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Copyright © 2008 by Pascal Willain. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Willain, Pascal, 1959-

Value in time : better trading through effective volume / Pascal Willain. p. cm. - (Wiley trading series)

Includes bibliographical references and index.

ISBN 978-0-470-11873-3 (cloth)

1. Investment analysis. 2. Stocks-Charts, diagrams, etc. I. Title.

HG4529.W539 2008

332.63 2042-dc22

2007049358

The world’s ever-growing population increasingly affects our daily lives. Like never before, this demographic challenge is forcing us to address critical issues: boosting the production of basic foods, finding new sources of energy, recycling base metals, and tackling environmental issues, to name a few.

In my view, the stock market provides people with a simple way to take part in these high-growth sectors by investing in companies that offer solutions to these problems.

However, because many people are too busy just trying to survive, they will not be able to adapt to or even recognize the coming changes.

Simply dedicating this book to these people does not help much, but perhaps monetary donations will. I have decided to offer free of charge the Effective Volume tool described in Chapter 1. I welcome, however, donations to the Nello and Patrasche Foundation, a foundation that my wife and I created some years ago for the benefit of handicapped orphans.

Foreword

You have opened a revolutionary book that explodes the envelope of standard technical analysis. It introduces several new tools that can help you recognize when a trend is likely to reverse. It reveals new ways to profit from trends and their reversals.

Pascal Willain used inexpensive off-the-shelf software to slice each trading day of a stock into one-minute segments, like cutting a long stick of salami into thin slices. He measures each slice to see whether prices rise or fall during that minute and discards the minutes with no changes. He finds the average one-minute volume for the day and separates the minutes with price changes into those with above-average or below-average volume. In each group, he adds up the volume of minutes with rising prices and subtracts the volume of minutes with falling prices. This gives him two cumulative volume lines: one for the minutes with above-average volume and the other minutes with for below-average volume. He named them Large and Small Effective Volume.

Pascal explains that the minutes with above-average volume reflect the impact of the big money. He discovered that Large Effective Volume often has predictive value. When you find a condition in which the big money starts pushing up a stock while the small money remains negative or neutral, an upside reversal is in the cards. When the big money starts pushing the stock down while the small money is flat or buying, a downside reversal is more likely.

Pascal compares his method to dropping down to the cell level and predicting the movement of the entire organism from the behavior of individual cells. He first described his concept of Effective Volume in the interview for my book Entries & Exits, but he goes much further in his new book.

The author introduces another key concept, which he calls Active Boundaries. His research shows that the group of professional traders in any given stock is relatively stable and they shoot for relatively steady gains. When the returns from a stock over a period of time reach their Upper Active Boundary, the expectations for a further rise diminish and a downside reversal is more likely. When a stock declines and hits its Lower Active Boundary, bullish expectations become high and the stock has a greater probability of an upside reversal. Numerous charts show how to catch reversals using these concepts. In addition to Effective Volume and Active Boundaries, Pascal describes several other concepts. He even provides what he calls “more complex examples for a second reading.”

Pascal has a very rare ability to stand apart from the crowd, to question accepted concepts, and to come up with new ideas. For example, while acknowledging his debt to my Force Index, he stands the original concept on its head by asking why not have a Weakness Index, and even suggests its formula.

This book abounds with examples of Pascal’s unorthodox approach. For example, he addresses a commonly heard rule, “You must buy when everyone else is selling,” and writes:

For me, this is a sure recipe for financial disaster. There are only two clear times when you should buy:

1. You buy when everybody else is buying, but you do it early in the trend.

2. You buy when everybody else has stopped selling. In other words, you buy when the supply of shares has dried up, when only a few shares are available for sale.

You have to invest time and energy in reading this book. Pascal, like many original thinkers, follows his own train of thought, sometimes leaving less prepared readers behind. During the past year I have been receiving the analytic e-mails in which Pascal shares his research into current markets. It took me a little while to catch on to these concepts, and I hope that e-mails from readers will prompt Pascal to offer both his software and his analyses to the wider public. Publishing a book is like giving birth to a baby. This baby will require a bit of nurturing to grow and become strong enough to stand on its own.

The reader must keep in mind that technical analysis alone is not enough to enable one to become a successful trader. Money management is essential for controlling risks, and you need good record keeping to learn from your profits and losses.

I expect the concepts of Effective Volume, Active Boundaries, and others in this book to become accepted by many serious traders. As always, the early adopters will reap the greatest rewards.

—DR. ALEXANDER ELDER

New York City
December 2007

Acknowledgments

If the Japanese government had not offered me ascholarship to study applied mathematics in the 1980s, I never would have been able to even think about creating new tools for the stock market.

If my friend Bob had not advised me some years ago to study technical analysis and buy Dr. Alexander Elder’s book, I would certainly by now be leading another life.

