Book Reviews, Trading

Book Review of The Trading Rule That Can Make You Rich by Edward Dobson

This is a book by Edward D. Dobson, the person that set up Traders Press Incorporated. The book was originally published in May 1979, and has gone through four printings, with the current book printed in August 2005. The title was apparently a quote by W.D. Gann on the 50% retracement phenomenon, which is the subject of this book.

After reading a number of trading books, I have grown to enjoy reading trading books published many years ago because they seem to contain much more nuggets of wisdom with much less ‘marketing’ compared to books nowadays. For example, books by/on Livermore, Nicolas Darvas, Wyckoff are some great examples. One publisher I noticed that publishes these kind of books is Traders Press, hence I am always excited to check out books published by them. I am not too sure whether the company is still surviving well as its website seem to be down the last time I checked. Nonetheless, it is interesting to pick up a book written by the person that set up the Traders Press.

I have come across this 50% retracement concept a few times before:

  • One explanation I had read was that at the 50% mark, among the people holding the stock, half of the people will be losers (i.e. those that bought at prices higher than the 50% mark) and half of the people will be winners (i.e. those that bought at prices lower than the 50% mark). Hence it is a level where there is “balance”. It’s an interesting concept, but for some reason, it is not something that makes intuitive sense to me, hence it did not stick.
  • I had also seen the Fibonacci levels before but again that did not stick because I don’t see any sound logical reasoning behind those levels.
  • Another time I came across a related concept was when I read an article by DBPhoenix on how a stock is strong if the price stays within the upper half of a bracketing consolidation. That I had understood but did not link it to the 50% retracement concept.
  • The final thing that brought all of these concepts together, was when I read Wyckoff’s My Secrets of Day Trading in Stocks. There it clearly laid out the fact that it is extremely natural for healthy stocks to react, and how the reaction amount can help you assess how healthy is the stock (i.e. the demand and supply). 50% was the key level highlighted, and how the stock moved from that 50% level helps to separate a healthy stock from a weak one.

It was only after this “journey” that I was interested when I came across this book. Without the journey, I might have just swept this book aside thinking that it is some crazy idea that was borne out of looking for patterns when there are none. So in a way, I was fortunate to have the experience of other related resources prior to reading this book.

This is a pretty thin book, with about 60 pages of content. It comes with lots of diagrams illustrating the concept, as well as lots of charts of commodity contracts where this rule has played out very well. I always like short books that explain their concepts in a concise, easy to understand manner, and this book is one of them.

In conclusion, it is a good book to read, especially if you are unfamiliar with the concept. If you have swept this aside as pure mystical forecasting, this book helps you to understand that it is essentially a manifestation of supply and demand dynamics on the instrument.

The 50% Retracement Rule or Halfway Point Method

  • After a major move in either direction the market has a tendency to retrace up to 50% of that move (Rule #41 of the 50 rules on How Young Millionaires Trade Commodities).
  • W.D. Gann
    • You can make a fortune by following this one rule alone. A careful study and review of past movements in any commodity will prove to you beyond doubt that this rule works, and that you will make profits following it.
  • Burton Pugh
    • The 50% reaction is one of the most valuable of market habits and the trader should follow and profit by this most dependable of all market laws…. This remarkable form of market action is far the safest and surest movement on which the trader can base his moves.
    • This is one of the most valuable market habits. Every swing either up or down will sooner or later be followed by a reversal of the market of half the distance covered by the swing. If wheat rallies twenty cents, it will decline ten cents. The decline may be much more than ten cents, but you can be sure of the ten…. Nearly all of the small rallies and reactions of the day show the same habit.
    • It is especially valuable in mild bull or bear markets as such markets work up or down by orderly steps…. These 50 percent reactions are caused by many of the smaller traders taking profits and waiting for this reaction to ‘buy in’ again.
  • Chester Keltner
    • A characteristic of markets is that they fluctuate. These fluctuations do not occur in a set, precise pattern. But they do tend to have certain general characteristics, and it is these general characteristics that provide the basis for the theory of action and reaction. The theory is that a reaction in an advancing market should retrace roughly one-half of the previous advance. Also a rally in a declining market should retrace roughly one-half of the previous decline.
  • Larry Williams
    • Often one will see a 50% correction in terms of time consumed by the move. That is, an upmove which takes place over twenty time periods (daily, hourly, weekly, etc.) will tend to be followed by a correction which consumes ten time periods before the original move resumes.

