Guppy Trading: Essential Methods for Modern Trading

By Daryl Guppy

A compilation of the very best of Daryl Guppy

Daryl Guppy has been one of Australia's foremost experts on share trading and charting for almost 20 years. His first book, Share Trading, is still a must-read for people wanting to learn about the market and is widely accepted as the best-selling trading book ever in Australia.

Guppy Trading contains detailed analysis of many topics, including:

• making effective trades based on news events and informed trading
• advanced application of the Guppy Multiple Moving Average to assess the true strength of a trend
• how to establish and improve trade entry, exit and stop loss points in volatile markets
• effective trading of international markets
• safely integrating derivatives to boost portfolio returns.

Guppy Trading contains 23 of the most enduring and important chapters from Guppy's earlier books, completely revised, and combines them with 10 entirely new chapters. These new chapters detail new trading methods and instruments that have been developed to create additional opportunities and ensure survival in interconnected modern markets. This comprehensive compendium is critical reading for traders looking to maximise their returns.

• Language: English
• Publisher: Wiley
• Release date: Apr 27, 2011
• ISBN: 9781742468723

Book preview

Part I: Modern trading world

Chapter 1: Different sea — same sharks

The 2008 Global Financial Crisis was a wake-up call for those who thought the sharks were friendly and the financial waters welcoming. Now it is much easier for the sharks to get into our pool and savage our savings. Easy access to the internet and modern technology have broken down the barriers between private traders and the large institutions, but some things never change. Now more than ever it’s survival of the smartest.

This book is about the changes wrought by modern markets, and we look at the Guppy trading methods that have stood the test of time. We introduce modifications and new methods designed to prosper in markets irrevocably changed by the Global Financial Crisis. This is the modern world and some things have changed forever. Before we are overwhelmed with change we revisit some of the foundations, which have not changed.

Trading is tough, but traders who work with smaller amounts of capital have an advantage over traders who must work with larger amounts of capital. This size advantage allows the smaller trader to outperform the market. It is an important trading edge and a foundation of the Guppy trading methods.

Everybody who trades or invests in the market looks for a trading edge. Most times they look in the wrong places and it may take many years and a lot of cash before they discover their mistake. A trading edge is an approach, a tool or a technique providing you with an advantage in understanding how the price of your stock is most likely to behave. There are four stages in developing a market edge, and the last is the most important because it gives part-time and private traders a gift to make their edge super sharp.

The first stage is the most simplistic edge based on a variation of insider trading. This relies on finding out information before others do. Insider trading is illegal, but the search for secret information is not. Understanding the price activity shown in figure 1.1 may provide clues to the insider information used by others. This clearly looks illegal, although it’s rarely enough to trigger a query from market regulators. One popular market approach is based on the idea that hidden somewhere in the company accounts and the details of the business is a fact or interpretation undiscovered by the rest of the market. This is not considered a suspect activity and this search method forms a foundation of the investment industry. These gems do exist but they are rare.

‘Find good companies that are undervalued’ appeals to our sense of the simple, but it rarely provides an investment edge for anyone other than the most skilled professionals. Knowing what is happening is important, but it usually does not provide the edge needed for success.

Some people try to use charting and technical analysis in the same way to find early information. Good chart analysis identifies developing patterns that may be created by traders with more information than the general public. These patterns are discussed in chapter 26, Patterns of informed trading.

The least harmful aspect of this is the search for leading indicators. These are technical analysis approaches claiming to provide advance information of trend changes, of exact market turning points, and at times they claim to tell the future. These are the least harmful because they usually only involve wasted time.

The most harmful development of this idea is found in very expensive trading programs, secret systems and other trading schemes sold to customers desperate for a trading edge. These promoters play on the belief there is a ‘secret’ to the market, and that exclusive information is required for success.

Figure 1.1: possible insider selling

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The second stage of developing a market edge comes with our understanding of personal trading techniques. Not only are there multiple markets to choose from, but there are also multiple useful trading and investment techniques. We could choose to trade only stocks, or banking stocks, or work in the derivatives market. Depending on the market or market segment we select, there is a specific range of techniques that work well. Our task is to find the techniques, or combinations of techniques, we can use successfully.

Our market edge is sharpened when we understand there is no single magic trading approach. Each of us is different, and our personality influences the way we see the market, the way we identify opportunity and the techniques we prefer to use. We sharpen the trading edge by specialising in a single market, or a small group of trading techniques.

