days before it bottoms.”If you use a stop, you won’t have this problem. Don’t let those smalllosses grow into big ones, and don’t allow a profit to turn into a loss. Usea stop-loss order on every trade.
Plan the Trade and Trade the PlanWhen you have a losing trade, you may wonder what you did wrong. Instead, try focusing on how well you executed the trade. Did you followyour plan? Did you even have a plan to follow? Did you buy in late or selltoo soon?Focus on the big picture. Are you in a streak so cold it makesAntarctica look like the sun’s surface, producing losing trade after losingtrade?• Paper trade until you start winning again. Then jump back in using thetechniques you refined when paper trading.
• Focus not on any one trade but on a series of trades. The smallloss you took today pales next to the blockbuster gain you made amonth ago.
Profit Barriers
13
• Recheck your trading system and see if tuning it gives better results. The market changes over time. Your trading system,whether mechanical or discretionary, needs to be able to copewith those changes.
Profit BarriersTrading barriers come in many forms—I experienced one firsthand.The newspaper said that brokerage firms were reporting better than expected earnings. My broker announced earnings and the stock jumpedup on the news. The company expected 2004 to be a good year. Whenthe price eased back down, I bought. The stock waffled up and down. Ifelt confident that the price pattern would develop into an earnings flagand the stock would take off, so I doubled my position.The general market turned down and sucked the life out of thestock. I was so confident in the stock performing that I lost 13%—about double the usual loss. The good news came when the market toldme I was wrong—I sold. I followed my plan.Avoid scenario trading. Some call this scenario trading—tradingon an idea or story. Enthusiasm for the story drowns out the warningbells. You only hear the siren song seducing you into a trade that is destined to fail. You watch the business reports on television or read aboutthem in the financial news or on the Internet. Scenarios are all aroundyou, trying to make you believe a new trend is starting. Don’t believe it.The trend is about to end.“I was into gold mining stocks once,” Jake said, “so I followed theprice of gold. I read a columnist who cited numerous experts whoclaimed that gold had bottomed. But month after month, gold continued down. It took almost two years to reverse, but by then . . .” He stoodup and showed me his empty pockets. “I didn’t contribute to my IRAthat year because what little I had left over went to pay for health insurance.” His hands turned into two fists, clenched so his knuckles turnedwhite. “I hate insurance companies.”Ignore rumors and chat. Following the chat room chat and buyinga pump-and-dump stock is another mistake traders make. Someone ofperceived authority says buy ABC because his Already-Been-Chewedgum is the best there is. The stock is selling for pennies and it will go tofive bucks in a heartbeat. He might be right. What he doesn’t tell you is
14
TRADING PSYCHOLOGY
that he’ll sell you his shares when the time is right, just before the stockcrashes. Don’t listen to the chat room chat. Make up your own mind.And when you do make a mistake, sell quickly.Set price targets. Not having a profit or loss target is a trading barrier to success. How will you know when to get out? Sometimes setting aprofit target means you call the top exactly. A loss target tells you whenyou are wrong and a stop takes you out. If you don’t set a profit target,raise your stop until price takes you out when the trend changes.Decide what’s more important, being right or making money?For some people, making money in the market is less important than being right. Think of those traders who hold on to a stock, riding it down,holding it regardless of the paper loss so that they can sell it when itcrosses the threshold back into profitability. They can brag that they havenever had a loss or that their win/loss ratio is 90%. Don’t be afraid to sell.Losses are the cost of doing business.Avoid emotional trading. “Winning streaks are another problem Ihave,” Jake said. “I get so elated that I buy anything. Then, someone comesalong with a rolled-up newspaper and swats me down. I lose all that I madeand more. But I feel good that I owe the government less money.”Don’t trade when you’re emotionally stressed (too excited or too upset). Sometimes you feel you have to double your bet so that you can getback to breakeven sooner. You’re angry and it’s time for payback. Youhaven’t had a winning trade in so long you’re sure this one is going to bethe big winner. You buy large and pump additional money into the position, tying to prop up the stock single-handedly. I’ve tried supporting astock. It doesn’t work because the market has other plans.I turned to Jake. He was fidgeting in the chair because he knewwhat I was going to ask.
