http://trott.tv visit for more: Your Source For Knowledge The Three Skills of Top Trading Behavioral Systems Building, Pattern Recognition, and Mental State Management HANK PRUDEN John Wiley & Sons, Inc. ffirs.qxd 2/28/07 4:09 PM Page iii Copyright © 2007 by Hank Pruden. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. Wiley Bicentennial Logo: Richard J. Pacifico No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. 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HG4529.P78 2007 332.63'2042—dc22 2006036653 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 ffirs.qxd 2/28/07 4:09 PM Page iv vii Contents Preface ix Acknowledgments xv About the Author xvii PART ONE Systems Building and Behavioral Finance 1 CHAPTER 1 Systems Building for the Three Skills of Top Trading 3 CHAPTER 2 Behavioral Finance 33 CHAPTER 3 The Life Cycle Model of Crowd Behavior 55 PART TWO Pattern Recognition and Discretionary Trading 87 CHAPTER 4 Wyckoff: The Man, the Method, the Mystique 89 CHAPTER 5 The Basic Elements of Charting for the Wyckoff Method 99 CHAPTER 6 The Wyckoff Method of Technical Analysis and Speculation 131 CHAPTER 7 Anatomy of a Trade 161 ftoc.qxd 2/28/07 4:09 PM Page vii PART THREE Mental State Management 173 CHAPTER 8 Trader Psychology and Mental Discipline 175 CHAPTER 9 The Composite Man 201 CHAPTER 10 Putting It All Together: Ten Principles for a Trader to Live By 235 Notes 265 Recommended Reading 269 Bibliography 273 Index 277 viii CONTENTS ftoc.qxd 2/28/07 4:09 PM Page viii ix Preface T his book gives the trader, the investor, and the analyst a true compet- itive advantage in the challenging markets of the twenty-first century. Today, there are powerful agitations in the United States and globally to shift responsibility for investing onto the shoulders of the individual. But, just as responsibility moves away from corporations and the govern- ment, the individual faces conflicting advice as to how to manage financial investments. The efficient market hypothesis is riddled with false assump- tions that lead to wrong results. Equally mistaken are brokers who advise their clients to buy and hold. The real behavior of markets, what the data show in numerous markets over many time frames, is that “Market ‘timing’ matters greatly. Big gains and losses concentrate into small packages of time.” (Benoit B. Mandelbrot) Some of the most successful traders are the ones who got their market timing right. Take, for example, George Soros, who during two months in 1992 profited about $2 billion by betting against the British pound sterling. Although few traders are in the same league as George Soros, most can profit from market moves concentrated in time. This book aims to equip the trader with a balanced set of skills for cap- turing the “packages of time” that make for big gain opportunities in the mar- ket. It will also help the trader sidestep the timing pitfalls stemming from superficial data analysis and erroneous interpretations of market indicators. To compete successfully the trader must become a Complete Trader. As you can see in the Three-in-One Trader Model (Figure P.1), three mutu- ally reinforcing elements form the Complete Trader. This book will help you develop skill within each of the elements of systems building, pattern recognition, and mental state discipline, giving you solid footing well along the path to becoming a Complete Trader. This book brings together the three skills of top trading: behavioral mod- els for systems building, pattern recognition, and mental state discipline. fpref.qxd 2/28/07 4:10 PM Page ix These three key skill areas work together to move the art and science of technical analysis and trading to the level of sophistication required in the twenty-first century. This book integrates elements of trading that are of- ten treated separately into a mutually reinforcing analytical package that makes intuitive sense. Part One of The Three Skills of Top Trading addresses systems build- ing and behavioral finance. There are three chapters devoted to this skill area. Chapter 1, “Systems Building for the Three Skills of Top Trading,” fo- cuses on the building of decision-support systems. It introduces the right-brain/left-brain idea. Several schematics show the relationships of the Life Cycle Model of Crowd Behavior, the Wyckoff Method of Technical Analysis and Speculation, and the tools for mental