journal of technical analysis (jota). issue 40 (1992, winter)

WINTER 1992 / 1993 ISSUE 40

A PUBLICATION OF THE MARKET TECHNICIANS ASSOCIATION

71 BROADWAY, 2ND FLOOR, C/O NYSSA l NEW YORK, NEW YORK 10006 l (212) 344-l 266

Issue 40

MARKET TECHNICIANS ASSOCIATION JOURNAL

Winter 1992 I1993

Editor

Michael J. Moody, CMT Smith Barney, Harris Upham

Los Angeles, California

Associate Editor

George A. Schade, Jr., CMT Scottsdale, Arizona

Printer

Tritech Services New York, New York

Publisher

Market Technicians Association 71 Broadway, 2nd Floor

New York, New York 10006

MT4 JOURNAL I WINTER 1992 I 1993 1

MARKET TECHNICIANS ASSOCIATION, INC.

Member and Affiliate Information

ELIGIBILITY: MEMBERSHIP is available to those “whose professional efforts are spent practicing financial technical analysis that is either made available to the investing public or becomes a primary input into an active portfolio management process or for whom technical analysis is the basis of their decision-making process.” Applicants for membership must be engaged in the above capacity for five years and must be sponsored by three MTA members.

AFFILIATE category is available to individuals who are interested in keeping abreast of the field of technical analysis, but who don’t fully meet the requirements for membership. Privileges are noted below.

DUES: Dues for Members and Affiliates are $150.00 per year and are payable when joining the MTA and thereafter upon receipt of annual dues notice mailed on July 1.

APPLICATION FEES: Applicants for membership will be charged a one-time application fee of $25.00; no fee for affiliates.

Benefits of MTA

Regular Members Affiliates

Invitation to Monthly MTA Educational Meetings - No charge Yes Yes

Receive Monthly MTA Newsletter Yes Yes

Receive MTA Journal Yes Yes

Use of MTA Library Yes Yes

Participate on Various Committees Yes Yes

Colleague of IFTA Yes Yes

Eligible to Chair a Committee Yes No

Eligible to Vote Yes No

Annual Subscription to the MTA Journal for non-members - $50.00 (minimum two issues).

Single Issue of MTA Journal (including back issues) - $20.00 each for members and affiliates, and $30.00 for non-members.

2 MTA JOURNAL / WINTER 1992 / 1993

STYLE SHEET FOR THE SUBMISSION OF ARTICLES

MTA Editorial Policy

The MARKET TECHNICIANS ASSOCIATION JOURNAL is published by the Market Technicians Associ-

ation, 71 Broadway, 2nd Floor, New York, NY 10006 to promote the investigation and analysis of

price and volume activities of the world’s financial markets. The MTA Journal is distributed to individuals (both academic and practitioner) and libraries in the United States, Canada, Europe

and several other countries. The Journal is copyrighted by the Market Technicians Association

and registered with the Library of Congress. All rights are reserved.

Style For The MTA Journal

All papers submitted to the MTA Journal are

requested to have the following items as pre-

requisites to consideration for publication:

1. Short (one paragraph) biographical presenta-

tion for inclusion at the end of the accepted article upon publication. Name and affiliation

will be shown under the title.

2. All charts should be provided in camera-ready

form and be properly labeled for text reference.

3. Paper should be submitted double-spaced if

typewritten, in completed form on 3% by 11 inch paper. If both sides are used, care should

be taken to use sufficiently heavy paper to

avoid reverse side images. Footnotes and refer-

ences should be put at the end of the article. Sub-

mission on disk is encouraged by arrangement.

4. Greek characters should be avoided in the text and in all formulae.

5. Two submission copies are necessary.

Manuscript of any style will be received and

examined, but upon acceptance, they should be prepared in accordance with the above policies.

Mail your manuscripts to:

Michael Moody, CMT Smith Barney, Harris Upham

333 South Grand Avenue, #5200 Los Anageles, CA 90071

MTA JOURNAL / WINTER 1992 I 1993 3

MARKET TECHNICIANS ASSOCIATION

Board of Directors, 1992-93

President Bruce Kamich, CMT MCM Inc. 71 Broadway, 11th Fl. New York, NY 10006 2121908-4326

Treasurer James Bohan Merrill Lynch, No. Tower World Finl. Center, 19th Fl. New York, NY 10281-1319 2121449-0552

Programs Pamela King Brean Murray, Foster Sec. 633 Third Avenue, 11th Fl. New York, NY 10017-6795 2121476-0756

Newsletter Jack Cahn, CMT Cahn/Vince 82 Company 5100 Oakland, #221 St. Louis, MO 63110 3141535-6810

Journal Michael Moody, CMT Smith Barney 333 So. Grand Ave., 52nd Fl. Los Angeles, CA 90071 2131486-8901

Accreditation William Raftery, CMT Smith Barney, 27th Fl. 1345 Avenue of Americas New York, NY 10105 212/698-6003

Membership Philip Roth, CMT Dean Witter Reynolds 2 World Trade Center, 63rd Fl. New York, NY 10048 2121392-3516

Officers/Office Manager

Vice-President/Long Range James Stewart, CMT NatWest Finl. Markets Group 10 Exchange Place, 22nd Fl. Jersey City, NJ 07302 201/547-2910

Secretary Fred Schutzman, CMT BFF Trading Group Inc. 130 Water Street, #3L New York, NY 10005 2121425-1440

Committee Chairpersons

Education Dodge Dorland LANDOR Investment Mgmt. 103 East 75th Street, #4FE New York, NY 10021 2121737-1254

Library Cay Lee, CMT B. T C. P.O. Box 1230 Valrico, FL 33594 8131685-0798

Ethics and Standards Philip Erlanger, CMT Fidelity Management 82 Devonshire Street - N9A Boston, MA 02109 6171570-7248

Placement Steven Nison, CMT Nikkhah Group at Refco 200 Liberty Street, 22nd Fl. New York, NY 10281 2121390-8658

IFTA Liaison Ken Tower, CMT UST Securities Corp. 5 Vaughn Drive Princeton, NJ 08543-5209 6091987-2300

Vice-President/Seminar Mike Epstein Sherwood Securities 55 Broadway, 21st Fl. New York, NY 10006 212/482-4000

MTA Office Manager Shelley Lebeck Market Technicians Association 71 Broadway, 2nd Fl. New York, NY 10006 2121344-1266 FAX: 2121673-9334

Marketing Ron Daino, CMT Smith Barney 1345 Avenue of Americas, 27th Fl. New York, NY 10105 2121698-6006

Computer Applications John Bollinger, CFA, CMT Bollinger Capital Management PO. Box 3358 Manhattan Beach, CA 90266 310/545-0610

Derivatives/Forex Ralph Vince 366 Miles Road Chagrin Falls, OH 44022 216/247-1962

Regional J. Les Williams, CMT Williams Capital Management PO. Box 120125 Arlington, TX 76012 8171548-8332

IFTA Conference 1993 David Krell, CMT New York Stock Exchange 11 Wall Street, 23rd Fl. New York, NY 10005 2121656-2865

4 MTA JOURNAL / WINTER 1992 I 1993

NOTES

TAl3LE OF CONTENTS

The Dow Divisor Myth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 John Carder, CMT The financial press

frequently reports that the stock market is

getting increasingly volatile. John Carder shows why this is not the case.

Point and Figure Perspective . . . . . . . . . . . . . . . . . . . . . . .ll J Adam Hewison Price is still the most

important piece of data that technical

analysts use. Adam Hewison shares a simple

way to get a long-term perspective on pure price.

ARTICLES

Globalizing Your Research- International Asset Analysis Simplified . . . . . . . . . . . . . . . . . . . . . . . . .13 Robert N. Friend When applying techni-

cal analysis to most internationally traded

assets, U.S. analysts tend to view price only in U.S. dollar values. Because the U.S. dollar

itself fluctuates in value, this may create

price contamination. Bob Friend explains.

Modified True Strength Index Versus an Exponential Moving Average . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 John Kozey The True Strength Index,

developed by William Blau, may represent an indicator with both moving average and

momentum characteristics. John Kozey

runs it against an exponential moving

average to see how it behaves.

MTA JOURNAL /WINTER 1992 / 1993 5

The Ten Tasks

of Top Trading.. . . . . . . . . . . . . . . . . .25

Van K. Tharp, Ph.D. and Henry 0. Pruden, Ph.D. Modeling is a

science that attempts to determine precisely

how experts perform a particular task well so that it can be broken into its essential

elements and taught to others. Van Tharp

and Hank Pruden have been working to model top trading performance and present

their model here.

Membership and

Affiliate Information . . . . . . . . . . . . .2

Style Sheet for the

Submission of Articles . . . . . . . . . .3

MTA Officers and

Committee Chairpersons . . . . . . .4

Editor’s Commentary . . . . . . . . . . . .7

6 MTA JOURNAL /WINTER 1992 ! 1993

Editor’s Commentary

The State of the Profession by Michael Moody, Editor

In the last decade, the Market Technicians Associa- tion has made significant progress in legitimizing the study and practice of technical analysis. The Education Committee has pursued a university affIl- iation for the MTA to expand the scope and amount of research in our field. Most important, we have developed consistent and rigorous standards for qualification as a Chartered Market Technician.

The challenge of the next decade will be to make our professional designation-Chartered Market Technician-enhance the investment community at large. The challenge of the next decade will be to make every participant in the financial markets aware of the power and reach of technical analysis- and to make every reference to tea leaves laughable and pathetic. The challenge of the next decade will be to make technical analysts proud of their accom- plishments, instead of apologetic.

The MTA Journal can meet the challenge and, at the same time, make peace between two rival factions.

A war has been raging in finance, since at least the 196Os, with the rise of Random Walk theory and the Capital Asset Pricing Model. There has been a needless battle between the academic and the market practitioner. The academic says, “The market is efficient and can’t be beaten.” The market practitioner replies, “Watch me.”

analysis really does work, but if so, they have done a blessed poor job of proving their case.

We won’t have to become academics to achieve this goal. We won’t have to regress away every bit of significance in data. Our tests can be empirical or quantitative or statistical-or observations of what happened under similar conditions before and some possible reasons why. We won’t have to become statisticians, but we will need good evidence for our assertions.

For the practitioner, technical analysis could become the bridge between the reality of the markets and the postulates of academia, which are now tenuously connected to that reality.

I hope that the MTA Journd will stir contro- versy about the state of the profession, excite people about practical applications backed by evidence, and provoke people to think and do research or write angry letters to the Editor-perhaps even slaughter a few sacred cows. I hope we can have fun while we do it, and achieve one of the goals of the Market Technicians Association: to make the MTA Journal a vibrant place to exchange ideas.

The academic has at his disposal complex and inflexible statistical methodologies, which are difficult for the uninitiated to comprehend, let alone refute. The market practitioner, however, has the wisdom of experience and clings to the certain knowledge that markets rarely work the way academics suggest.

We have our work cut out for us. In this great endeavor, I believe that we must align with the market practitioner. The MTA Journal must be oriented to the people that the academics have almost abandoned-the market professional, the futures trader, the portfolio manager. It is also clear that we, as professional technical analysts, will have to test our assertions. To paraphrase Norman G. Fosback: A few technicians may insist that technical

MTA JOURNAL I WINTER 1992 I 1993 7

The Dow Divisor Myth by John Carder, CMT

-

Every time a stock splits in the Dow-Jones Industrial Average, it is frequently noted that this will lower the Dow’s divisor and make it more volatile. This statement has been repeated so many times it is now accepted as gospel. Even though it is widely believed, it is simply not true.

