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fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 The ARTRof Trading Combining the Science of Technical Analysis with the Art of Reality-Based Trading BENNETT A. McDOWELL John Wiley & Sons, Inc. i fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 iv fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 The ARTRof Trading Combining the Science of Technical Analysis with the Art of Reality-Based Trading BENNETT A. McDOWELL John Wiley & Sons, Inc. i fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Copyright C 2008 by Bennett A. McDowell. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or oth- erwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748- 6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies con- tained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our Web site at www.wiley.com. Designations used by companies to distinguish their products are often claimed as trademarks. In all instances where John Wiley & Sons, Inc. is aware of a claim, the product names appear in initial capital or all capital letters. Readers, however, should contact the appropriate companies for more complete information regarding trademarks and registration. Library of Congress Cataloging-in-Publication Data: McDowell, Bennett, 1957– The art of trading: combining the science of technical analysis with the art of reality based trading / Bennett McDowell. p. cm. – (Wiley trading series) Includes index. ISBN 978-0-470-18772-2 (cloth/dvd) 1. Investment analysis. 2. Speculation. 3. Stocks. I. Title. HG4529.M385 2008 332.63′2042–dc22 2007049357 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 ii Disclaimer: This eBook does not include ancillary media that was packaged with the printed version of the book. fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 For my children, Heather Frances and Brady Bennett, with love and affection. iii fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 iv fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Contents Foreword ix Preface xi Acknowledgments xiii Diclaimer xv Introduction xvii PART I Reality 1 CHAPTER 1 It’s All About Reality 3 CHAPTER 2 The Reality of Price and Volume 7 CHAPTER 3 Managing Risk: Always Set a Stop-Loss Exit 13 CHAPTER 4 If It Sounds Too Good to Be True . . . 19 CHAPTER 5 Personal Methods to Increase Trading Success 23 CHAPTER 6 Identify Your Personal ART Profile 27 PART II Art 39 CHAPTER 7 Design Your Business Plan 41 CHAPTER 8 Selecting a Financial Market 47 v fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 vi CONTENTS CHAPTER 9 Selecting a Time Frame 55 CHAPTER 10 Selecting an ART Platform, Broker, and Data Feed 59 CHAPTER 11 Psychology and the Trader’s Mind-Set 63 CHAPTER 12 Artistic Simplicity 67 CHAPTER 13 The Art of Paper-Trading 71 PART III Science and Math 75 CHAPTER 14 Calculating Proper Trade Size 77 CHAPTER 15 Other Formulas and Recipes 83 CHAPTER 16 The Human Brain 87 PART IV ART System Basics 91 CHAPTER 17 ART Is the Total Solution 93 CHAPTER 18 Pyramid Trading Points (P and MP) 97 CHAPTER 19 Market Truths: Price Bars and Volume 115 CHAPTER 20 ART Reversal Bar Signals (1B and 2B) 121 CHAPTER 21 Trend-Trading Rules 135 CHAPTER 22 Countertrend-Trading Rules 141 CHAPTER 23 Scalping Rules 147 PART V Advanced Techniques 155 CHAPTER 24 When to Use Advanced Techniques 157 CHAPTER 25 Scaling Out and Scaling In 161 fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Contents vii CHAPTER 26 How to Trade Bracketed Markets 167 CHAPTER 27 Software Optimization and Average True Range (ATR) 179 CHAPTER 28 Stop and Reverse (SAR) 183 CHAPTER 29 Higher-Time-Frame Filter 187 CHAPTER 30 Other Filter Techniques 205 CHAPTER 31 Elliott Wave—Ungrounded Assessment 215 CHAPTER 32 Other Ungrounded Assessments 223 Epilogue 231 About the DVD 233 APPENDIX A ART Software Quick-Start 237 APPENDIX B ART Tips 241 APPENDIX C ART Software Technical Support 243 APPENDIX D Resources 247 Glossary 263 About the Author 285 Index 287 fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 viii fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Foreword T his is not your ordinary “get rich quick” book about trading the stockmarket. Rather, it is a guide to a multimedia approach to learningand trading, using the Applied Reality Trading R (ART R) method of trading. This book and the accompanying DVD explain the concepts and methodology. In addition, the purchase of this book includes a one-month time frame in which to actually learn to trade the system and apply it in real time. This is done by including the ART software for one month, including access to live streaming data and access to a few, designated brokerage firms that can trade directly through the software. In essence, everything that the reader needs—for learning and for seeing how the system works in actual markets—is included with this book. The ART trading methodology is built on software recognition of sev- eral time-tested patterns that can be easily identified for the user. While they are called specific names in the software, these are essentially break- outs and reversals—the meat and potatoes of technical trading. The chart patterns identified can be applied to any type of bar chart—daily, five- minute, weekly, and so on. Moreover, they can be applied to stocks, fu- tures, indices, and forex—or any other market that can be charted. What separates this methodology from many other computer- generated trading systems is that this is not a 100 percent mechanical “black box” system. Rather, this book (and the multimedia associated with it) teach the individual how to apply the various trading signals to the style of trading with which he feels most comfortable. Position traders can trade the trend signals from the software, while short-term swing traders may prefer to take minor signals generated along