ingly, it can often tell you wrong.This type of prediction when proven true can be morethan helpful, it can be valuable. Therefore, we try to gaugesuch predictions with other indicators, such as the KinematicModel. If the application of our model indicates you shouldsell a stock short, and an oscillator indicates this stock is
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overbought, you should be able to act with more convictionthan if going by our model alone. Take a look at Figure 3.2.Only the solid line concerns us now. At Point 3, the stock isconsidered overbought because this line lies between Lines Aand B. This indicates a correction in the offing—too muchbuying has taken place and selling is about to take over. AtPoint 5, the solid line is between Lines D and E, indicating thatthe stock is oversold—too much selling has taken place. Thismeans a recovery is probably on the way, with an increase indemand and price in the near future. Again, an oversold stockshould be in line for a price rise, an overbought one should bein line for a price decline.
figure 3.2 oscillator
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Some oscillators give their indication—their buy or sell signal—by crossing a zero line, Line C, as occurs at Point 8. Otheroscillators, such as a stochastic, consist of two lines—a fastsolid one and a slow dotted one. In this case, the fast one, referred to as percentage K, is the result of a complicated mathematical formula that takes into consideration momentum, rateof change, and range comparisons. The dotted second line, thepercentage D line, is a moving average of the percentage K line,and therefore moves more slowly. A stochastic gives its buy orsell signals when percentage K, the solid line, crosses percentage D, the dotted line. Crossover that occurs in the overboughtarea between Lines A and B, such as Point 3, is a sell signal.Crossover that occurs in the oversold area between Lines D andE, such as at Point 5, is a buy signal.The RSI is another oscillator. Though a relative strength indicator, it is very different from comparative relative strength.The RSI measures a stock’s relative strength compared to itselfas opposed to an index. It is derived from a complicated formula that takes into consideration not only a stock’s sellingprice, but also its trading volume and other factors.To use this oscillator, you have no more need to knowhow it is computed, than you have a need to know how a watchworks in order to tell time. I have to mention that I am sparingyou a detailed explanation despite the fact that doing so wouldnot only allow me to pad this book by another ten pages, butalso despite the additional fact that the last time I explainedhow the RSI is computed, about half way through, for at least agood two seconds, I could have sworn I actually understood itmyself.To use the RSI, you must keep in mind that it usually topsabove 70 and bottoms below 30, doing so before the stockprice reverses trend. However, the real value of this indicator
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is as a warning system. For example, take a look at Figure 3.3.Notice that while the stock is making a new high, the RSI is already on its way down. This divergence is clearly predicting areversal of trend in the near future.There are numerous other oscillators we could discuss.However, we won’t. In my experience, the stochastic and theRSI are far and away the most helpful, especially when used inconjunction with each other. The MACD oscillator (moving average convergence divergence) too often trails price behavior.Despite this unfortunate fact, it remains quite popular. Perhaps people feel that hindsight’s infallibility somehow makesup for its lack of timeliness. It is a pity that there is no security
figure 3.3 RSI
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pegged to the MACD of a basket of stock. We could all get richusing the price of this basket to predict the MACD.In the meantime, keep in mind that there are three basicbuy or sell signals an oscillator can give you:1. When it enters or crosses over in an overbought area,2. When it enters or crosses over in an oversold area,and3. When it crosses a zero line.
ACPSThe ACPS is the average cents per share that stocks on the NewYork Stock Exchange are up or down. For example, an ACPS of+50 means that the average stock share is up fifty cents. AnACPS of −50 means the average share is down fifty cents.This indicator’s significance as a measure of the market’sstrength is not so much in the number itself, but rather in itsdirection and rate of change. For example, if a 10:00 A.M. ACPSof +50 declines to +35 by 10:15 A.M., the inference would be aweakening market.The ACPS is especially incisive when used in conjunctionwith advance/decline figures. Let us say that at 11:00 A.M. theadvance/decline is 1805 up/590 down, while the ACPS is +50.Then at 11:15 A.M. we have an advance/decline of 1810 up/580down. Yet the ACPS has dropped to +30. Though the advance/decline is indicating a strengthening market, the ACPSindicates a weakening one. In this case, the ACPS is the moreconvincing indicator. A good guess as to what is behind thesefigures is that the market is experiencing some profit taking.Supply is coming in and stock prices are weakening as tradersnail down some profits.
