. We also need to base our trading plans on reliable signals.Not all times do the setups that trigger an entry work as perfectly as inthese examples, which is why I have other confirming signals to corroborate timing a trade signal. I also like to see if the methodology works in a diverse group, or noncorrelated markets. Testing for robustness, or how wella system or signal responds in different markets, helps validate the reliability of that signal. The chart in Figure 3.3 is a spot forex euro currencythat demonstrates the same setup and trigger that would enter a long position with %K and %D crossing over above the 20 percent line with a con-
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FIGURE 3.3RealTick graphics used with permission of Townsend Analytics, LTD.
firming higher closing high candle pattern. The sell signal also works wellas confirmed when %K and %D both cross over and close back below the 80percent line.
TIPS AND TRICKS TO HELPThere are other tips and tricks associated when using stochastics. Thereare fast stochastics and slow stochastics. The difference is in how the parameters are set to measure the change in price. This is referred to as agauge in sensitivity. A higher rate of sensitivity will require the number ofperiods in the calculation to be decreased. This is what “fast” stochasticsdoes. It enables one to generate a faster and a higher frequency of tradingsignals in a short time period. The previous two examples used the defaultfast stochastics settings, which help you discover the cycles of tops andbottoms faster than the slow stochastics setting will.
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Stochastics PatternsOne other method in which to use the stochastics indicator is trading off apattern called bullish convergence. It is used in identifying market bottoms—where the market price itself makes a lower low from a previouslow, but the underlying stochastics pattern makes a higher low. This indicates that the low is a “false bottom” and can resort to a turnaround for aprice reversal. Figure 3.4 shows how prices make a secondary low significantly lower from a primary low, which is posted by a low in the stochastics indicator.The reverse of this signal is a trading pattern called bearish divergence.It is used in identifying market tops—where the market price itself makesa higher high from a previous high, but the underlying stochastic patternmakes a lower high. This indicates that the second high is a “weak” highand can resort to a turnaround for a lower price reversal. Figure 3.5 shows
FIGURE 3.4RealTick graphics used with permission of Townsend Analytics, LTD.
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FIGURE 3.5RealTick graphics used with permission of Townsend Analytics, LTD.
how the market makes a secondary high, but the corresponding high in thestochastics is at a lower level than the price charts’ primary high point.This stochastic pattern can alert you to a false breakout. Notice the lowclose doji (LCD) off the secondary peak; and then as %K and %D both crossover and close back beneath the 80 percent line, a sell trigger is generated.That signal warns of an impending, prolonged downtrend of substantialproportion. Therefore, it is important to monitor for divergence patterns.
Rules to Trade ByThe bearish divergence pattern signals that there is an impending price reversal ready to occur in a market. As I mentioned previously, you can anticipate and get ready to place an order to act on the signal; but you shouldnot act until the confirmation of a lower closing low triggers the entry,which would be to act on the close or the next open. Here are four rules toguide you to trading a stochastics divergence pattern:
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1. The first peak in prices should correspond with a peak in the %K and
%D reading above the 80 percent level.2. The second peak must correspond to a significant higher secondary
price high point.3. If the secondary stochastics peak is less than or under the 80 percentlevel, this signals a stronger sell signal.4. Prices should make a lower closing lower to confirm a trigger to entera short position. Enter on the close of the first lower closing low or thenext open. The protective stop should initially be placed above the highof the secondary high.Figure 3.6 demonstrates a bearish divergence setup with the rules described. This is a 15-minute candle chart on the CBOT mini-Dow. The secondary high is established at 10940. Both %K and %D make a primary highabove the 80 percent line, and the secondary high in price corresponds with%K and %D below the 80 percent level. Once the long dark candle closesbelow the prior low (in fact, it closes below five prior candles lows), a sellsignal is triggered. The initial entry is made on that time period close or on
FIGURE 3.6RealTick graphics used with permission of Townsend Analytics, LTD.
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the next open, which in this case is 10897. The stop is placed at 10945,above the high of the secondary peak high. As you can see, the market continues to decline into the close down to 10836, for a 61-point gain had youexited on the close. That equates to a gain of $305 on a day trade margin of$500 per contract. Notice that as the market declines, the stochastics indicator remains below the 20 percent line as the %K and %D cross multipletimes but never back above the 20 percent level to trigger a buy signal untilafter the electronic day session close, which is 4 P.M. (CT).
