7.3
 
osite |nidex-Daily. 04/
|
         
Pete ee ce eee cece eens eter Bd Bees
 
 
1. The moving averages on the Nasdaq Composite converge and beginto spread out as the index rolls over.
2. The index makes a higher high. Go short tomorrow if the index tradesbelow today’s low (4323).
3. The index trades below the low of (2), 4322, triggering a signal.
4. The index loses over 1,000 points, nearly 25%, over the next four days.aBow Ties 89
Here’s an example in the futures market.
FIGURE 7.4
 
Orange duice 09/00- -Daily 07/17/2000 C=77.05
 
 
 
 
1. On 7/12/2000, the moving averages on September Orange Juice con-verge and begin to spread out as the market rolls over from anuptrend to a downtrend.
2. The market trades above the prior-day high.3. A signal is triggered as the market trades below the low of (2).
4. OJ drops over 3 points in two days.I90 Chapter 7
Here’s an example of no fill.
FIGURE 7.5
 
 
 
 
 
1. The moving averages on the Nasdaq Composite converge and beginto spread out again.
2. A higher high. Go short tomorrow 1-point below today’s low.
3. No fill and another higher high. Go short tomorrow 1 point below to-day’s low.
4. The index trades above its 20-day exponential moving average. Cancelorder. 
>
Bow Ties
O&A
Why use multiple moving averages?
When several moving averages converge at the middle of the Bow Tie,it suggests that the longer term and shorter cycles are coming to-gether. Once they spread out again, it suggests a new trend is beingformed.
So why not just buy the market as soon as it comes out of the conver-gence?
In spite of what many books on technical analysis will tell you, mov-ing-average crossovers do not work. I suppose in their defense, manyof these books were written before everyone had a computer sitting ontheir desk. Before computers, crossovers worked much better.
Do you think they used to work better because it wasn’t so obvious?Yes. Technology has helped to eradicate this edge.
Back to Bow Ties, does the countertrend movement (rule #2, a lowerlow for buys and a higher high for short sales) help to eliminate falsestarts?
Exactly. You often avoid false moves by waiting for a countertrend byonly entering if the trend re-asserts itself. Conceptually, it’s no differ-ent than pullbacks. Essentially, you are looking for thrust/trend, cor-rection and then resumption of trend.
Why cancel your entry order if the market trades back to the 20-dayEMA?
If a market comes all the way back to the 20-day EMA, it’s possiblethat what appeared to be a new trend is a false move. This doesn’tmean that the market isn’t worthy of trading. As you know, in tradingthere are no exacts. However, in any pattern, you should have a rulefor when you should step back and re-evaluate your analysis. Maybesome other pattern is forming? Maybe not.
But it’s okay for the market to trade back to the 10-day simple movingaverage?
I think it’s normal, and likely healthy, for a market to pull back to the10-day SMA.
9192 Chapter 7
Q.
You refer to the Bow Tie from downtrend to uptrend for longs anduptrend to downtrend for shorts. Does the pattern work on marketscoming out of consolidations or bases?
Yes. I discovered the pattern while studying markets that had majorchanges in trend—from up to down or from down to up. The beautyis that you avoid top and bottom picking by waiting for a confirma-tion of this rollover. A “half bow tie,” if you will, emerges when thePrice is coming out of bases/consolidations. These seem to work, but Iprefer the “rollover” pattern, as the chance exists that there are playersstill trapped on the wrong side of the market.
The “trapped” players will add fuel to the rally or sell-off for short set-ups?
Yes. 
 
CHAPTER 8
MICRO PATTERNS
oeoee0oesweetesdsesoedteeeeeesee ae aoo9o908 0 8
HIGH-LEVEL MICRO DOUBLE BOTTOM
As its name implies, a double bottom is normally considered a bottomingpattem as a market in a downtrend bottoms, has a false rally and thenmakes a final bottom at or slightly above the previous bottom. However,sometimes a market is so strong that it’s able to make the formation as partof a continuation move. In other words, it sells off very little while formingthis pattern. This is known as a high-level double bottom and is shown inFigure 8.1.
 