Charles Dow first developed his average in 1884 in his Customer’s Afternoon Letter. He calculated the average by adding the prices of eleven stocks and dividing by eleven (the number of stocks). Over the years, stocks were added to the average, and many were replaced. To keep from having gaps in the Dow average, the divisor was adjusted whenever a change was made to the average, or a stock in the average split. A thirty stock industrial average was intro- duced on October 1, 1928. The divisor at that time was 16.67. Over the years, the divisor has been adjusted down to its current’ level of 0.559. There is a commonly held misconception that the dropping divisor is causing the Dow Jones Industrial Average to become more volatile. This is only true in the limited sense of daily point change, and absolutely not true in terms of what really counts-daily percentage change.

Most of the claims are based on the simple statement that a lower divisor means that a one point change in one of the DJIA stocks will have a bigger effect on the DJIA. That much is true. A one point move in one of the DJIA stocks currently causes a 1.79 point change in the DJIA (the current divisor is 0.559 and l/0.559=1.79). If the divisor falls to 0.468 after Disney, Coke, Procter & Gamble and Merck split, a one point move in one of the underlying stocks will result in a change in the DJIA of 2.14. From this, the incorrect conclusion is drawn that the DJIA is made more volatile.

All that really happens is that while the other twenty-six stocks do have a slightly greater influence on the DJIA, the four that split will have a lot less influence on the DJIA. The DJIA is price weighted. It is the sum of the values of those thirty stocks divided by the divisor. If one stock splits four for one, a pre-split one point change in that stock is only a quarter point change in that stock after the split.

On April 16,1992, Disney closed at 152. The thirty stocks in the DJIA added up to 1881.875. Disney was 8.07% of the DJIA. If Disney had split four for one, then it would only be 38. The sum of the prices of the thirty DJIA stocks would only have been 1767.875, and the divisor would have dropped from 0.559 to 0.525 (=1767.875/1881.875*0.559). A four point change in Disney before the split would have caused a 7.16 change in the DJIA. After the split, the equivalent one point change in Disney would only cause a change in the DJIA of 1.90. Disney’s influence on the DJIA becomes only 26.5% of what it was before the split.

Since October 1, 1928, the DJIA divisor has dropped from 16.67 to 0.559. According to the myth, the DJIA should be almost thirty times more volatile, since a one point gain in an underlying DJIA stock now creates 29.82 times as big an increase in the DJIA as it did in 1928. That’s not the case.

Volatility Of The DJIA

3.00%

2.00%

Each bar in this chart represents the standard deviation of the daily changes in the DJIA during that year. The standard deviation is expressed as a percentage of the annual average of the DJIA for that year. The 77 year average of those values is 0.94% What does a reading of 1% mean? It means that approximately 32% of the days that year had a change (up or down) of more than 1% of that year’s average of the DJIA. As you can see, the late 1920s and early 1930s were accompanied by much more

8 MTA JOURNAL 1 WINTER 1992 11993

What is volatility? In the mathematical discipline of statistics, volatility is measured by standard deviation. Standard deviation is the square root of variance. Variance is the sum of the squares of the the differences from the average (mean). Large moves are emphasized by variance (and hence standard deviation) since their difference from the average is squared.

What does standard deviation mean? If you assume a normal distribution (bell curve), then 68% of the items measured are within one standard deviation of the average (mean). Over 95% are within two standard deviations of the average. Over 99.7% of the items measured are within three standard deviations of the average.

How was the chart constructed? In the chart showing the volatility of the DJIA, I have calculated each day’s change in the DJIA back to January 2nd, 1915. I then looked at each year, averaging all the daily changes and calculating their standard deviation (how much those changes varied) for that year. Notice that this eliminates the bias of trending markets, since we are measuring how far each day’s change is from that year’s average change. I then expressed that year’s standard deviation as a percent of that year’s average price. That’s what the bars are.

What does it all mean? If a bar on the chart is 1% high, then roughly two-thirds of that year’s daily changes were less than 1% and roughly one third of the daily changes were more than 1%. If a bar on the chart is 2% high, then roughly two-thirds of that year’s daily changes were less than 2% and roughly one-third of the daily changes were more than 2%. So a higher bar means that more of the daily changes in that year were relatively large (compared to that year’s average DJW--a higher bar means more days that year with big changes.

I I I I I

The DJIA Divisor I5 10 - 8-

5-

Copyright 0 1992 TOPleBE WV-m GRAPH=

P.O. Box 4283 Boulder, CO 80306 All rights nzserved

l-

0.5 - 1930 1940 1950 1960 1970 1980 1990

I I I I I I 1

MTA JOURNAL / WINTER 1992 / 1993 9

volatility than today, even though the divisor was nearly thirty times as large. The dropping divisor does not increase the volatility of the DJIA. If it did, the bars on the right of this chart would be climbing off the page.

One reason that people have accepted the myth so easily is that the DJIA is growing. As it gets bigger, the daily point changes get bigger. The chart of the Volatility of the DJIA points out that the percent changes have actually gotten smaller.

FOOTNOTE

1. As of April, 1992.

John Carder, CMT graduated from the University of Colorado with a B.S. in Mathematics. His firm, lbpline Investment Graphics, provides charts and analysis to newsletters and institutional customers.

10 MTA JOURNAL ! WINTER 1992 / 1993

Point and Figure Perspective by J. Adam Hewison

What I want to share with you in this note is one of the most powerful, and perhaps most overlooked technical tools today-point and figure charting. Despite all the information we receive and the myriad of technical studies available, it is important to remember that the market can only go three ways:

Up, Down, and Sideways

J20.00 310.00 a,o.oo ato. aaO.00 mo.00 a90.00 190.00 200.00 270.00 8 Y

aoo.00 270.00

These three scenarios hold true not only in the foreign exchange market, which is my specialty, but in all other markets traded, both globally and domestically. One of the methods we use to determine major and minor trends is point and figure charting. This method of charting has been around at least since the beginning of the century when it was written about by Charles Dow. Quite simply, point and figure charting measures price action which, in my mind, is still the most important element in the market place. In 1933 Victor de Villiers published a definitive work on point and figure charting. Almost 60 years later, his words still ring true in the market place:

z:: i;;,pg Bs,‘&> 260.00

260.00 740.00 z:z #IX” i@y’

240.00

aao.00

yi& ifl pp’ 210.00 PIO.00

f 200.00

y-g i&M 190.00

,To.oo / Q lQO.OO 170.00

,m.oo ~60.00 teo.00 MONTHLY SPOT (SO. 00 14o.m JAPANESEYEN

[])y 140.00 Kto.00 420.00 w$1 ;;z:$z , to.00 9 IO.00

Figure 1

19724992. We always start wlth the long-term monthly charts to give an indication of the major force behind the market. This monthly point & figure chart, going back tc 1972, which is a 5 Yen by 3 box reversal chart, clearly shows how negatlve the trend has been for the US. Dollar for the past 20 years.

“The Method takes for granted:

1. That the price of a stock, at any given time, is its correct valuation up to the instant of purchase and sales (a) by the consensus of opinion of all buyers and sellers in the world and (b) by the verdict of all the forces govern-

me.80 IY.80

ing the laws of supply and demand.

2. That the last price of a stock reflects or crys- tallizes everything known about or bearing on it from its first sale on the Exchange (or prior), up to that time.

3. That those who know more about it than the observer cannot conceal their future intentions regarding it. Their plans will be revealed in time by the stock’s subsequent action.”

When I was trading on the floor of the Chicago Mercantile Exchange, many of us were following the markets intraday with point and figure charts. In

Iae.Lo fifi I[! ii;:

,Y.vo 8ii%X ‘am.ma iYi3 y:z ,P.ao WEEKLY SPOT *‘*’ Pf 1P.u)

z:g JAPANESE YEN I,,.ma

,,o.wo i ,ao.Y)

t4e.m I w.90 ,I..CO

Figure 2

This weekly point and figure chart, which starts in June ‘91 and ends In Dctober ‘92, confirms what the monthly chart Indicated, and that was a lower US. Dollar. This weekly chart, which is a .9 Ven by 3 box reversal chart, clearly showed a sell signal for the US. Dollar when It moved below the 122.90 level.


0 0 lP.00

DAILY SPOT 8 122.00

tac.00 JAPANESE YEN

OX 12t.00 0x0

l20.00 0x0 t20.00 0 0

1 ,a.00 3 (8.00

Figure 3

This daily point and figure chart which starts in January ‘92 and ends in October ‘92, is a 5 Yen by 3 box reversal chart. A clear sell signal for the U.S. Dollar was given when it moved below the 131.00 level.

fact, we kept 10-30’s reversals and other combina- tions on the cattle and several other markets. When foreign exchange began trading in 1972, it was quite natural for traders to use some of the same methods that had been successful in other markets and the foreign exchange market lent itself perfectly to technical analysis. The major reason for this is that the economic cycle of a country tends to last longer in duration and therefore trends better than most commodity markets whose cycles tend to be much shorter and erratic. I still trade the foreign exchange markets with point and figure charts as well as some proprietary indicators, which we have found to be very useful. When following a market, I think it is vey important to follow it in three stages: daily, weekly, and monthly point & figure charts. I will illustrate this graphically because, if one works backwards, starting from monthly to weekly to daily, you have a much better feel for the longer-term flow of the market place and whether or not you want to be long or short that market.

I think a good case in point would be the long- term Japanese Yen chart. This chart is a monthly point & figure chart which begins in 1972 (Figure

1) and you can clearly see the continuation pattern to the downside for the Dollar against the Japanese Yen. Even though we have seen some rallies, the longer-term trend remains negative for the Dollar and it appears that the Dollar will have another push to the downside.

If you look at some of the shorter-term charts (Figures 2 and 3) it can sharpen your timing to trade in the direction of the major monthly trend. I believe

that if you look backwards, it will help you in your forward thinking. By just relying on price action in point and figure charting you are relieved of all the extraneous things such as overbought/oversold oscillators, divergences, and the myriad of what I call new technical tools which often confuse rather than clarify a market condition.

BIBLIOGRAPHY

De Villiers, Victor (1933). The Point and Figure Method of Anticipating Stack Price Movement.

Hew&n, Adam (1990). Right on the Money: The Definitive Guide to Forecasting Foreign Exchange Rates.

J Adam Hewison is president of The Rich Financial Group, Inc., Shady Side, MD.


Globalizing Your Research- International Asset Analysis Simplified by Robert N. Friend

Overview Significant profit opportunities may exist in the wake of the investment community’s continued failure to compensate for the distorting effect of the U.S. Dollar’s instability. When applying technical analysis to most internationally traded assets, analysts have acquired the habit of examining those assets’ US. Dollar values. Since the U.S. Dollar itself has been unstable for some time, contamination may exist for which they do not compensate. In the discussion which follows, this condition will be termed “Dollar Distortion.” Because this distorting effect corrupts so much analytic work, widespread invalid buy and sell signals may exist; profit opportunities may accrue to those who choose to take advantage of the condition.

Introduction I will describe a simple adjustment which will

be applied to the analysis of gold’s price. It will be suggested that a similar adjustment be made when analyzing other internationally traded commodities and commodity related common stocks. Problems with and limitations of adjustment methods will be considered. The study should be of value to those who are concerned with prices of commodities, commodity related stocks, collectibles, and currencies as well as with certain indices. In addition, those working with financial models using such assets might similarly benefit.

Discussion A vague awareness seems to exist that it is

important to report the U.S. Dollar’s value when reporting the price of certain other assets. Recently Wall Street Week’s host said, “The dollar is on a three week slide, and gold is up.“’ We observe that he sensed that gold’s price and the value of the dollar are in some way related. He also would seem to have acknowledged that his viewers shared his feeling. The connection, however, seemed weak. Even weaker is the connection indicated when one finds a market letter writer who occasionally presents the chart of a commodity valued in U.S. Dollars and valued then

in a second currency. Barron’s and The Wall Street Journal regularly carry a few indices in U.S. Dollar terms along with their values in “Local Currencies;” however, scant attention is paid to these. Outright rejection of any connection is naively expressed in the familiar charts which are disseminated presenting the U.S. Dollar values of foreign companies’ American Depository Receipts. Although the manufacturing and principal markets for a company’s products as well as its ownership may be foreign, we receive charts of its stock which have been constructed using U.S. Dollar values. Such charts are studied without thought being given to their possible unsuitability. One must look beyond this “U.S. Dollar blindfold” if one is to glimpse what is actually taking place in many markets. With little additional effort, this may be accomplished with performance considerably enhanced.

