Showing posts with label day-trading-for-a-living. Show all posts
Showing posts with label day-trading-for-a-living. Show all posts




Open interest

Open interest is the number of contracts held by buyers or owed by short sellers in any derivative market, such as futures or options.

Stock market shares are traded for as long as the company that listed them stays in business as an independent unit. Most shares are held as long positions, with only a small percentage of shorts. In futures and options, on the other hand, the total size of long and short positions is always identical, due to the fact that they are contracts for future delivery. When someone wants to buy a contract, someone else has to sell it to them, i.e., go short. If you want to buy a call option for 100 shares of Google, another trader has to sell you that option; in order for you to be long, someone else has to be short. Open interest equals the total long or the total short positions.

Futures and options contracts are designed to last for only a set period of time. A futures or options buyer who wants to accept delivery and a seller who wants to deliver have to wait until the first delivery day. This waiting period ensures that the numbers of contracts held long and short are always equal. In any case, very few futures and options traders plan to deliver or accept delivery. Most traders close out their positions early, settling in cash long before the first notice day. We’ll return to the topic of futures and options in Part Eight of this book on trading vehicles.

Open interest rises when new positions are being created and falls when positions are being closed. For example, if open interest in April COMEX gold futures is 20,000 contracts, it means that bulls are long and bears short 20,000 contracts. If open interest rises to 20,200, it means that the net of 200 new contracts have been created: both bought and sold short.

Open interest falls when a bull who is long sells to a bear who is short but wants to cover his short position. As both of them get out, open interest falls by the size of their trade, since one or more contracts disappear from that market.

If a new bull buys from an old bull that is getting out of his long position, open interest remains unchanged. Nor does the open interest change when a new bear sells to an old bear who wants to buy to cover his short position. In summary, open interest rises when “fresh blood” enters that market and falls as current bulls and bears start leaving that market, as illustrated in the table below:

Buyer                                                    Seller                                                 Open Interest
New buyer                                           New seller                                         Increases
New buyer                                           Former buyer sells                          Unchanged
Former seller buys to cover             New seller                                         Unchanged
Former seller buys to cover             Former buyer sells                          Decreases

Technicians usually plot open interest as a line below price bars. Open interest in any market varies from season to season because of massive hedging by industrial users and producers at different stages of the annual production cycle. Open interest gives important messages when it deviates from its seasonal norm.

Crowd Psychology

It takes one bull and one bear to create a futures or options contract. A bull who believes that prices will rise buys a contract. A bear who thinks that prices are going to drop goes short by selling a contract for future delivery. With a trade between a new bull and a new bear, open interest rises by the number of contracts they traded. A single trade is unlikely to move any market, but when thousands of traders make similar trades, they propel or reverse market trends.

FIGURE  TYH14 daily, 13-day EMA, open interest.

Open interest reflects the intensity of conflict between bulls and bears. It depends on their willingness to maintain long and short positions. When bulls and bears don’t expect the market to move in their favor, they close out their positions, reducing open interest.

There are two people on the opposite sides of every trade, and one of them will be hurt when prices change. In a rally, bears will get hurt, and in a decline, bulls will suffer. As long as the losers hold on, hoping and hanging on to their positions, open interest doesn’t change.

A rise in open interest shows that a crowd of confident bulls is facing down a crowd of equally confident bears. It points to a growing disagreement between the two camps. One group is sure to lose, but as long as potential losers keep pouring in, the trend will continue. These ideas have been clearly put forth in L. Dee Belveal’s classic book, Charting Commodity Market Price Behavior.

It takes conviction among both bulls and bears to maintain a trend. Rising open interest shows that both camps keep adding to their positions. If they strongly disagree about the future course of prices, then the supply of losers is growing, and the current trend is likely to persist. An increase in open interest gives a green light to the existing trend.

If open interest rises during an uptrend, it shows that longs are buying while bears are shorting because they believe that the market is overvalued. They are likely to run for cover when the uptrend squeezes them harder—and their buying will propel prices higher.

