Definitions of Upward and Downward Trend From Dow Theory

Upward Trend — An upward trend is a series of successive rallies that penetrate previous high points, interrupted by sell-offs or declines which terminate above the low points of the preceding sell-off. In other words, an uptrend is a price movement consisting of a series of higher highs and higher lows.

Downward Trend — A downward trend is a series of successive declines which penetrate previous low points, interrupted by rallies or increases which terminate below the high points of the preceding rally. In other words, a downtrend is a price movement consisting of a series of lower lows and lower highs.

Investment Philosophy

1. Don’t speculate unless you can make it a full-time job. 
2. Beware of barbers, beauticians, waiters — of anyone — bringing gifts of “inside” information or “tips.” 
3. Before you buy a security, find out everything you can about the company, its management and competitors, Its earnings and possibilities for growth. 
4. Don’t try to buy at the bottom and sell at the top. This can’t be done — except by liars. 
5. Learn how to take your losses quickly and cleanly. Don’t expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible. 
6. Don’t buy too many different securities. Better have only a few investments which can be watched. 
7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects. 
8. Study your tax position to know when you can sell to greatest advantage. 
9. Always keep a good part of your capital in a cash reserve. Never invest all your funds. 
10. Don’t try to be a jack of all investments. Stick to the field you know best. 

Capitulation on the Downside

Capitulation on the downside is a capitulation of the longs who bought stock, only to find that instead of going up, the stock is going down. They buy more as the price drops with the intention of averaging down, but this action only digs them deeper into the hole.

As the stock starts to bottom, the capitulation occurs and traders who are long panic and sell. They feel it is the end of the world and that the stock is going to zero. They want out at any cost. They can’t tolerate the discomfort and race to get out of losing positions. This massive sell-off kills the price of the stock, but at this point the traders no longer care about the price. At the low, a big buyer usually appears and takes out all these panicky sellers of stock. Which pushes the stock price up again. At the bottom, as sellers get out of their positions and eventually disappear, the selling dissipates, and the stock has nowhere to go but up.

Learn How To Execute a Trading System Flawlessly

The proper execution of your trades is one of the most fundamental components of becoming a successful trader and probably the most difficult to learn. It is certainly much easier to identify something in the market that represents an opportunity than it is to act upon it. However, there are some good reasons why it is so difficult to act on a trading signal other than what has already been identified as mental obstacles. To understand these reasons, you need to understand the nature of trading systems (defined as any methodology that consistently identifies an opportunity to buy or sell with a potential profit in some future moment), and how they interact with the markets and ourselves.

Most good trading systems, technical or otherwise, will take consistent money out of the markets over the long run. Many of these good systems have been available to the public for years. And yet, there is still a huge gap between what is possible and what almost everyone ends up with. The problem with trading systems is they define market behavior in limited ways when the market can behave in an infinite combination of ways. Systems mathematically or mechanically reduce relationships in human behavior characteristics to percentage odds of what could happen next. They can only capture a very limited number of these behavior characteristics compared to the billions that are possible. Any identified pattern may or may not be repeating itself with respect to the way the pattern or relationship progressed when it was observed in the past. Therefore, we never really know if it is valid or not until it has actually completed itself. The big psychological problem here is that people have difficulty acting on opportunities with probable outcomes.

Most people like to think of themselves as risk takers, but what they really want is a guaranteed outcome with some momentary suspense to make them feel as if the outcome had been in doubt. The momentary suspense adds the thrill factor necessary to keep our lives from getting too boring. When it comes right down to it, no one trades to lose, no one puts on a trade believing it is going to be a loser, and all systems will definitely have some percentage of losing trades. So it’s difficult not to be tempted into trying to guess which ones are going to be the losers and not participate.

As most of you already know, trying to outguess your trading system is an exercise in extreme frustration. Sometimes the system will give you signals to trade in ways that are completely contrary to your logic and reasoning. Sometimes the system will defy your reasoning and be right, and sometimes you will agree with the system and it will be wrong. You need to understand that technical trading systems are not designed to be outguessed. What I mean is, they aren’t designed to give you isolated signals of an opportunity to be taken when it seems right. What they do is mathematically define, quantify, and categorize past relationships in collective human behavior to give you a statistically probable outcome of the future.

Efficient Markets Theory

The stock market is a collection of individual human beings, and human beings are fallible. With almost every stock trade, one person is right and another is wrong. While the averages do in fact represent the net effect, or “collective wisdom” of market participants’ judgments about the future, history shows time and again that millions of people can be as wrong as one, and the stock market is no exception. The nature of the market simply allows participants to adjust and correct their errors rapidly. Any method of analysis that claims the markets are infallible is flawed at its roots.

The theory of “efficient markets” is a case in point. The main premise is that with the advent of computers, information is disseminated so fast and efficiently that it is impossible to “beat the market.” This is nothing more than an extrapolation into absurdity of Dow Theory’s tenet that “the averages discount everything.” It is also ridiculous. The idea that everyone receives all significant information simultaneously is absurd because everyone doesn’t agree on what is “significant.” Even if everyone did receive exactly the same information simultaneously, they would respond to it according to their own particular circumstances and preferences. If everyone knew exactly the same things and responded the same way, then there would be no market! You must always remember that markets exist to facilitate exchange, and exchange is the result of differences in value preferences and differences in judgments.

