How to Read Volume

See how two trading systems use volume to better understand price changes.

For traders and investors, volume does more than measure how many shares are changing hands between market participants within a given time period. With the right interpretation, volume can be a way to read the mood and psychology of the market, discover the strategies of large investors, and put price changes in context.

Toni Turner, an independent trader and best-selling author of A Beginner’s Guide to Short-Term Trading (Adams Media, 2008), says that she has had made more trading profits “by concentrating on reading volume than on any other indicator. It can show extreme enthusiasm or extreme fear and panic.”

The challenge, she cautions, is interpreting the data. Volume reflects demand, but doesn’t always tell you if it’s coming from buyers or sellers, or from large players or small. There are dozens of systems to interpret volume data into trading signals, here is how volume plays into a couple of popular systems: the CAN SLIM® investing system and The Wyckoff method.

The CAN SLIM Investment System

Volume, combined with price, is “critical to spotting emerging trends,” says Chris Gessel, executive editor and chief strategy officer of Investor’s Business Daily. He describes how price and volume are woven into the CAN SLIM investing system, a top-performing strategy recognized by the American Association of Individual Investors (AAII). The CAN SLIM system was developed by William J. O’Neil, chairman and founder of IBD and author of the best-selling book, How to Make Money in Stocks.

“Price and volume are the key to IBD’s market analysis,” says Gessel. “It’s how we spot new up-trends as well as corrections before they are widely known.”

One benefit of volume is that it can give you signals of what the major institutional investors are doing. Gessel says that IBD looks for stocks that are ending a period with little or no price change and make a big price move on high volume. “This may show that institutional investors are driving that move. You want to be on the same side as big investors.”

Because it can take institutional investors weeks or months to complete their purchases, Gessel says that “individual investors have a chance to piggy-back those purchases and ride those price run-ups.” If you watch price and volume carefully, he suggests, you can also detect clues it is time to get out.

Another key benefit to watching volume is to understand the general trend of the market. Since three quarters of stocks follow the general market trend, Gessel notes, it’s crucial you learn how to read the market action each day. Generally, stronger volume indicates a more important price change. “With market averages, we compare the day’s volume total with the prior sessions. An index that falls in heavier volume than the day before is generally negative. With stocks, you want to see how the daily volume total compares with average daily volume. A stock rising in above average volume is generally positive.”

One key rule, according to Gessel, is that “a breakout should come on volume at least 50% percent higher than average.” For example, look at the chart of Nu Skin (NYSE:NUS):

at-volume650

Chart is for illustrative purposes only.

“Nu Skin built a flat base from the beginning of August to the beginning of October,” Gessel points out, “never correcting more than 11%. It then broke out in huge volume on October 2, en route to a 50% gain in just two months. It’s been building another base since December.”

The biggest danger, Gessel warns, is that you don’t apply these volume rules to thinly traded stocks. “Stocks that trade under 400,000 shares a day are more volatile. It’s easy to get shaken out of a stock when it trades relatively few shares.”

Finally, Gessel suggests that investors and traders look at the fundamentals as well as charts. “Fundamentals lead you to the right stocks. Charts tell you when exactly to buy and sell them.”

The Wyckoff Method

The CAN SLIM system isn’t the only trading system that uses volume to interpret price changes. Richard Wyckoff developed a well-known trading method based on price and volume behavior. One of the leading practitioners of this method, David Weis, is an independent trader and co-author of Charting the Stock Market: The Wyckoff Method. “As a trader,” Weis says, “I look for changes in behavior that indicate when either the buyers or sellers are gaining the upper hand.”

One Wyckoff technique involves looking for a buying or selling climax. A trader looks for a larger than normal price range and heavy volume to spot a trend change. When using this system, the trader establishes a stock position after the price moves past support or resistance if it looks like the trend is reversing. “If there is little or no downward follow through when the price passes support, you can go long at the danger point where the risk is the least,” Weis says. He adds that failed breakouts above resistance can be used for shorting.

Weis admits he uses no mathematical indicators. Instead, his tools include the length of the daily range, the position of the close, and volume. “I’m looking for ending action which reflects a climatic top or bottom,” he suggests.

You may be able to recognize the climatic change by an unusual amount of volume, he notes, usually associated with a wide price range for the day. Wyckoff referred to this condition as hypodermics, when a market goes straight up. The chart of United States Steel (NYSE: X displayed below) is a classic example.

at-volume2

Chart is for illustrative purposes only.

“You see that bar on January 8?” Weis points out. “There hadn’t been a bar of that length for almost a year. Both the range and the volume were the largest since the price rise off the November 2009 low began.” For the next two days, the market moved lower on the increased volume. “All of these changes in behavior reflect topping action in the stock,” he says. “It’s typical climatic behavior.”

For Weis, the large range and heavy volume after a prolonged advance indicate the large operators are unloading their long positions under cover of public buying. “When the whole world is buying, it’s the easiest time to unload long positions undetected,” he says.

The rally of U.S. Steel on January 19 was accompanied by volume that was much lower than January 8. “This was a low-volume secondary test of the buying climax. When you see such climatic behavior, close out long positions. Aggressive traders should go short and place buy stops above the high.”

Weis admits it takes practice to learn how to read bar charts. As noted above, the basic ingredients are the daily range, the position of the close, and the volume. Another important ingredient, he says, is the interaction between the opening price and the day’s range. “If price opens below the previous three days’ lows,” he says, “and then rallies above unchanged only to fall back to close on the low, we know the buying effort failed on that day.”

It also helps to learn the meaning of some of the less dramatic-looking price bars. “If the daily range is narrow, and goes under the low of several days on heavy volume,” Weis explains, “and rebounds to close unchanged, we know some large buyers are holding the bag open to trap the sellers.” Put another way, the volume shows increased effort but the narrow range reflects little reward.

One of the mistakes many people make, Weis says, is to quantify volume into hard and fast rules. “These rules are guidelines but they don’t fit every situation. There are times when the market goes down on low volume because there is no demand. Conversely, prices can rally on low volume due to a lack of supply.”

Ignore Volume At Your Own Peril

Not studying volume is akin to “putting my hands behind my back and blindfolding me,” quips Turner. “Volume tells you the psychology of the market. It’s also one of the only indicators that is not derived from price, so it gives you a second opinion.” She says the goal for her is watching volume “from the bushes and pounce before everyone else.” No matter which method you use to study volume, there is little doubt that volume combined with price cannot be ignored by informed investors and traders.

Trading Strategies: What Worked

Look back at the most profitable strategies

The last five years of markets have given traders plenty of challenges and plenty of opportunities. From huge rallies to punishing crashes, and from record volatility to tight trading ranges — the markets have gone through a huge variety of conditions. As the new year starts, it’s worth taking a look back to see which strategies have made money, and which haven’t.

Fidelity’s Kent Thacker, director of brokerage products, tested the 30 trading strategies that come preprogrammed in Wealth-Lab Pro® through the last five years to see which ones would have made you the most money, and which would have cost you. Of course, just because these strategies worked in the past doesn’t guarantee they will work in the future — conditions may change — but using Wealth-Lab’s backtesting capabilities can help make you a more informed trader. Seeing what has worked in the past can help you make an educated decision in the future.

The top three To find out which of these trading strategies generated the most profits over the last five years through November 30, 2009, Thacker backtested all of the stocks in the S&P 500® Index using the 30 trading strategies built into Wealth-Lab Pro. For this test, he assumed an investment of $10,000 per trade.

The hypothetical results of the backtest are displayed below:

According to this test, the top three strategies for the time period were the LDL2 (0.96, 2, 3), the Moving Average Crossover strategy (20, 50), and the RSI Agita (20, 30, 55). This doesn’t mean you should run out and immediately use these strategies. But you could use the results “as a starting point to investigate further,” Thacker suggests. Here’s a closer look at these three strategies.

1. LDL2

The strategy: The LDL2 strategy is a technical trading strategy that tries to find stocks on a dip, and get in at the bottom. The system aims to enter the market at oversold levels and exit after the reaction has leveled off.

Analysis: The strategy was extremely sensitive to the volatility of the market. The large downward movements of 2008 and volatility of 2009 created buying dips that this strategy capitalized on, leading to a large net profit.

While this strategy was ultimately very profitable, investors may want to take a closer look. The buy-on-the-dip LDL2 has some limitations. Over the five years, an investor following this strategy would have made 33,000 trades. The large number of trades would not only be incredibly time consuming, but would also generate a lot of commissions.

Additionally, while this strategy did very well in 2008, the buy-on-the-dip strategy did not perform as well during the up markets from 2004-2007. Sustained upward trends provide fewer buying signals for “dip” strategies. An additional consideration for dip-buyers is that a prolonged downtrend could cause significant losses.

