.11 Cisco Systems L and reverse L continuation patterns. Created withTradeStation 2000i by Omega Research 1999.
relationship after the three- to five-bar correction generally points thedirection of the next thrust. Enter the market after the third day if closeand open point to continuation of the move.Stop is one range below the low of bar of entry. Target objective is50% to 100% of the prior thrust added to the high of the initial thrust.Figure 6.11 demonstrates the use of this tool on Cisco.DOUBLE TOPS AND BOTTOMS
Minute double tops and bottoms over a three- to five-day period is avery useful tool as a reversal pattern (Figure 6.12). Nate that widerange reversal bars are an important ingredient (Figure 6.13).
FIGURE 6.12bottoms.
Double tops/
FIGURE 6.13comparison.
Double bottom/
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FIGURE £.14 Cisco Systems double tops and bottoms, treated with TradeStation2000! by Omega Research1999.
Figure 6.I3A shows a valid double bottom as both days at the bottom have a wide range and high close. The double bottom in Figure6.13B is questionable as the second bottom reversal is small range. Figure 6.14 on Cisco Systems shows this pattern.
SMALL MORNING TAILSA trending market frequently has a counter move in the morning andthen reverses and has a powerful move in the direction of the prevailing trend in the afternoon (Figure 6.15). A small tail is when theopening to low is less than the high to opening. A possible long entrysetup is as follows:1. Market moves down from the opening to about mid-day.2. Movement down 19 less than a halfrange from the opening.3. Enter a stop buy above the high oropening of the day.4. If filled, enter stop of three to eightticks below the low of the day.
FIGURE 6.15movements.
Small morning
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The move does not necessarily have to happen on the day of the tail. Forinstance, it may dip down in the morning, and come back above theopening and close there. The following day is when the big trend daytakes place. Early confirmation of lack of supply is necessary.Further study on early morning strength followed by late day selling(and vice versa) is available from The Taylor Trading Technique byGeorge Taylor (Traders Press, 19501 and A Journey through Trading Discoveries by Peter Steidlmayer (1996).A number of people have written and discussed the merits andshortcomings of these studies which should be perused by market students who uses judgmental type trading.Taylor assumed that market momentum for the next bar would equalthe momentum of the prior two bars. The forecast for tomorrow's high,low and close are a function of the two prior bars action as shown in Figures 6.16 and 6.17. He had two ways to predict the next bars action:1. High to high movement of two prior bars for predicting the nextbars high. This assumes the same momentum of the highs. Thelow to low momentum predicts the next bar's low. The same holdstrue for the close (our innovation on closes).2. Low to high and high to low. This is also known as the crisscross. The low of bar one to the high of bar two projects the highof the next bar. This distance is added to the low of bar two topredict the high. The opposite is true for the low forecast. In allcases A1 is equal to A.Markets that are up in the morning may sell off in the afternoonand (vice versa). Just as the opening on some days is the low or high ofthe day that gives rise to the opening range breakout, there are many
FIGURE 8.16 Next bar forecast based on high to high, up to low, and close toclose.
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FIGURE 6.17close.
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Next bar forecast based on low to high, high to low, and close to
days that go both up and down. Steidlmayer calls this a rotating day.These targets are potential action points for the rotating day. Position istaken with the expectation that markets will find support or resistanceat these objective points. This methodology is difficult to incorporateinto an exact mechanical system. However, potential action points canbe clearly defined and rules may be defined such that subjective interpretation is kept to a minimum.A suggested way to use this information is to establish zones of support and resistance where the market is likely to reach and then changedirections. For instance, a zone of resistance might be the average of thehigh to high thrust, the low to high thrust, and the high of the priorday. You would look to sell in this zone with a half range stop. It hasbeen our experience that the market will enter one of these zones eachday. Trade with the trend and look at the nest lower time frame beforetaking a position. This is a beautiful way to trade the two- tothree-day moves. You are buyingon short-term weakness and selling on strength (and vice versa)every two to three days.Expansion of these basicideas is to use a three-day average for projections of zones ofsupport and resistance. Drummond geometry has expanded onthis work by trading around thethree-bar average and by use ofmultiple time frames.The last three bars may alsobe used to predict the zone of sup- FIGURE 6.18 Zone of support based onport as shown in Figure 6.18. The three prior bars.
