COME INTO MY TRADING ROOM A Complete Guide to Trading Dr. Alexander Elder www.elder.com John Wiley & Sons, Inc. New York • Chichester • Weinheim • Brisbane • Singapore • Toronto COME INTO MY TRADING ROOM A Complete Guide to Trading BOOKS BY DR. ALEXANDER ELDER Trading for a Living Study Guide for Trading for a Living Rubles to Dollars: Making Money on Russia’s Exploding Financial Frontier COME INTO MY TRADING ROOM A Complete Guide to Trading Dr. Alexander Elder www.elder.com John Wiley & Sons, Inc. New York • Chichester • Weinheim • Brisbane • Singapore • Toronto To my campers Copyright © 2002 by Dr. Alexander Elder. All rights reserved. Published by John Wiley & Sons, Inc. No part of this publication may be reproduced, stored in a retrieval system or trans- mitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Pub- lisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assis- tance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-22534-7. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com. CONTENTS Dedication iv Introduction 1 HOW THIS BOOK IS ORGANIZED 2 MALE OR FEMALE?4 PART ONE FINANCIAL TRADING FOR BABES IN THE WOODS 5 1 Invest? Trade? Gamble? 7 AN INTELLIGENT INVESTOR 7 AN INTELLIGENT TRADER 8 AN INTELLIGENT GAMBLER?12 2 What Markets to Trade? 15 STOCKS 16 FUTURES 18 OPTIONS 20 3 The First Steps 25 THE EXTERNAL BARRIERS TO SUCCESS 25 GETTING YOUR GEAR 32 ANALYSIS AND TRADING 39 PART TWO THE THREE M’SOFSUCCESSFUL TRADING 45 4 Mind—The Disciplined Trader 47 SLEEPWALKING THROUGH THE MARKET 49 A REMEDY FOR SELF-DESTRUCTIVENESS 54 THE MATURE TRADER 61 5 Method—Technical Analysis 67 BASIC CHARTING 68 INDICATORS—FIVE BULLETS TO A CLIP 84 v vi TABLE OF CONTENTS 6 Trading 123 SYSTEM TESTING 125 TRIPLE SCREEN UPDATE 128 DAY-TRADING 138 THE IMPULSE SYSTEM 157 MARKET THERMOMETER 162 EXITING TRADES 165 CHOOSING WHAT TO TRADE 183 7 Money Management Formulas 215 NO MATH ILLITERATES 217 BUSINESSMAN’S RISK VS. LOSS. 218 THE 2% SOLUTION—PROTECTION FROM SHARKS 220 THE 6% RULE—PROTECTION FROM PIRANHAS 223 POSITION SIZING 227 MONEY MANAGEMENT STEPS 230 PART THREE COME INTO MY TRADING ROOM 233 8 The Organized Trader 235 TRADER’S SPREADSHEET 236 THE EQUITY CURVE 238 TRADING DIARY 240 ACTION PLAN 242 9 Trading for a Living 245 DISCIPLINE AND HUMILITY 247 HAVE YOU GOT THE TIME? 251 THE DECISION-MAKING TREE 257 BEGINNER, SEMIPRO, PRO 264 GOING PRO 267 10 Come Into My Trading Room 271 EXCERPTS FROM THE DIARY 273 YOUR NEXT TRADE 298 Acknowledgments 301 Sources 303 Index 307 About the Author 313 INTRODUCTION ou can be free. You can live and work anywhere in the world, “Ybe independent from the routine and not answer to anybody.” With those words I began my first book, Trading for a Living. One of my great pleasures in the years since its publication has been meeting and becoming friends with people who became free thanks to suc- cessful trading. Several times a year I run a Traders’ Camp, a week of intensive classes at remote resorts. I enjoy my campers’ successes. A stockbroker became a full-time trader, closed his business, and moved to Rio to pursue a life-long interest in Latin women. A psychologist became such a successful options writer that she paid for an early retirement for her husband and moved with him to the Virgin Islands to become an expert in what she calls synchronous hammocking. A man bought a mountain in Vermont and trades from the house he built on its top. I wish all students could succeed, but it’s not that simple. How many psychiatrists does it take to change a lightbulb? Only one—but the bulb has to want to change. To succeed in trading you need several innate traits without which you shouldn’t even start. They include discipline, risk tolerance, and facility with numbers. A big fat guy who is often drunk and can’t kick a cigarette habit is unlikely to make a good trader—he lacks discipline. A nitpicker who obsesses over each dime is too tense to live with mar- ket risks. A daydreamer who cannot do simple arithmetic on the run becomes lost when prices change rapidly. In addition to discipline, risk tolerance, and ease