Secrets to Predicting Market Direction

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Tren Tra ng In c ator s Copit © 2011 b Jon Peson Publise b Maetplace Boos

TABLE OF CONTENTS

All its esee.

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Intoucon 3

further informaon should be addressed to the Permissions Department at Marketplace Books. This publicaon is designed to provide accurate and authoritave informaon in regard to the subject maer covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounng, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. From a Declaraon of Principles jointly adopted by a Commiee of the

Capte 1 : Seasonal Analysis 4 Capte 2 : Pivot Point Analysis 8 Capte 3 : Commitment of Traders Report 16 Capte 4 : ADX as a Trend Strength Indicator 23 Capte 5 : Stochascs & MACD 27

 American Bar Associaon and a Commiee of Publishers. Charts created using TradeStaon ©TradeStaon Technologies, Inc., 2001 2011. All rights reserved. No invesng or trading advice, recommendaon or opinion is being given or intended. TD Ameritrade, Inc. and John Person are separate and unaliated compa-

Capte 6 : Moving Averages 33 Capte 7 : Dow Theory 43 Capte 8 : Volume & Open Interest 48

nies and are not responsible for each others services or policies. This book, along with other books, is available at discounts that make it realisc to provide it as a gi to your customers, clients, and sta. For more informaon on these long lasng, cost eecve premiums, please call us at (800) 272-2855 or you may email us at [email protected]. eISBN 978-1-59280-461-0 978-1-59280-461-0

Capte 9 : Trend Lines 52 Capte 10 : Ellio Wave 56 In Closin 62

Tren Tra ng In c ator s I

Introduction

the most important trend trading

In addion, I will share techniques

and booms. As a result, their

concepts that many traders seem

on how to correctly apply trend

trading careers end quickly. quickly.

to either not know or completely

line analysis and integrate mul-

forget to incorporate when execut-

ple meframe techniques. I will

ing investment decisions using real

also show you some of the more

money.

reliable technical indicators for

1. Seasonal and intermarket

Pon fom Ten Analsis “The trend is your friend”  In simplest terms, trend is dened

analysis 2. Tradional trend line charng techniques 3. Technical indicators

helping to idenfy trend market condions.

It is a proven fact that more successful traders wait for a trend to be established and then try to prot by trading on the right side of the direcon of that price move for an extended period of me.

As the saying goes, “the trend is

The trick here is to stay disciplined

your friend”—unl the trend ceas-

and focused, but many trend fol-

es to exist. Many traders in the

lowers understand the signicance

course of their careers have tried

of seasonal analysis and they let

as the direcon of price over a

Many investors are familiar with

to idenfy when a trend ceases

historic data help them gauge how

period of me. There are many

the axioms, “sell in May and go

to exist and to capitalize on that

long they expect a trend to last.

techniques that can be used to

away,” or perhaps, “harvest lows

reversal. This is oen referred to

trade with the trend. Most prot-

are made in the fall,” but they fail

as ancipang a trend reversal, or

able longer-term traders choose to

to either adhere to their game

top or boom picking. While it can

trade in the direcon of the trend

plan or follow through with apply-

be extremely lucrave if you are

while intermediate-term traders

ing seasonal tendencies of sup-

right, unfortunately unfortunately very few trad-

will trade the longer-term trend

ply and demand funcons of the

ers are successful at picking tops

against pullbacks in the intermedi-

markets. I plan on sharing secrets

ate term me frame. Short-term

that I have also wrien about in

traders or daytraders will also

my second book Candlesck and 

use pullbacks against longer-term

Pivot Point Trading Triggers, Triggers, as

trends but may also incorporate

well as in the Commodity Trader’s

countertrend techniques in their

 Almanac,, which I co-authored with  Almanac

trading decisions.

Je Hirsch, so please consult either

This guide is designed to introduce you to what I consider three of 

of these tles if you wish to go further with your studies on trend.

Some of the most technically advanced studies are applied to trend trading. As I menoned, one of the simplest forms of analycal studies is understanding seasonal analysis. More complex analysis that I will introduce in this book

 In simplest simplest terms, terms, trend is i s dened as the direction of price over a period of time.

Tren Tra ng In c ator s includes pivot analysis, Ellio wave studies, and then going back

1

to the turn of the 20th century,

Seasonal  Analysis

the concepts of “trend phases” introduced by Charles Dow. All of  this will help you in your decisionmaking process for not only entering trades but also holding onto your trades. I was taught early on, nearly thirty years ago, to cut your losses short and let your winners ride. Understanding and applying

T

he key to achieving wealth by trading the markets—other than being on the right side of the

trend—is trend—is good risk management and being properly posioned in a trade. It is crucial that the individual individual trader fully comprehends the psychological impact trading has on one’s own psyche,

and more importantly, understanding understanding how very lile predictability there is in the market. That is where

some of these principles in this

seasonal analysis can help prepare traders and investors for what lies ahead, and when shis in supply

book will not only shed light on

and demand funcons can reverse or help accelerate trending market condions. I believe this book will

how to do that, but we will also

help you to successfully formulate a solid plan of aack in market trends.

share with you where you can acquire further educaonal material in order to master the techniques that many have acquired through the last half century. All the best, John L. Person

If the trader is armed with the right knowledge and can implement the applicaon of good, sound technical analysis methodology to help me entries, exits, as well as to establish risk and prot objecves, the odds of success can be improved immensely. Seasonal analysis analysis gives investors and traders an edge in capturing that elusive “predictability of the markets.” What many traders do not realize is that most markets demonstrate seasonal price paerns; meaning they tend to make highs or lows near the same me period year aer year. Stocks, commodies, and even foreign currencies have a strong tendency to demonstrate seasonal patterns. One of the greatest benets of incorporang seasonal analysis is being able determine when a market is in a weak or strong trend and me changes in the trend's direcon. The art of using history as a guide to predict future price moves is absolutely a mind-blowing experience, especially when you are able to prot from that knowledge. However, if it were that simple and reliable, reliable, everyone would be doing it, and every trader would be geng rich, and quickly. Unfortunately, Unfortunately, this is not the case.

Tren Tra ng In c ator s Seasonal analysis cannot forecast

banks’ massive prinng of curren-

to break down the cumulave

tunity. If, for example, I see a

the outcome of each trade. Trend

cies. In addion, government de-

prots, which aids in the decision-

decent risk/reward opportunity

moves from a seasonal perspecve

cit spending was out of control.

making process.

of perhaps a three to one setup, I

can either be muted or magnied,

Therefore, gold was being bought

depending on economic turmoil,

by any and all avenues of invesng

polical events, monetary and s-

perspecves.

cal policy (smulus) changes, and weather concerns that will impact supply and demand parameters. There are always unique events

may diversify posion taccs.

sis helps me as a trader: I am

In the case of this bullish seasonal

constantly scanning for trading

trend in gold, instead of loading

In the Commodity Traders

opportunies. We all know we

up on a long futures posion, or

 Almanac, 2010 Edion, Edion, I highlight-

can not take every trade, so there

 just buying into a bullish opon

ed one of the top seasonal trades

must be a ltering process to

strategy, I usually look to diversify

in August for gold:

help us decide which trade has a

my posion in a bullish trend situ-

higher probability, and then we

aon such as spreading my trad-

that will aect certain markets or sectors. A specic company can inuence prices.

Here is where seasonal analy-

can look at the risk to reward lay-

ing capital around. I may look to

“Seasonally, this is a strong

out. I like to look for a good fun-

buy a highly correlated gold stock,

 price period for gold unl late There are many mes when the

damental situaon and a market

and I will look at a near-the-money

September or early October. Look 

macro economic environment will

that has a proven track record of 

credit call spread in the exchange

to enter long posions on or 

enhance a seasonal situaon. Let’s

somewhat high level of predict-

traded fund (GLD). At the same

about August 25 and holding unl 

examine a case study using gold.

ability based on its past trading

me, I might expand my risk capi-

September 30. In the last 34 years

By August of 2010, the market was

history. I like to plan ahead, and

tal and look at a slightly out-of-

this trade has worked 20 mes for 

using seasonal analysis helps me

the-money short term credit put

in turmoil over whether or not a

a success rate of 58.8%. The last 

double dip recession was in the

in that process. I can start a shop-

spread opon posion. Finally, I

8 years have provided an amazing

making. Gold had been in a strong

ping list so-to-speak for which

might just take a reduced hold-

cumulave prot of $20,160 per 

uptrend as it was acng on its own

sectors enter a period of strength

ing of a long futures posion. This

 futures contract.”  contract.” 

or weakness, and based on my

way I am diversied in my actual

criteria, I can lter out which

trade, which can help me survive

areas to focus in on rather than

or take advantage of mulple out-

acng aer a market has already

come scenarios, whether the trend

moved. In addion, I can start

of gold connues sharply higher,

Seasonal analysis can not only

to lay out how much equity and

mildly higher, stays at, or drops

help dene when a trend move

which strategy I want to employ

rst and then takes o.

may take place, but can help one

to take advantage of the oppor-

merits, meaning there was global consumer demand and investment demand as many enes were looking at gold as a hedge against not only deaonary fears, but as a defense against longer term inaonary fears, due to central

USINg SEASONAL ANALySIS AS A FILTEr

Tren Tra ng In c ator s I think many traders get the mar-

the seasonal tendencies. The same

ket trend right at mes but fail in

technique enables traders to man-

their sense of ming and perhaps

age their risks more appropriately

over-posion themselves for a

rather than going “all in” in one

trade. Then, when a slight move

large overleveraged posion.

occurs against them or a draw-

Figure 1.1 is a seven-year average

down happens, as is oen the case

of gold’s price moves taken as of 

in the real world of trading, they

the end of April 2009. Noce that

can’t aord to hang on. This oen

between the August low and the

results in a loss, or they miss the

September low, the average of 

move enrely. enrely. An old saying of 

those lows would come in around

mine that may resonate with you if 

August 25.

you have had experience in trading markets: “The market will always

The seasonal analysis indicates

let you in the losers; the mar-

that this uptrend should connue

ket’s job is to keep as few winners

through the end of September

around as possible.” Diversifying

into early October. On average,

your trend trading strategy may

the market conducts a shor t-

help you overcome this issue.

term prot-taking prot-taking correcon or a trend reversal in the third week

One has to remember that his-

of October to the rst week of 

tory can and does repeat itself; the problem is the outcomes

rather sideways, sll adhering to

We have many scenarios that could

are not always the same. Let me

a seasonally strong period. Rather

unfold, so I believe a more pru-

explain. Perhaps the market is bull-

instead of moving up in value, it

dent, well-balanced trader can and

ish; it could move at lightning bolt

 just remained the same. Now of 

should diversify his or her posion

speed to the upside, not allowing

course there are the few mes

based on many dierent outcomes.

one to enter in a posion. Or the

when the market will not perform

By employing dierent strategies

market could move higher, but

according to its past historic sea-

with the same risk capital, one can

only by a small percentage. percentage. Or the

sonal tendency and moves down

sll prot handsomely if the mar-

market may not move higher but

against a long posion.

ket does indeed move according to

November. Aer that, gold prices have the best three month bullish trend period from November lasng into late February. Shor tterm traders can potenally experience a period of approximately ve weeks of stronger prices from August 25 through October 1.

Tren Tra ng In c ator s A quick review of recent history

traders uncover when the best

The graph shows the weekly

It was the next trading session

shows from the low made on

me of the year—on year—on average—a

Person Pivots overlaid on the

where the move really started to

August 25, 2009 at 950.60, gold

market trend can occur, either up

charts, and you could see in the

accelerate.

peaked by October 14, 2009 at

or down.

Commodity Traders Almanac, it

1079.50. 1079.50. Two weeks later it corrected to a low of 1034. Back on August 25, 2008, gold traded as low as 835.6, but it did take heat and fell further, rst to a low of  754.3 by September 11. However by October 11, just four weeks later, later, gold made a sharp rally, posng a high of 889.5. A diversied trader may have ridden the storm out beer than a fully vested, long, futures-only posion trader. On a side note, that high

Take a look at Figure 1.2, which is a daily gold chart for 2010. As you can see, prior to August 24, the trend was up.

stated, “Look to enter long posions on or about August 25.” The market made a correcve pullback on August 24, trading right down to the predicted support targets.

If you did not act on the 24th, but rather waited unl the 25th of  August to enter a long posion, you obviously would have had a beer advantage from a risk/ reward perspecve. This is where employing various bullish strategies would be instrumental, and help one become a more complete, well-balanced, diversied trader trying to capture a strong trending and strong bullish seasonal market condion.

made in October 2008 reversed

Buying on the close of business

hard in just 11 trading days, post-

and holding as of the date of this

ing from peak of 950.80 to a

wring, gold surged to a high of 

trough of approximately 695.50,

1288 by September 21. As of the

over a 250.00 dollar correcon

close the market, gold was at

per ounce of gold.

