via TheForexVillage.com
(Bold emphasis mine)
In 1974, an economist attended a conference organized by the investment
firm for which Tom DeMark was a technical analyst. “We were in a big
conference room and an economist comes in with two salespeople from a
brokerage in New York,” DeMark recalls. “They all sit around the table
and ask what interest rates are going to do. Everybody says rates are
going to go down, except me.”
As it turned out, DeMark was correct. He didn’t think much about the
episode, though, until he got a call approximately six months later. It
was the economist who had attended the conference. He wanted to know how
DeMark had developed his surprisingly accurate interest rate forecast.
“I explained that I had drawn a down trendline [on an interest rate
chart], and on the breakout of the trendline I took the difference
between the lowest price and the trendline immediately above it, and
added it to the breakout level to get my objective,” DeMark says. “He
thought I was nuts.”
The economist? Alan Greenspan.
Tom DeMark has a lot of stories like that. After 30 years in the
business, the 54-year-old trader, analyst and advisor has worked for or
with many of the biggest names in the trading industry, including George
Soros, Paul Tudor Jones, Leon Cooperman of Omega Advisors, Michael
Steinhardt, former treasury secretary Robert Rubin (when Rubin was a
partner at Goldman Sachs) and Jon Corzine (current U.S. Senator and
former Goldman partner). For the last five years he has advised Steve
Cohen and SAC Capital, one of the topperforming hedge funds in the
country. In all, DeMark has worked with four of the top traders profiled
in Jack Schwager’s series of Market Wizards books.
And, as the Greenspan story shows, if he hasn’t worked directly with
someone, DeMark has probably met them and will have a story about them,
to boot.
“Everybody in the business probably has something to say about me, good or bad,” DeMark says, laughing.
DeMark’s business is technical trading strategies and indicators. When
asked to summarize his techniques, DeMark quickly responds, “They’re all
original, all mechanical and all objective.”
These are the attributes on which DeMark hangs his hat, a response to
what he has always believed was an unhealthy level of subjectivity and
redundancy in much of the technical analysis world.
His inclination toward mechanical indicators and trading strategies is
rooted partly in his own personality and partly in the unique trajectory
of his career, which began on the institutional side of the business
and broadened to reach the retail trading community, spanning equities,
futures, interest rates, currencies and options. His three books, The
New Science of Technical Analysis (John Wiley & Sons, 1994), New
Market Timing Techniques (John Wiley & Sons, 1997) and DeMark on Day
Trading Options (McGraw-Hill, 1999 — written with his son, Tom Jr.) are
trading industry bestsellers. His indicators and techniques have
continued to work their way into the mainstream, thanks to their
presence on a number of popular trading platforms and networks — most
recently Bloomberg, which added his tools in May of this year.
Although DeMark may not be a household name to the generation of traders
who popped up online in the last few years, he’s been a major influence
in the technical trading community, often behind the scenes, for quite a
while.
Right place, right time
DeMark has said more than once that if he had to give advice on how to
get into trading, he would suggest people not follow in his footsteps.
DeMark started trading stocks in the late 1960s while still in college,
encouraged by a German professor and an uncle who exposed him to basic
technical analysis techniques, including point and- figure charting and
trendlines. He read a few books, made a few trades, but didn’t really
light the market on fire. “I basically broke even,” DeMark says.
After graduating from Marquette University in his home state of
Wisconsin, DeMark made stops in law school and graduate business school
without a clear idea of what direction he wanted to take.
“I didn’t know what I wanted,” he says. “I majored in German and
political science in college and I wasn’t sure what to do after I
graduated. I didn’t really like law school, so I didn’t go back [after
he broke his back in an accident]. In business school, I knew I wanted
to do something with the markets, but I wasn’t sure exactly what.”
DeMark’s first investment job in 1971 with Milwaukee-based NN Investment
Services (NNIS) set the tone for his career. DeMark started out as a
fundamental analyst at the company before becoming, almost by default,
the company’s primary technical market timer. DeMark essentially found
himself in the fortuitous position of working at a major investment firm
that encouraged him to do the unthinkable: research and develop develop
technical timing models.
According to DeMark, NNIS was the most “aggressive and progressive
trading operation in the country” at the time, meaning the company
looked favorably upon technical analysis and market timing concepts. In
fact, DeMark says the firm was flush with capital because its timing
acumen had helped it sidestep the 1973-1974 market meltdown. DeMark saw
his opportunity.
“Even though the senior people there all had MBAs and CFAs, they were
all closet market timers,” he says. “I started expanding on their work.”
DeMark was essentially given a blank check (a $12 million to $14 million
budget, he recalls) to research different technical techniques and
trading approaches. His employers “didn’t care what he did” as long as
they saw positive results. It was the perfect job for someone who was
quickly becoming obsessed with timing strategies, and he took full
advantage of it.
