indicated.When both %K and %D Lines change direction, and the faster %K Linechanges direction to retest a crossing of the %D Line, though doesn’t crossit, the incident confirms stability of the prior Reversal. A powerful move isunder way when the indicator reaches its extremes around 0 and 100. Following a Pullback in price, if the indicator retests extremes, a good entrypoint is indicated. Many times, when the %K or %D Lines begin to flattenout, the action becomes an indication the trend will reverse during the nexttrading range.
Periodicity of DFor commodities, the number of periods to use in stochastics is based on thecycle of the commodity being traded. First, determine the cycle of the commodity, then use the number of bars for stochastics corresponding to onehalf of the period of the cycle. If an 18-day cycle is observed, 9-day stochasticsare used. Shorter-term stochastics should be used to fine-tune an entry orexit at the point of decision. However, the analyst should immediately revertback to the optimum stochastic and be certain to trade with the trend.*
DivergenceQuite often Divergence appears on the chart. The price may be makinghigher highs, but the Stochastic Oscillator is making lower lows. Or, conversely, price may be making lower highs, and the Stochastic Oscillator ismaking higher highs. In either case, the indicator is often demonstrating achange in price before price itself is changing.The Stochastic Oscillator analysis system was originally developed byGeorge Lane back in the mid-1950s. At first, he believed the only valid signalwas the Divergence between %D and the securities price. Later, he recantedand stated this was not strictly true and, furthermore, adherence to theoriginal could get a beginning analyst into trouble.In an uptrending market, Lane has learned, many congested Tops, oftenDouble Tops or Triple Tops (see Chapter 9, Important Reversal Patterns, formore information on Double and Triple Tops), can take several time periodsto turn down and approach the bottom trendline. He refers to them as“Garbage Tops.”* “Stochastics Revisited” by George C. Lane, Technical Toolbox, a special monthly feature ofTechnical Traders Bulletin, December 1990.
AU3772_book.fm Page 656 Saturday, November 18, 2006 5:29 PM
656
Technical Analysis of Stock Trends
¢/BUSHEL
OATS – CBOTMARCH 1997
260
9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
240220200180
%D changed directionbefore %K
160Prices closing near lows
140PERCENT
14 DAY STOCHASTIC %K14 DAY STOCHASTIC %D
100
%K%D
24 1
508 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2SEPOCTNOV
9 16DEC
FIGURE 189. Oats Futures (with stochastic chart), May 1997. Reversals were signaled when the %D changed direction prior to %K’s change in late August and earlyOctober. Prices closed near their lows in mid-July, late September. Late October toearly November prices also closed near their lows, as shown by both %K and %DLines being at the bottom of their range. Chart courtesy of Market Research, Inc.(www.barchart.com).
When prices finally do turn down, they often bottom quickly and turnright back up again, creating “Spike Bottoms.” These are to be expected inan uptrending market. Knowledge of them can be helpful in strong trendingmarkets.
The 0% and 100% MisunderstandingsA misunderstanding some stochastic analysts have refers to the %K reachingthe extremes of 100% or 0%. When the %K Line reaches 100%, it does notmean that the prices can’t go higher. Conversely, even though the %K is atzero, prices can still go lower. Zero is not necessarily a Bottom; in fact, theopposite could be true. The extremes denote strength at the 100% level andextreme weakness at zero.* The misunderstanding comes from levels commonly believed to indicate “overbought” or “oversold.” When the %Kand %D Lines rise above 75%, it is considered an overbought situation.* “Stochastics Revisited” by George C. Lane, Technical Toolbox, a special monthly feature ofTechnical Traders Bulletin, December 1990.
AU3772_book.fm Page 657 Saturday, November 18, 2006 5:29 PM
Appendix C
657
Conversely, if they drop below 25%, it is considered oversold (some tradersuse 80% and 20% for the indicator levels). When the move is a sustainedmove, the price decline can continue for an extended period, with the oscillator remaining near the bottom.
