, can, in fact, be a very effective day-tradingmethod. Many very large intraday price moves have given trend linesignals. I recommend the use of trend line analysis as both an effectiveas well as time-tested method. While there is clearly some art to the sci-ence of trend line analysis, it is a technique which few traders use dur-ing these days of high-tech trading.
Flags and Pennants. A flag or pennant chart formation is exactlywhat its name implies. Figure 12-4 shows a few flags on intraday charts.As you can see, the narrowing portion of a flag usually develops into abreakout up or down. The trader using such formations will be alert tothe possibility of a breakout as the flag narrows, and he or she will tradewith the direction of the breakout.
Rounding Tops, Rounding Bottoms. Yet another classical chartformation is the rounding top or bottom. Figures 12-5 and 12-6 showsuch patterns on intraday charts. Day traders will want to sell short orexit long positions when the lowest portion of the rounding top has
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Figure 12-4. Flags or pennants on intraday chart.116 = Chapter Twelve
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Figure 12-6. Rounding bottom on intraday chart.Traditional Methods of Technical Analysis and Day Trading 117
been penetrated. Day traders will want to buy when the highest portionof the rounding bottom has been penetrated. In practice such formationsare rather rare on intraday charts. Study intraday charts and see howmany of these formations you can spot.
Breakaway Gaps. Typically such a pattern is a good one; however,the majority of research on such gaps has been on daily price charts. Inpractice, breakaway gaps rarely occur on intraday charts. Figure 12-7shows such a formation. Chartists feel that such gaps, if in the up direc-tion, are very bullish and, if in the down direction, are very bearish.
Key Reversals. A key reversal up occurs when a market tradesbelow the low of its last price bar, above the high of its last price bar,and closes above the close of its last price bar. My research has shownsuch patterns not to be too effective on daily bar charts, but they appearto be much more significant on intraday charts. Figure 12-8 shows sucha formation and its consequence.
A key reversal down occurs when the market trades above its lastprice bar, below its last price bar, and then closes below the close of itslast price bar. Figure 12-9 shows such a formation.
Reversals tend to be good signals for day trading, apparently muchbetter than they are for short-term or position trading.
 
Figure 12-7. Breakaway gap on intraday chart.118 ~~ Chapter Twelve
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Figure 12-8. Reversal down on intraday chart.
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Figure 12-9. Reversal up on intraday chart.Traditional Methods of Technical Analysis and Day Trading 4 19
Congestion and Breakouts. These are very important patterns onintraday charts. Congestion occurs when prices trade within a very welldefined range either after a rally or a decline or within an existing peri-od of strength or weakness. Figure 12-10 shows a few examples of pricecongestion. They also show what occurs after a breakout from conges-tion. As you can see, breakouts following periods of congestion can bevery profitable within the day time frame. I recommend you followthem. While this is not a totally mechanical methodology, it is not diffi-cult to use and can yield large rewards. It does take some training andexperience, however.
Summary and Conclusions
Although some traders will criticize the use of chart patterns as lackingthe kind of objectivity required in this day and age of computerizedtrading, I do not agree. I feel that the skilled chartist can trade muchmore profitably than can the pure technician. It is, however, much moredifficult to become skilled at recognizing and using chart patterns thanit is to read a simple technical indicator. But in order to do so the trader
 
Figure 12-10. Congestion and breakout on intraday chart.120 = Chapter Twelve
will need to have considerable experience, experience which can only beacquired through practice, practice, and more practice. Therefore, myadvice to would-be chartists who plan to use their skills for day tradingis to become very familiar with the patterns described above and withthose described in the standard technical analysis texts such as Edwardsand McGee.”
*R. D. Edwards and J. McGee, Technical Analysis of Stock Trends, John McGee, Inc., Springfield, Mass.,1966.1
A Unique Oscillatorfor Day Trading
An oscillator is a timing indicator which is comprised essentially of twoor more moving averages. To oscillate means to move back and forthbetween extremes. Hence, an oscillator is an indicator which changesvalues between two extreme levels. The stochastic indicator is an oscilla-tor, and so are RSI, MOM, and ROC. Not all oscillators are the sameeven though they are based on the same general idea. The basic con-struction of a two-line oscillator appears as shown in Figure 13-1. Asyou can see, the oscillator values generate buy and sell signals whenthey change their positions by crossing over one another. The simplestoscillator consists of two moving averages.
Such indicators as the moving average convergence-divergence(MACD) consist of exponential moving averages which generate buyand sell signals when they cross, very similar to the relationships shownin Figure 13-1.
Although MACD is a very effective technique for day trading, there isanother oscillator method which I feel has more potential for the daytrader. MACD, in my experience, is a very effective method for tradingshort-term price swings of from 2 to 6 days’ duration.
Figures 13-2 and 13-3 illustrate how MACD buy and sell signals occuron the intraday S&P futures charts. As you can see, MACD is an out-standing indicator for trading such moves. MACD is also an acceptableindicator for day trading, but I find that another oscillator is preferable.Specifically, I am referring to an oscillator which compares opening toclosing prices on an intraday basis.
121122 ~~ Chapter Thirteen
 
