How I trade for a Living

by Gary Smith
- first book ever read on the kindle
- great book starting off...then irrelevant later as he drifts off about how he trades which is very diff from me
- most important is that it taught me to care about market sentiment indicators and to use this as the subjective
** stopped chart analysis of Gary's trades at "A 9 to 1 up-volume day" on page 122 of pdf

Rick Pitino's Success Is a Choice is an excellent book on setting goals. Pitino maintains that dreams are where we want to end up and goals are how we get there. Goals give us the routine we need to accomplish our dreams. He also says that our long-term success is the result of the small victories we accumulate along the way—that by looking for incremental progress, the small successes will lead to larger successes and achievement of our goals. I could be the poster boy for Pitino's book. It wasn't until I set my goal of no losing months that I became a winner. Over the years, the accumulation of winning months led to the larger success of realizing my dream of trading for a living.

I get a laugh whenever I recall the advice given in one of the bestselling trading books. The
psychological guru pontificated on the beliefs that all traders must possess to succeed in the game, which were derived from his analysis of the beliefs of successful traders. These required beliefs include the following:
• Money is not important.
• It's okay to lose in the markets.
• Win the game before you start with confidence.
My track record certainly qualifies me as a top trader. However, my pattern is more like this:
• I trade for the money.
• I die after every loss, which sometimes eats away at me for days and weeks afterward.
• I begin each trade with a complete lack of confidence, convinced it will be a loser.

I also find it's beneficial to dwell on my losses—another no-no in psychological trading guru-
land. This way, I am less prone to repeat my mistakes. As for trading with a complete lack of
confidence, I find it pays to prepare for the worst in every trade and assume it will not pan out. This way, I am never caught off guard psychologically when the market moves against me.

I am a firm believer that success leaves clues and that it's important to study these clues. There's a strong correlation between studying success and achieving success. Successful people are students of success.

Many left-brainers also believe there is some sort of order and rationality to the markets. They use mechanical trading tools and mathematical formulae to measure this rationality. I much prefer to accept the chaotic and irrational behavior of the markets and devise trading strategies based on that irrationality.

I've often thought that the truly great traders are those who have been able to merge their left-brain analytical functions with their right-brain creative functions. After all, it takes creativity and imagination to develop a mechanical trading system that is different from the pack's.

Too often, though, traders become prisoners of their favorite indicators and lose the ability to think for themselves. What counts in trading is what the market is saying, not the indicators.

The point is that the action of the market always takes precedence over your indicators. Indicators are only used to warn us of a possible change in trend. The emphasis here is on possible.

From my experience, the crux of winning at the trading game boils down to the trader's understanding of market sentiment, so it's not surprising that my favorite indicators are sentiment based.

One reason for this is that, of the group of traders who speculate in stocks, futures, mutual funds, or options, it's the option traders who tend to be the least capitalized. As Richard Band describes them in Contrary Investing, "By nature, people who play the options market tend to be gamblers, dreamers, who hope to parlay a couple thousand dollars into a fortune. As a group, they represent the dumb money at its dumbest."

My favorite statistical models for measuring put/call ratios are the following:
• When daily total CBOE put volume doubles its 10-day average
• Single-day OEX readings of 1.60 puts over calls
• Consecutive daily CBOE put/call ratios of 1.00 or greater
• Equity-only put/call ratios above .75

As for put/call ratios, besides the readings at the extremes, I'm most interested when periods of strongly rising prices are met with heavy put buying and, conversely, when periods of strongly declining prices are met with heavy call buying—in other words, when there are divergences.

Other than the rare instances when the equity-only put/call ratio reaches above .75, I pay little
attention to equity-only ratios. Nor do I pay much heed to total CBOE put/call ratios. I'm primarily interested in the index ratios, which include the OEX and the S&P 500.

The High/Low Logic Index is most predictive if used with a 10-week moving average. Readings
above 4.5 percent constitute a sell signal, and below I percent, a buy signal. On a weekly basis,
readings above 7 percent and under 1 percent are considered extreme and, respectively, are sell and buy signals. Weekly readings over 10 percent are rare, but particularly ominous.

