0
1,295.681,259.00
1,372.00
1 ,496.00
Chapter 15.1:
1174.35
$INX - Weekly US L = 1297.28 –0.20 –0.02% B = 0.00 A = 0.00 O = 1297.71 Hi = 1298.69 Lo = 1294 .97 C = 1297.28 V = 0
AU3772_book.fm Page 299 Saturday, November 18, 2006 5:29 PM
299
7/199910/199900
4/2000
10/2000
01
C
4/2001
7/2001Created with TradeStation 2000i by Omega Research
7/2000
B
FIGURE 179.3.2. Dow Jones Industrials 1999-2000. Illustrating that patterns can be found within patterns, the Dow made a broadening topwhich resolved into a diamond, then a couple of triangles. (Not drawn here.) All of which could be looked at as a gnarly messy rectangle. It isnot so important to identify triangles in this situation as to recognize the general nature of the market — sideways to down. In general one ofthe more unruly situations in market history, as befitted the incredible (truly incredible, as in unbelievable) bull market it ended.
4/1999
A
300
99
INDU LAST-Daily 10/04/2001
AU3772_book.fm Page 300 Saturday, November 18, 2006 5:29 PM
Technical Analysis of Stock Trends
AU3772_book.fm Page 301 Saturday, November 18, 2006 5:29 PM
chapter sixteen
Technical Analysisof Commodity Charts(EN9: Following the practice of allowing the reader to discriminate between thework of Edwards and Magee and that of the Editor, a chapter on commodity trading,Chapter 16.1, has been added to the 9th Edition. See same.)A little thought suggests that the variously interesting and significant patterns which we have examined in the foregoing chapters on stock chartsshould logically appear as well in the charts of any other equities andcommodities that are freely, constantly, and actively bought and sold onorganized public exchanges. And this, in general, is true. The price trendsof anything where market value is determined solely (or for all practicalpurposes within very wide limits) by the free interplay of supply anddemand will, when graphically projected, show the same pictorial phenomena of rise and fall, accumulation and distribution, congestion, consolidation,and reversal that we have seen in stock market trends. Speculative aims andspeculators’ psychology are the same whether the goods dealt in be corporateshares or contracts for the future delivery of cotton bales.It should be possible in theory, therefore, to apply our principles of technicalanalysis to any of the active commodity futures (wheat, corn, oats, cotton, cocoa,hides, eggs, etc.) for which accurate daily price and volume data are published.It should be, that is, if proper allowance is made for the intrinsic differencesbetween commodity futures contracts and stocks and bonds.In previous editions of this book (EN9: Up to the 8th), traders who castlonging eyes on the big, quick profits apparently available in wheat, for example, were warned that commodity charts were “of very little help,” as of 1947.It was pointed out that successful technical analysis of commodityfutures charts had been possible up to about 1941 or 1942. But that thedomination of these markets thereafter by government regulations, loans,and purchases completely subject to the changing (and often conflicting)policies and acts of the several governmental agencies concerned with grainsand other commodities had seriously distorted the normal evaluativemachinery of the market. At that time, radical reversals of trend could anddid happen overnight without any warning so far as the action of the marketcould show. The ordinary and orderly fluctuations in supply–demand balance, which create significant definite patterns for the technician to read, did301
AU3772_book.fm Page 302 Saturday, November 18, 2006 5:29 PM
302
Technical Analysis of Stock Trends
not exist. And while fortunes were made (and lost) in wheat, corn, and cottonfutures during the World War II period, it is safe to say they were not madefrom the charts.However, during the past 5 or 6 years the application of technical methods to commodity trading has been reexamined. Under 1956 conditions, itappears that charts can be a most valuable tool for the commodity trader.The effects of present government regulation have apparently resulted in“more orderly” markets without destroying their evaluative function. Andallowing for the various essential differences between commodities andstocks, the basic technical methods can be applied.It may be in order here to discuss briefly some of the intrinsic differencesbetween commodity futures and stocks referred to above, and some of thespecial traits of commodity charts. To begin with, the most important difference is that the contracts for future delivery, which are the stock-in-trade ofthe commodity exchange, have a limited life. For example, the October cottoncontract for any given year has a trading life of about 18 months. It comes“on the board” as a “new issue,” is traded with volume increasing more orless steadily during that period, and then vanishes. Theoretically, it is adistinct and separate commodity from all other cotton deliveries. Practically,of course, it seldom gets far out of line with such other deliveries as arebeing bought and