The Hedge Fund Edge: Maximum Profit Minimum Risk Global Trend Trading Strategies (Wiley Trading)

193 Pages·1998·6.76 MB·English

by  Mark Boucher

THE
DNUF EGDEH
EDGE
Wiley Trading Advantage
THE
Trading without Fear / Richard W. Arms, Jr.
Neural Network: Time Series Forecasting of Financial Markets I E. Michael Azoff
Option Market Making / Alan J. Baird
DNUF EGDEH
Money Management Strategies for Futures Traders / Nauzer J. Balsara
Genetic Algorithms and Investment Strategies / Richard Bauer
Seasonality: Systems, Strategies, and Signals / Jake Bernstein
The Hedge Fund Edge / Mark Boucher EDGE
Managed futures: An Investor's Guide / Beverly Chandler
Beyond Technical Analysis / Tushar Chande
The New Technical Trader / Tushar Chande and Stanley S. Kroll
Trading on the Edge I Guido J. Deboeck
Trading the Plan I Robert Deel
The New Science of Technical Analysis / Thomas R. DeMark MAXIMUM PROFIT/MINIMUM RISK
Point and Figure Charting / Thomas J. Dorsey
GLOBAL TREND TRADING STRATEGIES
Trading for a Living / Dr. Alexander Elder
Study Guide for Trading for a Living / Dr. Alexander Elder
The Day Trader's Manual / William F. Eng
The Options Course: High Profit £f Low Stress Trading Methods I George A. Fontanills
e OhpTtions Course WorkboI oGk eo. AFrgoe ntanills
Trading 101 / Sunny J. Harris
Trading 102 I Sunny J. Harris
rAnalyzineg and Forehcasting Futurces Prices /u Anthony F.o Herbst B kraM
Technical Analysis of the Options Markets / Richard Hexton
Pattern, Price & Time: Using Gann Theory in Trading Systems / James A. Hyerczyk
Profits from Natural Resources: How to Make Big Money Investing in Metals, Food, and
Energy / Roland A. Jansen
New Commodity Trading Systems & Methods / Perry Kaufman
Understanding Options / Robert Kolb
The Intuitive Trader / Robert Koppel
McMillan on Options I Lawrence G. McMillan
Trading on Expectations I Brendan Moynihan
Intermarket Technical Analysis I John J. Murphy
oniletsaC .G kraM dna srewoP .J kraM / noitidE dr3 ,stekraM laicnaniF gnitsaceroF
Neural Networks in the Capital Markets I Paul Refenes
Cybernetic Trading Strategies / Murray A. Ruggiero, Jr.
The Option Advisor: Wealth-Building Techniques Using Equity and Index Options /
Bernie G. Schaeffer
Gaming the Market / Ronald B. Shelton
Option Strategies, 2nd Edition I Courtney Smith
Trader Vie II: Principles of Professional Speculation I Victor Sperandeo
Campaign Trading / John Sweeney
The Trader's Tax Survival Guide, Revised / Ted Tesser
The Mathematics of Money Management / Ralph Vince
Portfolio Management Formulas / Ralph Vince
The New Money Management: A Framework for Asset Allocation / Ralph Vince
Trading Applications of Japanese Candlestick Charting I Gary Wagner and Brad Matheny
Trading Chaos: Applying Expert Techniques to Maximize Your Profits / Bill Williams
New Trading Dimensions: How to Profit from Chaos in Stocks, Bonds, and Commodities /
Bill Williams JOHN WILEY & SONS, INC
New York Chichester • Weinheim • Brisbane • Singapore • Toronto
Acknowledgments
® .repap eerf-dica no detnirp si koob sihT
Copyright © 1999 by Mark Boucher. All rights reserved.
Published by John Wiley & Sons, Inc.
