and trends and imagine what trades youcould have made. In technical trading we’re going to learn rules about pricepatterns and apply them in the same way to all of the stock and futures markets. Before you move on to the next lesson and see these rules, think aboutwhat you already know about price patterns.
Can You Apply the Same Buy-Sell Principles to All Stocks?• Can you write down the rules you’ve used to buy and sell a stock, anystock? Can you write down the rules for when you would have exited thelong positions in the previous stock charts? If so, you’re a systematictrader.• When you look at a chart, do you see it in terms of continuous price moves?Do you look at the highs and lows of price swings? Do you draw conclusions, make up rules, and imagine that you can capture large profits?Looking at a historic chart is frustrating and deceiving. It makes youthink that you could have profited from the price moves. It’s much harderwhen you can’t see the future. However, high-tech display equipment letsyou see the past price movement of any stock. It has brought many newtraders to the table who think they can profit from future price movesbecause they can see the past.
THE IMPORTANCE OF TIMINGA few thoughts about timing are important before we move forward. Wewould like to think that we can profit from the news if we act faster thanothers. It’s not true.
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A SHORT COURSE IN TECHNICAL TRADING
• The market moves on anticipation. “Buy the rumor, sell the fact.” If youbought on every piece of good news published in the Wall Street Journal,you would be broke.• The market responds to the difference between the actual news and whatwas expected. The unemployment rate could have dropped 0.2 percent,and the market falls because it expected a drop of 0.4 percent.• Action does not always mean immediate reaction. When did the Fed startlowering interest rates? When did the market start to respond? In thecase of interest rates, it always takes more than one move by the Fedbefore you see a reaction in the economy.
EVOLVING MARKETSThe market is dynamic. It is not the same as it was, yet it is driven by thesame underlying economic forces.
What Has Changed?• The equipment has changed, allowing instantaneous analysis, programtrading, electronic orders (smart order entry), high-momentum trading,and unreasonable expectations.• Methods have changed, with far more systematic traders, especially professional fund managers.• Participants have changed, with a larger influence from pensions,designer funds, and institutional investors. Day traders are commonbecause commissions are low.• Electronic exchanges and side-by-side trading are new. You can beatyour competition by creating an electronic order the instant a system“signal” is triggered.• Globalization has changed the way world markets move, with alternatingleaders and followers.• There are more trading vehicles, including ETFs for index and sectorinvesting, and single stock futures.• Markets are noisier because of more participation. Sometimes they haveirrational swings because of piggy-backed orders. The frequency ofextreme moves is increasing, causing greater volatility.Will a system that worked in 1990 work in 2002? Probably not.Will the people who made money in the 1990s make money now? If theychange, too.
Timing Is Everything
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WORDS OF ADVICEThroughout this course there will be trading tips, trading insights, and someold-fashioned advice. Take some time to think about all of it.
Don’t Confuse Luck for SkillIn a prolonged bull market, all buyers are eventually right. They buy all dips,regardless of size, because it has always worked. As they gain confidence,they may add leverage by buying on margin. At the end of the bull marketthey are usually wiped out.• It’s a business, not a casino.• It’s all about risk.• Learn how to take a loss.• Don’t turn a profit into a loss.• Anticipation is the key to success.
CHAPTER 2
Charting the TrendThe trend is your friend.
n this chapter you will learn about the trend. The trend is simply thedirection of prices over some time period. No matter how much youlearn, you will always want to know the trend of the market.
ITRENDS
Trends are very easy to see on a chart. They are seen best over a long timeperiod—weeks, months, and years. If prices are going up, the trend is up; ifprices are going down, the trend is down. Here we get to the first problem.If prices go up and then down, is the trend up or down? Look at Figure 2.1,the S&P weekly chart. Is the price going up or down? The answer is “yes.” It’sgoing up in the long term, over the period of the entire chart, but down in theshorter term, the last two years.
