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Trading forex does not incur any commis- sions and futures commissions are much lower now so I doubt that this factor is so important anymore. The cost of buying at the ask and selling at the bid on every trade is a significant drag on performance over a given year. Now assume that we do almost one trade per day, or trades per year. We effectively start out in the hole by 7.
We need to make at least 7. Take a look at your own experience to see where you stand and how much headwind you have to overcome to break even. It might actually be worse than that. The most common form of forex trading is spot forex through a retail forex broker such as FXCM or Sterling Gent.
Brokers take an additional profit from the roll every day. We are now up to a 15 percent headwind to make any money. Stock investors tend to make money but that is largely because the stock market drifts higher over any decent, long period of time, not because stock investors are better investors. In addition, there is no time limit when you invest with stocks. Futures and options expire. Investors will often hang on to losing positions in stocks for years waiting for them to return to profitability.
The high leverage creates a mentality toward trading that works against traders. Contrast this mentality with the normal stock investing mentality that looks to buy and hold. The pressures of dealing with high leverage cause the usual forex trader to make a lot of mistakes. And those mistakes cost more than in the unleveraged stock world. The high leverage puts a lot of mental pres- sure on the forex trader that is simply not there in as high a degree for a stock trader. The sum of all these differences is that the forex trader has a much harder time making money than a stock trader.
The subtitle of this book is A Guaranteed Income for Life. This title was inspired by an infamous poker book from 20 years ago. I truly believe that the material in that book can create a guaranteed income for life. This is not BS. You must not deviate.
You must execute flawlessly. Only after you have mastered this material should you start to be creative. This self-discipline is critical to your success.
A lackadaisical attitude will put you back in the category of a losing trader. You will live a life that few can even comprehend. I wrote much of this book while hanging out near the beach in Belize. How can I do this?
Internet access. I do all my analysis and trading online. My first stop after the Singapore speech is a week in Bali. Guess what? I really only need Internet access for about 15 minutes a day. I prefer more than that because I post a lot of instructional videos on my educational Web sites and that takes more time and bandwidth. But how about just a few minutes at an Internet cafe´ in China or London or wherever?
The true goal for me, and most people trading forex, is not to make a lot of money but to gain freedom. I know that I presented a rather dismal picture about how hard it is to make money in the forex world. This is a very strong statement. How do I know that this is true? How can I be so sure? I have spent many years training traders.
I have been teaching these techniques for over 25 years. More important, I have been training retail investors with no experience at all trading let alone trading forex. It has been a very gratifying experience. I have really enjoyed watching people create a new life for themselves. Every single one of my retail educational clients has made money trading forex, except one.
And he is down just a little. At one point, I foolishly offered a mentoring program called Extreme Profits. What an idiot I am! All but one student doubled their money. These were normal retail in- vestors; no trading pros in the group. By the way, she was up 70 percent for the year. So I know that it can be done. I know that you can do it! you must execute flawlessly. Now go through this book. Execute the plan. Make money. Live the life you dream about. This book explains all the basics that a novice needs to know to get going.
At the same time, experienced traders will find the systems and methods, particularly my enhancements of classic methods, to be of signif- icant value. Every trader will find the sections on the psychology of trading and risk management will sharply enhance their profitability. Chapter 1 outlines the basic information you need to get started in trad- ing forex. But I assume that you know nothing about trading forex. Even if you have some experience trading forex, this chapter is worth reading for the examples.
Chapter 2 is where we really start the methods of making money in the forex market. This chapter introduces trend analysis. This technique is similar to what have been called s.
However, I add in a unique method to truly define which trends to jump onto and which ones to sidestep. In addition, I introduce to the public for the first time the Bishop tech- nique. This unique indicator has a tremendous track record of getting out of trades at major highs or lows. I will exit all my open posi- tions on any technique whenever I see a Bishop buy or sell signal. This fil- ter eliminates about half of my losing trades while only eliminating about 5 percent of my winning trades.
What a great tradeoff! It dramatically enhances the profit of the trend analysis and other techniques. Chapter 3 is all about channel breakouts. This classic technique has been around since the s. How- ever, I introduce several major enhancements to the classic technique that turbo-charge the profitability.
