Chapter 1 Philosophy of Technical Analysis
Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.
Philosophy or rationale
1. Market action discounts everything.
2. Prices move in trends.
3. History repeats itself.
As a rule, chartists do not concern themselves with the reasons why prices rise or fall. Very often, in the early stages of price trend or at critical turning points, no one seems to know exactly why a market is performing a certain way.
A trend in motion is more likely to continue than to reverse.
The fundamentalist studies the cause of market movement, while the technician studies the effect.
Market price tends to lead the known fundamentals. Stated another way, market price acts as a leading indicator of the fundamentals or the conventional wisdom of the moment. (* This is not correct! There is cause, then there is effect. Someone must know the change with fundamentals and act accordingly, thus move the prices. Otherwise, market is moved blindly.)
Chart reading becomes a shortcut form of fundamental analysis. (* This is not correct! One side statement.)
Because of the high leverage factor in the futures markets, timing is especially crucial in that arena. It is quite possible to be correct on the general trend of the market and still lose money.
One of the great strengths of technical analysis is its adaptability to virtually any trading medium and time dimension.
Technical analysis in stocks relies much more heavily on the use of sentiment indicators and flow of fund analysis.
Technical analysis in the futures markets is a much purer form of price analysis.
Chapter 2 Dow Theory
Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882.
Dow theory still forms the cornerstone of the study of technical analysis.
Basic tenets of Dow theory
1. The average discount everything.
2. The market has three trends.
3. Major trends have three phases.
4. The averages must confirm each other.
5. Volume must confirm the trend.
6. A trend is assumed to be in effect until it gives definite signals that it has reversed.
Dow relied exclusively on closing prices.
Chapter 3 Chart Construction
The bar chart shows the open, high, low, and closing prices. The tic to the right of the vertical bar is the closing price. The opening price is the tic to the left of the bar.
In the line chart, only the closing price is plotted for each successive day.
Point and figure chart - x column shows rising prices; o column shows falling prices.
Candlestick chart
Weekly and monthly charts compress the price action to allow for much longer range trend analysis.
Chapter 4 Basic Concepts of Trend
The important point to remember here is that the breaking of the third line is the valid trend reversal signal.
It's interesting to note that how often the number three shows up in the study of technical analysis and the important role it plays in so many technical approaches.
In general, most important up trendlines tend to approximate an average slope of 45 degrees.
If a trendline is too steep, it usually indicates that prices are advancing too rapidly and that the current steep ascent will not be sustained.
If a trendline is too flat, it may indicate that the uptrend is too weak and not to be trusted.
As in the case of the basic trendline, the longer the channel remians intact and the more often it is successfully tested, the more important and reliable it becomes.
The failure to reach the upper end of the channel is often an early warning that the lower line will be broken.
As a general rule of thumb, the failure of any move within an established price channel to reach one side of the channel usually indicates that the trend is shifing, and increases the likelihood that the other side of the channel will be broken.
Once a breakout occurs from an existing price channel, prices usually travel a distance equal to the width of the channel.
It should always be kept in mind that of the two lines, the basic trendline is by far the more important and the more reliable.
Usually, a minimum retracement is about 33% and a maximum about 66%. What this means is that, in a correction of a strong trend, the market usually retraces at least a third of the previous move.
The maximum retracement parameter is 66%, which becomes an especially critical area. If the prior trend is to be maintained, the correction must stop at the two-thirds point.
Gann and Fibonacci lines are used in the same way as speedlines. They are supposed to provide support during downward corrections. When one line is broken, pricess will usually fall to the next lower line.
The breakaway gap usually occurs at the completion of an important price pattern, and usually signals the beginning of a significant market move. Ater a market has completed a major basing pattern, the breaking of resistance often occurs on a breakway gap.
Breakaway gaps usually occur on heavy volume.
After the move has been underway for awhile, somewhere around the middle of the move, prices will leap forward to form a second type of gap (or a series of gaps) called the runaway gap (measuring gap). This type of gap reveals a situation where the market is moving offerotlessly on moderate volume.
The Exhaustion Gap. The final type of gap appears near the end of a market move. Near the end of an uptrend, prices leap forward in a last gasp.
The Island Reversal. Sometimes after the upward exhaustion gap has formed, prices will trade in a narrow range for a couple of days or a couple of weeks before gapping to the downside.
