I had planned to sell the book and do weekend workshops but I have decided to share what I have written for free on my Blog, I am fortunate enough to make a decent living doing what I love and if I can help others achieve that goal that is payment enough for me.
Each day I will post a page or chapter from the workbook. I hope you find it helpful. For some it may be a little too basic and others may disagree with my approach and the way I interpret the markets. I am good with that> If just 3 people benefit and pay it forward then I couldn't ask for more.
Here is the first post
Opportunity
Day trading, swing trading, or long term investing. The stock market provides opportunity for everyone. Whether you seek to earn daily income or you’re looking for a way to make your money work for you to provide additional income to achieve financial independence. The stock market can help you achieve your goals. The lure of easy money is very tempting and often people go rushing into the market with delusions of grandeur. Reality is 90% of day traders and many investors fail or struggle to break even. There are many reasons for this and the purpose of this workshop manual is to help you avoid those pitfalls regardless of the type of trader you want to become. Most people fail because this is a difficult, time consuming, emotionally charged industry that requires passion, hard work, strategy and discipline. If you are willing to learn, to do what it takes to succeed, this will serve as a map to help you get there.
My Journey
My background consists of being involved in the stock market for the better part of my life. My beginning was as a young strapping stud at the age 20. I had tremendous success over the years, along with some complete failures when it came to investing. Fortunately for me, my successes far outweighed my failures. It was that success that gave me my passion for stocks and investing. Ultimately it is that success that has allowed me to pursue my dream of making my living trading the market. I have worked hard all my life and been everything from a butcher to a baker but I was never a candlestick maker. I had a very successful career in the corporate world but my true passion has always been stocks and I needed to find a way to make a living trading them. Investing is a long term strategy and one that can pay off huge but it takes time, lots and lots of time. Its fundamental analyses and doing research, its understanding a company and its potential, reading the balance sheet and listening to conference calls while having some vision as to where things are heading. Investing is what gave me the funds to learn how to make a living trading. I like finding the hidden gems out there and I have the patience to let those gems develop. Some may refer to that as "bag holding" but if the bag you are holding continues to grow because the cash in it continues to expand well then that's a bag I don't mind holding onto.
Now, with the day trading tools, and the technical analyses of charts I have a whole new arsenal that has allowed me to achieve my dream of trading for a living. I have the tools to do so successfully. However, I am also still investing, I have become a hybrid I am an investor / day trader /unemployed comedian.
I am finally free, I can work from anywhere and I answer to no one. There is no better feeling in the world. This has been a long journey and one that I will continue to travel successfully. It is my best hope that this manual will contribute to your success as well. Regardless of what type of trader/ investor you wish to become.
I do not consider myself a ”GURU” and the opinions here are just my opinions. I am not a financial advisor nor am I a licensed securities trader. I decided to share what I have learned on my journey and what has worked for me. Results will vary for each individual and in no way am I suggesting that if you follow every word of this blog that it will guarantee success.
Where Do We Begin?
Let’s first start by asking you a question. Are you willing to do whatever it takes to succeed? Recognize that the odds are stacked against you. You will not learn to be successful in this business through osmosis! That would be like me hanging out with a bunch of gym rats and expecting my body to transform to look like theirs without putting in the hundreds of hours they spend getting the results they desire.
To be successful you will need to put in thousands of hours of HARD WORK. It will require you to learn how to evaluate your risk reward, technical analyses, develop a strategy/game plan, discipline, psychology /emotional intelligence, the markets and how they work, your strengths, your weaknesses, break bad habits, and change the way you think about the markets and money management. It’s a journey that requires true passion and commitment. One where you will likely have more losing trades than winners, where your will to succeed will be tested each and every day. Do you have what it takes? If you think you do then let’s get started.
Build a Strong Foundation
To be successful in trading there are four principles you need to learn. Consider this the foundation that you will need to build off of. First you need to do a reality check. By this I mean, you may want to be a day trader and have this be your new career but before you go quitting your job to venture off on your new career we are going to make sure your vision is grounded in reality. We are going to define what your risk tolerance is and what type of trader/ investor you should work towards becoming.
We are going to explore market psychology and your emotional intelligence to help you understand not just yourself but the crowd psychology of the market and the role it will play in helping you succeed. You may be surprised by what you learn about yourself and the crowd. Understanding the role of psychology and the dynamics of it are crucial to your success.
We are going to learn about the different phases of the market and how to analyze them. More importantly you will learn what to do for each market phase and various trading systems to navigate them. You will learn specific chart setups, classic patterns and some of my own signature setups, aligning on multiple time frames, volume Indicators, scanning tools, trends, channels, and a host of other technical trading tools and strategies. You will not learn every trading system out there nor will you learn every indicator that can be used. I tend to try and keep things as simple as I can and it has worked for me.
Money management is without question a huge component to the ultimate success or failure of any trader. This is probably the most neglected aspect of trading when it comes to beginners. If your money management is poor you will be out of business after a few losing streaks that are inevitable to happen. The losses can destroy an account if they are not managed properly. As long as you have inventory, meaning cash, then you have a fighting chance at success. Sound money management techniques will give you longevity and better odds for success as you continue to refine and learn your new trading skills. Simply put it keeps you in the game longer, and blowing up your account is not an option.
It is these four ideas that we are going to focus on and by the end of this compilation you will be better equipped to go after and achieve your goals of becoming a successful trader.
Reality Check
Reality Check
So let’s start by taking a hard look at who we are, what we are working with and what type of trader/investor we should be. I cannot tell you how many people I have talked to that have this fantasy of what they are going to do and what type of trader they are. I say fantasy because their perception of what it’s going to take to succeed if often flawed and not based in reality. For example If you have a $6000 dollar trading account and you think you are going to be able to quit your job and trade full time as a successful day trader you are living in fantasyland. The pressure of having paying your bills, to support yourself off of your trading earnings with add to the pressure and potentially influence you to make poor trading decisions. I am not suggesting you cannot take a $6000 dollar account and turn it into $100k and pay all your bills. I am sure there is someone out there that has done so but I would venture to say that it is few and far between.
It’s my opinion that if you want to be a full time day trader you need to have a minimum of 25 to 30K anything less and you have to deal with the PDT. The following is the link for the FINRA website and it will tell you everything you want to know about the “Pattern Day Trader “rule.
There are prop trading firms that give you an opportunity to leverage your capital and enable you to circumvent the PDT rule.
Proprietary (or prop) trading is a high-risk form of trading where instead of acting on clients orders and receiving commission payments, the trader assumes his own position with the capital of the firm. This means they will experience the full profit or loss of the position. Prop trading firms trade electronically and the traders can use the leverage of the firm to magnify returns (and losses).
For beginner traders, I think this is a bit like handing a loaded gun to someone with suicidal tendencies. I am not suggesting that you are guaranteed to fail but the amount of risk you are taking by leveraging up your account is tremendous. One losing streak could not only wipe out your account you could actually end up owing money. You need to know your abilities and your limitations. If you want to start using margin, then you should do so after you have established yourself as a consistent profitable trader with a solid trading system, and superb money management skills.
I don’t mean after you have one week of beginners luck as the market is ripping to new all-time highs. I mean a consistent track record in good times and bad for no less than one year. This is not a sprint to the finish line, nor is it a get rich quick strategy.
It’s a marathon, a chess game that requires you to be methodical in your approach and disciplined throughout the entire process. When you are first starting out, it should be about how well you are able to execute your specific style of trade, using a well-defined strategy that you are comfortable with. You need to evaluate your performance based upon how closely you adhere to your game plan/strategy and not about your percentage of gain or loss. Consistency is key, focus on the system and execution; evaluate your discipline within the process, by using this mindset, you will make it easier to identify where problems exist so that you can solve them. No matter what style of trader you are, consistent performance evaluation will greatly improve your chances for success. The profits will begin to flow consistently only after after you have established a sound disciplined system.
The four styles of day traders
Scalp traders, Momentum traders, Faders, Pivot players
Let’s look at each of the different styles in more detail and see if we can determine what style is best suited for your personality and risk tolerance. We also need to make sure you have the necessary amount of time, tools and account size to realistically pursue that style.
The scalp Trader: The scalp trader typically works with very short time frames often using 1 minute, 3 minute charts. Scalpers are looking to take quick scalps out of a stock as it breaks out of patterns intraday. It requires precise execution and market timing. Scalpers specialize in taking profits on small price changes it requires them to have a very strict exit plan since one large loss can eliminate many small gains that a scalper has worked to obtain. The whole strategy is based on achieving results by increasing the number of small percentage winners while sacrificing the percentage size of the wins. They often sell just after reaching profitability. Scalpers trade long or short and they typically take lots of trades throughout the day it would not be uncommon for them to take anywhere from 10 to 100 trades in a single day. This style requires you to have a fairly sizeable account and you will most likely need to trade with margin. You will need to be glued to your monitor the entire day with your eyes paying close attention to the markets and the stocks you’re attempting to scalp. You will be paying a boatload of commissions and one large loss can wipe out multiple wins. You will be all cash at the end of the day and have no exposure to the markets after the close.
