Mastering the Setup

Trading Skills for a New Generation PRESENTS:

MASTERING THE SETUP FEATURING:

Interactive Scans To Locate Outstanding Short-Term Trading Opportunities

Expos and Workshops across the USA Remarks by Alan Farley Editor/Publisher Hard Right Edge http://www.hardrightedge.com Brooke Publishers, Inc 290 West Stacey Lane Tempe, AZ 85284 Phone: 602-628-0262 Fax: 419-793-7191

Hard Right Edge offers swing traders and day traders a broad variety of tools and resources, including original online courses, stock scans, tutorials, tactics, links and workstations. HRE is not associated with any system, software or broker. This web site is owned and operated by Brooke Publishers, Inc, an Arizona corporation. Written and multimedia materials- © 2003 Brooke Publishers, Inc. All rights reserved.

Trading the 7-Bells Mathematics and vision work together to predict short-term price behavior. The 7-Bells define numerical scans that search the markets for original setup criteria that represent outstanding profit opportunities. The initial output then runs a gauntlet of visual filters to eliminate poor candidates. The remaining stock picks build an active basket for each market session. The swing trader then executes a Bell position according to a predefined plan when a setup displays anticipated price behavior. Market knowledge misses many lesser-known opportunities. 7-Bells return these forgotten patterns into the arsenal of modern tactics. These highly original setups reveal powerful mechanisms that feed directional price movement. They expose predictable aspects of crowd psychology, multiple time frame events and complex breakout triggers. And they represent advanced trading strategies to step in front of, stand behind or fade the emotional crowd. 7-Bells offer a powerful source to manage trading opportunity. They reduce information overload as they discard thousands of marginal issues that hold little interest to swing traders before proprietary scans begin their work. Each market day, 7-Bells probability filters can identify specific patterns that favor impending price change. But candidates that make this first cut must then survive an intensive secondary review before trade consideration. Consider both probability and time frame before using the 7-Bells candidates. Although these scans uncover outstanding prospects for short-term profit, many fail to trigger promising trades within a specific holding period. Swing traders should review the limitations of each setup as well as their powerful predictive characteristics before they execute positions. Not surprisingly, this is also true of all successful market strategies. The greatest value of 7-Bells has little to do with the daily output. Stock charts repeat these familiar patterns over and over again in all time frames. Internalize their mechanics and understand their powerful message. Then watch market vision grow and new opportunities come quickly. Remember that 7-Bells represent setups that may never happen. Lazy participants will lose money if they just take output and enter blind positions without completing their own analysis. These patterns display characteristics associated with predictable and profitable outcomes. But a specific stock may never act according to expectations. And only personal skill and excellent timing will book a profit, even when everything lines up perfectly. Each Bell setup focuses on a different aspect of market behavior. Some define breakout conditions while others signal the start of swing movement. Several of the patterns may break either way and require strategies that choose direction based on subsequent price movement. Extend focus and planning beyond the actual bar that follows the original Bell signal. Price action often lags the pattern by several bars and rewards patience. Review the patterns and decide which ones fit into the current personal trading plan. Experiment with a few ideas that consistently produce the best results and master them before moving on to others. Participants should not try to execute all of the scans at the same time. Choose only the strongest candidates from each Bell and cross-verify the opportunity with other landscape features. Marginal setups will fail unless overall conditions strongly support the play.

Short-term market conditions always favor some setups over others. Dip Trips and Coiled Springs respond well to strong bull markets. 3rd Watch candidates may dry up during corrections. Finger Finders and Power Spikes continue to print through all environments. Identify the broad Pattern Cycles before choosing a Bell strategy and align tactics to current sentiment. Then move to other opportunities if an original setup fails to do its job.

ABOUT HARD RIGHT EDGE Hard Right Edge offers students and visitors innovative trading education and technical analysis resources. Headquartered in Phoenix, AZ, HRE presents an independent source to build critical trading knowledge and effective profit execution. We are not affiliated with any broker, software or trading system. HRE educational tools and live seminars teach traders critical market skills at a very reasonable price. Take the opportunity to succeed in today's volatile markets with this unique web portal. In return, we'll provide proprietary trading knowledge that is affordable to all market aspirants. Step up to the demands of the modern financial markets with McGraw-Hill's best-selling "The Master Swing Trader". HRE founder Alan Farley reveals a hidden world of opportunity within common chart patterns through original concepts and applications. Packed with over 180 illustrations and dozens of proprietary trading strategies, this outstanding book will quickly find a home on every serious trader's bookshelf. Hard Right Edge wants you to reach your serious goals in market speculation. Let us help you master the critical edge that leads to outstanding trading performance.

ABOUT ALAN FARLEY, TRADER, LECTURER AND AUTHOR Alan Farley is a private trader and publisher of the Hard Right Edge web site, a comprehensive online resource for trader education, technical analysis and short-term trading tactics. He is the author of the McGraw-Hill best seller "The Master Swing Trader". Alan has been part of the market scene for over 15 years as a private investor, advisor and author. He is a powerful speaker on swing trading and Pattern Cycles, the original strategies and tactics illustrated throughout his highly popular web site. In addition to writing and speaking, Alan has also been featured in Barrons, Smart Money, Tech Week, Active Trader, MSN MoneyCentral, Online Investor, Los Angeles Times, America-Invest, Technical Analysis of Stocks and Commodities, TradingMarkets.com and TheStreet.com. He consults regularly with major financial news services on issues facing today's online traders and is a strong voice for the Net revolution changing the face of our modern financial markets. This speaker and author can provide your seminar, conference, workshop, meeting or expo with outstanding live presentations on today’s markets, swing trading, day trading or technical analysis. Send inquiries to [email protected]