Chapter 5 Major Reversal Patterns
Price patterns are pictures or formations, which appear on price charts of stocks or commodities, that can be classifies into different categories, and that have predictive value.
TWO TYPES OF PATTERNS: REVERSAL AND CONTINUATION
1. A prerequisite for any reversal pattern is the existence of a prior trend.
2. The first signal of an impending trend reversal is often the breaking of an important trendline.
3. The larger the pattern, the greater the subsequent move.
4. Topping patterns are usually shorter in duration and more volatile than bottoms.
5. Bottoms usually have smaller price ranges and take longer to build.
6. Volume is usually more important on the upside.
Topping patterns are usually shorter in duration and are more volatile than bottoms.
The completion of each pattern should be accompanied by a noticeable increase in volume.
THE HEAD AND SHOULDERS REVERSAL PATTERN
Most of the other reversal patterns are just variations of the head and shoulders.
The left and right shoulders (A and E) are at about the same height. The head (C) is higher than either shoulder. Notice the higher volume on each peak. The pattern is completed on a close under the neckline (line 2). The minimum objective is the vertical distance from the head to the neckline projected downward from the breaking of the neckline. A return move will often occur back to the neckline, which should not recross the neckline once it has been broken.
THE IMPORTANCE OF VOLUME
As a general rule, the second peak (the head) should take place on lighter volume than the left shoulder.
The most important volume signal takes place during the third peak (the right shoulder). Volume should be noticeably lighter than on the previous two peaks. Volume should then expand on the breaking of the neckline, decline during the return move, and then expand again once the return move is over.
FINDING A PRICE OBJECTIVE
In general, most valid double tops or bottoms should have at least a month between the two peaks or troughs. Some will even be two or three months apart.
The saucer bottom shows a very slow and very gradual turn from down to sideways to up.
Saucer bottoms are usually spotted on weekly or monthly charts that span several years. The longer they last, the more significant they become.
Spikes are the hardest market turns to deal with because the spike (or V pattern) happens very quickly with little or no transition period.
Chaper 6 Continuation Patterns
Continuatoin patterns are usually shorter term in the duration and are more acurately classified as near term or intermediate patterns.
There are three types of triangles - symmetrical, ascending, and descending.
The symmetrical triangle is also called a coil.
The ascending triangle has a rising lower line with a flat or horizontal upper line.
The descending triange has the upper line declining with a flat or horizontal bottom line.
As a general rule, prices should break out in the direction of the prior trend somewhere betwen two-thirds to three-quarters of the horizontal width of the triangle.
The accending triangle is bullish and the descending triangle is bearish. The symmetrical triangle, by contrast, is inherently a neutral pattern.
The triangle is considered an intermediate pattern, meaning that it usually takes longer than a month to form, but generally less than three months.
The expanding pattern, therefore, is usually a bearish formation. It generally appears near the end of a major bull market.
The flag and pennant represent brief pauses in a dynamic market move. In fact, one of the requirements for both the flag and pennant is that they be preceded by a sharp and almost straight line move.
Flags and pennants are among the most reliable of contiuation patterns and only rarely produce a trend reversal.
A bullish pennant resembles a small symmetrical triangle, but usually lasts no longer than three weeks. Volume should be light during its formation.
The wedge formation is similar to a symmetrical triangle both in terms of its shape and the amount of time it talkes to form.
The wedge pattern has a noticeable slant either to the upside or the downside. As a rule, like the flag pattern, the wedge slants against the prevailing tend. Therefore, a falling wedge is considered bullish and a rising wedge is bearish.
The rectangle is sometimes referred to as a trading range or a congestion area.
Chapter 7 Volume and Open Interest
Technicians believe that volume precedes price, meaning that the loss of upside pressure in an uptrend or downside pressure in a downtrend actually shows up in the volume figures before it is manifested in a reversal of the price trend.
On Balance Volume. A running cumulative total is then maintained by adding or subtracting each day's volume based on the direction of the market close.
It is the direction of the OBV line (its trend) that is important and not the actual numbers themselves.
It's when the volume line fails to move in the same directoin as prices that a divergence exists and warns of a possible trend reversal.
1. Rising open interest in an uptrend is bullish.
2. Declining open interst in an uptrend is bearish.
3. Rising open interest in a downtrend is bearish.
4. Declining open interest in a downtrend is bullish.
1. Toward the end of major market moves, where open interest has been increasing throughout the price trend, a leveling off or decline in open interest is often an early warning of a change in trend.
