As I write this article the market has driven itself into something of a flurry. From having such a good year we have entered a period that can best be described as high volatility range trading where the focus of interest for much of the year (commodity demand from China) has swung to another focus (the state of and outlook for the US economy).

One thing that never ceases to amaze me, and I would imagine everyone else is the way in which sentiment can turn on a dime. While speaking of dimes (or US dollars to be more precise) it is also quite remarkable to see how other things can carry on in the same direction for such a long time. This morning I saw that the Euro had hit another record level against the USD which may just go to show that when you are onto a winning thing then you should probably stick with it until such time as you are convinced it is not going your way. Without going into details you can look at the daily charts of a number of other currencies in the latter part of this year to get a very good illustration of what a turning trend may look like.

On that note there was another expression that was resurrected this year and that was ‘buy the dips’. This type of three-word strategy would have held a number of traders in very good stead over the course of this year as each successive fall in the market had been greeted with an ever more aggressive rally.

As the keen traders amongst you would remember, when the US sub prime issue became an issue back in the middle of the year we saw the market take a hit – then trade sideways – then another hit – and then away it went again. At the very low point of the downward swing the market was witness to some truly breathtaking selling pressure but then it was all over.

I believe the real danger of the buy the dips strategy is that you have to know when you are at the bottom of the dip. Like everything related to trading it is the easiest thing in the world to do when addressed as a post script. When the world is unfolding before you and you have precious trading capital on the line then it becomes a highly complex and emotionally-charged environment.

When you look back on any year the main thing that you notice is how many things you managed to forget – and this goes double when it comes to looking back on the sharemarket year that was. Overall this year cannot be called anything less than a spectacular one for traders and investors alike. At the outset I think the fact that record sessions on the main Australian indices became so commonplace was one of the more remarkable things that we have seen this year.

Whilst this in itself was remarkable it may seem in retrospect something of a siren song for the unwary. I believe the lesson is when record levels are becoming so regular that they are virtually relied on it may be a time to be if not cautious, then at least not to throw caution to the wind. This is not to say that we have gone from a golden age to doom and gloom but it does serve as a reminder that the character of a liquid market place is certainly a dynamic one.

Although it is only a subset, the most fascinating driver of the market certainly came from commodity prices. Amazingly there was interest in so many areas of the commodity market with metals – both base and precious – attracting attention as well as other areas such as the price of oil. Uranium too must be considered noteworthy not only for the growth that was seen in price but also for the great deal of anticipation that was pent up in its price. In a global environment where there is such competition for energy resources, there has been a real shift in the stance that exists for nuclear power and there has been a continued interest in the state of play for a number of the uranium miners as well.

It is hard to decide what is the most interesting of all the commodity movers but for my money it was the last minute dash to the finish line by oil. Oil has always been a very sensitive commodity and can easily be driven by a changing political environment or indeed by the prevailing condition of the weather.

At the moment there is an environment where we are on the cusp of USD $100/barrel oil which has driven all manner of

concern for inflation in the global economy but at the same time a real sense of fascination to see just how far the demand for black gold can go.

Oil is of course interesting for traders and non traders alike. Due to its impact on our daily lives, from the price that we pay at the petrol pump to the surcharges that are paid on air fares, oil is important.
The number two spot is largely the reason why we see commodities in the number one spot and that is China.

This amazingly populous country has become synonymous with demand for anything that Australia can dig out of the ground and has been a key driver locally over the course of this year. And whilst questions have been asked as to how long this level of demand could keep up there seems to be little sign of it slowing down. For a market riding on the back of copper and zinc this has proven to be quite wonderful for so many companies and the growth that has been seen in other areas of the economy. Apparently it has made the cost of property in Perth somewhat on the expensive side.

Many years ago now there was a traders’ favourite company that went by the name MIM Holdings which was very popular because the shares spent most of the time being quite cheap and the daily turnover of shares was enormous. After the company was taken over, people were for some time, left in the wilderness looking for an equivalent company that represented such a favourite amongst traders. Happily a lot of time has passed since then and there are many liquid and relatively cheap stocks that present themselves as new favourites.

Though the cheap part may now be debatable some of the uranium companies that have been listed in Australia have spent much of the year making big gains and have joined the leagues of the mid tier gold and oil companies as high turnover performers. Some of the volatility that they have displayed during the year has been nothing short of remarkable.

I think that one of the best trends that we have seen over the year has come from the US dollar. It is not necessarily to say that carrying longer term trade in currency would have yielded the greatest return for you but it was certainly a consistent movement to watch

It is some of this type of trend that makes me wonder why more people don’t view FX as a trading tool that can be held for days, weeks or months and instead focus their time on trying to eek a few pips here and a few pips there.

For those of you who like watching the screen there are probably no better markets around because of the constant action. If you are able to filter out this rapid up and down movement you can actually see some very impressive formations occurring in this market. Whilst the USD did not trend lower universally we saw some very consistent movements against a number of currencies.