Momentum traders: This strategy usually involves press releases like earnings reports; they can be fluff pieces or substantial news events. Typically it is a strong trending move that is supported with high volume. Momentum traders may buy the news release and ride the trend until it begins to lose its strength and exhibits signs of a reversal. Some momentum traders will fade the price surge when volume dries up and a bearish candle begins to form. Momentum traders could hold their positions for minutes or it could be for hours. They typically work with the 5 minute 30 minute and daily charts. Momentum traders are trying to jump on board and ride the train to a desired profit. There are many things a momentum trader will take into account. The news itself, the premarket or post market action, the overall market direction, the technical indicators for support and resistance and the overall risk reward profile. Momentum traders also need to stay glued to the screen. Potential pitfalls of momentum trading are chasing a stock after it has already made the bulk of its move. Closing a position too late, after saturation has been reached and volume dries up giving all the potential gains back. Failing to act swiftly and exit when the trade goes bad and riding the momentum the wrong way down the tracks.
FADERS: Fading involves shorting stocks after a parabolic move upward. It’s based on the assumption the stock has run too far too fast. They are overbought, early buyers want to start profit taking, and existing buyers are starting to lose confidence and getting shook out of their position. This requires a margin account and typically short sellers have several brokerages they trade with which allows them to be able to find the availability of shares to borrow. This can be extremely rewarding since stocks often take the steps up and the elevator down. Price target with this strategy is when buyers begin stepping in with conviction it’s time to book profits. Since shorting requires you use margin to make the trade it can be extremely risky. Let’s say you have a stock that has a news event and it begins to plummet. You short the stock in anticipation of it getting whacked, the stock is halted and the news is clarified with a statement form the company which turns out to be positive. Because of the margin element this could be a very painful experience. Fading also requires you to be glued to the monitor all day.
The Pivot Trader: A pivot point is a price level of significance in technical analysis that is used by the pivot trader as a predictive indicator of price movement in a stock. Pivot points are associated with support and resistance levels, a pivot point can be calculated as an average of the high, low and close of the previous day. These can be used to determine a measured move in the stock by subtracting or adding price differentials calculated from previous day’s trading ranges. They typically use short time frame intraday charts 3 minute, 5 minute and 15 minute. There is R1 through R3 and S1 through S3.The R represents resistance and the S represents support. In its simplest form, the strategy is to enter @ R1 or S1 scale @ R2 or S2 and then exit the balance @ R3 or S3. This again requires being glued to your monitor all day.
Day trading: Day trading can be extremely lucrative and allow you the freedom to be your own boss. You can day trade from anywhere in the world and if you have a disciplined strategy you can make a tremendous living. Realistically, I suggest that you have a minimum account size of 30k. Recognize that day trading requires you to be glued to the computer all day. If you have a full time job, day trading is probably not the right strategy for you. It can be extremely stressful; and it can lead to overtrading resulting in paying out large commissions to your broker. There will also be tax ramifications from taking short term capital gains. I recommend NOT using margin until you have established yourself as a consistently profitable day trader with at least one full year of experience under your belt. Pick one day trading strategy that you are most comfortable with and try to master it. Do not try to be a jack of all trades when you are first starting out.
One advantage of day trading is that you will not be subject to market /stock volatility from overnight exposure. This will give you piece of mind and allow you to sleep without worry that you may wake up to a huge gap down in an equity or the markets. Day trading is for technical guys that want to trade specifically from what they read on a chart. There is no fundamental analysis; it’s based purely on technicals, volume and price action. It will require you to learn how to read charts and recognize specific set ups. You will need to recognize support and resistance areas, be able to build your own scans and enjoy looking at thousands of charts.
To be successful, you will need to do this every single day and on the weekends. If you think your work day ends when the market closes you are misinformed.
So let me clarify this!
When starting out you should be working an eight hour day glued to your computer. At the end of that day you will be running scans looking for setups for the following day. You should be getting up at least an hour prior to the market open and looking for opportunities for the trading day by observing the premarket action and scanning press releases about the market and company specific events. If you are on the west coast like I am this can be quite daunting. Your weekends are when you should do the heavy lifting, so to speak, and run multiple scans, evaluate the technical health of the markets and specific indexes. You should also evaluate all of your trades from the prior week to determine where you are strong and where you need to improve.
The picture I am painting is not meant to scare you; it’s just a dose of reality. You will likely work more than you would be working for someone else. You will have to be self-motivated, and spend thousands of hours looking at charts for potential setups. You have to be mentally prepared for that inevitable losing streak, because it WILL happen. You will have to accept that all the hard work that you put in each day, may not pan out and you may miss opportunities that you were able to identify in your scans. You may spend hundreds of hours on preparation only to end the week with negative results.
When deciding to become a day trader you need to have your eyes wide open and understand completely the journey you are about to embark on. Paper trading or using a trading simulator is advised before you actually start trading in real time. Get a feel for your skill set and recruit a mentor or peer to help you evaluate your strengths and weaknesses. Dedication to continuing your education and the ability to stay motivated in the face of defeat along with a bank roll to withstand the learning curve will be essential if you are going to overcome the odds and your passion will be the fuel that ultimately leads to your success.
If day trading isn't something that fits your reality then let’s take a look at a longer term investing and trading styles.
Swing Traders, Position traders, Long term Value Investors, Long term Growth investors and Short Sellers
For me the number one and most important rule when it comes to any of these strategies is you must have some knowledge about the company. For me this is a fundamental strategy first and technical strategy second. It can be extremely powerful to align technical with fundamental. However, you need to recognize that a high percentage of technical breakouts fail. Holding a Biotech company overnight because it has a sweet looking setup into a binary event like FDA approval can be very rewarding or it can be an extremely painful lesson. Holding the latest hot small cap tech company that has a potentially game changing product but is burning through cash faster than the fed can print it, with no sign of profitability on the horizon thru earnings, can also be eye opening and devastating to your emotional state as well as your portfolio. VRNG would be a good example of that, I recently held it though its supreme court decision I had done a significant amount of due diligence and recognized it was a binary event and the outcome was unfavorable. I was prepared for that and adjusted my risk accordingly.Doing your due diligence by studying a company, its product, management, and financials will not eliminate your risk but it will help you determine the amount of risk you are willing to accept.
While day trading is full of excitement and stress that can lead to fast fortunes or quickly wipe out a portfolio. Investing can be a painstakingly slow process to wealth or a slow bleed to insolvency. It requires patience, vision, and the ability to recognize trends and opportunities early. You have to have the fortitude to wait for the story to develop and let all the pieces fall into place in the face of adversity. You have to feel comfortable reading a 10k /8k and balance sheet. You should be actively involved in conference call participation staying on top of developments that could change the investment thesis. I have yet to hear of a day trader that has become a billionaire strictly from day trading. There may be some day traders out there that are billionaires but I would suggest that their wealth comes from a mix of day trading, book sales, educational programs they produce, chat rooms memberships, and a host of other products and services. There are many examples of billionaire investors; Warren Buffet, Carl Icahn, Carlos Slim, and the Koch brothers are just a few that come to mind. This type of investing or trading does not require a huge bankroll. When I first started investing I did it with a thousand dollars.
Ultimately even if you decide to become a full time day trader it’s my opinion that you should also venture into becoming an investor at some point. Day trading is great for catching those small spikes a stock may have but investing can catch an entire run which can be substantially more profitable with less tax ramifications. Combining fundamentals with the technicals that are used in day trading and applying them to longer time frames can lead to astonishing investment results. So let’s go through each of the different styles of fundamental investors.
Swing Traders
Swing traders hold equity overnight for very short periods anywhere from one day to a couple of weeks at the most. These types of plays are great for momentum names that just broke out of a solid technical formation usually accompanied by some type of fundamental event like earnings. Typically a good breakout can last 3 of 4 days. Swing traders will work with longer time frames when it comes to chart analysis typically they use the weekly, daily, 60 minute and the 5 minute charts. This style of trade is ideal for the person that is still working full time but wants some exposure to the markets. It doesn’t require you to be glued to a computer all day and you can manage your risk with well-defined stop placement. With swing trading the tolerances are more liberal in terms of cushion for trade execution. You do not have to be as tight with stops and exits as you do with day trading. The benefit being you can capture a larger percentage of a gain.
The downside is you are subject to gap downs if something material were to happen to the markets or stock specific. Even if you have a stop placed you could still wake up to big losses and maintain possession of the stock even if it’s trading below your stop price. Stop losses do not get triggered on gap downs. Another thing worth noting is if you have a stop placed it’s not uncommon to see what is called “stop shopping” take place. For example let’s say you are in a stock and you have clearly defined a level of support where you feel as though if the stock were to violate that price it would be prudent for you to exit the position. You set your stop just below that support area. Odds are that if you see that area of support then so does everyone else. A stock can get flushed down just below that area in order to trigger all the stops that are placed there, which enable’s someone to pick up your shares on the cheap. After the stops have been shopped the price resumes its upward trend unfortunately leaving you on the sidelines.
Position Traders, Long term value, Long Term Growth
Position trading is considered long term investing. Position traders are not concerned about short term fluctuations. Typically position traders have done their due diligence and believe that eventually all the short term volatility will smooth out over time and continue to move in its primary trend. They can hold stocks for months to years. For technical analysis they typically look at the weekly or monthly charts to get a sense of where the equity is in terms of a given trend. It would not be uncommon to see a position trader “dollar cost average”. Dollar cost averaging is purchasing a fixed dollar amount of shares on a regular schedule regardless of the share price. Resulting in more shares being purchased when the price is low and less shares being purchased when prices are high. Position trades are typically in what could be considered safe equities with a big market capitalization like Microsoft, Cisco, Caterpillar, or IBM. They are considered slow movers or “thick stocks” meaning they have large amounts of shares available for trade in the float. They aren’t typically going to make 20 or 30 percent moves in a day. You can build a position in more speculative names that may be in the midst of a restructuring or potential turnaround with a thin float but these are not for the faint of heart. Regardless of the type of stock the basic premise is you are going to be holding it for a long time.