The Trend Depends on Your Time FrameIf you’re a very, very long-term investor, the trend will always be up becauseinflation and economic growth eventually will cause the stock index to makenew highs. If you’ve been holding Merck from 1994 through 2002, you’vewatched the price rise from $5 to $60, a gain of 1,100 percent. If you boughtMerck at the beginning of 2001 and held it through 2002, you watched theprice go from $90 down to $60, a loss of 33 percent.The trend is always a matter of time interval. Even over a few days, twotraders may see the same market as going in different directions. Each onecan make money or lose money within the same period by correctly or incorrectly deciding where to buy and where to sell.18
Charting the Trend
19
What Creates Trends?• Government policy. When economic policy is to target a growth rate of 3 percent, then the Federal Reserve (the Fed) raises and lowers interest rates toaccomplish this. Lowering rates encourages business activity. Raising ratescontrols inflation by dampening activity.• International trade. When the United States imports goods, it pays for it in dollars. That is the same as selling the dollar. It weakens the currency. A countrythat increases its exports strengthens its currency.• Expectations. If investors think that stock prices will rise, they buy, causingprices to rise. Consumer confidence is a good measure of how the public feelsabout buying.• Supply and demand. A shortage, or anticipated shortage, of any product willcause its price to rise. Too much of a product results in declining prices. Thesetrends develop as news makes the public aware of the situation.
The Trend Is Always Easier to See AfterwardLook again at the S&P chart in Figure 2.1. You can easily see the upwardtrend. But after an uptrend, how far down do prices need to fall before yousay that the trend is down? That’s a difficult question, and we’ll answer it in
FIGURE 2.1 S&P weekly 1996–2001. Is it going up or down? Yes. It was going up, and it’snow going down. If you’re a long-term trader, then you can still say that it’s going up.
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this chapter. Part of the answer depends on your time frame, but most of itdepends on the market itself.
What It Means to Be a Trend FollowerA trend follower buys when the price trend is up and sells when the pricetrend is down. A trend follower believes that, if the trend is up then it willcontinue to go up; therefore, trend followers make the assumption thattrends persist. If everything works as expected, the trend continues longenough to yield a profitable trade.
Why Should the Trend Continue?There’s a good reason why the trend persists. Most trends are the result ofgovernment economic policy. In the U.S. the Federal Reserve (Fed) targetsan economic growth of 3 percent. In order to accomplish that in a bad economy, they will lower interest rates. First they lower rates by 0.5 percent to seehow the economy reacts. Then they lower rates by another 0.5 percent andwatch (see Figures 2.2 and 2.3). This process of ratcheting down interest
FIGURE 2.2
Interest rates drive the stock market. Top: 10-year notes continuationseries. Bottom: S&P 500 Index. There’s a clear relationship between interest rates and the stockmarket but it’s not always the same. Interest rates always lead, but the market doesn’t alwaysrespond. T-note prices begin going up in January 2000 (interest rates declining), but the stockmarket has not yet reacted.
Charting the Trend
21
rates causes a trend in all of the markets that depend on rates and all companies that have debt—which is pretty nearly all of them.The biggest trends usually begin with a change in interest rates. Sometimes, the beginning can be a change in the value of the U.S. dollar. The dollar can drop when the U.S. imports much more than it exports. When you buyforeign products, you buy their currency as well.Expectation also drives prices. Will a hot summer cause a shortage ofelectricity, or a shortage of water? Will a weakening economy reduce thenumber of airline passengers and shorten hotel stays? Will the economystrengthen or weaken? These events don’t occur overnight; they evolve gradually. Prices rise and fall in anticipation.
The Reason for Shorter TrendsThere are other trends besides long-term interest rates and currency. You’llfind seasonal trends in many businesses that focus on travel and leisure, suchas airlines or hotels. The agricultural products are seasonal because theyhave a clear growing and harvest period. Heating oil is used during the winter
FIGURE 2.3 Cause and effect: good news versus bad news. When the stock market falls(S&P, center panel), short-term interest rates (Eurodollars, bottom panel) are lowered to start arecovery. When the stock market moves higher too quickly, rates rise to slow it down. The Fedmanages growth using interest rates; policy lasts for 6 months to 2 years. At the same time,a cheaper dollar (Dollar index, top panel) stimulates trade and encourages foreign investmentinto stocks.