Check the Weekly/MonthlyStochastics, as well as trend charting, should always look at the biggerpicture as well as the tight focus. If a daily chart is followed, it should becompared to a weekly chart for a better understanding of what is happeningin the longer term. The longer-term trend chart helps the analyst to understand developments leading up to the current market situation.Stochastics, used in combination with conventional charting techniquesand common sense, can work well. For example, if an unviolated trend isin force, with no Consolidations or Reversal Patterns forming, the stochasticsignal is likely false. If, however, a Symmetrical Triangle is forming and atrend is being violated, the signal is confirmed.
9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
CORN – CBOTMARCH 1997
¢/BUSHEL400380360340320300280PERCENT
14 DAY STOCHASTIC %K14 DAY STOCHASTIC %D
Near Zero
Overbought 75%
10050
Oversold 25%24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2SEPOCTNOV
9 16DEC
FIGURE 190. Corn Futures, March 1997. Even though the Stochastic Lines arenearly zero, many would consider this oversold. The price of the corn futures continues to decline. Some erroneously believe a Reversal is imminent when the linesare near zero. Near zero signifies extreme weakness. In a sustained move, the valuescan remain in the below 25% area for some time. In this example, the oscillatorremained low from early September through early November. Chart courtesy ofMarket Research, Inc. (www.barchart.com).
AU3772_book.fm Page 658 Saturday, November 18, 2006 5:29 PM
658
Technical Analysis of Stock Trends
Stochastics FormulaStochastics charts begin with three value calculations:• The Raw Value• %K• %DThe three values are plotted on a scale from 0 to 100. If the raw valueand %K are plotted on the same chart, it results in “fast stochastics.” Faststochastics show several up and down swings in a short period of time.When the %K and %D are used, they create “slow stochastics.” Slow stochastics have smoothed data lines.Stoachastics Raw Value = 100 ×
last close – 20-day low20-day high – 20-day low
%K is a 3-day Moving Average of the raw value.%D is a 3-day Moving Average of the %K.
Updating Stochastics FormulaNew %K = ⅔ previous %K + ⅓ new stochastics raw value.New %D = ⅔ previous %D + ⅓ %K.Raw value requires 20 days of information; the 20-day high is the highestprice and the 20-day low is the lowest price for a commodity during that20-day time period. They are not the high and low price from 20 daysprevious.Stochastics can be useful in analyzing changes in commodities trading.It has been around for more than 30 years and has a well-established trackrecord. Even so, like most systems of analysis, it is best used in combinationwith conventional charting techniques and common sense. The price of thecommodity is being traded, not the stochastic signal or other indicator.Although technical indicators can be helpful, they must always be viewedin the context of what is happening with the market trend.
Volume and Open InterestInvestors always like to see strong volume on market advances and lightvolume on declines. Volume is considered an important indicator of marketsentiment in the stock market. It is also important, but different, in the futuresmarkets.
AU3772_book.fm Page 659 Saturday, November 18, 2006 5:29 PM
Appendix C
9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
659
30 YEAR TREASURY BONDSMARCH 1997
POINTS118116114112110108106VOL & O.I1000000500000
24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2SEPOCTNOV
9 16DEC
FIGURE 191. 30-Year Treasury Bonds, March 1997 Futures. With futures trading,volume cannot push the market because for every buyer there must be a seller.Although volume is part of the big picture, forecasting from volume can be unreliable.Notice the volume decline in November, even though prices were still advancing.(See Chapter 6, Important Reversal Patterns, for more information on volume.) Chartcourtesy of Market Research, Inc. (www.barchart.com).
Volume as ConfirmationVolume patterns are considered normal on a day-to-day basis, and anysudden change represents a Divergence. Volume doesn’t have the samesignificance as with equity trading and the information is comparativelydelayed. Although volume is part of the picture, it is only somewhat usefulas a confirmation (in hindsight) of what other indicators are signaling.