The first enhancement is the principle of instant gratification, which is an underlying principle that will show you how to greatly enhance your understanding of the market, how to profitably trade, and how to boost your profits. I also introduce the rejection rule. This powerful enhancement cuts the risk of trading channel breakouts by at least half, yet it retains all the profit potential.
It basically monitors the health of a breakout and leaps out of the position if there is no follow-through. In addition, it cuts down on the psychological stress of trading channel breakouts. I then add in another exit strategy called the last bar. I got this idea from ace trader Peter Brandt.
It sharply reduces the risk in any given trade to a trivial amount. As you can imagine, cutting risk to small amounts dramatically enhances your profits at the end of the year. I introduce the Conqueror in Chapter 4. Another unique feature of this method is that it uses different exit techniques than the entry techniques. This is the only method I know that uses different exit and entry techniques. The Conqueror is a technique that has a very hard time entering the market. It wants all the conditions to be perfect before entering a trade but jumps out of the position at the slightest intimation of weakness in the trade.
I love this system and I think you will, too! Chapter 5 introduces how to use stochastics profitably. It seems like everybody uses stochastics; they are perhaps the most popular indicator in chart services.
Yet everyone is using them wrong. This chapter shows you how to profitably use stochastics while sidestepping the usual traps that drain money from your account.
I show you how I use stochastics to iden- tify short-term turning points and, more important, how to identify major turning points. As a bonus, I have included an amazing interview with the inventor of stochastics, George Lane. I had the privilege of interviewing him before he passed away. This hard-hitting interview reveals how he invented stochastics, where they got their name, and, most important, how George himself used stochastics to make money in his trading.
This interview is priceless. Another unique feature of this book is that I show you different profitable techniques to use over different time horizons.
The techniques discussed here are techniques that look at the market from the perspective of days to weeks. Chapter 6 introduces several techniques that trade over a much shorter term. These techniques hold positions for less than one day. These pattern-recognition techniques are great for those traders who want to make money during the day rather than over the next week or month.
I like to think about these trades as just churning out some nice profits day after day. But making a nice chunk of money during the day is a very nice thing. This chapter also introduces the multiunit tactic. This technique uses multiple contract positions to give you more flexibility in your exits.
xvi PREFACE This technique has a lot of positive psychological benefits while also giving a kick to your profits. You cannot control the profit you make unless you control the risk in your account. Ninety percent of forex traders lose money while only about 5 percent make money. I argue that one of the critical differences between the winners and the losers is that the winners know how to control the risk in their account. Chapter 7 drills down on this important subject and gives you clear instructions on how to control the risk in your account to ensure that you will be a profitable trader.
I even take risk management one step further and show you how to use it as an offensive weapon, not just a defensive one. The concept of using risk management as a method for enhancing profits is rarely talked about in the markets. This chapter is critical because you need to be able to survive the inevitable losing streaks without losing any significant money and to also be able to maintain the proper mental state. You must never get to a situation that is both financially and mentally debilitating.
The next chapter, Chapter 8, shows a new technique called the Sling- shot as well as the mini-Slingshot. I also use this chapter to extend the discussion of risk management. The Slingshot is a very interesting chapter due to the unique concepts embedded in it. It builds on the risk manage- ment concepts from the previous chapter.
I believe that risk management is actually the second-most important factor for investment success. Chapter 9 looks at the biggest block against making money in the markets: you.
It is your psychology. You are the biggest problem. Intellectual skills are trivial. You will rarely have prob- lems with the methods that I present in this book. The basic risk manage- ment rules are also easy to apply. But the psychology of trading is intense and few can master it. I want you to be a huge success; it is the real key to making money in the market.
Please do not disregard it or push it to the side. I am laying out a lot of profitable techniques in this book. You will fail. You need to be able to execute the techniques or the techniques are useless. I am a big believer in stress-free trading. Why should I trade if I get all wound up in stress while doing it?
Life is too short. Once again, we need to deal with the psychology of trading. This chapter goes into the reasons people trade. I also go into all the reasons that people lose money and show specifically how to overcome those reasons. Chapter 10 shows you how all these techniques fit together.
