadilywithout any majordips.

Price has remainedabove the 50 MAfor at least the past40 trading days(twomonths).

Second, there needs tobeanunfilledgapdownon the currentcandlestick (seedefinition).

Definition:Anunfilledgapdownisidentifiedwhen,

onthemarket'sclose,astock'sintradayhighpriceremainsbelowtheintradaylowoftheprecedingday'strading.

Sell short signal: Whenthese conditions havebeen met, a sell shortsignal is triggeredanytime after the gapdown day when pricetradesbelowtheintraday

low of the gap downcandlestick. Note: If atany timeprice tradesupinto the gap prior totriggeringthesellsignal,thesetupisnegated.

The Screening Tool Severalpremium charting packages,including eSignal andQuote.com, offer an unfilledgap hotlist function, but thisdoes not screen for

uptrending stocks. However,the following screenparameters, when inputtedinto Stockcharts.com's stockscreener,willsearchdailyforgap down setups inuptrendingstocks.

For the last marketclose:Allstockswith...Breakawaygapdown.60-day simple moving

average of volume fortoday is greater than500,000.60-day simple movingaverage of close fortodayisgreaterthan10.20-day simple movingaverage of close fortodayisgreaterthan50-day simple movingaverage of close fortodaytimes1.1.

The chart of EBAY in

Figure 10.5 shows the gapdown setup following astrong uptrend.Note that theintraday high on the gapdowndayremainedbelowthelow of the previous tradingday,andthatthe50MAisinasteadyuptrend.InFigure10.6,weseewhat

happened to EBAY shortlyafter thegapdownsetupwasconfirmed.Note that the dayafter thegapdownsetupwasconfirmed,EBAY

Figure 10.5 EBAY showingagapdownsetup.

Figure10.6EBAYtriggersasell signal in a gap downsetup.

Figure10.7SWIRshowingagapdownsetup.gapped down again.With anopening price below theprevious day's low, we hadourentrysignal.Whileittookafewdays toconsolidate the

new bearish posture, onceprice resumed its new trend,itreallytookoff.The chart of SWIR in

Figure 10.7 shows anothergap down setup following astrong uptrend.Note that thegap down candlestick here isquite long, which may leadsome to conclude that thepositionhasalreadygonetoofartowarrantanentry.Neverunderestimate thepowerofagap down. It is truly a trend

killer. All that is needed tocomplete thissetup isa tradebelowthe lowof theunfilledgapdownday'scandle.Althoughittookthreedays

togetmovingagainafterthatbig red stick, and indeed totrigger our sell short entrysignal,SWIRshowsjusthowpowerful thegapdownsetupcan be (Figure 10.8). NotethatSWIR'sgapdownintoa

Figure10.8 SWIR triggers asell signal in a gap downsetup.rising moving average mayhave looked tempting to the"buy the dip" crowd.Consider this a warning:

neverbuyadip tosupport inanuptrendingstockthattakesplace after an unfilled gapdown, however strong theuptrend!Youarelikelytogetcaughtinabulltrap.

TheBlueSeaBreakdown

Bearish: stronglytrendingmarkets

CharacteristicsThinkofthisas a reverse cup-and-handleformation. Like its bullishcousin outlined in thepreviouschapter,thissetupissometimes your only playduring prolonged bearmarkets when there just

doesn't seem to be any reliefin sight.Blue sea here refersto the new low territory thestock trades down into as itclearsatleastthreemonthsofpriorprice lows.Weconfirmthe breakdown by looking atan indicator that gives us avisual reference of recenttrendsinvolume.Key Indicators This setupreliesonfivepriceparameters

combined with one technicalindicator: on balance volume(OBV).Herearetherules:

First,theclosingpriceofthe stock (not just theintraday move) mustregister a new lowfollowing a previousnew low set within thepast20tradingdays.Itisimportant that the newlow be the result of a

recent and short-livedmoveinpriceratherthanaprolongedsell-off.Second, the current newclosing price low mustbe a significant low; nolow closing price lowshouldbe recorded inatleast the past threemonthsoftrading.Third, the new closingprice low cannot haveruntoofarbelowthe52-weekhigh for the stock.

We don't want stocksthat are toooverextended to thedownside. To preventthis, we calculate amultiple by taking the52-weekhighanddivideitbythenewlowclosingprice. This multipleshouldnotbemore than2.0. In otherwords, if astock's 52-week high is30.00, we would sellshort a blue sea

breakdown only if thenew closing low isgreaterthan15.00.Fourth, the currentbreakdown intoblue seaterritory (no pricesupport within theprevious three months)should be accompaniedby the lowest OBVreading seen in at leastthepastthreemonths.Fifth, the candle on thedayofthebreakdownto

anewlowmustbearedorblackcandle (close islowerthantheopen).Sell short signal: Whenall five of the theseparameters have beenmetonthesameday,wehaveasellshortsignal.

The Screening Tool In bullmarkets this screen will notreturn many candidates, butin a strong bear market it

should turn up severalpossible blue sea candidates.Since that first priceparametercannotbescreenedfor,afurthereyeballingofthecharts is usually required toweedoutinvalidsetups.

New52-weeklow.20-day simple

moving average ofvolumefortodayisgreater than500,000.60-day simplemoving average ofclose for today isgreaterthan5.Daily close fortoday is greaterthan or equal tomaximum highover 260 daysstarting today times

0.5.Daily OBV fortoday is less thandaily OBV for 60daysago.

In Figure 10.9, JNPRshows a blue sea breakdownsignal as it passes below athree-month low withconfirming new low in theOBV indicator. An entry atthe open of the next tradingdaycouldhavebeencovered

nine days later, for amaximum gain of +17percent. The stock ralliedshortly after that, so youwould likely have beenstopped out for somethingmorelike+12percent.In Figure 10.10, we see

XMSRconfirmingablueseabreakdown with supportiveOBVonthelastdayofApril.In this case,OBV first brokedown to a new three-monthlow, and the stock price did

not confirm the breakdownuntil the next day. However,once it confirmed—BAM!—the stock got a –50 percenthaircut.Notethatthestockis

Figure 10.9 JNPR shows ablueseabreakoutsetup.clearlyinasteadydowntrendas signaled by the steadilydownsloping50MA.Neither

moving averages nor trend-lines factor into this setupsinceanewthree-monthpricelow is evidence enough thatweareinadowntrend.One further thing to note

about the XMSR chart inFigure 10.10 is just howabruptly the downtrend canendinablueseabreakdown.With no immediate supportunderprice, these trades tendto move down quickly andsharply. But when bottom-

feeding hedgies (hedge fundtraders) smell blood in thewater, they like to move inwith size, creating panicamong the shorts.That is thepowerofshort-covering: it isprice manipulation at itsworstandcanwipeoutweeksofgainsontheshortsideinamatterofhours.

Figure10.10XMSRshowsablueseabreakoutsetup.Ifyouareontherightsideofthetradeitcanbeabeautiful

thing,butifyouareshortitisyour worst nightmare. Still,with the right stop-loss, thistradecouldeasilyhavenettedover a +40 percent return inthreemonths.Evenashorter-term hold of four weekswould have netted a +25percent return on equity, andin a down market no less.Thattrulyistrendtradingforaliving!Sometimes it can be scary

to short a stock already

trading at new near-termlows. It is counterintuitive tothe "buy low, sell high"mentality.OneexerciseIfindhelpful is to turn the chart Iam looking at upside down,and then ask: "Would I buythis stock?" If yes, then turnthe chart right side up againand short the heck out of it!To turnachartupside down,or invert it, is easy withStockcharts.com:simply type"$ONE"beforethesymbolas

youinputit.

TheRisingWedgeBreakdown

Bullish:weakly trendingmarketsBullish: strongly

trendingmarketsRange-boundmarkets

Characteristics This finalsetup is similar but notidentical to the bullish basebreakout mentionedpreviously. Like its bullishcousin, this setup can betradedinavarietyofmarkets.It is also a contrarian play.Here we are looking for astockthatisinanuptrendbut

is ready to fall out of thattrendindramaticfashion.Thewedge is created when theoscillationsoftheuptrendgetnarrower and narrower. Torender the setup valid, weneed to see indicators tell ustwo things about pricebehavior within the wedge:its momentum has to beslowing down and thereneeds to be evidence thatshares are being distributed(sold)morethanaccumulated

(bought).While longer holdsof this setup can returnspectacular gains, there isoften aquickburst of sellingactivity at the point ofbreakdown that can bringgainsof+10percentormorewithin a few days, makingthisanidealtrendtradesetup.Key Indicators This setuprelies on a price pattern(risingwedge)combinedwith

two technical indicators:MACD and on balancevolume (OBV). Here are thespecifics:

First, the stock must beclearly seen to be in anuptrend of some kind,either strong or weak(see precedingdefinition).Second,theupanddownswings of the uptrend

mustbetradingwithinanarrower and narrowerrange. When thishappens, price prints apattern called a wedge.You can better visualizethewedgebydrawinginsupport and resistancetrendlines under thebottoms of lows andoverthetopsofhighsinthe uptrend. To qualifyas a wedge, you musthave at least three price

point touches (not highorlowpivots,butsimplyintradaytouches)ateachtrendline, and the moretouches,thebetter.

Rising wedges canhave a flat top likethe ascendingtriangle shown inFigure10.11.Or they can looklike the patternshown in Figure10.12, where both

trendlines arerising.

Oncewehave identifieda wedge pattern in anuptrending stock, weneedtoconfirmthatitisa bearish rising wedge.We do this by referringto two technicalindicators: MACD andOBV.

Figure 10.11 Ascendingtrianglewedgepattern.

Figure 10.12 Rising trianglewedgepattern.

MACDmust bemakinga series of lower highswhileprice iswithin thewedge (price may ormay not be makinglowerhighs).OBV must fall below atrendline placed underthelowsoftheindicator.Sell short signal: A sellshort signal is triggered

in a risingwedge at thefirst red or black candle(close is lower than theopen) after thecandlestickonwhichtheOBV trendline broke tothe downside. You canalso enter on the day ofan OBV break if thatcandleisredorblack.

TheScreeningTool It isnotpossible to screen for rising

wedges using what iscommonly available, but thefollowingscreenwill turnupa few decent candidatesamong many false hits thatcanbeshort-listedforfurtherresearch. Readers who aremore adept at this sort ofthingthanIammightwanttofiddle around with theseparameters to make themmorerobust.

20-day simplemoving average ofvolumefortodayisgreater than500,000.60-day simplemoving average ofclose for today isgreaterthan10.50-day simplemoving average of

close for today isgreater than 20-daysimple movingaverageofclosefortoday.50-day simplemoving average ofclose for today isgreater than 50-daysimple movingaverageofclosefor40daysago.Maximum rangeover 30 days

starting today isgreater thanmaximum rangeover 15 daysstartingtoday.Maximum rangeover 15 daysstarting today isgreater thanmaximum rangeover5daysstartingtoday.Daily OBV fortoday is less than

daily OBV for 40daysago.Daily MACD line(12,26,9) for todayis less than dailyMACD Line(12,26,9) for 40daysago.50-day simplemoving average ofclose for today isgreater than 200-day simple movingaverageofclosefor

today.

In the absence of a solidscreen, you will just have toeyeball the charts on yourwatch list. In fact, this is abetter way to go because itallowsyou towatchawedgedevelopoverseveraldaysandweeks. That OBV triggersignalisreallythekeytothissetup:ifyoucangetinontheday that happens, you oftenwillbeinattheverystartofa

significant trend-down sell-off. The stocks that show upon theprecedingscreenmostoften have already triggeredtheirOBVtrendlinesignal.In Figure 10.13, NVDA

begins to trade within anarrowing range or wedgejust before breaking down.Note that once we have thetwo trendlines in place wecan clearly see that thesupport line is rising at asteeper pace than the

resistanceline.Theindicatorstoldusaheadoftimethat

Figure 10.13 NVDA breaksdown from a rising wedge

pattern.troublewasahead,andindeedit was. An entry at the closeon the day of the sell shorttrigger—the break of theOBV trendline—would havereturned +30 percent at themaximum extension of thetrade in just about fourweeks.Note,too,thatthesellshorttriggeroccurredpriortoprice breaking down out ofthewedgepattern.In Figure 10.14, CSCO

throws up a rising wedgebreakdownsignalfollowingabullishgapupinastrong

Figure 10.14 CSCO triggersOBV sell signal in rising

wedge.uptrend. Even though thepricehasnotyetclosedbelowthewedge,thisisstillavalidsignal and can be entered onthecloseofthetriggerdayata price of 20.75. Note thebearish candle on the triggerday and the bearishdivergence seen in theMACDindicator.Thatwedgebreakdownsell

trigger signaled the end toCSCO's uptrend. After price

took a few sessions to clearthe lower edge of thetrendline, it was a slow andsteadydropoverthenexttwomonthstohitaclosinglowof17.24,

Figure 10.15 CSCO risingwedgebreakdownsetup.for a nice return of +17

percent.Notehowthewedgebreakout triggered thetransition from a stronguptrendtoastrongdowntrendin CSCO shares in Figure10.15.

THE FINALSCREENINGPROCESS

Okay,soyou'veeyeballedallyour charts, run your specialscreens, and nowyouhave ashortlistofstockstoconsidereither buying long or sellingshort. The next thing youneed to do iswhittle this listof possible plays down toonly the most highlyqualified, most riskworthycandidates, which you willmonitor the next trading dayfor entries. Input each stock

into your Stockcharts.comchart setup with all theindicators I've listed in theaforementioned setups.Makesurethechartislargeenoughtogetagood,clearpictureofat least six months of dailydata.Youthenputeachsetupthrough a series of tests. Donot—I repeat, do not—betempted to skip this furthertesting. It is tedious andsometimesyields fewresults,butitisabsolutelyessentialif

you want to streamline yourshortlist down to the one ortwo best possible trades forthe day. In this process youaregoing fromyourB-list toyour A-list of stocks. Thislast step iskey toputting thegreatest number of odds onyourside.Here is how you would

further test or screen yourshortlists per the varioussetupswehavejustdiscussed.

BullishSetups

The pullback:You will favorstockswhere...

Volume on the dip tosupport is lower thanaverage.There isnocloseduringthe dip under the 50MA.The trendlinesupportingtheuptrendhasnotbeen

violated.There is no bearishdivergence seen in anyoftheindicators.Price has not put in adouble top formation(two equal price highs)onthedailychart.Theweekly chart showsthat price is not tradingjust under a majorweekly moving average(like the 50MA or 200MA).

Earnings are set to beannounced at least twoweeks after entry (toavoid unnecessaryvolatility).

The coiled spring: You willfavorstockswhere...

Volume in the coil islowerthanaverage.Thecoilislongerthan7candles but not longerthan15candles.

There is no close in thecoilunderthe50MA.There are more greencandles (close higherthantheopen)inthecoilthan red candles (closelowerthantheopen).At least twoof theRSI,CCIandOBVarerisingduringthecoil.Theweekly chart showsthat price is not tradingjust under a majorweekly moving average

(like the 50MA or 200MA).Earnings are set to beannounced at least twoweeksafterentry.

The bullish divergence: Youwillfavorstockswhere...

You see above-averagevolume during the lastlow.The last low is near anarea of previous price

support, long-termtrendline support, ormajor moving averagesupport.The divergences on theindicators relative toprice are strong (i.e.,much lower price lowplus much higherindicatorlow).Therearemorethantwoindicatordivergences.The last low is morethan 10 percent away

fromthe20MA.Theweekly chart showsthat price is not tradingjust under a majorweekly moving average(like the 50MA or 200MA).Earnings are set to beannounced at least twoweeksafterentry.

The blue sky breakout: Youwillfavorstockswhere...

You see above-averagevolume on the breakoutday.Thebreakouthighis thehighest price for sixmonthsormore.The breakout follows aperiod of priceconsolidation, withseveral unsuccessfulattemptstobreaktonewhighs.Earnings are set to beannounced at least two

weeksafterentry.

The bullish base breakout:Youwillfavorstockswhere...

You see above-averagevolume on the signalday.Pricehasnotyetbrokenoutofthebullishbase.The base is prolongedbeyond the minimumtimerequired.

There are more greencandles in the base thanredcandles.At least twoof theRSI,CCIandOBVarerisingduringthebase.Theweekly chart showsthebase lyingatorneara major weekly movingaverage(20,50,200).Earnings are set to beannounced at least twoweeksafterentry.

BearishSetups

The relief rally: You willfavorstockswhere...

Volume on the rally toresistance is lower thanaverage.There isnocloseduringthe dip above the 50MA.

The trendline containingthe downtrend has notbeenviolated.There is no bullishdivergence seen in anyoftheindicators.Pricehasnotprintedinadouble bottom orinverted head-and-shoulders formation onthedailychart.Theweekly chart showsthat price is not tradingjust under a major

weekly moving average(like the 50MA or 200MA).Earnings are set to beannounced at least twoweeksafterentry.

