UTERIZED TECHNICAL ANALYSIS
Overbought and oversold levels vary from market to market and fromyear to year. There are no magical levels marking all tops and bottoms.Oversold and overbought signals are like hot and cold readings on a ther-mometer. The same temperature has a different meaning in summer or inwinter.
Horizontal reference lines must cut across the highest peaks and the low-est valleys of RSI. They are often drawn at 30 and 70. Some traders use 40and 80 levels in bull markets or 20 and 60 in bear markets. Use the 5 percentrule: Draw each line at a level beyond which RSI has spent less than 5 per-cent of its time in the past 4 to 6 months. Adjust reference lines once everythree months.
Mass Psychology
Each price represents the consensus of value of all market participants at themoment of transaction. Closing price reflects the most important consensusof the day because the settlement of traders’ accounts depends on it. Whenthe market closes higher, bulls make money and bears lose. When the marketcloses lower, bears make money and bulls lose.
Most traders in all markets pay more attention to closing prices than toany other prices. In the futures markets, money is transferred from losers’ towinners’ accounts at the end of each trading day. RSI shows whether bulls orbears are stronger at closing time —the crucial money-counting time in themarket.
Trading Rules
RSI gives three types of trading signals. They are, in order of importance,divergences, charting patterns, and the level of RSI.
Bullish and Bearish Divergences
Divergences between RSI and prices give the strongest buy and sell signals.They tend to occur at major tops and bottoms. They show when the trend isweak and ready to reverse (Figure 31-2).
1. Bullish divergences give buy signals. They occur when prices fall to a31, RELATIVE STRENGTH INDEX 165
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ul ug epFigure 31-2. Seven-Day Relative Strength Index
RSI gives its best trading signals when it diverges from prices. Itsstrongest divergences are those in which prices rise to a new high or fallto a new low, while RSI fails to cross its reference line.
RSI tends to break its trendlines ahead of prices. In addition to theones marked, you can find several other examples on this chart wherethe breaking of RSI trendlines identifies turning points in the Swiss Franc.At the right edge of the chart, as soon as RSI breaks above its trendline, itwill confirm a bullish divergence and give a strong buy signal.
 
new low but RSI makes a more shallow bottom than during its previ-ous decline. Buy as soon as RSI turns up from its second bottom, andplace a protective stop below the latest minor price low. Buy signalsare especially strong if the first RSI bottom is below its lower refer-ence line and the second bottom is above that line.
2. Bearish divergences give sell signals. They occur when prices rally toa new peak but RSI makes a lower top than during the previous rally.Sell short as soon as RSI tums down from its second top, and place aprotective stop above the latest minor high. Sell signals are especiallystrong if the first RSI top is above its upper reference line and the sec-ond top is below it.166 COMPUTERIZED TECHNICAL ANALYSIS
Charting Patterns
Classical charting methods work better with Relative Strength Index thanwith other indicators. Trendlines, support and resistance, and head-and-shoulders patterns work well with RSI. RSI often completes these patterns afew days in advance of prices, providing hints of likely trend changes. Forexample, RSI trendlines are usually broken one or two days before pricetrendlines.
3. When RSI breaks its downtrendline, place an order to buy above theprice trendline in order to catch an upside breakout.
4. When RSI breaks its uptrendline, place an order to sell short below theprice trendline to catch a downside breakout.
RSI Levels
When RSI rises above its upper reference line, it shows that bulls are strongbut the market is overbought and entering its sell zone. When RSI declinesbelow its lower reference line, it shows that bears are strong but the marketis oversold and entering its buy zone.
It pays to buy using overbought signals of daily RSI only when theweekly trend is up. It pays to sell short using sell signals of daily RSI onlywhen the weekly trend is down (see Section 43).
5. Buy when RSI declines below its lower reference line and then ralliesabove it.
6. Sell short when RSI rises above its upper reference line and thencrosses below it.
More on RSI
Some traders try to find deeper meaning in RSI patterns. Some analysts havedescribed formations called positive and negative reversals, which theysaid forecasted the extent of any price move using RSI patterns. So far, therehave been no reports of conspicuous success using these patterns from any-one but their promoters.VThe Neglected Essentials
 
32. VOLUME
Volume represents the activity of traders and investors. Each unit of volumein the market reflects the action of two persons: One trader sells a share andanother buys a share, or one buys a contract and another sells a contract.Daily volume is the number of contracts or shares traded in one day.