“With every strategy there will be advantages and disadvantages,” Thacker says. “Part of the challenge is knowing what you are trying to accomplish by using this strategy.” Put another way, you need a plan and goals.

2. The Moving Average Crossover Strategy

The strategy: The Moving Average Crossover strategy is popular with many traders. It’s actually quite a simple strategy: Buy when a stock’s 20-day moving average (MA) crosses over the 50-day MA, and sell when the 20-day MA crosses below the 50-day MA.

Analysis: The idea behind this strategy is to buy at the beginning of the trend and ride it until it ends. “When you do hit a trend,” Thacker says, “you will be following its sweet spot.”

Toni Turner, best-selling author of A Beginner’s Guide to Short-Term Trading (Adams Media, 2008), was not surprised when we told her that the Moving Average Crossover strategy was ranked as a top-performing strategy in the backtest. “The Moving Average Crossover has worked the best for me. It is elegant in its simplicity.”

Turner adds that sometimes traders feel they need complicated charts loaded with indicators. “The simple truth is that if we establish a rule-based system and use moving average crossovers, we can make a very good living in the market,” she says. The default variables in Wealth-Lab Pro are the 20-day and 50-day moving averages. Turner uses those settings in her trading system, but also employs the 8-day and 13-day moving averages on a daily chart.

Looking at the results, the Moving Average Crossover strategy generated almost the same net profit as the LDL2, but with half as many trades.

Thacker noticed one variable that should be considered. “You can see that the percentage of winning trades (42%) is rather low. It means there are a lot of false breakouts, which can be discouraging to some people because you’ll have a series of small losses.”

3. Relative Strength Index (RSI) Agita

The strategy: The Relative Strength Index is a momentum oscillator — that means it looks at how quickly a stock is gaining or losing price and tries to detect changes in the pace of the price change. The indicator assumes that as the price gain or loss slows, you may be approaching a turnaround.

Analysis: The RSI strategy is built to take advantage of oversold conditions. The strategy paid off over the last five years, and particularly among the last two years — when this was the best-performing strategy of the 30 Thacker tested.

One reason it works so well is that the strategy continues buying stock as conditions grow more oversold, so that it builds up a larger position when prices are down, according to Thacker.

For this test, the RSI strategy’s win ratio was 67%, significantly more than the Moving Average Crossover strategy, which succeeded just 42% of the time.

Of course, the RSI strategy has risks as well. Followers of this strategy buy into positions as stocks become oversold, anticipating a rebound. If the downtrend continues, traders following these types of strategies can expect occasional significant losses. Traders can limit the impact of such occurrences by trading the strategy across multiple stocks, and by limiting the amount of trading capital devoted to such strategies.

A losing strategy In addition to finding out the top three strategies, Thacker also studied the less successful strategies for this time period. Using the default settings, the Bandwagon Trade was highly unprofitable.

Bandwagon Trade

The strategy: The Bandwagon Trade uses the Average True Range (ATR) as its main indicator. The ATR attempts to measure a security’s volatility over a certain period. After you enter the position, long or short, you immediately set an exit strategy using calculations built into the strategy.

Analysis: The bandwagon strategy struggled during the five-year period, failing to deliver significant profits in either the down market of 2008 or the rally of 2009. Chris Clark, director at Fidelity, thinks the poor performance might be due to the reactive nature of the trading strategy. “With this strategy, you are buying into positions after a strong initial move up or down,” says Clark. “With the high volatility we’ve seen, there haven’t been a lot of sustained uptrends or downtrends and you may be missing the price move.”

If you use a strategy that ends up at the bottom, like the Bandwagon Trade, you might want to examine why. Review your previous trades to determine if using this strategy makes sense in the future. Sometimes, a strategy that fails during one market cycle might shine in another.

Why backtest? The main reason to backtest is to “see if your strategy works before putting real money into it,” says Thacker. In addition, the next time someone tells you about a new trading strategy, you can verify the results. Several years ago, according to news reports, an investment bank backtested Bernard Madoff’s Ponzi-scheme trading strategy, and couldn’t match his data. This blaring red flag convinced them to invest elsewhere.

“Wealth-Lab Pro allows you to create your own strategy or tweak existing ones,” says Thacker. “At first, many people start with a pre-shipped strategy.” The program also allows you to play “what if” games, trying to create a better system.

He says you can also use Wealth-Lab Pro to go back in history to test how well a strategy would have performed during similar market conditions.

Rank strategies To rank your strategies or compare them to benchmarks such as the S&P 500® Index, Dow Jones Industrial Average, or Nasdaq 100, you will need to download Wealth-Lab Pro. There’s a 30-day trial period for Fidelity customers. After it’s downloaded, double-click on the Wealth-Lab Pro icon and an uncomplicated home page appears.

From the Tools menu, select Strategy Ranking, click + Add Strategies, then choose one or more strategies. Select Basic or Extended Scorecard, which displays the default measurements that come with the program. Finally, select Begin. The strategies are ranked and the information is displayed. To change the rankings, for example, click on Net Profit and the strategies will line up from most profitable to least profitable.

You can download additional strategies or modify the existing strategies with your own specifications.

Ranking strategies gives you some relative performance numbers, but by backtesting each individual strategy, you can gather even more data. You can easily tweak the value of the indicators and optimize the strategy for your own uses.

Volatile Markets: Insight on Trading Reversals

Enter too early or too late and you may lose money. That’s what trading reversals is all about—determining the correct entry point. With this strategy, you use specific technical indicators to recognize which stocks or markets are overbought or oversold, so you can trade in the opposite direction of everyone else. We talked to trading experts to gain some insight on when and why you may want to utilize this strategy.

When to get in

When you trade reversals, “you are basically saying you are smarter than the market,” says Dr. Alexander Elder, a professional trader and author of the best-selling book Come Into My Trading Room (Wiley, 2002). “After all, the price you see on your screen is what the market thinks is a fair price. The challenge of trading reversals is that every day the market gives you a reason to think the trend is over,” Elder says. “It’s not easy to keep holding when you’re afraid you’ll lose your profits.”

Howard Korstein, an independent trader with over 25 years of experience, agrees. “People come in too early because they’re afraid they’ll come in too late. They’ll stick out the pain of having further losses rather than wait for the trend to begin,” he says. Kornstein would rather be late than early, waiting until a stock stabilizes so he can buy at a slightly higher price. “I am looking for a sell-off that has stopped.”

Elder pays attention when a stock reaches its old high or old low. He is a buyer when a stock breaks down slightly below its old low and his indicators show a bullish reversal. “When everyone is afraid the stock is going to go down, I am interested in buying,” he says.

Kornstein agrees. “It’s often difficult to define if it’s truly a reversal that has turned into an established trend,” he says.

Alan Farley, author of The Master Swing Trader (McGraw-Hill, 2000) and founder of www.hardrightedge.com, likes to buy in mild times and sell in wild times. “I will watch the price action for three or four days,” he says. “My ideal entry point is when it’s quiet, the volume has dropped, and the market is not moving.” On the other hand, when the stock shoots up higher in a rapidly rising market, he’ll sell his position. “Buy when they’re crying, and sell when they’re yelling,” he quips.

What they buy

Farley says he never tries to pick tops or bottoms. “Amateurs try this, and they get crushed.” If a stock looks too high or looks too low, Farley says, it is not a reason to buy or sell. He would rather wait until the market bottoms out or turns around. “A turnaround won’t occur if a stock is moving straight up,” he says. “If the stock is going to extend, even your indicators won’t tell you when it’s going to stop. I will wait until the stock has established a range, has a transitional pattern, and all those people who own the stock are afraid to lose their profits.” He likes to give the owners a chance to be disillusioned, which is where the eventual sell-off comes from.

He uses the reversal strategy on volatile stocks such as Express Scripts (Nasdaq: ESRX) and Smith and Wesson (Nasdaq: SWHC). “On the other hand, it’s hard to use this strategy on a story stock like Apple (Nasdaq: AAPL) because there is so much news about it. I like less popular stocks that aren’t in the public’s eye.”

Conversely, Elder especially likes using the reversal strategy on blue-chip stocks. These stocks have wellestablished charts that are easier to identify for potential reversals. “You probably won’t get hit as hard with the large-cap companies,” he suggests.

According to Kornstein, a recent example of buying a reversal occurred with Countrywide Financial. Because of subprime problems, other financial leaders like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) sold off in unison with Countrywide, although they weren’t involved in the same kind of lending business. “Countrywide got hit because of the subprime problems, and all financial stocks plummeted. This created an opportunity to buy financial stocks at a lower price,” he says.

