May 1999 Letters To The Editor

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VOLATILITY INDICATOR

Editor,

The September 1998 article "Trading The Trend" by Andrew Abraham, in which he presented a volatility indicator, doesn't provide the information necessary for the educated layman who is interested in technical analysis. In my opinion, it should have provided more detail on some areas.

I understand the calculation of a 21-period weighted average of the true range, but why is the final value multiplied by 3? Is the volatility indicator in a rising market calculated by subtracting the 21-period weighted average of the true range from the highest close in the same 21-period?

Then when the market closes below the volatility indicator, is the volatility indicator calculated by adding the next day’s value of the 21-period weighted average of the true range to the lowest close in the 21 periods? I hope you can clarify this for me.
 

Tony Ramselaar, via E-mail

Weert, The Netherlands
The volatility indicator discussed by Abraham in the article was originally introduced by J. Welles Wilder in New Concepts In Technical Trading, published by Trend Research in 1978, available from the Delta Society (336 698-0500). Wilder explains that the constant used in the volatility system can range from 2.80 to 3.10 and was found by testing. The volatility indicator is a trailing stop-and-reverse approach. The volatility indicator is the average true range multiplied by the constant and subtracted from the highest close for long positions. Thus, if you are long, you should go short if the market closes below the volatility indicator. While you are short, the volatility indicator is added to the lowest close, and you go long if the market closes above the volatility indicator.

I hope this helps to fill in the gaps for you. -- Editor


SPREADSHEET CALCULATIONS APPRECIATED

Editor,

I have been a subscriber to your informative publication for a number of years and enjoy the articles very much. I wish to commend you on the February 1999 article "Directional Movement" by Stuart Evens. The sidebar on the calculation method for a spreadsheet is most appreciated.

I would like to perform similar calculations for mutual funds, which usually report the Nav (net asset value) at closing, with no mention of high and low. Could you advise me on how to modify the calculations to accommodate mutual funds?

I would also like to request that you consider an article on point and figure charting and include appropriate spreadsheet calculation methods.

Thank you for a job well done.

W.E. Wright, via E-mail
Since no high or low is given for mutual funds, you can't work with a price range, which is what the directional movement indicator is based on. Perhaps you could try substituting the closing price for the high and low, which would give you the directional movement of the close only. I haven't tried this; let us know if it works! -- Editor


VOLUME-PRICE RELATIONSHIPS

Editor,

Thank you for your very helpful response to my last letter, and congratulations on maintaining the high standard of your excellent magazine.

The use of volume-price relationships has obvious merit for the assessment of market interest in a share, and I am aware that some proprietary software aims to track the accumulation and divestment of stock. However, this would appear to be mostly tied to the provision of data, and as I prefer to use a spreadsheet-based system of my own, I am seeking sources of formulas suitable for such a system. Can you suggest any sources?

Trevor T. Bestow, via E-mail
See Staff Writer Stuart Evens' article in this issue, "On-Balance Volume," which includes a sidebar on calculating OBV in a Microsoft Excel spreadsheet. -- Editor


MONEY MANAGEMENT

Editor,

I have subscribed to your magazine for over a year now and enjoy the ideas and articles. However, as with most investment products, including software, I rarely find discussions on money management.

One of the first books I read on trading and a most highly regarded book in the industry, Market Wizards, showed that the key to success in this business is managing trade size and risk. While I know you have had articles on this subject, I believe it should be a regular topic. For example, how much of my portfolio should be in the market at one time? How should I size each trade? How much should I risk in each trade? How much should be in one segment of the market (for example, high techs)?

Most new investors and traders look for the Holy Grail system, or ways to get into the market. However, I believe that trading really begins once you are in a trade. I am also disappointed with the lack of software focused in this area. Most packages don’t include portfolio tracking, let alone providing useful information to help you size your next trade and understand your past trade performance. Learning from your past trades is one of the most powerful tools in helping one improve performance.

The market appears to be focused on the sizzle, not the real meat. Remember the only requirement to enter this business is cash. I hope your magazine will help readers keep their cash by providing better information in the area of money management.

Mike Schwartz, via E-mail
We agree that money management is a priority in trading, and we have published many articles over the years on money management, position size, risk, and setting stop-losses. Thank you for reminding us that traders cannot be successful for long without money management strategies in place.

In addition to a series of articles last year by Jeffrey Owen Katz and Donna L. McCormick on exit strategies and setting stops, as well as some discussion of trade management and money management in our monthly interviews, and the insight offered over the years by Technical Editor John Sweeney on risk and position size, here are a few other recent articles on the topic of money management. In addition, see also the next letter, "Variability of returns." -- Editor

Matching Money Management With Trade Risk (Volume 16, May 1998)
by Daryl Guppy
Manage your trades using technical analysis by identifying risk points as well as setting profit objectives.