Figure 13-2. Ideal oscillator signals.A Unique Oscillator for Day Trading 123
 
 
Figure 13-3. MACD signals used in short-term trading.
Opens versus Closes
Although there is no such thing as a 5-minute open or a 5-minute close,the concept is a simple one to understand. The first price tick of a 5-minute period is arbitrarily defined as the open, and the last tick of the5-minute time segment is arbitrarily defined as the 5-minute close.
The relationship is a simple one. It is based on the well-establishedpattern for closing prices in a bull trend to be higher than openingprices and for closing prices in a bear trend to be lower than openingprices. By comparing a moving average of the 5-, 10-, or 15-minuteopenings with a moving average of the 5-, 10-, or 15-minute closings, wecan quickly detect trend changes either before they occur or very earlyin their inception.
Figures 13-4a and 13-40 illustrate the ideal signals and relationship towhich I am referring using a 5-minute chart of S&P futures. Examine mybuy and sell signals in relation to price trend changes during the day.Figure 13-5 shows the same oscillator combination and signals on aSwiss franc chart.
As you can see from the illustrations, the signals are very reliable andtend to signal major moves. I call this method the O/C oscillator (O/C).Although the O/C method is wonderful for catching large intradayprice swings, it does have its limitations which I will discuss later on.124 = Chapter Thirteen
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Figure 13-44. Ideal oscillator signals.
 
Figure 13-4b. Open and close oscillator signals in 5-minute S&P.A Unique Oscillator for Day Trading 125
 
Figure 13-5. Open and close oscillator signals in 5-minute Swiss francs.
Before doing so, however, I’ll review the construction of the O/C oscil-lator, and then I'll give you rules for using it.
Construction of the O/C for IntradayTrading
The O/C is constructed as follows:
1. Use two smoothed moving averages (MAs) as follows:
a. A smoothed moving average of the opening prices consisting of 6to 10 periods on 5-, 10-, 15-, or 20-minute data.
b. A second smoothed moving average which consists of closingprices of 12 to 24 periods on 5-, 10-, 15-, or 20-minute data.
2. Buy and sell on crossovers of the two MA lines. When the MA of theclose crosses over the MA of the open, a buy is signaled, and whenthe MA of the close falls below the MA of the open, a sell is signaled.
3. You will need to adjust the lengths used as a function of the timespan you are using (i.e., 5-, 10-, 15-, or 20-minute data) and thevolatility of the market you are following. There are no hard and fastrules for doing this. You will need to use your judgment; however,after you work with this method for a while, you will become quiteadept at making the proper selections. (Formula for smoothed MA isin appendix at end of book.)126 = Chapter Thirteen
4. An important issue which you will need to deal with is the amount ofthe crossover. In other words, you will need to determine how muchof a crossover will be sufficient to generate a signal in either direc-tion. In this respect consider Figure 13-6. As you can see, the minorcrossovers, which do occur, are not reliable. They must be sufficientlylarge. You will need to determine the crossover amount or threshold.You can do this fairly easily be examining recent signals. Be sure tomonitor the O/C performance closely.
5. You may use O/C signals in the opposite direction to reverse posi-tions, or you may use a trailing stop loss to exit prior to a reversingsignal. Some subjective decisions may be necessary in exiting tradeswhich are initiated using O/C signals, but I stress that this is not atotally mechanical system. It does require decisions. It is, however, oneof the most sensitive methods I know for trading volatile marketssuch as S&P and the currencies. It has also worked well in other mar-kets. Naturally, you will want to be out of all trades by the end of theday, and you will wait for the next day to enter on new signals.
Examining Some Signals
Figures 13-7 through 13-11 illustrate O/C signals in a number of mar-kets using various time lengths along with my hand-written comments.
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Figure 13-6. O/C false signals.A Unique Oscillator for Day Trading 127
 
Figure 13-7. O/C signals on 10-minute data.
 
