Book Reviews, Trading

Book Review of Trading From Your Gut by Curtis Faith

This is a book by Curtis Faith who got famous as a “Turtle Trader” specializing in swing trading. The full title of this book is “Trading from your Gut: How to Use Right Brain Instinct & Left Brain Smarts to Become a Master Trader”.

In a nutshell, this book makes the point that while you can have well thought out logical trading rules, you should also train your mind when applying those rules to the point where you can see a price chart and intuitively know whether or not a trade meets your entry criteria and exit criteria. At that point, you no longer need to spend time manually determining if a trade can be done. Curtis’ conclusion is that trading is not about steeling yourself, suppressing your emotions and mechanically follow trading rules, instead traders should ‘listen’ to their gut to make full use of their brain.

A large part of the book goes into touching high-level aspects of a variety of topics, including psychological pitfalls, neural networks, taxonomies, different types of memories, emergent systems, etc. There are also “random stuff” like explaining what is a bid-ask, what is terminal velocity, the tactical flexibility of roman formations due to the availability of a strategic reserve, etc. In addition, there are also many examples given where people trusted their instinct and things turned out great. Personally, I felt that the book would be better without these high-level coverage of a whole bunch of different concepts. I would rather if  the author had gone deep into explaining how exactly these can be applied and implemented in trading. Hence I felt that the book can be written in a much more concise manner.

I like the parts of the book that writes about the psychology of market participants at various points in the market. A number of explanations did not go deep, but the explanations on the psychology of market participants at support and resistance levels are good. The explanations of the Rebound Swing Method is also well-explained.

All in all, this book is a quick and easy read, something that a reader can quickly go through in a leisurely setting. Some of the notable points from the book are captured below.

What’s in a Price

  • Price movements on a chart represents the movement in the aggregate psychology of the market participants.
  • Prices move up because buyers are more desperate than sellers, not because there are more buyers than sellers.

How Market Momentum is Generated

  • Market momentum is the result of a contagion of belief among market participants, which creates a reinforcing feedback loop.

Why Support and Resistance Levels Work

  • Support and resistance points must stand out visually as a high or low. A few days must have passed without the point being exceeded.
  • Resistance levels work because
    • [More sellers] Holders who were previously hoping to sell at a price higher than the resistance level got their hopes dashed earlier, so they will be more anxious to sell when the price reaches that resistance level again because they are afraid that they will not see the price again.
    • [Less buyers] Potential buyers would be less willing to buy because it would appear visually to be a high point.
  • Support levels work because
    • [More buyers] potential buyers who were hoping to buy earlier but did not, got their hopes dashed when the price went back up, so they will be more anxious to buy when the price reaches that visually low point again because they are afraid that they would not see that low price again.
    • [Less sellers] Potential sellers would be less willing to sell because if they bought at a higher price, they do not want to realize the loss (they will probably sell at breakeven!), and if they bought at a lower price, they are hoping for the price to go back up from that visually low point.
  • Resistance and support are also self-fulfilling because traders act on that expectation.

Why Does Resistance Turns Into Support and Vice Versa [my notes]