9394 Chapter 8FIGURE 8.1
 
Barr Laboratories, Inc. (C-Daily...07/12/2000 °........; boone bg
 
 
 
Corrections such as the above normally take place over several weeks tomonths. Sometimes, however, stocks are so strong that they will correctover much shorter time frames—forming a “micro” pattern.
Although still a discretionary pattern in nature, the High-Level MicroDouble Bottom is more easily defined than its bigger picture counterpart.We define the pattern as two pivot lows which form at or near the samelevel. To review, a pivot low is formed when a stock makes a lower lowfollowed by a higher low. This leaves a low surrounded by two higherlows.
  
Micro Patterns 95
Here are the rules for the High-Level Micro Double BottomFor Buys (Short sales are reversed):
1. The market should be in a strong trend as defined by a com-puter-based indicator such as ADX >= 30 and +DMI > -DMI or as de-fined under Trend Qualifiers (Chapter 3).
2. The stock must make at least a two-month.
3. The stock must make a pivot low, that is, a low surrounded by twohigher lows.
4, The stock must make another pivot low at or near the first pivot low.
5. Go long 1/16 above the high of the right side of the pivot low formedin (4).
ee!' l!
whe a
| | Low Low
 
6. If filled, place a protective stop below the lowest bar in the setup. Ifthis is more than 5% of the stock’s value, risk no more than 5%.LL96 Chapter 8
FIGURE 8.2
 
Extreme Networks-Daily 07/14/2000 C=142.000 | ©)
rr ee a 140
eee a a a TE 120
 
 
 
 
1. Extreme Networks (EXTR) qualifies as being in a strong uptrend byhaving an ADX of 37 and +DMI > -DMI (not shown). Other TrendQualifiers include its more than doubling in less than a month and itshaving wide-range bars higher (a), (b) and strong closes (a), (c).
2. The stock makes a new two-month high.
3. The stock forms two pivot lows near the same price level. Go long to-morrow at 104 3/4, 1/16 above the high of the second pivot forma-tion.
4. The stock trades at 104 3/4 and we go long.
5. Because the low of the setup (90 5/8), is more than 5% away from ourentry, we place our protective stop at 99 2 for a risk of 5%.
6. The uptrend resumes as the stock trades more than 40% higher overthe next five days.aMicro Patterns 97
Here we have two back-to-back examples in Sonus Networks, a hot IPO.
FIGURE 8.3
 
-
 
 
 
 
1. Sonus Networks (SONS) qualifies as being in a strong uptrend by ris-ing over 80% since its offering. (Note: ADX is not applicable on newissues.)
2. The stock makes a new high.
3. The stock forms two pivot points six days apart near the same pricelevel.
4. The stock trades above the high of the second pivot formation and wego long at 148 1/16, 1/16 above the pivot formation.
5. The stock trades over 57 points higher in three days and makes a newhigh.
6. The stock forms two pivot lows one day apart near the same pricelevel.
7. The stock trades above the high of the second pivot formation and wego long at 191 1/16, 1/16 above the pivot formation.
8. The stock trades 40 points higher over the next four days.I98 Chapter 8
Here we have an example in the Amex Biotech Index (BTK). Sector sig-nals can be used to help time entries in individual stocks within that sec-tor or can be traded in and of themselves through holder shares or sectoroptions.
FIGURE 8.4
 
     
 
"Created with SuperCharts by Omega Research © 1997
 
 
 
1. The Amex Biotech Index has an ADX below 30 (29) (not shown), butqualifies as being in a strong uptrend by its rising over 70% in lessthan a month. Other Trend Qualifiers include it having wide-rangebars higher and strong closes.
2. The index makes a new two-month high.
3. The index forms two pivot lows three days apart near the same pricelevel.
4. The index trades above the high of the second pivot formation, signal-ing an entry.
5. The trend resumes as the index rises over 100 points in three days. 
Micro Patterns 99
Q&A
Q. How did you begin noticing High-Level Micro Double Bottoms?
A.  Pullbacks are my favorite patterns. Many times I’d notice that eventhough a stock didn’t follow though on a rally out of a pullback, it stilldidn’t do anything wrong.
Q. Define wrong.
A. It would come back and test the level of the original pullback. I no-ticed that this became a level of strong support. 
100
Chapter 8
HIGH-LEVEL MICRO CUP AND HANDLE
The cup-and-handle pattern, popularized by William O’Neil, often pre-cedes large market moves. The pattern forms when a market sells off,bases (consolidates), rallies back up to the area of its original sell-off, andfinally, pulls back to form the handle. Cup and handles are traded in thesame fashion as pullbacks.
FIGURE 8.5
 