As you can see from the weekly chart below it hasn’t been all one way traffic but that is a series of higher peaks and troughs that Charles Dow would be proud of. In many ways I suspect that it is charts like this that make people leave the ultra short term trading behind and move toward the less ostentatious but profitable world of trend trading which possibly explains why people like Ed Seykota are just so remarkably wealthy.

Accolades must certainly go to traders who were willing to go against the grain of the market as the S&P/ASX 200 Index struck some pretty serious resistance in the latter part of the year. Despite talking to a number of astute traders who recognised the formation I am not sure that any of them were willing to go against the prevailing market sentiment. As we know it is a great sentiment to go your own way in the market and to make decisions that may not be in line with what everyone else is saying but going short at the peak of a bull market is quite another thing all together.

To read in the paper again that day trading is on the increase likely means that so too is volatility. For most day traders volatility is really their bread and butter because it allows them to extract enough movement out of the market with which to make viable profits. It would be reasonable to assume that as we have entered the latter part of this year that volatility has been on the up with movements of the main S&P/ASX 200 index of more than 100 points in a day have become quite common place which has meant that trend traders have required a particularly strong stomach to deal with the very big swings in the market.

It makes you think that perhaps we were spoiled in the early part of the year for what was coming in later.

It is interesting that for trend traders, tolerance of volatility is something that simply goes with the territory because you realise that the market doesn’t move in only one direction. You are tolerant though because it can be hugely profitable to capture big moves of the market. Fine sentiments indeed but naturally these things become more difficult to cope with when there is real money on the line that you are losing. To paraphrase Seykota – if you want to avoid whipsaws – stop trading. Again this is a fine concept that takes real stomach to be able to live by and this I believe may be one of the real tricks of trading – to be able to absorb enough experience that you can live by such mantras because it is probably near or impossible to do it just by wanting to.

In looking back at the year that was, I believe that so much of the result we can have relates back to the plans that we construct for ourselves. A lot of people that I have spoken to over the years have stated that they have a trading plan in their mind but don’t actually write it down. Something that changing market conditions do to you is shake your confidence.

Particularly if you have come off a very strong run of profits it can be very difficult to get used to giving some of these profits back.

A trader who has had winning trades frequently will likely enter into new trades in a relaxed if not completely casual manner. Conversely, a trader who has been stung one time too many may be very hesitant in their taking on new trades.

The reality is that the right course of action probably lies in the middle of these two but I suspect that this is then a position you will be relying on trading outcomes to get to. Better I believe than relying on outcomes that will be dependent on the market to achieve I would suggest that this is where planning and a very strong definition of your trading plan is an absolute must.

This way there is a lot less indecision. If you have developed a methodology that you are satisfied is a good one then the taking of trades when they present themselves should be relatively easy. Much easier than for the trader who looks at chart after chart and tries to make a subjective assessment of each of them.

If you read the book ‘Pit Bull’ by legendary Wall Street trader Martin Schwartz you may get the impression that he makes a lot of his decisions on the hop. Whilst to some extent this may be true it is something that is achievable only because of his vast experience and on top of that was the mass of prior planning that went into his trading. Intuition cannot be over valued but it should not be confused with things that have happened purely by chance.

It has been an interesting year to look back on but I have found previously that they all are. I think that rather than hoping for another year of big index gains next year, the better focus is on refining our individual trading methodologies which annoyingly involves doing a post mortem on all of the errors that we have made and trying to minimise them in the future. Of course it would be much more pleasant if we could instead do biopsies on our successes instead but it really seems that this improves little on our shortcomings. This way we are at least focusing on the things that we can control rather than simply hoping that things will go our way.

In this issue, the CFD Trade Review talked to the traders who finished on the top 10 ranking of the competition to find out about their experience and strategy that put them on the leaders’ board.

Trade Review (TR): What was your strategy when you entered the competition?

Dave Limburg (DL – #1): “My strategy didn’t change for the competition. I traded like I normally would and hoped that my returns would stack up. My strategy day to day is to look for price breakouts on the daily chart in strongly trending stocks and ride them till I see some signs of weakness. I usually hold trades for 2-3 days, but I would take a loss and walk away from a trade in minutes if it’s not working for me.”

Nichole Page (NP – #2): “My strategy was not to do too many trades. I started out with a known company that I believed to be a certainty and make good profit and use this as a base to allow bigger margins/positions and maybe increase risk taking.”

John Mittelheuser (JM – #5): “My trading strategy was to look for opportunities in my favourite markets such as the stock indices AUSSIE200, UK100, SPX500, also commodities US Crude Oil and copper. Generally I will trade with the trend looking to take positions once I believe a new swing top or bottom is forming.”