If open interest rises during a downtrend, it shows that shorts are aggressively selling, while bottom pickers are buying. Those bargain hunters are likely to bail out when falling prices hurt them, and their selling will push prices even lower.

When a bull is convinced that prices are going higher and decides to buy, but a bear is afraid to sell short, that bull can buy only from another bull who bought earlier and now wants to cash out. Their trade creates no new contract, and open interest stays unchanged. When open interest goes flat during a rally, it shows that the supply of losers has stopped growing.

When a bear is convinced that prices are going lower and wants to sell short, but a bull is afraid to buy from him, that bear can sell only to another bear who shorted earlier and now wants to cover, take profits and leave. Their trade creates no new contract, and open interest does not change. When open interest stays flat during a decline, it shows that the supply of bottom pickers isn’t growing. Whenever open interest flattens out, it flashes a yellow light—a warning that the trend is aging and the best gains are probably behind.

When a bull decides to get out of his long position, a bear decides to cover his short position, and the two trade with one another, a contract disappears, and open interest shrinks. Falling open interest shows that losers are bailing out, while winners are taking profits. When the disagreement between bulls and bears decreases, the trend is ripe for a reversal. Falling open interest shows that winners are cashing in and losers are giving up hope. It signals that the trend is approaching its end.

Trading Rules

1. When open interest rises during a rally, it confirms the uptrend and gives a green light to add to long positions. It shows that more short sellers are coming into the market. When they bail out, their short covering is likely to push the rally higher.

When open interest rises as prices fall, it shows that bottom pickers are active in the market. It gives a green light to shorting because those bargain hunters are likely to push prices lower when they throw in the towel.

If open interest rises when prices are in a trading range, it’s a bearish sign. Commercial hedgers are much more likely to sell short than speculators. A sharp increase in open interest while prices are flat shows that savvy hedgers are probably shorting the market. You want to avoid trading against those who likely have better information than you.

2. If open interest falls while prices are in a trading range, it identifies short covering by major commercial interests and gives a buy signal. When commercials start covering shorts, they show that they expect the market to rise.

When open interest falls during a rally, it shows that winners and losers alike are becoming cautious. Longs are taking profits, and shorts are covering. Markets discount the future, and a trend that is accepted by the majority is ready to reverse. If open interest falls during a rally, consider selling and getting out.

When open interest falls during a decline, it shows that shorts are covering and buyers are taking losses and bailing out. If open interest falls while prices slide, take profits on short positions.

3. When open interest goes flat during a rally, it shows that the uptrend is getting old and the best gains have already been made. This gives you a signal to tighten stops on long positions and avoid new buying. When open interest goes flat during a decline, it warns you that the downtrend is mature and it is best to tighten stops on short positions. Flat open interest in a trading range does not contribute any new information.

More on Open Interest

The higher the open interest, the more active the market, and the less slippage you risk when getting in and out of positions. Short-term traders should focus on the contracts with the highest open interest. In the futures markets, the highest open interest tends to be in the front months. As the first notice day approaches and open interest of the front month begins to drop, while open interest in the next month begins to rise, it signals to roll over your position into the next month.


Most people conduct their lives as if they will live forever — repeating the same mistakes, not learning from the past, and hardly ever planning for the future. Freud showed that the unconscious mind doesn’t have the notion of time. Our deep-seated wishes remain largely unchanged throughout our lives.

When people join crowds, their behavior becomes even more primitive and impulsive. Individuals may be ruled by the calendar and the clock, but crowds pay no attention to time. They act out their emotions as if they had all the time in the world.

Most traders focus only on changing prices but pay little attention to time. That’s just another sign of being caught up in mass mentality.

The awareness of time is a sign of civilization. A thinking person is aware of time, while someone who is acting impulsively is not. A market analyst who pays attention to time becomes aware of a dimension hidden from the market crowd.


Long-term price cycles are a fact of economic life. For example, the U.S. stock market tends to run in approximately four-year cycles. They exist because the ruling party inflates the economy going into the presidential election every four years. The party that wins the election deflates the economy when voters can’t take revenge at the polls. Flooding the economy with liquidity lifts the stock market, while draining liquidity pushes it down3.

