The trading truth.

People need to take a backward approach to the market to really understand it. The information out there to "teach", or "assist", traders is all deception. An act of confusing the masses to exploit that confusion. The markets do not define trading techniques, but the trading technique defines the market. I will show you how professional money can make money on every trade, every time. I will show you why you can not, due to under-capitalization. I will show you the merits and falsities behind technical analysis and fundamental analysis, why they work sometimes, and why they don't at other times. This is a long road, be patient.

After we examine how professional money screws the small guy, we'll go over some options that will tilt things in your favor. It is all dependent on buying power. The amount of buying power you have defines what you can and can not accomplish in the markets. Everything is a trade-off, you can not get something good without accepting something that is bad. We'll cover options and why they can and will kill your account if used improperly. We'll go over emotion, and why that destroys many accounts.

Market behavior is definable, but even knowing how it behaves does not mean you can exploit it. Without knowledge anyway. The markets now are very similar to when they were first traded. Nothing has changed, other than some slight modifications as of recent. In whole, they are the same. Options, 2x, 3x ETFs were introduced to bring in more participants. Pitfalls were concealed by the promises of riches and wild returns. Induction of confusion in the markets creates volatility, and volatility is profitability for the professional trader.

The technique of trading the markets, by professional money, defines how the market moves. Technial analysis, fundamental analysis, or whatever analysis you use is explained by this trading activity. Chart patterns are explained and so forth.

Every technique used to consistently profit from the markets is exactly what you are taught not to do. It is burnt into your mind, from the beginning of your learning process, to not do the things which the professionals do. The result of these trading techniques being known to the vast majority of people would result in decreased volatility and flat-lining markets.

The rules the market uses where discovered by myself accidentally. Thorough studying, exploring, back-testing, etc. all led to the same results... failure. Well, at least a success rate that was less than acceptable to me. So, I approached it with a different mindset. I lifted all constraints and started new. "What if?" was a constaint question which resounded in my mind. What if you had unlimited capital? That started me down the road to my discoveries.

It is a fact, given unlimited capital, you can trade every trade without loss. It is a matter of averaging in the trade. Try it, on paper of course, because there are gigantic pitfalls within this simplified technique that wil ruin an account that is limited in capital. Take a random stock, or ETF, or future, or whatever you like. Execute an initial trade of a single share/contract. Every 0.10 double the position. So, buy 1, buy another, buy 2, then 4, then 8, continue until you are 10% of the total capital utilized is in profit, then exit. It works, every time, I guarantee it. One better, buy a deep "in the money" put and a deep "in the money" call. Only add to the position that is showing loss by doubling the position. Exit when both sides are profitable.

Keep in mind, I am no professional writer. My thoughts may jump from here to there as I attempt putting them to text. I also have limited time to actually type out my thoughts, so please be patient.

Taking the above mentioned technique into account, I had to identify the limitations and pifalls of this type of trading. This opened up a whole new world. That world was revealled to me in parts. The more I delved into the matter, the numbers, the more things became self evident. The limitations were two primary factors. One was trading capital. No matter how much we wish it was not so, we all have limited capital to work with. Well.... most of us anyway (professional entities not included). The second limiting factor was market travel, or market depth. Market depth is identified by how much the market can move in one direction without retracing significantly to allow for a profitable exit. So began my studies, in depth to say the least.

Measuring one way market movement was a definite challenge indeed. I had to identify the time frame to use and a constant formula, or criteria, for measuring these moves. Once I nailed down the details, what I discovered really was interesting. I mean REALLY interesting.

Well, I wrote a whole crap load of information, my laptop died when I was pre-occupied and I lost it all. Oh well, let me try it again and hopefully I can word it as well as before.

My discovery was that every move within the market was compensated. Every move in every regulated index, stock, ETF, future, currency, etc. No move went uncompensated.

The magnitude of the primary uncompensated extension was difficult to predict every time. Historical information gave me the maximum historical extension. The maximum was reached very frequently without extending to new levels. The retracement of the extension was very predictable. There were two identified levels of extension, and I will get into them in more detail later.

As an extension moves, the level between the high/low of the extension and the level required to compensate the move becomes larger. This is the level of captured guaranteed return. For instance (numbers listed for example purpose only), a 20% extension requires a retracement to 12% of the level measured from the original launch point of the extension. Now, the 8% difference from the top/bottom to the retracement level is 8%, the percentage is actually larger when measured from the reference point of the current issues price quote. For simplicities sake, right now anyway, let's just say this is an 8% required move. So, an extension of 25% requires a move to the 14% level of the original extension launch point. This is a captured 11% guaranteed return.

So, the larger the extension, the larger the counter move required to compensate the move. Let's cover the basics here.



Before covering these basics, let me point something out. This chart is for example purpose only. You will gather nothing but incorrect information by studying this underlying chart. It is just something for me to draw on.

A. Is the launch. This is the beginning of the extension measurement. The criteria which needs met for this launch is very specific and detailed. It is almost never an obvious point of reference. It is exact in nature.

B. Is the current maximum of the run. The AB section is the extension. The extension remains in effect until compensated.

C. Is the deleveraging level. I'll cover this more in depth later, when I provide more information regarding how these levels (all of them) were confirmed by the number sequences present.