If use of U.S. Dollar pricing may lead one astray, are there practical options? It seems peculiar that so little attention has been given to this situation. We are safe in concluding that while some mild uneasiness may exist over freely employing the U.S. Dollar as a standard of value for most assets, outright awareness of the existence of difficulty does not seem to have developed.

Dollar-Generated Distortion For the moment we will hypothesize an Asset

“X,” for which all elements of worldwide supply and demand were continuously in balance during the August 26, 1992 trading day. Chart 1 shows this condition.

ASSET "X" 8-26-92

I 9 10 II II I 2 3 4 CHART1

MTA JOURNAL ! WINTER 1992 / 1993 13

Next consider Chart 2. It represents Asset “X” based upon its U.S. Dollar valueZ that same day. Chart 1 is a graphic representation of the worldwide market price of Asset “XI It is Asset “X” as seen by the international community. Chart 2 is a representation of the same Asset “X,” but it is from the viewpoint of those who are U.S. Dollar oriented. The oscillations are functions of the U.S. Dollar (inverted) only. Conclusions based upon Chart 2’s oscillations might be valid for the U.S. Dollar, but they would be of almost no value in the study of Asset “XIta

ASSET “X”

8-26-92

8 9 10 11 12 1 2 3 4

CHART 2

Had the worldwide value of Asset “X” steadily declined on August 26, the international investment community would have seen a graph similar to Chart 3~. Chart 3b combines that steady international price deterioration with the movements of the U.S. Dollar. It is the same Asset “X” as it would have been seen by the U.S. Dollar community.

This, of course, is typical of the charts which are commonly analyzed. The potential for erroneous predictions should be apparent.

Instability is the bane of technical analysis. One would never use an elastic tape measure to determine real estate dimensions, because the measuring device would stretch and shrink. It would be unstable. The measurement of Asset “X’s” value using the U.S. Dollar is similar poor practice. The U.S. Dollar’s value is constantly changing; it, too, is unstable. When Asset “X’s” value advances less than the U.S. Dollar declines, Asset “X” will up- pear to have advanced to a U.S. Dollar-oriented person, but the “price” will actually be declining for many holders of foreign currencies. Thinking of Asset “X” solely in U.S. Dollar terms may be quite misleading.

I ASSET “X” I 8-26-92

8 9 10 11 12

CHART 3A1

2 3 4

ASSET “X” - COMBINED TRENDS 8-26-92

8 9 10

dk~& 35’ 2 3 4

Alternatives to Dollar Pricing Dramatic insights may be unearthed by shifting

out of the conventional U.S. Dollar-based approach. Let us consider several charts of gold which were published as this article was being prepared. (See Charts 4 and 5.) Another asset could as easily have been considered at this point; however, gold tends to inhabit territory familiar to most readers of this discussion. These particular charts were selected solely on the basis of their wide dissemination. The discussion which follows could as easily have used any internationally distributed asset.

I I 1

Gold Prices

I” u s ddh


The characteristics of gold are so thoroughly covered in financial publications that I will do no more than mention that it finds use around the entire world. It is exchanged 24 hours a day with myriad currencies being employed. The U.S. Dollar is certainly not gold’s sole medium of exchange. For many years, however, to discuss its “price” has meant to discuss its U.S. Dollar price. The Western public accepts that it is gold’s U.S. Dollar price that is significant. When one considers that the U.S. Dollar no longer is the sole important international medium of exchange and is no longer the stable standard of value that it once was, its continuing survival as the popular standard of value for gold is remarkable.

If one no longer employs U.S. Dollar valuation for gold, what might then be utilized? A “basket” of many currencies suggests itself as a more logical standard with which to evaluate worth. One such basket might be the International Monetary Fund’s infrequently watched Special Drawing Right. The SDR is an index based upon a weighted basket of the currencies of the five4 largest exporting countries: the United States, Germany, Japan, France, and England? With a recent weighting of 42% US. Dollar, 19% German Mark, 15% Japanese Yen, 12% French Franc, and 12% British Pound, the Dollar had a towering position over any other individual component of the SDR.G

Conversion of any asset’s price into its SDRs value is easily accomplished by dividing the asset’s price by the SDR rate for the currency in which the price is quoted. The U.S. Dollar conversion rate is listed in each issue of The Wall Street Journal, Financial Times (London), and Barron’s under the heading “Foreign Exchange Rates” or “Exchange Rates.” Looking at the table that follows you will find an SDR rate for the U.S. Dollar of 1.38612. This means that a little over $1.38 was needed to purchase one SDR. Assume a price of $350 an ounce for gold.

The SDR price of gold = 35011.38612

= 252.5034 SDR per ounce.

Chart 6 repeats the Investor’s Business Daily Chart 5 but adds that of gold in SDRs as well. For this discussion the SDR value of gold will be termed “SDRGold;” the U.S. Dollar value of gold will be called “$-Gold;” the SDR value of oil will be called “SDR-Oil;” and the J.F! Morgan Trade-Weighted Dollar value of the Commodity Research Bureau Index will be called “TW$-CRB.”

Several obvious differences stand out between the two upper trendlines:

EXCHANGE RATES Wednesday, November 25,1992

The NawYorkforaig”excha”gesalll”gratas belowapplyto trading among banka In amounts of $1 mllllon and more, as quoted at 3 p.m. Eastern time by Bankers Trust Co., T&rate and other sowcas. Ratall transactions provide fewer ~“116 of foreign currency par dollar.

us. s cquiv. DUUS.S CWnttV wed. Tues. wed. Tua. Arpcnfina (Peso) __..____ 101 1.01 .w .w Austrari (Dollar1 ._.... .mo as2 1.493 1.a hJstr* IschlllinQ) . . .._. Bahratn (Dlnarl . . . . . .._. 2”6n: iz

Il.16 1111

tkbium (Franc) . . ..___ .(13061 z iz Brani (Cruzelro) _....... RIOIGM .CCZ 9376.01 9lM.W Bril*n(Poundl . . . . . . . . . . la00 1AxJ &36 Ass4

BDav Fcnvard . . .._ 15245 l.Rol 4566 Mn PoDav For-ward . .._. lJ174 15133 4590 ti

18MXw Far+ . . . . . 15076 Is37 A33 Aso ca (Dollars . . . . . . . . . .77n liu3 la56

X)Dav Forward . .._. 1% 2739 1m tm1 oODav Forward ..__ .7704 .76@5 125e3 1x13

1BoDav Farard _.._. .76Q .7614 lJoa5 13133 Czechosbv~b ( Kauna)

Cornmerclalratc .._. .035574S mull4 1.114) Xl&X Cbik (-1 .__._._......_ m27m an717 369.25 3M.07 China (Rmmlnbll . . . . . . .I0028 181028 50 ssm Cobmbia (Peso) . . . . .._. .WltU9 WI- 610.30 610.30 Denmark (Krm) . . . . . . .l626 .lt46 6.1409 6/lUl Ecusdoc lsucml

Ftoatlw rate ..__.....__ F inM IMarkkrl ___._.

Jm$ .m3528 lw3.01 lw3.01 .I%24 I.0476 511957

Frm (Frahcl ..__...... .1&97 .w4s.5 smo 5.4lc.s 3&Dav Fon*ard . .._. .lus7 .1- %41(0 SAlO PDDay Faward . . . . . .lgxs .I8113 m 552lo

lO@Dav Forward . . . . . .lW34 .17w4 JYSD 5sas t%rmmy (Mark) . . . . . . . 4301 AZ54 ‘1% t*

3GDav Faward . ..__ 6271 A234 1% l&Q ?&Day Forward ..__. A725 .6189 ly)65 14158

18&Dav Fwward . ..__ 614 .61x) lA2x 1.63u Greece (braclmH1 . . . . . now Kow (Dollar) . . . . Nundv lFcfl”f) . . . . .._ India (Ruoec) ______...... IMomia (Rwlah) . . . . IraM IPwn) .._ ..__..... IYaw (YrtelI . . . . . . . . .._ Itah (Ural . . . . _ . . . . . . . . . . . J~un (Yet-11 _._.._......_._

DDav Forward . ..__ s)Dav Faward . . . .

1mDav Forward .._._ Jordan lDina.rl _.......__. Ku-well (Dlnar) . .._..__._ LttHmrl (Pourxl) . . . . . . . Malavria (Rl”wlt) ..__ Marta (Lira) . . . . . . . . . . . . . Mrxica (PM)

Floatin rate _._....._. Mmdmd (Gui&r) __ )cr zedmd (cadlrr) . )(wre~ (Krm) _._...._. Pekistrr (R-1 ._____. Par-u (New Sol) ._....._.. Philipoim (Peso) . .._.. Pow motvl . . . . . . . ...” Perfwal (Escum . . . . . . SaudI Arti (RIYJII . . Sim (Dollar) . . . . . Smtfh Afrka (Rand)

Commarclal rata ..__. Fl”a”clal rate .._....._

sounl Koma (Won1 . . . . . Spain (Ptuta) . . . . _ . . . . . . Swdm (Krona) . . . . . . . . . S~lf~erM (Franc) . . .

3@Dav Forward . . . . . *Day Fwward .._..

M&Day Forward . . . . . Tdwm (Dollar) . . . . _ . . . . ThaIlend (Baht) .._...... Twhav (Llra) __.__...._.. ptid&WD~l’

Fiwwial _________._..... Venrzwb moflvrrl

Floating rate . . . . . .._._.

.ocum .I2m

.012/lal .a%52

.- 1.6574

Jxi6n .oaloiY nmo74 .U6C%l .m!ce7

1.4110 33361

.axIw 3960

3sQll

allnc6 St2 SlW .156l .a394 -61 IO

LitiiE mm77 36702

4117

.mQul .I7525

.01217w

.cctz 1.6403

.oolii om74

.mom

.zz I UIIO 3.3X1

.aMm

3z

f?d a1:wril

a.15 mm.03

22 l374.17

2::: 123.75

'?75

u7z.z 2Qs3

3310

3ml3 m m 78658 114.17 6AW 1.4270 l.oQ

4

3516.00

763

2mm 7.7370

c2.i im 1.15

2060.03 22% ls4.a

123&S la91 m.az 133.73

.6m

“Z2 2Q35

3310

3tt7.m 1.79a I.9367

6Q93

5z

lux ml6 1700 lA29S

--- SDR ______.........__ * 1.38612 1.~140 .ntu .72390 ECU . . . 1.23630 ImY)

Special Drawing Rights (SDR) are based on exchange rates for the U.S.. German. British. French and Jaoanese currencies. Sour& InternatIonalMonetary Fund.

Courtesy The Wall Street Journal


1. SDR-Gold peaked some 16 weeks before $-Gold. (Points “A” and “a”)

2. SDR-Gold exhibited lower highs and lower lows before $-Gold peaked. (Points “A” through “D” and “a” through “d.“)

3. The lower trendline of SDR-Gold was met at three distinct points: “A,” “E,” “G” and arguably at C. $-Gold was only met at “a” and “f’; “e” and “g” fell considerably below the declining trendline with “e” falling somewhat more than “g.”

4. SDR-Gold’s final plot was far below the declining trendline; whereas, $-Gold’s plot was near its trendline.

Chart 7 shows SDR adjustment of the inset on Investors Business Daily’s Chart 5. The most obvious significant difference is that while “e” has almost broken above “a” in the $-Gold chart, SDR-Gold at “E” is far below “A,” the 1992 high. SDR-Gold must

$-GOLD (Top) & SDR - GOLD (Bottom) 2nd London Fixing, Friday

] “ I . . ; , . . . ;.“;“‘;“‘; , . . ,

I CHART 6 I

$-GOLD (Top) & SDR - GOLD (Bottom) 2nd London Fixing, Friday (SDR x 1.3)

I CHART 7 I

DEVIATION FROM 30 - WK MA $-GOLD (Top) &SDR - GOLD (Below) I 1

. ,c1 :

Y . . I I .