If Dr. Elder had not recognized the novelty of my approach, and had not written about it; if he had not first introduced me to his own agent, Ted Bonanno, who helped negotiate the publishing contract, and then to Matthew Kushinka, my copy editor, who helped me find the proper flow of words in the English language; if Dr. Elder had not advised me on the book structure, the style, the title—even the look and feel of the cover—this book, frankly, would not exist. I am truly grateful for Dr. Elder’s help, especially considering how busy he is.

I also want to thank the four early readers of this book: Bob Grush, from the United States; Barry Silberman, also from the United States; Frédéric Snoy, from Belgium; and Thanassis Stathopoulos, from Greece. These four readers are independent traders who continuously look at improving their trading. Their comments and suggestions were of immense help to me, and I will always be grateful to them for their support.

The last word is for my loving wife and life partner Michiko. Thank you for your continuous love and support.

INTRODUCTION

Revolution Is at Your Doorstep

In the eighteenth century, a Japanese rice trader named Munehisa Homma noticed that it was possible to predict the evolution of prices by studying certain patterns of past prices. He invented what is now called candlestick analysis, still one of the most widely used technical analysis tools. He assumed at that time that current prices represent all known information about the markets. This hypothesis is still shared by many professional traders, although we will see how limited it can be.

In the twentieth century, many improvements in technical analysis appeared as new ideas emerged. These include Fibonacci retracements, Elliott wave analysis, moving average convergence/divergence (MACD) lines, and stochastics, to name a few.

In 2001, lightning struck, but it went largely unnoticed. Why? As has often been the case throughout history, this revolution was the natural result of a change that had different causes. Everybody noticed the change, but very few noticed the revolution. It was similar to Louis Pasteur’s discovery of microbes. That was a revolution, but the real change that made that revolution possible was the invention of the microscope.

The change that would bring about a revolution to the technical analysis of stock trading was decimalization. It happened on April 9, 2001, when traders began to measure stock prices to the penny instead of in sixteenths of a dollar (or 6.25 cents). The objective was to make the stock price fluctuations easier for the general public to understand (thereby attracting more retail investors), as well as to reduce the spread cost. On the contrary, as we will see later, this change had a large impact on the way institutional investors play the market. Decimalization killed market visibility and, as some believe, may have encouraged price manipulation. At the same time, decimalization allowed the precise detection of traders’ movements.

What you will find in this book is not just one tool, but a complete set of revolutionary tools. These tools are based on how market players act—not on their behavior or on their potential reactions, but on their real, tactical moves. These tools are so powerful that I believe they will eventually be programmed into your favorite stock-trading platform.

You probably know that kids learn new languages much more quickly than grown-ups do. An adult’s brain is already formed (the synapses are already connected), so changing the brain takes more than just installing some new wiring. Similarly, it will be easier for beginning traders to read and understand this book than for confirmed traders. Most confirmed traders have years of experience that have crystallized their habits; they have automatisms that follow given patterns and chart formations. Bring them a new idea, and doubt will set in, endangering their whole trading system.

However, if you are not already set in your trading ways, if you are not a monk who comes out of his cell to pray to the gods of trading at specific hours, then you will greatly enjoy this book. I will lead you down unexpected paths to a complete new vision of stock trading.

Since the time I started doing technical analysis, I have been awestruck by the specific art of charting and chart interpretation. There are so many superb books on the market explaining how to interpret chart patterns. When I try to interpret chart patterns, I feel like an amateur musician who reads an unfinished sheet of music and tries to figure out how it could develop into a full concerto. Technical analysis has become a true art form, and I am thrilled when I meet artists who have mastered their art.

Unfortunately, these great artists are on the verge of extinction. With the advent of computer trading and with the appearance of new tools such as those presented in this book, it is clear that traditional chartists will soon be forced to adapt in a new technical environment. In fact, everybody will have to adapt. The markets will be very harsh to those who do not.

At the outset of this book, I would like to thank one of the great artists in chart reading: Dr. Alexander Elder. I came to technical analysis after I read two of Dr. Elder’s books: Come into My Trading Room and Trading for a Living. I applied his methods, but even if I turned a good profit, I was not totally satisfied. I first tried to improve upon Dr. Elder’s methods, but soon I realized that I had to start from scratch. I came up with a set of concepts and tools and developed them into a full trading method. I sent Dr. Elder a technical paper that explained my tools, and we met in Amsterdam. I was a bit nervous when we met: Would Dr. Elder listen to me? Would he like the ideas? To interest Dr. Elder in my work, I even told him that my method was a continuation of his work, when the truth was that even if I had learned the basics of technical analysis through his incredibly eye-opening books, I was coming up with totally new concepts. For 30 minutes I presented my tools to Dr. Elder, while he asked for more information: Show me this and that. How do you calculate this or that? How do you get your data? I replied, “Just as you wrote in your book,” or “It is like the method you explain in your book.” But Dr. Elder looked at me and said in a deep baritone, “Noooooo ...this method stands on its own feet.” I was indeed lucky that Dr. Elder had looked at my tools the way a doctor diagnoses a patient—by concerning himself with the facts.