MACDIn simplest terms, moving average convergence/divergence is an indicatorthat shows when a short-term moving average crosses over a longer-termmoving average. Gerald Appel developed this indicator as we know ittoday, and he developed it for the purpose of stock trading. It is now widelyused for short-term trading signals in stocks, futures, and forex markets, aswell as for swing and position traders. It is composed of using three exponential moving averages. The initial inputs for the calculations were a 9-period, a 12-period, and a 26-period. The concept behind this indicator is tocalculate a value, which is the difference between the two exponential moving averages, which then compares that to the 9-period exponential movingaverage. What we get is a moving average crossover feature and a zero-lineoscillator, and that helps us to identify overbought and oversold marketconditions.I might add that because traders are now more computer savvy thanever before and because many charting software packages such asRealTick allow traders to change or optimize the settings or parameters, itis easy to change, or “tweak,” the variables in Appel’s original calculations.Traders can increase the time periods in the moving average calculations togenerate fewer trade signals and can shorten the time periods to generatemore trade signals. Just as is the case for most indicators, the higher thetime periods used, the less sensitive the indicator will be to changes inprice movements. MACD signals react quickly to changes in the market—that is why a lot of analysts, including myself, use it. It helps clear the picture when moving average crossovers occur. It measures the relativestrength between where current prices are as compared to past time framesfrom a short-term perspective to a longer-term perspective.The MACD indicator is constructed with two lines: One is the 9-periodexponential average (slow line), and the other is the difference between the12- and 26-period exponential moving averages (fast line). In general, whenthe fast line crosses above the slow line, a buy signal is generated; the opposite is true for sell signals.
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The MACD also has a zero baseline component, called the histogram,that is created by subtracting the slower signal line from the MACD line. Ifthe MACD line is above the zero line, prices are usually trending higher. Theopposite is true if the MACD is declining below the zero line. The MACD isa lagging indicator; that is, it is based off moving averages. We want to lookfor the zero-line crossovers to identify market changes and to help confirmtrade entries or trigger action to exit a position. As you can see in the emini–Standard & Poor’s (S&P) chart in Figure 3.7, the MACD readings crossback above the zero line, indicating a confirmed shift in momentum. Thatzero-line cross helped filter out the bottoming process. A long positionwould have been initiated at the close of the candle or at the next time period’s open at 1267.25, which resulted in an immediate price gain, carryingprices up over 1270.Clues that identify shifts in momentum as the market moves from oneextreme to another or from overbought to oversold to trigger a trading opportunity can be identified with the aid of MACD readings in both the moving average and the histogram component. While profits are higher when
FIGURE 3.7RealTick graphics used with permission of Townsend Analytics, LTD.
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buying the absolute bottom, that is a haphazard guessing game to play.Trading based on a set of rules and using a confirming indicator to identifya change in price direction and then following that price movement are thekeys to making money in the markets. Figure 3.8 shows an e-mini–S&P example; the intraday trend is established to be higher by 10 A.M., as the symmetry of higher highs and higher lows exists. The MACD confirms an HCDtrigger as the histogram bar crosses above the zero line, initiating a long at1234.75. Notice that the histogram bars continue to expand higher, confirming that the bullish momentum is accelerating. Identifying a zero-linecross is a powerful tool in confirming entries, and watching the progressionof the histogram bars may help you maintain a winning position.It is not in every single instance that we see the MACD signals work exactly the same as Figure 3.9 demonstrates. The histogram was not underthe zero line; therefore, a zero-line cross did not trigger. However, observing that the histogram bars move higher as prices start to advance wouldcertainly help confirm the strength of the uptrend.
FIGURE 3.8RealTick graphics used with permission of Townsend Analytics, LTD.
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FIGURE 3.9RealTick graphics used with permission of Townsend Analytics, LTD.