A Business Philosophy for Consistent Success

Translated into more businesslike terms, I base my business philosophy on three principles, listed here in order of importance: preservation of capital, consistent profitability, and the pursuit of superior returns.

These principals are basic in the sense that they underlie and guide all of my market decisions. Each principle carries a different weight in my speculative strategy, and they evolve from one to the other. That is preservation of capital leads to consistent profits, which makes pursuit of superior returns possible.

Becoming an Expert at Just One Market Behavior

Because there is so much information and because so much of that information is conflicting, the beginning trader will need specifically to limit his awareness of the market information to which he allows himself to be exposed. More is not better; it just creates confusion and overload that will ultimately lead to losses.

You need to start as small as possible and then gradually allow yourself to grow into greater and greater amounts of market information. What you want to do is become an expert at just one particular type of behavior pattern that repeats itself with some degree of frequency. To become an expert, choose one simple trading system that identifies a pattern, preferably one that is mechanical, instead of mathematical, so that you will be working with a visual representation of market behavior. Your objective is to understand completely every aspect of the system — all the relationships between the components — and its potential to produce profitable trades. In the meantime, it is important to avoid another possibilities and information.

Out of all the combinations of behavior possible, you are going to limit your focus of attention to just one combination. Consequently, you will be letting all the other opportunities go by. Starting small and gradually working into other combinations is a real exercise in discipline that has a couple of important psychological benefits. First, you will be building a base of confidence as you learn that you can, in fact, accurately assess what will most likely happen next. It is much easier to gain this confidence if you don’t overwhelm yourself with the market’s seemingly infinite possibilities. Second, by passing up other opportunities that you are not an expert at yet, you will be releasing yourself from any compelling desire to trade. Any compelling behavior is usually the result of some fear. That fear, in turn, will cause you to behave in many inappropriate ways.

If the idea of letting go of opportunities that don’t fit into your framework is troubling to you, then ask yourself, what is the rush? If you are confident in your ability to transform yourself into a successful trader, what difference could it make that you let go of some opportunities now for educational purposes? Once you learn to become the trader you want to be, you can then give yourself as much money as you desire. However, to get to that point, your objective should be to plan your development in such a way that you do the least amount of damage to yourself, both financially and psychologically. Then after you have developed the appropriate skills, taking money out of the markets can be as easy as almost everyone believes it is before he started trading.

Attribution and Bias Among Traders

Much of how we process the world consists of attributions: qualities that we attribute to ourselves and explanations that we attribute to events. As human beings, we are driven to make sense of our world, and attributions are an important element of that sense-making.

One of the most basic attributions traders make is to their gains or losses. Are profits and drawdowns attributable to the self; the result of positive or negative actions that we take? Alternatively, do we attribute gains and losses to outside forces or to sheer chance? How we attribute the outcomes of our trading performances will necessarily play a large role in what we do about those performances. If, for instance, we tend to attribute gains to the self, but losses to bad luck, we might stick with faulty trade ideas, exacerbating initial losses.

Traders with a self-serving bias tend to give themselves too much credit when trades go their way and rationalize situations that lose money. As a result, they are likely to become overconfident after a string of winning trades, raise their trading size/frequency, and place themselves at risk.

Reason dictates that there is a difference between a good trade (one placed with an edge in one's favor) and a winning trade (one that makes money), just as there is a difference between a bad trade (one that lacks an objective, positive set of expectations) and a trade that loses money. Sheer chance alone can create situations in which good trades lose money and bad ones happen to get lucky. The self-serving trader who overemphasizes the role of chance in losses creates a situation in which learning from experience becomes impossible.

But there is another kind of trader - one with an overinclusive attributional style - that tends to own losses and gains with equal fervor. By minimizing the role of chance, the trader attributes all outcomes to the self, feeling good when the profits are rolling in and becoming discouraged during (inevitable) periods of drawdown. This is the "illusion of control" documented in the research of a London Business School research team, who found that traders who thought they could predict markets shown to them (which were actually random price series) performed worse than less confident traders. The result is that you can reliably track traders' moods by their P/L statements.

Traders tend to blame their losses on such factors as "loss of discipline" and "overtrading" when, in fact, these are frequently the results of attributional biases. The majority of traders spend more time trying to understand market movements than trying to understand their own thinking about markets. An interesting line of research finds that individuals who experience increased emotion tend to shift their attributional styles, reducing their tendency to own negative outcomes. Successful traders not only need to be able to think about markets, but also think about their thinking. Awareness of a tendency toward bias can be a powerful antidote to biased decision-making.

Take the Loss When You Are Wrong

When you know you are wrong, close your position! Don’t rationalize, hope, pray, or anything else, just get out. Don’t change your position, hedge it, or anything else; just take the loss and get out!