essential stop-loss order is aninsurance policy which should be considered part of the cost of doing business.An ideal stop-loss is placed far enough away from the current tradingrange in order to not be activated by normal market fluctuations, yet be therefor a Major Reversal. But, the market is not an ideal universe. Reality saysthe orders will be placed too close or too far away. Of those two alternatives,too far away is preferable for many. Too close leads to frustration andincreased transaction costs. Left with only two alternatives, most investorswould lean toward the least frustrating, that of being too far away. Multipletransactions can also cause confusion and thereby increase risk.The too-far-away stop can be further honed and refined by mathematicalanalysis (e.g., standard deviation) or simple observation of the chart pattern,including levels of Support and Resistance. Placing the stop-loss away fromcurrent trading will cause the order to be activated only if trading violatesthe range. The too-far-away method can be improved with practice. Thesedistant stops do avoid reentry problems as well as keep slippage and transaction fees under control; however, the overall portfolio risk is greater.Whichever system is used, the primary caution is to avoid switching backand forth between too close and too far away. In some markets, flip-floppingcould easily lead to whipsawing by cutting profits both ways. (SeeChapter 27, Stop Orders.)
Weekly ChartsThe detail of the daily price chart is important, but it is also important todouble-check the daily chart by comparing it to the weekly or monthly pricechart. The longer-term charts give “the bigger picture” and help to explainthe development of current trends. “The Trend Is Your Friend” can be astrue in commodities trading as it is in equity trading.
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9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
643
CORN – CBOTMARCH 1997
¢/BUSHEL400380360340Trendline
320300280VOL & O.I400000200000
24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2 9 16SEPOCTNOVDEC
FIGURE 181. Corn Futures, March 1997. Although the patterns shown here areclear, there is a possibility that the downturn in July is the end of a Broad Head-andShoulders Pattern (including the head and right shoulder). Notice the decline involume during August. The lower volume is possibly under a right shoulder. It isimportant to determine if this was from a Head-and-Shoulders Formation (see weeklychart Figure 183). Triangle formations here seem to be quite accurate. (See Chapter 8for more on Triangles and Chapters 14, 15, and 40 for more on trendlines.) Noticehow the Downtrend Line aligns itself with the apex of a Triangle. Chart courtesy ofMarket Research, Inc. (www.barchart.com).
TrendsTrends usually endure for comparatively long periods of time and a tradingposition that doesn’t fight the trend ordinarily does better. As with equity chartpatterns, Uptrend Lines are drawn under the lows and Downtrend Lines aredrawn across the highs. Many chartists draw trendlines on both sides of thetrend to indicate the Trading Channel. Trendlines can be drawn through highsand lows or through closing prices shown by the dots on the right side of eachhigh–low bar (a dot to the left of a high–low bar indicates an opening price).If a commodity trendline isn’t broken, it remains, usually until at least twoclosing breaks occur. Many times a market will go sideways near the Bottomof a downtrend. The sideways trend gives traders time to believe the downtrend is over. For this reason they appear most often at the Bottom, and, thelonger Consolidating sideways trends continue, the stronger the next rally willbe. False turns happen most often at the Top where everyone gets nervous.Although the most reliable trendlines move at or near a 45-degree angle, anytrendline running consistently for more than 4 weeks tends to continue.
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9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
S&P 500 INDEX FUTURESCASH
INDEXVALUE
775750725Break700675
Trendline650625VOL & O.IVALUE400000
200000
24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2 9 16SEPOCTNOVDEC
FIGURE 182. Standard & Poor’s 500 Index (Cash). Although the weekly chart givesmore history to a trend, it will look at cash prices instead of futures prices, simplybecause of the narrowly defined futures life which has a beginning and an end. Thetrend in the 1996 market was unmistakably Bullish. After the July correction Resistance was continually penetrated and Support held firm until December. The December break was significant, but, at this point, appears to be a correction and notnecessarily a Reversal. (See Chapters 14, 15, and 40 for more on trendlines.) Chartcourtesy of Market Research, Inc. (www.barchart.com).
Market Timing IndicatorsThe reliability of chart trend patterns can be enhanced and improved byobserving other market timing indicators which have a track record forproducing reliable signals in the commodities markets. Often times suchindicators need confirmation of another system to enhance the timing ofbuys and sells. Chart patterns and other timing indicators fit together well.