1279.50. Seasonal analysis was

I menon this to support my previous statement that not all years are created equal from a seasonal perspecve in both the exact me of markets’ moves and in price swings. The key to focus in on is that seasonal analysis can help

instrumental in helping to dene a strong trend condion and therefore one may have enhanced trading performance. Even if you did not catch this trend, at the very least, seasonal analysis alerted you to a high probability situaon that

Tren Tra ng In c ator s may have kept you from trading on the wrong side of the market. Or as we say, ghng the trend. In addion to helping pick out a trend condion, seasonal analysis is absolutely instrumental in idenfying when a trend may cease to exist, and that is also a very valu-

QUICk QUIz 1. Wat is te e to aciein wealt b tain te maets? maets? a. Being on the right side of the trend management b. Good risk management c. Proper trade posion . All of the above

able piece of market knowledge, because one needs to be able to take prots in this business. In the remainder of this ebook, we will delve into more techniques to aid traders in idenfying trends and how to tread on the right side of the market.

2. Wat tpes of secuies emonstate seasonal paens? paens? a. b. c. .

Stocks Commodies Foreign currencies All of the above

3. Seasonal pice paens sow tat most maets mae is o lows nea te same me peio ea ae ea. a. True b. False

2

Pivot Point  Analysis

T

his chapter is devoted to my favorite technical tool, pivot points.. This is a tool that many traders either misuse or points do not understand enrely. I use pivot point analysis to

help conrm the market trend, or condion whether it is bullish or bearish. Then, I use the integrated formulas to project under those assumpons as to what the next me periods’ range might be. In addion, I use pivot analysis to conrm at what price level a potenal trend reversal level might be. As traders, we think about what more one wants than to stay with the trend, correct? Well, traders also need as much help in seng risk targets as they do prot targets. Pivot analysis helps me achieve both of these goals. This chapter will describe in full detail the principles behind the mathemacal calculaons as well as the raonale behind

4. Seasonal analsis can elp peict te outcome of eac tae. a. True b. False Fo te answes to tis qui, o to TaesLiba.com/TLEcone.. TaesLiba.com/TLEcone

the psychological impact that drives traders to make decisions around these levels. I will break it into separate secons to explain how it can be applied for idenfying support and resistance levels in trending market condions. This technical tool works for short and long term trend traders. It can be applied for stocks, futures, and in the foreign currency arena. Each investment vehicle has its own

Tren Tra ng In c ator s nuances, such as trading session

feel compelled not to learn about

all market parcipants’ collecve

a given session out of fear that

hours, me periods in which vol-

them because they seem compli-

percepon of value for that me

they would lose more by stay-

ume ows change, contract sizes,

cated. I will dispel that myth.

period. I want to quote the famous

ing in a long trade; they certainly

legendary trader Jesse Livermore, Livermore,

will respect that price point the

who stated nearly seventy years

next me the market trades back

ago this observaon: “The pat-

at that level. So the high and low

terns the traders and technicians

are important reference points.

observe are simply the reecons

With that said, pivot point analy-

of human emoonal behavior.” It

sis incorporates the three most

rings as true today as it did then.

important elements—the high, the

and decimal point placement so that you know how to correctly calculate the pivot point levels. First, you need to know the foundaon of the methodology of pivot point analysis; this will then allow you to apply it to the specic markets of  interest that you are trading.

POWEr OF PIvOT POINT ANALySIS

In my rst book, A book,  A Complete Guide to Technical Trading Taccs, Taccs, I illustrated many trading methods that one can apply using pivot point analysis with candlescks paerns, including the power of  mulple me frames, or what is know as conuence of various

The range, which is the high and

target levels. This chapter will

low of a given me period, accu-

highlight those techniques as well

rately reects all market parci-

low, and of course, the close of a given trading trading session. The most common formulas are:

as explain how to lter out and

pants’ exuberant bullishness and

Piot Point: the pivot point is the

The power in using pivot analy-

narrow the eld of the respecve

pessimisc bearishness for that

high, low, and close added togeth-

sis is that the strategy works in

support and resistance numbers

trading session, whether it is a day,

er and divided by three.

all markets that have established

and divulge various formulas that

a week, or a month. The high and

ranges, based on signicant vol-

are popular today.

low of a given period is certainly

ume or a large group of collecve parcipants. Aer all, the current market price equals the collecve acon of buyers and sellers. Pivot point analysis is a robust, me-tested, and best of all, tesable form of market analysis. This means that you can backtest to see the accuracy of this tool’s predicve analysis. The really unbelievable aspect of pivots is who uses them. In fact, many traders

P=(h+L+C)/3

important, as it mirrors human resistance 2: R2 is the pivot point

WhAT IS PIvOT POINT ANALySIS?

emoonal behavior.

Pivot point analysis is a mathemat-

a reference point for those who

ical formula designed to determine

bought out of greed thinking

the potenal range expansion

they are missing an opportunity.

based on a previous me period’s

They certainly won’t forget how

resistance 1: R1 is the pivot point

data, which includes the high,

much they lost and how the mar-

number mes two minus the low.

the low, and the close or sele-

ket reacted as it declined from

ment price. These variables from

that level. The opposite is true

a given me period’s range reect

for those who sold the low of 

number plus the high and minus Think of it this way: the high is

the low. r2=P+h-L

r1=(P2)-L

Tren Tra ng In c ator s Suppot 1: S1 is the pivot point

number mes two minus the high. S1=(P2)-h Suppot 2: S2 is the Pivot Point

number minus the high plus the low. S2=P-h+L

resistance 3 = h + 2 (Piot  – Low) Suppot 3 = L – 2 (hi – Piot) O r3 = (P-S1) + r2 S3 = P- (r2 - S1)

Some analysts add a third level to their pivot calculaons to help target extreme price swings on what has occurred on occasion, such as a price shock resulng from a news driven event. Currency mar-

resistance Leel 3

sively higher me period’s price

This is an extreme bullish market

support or resistance projecons.

condion generally created by

For example, from the daily num-

news-driven price shocks. This is

bers, I would look at the weekly

where a market is at an overbought

gures and then from the weekly

condion and may oer a day trad-

numbers, I would look at the

er a quick reversal scalp trade.

monthly numbers.

resistance Leel 2

There are other variaons which include adding the opening range.

ThE NExT LEvEL

I believe in looking at the progres-

In this case, that would involve simply taking the open, high, low, and close and dividing by four to derive the actual pivot point.

The longer the time  frame, the more more important or signifs ignificant the data.

P = (O, h, L, C) /4

We see this level when there is a bullish market market price objecve or target high number for a trading session. It generally establishes the high of a given me period. The market oen sees signicant resistance at this price level and

It is rare that the daily numbers

kets tend to experience a double

PrICE ACTION rEACTION

dose of price shocks, as they are

Let’s see what these numbers

or S2 numbers and when the mar-

exposed to foreign economic

mean and how price acon reacts

ket does, it is generally in a strong

developments as well as U.S. eco-

with these projected target levels.

trending condion. In this case,

nomic developments that pertain

Here is how the numbers would

we have methods to follow the

to a specic country’s currency. currency.

break down by order, what typi-

market’s ow, and we will cover

This tends to make wide trading

cally occurs, and how the market

this in more detail in the next few

ranges. Therefore, a third level of 

behaves. Keep in mind, this is a

secons. By focusing on just a few

projected support and resistance

general descripon and we will

select numbers and learning how

can be calculated. calculated.

learn what to look for at these price

to lter out excess informaon,

points to spot reversals in order to

I eliminate the analysis paralysis

make money and reduce risk.

from informaon overload.

will trade beyond the extreme R2

will provide an exit target for long posions.

resistance Leel 1 This is a mild bullish to bearish projected projecte d high target number. In low volume or light volality sessions, or consolidang trading periods, this oen acts as the high of a given session. In a bearish market condion, prices will try to come close to this level, but most mes will fail.

Tren Tra ng In c ator s Piot Point

sees signicant support at or near

Here is how I ulize me frame in

sense. If the exchanges and the

This is the focal price level or the

this level in a bearish market con-

my research. There are approxi-

banking system use a specic me

mean, which is derived from the

dion and it is a likely target level

mately 22 business days, or about

to sele a market, then that is the

collecve market data from the

to cover shorts.

four weeks in any given month.

me period that should be consid-

Every month there will be an estab-

ered for a close. They should know

prior session’s high, low, and close. It is the strongest of the support

Suppot Leel 3

lished range—a high and a low.

those are the rules that make

and resistance numbers. Prices

In an extremely bearish market

There are typically ve trading days

money move. I want to follow the

normally trade above or below

condion, this level will act as the

in a week. Now consider that in

money ow.

this area before breaking in one

projected target low or support

one day of one week in one month,

direcon or the other. As a gen-

area. A price decline to this level

a high and a low will be made. It

eral guideline, if the market opens

is generally created by a news-

is likely that this high and low may

above the primary pivot, be a

driven price shock. This is where a

be made in a minute or within one

PrEdICTINg hIghS ANd LOWS USINg ThE CALCULATIONS

buyer on dips. If the market opens

market is at an oversold condion

hour of a given day, of a given week

I believe in keeping things simple,

and may oer a day trader a quick

of that month. That is why longer-

and that less is more. I use the

reversal scalp trade.

term me frames such as monthly

numbers and the ltering method

or weekly analysis should be includ-

to help me select either the high or the low of a given trading ses-

below this level, look to sell rallies.

Suppot Leel 1 This level consists of a mild bearish

vALUE OF TIME FrAME

ed in your market analysis.

to bullish projected low target num-

Daily, weekly, weekly, and monthly me

In the world of 24-hour trading,

sion, and somemes this works to

ber in light volume or low volality

frames can and should be ulized,

the most popular queson I get

project both the high and the low

sessions, or in consolidang trad-

as well. To understand how price

from those studying and using

with amazing accuracy. Therefore,

ing periods. Prices tend to reverse

moves within the pivots, begin by

pivot points is: “What are the

it is important not to be bur-

at or near this level in bullish mar-

breaking down the me frames

mes that you derive the high,

dened with informaon overload.

ket condions, but most mes fall

from longer term to shorter term.

low, and close informaon?”

Remember:

short of hing this number.

As traders, we should begin with a

There are many dierent people

•

monthly me frame, where there is

Suppot Leel 2

a price range or an established high

At this level, we nd a bearish

or low for a given period and this

market price objecve or targeted

range, including its price points.

low number. The market oen

Pivot point calculaons help

telling many dierent stories. Here

determine when to enter and

is what I do and what seems to

exit posions.

work the best for me. For starters,  just keep things simple and apply some good old-fashioned common

•

They help as a leading price indicator for traders.

Tren Tra ng In c ator s •

Pivot points are used to proj-

not be applicable in most cases

This number represents the true

the preceding me frame. If they

ect support and resistance or

two, three, or four days later.

value of a prior session. In an

are, then to help lter out unnec-

uptrending market, if the market

essary informaon or excessive

gaps higher above the pivot point,

support and resistance numbers

then a retracement back to the

on my charts, I use the actual

pivot will aract buyers. Unl that

pivot point up to the R1 number

pivot point is broken by prices

for resistance, and then I target

actual highs and lows of trading sessions. •

•

The same principle goes for the weekly and monthly calculaons,

They help conrm other tech-

so at the end of that me period,

nical methods.

new data must be recalculated. recalculated.

Daily, weekly, and monthly

If in a given trading day, the mar-

trading below that level, traders

the S2 for the potenal low for

me frames can and should be

ket goes through my daily target

will step in and buy the pullback.

that me period’s trading range.

used.

numbers, the importance of the

Have you ever heard of the phrase

weekly and even monthly numbers

“if bullish, buy breaks”? Well, using

is what gives me an indicator for

the pivot point as a price level to

the next major target levels of sup-

buy helps traders dene at what

port and resistance.

price a break might occur.

In every week, there are ve trading days. In every month, there will be an established range—in other words, a high and a low. In one day of one week in one month, a

As you can see in the Figure 2.1, if  I determine the market is bearish, and if I understand the relaonship of the geometric distance of  the resistance and support targets,

The opposite is true in an extreme-

I can eliminate the R2 number,

ly bearish market condion; the

since in a bearish environment we

high and a low will be made.

USINg ThE ACTUAL PIvOT POINT

It is likely that the high and the low

pivot point will act as the target

should see a lower high. If I am

I use the actual pivot point for

will be made in a minute or hour

high for the session. If a news-

looking for a lower low, then I can

many things. For example, it is

of a given day of a given week in

driven event causes the market to

eliminate the S1 support number

important to understand that

that month. That is why longer

gap lower, traders will then access

as well, and now I have reduced

the pivot point can be used as an

me frames such as a monthly or

the news. Once prices come back

the eld to just three numbers.

actual trading number in deter-

weekly analysis should be used.

up to test the pivot point, if the

mining the high or low of a given

market fails to break that level

me period, especially in strong

and trade higher, sellers will take

cic me frames for determin-

bull or bear market trend con-

acon and start pressing the mar-

ing support and resistance levels

dions. In an extremely bullish

ket lower again.

for that parcular ming element

trend condion, the pivot point

only, and infers that the analysis or

can become the target low for

Technically speaking, in a bearish

that trading session.

market, the highs should be lower

Pivot point analysis relies on spe-

calculaons for the prior day will

and the lows should be lower than

Once again, I am not using the numbers to place orders ahead of  me (even though you could); I am using the numbers as a guide. These numbers work so well and oen act as a self-fullling prophecy because so many instuons and professional traders do use

Tren Tra ng In c ator s

them. Many hold dierently sized posions, and some traders may not wait for the exact number to hit. Instead, they may start scaling out of  posions (as I do). With this method, you can use these numbers as exit areas on your trades. As Figure 2.2 depicts, in a bullish market environment, by denion, the highs should be higher and the lows should be higher than the preceding me period. When I have determined that we are in a bullish trend, I target the S1 up to the pivot point for the low of  the session and the R2 for targeng the high. This will give me an idea of  what the potenal trading range will be. Take a look at Figure 2.3. It is a 15-minute chart using all ve pivot calculaons. We have a mid-point number which is the pivot point, with two upside resistance levels, and two downside support targets. I have a week’s worth of data starng from Wednesday Wednesday through the following Wednesday close. This chart is from thinkorswim thinkorswim by TD Ameritrade using the Person's Pivot indicator.