Mechanics of Applying the 50% Retracement Rule

  • Select identifiable points
    • The point from which to measure should be a discernible high or low point on the chart.
  • Use intraday extremes
    • I always use the intraday extreme as the point from which to measure, once I have decided which high or low points I am comparing. This seems to work much more consistently than using the closing level.
  • Handling trend moves with multiple intermediate retracements
    • If the market retraces more than halfway back, the reaction will quite often terminate at the 50% level as measured based on the “one level above” move (which is longer in length), as opposed to the immediate move.
    • If you have multiple moves of different lengths (but of same direction) to choose from in order to calculate an expected retracement level, calculate the 50% retracements for all the lengths and average them. Often this will give you a close approximation of the final support level which does prove successful in reversing the decline.

Precise Entry Point System (PEPS)

  • Definitions
    • Length of Move (LOM) = High Measuring Point (HMP) – Low Measuring Point (LMP)
    • Expected retracement = 50% * LOM
  • Entry
    • If dealing with only 1 contract, enter at the 50% level (i.e., HMP – 50% * LOM).
    • If dealing with a number of contracts divisible by 2, enter half of the intended position at 45% level, and the second half at the 55% level, if reached.
    • If dealing with a number of contracts divisible by 3, enter in 3 phases, at the 45%, 50%, and 55% levels.
    • Make sure the entry orders are placed well in advance because the price might just overshoot the 50% level slightly on an intraday basis and bounce back.
  • Stops
    • Put in a stop at the 66% level, on a close-only basis. Some “normal” reactions do go beyond this point, and reverse back to the original direction, but by far the majority stop before reaching 66%, especially on a closing basis.
    • As soon as the reaction has met support (resistance) and “bounced,” take out your initial stop at the 66% level, and raise (lower) it to a level that would assure no loss on the trade.
    • A more pragmatic variation would be to put our stop just under the low (over the high) achieved on the reaction in case the market “tests” the reaction low (high) before resuming the original trend direction.

Buy / Sell the First or Second Reactions Rather Than Subsequent Ones

  • It is much safer to buy (sell) the first or the second 50% reaction within the trend than subsequent ones.
  • The assumption is that the third or later reaction within a major trend is far more likely to be a trend reversal than are earlier reactions. In such a case, I would consider the likely possibility that the entire major trend may be corrected by approximately 50% at which level I would look for the market to meet support.

Only Trade with the Trend

  • Always trade with the trend. In uptrends, I seek to buy on 50% reactions, and consider only the long side. In downtrends, I seek to sell 50% rallies and consider only the short side.
  • Chester Keltner: “To be a successful trader he must know at all times the direction of the price trend and his position in the market must be kept in harmony with it. A trader attempting to take advantage of daily trend movements, for example, should never be short when the daily trend is up, and he should never be long when the daily trend is down.”

The Retracement Level Indicates Whether a Trend Will Continue or Reverse

  • Joseph Granville
    • The market application of the Principle states that if a market decline retraces more than 50% of the advance, then the entire advance is likely to be wiped out. Conversely, if the market retraces more than 50% of a decline, the theory holds that the entire decline will be retraced. Retracements of less than 50% would indicate that the original movement is still in force.
  • Burton Pugh
    • … In the advancing market shown in wheat and Studebaker the market makes about a normal upswing, then drops back approximately 50 percent of the upturn…. Finally the reaction will about equal or fully equal the upswing [i.e. the reaction is 100%, may happen after a short bounce and not immediately]. This indicates top has been made and the decline is in progress. The same holds good for the movements near bottom. When rallies equal the downswing, bottom has been made.
  • Chester Keltner
    • I personally don’t think one should accept too literally this concept that a bull move must always occur in three stages. I have seen bull moves end after only one or two stages of advance, but I would concede at least that after three stages have occurred there is added reason for suspecting that a bull move may have run its course.