DISCLAIMER 7-Bells are not stock picks. The sole purpose is to publish filtered output that meet certain criteria representing characteristics associated with the described trading strategies. If you buy or sell any stock solely because it appears on these scans, you will lose money. Individual traders must do their homework and analyze featured stocks to determine if they represent a profit opportunity. It is solely the trader's responsibility to make proper execution choices. Hard Right Edge and its offerings are for informational and educational purposes only. It is not our intent to advise you on what to buy or sell. Our intent is to inform you of our personal view of the markets, short-term trading strategies and opportunities. None of the stocks mentioned at this site should be bought or sold without you first doing your own analysis. None of the techniques discussed here should be undertaken without extensive study, back testing and paper trading analysis. It is very important for you to understand that our approach to trading can be very risky and volatile, which means that your losses may be extensive. Specifically day trading and swing trading involve high risk and you can lose a lot of money. HRE assumes no liability or responsibility for any decisions made by any reader or participant of this web site. The editors/publishers of Hard Right Edge and Morning Trader have no financial stake in any stock mentioned by the 7-Bells report at the time of publication. The editors/publishers rarely hold any stock position for longer than a few hours. No liability is assumed for publication of any third party opinions or analysis. Past performance is no guarantee of future results. We suggest you seek the advice of a financial professional before you make any changes to your current investment strategies. All data and information is correct to the best of our knowledge at the time of publication. Again, no guarantee or warranty is offered or implied.

The 7-Bells 1. DIP TRIP - Price that moves against a strong trend will rebound sharply. This Bell recognizes that buyers wait for pullbacks from strong rallies. It seeks to locate the natural level where a primary trend will reassert itself and force a reversal. Some Dip Trips head naturally to new highs after they bounce. Others will eventually fail and roll over into new declines. The swing trader must execute Dip Trips defensively and take whatever profit the market offers.

Scan (Uses Worden’s EasyScan™ language)

((C2 - C) / C2) * 100 > 4 AND RSI70.2 > 50 AND RSI14 > 50 AND C > AVGC200 AND C > 7 AND AVGV50 > 1000 Components: •

((C2 - C) / C2) * 100 > 4

The closing price drops more than 4% in the last two trading sessions. •

RSI70.2 > 50

Wilder’s Relative Strength Index set to a 70-bar period was greater than 50 two trading sessions ago. •

RSI14 > 50

The current bar’s Wilder’s Relative Strength Index set to a 14-bar period is greater than 50. •

C > AVGC200

The current bar’s closing price is higher than the 200-bar Exponential Moving Average •

C>7

The current bar’s closing price is higher than $7.00. •

AVGV50 > 1000

Average volume for the last 50 bars is greater than 100,000 shares/bar.

Filters: •

Sort output in descending order by current price vs. the 200-bar Exponential Moving Average. This represents the total point difference between price and the latest value for the average.

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Favor stocks in the top 20% of the sorted listing.

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Favor stocks that hit new highs in the last few bars over those within obvious congestion.

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Favor parabolic declines that follow parabolic rallies.

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Rule out stocks that gap down off their highs.

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Rule out stocks that have higher volume on the decline than the rallies that precede them.

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Rule out stocks that complete First Failure patterns on the decline.

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Avoid stocks that print strong intrabar bounces or inside bars on the decline.

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Avoid stocks with Hammer, Inverted Hammer, Hanging Man or Doji candlesticks on the signal bar.

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Avoid stocks with blowoff reversals at their highs.

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Avoid stocks that break obvious support on the decline.

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Avoid stocks in which the 14-period RSI turns down and declines through 80.

2. COILED SPRING - Constricted price gives way to directional movement This classic trade recognizes the importance of NR7 narrow range events. It points to potential Empty Zone interfaces between directionless negative feedback and the eruption of positive feedback momentum. The scan filters stocks through very high relative strength to favor upward price expansion to new highs. But the best results build a bilateral strategy that enters a position in whatever direction that price eventually breaks. Coiled Spring expansion often occurs 2-3 bars after the 7-Bells signal appears.


((H - L) < (H1 - L1)) AND ((H - L) < (H2 - L2)) AND ((H - L) < (H3 - L3)) AND ((H - L) < (H4 L4)) AND ((H - L) < (H5 - L5)) AND ((H - L) < (H6 - L6)) AND C > 7 AND AVGV50 > 1000 Components: •

(H - L) < (H1 - L1)

The current bar’s range is narrower than the last bar. •

(H - L) < (H2 - L2)

The current bar’s range is narrower than 2 bars ago. •

(H - L) < (H3 - L3)

The current bar’s range is narrower than 3 bars ago.

•

(H - L) < (H4 - L4)


(H - L) < (H5 - L5)


(H - L) < (H6 - L6)


C>7


AVGV50 > 1000


Filters: •

Sort output in descending order by current price vs. the 200-bar Exponential Moving Average. This represents the total point difference between price and the latest value for the average.

•


•

Favor stocks that pull back after a strong rally.

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Favor stocks with price near the mid-range of short sideways congestion or the top of long sideways congestion.

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Favor stocks that show declining volume as the congestion builds.

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Favor stocks that sit on the 20-bar MA or 50-bar MA.

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Favor stocks where the 20-bar MA = 50-bar MA.

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Favor stocks that print classic patterns such as triangles or flags.

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Favor stocks at important trendlines.

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Avoid stocks that hit new highs within 5 bars of the signal.

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Avoid stocks with strong overhead resistance.

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Avoid stocks in which the 14-period RSI turns down and declines through 80 near the signal bar.

3. FINGER FINDER - Candles flag reversals in the next smaller time frame. Hammers, Dojis and Haramis represent 1-bar predictive candlesticks when they print at certain levels. Finger Finders locate these important reversals and advise the swing trader to study the chart under the event. This setup provides early warning for several profitable opportunities that capitalize on subsequent price behavior. In favorable conditions, movement in the next smaller time frame allows specific strategies to beat the crowd in the door.