sold during the same period, or with the “cash” price ofthe physical cotton in warehouses. Nevertheless, it has this special qualityof a limited independent life, as a consequence of which long-term Supportand Resistance Levels have no meaning whatever.Second, a very large share of the transactions in commodity futures —as much as 80% certainly in normal times — represents commercial hedgingrather than speculation. (It is, in fact, entered into to obviate risk, to avoidspeculation.) Hence, even near-term Support and Resistance Levels haverelatively less potency than with stocks. Also, since hedging is to a considerable degree subject to seasonal factors, there are definite seasonal influences on the commodity price trends which the commodity speculator mustkeep in mind, even if only to weigh the meaning of their apparent absenceat any given period.A third difference is in the matter of volume. The interpretation ofvolume with respect to trading in stocks is relatively simple. But it is greatlycomplicated in commodities by the fact that there is, in theory, no limit tothe number of contracts for a certain future delivery which may be sold inadvance of the delivery date. In the case of any given stock, the number ofshares outstanding is always known. As this is written, there are in the handsof stockholders 13,700,203 common shares of Consolidated Edison, and thatquantity has not varied for many years nor is it likely to change for severalyears to come. Every transaction in Consolidated Edison involves an actualtransfer of one or more of those existing shares. In the case of commodityfuture contracts, however — say, September wheat — trading begins longbefore anyone knows how many bushels of wheat will exist to be deliveredthat coming September, and the open interest at some time during the life
AU3772_book.fm Page 303 Saturday, November 18, 2006 5:29 PM
Chapter sixteen:
Technical Analysis of Commodity Charts
303
of the contract may exceed the potential supply many times over — and allquite legitimately. EN9: Appendix C contains some material on the interpretationof futures volume data. As always volume data is a supplementary indicator to price.No one makes a profit on it.One more important difference may be mentioned. Certain kinds ofnews — news about weather, drought, floods, etc., that affect the growingcrop, if we are dealing with an agricultural commodity — can change thetrend of the futures market immediately and drastically and are not foreseeable given the present stage of our weather knowledge. Analogous developments in the stock market are extremely rare. EN: Except for acts of Godand Alan Greenspan.Under what might be called normal market conditions, those chart patterns which reflect trend changes in most simple and logical fashion workjust as well with commodities as with stocks. Among these we would listHead-and-Shoulders formations, Rounding Tops and Bottoms, and basictrendlines. Trendlines, in fact, are somewhat better defined and more usefulin commodities than in stocks. Other types of chart formations which areassociated with stocks with short-term trading or with group distributionand accumulation, such as the Triangles, Rectangles, Flags, etc., appear lessfrequently in commodities and are far less reliable as to either direction orextent of the ensuing move. Support and Resistance Levels, as we havealready noted, are less potent in commodities than in stocks; sometimes theyseem to work to perfection, but just as often they don’t. For similar reasons,gaps have relatively less technical significance.It is not the purpose of this book to explain the operation of commodityfutures markets, nor to offer instruction to those who wish to trade therein.This brief chapter is included only as a starter for readers who may want topursue the study further. They should be advised that successful speculationin commodities requires far more specialized knowledge, demands moreconstant daily and hourly attention. The ordinary individual can hope toattain a fair degree of success in investing in securities by devoting only hisspare moments to his charts, but he might better shun commodity speculation entirely unless he is prepared to make a career of it.EN: The Editor has been, during his checkered career, a registered CommodityTrading Advisor. At the beginning of that career, I discussed these subjects withMagee and received essentially the above comments which are here reproduced fromthe fifth edition. Subsequently, I observed among my associates and partners, andon my own, that futures are eminently tradable with the adaptation of techniquesand methods described in this book. It is also true, as Magee says, that futurestrading is so different in tempo, leverage, and character that the novice risks life,limb, and capital in entering the area unescorted. Resource references are essentialreading but the beginner is urged to educate himself before beginning trading withextensive study and paper trading.Note that Figures 180-197 as well as Chapter 16 from the 7th editionare now found in Appendix C.