Major cycles in agricultural commodities are due to weather and fundamental production factors, coupled with the mass psychology of producers. For example, when livestock prices rise, farmers breed more animals. When those animals reach the market, prices fall and producers cut back. When the supply is absorbed, scarcity pushes prices up, breeders go to work again, and the bull/bear cycle repeats. This cycle is shorter in hogs than in cattle because pigs breed faster than cows.

Long-term cycles can help traders identify market tides. Instead, many traders get themselves in trouble by trying to use short-term cycles to predict minor turning points. Price peaks and valleys often seem to flow in an orderly manner. Traders measure distances between neighboring peaks, and project them into the future to forecast the next top. Then they measure distances between bottoms and extend them into the future to forecast the next low. 

Cycles put bread and butter on the tables of analysts who sell forecasts. Few of them realize that what appears like a cycle on the charts is often a figment of the imagination. If you analyze price data using a mathematically rigorous program, such as John Ehlers’s MESA (Maximum Entropy Spectral Analysis), you’ll find that approximately 80 percent of what looks like cycles is simply market noise. A human mind looks for order—and even an illusion of order is good enough for many people.

If you look at any river from the air, it appears to have cycles, swinging right and left. Every river meanders in its valley because water flows faster in its middle than near the shores, creating turbulences that force the river to turn. Looking for short-term market cycles with a ruler and a pencil is like searching for water with a divining rod. Profits from an occasional success are erased by many losses due to unsound methods.

Indicator Seasons

A farmer sows in spring, harvests in late summer, and in the fall, lays in supplies for the winter. There is a time to sow and a time to reap, a time to bet on a warm trend and a time to get ready for a frost. We can apply the concept of seasons to financial markets. Taking a farmer’s approach, a trader should look to buy in spring, sell in summer, go short in the fall, and cover in winter.

Martin Pring developed the model of seasons for prices, but this concept works even better with technical indicators. Their seasons help recognize the current stage of the market cycle. This simple but effective model helps you buy when prices are low and sell short when they are high, setting you apart from the market crowd.

We can define the seasons of many indicators by two factors: their slope as well as their position above or below the centerline. For example, let’s apply the concept of indicator seasons to MACD-Histogram. We define the slope of  MACD-Histogram as the relationship between two neighboring bars. When MACD-Histogram rises below its centerline, it is spring; when it rises above its centerline, it is summer; when it falls above its centerline, it is autumn; and when it falls below its centerline, it is winter. Spring is the best season for going long, and autumn is the best season for selling short.
Indicator Slope           Position Relative to Centerline         Season                Preferred Action
Rising                            Below                                                     Spring                 Go long
Rising                            Above                                                     Summer             Start selling
Falling                           Above                                                     Fall                      Go short
Falling                           Below                                                     Winter                Start covering

When MACD-Histogram is below its centerline but its slope is rising, it is spring in the market. The weather is cool but turning warmer. Most traders expect the winter to return and are afraid to buy. Emotionally, it is hard to buy because the memories of a downtrend are still fresh. In fact, spring is the best time for buying, with the highest profit potential, while risks are relatively small because we can place a protective stop slightly below the market.

When MACD-Histogram rises above its centerline, it’s summer in the market— and by now most traders recognize the uptrend. It’s emotionally easy to buy in summer because bulls have plenty of company. In fact, profit potential in summer is lower than in spring, while the risks are higher because stops have to be farther away from the market due to heightened volatility.

When MACD-Histogram is above its centerline but its slope turns down, it’s autumn in the market. Few traders recognize that change and keep buying, expecting summer to return. Emotionally, it’s hard to sell short in autumn—it requires you to stand apart from the crowd. In fact, autumn is the best time for selling short.