“I subscribed to every advisory service and read every book,” he says.
“I got to know everybody in the business, and I’d fly people out to talk
about different ideas — everything and anything.”
DeMark left no stone unturned in his search for viable technical trading
approaches. What he found under those stones is another story. A
typical find was a doctor and supposed Fibonacci “expert” who offered
the following summation as proof of his qualifications on the subject:
“I’ve been married five times, I have eight kids and every 13 days I
take a vacation.”
Aside from unearthing such “wack jobs” that were all too prevalent in
the technical world, DeMark made what he considered a disquieting
discovery about many of the respectable technicians of the period: They
were all using very similar techniques.
“Everything was the same,” he says of the major technicians at the time.
“They all spoke the same language and they all had the same sentiment
indicators — nothing I really found valuable. How could there be an edge
in something if everybody else was doing it?”
DeMark’s discoveries brought him to two important conclusions: Much of
technical analysis was useless, and almost all of it was subjective.
DeMark’s mandate at NNIS was to find objective timing techniques that
identified exhaustion points, and which could be applied tomorrow the
same way they were yesterday. He decided the way to go was to develop
his own ideas based on first-hand analysis of the markets.
“I had taken every course, read every trading book and advisory service I
could find,” he says. “Ultimately, what I found was that what most
people were using were moving averages, trendlines and other basic
tools. I figured there had to be some value there, but there still
wasn’t any objectivity; nothing was totally mechanical. I had to work on
that myself.
“In 1975-76 I was given the assignment to design mechanical systems for
my firm. Our goal was to get buy signals before the lows and sell
signals before the highs. Because we were so big, we had to sell into
strength and buy into weakness [to get our positions off].”
It was during this period that DeMark initially developed many of the
basic market timing techniques — focusing on price exhaustion — that
would become his stock in trade for the next 20 or so years.
Another part of DeMark’s development was because his firm encouraged him
not to trade stocks as an analyst (to avoid conflicts of interest), he
began trading commodity futures. This brought him into contact with a
new universe of traders and analysts who, he found, were much more
technically sophisticated than those on the equities side of the
business. As a result of his position, DeMark was able to pick the
brains of many of the top traders in the business and break down their
techniques.
“I found out quickly that people on the commodities end of the business
were more creative,” he says. “They had to be more tuned in to what was
happening and sharper in their timing because of the leverage in
futures.”
Among the traders DeMark worked with at the time were Larry Williams,
whom he calls his best friend in the industry, Ralph Dystant (the
“creator of stochastics”) and Welles Wilder.
DeMark’s solo career began in 1978 when NNIS offered to set up a
consulting business in which he was a major shareholder. As a result, he
began directly advising outside clients, including General Electric,
the state of Oregon, the state of Illinois, Atlantic Richfield, Union
Carbide, Citibank and J.P. Morgan. In 1982 he left to form his own
company, Markets Advisory, which consulted for, among others, Larry
Tisch and George Soros, Steinhardt Partners, Goldman Sachs, Union
Carbide, Atlantic Richfield and IBM.
In 1987, DeMark joined Paul Tudor Jones as executive vice president and
head of system testing and market timing. Among the traders he worked
with was Peter Borish, now head of Computer Trading Corp., with whom he
set up a subsidiary company called Tudor Systems.
Since then, DeMark has traded and advised numerous clients, including
Omega Advisors and Cohen, whom he joined as a consultant and partner in
the fund.
The firm of which he is currently president, Market Studies Inc.,
provides consulting services and sells DeMark’s proprietary indicators,
which are now included on many popular trading platforms and analysis
packages, including CQG, FutureSource and Aspen Graphics (in addition to
Bloomberg).
Despite his passion for timing techniques, DeMark points out that
trading systems are only one part — and not the most important part — of
a trading plan. He acknowledges the role discretion often plays in the
techniques of top traders. And he admits to his own weaknesses in the
areas outside timing.
“Everyone thinks having a system is the answer, but it’s not,” DeMark
says. “You need discipline and money management — they’re more
important. You can be right on many successive trades and then let one
blow you up. The discipline is my biggest shortcoming.”
DeMark claims he is not as obsessive as he was a quarter century ago
(when he says he worked virtually around the clock and spent his spare
time doing things like charting his infant daughter’s heart rate), but
you wouldn’t know by talking to him. He talks a mile a minute, cramming
three ideas into the space of one, and running through his experiences
in the markets over the last 30 years.
Over the course of several conversations, DeMark explained the genesis
of his analysis approach, his predisposition toward countertrend trading
and the process of developing objective trading tools.
AT: Do you think you have a natural inclination to be countertrend, or
was that simply an outgrowth of your early work experiences?
