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THE NEW TRADING OF A LIVING- CLASSICAL CHART ANALYSIS

THE NEW TRADING OF A LIVING



CLASSICAL CHART ANALYSIS

When I bought my first stock, classical charting was the only game in town. I use quad-ruled paper and a sharp pencil to update my charts by hand. A few years later, pocket calculators became available, and I added simple moving averages. Later, a TI programmable calculator made it possible to insert tiny magnetic strips into its slit to perform more complex calculations, such as exponential moving averages and the Directional system.

Finally, an Apple personal computer appeared on the scene; you could use its joystick to move a cursor to draw trendlines. In contrast, today’s traders have access to immense analytic power at a very low cost.

While the key concepts of classical charting remain valid, many of its tools have been eclipsed by much more powerful computerized methods. The best quality of computerized technical analysis is its objectivity. A moving average or any other indicator is either rising or falling, and there can be no argument about its direction. You may puzzle over how to interpret its signals, but the signals themselves are clear as day.

Classical charting, on the other hand, is quite subjective, and invites wishful thinking and self-deception. You can draw a trendline across the extreme prices or across the edges of congestion zones, which will change its angle as well as its message. If you’re in a mood to buy, you can draw your trendline a little steeper. If you feel like shorting and squint at a chart, you’ll “recognize” a head-and-shoulders top. None of those patterns are objective. Because of their subjectivity, I’ve grown increasingly skeptical of claims regarding classical formations, such as pennants, head-and-shoulders, etc.

After having looked at hundreds of thousands of charts, I’ve concluded that the market doesn’t know diagonals. It remembers price levels, which is why horizontal support and resistance lines make sense, but diagonal trendlines are subjective and open to self-deception.

In my own trading, I use only a small number of chart patterns that are objective enough to trust. I pay attention to support and resistance zones, based on horizontal price levels. The relationship between the opening and closing prices and between the high and the low points of a price bar or a candle are also objective. I recognize “fingers,” also called “kangaroo tails”— very long bars that protrude from a tight weave of prices. We’ll explore these and a few other patterns in this section.

Charting

Chartists study market data to identify price patterns and profit from them. Most chartists work with bar or candlestick graphs that show open, high, low, and closing prices and volume. Futures traders also watch open interest. Point-and-figure chartists track only price changes and ignore time, volume, and open interest.

Classical charting requires only a pencil and paper. It appeals to visually oriented people. Those who plot data by hand can develop a physical feel for prices. One of the costs of switching to computerized charting is losing some of that feel.

The biggest problem with classical charting is wishful thinking. Traders seem to identify bullish or bearish patterns, depending on whether they’re in a mood to buy or sell.

Early in the twentieth century, Herman Rorschach, a Swiss psychiatrist, designed a test for exploring a person’s mind. He dropped ink on 10 sheets of paper and folded each in half, creating symmetrical inkblots. Most people who peer at these sheets describe what they see: parts of the anatomy, animals, buildings, and so on. In reality, there are only inkblots! Each person sees what’s on his mind. Most traders use charts as a giant Rorschach test. They project their hopes, fears, and fantasies onto the charts.

Brief History

The first chartists in the United States appeared at the turn of the twentieth century. They included Charles Dow (1851–1902), the author of a famous stock market theory,M and William Hamilton, who succeeded Dow as the editor of The Wall Street Journal. Dow’s famous maxim was “The averages discount everything,” by which he meant that the Industrial and Rail Averages reflected all knowledge about the economy.

Dow never wrote a book, only his Wall Street Journal editorials. Hamilton took over the job after Dow died and laid out the principles of Dow theory in his book, The Stock Market Barometer. He wrote a famous “The Turn of the Tide” editorial following the 1929 crash. Robert Rhea, a newsletter publisher, brought the theory to its pinnacle in his 1932 book, The Dow Theory.