3Chapter
The Truth aboutTrendlines
ere’s that financial statement you asked for,” Jake said. Hishands shook as he held it out to me. His veins bulged. When Itried to take it, he wouldn’t let go. His fingers seemed tippedwith glue. I pried it from his hand and then scanned the document.“Budgets are a way to go broke methodically.” He slumped lower inthe chair. “I can’t go on losing money like this.”“I’ll help you out. Which way did you come in?” I smiled at the jokebut Jake didn’t. “Sorry. Before you make your next trade, run it by me.”Trading stocks is a lot like fishing—patiently waiting for a chartpattern to appear and excitement when the chase begins. If you’re lucky,the sweetness of success will overcome the bitter taste of failure. You willhave both, but trendlines can help.
“H
A Trendline ExampleJake’s finger hovered over the keyboard when I snuck up behind him andasked, “Is that the trade?”He jumped and then yelled “Jeez!” I wondered if he was going tohave a coronary. He released his chest, took a deep breath, and thenpointed at the screen. “I’m going to buy that puppy.”15
THE TRUTH ABOUT TRENDLINES
16
“Do you like losing money?” I said in my best Clint Eastwoodimitation.He swung around in his chair and looked at me.“That trade is good for at most seven points, maybe as little as two.”He frowned then looked back at the screen, wondering how I knew.Figure 3.1 shows what he was looking at. The two lines surrounding thefalling wedge slope downward, joining at the wedge apex sometime inthe future. Volume also slopes downward as it does in many chart patterns. Breakout day volume—the day price closes above the top patternline—is high, but not worth writing home about. The upward breakoutconfirmed the falling wedge as a valid chart pattern and signaled a buy.Or did it?Jake turned back to me. “I don’t see it.”“The falling wedge predicts that 70% of the time price will rise to atleast the top of the wedge. If the rise stops there, the trade would beAmgen Inc. (Biotechnology, NASDAQ, AMGN)73
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FIGURE 3.1 A falling wedge with an upward breakout marked a buyingopportunity until a trendline, drawn along the tops connecting pointsA and B and extended down, warned that price might stall when itreached the trendline.
Trendlines: External, Internal, and Curved
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worth only two points. More likely, though, is that price will push higheruntil it hits a trendline connecting these two tops.” I pointed to peaks Aand B. “With a declining price trend, the chances are good that priceswill rise to meet the trendline and then plummet faster than a hot airballoon out of propane.” I leaned closer to the screen. “If you trade thestock perfectly, you’d make 10%, but with Murphy’s Law at the wheel . . .”I shrugged my shoulders.Out of spite, Jake placed the trade anyway. In early February 2004,the stock reached a high of 66.88, one point above the downslopingtrendline before the stock reversed and sank to a low of 52 and change.Jake read the manuscript over my shoulder. “I should have listened.”I turned around to face him. “How much did you lose that time?”“Enough money to pay for groceries for three years, or a month’sworth of health insurance premiums. Those bloodsuckers . . .” His jawtightened and his voice was a rattler hissing. “Tell me everything youknow about trendlines.”
Trendlines: External, Internal, and CurvedIf you look at almost any price chart, your eyes will find prices that zigzagbut still follow an imaginary path. That path is called a “trend.” If youdraw a line connecting the peaks or valleys along that trend, you get atrendline. A trendline can outline a chart pattern as it does in Figure 3.1(the falling wedge), or it can show a price trend (trendline A and B).Trendlines indicate buying or selling opportunities when price crossesthem.External Trendlines
Trendlines come in three flavors: external, internal, and curved. Externaltrendlines are straight lines drawn so that the line rests on the peaksor grips the bottom of valleys. Figure 3.2 shows an external trendline.Upsloping trendlines connect the valleys of a rising price trend. That way,when price crosses the trendline, it is an indication of a possible trendchange from up to down. In the stock market, knowing when the trendwill change is worth big bucks. Notice that prices zigzag as they movehigher, but they still follow the straight trendline.
