Wisdom of the Markets

What the Market Told Me

Andrew Dawson

Andrew Dawson has been investing and managing his own

money for over two decades. His interest in financial markets
began well before that and from an early stage he realised that
the keys to success were not what most traders believed them
to be. A good methodology is important, but the discipline to
follow the rules is what really matters. Every trader must learn
that it is a trader's ability to build the internal mental strength and
discipline that will determine the outcome of their trading. In
other words, ever trader must take charge and take
responsibility for their performance.

Copyright 2015 TraderinCharge.com

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Table of Contents
1

JUST STARTING? HERES 12 THINGS TO KNOW .......... 3

TRADING IS A BUSINESS ........................... 6

TRADING PREDICTIONS AND EXPECTATIONS ............. 9

MYTHS AND CLICHS THAT W ILL HURT YOUR TRADING .... 14

SOME NUGGETS OF MARKET W ISDOM ................ 18

ENTRY TIMING STRATEGIES ....................... 22

TRADING STYLES .............................. 26

USING MOVING A VERAGES AND MACD ............... 28

UNDERSTANDING OSCILLATORS .................... 31

10

KEEPING ACCOUNT OF RISK ....................... 36

11

A GAME OF PROBABILITY ......................... 41

Disclaimer: This eB ook is supplied for information and educational purposes only.
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Introduction
I have been interested in trading financial markets for almost as long as I
can remember. During this time I have encountered many fine people
both traders and authors from whom I have learned a lot. A lot of what I
have learned has been from my own experiences and from simply
observing and listening to the market.
Market traders have acquired a reputation for being aggressive and
opinionated without any particular virtues to justify these characteristics.
But my experience has shown me that the best traders are anything but
egotistical. Sure they are usually confident and purposeful, but an ability
to put their egos and opinions aside and listen to what the market is
telling them is one of the distinguishing characteristics of those I have
met.
This is a difficult balance to achieve: a good trader must be confident
and determined but must also be willing to accept that their opinions
perhaps beliefs would be a better word must always be subsidiary to
the facts that the markets presents. Perhaps, this ability is itself a sign
of self-confidence. It is the mental strength and security of mind that
they are not their opinions about the market. They are traders,
successful traders. And successful traders listen to the market and act
on what it tells them.
This eBook is Part 1 of a full collection of essays, articles and reviews
that I have written over the years. The full collection is available to
download free of charge from www.traderincharge.com.

General Rules for Traders

I know at last what distinguishes man from animals; financial worries.

Romain Rolland
In rising financial markets, the world is forever new. The bull or optimist
has no eyes for past or present, but only for the future, where streams of
revenue play in his imagination.
James Buchan
When an economist says the evidence is mixed, he or she means that
theory says one thing and data says the opposite.
Richard Thaler
Obviousness is always the enemy of correctness.
Bertrand Russell

Just Starting? Heres 12 Things to Know

Notice the title above. Its not things you have to learn, its what you
need to know before you even start to trade. Because if you dont know
these things then you will soon find trading to be a painful process and
you will start to look for ways to avoid the pain. There are some pains
you just have to be prepared to accept.

1. No one else has all the answers and no one else can make you a
successful trader. Neither is there a perfect system or plan. You
will have to find one that works for you. But you do not need to do
this from scratch. Seek help and accept help.
2. Try to specialise. Stick to one a or two markets or stocks or classes
of assets. Get to know your specialism really well because the
people you are trading against are likely specialising in only one or
two assets. You cannot know everything equally well.
3. Always try to keep it simple. Occams Razor, an approach to
problem solving dating back to at least the 13 th century, says that
the explanation for an observation that requires the fewest
assumptions is probably the right one and should be accepted as
such until proven false. Its the same with your analysis and trading.
You wont get better by adding more indicators, or more data.
Concentrate on making a few simple things work.
4. There is a lot of information in books and you might learn from
them. But they that will make you a better trader. Only you can do
that by taking what you learn and applying what works.
5. Trade in small amounts relative to your funds. Your trading fund is
a proportion of your liquid assets and any trade must only place a
small percentage of this at risk. Be careful of leverage. You can
lose more than you have invested if you dont do it right. Be wary of

anyone encouraging you to increase your investment. Its your

money. More risk may be in their interests, but not in your interests.
6. You are not trading in order to be right about anything. Indeed you
will be wrong a lot. Most of the time probably. Accept that. If you
have a problem with accepting that you are regularly wrong, even if
you dont do anything wrong, then trading may not be for you. You
are trading to make money, not to be right. Just dont lose much
when you are wrong.
7. You dont need to tell anyone else about your trading. Its not a
secret, but if your aim in trading is to gain the respect of others then
you should not be trading. And when you are wrong you will start to
hide it from them, and perhaps from yourself. You are trading to
make money. Nothing else.
8. Dont be looking for explanations for why the market has moved.
Just accept that it has moved, unless there is a really fundamental
change occurring. There is always plenty of news every day and
plenty of people to explain the news and how it is impacting. Ignore
them. They will be talking about something else tomorrow because
that is their job. Its not your job to listen.
9. Every emotion you experience is a liability if you allow it to affect
your trading decisions. You must never, ever trade on emotion.
10. There are an infinite number of opportunities in the future but none
at all in the past. So unless you have something to learn from
reviewing what you have done then make sure to leave a trade
behind when it is finished. Do not let it affect your next trade.
11. You are so unimportant that as far as the market and other market
operators care you dont exist. Its not just that the market doesnt
care about you and what you do and what you think or hope for; it
does not even care to know that you exist. The market will never
know anything about you. The flow of information is always one
way, from the market to you.

12. Much of what applies in the rest of the world is meaningless in the
market. Nothing has worth other than what someone else will pay
for it. The market has no memory. Every trade is independent.
Unless you lose your money, nothing you do today has any real
impact on what you do next. It does not matter tomorrow how good
you are today.

Trading is a Business

What if you came across a business where you needed no qualifications

to get into the business, start-up costs were very low, you do not need to
find customers or products, you can work from home any time and for
any hours you wish, and the potential profit is huge. Most people would
be tempted.
Trading is just such a business. So many people get into trading. Most
soon learn that it is very easy to trade. But to trade profitably well
thats a very different story. Because there is a drawback to this
business that many forget: the failure rate of new businesses in this
sector is extraordinarily high. Its probably in the region of 90 to 95% of
people who start trading will fail, with most stopping within the first year.
Of course, most people dont know that before they start. And so they
see only the opportunities. Worse, because its so easy to get started
they view it almost as a pastime, not as a business at all. As a result,
they forget that you need to apply established business principles and
thinking. These are required irrespective of your trading style, or what
markets or instruments or timeframes you use.
Trading is too expensive to be your hobby and too insecure to be
your job. If you treat trading as a past-time you will find it to be a very
expensive hobby. But if you take it on as your job then there is high
insecurity and no guarantee of reward, irrespective of what effort you put
in. It is a business in which you are making an investment of time and
money with no guarantee of a return, but no limit on the potential return
either. Look at it this way irrespective of how much time you will put in.
And like any other business you need good planning and sufficient
working capital. Like most businesses you should not expect to earn
profits from day 1. You will need to work hard to earn money.

