-term bar risk dis-tance between an open protective stop and entry, and yet participate in amove that is many, many times initial risk and which may develop into alonger than short-term move. This is how capital can be multipliedmany-fold without significant risk—by finding low-risk trades that returnmany times that risk, and by finding short-term risk opportunities thathave the potential to develop into longer-term moves than the originaltime frame one is looking at.
For our examples, and in our own use of this pattern, we first look atdaily bars and then go to half-hourly bars for the pattern. In other words,we screen a half-hourly pattern with a longer-term bar chart. Evenshorter-term traders could do the same thing on a shorter time frame.One could look at a half-hourly bar chart to screen 5- or 10-minute barpatterns for instance. The key point is that you are, entering with entrypoints set on a shorter time frame—and may be able to capture a movethat develops into a longer time-frame run-up in order to profit manymultiples of your initial risk."
The pattern we are going to show you is called the “flag within a flagpattern.”
As a brief side note, investors using these patterns should understandthat they can achieve better results, both in terms of reliability and profit-ability, by concentrating on commodities that meet our runaway criteriaand stocks that meet our runaway-up-with-fuel criteria as explained inour Science of Trading course and published monthly in our letter to cli-ents, Portfolio Strategy Letter. Adding these filters is certainly not neces-sary to very profitably trade these patterns, but it does also enhanceresults rather dramatically.
Investors lacking a list of runaway-up-with-fuel stocks, as well as allthose traders seeking as many investment opportunities as possible,should go through a daily process of reviewing all the stocks on the newhigh list. We're looking for stocks making new highs after having justbroken out of at least a 17-day flag trading range pattern. Again, the flagpattern is a sharp run-up in price followed by a consolidation for 17+days that does not retrace 38 percent of the initial sunup. We are lookingfor prices to break out on a gap from the prior close or on a large-rangeday. -
Let’s look at an example to clarify. Tuboscope, Inc. (symbol TUBO) beganto make the 52 week new high list in mid June when it broke out of a
 Trading Runaway Moves 185
FIGURE 24.1a Tuboscope, Inc.
 
 
on 0271197
10 DAY ROVING AUG40 DAY MOVING AUG.
tom
OL smn
 
 
FIGURE 24.1b Tuboscope, Inc.
 
 
   
12:00 16:00 10:00 44:09 10:00 44:00 19:00 44:00 10:00 14.0010100 14:00 10:00 14-00 10:00 14-00 1000 14-00
 
wOL2t we was Bite Is TO ae eH OH
 
 
 