ABS(O - C) < ((H - L) * .333) AND (H - L) > (.05 * C) AND (H > H1 OR L < L1) AND C > 7 AND AVGV50 > 1000 Components: •

ABS(O - C) < ((H - L) * .333)

The current bar’s range from open to close is less than 1/3 of the current bar’s range from high to low. Note that ABS represents the absolute value of any number or calculation. This removes the minus sign if the close is higher than the open on that bar. •

(H - L) > (.05 * C)

The current bar’s total range is greater than 5% of the closing price. •

(H > H1 OR L < L1)

The current bar’s high is higher than the high one bar ago or the current bar’s low is lower than the low one bar ago. This eliminates inside bars. •

C>7


AVGV50 > 1000


Filters: •

Sort output in descending order by total volume on the last bar.

•


•

Favor a Doji or Hammer with a much higher high or lower low than the last bar.

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Favor a Spinning Top with an open-close range well within the open-close range of the last bar.

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Favor stocks that reach major trendlines or moving averages on the signal.

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Favor wide range bars on high volume.

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Rule out a Spinning Top with the high-low range well outside the range of the last bar.

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Rule out a Doji or Hammer with a high-low range shorter in length than the range of the last few bars, unless it falls on a major trendline or moving average.

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Rule out stocks that print Finger patterns every few bars.

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Avoid stocks that gap up or down into the signal.

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Avoid stocks that break obvious support or resistance on the signal.

4. HOLE-IN-THE-WALL - Gap downs after strong rallies signal a trend change. Classic gap theory rarely discusses countertrend gaps that occur at the end of a dynamic uptrend. Tops should take time to dampen buying pressure and roll over. But the Hole-in-the-Wall points to a single bar that signals a major trend change. The gap may look like a breakaway gap that appears without a major topping formation. The Hole prints suddenly and invites swing traders to look for low-risk short sales while the crowd still believes the uptrend is in progress.


H < L1 AND RSI14.1 > 40 AND RSI70.1 > 40 AND C > 7 AND AVGV50 > 1000 Components: •

H < L1

The current bar’s high is lower than the low of the prior bar. •

RSI14.1 > 40

Wilder’s Relative Strength Index set to a 14-bar period was greater than 40 one trading session ago. •

RSI70.1 > 40

Wilder’s Relative Strength Index set to a 70-bar period was greater than 40 one trading session ago.

•

C>7


AVGV50 > 1000


Filters: •


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Favor only the first down gap after an intermediate high.

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Favor stocks with selloff volume higher than the last few bars of the preceding rally.

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Favor stocks that break below the 20-bar and 50-bar Exponential Moving Averages but remain above the 200-bar Exponential Moving Average.

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Favor stocks with a wide gap range relative to the stock’s price.

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Favor stocks near their highs after a substantial rally.

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Favor stocks in which the gap breaks below obvious support.

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Rule out stocks that print Hammers or Dojis on the signal bar.

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Rule out stocks that drop into obvious support on the gap down.

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Rule out ADRs and other stocks that actively trade overnight.

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Avoid stocks that print a narrow range on the signal bar.

5. POWER SPIKE - High volume events print the future direction of price. Volume events reveal the will of the crowd. Power Spikes uncover several different scenarios where participation peaks and establishes an important market direction. The swing trader must identify which type of Spike prints before choosing an appropriate strategy. Some Power Spikes point to breakouts or breakdowns while others evolve into pivoting ranges, with price that swings across the level attained during the event.


((V >= 3 * AVGV50) OR ((V >= 2 * AVGV50) AND (V1 >= 2 * AVGV50))) AND AVGV50 > 1000 AND C > 7

Components: •

V >= 3 * AVGV50

The current bar’s volume is greater than or equal to 3 times the average of volume over the last 50 bars. •

V >= 2 * AVGV50

The current bar’s volume is greater than or equal to 2 times the average of volume over the last 50 bars. •

V1 >= 2 * AVGV50

The prior bar’s volume is greater than or equal to 2 times the average of volume over the last 50 bars. •

AVGV50 > 1000

Average volume for the last 50 bars is greater than 100,000 shares/bar. •

C>7

The current bar’s closing price is higher than $7.00.

Filters: •


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Favor stocks that trade over 3 million shares for the daily scan.

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Favor obvious breakouts and breakdowns.

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Favor stocks that move out of long bases.

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Favor stocks that reverse from tests of major highs or lows.

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Favor reversal bars after long rallies and declines.

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Rule out narrow range and inside bars.

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Rule out acquisitions and splits.

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Rule out stocks in 2nd or 3rd bars after breakouts or breakdowns.

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Avoid ADRs.

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Avoid signals within obvious congestion.

6. BEAR HUG - Weak markets drop quickly after rallying into resistance. The Bear Hug combines two specific patterns that flag impending low-risk short sales. The first searches the markets for stocks in major bear markets that rally into resistance and reach overbought levels. The second finds narrow range events with low relative strength and other criteria that favor downward price expansion out of a NR7 congestion. Each pattern requires a different strategy to maintain risk management and capitalize on the breakdown.


FIRST SCAN: C < AVGC50 AND AVGC50 < AVGC200 AND RSI14.1 < RSI14.11 AND RSI14 > 25 AND RSI70 > 50 AND C > 7 AND AVGV50 > 1000 SECOND SCAN (same as Coiled Spring): ((H - L) < (H1 - L1)) AND ((H - L) < (H2 - L2)) AND ((H - L) < (H3 - L3)) AND ((H - L) < (H4 L4)) AND ((H - L) < (H5 - L5)) AND ((H - L) < (H6 - L6)) AND C > 7 AND AVGV50 > 1000 Components: •

C < AVGC50

The current bar’s closing price is below the 50-period Exponential Moving Average. •

AVGC50 < AVGC200

The 50-period Exponential Moving Average is below the 200-period Exponential Moving Average. •

RSI14.1 < RSI14.11

The prior bar’s Wilder’s Relative Strength Index set to a 14-bar period is less than Wilder’s Relative Strength Index set to a 14-bar period 11 bars ago. •

RSI14 > 25


RSI70 > 50


C>7

The current bar’s closing price is higher than $7.00.

