key in trading. Think ofwhat an auction is like. There is excitement. People are furiously bidding upthe price of an object. It attracts more buyers. Gosh, it even attracts peopleto bid on items they don’t even want. Then as value has peaked, the biddingdries up; and the last person with the highest bid is awarded the item (orstuck buying the high). Trading is essentially the same if you know whenit’s the right time or price level to enter the market and what signals to lookfor to exit a trade.There are all kinds of traders, and each one uses different forms ofanalysis. What I teach short-term stock, forex, and futures traders is thatthere is immediate equal access to the four common denominators thateach and every trade has to work with, without prejudice and exclusivity:(1) the open, (2) the high, (3) the low, and (4) the close. For stock traders,there is a fifth element: volume. Fugures traders who are longer term orwho like to confirm the strength or the weakness of a trend should also beconcerned with volume. In futures, unlike in stocks, the volume is not givento the investing public in realtime intraday. Truthfully, that is why the futures and forex markets depend on technical analysis to speed the analytical process to determine a market move on pure price action. After all, it ishow we analyze, interpret, and act on the information that makes us different as traders. As for forex, we do not have a means to measure volume as
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discussed previously. Therefore, it is wise for a forex trader to learn how toborrow information from the futures markets.
WHAT MAKES A SUCCESSFUL TRADER?The key elements to making money are this: Successful traders interpretcorrectly and act swiftly! Successful traders have the courage to act and actpromptly. I often ask what are the differences between successful tradersand not so successful traders are. I get all kinds of relatively good answersof why traders fail, mainly due to the fact that folks share their own bad experiences with me. The reason I give for success is very simple: Generally,a successful trader does not make a habit of consistently buying the high ofa given time period and riding the loss out until it “turns around.” Inversely,successful traders do not make a habit of consistently selling the low of asession and riding that loser out. Successful traders have a plan; they followthe market and go with the flow. After all, that is where the saying, “Thetrend is your friend,” came from. So we need to determine the trend. Thatis where charts come in handy.As Figure 2.1 shows, there are but three states the market is in: (1) bullish, or uptrend; (2) bearish, or downtrend; and (3) neutral, sideways, or
Uptrend
Downtrend
SidewaysFIGURE 2.1
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what is known as a consolidation phase. We can see the current trend orconditional state that the market is in. What we can’t see is when and byhow much that condition will change. That is one reason why many traderslose—they anticipate or guess which direction the market will go; theytrade without a plan or set of rules to enter a trade. If you do believe thatthe markets are an effective mechanism for reflecting the perceived valueon a given product at a given time, then you need to learn how to follow theflow of the market. A chart shows the market in its current condition. Untilthat condition changes, you need to go with the flow. So what signalsshould you look for when conditions change? When the market is in an uptrend, a simple signal is once the market ceases to increase its assignedvalue by establishing not only higher highs and higher lows but, most important, when a market stops making higher closing highs.As for a market that is in a downtrend, when different events occur—such as lower highs, lower lows, or, more important, lower closing lows—then it is starting to change conditions. If a bearish market or a bullishmarket changes conditions, it will most likely go into what is called a consolidation or congestion phase. Figure 2.2 shows the market moving froman uptrend to a congestion phase, or sideways pattern. What we need to dothen is, first, learn how to anticipate or discover what forecasting toolwould help us determine what the potential top of that uptrend would beand, second, understand what clues to look for once it establishes the topto help signal us that the trend may resume or that a reversal of the trendwill occur.
Resumption or Reversal?
Congestion
Uptrend
FIGURE 2.2
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WHERE’S THE CATCH?As the market starts to trade higher once, it enters a trend phase. Generallyspeaking, the market will pause or consolidate before resuming the uptrend. However, there lies the catch and what substantiates the RandomWalk theory. Not at all times do markets resume an uptrend from the consolidation phase. False breakouts and reversals do occur. Most bullishchart patterns, such as flags, pennants, rising wedges, and ascending triangles, are just an assortment of classical technical continuation patterns thatexist in trends. These work in bar charts and candle charts. The larger patterns tend to give a clue to the next move by forming in the direction of thetrend; the smaller corrective patterns, such as flags and triangles, lean awayfrom the trend. Sideways channels that form after a bullish trend have atendency to support off a past breakout point or an old high.Figure 2.3 shows weekly chart of Apple Computer; it had an amazingrun after it went out of a period of congestion and blasted off to the upside.Notice that after the bullish price direction resumed, prices do not make
FIGURE 2.3RealTick graphics used with permission of Townsend Analytics, LTD.