.adanaC ni ylsuoenatlumis dehsilbuP
Two broad groups of people deserve recognition and thanks for
-snart ro metsys laveirter a ni derots ,decudorper eb yam noitacilbup siht fo trap oN
del evah taht efil ym ni stneve eht rof dna koob siht fo gnikam eht
mitted in any form or by any means, electronic, mechanical, photocopying, record-
6791 eht fo 801 ro 701 noitceS rednu dettimrep sa tpecxe ,esiwrehto ro gninnacs ,gni up to it. The first people are what I term "the wind beneath my
-buP eht fo noissimrep nettirw roirp eht rehtie tuohtiw ,tcA thgirypoC setatS detinU wings." These are the people who directly helped me in ways that
lisher, or authorization through payment of the appropriate per-copy fee to the Copy-
made this book possible. The second group is what I term "the
xaf ,0048-057 )879( ,32910 AM ,srevnaD ,evirD doowesoR 222 ,retneC ecnaraelC thgir
[phone]. Requests to the Publisher for permission should be addressed toe sothhw eelpoep era esehT ".dnats I hcihw no ssentaerg fo sredluohs
YN ,kroY weN ,eunevA drihT 506 ,.cnI ,snoS & yeliW nhoJ ,tnemtrapeD snoissimreP ton ems ub ootme prnloenhee d ffnoia tn eeb sah yltceridni krow
Q ©ERWMRIELP E:liaYM-.EC ,8O00M6-05.8 )212( xaf ,1106-058 )212( ,2100-85101
only in putting this work together, but also in developing the con-
This publication is designed to provide accurate and authoritative information in cepts described in many of the chapters.
-bup eht taht gnidnatsrednu eht htiw dlos si tI .derevoc rettam tcejbus eht ot drager
Among those who have been the wind beneath my wings, I
lisher is not engaged in rendering professional services. If professional advice or
nosrep lanoisseforp tnetepmoc a fo secivres eht ,deriuqer si ecnatsissa trepxe rehto want to thank my parents, particularly my mother, who through-
.thguos eb dluohost em pleh ot gnihtyna ecifircas ot gnilliw neeb sah efil ym tuo
achieve my dreams. I want to thank my significant other, Anita
s seCrgnoCa fo tyraarbiLloging-in-Publicatio:atnaD
siht fo enon troppus dna pleh tnetsisnoc esohw tuohtiEwllis ,
-2691 ,kraM ,rehcuoB would have been possible. I am grateful to my coworkers for all
The hedge fund edge : maximum profit/minimum risk global trend
srehto dna sronnoC yrraL uoy knahT .troffe dna krow drah rieht
.rehcuoB kraM / seigetarts gnidart
y f)eigmartnasvdta gnkidarnt yeliaW( —h .mtc o.p sla I .troppus larom gnireffo dna gnidaerfoorp rof
.xedni sedulcnI ,nituS luaP dna oraliP ynoT ,ssenisub dnuf egdeh eht ni srentrap
)r8 e(-pa8al3pk5. 81-174-0 NBSI
whose faith and support led me into this industry. And I want es-
.seireS .II .eltiT .I .sdnuf egdeH .1
HG4530.B68 1998 -er esohw ,dneirf dna rentrap ym ,nosnhoJ moT knaht ot yllaicep
332.64'5—dc21 98-18230 search, faith, fascination, and support made this possible.
Printed in the United Stat-ehs toof Afom esrticrao.ffe suoiverp eht yb decnahne yltaerg si koob sihT
10 9 8 7 6 5 4 3 21 ers who act as the shoulders of greatness on which this effort
vi ACKNOWLEDGMENTS
edutitarg htiw egdelwonkcad fn otasreu tmmsroi sFIt , .sdnats
the contribution of Mr. "X," a great European money manager.
He asked to remain anonymous, but near the end of his life, he
shared with me his knowledge and system for financial success.
Mr. X, your work will indeed live on and not just with me.
Next I thank Marty Zweig and Dan Sullivan for their work on
avoiding negative periods in U.S. markets, which provided a
model of what to strive for, both internationally and across other
-alerroc lufrednow esoht lla rof ,ytraM sknaht ,oslA .sessalc tessa
rof htnom hcae htiw rettelswen ruoy dellif uoy seiduts noit Contents
decades—I saved them all and sought to apply my own reworking
of them to our master models.