-
 
Vertical Net-Daily 11/10/1999. C=50.500. 41.125...
 
rican la
  
 
4
Sometimes a market is so strong that it will form a bottoming patternwithin a trend. This is known as a running correction. Therefore, I havedubbed cup and handles that form during strong trends and above their50-day moving averages as “Running Cup and Handles” (originally pub-lished in The Trading Markets Guide to Conquering The Markets). This com-bines the best of both worlds: momentum and a bottoming pattern. Anexample of a Running Cup and Handle is shown in Figure §.6.aMicro Patterns 101
FIGURE 8.6
 
   
“Created with SuperCharts by Omega Researct
 
 
Taken one step further, stocks in extremely strong trends often form com-pressed or “micro” cup and handles. These occur over a period of daysas opposed to their bigger picture counterparts, which may take weeks tomonths to form.
Although discretionary in nature, the following rules and examplesshould help you be able to recognize the pattern.
1. The market should be in a strong trend as defined by a com-puter-based indicator such as ADX >= 30 and +DMI > -DMI or as de-fined under Trend Qualifiers (Chapter 3).
2. The market must make a two-month high.LL102 Chapter 8
3. The market should have a one to four day sell-off (a). This actionforms the left side of the cup.
Ml| L 4| (a)
4. The market must then trade sideways for one to four days (b). This ac-tion forms the bottom of the cup.
5. The market must then rally back up to at or near the original sell-off(c). This action forms the right side of the cup. 
Micro Patterns 103
6. The market should pull back for two to four days. Ideally, this shouldbe no more than 50% to 60% of the depth of-the cup (d). This actionforms the handle.
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100%
! |
7. Once the above rules have been met. Go long tomorrow, 1/16 abovetoday’s high.
8. If filled, place an initial protective stop (IPS) below the low of the han-dle. If this is more than 5% of the stock’s value, risk no more than 5%.
| l\, ——Ent|! es 
104 Chapter 8
FIGURE 8.7
 
 
 
 
PY N
Geron (GERN) qualifies as being in a strong trend by having an ADXreading of 64 and +DMI > -DMI (a) and by having risen over 400% ina month.
The stock makes a new two-month high.
The stock begins to sell-off, forming the left side of the cup.
The stock trades sideways, forming the bottom of the cup.
The stock rallies to near the level of the original sell-off, forming theright side of the cup.
The stock drifts lower. The action forms the handle and completes thecup. Go long tomorrow at 36 1/16, 1/16 above today’s high.
7. The stock trades at 36 1/16 and we go long.8. Because the low of the handle (33 3/4) is more than 5% away from
our entry, we place our protective stop at 34 1/4 for a risk of 5%.Note: In cases like this when the pattern-based protective stop isslightly greater than 5%, you could use the pattern-based stop (in thiscase, the low of the handle) and trade fewer shares to compensate forthe added risk.
The trend resumes as the stock nearly doubles over the next four days.aMicro Patterns 105
FIGURE 8.8
 
 
 
 
 
 
1. C-Cube Microsystems (CUBE) qualifies as being in a strong uptrendby having an ADX of 46 and +DMI > -DMI (not shown) and by hav-ing risen more than 40% in less than three weeks.
2. The stock makes a two-month high.
3. The stock sells off, trades sideways and rallies to near the level of thesell-off. This action forms the cup.
4. The stock sells off, forming the handle. Go long tomorrow at 61 5/16,1/16 above today’s high.
5. The stock trades at 61 5/16 and we go long.
6. Because the low of the setup (56 3/4) is more than 5% away from ourentry, we place our protective stop at 58 1/4 for a risk of 5%.
7. The trend resumes as the stock explodes more than 40% higher overthe next seven days.I106 Chapter 8
FIGURE 8.9
 