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lower closing lows until the second week in December. After that, as youcan see, it did move higher at the start of 2006; but the tweezer top formation (equal and opposite) contained the rally, and prices ended back wherethey started.
FIND THE CLUES!From a strict chart-reading perspective, finding the clues as to when a trendis nearing completion is a matter of watching the relationship of the closeof the time period for which you are trading to past highs and lows. If youstudy the chart in Figure 2.3, you will see the first leg or run-up in the market from September 2004 until the first lower closing low occurred inMarch 2005. The market never made a lower closing low during that timeperiod. Once it did, the market entered a consolidation phase. That was thefirst conditional change. The sequence of higher highs, higher lows, andhigher closing highs stopped; and a new conditional change occurred—themarket made a lower closing low and closed below the open twice in a row.The chart in Figure 2.4 zooms in on that specific area to help highlight whatoccurs when a trend pauses or exhausts itself.As traders, we are searching for information that will give us clues to anadvantageous entry spot to go long, whether it is at the beginning stages ofa bottom or breaking out of a congestion phase or a sideways channel. Determining the market condition, whether it is bullish, bearish, or neutral, iswhat will help us in our trading decisions. There are many forms of technical analysis studies to help us achieve that. The best form of trend analysisis the simple trend-line approach; you start with the lowest low point andthen draw the line up until the next corrective low point. Figure 2.5 demonstrates the most common way to draw a supporting trend line. After a longhard crash in IBM, a low was made on 4/17/2005 at 71.85 (the Weekly PivotPoint S-1 targeted a low of 72.50). Drawing a line from that low and extending it out to the second reactionary low and extending forward illustrated a rising trend. As the market kept bouncing near that support line(S-1), it advanced higher. Using this form of simple analysis will help youidentify the market’s condition and, therefore, develop a trading plan orkeep you focused to buy breaks.As for determining a bearish or downward trend, you need to draw aline from a peak, or top, in the market, as shown in Figure 2.6. You have aseries of lower highs to draw a resistance trend line. Start with the firstpeak, extend the line downward to the next high, and then extend the lineforward. This will help you remain focused that the market is bearish, andtherefore you want to focus on selling opportunities.
FIGURE 2.4RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 2.5RealTick graphics used with permission of Townsend Analytics, LTD.
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FIGURE 2.6RealTick graphics used with permission of Townsend Analytics, LTD.
As the trend line is drawn from the top and extended down to the nexthigh, notice that the highs are touching the newly drawn resistance line asthe market pushes away from the trend line. Also notice the sequence ofevents that occur. It is the opposite of what we saw in a bull trend: Pricesare making lower highs and lower lows and closing below the opens (as indicated by the dark candles); but more important, prices continually closebelow the prior time period’s low. In addition, the downtrend does not enduntil late November, when prices reverse these negative conditions. Theconditional changes that occur on the way down reverse at that time withhigher highs, higher lows, higher closes than opens, and, once again, themost important feature of all, higher closes than a prior period’s high.
BE ON GUARD FOR CHANGESI must reiterate that no one, no matter what, can foresee the future. Therefore, you must be aware that changes can and do occur. You must under-
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stand what drives these changes as reflected on the chart patterns. Onceyou can master identifying what drives price changes or trending marketconditions, then you need to learn how and when to execute a trade basedon those signals. Then the next phase is to manage the risks of the tradeand to learn how to exit the trade to harness the profits accrued in thetrade.I will teach you how to spot these changes and what you can do to protect yourself from giving back profits by scaling out of trades, which will becovered in Chapter 10. First, you need to be aware of the process that markets go through. Prices do go in trend mode as we have covered so far.From a technical standpoint, there are certain clues that candle charts illustrate to show you the true condition of the market. Pivot point analysiswill also help guide you as to price targets, either the high or the low orboth of a given session. If you have the understanding that markets can either continue the original trend or reverse it on a dime, then you will beable to filter out preconceived emotional opinions rather than “fight thetape,” as it is called. You will read that the mind can, will, and does playtricks on you when you are trading. So you need to focus on what the market is showing you at the current moment.The graph in Figure 2.7 seems a bit harsh—that a market condition
Not all consolidations resume trend!