How It Retraces Matters – Gradual Indicates More Support for Continuing the Original Trend

  • John Hill
    • If I am considering buying a 50% retracement following an upmove, I have noticed that this will be far more likely to produce a good trade if the retracement takes place gradually, if the market must slowly work its way down, than if it quickly and easily collapses to the 50% level.
    • Quite often, a fast 50% decline will be followed by a brief rally, then additional weakness ensues, often leading to a full retracement of the move up, even a move down to new lows. A gradual 50% retracement is more likely to be followed by a move to new highs. This applies in reverse to corrections of downmoves.
  • Chester Keltner
    • It should be emphasized of course that retracement (or correctionary) moves in actual markets are not always exactly one-half retracements. They can fall anywhere within the one-third to two-thirds area and not violate in any way the theory of auction and reaction.
    • The tendency, actually, is for retracement moves to be less than 50% in markets under the domination of either extremely bullish or bearish influences.
    • In markets in which the bullish and bearish factors are in relatively even balance, retracement moves tend to be in excess of 50% of the previous move.

Relationship with Fibonacci Levels

  • One thing I have noticed is that a very strong price move will retrace only 38%, and a weaker move will trace the full 62% (notable Fibonacci levels are at 38.2% and 61.8%).
  • I have also noticed that many times an ABC correction will retrace 38% on the A leg, and the C leg will extend to the 50% level (i.e. uptrend, move A corrects downwards by 38%, move B rallies up but below previous high, move C corrects downwards to the 50% level).

Use Length of Previous Move for Profit Target

  • The length or extend of any given “leg” within a given price trend (i.e. price move, in the same direction as the trend) will often approximate the length (extent) of the preceding leg, as measured from the extreme of the reaction following the leg.
  • Chester Keltner
    • Under the theory of action and reaction there is another rule that should be noted. It is that in an advancing market each stage of advance will tend to be equal to the previous advance, and in a declining market each stage of decline will also tend to be equal to the previous decline.
    • Again in this instance, the rule is not a precise one. In fact, in a normal bull market I would say that the stages of advance should tend to become broader, with the broadest move of all coming during the final phase of the bull market. In a normal bear market the tendency should be just the reverse.
    • On the basis of this rule, the technical market student can frequently accept profits against the trend to a good advantage on trades that are made in harmony with the trend movement.

Markets Where the Rule Doesn’t Work

  • When a market is in a trading range, and during the formation of certain chart configurations, such as a triangle or a rectangle, the rule proves virtually useless.
  • The period during which a market is making a straight line move, without any meaningful reactions presents no opportunity to use the rule profitably, and may even present opportunities to use it unprofitably.

Rule Works for Both Long and Very Short Term Timeframes

  • Although my analysis and discussion of the 50% phenomenon have centered exclusively around the daily bar chart, you will find that it is often found in longer term charts.
  • This principle seems to work not only on longer time periods as measured by daily, weekly, or monthly charts, but on a very short term basis as well. This is evident on price charts using increments as small as 2 minutes per bar, as well as on 5, 10, 15, and 30 minute charts, and on hourly charts, all of which I now utilize in my trading.

Resources Mentioned in The Book

  • Commodities Magazine article entitled “How Young Millionaires Trade Commodities
  • W.D. Gann’s How to Make Money in Commodities
  • Gerald Gold’s Modern Commodity Futures Trading
  • Burton Pugh’s Commodity Trader’s Instruction Book
  • Joseph Granville’s Granville’s New Strategy of Daily Stock Market Timing for Maximum Profit
  • Chester Keltner’s How to Make Money in Commodities
  • Edward Dobson’s Commodities: A Chart Anthology
  • Edward Dobson’s Commodity Spreads: A Historical Chart Perspective
  • Edward Dobson’s Understanding Fibonacci Numbers

-END-

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Discussion

2 thoughts on “Book Review of The Trading Rule That Can Make You Rich by Edward Dobson

  1. very nice. keep it up.

    Posted by KL | November 6, 2012, 8:35 am

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