RELY ON THE PATTERNSAnother method useful with the MACD indicator, and one that is more reliable for determining a trend reversal, is to identify the pattern called bullish convergence. This is where the market price itself makes a lower lowfrom a previous low, but the underlying MACD pattern makes a higher low,as shown in Figure 3.10. This indicates that the second low is a weak, or“false,” bottom and can resort in a turnaround for a sharp price reversal.This is similar to stochastics; however, since it is developed from movingaverages, the timing of the shorter-term versus the longer-term moving averages can delay such a signal. There is a high probability that MACD andstochastics work more so than other indicators with this pattern.As you can see in Figure 3.10, which is a five-minute chart on Intel, themarket made a lower low in the next trading session where the MACD histogram makes a higher low. Notice the HCD signal. Then as the price startsto appreciate, the MACD histogram triggers or confirms a long positionwith a zero-line crossover, and the progressively higher histogram bars con-
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FIGURE 3.10RealTick graphics used with permission of Townsend Analytics, LTD.
firm the positive momentum right into the close of the day. The MACD is avery useful tool as a confirming indicator once you have entered in a position, especially by following the histogram readings.The MACD has the same principles as far as a sell signal with what isknown as bearish divergence. This is where the market price itself makes ahigher high from a previous high, but the underlying MACD crossover linesmake a lower high. This indicates that the second high is a “weak” high andcan resort to a turnaround for a lower price reversal. In Figure 3.11, a dailychart in the FX spot euro currency, the MACD histogram helps identifyboth bearish and bullish divergence patterns.One other useful method in using MACD is to follow as stated the direction of the histogram bars to help confirm a turn or a change in trend.Figure 3.12 shows the price advance in the e-mini–S&P as the market closesin on a pivot point resistance level, and the market moves from a bullishcondition as prices move higher or in an overbought state and the histogram readings start to expand over 300. As the market price conditionschange, as the close is below the open, and as the market makes the firstlower closing low, especially near the pivot resistance line, the histogram
FIGURE 3.11RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 3.12RealTick graphics used with permission of Townsend Analytics, LTD.
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bars start rolling down or making lower highs as well. In a weak or downtrending market, the bars should also be making lower highs; and in thiscase, they are confirming a sell signal from the change in market conditionas well as the moving average crossover as prices trade under the movingaverage lines. This last example is what we will be going over in later chapters as we combine pivot point analysis with candle patterns.
SUMMARYIn conclusion, all oscillators, indicators, and most moving average studieswill give confirmation when a market shifts direction; and knowing thesesignals will help you identify a trading opportunity. They also will help giveyou a clue when a market is in an extreme price condition, described asbeing overbought and oversold. Therefore, as a trader, you need somethingthat gives you a better idea of entering a trade. The next few chapters willreveal ways by which you will learn how to identify shifts in momentum before looking at an indicator as confirmation. Impossible, you say? Well,there are certain patterns such as the high close doji, the jackhammer candle pattern, a low close doji, or the shooting star formation that, when upagainst a projected pivot support or resistance line, will alert you to a tradeentry faster than using these traditional indicators. When I introduce you tothe concept of using a pivot point moving average component as was usedin Figure 3.12, then you will see how it is possible.
CHAPTER 4
MomentumChangesHow to Spot Divergenceor Convergence
he battle to identify when a trend ends or when a trend will start isone of the key elements on which traders make their bread andbutter. When a market reaches an unsustainable price extreme eitherup or down, we want to be able to be prewarned so we can set up our trading account with the right contract sizes and preset the buy or sell orderand then wait for the trigger to act. We have the traditional indicators thatwe went over in Chapter 3 with stochastics and MACD (moving averageconvergence/divergence), but there is one more measure of data we havethat stock traders and longer-term futures traders have been using for overa hundred years. That one bit of data is called volume. The one disadvantage that foreign exchange (forex) traders have is that there is no way tomeasure volume data unless you “borrow” it from the futures markets, as Ishared in Chapter 1.
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VOLUME IS THE BEST PRICE CONFIRMATIONTOOL AND TREND INDICATORIn Chapter 1, we went over the basic rule structure for volume analysis. Buthow can we apply that to help confirm market price extremes? This is actually fairly simple, if you know what to look for. That is what this sectionis designed for. It does not matter what market you are trading, whether itbe stocks, futures, or forex. The principles are the same and apply to allthree markets. Remember that a good trader has a reason for entering atrade. A great trader waits until the signal triggers and then acts on that sig111
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nal. Just because a market goes up and is “too high” in value does not meanit is going down, at least not until the signals are present. Market price extremes are generally a reflection of high volatility; and with high volatilitycomes increased market participation or action, and that action is measured or reflected by high volume.
