,Trade with the Trend. To illustrate exactly how trends comeinto play, we construct a Kinematic Model.The Kinematic Model in Figure 2.1 could represent an indexsuch as the S&P 500, but we use it to represent individual
figure 2.1 the Kinematic Model
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stocks. Though it will prove extremely useful as a teachingand learning tool, please don’t mistake it for a perfect representation of the behavior of all stocks or any particular stockunder all situations. That is far from the case. This theoretical model is not built on any strict laws of science or nature.A quick look at the actual stock market will provide many exceptions to it. We use this model merely to illustrate whatyou should look for and how you should react to what yousee, and also to quicken these reactions, making them almostreflexive. Furthermore, this Kinematic Model will be used inconjunction with other market indicators we discuss in laterchapters.I have mentioned before that no two traders trade exactly alike. Likewise, no two people make the exact same useof this model. Take from it what you can, and leave only whatyou must.In general, stocks go through four phases:1. Accumulation2. Price markup3. Distribution4. Price markdownFigure 2.1 is an idealization of this behavior using a hypothetical stock, Amalgamated Banks and Casinos. The thin linerepresents price variations of this stock. The thicker parallellines represent trading ranges.Assume there are one million shares of Amalgamated outstanding. The $38 to $40 trading range on the left of Figure 2.1represents the accumulation by institutional and other largeinvestors of 900,000 shares. Those investors, believing that thecompany will do well and that the price will rise, were always16
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there ready to buy up the supply when Amalgamated droppedto $38. Some of them kept buying until the price reached $40.Then they would wait for the price to drop again, ready to buyup more shares. They have taken 90 percent of the outstandingshares of this stock out of the marketplace. This leaves only100,000 shares available. The institutions and people who haveaccumulated the stock can only be enticed to sell it by ahealthy profit, which means a higher stock price.Remember that this accumulation phase means the withholding of supply from the marketplace. New demand eventually comes up against reduced supply, ending the accumulationphase and starting the price markup phase. Demand is nowgreater than supply, so the stock price rises from $40 all theway up to $100. A large percentage of the stock holders whohave taken this pleasantly profitable ride are now either satisfied with their profits or believe that the stock price has finished its upward movement. They decide to sell and take theirprofits, ending the price markup phase.Renewed supply coming into the market begins the distribution phase. The price slips down to $98, spurring new demand. This drives the price back up to $100. Supply and demandbeing roughly equal, Amalgamated rises and falls a few moretimes within this distribution price range of $98 to $100.Finally, there comes a time when the supply still comingonto the market exhausts the demand. The price markdownphase begins when demand no longer swallows up all the supply. At this point, with supply greater than demand, the priceof Amalgamated drops.Now, let’s go back and take another, closer look at ourKinematic Model. This model is divided into four phases:1. An accumulation phase where stock price fluctuatesbetween $38 and $4017
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2. A price markup phase in which the price moves upfrom $40 to $1003. A distribution phase where the price fluctuates between $98 and $1004. A price markdown phase in which the price drops to$37What are the characteristics of an accumulation phase?First of all, price fluctuates within a trading range—in our particular model between $38 and $40. Yet this phase looks verysimilar to the distribution phase where the stock price fluctuates between $98 and $100. There is no reason why an accumulation phase cannot also occur within a $98 to $100 range.So what is the difference between these two phases? The difference is that during an accumulation phase, large investorsare taking shares off the market in anticipation of a price rise.During a distribution phase, they are returning these shares tothe marketplace and taking their profits.How can we be positive which phase we are in? There isonly one sure way—if we ourselves are doing the accumulatingor distributing. The next best way is to be in possession ofunimpeachable information. Even if there really is such a thing,in this case unimpeachable probably means indictable, whichoften means incarceration and always means the equally distasteful business of consorting with lawyers. Yet there aretools, methods, and even tricks for making a very educated,unindictable guess. Technical Trading Online familiarizes youwith the most worthwhile of these.Why is it important to know the difference between an accumulation and a distribution phase? Because their outcomesare opposite. The likely outcome of an accumulation phase is aprice markup phase—the time for the stock trader to buy long.