Figure 13-8. O/C signals in 5-minute S&P.128 Chapter Thirteen
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Figure 13-10. O/C signals in 3-minute S&P.A Unique Oscillator for Day Trading 129
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Figure 13-11. O/C signals in 5-minute coffee.
Summary and Conclusions
The O/C system is a sound and useful one for day traders. Its rules ofapplication for entry signals are specific, objective, and mechanical. It isreadily tracked by computer and tends to get on board when majormoves occur within the day time frame. ] recommend tracking thismethod in the more active markets, particularly those markets whichhave a high dollar value per tick. As with most day-trade systems dis-cussed in this book, entry signals are specific and objective. Exiting posi-tions, however, are less objective. This method, in particular, is amenableto the use of a fairly close trailing stop-loss. You may wish to exit at agiven price or time target. It is not uncommon for large profits to bediminished substantially as a result of waiting for a reversing signal.
Yet another suggested method of exit is to use a shorter-term timeframe for exit than was originally used for entry. If you use an entry sig-nal generated on a 10-minute S&P chart, you could exit when the 3- or5-minute S&P chart gave its subsequent reversal signal. At this pointyou would not reverse position, you would merely close the positionout. This, by the way, is an excellent method for exiting positions usingother timing signals than the O/C.Scalping the Markets
130
For many years, it was a given that scalping, or trading the market forextremely quick and relatively small moves, was the exclusive domainof the floor trader. Given the floor trader’s low commission costs andquick order executions, the ability to enter and exit markets promptlywas translated into profitable trading with relative ease. Although thescalping game has become more competitive in recent years, it is still agame which may be played with fairly good odds of success providedone is acquainted with the proper techniques.
Unfortunately, many futures traders do not understand how the major-ity of floor traders operate. This misunderstanding, or I should say lackof understanding, leads to the erroneous conclusion that we, as off-the-floor traders, somehow compete directly with traders on the floor. Thisis not necessarily true. What suits the floor trader in terms of technique andgoal is not necessarily right for the outside or off-the-floor trader. The majorityof floor traders prefer to trade markets which move in fairly narrow butwell-defined price ranges, thereby allowing them to buy and sell fre-quently, trading large positions for small moves. In other words, most floortraders are perfectly content to trade back and forth in a market, taking profitsof one or two ticks frequently during the course of each trading day. What thefloor trader misses in size of price move is easily compensated for in sizeof position. Whereas the average off-the-floor trader seeks to profit fromfairly large moves, the floor trader seeks to profit from small movesusing large positions.
Given the general availability of instant price quotations, computer-ized trading systems, and low commission costs, it is possible for ailtraders to become scalpers, assuming that they have the temperamentand motivation to do so. But I warn you that of all the possible day-trading methods and orientations, scalping is the most demanding, themost intense, and the most difficult to learn. Yet it is paradoxically sim-Scalping the Markets 131
ple in its goals and intentions. Before discussing some of my favoritescalping techniques, I'll first define both the goal of scalping and howscalpers do what they do.
What Is Scalping?
Although the term scalping most likely originated in the heritage of thewild, wild American West, the contemporary trend for outrage at themere mention of ethnic issues prompts me to side-step the derivation ofthis term. Simply stated, the scalper attempts to trade futures markets foronly several ticks, taking advantage of fairly narrow trading ranges in order to“buy the bid and sell the offer.” The scalper, who is usually a floor trader,attempts to capitalize on relatively quiet times in the markets, buying atthe prevailing price (the bid price) or hopefully at one or two ticksbelow the anticipated fair price and selling at a slightly higher price orwhat is called the offer price. The best way I can drive home the point ofwhat it is that scalpers do is to state succinctly that scalpers attempt to buyat wholesale and sell at retail.
