March 2006 ISSUE

2 Editor’s Note 28 Active Trader Interview

Nassim Nicholas Taleb: Profiting from market
3 Contributors uncertainty
4 Trader’s Bookshelf Author of Fooled by Randomness shares his unique views on
The latest trading and investing books. luck and the markets.
Inside the Market: By Jeff Ponczak By David Bukey
5 New York enters historic era 33 Trading System Lab: Double dipper
With its deal with Archipelago finalized, the New York Stock
Exchange could look quite different in the upcoming months.
Futures Watch: By Jeff Ponczak
36 NYMEX may have new partner
7 Fidelity upgrades Wealth-Lab Weeks after signing a deal with General Atlantic, the New
Fidelity’s latest improvement to its strategy testing product York Mercantile Exchange may instead hook up with the
incorporates fundamental data. Chicago Mercantile Exchange.
7 SEC rule comes under scrutiny By Jim Kharouf
A hedge-fund manager is taking the SEC to court over the 36 Futures volume shows no signs of slowing
new hedge-fund rule. It was another huge volume year for futures exchanges, both
8 Another currency firm leaves Refco in the U.S. and Europe.
A judge has allowed forex firm Advanced Currency Markets to 37 CFTC bill could force new margin rules
separate from Refco. A Congressional bill that reauthorizes the Commodity Futures
8 Stock analysts could face more restrictions Trading Commission would make the CFTC and SEC change
The NYSE and the NASD suggest additional rules regarding their margin practices.
conflicts of interest among stock analysts. 38 Russell 2000 products getting noticed
9 Quick Scalps Futures and options on the Russell 2000 index enjoyed huge
volume gains in 2005.
10 Trading Basics By Jim Kharouf
Placing stops: The personal “risk tolerance” myth
A look at a dangerous approach to risk and a few basics 38 Fast Fills
principles to keep in mind when placing stops. 39 Lind-Waldock returns to the futures scene
By Active Trader Staff A familiar name in the futures industry is back in the game.
11 Technology for Traders: Tech briefs By Jim Kharouf
A look at a multi-monitor setup for laptops and real-time 39 Ferscha leaves Eurex
“squawk boxes” for traders. While CEO Rudolf Ferscha was leaving Eurex, the exchange
By Active Trader Staff was looking for a partner for its U.S. business.
13 New Products 40 Futures Trading System Lab
14 Web Watch: AlphaTrade FN Narrowed breakout channel
A high-end data provider has started a financial Web site. 43 Futures Snapshot
Trading Strategies Volume, volatility, and momentum statistics for futures.
15 Medians on the move 44 U.S. Economic Briefing
There are indicators for identifying trends and indicators for News and numbers from the economic front.
identifying consolidation areas. The two should be used for
their respective purposes only.
46 ETF Snapshot
Volume, volatility, and momentum statistics for
By Thomas Stridsman
exchange-traded funds.
19 Sticking to the plan: Pattern trade case study
Pattern identification, early entry, and a takeover rumor
47 Business of Trading
A (tax) break for traders
resulted in a large winner in a matter of days.
Traders are eligible for numerous tax benefits. The key is
By Thomas N. Bulkowski
knowing what they are.
23 Advanced Concepts By Robert A. Green, CPA
The hidden factor in treasury futures pricing
A look at some of the hidden factors impacting treasury
49 Market Pulse
The put-call ratio as a contrarian indicator
futures prices.
Analyzing extremes in the CBOE’s put/call ratio since 1997.
By Keith Schap
By David Bukey
26 On the Market: Linda Raschke’s daily routine
In this excerpt from a previous interview in Active Trader,
55 Global Marketplace
International market performance and news.
Linda Raschke discusses her trading style and daily market
regimen. 57 Face of Trading: View from above
By Mark Etzkorn
58 Key Concepts
60 Trade Diary
ACTIVE TRADER • March 2006 • www.activetradermag.com 1
EDITOR’S
Note

“GOLD $1,000!” and other hype

F
2005.
orget crude oil, the over-hyped market story lately
has been gold — “yellow oil,” “South African tea.”
For months (years, really) an endless parade of talk-
ing heads has blathered about “$500 gold!” — talk
that finally proved prophetic in the last two days of November

That over the preceding three

uous adornment.
Gold crystallizes the psychological component of market
behavior — i.e., the willingness of traders and investors to
project a wide range of personal biases, misconceptions,
apprehensions, and bad habits onto a market. Why else would
there be so much ink and trading activity devoted to some-
thing that has been such a phenom-
years gold futures rallied 46 percent enally bad investment for so long,
was apparently of as little concern to and which has a relatively pro-
people hyping gold as it was to the Gold crystallizes the scribed role in the industrial mar-
general public. Over the same peri- ketplace?
od (roughly late November 2002 to psychological component That doesn’t mean gold won’t
December 2005), a less-romantic rally to $1,000 (many e-mails have
metal, copper gained 271 percent;
silver gained 80 percent; platinum,
of market behavior — the told me it will do precisely that). If it
could make it to $500, why not?
95 percent. Crude oil gained 199 per-
cent — and that was after selling off
willingness of traders and There will be plenty of people with
ready explanations of why it should
$10 from around $70 in September to
$60 or so in December. investors to project a be trading at $750, $1,000, or $1,250.
But to me that’s not the point. I’ll
The hype surrounding gold is be happy to miss the ride, because I
instructive. Gold has fewer industri- wide range of personal don’t think I’d have any real idea
al applications than copper and it when to get off, and the ride back
certainly is less vital to the world biases, misconceptions, down could be sharp and fast.
economy than crude oil. The larger On Dec. 22, news came out that
price gains of these other markets apprehensions, and bad new home sales had dropped 11
over the past few years reflect at percent in November — the biggest
least some sanity on the part of the
marketplace. That gold futures vol-
habits onto a market. monthly decline in a decade. Some
smart-aleck pundits had been pre-
ume is routinely five times as large dicting a cooling housing market
as copper volume does not. for, oh, a year or two at that point,
Even if that were not the case, it wouldn’t have stopped the but they were consistently shouted down by various real estate
usual assortment of sleazy brokerages, Internet pump-and- professionals and the numbers themselves, which continued to
dump artists, and other marginal life forms from hyping gold set and break records.
and gold stocks as the metal eclipsed $500 an ounce. For a The transformation of housing into a tradable asset class has
while, breathless e-mails touting various gold “investment been one of the more fascinating market stories of the past few
opportunities” (one included, without irony, the phrase “lust years. Unfortunately, uninformed speculators — who almost
for gold”) seemed to elbow out the usual slew of herbal viagra never think of themselves as uninformed, or speculators
and printer-cartridge spam for dominance in my inbox. A few (they’re investors, and they’ve done their homework!) — will
months ago oil and energy stocks were the focus of such mar- pay the heaviest price. They always do — in stocks, oil, gold,
keting efforts. A few months from now it will be something houses, or anything else you care to name.
else. But we should expect no less from such purveyors of free
“capitalism.”
The question is, why was $500 gold a story at all? The best
answer might be that gold still enjoys its hallowed, if now his-
torical, role as the ultimate hard currency and inflation hedge,
not to mention its enduring position as a status symbol — the
metal of choice for wedding rings and other forms of conspic- Mark Etzkorn, Editor-in-chief

2 www.activetradermag.com • March 2006 • ACTIVE TRADER

 THIS MONTH’S
Contributors
q Keith Schap is a freelance writer specializing in risk management and trad-
ing strategies. He is a former senior editor at Futures magazine and senior
technical marketing writer at the Chicago Board of Trade. He is the author of
numerous articles and several books on these subjects, including the recently
published The Complete Guide to Spread Trading (McGraw-Hill).

q Thomas Bulkowski ([email protected]) is a private investor

with 25 years of experience and is the author of several books:
Getting Started in Chart Patterns (John Wiley & Sons, 2006),
Encyclopedia of Chart Patterns, Second Edition (Wiley, 2005) and
Trading Classic Chart Patterns (Wiley, 2002). Before earning
enough from his investments to “retire” at age 36, he was a
hardware design engineer at Raytheon and a senior software engineer for
Tandy Corporation. His Web site, dedicated to chart pattern research, is locat-
ed at http://mysite.verizon.net/resppzq7.

q Thomas Stridsman is a trading consultant, strategy builder

(using Traders’ Studio system research and optimization soft-
ware, www.tradersstudio.com), freelance writer, and speaker.
Previously he was the senior researcher for Rotella Capital in
Chicago, a commodity trading advisor with more than $1 bil-
lion under management. He also is a long-time contributing
editor for Active Trader magazine and a former editor at Futures magazine. He
holds degrees in macro economics and social psychology and has written two
books, Trading Systems that Work (McGraw-Hill, 2000) and Trading Systems and
Money Management (McGraw-Hill 2003). He can be reached via his Web site,
www.ThomasStridsman.us.

q Robert A. Green, CPA, is CEO of GreenTraderTax.com

(GTT), a CPA firm, and GreenTraderLaw.com (GTL), a law
firm. He is the author of The Tax Guide for Traders (McGraw-
Hill, 2004). GTT provides tax preparation, accounting, con-
sulting, entity, and retirement plan formation services,
IRS/state tax exam representation, and sells trade-account-
ing software. GTL handles all legal work for any type of hedge fund in the
U.S. or internationally, and provides ongoing compliance services. For more
information on products and services, or toparticipate in free weekly confer-
ence calls, chat rooms and message boards, visit www.greencompany.com.

q Jim Kharouf is a business writer and editor with more than 10 years of
experience covering stocks, futures, and options worldwide. He has written
extensively on equities, indices, commodities, currencies, and bonds in the
U.S., Europe, and Asia. Kharouf has covered international derivatives
exchanges, money managers, and traders for a variety of publications.

q José Cruset ([email protected]) is a private trader, software engineer,

and trading system researcher. He holds an MBA and a NASD-Series 3 cer-
tificate and has worked many years in the banking industry.

ACTIVE TRADER • March 2006 • www.activetradermag.com 3

TRADER’S
Bookshelf
Recent releases
Confessions of a Wall Street Analyst: Winning the Day Trading Game: Lessons and Techniques
A True Story of Inside Information from a Lifetime of Trading
and Corruption in the Stock Market By Thomas L. Busby
By Dan Reingold Wiley & Sons, 2006
with Jennifer Reingold Hardback, 198 pages
Collins, 2006 $60
Hardback, 368 pages
$25.95 Busby shares the details behind his
devastating loss on “Black Monday”
Reingold was a telecom analyst for 14 in 1987 and how he bounced back by
years and wrote this exposé on creating a risk-averse, high-percent-
“Street” corruption three years later. age day-trading strategy. Also, he
He describes government investigations gone awry, the prolif- examines trader psychology and risk
eration of inside information, and encounters with former management. Other topics discussed
movers and shakers such as WorldCom’s Bernie Ebbers. are key trading numbers, tape read-
Reingold recounts incidents with brokerage firm employees, ing, emotional control, and finding
Wall Street executives, telecom executives, mutual fund clients, valuable news.
and the media.

Predicting the Markets of Tomorrow: A Contrarian

Investment Strategy for the Next Twenty Years
By James P. O’Shaughnessy
Portfolio, 2006
Hardback, 304 pages Note: Trader’s Bookshelf listings are summarized from the material
$24.95 provided by publishers. They are not reviews or endorsements.

O’Shaughnessy reveals the results of

his latest quantitative research on
how to beat the market. He says
large, fast-growth companies no
longer dominate the market, and a
new cycle of market beaters will
come from small and mid-size com-
panies, large company value stocks,
and intermediate-term bonds. He
also explains how to incorporate his perspective into several
investment strategies.

4 www.activetradermag.com • March 2006 • ACTIVE TRADER

INSIDE THE
Market BY JEFF PONCZAK

A new look

New York enters historic era

O n May 17, 1792, 24

traders gathered under-
neath a buttonwood tree
on New York’s Wall
Street and signed an accord that led to
the formation of the New York Stock
Exchange.
The final seat was sold Dec. 30 for
$3.55 million. Earlier in the month, a seat
sold for a record $4 million.
Under the terms of the Archipelago
deal, each NYSE member will get
$300,000 cash and 80,177 shares. With
Archipelago trading at $50 on Dec. 30,
made “silent” bids, and the top 1,366
bids (equal to the number of licenses
available) received licenses.
The final price turned out to be
$49,290. The exchange raised more than
$62 million in the auction, as 1,274 licens-
es were sold — more than the number of
Over the course of 200+ years, the the value of a seat was about $4.3 million. active seat holders. The licenses will be
NYSE became the most famous and most In January of 2005, a Big Board seat good for one year.
respected financial exchange in the could be had for less than $1 million, so In a nod to tradition, NYSE CEO John
world. But more than 210 years after its Thain named the new licenses “SEATS”
historic creation, another vote has the (Stock Exchange Auction Trading System).
potential to bring revolutionary change “We were very pleased with the results
to the Big Board. of the NYSE’s inaugural SEATS auction,
On Dec. 6, more than 95 percent of the and the response from our member
NYSE’s members voted in favor of a organizations was extremely positive,”
merger with Archipelago, the Chicago- Thain says. “Our goal was to create a fair,
based publicly traded electronic equitable and transparent system that
exchange that initially made its mark in would reflect the value of the license to
the late 90s as one of the original ECNs. directly access the (NYSE). It’s also a way
More than 1,300 members voted — 96 for the Exchange to generate revenue that
percent of those eligible — and only 59 supports our business growth.”
voted against the proposal. The approval With almost 100 licenses remaining,
by members is the last measure before the NYSE will offer them for $54,219 —
the NYSE becomes a publicly traded 10 percent above the auction price — on
company under the symbol “NYX,” a first-come, first-served basis.
which is likely to happen sometime in or those who sold off their seats at the last The auction creates revenue the NYSE
before March. The symbol “AX,” which minute likely made a substantial profit. is in much greater demand for as a pub-
Archipelago traded under, will be elimi- While those buying the seats stood a licly traded company. And, in other signs
nated. The NYSE would also change its chance of reaping a windfall if New York the Big Board is much more concerned
name to the NYSE Group. Group stock went up, they also faced about the bottom line than ever before,
There are myriad potential changes lockup periods of as long as three years floor brokers are now charged $5,000 to
the Big Board could make to its struc- for portions of the stock holdings. use the hand-held trading devices they
ture, such as using Archipelago’s tech- Regardless, it was a seller’s market in previously used for free.
nology for its electronic trading business, the days leading up to the final transac- Plus, the NYSE laid off 60 workers a
getting into the options and/or futures tion. There were 30 NYSE seats sold in all week after the member vote, citing cost-
business, phasing out the trading floor, of 2004. In 2005, there were 94, including cutting.
etc. However, any such changes would eight in the final week.
need approval from the SEC. More than just an investment vehicle, What really will change?
Nonetheless, the NYSE has already though, a seat has also dictated who is While auctions, seat sales, and increased
made a significant change. As of Jan. 1, able to trade on the floor of the exchange. fees for floor brokers are important to
exchange seats will no longer be for sale, With no more seats, the NYSE began shareholders and those that make their
as New York switches from a member- issuing trading licenses in early January. living on the NYSE floor, there are other
based organization to a shareholder- Licenses were given out via Dutch aspects of the merger that are far more
based organization. auction, meaning interested parties important to retail traders and investors.

ACTIVE TRADER • March 2006 • www.activetradermag.com 5

INSIDE THE
Market

The NYSE has never been the listing still does a small percentage of New York options business only adds credibility to
exchange of choice for active, short-term total volume. the options business.”
traders. The floor-based model, where But allowing orders sent to New York
the time it takes to execute a trade is to be executed on Archipelago (and giv- A bright future?
often up to the specialist, is not con- ing Arca access to the NYSE’s order With the potential for improved stock
ducive to someone who is holding a book) would put NYSE stocks on equal trading well in hand and a thriving
position for a short amount of time in an footing with Nasdaq issues, which are options business at its fingertips, it
effort to make a few pennies per share. favored by traders because they are able makes sense the NYSE might also want
New York has become increasingly to be executed automatically. to see if it can get involved in the futures
cognizant of its flaws (with some coax- game.
ing from the SEC) and in December Expanding its options? Futures exchanges are setting volume
began using its Hybrid Market electron- Another big question concerns the NYSE’s records virtually across the board, but
ic trading platform on 168 stocks. The interest in trading options. New York trad- access into the marketplace would not be
pilot program will last 90 days or until ed options until the early 90s, when its easy. Starting a futures exchange would
the SEC grants full approval of Hybrid. options business was bought by the be almost unthinkable because of all the
Hybrid will allow limit orders and Chicago Board Options Exchange. It has other issues the NYSE will have to deal
specific market orders to be automatical- made overtures about wanting to get back with upon completion of the merger.
ly executed, and the 1,099-share limit into the business, and its purchase of But if the NYSE is serious about being
and 30-second wait period between plac- Archipelago will make that infinitely easier. a player in futures, an opportunity has
ing consecutive orders will be eliminat- Archipelago recently finalized its presented itself. Eurex U.S., the floun-
ed. acquisition of the Pacific Exchange, one dering venture started by Eurex — the
The Big Board’s plans for Hybrid were of the six options exchanges in the U.S., top-volume derivatives exchange in the
in place long before the Archipelago putting the NYSE in the options business world — is looking for an equity partner,
deal, and Thain made it clear the NYSE by default. and Eurex admitted it has had discus-
Group would operate under two sys- However, the Big Board has given no sions with other exchanges.
tems — the Hybrid for NYSE orders, and indication as to whether it will take over Archipelago has long been rumored to
Archipelago’s for Arca orders. Pacific’s business or allow it to operate be one of those exchanges. While Eurex
Thain made this statement soon after as it currently does. In 2005, the PacEx U.S. has a limited product line (it trades
the deal was originally announced in was fifth among options exchanges in Russell-product futures and currency
April 2005, but the practicality of such a terms of total volume, although it was futures), it does have top-notch technol-
move may prove to be burdensome. fourth for the month of December. ogy and clearing facilities.
Certainly, Hybrid allows for a trade to The PacEx has made great strides in There are certainly issues surrounding
still be executed on the floor, an option options — it accounted for less than 9 Eurex U.S. (for starters, it is a money-los-
not available in Arca’s platform. But run- percent of total volume in August, but ing proposition), but a hookup with the
ning two electronic platforms with two did almost 15 percent of overall business NYSE would instantly give Eurex U.S. a
sets of IT professionals and two different in December — and is only starting to newfound respect.
rules doesn’t make much sense in a pub- reap the benefits of the Archipelago deal.
lic company where shareholders are only While it’s unlikely the NYSE Group A new era
concerned with the bottom line. would make any changes to the actual When ECNs took control in the late 90s
To completely eliminate Hybrid mechanics of the options operation, a and early 2000, the New York Stock
would also mean an end to the floor. name change — to the New York Options Exchange was all but left for dead. It has
While the demise of the NYSE trading Exchange or something similar — would proven itself to be quite resilient, howev-
floor has been long rumored, it has too provide better name recognition. er, and the Archipelago deal will likely
much history (and too many supporters) Still, that wouldn’t guarantee success, take the exchange in directions it has
to go away quickly and quietly. as the CBOE and the ISE are the clear never seen before.
The best hope for traders, at least in the leaders in the options arena and it’s The experience of the NYSE and the
short-term, is that the NYSE gives traders questionable as to how much time and technology and entrepreneurial nature
the option of trading Big Board stocks (or money the NYSE would be willing to of Archipelago have the potential to pro-
at least certain stocks) on either Hybrid or sink into the endeavor. vide traders with opportunities they
Archipelago. Archipelago is currently “It remains to be seen if consolidation haven’t had before. Things don’t always
capable of trading NYSE stocks, but only with other markets creates a threat,” says move swiftly in the financial markets,
as a result of trades sent through its own Bill Brodsky, CEO of the CBOE. “Having though, so the best short-term approach
order book. Because of this, Archipelago the New York Stock Exchange in the is to take a wait-and-see attitude.Ý

6 www.activetradermag.com • March 2006 • ACTIVE TRADER

A fundamental approach

Fidelity upgrades Wealth-Lab

F idelity Investments made its

mark in the financial world
as a mutual fund company
that helped its clients take a
long-term approach to the markets.
Recently, though, Fidelity has made a
big push into the world of the active trad-
“We have very short-term traders and
those with a little longer holding period,”
says Sanjeev Mirchandani, executive vice
president of Fidelity personal invest-
ments. “Both want to improve
their chances of making
money, so we wanted to pro-
According to Gold, more enhance-
ments to Wealth-Lab are on the way.
“You’ll see more of the same,” he says.
“We’ll have a richer tool set which will
create more trading opportu-
nities and increase ease of
use. It will be a broad-based
er, a move that was cemented in late 2004 vide them with the widest enhancement.”
when the company bought Wealth-Lab, a availability of variables.” And while the year 2005
high-end strategy-testing program. Also, Mirchandani says, saw plenty of consolidation
Fidelity, though, hasn’t forgotten its the newest version of Wealth- in the brokerage space,
roots, and its latest version of Wealth- Lab may cause some clients Fidelity was not a party to it.
Lab is loaded with fundamental data. who previously focused only on invest- Mirchandani says that isn’t by accident.
“This makes the program accessible to ing to take a look at short-term trading. “The best way to grow is to create
a broader group,” says Franklin Gold, Likewise, it also could help short-term value,” he says. “Acquisitions are expen-
vice president of Fidelity active trader traders get a better grip on their long- sive and difficult and don’t always go as
product development. term planning. planned. Plus, they are a disruption to
The new data allows traders to use The fundamental data goes back six the client.”
both fundamental and technical analysis years and there is a detailed explanation Mirchandani also believes the average
when creating a strategy. For example, if of each individual indicator (so if you trader is a lot more market savvy than he
you’re looking for stocks crossing above don’t know what profit margin or a was a few years ago.
their 10-day moving average on volume debt/equity ratio is, you can find out “You still have a lot of dabblers in the
that is at least 10 percent above normal, with one click). market, but now you have many who
you can modify the search even more by Wealth-Lab is available free of charge have the same level of sophistication the
stipulating that stocks must also have a to Fidelity customers who place at least professional traders had 10 years ago,” he
p/e ratio of below 20 or annual earnings 120 trades in a rolling 12-month period says. “We have definitely seen a broaden-
of more than $2. and have $25,000 in assets. ing of the trading public’s mindset.”Ý

Hedging your bets

SEC rule comes under scrutiny

P
lenty of hedge-fund managers the commission authority to regulate avoid registration by simply counting
have a problem with new hedge funds. the number of funds he ran.
Securities and Exchange Com- It also said compliance costs for fund An SEC lawyer admitted the SEC has
mission rules that will signifi- managers would be significant, and changed its definition of a client over the
cantly increase regulation of the U.S. those costs would have to be passed years, but in the hedge-fund ruling it is
hedge-fund business. down to the investors. meant to mean the individual investor.
However, none of them have gone as The rule, which requires all managers However, one of the judges in the panel
far as Phillip Goldstein. The New York- with more than $25 million in assets to told the SEC it seemed like the
based Goldstein, who runs the register with the SEC by Feb. 1, is also Commission was changing the meaning
Opportunity Partners hedge fund, being challenged by the U.S. Chamber of based on how it best suited them.
argued in December in front of a panel of Commerce. The rule was the brainchild of former
judges that the SEC should not be During the hearing, judges questioned SEC chairman William Donaldson. New
allowed to pass the new legislation. what the SEC meant by “client,” as the chairman Christopher Cox has not made
Goldstein’s lawyers, in a brief to the new rule mandates any manager with a any public comment on the challenges.
court, said the rule should not be minimum number of investors to regis- A ruling on the case is likely in
enforced because SEC law does not give ter. Previously, a fund manager could February or March.Ý

ACTIVE TRADER • March 2006 • www.activetradermag.com 7

INSIDE THE
Market

Too much is never enough

Stock analysts could face more restrictions

W hile new rules regarding

conflicts of interest and
disclosure among stock
analysts have helped the recent level of
stock research, the New York Stock
discussed in detail in any research report
put out by an analyst. However, the new
study suggests potential disclosures be
mentioned prominently on the cover of
the report, along with a Web link that
is already illegal at 10 firms that have pre-
viously admitted to conflict of interest
issues and paid a cash settlement.
The study suggests anyone who retal-
iates against an analyst for unfavorable
Exchange and the NASD believe more provides more details. research be banned from the securities
can be done. The study also suggests a loosening of industry, although the regulators admit
A new report, created by the two the rules regarding analysts investing in this is difficult to enforce.
groups at the behest of regulators, indi- mutual funds, hedge funds, and variable A final suggestion is to prevent ana-
cates that while stricter rules have led to annuities. And, it wants to change the lysts from doing research on broad-based
a better quality of research, conflicts quiet period for an analyst covering an indices, and to stop the recommendation
have still not been completely eliminat- offering from 40 days to 25 days, reason- of increasing/decreasing holdings in a
ed, and more rules are needed. ing that investors would benefit from specific index, sector, or industry (as
For starters, all potential conflicts — having information sooner. opposed to an individual stock) using no
e.g., the analyst’s firm does investment The NYSE and the NASD also want to other data than volume and price.
banking with the company being cov- eliminate the rule that permits investment The SEC will take the suggestions into
ered; the analyst owns stock in the com- bankers and others within a firm to review consideration, although no changes are
pany in his personal portfolio, etc. — are a research report before it is published. This likely in the short-term. Ý

Protecting the customers STOCK PERFORMANCE, 2005

Here’s how the stocks of trading-
Another currency firm related companies performed in 2005.

leaves Refco NDAQ 244.9%

AX 138.4%
VDM
ICE
-5.9%
-6.8%
APTD 76.2% NITE -9.7%

W
TRAD 76.1% VALU -10.2%
AMTD 68.8% RSHF -14.8%
ith its Capital Markets arm company. ACM now owns 74 percent of CME 60.7% TRAC -21.0%
soon to be bought by the firm, with Refco in control of the ET 39.5% NYFX -31.2%
FXCM, Refco is also losing other 26 percent. ACM did not want to SCHW 22.7% SIEB -36.9%
another of its currency arms. Advanced be sold off with the rest of Refco’s assets, BOT 16.1% ESPD -37.7%
Currency Markets (ACM), a forex divi- as that would give ACM no control over LAB 12.8% HLVC -75.0%
sion of Refco based in Switzerland, was its customers’ assets. ISE 6.9% ABWG -90.6%
taken away from Refco after a court For more on the currency markets, OXPS 6.7% RFXCQ -98.3%
decision in mid-December. sign up for a free subscription to IDC 4.5%
The courts ruled that ACM could Currency Trader magazine at www.cur-
lessen the ownership Refco had in the rencytradermag.com.Ý OXPS had IPO Jan. 27
ISE had IPO March 9
HLVC had IPO June 9
RFXCQ had IPO Aug. 11
BOT had IPO Oct. 19

8 www.activetradermag.com • March 2006 • ACTIVE TRADER

 • • • • • • • • QUICK SCALPS
NASDAQ, INSTINET DEAL FINALIZED
The Nasdaq’s acquisition of Instinet became official in
December. The Nasdaq will keep the Inet electronic trading plat-
form created by Instinet and integrate it into its own system,
while Instinet’s institutional business will be sold to a private
equity group. Nasdaq CEO Bob Greifeld said he expects Inet’s
platform to become a part of the Nasdaq’s within a year.

LEHMAN BROTHERS BUYS TOWNSEND

Townsend Analytics, the Chicago-based firm that produces the
RealTick trading platform, was purchased by Lehman Brothers in
late December. The deal gives Lehman an electronic platform
with an established customer base for its institutional trading.
Retail customers who use RealTick will not be affected by the
acquisition. “The RealTick platform includes many services that
will enhance the execution experience for our institutional,
hedge fund, investment adviser, prime broker, and clearing serv-
ices clients,” says Jeffrey S. Wecker, Lehman’s managing direc-
tor and global head of electronic client services.