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The likely outcome of a distribution phase is a price markdownphase—time for a trader to sell short.At the end of the accumulation phase, demand outstripssupply creating an upward price trend. The successful stocktrader must understand the psychology behind this trend inthe same way a chess player must understand the psychologybehind his opponent’s moves. Look at Figure 2.2, Point 14. Bythe time the stock price has risen to this point, it has caughtthe eye of a large number of traders. Most of them are regretting not buying in at Points 10 and 13, not to mention Point 8.However, this does not prevent them from hesitating onceagain. By the time Amalgamated rises to Point 16, these tradersare really kicking themselves. Every time the stock has risen,pent-up demand has increased. The small decrease in pricethat ends at Point 17 is just too much of an enticement for
figure 2.2 waypoints on the Kinematic Model
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many of these traders. They dive into the market in a rush, taking others along with them.A significant number of traders were reckless enough tobuck the trend. Maybe they thought they had some inside information, exclusive insight, or perhaps they saw no sane relationship between Amalgamated’s balance sheet and its pricerise. These skeptics have been selling short all along the way,waiting greedily for Amalgamated to crash. Whatever alibithey have for its continued rise, you can bet they are gettingnervous, very nervous. At Point 18, the short sellers have hadenough. They rush to buy in order to cover their shorts. Theirbuying, in combination with that fueled by pent-up demand,shoots Amalgamated’s stock price up into a buying climax( Point 22). This last, precipitous rise is characterized by awide price spread and huge volume.Now the pent-up demand, by definition, is no longer pentup. It’s spent. Once the traders who bucked the trend have already covered their shorts, this source of demand has alsoevaporated. How can demand keep from decreasing? It can’t, atleast not in our Kinematic Model. Satisfied traders taking theirprofits start to provide supply. Supply being greater than demand, Amalgamated’s price slips down from $100 to $98 atPoint 24. Let’s call this point the Reaction After Climax. This reduced stock price attracts new buyers, confident Amalgamated’s price rise will continue. They raise the price back up to$100, the former high, at Point 26. If the stock price breaksthrough to a new high, it just may keep on going. More likely, asour model illustrates, this is merely a test of the previous high(Point 22). Amalgamated slips back down to $98. This slightdrop proves enticing enough to draw in some more buyers, whofigure the stall in share price is just a consolidation. They drivethe stock back up to $100 at Point 28.
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Connecting Points 22 and 26, and extrapolating this lineforward, gives us a resistance line. Drawing a line parallel to theresistance line and through the Reaction After Climax (Point24) gives us a support line. Between the resistance and supportlines, you now have a distribution trading range of $98 to $100.Usually, after a few more unsuccessful tests of the resistance line, sellers begin to outnumber buyers. The market comesto believe that a new high in the near future is unlikely. Itshould not be any surprise to you that since supply then exceeds demand, share price falls. In the case of our model, it fallsthrough the support line at Point 30. With this critical psychological barrier broken, it free falls all the way to Point 31.We have now reached the place in our model where thepsychology behind it becomes most interesting, especially ifyour interest is stimulated by bloodshed. The ancient Greeksbelieved that one of the necessary aspects of tragedy had tobe the hero’s fall from a very high place. If it has not alreadybeen written, some day a doctoral candidate with an interestin the Classics and assets in the stock market, will write a thesis insisting that the high place the Greeks had in mind was astock’s distribution phase. And it would not surprise me ifsomeday someone unearths a long-lost Shakespeare tragedyabout a star-crossed stock trader. I guarantee you that thisplay’s last act will occur during a price markdown phase.It would not take much of a writer to milk the drama inherent in Point 34 or 37 on the Kinematic Model. Our hero would bethe starry-eyed schmoe who entered the market just belowPoint 30. Instead of selling short when the support line collapsed, he smelled a short-term aberration and a bargain stockthat was sure to recover and smash the $100 resistance line onits way up into the stratosphere. Well, he smelled wrong. By thetime our schmoe regains his sense of smell, Amalgamated