Assad Tannous (AT – #6): “The plan was to stick to my trading system as best as I could, but due to the short- term time frame of the competition (the competition ran for eight weeks) I decided to lock in profits sooner than I would have had I been trading my normal strategy. Basically what I do is buy three different break out patterns on volume. The three patterns are trend line break outs, horizontal break outs and flag break outs.”

Robert Bennetts (RB – #8): “My strategy was to trade the Aussie200 index and the AUDUSD currency pair, as these two instruments are what I follow most closely. I trade ona combination of both technical and fundamental analysis.”

TR: What was your best trade during the competition?

DL: “My best trade was a large long position on AED oil (AED). It was a trade I had been waiting for a while. The stock had been trending strongly for a year or so and consolidated just below $5.15. I knew that a break of this resistance would signal a powerful move. I bought a very large position on the breakout and added to it on the way up. I also bought another big chunk on the first pullback. I held this for a few weeks, and it’s rallied very strongly.”

NP: “My best trade was on BHP. I was watching the charts and noticed that it was trading at about a dollar less than it had been previously. I thought it was undervalued and I expected it to go back up. It did go up around 75 cents the next trading day, so I sold and made about $4,500 on them. I also had a good trade with ABC Children’s Centre. I bought when it was around the $7 mark and they announced a profit upgrade and the share went up so I thought I would sell them. It was good timing, as it has gone down since. I took a $5,000 profit from that trade.”

JM: “My biggest gain was made on the Aussie200 when I made $3,580 in one trade. I took the trade with the upward trend and exited near the previous resistance top.”

Craig Page (CP – #7): “I bought Great Southern near its 12 month low on the belief that at some stage over the next few months it would go up 25%. It didn’t quite get there by the time the competition finished but it certainly contributed the most to my finishing ROI. The Aussie 200 also did well for me for some short term trades.”

RB: “My most rewarding trade was going short on Rio Tinto at $98.30 and closing the position at $92.40. I saw that Rio Tinto had shot up to nearly $100 on takeover speculation without any real evidence of a takeover. I took a short position, and after the market had closed that day RIO announced that they were unaware of any takeover offer. The next day the shares dropped sharply and I took a very rewarding and considerable profit.

Unfortunately this was gold’s last gasp effort on the upside before it started falling down. By the time I came to my senses and exited I nearly wiped out close to half my trading account at the time, but I recovered from that.”

CP: “I only had 12 trades during the term of the competition and they were all winning ones. Certainly at some points they were down, but I had a long term positive view on what I was buying and made sure I had enough free equity to carry them if they dropped after purchase.

I don’t panic if my equity drops when I am buying something I believe is undervalued.”

Oil Search, Woodside and Santos have all seen gains of between 35-45% this year and Tap Oil has gained nearly 70%.

There are some typical trends regarding the movements of gold price and we have seen these evidenced this year. Gold is a traditional safe haven for bearish times and its price typically mirrors the oil price movements. As the world fears a US economic recession, we have seen gold rise to levels not seen in almost three decades. Major movements in gold prices are generally associated with several recurring themes – inflation, changes in the exchange rate of the US dollar, and heightened political and economic uncertainty.

The recent rally in gold price has seen it nearing the record levels of January 1980 and has been driven by a number of factors including the falling US dollar and concerns that higher oil prices will increase inflation. As with oil, it is quite likely that there is a high level of speculative activity driving it to record highs.

Newcrest Mining (NCM), the biggest Australian gold miner, did very little in the first nine months of the year then gained almost 40% since then around the same time that the gold price has gained 25%.

Demand for iron ore has again been strong with Australia’s big miners securing some very large contracts with Chinese steel producers during the year and there is some reason to believe they may struggle to keep up with the increased demand. Recent developments at the big end of town saw the world’s biggest miner, BHP Billiton (BHP) make an offer to merge with the worlds 3rd largest miner, Rio Tinto (RIO) which could potentially create a $400 billion giant that ranks in the top 10 companies in the world by market capitalisation. RIO’s share price subsequently went through the roof to near $150.

China continues to import iron ore at an increasing rate. In the first eight months of 2007 ore imports were 250 million tonnes, almost 15% up on the previous year. These imports came from 28 different countries, although Australia, Brazil and India accounted for 85% of the total.

Some of these price movements can be put down to speculators driving it higher, particularly as foreign investors may look for opportunities with a falling US dollar and there is some consensus that there has been some irrationality in recent price movements. When taking into account adjustments for inflation, we are seeing oil reach the equivalent of record highs of 1980s.

An unsettled Middle East, and to a lesser extent Northern Africa and South America, have also had an impact on prices as there is always fear that tension in these regions may spark supply problems and result in the producers being unable to meet demand.

Increasing demand from Asian economies is something that will not go away and continue to have an upward influence on prices. China now the 2nd biggest consumer of oil accounting for about 8% of the world’s daily usage and India is fast climbing up the rankings and the concern is obviously the increasing trend in these regions. However, none of these countries are anywhere near the levels of consumption in the US.