D. This is the level where the AB segment is compensated, thus neutralizing market bias and full-filling the guaranteed obligatory move.

The launch is the most vital point in this whole technique. A launch can be identified in real time with nothing but a calculator. If you know the launch, you see the high/low of the current extension, you know the current obligation of the market. This is very important when calculating what is required to remain even at the deleverage area and profitable at reset.

I use the word technique loosely, for this is not a technique, this is how and why the markets work how they do. Now, before you think I am a "know-it-all" smart ass, let me be very clear. I know how and why the markets do what they do, I know the probabilities of what will most likely happen, and even knowing this, it is not as easy to exploit this as it may appear. This will become more evident when I reveal the "why" behind this market behavior, and WHY it HAS to happen. There are many pieces of this puzzle which I have to explain, the big picture will not start becoming apparent until later down the road. Once I explain all these things, I need to cover what will work, what will not work, why they do and do not work, why patterns appear, why TA does and does not work, etc... etc... not to mention fielding questions that come in.

If traffic to this site becomes too large, too quick, I will wipe it all. I appologize in advance, but when the big picture becomes more apparent it will become extremely dangerous. If all this information became common knowledge it would actually destroy the trading markets. This would absolutely flat-line the markets, that is if every person knew this information. My advantage here is that people have come to question everything they hear regarding the trading markets. So the probability of this happening is slim to none, but it does exist.

So, what does this behavior tell us? How is it exploited, or how does it exploit us? There are many ways of both, but let's start off easy.

In the example mentioned earlier you have a simple excercise that shows the capability of averaging down. Does this have a similarity of many gambling techniques? Certainly. But it resembles these techniques in simplest forms only.

Market extensions and counter trend compensatory moves are created by the ratio required to average in a trade and always keep it profitable. This does not require a doubling of your position. Once an extension is established (identified), you keep a rolling count of the guaranteed return the markets are obligated to move to compensate the extension. Only the largest of market entities can average in a position from a 2% or lower extension. They have the buying "power" and capital required to power out of the position for profit, under any circumstance. When averaging in, the basic principal is to keep the de-leverage retracement at even, or slight profit. In the event capital utilization is pushed to extremes, upon a de-leveraging retracement, you can liquidate whatever size of the position required to free capital and support the potential of a larger extension.

The de-leveraging point within an extension is typically reached several times and launches a further upward move. It is destined to fail, at some period in time, due to the markets obligation to reset the entire extension and return to a state of neutrality. The de-leveraging point gives you the opportunity to re-size your position. You can calculate your return at reset in comparison to the capital required to support the further extension and define the position size accordingly. If the entire position is liquidated for even, you now can re-enter the fading trade at a larger extension percentage, thus guaranteeing a larger percentage return on the trade. The problem with liquidating the entire position and waiting for a further extension is this:

An extension retraces to the de-leveraging point. The market HAS an obligation to reset, it does NOT have an obligation to extend the primary extension. Liquidating the position at the de-leveraging point can leave you empty handed if it should break and fall straight to the reset point.

The principal of the rolling average trade is this... you never add to a position unless it improves your rolling cost average. This creates draw-down, which we will discuss in further detail later. If you shorted stock XXX at 31.00 on your last addition to the trade, the next short entry can not be less than 31.00, anything below 31.00 will actually increase capital utilization and decrease your power for averaging down should the extension move further. When first starting this fade trade technique, you can layout an entire matrix which defines how much to add, where to add, and what your cost average would be at any given level.

The only time where you would add to the above example below your last entry is to leverage up the position to keep the de-leverage point even. This will only happen when you use options that are effected by a decreasing delta/increasing theta. Simply put, the only time you will lose ground, without price movement, is when you use options that are not VERY deep "in the money".



Typically, the extension does not last very long. The compensating counter-move happens even more quickly. On occassion you may find an extension which takes more time than expected. This is where running front month options (trying to conserve capital and boost returns) gets sticky. An example is our current broad market extension. The launch for this extension happened in March, and it is a historical extension, never seen before. Running front month options would have required a calendar roll four times to bring you up to date. Each roll costs capital in the trade which does not increase profits upon reset of the extension. You are paying capital to reserve the delta you already have, you are not increasing delta to increase returns on profit. To make up for the increase in capital utilization and decrease in return upon reset of the extension you will then have to add more frequently or of a larger size than was originally allotted for. This will burn through capital, reduce buying and staying power, and get you into some serious trouble if the extension increases further and you are left with no capital to impove your cost average. Keep in mind, as the extension increases, the travel to reset is increasing also. Thus, your reset level may end up far above your break even level before the extension resides and you have to cut at losses.



Of course, stocks have no time factor, they do not lose value with time. There are two things that are always true regarding the markets.



1. Markets always trade in two directions

2. Time passes



Trading stock, or deep "in the money" options with lots of time left on them eliminates the second variable and exploits the first variable with fading the primary extension. Trading anything else with these variables has some detrimental risk factors involved.



Let's take a look at a trade matrix, and some basics regarding it.