2. A high open interest figure at market tops can be considered bearish if the price drop is very sudden.
3. If open interest builds up noticeably during a sideways consolidation or a horizontal trading range, the ensuing price move intensifies once the breakout occurs.
4. Increasing open interest at the completion of a price pattern is viewed as added confirmation of a reliable trend signal.
In the case of a blowoff at market tops, prices suddenly begin to rally sharply after a long advance, accompanied by a large jump in trading activity and then peak abruptly. In a selling climax bottom, prices suddenly drop sharply on heavy trading activity and rebound as quickly.
The put/call ratio is usually viewed as a contrary indicator. A very high ratio signals an oversold market. A very low ratio is a negative warning of an overbought market.
Chapter 8 Long Term Charts
Anyone who is not consulting these longer range charts is missing an enormous amount of valuable price information.
The proper order to follow in chart analysis is to begin with the long range and gradually work to the near term.
Chapter 9 Moving Averages
The moving average is a follower, not a leader. It never anticipates; it only reacts.
The longer averages work better as long as the trend remains in force, but a shorter average is better when the trend is in the process of reversing.
The most widely used triple crossover system is the popular 4-9-18-day moving average combination.
A buying alert takes place in a downtrend when the 4 day crosses above both the 9 and the 18. A confirmed buy signal occurs when the 9 day then crosses above the 18.
Bollinger Bands are placed two standard deviations above and below the moving average, which is usually 20 days.
The simplest way to use Bollinger Bands is to use the upper and lower bands as price targets.
Bollinger Bands expand and contract based on the last 20 days' volatility.
The 4 week rule is used primarily for futures trading.
1. Cover short positions and buy long whenever the price exceeds the highs of the four preceding full calendar weeks.
2. Liquidate long positions and sell short whenever the price falls below the lows of the four preceding full calendar weeks.
Chapter 10 Oscillators and Contrary Opinion
The oscillator is extremely useful in nontrending markets where prices fluctuate in a horizontal price band, or trading range, creating a market situation where most trend-following systems simply don't work that well.
The oscillator is only a secondary indicator in the sense that it must be subordinated to basic trend analysis.
1. The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its boundaries. The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. This warns that the price trend is overextended and vulnerable.
2. A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.
3. The crossing of the zero (or midpoint) line can give important trading signals in the direction of the price trend.
Market momentum is measured by continually taking price differences for a fixed time interval.
If the prices are rising and the momentum line is above the zero line and rising, this means the uptrend is accelerating.
Buy position should only be taken on crossings above the zero line if the market trend is up.
To measure the rate of change, a ratio is constructed of the most recent closing price to a price a certain number of days in the past.
Plotting the difference between the two averages as a histogram.
These histogram bars appear as a plus or minus value around a centered zero line. This type of oscillator has three uses:
1. To help spot divergences.
2. To help identity short term variations from the long term trend, when the shorter average moves too far above or below the longer average.
3. To pinpoint the crossings of the two moving averages, which occur when the oscillator crosses the zero line.
Commodity Channel Index (CCI) - compares the current price with a moving average over a selected time span; then normalizes the oscillator values by using divisor based on mean deviation.
CCI readings over +100 are considered overbought and under -100 are oversold.
Relative strength (RS) is determined by dividing the up average by the down average.
RSI=100*(up average)/(up average+down average)
RSI movements above 70 are considered overbought, an oversold condition would be a move under 30.
The 80 level becomes the overbought level in bull markets and the 20 level the oversold level in bear market.
A top failure swing occurs when a peak in the RSI (over 70) fails to exceed a previous peak in an uptrend, followed by a downside break of a previous trough.
A bottom failure swing occurs when the RSI is in a downtrend (under 30), fails to set a new low, and then proceeds to exceed a previous peak.
Divergence between the RSI and the price line, when the RSI is above 70 or below 30, is a serious warning that should be heeded.
Any strong trend, either up or down, usually produces an extreme oscillator reading before too long. In such cases, claims that a market is overbought or oversold are usually premature and can lead to an early exit from a profitable trend.
Stochastic oscillator is based on the observation that as prices increase, closing prices tend to be closer to the upper end of the price range. In downtrends, the closing price trends to be near the lower end of the range.
