Benjamin Bakkum 1

Investment Aptitude

“I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat

showed me a profit and I sold it out…Of all the speculative blunders there are few greater than

trying to average a losing game…Always sell what shows you a loss and keep what shows you a

profit,” writes Edwin Leferve in his fictional autobiography Reminiscences of a Stock Operator,

detailing the life of Jesse Livermore, the famous early 20th century trader (129). When growing

up working in New England bucket shops, Livermore kept a close eye on the figures he placed

on the tape for the crowds of amateur traders. After many years of observing the price action of

commodities as well as equities, he could pinpoint what changes in prices were setting up a large

movement in the underlying stock. Livermore had learned how to time the market. Nevertheless,

as Leferve illustrates, knowing when and where to enter a trade or investment is not always

enough. As portrayed in Reminiscences, Livermore had correctly identified an advance in wheat,

utilizing his experienced ability to time his entry, yet he still traded for a loss overall. This failure

to be profitable, however, does not discount the merits of predicting trends with valuation

techniques based on past performance, because with investing discipline, risk management, and

smart position sizing, these techniques come to fruition. Had Livermore quickly and

unemotionally cut his losses and let his winner run, the result would be contrastingly different.

Likewise, various methods of analyzing price action and a firm’s statistics in order to gage future

activity, when coupled with skilled management of the subsequent trade, can prove to be

immensely profitable. If their goal of spotting future upward movement were unattainable,

Warren Buffett and Benjamin Graham’s strategy of value investing would not be so widely used,

nor would trading desks employ technical analysis, implementing the predictive qualities of

candlesticks, price patterns, Bollinger Bands, stochastics, and Elliott Wave Theory.
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Investment Aptitude

Perhaps the most recognized form of investment, value investing has given birth to the

now cliché mottos of “buy-and-hold” as well as “buy low, sell high,” as it searches for when a

quality company is undervalued and poised to jump to its worthy price. The architects and

spokespersons of value investing, Warren Buffett and Benjamin Graham, are two of the most

touted investors of their respective days. Buffet, a follower of Graham even after Graham’s death

in 1976, was named the best money manager of the 20th century in 1999, having become a

millionaire four decades earlier. The two fall into the fundamental analyst camp, which evaluates

equities based on the state of the underlying company rather than the share price movement

depicted on the firm’s chart. Examining the longer term outlook, fundamental analysts and value

investors see a company’s balance sheet and cash flow statement as more important than its price

action. In addition, Buffett and Graham’s ideas concerning responsible investing dictate that in

order to reduce risk it is important to invest in industries that are understandable and easily

recognized by consumers such as Coca-Cola. Graham states in his The Intelligent Investor, “it is

clear that, at the least, a considerable momentum is attached to those companies that combine the

virtues of great size, an excellent past record of earnings, the public’s expectation of continued

earnings growth in the future, and a strong market action over many past years” (390). He

explains that it is easiest and less risky to predict a substantial move in price in established, large

cap companies with consistently growing earnings. This criterion represents the first step for

value investors in identifying solid and potentially profitable trades. Graham reinforces this

component in stating, “when the going is good and new issues are readily salable, stock offerings

of no quality at all make their appearance…Wall Street takes this madness in its stride, with no

overt efforts by anyone to call a halt before the inevitable collapse in prices” (392). Instead of

falling into this trap and being enveloped in the frenzy of higher prices, Graham attempts to find
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Investment Aptitude

the large, fundamentally sound companies which are priced lower than their intrinsic value, what

they should be trading for and will, in theory, eventually reach. He cautions traders to not look at

the explosive charts and technical signals backing the inflated smaller caps, but to find stocks

with a margin of safety, the second part of his and Buffett’s ideology, the difference between the

intrinsic value and the actual price. They hypothesize that these strong and undervalued stocks

have the highest probability of providing consistent returns, with the margin of safety providing

almost a guarantee that a share higher price will eventually be attained. “Thanks for the lecture,

says the gentle reader. But what about your “bargain issues”? Can one really make money in

them without taking a serious risk? Yes indeed, if you can find enough of them to make a

diversified group, and if you don’t lose patience if they fail to advance soon after you buy them,”

he continues (Graham 393). Finding the well known companies with attractive income

statements and timing an entry before they have reached their intrinsic value only has its merits

when added to the toolset of a disciplined investor, however. Graham stipulates that having the

patience and a lack of emotion to stay with the companies that have been predicted to rise in

price can be just as important as the timing itself. Both the methodology of anticipating the move

and treating the investment as a business are integral in earning a profit. Buffet, in the preface to