This particular matrix is of QQQQ and its current trading state. First thing to note is the blue line. These are the entry levels. The entry levels are not in even increments. There are many ways to average in the trade and try to keep it uniform and simple. This is the non-linear entry system. It uses a constant lot size with decreasing increments between entry levels. So, each level listed on the blue line, if you bought 1 share of the Q's, the red line is tracking the average cost basis. The second major entry system is linear. You enter in even price increments with an increasing lot size. You either vary lot size or price entry increments, or when customizing "on the fly" you can adjust both. Adjusting on the fly is after some experience, following that, you do not even require a matrix. When you get experience behind you, you know your cost average, the profit/loss at de-leverage and the profit/loss at reset. You can adjust as needed at that point.

Notice when the Q's hit 37.18 on its top in mid June (you need to view an actual chart). Where did we retrace to before making a higher high within the extension? About 34.40 right? Does this coincide with the matrix's de-leverage point?

Looking at this behavior of the markets, there are quite a few ways in which you can benefit from this averaging down trend fade. It is similar in principle to what you may have heard before... the average down return to mean trade. There is one huge problem with the approach traders take to fading the mean. The "mean" is used in most oscillators and many indicators. They calibrate to a channel of price movement and calculate a mean. The problem with this is there is never an actual "static" point of reference, or a starting point of a run which does not change. Indicators and oscillators change their focal areas depending upon the time frames used. Even when using the most accurate time frame to match actual launch and reset points, they do not even come close. A launch does not need to be at a low or high of a range, in fact it is rarely there. Many launches can form within what appears to be an already established trend. You can not take any pre-existing oscillators or indicators and modify them to measure the launches and resets, I have tried them all. You can however, start from scratch, write the code, and make an accurate indicator which notifies you of a launch, its percentage run, calculated deleveraging point and reset points. Unfortunately, I do not write code.

As long as you can increase delta, control theta (time) loss, and allocate capital accordingly (remembering to not get greedy aand deleverage the position if required to support the further potential extension), you can reep profit from this type of trade. This includes being a net seller of options, whether naked or the use of spreads. A directional trade which capitalizes on time decay is a great way to exploit this behavior. Yoou do have to adjust tthe trade by rolling strikes to maximize returns though. This goes the same with using ATM/ITM options also. Eventually, if you are not very deep ITM on your options, the price movement will catch the strike. At that point, rolling deeper ITM increases delta, and that is the name of the game, to average in delta and be present within the market when the obligatory counter-move begins.

This markets behavior can be exploited in many many ways. Even directly corellated issues will sometimes be out of sync. Where one will actually extend to the downside and the other is extended upward. This is an opportunity for a free profitable trade. If you are fading an up extension in one, while fading a down extension in another, where is your allocated capital going to be utilized? In one trade only. Once the position is established during a period of arbitrage you will then fade the position which moves against you, leaving the gaining position to run to reset. This decreases over-all draw-down and maximized capital utilization.

I'll briefly mention a few other techniques to maximize on this type of market behavior and go over them in more depth at a later time. Let me start by touching on a way to trade that is familiar tto most, and most will be comfortable with. This is the momentum trade.

The momentum trade-

When markets extend, up or down, and the extension is being faded by professional entities (which is always, there is always someone on the other side of that trade, right?), the extensions need relief to allow ffor deleveraging along the way. They may require being reset to continue also. Just because a run is compensated by hitting its reset level, it does NOT mean a reversal of trend is at hand. It plainly means that the specific issue being watched is now neutral and free to establish another extension or wander aimlessly. When markets extend, no issue is left behind when resetting. They will all reset eventually (as long as regulation is present on that issue). So, with that established, the momentum trade trades IN the direction of the primary extension. To do this an initial position is established at the deleveraging area. For this example, lets say we have an upward extension. The upward extension pulls back to the deleveraging point. Professionals are now covering shorts against the primary extension to decrease the position size and allow for the POTENTIAL continuance of the extension. They are not buying to open, but buying to close partial positions. We, on the other hand, will buy to open. At this point note there is potential to the upside, but obligation to the downside (eventually it needs to reset). Here we establish the initial position. One of two things now happen. Either the extension is relieved and free to continue, or the deleverage area fails to support a bounce and we head to the reset area. If we continue the extension (keeping in mind, unless a higher high is made, the extension does not increase) we set a profit exit level at the current high of the extension. This profit move is typically about 1/4 of the total extension. If exited, nothing keeps you from re-entering once the deleverage point is hit again. If the opposite happens and the deleverage area fails, you will add to the position at the reset level. The add is the same size (or your preference) as the initial position. When the reset level is hit, the markets downward "obligation" is full-filled, this very often results in the establishment of a new upward extension. Once this position is added to, you have two ways the trade will end. Either you exit once the high of the "old" extension is surpassed, or stop out for a loss slightly below the reset level. Exiting, for profit, at the deleveage point is also an option. This point was where you established the initial position. As an example of this, say we went long 1 share of XXX at 30.00 (deleverage point), it broke and we added 1 share at 29.00 (reset level). Our current cost average would be 29.50 ((30.00+29.00)/2). Exiting at the deleverage area after we added at the reset would result in a 1.00 profit ((30.00-29.50)*2).