18
THE TRUTH ABOUT TRENDLINESBJ Services (Oilfield Svcs/Equipment, NYSE, BJS)
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FIGURE 3.2 Shown on the weekly scale are the three types of trendlines:external, internal, and curved. The curved trendline highlights an ascendingand inverted scallop chart pattern.
The downsloping trendline beginning in mid 2003 is also an external trendline, but it rests on the price peaks. Draw downsloping trendlinesalong the price peaks to indicate a possible trend change from down to up.Notice that both external trendlines in Figure 3.2 do not cut throughprices but rest along the tops or bottoms of the peaks or valleys. Cuttingthrough prices is what differentiates an internal trendline from an external one.Internal Trendlines
Internal trendlines are lines of trend drawn so that they rest on the flatportion of peaks or valleys—and frequently cut through prices. If theprice peak were a hill, an internal trendline would rest on the ground. Anexternal trendline, by contrast, would only connect the tops of the tallesttrees. Figure 3.2 shows one example of an internal trendline. Notice howthe line cuts through prices instead of resting on them.“Why would someone want to use that?” Jake asked and pushed hisreading glasses higher on his nose.
Touch Spacing
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One technical analyst argues that the line better represents the trading behavior of the masses, whereas external trendlines show the behaviorof just a few traders, the ones that traded at the price extremes.Most chartists use external trendlines, especially when drawing chartpatterns, and that is my personal preference. Sometimes I’ll use an internal trendline to highlight a trend better, especially an unusually long one,or a chart pattern with a few price outliers.Curved Trendlines
Occasionally, the price trend is not straight, but curved as Figure 3.2shows. Draw a curved trendline along the peaks or valleys to highlightthe price pattern. The curved line in the figure shows a chart patterncalled an “ascending and inverted scallop.”Sometimes traders get excited about a stock and push prices up (ordown) at faster and faster rates. The price trend moves up at a good clip(30 to 45 degrees) and then starts curving upward in a parabolic arc.These vertical climbs can be both exciting and scary because prices movehigher than you expect, but you know that the rise is going to stop eventually. Then, everyone races for the exits, forcing prices to plummet.When price closes below a rising but curved trendline, that is the sell signal, and it can help you be one of the first out the door. A sharp reversaloften follows the breakout from a parabolic or steep trendline.For all three varieties of trendlines—external, internal, and curved—traders simply refer to them as trendlines. Whether you use an internal orexternal trendline is a matter of personal preference.
Touch SpacingWhen I wrote Trading Classic Chart Patterns (John Wiley & Sons, 2002),I conducted research on trendlines and proved what others had merelyspeculated. I looked at about 200 trendlines with narrow and wide touchspacing and found that larger price moves occurred after a breakout froma trendline with widely spaced touches.Figure 3.3 shows line AC has four trendline touches and the line isfive months long. On average, the touches are widely spaced. TrendlineAB has five trendline touches; four of the touches are just a day apart.That trendline has narrowly spaced touches.
THE TRUTH ABOUT TRENDLINES
20
Albemarle Corp. (Chemical (Diversified), NYSE, ALB)
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FIGURE 3.3 Trendlines with widely spaced touches perform better than doones with narrow touches.
I found that when the average spacing between touches was less thanthe median 29 days in a downsloping trendline, the resulting price riseafter an upward breakout averaged 36%. Trendlines with touches spacedwider than 29 days showed prices climbing 41%. The same applies to upward sloping trendlines. There, the median was 28 days between touchesand narrow trendline touches gave declines averaging 14%, but widelyspaced touches showed declines averaging 19%. The results from thesetests are for perfect trades without any fees, so don’t expect to replicatethem in actual trading.If you are considering trading a trendline with four touches in amonth compared to a longer trendline with four touches each one monthapart, trade the one with wider spacing. It will be more reliable, meaningthat price is less likely to pierce the trendline and reverse (a false breakout).“Let me see if I understand,” Jake interrupted. “Trendline AB haswidely spaced touches (see Figure 3.1), so I should have viewed it as aconcrete wall.”“That’s right. Price bounced off it and turned down. But there’s more.”