TheBearishDivergence:Youwillfavorstockswhere...

You see above-averagevolume during the lasthigh.The last high is near an

area of previous priceresistance.The divergences on theindicators relative toprice are strong (i.e.,much higher price highplus much lowerindicatorhigh).The divergences on theindicatorsarestrong.Therearemorethantwoindicatordivergences.The last high is morethan 10 percent away

fromthe20MA.Theweekly chart showsthat price is not tradingjust under a majorweekly moving average(likethe50MAor200).Earnings are set to beannounced at least twoweeksafterentry.

Thegapdown:Youwillfavorstockswhere...

You see above-average

volumeonthegapdownday.The high preceding thegapdownisatanareaofprevious priceresistance.The high preceding thegapdowncorrespondstobearish divergence onone or more of ourprimaryindicators.Earnings are set to beannounced at least twoweeksafterentry.

Theblueseabreakdown:Youwillfavorstockswhere...

You see above-averagevolume on thebreakdownday.The breakdown low isthe lowest price for sixmonthsormore.The breakdown followsa period of priceconsolidation, withseveral unsuccessfulattemptstobreaktonew

lows.Earnings are set to beannounced at least twoweeksafterentry.

Therisingwedgebreakdown:Youwillfavorstockswhere...

You see above-averagevolume on the signalday.Pricehasnotyetbrokenoutofthewedge.

You will favor risingwedges over ascendingtrianglewedges.There are more redcandles in the wedgethangreencandles.At least twoof theRSI,CCI, and OBV arefallingduringthewedge.Theweekly chart showsthe wedge lying at ornear a major weeklymovingaverage (20,50,200).

Earnings are set to beannounced at least twoweeksafterentry.

This final screeningprocess will force you tofocus only on those stocksthat have the highesttechnicalmerit.Thisfinallistis now ready for one lastquestion, and it is an all-important one: Is therisk/reward ratio worthtakingachanceon?

To calculate a stock'srisk/reward ratio, divide thepercentage of your expectedgain by the percentage ofyour initial stop-loss. If youplanontrailingastop-loss(tobe explained in the Chapter11) as the trade moves inyour favor, then you willneed only a 1.25 ratio orbetter. For example, if yourtarget price is +10 percent,then you can afford a stop-loss of (8 percent because as

thetrademovesinyourfavor,this percentage loss getssmallerandsmaller,andyourrisk/reward ratio becomesmore favorable. The bestrisk/reward scenarios,however,startat2.0orbetter.Anysetupthatcannotpredictat least a 10 percent returnbefore running intosignificant resistance shouldbescratched.One final note: Don't be

afraid to say, even after

several hours of hard work,that you simply do not haveany setups that have eitherenough technical merit or ahighenoughrisk/rewardratioto warrant your investment.As Donald Trump says,"Sometimes the bestinvestments are the ones youdon'tmake."Notthatweneedto take investment advicefrom The Donald, but thepoint iswell taken: it is bestto stand aside and see what

the next day's trading offersthan to risk good money inless-than-optimaltrades.

CHAPTER11ENTRIESAND

takeamomentheretoremindyou of what was writtenearlier about tradingpsychology. There I listedseveral major resources thatwill help traders workthrough the emotional andtemperamentalissuesthatcanso often undermine even themost robust trading systems.If you skipped over thatsection, and if you (likeme)struggle with strictlyfollowing the trading plan

you have laid out, then Isuggestyougobackandreadthrough that section of thebook again. Study one ormore of the resources listedthere. Spend aweek on youremotional control and youwill go far towardestablishing a lifetime ofprofitabletrading.

ENTERING THE

If you find a stock thatsatisfies all the requirementsof a particular setup, and ithas passed your furtherscreening process andpresents a favorablerisk/reward ratio, thenenteringthattradeismerelyamatter of picking the bestentry price and setting an

orderwiththebrokerfor thatprice.Ineverycaseforallthesetups, I recommend thefollowing as the mostreasonableandprofitablewaytopickthebestentryprice.

ForLongSetups

Once all yourrequirements for a valid

entryhavebeensatisfiedon the chart, enter thetradeonastopordersetat either $0.02 (forslower-moving stocks)or $0.05 (for faster-moving stocks) abovethe intraday high of theprevioustradingday.If the stock gaps upabove this buy point,thensetalimitorderforthat price and wait forthe price to come back

down.Ifitneverhitsthisbuy price, then considerthe trade a scratch andmoveon.

ForShortSetups

Once all yourrequirements for a validentryhavebeensatisfied

on the chart, enter thetrade on a stop order tosell at either $0.02 (forslower-moving stocks)or $0.05 (for faster-moving stocks) belowthe intraday low of theprevioustradingday.If the stock gaps downbelow this sell shortpoint, then set a limitorder for that price andwait for the price tocomebackup.Ifitnever

hits this sell short price,then either pay up foryour shares or considerthe trade a scratch andmoveon.

Letmeaddtothatlastnotean important principle: theentry is the least importantpart of trading. Too manytradersangstoutovershavingapennyortwoofftheirentryprice. I've seen tradersabandon excellent, extremely

profitable setups simplybecause they were afraid ofpaying up a nickel for theirshares. So don't worry abouttheentry.Ifyou'vegotagreatsetup and your entry price isnothitbytheendoftheday,don't skimp. Pay up andadjust your stop and targetaccordingly.Entering the trade is the

easy part. Knowing when toexit, now that is hard. Notonly is it hard, but for most

mortals it is close toimpossible to exit a tradeanywhereneartherighttime.Whenatradegoesagainstus,we either panic and sell toosoon or entertain irrationalhopes and hold on too long.When a trade moves in ourfavor,weeitherexittoosoonout of fear or hang on toolong out of greed. The truegeniuses of trading, themastersofthemousewhocanturn the chaotic noise of the

markets into profitableevents, are all extremelyproficientatknowingwhentoexittrades.That kind of genius, that

sixth sense that seems toknow intuitively just when apricewillpivot,isprobablyabirthright, a divine gift. Forthe rest of us,we need hard-and-fast rules; rules that, iffollowed, will restrain ouremotions and rational mindslongenough tokeepus from

making the kind ofembarrassing clown trades Idescribed in theIntroduction.In the following section Ioutline the rules. There areseveral exit strategiessuggestedhere.Tryeachonefor yourself to determinewhich strategy best fits yourtradingstyle.

STOP-LOSSES

Once you are in a trade, youwill need to put into actionyour exit strategy. Thatstrategy must take intoaccount two differentpossibilities: the trade goesagainst you and you need toexit in order to cut your lossshort, or the trade goes inyour favor and you need tobank the profit before,inevitably, the momentumfades. In this sectionwewill

deal with the first of thesetwo possibilities: how tomanagelosses.Remember, we are not

position traders and not buy-and-holders. Trend trading isnot about trying to grab thefull move of a stock's price,onlythe"meat"ofthecurrenttrend. We want a highpercentage of wins (at least+60 percent, but up to +80percentispossiblewithsomesystemsandincertainmarket

conditions), small losses, andno regrets about bankingsmall profits. Obviously, wewant our profits to run, butwearequickonthetriggertobank those profitswhen theybegin to dwindle (and theynearlyalwayswillifyouholdlong enough). The way weminimize our losses in theeventa trade turnsagainstusistosetastop-loss.Every trade you put on

needs to have an exact price

at which you will definitelysell it in the event the tradegoesagainstyou.Thisiswhatwe call a stop-loss: aspecifiedexityouwilltakenomatter what in order to cutyour losses. One more time:everytradeneedsastop-loss,and a stop-loss is that exactprice(notanotional,in-your-headprice"area"—givemeabreak!) at which you willclosethepositionintheeventofalossordecreaseinprofit.

I teach my students fourdifferent methods for settingstop-losses. The method thatworks best for you dependsonthekindoftraderyouare,yourtradingexperience,yourchart-reading experience,yourtoleranceforrisk,andsoon. I recommendexperimentingwiththesefourtypesofstopstoseewhichismost profitable for you.Remember, the only wrongwaytoputonastop-lossisto

putonnostop-loss.Thefourstop-lossmethodsare:

Apercentagestop-lossApricepatternstop-lossAn average true rangestop-lossA parabolic SAR stop-loss

PercentageStop-Loss

The percentage stop-loss istheeasiesttoset.Itworksthisway:tosetastop-loss,simplycalculate a percentage lossfromyour point of entry andset the stop at that price. Intrend trading, your expectedpercentagereturnvaries fromstock to stock, depending onthe issue's volatility and thepattern or setup you aretrading. In most cases,however,duetotherelatively

short-term nature of thesetrades,youwillwant tosetastop-loss no greater than −8percentonanygiventradenomatter what you expect togain from a successfulcompletion of the trade.Youshould move this stop at theend of each day, as long asthetrademovesinyourfavor,recalculating the percentagestop from the current closingprice. Some onlinebrokerages will allow for a

trailing stop, which willautomaticallyrecalculateyourstop-loss at every newintradayhigh(iflong)orlow(if short), or at every newclosingpriceifyouselectthatoption.

PricePatternStop-Loss

A more sophisticated stop-loss,andtheoneIusemyself,

is thepricepatternstop-loss:here we want to look for anarea on the chart of nearbyprice support (if long) orresistance (if short) that ifpriceweretoviolatethatareawouldsignal that the trade isnot likely to work out. Pricesupport or resistance cancome in the form of amajormoving average, an area ofprevious price reversal, or atrendline. Traders familiarwithBollingerBandsorother

forms of standard deviationenvelopes can also use thosetools to set price patternstops.The price pattern stop-loss

is a more reasonable way toapply stop-losses in that,instead of relying on anarbitrary distance away fromthe entry price, it uses adistance suggested by theprice action of the stockitself. Furthermore, a pricepatternstopgivesyouaquick

readon the risk/reward ratio.Say, for example, your stockisinastronguptrendandhaspulledbacktothe50MAandthentriggeredanentrysignalonly 3 percent above thatMA,andatthesametimeyoucalculate a target price of 12percent. Thiswould prove tobe an excellent risk/rewardentry. But in every case, Irecommend not riskingmorethanan8percentlossonanygiven trade. In most trades

you should set a stop-loss atsomething more like 5 to 6percent. The average loss inour Swing Trade Newsletter,for example, is 4.76 percent.Leave it to the investors andposition traders to take thedouble-digitlosses!

AverageTrueRange(ATR)

A third way to calculate a

stop-lossistousetheaveragetrue range (ATR) of thestock.The"R"inATRstandsfor the range of intradaymovement a stock makesfrom its intraday high to itsintradaylow;the"T"is therebecause this calculation alsoincludes the previous day'sclosing price, thusincorporating any overnightgap;andthe"A"signifiesthata running average of thesefigures iswhatmakes up the

indicator's end value. TheATRisameasurementoftheintraday volatility of thestock.Assharestendtotradewithinalargerintradayrange,ATR moves up. As priceconsolidates and the intradaymoves tighten, ATR movesdown.UsingATRtosetyourstop-loss means you arecorrelating the amount youare willing to lose with thestock's volatility: the greaterthe volatility, the greater the

potential reward,butalso thegreaterthepotentialloss.Most charting packages

will calculate ATR for you.ThedefaultperiodicityfortheATR is usually set at 14,whichworksjustfine.Doublethe ATR value and in mostcases you have a reasonableplacetosetastop-loss.Ifthatfigure ismore than8percentfromtheentryprice,thestockmay be too volatile for aswingtradeandshouldeither

beenteredverylightlywithatighter stop or not entered atall. The ATR has the addedadvantage of giving you avaluable tool for positionsizing, and it is used in avariety of formulas by fundmanagers seeking to reduceriskintheirportfolios.

ParabolicSARStop

A fourth and final way toinput a stop-loss, theparabolic SAR stop-loss, canalso be done with yourcharting package. Mostcharting packages will allowyou to overlay a parabolicSAR (stop and reverse)indicator on the price chart.This indicatorwasdevelopedbyWellesWilderasameansoftradingvolatilestocksinastop-and-reverse fashion: if

you were stopped out long,you would immediately goshort, and vice versa. Theindicator doesn't work thatwell on most stocks as anSARentrysystem,but it isahandy tool for setting stopexits. The SAR overlayconsists of a series of dotsunder each day's candlestick.Some lie under price lowsand some lie above pricehighs.Asthestockmovesupand down, these dots change

location.Theyevenchangeifthe stock trades flat. TheparabolicSARisdesignedasboth a price and a time stop:if the trade goes nowhere, oreven if it goes against you,your stop-loss tightens upregardless—hence, theparaboliceffectofthetool.Yourchartingpackagewill

tell you the value of thecurrent day's SAR, so thatvalue is thenyour stopprice.Figure11.1 is an example of

a chart with the parabolicSAR overlay on it (MRVL).You can see that the SARnicely catches the majortrends, but it loses moneyduring choppier marketmoves.

HOW TO BANKYOURPROFITS

The second possibility withyour open position occurswhenthetrademovesinyourfavor.Here you are leftwiththe more pleasurable butadmittedly very difficultdecisionofchoosingwhentoexitthetradewiththegreatestamount of profit. Manytraders struggle more withselling too early than withcuttinglosses.I teach my students four

different methods for taking

profitsontheirtrades.Again,the method that works bestfor you depends on the kindoftraderyouare,yourtradingexperience, your chart-readingexperience,your

Figure 11.1MRVL showingparabolicSARstoppoints.toleranceforrisk,andsoon.Irecommend experimentingwiththesefourtypesofprofitexits and see which worksbest for you. Remember, noonegoesbroketakingprofits.The four profit exit methodswewillcoverhereare:

ApercentageprofitexitA price support orresistanceprofitexit

An average true rangeprofitexitThe trailing stop profitexit

PercentageProfitExit

The simplest exit strategy isto use a percentage profitexit.Hereyoushouldplaceaprofit target limit order to

closethetradeatapercentageremoved from your entryprice that is 1.5 to 2.0 timesthat of your stop-loss. Forexample, if you have set a−5.0 percent stop-loss, thenyou would set your profitlimit order somewherebetween +7.5 and +10.0percent.Your stop-loss ordermay change as the stockmovesinyourfavor,butyoumust keep your profit limitorder in place at all times.

The trade is consideredclosedwheneitheroneortheother is hit and executes.With the kind of volatile,high-beta stocks we screenfor, this usually happenswithinafewdays.

Price Resistance or PriceSupportExit

Amore sophisticatedway of

setting a profit limit order isto look for anareaofnearbyprice resistance (if long) orprice support (if short) suchthatifpriceweretoreachthatareaitwouldlikelyattractthewrong kind of crowd (sellerspouncing at resistance orbuyers gathering shares atsupport). Price support orresistance can come in theform of a major movingaverage, an area of previousprice reversal, or a trendline.

Traders familiar withBollinger Bands or otherforms of standard deviationenvelopes can also use thosetools to set price patternstops. This is a morereasonable way to approachprofit limits, and it takesadvantage of your chart-readingskills.

AverageTrueRangeProfitExit

Athirdwaytocalculateyourexit target is to use anaveragetruerangeprofitexit.To calculate this, simplymultiply your ATR by 3,assumingyousetyourstopat2*ATR.Sosay, forexample,you are trading RIMM long,which is currently beingofferedat96.82withanATRof 3.25. If your entry pricewas 96.00, say, you wouldthen set your stop-loss at

96.00− (2×3.25),or89.50,andyour target limitorderat96.00+(3×3.25),or105.75.

TrailingStopProfitExit

The fourth and final way tobank your profits, and thewayInormallyuse,issimplyto take your stop-loss andmove it in response to anypositive movement in your

position (up for longs, downforshorts)onaclosingbasis.This is called a trailing stopexit,andstudiesshowitisbyfar the most profitable.Whyisthis?Becauseitfollowstheage-old trader's dictum: "Letyour winners run." Settingspecificprofit targetsisoftenthe favored choice for trendtradingbecause itkeepsyourturnover of trades flowingsmoothly. It is the rightchoice if you need your

trading account to produce asteady cash flow in order topay your bills. The problemwith using profit targets,however, is that you thenmiss out on those few bigruns that, in themselves, canbeallthefuelyouneedtogetyour account into the bigleagues.Infact,youcantakelossesinthemajorityofyourtrades, but if you cut themshort and let your winnersrun, those two or three huge

winnersyouareboundtogeteachyearcankeepyouatthetrading game a long, longtime.Read the Market Wizards

stories: nearly every traderthere looks back on one ortwo huge winners thatpropelled them from amateurwannabes into theprofessionaltradingarena.Soif you are not sure where toplace a profit target, or youthink your position could be

thenextGoogle,holdontoitfor a while with a trailingstop-loss and let the markettakeyououtofthetrade.