The third stage comes when traders apply money management to every trade. Losing is an inevitable part of winning and cannot be separated from our trading activities. This hungry, unwanted partner often consumes all our trading profits and much of our trading capital. We control these devastating impacts by using a risk management rule based on the 2% rule. The chart in figure 1.2 shows how these calculations and discipline protect the trader from devastating losses. It is tamed by techniques to safely grow our trading capital and protect trading profits. The exact combination depends on the market you select and the trading techniques you prefer.

To the novice, this solution seems a long way from the real business of buying and selling shares. The successful trader builds her success on close attention to the details of these techniques. They provide the most important aspect of her trading edge. The professional, full-time trader develops an edge from knowing her selected market, honing her technique and applying disciplined, accurate money management. In this book we discuss the combinations necessary to provide our trading edge.

The fourth stage is perhaps the most important of all and contributes to superior returns. The part-time trader has one additional edge that allows her to outperform her professional counterparts because it gives her a super-sharp edge. It comes in two parts. The full-time professional trader has to trade every day. The part-time trader does not. She simply waits for the absolutely best opportunity to develop, and then trades it.

Our small size, trading in thousands of dollars rather than hundreds of thousands of dollars, is also an advantage. We can trade smaller stocks and enjoy the advantages of price leverage. Using price leverage, the Australian stock IVA in figure 1.3 offered a 378% return over eight weeks. This low-volume stock turns a $10 000 position into $37 872 profit. The trading volume is large enough for the part-time trader, but too small for the professionals.

Figure 1.2: protection from large losses

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Time and small size are gifts given to part-time traders. Many foolishly squander these gifts with impatience and by taking good, but not excellent, trades. Use the gifts of time and size to make careful selections suitable for your preferred trading style. This is the super-sharp trading edge we use. Used correctly it gives an additional 20% to 30% on top of the underlying market performance. Traders who do not acknowledge their small size or use it incorrectly will deliver returns at about the same level as those delivered by the funds, which are constrained by their large size.

Figure 1.3: opportunity for the part-time trader

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Stay in touch with reality

The financial markets are like an ocean full of sharks where large financial institutions, mutual funds, savvy institutional traders and brokerages prowl for profits. The survival rate for the small fish, the private trader — the minnow, or the guppy[1] — is very low.

We are all part of a financial food chain, but the guppy does not have to provide a protein feast for the shark. The ocean is big enough for both of us. Let them eat someone else. As a small fish, I need to survive in order to grow into a bigger fish. You, as a private trader, need to learn and master those strategies most suitable for your size.

We need to consider survival strategies suited to the guppy of the markets. This is not to disparage the skills of professional traders, nor to underestimate the importance of the institutions and funds in providing liquidity. The purpose is to understand we are not them and their rules cannot be ours.

The private trader has a tremendous capacity for self-delusion. Many beginners assume they ought to follow and imitate large professional traders. They believe and hope that Warren Buffett’s investment objectives can also be theirs. We really do not understand Berkshire Hathaway’s objectives, but we know they consistently make money over a long period and we want to do the same. Warren Buffett attracts perhaps more than his fair share of myths. They include:

• long-term investing is for dividends — but his company Berkshire Hathaway does not pay dividends. It’s a pure capital appreciation investment

• Buffett has always been an investor — but his initial stake was built through takeover and merger arbitrage trading as revealed in Buffettology by Mary Buffett

• derivatives are dangerous and should be avoided — but Berkshire Hathaway turned in a second quarter profit fall of 40% or US$1.97 billion in July 2010 due to derivative losses.

The danger in these myths is in the way the unsophisticated believe them and then go on to make fundamental investing errors.

We confuse the activities and image of professional traders with success and try to imitate their behaviour, hoping success will follow. The foolish amateur feigns indifference as if he had a million dollars because he believes the market will soon give it to him.

All of this is, in a word, wrong.

Success does not require you to imitate the methods of institutional traders. There are important differences between us and them. Before we enter the water as private traders we need to know who we are and, just as importantly, what we are not.

What is the difference between Warren Buffett and us? What is the difference between a trader working on the floor for Morgan Stanley and us working for ourselves?

Our answers determine our trading techniques and even more importantly our money management techniques. The mutual funds and institutional traders make our money work for them. Our challenge is to make our money work for us.

There are eight significant areas of difference between traders and the big institutional investors. We look at each in turn.

Transaction size

The first difference is that Warren Buffett, George Soros, Jim Rogers and others all control several hundred million dollars of capital. Not only does this provide them with more capital to trade, but it provides a cushion against losses. The transaction size of each trade is routinely large.