Farley depends heavily on patterns to determine the best entry price using moving averages and stochastics to get a feel of who is in charge, bulls or bears. In general he looks at patterns, primarily those on the daily chart. “In reversals, you look at topping patterns or bottoming patterns depending on whether you are reversing from an uptrend or downtrend.” For example, a topping pattern is a double or triple top or a head-and-shoulders pattern. The basing pattern is softer, similar to a bowl-shaped pattern. “I might want to short a topping pattern or buy a basing pattern,” he adds.

Cautions

Even though you can short on the way up, many pros generally agree that shorting rallies is risky. “Trying to short an overbought stock is dangerous,” Kornstein says, “because the market might not consider it overbought.” For example, Whole Foods Market (NYSE:WFMI) is fundamentally overvalued with a P/E ratio near 35 (compared with a P/E of 15 for other supermarkets); nevertheless, the stock is in the portfolio of many institutions and has a large following. Therefore, Kornstein is comfortable buying this stock on a dip.

Likewise, Farley won’t short a rapidly rising market. “I’m not interested in selling short a strong uptrend.” He prefers to let the stock drop to a support level and go long at a better price. “If you are reading your technical indicators correctly,” he says, “you will find the spot the stock will pull back to, where it won’t go much farther—and that’s where you want to be a buyer.” Farley observes that a stock usually doesn’t reverse without first having some kind of a basing or sideways pattern.

According to Farley, the biggest mistake that people make using this strategy: “they believe a stock will go up forever, so they don’t protect their profits. If you have a profit, don’t assume that the direction will persist forever. You have to manage that position. You have to put a stop under it and be willing to take less profit. The market can unexpectedly turn around, catching you off guard.” This is one reason Farley enters tight stops on rapidly rising stocks that are in the profit zone.

Kornstein also suggests researching the stock you are trading. “To be successful, you have to understand the entire sector the company belongs to and take advantage of an opportunity.” It is not uncommon for Kornstein to watch a stock for weeks or months before taking a position. Many people do the opposite, Kornstein says, impulsively buying a stock based on the morning news. “I prefer buying stocks based on performance rather than on news.”

For those just starting out, Farley suggests trading fewer shares if you aren’t experienced using this strategy. In addition, study a basket of stocks in a specific sector until you become an expert on how these stocks trade, he says. Then use technical indicators and stock patterns to enter or exit your position.

Get Smart at Investment Seminars and Trading Shows

With the recent spike in market volatility, many traders are looking for ways to sharpen their trading skills. Investment seminars and trading shows offer excellent learning opportunities, but before you pack your bags, take time to think about your objectives. Are you hoping to find a “magic formula” that will improve your trading results? If so, experts say you might be disappointed.

Charles Githler, chairman of InterShow, which includes the Money Show, the Traders Expo, the Forex Trading Expo, and luxury cruise investment seminars, says that trade shows provide the “widest possible smorgasbord of advice, products, and services that you can sample.” He suggests that you think of these shows as continuing education. The goal is to improve your trading and investing skills while looking for new ideas.

Trade shows give you a chance to learn about the latest electronic trading products. In addition, you can receive one-on-one instruction on how to use specialized software. “These shows and exhibitions present material that individuals would not normally be exposed to,” says Howard Kornstein, an independent trader with more than 25 years of experience. If you are looking for additional advice, for a fee, you can sign up for a lunch with a panel of professional traders and television personalities who will discuss their experiences and provide market analysis.

Last February, more than 10,000 investors and traders attended the three-day World Money Show in Orlando, Fla. In addition to dozens of exhibitions and product demonstrations, the trade show also included both free and paid seminars.

Jim Jubak, senior markets editor for MSN Money and popular columnist of Jubak’s Journal, gave a number of presentations. “You hear all sorts of opinions at these shows,” he says. “You can go to sessions that say ‘Sell everything!’ or sessions that suggest you put 10% in the market now. You quickly get to see everything that is out there.”

How to prepare for a seminar

According to Kornstein, you should attend a trade show with an open mind. “Before I go to a show, I usually have an idea of whom and what I’m looking for, whether it’s software or information,” he says. Kornstein determines which specific vendors he wants to visit, rather than aimlessly wandering from booth to booth.

The biggest mistake that people make, according to Kornstein, is buying new software without taking the time to think it through. “Don’t make an impulsive decision,” he suggests. “Read over the contract multiple times. Sometimes it’s easy to sign up but difficult to get out.” He also suggests talking to other attendees to determine the most effective way to use a particular program or service.

Meet the experts

Trade shows are attended by well-known experts who offer attendees insight and analysis on the market and particular trading methods. For example, Dr. Alexander Elder, psychiatrist and author of several books, spoke at one of the paid seminars at the World Money Show. Alexander said that he would not be surprised if the market rallied for a couple of months before taking a dramatic plunge. He is currently finishing a book on shorting stocks titled Sell & Sell Short (Wiley, 2008).

“A good use of events like the World Money Show is to test your investing and trading ideas,” says Jubak. He believes you should purposely attend seminars that discuss views that are the opposite of what you believe. “You want to find someone to test your ideas against. You also want someone to bring you information that you don’t have.”

Although it can be exciting to meet your favorite expert, Jubak warns that some people take it too far. In fact, he feels the biggest mistake that people make is blindly following someone without thinking independently. “There is a subset of investors who believe that you need to find someone to follow,” says Jubak. “That doesn’t work for a lot of reasons.” For example, he says that because no one is right during all market conditions, you could end up getting bad advice. Rather than searching for a magic formula that may lead to trading profits, success more often comes from hard work and analysis.

How seminars can help you trade smarter

Jubak says that he learns as much from his million-plus readers as they do from him. Therefore, he attends seminars to get clues about what his readers are thinking. “I am able to see what’s on people’s minds and what’s worrying them,” he says. In fact, those worries and concerns are often what bring people to these events.

The most common question his readers have been asking is whether to sell certain stocks. To answer this question, Jubak has to play the role of psychiatrist, listening to readers to find out why they bought the stock in the first place. “If you don’t know why you own it, then holding it for the long term may be painful,” he says.

He believes that a key to investment success is “to know thyself. If you believe that a stock will come back because it has one of the world’s greatest products, you may want to buy more when it’s down. But if you can’t sleep at night because it’s down 20%, then perhaps you should do something different.”

Fidelity participates in the World Money Show

A steady stream of attendees stopped by Fidelity’s trading booth at the World Money Show. Fidelity representatives answered questions and demonstrated Fidelity’s Windows-based trading platform, Active Trader Pro® 1, as well as Fidelity’s back-testing tool, Wealth-Lab Pro® 2. At times, lines of people stood in front of the monitors, analyzing charts and studying stock quotes.

Bruce Johnstone, CFA®, managing director and senior marketing investment strategist at Fidelity, gave a seminar about investing in other countries. During his well-attended presentation, Johnstone suggested that people look at global opportunities, especially if there are cracks in the pillars of the U.S. economy. Johnstone’s talk was an “eyeopener,” says Githler.

Elder spent several hours demonstrating his trading methods during regular market hours on a live monitor. In response to a question about how to control greed, he told the attendees his key to success is not about trying to hit home runs. Just like Jubak, Elder also learns a lot from attendees. He enjoys answering questions and watching when that light goes on in a person’s head. “The reason I keep doing seminars is that every once in a while, it really catches, and people come up to tell me how much the seminar changed their life.”

While you shouldn’t expect to learn about a “magic bullet” that leads to investing success, interacting with presenters and attendees at these seminars can give you additional insights into market behavior and perhaps new trading methods, something that can be difficult to accomplish while sitting alone behind your computer screen. “You need to develop a system and a method,” says Elder. “Remember that trading is not a crapshoot.”

What You Can Learn From the Bid-Ask Spread

Stock Trading Just like buying a car or house, there is a tug of war between buyers and sellers of stocks. The difference between what someone is willing to pay and the price at which someone is willing to sell is the bidask spread, or the spread, as it is commonly called. Although ignored by some traders, the “spread” can provide clues about what might happen in the immediate future.

How is it determined?

A stock’s spread is carefully determined by the specialists on the floor of the New York Stock Exchange (NYSE) and the market makers on the Nasdaq electronic exchange, who publicly display the current bid and ask price. The only exception is if you trade via an Electronic Communication Network (ECN). (An ECN is an electronic order matching system in which investors and other market participants may participate. You can place orders through the ECN during the extended hours trading sessions. The ECN in which Fidelity participates may be linked to other ECNs, which increases the potential for an order to be matched.) In this case, traders themselves determine the spread. Specialists are required to maintain a fair and orderly market and one way to accomplish this is to post reasonable bid and ask prices. While they accommodate the market, because they trade for their own accounts, they also are in business to make money. It’s important to remember that specialists have access to the so-called “order book,” a list of all the buy and sell orders from customers.