• When the Dow declines while the advance/decline line is rising, the market will rise.
• When the Dow advances—especially to new highs—while the advance/decline line is falling, the
market will decline.
• When the Dow approaches a previous low and the advance/ decline line is well above where it was at the time of that previous low, it's time to become bullish.
• When the Dow approaches a previous high and the advance/ decline line is well below its previous reading, which corresponded with that top, it's time to be cautious.
• The direction of breakouts from trading ranges in the Dow and S&P can often be determined if the advance/decline line has already broken out of its trading range.

With but a few exceptions, a pronounced uptrend or downtrend in the Utilities eventually will be followed by the broader market.

Through the years, I've come to see there is a flow and rhythm to the market, and that rhythm is its momentum. Being a successful trader hinges on being in synch with this momentum.

V-bottom reversals occur intraday where the Dow has been in decidedly negative territory the entire trading session, down at least .75 percent, and then makes a furious comeback, closing either near the unchanged level or, preferably, up for the day. The later in the day the reversal occurs, the more significance I attach to it. I will instinctively trade V-bottom reversals if the previous day closed down or if the Dow has been in a recent downtrend. On the other hand, I don't attach much importance to V-bottom reversals occurring after a strong up day or during a period of rising prices. In most of these occurrences, I will already be in the market before the day of the V-bottom reversal.

Closely related to V-bottom reversals are the late-day upside surge patterns. These normally occur during the last 2 to 2 1/2 hours in a trading day that has seen trendless and choppy price action. These late-day price surges should take the Dow to a close of at least .50 percent above the prior day's close. As with the V-bottom reversals, this pattern is significant only when it comes after a down day or a period of declining prices.

One of my more reliable momentum patterns over the years has been the Friday-to-Monday pattern. Stronger-than-average strength on a Friday is expected to be followed by more strength on Monday (or Tuesday if Monday is a trading holiday). Conversely, extremely weak price action on a Friday is expected to lead to more weakness on Monday. A Friday-to-Monday momentum break pattern occurs when the expected strength or weakness on Friday doesn't carry over to Monday. These weekend momentum break patterns are highly significant and indicative of a short-term trend change.

A 1 percent true selling day occurs after a period of rising prices of at least two weeks in which the Dow, S&P, Nasdaq 100, and Russell 2000 indexes all close down 1 percent or more on the same trading day. These types of days often are trend busters and can be harbingers of serious price declines ahead. I use a little leeway, however, in defining such selling days. For instance, if three of the four indexes are sharply lower—say, down 1.5 percent to 2 percent or more—but one is down only .75 percent to 1 percent, then I interpret that as a true selling day.

However, my limit is .75 percent. This means that if any index is down less than .75 percent on a day when the rest of the indexes are sharply lower, there is buying interest in at least one segment of the market, which rules out a true selling day.

One trading rule I live by is to expect weakness on Monday if the preceding Friday is extremely weak. Conversely, extreme strength on Fridays should also lead to more strength on the following Monday. Any aberration in these patterns gets my immediate attention.

Prematurely taking profits is an exercise best left for fools and losers. To accumulate wealth, you need to maximize your winning trades as much as possible by riding them for as much as you can and for as long as you can.

If you recall, that was one of my deficiencies during the 19 years I struggled as a break-even trader. I always seemed to be on board markets that were about to blast off. But for whatever reasons, I always found a way to exit before the actual fireworks began. Then when the market did take off, I just sat there, unable to reestablish my position. Let me tell you, if you ever hope to succeed in the trading game, you better learn how to overcome this type of psychological trading defect.

Of all the patterns I trade, the least reliable is the 1 percent true selling day pattern. And it certainly gave a false signal on March 5. However, when it's wrong, I usually know within a day or two and get back in the market. As you will shortly see, when it's right, it more than makes up for its occasional false signals.

One comment about late-day reversals bears reiteration. They normally occur in the Dow and the S&P. Then on the follow-through day or days, technology usually leads the way. With that in mind, I usually look to buy into the technology sector on late-day reversals.

August 21, the Dow made a huge turnaround and closed down only 77 points. However, this did not come close to qualifying as a V-bottom or late-day reversal pattern. To have qualified, the Dow would have had to close up or just slightly in negative territory. I've seen too many of these quasi-reversal days when the Dow makes the big intraday comebacks but still closes firmly down.

Every Bull Market in history, and many good intermediate advances, have been launched with a buying stampede that included one or more 9-to-1 up days." More significant than a solitary 9-to-1 up-volume day are two such 9-to-1 days that occur within three months of each other.