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Banks and Casinos has hit Point 34, giving off a rather sickeningaroma. Though his hot stock has dropped 20 points since itspurchase, there is hope in his heart as it then shoots up a wholequarter, then another eighth. He was right all the time. He issure of it. And as our boy watches with more confidence, theprice rises another eighth. Just to make sure the recovery continues, he takes time for a little prayer, “Thank you, God. If youjust let me out of this mess, I’ll never again break the ThirdGolden Rule. No, Lord, this sinner will never again trade againstthe trend.”Sure enough, God answers his prayer, temporarily thatis, and Amalgamated goes up another 7⁄8, to Point 35. Unfortunately, this was just one of those feeble little rallies with itsbright, brief ray of hope illuminating a dark path down to despair and destruction. And as our hero watches his stock priceplunge, he remembers exactly what he ate for lunch, every little morsel. Doing so is easy. It is all on the way back up. Withnot a second to spare, he makes it into the bathroom and findshimself praying to another god, a porcelain one. He holds on tothat toilet with all his strength, as if it were anchored upon thespinning, wave-washed deck of a fragile little ship tossed mercilessly by hurricane driven seas.Against all odds, our hero weathers the storm and survives. He stops at the mirror on his way out of the bathroom,making an ineffective, half-hearted attempt to overhaul his appearance. Walking toward his monitors, he prays silently,“Please God, let there be a rally. Let me out of this position,and I promise to change my ways.”“No deal,” says God. Amalgamated is now on its waydown to Point 37. Our boy can neither eat nor sleep. All hecan do is drink coffee, which helps to explain why he can neither eat nor sleep. He watches the stock’s price sink, takingno solace in what should be a comforting fact: From the look22
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of his monitors, our schmoe is not alone. There are thousandof idiots out there, just like him.Finally, he decides to face up to his mistake, to do what heshould have done 30 points ago. Our hero decides to bite thebullet and bail out on his supposed bargain. Then, like an answered prayer, just as he is about to do so, Amalgamated hitsPoint 37 and starts to recover. Covering his position in Heaven,though unfortunately not on earth, our boy gives thanks toGod. For a little more insurance, he takes out his checkbook andstarts to write a generous contribution to the Salvation Army.However, before he can sign the check, the bottom drops out ofthe market for Amalgamated Banks and Casinos. His fellow investors, gutless thousands of them, just couldn’t take the heatanymore. The pressure was too much. They bailed out whetherthey had parachutes or not. Selling almost simultaneously, theydrive the stock price nearly straight down in a selling climaxcharacterized by a wide, wide price range and high, high volume. Our hero, beaten down in despair, staggers after the hoipolloi and closes out his own position.Prospective stock traders, remember this: Even intragedy there can be solace. Now, at least the pressure is off.Our hero and his comrades find relief in the fact that, even despite the verdict, at least their trial is over. Our boy calmlyleaves the office, telling himself that today he has reallylearned something, which is not an everyday occurrence.Now, instead of writing a check to the Salvation Army, he is onhis way there for supper, by foot. Our hero is at peace withhimself. Maybe he just wasn’t cut out to be a stock trader.Maybe he should look for a less stressful occupation. He pictures himself in a Santa Claus suit, ringing a bell next to a Salvation Army kettle. There is a beatific smile on Santa’s face,and also on his own. The Santa job seems appealing, almostidyllic, especially compared to trading stocks.23
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Dear Reader, the previous paragraphs are not pure fantasy, or even pure fiction. I know well of what I speak, from personal experience. Yes, your esteemed author has made similarmistakes. This book is written to save you the painful experience of doing the same. Just follow my four little oft-repeatedrules. In case you have forgotten, I’ll list them again. In case youhaven’t, read them anyway. The Four Golden Rules of StockTrading:1. Cut your losses.2. Let your profits run.3. Trade with the trend.4. Never average down your losing positions.Now that we have all promised ourselves not to repeatthe mistakes of our departed hero, let us buy for almost nothing his new nineteen inch monitors and return to the market.The first things we notice are some interesting occurrencesthat have happened since his tragic downfall. When the selling climax ended at Point 42, supply was just about exhausted. Anyone who had been inclined to sell either did soor got trampled to death in the rush to do so, thus leaving hisor her stock tied up in probate until the next Ice Age. Demandmay still be weak, but cannot be as weak as supply, not on thehigh side of Chapter 11 it can’t. Amalgamated Banks andCasinos, like a phoenix, rises from the ashes. Well, perhapsmore like a drugged walrus. You see, there were some smarttraders, previous readers of this very book no doubt, who haddecided to trade with the trend. They shorted at Point 33, oreven Point 30. Now, judging correctly that Amalgamated’sprice won’t drop any lower than $37, or perhaps merely deciding not to get greedy, they cover their shorts. Also, there are24