What the spread reveals

Although the spread won’t help you pick the right stock or choose the best entry or exit price, it can help you determine short-term trends. For example, you can see whether the spread is leaning toward buyers or sellers. “If you notice that people are buying on the ask price, then momentum might be developing,” says Howard Kornstein, an independent trader with over 25 year’s experience. “If buyers are willing to pay what the sellers are asking, the stock is trending up. This is an important clue.” Conversely, if stocks are selling at the bid price, this could be the beginning of a downward trend.

Look for changes

There are other clues in observing the spread. Deron Wagner, founder and portfolio manager of Morpheus Trading Group, a trader education service, suggests being careful when buying the offer or selling the bid. He suggests that professional traders study individual stocks and how specialists trade them. “When a stock is about to reverse direction after trending up throughout the day, sometimes the bid-ask spread suddenly widens,” Wagner explains. “If you are trading the stock intraday you might see the average spread is $.05 between the bid and ask. All of a sudden the spread widens to $.10 or $.15. This often precedes a reversal in the momentum in the stock.” Wagner also points out that if the stock is going up and is about to go back down, although the bid will start dropping, the specialists might not lower the ask price at the same time. “Buyers coming into the market might pay the higher price,” Wagner observes. “Soon, you might see the momentum reverse and the stock goes in the opposite direction. Be careful about paying the offer price under these conditions.” Conversely, if the bid goes up, but the ask price doesn’t, Wagner says that indicates stronger demand, which can precede a big upward move. In addition, “on days when there is a lot of demand and volume, a stock with a typical spread of 10 cents may trade with a tighter spread of two or three cents because there is more demand. So people are bidding higher and not willing to sell as much as the spread tightens.” “If you have a certain stock, learn to observe the bid-ask spread. Then you can determine what the average spread is on individual stocks so you can see changes. It’s not important how wide the spread is but the changes that occur,” he says. “Look for the shift in supply and demand.”

Spread info in Fidelity Active Trader Pro®

Fidelity’s Windows-based trading platform, Active Trader Pro1, provides information about spreads via Time and Sales data. Although not foolproof, Time and Sales will give you some clues as to the trend of the market based on the bid-ask spread. Think of Time and Sales as a quick snapshot of the market action. Below is a display of Time and Sales:

spread1

Snapshot of Market Action — For illustrative purposes only.

In the above example, the green and red arrows on the left give you visual clues of the changes in the last price. In other words, if the last sale price is higher than the previous sale price, you’ll see a green arrow. If lower, you will see a red arrow. If the last sale remains the same, there will be no arrow.

spread2

Snapshot of Market Action — For illustrative purposes only.

Another clue is the Bid Size and Ask Size, sometimes referred to as the “bid-ask ratio.” In the example above, the Bid Size of the last trade is 1,207 and the Ask size is 187. (The first line in the chart is the last trade.) For that second, there are more buyers than sellers. It’s possible that buying momentum is developing and buyers are competing with each other to get filled. In addition, if you also look at the size of the orders coming across the screen (in the first table above), you’ll notice large order blocks, for example, 4,000 shares and 3,200 shares. Putting these clues together, you could deduce that the momentum favors the sellers, that there is more pressure on the sell side if many of the trades are occurring at or near the bid price. Before decimalization and ECNs, volume was a more important indicator. Because of specialized software, however, it is possible for some traders to hide their true share size. Nevertheless, if you see numerous large blocks hitting on either the bid or the ask, it is not something you want to ignore. Another clue on Time and Sales is Last Price. By observing the Last Price, you can see whether the bid or ask price is being hit. If sellers with large positions are willing to sell the stock at the bid price, it could be a clue sellers are taking charge at that moment. Perhaps the stock will head lower.

Studying the spread

Another action you can take is studying the actual spread. Independent trader Kornstein points out this phenomenon: “In my opinion, the wider the spread on the stock, the greater the volatility and the more cautious you have to be.” Keep in mind that what is wide or narrow is relative. For example, a $500 stock might have a $.50 spread but that’s very narrow on such an expensive stock. On the other hand, a $50 stock with a $.50 spread is very wide. So you should account for the price of the stock when determining if a stock has a wide or narrow spread. Wagner agrees with Kornstein about being cautious with stocks with wide spreads. Wagner adds that stocks with wide spreads are often lower volume stocks. “A stock that is only trading 50,000 shares a day will likely have a wide spread,” Wagner says. “You could have a tough time getting out of the stock because there isn’t enough liquidity.” On the other hand, both Kornstein and Wagner will pay the current price or even more than the ask price, especially on a momentum trade. Kornstein says: “It might be only a three or four cent difference. It’s not worth it to me to miss out on a momentum trade for a few cents. I am willing to pay more if I see it moving up.” In other words, don’t lose a potentially profitable trade by pinching pennies. But that does not mean you must pay the ask price (or above) every time you buy stock. If you are an active trader, you can’t ignore the bid-ask spread no matter how insignificant it might seem. The spread, although not as useful as it once was because of decimalization, still provides valuable information for astute traders. By observing and studying the spread on individual securities, you can attain valuable clues that can help you determine immediate trends.

Tips From Four Top Traders

What can you learn from four successful, self-directed, off-floor traders? Active Trader e-Newsletter selected independent traders, who employ distinct trading strategies: position, intraday, swing, and day trading. Then Mike Sincere, author of five books on trading, including Understanding Options (2006)

Did you know you can use options to make money every month or every quarter? And you can use options as insurance, for example, to protect your stock portfolio. And if, on occasion, you wanted to speculate, you could leverage your money to double or triple your profits. It will cost you a lot less than if you bought stocks. And finally, if you like to short stocks, it can be safer to use option strategies than to use the stock market.

Speaking of safety, with most option strategies you know how much you can lose in advance. If used properly, options can be used by all investors and traders to generate income, for insurance, and to speculate. By the time you finish this book, you should have a good idea what options can do for you and whether you want to participate.

Discusses how to open an account, evaluate a stock, and place a trade; strategies for making money slow or fast, with the advantages and dangers of each; and ten costly mistakes that are easy to make.

Howard Kornstein: Swing Trading the Blue Chips

Howard Kornstein is a full-time independent trader with over 25 years experience trading stocks and options. He is also a former hedge fund manager.

Sincere: What would you say is the most common trading mistake?

Kornstein: It’s refusing to admit that you’re wrong. Then the trade runs away from you and you are further wrong. For example, everyone thought that Sirius satellite was going to be better than FM radio. The story was right but the stock has failed. In this case, you sell out and take the loss. In the stock market it’s better to assume you have a loser until it proves otherwise. It is also easier to exit the position if you think this way.

Sincere: What technical indicators do you use?

Kornstein: I have learned that the simpler the indicator, the better the chance for success. The 50-day moving average (MA) is my benchmark. I like a stock that has fallen below the 50-day MA, has stopped falling through the 50-day MA, and is now on its way back toward it.

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How Fidelity can help — Technical Events From RecogniaTM. All screenshots and stock symbols are for illustrative purpose only.

Sincere: Do you use fundamental analysis?

Kornstein: Yes. I always consider P/E (price/earnings) ratios. You must expect a stock with a low P/E ratio to have a longer holding period. On the other hand, the higher the stock’s P/E ratio, the faster and more volatile the trade will be.

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How Fidelity can help — Stock fundamentals. All screenshots and stock symbols are for illustrative purpose only.

Sincere: What are the most valuable lessons you’ve learned about the market?

Kornstein: I learned to be very cautious about news stories. Don’t place a trade based on a rumor. Another lesson I learned is when shorting, try not to carry the stock for more than two or three days. If after that period of time it’s still not in the profitable range, you should probably sell it.

Sincere: How long do you hold your stocks?

Kornstein: I give different time frames to different companies. For example, I expect the gains on a diverse company like General Electric (NYSE: GE) to be slow-upwards of one year to show a profit. For a NASDAQ technology company, I wouldn’t hold it more than a few days.

Sincere: Where do you cut your losses?

Kornstein: It depends on the position. If going long on a blue-chip stock like General Electric, I would give 5%. On a NASDAQ stock, I would give 3% or less. If shorting, one half of one percent.

Sincere: Do you believe that trading is similar to gambling?

Kornstein: The trade becomes a gamble when you say you have a 50/50 chance of it being a winner. On the other hand, if a person says I have an 80% chance that this company might perform well in this quarter, that’s not gambling. That’s making an investment decision based on the knowledge the person might have.

Sincere: What do you think most people don’t know about the stock market?

Kornstein: Most people don’t realize that the value of the stock is the perceived value, not the actual value. For example, Apple (Nasdaq: AAPL) is perceived to be better than Qualcomm (NASDAQ: QCOM) so people are willing to pay a higher multiple. As a trader, I avoid companies that are popular and carry a premium. The cost of the stock is far greater than the amount of profit the company can possibly make.