the most recent edition of The Intelligent Investor, sums up the relationship between timing and

risk management, “If you follow the…business principles that Graham advocates…you will not

get a poor result from your investments…Whether you achieve outstanding results will depend

on the effort and intellect you apply to your investments, as well as on the amplitudes of stock-

market folly that prevail during your investing career. The sillier the market’s behavior, the

greater the opportunity for the business-like investor” (viii). The floundering of the undisciplined

investors maximizes the returns of the smart and patient by injecting more capital into the market
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Investment Aptitude

which is reaped by the value investors who wisely hold steady in their defensively large cap

though undervalued investments. The value investing strategy puts forth the time and place of the

investment; the trader must put forth disciplined patience and strive for the award winning level

money management Buffett has practiced.

Contrastingly, aiming to predict much more short term moves compared to the “buy-and-

hold” outcome of the fundamental analysts and value investors, technical analysts simply look at

the chart before them instead of deeply investigating a company’s spreadsheets and quarterly

reports. Just as long term investors can be divided into those in the Graham and Buffet following

and those who hope to predict and profit from the smaller publicly available corporations, traders

can be categorized in their interpretations of price action. Some focus on the impact of intraday

movements within the wider angle of a few weeks to a year, while others target the patterns

constructed over the course of several months, and still others look at the implications of price

moves in oscillators and

indicators. Steve Nison, author

of Japanese Candlestick

Charting Techniques, explains

the merits of technical analysis

beyond simply timing profitable

trends, “Technicals are also an

important component of

disciplined trading…they
Figure 1
provide a mechanism to set

entry and exit points, to set

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Investment Aptitude

risk/reward ratios, or stop/out levels. By using them, you foster a risk and money management

approach to trading” (10). Nison, just as Graham, recognizes the need for intelligent decision

making and management of the trade after an entry has been timed. The two differ in their

methodology, however, with Graham advocating patience and conservative investments, and

Nison endorsing the use of candlesticks, an approach to charting derived from the far East.

Candlesticks portray the intraday patterns of an underlying asset, marking the open,

close, high, and low of the trading session. Figure 1 illustrates candlesticks applied to the chart of

the Dow Jones Industrial Average. The body of a candle, or the thicker portion of it, represents

the difference between the open and close of the trading day. And the shadows, or the thin lines,

exemplify the range between the high and low of the session. The red candles are down days, in

which the market opened at the top of the body and closed at the bottom of it. And white candles

are up days, with the market opening at the bottom of the body and closing at its top.

Candlesticks are most widely

used to predict changes in trend,

otherwise known as reversals.

What the candles indicate about

a reversal must be clarified,

however, “a trend reversal

signal implies that the prior

trend is likely to change, but not

necessarily reverse” (Nison 27).

Figure 2 One such candle that signals a

potential change is the doji,

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Investment Aptitude

which indicates that during intraday trading the market opened, moved higher or lower, reversed

until surpassing the open, until finally increasing or falling to close at, or near, the open. Figure

2 illustrates a doji on the chart of Amazon.com, which signals the possible end of the sideways

trend. The next trading day Amazon’s share price gaps higher, confirming the end of the trend

and breaking into a higher price range. While Figure 2 marks the significance of a doji in a

sideways trend, it can also be applied to up trends as well as down trends. Nison differentiates

the meaning between the two in describing, “as good as doji are at calling tops, based on

experience, they tend to lose reversal potential in downtrends. The reason may be that a doji

reflects a balance between buying and selling forces. With ambivalent market participants, the

market could fall due to its own weight. Thus, an uptrend should reverse but a falling market

may continue its descent” (151). Therefore, traders must not blindly follow the simple cookie

cutter implications of the doji and other candles, but understand what other possible outcomes

there may be, and manage risk by adjusting their position size accordingly. Subsequently, the

importance of combining disciplined management of the trade with the actual signals to enter

and time the market is apparent. And just as the value investor requires a margin of safety,

technical traders demand cleanly determined entries and exits based on price action which serve

to minimize losses and risk.

While analyzing candles unpacks the meaning of intraday trading within the whole of a

time period of weeks or months, patterns also emerge looking at the time period itself.

Commonly referred to as price patterns, shapes such as triangles, channels, and flags on a graph

often depict the consolidation of prices after a quick move on higher volume and in themselves

indicate another volatile change in prices. For instance, a common coiling pattern, the

symmetrical triangle, looks as though the price action is bound within a triangular box. The
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Investment Aptitude

chart of Agfeed Industries in Figure 3 portrays this pattern. After exploding out of the downtrend,

FEED begins to coil, making smaller and smaller moves until reaching the point on the right of

the triangle, where the price is forced to rocket up once more, signaling the beginning of the

uptrend. A strategy

applying price pattern

analysis to equities such as

FEED would obviously be

profitable in this instance.