Later, when Dr. Elder visited me in Belgium, he told me that I should not be so humble about my method. Instead of introducing it in a sort of technical manual, I should call it what it is—a revolutionary method—and explain it in terms that are as simple as possible. He then went through the structure of this book, simplifying and reorganizing it to make things easier to understand, and advising me on the types of figures I should use and how to present them. When I told him that he should become coauthor of the book, he then replied, “Noooooo ... it is not my method. Just write ‘Thank you, Alex’somewhere in the book. That’ll do it.”

Well, here you are, Alex: Thank you!

WHAT IS THIS REVOLUTION ABOUT?

First, I need to say that I am a dumb engineer, of sorts: I keep asking dumb questions, and I will continue to ask those questions until satisfactory answers are found that are also experimentally proven to be correct.

Here are a few questions for which I could not find satisfactory answers in the literature:

• How can you find out what institutional players are doing? Are insiders buying or selling?

• How can you see that news is coming?

• When is a stock cheap? When is it expensive?

• Why do trends exist? Where do they come from?

• What is the supply/demand equilibrium?

This book is therefore about finding out what insiders are doing, what large funds are doing, what traders’ expectations are, and how the equilibrium between supply and demand evolves. It is also about understanding when large funds are moving in and will eventually establish a new price trend, as well as knowing what buying power is necessary to support a trend, what will break trends, and when trends will be broken. In short, it is about reading the markets instead of guessing about them.

Traditional charts look very complex, because they are based mainly on prices. It is always difficult to make a decision based on one single piece of information (price), even if a price chart is supposed to include all the information about the market. The complexity lies in the guesswork, something at which traders need to become skilled if they want to be good traders.

Many books talk about large funds as the “smart money.” Smart money is a term I have a hard time accepting, because it implies that the individual trader is not smart. I prefer to say that information leaks and price manipulations are routine occurrences in the markets. The objective of these leaks and manipulations is to take advantage of others. I would not call that smart. The tools that I developed will not allow you to become smart in the way that most traders define it. But they will allow you to see through manipulation. You will become smarter, then, if you learn to see the markets more clearly and if this transforms you into a better trader.

I disagree with people who reduce the market to a competition between large players and individual traders, or who believe that market makers are behind the price moves. The market is much more complex than that, with an increasing number of connected, online traders scattered around the world, with 50 percent of the trades being computer-generated, and with large players often moving in opposite directions.

You will, however, have to keep the following point in mind: The new tools for reading the market that I show you will not enable you to read the market exactly, all the time, and forever. Markets evolve, and I believe that all tools for analyzing the markets must evolve, too, including mine.

HOW THE BOOK IS ORGANIZED

This book is divided in two regular parts, followed by a bonus section. The first part describes in detail the four new tools that I developed in order for each of them to find a solution to a specific problem. The second part integrates the various tools into trading strategies, and I show what works and what does not for either retail players or fund managers. Part Three, the bonus section, shows how to adapt the tools to sector analysis.

Part One: The Set of Tools That Will Change Technical Analysis

I developed the sets of tools presented in this section because I needed them for my own trading. Each tool addresses a specific issue with only one goal in mind: to better understand the market. I am convinced that these new methods of measuring the market have the power to change technical analysis as we know it today. The industry will be slow to adapt, but in the end, I believe that the tools that provide a better measure of the market forces will prevail.

Chapter 1: Effective Volume: An Open Window into the Market In Chapter 1, I show that the monitoring of the volume involved in small price changes from one trading minute to the next, which I define as the Effective Volume, is a very good tool to detect tactical moves by insiders and large players. The Effective Volume tool is excellent for detecting trendsetters and often allows the detection of coming price changes. I also review in comparison how traditional tools use volume data.

Chapter 2: Price and Value: The Active Boundaries Indicator Chapter 2 deals with the monitoring of price trends. It is based on the hypothesis that the group of active traders who follow a stock is relatively stable and that their automatic trading tools use buy/sell strategies that do not evolve in time. The Active Boundaries indicator takes advantage of this stability to capture trends between boundaries of expectation: The price of a stock has a great probability to reverse up when it hits the Lower Boundary (where expectation is the highest) and to reverse down when it hits the Upper Boundary (where expectation is the lowest).