Traders usually plot volume as a histogram — vertical bars whose heightreflects each day’s volume (Figure 32-1). They usually draw it undemeathprices. Changes in volume show how bulls and bears react to price swings.Changes in volume provide clues as to whether trends are likely to continueor to reverse.
Some traders ignore volume. They think that prices already reflect allinformation known to the market. They say, “You get paid on price and noton volume.” Professionals, on the other hand, know that analyzing volumecan help them understand markets deeper and trade better.
There are three ways to measure volume:
1. The actual number of shares or contracts traded. For example, theNew York Stock Exchange reports volume this way. This is the mostobjective way of measuring volume.
2. The number of trades that took place. For example, the London StockExchange reports volume this way. This method is less objectivebecause it does not distinguish between a 100-share trade and a 5000-share trade.
167168 THE NEGLECTED ESSENTIALS
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Volume
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Figure 32-1. Volume
To interpret volume, you need t link rye win rick
A. An increase in volume during an uptrend calls for higher pricesahead. Buy or add to longs.
B. Prices jump on more than double the average volume. It is a sign ofa potential blow-off movecTighten ng positions>
C. Prices rally near the level of their previous peak, but volume ismuch lower. This bearish divergence signals a tog: Sell tongs and
“go Short.
D. Prices collapse_on panicky volume. Such climax bottoms are usu-ally retested¢ Tighten stops on short positions >
E. Silver falls to a new low, but volume is lower than it was at pointD-a typical retest of a climax bottom¢Cover shorts and go long:
F. A new high in price is accompanied by an increase in volume, sim-ilar to what happened at point A. Continue to hold long positions.
 
3. Tick volume is the number of price changes during a selected time,such as 10 minutes or an hour. It is called tick volume because mostchanges equal 1 tick. Most futures exchanges in the United States donot report intraday volume, and day-traders use tick volume as itsproxy.32. VOLUME 169
Volume reflects the activity of buyers and sellers. If you compare volumebetween two markets, it will show which one is more active or liquid. Youare likely to suffer less slippage in liquid markets than in thin, low-volumemarkets.
Crowd Psychology
Volume reflects the degree of financial and emotional involvement, as wellas pain, of market participants. A trade begins with a financial commitmentby two persons. The decision to buy or sell may be rational, but the act ofbuying or selling creates an emotional commitment in most people. Buyersand sellers crave to be right. They scream at the market, pray, or use luckytalismans. Volume reflects the degree of emotional involvement amongtraders.
Each tick takes money away from losers and gives it to winners. Whenprices rise, longs make money and shorts lose. When prices fall, shorts gainand longs lose. Winners feel happy and elated, while losers feel depressedand angry. Whenever prices move, about half the traders are hurting. Whenprices rise, bears are in pain, and when prices fall, bulls suffer. The greaterthe increase in volume, the more pain in the market.
Traders react to losses like frogs to hot water. If you throw a frog into aboiling kettle, it will jump in response to sudden pain, but if you put a froginto cool water and heat it slowly, you can boil it alive. If a sudden pricechange hits traders, they jump from pain and liquidate losing positions. Thesame losers can be very patient if their losses increase gradually.
You can lose a great deal of money in a sleepy market, such as corn,where a one-cent move costs only $50. If corn goes against you just a fewcents a day, the pain is easy to tolerate. If you hang on, those pennies can addup to thousands of dollars in losses. Sharp moves, on the other hand, makelosers cut their losses in a panic. Once weak hands get shaken out, the mar-ket is ready to reverse. Trends can last for a long time on moderate volumebut can expire after a burst of volume.
Who buys from a trader who sells his losing long position? It may be ashort seller taking profits and covering shorts. It may be a bargain hunterwho steps in because prices are “too low.” That bottom-picker assumes theposition of a loser who washed out—and he either catches the bottom orbecomes the new loser.
Who sells to a trader who buys to cover his losing short position? It may170 THE NEGLECTED ESSENTIALS
be a savvy investor who takes profits on his long position. It also may be atop-picker who sells short because he thinks that prices are “too high.” Heassumes the position of a loser who covered his shorts, and only the futurewill tell whether he is right or wrong.