Tren Tra ng In c ator s

Using a ltering method as shown

LONgEr TIME FrAMES

in Figure 2.4, we eliminated the

When the market goes through the

excess support and resistance

projected daily target numbers,

lines, so now we have one resis-

I use the longer me periods to

tance and one support target

give me the next reliable price

level. Doesn’t this eliminaon pro-

objecve. That is where the

cess give a beer picture of what

signicance of the weekly and

may have happened as opposed

monthly numbers comes into play.

to what the real results were?

Take for example the weekly chart on the S&P 50 0 Exchange Traded Fund (SPY) in Figure 2.5 using the

monthly pivot levels. Noce when

the monthly pivots were projecng

the market was in a bearish trend

higher highs and higher lows? Not

in late 2008, the actual target

only can pivot point analysis help

levels were projecng out a lower

keep traders on the right side

high lower low scenario. Then, as

of a trending market condion,

the market reversed in a bullish

the support and resistance

trend throughout 2009, see how

target levels help navigate price

Tren Tra ng In c ator s Now here is where combining dierent me frames can be most useful. As you look at Figure 2.7, you will see the e-mini S&P 500 futures with the weekly and daily pivot levels. What I like to look for is what I call a conuence, or a synchronized setup of various me frames within a trend. For example, let’s say we are in a higher degree me frame bullish trend and the market pulls back to the weekly support. I also like to see a daily support level coincide with that weekly pivot support for a low-risk buy

extremes, allowing allowing one to set entry and exit orders according to the market price direcon. For those interested in commodies, the graph in Figure 2.6 is a daily price chart of crude oil futures with a weekly pivot analysis displayed. displayed. As you can see, the pivot levels recalibrate and give not only a conrmaon reading that the market is bullish by displaying higher highs and higher lows, it does so with exact pricing.

Tren Tra ng In c ator s setup. Noce the price acon on September 23, 2010. The market pulled back to the weekly support level (pink) and that day’s daily pivot (green) (green) coincided at the same level. As the day progressed, traders could not take the market any lower and by the end of the day, the longer-term ger-term trend stayed intact as prices connued higher. higher. By idenfying the support targets in advance, one was keen to the idea to at least look to “buy the dip,” or at the very least, not sell at the low of a retracement.

CONCLUSION Pivot point analysis is a valuable trading tool. Of course, there is no holy grail of indicators, but combining correlated technical tools to help you plan your trades will certainly give you

QUICk QUIz 1. Wat is piot point analsis? a. A mathemacal formula designed to determine the potenal range expansion based on a previous me period’s data. determining when to get into b. A system for determining a trade. c. An exit-planning technique. . All of the above 2. Wat is te most impotant element to piot point analsis? a. b. c. .

The high The low The close All of these points are vital to pivot point analysis.

an edge in the markets, especially if you are looking to trade both with a trend and looking

3. Te basic fomula fo te piot point is:

for clues as to when or at what price level the

a. b. c. .

trend may end. If you are interested in furthering your educaon on the use of pivot point analysis, analysis, including how to construct a trading methodology using a pivot point moving averaverage, take a look at my home study course from Traders’ Library, Candlescks and Pivot Point  Strategies.. Strategies

P+H-L (P x 2) – L (H + L + C)/3 (P x 2) – H

4. To unestan ow pice moes witin te piots, eamine me fames fom: a. Longer term to shorter term b. Shorter term to longer term Fo te answes to tis qui, o to TaesLiba.com/TLEcone.. TaesLiba.com/TLEcone

3

Commitment of Traders Report

T

here are many indicators and technical tools that can be used to help gain an edge in the market, espe-

cially in idenfying the strength of a trend, or more importantly, helping to me a trend reversal. You may be familiar with my “Person’s Pivots” and proprietary buy and sell signals, but believe me, I use other indicators and this chapter is focused on the “grand-daddy” of the consensus or contrarian indicators. indicators. I have been using this indicator since my start in the industry as a commodity trader back in the early 1980s. The tool I am talking about is none other than the C ommodity Futures Trading Commission (CFTC) Commitment of Traders report (COT). The data is like an insider informaon report, but it is legal. It acts like a true consensus of who literally “owns” the market. A trader can use this data to determine if market parcipants are too

Tren Tra ng In c ator s heavily posioned on one side of 

gate of all long open interest is

ons are added to the trader’s long

ally represents 70 to 90 percent 

the market in a long-term trend

equal to the aggregate of all short

and short futures posions to give

of the total open interest in any 

run, especially when we are enter-

open interest.

‘combined-long’ and ‘combined-

given market. From me to me,

short’ posions. Open interest, interest, as

the Commission will raise or lower 

reported to the Commission and 

the reporng levels in specic mar-

as used in the COT report, does

kets to strike a balance between

not include open futures contracts

collecng sucient informaon to

against which noces of deliver-

oversee the markets and minimiz-

ies have been stopped by a trader 

ing the reporng burden on the

or issued by the clearing organi-

 futures industry. industry. “ 

ing a seasonally strong or weak me period from a supply and demand perspecve. This chapter will provide a quick synopsis of  where to nd and how to use this

The terms and denion can be found at the CFTC’s website, website, but for ease of explanaon, I will quote it here:

report.

WhEN First, let’s discuss when this report is released and how you can use it. The COT reports provide a breakdown of each Tuesday’s open interest for markets, but they are not released unl Friday at 3:30 p.m. EST. Current and historical Commitments of Traders data is available as is historical COT data

“Open interest held or controlled  by a trader is referred to as that  trader’s posion. For the COT  Futures-and-Opons-Combined  report, opon open interest and  traders’ opon posions are com puted on a futures-equivalent futures-equivalent basis using delta factors supplied by the exchanges. Long-call and short put open interest are converted to long futures-equivalent open inter-

going back to 1986 for futures-

est. Likewise, short-call and long-

only reports, and to 1995 for com-

 put open interest are converted 

bined opons and futures reports.

to short futures-equivalent futures-equivalent open

The informaon is based on the open interest gures. Open interinterest is the total of all futures and opon contracts entered into and not yet oset by a transacon, delivery, delivery, or exercise. The aggre-

interest. For example, a trader  holding a long put posion of 500 contracts with a delta factor of  0.50 is considered to be holding a short futures-equivalent futures-equivalent posion of 250 contracts. A trader’s long and short futures-equivalent futures-equivalent posi-

zaon of an exchange. Clearing Clearing members, futures commission mer-

The data is collected as of the

chants, and foreign brokers (col-

close each Tuesday from each

lecvely called reporng rms) le

clearing rm by the corresponding

daily reports with the Commission.

exchange where a parcular com-

Those reports show the futures

modity is traded. It is then turned

and opon posions of traders

over to the Commodity Futures

that hold posions above spe-

Trading Commission (CFTC). They

cic reporng levels set by CFTC 

release the data each Friday at

regulaons. If, at the daily mar-

3:30 p.m. EST.

ket close, a reporng rm has a trader with a posion at or above

I should point out that it is logical

the Commission’s reporng level in

to watch for any major direconal

any single futures month or opon

price changes in the market that

expiraon, it reports that trader’s

you are analyzing from the me

enre posion in all futures and 

when the data was collected on

opons expiraon months in that 

Tuesday to the close of business

commodity, regardless of size. The

on Friday to watch for any drasc

aggregate of all traders’ posions

prices changes that may alter the

reported to the Commission Commission usu-

posion size of traders.

Tren Tra ng In c ator s kEy CATEgOrIES

to enter trades accordingly. accordingl y. Keep

INTErPrETATION

and the non-reportable posions

There are three categories to

in mind that the commercials are

Here are some general guidelines

category are net long, look at sell-

pay aenon to: non-commer-

not always right; they are not in

for interpreng the informaon

ing opportunies.

cials (professional traders, hedge

the market to me market turns.

presented in the Commitment of 

Examine Figure 3.1 on the e- mini

funds), commercials (banks and

They are hedging their risk expo-

Traders Traders report that I wrote about

sure in a cash posion.

S&P 500 index. See point “A,”

instuons, producers, or end

in my rst book, A book,  A Complete Guide

where the non-commercials are signicantly signicantly net long, and then

users), users), and non-reportable posi-

Since money moves the market,

to Technical Trading Taccs and in

ons holders (small speculators).

banks and large professional professional trad-

The Commodity Traders Almanac. Almanac.

point “B,” which shows the small

Many people ask if the large

ers are a bit savvier when it comes

A. If non-commercials non-commercials are net

speculators net short. This was

speculators and commercials have

to their business. Aer all, one

long, commercials are net long and

the reading that was released on

reportable posions, then how do

would think a bank has a good

the non-reportable posions cat-

March 6, 2009 from data collected

they gure out the small specu-

idea of what direcon interest

egory are net short, look at buying

on March 3, 2009. The actual bot-

lator’s posion? The answer is

rates are going to go once a cen-

opportunies. In other words, go

tom on the March e-mini S&P

simple; the long and short open

tral bank meeng occurs, right?

long with the pros.

contract was on March 6, 2009 at

interest calculated as “non-report-

This report reveals what the pro-

able posions” is derived by sub-

662.50. The market proceeded to

fessionals fessionals are doing in relaon-

B. If non-commercials are net

tracng total long and short open

ship to the small speculators. If 

short, commercials are net short

interest from the total “reportable

80 percent of small speculators

posions” category. That is one

are accused of losing their money

more reason why there is no avail-

trading, then it would stand to rea-

able informaon for the number

son that you would not want to be

of traders that exist in the “non-

in the market on the side of the

reportable posions” category.

small speculator.

This report helps uncover pos-

Therefore, in the short term, the

sible imbalances in markets that

non-commercials, non-commercials, professional professional

have been in a trending market

speculators, speculators, or hedge funds are

condion for quite some me, and

considered the smart money.

therefore can help you develop a game plan to look for ming clues

rally at the close of business on March 31, 2009 at 827.25, which

Tren Tra ng In c ator s

was priced in the June futures con-

Examine the chart Figure 3.3,

professional trader category, the

cials or large professional traders

tract, up almost 25 percent from

which is also on the e-mini S&P.

black line represents the commer-

(blue) and the small speculator or

the lows. The small speculators

This shows my TradeStaon indi-

cials’ posions, and the gray bars

general public, as highlighted in

were net short into that rally.

cators with a zero line histo-

represents the small speculator

gray.

gram color coded to idenfy the

net posion.

Figure 3.2 using TradeStaon shows my Person COT indicator reecng that the small speculators were short as the professional traders were long since early February of 2009.

three classes of traders and their respecve net posions as measured against the open interest numbers. The blue bars represent the non-commercial posion or

The chart starts from January

Without going into exact details of  2008, and as you can tell, it was this indicator or the exact gure

a very bearish market environenviron-

of each category’s net posion, I

ment. Noce that the gray his-

want to focus on the overall con-

togram lines are above the zero

sensus between the non-commer-

line, showing the small speculators

Tren Tra ng In c ator s were net long all the way down.

posted a low right at one of my

the CFTC Commitment of Traders

added to their net short posion.

The blue bars are below the zero

predicted pivot support levels and

Report, many small speculators did

Commercials were less short and

histogram line showing the large

set o a buy signal.

not follow that rule. In fact, noce

professional professional traders added to their

that they nally threw in the towel

net long posion.

professional professional traders were net short. In fact, you can even see that by late June of 2008, the commercials also commied to the short side.

The market did recover in what turned out to become an amazing rally. Professional traders held a net long posion (blue) right through early April. Commercials

and went net long darn close to both a seasonally weak me period and also near a predicted Person Pivot Point resistance target level (the red horizontal line on

At that point, we had a weekly buy signal intact, with the informaon that small speculators are building a new net short posion.