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high to low forecasts of the prior two days are used to forecast the expected low range for the next bar. This is the zone to consider a long position or liquidate a short.CLEAR OUT PATTERNS
This powerful tool is a form of spring orupthrust (Figure 6.19). The primary difference ix that it happens all in one day.Conditions are:1. The market opens above a priorresistance point such as a priorday's low.2. It moves down and takes out the FIGURE 6.19 Clear out action.low by a small amount (less thana half range). Stops are taken out.3. It reverses direction and takes out the high or opening of the day.This is the point to enter. New shorts are trapped.Beware if the market moves down a half range below the prior day'slow and just gets back to around or slightly above the low. The openingand first move off the opening the next morning holds the key.Anticipation is the key to using these patterns. At mid-morningenter stop buy at what may seem a very high price. When and if it getsthere later in the day. you are on board.OVERLAPPING AND NON-OVERLAPPING BARSOverlapping bars is where all of the bars are inside the range of theprevious bars (Figure 6.20A). Non-overlapping bars is where a bar orbars are not inside the range of the previous bars. Figure 6.20 shows that thelow of bar one is greater than the high ofbar three. Some judgment is involved intrading in this manner. This is a simplemarket principle that will let you get onboard a market when it is slightly oversold in an uptrending market and viceversa. The fundamental idea for a buy isto wait until a correction shows the high FIGURE 6.20 Overlapping andof a correction bar is less than the low of non-overlapping bars.
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the top bar in the thrust. You then buy on some expression of marketdownside exhaustion or a sign of strength such as:1. A narrow-range period implying supply exhaustion.2. An up bar that closes above two prior closes.3. Movement away from the opening and above two prior closes.Stops and take-profit orders should be placed upon entry into themarket. Strong uptrending markets have few non-overlapping downsidebars.Non-Overlapping Top and BottomA non-overlapping top is when a day sells completely below the low ofthe top bar (Figure 6.21). This may be the first day or several dayslater. A bottom is the mirror image. These are only guidelines. Youmust have a trading plan in place for market entry, stop, and liquidateor take profits.Uptrending markets have few downside non-nverlapping bars asshown in Figure 6.22A. A non-overlapping bar always occurs in a trendreversal as shown in Figure 6.22B. Look at the three bars following anon-overlapping bar for guidance. If the market is unable to rally backinto the top bar within three bars, it shows supply and further downside action is possible. Use of this idea is helpful in determining the direction out of a congestion zone.Markets lend to visit the same area two to three times. If markethas a non-overlap day on the downside, the sell point is 1 to .5 rangeabove the high of the non-overlap day. This works beautifully when amarket first enters congestion. Be careful after about the third tofourth swing as the market may be preparing to leave congestion.
FIGURE 6.21
Nonoverlapping tops and bottoms.
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FIGURE 6.22
Trend continuation and change.
TWO-DAY INTERSECTIONTwo wide-range bars to the upside that overlap only a small amount indicate aggressive demand for two bars in succession. The intersection ofthese two bars in a zone of support/resistance as shown in Figure 6.23Orders placed around these points can let one get on board with a smallrisk. Stops would be just outside the zone.
FIGURE 6.73
2 Wide range bars.
CHANNEL TRADING SYSTEMSThere are a number of channel systems commercially available that sellin the range of $3,000 to $10,000. Some have shown good profits over theyears and are based on exact mathematical rules. Others involve somejudgment in trading and cannot be programmed, The three types are:1. Keltner channels. This is a constant width channel based off amoving average such as a 10-day. The exact width is a percentage
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of the price. One has to use different amounts depending on thetime frame. One is looking for a channel width that encloses mostbut not all of the bars. The original Keltner used an averagerange above/below the channel.2. Bollinger bands. This is a standard deviation from an averageclose.
3. Donchian channels or Turtle system. This is a breakout from ahighest high or lowest low of a set number of days. The four-weekbreakout has been around for a long time as a trading system.As markets are in a trading channel mast of the time, the focus herewill be (in trading back and forth across these channels by using thetools presented in other chapters of this book. Some of these systemscan be programmed. Others require some judgment. The basic methodof trading these channels will be shown.