When shorts give up during a rally, they buy to cover and push the markethigher. Prices rise, flush out even more shorts, and the rally feeds on itself.When longs give up during a decline, they sell and push the market lower.Falling prices flush out even more longs, and the decline feeds on itself.Losers who give up propel trends. A trend that moves on steady volume islikely to continue. Steady volume shows that new losers replace those whowash out. Trends need a fresh supply of losers the way builders of theancient pyramids needed a fresh supply of slaves.
Falling volume shows that the supply of losers is running low and a trendis ready to reverse. It happens after enough losers catch on to how wrongthey are. Old losers keep bailing out, but fewer new losers come in. Fallingvolume gives a sign that the trend is about to reverse.
A burst of extremely high volume also gives a signal that a trend is nearingits end. It shows that masses of losers are bailing out. You can probably recallholding a losing trade longer than you should have. Once the pain becomesintolerable and you get out, the trend reverses and the market goes the way youexpected, but without you! This happens time and again because most ama-teurs react to stress similarly and bail out at about the same time. Professionalsdo not hang in while the market beats them up. They close out losing tradesfast and reverse or wait on the sidelines, ready to re-enter.
Volume usually stays low in trading ranges because there is relatively lit-tle pain. People feel comfortable with small price changes, and trendlessmarkets seem to drag on forever. A breakout is often marked by a dramaticincrease in volume because losers run for the exits. A breakout on low vol-ume shows little emotional commitment to a new trend. It indicates thatprices are likely to return into their trading range.
Rising volume during a rally shows that more buyers and short sellers arepouring in. Buyers are eager to buy even if they have to pay up, and shortsare eager to sell to them. Rising volume shows that losers who leave arebeing replaced by a new crop of losers.
When volume shrinks during a rally, it shows that bulls are becoming lesseager, while bears are no longer running for cover. The intelligent bears haveleft long ago, followed by weak bears who could not take the pain. Fallingvolume shows that fuel is being removed from the uptrend and it is ready toreverse.32. VOLUME 171
When volume dries up during a decline, it shows that bears are less eagerto sell short, while bulls are no longer running for the exits. The intelligentbulls have sold long ago, and the weak bulls have been shaken out. Fallingvolume shows that the remaining bulls have a higher level of pain tolerance.Perhaps they have deeper pockets or bought later in the decline, or both.Falling volume identifies an area in which a downtrend is likely to reverse.
This reasoning applies to long and short timeframes. As a tule of thumb,if today’s volume is higher than yesterday’s volume, then today’s trend islikely to continue.
Trading Rules
The terms “high volume” and “low volume” are relative. What is low forIBM is high for Apple Computer, while what is low for gold is high for plat-inum, and so on. As a rule of. thumb, “high volume” for any given market isat least 25 percent above average for the past two weeks, and “low volume”is at least 25 percent below average.
1. High volume confirms trends. If prices rise to a new peak and volumereaches a new high, then prices are likely to retest or exceed that peak.
2. If the market falls to a new low and the volume reaches a new high,that bottom is likely to be retested or exceeded. A “climax bottom” isalmost always retested on low volume, offering an excellent buyingopportunity.
3, If volume shrinks while a trend continues, that trend is ripe for a rever-sal. When a market rises to a new peak on lower volume than its pre-vious peak, look for a shorting opportunity. This technique does notwork as well at market bottoms because a decline can persist on lowvolume. There is a saying on Wall Street: “It takes buying to putstocks up, but they can fall of their own weight.”
4. Watch volume during reactions against the trend. When an uptrend ispunctuated by a decline, volume often picks up in a flurry of profittaking. When the dip continues but volume shrinks, it shows that bullsare no longer running or that selling pressure is spent. When volumedries up, it shows that the reaction is nearing an end and the uptrend isready to resume. This identifies a good buying opportunity. Majordowntrends are often punctuated by rallies which begin on heavy vol-172 THE NEGLECTED ESSENTIALS
ume. Once weak bears have been flushed out, volume shrinks andgives a signal to sell short.
More on Volume
You can use a moving average to define the trend of volume. The slope of a5-day exponential moving average of volume can define volume’s trend.You can also draw trendlines of volume and watch for their breakouts (seeSection 21). Volume breakouts confirm price breakouts.