Now let’s focus on late February

(black) grazed a neutral posion,

of 2009, when the media and

bouncing between a small net long

headline news proclaimed the end

and net short the enre rally. It

This brings me to an interesng

ket back to test the June high near

of the stock market and that the

was the small speculators (gray)

point—the summer of 2010 was no

1130. In any event, the CFTC report

economy as we knew it was com-

that commied to the short side

doubt a choppy and volale mar-

is a strong contrarian indicator.

ing to an end. It was a very dicult

all the way up.

ket. Granted, we traded to these

me; housing prices plunged, jobs were lost, foreclosures skyrocketed, and the stock market plunged.

idenfy trading opportunies, but

Here is another example of how

look back at how the small specu-

this report can help me major

lators were net long on the sum-

market reversals: the front

mer break. A low was made in the

page business news showed the

last week of August at the 1037

Japanese government intervened

SUMMEr 2010 ExAMPLE

level, the small speculators made

on behalf of the Yen’s value, the

a net short posion, commercials commercials

Here is where it gets interest-

headlines stated.

were reducing shorts, and the

ing, though. Seasonally speaking,

professional professional traders were holding

One arcle as the story hit the

stocks tend to weaken in late April

a net long posion. In fact, dur-

newswires read as if the mar-

through the May me period. I am

ing the rst week of September,

ket price acon was a shock. The

sure you are familiar with the say-

before the monthly employment

only real shock was the fact that

ing, “sell in May and go away.” I

report was released and the Labor

the Japanese government actu-

can assure you that according to

Day holiday, small speculators

ally intervened. I would argue

down and net short all the way

professional traders (blue) were

especially if you were a small

mounng a net long posion and

speculator.

the commercials (black) were

see how the small speculators threw in the towel, and aer a long losing bale being net long in a bear market nally went short, darn near the boom or “in the hole,” as we say. March of 2009

market needed to bring the mar-

levels quite well, which helped me

lators were net long all the way up. Wow—not a prey picture,

look at the gray histogram bars

This could be the ammunion the

“JAPAN SELLS yEN FOr FIrST TIME IN SIx yEArS”

So let’s review. The small specu-

On an interesng note, see how

beginning to shed shorts? Now

this chart).

predicted support and resistance

Tren Tra ng In c ator s that their government most likely

situaon, it is exactly what hap-

trader should make? Aer all, sell-

ket temperature reading. If the

was aware that there were a large

pened; speculators speculators who were net

ing Yen futures could be costly,

folks who trade their own as well

number of speculators holding

long needed to liquidate their long

especially with the increased vola-

as other people’s money need

long posions, and that is why

posions by selling, forcing the

lity; the leverage would kill you

to book a prot on a trade, it

they chose to intervene in the rst

price of the Yen versus the U.S.

if you were early on such a trade.

stands to reason if one is long,

place—in order to gain maximum

dollar lower.

Another consideraon would be

they would have to sell to get out,

the use of the CME’s electronic

and if they are short, they have

mini Yen futures contract, or put

to cover or buy back those short

opons on the Yen futures. A trad-

posions, right? right? Well, the non-

er could employ a combinaon of 

commercial traders are considered

these products to take advantage

hedge funds or professional trad-

of a strong seasonal tendency.

ers, and if they manage money

results with minimal eort. In this situaon, the Yen was primed for a sharp correcon; all it needed was a push o a cli, so to speak.

Was this move predictable? Seasonally speaking, speaking, yes. The yen has a tendency to peak against

If you were a stock trader and did not have a futures account, you could take an opons posion on an exchange traded fund— the Japanese Yen Trust (FXY). But again, ming is every thing. If you sold too early, you risk the

If you were a speculator taking a percentage of prots, you would be forced to sell in order to act quickly before all prots eroded. That is what typically causes an avalanche avalanche of sell orders. In this

age of prots on a quarterly basis. As with the Yen setup, the reason I was excited about this trade and was selling futures and buying put opons was simple. The stars had all lined up.

chance of adverse risk on a futures

A. Seasonally, the Yen

contract, since opons premi-

peaks against the dollar in

ums could lose value as theta or

mid-September.

me decay impacts the opon the U.S. dollar in mid-September.

then they look to take a percent-

premium.

Armed with only that informaon,

B. Large speculators speculators were holding holding a substanal net long posion in the market.

go long at a mul-year high. In fact

MArkET TEMPErATUrE rEAdINgS

one would most likely would want

Here is where the CFTC COT

uptrend for several months and

to look for a shorng opportunity.

report can help. I call it a mar-

was ripe for a correcon.

one would most likely not want to

So how to decide what choices a

C. The Yen had been in in a dened

Tren Tra ng In c ator s D. The end of the the quarter quarter was

speculators started to build a long

within two weeks.

posion around the rst week of 

Take a look at the chart in Figure 3.4 showing the Person Histogram

July and were fully commied to this uptrend.

COT report. As you can see, the

Now let’s examine the actual

commercials commercials were net shor t and

report to see the complete break-

the speculators were net long. The

down of the CF TC’s numbers.

The non-commercials (profession-

you can start to explore selling

al speculators) were long 66,038

opportunies. Just remember, if 

contracts versus short 13,995,

you are using opons, select strike

which was a whopping 40.9 per-

prices that are within the realm of 

cent of the open interest of the

reality and select the expiraon

market. The commercials were

month that will give you me for

long 60,724 versus short 108,489.

the trade to mature.

The non-reportable posion traders (small speculators) were more or less neutral as they were long 29,390 versus short 33,669 posions. If a market is entering a seasonally weak period and is fully loaded on the long side, as conrmed with the COT report, then

You can nd this report at naonalfutures.com/cc-report.htm.. alfutures.com/cc-report.htm

Tren Tra ng In c ator s QUICk QUIz 1. Te total of all futues an opons contacts entee into an not et oset b a t ansacon, elie, o eecise is efee to as: a. b. c. .

Consensus Open Interest Commitment of Traders Market Parcipaon

4

 ADX as a  ADX Trend Strength Indicator

A

s previously discussed, a trend can be idened by using

2. Te Commitment of Taes epot: a. b. c. .

Acts as a true consensus of who literally owns the market. Is published by the New York Stock Exchange. Is an insider informaon report. All of the above

3. Wat is te e cateo to pa aenon to wen eaminin te COT epot? a. b. c. .

Non-reportable posion holders Non-commercials Commercials All of the above

4. how is te small speculato’s posion etemine? a. b. c. .

By subtracng total open interest from the total reportable posions It is derived from the short open interest. There is no available informaon for the small speculator’s posion. By subtracng the short open interest from the long open interest. Fo te answes to tis qui, o to TaesLiba.com/TLEcone TaesLiba.com/TLEcone..

trend lines to idenfy either a series of higher highs and higher lows, or lower highs and lower lows. Moving

average ribbons and moving average channels can also help traders gauge the market’s direcon along with the strength of 

the trend. Because of the lag factor, it is oen more dicult for the trader to be prepared for a trend change or a period of non-trending acon. This can turn a protable trade into a losing one and frustrate beginning traders who may start quesoning their stop strategy. They may conclude that their stop was too ght and use a much wider stop next me, thereby increasing increasing the risk. They might alternavely decide that their stop was too wide and therefore use too ght of a stop on their next trade and get chopped up.

ThE Adx INdICATOr Traders can use the ADX indicator to determine whether a market is trending or not, as well as the strength of a trend. The ADX indicator is part of the Direconal Movement Index developed by Welles Wilder and discussed in his 1978 book, New  Concepts in Technical Trading Systems. Systems. Since the ADX is available

Tren Tra ng In c ator s in most charng plaorms, I will

Sugar prices remained in a trading

concentrate concentrate on the interpreta-

range for the next eight weeks.

on of the ADX, not the formula

In trading stocks and providing

by which it is calculated. calculated. Other

advice for clients through PA Stock

analysts like Chuck LeBeau, LeBeau, who

Alerts,, the ADX analysis can be Alerts

won the coveted Traders’ Library

important. The strongest signals

Traders Hall of Fame award, pro-

from the ADX occur when it drops

vides in-depth detail on how to

down to low levels in the 10 to

eecvely, and most importantly,

15 range and then crosses back

correctly use this indicator in his

above the 20 level. This is because

DVD course. course.

the very low ADX readings indi-

It should rst be noted that the

cate that the market has reached

ADX is not a ming indicator as it

an extreme level of non-trending

does not idenfy whether a mar-

behavior.

ket is moving up or down but is instead is designed to determine whether a market is trending or not. When the ADX is rising, then the market is trending either up or down, and conversely a declining ADX suggests a non-trending market. Remember the direcon

the me frame, the more reli-

to turn higher. This coincided with

able the signals. Sugar was one of 

the crossing of the 20-period MA

To the chart of Apple (AAPL) in

the strongest trending markets in

moving above the 50 period. By

Figure 4.2, I have added a 21-peri-

2009, as it more than doubled in a

the end of May, the ADX was clear-

od moving average of the ADX

single year.

ly rising, indicang that sugar was

as well as a doed line at the 20

now trending. It connued to rise

level. In both December 2008 and

during the summer and early fall,

February 2009, AAPL was unable

but in the middle of October 2009,

to move through resistance at

the ADX had turned lower (see

$103.75, but on March 23, 2009

arrow). This indicated that sugar

this resistance was overcome. The

was no longer trending, but this

ADX line dropped below the 20

should not have been taken as a

level in December and dropped

sign that sugar prices had peaked.

below 15 several mes in the next

of the ADX is more important than

In Figure 4.1, we have the weekly

its value.

chart of the connuous sugar

Like other methods discussed in this book, the ADX can be applied to weekly, daily, or intraday data. It is generally agreed upon by most technicians that the longer

USINg A 21PErIOd MOvINg AvErAgE

futures contract to which I have added the 20- and 50-period moving averages discussed earlier along with the 14-period ADX. The ADX was in a gradual downtrend into April of 2009 when it started

Tren Tra ng In c ator s average has proven to be useful. In

was sll below its 21-day weighted

a trending market, traders can use

moving average. Several days later,

a wider stop with more condence

the $52 level was overcome before

than is advised in a non-trending

MOS has a sharp pullback that

market. For my advisory service,

lasted several days.

PA Stock Alerts, Alerts, my analysis suggested buying Mosaic (MOS) at $45.68 (see Figure 4.3) and this level was reached on July 21, 2010. Just over a week later on August 2, 2010, MOS closed above next resistance in the $47.65 area. The 20- and 50-day moving averages had turned posive, but the ADX

three months. As AAPL moved

that AAPL was starng to trend.

through resistance, the ADX

The 20- and 50-day moving aver-

moved above its moving average

ages were also posive and the

as well as the 20 level.

gap between the moving averages

As discussed before, if a resistance level is overcome, it then becomes support and several days aer the breakout, AAPL declined back to test support (former resis-

had begun to widen. For the next month, both AAPL and the ADX connued to move higher as AAPL rose from $103.75 to over $130 per share.

tance) as indicated by the dashed

Understanding Understanding whether the ADX

vercal line. On this pullback, the

is rising or falling is of key impor-

ADX line was rising and above the

tance and to help beer idenfy

20-day moving average, indicang

the trend, a 21-period moving

From a trading standpoint, this pullback could have made some traders consider closing out their long posions, but the movement of the ADX above its moving average indicated that MOS was in the trending mode, so a wider stop was a beer idea. A week later, MOS was trading close to $60.

Tren Tra ng In c ator s INTErPrETINg STrENgTh

The best way to determine whether the ADX can help your trading is to

As I have stressed earlier in this chapter, a rising ADX line does not give

study it, and run it on your exisng posions as well as those trades you

you any indicaon on what direcon a market is moving, but helps you

are considering. In this way, you should have a beer idea whether or

determine the strength of a rally or a decline. Figure 4.4 shows Brish

not the ADX can help you in your trading.

Petroleum (BP) when its price started to decline during the laer part of April as support at $51.90 was broken at the end of the month. Remember, this support now becomes resistance. BP stock tested this resistance and moved sideways (see box in Figure 4.4) for nine days before resuming its decline. Even though prices were locked in a trading range, the ADX was rising strongly. It had previously dropped below the 15 level and then moved strongly above 20. Towards the laer part

QUICk QUIz 1. Te Adx inicato ienes: a. b. c. .

Trade ming opportunies The direcon of a market’s movement If a market is trending or not The lag factor

of May, the rise in the ADX slowed as BP prices connued to plunge. The ADX did not drop below its moving average unl early July as BP started

2. Ten lines can be use to ienf a seies of:

to rally and eventually moved from a low near $27 to over $41 per share.

a. Higher highs and lower lows, or lower highs and higher lows b. Lower highs and lower lows, or higher highs and higher lows 3. Moin aeae ibbons an cannels elp to ienf: a. b. c. .

The presence of a trend The market’s direcon The strength of a trend Both b & c

4. Te stonest Adx sinals occu wen: a. b. c. .

The indicator drops to the 10 to 15 range. The indicator crosses the 20 level. There is no trend. Both a & b Fo te answes to tis qui, o to TaesLiba.com/TLEcone TaesLiba.com/TLEcone..

Tren Tra ng In c ator s 5

Stochastics & MACD

make higher highs and the sele-

The second calculaon is the %D

ment price usually tends to be in

(3 period), and it is the moving

FAST vErSUS SLOW STOChASTICS

the upper end of that me peri-

average of %K.