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FIGURE 2.4
Summer rally in corn. The summer growing season provides more than oneopportunity to expect a problem with the corn crop. In 1990 prices began to rise before the cropwas planted and continued through the middle of the summer based on lack of rainfall and newsreports of devastation to land in some states. But technology won in the end, and the crop wasmuch larger than expected. Price fell to levels lower than the previous year. (Prices shown are anadjusted continuous series of futures contracts.)
and gasoline is consumed in larger amounts during the summer. These patterns can cause extreme trends that last about three months.There are always unexpected events that cause a surge in prices: a coldspell that could affect the orange juice crop in Florida or a good chance thata new cancer drug will be approved for a medical research company.Shorter trends can also be caused by expectation. The public expects earnings to improve because interest rates are dropping. The public expects thecost of wheat to be higher because there’s been very little rain in the Midwest.As the news confirms their opinion, prices move steadily higher. You reallydon’t know how the corn crop is affected by rain until it is harvested in October. Any rise in prices over the summer is expectation, not fact (see Figure 2.4).
FINDING THE TREND ON A CHARTWhat is the trend in Figure 2.5? It’s down because prices at the end of thechart are lower than prices at the beginning. Simple enough. There are periods when prices are rising, but the overall picture is a downward trend.
Charting the Trend
23
FIGURE 2.5 S&P daily, September 2000–December 2001. Is it an uptrend or downtrend?Are you influenced by how much of the chart is visible? Try to keep your long-term perspective.
The Trend Is Seen Best Using Weekly or Monthly ChartsEverything looks smoother when you see it at a distance. You can’t see thedetails. That’s especially true with price charts. A monthly chart lookssmoother than a weekly chart, a weekly chart is smoother than a daily chart,and a daily chart is smoother than an hourly chart.You can see the trend best on a weekly or monthly chart. You see moremarket “noise” on a daily or intraday chart. Market noise is the erratic up anddown movement that occurs over a period of a few days.
CHARTING THE TRENDIt’s time to draw classic trendlines on a chart in order to get a relativelyobjective assessment of the trend direction. It’s relative because you canchange the trend by choosing a longer or shorter trendline, or a daily, weekly,or monthly chart. There’s usually a way to make the chart say what you wantif you’re determined to force your opinion on your analysis. We’ll try to avoidthat approach. To begin, you’ll need to know that:
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• An uptrend (a support line) is formed by connecting the lowest risingprices.• A downtrend (a resistance line) is formed by connecting the highestdeclining prices
Where Do You Start?You can start a major upward trendline at a low price and then draw thetrendline up and to the right, touching the lowest price or prices. Using Ciscoas an example (see Figure 2.6) the upward trendline, A, starts at the low inOctober 1998 and touches the two lows in the third and fourth quarters of1999. After that, prices move quickly away from the trendline and only crossit on the way down.The major downward trendline, B, was started at the high of the move. Ofcourse, you don’t know the high until after prices have dropped significantly.At that point we can draw the line B from the peak, touching the high of theright shoulder where a second rally ended.
Down
wa Right shoulderrdTrendlineB
ne
dli
nTreC
rwaUp
wndra
Re
eA
lin
drendT
Intermediate Trendline
FIGURE 2.6
Trendlines drawn on the Cisco weekly chart. This company shows a clearmajor upward trend and a major downward trend. Lines can be redrawn to keep current with theprice move.
Charting the Trend
25
Redrawing the TrendlinesPrice patterns change and so should the trendlines. They need to be redrawnfrom time to time in order to stay current with the price move. When Ciscoprices begin to drop quickly in late 2000, we can redraw the downward trendline, C, at a sharper angle. Later, we might find that both lines, the originalone and the new one, are both helpful for trading. After a while, your chartwill look like a “work in progress” with redrawn lines everywhere.
How Many Points Should the Trendline Touch?You can draw a trendline with two points, but three or four are even better.The more points that lie on the same line, the more confidence we have thatwe’ve drawn the correct trendline. However, you can’t expect the lows tofall exactly on the same line—the market is just not that precise. If you cansee a clear trend, even though the bottom is a little ragged, then draw thetrendline anyway.In Figure 2.6, a shorter, intermediate trendline (the broken line) wasdrawn across the six bottoms during 1999. The first two low prices and thelast low price fall right on the line but the middle three go through the trendline by small amounts. You should still see it as a trend. A price that penetrates a trendline and then corrects itself is considered a strong confirmationof that trendline.
