you wanted to trade Amazon using a 200-day movingaverage, but when prices reached $90, the moving average was still lagging at
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$40. It finally turned down when prices broke below $50, capturing only onehalf of the profits. What could you have done?1. Place a fixed dollar stop, the amount you can afford to lose.2. Pick a support level on the chart that would signal a change of direction.3. Draw your own trendline that would signal a change of direction.4. Move the stop closer as profits accumulate in order to lose only a fixed
amount of your peak profits.All of these approaches have been used by traders, but not all of them aregood solutions. The most important rules to remember are:1. The best place to exit from a long position is the natural point where you
would want to enter a short position.2. The size of the stop-loss must be related to the speed of the trend. If you
are trading a slow trend, then the stop must be farther away.3. The stop should adjust to the volatility of the market. Your stop can be
closer if the price changes are small or the market is quiet, and larger ifprices are volatile.4. A stop-loss must not be closer than 11⁄2 times the current volatility (the
high to low range). If you want it closer, you should simply close outthe trade.5. You must first decide how you would reenter the trade once you are out.
USING A STOP-LOSS WITH CHARTED TRENDLINESThe most successful stop-loss is a support or resistance line. The next best isa trendline. Figure 8.1 shows the evolution of a trade and the changing stoploss levels.
Initial Placement of the Stop-LossWhether you enter a trend trade using a moving average trendline, a breakout, a swing method, or any other technique, the first stop should be belowthe most recent support level, and no closer than 11⁄2 times the current pricevolatility. In Figure 8.1 the first buy signal is during the beginning of November at about $24. Recent lows in October give a clear support level just under$15. That’s very far away, but a drop below $15 would clearly be a major
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Add trendlineafter 5th buy
New 3rd buyNew 2nd buyDid you raise the stop?5th buy signal
New trend buy
4th buy signal?5th stop-loss3rd buy signal
4th stop-loss
New 2nd stopNew 3rd stophit if intradaynot hit if MOC
New trend stop
3rd stop-loss position1st buy signal1st stop-loss
2nd buy signal—move stop higherNot good as stop—too close to volatility
FIGURE 8.1 Support levels used as a stop-loss. As profits develop in a long position, thestop is raised as new support levels are established.
change of direction. You may place the stop as close as $2 below your entryprice, given a daily volatility of $1.25; however, that would make yourchances of getting stopped out very high, even though the trend may still begoing up.The market tells you what to do. If you don’t like the trade because thenatural stop is too far away, find another stock to trade; don’t force the stopto be in a convenient place.
Raising the Stop-Loss to Protect ProfitsOnce the trade has been entered and the initial stop-loss placed, you do notever lower the stop-loss. You can raise the stop level by following these rules:1. If you are trading a breakout method and a secondary buy signal occurs
(a breakout but not the first breakout to the upside), move the stop to thesupport level that would give a sell signal. In Figure 8.1 the second buysignal occurs soon after the first one, and the new support level is nowvery close. You would use that level because you’re concerned about therisk. Experienced traders would not use that level because they see it as
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too close. The trade looks good after the second breakout, and you wantto give it a chance to develop without getting stopped out.2. When a new support level is formed, you can raise the stop to that level.New support levels follow a price pullback. The third and fourth buy signals are good examples. Each occurs after the prices run up and thenfalls back part of the way. When prices move above the recent highs, weget another buy signal. The new support levels, which were the lows ofthe pullback, become the new stop-loss points.3. Each time subsequent buy signals occur or new support levels are
formed, the stop should be raised.4. As the trade develops, you may be able to draw a significant trendline to
add another view of where the stop should be placed. The stop-loss canbe the higher of the nearest support level or the trendline. In Figure 8.1 avery nice trendline can be drawn after the fifth buy signal. Using thetrendline, a stop-loss or sell signal would occur at $65, well above the lastsupport level of $50. In this case the trendline is clear and a significantimprovement over the support level.