with numbers, suc- cessful trading requires 3 M’s—Mind, Method, and Money. Mind means developing psychological rules that will keep you calm amidst the 1 2 INTRODUCTION noise of the markets. Method is a system of analyzing prices and developing a decision-making tree. Money refers to money manage- ment, which means risking only a small part of your trading capital on any trade; think of the way a submarine is divided into many com- partments so that it won’t sink if one section becomes flooded—you have to structure your account this way. Psychology, trading tactics, money management—you can learn these skills. How long will it take you to become a competent trader and how much will it cost? What rules do you set, what methods do you use, and how do you split your trading capital? What should you study first, second, and third? What markets should you trade, and how much money can you expect to make? If these questions interest you, you picked the right book. You can succeed in trading. It has been done before, and it’s being done right now, today, by people who started from scratch, learned to trade and are making a good living at it. The best ones make fortunes. Others fail, out of ignorance or lack of discipline. If you work through this book, ignorance will not be a problem, and you will hear me yell at you again and again, pointing you towards disciplined, responsible, professional trading. Trading is a journey of self-discovery. If you enjoy learning, if you are not scared of risk, if the rewards appeal to you, if you are prepared to put in the work, you have a great project ahead of you. You will work hard and enjoy the discoveries you’ll make along the way. I wish you success. Now let us begin. HOW THIS BOOK IS ORGANIZED Books written from the heart acquire their own direction. They develop and change in the process of being written. You start with a plan, but the book takes over, and before you know it, you’re going much far- ther than planned. I began writing this book three years ago on a flight to New York, returning from a Traders’ Camp in Mexico. We had more beginners than usual, many of them women. They kept asking for a book that they jokingly called Trading for Dummies. There were no dummies in our group. Those campers were smart, sharp, and motivated—but they needed to learn the rules and the tools. I figured I would write a brief INTRODUCTION 3 practical introduction, call it Financial Trading for Babes in the Woods, and be done by Christmas. Three Christmases passed before I completed my project. The beginner part was easy, but I kept tunneling into the depths of trading, sharing what I learned in the nine years since Trading for a Living was pub- lished. I developed new indicators and systems. My money management became crisper, and I designed a new approach to record keeping. My work with hundreds of traders showed me how to teach people to turn their trading lives around and move from haphazard jumping in and out to a calm professional style. Take a few minutes to read how this book is organized, so that you may get full value out of it. Part One, Financial Trading for Babes in the Woods, is written pri- marily for those who are just becoming interested in trading. It lays out topics whose mastery is essential for success and puts up danger signs around the main pitfalls. Even experienced traders would do well to review this chapter, especially the concept of external barriers to success, which has never before been spelled out in trading literature, and the critique of the efficient market theory. Part Two, The Three M’s of Successful Trading, teaches you the three key aspects of trading—Mind, Method, and Money. Mind is your trading psychology. Method is how you go about finding trades and making entry and exit decisions. Money is how you manage your trading capital for long-term survival and success. Once we review the psychological rules, I’ll share with you my favorite analytic tools, some of which I have never before revealed. We will cover system testing, day-trading, and a new method for placing stops.