the way—even tradingwithin a trend, if desired. If you are uncertain which trading style might best suit you, the “ART Profile” exercise in this book will aid you in determining the style best suited to your personality. Risk control is stressed throughout—determining effective position size, setting stop-loss exits, and more. Exact entry and exit points are given with the signals, so that you can judge your risk beforehand, and therefore determine position size as well. One of the many unique features is that ix fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 x FOREWORD stops are based on market conditions (chart patterns and volatility) as op- posed to an arbitrary dollar amount. Therefore, the stops are more logical in terms of market mechanics, which prevents one from being stopped out prematurely, as might happen with “percentage risk” stops. Finally, the techniques can be applied to option trading as well. I have long espoused the idea that any successful stock trading technique can be translated into a profitable option trading strategy, as long as one acts ra- tionally in choosing the expiration month and striking price of the options to be purchased. This multimedia approach to learning may be new tomany readers, but the concepts and techniques associated with the ART software are well- suited to such an approach, and the benefits should be great for those who are willing to embrace the ART methodology and fit it into their “trading personality.” —LAWRENCE G. MCMILLAN Author, McMillan on Options, 2nd Edition fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Preface T his book, The ART R of Trading, is a unique opportunity for you, the trader or investor, to benefit from four fabulous things: 1. A sound trading system and software (Applied Reality Trading or ART) that gives you high probability entries, exits, and risk control—you get a free 30-day trial of the ART software with this book 2. Live streaming data direct from the markets to provide you with the truth and the reality of the financial markets—you get a free 30-day trial of live data with this book 3. The education on how to use the first fabulous two to generate profits 4. Superb brokerage services to execute your trades and investments once you have mastered the ART system Best of all, you get this right here in just one book. This means that for the price of one book, you will be able to experience the reality of technical analysis software and data to generate greater profits. You’ll see firsthand how technical analysis can enhance your fundamental analysis. Or, if you do not use fundamentals, you will see how ART can be used as a stand- alone decision maker for your trading and investing. Maybe you are currently making entry and exit decisions by looking at fundamental information that you can gather from news, corporate earn- ings, Fed statistics, or any other multitude of reports that are available to you on CNBC and in the Wall Street Journal. The reality is that those reports can be subject to distortion (a corpo- ration carefully manages how the numbers are revealed so as to look their best); exaggeration (it’s a slow news day and a commentator may need to enhance a story to make it newsworthy); and, of course, interpretation (a trader interprets a poor earnings report and panics out of a position to find out that the stock goes up, and up and up). How do we determine what is reality? How do we know when something is exaggerated or distorted? How do we make sense of the xi fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 xii PREFACE information and the world around us to determine how to make profitable financial decisions? That is where “reality-based” trading and investing come in. ART, Applied Reality Trading, can help you decipher the informa- tion that you receive from the market so that you can clearly understand it and act on it intelligently. This does not mean that you will be following someone else’s reality. Instead, you will be creating your own reality and personal financial ap- proach that works for you and makes you profits. Think about Columbus setting off to sail into the distance in 1492, when everyone else thought that the world was flat. That didn’t stop Christopher; he had his own reality, and he followed it and succeeded. Despite the naysayers, he was courageous enough to try a new approach—which is what you will be doing. You will be an explorer and you will discover your reality, and you will use that as your edge in the financial markets. The gift that ART and technical analysis can also give to you is clarity. You can include the ART trading software in your approach to confirm, or deny, an entry or exit. ART gives you the reality because it is based on the truths of the market—price and volume—and these cannot be distorted. My personal approach happens to be purely technical analysis using the ART software, but many of my students do combine fundamentals with ART. You will decide what is right for you, and this book is designed to bring you up to speed in trading with ART R and technical analysis. If you have never used technical analysis and charts to make better entry and exit choices, there is no time like the present! This book, The ART of Trading, gives you everything you need to get started. Enjoy the benefits of “reality-based” trading and technical analysis. I wish you all the best in everything that you do! BENNETT MCDOWELL San Diego, California January 2008 fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Acknowledgments T hank you to David Pugh at John Wiley & Sons for discovering us inNew York City in February 2007. David, you are a master of the artof publishing, and without you this book would not be possible. Your gift of knowing how to bring the pages together to make them the best they could be is greatly appreciated. And, thanks to