%K = 100 [(C - L14) / (H14-L14)]
C - latest close; L14 - lowest low for the last 14 periods; H14 - highest high for the same 14 periods
A very high reading (over 80) would put the closing price near the top of the range, a low reading (under 20) near the bottom of the range.
The second line (%D) is a 3 period moving average of the %K line - fast stochastics.
Taking 3 period average of %D - slow stochastics.
The major signal to watch for is a divergence between the D line and the price of the underlying market when the D line is in an overbought or oversold area.
A bearish divergence occurs when the D line is over 80 and forms two declining peaks while prices continue to move higher.
A bullish divergence is present when the D line is under 20 and forms two rising bottoms while prices continue to move lower.
Assuming all of these factors are in place, the actual buy or sell signal is triggered when the faster K line crosses the slower D line.
%R = 100 [(H14 - C) / (H14-L14)]
The place to start your market analysis is always by determining the general trend of the market.
The danger in placing too much importance on oscillators by themselves is the temptation to use divergence as an excuse to initiate trades contrary to the general trend.
Give less attention to the oscillator in the early stages of an important move, but pay close attention to its signals as the move reaches maturity.
Moving Average Convergence/Diergence (MACD)
The faster line (called the MACD line) is the difference between two exponentially smoothed moving averages of closing prices (usually the last 12 or 26 days or weeks). The slower line (called the signal line) is usually a 9 period exponentially smoothed average of the MACD line.
A crossing by the faster MACD line above the slower signal line is a buy signal. A crossing by the faster MACD line below the slower signal line is a sell signal.
An overbought condition is present when the lines are too far above the zero line. An oversold condition is present when the lines are too far below the zero line.
A negative, or bearish, divergence exists when the MACD lines are well above the zero line (overbought) and start to weaken while prices continue to trend higher (market top).
A positive, or bullish, divergence exists when the MACD lines are well below the zero line (oversold) and start to move up ahead of the price line (market bottom).
The MACD histogram consists of vertical bars that show the difference between the two MACD lines.
When the histogram is over its zero line (positive) but starts to fall toward the zero line, the uptrend is weakening. When the histogram is below its zero line (negative) and starts to move upward toward to zero line, the downtrend is losing its momentum.
To use weekly signals to determine market direction and the daily signals to fine-tune entry and exit points.
Contrary Opinion adds the important third dimension to market analysis-the psychological-by determining the degree of bullishness or bearishness among participants in the various financial markets.
The principle of Contrary Opinion holds that when the vast majority of people agree on anything, they are generally wrong. A true contrarian will first try to determine what the majority are doing and then will act in the opposite direction.
Consensus Index of Bullish Market Opinion - 75% as overbought and 25% as oversold.
If the overwhelming sentiment of market traders is on one side of the market, there simply isn't enough buying or selling pressure left to continue the present trend.
The 80%, who are holding much smaller positions per trader, are considered to be weaker hands who will be forced to liquidate those longs on any sudden turn in prices.
A contrarian position can usually be considered when the bullish consensus numbers are above 90% or under 20%.
The higher the open interest figures are, the better the chance that the contrarian positions will prove profitable. Wait for the open interest number to begin to flatten out or to decline before taking actin.
Contrary Opinion works better when most of the open interest is held by speculators, who are considered to be weaker hands. It is not advisable to trade against large hedging interests.
The failure of prices to react to bullish news in an overbought area is a clear warning that a turn may be near. The first adverse news is usually enough to quickly push prices in the other direction.
Chapter 11 Point and Figure Charting
The point and figure chart is a study of pure price movement.
The larger the number of boxes required for a reversal, the less sensitive the chart becomes. By using larger box size, fewer signals are given.
The 1 box reversal is generally used for very short term activity and the 3 box for the study of the intermediate trend. The 5 box reversal, because of its severe condensation, is used for the study of long term trends.
The principle of the horizontal count is based on the premise that there is a direct relationship between the width of a congestion area and the subsequent move once a breakout occurs.
The horizontal line to account across is near the middle of the congestion area. A more precise rule is to use the line that has the least number of empty boxes in it(the line with the most number of filled in x's and o's).
3 point reversal chart
If the last column is an x column, then look at the high price for the day.