Linda Raschke: Trading Stocks with Institutional Support

Linda Raschke is a professional trader for LBR Group and the co-author of a number of books including ETF Trading Strategies Revealed (Marketplace Books, 2006).

Sincere: How do you plan your first trade?

Raschke: I like to have an initial bias or plan before the market opens. I am looking for a certain play or setup, perhaps a breakout. I want to see where the market opens and where it is trading relative to the previous day’s high or low. I also note if there is a trend off the opening price, and if it starts making new highs or new lows outside of the first hour’s range.

Sincere: What do you look for in a stock?

Raschke: I look for patterns. I take it one step, one day, and one swing at a time. If you aim for too big of an objective, you won’t make it. It’s how you manage the trade or the risk once you are in the market. That’s the only thing you can control. If you make an execution error or you do the wrong size, you should correct it immediately. You have to take your hit and get out of it right away.

Sincere: What about time frames?

Raschke: I believe it is very important to study at least two time frames-the weekly and daily. For short-term trades, I use the hourly and 5-minute charts.

Sincere: How do you manage risk?

Raschke: If the market moves in my favor, I tighten the stops. I look for spots where I can take profits. I don’t think I will get 10 points when it will only give me 2 points. Everyone buys a stock and thinks it’s going to go up 10 points, but it might sit there for months.

Sincere: Do you always use stops?

Raschke: I can’t imagine putting on a trade and walking away from it without a stop. It’s like doing heart surgery with the lights out. If you are a home-based trader, you have a responsibility to have a stop in place. You also must know why you made that trade and what time frame you are playing for.

Sincere: What do you think drives market volatility?

Raschke: I think that people would be surprised that 40% of the S&P volume comes from automated “black box” algorithms playing for short term, two-second ticks. Everyone thinks the market is manipulated by this big master Wizard of Oz.

Sincere: So should a trader follow what the institutions are buying?

Raschke: Yes and no. When something is hot, it’s hot, and when it’s not, it’s not. When the Dow and S&P are testing their highs, you don’t buy a stock that hasn’t moved. It won’t be a dog forever, but go where the money flow and action is. Once a trend is in place, it can stay in place for a while.

Toni Turner: Using Technical and Fundamental Analysis

Toni Turner is a trader with over 16 years experience and the bestselling author of a number of books including A Beginner’s Guide to Day Trading Online (Adams Media Corp, 2007) and Short-Term Trading in the New Stock Market (St. Martin’s Griffins, 2006).

Sincere: How do you find stocks to trade?

Turner: I maintain a comprehensive watch list of sectors and industry groups. I evaluate economic conditions and which sectors and groups are most likely to benefit from those conditions. Then I analyze daily and weekly charts of those groups. I choose strong stocks with the potential to move higher in bullish environments, and weak stocks that are likely to move lower in bearish environments.

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How Fidelity can help — Market & Sectors Overview. All screenshots and stock symbols are for illustrative purpose only.

Sincere: So you focus on specific stocks and sectors?

Turner: Exactly. It’s detrimental to scatter yourself over a whole bunch of stocks that you don’t have expertise on. I used to know a trader who used to trade only one stock: GE. He went long, short, and bought and sold options. He knew exactly how that stock was going to act in any given circumstance.

Sincere: What technical indicators do you look at?

Turner: On the long side I keep it simple. I like the 20-day MA, the 35-day MA, the 50-day MA, and the 200-day MA. I keep the RSI (Relative Strength Indicator) and OBV (On-Balance Volume) on my charts. I also like stochastics to tell me if there will be a bullish divergence (the price of the stock drops to a new low while the indicator climbs higher). And of course volume is key-especially volume spikes.

Sincere: Where do you put your stops?

Turner: I usually place my initial stops under the low of the entry day. When the stock breaks out and trades for an hour, or so, I may raise my stop to a point just below a consolidation area on an hourly chart. That helps to minimize risk.

Sincere: Are the charts ever wrong?

Turner: Like the song says: Don’t believe your lying eyes. It’s not the chart that is wrong, it’s my lying eyes. Once we get a pattern in our head, the hardest thing you can do is to admit that pattern isn’t playing out the way you thought it would or the way it played out before.

Sincere: So how do you prepare for market uncertainty?

Turner: In the markets it means being nimble and open-minded and recognizing that perhaps this is the end of an uptrend and the beginning of a downtrend. Something out of the ordinary is always going to happen, so expect the unexpected. I’m always surprised when Mother Market is in a nastier mood than I thought possible, so don’t jump in too quickly.

Dr. Alexander Elder: A Trading Diary is the Key to Success

Dr. Elder is a psychiatrist, professional trader, and the author of several bestselling books including Trading for a Living (Wiley, 1993) and Entries & Exits: Visits to Sixteen Trading Rooms (Wiley, 2006).

Sincere: How did you get started as a trader?

Elder: I knew there was a game happening in front of my face and some people were making real money and I knew that I would stick to it until I was one of them. I worked to build my capital, which was tiny in those days, and eventually I figured it out.

Sincere: What kind of trader do you consider yourself?

Elder: A very cautious one. Most of my trades are from a few days to a few weeks. Occasionally I will put in a day trade. I have a number of positions that I have held for more than a year which can be profitable, although it’s not easy.

Sincere: What should traders do to be successful?

Elder: Keep good records. As long as you keep good records, you can learn from your mistakes. I don’t allow myself to have breakfast until my diary is updated. Keeping and reviewing your diary is how you become your own teacher.

Sincere: What have you learned about money management?

Elder: The most important rule of money management is my 2% rule. You cannot risk more than 2% of your account. I risk even less than 2% because I trade a fairly large account.

Sincere: What kinds of trades do you like the most and why?

Elder: Everyone told me I should follow the trend. I finally said, ‘I’m not a trend trader, I’m a reversal trader.’ It’s a dangerous way to trade, but I love trading reversals. I have certain tools and techniques that identify when a certain trend is weak. When it’s weak, I start trading it. I have eight methods or rules for identifying when a trend is starting to weaken.

Sincere: Where do you place your stops?

Elder: I put fairly wide stops in the area where I don’t expect prices to go. There’s a lot of back and forth in the market so having a tight stop is asking for trouble. I look at the chart and I put the stop at the point where I am proven wrong.

Sincere: At what point do you take profits?

Elder: I have technical indicators that determine when the move is becoming internally weak. It’s also important not to get too greedy. No one knows where the top is. If the market is acting strange, take the profits.

10 Essential Books

A list of highly respected titles that one author believes should reside on the bookshelf of today’s informed active trader

Trading books have flooded the marketplace during the past 15 years, as new technology has made online securities trading a widespread enterprise for many individuals. Investors routinely trade directly from their homes, workplaces and even on the move with the latest wireless handset capabilities. Amid this burgeoning era of online securities trading, demand for information and education has exploded, a likely result of the growing recognition among novice and emerging traders that securing profits in ever-changing markets can require considerable due diligence. That’s why Fidelity Active Trader eNews asked author and trader Michael Sincere to compile a list of “must-have” trading books. To produce his list of recommendations, Sincere spoke with several trading professionals.

Even if you consider yourself a sophisticated trader, you probably recognize that reading an insightful book on trading can be a great way to sharpen your skills. But with bookstore shelves brimming with trading tomes, how do you separate the informative and valuable from the vacuous and dull?

While any top-10 reading list is subjective, there are some titles that were consistently mentioned during my recent informal survey of professional traders and money managers. The following list of books appeared to have made a huge difference in the lives — and net worth — of many folks who make a living on Wall Street. This list is by no means comprehensive, but it’s a good start for those interested in reading what savvy traders consider to be “the classics.”

1. Reminiscences of a Stock Operator, by Edwin Lefèvre
As a young adult in the 1920s, Edward C. Johnson 2d developed a growing interest in the equity markets while watching his father act as trustee for several family trusts. His fascination with the markets increased after readingReminiscences of a Stock Operator, which draws on inspiration from the life of legendary trader and speculator Jesse Livermore. Several years later, in 1943, Johnson became president and director of a small, Boston-based mutual fund, now called Fidelity Fund, which was the first investment fund managed by Fidelity Management & Research Company (1946) — today one of the world’s largest and most-respected global research and investment firms.

Although written more than 80 years ago, Reminiscences is repeatedly mentioned by traders as one of the best educational tools for trading. It reads like a trader’s diary, but many traders believe the lessons included in the book are still relevant today.

