Dell Computer’s average daily volatility is more than fourtimes the average daily volatility of SPG and its price is more than threetimes the price of SPG. A winning setup on SPG may lead to, at most, asmall profit, whereas the same setup on Dell will lead to a much greaterprofit. Even if the prices of these securities were equal, the higher volatil-ity in Dell leads to larger moves than in the lower volatility stock.
This is just as true for the futures markets. No matter how successful you arein predicting the direction of a move, a lack of meaningful day-to-day movementvirtually guarantees that, as a short-term trader, you will be unable to makesubstantial profits.
We therefore must identify the markets that will provide us with themost profit-making potential. How do we do this? There are a number ofways, but the measurement I use is historical volatility (HV). This can bemeasured with a period of as short as 25 days or as long as 200 days (forreference in this chapter, we will use a 50-day HV number). As you cansee from Figure 6.1, as of December 1997, the most volatile commoditymarkets (hence the best markets to trade) are Natural Gas, Pork Bellies,and Coffee and the least volatile market (the worst market to trade) is theCanadian Dollar. The same holds true for equities. Figure 6.2 shows thebest stocks to look at (as of December 1997) for setups and obviously,unless market characteristics change, you will want to avoid stocks suchas utilities, REITs, etc.
Your volatility list should be adjusted on a weekly basis. This will assureyou of consistently knowing which markets are likely to provide youwith the best opportunities. Also, we must remember that there are over10,000 stocks and more than 30 commodity markets available to trade. Byusing volatility to filter out the quiet markets, you will be able to focuson where the action is on a daily basis. I can’t stress enough the impor-tance of this concept.
Finally, you may ask, “Aren’t I increasing my risk by trading in highlyvolatile markets?” The answer is yes, but if the setups you are trading arecorrect, your profits from these setups will be greatly increased becauseof the higher volatility.Trading Where the Action Is 35
Figure 6.1 50-Day Historical Volatility as of December 1997
Under 10% 10-20%
304%
 
Canadian Dollar Gold
DM YenSwiss FrancCattle
CocoaHogsSoybeanWheatCotton
 
Pork BelliesCoffeeNatural Gas
For future reference, you should be aware that the Canadian Dollar ishistorically a less volatile entity than Pork Bellies, Coffee, and NaturalGas, which tend to have 50-day volatility reading predominately above25 percent. Therefore, your position size and stop placement should re-
flect these inherent characteristics.
Figure 6.2 Highest 50-Day Historical Volatility Stocks as of December 1997
 
NYSECA—Computer AssociatesCMB—Chase Manhattan
CPQ—Compaq ComputerCTX—Centrex Corp.
TER—Teradyne
BSX—Boston ScientificPDX—Pediatrix Medical
SCI—SCI Systems
MWD—Morgan Stanley /Dean Witter
 
 
NASDAQALTR—Altera Corp.COMS—3 Com Corp.DELL—Dell ComputerKLAC—KLA-Tencor Corp.LLTC—Linear TechnologyTLAB—Tellabs, Inc.SNPS—Synopsys Inc.PSFT—People Soft Corp. 
CHAPTER 7
ADDITIONALVOLATILITY RESEARCH
In Investments Secrets of a Hedge Fund Manager, we showed what I stillconsider to be the best and most efficient way to correctly identify andmeasure the reversion to the mean principle as it applies to volatility. Byusing a 100-day period as the normalized base, we showed that when-ever a 10-day period volatility was 50 percent or less than the 100-dayperiod, a large market move was likely to occur (reversion to the mean).For example, if the 100-day historical volatility reading is 30 percent, a10-day historical volatility reading under 15 percent is likely to be fol-lowed by a large market move.
Since the book was released a few years ago, I have publistied additionalresearch on the subject. On the following pages you will learn some newand advanced volatility concepts which should assist you with your trad-ing. Please note that most of the examples shown use a six-day lowertrading period, As I stated earlier, almost any pairing of a shorter timeperiod versus a longer time period will identify markets that are likely toexplode. For the record then, any short-term versus long-term historicalvolatility reading under 50 percent will many times be followed by alarger than normal market move.
3738
Chapter 7
THE ADDED PROFIT FROM MULTIPLE-DAY SIGNALS
Our research has shown us that the longer the time frame a historicalvolatility ratio reading is under 50 percent, the larger the market movewill be. Ideally, we would like to see the historical volatility ratio readingstay under 50 percent for more than one day. The more days it is under50 percent, the more likely the market will explode.
Since ] live in Southern California, an appropriate analogy would be thatof an earthquake. The longer the build-up between quakes, the larger theresultant explosion will be. This principle holds- true with volatility. Thelonger the period of low volatility, the larger the move will be to revertvolatility to its longer-term mean.
Is this setup perfect? No! There will be times when the market has achange in overall volatility and is not accompanied by a large move.Over time though, this is a superior vehicle to use to identify potentialmarket explosions.
Let’s look at some examples.Additional Volatility Research 39
FIGURE 7.1a March 96 S&P 500 Futures—Historical Volatility
 