Consolidation
UptrendReversalFIGURE 2.7
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could be so bullish and yet completely fall apart at the seam after a consolidation period. What can and usually does happen is that a trader gets apreconceived notion that the value of a given market should continue tomove in one direction. Most traders will continuously buy breaks after aconsolidation period. Granted, that might be a correct notion; but it mightnot be the correct move, especially when proven wrong by the markets’conditional changes as highlighted by specific candle patterns.As you can see in Figure 2.8, the 5-minute e-mini–Standard & Poor’s(S&P) chart shows how a market moves from bullish (or an uptrend) to theconsolidation phase to a complete trend reversal. Drawing a simple trendline would help you identify a breakdown of the support; but the one mostimportant element that signaled a trend reversal was the fact that once themarket traded below the consolidation sideways channel support—morespecifically, closed below that level and remained below the channel support level—you had sufficient evidence to identify that the market’s bullishcondition had changed.
FIGURE 2.8RealTick graphics used with permission of Townsend Analytics, LTD.
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FOREX MARKETS FALL PREY TO REVERSALSLet’s examine a market that is not correlated to stocks, such as the eurocurrency, to see how this market phenomenon known as a trend reversaloccurs. Keep in mind that the markets are a reflection of the cumulativetotal (or sum) of market participants’ perceived value of a given product ata given time. We went over the fact of how massive the spot forex market’sliquidity is; not a single entity can manipulate prices. Something or someevent must drive traders’ opinions of the markets. One such event is a newsor economic report, which can change people’s opinions on a given market’s value.As we look at the euro currency chart in Figure 2.9, we see the marketdevelop into an uptrend, then consolidate, and then, bang, on the drop of adime, drastically reverse. This is the kind of trading environment in whichtraders can and do make lots and lots of money. If you know what to lookfor and if you understand once a market goes from trend to consolidation,you should be aware that the next possible outcome might not be a trendcontinuation but rather a complete trend reversal. Then you have a betterchance of not fighting against the current of the market, otherwise knownas the tape.
FIGURE 2.9RealTick graphics used with permission of Townsend Analytics, LTD.
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MOVING AVERAGES HELP!The next method for identifying whether the market is bullish, bearish, orin a consolidation phase is utilizing moving averages. The most familiarone is the benchmark 200-day moving average. Most technicians and shortterm traders feel this is a worthless time period, with which I agree forshort- to intermediate-term trading.Remember that the idea in using moving averages is to help determinethe true direction of the market. The longer the time period used in a moving average, the less effective it is for shorter-term trading. Keep in mindthat a 200-day moving average is over 28 weeks, more than half a year. TheFederal Reserve raised rates four times in 2005 in that same time period.That leaves way too much time and, more important, distance betweenprices and the moving average to generate buy or sell signals.When using moving averages the general guideline is simple:• If prices are above the moving average, look to buy pullbacks or totake buy signals, as the market is in a bullish mode or in an uptrend.• If prices are trading below the moving average, look to sell rallies or totake sell signals, as the market is bearish or in a downtrend.Another instance in which traders use moving averages in helping theirtrading is determining what is called “regression to the mean.” This is aterm many traders hear but really do not understand. It refers to the condition when prices deviate too far from the mean or average. At that tme,prices will regress, or return, to the average; or the market will pause orconsolidate until the average catches up to the price. You will notice whatI call a “gap band” signal. This is what will occur when the prices gap too faraway from the moving averages or bands and give a trader an opportunityfor a countertrend trade. Another way to describe this is that when a market deviates, or departs, too far from the moving average, it gives an opportunity for a speculator to take advantage of this condition, whichgenerally ends up with prices reaching an unsustainable extreme and thenreturning back toward the moving averages for a short-term price swing.The question is at what distance or price level do prices deviate, or movetoo far away, from the moving average before market prices return to themoving average or the market pauses in order for the moving average tocatch up to the prices.As you can see in Figure 2.10, the market trends higher; but at times wesee reactions that shift values from one extreme to another. How do we usemoving averages effectively? More important, which time frames andwhich set of conditional settings should we employ to give us a true senseor value of the market? We will cover a different concept using a pivot
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FIGURE 2.10
point method later in the book. Right now, I want to set the foundation behind the principle of why we use moving averages to help determine bullish, bearish, or neutral market conditions and how to trade theseconditions. I try to figure out not why a market moved, but rather where themarket is now in relation to specific points of interest, such as past openshighs, lows, and closes.