“This book remains one of my all-time favorites because every time I immerse myself in its pages, I am reminded of old lessons — plus, I always seem to learn something new,” says Toni Turner, best-selling author of A Beginner’s Guide to Short-term Trading and her latest, Short-Term Trading in the New Stock Market. “In today’s markets, where educational materials become outdated quickly, it’s a gratifying experience to read and reread Jesse Livermore’s pithy yet enduring advice.” Turner says one of her favorite lines from the book is the following: “A speculator must concern himself with making money out of the market and not with insisting that the tape must agree with him.”

John Carter, president of Trade the Markets, Inc. and author of Mastering the Trade, agrees. “This book is great because it’s so timeless. While the book is based on trading that took place in the 1920s, it applies equally well to today’s markets. It really shows that markets are all the same because they have one common element that hasn’t changed with time — human nature. Once a person understands how to trade ‘human nature,’ then, and only then, can they consistently make a living speculating in the markets.”

2. Trading for a Living, by Dr. Alexander Elder
Dr. Elder, a trader and psychiatrist, was one of the first traders to recognize the importance of the emotional aspects of trading. He pointed out that a superb trading system with a poor psychological profile often leads to an unprofitable portfolio.

“Elder focused on giving first-time traders their own trading plan so that you not only knew where to start, but you also had a good formula for managing risk,” says Deron Wagner, president of Morpheus Trading Group. “It was the first book I read after I got into trading and it helped me get my feet wet.” Wagner says that the sections of the book that deal with psychology and risk management are “must reads.”

On a personal note: Every time I discuss trading with Dr. Elder, I gain additional insight about what really goes on behind the scenes in the stock market. And that’s the essence of his book: It reflects his knowledge and understanding of what makes markets move up or down. Elder followed his first best-selling book with another, Come Into My Trading Room.

3. Market Wizards and The New Market Wizards, by Jack D. Schwager
These two complementary books are often mentioned as classics primarily because of the author’s probing question-and-answer techniques. In these books, Schwager delves into the minds of some of the country’s most successful traders to unlock the wisdom behind their profitable trading techniques.

Author Turner says the Schwager books are her favorites. “From these financial superstars, we discover not only terrific insight into the workings of the financial markets machine, we learn that along with their victories, these traders have experienced losses that were, at times, devastating. Yet, they emerged stronger and with renewed conviction that they could succeed in one of the world’s most challenging arenas. These two books remain timeless, compelling, and always present me with new nuggets of wisdom.”

4. How to Make Money in Stocks, by William J. O’Neil
William O’Neil, publisher of the popular financial newspaper Investor’s Business Daily, was one of the first investors to clearly explain how to select profitable stocks using both fundamental and technical analysis. In his best-selling book How to Make Money in Stocks, originally published in 1988, he introduced traders and investors to his rule-based, common-sense trading approach — CAN SLIM™. The acronym CAN SLIM stands for: Current quarterly earnings per share, Annual earnings per share, New products, Shares outstanding, Leaders, Institutional sponsorship, and Market direction.

“What’s so great about this book is that O’Neil takes the best strategies and combines them into one technique, CAN SLIM,” says Morpheus Trading Group’s Wagner. “He also gives specific rules that you can use when entering a position. Most important, he tries to keep you from buying stocks that will fall apart, and he does that by teaching you how to find quality stocks by combining fundamental and technical analysis.” Wagner adds that 80%-90% of the stocks that he buys are based on a modified version of O’Neil’s system.

During a previous interview I had with O’Neil, he explained how he first used CAN SLIM to turn a small amount of money into a fortune. With his profits, he started his financial newspaper based on the successful theories included in his book.

5. The Intelligent Investor, by Benjamin Graham
This best-selling book, originally published in 1949, is often referred to as the definitive work of fundamental analysis. College professor Benjamin Graham is considered by many to be the world’s greatest investment advisor of the 20th century because he introduced a generation of investors to a strategy called “value investing.” From an early age, Graham learned the importance of thoroughly researching a company and determining whether its stock price was a good value.

Graham’s book can be useful to both investors and traders, according to several professionals in both camps. Consider what independent trader Howard Kornstein says: “Traders should read and study this book. Although The Intelligent Investor was written more than 50 years ago, it is not outdated. The fundamentals of the securities marketplace have not changed. If you’re going to take a long position, it benefits you to choose a company that is fundamentally stable. By reading this book, you learn to identify companies that are fundamentally sound and in position for a possible trade. Anyone who trades a company that is not fundamentally stable is likely to execute a trade that could result in a significant loss.” Kornstein said he chooses trades using a combination of charts and fundamental valuation.

Although the original version of this book was found to be a difficult read for some novice traders or investors, the terminology of the latest version is markedly improved. Another highly respected Graham book — Security Analysis (originally published in 1934 with co-author David Dodd) — is considered a dietary staple for those considering a career in portfolio management.

6. One Up on Wall Street, by Peter Lynch (with John Rothchild)
Portfolio manager Peter Lynch led Fidelity Magellan Fund to a 28-fold per share gain from May 1977 to May 1990, and is recognized as the most successful mutual fund manager of this generation. When he wrote One Up on Wall Street, in 1989, an increasingly larger percentage of the U.S. population was investing in the equity market, but many newcomers had little knowledge about how to buy and sell stocks.

“My objective in writing the book was to communicate many of the basic investing principles I adopted over the years,” Lynch points out. “I felt it might help those people willing to put in the time and do the research work necessary to become a better investor.”

One of Lynch’s key messages was to understand the companies issuing their stock. With his friendly writing style, he explained in his book that investors could identify profitable companies based on their own experience and observations. For example, a person who worked in a shopping mall during his or her career might have an edge in the retail sector, just by watching which stores were busy and which products were big sellers. The person working at the mall could have seen a lot of good ideas just by observing consumers and talking with them. This kind of company observation helped generate several good stock ideas for Lynch in his term running Fidelity Magellan, and he would follow up on those ideas with rigorous fundamental research.

“For new investors, Lynch teaches you how to use what you already know to make money in the market,” wrote author and former portfolio manager Joshua Kennon, who included Lynch’s book in his own top-10 list on About.com.

Another important lesson Lynch sought to pass along to readers was that investing was serious business. He pointed out that many people spent more hours researching a new television set purchase than investing $20,000 in a stock based simply on a tip they heard from a neighbor.

7. Stock Trader’s Almanac, by Jeffrey A. Hirsch and Yale Hirsch
The Stock Trader’s Almanac is a reference book that many traders believe is a requirement for any serious trader. This almanac includes several graphs, historical charts, market data, forecasts, economic announcements, and a calendar of events, among other information. Although not 100 percent accurate in its recommendations, the book will give insight on historical market events and performance, and provide forecasts as to when the authors believe similar scenarios could occur in the future. In addition, the almanac will help identify specific trends that take place on a yearly or cyclical basis. For example, the book notes that the market tends to have higher trading volume during the first three weeks of a new calendar year. The authors also assess the probability of whether or not a similar trend could take place the following year.

8. Technical Analysis of Stock Trends, by D. Edwards and John Magee
Many traders who use technical analysis mentioned the Edwards and Magee book as “the bible of technical analysis.” The book claims to be “the first to produce a methodology for interpreting and profiting from the predictable behavior of investors and markets.” What traders feel strongly about is that this book shows them how to use technical analysis to make money trading regardless of market conditions. It thoroughly explains all of the key technical trading concepts, including chart patterns, relative strength, candlesticks, oscillators, momentum and volume, moving averages, and other indicators. In addition, the authors explain how to spot trends through the use of these technical indicators.

Professional trader Kornstein explains why he feels the Edwards and Magee book is so essential. “Basically, technical analysis is graphing the changes in price, time, and volume, and the mathematical derivatives that are formulated from this data,” he says. “The concepts taught in this book are as useful today as they were fifty or sixty years ago.”

For a less-intensive understanding of technical analysis, Kornstein recommends Martin J. Pring’s book Technical Analysis Explained. Pring covers the technical indicators of the markets by explaining the concepts in simple, easy-to-understand language.

9. Technical Analysis of the Financial Markets, by John J. Murphy
Technical Analysis of the Financial Markets guides you from the first application of Dow Theory and the basics of charting through the latest computer technology and most advanced analysis systems. Written by StockCharts.com’s John Murphy, a former director of Merrill Lynch’s technical analysis futures division, this book includes 400 charts that clarify key points of the following: candlestick charting, point-and-figure charting, oscillators, Elliot Wave Theory, Fibonacci, and other technical indicators.

Gail M. Dudack, chief investment strategist for Warburg Dillon Read, provided the following testimonial to Murphy’s book: “No one in this generation had contributed more to technical analysis than John Murphy. Through his series of books, he has opened the door to many and raised the standard for all who use technical analysis. His books should be required reading for everyone in the securities business and are never more than a step away from my desk.”