CHART 6

move considerably higher if this is to occur. Note the divergent angles at which trendlines “B-C-D” and “b-c-d” developed. Looking further you will find that $-Gold’s low occurred seven weeks before the SDR- Gold low. The structure of SDR-Gold called for continued caution.

Charts dealing with internal measurements are often more dramatically variant than those we have already examined. Below are 39-week moving average oscillators for $-Gold and for SDR-Gold.

The differences are numerous and striking. Sev- eral areas deserve attention:

1. The $-Gold 1987 oscillator low came earlier in the year (“a” vs “A”). An extended rally in the U.S. Dollar’s oscillator followed. SDR-Gold advised caution for another three months.

2. $-Gold’s cycle lows at “a” and “e” indicated that a 97 week cycle might be active SDR-Gold demonstrated an 85 week cycle “A” to “E”. Of course, an inconsistency exists.

3. An important oscillator high in $-Gold was seen at “b,” while SDR-Gold experienced a minor high (“B”).

4. A triple top (b,c’,d) developed in the $-Gold oscillator while SDR-Gold developed the single “C” peak.

5. $-Gold saw an oscillator peak at “d;” SDR- Gold’s oscillator was unexceptional at “D.”

6. The 1990-91 saw $-Gold’s oscillator rapidly advance (g-i’) while SDR-Gold’s oscillator actually declined rapidly (H-H’.) Notice the angle of the dotted lines h-h’. Dollar Distor- tion caused U.S. investors to believe that this was a period of bullishness while the opposite condition existed.

7. SDR-Gold experienced an oscillator high “H” which $-Gold’s oscillator did not match “l-r” in amplitude.

8. $-Gold experienced an oscillator low at “k” while the oscillator of SDR-Gold at “K” was in the normal range.

This list is hardly complete, of course.


S-BOLD AND 34 - Wk MA 2nd London Fixing, Friday BRENT OIL s-011. (TOP) and SDR - OIL x 1.3 (Bottom) 1 366 , \ ? 366 364

‘I

362 I 36O-b.A I I 120.5 1

91 0 N D J F M A M J 92

CHART 9

SDR -BOLD AND 34 - Wk MA 2nd London Fixing, Friday

290 ]

265 I

260 iz h

275

270

265

gi o N 0 J F M A M J 92

L CHART10

In Citart 9 you will see a dramatic $-Gold break- out above its 34-week moving average line. SDR-Gold (Chart 10) tells a significantly different story? Notice, as well, dissimilarity of the October-November peaks.

Let us move briefly to a chart of oil. Price quota- tions for petroleum products are typically given in U.S. Dollars. Chart II contrasts North Sea Brent $-Oil with SDR-Oil.

Notice that:

1. SDR-Oil peaked in May at “B”; it saw a lower peak at “D” in June. Contrast this with $- Oil peaks of “b and I‘d”.

2. SDR-Oil retraced over half of its advance from its March price low. $-Oil is above its comparable one-half level.

3. SDR-Oil’s June retracement to “E” fell below its “A” low. $-Oil’s “e” was above its “a.”

These charts suggest the extent to which Dollar Distortion has limited our effectiveness and the insights which may assert themselves when it is removed. Realms which obviously invite price adjust-

I,~‘-‘.’ 1 ” 1 hi A-------./ 1962 J A

CHART11

I S-CRB (Top) and TWS - CRB (Bottom) (TW$-CRB x 2.1) I

250

240-

230-

170 A 90

A 91 ,. 92

CHART12

ment include, but are not limited to, metals, jewelry, stamps, most edible commodities, works of art, etc. as well as related stocks and indices which are single-currency based. The impact of this work might suggest reexamination of markets which have previously seemed unresponsive to technical analysis.

Although those adjustments which have been examined thus far have employed the SDR, one might find that other currency baskets are more appropriate. Since three major international trading blocks of nearly equal size seem to be emerging now, a composite currency basket weighted approximately l/3 European Currency Unit, l/3 Japanese Yen and 113 U.S. Dollar might be worthy of use. One might also consider working with the FINEX Dollar InddM or the Federal Reserve Board Trade-Weighted Dollar. Their content is 20.8% German Mark, 13.6% Japanese Yen, 13.1% French Franc, 11.9% British Pound, 9.1% Canadian Dollar, with the balance in other Western European currencies. “The Dollar IndexSY parallels the (U.S.) Federal Reserve Board’s Trade-Weighted Dollar index.” It is calculated and

MTA JOURNAL / WINTER 1992 I 1993 17

published every 30 seconds by FINEX.8 The J.F! Morgan Trade-Weighted Dollar Index of fifteen currencies is of somewhat similar nature and is yet another basket to consider. The financial section of many daily publications report the Dollar Index” figure. The author locates the FRB Index in the foreign exchange section of the New York Times or in Investors Business Daily; other sources, including the Federal Reserve Board exist. The J.I? Morgan Trade Weighted Dollar Index receives international dissemination. Publications which carry it daily include The Wall Street Journal, U.S.A. Today and Financial Times (London); Friday’s figure appears in Barron’s.

Although these baskets are useful devices for measurement of the U.S. Dollar’s value, they are seriously flawed for the purpose to which we would put them. None of them contains the U.S. Dollar. Exclusion of the U.S. Dollar from any basket may crucially distort value by removing the Dollar Block from a basket which must reflect international worth. This critical distortion demands adjustment. To overcome the difficulty the technician should com- bine such index numbers with the U. S. Dollar to form a new basket. A U.S. Dollar weight of something between 25% and 40% should be appropriate.

In Chart 12 the J.F! Morgan Trade Weighted Dollar and the U.S. Dollar have been combined on a 75%-25% basis (per the previous paragraph) and used to adjust the Commodity Research Bureau’s dollar-based index. The chart is included to demon- strate that the previously cited baskets may be employed as easily as was the SDR. Notice in particular the early 1991 period marked “A’‘-“B” during most of which commodity prices were rising worldwide while seeming to fall in the U. S. Then note “B’‘-“C” when the opposite condition existed.

Inappropriate Adjustments and Other Considerations

One must understand that Dollar Distortion can only come into play when an asset’s value is of importance from an international point of view. As extreme examples, the dollar value of a locally owned U.S. utility or of a minor league baseball ticket would normally not require adjustment. The less involved an asset is with the international community the less is the gain which adjustment will produce.

This study has not dealt with intraday U.S. market data. As the work has been insufhcient in this regard, it should not be assumed that intraday data should also be price adjusted. Obviously, the subject demands exploration. The technician should be aware of several less obvious considerations when applying the techniques which we have been discussing:

Caveat I. The Currency Basket Problems Certain difficulties may develop when these ad-

justment factors are used. Since international trade patterns are in constant flux, the trade weights within baskets should be frequently changed; unfortunately, such changes are rarely made. Equally uncommon are weight changes based on the shifting of relative currency values. Imperfections also result when significant trade relationships are overlooked. The major trading partners of the U.S. include Canada, Germany, the United Kingdom and Japan? Their currencies are central to most trade-weighted baskets. Although United States trade, both legal and illegal, with Central and South America is extensive, these currencies escape most baskets. Such omis- sions cause an index to suffer.

Although this paper will not deal with the question, it is possible that a different adjustment factor is desirable for each asset. U.S. precious metal bulls favor silver while Japanese favor platinum. Open interest in platinum is about seven times larger in Tokyo than in New York.‘O Under these circumstances it seems unlikely that the same currency basket mixtures would be appropriate for both silver and platinum.

Having agonized over the shortcoming of the tools which are available, we should realize that they are vastly superior to the unadjusted U.S. Dollar. The currency baskets which have been cited are exceedingly useful and should be enthusiastically employed. Im- provement of the devices should be encouraged and new baskets should be welcomed.

Caveat II. The Political Problem Political difficulties may face those using these

methods. One must be prepared for opposition from associates and clients; change generates resistance. Paradigms shift slowly. The U.S. technician may find that national pride will produce hostility toward her/his retreat from the U.S. Dollar Standard. Xenophobia aside, the technician always faces problems when presenting forecasts which are viewed as “bad news.”

Caveat III. The Work Load Problem Upon adjusting for Dollar Distortion, one will

find that most technical evaluations and predictions will require revision. Entirely new data sets will be imposed upon studies using Gann, Fibonacci, relative strength, trendline, stochastic, pattern, etc. The amount of available information will more than double! Although the information overload will increase, the possibility of replacing weak data with more reliable information urgently suggests doing so. It should be kept in mind that it is because of the continuing popular use of weak data that this profit opportunity has developed.

18 MTA JOURNAL /WINTER 1992 / 1993

Investment and Trading Applications The technician might well think of this

methodology as being investment “radar.” It reveals conditions which may be hidden from others. To take best advantage of those lacking this “radar,” a market must also be watched as others watch it. When Dollar Distortion causes different forecasts to unfold, positions should be assumed on the basis of the adjusted data. Some interpolation may be necessary to determine entry and stop-out levels.

Warning: To the extent that dollar-priced charts produce self-fulfilling prophesies, these techniques may temporarily fail. It is vital to observe conventional charts as well as adjusted charts.

Summary This article has examined problems presented by

U.S. Dollar pricing. It was seen that parts of our work have been corrupted by the U.S. Dollar’s erratic movements. Consideration was given to methods by which this distorting factor might be removed. Such adjustments produced substantial chart alterations which, in turn, suggested dramatically revised forecasts. It follows that the use of the suggested adjustment methods could reveal significant new profit opportunities.

FOOTNOTES

1. Randall, Carter, Wall skeet Week, g/6/91.

2. FINEX Dollar Index”’ as proxy.

3. Except to the extent that any correlation between “Asset X” and the U.S. Dollar might exist.

4. From 1974-80 it was a weighted average of the currencies of the 16 largest trading nations.

5. American Academic Encyclopedia Bibliography: Fergeson, Tyrone, The Third World and Decision-Making in the Znterna- tional Monetary Fund, 1988; Killick, Tony, et al., The ZMF and Stabilization: Developing Country Experiences, 1984; Southard, Frank A. Jr., The Evolution of the International Monetary Fund, 1988; Tew, Brian, The Evolution of the International Monetary Fund, 1988.

6. The Role of the SDR in the International Monetary System, International Monetary Fund, Washington, DC, 1987.

7. Many longer term moving average studies produced similar results.

8. New York Cotton Exchange, Finer U.S. Dollar Index Futures, Four World Trade Center, New York, NY 10048.

9. Investment Guide, American Investment Services, Inc, Great Barrington, IvIA 01230, l/31/92.

10. CRB Futures Market Service, Commodity Research Bureau, New York, NY, l/10/92.

Robert N. Friend is the Senior Associate of Friend Financial Services, an organization which has managed trust, estate and retirement find investments since 1963. He was a member of the founding Advisory Board of the American Association of Individual Znvestors and from 1979 to 1933 served as a Contributing Editor of its journal.

MTA JOURNAL / WINTER 199211993 19

I

Modified True Strength Index Versus an Exponential Moving Average by John Kozey

Abstract: The True Strength Index (TSB, developed by William Blau, is a cross between Wilder’s Relative Strength Index and Appel’s Moving Average Con- vergence Divergence indicator. Blau has described the TSI as being “very smooth and is usually more timely than moving averages taken directly on price.” This paper reviews the results obtained by using a slightly modified version of TSI (MTSI) and comparing it with exponential moving average studies, with and without transaction costs. In both cases, MTSI reduced the number of transactions, and produced a better rate of return when transaction costs were included.

downward price movements separately. This separa- tion makes it possible “to lose sight of the underlying ‘whole momentum’ process.“* Therefore, Blau described an alternative measure, namely, the ratio of daily price change divided by the absolute value of price change. The formula is:

(1) (Ls-LS.1) where

Introduction Everyone would like an ideal market indicator

or at least a nearly perfect one. William Blau’s True Strength Index (TSI) is an attempt to move closer toward such an indicator. His first published article listed the desirable characteristics of a “perfect indicator.“’ These are keeping up with price trend (moving average characteristics), showing the amount of price movement (momentum characteristics), and identifying turning points.