AU3772_book.fm Page 304 Saturday, November 18, 2006 5:29 PM
304
Technical Analysis of Stock Trends
104SEPTEMBER OATS
96
Chicago
1947
88
GGG
807672686460Sales100’s125100755025
S
H
S
JANUARY FEBRUARY
MARCH
APRIL
MAY
JUNE
JULY
4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9
FIGURE 179.4. (Fig. 180, 5th edition). Oats. Oats, for obvious reasons, traced more“normal” patterns than Wheat during the 1940s. This chart contains an H & S bottom,a Symmetrical Triangle which merged into the Ascending form, a gap through aformer top level, and an interesting trendline. The Island shake-out through thetrendline was an extremely deceptive development.
AU3772_book.fm Page 305 Saturday, November 18, 2006 5:29 PM
Chapter sixteen:
Technical Analysis of Commodity Charts
305
35.00
34.00
OCTOBER COTTON
1947
33.00
32.00H7??
31.00
??S7
S730.00
29.00
28.00
27.00
FEBRUARY
MARCH
APRIL
MAY
JUNE
JULY
AUGUST SEPTEMBER
8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20
FIGURE 179.5. (Fig. 181, 5th edition). Cotton. In contrast with the grains, the technical action of the Cotton futures markets has been fairly consistent with normalsupply–demand functioning ever since prices rose well above government supportlevels. In this daily chart of the 1947 October delivery (New York Cotton Exchange),the reader will find a variety of familiar technical formations, including criticaltrendlines, a Head-and-Shoulders top that was never completed (no breakout), andSupport–Resistance phenomena much the same as appear in stock charts. Doubletrendlines are not at all unusual in Cotton charts.
AU3772_book.fm Page 306 Saturday, November 18, 2006 5:29 PM
AU3772_book.fm Page 307 Saturday, November 18, 2006 5:29 PM
chapter 16.1
Technical Analysis ofCommodity Charts, Part 2A 21st Century PerspectiveIn the search for the Philosopher’s Stone more sweat and money have beenput into the area of commodities and futures than were ever expended inthe securities arena. There is a simple reason for this. Great fortunes aremade and lost with much greater rapidity in the futures area than in securities. Of all the great dramatic moments in stock market history few are somemorable as the great Hunt silver market, or Soros facing off against theBank of England, or of gold soaring to $1000 an ounce. And the saga continues in 2005. $50 oil? $60? $70? $100? And the effects, economic and psychological! In dimly lit garrets and brightly lit computer rooms thousandsof researchers concoct systems to trade these markets — corn, soybeans,silver, copper...