One of the success stories in the local market has been AED Oil (AED) whose share price has more than doubled this year following good progress with some of its exploration in the Timor Sea.

Again, China is behind the growth in demand as consumption has been increasing steadily at around 8-9% in recent times. RIO Tinto is set to become the world’s biggest aluminium producer following its recent acquisition of Canada’s Alcan.

Zinc prices came off heavily early in 2007 and despite a recovery in May, is currently sitting 28% lower than at the beginning of the year due to an increase in production efficiencies resulting in increased supply. However, current prices are still twice what they were two years ago and China is marginally a net importer of Zinc which is always a good sign. Zinifex traded steadily in the $16 to $18 range apart from a period during the middle of the year when sharp increases were followed by even steeper falls around the time of the August correction. It is currently down around 15% for the year.

A rising Australian dollar also has an impact on any unhedged exports which can not be ignored given it has risen around 14% against the US Dollar this year.

The increase in overall commodity prices has a general inflationary effect given that these extra costs flow through to finished goods and the economy has felt the effect of these recently.

However, there seems to be no slowing the demand from Asia in the near future and this is one of the reasons behind the strength in the Australian market and its occasional immunity to fears of a US slowdown. Critical in each market will be the potential issue of over supply as new producers come on to the market to take advantage of historically high prices.

Another area of general concern is inefficiencies in production chains as they struggle to keep up with the amount of raw materials coming through. Certainly with such a keen focus on this sector, the volatility can be expected to continue and we look forward to seeing what opportunities will be presented in 2008.

There was an interesting development at the lower end of the market with Murchison Metals making a takeover bid for Mid West Corporation with the latter’s share price rocketing from $0.91c to $5.00 by the October offer. There is a lot of speculation at the lower end of the market and we could see further take overs of the smaller companies as there is a rush to get involved in the Chinese demand for raw materials.

The last four years have seen a shortage in wheat production causing a drawdown on supplies and this year was no different with crop problems predominantly in the US and Europe and the effects of the drought in Australia.

This caused wheat prices to hit an all time high of US$9.60 a bushel up from US$4.99 a year earlier. AWB started the year at $3.02 and peaked over $4 in July before losing almost half it value in the following two months. It now sits around $2.90.

Aluminium prices have been on a steady increase for the last five years and after peaking at US$1.40/lb in March 2006, maintained around US$1.20 for the first half of the year as strong demand supported the price. However, the latter half of the year has seen prices fall over 10% as productions levels increase and there is a net over supply in the market.

“It was a flawed assumption, thinking that the broker knows what he’s telling you,” Chris added.

This disappointment gave him a challenge. In his mind, if he can’t rely on the broker to learn about trading, then he would do it himself. He would learn how to trade and in order to do that he needs to be in the industry. So he got a job in a stockbrokerage firm only to find a bigger disappointment.

His first hand experience in working inside a brokerage company ignited his desire to learn how to trade on his own. He put his scientific mind into action and started learning everything he could. Before long he was trading his own account and then some for clients

From share trading Chris got into the more advanced area of derivatives trading. At that time it suited him because of the short-term time frame where prices fluctuate very rapidly and trading opportunities abound. However, this would prove short-lived as well.

“After several years in the market and seeing different market conditions, it dawned on me that trend trading is much better in so many ways compared to short-term trading. I think all traders are initially attracted to the short term aspect of trading in the belief that if they turn the account over enough it will grow at a much quicker rate,” Chris said.

He added, “Short-term trading appeals to a certain mindset. It could wear you down quite easily. Also, I don’t think short-term traders realise it but they don’t make as much money as they think they do.”

Chris believes that the transaction cost involved in short-term trading are detrimental to your trading account, particularly if you’re just starting and you have quite a relatively small trading capital.

“In terms of transaction costs short term systems are very expensive even with the low cost brokerage on offer today. Transaction costs can kill your trading account if you don’t watch it. They may be small and may look small, but they still erode your capital,” he said.

Nowadays, Chris trades a combination of derivatives including contracts for difference (CFDs). He’s developed his own mechanical trend following system that usually let him stay on a trade for as long as several weeks or for a short time like a few days.

When it comes to using leverage, Chris said: “I believe leverage can enhance trading returns if it is used prudently. The problem is most people are seduced by the leverage and have little concept of how much damage it can do.

“I wouldn’t recommend it (use of leverage) for those who are just starting. I know they have an enormous appeal to people, but it becomes problematic if people don’t know how leverage works,” he said.

Based on his own personal experience, Chris said: “I’ve been lucky in my use of leverage. I was lucky in the sense that it didn’t bite me when I was new to it. I’ve seen some people who blew their trading account before they learned or fully understood the power of leverage. Leverage cuts both ways, it can double your returns but it can also double your losses.”