By this point, I will have shown you a collection of powerful techniques for making money trading forex. This chapter shows how they all fit together into a coordinated program for profits. Each technique has a different purpose from the other techniques. So the totality of the techniques is truly greater than each technique separately. Once again, this is a very unique approach.
Most books will present techniques but no framework. You should come away from reading this book with a concrete and comprehensive approach to making money trading forex. You will have a toolbox full of profitable techniques. You will understand how to man- age your risk. You will understand how to have a stress-free psychology of trading.
Good luck! This volume completely swamps the global stock market. It is not hard to understand why forex is traded the most. Nobody needs to buy stocks but we must all deal directly or indirectly with the foreign exchange forex world. Global trade is huge.
Every time a barrel of oil is bought, dollars must also be bought by everybody but Americans. Japanese must change their yen into dollars to buy oil since oil is priced in dollars. Every time an American buys a Japanese car, dollars are swapped for yen to buy the car.
Every time a kid watches a Disney movie in Poland, dollars are demanded. Cross-border capital flows for investment contribute another massive quantity of foreign exchange transactions. Perhaps the largest component of daily volume is speculation. This is mainly done by banks and other financial institutions around the world. Every day, banks trade among themselves looking for speculative profit.
In addition, major banks try other strategies to make money. Perhaps a large order had come into a bank that was large enough to change the price of the currency. This piece of knowledge could create additional profit opportunities for the bank that knew about the order.
This will be discussed later in this chapter. Let me assume that you know something about investing in general, perhaps in stocks, and focus on how the forex market is different from other markets. We had a client who was a cotton merchant from Turkey. He speculated in forex as a paying hobby. What he wanted to do was to sell 1 billion British Pounds. The only currency that is capitalized is the Pound; all others are lowercase.
Forex trivia! We were shocked at the size of the order. That would be a huge order for any major financial institution, let alone for a single individual.
We were the counterparty on all orders from our customers so we were expected to take the other side of his trade. No way. All foreign exchange trading, except for a small amount on the Inter- national Monetary Market, is over the counter.
There is no exchange. All transactions are done over the phone, with a broker, or via some electronic means between two entities. Entities are usually financial institutions but are often corporations and sometimes individuals. That means that when a retail investor, such as myself, puts in an order through an online broker, the counterparty is practically unknown.
It could very well be the broker. However, the broker could be aggregating prices from different brokers or institutions. The source of the prices are unknown, which is very dif- ferent from the stock market because a stock is generally traded only at one place, such as the New York Stock Exchange NYSE. Technically, the NASDAQ is an over-the-counter market that is centralized in one place so it is, effectively, an exchange.
Forex is completely diversified. Back to the yard of cable. The size of his order meant that we had to lay off the risk to other dealers. But there was no way that we could find a dealer to take the whole billion Pounds. Even million Pounds was a large order. It was very late in the afternoon and I only had a few forex dealers on the desk. My main trading desk was in the form of a large T with me at the top of the T.
I could see and hear everything on the desk this way. I started grabbing dealers from other desks. It took a few minutes but I soon assembled a cast of ten forex, bond, and cash dealers arrayed in front of me, five on each side of the bottom of the T. We knew that the pressure of selling 1 million cable was going to cause a sharp drop in the price of the Pound Sterling.
It was a huge order. This is called front running and is legal in forex and bond trading but illegal in stock trading. I told each trader to call a different bank and get a price for million Pounds. In the interbank world, you ask for a price from the other bank. The other bank must offer you a two-sided market. The Basics of Foreign Exchange Trading 3 This means that they must give you a quoted price for both buying and sell- ing. Notice that 43 and 45 are not complete prices.
The complete price might have been 1. But dealers only speak about the last two figures of the price. In fact, the price of 43—45 was likely barked into the phone with the implication that we better quickly tell them whether we were buy- ers or sellers.
I told my dealers to raise their hand when they had a price. I gave them the sign to sell as soon as I saw my tenth dealer raise his hand. We were able to sell all billion Pounds that our client wanted us to sell.