This paper will address some practical inter- pretations of a modified TSI formula (MTSI). Specifically, it will explore whether or not there is,

I&S-LS.l)l

LS = last sale on a given period

LS.l = last sale one period prior.

In many cases, RSI values are exaggerated due to extreme price excursions, which relegate the RSI to being an overbought/oversold indicator. Whether this “noise” is desirable or not is arguable according to individual tastes. TSI uses double exponential smoothing for those who want to temper the relative noise level.

The formula for Blau’s TSI is:

(2) TSI(y,z) = lOO* EMAZ*(EMAV*(LS-LS.l)) where

EMA,*(EMAy*(I(LS-LS.l)l) 1

TSI@,z) = True Strength Index for smoothing periods y and z.

EMAy = exponential moving average for the first period.

in fact, any information in this concept that may have value. An exponential moving average com-

EMA, = exponential moving average for the second period.

parison will be made to examine under what market conditions MTSI can add value to investment decisions.

True Strength Index Defined Blau pointed out that moving averages help to

define price direction, but their shortcoming is that they lag current price movements. Even so, he incor- porated exponential moving averages (EMAs) from 20 to 300 days in his published work on TSI, since he wanted to show price trends. Blau found the oscillating characteristics of Wilder’s Relative Strength Index (RSI) desirable. He wanted to incor- porate these traits into an indicator but considered RSI to be too unstable because RSI uses upward and

The TSI ratio will have a maximum value of 100 and a minimum value of - 100. If the second smoothing factor is set to 1, the TSI would be comparable to RSI except for scaling.

This author used a combined second smoothing of Blau’s original formula in order to reduce the number of calculations, as follows:

(3) TSIC.y,z) = 100*EMAZ*(EMAy*(LS-LS.1) )

(EMAy*I(LS-LS.l)/)

The results of using this modified version of TSI differ only slightly from those produced by Blau’s more computational formula, and directional changes given by both indicators were in complete

20 MTA JOURNAL! WINTER 1992 / 1993

-

agreement when compared in sample tests. The Modified TSI shown in Formula (3) was used in this study.

Simple Trading Strategy Study Anyone considering MTSI or any new tool wants

to bring new or improved features to existing indicators. This objective includes reducing the number of trades on current indicators or presenting better information.

In his second article, Blau wrote that “The true strength index is very smooth and is usually more timely than moving averages taken directly on price.“3 As this indicator has little published information to date, this paper will make an exploratory analysis into a moving average comparison using TSI versus a similar period exponential moving average.

The moving average period selected was 50 days because of its popularity among market technicians and because of the need for a long enough period to determine if a trending nature to TSI similar to an EMA exists. The exponential smoothing factor used in the study was 0.1132. The 16-period second smoothing factor was arrived at as follows. Blau suggested that users of TSI try second smoothing factors of one-half the time frame of the initial smoothing factor. Therefore, a 50 day EMA would have a 25 day EMA second smoothing. A visual comparison of different values for the second EMA led to the conclusion that this “half the periods” smoothing factor could be improved. Many individual stock chart observations were made. Since the 3:l ratio is very close in behavior to the 2:l ratio, the 3:l ratio was used in this study. Unless the ratio gets very small, the results do not appear to be otherwise affected.

The study began by comparing MTSI with its two smoothing factors to a like period EMA on individual stocks. The 50 day time frame was used for the reasons already stated and, secondly, because the trading signals generated would show how the MTSI can “hold onto” trending markets. The common stock universe was the first 45 alphabetical names in the Standard Jz Poors 100 Index with the exception of BankAmerica Corp., for which data was incomplete.

The time period under observation was relatively short: December 17,1991, through close of trading on July 10,1992. This time frame, in spite of its short length, was long enough to generate 80 MTSI buy signals and 230 EMA buy signals.

A buy signal for MTSI (50,16) was triggered when the index changed direction from a negative to a positive value based on computations made

Table 1. INDIVIDUAL STOCK RESULTS

MODIFIED TRUE STRENGTH INDEX SIMPLE EXPONENTIAL

I I I I I EK 21 lj -3.51 I 71 31 -2.1 El3 I 21 II O.Al 91 11 6.0

I

c I 1 81.3 1 80.4’ wx 2 2 21.2 3 2 45.: FIR 2 I -1.2 4 2 i.7

R4E 1 1 A&A 2 2 36.1

I !

w I I II 36.8 3 2 30.7' GE 1 A 11 1.0 9 I 2.0 GM I I Ii 22.4 3 2 33.4 GWF 1 A 11 6.8 V 3 11.3

I I I I I I I HAL I 41 01 -26.11 81 II -12.3

using closing prices. This was done since Blau intended to create an indicator with momentum characteristics, thereby enabling users to define areas of positive (above zero) and negative (below zero) price trends. The assumed purchase price was the closing price on the day that the MTSI changed direction from negative to positive. (Although this closing purchase may be seen as taking advantage of hindsight, the fact that there is a comparative study being undertaken should not impact the study’s results, since the same process is used for the EMA comparison).

A signal to sell was given when the MTSI moved from positive to negative. For the 50 day EMA, buy and sell signals came from similar midline cross- overs between negative and positive values. Trans- actions costs were initially assumed to be zero with no market friction when buying or selling. It is

MTA JOURNAL / WINTER 1992 / 1993 21

Table 2. Summary of Values A. Without Transaction Costs

Nut&a of Trades Number of Wm (XI.O%) wm Parmage

Number of Winning Stocks (n/lh91- 7/10/92)

wtig Percent of stocks (lYl@‘l - 7/10/92)

TtxalPctuntgainAoss Numbu of Smcks

Avaw eaia (los.9 pa sllxk

Avcnee I& ‘Jo=) pa nadc

80 230 41 81

51.25% 35.22%

30 36

66.67% 80X0%

491.00 635.00 45 45

lO.sQ% 14.11%

6.14% 2.76%

The 80 MTSI trades generated were 35% of the 230 EMA trades. It appears that the first advantage of using MTSI is that it generates far fewer trades than a comparative EMA. The second advantage is the win ratio of 51.25% versus 35.22%. In spite of the higher win ratio MTSI lagged behind its comparative 50 day EMA in total percentage points gained and on a per stock basis. The third advantage, revealed upon a closer inspection of the results, is that whipsaws were avoided. So although the higher win percentage of MTSI did not follow through into commensurately higher returns, there was a benefit in using MTSI over EMA to traders who were looking for a higher percent gain per trade.

I?. Including Transactions Costs

Table 2. Including mansaction Costs*

Numba of Stocks Nut&a of Trades Total Percent Gain (loss)

45 45 80 2M

491.0% 635.0%

Tnnunioaw -160.0% -4am% (Tndes x 2%)

Net Pexeot Gain (loss) 331.0% 175.0% Average Gain (loss) pa 7.36% 3.89%

&Sk TSI Enh-t per +3.53%

slwk Avenge Gain (loss) per 4.14% 0.76%

Rade

*Assume 1% tmnsactlon costs upon purchase and again upon sale of a posltlon. All positions are assumed to be liquidated at the end of the observation period.

When transaction costs and trading friction are included, the results vary significantly, as shown in Table 3. Real world trading is such that it is reasonable to assume transaction costs and market friction of 1% on trade entry and again on exit. These costs highlight MTSI as a comparatively better tool. As Table 3 shows, the fact that one-third the number of transactions for MTSI as against the 50 day EMA are made, contributes to lower total market impact. This is a very real advantage in the practical application of any indicator. The Modified True Strength Index shows a superior overall net gain versus a 50 day EMA of 331% to 175%. The MTSI individual stock return of 7.36%, compared to the EMA per stock return of 3.89%, is an improvement of 89% of the EMA return. Finally, on a per trade basis, the 4.14% MTSI return is a 544% improvement on the 0.76% EMA return.

important to note that these results were generated during a period of generally rising stock prices, particularly after December 20, 1991, when the Federal Reserve Board of Governors lowered the discount rate a full percentage point.

Results The individual stock results are presented in

zbble 1. summary results for the portfolio excluding transaction costs are presented in Table 2. A win was defined as a trade having a return greater than 0%, so trades that broke even were not included in this column. Dividends and stock splits were not included. Summary portfolio results, including transaction costs of 1% on trade entry and exit, are presented in Table 3.

-

Observations on Individual Stocks The Modified True Strength Index has a clear

ability to latch onto a price trend and ride it out when compared to a 50 day EMA. Ford and General Dynamics are examples of stocks in Table 1 with stock uptrends where MTSI rode the trend throughout the study period.

Brunswick’s chart in Figure 1 shows what seems to be the more valuable aspect of MTSI over an EMA. The first line (from left to right) is MTSI and the second line is a 16 day EMA of the original MTSI (this exponential smoothing of MTSI was not used in this study). In June, the MTSI kept the long position intact until the last possible moment before turning its single trade during the study period into a closed transaction on June 8, by virtue of crossing from positive to negative territory. By comparison, the EMA (not shown) gave its 8th and final exit

22 MTA JOURNAL / WINTER 1992 ! 1993

Figure 1

MTSI WITH TRAILING MOVING AVERAGE (Right) MTSI WITH TRAILING MOVING AVERAGE (Right)

DAILY PRICE RANGE (Left) SELL LONG POINT IS CIRCLED DAILY PRICE RANGE (Left) SELL LONG POINT IS CIRCLED

Source: Bridge, Inc. Source: Bridge, Inc.

signal on June 3, with only 3 of its 8 signals netting winners, excluding transaction costs.

Dow Chemical in Figure 2 is an excellent example of riding out a trend. Although Table 1 shows that the MTSI return is 9.8%, the EMA return of 21.0% was higher due to the fact that the EMA was able to enter and exit quicker. The divergence indicator value of MTSI is that on this chart the user can see the difficult market period in the MTSI line by its downward slope and choppy behavior. It seems that the smoother the MTSI line is, the more con& dence one has that the price trend will remain neutral to up. If MTSI turned upward again while still above zero, we would expect the upward price trend to continue.

Baxter and Halliburton were two stocks where MTSI had zero winning trades and losses. Baxter’s price behavior (not shown) was that of choppy daily high and low prices which lent themselves better to trading tools of a shorter term, oscillating nature. Halliburton’s price chart also showed a similar, choppy cycle earlier in the period, albeit more of a trading range. Although any user of MTSI or EMAs may have profited in the upmove from mid-April to mid-June, the buy signal (as defined in this study) came late in the move up and the subsequent sell signal came too late to exit at a profit. In both of these stocks, MTSI was exhibiting characteristics of a moving average rather than an oscillator if left to a strict negative and positive crossing discipline.

Conclusion The Modified Strength Index does not appear to

be able to outperform the market in a period of

Figure 2

i’ i

generally rising prices. It, however, shows conser- vative trading characteristics for those looking for risk averse tools. The MTSI results in fewer transactions and better returns per transaction when compared to a 50 day exponential moving average. There is even more of a positive impact for MTSI over this EMA when transaction costs are considered in the return calculations. MTSI can be useful, in the same manner as an EMA, for maintaining a position in trending markets.

MTSI offers the visual ability to observe a trend vis-a-vis the “whole momentum” process that William Blau described, which is reflected in the smooth or choppy behavior of the MTSI line itself, as well as its ascending or descending behavior! In fact, because double exponential smoothing is used, a rachet-like upward or downward movement, or any type of staccato behavior, of the MTSI line will alert the user that the trend of the item being analyzed could be very troublesome to project from a price-only standpoint. In markets that are prone to price movements in fits and starts, MTSI appears to be better than an identical period EMA, since EMA is a single-smoothed tool. But it can be expected that both of these techniques will perform poorly in this situation. MTSI would also not perform well in drift- ing, directionless markets that are characterized by relatively narrow trading ranges.

