ated by moving higher between the buy and sell points.
“Why not just cut a few zeros off my numbers and use them anyway?” Then his eyes lit up. “That’s what you’re doing with your trades,isn’t it?”
EMCFigure 10.7 shows the next sample trade. Clearly, the stock is in a downtrend. Does that mean you should short the stock? The inset shows theS&P 500 index. Both charts are on the weekly scale, incidentally. The index bottoms in August 2004 and bumps up for a few weeks. The lastweek shown closes lower than the prior week, so the index might beturning down. Do you trade this stock?What I saw on the chart was worth trading. The weekly scale givesyou a hint as few patterns I discussed required that scale. The paralleldownward spikes (far right) in the stock are a pipe bottom chart pattern.The pattern confirmed the following week when price closed above thehigher of the two spikes.
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EMC Corporation (Computers & Peripherals, NYSE, EMC)-17-15-13-11-9-8-7-6
S&P 50011161034
-5-4
952-3
MA M J J A S O N D04FM A M J J A S
F M A M
J
J A
S O N
D 03 F M A M
J J A
870829788
S O N D 04 F M A M J J A
-2
-1
FIGURE 10.7 The stock is in a downtrend but the general market has beenmoving up for a few weeks. Do you trade this stock?
Figure 10.8 shows the chart on the daily scale. The inset shows theindex until the day I sold. Point A is where the pipe occurs on the weeklyscale. Here is my notebook entry for the trade:8/26/04. I placed an order to buy 1,400 shares, at 11, stop.The stock is moving sideways, consolidating, and it’s a shark32 pattern [that’s a three-day symmetrical triangle, with eachsucceeding day having a lower high and higher low]. I amhoping for an upward breakout from this congestion region.Fundamentals are with me as price has been climbing withbrokers recommending the stock. The last earnings report wasa good one. Buy reason: pipe bottom.The buy stop at 11 wasn’t filled because price failed to climb that far.On August 30, I bought 1,400 shares at 10.53. I put a stop at 9.91(below the 10 round number) for a potential loss of 6%. The target was12, the site of overhead resistance. That was a good call as price stalled
EMC
251
EMC Corporation (Computers & Peripherals, NYSE, EMC)-15
SymmetricalTriangle
S&P 5001215
-14
11931171
-13
Sold
114904
Dec
Jan 05
1127
-12
RisingWedge
B
-11
-10
Bought
A
Apr
May
Jun
Jul
Aug
-9
Sep
Oct
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Jan 05
-8Feb
FIGURE 10.8 The chart shows the two buy and one sell orders. The blackdots are stops.
near there in late September and found support at the base of the risingwedge. My notebook again:My guess was that the S&P would break out upward from adescending broadening wedge. It didn’t as the inset shows. Buyreason: pipe bottom with lots of support at 10.50. Marketmay be choppy going into September, Dow Jones Industrialsare down 20 points as is the NASDAQ. Large dip down (inAugust) washed out the sellers and a small shark-32 pattern/symmetrical triangle suggests price is going to break out soon.Volume has been sloping down, supporting the coming breakout. Hope it’s to the upside.I raised the stop to breakeven, 10.53, on 9/14 but canceled it aweek later because I felt it was too close: “This stock has thrown backand is searching for a reason to go higher. I may buy more and don’t wantto get stopped out on a brief dip.” The throwback is the decline afterpoint B.
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That same day, I bought “1,100 shares, less than the 1,400 I wouldnormally trade because this stock may confound me and move lower. It ishaving difficulty moving up, so it is not acting exactly as expected.” Theorder filled at 10.96 and I place a stop at 9.91 on the 2,500 shares. “Buyreason: Buy after throwback. This is another opportunity to buy in. TheFibonacci retrace from 8/13/04 to 9/14/04, at 38%, supports the currentprice.” That’s the decline from B to the second buy point as a retrace ofthe move up from A.I used a progressive or trailing stop as prices climbed. I raised it fourtimes, with the final one being at 13.53. That was in mid-December andthe black dots on the chart show the location and date. Notice that Iplaced the stops below the prior valley or round number—regions ofsupport in each case.I should have sold a few days sooner when the price broke outdownward from the symmetrical triangle. On the trade, I made $7,000or 26%. Since I sold, the stock has eased lower. Each buck that the stockdeclines means a loss of $2,500, so timely selling is important.