Know that you will not be treated lightly just because you are a
small business or a newcomer. From day 1 you are competing
against the most experienced players. This is a double edged sword.
You will never have a brand or a reputation to rely on, but neither do
they. So you can play pretty much the same game as everyone else ,
right from day 1.
You must have a good plan. This plan needs to be not just a high
level outline of your objectives but a detailed plan of how you will
operate the business. If must be written down, but it should not be set in
stone from day one. It will need to develop and grow over time while
remaining consistent and true to what you set out to do. And it must be
realistic and based on good foundations because you have to be able to
implement it all the time. The plan must not be based on wishful thinking
or emotions.
Have your funding in place before you start to invest. This is good
business practice. But dont use debt. Know how much you are willing
and able to lose. Thats your trading fund.
Be willing to accept yourself as your own boss. You have no-one
else. So you must be willing to monitor yourself, accept your mistakes
and have the discipline to put things right. This is one of the most
difficult things, but it is much the same for anyone starting out on their
own in any business.
Capital protection is paramount. Profits will arise over time if you limit
losses. But if you lose too much you will never have the opportunity to
earn profits. Most people who start trading stop doing so within a few
months. Its not just that they are not earning good enough profits. Its
generally that they lose their trading fund. You must avoid this.

You need an exit strategy. Know when to take on risk but know also
when to exit or back away. Overtrading is a danger as in any business,
but you must also know how to get out of a trade, not just how to find an
opportunity.
You are not your trades. If you were selling cars you would not identify
your personality with the cars you sell. Entering and exiting trades is
your business. It is not you. If a trade goes bad it does not diminish
you. You simply got it wrong, just like every other trader does. Learn
why it went wrong if you can accept that you made a mistake, learn
from your mistake, and dont make that mistake again.
Trading is your business, it is not your life. Have a life. If you have a
bad day trading then that is just what it is. Its no more than that. The
same applies if you have a good day. Tomorrow starts again with many
opportunities to make it a winning day. In the interim, get on with your
life. Trading is just a business to earn you money. Never look for it to
be any more than that. There are far more enjoyable ways to spend
leisure time.

Trading Predictions and Expectations

Look at almost any website about trading. There will probably be 3

elements present: some information about the market; a product that is
being sold; and some prediction about a market. This prediction may be
the product and make take many forms such as software, a new
indicator, or a tip sheet or some other way to see what is going to
happen. The impression that is created is that being able to predict what
will happen is the way to profits.
Except that it is not. You cannot know what is going to happen in the
market so prediction is futile and any trading plan or product that is
based on prediction will fail. Following a plan that is doomed to fail is not
the way to profitable trading.
About 100 years ago, J.P. Morgan, the famous American bank magnate,
was asked by a reporter what he thought the market was going to do. He
replied that it would fluctuate, as always. How true. And his answer also
shows that even he did not know in what direction the market was going
to move. So he made no prediction. And if J.P. Morgan could not say in
what direction the market would move then perhaps we should accept
that neither can we.
Still, its easy to see why traders would focus their analysis on trying to
predict the market. After all, if you could do that successfully then trading
profitably would be more or less guaranteed. But you cannot know and
do not need to know how the market will move in order to be profitable.
So dont ask: what will happen? Instead, always ask: what is happening
in the market? Then ask: how will I react to what the market does?
Focus on what you know and use this information to guide your trading
by making decisions regarding different possibilities. Then assess and
control the risks that are associated with your decisions.

The market will either move up, down or sideways. By looking at a chart
we can know in what direction it has been moving in the recent past. So,
it will either continue in this direction, reverse direction, or move
sideways. And while we never know for certain which is likely to happen,
by observing patterns and other indicators we can aim to assign different
probabilities to each possibility.
If a market is in a trend then it continues to move in that direction unless
it reverses. And it only reverses once for the trend to be over. So most of
the time the trend is going to continue.
A strategy based on this simple observation is quite different from the
age old saying that you make money in the financial markets by buying
low and selling high. Obviously this is true but only in hindsight.
Because how do you know that the price the market is offering at any
point in time is either high or low? If the price has fallen and is below
where it was last week, is this a low price? If we buy in then perhaps it
will continue to fall lower! This approach will only work if you manage to
buy in the short time periods when the price is falling and just about to
reverse, or has just reversed. And what are the chances of this given
that most of the time the market is not in this timeframe?
Traders make money not by following a buy low and sell high strategy
but by buying at the market price and selling at a future higher price or
selling at the market price in order to buy back at a future lower price.
So, there are no mysteries here, no secret formulas, no fancy software.
Instead there is a proven strategy which combines easily stated and
understood rules with experience to make the right decisions when
discretion is required and the mental discipline to keep doing this.

10

But this is not the end of the process. Indeed, many writers and
experienced traders contend that identifying trades is a relatively small
part of the process. One of the most important aspects of trading is
managing risk and deciding not only what to trade but how much. And
most importantly, you need to know when to get out of a trade. After all,
no-one ever makes money by entering a trade. You make your profit
when you exit the trade. So you have to be able to form an expectation
about what the trade has to offer.
Indeed, you have to be able to form expectations about what your
trading in general can provide to you. To get a handle, first break the
outcome, i.e. the level of returns, down into its determinants and see
what might be expected of each element. Its best to consider this in
terms of percentages and so, provided the account is adequately funded
to provide sufficient liquidity for trading, the size of the account, within
reason, is not relevant. The return is determined by three variables:
The percentage of winners among overall trades;
The ratio of the average value of winners to loses
The percentage of the account that is put at risk on each trade.
One interesting factor to note is that, as we go down this list, the traders
ability to control the outcome in relation to each factor increases. The
trader has the ability to exercise a high level of control in relation to the
final factor, some control in relation to the second, but does not have a
lot of control in relation to the first. This is important as most traders
appear to place most emphasis on the first as the key to success by
aiming to identify a strategy that will produce a high percentage of
winning trades. It is understandable why this should be so, but it is also
contradictory to place most effort on a factor where there is little chance
of success. Far better to concentrate on those elements that can be
controlled.

11

The percentage to risk on any trade should be known in advance and be

treated as an absolute rule, never to be broken. A limit of 2% of your
trading fund is a commonly stated rule. Control of the second factor will
be achieved through setting strict stop losses and targets at appropriate
levels although targets can always be extended and only taking
trades where the identified potential gain is a pre-defined minimum
multiple of the potential loss. Most authors on trading recommend that
this should be in the range of 2.5 or above. So, a trade is only taken if
the analysis indicates that the potential gain given the markets
behaviour is 2.5 times the value of the amount that is placed at risk with
the stop loss having been set also based on the markets behaviour.
This leaves the first issue in the list: the percentage of winners. At first
sight it would appear that a trader who knows nothing will achieve 50%
winners and this is true to an extent (ignoring commissions and other
costs). However, this expectation ignores a key issue which is that
making profits requires not only that a trader gets the direction right i.e. a
long trade when the market rises, but that the trader also gets the timing
right. A trader may very often find that the analysis that the market will
rise over a certain period proves to be correct but it takes a dive first
before reaching a target and a stop is hit. The direction was right but the
timing was wrong and the trade is a loser.
The only way to avoid this would be to set a very wide stop loss or none
at all. The result is that if we do aim to control our risk then we will no
longer achieve 50% winners by random trading. Instead, we will have
50% losers due to direction and perhaps in the region of a further 40% of
the remaining trades will lose due to timing issues. On the basis of
these figures the expectation should be that in the region of 30% of
trades will be winners i.e. 50 out of each 100 trades will lose because
the direction is wrong and 20 will lose due to timing issues with the trade
being stopped out before it moves in our direction.