When MACD-Histogram falls below its centerline, it’s winter in the market. By then, most traders recognize the downtrend. It is emotionally easy to sell short in winter, joining many vocal bears. In fact, the risk/reward ratio is rapidly shifting against bears, as potential rewards are becoming smaller and risks higher because stops have to be placed relatively far away from prices.

Just as a farmer must pay attention to the vagaries of weather, a trader needs to stay alert. An autumn on the farm can be interrupted by an Indian summer, and a market can stage a strong rally in the autumn. A sudden freeze can hit the fields in spring, and the market can drop early in a bull move. A trader needs to use several indicators and techniques to avoid getting whipsawed.

The concept of indicator seasons focuses a trader’s attention on the passage of time. It helps you plan for the season ahead instead of mindlessly following other people.

FIGURE  VRTX daily, MACD-Histogram 12-26-9.

Market Time

We measure time using calendars and watches, but seldom stop to think that our own perceptions of time are far from universal. We keep track of time in human terms, while huge areas of life move on vastly different timelines.

For example, we think that the ground under our feet is stable, while in fact continents move constantly. They traverse only a few inches per year, but this is enough to radically change the face of the globe over millions of years. Within shorter time-frames, weather patterns change over centuries. Ice ages and warming periods alternate with one another. At the other end of the scale, there are physical particles that survive only a tiny fraction of a second. There are insects that are born, mature, procreate, and die within a single day.

Turning to trading, let’s keep in mind that time flows at a different speed in the market than it does for us as individuals. The market, composed of huge masses of human beings, moves at a much slower speed. The patterns you recognize on your charts may have predictive value—but the turns they anticipate are likely to occur much later than you expect.

The relative slowness of crowds can bedevil even experienced traders. Time and again we find ourselves entering trades too early. Beginners are typically late. By the time they recognize a trend or a reversal, that move had been underway for so long that they miss most, if not all of it. Newbies tend to chase old trends, but the more experienced analysts and traders tend to run into an opposite problem.

We recognize approaching reversals and emerging new trends from far away—and jump in too soon. We often buy before the market finishes tracing a bottom or sell short well before it completes a top. By getting in too early we can end up losing money in trends that are too slow to turn.

What should we do? First of all, you need to become aware that the market time is much slower than your own. Second, consider not putting on a trade when you notice an early reversal signal. A better signal may well emerge later, especially at market tops, which take longer to form than bottoms.

It pays not to be greedy and trade a smaller size. A smaller position is easier to hold while a reversal is taking its sweet time. Be sure to use multiple timeframes for market analysis: this is the essence of Triple Screen, the system we’ll review in a future chapter.

The Factor of Five

Most beginners casually pick a timeframe that looks good to them—it can be a daily or a 10-minute chart, or any other—and ignore others. Few are aware of the fact that the market lives in multiple timeframes. It moves simultaneously on monthly, weekly, daily, and intraday charts—often in opposite directions.

The trend may be up on the daily charts but down on the weeklies, and vice versa. Which of them will you follow? And what will you do about the intraday charts, which may well contradict either the weeklies or the dailies? Most traders ignore all timeframes except for their own—until a sudden move from outside of their time-frame hits their account.

Keep in mind that neighboring timeframes are linked by the factor of approximately 5. If you start with a monthly chart and proceed to the weekly, you’ll notice that there are 4.5 weeks to a month. As you switch from a weekly to a daily chart, you know that there are 5 trading days to a week. Turning to intraday analysis, you may look at an hourly chart—and there are approximately 5–6 hours to a trading day. Day traders can proceed even further and look at 10-minute charts, followed by 2-minute charts. Each is related to its neighboring timeframes by approximately the factor of five.

The proper way to analyze any market is to review at least two neighboring time-frames. You must always start with the longer timeframe for a strategic view and then switch to the shorter timeframe for tactical timing. If you like using daily charts, you must first examine weekly charts, and if you want to day-trade using 10-minute charts, you first need to analyze hourly charts. This is one of the key principles of the Triple Screen trading system.