Some positions are taken because the fundamentals suggest the equity is priced below its intrinsic value. Other positions are taken for projected growth regardless of a company’s fundamentals. A good example of each would be Microsoft for value and Facebook for growth. Microsoft was considered cheap because of the amount of cash on hand, dividend yield and the lock they had in the PC market. If you were to look at the intrinsic value it appeared cheap. Until recently, it was a value trap. The company failed to unlock that value for shareholders, trading at a very low multiple and staying in the same price range for 5 years because it was considered to be a dinosaur unable to change with the times and produce meaningful returns for its shareholders.
Facebook and Twitter trade at very high multiples not because of their balance sheet but because of the perception of growth potential. People are willing to pay a premium because they believe that eventually the company will grow into or surpass all expectations. These companies are often over valued and can develop into long term momentum stocks like Amazon, Tesla or Netflix. Growth stocks typically do not pay dividends and reinvest their retained earnings into capital projects. Growth companies are not always growth stocks. A true growth stock is expected to grow at an above average rate relative to the overall market. Some anticipated high growth companies can grow without their share price following Groupon and Zynga would be good examples. After the big stock market crash in 2008 there were some stocks that could be classified as both value and growth. Wynn resorts, Las Vegas Sands and Melco were good examples of this. They all had perceived intrinsic value and potential high growth with the development of the Macau gaming market.
This type of investing could be considered the hold and hope strategy. However, if you have your sights set on a longer term time horizon and you have done your due diligence this can be an extremely rewarding strategy. I have had some tremendous wins over the years with this type of investing. Marvel enterprises, Sirius Satellite radio and Melco Crown are just a few that come to mind. If you have the patience and the will to spend hours studying a company while staying on top of current events that may impact your investment thesis the results can be tremendous.
Short Sellers
Short sellers are disliked by the average retail Investor because it can be considered “un- American” to be betting against a company and counting on its demise or failure to make a profit. I like to compare short sellers to the guy that bets against the shooter at a craps table. The truth is a successful short seller is shrewd and meticulous with their assessment of a company’s financials. They spend thousands of hours researching to determine if a stock or a market is inflated. Often times they could be shorting a stock or market with the belief that that there are serious fundamental issues like accounting fraud that are not yet known to the average investor. Or there is a bubble like the one created by over leveraged financial firms that led to the housing collapse in 2008.
Short Sellers play a vital role in our markets and one could argue that their research is more stringent and exhausting than the average long term investor is willing to endure. Shorting an overpriced stock or market makes their opinion heard and helps regulate prices. The misconception with shorting is the perceived notion of unlimited risk. In theory the loss potential is infinity. However, you can manage a short trade just as well as a long trade, limiting your risk with stops. The real danger is being subject to gap ups. Longs are subject to the same issue with gap downs. It can be more risky to be long stocks in a bear market where it’s not uncommon to see a market decline by 20 percent or more. Unlike a long term investor who may simply buy and hold a stock, the short seller is holding until the perceived balance of price and intrinsic value are returned to normalcy. The danger is being early since prices can stay inflated and overvalued for quite some time until the next down cycle.
The ugly side of short selling is the firms or individuals that run “short and distort” campaigns to temporarily damage the share price with inaccurate or speculative articles that undermine the stock so that they can benefit from their already established short position. So called “cult stocks” are often targets of these types of practices since the investors in these equities are often emotionally invested in the names and it can create quite a feeding frenzy on social media. One thing I have always found interesting is that there appears to be two cults in cult stocks. One is long and the other is short. The shorts will call the longs cult followers because of their passion and conviction in the company’s long term outlook. Yet the shorts are just as passionate with their conviction that it’s a pump and dump or a bankruptcy waiting to happen. If you do your due diligence you will be comfortable recognizing fact from fiction and use these despicable events to load up shares of an unfairly beaten down equity.
While this breakdown of the different styles and types of investors may not have covered all that exist it gives you a basic understanding of the most common. The questions you need to ask yourself are; what will your bankroll and your time allow? What is your time horizon? Are you more comfortable with fundamentals or technicals? Which style will you enjoy the most?
We are all different and every style can be successful. Aligning yourself with the style that works best for you will give you a powerful head start. Focus your time and energy on becoming consistently successful at your chosen style. The shotgun approach will only confuse you and limit your ability to achieve the results you desire.
Goals
A dose of reality is also needed for expectations when you are just beginning your journey. One of the most damaging things that can happen to a new trader is beginners luck. The taste of success can be bitter sweet. It happens to everyone and it has happened to me. You place a few trades in a roaring bull market and you make a nice chunk of money. All of a sudden you are a natural, saying things like; this is easy, I got this, piece of cake, I am the master of the universe! Well maybe not the last one but you get where I am coming from. After that nice little winning streak you start bumping up your bets since you are so confident that you are in control of your destiny and your destiny is to RULE THE STOCK MARKET!
In reality you have no game plan; you have no technical or fundamental understanding of why you are making the moves you are making. Or even worse you have just enough knowledge to make yourself dangerous. All you know for certain is that you are about to make a lot of money.
This is typically when it happens. All of a sudden your luck changes and you start losing money. You are so confident in yourself that you start adding to your position. You’re reading twitter feeds and message boards where people are saying this stock is going to the moon. Who cares if it’s already up 150 percent in 4 days, this is just the beginning. You will read anything that helps you reaffirm your own beliefs. You add more to your position and then the stock plunges. You feel like you have been kicked in the gut. Then you start asking yourself if you should get out or buy more. You are getting to the point where you are too scared to buy more and too proud to take your losses. The stock continues to plunge and seems to be picking up steam. You are paralyzed; you want to do something but what? You start telling yourself it can’t go any lower and yet it does. You are sick to your stomach and you are sitting on a big loss. You rationalize keeping your position since you have already lost so much. You might as well hold it until it comes back. Does this sound familiar to you? If you haven’t experienced this, hopefully, this book will help you avoid that painful lesson.
Unfortunately there is no magic formula, black box trading system or silver bullet that I or anyone else will give you that will guarantee your success. There are thousands of systems and tools out there and none of them is bullet proof.
3 Goals for Success
#1 Discipline
It’s my belief that the first goal and probably the most critical is your ability to be disciplined.
You have to have enough self-discipline; to never stop learning, to develop a game plan for each trade, to know your ideal entry, exit and reason for entry, to review the market conditions, to know your risk reward, to stick to your game plan and execute, to being flexible and change strategies when the market dynamics change, to take profits when they are there and cut losses while they are small, to continue in the face of defeat, to know when to walk away, to learn technical analysis, to scan for setups, to review your performance, to be independent, to seek the support and critique from peers and mentors.
You may have noticed that there are some conflicting ideas in that list. That is intentional, the markets are dynamic and they are constantly changing. What worked last year, last week or yesterday are not guaranteed to work tomorrow. You need to be flexible, having just one style of trade if fine as long as you know that there will be times where you need to walk away and wait for market conditions to become more favorable to your style.
You may have the best system, with the best education and the best intentions but it will be discipline that will be the secret to your success. Without it you will be fighting a losing battle. The goal should be to treat this like a true professional would treat any business. Keep a trading log that shows the date time and price of each entry and exit. The type of trade, where your stops were set, where your targets were set for you to book profit, the reason you took the trade, commissions and what your actual results were from the trade. It would also be advised to give an indication of what the overall market was doing at the time of your trade. Review these trading logs each day or at the very least each weekend. The goal is to learn where you are strong and where you are weak in each market cycle. The most critical goal of discipline is to protect your capital and limit your losses. This requires you to have trading plans and a sound money management system. Losses in any business are bound to happen and like any business you need to recognize the source and correct it. There will be more on Money management later.
2) Emotional Intelligence
A true professional trader has their emotions in check. There have been a lot of headlines lately on HFT (High Frequency Trading) computer programs that use algorithms to measure crowd sentiment in individual stocks and markets. They move in and out of positions in fractions of a second aiming to capture a fraction of a cent in profit. There is not one ounce of emotion in the trade it’s all computer driven. As a day trader this is one example of who you’re competing against.
A professional trader recognizes that it’s easy to become emotionally attached for the new day trader. Trading can give the same high as gambling when you are right on a trade and it can bring on depression and fear when a trade goes against you. Your goal is to manage your emotion; there should be no feelings of elation or depression during your trading. It’s a business, you are going to have ups and downs when emotions get involved humans have a tendency to make irrational decisions. This is the main reason it is so important to have a defined risk reward plan in place. If the trade hits your target you book profits and move onto your next plan. If you get stopped out you take your loss and move on to your next plan. The market doesn’t know you; it doesn’t care about your feelings, it doesn’t care if you make or lose money, it’s not personal!
