• What is your edge in the market? How do you know?
• How stable/strong is your edge?
• What do you need to work on to improve your performance?
• What do you do best?
• What can you do better?

Thinking a bit deeper about these questions: What is your edge in the market? How do you know? If you are going to be successful trading, you absolutely must have an edge in the market. Money management is not an edge. Psychology is not an edge. An edge is something that lets you pull profits out of an extremely competitive market environment, that gives you some edge over the randomness that dominates price movements. How do you know what your edge is? If you can’t answer these questions, you don’t have any business putting risk on in the markets. You do not have an edge because you bought a book or took a training course, no matter how much money you paid or who taught you. You must have sufficient math skills to understand probability and randomness and truly understand your edge in the market.

How stable/strong is your edge? There are very, very few persistent edges in the market. Most come and go, and may not be reliable in the future. How is your edge on this scale? Again, how do you know?

What do you need to work on? Most people tend to focus on what they do best, and to avoid focusing on their weaknesses. This makes sense in some cases, and it certainly is easier psychologically. However, from a performance perspective, and especially for someone developing skills, finding and working on your weaknesses is often the key to the fastest progress. If you are a beginner, you may be doing many things wrong, but a good mentor or coach can point you to the most pressing issues you should address first. Commit to finding your weaknesses and improving them, and watch your overall performance grow by leaps and bounds.

What do you do best? Yes, I think the majority of your time should be spent on addresses your weaknesses, but don’t neglect your strengths. Chances are, there are a few things you do really well. Know what those are, protect those strengths, and work to improve them. For beginners, it probably makes sense to focus most of your attention on strengthening weaknesses and improving faults. For more experienced practitioners, the path to improvement is often marked by your strengths. Find them, nurture them, and watch your performance grow.

What can you do better? No matter who you are, how good of a trader you are, or how good your year was, there’s always something you can improve. Make a concrete list of the three top things you want to work on, and focus on those early next year. This is not a vague “New Year’s resolution”—it is a concrete action plan for growing as a trader.
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It is critical that traders understand the subtleties of every tool they use. They should know how they react in every possible market environment, and furthermore, must understand the complex interactions between multiple tools. This may lead to an approach that disregards a lot of information that many traders assume to be useful, but, for instance, why would you use indicators that do not add to your analysis? Why would you listen to news that is old news and is already fully priced into the market? Why would you try to guess how complex fundamental factors might influence the price if you do not have the skills to fully understand those fundamentals? Why would you solicit opinions from traders who may trade with completely different styles and may be less competent and knowledgeable than you are? Traders do all of these things, but most of them do not make sense. Limit your scope to tools that truly add value.

I am setting the stage for a number posts that will expand on this idea. I’ll show you examples (like the Santa Claus post), and give you tools and techniques you can use to understand what’s happening in the market. We’ll also look at a number of very commonly used tools that show no quantifiable edge (maybe we’ll start with moving averages or Fibonacci retracements), and we will find some things that do.
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Sometimes, important technical patterns are easy to miss. A small bar near the extreme of a recent thrust (near the extreme means near the low of a downthrust or the high of an upthrust) can often function as a small consolidation. It is possible to initiate shorts on a breakdown out of this pattern, but such a move may take 2-3 days to develop. I have written about this potential short in Gold extensively, both in my research for Waverly Advisors and in a few notes on this blog. This is an example of a very small, tight consolidation that can provide a favorable entry into a move that is already underway. (Of course, consider the possibilities for pattern failure and plan accordingly.)

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A few lessons and thoughts as a followup to yesterday’s post on APPL:

• Everyone in the world was talking about AAPL the day after the large decline about two weeks ago. Bloggers and media commentators were busy trying to be right and to explain why their view on Apple was correct. Daytraders were patting themselves on the back for catching some of the bounce. By comparison, no one was watching Apple yesterday when the “easy” trade set up.
• The best technical trades set up when no one is watching.
• Beware groupthink. Social media promotes groupthink.
• You have to understand the patterns and watch the market. The correct entry was on the close of the day of the failure test. If you waited, today gapped up and didn’t really look back. Knowing your patterns and probabilities gives you the confidence to trade an unpopular opinion.
• This is an example of a trade that worked easily. At this point, your stop should be a little bit below your entry. Yes, there is still gap risk, but actively tightening the stop is an important part of trade management. (Of course, you can overdo it and tighten too aggressively. Make sure you are responding to fluxing probabilities, not to your fear and emotions.)
• Maintain the discipline of taking partial profits at 1X your initial risk. Depending on where your entry and stop were, this level may have been hit, but is certainly very close.

I investigate these issues and show many examples of this pattern in The Art & Science of Technical Analysis.

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One of my most reliable patterns has been the simple failure test, which you will also hear called a bear trap, or a 2B entry. This is also one of the simplest patterns to illustrate, and so was the first trading pattern I chose to cover in The Art & Science of Technical Analysis. In this trade, we see a market make a probe beyond (below for support, and above for resistance) an important level, and then quickly reverse. Conceptually, it is not wrong to think that the market has simply run the stops, but found no conviction beyond the level.