—
 
 
 
 
1. Alexion Pharmaceuticals is in a strong uptrend.2. The stock makes a new two-month high.
3. The stock sells off and then trades sideways and rallies back up nearthe level of the two-month high (2). This action forms the cup.
4. The stock then drifts lower to form the handle. Go long tomorrow at34 11/16, 1/16 above today’s high.
5. The stock gaps open to 35 and we go long.
6. The stock explodes over 40% higher as the trend continues.aMicro Patterns 107
FIGURE 8.10
 
Biotech Holdings - BBH-Daily. 02/17/2000...  O lore |
 
 
 
1. The Biotech HOLDRS (BBH) are in a strong uptrend.2. The shares make a new two-month high.
3. The shares sell off, trade sideways and then rally back up near thelevel of the original sell-off. This action forms the cup.
4. The shares drift lower forming a handle. Go long tomorrow at 1797/16, 1/16 above today’s high.
5. The shares trade at 179 7/16 and we go long.
6. The trend resumes as the shares rally over 28 points in three days. 
108 Chapter 8
>
PO PO
Q&A
The Micro Cup and Handle seems very discretionary. Any tips onhow to recognize them?
The best way to learn this pattern is to look at charts, lots of charts.After a while, you'll find your eye drawn to the pattern.
Any other tips?Yes, look for other patterns that may also be setting up.Such as?
Double Top Knockouts that don’t trigger immediately often set up asMicro Cup and Handles. Also, sometimes pullbacks set up as MicroCup and Handles. 
 
SECTION THREE
VOLATILITY 
 
CHAPTER 9
FINDING EXPLOSIVEMOVES: AN ADVANCEDLESSON IN SWINGTRADING
We predict that the use of historical volatility will beone of the growth areas for financial markets in thelate ‘90s. Up until now, the use of historical volatilityhas been confined mostly to the options market, butwe have found it can be equally applied to thefutures and equity markets.
— Connors and Hayward,Investment Secrets of aHedge Fund Manager
As swing traders, our goal is to find markets that have the potential tomake large moves over a short time frame. One of the greatest tools that canhelp us accomplish this goal is the study of volatility. Although the conceptscan be a little overwhelming at first, I can assure you that they are wellworth your effort to learn them.
11 
112
Chapter 9
HISTORICAL VOLATILITY
Historical volatility (HV), also known as statistical volatility, is the stan-dard deviation of day-to-day price changes expressed as an annual per-centage. Its complete calculation can be found in the appendix. However,don’t get too caught up in the details of the formula and have your com-puter do the work for you. Just know that it’s a measurement of howmuch a stock has fluctuated in the past and can be used as a gauge forhow much the stock will likely fluctuate going forward. For instance, sup-pose the 50-day HV on a $100 stock is 10%. Assuming a normal distribu-tion of stock prices and that volatility remains the same, this stock has a66% chance (one standard deviation) of trading between $90 ($100 less10%) and $110 ($100 + 10%) one year from now.
Again, don’t get too caught up in the math. The main thing you shouldknow about HV is that stocks with higher HV readings have fluctuatedmore in the past than stocks with lower HV readings. And further, thosestocks with higher HV readings will likely fluctuate more in the futurethan those stocks with lower HV stocks. Therefore, as a short-term trader,we must focus on those stocks with higher HV readings as we are look-ing for an immediate move.
TRADING WHERE THE ACTION IS
Larry Connors, a pioneer in volatility research for the stock and com-modity markets, has dubbed using HV to select stocks “Trading WhereThe Action Is.” In Connors On Advanced Trading, he states: “As short-termtraders, we do not have the luxury of waiting for a market to move. Be-cause our profits tend to be small, we need to be trading those specificmarkets that provide us with the opportunity to maximize our profits ona daily basis.”
I fully agree with Larry. As an example of the potential for higher HVstocks, refer to Figure 9.1 of Geron Corp. The stock had a 50-day HVreading of 95% in late 1999. This suggested that the stock statistically hadthe potential (a 66% chance) to trade either 95% higher or 95% lowerover the next year. Notice that the stock skyrockets over the next fewmonths and trades nearly 700% higher. Jt then tops out and loses 80% ofits value in the following months. As you can see, stocks with higher HVreadings have the potential to make extraordinary moves. In fact, all ofthe examples used in this manual had a 50-day HV reading of at least40% and most had readings of 80% or higher.Finding Explosive Moves: An Advanced Lesson in Swing Trading
FIGURE 9.1
113
 