10. The Essays of Warren Buffett: Lessons for Corporate America, by Warren E. Buffett and Lawrence A. Cunningham
This book is a collection of annual report letters by legendary investor Warren E. Buffett to shareholders of Berkshire Hathaway, Inc., the holding company for which he serves as chairman and CEO. Buffett is widely regarded as one of the most successful investors of the 20th century. Reading this collection of shareholder letters, carefully arranged and edited by Lawrence A. Cunningham, is like taking a course from Buffett himself, as you learn the thoughts and theories behind his investing practices.

In his shareholder essays, you won’t find Buffett commenting much about the stocks he owns, but he loves to discuss the basic principles behind his investments. Many of his principles are derived from his study at Columbia University, where he learned — and later worked — under the tutelage of professor Benjamin Graham (The Intelligent Investor, Security Analysis).

Buffet’s folksy writing style has made his letters among the most widely read financial documents on Wall Street each year. In his company’s 1989 report, Buffett wrote:

“We hope to buy more businesses that are similar to the ones we have, and we can use some help. If you have a business that fits the following criteria, call me or, preferably, write. Here’s what we’re looking for:

(1) Large purchases (at least $10 million of after-tax earnings),

(2) demonstrated consistent earning power (future projections are of little interest to us, nor are “turnaround” situations),

(3) businesses earning good returns on equity while employing little or no debt,

(4) management in place (we can’t supply it),

(5) simple businesses (if there’s lots of technology, we won’t understand it),

(6) an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

“We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer — customarily within five minutes — as to whether we’re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give.”

Buffett is not immune to owning up to poor investing results, either. Witness this commentary from 1999’s annual report letter:

“Even Inspector Clouseau could find last year’s guilty party: your Chairman. My performance reminds me of the quarterback whose report card showed four Fs and a D but who nonetheless had an understanding coach. ‘Son,’ he drawled, ‘I think you’re spending too much time on that one subject.’ My ‘one subject’ is capital allocation, and my grade for 1999 most assuredly is a D. What most hurt us during the year was the inferior performance of Berkshire’s equity portfolio — and responsibility for that portfolio, leaving aside the small piece of it run by Lou Simpson of GEICO, is entirely mine.”

Also Worth a Look
The following are titles that many traders and investors also believe are worthy of consideration:

You Can Be a Stock Market Genius (Joel Greenblatt)

The Little Book That Beats the Market (Greenblatt)

Security Analysis (Benjamin Graham)

Technical Analysis Explained (Martin J. Pring)

Winning on Wall Street (Martin Zweig)

Options as a Strategic Investment (Lawrence G. McMillan)

Tools and Tactics for the Master Day Trader (Oliver Velez and Greg Capra)

Beating the Street (Peter Lynch, with John Rothchild)

Confessions of a Street Addict (James J. Cramer)

How I Made $2,000,000 in the Stock Market (Nicolas Darvas)

The Disciplined Trader: Developing Winning Attitudes (Mark Douglas)

The Master Swing Trader (Alan S. Farley)

The Stock Market Course (George A. Fontanills)

Buffett: The Making of an American Capitalist (Roger Lowenstein)

The Warren Buffett Way (Robert G. Hagstrom; foreword by Peter Lynch)

Trading to Win (Ari Kiev M.D.)

High Probability Trading (Marcel Link)

When Genius Failed (Lowenstein)

Extraordinary Popular Delusions and the Madness of Crowds (Charles Mackay)

Japanese Candlestick Charting Techniques (Steve Nison)

Mastering the Trade (John F. Carter)

Trade Your Way to Financial Freedom (Van K. Tharp)

Secrets for Profiting in Bull and Bear Markets (Stan Weinstein)

A Beginner’s Guide to Short-Term Trading (Toni Turner)

10 Common Trading Errors

Many novice and emerging stock traders charge full throttle into the markets with high profit expectations, but find out fairly quickly that making money consistently isn’t as easy as they expected. For some, this realization can be quite discouraging, particularly because there are few pursuits that fuel human emotion as significantly as trading. The prospects of making money often lure people into the trading arena, but the reality of losing money can be a quick deterrent.

In truth, most professional Wall Street traders have made many trading mistakes, according to trading experts. The key to their eventual success, however, is that the professionals study their mistakes and learn how to minimize them going forward. “It’s all right to make mistakes,” admits Dr. Alexander Elder, psychiatrist and author of Come Into My Trading Room. He adds, “If you aren’t making mistakes, you aren’t learning. But it’s absolutely unacceptable to repeat those mistakes.” Like most serious traders, Elder has made a significant number of errors in his trading career. “The wonderful thing about the stock market is that you always know when you’re right or wrong. If you’re losing money, then you’ve probably done something wrong. Eventually, if you learn not to repeat making the same errors, you’ll start running out of them.”

The following article takes a look at 10 of the most common mistakes made by active stock traders.

1. Little Preparation or Training

When you enter the market arena, you had better be prepared. However, few traders perform the necessary due diligence before moving headlong into the markets, says Robert Deel, CEO and trading strategist for Tradingschool.com. “If you are going to swim with the sharks, you better learn from the sharks,” Deel suggests. “The market is a food chain — the big fish eat the little fish.”

Deel says few books teach you everything you need to know about trading stocks, so he recommends stacking the odds in your favor by reading as many as possible. “You shouldn’t underestimate the time, dedication, and commitment it takes to be a successful trader. You can’t just walk into the market with a handful of money and expect to take money away from the professionals. If that’s the case, you’re gambling, not trading.”

Dr. Elder agrees that many people underestimate what it takes to be a profitable trader. Not having the benefit of a business school education or on-the-job training with a financial firm, Elder says it took him a long time to become a successful trader. “I had to overcome a huge disadvantage — a formal education,” he quips. Elder says that while a background in financial services would have been helpful for him, sometimes highly educated traders can tend to get too caught up in technical analysis. “The market doesn’t always work that way,” he says. “Markets have a high degree of volatility. How you function in an atmosphere of uncertainty can be much more valuable than the type of analysis you use.”

2. Being Too Emotional About Money

According to professionals, the reason many emerging traders fail to consistently earn profits is because of their perceptions of money. Trading expert Deel says that he gives all of his students a psychological test when they come to class. On the test, students are required to describe — in one word — what money means to them. Nine times out of 10, the answers are “safety,” “security” or “power,” he says. “Too many traders get so emotionally involved in their trades, long or short,” Deel points out. “If a trade goes against them, many feel they are losing safety. That’s why they tend to react so emotionally.”

Deel says that no one can properly prepare a trader for the emotional roller coaster of the stock market. “Many are afraid of being branded a loser,” he says. “To keep from being wrong, many people often will let a stock go negative against them. Let’s say they put a stop at 30. As it drops to 29, then 28, they sometimes decide to go against their original trading plan. To keep from selling at a loss, they suddenly decide to hold for the long term. That’s often a painful error.”

Dr. Elder agrees: “If you came into my trading room and sat across from me, you wouldn’t know if I was making $10,000 that day or losing $10,000. I don’t show that much emotion. I’m more concerned about the longterm outcomes of my trading. It’s more appropriate to look at your account at the end of the month or year, as opposed to your daily results.”

Fortunately, there are ways to desensitize one’s emotional connection to money. Elder and Deel both suggest that by trading smaller share sizes, such as 100 shares per trade, emerging traders can teach themselves to be less emotionally charged. Trading in smaller quantities can help minimize both the losses and the emotional distress that often comes with losing larger amounts of capital. Over time, as a trader becomes more successful, experts suggest slowly raising the share size — without raising your blood pressure — until a personal comfort zone is reached.

3. Lack of Recordkeeping

It’s understandable why traders become emotional when trading stocks. Elder says: “When you make a trade, everything is going up or down. It can feel like you have no control over what is happening. By the very nature of buying and selling, total strangers are giving you money or taking away money, and that can be very stressful.”

To help bring these emotions under your control, Elder recommends you keep a trading diary. “Every time you enter a trade, print out the chart and write down why you entered the trade, whether it was fundamental, technical, or a tip,” Elder says. “I write the entry on the left side and my exit on the right side.” He says the diary helps you achieve two goals. “The first is to make money. The second is to become a better trader. You might not succeed on the first goal, but you must absolutely succeed on the second goal. You should try to become a better trader after each trade.”

Elder believes keeping good records is essential. “Show me a trader with good records and I will show you a good trader. Even if you’re losing money little by little, you’re learning from your mistakes. I believe money management and recordkeeping are even more important than technical analysis — and I’m a guy who wrote two books on technical analysis.”

4. Anticipating Profits

Most traders don’t want to acknowledge that a trade could turn against them. They enter the market assuming they’ll be successful, refusing to look in the rearview mirror. It’s also common for emerging traders to use a calculator to predict how much they’ll make and how they’ll spend the unrealized profits!