There are other techniques asso-

It is calculated as follows:

ciated when using stochascs,

od’s trading range.

including fast stochascs and slow

When the momentum starts to %d=100(hn/Ln)

slow, the selement prices will

stochascs.

eorge C. Lane is credited

G

start to fade from the upper

with creang the formula

boundaries of the range and the

for stochascs stochascs,, a range-

stochascs indicator will show

It is important to understand the

change in price. This is referred to

based momentum oscillator indica-

that the bullish momentum is

rules of how to interpret buy or

as a gauge in sensivity. A higher

tor. His indicator is a popular tech-

starng to change. The exact

sell signals. When the readings are

rate of sensivity will require the

nical tool used to help determine

opposite is true for bear or down-

above 80 percent, and %K crosses

number of periods in the calcula-

whether a market is overbought,

trending markets.

over the %D line and both lines are

on to be decreased. This is what

poinng down, a “hook” sell signal

“fast” stochascs does; it enables

is generated. A conrmed sell sig-

one to generate faster and higher-

nal is triggered once both %K and

frequency trading signals in a short

%D close back beneath the 80 per-

me period.

meaning prices have advanced too far, too soon, and are due for a downside correcon. Stochascs can also help to idenfy oversold

There are two lines that are referred to as %K and %D. These are ploed on a horizontal horizontal axis for a given me period and the ver-

markets, meaning prices have

cal axis is ploed on a scale from

declined too far, too soon, and are

zero to 100.

due for an upside correcon. The indicator itself is based on a math-

The formula to calculate the rst

emacal formula that is computed

component, %K (14 period) is as

to compare the selement price of  follows: a specic me period to the price range of a specic number of past

Te alue of %k =c-Ln/hn-Ln*100

periods.

c=closin pice of cuent peio, Ln= lowest low uin n peio of me, hn=iest i uin n peio of me an n=numbe of  peios.

The theory is based only on the assumpon that in a bull, or uptrending market, prices tend to

hn= te n peio sum of (c-Ln).

The dierence is how the parameters are set to measure the

cent line. Markets need volality in order The exact opposite is true to gen-

to move and we need markets to

erate a buy signal when %K cross-

move in order to trade. We also

es above %D. When the reading is

need to base our trading plans on

below 20 percent, and both lines

reliable signals. Not all mes do

are poinng up, a “hook” buy sig-

the setups that trigger an entry

nal is generated. A conrmed buy

work as perfectly as in Figure 5.1,

signal is triggered once both %K

which is why I use other conrm-

and % D close back above the 20

ing signals to corroborate trad-

percent line.

ing signals. signals. I also like to see see if the methodology works in a diverse group or non- correlated markets.

Tren Tra ng In c ator s

To test how robust, or how well a signal responds in dierent markets

low from a previous low, low, but the underlying stochasc paern makes a

helps validate the reliability of that signal.

higher low. This indicates that the low is a “false boom” and can resort

Figure 5.2 is a Spot FOREX Euro Currency chart that demonstrates the

to a turnaround for a price reversal.

same setup and trigger that would enter a long posion with the %K and

Market prices can and usually do vacillate around the actual pivot point

%D crossover above the 20 percent line with a conrming higher closing

number before making a decision on a direconal price move. It is at

high candle paern. The sell signal also works well as conrmed when

these points, or market condions, that you want to use a indicator to

%K and %D both cross over and close back below the 80 percent line.

help measure the true strength or weakness of the price acon. That is what the Stochascs indicator does. In Figure 5.3, we see how a second-

BULLISh CONvErgENCE

ary low is marked with a higher indicator low.

One other method to use the stochasc indicator is trading with a pat-

Once we draw the corresponding lines, it appears as if prices and the

tern called bullish convergence convergence,, seen in Figure 5.3. It is used in idenfy-

indicator are actually actually converging. converging. This is hinng that the secondary secondary low

ing market booms. This is where the market price itself makes a lower

is not as bearish as it seems, and that a market rally can occur.

Tren Tra ng In c ator s

In essence, this is exactly what happens, and as prices trade above both

The example in Figure 5.4 shows how the market makes a secondary

moving average values, we have a nice trigger to go long for a quick

high, but the corresponding high in the stochascs is at a lower level

protable scalp.

then the primary high point. This paern can alert you that if the market appears to be ready for a new bull trend, the stochascs readings

BEArISh dIvErgENCE

should be equal to or higher than the primary peak level.

Another signal is a trading paern called bearish divergence divergence,, seen in

Likewise, Likewise, a higher high that is accompanied with a lower stochascs

Figure 5.4. It is used in idenfying market tops. This is where the mar-

reading indicates a potenal trend reversal, especially when prices are

ket price itself makes a higher high from a previous high, but the under-

near a pivot resistance level. Noce the lower closing low o the sec-

lying stochasc paern makes a lower high. This indicates that the sec-

ondary peak, and then as %K and %D both cross over and are beneath

ond high is a “weak” high and can resort to a turnaround for a lower

the 80 percent line. This helps conrm the sell signal, which was trig-

price reversal.

gered with the moving average crossovers and the lower closing lows.

Tren Tra ng In c ator s Bearish divergence signals warn

If the secondary stochascs

were the dierence between a

two exponenal moving aver-

you that there is an impend-

peak is less than or under the

12-day and a 26-day exponen-

ages, which then compares that to

ing downtrend of a substanal

80 percent level, this signals a

al smoothed average. The signal

the 9-period exponenal moving

amount. Therefore, it is impor-

stronger sell signal.

line used is a 9-day smoothing of 

average. What we get is a moving

today’s MACD value, subtracted

average crossover feature and a

from today’s, or the last me

zero line oscillator, and that helps

count’s MACD value. Most chart-

us to idenfy overbought and

ing packages give the 12-period,

oversold market condions. The

26-period, and the smoothed

chart in Figure 5.5 shows how the

average of a 9-period for the sig-

MACD helps to conrm buy and

nal line.

sell signals.

There are many variaons and

I might add that since traders are

most charng soware packages

now more computer savvy than

allow you to change the parame-

ever before, many charng so-

rmaon of a lower closing low

MOvINg AvErAgE CONvErgENCE/dIvErgENCE

ters. Just remember, the less me

ware packages allow changing or

triggers the entry, which is on

MACD in its simplest terms is an

periods you input, the more sensi-

opmizing opmizing the sengs or param-

the close or the next open. Here

indicator that shows when a short-

ve the indicator will be to price

eters. In other words, it is easy to

are rules to guide you to trading

term moving average crosses over

changes. Therefore, with fewer

change or “tweak” the variables in

a stochascs bearish divergence

a longer-term moving average.

me periods, an indicator will gen-

Appel's original calculaons. calculaons.

paern:

Gerald Appel developed this indi-

erate more signals. Longer me

•

The rst peak in prices should

cator as we know it today for the

periods help smooth out the false

correspond with a peak in the

purpose of stock trading. It is now

cross-over signals. Some varia-

%K and %D readings above the

widely used for short-term trad-

ons to consider are a 10-period,

80 percent level.

ing signals in stocks, futures, and

a 24-period, and for the smoothed

Forex markets, as well as for swing

average signal line, use an 8-peri-

and posion traders.

od input.

It is composed of three expo-

The concept behind this indica-

Just as is the case for most indica-

nenal moving averages. The

tor is to calculate a value, which

tors, the higher the me periods

inial inputs for the calculaons

is the dierence between the

tant to monitor for divergence paerns.

•

•

Prices should make a lower closing low to conrm a trigger

The bearish divergence paern

to enter a short posion. Enter

signals or forecasts that there is

on the close of the rst lower

an impending reversal in prices

closing low or the next open.

and that one is ready to occur. As

The protecve stop should ini-

I menoned previously, one can

ally be placed above the high

ancipate and get ready to place

of the secondary high.

an order to act on the signal, but you should not act unl the con-

•

The second peak must correspond to a signicant higher secondary price high point.

Traders Traders can increase the me periods in the moving average calculaons to generate less trade signals and shorten the me periods to generate more trade signals. The 15-minute chart in Figure 5.6 shows many signals generated.

Tren Tra ng In c ator s

used, the less sensive the indicator will be to changes in price

MACD also has a zero base line component, called the histogram, which

movements.

is created by subtracng subtracng the slower signal line line from the MACD line. If 

MACD signals react quickly to changes in the market and that is why a lot of analysts including myself use it. It helps clear the picture when

the MACD line is above the zero line, prices are usually trending higher. The opposite is true if MACD is declining below the zero line.

moving average crossovers occur. It measures the relave strength

MACD is a lagging indicator since it is based o of moving averages. We

between current prices as compared to past me frames, giving a short

want to look for the zero line crossovers to idenfy market changes and

term perspecve relave to a longer term perspecve.

help conrm trade entries or to trigger acon to exit a posion.

To understand how to use this indicator, always remember that when

Watching Watching for clues that idenfy shis in momentum as the market

the fast line crosses above the slow line, a buy signal is generated. The

moves from one extreme to another or overbought to oversold to trig-

opposite is true for sell signals.

ger a trading opportunity can be idened with the aid of MACD readings in both the moving average and the histogram component. While

Tren Tra ng In c ator s Currency, the MACD histogram

that the high close doji (HCD) trig-

helps idenfy both bearish and

gers a buy that is conrmed and is

bullish divergence paerns.

in sync with the stochascs signal.

You may have the impression I prefer the stochascs over the

Buy and sell signals with a bull-

absolute boom, that is a haphaz-

ish and bearish divergence as

ard guessing game to play. Trading

described in the last chapter

based on a set of rules and being

can also be found using MACD.

able to use a conrming indicator indicator

However, with the MACD, we can

to idenfy a change in price direc-

see the convergence and diver-

on and then following that price

gence in the moving average lines,

movement is the essence of how

and it is more reliable when they

to make money in the markets.

appear in the histogram bars. In Figure 5.7 with the chart for Euro

whopping 237 pips dierence.

MACD study, and for the most

This frequently occurs where

part, I do. The fast stochascs indi-

MACD lags other indicators, how-

cator generally gives conrmaon

ever, it is most helpful as a trend

on my triggers earlier than the

momentum conrmaon tool.

MACD studies. In Figure 5.8, noce

it is more protable in buying the

The MACD triggers six days later a

Tren Tra ng In c ator s As you follow the ow of the market, you may noce where the MACD triggers a false sell signal, but the stochascs does not. However, once the stochascs %K and %D close below the 80 percent level, MACD helps to conrm the exit.

QUICk QUIz 1. Te stocascs inicato is use to etemine if: a. a market is overbought or oversold b. prices have moved too far, too soon c. a correcon is due . all of the above 2. A “false boom” is oen eeale b wat stocasc inicato paen? a. b. c. .

Bullish convergence Bearish convergence Bearish divergence Bullish divergence

3. A “wea i” is oen eeale b wat stocasc inicato paen? a. b. c. .

Bullish convergence Bearish convergence Bearish divergence Bullish divergence

4. Te moin aeae coneence/ieence inicato: a. Shows when a short-term moving average crosses over a longer-term moving average. b. Is composed of three exponenal moving averages. c. Idenes overbought and oversold market condions. . All of the above. Fo te answes to tis qui, o to TaesLiba.com/TLEcone.

6

Moving  Ave  A verag rages es

A

simple way to determine the trend is to draw trend lines. In an uptrend, we should see a sequence of higher highs and higher lows. So we would draw a line against the

lows and extend it outward to forecast a support level someme in the future. In a downtrend, as the sequence of events shows lower highs and lower lows, we would draw a line against the top of the highs and extend it outward to help predict a resistance

point in the future. Another method used in determining trend line support and resistance is through the use of moving averages. The moving average is generally calculated by taking the average of the closing price of a dened number of sessions. The moving average is one of the most widely ulized indicators in technical analysis. The reason that this is the case is that the moving average is easily idenable and easy to backtest. Many automated automated trend trading systems use moving averages or some derivaon of a moving average method to generate buy and sell signals. Moving averages are considered classic indicators and are very popular with traders today. today. Most technicians technicians view the moving average as a way to signal a change in the direcon of  the trend, and even for idenfying levels of support and resistance. They can also be used as a way to smooth out the volality of the market.

Tren Tra ng In c ator s Traders Traders can use just one moving

indexes versus the futures stock

As we have discussed previously

given number of me periods and

average or combine a few dier-

index products. So when using

in this book, all traders, analysts,

dividing the sum by the number

ent ones and overlay these on

moving averages, it is important to

and technicians have equal access

of me periods. A 10-day simple

their charts. By using short-term, short-term,

understand that the variables and

to the most important common

moving average is the 10-day sum

intermediate-term and a longer-

parameter sengs of one instru-

denominators. Those are the the open,

of closing prices, divided by 10.

term moving average overlaid

ment may be more or less sensi-

the high, the low, and the close.