Secure Fractional Money Management  (Volume 16, July 1998)
by L. Zamansky, Ph.D., and D. Stendahl
Here's how to find a new fractional value of capital to invest in every trade to maximize returns subject to a constraint on drawdown, using a variation of the optimal f money management strategy.

Zero Cost Averaging (Volume 16, April 1998)
by Terrence M. Quinn and Kristin A. Quinn
This technique steps in to assist in the management of the investment after the investor has determined which securities to purchase and when to open the position.

The Basics Of Managing Money (Volume 15, September 1997)
by Mark Vakkur, M.D.
Why is money management one of the first items that professional traders stress? Here's an overview of risk and several simple mechanical approaches to money management.

Trading With A Variable Position Size (Volume 14, May 1996)
by Tom O'Malley
Once a position has been put on, some traders will hold it at a constant size throughout the life of the trade, while other traders will vary the size. Which is better?

Charting Equity (Volume 14, May 1996)
by Joe Luisi
Information on money management, what it is and how to use it can be hard to come by. Few traders understand or use money management techniques. Here are several techniques that you can use to get a better understanding of money management.

Using Maximum Adverse Excursion For Stops (Volume 5, April 1987)
by John Sweeney
The lesson here is: Minimize the size of your largest loss. Study past contracts to determine their maximum adverse excursion under the trading rules you use. I use a simple trend-following system with rate contracts and currencies.


VARIABILITY OF RETURNS

Editor,

I found Technical Editor John Sweeney's articles about volatility of returns in the May 1998 ("Volatility Of Returns") and December 1998 ("The Volatility Edge") STOCKS & COMMODITIES confusing. I am having trouble sorting out the difference between trading volatility and variability of returns as volatility is described in the articles.

As I understand the markets, volatility is important to make markets work, and investors or traders are always trying to limit the variability of their returns. I agree with Serguey Sayta's comment given in the December article that other things aren’t always equal. Sayta suggested one approach to improve the number of positive trades compared with the number of negative trades. But what about the size of the positive trades compared with the size of losing trades? What about diversification?

In the May article, Sweeney allowed the returns to range randomly from -50% to +50%. I assumed that this represented the size of the losses or gains from each trade. The importance of exit strategies to limit the size of the ratio of the losses to the size of the winning trades has been covered in many articles and interviews in STOCKS & COMMODITIES. The importance of money management can also be shown by altering the random return volatility spreadsheet. In so doing, it becomes very apparent that limiting the size of the losses is one of the most important things that an investor or trader can do to improve performance.

Along this line, Sweeney pointed out in Figure 4 of the December article that limiting losses and letting profits run is an old axiom. It is still one of the most important things required to make a person a good investor or trader.

The importance of diversification for protecting capital and limiting risk has also been covered in many articles and interviews in STOCKS & COMMODITIES. A well-diversified portfolio will go a long way toward limiting the variability of returns.

In sum, a person following his trading plan and limiting the size of his losses should limit the negative side of the returns to much less than -50%. By using diversification, he should smooth out the variations in returns. Throw in more positive returns than negative, as suggested by Sayta, and that person will be trading successfully for many years.

Ethan A. Schrader, via E-mail

VOLATILITY DATA VIA INTERNET

Editor,

I enjoyed your review of the OddsCalc software in the February 1999 STOCKS & COMMODITIES. Your inclusion of Websites that give volatility data was useful information. Please allow me to also point out our Website, https://www.optionstrategist.com, where we post free volatility data weekly. It includes various measures of historical (statistical) volatility, as well as the current implied volatility reading and the percentile of implied volatility for all 3,000 or so entities that have listed options.

Experienced option traders are using sophisticated probability calculations these days. A Monte Carlo simulation is helpful to provide an idea of the probability of a stock or future ever hitting a breakeven point during the life of a position — not just the probability at the end of the option’s life. This is particularly necessary for naked-option writers.

For example, in the review, an example is given where a naked orange juice strangle is written based on the fact that there is an 83% chance that the out-of-the-money options will expire worthless. However, a naked-option writer will normally take defensive action if his naked options go into-the-money at any time during the life of the position. So the real probability that one needs to know is, "What are the chances of orange juice ever hitting the call's strike or the put's strike during the time between now and expiration?" That chance is going to be much less than 83% -- perhaps something on the order of 60%. At a 60% probability, one might not actually take the trade.