Using the Closing Price for the Stop-LossAlthough your instincts may prefer exiting a trade at the moment it dropsthrough your stop-loss, it is not the most profitable approach. Prices can bevery volatile during the day. Much of this volatility is caused by moderate-sizeorders hitting the market during quiet periods. Yes, there are quiet periods.Most activity occurs at the open and falls off to a low at lunchtime. Afterlunch, volume increases until activity is again high in the last half-hour oftrading. Volume during the day has a “U” pattern. Much smaller orders canmove prices in the middle of the day.To protect yourself against false breakouts, exit your trade only when thestop-loss level is broken as of the close of trading. If prices break belowthe stop during the trading session but close above your stop price, you don’tget out. There is a special order for this type of trade, called a stop close only.If you want to move your Amazon stop up to $42 but only exit if prices closebelow $42, then your order is:SELL 1000 AMZN 42.00 STOP CLOSE ONLYFigure 8.1 shows an example in late March of an intraday penetration ofthe stop level but a higher close. Prices fell to $57 although the stop order
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was at $58. Prices closed higher than $58; therefore, the trade was not closedout. Because of the increased volatility, the stop was lowered to the low ofthe day, $57. This conflicts with an earlier rule, don’t ever lower the stop, butthere is always an exception.
If Volatility IncreasesYou want to keep your stop farther away if volatility is high and closer ifvolatility is low. When volatility increases, the stop should be farther from thecurrent price, but do not lower it. Instead, it should be raised at a slowerrate as new support levels are formed. That should be a natural process incharting. With higher volatility, prices make larger swings, and the supportlevels are farther away. This can also be seen in Figure 8.1 as prices declinefrom their highs. The price swings cause highs and lows to be farther apartthan they were on the bull move.If you are concerned with the volatility of the market or concerned withhow far away the stop is placed, you should exit the trade. Next time youshould trade a smaller position or pick a stock with less volatility.
Fixed Dollar Stop-Loss and Changing VolatilityLook at using a fixed dollar stop-loss from another viewpoint. At thebeginning of the Amazon chart a $2 stop-loss might have worked. Nearthe top of the chart, prices were moving $20 in a single day. If you keepusing the same size stop-loss as volatility increases, you will get stoppedout on the first price drop. You would net less than if you simply closed outyour trade.Fixed stops are just as bad if volatility is declining. You start with a $30stop-loss when the volatility is $20, and prices move lower. Volatility drops to$5 and your stop is still $30 away. Your risk is now greater than your profitpotential.
USING A TWO MOVING AVERAGE SYSTEM TO REDUCE RISKAnother simple way to control the risk of a trend-following system is to usetwo trendlines instead of one. The rules for a two-trend system are:1. Choose a long calculation period (between 50 and 200 days) and a short
calculation period (between 5 and 30 days) for two moving averages.
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2. Buy when both trendlines are up, and sell when one trendline turns down
(the fast one will always turn down before the slow one).The risk of this two-trend system is dependent on the speed of the fastesttrend. The shorter the calculation period, the smaller the risk. Instead of onelong trade that captures a big price move, this method will have a number ofsmaller trades. The total profits will usually be less that the single-trendapproach, but so will the risk. The resulting reward-to-risk ratio may be muchbetter with the two-trend approach—and you won’t be giving back half ofyour profits at the end of a major price move.
An Amazon ExampleUsing Amazon from October 1998 through April 1999 (see Figure 8.2), we plotboth an 80-day moving average (the straighter, smoother trendline) and a10-day moving average. The trading rules are to buy when both trends aremoving up and sell when the fast trend turns down.
Using two moving averages you canonly be long during this period whenboth trendlines are moving upThis avoids the large drawdownafter the peak in the middle ofthe chart
Close out long whenshort-term trend turns down
Close outand reenter
Enterlong
Close-outlong
Enter long
Enter long
FIGURE 8.2
Using a 2-trend system to control risk. Instead of using a very slow trendand giving back a large part of the profits at the end of the trade, a 2-trend system generatesmany smaller trades, each with much lower risk.
