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The Connors Group, Inc. 15260 Ventura I3Ivd., Suite 2200 Sherman Oaks, CA 91403 Connor:. Research 10 Exch<lnge Pl�ce Suite 1800 Jersey City, NJ 07302 CONTENTS ACKNOWL EDGMENTS IX CHAPTER 1 INTRODUCTION 1 CHAPTER2 THINK DIFFERENTLY RULE 1 - BUY PULLBACKS, NOT BREAKOUTS 9 CHAPTER3 RULE 2 - BUY THE MARKET A FTER IT'S DROPPED; NOT AFTER IT'S RISEN 17 CHAPTER4 RULE 3 - BUY STOCKS ABOVE THEIR 200-DAY MOVING AVERAGE, NOT BELOW 19 CHAPTER 5 RULE 4 - USE THE VIX TO YOUR ADVA NTAGE ... BUY THE FEAR, SELL THE GREED 27 CHAPTER 6 RULE 5 - STOPS HURT 31 CHAPTER 7 RULE 6 - IT PAYS TO HOLD POSITIONS OVERNIGHT 35 CHAPTERS TRADING WITH INTRA- DAY DROPS - MAKING EDGES EVEN BIGGER 39 CHAPTER 9 THE 2-PERIOD RSI - THE TRADER'S HOLY GRAIL OF INDICATORS? 53 CHAPTER 10 DOUBLE 7'S STRATEGY 75 CHAPTER 11 THE END OF THE MONTH STRATEGY 83 CHAPTER 12 5 STRATEGIES TO TIME THE MARKET 91 CHAPTER 13 EXIT STRATEGIES 109 CHAPTER 14 THE MIND ]]7 CHAPTER 15 THE FINALE 141 IX ACKNOWLEDGEMENTS " :., ,; " ::: r. " " .. !;I r. " := 11 III 1;1 II It II III r. :I II 11 1:1 a II a a a A book may have an author's name on the cover but in reality most books are written by a team. I want to thank the following people who helped make this a true team effort. Research - A speciallhank you to Cesar Alvarez, the Director of Research of Connors Research LLC, along with David Weilmuenster and Amit Ehrenreich. Also thank you to Paul Sabo for your research insights, especially in the market timing strategies. Terrific job gentlemen! Editing -Thank you to Danilo Torres, Camille Butier, Nicholas Collard, Brittany Connors and Tyler Levinsky for the many suggestions and corrections you made along the way. Your input was invaluable and greatly appreciated. CHAPTER 1 Introduction 1) II V II II III II 1I II 1:1 a II iii 1;1 II II II 1:1 CI II l;I a 1:1 II II It In the late summer of 1987, I made the decision to leave the brokerage industry and trade for myself full time. The one problem with that goal \-vas that I knew no one else who had even attempted this. Nor were there any books or courses available that showed the path to be able to do this. Money was not the problem. I was fortunate enough to have been hired by Merrill Lynch in -1982 when the Dow was at 800. Five years later and the market 300'X, higher; I had the good fortune to be earning about 3�5 times more than nearly everyone else who I had gone to college with just a few years back. The real problcl/J was a lack of credible ill/ormation 011 how to trade! The reality was that in 1987, real traders didn't talk about \vhat they did or how they traded. Seven years later, I reached my goal. In 1994, I left Donaldson Lufkin and Jcn� rette (if Merrill Lynch was my undergraduate school, DLJ was my graduate 2 Chapter J school). On Monday, March 4, 19941 got up at 5 o'clock i.n the morning and looked out over the Pacific Ocean from Malibu California. I had begWl my first day of professional tradjng. More than two hundred years ago Samuel Johnson said, "When a man knows he is to be hang{.'d in a forh1ight it concentrates his mind \AlOnder­ fully." That saying was never more true than for me in 1994. Having been making a healthy Six-figure salary just about every year for the previous dC'cadC', I was now faced with the knmvlcdge that there \.-vould be no in­ come tmless 1 performed. It ,"vas a scary thought for someone who didn't want to spend his life wearing a white shirt and blue tiC', especially since I had a family to provide for, including my two young daughters. Jump ahead to today and the world is very much different. In some \..."ays it's good and in other ways . . . it's not so good. It's good in thai there is an abtmdance of information on how to trade. Sometimes I think it's everywhere. And if someone doesn't vvant to take the time to learn how to trade, they can turn on the television and have the stock picks fed to them all day long. According to a recent article in Fortll1/e magazine there are at least 100 different people every day parading through CNBC telling you which stocks to buy. Add media outlets like Fox BIISil/{?ss, and everything else on the lntemet, magazines, television, and radio and you can pretty much guarantee that any stock that's moving will likely be mentioned. Another part of the good is the advanced ability to quantify strategies. When I was teaching myself how to trade, I quantified by hand. J still have notcbooks of tests that I did by hand, writing down the entry and the cxit Illtroe/uctiol! 