Money FlowOpen-interest figures are normally plotted on a line above the volume information. In a general sense, they measure the amount of money flowing intoand out of the futures market. When both sides of a trade are new to themarket, the open interest increases. If one side is new and the other is old,open interest is unchanged. When both sides close out, open interest declines.Analysis of open interest is complicated by (EN: the following factors:)seasonal implications (e.g., hedging activities tend to be heaviest at harvesttime); speculative interest; whether the futures are nearby (it is better to
AU3772_book.fm Page 660 Saturday, November 18, 2006 5:29 PM
660
Technical Analysis of Stock Trends
watch total open interest rather than month by month); intermarket; andintramarket spreading.The relationship between open interest and volume is illustrated in thefollowing table:
Relationship Between Open Interest and Volume:
1.2.3.4.
PriceAction
OpenVolume
Interest
Market
UpUpDownDown
UpDownUpDown
UpDownUpDown
StrongWeakWeakStrong
Open interest and prices will rise as new money flows into the market.Buyers are willing to pay higher prices and sellers are willing to receive them(the number of buyers and sellers is always equal). It is a Bullish situationfor the commodity.When prices rise and open interest declines, there are few new buyersand money is leaving the market. Rallies can be caused by the covering ofshort positions exiting the market. Although the situation can obviously beBullish for the short term, it will turn Bearish. Any rally will falter withoutnew money coming into the market; however, short covering can take longerthan expected.When prices are falling and open interest is rising, and new money iscoming into the market and there is selling pressure, it is considered Bearish.Prices fall and open interest falls is the opposite of situation 2. Shortsellers are staying in the market and long-position holders are closing. Thereis little new money coming into the market and the situation is initiallyBearish, but can turn Bullish. As the declining momentum slows, short sellerswill quickly begin to cover and new money often returns.
New MoneyFutures are dependent on new money for price stability and growth becausefor every buyer there is a seller. With equity stocks, it is possible to havepressure situations with more buyers than sellers or the other way around.It is the new money in futures that creates the rising prices in an uptrend.New money coming in will cause the open interest and volume to rise, butto be a truly Bullish indicator, they must be accompanied by rising prices.The action might be over by the time all three are observed.
AU3772_book.fm Page 661 Saturday, November 18, 2006 5:29 PM
Appendix C
9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
661
30 YEAR TREASURY BONDSMARCH 1997
POINTS118116114112110108106VOL & O.I
O/I Declining/Prices Rising
O/I Rising/Prices Rising
1000000500000
24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2 9 16SEPOCTNOVDEC
FIGURE 192. 30-Year Treasury Bonds, March 1997 Futures. When prices rise andopen interest declines, there are few new buyers and money is leaving the market.Rallies can be caused by the covering of short positions exiting the market. Althoughthe situation can obviously be Bullish for the short term, it will turn Bearish. In thisexample it didn’t turn so Bearish, but rather sideways until the open interest beganto increase with prices. The rising prices showed the entrance of new money. Rallieswill falter without new money coming into the market; however, short covering cantake longer than expected. Note the decline in open interest even though pricesadvanced. Open interest didn’t show a significant increase until early November.Chart courtesy of Market Research, Inc. (www.barchart.com).
Even though volume and open interest data have value as far as the bigpicture is concerned, the data can be late and unreliable if used alone forforecasting short-term. Other indicators can be more reliable, with volumeand open interest used in a more general sense or for confirmation.Volume data with equities can have greater significance because ofimmediacy and the fact that an imbalance of buyers and sellers can exist. Infutures trading there is a seller for every buyer. Open interest data can havesome significance, but it is often not as reliable as other indicators for tradingpurposes.*
* “Volume and Open Interest” from the Technical Toolbox, a special monthly feature of theTechnical Traders Bulletin, July 1990.