Michael Lewis describes his first steps in the London office of Salomon Brothers in Liar’s Poker:

My first order. I felt thrilled and immediately called the US Treasury trader in New York and sold him three million dollars worth of Treasury bonds.

Quite clearly we are not in the same league. The most inexperienced, junior, untried and untested institutional trader moves more capital in a day than many private traders do in a lifetime.

Their size allows institutions to diversify, buy the best research and have a cushion against trading losses. When we trade with small capital we rapidly become shark food if we play by their rules. The first step is understanding this basic difference. The second step is accepting the difference. The third step is choosing a trading method to fit your size.

The margin of profit

The net profit of a trade depends on entry, exit, transaction size and expenses. Institutional traders control millions of dollars, but generate shark-sized returns from many trades with small margins. They scalp the market by shooting for just a few ticks of profit and make money, thanks to their huge size.

For private traders, profit margins are more realistically measured by the percentage return on capital.

Michael Lewis talks of narrow margins:

Dash knew what [the bond prices] should be … If a price was off by an eighth of 1 per cent, he’d pile half a dozen institutional investors into a trade to make that eighth of 1 per cent. He called his technique nips for blips.

Institutional traders generate huge profits, but their margins are thin. They scalp the market by skimming a small return from each trade. They succeed in this because of the volume of capital.

Can we play the same game? With stocks, two ticks might be as low as $20. And these are profits before brokerage commissions. Every trade also has to cover slippage and overheads such as data costs. After these bills get paid we need to make a return better than the rate of inflation.

These figures are the bare survival margin. To prosper, we have to add enough further gain to be competitive with the return from a riskless cash account. We require a premium for the additional risk we take by entering the market. If we are trading with leverage, then factor in the cost of borrowed capital also. Only after these calculations comes the real profit.

A few ticks is good money for institutions but murder for the private trader. To survive, to prosper and to succeed, the private trader needs a different strategy and different tactics. Changes in modern markets mean we can now use similar tactics in some situations, and we discuss these in chapter 29, Derivative gold.

The ‘no risk’ boss

Trading means choosing and then managing risk. What can we learn from institutional traders? Forget the collapse of Lehman Brothers and Bear Stearns. We are told these are the result of rogue traders but in reality institutional traders often lose a great deal of money — only their bosses usually step in to prevent lethal bleeding. Jim Paul provides a starting point. He writes in What I Learned Losing a Million Dollars:

The market … started down that Monday and I proceeded to lose on average about $20 000 to $25 000 a day, every day for months. By the middle of October I was under water. I didn’t know how far under I was, but I knew I’d lost most of my money … On November 17th one of the senior managers from the brokerage firm came into my office and proceeded to liquidate all my positions.

Overcoming fear and bailing out of a trade as soon as it goes against you is the greatest challenge for every trader. You, as a private trader, have no boss to take you off a sinking ship and put you into a lifeboat. Nobody will step in to help you maximise a winner or exit a losing trade.

Your ability to handle risk and take the tough decisions is what will make you a successful trader. If you copy the institutional traders you will be washed out of the market very quickly because you cannot have losses like them. This is one of the most fundamental differences between yourself and company traders. It is your major weakness, and only by acknowledging and confronting it can you overcome this handicap.

Trading the news

On reflection it is easy to accept that if we do not have the capital size to survive on the small profit margins generated from each trade then we cannot afford to let our losses get out of hand. But do the basics of trading remain the same for the big players and ourselves? Let’s take George Soros as our guide as he writes about Saturday, 28 September 1985 in The Alchemy of Finance:

We live in exciting times. The emergency meeting of the Group of Five finance ministers … constitutes a historic event … after the meeting of the Group of Five last Sunday, I made a killing of a lifetime. I plunged in, buying additional yen on Sunday night (Monday morning in Hong Kong) and hung onto them through a rising market.

Soros was trading news. He was using his knowledge and his understanding of the market, and he made a judgement to anticipate the way the crowd would react to specific news.

It is difficult for private traders to compete on this level. As the smallest fish in the food chain, they receive the news last. If they hear market rumours from a newspaper or a chat room the market has already moved. Even watching CNBC it is difficult to trade news unless they are able to interpret the news and its impact on the market. In chapter 28, Indexing the news, we look at the way private traders trade some news events.

The intelligent private trader concentrates on movements in price action and is prepared to take advantage of this after the news event has nudged a trend to change.