•

AVGV50 > 1000

Average volume for the last 50 bars is greater than 100,000 shares/bar. •

(H - L) < (H1 - L1)

The current bar’s range is narrower than the last bar. •

(H - L) < (H2 - L2)


(H - L) < (H3 - L3)


(H - L) < (H4 - L4)


(H - L) < (H5 - L5)


(H - L) < (H6 - L6)

The current bar’s range is narrower than 6 bars ago.

Filters: First Scan •

Sort output in descending order by current price vs. the 200-bar Exponential Moving Average. This represents the total point difference between price and the last value for the average.

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Favor stocks that rally into resistance after a selloff.

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Favor stocks with topping patterns at resistance.

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Favor stocks that show strong volume on the prior selloff and declining volume on the rise.

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Favor stocks that reach the 50-bar Exponential Moving Average.

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Favor stocks that gap down out of bear rallies.

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Favor stocks with adequate reward between current price and the major low of the prior selloff.

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Avoid stocks near oversold readings.

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Avoid stocks in long sideways congestion.

Second Scan •

Sort output in descending order by current price vs. the 200-bar Exponential Moving Average. This represents the total point difference between price and the last value for the average.

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Favor stocks in the lower 60% of the sorted listing.

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Favor stocks below the 50-bar Exponential Moving Average.

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Favor stocks below the center 20-bar Bollinger Bands.

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Favor stocks in tight sideways congestion after a selloff.

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Favor stocks with several inside bars after a selloff.

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Favor stocks with strong volume on the selloff.

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Avoid stocks that sit at obvious support.

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Avoid stocks near oversold readings.

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Rule out stocks in extended bases.

7. 3rd WATCH - Breakouts through triple tops signal major uptrends. The markets rarely break out on the first test of a prior high. 3rd Watch recognizes this double top failure and looks for strong stocks that exceed the old highs after another pullback. This classic setup flags major breakouts after well-defined bases as well as Cup and Handle events. 3rd Watch also works through all time frames and identifies intermediate opportunities in smaller congestion patterns or shortterm ranges.


V >= 1.5 * AVGV50.1 AND C > MAXC125.1 AND MAXC20.1 < MAXC105.21 AND C > 7 AND AVGV50.1 > 1000 Components: •

V >= 1.5 * AVGV50.1

The current volume is greater than or equal to 150% of the prior bar’s 50-period Volume Moving Average •

C > MAXC125.1

The current closing price is higher than the highest price of the prior 125 bars.

•

MAXC20.1 < MAXC105.21

The highest closing price of the prior 20 bars is less than the highest closing price of the 105 bars that precede them. •

C>7


AVGV50.1 > 1000

Average volume for the prior 50 bars is greater than 100,000 shares/bar.

Filters •

Sort output in descending order by current volume.

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Favor stocks that break out above a horizontal base.

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Favor stocks that close near the high of their range.

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Favor stocks that close above the intrabar high of the previous closing high.

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Favor stocks that close at all time highs.

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Favor stocks with deep pullbacks just prior to the breakout.

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Favor stocks that break above major trendlines.

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Favor stocks that print higher volume than the last 125 bars.

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Avoid stocks that rise into a trendline drawn through the prior highs.

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Avoid stocks that rise into any gaps from the last 500 bars.

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Avoid stocks with any down volume histograms in the last 60 bars taller than the current bar volume.

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Rule out stocks in mergers or acquisitions.

7-BELLS Examples and Images

FIG.1: MARKET EXPANSION-CONTRACTION: Look for markets to alternate between expanding and contracting price bars. This movement often tracks the underlying trendrange axis.

FIG.2: 3D CHARTING Smart traders watch their markets in more than one time frame. This 3-dimensional analysis recognizes that trends move independently of each other and may be in conflict at the time of trade entry.

FIG.3: MOMENTUM-SWING AXIS Positive-negative feedback tracks the expansion-contraction cycle. This follows the axiom that low volatility can only be replaced by high volatility, and vice-versa.

FIG.4: MOMENTUM OSCILLATION A reaction tends to follow every market action. Periods of strong trends respond with sharp pullbacks and countertrend movement. This wavelike motion sets up opportunity for the observant trader.

FIG.5: TREND-RANGE AXIS The markets alternate horizontal and vertical price movement. Most traders seek the vertical when planning their positions but good profits can be achieved by trading within the boundaries of narrow price ranges.

FIG.6: 38-62 PULLBACK SETUP An excellent pullback trade sets up when the 62% retracement of one trend leg matches the 38% retracement of another one. Look for cross-verification at these important price levels to increase the odds of a successful position.

FIG.7: FIBONACCI RETRACEMENTS Retracements are valid within all time frames but noise increases as chart length shortens. Expect more violations on 5-minute charts than daily ones. Try to find other intraday landscape features rather than relying on retracement alone.

FIG.8: EXECUTION ZONE AND TARGET Look for the optimum entry price through detailed analysis, and then plan your move by placing a small price zone in front of this execution target. When price enters the zone, focus your attention on the tape and short-term chart.

FIG.9: USING CROSS-VERIFICATION When strong trends pull back, look for landscape features that may offer strong support. A large crowd of hopeful buyers should be waiting when price gets there. But act quickly and stay defensive. These bounces often fail before they reach an old high.

FIG.10: INTRADAY VOLUME Avoid intraday volume readings unless a stock shows significant activity within each tick. These highly liquid issues print volume trends as faithfully on intraday charts as longer-term ones, except for a bias toward first and last hour action.