As a trader, I enter markets based on expectations of momentum follow-through. When my expectations aren't met, I immediately exit—no waiting, hoping, or praying.

Always remember that the most bullish thing a market can do is rise on extreme momentum. Yet many people are fearful that this type of extreme strength is an invitation for a market correction. Historically, extreme strength only leads to additional strength. This is even more so if the momentum surge occurs after a period of declining prices such as the situation prior to October 8, 1998.

The most bullish thing the market can do is not collapse when everyone is expecting it to.

I know that regardless of how bearish I may be, the market is always right and tells it own story best. Always remember that traders react to the evolving market, they don't predict and they don't anticipate. What separates the good traders from the not-so-good is the quickness of their reaction time.

Regardless of the study, it simply doesn't pay to be shaken out by extremely weak days in the market. Extremely weak trading days invariably lead to strength, not weakness.

I exit my positions on the weakness that precedes the real debacle days. In other words, debacle days rarely come from out of the blue. There is usually a period of a few days or weeks that leads up to the climactic selling days. It's at that initial weakness where I exit my positions and go to cash.

As you have seen, I trade various momentum patterns. In trading these patterns, there are no ifs, ands, or buts. Either the market immediately responds in my favor or I exit my position. How much simpler can a money management strategy get? If I buy because of extreme strength on a Friday that doesn't follow through on Monday, I'm gone. If I buy because of a late-day V-bottom upside reversal or price surge and there is no carryover buying the following day, I'm gone. If I buy the Nasdaq 100 because of a day or two of extreme positive divergence and the divergence dissipates the next day, I'm gone. I always enter or exit a market based on particular expectations. When the market proves me wrong by not immediately confirming those expectations, I act accordingly.

My most basic money management precept is that wealth accumulation comes from maximizing your winning trades—meaning that the name of the game is to make the big money when you are right. I'm a very conservative trader who becomes very aggressive when I get on board a winner. My method of exploiting winning trades is to continually add to my position on a scale-up, as taught by Darvas and Livermore. I try to milk winning trades for as long as I can and for as much as I can. Some would call this a pyramiding strategy. Try this type of strategy with futures, options, or any leveraged trading vehicle and you can get your head handed to you on just the slightest price reaction.

READING LIST

Books 1 through 7 in the following list are my favorite books of all time and appear in their order of importance to me. I have not included the previously recommended books on mutual funds.

1. How I Made $2,000,000 in the Stock Market, by Nicholas Darvas (New York: Lyle Stuart,
1986). No surprise here, as I've mentioned this book throughout How I Trade for a Living. This is my favorite trading book for primarily sentimental reasons. I wouldn't expect others to feel as much of an impact as I did when I read an earlier edition in 1961. Traders are always asking me specific mechanical questions about the Darvas methodology. I tell them that the Darvas book, as with any of the books I recommend, should be read for its concepts and not for black-and-white trading rules.

2. Reminiscences of a Stock Operator, by Edwin Lefevre (New York: John Wiley & Sons, 1994).
This is my kind of book—all text and not a chart in sight. This is the kind of book that should be read annually. Livermore's insights on trading are just as valuable today as they were nearly 100 years ago. This goes to show you that successful trading is simply a matter of following the principles of cutting losses and adding to your winners as you let your profits run.

3. Dow 1000, by Benton Davis (Larchmont, NY: American Research Council, 1964). This is another one of those books that I like more for sentimental reasons than for actual content. Davis, like Nicholas Darvas and Jesse Livermore, stresses letting the market tell you what to do and not your opinions. Dow 1000 contains my favorite piece of trading advice: "THE STOCK MARKET IS ALWAYS RIGHT AND ALWAYS TELLS ITS OWN STORY BEST." The capital letters are just as they appeared in Davis's book.

4. The Education of a Speculator, by Victor Niederhoffer (New York: John Wiley & Sons, 1997).
While the books by Darvas, Lefevre, and Davis may be my three favorite books of all time,
Niederhoffer's book is the best I've read about trading. Admittedly, Niederhoffer's book reads like a doctoral thesis, but it is well worth the effort. This is the only trading book I reread immediately after my initial reading—it was that good.