More on Redrawing TrendlinesRedrawing the trendline is a normal part of tracking the direction ofprices. In the S&P chart shown in Figure 2.7 the first trendline is drawnfrom the October 1998 low to the October 1999 low (line A), then redrawnto touch the lows of February after a new high is made in March 2000(line B), and redrawn a third time along the lows of April, May, and June(line C ). We can stop redrawing the upward trendline after the downwardtrend begins.
Which Trendlines Are More Important?If an upward trendline is drawn from one long-term low to another, it is moreimportant than a line connecting two intermediate lows. If a trendline can bedrawn across three or more lows (even though one point might poke throughthe line by a small amount), it is more important than a line through twolows. If a trendline is not violated, it gains in importance.
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A SHORT COURSE IN TECHNICAL TRADING
A
B
C
FIGURE 2.7
Weekly S&P futures continuation chart. Upward trendlines are redrawn afternew highs and then stop after the downtrend begins.
Charting the Trend on Daily PricesUp to now the charts used in the examples have been weekly and monthlybecause they show the trend more clearly, but daily charts will be used for ourtrading. We need to learn what to expect. In Figure 2.8 trendlines are drawn onan S&P daily chart. The first downward trendline, A, is perfect. It touches threepoints and crosses the final upward move as prices gap through the trendline.However, trendlines on daily charts can be confused by market noise.The upward move in October and November does not provide a thirdpoint for the trendline. You can redraw the upward trendline a number oftimes, and none of them will look as good as the downtrend line. Because ofthe increased noise, daily prices won’t line up as clearly as weekly prices andthe trends won’t be as easy to draw. When you’re trading, be prepared forfrustrating periods where you get in and out of the market because of noise.You need to hang on through those periods until the clear trends return.
The Evolving Trend of EnronOne of the best recent examples of the benefits of charting is the demise ofEnron. As the news tells it, a well-paid analyst continued to recommend the
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Charting the Trend
Tr
en
dli
ne
A
FIGURE 2.8
Trendlines on a daily S&P chart. The downtrend is very clear, but the initialuptrend doesn’t fit very well. The redrawn uptrend seems to be better, but market noise thatshows up on a daily chart makes it difficult to find a clear pattern.
purchase of Enron while prices were falling to $10 (see Figure 2.9). Was it aconflict of interest or simply bargain hunting? Now that you’ve been introduced to charting trendlines, when would you have sold your Enron shares?For certain, there is a major upward trendline that connects the lows during the summer of 1998 with the lows of December 2000. If that line is continued, it crosses the price decline in May 2001 at about $55. The fast breakin March 2001 that took prices from just under $70 to the low $50s gives us
Tip: Real Market ConditionsReal market conditions are never perfect for the technical trader. Each stock orfutures market has its own personality. Instead of a bull market correction stopping at the trendline, it will stop a little above or below the trendline before starting back up. It’s smart to give a little room for a false break of the trendline. Afterall, this isn’t an exact science—prices are moved by news, emotion, and occasionally facts that create a public opinion.Exactly How Much Do You Let Prices Penetrate the Trendline?About 10 percent of the current price volatility. Let’s say that IBM has been moving in swings of $5. Allow an extra 50¢ for excessive movement.
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FIGURE 2.9 Enron during its best and worst times. How would you have traded it usingclassic trendline charting?
the idea that there was an intermediate trendline across the lows of the topping formation from the first quarter of 2000 until the break in May 2001.Whenever you question why you’ve decided to trade technically, think ofEnron. Any chartist or technician would have been safely out before theworst of the news caused the final collapse of the stock price. How could anyrational person recommend holding Enron down to $10?
TREND TRADING RULES FOR TRENDLINESIt may seem clear from the charting examples that the trendlines show whereto buy to enter a trade and sell to exit; however, traders place their orders ina few different ways:
Entry Rules• Buy when the price closes above the downtrend line (conservative).• Buy when the intraday price penetrates the downtrend line (aggressive).• Buy in an upward trend when prices decline to near the upward trendline.