The decade of the 1930s was the Golden Age of charting. Many innovators found themselves with time on their hands after the crash of 1929. Schabacker, Rhea, Elliott, Wyckoff, Gann, and others published their books during that decade. They went in two distinct directions. Some, such as Wyckoff and Schabacker, saw charts as a graphic record of supply and demand. Others, such as Elliott and Gann, searched for a perfect order in the markets—a fascinating but ultimately futile undertaking.

In 1948, Edwards (a son-in-law of Schabacker) and Magee published Technical Analysis of Stock Trends, in which they popularized such concepts as triangles, rectangles, head-and-shoulders, and other chart formations, as well as support, resistance, and trendlines. Other chartists applied these concepts to commodities.

Markets have changed a great deal since the days of Edwards and Magee. In the 1940s, the daily volume of an active stock on the New York Stock Exchange was only several hundred shares, while now it is measured in millions. The balance of power in the stock market has shifted in favor of bulls. Early chartists wrote that stock market tops were sharp and fast, while bottoms took a long time to develop. That was true in their deflationary era, but the opposite has been true since the 1950s. Now bottoms tend to form quickly, while tops tend to take longer.

The Meaning of a Bar Chart

Chart patterns reflect the sum of buying and selling, greed and fear among investors and traders. Many charts in this book are daily, with each bar representing one trading day, but the rules for understanding weekly, daily, or intraday charts are remarkably similar.

Remember this key principle: “Each price is a momentary consensus of value of all market participants expressed in action.” Based on it, each price bar provides several important pieces of information about the tug-of-war between bulls and bears.

The opening price of a daily bar tends to reflect the amateurs’ opinion of value. They read morning papers, find out what happened the day before, perhaps ask for a wife’s approval to buy or sell, and place their orders before driving to work. Amateurs are especially active early in the day and early in the week.

Traders who researched the relationship between opening and closing prices found that opening prices most often occur near the high or the low of the daily bar. Buying or selling by amateurs early in the day creates an emotional extreme from which prices tend to recoil later in the day.

In bull markets, prices often make their low for the week on Monday or Tuesday, when amateurs take profits from the previous week, then rally to a new high on Thursday or Friday. In bear markets, the high for the week is often set on Monday or Tuesday, with a new low toward the end of the week.

The closing prices of daily and weekly bars tend to reflect the actions of professional traders. They watch the markets throughout the day, respond to changes, and tend to dominate the last hour of trading. Many of them take profits at that time to avoid carrying trades overnight.
FIGURE  TSLA daily.

Professionals as a group usually trade against the amateurs. They tend to buy lower openings, sell short higher openings, and unwind their positions as the day goes on. Traders need to pay attention to the relationship between opening and closing prices. If prices closed higher than they opened, then market professionals were probably more bullish than amateurs. If prices closed lower than they opened, then market professionals were probably more bearish than amateurs. It pays to trade with the professionals and against the amateurs. Candlestick charting is based, to a large extent, on the relationship between the opening and closing prices of each bar. If the close is higher, the candle is white, but if it is lower, the candle is black.

The high of each bar represents the maximum power of bulls during that bar. Bulls make money when prices go up. Their buying pushes prices higher, and every uptick adds to their profits. Finally, bulls reach a point where they cannot lift prices— not even by one more tick. The high of a daily bar represents the maximum power of bulls during the day, while the high of a weekly bar marks the maximum power of bulls during the week.

The highest point of a bar represents the maximum power of bulls during that bar.

The low of each bar represents the maximum power of bears during that bar. Bears make money when prices decline. They keep selling short, their selling pushes prices lower, and every downtick adds to their profits. At some point they run out of either capital or enthusiasm, and prices stop falling. The low of a daily bar marks the maximum power of bears during that day, and the low of a weekly bar identifies the maximum power of bears during that week.

The low of each bar show s the maximum power of bears during that bar.

The closing price of each bar reveals the outcome of the battle between bulls and bears during that bar. If prices close near the high of the daily bar, it shows that bulls won the day’s battle. If prices close near the low of the day, it shows that bears won the day. Closing prices on the daily charts of futures are especially important because your account equity is “marked to market” each night.