However, risk management

again proves to be salient.

At the pinnacle of the

triangle, it is possible that

Figure 3
FEED could have broken

down and reentered its long

term downtrend. Yet after waiting for confirmation of the new uptrend, a large part of the

possible gains would have been lost. Therefore, a trader must be cautious, comparing where the

market as a whole lies in order to predict in what direction FEED should break out to. Another

option would be to enter FEED before the break out with a small position size in order to not

miss out on the initial advance in price. And then add to the position after confirmation of the

uptrend is received to increase profit from the resulting move. Even though historically a high

percentage of stocks do indeed break out, there is the additional possibility that Agfeed would

make no significant jumps in share price for the time being. This is where risk management

becomes even more important. Charlie Wright explains in Trading as a Business, “I have never
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Investment Aptitude

been able to predict when the market was going to facilitate trade and get in for the big move.

Instead, I…ensure that I will be in for the big ride and my losses will be minimized while I wait.

It’s just a matter of good business sense” (9). Price patterns and all methods of predicting the

market merely signify an increase in the probability of certain scenarios taking place based on

what has normally preceded those moves in the past. They are not definite indications. And their

merits do not lie in being a golden way to capture millions from the markets, but in comprising

part of a team of skills traders can implement entering, during, and exiting a trade.

In addition to interpreting the literal price action, indicators can be applied to the chart as

well as viewed in the form of oscillators. John Bollinger developed what has come to be known

as Bollinger Bands in an effort to provide another tool for predicting the beginning of break outs

and trends. The bands are constructed above and below the central point of the price, and are

calculated by including the average price and average volatility of a given time period. John

Bollinger identifies the most

appealing indication made by

his bands, The Squeeze, in

stating, “The Squeeze draws

more questions than any other

aspect of Bollinger Bands and is

without doubt the most popular

Bollinger Bands topic. There is

something about a dramatic

Figure 4
and/or prolonged contraction of

the bands and the subsequent

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Investment Aptitude

explosion of activity that captures the attention” (119). Figure 4 gives the appearance of several

of these “squeezes.” When the bands converge on the actual price, it is reasonable to believe that

a major breakout is about to take place. Looking at the chart of FEED with the bands applied, at

the points where the price breaks out of its down trend and then the resulting triangle, the bands

close in on each other and then expand as the stock breaks out. Thusly, traders monitor the bands

for periods where they begin to move in on the price, sensing a break out and resulting profits.

Oscillators such as stochastics can also be applied to such a situation. The stochastic oscillator

creates hills and valleys which represent when the underlying equity is either overbought or

oversold by comparing its closing price to historical prices. Its time frames are adjustable,

making it applicable

and easy to interpret

on any period given

on a graph. Figure 5

represents the

stochastic oscillator

applied to the chart

of Bank of America.

As apparent on the Figure 5

graph, when the

stochastic reaches

over the 75 level it is

probable that the

share price will soon

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Investment Aptitude

drop or at least consolidate. The opposite is true when it dips below the 25 level. Also, between

January and March it appears there is an upward trend in the indicator, even while the price

continues it’s down trend. This scenario represents a divergence in the price and oscillator,

signaling a change in trend in the future, which then soon arrives in mid March. Figure 5

illustrates the blatant power of these indicators and technical analysis, yet even with these tools,

the lessons expounded by Graham, Buffett, and Nison concerning risk management ring true

even in the calculating mind of Bollinger as he writes “time frames are inferred, indicators are

recommended, and approaches are discussed. In some places the recommendations are specific

and in others deliberately vague. All have one thing in common: You must suit yourself if you

are to be successful” (30). He elucidates that much like value investors develop their own

research about a company and a margins of safety, traders need to utilize indicators in relation to

their portfolio and amount of capital to reduce their risk. Bollinger implies that superb risk

management has to be done individually and while key, cannot be taught easily. Therefore

traders and investors are required to, through trial and error and over the course of years, gain

and understanding of how to integrate market timing with money management in the context of

their unique market posture if they intend to unleash the potential of predictions made by

whichever strategy.