12

Only 30% winners! Surely not. And this is where inexperienced traders
make the mistake of starting to search for the golden strategy that will
provide 60% or 70% winners. But the evidence is that the best traders
target and expect that perhaps 35 to 40% of trades will be profitable.
The important point to notice is that if they have controlled the factors
that they can control they are very profitable.
Assume a fund of $10,000 with 1 trade per day over the course of a year
of 240 trading days, with 2% risked per trade, 35% winners and a ratio of
winners to losers value of 2 to 1. These seem like quite conservative
assumptions. A total of 156 trades lose money with each one losing
$200. There are 84 winning trades and each one wins $400. Total
profits for the year are $2,400 or 24%. If maintained over a prolonged
period this would be a very profitable business with the fund at the end
of 10 years having risen to $86,000. Far from being conservative, this
would be a hugely successful outcome.
However, new traders find it very difficult to accept that losing on over
60% of their trades should be considered to be normal and concentrate
on trying to improve their analysis rather than their risk control and trade
management. If this results in them paying for systems that promise
higher wins rates then they will increase their costs and will be distracted
from what is really needed. Even more seriously, many traders focus on
trying to improve returns by relaxing the risk constraint and increase
their position sizes. This is the greatest danger to their accounts.

13

Myths and Clichs that Will Hurt Your Trading

The financial markets love pithy sayings to convey complex ideas. Many
of these get reflected in mainstream commentary. Some are useful but
not all. And there are many sayings and commonly held beliefs around
investing that are simply wrong and should be dismissed. Here are
some that you should avoid.

Investing in the markets is just gambling.

A share of common stock is ownership in a company. It entitles the
holder to a claim on assets as well as a fraction of the profits that the
company generates. There are many variables involved but, over the
long term, a company is only worth the present value of the profits it will
make. In the short term a company can survive without profits because
of the expectations of future earnings, but eventually a company's stock
price can be expected to show the true value of the firm.
A future is a contract for ownership of a physical product. Commodity
contracts are worth the value of the commodity based on its use value in
the real economy. Gambling, on the contrary, is a zero-sum game. It
merely takes money from a loser and gives it to a winner. No value is
ever created.
Markets rise and fall for a reason.
Sometimes there is a clear reason why a market has moved, but not
always. Markets fluctuate. Either way, what does it benefit you to put
effort into knowing why a market rose or fell on any particular day?
Usually there is no benefit. Its much better to just accept that a price
changed and act accordingly.

14

 The market always rises in the long term.

True if you are willing to wait long enough, but the long term can be very
long indeed. If you had bought shares before the Wall Street crash it
would have taken about 25 years for them to recover from a 90% loss. If
you bought in the mid-1960s you would have waited until the mid-1980s
to see a profit. And the market was lower in early 2013 than it had been
in the late 1990s. Timing is important with a buy and hold strategy just
like other approaches.
Stocks that have fallen heavily will go back up, eventually.
Whatever the reason for this myth's appeal, nothing is more destructive
to amateur investors than thinking that a stock trading near a 52-week
low is a good buy. Think of this in terms of the old Wall Street adage,
that traders who try to catch a falling knife only get hurt. Price is only
one input to your decision. Buying simply because a market price has
fallen will get you nowhere.
Stocks that go up must come down.
The laws of physics do not apply in the stock market. There is no
gravitational force that pulls stocks back to even. Its not that stocks
never undergo a correction. The point is that there is no reason the stock
price of a great firm run by excellent managers won't keep on going up.
You Objective is to Buy Low and Sell High
There is an insurmountable problem with this approach. You never
know what is meant by low in advance. You can only see it well after
the event. Is a price today that is below yesterdays a low price? If it
goes even lower tomorrow then todays price will look high. Buy Low,
Sell High might explain how a fortune was amassed but it is of no use as
a strategy. Buy at the market price and sell at a higher market price is

15

the real objective. You can observe the market price in real time. The
required skill is to find stocks that will have a higher price in the future.
Technical analysis is nonsense.
Technical analysis is just the analysis of charts and data related to how
a market is performing. Theres nothing unique to the markets in this as
such processes are used regularly throughout business. Indicators are
just statistics to help clarify the data. The chart is just an accurate
representation of what has happened. It does not tell you what is about
to happen. But if patterns are recognised over time then it is reasonable
to assume that such patterns are likely to continue to appear as these
patterns represent the actions of market participants in different
situations. People dont change and so they are likely to continue to act
and react in similar ways. Therefore the interpretation of a chart pattern
is just a conclusion that one thing has a slightly better chance of
occurring than an alternative. Thats enough to give you an edge.
Fundamentals are all that matter.
If this were the case then good news about a company would lead to a
price rise. But the reverse is often the case as even good news might
not be as good as expected. Expectations are not fundamentals and as
long as positive expectations continue then a stock can continue to rise.
Its the perception of fundamentals that matters, not the actual numbers
themselves.
Only brokers and rich people make money by investing.
Although many claim to be able to call every market turn, the fact is you
cannot predict what the market will do next. So individuals know as
much about what will happen as do the experts. In any case, with the
internet, pretty much all the data and research tools that were previously
available only to insiders are now available for individuals to use. Many

16

actually contend that individuals have an advantage over institutional

investors. Big money managers are under extreme pressure to get high
returns every quarter. Their performance is often so scrutinized that
they can't invest in opportunities that take some time to develop.
Individuals have the ability to look beyond temporary downturns in favor
of a long-term outlook.
You cant go broke taking a profit.
Unfortunately you can. You will only be right on perhaps 35 to 40% of
you investments. So you must make a large enough profit on these to
pay for the 65% on which you lose. Taking small profits may be a poor
strategy. What many do not realise is that finding good exits is at least
as important as finding good entry points when trading.
Paper losses dont count.
A paper loss exists when you would lose on an investment if you closed
out the position but you have decided not to do so. The danger is that
by not recognising this as a loss you have an incentive to hold on to the
investment. This means that a small paper loss can become a big paper
loss and eventually a big realised loss. This is the worst possible
outcome.
Buy stocks that pay good dividends.
High dividend stocks may look good as they will be paying a yield well
above the interest rate. But why is the market priced at a level to require
such a premium? The answer is that there is risk and the risk adjusted
return from such stocks is no higher than what would be available
elsewhere. Why should you wish to take on such additional risks?

17

Some Nuggets of Market Wisdom

Some of these I have picked up through my own experiences in the

markets. Others I have heard repeated while more I have seen written
in various places. From wherever they come, I consider them all to be
worth repeating. And just in case you are wondering, I think I have been
guilty of contravening every one of these nuggets at some time or other.
Dont apply everyday logic to the market.
What may appear as sense to you will be ignored or avoided by
someone else. Always remember that if you decide it makes sense or is
logical to buy at a certain price, you can only do so because someone
else has decided it make sense to sell at that price (or a bit lower if there
is a broker involved).
Never average down on a losing position.
If you have a losing position then that is a bad investment. Increasing it
is just buying more of a bad thing. Why do you want more of a loser?
You want winners.
Its not about being right, its about making money.
The best traders are wrong at least as often as they are right. They just
accept they are wrong and move on. You must have a single objective
or you will end up with contradictions. Worse, because you are certain
to be wrong regularly you will experience emotional distress if your
objective is to be right.
Its the long term that matters.
Even someone who knows nothing or does all the wrong things can get
lucky in the short term and earn money. But it takes skill to be profitable
in the long term. You almost certainly wont be lucky for long.