Stacey Small (David’s right-hand assistant) for her patience, kindness, and many hours of expert templating. Also thank you to Larry McMillan, a friend and brilliant trader, for writing the Foreword. TradeStation was one of the first two compatible platforms that the ART software was available on when released in 2003. A huge thank you to Janette Perez for her support of The ART R of Trading and for letting her TradeStation clients know about the value of using the TradeStation platform with the ART software and system. Also, thanks to Ray Fitzgerald at eSignal data services (also one of the first two platforms available for ART) for giving our clients that personal service they have come to appre- ciate over the years. Also, I’d like to send a warmhearted thank you to Peter Smith at TD AmeriTrade. The newest ART platform available as of today is Quote- Tracker (which makes ART compatible with TD AmeriTrade), and, Peter, you made that into a reality. Your persistence and creativity are an inspira- tion. Another new platform is NinjaTrader, which has expanded our com- patibility tremendously, and thanks to Raymond Deux for making that a smooth integration. So many folks have helped us along the way, and I’d like to send a spe- cial thank you out to: Ed Schramm and Yves Pittleoud. Your friendship and support have made the journey a fun and rewarding one. And, of course, thanks to our many wonderful clients who have helped to shape the edu- cational content we’ve developed since 1998. Last, but most certainly not least, thanks to the women in my life. To my mother, Frances McDowell: Thank you for your encouragement, xiii fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 xiv ACKNOWLEDGMENTS support, and love every step of the way—and also for being so nice. And to my wife, Jean McDowell, for your love, for taking care of the kids, and for being my best friend and a great partner all in one. My deepest thanks go to all of you for making my journey a fun and exciting one! fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Disclaimer T he information in The ART R of Trading is intended for educational purposes only. Traders and investors are strongly advised to do their own research and testing to determine the validity of any trading idea or system. Trading in the financial markets involves substantial risk and TradersCoach.com, Bennett A. McDowell, or affiliates assume no respon- sibility for your success or failure in trading or investing in the markets. For this reason you should only use money you can afford to risk. Fur- thermore, past performance does not guarantee future results. Thus, even if you were successful with your trading and investing in the past, you may not be successful in the future. TradersCoach.com and Bennett A. McDowell make no performance representation or guarantee of any kind or nature. TradersCoach.com encourages you to conduct your own re- search and engage in numerous practice trades prior to risking any actual money. Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since trades have not actually been exe- cuted, results may have under- or overcompensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading pro- grams and ideas in general are also subject to the fact that they are de- signed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed. xv fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 xvi fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 Introduction O ne of the benefits of purchasing this book is that you will be ableto experience firsthand the value of trading with the Applied RealityTrading software free by using your 30-day trial that is included with the book. This is a unique opportunity for you to get in the driver’s seat and test drive the software on the markets and time frames you like to trade. Plus, the software is ideal for any market and any time frame, which means whether you are an investor, day trader, or position trader, Applied Reality Trading will give you exact entries and exits into the market and will take the guess work out of your finances. This introduction outlines briefly how the book is laid out and what the companion DVD video pro- gram will do to help you with your trading and investing. APPLIED REALITY TRADING IS KNOWN AS ART The ART R of Trading will introduce you to a new way of trading and in- vesting with a technical analysis system called Applied Reality Trading. Also known as ART, this system is a comprehensive trading methodology including software that labels the ART signals on financial charts so that you can easily see exact trade entries and exits. In addition, the software has voice technology that alerts you when to enter trades and exit trades. The ART software is easy to use, and it processes complex algorithms and market information to give you high-probability trades and investment information. ART answers the questions of when to buy and when to sell. ART also answers the question of how to protect yourself from large losses by using effective risk control and money management. While ART adds structure to your trading and investing, it also allows you the flexibility to tailor it to your personal style and experience level. You can use ART to trend trade, scalp, or countertrend trade. Or you can use the system to time your investments. ART is capable of doing all this since it is not a “black box” (100 percent mechanical) trading system. xvii fm JWBK099-McDowell February 20, 2008 12:49 Char Count= 0 xviii INTRODUCTION The flexibility built into Applied Reality Trading allows you to integrate your financial beliefs with ART to create your own unique system that al- lows you to be a true artist in the financial markets. That is when you can become a master of the “Art of Trading.” REVOLUTIONARY LEARNING EXPERIENCE You

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