Make no mistake, the stock market is a battle field, it’s a war that is taking place between buyers and sellers. For every buyer there is a seller and everyone wants to be right about their position. The professional trader is cool as a cucumber through wins and losses. It’s business and there are going to be gains and losses, what they are focused on is keeping losses very small and taking profits when they are there. They don’t even need to have more wins than losses to be profitable as long as they manage their trades with a disciplined unemotional approach. They know their maximum loss and their potential gain. The professional does not hold a stock a few minutes longer once their stop is hit. They do not hold and hope it’s going to come back. They sell and move on. Once their target for profit is hit they do not decide that they are going to let it run so they can capture more profit or double down on their position because they think the stock is going to the moon. They book profit and move on.
For the professional trader it’s all mapped out in the plan and they execute the plan without emotion. The plan may be that they intend on doubling up on a position if it hits a specific target or crosses resistance area with conviction. The plan may consist of scaling out half the position at one price target and quarter at another, leaving the balance for a lotto play. It may be to go short on a stock that they took long if it breaks a specific area of support with conviction. Nothing is left to chance, they know that they need to follow the rules of their plan. They do not start making decisions based upon their gut feeling or their perception of what a stock should be doing. They make logical, strategic decisions based on the price action of a stock.
I know this sounds easier said than done. I mean after all we are humans and not computers. We are going to have good days and bad days. We are going to have personal issues that we deal with in life outside of trading that can impact our emotional state. Maybe there are financial issues, health issues or family issues that are taking heavy toll on our emotions. The professional trader knows when to walk away if he is not in the right emotional state. One of the beauties of this particular career is you are not forced to trade if you don’t want to. If you are emotionally charged about something and not thinking clearly then simply DO NOT TRADE! The market will be there tomorrow and the day after that. Have a plan and get your emotions in check before you attempt to trade.
#3 Independence
With the rise of the internet and the availability of chat rooms and other forms of paid trader services there is a natural tendency for new traders to seek out “Trading Gurus” to follow for advice. You will see hundreds of services out there all trying to differentiate themselves by the amount of money they claim to be making each day. Some services have verified trades and others are asking you to take their word for it. Whether the actual performance is true or not doesn’t matter in my opinion. Ask yourself why they post these numbers? Is it because it ignites an emotional response; people want to surround themselves with proven winners. The bigger the numbers the more attractive the service sounds. If you see that they are making 50 grand a week, then you can assume you will make 50 grand a week.
It is important to get a formal education in trading and equally important to find likeminded individuals for idea generation as well as mentors and peers for trade review. Taking what you learn and establishing your own identity while relying upon your own trading strategies should be a priority in your journey to becoming a successful trader.
There is a tendency for new traders to rely upon gurus because it makes them feel more comfortable believing they aren’t alone in their journey. They have the Guru to depend on for their success. Reality is gurus come and go and their success does not mean you will succeed. Most people like to be part of a group and we tend to rally around our leader. Following a leader can lead to impulsive behavior where you enter trades without a complete understanding as to why you’re taking the trade. Your entries and exits are usually late to the party and limit your ability to profit from them. Group members tend to believe in other members and especially leaders more than they believe in themselves. Ultimately, someone else is not going to make you rich, that you will have to do on your own. Being part of a chat room or trading mentoring service is valuable as long as your recognize that you must take what you have learned and use it to develop your own style and create your own trading plan. The weakest part of any trading system is you. Traders fail when they follow someone else into trades because it’s reactionary and not meticulously planned out. Building your own plan and executing the plan successfully will help you establish self-confidence and eventually your own independence. Just trying to follow someone will actually hinder your ability to grow and become successful.
Look at it like a crutch; the more you lean on the crutch the longer it takes for you to build the strength needed to stand on your own two feet. Having a guru allows you to transfer the weight of responsibility elsewhere and take the monkey off your back. If you have a bad trade it’s the guru’s fault because they picked the trade. Even though, they probably made money on the trade, it’s still their fault that you lost money.
The third critically important goal for every new trader should be to learn how to rely on and believe in yourself. Chat rooms and gurus are great but your own independence should be your ultimate goal. It’s important to recognize the psychology of the masses and it pays to let the trend be your friend. However it’s equally important to establish your own independence. Don’t just follow the herd!
Psychology over Mechanics
You may have noticed that these three goals had no monetary targets. I didn’t suggest that you should try to make 1000 dollars a week or 300 dollars a day. The monetary goals of each individual will be specific to their own wants and needs. Some may want to make just enough for a comfortable living and others may want to become the first billionaire day trader. The three goals I have just outlined are more psychological than they are mechanical and it’s my belief that if you can successfully achieve each of them your ability to succeed will greatly improve. We will go over the mechanics of trading and the tools at your disposal to help you achieve your desired results but the tools are only as strong and effective as the person using them. Your mind needs to be in the right place psychologically if you want to achieve superior results.
Market Phases: There are four phases to individual stocks and markets movements. Cyclical patterns that develop and can vary in duration. Markets and stocks go up, peak, go down and bottom where accumulation begins. When one cycle completes, the next one begins. It is highly improbable that you will pick the exact bottom or top of a cycle. However understanding them will help you maximize your probability of investment success and trading returns.
Accumulation Phase:
This phase is ideal for the long term or swing investor. After the markets sell off and bottom, then the accumulation phase begins. There are no more sellers, the fear is starting to subside and the healing is beginning. Stocks are consolidating in a sideways pattern establishing a base from which they can begin to rise. This is typically when the so called “SMART MONEY” begins buying. Value funds, smart money managers and experienced traders assume the worst is over and it’s time to start dipping the toe. Valuations are attractive but sentiment is often still quite bearish. There is typically an immense amount of doom and gloom still in the media and the few long term holders that held on through the correction have finally capitulated and thrown it the towel. Usually this is the “RETAIL INVESTOR” that probably got into the party late as the market was topping out and held all the way through the pain of the correction. Just as they decide to quit, others have decided it’s time to pick things up at fire sale prices. This happens with markets and in individual stocks. Sentiment gradually begins to shift from negative to neutral.
Market up Phase:
Markets have stabilized prices are starting to climb. Early adapters start taking notice and begin to deploy capital, technicians that are seeing stocks or markets putting in higher highs and lower lows recognizing that there is a subtle shift in market sentiment. Generally the media is now talking about the green shoots of a possible recovery but unemployment is still high and continues to rise. Human nature begins to take place and as this phase progresses. Greed begins to take hold, where fear of being stuck in the market is now replaced with being fear of being left out of the market. When this phase nears its end is when the irrational exuberance begins to take hold while logic and reason escape reality. Volumes increase dramatically, stocks climb to mind blowing valuations, “SMART MONEY” and insiders are unloading shares. Unfortunately as they are unloading and the markets level off the “RETAIL INVESTOR” sees this as an opportunity to get in after sitting on the sidelines for the majority of the rally. Prices make a parabolic move higher on massive volume and signal a selling climax or topping out. Euphoria is the feeling of the day and typically the end of the run or popping of the bubble marked by a reversal day.
Distribution Phase:
This phase of the cycle is when the bears begin to take control and sellers dominate. All the bulls out there have begun changing their tune and are starting to suggest that the markets may be under pressure. Prices are locked in a trading range unable to make new highs; each attempt is met by heavy selling. Support levels eventually break down and now become resistance as the selloffs begin to pick up steam. Emotions run high as fear of loss dominates with brief moments of hope as markets tend to bounce giving the illusion they are getting ready to take off again. Valuations are still extremely high in comparison to historical values. Volatility picks up as markets and stocks make erratic and dramatic moves in either direction. Eventually sentiment changes and can be accompanied by some geopolitical or economic event. Smart money is already out and sitting on the sidelines waiting for the appropriate time to start shorting. Those that fail to get out in this phase typically become the famous “Bag Holders”.
Market down phase:
This is the most painful and fearful phase of the cycle. The “Bag Holders” that chose to hang on for the ride holding their positions. Their knuckles are white and the whites of their eyes are clear for all to see as the selling intensifies. It’s not until there is a capitulation of selling often resulting in a loss of 50 percent or more for these diehards when they finally relinquish control of their shares and give into the market pressures. Sadly this is what the pros want to happen and for the astute investor, this is the buy signal they have been patiently waiting for. They recognize that a bottom is near and the time to start accumulating is approaching. New investors begin buying so they can take advantage of the next ride up and a whole new cycle is born.
Duration: Cycles happen every day in individual stocks it just depends on what time horizon you are watching. Market cycles can last a few weeks or many years. If you are using a 5 minute chart you could see a cycle play out several times in a single day. If you are a long term investor using daily or weekly charts you could see a cycle last for months or years. Recognizing what phase of the cycle you are in should play a big role in your preparation for trading and help you achieve better results.
Examples
Perception is everything.
The examples above illustrate how different time frames run through cycles.
The first chart looks pretty scary however it’s a 5 minute chart and its cycle went from accumulation at 3 dollars, marked up to 3.20, marked down to 3.04 and then began consolidating at 3.07. The total cycle lasted roughly 4 hours.
The second chart is the same stock on a weekly time frame where its cycle began in July 2013 and it’s still active in April 2014. The price range went from accumulation at a $1.06 base, marked up to a 4.25 peak, marked down and currently sits at 3.04 still looking for its new base of accumulation where the cycle will be completed.
Notice how similar both charts appear yet the magnitude of the move is very different. We will be going over timeframes later in the book.