The distance between the high and the low of any bar reflects the intensity of conflict between bulls and bears. An average bar marks a relatively cool market. A bar that’s only half as tall as average reveals a sleepy, disinterested market. A bar that’s two times taller than average shows a boiling market where bulls and bears battle all over the field.

Slippage tends to be less in quiet markets. It pays to enter trades during short or normal bars. Tall bars are good for taking profits. Trying to enter a position when the market is running is like jumping onto a moving train. It would be safer to wait for the next one.

Japanese Candlesticks

Japanese rice traders began using candlestick charts some two centuries before the first chartists appeared in America. Instead of bars, their charts had rows of candles with wicks at both ends. The body of each candle represents the distance between the opening and closing prices. If the closing price is higher than the opening, the body is white, but if the closing price is lower, the body is black.

The tip of the upper wick represents the high of the day, while the bottom of the lower wick represents the low of the day. The Japanese consider highs and lows relatively unimportant, according to Steve Nison, author of Japanese Candlestick Charting Techniques. They focus on the relationship between opening and closing prices and on patterns that include several candles.

The main advantage of a candlestick chart is its focus on the struggle between amateurs who control openings and professionals who control closings. Unfortunately, many candlestick chartists neglect Western tools, such as volume and technical indicators.

Candlesticks have become quite popular worldwide, and some traders ask me why I continue to use bar charts. I am familiar with candlesticks, but I’ve learned to trade using bar charts, and I believe that using open-high-low-close bars plus technical indicators gives me more information.

Your choice of a bar or a candlestick chart is a matter of personal preference. All concepts expressed in this book can be used with candlestick as well as bar charts.

Efficient Markets, Random Walk, Chaos Theory, and “Nature’s Law”

Efficient Market theory is an academic notion that nobody can outperform the market because any price at any given moment incorporates all available information. Warren Buffett, one of the most successful investors of the century, commented: “I think it’s fascinating how the ruling orthodoxy can cause a lot of people to think the earth is flat. Investing in a market where people believe in efficiency is like playing bridge with someone who’s been told it doesn’t do any good to look at the cards.”

The logical flaw of Efficient Market theory is that it equates knowledge with action. People may have knowledge, but the emotional pull of the crowd often leads them to trade irrationally. A good analyst can detect repetitive patterns of crowd behavior on his charts and exploit them.

Random Walk theorists claim that market prices change at random. Sure, there is a fair bit of randomness or “noise” in the markets, just as there is randomness in any crowd. Still, an intelligent observer can identify repetitive behavior patterns of a crowd and make sensible bets on their continuation or reversal.

People have memories; they remember past prices, and their memories influence their decisions to buy or sell. Memories help create support under the market and resistance above it. Random Walkers deny that memories influence our behavior.

As Milton Friedman pointed out, prices carry information about the availability of supply and the intensity of demand. Market participants use that information when deciding to buy or sell. For example, consumers buy more merchandise when it is on sale and less when prices are high. Financial traders are just as capable of logical behavior as homemakers. When prices are low, bargain hunters step in. A short-age can lead to a buying panic, but high prices choke off demand.

Chaos Theory has achieved prominence in the recent decades. Markets are largely chaotic, and the only time you can have an edge is during orderly periods.

In my view, markets are chaotic much of the time, but out of that chaos, islands of order and structure keep emerging and disappearing. The essence of market analysis is recognizing the emergence of orderly patterns and having enough courage and conviction to trade them.

If you trade during chaotic periods, the only ones to benefit will be your broker, who’ll collect his commission, and a professional day-trader, who’ll scalp you. The key point to keep in mind is that once in a while a pattern emerges from chaos. Your system should recognize this transition, and that’s when you should put on a trade! Earlier we spoke about the one great advantage of a private trader over professionals—he may wait for a good trade instead of having to be active each day. The chaos theory confirms that message.