Likewise, risk management must be practiced even more greatly when following

sometimes skeptical theories. Developed in the 1940s by R. N. Elliott, Elliot Wave Theory

connects collective human behavior with the Fibonacci sequence to come to the conclusion that

the market acts in trends composed of five “waves” or smaller trends after which three corrective

waves move the share price in the opposite direction. The theory goes on to propose that five or

three even smaller waves compose the original primary five and corrective three waves. After the
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Investment Aptitude

publication of Nature’s Law: the Secret of the Universe, in which Elliot explains the sum of his

analysis concerning the theory, it has reached widespread use, but has been met with criticism

concerning its subjectivity and its multiple interpretations that have cropped up. Figure 6 applies

his theory to United Health Group’s chart. Within the upward trend between March and June,

five smaller

waves are

apparent within

the larger trend.

As the five waves

mean this trend

5
has completed its

cycle, according 4
3
2
to Elliott Wave
1 1

theory the trend

should now
Figure 6
reverse. There

are still many

traders, who

prescribe to this idea and Elliott’s investing doctrine, which look for the waves on numerous

charts of share prices and who have profited greatly from what seems to be a natural cycle within

the markets. Yet again, however, discipline accompanies these successes. In his book, The New

Market Wizards, Jack D. Schwager describes a story in which he overlooked one of his trading

rules to not listen to whatever tips and theories were swirling around Wall Street. Jack listened to
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Investment Aptitude

his friend, Harvey, an Elliottician, concerning a trade he believed to be a definite winner. Come

the next trading session, the security gapped in the opposite direction Jack and Harvery were

hoping for and caught up in the emotion of the trade, and voiding another one of his rules, Jack

opted not to cut his losses, deepening the erosion of his capital. Learning from Jack’s mistake,

traders need to remain cognizant of the market’s inherent risks and position themselves in a way

which will maximize the profits capable by their strategy and minimize the losses, even when

harnessing the complex theory of Elliott Waves.

As exposed in the successes of Buffett, Graham, Nison, Bollinger, Elliott, and the charts

portraying the correct forecasting of technicals, attempting to time the market does have its

merits in profitability and being a component of a group of skills which lead to investing success,

regardless of what the proponents of the Efficient Market Hypothesis may argue to the contrary.

However, none of these techniques represent a golden key which will open up millions for any

passerby who might stumble upon and use them. In fact, though they focus on differing aspects

of a company and its share price and operate on different time frames, fundamental and technical

analysts are comparable in that they use mechanisms through which to predict market

fluctuations and have a historical basis. Charles Faulkner explains further in an interview for The

New Market Wizards, answering a question on what characteristics can be found in successful

traders, “they have a perceptual filter that they know well and that they use- By perceptual filter I

mean a methodology…Classical chart analysis, Elliott Waves, or Market Profile-all [of] these

methods appear to work, provided the person knows the perceptual filter thoroughly and follows

it” (161).The great investors in the past and present illustrate that whether they use fundamental

or technical analysis, adequate risk management must also be in their trading repertoire for any

significant and consistent returns. The investor or trader must tailor whichever strategy to his or
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Investment Aptitude

her market posture and remain disciplined. While observing historical price action and what

implications past balance sheets can have on share price may result in profitability, only with

discipline will cash flow remain positive. It is a common Wall Street adage that “if you treat

trading like a hobby it will pay like a hobby, if you treat it like a business it will pay like a

business” (NP).
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Investment Aptitude

Works Cited

Bollinger, John A. Bollinger on Bollinger Bands. New York: McGraw-Hill, 2001.

Graham, Benjamin, and Jason Zweig. The Intelligent Investor The Definitive Book on Value
Investing. A Book of Practical Counsel (Revised Edition). New York: HarperBusiness
Essentials, 2003.

Lefervre, Edwin. Reminiscences of a stock operator. Hoboken, NJ: John Wiley, 2006.

Nison, Steve. Japanese candlestick charting techniques a contemporary guide to the ancient
investment techniques of the Far East. New York: New York Institute of Finance, 1991.

O'Neil, William J. How to make money in stocks a winning system in good times or bad. New
York: McGraw-Hill, 1995.

Schwager, Jack D. The New Market Wizards Conversations with America's Top Traders. New
York: Collins, 1994.

Wright, Charles F. Trading as a Business. Justin, Texas: Omega Research Inc., 1998.

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Brock, William, Josef Lakonishok, and Blake Lebaron. "Simple Technical Trading Rules and the
Stochastic Properties of Stock Returns." The Journal of Finance 47 (1992): 1731-764.

"The Intelligent Investor: Benjamin Graham." Welcome to Investopedia.com - Your Source for
Investing Education. 30 May 2009
<http://www.investopedia.com/articles/07/ben_graham.asp>.

"Where did the Wave Theory come from?" Elliott Wave International: Expert Market Forecasting
using the Elliott Wave Principle. 30 May 2009
<http://www.elliottwave.com/introduction/wave_theory.aspx>.