HISTORICAL VOLATILITY
 
 
1. The 6-day/100-day historical volatility ratio reading is under 50percent for two consecutive days (please refer to the values on theleft-hand axis, not those in the box).
FIGURE 7.1b March 96 S&P Futures
 
 
 
2. As you can see, after the multiple day historical volatility readingsunder 50 percent, the March S&P’s explode more than 16 points tothe upside over the next two trading sessions.
 40 Chapter 7
FIGURE 7.2a American Online
 
   
&
<AHCHAPCO< ANT
 
1. Here we have American Online (AOL) with a multiple day histori-cal volatility reading under 50 percent. This signal remains for twoweeks (!), thereby increasing the pressure on the market to explode.
FIGURE 7.26 American Online
 
2. On September 2, AOL moves 4 3/8 points higher on double its av-erage daily volume. The breakout holds and the stock rises morethan 20 percent in a week.
 een]Additional Volatility Research 41
FIGURE 7.3a December Corn
8
x
ashe
wisronion waariciy |:@ ay 9.202 tat |Cty 9.2 Lest |eCany 9.20% Last |)A 10S seas cant
<AHCHADTFO< ANT
 
1. In mid to late September 1997, corn goes through a two-week ex-tremely low volatility period as measured by historical volatility.
FIGURE 73b December Corn
 
 
2. On October 3, the market wakes up as volatility reverts to its mean.December corn rises more than 30 cents in only six trading days.
 eT42 Chapter 7
FIGURE 7.4a British Pound
 
a
PpCcTVvaLATILItrY
 
1. A sustained period below normal volatility tells us a large move isnear.
FIGURE 7.4b British Pound
 
 
 
 
2. The market moves 150 points higher.
3. The British Pound explodes to a closing high of 166.66 in a weekand a half.
 AAdditional Volatility Research 43,
FIGURE 7.5a American Online
wf.
HISTORICAL VOLATILITY,6 aay 14.7% Lest
6 doy 14.7% Lest
10 day 17.02 Lest
100 amy 50,2 Last
PCcTVv
‘aoLAxTtILITtY
 
 
1. Here is AOL again, this time a few months earlier. For one week,the 6/100 historical volatility reading is under 50 percent.
FIGURE 7.5b American Online
 
2. Signal period.3. A better than 35 percent change in prices over a few weeks.
  
44 Chapter 7
COMBINING MULTIPLE-PERIOD HISTORICALVOLATILITY READINGS
One of the ways to closely pinpoint when a market is likely to have alarge move is to look at multiple period historical volatility readings un-der 50 percent. My research and trading has found that combining a 1C-period reading and a 6-period reading is a superior method to only usinga 10-period reading. This holds true both on a daily basis and on anintraday basis.
Let’s look at a few examples.
FIGURE 7.6 January Soybeans
 
   
 
 
1, _ Both the 10/100 historical volatility reading and the 6/100 historicalvolatility are under 50 percent, signaling a large move is near.
2. Over a six-day period, beans drop more than 50 cents.
 aT
Additional Volatility Research 45
FIGURE 7.7 An Intraday S&P Setup Using 40-Minute Bars—
 
 
23
o —
P=
1. A 10/100 historical volatility reading combined with a 6/100 his-torical volatility reading under 50 percent.
 