Price, Float and Volume
What does price mean to you? How is price determined and what influences the direction it travels? For every buyer there is a seller, and for every seller there is a buyer but how is the price determined? Mass psychology is ultimately what influences the price of anything in life. Whether you are buying a car, house, tulips, or concert tickets, price is determined by supply and demand. Perception of value is determined by the greater fool. As long as demand outpaces supply, prices will continue to rise. When demand dries up and supply is plentiful prices start dropping to attract buyers.
An extreme example of this is the recent housing bubble that we experienced in 2007-2008. Housing prices skyrocketed because there was limited supply to satisfy the overwhelming demand. Everyone wanted to own a home and people that already owned were using them like piggy banks as prices hit stratospheric values. Eventually the bubble burst and prices came crashing down to earth bringing prices to ridiculously cheap valuations as fear took over and no one wanted to own a home. People were underwater and walked away from their homes damaging their credit and losing substantial amounts of personal wealth. The whole crisis nearly bankrupted our country and it was all created by supply and demand accompanied with a large dose of fear and greed.
On a smaller scale this battle occurs every day in the stock markets / individual stocks. With stocks there is a float. This is the total number of shares available for trade. Float is derived by subtracting closely held shares by insiders and institutions by the total number of outstanding shares. A small float would be anything under 100 million shares and would be considered a “Thin stock”. A really “Thin Stock” would be anything under 20 million. and liquidity is scarce meaning they are difficult to get in and out of because supply is not there. These will be the socks that have really wide spreads on the bid and the ask. They are also the stocks that can make a 20% to 100% move in a single day. They are extremely volatile and if you’re not careful you can get burned. Many of these stocks are often associated with “Pump and DUMP” campaigns where paid advertisers send out really fancy publications with all these potential scenarios that could possibly someday amount to a company becoming a huge behemoth because of their new product, technology or industry they are involved in. We will go over advertising campaigns, and press releases more in depth later.
It’s important to note that many penny stocks have a large float with hundreds of millions or even a billions of shares. When it’s trading @ .001 cents liquidity is still a problem and the price of the security can be easily manipulated with a relatively minimum amount of funds.You have to look at the market capitalization. Which is the number of shares outstanding multiplied by the current price. Pay close attention to the average daily volume. Chasing one of these stocks can be a very painful experience so caution is advised. You don't want to buy a couple hundred thousand shares of a penny stock that you are unable to sell
A “Thick stock” is when you have over 500 million shares in the float and they are big corporations> not penny stocks. While these stocks are extremely liquid they are often less likely to make big percentage moves in a single day since there is too much supply. These are often huge corporations that have already experienced significant growth and have become so big that it becomes difficult for them to move the needle in earnings or growth. That is why these big companies start paying dividends or begin share buyback programs to reduce the float and try to attract value investors. They are slow movers but they provide a certain level of security since they often have tremendous balance sheets with very predictable earnings. This is the ideal type of stock for the long term investor that just wants to buy a stock throw it in his IRA collect the dividend and look at it again in a few years; Microsoft, GE, IBM, CSCO would all be good examples of “Thick Stocks”.
Getting back to price, what indicator can we use to help us determine mass psychology? What is it that can give us some insight into whether or not the price of a stock is being impacted by something substantial?
Let’s imagine there is a house going to auction. You pull up to the auction and there is a huge crowd out front of the property. A frenzy of bids start flying as soon as the auction begins, offers are coming in from all over the place the price is climbing at a rapid pace. People get bid out of the process because they hit their limit and the rise in price starts to decelerate. Attendees of the crowd begin packing it in and start heading towards their cars. There are just a handful of bidders left in the game and eventually the greater fool locks in the price and walks away with the keys. In their mind they are not a fool at all because they got what they wanted at a price they were willing to pay. Maybe they plan to live there for the rest of their life and they love the house so much it doesn’t matter to them if they overpaid a bit.In the stock market the last person to buy the shares at the highest price often becomes the"Bag Holder". That can change over time. They may be the "bag holder" in day trading terms but they could be huge winners on a swing trade or long term investment.
The more volume there is, the stronger the conviction is when it comes to the direction the price is moving. Volume is used to confirm trends and chart patterns. When a price moves up or down dramatically with high volume; it confirms the strength or relevance of the move. Volume can also help identify a trend reversal. Let’s say a stock has been trending down for several months or years and then jumps up 10 percent on 20 times its normal average daily trading volume. This could be the sign of a major trend reversal. If the price were to jump 10 percent on below average volume then the move clearly lacks conviction and should probably be viewed as a potential bull trap.
Volume should move with the current trend. If the price of a stock is in an upward trend then volume should increase and vice versa. If the price continues to rise but the volume is declining it could be a sign the trend is losing steam and weakness is starting to set in and the end of the run may be near. Divergences are created when a stock continues in a clear trend up or down but the volume is declining.
Example of volume confirmation
Price has a memory and I am going to give you an exaggerated example of something most of you should be able to relate to. Let’s imagine going to the gas station one week where you fill the tank at a price of 2.89 a gallon. A week later you go back to the same gas station and the price per gallon is now 3.15. Instead of filling the tank you decide to fill it half way since it was just 2.89 a week ago. A few days later you go back and the price is now 3.50 a gallon. This time you fill the tank because you are afraid the price is going to be even higher the next time you need gas. You go back a week later and just as you feared the price is over 4 dollars a gallon. Do you fill the tank or only put in a half tank? The highest price you have ever seen on gas is 4.50 a gallon and last time you filled up at that price it went down 20 cents a week later so you decide to just put in just a half tank. As you are driving around you are paying attention to the price other gas stations are charging making a mental note of a station that is selling gas cheaper than what you have been paying for it you may even start going there for gas. When prices get to high you start contemplating carpooling, taking the bus or riding your bike to work. Your memory of price impacts your actions and your actions are impacting supply and demand. If enough people start taking the same action the price will react accordingly.
Stocks prices have memory as well and there are areas of supply that need to be absorbed before they can continue to move in either direction. Let’s say you buy a stock at 5 dollars and the price drops dramatically. It goes down to its former low which was firm support in the past. It eventually breaks through that support after soaking up the supply of stock that people bought when they thought it was too cheap to resist. Once that level of support is broken it now becomes resistance on the way back up. The stock tumbles to new lows and builds a base. Eventually it begins to rise and that previous low serves as a ceiling because people that have been holding on through the correction are now trying to unload their supply just so they can break even. Not until that supply is absorbed can the price continue to climb. If that supply gets absorbed it may climb back up to your 5 dollar entry and if it does what are you going to do? Barring any significant news that would lead you to believe it’s going much higher, you are likely to try and exit the trade so you can break even which creates more supply. There are technical areas like moving averages that will also act as supply zones. These areas of former price support and resistance, as well as technical indicators, can help determine where there are areas of supply are and what our risk reward potential is before establishing a new position.
Example
Each time an area of resistance or support is challenged or tapped supply gets absorbed which increases the odds of the stock being able to move on to its next area of support or resistance.
Imagine there are tiered bowls of water, you take a sponge and dip it in the bottom bowl of water. Each time you do this the water is absorbed until there is nothing left. There is no more supply to be absorbed which allows you to move up to the next bowl and start absorbing the water there.
The bowls represent supply, bigger bowl more supply, smaller bowl less supply. The sponge or a wet vacuum represents demand, bigger the sponge or more powerful wet vac means quicker absorption. The water represents the float, how much water is available will impact how long the water can be supplied. While the spigot represents the volume of water coming in. The tier levels represent price.
Now imagine the spigot over the top bowl controlling the volume of water flow. Open the spigot up too much and eventually the bowl can’t hold all the water and begins to overflow to a lower level of support where it will pool up until it can find an even lower level. If the spigot is wide open, the bowls and the sponge simply won’t work because the volume it too much for them to handle and it eventually creates a waterfall sending the price to a lower level rapidly. Turn the spigot off or to a slow drip and you can start absorbing all the water in the lowest bowl until nothing remains. If you want more water you have to start getting it from the next higher bowl which comes with a higher price. Absorbing a full bowl of water takes time and it is a slower process than when the spigot is wide open and overflowing the bowls but eventually you will absorb all the water with a sponge.
If the well runs dry you will have no choice but to start getting your water from the bowls which limits the supply and drives the price even higher as demand is outpaces supply. This is when you break out the wet vac to soak up as much supply as fast as you can before the water is all gone and you have to start importing it from another well.
This example should give you a good visual of how supply and demand combined with float and volume determines the price.
These areas of support and resistance exist in all time frames and if you can align them it gives you a more powerful setup.
Mass psychology of the markets is the spigot that controls the water flow. If the majority of the market is in a panic then the spigot is wide open flooding the market with too much supply. If the majority of the market is thinking that there is a drought and water is running out then they break out the shop vac and start sucking up supply hoarding as much as they can. Without the masses there would be no supply and demand.
It’s critical that you recognize what the majority is thinking so you can participate in the early stages of a psychological transition in markets or stock since this is when the bulk of your profits will be made. As the psychology becomes more balanced the profits are harder to come by, stocks base out in a tight range waiting for the next catalyst to determine the direction of its next move. This can be considered “choppy action” meaning there is no clear direction of the masses or market psychology.
Day traders are looking for stocks where the psychology of the masses is about to change and hit extreme levels on much shorter time frames like the one, three or five minute charts using the 15, 30 minute and possibly the daily charts for multiple time frame alignment. Time frames will vary based on personal preference.