Rohm and HaasFigure 10.9 shows the chart of Rohm and Haas, and the inset shows theS&P 500 index. The index formed a right-angled, descending broadening top—but did that give a clue to the direction the stock would take?For stocks, 51% of the time a stock breaks out upward from the chartpattern, so that was no help. Would you trade the stock?The stock made a new high after the release of earnings even as theindex moved horizontally. The twin peaks in May and June (A and B)confirmed a valid double top when price closed a penny below the valleybetween the two peaks. However, price busts the pattern when it risesabove peak B and that leads to a strong rally.Figure 10.10 shows how I traded the stock. Here is my notebookentry:11/26/03. I bought 300 shares at market, filled at 40.12. Thisis an earnings flag trade. Quarterly report on 10/30 at 35.36launched the flagpole. It topped out at 40.57 [A]. Thus, themeasure is 5.21. From the flag low at 38.05 [B], that means a
Rohm and Haas
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rise to 43.26 [C]. I expect this to near 45 before stopping, justbecause of round number resistance and wishful thinking. Yesterday, the closing price pierced the flag’s downsloping trendline, signaling a buy. Chemicals are strong in a weak market,so that is also good news. Volume is heavy on the flagpole risethen lower on the flag itself. Today is the day before Thanksgiving, so expect low volume and high volatility. Sell at 38.90[a stop-loss point], otherwise set a sell order at 45. On theweekly chart, the flag low matches a long-term down trendlinefrom peaks in late March and July.The earnings flag comprises the flagpole (the near vertical rise fromthe earnings release, upward) to the flag itself at A to B. The long-termtrendline I mention would serve to support the stock because pricesin the flag were trading above the trendline. The black dots in Figure10.10 show where and when I placed the stops. The first was at 38 on12/22/2003. I moved it up to 39.90 on 12/31 and to 40.65 on 1/7/2004.Rohm and Haas Company (Chemical (Specialty), NYSE, ROH)-41
S&P 500
-401044
-39
EarningsReleased
1016
-38-37
98803
Sep
Oct
Nov
-36
960
-35
B
A
-34-33-32
ConfirmationLine
-31-30-29-28-27-26-25
03
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Sep
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FIGURE 10.9 An earnings announcement gives a key to how the stock willperform. Do you trade this stock?
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Rohm and Haas Company (Chemical (Specialty), NYSE, ROH)C-43
DSold
-42
A
-41
E-40-39
Bought
-38
B
-37
S&P 500
1145-36
EarningsReleased
1095
03
Nov
Dec
Jan 04
1045
-35
995
-34-33
03
Nov
Dec
Jan 04
Feb
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-32Jun
FIGURE 10.10 Good entry but a poor exit cut a potential profit of $950to $115.
For a time, the trade did well. The stock moved up after I boughtand then continued higher in a small measured move up pattern (B to Dis the first leg, the corrective phase is D to E, and the second leg is E to C).Here are the notes on the sale:1/22/04. I was stopped out at 40.60 when prices blew throughmy stop at 40.65. Oil prices have been shooting up and naturalgas prices as well. If I had to do this again, I would put an orderto sell at the measured move up (MMU) profit target of 43.26.Prices topped out at 43.69. That would have made me $950 inabout two months. I got worried when prices pierced thetrendline, moving down. Maybe that was a sell signal, but Iwanted to give the stock every opportunity to do well. I expectprices to rebound and move higher. I made about $115, net.Higher oil and natural gas prices make producing chemicals moreexpensive because they are often used as feedstock. Specialty chemical
JLG Industries
255
companies are more immune to price changes than companies makingbasic chemicals.The MMU I reference is the move from the earnings release to A, acorrective phase to B, and a second leg rise to C. In a well-behavedMMU, the move from the trend start to A is supposed to equal the movefrom B to C. In this case, it did almost exactly, but I used the earnings release and not the trend start in the measure.The trendline I mentioned is the dashed line. When price closedbelow the line, it was a sell signal that I chose to ignore. If I sold the dayafter the trendline break, I would have made about $550 on the trade.The inset shows the S&P 500 index climbing in a straight-line fashion even as the stock started tumbling. The market tide provided littlesupport to the stock.Looking back on this trade, placing a sell order at the predicted target of 43.26 would have worked out perfectly. Even selling when pricepierced the trendline would have saved me some bucks. The good news isthat I did sell, saving me from taking a pasting as prices dropped to a lowof 35.90.