AU3772_book.fm Page 662 Saturday, November 18, 2006 5:29 PM
662
Technical Analysis of Stock Trends
Wilder Relative Strength Index (RSI)Although relative strength, comparing a security price to a benchmark indexprice (such as the Standard & Poor’s 500 Index), has existed for many years,the Wilder Relative Strength Index was developed by J. Welles Wilder as asystem for giving actual buy and sell signals in a changing market.Relative Strength is often used to identify price tops and bottoms bykeying on specific levels (usually “30” and “70”) on the RSI chart, which isscaled from 0–100. The RSI can also be useful to show:1.2.3.4.
Movement which might not be as readily apparent on the bar chart.Swing failures above 70 or below 30, warning of coming Reversals.Support and Resistance Levels appear with greater clarity.Divergence between the RSI and price can often be a useful Reversalindicator.
The Relative Strength Index requires a certain amount of lead time inorder to operate successfully.
Swing Failures (“W” Formations)When a Relative Strength Index Line spikes down and penetrates 30 on theIndex Scale, then moves up, then is followed by another down spike (lessthan the first), a buy signal is generated as the index line rises to a levelequal to the middle of the “W” Formation. A sell signal appears in a similarmanner, but spiking up rather than down (an upside down “W”), above 70on the index scale.
DivergenceProbably the most common and significant trend pattern in virtually alltechnical indicators is the pattern of Divergence. Divergence refers to instruments which normally follow the same general direction together movingapart and proceding in different directions, and indicates trend weakness inthe current direction. It often signals a reliable Reversal. Divergences intrends are analyzed between the Dow Industrial Average as compared tothe Dow Transportation Average, stock prices compared to indexes (e.g.,Standard & Poor’s 500 Index) or between futures prices and a 10- to 14-dayRelative Strength Index. Traders will often wait for a confirmation of aDivergence before placing their transactions in order to not be taken in byfalse signals.
AU3772_book.fm Page 663 Saturday, November 18, 2006 5:29 PM
Appendix C
663CORN – CBOTMARCH 1997
¢/BUSHEL400
9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
380360340320300280PERCENT
100
14 DAY RELATIVE STRENGTH
Sell
Swing Failures
Buy50
Swing Failures24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2 9 16SEPOCTNOVDEC
FIGURE 193. Corn Futures, March 1997. The sell signal in July had excellent timingfor a trade. The buy signal appeared in the 14-day Relative Strength Index as the linepenetrated the high point between the Swing Failures in early October and earlyNovember. Also, there is an important Divergence between the RSI moving sidewaysand the downtrend of prices. Divergence between prices and a Relative StrengthIndex is considered an important Reversal signal. The late July through August timeperiod possibly has other Failure Swings followed by penetrations, but they are notas well defined as the others. Chart courtesy of Market Research, Inc. (www.barchart.com).
Time PeriodsAlthough the most popular time period appears to be the 14-day RelativeStrength Index, other time periods can be used. Shorter, 6-day RSIs arefrequently used for intraday analysis to find profit-taking points after theRSI reaches 75 or higher and pulls back. The shorter RSI is more responsivein showing a pause in the current trend. Some go further and use a verysensitive 3-day RSI to determine reentry points as the indicator moves backto neither overbought nor oversold (between 70 and 30). A 10-week RSIDivergence is often used with financials. It frequently gives good signals instock indices, bonds, and currencies. However, weekly signals appear to besomewhat less accurate and frequent in other markets.** “Relative Strength Index (RSI)” from the Technical Toolbox of the Technical Traders Bulletin,September 1989.
AU3772_book.fm Page 664 Saturday, November 18, 2006 5:29 PM
664
Technical Analysis of Stock Trends
POINTS
30 YEAR TREASURY BONDSMARCH 1997
118
9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
116114Resistance
112110108Support
106PERCENT
Divergence14 DAY RELATIVE STRENGTH
100
Buy
50
Sell24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2 9 16SEPOCTNOVDEC
FIGURE 194. 30-Year Treasury Bond Futures, March 1997. Overbought is above 70and oversold below 30. The RSI dropped to the 30 mark in late August, but didn’tsharply penetrate, showing a weak buy signal for the sensitivity of this 14-dayindicator. Although a sell signal was generated after the above 70 Failure Swings inNovember, an even stronger signal was given by the Divergence between the futuresprices and the Relative Strength Index. (See Chapter 12, Support and Resistance.)Chart courtesy of Market Research, Inc. (www.barchart.com).