FIGS.11 and 12: TRADING WITH CANDLESTICK PATTERNS Hammer and Doji candlesticks uncover reversals that are taking place in the time frame below the candle. After one of these important signals prints, pull up a lower time frame chart and look for patterns that reflect the reversal and point to low-risk fade entry.

FIG.13: INTRADAY CANDLESTICKS The value of intraday candlesticks depends on the specific issue. Some stocks print multiple candle signals that have no validity. More liquid issues print more valid signals. Look for intraday candles with both greater range and greater volume to increase the dependability of short-term readings.

FIGS.14-15: EMPTY ZONE BREAKOUTS The best empty zone signals come at the NR7: the narrowest range bar of the last 7 bars. These narrow range plays come in many forms. Look for their influence on both daily and intraday charts. As with other short-term plays, highly liquid stocks make the best candidates for intraday Coiled Springs.

FIG.16: SHORT SALES The best short sales come in trades that avoid the short squeeze. Selling common declines sets up the trader for failure. Instead, look for hidden resistance (such as this parallel price channel) and enter short sales very close to natural barriers. Short sale profits depend on quick reflexes. Try to exit on expanding, downward price bars rather than waiting for the market to find support and bounce.

FIGS.17-18: SHORT SALES Sell short on pullbacks into strong resistance. Keep in mind that declining markets will violate resistance barriers more forcefully early in a downtrend. So look for well-established bear markets before choosing the short-sale entry level. Short sales on the intraday chart often carry less risk than the daily chart. Most short squeezes tend to occur during the first and last hours.

FIG.19: COILED SPRING SHORT SALES Use narrow range bars to reduce risk on the short sale. Enter before the breakdown with a tight stop loss on the other side of the bar. If proven wrong, the trade will stop out with a very small loss.

FIGS.20 SHOCK GAPS High volume gaps have an immediate impact on the charting landscape. When they occur against the prevailing trend, they set up strong conflict that opens the profit door for the observant trader. The Hole-inthe-Wall represents one such gap.

FIG.21: FIBONACCI AND GAPS Place Fib grids over new gaps to see where they fit into the charting landscape. They will often print right at significant retracements. For example a gap at the 50% retracement suggest an important change in trend during a pullback. Fibonacci also helps the trader to identify specific gap types, such as the breakaway, continuation and exhaustion varieties.

FIGS.22 and 23: HRE CLASSIC=3RD WATCH 3rd Watch uncovers many variations of the classic cup and handle pattern. These may form horizontally but can appear at many different angles. The most bullish formation has a slight downward bias. This allows strong tension to build before the breakout. Look for this fascinating pattern in all time frames. It is especially prevalent during the afternoon hours on intraday charts.

The Art of the Setup Syllabus for Traders Cookbook presentation International OnlineTrading Expo - Ontario, CA - August 2000

Some materials republished with permission from The Master Swing Trader © 2001 McGraw-Hill and Brooke Publishers. All Rights Reserved.

Swing traders study the charting landscape to measure the active environment and identify promising setups. They pick opportunities that match the current Pattern Cycles, implement thoughtful positions and respond quickly to changing conditions. They take small losses when proven wrong without hesitation or second-guessing. Defensive trade management guides their tactics, emotions and logic from initial planning through final profit taking. The crowd trades one step behind new opportunities throughout the Pattern Cycle. They first chase markets or buy dips through brief periods of strong momentum. But as a rally fades, this restless herd ignores the warning signs and throws money at failing patterns. Meanwhile swing traders see the evolving breakdown and change tactics quickly. They feed profitably on current conditions until herd survivors finally shift gears. This quickly closes off the new market inefficiency and forces them to again respond with fresh strategies to keep ahead of the crowd. On and on it goes. The seeds of change reveal themselves through repeating patterns. These signposts define characteristic crowd behavior at major Pattern Cycle intersections. They uncover classic market mechanisms that should resolve in a predictable manner and have consistent reward:risk profiles. They work through the force of herd behavior but lose their effectiveness when the crowd finally responds and catches up to the prevailing market direction. Opportunity has many faces. A few classic setups have captured the imagination of both traders and the media over the years. But charts exhibit dozens of other lesser-known, highly predictive formations. Since these patterns avoid the crowd’s common knowledge, they remain more dependable over longer periods than popular setups. They also require greater effort than the classic Double Top or esoteric Holy Grail. Swing traders must review endless charts, apply complex filters to lower noise and play only those formations that have the highest odds at any time.

Will the next 5 points be up or down? Charts often lack classic patterns to predict future price direction. But original formations still guide swing traders through the reward:risk minefield. Study the horizontal price bands that surround this last Novellus rally. Price fails at least 8 times in 5 months above the zone while Clear Air triggers more than 10 selloffs below it. This original pattern offers great danger for longs and good opportunity for shorts.

A very simple mechanism underlies all setup opportunity: patterns predict outcomes as they reveal the will of the crowd. Since emotional herd behavior drives a common will at key market intersections, patterns point to direction and time. Choose the right direction at the right moment and book a profit. Diverse crowds respond to different time frames and conditions. This allows predictable setups to print through all market cycles. The art of the setup has evolved considerably since the days of Dow and Livermore. Over the decades, modern gurus unveiled dozens of short-term strategies with many layers of swing and time analysis. These complex pattern and math-based signals now fill the market landscape. While futures gave birth to many of these ideas, their tactics have slowly migrated into hands of equity traders. As a result, large cap stocks now offer virtual index markets with highly skilled professionals competing for profit. Well-trained eyes will uncover both classic and original setups. The markets work through a finite number of directional forces. These induce similar chart formations over and over again. Some draw perfectly according to the blueprint seen in a textbook or web site. Others have never been catalogued but carry great predictive power. So how can the swing trader recognize these special patterns and apply effective strategies that capitalize upon them? The answer lies in their left-right brain interaction. Patterns represent archetypes of underlying crowd behavior. The artistic mind perceives this order instinctively through pure visual process. In other words, the pattern looks bullish or bearish but the swing trader doesn’t understand why at first. The scientific mind then joins the process and applies reason. It evaluates reward:risk through cross-verification, reviews the numbers and formulates a trading strategy. These logical tactics capitalize on the original setup as they respond to the vision of the artistic mind. The position moves into a measured profit or loss although the formation has never been named, categorized or compared to a book illustration.