Charting the Trend
29
Exit Rules• Sell when the price closes below the upward trendline (conservative).• Sell when the intraday price penetrates the upward trendline (aggressive).Notice that the aggressive trader buys during the day when prices crossthrough the trendline. A more conservative trader will wait to see if theclosing price is going to be above the trendline. Price action during the daycan be very volatile and the direction of prices can change, and often does,from midday to the close. On the other hand, if important news reachesthe market during the earlier trading hours, the first one that buys gains themost profit. You can only decide your style from practice. Start with the closing price as a measure of direction until you are confident that another wayis better.
Getting Out of the TradeWhen the upward trend is finished, prices will move down through the trendline. At that point you sell, closing out your trade, hopefully with a profit.However, not all trades are profitable. About two-thirds of all trend tradeslose money, and yet trend trading is still a reliable, profitable way to trade.Profits Through Persistence. The majority of times, a change of directiondoes not turn into a trend; however, when prices do continue in one direction, they produce good profits. Success is a matter of numbers. You canexpect 6 to 7 out of 10 trend trades to be losses, some small, some a littlelarger. Of the 3 or 4 good trades you can expect one small profit, twomedium-size profits, and one large profit. On average, a profitable trend tradeshould be about 2.5 times the size of a loss. With enough trades, that shouldresult in a net profit in your trading account.As an example, say we lose $100 on each of the 6 losing trades, for a totalloss of $600. On the four profitable trades we get an average of $250 per tradefor a total profit of $1,000. The individual profits are most likely $100, $200,$200, and $500. That’s a $400 gross profit less some slippage for enteringand exiting and commissions on 10 trades. If instead of 6 losses there were7 losses and 3 profits, we would net only $50. Expect the real results to besomewhere in between $50 and $400.As a trend trader, you should expect mostly small losses, some smallprofits, and a few large profits.
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What Can You Expect Your Trading Results to Look Like?• Most trades will be small losses• About 25 percent of the trades will be small or medium-size profits.• About 10 percent of the trades will be larger profits.• A small number of trades will be very large profits.Trend trading is successful because of the occasional very large profit.
The Fat TailTrend trading is successful because losses are kept small and profits areallowed to grow. That technique is called conservation of capital. Whatmakes trend trading profitable in the long run is the unusually large numberof big profits compared to what is expected in a normal distribution. Forexample, in a normal distribution of 1000 coin tosses, half of them would besingle runs of heads or tails. Half of those, 25 percent, would be a sequenceof either two heads or two tails. Half of the remaining, 12.5 percent, would besequences of three in a row, and so on. Therefore, in 1,000 coin tosses youcan expect only one run of 10 heads or tails in a row.Apply that to prices. In 1,000 days of trading (about four years) youwould expect only one time that prices would go up or down 10 days in arow. However, that happens much more often than once; therefore, pricemovement is not normally distributed, and not random. It has a fat tail distribution. There are fewer days where prices turn from up to down, or downto up, and more longer runs. That’s what makes trend trading profitable.
IMPACT OF THE TIME HORIZONBefore leaving trendlines, think about the importance of the length of thetrendline and the use of daily, weekly, or monthly data:• Using major tops and bottoms to draw a trendline identifies the most important trends; monthly and weekly charts will show these points clearly.• Longer time horizons put the points where the trend changes fartheraway, causing a longer delay, or larger lag, in your decisions.• Longer time horizons allow larger price swings; therefore those tradeshave larger risk.
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31
• Longer time horizons are more reliable because they allow prices morefreedom of movement. Even in a trending market, prices do not gostraight up or straight down.These features show a trade-off between reliability and risk. You need toaccept more risk to have better results. All trading has choices between riskand return. You can never have both large profits and low risk.
A Computerized Approach: Finding the Points Automaticallyfor Drawing TrendlinesMost analysts will look at a chart and pick the low prices that will be used todraw an uptrend line. However, you also can find those points automatically.Anyone who enjoys working with a spreadsheet or writing a computer program might find the rules for finding those points a good first step towardautomating a trading method.In Figure 2.10 the dots above the price peaks mark the swing highs, andthe dots below the bottoms are the swing lows. They are called swing highs
FIGURE 2.10 Finding the tops and bottoms automatically. The points showing the topsand bottoms of this S&P chart are separated by price swings of at least 5 percent.