Volume-based indicators provide more precise timing signals than volumealone. Traders’ Index, Herrick Payoff Index, Force Index, and others includevolume data (see Chapters 6 and 8).
33. VOLUME-BASED INDICATORS
Traders can use several technical indicators to help them analyze volume.Some traders track a 5-day exponential moving average of volume. Its slopeidentifies the trend of volume (see Sections 25 and 32). Others use On-Balance Volume and Accumulation/Distribution.
On-Balance Volume
On-Balance Volume (OBV) is an indicator designed by Joseph Granville anddescribed in his book, New Strategy of Daily Stock Market Timing. Granvilleused OBV as a leading indicator of the stock market, but other analysts haveapplied it to the futures markets.
OBV is a running total of volume. It rises or falls each day, depending onwhether prices close higher or lower than on the previous day. When a stockcloses higher, it shows that bulls won the day’s battle; its volume on that dayis added to OBV. When a stock closes lower, it shows that bears won theday, and that day’s volume is subtracted from OBV. If prices closeunchanged, OBV stays unchanged.
On-Balance Volume often rises or falls before prices — it acts as a leadingindicator. As Granville put it, “Volume is the steam that makes the choo-choo go.”33. VOLUME-BASED INDICATORS 173Crowd Psychology
Prices represent the consensus of value, while volume represents the emo-tions of market participants. It reflects the intensity of traders’ financial andemotional commitments, as well as pain among losers (see Section 32).OBV is a running total of volume. It tracks changes in traders’ involvementin the market and the intensity of their pain.
A new high in OBV shows that bulls are powerful, bears are hurting, andprices are likely to rise. A new low in OBV shows that bears are powerful,bulls are hurting, and prices are likely to fall. When the pattern of OBV devi-ates from the pattern of prices, it shows that mass emotions are not in gearwith mass consensus. A crowd is more likely to follow its heart than itsmind. This is why changes in volume often precede changes in prices.
Trading Signals
The patterns of OBV tops and bottoms are more important than the absolutelevels of this indicator. Those levels depend on when you start to calculateOn-Balance Volume. When OBV rises or falls together with prices, the trendis confirmed. If prices reach a new high and OBV reaches a new high, theuptrend is likely to continue. If prices reach a new low and OBV falls to anew low, the downtrend is likely to continue. It is safer to trade in the direc-tion of a trend that is confirmed by OBV (Figure 33-1).
1. When OBV reaches a new high, it confirms the power of bulls, indi-cates that prices are likely to rise even higher, and gives a buy signal.When OBV reaches a new low, it confirms the power of bears, callsfor lower prices ahead, and gives a signal to sell short.
2. OBV gives its strongest buy and sell signals when it diverges from _rices. If prices rally, sell off, and then rise to a new high, but OBVrallies to a lower high, it creates a bearish divergence and gives astrong sell signal. If prices decline, rebound, and then fall to a newlow, but OBV falls to a more shallow bottom, it traces a bullish diver-gence and gives a strong buy signal. Long-term divergences are moreimportant than short-term divergences. Divergences that develop overthe course of several weeks give stronger signals than those that lastonly a few days.174 THE NEGLECTED ESSENTIALS
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Figure 33-1. On-Balance Volume
When OBV moves in gear with a trading vehicle, it confirms its trend.The uptrend A of OBV confirms the stock rally. Its break in March givesa sell signal. There are two shorting signals at the top. The first, in earlyApril, is given by a bearish divergence between OBV and price. Twoweeks later, OBV breaks its support B, giving another signal to sell short.The downtrendline C of OBV confirms the slide of AppleComputer-hold shorts. An upside breakout in July gives a signal to covershorts.
 
3. When prices are in a trading range and OBV breaks out to a new high,it gives a buy signal. When prices are in a trading range and OBVbreaks down and falls to a new low, it gives a signal to sell short.
More on OBV
One of the reasons for Granville’s success in his heyday (see Section 6) wasthat he combined OBV with two other indicators—the Net Field Trendindicator and the Climax indicator. Granville calculated OBV for eachstock in the Dow Jones Industrial Average and rated its OBV pattern as ris-ing, falling, or neutral. He called that a Net Field Trend of a stock: It could33. VOLUME-BASED INDICATORS 175
be +1, -1, or 0. Climax indicator was a sum of the Net Field Trends of all 30Dow stocks.