Rocket ScientistsAt times individual traders and groups of traders have plundered (harvested?) these markets for fairy tale profits. I know whereof I speak, havingbeen a principal in California’s first licensed commodity trading advisorwhich was founded by the NASA rocket scientist R.T. Wieckowicz. Duringthe 1970s as the stock markets ground futilely around the 1000 level on theDow the futures markets returned yearly gains in the 100% range. Consistently. For years. Those were the years of the California systems traders andthe beginning of computerized trading. From the primeval slime of NASAthe rocket scientists emerged to create a renaissance in market technology.At the time it seemed clear that science and genius had at last conqueredthe markets and that clients would come buzzing from the world over likebees to a honey pot and that the rivers of profits would last forever. Theydid last for some time, and then the markets changed. Mechanical systemswhich cut through the markets like a reaper in a wheat field in bull marketsgrind up capital like sausage in sideways markets. Science and genius wererevealed as the happy combination of man, moment, system, and market.307
AU3772_book.fm Page 308 Saturday, November 18, 2006 5:29 PM
308
Technical Analysis of Stock Trends
Turtles?During the 1980s from the sea came crawling the Turtles. Progeny of theprotean trading wizard, Richard Dennis, the Turtles again harvested outsizeprofits from the markets, running it is said in the 80% yearly range. The socalled Turtles got their name from a comment that Dennis is reported tohave made that traders were made not born and he was going to raise traderslike turtles. Additional reading about the Turtles is available in Jack Schwager’s fascinating book and books, Market Wizards, et al. Schwager’s booksare required reading for aspiring traders. And, the trading manual of theTurtles will be found in Appendix E of this ninth edition. This workbook,written by Curtis Faith, an original Turtle, contains virtually all of the elements necessary in a trader’s systems and procedures manual. The manualwas prepared according to the training Dennis gave his Turtles. Serioustraders do not operate without some such document. Certainly all of theserious traders I have known (a considerable number) have had fully developed manuals like the Turtle workbook. I have attached the Turtle workbookas an appendix rather than others in my possession because it is publiclyavailable at originalturtles.org and because it is beautifully articulated.In the late ’90s the Turtles were made into turtle soup in the futuresmarkets as the majority of systems traders wound up as hamburger meat.Is there a moral? Yes. The markets giveth and the markets taketh away. Science andgenius are again revealed to be the happy combination of man, method, moment,and market.The Turtle system is basically an adaptation of Richard Donchian’s channel breakout system. In the Donchian system the trader goes long when the20 day high is broken and sells and goes short when the 20 day low is broken.In the 1970s Dunn and Hargitt evaluated a number of mechanical tradingsystems and found that Donchian’s system was superior to the others evaluated at that time. Will Donchian’s system still work? Yes, in broadly trending markets. Will the Turtle system still work? Yes, in broadly trendingmarkets. And, like virtually all mechanical systems they don’t know whetherthey are in a broadly trending market or not. They are blind. All they seeare ones and zeros. The addition to these systems of prudently applied chartanalysis will immeasurably improve their performance and risk characteristics.
The Application of Edwards and Magee’s Methodsto 21st Century Futures MarketsDuring my career as a Commodity Trading Advisor I have known a numberof successful traders and advisors who used what I would describe as Mageetype chart analysis to make their trades. Often there were other elementsinput into their decision making process, but manual charting was a keyfactor in their operations. Some of these traders used simple trendline analysis with price or volume filters and some used a combination of trendlinesand support and resistance. All were trend followers.
AU3772_book.fm Page 309 Saturday, November 18, 2006 5:29 PM
Chapter 16.1:
A 21st Century Perspective
309
Having looked at the futures markets with some attention over the pastseveral years it seems to me that there is no reason why chart analysis shouldnot work as well now as it has always worked. Essentially the questionsraised by securities trading are the same as those presented by futurestrading in the analysis of a chart. Is there a trend? Where are support andresistance? Is there a breakout? Are there waves and wavelets? How do youenter and how do you exit?The great bug-a-boo of securities traders coming to the futures tradingis the speed of the game. Like college football players stepping up to theNFL there is a brutal learning curve and rookies are the most likely to getkilled. I am not going to make any effort here to present a primer for newfutures traders. Rather I will look at some futures charts at the end of thischapter in order to show the journeyman that chart analysis can be used asa decision making method in these dramatic markets. Again, chart analysishas the weakness (or strength) of being a qualitative process. It will not makedecisions for the average trader, as a mechanical system will.On the other hand a breakout is a breakout. A gap is a gap, leaving asidethe question of limit move gaps for the moment. A trend is a trend. And hereis the great advantage that a firm grasp of charting methods can give thepractitioner. It can give him the perspective to recognize the essential nature of themarket at hand and choose to wait or to enter. Mechanical methods not having thequalitative discrimination of an experienced chartist will blindly take everytrade until they are out of