18

Always be flexible with your expectations, never with your rules.

This seems so obvious but consider how often poor traders do exactly
the opposite. The try to mould the market to their wishes, they trade
impulsively and randomly, and they refuse to accept when they are
wrong. Exactly the opposite of what they should be doing.
Be patient with your winners, never with your losers.
It is one of the sternest tests of discipline to cut losses short and allow
winners to run. All your instincts scream to do the opposite to take
your profits before they disappear and to give losing trades a chance to
recover. Dont leave it to chance have strict hard stops.
Even breaking news will not give you an edge.
If the information is public then it will very soon be priced in. You need
to be ahead. The only way you will do this is to act as momentum rises
in line with a trend at a higher timeframe.
Trust you trading plan.
To a large extent you are on your own making your own decisions and
taking responsibility for the outcome. You need to have a plan or else it
can be very lonely. But if you dont trust your plan and trade according
to your plan then there is no point in having a plan. Trust your plan o r
get a new one.
Never fight the trend.
You dont know what will happen next but if a market is moving in a
particular direction then it stands to reason that it is more likely to
continue to move in that direction than to reverse and move in the
opposite direction. There is no guarantee but even a slightly greater
probability may give you enough of an edge while attempting to fight the
trend puts you at a disadvantage.

19

The market will act as it will.

It may not be logical how the market moves. It may not make sense or
even be explicable. So what. Just accept it.
Bear markets are more violent than bull markets.
All the evidence supports this observation, suggesting that fear is the
dominant driving force when compared to greed. The stock market will
usually fall 3 to 5 times as fast as it rose over a certain price range. This
does not really apply at short timeframes where market noise dominates.
Do more of what works and less of what does not work.
Sounds very sensible, but you have to know what is working and what is
not. So you need to keep monitoring your actions and performance.
Never look for perfection.
There is no Holy Grail of trading even though you will find many people
ready and willing to sell you a sure winning system for a reasonable
price. Why dont they just use it themselves to make a killing? Steady
long term profitability is your objective.

20

Technical Issues

The financial markets generally are unpredictable. The idea that you
can actually predict what's going to happen contradicts my way of
looking at the market.
George Soros
Wall Streets graveyards are filled with men who were right too soon.
William Hamilton
In the stock market, those who expect history to repeat itself exactly are
doomed to failure.
Yale Hirsch
No matter how good the science gets, there are problems that inevitably
depend on judgement, on art, on a feel for financial markets.
Martin Feldstein

21

Entry Timing Strategies

While finding a trade is only part of any plan and there are many ways to
go about this, identifying when the trade should be entered is a crucial
feature. This is usually described as timing and can be one of the most
frustrating parts of trading for experienced traders as well as
newcomers. This will be particularly the case if you continue to think
that being right means anything. Because it will be a regular occurrence
that you are right about what the market will do, but lose on the trade
due to a timing problem.
In truth there are probably as many timing strategies and styles as there
are traders, but different approaches are commonly categorised under
various headings that appear regularly in the literature. Here are some
of more commonly encountered.
Breakouts
The concept of support and resistance is one of the first technical ideas
any trader will encounter and is often intuitively accepted even by
traders who primarily use fundamental analysis.
The CANSLIM
approach discussed below it a good example of this. Entering a trade
on a breakout basically means identifying a price level such that a move
by the security beyond that level indicates that a further move of relative
importance is likely to occur in that direction. Because the breakout
indicates that a move has started in a defined direction it is a popular
approach to timing.
Breakouts are therefore highly compatible with trend following and
indicate a time when a pullback has ended or a period of sideways
movement gives way to a trend. They may also be final confirmation
that a long term trend has ended. However, it is important to ensure that
any breakout is supported by confirming factors. Depending on the style

22

of trading being used this may be momentum, news, an increase in

volume or some other relevant factor.
Retracements
A retracement entry strategy is somewhat more complex. Again it helps
to have identified a support or resistance level. But it is also necessary
to have identified a trend that you are confident remains in place. The
basic rationale is that no trend proceeds in a straight line but pulls back
every so often. Sometimes this pullback, or retracement, may end at a
recognizable trendline but there is no guarantee of this. Often it is
necessary to watch for a loss of momentum in the pullback using a
timeframe at least one level shorter than the timeframe that is used to
identify the trend. The key information is to identify a signal that the
retracement is over.
Entering on a retracement may have a somewhat lower success rate
than from a breakout but the benefit is that there is a better risk reward
ratio. A close stop can be used since a further move in the direction of
the retracement simply means the pullback is not over. If the trade is
successful then it is being entered right at the start of the move, well
before any breakout occurs.
Channels and Reversals
These are usually thought of as distinct but I will treat them together
here. The key requirement is that there is no trend the market is
trading in a channel, sometimes described as a trading market or a
trend has weakened or ended and the trader assumes that it will
reverse. Again some form of support or resistance needs to be
identified. The assumption is that the market will hit that level and will
not break through. Low levels of momentum or low volume will increase
the confidence of entering when the level is hit as the market will not
have sufficient power to break through. Having a clear, firm exit strategy
is essential as the trade will be fairly short term. There is no trend to

23

support staying with it long term and the channel will have an opposite
extreme. This target should be treated as a firm level and not usually
extended.
Momentum
While momentum is a key input into the entry decision in the above
strategies and is also considered a distinct trading style in itself, it is
particularly important in timing trade entry. The main difference is that
much less attention is paid to identifying a particular level such as
support tor resistance. Instead the emphasis is placed on the behaviour
of a preferred indicator such as MACD. A trend should first be identified
and only trade in line with the trend. A move of the indicator, such as a
cross of a line or a move to an extreme is taken to indicate that the trend
is strong or strengthening and so price is likely to continue to move in
this direction. In contrast, a divergence suggests that the trend is weak
and you should consider exiting an open trend.
Momentum is a very flexible approach as it does not rely on the market
approaching any particular point and, if used properly, there is a good
success rate. Key requirements are that there is a trend and that the
indicator(s) are used in an appropriate manner. Its usually best to rely
on just a small number and not try to complicate the process. Hard
stops should be used but the target can be adjusted as long as there is
no indication that the trend is weakening. Its also best not to use this
approach if the market is approaching a known support or resistance
level, if the trend is overly extended, or if a major news announcement is
imminent. Be careful also of entering momentum trades on low volume.
Position trading
Position trading would normally be considered to be somewhat more
long term. The objective here is to be in the market even before a move
takes place. As such, the analysis tends to be based on fundamental
factors. If the move then begins, technical approaches such as

24

breakouts or momentum can be used to further build the position. This

implies that the initial position is not sufficiently large enough to exhaust
your full risk tolerance, or that the initial stop is moved closer before a
new entry.
In some respects this strategy looks similar to momentum or trend
trading but the difference is that the initial entries are made before those
strategies would indicate. As the trade progresses, retracements may
also be used to build the position. Position trading is therefore quite a
sophisticated approach as it relies on fundamental analysis and various
uses of technical tools. The big advantage is that very good risk reward
ratios can be obtained.
These approaches can seem quite similar and indeed there are
similarities. However, each has essential features and precision
requires that a trader is clear about which approach they are using and
implement it accurately. As a result, it is probably best to try to
concentrate of developing proficiency in one or two approaches rather
than hunting around to find a model to fit every market.