OVERBOUGHT MARKET CONDITION—A DEAD GIVEAWAYIf you drop a boulder off a cliff, it falls at a speed that is much greater thanthe speed of the boulder being pushed up a hill. That is the analogy of whathappens when a bull market or uptrend stretches too far too fast, or is“overbought.” So we look for these types of conditions in which to ride theprice direction if we are looking to establish a short position or we want toexit a long position before the boulder falls. Using volume analysis in conjunction with indicators is a powerful tool to help you determine whether amarket price trend may continue. Look at Figure 4.1. This chart on Amazon
FIGURE 4.1Used with permission of www.GenesisFT.com.
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is a dead giveaway that the price appreciation was unsustainable; as wesee, the market moved from a bullish trend to a consolidation phase withhigher highs. However the volume levels were declining, giving a directclue that the price advance was unsustainable. When combined with thelow close doji pattern, which we will disclose in Chapter 8, and a shootingstar, there was no reason to stay long this market. Notice that as pricesstarted to depreciate, the volume increased, which reflected sellers’ activeparticipation, which attracted more selling.
THE “COMEBACK” KID STOCKIn Figure 4.2, we see one of the greatest success stories in 2005 for any company, Apple Computer. It just could do no wrong, except when the price ofthe stock advanced too far too fast, culminating in an overbought unsustainable price extreme. The fundamentals were quite rosy, as holiday saleswere through the roof on iPods and accessories. You want to talk about a
FIGURE 4.2Used with permission of www.GenesisFT.com.
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racket; this company has products on top of products that accessorize theaccessories, none of which are inexpensive. What a gold mine! Holidaysales were strong, and the market blasted off. In fact, notice the gap up,then notice the gap down, leaving what we technicians call an island top.(This formation is covered in Technical Trading Tactics on page 75.) Italso formed the low close doji pattern. It really is the volume that helpedconfirm the market’s overbought condition. As prices broke out of the sideways pattern, from a high near 75 as it went onward to over 85, seethe volume decline showing fewer market participants wanting to join theprice advance. As the sell-off materialized, like a boulder falling off a cliff,more participants started selling as volume increased, signaling a strongprice reversal.
BLOW-OFF TOPS ON VOLUME SPIKESVolume levels help confirm the true strength of a price move if the marketdemonstrates a price increase. If volume does not confirm the market’snew assigned value, something is wrong and a price reversal is imminent.Volume is also a great indicator of blow-off tops, or what is called an exhaustion rally. Volume spikes or surges can and do indicate price reversals,especially after a price advance on declining volume is preceded by a lackof price follow-through. As we study the chart in Figure 4.3, you see that thehuge price advance is accompanied with abnormal or heavier than usualvolume. You would anticipate that a breakout to sharply higher levelswould occur. The high volatility reflects the increased volume levels; and asthe next time frame shows, there is no follow-through to back the price advance. This is a clear sign of a price reversal. The low close doji trigger alsoseals the deal that this was simply a one-day wonder rally that failed, and aprice reversal was to be expected.
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FIGURE 4.3Used with permission of www.GenesisFT.com.
INTEGRATE VOLUME AND INDICATORSVolume helps the position trader identify the strength of the trend of thelack of conviction of market participants. Take a look at Toll Brothers inFigure 4.4. This stock took a complete nosedive starting in mid-July. Manythought that the bottom was in and that a rally would take this homebuilder back to the highs. Not quite so, said the volume! There was a rallyattempt, but it was on lower volume. Adding the MACD indicator showsconfirmation that a price trend or market rally would not occur. The MACDsignaled a negative zero-line cross, and the moving average componentscrossed as well. The low close doji trigger did not help matters for hopefulbulls either. As the failed rally crumbled, the downtrend resumed and volume started to increase, confirming a bear trend. The MACD indicator continued to back that downtrend, warning traders that lower prices wouldprevail.I want to illustrate how you can integrate volume with both MACD and
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FIGURE 4.4Used with permission of www.GenesisFT.com.