TD: I tended to look at things that way because I was always working in
an institutional environment. In that kind of situation you’re dealing
with size positions and you want to go the other way [sell into uptrends
or buy into downtrends] to get your trades off efficiently.
AT: So you were never someone who focused on the longer-term trend and looked to enter on small corrections or pullbacks?
TD: Pullbacks still represent exhaustion, so that’s a viable technique.
But you don’t want to be a typical trend-follower because of the price
vacuums and gaps, which result in slippage. Trading commodities helped
me a lot, because it made me realize that if you’re trying to catch a
trend, you have slippage all the time. But if you go against the trend,
slippage goes your way — it works in your favor.
AT: Do you think your techniques are applicable across markets and time
frames — say, stocks and futures, and intraday bars as well as daily or
weekly bars?
TD: Yes, all time frames and all markets. I don’t believe in developing a system or indicator for one market.
AT: You haven’t found that some techniques only work in certain situations or markets?
TD: No, I haven’t seen that, but I’ve never gone in that direction. I think of those kinds of things as optimized.
AT: Was your approach to break indicators open, so to speak, to see how they work and then try to improve on them?
TD: Yes, I did that with everything. There are certain concepts that
have value, but I think people sometimes apply them incorrectly.
A market can basically do two things: It can trend up or down, or it can
move sideways. But you can’t use the same indicators or techniques for
both situations. Indicators like oscillators work in sideways markets
but not in trending markets, and trend indicators like moving averages
don’t work in sideways markets.
So I tried to find a different way to apply moving averages to address
the reality of this situation. I don’t use traditional moving averages,
but I use the concept of moving averages. For example, I’ll start the
process when there’s a high lower than the prior 12 highs — that’s when I
know the market is in a downtrend; the opposite would be true for an
uptrend.
At that point, I’ll begin calculating a five-day moving average of the
highs. If the market closes above the moving average and opens above
that close the next day, that constitutes an upside breakout. But the
moving average is only active four days, unless the market makes another
high that’s lower than the prior 12 highs. Basically, the market has to
provide evidence it’s in a trend — a high lower than the prior 12 highs
or a low higher than the prior 12 lows — before I’ll apply the moving
average. And when that prerequisite is no longer in effect, the moving
average is cancelled.
AT: Do you have a preference toward a particular time frame or trade length — short-term, intermediate, long-term?
TD: Well, I don’t think it’s useful to think of things that way. Rather
than thinking in temporal terms, I think it’s better to think of things
in terms of percentage moves. For example, short-term might be a 5- to
10-percent move, intermediate might be a 10- to 25-percent move and
long-term might be a greater than 25- percent move. In some cases, a
trade might meet a long-term projection in a single day. If you
accomplish your objective, you should get out of your trade, no matter
how long it took.
AT: One of the early indicators you developed when you were at NNIS
helped identify likely buyout candidates. How did that come about?
TD: I created a lot of models to measure buying pressure and selling
pressure. The indicator was an outgrowth of an attempt to improve on the
accumulation-distribution tools being used at the time. As it turned
out, the indicator was finding buyout candidates before they were
announced.
People were using close-to-close calculations, multiplied by volume, to
calculate price-volume indices like on-balance volume. The problem with
an indicator like that is you didn’t know when it would break out. Also,
you couldn’t relate it from one stock or commodity to another.
The indicators I was developing were all volume weighted, but instead of
a conventional close-to-close approach, I was comparing the close to
the open and relating it to the high and low of the day. So, for
example, if a stock opened on its low and closed on its high, you knew
it was all buying pressure. The approach was to take the close minus the
open, divided by the high minus the low, multiplied by the volume
[(C-O)/(H-L)*V].
Now, that basic formula provided a cumulative index, but it wouldn’t
tell you when a stock would rally or decline if you got a divergence; it
also wouldn’t tell you which stock was better than another stock.
So I took the buying pressure divided by buying pressure plus selling
pressure, which told me what percentage of the activity was buying
pressure. Then I calculated the rate-of-change over different time
periods — say, a 13-period, an 89- period and a 144-period calculation.
This was the TD Pressure Index.
In the process of putting together this indicator, I noticed something
interesting, which I hadn’t expected: Markets make their lows not
because of buying coming into the market, but because of selling leaving
the market.
That’s important. You can see the dissipation of selling as a stock goes
lower — the change in the number of shares bought vs. the number of
shares sold. Say you start out with 20 shares bought vs. 40 shares sold.
As price moves lower you’ll see 18 shares bought vs. 20 sold, and then
right at the low you’ll see 16 shares bought for 8 shares sold. The
selling dries up. At tops you’ll see just the opposite: It’s not that
people are selling at the highs, it’s that the buying evaporates, so by
default, prices come down.