Before getting into the next trade type, the rolling delta trade, I am going to take a moment here to comment on the validity of technical analysis as a whole. Before I get started, let me assure you, I have gone my rounds and paid my dues in terms of technical analysis. At one point, technical analysis was my holy grail. In hindsite, as most technical analysis is, I discovered many mistakes which I had fallen victim to.

The markets need participants for the game to go 'round. New money needs brought in each and every day. If not, those who continue to exploit the masses would eventually have no individuals to exploit. A market particpant comes in, gets washed out, and then a replacement is required. Either entice in new money, or make that individual which washed out believe he really can make money in the market so he gives it another shot. This is where the introduction of options came into the markets, as well as 2x/3x ETFs, and the focus on technical analysis. Technical analysis gives you the perception that you have a trading edge within the markets. An edge, which you believe will outweight all the odds already stacked against you (limited capital, spreads, greeks, etc.). What is actually stacked against you is far beyond what you can possibly fathom. The markets and their regulating entities have had decades to decieve the masses, and they are damn good at it. The perceived "magic", or clairvoyancy, of technical analysis in any shape or form, will not overcome this. In the end, all odds return to mean, and for the average Joe, that is approximately 0%.

Advertently, or in-advertently, the vast majority of those who teach technical analysis, or utilize it to further their gains outside of the market do so deceavingly. Many are just attempting to be helpful, while others outright mislead individuals to get them into the markets. It is hard to tell which is which, in the end it doesn't really matter. It is common human behavior for people to want company. They will teach their methodology, this way, if they should fail, they will not fail alone. But, back to technical analysis and its validity.

Markets and their respective charts depict patterning processes. The bearish head and shoulders, flags, triangles (all forms), and so forth. These patterns are created by the interaction of channels, or diagonal trading ranges. Channels are present in every time frame and there are always multiple channels within every chart. These channels are created by the trading ratio's of large entity traders utilizing fade techniques to regulate the markets. As mentioned previously, there are key deleveraging and reset areas in every market extension. The rate of incline/decline in an extension when graphed out with its non-static deleverage area and reset points create channels. For instance (numbers given for exmple purpose only), if you were fading an incline, shorting at higher prices only, and the deleverage point comes around. You now cover whatever portion of the position is required for you to fade a potential further extension. This, of course, is buying shares to cover the short. This buying pressure will cause a bounce in the direction of the extension being faded. You freed up capital to support a larger move. A higher high comes around and you begin shorting again, selling to the enthusiatic masses. Now, the deleverage area has shifted. The higher the high, the higher the deleverage points and reset points become. You drop to the deleverage point and repeat the process until the deleverage point gives way and the reset area is hit. This price action creates channels. If the launch point is 30.00 on stock XXX, we travel up to 40.00, the deleverage point may now be 37.50.We deleverage, the crowd gets involved and now we jump to a 43.00 high. The deleverage point has now shifted to maybe 39.00. This, in time, creates the channel. There is also a channel that exists at the reset to high range. This whole process is why you will see "harmonic" lines within channels. These are lines parallel to the upper and lower channel levels but are defined between the upper and lower channel. To make channel analysis a bit more confusing, we have to take into two considerations. First off, different entities will be a little more aggressive than others. One may use a 15% deleverage and 30% reset while others may use 20% and 35%. This will cause a variation of sloping channels, typically one over-lapping the other (ascending/descending wedge anyone?). The second, is the presence of basket trading. Large entities like to do things without showing their full intention. It is kind of hard for them to hide billions of dollars within a single issue. To help conceal this volume, they can distribute out amongst issues within related sectors. For instance, they can utilize the DJI to follow the extension, utilizing it for buying and deleraging/exiting. When they actually sell the rising extension, they can balance a load of 30-40 stocks and distribute volume on a dollar basis ratio to each issue. This will create channels within these issues regardless of any other trading activity happening within that issue. This is where the "internal" definable channels come into play, yet, each individual issue has its own assigned regulators also, just to keep things in check.

A recent example of a terribly failing pattern is the head and shoulders pattern which formed in all the major indices and failed to complete last week. The DOW deleveraged the March launch in the week of 6/22. The S&P deleveraged in the week of 6/22 also. The NASDAQ, on the other hand, had not had the opportunity to deleverage. The deleverage level was actually the neckline of the recent head and shoulders within the major indices. The week of 7/6 the NASDAQ finally had the opportunity to deleverage. Now, the delayed deleverage, and the intensity of the incling extension on the NASDAQ had some regulating players really pushing some capital limitations. They needed to position size for a possible upward continuation of the extension. This was some massive short covering by professional money. So, what where the odds the NASDAQ hits an extremely overdue deleverage point and falls through it to complete the breakout of a head and shoulders pattern? Slim to none. Yes, there is an obligation to the downside within the market, but falling straight through a deleverage area that was overdue is not all that probable. A bounce was expected, by me anyway, the intensity of that bounce is really unknown. A higher high has now been made, and the next deleverage point is now a little higher than the last, but its actual "need" is a little less.

Indicators and oscillators actually measure and calibrate to channels. You can draw channels of confinement on most indicators which coincide with a channel found on the chart. These indicators and/or oscillators also have no static points of reference (launches), which keeps them calibrating to newly created channels. Changing time frames within any oscillator or indicator will typically give you an entirely different picture. Regardless of the time frame your trading, another time frame may catch you blind-sided, not to mention the inaccuracies I already mentioned with indicators/oscillators.