Pattern Recognition Learn the classic setups first to recognize them instantly on any time frame chart. Then move on to more original predictive patterns. The 7-Bells present swing traders with the next level in pattern setups. These classic archetypes describe broad, predictable market forces that print through all time frames and offer outstanding trades. They fill in the missing space between the few well-known setups and the broad order of the Pattern Cycle. Develop the skill to recognize unique setups that don’t appear in print. Internalize how Pattern Cycles phase through different environments. Markets will draw many variations on better-known patterns at logical intersections between adjacent stages. Even simple reversals may morph into a variety of complex mutations that can offer substantial profits. First see if the pattern looks like a classic one. If so, list the potential differences in terms of underlying tendency and S/R mechanics. Then examine the broad formation to locate any natural ejection points. Consider execution when it organizes well in time, direction and breakout level. Many trading signals appear within the daily noise. But so do whipsaws and fakeouts. Filter all potential setups through their misinformation. Look for stop gun violations at key S/R barriers. Each one can desensitize enthusiasm or fear when price reaches that level again. Evaluate the sequence of highs and lows within the pattern. Do they carry a common message through a series of ascending or declining prices? Or does conflict pull the action into unexpected places? Check external forces for alignment with the setup bias. Avoid positions when they lack support from the broader market.

3 well-placed lines and a triangle draw a 12-point Xilinx profit. This simple pattern uses important rd elements of The Big W, 5-Wave Decline, First Rise, and 3 Watch. Yet the setup depends only on basic trendline interpretation and good timing. Original patterns that generate the most visual tension offer the greatest profit opportunities. Swing traders fail when they lose vision. The scientific mind assumes so much control that all charts start to look alike and excellent setups fade from view. Perfect patterns and indicators rarely print in the modern market environment. Learn to execute comfortably in a debris-filled landscape. Alternatively, don’t chase every crossover as a major signal or see meaningless price bars as textbook setups. When the eyes play unfortunate tricks, get away from the execution terminal and head for the beach until they can be trusted again. Pattern recognition does not work for everyone. Many western participants have great difficulty dealing with intuition and visualization. They will find far greater success if they build trading systems that rely on heavy math input and frequent back testing. Systems and discretionary trading do not mix well. If headed down the scientific path, abandon classic setups and rely on pure numerical output.

Managing Opportunity Good patterns never signal exactly when to trade or when to stand aside. They point to directional and time interfaces that will trigger predictable movement under the right circumstances. Swing traders must then formulate tactics that capitalize upon price change if it proceeds and protect them from loss if it fails. There is no single method to trade any pattern and no setup will evolve the same way twice. So the chosen strategy must capture expected opportunity while managing unexpected risk.

One good Adobe triangle deserves another. An overnight gap completes one triangle breakout and price action immediately draws an identical pattern. This invites many longs that missed the first move and hope for an easy profit. But the market has other plans. Professionals use this common formation to set up the crowd for failure and quickly shake out weak hands with a sharp decline. True direction reappears the next morning when price jumps back above the broken triangle and heads higher. Categorize each setup as original or classic. This predicts the level of public participation and whipsaw. For example, the odds for a pattern failure greatly increase when a large crowd sells the same Head and Shoulders setup. But a carefully chosen Dip Trip responds to basic tactics most of the time since the setup does not encourage a popular response. Shift strategy when a large crowd trades the pattern. Always consider going the other way if it fails or standing aside through the first whipsaw for the true direction to emerge. Enter an opportunity before its breaks whenever possible. Risk remains low until price finally expands. Swing traders can efficiently enter and terminate several low cost positions while they wait for a bigger move. But always keep one eye on the clock. Time eventually moves against a promising setup if it just sits there. Technical indicators start to roll over and the pattern quickly displays an unfavorable message. Choose entry levels wisely and exit immediately if conditions deteriorate. Exercise patience when a setup ejects without trade entry. Risk rises dramatically as a crowd joins the action and volatility expands. Shift execution tactics to pullback entry but be willing to stand aside if the market starts to run. A promising setup must stand on its own merits after a pattern break. The price expansion alters the reward:risk calculation and forces a realtime reevaluation. Execute on a low-risk pullback if this new analysis supports the opportunity. But consider that many good patterns only predict a single price swing and profit potential evaporates as soon as the move begins. Predefined strategies work well when setups print on daily bars and allow detailed evening analysis. But many excellent patterns suddenly appear in real-time during the intraday session. The swing trader must internalize these archetypes so that their midday appearance permits spontaneous action. Very short-term setups produce excellent short-term profits. But intraday charts exhibit much higher noise levels than daily charts. Don’t wait for perfect pattern alignment or good opportunities will be lost. Expect more stop gun extremes, trendline violations and dirty candle prints during the trading day.

Align intraday setups to natural time of day tendencies. For example, the middle of the day exhibits fewer pattern failures than the first or last hour. But 2 or 3-day setups that point to a first or last hour ejection can offer highly profitable opportunities. Some patterns work better in the intraday environment than others. Avoid those that depend on specific volume characteristics. Intraday bias ensures that false volume readings will confuse signals. Excellent setups never reduce the need for cross-verification. In fact, external elements of the charting landscape combine to define that pattern’s reward:risk. Breakout and swing levels should always correspond to other well-established support or resistance. Use multiple time frames to confirm that larger market forces align with the opportunity. Check major moving averages and indicator settings to uncover any divergences that could undermine the position.