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those traders who see no long-term change in Amalgamated’sprospects despite the drop in stock price. They and othertraders, for various reasons, judge Amalgamated a bargain.Demand picks up and so does share price, to $39 at Point 43.Let’s call this point the Rally After Climax.No rally can last forever, and a Rally After Climax rarely—very rarely—comes even close to lasting forever. There are always some pure-bred short sellers out there, convincedAmalgamated is on its way to Chapter 11. There are also someof those buyers who entered at Point 42 looking for a littlebump. They got it and are satisfied to take their profits. Soshare price drops back down to $37 at Point 45, at the sametime testing the resistance line. The resistance line passes thistest, and what do you know? We have got ourselves anothertrading range.So now, while Amalgamated is caught within a tradingrange, it’s time to find another, more active stock, or betteryet, time to take a short break.At the risk of shocking you, perhaps out of a reader’s stupor, let me state that the Kinematic Model is just that, a model.If you cannot fathom this as plain logic, please accept it as aleap of faith. Real stocks in real markets during a distributionphase will not fit our model exactly. However, you may be surprised by how close they can come. Another thing to keep inmind, the Kinematic Model is more easily applicable to weeklyand daily charts than it is to five-minute charts.In case our model is wearing you out, let me try to lengthenyour attention span by reminding you why you are reading thisbook: It certainly isn’t for the “juice,” no more than you shouldbe trading stocks for the “juice.” No, this book is for people whowant to trade stocks for profit, which in this book means financial profit. Understanding our Kinematic Model will help you acquire these profits. Stocks can do three things: go up, go down,25
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or remain unchanged. When they are going to go up, you wantto buy long. When they are going to go down, you want to sellshort. When they aren’t going anywhere, you want to go somewhere else before their tight trading ranges mesmerize you.Our model, when applied to an actual stock, is an indicator of what that stock will do. It teaches you how to look at thestock and what to look for. It trains you to take a judgmentalapproach by showing you what evidence to weigh. It enablesyou to make more informed decisions and find more compelling reasons to enter positions and, when necessary, abandon them. You will be able to systematize your trading, thusreducing the uncertainty and the stress that can accompany it.Once you have taken a reasoned position, you will then havethe confidence and conviction to act quickly, unflinchingly, andforcefully to either support or abandon that position.Over time, your reactions will become not only more effective, but also more reflexive. They need to. Evander Hollyfieldcouldn’t stop and prepare a strategy for every punch MikeTyson threw at him. Most of Hollyfield’s strategy should havebeen taken care of before he entered the ring. The rest shouldhave been worked out between rounds. When Tyson’s left hookwas on its way, there was no time for Hollyfield to strategize:“Let me see. The conditions are as follows. Tyson’s left hook isone foot from my noggin. My options are—” If Hollyfield everdid resume this train of thought, it would probably be from ahospital bed. No, this was no time to strategize; it was time toreact. Studying our model, then applying it thoughtfully and judiciously to your daily trading, will improve both your understanding and reaction time. Don’t ever assume it will make youbulletproof. Hell, it won’t even make you teeth proof. Anyonewho enters the market, no matter how exceptional his or herstrategy, knowledge, and discipline, is always at risk, and from
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directions and weapons that can and will be surprising. Forgetthis fact, and you may lose more than a piece of your ear. Evander Hollyfield still has all the equipment necessary to sit down.That said, let’s see if we can use the Kinematic Model tomake some money. Look at Figure 2.3. What do we see between Points 1 and 10? Not just a trading range, but also an accumulation phase. What do we see between Points 20 and 30?Another trading range, but this time it encompasses a distribution phase. Despite their opposite outcomes, both phasessure look similar. An accumulation phase’s most likely resolution is up, a price markup phase. A distribution phase’s mostlikely resolution is down, a price markdown phase. So towardthe end of an accumulation phase, you should be looking forbuy long signals. Toward the end of a distribution phase, youshould be looking for sell short signals.