money. The experienced chart analyst can sit backand say, this market has not yet made a bottom and the time to begin tradingit long has not yet come. Or, he can recognize the essential differences betweena trading and a trending market and adjust his tactics accordingly.As Magee noted in Chapter 16:Under what might be called normal market conditions, thosechart patterns which reflect trend changes in most simple andlogical fashion work just as well with commodities as with stocks.Among these we would list Head-and-Shoulders formations,Rounding Tops and Bottoms, and basic trendlines. Trendlines, infact, are somewhat better defined and more useful in commoditiesthan in stocks. Other types of chart formations which are associated with stocks with short-term trading or with group distribution and accumulation, such as the Triangles, Rectangles, Flags,etc., appear less frequently in commodities and are far less reliableas to either direction or extent of the ensuing move. Support andResistance Levels, as we have already noted, are less potent incommodities than in stocks; sometimes they seem to work toperfection, but just as often they don’t. For similar reasons, gapshave relatively less technical significance.These words remain true today, as do virtually all the principles enunciated in this book by Edwards and Magee and myself. In fact most futures
AU3772_book.fm Page 310 Saturday, November 18, 2006 5:29 PM
310
Technical Analysis of Stock Trends
charts if given to an analyst without issue identification and dates wouldnot be identifiable as commodity charts. Of course when limit moves appearthe difference slaps one in the face. And on this point I might differ fromMagee slightly as regards gaps. Obviously limit move gaps have breathtaking significance. But all in all it seems to me that gaps often say the samething to futures analysts that they say to stock analysts.Another mathematical reason might be adduced for the practicality ofusing simple chart analysis to trade futures. That is the tautalogical nature ofthe method. A trend is a trend, and a trendline is a trendline. If you enter asuspected trend (setting a protective stop at a technically analyzed place) andfollow the trend using Basing Points or observing the trendline and exiting ona break and reversal there will be no difference from doing the same with astock. Well, some difference. Due to the leverage you will be required to behyper aware of risk. In futures the penalty for holding a position through “anormal reaction” can be extremely harsh. That is why stops are so important.
StopsSome traders set their stops using money management rules rather thantechnically identified points. I believe it is always better to find the technicalpoint using a basing point, or support and resistance. To me it makes bettersense to adjust position size to control risk as I described in Chapter 26. Andthe use of money management stops has been very successful for manytraders. If some logical and disciplined method of setting and observing stops isnot installed the trader is assured of failure.A money management stop is, simply enough, a stop calculated bydeciding to risk 2% (or 3 or 4 or x%) of capital on a trade. For example,William O’Neil says that when a stock trader enters a position he should seta stop 8% under his entry price. This is a little crude, and not strictly speakinga money management stop, but is better than no risk calculation at all. In astricter sense, if we said that we wanted to limit the risk of the trade to 3%of capital we would use the 8% rule to set the stop and the Scott Procedurein Chapter 26 to determine the number of shares or contracts. The Turtlesystem in Appendix E contains similar procedures. Numerous studies haveproven that the size of the risk per trade — 1%, 2%, 3% — is directlycorrelated to equity volatility.
A Variety of MethodsAs noted above a competent chart analyst may, in my opinion (and in Magee’sopinion), perform profitably in the futures markets. There are other questions,of course, namely of character, temperament, intelligence, judgment, etc…, Letus leave those questions to Dr. Elder and confine ourselves to the methodquestion. Chart analysts proved their abilities in the futures markets long beforecomputers existed. In fact long before in the case of Japanese rice traders,enlightening their efforts with candlesticks in the 18th century.
AU3772_book.fm Page 311 Saturday, November 18, 2006 5:29 PM
Chapter 16.1:
A 21st Century Perspective
311
In the 1970s I saw point and figure chartists enjoy great success at DeanWitter and Merrill Lynch and other major firms in futures. I have seen leastsquares curve fitters, moving average calculators and abstruse statisticalanalysts all enjoy profitable outings in commodities. Not to speak of theTurtles who, using naturalistic high low systems, harvested good profits inthe markets. As the saying goes, gateless is the gate and many are the waysto the great Dow. Although I have enjoyed great success myself usingmechanical number-driven systems over the years I have become more andmore attracted to “natural” systems. Chart analysis is essentially natural, asis the Turtle system. The Dow Theory is a natural system. In a natural systemno mathematical algorithm comes between the analyst and the data. Theessential, more, quintessential, weakness of all number-driven systems istheir blindness. They do not have the ability to discriminate between theforest and the trees. The experienced human chartist can see (and hear) thechanging rhythms of the market and respond to them, responding to factorstoo subtle (and even subconscious) to program. But even natural systems,like the Turtle systems, can fall into this trap. When the markets learn thata lot of capital is waiting just above the 20 day high they will set a trap forit. For “markets” you may read “they.” If you apply the knowledge of thisbook to such situations you may avoid the trap.