Figure 1 Daily 30 minute and 5 minute cart
While swing traders and longer term investors will use monthly weekly and daily time frames on their charts.
Figure 2 Monthly, Weekly and Daily Charts
It should be noted that the longer time frame is considered the DOMINANT time frame. For example while a stock will have mini patterns develop in shorter time frames the dominant trend is the trend established by the longer term time frame. Let’s use PDFS to illustrate this example.
Figure 3: Weekly chart with dominant trend line
Figure 4: Daily chart with weekly dominant trend line
Figure 5: 4 Hour chart with weekly dominant trend
Notice how in each time frame there are mini trends that form and different types of patterns develop that technical traders look for. A strong indicator to look for to confirm trend is higher highs and higher lows in an uptrend and lower highs and lower lows in a downtrend. The charts get more erratic and develop more patterns as the window of time gets shorter. Yet the overall dominant trend remains intact. The time frame you are trading in can look significantly different than a longer term time frame, taking a step back and looking at a longer term time frame can help you identify the dominant trend. Having alignment on multiple time frames will give you more confidence that your strategy is a sound one and help identify ideal entry and exit points. Paying attention to the volume will give you an indication of what the mass psychology is and how likely it is for the dominant trend to continue.
Figure 6: Weekly break in dominant trend
Figure 7: Daily dominant trend break
Identifying what phase of a cycle the market is in will also help you determine how serious a long term trend break is for individual stocks. If the market is beginning its distribution phase it is likely that the trend break will intensify once the mark down phase begins since 90 percent of stocks are going to follow the overall markets lead. This is where shorts are likely to become more aggressive. Shorts will wait for confirmation of the trend line break and an increase in selling volume supported by a weak market to build on their short positions. When price bounces up into resistance like moving averages or former price support on low volume the shorts add to their positions setting a stop loss just above the resistance point.
Position sizing
Press releases, Rumors, Analysts and Earnings
How does a trend start and what keeps it moving that direction?
It’s all about perception; company generated press releases, rumors, analyst opinions (upgrades and downgrades), articles published by buy side or sell side authors, and of course earnings all contribute to the direction, duration and strength of a trend.
We know that buyers and sellers move a stocks price but it’s the mass perception of a story, rumor, analyst opinion or earnings that move the stock and get people’s attention. How compelling the story is or how strong the earnings are and how they are perceived by the masses that will determine the strength of the trend.
A perfect example of perception and how it impacts stock price is the legalization of marijuana for recreational use in Colorado. There are whole group of new startups, mostly penny stocks that have emerged and claim to have the inside track on this new and dynamic industry that is sure to reap billions in earnings for the early adapters and first to market. The story is so compelling that many of these names have absolutely zero earnings, tons of debt and yet they trade at insane valuations on the perception that they will grow into those valuations because the industry is just getting started. Everyone wants a piece of the pie and they are willing to risk their hard earned capital to be part of the story.
I recently had a close friend that knows how involved I am with stocks call me and tell me how he is making a killing on this “Pot Stock” PHOT. He had bought it @ 19 cents and it was already at 50 cents. He felt it was just getting started and wanted my opinion since he was planning on doubling down on his position. I told my friend that he needed to be careful and instead of doubling down he should consider booking some profit. The stock was trading below a nickel only a few months prior and was now trading up over 1000% on perception. There were no earnings to justify this incredible move. It was all based on speculation along with some buy side fluff pieces published by the company and individual authors. Unfortunately my friend decided that the story was just to compelling and doubled down without booking any profit. A week later the stock went to .77 cents a share and looked as though it was heading to $1.
My friend and I spoke again and he went out of his way to let me know how well his pot stock was doing. Once again I suggested that he consider booking some profit and reap the rewards of his good trade before the story changes. He was steadfast in his belief that this was just the beginning and it would be a one way ticket to early retirement as a multi-millionaire. The stock began pulling back to the 50 cent level which also happened to be its 50 day moving average after peaking out @ .77. Then the unthinkable happened and the SEC halted the stock to investigate some trading irregularities. It remained halted for 10 trading days and once it reopened it began trading @ .20 cents, then went as low as 10 cents and currently sits @ 18 cents. I have not spoken to my friend but I am confident that not only did he lose all the profit he was sitting on but he is now sitting in a losing position.
Fundamentals Matter if you are going to hold a stock overnight
Was my friend being too greedy? Did he get caught up in a Pump and Dump campaign?
I have no opinion on whether PHOT is a viable business or whether it will eventually be able to produce tremendous earnings. I simply do not know enough about them or their business. The reality is earnings do not exist for them today and there was nothing substantial to drive the price higher. The move was based on emotion and hype. Day traders and momentum traders thrive on these types of story stocks because they recognize them for what they are. Trading vehicles that can provide explosive returns in a very short period of time but they also recognize that these events are usually short lived if there is nothing material behind the move.
I am not suggesting avoiding story stocks, some traders make a killing off of them. What I am suggesting is that you know the difference between a “FLUFF PIECE” and something “MATERIAL or SUBSTANTIAL”. A company that reports better than expected earnings and raises their outlook for the remainder of the year by a wide margin would be considered substantial. A company that reports it has become cash flow positive and is on the road to profitability in the next couple of quarters is substantial. A company that reports that the industry they are entering is a mutli-billion dollar opportunity that they could potentially get a big piece of would be considered fluff.
An author that writes an article based on his opinion is a “FLUFF PIECE” and often written for a “PUMP and DUMP Campaign” or it can be an attempt to derail a stocks accent as a “HIT PIECE” that is part of a “Short and Distort Campaign”. You can differentiate these articles from legitimate stock analysis by paying close attention to the claims that are being made and whether or not they are using facts and fundamentals to support their thesis as opposed to supposition, hearsay and opinion.
Companies themselves can also send out Fluff press releases designed to inflate the stock price so they can sell more shares and raise capital, diluting the shares of the existing stock holders.
It’s important that you check the balance sheet of a company that reports some FLUFF before you go jumping in. Many small cap companies and biotech’s use this strategy to refill their coffers just to stay afloat.
Companies will also release some fluff prior to their earnings release to give the illusion that their earnings may be better than expected. This can give the stock price a dramatic rise into earnings, only to be taken down again when the actual earnings hit. This is called a “buy the rumor and sell the news” event. Earnings reports can be deceiving and a big disappointment if the stock has already made a strong move in anticipation of a good report. Even if the earnings are strong the news has already been priced into the stock and if they fail to raise guidance or merely guide in line with the street expectations then the stock is likely to stay flat or pull back.
Analyst upgrades can also move a stock but they too can have a hidden agenda. I can't tell you how many stocks over the years I have seen analysts raise to a buy or lower to a sell and have the stock react initially in that direction and then do the exact opposite.
Jim Cramer often gives buy and sell recommendations every day on his show, Buy buy buy >Sell sell sell > and it then has the CRAMER EFFECT where it will make a move the following day. That move often fades in a day or two. Cramer hated two of my biggest winners the entire MPEL and MVL Marvel Enterprises which was bought by Disney for 55 bucks a share. The whole run up in Marvel people would call into the show and Cramer would say SELL SELL SELL. However when Disney finally bought them for 55 a share. The management at Disney were geniuses for paying up to acquire Marvel.
A recent buy recommendation was SD when it was near 7 and now sits below 5. My point is that no one really knows what a stock is going to do. I actually like SD as a long term turnaround story but it was a bit extended @ 7. Be skeptical of analysts with firms that have investment banking relationships with publicly traded corporations. Davide Faber actually wrote a pretty interesting book "The Faber Report How Wall Street Really Works an How you can make it work for you". It opened my eyes to a lot of things that take place in the analyst community.
“Sand bagging” is another tactic that can be used by companies. This is when a company intentionally lowers expectations of forward guidance so they can handily beat expectations in the following quarter. It’s the under promise and over deliver setup. Over the years I have learned the hard way not to hold stocks overnight into binary events like earnings unless I have done some real due diligence and am planning to hold it for the long term.
Day traders and momentum traders aren’t normally concerned with the fundamentals they are paying attention to the price action and the technical set ups. Swing traders, position traders and long term investors place fundamentals above technical. Day traders and momentum players would rather sit on the sidelines through an event like earnings and look for a setup after the event. Swing traders and investors often hold through these events if they have enough conviction that the fundamental story remains intact and that the dominant trend will continue.
Dominant trends can stay intact until something meaningful contradicts the mass psychology. It must be an event equal to or greater than the previous perception in order to change the trend of a stock. An SEC investigation or a compelling article on accounting irregularities, earnings miss with lowered guidance and heavy insider selling could all change the dominant trend of a rising stock. An earning’s beat with raised guidance and heavy insider buying could be the catalyst to break the dominant trend of a falling stock and start a new trend higher.
Always remember that earnings and fundamentals are only as reliable as the companies that present them. Enron, WorldCom and a host of other names appeared to be on sound financial footing yet turned out to be some of the biggest scams ever encountered by the investment community. Being skeptical of press releases and articles based on hype and opinion can give you the upper hand when it comes to trading.