Some things to think about here: there are risks. The correct entry is to go home long AAPL on the close, with a stop somewhere around yesterday’s low, but there is always the risk of a gap down opening that doesn’t look back. Under this scenario, your loss can be several times your anticipated risk, so I often suggest trading this pattern on smaller risk than your other trades. Note also that you should consider expectations from this pattern. This is not a pattern that, alone, is likely to set off a major inflection (though it can mark one if supported by other factors.) In this case, the preponderance of evidence points down, so perhaps use a signal like this to initiate a nimble countertrend play for the short-term, or to take partial profits on existing short positions.

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The challenges of becoming a trader are similar in many ways to those faced by doctors, lawyers, or engineers in that a period of education is followed by a grueling period of apprenticeship and on-the-job training. Many people give up and fail at some point in the process and move to other careers, but some make it through and become competent. Fewer still achieve real mastery and rise to the top of their profession—the elite in any discipline are rare.

In the interest of moderating expectations, it might be useful to lay out a rough road map of the typical path of trader development:

• Pretrader. Everything is new at this stage, and everything is difficult. This is the point where the trader is learning the very basics of charting and of market structure and is also just starting to explore the marketplace.
• Novice trader. At this stage, traders are not trading to make money; they are trading for experience and to begin to deal with the emotional challenges of trading. One of the main signs of progress in this stage is that the trader will start lose money more slowly than before—still losing, but losing less often and less consistently.
• Early competent trader. The first step toward making money is to stop losing money. A trader whose wins and losses balance out (before commissions) has taken the first steps to competence. (At this stage, the trader is still losing money due to transaction costs and other fees.)
• Competent trader. The first stage of real competence is achieved when the trader is able to cover transaction costs with trading profits. Reaching this stage may take a year and a half to two years, or more. Consider this carefully—two years into the journey a realistic expectation is to finally have accomplished the goal of being able to pay for your transaction costs. This may not seem like much, but very few individual traders ever survive to this stage.
• Proficient trader. Here the trader starts making money. Errors and mistakes are far less frequent, but, when they do happen, they are corrected and reviewed, and the lessons are quickly assimilated. The trader has been exposed to the stressors of trading so many times that they have now lost most of their emotional charge and is able to approach the markets in an open, receptive state. As competence grows, the trader can look to manage more money; developing the skills of trading larger size and risk becomes a focus.
• Experienced trader. It is difficult to imagine a trader becoming a true veteran without living through a complete bull/bear market cycle—about a decade in most cases. This trader has finally seen it all and has also become cognizant of the unknown and unknowable risks that accompany all market activity. It is possible for developing traders to gain much of this veteran trader’s knowledge through study at earlier stages of development, but there is no substitute for experience and seeing events unfold in the market in real time.

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Crude Oil is consolidating lower following the break of the trendline. This pattern is perhaps more clear on the weekly chart, but it appears to be a small daily consolidation pointing lower. I used the term “nested pullback” in The Art & Science of Technical Analysis to refer to this pattern: a small, lower timeframe consolidation that occurs within the resolution of a directional, higher timeframe pattern. These trades can offer exceptional reward/risk characteristics with strong probability of a profitable resolution.

(Note that USO can be used to execute this trade, rather than futures, but be mindful of overnight gap risk.)

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To run this test, I used about 90 years of the Dow Jones Industrial Average because of the long data history. It is a reasonably good, but not great, proxy for the broad market—good enough for this purpose. I first took daily closes, then converted them to percent returns. Since daily returns tend to be small, I went one more step and converted them to basis points, just because it is easier to deal with a number like 2 than .0002. (A basis point is one one hundredth of a percent, so 1% = 100 bp, 0.1% = 10bp, etc.) Let’s work first of all with recent data. Here are some summary stats for all daily returns:

Be sure we understand what this table is telling us: There have been 3,019 trading days with an average daily return of 1 basis point (=.01%). The worst day was -7.87%, and the best day saw the market go up a little over 11% on that day. The important thing here is to understand the thought process: we need to know what “all” days look like as a control group, so we can contrast them with the days that have the specific condition we are interested in. In this case, let’s compare them to trading days in December, since that’s when Santa comes.

Now, this is getting interesting. December shows an average return almost seven times the average of all days in the year. Another thing to notice is that the standard deviation, which is a measure of how widely spread out values are, is smaller (though let’s not focus on the standard deviation for this post.) Not only are the daily returns larger, but we seem to know where they will be with more certainty (if this dataset shows tendencies that continue into the future.) Conventional wisdom (and seasonal analysis) tells us that volatility tends to contract into the end of the year; this table seems to support that. Let’s dig just a bit deeper, and look at what happens if we break out the last two weeks and the last week of the year separately.