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price and volumePrice tells us what is happening. Volume tells us how it is happening. Let’s say you have a stock with an average daily trading volume of about one million shares and a normal pricefluctuation of about a point. One day it trades two millionshares and goes up four points. Any day trader who does notfind this action interesting should be checked for a pulse. Atrain appears to be leaving the station and a shot of adrenalinein his or her bloodstream should be yelling, “Jump aboard!”Well if you think adrenaline levels are the key to successfulday trading, you might as well throw this book away because itsure won’t save your balance sheet. Any stock trader in thehabit of jumping aboard trains without first trying to figureout where they are headed will eventually end up as blood onthe tracks.The question is, “How do you keep your emotions incheck to analyze a fast-moving situation such as this with astone-cold eye?” The answer is, “Through rote.” Whenever youare enticed by the movement of a stock, force yourself to examine it through the very same frame of reference—that ofsupply and demand. Ask yourself the same, exact, seven-wordquestion: What is happening with supply and demand? I cannot guarantee that you will come up with an answer, butmerely by asking the question, I can guarantee a large, suddendrop in your adrenaline level.Getting back to our example, the stock’s volume not onlyjumped, it doubled from one million to two million. Share pricealso jumped, four points, as opposed to a daily average movement of a single point. I hope you remember the question wenow force ourselves to ask. If not, check back six sentences.Supply is obviously still there, but the demand has outstripped it. Let us assume that out of the two million share
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volume, 1,800,000 came in as buy orders and 200,000 came inas sell orders.Now the next day volume stayed just as high, two millionshares. Yet the stock price only went up a quarter. What doesthis tell us about supply and demand? It tells us that supplyand demand are more or less in balance. So now we know notonly what is happening, we know how it is happening.In addition to knowing what is happening and how it ishappening, it is important to know where it is happening. Is itin an accumulation phase, a distribution phase, an uptrend, ora downtrend? Are price/volume relationships giving strong indications as to future action. For example, in an uptrend whenyou see volume drop on a reaction and rise again on a rally,this indicates a continuation of the uptrend. Therefore, a longposition is called for. Conversely, in a downtrend, if volumedrops in a rally and rises again during the following price decline, this indicates a continuation of the downtrend, time forthe trader to be selling short.Let us look at some less obvious scenarios. Assume on aparticular day a stock rises four points on a volume of 100,000shares. Average daily volume had been one million shares. If wewant to know where the stock is going to go from here, we better find out exactly where “here” is. This suspicious breaking ofresistance on low volume tends to indicate the end of a distribution phase and a Shake-Up-Fake-Out-Before-the-Breakdown.Such analysis may not supply us with enough conviction to sellshort, but it is fair warning against going long.Alternately, let us say a high volume of supply has beencoming in to meet demand, creating a ceiling the stock pricecannot surpass. It is very likely that this resistance is takingplace at the end of a distribution trading range. As it begins toseem less and less likely that the stock price will break throughthe resistance line, demand will more than likely decrease,58
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taking the stock price with it into a markdown phase. Lookingat the same phenomenon from a different angle, we can say thathigh volume at the top of a distribution range, with a narrowprice spread, tells us that supply and demand are in equilibrium. If demand falls, so will price.Conversely, if we get high volume and a very narrow pricespread just off the support line of an accumulation phase, whatdoes this tell us? It tells us that increased demand is sucking upsupply, which in turn means we should expect a markup phaseimminently.As regards both uptrends and downtrends, increasing volume in the direction of the trend and decreasing volume on reactions indicate a continuation of these trends. The oppositeindicates a possible imminent reversal of trend. When facingthe latter, the aware trader, especially the day trader, shouldnot only consider abandoning his position, but also possibly reversing it.