Keltner ChannelChester Keltner was a noted technician who might be considered one ofthe earliest system traders. His book How to Make Money in Commodities, published in 1960, contained a system called the 10-day MovingAverage Rule. This is a simple system that uses a constant width channel to time buy/sell signals. The rules are:
1. Compute the daily average price (high + low + close)/3.2. Compute a 10-day average of the daily average price.
3. Compute a 10-day average of the daily range.4. This daily overage range is added or subtracted from the 10-daymoving average to form a band or channel.
5. Buy when the market penetrates the upper band and sell whenthe market breaks the lower band.It is always in the market. Computer testing shows this to be an ineffectual system. This system is buying on strength and selling onweakness. A number of people have expanded on this basic concept oftrading the bands as follows:1. Instead of buying at the upper band, you sell and vice versa. Thismakes good reasoning because markets are in a trading rangemost of the time. The disadvantage is that one may not be onboard a strong move in the market.2. The number of days are changed. A number of systems use athree-day average with bands around that average.
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3. A number of systems use a lower time frame to time entry intothe market. For instance, if the market reaches the upper band,you do not act until the nest lower or higher time frame gives asignal.Keltner Channel System ModifiedChannel trading can be used in anymarket on any time frame depending on your style of trading (Figure6.24). They also can be used as aday-trading vehicle in S&Ps. Therules are:1. Three- and 10-bar movingaverages of the closes areused. The averages are disFIGURE 6.24 3 bar channels.placed forward by one bar.The longer-term average isthe trend indicator. The shorter -term average with channels isused to detect abort-term overbought /oversold conditions. Basictheory is to buy when the market is oversold or a short-termbasis with the longer-term trend up and liquidate on marketstrength. Buy on weakness, sell on strength but trade in the direction of the longer term trend and vice versa.2. Trend. The trend is determined by the slope of the 10-period average line, the pivot points, and thrust direction.3. Channel width. The top channel line is the average of the lastthree highs and the reverse for the lower channel.4. Support and resistance zones. Some subjectivity is required. Ifthe low bar is wide range, the buy zone is the width of the moatrecent narrow range bar measured from the pivot point low,5. Thrust and basic ABC corrections will be utilized.Entry for Longs with Trend Up
Go long at one of the following as shown in Figure 6,25:1. Buy in the support zone (Figure 6.25A).2. Buy at the 10-bar average when it is below the lower three-daychannel bar (Figure 6.25B).3. Buy at the lower trend channel if it is below the 10-bar average(Figure 6.25C),
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FIGURE 6.25
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Action points for channel trading.
Taking profile requires judgment. Profits are taken as marketsenter the resistance zone or by use of a trailing stop once a market enters the sell or resistance zone. The sell zone is:1. In the range of the top bar.2. At the top channel line if above the 10-bar average.3. At the 10-bar average if it is above the channel top.If a trailing stop is used, take profits on:1. On re-entry into the channel if prior close was outside the channel.2. On a close below the opening outside the top channel.3. On a 50% opening range breakout to the downside.The system requires use of some subjectivity on exactly which ruleto use in a particular trading situation. This is where use of the big picture discussed in Chapter 1 comes into play. For instance, if the marketis in the first part of a congestion phase, then profits are taken morequickly. However, if near the termination of the phase, then you mighthold in anticipation of a breakout.Stops
Enter a stop one entry bar range from point of entry, if stopped out on along trade do not re-enter the market on the long side until the markethas moved back up above the three- or 10-bar average and then backdown to an oversold condition. If long and high of entry bar is takenout, move stop to just below entry bars low.
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FIGURE 6.26 Bonds channel trading (June 2000). Created with TradeStation2000iby Omega Research 1999.