The chaos theory also teaches us that orderly structures that emerge from chaos are fractal. The sea coast appears equally jagged whether you look down on it from space or an airplane, from a standing position or on your knees through a magnifying glass. Market patterns are fractal as well. If I show you a set of charts of the same market, having removed time markings, you will not be able to tell whether it is monthly, weekly, daily, or a 5-minute chart. We’ll return to this theme, and you’ll see why it is so important to analyze markets in more than one timeframe. We’ll have to make sure that buy or sell messages in both timeframes confirm each other, because if they don’t it means that the market is too chaotic and we should stand aside.

Nature’s Law is the rallying cry of a clutch of mystics who claim there is a perfect order in the markets (which they’ll reveal to you for a price). They say that markets move like clockwork in response to immutable natural laws. R. N. Elliott even titled his last book Nature’s Law.

The “perfect order” crowd gravitates to astrology, numerology, conspiracy theory, and other superstitions. Next time someone talks to you about natural order in the markets, ask him about astrology. He’ll probably jump at the chance to come out of the closet and talk about the stars.

The believers in perfect order in the markets claim that tops and bottoms can be predicted far into the future. Amateurs love forecasts, and mysticism is a great marketing gimmick. It helps sell courses, trading systems, and newsletters.

Mystics, Random Walk academics, and Efficient Market theorists have one trait in common. They are equally divorced from the reality of the markets.

Support and Resistance

A ball hits the floor and bounces. Toss it up, and it’ll drop after hitting the ceiling. Support and resistance are like a floor and a ceiling, with prices sandwiched between them. Understanding support and resistance is essential for understanding price trends. Rating their strength helps you decide whether the trend is likely to punch through or to reverse.

Support is a price level where buying is strong enough to interrupt or reverse a downtrend. When a downtrend hits support, it bounces like a diver who hits the bottom and pushes away from it. Support is represented on a chart by a horizontal line connecting two or more bottoms.

Resistance is a price level where selling is strong enough to interrupt or reverse an uptrend. When an uptrend hits resistance, it acts like a man who hits his head on a branch while climbing a tree—he stops and may even tumble down. Resistance is represented on a chart by a horizontal line connecting two or more tops.

It is better to draw support and resistance lines across the edges of congestion areas where the bulk of the bars stopped rather than across extreme prices. Those congestion zones show where masses of traders have changed their minds, while the extreme points reflect only panic among the weakest traders.

Minor support or resistance causes trends to pause, while major support or resistance causes them to reverse. Traders buy at support and sell at resistance, making their effectiveness a self-fulfilling prophecy.
FIGURE  NFLX weekly.

How do we identify trends? Not by trendlines. My favorite tools are exponential moving averages that we’ll review in the next section. Trendlines are wildly subjective—they are among the most self-deceptive tools. Trend identification is an area in which computerized analysis is miles ahead of classical charting.

Memories, Pain, and Regret

Our memories of previous market turns prompt us to buy and sell at certain levels. Buying and selling by crowds create support and resistance. Support and resistance exist because people have memories.

If traders remember that prices have recently stopped falling and turned up from a certain level, they are likely to buy when prices approach that level again. If traders remember that an uptrend has recently reversed after rising to a certain peak, they tend to sell and go short when prices approach that level again.

For example, all major rallies in the stock market from 1966 until 1982 ended whenever the Dow Jones Industrial Average rallied into the area between 950 and 1050. That resistance zone was so strong that traders named it “a graveyard in the sky.” Once the bulls rammed the market through that level, it became a major support area. It hit the level of $1,000/oz four times, dropping after each attempt. After the price of gold broke above that level on its fifth attempt, the level of $1,000/oz turned into a massive support level.

FIGURE  GOLD weekly.

Support and resistance exist because masses of traders feel pain and regret. Traders who hold losing positions feel intense pain. Losers are determined to get out as soon as the market gives them another chance. Traders who missed an opportunity to buy or sell short feel regret and also wait for the market to give them a second chance. Feelings of pain and regret are mild in trading ranges when swings are relatively small and losers do not get hurt too badly. Breakouts from those ranges create much more intense pain and regret.