 
 
BEBERIBIIIITILILE
 
 
 
 
2. The S&P’s explode 8 points higher within a day.A46 Chapter 7
FIGURE 78a Estee Lauder
K<AHOHADrO< ANT
 
1. In this example, the 6-day historical volatility is well under the 50percent level and the 10-day is at 50.2 percent. When the number isthis close, I will not stand on ceremony, as the reversion to themean principle will certainly kick in.
FIGURE 7.8b Estee Lauder
 
 
2 Signal date.
3. A nearly 20 percent move in prices six trading days later.
 Additional Volatility Research 47
FIGURE 7.9a Viasoft
a
PCcTVvautAsTItLITY
 
1. Viasoft, an extremely volatile stock, nas a 6-day and 10-day volatil-ity reading more than 50 percent under its 100-day reading.
FIGURE 7.9b_ Viasoft
 
 
2. Signal date.
3. An explosion in price as the stock moves more than 20 percenthigher within six trading days.
 48 Chapter 7
FIGURE 7.10
PcTVvQOLATItLI+Y
 
SUMMARY
The one drawback to using multiple readings is that it gives a traderfewer signals than does a single reading. The advantage is that it does aneven better job of pinpointing explosive opportunities that lead to largergains.
FILTERING FALSE VOLATILITY SIGNALS
When a market has a very large, extraordinary move, historical volatilityreadings under 50 percent are usually false. This lesson is important toremember.
The extraordinary move causes the 100-day reading to increase drasti-cally, thereby causing a long period of 6/100 and 10/100 readings under50 percent. At these times we must wait for the 100-day reading to revertto its normal mean.
Let’s look at the crash of 1987. As you can see from the Figure 7.10, thehundred day reading exploded from 20 percent to approximately 50 per-
Historie, volaTturty |10 day 29.2% Last6 day 22.5% Lost |6 day 22.5% Lost |: 
Additional Volatility Research 49
FIGURE 7.11
HISTORICAL YOLATILITY10 day 11.8% Last
PCcTVvQLATILL+Y
 
 
cent after the crash. During the months of November, December, January,and February, there were many 6/100 and 10/100 readings under the 50percent ratio. These were false signals due to the volatility created duringOctober.
By March 1988, the effects of the crash were no longer part of the 100-daycalculation and the 100-day volatility began making its way back to the20 percent level (see Figure 7.11). We therefore must wait a full 100 daysto remove the extraordinary event from our calculations.
Among the events that have triggered this type of move have been thecrash of 1987, the semi-crash of 1989 and the oil crisis in 1990, Obviously,these types of situations are rare but when they do occur historical vola-tility readings are skewed and must not be used until they become nor-malized. 
Chapter 7
HV THRUSTS
One of the filtering techniques I use to trade historical volatility is tocombine extreme readings with range expansions. Extreme readings thatare accompanied by single-day large moves tend to have a higher likeli-hood of both short-term and intermediate-term follow-through.
Here are the rules:1. Identify a market whose 6-day or 10-day volatility is less than 1/2its 100-day reading. As we discussed, it is even better to have both
readings under 50 percent or for either reading to have multipledays under 50 percent.
2. On the day of the readings under 50 percent look for a daily pricerange that is larger than the daily range of the previous nine days.
3. If rules 1 and 2 are met, expect a follow-through in the direction ofthe large-range day for the next one to ten days.Additional Volatility Research 51
FIGURE 7.12a June 96 British Pound
 
 
1, April 8—The six-day historical volatility reading has been less thanhalf the 100-day reading for three consecutive days.
FIGURE 7.12b June 96 British Pound
 
 
       
   
wi (59.12 onae 152.308 cCtese?or 1903 etoes
 
a »
2. On April 9, the British pound breaks to the downside and its rangeis larger than the daily range of any of the previous nine days.
3. The next day the sell-off continues taking the pound to as iow as150.30 intraday.
  