An indicator can be built with the launch/extension/deleverage/reset information, but it would only consist of one time frame. That time frame would be "current". Every second traded would need analyzed. The indicator would look similar to the popular MACD. The line would deviate from the zero line in direction of the current extension. As the extension expands, so would the "momentum" line. There would be triggers similiar to the RSI indicator, a +80% or -20% may trigger trade entry based on historical extension data. The line would return to 0 quicker than it would rise, for only a fraction (in percentage terms) of the rise needs to be retraced to reset the market back to neutral.

So, does technical analysis has any value? Well, if it is the only thing you have, yes. Knowing what I know, would I use it? No.

It never ceases to amaze me new ways people come up with to examine the same data, as if a more complex data structure will increase the probablilites of a successful trade. The notion of technical analysis being explained from mass human emotion and reaction to the markets, come on now, little far fetched isn't it? If you look hard enough, you will see what you want to see, if someone tells you something enough, you will begin to see that also. You need to remove emotion and decision from the trade, the markets are what they are, regardless of how you feel about them. Decisions cause stress and second guessing, which causes emotion. The more you second guess, or give in to emotion, the more you will be exploited in the market environment. You need to identify the way markets behave, under any circumstances. Find the constant and exploit that constant, without emotion, without decision.

Ok, enough of that. Concerning fundamental analysis... well, basically the same thing. It impacts the primary extension to some degree, but the reset is always required, the fundamentals are not going to fill you in on when that will happen.

Sometimes I need to step back and realize, the vast majority of people who have money in the markets have no clue to most of my terminology. Most people do not even know what an option is, let alone their greeks. If you have questions, no matter how simple you think they may be, email me at thetradingtruth@gmail.com . I have been to many blogs and such where the volume of traffic to such blog is well known. Even the largest of these blog sites are less than 20-30K visitors per day. That is not much in the whole big picture. Keep in mind, the majority of this traffic is repeat visitors also. So, if you feel "in the dark", you are not alone.

Let's touch briefly on another trade technique, the rolling delta trade...

The rolling delta trade fades the primary trend. It is used as a low cost high percentage return trade for stock (not ETFs typically) which have huge extensions. Using the primary and secondary fade trades involves constantly increasing, or maintaining, delta against the trend. Delta management can be used via purchase of shares or options. The rolling delta trade uses options only. It utilizes "out of the money" options with a consistent position size. In place of increasing the position size, by adding larger lots, or smalling increments of entry, it increases or maintains delta by vertically rolling your options. The options are purchased "out of the money" with plenty of time on them. The moves we are looking for on these plays are typically pretty large, hence they may take some time to deliver. The options are purchased with a strike price near the deleverage area. As the extension continues and price moves against you, you roll the strikes up to the next strike level at a decreased cost. The rate at which you roll the strikes is dollar for dollar, thus the more you are required to "roll up" the options, the more distance from top to reset you will capture. When calculating estimated returns on the trade, I like to calculate for pure intrinsic value only at reset. If the rolling delta trade goes on for quite some time, you may have to roll out in time also. Eventually, if the run is taking an extreme amount of time, and moves against you in a big way, you may have to add a few contracts to keep the reset level in profit.

Stocks which are extended 60-70% and beyond work best with this method. This is also why ETFs are not a preffered play with the rolling delta trade. Ask away with questions, I am sure I am leaving out quite a bit, but it is Friday! I will attempt to get some written this weekend and touch on arbitrage pair trades, people really like them, for they are 100% hedged. I will also be touching more on averaging down and the advantages of doing such. Why "staying power" and "buying power" are crucial. Until then, enjoy the weekend.

Quickly, don't know if I have enough time to address the issue, but, here goes. I have received a few emails regarding releasing information such as this. Let me explain a few things.

First off, there is some key information I leave out, and will continue to leave out. This is where to start measuring these extensions from, where the rolling average starts. There is a reason you do not find information like this on the web, it is not to be shared to the public. Go ahead, try googling it, you won't find ANYTHING pertaining to it. Kind of interesting, huh? Let's think about the repercussions if this information was out there for all to absorb. If I gave detailed information for identifying these points of measurement, how to fade them, and how to profit under any circumstance given propper capitalization. What if every rise was sold, and every drop bought by the masses? The markets would flat-line.... it very well could disrupt the entire market beyond repair.

Look at it in a larger scale... who backs these larger entities that exploit the masses? Who regulates the market so nothing catastrophic would ever happen? Say one of these major regulating entites got in trouble, they were fading a move and some other regulating entities were forced to cover for huge losses, thus putting the pressure upon the remaining regulators to absorb that move. It snowballs. Say you and I were fading a huge down move, the move extended beyond your capability of cost averaging with the available capital on hand. You are forced to sell at huge losses. Either I then have to absord that selling pressure, or throttle back to buy at much lower prices. This increases my draw-down and someone needs to absorb what you sold! Now, if this were to happen on a grand scale, who is the backstop? Say Morgan Stanley fails to support the markets and GS has to step in and absorb where MS failled. But, GS just don't have that amount of coin to support that type of failure, and they know it! So, Mr. Fed, either you have our back and we regulate the market with your assistance, or the entire financial system goes down in flames.....