When the market stays flat for a while, traders get used to buying near the lower edge of its range and selling or even shorting near the upper edge. When an uptrend begins, bears who sold short feel a great deal of pain. At the same time bulls feel an intense regret that they didn’t buy more. Both are determined to buy if the market declines to the breakout point and gives them a second chance to cover shorts or to get long. The pain of bears and regret of bulls makes them eager to buy, creating support during reactions in an uptrend.

When prices break down from a trading range, bulls who bought are in pain: they feel trapped and wait for a rally to get out even. Bears, on the other hand, regret that they haven’t shorted more: they wait for a rally as a second chance to sell short. Bulls’ pain and bears’ regret create resistance—a ceiling above the market in downtrends. The strength of support and resistance depends on the strength of feelings among masses of traders.

Strength of Support and Resistance

The longer prices stay in a congestion zone, the stronger the emotional commitment of bulls and bears to that area. A congestion area hit by several trends is like a battlefield with craters from explosions: its defenders have plenty of cover and are likely to slow down any attacking force. When prices approach that zone from above, it serves as support. When prices rally into it from below, it acts as resistance. A congestion area can reverse those roles, serving as either support or resistance.

The strength of those zones depends on three factors: their length, height, and the volume of trading that has taken place in them. You can visualize these factors as the length, the width, and the depth of a congestion zone.

The longer a support or resistance area—its length of time or the number of hits it took— the stronger it is. Support and resistance, like good wine, become better with age. A 2-week trading range provides only minimal support or resistance, a 2-month range gives people time to become used to it and creates intermediate support or resistance, while a 2-year range becomes accepted as a standard of value and offers major support or resistance.

As support and resistance levels grow very old, they gradually become weaker. Losers keep washing out of the markets, replaced by newcomers who don’t have the same emotional commitment to very old price levels. People who lost money only recently remember full well what happened to them. They are probably still in the market, feeling pain and regret, trying to get even. People who made bad decisions several years ago may well be out of that market, and their memories matter less.

The strength of support and resistance increases each time that area is hit. When traders see that prices have reversed at a certain level, they tend to bet on a reversal the next time prices reach that level.

The taller the support and resistance zone, the stronger it is. A tall congestion zone is like a tall fence around a property. If a congestion zone’s height equals one percent of current market value, it provides only minor support or resistance. If it’s three percent tall, it provides intermediate support or resistance, and a congestion zone that’s seven percent tall or higher can grind down a major trend.

The greater the volume of trading in a support and resistance zone, the stronger it is. High volume shows active involvement by traders—a sign of strong emotional commitment. Low volume shows that traders have little interest in transacting at that  level—a sign of weak support or resistance.

You can measure the strength of support and resistance in dollars if you multiply the number of days a stock spent in its congestion zone by its average daily volume and price. Of course, when making such comparisons, we should measure support and resistance zones for the same stock. You can’t compare apples with oranges or AAPL with some $10 stock that trades a million shares on a good day.

Trading Rules

  1. Whenever the trend you’re riding approaches support or resistance, tighten your protective stop. A protective stop is an order to sell below the market when you are long or to cover shorts above the market when you are short. A stop protects you from getting badly hurt by a reversal. A trend reveals its health by how it acts when it hits support or resistance. If it’s strong enough to penetrate that zone, your tight stop will not be triggered. If a trend bounces away from support or resistance, it reveals its weakness. In that case, your tight stop will salvage a good chunk of profits.
  2. Support and resistance are more important on long-term charts than on short-term charts. A good trader monitors his market using several timeframes, but assigns more weight to the longer ones. Weekly charts are more important than dailies. If the weekly trend is strong, it is less alarming that the daily trend is hitting resistance. When a weekly trend approaches major support or resistance, you should be more inclined to exit.
  3. Support and resistance levels point to trading opportunities. The bottom of a congestion area identifies the bottom line of support. As prices decline towards it, be alert to buying opportunities. One of the best patterns in technical analysis is a false breakout. If prices dip below support and then rally back into the support zone, they show that bears have lost their chance. A price bar closing within a congestion zone after a false downside breakout marks a buying opportunity; set a protective stop in the vicinity of the bottom of the recent false downside breakout.