REAL-TIMETRADING

In this chapter you have anaccount of everything youneed to know to execute

profitable trend trades. Whatisnothere,andindeedcannotbe here, is perhaps the mostimportant part of trendtrading: real-time experience.There is no substitute for thecountlesshoursitwilltaketoput this knowledge intopractice in a way that willlead you to find technicallysound trading setups, makeconsistently profitable trades,take reasonably small losses,and ultimately ramp up your

tradingaccounttonewhighs.Toputintopracticewhatyouhavelearnedinthischapter,Isuggest you take thefollowingactionsteps:1.Read this chapter at leasttwice. We all read throughourprejudices,andthesemaycause you to overlookimportantbitsofinformation.Gobackoverthismaterial tobe sure to catch items youmayhavemissedon the firstreading.

2.Spendseveraltradingdaysjust eyeballing your watchlists. There is no substitutefor putting in hours of chartreading for the setups weteach in this book. You willneed to so internalize thesesetups that they becomesecond nature to you. Youneed to gain that intuitivesense for stocks that looksomewhat like a particularsetup but have other issuesgoing on that likely would

weigh against the setup, andthatintuitivesenseforasetupthat is just so outrageouslyperfect that you can hardlywaittoenteryourpositionthenextday.3. Give serious thought toposition sizing. This couldconstituteanentirechapterbyitself, but instead of boringyou with my theories let mesuggestthatyoureadChapter12ofVanTharp'sbookTradeYour Way to Financial

Freedom. Short of that, Ialways recommend that mystudentsdividetheiraccountsinto equalmonetary amountsand put no more than thatamountintoeachtrade.Whenyouare first startingout as atrend trader, you should govery lightly into your trades(dividing by 10 ought towork).Youcanincreaseyoursize as you gain moreexperience. It is also not abadideatoscalebackonsize

during a losing streak andincrease in size during awinning streak. That mayseem counterintuitive, but inthe game of trading, losingtends to beget more losingand winning tends to begetmorewinning.

PARTFOURTRENDTRADINGWITHOPTIONS

CHAPTER12OPTIONSBASICS

asset class: stock options.Optionswill addagreatdealof flexibility to your trendtrading.Don't like the risk inacertainsetup,butyoureallylike the chart? Trade theoptions instead. Don't havemuch cash on hand, but youwant toget inonapredictedmove in Google (currentlytrading well over $500 pershare)?Buy theoptionsforalot less.Doyouhavea largeamountofprofitinyouropen

positions, and you fear themarketsareabouttoreverse?Add some price insurance—with options. Want to profitfrom the huge moves thattake place during earningsseason but don'twant to riskbeingonthewrongside?Youcan do that too—with (youguessed it!) options. So, youmaybeasking,whattheheckareoptions?

WHAT AREOPTIONS?

Options are traded just likestocks. You can either buythem in the hope that theywill rise inpriceorsell themshort (this is also calledwritinganoption)inthehopethat they will fall in price.There are only two kinds ofstock options: calls and puts.

Call options tend to rise inprice as the stockprice rises.Put options tend to rise inprice as the stock price falls.So both the buyer of a calloptionandthewriterofaputoption, generally, are bullishon the stock. And both thewriterofacalloptionandthebuyer of a put option,generally, are bearish on thestock.Option buyers have rights,

and option writers have

obligations. Option buyershave the right, but not theobligation,tobuy(ifacallisbought) or sell (if a put isbought) the underlying stockataspecifiedprice.Thisrightremains in place until theoption expires. Each optioncontract you purchase willhave a specified expirationmonth associated with it.Options expire on the thirdFriday of their expirationmonth. Option writers have

theobligationtosell(ifacallissoldshort)orbuy(ifaputis sold short) the underlyingstock at a specified price.This obligation remains inplaceuntiltheoptionexpires.There are no margin

requirements if you want topurchase an option becauseyour risk is limited to thepriceoftheoption.Anoptionpurchaserequirestheaccounttobedebitedintheamountoftheoption'spurchaseprice,or

premium. Option writers, onthe other hand, receive acredit to their account in theamount of the option'spremium for selling thatoption.Theyget to keep thisamount if the option expiresworthless on its expirationdate. However, since optionsellersalsohaveanobligationto buy (put) or sell (call) theunderlying stock if theiroption is exercised by theperson they sold their option

to (the assigned optionholder), they assume a riskgreaterthantheamountofthepriceoftheoption.Therefore,writing an option alwaysrequires the use of a marginaccount.Notallbrokersallowfor the writing or selling ofoptions unless the writer orselleralsoownssharesoftheunderlyingstock.

STOCK OPTIONSTERMINOLOGY

Totradeoptions,youmustbeacquainted with theterminology of the optionsmarket. I've provided here alist of the most commonlyused terms associated withbuying and selling stockoptions.

At-the-MoneyAn option is at-the-money ifthe market price of theunderlying interest is at ornear the underlying stockprice.Generally, at-the-money

options cost more than out-of-the-moneyoptions.

BuytoCloseBuying to close iswhen you

buy a contract that you arecurrentlyshort.

BuytoOpenBuying to open a position iswhenyoubuyacontract thatyoudon'talreadyown.

CallOptionAcalloptionisacontractthatgives the holder the right tobuy the underlying for the

strike price anytime untilexpiry.

DeltaThereareseveralGreeklettersymbols used in optionsterminology that refer tochanges in an option'spremium.Themostimportantof these for our purposes isdelta.Delta refers to a ratio

between option premium and

stock price. This relationshipis not normally a 1:1 ratio.Most often it is around 0.5:1(and often less than that). Inother words, if the delta foran option is 0.5, then forevery $1 move in the stock,thereisacorresponding$0.50move in theoptionpremium.That may make it seem likeoptionsarenotasgoodadealas stocks, but the fact thatoptionsareleveragedbyprice—ittakesalotlessmoneyto

control100sharesbuyingtheoptionsratherthantheshares—makes themveryattractivedespitethedeltaratio.There is some good news

regardingdelta: itchangesasthe stock price moves moreand more in-the-money.Usually, at the strike pricedelta is around 0.5.Deep in-the-money options, however,can move at closer to a 1:1ratio. The opposite is true aswell:ifthestockmovesaway

from the strike price and outof the money, delta tends todecrease.This factor alone—the delta factor—makesoptions very attractive fortrend trading: as a positionmoves in our favor, ouroptions increase invalueatafasterandfasterrate,butasaposition moves against us,they decrease in value at aslowerandslowerrate.

ExerciseStyle

American Style:American-style optionscanbeexercisedanytimeuntilexpiry.European Style:European-style optionscanbeexercisedonlyonexpiry(notbefore).

ExerciseandAssignment

Exercise is when the optionholder decides to use theoption to buy or sell theunderlying stockat the strikeprice.Assignment iswhenanoption seller (called thewriter of an option) isrequired to buy or sell theunderlying stock due to theobligation from writing theoption. An option holderexercising an option willcause an option writer to beassigned.

ExpirationDateAstockoptionexpiresbythemarket's close on the thirdFriday of the expirationmonth.Alllistedoptionshaveoptions available for thecurrent month and the nextmonth as well as specificfuturemonths.Eachstockhasa corresponding cycle ofmonthsthattheyofferoptionsin. There are three fixed

expiration cycles available.Theyareasfollows:1. January, April, July, andOctober2. February, May, August,andNovember3. March, June, September,andDecemberThedatetheoptionexpiresisreferred to as the expirationdate.

Holder

Theholder is thepersonwhobought an option contract.People who buy an optiontheypreviouslywrotearenotholders, they are just closingan existing position. Optionholdersaresaidtobelongtheoptiontheybought.

In-the-Money

Call options: Theunderlyingstockpriceis

above the option strikeprice.Put options: Theunderlyingstockpriceisbelow the option strikeprice.Note: All options withintrinsicvaluearein-the-money.

Generally, in-the-moneyoptionscostmoretopurchasethanat-the-moneyoptions.

IntrinsicValueIntrinsic value is the portionofanoptionspremiumthatisattributed to the value thatcouldcurrentlyberealizedbyexercising andsimultaneously closing outthe position in the openmarket.

LongIfyouownasecurityorstock

option, you are said to belongthatsecurityoroption.

Out-of-the-Money

Call options: Theunderlyingstockpriceisbelow the option strikeprice.Put options: Theunderlyingstockpriceisabove the option strikeprice.

PremiumApremiumisthepricethatispaidforanoptioncontract.An option's premium is

determined by a number offactors including, but notlimitedto,thecurrentpriceofthe underlying asset, thestrikepriceof theoption, thetime remaining untilexpiration (time value), andthevolatilityofthestock.An

optionpremiumispricedonaper-share basis. Each optiononastockcorrespondsto100shares. Therefore, if thepremium of an option ispriced at 2.50, the total costforthatoptionwouldbe$250percontract(2.50premium×100 shares per contract).Buying an option creates adebit in the amount of theoption's total cost to thebuyer's trading account.Writing or selling short an

option creates a credit in theamount of the option's totalcost to the seller's tradingaccount.

PutOptionAputoptionisacontractthatgives the holder the right tosell the underlying for thestrike price anytime untilexpiry.

SelltoCloseSelling to close is selling acontractyoucurrentlyown.

ShortIfyousellasecurityorstockoption you didn't alreadyown,youaresaidtobeshortthatsecurityoroption.

TimeValueThe time remaining until

expiration of a purchasedoption has a monetary valueinoptionstrading.Thisvalueis called the option's timevalue. Time value increasesthe further away fromexpirationtheoptionis,anditdecreasesastheoptionmovescloser to expiration. The rateof this decrease changesexponentiallyovertime,soasan option moves closer andcloser to expiration, theoption's time value decreases

atafasterandfasterrate.Onthedayofexpiration,optionspossess no time valuewhatsoever.

StrikePrice(ExercisePrice)The strike price is the pricethat the underlying assetwillbe bought or sold at if anoptioncontractisexercised.Options are available in

several strike prices aboveandbelowthecurrentpriceof

the underlying asset. Stockspriced below $25 per shareusually have strike prices atintervals of $2.50. Stockspriced over $25 usually havestrikepricesat$5intervals.

UnderlyingThe underlying is somethingthat an option contract isbased on. This could be astock, an index, a foreigncurrency,aninterestrate,ora

futures contract. Theunderlying is commonlyreferred to as the underlyinginterest, underlying asset,underlying security, orunderlyingstock.

WriterAwriterissomeonewhosoldan option contract to open aposition. The writer is theperson who is taking on therisk (underwriting the risk).

People who sell an optionscontracttheyalreadyownarenot writers, they are justclosing an existing position.Optionwriters are said to beshorttheoptiontheywrote.

Write(SelltoOpen)Selling to open is sellingshort anoptionscontract thatyou don't already own. Thewriteristhepersontakingonthe risk (underwriting the

risk). People who sell anoptions contract they alreadyown are notwriters, they arejust closing an existingposition. Option writers aresaid to be short the optiontheywrote.

SUMMARY OFHOW OPTIONSWORK

Stock options give youtherighttobuyorsellanunderlyingstock.If you buy an option,you are not obligated tobuy or sell theunderlying stock; yousimply have the right todoso.Ifyousellanoptionandthe option is exercised,you are obligated to

deliver the underlyingstock (if you bought acall) or take delivery ofthe underlying stock (ifyouboughtaput)at thestrikepriceoftheoption,regardless of the currentprice of the underlyingstock.Options are good for aspecifiedperiodof time,after which they expireand you lose your rightto buy or sell the

underlying instrument atthespecifiedprice.Optionswhenboughtaredonesoatadebit to thebuyer.Options when sold aredone so by giving acredittotheseller.Options are available inseveral strike pricesrepresenting thepriceofthe underlyinginstrument.The cost of an option is

referred to as the optionpremium. The pricereflects a variety offactors including thecurrent price of theunderlying stock, thestrikepriceoftheoption,the time remaining untilexpiration, andvolatility.Optionsarenotavailableon every stock. Thereare approximately 2,200stocks with tradable

options. Each stockoption represents 100shares of a company'sstock.

ADVANTAGES OFOPTIONS

Optionsarethemostversatiletrading instrumentsavailable.

They can, for example, betraded on a wide variety ofinstruments,includingstocks,stock indexes, exchange-traded funds (like theQQQQ), commodities,currencies, and bonds.Options on all theseinstruments function inexactly the same way asdescribed previously. Ourfocus here, however, will beonstockoptions.Options are also versatile

because they canbeused fora larger variety of reasonsthansimplestocks.

Options are used tohedgeagainstrisk.

If you have 1,000 shares ofIBM, for example, andsuspect that the stock mightbe in for a drawdown, youcan buy 10 put options (orsell 10 calls), which wouldincrease in value in that

event. Once the sell-off wasover, you could then sell theputs for a profit against thelosssufferedinthestock.Theeffect is twofold: you arepartially protected against aloss in the stock, and theprofit from the option saleservestolowertheentrycostoftheIBMstock.

Optionscanalsobeusedto profit from periodswhen the markets are

volatile andunpredictable.

There are certain market-neutral strategies usingoptionsthattakeadvantageofthe fact that options tend togaininvalueatanincreasingrate as a stock movesfavorably, but decrease invalueatadecreasingrateasastock moves unfavorably.This is the aforementioneddelta factorofanoption,and

it can yield incrediblyconsistent gains if playedwisely. If, for example, oneexpects RIMM to movewildly on its earningsannouncement, but you arenot sure whether that movewill be up or down, you canpurchasebothacallandaputon RIMM. If on the day ofthe announcement RIMMtrades up strongly, you canselltheputforalossandholdthecallfor thegain.Because

of the delta factor, the putshoulddecrease invalue at arate slower than the increasein value of the call option.This is a profitable variancethat can be exploited againandagain,particularlyduringearnings season. We willteach you how to implementthisstrategylater.

Optionsgive thesmalleraccount trader anincredible amount of

leverage with which toplay higher-pricedstocks.

By buying a call or putinstead of the actual stock, atrader with only a couplethousand dollars to trade canstill control round lots of thestock instead of having topurchase odd lots (less than100 shares). He or she cantakefullpositionsinsomeofthe higher-priced stocks, the

big movers, when normallythe smaller trading capitalwould have prohibited it.With options, a smalleraccount trader can takemultiple positions withouttyingupallhisorhercash.But the primary advantage

of stock options versussimple stocks is leverage.Leverage is here defined asthe advantage gained by theinvestor who can make asmall amount of money do

the work of a much largeramount.Instockoptions,youcanfrequentlyputyourselfina situation where every $1invested in options is doingwork equivalent to $10 ormoreinvestedinstocks.Let's give a real-world

example. Let's say I wantedto buy 500 shares of EBAYbecause I think it is going togo up over the next fewweeks. Currently EBAY istrading at about $40 per

share.Sothose500sharesofEBAY are going to cost me$20,000.Let's also say that Iam right: over the nextmonth, EBAY goes to $50.My500sharesarenowworth$25,000.Ihavemadeaprofitof:$5,000,or+25percentonmy original investment, lesscommissions. Here is asummaryofmystocktrade:

Buy 500 shares EBAY@$40:cost$20,000

Stockgoesto$50:profit$5,000,or+25percent

Anytime you can bank a 25percent gain in a month,you'vemadeanicetrade.But now let's say, instead

ofbuyingthestockoutright,Ipurchasedcalloptionson thestock instead. If EBAY istrading at $40, and I think itis going to go up, I wouldwant to buy calls at the 40strikeatleasttwomonthsout

(to give my trade time tomature). Currently thepremium on these options isabout4.00,oracostof$400percontract.I'mgoingtobuyfive contracts at a cost of$2,000.Again, I'm right, andEBAY rockets to $50. At adelta of 0.5, which thenincreases to about 0.7 as thecallsmovefrombeingat-the-moneytobeingin-the-money,the premium on my callsincreases from 4.00 to about

10.00.Thosefiveoptionsarenow worth $5,000. I havemade a profit of $3,000 lesscommissions. While this islessthantheprofitmadewiththe stock purchase, itrepresents an overall gain ofan astonishing +150 percent.Toputthisintoperspective:ifIhadputthesameamountofmoney into the options as Ihad put into the stock($20,000), I could havebought 50 calls. Those 50

calls would have risen to apremiumvalueof$50,000,oranetprofitof$30,000versusthe$5,000Imadetradingthestock. That's 600 percentleverage. That's what I'mtalking about with options.Leverage,baby,leverage!Sotosummarize:

Buy5EBAY40calls@$400:totalcost=$2,000Stockgoesto$50:profit= $3,000, or +150

percent

ButwhathappensifEBAYdoes not move in myexpecteddirection?If insteadof shooting up $10, it drops$10? What happens to myinvestment then? Well, if Ihadsimplybought500sharesofthestock,Iwouldbedown$5,000. My $20,000investment would now beworthonly$15,000,foralossof 25 percent. But if I had

bought five call contractsinstead of the stock, Iwouldalso be down, but not asmuch. Again, delta works inour favor in the event of aloss. As EBAY's stock pricemoves against us, and ouroptionsgofurtherandfurtherout-of-the-money, the rate ofdecrease in the premiumvalueslowsdown.Iwilllosesome time value during thedays of EBAY's sell-off, butthe overall amount of loss in

premium tends to decreaserelative to the loss in theunderlyingstock.Thismeansthat buying the optionsprovides less risk thanowning the stock. Forexample:

EBAYgoesfrom$40to$30 = $5,000 loss onstocktrade.But:My call options gofrom 4.00 to 2.00 =$1,000 loss on the

options trade (comparethis to a $3,000 gain ifthe stock makes thesame 10–point move totheupside).So: The optionsrisk/reward ratio is 3.0times greater than thestock purchase, thankstothepowerofdelta.