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The buy signal is taken at the end of October 1998 when the faster trendline crosses above the slower one. The entry price was $20. The faster trenddoesn’t turn down until mid-January, on the fifth day after prices penetratethe fast trendline moving lower. The exit price is about $70 while the slowtrend is moving smoothly through the $35 level.The fast trend briefly turns up again at the beginning of February and weenter a long and get out three days later when the trend turns down for aloss of about $3. In late February we get another chance to go long, this timeholding the trade until late March for a profit of only $5 (we were executedfar from the trendline on the days the trend turned up and down). The nextbuy signal lasts about one month and nets another $15. At the very end ofthe chart there are a few choppy price changes that should have cost about$5 in total.These trades yielded a total profit of $62 per share. Meanwhile, theslower trend continued to move higher, and the current price is about $98,which gives a net open profit of $78. The word open needs to be emphasized.You have a larger profit in the slower trend, but you haven’t yet closed out thetrade. A lot can happen if you don’t take your profits, yet a trend systemwon’t let you out until the trend turns. If prices head down now, you will onlycapture about $70. You would have taken a greater risk than with the twotrend system and ended up with a smaller profit. Long-term trends work, buttwo trends work better than one.
THE REALITY OF TRADINGA stop-loss doesn’t work when you’re trying to protect yourself against disaster—when a price shock hits. When a truly unexpected, volatile event hitsthe market, prices jump. Very, very little trading occurs as the price drops farpast your stop order. You don’t get executed until prices stop dropping.You ask, “Aren’t I automatically filled when my stop is in the market?”No. As a seller, you’re only filled when there is a buyer. When prices dropsuddenly, such as on 9/11, there are only a few buyers and loads of sellers.You can only be sure you’ve been filled on a sell order if prices print higher.Then all the sell orders have been absorbed. In the case of a price shock, youcan be sure of getting executed at the lowest price of the move.So why use a stop order if it doesn’t get filled? Sometimes the pricepauses in a decline and lets you get out. That’s better than not at all. If youuse a stop-loss as part of your normal strategy and there are no price shocks,
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you should get filled near your price. Always set the stop-loss at the pointwhere the reason for the current trade disappears.
A Few Good Reasons to Use a Stop-Loss1. Using a stop-loss forces you to identify the risk of your trade. You must
not enter a trade without knowing the risk.2. A stop-loss works best when it is set at the point where the reason for the
current trade disappears.3. Used correctly, a stop-loss will reduce risk more than it will reduce prof-
its. If you are stopped out, be sure you have a plan for reentering the nexttrade.4. A stop-loss is not likely to save you in a price shock, but you might get
lucky.5. A stop-loss lets you sleep better.6. Done correctly, a stop-loss is like the cost of insurance—you don’t mind
paying but don’t want to collect.
THE TRADING TIPS1. Free exposure, a necessary ingredient for fast trading. Fast trading
requires concentration on entry timing. The first few minutes or hoursare the difference between profits and losses. In order to create profitsquickly, you need to look for opportunities where the market will giveyou free exposure. Free exposure is a burst of price movement. Withoutfree exposure your losses may eventually outweigh your profits.Breakouts are the most common place to look for free exposure.When there is a clear trendline after a sustained downward move, orclear support and resistance marking a sideways period, you need toprepare for the breakout. For example, as prices get closer to the resistance level in a sideways move, you need to place your buy order belowthat level so that if prices rally to new highs, you are in the trade earlyand profit by being swept along with the movement. You may benefitfrom a gap if a lot of orders are clustered at the breakout point. You’vegotten free exposure.What if prices don’t break through resistance? If you are already inthe trade and prices start turning down, then get out and take a smallloss. When prices look as though they want to test the highs again,
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place your order ahead of others. It may take a few tries, but the endresult is success.2. Don’t day trade. Day trading requires full immersion all day. You need to
get the basics under control. Day trading speeds up the process so thatmistakes occur much more often. It’s best to evaluate the price patternsafter the market closes and work out a plan. Place your orders before theopen of the next day3. Be careful if your buy and sell orders can both be reached on a volatile
day. You’ll need to look at an intraday chart at the end of the day to findout which order was executed first. It’s important to be accurate.4. Include orders for both a profitable scenario and a losing one. When
you enter a trade, you must also know where you’re going to exit. Youdon’t always need to place your exit order on the same day you enter, butyou must know where the trade goes wrong. On the day after you’veentered your trade, start placing your stop-loss order to protect your risk.You can also place your profit-taking order if you have one.5. Don’t be ambiguous. “I think it’s going to sell off” is not a reason for a
trade. When you’re logging your reasons on the trade blotter, keep ittechnical.