William O'Neil has done tremendous work on stock selection
ni skcots gnimrofrep-pot eht dnif ot syaw gnizisahpme ,airetirc
no krow gnireenoip enod sah olleippaC knarF dna ,tekram hcae
the importance of institutional discovery in the odyssey of a Introduction 1
nosleN ,elihwnaeM .ecnenimorp ot ytirucsbo morf esir s'kcots ksiR fo ecnatropmI ehT
2
Freeburg has applied a never-ending, incredible stream of timing
How It All Started
5
systems to a whole host of asset classes providing me with many
ta elpoep eht lla ot detbedni ylsuodnemert ma I ,oslA .sthgisni retsaM tekraM a ezingoceR ot woH 6
Bank Credit Analyst for their rigorous work and insight into the Understanding Is Key to Success 9
liquidity cycle acrossk mooost Btra dsaibhleT m anrkie hts coan othrep gploAbe. eht fo weivrevO 9
My heartfelt thanks go to Ludwig von Mises, Ayn Rand, and
-oce nairtsuA fo nor iitseaehvtlr efrsloeefr sdpsr abhtoR yrruM sehcaorppA tnemtsevnI lanoitidarT fo ksiR ehT 1
16
nomics, the ideals of capitalism, and truth. I am grateful for the
tekraM lluB mreT-gnoL a fo stceffE ehT 16
work of Paul Pilser for putting economic myth in its place and
seitiuqE ni snruteR mreT-gnoL 19
bringing forth the theory of alchemy. I want to acknowledge
Stanley Kroll for his work on money management andst ekJraaMy raeB tsniaga noitcetorP 26
dna elcyc ytidiuqil eht fo gnidlem tnaillirb sih rof rekcabahcS skcotS pihC eulB 28
.noitceles dnuf lautum Investment Criteria
30
ot woh em gnihcaeter rof snibboR ynoT knaht I ,yllaniF
High Returns and High Consistency—The Tradeoff 35
change and grow and for exposing me to some of the ideas on
Summary
ton sah ohw ereht tuo enoyna si ereht fI .desab si krow siht hcihw 41
evah I srotavonni taerg eht fo yna fo egdelwonk eht fo knurd tey
acknowledged here, let me encourage you to partake immediately 2 Liquidity—ThesemirP yllaicifitrA tahT pmuP
Investment Flows
.tnemhcirne nwo ruoy rof 43
Understanding the Austrian Interpretation of
M.B. the Liquidity Cycle 45
The Liquidity Cycle Illustrated with an
Island Economy
48
STNETNOC iiiv CONTENTS ix
15 seimonocE nredoM ni elcyC ytidiuqiL ehT 891 smargorP laicoS suortsasiD
Timing the Liquidity Cycle 62 202 seiciloP egaW muminiM
98 seguaG cimonocE gnidnatsrednU Economic Freedom Index 204
Implications for U.S. Markets 100 When Investing, Look for Countries with
Summary 106 Low Impediments to Growth 206
Profiting from Understanding Distortions 207
3 Index Valuation Gauges—Do Not Ignore the
902 snoitrotsiD .S.U emoS
Price You Pay 111
Evaluating Government/Media Hype 220
Using Index Valuation Gauges 111
722 sdnerT dna semehT raluceS
Limitations of Index Valuation Analysis 115
Examples of Secular Themes and Trends 230
Using Gauges for Mutual Funds 116
Summary 239
Valuation Gauges for International Markets 117
Summary 122 d na gSnoL aihretirCo noitcreleS yttiuq—E 7
How Profits Are Magnified 240
4 Macro Technical Tools—Making Sure the Tide 142 . sdnuF lautuM
421 noitceriD thgiR eht ni gnivoM sI
542 noitceleS kcotS laudividnI
The Argument for Technical Analysis 125
842 sratS dexiF dna sroeteM gniyfitnedI
Taking a Wider View 128
Equity Fuel 261
031 sdnerT mrifnoC ot sisylanA lacinhceT gnisU
562 htworG tsniaga ecirP gnirusaeM
Reading the Message of the Markets 132
072 sdohteM yroehT oiloftroP nredoM
431 sisylanA lacinhceT fo weivrevO
372 . dohteM gnidarT kcotS
641 slooT lacinhceT fo msicitirC gnirewsnA
Summary 285
Summary 150
782 mehT tiolpxE ot sledoM dna sessalC tessA rehtO 8
yenoM dna ygetag Rrisnkt—SiSonun diatnoC 5
Outperformance and Asset Allocation 287
Management Methods and the Principles of
Building a Portfolio 293
Character Necessary to Achieve Them 151
Exploring Asset Classes 294
251 seluR tnemeganaM yenoM
Summary 327
Principles of Character 161
htgnertS evitaleR labolG dna sledoM noitacollA tessA 9