stochastics so you can see how helpful volume analysis can be to indicateoverbought market conditions. Armed with this information, you will havean easier job identifying trading opportunities and a less stressful timechoosing a strategy. Figure 4.5 shows Toll Brothers at its peak. It was amedia darling. The housing bubble was ready to burst; so when people saythey never saw it coming, they just did not know what to look for. The market went into a blow-off phase, which resembles the pattern or conditionthat Apple Computer was in in Figure 4.2. The volume was declining onhigher prices, the MACD had a lower high, and stochastics confirmed thebearish divergence. A low close doji pattern formed at the top (which waswithin pennies of the monthly pivot resistance number). Once the price reversal occurred, you can see how much volume picked up, confirming thetrend reversal. In fact, the average daily volume levels increased as thedowntrend materialized.
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FIGURE 4.5Used with permission of www.GenesisFT.com.
BULLS TAKE CHARGEI illustrated the relevance of volume confirming technical indicators andstated the principles that apply to all actively traded markets, includingforex or spot currency traders. The opposite signals work for identifyingbottoms in all actively traded markets. Let’s look at one of my favoritestocks, Starbucks. What an experience! Paying two bucks for a cup of blackjoe! I’ll tell you what, if it hadn’t been for my friend Les Zieba (my coffeeconnection) and Starbucks, this book would most likely never have beenfinished. Just on my intake of Ventes alone writing this book, I probablyadded a dollar per share to the value of this stock. In any event, let’s look atthe chart in Figure 4.6. The stochastics and, more important, the MACD displayed a solid bullish convergence, with corresponding higher lows asprices made lower lows. As the price dipped, forming a hammer, noticehow the volume levels declined. As we discussed in Chapter 3, the MACDcan trigger a signal later than stochastics can, and here we see that occur.The point is, the volume levels were declining on newer lows, indicatingthat this market was percolating—ready to reverse higher, full steamahead!
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FIGURE 4.6Used with permission of www.GenesisFT.com.
TRADERS NEED TO ASK MORE QUESTIONSI always like to ask myself questions about a market or a potential tradingopportunity. One such question is, If a market is so bearish, why does it notgo down? Figure 4.7 shows Agilent Technologies, a solid company that wasone of the many tech darlings that imploded. As we see, the market appearsready to decline and fill the gaping hole called a gap between 26 and 28 inAugust 2005. Notice that the chart pattern makes a lower low formed by ahammer candle. But the market decline was on significantly lower volume.On one hand, one would think the gap would be “filled” as prices trade backnear the low end of where the gap was created near 26 per share. But on theother hand, volume and both the MACD and stochastics indicators workedtogether to indicate otherwise. Prices reversed sharply higher based off thejackhammer pattern (we discuss this very bullish pattern and the rules totrade it in Chapter 8). As the price of this stock traded higher, notice thevolume levels moved in the price direction, meaning volume was increasingon increasing prices.You can identify overbought or oversold conditions based on a variety
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FIGURE 4.7Used with permission of www.GenesisFT.com.
of methods. Volume studies help me understand what the true strength orweakness of a trend is. When prices are making what can be perceived as a“false high,” meaning a higher high, it is accompanied on lower volume levels. When volume levels are not moving parallel with prices, a divergence isoccurring. So if prices are moving up, we should see volume moving up.When price is going up and volume is going down, something is wrong andI need to ask myself why. It is at this point that I am aware that somethingis not internally correct with the market, especially if the fundamentals arewildly bullish. If volume is not confirming the price action, I should takethat clue and should start looking for strategies in which to capture a potential trend reversal opportunity, whether it is by liquidating a long or byinitiating a short position or by buying a put option or by taking on anotheroption strategy.The same holds true for the opposite condition: When prices are making a false bottom, we have a bullish convergence or oversold condition.That situation exists and can be spotted as the price direction is not confirmed by volume. If prices are making lower lows, if the market is trulybearish, we should see heavy volume. When volume levels are light and
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prices are declining, it is a signal that selling pressure is drying up. Then asprices reverse higher to confirm a true turnaround, we should see volumeincrease as buyers come into the market. This is exactly what happens inFigure 4.7. In addition, using the indicators to help spot these false bottomswill give you added confidence not only to execute a trade but also, moreimportant, when.