Geron Corp-Daily 04/17/2000 C=17.375 -1.937
80% Drop. | gg
  
    
ae pe yoga he| 700% a, yt hh
Sy oyHas In
 
  
“yh eeVolatili
——
  
 
 
          
 
 
APPLYING HV
I use HV a lot like I use ADX. I don’t plot it on each and every chart.Rather, I use it as a filtering tool] when (computer) scanning throughstocks. That is, by requiring the stocks have an HV reading of 40% orhigher, it helps to weed out stocks with less potential.
MEAN REVERSION
In Option Volatility and Pricing Strategies, Sheldon Natenberg states thatvolatility tends to be mean (average) reverting. This complex concept canbest be described in a joke: If you know someone who’s normally meanand they are nice to you for a few days, chances are they will revert backto being mean. Seriously, “mean reversion” suggests that lower-than-nor-mal volatility levels will revert back to higher or more average readings.
In Investment Secrets Of A Hedge Fund Manager, Larry Connors and BlakeHayward expanded on Natenberg’s work and showed that when shorterterm HV readings dropped below 50% of their longer-term HV readings,114 Chapter 9
a large market move was prone to ensue as volatility reverts back to itsmean.
As an example, referring to Figure 9.2, Analog Devices (ADI), notice thatthe six-day HV reading (33.39) dropped to less than half of the 100-dayHV Reading (68.39) as the stock traded sideways. Referring to Figure 9.3,the stock explodes higher (a) as the short-term volatility reverts back tomore normal longer-term levels (b).
FIGURE 9.2
 
Analog Devices:Daily 02/15/2000 C=29.968 +718
aan JE
 
 
 
 Finding Explosive Moves: An Advanced Lesson in Swing Trading
FIGURE 9.3
115
 
——
Analog Devices-Daily 02/24/2000 C=40.312 +3.406
 
 
Although Connors and Hayward showed that large moves often occurout of low-volatility situations, they did not attempt to predict the direc-tion of the move. They stated: “The Connors-Hayward Historical VolatilitySystem has an uncanny ability to predict major moves. Unfortunately, it doesnot tell you in which direction the move will be. Therefore, the strategy you se-lect will depend upon the strategies and indicators you are comfortable with.”
I agree with Connors and Hayward. Therefore, when I encounter a mar-ket that has low short-term volatility readings versus its longer-term, Ilook for setups described in this manual that might suggest which waythe market is headed.
HV RATIOS
Before we get into examples of applying short- versus long-term volatil-ity readings to stocks, let’s look at an easier way to recognize this rela-tionship. This relationship can be expressed as a ratio. That is, to dividethe shorter-term HV (six-day) reading by the longer-term (100-day) vola-
 
 I116 Chapter 9
tility reading. When the ratio drops below 50%, we know that the markethas the potential to make a large move as volatility reverts back to itsmean. Figure 9.4, is the same stock described earlier except that the100-day HV reading and six-day HV readings have been replaced withthe ratio of the six-day HV divided by the 100-day HV. Notice that theratio drops below 50% (a) right before the stock makes a large move (b).
FIGURE 9.4
 
 
 
 
Let’s look at some swing-trade setups that also had low 6/100 HV-ratioreadings.Finding Explosive Moves: An Advanced Lesson in Swing Trading 117
Here we have an example of a Trend Pivot Pullback with a low 6/100HV ratio.
FIGURE 9.5
 
 
 
 
 