As you can understand, the price markup from wholesale to retail,although very high in some businesses, is not too high in the scalpingbusiness. Frequently, the markup amounts to only one or two priceticks. However, at $30 or more per price tick in Treasury bond futures,the prospects for profitable scalping are considerable. If the trader ispaying very small commissions ($14 or lower per trade), then a goodportion of each price tick per contract is profit. What the scalper maygive up in the way of price movement, he or she can compensate for interms of position size. From the scalper’s point of view, a trade of twoticks’ profit on 500 contracts works out to 1000 ticks—1000 ticks afterapproximately $15 in costs (which is a very high cost for the floor trad-er) works out to roughly $16,000 profit. Assuming a commission rate of$8 and often much, much lower for the floor trader, the profits are evenmore substantial.
It is now possible for traders who are not on the floor of the variousexchanges to trade in a fashion very similar to what floor traders dowhen they scalp the markets. Using some of the techniques discussed inthis book, the average trader who is willing to sit at the computer screenand watch the market tick-by-tick all day long can scalp in a fashionsimilar to floor traders. During the last few years, many floor traders,realizing that scalping is possible without being on the floor of theexchange, have left to become upstairs traders. An upstairs trader tradesas if he or she were on the floor but is, in actuality, trading from anoffice, usually located in the exchange building.132 = Chapter Fourteen
Rules for Scalping
In order to scalp the markets effectively, you must apply certain ruleswhich do not necessarily apply to other forms of day trading. You willneed to know and observe these rules carefully and consistently if youplan to become a successful scalper:
1. To compensate for the relatively small size of moves which you willattempt to be capturing as a scalper, you will need to trade considerablylarger positions.
2. If you are not willing to accept the risk of trading larger positions, thenyou cannot scalp the markets in a fashion which makes trading worthyour while. After all, if you plan to scalp bonds for one or two ticks at atime three or four times a day, and if you are unsuccessful in yourefforts one or two times a day, then the bottom line of your trading on aone-contract basis may only be one tick. Subtracting from this commis-sion costs, your scalping will prove to be a losing proposition or a mini-mally profitable venture, above and beyond what you have lost in termsof time. Therefore, it is necessary for you to make a commitment to larg-er positions, perhaps 5 or 10 contracts at a time, and to increase yourposition size once you have mastered the various scalping techniques Iwill suggest in this chapter.
3. To be a successful scalper, you will need to take your losses as well as yourprofits very quickly. If, for example, you are long T-bonds at $105.20expecting a move to $105.22, then you must enter orders to sell at$105.22, since you have set yourself a two-tick target. To expect $105.23or $105.24 would not be consistent with your scalping goals. The idea isto take numerous small profits of several ticks on large positionsthroughout the day. Only by following this goal will you achieve suc-cess as a scalper.
4. You must pay close attention to the market you are trading at alltimes. This means that you will be able to trade only one market at atime, since you will need to be at the screen watching every tick. If youhave a multiple screen monitor, it may be possible to scalp more than onemarket at a time; however, I think that pragmatically this would be diffi-cult. In addition to these rules, which are more operational rather thanmethodological, important techniques are explained in the next section.
Suggested Methods of Scalping