This makes GS, and others, look like the bad guys in the eyes of the public, when in actuallity, they saved your bacon! What if the Fed had to be a little more discrete upon backing those that look like criminals in the eyes of the public? Hmmmm..... how could they hand over billions in capital to regulating entities to support the market from further collapse? Not further collapse, but a more contolled decline, to avoid the outright failure of the system. Here's an idea! As the Fed, let's buy everything they have to sell, let them average down the incline and take the money through the market! As these entities distribute everything with a ticker symbol, the Fed and the public it pumped can buy it all, this will give these entities the capital required to keep the coming decline under control, prevent disaster, and make the coin to pay us back! Straight from the pockets of Joe Lunchbucket!

Ok, theories, theories, right? In this market, there are not bulls and bears. There is "you" and "them", they show no mercy, and they will rip your head off without disturbing their lunch. You need to get your head screwed on straight and play their game. It is just how the system is, how markets work, I did not make the system, nor did I define the parameters of how it works. That is just purely numerical in nature. Your either with them, or your lunch meat, plain and simple.

The "golden ratio", Fibonacci sequences, infinite number sequences, are there for a reason, they all define ratios. 10:3, 20:6, 40:12 are all the same damn ratio. That does not mean that first number will never get larger, it just defines the parameter of the number that has to follow. Nothing really defines the length or magnitude of the extension, but the magnitude of the extension surely defines what needs to eventually come next.

Let's jump into the "paired arbitrage trade". This trade type exploits the imbalances created amongst different trading issues. Each side of the trade directly hedges the other and is executed as a perfectly balanced delta trade. I prefer to utilize this technique on highly regulated ETFs, but the general principal will work with other issues as well.

Markets "breathe", or move as a collective whole. Some issues run stronger at times than others, and some run weaker than others at given times. The strength of the extension, or one way uncompensated movement, within an issue as compared to another issue really does not have any direct correlation. It does have "potential" to correct an imbalance there, but those imbalances go uncorrected more often than not. The imbalance I am interested to exploit is the direct ratio of one issues extension high/low to reset compared to anothers extension high/low to reset. Since all extensions reset/compensate eventually, an issue that has more travel to reset will run relatively strong/weaker (depending on extension direction) than an issue with a smaller area to cover to reset.

First, again, these numbers are for example.

What we are comparing is not the extension itself, line AB, but the distance of travel to reset/deleverage, line BC. The percentage to reset (or deleverage) is measured from point B to the current reset level. If two remotely correlated issues (not directly opposite like an ETF and its inverse) vary in percentage move to reset it will eventually close this gap. This is due to the tendency for ETFs and/or indices to reset at about the same time period. If DIA had an 8% travel to reset, and QQQQ had 10% travel to reset, there is an imbalance present. The markets tend to correct the difference amongst ETFs.Indices, then proceed to correct the overall market imbalance (run to reset). In either event, whichever happens first (correct the imbalance, or correct the general market), these variences will close their gap. They may seperate farther before closing, but they will close. The DIA/QQQQ example listed here would indicate on a strong upward market day DIA should run stronger than QQQQ, on a weak market day, QQQQ should be more weak than DIA. A delta balanced arbitrage pair trade could be executed to go long DIA and short QQQQ. These imbalances close quickly, typically on overnight gaps. I like to initiate these trades at the close and add at the next open if the difference increase, or close the position if the difference corrects. Delta balancing the pair and such will be covered later. I want to get back to the overall principal of averaging a position. I seen hundreds of people getting stopped out within the last day or two at losses which could have been prevented, so I will prioritize that subject first.

Ok, back to averaging down. Why do it? To make money. Period. It takes staying power to stay the course of the trade. Averaging in gives you staying power. How many times has your stop been tripped to just find you were right anyway? More times than not I am sure. Markets trade in two directions, always. Most traders look at trading in this light... Control losses, keep stops, lose many, win few, but have winners be larger than losers. Weigh risk:reward, have few large winning trades and many small losers. Well, you can manage risk:reward with averaging, it is just a little more complex of a calculation. Also, most traders do not take into account a third equation... the percentage chance of exiting the trade at profit! Everything in trading has a trade off. A trade which is high risk, high reward, has a low % chance of success. A trade with low risk, low reward, has a high % chance of success. A simple example, an option which is 40% "in the money", expires this week. What are the chances this option expires with 0.00 value? Slim. Chance of it gaining huge (in camparison to capital utilized)? Slim. Low risk, low reward. Now, an option that is "out of the money", same expiration. Chances of expiry with 0.00 value? Great, potential of large gain? Sure... High risk, high reward, slim chance of that great gain.

When averaging in a position, you have to be more wrong than a traditional stop gain: stop loss trade. When averaging in, if you are correct after your first entry, your gains are smaller, after a second entry, reward expands. This gives you more room to let the trade move before pulling the plug, or it gives you "staying power". For instance, say we buy 3 shares of XXX at 50.00, stop at 49.50 target of 52.00. 1:4 risk reward, low chance of success (a 1:1 risk reward is about 49% depending on spread, considering options, a 1:1 has about 35-45% (or lower even)depending on delta).