Maybe we are a little bit less impressed here, but the effect does appear to hold. (Also not shown in this table is the closing print for the year has been higher than the open of the previous 4 weeks 75% of the time.) So, yes, Virginia, there is a Santa Claus rally, but wait… we are not done yet. Take a look at the following table, which reproduces this table in roughly 2 decade segments.

Now we start to see a clear pattern, and the truth is ugly for the Santa Claus rally. Each segment shows a weaker and weaker effect—the last week of the year, which since 2000 has yielded an average daily return of 0.05%, gave a 0.25% return in 1940-1959, and a whopping 0.4% (per day) in 1922-1939. By comparison, today’s effect is anemic. Probably the best way to put this is, “Yes, Virginia, there has been a Santa Claus, and if you were a good investor he probably brought you money. He probably even did this for decades and decades, but he seems to be getting tired, and I’m not sure we can count on him showing up next year, or the year after that. If we hang our hopes on Santa Claus in the market, it seems like we might be frustrated. There must be a better way.”
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The Art & Science of Technical Analysis

Why sell a book?

This is a good question, and there are a few answers. First, I like to teach. I always have, and I think I am pretty good at it, especially when it comes to high level skills like chess, music, or trading. I have been teaching all my life (even when I was spending 14 hours a day, 6 days a week in a professional kitchen, I often taught a cooking class on my off day), and the book is a logical extension of that desire to teach.

Second, the discipline of writing the book was good for me. I wrote the first draft in about a month and a half, but the long work outlining and planning forced me to codify and to clearly define my trading. I found that there were things I had been doing for years that could be cleaned up a bit. Also, I was coming out of a period of trading where I was trying a style and a timeframe where I had no edge. I wrote the book at the same time I returned to the style of trading I had done for many years. My trading results were outstanding, and writing the book was somewhat cathartic. Writing the book made me a better trader.

Third, there really was an altruistic component to my motivation. My friend Mike Bellafiore told me that I should only write a book that would be a gift to the trading community, that no other reason for writing a book could really make it worthwhile. He was absolutely right. I want the book to sell well because I want this information to be in every developing trader’s hands. No one writes a trading book to get rich—even at a very high level of sales if you think of the project on a per hour basis, you’re not even making minimum wage. That’s not why I want everyone to read the book. I have seen so much garbage sold to struggling traders under the umbrella of education for many years, and so little material that really focuses on helping that trader find her edge. I wrote this book to, hopefully, correct some of those errors and to give people information that could have saved me a lot of time, money, and anguish along the way.

You might logically ask if I think selling a book will degrade my edge in the amrket, and the answer is I can’t imagine that it could. First of all, what I do has a large discretionary component. Two traders are going to make slightly different decisions given the same set of data, and that is ok. Second, there was a tremendous amount of quantitative work cut from the book (the original was over twice as long as the final version), and most of that was research supporting the trading styles and patterns that I used in the book. I know this stuff has a statistical edge because I have researched it on every timeframe, every asset class, and they hold up even on very old, historical data. (Equities in the 1700-1800′s, commodities in the Middle Ages, etc.) As long as people continue to make decisions on response to risk and opportunity in the financial markets, the big picture market moves will be the same. As long as the trader stays out of the noise, minimizes transaction costs, and avoids mistakes, it is hard to imagine anything significantly degrading the edge in this style of trading.

So, if you haven’t already, please check out The Art & Science of Technical Analysis. You can see several of the chapters in full text on Amazon, and make a decision about whether it might add something to your trading. I also want to take a moment to thank all of my readers who have left reviews. If you’ve read the book and found it useful, and if you’d be inclined to leave a review on Amazon, I would certainly appreciate it. The reality of the publishing business today is that those reviews are important and influential. Your feedback can be very helpful to me, and to other potential readers. As always, if you have questions, keep ‘em coming.

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Too many times, when people talk about “trading patterns” they are focusing on entry patterns. Yes, it is important to have patterns that show a positive expectancy, but the decisions made after trade entry, what we call trade management, probably contribute more to profitability than entry location. Some of the most important questions concern stop location. (Stop, in this sense, does not refer to an order actually placed in the market. It can simply be a price level at which you decide it is time to exit all or part of the trade.)

I entered a long position in the USDJPY (short Yen) quite some time ago against a stop around 81.00, looking for a quick upside breakout. When the upside breakout did not develop, it became apparent that the market was holding a broad consolidation pattern, and that there was the possibility of a complex consolidation, so I did not tighten the stop significantly. However (and this is the key) yesterday’s action was a sharp upside breakout above previous resistance. Now the stop can be tightened significantly. Extremely aggressive traders will want to put it somewhere in yesterday’s range, while a more conservative approach sees it a bit under yesterday’s low. In all cases, the operative idea is that this breakout should continue higher with minimal back and fill. No sense taking a large loss on a trade once it starts working like this—tighten that stop and devote your precious mental capital to other issues.

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