One of Chris’ lucky trading experiences was the 1987 crash. It was lucky for him because he was not in the market.

“Before the crash I’ve been thinking of doing my MBA and it’s just a few months before the actual crash that I took my money out of the market because I need it for an MBA I intended to do. So, I was lucky then,” he said.

With more than 25 years of trading experience behind him and over 100 students who have completed his mentoring program, Chris said there are still some misconceptions in a lot of people’s minds when it comes to trading.

Two of the most common ones he said are: People think that trading is not a business and that it takes time to get it going. The other one is that people think there is a secret to successful trading and there must be someone out there who knows the secret and if you pay that someone he/she will tell you the secret.

“There is no secret at all,” Chris said. “All I can say is don’t do your dough. Markets have very few rules that pertain to individuals outside of the various rules for settlement but they do have one guiding rule and that is no money no play.”
One other word of insight from Chris for traders and would-be traders, “People don’t fail (in trading) because of lack of intelligence – the market doesn’t care no matter how intelligent or unintelligent you are. The key is persistence. If you keep going and take note and learn from your mistakes, you will be more successful in the long term. People grossly overestimate what they will achieve in the short term but they also underestimate what they can achieve in the long term.”

The most obvious advantage of short trading is the ability to benefit from falling prices which is of particular note if the market overall is on the slide. The most obvious risk is the unlimited losses that can flow if the short position relates to CFD show price continues to rise. The question that you need to ask yourself though is whether or not it is something that you would utilise regularly when the market is generally very bullish as we are seeing at the moment.

If you are trading in the very short term then the overall direction of the market becomes less important because you are only looking to benefit from very short term movements anyway and this is the case regardless of whether or not you are looking for positive or negative movements.
What this means is that if you are looking for short term short trades then you are probably less concerned whether the share price is trending higher or lower but more where you think the share price will be in the next day or so.

A lot of traders who look for this type of trade will be looking for stocks that have had a very sudden positive move and will go short to take advantage of any share price retracement.
The position that you take though doesn’t have to be as short term in nature as the one described above. You may look for a stock that is in a downtrend and take a short position that would benefit if this existing trending movement continues.

This may indeed be very similar to the way that you assess positions that you want to take a long position in e.g. you go long in an uptrend and you go short in a downtrend. This sounds very simple but the longer the timeframe that you trade using then the more susceptible you will be to the overall direction of the market. You have quite possibly heard the expression that a ‘rising tide will float all ships’ which suggests that in a bullish markets the bias for a lot of companies will be to the high side. If nothing else, this would likely mean that in a bull market your overall CFD portfolio will likely be quite heavily biased toward the long side.

Having said that though, some people find the idea of carrying at least 1 or 2 short positions, even in bull markets, quite appealing. Some people would refer to this as a short/long bias. This would mean that in a bull market, if you held 10 positions in your trading portfolio you would look to carry 1 or 2 short positions overall. The idea behind this is that you will not be tied to the market going only in 1 direction (directional diversification) and carries with it the additional benefit of giving you some degree of insurance against a market becoming range bound or even bearish over the short term. It is very important that if you look to go down this path you are careful with the positions that you chose.

You can’t simply decide that you want to carry some short positions and then not pay enough attention to the ones that you select.

The interesting thing with selecting short positions is that you can often use the opposite set of criteria that you might use to select a long position. For instance, you may use a straight edge trendline retracement as your entry criteria for a long trade. In this type of strategy you are looking at the trend line being upward sloping.

You can see how easily this same rationale might be applied to a short trade using a downward sloping trendline. Perhaps you use oscillators that gyrate between overbought and oversold levels. It is quite possible that the methodology you use in this case to seek long positions if applied in something close to the opposite fashion may be useful as a means of selecting and timing your entry into short positions.

It would be generally suggested that short trading should take place over a smaller time frame than would the equivalent long trade. Short traders will generally be looking for a more sudden movement than they would see occurring on the long side. Consensus would agree that markets (and indeed individual stocks) fall faster then they rise – or in other words a company that is in favour will generally see its share price climb at a slower pace that one that is out of favour will see theirs fall.

The dilemma is of course the desire to have the benefit of short term upswings without having to deal with any sort of retracements. This type of desired outcome is usually associated with a short term trading strategy. However, there may be some common ground in between the two aims. Firstly, sticking with a trend over a period of months (or even years) can be a profitable type of position trading. The key task with this kind of position is to monitor it and have an exit strategy.

The temptation comes when people want to lock in profits as soon as they become available and this can lead to another peril of trading. If you sit and watch prices all day long it may put you in a position that you will want to close out your profitable positions as soon as they tick down a cent or two because you fear that this is the turning point.

This can amount to ultra short tem trading (called scalping), which can have a number of disadvantages.