 A
186
Chapter 24
six-month trading range. (It also met our runaway-with-fuel criteria), Itmoved up from a low of 11 1/2 on 2/11 to 20 3/8 on 7/3, an 8 7/8 pointmove. From 20 3/8 it developed a consolidation pattern that declined to18 5/8, a drop of 1 3/4 points, or 19.7 percent of the prior upmove (<38percent). The consolidation lasted 17 days or longer before a breakoutdeveloped on a gap on 7/23. Our criteria for a flag breakout on a dailychart were met. Note that we need to first find daily flag patterns makingnew 52-week highs before looking for what will ultimately be our twoshorter-term patterns. In this way we are adding a short-term element toan already explosively profitable situation.
Now an investor could certainly buy the breakout and use an open pro-tective stop just below 18 5/8 with pretty low risk for a decent trade,meeting the criteria established in our courses flag pattern. But we're go-ing to show you how you can get far more bang for your buck by addinga short-term pattern to this already lucrative setup.
We suggest investors monitoring ‘the new high | list daily put alarms abovethe high levels of all those stocks’ that have ‘made new. highs and haveconsolidated in a flag pattern for 17 days or more without retracing 38percent of the prior upmove, so as not to miss an opportunity. One coulduse CQG, Bloomberg, TradeStation, Investigator, or even several sourceson the internet (like Quote.com) to set these alarms.
The short-term flag within the longer-term breakout works as follows:once you get alerted of a breakout or a new high following a breakout,go to the half-hourly chart. Often, following an initial upthrust half hour,a stock will consolidate, making a short-term flag pattern of four bars ormore that does not retrace 38 percent or more of the last half-hourly up-swing. A breakout above the high bar of this half-hourly pattern is theentry signal, with a protective stop-loss (ops) below the low of this half-hourly flag pattern. :
TUBO for example, broke out on 7/23, consolidated via a half-hourlystochastic correction and rose to new highs again on 7/28. It made a flagpattern consolidating between 22 1/4 and 21 3/4 for eight half-hourlybars before breaking to new highs again in the second half hour of 7/29,where it could be purchased at 22 3/8 to 22 5/16 with a 21 5/8 protectivestop—a risk of only 3/4 points. By the end of the day the stock hadtraded as high as 24 1/4, closing at 23 5/8. Traders could exit half thetrade when original risk is first covered, making the trade a break-even atworst and let the rest ride. This is one way to build a big position withlow risk in a runaway stock.
 eg ASS
Trading Runaway Moves
A trader risking 1 percent of capital per trade (risk = distance betweenentry and protective stop) starting with $100,000 account could haverisked $1,000 or if we allow a generous slippage and commission esti-mate of 1/4 point, could have purchased 1000 shares. Taking a quick 1/2position profit at 23 3/8 to clear risk would have yielded $475 after com-missions and open profits at the close were $625 on the remaining 1/2position—a profit of 1.1 percent in a day with the strong possibility ofbeing able to hang on to 500 shares of a stock that has just broken out ofa trading range and is likely to move much higher with no more risk tooriginal capital (at least theoretically) because the profit taken on the first1/2 position more than covers the risk on the second 1/2. We have justlocked in a large potential profit with very little risk—and a portfoliofilled with several of these trades can return large amounts of profit withvery little risk of capital, which is what we're trying to accomplish astraders.
Remember that once a stock or future emerges from its flag base it wil!go on our list to watch for this pattern each time it moves into new 52week high territory until it gets overvalued (stock: PE its five-yeargrowth rate or its current quarterly earnings growth rate), overowned in-stitutionally (stock: 40 percent or higher institutional + bank ownershipof capitalization), overbought (weekly, daily, and monthly RSI above 85),until the trend turns (below 50-day moving average is a good rule ofthumb but I prefer the GTI trend method as explained in my Science ofTrading Course), or unti! the Relative Strength drops below 65 on a reac-tion or below 80 on a new high. In other words, once a stock breaks outof a flag if it continues to not violate any of the above criteria we stillwatch for internal half-hourly flags on each new 52-week high becausethe stock still shows strong potential for a big move. The prime time tobuy is just after a breakout, but one can continue to watch for this short-term pattern even if the stock has broken out recently and continues to beone of the strongest in the market as shown in the following example (seecharts of CTS.).
CTS first broke out of a trading range flag in early April and tradedsharply higher making the new high list almost daily into early June,where it formed another flag and broke out in early July. On July 23 itmade a strong close to new highs on a wide half-hourly bar. lt was stillundervalued via its quarterly and five-year growth rate compared to PE,still owned less than 40 percent by institutions, not yet wildly overboughton a weekly, daily and monthly basis all at once, was definitely in a
187
 188 Chapter 24
FIGURE 24.2a CTS
 
: COMPOSITE? TRADE|Last eat,
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FIGURE 24.2b CTS
 
 
   
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Trading Runaway Moves
strong uptrend with RS above 90. And making new highs yet again. Itclearly qualified for a potential short-term internal flag pattern.
The next morning it consolidated for five half-hourly bars below thehighs of the last bar of July 23 (75 1/2) with a low of 75 1/8. When itbroke above 75 1/2 if you bought the high of that half hour you got in at75 5/8 and could have used a 75 protective sell stop—a risk of only 5/8of a point. 1100 shares could be purchased with 1 percent risk. July 24closed at 79 13/16 a profit of 4.19 points or almost five times your initialrisk! If you took quick profits on 1/2 position at 76 5/8 you still endedup over $2,600 on the day (2.6 percent) and had no original capital at riskin a very explosive stock that has continued to move higher.
What about bear markets and what about futures? Surely if the pattern isrobust it should hold up in runaway down vehicles as well as runawayup markets. Our next example should help answer those questions. Ifyou run a relative strength analysis (O’Neil’s RS) on futures contractsaround the globe you can pinpoint the strongest and weakest futures justas you can in stocks. One of the weakest futures recently (RS < 5) hasbeen the nearby D-Mark futures. There was a very recent flag within aflag pattern in this runaway bear market.
On June 30 (see D Mark charts), the D-Mark gapped down to a new lowbreaking out of a daily chart flag pattern. It continued to decline thereaf-ter. On July 22 the D-Mark gapped down on the open to a new low—with a new low, clear very bearish runaway characteristics, and superlow RS, traders should be on the lookout for bearish flags within a flag inthis market. The D-mark consolidated and then made a big thrust to newlows on the seventh 1/2-hourly bar of the day. It then made a four-barflag pattern on the 1/2-hourly chart off of 5515 low and a rally to 5528.Traders with a $100,000 account would have sold five contracts on a 5514stop with a 5529 protective stop for a 15-tick risk, about $200 after com-missions per contract risk. The market closed at 5502 and in order tocover risk traders would have taken a quick $400 profit after commis-sions on three contracts, keeping two open with risk more than coveredby profits taken. With the D-Mark continuing to collapse, traders whotook a 1 percent risk on 7/22 would now have $3,200 (3.2 percent) inopen profit on those remaining two contracts with large potential profitson a break-even worst-case situation.
When a futures contract is especially bearish we can apply the exact samepattern in reverse for short signals. And when the stock market eventu-ally turns lower in a bear market, we can do the same in stocks, Until
189
 ATT190 Chapter 24
FIGURE 24.3a .D-Mark
 