FILLING IN THE GAPAs you can see in Figure 2.10, the gaps that occur show that prices movetoo far too fast in one direction, which is a condition known as overboughtor oversold. Those moves are unsustainable and thus form what we callovervalued or undervalued in relation to the trend line or moving average.Most market behavior as reflected by the human emotional state goes intoextremes. This is even the case in trending markets: They move either toofast or too far in any one direction and then simply pause or correct backabove or below the various moving averages, as you will see. The chart in
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Figure 2.11 is the spot euro currency. This market has an inverse relationship with the U.S. dollar. As the dollar moved lower, the euro moved higher,and vice versa. Notice that when it separates too far away from the longerterm moving average (M/A), it would return back to test the M/A as a support line or fill the gap, as it is known. Finally, as it breaks below the M/Asupport in the middle of September, it declines too far too fast and returnsback up to test the line, which now acts as a resistance trend line.In conclusion, trend lines and moving averages help us determine theprice direction of a given market at a given time. They can also help us discover when a market is overbought or oversold. In simple terms, when weuse moving averages, the more time periods we use, the slower or less sensitive moving averages are to price changes. Prices will trade and closebelow a moving average in a bearish market condition, or a downtrend; andprices will trade or, more important, close above a moving average in a bullish market condition, or uptrend. Introducing more than one moving average with two different calculated values, such as 10-period and 20-periodsimple moving averages on a closing basis, will generate buy and sell signals as one value crosses above or below the other. We can compute andchange the variables we use as well, such as closes and volatility calcula-
FIGURE 2.11RealTick graphics used with permission of Townsend Analytics, LTD.
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tions. Moving averages help in the development of trading strategies, as wewill see in later chapters. There are also variables other than just a simplemoving average based on a closing time period that you can use. I will introduce to you a pivot point moving average method in Chapter 6.Forex, or currency, markets tend to establish longer-term trends, somoving average studies are very popular with these markets. Also, movingaverage systems can be back-tested; therefore, hypothetical results can beproduced for those looking to explore running a hedge fund.In the next few chapters, we will introduce the pivot point system andincorporate that as one of our moving average values. We will blend thiswith a series of conditions and introduce various time frames to help us determine:••••
Market condition and direction.Overbought or oversold conditions.Potential turning points or reversal areas.A moving average system to determine buy and sell signals.
If you are looking to improve your skills as a trader, then these next fewchapters will help. I hope I will inspire you to learn how to develop a predetermined game plan, to act on that plan, and to manage and maintain theprofits in the trade and to learn how and when to cut the trade when themarket signals to do so.If you understand the three directions in which a market can go—up,down, or sideways—then you will have an edge on learning how to “readthe tape,” which should enable you to cut losses and let your winners ride.