state dis- cipline found in the Ten Tasks of Top Trading. x PREFACE P a t t e r n R e c o g n i t i o n a n d D i s c r e t i o n a r y T r a d i n g B e h a v i o r a l F i n a n c e & S y s t e m s B u i l d i n g T r a d e r P s y c h o l o g y a n d M e n t a l D i s c i p l i n e THE TEN TASKS OF TOP TRADING© Investment Psychology Consulting The Pruden Model 3 Mutually Reinforcing Links Make the Complete Trader The Wyckoff Method Percentage of Adopters and Extent of Move 100 90 80 70 60 50 40 30 20 10 0 Price Duration of Move CONTRARY OPINION GREED FEAR VOLUME & SENTIMENT Dive rg e © I - A ccu m ul at io n II-Mar kup III -D is tr ib ut io n IV -M ar kd o w n Early Adopters Innovators “Insiders” Early Majority Late Majority Laggards “Odd-Lotters” Background: Monetary conditions Momentum Feedback C on fir m © TIME The adoption/diffusion life cycle model is modified here to fit the stock market. Here, we see the four technical analysis parameters used in the decision-making process—price, volume, sentiment, and time. Percentage of Adopters and Extent of Move 100 90 80 70 60 50 40 30 20 10 0 Price Duration of Move CONTRARY OPINION GREED FEAR VOLUME & SENTIMENT Dive rg e © I - A ccu m ul ati on II-Mar kup III -D is tr ib ut io n IV -M ar kd o w n Early Adopters Innovators “Insiders” Early Majority Late Majority Laggards “Odd-Lotters” Background: Monetary conditions Momentum Feedback C on fir m © TIME The adoption/diffusion life cycle model is modified here to fit the stock market. Here, we see the four technical analysis parameters used in the decision-making process—price, volume, sentiment, and time. FIGURE P.1 Three Mutually Reinforcing Links Make the Complete Trader fpref.qxd 2/28/07 4:10 PM Page x Chapter 2, “Behavioral Finance,” serves as a resource chapter for the trader. It defines the field of behavioral finance, gives a brief historical review, and explains how behavioral finance can be subdivided into individual behavior and mass psychology. Chapter 3, “The Life Cycle Model of Crowd Behavior,” explains how and why a trader can build a technical decision-support system. The Life Cycle Model defines the four key dimensions of price, volume, sentiment, and time. It also shows how indicators that measure these parameters are integrated into a mutually reinforcing decision frame- work. The S-shaped and bell-shaped curves of the Life Cycle Model’s visual schematic are complemented by an analytical checklist for weighting indicators. Part Two covers pattern recognition and discretionary trading, with a focus on the Wyckoff method of technical analysis and speculation. There are four chapters devoted to this skill area. Chapter 4, “Wyckoff: The Man, the Method, the Mystique,” shares tales of Richard D. Wyckoff, reveals the history behind Wyckoff’s time-tested pattern recognition method, and proposes that his princi- ples are increasingly relevant to the trader of today. In addition, it in- troduces the five steps of the Wyckoff method of technical analysis and speculation. Chapter 5, “The Basic Elements of Charting for the Wyckoff Method,” defines and illustrates the usage of the basic vertical line or bar chart and the construction and usage of the figure or point-and-figure chart. It also includes the proper procedures for drawing trend lines, trend channels and support and resistance lines within a trading range. In addition, charts show comparative strength and weakness, the role of price spread, volume, and divergences. Finally, you will learn how to coordinate bar and figure charts. Chapter 6, “The Wyckoff Method of Technical Analysis and Specula- tion,” defines and illustrates the application of Wyckoff laws, tests, and schematics. This chapter describes the three basic Wyckoff laws: sup- ply and demand, effort versus result, and cause and effect. The nine Wyckoff tests are crucial for enabling the trader to identify and enter a trading position that has very favorable reward-to-risk odds. The ana- lytical checklists of the three laws and tests are complemented by vi- sual schematics of trading ranges for accumulation and distribution. Even though Wyckoff’s method is a judgmental method and not a me- chanical system, these laws, tests, and schematics are designed to give the trader a logical, systematic approach to chart analysis. Preface xi fpref.qxd 2/28/07 4:10 PM Page xi Chapter 7, “Anatomy of a Trade,” offers