As the name implies, a moving

on top of the chart, you can see

ve to another due to liquidity and

This chapter is dedicated to vari-

average moves or is considered

the trend direcon of market

trading hours.

ous moving average types, which

a rolling indicator because as a

includes examining these four vari-

new date emerges, you remove

ables. Most traders use the close

or drop the old date in your con-

as their price input for calculang a

nuously rolling new data as it

moving average. There are advan-

becomes available.

prices from a dierent perspecve. Dierent markets such as futures, stocks, exchange-traded exchange-traded funds, and foreign currencies all have their own parcular nuances such as trading hours and trading me frames. So it is important to understand that one set of parameters in the moving average may not work as eciently in one market versus another. For example, in the spot foreign currency markets, such as the euro currency, the trading hours are virtually around the clock ve days a week, compared to trading in the Euro Currency Exchange Traded Fund (FXE), where we have a limited trading session from 9:30 a.m. to 4:15 p.m. EST. This relaonship of me trading dierences even exists between the cash stock

WhAT ArE MOvINg AvErAgES? In its simplest terms, a moving average takes a measurement of  past price acon to help smooth out price data. As the calculaon is formulated with each new date as the name implies, the sum moves as an older date is dropped. Since we are using past data to calculate the formula, moving averages are considered a trend following or

tages and disadvantages to only using a close variable input as your moving average. But rst let’s discuss the various types of moving averages, and then we will discuss the parameter inputs to use and the reasons and purposes for measuring these values.

conrmaon indicator. Since mov-

SIMPLE MOvINg AvErAgE

ing averages are based on past

There are two main types of mov-

price acon, they simply cannot be

ing averages. The rst is a simple

leading price indicators. When we

moving average (SMA), which is

discuss past price acon, remem-

dened as dividing the sum of 

ber the shorter the me frame,

two or more gures by the num-

the more sensive the moving

ber of gures. When we apply

average will be to price changes.

this to market analysis, it means adding up the price inputs for a

By averaging the price data, a smoother line is produced and the trend is much easier to recognize. The disadvantages of the simple moving average is that it only takes into account the me period of the sessions covered in the calculaon and it gives equal weight to each day’s price.

ExPONENTIAL MOvINg AvErAgE The next calculaon is using what is known as an exponenal moving average (EMA). Exponenal moving averages are calculated from complex formulas and have

Tren Tra ng In c ator s become the most common aver-

the subject. One such arcle was

pare one me frame versus anoth-

by Frank Hochheimer who wrote

MULTIPLE MOvINg AvErAgES

ages used today by many quote vendors, analysts, and traders

an arcle way back in the 1978

The use of mulple moving aver-

a longer-term outlook. Figure 6.1

since they are weighted to give

Commodity Yearbook entled, Yearbook  entled,

ages gives a trader read of the

shows a daily chart of the Russell

more importance to the newest

“Computers Can Help You Trade

market from dierent perspec-

2000. The white doed line is a 20

data from current market condi-

the Futures Markets.” He con-

ves. Generally speaking, when when

day simple moving average based

ons as older data becomes less

ducted a study on 13 dierent

we use more than one moving

on the close, as compared to the

important as me passes and is

commodity markets to nd the

average, average, we are looking to com-

solid black line, which is a 50-day

eventually ltered out.

opmal moving averages between

Calculang all these numbers by hand or even with a calculator is tedious and me-consuming, but fortunately computers can now

simple, weighted, and exponenal in order to determine the best and most consistent cumulave net prots.

gure all this this out for us. A simple

One of his ndings was that each

moving average is straighorward

individual market had its own

and has minimal mathemacal

opmal moving average sengs.

requirements.

Another of his ndings was that simple moving averages outper-

hISTOry OF MOvINg AvErAgES

formed both linear weighted and

We have the aerospace industry

the computer era emerged, more

to thank for the use of simple,

and more traders have developed

weighted, and exponenal mov-

their own backtest studies to op-

ing averages. The formula was

mize their sengs for individual

originally used as a way of calcu-

markets for their individual trad-

lang the trajectory of missiles.

ing needs. In this chapter, we will

As for applying moving averages

reveal various methods and combi-

to trading, many books and maga-

naons from parameter sengs to

zine arcles have been wrien on

exponenal moving averages. As

the use of mulple simple moving average me frames.

er. Usually it is a short-term versus

Tren Tra ng In c ator s simple moving average based on

30-, 40-, 50-, 60-, 70-, and 80-peri-

the close. Buy signals are gener-

od moving average system over-

ated when the short-term moving

laid on your price chart. Ribbons

average is above the longer-term

can be used to determine a weak

moving average. An addional l-

or strong trend. With all the mov-

ter can be used to go along when

ing averages poinng in the same

the current price is trading above

direcon, the trend is said to be

both moving averages. You will

strong. Price reversals are con-

noce that by mid March of 2010,

rmed when all the moving aver-

a strong uptrend had developed

ages have crossed over each other

and the shorter-term 20-day mov-

and start to move in the oppo-

ing average acted as support unl

site direcon. Figure 6.2 uses the

mid-May, when prices broke below

e-mini S&P futures contract, illus-

both the 20- and then 50-day

trang an exponenal weighted

moving average. A reversal sell sig-

8-period moving average ribbon

nal would have occurred by early

combined with the 20- and 50-day

June. The short-term moving aver-

simple moving average.

age was below the longer-term

A good bullish setup to determine

moving average, and as an addi-

a high quality trade is not only

onal lter, current prices were

when the shorter-term moving

trading beneath both moving aver-

averages cross up over the inter-

age values.

mediate and longer-term sengs; in addion, we look for prices to

MOvINg AvErAgE rIBBONS

lengths. Since most computers and

by a specic me period, or by a

Moving beyond the use of two or

trading soware plaorms have

percentage. To create a simple

three dierent me period mov-

advanced graphics cards, the rib-

moving average ribbon for exam-

An addional lter would be if the

ing averages is the moving average

bons are mostly seen using gra-

ple, you start by using a 10-period

market closed at least two con-

ribbon. The ribbon as it is called is

dient colors. The ribbon moving

moving average, using 8 moving

secuve me periods above the

created by using a series of expo-

average method starts with one

averages increasing by 10 periods,

moving average sengs, as this

nenal moving averages of various

me frame and increases either

so that you will have a 10-, 20-,

would reduce the likelihood of a

close above all moving averages.

Tren Tra ng In c ator s reversal failure. Since most failed

high, and the the low. For this secon,

market reversals or false breakouts

we want to focus on taking a mov-

occur almost immediately, waing

ing average of both the high and

for conrmaon by mulple closes

the low. In doing so, we will form

reduces the likelihood of a failed

a moving average channel. The

breakout. The downside to this l-

raonale here is that if we are in

tering method is that we increase

a strong uptrend, prices will con-

the risk factor because prices have

nue to close above past or prior

moved higher from the lows and

highs and will connue to move up

we reduce the potenal lion’s

unl the market or current prices

share of the prots since the trend

close below the average of past or

in this trade will have been su-

prior lows.

ciently intact.

In Figure 6.3, we have an e-mini

Another lter I use is if the real

S&P chart based on a ve-minute

body (open, close relaonship) is

me interval. interval. We took a seven-

above the moving average sengs

period simple moving average of 

for two or more periods. Others

the highs and a seven-period sim-

have used the enre range to help

ple moving average of the lows.

lter higher quality setups to enter

As you can see from this example,

posions when trend trading using

a strong uptrend developed once

moving averages.

the market closed above the upper channel or the seven-period mov-

MOvINg AvErAgE ChANNELS

ing averages of the highs. Noce

As we discussed previously, previously, there

the lower band or the seven peri-

are four main variables that we

od moving averages of the lows,

all have equal access to and can

the market entered a dened

use to input for moving averages.

downtrend. downtrend. The moving average average

BOLLINgEr BANdS

These are the open, the close, the

channel method helps traders stay

The moving average channel is a

on the right side of the market by

simple and less complicated meth-

that once the market closed below

idenfying posive or negave

od to calculate than using volality

momentum or strong trending

bands such as the more popular

market condions.

and famous technical tool known as Bollinger Bollinger bands. Bollinger bands are made up of three moving average components in which the width of the bands expand or

Tren Tra ng In c ator s contract as price volality increas-

the lower Bollinger band, one may

CONFIrMINg INdICATOrS

is intact is not only when prices

es and decreases. The bands are

look to take a buying opportunity.

A word of warning when it comes

close outside of the bands, but

measured based o of the center

But when prices close below the

to using indicators for conrma-

also when the Bollinger bands

moving average component using

lower Bollinger band, traders can

on—make sure they are not

widen and point in the direcon

a 20-day simple moving average.

develop either an exit strategy

similar in nature or related in

of that trend. In addion, Bollinger

The upper band is calculated by

on long posions, or start to sell

parameter sengs. Remember;

bands can act as a gauge of vola-

mulplying the standard deviaon

short, ancipang that prices will

avoid collinearity when using

lity when the bands contract or

by two and the lower band is cal-

connue lower.

addional technical indicators for

come together; it shows when

On the other hand, as prices reach

conrmaon.

the market is in a period of low

culated by subtracng the 20-day moving average by two standard deviaons. •

•

gies from long posions or start

moving average

to implement short trades. It is

(20-day standard deviaon of  price x 2) •

can start to look at exit strate-

Middle Band = 20-day simple

Upper Band = 20-day SMA +

important to note that in strong trending periods, prices will “walk the band,” meaning they will connue to move up or down when

Lower Band = 20-day SMA -

selement prices occur outside of 

(20-day standard deviaon of 

the bands averages. Just because

price x 2)

prices “tag” the Bollinger bands,

Simply put, two standard deviaons means that 87 percent of  all prices will close inside the Bollinger bands. The Bollinger Bollinger bands try to help us uncover whether prices are too high or too low in relave terms. A simple trading plan can be executed so that when price touches

volality or a consolidaon phase.

towards the upper band, traders

The benet to traders here is that

 Make sure sure that  indicators used   for conrmation conrmation are not similar in nature or related in  paramet  para meter er settings.

meaning they are drawn either

once you understand that markets go through phases of volality or trend phases and then pause into consolidaon periods, it is the Bollinger bands that can help idenfy these dierent cycles or phases by examining the narrowing or widening of the bands. Figure 6.4 shows a daily candle chart on Google (GOOG) with a

to the upper or lower band, this

For example, avoid following

20-period simple moving average,

in itself is not a buy or sell signal.

any indicator that uses an 18- to

using the standard deviaon from

In order to improve the quality

22-day simple moving average set-

the formula formula menoned above. In

of the trade signal, one needs an

ng, because Bollinger bands use

early April 2010, prices broke out

addional indicator indicator for a trade

the 20-day simple moving aver-

to the upside of the top band, but

conrmaon.

age for the middle band. A really

experienced a large gap lower in

good sequence of events to watch

price as the market trended lower.

for to conrm that a strong trend

Noce the direcon of the three moving average components all

Tren Tra ng In c ator s cators or trading techniques for conrmaon before entering trades, and Bollinger bands are no excepons.

CONFIrMINg PATTErNS Other means of conrming indicators can be the use of just simple patterns such as “M” top and “W” boom formaons. By denion, a “W” boom is a series of higher highs and higher lows, and an “M” top formaon is a series of lower highs and lower lows. In Figure 6.5, we see a

pointed down and prices hugged or “tagged’ the lower band. This illustrated a bearish market turn and downtrend. It wasn’t unl late July that prices traded back up above the middle band, which by early August acted as support. Besides idenfying support and resistance targets, Bollinger bands can also aid traders in uncovering direconal trend changes. As with most indicators, traders should incorporate other indi-

Tren Tra ng In c ator s daily chart on Wells Fargo (WFC).

ful to actually take the average

is that traders can focus on the

act as resistance. resistance. This is one idea

As you can see, right around July

of moving averages. Instead of 

signal and the price to moving

that may help you start to devel-

5, we have a series of lows and

having excess informaon or mul-

average relaonship. If the market

op your own automated trading

closes beneath the lower Bollinger

ple moving averages overlaid on

truly is in a sell mode or bearish

system using moving averages to

band. Five days later, we suddenly

charts, you can more easily work

trend condion, then the average

idenfy trends.

nd the market piercing through

with one moving average overlaid

of both moving averages should

the middle band, almost closing in

on prices. The benet here is if 

on the upper upper band. As the market market

you have a charng program that

pulls back, noce it forms a sec-

can give indicaons of when mov-

ondary low on July 20, which is a

ing averages cross over, generang

higher low. This is what starts to

buy and sell signals, and you can

form the “W” paern.

use the moving average as a direc-

In addion, the secondary low is above or inside the lower Bollinger band. To take one step further,

onal moving trend line. It will not burden you with informaon overload and clog up your graphs.

you will also see that the July 20

In essence, with soware program

low is formed with a higher close

such as Genesis, TradeStaon,

than open sequence. Swing trad-

or Thinkorswim’s charts, trad-

ers can look to buy near the close

ers can have indicators built-in

of this bar at 25.91, placing stops

to give alerts or arrows when a

below the low formed on July 5 at

crossover of two moving averages

24.60. The prot objecve would

actually occurs. As you can see in

be near the top of the Bollinger

Figure 6.6, you only have to have

band at 28.55.

one moving average overlaid on prices, but as the arrow poinng

AvErAgINg MOvINg AvErAgES

down shows, you have a sell sig-

When you are using a series of 

of intersecon of the crossover

moving averages, it can be help-

from the hidden moving average.

nal that develops from the point

Once again, the advantage here

Tren Tra ng In c ator s PIvOT POINT MOvINg AvErAgES

my favorite moving average con-

This informaon provides a clear

when markets are in a trending

cepts is using the typical price for

picture of the “average true price”

phase, and when applied correctly,

We have not discussed calculat-

a specic me period—otherwise

as a gauge of bullish or bearish

they allow the trader to let prots

ing a moving average using a

known as the pivot point—which is

market condions for that me

run and cut short their losses. That

combinaon of the four common

derived from taking the sum of the

period. In Figure 6.7, we have a

is, if one devises a specic trading

denominators (open, high, low,

high, low, and close and dividing

daily chart on the e-mini S&P.

plan with buy and sell signals that

and close) or averaging out one or

by three. The formula again is:

Noce that the pivot point mov-

have incorporated the use of mul-

ing average “hugs” prices closely

ple moving averages.

more of these components. One of 

(h+L+C) (h+L+C) / 3 = Piot Point

when we are in a trend mode. The moving average acts as a support in an uptrend phase and this moving average acts as a good resistance line in a downtrend phase. Always remember that the shorter the me frame, the more sensive the moving average will be to direconal price changes. The moving average used here is a simple moving average using a veperiod pivot point seng rather than the close.