To scalp a market effectively, you must first isolate a specific tradingrange which is clearly defined in terms of support and resistance or inScalping the Markets 133
terms of bid and offer. As you know, the bid price is the price at whichbuyers are willing to buy; the offer price is a price at which sellers arewilling to sell. In most cases, there is a spread, or difference between thetwo, sometimes of one tick in size and other times several ticks in size,depending upon the market. In Treasury bonds, the bid offer spread isusually one tick. Therefore, by knowing the bid and the offer, the scalperwill attempt to buy at the bid price and sell at the offer price, otherwiseknown as buying the bid and selling the offer.
Here is a suggested technique for taking advantage of the bid-offerspread. Assume that Treasury bond futures have been trading in a fairlynarrow trading range after the initial opening volatility has been digest-ed. The market begins to trade between $103.15 and $103.17, a two-tickrange. As long as the market continues to trade in this range (and thiscould change at virtually any time), you will want to buy at the lowerend of the range and sell at the higher end of the range. In order to dothis, you will enter specific price orders to buy at $103.15. Fill-or-killorders should be used wherever possible. Therefore, you will enter anorder, for example, to buy March 1993 bonds at $105.15 fill or kill.Within several minutes, you will know whether you have been filled. Ifyou have been filled, you will then enter an opposite order to sell, per-haps at $105.16 or $105.17 which is within the asking price range.
This is the very basic technique of buying at the bid and selling at theoffer. As you can see, it is considerably more difficult to do off the floorthan it is on the trading floor, since floor traders know immediatelywhether they have been filled without having to wait for a third party toconfirm the price execution. The on-the-floor trader can, therefore, tradewith much greater speed than can the off-the-floor trader, who mustawait confirmation of order fills. Depending upon the firm with whichyou are doing business, the use of fill-or-kill orders may, if used too fre-quently, alienate brokers as well as floor traders. Therefore, the fill-or-kill order should be used only when absolutely necessary or in caseswhere the firm you are dealing with has no objections.
Another technique would be to use a price order and to give the mar-ket sufficient time to fill your order. In this case, I recommend workingwith a brokerage firm that will report your fills back to you as quicklyas possible. The problem with scalping away from the pit is not know-ing whether you have been filled.
Moving Average Channels
One of the methods described earlier in this book, the MAC (movingaverage channel) lends itself readily to use by scalpers. My recommend-134 = Chapter Fourteen
ed parameters for the MAC are 10 units of the high and 8 units of thelow. For scalpers these parameters are likely to be somewhat long. I rec-ommend instead using 5 units of the high and 4 units of the low.
Figure 14-1 illustrates how the MAC will look in relation to 5-minuteprice bars in T-bond futures. Figures 14-2 and 14-3 illustrate the samemethodology in Swiss francs and S&P futures.
These illustrations are included here merely as examples, but they arefairly typical in terms of structure and clearly show that scalping themarket by buying the low of the channel and exiting at the high of thechannel in an up trend is a good procedure. Conversely, in a down —trend, you may scalp the market by selling the high of the channel andbuying the low of the channel.
Alternatively, in sideways trending markets, the procedure is to buythe low of the channel, reversing position and selling the high of thechannel, and then reversing position again by covering shorts at the lowof the channel and going long.
Ideally, this technique will work in any market which has establishedsome specific channel relationships. It is your job to identify marketswhich are suitable for scalping. I have included several more exampleswhich will help you identify the types of markets you want to trade forscalping purposes. Remember that as a scalper it is your job to exit profitableand losing positions quickly in order to capitalize on the many price swings
 