52 Chapter 7
FIGURE 7.13a US Long Bond
 
 
HISTORICH_ VOLATILITY.6 doy 12.1% Last. 6 dy 12.1% Lost—— 6 day 12.1% Last—— 100 day 9.50% Last
<dGHPHAPrOo< ANT
 
 
1, The 6-day historical volatility is under 50 percent the 100-day his-torical volatility.
FIGURE 7.13b US Long Bond
 
2. Largest daily range of previous nine days.A Sa.Additional Volatility Research 53
SUMMARY
Measuring historical volatility as we do identifies tightly wound markets.The larger-range day confirms a breakout and many times these break-outs can be substantial. 
SECTION THREE
NEW PATTERNS
T have always been fascinated by bar patterns. To me, they tell a story ofwhere a market has been and more importantly, where a market is likelyto go.
The following three chapters are the easiest ones to understand in thebook. They are simple chart patterns that provide an edge when trig-gered. The “8-Day High/Low Reversal Method” and the “Spent MarketTrading Pattern” are setups that identify times when markets are likely toreverse. The “1-2-3-4” pattern is a wonderful setup which allows you toclimb aboard strongly trending markets after they have had a brief pull-back. All three patterns also combine good money management tech-niques by using tight protective stops.
  
CHAPTER 8
1-2-3-4
Among the benefits I have received from writing two books are the trad-ers I have met whom I now consider friends. One of these traders is JeffCooper. Jeff makes his living doing what most people only dreamabout—he mostly day tradés momentum stocks.
Over the past few years Jeff and I have had long conversations on how toidentify which stocks and commodities are likely to have large movesand how to properly climb aboard for these moves. Most traders (bothstocks and futures) can identify markets that are in a runaway mode, butmany do not have a proper method for climbing aboard as the movecontinues.
Here is a trading pattern Jeff and I developed which first was introducedto the trading world in his book Hit and Run Trading. Both he and I usethe setup as a fundamental part of our strategy. We believe it solves thepredicament of when and how to enter runaway markets.
By way of background, W. D. Gann, more than 65 years ago, observed aninteresting phenomenon for extremely strong markets and extremelyweak markets. He noted that very strong and very weak markets usuallydo not correct for more than three days. 
Chapter 8
As Jeff and I worked on our methodology to enter these markets, it be-came clear that Gann’s analysis and insight were absolutely correct. It isamazing how often a runaway market will experience a few days pauseand then resume its trend.
The “1-2-3-4" trading pattern is a specific short-term setup which com-bines:
« ADX
+ Pattern recognition
+ A specific price entry placement to give a trader the opportunity toprofitably enter in the direction of the resumption of a longer-termtrend.
Here are the rules:
FOR BUYS1, Identify a market whose 14-day ADX is greater than 30. The higherthe ADX, the better.
2. The 14-day +DI reading must be greater than the 14-day -DI read-ing. (If you do not understand ADX, please see either Street Smartsor Hit and Run Trading.)
3. Wait for the market to have a 1-2-3 correction. This means that themarket must make three consecutive intraday lower lows or anycombination of two lower lows and an inside day. The exampleswill clarify this further.
4, On day four only, buy 1 tick (1/8 for equities) above the day-threehigh.
5. When filled, your initial protective stop should be near the day-three low.
6. As the position moves in your favor, you should trail your stops. Inthis setup we tend to allow for a littie more breathing room on ourstops because of the upside potential of the move.
  
12-34 59
FOR SELLS1. ADX > 30. The higher the ADX, the better.2. The -DI must be greater than the +DI.
3. Wait for a 1-2-3 rally. Three higher highs or any combination or twohigher highs and an inside day.
4. On day four only, sell (short for equities) 1 tick (1/8) below theday-three low.
5. Your initial protective stop should be near the day-three high.6. As the position moves in your favor, trail your stops.Let's look at some examples from the futures and equities.el60 Chapter 8
FIGURE 8.1 May 96 Crude
 
 
 1-2-3-4 61
In late March, the ADX for crude oil is well above 30 and the +DI isgreater than the -DI, signifying an upward trend.
1, March 27 has a lower low.2. March 28 has a second lower low.
3. March 29 is an inside day. We will buy one tick above theMarch 29 high of 21.65 on April 1 only.
The market explodes higher and we are long. Our initial protectivestop is near the March 29 (day 3) low.
The 1-2-3-4 trading pattern does a nice job of letting us participatein a better than $3,000 per contract upside move.62 Chapter 8
FIGURE 8.2 Gucci
 
