Contents

Cover

Series

Title Page

Copyright

Dedication

Preface

Acknowledgments

Part I: The Foundation of Technical Analysis

Chapter 1: The Trader’s Edge

DEFINING A TRADING EDGE

FINDING AND DEVELOPING YOUR EDGE

GENERAL PRINCIPLES OF CHART READING

INDICATORS

THE TWO FORCES: TOWARD A NEW UNDERSTANDING OF MARKET ACTION

PRICE ACTION AND MARKET STRUCTURE ON CHARTS

CHARTING BY HAND

Chapter 2: The Market Cycle and the Four Trades

WYCKOFF’S MARKET CYCLE

THE FOUR TRADES

SUMMARY

Part II: Market Structure

Chapter 3: On Trends

THE FUNDAMENTAL PATTERN

TREND STRUCTURE

A DEEPER LOOK AT PULLBACKS: THE QUINTESSENTIAL TREND TRADING PATTERN

TREND ANALYSIS

SUMMARY

Chapter 4: On Trading Ranges

SUPPORT AND RESISTANCE

TRADING RANGES AS FUNCTIONAL STRUCTURES

SUMMARY

Chapter 5: Interfaces between Trends and Ranges

BREAKOUT TRADE: TRADING RANGE TO TREND

TREND TO TRADING RANGE

TREND TO OPPOSITE TREND (TREND REVERSAL)

TREND TO SAME TREND (FAILURE OF TREND REVERSAL)

SUMMARY

Part III: Trading Strategies

CHAPTER 6: Practical Trading Templates

FAILURE TEST

PULLBACK, BUYING SUPPORT OR SHORTING RESISTANCE

PULLBACK, ENTERING LOWER TIME FRAME BREAKOUT

TRADING COMPLEX PULLBACKS

THE ANTI

BREAKOUTS, ENTERING IN THE PRECEDING BASE

BREAKOUTS, ENTERING ON FIRST PULLBACK FOLLOWING

FAILED BREAKOUTS

SUMMARY

CHAPTER 7: Tools for Confirmation

THE MOVING AVERAGE—THE STILL CENTER

CHANNELS: EMOTIONAL EXTREMES

INDICATORS: MACD

MULTIPLE TIME FRAME ANALYSIS

CHAPTER 8: Trade Management

PLACING THE INITIAL STOP

SETTING PRICE TARGETS

ACTIVE MANAGEMENT

PORTFOLIO CONSIDERATIONS

PRACTICAL ISSUES

CHAPTER 9: Risk Management

RISK AND POSITION SIZING

THEORETICAL PERSPECTIVES ON RISK

MISUNDERSTOOD RISK

PRACTICAL RISKS IN TRADING

SUMMARY

CHAPTER 10: Trade Examples

TREND CONTINUATION

TREND TERMINATION

FAILURE TEST FAILURES

TRADING PARABOLIC CLIMAXES

THE ANTI

TRADING AT SUPPORT AND RESISTANCE

SUMMARY

Part IV: The Individual, Self-Directed Trader

CHAPTER 11: The Trader’s Mind

PSYCHOLOGICAL CHALLENGES OF THE MARKETPLACE

EVOLUTIONARY ADAPTATIONS

COGNITIVE BIASES

THE RANDOM REINFORCEMENT PROBLEM

EMOTIONS: THE ENEMY WITHIN

INTUITION

FLOW

PRACTICAL PSYCHOLOGY

SUMMARY

CHAPTER 12: Becoming a Trader

THE PROCESS

RECORD KEEPING

STATISTICAL ANALYSIS OF TRADING RESULTS

SUMMARY

Appendix A: Trading Primer

THE SPREAD

TWO TYPES OF ORDERS

CHARTS

Appendix B: A Deeper Look at Moving Averages and the MACD

MOVING AVERAGES

THE MACD

Appendix C: Sample Trade Data

Glossary

Bibliography

About the Author

Index

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

The Wiley Trading series features books by traders who have survived the market's ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional, or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future.

For a list of available titles, please visit our Web site at www.WileyFinance.com.

Copyright © 2012 by Adam Grimes. All rights reserved.

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

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

Charts generated with the TradeStation platform and code in EasyLanguage format are used with permission. © TradeStation Technologies, Inc. 2001–2011, All rights reserved.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Grimes, Adam, 1973–
The art and science of technical analysis : market structure, price action, and trading strategies Adam Grimes.
pages cm. – (Wiley trading series ; 544)
Includes bibliographical references and index.
ISBN 978-1-118-11512-1 (cloth); ISBN 978-1-118-22427-4 (ebk);
ISBN 978-1-118-23814-1 (ebk); ISBN 978-1-118-26247-4 (ebk)
1. Investment analysis. I. Title.
HG4529.G75 2012
332.63′2042–dc23
2012000874

To my wife Betsy. Without her unfailing love and support I could have accomplished nothing.