The private trader enters the market armed with the tools of technical and chart analysis. These inexpensive but powerful tools help counteract the advantage institutions enjoy with their access to fast-breaking news. The Guppy methods we discuss show how these tools are deployed to our advantage.

Entering and exiting trades

Everybody closes out a trade to make a profit, or to cut a loss. This assumption ignores two additional factors that make institutional trading fundamentally different from private trading.

Institutions often enter positions for reasons that have nothing to do with their views of the market. A bank whose customers are buying Japanese yen may find itself short yen and start buying yen futures, simply to protect itself from market risk, while working to unwind its cash position.

Institutions also exit positions for reasons that are alien to private traders. One of the largest sectors of the financial industry is the retirement or superannuation fund sector. By law, these funds must keep balanced portfolios, prudently weighted in several investment areas. Their decision to sell a particular stock may be driven by the need to adjust portfolio weightings and have little to do with the health of the stock.

Our objectives as private traders do not include the legal need to keep a balanced portfolio, nor a requirement to wind down sector positions based on fear of being out of step with Wall Street.

When law or circumstance forces sharks to spit out good food, we can find trading opportunities. By learning to swim a short while with the crowd the guppy can benefit and still avoid becoming shark food.

Trading environment

Most of the men were on two phones at once. Most of the men stared at small green screens full of numbers. They’d shout into one phone, then into the other, then at someone across a row of trading desks, then back into the phones, then point to the screen and scream, ‘F– – – !’ Thirty seconds was considered a long attention span.

Does this office portrayed by Michael Lewis sound like your trading office? I trade from home, from a quiet room overlooking the garden. There is no overt emotion associated with entering a trade, although grinners are winners and it is pleasing to see it go as planned. It is disappointing to see a trade go against me, but with proper risk control, it is never depressing.

Until we are able to trade and make a living from our trading, it is the cash book and the journal, the classroom, the hospital office, the agency or the shop floor that defines our working environment.

Private traders tend to trade alone. They lack the support of peers and the support of other people who are involved in trading. Private traders work alone and they are easy prey to their emotions, particularly fear and avarice. Isolation is severe and its effects — depression and impulsive trading — can be harsh.

The solitude of home is not a good place for those who are desperate for human contact with the market, its crowds and the excitement. Internet chat rooms are a poor substitute for peer support because they are populated by so many losers hiding behind false names, imaginative boasts and time-wasting, ill-informed tips. It’s an amusing sub-world, but not the real market.

The solitude of home is a fine place from which to observe the crowd, to trade with discipline and without distraction or pressure to act constantly. The ability to trade with confidence and keep focused is a strength the part-time private trader needs to cultivate. It is one of our advantages over institutional traders.

Offices and equipment

I had a special desk that was on a copper pedestal coming out from the floor. On top of the pedestal was a giant 3’ × 6’ × 7’ piece of mahogany. The table top looked like it was suspended in mid-air. The credenza didn’t touch the floor either. It was a matching piece of wood bolted to the wall, also looking like it was suspended.

Did this help Jim Paul trade? Given he lost over a million dollars, a handsome office wasn’t particularly useful.

Institutional trading is characterised either by traders jammed side by side in a bedlam of noise, heat and limited space in a single trading room, or by a symbolic power arrangement where the office is dominated by THE DESK.

A private trader does not need extravagance. Nor is he forced into the worker-ant colony, battered by the need to trade all the time. Simple, comfortable space is an advantage enjoyed by a private trader. You are likely to have one to three computer screens and a reliable broadband connection.

The length of the internet connection between our trading business and the market has no effect on our ability to trade. It’s the key foundation advantage of the 21st century.

Access to research and information

Institutions have many advantages when it comes to research. They have large support staffs for ferreting out information. They pay for information by directing commissions to its sources. Who is likely to receive market-moving news first — a reporter earning $60 000 a year or a fund manager who throws $60 000 commissions to a good source in one day? Access to hot information gives institutions an edge. Private traders are always further down the line for the up-to-date research.

Access to research and information is an undisputed edge enjoyed by the mutual funds and institutions. However, it is only an edge if you are trading on their terms.

To survive we have to step outside the traditional pool and make much more use of technical analysis and charting tools to identify the mood of the market, to find the twitches in the stock price and to trade the profitable entry and exit points.

Swimming with sharks

We need to compete with the sharks of the financial markets. We have to do it on our terms, not theirs. Savvy institutional traders leave their marks as they move money in the markets, and we identify them using technical analysis.