$900, 1300 300
11-00 15+00 9:00 _ 194 :om 130”, OM TMD #001390 220
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 LL a Sy SeeTrading Runaway Moves 191
such time that new 52-week lows move above new 52-week highs, werecommend investors stick with bullish patterns in the U.S, stock market.
The bottom-line is that this simple pattern allows us to get in on a goodshort-term day-trade, and also leaves open the potential of a much morelucrative opportunity in the some of the most explosive stocks or futuresavailable in the markets. It allows us to position heavily in the strongeststocks, but in a way that takes very small risk to original capital and yetstill allows traders to profit at sometimes astronomical rates.
If you can’t take enough profits the first day (or second day if it is en-tered in the second half of the day) on half the position to cover the riskon the remaining half then get out and wait for another opportunity.Cautious traders may only want to take trades in the first half of the dayso that they don’t have to take overnight risk unless they have large openprofits and have booked profits on a day trade in the first half position.More cautious traders may also want to book the whole profit at theclose unless the close is at least as far above your entry as your originalprotective stop was below it.
Traders should note that we are finding this simple pattern in new-highstocks at least twice a week—which should continue as long as the broadmarket remains strong. This is many more opportunities than any tradercan exploit with limited capital. We hope you can watch and profit fromsuch a pattern in the future, and that it becomes a key arrow in yourquiver of short-term trades toward maximum profits. In addition, wehope short-term traders note that the huge upside potential of this tradecomes from taking a risk on a short-time frame and getting into a movethat can last much longer and move up many many times that smallinitial risk. Probably the biggest problem with short-term trading is thatit is rare to get a reward 10 or 20 times risk because you have to get outat the end of the day. However by positioning in vehicles set to move upsharply on a daily basis, by taking quick day-trade 1/2 profits, and byonly staying in overnight when a large profit exists at the close, short-term traders can not only book reliable trades consistently, but can oftenfind a ten-bagger without taking very large risks—and without having towait years to realize it by using this pattern. 
CHAPTER 2 5
GIPSONS
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This strategy was created and written by Derek Gipson, a friend of mine and anextraordinary researcher. Derek will share with you his findings regarding pre-dicting direction during times of low volatility. The academic world has claimedfor 40 years that volatility and price direction are not correlated. Derek's findingsof a directional-trend bias in low-volatility, high-ADX situations, appears to re-fute the academic assertion.
By way of personal background, Derek is a trader for a major investment firm. Ihave known him for more than seven years and have regularly relied on him toassist me with my research, What makes Derek's work special is that he beginswith the premise that markets have inherent features which repeat themselves. Hebuilds his models based on these features. You have heard me use the term “con-ceptually correct” in describing a strategy. By looking at the markets as he does,Derek's research leads to strategies that are both conceptually correct and profit-able,
A built-in feature of all markets is the concept that periods of low volatil-ity lead to periods of high volatility and vice versa. This has been showntrue by academics for more than 40 years. The general consensus amongacademics is that even though volatility can be predicted, the price move-ment accompanying a change in volatility cannot be. In the followingpresentation, I will show you why I disagree and I will show you the
 