Preface

The book you are holding in your hands is the product of nearly two decades of my study and experience as a trader, covering the full span of actively traded markets and time frames. I owe much to authors and traders who have come before me, for no one produces anything significant in a vacuum. I would not have been successful without the help and guidance of my mentors, but I learned many of the lessons here from my own mistakes. In some ways, this work represents a radical break from many of the books that have preceded it, and I hope it encourages you to question much of the traditional thinking of technical analysis.

This book does not present a rigid system to be strictly followed, nor a set of setups and patterns that can be assembled at the trader’s whim. Rather, it offers a comprehensive approach to the problems of technically motivated, directional trading. The book is structured to be read from beginning to end, but individual sections and chapters stand on their own. Through the entire work, deliberate repetition of important concepts helps to build a complete perspective on many of the problems traders face. The tools and techniques must be adapted to the trader’s personality and business situation, but most will find a firm foundation between these covers.

There are some underlying themes, perhaps not expressed explicitly, that tie this work together, and they may be surprising to many readers: Trading is hard. Markets are extremely competitive. They are usually very close to efficient, and most observed price movements are random. It is therefore exceedingly difficult to derive a method that makes superior risk-adjusted profits, and it is even more difficult to successfully apply such a method in actual trading. Last, it is essential to have a verifiable edge in the markets—otherwise no consistent profits are possible. This approach sets this work apart from the majority of trading books published, which suggest that simple patterns and proper psychology can lead a trader to impressive profits. Perhaps this is possible, but I have never seen it work in actual practice.

This book is divided into four parts:

Part One begins with a look at some of the probability theory supporting the concepts of successful trading. Next comes an in-depth look at a specific approach to chart reading that focuses on clarity and consistency lays the foundation for building and understanding of price patterns in markets. This section concludes with an overview of the Wyckoff market cycle, which is already well known in the literature of technical analysis.

Part Two focuses on the details of trends, trading ranges, and critically, the transitions from one to the other in considerable detail. This is a deep look at the underlying foundation of price movements, and there is information here that, to my knowledge, has never appeared in print before.

Part Three might appear, at first glance, to be the meat of this book, as it includes specific trading patterns and examples of those patterns applied to real markets. It also advocates a way of looking at indicators and other confirming factors that requires a deep understanding of the nuances of these tools. One of the key elements of any trading plan is how the trader sizes the trade and manages the position as it develops; these elements are also covered in considerable depth. Much attention is devoted to the many risks traders will encounter, both from the market and from themselves. Though most traders are going to be tempted to turn directly to this section, remember that these patterns are only the tip of the spear, and they are meaningless unless they are placed within the context provided by Parts One and Two.

Part Four is specifically written for the individual trader, and begins by focusing on elements of psychology such as cognitive biases and issues of emotional control. Chapter 11 takes a look at many of the challenges developing traders typically face. Though it is impossible to reduce the trader development process to a one-size-fits-all formula, the majority of traders struggle with the same issues. Most traders fail because they do not realize that the process of becoming a trader is a long one, and they are not prepared to make the commitment. This section concludes with a look at some performance analysis tools that can help both the developing and the established trader to track key performance metrics and to target problems before they have a serious impact on the bottom line.

Last, there are three appendixes in this work. The first appendix is a trading primer that will be useful for developing traders or for managers who do not have a familiarity with the language used by traders. Like any discipline, trading has its own idioms and lingo, an understanding of which is important for effective communication. The second expands on the some specific details and quirks of moving averages the MACD, which are used extensively in other sections of this book. The last appendix simply contains a list of trade data used in the performance analysis of Part Four.

This book is written for two distinct groups of traders. It is overtly addressed to the individual, self-directed trader, either trading for his or her own account or who has exclusive trading authority over a number of client accounts. The self-directed trader will find many sections specifically addressed to the struggles he or she faces, and to the errors he or she is likely to make along the way. Rather than focusing on arcane concepts and theories, this trader needs to learn to properly read a chart, and most importantly, to understand the emerging story of supply and demand as it plays out through the patterns in the market.