Trendline Length
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Trendline TouchesI also looked at the number of times price touched a trendline. Experienced traders say that the more times price touches a trendline, the moresignificant becomes a breakout from the trendline. I proved that true.For example, I look at 85 downsloping trendlines that had pricetouching the trendlines three times. After an upward breakout, priceclimbed an average of 33%. Then I compared it to 40 trendlines withfive touches and found that the postbreakout rise averaged 57%.To check this result, I split the trendlines into those with four touchesor fewer. They showed gains averaging 35%. Those trendlines with morethan four touches climbed an average of 48%. Again, those trendlines withmore touches led to better performance after the breakout.I conducted the same research using upsloping trendlines and foundsimilar results, but the performance difference was closer.
Trendline LengthOf all trendline features, length is one of the important ones. Do long trendlines perform better thanshort ones after breakout? Yes. I found that the median length for downward sloping trendlines thatI used was 139 days. Trendlines shorter than themedian saw price climb an average of 33% after thebreakout, but long trendlines soared 43%.As a check, I used another method and sortedthe trendline length into three categories: short term(0–3 months), intermediate term (3–6 months),and long term (more than 6 months). Short-termtrendlines had postbreakout rises averaging 34%.Intermediate- and long-term trendlines had gainsaveraging 35% and 46%, respectively. I found similar results for upsloping trendlines.Trendlines are like diving boards: You get abetter bounce from a longer diving board than ashorter one.
short termlasts up to threemonths.
intermediatetermis between threeand six months.
long termmeans lastingover six months.
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THE TRUTH ABOUT TRENDLINES
Trendline AnglesAnother important consideration is the angle that the trendline makeswith the horizontal. The steeper the trendline, the worse the performance. That’s the conclusion I reached when I researched trendline angles. I measured the angle from the horizontal and sorted the trendlinesby the angle they made. For both up- and downsloping trendlines, thedistance that prices moved decreased the steeper the trendline became after a breakout. (For upsloping trendlines, a trendline breakout means aclose below the trendline; for downsloping trendlines, it’s a close abovethe trendline.)“How do I use that?” Jake asked.“Look for trendlines that slope 30 to 45 degrees. Trendlines withthose angles can last a long time. However, if the trendline slopes upwardat, say, 60 degrees or more, then you’d better tighten your stop.” Thatmeans adjusting your stop-loss order often, moving it closer to the current price. The price may continue soaring, but when the turn comes,the resulting decline will likely be rapid. A tight stop limits the dollarsyou give back.Jake’s fingers were laced together and his thumbs were twiddling,making small circles that chased each other. “Are we done yet?”“Not as exciting as driving a racing car?”His eyes lit up and his mouth opened to speak.“No,” I said before he could regal me with his latest exploit. “We’renot even halfway through trendlines and it’s important. You want tomake enough money to pay for your health care, don’t you?”Jake became a model student.
Trendline and Breakout VolumeDoes volume influence how far price will move after a trendline breakout? Yes. Let’s take trendline volume first. I did a study of volume andtrendlines and found that upsloping trendlines that had volume trendingupward over their length resulted in a decline averaging 19% after adownward breakout. When volume receded over the length of the trendline, the decline averaged just 14%.
Measure Rule for Trendlines
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For downsloping trendlines, when volume climbed over the courseof the trend, price climbed 30% after the upward breakout. A recedingvolume trend had prices climb by 45%. In short, here’s what I found:• Expect a larger price decline after a breakout from an upsloping trendline if volumeis trending up.• Expect a larger price decline after a breakout from a downsloping trendline if volumeis trending down.
breakoutvolumeis the volumelevel on thebreakout day.