STOCK PRICES OF TRADING-RELATED FIRMS

Company Symbol Exchange Closing 1-month % 52- 52- Avg. Market
price change change week week daily cap
1/5 high low vol.* ($)
Brokerages
OptionsXpress OXPS NASD 27.4 2.46 9.86% 25.19 12.48 1.21M $1.55B
E*Trade ET NYSE 21.73 1.62 8.06% 21.71 10.53 3.51M $8.13B
TradeStation TRAD NASD 14.39 0.82 6.04% 13.22 5.66 667,000 $557M
Ameritrade AMTD NASD 25.11 0.68 2.78% 25.26 9.91 4.10M $10.2B
Charles Schwab SCH NASD 15.81 0.24 1.54% 16.14 9.65 4.73M $20.4B
Track Data TRAC NASD 2.99 0.023 0.78% 3.84 1.95 12,800 $25.1M
Refco RFXCQ Pink Sheets 0.45 0 0.00% 30.55 0.3 285,000 $57.4M
Rush Financial Technologies RSHF OTC BB 0.26 -0.03 -10.34% 0.33 0.16 17,800 $9.23M
Siebert Financial SIEB NASD 2.55 -0.3 -10.53% 4.5 2.34 9,880 $56.3M
AB Watley ABWG Pink Sheets 0.016 -0.014 -46.67% 0.29 0.01 146,000 $458,000
Exchanges/Trading firms
Intercontinental Exchange ICE NYSE 39.31 2.5 6.79% 44.21 31.27 378,000 $2.18B
Chicago Mercantile Exchange CME NYSE 364 2 0.55% 396.9 163.8 544,000 $12.5B
International Securities Exchange ISE NYSE 30.26 -2.92 -8.80% 33.44 19.71 771,000 $1.11B
Chicago Board of Trade BOT NYSE 87.15 -8.82 -9.19% 134.5 79 217,000 $4.60B
Nasdaq Stock Market NDAQ NASD 36.95 -5.09 -12.11% 45.23 7.6 1.27M $3.03B
Archipelago AX AMEX 51.92 -8.46 -14.01% 62.35 15.7 475,000 $2.37B
HLV Trading HLVC Pink Sheets 0.011 -0.009 -45.00% 0.1 0.005 108,000 N/A
Market makers/Specialists
Vander Moolen VDM NYSE 8.2 2.71 49.36% 8.65 4.57 185,000 $314M
LaBranche LAB NYSE 10.08 -1.39 -12.12% 11.87 5.25 570,000 $611M
Knight Capital Group NITE NASD 9.08 -1.46 -13.85% 10.9 7.28 1.21M $926M
Miscellaneous
Nyfix NYFX Pink Sheets 4.45 0.42 10.42% 8.05 2.07 111,000 $144M
AlphaTrade APTD OTC BB 0.35 0.03 9.37% 0.5 0.2 24,800 $9.80M
Interactive Data Corporation IDC NYSE 22.6 0.25 1.12% 23.43 19.05 78,500 $2.11B
eSpeed ESPD NASD 8.15 -0.16 -1.93% 12.14 6.73 128,000 $407M
Value Line VALU NASD 34.02 -5.94 -14.86% 43.04 33.36 2,610 $340M
*over last 30 trading days

ACTIVE TRADER • March 2006 • www.activetradermag.com 9

 TRADING Basics

Placing stops: The personal “risk-tolerance” myth

The bad news: The market doesn’t care what you’re
comfortable risking. The good news: You don’t need
BY ACTIVE TRADER STAFF to rely on your feelings to place stops.

O
ne of the most dangerous ket’s average daily and weekly moves trade, you might have found that 55 per-
clichés in trading is that how provides a resounding “no” to this ques- cent of the time price fell 1.25 to 1.5 points
much you risk is a matter of tion. Say you have $20,000 in your trading below the entry price before rallying. To
personal preference — akin account and you’ve decided you’re com- avoid the chance of getting stopped out
to whether you like your meat medium fortable risking $1,000 on a trade. (We will on such moves, you could place your
rare or medium, or your martinis ignore for the moment this represents a 5- stop more than 1.5 points below the entry
straight up or on the rocks. percent risk of account equity — a high point. This might not feel “comfortable”
Have you ever listened to an industry percentage by most standards.) Because a to you, but it’s what the market is telling
speaker or author conclude a discussion one-point move represents $1,000, you you is necessary.
of a trade setup with the advice that you would have to place your stop at 79 to Now let’s revisit the topic of trade risk
“always need to place a stop to protect keep the trade in your comfort zone. as a percentage of account equity. In this
yourself”? When asked where that stop This trade plan might be psychologi- example, 5 percent of account equity
should be placed, the answer is often cally comforting, but it’s also a virtually was initially risked on the trade. One of
something like, “Risk is a matter of per- guaranteed loss. Assuming this instru- the more useful trading clichés is that
sonal preference. Every trader must deter- ment keeps trading in line with its aver- professional money managers typically
mine what he or she is comfortable risk- age performance, you could expect price risk only 1 to 2 percent of account equity
ing.” to be 1.5 points higher or lower when it per trade. Again, this is painting in
In case you didn’t hear the “thump,” closes one week from now. If you bought broad strokes, but it is true that the less
that was somebody punting. Most likely, at the absolute low for the week, you capital you risk per trade, the less likely
the person a) doesn’t have a clue where might be lucky enough to see a 2.5-point you are to be destroyed by a handful of
the stop should be placed, or worse, b) gain sometime during the week. At any large losing trades.
knows that virtually any stop will hurt rate, a 5-point move in one week is prob- Risk becomes an increasingly more
the strategy’s performance and doesn’t ably not in the cards. complex topic as you trade more instru-
want to tell you that. On the other hand, the daily close-to- ments and strategies. But keep in mind
Besides the basic issue of whether close move is .75, which means your 1- you always need to balance risk in two
stop-loss orders are always necessary or point stop could be hit in less than two fundamental ways: 1) as a dollar amount
advantageous, the hard truth is that days. The average daily range is 1 point, based on a percentage of total account
effective stop placement is a challenge. so if the next day’s high is lower than equity, and 2) as a percentage of the mar-
However, it does not have to be based on your entry price and the market is ket price (the difference between your
hunches or how comfortable you feel. falling, you could easily be stopped out entry price and your stop). Among other
Imagine the following scenario: in less than 24 hours. things, doing so will determine how big
You’re trading an instrument with an Basically, you’ve put yourself in a your position should be.
average daily range of one (1.00) point, position with a high probability of losing For example, say you’re risking 2 per-
and each 1-point move represents because your stop placement is arbitrary cent of your account per trade represent-
$1,000. The average move (up or down) — based on a “gut feeling” of how much ing $2,000 (which means you have
from the close of one day to another is money is appropriate to lose, rather than $100,000 in your account). You go long a
.75. The average weekly range (high to analysis. stock at $50 using a tested strategy that
low) is 2.5 and the average move from In this case, the market itself — by indicates your stop should be three
the close of one week to the next is 1.5. virtue of its most basic price movement, points away (at $47). To determine how
Say you get a buy signal on Monday or volatility, statistics — was telling you many shares to buy, divide the amount
and go long on the close at 80; you expect a 1-point stop was not a good idea; to of money you can risk on the trade by
to make at least a 5-point profit on your stay in this position long enough to prof- the stop size, in this case 2000/3, or 666
trade. You want to protect your position it, you needed to use a wider stop. shares (rounded down).
with a stop-loss order if the market goes This example obviously simplifies So the next time someone describes a
against you. Where do you place it? many facets of a trade. In practice, analy- trading strategy and suggests you
Should this decision simply be based on sis of a trade setup’s characteristics will should place a stop where you feel
a dollar amount you feel “comfortable” help determine an appropriate stop. For “comfortable,” remember one thing:
losing, as so many people often advise? example, by analyzing 50 previous exam- When it comes to stops, skip the comfort
The basic information about this mar- ples of the setup you were using for this and go directly to the facts. Ý

10 www.activetradermag.com • March 2006 • ACTIVE TRADER

 Technology for TRADERS

Three pieces of technology

Tech briefs on display at the recent FIA Expo

offer traders new screen display
BY ACTIVE TRADER STAFF options and live news services.

A
FIGURE 1 DUALHEAD2GO
few tech products for traders stood out
The DualHead2Go adapter lets you attach two additional monitors to a
at the recent Futures Industry Associ-
laptop so they appear as one double-wide screen or two individual ones.
ation Expo in Chicago: a new multi-
monitor adapter for laptops
(DualHead2Go), and two “squawk boxes” (Trade
The News and Need To Know News) that broad-
cast market news directly to your PC. Here’s a
brief overview of these products.

DualHead2Go
In November Matrox Graphics introduced
DualHead2Go, a device that lets you attach
two additional monitors to a laptop. While
installing one external monitor is fairly simple,
there has been no easy way to build a portable
system with two additional monitors until
now. Matrox Graphics’ new product simplifies
this process.
DualHead2Go doesn’t require more video
Source: DualHead2Go memory to handle that extra monitor. Instead, it
“tricks” your laptop’s existing video card into
thinking it’s installing one double-wide (2560 x
TABLE 1 SQUAWK BOX COMPARISON 1024) monitor. According to Jean-Levy
Beaudoin, Matrox’s business-development
Product: Trade The News Need to Know News manager, DualHead2Go asks the graphics card
What it is: Audio broadcast that Two news channels to work a little harder than normal, but it hasn’t
reports breaking economic focusing on futures, had any problems performing with compatible
news and real-time fixed income, and domestic laptops.
commentary from the S&P stocks. Unlike an internal multi-monitor graphics
500 and Nasdaq 100 card, DualHead2Go is an external box that’s
futures pits. easy to install and configure. Simply attach the
Who it is for: Stock, futures, bond, and Same. adapter to your CPU and plug in both moni-
currency traders. tors (Figure 1). The adapter also includes soft-
Web site: www.tradethenews.com www.needtoknownews.com
ware that can configure both additional moni-
Price: News and futures market $95 per month; free
tors as one big screen, two distinct ones, or
audio channels $150-$350 two-week trial.
“clones” of the original laptop display. The
per month; NewsStation
only — $30 per month; software also ensures pop-up windows
free one-week trial. appear in either monitor instead of stretching
Upside: Listening to three channels Cost; news also includes across two screens, which can be annoying.
at once is easy. NewsStation occasional price updates However, DualHead2Go only reads analog
software is well-designed (session lows/highs). signals; it doesn’t yet support digital signals as
and comprehensive. many high-end, flat-panel screens do.
Downside: Cost. No pit-based broadcasts. (Matrox’s Beaudoin says a digital version is a
Minimum OS: Windows 2000 OS: Windows 98, 98 se, future possibility.)
system (or higher); broadband ME, 2000, XP, 2003; Also, DualHead2Go isn’t compatible with all
requirements: Internet connection. DirectX 8.1 (or higher); laptops. To find out whether your system works
at least 256 MB RAM with the adapter, visit Matrox’s Web site, which
recommended; broadband features a list of compatible machines and soft-
Internet connection. ware that tests your system automatically
(www.matrox.com/graphics/offhome/sup-
Source: Trade the News, Need to Know News

ACTIVE TRADER • March 2006 • www.activetradermag.com 11

FIGURE 2 TRADE THE NEWS

You can listen to three channels (news, S&P 500 futures, and Nasdaq
100 futures) simultaneously and search its news database by ticker Figure 2’s lower window shows the service’s
symbol or keywords. streaming news headlines, which also appear in sev-
eral categories (macro economic news, energy, finan-
cials, etc.). Small pop-up windows also appear as
news breaks. You can subscribe to this NewsStation
feature (without audio) for $30 per month, which also
lets you search its historical database by ticker sym-
bol or keyword. Much of this fundamental data is
available free at Yahoo! Finance, but Trade The News
also adds its own stories from more than 350 sources.
Need To Know News. This VoIP service is cheaper
than Trade The News, but it doesn’t have as many
features. For instance, Need To Know News doesn’t
broadcast constantly from the futures pits. Instead, it
offers two news channels: fixed income/futures and
domestic equities. Both channels deliver market-
related news, and you can adjust their volumes to lis-
ten to them at the same time.
While Need To Know News doesn’t track the
S&P’s bid-ask spread, it does mention whenever
indices, major futures contracts, currencies, and
stocks hit daily highs or lows.
Figure 3 shows its interface, which also lets you
Source: Trade the News search for news by ticker symbol and even send
questions to the broadcasters. Economic and earn-
ings calendars, a news archive, and other fundamen-
port/dh2go/home.cfm). tal data (analyst coverage, upgrades/downgrades) are also
DualHead2Go costs $169, so it might not be practical unless available on the firm’s Web site.
you use a laptop as your primary machine. Although the Performance. Overall, we had no trouble installing Trade
adapter is also compatible with some desktops, you can now The News and Need To Know News, and the platforms per-
find internal video cards that support two or more monitors formed flawlessly. The software might interfere with your fire-
for around $100. (For more information about creating a multi- wall, but both companies told us this issue can be easily fixed.
monitor desktop system, see “Multi-screen trading,” Active The news channels are also available over the phone for those
Trader, June 2005.) without Internet access. Ý
Market news channels
Trade the News and Need To Know News are two real-time, FIGURE 3 NEED TO KNOW NEWS
squawk-box services that broadcast economic news and track This lower-priced platform also broadcasts breaking economic
equity, futures, and fixed-income markets. Both products’ plat- and market news as it hits the Street.
forms use Voice over Internet Protocol (VoIP) technology to
deliver live audio via a broadband Internet connection. While
features and monthly costs vary (see “Squawk box compari-
son”), both products combine news commentary with text-based
fundamental research that includes headlines, earnings
announcements, and economic calendars.
Trade The News. This firm has broadcast live audio since 1996
and offers three channels: news commentary, S&P 500 futures,
and Nasdaq 100 futures. The news channel is its main product,
which describes economic reports and company announcements
(among other market-related data) as they hit the Street. Its S&P
and Nasdaq futures channels are broadcast directly from the trad-
ing floor; you can hear floor traders yelling in the background.
The announcers track price moves by reading the floor
traders’ and clerks hand signals, which can be cryptic if you’re
unfamiliar with the lingo. For example, “20 bid at a half”
means the bid-ask spread is 0.20-0.50. Fortunately, Trade The
News explains these terms clearly on its Web site.
If you subscribe to all three channels, you can listen to them
simultaneously. Each feed has its own volume control, so it’s
fairly easy to distinguish among them (see Figure 2’s upper
window). Source: Need to Know News

12 www.activetradermag.com • March 2006 • ACTIVE TRADER

NEW
Products
q Fidelity Investments has enhanced Wealth-Lab Pro, its
strategic trading technology available at no extra charge
to Fidelity active trader customers who place more than
120 trades over a rolling 12-month period. Wealth-Lab
Pro now provides active traders with six years of inte-
grated fundamental balance sheet, income statement,
and calculated ratio data as reported quarterly by com-
panies. Fundamental data includes assets, earnings,
sales, employees, liabilities, and more. Calculated ratio
data includes return on assets, trailing price/earnings
ratios, price/cash flow ratios, price/sales ratios, return
on equity, dividend yield ratio, sales per share ratio, and
more. This fundamental data is available at no cost and
is integrated with technical trading data including 10
years of daily prices for individual securities and 18
months of intraday data. Additionally, Fidelity has
enhanced Wealth-Lab Pro with a new “Getting Started”
home page that helps customers develop, back-test, and
trade based on trading systems. Links take customers
directly to tools that help accomplish specific tasks and
include right-click help capability with easy-to-follow
definitions and instructions. The redesigned home page
also includes recently viewed ChartScripts and tips for
navigating Wealth-Lab Pro’s comprehensive suite of
resources. For more information, visit www.fidelity.com.

q Barclays Capital is the latest bank to go live on Reuters without having to be present to enter or exit. The standalone
Trading for Foreign Exchange (RTFX).The Barclays RTFX service platform replaces the trader’s standard platform and e-mail
will initially be available in Asia. Barclays Capital’s launch program with a single platform. When an e-mail is received in
brings banks and other financial participants in Asia the abili- FX-Auto, the order is immediately placed in the trader’s
ty to trade on all 68 currency pairs Reuters provides a service account. For more information, visit www.fx-auto.com.
for. Deutsche Bank also plans to go live on RTFX soon. Reuters
Trading for Foreign Exchange allows banks and their cus- q Chicago Board of Trade member Jonathon Stone is now
tomers to trade forex from their Reuters desktop. For further offering speed trading as part of his trading course. Speed
information about Barclays Capital, visit www.barclayscapi- trading is a precise (entry and exit points) form of day trading
tal.com; for Reuters, visit www.about.reuters.com. for electronically traded markets, such as the E-Mini S&P, the
Nasdaq, Mini Dow Jones, 10-year T-notes, bonds, and curren-
q Dynamic Trend Inc.’s Dynamic Trend Profile — a high-end cies, etc. It is designed to minimize risk. For information or a
technical analysis program designed for active traders — will free trial call (847) 295-0056 or visit www.jonathonstone.com.
be powered by eSignal’s real-time data. The combined services
bring eSignal’s technical charts and indicators together with q Charles Schwab & Co. has launched Options Strategy Finder,
Dynamic Trend Profile’s specialized market scans. Dynamic a Web-based tool designed to help options investors identify
Trend Profile uses a series of easy-to-read, color-coded graphi- strategies that meet their specific investment objective. The
cal windows to help investors determine trading opportuni- Options Strategy Finder, which is accessible on schwab.com,
ties. Dynamic Trend Profile incorporates a top-down approach presents investors with trading strategies tailored to their out-
to trading by dividing the market into several categories (day look on a particular security and their individual investing
trading, swing trading, and position/options trading) in order needs. It may also provide no strategies, implying that estab-
to determine the phase and strength of the overall market in lishing a position on a particular security is not advisable at the
each category. Dynamic Trend Profile is available for purchase current time. The tool, which includes help screens, arrives at
online at www.dynamictrend.com or by calling (330) 645-0800. the results by first prompting investors to answer six questions
Visit eSignal’s Web site at www.esignal.com for a complete list designed to evaluate the criteria of a specific security and the
of features and pricing options. ultimate investment goal. Based on the investor’s responses to
the anticipated direction, magnitude, velocity, implied volatili-
q FX-Auto is a new platform that enables forex traders to auto- ty, expected volatility, and risk, the tool lists appropriate
matically trade third-party signals from various forex services strategies. For more information about Schwab’s options trad-
and consultants. It allows traders to monitor and control trades ing products and services, visit www.schwabat.com\options.

ACTIVE TRADER • March 2006 • www.activetradermag.com 13

WEB
Watch

AlphaTrade FN

C
ALPHATRADE FN
anadian firm AlphaTrade AlphaTrade FN has standard financial info, but its Java-based quote screens
pays its bills by being a data allow data to be updated automatically.
provider, offering traders
real-time quotes, charts, and
other similar features. In that sense, it
competes with the likes of eSignal and
Real Tick.
AlphaTrade’s new venture, however,
competes with Yahoo. The AlphaTrade
F i n a n c i a l N e t w o r k (www . a l p h a -
t r a d e f n . c o m ) is a one-stop Web site
where traders and investors can gather
information about the markets and indi-
vidual stocks.
AlphaTrade FN has taken a somewhat
minimalist approach to the site, focusing
on data and eschewing any commentary
or market outlooks (although there is no
shortage of shilling for AlphaTrade’s wire-
less product and real-time quotes offer-
ings).
To differentiate itself, AlphaTrade FN
uses a Java-based format, which provides
an advantage over typical Web sites. For
example, on the home page, the upper left Source: AlphaTrade FN
corner features an intraday chart and data
on five indices — the Dow Jones, Nasdaq Composite, S&P 500, which is helpful.
Russell 2000, and Toronto Stock Exchange Composite. Thanks The Quotes and Data page is mostly standard, too, offering
to the Java environment, the index values are automatically information such as average volume, 52-week high, etc., as
updated, and switching from one chart to the next requires well as links to fundamental data and balance sheets, income
nothing more than moving the cursor over the name of the statements, etc. You can also access an options chain and, as
index. with other data, the intraday information automatically
The same is also true of the “Markets” page, which has a updates on the page.
table listing six major foreign currencies against the U.S. dollar. Plus, you can switch between intraday, 5-day, 1-month, 3-
Because the table is Java, it automatically updates. month, 6-month, and 1-year charts just by mousing over them.
The Foreign Exchange page lists the value of 24 foreign cur- Two-year and 5-year charts are also available.
rencies vs. the U.S. dollar — everything from the euro to the The news page is typical for a financial Web site, although it
Malaysian ringgit. These 24 currencies can also be valued offers some good sorting capabilities.
against the Canadian dollar, the Japanese yen, the euro, the The last five symbols accessed — currencies as well as stocks
British pound, and the Australian and New Zealand dollars. — are saved on the home page under the “Your Recently
The Currency Converter page shows crossrates for major Queried Symbols” table.
currency pairs and also has a currency converter tool at the bot- AlphaTrade FN won’t be much help to very active, intraday
tom. traders. Much of the data is delayed, and even with the auto-
The Market Movers page allows you to filter stocks by daily matic updating, prices don’t change fast enough to be helpful.
percent gain/loss, dollar gain/loss, volume actives, and traded However, for those looking for an alternative to the overload of
value on a handful of exchanges. This is pretty standard stuff, information presented by some financial sites, AlphaTrade FN
but AlphaTrade FN has this data for up to four previous days, might be a good choice. Ý

14 www.activetradermag.com • March 2006 • ACTIVE TRADER

 TRADING Strategies

MEDIANS ON THE MOVE

Most traders are familiar with moving averages, but they probably don’t know the
median calculation creates a much more efficient tool for shorter-term traders.

FIGURE 1 PRICE SIMULATION

A “moving median” will often lag price a bit more than a moving average of
the same length, but as soon as the market starts to consolidate, the median
BY THOMAS STRIDSMAN price will quickly move closer to price.

M oving averages are often

used to isolate trends,
but they are also some-
times used to identify
support and resistance. The basic argu-
ment for using moving averages to
define trends goes something like this:
By smoothing out the price moves of a
certain cycle length, you avoid acting on
market moves that are merely short-
term overreactions to exogenous signals
(surprising news and other market
shocks) and not a part of the normal
market activity within the cycle you’re
attempting to isolate.
In theory, this would mean that while
price reflects all exogenous signals and
general market noise, a moving average form a perfectly straight, horizontal line cycle. However, because any moving
of price will only reflect the moves of the through the price wave; it would pull average lags price action relative to the
market cycle of the next higher degree. higher or lower only if an even longer length of the average (i.e., the longer the
For example, picture a market oscillat- price cycle was “running underneath” average, the more it lags price), price
ing in a perfect wave with all the tops the 200-day cycle. will change direction before the average
and bottoms occurring at the same Thus, if you use a 200-day moving does, and at some point price will have
respective prices and 200 days from bot- average you are essentially trying to to cross above or below the average in
tom to bottom and top to top. In this smooth out the effects of a 200-day price question.
case, a 200-day moving average would cycle to highlight a longer-term market If a particular average has some sig-

ACTIVE TRADER • March 2006 • www.activetradermag.com 15

 Code series from lowest to highest. If the data
series has an odd number of values, the
The following system code can be copied at www.activetradermag.com/code.htm:
median is the middle value — the one
that has the same number of smaller val-
Sub AtmMarch (LookBack, DaysInTrade As Integer, LossMult As Double)
ues below it as it has larger values above
'Copyright (C), 2005: Thomas Stridsman
it. If the number of data points is even,
'Created with Traders’ Studio, Version 1.3.4
the median is the average of the two val-
ues closest to the middle. For example,
Dim MyArray As Array
for the series (2, 8, 4, 1, 6, 5, 7), the medi-
Dim Counter, ArraySize, ArrayMidPoint As Integer
an is 5 (1, 2, 4, 5, 6, 7, 8). For the series (2,
Dim MinMove, EP, HC As Double
8, 4, 1, 5, 7), the two middle values are 4
Dim ATR, MyTypical As BarArray(50)
and 5, so median value is (4 + 5)/2, or
4.5.
MinMove = GetActiveMinMove()
When applied to a price series, a
ATR = Average(TrueRange, LookBack, 0)
median of a certain length will often lag
price a bit more than a moving average
ArraySize = LookBack * 2
of the same length, but as soon as the
ReDim(MyArray, ArraySize)
market starts to consolidate at a new
For Counter = 0 To (LookBack - 1) Step 1
level, the median will quickly move clos-
MyArray[Counter * 2 + 0] = Close[Counter]
er to price, as shown in Figure 1. The
MyArray[Counter * 2 + 1] = Close[Counter]
blue line in Figure 1 represents price, the
Next
red lines represent moving averages, and
NumSort(MyArray)
the green lines represent median values.
The solid red and green lines are 10-peri-
ArrayMidPoint = ArraySize / 2
od values, and the dashed lines are 20-
period values. The dotted lines represent
MyTypical = (MyArray[ArrayMidPoint-1] + MyArray[ArrayMidPoint]) / 2
“ideal” 10-period lines, as if the middle
'SUBSTITUTE WITH THIS TO RUN MA SYSTEM: MyTypical = Average(Close, LookBack)
consolidation level never happened.
Another way to interpret the differ-
If Close < MyTypical Then
ences between the median and the aver-
Buy("Buy", 1, MyTypical + MinMove, Stop, Day)
age is the median tends to lag the average
End If
at the beginning of a trend but lead the
average at the end of a trend. Let’s follow
If MarketPosition = +1 Then
the solid red and green lines in Figure 1
EP = GetEntryPrice(0)
to get a feel for what is going on.
HC = Highest(Close, BarsSinceEntry, 0)
When price breaks above 5, both the
ExitLong("XL-L", "Buy", 1, Max(EP, HC) - LossMult * ATR - MinMove, Stop, Day)
moving average and the median are at 4,
If BarsSinceEntry >= DaysInTrade Then
but as price moves higher the average
ExitLong("XL-T", "Buy", 1, 0, Market, Day)
moves with it while the median stays
End If
behind. It does so because even though
End If
new prices are introduced into the total
price data set, there still are enough val-
End Sub
ues remaining from the consolidation
period to keep the median in line with
nificance, a successful price-moving pened half a cycle ago), the moving aver- the consolidation.
average crossover would correspond to a age will seldom be relevant to a consoli- As soon as the second consolidation
significant market sentiment shift, long dation the market currently might be in. starts, it pulls the green median line clos-
term or short term. Similarly, a failed For that role there is a similar but er, past the red moving average line.
crossover would mean sentiment is not much better tool — the median. That this is a result of the consolidation
ready to shift — which is why moving is apparent from the dotted lines that
averages can function as sloping support Using the median instead of the average move independently of the consolida-
and resistance levels that run below or The median and average are close math- tion. In this case, the green line doesn’t
above price. ematical cousins, as they are both cross above the red line until about peri-
However, this also hints at why mov- designed to identify a single representa- od 20, long after the consolidation is
ing averages are not so good at defining tive value out of a group. The difference over. Also, the crossing itself is more of a
traditional horizontal support and resist- is the moving average calculates this work in progress, stretching over several
ance. Because the current moving aver- important value, while the median picks days.
age value will depend on price action it. As soon as the consolidation is over,
that happened one cycle ago (or some- This is how it works: When finding the solid red line once again crosses
times even worse, price data that hap- the median value, you first sort the data above the solid green line, while the

16 www.activetradermag.com • March 2006 • ACTIVE TRADER

green median line lingers around the TABLE 1 MOVING AVERAGE SYSTEM
consolidation area for another several
periods. But as soon as it is clear price For a 12-day look-back period, the median system produced a net profit of
has consolidated just below 25, the $16,500 over 55 trades, and a for-profit factor (gross profit divided by the
median line again jumps ahead of the gross loss) of 1.53.
average line, positioning itself as a great Settings Net profit Trades Win % Avg trade DD PF
support line at the bottom of the consol-
10,10,1.6 17,290 62 0.47 278.87 -6,280 1.46
idation area. The way the median line
functions as support or resistance is 11,10,1.6 19,470 59 0.49 330.00 -5,100 1.58
helpful for traders who like to identify 12,10,1.6 16,460 55 0.49 299.27 -5,230 1.53
and trade typically horizontal support 13,10,1.6 12,820 54 0.46 237.41 -7,700 1.38
and resistance areas.
To understand why, look again at the 14,10,1.6 20,080 54 0.50 371.85 -7,110 1.66
median line during the initial consolida- 15,10,1.6 19,680 49 0.55 401.63 -4,410 1.76
tion period. After price breaks out of the 16,10,1.6 17,990 46 0.54 391.09 -4,490 1.73
consolidation area, notice how the medi-
17,10,1.6 22,360 46 0.57 486.09 -4,630 1.94
an line remains at 5 for several periods.
Had price turned around and moved 18,10,1.6 27,830 43 0.60 647.21 -4,440 2.46
back down again, the green median line 19,10,1.6 19,930 42 0.60 474.52 -4,690 1.95
would have identified the top of the lat- 20,10,1.6 21,830 43 0.60 507.67 -5,060 2.02
est support-resistance area perfectly
Average 19,613 50 0.53 402.33 -5,376 1.77
while the red average line would have
missed it completely.
A trader might have entered a short
position on the cross back below the
TABLE 2 MEDIAN SYSTEM
moving average, unaware of the signifi-
cant support just below. Granted, in this For a 12-day look-back period, the median system produced a net profit of
case the support was obvious, but that $28,500 over 59 trades and a profit factor of 2.00.
isn’t always the case in real trading.
Another example is a trader who goes Settings Net profit Trades Win % Avg trade DD PF
long on the break above 5 then trails the
10,10,1.6 21,710 65 0.48 334.00 -5,650 1.60
position with a stop close to the average
line, again unaware the median line bet- 11,10,1.6 22,090 61 0.48 362.13 -5,470 1.65
ter represents the levels likely to be 12,10,1.6 28,520 59 0.49 483.39 -4,620 2.00
retested. 13,10,1.6 21,830 52 0.48 419.81 -4,690 1.82
At the second consolidation, notice
how the median line first places itself at 14,10,1.6 16,940 53 0.47 319.62 -5,880 1.54
the bottom of the consolidation, then 15,10,1.6 15,840 50 0.48 316.80 -5,940 1.57
jumps a bit higher to reflect the top part 16,10,1.6 20,170 54 0.52 373.52 -5,870 1.64
of the same consolidation area as price
17,10,1.6 31,350 47 0.60 667.02 -3,780 2.61
moves higher. Finally, it forms as a sup-
port line at the bottom of the last consol- 18,10,1.6 33,910 46 0.63 737.17 -4,390 2.83
idation. How long it remains at the top 19,10,1.6 28,950 43 0.63 673.26 -3,760 2.58
or bottom of the most recent support 20,10,1.6 24,330 46 0.59 528.91 -3,980 2.04
depends on how long that support lasts
Average 24,149 52 0.53 474.15 -4,912 1.99
relative to how many periods of data go
into the median value calculation.