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Setups
There is a wide variety of technical set ups out there and it is not my intention to try and outline all of them. I have discovered over the years trying to learn every system, style of trade, indicator or set up can actually do more harm than good. I have learned that keeping things simple and focusing on a handful of setups that I seem to excel at works best for me. You do not have to know everything in order to be an exceptional trader you just need to know a few things and do them exceptionally well. Set ups or technical patterns will develop in every time frame and you can use them to help determine your entry and exits. The strength of these patterns are more likely to succeed if a longer term time frame supports your bullish or bearish setup.
Dolla Holla or Round Number Roll
If you follow me on twitter you will often see me calling out the “Dolla Holla”. Traders seem to be fixated on round numbers. As a stock approaches a round number people seem to assign some level of significance with the cross of that round number. It can be the $1 dolla holla or the $30 dolla holla it doesn’t really matter but as it approaches the round number, in either direction up or down, it often becomes a magnet. If it crosses below a round number it seems to confirm the stock is broken and if it crosses above the stock is in play. As always volume is your indicator when trying to assess the strength of a round number roll. You want to see volume rising as you approach a round number to help justify the intensity and conviction of the move.
Figure 13 Round number roll BAC
Figure 14 Round Number Roll Support and Resistance WFM
The concept of the trade is to enter the stock just prior to or at the time of its round number roll in either direction. Pay close attention to the volume as the round number approaches and the price eventually crosses. If it breaks a round number on weak volume consider booking profit and waiting for a more convincing break supported by strong relative volume. This can be a great day trade setup or swing trade. The 1, 5, and ten dollar holla’s can be especially powerful since they can be associated with a continued listing on an exchange, investment worthy or unworthiness by hedge funds, and mutual funds due to their bylaws and certain covenants pertaining to the minimum share price they are allowed to invest in.
Gaps
Gaps occur on daily charts and are typically created by some type of news event that creates an imbalance of buyers and sellers prior to the market open. Gaps can also occur mid-day if a stock is halted pending news and then reopens for trade. If the news is good you get a gap up if the news is bad you get a gap down. Earnings, FDA approval or failure, upgrades downgrades, potential sale, or guidance updates by companies can all have a gap effect. Once again volume is a key indicator in determining the strength of the gap.
Gap and Go
Figure 15 Gap Up with continued follow through
Gap and Fade
Figure 16 Gap Down and Fade
Depending on your style and the time frame you are trading in, Gap trades can vary. If you are a day trader you may be looking to play the gap at the first sign of a reversal candle accompanied by volume for either a bounce or a fade. If you are a swing trader you may want to take a position after a failed attempt to fill the gap. If you get a gap up or gap down through a significant area of resistance or support it is likely the direction of the gap will continue. Look for the price to test that area for a potential entry.
Gap fills
Often times the gaps that are created on daily charts will experience what is called a gap fill. Sometimes they can fill in the same day and sometimes it can take days or weeks to fill. Not all gaps will be filled as it depends on what type of gap it is common, breakaway, continuation or exhaustion gap. Where these gaps occur in the chart pattern will help you identify what type of gap it is. To learn more about the types of gaps you can research them online. As I indicated earlier Gaps are usually accompanied by some type of news or fundamental event. People have a tendency to overreact to these events with their own misinterpretation of how significant the event is in terms of price action resulting in overshooting on the upside or downside, irrationally pricing the stock temporarily. When a stock gaps it often loses its technical support and resistance and needs to reestablish the point of its gap up or down as its line of support or resistance.
Figure 17 Gap Fill to support
Bull Flag
Figure 18 Bull Flag Up Trend
Bear flag
Figure 19 Bear Flag Down Trend
Pennant or ascending/ descending triangles
Figure 20 Bull Pennant at the beginning of a trend reversal
Figure 21 Bear Pennant in a Down Trend
Flags and pennants are basically the same style of setup and for me the easiest to identify. They both have the appearance of a pole either up or down followed by the formation of a pennant or flag.
The pennant starts out wide and continues to narrow into tight candles forming a triangle pattern. The candles get extremely tight and typically you get a break in either direction with incredible force like a spring that has been squeezed until it can’t be squeezed any more. Once it’s released all that energy has to go somewhere and that is usually reflected in the price action.
Flags build off the pole in more of a rectangular range until eventually it breaks the range in either direction.
Both of these setups are can be found in just about any time frame and are typically impacted by the dominating trend of a longer term time frame.
Base breakout
Figure 22 8 Month Base Breakout Daily
Base breakouts are just what they suggest. A stock builds a base, the duration of that base can be anywhere from hours to months or even years. The longer the base and more powerful the break when it leaves that base often equates to the duration and size of the run.
Range break
Figure 23 Range break 5 minute With Pennant and Bull Flag
Range breaks are when a stock trades within a range of price and eventually take out that range. As it trades within a range it builds energy until eventually the bulls or bears cause a significant move. Unfortunately range breaks have a tendency to give false breakouts quite often since everyone knows the range and it can easily be manipulated. Trading range breaks requires patience and is best played once the break is confirmed with high volume. If the stock falls back into the range it’s most likely a failed range break.
Flat top Breakout
Figure 24 Flat top break out daily>
Notice the bull flag forming at the far right of the chart
Flat top breakouts are again just what the name suggests. The stock trades in a range for a period of time. The price of the stock continues to test a specific price. Think of this setup as a game of PONG. For you old timers like me that shouldn’t be a problem, for you youngsters Pong was a game where you had a ball that you would bounce up into a brick wall and with each hit you would weaken the wall until eventually you break through to the other side. Flat top breakouts are the same concept each time the price hits the wall it weakens. The more hits the wall takes and the longer the duration it takes to break through the more powerful the break becomes. Just like in the game pong the more hits the wall would take the faster the ball would move and the energy would continue to build until its eventual release.
Figure 25 Channel trade daily
Figure 26 Box Trade Daily with bull flag
Box trading or channel trading uses an established range where there is enough variation in price to make trading within the box or channel possible. The concept is to sell or go short at the top of the box or channel and buy or go long at the bottom of the box / channel placing a stop loss stop just above or below the channel.
BOSS (Bounce off Strong Support) trade
Figure 27 BOSS Example Daily
BOSS trades are bounce plays off of some sort of strong support. The more indicators you have as support the stronger the bounce is likely to be. Moving averages, Fibonacci levels, price support, trend lines, Bollinger bands, pivot points, and a host of other indicators can serve a support for a bounce. Aligning multiple indicators increases the odds of a successful bounce play. The same can be said for a reversal at resistance for a fade trade.
Cup with handle
Figure 28 Cup with Handle Formation Weekly
There are several variations, a cup with handle, cup without handle, saucer with or without a handle. The concept is relatively the same where you get a nice rounded bottom back up to a resistance price from the left side of the chart to the right side of the chart where you may or may not have a handle form and then break out. One of my favorite books to explain this setup in detail is “How to Make Money in Stocks” By William J O’Neil founder of Investor’s Business Daily.
Double top or M formation
Figure 29 Double top M Formation Daily
Double bottom or W formation
Figure 30 Double Bottom W formation daily>
Notice the pennant forming at the far right of the chart
Double bottoms and tops are fairly self-explanatory. You can identify these patterns by because of the M and W they create. They are created at the peak or bottom of a longer term trend marking the peak of an uptrend or the reversal of a downtrend. The stock has to break through a support line with significant volume in order for the trend reversal to be confirmed.
Red to Green play
Figure 31 Red to Green Play 5 Minute
Red to green play was taught to me by Kunal from Bulls on Wallstreet and I am pretty sure he created the trade. It is meant to be a day trade where you have a stock that broke out the day prior on good volume and then flushes lower after the open on the following day to a level of support where price is actually in the red and volume tapering off during the decline. Then you have a reversal with volume building as it retakes the high of the day and then continues in to green territory.
Snap back plays
Figure 32 Daily Snap back play
Parabolic Short
Figure 33 Parabolic Short >Notice gap and Fill
Both parabolic shorts and snapback plays incorporate the same concept. They occur after you have an irrational move to either the upside or downside in a very short period of time. The price goes parabolic overshooting and becoming overly stretched and primed for a sharp and swift reversal. This is meant to be more of a day trade. However, as you can see from the examples above, swing trades will also work, you have the patience and risk tolerance to stay in the trade.
What is your Favorite Setup?
Each of the examples above has their own unique characteristics not all of the setups will work for you. Some of the setups like the cup and handle, double top, double bottom formations are better suited for swing or longer term time frames. However you will probably be able to identify those patterns in shorter time frames. There are many more setups out there like the head and shoulders; squeeze play and probably about 1000 more that I don’t even know exist.
The objective is to focus on two or three setups and learn as much as you can about them. The ones I have listed above are some of my favorites. I use some of them for my swing and long term hold account, I use others for strictly day trading. There are certain setups that I consistently play better than others and those have become my Go To setups.
Train your eye to recognize these patterns as you go through your scans each day. As you run more and more scans it will become second nature and you won’t have to fabricate the setup it will just appear.
When I first started running scans it would take me hours to complete. Reading a chart is very subjective and it’s easy to get caught up in your own interpretation. I spent so much time on each chart trying to identify patterns that if I stared at a chart long enough and I could make it say anything I wanted it to say. I learned the hard way that if you have to create a setup then it’s most likely not a very good setup. Going through 1500 scans used to take me a better part of a day and now it takes about a half hour. I have trained my eye to recognize the setups I excel at and those are the ones I focus on. I use the daily time frame to do all my scans for idea generation.