JLG IndustriesFigure 10.11 shows price shooting up in late September on an earningsannouncement. Before that, the stock confirmed an Eve & Eve doublebottom (EEDB) when price closed above the highest peak between thetwin bottoms. The EEDB suggested that price would rise and it does,peaking in early October. The rise exceeded the left side (W in the figure)of a Big W chart pattern. A Big W is a double bottom with tall sides.The inset shows the S&P 500 index ending on the same day as thestock chart. Do you trade this stock? If so, how?Figure 8.5 shows how I traded this stock a week earlier, but thistime I bought 1,000 shares, filled at 16.43. Here are my notes from thetrade shown in Figure 10.12:10/11/2004. This is approaching the 62% retrace from thelow at 14.21 [A] to the high at 17.98 [B]. I think, after threedown days and perhaps another today, the stock will move uptomorrow. More traders will return from the Columbus Day
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holiday and help the market move up. This may move horizontally, gathering strength for the next up move. I placed astop at 14.43, below the gap, below the pennant apex, and below the 62% retrace, but the loss is large: 12%. Upside target:17.45, just below the round number resistance of 17.50, andbelow the tail’s high at 17.98.The tail I mentioned is at point B. The black dots on Figure 10.12are the stops positioned at the price and day of placement: “Future S&Pdirection (guess): Down but it might curl around in a partial declinefrom a broadening pattern. I actually think that’s likely as the descendingprice falls on an upward supporting trendline. The S&P is up today by aminor amount.”I show the broadening chart pattern in the top inset of Figure10.12, and how the S&P looked when I placed the trade in the inset ofFigure 10.11. The Figure 10.11 inset gives you a better idea of where thepartial decline would be—at the end of the figure if price rounded up.Instead, the index continued down, eventually touching the bottombroadening pattern trendline (see the top inset in Figure 10.12).JLG Industries (Machinery, NYSE, JLG)
-17
W
ConfirmationLine
EarningsReleased
-16
-15
-14
-13
S&P 500
Bottom1
1128
Bottom2
-12
1106-11
108404
AugJan 04
SepFeb
OctMar
1062
Apr
May
Jun
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Aug
Sep
Oct
-10
FIGURE 10.11 The stock is trending down after a quick rise. How do youtrade this one, or do you?
JLG Industries
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JLG Industries (Machinery, NYSE, JLG)S&P 500
-20
Sold
11821152
Bought
1122
B
-19
-18
109204
Sep
Oct
Nov
-17
1062
-16
Pennant
-15
JLGA
1713
-14
97
-13
5
1998 1999 2000 2001 2002 2003 2004
3
ep
Oct
Nov
Dec
Jan 05
Feb
-12
FIGURE 10.12 This swing trade turned out well, timing the sale almostperfectly in the ascending scallop chart pattern.