 
 
 
 
 This strategy works especially well with higher priced momentum stocks.
A.B.
ADX is greater than 30 and +DI > -DI.1. A lower tow.
2. A-second lower low.
3. A third lower low.
We buy on the opening as it is at least 1/8 point above the April 1high of 48 1/8. Our initial protective stop is near the low of April 1of 47 3/8.
Gucci trades nearly 6 points higher (12 percent) in four trading ses-sions.
12-34 6364 Chapter 8
FIGURE 83 Pork Bellies
 
 
 As you can see from the top chart, May bellies are in a strong up-trend. In mid-April, the ADX is greater than 30 and the +DI isgreater than the ~DI.
A 1-2-3 Setup1. A lower low.2, A second lower low.3. An inside day.4,
. Bellies trade lower in the morning and then begin an upwardrise. We are filled at 74.52 and our initial protective stop is nearthe previous day’s low.
May Bellies trade more than 15 cents higher ($6,000 per contract)over the next two weeks.
1-234 65NS66 Chapter 8
FIGURE 8.4 Micron Technologies (MU)
 
 
 
 This strategy works equally well on the short-side for equities. Here is anexample when the semiconductor stocks collapsed in late 1995.
A. ADX > 30,-DI > +DI—A bear trend.
B.
1, First higher high.
2, Second higher high.
3. Third higher high.
4, Sell short at 53 3/4,
Micron drops 12 points in five trading sessions.
1-2-3-4
6738 Chapter 8
SIGURE85 June Bonds
 
 
 ™ mon f >
. The ADX and DI confirm a strong downward trend.. Three consecutive higher highs.
. Trades one tick under the March 5 low.
. Bonds lose more than 3 points in three days.
Three consecutive higher highs.
Even though a fourth high is made intraday, we still trade todayunder the previous day’s low and we are short.
. Bonds again lose approximately 3 points, this time in four days.
1-2-34 6970
Chapter 8
SUMMARY
As you can see, this pattern works well in both futures and equities. Anadded benefit to trading this strategy with stocks is there are signals al-most daily.
One of the hardest things to do is climb aboard a market that is in arun-away mode. As markets rapidly rise, the likelihood of entering near atop increases. By waiting for a pullback, which is a natural market phe-nomenon, and then climbing aboard as the trend resumes, you are look-ing at a lower risk entry for your trading. Also, by risking only a smallamount (with your protective stops), you have an opportunity to partici-pate in some potentially very large market moves.
Finally, even though I am not a fan of buying options, this setup obvi-ously lends itself to call and put buying. From some of the moves thatoccurred in the examples, option traders surely benefited. 
CHAPTER 9
THE 8-DAY HIGH/LOWREVERSAL METHOD
eeaceeeeeeeeeseeeee eee eee eee eee eee eee
One of the earliest observations, made both by traders and academicresearchers, is that markets go through various dominant cycles. Thesecycles range from decades to minutes. I suspect, the cycle many readersare most familiar with is the Taylor 3-Day Cycle: the Buy Day, Sell Day,Sell Short Day pattern discovered by George W. Taylor and described inStreet Smarts.
Here is “The 8-Day High/Low Reversal Method,” a longer-term cycle-trading methodology. The method is a distant cousin of Gerald Appel’s8-Day Action System which was introduced as an S&P scalping systemapproximately a decade ago. The 8-Day High/Low Reversal Method ex-ploits the fact that normally markets go through three to four week cy-cles. Markets tend to rise for half this period and then decline for theother half. Instead of blindly trading the cycle and guessing at an entry,this methodology waits for a market to test its cycle’s highs or lows andif the test is successful, we climb aboard for the reversal.
Markets tend to have dominant cycles. Too many of us, though, havebeen wrongly influenced by the prognosticators who attempt to predictmarket highs and lows based on these cycles. In reality, although markets
71 
72 Chapter 9
do not strictly adhere to these cycle points, it does not mean we cannottake advantage of them.
The 8-Day High/Low Reversal Method works because it combines anobserved market cycle with confirmed price action. The method is furtherenhanced with the use of tight money management.
Because it may be difficult to grasp at first, | have included additionalexamples. Before we go to the examples, let’s look at the rules.
FOR BUYS1. Day one must be an eight-day low.2. Day two must trade above the day-one high.
3. Days three or four or five or six must trade under the day-two low(this can be a new low).
4. | When condition three is satisfied, we buy one tick (1/8 for equities)above the day-two high as long as the one-tick breakout occurswithin four trading days of condition three.
5. Our stop goes one tick below the day-two low.
FOR SELLS
1. Day one must be an eight-day high.
2. Day two must trade below the day-one low.
3. Days three, four, five, or six must trade above the day-two high(this can be a new high).
4. When condition three is satisfied, we sell (short) one tick (1/8 forequities) below the day-two low as long as it occurs within fourtrading days.
5. Our stop is placed one tick above the day-two high.
Let’s look at a handful of examples.
  
