WIXLIB

IntroductionxiiiSTRUCTURE OF THE BOOKThis book is divided into three main parts. Chapters 1 through 3 coverthe basic concepts of the market as well as the tools of the trading gamethat you must be familiar with to level the playing field with seasonedprofessionals. You will learn about Market Makers, online teachingforums, and order-routing methods. You may or may not want to participate in online chat rooms, but they have unquestionably become amajor force in the market and can dramatically impact the movement ofcertain stocks. Without understanding these forces, you are playing withone eye closed to the reasons behind those moves. Finally, the advancedtools of an active trader will be discussed.The next section, Chapters 4 through 8, is an in-depth look atmomentum, its root causes, and key factors in identifying who the market players are behind it. By understanding who is responsible for themomentum and the psychology behind the forces that push and pull onthe market, you will then be able to spot predictable momentum patterns.This section explores several niche patterns that tend to repeat themselvesover and over again in certain market conditions. You will also learn tospot certain stocks, called indicator stocks, that tend to lead the movementof the general market and give you an edge on what the market is aboutto do. It will also give you specific methods of assigning a mathematicalscore to each of the major causes of market momentum, creating a matrixthat enables you to determine how certain patterns will react under thesedifferent market conditions.Chapters 9 through 14 examine specific methods, rules, and mindsets that are an absolute necessity for every successful and profitabletrader. It explores how the time of day you trade is just as important ashow you trade and how to create the proper mindset to ensure you donot fall for the most common pitfalls that take most traders out of thegame. The section titled “The Golden Rules of Trading” spells out clearcut rules that I have spent years developing. If you read nothing else, readthese rules.The book concludes with a discussion on what I call momentuminvesting, a unique form of trading that takes the best of two distinctlydifferent forms of trading: momentum trading and investing. No matterwhat your form of trading is, this section will enable you to capture theexplosive gains of momentum trading while participating in the slower,longer-term trades of investing.

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1CHAPTERTHE BASICSThis chapter will discuss the genesis of the stock market and provide youwith a quick background of the different exchanges and the players whocontrol it. Without this understanding of who controls the trades andtheir motivation behind the scenes, traders cannot fully participate in themarket with open eyes. An in-depth discussion in Chapter 3, “Tools ofthe Trade,” will explore the different brokerage and execution servicesavailable. The last topic covered will be the type of equipment requiredto participate in the new electronic trading world.THE START OF IT ALLWhen individuals asked how the market was doing many years ago, theywere referring to the Dow Jones Industrial Average. The Dow JonesIndustrial Average, or Dow, is a basket of 30 stocks that is perceived asindicative of the stock market as a whole and its relative strength orweakness. The index includes stocks such as Alcoa (AA), Boeing (BA),Caterpillar (CAT), General Electric (GE), and Walt Disney (DIS).The Dow Jones Industrial Average was introduced by Charles H.Dow in May of 1896 and at first was not widely followed. Charles Dowbegan with 11 stocks to try to apply a visualization of the market shortterm trends. It was a very simplistic approach and one that we may scoffat in current times. However, it was a key building block to how we viewthe markets today. In 1916, the index was expanded to 20 stocks and thenin 1928, to 30 stocks. Periodically, stocks are removed and replaced withnew ones, but they are all leaders in their industry and are widely held.Later in 1929 came the Utilities and the railroad average was renamedTransports in 1970.Copyright 2002 by Mtrader.com.Click here for Terms of Use.1

2Trading on MomentumWith the advent of the Internet age, the Dow has seen some changesin its lineup. In the latter part of 1999, Intel Corporation (INTC) andMicrosoft Corporation (MSFT) ousted Union Carbide (UK) and Chevron(CHV) and were the first two Nasdaq-related issues to be included in theAverage. Many new indices are available now such as the Russell 2000,Nasdaq, Wilshire 5000 Total Market, AMEX, and Standard & Poor’s 500.Basically, each analyst follows a different spectrum of the market andeach of these indices represents a more specific set of sectors or stocksthat are included. For example, the Russell is a measure of small caps,whereas the Wilshire is representative of the entire marketplace.With the explosion of online trading in the past decade, many market participants are now keeping a close eye on the Nasdaq and the S&P500. The Wilshire 5000 has also been watched as a close indicator as it issuggested to be representative of the whole market. Today, when someone asks how the market is doing, we need to clarify which one as eachone tends to have a life of its own. One day the Dow may be up 120 pointsand the Nasdaq down 150 as each has its own character and differenttypes of stocks it represents.These indices are all made up of stocks that are traded on exchanges.Several exchanges are available, but the two most notable are the NewYork Stock Exchange (NYSE) and the National Association of SecuritiesDealers Automated Quotation (Nasdaq). The NYSE registered with the U.S.Securities and Exchange Commission in October of 1934 as a nationalsecurities exchange. In 1971, the Exchange was incorporated as a not-forprofit corporation.The NYSE is an open auction system located in a 36,000-square-footfacility. Institutions and retail investors are represented by Exchangemembers in which they call out bids and offers for stock in specific locations on the physical trading floor. The laws of supply and demand govern the price for stocks in this Exchange. The NYSE uses a marketspecialist whose job is to keep a fair and orderly market in the issues thathe or she has control over.Orders to buy and sell are sent directly to the specialist either electronically or from the agent representing institutions and retail investors.The benefit to having all order flow to a single specialist is the presenceof liquidity. This ensures that prices do not fluctuate in a less thanorderly fashion. This is intended to provide the individual with openaccess to several potential buyers and sellers to get the best price that youcan for your transaction. In contrast to the specialist system, the Nasdaqmarketplace uses a totally different system.