Moving AveragesMoving Averages are some of the oldest technical indicators, and remainsome of the most useful indicators for market analysts. A Moving Averageis the average price of a security at a specific point in time. A Moving Averageshows a trend. The purpose of the Moving Average is to show the trend ina “smoothed” manner, with less apparent volatility. Although a smoothed
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¢/BUSHEL
CORN – CBOT
AS OF: 12/20/969 WEEK MOVING AVERAGE18 WEEK MOVING AVERAGE
550
H
500450S
S
400350300
Neckline
250VOL & O.I1000000500000
1995J A S O N D J
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1996F M A M J
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FIGURE 183. Weekly Corn Prices (Cash). As was suspected in the corn daily futuresprice chart (Figure 181), a broad, 9-month Head-and-Shoulders Topping/Patternformed in the corn market. The left shoulder occurred in mid-December 1995, withthe head in May–June of 1996, and finally the right shoulder (on lower volume) inAugust. Although the Consolidation could be the Bottom, it appears to be viewedwith some caution in the November–December area. (See Chapters 6, 7, and 8 formore information on Head-and-Shoulders Formation and measuring.) Chart courtesyof Market Research, Inc. (www.barchart.com).
trend can be considered a chart pattern (EN: i.e., trendline), Moving Averagesgive unique signals that can be used in conjunction with other traditionalchart patterns.
Time SpanThe user selects the time span. For stocks, the most common time periodsare 10-day, 30-day, 50-day, 100-day, and 200-day Moving Averages. Mosttechnicians, however, use variations of these numbers to suit their individualneeds. There isn’t just one “right” time frame. Moving Averages with different time spans show different stories. The shorter the time span, the moresensitive the Moving Average will be to price changes. The longer the timespan, the less sensitive or the more smoothed the Moving Average willappear.The other factor to define is the price used in computations. The mostcommon price used is the close for a particular day. However, technicians
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9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
POINTS118
30 YEAR TREASURY BONDSMARCH 1997
116114112110108106VOL & O.I100000050000024 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2SEPOCTNOV
9 16DEC
FIGURE 184. 30-Year Treasury Bond Futures (March 1997). Here again are Trianglepatterns indicating approaching market breaks. The first in July broke significantlyto the upside with an accompanying increase in volume. The second break in midAugust had a decline, as did the break in late November. Although the October breakshowed a slight increase in volume, September’s break only had a Minor increase.Support held well in four instances: June, July, and two in September. Resistancefrom July–August held in early October, but when penetrated later in the month hada significant Rally. (See Chapter 7 for more on Triangle formations.) Chart courtesyof Market Research, Inc. (www.barchart.com).
use several other variations. They are (high + low)/2; (close + high + low)/3;(open + close + high + low)/4; and the weighted variation is (high + low +close + close)/4. Closing prices are significant because they represent positions that investors are willing to carry overnight.
Single Moving AveragePerhaps the best way to understand a Moving Average is with an example.Assume we have been tracking the closing price of IBM for the past 100 daysand want to create a 50-day Moving Average. First, add the closing pricestogether for the first 50 days. Then divide this amount by 50. This is the firstpoint plotted on the chart. Then add the closing prices together for Day 2through Day 51. Next, divide this amount by 50, establishing the secondpoint on the chart. Then add the closing prices for Days 3 through 52 togetherand divide the number by 50, etc. Connect all the points plotted together ina line and run it through the price bars.
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IBM (Daily)1201161121081041009692AVolume
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FIGURE 185. IBM 1996, 50-Day Moving Average (Exponentially Smoothed). Theplotted Moving Average shows a smoothed price trend. A buy signal is given whenprice crosses above the Moving Average and the Moving Average is directed upward.A sell signal is given when price drops below the Moving Average and the MovingAverage is directed downward. Buy and sell signals are not given when the MovingAverage changes direction but price does not cross above or below the MovingAverage. Chart courtesy of AIQ MarketExpert (www.aiqsystems.com).