Deel thinks that it’s dangerous to anticipate how much you’ll make in advance. “Let the market tell you what you are going to make. Anytime you say ‘I have to…’ you’re in for potential trouble. Remember: The market doesn’t care about you.”

He suggests that entering the market with a neutral attitude is a good approach. “My mantra: What is, is. If you’re in an uptrend, go long. If you’re in a downtrend, go short. If you’re overbought, wait for a reversal and go short. If you are oversold, wait for a reversal and go long.”

5. Blindly Following Mechanical Systems

A large percentage of traders use technology — in the form of online trading platforms that provide charting, research, and backtesting tools — to help them refine their strategies. A computer and software can provide important information about the technical and fundamental characteristics about stocks. However, many traders make the common mistake of relying too much on these tools without a full understanding of their capabilities.

“People think that the computer is a replacement for what is between the ears,” Deel says. “They think the box is going to give them the answer. A lot of people gravitate toward mechanical trading systems that are supposed to take over the trading for them.” He contends that if you don’t know how these trading signals are generated, then you are using software to think for you. “When you give up thinking and analyzing,” he says, “you are toast. If you are blindly following mechanical systems to buy and sell, it’s likely that you’re unsure of exactly what you’re doing.”

6. Not Learning How to Short

If you fail to learn how to utilize short trading strategies, then you have cut yourself out of a number of profitable trades, experts say. Many people think that shorting is un-American or too risky. However, by not learning know how to go short, you’re putting up a roadblock to one of the potential trading avenues you have to earn profits, particularly during a declining market.

Deel is adamant about shorting. “I believe it’s essential that traders learn how to short. It’s one of my first rules: Thou Shall Learn How to Short. Because of fear or ignorance, many Americans never learn to short in their lifetime. They’re afraid of unlimited risk. But shorting a stock is no more risky than going long.” He cautions that traders need to be very disciplined when shorting. “You can’t hang on. If the stock goes up, then you get out. It’s that simple.”

Dr. Elder concurs with Deel’s view on shorting. “The market is a two-way street, and the person who doesn’t short is missing a part of the game.” Because stocks tend to go down faster than they tend to go up, Elder says that shorting may be best suited for short-term time frames. For emerging traders looking to learn how to short, Elder suggests that traders find a stock that they believe has poor prospects and sell short no more than 100 shares. Minimizing the size of a trade can help ease a trader into the strategy of shorting without incurring excessive risk.

Editor’s note: Margin trading entails greater risk and is not suitable for all investors. Please assess your financial circumstances and risk tolerance prior to trading on margin.

7. Lack of Specialization

Many people are attracted to trading because they think it’s an easy vehicle for making money. However, there are several types of securities that can be traded in today’s markets, including stocks, options, commodities, futures, and currencies. For emerging traders, it can seem like a daunting task to learn the characteristics of each security type. Therefore, it’s often helpful to specialize. “When emerging traders don’t initially specialize in some segment of the markets,” Elder says, “they could be susceptible to over-engaging in whatever hot market segment comes along. Successful trading takes time, so it’s quite helpful to be dedicated and committed to a particular category.”

Most trading experts suggest that if you want to trade successfully, you need an edge. What do you know that will give you some degree of conviction? “If you don’t know the answer to this question,” he continues, “then you have no business trading. My answer: I know a few things about technical analysis because I wrote a few books on it. I can analyze charts with some degree of depth. I’ve been trained to recognize what is real and what is fantasy. And I’m extremely disciplined.”

8. Improper Timing

It’s very common for emerging traders to make timing mistakes. Quite often, a trader may have a good idea, but discovers that he or she bought the stock at an inopportune price. Timing a trade is never an exact science, but it’s important for traders to recognize that there are times when it might be prudent to lock in a profit or cut a loss.

“Smart people get in too early and beginners get in too late,” Elder says. “If you wait long enough, a stock may start to look like a good idea, but by then it’s often too late.” To illustrate this point, Elder said Google (GOOG) seemed like it would have been a good short when it’s share price recently dropped from 300 to 276, but the move had already been made. Waiting until a chart pattern has been fully established can often result in a missed opportunity.

According to Deel, smart traders should not look for just overbought or oversold conditions, but extreme overbought and oversold conditions. Taking advantage of extremes could help traders better manage their portfolio risk. However, there are no guarantees that the current trend for a stock in an extreme situation won’t continue.

In identifying trading opportunities, Deel uses a one-year time frame because there are a lot of data points. He is very conscious about timing his entry and exit points. “It’s those movements up and down that make money. I want to feel positive about a stock three days after I bought it. If not, something is wrong.”

9. Placing Improper Stops

Many traders incorrectly place stop orders, causing their positions to get stopped out too early and failing to capture much profit. It’s common for emerging traders to place stops according to a set percentage, such as 2%, or a set amount. How much a trader is willing to lose depends on his or her risk-tolerance.

Deel says that many traders have been given incorrect advice on placing stops. “You place stops according to what the market is telling you, such as support and resistance levels,” he says, “not according to profit goals. The market doesn’t care how much money you need to make.” Deel says that early in his career, he was constantly stopped out early, roughly 60% of the time in his estimation. “What I discovered was the market tends to move within a certain range under normal circumstances.”

Today, Deel no longer places stops according to a percentage amount or how much money he is willing to lose. “Now, when I place a stop, I let the stock’s behavior, or standard deviation, tell me where the best stop placements are. When I let the stock tell me where to place the stop, I get stopped out only about 20% of the time.”

Standard deviation is simply a range, both high and low, of a stock’s normal volatility based on a certain time period. Deel typically places three different stops using standard deviations. “Every stock has a specific standard deviation,” he says. “It’s as different as a fingerprint.” You can find the standard deviation by using Bollinger Bands, which give you stop losses and an upside price projection. Using Bollinger Bands, the stock price should be within the upper and lower ranges. “Ninety-five percent of all price activity falls within two standard deviations,” he says. He plots Bollinger Bands using an exponential calculation, rather than simple. “You can determine a stock’s high and low ranges and what it can move based on standard deviation and probabilities.”2

10. Not Calculating a Stock’s Risk-Reward Ratio

Many traders do not calculate the risk-reward ratio of a stock trade before they establish a position. A stock’s risk-reward ratio is the relationship between an investor’s desire for capital preservation at one end of the scale and a desire to maximize returns at the other end.

How do you determine a stock’s risk-reward profile? Through experience, traders tend to find their own comfort level for determining this ratio — there is no magic number. There are three common components of a stock’s risk-reward ratio: current stock price (a known); and a profit objective and stop exit price (both subjective). Calculating a profit objective and a stop exit for a trade often involves many factors, such as standard deviation or technical indicators, including Fibonnaci and moving averages.4

Deel looks for trades that give him what he believes is at least a 2.5 times greater reward (gain) than the possible risk (loss). At a minimum, if he calculates that he could lose more than $1,000 versus a $2,500 gain, he won’t make the trade. For Deel, 2.5:1 is his risk-reward ratio. But once again, that number is an arbitrary one that works well for Deel. A stock’s risk-reward ratio can be different for each trader based on personal preference or the particular type of trade being considered.

“Every stock is a turkey until proven otherwise,” he says. “This is part of the screening process of a stock.” Deel says he’s very picky about the trades he makes. “I’ve sat by great traders who see a perfect setup but not the risk-reward. They get in, and it reverses. If I’m going to risk a dollar on a stock, I want to estimate that I can make $2.50 or more before I make the trade. Otherwise, I move on to the next stock.”

Figure 1 (below) is an explanation of how Deel calculates the risk/reward profile of a stock.

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Figure1: This image details a method for calculating the risk/reward ratio of stocks. Shown for illustrative purposes only.

Recommendation: Before you enter a trade, the first question you should ask yourself is: What is the riskreward ratio of trading this stock? If you are a novice trader, using a low risk-reward ratio could help lower your potential downside.

Bottom Line

It’s common to hear about the victories people have trading stocks, but you rarely hear about the losses. As a result, it’s easy for emerging traders to get lulled into thinking that successful trading involves little more than knowing the ticker symbol of the latest idea from your neighbor, coworker or poker buddy. Most Wall Street experts recognize that trading is a complicated and challenging business requiring an ongoing commitment. As a child, you didn’t learn to ride your bike without taking a few falls. You didn’t learn to catch a baseball without dropping the ball at least a few dozen times. And you didn’t master your profession without making several mistakes along the way.

It’s no different trading stocks. Most successful traders are constantly studying their craft, looking for an additional edge that may help them make more-informed decisions.

Understanding that mistakes are part of the process and learning to reduce them could help you develop a more disciplined, consistent approach to trading.