Similarly, a true upside breakout should not be followed by a pullback into the range, just as a rocket is not supposed to sink back to its launching pad. A false upside breakout gives a signal to sell short as a price bar returns into the congestion zone. When shorting, place a protective stop near the top of the false breakout.

On Placing Stops Experienced traders tend to avoid placing them at round numbers. If I buy a stock near $52 and want to protect my position in the area of 51, I’ll put a stop a few cents below $51. If I go long at 33.70 in a day-trade and want to protect my position in the area of $33.50, I’ll put that stop a few cents below $33.50. Because of a natural human tendency to use round numbers, clusters of stops accumulate there. I prefer to place my stops at the far ends of such clusters.

True and False Breakouts

Markets spend more time in trading ranges than in trends. Most breakouts from trading ranges are false breakouts. They suck in trend-followers just before prices return into their ranges. False breakouts hurt amateurs, but professional traders love them.

Professionals expect prices to fluctuate most of the time, without going anywhere far. They wait until an upside breakout stops reaching new highs or a downside breakout stops making new lows. Then they pounce—fade the breakout and place a protective stop near the latest extreme point. It’s a tight stop, and their monetary risk is low, with a big profit potential from prices returning towards the middle of the congestion zone. The risk/reward ratio is so good that professionals can afford to be wrong half the time and still come out ahead of the game.


FIGURE  EGO and the Euro daily.

The best time to buy an upside breakout on a daily chart is when your analysis of the weekly chart suggests that a new uptrend is developing. True breakouts are confirmed by heavy volume, while false breakouts tend to have light volume. True breakouts are confirmed when technical indicators reach new extremes in the direction of the new trend, while false breakouts are often marked by divergences between prices and indicators, which we’ll discuss later in the book.

Trends and Trading Ranges

A trend exists when prices keep rising or falling over a period of time. In a perfect uptrend, each rally reaches a higher high than the preceding rally, while each decline stops at a higher level than the preceding decline. In a perfect downtrend,  each decline falls to a lower low than the preceding decline and each rally tops out at a lower level than the preceding rally. In a trading range, most rallies stop at about the same high level, and declines peter out at about the same low level. Perfect patterns, of course, aren’t that common in financial markets, and multiple deviations make life harder for analysts and traders.

Even a quick look at most charts reveals that markets spend most of the time in trading ranges. Trends and trading ranges call for different tactics. When you go long in an uptrend or sell short in a downtrend, you have to give that trend the benefit of the doubt and use a wider stop, so as not to be shaken out easily. In a trading range, on the other hand, you have to use tight stops, be nimble and close out positions at the slightest sign of a reversal.

Another difference in trading tactics between trends and ranges is the handling of strength and weakness. You have to follow strength during trends—buy in uptrends and short in downtrends. When prices are in a trading range, you aim to do the opposite—buy weakness and sell strength.


FIGURE  FB daily, 22-day EMA.

Mass Psychology

When the trend is up, bulls are more eager than bears, and their buying forces prices higher. If bears manage to push prices down, bulls return to bargain hunt. They stop the decline, and force prices to rise again. A downtrend occurs when bears are more aggressive and their selling pushes markets down. Whenever a flurry of buying lifts prices, bears sell short into that rally, stop it, and send prices to new lows.

When bulls and bears are about equal in strength, prices stay in a trading range. When bulls manage to push prices up, bears sell short into that rally and prices fall. As they decline, bargain hunters step in and buy. Then, as bears cover shorts, their buying helps fuel a rally. This cycle can go on for a long time.

A trading range is like a fight between two equally strong street gangs. They push one another back and forth, but neither can control the city block. A trend is like a fight in which a stronger gang chases the weaker gang down the street. Every once in a while the weaker gang stops and puts up a fight but then turns and runs again.

Crowds spend most of their time aimlessly milling around, which is why markets spend more time in trading ranges than in trends. A crowd has to become agitated and surge to create a trend. Crowds do not stay excited for long—they go back to aimlessness. Professionals tend to give the benefit of the doubt to trading ranges.