6 The Essence of Consistent Profits—Understanding 166
Analysis—Const923ructi noiloftrgoP a
Austrian Alchemy 923 168 sledoM noitacollA tessA gnisU
Alchemy versus Economics 174
rof neercS radaR :htgnertS evitaleR labolG
081 mgidaraP htworG nuR-gnoL ehT Flexible Asset Allocation 336
Negative Tax Policies 190 Summary 343
x CONTENTS
sredarT mreT-trohS rof seigetartS :A xidneppA 345
sevoM yawanuR gnidarT 347
Appendix B: Recommended Books, Services,
355
Data Sources, and Letters
Letters and Services 355
erawtfoS dna secivreS ataD 358
359
Books Introduction
360
tropeR eerF
fo teehsdaerpS retsaM :C xidneppA
Systems Performance 362
365
Index
r tora rdoetrs—evlanrr isgo mye raelvl—e rof nettirw si koob sihT
who wants a methodology to consistently profit from the markets
.sksir eguh gnirrucni tuohtiw
In this era of exploding U.S. and global stock markets, many
investors are focusing most of their attention on returns, not on
siht ni detacovda seigolodohtem eht taht yas ylefas nac I .ksir
ot rettelswen ruO .snruter laitnetop gnisaelp ylhgih reffo koob
rep tnecrep 23 revo fo snruter launna egareva nwohs sah stneilc
year since 1992, without a losing year and, more significantly,
-uod naht erom sah siht( tnecrep 01 revo fo nwodward a tuohtiw
revo ]P&S[ 005 s'rooP & dradnatS eht fo nruter latot eht delb
this period). During this same period, the funds I have con-
sulted for have done even better in terms of both risk and re-
turn, with real money, investing millions of dollars globally.
seigolodohtem eseht hcihw no stpecnoc eht gnihcraeser ni dnA
are based, my colleagues and I have gone back to the early 1900s
to verify their rigor. Thus while I am confident that the method-
ologies described here can enable you to pull consistently large
sneprahs koob eht taht epoh osla I ,stekram eht morf stiforp
your focus on two equally important factors of investment—risk
and market understanding.
2 INTRODUCTION THE IMPORTANCE OF RISK 3
during the 1979 runup in gold prices. I had read several books
THE IMPORTANCE OF RISK
convincing me that gold could do nothing but explode in price,
ehT .skcots dlog no snoitpo otni sgnivas eritne ym degnulp I dna
Recounting a personal experience may be the most effective way
tnecrep 005 ylraen yb degrus tnuocca ym dna ,ffo koot snoitpo
to explain why risk should be of paramount importance to in-
from March 1979 to January 1980. Pure luck helped, as I was
-af ym ,dlo sraey enin tsuj saw y I1 lnr9ae7eh0 wesh, t nI .srotsev
-ram dlog eht erofeb tsuj snoitpo 9791 rebmeceD ym tixe ot decrof
ther died of cancer. He had struggled to try and leave me a trust
.0891 yraunaJ ni gninnigeb dehsarc dna dekaep tek
fund with enough money to finance my future college education.
-uger saw I ,0891 ylrae yB .gub evitaluceps eht thguac dah I
nehw ega egelloc gnihcaer litnu og ot edaced a tsael ta dah I ecniS
larly speculating in a host of highly leveraged commodity posi-
my father set up the trust, he put it into stock funds managed by a
tions. Not knowing what I was doing, I lost small amounts of
bank. From the end of World War II to the late 1960s, stocks had
h '8cr1aM trohs thguac tog I nehw ,1891 litnu yltnetsisnoc yenom
been in a wonderfully profitable bull market. The public was par-
egnarO trohs saw I .1891 ylrae ni ezeerf a gnirud eciuJ egnarO
ticipating in stocks to the highest degree since 1929, and the pre-
Juice, which shot up from around 80 to 130 in a series of limit-up
gnol eht revo skcots otno gnuh tsuj eno fi taht saw modsiw gniliav
enoyna detneverp dna keew a naht erom rof detsal taht sevom
fo epyt rehto yna ylraen naht nruter retteb a dewohs yeht ,nur
short from being able to get out of positions. By the time I could
asset. (This type of environment should sound quite familiar to
erom dna tnuocca ym fo flah ylraen tsol dah I ,strohs ym revoc
investors of the late 1990s.)