Advantage, median December 2005. od. The green line is the median and the
What is clear from this analysis is how Tables 1 and 2 show the results from a red line is the average. Notice how the
much better a “moving median” is than few different look-back periods for both green median line fluctuates around the
a moving average at identifying and indicators, using a maximum holding red average line (which is a little
staying with the most recent significant period of 10 days and a trailing stop run- smoother).
price levels — something of utmost ning 1.6 average true ranges (ATR, see The two lines don’t look much differ-
importance for short-term traders, who “Key Concepts,” p. 89) below the most ent, but the difference in trading per-
often rely heavily on such levels. To illus- recent highest close. One contract was formance is quite significant. Tables 1
trate, let’s see how a system using both traded in both cases, with one tick slip- and 2 show the median-based system
these techniques fared in a simple histor- page deducted for each entry and exit. did much better (overall and for most
ical back test on the Russell 2000 E-Mini Figure 2 is a price chart with both lines individual settings) than its moving
contract (ER2) from February 2002 to marked, using a 20-day look-back peri- average based cousin. For example,

ACTIVE TRADER • March 2006 • www.activetradermag.com 17

 FIGURE 2 MOVING MEDIAN VS. MOVING AVERAGE LINES

The 20-day moving median (green) and moving average (red) lines are shown with price. Although the difference in
appearance between the two lines doesn't look like much, the difference in trading performance is quite significant.

Source: TradeStation

using a 12-day look-back period, the firms the idea that it is helpful to high- And for those of you who wondered,
median system produced a net profit of light the many cycles at work in a market. the median calculation was used in the
$28,500 over 59 trades and a profit factor In this case, though, we aren’t isolat- system in the article “System-testing
(gross profit divided by the gross loss) of ing the effects of one cycle, but the redundancy” (Active Trader, February
2.0. Meanwhile, the corresponding num- effects from two intersecting cycles. The 2006). The only difference between the
bers for the average system are $16,500 fact the moving-average system (which one used here and the one in last
over 55 trades, and a profit factor of 1.53. is better at following trends and cycles) month’s article is the parameter settings.
did better than the median system
A note on cycles (which is better at isolating cycle tops Trading, median rare
The red and green numbers in Tables 1 and bottoms, or consolidation areas) at The analysis shown here indicates that
and 2 show the times the average system exactly half the distance between these more often than not an intermediate-
performed better than the median sys- two known cycle lengths suggests the term trader is better off using a median
tem, which were look-back periods of 14 possibility of developing a system that indicator to identify important support
to 16 days. tries to capitalize on the times the short- and resistance levels; the good old mov-
This is very interesting, because previ- er and longer cycles intersect in some ing average is better for isolating trends,
ous research indicated there is a natural way. The average-based system could but of less use in identifying actual entry
9- to 10-day stock market cycle, and then, perhaps, be fused with a median and exit points. Ý
another one of approximately twice that system focusing on the 10- or 20-day
length — about 18 to 20 days. This con- consolidation areas. For information on the author see p. 3.

18 www.activetradermag.com • March 2006 • ACTIVE TRADER

 TRADING Strategies

STICKING TO THE PLAN:

Pattern trade case study
Leaving profits on the table can sting, but deviating from your trading plan
could cost you much more in losses later on.

BY THOMAS N. BULKOWSKI Strategy Snapshot

W
Strategy: Pattern breakout
Setup/ A reversal chart pattern near the yearly low.
hat do you do when
conditions: The general market should be moving up or predicted to do so.
price reaches its target in
Indicators are bullish or showing bullish divergence.
just days instead of the
Be wary of overhead resistance, especially when established by
expected weeks or
down-sloping trendlines.
months? Do you sell immediately to har-
vest those gains or hold on to try to cap- Entry: Buy near the confirmation (breakout) price.
ture even larger profits? That’s the Stops: Place an initial stop below the chart pattern low, unless the stop is
dilemma this trade presented. too far away from the entry price; avoid “round number” stop
Figure 1 shows a chart of Ameritrade levels.
(AMTD) — the typical blank canvas Raise the stop as price rises, placing the stop a few cents below
every trader faces. Finding patterns the prior minor low. Adjust accordingly if it’s too close or too far
worth trading is the first step in locating away.
a profitable trade setup. Look over the Note: An initial stop with a potential loss of 10 percent is reasonable,
chart and identify as many chart patterns but it can be higher for volatile stocks priced below $20.
as you can. In this chart I found ascend-
Exit: For short-term trades, when price hits the target, sell.
ing and symmetrical triangles, a triple
For long-term trades, raise the stop as price rises, eventually
bottom, and a head-and-shoulders bot-
closing out the trade.
tom, among others.
Figure 2 shows these pat-
FIGURE 1 BLANK CANVAS
terns. On the left is a large
symmetrical triangle with a The trade process begins by searching for tradable chart patterns. There are several
downward breakout. Price represented in this chart.
pulls back into the pattern
before the downtr end
resumes. The triangle apex is a
common support or resistance
zone, as are the pattern’s
trendlines extended into the
future. At the bottom of the
July 2004 decline, a head-and-
shoulders bottom forms. The
price levels of the two shoul-
ders are uneven but they are
symmetrically spaced on
either side of the head. The for-
mation highlights a strong
(albeit large) support zone, one
that will help form a base for
the triple bottom in April 2005.
The head-and-shoulders
bottom reversal was followed
by a descending triangle. My
analysis showed that 64 per- Source: Proprietary software (Thomas Bulkowski)

ACTIVE TRADER • March 2006 • www.activetradermag.com 19

 FIGURE 2 PATTERNS EMERGE
In this case, the trade was triggered by a breakout above the (green) trendline connecting
cent of descending triangles
the price peaks between the second and third troughs of a triple bottom pattern that
break out downwar d,
formed near the yearly low. This was an early entry signal. The red trendline denotes
although this one did not:
overhead resistance.
Price climbed and
approached the overhead
resistance established by the
symmetrical triangle before
heading down to form the
triple bottom.

The notebook and

the indicators
I log each trade I make in a
computerized notebook. For
the buy side, the notebook
contains the date, trade time,
fill, stop-loss, target, predicted
market direction, and reason
for the trade.
I have recently changed the
list because I found myself
making trades without run-
ning through a complete
checklist — which is like land- Source: Proprietary software (Thomas Bulkowski)
ing a jet without putting the
wheels down. Now the note-
book forces me to check my favorite indi- FIGURE 3 THE INDICATOR PICTURE
cators, such as the commodity channel The CCI, RSI, and Bollinger Bands all provided at least some indication an up
index (CCI), relative strength index (RSI), move was possible.
Bollinger Bands, the performance of other
stocks in the industry, and support and
resistance zones. (For more information on
the CCI, RSI, and Bollinger Bands, see
“Key Concepts”.)
When I consult an indicator, it’s usual-
ly to check for divergences (when price
moves one direction and the indicator
moves the other). Both the CCI and RSI
are good at highlighting divergences, but
these indicators also can diverge for
months without a price reaction.
The CCI did issue a crossover buy sig-
nal (the 20-day CCI crossed above a five-
day exponential moving average of the
CCI line) on May 4 (the day before the
trade) and confirmed it by rising above
the zero line the next day (Figure 3). The
indicator showed bearish divergence
between the middle and last bottoms of
the triple bottom (a higher price low
complemented by a lower indicator
low), suggesting the coming price move Source: TradeStation
might be downward.
The 16-day RSI was oversold at the Bollinger Bands can help determine er volatility and a potentially brisk price
first bottom of the triple bottom and turning points. When price approaches a move ahead.
moved into the neutral zone thereafter. band, it tends to bounce off it and return to
The RSI made a bullish divergence the prior band — especially if the band is The upside
between the first and third bottoms in horizontal at the impact point. The 20-day The next step is to look for overhead
the pattern. Such contradictions are one Bollinger Bands went horizontal at the resistance (a target price) and underlying
reason I place the most emphasis on one third bottom of the triple bottom and the support (a stop price). I ignore arbitrary
“indicator” — price. bands narrowed slightly, suggesting high- risk-reward ratios because the reward

20 www.activetradermag.com • March 2006 • ACTIVE TRADER

 FIGURE 4 TIME TO SELL
After the buy, the stock gapped upward on a merger
often exceeds any target I set, and the trade’s direction, the rumor. The position was exited with a 25-percent profit (in
risk of a loss diminishes as I raise the stop can quickly be three days) after price touched the target level intraday.
stop. Abandoning a trade because the raised to narrow the
reward seems minimal is like focusing potential loss to less
on profits. When I do that, I tend to close than 10 percent.
out a trade sooner than I should because The S&P 500 index
I want to protect profit. Instead, when made a low in mid-
long, I search for clues the uptrend is April 2005 and a
ending. higher low about two
For the target price of a chart-pattern weeks later, coincid-
trade triggered by a breakout near the ing with the last bot-
yearly low, I scour the chart looking for tom of the triplet in
overhead resistance. It’s vital to know AMTD. A higher low
how far price is going to move. My note- suggests the begin-
book entry in this case discussed two ning of a new trend.
resistance zones. The first was at 14 — the My guess was that
approximate level of the November 2004 the index would con-
peak. Price often stalls at old highs, form- tinue upward and
ing double and triple tops. Although help the stock climb.
price might stall at such levels, in a bull A traditional buy
market it’s rare that price reverses trend signal appears when
at an old high. A study of twin peaks price closes above the
showed that price resumed the uptrend highest peak in the
65 percent of the time without closing pattern. A quicker Source: Proprietary software (Thomas Bulkowski)
below the lowest low
between the twin peaks first FIGURE 5 INVERTED DEAD-CAT BOUNCE?
— that is, without confirm-
ing a double top. Although the stock seemed to be setting up an iDCB and potential decline, price continued
The second resistance to move higher after the rumor of an intended buyout turned out to be fact.
zone I mentioned in my
notebook appears as a red
line in Figure 2. It’s a trend-
line drawn across two peaks
and extended downward.
On numerous occasions, I
have seen price climb to such
a trendline and then reverse.
I’ve avoided many losing
trades because of overhead
resistance setup by a down-
sloping trendline.

The downside
What about a stop price?
Below the lowest low of a
triple bottom is always a good
location for a stop. If it does
drop that far, there’s a good
chance it will keep going
down. Source: Proprietary software (Thomas Bulkowski)
Unfortunately, a stop
below the lowest low in the believed a closer stop would help if price
pattern can also represent a substantial entry is to trade it when price climbs collapsed; otherwise, the loss would
loss. In this case, however, the potential above a down-sloping trendline connect- have been 11 percent (green line) or 13
loss was just 8 percent. For an initial stop ing the peaks between the bottoms, percent for the traditional entry (above
setting on a low-priced stock like this shown as a green line in Figure 2. I decid- the highest peak). Other stocks in the
one, I consider anything less than 15 per- ed to buy even earlier, on the last day industry were mixed. Many were trend-
cent acceptable, and any loss less than 10 (May 5) on the chart. Buying before con- ing down in straight-line runs, but sever-
percent is good. If the analysis is correct firmation is not something I recommend, al had bounced, making higher lows and
and the market winds are pushing in the but I had my doubts about this trade. I showing signs of turning upward.

ACTIVE TRADER • March 2006 • www.activetradermag.com 21

 The iDCB pattern

The position
I got filled at 10.78, about mid-range for
T he “dead-cat bounce” refers to a type of price behavior that sometimes
occurs when disaster strikes a market. For example, if a company
announces worse-than-expected earnings, the stock often tumbles,
bounces higher, and then eases back down, making new lows over the coming
months. Other dead-cat bounces often follow on a quarterly basis as the com-
the day and slightly above the 10.74
close. I placed the stop at 9.89, an odd- pany announces additional earnings surprises.
number price, to avoid round-number The inverted dead-cat bounce (iDCB) is simply the price action that can occur
support where many other traders place when unexpected good news “strikes”: Price rises after the news and then
their stops, and two cents below the declines, sometimes giving back all or more of the gain.
lowest valley in the triple bottom. The However, the typical price action in these cases is not a true inversion of a
target price was 14. dead-cat bounce because the stock usually continues lower instead of turning
Figure 4 shows the stock made a back up. In an inverted dead-cat bounce, price jumps at least 5 percent in one
wide-range bar the day after the entry day, peaks within a day or two, and then tumbles.
on an unsubstantiated rumor of a merg- For more information on these patterns, see “Trading disaster: The dead-cat
er between Ameritrade and E-Trade. bounce” (Active Trader, May 2004, p. 44) and “The inverted dead-cat bounce,”
Both stocks closed higher. The next trad- Active Trader, January 2005, p. 32).
ing day, May 9, news appeared that E-
Trade had informed Ameritrade of a Additional reading
takeover bid. That sent price gapping
Books by Thomas Bulkowski:
upward. I usually ignore the market
until after the close, but not this time. I Encyclopedia of Chart Patterns, Second Edition (John Wiley & Sons, 2006)
worried about the stock forming a pat- Getting Started in Chart Patterns (John Wiley & Sons, 2005)
tern called an inverted dead-cat bounce,
Trading Classic Chart Patterns (John Wiley & Sons, 2002)
or iDCB. Essentially, this meant there
was the potential for the stock to turn
Active Trader articles by Thomas Bulkowski:
down after a big up move and keep
dropping (see “The iDCB pattern”). “Breakout trade case study” January 2006, p. 32
With the stock up intraday 25 percent, “Chart pattern review: Tops, bottoms, and flags” October 2005, p. 22
it qualified as an iDCB, so selling the day
“Chart pattern review: BARRs, cups, and diamonds” September 2005, p. 34
after the large price move seemed to be
appropriate. Price had hit the $14 price “Chart pattern review: Broadening patterns” August 2005, p. 40
target exactly intraday and then backed “Throwbacks and pullbacks” July 2005, p. 46
down to $13.50. I sold at that price and
made 25 percent in just three days. “The Big W pattern” April 2005, p. 28
What happened after that? Figure 5 “The inverted dead-cat bounce” January 2005, p. 32
shows that price pushed higher as the
“High, Tight Flag: Helps squeeze out profits” December 2004, p. 34
rumors turned out to be true (E-Trade
did make a bid, but the companies never “Trading ‘busted’ patterns” November 2004, p. 42
merged). The stock recently peaked at “Half-staff patterns: Profiting from flags and pennants” September 2004, p. 48
over 22.
“Three falling peaks: Bearish trend change pattern” August 2004, p. 32
Lessons “Chart Patterns: Does size matter?”June 2004, p. 44
Does the missed profit opportunity “Trading disaster: The dead-cat bounce” May 2004, p. 44
bother me? Sure. But I take comfort from
having followed the trading plan. “Broadening patterns: Clues to breakout direction” April 2004, p. 36
Deviating from a plan can create trad- “Technicals meet fundamentals in the earnings flag” February 2004, p. 30
ing problems. Imagine if I decided to
“A different breed of scallop”January 2004, p. 32
hold onto the stock. The next time a sim-
ilar situation developed I would be “The three rising valleys pattern” December 2003, p. 28
reluctant to sell, which might result in “Pipe bottom reversals” November 2003, p. 28
giving back a large profit. If I didn’t stop
“Grabbing the bull by the horns” September 2003, p. 46
that pattern of behavior, I would have
trouble selling any position, and then I “Head-and-shoulders bottoms:
would become gun shy about placing a More than meets the eye” August 2003, p. 32
trade, which would result in delayed
“Tom Bulkowski’s scientific approach” September 2002, p. 32
entries and larger losses. Besides, you
never go broke taking a profit, especial- Note: A special collection of past Tom Bulkowski articles will be available at a
ly 25 percent in three days.Ý 50-percent discount from Feb. 6-28 through the Active Trader Store.
You can purchase and download past Active Trader articles at
For information on the author see p. 3.
www.activetradermag.com/purchase_articles.htm.

22 www.activetradermag.com • March 2006 • ACTIVE TRADER

 ADVANCED Concepts

THE HIDDEN FACTOR

in treasury futures pricing
Those looking for insights into the treasury market should analyze the
interesting relationships between the cash and futures market, as well as
interest rate movements.
TABLE 1 DATA FOR CALCULATING FUTURES INVOICE PRICES
BY KEITH SCHAP
Security Price decimal Conversion factor

F
TYMS 112.046875
ar too many traders seem confused about 4.875 of Feb. 12 105.328125 0.9402
the origin of Treasury futures prices and 4 of Feb. 15 99.015625 0.8568
the behavior of these prices when yields
are in flux. Day counts Days
The first sign of this confusion often is a call to Coupon period Feb. 15 to Aug. 15, 2005 181
a broker or exchange economist asking what the Since last coupon period Feb. 15 to June 20, 2005 125
yield of the futures is. When told Treasury futures
don’t have a yield, these callers likely ask how the
10-year T-note futures price will respond if the 10- April 2005, 12 cash T-notes were eligible for delivery into the
year Treasury yield goes up or down 40 basis points (bps). June futures contract (TYM5), but assume there were only two
There is no simple answer to this question. But the confusion issues available — the 4.875-percent note maturing in
can be cleared to a degree. First, the yield quote these callers February 2012 (more simply, the “4.875 of Feb. 12”) and the 4
cite is invariably that of the most recently issued, or “on the of Feb. 15. On April 4, the 4.875 of Feb. 12 priced at 103-162
run” (OTR), T-note. The futures contract, however, tracks the (103.50625) to yield 4.279 percent. The 4 of Feb. 15 priced at 96-
“cheapest to deliver” (CTD) security, which is almost never the 136 (96.4250) to yield 4.45 percent.
OTR. Second, the futures price derives not from the CTD spot Based on the quoted prices, the 4 of Feb. 15 looks cheaper. In
price (i.e., the price for immediate delivery) but from the for - fact, the 4.875 of Feb. 12 was the highest priced issue of all
ward price of the CTD T-note. those eligible for delivery, yet this was the CTD issue.
Fortunately, most traders have no need to work through the This isn’t as strange as it appears. At delivery, the long must
determination of CTD and the forward price. This is a little like pay the short the “futures invoice price,” which is the futures
not having to know how to build a watch to tell time. Still, it price times the “conversion factor” of the note being delivered,
can be helpful to walk through the process once to gain an plus the coupon interest accrued since the last coupon payment:
understanding of what goes into the derivation of a Treasury
futures price. Invoice price = (futures price * conversion factor) + accrued
interest.
Identifying the cheapness in cheapest to deliver
Technically, the 10-year T-note futures contract binds the Conversion factors are the prices of each note repriced to
futures buyer to take delivery of a cash T-note from the futures yield 6 percent. This more or less calibrates the very different
seller during the specified contract month. The most important issues to make them more nearly interchangeable. The CBOT
aspect of the delivery process is the short seller has all the Web site offers an excellent discussion, as well as a listing of
choices. The short decides which of the eligible securities to current conversion factors for all maturities.
deliver and when in the delivery month to make delivery. The When the yield curve slopes upward (where the longer the
long must pay for whichever security the short wants to sell maturity, the higher the yield), it makes sense to make delivery
whenever in the delivery month the short decides to deliver. as late in the delivery month as possible. Your cost of financing
With regard to the June 2005 delivery month, the futures is less than the interest you accrue while holding the security.
seller theoretically could have delivered any of 12 Treasury Assume, however, a short chose to make delivery on June 20,
securities. In practice, the seller will deliver the security that 2005, and had to choose between the 4.875 of Feb. 12 and the 4
makes the most economic sense — for the short — to deliver. of Feb. 15. Table 1 sets forth the data needed to calculate the
This will be the CTD T-note. futures invoice prices for these two T-notes. This is the price
To underscore, “cheap” in the phrase “cheapest to deliver” the long must pay the short at delivery.
doesn’t mean lowest price, and this has caused many a stum- The first step in calculating the futures invoice prices is to
ble in people’s thinking about Treasury futures. find the adjusted futures prices for each cash security (futures
Consider the June 2005 10-year T-note contract. As of early price * conversion factor):

ACTIVE TRADER • March 2006 • www.activetradermag.com 23

 Repo rates — Financing the futures invoice prices. Table 2 lays out the details.
the fixed-income markets The contrast becomes even more striking when you consid-
er what would happen in either case at delivery. Multiplying

T
the full prices and the futures invoice prices by 1,000 produces
the dollar equivalent value of $100,000 par of each security.
he “repo rate” is the financing rate used in the Table 3 uses the relevant dollar values to show the results from
fixed-income markets. Repo is short for “repur- delivering either of these cash T-notes. Clearly, it is advanta-
chase agreement.” In a repo transaction, one geous for the short to deliver the 4.875 of Feb. 12. To deliver the
party buys a T-note (or other security) with the under- 4 of Feb. 15 results in a $3,013.87 loss for every $100,000 par
standing the other party will buy it back for an agreed- delivered. At the level of $10 million par, this is a $301,387 loss.
upon price. The term of these transactions is usually Thus delivery of the 4.875 of Feb. 12, which essentially breaks
overnight, but it can be longer. Any repo rate for a term even, is the better action. This is the sense in which the 4.875 of
longer than overnight is called “term repo.” Feb. 12 is cheapest to deliver.
Despite the language of buying and selling, a repur-
chase agreement is essentially a loan. The party striving Searching for the CTD forward price
to acquire the security in question is loaning the value of A Treasury futures price is a forward price—a price today for
the security to the security holder. The repo rate is the delivery at a future date. Given an upward sloping yield curve,
cost of credit for this transaction. delivery will typically take place at the last possible moment.
When those who want a security try to pry it out of the Relative to TYM5, this will be the last business day of June
hands of reluctant sellers, the security “goes on special.” (Thursday, June 30, 2005). Thus, the TYM5 price is a forward
This means the demanders bid the repo rate lower and price based on the assumption of a June 30 delivery of the CTD
cash T-note.
lower until at least some security holders decide to part
During the spring of 2005, the June 10-year Treasury note
with some of their holdings. The 2 percent repo rate of
futures contract was derived from the 4.875 of Feb. 12, which
May 20 indicates a fair degree of specialty, especially
was CTD during the three months prior to delivery. To find the
given the recent increase in general repo to 2.85 percent. futures fair value price, you need to find the forward price of
But the 0.35 percent repo rate of May 27 suggests the the CTD issue and divide the forward clean price (the quoted
futures shorts were getting desperate. After all, at 2.85 price without accrued interest) by the conversion factor of the
percent, the holder of $10 million par of the 4.875 of Feb. CTD T-note (0.9402).
12 could have borrowed $10.73 million for $849 daily A fixed-income forward price is the spot price (the price for
interest. At 0.35 percent, the borrowing cost for that immediate delivery) minus carry. Carry, in turn, is the differ-
amount drops to $104 daily. When the borrower can turn ence between the coupon, or interest, income earned for a
around and earn something close to the 3 percent fed given period and the cost of financing the security for that
funds rate, this is strong incentive to turn loose some period at the relevant repo rate.
inventory. Fixed-income securities pay interest twice a year. For exam-
ple, the 4.875 of Feb. 12 pays coupon interest on Feb. 15 and
Aug. 15 every year. Further, the seller of any fixed-income
security is entitled to the interest earned from the last coupon
futures price * conversion factor = adjusted futures price payment to the day of the sale. This accrued interest is added
112.046875 * 0.9402 = 105.346472 to the quoted price, or clean price, of the T-note to arrive at the
112.046875 * 0.8568 = 96.001763 “full price” of the note. In 2005, the Feb. 15 to Aug. 15 interval
amounted to 181 days, so on April 4, 2005, an owner of this
The second step is to determine how much accrued interest security would have earned $0.013467 per day for every $100
must be added to the adjusted futures price, using this formula: par of the security held (4.875/2 * 1/181 = 2.4375 * 0.005525 =
0.013467). This is the daily coupon.
coupon days since last coupon payment The daily financing calculation is slightly more complicated
Accrued interest = ———— * ———————————— but still nothing more than basic arithmetic. The formula for
2 days in coupon period daily financing is:

4.875 125 Daily financing = (spot price + accrued interest) * repo/100

1.6833375 = ———- * ——- * 1/360
2 181
On April 1, the spot price of the 4.875 of Feb. 12 was
4 125 103.50625 (103-162 in points and 32nds), and the accrued inter-
1.3812 = — * ——- est was the daily coupon for the 45 days from Feb. 15 to April
2 181 1, or 0.6060082. The relevant repo rate was 2.55 percent, so
daily financing was 0.007375 ([103.5063 + 0.6060082] * 2.55/100
Given all this, the futures invoice price for the 4.875 of Feb. * 1/360). (Note that repo rates are money-market rates and, by
12 turns out to be 107.0298095 (105.346472 + 1.6833375), or convention, the money-market year has 360 days.)
approximately 107-01 in points and 32nds. The futures invoice Given these two calculations, daily carry was 0.009861
price for the 4 of Feb. 15 turns out to be 97.382963 (96.001763 + (0.013467 daily coupon - 0.007375 daily financing) for each
1.3812), or approximately 97-12. Based on these numbers, the 4 $100 par of the security. There were 87 days to delivery (April
of Feb. 15 still looks cheaper. 1 to June 30 is 90 days, but the quote is for the next business
But suppose the short had to buy either cash security in the day which, because April 1 was a Friday, bumps the day count
spot market to deliver it. The price for a cash T-note is the quot- to 87), so the total carry for the period was 0.530024, or 16.96
ed spot price plus the same accrued interest used in calculating 32nds (0.006092233 * 87). Based on this, the forward price of the