193Le SC
194
Chapter 25
method that identifies specific situations where there is a directional biascoming out of low-volatility situations.
Before going forward, let’s review a few basic concepts that I will be us-ing. The 6/100 historical volatility (H.V.) reading under 40 percent meansthat the six-day H.V. is .4 or less of the 100-day number. When this oc-curs, markets are poised to explode. ADX is a mathematical measurementwhich calculates the strength of a trend. The higher the ADX, the strongerthe trend. +DI and -DI calculate the direction of the trend. +DI is greaterthan -DI means the market is rising and vice versa.
I have spent the last two years doing research uncovering specific situ-ations when direction and volatility coincide. I have done this research tofurther my trading in the options market but the methodology I amabout to reveal can and should be used in both the futures and equities.
Here are the rules:
1. Identify the markets or stocks which are trending most strongly. I
use a 14 period ADX reading and I look for readings above 25. The
, higher the reading, the better. 1 also identify the trend with +DI and
-DI. This is critical because we only trade in the direction ‘of thetrend.
2. Ifa market or equity qualifies with a high ADX reading, I then waitfor its 6/100 day historical volatility reading to drop under .40. Thismeans the six-day reading is less than 40 percent of the 100-dayreading, I prefer a lower reading because it tells me the market istruly poised to explode.
3. When rules 1 and 2 are met, I then wait for the market to resume itsmove in the direction of the trend. I will not take signals oppositethe trend. A long entry is triggered for uptrending markets whenthe high of the signal day is exceeded; a short entry is triggered fordowntrending markets when the low of the signal day is taken out.
4. My initial protective stops are extremely tight. For uptrending mar-kets, my initial protective stop is usually near the low of the signalday and for downtrending markets, my initial protective stop isnear the high of the signal day.
 SSSAGipsons 195
5. Exits: There are three ways to exit profitable positions.a. Follow the price with a trailing stop until you are stopped out.
b. Look to make a specific percentage return on your investment.That is, if you buy an option at 5, you might have a target exit at7 1/2 to 10; for stocks you should look to exit at profit levels ofat least 5 to 10 percent, etc.
c. My recommendation: Exit half your position and tighten yourstops on the other half when the 6-day H.V. reading reaches the100-day reading. This shows that volatility has returned to nor-mal.
Let’s look at four examples to help better understand how to trade thismethodology.ee196 Chapter 25
FIGURE 25.1a IBM
 
HISTORICAL VOLATILITY
6 day 36.1% Last6 day 36.1% Last
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FIGURE 25.1b IBM
 
 
 
 
 
 
  
Gipsons 197
FIGURE 25.1¢ IBM
 
 
 
COMPOSITE TRADE
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November 13, 1996—IBM has a six-day H.V. reading of 11.6 percentwhich is less than 40 percent of its 100-day reading of 30.9 37.5 percent).At the same time (Figure 25.1b) its ADX reading is well above 25 and its+DI > -DI signifying an uptrend. On November 14 (Figure 25.1c) it tradesabove its signal-day high triggering a buy signal and proceeds to explodenearly 19 points in four days.RL198 Chapter 25,
FIGURE 25.2a Pediatrix Medical Group
 
HISTORICAL VOLATILITY6 day 37.4% Lost6 day 37.4% Last6 doy 37.4% Lost (*——— 100 day 61.5% Lost
8
KAHPHAPCO< ANT
 
FIGURE 25.2b Pediatrix Medical Group
 
 
  
Gipsons
FIGURE 25.2¢ Pediatrix Medical Group
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This is a terrific example because it shows a stock collapsing while therewas a major uptrend in the overall stock market. November 8-13 (Figure25.2a) shows a period of extreme low volatility combined with a down-trending market as defined by ADX (Figure 25.2b). November 11 (Figure25.2c) shows a false move to the downside and when we again enter onNovember 14, we are amply rewarded with an almost 20 percent move tothe downside.aS
200 Chapter 25
FIGURE 25.3a November Crude
 
   
 
HISTORIC. VOLATILITY
6 doy 24.2% Lost6 doy 24.2% Last6 doy 24.2% Last
100 doy 21.5% Last
                
x&
8
KAHCHADTO<K ANT
FIGURE 253b November Crude
 
 
 
 
 Ah SASSGipsons 201
FIGURE 25.3¢ November Crude
 
 
 
Figure 25,3a shows the 6-day reading at less than 40 percent the 100-dayreading. At the same time, Figure 25.3b shows crude is clearly in an up-trend. We buy on the opening of August 12 as the trend resumes.a TE,202 Chapter 25
FIGURE 25.4a December 96 S&P 500 Futures
KAHCHADTO<K AND
 
FIGURE 25.4b December 96 S&P 500 Futures
 
 
  
Gipsons 203
FIGURE 25.3¢ December 96 Sé&P 500 Futures
 
 
 
 
 