There are several otheradvantagestothepurchaseofstock options versus the

purchase of the underlyingstock. For one, there is nouptickrulewhenyouwanttoprofit from a stock's sell-off.Ifyoushortastock,normallyyoumustwaitforabiduptickbefore you can enter theposition.Notsowithoptions.Yousimplybuytheputattheoffer price. There is no needforanuptick.With puts, there are no

dividendsandmargininteresttopay.Ifyoushortthestock,

however,youwillbechargedintereston50percentofyourinvestment (margin fee), andyou will also be charged foranypayabledividend if thereisone.

DISADVANTAGESOFOPTIONS

Therearesomedisadvantages

with options that should bepointed out, before anyonethinks they have found theidealtradingvehicle.

Time value decay:Options lose value asthey approachexpiration, and there isnothing you can do tostopit.The rate of time valuedecay increases overtime: the closer the

optiongetstoexpiration,the faster the decay-seeFigure12.1.Full loss of investment:If the trade goes againstyou and you hold theoption to expiration(which we cautionstrongly against in anycase), your option willexpireworthless.

This means youwill have to reduceyour per-trade

investment size,thus reducing youroverallgains.It also makescompounding gainsmoredifficult,since100 percentcompounding canlead to irreparabledamage if you takealargeloss.

Withoptions there is nopre– or postmarkettradingavailable: ifyou

see bad news come outovernight and you owncalls, there is nothingyoucandoaboutituntilthenexttradingday.There is normally lessliquidity in options thanin stocks: Some out-of-the-money options donottradeeveryday.

Ingeneral,themoreliquid a stock is,and the closer tobeing at-the-money

the option strike is,themore liquid theoptionwillbe.

Therearelargerspreadsbetweenbidandask.

In well-tradedstocks, the spreadon the stock optionis usually 0.10 to0.20.In less liquidstocks, the spreadcan be 0.40 ormore.

Options cannot betradedinsomeIRAs.

Some IRAs restrictoptions trading topurchase only andforbid the writingofoptions.

Figure 12.1 is a clear,visual example of theexponential increase in therateoftimevaluedecayasanoption approaches itsmaturity at expiration. This

fact increases the risk valueof options as they are heldover time: if the underlyingstock does not move in afavorabledirectionwithina

Figure 12.1 Time decaycurve.shortperiodoftimefollowingthe option's purchase, thechances of that optionbecomingprofitabledecrease;the longer the delay, the lesslikelythechanceforprofit.

BASIC OPTIONSPARAMETERS

Option contracts possessfour identifiers: theunderlying, the expirationmonth, the strike price, andthetype.

The underlying = whatmarket the optionrepresents (stock, index,etc.)Expiration date = thethird Friday of themonth in which the

optionexpiresStrike price = the priceat which the optionowner has the right (notthe obligation) topurchasetheunderlying

Options are classified asbeing in-the-money (ITM),at-the-money (ATM), orout-of-the-money(OTM).

ITM = the call strikeprice is less than the

underlyingprice;theputstrike price is greaterthan the underlyingprice.ATM = the call/putstrike price is the sameastheunderlyingprice.OTM = the call strikeprice is greater than theunderlyingprice;theputstrike price is less thantheunderlyingprice.

Type = calls or puts. There

areonlytwotypesofoptions:calls and puts (see Figures12.2and12.3).

Figure 12.2 ITM options

pricing.

Figure 12.3 OTM optionspricing.

A call option gives theoption buyer the right,butnottheobligation,topurchase the underlyingmarket (100 shares peroptioncontractonstock)at a specified price (thestrike price) at any timebetweenoptionpurchaseandoptionexpiration.

Calls bought makemoney as themarketgoesup.Calls sold or

written makemoney as themarket goes downorstaysflat.

A put option gives theoption buyer the right,butnottheobligation,tosell the underlyingmarket (100 shares peroptioncontractonstock)at a specified price (thestrike price) at any timebetweennowandoptionexpiration.

Puts bought makemoney as themarketgoesdown.Putssoldorwrittenmakemoney as themarket goes downorstaysflat.

Options have two kinds ofvalue, which combine tomake the premium you mustpaytoownthem:

Intrinsic value (IV) is a

function of a variety offactors including theprice of the underlying;IV increases as theoptionmoves further in-the-money; IV becomes0once an option is out-ofthe-money.Time value (TV)decreases as the optionmoves closer toexpiration; TV becomes0atexpiration.

Example1EBAY Oct 45 calls (EBAYwas currently trading in Julyat$40).

Option was trading at4.00($400percontract).IV=$0;TV=$4.00.

Example2

EBAY Oct 35 calls (EBAYwas currently trading in Julyat$40).

Option trading at 8.00($800percontract).IV=$3.00;TV=$5.00.

Note: The volatility of theunderlying stock affects timevalue:

Decreased volatility =loweredTV.

Increased volatility =increasedTV.

DR. STOXX'SRULES FORTRADING STOCKOPTIONS

In this section I am going to

outline the basic rules I usefor trading options on ourBefriend the Trend Tradingtrend trade picks. Many ofournewslettersubscribersuseoptions on our picks withtruly incredible results.Someuse options exclusively andso do not trade those pickswhose options do not meetthe criteria outlined here.Others use options when theprice of the underlying stockistoohighfortheiraccounts.

Either way, you will learnherehowtotrend-tradestockoptionswiththeleastamountofrisk.If you are already a

successful trend trader, thenyou will have no problem atall becoming a successfuloptions trader.SimplyfollowtherulesasI'veoutlinedthemhere. Remember, these rulesarenot optional. If youwantlong-term trading successwithoptions,youmustfollow

these rules to the letter. Youhave no choice. Due to theirleverage, you cannot tradeoptions in the samewayyoutrade stocks. It may work inthe short term, but longerterm, youwillwipe out youraccount. Please do not skipthis section.Read these rulescarefully, write up a briefsummary of them in yourown words, and post themnext to your tradingcomputer.

1.Neverbuyoptionswithlessthanonemonth toexpirationunlesstheyaretobeusedfordaytrading.

In this way you avoidtheworstperiodfortimevalue decay and thustakesomeoftheriskoutofyourtrade.

2. Avoid options on stocksthat trade fewer than 1millionsharesperday.

Options are much lessliquidthanstocks,sowecanincreaseourchancesof getting a decent fill,and of a reliable exit, ifwetradeoptionsonlyonthemostliquidofstocks.

3.Avoidoptionswithspreadslarger than 10 percent (e.g.,0.2on2.00option).

The spread is thedifference between the

asking price and the bidprice; it is a premiumyou have to pay to theexchange's marketmakersinordertoputonthetrade.The greater the spread,themore the underlyingstockhastomovetogetyou to a breakevenpoint;themorethestockhas tomove, thegreateryourriskinthetrade.AruleofthumbIliketo

followisthis:ifaspreadis greater than 0.10, Iusually enter a limitorder between thespread; if the spread isgreater than 0.30, Iusually avoid tradingthat option. Yes, I missoutonsomegreattradesdoingthis,butthat'sjustme. I hate to paypremium for anything(justaskmywife!).Some options that are

heavily traded (such asoptions on the QQQQ)have spreads as narrowas0.05.New rules haverecentlycomeintoeffectthat allow optionsexchanges to offerspreads in 0.01increments. This shouldserve options traderswell, as they will thenhave greater pricingcontrol, and thusnarrowerspreads.

4.On short-term plays (lessthantwoweeks),buythenextmonth's strike (payingattentiontorule#1).

For example, if today isJuly6andIwanttobuyEBAY calls because Ithink EBAY is likely togoupinpricewithinthenextonetotwoweeks,Iwould not buy the Julyoptions, since we areless than one month

from July's expirationdate, but would insteadbuythenextmonthout.

5. On longer-term plays(more than two weeks), buythestrikeatleasttwomonthsout.

For example, if today isJuly6andIwanttobuyEBAY calls because Ithink EBAY is likely togoupinpricewithinthe

nextthreetofourweeks,Iwouldnotbuythenextmonth out, since fourweeks would put us intheworstphaseof thoseoptions' time valuedecay curve. Instead, Iwould buy the nextexpiration out after that,which for EBAYmeanstheOctobercalls.

6. Buy the closest in-the-moneyorat-the-moneystrike.

For example, if GE istrading at 27.00, youwould buy the 27.50strike(putsorcalls),butifGEistradingat26.00,youwouldbuythe25.00strike(putsorcalls).Note: In general(assuming you trade awinningsystem)...Trading far OTMoptions have a lowerwinningpercentagebutahigher-percentage return

if the trade is successful(lower premiums paidbutabiggermoveinthestock is needed tomakeaprofit).Tradingfar ITMoptionshave a higher winningpercentage but lower-percentage returns(higher premiums paidbut a smaller move inthe stock is needed tomakeaprofit).

7. If you are only tradingoptions,commitnomorethan50 percent of your totalaccountatanyonetime(keepat least50percentreserveincash), and spread this outover at least five positions(roughly 10 percent of yourtotalaccountpertrade).

Options are high risk.Anything less than thiskind of allotment runsthe risk ofwiping out a

significant portion ofyour account, and youroverall returns willsuffer, if you are notforced to close youraccount altogether. Itwill happen. Even withthe most robust ofsystems, losses happen.And with options, thiscan mean a total loss ifyou are not careful topay attention to positionsizing.

If you trade stocks andoptionstogether,asIdo,Isuggestputtingonly20percent of your totalaccountintooptionsandtheremaining80percentof your capital to workinstocks.

8.Be quicker to take profitson options than on stocks(because of time valuedecay).

Lossescanbeheldabitlonger sincedeltaworksin your favor (deltaslows down as theoption moves furtherOTM).Keepinmindthatevenanice gain in an optiontrade can disappearquickly if you hold ontoo long, even if thestock does not moveunfavorably.At all times, respect the

inevitability of timevaluedecay!

9. Determine a percentagestop price (25 to 40 percentrecommended) and set anaudible alert near this price(or set an alert on theunderlyingstock).

Do not set an actualstop-lossonoptions;duetotheirwiderspreadandlowered liquidity, a real

stop-loss on an optiontrade is notrecommended.

10. Set a limit sell order atyour target basedonanestimated move in theunderlying×delta.

For example, say KLAC istrading in early July around$50andyouexpect thestocktomoveto55:

SoyoubuyKLACSept

50 calls @ 5.00 (delta0.50).As soon as you areexecuted,youshouldseta limit sell order, goodtill canceled (GTC), at7.50 ($5 move × 0.50;50percentgain).

11.Never takemore thana -40 percent loss on anyoptions position or - 5percent of your totalaccount, whichever is

smaller.

This rule holds only forthe single positions, notthe compoundpositions,whichrequire theuseofmore than one option atonce. In the compoundpositions, your potentialloss is generally limitedand is usually nowherenear-40percent.A 5 percent lossguarantees that you will

beabletoputonatleast20 options trades beforeyourunoutofmoney.Ifyou can't turn a decentprofit with 20 optionstrades, then you shouldbe out of the gamealtogether.

12.Once an option positionhas a profit of 50percent, close thepositionifittradesdowntobreakeven.

There is an old adagesaid about options:Profits once lost rarelyreturn. If you have adecent return in youroptions position and itsuddenly fizzles back toyour entry price, it isprobably a good idea toclose the position atbreakeven to avoid aloss.Due toavarietyofpricing factors, andunlike the tragic

Sisyphus,optionshaveahardertimeclimbingthehill the second timearound.

13.Holdallcompoundoptionpositions (covered calls,bull and bear spreads)toexpiration.

The one exception tothis rule is for thestraddle,whichyouwilllearn about in Chapter

14. If youareprofitable inasingle option position(calls, puts, naked callsand puts), close theposition two weeksbeforeexpirationand, ifyou want to remain intheposition,buythenextmonth's position at thenearestITMstrike.

This is called rolling

over your position; ifyoureinvestyourprofitsby buying a largerposition in the newoption, you arepyramiding yourposition. Both are goodideas as long as yourposition is nicelyprofitable. This is howyou can get ten-baggersandmorefromoptions.

Okay, those are my must-

followrulesforswingtradingstock options. Remember, ifyouaregoingtobuyorwritea stock options contract, youmust have a reasonabledegree of confidence in thefuture direction of theunderlying stock, just as youwould if youwere to buy orsellshort thestockitself.Forthisyouneedasoundtradingstrategy.Andifyouemployamarket-neutralapproachtoanoptionsposition, youneed to

be reasonably sure that thestock is about to make asizeable move, one way ortheother.Forthis,again,youneedasoundtradingstrategy.Onefinalnote,andit isan

important one: you can be asuccessful stock optionstraderonly ifyouarealreadyasuccessfulstocktrader.Itisstrongly recommended thatyou not trade options untilyou have a proven trackrecordofstrongstock-trading

gains.Youcangoalongtimelosing at the stock-tradinggame and still maintainenough capital to mount acomebackonceyou'vegainedthe necessary experience.However, the highlyleveraged nature of optionsensures that losing at thestockoptionsgameisashort-livedexperience.

CHAPTER13OPTIONS

STRATEGIES:BULLISHTRENDS

IT bears repeating that youneed to know, before youenter any options position,whether you are bullish,bearish, or neutral on theunderlyingstock,andtowhatdegree you are so. Optionstrading also requires you toassess your risk tolerance sothat you can select theappropriate optioncombinationtoeitherincreaseorreduceyourriskexposure.

With this in mind, thefollowing list of options-trading strategies is offeredfor your consideration. Thelist is set up to allow you tochoose the best optionsstrategybasedon:

Your directional bias ontheunderlyingstockYour risk tolerance fortheparticulartrade

Directional bias here means

inwhichdirectionyouseethestockmovingasittradesintothe near future. And risktolerance refers to yourconfidence level regardingthe trade: if it is high, youmight want to assumeunlimitedrisk(withunlimitedupside potential) and use astop-loss; if it is not veryhigh, you might want toassume limited risk (whichusually goes along withlimited upside potential).

Onceyouhavedecided thesetwo elements, you are readyto select the appropriateoptions-trading strategy forthe stock you wish to profitfrom.Sothefirstquestiontoask

yourself is: "What is myoutlookonthestockIwanttotrade?"

Bullish: I expect asignificantpricerise.Bearish: I expect a

significantpricefall.Neutral:Iexpectamoveup or down but am notsurewhich.Volatile: I expect astrongmoveupordown.

BULLISHSTRATEGIES

Let's assume you are bullishonyourstock.Youhavenowsatisfiedyourdirectionalbiasquestion.Nextthingyouneedto do is determine your risktolerance, or more precisely,how confident you are thatyour stock is going up by asignificantamount.So you now need to ask

yourself, "Just how bullishamIonthisstock?"

Very bullish: Requires a

higher-riskstrategy.Moderately bullish:Requires a moreconservativestrategy.

Now it is time to lay outour strategies for thesevariousscenarios.

VERYBULLISH

Strategy1:BuyCallsStrategy rationale: Theinvestor thinks that thestockwillrisesignificantlyintheshortterm.

Strategyimplementation:Calloptions are bought at thenearestITMstrikeprice.

Upside potential: The profitpotential is unlimited andrises as the stock pricerises.

Break-even point at expiry:Strikepriceplusthespreadandcommission.

Downsiderisk:Limitedtothepremium paid-incurred ifthestockatexpiryisat,orbelow,thestrikeprice.

Margin:Notrequired.Comment: If themarketdoeslittle, then thevalueof theposition will decrease astheoptiontimevaluefalls.

Strategy2:SellNakedPutStrategy rationale: Theinvestor is bullish on thestock and quite certain thestockwillnotdeclineovertime.

Strategy implementation: Putoptions are sold orwrittenatthenearestATMorITMstrikewithout also holdingashortpositioninthestock(hence, anaked put). If aninvestor is very bullish,then deeper ITM puts

wouldbesoldorwritten.Upside potential: Profitpotential is limited to thepremium received. Themore the option is ITM atpurchase, the greater thepremiumreceived.

Break-even point at expiry:Strikepricelessthespread.

Downsiderisk:Lossisalmostunlimited ("almost," sincetheunderlyingpricecannotfall below zero). This is ahigh-riskstrategy,although

stops can be used to limitthat risk. There is thepotential for a catastrophicloss if the stock crashesovernightduetobadnews.