When the stock market rallied and the Climax indicator reached a newhigh, it confirmed strength and gave a buy signal. If the stock market ralliedbut the Climax indicator made a lower top, it gave a sell signal.
You can view the Dow Jones Industrial Average as a team of 30 horsespulling the market wagon. The Climax indicator shows how many horses arepulling uphill, downhill, or standing still. If 24 out of 30 horses pull up, 1down and 5 are resting, then the market wagon is likely to move up. If 9horses pull up, 7 pull down, and 14 are resting, then the wagon is ready toroll downhill.
OBY, the Net Field Trend indicator, and the Climax indicator can be eas-ily programmed on a computer. It would be worthwhile to apply them to adatabase which includes all stocks of the S&P 500 index. That may producegood signals for trading S&P 500 futures or options.
Accumulation/Distribution
This indicator was developed by Larry Williams and described in his 1972book, How I Made a Million Dollars. It was designed as a leading indicatorfor stocks, but several analysts have applied it to futures. The unique featureof Accumulation/Distribution (A/D) is that it tracks the relationship betweenopening and closing prices, along with volume.
If prices close higher than they opened, then bulls won the day and A/D ispositive: If prices close lower than they opened, then the bears won and A/Dis negative. If prices ‘close where they opened, then nobody won and A/D iszero. A’ running total of each day’s A/D creates a cumulativeAccumulation/Distribution indicator.
A/D credits bulls or bears with only a fraction of each day’s volume. Thatfraction depends on the day’s range and the distance from opening to closingPrice. The greater the spread between opening and Come price relative to ..daily range, the greater the change in ‘Accumulation/Distribution.
 
Close — OpenHigh —- Low
+ Volume
For example, if the distance from today’s high to low is 5 points but the dis-tance from the open to the close is 2 points, then only 2/5 of today’s volume176 THE NEGLECTED ESSENTIALS
is credited to the winning camp. The pattern of A/D highs and lows is moreimportant than its absolute level, which depends on the starting date.
When the market rises, most people focus on new highs. But if pricesopen higher and close lower, then A/D, which tracks their relationship, turnsdown. It warns that the uptrend is weaker than it appears. If A/D ticks upwhile prices are down, it shows that bulls are gaining strength.
Crowd Behavior
Opening and closing prices are among the most important prices of the day.The opening price reflects all the pressures that have gathered while the mar-ket was closed. Openings are often dominated by amateurs who read theirnewspapers in the evening and trade in the moming.
Professional traders are active throughout the day. They often tradeagainst the amateurs. As the day goes on, waves of buying and selling byamateurs and slow-moving institutions gradually subside. Professionals usu-ally dominate the markets at closing time. Closing prices are especiallyimportant because the settlement of trading accounts depends on them.
AJ/D tracks the outcomes of daily battles between amateurs and profes-sionals. It ticks up when prices close higher than they opened — when profes-sionals are more bullish than amateurs. It ticks down when prices closelower than they opened—when professionals are more bearish than ama-teurs. It pays to bet with the professionals and against the amateurs.
Trading Rules
When the market opens low and closes high, it moves from weakness tostrength. A/D then rises and shows that market professionals are morebullish than amateurs. This means that the market is likely to move higherthe following day. When A/D falls, it shows that market professionals aremore bearish than amateurs. When the market moves from strength to weak-ness, it is likely to reach a lower low the following day.
The best trading signals are given by divergences between A/D andprices.
1. If prices rally to a new high but A/D reaches a lower peak, it gives asignal to sell short. This bearish divergence shows that market profes-sionals are selling into the rally (Figure 33-2).33. VOLUME-BASED INDICATORS 177
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ec anFigure 33~2. Accumulation/Distribution
Accumulation/Distribution gives i ong gals when divergesffom prices. A bullish divergence gives a buy signal at the October bot-tom. Four months later and $30 higher, a bearish divergence gives a sell
signal. Take profits on long positions and go short.
 
2. A bullish divergence occurs when prices fall to a new low but A/Dstops at a higher low than during its previous decline. It shows thatmarket professionals are using the decline for buying, and a rally iscoming.