Relative Strength FormulaRSI is based on the difference between the average of the closing price onup days vs. the average closing price on the down days. A time period of14 days is common, but other periods can also be used.RSI = 100 − (100 I + U D)U = average of upward price closes (EMA of gains)D = average of downward price closes (EMA of losses)Relative Strength Indexes have become popular as countertrend oscillators. They give reliable overbought and oversold indications in most marketsand can show long-term Divergence Patterns indicating Major Tops andBottoms. The buy and sell signals given by an RSI are generally clear, butcan be adjusted to greater sensitivity for short-term or long-term trading.
AU3772_book.fm Page 665 Saturday, November 18, 2006 5:29 PM
Appendix C
665
ROUGH RICE – CBOTJANUARY 19979 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
¢/LB11.010.810 .610.410.210.09.8PERCENT100
14 DAY RELATIVE STRENGTH
50
Sell24 1
8 15 22 29 5 12 19 26 2JULAUG
Buy9 16 23 30 7 14 21 28 4 11 18 25 2 9 16SEPOCTNOVDEC
FIGURE 195. Rough Rice Futures, January 1997. The signals won’t precisely hit theprice bottom or top, but with Rough Rice they hit reasonable levels before theReversals. The sell signal came in July, after the RSI (above the 70 level) showed twodown spikes with an upturn rising above the middle between the spikes. The buysignal came after a similar situation (below the 30 level) in October. Chart courtesyof Market Research, Inc. (www.barchart.com).
Chart patterns offer commodities traders another visual perspective ofwhere prices are likely to go and when they are likely to reverse. Althoughchart patterns have a history of success and need no validation, it is interesting to see how well they match the signals given by oscillators, bands,Moving Averages, and other indicators. Identical signals of trend and changebetween chart patterns and other indicators are common. In fact, if identicalsignals do not appear, the validity of those appearing should be questioned.One of the most frustrating tendencies of all indicators is to give false signalsfrom time to time. The frustration can be partly moderated by using morethan one signal-producing indicator. Confirmed signals and trends, withexperience and understanding of the markets, produce profitable tradingresults.
Important Concepts in Commodities/Derivatives Trading• Prices are influenced by external factors such as weather changes,supply, and demand.• Futures trading is mostly made up of hedgers and speculators in fora shorter period of time than with stock trading.
AU3772_book.fm Page 666 Saturday, November 18, 2006 5:29 PM
666
Technical Analysis of Stock Trends•••••
••••
Futures can have an unlimited number of contracts open.Futures have an expiration date which will influence prices.Stop-loss orders are essential.Make use of more than one indicator to make a buy or sell decision.Trendlines are the most important patterns and can be drawn on theindicators as well as on the prices. Divergence is one of the morereliable signals.Chart patterns can be used in combination with other indicators.Trades are made on prices, not on indicators.Look at the big picture by observing longer-term trends (weekly,monthly).Time periods can be altered on indicators to give a more sensitivepicture (fewer time periods) or smoother picture (greater number oftime periods).
S & P 500(Daily)
678.4665.6652.8640627.2614.4
ARSI Wilder
M
J
J
A9664320
FIGURE 196. Standard & Poor’s 500 Index Futures (SPX). Using a 3-day period fora Wilder RSI gives a clear buy signal, whereas the 14-day time period is indefinite.The shorter time period is more sensitive to recent moves and can give more definitebuy signals. Charts Courtesy of AIQ MarketExpert (www.aiqsystems.com). (Figure197 on the following page also illustrates this concept.)