concrete and complete ex- amples of the diagnosis of a trading range and the identification of chart locations to take high-reward, low-risk trading positions. The second half of the chapter shows step by step how an expert Wyckoff- oriented trader entered, followed through, and exited trading posi- tions using options on an energy company’s stock. In addition, this chapter introduces nine new tests for reaccumulation as a supple- ment to the nine classic buying tests for accumulation. Part Three covers trader psychology and mental state discipline. There are three chapters devoted to this skill area. Chapter 8, “Trader Psychology and Mental Discipline,” transitions us into Part Three by drawing on Wyckoff’s observation that the mastery of a sound methodology is only half of the trader’s battle; the other half is the mastery of one’s emotions and mental state. At the center of this chapter is a model, the Ten Tasks of Top Trading, which provides the trader with a system for accessing the appropriate mental state for each key task of a trading campaign from diagnosis to action to exiting a trade. Chapter 9, “The Composite Man,” introduces the concept of the Com- posite Man, a powerful tool for mastering trading methodology, unique to the Wyckoff method. In addition, the concept of the Com- posite Man serves as a useful device in the quest for mental state con- trol. This chapter explores in depth the nature and use of the Composite Man and introduces several other complementary tech- niques to capture the proper mental state for effective trading. Chapter 10, “Putting It All Together: Ten Principles for a Trader to Live By,” is at once an introduction to The Three Skills of Top Trading and a summary and conclusion to the book. The chapter concludes with an example of a three skills trader, Weylin Canada, foreign currency trader. The case study of Canada’s trading reveals his growth as a trader, his adoption and application of the Three Skills of Top Trading, and examples of his technical analysis and trading actions using charts of currency pairs. Most important, it illuminates the three key skills: (1) He works with a behavioral model, a theory, an idea about how the world works that helps him gain profits. (2) He applies both pattern recognition and quantitative technical analysis tools. (3) He pays attention to his mental state control, which galvanizes him when he needs to take action and extract gold from the veins of ore that his system helps him spot on his price charts. xii PREFACE fpref.qxd 2/28/07 4:10 PM Page xii The Three Skills of Top Trading speaks to both the astute and the as- piring trader who wishes to sustain or gain an edge in trading to meet the challenging markets of the twenty-first century. The competitive edge is going to those traders who embrace skill sets reminiscent of the old-time traders and technicians who lived and worked on Wall Street in the early decades of the twentieth century. This book reveals how the new science of behavioral finance accelerates and enhances these skills and helps to make them accessible to traders of all levels. In addition, this book addresses the needs of a wide variety of traders. Almost all traders can capitalize on at least one of the elements of the Three Skills model. For example, I believe that systems traders will find the message of Part One, “Systems Building and Behavioral Finance,” to be quite rewarding; the Life Cycle Model of Crowd Behavior is especially versatile and rigorous. On another front, swing traders who use pattern recognition can benefit from the Wyckoff laws, tests, and schematics of- fered in Part Two. Finally, tape readers, and indeed all traders, can benefit from studying three sections located in Part Three: “The Ten Tasks of Top Trading,” “Chart Reading in the R-Mode,” and “A ‘Sealed Room’ and ‘Only One Client.’” However, this book is truly greater than the sum of its parts, and the trader who integrates every facet of The Three Skills of Top Trad- ing should have the decisive competitive edge in the twenty-first century. The Three Skills of Top Trading is designed both to stand alone and to supplement and complement other books currently available on techni- cal analysis and trading. I encourage you to read it carefully and to return to it often. Let it be your guide as you forge ahead along the path to better trading and expanded