CHAPTER 1The Basics3The Nasdaq opened to the world on February 8, 1971, in responseto Congress asking the Securities and Exchange Commission to conducta study of all securities markets in the late 1960s. The SEC, after findingthe Over-The-Counter (OTC) securities markets unknown and fragmentary, offered automation as a solution. This challenge was set forth to theNational Association of Securities Dealers, Inc. (NASD) for implementing theprogram.Throughout the mid-1970s and 1980s, several key enhancementswere made to the Nasdaq system. Inside quotations were displayed thatoffered the best Bid and Ask prices visually. This narrowed the spread(difference between the Bid and the Ask) in the majority of the 2,500Nasdaq stocks at that time. The Small Order Execution System (SOES) wasintroduced to automatically execute small orders against the insideprices. Finally, in 1997, the SEC approved the Nasdaq’s request to beginquoting stock in spreads as narrow as 1 16 to produce better prices.Whereas the NYSE is an actual trading floor, the Nasdaq is a huge computer network that has fueled the trading frenzy that has emerged overthe past 10 years.MARKET MAKERSIn the Nasdaq marketplace, instead of specialists providing liquidity andorderly pricing, Market Makers assume this role. Market Makers areindependent dealers that actively participate for order flow. They displayquotations that are indicative of their willingness to buy and sell at certain price levels. Over 500 market-making firms provide the needed liquidity in the Nasdaq marketplace.This liquidity provides investors with supply and demand toenhance an immediate and incessant trading atmosphere. Market Makersparticipating in this type of trading are required to follow basic rules setforth by the SEC. They must provide a reasonable two-sided market inthe issues that they make a market. They do this by disclosing their buyand sell quotations. They must honor their quoted prices against liability orders and report the trading in a timely manner per regulations. Theymust also display both quotes and orders according to the regulations inthe Order Handling Rules developed by the SEC.Basically, four types of market-making firms are available. They areretail, wholesale, regional, and institutional. Retail firms employ a retailbrokerage network that caters to individual investors. They tend to facilitate order flow for their clients to provide liquidity for the price of the

4Trading on Momentumstock to ensure stability. Wholesale firms exist to trade shares for institutional clients. They also act as an agent for broker-dealers that are notregistered Market Makers in a particular issue but need to fill an orderin that stock for their own clients. Wholesale firms tend to be an important facilitator for the other three types of firms.The institutional firm provides service to pension funds, mutualfunds, insurance companies, and other types of money management entities that want to execute large block orders. The regional firm tends tofocus on only companies and investors in a certain region of the country. This allows them to provide more in-depth analysis of companies inthat area for their clients.Since 1971, the Nasdaq market has split into separate markets. TheNasdaq is now made up of the Nasdaq National Market, The NasdaqSmallCap Market, and the OTCBB (OTC Bulletin Board). The NationalMarket lists over 4,400 companies. This National Market contains issuessuch as Microsoft (MSFT), Dell Computers (DELL), Intell (INTC), Cisco(CSCO), and other large and widely known companies of the world. TheSmallCap Market has about 1,800 securities. The less established companies are usually found in this market until they can meet the more rigidrequirements of the National Market. The OTCBB lists a group of stocksthat tends to be issues that traders stay away from, as their future isuncertain at best.ELECTRONIC COMMUNICATIONS NETWORKSIn the Nasdaq Stock Market, we have two groups of market participants.The first group we talked about already, the Market Makers. Theyprovide the liquidity necessary to keep stock prices stable and orderly.The alternate group is made up of Electronic Communications Networks(ECNs). An ECN is a private trading system and is a relatively newaddition to the Nasdaq marketplace. ECNs simply match buy orders tosell orders. If the order cannot be matched, the order is placed to therespective ECN order book until such a match can be made. In 1997,when the SEC order handling rules were implemented, ECNs wereincorporated into the structure. ECNs are required to register with theNasdaq and are required to follow NASD Regulation to participate inthe marketplace. ECNs are basically order books that match orders atspecific price levels. There is no human intervention with ECNs. If theorder on the book is matched, it’s executed, sometimes with priceimprovements.