What about breakout day volume? I compared volume on the dayprices staged a breakout to the three-month average and found the following to be true:• Upsloping trendlines with heavy (above average) breakout volumemean a larger decline—19% versus 16%.• Downsloping trendlines with light (average or below average)breakout volume mean a larger rise—39% versus 36%.Because the performance difference is not massive, don’t bet that a large price change will occur, anddon’t think that price will rise by 39%. As I mentioned, the statistics in this chapter are for comparisonpurposes only because they result from 200 perfecttrades. They represent the price rise or decline after abreakout to the ultimate high or low, respectively.
Measure Rule for TrendlinesWhen price closes below an upsloping trendline,how far will it fall? One answer to that questioncomes from the measure rule. Figure 3.4 showsan upsloping trendline. The measure rule is a toolused to help predict how far prices will decline aftera breakout. To use the rule, find the breakout where
measure rulevaries from pattern to patternbut is usually thepattern heightadded to (upwardbreakouts) orsubtracted from(downward breakouts) the breakoutprice. The resultis the predictedprice target. Priceoften falls short ofthe target, so usehalf the height inthe measure rulecomputation.
THE TRUTH ABOUT TRENDLINES
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price closes below the trendline (point D). Then look for the widest distance between prices and the trendline until the last time price touchedthe trendline. The last touch happened at point C, so the widest verticaldistance is between points A and B. The price difference between thosetwo is 20.75 points in this example. Subtract the difference from thebreakout price (point D, the point where price intersects the trendline)to get the target price, which turns out to be 12.25. Price reaches the target (not shown) in September 2001.“What happens if the prediction is a negative number?” Jake asked.At least he’s paying attention, I thought. “In that case, either thecompany is about to go bankrupt or the trend is about to change. Probably the latter.”
Advanced Micro Devices, Inc. (Semiconductor, NYSE, AMD)49
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FIGURE 3.4 Use the distance from the trendline to the price high (A–B),measured vertically then projected downward from the breakout (D) to geta postbreakout price target. This is the measure rule for trendlines, but itonly works between 63% (upsloping trendlines) and 80% (downslopingtrendlines) of the time.
1-2-3 Trend Change Method
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That’s the good news. The bad news is that this method works only63% of the time, according to my tests. You can apply this technique todownsloping trendlines in the same manner. Find the widest distance between price and the trendline from the breakout to the prior trendlinetouch and project the difference upward from the breakout price. Fordownsloping trendlines, the method works 80% of the time. Thus, whenpredicting a target, be conservative and assume that prices will fall shortof the target.
Drawing TrendlinesNow that we’ve explored trendline features, what’s left? Answer: Figuringout how to draw them. Some analysts argue that it’s harder than justconnecting several peaks or valleys. It’s not, unless you are searching for atrend change. I’ll discuss that in a moment.If you see several peaks that line up, then draw a trendline acrossthem. The same goes for valleys. Sometimes you’ll want to draw bothand form a channel—two parallel trendlines with prices bouncing between them. Think of the channel as a price conduit. When price reachesthe bottom of the channel, buy the stock, and sell when it shows signs ofturning at the top of the channel. If price fails to reach the top (bottom)of the channel, that may signal a weakening (strengthening) trend andtime to sell (buy). The odds increase—but not guarantee—that whenprice reaches the bottom (top) of the channel, prices will stage a downward (upward) breakout and punch through the trendline.“What have we learned, Jake?”“We learned that two peanuts were walking down the street. Onewas assaulted. Get it? A salted? Sorry. Please continue.”
1-2-3 Trend Change MethodBy definition, when price closes below an upsloping trendline, price is nolonger trending up. The same applies to downsloping trendlines. A closeabove the trendline means price is not trending down. But that does notmean price has changed trend.“I’m confused,” Jake said.
26
THE TRUTH ABOUT TRENDLINES
when price goesfrom trending upto down or horizontal, or horizontal to up or down.