laer yM .punur s'dlog morf deniag dah I stiforp eht fo flah naht
Things did not go according to plan beginning in 1972. From
education had begun, and I realized that I needed to study the
-rep 07 revo yb denilced dnuf tsurt taht fo eulav eht ,5791 ot 2791
eht morf yltnetsisnoc tiforp ot ylhguoroht erom hcum tcejbus
a fo secirp kcots labolg dna .S.U ni enilced eht htiw gnola tnec
markets. The easy money I had first thought was for the taking
commensurate amount (the S&P and Dow dropped by around
had really been luck. Having seen two accounts lose more than
50% during this period, but the broader market dropped by much
.ksir gnitimil fo ecnatropmi eht dezilaer won I ,eulav rieht flah
more than that). By the time I started college in the early 1980s,
The mathematics of losses and risk is sometimes lost on in-
even the blue chip indexes had lost more than 70 percent of their
vestors until they actually experience it up close and personally.
value from 1972 in after-inflation terms. While my trust had re-
uoy snaem taht ,eulav ni tnecrep 07 spord tnuocca ruoy nehW
covered somewhat from 1975 to the early 1980s, it was nowhere
won't get back to breakeven until you have made over 230 percent
ylrae eht nI .deid rehtaf ym erofeb neeb dah ti level eht raen
kniht dluow enO !riaf smees yldrah tI .yenom gniniamer ruoy no
1970s/ he believed he had provided enough funds for me to go to
that if you dropped 70 percent, you ought to be able to get back to
an Ivy League school—but a decade later the diminished trust led
.skrow ti yaw 0ep7he tre tcdoeannm st— iu toabyhu tnt ehw neve
tsurt eht dluoc y raoUwf .t Copno.- noBIt e.edrmkaeetlseniy
As I started to voraciously study the works of investors who had
have covered the cost of an elite private school.
-ni taerg tsom taht deciton I ,sniag nur-gnol tnacifingis edam
n eedb evaih dfluofw iti tacht suai tkccailfp l aotct irotsih ehT
ssol tsegral rieht( snwodward peek ot thguos sredart dna srotsev
worse investment class than stocks from 1972 to 1982. Even ex-
from an equity high) around 20 to 30 percent or less—and most
-xe sihT .ylroon pBe urdfrfiaedWt t dna notelpmeT nhoJ ekil strep
-sus ot dah yeht snwodward eht fo smret ni sniag rieht derusaem
ot del tahw dnatsrednu ot erised neek a htiw em tfel ecneirep
tain to generate those gains. An investor who loses more than 20
gnol a hcus revo seitiuqe fo snruter eht ni ytirapsid eguh a hcus
percent must show gains of 30 percent or higher just to get back to
period. It also provided an extremely valuable lesson regarding
o pt rareoy dar onufa hncte eveer,oe mv eekant —dluoac tnahdt
risk, which I sadly had to learn again with my own money before
.rotsevni tnellecxe na
.ni knas yllaer ti
-ni ,emoh tih drawer tsniaga ksir gnihgiew fo tpecnoc eht sA
hcus dna sboj remmus morf sgnivas ym gnitsevni nageb I
vestment performance suddenly meant more to me than making
when I was a sophomore in high school. My first real killing came
HOW IT ALL STARTED 5
4 INTRODUCTION
HOW IT ALL STARTED
big gains: it meant measuring those gains against the risk I was
taking to achieve them.
ni yelekreB-ainrofilaC fo ytisrevinU eht morf gnitaudarg retfA
hguorht gniog morf ereht tuo nosrep eno tsuj tneverp nac I fI
the mid-1980s, I first traded on my own for a bit. While at a con-
gnitirw neht ,2891 ot 2791 morf dah I ecneirepxe lufniap emas eht
-udividni yek owt tem I ,rekaeps a saw I erehw gnidart no ecneref
this book has been a worthwhile effort. I hope I will convince more
als: Tom Johnson, a Stanford Ph.D., and Paul Sutin, his student at
than one of you. Similarly, if I can get one or more investors and
the time. They liked some ideas I had expressed on seasonal com-
traders to think of performance not just in terms of total returns
modity straddles, and we decided to begin doing historical re-
-ward htiw derapmoc drawer fo smret ni tub ,nur trohs eht revo
search together, initially on ways to dispel the myth of the
g nol eht revo ycnetsisnoc dna nword un,oot raF .desaelp eb lliw I
efficient market hypothesis, which had broad academic accep-
many fund-rating services only list performance in terms of re-
tance and basically held that achieving higher than average profit
yltnetsisnoc ot gnitnaw srotsevnI .ksir gnirongi yllatot etluihrwn,
with lower than average risk was impossible.