By taking the rate-of-change of the ratio of buying pressure divided by
the combination of buying and selling pressure I was able to identify
buyouts when the indicator got to a high extreme. There were five or six
stocks out of a total of 32 I found over a three-year period where I
went to management — we were managing their pensions in some cases — and
told them, “Look, we can tell by this indicator that you’re going to be
bought out.” One company told us, “There’s no way — we know where every
share is in the U.S.” As it turns out, they got bought by a foreign
buyer. They used to call me the Grim Reaper.
AT: Do you ever do a top-down kind of analysis, where you first look at
sectors and then move down to analyze the most tradable stocks in that
sector?
TD: Yes, you can look at the signals in terms of a sector index, for example, and then look for setups in the individual stocks.
AT: Have you done any research regarding market tendencies on certain
days of the week, or leading up to certain times of the year?
TD: I haven’t really done much work there. I think there’s something to
Mondays, because they often represent a premeditated move in the market.
A gap on a Monday is significant because it gives you an indication of
direction, especially if the gap holds. On Mondays people have had the
weekend to think about things, and the major institutions have meetings
before the opening. If they make a decision on a particular stock that
has longer-term implications, it can cause a stock to gap open.
AT: Do you believe in using any kind of discretion in trading, or do you
favor completely mechanical approaches? Do you see other people who are
successful — perhaps using your tools — who blend in discretion?
TD: There are essentially three ways of looking at the market. Most
people operate on the first level, which is to look at a chart and
guess. There’s no consistency. The second way is to use indicators;
there’s some subjectivity involved, but at least you have a roadmap. The
third level is to use indicators in a very systematic approach.
Ninety-nine percent of people operate on the first level, three-quarters
of a percent operate on the second level and the last quarter-percent
operate on the third level. My feeling is that the typical chartist is a
chart artist. I want to be a chart scientist. When I was developing
techniques, I wanted everything to be mechanical.
But having said that, I know traders who use my techniques on a
discretionary basis — they use them as confirmations. There has to be
some discretion involved. Fundamentals ultimately dictate long-term
moves and if you go against them, you’re going to be wrong.
AT: Do you find it useful to treat the long and short sides of the market differently?
TD: No, I don’t think you can do that. My approaches are symmetrical.
AT: Don’t you see a difference in the way rallies and sell-offs behave?
TD: Seventy-five percent of the time the market will be in a trading
range and any oscillator will work. It trends up 15 to 18 percent of the
time and down 8 to 10 percent of the time. The reason is that buying is
a cumulative process and the analysts become more bullish as the market
goes up and people buy more on margin, but selling is a one-decision
event. That’s why markets go down more quickly than they rise.
AT: But since that makes a difference in how markets move, don’t you
think that calls for a difference in designing indicators and
strategies?
TD: Well, you have a point, but I don’t think so.
AT: Can you describe the trendline based projection technique you used to
make the interest rate call that caught Greenspan’s eye.
TD: Take the lowest low beneath the most recent trendline and calculate
the difference between it and the trendline, and add that amount to the
breakout point.
AT How did you make trendlines mechanical?
TD: For a down trendline — a TD Supply line — you take the most recent
high preceded and succeeded by a certain number of lower highs and
connect it to the next most recent high preceded and succeeded by the
same number of lower highs. You can adjust the number of bars to make it
longer or shorter term. Level 1 would be a high preceded and succeeded
by one lower high, a Level 10 line would be a high preceded and
succeeded by 10 lower highs.
You always connect two points only, and connect the two most recent
according to these rules. Most people are accustomed to starting at the
left side of the chart and connecting the most distant point and
connecting it to the nearest point. But by connecting to the two most
recent pivot points, you’re able to keep adjusting to the market.
Then you can use qualifiers to determine the effectiveness of the
breakout. If a qualifier is there, it will probably breakout
successfully. If a qualifier isn’t there, an intraday breakout will
probably fail. Failed breakouts like that can be good one-day trades:
You fade the unqualified breakout and follow the position with a stop.
AT: Do you think that perhaps having to do things by hand — rather than
having the software on your desktop do it for you — helped you, in that
you developed a unique approach and understood your techniques down to
the smallest detail?
TD: Definitely. The real laboratory was my trading. If I didn’t trade, I
wouldn’t have been as intimately involved in the market. I was losing
money, and I had to develop things — necessity is the mother of
invention. And I didn’t have much money back then. I would tell my wife,
“This is my tuition.” I just kept pressing as much as I could. The
result of pressing a bad position was that I acquired knowledge.
So, it was a twofold learning process: Examining charts — something you
were forced to do because you didn’t have computers — and second, losing
money. Those were the two catalysts.
If I’d had then the kind of computing power available now, I think I
wouldn’t have had the same kind of investment I had in the whole
process. I wouldn’t have been as closely connected to things.
For more trading insights from Tom DeMark, visit www.activetradermag.com.
BY MARK ETZKORN