We sold them all at the current market price. But then all hell broke loose. The pressure from our order caused a vacuum to open up under the price. We may have sold a billion cable at 43 but the price was pips lower in a fraction of the second.
A pip is the smallest normal increment that a currency trades in even though some brokers quote in tenths of a pip. A general rule of thumb is to start with the far-left digit in a price and count to the right five places and that is a pip. The yen under In that case, only count four places. Always ignore decimal places. Our phone board lit up like Times Square. All ten of those dealers we had just sold to were screaming into the phone some variation of how we had stuffed them and how our parentage was suspect.
They were scream- ing about how they were now holding a big position in Pounds and had nowhere to lay off the risk since we had basically forced the market to go long. They now owned 1 billion cable and had no one to lay off the risk to since we had just swamped the market. We let the other dealers vent for a minute or two and then explained that we had no choice in how we handled the order.
They all stopped venting and agreed that they would have done exactly the same thing and there were no hard feelings. Indeed, we found ourselves on the other side of such a trade over and over again. This is financial Darwin in action. Now, remember, we sold short 20 million Pounds before we stuffed the market. We had a huge profit in that posi- tion now. I remember one of my traders saying to me that we just had a good year in the last minute.
Yes, we made a lot of money on that trade. It was now time to mend some bridges. We would dole out our 20 million to the dealers that had com- plained the least to reward their attitude. On this trade, we were not trying to get the best price. But for ourselves, we wanted to get out at a reasonable price and, at the same time, give back a little love to the market after we had decimated it.
In this case, we called a few brokers and, after letting them rant a little more, told them that we were buyers of cable. That was a signal to them that they could move the price up a pip or two and make a little money on our order. Did I mention that trading forex is the most cutthroat of all the major markets to trade in? The Deutsche mark was still being traded when I was a dealer. The euro came later. Deutsche Bank was the premier bank trading the mark.
They were the big dog in the mark and really made the market for the mark. They had all the big clients so they saw most of the flow into the market. I mentioned before that we would generally quote a market with both sides. If we quoted a price of 65—67, that meant that we would sell it to whoever called us for a price at 67 and buy it from them at That meant that they wanted a price for me to both buy or sell the D-mark.
They could be buyers or sellers. This process keeps the system fair. Otherwise, consider if I knew that they wanted to be buyers. I could then shade the price a little higher so they would have to bid up to my price to buy. That way, I would make a little more money.
The two-sided quote keeps the market fair and also keeps the dealers on the ball. The same situation applies to the online forex world. Two prices are always on the screen. The lower price is the bid and is the price that we will get when we sell a contract of forex. The higher price is the ask, or offer and is the price you will pay when you buy a contract of forex.
I was always very afraid when Deutsche Bank would call me looking for a price on the mark. They were the largest dealer in the currency. They knew what the price was and had a huge inventory of marks. They wanted to see if I was quoting the price of the mark correctly. However, they would do a trade with me if I was quoting the price incorrectly. But they would sell to me if I quoted them 64— They would sell to me at 64 knowing that they could buy at 63 from their clients, thus making a pip on the trade.
That meant that I had quoted the market correctly. I would have most certainly lost money if they had done a trade with me. They knew that market far better than I did. There are a lot of different currencies in the world to trade but the volume is concentrated in just a few.
You are always long one side of the pair versus being short the other side of the pair. You can be long or short either side. That is the convention.
First, what does CHF stand for? It stands for Confederation Helvetia franc. The currency unit is called the Swissy even though the pair starts out with a USD. Foreign exchange in the interbank world is usually traded in units of a million dollars. The normal futures contract calls for delivery of , of whatever is being traded.
So the Swiss franc contract calls for delivery of , Swiss francs. The usual minimum unit that a pair can trade is called a pip. You can find out the value of a pip by multiplying the pip by the contract size that you are trad- ing. For example, suppose that you are trading a standard online contract of euro. The euro is quoted like 1.
One figure to the left of the decimal place and four to the right although there are now online brokers who quote in tenths of pips. So take the rule of thumb that the pip is the fifth figure from the left the ex- ception being yen when it is quoted under The value of a pip for a standard online contract would be 0.