When daily high price is not high enough to fill the next x box, look at the low price to determine if a 3 box reversal has occurred in the other direction.
In an uptrend, the bullish support line is drawn at at 45 degree angle upward to the right from under the lowest column of o's.
In a downtrend, the bearish resistance line is drawn at a 45 degree angle downward to the right from the top of the highest column of x's.
1. A simple buy signal can be used for the covering of old shorts and/or the initiation of new longs.
2. A simple sell signal can be user for the liquidation of old longs and/or the initiation of new shorts.
3. The simple signal can be used only for liquidation purposes with a complex formation needed for a new commitment.
4. The trendline can be used as a filter. Long positions are taken above the trendline and short positions below the trendline.
5. For stop protection, always risk below the last column of o's in an uptrend and over the last column of x's in a downtrend.
6. The actual entry point can be varied as follows:
a. Buy the actual breakout in an uptrend.
b. Buy a 3 box reversal after the breakout occurs to obtain a lower entry point.
c. Buy a 3 box reversal in the direction of the original breakout after a correction occurs. Not only does this require the added confirmation of a positive reversal in the right direction, but a closer stop point can now be used under the latest column of o's.
d. Buy a second breakout in the same direction as the original breakout signal.
After an uninterrupted move of 10 or more boxes, place a protective stop at the point where a 3 box reversal would occur. If the position does get stopped out, reentry can be done on another 3 box reversal in the direction of the original trend.
Advantages
1. By varying the box and reversal sizes, these charts can be adapted to almost any need. There are also many different ways these charts can be used for entry and exit points.
2. Trading signals are more precise on point and figure charts than bar charts.
3. By following these specific point and figure signals, better trading discipline can be achieved.
Chapter 12 Japanese Candlesticks
Days in which the difference between the open and close prices is great (small) are called Long Days (Short Days).
Spinning Tops (indecision) are days in which the candlesticks have small bodies with upper and lower shadows that are of greater length than that of the body.
When the open price and the close price are equal, they are called Doji lines.
The Long-legged Doji has long upper and lower shadows and reflects considerable indecision on the part of market participants.
The Gravestone Doji has only a long upper shadow and no lower shadow. The longer the upper shadow, the more bearish the interpretation.
The Dragonfly Doji is the opposite of the Gravestone Doji, the lower shadow is long and there is no upper shadow. It is usually considered quite bullish.
Once the short term (ten periods or so) trend has been determined, Japanese candle patterns will significantly assist in identifying the reversal of that trend.
Dark Cloud Cover
This is a two day reversal pattern that only has bearish implications.
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| Dark Cloud Cover |
The opposite of the Dark Cloud Cover, it has bullish implications.
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| Piercing Line |
Evening Star and Morning Star
The Evening Star is a bearish reversal candle pattern. The first day of this pattern is a long white candlestick which fully enforces the current uptrend. On the opening of the second day, prices gap up above the body of the first day. Trading on this second day is somewhat restricted and the close price is near the open price while remaining above the body of the first day. The body for the second day is small. This type of day following a long day is referred to as a Star pattern. A Star is a small body day that gaps away from a long body day. The third and last day of this pattern opens with a gap below the body of the star and closes lower with the close price below the midpoint of the first day.
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| Evening Star |
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| Morning Star |
Bullish continuation - long white day; 3 small body days (at least 2 have black bodies) trend downward; on the fifth day, long white day closes at a new high.
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| Rising 3 Method |
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| Falling 3 Method |
Filtered Candle Patterns
While the short term trend of the market must be identified before a candle pattern can exist, determination of overbought and oversold markets using traditional technical analysis will enhance a candle pattern's predictive ability.
Candle patterns are considered only when %D is in its presignal area (<20%, >80%).
Chapter 13 Elliott Wave Theory
There are three important aspects of wave theory - pattern, ratio, and time.
Pattern refers to the wave patterns or formations that comprise the most important element of the theory.
Ratio analysis is useful in determining retracement points and price objectives by measuring the relationships between the different waves.
Time relationship also exist and can be used to confirm the wave patterns and ratios (considered less reliable in market forecasting).
Elliott Wave Theory says that the stock market follows a repetitive rhythm of a five wave advance followed by a three wave decline.
Wave 1, 3, 5 - called impulse waves - are rising waves, while waves 2 and 4 move against the uptrend. Waves 2 and 4 are called corrective waves because they correct waves 1 and 3.
