Wednesday, December 19, 2012

Bulkowski, Trading Basics

Thomas N. Bulkowski is an inveterate tester. So even though this book is entitled Trading Basics, it is by no means a run-of-the-mill introduction. It analyzes money management, investigates whether stops really work, looks at support and resistance, and shares 45 tips every trader should know. It is the first of a three-book series, Evolution of a Trader, to be published by Wiley. The second volume will be Fundamental Analysis and Position Trading; the third, Swing and Day Trading.

Although I’m sure readers will dispute some of Bulkowski’s findings as well as some of the studies he cites, the fact is that he has actually crunched the numbers. He does not rely on anecdotal evidence. For example, he used a battery of tests to show that scaling out of positions bought at the start of the month and held until either the end of the month or when sold by scaling out or being stopped out (scaling out at two times a 21-day average of the high-low price change and moving the stop to breakeven after scaling out, with the stop trailed upward 10% below the highest high) reduces profits. I’ve conflated a series of Bulkowski tests here and in consequence made them only marginally intelligible, but the results stand. Although scaling out handily beats buy and hold by a margin of 10 to 1, it leaves money on the table if price is rising and incurs larger losses if price is dropping.

What about stops? Do they work? Bulkowski devotes a twenty-page chapter to this question and considers an assortment of stops. The answer, he concludes, is complicated. Traders “have to be selective in how they use stops” because “being stopped out means profits get whacked in half and yet the risk of loss does not diminish much.” (p. 61) That seemingly counterintuitive conclusion should inspire traders to study Bulkowski’s tests in order to figure out a way to improve their reward/risk ratio by using the right kinds of stops (and sometimes no hard stops at all) intelligently.

Although mantras are challenged throughout, Trading Basics is not a downbeat “what doesn’t work” book. On the contrary, Bulkowski offers a plethora of ideas for successful trading such as the inverted dead-cat bounce. As one might expect given the author’s previous works (one reviewed only last week), most of the ideas are pattern-based. If you’re a pattern trader, you’ll be in your element. But even if you’re not, this book has a host of challenging theses that just might lead you to rethink how to make money trading and perhaps even to devise a few tests of your own.

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