The value of a pip actually changes during the day as the value of the underlying in- strument changes. In addition, some brokers may change the contract size less often. It is always best to double-check with each broker.
This is because the futures contracts are standardized at , francs, euros, or whatever. Thankfully, no. There is no margin or good-faith deposit in the interbank market. Instead, banks do deals with each other simply on credit.
A bank will have its credit officers examine the credit of the other potential trading banks. The risk in the forex world is not strictly a credit risk since there is no credit being extended.
There is just a delivery risk. The risk in this transaction is called delivery risk because the other side of the trade may fail to deliver, in this case 5 million euro. Forex trades are settled within one day so the delivery risk is a one-day risk.
In the interbank world, the initial trade gets rolled over every day as if it were a new trade. The delivery risk is eliminated from the previous day but the very same delivery risk comes into play until the very last day when everything is reversed and there is no risk. It is very dif- ferent in the online forex and futures worlds.
Here, we must post a margin deposit every time we do a trade. Although it is termed margin, it is differ- ent from margin in the stock world. Interest must be paid on the balance owed to the broker. Margin in the forex world is simply a good-faith deposit. You can even sometimes earn interest on it. The broker will freeze a certain amount of money for each contract you enter into. They will not allow you to put on a trade if there is not enough margin in the account.
The broker will allow us to enter no more than two contracts. If the position starts to lose money, the broker has the right to liquidate the position. They do that to make sure that you always have enough money in your account in case a position goes against you. And, yes, they will liquidate your open positions in an instant if you go below the margin position in your account.
The situation is similar in futures. For example, suppose that the market is 63 bid and 66 offered or asked. You will have to buy at 66 if you want to buy or sell at 63 if you want to sell. For the interbank and futures trader, the price on the screen will show 66 and it will appear that you have a break-even trade. However, if you were to instantaneously try to sell it, you would sell it at 63 for a three-pip loss. Online brokers will immediately show that you have a three-pip loss because they will show the bid price as the last price not the last price.
No matter how it is presented, you will have an instant loss of three pips when you enter a trade with a three-pip spread. But, obviously, it can also go the other direction. That compen- sates them for providing us with the ability to trade whenever we want to.
Futures traders and sometimes interbank players must pay a commission. Futures traders must always pay a commission to their broker to execute their trade. Interbank traders will sometimes execute a trade through an interbank broker and will have to pay a pip or a half pip to the broker to execute that trade. Transaction costs become more important the shorter the time hori- zon of the trader.
A three-pip spread over months is irrelevant. But three pips is highly important for a trader who is doing many trades throughout the day. Their profit objective may only be 20 pips; three pips is a significant hit on profitability. Remember, the trader has to implicitly pay the three pips when you both enter and exit a trade. Effectively, the day trader is paying six pips to make IT NEVER STOPS Technically, forex trading begins Sunday morning in Tel Aviv and goes to Friday afternoon in New York.
However, the Tel Aviv session is so small that it is usually ignored and trading starts on Monday morning in Welling- ton, New Zealand. Traditionally, the trading day begins in Wellington because it is the first trading center that opens. However, Wellington is a small trading center so there is little trading. Trading really becomes more active when Sydney and Tokyo open. The London forex center is the center with the highest volume, so trading really takes off when it opens.
New York opens when London is at lunch and is the center with the second-highest volume of trad- ing. The period with the highest volume is during the afternoon in London and the morning of New York. London then closes, leaving New York as the final trading center open for the day. There is decent volume in the New York afternoon except, perhaps, on Friday afternoon.
The slowest time of the day is between the time New York closes and Wellington opens. The cycle never ends. MY BIGGEST LOSING TRADE There are three main orders you can place in the forex market though on- line brokers can be more creative. The first order is the market order. As mentioned earlier, the market always has a bid price and an ask, or offer, price. A market order to buy is always filled at the ask and a market order to sell is always filled at the bid. The only exception is when the quantity to buy or sell is larger than the quantity on the bid or ask.