The three corrective waves are identified by the letters a, b, c.
Being able to determine between threes and fives is of tremendous importance in the application of this approach. That information tells the analyst what to expect next.
One of the most important rules to remember is that a correction can never take place in five waves.
A zig-zag is a three wave corrective pattern, against the major trend, which breaks down into a 5-3-5 sequence.
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| Bull market zig-zag |
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| Double zig-zag |
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| Regular Flat |
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| Expanded Flat |
Triangles usually occur in the fourth wave and precede the final move in the direction of the major trend. (also b wave)
Elliott's triangle is a sideways consolidation pattern that breaks down into five waves, each wave in turn having three waves of its own.
Corrective patterns tend to alternate. In other words, if corrective wave 2 was a simple a-b-c pattern, wave 4 will probably be a complex pattern, such as triangle. If wave 2 is complex, wave 4 will probably be simple.
Once five up waves have been completed and a bear trend has begun, that bear market will usually not move below the previous fourth wave of one lesser degree; that is, the last fourth wave that was formed during the previous bull advance.
Fibonacci numbers - 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144...
1. The sum of any two consecutive numbers equals the next higher number.
2. The ratio of any number to its next higher number approaches .618(after first four numbers).
3. The ratio of any number to its next lower number is approximately 1.618.
4. The ratio of alternate numbers approach 2.618 or its inverse, .382.
Fibonacci rations and retracements
1. One of the three impulse waves sometimes extends. The other two are equal in time and magnitude. If wave 5 extends, wave 1 and 3 should be about equal. If wave 3 extends, waves 1 and 5 tend toward equality.
2. A minimum target for the top of wave 3 can be obtained by multiplying the length of wave 1 by 1.618 and adding that total to the bottom of 2.
3. The top of wave 5 can be approximated by multiplying wave 1 by 3.236 (2x1.618) and adding that value to the top or bottom of wave 1 for maximum and minimum targets.
4. Where waves 1 and 3 are about equal, and wave 5 is expected to extend, a price objective can be obtained by measuring the distance from the bottom of wave 1 to the top of wave 3, multiplying by 1.618, and adding the result to the bottom of 4.
5. For corrective waves, in a normal 5-3-5 zig-zag correction, wave c is often about equal to the length of wave a.
6. Another way to measure the possible length of wave c is to multiply .618 by the length of wave a and subtract that result from the bottom of wave a.
7. In the case of a flag 3-3-5 correction, where the b wave reaches or exceeds the top of wave a, wave c will be about 1.618 the length of a.
8. In a symmetrical triangle, each successive wave is related to its previous wave by about .618.
Chapter 14 Time Cycle
Two conclusions by Dewey -
First, that many of the cycles of seemingly unrelated phenomena clustered around similar periods.
The second discovery was that these similar cycles acted in synchrony, that is, they turned at the same time.
The principle of Summation holds that all price movement is the simple addition of all active cycles.
The principle of Harmonicity means that neighboring waves are usually related by a small, whole number.
The principle of Synchronicity refers to the strong tendency for waves of differing lengths to bottom at about the same time.
The principle of Variation is a recognition of the fact that all of the other cyclic principles already mentioned are just strong tendencies and hot hard and fast rules.
The principle of Nominality is based on the premise that, despite the differences that exist in the various markets and allowing for some variation in the implementing of cyclic principles, there seems to be a nominal set harmonically related cycles that affect all markets.
The cycle crests act differently depending on the trend of the next longer cycle. If the trend is up, the cycle crest shifts to the right of the ideal midpoint, causing right translation. If the longer trend is down, the cycle crest shifts to the left of the midpoint, causing left translation. Therefore, right translation is bullish and left translation is bearish.
The seasonal cycle refers to the tendency for markets to move in a given direction at certain times of the year.
The strongest three month span for the stock market is November through January. February is weaker, but is followed by a strong March and April.
Chapter 15 Computers and Trading Systems
As useful as it is, the computer is only a tool. It can make a good technical analyst even better. It won't turn a poor technician into a good one.
Chapter 16 Money Management and Trading Tactics
Any successful trading program must take into account three important factors: price forecasting, timing, and money management.
1. Price forecasting indicate which way a market is expected to trend. The forecasting process determines whether the trader is bullish or bearish.
