THE TRADING BOOK

A COMPLETE SOLUTION TO MASTERING TECHNICAL SYSTEMS AND TRADING PSYCHOLOGYBy ANNE-MARIE BAIYND

McGraw-Hill

Copyright © 2011 Anne-Marie Baiynd
All right reserved.
ISBN: 978-0-07-176649-4

Contents

Chapter One

An Introduction to the Markets

"You cannot step twice into the same rivers; for other waters are ever flowing onto you." —HERACLITUS

As long as we keep conscious of the fact that the markets are a living enterprise, run by fickle, changeable beings, we'll grip the notion that they are never the same place twice. As Mark Twain once said, "History does not repeat itself, it merely rhymes." The same is true of markets. The general "introduction to the markets" chapter normally describes the basic structure of the markets with equities, futures, forex, or some other trading instrument. Although that is important, and the structures are a good thing to understand, I will leave that to other authors. The nature of this work suggests we take an alternate view of the market at the outset in the not-so-typical way—not the overview of the forest, but a look through the trees while keeping very aware of the fact that we are in a forest.

This view is even more unusual when we consider that our approach to trading will be largely technical in nature. Our ability to grasp this view, however, will assist us in observing the market as an entity, not just an amalgam of technical pieces, and that, in turn, will transform you into a trader who thinks on a grand and, at the same time, granular scale.

By accepting that the market is an entity in constant flux, we cannot approach trading in a cookie-cutter manner, no matter how much we would like to. Instead, to trade at maximum efficiency, we must set that cookie cutter aside to make real tracks toward our end goal of superior, consistent returns. The same actions will not always be required in response to occurrences of the same type all the time. Did the full impact of that sentence seep through? The markets are never exactly in the same place twice, and each time we witness a technical event, the meaning of that event may not be the same as the last time we saw it. The markets require that we remain in a thinking and analytic state in order to perform well within it.

Here's what I mean: if the general rule is "short below the moving average break or crossover," that might not be the specific action you need to implement due to another extraneous event also unfolding. The day is never as simple as the "if-then" statement. If you are looking for that kind of road map in trading, your search will be exhausting, never ending, and oh, by the way, an exercise in futility. It is never as simple as "tell me when to buy and sell." Trading well means we are always discerning and appraising. We will need the power of discretionary thought to move through our trades. Only then will we achieve excellence in performance. This notion unnerves many newer traders because we all realize that there are things we don't know. The problem is that we just don't know that we don't know these things until we realize we didn't know them in the first place, and that comes only after we know them, no? By then, the market has usually charged us dearly for the access to the knowledge. Right? Yes, the road most traveled, indeed. So how do we navigate the markets as a technician? In order to answer that question, we must ask ourselves the following question.

WHAT IS TECHNICAL TRADING?

Technical trading uses charting methods and analyses to determine market movement. Completely different to fundamental analysis, all technical analysis uses are the formations that the charts develop as the stocks move through particular price points. It is a method that assumes there is a way to discover patterns that accurately predict future events based on prior market formations. Technical trading attempts to identify areas of entry and exit that skew our chances of being correct to greater than a coin toss (fifty-fifty). The use of technical indicators does not imply causality; that is, one event does not cause the other. Instead, we approach the technicals in the framework that they have a likelihood of appearing together. This can also be called probability bias.

In case the following thought has not occurred prior to this moment, we actually use probability bias in every aspect of our lives. Some of the most common events utilize the bias, such as knowing that if you see the mailman driving down the street, it is likely that your mailbox will have something in it shortly. Will it happen every single time? Maybe not, but it sure does happen a lot. Does our mailman cause us to have mail? No, he does not. What causes us to have mail is the person or persons who mailed us. He just happened to be the conduit of transport. What about the caller ID on our phone showing the chattiest friend we have calling? We are quite aware that if we answer it, it is most likely that we'll be on the phone for a while. Will our friend talk ad nauseam every time? Perhaps, and perhaps not. Again, it is the possibility of the event that we are considering that causes us to contemplate a decision. So it is with technical trading.

We work on identifying patterns that seem to happen in clusters, and we choose to make decisions based on what we assume is highly probable of occurring. We make the choices simple, but decisions to execute and act will always be less than completely straightforward. Our ability to discern the minor shifts in the market action that might require us to take the extra step, waiting for further confirmation (another signal) before our decision to enter or exit the trade, will be the delineator between success and failure.

REALITY AND PERCEPTION

Many of us think of the market as a logical mechanism. People who are not acutely aware of markets and how they operate will argue this fact without ceasing. In fact, there are scores of intellectual economic studies that try to reassure us that Adam Smith's notion of the free hand of the market (the natural order and market laws of supply and demand will drive market efficiencies to maximum output and fairness) operates well, and hence it is sufficient for markets to function without intervention. There are also scores of other books that suggest that Keynesian economics (a theory that states that government intervention is not only favorable but highly necessary for markets to run well) is necessary for order in markets to continue.

Markets aren't really orderly though, and they are never in balance for more than an instant—if ever. The market is a giant pendulum that swings from one extreme to the other, forced there by a variety of reasons that numerous pundits pontificate (inaccurately many times) daily. If we know the market operates as a giant swing, then as traders we must work at being keenly aware of the direction of the oscillations and signals that accompany tipping points, which often lead to reversal. There are no markets that operate efficiently on a consistent basis; instead, the ebb and flow caused by sentiment shift, panic, euphoria, greed, and disbelief drives us through the peaks and valleys. If we can firmly cement this simple concept, we will avoid one of the worst mistakes an inexperienced trader will make: trading what we think and not what we see.

Sometimes It Is Best Not to Trade What You Think

Sounds like an oxymoron, doesn't it? Yes, this statement does need some qualifiers, so here they are. First, if we think something...