.taht naht retrams hcum eb ot evah stekram eht ni llew mrofrep
Dr. Johnson and I began a research effort that lasted more
The goal of this book is to present a methodology for achieving market-
than three years and involved testing and developing nearly
beating long-run returns with substantially lower risk than the long-run
every theory we could get our hands on that had to do with
risk of U.S. and global equities. However, just as important as giving
tpecnoc yreve detset eW .ecnamrofrep gnitaeb-tekram gniveihca
the reader such a methodology is to do it with honesty and in-
we could find going back to the early 1900s (or earlier, where data
tegrity, based on the philosophy I have identified as essential for
sa morf sexedni kcots emos dna sdnob rof sdrocer dnuof ew ;tsixe
-xe tsum I ,siht od oT .sniag tekram tnetsisnoc ksir-wol gniveihca
long ago as the 1870s). We were striving to find something histor-
plode some myths and misconceptions. And perhaps the most im-
ically rigorous.
portant lesson I have for market participants is that the answer to
-tset eht )1( :yduts fo saera owt no detartnecnoc hcraeser ruO
their quest for superior performance doesn't lie in a Holy Grail
ing of market-beating concepts and methods, and (2) the de-
system, but in their own development of the skills necessary to
tailed study of all those who had achieved market-beating
understand major market movements.
-erp eht ni dna yllacirotsih sisab drawer/ksir a no ecnamrofrep
While I provide dozens of specific systems and rules along
sent. Tom put significant resources into developing software
with their historical records of market-beating risk/reward perfor-
that could test and show intricate statistics for any simple or
dnatsrednu ot tnatropmi erom raf si ti taht ssertsm oasnlac eI,
complex trading system or data-set/concept for trading stocks,
what lies behind their success and to keep abreast of anything that
siht gnidliub fo tluser a sA .seicnerruc dna ,seitidommoc ,sdnob
could change those underlying principles than it is to follow those
huge database and accompanying software, Tom and I also
exact rules and systems. This distinction is, in fact, the difference
-tset rof erawtfos siht fo esu eht gnilles ssenisub llams a detrats
.mret gnol eht revo sretsam tekram dna secivon tekram neewteb
,sredart ,srotsevni llams dna egral ynaM .saedi s'elpoep rehto gni
The market novice constantly searches for "magic" systems that
and institutions hired us to test their ideas or systems on our
yrassecen eht poleved ot seirt retsam ehT .enutrof a reviled lliw
saedi eht rof sisab eht si troffe hcraeser sihT .esabatad mret-gnol
skills and insight into markets and economics to consistently see
luaP ,nosnhoJ moT ot lufetarg ma I dna ,koob siht ni detneserp
.tnemnorivne gnimochtrof eht ni krow lliw seigolodohtem tahw
Sutin, and the many others who helped put that research effort
As I discuss in Chapter 6, the novice tries to find fish holes
tekram taerg eht ot edutitarg fo tbed eguh a ewo osla I .rehtegot
o fitn wd oh snrael retsam eht elihw ,yadot gnitib e efrhiasth erehw
masters whose ideas we retested and found to be rigorous. I
the fish holes where the fish are biting every day. The book is de-
have no false pride about acknowledging ideas from others—
e cinivvoenst otrre/vnoc nac taht slliks eht edivorp ot dengis
my primary concern is with what actually works. Appendix B
traders into potential market masters.
6 INTRODUCTION TO RECOGNIZE A MARKET MASTER
krow esohw srehcraeser dna srotsevni taerg eht fo t-sil a seedivorpr ni tub ,yreviled serutuf dna yrtne neewteb doirep eht rof etar
I have found to be exceptional; I urge you to read as many of rehtehw stcelfer serutuf ybraen fo tnuocsid/muimerp eht ytila
their works as you can. tcudorp fo yrotnevni egral ylrevo ro egatrohs mret-trohs a si ereht
(or a reason for investors to panic-buy or panic-sell the underly-
ing instrument immediately). Since other financial instruments
RETSAM TEKRAM A EZINGOCER OT WOH such as currencies had shown a tendency to trade at a premium
I ,stekram raeb ereves gnirud tnuocsid a ta tub ,emit eht fo tsom
A real-life example will illustrate the difference between a m-sys eaht tarhtk tnaeem tsihT .ralimis eb dluow P&S eht taht denosaer
master who strives for understanding and a market novice who tem would likely fail in a severe bear period. I tried to convince
moT ,ecnedicnioc egnarts emos yB .smetsys lacigam rof sehcraes the client to add stop-losses and some sort of filter to protect him
-ed taht os ro raey a fo naps eht nihtiw stcejorp owt deldnah I dna against a bear market period if he wanted to continue to trade the
-ta dah srotsevni eseht fo htoB .tpecnoc cisab emas eht no dednep system on its own.