So, when using probability calculations, an option trader must be careful to calculate the probability of what he is actually going to do while the position is in place. If one plans to blindly stay short the naked strangle until expiration, no matter what happens, then the probabilities as shown in OddsCalc will suffice. However, if one plans to take defensive action to prevent large losses, then I would recommend a Monte Carlo simulation.

Lawrence G. McMillan

President, McMillan Analysis Corp.
https://www.optionstrategist.com
E-mail: mac19@ix.netcom.com



BEGINNER TRADER NEEDS HELP

Editor,

I am interested in learning more about what traders do, how they make money, and becoming a home trader at some point.

Do you have any suggestions for beginner reading material that would explain the basics? How about something that would enable me take part in some active trading?

Jason W. Jones, via E-mail

 
Here is a list of classic reading material on technical analysis and the stock market:

Colby, R.W., and T.A. Meyers [1988]
The Encyclopedia Of Technical Market Indicators, Dow Jones-Irwin.

Edwards, Robert D., and John Magee [1997]
Technical Analysis Of Stock Trends, 7th ed., Amacom.

Fosback, Norman G. [1985]
Stock Market Logic, The Institute for Econometric Research.

Graham, Benjamin, and David Dodd (originally); Sidney Cottle et al. (5th ed.) [1988]
Graham & Dodd’s Security Analysis, 5th edition, McGraw-Hill.

Krausz, Robert [1997]
A W.D. Gann Treasure Discovered, Geometric Traders Institute, Inc.

Meyers, Thomas [1989]
The Technical Analysis Course, Probus Publishing.

Murphy, John J. [1991]
Intermarket Technical Analysis: Trading Strategies For The Global Stock, Bond, Commodity And Currency Markets, John Wiley & Sons.
_____ [1997]. The Visual Investor, John Wiley & Sons.

O'Neil, William J. [1988]
How To Make Money In Stocks, McGraw-Hill.

Pring, Martin J. [1985]
Technical Analysis Explained, McGraw-Hill.
____ [1992]. The All-Season Investor, John Wiley & Sons.

Rhea, Robert [1934]
The Story Of The Averages, Rhea, Greiner & Co.
_____ [1962]. The Dow Theory, Rhea, Greiner & Co.

Sperandeo, Victor [1991]
Trader Vic: Methods Of A Wall Street Master, John Wiley & Sons.

Wyckoff, Richard D. [1931]
The Richard D. Wyckoff Method Of Trading And Investing In Stocks, Wyckoff Associates, Park Ridge, IL.

Here are some classics on commodity trading and technical analysis:

Kaufman, P.J. [1987]
The New Commodity Trading Systems And Methods, John Wiley & Sons.

Murphy, John J. [1991]
Intermarket Technical Analysis: Trading Strategies For The Global Stock, Bond, Commodity And Currency Markets, John Wiley & Sons.
_____ [1986]. Technical Analysis Of The Futures Markets, New York Institute of Finance.

Schwager, Jack D. [1984]
A Complete Guide To The Futures Markets, John Wiley & Sons.
_____ [1996]. Schwager On Futures: Technical Analysis, John Wiley & Sons.
_____ [1995]. Schwager On Futures: Fundamental Analysis, John Wiley & Sons.

For getting started with trading, you may wish to paper trade or practice with a simulation program first (several have been reviewed in this magazine in the past year or two) while you work out a trading plan. -- Editor


NEW BEAR FUND FROM RYDEX

Editor,

Since I prepared the February 1999 article on designer funds for STOCKS & COMMODITIES, a new and important fund has since become available from Rydex Corp. that I wanted to mention -- the Arktos fund (RYAIX).

This fund is important because it has the objective of moving inversely to the Nasdaq 100 and thus provides a convenient opportunity for "shorting" the Nasdaq 100. Rydex's Otc fund moves in unison with the Nasdaq 100, so these two funds can make a great pair for trading models. The Arktos fund is now a very significant fund with more than $70 million invested as I write this letter in February 1999. By the way, the word "Arktos" has real meaning -- in Greek, it means bear.

Gary H. Elsner, Ph.D.

Editor, Achieve Profits, Inc.
https://www.AchieveProfits.com



ERRATA: TRADERS' TIPS

Editor,

In reviewing the TradeStation Traders' Tip that was published in the March 1999 STOCKS & COMMODITIES, I noticed a small problem in the name that I used for the function. The name of the function should have been "StochasticCustom." I inadvertently specified the name as "StochCustom."

Gaston Sanchez

EasyLanguage Specialist
Omega Research

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