Dual Moving AveragesMoving Averages can become more powerful when multiple Moving Averages are plotted. One combination is to plot a 9-day Moving Average andan 18-day Moving Average on the same chart. A buy signal is given whenthe 9-day Moving Average crosses above the 18-day Moving Average andboth Moving Averages are in an upward direction. A sell signal is givenwhen the 9-day Moving Average crosses below the 18-day Moving Averageand both Moving Averages are declining.Although any number of Moving Averages can be used, the use of threeor four is not uncommon. Dual Moving Averages appeal to many technicalanalysts. Research shows using two averages tends to be the most effective.Like many other indicators, averages can be unreliable or difficult to tradein fast markets. They contain data not within the current range of volatility;the data never reach the present. The averages do call attention to the currentmovement in relation to the past.False signals can be given when prices fluctuate in a Broad SidewaysPattern. To compensate, technicians use other indicators to confirm the direction of price. Looking to the chart patterns can be the indicator of choice for
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9 DAY MOVING AVERAGE18 DAY MOVING AVERAGE
SOYBEANS – CBOTJANUARY 1997
¢/BUSHEL
825
Buy
Buy
800775
Sell
750Buy
725
Sell
700675Sell
VOL & O.I200000100000
24 1
8 15 22 29 5 12 19 26 2JULAUG
9 16 23 30 7 14 21 28 4 11 18 25 2SEPOCTNOV
9 16DEC
FIGURE 186. Soybean Futures, January 1997. A chart with four buy signals andfour sel1 signals, some with only minor gains. Watchers of Moving Averages needto establish which signals are significant enough for them to make a trade. (SeeChapter 36, Automated Trendline: The Moving Average.) Chart courtesy of MarketResearch, Inc. (www.barchart.com).
these occasions. Pattern Formations will be Rectangles, Triangles, Pennants,or other Consolidations. Seeing them on a chart can clarify the MovingAverage signals. (See Chapter 11 on Consolidation Formations.)
Weighted and Exponential Moving AveragesThere are two other types of Moving Averages, the Weighted Moving Average and the Exponential Moving Average. If a simple Moving Average iscentered, the signal is delayed. To overcome this, many technicians use aWeighted Moving Average where the data are weighted in favor of the morerecent data. A Weighted Moving Average reverses direction more quicklythan a simple Moving Average.The most frequently used method to weight a Moving Average is, for a5-day Moving Average, multiply the first observation by 1; the second observation by 2; the third observation by 3; the fourth observation by 4; the fifthobservation by 5. Then divide this sum by the sum of the weights. In thiscase, the divisor is 1 + 2 + 3 + 4 + 5 = 15. The sum in the first part of theequation is divided by 15. With a Weighted Moving Average, a buy or sellsignal is given when the Weighted Moving Average changes direction.
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An Exponential Moving Average is a form of a Weighted Moving Average. To construct a 20-day Exponential Moving Average, first construct a20-day Simple Moving Average. The Simple Moving Average becomes thestarting point. Assume the Simple Moving Average value for Day 20 is 42;the Simple Moving Average value for Day 21 is 43; and the Simple MovingAverage value for Day 22 is 44. We then subtract the Day 20 Moving Averagevalue from Day 21 Simple Moving Average value and get a difference of1.00. This value (1.00) is multiplied by an exponent. In this case, the exponentis 0.1. Next, add 0.1 to the Simple Moving Average value of Day 20. TheExponential Moving Average value of Day 20 now becomes 42.100. And thisgoes on indefinitely. To calculate the exponent, divide 2 by the time period.In our case, we divided 2 by 20 to arrive at 0.1.The average itself can act as an area of Support and Resistance. The moretimes a Moving Average is touched, the greater the significance of a violation.A penetration of a Moving Average is a signal that a change in trend maybe taking place. Confirmations of trend changes should be confirmed fromalternative sources. Generally, the longer the time frame of the MovingAverage, the greater the significance of a crossover.
Moving Average CaveatThe largest difficulty with Moving Averages is their reliance on trendingmarkets. Flat or Consolidating markets will create similar Moving AverageLines (see Chapter 11, Consolidation Formations). Another annoyance is fora quick-turning market to be well ahead of the turn in the Moving Averages,which are buoyed up by the numbers from previous dates. AlthoughWeighted or Exponential Averages partly get around being buoyed, theytend to whipsaw with the market and the smoothing factor is lost. These arereasons for not being dependent on Moving Averages alone. Traditional chartpatterns can be useful in combination with Moving Averages.EN9: Without a doubt one of the most important contributions chart analysiscan make to a mechanical system is to make the user aware of the state of the market.A competent analyst should recognize the difference between trading and trendingmarkets and adjust his tactics accordingly. Unfortunately few traders seem to usethis “hybrid” approach. They fear “discretionary trading,” not trusting their ownemotional strength to deal with the enormous stress of futures trading.