2. Trading tactics, or timing, determines specific entry and exit points. It is quite possible to be correct on the direction of the market, but still lose money on a trade if the timing is off.
3. Money management covers the allocation of funds.
Some General Money Management Guidelines (refer primarily to futures trading)
1. Total invested funds should be limited to 50% of total capital. The balance is placed in Treasure Bills.
2. Total commitment in any one market should be limited to 10-15% of total equity.
3. The total amount risked in any one market should be limited to 5% of total equity. This 5% refers to how much the trader is willing to lose if the trade doesn't work.
4. Total margin in any market group should be limited to 20-25% of total equity.
Stop placement is an art. The trader must combine technical factors on the price chart with money management considerations. Protective stops placed too close may result in unwanted liquidation on short term market swings (noise). Protective stops placed too far away may avoid the noise factor, but result in larger losses.
That profit objective (the reward) is then balanced against the potential loss if the trade goes wrong (the risk). A commonly used yardstick is a 3 to 1 reward-to-risk ratio.
The trending portion of the position is held for the long pull. The trading portion of the portfolio is earmarked for shorter term in-and-out trading.
The worst time to increase the size of one's commitments is after a winning streak. That's much like buying into an over bought market in an uptrend. The wiser thing to do (which does against basic human nature) is to begin increasing one's commitments after a dip in equity.
Tactics on Breakouts: Anticipation or Reaction?
The trader could take a small position in anticipation of the breakout, buy some more on the breakout, and add a little more on the corrective dip following the breakout.
The Breaking of Trendlines
If the trader is looking to enter a new position on a technical sign of a trend change or a reason to exit an old position, the breaking of a tight trendline is often an excellent action signal.
Trendlines can also be used for entry points when they act as support or resistance. Buying against a major up trendline or selling against a down trendline can be an effective timing strategy.
Using Support and Resistance
The breaking of resistance can be a signal for a new long position. Protective stops can then be placed under the nearest support point.
Rallies to resistance in a downtrend or declines to support in an uptrend can be used to initiate new positions or add to old profitable ones.
Using Percentage Retracements
In an uptrend, pullbacks that retrace 40-60% of the prior advance can be utilized for new or additional long positions.
Bounces of 40-60% usually provide excellent shorting opportunities in downtrends.
Percentage retracements can be used on intraday charts.
Using Price Gaps
Buy a dip to the upper end of the gap or a dip into the gap itself. In a bear move, sell a rally to the lower end of the gap or into the gap itself.
Types of trading orders
1. The market order instructs your broker to buy or sell at the current market price.
2. The limit order specifies a price that the trader is willing to pay or accept.
3. A stop order can be used to establish a new position, limit a loss on an existing position, or protect profit.
4. A stop limit order combines both a stop and limit order.
5. The market-if-touched (M.I.T.) order is similar to a limit order, except that it becomes a market order when the limit price is touched.
Important elements of money management and trading -
1. Trade in the direction of the intermediate trend.
2. In uptrends, buy the dips; in downtrends, sell bounces.
3. Let profit run, cut losses short.
4. Use protective stops to limit losses.
5. Don't trade impulsively; have a plan.
6. Plan your work and work your plan.
7. Use money management principles.
8. Diversify, but don't overdo it.
9. Employ at least a 3 to 1 reward-to-risk ratio.
10. When pyramiding (adding positions), follow these guidelines.
a. Each successive layer should be smaller than before.
b. Add only to winning positions.
c. Never add to a losing position.
d. Adjust protective stops to the breakeven point.
11. Never meet a margin call; don't throw good money after bad.
12. Close out losing positions before the winning ones.
13. Except for very short term trading, make decisions away from the market, preferably when the markets are closed.
14. Work from the long term to the short term.
15. Use intraday charts to fine-tune entry and exit.
16. Master interday trading before trying interday trading.
17. Try to ignore conventional wisdom; don't take anything said in the financial media too seriously.
18. Learn to be comfortable being in the minority. If you're right on the market, most people will disagree with you.
19. Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.
20. Keep it simple; more complicated isn't always better.
Chapter 17 The Link Between Stocks and Futures: Intermarket Analysis
Early warnings signs of inflation and interest rate trends are usually spotted in the futures pits first, which often determine the direction stock prices will take at any given time.