5. Why the Best-Laid Investment Plans Usually Go Wrong, by Harry Browne (New York: William Morrow and Company, 1987). Part One, which encompasses the first 235 pages of the book, is a must-read. Ignore Part Two completely, since it's about an outdated investment strategy. I underlined more passages in Harry Browne's book than in any other. His first paragraph tells it all: "The best-kept secret in the investment world is this: Almost nothing turns out as expected. Forecasts rarely come true, trading systems never produce the results advertised for them, investment advisors with records of phenomenal success fail to deliver when your money is on the line, the best investment analysis is contradicted by reality."

6. Mind over Markets, by James F. Dalton, Eric T. Jones, and Robert B. Dalton (Chicago: Probus,
1993). This book is about a trading methodology called Market Profile. Although this methodology is much like mine, I've never completely grasped Market Profile. I recommend Mind over Markets not for the method it preaches, but for its presentation of what it takes to become a successful trader.

7. The Tao Jones Averages, by Bennett Goodspeed (New York: E.P. Dutton, 1983). If you are a
struggling analytical-type trader, then it is probably because you tend to resist change by making fixity out of flux. Or as Goodspeed likes to say, "trying to understand running water by catching it in a bucket."

8. Rogues to Riches, by Murray Teigh Bloom (New York: G. P. Putnam's Sons, 1971). This author went in search of investors and traders who had conquered the market because of some special insight or trading method.

9. If They're So Smart, How Come You're Not Rich?, by John L. Springer (Chicago: Henry Regney Company, 1971). Read this book and you will understand how at such a young age I came to mistrust anyone labeled as a market expert.

10. Why Most Investors Are Mostly Wrong Most of the Time, by William X. Scheinman (New
York: Weybright and Talley, 1970). Yet another book that takes an unconventional approach to
trading. Scheinman presents a methodology for measuring investor sentiment.

11. Wiped Out, by Anonymous Investor (New York: Simon & Schuster, 1966). How a typical
investor lost all his money because he thought there were experts who knew better.

12. A Fool and His Money, by John Rothchild (New York: Penguin Books, 1988). The odyssey of
an average investor as he searches far and wide for that one expert or guru who has all the answers.

The next five books are recommended for their research, indicators, and investing techniques.

13. Stocks for the Long Run, by Jeremy J. Siegel (New York: McGraw-Hill, 1998). I often use
Siegel's book as a reference when debating the perennial prophets of pessimism in the various
newsgroups.

14. Stock Market Logic, by Norman Fosback (Chicago: Dearborn Financial Publishing, 1995). If
ever updated, this investment classic would become an investment bible.

15. Winning on Wall Street, by Martin Zweig (New York: Warner Books, 1997). Zweig has
ingrained traders with the credo that you never fight the tape and never fight the Fed. After reading his book, you will understand why.

16. Stock Trader's Almanac, by Yale Hirsch (Old Tappan, NJ: The Hirsch Organization). This
reference book is updated annually and is the best source on historical seasonal trading patterns.

17. 101 Years on Wall Street, by John Dennis Brown (Englewood Cliffs, NJ: Prentice Hall, 1991).
This is my favorite reference book on the market. It covers 101 years (1890 to 1990) of market
history. It's complete with charts and statistical information, and compares all the bull and bear
markets.

18. Market Wizards (New York: Harper & Row, 1990) and The New Market Wizards (New
York: Harper Business, 1992), by Jack Schwager. There have been many books about trading
masters and mavens and what makes them tick, but Jack's interviews with the market wizards are by far the best. Beware, though: Some of these market wizards have lost their touch and have become promotional wizards, peddling systems, seminars, and fax services.

19. The Trader's Edge, by Grant Noble (Chicago: Probus, 1995). How can I not like a book in
which the author gives me three paragraphs of exposure? Yet another book that takes an
unconventional view of the trading game.

20. Winner Take All, by William R. Gallacher (Chicago: Probus, 1994). Ditto #19 about being an
unconventional trading book.

21. Trading for a Living, by Alexander Elder (New York: John Wiley & Sons, 1993). As a rule, I
dislike trading books that present a hodgepodge of trading methods. I much prefer books about one trading method and how the author made it work for him or her. But Elder's book is the exception to my rule. The first 68 pages, about the psychology of trading, are what set this book apart. This book is especially recommended for futures traders.

22. Pit Bull, by Martin Schwartz (New York: HarperBusiness, 1998). I have a thing about trading
books by real traders—and Marty Schwartz is definitely a real trader. You'll see that he is also a big believer in synthesizing indicators.