Options to protect profit during a price fall and benefit from a long-term up trend are a little limited. One option to consider is called scaling. This would involve something like taking a long position in a CFD which has had a retracement to the trend line (or moving average) and is starting to move higher again. Assuming that the position begins to move in your favour and increases in value you may then start to look to momentum indicators to determine when this immediate upswing appears to be coming to a halt. At this time, your response may be to close a portion of your position which locks in a portion of your profits.

The potential advantage of this strategy is two-fold. If the price of the CFD continues to rise then a portion of your original exposure is still intact.

This also allows for a return to the trend line. If the price of the CFD falls back to the trend line and then turns once more to move higher then this gives you an opportunity to add to your position. Because some exposure remains intact, you are however still exposed to losses.

You could argue that it would be more profitable to aim to unwind your entire position at the top of the movement away from the trend line and then re-enter once it returns to the trend line. While this may be true, achieving it is very close to a trading utopia and to do so is akin to picking the top and the bottom of the market - a very difficult thing to do.

In order to take advantage of these short term movements, crystallizing a portion of your profits allows you to lock in a portion of the gains.

Lowering your position size whilst at the same time maintaining some of exposure allows you to take advantage of future potential CFD price increases and reduces risk of loss to an extent.

If the position returns to the trendline and then continues lower, you may feel you are forced to close out the remainder of your CFD position to control you loss. It is unfortunate that virtually any defensive strategy places a cap on your available upside but it is a sensible trade off to make considering the potential benefits that it delivers by helping to manage the significant risks that are involved in CFD trading.

Companies and commodities have a certain value in a market place and will be priced accordingly. The emotional human element of traders moving around value creates swings between supply and demand of over bought or oversold situations as a market moves within its trending path. As short term traders, we take advantage of any pattern we can recognize. We have a level of confidence about each pattern and how they fit into a larger pattern.

New traders use indicators to identify certain aspects of the patterns. However, they take you away from truly understanding the market. Once you understand how an indicator is calculated and what it does, it won’t take long for you to see the chart patterns. If you focus on the three key elements of price, pattern and volume it brings your attention back to the actual market. All you need to know is in the price and volume, it is the volume that creates the price and it is the price that creates the patterns.

Pattern recognition takes observation, study and time. Every 12 weeks I manually go through the whole ASX market from A

to Z then I place 200 – 400 stocks in a watch list. I then go through that watch list every day, observing each pattern unfold and take shape. By observing each stock every day, I learn all I need to know.

I also need to know how other markets affect that stock, i.e. commodities are one of the major influences. For example, US Spot Gold has just reach US$800 (8 is a Tradinglevel key number, I would expect the market to spend time here). This key number will affect gold stocks, so it is imperative to chart commodities. The Indices are mostly governed by the larger stocks such as BHP Billiton, which contributed 364 points of this year’s 1079 point rise in the S&P 200 Index - 35% of the total. Rio Tinto contributed another 54 points, or almost 15% of the total.

When it comes to patterns, there are the traditional ones which are essential to understand and which should be your first port of call. These include trend reversals, i.e. double tops, double bottoms, head and shoulders, falling and rising wedges and others. Then there are trend continuation patterns such as ascending and descending triangles, cup and handle, flags and pennants, channels and rectangles.

It is imperative to understand the mountainous pattern at the beginning of a trend because the next part of the trend i.e. is the middle, is the most powerful part. This is normally the break out or the gapping period where the volume is the greatest.

The end of a trend is where the distribution starts to finish in price and volume. In terms of the pattern you will start to see the smaller waves / trends start to overlap one another, not as much as in the beginning of the trend. This overlapping is a sign of weakness at this stage (old highs do not support the market).

You will also notice in the market depth, there will be sellers moving into the Ask side especially building up around whole numbers. The scales of market depth will have more sellers than buyers.

Elliott Wave Theory is probably one of the better

methods in understanding trends because it breaks down from macro to micro in terms of wave structures. These waves represent the emotional nature of human behaviour. It is the psychology of the market and if you can understand your own psychology then you may start to understand market psychology, which creates these patterns.

A technical trader tracks the weight of shares – that is the volume that is coming and going. However, it may seem impossible (particularly for new traders) to understand all those squiggly lines on a chart. It takes time and observation to start the recognition process of price patterns and how the price relates to the volume.

There needs to be meaning in what you’re looking at, and an understanding of the relationship between volume, price and the patterns.

Once all the basic chart patterns are understood you can move onto understanding the internal structures of these patterns.

The best way to do this is by studying Elliott Wave, which not only looks into the behavior of the market, but also provides a set of rules that can be applied to each sub wave. For example a traditionalist would see a head and shoulders pattern and an Elliott Wave follower would see much further into the internal structure.