MOvINg AvErAgE OSCILLATOrS ANd hISTOgrAMS If I have not stated it already, let

As the saying goes, “the trend is your friend,” but the age-old queson begs, so when does the trend end? To help answer this queson, savvy technicians and computer geeks who like to develop their own indicators can devise an oscillator to compare the dierence between two moving averages, as well as closing price to the distance of those moving averages. Based on moving average values, it is very relevant and possible to develop a histogram component by seng a standard deviaon of  where a closing price is located to the last known value of the moving average.

me make sure we cover this sub ject now—because moving averaver-

Based on a historical viewpoint, viewpoint,

ages are trend-following mecha-

an oscillator like this can be used

nisms, they obviously work best

to help determine the strength

Tren Tra ng In c ator s or weakness of a trend. In other

I created this histogram, I under-

words, this method can be used

stand and have more condence

to determine if prices have more

in what it’s trying to tell me, and

room to run, or if they have

therefore it helps me make a bet-

reached an overbought or over-

ter educated and informed trading

sold condion by looking at the

decision.

values of the current market price

MOvINg AvErAgES SUMMAry

and the moving averages. As prices depart too far from the means or the short-term moving

In summary, moving averages can

average starts to aggressively pull

be used in a variety of ways other

too far from the longer-term mov-

than just looking at a 200-day

ing average, one can construct a

moving average based on the close

histogram to help illustrate this

(which is the normal seng that

relaonship. It is even possible to

most stock pundits or the media

trade a convergence or divergence

will quote), as you can see from

based o of the paern in the

this chapter. You have now learned

histogram, similar to what is used

that there are a variety of param-

with MACD. Figure 6.8 shows a 15-minute intraday chart on the Euro Currency FX using my TradeStaon TradeStaon plaorm. I have a simple moving

age oscillator, which helps me

a higher low. We call this bullish

generate buy and sell signals, and

convergence. convergence. What this indica-

gives me clues to when the market

tor has idened is that the price

has reached an oversold or over-

has departed too far from the

bought condion.

means and that this downtrend

average overlaid overlaid on the chart to

Look at the low at the 7:30 a.m.

help me idenfy trending marmar-

me frame; now look at the corre-

ket condions. condions. As you can see, see,

sponding histogram reading. Then,

the boom secon of the chart

take a look at the low at approxi-

has what is labeled the Person

mately 9:45 a.m., and you should

Histogram. This is a moving aver-

see that the histogram reading has

that started approximately at 6:30 a.m. has likely exhausted itself. This is a very valuable tool in my trading because it helps me make the determinaon of entering and exing trades. Due to the fact that

eter sengs you can ulize in different ways in order to capture a reading of what these moving averages are telling us about the condion, and more importantly, importantly, the trend of the market.

Tren Tra ng In c ator s QUICk QUIz

7

1. Te simple moin aeae is calculate: a. From complex formulas b. By summing the price inputs for a given me period and dividing that sum by the number of me periods c. By dropping old price data as new price data emerges . From a series of weighted averages

Dow Theory 

C

harles Dow was one of America’s most famous stock

2. Wen calculan te eponenal moin aeae, a. b. c. .

Past market condions must be taken into consideraon. More weight is given to newer data. Backtesng conrms accuracy. A calculator should be used.

3. To elp etemine te stent of a ten, use: a. b. c. .

Moving average channels Exponenal moving averages Moving average ribbons 50-day moving averages

market observers. His reputaon revolved around the fact that the market made connued gyraons. He

observed that the stock market moved in three phases. His observaons included that the market had short-term daily uctuaons, an intermediate-term trend called a secondary wave, and a longer-term trend called the primary wave. The primary uptrend was characterized by three upward swings. It was the work of Charles Dow that Ralph Ellio incorporated to create the Ellio wave theory. Back in 1897, the Wall Street Journal printed out two main indexes. One was the Industrial Average and the other one

4. Te Peson istoam elps a tae to: a. b. c. .

Make the determinaon of entering and exing trades. Generate buy and sell signals. Idenfy market condions as overbought or oversold. All of the above.

was the railroads, which is now what we call the Dow Jones Industrial Average, Average, and the transportaon index. Back in the early 1900s, it was very easy to manipulate manipulate an individual stock. It was nearly impossible to manipulate a group of stocks, and that was what Charles Dow believed would be a beer way to gauge the strength of the economy, by looking at the overall

Fo te answes to tis qui, o to TaesLiba.com/TLEcone TaesLiba.com/TLEcone..

trend of these indexes. That way, it gave him a beer idea of  the bigger picture of the trend of the market. There was a third index added called the Dow Jones Ulity Index, and it helped to conrm a boom or bust cycle.

Tren Tra ng In c ator s Charles Dow had certain principles of conrmaon—if two of the three

dOW’S BULLISh PhASE ThEOry

sectors were rising, this would be good conrmaon that the economy

Dow believed an overall bull or bear market was created by three dis-

was in a bullish market trend condion, and therefore one could look

nct phases. A bullish buy signal was established once the market trad-

at buying stocks. If the industrial and the transportaon indexes were

ed above the high of a previous rally aer a denive downtrend (see

declining, that would signal an overall weakness in the economy and

Figure 7.1). Once prices trade above a previous high aer forming a dou-

that one may want to look to take prots in the markets. These were

ble boom, or what is known as a “W” paern, a buy signal is iniated.

known as simple but strong strong conrming index tools. Through me, we have seen many changes, including newer indexes, like the technology

If you examine the graph in Figure 7.2, you will see the disnct “W”

sector as represented by the NASDAQ. Now we also have exchange

paern or the double boom. Once the market trades back above the

traded funds (ETFs) on indexes like the S&P 500 called the SPDRs (SPY)

rst swing high, a buy signal was iniated. This is a weekly chart on

or the NASDAQ (QQQQs). To take maers further, we now have ETFs on the top sectors such as nancials (XLF), material stocks (XLB), the energy sector (XLE), and even consumer staples (XLP) just to name a few.

Tren Tra ng In c ator s the e-mini NASDAQ 100 futures.

comprise the market’s makeup

is the bull market. They just want

high, the feeling that one can’t

When combining this setup with

are in my opinion: precauonary

to get in something before missing

lose prompts the need to borrow

an understanding of Dow three

fear, lack of discipline, and greed.

the move. This is when we witness

money or become heavily lever-

wave phase theory, it is amazing

The beginnings of a bull phase are

a lack of discipline; investors buy

aged in the market. market. This was the

to see this acon as recently as

as markets are forming booms

 just to get in, and they they lose sight of  case in 2000 as the “tech wreck,”

the low in March of 2009. It’s been

known to be in accumulaon phas-

their trading plans.

approximately 100 years since

es; this is known as Phase One.

Dow rst published his work, and

Investors who are cauous buy

Pase Tee

technology sector as represented

we sll see these setups working.

high-quality, high-quality, beaten-down stocks

Phase Three is generally when

by the NASDAQ. My theory is that

Idenfying and trading a newly

and limit purchases. In other

the irraonal exuberance state or

due to the massive inicon of 

discovered trend requires requires a bit of 

words, they are just nibbling at

extreme speculaon takes place.

monetary loss on a large audience

knowledge in what to look for, as

this point. Typically, investors start

Investors will do anything to get

of speculators, it my take years if 

well as paence and discipline. The

buying ulity stocks or high divi-

in on the acon, greed takes

not another decade or a terric

setups are there and they work,

dend yielding stocks. They want to

over, and this is where you nd

bull market to aract those who

if you know what to look for and

make money, but are afraid of los-

increases in margin trading. Many

lost money in that event to come

how to apply these principles.

ing, thus they are being cauous.

will borrow money to buy stocks

back into the market again.

As the fear of loss prevails, there is

to not only get in on the acon,

BEgINNINgS OF A BULL MArkET

lile in the way of courage.

In Figure 7.2, the price acon

but also with real hopes to “get

showed a steady stream of rising

rich quick.” Stock picking based on

Pase Two

prices aer the conrmaon buy

Once you have idened a bull-

value or posive earnings is usually

signal. Prices connued steadi-

ish setup, applying the concept

Then as the trend matures, we

not important at this stage of the

ly higher throughout 2009 and

of Dow’s theory can help you not

enter into what is known as Phase

game. People just get in believing

into early 2010. Certainly by mid

only potenally ride a trend a bit

Two. As the market starts to prove

stocks will keep going up.

February of 2010, phase one and

longer, but his theories can help

itself by displaying higher prices, volume starts to increase as more

This is the ulmate state of greed;

two were completed. As Figure

you correctly idenfy when a

and more investors buy as their

all levels of logic are abandoned,

7.2 shows, we had not yet expe-

trend may be exhausng itself.

emoons rule, and there is no lon-

rienced a typical phase three bull

ger that precauonary level of fear

market condion since prices did

that existed as it did in phase one.

not escalate to an irraonal exu-

The condence level is excessively

berance state. In fact, we had yet

condence level rises. Investors will

Pase One

start buying lower grade and small

The principles behind the emo-

cap stocks, just to get in the mar-

onal state of the masses who

ket before what they now believe

as it was called, posted the top in the stock market, in parcular the

Tren Tra ng In c ator s to experience any criteria for the beginnings of a bear market which I will explain now.

dOW’S BEArISh PhASE ThEOry A bear market or bullish reversal move is commonly idened once prices break below an important support level or old low. I like to sell against a failed double top as prices trade below the old low for conrmaon. In Figure 7.3 below, a sell signal occurs as prices trade below the low of what is also known as an “M” top paern. I just menoned the “tech wreck” that occurred in late 2000, and the graph in Figure 7.4 is a monthly chart on the e-mini NASDAQ 100 futures contract that shows a text book case of the “M” top paern that iniated not only a substanal sell signal but also the end of that bull mar-

ket’s trend. The three phases of the bullish side were very prominent in the rally preceding the bear market. As of this wring, we have sll not even come close to the highs made back then. In fact, many companies are either out of business or were acquired by others. Now, let’s look at Figure 7.5, a daily chart on the U.S. dollar index. Here is a classic double top or “M” top paern that iniated a signicant bear market move. Granted, this index was not around when Charles Dow stated his theories. However, when applying his theories on a bear mar-

Tren Tra ng In c ator s Pase One: distibuon Dow believed that like a bull market, there were three part s to a bear market, beginning beginning with the distribuon phase. This is where there is a longer bale between bulls and bears, mainly when the general public is buying as professionals are selling to unload their long posion. Have you heard the phrase, “tops take longer to form than booms?” Noce in Figure 7.5 that the top lasted over one month before the sell signal was generated as the market entered a signicant bear trend.

Pase Two: Panic Phase two is what was termed the “panic” period. This is where prices accelerate rapidly to the downside, downside, usually without any upside correcon. This could be a period where the media may be publicizing the fact that the bull market has ended and traders who were long might look to liquidate liquidate their longs to stop the bleeding.

Pase Tee: Capitulaon Phase Three is what I call the capitulaon period. We will see larger down days than before, and volality is ex tremely high as measured by wide price swings. But overall volume starts to dry up as extreme pessimism reigns supreme. ket condion combined with the failed double top paern, one would be able to ride this bear trend for a substanal prot. The similaries between these two markets are simply too strong to ignore. Both the NASDAQ 100 and the U.S. Dollar were highly visible in the media, but it is the “M” top paern that is consistent with creang a signicant bear market trend. Let’s review Dow’s bear market theories.

I believe it is due to the mass psychological aspect of human behavior that has proven the Dow Theory again and again. It has certainly not only stood the test of me, but it is applicable in markets that did not even exist in his own day. Apart from imbalances in supply and demand, it is the understanding of the three principles of precauonary fear, lack of discipline, and greed that will help you dene a trend. Truly successful trend traders plan out their trades, from when to enter to where

Tren Tra ng In c ator s to place their stops. They have faith in their methodology and act with courage when it is me to place an order. Greed does not dictate their trades, price acon does.

QUICk QUIz 1. dow’s teo on te maet’s aons inclue: a. b. c. .

Short-term, intermediate-term, intermediate-term, and long-term trends Daily, secondary, and primary waves Ellio, Gann, and Dow uctuaons Both a & b

2. Accoin to dow, te tee pases of a beais maet ae:

8

 Volume  Vol ume and and Open Inte Interest rest

T

rend analysis comes in many forms and indicators. Aer understanding and examining the direcon of price, which includes the close as well as the current close as

compared to past price acon (old highs, lows, opens, and closes), the next best conrming indicator for trend traders is vol-

a. b. c. .