crossoversMonitoring crossovers is a very popular technique of somevery successful traders, especially day traders. The superiorquote screens provided by some online information servicescan be set to show advancing issues in green and declining issues in red. The individual quotes can also be arranged ingroups, which usually means by industry. Let us say you arestudying the pharmaceutical group and see mostly red. Thistells you that the pharmaceutical group is bearish. If on another day it is mostly green, this means the group is bullish.Assume a particular stock opens at 80 and goes downtwo points. There are now a lot of buyers who have positionedwrong at 80 and want out. If the stock rises back up to 80,many of these buyers will bail. This means they will add to59
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supply, perhaps sending the stock back down to 78, and upand down again in a trading range. Each time the price risesback to 80, the added supply will keep it from rising over 80.This makes 80 a point of resistance. However, eventually, ifthis movement continues, all the people who want to bail outand break even for the day at 80 will get the chance to do so.Now the stock may go up to 801⁄8 , crossing over from a declining to an advancing issue, and from red to green.That change in color is the eye-catching shattering ofa psychological barrier, especially to the day trader. That 1⁄8point change in color is very often enough to get his butt offthe bench and onto the field, thus giving the stock a realboost. Here the day trader was, looking for, praying for a stockwith momentum, when a dinky 1⁄8 point of change which mostlikely would have been ignored if it had not entailed a changein color from red to green, sets off this huge adrenaline rush inhim and all his day trading friends, a rush strong enough toturn an imagined 1⁄8 point of momentum into some bona fidemomentum, thus giving the stock a healthy and profitableboost. Nowhere is prophecy as potentially self-fulfilling as inthe stock market, at least in the short run.Prophecy aside, the fact that share price has brokenthrough a point of resistance is an additional indication thatthis stock, at the very least, should be watched carefully. Supply just may be exhausted. A sharp rise in price would tend toconfirm this. If this stock goes on to pass its all-time high, let’ssay 86, it will break another point of resistance. This may causeshort covering, the unleashing of pent-up demand, and the activation of automatic buy stop orders. It is no coincidence thatbuy stops are often clustered above resistance points. Manytraders use these orders to enter long positions on significantsigns of strength. Obviously, this activation, along with short
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covering and the unleashing of pent-up demand should in concert cause an additional jump in price.
quick quotesGMO 85N 1:59
L 861⁄4
Chg +3
B 861⁄ 8
A 865⁄ 8
1
1
Lo 84 ⁄ 2
1
AH 87 ⁄4
1
AL 47 ⁄ 8
LTV 100
1
EPS 3.93
PER 21.95
DIV 2.00
Y 2.32
H 86 ⁄4C 83 ⁄4
S 10 x 8 V 2,183,300E X 11/9/98
On the first line we have the stock symbol, GM for General Motors. The last trade (L) was at 861⁄4. The change (Chg) is plus 3from the previous day’s close. The bid (B) is 861⁄ 8 . The askingprice (A) is 865⁄ 8 . The size (S) is 1,000 shares on the bid side and800 on the offered. The total volume traded ( V ) that day up tothe second is 2,183,300 shares. On the second line, the openingprice (O) for the day is 85. The day’s high (H) is 861⁄4. The day’slow (Lo) is 841⁄ 2 . The all-time high (AH) is 871⁄4. The all-time low(AL) is 471⁄ 8 . The last trade’s volume was 100 shares. On thethird line, N stands for New York Stock Exchange. The previousnight’s close (C) was 831⁄4. The earnings per share (EPS) is$3.93. The price/earnings ratio (PER) is 21.95. The dividend(DIV ) it pays is $2.00. The yield right now is 2.32 percent. Itwent ex-dividend (EX) 11/9/98.You can trade off a quick quote using the opening price asa support or resistance point, and using the all-time high as aresistance point.
candlesticksWe will not discuss bar charts in this book because the subject is fairly straightforward, there are myriad books that
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cover the subject, and it would put us all to sleep. We will discuss candlesticks, an increasingly popular charting technique,and one that I endorse wholeheartedly.Candlesticks were developed by the Japanese about threehundred years ago to chart price activity in a way that facilitates the gauging of markets. They are every bit as useful today.Candlesticks remained a secret to the Western world until 10years ago when Steve Nison brought them to our attention. Heremains the pre-eminent round-eyed authority on candlesticks.I highly recommend his book, Japanese Candlestick ChartingTechniques (New York Institute of Finance, Simon & Schuster,1991, New York).We have just examined the Quick Quote. It tells us a lotabout a stock, sometimes too much. Deriving only the information we want from all the information listed can be confusing.When trading, especially day trading, the speed with which oneacts can spell the difference between profit and loss. Some mental input does require thought, but much of it can be processedby reflex in a fraction of the time. In day trading particularly, information that can be handled reflexively must be handled reflexively to save time. Candlesticks offer at a glance informationthat must be derived from a Quick Quote, plus additional information about supply and demand.In Figure 3.4 we have the two kinds of candlesticks, onewhite or hollow and one black or solid. The widest part of thecandlestick is referred to as the real body. We will refer to itas the body. Usually, but not always, a line extends from thetop of the body, the bottom, or both. The Japanese refer tothis line as an upper or lower shadow. We shall call it thewick. The corresponding parts of both candlesticks in Figure3.4 represent the exact same dollar values. Yet these two candlesticks represent different, in some ways opposite, marketconditions.62
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figure 3.4 candlestick characteristics