AU3772_book.fm Page 667 Saturday, November 18, 2006 5:29 PM
Appendix C
667
S & P 500(Daily)
678.4665.6652.8640627.2614.4
ARSI Wilder
M
J
J
A9664320
FIGURE 197. Standard & Poor’s 500 Index Futures (SPX). Using a 3-day period fora Wilder RSI gives a clear buy signal, whereas the 14-day time period is indefinite.The shorter time period is more sensitive to recent moves and can give more definitebuy signals. Charts Courtesy of AIQ MarketExpert (www.aiqsystems.com).
AU3772_book.fm Page 668 Saturday, November 18, 2006 5:29 PM
AU3772_book.fm Page 669 Saturday, November 18, 2006 5:29 PM
appendix D
Resources•••••
Section 1: Important and Indispensable SitesSection 2: References for Further StudySection 3: Investment-Oriented SitesSection 4: The Sharpe RatioSection 5: Calculating Volatility and Examples of Professional RiskAnalysis• Section 6: Gambler’s Ruin• Section 7: The Essence of Fundamental Analysis• Section 8: Software Packages and Internet Technical Analysis Sites
Section 1Important and Indispensable SitesContact information for:john magee technical analysis::delphic options research ltd (jmta::dor)emailjmta::dor website
bassetti@edwards-magee.comwww.edwards-magee.com
SEC Enforcement
enforcement@sec.gov
(Whenever I receive touts or investment spam, I immediately forward it to thisimportant branch of the SEC. All responsible investors should do the same.)TEKNIPLAT chart paper
visit www.edwards-magee.com
Volatilities and Options:
www.optionstrategist.comwww.cboe.comwww.traders.comwww.omegaresearch.comwww.comstar.comwww.aiqsystems.comwww.tradestation.comwww.equis.comwww.prophet.netwww.morningstar.netwww.gomez.comwww.sec.gov/mfcc-int.htmwww.stockcharts.com
Software reviews and infoSoftware demos and packages
Web analysis siteMorningstarIndustry EvaluationsMutual Fund Cost CalculatorInternet Analysis
669
AU3772_book.fm Page 670 Saturday, November 18, 2006 5:29 PM
670
Technical Analysis of Stock Trends
Section 2References for Further StudyOn Volatilities and Options:(and futures)DOW Futures and OptionsAMEX ishares (DIA, QQQ, ETC)On betas
www.optionstrategist.comwww.cboe.comwww.cbot.comwww.amex.comwww.finance.yahoo.com
On Risk:Value at Risk, Jorion, Phillipe; New York, John Wiley & Sons, 1996.Against the Gods, Bernstein, Peter; New York, John Wiley & Sons, 1996.Risk Management 101 (software), Zoologic Inc.See also Appendix E and Chapter 42On Candlesticks:Japanese Candlestick Charting Techniques, Nison, Steve; NYIF, New York, 1991.Beyond Candlesticks, Nison, Steve; New York, John Wiley & Sons, 1994.On Futures:Schwager on Futures, Technical Analysis, Schwager, Jack; John Wiley & Sons, 1996(and other titles by Schwager in References).On Portfolio Management:The Journal of Portfolio ManagementRisk Management 101 (software), Zoologic Inc.
Section 3Investment Oriented SitesAARP Investment ProgramAccutradeADR.comAmerican Association of Individual InvestorsAmerican CenturyAmerican Express Financial Services(American Express now advertises free tradesfor some accounts)American Stock ExchangeAmeritrade (has little-advertised free trade site)Annual Report GalleryBarron’sBigChartsBloomberg FinancialBonds Online
www.aarp.scudder.comwww.accutrade.comwww.adr.comwww.aaii.comwww.americancentury.comwww.americanexpress.com/direct
www.amex.comwww.ameritrade.comwww.reportgallery.comwww.barrons.comwww.bigcharts.comwww.bloomberg.comwww.bondsonline.com
AU3772_book.fm Page 671 Saturday, November 18, 2006 5:29 PM
Appendix DBriefing.comBrill’s Mutual Funds InteractiveBusiness WeekCBS