figure 2.3 buy signals
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Take a closer look at the accumulation phase. At Point 7,the support line has withstood three tests. You should at leastbe thinking about buying on support. The resistance line hasalso withstood three tests, but because this is an accumulationphase, it is a good bet that this resistance will eventually bebroken. There is another good bet about how it will be broken.Say you are walking down the street one morning whenyou hear a scream. It comes from a house with smoke pouringout a window. What do you do? That’s right, you check yourwatch to see if you have enough time before the market opens.By chance, you do. Of course the windows are too high to reach,and the doors are all locked. The screaming continues. Youcheck your watch again. If you are going to make the market’sopening, you had better break down the door and do it fast. Youslam your shoulder into the door. It holds. You do it again, meeting the same resistance. You continue to slam your shoulderinto the door. The feel of impact tells you something is about togive and hopefully it won’t be your collar bone. Sure enough, onyour next try, the door flies open and you fly in after it. Therewas no way you could have stopped yourself for a precautionary sniff at the threshold. No, by now you are inside, way inside,eating smoke. The force needed to break open the door and thesudden removal of resistance propelled you forward with addedmomentum. This is exactly what happens at Point 10 on ourmodel. Point 8, if not Point 6, had been our first buy signal, andour next one, just past Point 10 and called the Break High, is afar, far stronger signal—resistance has been broken and momentum is propelling share price higher. Even if you bought atPoint 8, this is a good time to buy again.What then should you do between Points 12 and 13? Thatdepends on exactly what type of trader you are. Chapter 6 isdevoted solely to a discussion of this subject. In the meantime,
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let it suffice to say that there are four main types of traders.Their defining, though not sole characteristic, is the timeframewithin which they hold their positions. The day trader can easily take and abandon 50 stock positions in a day, some of themlasting seconds and none extending overnight. The overnighttrader usually buys his stocks in the afternoon and sells themall before lunch the next day. The swing trader will usuallykeep his positions from a few days to a few weeks. The position trader buys stocks with the intention of keeping them forat least a few weeks.Returning to our model, many of those traders who boughtin between Point 8 and Point 12 are day traders and overnighttraders. They are quite willing to take their profits now. Shouldthey be? If they are pure day and overnight traders, they certainly should be. Their style is to move in and out of trends suchas this numerous times. The position trader has no intention oftaking his profits until he judges the stock to be in or close toits distribution phase. The swing trader is another story. If hethinks Point 12 is the start of a reaction, a drop in price, then heshould take his profits and climb back aboard as soon as theuptrend resumes. In hindsight, there proved to be no point inthis. However, if hindsight did not always come too late, itwould be called foresight. The decision to sell could have beenquite judicious at the time. Here we have the market movingsideways in a consolidation. For those intending to hold on, asmall drop in price would also be acceptable. The lateral movement ends in an upturn just after Point 13. This is our thirdbuy signal.Remember our first buy signal was at Point 8, if not Point6, both points of support. You may have bought at Point 7 because you thought, wrongly in the case of our model, that Point7 would be the Break High, or because you were confident,