Moving Average Convergence Divergence (MACD)MACD, an oscillator, is derived by dividing one Moving Average by another.Basically, it combines three Moving Averages into two lines. In today’s computer programs, the Moving Averages are usually exponentially weighted,thus giving more weight to the more recent data. It is plotted on a chart witha horizontal equilibrium line.The equilibrium line is important. When the two Moving Averages crossbelow the equilibrium line, it means that the shorter EMA is at a value less
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than the longer EMA. This is a Bearish signal. When the EMAs are abovethe equilibrium line, it means that the shorter EMA has a value greater thanthe longer EMA. This is a Bullish signal.The first line is the difference between a 12-period Exponential MovingAverage and a 26-period Exponential Moving Average. The second line(signal line) is an approximate exponential equivalent of a 9-period MovingAverage of the first line. The exponential values being 0.15, 0.075, and 0.20.A MACD can be displayed as a line oscillator or a histogram.Software allows a user to change values when calculating MACD. Somesystems require the entering of exponential values, and others use the actualnumber of periods for the three Moving Averages. There is a caution onchanging original values of MACD to curve fit the data. It is recommendedthat two differing sets of values be used, one for the buy-side and anotherfor the sell-side. Both use a 9-period (0.20) signal line, but the 0.15, 0.075combination is for the sell-side only. The buy-side values are 8-period (0.22)and 17-period (0.11). The sell-side formula is normally slower (EN: with theintention of buying quickly and letting profits run). It is probably best to staywith the standard sell-side formula in the commodities market; even thoughslower, it should be more reliable in most situations.
S & P 500(Daily)
MACD
F
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678.40665.60652.80640.00627.20614.40601.60588.808.004.000.00(4.00)(8.00)
FIGURE 187. Standard & Poor’s 500 Index 1996, MACD. Buy signals are generatedwhen the faster line crosses the slower line from below. Sell signals come from theopposite, when the faster line crosses the slower line from above. It is easy to see someof the difficulties and risks involved with mechanically trading every buy and sell signalfrom MACD. Using different periods for buy and sell can help overcome some of thedifficulties, but using other indicators, such as trendlines drawn on the MACD line, canalso assist the trader in selecting entry and exit points. The use of trendlines here changesthe number of trades from nine to three and they are all on the right side of the market.Chart Courtesy of AIQ MarketExpert (www.aiqsystems.com).
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Buy and Sell SignalsBuy signals are generated when the faster line crosses the slower line frombelow. Sell signals come from the opposite, that is, when the faster linecrosses the slower line from above. Beware of mechanically trading everyMACD crossover, as it can lead to whipsaws and substantial drawdowns.The fact is, narrow trading ranges give many false signals which can beavoided with additional interpretation. EN9: This additional interpretationbeing conscientious observance of the bar charts.
MACD Overbought–OversoldGerald Appel, who originally developed MACD in 1979 (as a stock markettiming device), sets the overbought and oversold signals for the S&P Indexas a plus or minus 2.50 on the MACD scale. With the NYSE Index herecommends plus or minus 1.20. When the Differential Line crosses intothese areas, a signal is generated for buy or sell. Similar levels can beobserved and established for any market, thereby eliminating the whipsawing of short price swings. MACD is best used as a long-term analysis tool.
MACD Trendlines, Divergences, and CombinationsDrawing a trendline along the MACD and trading when the trendline isviolated can often precede a change in the market. MACD crossovers havemore significance when they are preceded by, or are in conjunction with, aviolation of the trendline. Aggressive traders can use the trendline break asan action signal and cautious traders can wait for further confirmation.However, it is possible to have a trendline break and a delayed crossover,which can be frustrating.Divergence is one of the most common and effective patterns in technicalanalysis. Patterns where the MACD shows Divergence from what the pricesare doing can be an important signal, although the pattern needs time todevelop and should not be anticipated.Combining crossovers with other technical patterns can make the MACDsystem more reliable as a system for trading. Major Trends are identified byusing a long-term MACD to confirm the short-term MACD. A monthlyMACD can be used to confirm weekly patterns, the weekly pattern canconfirm the daily, and the daily can be used for confirmation of intraday.Shorter-term signals can be traded in the direction of longer-term MACD;this helps avoid problems of whipsawing markets. As with other commodities trading systems, the use of stop-loss orders is recommended.
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ReversalsReversals in the direction of a Moving Average are usually more reliablethan a Moving Average Crossover. In an uptrend, the following conditionsapply:• Long positions are maintained as long as price remains above theMoving Average.• If price crosses above the Moving Average, a buy signal is generated.• If price falls to the Moving Average but doesn’t cross it and thenmoves back up, a buy signal is generated.If a price drops sharply below the Moving Average Line a reboundtoward the Moving Average Line may occur, resulting in a whipsaw action.In a downtrend, short positions are held as long as price remains below theMoving Average. A sell signal is generated when price moves above a declining Moving Average Line. If price moves up to the Moving Average Linebut doesn’t cross it and drops down again, a sell signal is generated.*
Bollinger Bands (BB)Developed by John Bollinger (as the Financial News Network’s Chief Technical Analyst), Bollinger Bands are Alpha–Beta bands positioned two standard deviations from a 20-day Moving Average. They were developed in anattempt to improve on the concept of fixed-width trading bands (tradingbands drawn parallel, at a fixed distance to a Moving Average). Bollingerselected standard deviations because the calculation involves squaring fromthe average; it makes the system responsive to the short-term price changes.
