qxd 2/28/07 4:08 PM Page i The Three Skills of Top Trading ffirs.qxd 2/28/07 4:08 PM Page ii Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, 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, visit our web site at www.qxd 2/28/07 4:09 PM Page iii The Three Skills of Top Trading Behavioral Systems Building, Pattern Recognition, and Mental State Management HANK PRUDEN John Wiley & Sons, Inc.qxd 2/28/07 4:09 PM Page iv Copyright © 2007 by Hank Pruden. 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: Pruden, Hank, 1936– The three skills of top trading : behavioral systems building, pattern recognition, and mental state management / Hank Pruden.—(Wiley trading series) Includes bibliographical references and index. Stock price forecasting.63'2042—dc22 2006036653 Printed in the United States of America.qxd 2/28/07 4:09 PM Page v To Sarah—my precious wife, lifelong love, and best friend ffirs.qxd 2/28/07 4:09 PM Page vi ftoc.qxd 2/28/07 4:09 PM Page vii Contents Preface ix Acknowledgments xv About the Author xvii PART ONE Systems Building and Behavioral Finance 1 CHAPTER 1 Systems Building for the Three Skills of Top Trading 3 CHAPTER 2 Behavioral Finance 33 CHAPTER 3 The Life Cycle Model of Crowd Behavior 55 PART TWO Pattern Recognition and Discretionary Trading 87 CHAPTER 4 Wyckoff: The Man, the Method, the Mystique 89 CHAPTER 5 The Basic Elements of Charting for the Wyckoff Method 99 CHAPTER 6 The Wyckoff Method of Technical Analysis and Speculation 131 CHAPTER 7 Anatomy of a Trade 161 vii ftoc.qxd 2/28/07 4:09 PM Page viii viii CONTENTS PART THREE Mental State Management 173 CHAPTER 8 Trader Psychology and Mental Discipline 175 CHAPTER 9 The Composite Man 201 CHAPTER 10 Putting It All Together: Ten Principles for a Trader to Live By 235 Notes 265 Recommended Reading 269 Bibliography 273 Index 277 fpref.qxd 2/28/07 4:10 PM Page ix Preface T his book gives the trader, the investor, and the analyst a true compet- itive advantage in the challenging markets of the twenty-first century. Today, there are powerful agitations in the United States and globally to shift responsibility for investing onto the shoulders of the individual. But, just as responsibility moves away from corporations and the govern- ment, the individual faces conflicting advice as to how to manage financial investments.
The efficient market hypothesis is riddled with false assump- tions that lead to wrong results. Equally mistaken are brokers who advise their clients to buy and hold. The real behavior of markets, what the data show in numerous markets over many time frames, is that “Market ‘timing’ matters greatly. Big gains and losses concentrate into small packages of time.
Mandelbrot) Some of the most successful traders are the ones who got their market timing right. Take, for example, George Soros, who during two months in 1992 profited about $2 billion by betting against the British pound sterling. Although few traders are in the same league as George Soros, most can profit from market moves concentrated in time. This book aims to equip the trader with a balanced set of skills for cap- turing the “packages of time” that make for big gain opportunities in the mar- ket.
It will also help the trader sidestep the timing pitfalls stemming from superficial data analysis and erroneous interpretations of market indicators. To compete successfully the trader must become a Complete Trader. As you can see in the Three-in-One Trader Model (Figure P.1), three mutu- ally reinforcing elements form the Complete Trader. This book will help you develop skill within each of the elements of systems building, pattern recognition, and mental state discipline, giving you solid footing well along the path to becoming a Complete Trader.
This book brings together the three skills of top trading: behavioral mod- els for systems building, pattern recognition, and mental state discipline.qxd 2/28/07 4:10 PM Page x x PREFACE The Wyckoff Method Price Price 3 Mutually Reinforcing Links 100 100 Make the Complete Trader TEN Move 90 ExtentofofMove 90 conditions conditions 80 80 Momentum Momentum andExtent 70 TASKS 70 60 Feedback 60 Adoptersand Feedback 50 Adopters 50 40 40 of of OF TOP 30 VOLUME & Percentage 30 SENTIMENT VOLUME & Percentage 20 SENTIMENT 20 10 10 0 TRADING© 0 Duration of Move FEAR CONTRARY DurationOPINION of Move GREED FEAR CONTRARY OPINION GREED adoption/diffusion life cycle model is modified here to fit the stock market. Here, we see the four technical analysis parameters adoption/diffusion used inisthe life cycle model decision-making modified here to fitprocess—price, volume, the stock market. Here, sentiment, we see the and fourtime. technical analysis parameters used in the decision-making process—price, volume, sentiment, and time.