Chapter 3: When Volume Diverges from Price In Chapter 3 I show that the historical comparison of price trends to Effective Volume trends allows detecting, for a specific stock, thresholds that define levels of high accumulation or distribution. This Divergence Analysis, after being adjusted for volatility discrepancies between price and volume, produces buy and sell signals that prove to be very effective. I then show how the combination of Active Boundaries and Divergence Analysis can lead to a set of trading rules that could be combined to form a trading strategy.

Chapter 4: Supply and Demand: The Key to Trading Chapter 4 takes a hard look at the supply/demand equilibrium as the major market force. This study leads to the presentation of the Supply Analysis tool. The Supply Analysis tool is based on the calculation of the probability that a share will be offered for sale, depending on the price at which it was bought, the time elapsed since it was bought, and the price evolution since then. I then show in practical examples how the Supply Analysis tool, combined with the Effective Volume tool, can very effectively measure the supply/demand equilibrium and therefore lead to winning trades.

This chapter then moves on to study how funds play in an illiquid environment. It shows that funds have great difficulty making money, primarily because of the large size of the positions they must take. Finally, we discover that markets are very efficient and that therefore price manipulation by funds is not likely to occur. This leads us to the conclusion that traditional funds will not be able to beat the market.

Part Two: Trading Strategies

After developing in the previous section a set of new tools that can be used independently, this section shows how these tools can be combined into various trading strategies. These trading strategies are tested against a buy/hold trading method not only in terms of risk/return balance, but also in terms of the total efforts that a trader must invest in order to sort out the best trading opportunities.

Chapter 5: Performance: The Risk/Return Balance Chapter 5 shows that at the level of the trading strategy the risk/return balance is best measured using:

• For the risk: the expected monthly loss transferred (MLT) by the trading strategy to the portfolio.

• For the return: the yearly expected return (YER) of the trading strategy. A performing trading strategy must produce a YER higher than that produced by a standard buy-and-hold strategy.

We will also see in Chapter 5 how the profit target, the stop loss, and the time limit parameters can be used to manage an opened trade.

Chapter 6: Automated Trading Systems Chapter 6 first reviews the alert and production screens, two information displays used to alert the trader to the evolution of a set of stocks. These two screens summarize the material covered in Chapters 1 through 4.

Chapter 6 then combines the tools introduced in Chapters 1 through 4 into various trading strategies. We gradually discover the characteristics of the three pillars of good trading strategies: the discovery of value, the selection of the right buying trigger, and the management of the trade evolution.

Part Three: The Bonus Section

This part is called a bonus section because it opens the door to the understanding of different facets of trading using the trading tools introduced in Chapters 1 to 4.

Chapter 7: The Market Is a Two-Way Street: Shorting Strategies After explaining the “tick test” rule, Chapter 7 studies how the various tools can be used for shorting strategies.

Chapter 8: Market and Sector Analysis Chapter 8 shows how the application of the Active Boundaries tool to the general market trend can help in determining when the market is overpriced. It then studies how a modified version of the Effective Volume tool can be used to study sector movements.

READY FOR THE REVOLUTION

The revolution of decimalization is here to stay. The only way that investors and traders can avoid becoming victims of insiders and manipulators is to use techniques that detect their moves. This is why I believe that tools such as those I present in this book will be widely used in the coming years.

You will see that the different concepts introduced in this book are very simple in nature. The mathematics may look complex at first, but in fact it is mostly addition, subtraction, multiplication, and division. It is important that you understand what the math represents, what it measures, and how you can take advantage of what it tells you.

But it is not the math that is doing the trading; it is the trader.

PART ONE

The Set of Tools That Will Change Technical Analysis

CHAPTER 1

Effective Volume

An Open Window into the Market

When you are considering a stock to trade, you have to view yourself as a doctor treating a patient. You have three points of view to help you in your diagnosis:

1. The patient’s general condition: age, gender, any preexisting conditions, regular exercise or not, smoking or heavy drinking, and so on.

2. The patient’s symptoms: pain, fever, swelling, and the like.

3. The patient’s internal examination: a blood test, a scan, an X-ray, and so on.

When analyzing a stock, you may think that the general condition is the fundamental analysis: earnings, profit growth, and so on. It may disappoint you to learn that these are only external measures of value. Value itself is useless if not compared to how it is priced. How value is priced is also virtually useless if you do not know what the expectation of shareholders is. Indeed, being a shareholder means possessing equity (value) for which the shareholder expects a return.

You will understand in Chapter 2 that the general condition of a stock is partly represented by its price trend. You will often see a price moving above and then below its price trend, indicating the evolving perception of value. Good trading requires you to catch this perception of value. I translate it into the measure of the expectation of active traders. You need to position your trades in harmony with this expectation: buy when expectation is high, and sell when it is low. Chapter 2 explains this expectation concept and how to measure it. It is my first pillar for successful trading.

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!