Based on the stock universe observed in this study, the inclusion of transaction costs and market friction give MTSI an advantage over EMA in every compared category. The number of transactions were reduced by two-thirds because MTSI avoided whipsaws. The average gain per stock increased


89%, while gains per trade improved over fivefold. The results of this study lead to some observa-

tions. Most importantly, anyone using exponential moving averages may want to use MTSI, as there is some evidence of its relative advantages. Also further studies on the second smoothing factor, which was not analyzed in detail, could lead to more profitable advantages. Finally, a casual analysis (not discussed here) shows that using the numerator of the MTSI equation appears to behave remarkably the same as the full MTSI equation, therefore, hinting at further computational advantages. The Modified True Strength Index appears to have exciting components that improve exponential moving average analysis.

FOOTNOTES

1. Blau, William, “True Strength Index”, Technical Analysis of Stocks and Commodities, Vol. 9, No. 11 (November, 1991), 18.

2. Ibid., 24.

3. Blau, William, “Trading With the True Strength Index”, Technical Analysis of Stocks and Commodities, Vol. 10, No. 5 (May, 19921, 64.

4. Personal Interview with William Blau on July 24, 1992.

John Kozty is Vice President of Equities fir Bridge Znfbrmatian Systems in New York City. He is responsible for working with Bridge Trading Company in the promotion of market infbrmation analysis through direct client involvement, seminars and investment industry activities Prior to that, he was an institutional salesman at Oppenheimer & Co. and Merrill Lynch Capital Markets, where he specialized in equity derivatives. His current focus is on supply/demand analysis and technical strategies, including hedging and risk analysis

24 h,f’lA JOURNAL /WINTER 1992 / 1993

The Ten Tasks of Top Trading by Van K. Tharp, Ph.D. and Henry 0. Pruden, Ph.D.

Our purpose at Investment Psychology Consulting is to model or duplicate successful trading. Modeling is a science that developed within the last decade. An expert modeler can determine how people perform a task well and teach that skill to others. We have been developing such a model for trading success.

We are in the process of modeling every type of trading (day trading, floor trading, position trading, fund management). We already have most of the essential elements of all of these types of trading. We are simply refining our models and developing training programs to teach top-level trading performance to others.

The first and most important aspect of modeling is task decomposition to determine the different tasks involved in the behavior you want to model. Unfor- tunately, most traders, even the best ones, don’t know what those tasks are. When you ask them, you get responses like:

l “I don’t really know. I trade when it feels right. It’s mostly gut feel.” l “Well, I get up in the morning, and I do other things until the markets close, and then I turn on my computer and the data comes in via the modem, the computer cranks out an analysis, the orders go out to the brokerage network, and then I do other things. That’s effectively what I do broken down into tasks!’ l ‘The formula for what I do is look for X, Y, and Z. When I see that pattern and the market hits my entry point, I get inl’

These responses only begin to detail the tasks that are involved in trading.

In an interview in Technical Analysis of Stocks and Commodities (April, 1987)’ I mentioned the importance of knowing the different tasks involved in trading. That interview stimulated Dr. Pruden to start thinking about them. He came up with a model which included seven different tasks.* We’ve subse- quently added three more, and now believe the model to be complete and accurate. This model is the starting block for understanding successful trading.

*Dr. Pruden developed the first version ofthis model and has helped greatly in producing the current form of the model.

The Ten Tasks The ten stages in the model are illustrated in

Figure 1. These ten tasks fit the metaphor of a hunter, a predator, or a warrior. For example, in his book, The Art of War, Sun Tzu points out that bat- tles are won before they start? Think about the implications of that statement. In the case of trading, it means that your mental state and preparation virtually determine whether you will win or lose in a given trade before you even open the position. Perhaps that statement is a little strong, but I believe that your mental state and preparation determine whether you will win on the average The statement also points out the importance of the first stage of successful trading, a task called self-analysis.

1. Daily Self-Analysis. Successful trading is 40% risk control and 60% self-control. In turn, the risk control portion is one half money management and one half market analysis? Thus, market analysis is only about 20% of successful trading. Yet most traders emphasize market analysis while avoiding self-control and de-emphasizing risk control. To become successful, traders need to invert their priorities.

Trading involves human performance, and that performance can be objectively measured in terms of profits and losses. You can’t hide from your performance record. Your performance is either profitable, breakeven, or losing. Since ~0’0~ are the most important factor in your performance, doesn’t it make sense to spend time analyzing yourself? The best traders do it subconsciously. You will probably be one step ahead of them if you make a conscious effort to begin each day with self-analysis.

Stressors, or anything that detracts from your performance such as a cold or illness, are going to impact upon your trading. What if your normal performance is breakeven and you have a cold which reduces your performance by lo%? Suddenly, you’re going to start losing money. Even if your typical performance is profitable, if some stressor reduces it by lo%, then you might find yourself at breakeven or losing money. As a result, you are better off stay- ing away from trading until you eliminate the stress


from your life. Yet if you don’t spend some time analyzing yourself prior to trading, then you are likely to trade out of habit. And if you do trade under these circumstances, then you’ll wonder why you suddenly start losing.

DAILY SELF-ANALYSIS

I

DAILY MENTAL REHEARSAL

1

DEVELOPING A LOW-RISK IDEA

1

STALKING

r&is+ A

$E+Eiy

PERIODIC REVIEW

Figure 1 The Ten Tasks of Top Trading@

Numerous people find that their best trades are the hardest trades to take. You generally go against the crowd in the best trades. As a result, when most people believe you are wrong with enough conviction to be in the market, and you’re around a lot of them, it’s very hard to go against them. As a result, people who trade in a crowd perceive their good trades to be “hard trades.” Let’s assume that for you the hard trades are the big winners. How do you know if a trade is hard, or whether you are simply not in the mood to trade? You don’t. Self-analysis allows you to distinguish between the “hard” trade and those times when you make the trade seem hard.

You might do self-analysis in several ways. The

easiest method is to develop a rating scale going from 1 to 8, with 1 being poor and 8 being great. A sample rating scale is illustrated below:

HOW I FEEL TODAY

1 2 3 4 5 6 7 8 POOR GREAT

At the beginning of each day, spend about 30 seconds meditating. Go inside yourself and determine how you are feeling that particular day. Rate yourself on the scale, with 1 being your worst, 8 being your best, and 4 to 5 being average. For a month or so, compare your trading performance with your morning ratings. You will find that trading may not be worthwhile unless your rating is above a particular level. When you discover what that rating level is, make a rule not to trade unless your self- rating is above it.

An even more effective way to conduct self- analysis is by means of a parts analysis. In essence, I find the belief that we are composed of parts, most of which are in your unconscious mind, to be useful. You might think of your parts as your various roles in life, although they are probably more extensive than that. Each part is formed to carry out some positive intention. For example, you might establish a part to protect you or to increase your security, to help you make money, to have fun, to bring love into your life, to bring excitement into your life, etc Since most of these parts are unconscious, you are not aware of them. In fact, you probably don’t pay attention to any of them. As a result, each part simply finds behaviors to fulfill its intention. Those behaviors are not necessarily in your overall best interest, since the behaviors of one part often will conflict with the behaviors of another. For example, if a part wants your attention, it will produce some signal to get that attention. If you ignore the signal that it gives you, it will produce a more dramatic signal. This process continues until it finally gets your attention. Unfortunately, many traders do not respond to these signals until they become very dramatic such as extreme anxiety or a major loss.

People can learn to determine what parts are active and how to communicate with those parts easily. What happens is that once parts know that you are willing to pay attention to them, then they do not have to produce dramatic signals to get your attention. Self-analysis, using the parts model, amounts to a short dialogue with your parts in the morning. It might simply amount to asking yourself, “Does anybody (i.e., any of your parts) need anything?’ while you pay attention to any signals you get. Be sensitive to a range of internal cues. Your parts might communicate by means of a voice, a visual image, or


a feeling of some type. Be open to such signals throughout the day.

When you do this process every morning, it only takes 15 seconds to a minute to complete. Further- more, the parts dialogue method of self-analysis has an advantage over the self-rating method in that if you have a problem, you can deal with it immediately by finding an appropriate way to meet the needs of the part in distress. In contrast, if you just give yourself a poor rating without knowing the source of the problem, then all you can do is not trade.

Self-analysis, when practiced regularly, can make an immense difference in your trading. If you do it, we think you will be amazed at the improvement in your trading results.

2. Daily Mental Rehearsal. One of the most important activities to improving almost any form of human performance is mental rehearsal. Trading is no exception. Remember how important mental rehearsal is for top shooters. The top shooter in the world rehearsed every single shot that might be necessary in a shooting match. The second best shooter believed that rehearsal was important, but he did not rehearse the entire match. Most shooters, in contrast, do not even practice mental rehearsal. Similarly, most traders fail to practice mental rehearsal. How about you?

Top Athletes-from professionals to Olympians- mentally rehearse their performance prior to acting. For example, Billy Casper, one of the best golfers on the PGA Senior Tour, almost never three-putts a green. Casper claims that he learned to putt in almost total darkness and that experience taught him to really concentrate on the internal image of the putt he is attempting to make. Extreme con- centration on his internal mental image is what makes him one of the world’s best putters.

The rehearsal task allows you to pre-plan how you will carry out any of the trading tasks so that the actual task is automatic It allows your to antici- pate problems and develop appropriate solutions to them. And most importantly, mental rehearsal helps you avoid mistakes. Nevertheless, there are appropriate and non-appropriate ways to do the rehearsal.

One of my clients uses a planning log for his next trading day. One entry he showed me went something like this:

Tomorrow will be hell. I will be tempted to trade- probably from both sides of the market and probably several times. In addition, the market is due for a big swing tomorrow and they will try to grab my stops. It’ll be a real test of my mental state control. . .

His plan anticipates problems, but from the wrong framework. He is actually programming himself for a day of “Hell.” Typically, you get what you program yourself to get. Instead, he could have said the following:

Tomorrow will have some interesting challenges. The market may come close to my stops. That is part of the game of trading. I will stick to my rules and practice mental state control throughout the day.

In this second form of mental rehearsal, he is anticipating the same events. However, the events are challenges, not “hell.” More importantly, he is rehearsing carrying out his plan and following his rules, despite potential challenges. As a result, his rehearsal will be very effective.

A client in my Super-Trader Program performs his mental rehearsal by listening to a 60 minute tape each day. He has made tapes covering most of the important tasks in this model. Each tape includes a description of the task and the appropriate mental state, as well as music and poetry to help him achieve the correct mental framework for the task.

3. Developing A Low-Risk Idea. The predator must know the location of his prey, the water holes used by his prey, and the habits of his prey. Once he knows that information, the predator can relax until the prey appear. The next stage in the model, as a result, involves developing a low-risk idea.

I initially called this task “market analysis.” However, one of the best traders in the world told me that market analysis for most traders amounts to building a straw house. They collect data about the markets; they look at different patterns of charts and specific market indicators; and they even make predictions about the future direction of the market and then focus on trying to help those predictions come true. However, they don’t consider the prob- abilities of winning and losing or the amount that might be won or lost. In other words, what most traders do in terms of market analysis has nothing to do with making low-risk trades. Hunters like to build straw houses, but that activity has nothing to do with catching prey. It amounts to spending time and energy on what you think is important, while you avoid the really important issues. Building a straw house has more to do with giving you a false sense of security. Your straw house might indicate where you live and dictate the boundaries of your territory. In that sense, having a straw house is important.