Trading Timeframes

How long do you plan to hold your next trade? Do you think it’ll be a year, a week, or an hour? A serious trader plans the expected duration of every trade. Various timeframes offer different opportunities and carry different risks. We can roughly divide all trades into three groups:

1. Long-term trading or investing—The expected duration of a position is measured in months, sometimes years.
Advantages: requires little day-to-day attention and may lead to spectacular gains.
Disadvantage: drawdowns can be intolerably severe.

2. Swing trading—The expected duration of a trade is measured in days, some-times weeks.
Advantages: a wealth of trading opportunities, fairly tight risk control.
Disadvantage: will miss major trends.

3. Day-trading—The expected duration of a trade is measured in minutes, rarely hours.
Advantages: great many opportunities, no overnight risk.
Disadvantages: demands instant reflexes; transaction costs become a factor.

If you decide to operate in more than one timeframe, consider making those trades in different accounts. This will allow you to evaluate your performance in each timeframe rather than lump together apples and oranges.


The decision to invest or trade for the long term is almost always based on some fundamental idea. You may recognize a new technological trend or an exciting product that can greatly increase the value of a company. Investing demands a firm conviction and a great supply of patience if you are to hold that position through the inevitable pullbacks and periods of flat prices. These tough challenges make successful investing extremely hard.

Major trends that are easily seen on long-term charts appear uncertain and foggy in real time, especially when a stock enters a drawdown. When your investment drops 50% or more, wiping out the bulk of paper profits—a common development for long-term positions—few of us have enough conviction and fortitude to continue to hold. Let me illustrate this using an example of Apple Inc. (AAPL), a darling of several bull markets.

AAPL survived its near-death experience in 2003, when its battered stock was rumored to be a takeover candidate, and grew to become the highest-capitalized, publicly traded company in the world, before collapsing from that top in 2012. Its uptrend looks grand in retrospect, but ask yourself, honestly, would you have been able to hold though multiple drawdowns, some of them exceeding 50%. Remember that such drawdowns often mark the ends of uptrends.

A sensible way to deal with the challenge of investing is to implement your fundamental idea with the help of technical trading tools. When you decide to buy, check out technical signals to ensure you’re getting a relative bargain rather than paying full price. If your investment soars, use technical tools to identify overvalued zones; take your profits there and be ready to repurchase during the inevitable pullbacks. This plan demands a high degree of attention, focus, and perseverance.

FIGURE  AAPL weekly.

FIGURE  F monthly, 26- and 13-months EMA with the Impulse system, Autoenvelope, MACD Lines and MACD-Histogram (12-26-9), and Force Index 13-months EMA with ATR channels.

Fundamental analysis can help you find a stock that may be worth buying. Use technical analysis to time your entries and exits. Be prepared to buy and sell more than once during a major uptrend.

Swing Trading

While major trends and trading ranges can last for years, all are punctuated by short-term upswings and downswings. Those moves create multiple trading opportunities, which we can exploit. 

I especially recommend swing trading for beginning and intermediate traders. The more trades you make, the more you learn, provided you manage risk and keep good records. Swing trading teaches you faster than long-term investing, whose lessons take years to complete. Swing trading gives you time to think, unlike day-trading, which demands instant reactions. Day-trading is too fast for beginners.

Short-term swings can be substantial enough to generate meaningful profits, without the gut-wrenching drawdowns of position trades. Swing trades don’t require watching the screen all day. In where hundreds of traders compete, most trades last a few days. Some members carry their trades for weeks and even months, while others hop in and out within hours—but the holding period for most members is measured in days. Swing trading hits the sweet spot among time horizons.

I piggyback one or more of the Spiketrade group’s picks almost every week. The chart of HES comes from my diary of one of those trades. My profit in the HES trade was $1.92 per share. You can calibrate the amount of risk you accept and the size of potential profit by deciding how many shares to trade. We’ll address this essential question in chapter 50, in the section on the Iron Triangle of risk control.
FIGURE  HES daily, 26- and 13-day EMA with 4% envelope, MACD Lines and MACD-Histogram (12-26-9), the Impulse system, and 2-day Force Index.