 
1. Alpharma (ALO) has 6-day HV/100-day HV reading below 50%. Thissuggests a large move is imminent, as volatility is prone to revert backto its mean.
N
. The stock sets up as a Trend Pivot Pullback (see Chapter 6 for details).
»
An entry is triggered on the Trend Pivot Pullback.
rs
» The stock explodes higher as volatility reverts back to its mean (a).I118 Chapter 9
Here we have an example of a High-Level Micro Double Bottom withlow 6/100 HV readings.
FIGURE 9.6
 
l2 Technologies-Daily 12/08/1999 C=82.500codecs cc hee cueseeeleeveettedeeeeeetuetustseeees : veeeeeeee be eees beeiees : a. yl 75
ee ee eee a e Leo
       
vo eettedieseesdocteeusdeetedtee dosed amproyllan atpeest wos
“
       
6/100. AY:a
 
 
 
1. [2 Technologies (ITWO) has 6-day HV/100-day HV reading below50%. This suggests a large move is imminent, as volatility is prone torevert back to its mean.
2. The stock sets up as a High-Level Micro Double Bottom (see Chapter8 for details).
3. An entry is triggered on the High-Level Micro Double Bottom.
4. The stock explodes higher as volatility reverts back to its mean (a).Finding Explosive Moves: An Advanced Lesson in Swing Trading 119
FIGURE 9.7
 
Sandisk Corp-Daily 03/02/2000 C=104.875 +6.500°: (2) CO I
oN +Nt
beeen eee ee 2 eee ee | eee TCT
   
 
 
 
 
1. Sandisk (SNDK) has a 6-day HV/100-day HV reading below 50%.This suggests a large move is imminent, as volatility is prone to revertback to its mean.
2. The stock sets up as a Double Top Knockout (see Chapter 6 for de-tails).
3. This is where discretion comes in. Although the Double Top Knockoutdidn’t trigger right after the setup (day one), the fact that the stockheld at high levels and began to rally, combined with a low-volatilitysituation, made the setup still worthy of considering. Therefore, whenthe stock trades above the entry of the DT-KO, we go long.
4. The stock explodes over 30 points higher as volatility reverts back toits mean.I120 Chapter 9
Here we have an example of a shallow pullback with low 6/100 HVreadings.
FIGURE 9.8
 
-—-
 
 
 
 
1. Creative Technology (CREAF) has a 6-day HV/100-day HV readingbelow 50%. This suggests a large move is imminent, as volatility isprone to revert back to its mean.
2. The stock, which has been in a strong uptrend, forms a seven-bar shal-low pullback.
3. An entry is triggered on the pullback.
4. The stock explodes higher as volatility reverts back to its mean (a).Finding Explosive Moves: An Advanced Lesson in Swing Trading 121
Here’s another example of a shallow pullback with low 6/100 HV read-ings.
FIGURE 9.9
 
 
3Com: Corp-Dally 07/12/2000 c=64. 875 +8. 125 :
 
 
 
 
1. 3Com (COMS) is in a strong uptrend.
2. The 6/100 HV ratio drops below 50%. This suggests a large move isimminent as volatility is prone to revert back to its mean.
3. At the same time, the stock sets up as a shallow pullback.
4. The stock explodes nearly 20% higher in one day, as volatility revertsto its mean (a). 
SECTION FOUR
MARKET TIMING 
CHAPTER 10
MARKET TIMING FORSWING TRADING
A rising tide lifts all boats.— old Wall Street adage
Tn this chapter, we will look at how to gauge the overall direction of themarket to help time swing trades. This involves discretionary analysis, sys-tem analysis and sector analysis.
DISCRETIONARY ANALYSIS
When analyzing the overall indices, I first look for any Trend Qualifiersthat might suggest an overall trend. These include how the market is trad-ing relative to its 10-SMA, 20-EMA and 30-EMAs (Daylight, slope, properorder). I also look for setups and concepts described in this manual, suchas Trend Knockouts (TKOs), Simple Pullbacks (SP), etc. I check for theseon both the cash indices and in the futures market. As an example (Figure10.1), notice that in the sharp uptrend of the Nasdaq Composite from No-vember of 1999 through January of 2000 there were Trend Qualifiers in themoving averages such as positive slope and Daylight, and they were inproper uptrend order. Also notice that there were setups such as TrendKnockouts (TKOs) and Simple Pullbacks (SP) along the way.
 
125
 126 Chapter 1