The Hard Right Edge

Trends and ranges are easy to see in the middle of a chart, but as you get close to its right edge, the picture becomes increasingly foggy. The past is fixed and clear, but the future is fluid and uncertain. Trends are easy to recognize on old charts, but, unfortunately, our brokers don’t allow us to trade in the past—we have to make trading decisions at the hard right edge.

By the time a trend becomes perfectly clear, a good chunk of it is already gone. Nobody will ring a bell when a trend dissolves into a trading range. Many chart patterns and indicator signals contradict one another at the right edge of the chart. You have to base your decisions on probabilities in an atmosphere of uncertainty. 

Most people feel very uncomfortable dealing with uncertainty. When their trade doesn’t go the way their analysis suggested, they hang onto losing positions, waiting for the market to turn and make them whole. Trying to be right is an unaffordable luxury in the markets. Professional traders get out of losing trades fast. When the market deviates from your analysis, you have to cut losses without fuss.

Methods and Techniques

Keep in mind that there is no single magic method to clearly and reliably identify all trends and trading ranges. It pays to combine several analytic tools. None of them is perfect, but when they confirm each another, a correct message is much more likely. When they contradict one another, it’s better to pass up a trade.


FIGURE  UNP daily, 22-day EMA, Directional system, MACD-Histogram.


  1. Analyze the pattern of highs and lows. When rallies keep reaching higher levels and declines keep stopping at higher levels, they identify an uptrend. The pattern of lower lows and lower highs identifies a downtrend, and the pattern of irregular highs and lows points to a trading range.
  2. Plot a 20- to 30-bar exponential moving average. The direction of its slope identifies the trend. If a moving average has not reached a new high or low in a month, then the market is probably in a trading range.
  3. When an oscillator, such as MACD-Histogram rises to a new peak, it identifies a powerful trend and suggests that the latest market top is likely to be retested or exceeded.
  4. Several market indicators, such the Directional system, help identify trends. The Directional system is especially good at catching early stages of new trends.

Trade or Wait

Having identified an uptrend, you need to decide whether to buy immediately or wait for a dip. If you buy fast, you’ll get in gear with the trend, but on the minus side, your stops are likely to be farther away, increasing your risk.

If you wait for a dip, your risk will be smaller, but you’ll have four groups of competitors: longs who want to add to their positions, shorts who want to get out even, traders who never bought, and traders who sold too early but are eager to buy again. The waiting areas for pullbacks are notoriously crowded! Furthermore, a deep pullback may signal the beginning of a reversal rather than a buying opportunity. The same reasoning applies to shorting in downtrends. 

If the market is in a trading range and you’re waiting for a breakout, you’ll have to decide whether to buy in anticipation of a breakout, during a breakout, or on a pullback after a valid breakout. If you aren’t sure, consider entering in several steps: buy a third of the planned position in anticipation, a third on a breakout, and a third on a pullback.

Whatever method you use, remember to apply the key risk management rule: the distance from your entry to the protective stop, multiplied by position size can never be more than 2 percent of your account equity. No matter how attractive a trade, pass it up if it would require putting more than 2% of your account at risk.

Finding good entry points is extremely important in trading ranges. You have to be very precise and nimble because the profit potential is limited. A trend is more forgiving of a sloppy entry, as long as you trade in the right direction. Old traders chuckle: “Don’t confuse brains with a bull market.”

Specific risk management tactics are different for trends and trading ranges. When trend trading, it pays to put on smaller positions with wider stops. You’ll be less likely to get shaken out by any counter-trend moves, while still controlling risk. You may put on bigger positions in trading ranges but with tighter stops.

Conflicting Timeframes

Markets move in several timeframes at the same time. They move simultaneously, and sometimes in the opposite directions on 10-minute, hourly, daily, weekly and monthly charts. The market may look like a buy in one timeframe but a sell in another. Even indicator signals in different timeframes of the same stock may contradict one another. Which will you follow?

Most traders ignore the fact that markets move in different directions at the same time in different timeframes. They pick one timeframe, such as daily or hourly, and look for trades there. That’s when trends from other timeframes sneak up on them and wreak havoc with their plans.