Though this book is primarily written for that self-directed trader, there is also much information that will be valuable to a second group of traders and managers who do not approach markets from a technical perspective or who make decisions within an institutional framework. For these traders, some of the elements such as trader psychology may appear, at first glance, to be less relevant, but they provide a context for all market action. These traders will also find new perspectives on risk management, position sizing, and pattern analysis that may be able to inform their work in different areas.

The material in this book is complex; repeated exposure and rereading of certain sections will be an essential part of the learning process for most traders. In addition, the size of this book may be daunting to many readers. Once again, the book is structured to be read and absorbed from beginning to end. Themes and concepts are developed and revisited, and repetition is used to reinforce important ideas, but it may also be helpful to have a condensed study plan for some readers. Considering the two discrete target audiences, I would suggest the following plans:

Both the individual and the institutional trader should page through the entire book, reading whatever catches their interest. Each chapter has been made as self-contained as possible, while trying to keep redundancy to an absolute minimum.

After an initial quick read, the individual trader should carefully read Chapters 1 and 2, which provide a foundation for everything else. This trader should probably next read Part Four (Chapters 11 and 12) in depth, paying particular attention to the elements of the trader development process. Next, turn to Chapters 6 and 10, which focus on often-misunderstood aspects of risk and position sizing. Two important aspects of the book are missed on this first read: in-depth analysis of market structure and the use of confirming tools in setting up and managing actual trades. These are topics for deeper investigation once the initial material has been assimilated.

For the institutional trader, Chapter 1 is also a logical follow-up to a quick read. Next, Chapter 2 would provide a good background and motivation for the entire discipline of technical analysis. Chapters 8 and 9 will likely be very interesting to this trader. For managers who are used to thinking of risk in a portfolio context, there are important lessons to be learned from a tactical/technical approach to position and risk management. Last, many of these readers will have an academic background. Chapters 2 through 5 would round out this trader's understanding of evolving market structure.

Following both of these study plans, it is advisable to then begin again from the beginning, or perhaps to turn to the parts of the book not covered in these shorter plans and pick up what you have missed. Intellectually, the material can be assimilated fairly quickly, but flawless application may remain elusive for some time. Additional materials supporting this book, including a blog updated with examples and trades drawn from current market action, are available at my web site and blog, www.adamhgrimes.com.

The title of this book is The Art and Science of Technical Analysis. Science deals primarily with elements that are quantifiable and testable. The process of teaching a science usually focuses on the development of a body of knowledge, procedures, and approaches to data—the precise investigation of what is known and knowable. Art is often seen as more subjective and imprecise, but this is not entirely correct. In reality, neither can exist without the other. Science must deal with the philosophical and epistemological issues of the edges of knowledge, and scientific progress depends on inductive leaps as much as logical steps. Art rests on a foundation of tools and techniques that can and should be scientifically quantified, but it also points to another mode of knowing that stands somewhat apart from the usual procedures of logic. The two depend on each other: Science without Art is sterile; Art without Science is soft and incomplete. Nowhere is this truer than in the study of modern financial markets.

ADAM GRIMES

September 2011

New York, New York

Acknowledgments

First, to Linda Raschke: I owe you a debt I can never repay—who would have thought your kindness that began with answering a simple e-mail so many years ago would have had such a profound impact on someone’s life?

Jose Palau, you played a seminal role in helping me crystallize the ideas for this book. There were times in our arguments that I wanted to punch you, and I’m sure it was mutual. In the end, much of what is good in this book came from those discussions, and, as you said, “there is no spoon.”

There have been many others along the way who have challenged my thinking with new ideas and helped to drive out imprecision and errors in my trading. To Larry Williams, Mark Fisher, Chris Terry, Ralph Vince, Chuck LeBeau, Victor Niederhoffer, Michael Gunther, Louis Hazan, Mark D. Cook, David McCracken, Doug Zalesky, and Andrew Barber, thank you. Andrew Karolyi and Ingrid Werner, you expanded my thinking and opened my mind to new possibilities.

The first draft of this book was produced in 45 days, but then the real work began. Henry Carstens, David Dyte, and Dr. Brett Steenbarger provided invaluable guidance in the early stages of this project, and helped me to see some of the problems from many perspectives. Perry Kaufman provided some good quantitiative insights and critique. Travis Harbauer, you were the best intern imaginable. Being willing to get on a train at 10:00 p.m. on a Friday night with a flash drive is far above and beyond the call of duty! And Aimin Walsh—how (and why) does someone meticulously proofread a 900-page manuscript in a single week while having a real life, a job, and, presumably, sleeping sometime in between? My mother, Lila Grimes, persevered in reading and editing early versions of this manuscript, a difficult task but a valuable perspective from someone not familiar with the subject matter. Thank you also to my small army of interns who proofread, crunched numbers, and made a thousand small improvements to my work: Benjamin Shopneck, Ethan Tran, Austin Tran, and Fred Barnes. This project would have taken far longer, and the finished work would have been much weaker, without your contributions. Thank you so much to all of you.