CHAPTER 1The Basics5At the time of this book, nine ECNs are currently registered. Theyare Archipelago L.L.C. (ARCA), Attain (ATTN), B-Trade Services L.L.C.(BTRD), The BRASS Utility (BRUT), Instinet Corporation (INCA), Island(ISLD), NexTrade (NTRD), Spear, Leeds & Kellogg (REDI), and StrikeTechnologies (STRK). ECNs became more prevalent as the online trading explosion occurred. Institutions and Market Makers use ECNs to provide themselves with anonymity when entering orders for stocks at pricelevels. One of the advantages of ECNs is that active individual traderscan utilize ECNs to bypass Market Makers in the attempt to get a betterprice when Market Makers are not present at inside price levels.ECN orders are routed in a way that they are first matched againsta pending order. If the order is unable to be matched immediately, it isposted to an order book on the quote screen until either the individualcancels the order or a matching order executes against it. The primarychoice of active traders in the past few years has been the ISLD ECN. Theamazing amount of volume that ISLD constitutes on a daily basis hasprompted some desires to have ISLD become its own exchange. Whatstarted out as a quotation-driven market has evolved into a quotationand order-driven marketplace for investors and active traders.In the NYSE, stock symbols are comprised of one, two, or three letters. For example, Agilent Technologies has the symbol A. Boeing Co. hasthe stock symbol BA. Caterpillar Incorporated has the stock symbol CAT.In the Nasdaq, symbols are either four or five letters. For example,Microsoft Corporation has a stock symbol MSFT. Nasdaq stocks thathave a fifth letter usually have a meaning associated with that fifthletter. You can find what these definition symbols mean at efinitions2.stm#nasdaq issues. An example would be on a stock like IRIDQ. IRID isthe symbol for Iridium and the Q is defined as a company in bankruptcyproceedings. These fifth letters are especially important to traders as youwant to avoid stocks with uncertain futures. Those that are delinquentwith their filings or in bankruptcy are stocks that have clouded futuresat best and are not worth our time.We spend a lot of time talking about the different exchanges, butmomentum traders primarily concentrate on stocks traded on theNasdaq. These stocks tend to be more technology oriented, and by usingthe Market Makers and ECNs, they produce more intra-day momentum.Momentum traders do trade stocks on the other exchanges, but they tendto be larger and more stable, which leads to less volatility and momentum. Momentum traders do not care whether or not a stock is moving

6Trading on Momentumup or down; all that is required is movement and momentum and as suchwe concentrate mostly on Nasdaq stocks.THE ESSENTIALSTraders often ask about hardware, software, and data requirementswhen they are setting up shop in their homes or offices to begin trading.With the introduction of online trading through brokers such asE*TRADE and Ameritrade, the Internet has placed the power of information dissemination at the trader’s fingertips. This not only empowersthe individual to make his or her own trading decisions, it allows usaccess to applying our decisions to market participation in real time.The explosion of online trading is a by-product of the increased efficiencyin data distribution and the personal desire for self-directed decisionimplementation.Many brokers are offering lower commissions and complete datapackages to pull traditional investors and active traders away fromhigh-priced brokers. Many commission rates are under 20 per trade anddepending on the level of activity or size of one’s portfolio, the data package is free. What was once available to us only through our broker is nowavailable to us with a few clicks of the mouse. At face value, we are ona more level playing field. Obviously, the public is still the last to knowin some areas, but we certainly have more access to more informationthan ever before.We are in a stage of technological advancement when hardware thatis bought today is obsolete within a year. Processing speeds are faster andmore user-friendly functions are enhanced. One year ago, 5 gigabytes ofhard-drive space was more than enough to store most of our applications.Sixteen megabytes of RAM was enough memory to allow our computerto function efficiently.The first component that one must have is at least one computer.The computer that you choose should include at least a 500-megahertzprocessor. It should also include at least 128 megabytes of RAM as youwill be pulling a lot of data down into your computer and it needs to beprocessed and displayed as fast as possible.The monitor that comes with your computer should be at least 17inches. Advanced traders often find themselves with limited screenspace and would gladly pay for a larger screen. With recent deals andrebates through some of the larger computer stores, a brand name computer can be bought for as little as 500.

The Basics7AMFLYMany advanced traders like to have at least two computers ormonitors when watching stocks throughout the day. Some have electedto network their systems to provide more efficiency through their datafeeds. Although this may seem like something that is beneficial, beginning traders should start small and build as they progress. There is noreason to go out and buy two or three computers and monitors if, in sixmonths, you decide trading is not going to work for you. It’s best to keepyour capital for trading and as you begin to profit over time, expand yoursystems with your portfolios.The most important component a trader needs is a fast connectionto the Internet. Traders have often joked about using carrier pigeons tosend in their orders because their connection to the Inte

A momentum trader doesn’t care what a stock will do next month, next week, or even in the next hour, only how it is currently reacting. By trading only what the tape is currently showing, it removes the guess-work of what will happen in the future. Momentum trading is unique in that it take