One of the best learning techniques involves returning to your closed-out trades two months later and replotting their charts. Trading signals that looked foggy when you saw them at the right edge of the screen become clear when you see them in the middle of your chart. Now, with the passage of time, you can easily see what worked and what mistakes you may have made. Creating these follow-up charts teaches you what to repeat and what to avoid in the future. Updating the charts of closed trades turns you into your own instructor.

Each week the Spiker who won that week’s competition posts a diary of his trade. Different people use different indicators and parameters. Peter’s trade gained almost 11% in three days. Of course, we can’t allow ourselves to get intoxicated by such numbers. A beginner looks at them, multiplies them by the number of weeks in a year, and goes crazy throwing his money at the markets. Such spectacular gains are inevitably interspersed with losses. A professional trader carefully manages his money, quickly cuts losing trades and protects his capital to allow his equity to grow.

If investing is like hunting the big game, swing trading is like rabbit hunting. If your livelihood depends on hunting, shooting rabbits is a much more reliable way of putting meals on the table. Carefully entering and exiting swing trades, while cautiously managing money, is a realistic way of surviving and prospering in the markets.


Day-trading means entering and exiting trades within a single market session. Rapid buying and selling in front of a flashing screen demands the highest levels of concentration and discipline. Paradoxically, it attracts the most impulsive and gambling-prone people.

Day-trading appears deceptively easy. Brokerage firms hide customer statistics from the public, but in 2000, state regulators in Massachusetts subpoenaed brokerage house records, which showed that after six months only 16% of day-traders made money.

Whatever gaps you may have in your knowledge or discipline, day-trading will find them fast and hit you hard in your weak spots. In swing trading, you have the luxury of being able to stop and think, but not in day-trading.

The person who is learning to trade is much better off using end-of-day charts. After you grow into a consistently profitable swing trader, you may wish to explore day-trading. You’ll use your already developed skills and will only need to adjust to a faster game. A market newbie who stumbles into day-trading is a gift to the pros.

Make sure to write down your action plan for day-trading: what will prompt you to enter or exit, to hold or cut. Be prepared to invest plenty of time: day-trading chews up long hours in front of multiple screens.

Another difficulty of day-trading is that you shoot at much smaller targets. This is reflected in the height of price channels. Elsewhere in this book, you’ll read that a good measure of a trader’s performance is the percentage of the channel or an envelope he captures in a trade. Taking 30% or more of a channel’s height earns you an A grade, while capturing 10% of that channel earns you a C. Let’s apply these ratings to several stocks that are popular with day traders. The exact figures will change by the time you read this book, but today I get the following numbers for channel heights on the daily and 5-minute charts:

                Daily Channel  “A” Trader  “C” Trader  5-Min Channel  “A” Trader  “C” Trader
AA              55                       16.5                5.5               2.5                         0.75             0.25
AMZN       27                         8.1                2.7               2.2                         0.66             0.22
MON          7                           2.1                0.7               0.6                        0.18             0.06

A swing trader who uses daily charts can do very well in these active stocks. He can really clean up if he is an A level trader, but even if he is a C trader, taking only 10% out of a channel, he can stay comfortably ahead of the game while learning to trade. On the other hand, a person who day-trades the very same stocks must be a straight A trader in order to survive. Anything less and his account will be ground up by slippage, commissions, and expenses.

If, after developing a successful track record as a swing trader, you decide to day-trade, you’ll be able to use most of the tools and techniques you’ve already learned.

When a friend who is an Olympic rowing coach taught me to row, he focused on developing the correct stroke. A competent rower always moves his oars exactly the same way, whether it’s a leisurely weekend row or the final stretch of a race. What changes are power and speed. The same with day-trading: the technique is the same, but the speed is different. If you learn to swing trade, you can apply your technique to day-trading. And then you can go in reverse, and apply day-trading techniques to swing-trade entries and exits.

Day-trading can be a profitable pursuit, but keep in mind that it’s a highly demanding professional game and most definitely not a casual activity for beginners.