As prices climbed, I raised the stop to 15.48 and 16.43 as the dotsshow, positioned just below the prior valley low. The last stop was muchtoo far away from the current price, 19.65 versus the stop at 16.43—16% lower.The stock traced a chart pattern called an ascending scallop. Theday after prices peaked, I placed an order to sell 1,000 shares at the market open, filled at 19.85. Here is my notebook entry:Sell reason: Hitting a round number [20]. On the monthlyscale, it’s at a horizontal trendline of a right-angled descendingbroadening pattern [see lower inset in Figure 10.12]. I anticipate a drop to 18 (50% retrace of prior up move) then a punchthrough the trendline. Buy on retrace bottom, at 18. This hasbeen trending upward for too long without a retrace. Overhead resistance should prevent price from moving up muchhigher. Volume is dropping even as prices rise. This may coastup to 21 (site of old horizontal trendline) before collapsing.The ascending scallop will retrace, forming a handle. I want tosidestep the retrace and buy again after price drops.
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The company announced earnings apparently after the close because the next day, price gapped lower, dropping below 18. With thistrade, I got lucky by buying near the retrace low and selling near thepeak, an almost perfect swing trade. I made $3,400 or 21%.
Southwest AirlinesFigure 10.13 shows the next trading scenario. A descending triangle topsthe chart. The breakout is downward and a pullback at point A givestraders one last opportunity to sell or short the stock before the declinereally begins. The airline stock hits an air pocket and drops rapidly forthree days before consolidating—moving sideways in December—thenprice continues the decline but at a more leisurely pace.The S&P 500 index shows a descending broadening wedge, butone with a hefty amount of white space—more than I like to see. Thepattern would look better if the peak in early May rose up and touchedthe top trendline.Southwest Airlines Company (Air Transport, NYSE, LUV)
A
-20-19
DescendingTriangle
-18-17
-16
S&P 500-1511481130
-14
1112109404
Apr
May
Jun
-13
1076-12
Sep
Oct
Nov
Dec
Jan 04
Feb
Mar
Apr
May
Jun
-11
FIGURE 10.13 A descending triangle with a pullback at point A predicts adecline. Do you trade this stock in June?
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Having reviewed the stock and index trends, do you trade the stockand if so, then how can you justify it?Figure 10.14 shows how I traded the stock and what developed inthe price action. In the inset, I replaced the descending broadeningwedge with a broadening bottom pattern in April and a new symmetricaltriangle in June. The triangle busted as price climbed little before the index plunged.I show a right-angled, descending broadening formation (RABFD)in the stock during April and into May. The upward breakout threw backto the top trendline and had trouble lifting off the runway.Here are my notes on the purchase:I bought 1,000 shares at 15.81, stop at 14.27, or 10% lower.This is just below the low on 4/21/04. Upside target: 17, usingthe measure rule for the RABFD: 15.30 + (15.30 – 13.56).Other airlines are moving lower, so I don’t really trust this trade.Long term, I think the price is a good one. Short term, whoknows? S&P direction over pattern lifetime: Down. Futuremarket direction (guess): Dow transports will stall soon as itreaches old high in January. S&P: same. Buy reason: Throwback from RABFD completed and oil prices are trendingdown. Since most of the fuel is hedged, the price won’t makemuch difference. If the airline can fly through the HCR in Dec03 [shown in the inset], then this has a chance of moving up.I show the stops as black dots on the chart. The measure rule for theRABFD uses the height from the horizontal top trendline to the lowestvalley in the pattern added to the breakout price (the value of the toptrendline). I show the horizontal consolidation region (HCR) as thezoom in December. The only time the stock paused at this region wasduring the weeks surrounding the purchase.On June 25, the company announced a tentative accord with theflight attendants union after two years of negotiations, and the stockjumped nearly 8% on the news. I thought of selling as I was working onthe inverted dead-cat bounce chart pattern for an article. My researchshowed that when prices rise 5% to 20%, they decline, giving back nearlyall of their gains and sometimes more. However, I decided to hold on because I didn’t view the 8% gain as very exciting when I was shooting for
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Southwest Airlines Company (Air Transport, NYSE, LUV)
-20
S&P 5001148
-19
1130-18
1112
Accord
109404
May
Jun
Jul
-17
Bought
1076
Sold
-16
-15
HCR-14
-13
-12
03 Nov
Dec
Jan 04
Feb
Mar
Apr
May
Jun
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-11Sep
FIGURE 10.14 A throwback to the broadening pattern turned into aninverted dead-cat bounce with a late exit.