The premium (or spread) between S&P 500 futures over the cash index diminishes as the futures contract approaches expiration. Each day, institutions calculate what the actual premium should be - called fair value.
Bond price move in the opposite direction of interest rate or yields. When bond prices are rising, yields are falling. That is normally considered positive for stocks. Falling bond prices, or rising yields, are considered negative for stocks.
On a short term basis, sudden changes in trend in the S&P 500 futures contract are often influenced by sudden changes in the Treasury Bond futures contract.
Commodity prices usually trend in the opposite direction of bond prices.
A rising U.S. dollar normally has a depressing effect on most commodity prices. In other words, a rising dollar is normally considered to be noninflationary. The gold market usually acts as a leading indicator for other commodity markets.
Gold mining shares can be used as leading indicators for gold prices.
The general idea is to rotate your funds into those sectors of the market whose relative strength lines are just turning up, and to rotate out of those market groups whose relative strength lines are just turning down.
Chapter 18 Stock Market Indicators
The most common way to calculate the AD (advance-decline) line is to take the difference between the number of advancing issues and the number of declining issues. The danger appears when the AD line begins to diverge from the Dow.
Historically, the AD line peaks out well ahead of the market averages, which is why it's watched so closely.
McClellan Oscillator is constructed by taking the difference between two exponential moving averages of the daily NYSE advance-decline figures.
A McClellan Oscillator reading above +100 is a signal of an overbought stock market. A reading below -100 is considered an oversold stock market.
The McClellan Summation Index is a cumulative sum of each day's positive or negative readings in the McClellan Oscillator.
In a strong market, the number of new highs should be much greater than the number of new lows.
Whenever the new highs reach an extreme, the market has a topping tendency. Whenever new lows reach an extreme, the market is near a bottom.
The Arms Index is a ratio of a ratio. The numerator is the ratio of the number of advancing issues divided by the number of declining issues. The denominator is the advancing volume divided by declining volume. On an intraday basis, a very high Arms Index reading is positive, while a very low reading is negative. The Arms Index is a contrary indicator that trends in the opposite direction of the market.
TICK measures the difference between the number of stocks trading on an uptick versus the number trading on a downtick.
A rising TICK indicator and falling Arms Index (TRIN) are positive, while a falling TICK indicator and a rising Arms Index (TRIN) are negative.
In the "Open" version of the Arms Index (Open Arms), each of the four components in the formula is averaged separately over a period of 10 days.
On the Equivolume chart, each price bar is shown as a rectangle. The height of the rectangle measures the day's trading range. The width of the rectangle is determined by that day's volume.
A CandlePower chart combines equivolume and candlesticks. The width of each candle is determined by volume.
A comparison of the Russell 2000 and the S&P 500 tells us whether the "troops" are following the "generals".
Chapter 19 Pulling It All Together - A Checklist
Technical analysis is much like putting together a giant jigsaw puzzle. Each technical tool holds a piece of the puzzle.
Technical checklist
1. What is the direction of the overall market?
2. What is the direction of the various market sectors?
3. What are the weekly and monthly charts showing?
4. Are the major, intermediate, and minor trends up, down, or sideways?
5. Where are the important support and resistance levels?
6. Where are the important trendlines or channels?
7. Are volume and open interest confirming the price action?
8. Where the 33%, 50%, and 66% retracements?
9. Are there any price gaps and what types are they?
10. Are there any major reversal patterns visible?
11. Are there any continuation patterns visible?
12. What are the price objectives from those patterns?
13. Which way are the moving averages pointing?
14. Are the oscillators overbought or oversold?
15. Are any divergences apparent on the oscillators?
16. Are contrary opinion numbers showing any extremes?
17. What is the Elliot Wave pattern showing?
18. Are there any obvious 3 or 5 ware patterns?
19. What about Fibonacci retracements or projections?
20. Are there any cycle tops or bottoms due?
21. Is the market showing right left translation?
22. Which way is the computer trend moving: up, down, or sideways?
23. What are the point and figure charts or candlesticks showing?
After you've arrived at a bullish or bearish conclusion, ask yourself the following questions.
1. Which way will this market trend over the next several months?
2. Am I going to buy or sell this market?
3. How many units will I trade?
4. How much am I prepared to risk if I'm wrong?
5. What is my profit objective?
6. Where will I enter the market?
7. What type of order will I use?
8. Where will I place my protective stop?
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