24 www.activetradermag.com • March 2006 • ACTIVE TRADER

 TABLE 2 COMPARING JUNE 20, 2005, QUOTED, FULL,
AND FUTURES INVOICE PRICES
4.875 of Feb. 12 is the 103.50625 spot price The price for a cash T-note is the quoted spot price plus the accrued interest
minus 0.530024 carry, or 102.9762258.
used in calculating the futures invoice prices.
This divided by the 0.9402 June conver-
sion factor yields a futures price of Security Quoted price Accrued Full Futures
109.525873, or 109-168. (decimal) interest price invoice price
Consider what will happen to the 4.875 of Feb. 12 105.328125 1.683375 107.0114625 107.0298095
futures price if, after another week, the 4 of Feb. 15 99.015625 1.381200 100.3968250 97.3829630
yield of the CTD changes but the repo rate
doesn’t change. On April 8, the CTD yield
had risen from 4.279 to 4.314 percent, and TABLE 3 DETERMINING WHICH T-NOTE TO DELIVER
the term repo rate remained at 2.55 percent.
Rising yields should mean lower fixed- It is better for the short to deliver the 4.875 of Feb. 12 rather than the 4 of
income prices, and the CTD price dropped Feb. 15.
from 103-162 to 103-092 (a 7/32 drop) while Security You must pay To receive Invoice less
the TYM5 fair value price dropped from (full price) (futures invoice) full price
109-166 to 109-108 (a 5.8/32 drop). 4.875 of Feb. 12 $107,011.46 $107,029.81 $18.35
Suppose the repo rate had not 4 of Feb. 15 $100,396.83 $97,382.96 -$3,013.87
remained the same but had risen to 3.05
percent, a 50 bp increase. Assuming the
other pricing data remained the same, TABLE 4 COMPARING REPO, FED FUNDS, YIELDS, AND PRICES
this repo shift would have resulted in a
110-066 futures fair value. The futures When the price changes seem to part company in a major way, as was the
price would have risen when the yield case between May 20 and 27, there can be a pronounced change in term repo.
change led you to expect a price decrease. This is a much more important pricing factor than most traders realize.
This is a hypothetical example, but sever-
al similar repo shifts in recent years have Term General Fed funds CTD OTR TYM5 CTD cash
caused futures prices to move with yields repo repo target yield yield fair value price
rather than in the opposite direction. This 4/1/05 2.55 2.70 2.75 4.279 4.450 109-166 103-162
underscores the importance of not over- 4/8/05 2.55 2.70 2.75 4.314 4.488 109-106 103-092
looking the effect of repo rate changes in 4/15/05 2.55 2.70 2.75 4.075 4.271 110-292 104-230
the pricing of Treasury futures. 4/22/05 2.55 2.85 2.75 4.062 4.252 111-010 104-252
Further, based on these few examples, 4/29/05 2.50 2.85 2.75 4.011 4.201 111-125 105-026
you can draw some conclusions about 5/6/05 2.50 2.85 3.00 4.070 4.259 111-012 104-230
how a change in the repo rate will affect 5/13/05 1.85 2.85 3.00 3.937 4.120 111-266 105-162
the futures price. An increase in the repo 5/20/05 2.00 2.85 3.00 3.930 4.126 111-302 105-172
rate will increase daily financing and 5/27/05 0.35 2.85 3.00 3.861 4.073 112-090 105-300
lower daily carry (remember that daily
coupon will not change). Lower carry
results in a higher forward price relative to a given spot price, and CTD prices seldom change exactly the same amount given
and a higher forward price results in a higher futures price. any yield change. But when the price changes seem to part
Leaving out all the interior steps, a higher repo rate results in a company in a major way, as between May 20 and 27, look for a
higher futures price. Conversely, a lower repo rate, which will pronounced change in term repo. This proves to be a much
increase carry, will lower the futures’ fair value price. more important pricing factor than most traders realize.
Late May 2005 provided an example of what can happen
when repo rates drop precipitously. On May 20, the 4.875 of Where to look when treasury futures prices are confusing
Feb. 12 was priced at 105-172 to yield 3.930 percent. Although When one of the Treasury futures markets seems to be behav-
the Fed had raised its Fed funds target to 3 percent on May 3 ing oddly, the first thing to look for is a change in CTD status.
and general repo had risen to 2.85 percent, term repo for the During the run-ups to the four 2005 delivery months, 10-year
4.875 of Feb. 12 had dipped to 2 percent. The interaction of CTD seems to have been relatively stable. However, during
yield, repo rate, and days to futures delivery resulted in a May 2004, 10-year CTD bounced back and forth between the
TYM5 fair value price of 111-303. (Futures actually traded 4.875 of Feb. 12 and the 4.25 of Aug. 13. Such changes can throw
slightly above fair value at 112-015.) off spread relationships and cause other trading anomalies.
A week later, on May 27, the CTD yield had dropped to Several on-line quote services list the deliverable issues for each
3.861. If the repo rate had stayed at 2.00 percent, carry for the Treasury futures contract and indicate CTD status. If you are
30 days remaining to assumed futures delivery would have lacking access to such a source, ask your broker for help.
been 7.21 32nds, and TYM5 fair value would have been 112-14. The next thing to look for is variation in repo rates.
In fact, the repo rate on the 4.875 of Feb. 12 dropped to 0.35 per- Unfortunately, the repo market is relatively opaque to most
cent which made actual carry 11.93 32nds, and TYM5 fair value futures traders, and repo rates, other than general repo, tend
was 112-09, 5/32 lower than it would have been without the not to be readily available. Any time you think repo rates could
precipitous drop in the repo rate. If the hypothetical 112-14 have a significant effect on futures prices, you should contact
price matches normal expectations given a yield change of this your broker. Any broker who doesn’t know where CTD repo is
size, you can see how a large change in the repo rate can throw can find out for you. This is too important a part of trade plan-
off a forecast. ning to shrug off. Ý
Table 4 tracks repo, fed funds, yields, and prices at weekly
intervals during April and May 2005. The futures fair value For information on the author see p. 3

ACTIVE TRADER • March 2006 • www.activetradermag.com 25

 On The MARKET

LINDA RASCHKE’S daily routine

In this excerpt from an interview in the February 2004 issue of Active Trader,
Linda Raschke discusses her trading style and daily market regimen.

BY MARK ETZKORN

“S tick an offer out there at 59.25…wait, just offer

them out at 59.”
Linda Raschke momentarily interrupts her discussion of
trend days in the stock market to put in an order to sell out (at
1,059.00) a long scalp position in the E-Mini S&P futures. It’s
early afternoon and she has spent nearly every minute of the
last seven hours in the same chair, splitting her time between
monitoring charts, posting commentary and trade alerts for
subscribers in her online trading room, and trading.
When her order is in the market, Raschke picks up the con-
versation where she left off. Raschke can talk non-stop about
trading, jumping from topic to topic and using a verbal short- — a popular speaker and author (see “Linda Raschke: Top
hand born of years of immersion in the field. trader keeps it simple,” Active Trader, August 2000, p. 56).
“When you’re scalping, you have to remember the shorter Although she is 23 years into a career that has encompassed
the time frame, the higher the noise level,” she says. “And the everything from floor trading to money management, she does
higher the noise level, the more back-and-fill the market will not appear to be heading into an early retirement. Between her
have and the greater the odds that if you’re trailing a stop, your personal trading, Web site (www.lbrgroup.com), online trad-
stop will be hit. So for scalp trades, I don’t use trailing stops ing rooms, and occasional seminars and conferences, she’s
and I exit in one piece. plugged into the markets virtually around the clock.
“You have to recognize how much edge you’re giving up Although Raschke is known today mostly as a short-term
just by having the bid-ask,” she continues. “You’ll always do futures trader who focuses primarily on the S&P 500 stock
best when you’re scalping if you’re more conscientious about index futures, she is active in several time frames, markets, and
initial trade entry. It’s important to try to buy on the bid and trading styles.
sell on the offer more than 50 percent of the time. That might In early November 2003 I spent a day in Raschke’s trading
mean you buy on the bid when you enter and you exit at the office as she juggled her various responsibilities. Our conver-
market, or vice versa. sations took place when she wasn’t making trades, attending
“On a longer time frame, when the power of the trend or to her online trading rooms, or comparing notes with her staff
momentum is behind you, initial trade location is not nearly as and fellow traders.
critical. You put the trade on because you’re playing for a Even when she’s talking to me, she always seems to have at
longer ride — the most important thing is to not miss that least one eye on what’s happening in the markets. And until
trade. With a trend-following system, for example, maybe 30 she finishes her post-close commentary — more than eight
percent of the trades are really good and you can’t afford to hours after we first sit down — she never leaves her designat-
miss those.” ed seat in the trading room.
Raschke has been a fixture in the trading industry for years

26 www.activetradermag.com • March 2006 • ACTIVE TRADER

A day in the life along with your specific patterns or strategies?
Raschke’s day begins a little before 8 a.m. ET, more than 90 LBR: Yes. One way to find good potential long-side stock can-
minutes before the New York Stock Exchange open. Raschke’s didates, for example, is to identify the up-trending stocks with
home and office are in south Florida’s horse country — an the best relative strength at the beginning of a quarter.
interesting blend of rural casualness and suburban modernity. A better word to describe it might be the stocks that are “best
Most of the homes are less than a dozen years old, but many of bid,” or “most well-bid.” I look at the number of days stocks
the local roads are intentionally unpaved to make them more trade from low to high and how steady their bids are for the
amenable to riding. Miles of crisscrossing white horse fence two-week period. In other words, I want to see only shallow
bracket the multi-acre properties in the area, most of which retracements. So it’s not necessarily the stocks are up the high-
have built-in stables; many, like Raschke’s, also have riding est percentage the first two weeks.
arenas on the grounds. Every quarter the institutions seem to have a theme, and
After saying hello to Raschke’s three horses, we walk there’s an element of crowd behavior — nobody wants to be
around to the office that extends off the back of her house and left behind. So if Abbey Cohen, or whoever the powers that be
flanks a pavilioned swimming pool. The trading room is, like at a particular time, decide drug stocks are in, they all have to
her house, airy with high ceilings and filled with sunlight from own drug stocks in their portfolios because they’re afraid of
windows on three sides. One set of doors opens onto the pool underperforming each other. It’s really blatant.
and patio; the other opens onto the stables and riding grounds The stocks — and I stick to the big-cap stocks in our data-
beyond. base — that are best bid in the first two weeks tend to stay the
Two tiers of computer monitors blanket adjacent walls and a strongest throughout the whole quarter. That group or sector is
large ViewScan atomic clock perches in the corner where the in vogue, so to speak.
walls meet. The trading “desks” are large wooden tables on
which sit phones, a laptop, printers, keyboards, mice (the com- AT: What’s an example of a pattern you use in trading?
puter kind), and occasionally a vocal long-haired cat (the LBR: Here’s an interesting one based on a failed pattern: If
mammal kind). Two dogs, one big and laconic, the other small today has the widest range of the past four days and an up
and energetic, occasionally wander in and out of the room. close, the odds the low of the bar will be taken out in the next
Some semi-tropical greenery decorates different corners of the two days is the least-probable scenario.
room. We came up with a great little system based on that: If you see
There is no TV — no obligatory financial news station dron- a wide-range bar with a lower close or a higher close and the
ing in the background. Early in the morning music is playing, high or low of that bar is taken out within two days, it’s a signal.
but for most of the day the room is filled primarily with the If there was a down-closing wide-range bar and the market
quiet hum of computer drives and air conditioning (it’s early takes out the high of that bar within two days, it’s a buy signal,
November but the temperature still creeps into the low 80s), because that’s the least-probable scenario — it occurs maybe 20
punctuated by bursts of typing, Raschke’s observations about percent of the time. And when the least-probable scenario
trading and the occasional phone call. Overall, the environ- plays out, there’s a very powerful reason why.
ment is about as laid back as you can imagine in trading.
AT: Even though you emphasize the primary role of price
Price behavior, probabilities and market relationships action, you still seem to use indicators in certain roles.
After posting her pre-opening comments in the trading room, LBR: You have to put indicators in context. They’re back-
Raschke talks about her trading principles, her day-to-day ground information — never the primary reason for a trade.
approach to the markets, and the difference between discre- That said, you can use indicators to objectively scan and
tionary and mechanical trading. rank things. I can create a list of the markets or stocks with the
“Everything I do is based on actual chart points,” she says. lowest ADX (average directional movement index — a trend
“I’m always looking at the swing highs or the swing lows. I strength indicator) values on a daily basis, for example.
never calculate Fibonacci numbers, Gann retracements, artifi- Indicators also allow you to see something very quickly (she
cial pivot points, or other things like that because I’ve never pulls up a chart). My eye can see a rally in an oscillator, price
found any edge or any statistical significance from testing resistance at the moving average and a little bear flag. If I just
them. look at a plain bar chart, I can’t put the price action into context
“But I can quantify chart points,” she notes. “I can quantify as fast. Indicators can help you process the information a little
and test something like, ‘If the market made new momentum more quickly.Ý
lows and there’s a reaction up by half an ATR (average true
range; for more information, see “Key Concepts” on p. 88), what are Note: For the complete two-part interview, see “Linda Raschke
the odds the market will trade below that low?’ I can deter- keeps up the pace” and “Trader toolbox” in the February and
mine there’s, say, a 68-percent probability of that happening. March 2004 issues of Active Trader. Linda Raschke will be speaking
at the Traders Expo in New York on Feb. 18 (www.tradersexpo.com).
AT: Do you use any kind of market or stock selection process

ACTIVE TRADER • March 2006 • www.activetradermag.com 27

 Active TRADER Interview

NASSIM NICHOLAS TALEB:

Profiting from market uncertainty
This options trader and
philosopher bets against
the crowd. He explains
why traders continue
to underestimate the role
of randomness in the markets
and how betting on the
possibility of rare events
provides an edge.

BY DAVID BUKEY

N assim Nicholas Taleb has traded options for more

than 20 years, either for major investment banks
or on his own as a fund manager and pit trader —
but he bristles at being labeled a trader.
Taleb describes himself as a philosopher who argues that
traders underestimate the role of randomness, and fund man-
agers’ successful track records might be more easily explained
Taleb first realized that long OTM options can produce
unusual returns after he began trading currency options for
Banque Indosuez in late 1984. When leaders of the G-5 coun-
tries (U.S., Japan, West Germany, France, Britain) agreed to
devalue the U.S. dollar by signing the Plaza Accord on Sept. 22,
1985, he held long OTM options that surged in value, which
caught his bosses off-guard.
by luck than skill or experience. “They said it’s impossible for such a small position to gen-
Unlike many options traders who collect premium from sell- erate so much profit,” Taleb says. “So I learned two things —
ing out-of-the-money (OTM) options, Taleb focuses on buying the market could deliver these crazy events, and people didn’t
far OTM options that have a low probability of making money understand these payoffs.”
but post extraordinary returns if they do. Taleb has spent the past two decades studying the characteris-
Instead of studying how the market did move, Taleb ana- tics of options, but it was his windfall following the 1987 stock
lyzes all the scenarios that might have occurred as well. Wild market crash that put him on the map. His long position in front-
market spikes and crashes are admittedly rare events, but their month eurodollar options gained 67,000 percent as the market
reward is so large it offsets their infrequency. gapped up 370 basis points on Oct. 20, the day after the crash.
“The likelihood is completely irrelevant compared to the Despite this success, Taleb had a love-hate relationship with
payoff,” Taleb says. the markets, so he decided to become a scholar and research

28 www.activetradermag.com • March 2006 • ACTIVE TRADER

the science of uncertainty. In addition to holding top trading deutschemark I didn’t know what to do with them. The posi-
positions at Credit Suisse First Boston, Union Bank of tion was so large, it took me a week to go delta neutral. That
Switzerland, CBIC-Wood Gundy, Bankers Trust, and BNP- was when investment banks did not compensate based on
Paribas, Taleb earned an MBAfrom Wharton and a Ph.D. from income. But I didn’t really care about the money — it was just
the University of Paris. the feeling that I was right.
He also wrote two books: Dynamic Hedging (John Wiley & Here’s one thing you can learn from this: If you owned an
Sons, 1997) and Fooled by Randomness (Textere, 2001). Taleb is option that was 20 standard deviations out of the money —
perhaps best known for Fooled by Randomness, which explains and I had plenty of those — how many cumulative months of
why we’re genetically disposed to misjudging probability. The time decay could you sustain if it moved into the money?
book, now in its third edition, explains the relationship
between luck and the markets with simple, entertaining exam- AT: I don’t know. A few dozen?
ples and describes why market moves are too unpredictable to NNT: I quizzed traders, and they were telling me two or three
analyze with standard statistical techniques. years. But it was 67,000 months of time decay. You get paid
After finishing his Ph.D. in 1998, Taleb founded Empirica, a 67,000 times your bet.
private investment fund, which he actively managed until
2002. He won’t discuss its performance record, although he AT: Is this what you meant in Fooled by Randomness when you
continues to trade options and earned a seven-figure income discussed the importance of asymmetrical bets — that to
from trading last year, according to 2004 tax returns disclosed measure an outcome you need to consider both probability
to Business Week last fall. and the size of the payoff?
Currently, Taleb is a professor in the sciences of uncertainty NNT: Exactly. It means you don’t need the event to happen
at the University of Massachusetts at Amherst and also teaches often for you to be compensated. And you don’t need to be
at NYU and the University of Paris. He spoke with us in early right on the event, because you can bleed for 67,000 months
December about his market experiences, the nature of options, and still be ahead. After the crash, I told management at Credit
the flaws in using the bell curve to price options, and why our Suisse First Boston, “Let me bleed 67,000 months before you
brains have trouble judging probability. question my strategy.”

AT: You mentioned in Fooled by Randomness that the 1987 AT: How did they respond?
stock market crash really made you as a trader. What hap - NNT: They couldn’t quite understand. When I quizzed them,
pened? they said “Well, I’m sure you got 40 to 50 times your payoff.” I
NNT: I was long out-of-the-money OTM options in about any- then realized I no longer had anything to prove. All you need
thing that traded. People were laughing at me. is a 20-sigma (standard deviation) event.
But if you have a 24-sigma event on an option that’s 24 stan-
AT: On both sides of the market? Calls and puts? dard deviations out of the money, your payoff is 750,000 times
NNT: Yes, particularly in financials and currencies — eurodol- your bet, which is what happened in eurodollars. It is totally
lars, the deutschemark, and the Japanese yen. My largest posi- irrelevant whether these events happen every 20 or 50 years.
tion was in the yen because its volatility was tremendously Secondly, the further out of the money an option is, the more
low. I also had a collection of [other long OTM currency complicated it is for the human mind to calculate its properties.
options], like Swiss franc/Australian dollar and Swiss/Kiwi
(New Zealand dollar). AT: So could you conclude that extremely out-of-the-money
In October 1987, I went to a symposium in Philadelphia. The options are undervalued?
market had effectively been dead, particularly the financials NNT: No. I don’t know whether those options are over or
and currencies. I was on stage with five other traders, and they undervalued. But look what can happen if you’re wrong. A
all said this is the death of volatility. Their idea was central single large deviation can make you right, but 750,000 months
banks now run the world. The banks are getting sophisticated of no deviation can’t prove you wrong.
and can force stability just like they can control inflation. After the 1987 crash, I decided that people didn’t quite
There’s no reason to buy an option because the world is mov- understand option payoffs. At that point, I decided to leave
ing into a far better regime of managed movement. So anybody options and become a scholar. But I kept a foot in options out
buying an option was an idiot. of addiction. I specialized in exotic options because they also
These guys depressed me. I thought my life was over, have complicated payoffs.
because we’re not going to have volatility — or at least no large
deviation. Of course, the stock market crashed a few days later AT: What do you mean by exotic options?
and the rest is history. The first thing I noticed [as the market NNT: Binary options — options on more than one instrument
tanked] was stocks didn’t move the most. and either-or scenarios, where you can get either coconut oil or
a Treasury bond. I also took a sabbatical as a pit trader at the
AT: What did? Chicago Mercantile Exchange [beginning in 1992].
NNT: The eurodollar front-month option. Someone was
squeezed and forced to liquidate their position, and it opened AT: What was that experience like?
up 370 basis points the day after the crash (Oct. 20 — see Figure NNT: I suddenly discovered a whole sector of self-employed
1). I had to check the screen to see if it was right. traders. It was nice not trading for a large bank where people
I also had so many out-of-the-money options in the tell you what positions you should have. These traders were

ACTIVE TRADER • March 2006 • www.activetradermag.com 29

 Long butterfly
Market bias: Non-directional. AT: Why is it so much work?
NNT: If you want to place butterflies in
Components: Options with three different strike prices at equidistant 500 securities, it’s a lot of work because
intervals: Buy one each of the highest and lowest strike you have to adjust them dynamically. But
price options and sell two of the middle strike price options. if you want to buy strangles in 500 differ-
ent securities, it’s a no-brainer. (A butter -
Rationale: To benefit from the short options’ decreasing volatility and fly options strategy sells options with strike
accelerating time decay. You can use this strategy if you prices near the current price and buys options
think the underlying market will be at or close to the further away from the money to protect them.
middle strike price at expiration. A long strangle buys options both above and
below the market in hopes that the market
Maximum profit: The premium collected from the two short options plus any will exceed those strike-price thresholds by
remaining value in the long options (occurs when the expiration. See “Long butterflies”.)
underlying market settles at the strike price of the middle If you care about performance, you
options at options expiration). should short at-the-money options,
which expire and have very unstable
Maximum loss: The initial price paid for the spread. deltas. Sometimes they bite you at expi-
ration, so you have to monitor them. The
You can structure a butterfly entirely of puts or calls, or a mixture of both. You amount of labor involved in strategies
choose three strike prices at equidistant intervals and buy one each of the high- that have both long and short options is
est and lowest strike price options and sell two of the middle strike price astronomically higher than just buying
options. The middle, two-option part of the spread is the “body” of the but- options.
terfly, and the upper and lower options are the “wings.”
While the standard long butterfly is most profitable when the market closes AT: So the long out-of-the-money
at the short option’s strikes, Taleb likes to combine this position with long options aren’t as risky because their
extremely OTM options that could produce large gains if the market spikes sig- gamma — delta’s rate of change — isn’t
nificantly up or down. that high?
NNT: Exactly. When they pay off, [the
reward] is huge. But when you’re selling
scalpers, making income around the clock — $500 an hour just options, you need a lot of traders. For
like lawyers. They were their own bosses and didn’t really care example, two or three traders can trade long out-of-the-money
about what others thought. options on 500 instruments, but when you’re using long and
short strategies, two or three traders can only monitor 50 or 60
AT: That appealed to you? positions. We invest in traders who sell at-the-money options,
NNT: I liked it. Before I became a pit trader, I was managing and we concentrate on just buying the “wings” (the out-of-the-
director at UBS and had to wear a tie and go to meetings. In the money puts and calls of the butterfly position).
pit, you’re making moderate income, but you’re in control of
your life. AT: Are your other traders placing butterfly positions or sim -
ply selling ATM options?
AT: If you enjoyed trading in the pits, why did you stop? NNT: I call it a mixed strategy. Some of the traders sell at-the-
NNT: I wasn’t made for the pits. And I specialized in exotic money options and buy the wings (creating a complete butterfly
options, not executing trades. Also, I was in the pit in 1992-93, position), and some just sell these options, while we buy the
when the market had zero volatility, which is bad if you’re buy- wings for them. But you need a lot more that just a butterfly
ing options. It was like watching grass grow. position. I buy butterflies and also buy a lot more wings.

AT: Are the options you buy so far out of the money that you AT: What’s the benefit to this approach?
have to use the over-the-counter market or can you buy them NNT: A butterfly position allows you to wait a lot longer for the
on exchanges? wings to become profitable. In other words, a strategy that
NNT: You can buy them on the exchange. But you may have to involves a butterfly allows you to be far more aggressive [when
wait years for them to pay off while using other strategies. You buying out-of-the-money options].
have to be extremely patient or not care at all about perform- When you short near-the-money options, they bring in a lot
ance. After the 1987 crash, I had the luxury of not caring. If one of cash, so you can afford to spend more on out-of-the-money
event can pay 2,000 years of time decay, you can really afford options. You can do a lot better as a spread trader.
to wait a few years [for another one]. You can make some money in options, but the larger the
deviation, the less we understand. Secondly, it doesn’t mean all
AT: But meanwhile you could sell near-the-money options? out-of-the-money options are priced wrong.
NNT: Yes, but it’s a lot of work. Now I have an economic inter-
est in other traders (through the Empirica fund) that sell near-the- AT: So there’s no way to value extremely out-of-the-money
money options. options?

30 www.activetradermag.com • March 2006 • ACTIVE TRADER

NNT: Right. They’re so far out there, you FIGURE 1 EURODOLLARS AND THE 1987 MARKET CRASH
don’t have enough months in history to
The front-month eurodollar options surged 370 basis points on the day after
figure out [the correct price]. There are
the 1987 crash (Oct. 20) — a 24-standard-deviation move. Taleb owned far
techniques by Professor Benoit
OTM options that paid 67,000 times his bet.
Mandelbrot that seem to be convincing,
though.
When you bet against the tails (i.e.,
selling out-of-the-money options and hoping
large deviations won’t occur), it takes a long
time to be proven wrong. But when
you’re wrong, you lose everything. In
our society, if something doesn’t happen
for awhile, we forget about it. On the
other hand, there’s what I call the “suck-
ers’ volatility” — whenever people have
a plausible reason to buy volatility, don’t
get close to it.

AT: Because it’s too expensive already?

NNT: Let me give you an example. If you
went to JFK airport and offered terrorist
insurance to passengers, you can get
them to pay up to X dollars. But if you
try to sell them general insurance, which
of course includes terrorism, how much
would they pay for it? They would pay Source: TradeStation
less.
AT: What is the Power Laws distribution?
AT: Why? NNT: It’s a different statistical paradigm in which the word
NNT: Because there are some properties of the human brain volatility is not used. Volatility is a concept that is ingrained in
such that the vividness of the terrorist possibility may cause the Gaussian bell shape distribution. In real markets, it doesn’t
you to overpay. You won’t pay on valuation or probability, but mean anything, because they can have very large deviations.
how explainable it is to your brain. You’re likely to pay more The essence of a power laws distribution is that the ratio of
for an option that delivers a given payoff. deviations stays close to a constant. For instance, the number of
We’re not programmed to deal with variables that can take people with wealth higher than $1 billion in relation to those
very large deviations. We tend to not pay at all for things when with $2 billion or more is the same as the number of those with
we don’t have reason to pay for them, but overpay when we wealth higher than $200 million in relation to those with a for-
see a reason. tune of $100 million. The inequality is the same regardless of
wealth. The same applies to market movement.
AT: I inferred from your book that using historical data may If you shoot to minimize daily variations, you may even
be a good idea to generate trade ideas, but it isn’t a good increase your risk. Instead, you want to minimize the number
way to measure risk. Is any historical data worth testing? of losses over 10 percent. If, for example, you’re flying in a
NNT: It is worth analyzing. You cannot ignore past data, but plane, you’re more concerned with the risk of a crash than how
you have to be careful about what you’re interpreting from it. bumpy it may be.
You can’t [use it to determine the probability of rare events]. There are two types of volatility — tail and regular. More of
Large deviations can’t easily be seen from past data. the volatility in the world is explained by a few deviations. Just
The bell-shape distribution is a fraud. For the bell curve, like a small number of movies explain the bulk of movie sales,
much of the deviations are delivered by regular volatility. But a small number of days in the market explain the bulk of its
in the markets, much of the deviations are delivered by the tails volatility. In the real world, a small number of days represent a
(extremely large, infrequent moves). People use the bell curve huge percentage of returns in the S&P.
because it simplifies things and gives the illusion of under-
standing what’s going on. AT: In Fooled by Randomness, you distinguish between ran -
If you use past volatility to predict future volatility, it would domness in the physical world and randomness in the mar -
hardly predict anything. The bell curve does not apply to kets. How is this related?
something that has fat tails. Now, Mandelbrot’s theory of NNT: Take height for example. You have zero probability of
Power Laws distribution is used everywhere except in finance seeing someone in Chicago who is 10 feet tall. A one-million
— in science, in sociology, and on the Internet. (For more details foot tall person isn’t possible, either. But a currency or stock can
about the bell curve and Taleb’s argument, see “Taleb’s critique of the take any value. For example, in Germany in the 20s, the
bell curve”). deutschemark went from four to four trillion. There’s absolute-
ly no friction — nothing can stop it from taking a crazy value.