 
On (Figure 25.4a), November 13, 1996, the six-day H.V, reading is lessthan 40 percent of the 100-day H.V. The ADX reading (Figure 25.4b) is apowerful 44 and the trend is up. A buy signal (Figure 25.4c) is triggeredthe next day on November 14 and the futures explode nearly 25 points ineight trading sessions.
SUMMARY
Gipsons are obviously not 100 percent correct, but they do give you anedge in predicting direction during periods of low volatility. What occursis, a strongly trending market (ADX) rests (low volatility), and when itsrest is over, the trend resumes and many times does it in explosive fash-ion. I mentioned earlier that I created this methodology mostly to use inmy options trading, but it assuredly lends itself to traders looking forshort-term moves in the futures and equities markets. 
CHAPTER 26
MAXIMIZING PROFITSIN SHORT-TERMMARKET DECLINES
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Imagine this scenario: It is late Friday aftermoon and the stock markethas been acting poorly over the past few days. Bigger picture, the markethas risen for six straight years without a major correction. With 14 min-utes to go in trading, a major negative news event with long-term conse-quences hits the wires. The market immediately begins to sell off. Youradrenaline is racing because you know that this sell-off will surely followthrough on Monday. :
Do you have an exact game plan to fully maximize the profit potential ofthe situation?
Common sense tells you to either buy OEX puts or to sell the S&P futuresto capture the profits. This chapter will show you these strategies arepotentially wrong (certainly not the best) and will show you whichstrategies are the best to exploit the situation.
205a)
206
Chapter 26
USING OPTIONS
Do not buy OEX and SPX puts! Do buy puts on the brokerage houseindex (XBD), the NASDAQ 100 index (NDX), and the insurance index(UX).
There are a number of reasons for this, but let’s look at the most impor-tant: implied volatility. During periods of market weakness and periodsof uncertainty, the implied volatility of the OEX options (especially theputs) greatly increases. This means that you are almost certainly buying over-valued options. These options will become even more overvalued in thescenario I presented because of the thousands of traders who havereached the same conclusions as you. I have witnessed times where theputs options were so overpriced that they actually lost value after themarket opened lower the next day. (Traders think, “No market crash—sell the puts.”)
Which options should | -you“use to participate in a market sell-off? Thefollowing three are-in my"opinion, the best.” :
Strategy #1—Buy Puts on the Brokerage House Index (XBD), theNASDAQ 100 Index (NDX), and the Insurance Index (IUX)
Why these three indices? Three reasons.
1. These three indices will not only participate in any market decline,they will probably exceed the broader market decline.
Let’s look at the three indices individually:
+ On Monday, October 17, 1987, the stock market as a whole lost 22.6percent. Not only did the brokerage house stocks also decline, theylost an average of a nearly 29 percent for the day. Why? Who are thebiggest losers i in a bear market? (Enough said).
« The NASDAQ 100 (NDX) is made up of the 100 largest OTC stocks.This index is more volatile than the S&P 500. Because of this volatil-ity, the index usually drops on a percentage basis more than theother averages.
« The insurance index is the most conservative of the three indices.This index should especially be used when a stock market sell-off isaccompanied by a drop in the bond market. Why? Because insurancecompanies’ profits are tied to the profitability of their stock and bond
 Maximizing Profits in Short-Term Market Declines 207
portfolios. Insurance companies get hurt badly when both stock andbond markets drop. An example of this occurred on March 8, 1996,when bonds collapsed. The stock market dropped just under 3percent, yet the insurance index lost more than 4 percent of its value.
2. The options on these three indices are usually priced in-line withthe historical volatility readings. Let’s look at the pricing of these asof March 29, 1996.
As you can see from Figures 26.la, 26.1b, 26.2a, 26.2b, 26.3a, and26.3b, the historical volatility for the XBD index is 23.1 percent andthe implied volatility is approximately 27 percent, the historicalvolatility for the NDX is 27.6 percent and the implied volatility isapproximately 24.5 percent. The historical volatility for the TUX in-dex is 15.4 percent and the implied volatility is approximately 17.9percent. During market sell-offs, the puts on the OEX are at timesas much as 50 percent overpriced, whereas these three indices basi-cally trade in-line. You are therefore not “paying up” as you are onthe OEX.
3. The final reason for trading these indices instead of the OEX, is thatthe option prices of the indices are not as quickly marked up bytraders. Whereas traders stampede into the OEX options and imme-diately inflate the prices, trading in the three indices is more or-derly. Also, because the pricing mechanisms of these indices tend tobe done off the cash market, one has more time to get in before asell-off snowballs.AS208 Chapter 26
FIGURE 26.1a Brokerage House Index—Historical Volatility
 
 
 
FIGURE 26.1b Brokerage House Index—Implied Volatility
 
XBD Index OuT 0G28 Index OH TScreen printed.
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