Figure 14-1. The 5/4 MAC and 5-minute T-bond futures.Scalping the Markets 135
 
Figure 14-2, The 5/4 MAC and 5-minute Swiss franc futures.
 
Figure 14-3. The 5/4 MAC and 5-minute S&P futures.136
Chapter Fourteen
each day. It is especially important to exit your losing positions promptly sothat your small profits will not be erased by one large loss. Unfortunately, thishappens all too often. Sadly, some traders will scalp the markets veryeffectively all day long, only to allow one large losing trade to eliminatetheir entire profit for the day or worse. Therefore, the scalper should beparticularly attuned to exiting positions which are not working, quickly,without hesitation, and, of course, decisively.
Point-and-Figure Charting
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Another technique which lends itself readily to use by scalpers is point-and-figure charting. This book cannot provide you with a detailed dis-cussion of point-and-figure charting, but I will tell you that many floortraders I know use point-and-figure charts with great success on thetrading floor. Their charts are kept up to date as they trade. Figures14-4 and 14-5 show two sample intraday point and figure charts as wellas my illustrations of how to determine support and resistance levelsfor the purpose of buying and selling. Also, I recommend reading sev-eral of the excellent point-and-figure texts available. Here are some sug-gestions:
 
Figure 14-4. Intraday point-and-figure signals.Scalping the Markets 137
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Figure 14-5. Intraday point-and-figure signals.
The Market Profile
The market profile is yet another technique which can be used for thepurpose of scalping. J. Peter Steidlmayer, developer of the technique inassociation with the Chicago Board of Trade, has published many finearticles and several books on the topic. In addition, Dalton and Jonespublished Mind over Money, which describes their adaptation of themarket profile technique in great detail. Since the market profile is anextremely detailed and extensive topic, I will not discuss it herein, but Iwill tell you that if you understand the profile you can use it very suc-cessfully for the purpose of day trading. Of particular importance inusing the profile is the TPO count and the concept of market balance.The best type of day for trading for scalping the market is whatSteidlmayer identifies as the normal distribution day. As \ noted earlier, Isuggest you read any of the excellent references available on the marketprofile such as Pete’s excellent books or Mind over Money (Probus Books,Chicago, 1989) by Dalton and Jones.
Scalping on Rising or Falling
MarketsI have not yet said enough about the procedures for scalping withinexisting trends. Although most scalpers can do extremely well in side-138 = Chapter Fourteen
ways markets which move back and forth regularly between supportand resistance, scalpers can also profit handsomely during quick moveseither up or down. Such moves tend to occur most often after the releaseof certain government reports, statements by supposedly knowledge-able officials, or international news events. Should you happen to be onthe correct side of a market which begins to move sharply in your favor,then take advantage of the move by exiting your position immediately.It is always easier to exit a position while prices are moving within yourfavor than it is to do so when prices have started to change direction.Therefore, the successful scalper will want to take advantage of suchbulges, or craters, as I prefer to call them, by entering orders while themarket is still moving in your favor. Do not wait until the trend has eitherslowed, lost momentum, or changed direction.
There is a certain degree of tape-reading skill involved in followingsuch a procedure; however, it can certainly be developed with experi-ence. As an illustration, consider the chart and accompanying tickprintout shown in Figure 14-6. As you can see, this market bulged,began to trend sharply higher, peaked, and then turned lower. Thescalper who took advantage of the bulge to exit per my illustrations didwell. However, the scalper who failed to do so did not profit handsomelyat all.
 
Figure 14-6. Tick data—time and sales.Scalping the Markets 139
Summary
Scalpers find themselves in a unique category of day traders. Not onlydo they seek to trade within the day time frame, but they also attempt tocapitalize on the most minute of moves during the day. In order to be asuccessful scalper, you must either possess or develop specific skills toassist you in your endeavors. Since the scalper seeks to profit only onextremely small moves of several price ticks, it is of paramount impor-tance that positions be entered and exited quickly and that trading bedone on a large scale in order to compensate for the relatively small sizeof price moves. The scalper who truly wishes to be successful must bewilling to trade large positions, to take small moves out of the market,and to do so many times each day. While I feel that in some ways the jobof the scalper is more well-defined and more easily implemented thanthat of the more traditional day trader, it is also an extremely demand-ing role inasmuch as large positions which move against the scalperquickly can prove very costly. Therefore, if you intend to be a scalper,begin to increase your position size slowly and do so only as a functionof your financial ability.
Buying into Large Declines or Sellinginto Large Rallies
Many traders feel that they can successfully scalp a few ticks out of amarket by buying into large price declines in bull trends or selling intolarge price rallies in bear trends. This certainly makes a great deal ofsense in terms of ideal thinking; however, in practice it is a very riskyprocedure because large price declines can continue well beyond theo-retical support levels and large price rallies in existing bear trends cancontinue well beyond theoretical resistance points. Nevertheless, veryquick money can be made during such moves. The scalper can takeadvantage of these, provided certain rules are followed.
First, I refer you to my book Short-term Trading in Futures (ProbusPublishing, Chicago, 1988) for additional methods of support and resis-tance trading on a short-term basis. In particular, consult the section onprice spikes and probes. These two techniques, namely buying onprobes to support and selling on probes to resistance, can prove veryeffective to the scalper who is willing to establish a position duringlarge declines to support or large rallies to resistance but who must alsobe willing to exit these positions very quickly, right or wrong. An illus-tration will serve to clarify what I am suggesting. If you will recall mydiscussion of price spikes and probes, I noted that when a market140 Chapter Fourteen
declines quickly to a previous price spike on the down side that veryquick rallies can develop within a matter of seconds or minutes. This isparticularly advantageous to the scalper who will anticipate suchmoves; moves which usually occur in response to significant govern-ment reports or other scheduled news items.
Conclusions
No matter what method you use for scalping the fut