The institutions have their edge in the market. Their size allows them to ride out losses and buy the best research. Their traders survive and prosper on narrow profit margins by trading very large pools of capital.

As private traders we have a very limited ability to withstand losses, and we need to get a good profit margin from most of our trades. If we compete with the institutions on their terms, we lose. We win only if we capitalise on our strengths.

What main advantages do we have as private traders?

Our first advantage is time. The institutions, like all sharks, need to eat very often and they must move all the time. Their traders have to trade when they come to the office in the morning. Private traders are under no such pressure — we have the luxury of deciding whether the risk–reward ratio is attractive enough to trade. We are able to take our time in establishing trading as a business. The progress from start-up to survival is usually spread over years.

The second advantage is that technology provides us with the tools to even out the playing field. Inexpensive powerful computers, better software and cleaner electronic data help close the gap between us and them. Information flows more freely, more rapidly and at a lower cost.

A third advantage is that by identifying where the big money is moving, we can follow the sharks to trading opportunities. The person on the other side of the trade is not always smarter than we are.

A final and most important advantage is the understanding that the same information can be used simultaneously by many people to make money in the market. The institutions may trade news, but they buy and sell price. As private traders we have access to price data we can analyse in depth using technical analysis software.

We should copy what is appropriate and relevant from the institutions, but we should not copy slavishly. A guppy that stakes out the middle of the ocean is instant shark food. We must plan for survival and growth. Nobody else cares about your survival as much as you do.

The more things change, the more some things remain the same. Conquering greed is a market constant, and we look at these challenges in the next chapter.

[1] For those with a curiosity about the history of the word, the fish Girardinus guppyi or guppy was named in 1866 after Dr Lechmere Guppy, a distant relative of the author and an Amazon explorer.

Chapter 2: Behavioural finance for crowds

GREED stands for Greater Returns Expected Every Day. It is the strongest unfettered emotion felt by every trader and it is a pole star constant in the investment universe. It stands at the centre of behavioural finance, but its impact is more important than the simple parlour tricks created by superior mathematicians to show logic flaws in everyday thinking. It keeps us in losing trades and paradoxically helps turn winning trades into losers because we delay the exit in the hope of recovering lost profits. It gives shape and substance to markets and market behaviour because the market is our personal behaviour extrapolated.

Greed is home grown, but it is triggered by the crowd we mix with. Greed distorts our thinking, harms our reactions and drives us into a self-deceiving financial suicide. Harnessing greed requires balancing the difference between personal behaviour and the behaviour of the market crowd. Increased market communication speed has accelerated the swings of greed and fear. Catching and profiting from the turn in sentiment requires better trade management. The behavioural triggers remain largely the same and they create a foundation for our trading methods.

We profit from understanding these differences and the way the differences impact on market behaviour. We need to refresh our broad understanding of these differences so we can use them to analyse market behaviour. Then we set achievable trading goals for individual stocks.

Difference between traders and investors as groups

Broadly speaking, investors see market investing as calling the long-term market trend. Called correctly this is very profitable, but it is only suitable for cash you can afford to tie up for years. This market approach places a strong emphasis on dividend returns as well as capital gains.

An investor is seldom alone and can draw on plenty of support. There is a financial support industry — herds of financial advisers, fund managers and brokerages, all of whom sell support to the investor. These are guides in the financial jungle. Investing, by its very nature, is a long-term venture. Any doubts about temporary dips in portfolio value are dispelled by members of the financial support industry. They bring out charts that reduce the 1930s depression to an insignificant dip. They conveniently ignore the fact it took 25 years and a world war for the DOW to regain its 1929 highs. The investor rarely feels he is alone. The hands-off approach feels acceptable because ‘everybody else’ is doing it. This is a comfortable feeling for many market participants.

The investor favours a comfort zone created by having a professional guide to run the adventure. Some investors run their own adventures, but they listen to the professional guides — they run when they run, and bluff when they bluff. These common characteristics give body and form to movement in the market. A real jungle guide can distinguish between a venomous snake and a harmless python. Uninformed investors often run away from both.

Again, broadly, trading is about taking advantage of short- and intermediate-term price differences, managing risk and understanding that reward is determined not by your choice of stocks but by your exit from good and bad trades. Trading is always about making a capital gain from the trade. The objective is to take a profit from the changes in price.

It is about recognising when a move has started, and getting out before the move has finished. It is not about calling the market correctly, but about trading the market. A position is neither right nor wrong — it is either profitable or unprofitable. Completing a successful trade does not require forming a precisely accurate view about the market’s direction. It does mean recognising a trading opportunity and taking advantage of it.