TRADING GAME #2Now that you’ve had some practice trading, it’s time to change the rules.We’re going to reduce the number of stock and futures markets that you’lltrade and increase the size of the positions. Risk now comes into play.1. Forget all of the positions you are now trading.2. You have $100,000.3. You will trade only four stocks. Try to select them from different groups
and make sure they are actively traded—for example, Amazon (AMZN),General Electric (GE), Microsoft (MSFT), and Exxon-Mobile (XOM).4. Each stock trade will be 5,000 shares. No partial orders are allowed.5. You may go short stocks (there is no uptick rule and no borrowing
money; capital will count as though a short position was a long position).6. You will trade two futures, the S&P 500 and Treasury notes. Pick the
nearest contract to delivery. Delivery months are March (H), June (M),September (U), and December (Z).
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7. You trade only 1 contract each of S&P and Treasury note futures. There
will be no commissions.8. You will start with no positions. Begin your accounting with no open
trades and no history. Prepare the history as before.9. Profits will count. In the first game it was important to try out the tech-
niques. Now you need to pay attention to how near or far you place yourstop-loss order. If you’re placing your stops too close or too far away, themarket will tell you that you’re right or wrong.10. No day trading, please.11. Keep track of your capital in use. You could lose everything. Remember
that 5,000 shares of a $50 stock is $250,000. It adds up. One contract ofthe S&P 500 may cost only $20,000 in margin to trade, but a 20-pointmove in one day is a profit or loss of $5,000, 5 percent of your capital.That adds up, too.12. Continue writing a brief explanation with each order.13. By now you should be able to keep the correct accounting of your posi-
tions. In real trading you must know your profits and losses every daybefore you enter the new orders.14. Do not lose more than 20 percent of your capital on any one trade. A bet-
ter risk is 10 percent. Large risk means that you’re not diversifying, buttrying to profit from one good trade. You should have a number of tradesworking at the same time. You should expect three of four trades to beprofitable. If two of four are profitable you’re still okay. If one of fouris profitable, then you’re not looking at each market as a unique opportunity. You need the diversification to control risk. Be sure your tradesreflect the special patterns of each market.15. Enter your orders clearly.16. Don’t forget: We are trading, not investing. Don’t hold your trades long—
two to five days is about right. Target a reasonable profit. Get out whenit goes the wrong way.Good luck!
Questions1. The best place for a stop-loss is (a) as close as possible, (b) based on how
much you can afford to lose, or (c) a support or resistance level.
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2. What is the closest point at which you would place a stop-loss order?
Why?3. When you enter a new long position, where would you place your initial
stop-loss?4. If you have just entered a long position, when would you raise your stop-
loss for the first time?5. What is the advantage of using a stop close only order on your long
position?6. Why would you use a fast and a slow trend instead of just a slow trend?7. If you’ve placed your stop-loss at $35 for your long position (entered at
$40) and a price shock causes a sudden, large drop to $25, what are youlikely to get as your exit price?
CHAPTER 9
One-Day ChartPatterns andReversals
atching a chart develop is fascinating. It is a study in human behavior. If that stock or futures market is traded in large volume, then itis a study in mass psychology. The classic examples of investorbehavior have been reviewed many times, but none better than in Mackay’sExtraordinary Popular Delusions and the Madness of Crowds, where hedescribes the history of the South Sea Bubble and Tulipmania. You may drawyour own conclusions as to whether the Japanese Nikkei or the Nasdaq indexwere similar “bubbles.”Index markets have much greater liquidity than individual stocks. It wasCharles Dow who decided to create an index to reduce the effects of manipulation in a single issue. His analysis was based on the reliability of index patterns. Although stocks are much more liquid than in Dow’s time, the playersare also far larger. Institutions with pension funds and large investment fundswill overwhelm all other traders when they are entering or exiting one stock.They can create a pattern in one stock that reflects their own actions, yet thatprice movement can be absorbed into a larger index, such as the S&P 500,with little significance.In this chapter we will look at one-day chart patterns, those reflected ina single bar showing the opening, high, low, and closing price of the day. Ofcourse, that bar only makes sense when viewed relative to the previous bars.Some of these patterns only exist after the fact; that is, you can’t tell they’veoccurred until you look back at the chart a few days later. These patternshave less value because they don’t give immediate feedback, but they help topaint a larger picture. We’ll see how anticipation of some of these patternscan give you free exposure, the ability to profit from the action of the masses.