Everything You Need to Know as a Chart Analyst Trading FuturesJack be nimble. Jack be quick. Jack jump over the Candlestick. Yes, it is true,as the leverage is 10 times greater the speed is 10 times faster. I have illustrated in Figure 179.5.3 the combination of a very tight trendline with a runday which it seems to me is a good current (21st century) combination.Otherwise the same qualities which make a good security trader make agood futures trader once the great leap to leveraged quick-fire markets ismade. If you have been successful trading stocks you will probably besuccessful trading futures. And you probably should practice on stocks whilestudying futures. A sobering fact which I often recount to my graduatestudents is that Richard Wyckoff worked in the securities business for 8 yearsbefore making his first investment. He studied the markets an additional 6years before trading.The Magee methodology will serve as a valuable cornerstone of yourfutures operations, and you must never cease studying. Mechanical systemshave their attractions, especially when seasoned with experienced chartanalysis. And no method will survive unless practiced with diligence, persistence, judgment, and patience. Time and again you will hear famoustraders say, when asked the secret of their success, “discipline.” What theymean by discipline is their ability to measure and contain the risk, set a stopbased on technical or money management procedures and then honor the stop.The most important lesson the futures trader has to learn from Edwardsand Magee is the ability to see the character of the market, trading ortrending, and then to adjust his tactics accordingly.
AU3772_book.fm Page 312 Saturday, November 18, 2006 5:29 PM
312
Technical Analysis of Stock Trends
The Return of the Great Markets of the ’70sIn the next great bull market in commodities, which may be about to occuras this book goes to press in 2006 (cf. following charts this chapter), thesemethods and systems derived from them will once again reap windfallprofits.I have attempted in this ninth edition of this classic book to show thebook’s usefulness to the intelligent futures trader. Simple classical chartanalysis alone can be successful in the futures markets in the hands of anexperienced competent analyst. Natural mechanical systems such as theTurtle system have been effective and will be again, perhaps with sometweaking (such as imposing a chart analysis super-structure). Wave analysismethods such as the Basing Points procedure of Chapter 28 can be used.Even number driven systems, such as moving averages, can be successfulespecially if combined with chart analysis.@GC.C(D) - Weekly COMEX L = 419.30 –0.70 –0.17%
O = 419.80
C = 419.30419.30397.00
380.30
377.00359.00341.00325.00309.00394.00279.00266.00
1997
1998
1999
2000
2001
2002
2003
2004Created with TradeStation
FIGURE 179.5.1. A Rounding Bottom in Gold 1997-2004. “These patterns, whenthey occur after an extensive decline, are of outstanding importance, for they nearlyalways denote a change in Primary Trend and an extensive advance yet to come.That advance, however, seldom carries in a “skyrocket” effect which completes theentire Major Move in a few weeks. On the contrary, the uptrend that follows thecompletion of the pattern itself is apt to be slow and subject to frequent interruptions,tiring out the impatient trader, but yielding eventually a substantial profit.” So saidRobert Edwards in remarking on Rounding Bottoms in stock charts. As may be seenhere this Rounding Bottom consists of a downtrend, a false signal off the DoubleBottom (upon which a pretty penny might have been made by the agile trader), anda handsome uptrend. And it all looks like a huge Rounding Bottom.
AU3772_book.fm Page 313 Saturday, November 18, 2006 5:29 PM
Chapter 16.1:
A 21st Century Perspective
313
@SI.P(D) - Weekly COMEX L = 7.035 +0.077 +1.11% B = 0.000 A = 0.000 O = 6.985 Hi = 7.085 Lo = 6.980 C = 7.045 V = 145
8.000
7.045
6.00
6.000
5.000
1998
1999
2000
2001
2002
2003
20042005Created with TradeStation
FIG