Monday, April 25, 2011

Elder, The New Sell & Sell Short

Most traders have read Alexander Elder’s Trading for a Living, originally published in 1993. Elder has, of course, written other popular books such as Come into My Trading Room (2002) and Entries and Exits (2006). His latest work, The New Sell & Sell Short: How to Take Profits, Cut Losses, and Benefit from Price Declines (Wiley, 2011) is an expanded second edition of his 2008 book. It comes with a built-in study guide: three sets of questions and answers. Although it is a paperback, the charts and graphs are printed in color and the stock is of high quality.

The first part of the book covers Elder’s signature contributions to the trading literature: psychology, risk management, and record-keeping. It is brief because we’ve been there before, but Elder does describe some new ways to keep records—an ongoing project because he believes that “the single most important factor in your success or failure is the quality of your records.” (p. 341)

Part two tackles the all-important question of how to exit a (long) trade. Elder offers three alternative scenarios: sell at a target above the market, be prepared to sell below the market using a protective stop, and “sell before the stock hits either a target or a stop—because market conditions have changed and you no longer want to hold it.” (p. 59)

Elder then moves on to shorting stocks, futures, and forex; he also has a section on writing options. Finally, he points out some lessons of the 2007-2009 bear market.

I debated what specifics to share in this post because I realize that my readership is diverse. Some are new to the game and have never shorted a stock in their lives, others have extensive experience on both sides of the market. Here are two tidbits that should be of interest to readers at all stages of their trading careers. Both deal with stop placement—the first an initial stop (compliments of Nic Grove), the second a trailing stop (the creation of Kerry Lovvorn).

Elder explains that “the worst misconception about stops is that one should place them on long positions immediately below the latest low. … The level immediately below the latest low is where amateurs cut and run, while professionals tend to buy.” (p. 102) An alternative is to have an even tighter stop on stocks that have reached a defined level of support. “Nic suggested looking for the low where most people would place their stops and then examine the bars that bracketed that low on each side. He would then place his stop a little below the lower of those two bars.” (pp. 116-17)

The volatility-drop trailing stop is designed to be used once the trade’s target has been hit but the market is moving “in a way that seems to have potential for an additional reward.” The trader who wants to keep part of his position on might proceed along the following lines. “Suppose I use Autoenvelope to set my price target when I enter the trade. The normal width of the envelope is 2.7 standard deviations. If I want to switch to a trailing stop once that target is reached, I will place it one standard deviation tighter—at 1.7 standard deviations. As long as the move continues along the border of a normal envelope, I’ll stay with it, but as soon as the price closes inside of the tighter channel, I’ll be out.” (p. 125)

The New Sell & Sell Short is appropriate for traders and investors who are relative novices (definitely not rank amateurs). It explains how to exploit the asymmetry of markets; the path up and the path down are not, contrary to Heraclitus, one and the same. And, as we have come to expect from Elder, it stresses how to do this while keeping risk manageable.

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