profits. Preface xiii fpref.qxd 2/28/07 4:10 PM Page xiii xv Acknowledgments I wish to acknowledge the important contributions of several individuals to both the content and the processing of this book. I have enjoyed the support of many editors and colleagues over the years. In particular, I want to thank Jack Hutson, editor in chief of Technical Analysis of Stocks & Commodities, and Charles D. Kirkpatrick, editor of the Journal of Technical Analysis, for their early, ongoing en- couragement and publication of many of the ideas put forth in this book and for the access they provided. Many thanks also to Dr. Van K. Tharp of the Van Tharp Institute, who served as both a mentor and a collaborator in the creation of the Ten Tasks of Top Trading, and to the members of the Technical Securities Analysts Association of San Francisco, especially Bruce Fraser, Audrey Lewak, and Jim Forte, certified market technician, for sharing their observations and practices. My very deep thanks go to Craig Schroeder of the Wyckoff/Stock Market Institute for the provision of charts, concepts, and schematics depicting the Wyckoff method, and to Daniel Pink, whose A Whole New Mind: Why Right-Brainers Will Rule the Future provided insights and inspirations. Finally, my appreciation goes to Weylin Canada for can- didly, openly, and thoroughly sharing his experience as a Three Skills trader. With respect to the process of compiling, editing, and creating this book, I owe a great debt of gratitude to my daughter, Laura Pruden. Laura served as the key person behind the thorough, proper, and timely comple- tion of this book. In addition, I appreciate the valuable input by my wife, Sarah Pruden, and the efforts of Goldie Aranha, Cassandra Dilosa, Jimmy Lam, Mukesh Punjabi, and Lynette Webb, all of Golden Gate University, San Francisco, California. flast.qxd 2/28/07 4:10 PM Page xv I want to acknowledge the guidance and support of my editors at John Wiley & Sons, Inc., namely Kevin Commins and Emilie Herman. Emi- lie worked hard and long with Laura and me in our team effort to deliver a book that meets Wiley’s high standards. xvi ACKNOWLEDGMENTS flast.qxd 2/28/07 4:10 PM Page xvi xvii About the Author H enry Oliver (Hank) Pruden, Ph.D., is the author of dozens of articles on behavioral finance, trader psychology, and technical analysis. A full-time trader for his own account for two decades, he is currently a Professor of Business Administration and Executive Director of the In- stitute for Technical Market Analysis at Golden Gate University in San Francisco, California. He earned his Ph.D. (with honors) in Marketing at the University of Oregon in 1968, his M.B.A. from the University of Califor- nia, Berkeley, in 1965, and his B.S. from California State University, Chico, in 1961. Formerly, he was a professor in the College of Business at the Uni- versity of Texas at Austin and a visiting professor at Northwestern Univer- sity’s Graduate School of Management. Hank is the president of the Technical Securities Analysts Association of San Francisco (TSAASF) and vice president, Americas, for the Interna- tional Federation of Technical Analysts (IFTA), and previously served as editor of the Market Technicians Association Journal for 11 years. He gives seminars to individuals and businesses worldwide and in the past decade has been a speaker on every continent but Antarctica. Highlights of his international speaking include serving as IFTA’s educational ambas- sador to Europe in 2004 and 2005 and circling the globe speaking on the Wyckoff method for Dow Jones Telerate in 1997. Dr. Pruden received awards for teaching excellence at both the Uni- versity of Oregon and the University of Texas at Austin, and for research and scholarship at Golden Gate University. He has been honored for excel- lence in education by the Market Technicians Association and for Out- standing International Achievements in Behavioral Finance and Technical Analysis Education by P.I. Graduate Studies of Kuala Lumpur, Malaysia. In flast.qxd 2/28/07 4:10 PM Page xvii 2006, his research was highly commended by the Emerald Literati Net- work Awards for Excellence. Hank lives with his wife, Sarah, near San Francisco. His web site is www.hankpruden.com. xviii ABOUT THE AUTHOR flast.qxd 2/28/07 4:10 PM Page xviii PART ONE Systems Building and Behavioral Finance ccc_pruden_001-002_pt1.qxd 2/12/07 9:55 AM Page 1