I probably would have put off writing this book much longer if not for the encouragement of Mike Bellafiore. His advice, to “make a book that will be a gift to the trading community,” guided my actions at every step.

Last, but certainly not least, Kevin Commins and Meg Freeborn at John Wiley & Sons, your work supporting a first-time author was fantastic. Thank you for dealing with my questions and for navigating the complexity of this manuscript so well. It has been a joy working with you.

PART I

The Foundation of Technical Analysis

CHAPTER 1

The Trader’s Edge

If you would be a real seeker after truth, it is necessary that at least once in your life you doubt, as far as possible, all things.

—René Descartes

There is something fascinating and mesmerizing about price movements in actively traded markets; academics, researchers, traders, and analysts are drawn to study markets, perhaps captivated as much by the patterns in the market as by the promise of financial gain. Many people believe that price changes are random and unpredictable; if this were true, the only logical course of action would be to avoid trading and to invest in index funds. This is, in fact, what a significant number of financial advisers recommend their clients do. On the other hand, there are analysts and traders who believe that they have some edge over the market, that there is some predictability in prices. This camp divides into two groups that historically have been diametrically opposed: those who make decisions based on fundamental factors and those who rely on technical factors. Fundamental analysts and traders make decisions based on their assessment of value, through an analysis of a number of factors such as financial statements, economic conditions, and an understanding of supply/demand factors. Technical traders and analysts make decisions based on information contained in past price changes themselves.

Our work here concerns the latter approach. Few traders make decisions in a vacuum; technical traders may consider fundamental factors, and fundamental traders may find that their entries and exits into markets can be better timed with an understanding of the relevant elements of market structure, money flows, and price action. Most traders find success with a hybrid approach that incorporates elements from many disciplines, and there are very few purely technical or fundamental decision makers. The key distinction, for us, is that technically motivated traders acknowledge the primacy of price itself. They know that price represents the end product of the analysis and decision making of all market participants, and believe that a careful analysis of price movements can sometimes reveal areas of market imbalance that can offer opportunities for superior risk-adjusted profits. Building the tools for that analysis and learning how to apply them is the purpose of this book.

DEFINING A TRADING EDGE

Most of the time, markets are efficient, meaning that all available information is reflected in asset prices, and that price is a fair reflection of value. Most of the time, prices fluctuate in a more or less random fashion. Though a trader may make some profitable trades in this type of environment purely due to random chance, it is simply not possible to profit in the long run; nothing the trader can do will have a positive effect on the bottom line as long as randomness dominates price changes. In theory, in a true zero-expectancy game, it should be possible to trade in a random environment and to break even, but reality is different. Trading accounts in the real world suffer under the constant drag of a number of trading frictions, transaction costs, errors, and other risks. Together, these create a high hurdle that must be overcome in order to break even. It is even possible for a trader to work with a positive expectancy system and still lose a significant amount of money to the vig.

Newer traders especially are often drawn to focus on elements of performance psychology and positive thinking. There is an entire industry that caters to struggling traders, holding out hope that if they could just get their psychological issues resolved, money would flow into their trading accounts. However, this fails to address the core problem, which is that most traders are doing things in the market that do not work. Excellent execution, risk management, discipline, and proper psychology are all important elements of a good trading plan, but it is all futile if the trading system does not have a positive expectancy. These are essential tools through which a trading edge can be applied to the market, and without which a trader is unlikely to succeed in the long run. However, none of these is a trading edge in itself.

A positive expectancy results when the trader successfully identifies those moments where markets are slightly less random than usual, and places trades that are aligned with the slight statistical edges present in those areas. Some traders are drawn to focus on high-probability (high win rate) trading, while others focus on finding trades that have excellent reward/risk profiles. Neither of these approaches is better than the other; what matters is how these two factors of probability and reward/risk ratio interact. For instance, it is possible to be consistently profitable with a strategy that risks many times more than what is made, as long as the win rate is high enough, or with a much lower percentage of winning trades if the reward/risk ratio compensates. In all cases, the trading problem reduces to a matter of identifying when a statistical edge is present in the market, acting accordingly, and avoiding market environments that are more random. To do this well, it is essential to have a good understanding of how markets move and also some of the math behind expectancy and probability theory.

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!

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!