Those conflicts between signals in different timeframes of the same market are one of the great puzzles in market analysis. What looks like a trend on a daily chart may show up as a blip on a flat weekly chart. What looks like a flat trading range on a daily chart shows rich uptrends and downtrends on an hourly chart, and so on.

The sensible course of action is this: before examining a trend on your favorite chart, step back to explore the charts in a timeframe one order of magnitude greater than your favorite. This search for a greater perspective is one of the key principles of the Triple Screen trading system, which we’ll discuss in a later chapter.

When professionals are in doubt, they look at the big picture, while amateurs tend to focus on the short-term charts. Taking a longer view works better —and is a lot less nerve-wracking.

Kangaroo Tails

Just when you think a runaway trend will keep on going—pop!—a three-bar pattern forms a kangaroo tail that flags a reversal. A kangaroo tail2 consists of a single, very tall bar, flanked by two regular bars, that protrudes from a tight weave of prices. Upward-pointing kangaroo tails flash sell signals at market tops, while downward-pointing kangaroo tails occur at market bottoms.

While daily charts are shown in the illustration, you can find kangaroo tails on the charts of all timeframes. The longer the timeframe, the more meaningful its signal: a kangaroo tail on a weekly chart is likely to lead to a more significant move than a tail on a 5-minute chart.

Kangaroo tails, also called “fingers,” are on my short list of reliable chart formations. They leap at you from the charts and are easy to recognize. If you doubt whether a kangaroo tail is present, assume it is not. Real kangaroo tails are unmistakable. They occur in the broad market indexes as well as individual stocks, futures, and other trading vehicles.

Markets constantly fluctuate, seeking levels that generate the highest volume of trade. If a rally attracts no orders, the market will reverse and look for orders at lower levels. If volume dries up during a decline, the market is likely to rally, seeking orders at higher prices.

Kangaroo tails reflect failed bull or bear raids. A kangaroo tail pointing up reflects a failed attempt by the bulls to lift the market. They’re like a group of soldiers that take a hill from the enemy, only to discover that the main force has failed to follow. Now they escape and run downhill for their lives. Having failed to hold the hill, the army is likely to move away from it.


FIGURE  BIIB and FDO daily.

A kangaroo tail that points down reflects a failed bear raid. Bears aggressively sold the market, pushing it lower—but low prices did not attract volume and bears retreated back into the range. What do you think the market is likely to do next, after it failed to continue moving down? Since it found no orders below, it’s likely to turn up and rally.

When markets recoil from kangaroo tails, they offer trading opportunities. It was J. Peter Steidlmayer who pointed out years ago that a bar that looks like a finger sticking out of a tight chart pattern provides a valuable reference point for short-term traders. A kangaroo tail shows that a certain price has been rejected by the market. It usually leads to a swing in the opposite direction. As soon as you recognize a tail, trade against it.

An experienced trader can recognize a kangaroo tail during its third bar, before it closes. For example, you may see a range that held for several days on a daily chart, but then on Monday the stock explodes in a very tall bar. If on Tuesday it opens near the base of the Monday’s bar base and refuses to rally, consider selling short before the market closes on Tuesday. If the market has been in a trading range for a week and then traces a tall bar down on Wednesday, get ready on Thursday: if prices trade in a narrow range near the top of the Wednesday bar, go long before the market closes on Thursday.


FIGURE  IGT Daily.

Remember that trading against the tails is a short-term tactic; on the daily charts, these signals fizzle out after a few days. Evaluate kangaroo tails against the background of the current market. For example, when running a long-term bullish campaign in a stock, be alert to kangaroo tails. A tail pointing up may well suggest profit taking on existing positions, while a tail pointing down identifies a good spot to add to long positions.

Using stops is essential for survival and success in the markets. Putting a stop at the end of a tail would make your stop too wide, risking too much capital. When trading against the tail, place your protective stop about halfway through the tail. If the market starts “chewing its tail,” it is time to get out.

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