Figure 6.26 demonstrates these ideas. There may be some tradesthat were overlooked. This should give you the basic understanding oftrading the Keltner Channels. Several courses are available that havedifferent bells and whistles on this approach. They sell for $3,000 to$10,000. Some use indicators to determine trend. The use of pivotpoints, slope of the 10-day line, short-term patterns, and the big picturemay be as effective as any method. You might examine the basic conceptand develop your own techniques of entry and exit based on your comfort level of trading.Bollinger BandsDeveloped by John Bollinger, this method is based on using two standarddeviations as a band above and below a moving average of say 14 or 20days. The idea is to buy when the market penetrates the upper band andvice versa. As volatility increases, the bands increase and vice versa. Oneof the beet long-terms systems using this basic idea was developed byKeith Fitschen called Aberration.The Bollinger bands are great for immediately sizing up a market.We like to use a 20-day moving average with one and two standard deviations shown. A quick glance at a chart will tell you trend, volatility,and overbought/oversold conditions. A market above one standard deviation is overbought. If shove two standard deviation, it is extremelyoverbought. Look at any chart and you will note that most of them willpullback to the average even in strongly trending markets. The marketmight be traded in this manner:
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1. If the market is oversold, look for patterns on which to buy onboth the current time frame and the nest lower time frame. Ifshort, be alert for taking profit at a sign of a selling climax ordemand overcoming supply.2. IF the market is overbought, do the exact opposite.3. If the bands are narrow, then look to buy puts and calls.4. If the bands are widening, then sell calls and puts.You should trade with the trend. This does not hold true at marketturning points. A number of patterns such as a spring or upthrust arecounter trend signals and frequently yield the moat profit.Figure 6.27 shows a few of the patterns that stand out with the oneand two standard deviation bands shown.
FIGURE 6.27 Bollinger Bands S&Ps daily (December 1999). Created withTradeStation 2000i by Omega Research 1999.
THE PULLBACK
Buying on a pullback after a sign of strength will enable you to get onboard a move with lower risk of being stopped out of the trade. A onerange stop might be used by buying on a pull back on short-term weakness. A larger stop is necessary if you buy on strength.Most thrusts will have a pullback of about 50%. Figure 6.28 showsseveral types of pullbacks or corrections. You are buying on short-termweakness in anticipation of a turning point. A trade may be safer if you
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FIGURE 6.28
Types of pullbacks
enter the markets on the pullback rather then entering on the thrusts.True, you will miss some big moves, but a stop can be entered with lessrisk. The pullhacks provide information on whether the thrust was exhaustion or the beginning of a significant move.Disadvantages include:• Some big moves may be missed by waiting for the pullback toenter the market.• You never knows at what level on the pullback to enter the market.Some techniques have been described earlier in this book. One possible answer to the problem is to look at the lower time frames.Minor reversal patterns in the lower time frames should take place
FIGURE 6.19 Yahoo—The pullback. Created with TradeStarion 2000i by OmegaResearch1999.
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prior to entry. Also the higher time frame shows areas of supportor resistance. This may reduce the number of whipsaws.* The pullback just might be a reversal of trend and one is facedwith a loss.The chart on Yahoo (Figure 6.29 on page 122) identifies some obviousthrusts followed by the pull back. The pullback failures are also noted.HIGH OF LOW BAR FOR BUYING/LOWOF HIGH BAR FOR SELLINGFigure 6.30 identifies the buy zone andsell zone. The obvious method of tradingthis pattern is to buy when market enters the buy zone and vice versa. You canplace orders in these zones with a stopbelow them or look at a lower time frameand wait for some evidence of demand/supply prior to taking a position.If the market decisively penetratesthe zone, then it is no longer an area foraction as support or resistance did nothold. The chart of Royal Dutch (Figure6.31) illustrates this technique. Buy/sell
FIGURE 6.30 Buy at low bar,sell at high bar.
FIGURE 6.31 Royal Dutch Petroleum high/low bars for market entry. Created withTradeStation 2000i by Omega Research 1999.
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points have not been identified, but you can nee the basic approach tothis methodology.