The 8-Day High/Low Reversal Method 73
FIGURE 9.1 S&P Dec 96
 
 
 
1. Aneight-day iow (day one)2. Day two trades above the day-one high.
3. The next day trades under the day-two low. We will buy above thehigh (of day two) today (day three) or over the next four tradingsessions only if the price trades one tick above the day-two high.
4. We are triggered at 663.15 and our stop is one tick under the day-two low.
5. The market explodes more than 25 points higher over six tradingsessions. 
74 Chapter 9
FIGURE 92 July Copper
 
1. Aneight-day high (day one)
2. The next day, we trade under the day-one low.
3. Three days later, we trade above the day-two high.4
The attempted rally is short-lived and our sell signal under the day-two low is triggered. Our stop is one tick above the day-two high.
5. The market collapses over the next three days. 
The 8-Day High/Low Reversal Method 75
FIGURE 9.3 Microsoft
 
 
Here is a variation of the method. Notice how rules three and four are
triggered the same day.
1. Aneight-day low (day one).
2. The next day it trades above the previous day’s high.
3. We trade under the day-two low and immediately reverse to tradeabove the day-two high,
4. Microsoft trades more than 6 points higher over the next week. 
76 Chapter 9
FIGURE 9.4 December Cocoa
High 1444 on OWZ1796 [re eee beeeceee eeveefe 1390.25 Close |: i :tow 1390 on 0900/96 |: : ‘ :
 
 
1. Aneight-day high.2. We trade under the day-one low.
3. We trade above the day-two high and our sell stop is placed onetick under the day-two low.
4. Our entry is triggered two days later and the 8-Day High/Low Re-versal Method profits as cocoa sells off. 
The 8-Day High/Low Reversal Method 7
FIGURE 9.5 December Bonds
 
Lest 100-23
High 103 on 0993/96fe 107.327 Close?Low 105-09 on 09/06/96
 
 
An eight-day low.Trades above yesterday's high.Trades under the day-two low.
- 2: Np
The shorts are forced to scramble as a short-term bottom has beenmade. 
: Chapter 9
GURE 9.6 IBM
 
 
 
1, Aneight-day high (day one). /2, The next day we trade under the day-one low.
3. Four days later (our time limit), IBM trades above the day-two highand then trades under the day-two low. We sell the stock short andby the end of the day, 1BM is trading more than 12 points underour entry point. 
The 8-Day High/Low Reversal Method 79
FIGURE 9.7 December Coffee
 
Even though I mostly short-term trade, this setup did a nice job of get-ting into an intermediate term bottom in coffee.
12.3.4.5.
An eight-day low.
We trade above the day-one high.Trades under the day-two low.
We buy one lick above the day-two high.
A solid low-risk move over four weeks.
Notice the strength of this move. The market does not make two consecu-tive lower lows after the buy signal is triggered. This is fairly rare but itdoes show what markets will do when the selling is completed and le-gitimate bottoms are made. 
80 Chapter 9
SUMMARY
As you can see, this is a fairly low-risk setup that does a nice job ofidentifying markets that are likely to experience short and intermediateterm reversals. Also, you may want to combine it with the Two-for-Onemoney management method (see Chapter 28) to allow you to particip