Investment Psychology The Pruden Model Consulting FIGURE P.1 Three Mutually Reinforcing Links Make the Complete Trader These three key skill areas work together to move the art and science of technical analysis and trading to the level of sophistication required in the twenty-first century. This book integrates elements of trading that are of- ten treated separately into a mutually reinforcing analytical package that makes intuitive sense. Part One of The Three Skills of Top Trading addresses systems build- ing and behavioral finance. There are three chapters devoted to this skill area.
Chapter 1, “Systems Building for the Three Skills of Top Trading,” fo- cuses on the building of decision-support systems. It introduces the right-brain/left-brain idea. Several schematics show the relationships of the Life Cycle Model of Crowd Behavior, the Wyckoff Method of Technical Analysis and Speculation, and the tools for mental state dis- cipline found in the Ten Tasks of Top Trading.qxd 2/28/07 4:10 PM Page xi Preface xi Chapter 2, “Behavioral Finance,” serves as a resource chapter for the trader. It defines the field of behavioral finance, gives a brief historical review, and explains how behavioral finance can be subdivided into individual behavior and mass psychology.
Chapter 3, “The Life Cycle Model of Crowd Behavior,” explains how and why a trader can build a technical decision-support system. The Life Cycle Model defines the four key dimensions of price, volume, sentiment, and time. It also shows how indicators that measure these parameters are integrated into a mutually reinforcing decision frame- work. The S-shaped and bell-shaped curves of the Life Cycle Model’s visual schematic are complemented by an analytical checklist for weighting indicators.
Part Two covers pattern recognition and discretionary trading, with a focus on the Wyckoff method of technical analysis and speculation. There are four chapters devoted to this skill area. Chapter 4, “Wyckoff: The Man, the Method, the Mystique,” shares tales of Richard D. Wyckoff, reveals the history behind Wyckoff’s time-tested pattern recognition method, and proposes that his princi- ples are increasingly relevant to the trader of today.
In addition, it in- troduces the five steps of the Wyckoff method of technical analysis and speculation. Chapter 5, “The Basic Elements of Charting for the Wyckoff Method,” defines and illustrates the usage of the basic vertical line or bar chart and the construction and usage of the figure or point-and-figure chart. It also includes the proper procedures for drawing trend lines, trend channels and support and resistance lines within a trading range. In addition, charts show comparative strength and weakness, the role of price spread, volume, and divergences.
Finally, you will learn how to coordinate bar and figure charts. Chapter 6, “The Wyckoff Method of Technical Analysis and Specula- tion,” defines and illustrates the application of Wyckoff laws, tests, and schematics. This chapter describes the three basic Wyckoff laws: sup- ply and demand, effort versus result, and cause and effect. The nine Wyckoff tests are crucial for enabling the trader to identify and enter a trading position that has very favorable reward-to-risk odds.
The ana- lytical checklists of the three laws and tests are complemented by vi- sual schematics of trading ranges for accumulation and distribution. Even though Wyckoff’s method is a judgmental method and not a me- chanical system, these laws, tests, and schematics are designed to give the trader a logical, systematic approach to chart analysis.qxd 2/28/07 4:10 PM Page xii xii PREFACE Chapter 7, “Anatomy of a Trade,” offers concrete and complete ex- amples of the diagnosis of a trading range and the identification of chart locations to take high-reward, low-risk trading positions. The second half of the chapter shows step by step how an expert Wyckoff- oriented trader entered, followed through, and exited trading posi- tions using options on an energy company’s stock. In addition, this chapter introduces nine new tests for reaccumulation as a supple- ment to the nine classic buying tests for accumulation.
Part Three covers trader psychology and mental state discipline. There are three chapters devoted to this skill area. Chapter 8, “Trader Psychology and Mental Discipline,” transitions us into Part Three by drawing on Wyckoff’s observation that the mastery of a sound methodology is only half of the trader’s battle; the other half is the mastery of one’s emotions and mental state. At the center of this chapter is a model, the Ten Tasks of Top Trading, which provides the trader with a system for accessing the appropriate mental state for each key task of a trading campaign from diagnosis to action to exiting a trade.
Chapter 9, “The Composite Man,” introduces the concept of the Com- posite Man, a powerful tool for mastering trading methodology, unique to the Wyckoff method. In addition, the concept of the Com- posite Man serves as a useful device in the quest for mental state con- trol.