The white or hollow candlestick tells us that Stock Aopened at $80, a value that corresponds to the bottom of thecandlestick’s body. At some time during the day, it fell to alow of $79, as represented by the lowest point of the bottomwick. Also, at some time during the day, this stock reached ahigh of $85, as represented by the highest point of the topwick. The top of the body, located to signify $84, representsthe closing price of Stock A. Though both the day’s high andlow are important, the Japanese consider the opening andclosing prices as even more important. Because this stockclosed higher than it opened, it is represented by a bullishwhite or hollow candlestick.The bearish black or solid candlestick always representsa stock that closed lower than it opened. In Figure 3.4, asidefrom color, the only difference between the two candlesticks isthat Stock B opened at $84 and closed down, at $80.63
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Look how much one quick glance tells us about the stocksrepresented by these two candlesticks. Stock A closed up $4,while Stock B closed down $4. Their days’ highs were $85, andtheir lows were $79. Because of the wide price range represented by these candlesticks, we can infer that demand controlled the price of Stock A, and supply controlled the price ofStock B. However, the greatest value of candlesticks is theirability to represent the movement of one particular stock at intervals ranging from minutes to years. These representationsnot only give quick insight into the interactions of supply anddemand on the stock, they enable you to pick up the trend at aglance, often warning you about imminent reversals of trend. Atrick to help you remember that a white or hollow candlestick isbullish is to remember that hollow conveys lightness or floatingup. The bearish black or solid candlestick conveys solidness,heaviness, and sinking.It is time for a quick course on what the different shapesof some candlesticks tell us. The longer the body of a candlestick, the more bullish or bearish the stock it represents. Candlesticks with very small bodies, such as that representingStock C in Figure 3.5, portray very small price ranges for theperiod represented. They are referred to as spinning tops.Stock C, though bullish, is only barely so. Supply and demandare almost in balance.The candlesticks representing Stocks D and E are referredto as shaved topped. Stock D closed at its high, a bullish pointthat adds some more bull to an already bullish stock. Stock Enever once beat its opening price, a bearish point to consider.The candlesticks representing Stocks F and G are referredto as shaved bottomed. Stock F never sunk below its openingprice, a slightly bullish point. Stock G did manage to top itsopening price. Still, it closed down at its low for the period—abearish point.64
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figure 3.5 candlestick shapes
In Figure 3.6, the almost bodiless candlestick representing Stock H is called a Doji. We can see from the $4 range thatthere was quite a battle between demand and supply, whichended in a draw, meaning no change in share price for theday. A slight change in price still qualifies as a Doji, as does a
figure 3.6 Doji candlesticks
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candlestick which had a range that went higher or lower inone direction than in the other, as those representing StocksI and J.Let us take a look now at Figure 3.7 which describes themovement of one particular stock over a period of days. Onlythe last day is represented by an actual candlestick. This particular type of candlestick is called a Hanging Man. It can beblack or white, but it has to occur during an uptrend. It canhave a very small upper wick. The defining feature is that thelower wick must be at least twice as long as the body. If youcan picture the very small upper wick as a head, and the longlower wick as legs, then you can actually picture this candlestick as a hanging man. You will soon see that it is no coincidence that its name has an ominous sound.What does the candlestick in Figure 3.7a tell us? First ofall, it is black or solid, which means the stock closed down. Italso gapped open and barely beat its opening price. Shareprice took a free fall, but did make somewhat of a recovery. If Ihad a position long on this stock, I would be worried. If thebody were white instead of black, I would be only slightly lessfigure 3.7 the Hammer and Hanging Man candlesticks
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worried. The prolonged upturn in price seems to be losing momentum and a reversal of trend could be in the offing.Now take a look at Figure 3.7b. Here we have a prolongeddowntrend. The bullish candlestick at the bottom, thoughshaped like a Hanging Man, is called a Hammer. It tells us a serious price drop ended in a recovery, and the stock closed up.This looks like another reversal of trend, but in the oppositedirection. If the candlestick had been black, this would havemade it only slightly less bullish.Another signal of reversal is an Engulfing Pattern. First letus examine one at the end of an uptrend, as in Figure 3.8a. Thesecond to last candlestick is bullish and gives no sign of a reversal. The big, black, bearish Engulfing Pattern that followsand overshadows it signals a possible reversal of trend. Figure3.8b. is the negative image, this time telling you to go long. TheEngulfing Pattern must be the opposite color of the precedingcandlestick.Two of the strongest reversal patterns are the Doji Morning and Evening Stars. The Doji Morning Star appears during adowntrend as depicted in Figure 3.9a. It gaps open and closes
figure 3.8 Engulfing Patterns
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figure 3.9 Doji Morning and Evening Stars
at or very near the same price. Its opposite, Figure 3.9b, is theDoji Evening Star.Candlesticks can give extraordinary insight into marketbehavior, and they can do so at a glance. There are many otherilluminating types we have not discussed. Try to apply theones we have discussed. If you find them helpful, you will finda look at Mr. Nison’s book even more so.