ACTIVE TRADER • March 2006 • www.activetradermag.com 31

 Taleb’s critique of the bell curve

I
f a set of values is said to have a normal distribution, or negative price movements in many financial instru-
it means the values adhere to the form of the stan- ments. It leaves room for many more big price swings than
dard “bell curve” (Figure A). In a bell-curve distribu- would the bell curve.”
tion, a one-standard-deviation calculation above and In a bell-curve distribution, the number of large devia-
below the mean will contain approximately 68 percent of tions is drastically reduced as values hit their extremes,
all the values in the set. For example, if the average of causing traders to ignore these rare events. For example,
several values is 1.21 and the one standard deviation cal- the probability of a three-standard-deviation event is one
culation is 0.11, 68 percent of the values will be some- in 740, and the probability of a six-standard-deviation
where between 1.10 (1.21 - 0.11) and 1.32 (1.21 +0.11). event is one in 1 billion. However, the ratio between a
(For an explanation of how variance and standard devi- five-standard-deviation move and a 10-standard-deviation
ation are calculated, see “Key Concepts”.) occurrence is much lower than in the first instance (one in
However, Taleb doesn’t believe this approach applies to 3,500,000 vs. one in 130*1021), which means it becomes
financial markets because market prices are arbitrary. much less equal as the curve increases.
While the bell curve may be a valid way to analyze the In contrast, a power law distribution has a constant
height of humans — the majority will be average height ratio, meaning the change in probability between a six-
and the extreme outliers are rare events — in the markets, and 12-standard-deviation event is the same as the ratio
these outliers (crashes and sharp spikes) actually occur between a two-and four-deviation move. For power laws,
more often than the bell-curve distribution shows. When as the numbers get higher, the ratio stays the same.
Taleb is looking for “fat tails,” he’s
betting on the possibility an extraordi- FIGURE A GAUSSIAN BELL CURVE
nary move might occur in that instru-
ment. The Gaussian (or "bell") curve shows the standard deviation of the val -
Rejecting the bell curve has huge ues around the mean. Taleb argues that financial markets are too errat -
implications for finance because stan- ic for prices to conform to this model.
dard risk-management tools (Sharpe
ratio, value at risk, etc.) assume 68%
volatility represents real risk. Taleb One standard
argues against this assumption and is deviation
also critical of the Black-Scholes option
Two standard Two standard
pricing model, which uses volatility as deviations deviations
one of six parameters of an option’s
price. Three Three
Instead of using the Black-Scholes standard standard
formula to price OTM options, Taleb deviations deviations
uses a relatively new distribution theo-
ry called Power Laws, developed by
Yale Professor Benoit Mandelbrot,
Mean value
author of The (Mis)behavior of
Markets. Mandelbrot explains in his
book, “A Power Law applies to positive

NNT: No. I’m very emotional, which is why I don’t like trading.
AT: Have there been other times besides the 1987 stock crash That’s why I wanted to retire after the crash of 1987. I like
when you received a large payoff from this approach? options intellectually, but I don’t concentrate as well when I
NNT: Yes, but all you need is one event to disapprove the have a position on.
Gaussian bell curve. You weaken your point by looking for
more events. I just had to bet these rare events were possible.AT: Do you just have to deal with the emotional side of trad -
You don’t have to back test if someone tells you, “If you open ing, or is there a way to minimize it?
NNT: I have to deal with it. My strength is that I’m emotional,
this door, it’s possible to have this event.” The other guy (i.e., an
options seller) is betting it’s impossible to have this event. but that’s also my problem. I’ve always wanted to be out of the
markets, but I have this love for options.
AT: Did your success in the stock market crash and your expe - What bothers me is not the trading but what comes with it
rience buying out-of-the-money options help keep your emo - — the emotions and dealing with investors. Trading is like
tions in check afterward as you were buying out-of-the- chocolate — a little bit is good for you, but a lot [can hurt you].
money options and consistently losing those small premiums? It should be done in small doses. Ý

32 www.activetradermag.com • March 2006 • ACTIVE TRADER

 FIGURE 1 TRADE EXAMPLE
The system trades often and always exits within three days of entry.

Double dipper

Market: Stocks.

System concept: Many countertrend stock

concepts are based on the idea that down-
turns are followed, sooner or later, by
upturns. Such systems typically buy with a
limit order at a low price, expecting the
stock will move up.
The optimum limit price usually
depends on both the individual stock’s
volatility and the overall market volatility.
Some systems use additional filters to limit
entries only when certain patterns occur.
The following study explores a simple
dip-buying system that incorporates a sec-
ond buy order that can improve system
results significantly. The basic system Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

places a limit order 3 percent below the last

closing price and waits three days for a 3-per- FIGURE 2 EQUITY CURVE
cent profit. If the profit doesn’t occur within
this period, the position is exited on the close Overall, the system’s equity curve increased relatively smoothly.
of the third day.
An additional limit order to buy a second
time is placed 1 percent below the first order
— i.e., 4 percent below the last closing price.
As a result, the system can enter one or two
positions the same day. The second position
uses the same exit rules as the first position.
Figure 1 shows various trades in Apple
(AAPL). The system repeatedly enters and
exits the market. On May 30 it opened two
positions and closed them with 4.5-percent
and 3.5-percent profits the next day at the
open. On June 1, a similar situation devel-
oped: The system entered two trades near the
low and was able to sell both positions the
next day with 16- and 15-percent profits. The
following days have similar examples. The
system was able to exit all positions with a
profit of at least 3 percent.
On June 22, however, the system initiated a
trade that couldn’t be closed with a profit
within three days; it was exited on the close of
the third for a 4.3-percent loss.

ACTIVE TRADER • March 2006 • www.activetradermag.com 33

 FIGURE 3 DRAWDOWN

Rules: Most drawdowns were around 10 percent and the system recovered from
them quickly.
1. Go long tomorrow at limit at 3 percent
and 4 percent below today’s close.
2. Exit long at limit at 3 percent above
the entry price or after three days at
the close.

Money management: Risk 10 percent of

available equity per position.

Starting equity: $1,000,000 (nominal).

Deduct $8 commission per trade, plus 0.2-
percent slippage per market order.

Test data: The system was tested on the

Active Trader Standard Stock Portfolio on daily data, which
contains the following 17 stocks: Apple Computer (AAPL), System results: The system showed a steady increase in the
Boeing (BA), Citibank (C), Caterpillar (CAT), Cisco (CSCO), portfolio equity curve (Figure 2), with only minor backslides.
Disney (DIS), General Motors (GM), Hewlett Packard (HPQ), The drawdown curve (Figure 3) shows most drawdowns were
International Business Machines (IBM), Intel (INTC), approximately 10 percent or less and the system was able to
International Paper (IP), J.P. Morgan Chase (JPM), Coke (KO), recover from them quickly. However, on three occasions,
Microsoft (MSFT), Starbucks (SBUX), AT&T (T), and Wal-Mart drawdowns came close to 20 percent.
(WMT). The system did quite well at catching profitable trades, as
evidenced by its percentage of winners (60.5 percent). This is a
Testing period: January 1995 to August 2005. good sign, as it supports the theory on which the system is

STRATEGY SUMMARY
PERIODIC RETURNS
Profitability Trade statistics
Net profit ($): $1,560,882.75 No. trades: 4,483 Avg. Sharpe Best Worst Percentage Max. Max.
return ratio return return profitable consec. consec.
Net profit (%): 156.09 Win/loss (%): 60.50
periods profitable unprofitable
Annualized gain (%): 9.86 Avg. trade ($): 348.18
Exposure (%): 38.79 Avg. trade (%): 0.23 Monthly 0.89% 0.67 16.84%-13.17% 60.00 10 6
Profit factor: 1.14 Avg. hold time (days): 2.26 Quarterly 2.64% 0.71 22.48%-13.31% 62.50 6 2
Payoff ratio: 0.75 Avg. winner (%): 3.03
Recovery factor: 3.56 Avg. hold time (winners): 1.78 Annually 10.27% 1.02 25.40% -4.71% 90.00 5 1
Drawdown ($): Avg. loser (%): -4.04
Max. DD (%): -23.50 Avg. hold time (losers): 3.00 LEGEND: Avg. return — The average percentage for the period • Sharpe ratio —
Longest flat period: 526 Max. consec. win/loss: 32/12 Average return divided by standard deviation of returns (annualized) • Best
return — Best return for the period • Worst return — Worst return for the peri -
od • Percentage profitable periods — The percentage of periods that were prof -
LEGEND: Net profit — Profit at end of test period, less commission • itable • Max. consec. profitable — The largest number of consecutive profitable
Annualized Gain — Compounded annual growth rate • Exposure — The area periods • Max. consec. unprofitable — The largest number of consecutive
of the equity curve exposed to long or short positions, as opposed to cash • Profit unprofitable periods
factor — Gross profit divided by gross loss • Payoff ratio — Average profit of
winning trades divided by average loss of losing trades • Recovery factor — Net
Trading System Lab strategies are tested on a portfolio basis (unless
profit divided by max. drawdown • Max. DD (%) — Largest percentage decline
otherwise noted) using Wealth-Lab Inc.’s testing platform.
in equity • Longest flat period — Longest period, in days, the system is between
If you have a system you’d like to see tested, please send the
two equity highs • No. trades — Number of trades generated by the system •
Win/loss (%) — The percentage of trades that were profitable • Avg. trade ($): trading and money-management rules to [email protected].
The average profit/loss for all trades in dollars • Avg. trade (%) — The average
profit/loss for all trades • Avg. hold time — The average holding period for all Disclaimer: The Trading System Lab is intended for educational purposes only to
trades •Avg. winner — The average profit for winning trades • Avg. hold time provide a perspective on different market concepts. It is not meant to recommend
(winners) — The average holding time for winning trades • Avg. loser — The or promote any trading system or approach. Traders are advised to do their own
average loss for losing trades • Avg. hold time (losers) — The average holding research and testing to determine the validity of a trading idea. Past performance
does not guarantee future results; historical testing may not reflect a system’s
time for losing trades • Max. consec. win/loss — The maximum number of con -
behavior in real-time trading.
secutive winning and losing trades

34 www.activetradermag.com • March 2006 • ACTIVE TRADER

based — that most dips are followed by upturns. exposure is less than twice the original exposure and, conse-
With an annualized profit of 18.66 percent, buy-and-hold quently, a lower APR is enough to prove the effectiveness of
outperformed the system. However, the system’s profit of 9.86 the second-dip buy.
percent is still very good, and it had a much lower maximum The results improve considerably when using two buy
drawdown than buy-and-hold (23.5 percent
vs. 63.53 percent) over the same simulation
period. FIGURE 4 COMPARISON OF ONE-ENTRY AND TWO-ENTRY SYSTEMS
The number of trades (4,483) is extremely Adding a second buy order to the system significantly improved results
high and the average profit per trade (0.23 across a wide range of parameters. (PT = profit target; Dip = dip level;
percent) is very low, which means the sys- Time = number of days in holding period.)
tem’s profits come from many small gains.
This produces a smooth equity curve.
Unfortunately, it also increases total com-
mission costs. We applied a flat fee of $8 per
trade, resulting in a total commission of
$71,728 (!) after 10 years. So be careful, espe-
cially when trading with less capital than
used in the simulation. Also, slippage might
be higher in real trading than the 0.2 percent
applied in the test.
To check the validity of the second buy
order, we conducted an additional test, with
and without the second buy order, across a
range of parameters: different dip levels (2
percent and 3 percent), profit targets (1 per-
cent to 5 percent) and holding periods (1 to 5
days). We compared the APR (annualized per-
centage return over 10 years) of the system
using one entry order with the APR of the sys-
tem using two entry orders; the second order is always set 1 per- orders, regardless of the number of holding periods or the dip
cent apart from the first order. or profit target levels. For holding periods of one or two days,
In Figure 4, the results from the system using one buy order almost all APRs of the one-buy system are negative, whereas
are colored orange; the results from the system using two buy the APRs for the two-buy system are almost all positive. For
orders are colored yellow. Comparing the results of the one- holding periods of two to five days, the two-buy APR is almost
order system to those of the two-order system is a reminder always more than twice the one-buy APR.
that a profitable system can often be improved just by increas-
ing its exposure, i.e., its position size. Bottom line: Adding a second buy order to a simple dip-buyer
When the system uses two entry orders it is more exposed to system improved profits much more than simply doubling the
the market, and it should therefore have a higher return than position size. You might even consider adding a third buy
the system using only one entry. (This rule is valid in most cir- order and experiment further with the parameters.
cumstances; see “Optimizing a position size,” Active Trader , Always test your system over a broad range of parameters
April 2005, for a detailed discussion about this issue and excep- for stability. Also, avoid using too high exposure, as situations
tions to the rule.) Doubling the position size (keeping all other can develop in which the system will not have enough capital
variables constant and assuming enough capital is available to to execute all trades.
take all trades) leads to an APR that is twice as high; or twice Also keep in mind that a current portfolio might not contain
as negative in the case of unprofitable systems. the same stocks that existed at the beginning of a simulation
Consequently, if we want to prove that including such a rule period; some disappear because of mergers or bankruptcy.
makes sense, adding a second entry order should lead to more
than twice the original APR. We ignore the fact that in some —José Cruset of Wealth-Lab
instances the second order might not get filled. If this occurs,

ACTIVE TRADER • March 2006 • www.activetradermag.com 35

FUTURES
Watch
Could it be the CME?

NYMEX may have new partner

BY JIM KHAROUF

N ew York Mercantile Ex-

change (NYMEX) officials
altered the terms of their
General Atlantic deal in
January in an effort to appease angry
shareholders and were seriously consid-
ering another competing bid from the
ing. Among the issues addressed,
Steinhause says Nymex will scale back
on the number of total shares from 208.1
million to 89.7 million and leave current
benefits to all Nymex stockholders.”
The letter goes on to say, “Neither the
board nor staff is being compensated,
whether by cash or stock, for completing
the General Atlantic investment, nor are
there any secret stock option plans. The
Board will benefit from this transaction
Chicago Mercantile Exchange (CME). solely as stockholders, in the exact same
General Atlantic reportedly dropped way our other stockholders will bene-
a clause in its deal that effectively rejects fit.”
any other offers for NYMEX. Sources say Steinhause did not address a potential
the CME made an offer to NYMEX that CME bid. However, that has not stopped
was higher than General Atlantic’s $135 NYMEX member Cataldo Capozza from
million bid (a 10-percent stake in the attempting to generate a petition to elect
company). Neither the CME nor new board members.
NYMEX have commented on the over- Capozza has suggested a special
ture. meeting to elect “25 members to a newly
A source close to the deal says several constituted board of directors.” NYMEX
scenarios could unravel. A three-way bylaws require that 10 percent of
deal with General Atlantic, the CME, NYMEX’s shareholders sign a petition to
and NYMEX could be brokered. Or, the hold a special meeting. The current plan
General Atlantic bid could be dropped by-law amendment rules and special calls for a reduction in the board from 25
altogether in favor of the CME’s. meeting requirements as is. to 15 after the General Atlantic deal is
“What has to play out now is the Steinhause’s letter defended the selec- approved.
design,” says the source. “Do they [work tion process of General Atlantic, stating An exchange spokesperson said that
out] a deal with CME, or a three-way “We ran a fair and transparent strategic no such petition had been brought for-
deal with CME and General Atlantic?” review process, using top-notch legal ward as of early January. A proxy state-
A CME deal would work on several and financial advisors, to arrive at the ment meeting was scheduled for late
levels for NYMEX, the source says. The conclusion that provides the greatest January.Ý
CME could solve many of NYMEX’s
technology platform and distribution
issues by using Globex, and both
exchanges share the same Clearing 21
2005 brings more records

Futures volume shows

technology.
“An extra $10 million or $20 million
bid from the CME won’t have much of
an impact on them if they can achieve
some of their strategic aims,” the source
no signs of slowing

S
says. “The deal could get their foot in the
door at NYMEX, get Globex in there, tock prices for the Chicago with the CME, the CBOT, and Eurex all
and set the tone for more joint ventures Mercantile Exchange, the setting annual volume records. Euronext
or a possible merger.” Chicago Board of Trade, turned in its second-best year ever.
The source says a deal or significant Euronext, and Deutsche Börse Eurex led the way with volume of 1.25
details could be hammered out with the (parent company of Eurex) all skyrocket- billion contracts, the Frankfurt,
CME as early as mid-January. ed in 2005, and a glance at the volume Germany-based exchange’s third
Meanwhile, NYMEX chairman totals for the “Big Four” derivatives straight year of more than a billion con-
Mitchell Steinhause stated in a letter to exchanges helps explain why. tracts, and an increase of 17 percent from
members that a revised proxy statement The Chicago exchanges and their 2004 (Figure 1).
reflecting certain changes in terms of the European competitors combined to Equity-based derivatives (43.8 million
General Atlantic deal will be forthcom- trade almost 3.7 billion contracts in 2005, contracts) and capital market products

36 www.activetradermag.com • March 2006 • ACTIVE TRADER

But will it pass?

CFTC bill could force new margin rules

T
he Commodity Futures Trading one with very little movement. that it gives the CFTC addition-
Commission Reauthorization The new ruling will replace the al power in regulating natural
Act of 2005, the legislation that “one-size-fits-all” approach with gas products besides futures
rubberstamps the existence of one that considers margin on a (which the CFTC already has
the CFTC while also including key rule case-by-case basis. authority over). The provision
changes, passed the House in early This is similar to how U.S. spells out how the CFTC can
December by unanimous consent. futures exchanges set margin — use its surveillance and record-
The bill was sent to the Senate on Dec. based on historical volatility keeping powers to make sure
15, but no timetable has been set for a vote. and price moves, high enough to cover natural gas trades are as transparent as
The most important aspect of the Act virtually any daily price change that possible and increases the penalties for
for traders is the mandate that the might occur. violating the rules.
Securities Exchange Commission (SEC) The new margin rules must go into However, some believe the natural gas
and the CFTC establish risk-based port- effect by Sept. 30, 2006. The SEC will han- amendment will make it more difficult
folio margining rules for stock options dle the stock-option margining by itself, for the bill to get passed, as there is some
and single-stock futures. but the two regulators will need to work debate over exactly how much power the
Portfolio-based margining, which is together for an outcome on SSF margining. CFTC should have, and the inherent con-
used in virtually every country in the The SEC and CFTC will also combine flict over giving the regulator power to
world, but only partially in the U.S., con- forces to reach a ruling regarding certain handle non-futures transactions in one
siders the overall risk of a group of trad- debt and foreign-security indices. The product group while the potential for
ing instruments before establishing mar - Commodity Futures Modernization Act, trouble in another product group is just
gin, as opposed to using a set margin for which reauthorized the CFTC in 2000, as likely.
all products in a particular group. “suggested” the SEC and CFTC work Regardless of how difficult the bill
For example, current margin require- together to establish trading and listing may be to pass, those on the options and
ments for both stock options and single- rules for such indices, but no work was single-stock futures side believe the leg-
stock futures (SSFs) are around 20 per- ever done. islation will be enough to entice the SEC
cent. However, some SSFs rarely move As a result, futures exchanges have and the CFTC to enact portfolio-based
more than a few percentage points in a been hesitant to list new products in that margining. The concept has been pushed
day, while others make double-digit per- group because they were uncertain how by the exchanges for quite some time.
centage moves somewhat often. the regulation would work. “Portfolio margining doesn’t need leg-
Nonetheless, the margin is the same for The latest reauthorization act requires islation,” says William Brodsky, CEO of
both products. the regulators to authorize trading by the Chicago Board Options Exchange. “I
Likewise, the margin on a highly June 30, 2006. believe there will be portfolio margining
volatile option is no different than that of Another important aspect of the bill is in 2006.”Ý

FIGURE 1 EXCHANGE VOLUME

(42.4 million contracts), such as the Euro- keeping them the
Bund, Euro-Bobl, and Euro-Schatz, were most actively traded Futures volume at the “Big Four” exchanges has
Eurex’s two most popular product futures contract in improved — often dramatically — every year since 2001.
groups. the world.
The CME also reached the billion-con- CBOT volume
tract mark, turning in annual volume of increased for the
1.05 billion — a 34-percent increase from fourth straight year,
last year and the CME’s sixth-straight as total volume of
year of double-digit gains. more than 674 mil-
Seventy percent of CME volume was lion contracts repre-
done on Globex, the CME’s electronic sented a 12.9-per-
trading platform. That total is up from 57 cent increase from
percent a year ago. 2004. Electronic vol-
All four of CME’s product groups — ume accounted for
interest rate, foreign exchange, equities, 65 percent of total
and commodities — set individual vol- volume, up from 58
ume records in 2005. Eurodollar futures percent a year earli-
averaged 1.6 million contracts per day, er.Ý Data source: CME, CBOT, Eurex, Euronext

ACTIVE TRADER • March 2006 • www.activetradermag.com 37

 FUTURES
Watch continued
Small caps are where it’s at
Russell 2000 products getting noticed
BY JIM KHAROUF

P
ropelled by a combination of Meanwhile, Financial Group in
higher volatility and investor options on E-Mini Chicago, says the E-
interest in the small cap sector, Russell 2000 futures Mini Russell 2000
Russell 2000 index derivatives reached a new high index futures repre-
contracts posted record volumes in 2005 with 27,927 contracts sented the largest open
on equity options and futures exchanges. traded in October, surpass- interest of any index held
Russell 2000 futures posted strong vol- ing the previous record of 20,049 by his firm’s customers.
umes at the Chicago Mercantile contracts in August. On Nov. 22, “It has become quite popular because
Exchange (CME). E-Mini Russell 2000 CME reached a year-to-date volume of its nature,” Wasendorf says. “It’s an
futures (ER2) set a record with 3.23 mil- record with 132,850 E-mini Russell 2000 index with a broad appeal.”
lion contracts traded in October, topping options. The Chicago Board Options Exchange
the previous high of 2.85 million in April The futures contract has attracted a (CBOE) posted a record in the Russell 2000
2005. Volume in 2005 rose 68 percent to strong retail following. Russ Wasendorf ETF (IWM) options contract in October.
28.9 million contracts. Sr., chairman and CEO of Peregrine More than 2.6 million contracts traded, up
527 percent from September, making it the
second most-active index option behind
the S&P500. For the year, the CBOE’s IWM
• • • • • • • • FAST
FAST FILLS options volume was up 229 percent from
2004 to 16.2 million contracts.
ANOTHER ASIAN ACCORD FOR THE CBOT One reason for the stellar business in the
q The Chicago Board of Trade and the Singapore Exchange IWM has been the strong demand from
announced plans to form an overseas exchange in the third quar- institutional investors for small cap index
ter of 2006. The exchange will trade commodities and will be all- contracts, says Terry Andrews, managing
electronic. The move is sparked by significant CBOT volume in director at Chicago Trading Company
metals and grains by Asian and European customers. The CBOT will (CTC) and primary market maker for the
provide the trading technology, and the SGX will handle clearing. IWM contract at the CBOE.
“For years people have been looking
WAIT, YOU’RE SUING US? for a better hedge for small cap portfo-
q While two funds run by Jim Rogers sit in limbo pending further lios,” Andrews says. “There wasn’t suffi-
action in the Refco case, two investors in the funds have sued cient liquidity in the listed Russell prod-
Rogers, claiming the fund managers breached their fiduciary duties ucts or small cap sector. Investors of IWM
by allowing the funds to be transferred into unregulated accounts. and related options began to reevaluate
The investors are suing for their fund assets; if the Refco case is the potential opportunities and leverage
settled in Rogers’ favor, the two are still seeking compensatory available with the use of the IWM.
damages. Rogers has $373 million in assets frozen at Refco. “The IWM is now an actively traded
and liquid product recognized in the
THE DOWNSIDE OF BEING PUBLICLY TRADED
investment community. Given the
q The CBOT laid off 40 employees in late December, all in the
demand for the small cap sector, the use
technology and operations departments. The move could save
the exchange up to $11 million, although buyouts and other sev- of these products will continue to grow.”
erance packages will cost the CBOT as much as $2 million. The CBOE has not been the only
exchange posting big numbers in the
PLAINTIFF OR DEFENDANT, TT TOUGH TO BEAT IWM contract, which is listed on all six
q Chicago-based software firm Trading Technologies won another U.S. options exchanges. The Inter-
court battle in early January when a judge ruled in its favor in a national Securities Exchange (ISE)
lawsuit with futures trading firm Rosenthal Collins. TT sued reported a record in October of 1.07 mil-
Rosenthal Collins, claiming patent violation, but Rosenthal Collins lion, up from 477,635 contracts traded in
countersued, claiming TT used deceptive and unfair business September. In December, 1.06 million
practices. Most of the counts in the charge were dismissed, with IWM contracts were traded at the ISE.
the exception of charges that TT was “overreaching” its copy- Frederic Ruffy, analyst and instructor of
right protection. A judgment on that matter was deferred. Optionetics in Redwood, Calif., says the
Russell 2000 index has shown more volatil-
MAYBE THERE IS HOPE YET ity than other benchmark indices. And over
q Volume at single-stock futures firm OneChicago, the lone the past two months, investors have shown
remaining SSF exchange, increased 188 percent in 2005 from the more pessimism about the small cap sector
year before. More than 5.5 million contracts traded hands dur- as illustrated by the high put to call ratio —
ing the year, and open interest hit a record-high 1.6 million in more than 2.0 — in the IWM.
mid-December. OneChicago lists 208 SSFs, with GE, Exxon, and
“The high put volume indicates the
Citigroup leading the way volume-wise.

38 www.activetradermag.com • March 2006 • ACTIVE TRADER

recent increase in interest is not just spec- which has maintained a multiple-listing than the Nasdaq 100.
ulators betting on market moves but also licensing approach. Its contracts are listed “Nasdaq used to be the index with the
investors using puts as protection against on all six U.S. options exchanges and four most zip to it and that’s not true any-
a move lower in small cap stocks,” says futures markets. Kelly Haughton, strate- more,” Haughton says. “There’s a bit
Ruffy, whose firm provides investment gic director for the Russell indices, says more zip to the Russell 2000 these days.
education and analysis services. the Russell 2000 in particular is doing well Another factor is that we’re getting more
The growing success for Russell indices because it is a hot market sector and expanded coverage with the 2000 index
is good news for the index company, appears to have captured more attention options being at both ISE and CBOE.” Ý

U.S. arm seeks partner

Ferscha leaves Eurex

E
urex announced in early January to begin a U.S exchange that would com- Chicago exchange.
it was seeking an equity partner pete with the Chicago futures markets. Ferscha has long claimed that anti-com-
for its floundering U.S. venture. Eurex U.S. began trading in February petitive measures by the CBOT and the
However, the man responsible 2004 and offered U.S. Treasury products CME were largely responsible for Eurex
for creating Eurex U.S. won’t be around in direct competition with the Chicago U.S.’s troubles. Eurex U.S.’s antitrust law-
to see it. Board of Trade. suit against the two Chicago exchanges is
Rudolf Ferscha, CEO of Eurex since However, despite brief periods of suc- still pending.
2000 and the driving force behind the cess, Eurex U.S. never made a significant With or without Ferscha, the future of
firm’s U.S. venture, left Eurex on Dec. 31 dent in the CBOT’s volume, and in the Eurex U.S. is still in question. The
in what the exchange is calling a “mutu- summer of 2005, Eurex U.S. abandoned exchange has been a financial drain on
al agreement.” its Treasury strategy and decided to take Deutsche Börse, but it seems Eurex has
Kurt Viermetz, chairman of Eurex’s par- on the Chicago Mercantile Exchange’s thrown too much time and money into
ent company, Deutsche Börse — of which currency futures business. its U.S. venture to give up now.
Ferscha was a board member — said in a So far, Eurex U.S. has failed to provide In a press release, Eurex said, “(I)t is in
statement, “On behalf of Deutsche Börse, I the CME with much competition, either. discussions with a number of U.S.
thank Rudolf Ferscha for his service to the Total volume for Eurex U.S. currency exchanges over a partnership to further
company. Mr. Ferscha has fulfilled his futures in December was almost 70,000. develop its U.S. business. Any resulting
duties in a highly professional manner in a The CME averages more than 350,00 cur- agreement would call for the partner
stable and growing, however at times, dif- rency contracts per day. exchange to take a stake in Eurex U.S.”
ficult market environment. We respect his In November, Eurex U.S. abandoned While Eurex did not specify which
wish to take over new responsibilities out- its plans to list products traded on Eurex exchanges it was talking to, Archipelago
side the company.” in Frankfurt, Germany — most notably and the Philadelphia Stock Exchange have
Ferscha spearheaded Eurex’s decision German government bonds — on its long been rumored to have interest.Ý

What’s in a name?