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rightly in the case of our model, that even if the price droppedto Point 8, it would rise back again to $40, the line of resistance, and the trading range would continue.You can see from the Kinematic Model that it is wise,when buying on support, to wait for some slight confirmationthat stock price is starting back up. Therefore, our first buysignal should come just after and above Points 6 or 8. Furthermore, watch your stock closely as it approaches Points 7 and10. If you bought at Point 6, it is usually wise to take your smallprofit just as share price starts to drop again, right after Point7, even if (and because) you are sure the price will bounceback up again to Point 10. Just be alert and ready to buy inagain right after the upturn at Point 8.There is another very important reason to wait for a slightupturn before buying on support, as Figure 2.4 illustrates. Tohelp you remember it, we will give this phenomenon an indelible name: the Shakeout-Fake-Out-Before-the-Breakout. Don’t
figure 2.4 sell signals
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for a second forget that you are not the only drooling, overconfident genius who has discovered this trading range and who isbuying on support and selling on resistance. You may also beamong those who have stop loss orders just below the line ofsupport. Let’s say, as sometimes happens, a very slight breakin support at Point 8 sets off some of these stops, thus increasing supply just enough to cause another slight drop in shareprice. Now, instead of share price recovering, the additionaldrop sets off more stops, dropping the share price further, andso on until all stops have been activated and a precipitous fallin share price ends at Point 9.Notice, however, that stock price recovers. The BreakHigh still occurs at Point 10, as if the Shakeout-Fake-OutBefore-the Breakout hadn’t even happened. Unfortunately foryou, if you had set an automatic stop, the Shakeout-Fake-Outknocked you off your rocketing stock way before it even recovered to $38. Clearly it would have been better for you tohave placed a mental stop, but in all honesty you may have activated it yourself anyway. In any case, the sooner your stopwas activated, the less your loss. And if you were smartenough to continue monitoring the stock, you could havejumped back on very soon after Point 9. This would have notonly made you an extra few bucks, it would have saved yousome mental wear and tear between Points 8 and 9.How can you be positive that a precipitous price drop toward Point 9 is merely a temporary price aberration to becalmly weathered, a Shakeout-Fake-Out. You can’t, not positively. However, when you see a similar occurrence involving areal stock, check the volume, and check it fast. You won’t havemuch time to act, if action is in fact necessary. A very largeprice drop and very small volume is a good, though not foolproof indication of a Shakeout-Fake-Out-Before-the-Breakout.If you do bail out, and even if you don’t, you may want to follow31
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the stock price down with an automatic buy stop order justabove it. We will discuss this entry strategy later.In review, return to Figure 2.3. Our first buy signals—signals to buy on support—occur at Point 6 or 8, or better yet,just after them at the slightest confirmation of an uptrend.Our second and superior buy signal, the Break High, occursjust past Point 10. Now our third buy signal, Support AfterBreak High, occurs at Point 13. These are the three buy signalsyou should watch for at the end of an accumulation phase.Monitoring a distribution trading range is a similar exercise, as illustrated in Figure 2.4. At Point 29, the resistance linehas already been tested a few times. Chances are it will outlast the support line in the near future. So just after Point 29,when Amalgamated’s price starts on its way down again, canyou be fairly confident it will fall at least to or close to the support line? You can, and you should recognize this point as SellSignal 1—sell short just after the point of resistance.Now we come to Point 30 and the opportunity for anotherbrilliant metaphor. Think of the support line as ice on a lake.You are skating along and the ice seems fine. You decide to testit with a jump. Sure enough, there’s support. It holds for another jump, and one more. Then you just happen to see thatgood-looking new face in town smiling right at you. You returnthe smile and explode into the air with by far your highest jumpof the day. Bad move. The ice cracks. Ice water is no support atall. You don’