Even when you identify a pattern it is still difficult to know with any kind of certainty how it will develop as it builds out the far right of the chart over time. That is why I use the daily for idea generation and shorter time frames to pinpoint entry and exit strategies. Always being cognizant of the overall markets conditions and how that may impact the setup and performance of my trades. Try to identify and master one or two setups. When you can consistently execute trading them you will experience tremendous success.
Money Management
Position Sizing, Risk Reward, and Stop losses
If you are going to last through the ups and downs of trading for a living or investing for your future sound money management is a MUST! Position sizing, risk reward and measured moves all play a key role in establishing a healthy balanced approach to achieving lasting success.
Putting it all on black is a disaster waiting to happen when you gamble at the roulette table. Putting all your investment dollars in one or two stocks without a game plan is virtually the same type of gamble. Risk appetite and individual goals will play a role in how aggressive or how conservative each individual is with their trading / investment portfolio.
Regardless, the principles of sound money management must be established before entering any trade. You must have a clear understanding of what you are risking, the maximum loss you are willing to accept and the amount of profit you are hoping to obtain. You should have a minimum risk reward scenario of at least two to one. Meaning you are willing to risk losing $100 to make $200 at the very minimum. Ideally you want setups where the risk reward is much higher like 5 to one or more. Having and established plan should help remove the emotion from the trade as long as you are disciplined enough to stick to your trading plan. When evaluating a trade the most important thing to consider is not how much you can make but how much you can lose if the trade goes against you. Always be thinking about the potential worst case scenario.
Holding through an earnings release or FDA event is a binary event that is nearly impossible to assign a risk reward equation to. How do you gauge the risk, potential loss or reward on an event like that? How do you know where the stock will fall too if it’s a huge earnings miss or failed drug? Realistically you don’t, and that makes that trade extremely dangerous.
I am not saying that you can never hold through earnings or through an FDA event. What I am saying, is use funds that you would assign to your gambling or lottery fund. I often hold what I call lotto shares through events such as these and I will go into more detail later on the concept. What makes people hold through events like these?
Fantasy, hope, and dreams of having the next huge winner that will make them an overnight millionaire. They are afraid that if they don’t hold through the event they will miss the huge opportunity never really considering that it could go the other way. If they focused more on what could go wrong then they would probably adjust the amount they are willing to gamble.
Every individual has their own threshold for risk. You will have to set your risk reward ratios and be disciplined enough to adhere to those ratios.
Let’s go through a couple of examples of how I determine my risk reward on Trades I have taken recently using both a day trade and swing trade as examples.
The first is a day trade that I took this Friday. IG had a nice pennant breakout the day prior on big volume off of 20ema support from a press release. What I was hoping for was a red to green move the following day after the open or a gap and go setup. We got a red to green. The market was in bounce mode and the previous day’s resistance was in the 8.90 range just below the 9 dolla holla, which if you follow me, you know I love round number rolls. My alert was set for 8.84 but I didn’t need it since I was watching it for the open. The white chart is my Scottrade elite chart 5 minute 2 day chart. I have MACD Volume and Pivot points along with the VWAP and 10 and 20 EMA. I wanted it @ 8.85 but could not get my fill so I took it @ 8.88 limit order. I had my mental stop 8.76 so my risk was 12 cents my first target was the pivot @9.34. That target was hit where I scaled half my position. The next target to scale was 9.50 and a lotto target of 9.93. I closed out the second half of the trade @ 9.22. The stock could still be in play Monday however, my lack of conviction in the health of the market made me feel the best course of action was to close out the trade and lock in profit. So risk was 12 cents and reward to my first target was .46 cents reward. Nearly a 4 to 1 risk reward ratio. Had the stock hit my second target @ 9.50 it was 5 to 1. The lotto target nearly 9 to 1. Very favorable, clearly defined risk reward ratio and even though I did not hit all my targets it was still a nice trade.
Figure 34 Scottrade Elite chart 5 minute 2day With MACD VOLUME PIVOT VWAP 10 EMA and 20EMA
Figure 35 Daily, 30 minute and 5 minute TC2000 time frames
The second example is a starter swing position. When I take a swing I have more leeway with my stop since my time horizon is longer. HERO looked good to me on multiple time frames to start building a position. There has been recent insider buying @ 3.17 the candle was out of the lower BB and it was testing a multi-year low so I felt I had some relatively strong support. My entry was 2.23 my stop OR potential add to my swing is 1.98. My first target to scale is 2.63 second is 2.90 and 3rd is 3.11. If it were to take out 3.11 on high volume I would hold a few for the lotto play and let them run raising my stop along the way. I have not sold any shares as of yet but will scale a few if I hit my first target. There is potential for a snapback play in the stock and snapbacks can be really powerful. The nice thing about this trade is I can also take it for a day trade if the move is powerful enough. Since it’s in my swing account and I have alerts set for targets I can scale out and take some profit while at the same time deciding if I want to take it for a day trade in my trading account. On my swing if I were to stop out @ 1.98 I am risking .25 cents to make .40 for my first target, .67 second target, 88 cents on my third target. Risk reward to first target not ideal only 1.6 to 1 but as I said I have more tolerance with swings. If it were to fall to 1.98 I would consider adding to my position and bringing down my dollar cost average. My second target gets more favorable @ 2.68 to 1 and my third target 3.5 to 1. There are several factors for me to consider before adding to my swing like market conditions, company specific news, volume, Stochastic, MACD on the daily and the weekly charts. As of today I am up on the trade but it is yet to be determined whether or not it will be a winning trade.
Figure 36 HERO Weekly time frame
Figure 37 HERO daily time frame
Figure 38 HERO Daily,30 minute and 5 minute time frames
The more prepared you are with your plan on risk reward the less likely you are to react with emotion. This is not to say that something drastic can't happen like a halt of the stock and a gap down. That risk is always present but at least there is a plan in place that I can try to adhere too where I have a clear understanding of what I am putting at risk. If HERO were to announce bankruptcy tomorrow I am comfortable with my position size and neither my account or my emotional state will be devastated from the loss.
A good example of this and a good example of why Biothech's are binary event stocks that present both tremendous opportunity as well as tremendous risk.Many traders and investors will not hold Biothech's over night
TXNP which is actually in my video and on my watchlist (you can take take that one off the list : ) failed its mid stage study this morning. The stock is down over 50 percent pre -market. I have a small swing position in the stock and will be looking to unload at some point either today or over the next few days. I was aware of the risk and my position was not large enough to be concerned about. This doesn't mean I enjoy taking a loss. It was a lotto play and it is part of doing business. You are going to have wins and you are going to have losses.
Position sizing
Figure 39 this is what can happen if you don't manage risk with optimal position sizing
This is probably one of the most important, if not, the most important area that is likely the most overlooked and abused by new traders.
Ideally you never want to risk more than 1 to 3% MAX of your entire account value in one trade. An optimal position size should be determined by the risk you are intending to take. Let’s assume for example you have a $6000 dollar account. That means you are limited to taking a loss between $60 and $180 on any one trade. When deciding whether or not to take a trade you must know where your stop will be placed.
Now let’s assume you are considering taking a trade in a stock that is trading @ $4.90 for the five dolla holla round number roll. There is decent support at 4.79 and you would be comfortable placing your stop @ 4.75. You are risking .15 cents per share so if you are looking to only risk 1% or $60 dollars of your $6000 dollar account you would trade 400 shares or $1916.00 with a 4.90 entry. If you are willing to risk 3% or $180 dollars of your account you would trade 1200 shares or $5880.00 with a 4.90 entry. For beginner traders I strongly recommend sticking to the 1% target. Keep in mind that you are risking more in dollar terms and if the stock were to get halted you have a significant amount of your portfolio at risk. However, if you are trading with a specific plan and you have your stop set, barring any extraordinary event occurring, you have clearly defined your risk, as long as you adhere to your stop loss.
Knowing the amount you are risking with your stop will help you determine your position size. If it’s a dollar risk to your stop on a 60 dollar stock you can take 60 shares on the trade. If it’s 50 cents on a 25 dollar stock you can take 120 shares. If it’s 5 cents on a 2 dollar stock you can take 1200 shares. Each trade is risking 1 percent or 60 dollars from a 6000 dollar account.
For some traders setting a daily, weekly or monthly stop level is incorporated. They are seasoned, full time day trader’s that have an established track record of consistent positive returns. They often make split second judgments on position sizes based on the action in the stock and set a limit near or equal to their average return per day, week or month. So if they average $500 a day in profit they may have a stop of $450 dollars for a day. Once they hit that amount of loss they stop all trading for the day. One losing day will not impact their week but walking away once they have lost their allocated amount does give them control of their overall risk.
For larger account sizes of say 100k and up, you may choose to have a fixed dollar amount like $800 dollars which is significantly less than 1% risk. So if you take a trade on a 10 dollar stock and you have a stop risk of .50 cents you can take 1600 shares if the stop is triggered @ 9.50 you lose $800.00.
Position sizing will vary upon experience, comfort level, track record, and account size for each trader. If you take a trade and you instantly go into panic mode when the stock drops 10 cents you are trading outside of your comfort level. This can lead to emotional reactions and should tell you that you need to reevaluate your position sizing strategy to something more suited to your risk tolerance.
Make sure you have an escape plan to help determine your position sizing.
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