Price usually moves in a zigzag fashion, likeclimbing stairs, so price may pierce the trendline,rebound, and continue rising. The 1-2-3 trendchange method takes the guesswork out of determining a trend change. Here are the three rules forupsloping trendlines:
trend change
1. Draw a trendline from the lowest valley before the highest peakand leading to the highest peak on the chart such that the trendline does not overwrite any prices between them. Look at Figure3.5. I show a dashed line AB connecting the lowest valley to thehighest peak. Notice how the line overwrites prices. Swivel theline from point B to the right until the line touches but does notoverwrite prices. I show the trendline as line AC1. Point 1 is thebreakout. Incidentally, this method of drawing a trendline is agood one to learn for all of your trendlines.2. Price should retest the high after the trendline break. That meansprice should attempt to climb back to the price level of the highestAlaska Air Group, Inc. (Air Transport, NYSE, ALK)55
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FIGURE 3.5 Shown is the 1-2-3 method of detecting a trend change. Point1 is the breakout from an upsloping trendline. Point 2 is a test of the high,and point 3 is near a close below a recent low.
1-2-3 Trend Change Method
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peak but not exceed it by much, if any. I show this attempt atpoint 2.3. Finally, price must close below the lowest valley between points1 (the breakout price) and 2 (the retest of the high). I mark thisvalley with a horizontal line ending at point 3.When all three conditions become true, then the trend has changedfrom up to down.How well does this method work for upsloping trendlines? By mydefinition, a trend change is a 20% decline in prices after the breakout. Itested the 1-2-3 trend change method on 67 trendlines that obeyed theabove conditions. I found that the average decline was 21% after thebreakout, which is higher than the 17% decline for all trendlines that ignored the 1-2-3 approach. Unfortunately, only 43% of the 67 trendlinesaccurately predicted a decline of at least 20%. Before you draw conclusions about this method, note that the sample size is small and there areways to improve the sell signal that I ignored during testing called the2B method. (For more information, see Victor Sperandeo, Trader Vic:Methods of a Wall Street Master, John Wiley & Sons, 1991.)You can use the 1-2-3 trend change method for downsloping trendlines to denote a trend change. Here are the steps:1. Draw a downsloping trendline from the highest peak to the lowestvalley such that it doesn’t intersect prices until after the lowest valley.2. Price should retest the low after the trendline break.3. Price must rise above the highest peak between the breakout andthe retest.In Figure 3.5, assume that point 1A is the highest peak on the chart.Step 1 says draw the trendline downward to the lowest valley such that itdoesn’t intersect prices until after the lowest valley. I show the line as1A2A, with the lowest valley being point D. Along the way, the trendlinetouches but doesn’t cross prices between points 1A and 2A until afterpoint D.Step 2 says prices should retest the low. That happens at 2A whenthey approach but do not exceed the valley low at D. Finally, step 3 sayslook for a rise above the peak between the breakout (a close above thetrendline, shown directly below 3) and the retest (2A). I show that as thehorizontal line 3A. When price closes above that line, it signals a trendchange.
THE TRUTH ABOUT TRENDLINES
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How often does the 1-2-3 trend change method work for downsloping trendlines? Again, I classify a trend change as a rise of 20% after thebreakout, and 73% of the 101 trendlines I tested that matched the threesteps in the 1-2-3 method showed an average rise of 35%. While the73% rate I consider good, the 35% result falls short of the 38% averagerise posted by all trendlines excluding those used in the 1-2-3 test. Nevertheless, for both up- and downsloping trendlines, I consider the 1-2-3trend change method to add value.
Sample Trade Using TrendlinesJake plopped into the chair beside me, smiling. “Are you telling themabout my trendline trade? I’m thinking of spending the profits from it ona pilot’s license for a hot air balloon.”Figure 3.6 shows a trade he made with two trendlines giving thebuy and sell signals. On the weekly price chart, using a logarithmic scale,he bought the week after price broke out upward from the ascending,broadening wedge (ABW).Advanced Micro Devices, Inc. (Semiconductor, NYSE, AMD)46413733292623
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FIGURE 3.6 In the sample trade, Jake traded this trendline to double hismoney.
Advanced Trendline Tactics
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The ABW is a chart pattern with two trendlines that widen overtime, but both tilt upward. A close above top trendline A occurred theweek before he bought, and it is the buy signal.Prices followed trendline B higher until late July. That’s when price