W
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GAPSA gap is a day in which the low price is above the high of the previous day(upward gap) or the high is below the low of the previous day (downwardgap). A gap is most often reaction to unexpected news. Gaps are more common in individual stocks than indices. Individual stocks likely will providesurprising news of quarterly dividends, guidance, new products, failure toget Federal approval for a new drug or acquisition, scandals, and countlessother items.A gap also can result from many buy orders clustered at the same place.This often happens when a stock has been trading in a clear sideways range.Traders will place buy orders at the point of a new high price, looking for abreakout to start a new upward trend. When prices touch that level, all of theorders are triggered, there are many more buyers than sellers, and the pricejumps up.
Common GapGaps occur often. They can be seen as a small white space on a chart. Mostof them are not important. When you look back at a chart, many of these gapsoccur within a trading range. They don’t result in a new high or low price, andthe patterns that follow don’t begin a new trend or show any signs of beingsignificant.You can call a common gap simply a “gap” or a “plain old gap” or simplyignore it. A common gap is filled within a few days. That is, if prices jumpedup, then they will drift lower with the next few sessions until the subsequentprice lows overlap the gap. In the beginning of September 1999 (see Figure9.1) Microsoft prices gapped higher by about 50¢ from their previous high of$92 (gap #3). In the next two days prices traded slightly higher and then filledthe gap by trading below $92. Common gaps are always filled within a fewdays. You need to wait before you know that it was a common gap.
Breakaway GapThe breakaway gap is the most useful of all gaps because it can be used at themoment it occurs. It is a price jump that breaks the previous chart pattern. InFigure 9.1 the breakaway gap (gap #2) in late August occurs after a $20 dropand a short sideways period. It is easy to recognize when it occurs, but noteasy to trade profitably unless it occurs at the exact point of a resistance line.
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1
354
2
6
FIGURE 9.1 Microsoft gaps. There are six gaps during the period from July throughNovember 1999. Three of the gaps, during September and October, would be considered common gaps. They did not result in new highs or lows, and the price movement that followedwasn’t important.
A breakaway shows a change in investor attitude. Larger gaps occurwhen there is more participation and the breakout pattern is clear. When it isclear, traders bunch their orders together at the same obvious point. It is astrong, reliable trading signal.Two Breakaway Gap Examples. There are two obvious breakaway gapsin Figure 9.1, a sharp move up in late August (gap #2) and another smallerbreakout in late November (gap #6). With gap #2, if you had waited for theend of the day to act, you would have been long just above $92, nearly $5higher than the previous day. There would have been quite a few days inwhich prices traded higher and you could have made a small profit. Sometraders would have been nervous when prices fell under $92 and taken a loss.In the second case the breakaway gap was larger, but the day’s tradingrange was smaller. You would be long on the close at $94. In this exampleeach of the next 10 days would have been profitable although there wereno new highs. To a short-term trader these look like breakaway gaps; fora longer-term view they might be common gaps. For the long-term trader a
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breakaway gap would occur on a jump above the highs at 98, or below thelows at 82.Trading the Breakaway Gap. To take advantage of a breakaway gap, youneed to be long before the upward breakout. Most profits are made by anticipating, not following. That’s not an easy task. You need the profit from thejump and price flow if you are to get free exposure.Anticipating the gap makes most sense when the trading pattern is clear,when there is a strong downtrend line that any fool can see, and when priceshave been trading in an obvious sideways pattern. You can then place yourbuy order slightly below the point of breakout, inside the trading range. Youmight be wrong a few times and take a small loss, but the profit from thebreakout should be enough to recover all the losses.Figure 9.2 shows different types of gaps on an Amazon chart. The firstbreakaway gap in December 1998 occurs on a move through clear resistancejust below $40. It is an opportunity for free exposure. The other breakawaygap in July 1999 is not as clear on the chart, but price might have fallenquickly through recent support right after the opening bell.