25

Trading Styles

Momentum Trading
This approach aims to trade only with the prevailing trend but to enter
trades as momentum builds in line with the trend and (possibly) close
trades as momentum declines. It is based on four important beliefs
about markets. If you accept these then this style might be for you.
1.
A trending market is more likely to continue to move in the
direction of the observed trend than to reverse. The trend continues
until it is seen to end and a trend only ends once. Favourable
momentum increases the odds that the trend will continue.
2.
Established trends generally do not just fizzle out but end in
euphoria and then capitulation. This means that while some of the
fastest gains come towards the end of the trend this is also a warning
that the trend is coming to an end and a sharp reversal will result. This
final rush also sees a big move away from the mean, for example, a
sustained move outside a Bollinger band.
3.
Increases in momentum tend to occur before and therefore lead
moves in price. Similarly divergences in momentum tend to signal an
increased probability of reversal. This will be seen on indicators, a jump
in trading ranges or a gap. The best trades are entered before the price
move based on the indicators. However, an extreme move in an
indicator may signal a blow off top or capitulation i.e. a warning that the
the end of a trend in nearing.
4.
Low volatility in a trading range often precedes a breakout and an
increase in volatility soon after. Not every successful trade will start with
one of these things happening. However, if you do observe them then
they can form the basis to plan a trade and give extra confidence. In

26

particular, do not trade against the direction that may be implied by such
an observation.
Swing Trading
Swing trading aims to use technical analysis to identify trading
opportunities where there is a potential for a strong high momentum
move in a period of a few days. Many private traders use this approach
and a successful entry may develop into a longer term trade if a trend
emerges. Only technical analysis is used and timing is very important
with good risk control.
To be a successful swing trader you must:
Know the overall trend of the market at a time period longer than
the one you intend to use to time the entry and only trade in line
with this trend irrespective of what a chart of an individual stock
might indicate;
Make sure the charts at various timeframes are not conflicting;
Look to enter close to the start of a trend and although you might
enter an established trend, beware of entering a mature trend;
Use multiple indicators such as moving averages, volume, MACD
and stochastics and trade only when you get confirming signals;
Specialize in a limited number of markets that you know well;
Always have a trade management plan in place before you enter.
This will show an appropriate stop, a target, and an indication of
when you intend to move the stop closer and add to the position.
Simply identifying an opportunity and timing the entry is not
enough;
Only take trades that have a reward to risk ratio of a least 2 to 1;
Make sure you have the mental preparation to stay with a good
trade for a long period, to exit a poor trade quickly and to re-enter
a position following an exit if the signals are good.

27

Using Moving Averages and MACD

A Moving Average (MA) shows the average value of a security's price

over a period of time. As the security's price changes, its average price
moves up or down. A MA is usually calculated using the closing price
but can also be calculated on the basis of the opening, high, low or mid
price. It is generally drawn on the same chart as the price.
One interpretation of a moving average is that it indicates the fair value
of a security as it reflects the price that the market considered fair over a
recent period. Thus, it removes market noise which may cause prices
to rise or fall at any time. As a result, moving averages are very useful
in identifying levels of support and resistance.
There are various types of moving averages, but simple and exponential
(EMAs), where more weight is assigned to the most recent data, are the
most common. A simple moving average is calculated by adding the
closing price of the security for a number of time periods and then
dividing this total by the number of time periods. An important element
in the calculation is the number of time periods used.
The key is to find a moving average that will be consistently useful. The
most popular long term moving average for major market cycles is the
200-day moving average. In the medium to long term the 50 day and 65
day are popular with 21-26 days used for the short term and 9 to 13
days for very short term. The 50 hour EMA often provides intra-day
support or resistance.
A popular interpretation is to compare the relationship between a moving
average and the security's price. In some setups, a buy signal may be
generated when the security's price rises above its moving average and
a sell signal is generated when the security's price falls below its moving
average. However, a moving average is not intended to get you in at the

28

exact bottom nor out at the exact top. Rather, it is designed to keep you
in line with the security's price trend by buying shortly after the price
bottoms and selling shortly after it tops.
Another use is to compare two moving averages and to identify a buy or
sell signal when a fast moving average crosses above or below a slower
one. This indicates the trend.
A moving average may also be calculated on an indicator. Indicators
that are especially well-suited for use with moving averages include the
MACD, ATR, Momentum, and Stochastics. Whipsaws i.e. false signals,
can also be reduced, at the expense of slightly later signals, by plotting a
short-term moving average on an oscillator such as the RSI.

Indeed, the MACD (Moving Average Convergence/Divergence is a trend

following momentum indicator that shows the relationship between two
moving averages of price. It is calculated as the difference between a
26-day and 12-day exponential moving average with a 9-day exponential
moving average, called the signal line, plotted on top of the MACD to
show buy or sell opportunities. The difference between the MACD and
the signal line is often plotted as a histogram.
There are three popular ways the MACD is used in set-ups:
Crossovers: sell when the MACD falls below its signal line i.e.
when the histogram crosses below zero, and buy when the MACD
rises above its signal line. It is also popular to buy/sell when the
MACD line goes above/below zero.
Overbought/Oversold Conditions: when the shorter moving
average pulls away dramatically from the longer moving average
the MACD rises. This may be an indication that the securitys
price may be overextending and will return to more realistic levels.
MACD overbought and oversold conditions vary from security to

29

security and you need to know if a trend is in place as a trend will

nullify this signal.
Divergences: If movement of the MACD diverges from the security
it may be an indication that an end to the current trend is near. A
bullish divergence occurs when the price is making new lows while
MACD fails to reach new lows and a bearish divergence occurs
when price is making new highs and the MACD fails to reach new
highs.
In summary, moving averages are among the easiest of technical
indicators to understand, particularly for someone new to the subject.
They are also among the most useful and moving averages, along with
some closely related indictors such as MACD and Bollinger bands, can
be a firm basis or a trading system.

30

Understanding Oscillators

An oscillator is a technical indicator that fluctuates above and below a

centreline or between set levels as its value changes over time.
Oscillators can remain at extreme levels (overbought or oversold) for
extended periods, but, because they can only move within certain
ranges, they cannot trend for a sustained period. In contrast, a security,
a moving average or a cumulative indicator like On-Balance-Volume
(OBV) can trend as it continually increases or decreases in value over a
sustained period of time.
There are many different types of oscillators and some belong to more
than one category. There are two main types: centered oscillators and
banded oscillators. Generally, centered oscillators are best suited for
analyzing the direction of price momentum, while banded oscillators are
best suited for identifying overbought and oversold levels.
Centered oscillators fluctuate above and below a central point or line.
These oscillators are good for identifying the strength, or direction, of
momentum behind a securitys move. In its purest form, momentum is
positive (bullish) when a centered oscillator is trading above its centre
line and negative (bearish) when the oscillator is trading below its centre
line.
MACD is an example. MACD is unique in that it has lagging elements
as well as leading elements. While the moving averages on which it is
based are lagging indicators, and would be classified as trend-following,
MACD also incorporates aspects of momentum or leading elements.
Even though there is no range limit to MACD, extremely large readings
are unlikely to last for long.
Rate-of-change (ROC) is another centered oscillator that fluctuates
above and below zero. As its name implies, ROC measures the