3 and then adding up the results. What used to take dClYs to test, today takes minutes. And now my research process is simpler and more efficient with my Director of Research being one of the peopte who helped Microsoft further create and build out Excel in the 1990's. TIle not so good news is that many of the edges I saw i.n the 1990's are no longer there. Markets have become more efficient. In 1995 you could sit in front of a Bloomberg screen, and if you were patient enough YOLI could catch 1-2 important news stories each day that were released by Bloomberg 2-3 minutes before Dow Jones reported them. And considering that at the time, most institutions relied upon Dow Jones News, you simply had to disseminate the news, make the trade and you would often be rewarded vvithi.n a fevv mi.nutes. Not a bad way to make a living. Today though, that advantage is gone. Another way to go about it is to do dS many good traders were doing at the time. Keep a list of good stocks, especially REITs with rising dividends, and wait for a retail trader to dump somc of their holdings. The specialist would take the stock down 5-1ou,.�, in a hE'artbeat, and thE'n a bid for size would come in. All you had to do was stE'P in front of the bid and place a stop just under the bid. TIlis game used to drive the bigger players crazy. But for nimble individual traders, it was the 1990's version of an ATM. I could share with you many of these strategies. But what worked then is not always relevant to what works today. In this book, I'm going to show you what worked then and STILL works today. And even though there is no guarantee of future performance, the hope is that they will continue to work for years to comc. 4 C/wpfc'r 1 In this book, I'll share with you more than two decades of research and trading knowledge. I've been very fortunate to have gotten to knm\' some great traders and in one way or another, their thoughts are encompassed in my o\"'n. The ability to learn from people like Kevin Haggerty \",ho ran Fidelity Capital Markets Trading Desk for 7 years and co-founded Trad­ ingMarkets \vith me, has been invaluable. I've also co-written a book (Street Smarts) with Linda Raschke who was featured in the book New Mar­ ket Wizards, and is one of the best S&P traders I've ever seen. She's one of the only traders [ know who could probably flip a coin to decide \-vhich way to trade the S&Ps and turn that pOSition into a profitable trade. That type of trading skill is tmparalleled. Another Market Wizard, and some­ one who is a close friend, is professional options trader Tony Saliba. Tony and his team are some of the more successful options traders in the world. Many options traders succeed for a few years. Tony and his team have suc­ ceeded for over thirty. The one thing these people have in common is that they know 'what it's like to trade from a position of strength. Each has the institutional and floor experience to fully understand that in order to consistently make money from the market, they want to buy into the selling and sell into the buying. The statistics and the strategies YOll will find in this book, further confirm this. f've also had the good fortune of learning from many other successful traders. Through my books and our TradingMarkets website, I've gotten the opportunity to witness many traders take our research, apply their own tmique touches, and make it even better. Many of these traders have gone on to start their own trading and money management finns. TIley fol­ lowed their dream and have become successful because of their brains and most importantly their tenacity. Introduction 5 I've learned that people trade for many reasons. The goal of making money is obviously an important part of that reason. But I believe it goes even further than that. For many it's the never ending challenge of figuring out a game that may be the most complex and fascinating game in the \vorld. It's a game with a fixed set of rules, but with the pieces always moving. Every day brings ne\v opportunities and challenges and as time passes they become expo­ nentially larger as mOre markets become liquid and more trading instru­ ments become available. When I started trading in college in the late 70's, there were only stocks, and a few commodities. A few years later when I joined Merrill Lynch, the Dow was at 800 and there was no such thing as index futures. Today, the markets have become global and the exchanges have transformed themselves from government controlled entities into publicly traded corporations whose mantra is growth through teclmology and new product development. It's capitalism at its best and it continues to offer us the ability to play a game that gets better every day. The follmving chapters are a combination of market philosophy, market psychology, and market strategies. They encompass many markets and can be applied both in