THREE BARS UP/DOWNA two- or three-day bar movement withthrusts above each bars high is frequentlyan action point (Figure 6.32). This is anarea where the market is stretched, and perhaps exhausted. A small amount of sellingcan and often does lead to a retracement ora resumption of a downtrend (vice versa).Most markets will at least have a pull-back FIGURE 6.32 Three bars up.after such action.The basic theory is that thrusts two and three will equal thrustone. Inside days are ignored. The following rules are (for sell sideonly):1. Liquidate and perhaps reverse a position on the three relativelystrong up bars in succession. Ignore inside days. Enter order attarget points or on a close below opening on third day.2, Targets for the third bar are: (a) Thrust method as shown aboveand (b) 0.5-1.0 range of bar one added to the high of bar one.3. Use a 1.0 range stop above entry point. Move to high of third daywhen the low of entry bar is penetrated.4, Take profit point (if short position taken) is in the lower 1/4 rangeof the first bar of the three bar thrust if a short-term trader.This is not a system by itself. It enables you to take profits or entera trade under stretched conditions. The chart of Yahoo, Figure 6.33.demonstrates this thrust method.Profit ProtectionIf market makes a three-day up swing in your favor giving quick largepotential profits, they may be protected by:• Liquidate on any three-day up.• If the high on three-day up IB penetrated, enter stop one tickbelow the low on the third day.
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FIGURE 6.33 Yahoo—two to three bar thrusts as action point. Created withTradeStation 2000i by Omega Research 1999.
• If the market closes below mid-range on third day, get out. Ignoreinside days.• Enter stop below each day's low.DYNAMITE TRIANGLEA powerful tool in your arsenal is the dynamite triangle. It enables youto get on board a fast-moving market and exit with a close stop if wrong(Figure 6.34).The setup is several bars of relatively tight formation. The bar priorto breakout usually closes in the direction of the breakout. Movementmay go either way out of this formation but usually goes in the same
FIGURE 6.34
Dynamite triangles.
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FIGURE 6.35 Soybeans (November 1999). Created with TradeStation 2000i byOmega Research - 1999.
direction as it entered. Entry may be made on the bar prior to breakoutor on penetration of the tight trendline. Stop is immediately entered onthe other side of the formation. Immediate failure does occur but that inwhy stops must be in place. Set up conditions are:1. Market makes a strong movement out of congestion.2. Market remains in a tight formation with small ranges for twoto four bars.3. Market continues its movement in the direction of the thrust bypenetration of a light trendline or close in direction of thrust.4. Your entry point is to take action following the setup conditions.Review Figure 6.35 and then look for this formation on additionalcharts. You may be surprised at the beauty and simplicity of this simpleformation.NARROW RANGE/WIDE RANGEA narrow-range bar (NR) followed by a wide-range bar (WR) is often asignal at market turning points. It is movement away from a period ofrest. Entry taken at these levels frequently leads to immediate profits orgetting you on board for the bigger move.
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Entry for buy (sell opposite) is:1. Enter on close of wide-range bar or2. Enter on the pullback to mid-range of the wide-range bar or athigh of narrow-runge bar.Stop should be on the other side of the narrow-range bar.This is not a stand alone pattern, but it is great when other filterssuggest a possible turning paint area. Figure 6.36 shows a number ofnarrow-range/wide-range signals. Although not totally inclusive, thischart should give you a basic understanding of this powerful littleidea. Exits are not shown, but they are every hit as important as theentry.
FIGURE 6.36
Narrow range-wide range.
TWO-DAY FLIP (2DF)
This pattern occurs after a strong thrustbar in one direction which gives the appearance of strong demand (if up) but openslower the next morning with sell off all day(Figure 6.37). The abortive demand is overand supply is the dominant force. Two-dayflips are frequently seen at market tops orbottoms. Both bars should have above average ranges. Figure 6.38 shows some two-dayflips on Cisco Systems.
FIGURE 6.37
Two bar flip.
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FIGURE 6.38 Cisco Systems narrow range-wide range reversal CreatedTradeStation 2000i by Omega Research * 1999.
with
TIGHT FORMATION BREAKOUTA wide-range breakout where thebreakout bar has a wider range daythan several previous bars is generallya valid signal. You should go with it,provided it is in the direction of thetrend. The prior days should be overlapping or in a tight range. It may beas many as seven to 10 bars or as fewas two where it then becomes a simplenarrow- range/wide- range formation.This is frequently called a breakoutfrom a tight formation (Figure 6.39).
FIGURE 6.39 Breakout from atight formation.