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For Computer Mavens:Finding the Swing Points Automatically Using a SpreadsheetSet up your columns with the following data:A DateBHigh priceC Low priceD Closing priceC3 Put the minimum swing percentage value in cell C3 (for example, 5% = .05)Put the following formulas in the corresponding cells. Row 6 initializes the process.E6 = B6 (the current swing high)F6 = C6 (the current swing low)G6 = IF (D6 > (E6 + F6) / 2,−1,1) (where −1 is a downswing and +1 is an upswing)Row 7 is the beginning of the repeated process. Row 7 can be copied down.E7 = IF($G6 = −1#AND#B7 > E6,B7,IF($G6 = 1,B7,E6))(the new current low)F7 = IF($G6 = 1#AND#C7 < F6,C7,IF($G6 = −1,C7,F6))(the new current high)G7 = IF($G6 = −1,IF(C7 < E7 − $C$3× D7,1,$G6),IF(B7 > F7 + $C$3× D7,−1,$G6))(test high or low)H7 = IF($G7 = 1#AND#G6 = −1,E7,H6)(the new swing high)I7 = IF($67 = −1#AND#G6 = 1,F7,I6))(the new swing low)
and lows because they are separated by at least a 5 percent price move in thisexample. You can choose any percentage. A larger percentage identifiesmajor points, while smaller percentages show minor points. Major points aremore reliable.When we use the dots in Figure 2.10, we draw an upward trendline onlywhen the bottom dots are rising and a downward trendline when the topdots are falling. The trendlines do not need to be formed by connecting consecutive dots.
EVOLUTION OF A TRENDThe trend is constantly being redrawn based on new highs and lows. In Figure 2.11, only the automatically calculated swing highs and lows are used togive you an idea of how your chart will look as time creates new patterns.Some of the main features of this Amazon chart are:• The highest point, 1, on the left remains the highest throughout thisperiod.
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Charting the Trend
1EC
D2F
A
3
4
B
5
G
H
FIGURE 2.11
Evolution of a trend. In this Amazon chart we see how trendlines need tobe redrawn as price patterns develop. This chart used only swing highs and lows computedautomatically. The result shows that these trendlines clearly mark the changes in price direction.
• The downward trendline, A, beginning at point 1, is redrawn each timeprices move above the existing downward trendline (B, C, D, and E), creating a new swing high.• An intermediate downward trendline, E, may be drawn beginning fromanother high (see mid-April 2001).• Other downtrend lines (G and H ) begin in July 2001 at point 4 afterprices drop.• Good lines are confirmed by the market, often with a price gap.• The major downward trendline, E, formed by connecting points 1 and 4,seems to hold after the rally to point 5 at the far right.
MAKING THE TREND WORKIt is easier to see a trend using a weekly chart instead of a daily chart, buttrading using a weekly chart is very slow and exposes you to larger priceswings and larger risk. Many professional traders will use the weekly chart to
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draw the major trend, but a daily chart to decide where to get in and out. It iseasier to find the trend on a weekly chart, and this assures us that we don’tloose sight of the correct trend.
Questions1. What is the reason for drawing a trendline?2. What is the intended relationship between interest rate changes andstock market changes?3. If you wanted to see the trend on a chart more clearly, would you use adaily, weekly, or monthly chart? Why?4. How could you have a chart where the trend was both up and down?5. In the S&P monthly chart shown in Figure 2.12, draw the major uptrendlines as they develop. Is there a point (or points) at which you would havegone short?
FIGURE 2.12 The S&P futures monthly continuation series shows the sustained bullmarket of the 1990s and the peak in 2000.
Charting the Trend
35
6. Using the chart of Cisco during 1998 shown in Figure 2.13, draw thetrendlines and outline the (ideal) trades you would have made based onthe price penetration of the trend.
FIGURE 2.13
Daily Cisco prices from February through October 1998. A stronguptrend followed by a difficult, volatile period makes finding the trendlines more challengingbut makes trading more exciting.
CHAPTER 3
Breakout Trends
pward and downward trendlines, or angled trendlines, are not theonly way of finding the trend. Although they are the classic method,there is a simpler way of identifying the trend that many think is morepractical for trading. It’s called a breakout.
