chapter ten

Pitfalls and How to Avoid Them

• Why the Unexpected Occurs

• Recognizing Psychoiogical Barriers

• Counteracting the "Outside Influence"

• Overcoming Greed

• Beat the "Persimmon Effect"

• The Bugaboo of Time Distortion"-and What to Do About It

• Dealing With "Scale Effect"

• Combating Emotional Cyclicality

• In a Nutshell

Understanding provides control and control permits attainment. This is true in all areas of human endeavor, and no less true as regards the market.

Before the Dow theory of price motion was formulated, little or no true control was possible in investing. A few gifted individuals did indeed make fortunes in the market, but it is to be suspected that they did so by intuitively acting on information inherent in price motion.

In more recent years chartists and other "technicians" have advanced the measure of knowledge of price fluctuations still more, and an improved degree of control has become possible as a result. It is the authors conviction that recognition of cycUcality in price motion advances the cause a step further.

This is certainly not the end of the line. Other bits and pieces of knowledge will fail into place as time goes on. This means that the predictive processes described here are not perfect. This further means that operation with these concepts will not always produce the desired results.

It is the purpose of this chapter to outline a few of the resulting pitfalls in the hope that you may then more easily avoid them.

WHY THE UNEXPECTED OCCURS

There are three principal causes of cyclic analysis going awry. The one which must be most guarded against is the totally unpredictable fundamental factor which hits a specific stock without warning. This differs completely from the long-term, smooth, underlying fundamental push characterizmg 75% of price motion. This is the factor that either throws investors into a selling panic, or causes them to flood the issue with buy orders no matter how high the price is driven.

If this occurs in such a sense as to aid your transaction, you should shift immediately to the use of terminal sell signal criteria. If it occurs in such a sense as not to aid your transaction, let your trailing loss level signals be your guide.

These situations do not occur often. When they do, proceed as described and put your funds to work in another issue.

The second cause of difficulty is the unpredictability of magnitude-duration fluctuation of your trading cycle.

Go back now to Figure IX-4. A study of this variable in the cyclic components shows that you can usually avoid trouble here by using sufficient past data in your analysis. The variations are not sudden, and an increased span of past data can help warn you when magnitude is due to dry up on a particular cycle.

A publication that is of considerable help in this regard is Standard and Poors Trendlines, Current Market Perspectives. Although this service does not include all of the issues in which you will be interested, it does include neariy 1000-on both exchanges. These are weekly high-low charts covering about four years.

Never overlook the signs of occurrence. These are:

J. Failure to fill constant-width envelopes, and

2. The formation of triangles, coils, wedges, and diamonds, in the manner of the first one described for Figure -9.

When this occurs due to components of shorter duration than your trading cycle, it can be a great aid. But when it occurs due to the trading cycle itself, trouble Is at hand, and investment in the issue should be temporarily avoided.

Once again you will find it rather rare to be caut in these circumstances, but if you are, your traihng loss levels will protect you against major loss.

The third source of difficulty is caused by overiooking the status of longer term components. Sometimes these will be just emeig from a crossover point of magnitude-duration fluctuation, and hence are not readily observable in past data. At other times this occurs because of the use of an inadequate span of past price history in your analysis.

To guard against this, always keep clearly in mind all of the components of the price-motion model. When performing a cyclic analysis the status of as many of these as practical must be taken into account. If doubt exists, resort to the computational methods of Chapter Six, or select another issue on which to trade.

RECOGNIZING PSYCHOLOGICAL BARRIERS

Your techniques can be mastered to perfection and you can stitl get into trouble with trading. The reasons are psychological in nature. There are several varieties of these barriers and the most important single thing you can do to overcome them is simply recognize that they exist.

COUNTERACTING THE OUTSIDE INFLUENCE

This one is always present, but is of special significance if you have been operating in one way in the past and decide to convert to the methods described in this book. Lets see how it works by example:

Youve been trading in the market for some time with mediocre results. You havent really had any Iccal basis on which to make your decisions-no consistent and unified trading method. You have relied heavily on advice from friends, your broker, etc.

Now you are suddenly exposed to the price-motion model and the resulting techniques of trading. You test it on past stock price-action data. It works in the tests, and youre excited; you are eager to put it to the real test!

You conduct your scans, puU together a stable, and complete your analysis. You are now waiting for an action signal, and have funds free for the transaction when the time comes.

Before this comes about, however, the phone rings. Your broker is on the Une. He says XYZ company is the object of an acquisition move. The stock is now at 21 and the prospects are for 32 when the tender offer is made pubUc. He strongly recommends a purchase.

You hesitate. You know your broker has your best interests at heart. His suggestion is tempting. Hes been in the business for a long time and knows it inside and out. You, however, are only a neophyte. Youve just latched onto a method you think wiU work, but it hasnt really made you any profits yet. And the last tune he gave you a tip you made $1000 in three days. Your self-confidence drains and you eagerly put your waiting funds into XYZ.

Now it doesnt really matter whether you make or lose money on this particular transaction. The point is you are still following your old method of trading on information, which has proven that it provides mediocre results in the long run!

You have:

1. Made up your mind to try something else, because of the evidence that the old method doesnt work consistently.

2. Suddenly changed your mind, and reverted to the old method anyway, because of outside influences.

Now, no real harm has resulted m this case since were only really talking about whether you inaugurate a new system right now or some time later. However, let the same thing occur a er you have made the switch-and youre in trouble.