Possible exhaustion gap
Common gapBreakaway gapRunaway gapPlainold gap
Breakaway gap
FIGURE 9.2 An assortment of Amazon gaps. This Amazon chart shows a good sample ofdifferent gaps. The breakaway gap occurs when prices move out of a previous sideways pattern,or change direction. A runaway gap occurs in the middle of a sustained trend.
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Exhaustion GapA gap that occurs just after the peak of an extended, extreme run-up is anexhaustion gap. It is caused when traders realize that prices cannot to gostraight up because the stock is already overpriced, and the buyers suddenlydisappear. An exhaustion gap is usually followed by a substantial drop inprices, but that does not mean new highs won’t occur after prices stabilize. Itsets up an interesting trading pattern.The price peak that precedes an exhaustion gap becomes a major clearresistance level. As prices move back toward that high, traders will be looking to sell at any opportunity. In Figure 9.2 we see an exhaustion gap twodays after the high in April 1999. On the following day, prices trade up intothe gap, closing slightly higher on the day, and afterward prices fall. There aretwo more exhaustion gaps in Figure 9.2, one following the peak in July 1999and a small one in August 1999. Both of these secondary peaks show lowervolatility and occur well below the highest price; therefore, we would treatthem as a short-term indicator. When prices move above the high of the thirdpeak, we quickly accept the fact that the recent top was not important.A true exhaustion gap must be seen in context with other prices. Itshould follow inceasing volatility, preferably extremely high volatility. It shouldfollow an unusually high price. Prices should continue to be volatile duringthe decline. The second and third exhaustion gaps in Figure 9.2 do not satisfythe high volatility and high price criteria needed.
Runaway GapsA runaway gap confirms a trend and indicates acceleration in the pricemove. It is a good confirmation of direction and, if you are long the Euro inDecember of 2000 (as in Figure 9.3), it quickly adds to your profits.Runaway gaps are marked in Figures 9.2 and 9.3. They occur while pricesare already in a trend. They may be caused by latecomers trying to jump onboard a moving train. The sellers aren’t interested because the trend is stillmoving up quickly; therefore, the buyers need to pay a higher price to join in.Being late to the party is never a good idea. In Figure 9.3, those who boughtthe Euro at .9250 would have been lucky to have captured any profit. It’smore likely that a trader who was late getting in will be late getting out.
SpikesA spike high is seen as a day in which the high is well above the high of thepreceding and following days. It is at least a local top; it could be a major top.
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Runaway gaps
Spike
Breakaway gap
SpikeBreakaway gapSpike
FIGURE 9.3 Euro chart showing gaps and spikes. This Euro chart has a collection ofgaps and spikes. Note that the first two spikes, in November 2000 (an upward spike) and April2001 (a downward spike), were broken with breakaway gaps.
It usually can be seen the day after it occurs. In Figure 9.4, U.S. bonds showspikes in mid-June, mid-July, and mid-August. In each case it took more thana week before new highs exceeded the high of the spikes. Spike highs aremost useful if the close of the day is near the lows. We then have some earlywarning that the spike high will be a top.A Word of Caution about Spikes. Spikes may seem infrequent and obvious because most potential spikes disappear into normal price patterns.That is, after an upward jump, prices continue higher or form a sidewayspattern so that the potential spike becomes an invisible part of a larger pricepattern. That makes a spike a less dependable pattern for trading.In Figure 9.4 we can see that three days after each spike, the priceslooked as if they might fall sharply. Instead, prices started back up, movingabove the spike high before correcting and finally moving higher. Each ofthese cases proved a good short-term opportunity, but not the beginning oftrend change.On the far right of Figure 9.4 we see two volatile one-day price drops afterthe high. Had prices opened higher and remained higher after either day, we
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FailedtestSpike #3
Failedtest
Spike #2
Spike #1
Failedtest
FIGURE 9.4 False tops in bonds. From June through October 2002, U.S. bonds show threespikes that form potential V tops after one to three days following the spike. Each spike wasfollowed by an attempt to move higher, each time making new highs then falling back. Patternslook very different when you are trading than when you look at the chart in retrospect