The trader’s temperament favours independent decision-making, self-reliance and low-risk situations where risk is effectively managed by the action the trader takes. By the time the jungle guide has steered his party away from the threat, the trader has already discovered new paths to opportunity.

Many smaller market participants are confused about these essential differences between investing and trading. Their confusion leads to poor decision-making and then to substantial losses. They trade by taking a position in a number of stocks, then, when a position goes against them, they hold onto it as an ‘investment’.

The hopes and fears of the small unsuccessful trader are no different from those of the successful trader. Success lies in the self-discipline of the latter. These hopes and fears drive the market. Our task is to recognise these characteristics — these comfort zones — as they are manifested in the market by various groups, and to take advantage of the opportunities presented. The characteristics show up in price movements and these movements seduce many investors into thinking they want to become traders.

All of these groups — investors, private traders, funds, banks, institutional traders and others — make up the market crowd. Every crowd member has four choices. She can buy, or sell, or consider buying or selling. These choices define membership of the market crowd and are reflected in the activity of the crowd.

Unlike individuals, crowds tend to behave in a common fashion, and when we talk of the crowd in this and later chapters we refer to this characteristic. The investigation of crowd behaviour is the foundation for Guppy trading methods. A crowd is more than a group of people assembled in one place at one time. A restaurant may be crowded, but it is full of small groups of people who do not interact with others. But as soon as the smoke alarm goes off and somebody yells ‘fire!’, the people in the restaurant behave as a crowd. United by a common emotion, strangers become linked with other strangers by virtue of the event and their reaction to it. These united crowd reactions also drive the market.

Buy low, sell high

Crowds hang out around prices. Hope coupled with greed creates the highs, and fear shapes the lows. Every stock chart reflects this when it makes new highs followed by new lows several weeks or months later. This up-and-down pattern is reflected in the old trading-from-the-long-side adage ‘buy low and sell high’. Many in the crowd take this as a holy grail, meaning ‘buy at the absolute low and sell on the absolute high’. They waste small fortunes trying to catch such extremes, and having missed them, let go of the trade. Experience suggests that catching the top, let alone the bottom as well, is due mainly to luck.

As indicators of group hope and fear, these price extremes are useful as absolute benchmarks against which trading techniques and performance can be measured. These are the theoretical goal posts.[1]

The very bottom and the very top of each price move provide the theoretical maximum price move we may catch. Note the words ‘theoretical maximum’. Whatever trading system or technique we use, it is unlikely to consistently have us enter at the very bottom and exit at the very top. In reality our entry is more often some distance above the bottom and our exit some way below the top. Understanding and accepting this is an important step towards better trading and better trend trading. Modern market volatility makes it even more difficult to catch the bottom and the top of a price move.

When we accept that catching 100% of the move is absolutely unlikely, we give ourselves permission to concentrate on catching the section of the move that is possible. We should only use this theoretical maximum spread as a measuring rod for our own gains taken from the market and not as a stick to punish ourselves with.

Why should we accept that catching 100% of the move is unlikely, particularly if moves have become smaller and of shorter duration?

Crowds create tides of market movement by acting together in pursuit of profit. Crowds united by common characteristics — their comfort zones — have similar reactions to any given event. Just as the ebb and flow of waves spreads above an ocean tide, the surface of the market is rippled by individual waves with their own peaks and troughs. In the ocean, a gust of wind may whip up the waves, increasing the distances between the peaks and the troughs. These wind gusts are not usually sufficient to change the direction of the tide.

In the market there are similar gusts of wind. The causes are diverse. The collapse of a major American bank, an earthquake, speculation about an early election, rumour of a higher-than-expected inflation figure — the list of possible causes is endless and well explored by television commentators and others.

We can model the impact of these gusts, but we cannot duplicate them. It is difficult to find a market gust that can be isolated, taken apart, analysed, reassembled and tested for validity in a live market. Yet in individual stocks, the price spikes and catastrophic dips seem to suggest there are gusts at work. This is where the trader wants to work.

The market forces producing these gust-driven waves are reflected as price differences. We can best observe market forces through the action of price. We recognise their existence through inference based on price movements and volume.

Our understanding of the forces at work may well be forever incomplete, but this does not prevent us from recognising such forces exist and from taking advantage of them. We are compelled to accept the uncertainty of the cause, but at the same time we can act upon the certainty of the effect.

What we need to understand is that the multitude of attitudes and reactions that cause the market