31

percentage price change over a given time period. When the indicator
is above 0, the percentage price change is positive (bullish). When the
indicator is below 0, the percentage price change is negative (bearish).
As with MACD, ROC is not bound by upper or lower limits. This is
typical of most centered oscillators and can make it difficult to spot
overbought and oversold conditions.
Banded oscillators, which fluctuate above and below two bands that
signify extreme price levels, offer a better alternative to gauge extremes.
The lower band represents oversold readings and the upper band
represents overbought readings. Most banded oscillators fluctuate
within set upper and lower limits, but the Commodity Channel Index
(CCI) is an example of a banded oscillator that is not range bound. The
set bands are based on the oscillator and change little from security to
security, allowing the users to easily identify overbought and oversold
conditions.
The Relative Strength Index (RSI) and the Stochastic Oscillator are two
examples of banded oscillators. With RSI, the bands for overbought and
oversold are usually set at 70 and 30 respectively. A reading greater
than 70 would be considered overbought and a reading below 30 would
be considered oversold. For the Stochastic Oscillator, a reading above
80 is overbought and a reading below 20 is oversold. Making
adjustments to the bands is usually a judgment call that will reflect a
traders preferences and the volatility of the security.
Two important points are worth noting here.
First, the terms
overbought and oversold can be confusing. Just because an indicator
might enter an overbought area it does not follow that price is about to
fall. Banded oscillators can stay in these areas for long times in trending
markets and so they are best used in trading ranges or with securities
that are not trending. Therefore their use and interpretation depends on
knowing if the market is trending or not Second, it should be noted that

32

oscillators that are in the same group will both provide similar signals.
Therefore, using two similar oscillators together does not increase the
confidence with which you can draw any conclusion and you are better
to choose one and to stick with it.
Oscillators generate buy and sell signals in various ways. Oscillators
can also signal that something is amiss with the current trend or that the
current trend is about to change. Even though oscillators can generate
their own signals, it is important to use these signals in conjunction with
other aspects of technical analysis. Most oscillators are momentum
indicators and only reflect one characteristic of a securitys price action.
Volume, price patterns and support/resistance levels should also be
taken into consideration.
Divergence is a key concept behind many signals for oscillators.
Divergences can serve as a warning that the trend is about to change or
set up a buy or sell signal. A positive divergence occurs when the
indicator advances and the underlying security declines. A negative
divergence occurs when an indicator declines and the underlying
security advances.
Even though securities develop trends, they also fluctuate within those
trends. If a stock is in a strong uptrend, buying when oscillators reach
oversold conditions (and near support tests) will work much better than
selling on overbought conditions. During a strong downtrend, selling
when oscillators reach overbought conditions would work much better. If
the path of least resistance is up (down), then acting on only bullish
(bearish) signals would be in harmony with the trend. Attempts to trade
against the trend carry added risks.
Centreline crossovers can also provide signals. As the name implies,
centreline crossover signals apply mainly to centered oscillators that
fluctuate above and below a centreline which is sometimes interpreted

33

as a buy or sell signal. A buy signal would be generated with a cross

above the centreline and a sell signal with a cross below the centreline.
For MACD or ROC, a cross above or below zero would act as a signal.
Movements above or below the centreline indicate that momentum has
changed from either positive to negative or negative to positive.
When a centered momentum oscillator advances above its centreline,
momentum turns positive and could be considered bullish. When a
centered momentum oscillator declines below its centreline, momentum
turns negative and could be considered bearish.
A centreline crossover can also be used as a confirmation signal to
validate a previous signal or reinforce the current trend. If there were a
positive divergence and bullish moving average crossover, then a
subsequent advance above the centreline would confirm the previous
buy signal. Failure of the oscillator to move above the centreline could
be seen as a non-confirmation and act as an alert that something was
amiss.
Chaikin Money Flow is an example of a centered oscillator that places
importance on crosses above and below the centreline. Divergences,
overbought levels and oversold levels are all secondary to the absolute
level of the indicator. The direction of the oscillators movement is
important, but needs to be placed in the context of the absolute level.
The longer the oscillator is above zero, the more evidence of
accumulation. The longer the oscillator is below zero, the more
evidence of distribution. Hence, Chaikin Money Flow is considered to be
bullish when the oscillator is trading above zero and bearish when
trading below zero.
To improve the robustness of oscillator signals, traders can look for
multiple signals. The criteria for a buy or sell signal could depend on up
to three separate yet confirming signals. A buy signal might be

34

generated with an oversold reading, positive divergence and bullish

moving average crossover. Conversely, a sell signal might be
generated from a negative divergence, bearish moving average
crossover and bearish centreline crossover.
Oscillators are also most effective when used in conjunction with pattern
analysis, support/resistance identification, trend identification and other
technical analysis tools. By being aware of the broader picture,
oscillator signals can be put into context. It is important to identify the
current trend or even to ascertain if the security is trending at all.
Oscillator readings and signals can have different meaning in differing
circumstances. By using other analysis techniques in conjunction with
oscillator reading, the chances of success can be greatly enhanced.

35

10

Keeping Account of Risk

What is the main difference between an experienced trader and a new

trader? Its not a trick question. One has been in the markets for a
period of time while the other has not. A bit too obvious surely? But
theres a deeper truth in this answer than might at first appear.
Lets assume that both experienced and new traders are interested in
being in the market and that both want to make money. What stops the
new traders from becoming, over time, experienced traders? The
answer is being unable to stay in the market because they lose their
trading fund. And there is an insight. Experienced traders are those
who have not lost their trading fund.
So experienced traders know that the reason they are still in the market
is that they did not lose money. So thats what they focus on because
they want to ensure that they stay in the market. But what do new
traders focus on? Making money. Thats the crucial difference.
Experienced traders ensure they avoid losing money through good risk
control. So money management must be the first requirement for any
trader.
The importance of controlling risk is stressed by a number of the authors
of my favourite books on trading, in particular Alexander Elder and Van
Tharp. Its not going too far to say that these authors place controlling
risk above all other aspects of trading methodology.
My own approach is fairly simple. I identify the stop and target, which
also allows me to assess the risk reward ratio, before I enter any trade.
It is important to identify the stop position before looking at risk. This is
to ensure that the stop is set in accordance with whatever rules for
managing the trade are being used and what is seen on the chart in

36

terms of support or resistance or other relevant information, rather than

setting the stop to allow a particular position size to be taken without
exceeding the risk allowance. I then choose the position size that will
limit the risk on any trade to under 2% of my trading capital. These are
simple calculations. This ensures that the maximum risk on any trade is
controlled.
Alexander Elder describes two types of calamities that can befall a
trader: death by piranha bites and death by shark bites. All the above
comes under the heading of the shark bite the danger that a single
catastrophic loss will decimate the fund. Keeping risk per trade below
2% of your trading fund will avoid this. Piranha bites refer to the danger
that a portfolio can be eaten away by a lot of relatively small losses.
Elders recommendation to avoid this is to monitor total losses in any
month and if these exceed 6% of the funds value then cease trading for
that month. Im not totally sure if all open trades should be closed, but
certainly no new trades should be opened. His reasoning is that there is
clearly something wrong either with the analysis, or the market or the
traders thought process and so its best to just get away from the
markets for a while and then start anew with most of the portfolio still
intact.
This might be good advice sometimes, but Im not totally convinced.
Instead I concentrate on controlling total open risk, in other words, if
there is a certain percentage of risk open then I wont enter any more
trades. Having said this, if I experienced a drawdown of, say, 10% in a
short period then I would likely back away for a while.
The aggregation of the risk in all open trades can be considered to be
the total portfolio risk and a question arises as to how great this should
be. There is no simple answer as it depends on how correlated the
various trades in the portfolio are. Measuring this accurately is not