a desoporp yrraL yhWrcriiahlLlwia ymnbis ,ranimes a dednet I described two types of stop-loss and trend filters the client
eht neewteb ytirapsid muimerp/tnuocsid eht no desab metsys e lsaetfhoptt ;teiuscu rl etvhagtohim deluofwr ,iresvtewmsoo,hrf
saw tpecnoc eht ,tib a gniyfilpmiS .serutuf ybraen dna hsac P&S dias eH .esnopser s'tneilc eht yb desirprus saw I .6891 ot 2891
serutuf eht taht emit yna serutuf P&S eht yub dluohs eno taht morf ffo koos wte oeorkHd!? " yllaer ti ,na, e"eYmkoiu l gnihtemos
-wollof eht ot dloh dna ,P&S hsac eht ot tnuocsid a ta gnisolc erew eht dah I dna ,metsys lanigiro eht tuoba deticxe yrev gniteem ruo
noisrev eht ni ssol-pots yna esu t'ndid yrraL .esolc elbatiforp gni strange feeling that he hadn't heard a thing I said about stop-losses
of the system we were given by our first customer. and trend filters.
The first customer—a market novice—had attended Larry's This client called back every few months to gloat that he was
seminar and began to trade this particular system (Larry usually still making money with the original system and had been able to
m'I os ,enoyna tuoba tsuj naht ranimes a otni smetsys erom skcap dah ti ,metsys a elpmis os rof ,tcaf ni dnA .ti ot erusopxe sih ot dda
ehT .)ranimes eht ta smetsys hcus ynam fo eno tsuj saw siht erus worked remarkably well, generating thousands of dollars a year
-dart siht hgut ponrreohtfsittis snoc gniwohs saw ohw ,remotsuc per contract since 1982. It was very rare that one needed an extra
driht a detnaw dna metsys eht fo sseccus eht ta dekcohs saw ,gni tcartnoc rep hcae niatniam ot nigram laitini lamron dnoyeb 000,5$
party to evaluate it before committing more capital to it. The year position, since it was usually only held until the first profitable
was late 1986. eh emit yreve ezis gnidart sih desaercni dah tneilc eht os dna ,esolc
-rofrep lacitnedi tsomla dnuof dna metsys eht detsetkcab I had extra margin plus $5,000. He had made around $10,000 per
mance to that illustrated by Larry Williams in his seminar. The ,72 rebotcO nO .7891 rebotcO litnu pu ,gninokcer sih yb ,tcartnoc
ereht os ,2891 ni edart ot nageb ylno serutuf P&S taht saw melborp serutuf rebmeceD P&S eht ,hsarc tekram taerg eht fo yad eht ,7891
wasn't a timeframe long enough to evaluate the system properly. I closed at a discount to the cash S&P, and this novice trader had du-
I taht snoitavreser suoires owt denialpxe dna tneilc eht htiw tem ta esolc eht no dluoc eh sa stcartnoc ynam sa thguob yllufit
-cetorp ssol-pots fo kcal eht saw tsrif ehT .metsys eht tuoba dah around the 874.00 level. The next morning, the December S&P
gnitiaw tnedicca na si sessol timil totni soeond t—aht maentsyys opened at 859.00 and proceeded to plummet to the 844.00 level
od ot dah melborp dnoces ehT .hcraeser ym ot gnidrocca neppah ot tniop 00.1 rep 005$ saw tcartnoc P&S eht( retfaereht ylkciuq yrev
gniyfilpmis niagA .lareneg ni stekram serutuf gnidnatsrednu htiw at that time). This meant that on the open, the novice trader faced
muimerp a ta edart stekram serutuf tcartnoc ybraen tsom ,yltaerg a potential margin call, because he had a $7,500 per contract loss
ot tnuocsid a ta edart tub ,tekram llub a gnirud hsac gniylrednu ot sa ylkciuq sa detixe redart ehT .moor 000,5$ dewolla ylno dah dna
,yllaciteroehT .tekram raeb a gnirud tekram hsac gniylrednu eht he could to avoid potential ruin. He sold out very near the lows at
the futures should trade at a premium to cash equal to the T-bill around 846.00 average fill for a one-day loss of just over $14,000
8 INTRODUCTION
OVERVIEW OF THE APPROACH IN THIS BOOK 9
per contract, which basically wiped him out completely. Had he
potential situations where he would find low-risk opportunities
used the trend filter and stop-loss I had recommended, he would
for profit. One wanted to be camped out by a fishing hole someone
have made far less profit until October 27,1987, but he would have
tsaf sa kooh sih tiab dna gnitib ee rfehiwst he rehw dnuof dah esle
still made money through the crash. It is also worth noting that if
as possible. The other was simply looking for another way to find
he had had hugely deep pockets and courage of steel, he could have
a fishing hole where fish might be biting for a while.