Multiday setups improve results when they execute during specific intraday periods. This 3-day Qualcomm channel signals an impending breakout right near the session close. Last hour entry exits the next morning with a healthy profit as opening volatility favors an expanding market. Use time of day bias whenever possible to fine-tune setup decisions. Combine original and classic setups into a trading style that produces continuous profit opportunities. Look for these important patterns through all markets and time frames. Choose an appropriate strategy for each trade that defines low risk entry, profit targets and stop loss. Always consider the impact of pattern failure. When these setups eject in the wrong direction, they may offer a better reward:risk profile than the expected outcome.

2 Classic Applications The following patterns represent classic applications of trading science. Their persistence over the years establishes them as profit makers for many generations. Although the Head and Shoulders and 2B Top execute from the short side, both formations flip over to trigger effective bottom trades. Note that these applications seek to defensively manage risk at natural entry levels due to their popularity. Keep in mind that every good trade has more than one successful strategy. This presentation offers just a few fresh ideas to pick the market’s pocket.

HEAD AND SHOULDERS This well-known pattern presents a variation of the double top. The most obvious setup executes a short sale as the formation breaks the support of a lower trendline.

Description •

The lower trendline (neckline) may ascend, descend or lie at a horizontal angle on the price chart.

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The pattern forms a major high between two lower highs of equal height. The smaller extremes represent the shoulders while the taller one forms the head.

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The shoulders often rise to a 50% or 62% retracement of the major top.

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Volume should decline through each of the 3 highs but excellent trades still arise when price action violates this rule.

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The event should print near the end of a sustained rally.

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The pattern completes when price breaks down through the neckline.

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Avoid formations that appear near intermediate bottoms. These levels should produce upside down Inverse Head and Shoulders patterns.

The stock chart offers no clues to signal the pattern’s appearance until the neckline forms after the second low. The lower the slope of the neckline, the more bearish the pattern. Don’t rush to enter a trade as soon as the neckline breaks. Modern markets whipsaw these zones severely. The best entry comes after price pushes back above support during a short squeeze but then falls from its own weight back through the neckline.

Setup Tactics

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Nextel begins a double Head and Shoulders variation with an Adam and Eve top. Note that the second head takes almost twice as many bars to complete as the first one. This saps the remaining bull power in a highly efficient manner.

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First Failure draws a 100% retracement of the last trend leg and flags a possible Head and Shoulders. Draw a potential neckline (2) under the relative lows.

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Lay a Fibonacci Grid from the first low to the Head high. The left shoulder prints near 50% of the distance to the major high. Draw a horizontal line from the left shoulder (1) to target the expected height of the right shoulder.

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Watch the price action as it approaches the line to identify the expected reversal that forms the right shoulder (3). Drop down to the next lower time frame and review the trend that begins at the 2nd low. This will often show a clear reversal pattern in great detail.

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Look for bars to drop off the right shoulder at the same angle as the decline of the left shoulder.

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Measure the distance from the top of the head to the neckline (6) to estimate a target for the eventual break through the neckline.

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Draw intermediate S/R zones within the pattern (4) to estimate natural short squeeze levels. Use any reversal back below the line (5) as a sell signal.

Execution and Position Management

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The neckline (1) up close on a 60-min chart reveals many whipsaws. An aggressive trader can place a short sale limit order 1-2 ticks below the initial line break (2) but lift the order immediately if price pushes past it without entry. Do not chase the selloff under any circumstances.

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If filled, exit the trade immediately if price moves 1-2 ticks above the neckline.

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The 1st bounce after a neckline breaks will always show strength. Take the first direct downdraft and exit quickly. Save longer-term short sales until whipsaws (3) work their way through the system.

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Watch for price to pierce the neckline, rally into major resistance within the pattern and fall back below the line. This immediate sell signal takes out the early shorts and late buyers as it reveals the pattern’s true intentions.

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Avoid longer-term short sales until low risk opportunities appear. This strategy reduces profits when markets head straight down but avoids serious losses when they head straight up.

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Breakdowns often pause to build bearish congestion before a new trend continues. Wait for that smaller pattern to telegraph lower prices and then enter the market quickly. Note how the break of the rising NXTL trendline (4) signals lower prices. Use it for immediate entry.

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The decline ends just below 40. This level stands within a point of the initial target drawn from the top to the neckline.

Reward:Risk Swing traders face a constant whipsaw risk with this popular pattern. The safest positions rely on the shortest time frames. Price expands sharply each time that it falls back through the neckline. This powerful mechanism invites many profitable short positions. But short squeezes also ignite suddenly in this volatile environment. Profits must be taken quickly and without hesitation. Avoid longer-term short sales at the initial break. Look for both pullbacks and whipsaws to run their course before the market heads lower. Then wait for a clear signal of the next price break.

2B TOP This setup presents a double top variation that allows much earlier entry than the Head and Shoulders pattern. Low-risk short sales can execute as early as the first bar after price falls below a prior high.

Description •

The pattern begins as a failed test of the last high.

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Subsequent rallies to this price level do not reactivate this setup as the odds then favor a breakout to substantial new highs.

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Price must exceed the last high for at least one bar before it falls back below that level.

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The rise to the 2nd high should take more bars than the rise to the 1st high.

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Look for the test to print a candlestick shadow above the last high but a real body below it. These may draw Shooting Star or Doji patterns.

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Keep an oscillator active in the lower pane as price rises into the test. The indicator should roll over from an overbought state before the 2nd high prints.

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Flip over and apply identical setup rules to 2B Bottom reversals that appear at new lows.

Swing trade entry after initial failure depends on the topping pattern. Never expect an immediate decline to much lower levels since the 2B reversal falls back into congestion that must still be broken. Odds increase that the 2nd high will fail when the 1st high rises into a parabolic rally. Watch for heavy volume at the 1st high and much lower participation as price rises into the test of that level.

Setup Tactics

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Novell doubles in price in less than 3 weeks and prints a major high at 43. Note the deep pullback and small Descending Triangle failure before price pushes back into a test of the last high.

