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