A fundamental principle of modeling is that those elements which are important to a skill will be present in everyone who performs that skill at a top level. In contrast, elements which are present in

1


one person at the top of a skilled area, but not in another, are probably idiosyncracies. Since successful traders analyze the market in different ways, the type of analysis one does is not that important as long as it helps to minimize the risk taken. In addition, since there are countless examples of successful traders training other people in their methodology yet not being able to transfer their success, the methodology per se must not be a critical aspect of that success. What top traders aII do, on the other hand, is develop a low-risk idea. If your market analysis focuses on developing a low-risk idea, then you are performing a useful task in terms of making money as a trader.

Most traders analyze the market in order to predict prices. Predicting prices has little to do with successful trading. What is important is determining when the risk is overwhelmingly in your favor and then controlling that risk (i.e., through the next five tasks in the model). You have already learned that the development of a written game plan for generating low-risk ideas is a critical task in prepar- ing to become a top trader.

There are several subtasks to developing a low- risk idea. The first subtask involves gathering data (i.e., recording the high, low, opening and closing prices; the volume; the advance decline ratio in the stock market; sentiment indicators; etc.). It involves transferring information into your charts, your computer, or your tables. Other subtasks involve creative brainstorming and determining the risk behind those ideas. We are exploring these subtasks in more detail, and we will provide a further update when more information is available.

Most traders gather data and jump to a conclusion at the same time. For example, if you have a bearish bias, then most of your trades will tend to be on the short side-even in a major bull market. When you interpret data you begin to form an opinion which will strongly influence any subsequent operations that you do. Be objective and dispassionate while your are doing the analysis. Complete the entire data gathering phase of market analysis before you brainstorm. Once you have generated a number of ideas, determine the risk behind each idea. Don’t jump to conclusions until the entire sequence is complete.

Avoid the opinions of others while you are developing your low-risk idea. The thoughts of others can easily result in your jumping to a conclusion prior to completing your own analysis. In addition, other people are usually wrong, so you do not want to accept the crowd sentiment. The only exception to this rule is if you know someone who accurately signals market turns by his euphoria about the

market continuing a move. If you know such a person, then consider using that person’s reaction as one of your sentiment indicators.

Document the development of your ideas. This documentation will provide you with valuable information in some of the later tasks that you will need to do, such as your daily debriefing and your periodic review.

Once you have a low-risk idea about how to trade, you must take that idea to the market. Thus, the next task in the model is “stalking” your idea in the market.

4. Stalking. Imagine the following scenario: You have developed an idea that you think has little risk and you want to open a position. You have two choices. You could just jump into the market or you could attempt to find the best possible price by becoming a day-trader. The essence of “stalking” is to find the best possible price for entry. Thus, stalking is another form of risk control.

Think about the predator after its prey. Have you ever watched a young cat chase a bird? It sees the bird and then runs after it. The young cat gives the bird a lot of warning, so it has little chance of catching the bird unless the bird flies right into it. Con- trast the young cat with the mature cat. The mature animal stalks the bird. It waits until the bird gets close enough so that the kill is almost certain. At that moment it pounces. The mature cat will expend little energy unless it knows that there is a good chance of success.

Top traders love the hunting metaphor to describe what they do. One of them, for example, claims he is like a cheetah. The cheetah can outrun any animal, but it still stalks its prey. It won’t attack until it is right on top of its prey. In addition, the cheetah usually waits for a weak or lame animal to get close. Another top trader told me that he trades like a lion. He watches the herd for weeks until something other than his presence causes the herd to panic. When the herd panics, he then chases a weak or lame animal that appears most confused. The difference between an average hunter and a really skilled animal like the swift cheetah or the cunning lion is that the skilled hunter waits until the odds are overwhelmingly in his favor.

Stalking means making sure the odds are even more in your favor by paying attention to the smallest time frame possible for you. This means that you must narrow your focus to find the best possible entry price in the day (e.g., by selling an intraday rally or buying on an intraday decline). Steidlmayer’s Market Profile@ was designed for this purpose, but other technical signals3 will give you the same information.

28 MTA JOURNAL ! WINTER 1992 / 1993

Stalking is difficult for most people because it a time for prompt, courageous action. requires a mental state that is totally different from Similarly, the action stage needs to be very accu- the mental state required in the next task, the action rate. Both you and your prey are moving rapidly. If phase of trading. The mental state for stalking your you are not extremely accurate, then you are likely idea involves a broad focus, a slowly moving time to miss. You may even get hurt. Accuracy should not frame, and a strong intensity. These qualities are a be a problem, however, if it is carefully practiced and distinct contrast to the mental characteristics that rehearsed in advance. For example, write down your most people have when they have developed a low- order ahead of time. Read it to your broker in a clear risk idea about the market. Most traders, after firm voice. Have your broker read it back to you after analyzing the market, are energized and ready to you finish and at the time of confirmation. act. By doing so, they don’t miss an opportunity, but The contrast between the requirements for the they also increase their risk because they are “stalking” task and the “action” task is so dramatic rehearsing action rather than responding to actual that many traders cannot make the abrupt shift. market conditions. They are either energized and prepared to act or they

When you are “stalking,” you need to get into are cautious and wary of any action. As a result, they the flow of the market. Become sensitive to a range either take the trade immediately and increase the of cues! The market is sending you numerous signals risk of the situation, or they concentrate on getting if you pay attention to them. Learn how to read and the best possible trade and end up getting nothing. interpret those cues. One of my clients, a long time 6. Monitoring. Once a trader has a position in frame trader who only puts on occasional trades the market, he must monitor that position. In a begins the stalking task by paper trading a position sense, the hunting metaphor breaks down for in the opposite direction of the one he is planning. monitoring. Imagine a tiger attacking a buffalo. This helps him develop “finger-tip” feeling for the Monitoring would occur at the split second the tiger market. At the same time, he knows that the best lands on the back of the buffalo. He must instan- time to get out of his paper trade is also the best time taneously decide to either make the kill or to abort to open his planned position. because the buffalo is bigger and stronger than he

5. Action. The action stage only takes an instant. is. Fortunately, traders have a longer time frame to But to perform it correctly, you must be aggressive, make the same decision about the market. bold, and courageous. You just do it. The trader must The nature of the monitoring task depends upon have quickness, accuracy, and a narrow focus of the trader’s time frame for keeping his position. For attention-concentrating on getting the trade off a top day-trader, the stages of stalking, monitoring, accurately and quickly. He must be quick or he will taking profits, and aborting are somewhat circular. miss the opportunity. And he must be accurate, or Day-traders may take several positions each day and he might find himself with something other than may do all these tasks together. The constant need his prey. to shift mental states between tasks is one reason

The action phase of trading must be strong and that so many people lose money day-trading. intense. A weak response will not get the job done, A top position trader, in contrast, will wait for because it lacks the necessary commitment. Imagine exceptional opportunities and then allow them to what would happen if a lion or tiger fails to go all- unfold. As a result, the monitoring process is more out when it attacks its prey. The answer is obvious. relaxed for the position trader. Nevertheless, com- It would go hungry. placency can destroy even the longest term trader.

Action involves commitment to entering a Monitoring may consist of two subtasks, espe- market position. If the trader has completed the first cially for the longer-time-frame trader. The first three tasks, then he knows the consequences of this subtask, detailed monitoring, is similar to stalk- commitment. He knows he is ready. He knows the ing. It involves paying detailed attention to the pulse maximum loss he is willing to tolerate and the of the market while getting ready to take action by potential profit. He knows that the risk is over- adding to your position, by aborting, or by taking whelmingly in his favor, and as a result, the com- profits. On the other hand, when the market is mitment is easy to make. moving comfortably in your favor on a long-term

When action is appropriate, reflection, second time frame, the trader can step back from the market guessing, and delays are inappropriate. You should into more of an “overview” position. Thus, the second have reflected on the consequences of your trade in subtask might be called overview monitoring. the tasks prior to the action stage. When a trader Detailed Monitoring. Detailed monitoring thinks about consequences at the time of action, he begins as soon as one opens a position. If you correctly cannot act with abandonment. The action stage is stalked your position, then the market should move


in your favor soon after you open it. If it does not, then you probably do not belong in that position. As a result, a trader needs to pay close attention to the fine details of the market. He should be alert, vigilant, and suspicious.

I frequently recommend that my longer-time- frame clients rate their position three times a day for the first three days according to “how easy it feels.” A typical scale might look like the one illustrated below:

Easy Neutral Hard

ttttttt

“How Easy Does It Feel” Scale

Use a scale similar to this one at the beginning, middle, and end of each of the first three trading days. If the position does not feel “easy” by the end of the three day period, then it probably is a bad trade for you to be holding. On the other hand, if it is easy to hold, then you can probably switch to “overview monitoring.” If you trade around other traders and are influenced by their opinions, then a good trade might feel “hard” because you are holding it against the crowd. If this is the case, then reverse the rules given above.

Switch back to detailed monitoring only when action of some sort might soon be necessary or for a periodic check of our position. You might, depend- ing on your time frame for the trade, switch back to detailed monitoring once each day or once every three days.

Overview Monitoring. During overview monitoring, the trader broadens his focus and steps back from the market. He is looking at the forest instead of the detail of the trees. When a trader is in the overview phase of monitoring, he is more detached and objective. He is more patient and calm. His focus is much broader and his time frame is slower.

The worst mistake that one can make during the monitoring phase is to rationalize and distort data according to expectations. The purpose of monitoring the market is to pay attention to market signals. The trader who interprets signals according to his expectations is not performing this task adequately.

During overview monitoring, the trader is simply surveying the conditions. He is comparing market events as they unfold with his plan and his knowledge of what various market events mean. If everything is going according to his plan, then monitoring can remain a detached and relaxed process. Some traders give away big profits simply

taking a dollar profit. On the other hand, if events do not unfold according to plan, then the trader needs to focus on the details of the trade (i.e. switch to detailed monitoring).

The monitoring stage is a form of risk control. If a trade is good, then it should be easy to hold because it is moving in one’s favor. When the market moves in support of your position, the trader can change his stop level to decrease his risk or even lock in a profit. On the other hand, if nothing happens, if the market behaves unexpectedly, or if the trader is uncertain, then he should get out or, at minimum, reduce his exposure to a loss by reducing the size of his position.

7. Abort. The two stages which occur after monitoring are action-like stages much like the task of opening the position. These stages are “abort” or “take profits.” One could argue that these stages involve “searching for the right opportunity to act” and “acting.” On the other hand, since many traders search for the right opportunity during the detailed monitoring phase, we simply call these “action” stages.

Developing a low-risk idea and marketing your idea allows you to plan risk control. Planning your risk is not nearly as important as executing your trades in a manner in which you can actually control your risk. In executing trades, the golden rule of trading, “Cut your losses short and let your profits run,” comes into play. Controlling risk involves aborting and taking profits under the appropriate conditions.

Most successful traders have one or more of the following three beliefs about aborting a position:

0) If the market is going against you, then that is the most critical time to get out. You can’t afford to lose big. Some traders enter a position with a stop and get out when the stop is hit. However, other traders expect the market to go in their favor as soon as they open the position. If it does not, then they get out. The issue of when to get out depends upon the maximum amount of loss you are willing to tolerate. However, if your best trades immediately go in your direction, then when you open a position and the market starts going against you, don’t wait for your stop to be hit. If it’s going against you, then it’s not the trade for you. Get out! Limit your risk.

(2) When the original reason for a trade no longer exists, get out of the market. And when you are uncertain, get out.

One of my clients, for example, had a problem with uncertainty. He said “I don’t know what to do when

because they are unable to relax when the markets uncertainty comes up. You haven’t described uncer- move in their favor. You don’t get rich, as a rule, tainty in your books and I don’t know how to handle it.”


-

I responded, “What percentage of your trades make money?’

“About 40%‘: he said.

Then I asked, “When you’re uncertain, what percentage of those trades make money?” He couldn’t remember ever making money when he was uncertain, so I said, “If you’re uncertain, just get out.” Rather than trying to control your uncertainty, treat it as a valuable signal about what you should do.