Margin:Alwaysrequired.Comment: If the stock doeslittle, and time passes, thepositionislikelytobecomeprofitable as time value intheoptionerodes.

MODERATELYBULLISH

Strategy1:BullCallorPutSpreadStrategy rationale: Theinvestor thinks that the stockprice will rise modestly andnotfall,butwantstolimitthedownsideriskjustincase.

Strategy implementation: Acall option is bought at thenearest ITMstrikeprice, andanother call option is sold orwritten at the nearest OTMstrike price; this produces adebittotheaccount.ORAputoption isboughtat thenearest ITM strike price,and another put option issold or written at thenearest OTM strike price;thisproducesacredittothe

account.Upside potential (in the caseof a bull call spread):Limited to the differencebetween the two strikes(normally $500 percontract) less the initialdebit; maximum profit isgained if the stock atexpiry is above the higherstrike.

OR(In the case of a bull putspread): Limited to the

initial credit; maximumprofitisgainedifthestockat expiry is above thehigherstrike.

Downsiderisk (in thecaseofabullcallspread):Limitedonlytothenetinitialdebit;maximumlossisseenifatexpiry the stock price isbelowthelowerstrike.

OR(In the case of a bull putspread): Limited only tothe difference between the

two strikes less the initialcredit; maximum loss isseen if at expiry the stockprice is below the lowerstrike.

Margin:Requiredonlyonthecallssoldorwritten.

Comment:Timevalueerosionis not too significant afactor in this strategy duetothebalancedposition.

Strategy2:CoveredCalls

Strategy rationale: Theinvestor thinks that thestock price will risemodestly over time but isworried about a possibledrawdown first and wantstolimitthedownsiderisk.

Strategy implementation:Theinvestor buys theunderlying stock (hence,coveredcall asopposed tonakedcallwhereonedoesnot own the stock) andsellsorwritesacall(1per

100 shares owned) againstthe stock at the nearestOTMstrikeprice.

Upside potential: Limited tothe difference between thepurchasepriceofthestockand the strike price, plusthecreditforthecallsold.

Downsiderisk:Limitedtothedrop of the underlyingstocklessthecreditforthecallsold.

Margin:Requiredonlyonthecalls or puts sold or

written.Comment:Timevalueerosionworksinyourfavorin thistrade.

CHAPTER14OPTIONS

STRATEGIES:BEARISHTRENDS

NOW, let's assume that youare bearish on the stock youwish to purchase options on.Again, you have nowsatisfiedyourdirectionalbiasquestion. The next thing youneed to do is determine yourrisk tolerance, or, moreprecisely, how confident youare that your stock is goingdown by a significantamount.So you now need to ask

yourself, "Just how bearishamIonthisstock?"

Verybearish:Requiresahigher-riskstrategy.Moderately bearish:Requires a moreconservativestrategy.

Now it is time to lay outour strategies for thesevariousscenarios.

VERYBEARISH

Strategy1:BuyPutStrategy rationale: Theinvestor thinks that thestock will dropsignificantly in the shortterm.

Strategy implementation: Putoptions are bought at the

nearestITMstrikeprice.Upside potential: Profitpotential is unlimited andrises as the stock pricedeclines.

Break-even point at expiry:Strike price plus thespread.

Downsiderisk:Limitedtothepremium paid—incurred ifthe market at expiry is at,orabove,thestrikeprice.

Margin:Notrequired.Comment: If the stock does

little, then thevalueof theposition will decrease astheoptiontimevaluefalls.

Strategy2:SellNakedCallStrategy rationale: Theinvestor is bearish on thestock and quite certain thestock will not appreciateovertime.

Strategyimplementation:Calloptions are sold orwrittenatthenearestATMorITM

strikewithout also holdingalongpositioninthestock(hence,anakedcall). Ifaninvestor is very bearish onthestock,thendeeperITMcalls could be sold orwritten.

Upside potential: Profitpotential is limited to thepremium received. Themore the option is ITM atpurchase, the greater thepremiumreceived.

Break-even point at expiry:

Strikepricelessthespread.Downside risk: Loss isunlimited (since in theorythe price of a stock couldrise to infinity). This is ahigh-riskstrategy,althoughcertainlystopscanbeusedto limit that risk. There isthe potential for acatastrophic loss if thestock gaps up overnightdue to unexpected goodnews.

Margin:Alwaysrequired.

Comment: If the stock doeslittle, and time passes, thepositionislikelytobecomeprofitable as time value intheoptionerodes.

MODERATELYBEARISH

Strategy1:BearCallorPutSpreadStrategy rationale: Theinvestor thinks that thestock price will risemodestly and not fall butwantstolimitthedownsideriskjustincase.

Strategy implementation: Acall option is sold orwritten at the nearest ITMstrike price, and anothercalloptionisboughtat thenearest OTM strike price;

thisproducesanetcredittotheaccount.

ORAputoptionissoldorwrittenat the nearest ITM strikeprice, and another putoption is bought at thenearest OTM strike price;thisproducesanetdebittotheaccount.

Upside potential (in the caseof a bear call spread):Limited to the initial netcredit; maximum profit is

gained if the stock atexpiry is below the lowerstrike.

OR(In the case of a bear putspread): Limited to thedifferencebetweenthetwostrikes (usually $500 percontract) minus the initialnet debit; maximum profitis gained if the stock atexpiry is above the higherstrike.

Downsiderisk (in thecaseof

abearcallspread):Limitedonly to the differencebetween the two strikesminustheinitialnetcredit;maximumlossisseenifatexpiry the stock price isabovethehigherstrike.

OR(In the case of a bear putspread): Limited only tothe net initial debit;maximumlossisseenifatexpiry the stock price isabovethehigherstrike.

Margin:Requiredonlyonthecalls or puts sold orwritten.

Comment:Timevalueerosionis not too significant afactor in this strategy duetothebalancedposition.

CHAPTER15OPTIONS

STRATEGIES:NEUTRAL

THE EARNINGSSEASONPLAY

In thissection, Iamgoing tointroduce you to one of myfavorite options strategies,which can be used only atcertain times of the year: thefour earnings seasons. The

timing of earnings seasonswillvaryslightlyfromyeartoyear as different companieschange their earnings datesover time.For themost part,theyfollowthechangesoftheseasons.Generally,wheneveranewseasonbegins—winter,spring,summer,fall—wecanlookforward toa freshbatchof earnings reports over thenextfourtofiveweeks.With earnings reports

comes a well-recognized

phenomenon: incrediblemarketvolatility.Theoptionsstrategy I will outline in thischapter—called the straddle,oneofthemostmechanicalofall options-trading strategies—will show you how tocapitalizeonthisvolatility.In its simplest form—

straddle on, straddle off—wecan expect returns from astraddlepositioninthe+10to+20 percent range for a holdthat can last anywhere from

two to five days. As long asyou follow my rules to theletter as listed here, youshould expect about a 60percent win rate with thisstrategy. And because this isa compound position (i.e.,both long and short at thesame time), the losses whenincurred are normally small.In its more complex form—leg into the straddle, leg outof the straddle—returns canrunto+50percentormorein

five to eight trading days(legging in and legging outwill be defined later). Boththe simple and the complexforms are taught here. I willfirst narrate the tradingstrategy, then I will offer amoreconcisesummaryat theendofthischapter.

FINDING THERIGHTSTOCKS

What we are looking forwhenwe put a straddle on astock during earnings seasonis an optionable, liquid,highly volatile stock that isjust about to report to thepublic its quarterly earningsresults, and which at pastearnings reports hasfluctuated wildly in price.Whether the stock tends totrade up or down followingearnings does not matter;

whatmattersisthatittendstomove big one way or theother. Three days before thereport goes public, we aregoing to put on (the simpleversion), or leg into (thecomplex version), what iscalled a straddle. We willhold this position for up tofive days following theannouncement (up to sevendays in all), during whichtimewewill look to take theposition off, in most cases,

foraniceprofit.First, let's go over the

searchprocessstepbystep.Asuccessful straddle playrequires a stock that satisfiesthefollowingsixcriteria:1. It is going to report itsearnings three market daysfromnow.2. It is going to report itsearnings after the marketclose, on Monday throughThursday (normally nocompany reports earnings on

aFriday).3.It isavolatileorhigh-betastock.4.Itisaliquidstock(ithasalargedailyvolume).5. It is priced over $40 (thehigher,thebetter).6. Ithasahistoryofgappingup or downmore than $1.00on the day after its earningsannouncement.The first step is to find a

stock that is about to reportearnings. This is easily done

with a free search ofYahoo!Finance's earnings calendar.You will find a link for thiscalendar athttp://biz.yahoo.com/r/. Lookunder "Company Earnings"for the Earnings Dates link.Click on that link and youwillcometoapagethatlists,daybyday,allthecompaniesthatarereportingearningsforthe current week. You canalso click ahead to the nextweek to see what is coming

up. When you do that, youshould be looking at a pagethat looks something likeTable15.1.Alcoa is the company

thought tousher ineachnewearnings season, since it islisted first in anyalphabeticallyorderedlistandthus is given a privilegedposition among thecompanies announcing theirearnings (one of those funnyWall Street rituals). So once

AAreports,itistimetobeginscanning the earningsannouncement pages like theone shown in Table 15.1.Early in the season you willsee about this number ofcompanies reporting eachday, 10 to 20. But the pacequickly picks up, and duringthethickTABLE 15.1 EarningsAnnouncement SchedulefromYahoo!

of the season you will seenumbers well over 100reportingeachday.Whenwe

are out of earnings season,you may see several dayswithout any companiesreporting.We want a stock that is

going to report in threetrading days. Assume thattoday is July 19. I willtherefore be looking for astock that is set to report onJuly 22 after the close. Thereasonwe look only at thosestocks that report after themarket closes is that the

larger moves occur then, asthe news has a chance to bereportedovernighttoalargeraudience. It allows bothevening traders and morningtraders to have a chance tomovetheshares.Here is part of the actual

list of companies that wereset to publicly report theirearningsonJuly22,2006.Asyou can see from this partiallist (only A through Ccompanies), we are now in

the thick of the earningsseason(Table15.2).This is a long list (andwe

areonlyuptotheC's),butwecansoonwhittle itdowntoamanageablenumber.First,weeliminateallthosestocksthatreport "before market open."We are not interested inthose. We can also deletethose where "time [is] notsupplied." Most of those aresmaller companies wewouldn'twant totradeinany

case.So,after the first roundof elimination, this is whatweareleftwith:

Ofthelistthatremains,wewant to select only thosecompaniesthattradeatleast1million shares each day andare reasonably volatile (theytradeupanddownwildlyatapace quicker than either the

Nasdaq or the S&P 500). Ifyou are an active trader, as Iam, and you work from awatch list of stocks selectedfor their high volume andvolatility, as I do, you onlyneed eyeball the precedinglisttorecognizeyourfavoritehigh-beta stocks to short-list.But if you are not familiarwiththesymbolsofthemostTABLE 15.2 EarningsAnnouncement Schedule:

Mid-Season

volatile stocks (and, hence,thebesttrend-tradingstocks),then we have provided herefor you an easy method forchecking.Tocheckforaveragedaily

volumeandvolatility,simplytype the stock ticker at theendofthisURL(afterthe"="sign) and paste it into yourWeb browser. Once it is inyour browser, simply deletethe symbol and type inanother one to check the full

list:http://finance.yahoo.com/q/ks?

s=ThisistheKeyStatisticspagefrom Yahoo! Finance, whichwill give you a reading bothof the average daily volumeand of beta, which, asmentioned, is a function ofthe stock's volatility relativeto the S&P 500. Here, then,are the rules for furtherelimination using thisinformation:

Eliminateallstockswithless than1milliondailysharestraded.Eliminateallstockswithlessthan2.0beta.Eliminate all stockspricedlessthan40.00.

This process of eliminationhasnowwhittledourlistofA—C stocks down to two:AMZN and BRCM. Nosurprises there. To all activetraders—at least at this

writing—these are veryfamiliar symbols, and arenearly always on the list ofgreattradingvehicles.Thenext thingwedowith

these two stocks is go to thecharts and ask this question:What have AMZN andBRCM done in the previoustwo quarters at theannouncement of earnings—are they overbought,oversold, or somewhere inbetween?

AMZN last reportedearnings after the bell onApril 22. In anticipation oftheannouncement,tradersranpriceuptoashort-termhigh,andtheywereright:thenewswas great. AMZN beatestimates by +21 percent!However, on the dayfollowing the announcement,the market sold off stronglyovernight on the news (it'sanother one of those weirdWall Street rituals!), and the

stock gapped down. Thissignaledabuyingopportunityto traders, who then ralliedthe stock back up intoresistance(seeFigure15.1).That is exactly thekindof

volatility that can turn astraddle into an easywinner.This is just what we arelookingforwhenwegobackto the previous two quarters'announcements.Two quarters ago, AMZN

againshowedgreatmove-

Figure15.1 AMZN showingearningsvolatility.ment. The stock wasoverboughtandnearnew52-weekhighs.Earningscameincold, and the stock gapped

down sharply and then wentinto a tailspin for severalweeks. Figure 15.2 is whatthechartlookedlike.Again,anothereasywinner

for the straddle strategy.Clearly, AMZN is going onourlistofstraddlestoputon.Itsatisfiesallourcriteria:itisoptionable and highly liquid,it has a high beta (is veryvolatile), and it goesabsolutely bonkers atearningstime.

Now, let's take a quicklookatBRCM.LikeAMZN,BRCMreportedafterthebellon April 22, 2004. Inanticipation, traders took agreatlyoversoldstockandranit up strongly (this is perfectfor our legging-in strategy—see later description).On theday of earnings, BRCMgapped up strongly tocontinue the trend, then thesharesmetwith resistance. Itcame crashing back down

again over the next severaldays(seeFigure15.3).

Figure15.2 AMZN showingearningsvolatility.

Figure 15.3 BRCM showingearningsvolatility.In the previous quarter,

BRCM did something verysimilar. It ran up into theearnings announcement,gapped up hugely the day

after the announcement wasmade, then proceeded to selloff forseveraldaysafter that(seeFigure15.4).Now we will add both

AMZNandBRCMtoourlistof straddles to put on. Theyhave satisfied all our entryrequirements, and both aregreat candidates for hugereturns during the week ofJuly 19, as we straddle eachstockwithapairofoptions.Thenext thingwewant to

knowis this:whereare thesestocks with respect tooversoldoroverboughtlevelsthreedaysbeforeearningsareannounced? Ifweget a clearoversold or overboughtreading on that day, thenwearegivenagreen light to legintothestraddletrade.Ifnot,thenwewill have to wait toput the straddle on into thecloseofthedaythatearningsaretobereported.Both

Figure 15.4 BRCM showingearningsvolatility.AMZN and BRCM, asmentioned, are announcingafter the close on July 22.This means that we willcheck their chartson July19

todeterminetheselevels.We use the following

technical indicators to tell usjustwherethesestocksareonthe oversold-overboughtspectrum:

RSI(5)readingLess than 30(oversold) or morethan 70(overbought)

Stochastics %K (5)

readingLess than 25(oversold) or morethan 75(overbought)

CCI(20)readingLess than – 100(oversold) or morethan + 100(overbought)

Weneedtoseeatleasttwoout of three of these

indicators give oversold oroverbought readings in ordertogetagreenlighttolegintothetrade.OnJuly10,BRCMhad readings of 24.6, 6.24,and – 140.5. AMZN hadreadingsof18.3,23.17,and–108.4. Clearly, both stocksare in an oversold condition.Ifthesenumbersweretoholduntil July 19 (three daysbefore each announcesearnings), we would thenhave given the green light to

leg into these straddles.Again, if we do not get agreen light, we will not leginto the trade. We will waituntil the day of earnings toput on both sides of thestraddle.Definition:Leggingintoanoptionsstraddleoccurswhenwebuyeachsideofthestraddle—thecallsandtheputs—ondifferentmarketdays.Leggingout

ofanoptionsstraddleoccurswhenweselleachsideofthestraddleondifferentmarketdays.Thealternativeissimplycalledputtingonthestraddle:herebothsidesofthetradeareboughtonthesamemarketday,andusuallyatthesametime.Legging in is thepreferred

modeofentry,sinceithasthepotential of maximizing our

gains. But this is a morecomplex formof the straddleand requires some markettiming. The simpler form ofthe straddle is to put thestraddle on during the daythat earnings are to beannounced.Thiscanbedonein the morning or afternoon;it doesn't matter. In bothcases, however, we will belegging out of the trade. Justhowthesearealldonewillbeexplainedlater.