20%. Price did, however, touch my target of 17 exactly, and that shouldhave been a selling cue. Had I sold then, I would have made over $1,100.As my research predicted, the stock hit turbulence and dropped. Igrabbed my parachute and pushed my way out the door on July 13, bailing out at a price of 15.41.Fortunately the stock climbed enough for me to raise my stop and Ilost only $430 or less than 3% on the trade.
11Chapter
The Art of TradingChecklists
efore I get to the checklists, let me tell you about my tradingday—I’ll explain the details later. I’m an end-of-day trader, a position trader. I don’t day trade stocks but hold them for weeks,months, and sometimes years. I review the stocks that I follow, and if Idon’t see anything interesting, I’m done for the day. I can go weeks without trading a stock, and I usually spend about onehour each day looking for trades or updating mydatabase. The rest of the day is free time.day tradingI start my day by reading the Wall Street Jourentering andnal, which takes about 1.5 hours in itself becauseexiting a tradeI’m a slow reader and I find much that interestsusually withinthe same day.me. I circle any significant news that happens inthe companies that I follow. Those events includerating upgrades and downgrades, earnings reports,insider transactions, monthly sales data, explanations of large pricemoves (dead-cat bounces), and so on.After I finish reading, I head upstairs to my office where I updatemy database with the latest stock quotes and the newspaper news. My
B
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THE ART OF TRADING
computer software that I wrote shows those events so I can watch howprice develops over time.When completed, I rank the 350 securities that I follow by industryperformance. This is what I call “industry relative strength.” The rankingtells me which industries are doing well and which ones are not.I’ll run my personal holdings through what I call “filters.” Filtersapply indicators to the stocks. Divergence and trading signals are whatthe filters tell me, but I don’t get excited about them. I use the industryrank and indicator signals as backstory. They give me a feel for how themarket and my stocks are shaping up. Sometimes I’ll see a bearish divergence that suggests I’ll have to sell a stock soon.After that, I count my pennies, looking at the value of my holdings.Then, I review the charts on what I own looking for sell signals, checkingon the stops (some may need to be raised), and occasionally a buying opportunity. Sometimes price will approach my stop and, instead of lettingit hit, I’ll just sell the stock. That cuts my loss.The last thing I do is review every security that I follow. Each stockthat appears does so by industry first, alphabetically second. That way, Iget a feel for how each industry is behaving. If I see something interesting, I can page back and forth within the industry, checking how theother stocks are reacting to the news. Because many stocks may show thesame chart pattern, I can select the most appealing one of the group using this method.The 350 security review can be as short as 15 minutes or last anhour, sometimes longer. If the market is tumbling, I won’t be enthusiasticabout spending much time because I know trading would be throwingmoney away. When the market is moving up, I may spend more timelooking for trading candidates and if I find one, then the explorationbegins.This is Jake. Tom doesn’t know that I hacked into his computer andadded this note, so don’t tell him. With any luck, this will get printed. All Iask is for a chance to prove that money can’t make me happy. Here he comes.Bye!
Before BuyingIn the checklists that follow you’ll see duplicate entries. The rules for notbuying a stock are sometimes the same as for selling.