  • Resistance turns into support because
    • [Sellers turn into buyers] Sellers that have sold at the resistance level during the breakout would be regretting their sell decisions, and would re-enter into the positions when the price comes back down again. This works the same for short sellers who will close their positions.
    • [Buyers buy more] Buyers that have bought and profited would have wished they had bought more, so they buy more when they prices come back down again.
    • [Buyers turn into sellers] There would be buyers that have bought and quickly sell out as their bet turns sour (when prices reverse back) and take a minor loss.
    • [Sideliners turn buyers] People who were staying at the sidelines and saw the price break through the resistance, but did not buy at the time, would regret and would buy when the price came back down again.
  • Support turns into resistance because
    • [Buyers turn into sellers] Buyers that have bought at the support level during the breakdown would be regretting their buy decisions, and would want to sell at the same level to breakeven (this effect is more pronounced the longer the distance between the purchase price and the new lower support level. If the distance is short, this effect will be weak.)
    • [Sellers sell more] Sellers (or short sellers) that have sold and profited would have wished they had sold more, so they sell more when the price goes back up again.
    • [Sellers turn into buyers] There would be sellers that have sold and quickly bought back as their bet turns sour (when prices reverse back) and take a minor loss.
    • [Sideliners turn sellers] People who were staying at the sidelines and saw the price break down through the support, but did not short at the time, would regret and would short when the price came back up again.
  • From the above, it seems that the distance between the old resistance and the new resistance, or the distance between the old support and the new support matters. The greater the distance, the more the old resistance becomes a strong support, or the old support becomes a strong resistance.
  • Another way to think about it is that when a support is broken, there was excess supply at that price level, so when the price goes back up to that level, we would still expect excess supply. Vice versa for the situation when a resistance is broken by excess demand.

Do Trendlines Work? [my notes]

  • There does not appear to be any fundamental logic supporting that trendlines work.
  • After all, nobody thinks in terms of angled lines to determine price levels to buy or sell (unless they have been indoctrinated with the ‘rules’ of trendlines).
  • The only reason why trendlines would work is due to a self-fulfilling prophecy created by legions of traders schooled in that manner.
  • Why then do trendlines appear? Well, if you have a trending stock, you can draw a trendline, it is merely an ‘output’ that can be obtained from a trending price series. Trends by themselves, are generated from greed and fear.

Typical Psychology of Market Participants

  • When the market suddenly plunges, potential buyers who were thinking of buying, would reconsider and wait. They will be waiting for a lower price because they are afraid of the market dropping further.
  • The more the number of participants that bought at lower prices, and the lower those prices are, the stronger is the selling pressure as the stock goes up. This is because traders that bought low are willing to sell as they fear the price dropping.

The Rebound Swing Method

  • Premise: Market generally moves several days in one direction after a rebound off a clear support / resistance level.
  • Suitable market environment: Taking a position in line with the major trend (long in a rising market, short in a falling market – determine the kind of market by just visually looking at the market index over the last 6 months), or in range-bound markets.
  • How it should play out
    1. Price bounces off a visually clear resistance level.
    2. Price bounces off a visually clear support level.
    3. Price turns back down to the same support level, either breaks down or approaches.
    4. A rebound happens when the price goes higher than the  previous day’s high. Place a buy order just above that previous day’s high.
    5. In order for the rebound to be significant, the breakout price (i.e. previous day’s high) should be higher than the support level by an amount equal to 10% of the distance between the support and the resistance levels.
    6. Place a stop just below the low price of the day the stock rebounded (i.e. the day when you placed the buy order). Alternatively, pick a line visually that represents the support, then pick a price point below it for the stop loss.
    7. On the day the price moves more than halfway to the resistance level, place a stop at the previous day’s low.
  • The likelihood of the trade being successful increases if:
    • The stock’s resistance and support levels are aligned with the index’s
    • The price breaks through the support level before rebounding so that it would have taken out traders’ stop losses.
  • This method should only be used if the potential profit (distance from entry point to resistance level) is at least twice (preferably 2-4 times) the entry risk (distance from entry point to stop loss point).

System Testing

  • One way to test trading ideas is to measure the “edge ratio” for a period of a certain number of days (e.g. 5 days) after a trade entry criteria is reached. The “edge ratio” is equal to the Maximum Favorable Excursion (MFE) adjusted for volatility, divided by the Maximum Adverse Excursion (MAE) adjusted for volatility. It essentially measures how much more a stock moves in a desirable direction vs. a non-desirable direction.

Other Points

  • Research by psychologist Gary Klein found that when faced with a decision, experts’ right brain quickly (intuitively) zoomed in on a solution and the left brain then logically evaluates the solution to check it for viability. Novices tend to use their left brain immediately by analysing each possible solution logically, which used much more time.
  • Vertical climbs will always end crashing down.


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