the United States and abroad. Philosophically, [ live ill the world of reversioll to the mean wllell it comes to trading. What that sim­ ply means is that something stretched too far will snap back. J didn't come up with that idea. It's been around for decades. What I have done though is aUempt to quantify it. It's one thing for someone to give you a handful of ruJesand say "trust me, this works." It's another thing to have it backed up by statistical evidence. In my book How Mnrkl!ts Really Work \ .... e quantified a great deal of short­ term behavior. We shmved hovv buying the market after its dropped 6 Chapter 1 three days in a row outperformed the times that it had risen three days in a row. In chapter after chapter, it was shown statistically that bllyillg low alld sellillg Iligh outperformed bllyillg high mId seIJing higher for sllort-tel'm tradillg. In this book, we'll do the same and we'll go further. This book is not only about the statistics. It's about taking statistics and putting them to \vork. In 2003 in How Markets Really Work we asked, "Why has base­ ball embraced statistics to make decisions whereas Wall Street is run on hearsay? Why is Billy Beane, the General Manager of the A's, able to suc­ cessfully run an organization \'vith a limited budget using st,'}listics yet most financial market analysts still use "opinions" to manage literally tril­ lions of dollars? Since that book was written, two baseball teams \vhich rely upon statistics to guide their decisions have won three of the past four World Series (the Red Sox have won two \,yorld Series and the Cardinals the other). Each of these teams relied upon the proper statistics to guide them and then properly applied them. In this book, you'll get to do the same. You'll have the statistics in front of you and I'll teach you the ways to apply them. Here is how the book is laid out. First we'll look at certain behavior which is inherent in the marketplace. This behavior is not something that the mainstream press even begins to understand. You will learn that what seems to be logical and obvious is often rong when it comes to trading. We'lJ then look at pullbacks and why they have worked. We'll look at daily puHbacks, intra-day pullbacks and how One oscillator, the 2-period RSI, can help you identify when and how to trade these pullbacks. We'll then move onto the Strategies section. All of the strategies you will learn are backed by more than a decade's worth of research. I'll share the rules to each of the strategies and their results with you. You'll leam stock strategies and 5&1' timing strategies, again all quantified. For those of you Introd/lction 7 \-\'ho are looking for daily strategies to apply, you'll find them here. For those of you who like to do your m\'n research and want to go further \vith these concepts, there's a potential goldmine here for you to run with. We'll then look closely at exits. Cetting into a trade is one thing. But the edges can be maximized with the proper exits. We'll look at a handful of ('xit strategies and the statistics to verify that they're valid to use. We'll end this book with what may be the most important aspect to your trading success. It's psychology. But instead of us covering the same ground that many other books have covered, \ve'rc going to go further. We'll discuss real world situations that you'll be faced with for the rest of your trading life. And then I'll share with you an interview I did a few years back with a lO-year Navy Seal veteran. In this inh.'rviL'w, you'll not only learn how to become a better trader; you'llieam how to become bet­ ter in everything you do in life. I hope you learn a great deal from the knowledge in this book. Now let's get started. CHAPTER2 Think Differently: Rule 1- Buy Pullbacks, Not Breakouts George: /t's 110t working, Jerry. /t's jllst 110t working. Jerry: What is it that iSII't workillg? George: Why did it all fllrll Ollt like this for me? I had so mlldl promise. I was persOIwblc, I was bright. 011, maybe 1I0t academically speaking, bllt ... I was perceptive. 1 always kl10w when someone's IIIlcolllfortable at a party. It became very clear to lIle sitting Ollt there today, flwt every decision I've ever made, ill Illy ell tire life, has been wrong. My life is the opposite of everything J wallt if to be. Every ii/stine! 1 have, be it sOll/cllii/Ig to wear, something to eat. .. It's all beeH wrong. Waitress : TlIl1a all toast, coleslaw, Clip of coffee. George: Yenh. No, 110, 110, wail a minute, I always have tll/W 011 toast. Noth­ illg's ever worked alit for me with tWin all toast. / wallt the cOlI/plete opposite of tlllla all toast. Chickell sa/ad all rye, III/toasted ... alld a CllP of tea. 9