Lind-Waldock returns to the futures scene

BY JIM KHAROUF

M
an Financial brought back the Waldock. “It has such a strong brand — name. Sachs says the firm will embark on
well-known brokerage name a 40-year heritage of excellence with the an aggressive print, online, and television
Lind-Waldock in November in retail futures audience. It was an easy marketing campaign through 2006.
an effort to rebuild Lind-Waldock decision to resurrect the name.” Sachs admitted the Lind-Waldock
in the aftermath of the Refco scandal. Founded in 1965, Lind-Waldock was operation lost customers, just as virtually
Man, which purchased Refco in bank- one of the first brokerages to cater specif- every division of Refco has since the com-
ruptcy court in October, announced that ically to individual futures traders. The pany became embroiled in an accounting
Lind-Waldock will continue to be part of firm is known in the industry as an inno- scandal that led to the arrest of CEO Phil
Man, but will operate its retail business vator. It was the first futures commission Bennett and the bankruptcy of the com-
separately from Man’s. Lind-Waldock merchant (FCM) to develop its own pany. However, Sachs adds that resur-
will continue to offer customers the same order-routing system to the trading recting the Lind-Waldock name is
services and technology, and no major floors of U.S. exchanges, the first to offer already bringing customers back.
changes are expected at the firm. clients an online order-entry platform, “Since the news announcement, we’re
“We will continue to operate as a and the first to offer discount trading. already seeing some clients coming
stand-alone entity, as a division of Man,” Lind-Waldock was purchased in 2000 back,” Sachs says. “I expect before long
says Mark Sachs, president of Lind- by Refco, dropping the Lind-Waldock to get back to where we were.”Ý

ACTIVE TRADER • March 2006 • www.activetradermag.com 39

FUTURES
Trading System Lab
Narrowed
breakout channel FIGURE 1 TRADE EXAMPLES
Using the second highest/lowest prices over the past 20 days resulted in better
trade signals than the traditional channel breakout approach. Here, these
Market: Futures. channels caught an up move in corn in January 1997 as well as a down move a
few months later.
System concept: Many trend-following
systems track highs and lows over cer-
tain look-back periods (e.g., 20 days)
and go long when price hits these highs
and sell short when price reaches these
lows. The goal is to catch the trend on a
breakout above or below these levels, a
method first developed by Richard
Donchian.
Because many trend followers track
these levels and enter the market once
price hits them, so it can be difficult to
get a good fill. (The September 2005
Futures Trading System Lab discusses
this concept — see “Support-resistance
detection system,” p. 78.)
This system narrows the breakout
channel slightly to place trades before
other traders do. Instead of waiting for
price to hit its highest/lowest level in a
certain look-back period, the system
enters the market on the second high-
est/lowest point of the past 20 days. It Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
uses two indicators (HighestN and
LowestN) to track the nth highest/lowest FIGURE 2 EQUITY CURVE
price during this period. (The parameter n
can be of any integer value; in this case it is 2. System equity rose consistently until 1999, suffered large drawdowns over
Both indicators are available free at the next three years, and then grew strongly through January 2005.
www.Wealth-Lab.com.)
Figure 1 shows several trade signals in
corn futures. On Jan. 10, 1997 price merely
touched the second highest value and went
long. Had the system waited for price to cross
at the standard (highest/lowest) channel
level, it would have entered two days later
and at a higher (i.e., worse) price.
The system exited on April 4 when price
touched the second lowest low of the past 20
days — a 72-point gain. At this point, the sys-
tem sold short, caught most of the down-
trend, and exited on July 15 with a 74.5-point
profit.

Rules:
1. Go long with a stop at the second high-
est high of the last 20 days.
2. Exit longand go short with a stop at the
second lowest low of the last 20 days.

Starting equity: Starting equity is $1,000,000.

Deduct $20 commission per round-trip trade
per contract. Apply two ticks of slippage per
market order.

40 www.activetradermag.com • March 2006 • ACTIVE TRADER

 FIGURE 3 DRAWDOWN CURVE

The system had large drawdowns of up to 30 percent in 2001 and 2002,

but it was less volatile before and after this period.
Money management: Risk a maximum of one
percent of total account equity per position. The
number of contracts is calculated using the basis
price, the stop-loss level, the contract’s point
value (i.e., the dollar value of a one-point move),
and the portfolio’s total equity. The basis price is
the price entering the new position, and the stop
level is the opposite side of the breakout channel.
For example, the S&P 500 E-Mini has a point
value of $50. Assume the system goes long at a
basis price of $1,000 and its risk-stop is 950. To
determine the trade’s dollar risk, multiply the
point value ($50) by the difference between the
basis price and the risk-stop (50, or 1,000 - 950). (JY), coffee (KC), wheat (W), live cattle (LC), lean hogs (LH), nat-
Therefore, a single contract’s dollar risk is $2,500. ural gas (NG), sugar (SB), silver (SI), Swiss franc (SF), and 30-
If the portfolio’s total equity (before entry) is $1,000,000, and year T-bonds (US). This test used ratio-adjusted data from
we do not want to risk more than one percent of our total equi- Pinnacle Data Corp.
ty ($10,000), we could buy four contracts (4 * $2,500 = $10,000).
Had total equity been less than $250,000, we would not have Test period: January 1995 until January 2005.
been able to take this position because its dollar risk would
exceed our system’s one-percent equity risk. This position-siz- Test results: Figure 2’s equity curve can be divided into three
ing method keeps us out of risky trades that have the potential main parts. First, system equity increased steadily with small
to ruin our account. drawdowns from 1995 to 1999. Then, a large drawdown began,
which lasted until mid 2002. Finally, system equity grew strong-
Test data: The system was tested on the Active Trader Standard ly through January 2005. The system generated more than half
Futures Portfolio, which contains the following 20 futures: its profits in this final period, but it continued to be volatile.
British pound (BP), soybean oil (BO), corn (C), crude oil (CL), Its maximum drawdown reached almost 30 percent, which
cotton (CT), E-Mini Nasdaq 100 (NQ), E-Mini S&P 500 (ES), is in-line with other trend-following systems (see Figure 3). Its
Five-year T-note (FV), eurodollar (ED), gold (GC), Japanese yen low percentage of gains (38.9 percent) and long average hold-

STRATEGY SUMMARY
PERIODIC RETURNS
Profitability Trade statistics
Net profit ($): 2,006,844.50 No. trades: 1,575 Avg. Sharpe Best Worst Percentage Max. Max.
Net profit (%): 200.68 Win/loss (%): 38.92 return ratio return return profitable consec. consec.
Annualized gain (%): 11.64 Avg. profit/loss (%): 0.42 periods profitable unprofitable
Exposure (%): 20.86 Avg. profit/loss ($): 1,274.19 Monthly 1.08% 0.66 18.20% -11.14% 54.17% 7 5
Profit factor: 1.16 Avg. winner (%): 6.96
Payoff ratio: 1.86 Avg. loser (%): -3.75 Quarterly 3.16% 0.70 26.83% -8.61% 55.00% 4 4
Recovery factor: 2.83 Avg. hold time (days): 29.78 Annually 12.93% 0.72 38.54% -12.03% 60.00% 4 3
Drawdown Avg. hold time (winners, in days):49.96
Max. DD (%): -29.85 Avg. hold time (losers, in days): 16.92
Longest flat days: 854 Max. consec. win/loss: 8/13 LEGEND: Avg. return — The average percentage for the period • Sharpe
ratio — Average return divided by standard deviation of returns (annualized)
LEGEND: Net profit — Profit at end of test period, less commission • • Best return — Best return for the period • Worst return — Worst return
Annualized gain — Compounded annual growth rate, or annual percentage for the period • Percentage profitable periods — The percentage of periods
return • Exposure — The area of the equity curve exposed to long or short that were profitable • Max. consec. profitable — The largest number of con -
positions, as opposed to cash • Profit factor — Gross profit divided by gross secutive profitable periods • Max. consec. unprofitable — The largest num -
loss • Payoff ratio — Average profit of winning trades divided by average loss ber of consecutive unprofitable periods
of losing trades • Recovery factor — Net profit divided by max. drawdown
• Max. DD (%) — Largest percentage decline in equity • Longest flat days Trading System Lab strategies are tested on a portfolio basis (unless
— Longest period, in days, the system is between two equity highs • No. otherwise noted) using Wealth-Lab Inc.’s testing platform.
trades — Number of trades generated by the system • Win/Loss (%) — The If you have a system you’d like to see tested, please send the trad-
percentage of trades that were profitable • Avg. profit/loss — The average ing and money-management rules to [email protected].
profit/loss for all trades • Avg. winner — The average profit for winning
trades • Avg. loser — The average loss for losing trades • Avg. hold time — Disclaimer: The Trading System Lab is intended for educational purposes only to
The average holding period for all trades • Avg. hold time (winners) — The provide a perspective on different market concepts. It is not meant to recommend
average holding time for winning trades • Avg. hold time (losers) — The or promote any trading system or approach. Traders are advised to do their own
research and testing to determine the validity of a trading idea. Past performance
average holding time for losing trades • Max. consec. win/loss — The max -
does not guarantee future results; historical testing may not reflect a system’s
imum number of consecutive winning and losing trades behavior in real-time trading.

ACTIVE TRADER • March 2006 • www.activetradermag.com 41

FUTURES
Trading System Lab continued

ing time (30 days) are also typical of trend-fol- FIGURE 4 TESTING DIFFERENT PARAMETERS
lowing systems. The annual sharpe ratio (0.72)
isn’t good. The system didn’t perform well Narrower breakout channels are more profitable in shorter look-back
mainly because of its high volatility, especially periods than traditional ones.
after the middle of 2002.
But it only risked a maximum of one percent,
so you could consider risking more. This will
lead to higher exposure and gains, but also to
higher drawdowns and risks.
For comparison, we tested a traditional break-
out approach using the highest/lowest levels
over look-back periods from 10 to 60 days. All
other parameters (position sizing, commission,
slippage, etc.) remained the same. Figure 4 com-
pares the profitability of the standard breakout
approach (blue bars) to the narrowed breakout
channel approach (red bars) over various look-
back periods. Note: for comparison purposes,
these tests began on the 60th day, so profits for
the 20-day look-back period differ slightly from
the Strategy Summary on p. 67.
According to Figure 4, the second high-
est/lowest levels either match or exceed the traditional break- dard breakout channel across a large range of look-back peri-
out’s profitability for look-back periods shorter than 50 days. ods. However, further investigation is necessary in different
For 10-day periods, this narrower channel even changes a loss markets and time periods to confirm this.
into a gain. Look-back periods between 10 and 25 days benefit- You could even test the third or fourth highest/lowest val-
ed the most from this alternative method. ues to see if these changes might improve results further. But
don’t forget to test your system across a large range of look-
Bottom line: It makes sense to use the second highest/lowest back periods to prove its stability.
price on breakouts instead of waiting for the standard signal.
Figure 4 suggests this method is more profitable than a stan- — José Cruset of Wealth-Lab

42 www.activetradermag.com • March 2006 • ACTIVE TRADER

 FUTURES
Snapshot
Date: Dec. 30, 2005
The following table summarizes the trading activity in the most actively traded futures contracts. The infor- Legend
mation does NOT constitute trade signals. It is intended only to provide a brief synopsis of each
market’s liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the
different fields. Volume figures are for the most active contract month in a particular market and may not Vol: 30-day average daily vol-
reflect total volume for all contract months. ume, in thousands.
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applica -
ble). Price activity for CME futures is based on pit-traded contracts, while price activity for CBOT futures is based on OI: Open interest, in thou-
the highest-volume contract (pit or electronic). sands (unless otherwise indi-
cated).
Pit E- 10-day % 20-day % 60-day % Volatility
Market Sym Sym Exch Vol OI move Rank move Rank move Rank ratio/rank 10-day move: The percentage
S&P 500 E-Mini ES CME 697.1 1.01 M -1.80% 100% -0.77% 0% 4.50% 73% .24 / 19% price move from the close 10
10-yr. T-note TY ZN CBOT 633.9 1.49 M 0.78% 45% 0.94% 100% -0.06% 2% .25 / 47% days ago to today’s close.
5-yr. T-note FV ZF CBOT 362.3 1.05 M 0.07% 27% 0.81% 85% -0.11% 8% .22 / 39%
20-day move: The percentage
Eurodollar* ED GE CME 273.3 1.32 M -0.02% 31% -0.29% 79% -0.39% 13% .06 / 53%
price move from the close 20
30-yr. T-bond US ZB CBOT 256.6 520.6 1.63% 58% 2.52% 100% 0% 0% .37 / 79%
days ago to today’s close.
Nasdaq 100 E-Mini NQ CME 215.3 316.6 -3.38% 100% -2.64% 50% 4.83% 40% .27 / 24%
Eurocurrency EC 6E CME 124.3 134.5 -1.21% 80% 1.07% 57% -1.00% 18% .31 / 32% 60-day move: The percentage
Russell 2000 E-Mini ER CME 100.3 250.4 -1.41% 50% -1.62% 14% 2.03% 19% .25 / 7% price move from the close 60
Crude oil CL NYMEX 94.8 235.7 1.75% 18% 4.40% 60% -4.48% 14% .30 / 47% days ago to today’s close.
2-yr. T-note TU ZT CBOT 81.2 317.1 -0.01% 0% 0.01% 14% -0.09% 9% .13 / 14%
Mini Dow YM CBOT 81.2 63.6 -1.69% 100% -1.60% 46% 3.83% 71% .27 / 31% The “% Rank” fields for each
Japanese yen JY 6J CME 54.7 147.0 -1.58% 63% 2.80% 64% -3.35% 50% .22 / 34% time window (10-day moves,
S&P 500 index SP CME 53.7 571.8 -1.80% 100% -0.77% 0% 4.51% 73% .24 / 19% 20-day moves, etc.) show the
percentile rank of the most
Corn C ZC CBOT 52.5 278.5 5.38% 33% 13.95% 88% 5.38% 36% .37 / 80%
recent move to a certain num-
Gold GC NYMEX 52.5 176.2 2.43% 23% 3.26% 34% 11.33% 80% .31 / 55%
ber of the previous moves of
British pound BP 6B CME 47.9 75.8 -2.57% 40% -0.79% 32% -2.35% 50% .55 / 97% the same size and in the same
Soybeans S ZS CBOT 43.4 112.6 2.52% 25% 7.58% 88% 6.85% 55% .34 / 80% direction. For example, the “%
Swiss franc SF 6S CME 34.5 84.5 -2.10% 71% 0.68% 19% -1.44% 27% .40 / 37% Rank” for 10-day move shows
Canadian dollar CD 6C CME 32.0 101.3 -0.45% 13% 0.21% 17% 1.73% 22% .31 / 73% how the most recent 10-day
Sugar SB NYBOT 28.8 296.0 5.84% 15% 13.62% 60% 28.43% 87% .15 / 13% move compares to the past
Natural gas NG NYMEX 27.8 65.0 -18.55% 50% -13.83% 74% -21.08% 86% .79 / 100% twenty 10-day moves; for the
Heating oil HO NYMEX 25.2 51.4 -0.98% 0% 1.79% 38% -13.66% 66% .26 / 47% 20-day moves, the “% Rank”
Unleaded gasoline HU NYMEX 23.9 46.7 6.84% 17% 10.55% 76% -14.30% 31% .30 / 73% field shows how the most
recent 20-day move compares
Crude oil e-miNY QM NYMEX 23.4 6.6 -0.10% 0% 4.40% 60% -4.48% 14% .30 / 47%
to the past sixty 20-day moves;
Australian dollar AD 6A CME 22.0 58.1 -1.72% 22% -1.21% 28% -2.86% 70% .44 / 56%
for the 60-day moves, the “%
S&P MidCap 400 E-Mini ME CME 19.3 39.7 -1.16% 80% 1.17% 8% 3.99% 39% .20 / 0% Rank” field shows how the
Wheat W ZW CBOT 18.2 123.6 6.47% 65% 11.07% 76% -1.68% 24% .55 / 70% most recent 60-day move com-
Silver SI NYMEX 18.1 71.4 2.95% 27% 4.60% 23% 19.73% 87% .29 / 15% pares to the past one-hundred-
Soybean meal SM ZM CBOT 14.2 23.4 5.28% 33% 14.51% 83% 21.19% 95% .34 / 78% twenty 60-day moves. A read-
Fed Funds** FF ZQ CBOT 13.5 114.7 -0.10% 25% -0.10% 3% -0.49% 35% .20 / 72% ing of 100 percent means the
Mexican peso MP 6M CME 13.3 84.0 1.38% 29% -1.58% 88% 1.25% 23% .39 / 39% current reading is larger than
Soybean oil BO ZL CBOT 11.3 24.8 -0.47% 17% 1.24% 6% -10.69% 90% .23 / 22% all the past readings, while a
Nikkei 225 index NK CME 10.1 60.3 6.72% 94% 5.56% 39% 19.26% 91% .30 / 75% reading of 0 percent means the
current reading is lower than
Coffee KC NYBOT 8.3 49.3 9.45% 90% 11.04% 82% 15.53% 97% .60 / 78%
the previous readings. These
Cotton CT NYBOT 7.9 70.4 2.23% 47% 5.16% 50% 0.82% 3% .15 / 14%
figures provide perspective for
Nasdaq 100 index ND CME 7.9 50.8 -3.38% 100% -2.64% 50% 4.83% 40% .27 / 23% determining how relatively
Lean hogs LH HE CME 6.3 45.3 1.40% 19% 3.04% 29% -4.29% 31% .14 / 3% large or small the most recent
Live cattle LC LE CME 6.0 34.6 2.17% 41% 2.12% 33% 6.73% 16% .13 / 18% price move is compared to past
Dow Jones Ind. Avg. DJ ZD CBOT 5.5 33.1 -1.69% 100% -1.60% 46% 3.83% 71% .27 / 30% price moves.
Copper HG NYMEX 5.3 22.2 -4.65% 80% -5.81% 100% 15.63% 73% .38 / 75%
Cocoa CC NYBOT 5.2 47.0 2.45% 38% 2.66% 30% 8.75% 88% .38 / 57% Volatility ratio/rank: The ratio
Mini New York Gold YG CBOT 2.9 2.3 2.47% 23% 3.28% 34% 11.33% 79% .31 / 59% is the short-term volatility (10-
Orange juice JO NYBOT 2.7 19.4 -2.38% 25% 1.71% 14% 20.21% 54% .17 / 15% day standard deviation of
prices) divided by the long-
Feeder cattle FC GF CME 1.8 14.9 1.25% 44% -2.04% 72% -1.58% 65% .20 / 20%
term volatility (100-day stan-
Platinum PL NYMEX 1.6 9.7 1.11% 13% -2.18% 69% 6.40% 70% .18 / 3%
dard deviation of prices). The
LIBOR EM CME 1.3 16.3 0.01% 67% -0.11% 2% -0.52% 38% .02 / 29% rank is the percentile rank of
*Average volume and open interest based on highest-volume contract (June 2006) the volatility ratio over the
**Average volume and open interest based on highest-volume contract (February 2006) past 60 days.

This information is for educational purposes only. Active Trader provides this data in good faith, but it cannot guarantee its accuracy or time -
liness. Active Trader assumes no responsibility for the use of this information. Active Trader does not recommend buying or selling any mar -
ket, nor does it solicit orders to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The
reader assumes all responsibility for his or her actions in the market.

ACTIVE TRADER • March 2006 • www.activetradermag.com 43

 The ECONOMY

U.S. ECONOMIC BRIEFING

FED SUGGESTS TIGHTENING CYCLE MAY END
FIGURE 1 QUARTERLY GDP PERFORMANCE
q The Federal Reserve raised its Fed Funds rate to
4.25 percent from 4.0 percent on Dec. 13, its 13th con- Gross domestic product grew 4.1 percent in the third quarter of
secutive rate hike of 25 basis points since June 30, 2005 — its fastest pace since the first quarter of 2004.
2004. The latest increase was no surprise, but the
Fed’s statement implied its current rate-tightening
cycle might end soon.
The Federal Open Market Committee’s (FOMC)
Dec. 13 announcement contained a subtle, but
important, change. The committee deleted the
phrase “policy accommodation can be removed at a
pace that is likely to be measured,” which previous-
ly signaled further rate increases were necessary.
Instead, the FOMC announced, “further measured
policy firming is likely to be needed,” suggesting the
Fed may tighten rates again at its Jan. 31 meeting
before pausing.
However, meeting minutes released Jan. 3
revealed the committee disagreed regarding “how
much further tightening might be required.” Fed
members then agreed future economic data should Source: Bureau of Economic Analysis
help guide their policy.
The S&P 500 rose slightly in anticipation of the statement gained 0.72 percent in three days following this event, then
and jumped 0.23 percent once the announcement hit the Street plunged 0.96 percent on the fourth day.
at 2:15 p.m. (ET) on Dec. 13. The market posted a 0.56-percent
gain that day and rose another 0.42 percent Dec. 14 before giv- PAYROLLS DISAPPOINT, BUT NOVEMBER GAINS REVISED
ing back those gains over the following three days. The S&P HIGHER
remained flat one week after the event. q Non-farm payrolls added just 108,000 jobs in December
This post-announcement pattern matches the
market’s historical behavior over the past 12 years.
FIGURE 2 PAYROLLS VS. UNEMPLOYMENT RATE
The S&P gained an average 0.32 percent on days in
which the Fed announced rate changes (hikes and Employers added 305,000 jobs in November, which boosted the non-
cuts) since 1994. The market also climbed another farm payrolls' three-month average to 122,000. The unemployment
0.14 percent the next day before relinquishing most rate held steady at 5 percent as its three month average rose slightly.
of those gains on the third and fourth days.

GDP GROWS AT FASTEST PACE SINCE Q1 2004

q Gross domestic product (GDP) increased 4.1
percent in the third quarter of 2005, according to
the Bureau of Economic Analysis’ final (third) esti-
mate. While the increase isn’t as strong as prelimi-
nary estimates (4.3 percent), it represents the econ-
omy’s quickest pace since the first quarter of 2004.
Figure 1 shows quarterly GDP growth (at annu-
al rates) since 2002.
This third-quarter increase represents the largest
gain in six quarters and was fueled by consumer and
government spending. However, the bureau low-
ered its final reading because consumers had spent
less on durable goods than originally estimated.
The S&P 500 remained flat on GDP announce-
ment days over the past 10 years (1994 to 2004)
before climbing an average 0.36 percent the follow-
ing week. However, the S&P broke this historical
Source: Bureau of Labor Statistics
trend after the Dec. 21 GDP release: The market

44 www.activetradermag.com • March 2006 • ACTIVE TRADER

 FIGURE 3 OVERALL VS. “CORE” INFLATION
Year-over-year gains in the consumer and producer price indices have
after gaining 305,000 in November, upwar dly dropped sharply from the multi-year highs set in September. While
revised from prior estimates of 215,000. Economists annual gains in core PPI levels also fell, core CPI readings remained flat.
expected December’s increase to reach 200,000.
December’s unemployment rate unexpectedly fell to
4.9 percent from 5.0 percent in November.
Figure 2 compares the three-month averages of
non-farm payrolls (through November) and the
unemployment rate over the past two years. While
the average jobless rate has stabilized around 5.0 per-
cent since August, average payrolls rose for the first
time in three months because of November’s strong
increase.
The S&P500 surged 0.67 percent at the open as the
December jobs report was announced on Jan. 6.
However, the market traded sideways as the Bureau
of Labor Statistics released its November jobs report
before sliding during three of four days following the
event — a cumulative loss of 0.73 percent. Historically,
the market has tended to climb on announcement
days since 1994, but the S&P gave back that 0.21-per-
cent average gain in the following week. Source: Bureau of Labor Statistics

CONSUMER AND PRODUCER PRICES DROP Institute’s reading remains well above 50, which means the
q Both consumer and producer price indices declined sector continued to grow, just at a slower pace.
sharply in November. The consumer price index (CPI) fell 0.6 Figure 4 shows changes in ISM manufacturing index values
percent — its largest monthly drop in more than 50 years. over the last 12 months (through November). Although manu-
October’s CPI reading rose 0.2 percent, and economists expect- facturing growth has slowed somewhat since September, it has
ed a smaller decrease (0.4 percent). November’s core CPI, rebounded from May’s recent low (51.4).
which omits food and energy, climbed 0.2 percent, matching The S&P 500 soared 1.62 percent — its largest daily gain in
October’s increase and market forecasts. more than two months — as the ISM released its December
The producer price index (PPI) slid 0.7 percent in November manufacturing report on Jan. 3. Over the past 10 years, the S&P
compared to a 0.7-percent increase in October. Economists has followed a mixed pattern — an average 0.31-percent
expected a decline of 0.5 percent. Core PPI levels rose 0.1 per- announcement-day gain before languishing in the subsequent
cent after dropping 0.3 percent in October, a smaller-than- week.Ý
expected increase.
Figure 3 compares the year-over-year gains in con- FIGURE 4 ISM MANUFACTURING INDEX
sumer and producer prices to their core levels in the The Institute's Purchasing Managers' Index declined 1 percent to 58.1
past 12 months. Annual increases in consumer and in November. Although the manufacturing index is slightly below its
producer prices have dropped at least 1.2 percent after recent September high (59.4), it remains well above the multi-year
reaching multi-year highs in September. Year-over- low reached in May (51.4).
year increases in core levels also moderated slightly in
the past year.
The S&P500 declined 0.14 percent as the November
CPI report was announced at 8:30 a.m. on Dec. 15 and
the market sold off another 0.89 percent on the three
subsequent days. However, the S&P reacted differently
after the PPI announcement hit the Street on Dec. 20 –
it remained flat that day before regaining 0.72 percent
during the following three days.
Historically, the S&P 500 traded sideways in the
week after CPI announcements since 1980. But the
market has climbed an average 0.54 percent in the
week following PPI reports over the past 10 years, a
pattern that’s been fairly reliable.

MANUFACTURING GROWTH SLOWS AGAIN

q The Institute of Supply Management’s (ISM) man-
ufacturing index fell 3.9 percent to 54.2 in December
from 58.1 in November. While this decline marks the
manufacturing index’s third consecutive drop, the Source: Institute of Supply Management

ACTIVE TRADER • March 2006 • www.activetradermag.com 45

 ETF
Snapshot
Date: Jan. 3, 2006
The following table summarizes the trading activity in the most actively traded exchange-traded funds. The information does NOT constitute
trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility. See
the legend for explanations of the different fields.
1-year 10-day % 20-day % 60-day % Volatility
Market Sym Sector Category Vol move move Rank move Rank move Rank ratio/rank
(Positive one-year performance)
Brazil EWZ Regional iShares 1.25 M 68.02% 3.88% 60% -1.47% 22% 11.60% 15% .25 / 63%
Oil Services OIH Energy HOLDRS 7.27 M 67.25% 4.21% 38% 5.16% 33% 21.74% 78% .33 / 23%
South Korea EWY Regional iShares 614.2 65.40% 8.43% 100% 11.75% 95% 19.92% 93% .33 / 57%
Mexico EWW Regional iShares 808.6 55.50% 3.48% 50% 3.85% 25% 21.05% 83% .24 / 25%
Energy XLE Energy SPDR 17.12 M 52.09% 3.19% 50% 2.99% 45% 8.79% 35% .41 / 50%
Emerging Markets EEM Emerging Markets iShares 2.14 M 43.77% 4.63% 89% 6.21% 69% 15.62% 89% .29 / 42%
Biotech BBH Biotech HOLDRS 500.5 37.70% 2.12% 100% -1.77% 30% 11.83% 50% .33 / 58%
Canada EWC Regional iShares 371.8 36.89% 2.79% 50% 3.98% 36% 11.30% 53% .30 / 57%
Japan EWJ Regional iShares 21.83 M 31.48% 5.05% 70% 9.50% 100% 17.52% 93% .24 / 50%
Semiconductor SMH Technology HOLDRS 14.14 M 20.96% -0.32% 0% -2.59% 13% 7.48% 65% .29 / 15%
Utilities XLU Utilities SPDR 2.12 M 18.91% -0.96% 25% 1.36% 33% 0.03% 0% .19 / 8%
EAFE* EFA Index iShares 3.42 M 18.27% 1.69% 19% 4.37% 80% 8.23% 80% .43 / 90%
S&P Midcap 400 Index MDY Index Trust 2.28 M 17.85% 1.19% 58% 0.31% 3% 8.65% 78% .23 / 12%
Germany EWG Regional iShares 647.1 15.23% 2.39% 40% 5.97% 88% 7.87% 58% .35 / 60%
S&P SmallCap 600 Index IJR Index iShares 1.67 M 14.33% 0.02% 0% -1.46% 23% 6.27% 67% .28 / 13%
Dow Jones U.S. Real Estate IYR Real Estate iShares 2.32 M 14.10% -0.21% 14% -0.30% 3% 6.89% 77% .23 / 30%
Russell 2000 Growth Index IWO Index iShares 1.20 M 11.97% 0.64% 30% -0.57% 0% 7.87% 68% .29 / 17%
Taiwan EWT Regional iShares 2.72 M 11.38% 6.08% 100% 8.12% 83% 12.35% 93% .38 / 50%
Russell 2000 Index IWM Index iShares 25.87 M 11.03% 0.31% 11% -1.12% 17% 7.11% 68% .27 / 13%
Russell 2000 Value Index IWN Index iShares 1.07 M 10.02% 0% 0% -1.42% 26% 6.01% 64% .24 / 10%
Nasdaq Biotechnology Index IBB Biotech iShares 812.5 9.27% 2.18% 89% 1.75% 31% 7.03% 33% .55 / 88%
Russell 1000 Growth Index IWF Index iShares 1.65 M 8.83% -0.59% 30% -0.50% 30% 6.90% 80% .23 / 27%
Russell 1000 Value Index IWD Index iShares 1.21 M 8.76% -0.03% 0% 0.40% 0% 5.64% 87% .30 / 35%
Health Care XLV Health Care SPDR 829.3 8.66% 1.29% 21% 2.98% 78% 4.32% 99% .27 / 8%
Materials XLB Materials SPDR 1.84 M 8.49% 3.76% 100% 2.66% 26% 17.43% 100% .30 / 40%
S&P 500 Index SPY Index Trust 52.34 M 7.94% 0.27% 18% 0.42% 13% 6.86% 97% .24 / 32%
Nasdaq 100 QQQQ Index Trust 70.65 M 7.19% -0.65% 31% -1.89% 50% 8.00% 77% .22 / 7%
Financial XLF Financial SPDR 8.26 M 7.05% 0.69% 33% 0.28% 5% 10.88% 99% .15 / 7%
Industrial XLI Industrial SPDR 850.2 4.70% -0.13% 22% -0.19% 20% 7.08% 95% .18 / 3%
S&P 500 Index IVV Index iShares 1.36 M 4.52% -0.22% 0% 0.42% 3% 3.11% 56% .30 / 28%
Dow Jones
U.S. Select Dividend Index DVY Dividends iShares 438.5 4.22% -1.22% 67% -0.92% 4% 2.84% 60% .34 / 52%
Technology XLK Technology SPDR 1.41 M 4.10% -1.21% 15% -3.22% 57% 5.70% 76% .25 / 15%
Lehman 20+Yr Treasury Bond TLT Bonds iShares 814.4 3.96% 1.19% 46% 2.55% 96% 0.34% 23% .35 / 55%
Dow Jones Industrial Average DIA Index Trust 5.92 M 2.48% -0.17% 0% -0.45% 12% 5.28% 98% .25 / 20%
Regional Bank RKH Regional Bank HOLDRS 722.3 2.45% -0.49% 11% 0.51% 2% 10.83% 100% .19 / 10%
Consumer Staples XLP Consumer SPDR 983.7 2.45% -1.51% 63% -0.38% 24% 2.54% 79% .45 / 18%
S&P 100 Index OEF Index iShares 509.4 2.40% -0.45% 33% -0.52% 8% 5.21% 99% .34 / 35%