survived the day—the system actually did work, it just required a
ton of margin, but this trader was going for maximum profits.
A few months later, we were reviewing the trading of an excel-
SSECCUS OT YEK SI GNIDNATSREDNU
lent investor for input on how he could improve his already stellar
performance. Among the concepts he listed as exploiting was the
There are many books, courses, and software that purport to sell
same Larry Williams concept of looking for buy signals near the
Holy Grail systems. They are mostly hype that is based on a per-
close of a day or on the day following one in which the nearby
ception of the world that does not jibe with reality. One of the rea-
S&P futures closed at a discount to cash. I inquired about the con-
sons there are so many such books and services is that there are so
cept and found that he had gone to the same seminar. However, I
many traders and investors hunting for such systems. The pot of
no gniyub on enod dah eh taht sedart lautca s'redart siht ni deton
gold they are hunting for, however, isn't at the end of the rainbow.
October 27, nor during future signals during the October-No-
That pot is built, coin by coin, based on your skills as a trader/
.doirep 7891 rebmev
investor, and on your ability to consistently find reliable ways to
I asked this second trader why he had avoided these trades.
limit your risk while participating in opportunities that have much
-inutroppo esoht rof kool ot yrt I eruS" .deilper eh "?stun uoy erA"
more reward than the risk you are taking. The pot of gold doesn't
ties, but only when I can do so with limited risk and use a stop-
lie in some system outside yourself; it lies in the set of skills and
loss. Besides, the risk of the market falling further was just too
degree of understanding and insight that you build within. That is
large—no one understanding what was going on at the time would
why I want to give investors more than a methodology; I want to
derongi I ,tcaf ni dnA .esolc eht no gnol gniog deredisnoc neve evah
help them understand what builds profitable methodologies and
all of those signals until I was pretty sure we weren't in a consis-
what underlies investing and trading success.
tent downtrend, because in a consistent downtrend, closing at a
So this book has chapters that are purely methods and systems
discount to cash might be normal."
based on a concept, but it also has chapters that give the reader in-
Now while the novice trader made several mistakes besides ig-
sight and understanding into basic principles of success required
noring the basic rules of limiting risk and understanding what un-
to profit from the markets long term as well as to understand the
derlies a system being used, what really differentiated him from
-ucitrap ni ,6 retpahC hguohtlA .stiforp tekram dniheb scimonoce
redart ecivon ehT .rof gnikool saw eh tahw saw redart retsam eht
lar, may seem long and complex to the reader who just wants tech-
was looking for a magical system that, when applied, would print
niques, investors who do not understand the concepts in that
cash for him. He didn't want to be bothered with potential short-
,srotsevni sa toof eht ni sevlesmeht toohs yletamitlu lliw retpahc
o t yldab fos detnaiw eh ensau ancie dbl osggn dfiom otocp sih
and may even contribute to destroying the mechanism that makes
system. Conversely, the master trader was simply looking for ideas
investing profit opportunities possible in a free economy.
or systems that he could understand and utilize to help find low-
risk, high-reward potential trading/investing opportunities. He
wouldn't have dreamed of trading a system he didn't understand,
OVERVIEW OF THE APPROACH IN THIS BOOK
or investing without proper stop-loss protection. He wasn't look-
ing for magic; he was searching for ideas, concepts, systems, and
dna sloot xelpmoc eht lla edulcni ot elbissopmi si ti ,lla fo tsriF
methods that would help him add another arrow to his quiver of
models that I use in my investment approach in a book of this