Firstly he would see the head and shoulders as a 3rd, 4th or 5th wave on the left side of the structure and the right hand side would be an A, B and C wave. All of these waves have sub waves that have rules that make them what they are. They can be broken down even further with sets of rules. There are many roads that lead to Rome and it is very helpful to be able to see patterns from different points of view.

owever, patterns are just one dimension of the picture. A car is no good without petrol. Volume is the fuel of the market and if you apply patterns and volume together, then you can develop a real feel for the market. Volume lets you know where the weight is and how strong the market is for any time frame.

In the short term – that is day trading, it’s the market depth you need to be able to read, for longer term trades you can read it in the chart. The simple rule for reading volume is the volume bar’s relationship to the price bar (open high low close) and the previous period’s volume bar.

The normal flow of volume will increase during the trend and decrease through the correction. There are many more subtle points to understand and is definitely worth the effort as volume is definitely one of the major keys to successful trading as it gives you a real grasp on what’s happening in the market.

On Wednesday, 28th February 2007 the Australian stock market lost almost 200 points in one day after the US stock markets wiped out almost 400 points the night before.

It was one of the heaviest market falls in recent history with most of the global stock markets following a sort of domino effect that started with the China stock market closing 9 per cent down in one day. When the China stock market closed the UK market (FTSE) plunged almost 150 points on open. And with the jitters already spreading in the US by the time the UK markets close the American markets nose-dived close to 400 points in one day.

While it may still be early to make a call whether this ‘correction’ is over or not and while market observers and analyst are still debating the causes of the massive sell-off, CMC Markets’ Trade Review spoke to some private traders to find out how they traded during this most recent market volatility. We talked to several CFD traders who had open positions while the markets were falling.

The following interview would give an insight on what goes on in a trader’s mind at the face of a market correction, some trading strategies to employ in such a massive sell-off and how to deal with a market that seems to have a mind of its own.

TRADE REVIEW (TR): Did you have open trades before and when the markets had a massive fall on Wednesday (28th February)?

Justine Pollard (JP): Yes, I had 12 CFD positions open and I was stopped out of five positions.

Hamish Thompson (HT): Yes I had trades open on mostly trend following style. Some of these gapped down through our stops but that happens from time to time. Most of the trades I had open were long and most of them were in varying degrees of profit.

I had some short trades open as well but not many because the market was trending up so strongly.

Anita Eliezer (AE): I did have some open long CFD positions, and they all went down except for Woolworths, which was the only company that went up by 40 cents that day. I held a few banks – CBA, NAB and insurance company QBE. I also had 20 long positions on the FTSE.

TR: Did you make money on your open trades?

JP: Yes. Two of my long positions went up on the day and I moved my stop loss levels on them.

I was stopped out of one position, which has already made a 662% profit based on my original CFD position size.

HT: I made some money on two CFD positions and I was stopped out in two others prior to Wednesday and I already made good money on those anyway.

AE: One of my open CFD long positions actually closed higher on the day. Though most of my positions were closed out, I was able to reduce my exposure (to the markets) a few days before, so overall, I wasn’t affected that much after all.

TR: Did you lose money on any trade at all?

JP: I had four long positions were I lost a small percentage of my total capital. In one trade I lost 1% of my total trading capital, which was the biggest loss for that day. Another trade lost 0.6% of my total trading capital due to slippage, but it was still a small loss. Two other trades lost 0.7% and 0.6% of my trading capital respectively.

However, overall at the end of the day I was in profit with the positions I was stopped out of. I took four small losses and one large profit, which more than made up for the losses.

HT: I lost some money on a couple of CFD positions opened just a few days that week.

AE: All in all, the market drop hasn’t affected me too much. It’s because I have been watching the market and I thought it was too frothy. As a result, I had started reducing my positions a few weeks ago. Fortunately, whenever there were big upward swings in the Australian market, I would get out of positions I was holding, or at least reduce them.

TR: What was your initial reaction to the market fall?

JP: I was out for the day and did not come home until 1pm. I was aware of the fall as I checked the US market action in the morning. I have my stop loss orders in place and a portfolio heat level that was currently at 3%. And I knew the market will exit my positions for me if the CFDs fall to my stop loss levels.

HT: These days I let my systems take care of what I should do. Most long positions were stopped out and I had a few shorts open that did reasonably well and are still going.

AE: My initial reaction to the fall, since I’d been expecting it, was relief. I say “relieved” because the market was too frothy, and I was reluctant to take on big long positions. When the market drops, it

gives traders like me a far better entry point.

TR: Did you go short on any position? Did you buy into the dip?

JP: I ran my system scans at 3.30pm as I always do and did open one position that came up in my system. It was actually a long position. I did not receive any short signals. Whilst the market did fall, no trend lines or significant support lines were broken, so I did not receive any short signals.

HT: I got a lot of dip buy entries especially on the US market the day after the big fall but only a few of them got filled the next day as it was up a bit understandably. I had a few dip buy trades and waiting for a bounce in the market to get me out.