(Negative one-year performance)

Telecom TTH Telecom HOLDRS 372.2 -7.41% -1.48% 31% -3.24% 43% 2.66% 63% .22 / 20%
Consumer Discretionary XLY Consumer SPDR 973.3 -4.40% -1.23% 50% -1.76% 33% 4.20% 59% .14 / 12%
Malaysia EWM Regional iShares 781.4 -3.26% -3.67% 58% -2.01% 58% -5.79% 89% .91 / 95%
Retail RTH Retail HOLDRS 2.70 M -1.89% -2.74% 87% -1.94% 45% 4.66% 48% .24 / 40%
Lehman 1- to 3-year
Treasury Bond SHY Bonds iShares 498.1 -1.18% -0.09% 9% 0.19% 81% -0.09% 3% .28 / 40%
Internet HHH Internet HOLDRS 456.8 -0.74% -3.00% 67% -1.72% 33% 12.43% 71% .17 / 5%
Pharmaceutical PPH Pharmaceutical HOLDRS 895.0 -0.44% 2.52% 23% 5.86% 94% 2.28% 100% .20 / 38%
* Europe, Australasia, and the Far East
Legend day moves, 20-day moves, etc.) show the per- ings, while a reading of 0 percent means the
Vol: 30-day average daily volume, in thou- centile rank of the most recent move to a cer- current reading is lower than the previous
sands (unless otherwise indicated). tain number of the previous moves of the same readings. These figures provide perspective for
1-year move: The percentage price move size and in the same direction. For example, determining how relatively large or small the
from the close one year ago (250 trading days) the “% Rank” for 10-day move shows how the most recent price move is compared to past
to today’s close. most recent 10-day move compares to the past price moves.
twenty 10-day moves; for the 20-day move, the Volatility ratio/rank: The ratio is the short-
10-day move: The percentage price move
“% Rank” field shows how the most recent 20- term volatility (10-day standard deviation of
from the close 10 days ago to today’s close.
day move compares to the past sixty 20-day prices) divided by the long-term volatility
20-day move: The percentage price move moves; for the 60-day move, the “% Rank” field (100-day standard deviation of prices). The
from the close 20 days ago to today’s close. shows how the most recent 60-day move com- rank is the percentile rank of the volatility
60-day move: The percentage price move pares to the past one-hundred-twenty 60-day ratio over the past 60 days.
from the close 60 days ago to today’s close. moves. A reading of 100 percent means the
The “% Rank” fields for each time window (10- current reading is larger than all the past read-
This information is for educational purposes only. Active Trader provides this data in good faith, but cannot guarantee its accuracy or timeliness. Active
Trader assumes no responsibility for the use of this information. Active Trader does not recommend buying or selling any market, nor does it solicit orders
to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or
her actions in the market.

46 www.activetradermag.com • March 2006 • ACTIVE TRADER

 The Business of TRADING

A (TAX) break for traders

The rich may not have many tax benefits, but traders sure do. Find out how to
take advantage of the numerous tax breaks at your disposal.

BY ROBERT A. GREEN, CPA

T he new year brings tax time — a time most

Americans dread.
Tax laws are far more complex than they need to
be. Tax forms and software programs can make your
head spin, and it’s costly and time-consuming to seek
the help of an expert.
Tax reforms have taken place recently, but don’t
expect to be able to file your taxes on a postcard any-
time soon. There is little relief for the 2005 tax year.
Nonetheless, taxes are inevitable, so you might as
well know how to mine the tax code and get your
share of the (tax savings) gold.

Do the rich pay less?

Popular dogma says there are two tax codes — one
for the poor and middle class and a more favorable
one for the rich. ing and longer holding periods usually don’t qualify. If you fall
In theory, poor and middle-class taxpayers are stuck with in the middle, you should consult a trader tax professional.
the existing tax code while the rich can afford to hire high- There are no solid rules, but assume you need one to three
priced experts to circumvent the tax laws using tax shelters, trades per day, every day. Be prepared to explain to the IRS any
tax-avoidance schemes, and plain old tax planning. days you don’t trade, and don’t have a pattern of trading laps-
Most tax shelters and avoidance schemes are now against es — the IRS likes to jump on that.
the law, but it has been true in the past that the wealthy could Reasonable excuses for not trading may include: lack of cap-
afford to hire better tax professionals. ital, reassessing your trading plan and/or the markets, new
However, thanks to the Internet, taxpayers of all income lev- training, family/business problems, and vacation.
els can get smart tax planning at a reasonable cost — in some Unreasonable excuses include retirement, personal activities,
cases without any cost. and lack of desire.
Search any tax term on Google and you will find valuable The IRS can attempt to deny trader tax benefits by claiming you
information together with the latest and greatest tax strategies. are merely an active investor and not seriously in pursuit of mak-
The new business model for CPAs and attorneys is to research ing a living by trading. They may also to argue your trading is a
new tax ideas, publish articles about them, and attract new hobby; however, you can usually overcome the hobby argument.
clients who want help in execution of those ideas.
The nuances of tax reporting
Is it better to be rich or a trader? You don’t need to elect trader tax status or make a filing with
The wealthy may not get more tax breaks than the middle the IRS or state tax authorities. You simply need to file a
class, but business owners — e.g., traders — certainly do. Schedule C (Business Profit or Loss) with your Form 1040.
Traders can deduct all expenses from revenues and only pay However, don’t report your trading gains on Schedule C.
taxes on their net income. Conversely, investors face a $3,000 Instead, trading gains and losses are reported on Schedule D
capital-loss limitation, investment interest and expense limita- (Capital Gains and Losses), unless you elect mark-to-market
tions, and the potential for the alternative minimum tax (AMT). (MTM) accounting in which case you use a Form 4797 Part II
If you traded all day, everyday in 2005, you may qualify as a (Sale of Business Property — Ordinary Gain or Loss).
business trader, even if you had another job, business, or sig- Commodities and futures traders report trading gains and
nificant activity. Part-time traders with sporadic lapses in trad- losses on Form 6781. Portfolio interest and dividend income is

ACTIVE TRADER • March 2006 • www.activetradermag.com 47

reported on Schedule B. Home/office expenses go on Form 8829, income (wage, portfolio, capital gains, or otherwise).
while depreciation and amortization is reported on Form 4562. Plus, if you have negative taxable income, ordinary losses
and your business expenses are part of a net operating loss
The Schedule C red flag (NOL) deduction, which may be carried back two tax years
Unfortunately, while reporting only business expenses on (and/or forward 20 years) — even if you were not a trader in
Schedule C is the best route tax-wise, it is also likely to raise those years.
some eyebrows at the IRS. A Schedule C without trading gains MTM must be elected by April 15 of the current tax year. For
is a losing business to many IRS agents, who may not know example, a trader who wishes to have MTM for 2006 can attach
trader tax law to begin with. a note of election to his 2005 tax return (or extension), filed by
Agents and IRS computer programs are trained to snag April 15, 2006.
Schedule Cs with losses. You can prevent this problem by
transferring some or all of your business trading gains from Extend yourself
Schedule D, Form 4797, or Form 6781 to “zero out” Schedule C If all of this seems a little confusing and you’re not sure you can
(since traders don’t report gains on Schedule C). get everything done by April 15, relax. File an extension, and
It is also strongly suggested you explain things to the IRS using you’ll have until Oct. 15 to file all your tax forms. In the past, you
footnotes attached to your tax forms. Keep them simple but cover needed to file one extension to make Aug. 15 the due date, then
all the bases. Footnotes for business traders answer most IRS another to get to Oct. 15. This year, only one filing is needed.
questions and can be very helpful in preventing an IRS audit. Regardless, the extension only gives you more time to file, not
to pay. You still must pay 90 percent of what you owe by April
Plan B 15. Don’t forget to attach your MTM election to your extension.
There are other ways to avoid the Schedule C red flag problem.
One is by forming a business entity. This gives you the presump- The experts are still best
tion of a business purpose, although you still must qualify for Trader tax breaks are highly nuanced and confusing. MTM,
trader tax status. while mostly a godsend for traders, can be problematic if a
A job in addition to trading could be helpful. By filing both trader has large capital loss carryovers.
an individual tax return and an entity return, you may be able Wash sales are not always bad. In some cases, they can be
to confuse the IRS, which is fair game since the IRS is a little turned into ordinary losses.
prejudiced towards part-time traders. It will not see both While there is a good deal of free information available,
returns at the same time and may not see you also have a W-2 there are also books and guides available for less than $100 that
or other significant activity on your individual tax return. provide additional information and tax-saving techniques. If
There are other good reasons to have a trading entity. For you have further questions, consider a paid consultation with
starters, you unlock the opportunity to have two important a trader tax expert.
AGI deductions: a tax-deductible retirement plan and tax- However, make sure the person you are dealing with is, in
deductible health-insurance premiums. fact, an expert. You wouldn’t go to a general doctor if you had
Also, an entity allows you to make a MTM election later in the heart trouble, so don’t settle for a CPAwho is not well versed in
year. While individuals must elect MTM by April 15 of the exist- trader tax issues. Your local CPA storefront that opens during
ing tax year, entity taxpayers have 75 days after the inception of tax season most likely has part-time accountants who are light-
a new entity. ly trained. They aren’t savvy CPAs, let alone trader tax experts.
If you are not married and a full-time profitable trader, a A full-time CPA is probably not much better. Some tend to
single-member LLC is probably your best choice. If you are a talk traders out of electing MTM. Their style of line-by-line
part-time trader, though, it’s better to file a separate S-Corp trade accounting will cost you a fortune and they may cause
return. you to miss out on many tax breaks.
If you are married, a husband/wife general partnership return Thanks to the Internet, accountants have become experts in
is good. You will file the same partnership tax return an LLC files a particular discipline, such as trader tax issues. And because
without the costs of forming and maintaining an LLC. these firms are virtual, it doesn’t matter where you live.
Husband/wife partnerships may be applied to prior periods, too.
The only entity a trader should not form is a C-Corp. C-Corps The bottom line
pay taxes twice — once on the entity level and a second time on There are plenty of good resources (the Internet, books, maga-
the individual level. C-Corps are best left for public companies. zines) for trader tax issues. You can use the information to file
Your entity should be formed in your home state. Do not a tax return on your own, but this is probably not the best idea.
attempt to form the entity in a tax-free state. This is a tax-avoid- Utilize consultations and/or tax-preparation services from
ance scheme that could get you into trouble with the IRS. trader tax firms for even more value.Ý

MTM gives you tax loss “insurance” For information on the author see p. 3.
Only business traders are entitled to elect MTM accounting
(IRC 475). MTM reports unrealized gains and losses as realized
during the tax year, but the most important benefit to traders is Related reading
that MTM reclassifies capital losses as ordinary losses. Books by Robert Green, CPA
Capital losses are subject to a $3,000 annual loss limitation,
The Tax Guide for Traders (McGraw-Hill, 2004)
but ordinary losses are business losses that offset any type of

48 www.activetradermag.com • March 2006 • ACTIVE TRADER

 MARKET Pulse

THE PUT-CALL RATIO

as a contrarian indicator
Many traders believe the put/call ratio’s
T he put/call ratio measures
the relationship between
put and call option volume
in a market. It was original-
ly applied to index and equity options
traded at the Chicago Board Options
Exchange (CBOE), but it can be calculat-
extremes signal market turning points, but ed for any market with sufficient option
volume.
interpreting this indicator isn’t that simple. The put/call ratio divides put option
volume by call option volume for a
given time period. The indicator tracks
market sentiment — option traders’
bullish or bearish outlook. The basic
BY DAVID BUKEY premise is, as the market drops

FIGURE 1 PUT/CALL RATIO — MARKET TOP (2000)

The smoothed OEX put/call ratio seems to mirror the market’s moves by peaking near the S&P 500’s highs in January,
March, and September 2000. However, the equity only ratio, which represents the bets of individual traders, tends to
move in the opposite direction of the market.

Source: MetaStock

ACTIVE TRADER • March 2006 • www.activetradermag.com 49

 The put/call ratio

T
he put/call ratio compares Chicago Board Options Exchange (CBOE)
put option volume to call option volume. The ratio was first developed
by Marty Zweig in 1971, and traders typically use it to gauge market Receipts (SPY), which reflect the S&P500
sentiment. index, behaved in the first two weeks
To calculate the ratio, divide the volume of put options by the volume of call after extreme daily highs and lows in
options for a given time period. You can track the put/call ratio for any time both OEX and equity put/call ratios
frame (intraday, daily, weekly, monthly, etc.), but a daily ratio is most common. since 1997. Overall, these extremes did-
Also, the put/call ratio can be calculated for any instrument with tradable n’t generate reliable contrarian trading
options — individual stocks, futures, and so on. signals in the traditional sense, but there
The ratio measures market sentiment because traders use puts and calls for were other tendencies that deserve atten-
different reasons. Puts are typically traded more in declining markets and peri- tion.
ods of uncertainty. Similarly, calls are generally more active when the public is
bullish about the market. Accordingly, the put/call ratio is typically interpret- Defining put/call ratio highs and lows
ed in contrarian fashion because traders assume the public is wrong about the Because daily put/call ratio values are so
market’s direction when the indicator reaches either extreme. volatile, a 10-day exponential moving
For example, put volume tends to spike when the market sells off as average (EMA, see “Key Concepts”) was
traders become more protective of their long positions. Also, unusually high used to filter out short-term jumps and
call volume typically occurs after the market has already rallied and the pub- identify more meaningful extreme val-
lic is quite bullish about its direction. According to this logic, high put vol- ues.
ume appears prior to a rebound, and high call volume precedes a drop. The criteria to find high and low
However, these tendencies are only generalizations — interpreting the put/call ratio values:
put/call ratio is rarely as simple in practice. For instance, not all extremely
high put/call ratio values precede sell-offs, and not all low readings lead to 1. The ratio’s 10-day EMAvalue must
rallies. make a 120-day high.
The CBOE tracks three put/call ratios: total, S&P 100 index (OEX), and the 2. The ratio’s 10-day EMAvalue must
equity-only (individual stock) ratio. The exchange offers intraday updates (at make a 120-day low.
30-minute intervals) of all three put/call ratios. Daily historical data for the
OEX and equity ratios goes back to October 2003, while 10 years of total ratio When the put/call EMAhits a 120-day
daily values are available at www.cboe.com/data/PutCallRatio.aspx. high, put option volume is dominating
call option volume, which is traditional-
ly seen as a sign of excessive bearishness.
investors become increasingly bearish extremes as trade signals seems com- If the EMAvalue drops to a 120-day low,
and buy more puts, which protect pelling, there are several problems to this investors are trading many more calls
against further sell-offs. However, when conventional approach. For instance, than puts, which is usually interpreted
the market outlook is bullish, investors how do you objectively define extremely as a sign of overwhelming optimism. In
tend to buy more calls, which gain value high and low levels? studying both equity and OEX put/call
when the market rallies. Instead of using actual values as buy ratios, these events turned out to be rela-
Traders who analyze the put/call ratio and sell thresholds, it’s best to measure tively rare — appearing roughly once
look for extreme values and use it as a them on a relative basis (i.e., every two months since Jan. 8, 1997.
contrarian indicator, betting the crowd is higher/lower than the prior X days). The analysis then measured how SPY
wrong about the market’s direction. For Also, ratio values can be quite volatile, reacted on each of the 10 days after the
example, unusually bullish sentiment so a moving average is often used to help ratio’s 120-day highs and lows.
typically appears after stocks have ral- smooth the data and filter out noise.
lied significantly and investors antici- The put/call ratio can be applied to Put/call ratios at market
pate further gains. Contrarians believe any instrument in which options are trad- tops and bottoms
excessive optimism signals market tops, ed. The CBOE tracks total put/call vol- Figure 1 shows a daily chart of SPY
because if everyone has already bought ume, but it also distinguishes between (lower window) around the time of the
stock, buyers then disappear, and sellers S&P 100 (OEX) volume, which typically March 2000 market peak. The figure’s
drive prices lower. Similarly, extreme represents professional traders, and equi- upper window shows the 10-day EMAs
pessimism should pinpoint market bot- ty volume, which contains smaller of the OEX, total, and equity put/call
toms because once sellers dump shares, traders. Many traders consider equity ratios (green, blue, and red lines, respec-
only buyers remain. options volume the best measure of pub- tively).
Higher put/call ratio values imply lic sentiment, because institutions use the Comparing the OEX and equity
bearish sentiment because more puts are OEX for hedging purposes, making it less put/call EMAs as the market peaked in
traded than calls; lower readings suggest reliable as a contrarian indicator. 2000 reveals an important distinction:
bullish conditions since calls are more The following analysis shows how the The OEX ratio hit 120-day highs as SPY
widely traded. Although using these Standard and Poor’s Despositary reversed in January and September,

50 www.activetradermag.com • March 2006 • ACTIVE TRADER

FIGURE 2 PUT/CALL RATIO — 2001 AND 2002
While the smoothed OEX put/call ratio hit 120-day highs near market tops, the equity only put/call ratio spiked as the mar -
ket bottomed after the Sept. 11 attacks and fell to a 120-day low as the S&P 500 hit a six-week high in mid-August 2002.

Source: MetaStock

while the equity ratio hit a 120-day low In contrast, the 10-day EMA of the proved to be a fairly accurate contrarian
roughly 10 days before SPY’s historic OEX ratio reached a 120-day high on Jan. signal.
high on March 24, 2000. This suggests 3, 2002 prior to SPY’s downturn over the
professional traders are bearish at mar- next month. And the OEX ratio fell to a Bearish sentiment precedes
ket tops as retail traders remain bullish. 120-day low on Feb. 3 as SPY rebounded market jumps
Also, the equity put/call ratio reached a slightly until early March. Figure 3 shows the average daily SPY
120-day high on Sept. 17 only after SPY move for each of the 10 days after the
had dropped 11.66 percent in the previ- Equity put/call ratio as accurate equity put/call ratio EMA rose to a 120-
ous six weeks. contrarian signal day high. The figure also compar es
Figure 2, which shows SPY and all This anecdotal evidence implies profes- SPY’s cumulative gain or loss (i.e., from
three put/call EMAs from March 2001 to sional traders were more accurate when the close of the extreme day to the close
November 2002, highlights a similar predicting the market’s direction than 1, 2…10 days after) to its benchmark
relationship. The equity put/call ratio individual traders, but studying how (typical same-length) price move since
rose to a 120-day high in response to the SPY responded to 120-day extremes in 1997.
Sept. 11 terrorist attacks. Although SPY both the OEX and equity put/call ratios The market surged an average 0.54
dropped another 9.74 percent before showed the results weren’t as clear as percent in the first two days after the
recovering a week later, this extremely Figures 1 and 2 suggest. equity ratio hit this bearish extreme. SPY
high ratio value would have been a prof- Overall, the market behaved more gave back this initial gain on the third
itable longer-term buy signal. Similarly, predictably after high/low extremes in day, but the market climbed on each of
the public mood turned bullish as the the equity ratio than it did following its the remaining seven days to post a total
equity ratio fell to a 120-day low on Aug. OEX-ratio counterpart. The remaining 1.57-percent gain. Table 1 shows the sta-
16, 2002, just before SPY peaked and fell analysis focuses on 120-day highs and tistics behind 120-day highs and lists
another 20.66 percent by Oct. 10. lows in the equity put/call ratio, which each day’s average, median, maximum,

ACTIVE TRADER • March 2006 • www.activetradermag.com 51

 FIGURE 3 PUT/CALL RATIO HIGHS (EQUITY ONLY)
When the put/call ratio’s 10-day EMA hit 120-day highs, the market climbed
during nine of the 10 following days to rise an average 1.57 percent overall.

and minimum values. The table also

shows each day’s standard deviation
and percentage of gains (“Pct. > 0”) as
well as its largest intraday close-to-high
up move (LUM) and close-to-low down
move (LDM).
Half the daily average values don’t
match their medians, which implies
Figure 3 is somewhat misleading. For
example, during the first week the aver-
ages are larger than their medians. The
statistics are more in line during the sec-
ond week, but the overall 10-day median
gain is nearly 1 percent less than its aver-
age counterpart (0.59 vs. 1.57 percent,
respectively).
However, the market has a noticeably
higher chance of gains in the second
week, which corresponds with the SPY
rally shown in Figure 3.
put/call ratio EMA fell to 120-day lows. during this period.
Market lags bullish sentiment While no distinct market patterns appear The market slipped 0.14 percent on
Figure 4 shows SPY’s average daily following these events, it’s clear SPY the first day after put/call ratio lows,
moves in the 10 days after the equity underperforms its typical price behavior rebounded 0.32 percent on the second

TABLE 1 PUT/CALL RATIO HIGHS — STATS

If you compare each day’s average and median values, you’ll notice the market was not as strong in the first week after
put/call ratio highs as Figure 4 suggests (especially day 5). However, the medians tended to outperform their averages in the
second week.

57 instances Day 1 LUM LDM Day 2 LUM LDM Day 3 LUM LDM Day 4 LUM LDM Day 5 LUM LDM
Avg: 0.37% 1.37% -1.30% 0.17% 1.25% -1.09% -0.46% 0.74% -1.41% 0.05% 1.12% -1.32% 0.43% 1.40% -0.96%
Med: 0.10% 0.96% -1.09% 0.03% 0.89% -0.65% -0.57% 0.55% -1.22% -0.24% 0.80% -1.09% -0.05% 0.89% -0.62%
Max: 5.77% 6.52% 0.00% 5.37% 5.37% 0.00% 3.33% 3.40% 0.00% 5.37% 5.37% 0.00% 5.38% 6.65% 0.00%
Min: -2.59% 0.00% -5.28% -3.18% 0.00% -5.28% -3.18% 0.00% -4.97% -4.71% 0.00% -4.97% -3.48% 0.00% -3.76%
Standard deviation: 1.90% 1.40% 1.31% 1.83% 1.22% 1.16% 1.41% 0.79% 1.12% 1.81% 1.18% 1.25% 1.96% 1.43% 1.05%
Pct. > 0: 50.88% 50.88% 35.09% 45.61% 47.37%

Day 6 LUM LDM Day 7 LUM LDM Day 8 LUM LDM Day 9 LUM LDM Day 10 LUM LDM
Avg: 0.04% 1.04% -1.15% 0.27% 1.11% -1.09% 0.34% 1.15% -1.00% 0.32% 1.16% -1.04% 0.02% 0.89% -1.16%
Med: 0.32% 0.83% -0.65% 0.17% 0.83% -0.69% 0.45% 0.87% -0.64% 0.30% 0.90% -0.65% 0.08% 0.85% -0.82%
Max: 3.75% 3.88% 0.00% 4.80% 4.87% 0.00% 4.80% 4.87% 0.00% 4.80% 4.87% 0.00% 3.75% 3.88% 0.00%
Min: -7.13% 0.00% -8.10% -3.48% 0.00% -3.67% -3.00% 0.00% -3.64% -3.00% 0.00% -4.95% -3.00% 0.00% -4.95%
Standard deviation: 1.78% 0.88% 1.43% 1.70% 1.14% 1.01% 1.64% 1.08% 1.05% 1.68% 1.14% 1.11% 1.24% 0.73% 1.10%
Pct. > 0: 57.89% 54.39% 63.16% 61.40% 56.14%

52 www.activetradermag.com • March 2006 • ACTIVE TRADER

 FIGURE 4 PUT/CALL RATIO LOWS (EQUITY ONLY)
Although the S&P 500 rallied an average 0.32 percent in the second and third
days after the put/call ratio’s 10-day EMA fell to 120-day lows, the market
lagged its benchmark during most of this period.
If you compare the table’s daily stan-
dard deviations to those in Table 1, it’s
obvious the market is much more
volatile after extremely high put/call
ratios than extremely low readings. This
makes sense because puts tend to be
more widely traded than calls during
periods of uncertainty.

A longer-term view
Tracking the market’s behavior up to
two months after the equity put/call
ratio’s 10-day EMA reached extreme
highs and lows revealed trends similar
to those in Figures 3 and 4. Figure 5
shows SPY’s cumulative average gains
or losses in the 15-, 20-, and 40-day peri-
ods following put/call ratio highs (red
bars) compared to its behavior after
put/call ratio lows (blue bars). Market
benchmarks (yellow bars) are also
shown — the average same-length
moves over the past eight years.
The figure shows SPY continued to
and third days, and then relinquished Table 2 shows the statistics for 120-day rally — and outperform its benchmarks
that gain on the fourth day. SPY put/call ratio lows. Although there isn’t — up to 40 days after put/call ratio highs,
remained below its benchmarks in the much difference between average and while it traded sideways following
second week and was flat by the end of median values, the medians are slightly put/call ratio lows, a sign the crowd has
the 10th day. larger than the averages. been wrong at extremely bearish levels.

TABLE 2 PUT/CALL RATIO LOWS — DETAILS

Daily average and median values aren’t identical, but they are more closely matched following put/call ratio lows than highs.
Also, daily standard deviations are much smaller following put/call ratio lows than their corresponding highs.

42 instances Day 1 LUM LDM Day 2 LUM LDM Day 3 LUM LDM Day 4 LUM LDM Day 5 LUM LDM
Avg: -0.14% 0.60% -0.85% 0.21% 0.78% -0.72% 0.11% 0.68% -0.68% -0.34% 0.57% -1.04% -0.03% 0.60% -0.86%
Med: 0.02% 0.33% -0.54% 0.13% 0.64% -0.44% 0.12% 0.58% -0.48% -0.21% 0.51% -0.69% 0.00% 0.41% -0.72%
Max: 2.34% 2.79% 0.00% 4.67% 5.03% 0.00% 4.67% 5.03% 0.00% 2.60% 2.94% 0.00% 2.60% 2.94% 0.00%
Min: -3.32% 0.00% -3.70% -1.80% 0.00% -3.12% -1.80% 0.00% -3.12% -2.83% 0.00% -3.48% -2.15% 0.00% -3.12%
Standard deviation:1.19% 0.73% 0.86% 1.16% 0.90% 0.76% 1.03% 0.81% 0.72% 1.06% 0.56% 0.89% 1.04% 0.70% 0.76%
Pct. > 0: 52.38% 66.67% 57.14% 40.48% 50.00%

Day 6 LUM LDM Day 7 LUM LDM Day 8 LUM LDM Day 9 LUM LDM Day 10 LUM LDM
Avg: 0.07% 0.76% -0.71% 0.03% 0.79% -0.73% 0.09% 0.76% -0.69% -0.04% 0.70% -0.77% 0.00% 0.78% -0.74%
Med: 0.12% 0.60% -0.55% 0.19% 0.59% -0.50% 0.13% 0.54% -0.56% -0.03% 0.58% -0.59% 0.10% 0.64% -0.43%
Max: 2.60% 2.94% 0.00% 2.60% 2.94% 0.00% 2.60% 3.17% 0.00% 2.71% 2.79% 0.00% 1.99% 2.35% 0.00%
Min: -2.27% 0.00% -3.12% -3.81% 0.00% -3.96% -3.12% 0.00% -3.36% -2.65% 0.00% -2.85% -3.81% 0.00% -3.96%
Standard deviation:0.99% 0.68% 0.72% 1.21% 0.69% 0.88% 1.12% 0.82% 0.75% 1.01% 0.66% 0.73% 1.17% 0.64% 0.90%
Pct. > 0: 57.14% 61.90% 61.90% 47.62% 54.76%

ACTIVE TRADER • March 2006 • www.activetradermag.com 53

 FIGURE 5 LONGER-TERM SPY MOVES
The market continued to rally after the put/call ratio hit 120-day highs (red
bars), but it lagged its benchmarks (yellow bars) after put/call ratio lows
(blue bars) — a sign this ratio is an accurate contrary indicator.
Not only did the S&P climb an average
1.57 percent in the first two weeks after
120-day put/call ratio highs (see Figure
3), it rose at least 0.44 percent in the third
and fourth weeks after these events. By
the end of the second month (40 days),
SPY posted a 2.86-percent gain.
In contrast, the S&P underperformed
its benchmark in each of the three
longer-term periods following days in
which the put/call ratio sank to 120-day
lows. Although SPY climbed 0.30 per-
cent from day 10 to day 15, the market
sank 0.67 percent during the fourth
week and was roughly flat by the end of
the 40th day after these events.