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Stretch a Fib Grid across the original rally (1) to locate S/R for the topping formation. The triangle pattern sits right on the 38% retracement.

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Use the Stop Gun low (2) to signal the eventual top breakdown.

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Track the rally into the 2nd high with a Stochastics or RSI oscillator. Watch for a rollover pattern right near the test. NOVL Stochastics prints a small double top (4) right at the reversal after falling from an overbought level.

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The stock breaks to a new high and closes with a bullish bar (3). But the next morning it gaps down below the old high.

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Drop down to the next lower time frame. That pattern exhibits a major Hole in the Wall reversal within the down bar. The first sell signal generates when the gap remains unfilled after the first hour of trading.

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Next support level after the gap sets up just below 40 (5). A second sell signal triggers when that trendline, horizontal line and market number all break together.

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Realign the Fib Grid to the 2nd high (6) and use that setting to study the topping pattern. Note how the shift moves NOVL’s support right to the 50% retracement.

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The longer trendline (7) breaks and pushes the selloff into the center Fibonacci retracements where it tests the congestion low several times.

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Look for simple swing opportunities within the congestion (8) or stand aside until the breakdown completes.

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The pattern finally breaks at 50% (9) but progress slows at 62% support. A sharp bounce develops (10) as Fibonacci works its magic again.

Execution and Position Management

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Many swing opportunities appear within the double top congestion. Most of these depend on real-time market access and a short holding period. As the pattern evolves, price approaches a final breakdown that allows broader position trades.

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Violation of the 62% retracement (1) finally signals the start of the new downtrend. Price takes out the old low and expands sharply. Sell the break with a tight stop on the other side of the 62% level. Execute close to the break point or pass up the trade. Remember that a 2B Bottom can reverse price quickly here.

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The sharp initial drop from the 2nd high predicts a possible Mesa Top reversal with a decline that prints at a Trend Mirror image to the prior rally. The collapse between 26 and 20 perfectly matches the December parabola through this level.

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The initial break pulls back to the 62% retracement (2) and generates a high-profit, low-risk short sale entry.

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The downtrend evolves into a descending Parallel Price Channel (3) that drops NOVL through a large First Failure (5) pattern that marks a 100% retracement of the major rally.

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The channel finally breaks and expands into a huge down gap (4) but the small violations on the last bar offer few clues to the overnight shock event.

Reward:Risk Swing traders risk frequent trend relativity errors with these evolving reversal patterns. Some believe they can short the entire decline by selling into the 2nd high. Others cheat themselves by taking a small profit when a little patience yields a much bigger one. This setup illustrates the importance of the charting landscape and the need to find all the hidden obstacles before trade execution.

Selected Slides from Ontario Presentation

1.

Markets use up many more bars drawing ranges than they do creating trends. That’s one reason why making money in the markets can be so difficult. Traders must apply all of their skills to answer one deceptively simple question: is the current market rangebound or trending?

2.

The Execution Target and the Execution Zone identify the two most important price levels watched by the active trader. The Execution Target defines that place in time and price where a promising trade setup suggests that a position should be taken. The Execution Zone surrounds the Execution Target and advises the trader to shift attention when advancing price enters its boundaries. The type of tape action and chart development drawn within this narrow space tells the trader whether or not to pull the trigger.

3.

The concept of fractals confuses many market participants. But they are as simple to understand as an echo in a mountain canyon. Price patterns tend to repeat themselves within smaller and smaller time intervals within individual markets. In this striking example, Global Industries draws a cup and handle breakout pattern. Look closely at the handle on the right side of the graphic. The chart draws a complete cup and handle structure within the larger handle.

4.

The markets have a very difficult time printing clean double bottom reversals. In many cases, they will first take out the old low and then reverse strongly. The 2B Bottom reflects this process in action. The best 2B trade entries wait for price to jump back across support. Look for a Hammer or Doji candle to confirm the trade. Set a stop loss under that low.

5.

The 2B Top flips over the price mechanics of the 2B bottom. Strong selling often greets price the first time that it attempts to take out a significant high. Short-sellers and shareholders that missed a profitable exit generate strong downward pressure on this first rally. Alternatively, traders should rarely sell the second test of a significant high. This “3rd rise” often leads to a strong breakout.

6.

The dip trade comes in many forms. For example, the Holy Grail has found its way into modern trading literature as a proprietary long-side strategy. But smart traders can apply many common variations on dip plays already in the public realm. Look for pullbacks to all types of support, including horizontal price levels, Fibonacci retracements and moving averages. This is where the crowd will appear to support a falling market.

7.

Some market gurus charge large sums for the secrets of price patterns that they “discovered” for your benefit. But the underlying master pattern provides the mechanics for all the formations that traders will ever find on price charts, including the ones that gurus are trying to sell you. Take the time to learn the common structure of these Pattern Cycles, rather than throwing money at a small market mechanism that appears to turn profits.

8.

This proprietary pattern looks very much like a pattern failure on a Head and Shoulders. The markets draw a finite number of patterns over and over again. These limited formations then act and react according to dependable rules of price development. Mastery of this simple concept allows the trader to successfully execute setups that few others will ever see.

9.

Cross-verification underlies all forms of price analysis. High-probability trades line up where many diverse forms of support and resistance intersect with each other. Start by overlaying a complex landscape of primary indicators on top of the price action. Well-chosen Bollinger Bands and moving averages pinpoint significant price development when combined with effective pattern analysis.

10.

Modern markets breathe through the expansion and contraction of price bars. The well-trained eye can quickly scan watch lists and identify stocks on the verge of price expansion. Look for variations of flags and triangles to uncover most of this new opportunity. Never assume the direction of a breakout until price bars signal the event. Often a sudden move in the direction opposite to the formation’s natural bias will yield the best trade.

Mastering the Setup

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