37

simple and might be beyond the requirements of individual traders and

my advice is not to get overly hung up on this. Instead I use a few
simple assumptions and rules.
If there are two trades open in the same security using the same set-up
then the total risk for these trades must not exceed 2%. This means that
if I open a trade with risk of 2% then I cannot open a further trade in that
security unless and until I have moved my stop up closer to the entry
level. This also ensures I will never average down. However, if I am
using two very different set-ups lets say there is a swing trade open
with an expected time horizon of a few weeks and I wish to open a day
trade that I will definitely not hold overnight then I will allow a total risk
of 3% for these two trades. The reasoning is that, although the
securitys price in the two trades is obviously 100% correlated, a move
that might be large relative to the distance to the stop in the day trade
will be relatively small in terms of the longer term trade.
If there are two trades in different equities in the same overall market
then I assume a 65% correlation. Therefore, once the risk on each trade
is below 2% as it must be, the total risk is the sum multiplied by 0.65.
This is based on a general view that approximately 65% of a stock
movement is due to overall market movement. Of course, if the two
stocks are closely associated in some manner or in the same sector
then it would be prudent to assume 100% correlation.
This is important since it is necessary to control total portfolio risk. After
all, even if the portfolio comprises trades in quite different stocks and a
couple of currencies, it is conceivable that a sudden market move could
move all against me. The is no simple answer to address this, and
trader discretion based on experience is required.
As a general rule I would not wish for total portfolio risk, adjusted if you
wish for a correlation factor in the region of 65 to 100%, to exceed 15 to

38

20% of the trading fund. I would only allow it to move towards the higher
end of this range if there were a number of day trades included or if the
volatility in the market was low. For example, if the VIX was moving
within a well defined range below 20. I would also want the total to be
considerably lower over a weekend if there were Forex trades open as
these can gap when the Asian markets open on Sunday night.
Despite all this, there are a few loose ends that can cause questions to
remain in traders minds. One of the most important arises when a trade
is in profit and the stop has been moved to the entry level so, in the way
it has been discussed so far, there is no risk open. And yet, if the trade
was closed now, the profit would be booked, whereas leaving it open
introduces the risk that some or all of the profit could be lost. Clearly
there is a risk associated with this trade but it is qualitatively different.
To recognise this difference I term this trade risk whereas the previous
risk i.e. the potential loss when the trade is opened, is fund risk.
There does not seem to be much consensus among writers on how this
should be managed. The 2% rule is not appropriate here as it could
cause a stop to be moved too close and be hit by a temporary spike in
the market. A common rule appears to be to move the stop to ensure
that a certain percentage of the profits are protected this percentage
usually lies in the region of 50 to 75% depending on whose work you are
reading. This is not a bad approach but, again, it is important that
following this rule does not lead to moving the stop too close. An
alternative might be to take partial profits by selling some of the stake
but this introduces its own risk as it means that you risk losing out on
further gains.
Its not easy, but I emphasise the importance of not moving the stop to
protect profits and setting it at an inappropriate level. So always set the
stop according to rules regarding the chart pattern. Again, I try to
manage this risk by looking at total risk including both fund risk and trade

39

risk. In other words, I look at the total that could be lost from the current
value of the fund, including any unrealised profits, and see if I am
comfortable with this. After all, it might be better to reduce this through
exiting a poorly performing trade than risking being stopped out of a
good trade in profit as a result of moving a stop too close.
I dont like to see total trade risk exceed 25% of the fund. This may
seem excessive, but it includes unrealised profits and so this is not
putting 25% of my fund at risk in the way in which this is usually
considered. Also, I will take a simple aggregation and ignore any
correlation factors.
This might seem like there are a lot of calculations required but it is very
easy to set up a spreadsheet to keep a running total of the open risk.
And you should have this in place. In any case, it is probably not a good
idea to have trades in more than 10 or 12 instruments open at any time
and so the calculation can be done fairly quickly anyway.
Remember, controlling your risk is at least as important as the
methodology you use to identify trade opportunities and entries, but
even following all these rules the time required will still only amount to a
fraction of the time that most traders apply to finding trades.

40

11

A Game of Probability

Most people are familiar with the game of dice. If played with a fair set
of dice then each player has an equal chance of winning. Over a
sufficient number of throws, the expected outcome is zero, assuming
there are no costs to playing the game such as a casino operators cut.
There is no strategy that can be employed fairly to alter this outcome
such as favouring one hand over the other, or saying something during
the throw, or insisting on going first or second so the outcome of each
throw is randomly distributed as is the outcome of each game. If a
player wins it is purely a matter of luck and so their performance in one
session provides no insight in relation to their likely performance in the
next session or over the longer term.
At first glance, trading in a market such as Forex or commodity futures
might appear to be a bit like this. After all, any security will eventually
either go up or go down and so, leaving aside the market makers
commission, the expected outcome would appear to be zero, in the
absence of a strategy. In fact, this is not the case for a private trader
with limited funds because of the importance of controlling risk. This
requirement actually moves the odds against you on any trade, even
though it increases the long term possibility of success.
A strategy makes all the difference even in a game of dice once we
change any of the underlying rules. A story is told that Warren Buffet
once challenged Bill Gates to a game of dice1. When he looked at the 3
pairs of dice offered by Buffet, Gates noticed that the numbering on each
had been changed from the usual 1 to 6 with opposite sides equaling 7,
but Buffet assured him that the dice were otherwise fair and that Gates
could choose which pair he wished to use. Gates hesitated, knowing
that Buffet liked to play games but that he seldom entered a game,
1

This story is contained in FX Trader magazine, October-December, 2010, (pages 7-10). See Dicing with the
Devil by Gavin Francis. Ive no idea if the story is true and it doesnt really matter as the point is well made.

41

anymore than he would enter an investment, without a strategy that

would tilt the pay-off in his favour. However, he also knew that Buffet
would not lie to him about the fact that the dice where normal other than
the numbering that he could see.
There were 3 pairs of dice which we will label A, B, and C. Each die in
each pair had the same numbering. The numbering on the dice was as
follows. Set A had 2 sides with the number 5 on each and 4 sides with
the number 2 on each. Set B had 4 sides with the number 4 on each
and 2 sides with the number 1 on each. Set C had the number 3 on
each side. The dice appear equal since the sum of all sides on each is
18, irrespective of the pair that is chosen.
Gates considered the situation for a while and said that he would be
happy to play the game with the sets of dice Buffet offered but only if
Buffet made his choice of which set he would play with first, and only
then would he choose his set. Buffet decided not to accept the revised
rule.
So, what was going on here? If Gates was willing to play he must have
considered that the game was not inherently loaded against him, but
why would he insist on giving up the opportunity to choose between the
3 sets? After all, if one set was preferable then surely Buffet would know
this and would gain an advantage by having the first choice and using
this set. This would leave Gates with a choice between only 2 inferior
sets. But then Buffet also refused this apparent advantage.
To see what is going on here we need to calculate the percentage of
games we should expect to win using each set of dice over a series of
games. The data we need are shown below in Table 1. What emerges
is that these sets of dice were what mathematicians would describe as
non-transitive, in other words, no set beats both of the other two sets.