CHAPTER 3
How to ReadOscillators to SpotOverbought orOversoldConditions
n a bullish market environment, prices break out of a previous rangeand trade higher. Depending on the move, sometimes the marketreaches an unsustainable extreme, which we refer to as “overbought.”After all, market prices can’t go up forever without a pause. The outcomevaries when markets reach overbought conditions. They can, as stated,pause or consolidate, correct back down a bit, or completely reverse theentire price advance. Understanding when a market is likely to reach anoverbought condition is vital to knowing when to take a profit in a long position, especially after a long uptrend, or when to profit from a countertrendtrade opportunity. This is also referred to as a “mean-reverting strategy” or“trading against the trend.”We can measure or profile a market price extreme several ways: One isby looking at past price resistance levels; another is by looking at thestrength or weakness of the market’s move by using certain technical indicators that measure the current price, relative to previous highs and lows.Some of my favorite tools that I use to compliment my trading methodinclude predictive analysis based on pivot point studies, as we will see inthe following chapters, with a strong emphasis on studying pure price action, as we discussed in Chapter 2, by identifying higher closing highs in anuptrend and lower closing lows in a downtrend.I look to identify certain chart patterns or a signal that shows a shift inmomentum; and then I look for a sequence of events, such as higher closing highs at predetermined support levels or lower closing lows at predetermined resistance levels determined by the aid of pivot points analysis,
I
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into which I incorporate various time frames to help me pin down reversaltarget levels. This method is great for short-term day trading to long-terminvesting. This method also works when I am looking at a swing trade,which is a trade that may last anywhere from one to three days. For longerterm trading, I use volume studies in the stock and futures markets to helpme confirm the strength or weakness of a trend or to gather a clue as towhen a major reversal is ready to occur. For spot foreign exchange (forex)currency trading, volume figures are available to use from the futures markets; but because those figures are not available until the end of day, theyare not good day trading indicator tools. Therefore, the use of oscillatorsand indicators help to confirm the condition of the market once I am in atrade or about to make a trade based on an extreme price swing.Some questions that are often asked when I am giving a seminar or apresentation at a conference are: How many indicators do you suggestusing at one time? Do you get analysis paralysis from using too many? Theanswer is that I use two indicators: stochastics and moving average convergence/divergence (MACD).Since trending conditions exist for less than 30 to 40 percent of thetime, you can anticipate that after a nice trend directional move, the marketwill move in a consolidation phase, or “whipsaw” as most people call it. Inchoppy range-bound conditions, stochastics is your friend; in trending market conditions, MACD will give you solid signals.The myth surrounding MACD is that one of the best indicators outthere is not necessarily true. So goes the old adage that there is no holy grailfor any single trading indicator or style. This is due to the fact that marketschange, as do market conditions and people’s perception on a product’sgiven value or anticipated value in any given time. I believe that the stochastic indicator is a more useful tool than the MACD during certain market conditions and for determining various signals, such as divergences orconvergences. They both can be used for pinpointing reversals.It is likely that one will give a faster signal than the other, and viceversa. The one fact is that in trending markets, MACD can be your friend byhelping you to stay in a trade longer, thus milking a position for more thanyou would imagine. This chapter will show several rules and techniques forusing both of these indicators.
STOCHASTICSStochastics, a range-based oscillator, is also considered a momentum oscillator. George C. Lane is credited with creating the formula. I had the
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privilege of working for George back in 1980. His indicator is a populartechnical tool used to help determine whether a market is overbought,meaning that prices have advanced too far too soon and are due for adownside correction, or oversold, meaning that prices have declined too fartoo soon and are due for an upside correction. Stochastics is based on amathematical formula that is used to compare the settlement price of aspecific time period to the price range of a specific number of past periods.The method works based on the premise that in a bull, or up-trending,market, prices will tend to make higher highs and that the settlement price,or close, will usually tend to be in the upper end of that time period’s trading range, or at least closer to the high. When the momentum starts to fade,the settlement prices will start to push away from the upper boundaries ofthe range; and the stochastics indicator will show that the bullish momentum is starting to change. The exact opposite is true for bearish, or downtrending, markets.There are two lines that are referred to as %K and %D. These are plotted on a horizontal axis for a given time period, and the vertical axis is plotted on a scale from 