the Dow TheoryAlthough the Dow Theory is somewhat overrated and outdated, a day trader should be acquainted with it. Dow Jones’three major averages are Industrials, Transports, and Utilities.The Industrials includes thirty stocks, the Transports fifteen,and the Utilities twelve. These averages originated back in the1920s, but they have been updated, Microsoft being the mostrecent addition. However, these updates still fail to includemany of the Internet stocks that are such driving forces intoday’s market. Additionally, these indexes are comprised of a68
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relatively very small number of stocks. Therefore, the S&P 500and the New York Stock Exchange Composite are far better indicators of the market as a whole. Still, the Dow Jones Averages do retain quite a bit of credence.The Utility Average reflects interest rates. The lower therates, the more money business can borrow for expansion andother needs. If business is going well, it is manufacturing andselling goods. Collaterally, earnings are healthy and so arestock prices. However, just because industry is operating atfull tilt, it does not necessarily follow that the goods producedare being shipped. They could merely be expanding inventory.So the health of the industrial sector must also be reflected inthe health of the transportation sector.Remember, the main importance of the Utility Average isas an indicator of the trend in interest rates. If the Dow JonesUtility Average is rising, this indicates that interest rates aregoing down. Low interest rates allow for the expansion of business, sending the Industrial Average higher. Low interest ratesalso encourage capital to flow into the stock market as opposedto the bond market, thus protecting and even increasing stockprices. More goods shipped by industry raises the TransportAverage. A rise in all three averages creates among traders confidence in the economy as a whole. However, when there is a divergence, and either or both Transports and Utilities are down,traders become wary no matter how high and fast the IndustrialAverage is rising.
On Balance VolumeThese days, when everyone has access to a computer, On Balance Volume (OBV ) has been somewhat supplanted by otherindicators. There are a number of theoreticians’ formulas forOBV, but the most popular is probably Joe Granville’s. This69
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indicator is a running total. When a stock’s price goes up, itsvolume is added to the total. When it goes down, the volume issubtracted. For example:Day
Price
Change
Volume
On Balance Volume
MondayTuesdayWednesdayThursday
$1001001⁄41001⁄ 21001⁄4
+1+1⁄4+1⁄4−1⁄4
100,000200,000500,000200,000
+100,000+300,000+800,000+600,000
You use these figures as an indication as to whether astock is under accumulation or distribution. Over time, OBVfigures will give you a line. If this line trends upward, it is indicating that this particular stock is under accumulation. If ittrends downward, the indication is that the stock is in a distribution phase. Make sure you check other indicators forconfirmation.OBV is most useful to the position trader. Though of littlehelp in timing the taking of a position, it weighs in nicely on theadvisability of taking that position in the first place. A stock’spast and current price movement may be encouraging, but OBVoffers valuable input as to whether this movement is likely tocontinue.
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continuation and reversalsignals for trendstrends: oh, when will they start?oh, when will they end?
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In our model, the accumulation and distribution phases looklike those in Figure 4.1a. In the real world, it may look more likeFigure 4.1b. How can you be sure Figure 4.1b is an accumulation or distribution phase? You can’t, but with experience youwill learn to judge with enough confidence to act with the conviction necessary to be a successful stock trader.
reversal signalsBy definition, the successful trader has to be able to spot atrend. Obviously, the sooner he can do so, the sooner he cantake a position and the more points he can get out of one. Moreimportant, if he has already taken a position, the sooner hecan spot a reversal of trend, the sooner he can abandon thisposition, and the more likely he can walk away solvent.Let us assume the market is down, and you are a daytrader looking through five-minute charts for a stock to short.Contrary Conglomerations, Inc. (Figure 4.2a), catches your eye.You start observing at Point 4, and no way does this look like agood bet to sell short. Still, the way Contrary Conglomerations,
figure 4.1 accumulation and distribution phases
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figure 4.2 five-minute versus daily charts
Inc., is bucking the market trend impresses you enough tokeep watching it.Well, if you like action, this stock proves worth watching.The drop in altitude from Point 5 to Point 8 makes you gladyour breakfast is