THE IMPORTANCE OF EXITSEntering a trade is far easier than exiting a trade because this is whenyour mind is clearest. When you are in a trade, your emotions are totally involved. That is why you should determine under what conditionsand where you will exit a trade before it is made.
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Considerable emphasis is always placed on how you enter the market. Exiting a trade is of equal importance. The entry and exit from atrade must be designed to work in harmony because they are closely related. For instance, entering a trade on an 80-day breakout and exitingthe trade through a four-day breakout are not compatible.One entry technique is shown in Table 6.1. Six different methods ofcoming out of the trade were then tested against this constant entrymethod. This demonstrates the importance of exits from a trade. Testswere run on 24 different futures over the period from January 1984through June 1999. One contract was traded per signal. No commissionor slippage was included• Entry method: Opening range breakout, two patterns, and onetrend filter. (Same entry for all examples.)• Exit methods: Six methods of getting out of the trade are shown.This includes a reversal technique, four filter methods, and daytrade.
*Required capital is the amount required to limit max drawdown to 20%.** These are the same signals used for entry.
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Profits vary from $30,000 per year to $60,000. Maximum drawdown is from a low of $20,000 to S160,000. Return on capital required is5.0% to 49%. This example is not recommended as a trading system andis represented merely to show the importance that your exit has in yourtrading.Conclusions from Table 6.1 emphasize the importance of protectingprofits once they are achieved by relatively close stops rather than waiting for the reverse signal to take place. As an example of how to usethese tools, a hypothetical study of two people trading Yahoo is shown inFigures 6.40 through 6.43. Figure 6.40 shows one year of trading Yahoowith various market principles.Investor Bob bought 300 shares of Yahoo at 58, when his broker toldhim it was making new highs. He is a long-term investor and does notbelieve in all this chart mumbo-jumbo. His investment was $17.400. Hestill owns his 300 shares which are now at 178. This gives him a profitof $120 per share or a net profit of S36.000 over a one-year period. Thisis a return of about 200%. Not bad.Trader Bill is an avid chartist and believes the forces of supply/demand are shown on the chart. His philosophy is to trade a maximum of300 shares with no pyramid trading. His trades were as follows (seeFigure 6.41):Point 1; The long-term trend is up when the market hit 50 and hebegan looking for a point of entry. He bought 300 shares at 45 upon
FIGURE 6.40 Yahoo—Demonstration of market principles (November 12. 1999).Created with TradeStation 2000i by Omega Research 1999.
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FIGURE 6.41 Yahoo—Demonstration of market principles (December 31, 1998).Created with TradeStation 2000i by Omega Research 1999.
seeing the trading tools of trend up, trend up confirmed and penetration of the 04 line.Point 2: He had another chance to buy at point 2, but did not as hehad his 300 shares (Figure 6.41).
FIGURE 6.42 Yahoo—Demonstration of market principles (May 17, 1999],Created with TradeStation 2000i by Omega Research 1999.
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FIGURE 6.43 Yahoo—Demonstration of market principles (November 10, 1999).Created with TradeStation 2000i by Omega Research 1999.
Target 1: Sold 100 shares at 84 for a profit of 39 or ! 3,900 (Figure6.41).Target 2; Sold the remaining 200 shares at 100 as the market hadreached the second target and had penetrated a three-day low.Profit of $55 on the 200 shares or $11.000. Total profit of $14.900(Figure 6.41).Point 3: Purchased 300 shares at 102 baaed on the long-term trendremaining up and seeing the short-term filters of trend up, trendup confirmed, non-overlapping bars and 0-4 lines penetration. Stoploss was entered at 88. Sold 100 shares at 145 for 43 points profit or$4,300 (Figure 6.42).Target 2: Sold the remaining 200 shares at 180 on the downsidepenetration of the second target. Profit of 78 on 200 shares or$15,600. Total profit now stands at $34,800 (Figure 6.42).Point 4: Bought 300 shares on the reversal day at 143 for a possiblemove back toward the top. Stop at 119 (Figure 6.42).Point 5: Sold all at 184 as this was the low of the high bar. The deepA leg forecast that the high would not be broken. Profit of 4