Keep in mind that astraddle is a market-neutralstrategy,meaningthatwearenot sure going into the tradeinwhichdirectionthestockislikely to go after we put theposition on. We just believethat the stockwillmove,andmove big, in response to itsearnings announcement.Whetheritmovesupordownmakes no difference to us.We will profit either way aslong as the move is big

enough.The straddle is also, like

the bull and bear spreadspreviously described, acompound trade. This meansthatwearegoingtoenterandexit more than one type ofoption. We will, in fact, bebuyingbotha call andaput.These may be bought atseparatetimes,whichiswhatwemeanby legging intoandleggingoutofthetrade.Hereishowwedefinethestraddle

MARKETNEUTRAL

Strategy:StraddleStrategy rationale: Theinvestor thinks that thestock will be very volatile

in the short term but doesnot know which way thestockwillmove.

Strategy implementation:Thecall option and the putoption are bought at thesame ATM strike price; ifthe stock price is betweentwo strikes, then the callandtheputareeachboughtattheneareststrike.

Upsidepotential:Unlimited.Break-even point at expiry:This trade is never held to

expiration;thetradealwaysremains at or nearbreakeven less spread andtimevaluedecay

Downsiderisk:Limitedtothetwopremiumspaid.

Margin:Notrequired.Comment: The position losesvalue with the passage oftime as the time valuedecreasesonoptions.

PUTTING ON THESTRADDLE

Nowwe are ready to put thetrade on. We have twooptions here: either we leginto the trade, meaning thatwewill buy the two sides ofthepositionondifferentdays,or we will simply put thetradeonbybuyingbothsidestogether.

Wearegivenagreen lighttolegintothetradewhenthestock is either oversold oroverbought three days beforethe earnings announcement.Herearetherulesforleggingintothetrade:Three days before

earnings,checkthechart.

If oversold, buy the calloptions at the close ofthatday,andon thedayof the earnings

announcement, buy theputsattheclose.If overbought, buy theput options at the closeof that day, and on theday of the earningsannouncement, buy thecallsattheclose.

That is how we leg into thetrade. Of course, you cantinker a bit with the "buy atthe close" idea. If you aregoingtolegintothecalls,for

example, and the market isstrong in the morning, youmight want to buy themearlier in the day rather thanonly at the end. But thesimplestentry is tobuy themjusta fewminutesbefore themarket closes at 4p.m.EST.Keepinmindthatoptionsdonot trade in after-hourstrading (at least not yet—inthefuturetheylikelywill).Legging into the straddle

positionisastrategyaimedat

maximizing the potentialreturnofonesideofthetradeprior to the big move. Thetheory here is that in anoversold or overboughtmarket, traderswillmovethestockintheoppositedirectiona few days before theannouncement in anticipationof a contrary move after theannouncement.Theothermodeofentryis

lesscomplex.Ifwedonotgeta green light to leg into the

trade, we will simply buyboth sides of the trade, bothcall and put options,sometimebeforethecloseonthedayoftheannouncement.Here is an important note:

we want to buy the samestrike price for each side ofthetrade,anditshouldbethenearest strike possible.Choosing an expirationmonth will follow the samerules foralloptions tradesaslistedpreviously.

TAKING OFF ASTRADDLE

We have selected our stocksto straddle and have enteredboth sides of the trade: callsand puts. Now we need toknowhowlong toholdboth.Hereishowwedothis.Weexpectalargemoveto

occur in the stock overnightasthenumbersareannouncedandspeculatorspileonordersin the after-market tradingperiod. By 9:30 a.m. EST,when the market opens thenext day, we should see asizeable gap in price relativetothepreviousday'sclose.Ifthe gap is up, then our callsaregoingtorampupinvalueandbecomewinnersforus.Ifthegapisdown,thenourputsaregoingtorampupinvalue

and become winners for us.Ofcourse,theoppositeistruefortheothersideofthetrade.Inagapupourputsaregoingto stink, and in a gap downour calls are going to stink.But here is the great thingabout options, and whatmakes the straddle such alow-risk play: because of thedeltafactor,thelosingsideofthe trade will not lose asmuch as the winning side ofthetradewillwin.

As mentioned previously,delta,ortherateofchangeinan option's premium tochange in the value of theunderlyingstock,increasesasatrademovesmoreandmorein-the-money, and itdecreases as a trade movesmore and more out-of-the-money. Inotherwords,abiggapupwillincreasethevalueof our calls more than itdecreases the value of ourputs—andviceversaonagap

down. To our bottom line,thismeansthataslongasthestock moves big, we shouldalways show a profit on thetrade because of the deltafactor, and normally thatprofitislargeenoughtocovercommissions and the spreadand still post a solid double-digit-percentagewinner.Now, after the opening

gap,what usually happens isthat a "fade the news"mentality takes over, and

traders seek to close thegap.Thisisnotalwaysthecase,sowe always have to anticipatea run in the direction of thegap.Often, however, thegapwillcloseandthemarketrunsin the opposite direction (amovewecall,poetically,gapand crap). With all this inmind, we can now establishour rules for closing out thestraddleposition.Hereishowwetakeoffthe

straddle.

If themarketwasoversold(we legged into the straddle)andgapsupmore than$1.00on the open after theannouncement:

Wewill sell our puts atthe open and hold ourcalls.We will hold our callsfor every day the stockputs in a green candle(close is higher than theopen) up to five trading

days after theannouncement.Ifwearestillinourcallson the fifth trading dayafter the announcement,wewill sell them at theclose.

If themarketwasoversold(we legged into the straddle)and gaps down more than$1.00 on the open after theannouncement:

Wewill sell our calls atthe open and hold ourputs.We will hold our putsfor every day the stockputs in a red candle(close is lower than theopen) up to five tradingdays after theannouncement.Ifwearestillinourputson the fifth trading dayafter the announcement,wewill sell them at the

close.

If the market wasoverbought (we legged intothe straddle) and gaps downmore than $1.00 on the openaftertheannouncement:

Wewill sell our calls atthe open and hold ourputs.We will hold our putsfor every day the stockputs in a red candle

(close is lower than theopen) up to five tradingdays after theannouncement.Ifwearestillinourputson the fifth trading dayafter the announcement,wewill sell them at theclose.

If the market wasoverbought (we legged intothe straddle) and gaps upmore than $1.00 on the open

aftertheannouncement:

Wewill sell our puts atthe open and hold ourcalls.We will hold our callsfor every day the stockputs in a green candle(close is higher than theopen) up to five tradingdays after theannouncement.Ifwearestillinourcallson the fifth trading day

after the announcement,wewill sell them at theclose.

If the market was neitheroversold nor overbought (wedid not leg into the straddle)and gaps up or down morethan $1.00 on the open aftertheannouncement:

Wewillsellthewinningsideofthetrade(callsina gap up, puts in a gap

down) at the open andhold the losing side ofthetrade.We will hold our callsfor every day the stockputsinagreencandle,orputs for every day thestock puts in a redcandle,uptofivetradingdays after theannouncement.Ifwearestillinourcallsor puts on the fifthtrading day after the

announcement, we willsellthemattheclose.

If the market fails to gapmore than $1.00 at the open,thenwehaveajudgmentcalltomake.Generally,ifthegapis between $0.50 and $1.00,wecanstillsimplyfollowtherulesaslistedpreviously.Thelarger the dollar amount ofthe gap, however, the moreprofitable the trade will be.Thisiswhyitissoimportant

toselectstocksthatarehigherinprice,areveryvolatile,andhave had a history ofmultibuckergapsatearnings.But if in the event a stock

that has met all our otherconditionsfailstoopenwithagap larger than $0.50, hereare the general rules tofollow:

Ifthemarketisoversold:selltheputsandholdthecalls, as previously

described.If the market isoverbought:sellthecallsand hold the puts, aspreviouslydescribed.If the market is neitheroversold noroverbought: sell thelosing side of the tradeand hold the winningside, as previouslydescribed.

Our expected returns on

any straddle depend a lot onwhether we legged in or not(we will always leg out). Aperfect straddle trade is onewhere we generate a niceprofitinthe three days prior toearnings on our first leg in.We have to cash it out thenext day on the gap for lessthanourmaximumprofit,butwe still bank, say, +10percent. Then the other sideof the trade, which we just

bought on the day ofearnings,getsagreatramp-upon the following day's gap(let's say it ramps up 25percent on the close) andcontinues to run for the nextfivedays.Bythecloseofthefifthday,itmayhavedoubledinpremiumvalue.Thiswouldgive us a total return oninvestment of +55 percent(+110 percent total dividedby 2) in eight trading days.While not all straddles run

this well, enough do if youfollow our rules to the lettertomakethisaveryprofitablesystem. Losses are normallysmallandusuallyjustinvolvethe loss of some time valueand the loss on spreads andcommissions.While these returns may

soundideal,keepinmindthatstraddles work only duringthe peak of earnings season,sowe have only about a 12-to 16-week window each

year. Moreover, there arequiet market cycles wheneven the most volatile ofstocksdonotmovethatmuchin response to earnings.During the straddle off-season, or when the marketsarelessvolatile,wewillneedto turn tooneormoreof theother options strategies listedintheprevioustwochapters.

THE STRADDLESTRATEGY:AN11-POINTREVIEW

Thestraddleisoneofthebesttrading strategies you canhave in your arsenal ofstrategies. It takes somepractice to execute correctly,however,sothebestadviceIcan give is to trade the

straddle initially with a verysmallamountofcapital(youcanstartwithjustone contract per side to getthe feel of it). But after anearnings season or two, youshould be able to putstraddles on and off withsomedegreeofcomfort.Here is a review of the

system as we outlined it inthischapter:1. Get a list of stocksreporting earnings three

tradingdaysfromtoday.2. Eliminate all stocks notreportingearningsafterthebell.

3. Eliminate all stocks nottradingmorethan1millionsharesperday.

4.Eliminateallstockswithabetalessthan2.0.

5.Eliminateall stockspricedlessthan40.00.

6. Check the chart todetermine whether thestock gapped more than

$1.00 at its last twoearnings announcements.Eliminate those that didnot.

7. Check the chart todetermine whether thestock is oversold oroverbought using thefollowingindicators:

RSI (5) reading: lessthan 30 (oversold) ormore than 70(overbought)

Stochastics %K (5)reading: less than 25(oversold) or more than75(overbought)CCI (20) reading: lessthan–100(oversold)ormore than + 100(overbought)

8. We need agreement fromanytwooftheseindicatorsto register an oversold oroverboughtcondition.Ifweget such a condition, then

wewilllegintothetrade:

Buy the calls three daysbefore earnings ifoversold.Buy the puts three daysbefore earnings ifoverbought.Then buy the other halfof the trade before theclose on the day of theearningsannouncement.

9. If neither oversold nor

overbought, we will buyboth sides of the trade onthe day of theannouncement.

10. We will buy the samestrikepriceforeachsideofthetrade,anditwillbetheneareststrikepossible.Theexpiration month chosenshould follow the samerules foralloptions trades,aslistedinChapter12.

11. We will hold both sidesover the earnings

announcement,thenlegoutof thetradeusingtheruleslisted in the previoussection.There is no substitute for

hardworkandreal-time,real-money experience when itcomes to mastering the fineart of trend-trading options.You have in this and thepreceding two chapters anumber of strategies forenhancing your trend-tradingreturns using stock options.

Now is the time to put thisinformation to work. Startsmall:buyacoupleofcallsorputs instead of shares in astock that meets one of ourtrend-trading setups. Afteryouarecomfortablewiththat,try one of the compoundstrategies listed here. If weareinearningsseason,trythestraddle. You may soon findyourselfpreferringoptions tostocks.Butletmerepeata warning I stated at the

beginning of this section onoptions: don't even thinkabout trend-trading optionsuntilyouarefirstaprofitabletraderofstocks.Theleveragefound in options, along withthevariousfactorsthatweighagainst your profit margin(thespread,timevaluedecay,decreasing delta), will soonbringyourtradingcareertoaswift demise if you haven'tyet mastered the art of trendtrading.

PARTFIVETRADINGFORA

LIVING

CHAPTER16THEBIGGER

VISION:WHERETRENDTRADINGCANTAKEYOU

ofuse.IN this last chapter of thebook, I'd like to share withyou two things. First, I wantto talkaboutsomeof the lifelessons that can be learnedfrom trading. I'm of theopinion that if you are notwillingtolearntheselessons,if pride prevents you frombuildingthekindofcharacterthat can both trade well andlive well at the same time,

then you aremuch better off—and your friends andfamily aremuch better off—if you can find some otherwaytoimproveyourincome.And second, I want to

sharewithyouavisionIhavefor where I'd like to see thewhole stock-tradingphenomenongooverthenextdecade or two. It is a visionbornoutofbothmy love forthe trading game and mysense that it can provide

immense benefit to a large,growing, and increasinglyfrustrateddemographicinoursociety: the overworked,underpaid, and, all too often,exploitedworker.

TRADE FOR ALIVING; TRADEFORLIFE

The phrase that begins thissectionis themottoIgavetoBefriendthetrend.com at itsinception back in October of2002. The first half of themotto is taken from the titleof Alexander Elder's famousbook,thebookthatsogreatlyinfluenced my shift fromfundamental to technicalanalysis(readthestoryintheIntroduction) and, of course,that sogreatly influenced the

title of this book. I havealways loved the phrasetradingforaliving.Itevokesall thehopeandpromise thatcaused so many doctors andlawyersbackinthelate1990sto leave their lucrative jobsand set up trading stations inthe basements of theirsuburbanhomes,andsomanybusboys and taxi drivers tobuy shares of Amazon andQualcomm inbetween shifts.To trade is to hope: to hope

for a better life. But unlikemany other hope-inducingschemes, trading is one thatcan reasonably fulfill what itpromises.Iamconvincedthatanyone

with the right mindset,strategic tools, and real-timeexperience can become asuccessful trader—successfulenoughtogetoutofdebt,paycash for a daughter's collegeeducation, retire early, andendow a scholarship at an

almamater.Beyond financial success,

however, the school oftrading can also be animportant teacher ofcharacter. This is where thesecond half of our mottocomes in: not only cantradingprovideagoodliving,it can also help you "get alife."Traderssometimesgetabad rap for being self-centered egomaniacs, and nodoubt this is trueforsomeof

the better-known names inthe business. In many waysWall Street functions a lotlike Las Vegas: theenticement of a huge payoffhas a tendency to lure someof humanity's most seriouslyflawed characters. However,for every "mad money"clown, there are 10 serious,principled, self-possessedtraders grunting out a solidliving for themselves andtheir families with great

integrity and generosity ofspirit.I'mconvincedthattheyare thatway, at least in part,because of their trading.Funny thing about trading: ithas this odd way ofreinforcing virtuous habits ofcharacter.Let me suggest five ways

inwhichtradingcanhelpyouimproveyourpresenceinthisworld.Isyourspouseanxiousnow that you are thinkingabout taking up trading for a

living?Thenhandhimorherthispartofthebook.Spousesmight be surprised to learnthat the people they aremarried tomaywell becomebetter spouses as a result oftheirtradingcareers.

TradingTeachesPatience

Probably the most obviouslesson you can learn from

trading is tobemorepatient.Whether you are planning toholdatradeforseveralweeksor only a few minutes,successful trading requirespatience. Patience means thegood-natured willingness tosuffer (the Latin root of theword patience means "tosuffer") from the delay of ananticipated good. In trading,the good anticipated is ahealthy profit. Oftentimesmarket conditions are such

that that good is delayed oreven negated altogether.What do impatient tradersdo? They act impulsively;they panic; they makemistakes. They trade in andout when they should beholding. They dump smalllosers just before they turninto winners, and they dumpsmallwinnersjustbeforetheyturn into jackpots. No,impatient, impulsive traderswill never win at the trading

game.Thenwhowins?Thosewiththefortitude—acardinalvirtue,by theway,accordingto St. Thomas Aquinas—towait out the markets day inanddayout as theypatientlyapply their time-tested trend-tradingsystems.Inadditiontotrading,Iam

also a runner. I've run onemarathon (and will never dothatagain!)anddozensof5Kand10Kraces,andIputin20to 30 miles per week on the

roads around our home.Running is a great deal liketrading. On a long trainingrun, it is imperative that yousettle into a quiet, efficientpace in order to put in themiles needed to build up thecapacity to endure the fasterpace of the race. Go out tooquicklyandyouriskbreakingdown before your goaldistance. The correct pacingon a long run requirespatience: the runner must

hold himself back, notimpulsivelysurgeforward,inorder to complete the goal.Thesameistruewithtrading.The trading game is amarathon run, not a sprint,and to win it you mustpatientlypaceyourself.

Trading Teaches You How toListen

Toreadachartproperly,youhavetopaycloseattentiontowhatthechartistryingtosay.Youhavetodeveloptheskillof listening to somethingother than yourself. Toomanyofustodayaregreatattuning in to ourselves. Weengage for blissful hours inself-dialogue, and whenspeaking with others we areconstantly thinking of waysto turn theconversationbacktowhatwereallywanttotalk

about. Few of us are verygood at listening. Do youwant to be a great trader?Then you must become agreatlistener.The chart is a pictorial

form of language. The pricepatterns, the indicators, theebb and flow of volume:thesearethewordschartsuseto speak to us. The tradermust be able to hearwhat issaid and respondappropriately. Sometimes

charts just speak noise. Weavoid those charts.Sometimes charts speakbeautifulmusic.Thosearethechartsweplay.Ineithercase,we need to listen attentivelyto hear what the charts havetosay.Listen to this, men:

according to all the polls,whatdowomenwantmostina man? No, not that! Whatwomen want most is a manwho will listen to them, pay

attentiontothem,amanwhowill "get" them. Guys, writethis down: trading can makeyouabetter listener,andthatcan make you downrightsexy!