For example, you want to sell eight contracts at the market. The bid is 79 but there are only five bids at that price. There are three bids just below that at So you would sell five at 79 and three at A market order must be filled by the broker at the best bid or ask immediately.
A limit order is an order to buy when the market goes lower or to sell the market when it rallies. A limit order would be to buy the pair when it dips to a level below the current market.
So, for example, you would put in an order to buy two contracts at 33 limit. Your order will be filled when the market trades or is offered at You will use the limit order whenever you want to buy a dip in the market or sell a rally. The stop order is the order I use more than any other. A stop order is used when you want to buy something at a price higher than the current market or wish to sell a pair at a price below the current market price.
Consider this: The market is 38 bid and 39 ask. A stop order would be used to buy the pair when it rallies up to So, for example, an order to buy two contracts at 45 stop would be placed. It becomes a market order when the market trades or is bid at The order will be filled at whatever the best offer is at that time. Use a stop order when you want to buy a pair at a price higher than the current price.
A stop order is often called a stop loss order because the most common use of a stop order is to exit a position. To exit the trade, you should it trade down to You would enter an order to sell at This would become a market order to sell if the market trades or is offered at However, I use stop orders almost exclusively. Buy low, sell high, they say to me.
The first problem with limit orders is that you almost always have a losing trade immediately. For example, you have an order to buy a pair at 85 limit. You can only be filled if the market trades at 85 or is offered at In the real world, the price will drop below the 85 limit price in order to get filled.
The next pip after you have been filled will be 84 and, most likely, the price will move even lower before finding support. That means that you will be sitting on a losing trade right away.
The market is telling you that the situation is bearish because it is dropping in price. I never want to go against the market.
It is bigger, faster, smarter, and better looking than I am. We will always lose the battle if we fight the market. Entering on a stop order creates a very different dynamic. You are nearly always in a profit position immediately. After all, you can be filled on a stop order until the market is trading at or higher than your stop or- der.
The short-term momentum of the market will nearly always push the price beyond your entry price by at least a little bit. More important, using entry stop orders ensures that we are in tune with the market. We are only buying when the market is bullish and only selling when the market is bearish. This means that we have the wind to our back, not to our face. We are in sync with the market and, there- fore, have the power of the market behind us.
It may not stay there long but it is always better to at least be in tune with the market for at least the beginning of any trade. The only time to use limit orders is when there is a liquidity problem with buying on a stop. I would have to use limit orders to buy when I traded for institutions because the size of my stop order would cause the market to go sky high. I was heading up a derivatives trading desk in the late s. One of the derivatives we dealt and traded was options on forex.
We had a book of derivatives and then used a large quantity of forex to hedge the risk. There was a big economic release coming up that day.
I was using forex futures to hedge my position. In particular, I was short the Swiss franc in large quantity and other currencies in lesser quantities. I was short hundreds of contracts. The number was released and the market skyrocketed. I ended up having my protective stop filled about ticks or pips above where my stop had been placed! There was a complete vacuum of orders above the market. The other interesting thing is that the cash market peaked about pips under the futures market.
In other words, there was much more liquidity in the cash market than in the futures market. I got hammered. It seemed like the longest walk in my life as I trudged through the trading room to report my loss to my boss, the treasurer of the bank. In this case, the price jumped over the stop order leaving me with a fill pips beyond the stop order. That can happen with stop orders.
It is fairly common to have a stop order filled a pip or two away from the stop level in your order. Just get used to it. I like that imbalance. I want to get out at my price when I use a stop to protect an open position. On the other hand, I feel fortunate to get out, even with a bad fill, when the market gaps down beyond my stop because that means that there is so much pressure that there is no buying in the market. Note that this kind of situation never occurs with a limit order.
You will always be filled at your limit price. Of course, you may be in deep trouble if that happens. A big news item comes out and the market drops precipitously.
You will be filled at 50 but the next print of the price may not be until Basically, you were filled at a price that was way above the market. A market order will always be filled when the market is moving dramatically. However, it may be far away from the price on the screen when you entered the order and you may be left chasing the market to get filled.