CHAPTER 5
Pivot PointsDetermine Key Price Supportand Resistance Areas andthe Importance of Confluence
his chapter is the heart and soul of the book. It will explain themethodology of pivot point analysis from “A to Z,” or should I say “R3.” This chapter will describe in full detail the principles behind themathematical calculations and the rationale behind the psychological impact that drives traders to make decisions around these predicted support(S) and resistance (R) levels. I will break this chapter into separate sectionsto explain how pivot points can be used for short- and longer-term stocktrading; how it applies to futures trading, especially when day trading stockindex futures; and finally how it applies to the spot foreign exchange(forex) markets. Each investment vehicle has its own nuances, such astrading session hours, time periods in which volume flows change, contractsizes, and decimal point placement so that you know how to correctly calculate the pivot point levels. You need to know the foundation of themethodology of pivot point analysis first, so you will know how to thenapply it to the specific markets of interest that you are trading.The power in using pivot point analysis is that it works in all marketsthat have established ranges, based on significant volume or a large groupof collective participants. After all, the current market price equals the collective action of buyers and sellers. Pivot point analysis is a robust, timetested, and, best of all, testable form of market analysis; that is, you canback-test to see the accuracy of this trader’s tool’s predictive analysis. Thereally unbelievable aspect of pivot point analysis is who uses it. In fact,many traders feel compelled not to learn about it because it seems complicated. I will dispel that myth. Other traders who had read my previous book
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felt that since I had mentioned futures, rather than equities or forex, pivotanalysis did not apply to those specific markets. The truth is that manyleading educators in the field of forex and stock trading have either boughtmy advanced trading course or attended one of my live two-day tradingseminars and now share these methods. These are the same techniques Iwill explain and teach in the following chapters and reveal in the accompanying CD (compact disc).Remember I explained previously that as a trader you have the rightand the obligation to understand everything there is about trading. Youneed to have a good understanding of game theory. Many traders today usea “black box” method, which is run by algorithm means, that triggers tradesautomatically. You must understand what goes into building a trading system and how it triggers the automatic reaction when a market price hits ator near a specific level. You are competing not just against fellow traders,but against institutions and major investment groups as well as savvy computer experts, who have a method for removing the emotional elementfrom trading. So what are these levels, and why do we see major reactionsor reversals from these mysterious points on the charts?
SUPPORT AND RESISTANCE IN DISGUISEIf a market departs too far from the mean or moving average, there are twosides to consider: one from a profit perspective, and the other from a riskperspective. Institutions and professional traders know this and will have apredetermined price level calculated to either enter or exit a position. Inlaymen’s terms, if a market went too far too fast, it is time to get out andtake a profit or to take advantage of an extreme price move by initiating acountertrend trade. So in order to gauge what the standard deviation is,many professional traders use pivot point analysis because it is based on atestable method.Pivots are disguised price points because they cannot be detected mosttimes using such conventional technical analysis techniques as traditionalsupport and resistance trend lines, Fibonacci levels, and Gann fan angles,and indicators like moving averages and such oscillators as the CCI (commodity channel indicator), stochastics, and the MACD (moving averageconvergence/divergence) studies. It is imperative that you know how to determine where the pivots are so you are aware at what time and price levelthe market will most likely change direction. That does not mean to say thatat times pivot points coincide or line up near one of these other technicalstudies. In fact, pivot point levels coincide frequently with Fabonacci extension correction levels, which are referred to as confluence or coincidental factors. I will explain that in more detail as well.
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Pivot point analysis is the best “right side” of the chart indicator, as Ilike to call it, due to its predictive accuracy. It is a mathematical formula, asI understand, originally developed by Henry Wheeler Chase in the 1930s.Chester W. Keltner used part of the formula to develop the Keltner bands asdescribed in his book, How to Make Money in Commodities (Keltner Statistical Service, 1961). However, it was really Larry Williams who was credited with repopularizing the analysis in his book How I Made One MillionDollars Last Year Trading Commodities (Windsor Books, 1979). Don Lambert, the creator of the commodity channel indicator, uses the pivot pointformula that makes the CCI work.In my first book, A Complete Guide to Technical Trading Tactics(Wiley, 2004), I illustrated many trading methods that you can apply using