TradingTeachesYouHowtoBeForgiving

Imagine this scenario: yourun your scans, you eyeball

your charts, and after severalhours of intensive researchyoucomeupwithwhatlooksto be the best trade of theweek.Infact,thischartisthebest-looking chart you haveseen in a long time. Themarkets have been choppyand tough to trade lately, butthissetuplookslikeasurefirewinner. So at the open youfire off your stop-limit orderto enter the trade, and sureenough, half an hour later it

executes. You are now longXYZinsize.Itclosesthefirstday with a +3 percent profit—notabadstart.Itclosesthesecond day at a +5 percentprofit,andthethirddayat+7percent. All is well, and youenvisionthetradehittingyour+15 percent profit target bythe end of next week. Thatevening, however, thecompany comes out withsome bad news: earnings arenot going to be as great as

everyoneexpectedandsothecompany is lowering itsguidance figures by aconsiderable amount. Thenext day, the stock opensbelow your entry price andproceeds very quickly totrade down through yourstop-loss.You are out of thetrade with a loss. In a quickWall Street minute yourhopeshavebeendashed.How do you feel at this

point? I'll tell you how you

feel. You feel betrayed andresentful. The company'smanagement let you down.Theyarebumblingidiots.It'salltheirfault!Or,ifyouareaneurotic like me, you willblame yourself. You shouldhave done more research.You shouldhave taken someprofits while you had thechance.Youshouldhaveseenthat internal weakness in thechart.Ifonlythis,andifonlythat,youwillsay.Regretand

shamecoloryourmood.Now, those are perfectly

understandable emotionalresponses to a disappointingexperience. But are they thebestwaytorespondtoatradegone bad? Of course not.Over time, those negativeexperiences (and at timesthey will come in largebatches)willeventuallydriveyououtofthetradinggameifyou can't get a handle onthem. This is precisely what

trading teaches us to do: inordertogetbeyondtheblamegame or the "woe is me"game,weneedtolearntheartof forgiveness. Forgive thecompany for mishandling abadquarter.Forgivethechartfornotdrawingyourattentionmore strongly to that hiddenpocket of weakness. Forgiveyourselffornotbeingdiligentenough, or prescient enough,orwhatever enough. Forgiveandforgetandmoveontothe

next trade. It is an essentiallesson to learn in life—toforgivethemistakesofothersas well as your own—and itisanessential lesson to learnin the process of trading forlife.

Trading Teaches You to HoldYourBiasesLoosely

AbiasissimplyapartialityI

hold toward some expectedoutcome. Negatively, biasescanhinderusfromevaluatinga situation objectively.Positively, abias is often theonly reason Iwould evaluatea situation in the first place.Let me illustrate. It is oftensaidthatthereisaliberalbiasin the media today. For thesake of argument, let'sassume that that is true.Negatively, this means thatmedia investigations of an

event may not provide uswith an objective reading ofwhat actually happened.Instead, what we get is anassessment from the liberalperspective, not the wholestory. But positively, thatliberal bias is likely whatinitiated the investigation inthe first place. Without thatbias, there might not havebeen enough interest togenerate a news story at all.Hence, biases can play a

productive role if kept incheck: they generate theinitial interest in an outcomeand give that outcome itssignificance.Statistics defines accurate

resultsas results thatare freeof all bias. Science defines awell-designed study as onethat is free of all bias. Butstock trading is not soobjective.We need an initialbias—bullish, bearish, orsomething in between—in

order to generate our initialinterest in, and then ourdirectional commitmenttoward, a particular tradingoutcome.Weneedasenseofwhere we see the marketsheadedovertheshort termatleastsothatwecanapplythemost profitable tradingsystems for thatmarket type.And we need to knowwhether the chart we arescrutinizing ismore likely tomove up, down, or sideways

inthenearfuture.Thisiswhytrend traders use technicalanalysis: moving averages,trendlines, candlesticks, andindicators all help us build arational, probabilistic biastowardthemarketsingeneralas well as toward ourindividualtrades.Traders get into trouble,

however,whentheyclingtooclosely to their biases. Learnthis market mantra: "Let themarketsdowhattheywantto

do!"Ifourbiasgetsusintoatradeanditturnsoutthatourbias was wrong, we need tocling loosely enough to it tolet it go. Too strong a biaswill prevent us from doingwhatweshouldbedoingwitha trade gone bad: taking thequick loss and moving on.Biases can also hurt us withourwinners.Howmanytimeshave we held on to a nicewinner, believing in our biasthatitwouldbeabigjackpot

win only to see those paperprofits dwindle to nothing?All too often, no doubt. Soagain,tradersneedtoholdaninitial bias toward themarkets and truly committhemselvestoitintheformofreal-money trades, but theymust also refuse to cling tothatbiaswhenitprovestobeamisread.

Trading Teaches You to Be

Humble

This brings us to our lastlesson: along with holdingloosely to our biases, tradingteaches us to hold loosely toour pride. The markets arejust too big for any meremortal to conquer. There aretoo many vectors, too manyinputs, too many inter- andintramarket relationships, forany single person to get a

handle on them all—but puttogether a string of healthywinners and you will soonfeel like you are (blast thefanfare)MasteroftheMarketDomain! Strike down thatattitudeassoonasyoufeelitcreeping up on you. No one—not Buffett, not Cramer,not Seykota, not Soros—masters themarket. The bestwe can do is to learn time-tested systems that put asmuch probability on our side

as possible, and then bediligent in applying thosesystemsdayinanddayout.Trading psychologist

Bennett McDowell suggestsin an online article that ahumble, submissive posturetoward the power of themarkets is of much greaterbenefit than an aggressivestance.Hewrites:

Some new traders whohad to be aggressive intheir chosen businesses

tend to think they needtobeaggressivewiththemarkets. It seemslogical. In fact, that iswhat made themsuccessful before assales people, managers,executives, doctors,business owners,entrepreneurs, etc. Intrading however, thisaggressive type ofbehavior canactuallybeyour biggest weakness.

The belief that you canforce the market to dowhatyouwantandmakeyour trade work, justwon't happen! Themarkets are too big. Infact some of the mostsuccessful traders Iknow approach themarket passively! Theytend to "Follow" themarketsandnotforceanoutcome.

Again, learn this maxim:

"Letthemarketsdowhattheywanttodo!"Thisbookgivesyou the toolsnecessary todojust that and earn a greatliving from them. In truth,trend trading is really allabout trend following. Youwillnote that innearlyeverysetupweofferhere,atrendisalready in place—either inprice, in the indicators, or inboth—before we enter thetrade. The prideful traderwants to glory in trying to

outthink the markets, to buywheneveryone is sellingandto sell when everyone isbuying in the hopes ofcatching the reversal beforeanyone else sees it. Butunless you have insiderinformation, or you are asbusiness savvy as a WarrenBuffettoraPeterLynch,itisbesttostickwithwhatworks.What works in trend tradingis a humble posture towardthemarket,lettingittellusas

clearly as possible what it islikelytodonext.Another area where pride

needs to be swallowed andhumility adopted is that ofsticking firmly to yourtrading systems.Letme giveyou an example from one oftheworst trades I'vemade inrecent memory. While mytrading systems normallyrequirethatwesellpriortoanearnings announcement, Idecided to hold one of my

positions over theannouncement in the hopethat the company, like it didin the previous two quarters,would beat Street estimates.The company closed tradingatapriceof25.48,afull+12percent over our entry price.Our subscribers happilylogged their nice gain andmoved on. I, however, wokethe next morning to find thesame stock trading below20.00 after both earnings per

share (EPS) and guidancecame in below the Street.And when the dip buyersfailed to come to my rescue(the stock traded brieflyunder 18.00), I finally soldmy position for a veryembarrassingloss.This kind of agonizing

mistake happens even to thebest of traders, but it cannothappen to successful tradersvery often. What caused meto hold overnight? Well,

greed, pure and simple, yes,but also pride—the pridefulattitudethatledmetobelievethat I knew better than myowntradingsystems.Imaginethat!Soinshort,forthesakeofyourtradingsuccess,adoptahumbleattitudetowardboththemarketsandyourvarioustrading disciplines. Bothknowbetterthanyoudo.

DR. STOXX's BIGVISION: MAKEEVERYONE ATRADER

Several years ago I sat in acommuter'scaféinNewYorkCity's Grand Central Stationwith my brother-in-law,Tony. As the caffeine beganto whirl in our brains, we

talkedofourmutual love fortrading and how we bothwerelookingforwaystotakeour trading to the next level.By that timeIhaddevelopedmostofthesystemstaughtinthis book, and my onlinetrading store,Befriendthetrend.com, hadjustbeenlaunched.Tonyisacomputer programmer,amongotherthings(includingowninghisownISP),andhesuggestedthat theremightbe

awaytoautomatemynightlyresearch routine. Hedescribed the possibility ofsoftware that would screenfor each of our setups,suggestentrypricesandstop-losses,andevenconnecttoanOLB to send in the tradeorders automatically. In thisway,youcouldtrulytradefora living while beingcompletely occupied withsome other activity (such asyourdayjob).

That conversation neverdid get much further thanthat, unfortunately. I am stillwaiting for Tony to sell hisbusiness and devote himselffull-time toprogrammingoursoftware. But theconversation started methinking of ways I couldexpand the outreach of ourservices.Overthenextyear,Ibegan writing up varioushow-to manuals on differenttrading strategies including

swing trading, day trading,and e-minis trading. All ofthese have sold very wellover the years, and they arestill hard to keep in stock.Then we held a four-houronline seminar for over 200beginning traders. Theseminar was so successful,we put on a second seminarfor intermediate to advancedtraders the nextmonth. SoonI started getting calls fromtraders to serve as their

personal trading coach. Thencame requests that I set up ahedge fund for our clientswho were too busy to tradefor themselves. So we did,and the Befriend the TrendFund was born (nowapproaching its fourth year).Then there were requests forarticles to tradingpublications. And now thisbook.Inshort,mypassionfortrading quite quickly becameasmallcottageindustry.

Now, as we head into ourseventh year in business atBefriendthetrend.com, I findmyself asking, "What's next?Where does the dream gofrom here?" Well, I'm notsure where it will go fromhere,butIcantellyouwhereI'd like it to go. Let me insummary form lay out avisionofwhereIhopetoseethe trend-tradingphenomenongooverthenextdecade (and

Befriendthetrend.com alongwithit).

TradingCenters

I'd love to see thedevelopment of trading andeducationalcentersacrosstheUnitedStatesandabroad.I'mnot talking here about thenotorious"propshops"ofthe1990s, so many of which

eitherwent bankrupt orwereindicted for fraud. What Ienvisioninsteadisaseriesoffranchise-worthy storefronts,located in suburban shoppingmalls as well as downtownbusiness districts, that wouldhouse trading stations,plentyof flat panels showingfinancial news, and overheadmonitors to flash marketupdatesandchartsof interestonlargescreens.Thesewouldbe cool, hip places— with

attention paid to interiordesign—where traders couldhangouttogether,talkstocks,trade their accounts, andalong the way, learn a thingor two. Managers of eachcenterwouldbehighlyadeptat technical analysis andreading between the lines ofmoney flow and would beavailabletotradersforadviceand training. Stocks showingpromising technical setupswould be called out over

loudspeakers and their chartsflashed up on the screens. Inback rooms, seminars wouldbe taught each day for thosewanting to strengthen theirtradingskills.Espressowouldbe served during markethours and then microbrewsafter the close. Heck, forgetabouttrading;itwouldjustbealotoffuntohangoutthere,wouldn'tit?I'm not sure what the best

business plan would be to

make sure these centers areprofitable.Perhapstheycouldcomeunderthewingofsomeof the bigger Wall Streetbanksasanextensionoftheirprivateclientservices.What'sin it for them? A number ofthings: increased customerbase, enhanced customerloyalty, positive branding(think Goldman Sachs meetsStarbucks), investmentdiversification (throughowning commercial

property), and certainly anincrease in commissionrevenue, to name a few.Monthly membership fees, acut on the commissionstructure, and sales frombeverages, music, seminars,and educational materialswould likely make theindividual shopsanattractivefranchise.

AutomatedMoneyMachines

Well, one problem with thetrading centers idea is thatmarket hours are usuallywhen everyone has to work,doggoneit.Noteveryonecan(yet) tradefora living.Someofushavetokeeptheolddayjob.Sowhoisgoingtospendtime there on a Tuesdaymorning at 10 a.m.? Mostlyretirees and the unemployed,both groups that tend not tohavethekindofdiscretionary

funds needed to open atradingaccount.So here is an alternative

that would also serve thesame purpose of bringingmore people into the tradinggame: build software for useat home that wouldcompletely automate thetrading process. If we canfind a way to mechanize thesetupscreening,andifwecanfind a way to enter ordersautomatically,andifthesame

software can then updatethose orders at each marketclose, in effect we will havecreated an automatic moneymachine.Wewillhaveturnedall my years of hard workintoaregularATM.Is this possible?Sure it is.

Currently there exist chartpattern recognition software,technicalparameterscreeningsoftware, and automatedorder entry and ordermanagement systems. Why

couldn't all these be puttogether into a singlepackage? Why couldn't wedesign software to (1)determine the generalmarkettype (as mentionedpreviously), (2) screen fortrade setups to match themarkettype,and(3)enterandexit those setupsautomatically, in hands-offfashion?Certainlythiscanbedone.Anysoftwareengineersoutthereinneedofajob?

Okay, there is one glaringproblem facing the creationand marketing of such atradingmachine.Let'ssaywewere successful in buildinganautomaticmoneymachinethat would screen for andtradeonly themost fittingofall our trend-trading setups.Andlet'ssaywethenwantedto offer this software to thepublic.Sowehireatop-notchadvertising firm and get theword out. We put on e-mail

campaigns; we send outdirect-mail fliers; we buyradio and even televisiontime. And soon the orderscome streaming in. We sell500copies...andthen1,000. . . and thenword ofmouthkicks in and we are quicklyup to 5,000, then 10,000.Then we make a fewrefinements,bringoutthe2.0version, and sell another10,000 copies. So now thereare 20,000 traders out there

using our money machine totrade their accountsautomatically. That's areasonable figure for a pieceof software that might retailfor around $2,000 (plus themonthlydatafee).Do you see where this is

going? Let me spell it out.Say the machine issues asignal tobuyKLACat50.00per share. KLAC is a prettyheavily traded stock. Theaverage number of shares

tradedisaround5millionperday. But look what happenswhen 20,000 traders get thesame signal to buyKLACat50.00pershare.Ifeachtradertakes an average position of500 shares (somea lotmore,some a lot less), that makesfor 10 million shares aimingat a single entry price of50.00. That's over twice theaverage daily volume tryingtoenterthemarketinthefirstminute of trading. Is that

going to happen? No way.EitherKLACwillgapupandover50.00andnotlookback,or it will gap open at 50.00,run up a bit, then collapseonce all that volume isassimilated. Neither scenarioprovides a profitable tradingenvironment.Is there a solution? Yes

there is, and it's calleddiversification. We need tocomeupwithnotonemoneymachine but dozens of them.

We need to have moneymachines for day traders,scalpers, swing traders,overnight and positiontraders; for those with high-risk and those with low-risktolerances; for large accountandsmallaccounttraders;forprofessional moneymanagers;andfortheaverageJoe trading his IRA. Thencome the sector moneymachines, the ETF moneymachines, the e-mini money

machines, the Forex moneymachines—and on and on itgoes. In this way we spreadthe wealth, the order flow,and,hence,theriskaswell.

Personal Trading CoachesNetwork

One last dream I have fortrend trading over the nextdecade is to establish a

network of personal tradingcoaches. These coacheswould be trained at one ofseveral training facilities (seethe trading centers ideamentioned previously) toserve individual traders inneedofprivatecoaching.Andwhy not? Today we havefitness coaches, weight losscoaches, childbirth coaches,and motivation coaches. Wehire coaches to help us learnhow to cook, knit, do yoga,

and get closer to God. Whynot hire a coach to help uslearnhowtotrade?I envision a network of

dedicated, licensedprofessionaltraderswho,asameans to supplement theirincome, would travel to theclient's home for a series ofone-on-one sessions. In thisprivate setting, every aspectof trading could be covered,fromsettingupthewatchliststo screening out the best

trades. Higher-level skillssuch as tape reading, spreadtrading,andhedgingcouldbetaught to more advancedclients.Andallclientswouldbenefit from various tradingvisualizationexercises ledbythe coach in order to bolsterthehealthytrader'smindset.I know that this kind of

one-on-one mentoring reallyworks well for taking amediocretrader,evenalosingtrader, to a high level of

trading success. I've beenprivilegedtocoachseveralofourclientspersonally,intheirhomes at their owncomputers, andhave found itto be a very rewardingteaching experience.Certainly it is the mostefficient way to conveytradingknowledge.Oftenitissimply a matter of spottingone thing the trader wasdoing wrong and thensuggestingaremedy.Inother

cases it is a matter of doingsome serious structural workon the entire trading system.However the coachingproceeds, it is a wonderfullyeffectiveprocess,andIwouldlike to see it become moreandmoreaccessible.