42

Table1: % won

Numbering on
faces on each
set

% of throws
won

Set A

Set B

Set C

AxB
66.7%

BxA
33.3%

CxA
66.7%

AxC
33.3%

BxC
66.7%

CxB
33.3%

For example, lets say that Gates did not spot the implications of the
numbering on the dice and had agreed to go first and chose set B.
Buffet would immediately know to choose set A and so would win 4 out
of 6 times the dice are thrown i.e. 66.7% of the time. Seeing this and
thinking he had learned something, Gates would want to play again and
this time would probably take set A. Buffet would immediately choose
set C and would easily win the game since C beats A 2 times out of 3, or
66.7% of the time. If he still had not copped on, Gates might decide to
try his luck with set C. Buffet would then simply choose set B and again
win 66.7% of the time.
So, no matter which set the first player chooses in this game the second
player will always win. Agreeing to go first, while seeming to give you a
better choice, is like trying to play rock-paper-scissors and showing your
hand first. By agreeing to go first you are not gaining an advantage but,
rather, you are providing the key piece of information to your competitor
that they require to make their strategy successful.

43

This type of outcome is also often seen in business when the first firm to
bring a new, genuinely innovative product to market does not get the
greatest market share. Instead, this often goes to a second firm which
mostly copies the first, usually with some minor innovations, but learns
from any mistakes made by the first firm thereby greatly reducing its
risks and, therefore, its costs.
So, what has this to do with trading? For simplicity we will now assume
that the game is played by each player only throwing 1 die each time
from the set they have chosen. Lets also assume that rather than the
simple win/lose outcome that is used in a game of dice, you still win if
you throw a larger number than the other player, but your winnings are
equal to the number you throw. If you throw a smaller number than your
opponent then your loss is equal to the number thrown by the other
player. For example, if you are playing with a die from set A and you
throw a 2 while your opponent is playing with set B and throws a 1, then
you win 2 points (or Euro or $). However, if the other player throws a 4,
then you lose 4.
Consider the information shown in Table 2. It summarises the outcomes
that would be produced for all possible decisions by the players in
relation to which set they wish to use, assuming that they play 36 throws
each and that each possible outcome appears just once.
Table 2:
Payoff
Expected
payoff

Set A

Set B

AxB +12

BxA

-12

AxC

-10

BxC +10

-2

Set C
CxA +10
CxB

-10
0

The relative ordering is unaffected so Buffets attempted trick on Gates

would still work i.e. B beats C and A beats B, but C beats A. However,

44

only A has a positive payoff overall. Importantly, this arises because set
As potential losses are smaller than the potential gains, while the
reverse is true for set B.
Obviously, the series of numbering on the dice as described here was
chosen to achieve this outcome and is only one of many options that
would bring about non-transitive sets of dice. However, it illustrates a
very important lesson in relation to trading and the correct strategy to
employ.
The set of dice C with the number 3 on every side can be considered as
equivalent to a risk-free investment on every throw. There is no doubt
about the outcome of the throw, you will get a 3, and while some
alternative investment might have provided a larger return on any
particular throw, they win exactly 50% of the time with 24 wins against A,
out of the 36 possible outcomes, and 12 against B.
Set B is akin to the strategies that are employed by hedge funds, among
others. Compared to risk free investments they win more often in terms
of returns. Against A they will win on 16 of the 36 possible outcomes
and against C they will win on 24 of the 36 possible outcomes giving a
total of 40. i.e. 55.6% of the time. However, many of the wins are small
and there are some relatively large losses. But the important issue for
these hedge funds is that most of the time they are providing superior
returns and then they need only to ensure that the losses are rare and
do not destroy their capital base.
Set A looks unpromising in terms of the number of trades that are won.
It wins 20 out of 36 against B and only 12 against C for a total of 32 i.e. it
wins only 44.4% of the throws. And yet, because the losing trades are
relatively small compared to the losing trades, this strategy produces a
positive payoff.

45

There are three very important lessons here, apart from not playing dice
with Warren Buffet, or Bill Gates for that matter. The first is that the
individual trader, particularly if they are trading on margin, must
approach the market with a strategy that will shift the odds in their
favour. They must know and understand their strategy and must follow
its rules.
Second, the trader must focus on controlling losses. Once in a trade,
the only thing you can control is exposure to risk, the ultimate control
being to exit the trade and eliminate the risk. So, your only strategy is to
manage the trade in terms of its associated risk. As the example of the
dice shows, this is a vital element in a strategy where you have no
control over the outcome, be it how the dice will land or where the
market will go.
Third, in assessing any strategy, whether during the development stage
or when it is employed and records are kept and monitored, the
percentage of wins is not the only, and perhaps not even the most
important, measure of performance. Set A above had the lowest
expected number of wins, but it represented the only strategy that
provided a positive pay-off. In trading, the ratio of wins to losers is the
key.
This final point might not be as simple for an active trader to monitor as
might first appear. For example, the trader might enter and get stopped
out for a loss on one currency pair and leave it at that. He or she might
then enter a trade in a different pair and exit with a small profit for some
good reason and re-enter later. This can happen a number of times
over the course of a trend. In effect, all these trades are the one trade
so the comparison is between the cumulative gains on these trades and
the loss initially. This can be very difficult to monitor so the best
approach is to set the stop and target before entering.

46

A stop must always be an absolute: the trade ends if it is hit. The target
is somewhat more notional in the sense that it represents a level that, it
can reasonably be argued, the security has a good chance of reaching,
but it does not mean that the trade will be kept opened until this level is
reached. It can also be extended. A trader will very often decide to exit
and re-enter before this target is reached. However, by setting both the
stop and the target at the same time and using a similar type of analysis,
the trader can ensure that the potential gain in any tradable set-up is a
sufficient multiple of the appropriate risk before entering the trade.

47

Conclusion
This eBook is Part 1 of a larger collection of essays, articles and reviews
that I have written over the years. The full collection is available to
download free of charge from www.traderincharge.com.
The various chapters are arranged under 4 headings and cover general
ideas that will assist traders, technical issues, ways to improve your
mental approach to trading, and some reviews of my favourite trading
books. This eBook covers the first two sections. In total, the full
collection contains almost 30 chapters and over 100 pages and includes
the following chapter headings:
Are Traders Rational?
Good and Bad Emotions
Objectivity, not Subjectivity
Trading with Discipline
A Trader in Control
Turn it Around
Trading as War
Market Bubbles
Mark Douglas on Psychology
Lessons from the Trading Wizards
A Traders Wisdom Lives On
Elders Three Ms of Trading
Murphys 8 Technical Principles
Donchians 20 Trading Guidelines
ONeillss 20 Rules of CANCLIM
Favourite Quotes

48

As well as direct encounters with traders and my own experiences, the

material has been derived from many sources. The contents are my
own interpretation, recollections and reviews of articles, books and
experiences that I have encountered over my trading career.
In compiling the book I was somewhat heartened to see that my views
have not changed much over the years. Some of the opinions might be,
or become, yours too. If so, I hope you find them useful and profitable.
You can get the full collection by clicking here or on the image below.

49

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