THE BOTTOM LINE Knowing the nitty-gritty of forex trading is important when you want to make money in the market which is always! Learn how to enter orders correctly and enhance your profits through understanding which orders will optimize your order. CHAPTER 2 Trend Analysis The Basis for All Technical Analysis n the late s, I used to trade a lot of mechanical technical systems.
I I had fundamental regression models of just about every market you could think of. I worked all day just feeding my computer with data and then putting in orders based on the output. But I had an epiphany. Why was I working so hard? I went through all my systems and real- ized that many of them were so highly correlated that there was no point to them. I also applied the Pareto Principle, which states that 80 percent of the profits will come from 20 percent of the methods.
And, in fact, that was basically the truth. I could cut out 80 percent of my work but still make 80 percent of the profits. In the mids I had the opportunity to interview Peter Brandt. He was a purist in using classical chart anal- ysis.
One of the things he said to me was that there are only about eight to twelve mega markets in the futures world each year. I looked at futures charts going back many years and he was basically right. He then went on to say that his job as a position trader was to capture only those mega moves.
His ideal trading year was if he caught only those trades. He felt the ideal year would only have eight to twelve trades. Every other trade was not worth the risk. So I decided to strip my trading down to the bare essentials. I wanted to really get to the heart of trading. No BS, just rock-bottom truth. The basic truth of trading is that we must be long when the market is bullish, be short when it is bearish, and stand aside when it is neutral.
Simple, yes? Let me say it again. Be long when bullish, be short when bearish, and stand aside the rest of the time. Easy to say, but is it easy to do? WHAT IS A TREND? Turns out that there is a classic definition of a bull or bear market. A bull market is any market that is making higher highs and higher lows.
A bear market is any market that is making lower highs and lower lows. A neutral market is any other condition. Once again, this is very simple. However, it is simple only if we agree on what a high or low is. And that has traditionally been a subjective decision. The highs and lows that we are looking for will be called swing highs and swing lows.
That will clear up some confusion with the highs and lows on each daily bar. In this chart, you and I likely agreed on where the swing highs and lows were. We intuitively agreed. But what if we disagree? What about the high five bars before the end of August? We skipped over those because we agreed that they were not important or significant. So the real key is to understand which swing highs are significant.
We intuitively skipped over the insignificant highs and lows. But there may come a time when we may disagree on the significance of a given high or low. It would be better to have an objective way to determine the significance. My friend Tom DeMark is perhaps the most innovative technical ana- lyst in history.
He has probably added more and better technical indicators than anyone in history. One of his innovations is the idea of creating ob- jective standards for what was traditionally considered subjective. For ex- ample, how do you label Elliott Waves? His ob- jective criteria eliminates the subjectivity that is often found in such types of technical analysis as Elliott Wave and classical chart analysis.
No longer will you and I disagree about the proper slope of a trendline or the Wave count. First, let me clarify some terms.
The words high and low have two meanings. So the highs and lows on the chart that I circled are swing high and swing lows.
Basically, DeMark showed that certain swing highs and swing lows are significant and other swing highs and swing lows are insignificant. The way he did it was ingenious.
I think we can agree that the high in the middle of April is more impor- tant than the highs in the middle of October. We can see that very clearly on the chart. DeMark created a method for determining how significant a swing high or swing low is. The following is my interpretation of what I learned from him. The basic idea is to identify every swing high with an objective rating system. The high in mid-August is the most important high on the chart because it is the highest high on the chart.
The lows made in December and January are the two most important lows because they are the lowest lows on the chart. Major highs and lows show up as major highs and lows because they are the most extreme.
Choose a swing high or swing low in Figure 2. Now, look at the bar after this one and all the bars to the left of it. To be defined as a swing high there must be one bar to the right that has a lower high than the day we are looking at and at least one bar to the left of it with a high lower than the high on the day we are looking at. That simple test defines a swing high reverse everything for a swing low. We have objectively defined every swing high.
The circled bar at the high in August is a swing high but the bar to the left is not. So it is not a swing high. The bar to the right of the circled bar is also not a swing high because it has a lower bar to the right but the circled bar has a higher high than the bar that we are looking at.
The next step in the analysis is to rank the swing highs and lows.
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