Bottom line
This study confirms the equity put/call
ratio is a mixed contrarian signal. When
market sentiment hit a bearish extreme,
the S&Prallied in the following 40 days.
However, the market’s behavior was
less straightforward after bullish
extremes — the market was basically
flat following put/call ratio lows, but no
sustained sell-offs occurred.
Related reading
One limitation of the analysis is that “Put-Call inversions: Separating the smart money from the dumb”
it focused exclusively on option volume Active Trader, June 2002.
and didn’t incorporate actual price Contrary to popular belief, there’s more than one put/call ratio, and looking at
behavior. For instance, you might be the wrong one at the wrong time can give you a misleading picture of the mar-
able to uncover compelling trade oppor- ket. This look at divergences between different put/call ratios can tell you
tunities if you combined extremely high which way the smart money is betting.
put/call ratio signals with previous
market declines or extremely low ratios “Indicator insight: Put/call ratio”
with a prior rally. Ý Active Trader, May 2002.
An explanation of how to calculate and interpret the put/call ratio.

“Getting sentimental about options”

Active Trader, March 2002.
Successful option trading depends on a number of variables, but one many
traders overlook is sentiment analysis. Find out what different sentiment tools
represent and how they can round out your trading.

“Getting started in options”

Active Trader, April 2001.
Here’s what you need to know to get started in the world of puts and calls.

“Going against the crowd”

Active Trader, November 2000.
The put-call ratio has long been used as a measure of market sentiment. Here’s
a new twist on an old approach that can help you catch turning points based on
short-term put-call extremes.

You can purchase past Active Trader articles at www.activetradermag.com/pur -

chase_articles.htm and download them to your computer.

54 www.activetradermag.com • March 2006 • ACTIVE TRADER

 GLOBAL Marketplace

EUROPE q China’s State Information Center (SIC), a government

think thank, predicted 2006 GDP growth of between 8.3 and
9.3 percent. The SIC presented three different scenarios, each
q France’s October jobless rate fell 0.1 percent to 9.8 percent involving differing levels of CPI and retail sales growth, that
compared to the previous month and dropped 0.3 percent com- would put the GDP increase at either 8.3, 8.8, or 9.3 percent.
pared to the same month a year earlier.
q India’s GDP could grow by as much as 7.7 percent over the
q The new German economy minister told reporters he saw next year, according to Bank of America. In a report, economist
Germany’s GDP growth for 2006 somewhere between 1.5 and Mickey Levy said “economic activity continues to transition
1.8 percent. The original projection was for 1.2 percent growth, from the public to the private sector.” However, Levy warned
thanks in large part to rising oil prices that remained high of higher inflation that could lead to interest rate hikes.
longer than anticipated. However, the new forecast comes
amid expanding exports and the belief that declines in domes-
tic construction spending will end.
AMERICAS
ASIA & THE SOUTH PACIFIC q Argentina’s unemployment rate fell 1.0 percent in Q3 to
11.1 percent compared to Q2 and decreased 2.1 percent from
q Australia’s economy in the third quarter grew 0.2 percent the same quarter in 2004.
compared to Q2 and increased 2.6 percent compared to Q3
2004. This marks 19 consecutive quarters of growth since a q Canada’s GDP rose 2.8 percent in Q3 and posted a 6.2-per-
decrease in Q4 2000. Construction, finance, and insurance con- cent increase over the same quarter a year earlier. The coun-
tributed the most to Q3 growth, offset by weaknesses in min- try’s unemployment rate for November fell to 6.4 percent, its
ing and agriculture. The country’s unemployment rate in Q3 lowest level in more than three decades. The rate is 0.8 percent
dropped 0.1 percent to 5.1 percent compared to the previous lower than November 2004, as Canada created more construc-
quarter and decreased by the same percentage compared to the tion jobs.
third quarter of 2004.
q Argentina paid off its debts to the International Monetary
q Hong Kong’s economy grew 2.7 percent in Q3 over Q2, Fund. The IMF confirmed in early January Argentina’s pay-
enjoying a ninth-straight quarter of expansion. GDP increased ment of almost $10 billion, which was accomplished by using
8.1 percent compared to the same quarter a year earlier. the country’s foreign reserves. Brazil has also announced its
“Despite the ongoing external uncertainties stemming from intentions of paying off the $15 billion it owes the IMF. Brazil
high oil prices, rising U.S. interest rates and exchange rate and Argentina had two of the IMF’s largest loans.
movements, their impact on Hong Kong’s external trade have
so far been very moderate,” said K.C. Kwok, government econ-
omist, in a statement. AFRICA
q India’s third-quarter GDP was up 11.5 percent from Q2.
Trade, hotels, transport, and communication contributed the q South Africa’s GDP in the third quarter increased 4.2 per-
most to the economy, as GDP grew 8 percent over Q3 2004. cent over the previous quarter, as the manufacturing, retail
trade, and finance/business industries contributed 0.9 percent
q Japan’s October jobless rate increased 0.3 percent com- in real value to the economy. The GDP data from Q1 and Q2
pared to the previous month, but dropped 0.1 percent com- increased 4.6 percent and 5.4 percent, respectively, according
pared to October 2004. to Statistics of South Africa.

NON-U.S.-DOLLAR FOREX CROSS RATES

1-month 3-month 6-month 52-week 52-week
Rank Currency vs. Symbol Current gain/loss gain/loss gain/loss high low Previous
1 Aussie $ Pound AUD/GBP 0.4262 -0.84% -2.06% 0.09% 0.4398 0.4022 2
2 Euro Yen EUR/JPY 139.489 -1.35% 2.47% 4.34% 143.605 130.6 3
3 Pound Euro GBP/EUR 1.456 -1.43% -1.21% -1.57% 1.5124 1.4086 6
4 Aussie $ Euro AUD/EUR 0.62 -2.35% -3.35% -1.65% 0.6424 0.5767 4
5 Pound Yen GBP/JPY 202.96 -2.87% 1.27% 2.80% 213.03 189.5 5
6 Aussie $ Yen AUD/JPY 86.4315 -3.80% -0.83% 2.79% 91.34 76.95 1
As of: Jan. 4, 2006

ACTIVE TRADER • March 2006 • www.activetradermag.com 55

 FOREX (VS. U.S. DOLLAR )

Current price 1 month 3-month 6-month 52-week 52-week Previous

Rank Currency vs. U.S. dollar gain/loss gain/loss gain/loss high low rank

1 Japanese yen 0.008492 2.38% -3.20% -5.46% 0.00983 0.00824 9

2 Singapore dollar 0.6019 1.74% 1.98% 1.91% 0.6186 0.5858 4

3 Euro 1.184 1.01% -0.66% -0.91% 1.358 1.1638 6

4 Swiss franc 0.7615 0.39% -0.88% -1.26% 0.8793 0.7525 7

5 Canadian dollar 0.8608 0.27% 0.24% 6.61% 0.8748 0.7851 2

6 Hong Kong dollar 0.129 0.00% 0.08% 0.23% 0.1291 0.128 3

7 British pound 1.7228 -0.45% -1.90% -2.63% 1.9324 1.7048 8

8 Australian dollar 0.7338 -1.35% -4.05% -2.59% 0.7988 0.7233 5

9 Brazilian real 0.428 -5.70% -4.81% 0.79% 0.4641 0.3596 1

As of: Jan. 4, 2005

GLOBAL STOCK INDICES –

1-month 3-month 6-month 52-week 52-week Previous

Rank Country Index Current gain/loss gain/loss gain/loss high low rank

1 India BSE 30 9,648.08 7.12% 8.79% 24.57% 9,664.94 6,069.33 1

2 Japan Nikkei 225 16,361.54 5.74% 16.03% 28.79% 16,445.56 10,770.58 2

3 Australia All ordinaries 4,765.1 4.01% 3.64% 11.13% 4,767.7 3,886 10

4 Germany Xetra Dax 5,523.62 3.90% 6.98% 16.30% 5,523.67 4,157.51 3

5 Canada S&P/TSX composite 11,441.58 3.81% 4.20% 13.11% 11,456.12 8,952.79 4

6 France CAC 40 4,838.52 3.64% 3.89% 11.86% 4,838.52 3,804.92 6

7 UK FTSE 100 5,714.6 3.26% 3.85% 9.28% 5,716.4 4,765.4 9

8 Singapore Straits Times 2,384.14 2.17% 2.53% 6.84% 2,399.75 2,061.99 7

9 U.S. S&P 500 1,273.46 0.66% 4.63% 6.21% 1,275.8 1,136.15 5

10 Hong Kong Hang Seng 15,200.06 0.00% -1.20% 6.72% 15,508.57 13,320.53 8

Rank: Currencies and indices are ranked by their one-month gain/loss.

As of: Jan. 4, 2005

56 www.activetradermag.com • March 2006 • ACTIVE TRADER

 The Face of TRADING

View from above

BY ACTIVE TRADER STAFF

Name: Charlie French

Age: 62
Lives and works in: Huntley, Ill.

A fter retiring from the world of corporate finance at the

end of 1998, Charlie French began managing his retire-
ment funds and other financial assets. At the time, his
money was divided between several large brokerages.
Throughout his life, French had always been a fairly aggres-
range, and moving average activity. He then narrows the field
down to about 30 stocks.
“I’ll flip through the charts to see which ones are of interest.
I want to see how they are moving,” he says.
In general, French prefers to trade stocks that have at least half
sive investor, with 100 percent of his assets in equity funds. a million to a million shares traded daily and are priced at $7 or
However, in 2000 when the U.S. equity market topped and higher. He utilizes several technical indicators in his short-term
tumbled sharply lower, French became disenchanted with the trading strategy and looks for a variety of discretionary set-ups
way his money was being managed. within 30-minute and 5-minute candlestick charts.
“I became disgusted with the professional managers,” he For example, one of his setups consists of applying Bollinger
says. “It became obvious that their number one interest was Bands on intraday candlestick charts. “I look for stocks going out-
making commissions and money for their firms. I decided that side the bands,” he says. When a stock exceeds a Bollinger Band,
the only way I could preserve or grow my assets was to French will look for a “rounding” three-candlestick pattern, which
become more active.” will include the candle exceeding the band, a smaller candle
French began attending various investment seminars and reflecting indecision, and a candle going higher (or lower) back
joined the Cornerstone Investor’s Network group in the into the band. When this happens, “the market mood has changed
Chicago area. Coming from a background in corporate finance, abruptly. I like those [setups],” he says.
French admitted that, “in finance, everything has to be funda- He trades from both the long and short side and uses stops
mentals and in-depth analysis, focused on earnings.” But, that are 2-6 percent of the cost of the stock. With the Bollinger
when shifting his interest toward more active trading, he found Band trade setup, French has found the market will generally
he didn’t have the time and energy to study every stock. gravitate back toward the middle band.
“My profession had always steered me toward the funda- “I watch it when it gets to the center,” he says. “Usually it
mentals, but now I’ve become convinced that technicals are will break out and come out the other side.”
much more important,” he says. “It was a complete about-face.” At that point, French would take profits on his position and
Over the past several years, French has implemented a new go short a second trade, with a target at the middle band.
strategy. He still has some funds under management at a large
brokerage house and he has 401(k) assets. But he has added Most important lesson learned: “I like to play poker and I like
short-term equity trading into the mix. to play aggressively. But I’ve learned that being aggressive in
“My number one objective is to stay attuned to the market the markets can cause people to go broke. I’ve had to learn
on a daily basis so I can better supervise and manage my 401(k) patience, discipline, and money management.”
monies as well as be knowledgeable with the large broker,” he
says. “Now, I don’t just have to take his advice; I feel confident When not trading: French spends time with grandchildren, is
challenging him or offering him advice.” active on the finance committee of his homeowner’s associa-
He describes his trading and investing strategy as a two- tion, and works out at the gym.
layer approach. The first layer involves developing a longer-
term view by looking at the markets like “a helicopter watch- Best thing about trading: “Knowing that I am taking owner-
ing from above.” This allows him to make moves in his major ship of my assets and am not at the mercy of someone else.”
funds from once a month to once a quarter.
The second layer involves his daily short-term stock trading Best resources: Cornerstone Investor’s Network, Schaeffer’s
activities. “That forces me to stay attuned to what is going on Investment Research daily newsletter, BigTrends.com.Ý
in the marketplace.”

Before trading: French was chief financial officer of Kellogg Trading setup
North America for 32 years before retiring.
Hardware: Pentium 4 with 1.2Ghz, 512 RAM,
Trading methodology: French has apportioned his assets 19-inch flat-panel monitor
roughly 45 percent in his 401(k) accounts, 45 percent with a Software: TC Net, Tradestation,
large broker, 5 percent with a forex money manager, and 5 per- Dr. John Clayburg’s indicators
cent for daily trading. Internet
He puts on about 60 stock trades per week. His trades last connection type: Broadband
from intraday to two to three days. He scans more than 7,000
Brokerage type: Interactive Brokers
stocks on a daily basis, screening for price range, volume

ACTIVE TRADER • March 2006 • www.activetradermag.com 57

KEY
Concepts

At the money (ATM): An option whose strike price is iden- 1. Calculate the typical price for each bar, which is the
tical (or very close) to the current underlying stock (or futures) sum of the high, low, and closing prices divided by three.
price. 2. Calculate a moving average of the typical prices over a
desired look-back period (e.g., 10 bars).
Bollinger Bands: Bollinger Bands are a type of trading 3. Calculate the difference between each typical price
“envelope” consisting of lines plotted above and below a mov- over the look-back period and the moving average of the
ing average, which are designed to capture a market’s typical typical price for the respective bar.
price fluctuations. 4. Sum the absolute value of all the differences from
The indicator is similar in concept to the moving average step 3 and divide by the look-back period.
envelope (see Indicator Insight, Active Trader, September 2002, 5. Subtract the value calculated in step 2 from the last
p. 84), with an important difference: While moving average bar’s value as calculated in step 1, and divide it by the
envelopes plot lines a fixed percentage above and below the value calculated in step 4 times 0.015. (The factor 0.015
average (typically three percent above and below a 21-day sim- will force most readings to fall within +/- 100.)
ple moving average), Bollinger Bands use standard deviation
to determine how far above and below the moving average the Theoretically, there are no limits to how high or low CCI val-
lines are placed. As a result, while the upper and lower lines of ues can go. Because of its construction, however, most markets
a moving average envelope move in tandem, Bollinger Bands should have a large majority of their CCI values between the
expand during periods of rising market volatility and contract +/- 100 levels, and very seldom should you see readings above
during periods of decreasing market volatility. or below 300.
Bollinger Bands were created by John Bollinger, CFA, CMT, The most basic way to interpret CCI is to look for a reading
the president and founder of Bollinger Capital Management above or below a significant level, as determined by past study
(see Active Trader, April 2003, p. 60). of the indicator. Typically these levels are +/-100, but other lev-
By default, the upper and lower Bollinger Bands are placed els could be used, including “asymmetrical” values (e.g., -150
two standard deviations above and below a 20-period simple and +200), depending on whether you use the indicator to con-
moving average. firm breakouts or to look for tops and bottoms, its two main
uses.
Upper band = 20-period simple moving average + 2 stan- For more information, see the following articles: “Indicator
dard deviations Insight: The Commodity Channel Index” (Active Trader,
December 2001); “The CCI stochastic” (Active Trader,
Middle line = 20-period simple moving average of closing September 2004), and “The CCI Ghost” (Active Trader, May
prices 2004).

Lower band = 20-period simple moving average - 2 standard Delta: The ratio of the movement in the option price for every
deviations point move in the underlying. An option with a delta of .5
would move a half-point for every 1-point move in the under-
Bollinger Bands highlight when price has become high or lying stock; an option with a delta of 1.00 would move 1 point
low on a relative basis, which is signaled through the touch (or for every 1-point move in the underlying stock.
minor penetration) of the upper or lower line.
However, Bollinger stresses that price touching the lower or Delta-neutral: An options position that has an overall delta
upper band does not constitute an automatic buy or sell signal. of zero, which means it’s unaffected by underlying price move-
For example, a close (or multiple closes) above the upper band ment. However, delta will change as the underlying moves up
or below the lower band reflects stronger upside or downside or down, so you must buy or sell shares/contracts to adjust
momentum that is more likely to be a breakout (or trend) sig- delta back to zero.
nal, rather than a reversal signal. Accordingly, Bollinger sug-
gests using the bands in conjunction with other trading tools Exponential moving average (EMA): The simple mov-
that can supply context and signal confirmation. ing average (SMA) is the standard moving average calculation
that gives every price point in the average equal emphasis, or
The Commodity Channel Index: The CCI measures how weight. For example, a five-day SMA is the sum of the most
much price (most often, the typical price of a bar) deviates recent five closing prices divided by five.
from the average price over a specific look-back period (e.g., Weighted moving averages give extra emphasis to more
five bars, 10 bars, etc.). Despite its name, the commodity chan- recent price action. Exponential moving average (EMA)
nel index (CCI) has nothing to do with channels, nor is it lim- weights prices using the following formula:
ited to commodities.
The indicator fluctuates around a “zero line,” with a major- EMA= SC * Price + (1 - SC) * EMA(yesterday)
ity of its readings between -100 and +100. High readings mean where
the current price is unusually high relative to the average price SC is a “smoothing constant” between 0 and 1, and
over the look-back period. EMA(yesterday) is the previous day’s EMAvalue.

58 www.activetradermag.com • March 2006 • ACTIVE TRADER

 would be 2. The resulting RSI would be 100 – (100/[1+2]) = 100
You can approximate a particular SMA length for an EMA – 33.3 = 66.67.
by using the following formula to calculate the equivalent
smoothing constant: True range (TR): A measure of price movement that
accounts for the gaps that occur between price bars. This cal-
SC = 2/(n + 1) culation provides a more accurate reflection of the size of a
where price move over a given period than the standard range calcu-
n = the number of days in a simple moving average of lation, which is simply the high of a price bar minus the low of
approximately equivalent length. a price bar. The true range calculation was developed by
Welles Wilder and discussed in his book New Concepts in
For example, a smoothing constant of .095 creates an expo- Technical Trading Systems (Trend Research, 1978).
nential moving average equivalent to a 20-day SMA(2/(20 + 1) True range can be calculated on any time frame or price bar
= .095). The larger n is, the smaller the constant, and the small- — five-minute, hourly, daily, weekly, etc. The following uses
er the constant, the less impact the most recent price action will daily price bars for simplicity.
have on the EMA. In practice, most software programs allow True range is the greatest distance of the following:
you to simply choose how many days you want in your mov-
ing average and select either simple, weighted, or exponential 1. Today’s high and today’s low.
calculations. 2. Today’s high and yesterday’s close.
3. Today’s low and yesterday’s close.
Gamma: The change in delta relative to a change in the
underlying market. Unlike delta, which is highest for deep Average true range (ATR) is simply a moving average of the
ITM options, gamma is highest for ATM options and lowest true range over a certain time period. For example, the five-day
for deep ITM and OTM options. ATR would be the average of the true range calculations over
the last five days.
In the money (ITM): A call option with a strike price below
the price of the underlying instrument, or a put option with a Variance and standard deviation: Variance measures
strike price above the underlying instrument’s price. how spread out a group of values are — in other words, how
much they vary. Mathematically, variance is the average
Out of the money (OTM): A call option with a strike price squared “deviation” (or difference) of each number in the
above the price of the underlying instrument, or a put option group from the group’s mean value, divided by the number of
with a strike price below the underlying instrument’s price. elements in the group. For example, for the numbers 8, 9, and
10, the mean is 9 and the variance is:
Relative strength index (RSI): Developed by Welles
Wilder, the relative strength index (RSI) is an indicator in the {(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = .667
“oscillator” family designed to reflect shorter-term momen-
tum. It ranges from zero to 100, with higher readings suppos- Now look at the variance of a more widely distributed set of
edly corresponding to overbought levels and low readings numbers: 2, 9, and 16:
reflecting the opposite. The formula is:
{(2-9)2 + (9-9) 2 + (16-9)2}/3 = (49 + 0 + 49)/3 = 32.67
RSI = 100 – (100/[1+RS])
where The more varied the prices, the higher their variance — the
RS = relative strength = the average of the up closes over the cal- more widely distributed they will be. The more varied a mar-
culation period (e.g., 10 bars, 14 bars) divided by the average of the ket’s price changes from day to day (or week to week, etc.), the
down closes over the calculation period. more volatile that market is.
A common application of variance in trading is standard
For example, when calculating a 10-day RSI, if six of the deviation, which is the square root of variance. The standard
days closed higher than the previous day’s close, you would deviation of 8, 9, and 10 is: .667 = .82; the standard deviation
subtract the previous close from the current close for these of 2, 9, and 16 is: 32.67 = 5.72.
days, add up the differences, and divide the result by 10 to get
the up-close average. (Note that the sum is divided by the total
number of days in the look-back period and not the number of Volatility: The level of price movement in a market.
up-closing days.) Historical (“statistical”) volatility measures the price fluctua-
For the four days that closed lower than the previous day’s tions (usually calculated as the standard deviation of closing
close, you would subtract the current close from the previous prices) over a certain time period — e.g., the past 20 days.
low, add these differences, and divide by 10 to get the down- Implied volatility is the current market estimate of future
close average. If the up-close average was .8 and the down volatility as reflected in the level of option premiums. The
close average was .4, the relative strength over this period higher the implied volatility, the higher the option premium.

ACTIVE TRADER • March 2006 • www.activetradermag.com 59

TRADE
Diary
Playing out a theme
in crude oil futures.

Trade

Date: Wednesday, Dec. 7, 2005.

Entry: Long January 2006 crude oil futures

(CLF06) at 59.80.

Reason(s) for trade/setup: In one of last

month’s Trade Diaries, we described a long
trade in crude oil in which we took profits
early with the intention of “monitor[ing] the
market for another opportunity to enter on
the long side if the overall conditions remain
intact.”
Two days after exiting that trade on Dec. 5,
an opportunity presented itself. Crude
pulled back to a low of 59.60 on Dec. 6, then Source: TradeStation
opened strongly (at 60.45) on Dec. 7. We
bought when the market again pulled back below 60.
“Futures Insight: Crude oil” (Active Trader, June 2004) high- Profit/loss: +1.00 (1.7 percent).
lighted many monthly performance statistics, among them the
fact that December has been, on average, the most volatile Trade executed according to plan? Yes.
month for oil — but not a standout in terms of direction —
which would imply the best opportunities are for catching Outcome: The market initially looked like a repeat of last
short-term swings. month’s trade in that the market sold off shortly after we entered.
December had started off on a bullish note, helped in part by We set a stop not too far below 59, believing a move too far or too
overreaction to cold winter weather enveloping the country. prolonged below this level would trigger further selling.
We thought a long trade would be further supported by chart The market essentially reversed course the next, closing (at
watchers who would look for a bounce off support that they 60.66) near its high and just a little shy of our profit target. The
would likely perceive around 59. market rallied as high as 61.18 on Dec. 9, but we were quite
happy with exiting at 60.80 with a one-point profit, as the mar-
Initial stop: 58.83, which is .28 below the low of the entry day. ket collapsed later in the session, dropping as low as 59.05
before closing at 59.39.
Initial target: 60.80, which is the Dec. 5 high. Having already Putting the trades in the context of the market’s tendency
been exposed to the rough ride of this volatile market, we will toward choppiness at this time of year called for taking modest
exit the entire position at this level and then reassess trade con- profits. In this case, the approach worked. Ý
ditions.
Note: Initial targets for trades are typically based on things such as the
historical performance of a price pattern or trading system signal.
Result However, individual trades are a function of immediate market behav -
ior; initial price targets are flexible and are most often used as points
Exit: 60.80. at which a portion of the trade is liquidated to reduce the position’s
open risk. As a result, the initial (pre-trade) reward-risk ratios are con -
Reason for exit: Initial target reached. jectural by nature.

Trade summary
Date Future Entry Initial Initial IRR Exit Date P/L LOP LOL Trade
stop target length

12/7/05 CLF06 59.80 58.83 60.80 1.03 60.80 12/9/05 1.00 (1.7%) 1.00 0.70 2 days

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit during
lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).

60 www.activetradermag.com • March 2006 • ACTIVE TRADER

TRADE
Diary
A profit slips away, but a stop
prevents a trade from turning
into a loser.
Trade
Date: Friday, Dec. 9, 2005.

Entry: Long the Semiconductor HOLDRS

(SMH) at 37.75.

Reason(s) for trade/setup: The stock market

staged a modest intraday turn on Friday,
Dec. 9 after sagging for a week. SMH had
been among the top-10 percentage gainers
over the previous two weeks (in early
December it traded at its highest levels since
April 2004), despite tumbling to 37 on Dec. 8.
If the market is going to stage a year-end Source: TradeStation
rally (the holiday season kicks into high
gear the following week), we are looking at a sector that could days followed by a day that gained more than 2 percent from
attract above-average trader interest. In short, the trade is the preceding close and closed near its high; there were 34
based on the idea of going long a particularly strong sector in other instances since 2001. The subsequent price action was, on
a broader bullish situation. average, bullish over the next three days.
SMH was the strongest U.S. ETF on the second full day of
Initial stop: If a rally doesn’t materialize quickly, we don’t the trade (Dec. 12), gaining 1.11 percent on the day. By com-
want to be in this position. The stop is set at 37.23, toward the parison, the best-performing broad index that day, the Nasdaq
bottom of the day’s range — we won’t wait for a test of the pre- 100, gained 0.34 percent.
vious day’s low of 37.00. The trade reached its largest open profit on Dec. 13 when
SMH peaked at 38.80. Travel at this time made it difficult to
Initial target: 39.13, which is the Dec. 6 high. Take partial prof- monitor the markets closely, so we raised the stop to 37.80 to
its and trail a stop for the remainder of the position. prevent a loss on the trade. The market moved sideways to
lower over the next few days before selling off sharply on Dec.
19. By Dec. 30 it had traded down to 36.51 as the broader mar-
Result ket also sagged.
Although it seems a shame to have given up a 2.8-percent
Exit: 37.80. gain, it’s ultimately more important the trade didn’t turn into
a loss. The trade plan was, in essence, followed: The adjust-
Reason for exit: Discretionary exit based on developments in ment to the stop was a sensible reaction to an extra-market fac-
the broader market. tor — the unexpected need to travel. Ý

Profit/loss: +.05 (.01 percent). Note: Initial targets for trades are typically based on things such as
the historical performance of a price pattern or trading system signal.
Trade executed according to plan? Yes. However, individual trades are a function of immediate market
behavior; initial price targets are flexible and are most often used as
Outcome: SMH closed 3 cents off the high of its day on Dec. 9, points at which a portion of the trade is liquidated to reduce the posi -
which seemed like a good start to the trade. We tested a pattern tion’s open risk. As a result, the initial (pre-trade) reward-risk ratios
that consisted of a 4-percent or greater drop over the past five are conjectural by nature.

Trade summary
Date Future Entry Initial Initial IRR Exit Date P/L LOP LOL Trade
stop target length
12/9/05 SMH 37.75 37.23 39.13 2.65 37.80 12/19/05 .05 (.01%) 1.05 — 6 days

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit during lifetime
of trade); LOL — largest open loss (maximum potential loss during life of trade).

ACTIVE TRADER • March 2006 • www.activetradermag.com 61