0 percent to 100 percent. As you will see from theformula, %K will be the faster of the two lines and will change direction because the %D line is a moving average of %K. The unique feature of the stochastics reading is the moving average crossover feature.Stochastics is a range-based oscillator with readings between 0 percent and 100 percent. The main guidelines reflect the thought that readingsover 80 percent indicate that a market condition is overbought and ripe fora downside correction and that readings under 20 percent signal the marketis oversold and ripe for a bounce. While that certainly is the case, generallyspeaking, I look for more clues within the indicator to trigger a trade signal.The formula to calculate the first component for fast stochastics usinga 14-period look back setting for %K is:%K = c – Ln/Hn – Ln * 100where c = closing price of current periodLn = lowest low during n period of timeHn = highest high during n period of timen = number of periodsThe second calculation is the %D (3-period). It is the moving averageof %K.%D = 100(Hn/Ln)where HN = the n period sum of (c – Ln)
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RULES TO TRADE BYWhen using stochastics as a confirming tool, I see the indicator corroboratethe timing of a market turn associated with a higher closing high, especially when it is in proximity of a targeted support level based off a pivotpoint level. These rules will help to make better trading triggers for buy andsell signals.• When the readings are above 80 percent and %K crosses below the %Dline and both lines close back down below the 80 percent line, then a“hook” sell signal is generated.• When the readings are below 20, percent, once %K crosses above %D,and once both lines close back up above the 20 percent level, then a“hook” buy signal is generated.The market in Figure 3.1 is a 15-minute candle chart on the ChicagoBoard of Trade (CBOT) mini-Dow contract. The buy signal or trigger is generated once %K and %D both cross over and back above the 20 percent line.It also confirms the first time after the downtrend that the market makes a
FIGURE 3.1RealTick graphics used with permission of Townsend Analytics, LTD.
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higher closing high. We have not yet discussed candle patterns; but forthose already familiar with that charting method, you will notice that it is ahigher close above the doji high. The trigger to go long is on the close or thenext open, once the market makes a higher closing high, which in Figure 3.1would be at 10810.When the market trades near the daily projected resistance, as determined by using pivot point analysis, once prices start to make lower closing lows, which is a clue that helps us identify that the uptrend hasconcluded. That is what generates a sell signal at 10838. That would be aprofitable scalp of 28 points at $5 per point, which is $140 on a day tradingmargin of $500, which is what most futures brokerage firms charge.
STOCHASTICS CONFIRMS THE TURNNow looking at the sell signal, we would have an opportunity to go short at10838 as the market pivots and turns, as I say, off the resistance level as thestochastics confirms with a %K and %D hook sell signal once both linescross and close below the 80 percent line. Follow the flow of the marketafter that point: lower highs, lower lows, and, more important, lower closing lows all the way down to a low of 10739. That is a 99-point decline or$495 per contract—almost a 100 percent return on your day trading margin.As the market declines, we see the stochastics crossing above and backbelow its respective values; but never does it cross back and close abovethe 20 percent line. I am asked at what level do you take profits. I will goover specific target exit levels later; but for right now, the most simplisticanswer is at the last trading price near 10758. The reason is that this wouldhave been a day trade; and as you can see from the bottom of the chart, theday is running short on time. Profit objectives can be based not only onprice targets but also on time limits.Figure 3.2 shows a pattern similar to that in Figure 3.1: a higher closeabove a doji high. Candle chart aficionados may see a variation of a morning doji star pattern. I keep it very simple; I call it an HCD pattern, whichstands for a high close doji. This pattern has specific rules on entry andexits and will be disclosed in just a bit. For now, please focus your attentionon the fast stochastics, as %K and %D both confirm the trigger to go longonce both lines cross and close above the 20 percent line. That trigger corresponds on the close of the candle, which was 10756. As the market moveshigher, follow the flow again as the momentum builds. The stochastics doesnot generate a sell signal, as the high was made at 10805. We see acrossover of %K and %D above the 80 percent line, but the stochastics doesnot close back under that line.The 20 percent and 80 percent levels in relationship with the %K and
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FIGURE 3.2RealTick graphics used with permission of Townsend Analytics, LTD.
%D values will help confirm your entries and exits in the markets, especially when you follow the trend or market flow as shown by the candlecharts. There is a reason why I have focused on the high close doji signal,as we shall soon discover from a back-test study on percentile perspective.But once again, this chapter is to help you better understand the confirming power that stochastics offers.Markets need volatility in order to move, and we need markets to movein order to trade