(3) When time is against you, you probably should be in a better position, so get out. Many of the people reading this are speculators, as opposed to floor traders or commercial traders. Your primary advantage to trading is that at any particular time you don’t have to be in the market. Use that advantage! Enter and stay in a position only when it is fully advantageous for you to do so.

Aborting involves a quick, accurate, and very focused mental state. Once you determine, through the monitoring process that it is appropriate to get out of the market, then you must immediately shift mental states to abort properly. If the predator decides that the prey he’s selected is inappropriate (i.e., it’s too big and strong for him), then he retreats quickly. A quick retreat allows him to survive to hunt again another day.

A quarterback can sense if the play is going to work out as soon as he gets the ball. If he senses that he is in a “busted” play, then he needs to do whatever is necessary to keep from losing ground. He may throw the ball out of bounds just to make sure that he doesn’t lose yardage. What’s important for him is to have the best possible position when the next opportunity comes. He doesn’t want to lose ground.

If you have trouble aborting a position, then look at “pro” and “con” scenarios together. Allow the evidence against your position to unfold and then allow the evidence for your position to unfold and compare the two pictures together in your mind. If the evidence is against your position, them simply call it a bad trade and get out.

8. Take Profits. Many traders claim that their game plan emphasizes trade entry but not trade exit. As a result, they argue that they do not make enought profit on each trade. If you have not thought about trade exit prior to opening a position, then you have a problem with your game plan because you have not adequately calculated the risk involved in the position. If you’ve calculated risk properly, then you should know two elements ahead of time: 1) your changes of being right on that trade and; 2) the size of your potential profit versus your potential loss. If you don’t have that information (at least generally),

then you still need to work on your game plan. A properly-designed low-risk game plan will give

you optimum profits within your comfort level for trading. Thus, the task of maximizing your profits should simply be one of following your plan. For example, if you have a plan that gives you a 50% return each year and you maintain that record year after year, compounding your profits, then you will be one of the best traders in the world. Some of my clients have designed plans that give them three digit rates of returns each year. As a result, all it takes for any of them to become one of the best is to avoid self-sabotage by becoming too greedy or too fearful. If you concentrate on anything other than maintaining consistency, then I believe your concen- tration is misplaced.

Top traders have four primary beliefs about taking profits. Taking profits is equivalent to the predator’s kill. When the predator acts, he must be quick and decisive. Thus, the first belief is that if market conditions change so that your reason for your trade no longer applies, then take your profits. Avoid being greedy. Just react to the signals provided by the market.

A second belief about taking profits is to do so when the market reaches your objective. Be patient and allow the market to move toward the target. If you set your targets at extreme levels, then you probably don’t give up much by taking your profits at those levels. In most cases, market conditions will probably change before your target is reached, so you can get out simply by acting when those occur. If the market hits your target, however, I recommend that you take profits by continuing to move your stop closer to the market price as the target is reached. Wait for the market to take you out. If the market keeps moving rapidly in favor of your position, then you have no reason to take profits.

A third belief about taking profits is that one should do so if market volatility changes dramatically, thus altering the risk parameters of the trade. Volatility typically increases when a market becomes popular and mass hysteria exists. Although a lot of profit potential may exist in that market, the risk is much greater compared to the potential profit. As a result, increasing volatility after you’re in the market might be a good reason to take profits.

Bear market moves are often climatic, and that climatic portion of the move may go past your target area. However, if you wait for the climatic portion of the move to end, you might get whipsawed in the opposite direction as soon as the move ends. As a result, the fourth belief is that when such a move occurs, you should take profits immediately.

9. Daily Debriefing. The ninth task in the


model is a daily debriefing. Most good traders do it, either formally or informally. I think a daily debriefing is essential for consistent, top performance. It provides an important transition period between trading and being out of the market.

The idea behind the daily debriefing is to deterine whether or not you made a mistake during the day. A mistake, however, has nothing to do with losses. A trading mistake means not following one’s trading rules and one’s plan of action. In fact, traders should pay special attention to mistakes made while making money. Just because a predator chases its prey through an area filled with quicksand or tar without setting stuck, doesn’t mean that it is safe to do so again. The LaBrea Tar Pits in Los Angeles contain the bones of many more predators than prey, because numerous predators made the mistake of going after the other animals caught in the tar.

Look at your written trading rules and the written notes you made when you were developing your low-risk idea. What can you do if you made a mistake by not following your rules?

l First, avoid self-recrimination-telling yourself that you “should have” done this or you “could have” done that. Instead, resolve not to repeat that mistake again.

l Second, replay the trade in your mind. Prior to making that mistake, you reached a choice point. At that choice point, you had a number of options available to you.

l Third, mentally go back in time to that choice point and review your options.

l Fourth, for each possible option, determine what the outcome would be if you had taken it. Be sure that you give yourself at least three good choices and mentally rehearse them. Some generals are known for fighting the strategies of the last war. Those who do usually lose the battle. Always give yourself as many choices as possible, so that you don’t get stuck with limited options or a forced choice.

l Fifth, once you’ve found a least three options with favorable outcomes, mentally rehearse carrying them out in the future when you encounter similar situations. Once you’ve practiced them in your mind, you will find that selecting one of them is easy when you encounter a similar situation in the future.

When you do follow your rules, pat yourself on the back at the end of your debriefing. If you followed your rules and lost money, then pat yourself on the back twice. You may have lost money this time, but in the long run following your rules will make you money. Mistakes, on the other hand, will not result in long term, consistent profits.

Once you have analyzed your day’s trading, sum- marize it in writing. Write down your mistakes and your new choices for that situation. This written information will be very important when you begin the next task of doing a periodic review of yourself and your game plan for trading.

The daily debriefing shouldn’t take more than 5 or 10 minutes, so do it every day. It is one of the most important tasks of the ten part model. Get through it. Then put the trading day behind you, because tomorrow is a new trading day.

10. Periodic Review. The tenth task in the model is a periodic review of what you’re doing. Markets change and you change. As a result, you need to be sure that your rules are still appropriate for both you and the markets. In addition, once you develop a sound business plan, I don’t recommend that you change your rules on the spur of the moment or without a thorough review. The day you do your periodic review is the time for rule changes. It’s also a time to be away from the market. You cannot objectively review yourself and your rules while you are actively involved in the markets.

How often you need a periodic review depends upon your time frame for trading. If you make several trades (or more) each day, then you need to review your rules every three to four weeks. If you trade three or four times each week, then a periodic review is necessary every three to four months. If you trade several times each month, then a semian- nual review is appropriate. Finally, if you trade less than once a month, then an annual review is probably sufficient.

When you do your periodic review, first go through your written debriefing statements. Once that information is fresh in your mind, go through your entire business plan step by step. You need to review your trading diary and determine your strengths and weaknesses. Give yourself a whole day to do a periodic review. It is an important part of maintaining consistency.

The Task of Being Out of the Market I have saved the most important part of the

model until last-taking care of yourself when you are out of the market.

TOP TRADERS WHO LAST LEAD WELL BALANCED LIVES

To understand the importance of how you live your life when you are “out of the market,” consider the parts model discussed earlier in the self-analysis section. You’ve created a number of parts with various needs. All of your parts have good intentions. If you do not take care of your needs when you are


Attitudes to Become a More Successfir Investor

Investment Psychology Guide No. 4: How to Develop Discipline to Become a More Successfil Investor

Investment Psychology Guide No. 5: How to Make Sound Decisions to Become a More Successful Investor

Van K. Tharp, Ph.D., Znvestment Psychology Consulting, is a research psychologist specializing in the psychology of trading.

Dr. Pruden is a speculator and an educator. He is a member of the MTA and the TSAA of San Francisco. Dr Pruden frequently teaches classes on technical analysis at Golden Gate University in San Francisco, California.

The Ten Tasks of Top Trading 0 Investment Psychology Consulting


away from the market, then your parts will act to fulfill those needs while you are in the market. If you don’t play or add excitement to your out-of-the- market life, for example, and part of you desires those aspects of life, then you’re going to get those needs met while you’re in the market. Getting those needs met while you are in the market will not make you money in the long run. I guarantee it. As a result, you must deal with the needs of your parts while you’re out of the market.

You might argue that “out of the market” is not a trading task. Yet it is the most important task for trading success. If you ignore important aspects of your life when you are out of the market, you will have trouble ignoring those aspects while you are in the market.

Many people want to be in the market to avoid personal issues. You cannot escape personal problems by trading in the market. What happens, unfortunately, is that the market magnifies those problems. A compulsive gambler is probably the best example of how failure to deal with personal issues can result in market disasters.

One of my clients called me, saying that he couldn’t follow my suggestions. He couldn’t bring himself to trade most of the time. When he did trade, he did the opposite of what he really wanted to do. He also told me that the material didn’t seem to help him in solving his personal problems. In addition, during our conversation he also told me that he only had $5,000 with which to trade commodities and he had been trading for over nine years with no nest egg and never more than $5,000 in his trading account. I recommended that he immediately sus- pend trading and seek help in solving his personal problems which I believed to be serious. Traders with serious personal problems cannot trade successfully because they will bring those personal problems to the market. I also recommended that once he had solved those problems that he continue to stay away from the market until he had enough capital to trade with-in his case, about $50,000. Once he had solved his personal problems and raised enough money to trade effectively, he had a chance to become a good trader. Although my advice would have saved him thousands of dollars and would have given him the opportunity to become a successful trader, I doubt if he took me seriously.

Consistent, top traders keep their lives in balance and that makes trading fun. In addition, they also seem to realize their overall purpose in life. Predators are helpful to the whole system. They weed out the weak members of their prey and in doing so strengthen the herd. As a result, they serve a very useful purpose. Similarly, strong traders serve

as predators for weaker traders and weed them out of the market. As a result, they strengthen the markets by their presence. As long as you keep that perspective in mind, then you can continue to have success. Traders who have a lot of initial success tend to lose that perspective. They suddenly believe they are bigger than the markets. As a result, the market teaches them humility by wiping out most, if not all, of their capital.

Many traders will take a lot of money at some time in their trading lives and then give it back. Why? Because they don’t keep the overall ecology of the system in mind. They use the markets to prove something to themselves that has nothing to do with trading. What happens to them? They ignore their overall purpose. They increase their trading dramatically or, if they are big enough, they try to corner the market (as the Hunts tried to do with silver) and fail miserably. As a result, they lose everything and are forced out of the market.

Being out of the market means BEING OUT of the market. It’s important to exercise, take a vacation, and even take a break during the day. And when you do those things, do not take the market with you. When you start worrying about trades that you might have missed and a thousand other possi- bilities, you are like a puppet on a string and the market is pulling your strings. If you take the market with you, then those parts of you that wanted the vacation or the break will disrupt your performance during those times in which you need to give your full attention to the market. Remember:

You don’t have to catch every move! There is always another opportunity!

REFERENCES

1. John Sweeney, “Interview with Van K. Tharp, Ph.D.: Trader’s Psychologist,” Technical Analysis of Stocks and Commodities. Technical Analysis, Inc. (Seattle, WA), April 1983, pp.7-14.

2. Sun Tzu, The Art of War, Edited and with a foreword by James Clavell. Dell Publishing, 1983.

3. J. Peter Steidlmayer, Steidlmayer on Markets, New York: John Wiley and Sons, 1989.

BIBLIOGRAPHY

Dr. Van Tharp’s Five-Volume, Four Tape Course in the Psychology of Investing (published by Investment Psychology Consulting):

Investment Psychology Guide No. 1: How to Use Risk to Become a More Successfir Investor The material for this “Ten Tasks of Top Trading” article were largely adapted from this text.

Investment Psychology Guide No. 2: How to Control Stress to Become a More Successful Investor

Investment Psychology Guide No. 3: How to Control Losing


NOTES


journal of technical analysis (jota). issue 40 (1992, winter)

Economy & Finance

mta journal winter

mta members

mta library

single issue of mta

mt4 journal

floor new york

monthly mta newsletter

financial technical