FINALTHOUGHTS

hobbies you can have. Overtime, and with the righteducation and experience, itcanbecomeaveryprofitablehobby—soprofitable, in fact,thatyoucanmakeaverynicelivingfromitandneverhaveto hold a real job again(unlessyouconsidersittinginfront of a computer andclicking a mouse now andthenarealjob).Ibelievethatyou now hold in your handsall youneed to know to take

your trading to the highestlevels of success. Trendtrading is right at the sweetspot of what trading is allabout, and this book is yourkeytolearninghowtotrend-trade.Trend trading can be the

means to many wonderfuland important ends, but assoon as it becomes yourraison d'etre, you have lostthebattleforbalance.Hereisa test:What is the first thing

you think about when youwake up? What is the lastthing you think about as youdriftofftosleepatnight?Isitthe same thing? And is thatthing trading?Nowhere is awarning:ifyourfirstandlastthoughtsof thedayareabouttrading, then trading for youisnolongerahobby—itisanaddiction.It is natural (and I'm

speaking from experience) tobe so excited about your

tradingsuccesses that the joyand hope of it all coloreverythingelseyoudowitharesplendent glory. It islikewise natural (again fromexperience) to feel sodespondent about yourtrading failures thateverything else you do isburdened by a darkmelancholy. If you do nothave some means of gettingbeyond this emotional rollercoaster, of living a life of

stable productivity despitewhat the market does, it isperhaps best if you do nottake up trading at all. Orbetter yet: determine rightnowtobuildintoyourselfthekind of character that canfunctionwell,relatewell,andin every way be wellregardlessofwhatthemarketdoeswithyourmoney.You now know where to

open your online tradingaccount, which charting

packagetouse,howtosetupyour charts and watch lists,how to scan and screen eachday forviable setups,how towhittle your results down tothe best one or two setupseachday,andatwhatpricetoenter and exit your trades.You also have a variety ofresources that should helpyou develop the sort ofmental approach to yourtradingthatwillallowyoutofollowourguidelines.Thisis

acompletesystem.Study thesetupsinthisbookuntil theirvarious parameters arememorized.Thenapply themrigorously, and watch asslowly, over time, youraccountbeginstoblossom.I want to leave you with

threefinalthoughts.The first is this:bepatient

with yourself and with yourtrading. Trend trading is notby any means a get-rich-quick scheme, but it

potentially is a get-rich-slowscheme. You will see netgains over time. Over thelong haul (and Imean years,not months), you will seesubstantial gains. Stick withthissystemfora lifetimeandyou may very well seephenomenalgains.Thesecondisthis:thereis

alwaysroomineverytrader'stoolbox for ingenuity. WhileI've made every effort tomake our 10 trading setups

and our options systems asmechanicalaspossible,1,000traders reading thisbookandapplying our 10 setups willnot come up with the samestockstotrade.Thereisroomfor interpretation, evenexperimentation within thebasic parameters. It isimportant to find what youare most comfortable with,what best suits yourtemperament and lifestyle,and thenstickwith that.And

that sticking-to-it-ness reallyis the key: once you haveyoursystemestablished,stickwithit!The third is this: you can

do it! No matter whatlanguage you speak, whereyou went to school, howmuchmoneyyouhavetostartwith(okay,thatonemattersalittle),youcanopenatradingaccount,buyafewshares,putonstop-lossandtargetorders,andmakesomemoney.Don't

letfeargetinyourway.If confusion is now your

obstacle,thenthatismyfaultand I am wholeheartedlysorry.Writeme, "Dr Stoxx,"atsupport@befriendthetrend.comif you have any questions. Iam always here to help.Godbless you in all yourendeavors, and especially asyoutrend-tradeforaliving!

AcceptanceandCommitmentTherapy(ACT)AIM system. See Automaticinvestment management(AIM)American-styleoptionsAnalysis, technical. SeeTechnicalanalysisApple Inc., See alsoMacintoshcomputersAssigned option holder,definedAssignment,options

At-the-money,definedAutomatedmoneymachinesAutomatic investmentmanagement(AIM)Averagedailyvolume:

checkingonlineaswatchlistcriterion

Averagetruerange(ATR)

Baruch,BernardBearishdivergenceBearishoptionsstrategiesBearishtrends:

defineddeterminingoptionsstrategiesstockselectionandtechnicalanalysistypesof

BefriendtheTrendTrading:ETFsandgrowthofhedgefund

mottonewslettersoptionstradingrulesseedsofandshortsellingspreadsheethelpstockselectionwatchlistsWebsite

Benchmarks,generalmarketBeta:

checkingonlineandstraddlestrategyaswatchlistcriterion

BloombergTelevisionBlueseabreakdownsetupBlueskybreakoutsetupBollingerBandsBroadwingBrokaw,TomBrokers,onlineBTTT-MAX,explainedBuffett,WarrenBullflagsetupBullishbasebreakoutsetupBullishdivergencesetupBullishoptionsstrategiesBullishtrends:

defineddeterminingoptionsstrategiesstockselectionandtechnicalanalysistypesof

Buy-and-holdinvestingBuying strategies. See EntrystrategiesBuytoclose/open,defined

CalloptionsCandleglance(Stockcharts.com)Candlestick formations. SeeJapanesecandlesticksCAN-SLIMstrategyChannellinesCharacterbuildingCharitablegivingChartreading

markettypespracticescoring

Charts,price:eyeballingimportanceofindicators role in technical

analysissettinguptrendlines/channels

CheapStocksNewsletterClearstation.comCNBCTelevisionCNN-FinancialNetworkCoachingnetworksCoiledspringsetup

Commissions,minimizingCommodity channel index(CCI)Computers:

hardwaresoftware

ConsolidationbasesCosts,trading:

commissionsstart-up

Cramer,JimCup-and-handleformation

Darvas,NicolasDatekDaytrading:

disfavorofgoalsforastrend-tradingsystem

Deadcatbounce,definedDeltafactor:

definedandoptionsstrategies

andstraddlestrategyDIA. See Dow JonesIndustrialAverageDial-up service, versus high-speedDigitalTigersDirectionalbiasDirectionality, market. SeeMarkettrendsDivergence:

bearishbullish

DojiformationsDouglas,Mark

Dow Jones IndustrialAverageDowntrend,definedDowntrendingstock,defined"Dr.Stoxx,"22

tradingrulesvisionsforfutureWebaddress

Earningsseasonsstrategy:executionoflogicbehindstockselectioncriteria

Elder,AlexanderEngulfingformationsEntrystrategieseSignalsoftwareE*TradeEuropean-styleoptionsEveningstarformationsExchange-traded funds(ETFs):chart-readingpractice

asscreeningtools

ExercisingoptionsExitstrategiesExpectancy,definedExpirationdateEyeballingtechnique

"Fadethenews"factorFarley,AlanS.,Futureoftrading(Dr.Stoxx)

automated moneymachines

personal tradingcoaches

tradingcenters

Gapandcrap,definedGapdownsetupGeopolitics, effect on stock

marketGet Out of Your Mind andIntoYourLife(Hayes)GoldmanSachs

HammerformationsHardware, trading. SeeComputersHayes,Steven

Hedge funds, Befriend theTrendHedgiesHedgingagainstriskHermeneuticalproblemHolder,optionsHow I Made $2,000,000 intheStockMarket(Darvas)How to Make $1,000,000 inthe Stock MarketAutomatically(Lichello)How to Make Money inStocks(O'Neil)

Indexes,asbenchmarksIndexNewsletter,TheIndicators,technical

CCIdefaultchartsetupMACDOBVRSISMAsstochastics

straddlestrategyInteractiveBrokers(IB)International Institute ofTradingMastery,Inc.Internet service providers(ISPs)Internet trading, effect onstockmarketIn-the-money,definedIntrinsicvalue,definedInvestradeIQChartsIRAs,optionsand

Japanesecandlesticks:

as component oftrending

formationsJournals,trading

LegginginLeggingoutLeverage,optionstradingLichello,RobertLifelessons,trading-related:

characterbuildingforgivenesshumilitylisteningskillspatienceproductivebiases

Liquidity:ofoptionsandstraddlestrategy

valueofLong,definedLosingpositions:

caveatsminimizing

Losses, managing. See Stop-losses

Macintoshcomputers:

chartingsoftwareforversusPCs

MadMoney(CNBC)Margincalls,shortsellingMarginrequirements:

forbearishstrategiesforbullishstrategiesforoptions

Markettrendsbearishbullishrange-boundandtechnicalanalysistypesof

MarketWizards(Schwager)MarketWizardstoriesMaster Swing Trader, The(Farley)MAXsystemMBTradingMcDowell,BennettMedved,JerryMerrillLynchMetaStocksoftwareMonitors,computerMorningstarformationsMovingaverages:

as component of

trendingMACDindicator

NakedcallsNakedputsNasdaq,asbenchmarkNetZeroNirvanaSystemsNison,Steve

Nontrending markets. SeeRange-boundmarkets

OmniTrader (NirvanaSystems)Onbalancevolume(OBV)O'Neil,WilliamOnline brokers. See Brokers,online

Optionstrading:advantagesofbearishstrategiesbullishstrategiesdisadvantagesofearningsseasonscriteriaexplainedparametersrulesforstraddlestrategyterminology

Oscillators,technicalOut-of-the-money,definedOvernighttrading

Overtrading

ParabolicSARstop-lossPCsversusMacsPercentageprofitexitPercentagestop-lossPiercingformationsPivothigh,definedPositiontrading

Premium,options:definedfactorscomprising

Price.SeealsoCharts,price as component of

trendingasentryfactoroptionsaswatchlistcriterion

Pricecharts.SeeCharts,pricePricepatternstop-lossPriceresistance/supportexitPricetrend,definedProfittaking

PsychologyoftradingPullbacksetupPutoptions

as alternative toshorting

definedin-/out-of-the-money

PuttingonthestraddlePyramiding,defined

QQQQ,definedQuote.comQuotetrackersoftware

RAMrequirementsRange-bound markets. SeealsoChannellines

defined

exampleandtechnicalanalysistradingstrategiesfor

RBCCarlinEquitiesRealTicksoftwareRecord-keepingjournalsRectanglebasepatternsRelativestrengthindex(RSI)ReliefrallysetupRising wedge breakdownsetupRisingwedgepatternRisk:

managing

optionstradingstraddlestrategytoleranceforandtrendtrading

Risk/rewardratioRockefeller,JohnD.Rollingover,definedRuleofThreeRussellIndex,asbenchmark

S&PIndexes,asbenchmarksSatelliteserviceScalpingSchwabSchwager,JackScottradeScreening:

for bearish divergenceplays

forblueseabreakdownplays

for blue sky breakoutplays

for bullish basebreakoutplay

for bullish divergenceplays

forcoiledspringplaysETFsasforgapdownplaysforpullbackplaysforreliefrallyplays for rising wedge

breakdownplaystoolsforwinnowingprocess

Sector indexes, as

benchmarksSelltoclose,definedServiceproviders:

feeversusfreeISPsonlinebrokers

Setups,stock-screening:bearishdivergenceblueseabreakdownblueskybreakoutbullishbasebreakoutbullishdivergencecoiledspringgapdown

pullbackreliefrallyrisingwedgebreakdown

Seykota,EdShortsellingSiliconInvestorSimple moving averages(SMAs)Software.SeeComputersSPY,definedSPYchartexamples:

withallindicatorsbearishmarketsbullishmarkets

withCCIwithMACDwithOBVrange-boundmarketswithRSIwithSMAswithstochastics

StochasticsStockcharts.com:

for bearish divergencesetup

for bullish divergencesetup

Candleglancefeature

chartingservicesforcoiledspringsetupsforgapdownsetupforpullbacksetupsforreliefrallysetupwatchlistscreening

Stock indexes, trend tradingandStock market. See alsoMarkettrends

author'sinitiationintodescriptionof

Stock options. See Optionstrading

Stocks, selecting. SeeScreening;TrendtradingStop-losses:

dailyadjustingofmethodology

Straddlestrategy:executionoflogicbehindstockselectioncriteria

Strikeprice,definedSuretradeSwingTradeNewsletterSwingtradingSymmetricaltrianglepattern

TC2000chartingsoftwareTechbubble,WallStreetTechnicalanalysis,astradingmethodologyTerrorist attacks, effect onmarketsTharp,VanK.Timevalue

TimevaluedecayTools,trading

hardwareISPsonlinebrokerssoftware

Traders,successful:charactertraitspsychologyofrulesfor

TradeYourWaytoFinancialFreedom(Tharp)Trading. See also Trendtrading

a.m.versusp.m.caveatsascharacterbuilderhobbyversusaddictionashome-basedbusinessforlifereal-timetipsrecord-keepingjournalsvalues-basedvisionaryideasfor

Trading Behavior Dynamics,Inc.TradingcentersTradingforaLiving(Elder)

Trading in the Zone(Douglas)TrailingstopsTrendlessmarket,definedTrendlinesTrendTradeNewsletterTrend trading. See alsoBefriend the Trend Trading;Markettrends;Trading

advantagesof bearish divergence

setup blue sea breakdown

blueskybreakoutsetup bullish base breakout

setupbullishdivergencesetup versus buy-and-hold

investingcoiledspringsetupdefinedfutureofgapdownsetuplifelessonsfrompullbacksetupreliefrallysetuprisingwedgebreakdown

setupselectingbearishstocksselectingbullishstockssubjectivityandsystemscomprising

Trianglepatterns:consolidationbases narrowing channel

formationwedges

Trump,Donald

Underlyingasset,definedUnfilledgapdownUptrend,definedUptrendingstock,definedU.S.NewsandWorldReportU.S.Trader'sExpo

Values-basedtradingVectorVestsoftwareVision,author'sVolatility,market:

exploitingmeasuringandoptionstradingandstraddlestrategyandtimevalue

Volume. See Average dailyvolume

WallStreetJournalWatchlists:

eyeballingtechniquemaintainingsettingup

Websites: Befriend the Trend

Tradingcandlestick-relatedDr.Stoxx

InternationalInstituteofTradingMasteryYahoo!Finance

WedgepatternsWhitmanStockMarketGameWilder,WellesWordenbrothersWriter,options

Yahoo!Finance

Zwanger,Dan

ABOUTTHEAUTHOR

been actively involved in themarkets since 1996,following several years ofstudying technical analysis.He holds a master's ofdivinity degree fromPrinceton TheologicalSeminary, and master's anddoctorate degrees inphilosophyandtheologyfromOxford University. Inaddition to trading andmanagingasmallhedgefund,Dr. Carr is a tenured

professor of religious studiesand philosophy at MountUnion College in Ohio. Hehas been interviewed by theWall Street Journal andU.S.News and World Report forhis insights into tradingpsychology. His previouspublications on trading haveappeared in Active Traderand Technical Analysis ofStocks andCommodities. Dr.Carr is also theauthorof thepopulartextbook,Introducing

Death and Dying (2005:Prentice-Hall).Dr.Stoxxbegan tradingas

a part-time hobby until twoyearsof losses forcedhim todo more research. Heattended several tradingseminars and studied undersomeof the topnames in thebusiness,includingAlexanderElder, Steve Nison, andWelles Wilder. Soon hebeganexperimentingwithhisown trading systems. The

result was a set of time-tested, proprietary tradingmethods that have proved tobeveryprofitableinalltypesof market conditions. Thesesystems are based on theessentials of technicalanalysis but also incorporateDr.Stoxx'suniquemethodofassessingmarketpsychology,sector strength, and generalmarket directionality. Highlyskilled as a tape reader, Dr.Stoxx possesses an uncanny

abilitytotimehisentriesandexits,oftenjustpriortomajormoves. Dr. Stoxx is CEO ofBefriendtheTrendTrading,aWeb-based advisory andtrading education service(www.befriendthetrend.com).He also serves as generalpartner of a capitalmanagement company thatprovides wealth-creatingopportunities for accreditedinvestors.Dr. Stoxx lives with his

wife and two daughters innortheastern Ohio. He is infrequentdemandasaseminarspeaker and private tradingcoach. For bookinginformation, please sendenquiries todrstoxx@befriendthetrend.com.

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