AE: One week after the initial fall, the markets went up by 118 points, so I’ve just started dipping my toes back in again.

TR: Can you give some insights into what’s going on in your mind during the fall and for the past few days given the market volatility?

JP: Just to trade my system and follow the signals. I was not worried at all, as I have faith in my trading system and having traded

through the World Trade Centre crash.

HT: This fall was due and I am getting better at handling it as well as designing systems that complement each other better. It is however, hard not to give a bit back to the market when it turns over like it just did. Going forward though, it gives us some more volatility to trade with especially with mean reversion systems and a little more possible upside now the market has had a correction.

AE: I feel this is something we had to go through, and this is exactly what happened in May 2006. The fundamentals in the established markets such as in the US, Europe and Australia, seem fine. So I don’t see a reason why the market should correct 20% or so. I am expecting between a 5% to 10% correction.

TR: What are some of the pointers can you give to those who are just starting to trade when a market correction like this happens?

JP: Ensure you take action and follow your stop loss orders. Size all your trades based on 1% or 2% risk and manage a portfolio heat level of no more than 5%.

HT: Those starting to trade at these times need to be careful and keep their risk

under control at these times as well as any other. The best way to do that is have a pre-defined system and stick to it. Preferably a mechanical one that is backtested so they know what trades to put on and what drawdown to expect. If they don’t have a system then I would say they have less than a 50/50 chance of making any money or indeed keeping what they already have.

AE: An inexperienced trader or someone starting out should stay on the sidelines until the market stabilises. Or else you’ll be drenched. Always have stop losses in place so if the market moves violently, at least your stop will trigger, and your losses will be limited.

Three traders trading the same falling market using different trading strategies. These traders showed you should consider good trading principles such as:

• Make sure you have stop loss in place.
• Keep your portfolio heat to a minimum.
• If you’re new in the markets, stay on the sidelines until the market has stabilised.
• Keep your risk under control.
• Follow and stick to your system.
• Trade with the trend – buy when prices are going up and sell when prices are going down.

As a trader Cook is a firm believer of putting in the hard work and spending the time to study and get to know the markets.

“Over the years I’ve realised that I’m an old-fashioned tape reader. I have a feel for the situation in the market (that comes only with experience). I understand the influences affecting the market – where to buy and sell and how to apply them in my trading,” Cook said.

As a result of his deeply seated interest in the market his desire to understand its every move, Cook discovered what is now known as the Cook Cumulative Tick Indicator TM – an overbought/ oversold indicator that he uses as an overall sentiment reader for the market.

“I wouldn’t say I developed it (the indicator), it must have been there for ages and it so happened that I was able to harness it. It’s like someone working in a science laboratory for a long time and suddenly realised or discovered this pattern,” Cook said as he related how he spent years in testing the indicator and how it proved accurate in his reading and analysis of the markets during the past decades.

While the Cook Cumulative Tick Indicator TM is at the core of his trading strategy and has proved to be financially lucrative for him, it has also gained Cook some ‘notoriety’ in some pockets of the market during previous years of market upheavals.
For example, in February 2000 during a speech in New York City, Cook was in front of a standing room only crowd wanting to hear what he had to say about market direction then. Of course it was at the height of the technology boom and everyone was interested in the stockmarket.

Cook recalled that the first words that came out of his mouth at that time were: “Those of you who are in the stockmarket now, you should get out or you will be killed.”

In the same speech Cook predicted that the Nasdaq will fall by 50 percent. He admitted he was wrong. It had a massive 80 per cent fall which brought on the dot.com bust.

With three decades of trading experience behind him, Cook said, “I’ve been in this business long enough to know that you need to preserve your capital to be able to stay trading. Some people may not want to hear what I have to say (about the markets and about trading), but I am clear-cut, black and white type of person. If I see bullish or bearish signs in the market, I tell it as it is.”

While he still trades very actively and keeps an ongoing interest in the markets, Cook had already trained his son and a couple of other traders to continue his trading business.

He’s also sharing his trading expertise through his mentoring program which has an international network of traders who have personal access to Cook on a regular basis.

“I had a heart condition two years ago. My heart stopped for 22 seconds and I was given intravenous medication to restart my heart. That experienced served as a wake up call and helped me put things in perspective that life is fragile and you don’t know what’s around the corner,” Cook said.

“Over the last couple of years I started a mentoring program to pass on my trading experience. I want to give back something now because trading has been good to me. I’ve been blessed and I want to be able to share this with others who will be interested in carrying it on.”

“One of edicts to myself and my students is that you must finish the day with a winning trade. That is imperative to confidence and healing. Trading is like an enemy that will tear at your finances and confidence if you allow it,” Cook said.

However, he is upfront for those who are thinking of getting him as a mentor. Be prepared for the hard work and long hours of studying the market. Those who just want to make the money now (ASAP) need not apply