Overbought or OversoldThe primary purpose of the developed Bollinger Bands is to indicate whetherprices are relatively too high or too low. Once the determination is made,the trader can turn to other indicators for trading signals (such as a RelativeStrength Indicator).
CustomizingThe standard deviation value can be altered. Some traders increase the valueof the standard deviation from two standard deviations to 2.5 standard* “The Moving Average Convergence–Divergence Trading Method” from Technical Toolbox, aspecial monthly feature of Technical Traders Bulletin, January 1990.
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deviations away from the Moving Average when using a 50-day MovingAverage. Conversely, many technicians lower the value of the standard deviation from two to 1.5 standard deviations away from the Moving Averagewhen using a 10-day Moving Average. Any alteration should have the bandscontaining most but not all of the data.
Bollinger Bands with Other IndicatorsSince Bollinger Bands do not generate buy and sell signals alone, they areused with other indicators, such as a Relative Strength Index (RSI) or chartpatterns. When price touches one of the bands, it can indicate a continuationof the trend; or it might indicate a Reversal. Bollinger Bands need buy andsell signals from other sources (see Chapter 30, Support and Resistance).When combined with an indicator such as RSI and chart patterns, Bollinger Bands can become quite powerful. RSI is an excellent indicator withrespect to overbought and oversold conditions. When price touches theupper Bollinger Band, and RSI is below 70, it is an indication that the trendwill continue. Conversely, when price touches the lower Bollinger Band, andRSI is above 30, it indicates the trend should continue.
S & P 500(Daily)678.40665.60652.80640.00627.20614.40601.60FRSI Wilder
M
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588.8096.0080.0064.0048.0032.0016.000.00
FIGURE 188. Standard & Poor’s 500 Index 1996, Bollinger Bands. John Bollinger’s“Bollinger Bands” have gained an excellent reputation as a reliable indicator for stocktrading and commodities trading. Bollinger’s intent was to create a system wherebythe market would tell him what it was doing, rather than his trying to impose anexternal discipline on the market. The bands indicate overbought and oversold, butrely on other indicators for buy and sell signals. Here with RSI Wilder, as discussedin text. Chart Courtesy of AIQ MarketExpert (www.aiqsystems.com).
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If a price touches the upper Bollinger Band and RSI is above 70 (possiblyapproaching 80) the trend may reverse and decline. On the other hand, if aprice touches the lower Bollinger Band and RSI is below 30 (possiblyapproaching 20) it indicates the trend may reverse and move upward.
Driven by Market VariablesThe logic behind Bollinger Bands was to create a system driven by marketvariables, rather than trying to impose an external discipline on the market.It asks the market what is happening, rather than trying to tell the marketwhat it is doing. Charting follows the same line of reasoning and can beeffectively used with the bands.*
StochasticsThe Stochastic Oscillator, developed by George Lane, compares a security’sprice closing level to its price range over a specific period of time. With thisindicator, Lane theorized, in an upward-trending market, prices tend to closenear their high; and during a downward-trending market, prices tend toclose near their low. As an upward trend matures, prices tend to close furtheraway from their high; as a downward trend matures, prices tend to closeaway from their low.
ClustersThe Stochastic Indicator attempts to determine when prices start to clusteraround their low of the day in an uptrending market, and cluster aroundtheir high in a downtrend. Lane theorizes these conditions indicate a TrendReversal is beginning to occur.
%D Line and %K LineThe Stochastic Indicator is plotted as two lines, the %D Line and %K Line.The %D Line is more important than the %K Line. The stochastic is plottedon a chart with values ranging from 0 to 100. The value can never fall below0 or above 100. Readings above 80 are considered strong and indicate a priceis closing near its high.
* “Bollinger Bands,” TTB Interviews John Bollinger, from Technical Traders Bulletin, July 1990.
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Readings below 20 are strong and indicate a price is closing near its low.Ordinarily, the %K Line will change direction before the %D Line. However,when the %D Line changes direction prior to the %K Line, a slow and steadyReversal is often