More on Accumulation/Distribution
When you go long or short, following a divergence between A/D and price,remember that even market professionals can go wrong. Use stops and pro-tect yourself by following the Hound of the Baskervilles rule (see Section23).
Volume Accumulator, designed by Marc Chaikin, is an indicator verysimilar to A/D. Volume Accumulator uses a mean price for the day instead ofthe opening price. It is especially useful for those analysts who do not have178 THE NEGLECTED ESSENTIALS
access to opening prices. Its trading signals and rules are similar toAccumulation/Distribution.
There are important parallels between A/D and Japanese Candlestickcharts. Both focus on the differences between opening and closing prices.A/D goes further than candlesticks by taking volume into account.
34. OPEN INTEREST
Open interest is the number of contracts held by buyers or owed by shortsellers in a given market on a given day. It shows the number of existingcontracts. Open interest equals either a total long or a total short position.
Stock market shares are traded for as long as a company stays in businessas a separate unit. Futures and options traders, on the other hand, deal in con-tracts for a future delivery that expire at a set time.
A futures or options buyer who wants to accept delivery and a seller whowants to deliver have to wait until the first notice day. This waiting periodensures that the numbers of contracts that are long and short are always equal.
In any case, very few futures and options traders plan to deliver or to acceptdelivery. Most traders close out their positions before the first notice day.
Open interest rises or falls depending on whether new traders enter themarket or old traders exit it. Open interest rises only when a new buyer and anew seller enter the market. Their trade creates a new contract. For example,if open interest in April COMEX gold is 8500 contracts, then 8500 contractsare held by bulls and 8500 contracts are owed by short sellers at the close ofthat day. If open interest rises to 8600, it means that the net of 100 new con-tracts have been bought and sold short.
Open interest falls when a trader who is long trades with someone who isshort. When both of them close out their positions, open interest falls by onecontract because one contract disappears. If a new bull buys from an old bullwho is getting out of his long position, open interest remains unchanged:Open interest also does not change when a new bear sells to an old bear whoneeds to buy because he is closing out his short position.
 
Buyer Seller Open InterestNew buyer New seller increasesNew buyer Former buyer sells UnchangedFormer seller buys to cover New seller Unchanged
Former seller buys to cover Former buyer sells Decreases
 34. OPEN INTEREST 179
Most futures and options exchanges release open interest data one daylater than prices. Some exchanges provide phone numbers to call for prelimi-nary figures on open interest.
Technicians usually plot open interest as a line below price bars (Figure34-1). Some chart services also plot average open interest for the past severalyears. Open interest gives important messages when it deviates from its sea-sonal norm. Open interest varies from season to season in many marketsbecause of massive hedging by commercial interests at different stages inproduction cycles.
Open interest in currency futures tends to drop four times a year, at thetime of a contract rollover. If open interest does not drop during a rollover, itshows a strong commitment among traders to the existing trend, which islikely to accelerate.
Crowd Psychology
It takes one bull and one bear to create a futures or options contract. A bullbuys a contract if he is convinced that prices are going higher. A bear sellsshort a contract if he is convinced that prices are going lower. When the twotrade, open interest rises by one contract. A single trade between one bulland one bear is unlikely to move the markets. But when thousands of tradersmake their trades, they propel or reverse market trends.
Open interest reflects the intensity of conflict between bulls and bears. Itreflects the willingness of longs to maintain long positions and the willing-ness of shorts to maintain short positions. When bulls and bears do notexpect the market to move in their favor, they close out their positions andopen interest shrinks.
There are two people on opposite sides of every trade. One of them getshurt when prices change. If prices rally, bears get hurt. If prices fall, bulls gethurt. As long as the losers hope, they hang on, and open interest does notchange.
A rise in open interest shows that a crowd of confident bulls is facingdown a crowd of equally confident bears. It points to a growing disagree-ment between the two camps. One group is sure to lose, but as long as poten-tial losers keep pouring in, the trend will continue. These ideas have beenclearly put forth in L. Dee Belveal’s classic book, Charting CommodityMarket Price Behavior.
Bulls and bears keep adding to their positions as long as they strongly dis-180 THE NEGLECTED ESSENTIALS
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