We have an cost basis of 50.00, we stop out we lose 1.50 (0.50*3), we hit target, 6.00 gain (woohoo!)

Ok, second, let's average in, same stop/target. First buy 50.00... now we run to target for a gain of 2.00, or drop to 49.83 and add a second share. Ok, we dropped to 49.83 and added, our cost average is now 49.915 (50.00+49.83/2). We run to target for a gain of 4.17, or drop to 49.66 where we buy our third and final share. Our cost average is 49.83. We now run to target for a gain of 6.51, or stop out for a loss of 0.99. Now, compare the trades.... Just for the sake of saying both trades had even odds of successful completion. Trade A had a lower best case reward and a larger potential loss. Trade B had a larger potential gain (6.51 compared to 6.00) and a lower loss if you were completely wrong (0.99 compared to 1.50).

Trade A had these potential outcomes:

Gain 6.00

Lose 1.50

Trade B had these potential outcomes:

Gain 2.00

Gain 4.17

Gain 6.51

Lose 0.99

The advantages of averaging in are great. This comparison was an equal stop:target comparison.

If we were going to risk 1.50 total we could have let the price drop lower and average in at that level, thus giving more "room" for the trade to work out, or give us "staying power" to stay the course.

That was a very simplistic look, let's take things a bit more into the mind boggling realm. How does averaging affect the markets, or decide what the market can and can't do?

Depending on the extension entry (% extended before intitial entry) and your way of compounding the position, decides how much of a move you can cover and always keep within a profit zone upon retracement. To show how the professionals do this, on this large of a move (example below), I would need a matrix with 100 or more tiers, but this should get the point across.

The matrix above starts with roughly a 30% extension entry. If entered at this level, using the additions listed (size and price), you can average in all the way up to 130% of an extension while always keeping the deleverage level even or better and the reset at a substantial profit. When you get to larger levels of extension, and come down to the deleverage area, you can resize the position and build a new matrix with lower risk and higher reward because, eventually, the market will compensate.

For instance, say GS climbed to 130.00, then came down to the deleverage area (which it did). At that point in the matrix, we have 900 shares at an average cost basis of 117.15 (my matrix spits all this out for me, that part is not posted). If we dropped 400 shares for even, we now have 500 shares at even, which means we are at 117.15 on GS. Lets plug this in to the matrix now, and extend our reach of coverage.

Now we are covering up to a 160% increase (as compared to 130% in the first matrix). We dropped our capital utilization and locked in a higher % return per dollar utilized. The capital allocation has also dropped, which can free capital for other purposes.

The profile of the first trade was:

Capital allocation 900, 693 (tier size in matrix is x100)

Profit range 254.00 to 100,657

Draw-down at 20th tier 11.59%

The second profile how has these characteristics:

Capital allocation 564,654

Profit range 4,200.00 to 59,572.00

Draw-down at 20th tier 15.74%

On a per dollar basis of utilization, we are now guaranteed a higher percentage of return when a retracement commences. We are locking in profit on something that has not happened yet! But, IT WILL happen... eventually. This is staying power.

The basic principal, the earlier you enter the extension, the more buying power is required at higher levels to average down the trade. Waiting until the extension matures more before entering allows you to maintain the average and keep the deleverage and reset levels profitable with less capital and yielding a higher percentage return on capital utilized. Keep in mind, the first matrix had an allocation of almost 1 million, yet, only 105K was "in utilization" at the time of deleveraging.

The capital that was allocated, yet not "in utilization" can be used to hedge, or place arbitrage trades where the position can be liquidated quickly to support the primary trade. The balance of the professional trade is "allocation" vs. "utilization". Capital allocated, but not in current "utilization" is wasting buying power. You need it there, on demand, but can make profit off it in other ways. So, the phrase "a lot of money on the sidelines" is money reserved to fade a further move IN THE SAME direction which we are already headed!!! Not capital in reserve to pump the market. You see what they want you to see.

The above example is the most extreme, in fact, an extension of 130-150% has never been seen in any regulated issue. I am just blowing it out of proportion to show you the jist of the technique.

I should take the opportunity to state that not every stock is regulated. Penny stocks, low capitalization stocks, and low volume stocks are not held to the rules of the market as strictly as regulated stocks. They do adhere to the same general principal, but are subjective to much greater volatility and can bend some of the rules. In historical study of hundreds and hundreds of traded issues, these are the types of things you may want to avoid:

Stocks trading under 15.00
Volume less than 2 million average daily
Any stock that launches with a 10% gap or more (there have been 3 issues out of hundreds which have violated general market rules, all three issues launched the extension with a greater than 10% gap in pricing. This phenominon I can only contribute to "true" insider trading information. Where the outcome of an event was truly known by a large entity and they risked not being investigated by the behavior presented within the pricing action).

Added info 9/30/09:

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While I sit and do not much of anything, I'll attempt explaining some geometry, probabilities, and characteristics of market extensions and their counter parts.

