THE NEW TRADING FOR A LIVING Psychology • Discipline Trading Tools and Systems Risk Control • Trade Management Dr. Alexander Elder www.elder.com www.spiketrade.com WILEY Cover design: Paul DiNovo Copyright © 2014 by Dr. Alexander Elder. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. Library of Congress Cataloging-in-Publication Data: ISBN 978-1-118-44392-7 (Hardcover) ISBN 978-1-118-96367-8 (ebk) ISBN 978-1-118-96368-5 (ebk) To the memory of Lou Taylor— a wise man, a savvy trader, and a true friend. Contents Preface Introduction 1. Trading—The Last Frontier 2. Psychology Is the Key 3. The Odds against You PART 1: Individual Psychology 4. Why Trade? 5. Reality versus Fantasy 6. Self-Destructiveness 7. Trading Psychology 8. Trading Lessons from AA 9. Losers Anonymous 10. Winners and Losers PART 2: Mass Psychology 11. What Is Price? 12. What Is the Market? 13. The Trading Scene 14. The Market Crowd and You 15. Psychology of Trends 16. Managing versus Forecasting PART 3: Classical Chart Analysis 17. Charting 18. Support and Resistance 19. Trends and Trading Ranges 20. Kangaroo Tails PART 4: Computerized Technical Analysis 21. Computers in Trading 22. Moving Averages 23. Moving Average Convergence-Divergence: MACD Lines and MACD-Histogram 24. The Directional System 25. Oscillators 26. Stochastic 27. Relative Strength Index PART 5: Volume and Time 28. Volume 29. Volume-Based Indicators 30. Force Index 31. Open Interest 32. Time 33. Trading Timeframes PART 6: General Market Indicators 34. The New High–New Low Index 35. Stocks above 50-Day MA 36. Other Stock Market Indicators 37. Consensus and Commitment Indicators PART 7: Trading Systems 38. System Testing, Paper Trading, and the Three Key Demands for Every Trade 39. Triple Screen Trading System 40. The Impulse System 41. Channel Trading Systems PART 8: Trading Vehicles 42. Stocks 43. ETFs 44. Options 45. CFDs 46. Futures 47. Forex PART 9: Risk Management 48. Emotions and Probabilities 49. The Two Main Rules of Risk Control 50. The Two Percent Rule 51. The Six Percent Rule 52. A Comeback from a Drawdown PART 10: Practical Details 53. How to Set Profit Targets: “Enough” Is the Power Word 54. How to Set Stops: Say No to Wishful Thinking 55. Is This an A-Trade? 56. Scanning for Possible Trades PART 11: Good Record-Keeping 57. Your Daily Homework 58. Creating and Scoring Trade Plans 59. Trade Journal CONCLUSION: A Journey without an End: How to Continue Learning Preface Trading for a Living was published in 1993 and became an international best seller. It remains at the top of many reading lists, as friends recommend it to friends and trading firms give it to their new hires. All these years, I resisted revising my book because I trusted and liked its internal logic. I traded, traveled, wrote other books, and taught a few classes. Now, 21 years later, I agreed to update my most popular book so that you can benefit from the new technologies as well as the lessons I’ve learned. My late great friend Lou Taylor, to whom this book is dedicated, used to joke: “If I get half a percent smarter each year, I’ll be a genius by the time I die.” Revising my very first book felt like reliving my youth with the benefit of experience. In planning this update, I thought of a building complex in Vienna, Austria called the Gasometer. At its core are multistory storage tanks, erected by Austrian bricklayers in 1927. When modern technology made huge gas cylinders obsolete, architects converted them into modern apartments. They punched wide openings in brick walls, creating panoramic views, installed floors and elevators, and added glass-enclosed penthouses. I used to stay in one of them and wanted my new book to follow that model of blending old craftsmanship with new technology. Before you begin reading this book, ask yourself: what’s the single most important step you can take to become a successful trader? Psychology is important. Since I was actively practicing psychiatry while writing the original Trading for a Living, its psychology part stood the test of time and I changed it very little in this new edition. Market analysis is very important—but remember that when we look at a chart, we deal with only five pieces of data—the open, the high, the low, the close and volume. Piling up masses of indicators and patterns on top of those five values only increases confusion. Less is often more. If you’ve read Trading for a Living, you’ll see that I’ve reduced the number of technical chapters and moved some of them into a downloadable addendum. On the other hand, I added several new chapters that focus on new tools, notably the Impulse system. I also added a section on stops, profit targets and other practical details. Money management is extremely important because financial markets are hotbeds of risk. That was the weakest part of the original book, and I completely rewrote it. One of many tools you’ll discover will be the Iron Triangle of risk control. Psychology, trading tactics, and money management are the three pillars of success, but there is the fourth factor that ties them together. That factor—which integrates all others—is record-keeping. Keeping good records will enable you to learn from your experiences. It’ll help you break out of the vicious circle of small gains and big losses, running like a squirrel in a barrel, sweating and stressed but never getting anywhere. Keeping good records will make you your own teacher and a better trader. I’ll show you several types of records you need to keep and will share several of my trade diaries. If you’re a new reader, welcome to the journey. If you’ve already read Trading for a Living, I hope you’ll find this new book two decades smarter than the first. Dr. Alexander Elder New York–Vermont, 2014 Introduction 1. Trading—The Last Frontier You can be free. You can live and work anywhere in the world. You can be independent from routine and not answer to anybody. This is the life of a successful trader. Many aspire to it but few succeed. An amateur looks at a quote screen and sees millions of dollars sparkle in front of his face. He reaches for the money —and loses. He reaches again—and loses more. Traders lose because the game is hard, or out of ignorance, or from lack of discipline. If any of these ail you, I wrote this book for you. How I Began to Trade In the summer of 1976, I drove from New York to California. I took along a few books on psychiatry (I was a first-year psychiatric resident), several histories, and put a paperback copy of Engel’s How to Buy Stocks into the trunk of my old Dodge. Little did I know that a dog-eared paperback, borrowed from a lawyer friend, would in due time change the course of my life. That friend, incidentally, had a perfect reverse golden touch—any investment he touched went under water. But that’s another story. I gulped down the Engel book in campgrounds across America, finishing it on a Pacific beach in La Jolla. I had known nothing about the stock market, and the idea of making money by thinking gripped me. I grew up in the Soviet Union in the days when it was, in the words of a former U.S. president, “an evil empire.” I hated the Soviet system and wanted to get out, but emigration was forbidden. I entered college at 16, graduated medical school at 22, completed my residency, and then took a job as a ship’s doctor. Now I could break free! I jumped the Soviet ship in Abidjan, Ivory Coast. I ran to the U.S. Embassy through the clogged dusty streets of an