Before Buying
263
Here’s what I look for before buying a stock: Check the averages. I review several each day: the S&P 500, theDow Industrials, transports, utilities, and the NASDAQ composite. I use the S&P 500 as the proxy for the general market. Check the market trend. Trade in the direction of the markettrend. For me, that means buying when the market is rising andsitting in cash or collecting dividends from utility stocks in adown market.When reviewing the general market, I look for support andresistance zones then project price movement into the future. If Ithink the market will rise, then I’m more likely to buy. If I expect the market to drop, I’ll avoid buying. However, I usuallywon’t sell a stock just because I think that the general market orindustry will go down. Flip to the weekly scale (or the next highest period) and paythe most attention to the market trend. This removes the dayto-day noise that clutters the screen and shows you tradabletrends. Check the industry. Check other stocks in the same industry toget an idea of whether your trade will be successful.• Are the other stocks showing signs of topping out? If so thenconsider skipping the trade.• Are the other stocks bottoming? That may suggest a time tobuy if prices reverse.• If you can show several stocks on the same screen, find whichone leads the pack and study it for clues to future pricedirection. Look at the weekly scale. I look for chart patterns on the dailyscale so I switch to the next higher period to look for any threatening chart patterns in the stock I want to trade. OccasionallyI’ll use the monthly scale. If you trade intraday, then go to thenext higher period.• Is the stock trending in the same direction as on the shortertime scale? If yes, then that supports a buying decision.• Do you see any existing chart patterns? My software shows allthe patterns that I already found so I don’t have to search forthem.
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THE ART OF TRADING
• Do you see underlying support or overhead resistance? Thosemay cause pullbacks and throwbacks, respectively, which hurtperformance.• Draw trendlines to see where price may bounce off the trendline in the future. Score the chart pattern. I use my book, Trading Classic ChartPatterns, to score the chart pattern and gauge how likely thestock will reach the price target. If the score is negative, then Iusually skip the trade. A surprising number of times a negativescore has saved me from making a losing trade. Review the current chart pattern history. For the chart patternyou are about to trade, find one in the same stock and see how itperformed in the past. Check the indicators. What are they telling you? I use the commodity channel index (CCI with 20-day lookback, DCCI with5-day lookback). It gives short-term trading signals, which Iusually ignore. I use it to check for divergence with the stockprice. If the CCI shows lower peaks but the stock has higherones, then the stock will likely turn down. It might not happenimmediately, but that is the way to bet. The reverse is true forbullish divergence. If the CCI has higher valleys but the stockhas lower ones, the stock will likely turn upward—eventually.I like to see peaks or valleys about a month to six weeks apart.Divergence using peaks or valleys farther apart tends to be lessreliable. I use the following:• Relative strength index (RSI with 16-day lookback, 70/30overbought/oversold threshold): I use this for divergence andas an indicator of overbought (too pricy) or oversold (toocheap). I don’t use this indicator anymore. I get better divergence with CCI and a stock can remain overbought or oversold for months, or I never get a signal for a year or more withthe default settings.• Bollinger bands (using a 20-day moving average): When thebands narrow (low volatility) that tells me price is goingto make a big move. Price often bounces from one band tothe other, especially when the band is horizontal and pricetouches it.
Before Buying
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• Is the stock price diverging from the indicator?• Is the indicator signaling a trade?• Check for failure swings. These are little M- or W-shaped indicator patterns that may signal a short-term trend change.• Figure 11.1 shows what I mean by divergence and failureswings between price and the RSI. The trendlines show pricediverging with the indicator in July (bullish divergence) andNovember (bearish divergence). Failure swings appear in thecircles and they show short-term turning points in the pricetrend. I’ve read that failure swings should span the horizontalindicator signal lines (30 or 70 for the RSI) and point in thedirection price should take, but I don’t know how importantthat is. Only the November failure swing obeys those constraints, and price changes from trending up to going horizontal. The W-failure swings show timely price trend changes.
-54
Target
-53-52-51-50-49-48-47-46-45-44-43-42-41
Jul
Aug
Sep
Oct
M-FailureSwing
Nov
Dec
Jan 05
-4096
Divergence
8472604836
W-FailureSwing
24
RSI
FIGURE 11.1 The stock diverges with the RSI indicator (trendlines)and failure swings appear at turning points (circles).
12
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THE ART OF TRADING
 Review the industry relative strength. This differs from theRSI. I measure the relative strength of the 35+ industries that Icheck on a daily basis, ranked for the price change over time. (Imostly use the difference between the current closing price andthat of 6 months ago). I concentrate my trades on the top 10performing industries and industries that are moving up therankings at a good clip. You’ll find that industries performingwell will continue to do well, usually