First, let's identify the labeled areas. A. Is the launch of the extension, this is where the price of the underlying increases at a point where compensation can not keep up. B. Is the extension top, this changes each time a higher high is made in an upward extension, or a lower low in a downward extension. C. Is the counter-trend, or retracement target. There are two targets, or two stages of C. One is the deleveraging retracement, and the second is the compensatory retracement. D. is where we would extend to to make another demarkation of C (a higher high) if the C compensatory objective was not met (the extension did not fully compensate).

The AB segment rules the trade, everything that happens within the trade, or until compensation occurs, is dependent upon the maon extension (primary extension). The AB segment is somewhat dependent upon historical study, but not entirely. The historical max, average, and mean value of this percentage number can be a good gauge of basing your trade. You can always default to the general market numerical values when in question. Just calculate the loss at stop, and re-initialize the trade if you miscalculated. The AB segment has a few interesting characteristics. The smaller the percentage of extension, the greater the chance a deflection will occur from area C in the same direction as the primary extension. The larger the AB segment, the greater the probability a full reset, or compensation, will occur at area C. The market needs regulation, and this is the basis behind the rules followed. So, a quick conclusion, the smaller the percentage extension of the AB segment, the greater the probability a momentum play will work when area C1 (deleverage point) or area C2 (compensation point (or reset point)) is hit. The greater the percentage extension of the AB segment, the better the %ROI offered on a fade trade with averaging down concepts.

While I am at this point, let me mention something concerning averaging in a trade, and my number of tiers I use on posted trades. When averaging down a trade, the further the extension moves, the less impact your additions have to affecting your overall rolling average. You can compensate this effect by A. Increasing additions with smaller price movements of the underlying. B. Increase overall size of the addition (non-static lot sizes), or C. Use fewer tiers, stop out and re-initiate more frequently.

The third option has some very good merit. This is why... Let's look at the effect, or impact, on cost average using symetrical lot sizes. This example is entering at 50.00 covering a possible extension up to 60.00 using a constant lot size of 1. I am only listing the first six entries and calculated rolling averages:

Here are the entries:
50.00
51.30
52.43
53.41
54.27
55.02

Here are the calculated rolling cost averages:
50.00
50.65
51.24
51.79
52.28
52.74

You will see, in this example, the rolling cost average is impacted less as we accumulate more shares/contracts. The first addition has the most impact upon cost average. When adding one share at 51.30, we increased our cost average (which is a good thing, this is a short!) by 0.65. Adding another lot at 52.43 increase the ACB (average cost basis) by 0.59. This number increasingly gets smaller. Until, when you are very deep into a high tiered trade, it impacts your ACB very little. You have the option of stopping out, calculate the position size required to keep the deleverage point at break even, and use a tiered matrix with less numbers of tiers. This works fine, but, as I say.... there is ALWAYS a trade-off.

The trade-off, when using less tiers is there is less consistency to the calculated %ROI of utilized capital. The resulting gains of the trade become wider in their range of return. Let me attempt to explain. Averaging in frequently gives you a smoother curve to your ACB, resulting in a more consistent return percentage-wise throughout the duration of the trade. Using less entries makes the percentage gain a little more sporadic. An example would be as such: If you had a three tier set-up, and price of the underlying came up 0.01 short of the third entry trigger, your return would be much less than if that last cent where achieved before turning and heading to the reset price. More entries makes this increment smaller, thus having a more smoothing effect. Each tier has a worse and best exit point. If the trigger was hit and not exceeded by even 0.01, this is the best exit for that tier range. If you came up 0.01 short of the next tier entry, it is worse case exit for the current tier (which is still a positive return if you calculated correctly).

Ok, back to the extension geometry. The BC segment, or BC1/BC2 to break it down further, is the counter trend retracement depth. The point C is a compound target, first is the delevage, second the reset. The smaller the AB segment, the greater a continuation from C1, or a new extension beginning from C2 in the same direction of the last primary extension. C1, the deleverage point, allows the fade trader a point to re-calculate his/her trade matrix and adjust the position, for this is the "break-even" point, where the total P/L is a wash. C2, the reset point, is the point of exit, this is the profitable exit and will return your calculated ROI when the trade was initiated. C1, and C2, is a percentage related movement which corresponds with the AB segment. The market standard is the C1 level is about 23.6% and the C2 area is 38.2%. Different traders, depending on capital and agressiveness, may use values that are less than these percentages, but these are the deepest "guaranteed" areas of retracement. Bear in mind, you will find this rule is adhered to ONLY if you have calculated your launch point correctly. The launch is the key to the entire process!!!

The CD segment is actually a continuation of the AB segment if the extension has NOT reset, or starts a new AB segment if a new extension (a new launch) occurs. An extension, which remains within an issues frequent oscillation trade range is noise. It keeps resetting and no playable extension materializes. This "noise" area depicts that the issue is in a neutral state, and has no biases in any direction. Entering any type of trade within the confines of an issues neutral state is EXTREMELY dangerous. An issue can violently launch from a state of neutrality at any time and its lack of limitations at that point will crush many a trader. An issue may make hundreds, or thousands, of 3% extensions (just a number, each issue has its own value) and reset very quickly, not allowing us to exploit this movement. This is the threshold level which anything less is considered "noise".