Distribuon, panic, and capitulaon Precauonary fear, lack of discipline, and greed Irraonal exuberance, extreme speculaon, and accumulaon accumulaon Lower high, lower low, double boom

3. duin a bull maet, ou ae most liel to n taes epecn to “et ic quic” in wic of dow’s pases? pases? a. b. c. .

Phase One Phase Two Phase Three None of the above

4. Accoin to dow, conmin an oeall ten amon aious inees enables one to aue te stent of te econom. a. True b. False

ume. There is one more exclusive indicator for futures traders and that is open interest. These are important tools which will give clues to the strength or weakness of a trend, or as we technicians say, the health of  the trend—so let’s review the basics.

vOLUME The denion of volume is the number of trades for all shares in stocks, or for commodies, the total amount of trades for all contract months of a given futures contract both long and short, combined. For example, stock index futures like the e-mini S&P’s or the foreign currency contracts contracts all trade on quarterly quarterly expiraons, which include March, June, September, and December contract months. The volume will represent the total for all the trades in each contract month.

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Tren Tra ng In c ator s Most technical analysts believe that volume is an indicator of the

•

strength of a market trend. It is also a relave measure of the dominant behavior of the market. Volume is the measurement of the market’s acceptance or rejecon of price at a specic level and point in me.

and can be used to predict a reversal. •

ing in price and the volume is increasing, the market is said to be in a

Decreasing volume with a weaker price environment shows that fresh sellers are reluctant to enter the market and could be a sign of 

There are several theories and so- called rules when using volume analysis on price charts. The rst rule to remember is: if a market is increas-

Decreasing volume while prices are climbing may indicate a plateau,

a future downtrend. downtrend. •

Excessive volume volume while while prices prices are high indicates indicates that that traders are selling into strength and oen creates a price ceiling.

bullish mode and can indicate further price appreciaon. •

Excessively low volume volume while while prices are low indicates that traders traders are buying on weakness and oen creates a oor.

 If a market market is increasing in price and the volume is increasing, the market is said  to be in a bullish mode and can indicate  further price appreciation. appreciation. The opposite opposite is true for a declining market.

In Chapter Six, we discussed the use of moving averages. One technique that many traders use is taking a moving average of daily volume. This helps examine the overall trend of volume as well as lter and pinpoint abnormal decreases or increases in trading volume acvity. Let’s examine the graph below in Figure 8.1. This is a weekly chart on the stock Nelix, Inc. (NFLX), which as you can see experienced a stratospheric price increase starng in early 2010. The upper poron of the chart shows the candlesck price chart and the boom poron reects

The exact opposite is true for a declining market. market. However, However, if a substanal daily market price increase or decrease occurs aer a long steady

the bar histogram of weekly volume with a 20-week simple moving average overlaid on the volume graph.

uptrend or downtrend, especially on unusually daily high volume, it is

The low made in February of that year was marked by a bullish rever-

considered to be a “blow-o top or boom,” and can signal a market

sal on—at that me—the heaviest weekly volume. As the price trend

turning point or trend reversal. Here are some guidelines guidelines to use when

climbed higher, higher, noce that the direcon of volume also increased, con-

using volume analysis:

rming the rally was real and sustainable. This shows there was an accu-

•

Increasing volume in a rising price environment signals excessive buying pressure and could lead to a substanal advance.

•

Increasing volume while prices are falling may signal a bear move.

mulaon of shares, or as we idened in the rst bullet point, increasing increasing volume in a rising price environment. It signals excessive buying pressure and in this case it did lead to a substanal price advance.

Tren Tra ng In c ator s ket and more new money is ow-

IdENTIFyINg OPPOrTUNITy

ing into the market. This reects

This informaon can be used to

why the price increases.

idenfy an opportunity when

Of course, the exact opposite

there is a major top or boom in

is true on a declining market.

the futures markets. If you are a

Charsts combine both the price

stock trader, you may also want to

movement and the data from vol-

pay aenon to this data, espe-

ume and open interest to evalu-

cially if you are trading high beta,

ate the “condion” of the mar-

or stocks highly correlated to

ket. If there is a price increase on

underlying commodity markets.

strong volume and open interest

For example, in the graph in Figure

increases, then this is a signal that

8.2, we have a daily chart on corn

there could be a connued trend

futures. There are several compa-

advance. The opposite is true for a

nies that come to mind that have

bear market when prices decline.

a vested interest in what happens

If price increases, increases, volume stays

to the trend in corn prices; one is

relavely at or is lile changed,

Archer Daniels Midland (ADM) and

and open interest declines, this

another is Bunge (BG).

reects a weakening weakening market con-

A good queson to ask would be:

dion. This is considered to be a

can higher corn prices help or hurt

bearish situaon because if open

a company’s boom line? To a

OPEN INTErEST

short, and for every buyer there is

interest is declining and prices are

a seller. The open interest gure

stock trader, it would be important

On the other hand, open inter-

rising, then this shows that shorts

represents the longs or shorts, but

on a price advance to ascertain

est reveals the total amount of 

are covering by buying back their

not the total of both. So the gener-

if the move was sustainable and

open posions that are outstand-

posions rather than new longs

al theory for open interest is that

accompanied by widespread accu-

ing in existence and not oset or

entering the market. That would

when prices rise and open interest

mulaon, rather than a short lived

delivered upon. Remember that in

give a trader a clue that there is a

increases, this reveals that more

price spike. Here is where volume

futures trading, this is a zero sum

potenal trend reversal coming.

and open interest would help one

game. For every long there is a

new longs have entered the mar-

gather further evidence.

Tren Tra ng In c ator s

Noce in Figure 8.3, we have three

price advance, accompanied with a

there could be a sustainable sustainable price

Hecla Mining (HL). Now whether

separate panes. The top secon

rise in open interest, revealing that

advance over me.

you are a futures trader or a stock

is a candlesck, the middle is the

traders are adding to longs with

open interest data, and the bot-

an increase in trading volume. This

tom secon is a volume histogram

indicates that traders are accu-

with a 20-day moving average

mulang posions and that the

study overlaid on the bar graph.

health of this trend is very strong.

From late June of 2010, we see the

This helps one to understand that

Let’s examine the graph in Figure 8.3 further. Gold can be traded as a futures contract, or stock traders can trade an exchange traded fund (GLD), (GLD), or highly correlated stocks such as Newmont Mining (NEM) or

trader, here is where volume and open interest analysis can help traders understand the overall health of the trend. This informaon may help traders stay with the trend a bit longer. Like the

Tren Tra ng In c ator s old saying goes, “ride the winners and cut your losses,” using these technical tools may help you to see if the price advance or the trend is sustainable. As the chart shows, once again as prices start to boom in late July of 2010, the open interest gures shown in the middle secon start to increase. This is also accompanied by an increase in volume. Together, this signals that the start of the new bullish trend is healthy and sustainable.

CONCLUSION There are many indicators that rely and are

QUICk QUIz 1. volume is an inicato of te ealt of a maet ten. a. True b. False 2. If olume is inceasin in a isin pice enionment, ten: a. b. c. .

The market is in a bullish mode The market is in a bearish mode Further price appreciaon can be expected Both a & c

3. deceasin olume in a weae weae pice enionment:

built based upon prices, but very few are derived using volume studies, and as far as commodies are concerned, the open interest data. Both tools are instrumental for the traders who want to stay on the right side of the trend and are easy to access. Remember, these tools help conrm the overall health of the market trend.

a. b. c. .

Indicates a plateau. Can be used to predict a reversal. Could be a sign of a future downtrend. Indicates a bear market.

4. Wen pices ise an open inteest inceases:

9

Trend Lines TrENd LINE ANALySIS

I

was taught nearly 30 years ago, the most protable way to trade is with the trend. So naturally, it’s impor-

tant to idenfy what the trend is and in what market condion you are trading. Unfortunately, many people do not adhere to this advice, either by trying to outsmart

the market or leng their intelligence intelligence or ego interfere with a simple raonale of  idenfying the current market condion. In this chapter, I will disclose some of the more proper methods for idenfying the market condion, or what we call the trend, by simple line drawing techniques

a. b. c. .

New longs have entered the market. New shorts have entered the market. Money is owing out of the market. Traders Traders are taking prots. Fo te answes to tis qui, o to TaesLiba.com/TLEcone.. TaesLiba.com/TLEcone

and ways to help idenfy when a market trend is potenally exhausng itself  or running out of steam. I will also show some of the techniques that I learned early in my career on how to correctly use trend line analysis to help me implement trades. Most importantly, based on these techniques, I will cover how to look for

Tren Tra ng In c ator s inial entry points of interest, stop placement levels, spots to add on

FIrST ThINgS FIrST

posions once a trend is maturing, and places to move protecve stop

I was always taught if you are going to analyze the market, you need to

orders based on the use of drawing lines on my charts.

gure out where prices can go. To do that requires you to look at where

Throughout the history of the trading industry, many phrases and cli-

prices have been. Start with looking at the longer-term picture. Drop

chés have evolved due to past human errors and successes. From my

down to the intermediate term and then to the short-term me frame.

30-plus year career, I would like to share with you some of the tech-

For longer-term invesng invesng requiring more than one month, I will start

niques and taccs for successful trend trading based on some of those

with the monthly chart. Drop down to a weekly chart and use my daily

phrases.

or end-of-day charts. For swing trading, I will sll look at the weekly and daily me frames, but include a 60-minute chart. For day traders, I like

ThE TOP FIvE SECrETS TO rEMEMBEr WhEN TrENd TrAdINg 1. The trend is your friend. 2. The trend is your friend unl it ends. 3. Never ancipate when a new trend will begin; markets have a habit of 

moving further than traders expect. 4. When in a bullish trend, buy pullbacks. 5. When in a bearish trend, sell rallies.

to look at the weekly and daily market direcon and then take trades based o of the 5- and 15-minute me frame. As for drawing trend lines, the important thing here is to idenfy the pivotal swing points, both highs and lows, and then extend a line out to help idenfy the trend’s direcon. Let’s examine Figure 9.1. This is a chart on Potash (POT). I have purposefully made a black and white chart so that if you print this page out, it will be seen clearly. From the low marked point “A,” which was created by a “W” boom paern as the right side low was formed by a hammer candlesck, the market moved up to the rst pullback low, or swing low. This is where we would con-

In this chapter, we will go over the proper techniques for drawing trend

nect the trend line and extend out in the future. As the saying goes,

lines such as lines drawn from lows, from highs, and from range mid-

“the trend is your friend unl it ends.” Here is how correctly drawing

points. We will discuss the importance of the condion and locaon of 

trend lines can help you idenfy a change in a trend’s direcon.

those trend lines specically, the angle, degree, and separaon from price to the trend line.

Once prices have traded beneath the longer term extension, say for two consecuve closes below the trend line, one can argue that the trend has changed direcon. Aer the peak at point “B,” the trend started to

 Iff you  I you ar aree goi going ng to an anal alyz yzee the the mar marke kett, you you need to gure out where prices can go.

reverse and change direcon. So does one look to buy the pullback as prices start to close back in on the line extension? If one did not enter at the beginning phase of this “W” boom paern, then one could look for

Tren Tra ng In c ator s

a low risk trade setup by buying

small loss. As you can see, prices

Let’s examine the next graph in

towards this support line, that

a test of the trend line extension.

connued lower. Once a reversal

Figure 9.2; this is a weekly chart

would be a targeted area to look

However, once prices fail to con-

occurs, traders wait for “bounces”

on McDonald’s (MCD). Another

to enter a long posion. As we

nue higher and close beneath the

or rallies to sell against. One such

double boom forms, creang

say, this denes buying pullbacks

uptrend line; in other words, fail

rally occurs in early May as the

the “W” paern from point “A” to

in a bullish environment. Point “C”

to hold the trend line support, the

chart shows. To determine future

point “B.” If one wanted to draw

intersects right at the trend line

trader should exit the long posi-

overhead resistance, one would

a textbook upward sloping trend

extension. Noce that the candle

on. This would result in a loss,

draw a line against the high at

line, it would exist at a nearly 45

formaon is a bullish engulng

but as the example here shows, a

point “B” and extend out.

degree angle. Once prices retrace

paern, which may help to con-

Tren Tra ng In c ator s However, once prices break out and above that level, if the market is to prove itself to be bullish, prices should not trade back under that line. The line of old resistance should prove to become the new line of support. Instead of buying the market on the rst breakout of old resistance, most conservave traders will wait unl the market pulls back to the horizontal line and then they will go long with close stops because the price acon should hold based on the theory that old resistance should act as new support. In this example, trend line “B” has acted under that old axiom.

QUICk QUIz 1. Pope ten line analsis can elp taes ienf: a. b. c. .

Inial entry points Stop placement levels Add-on posions All of the above

2. Wen in a bullis ten, bu pullbacs. a. True b. False 3. Wen in a beais ten, sell pullbacs. a. True b. False 4. A tae soul eit te lon posion:

rm the posive momentum as

support. Figure 9.3 helps to illus-

prices bounce o of the newly

trate this technique. In Figure 9.3,

constructed support trend line.

using the same weekly chart on

We have addressed how to properly idenfy bullish trend lines, one area that I believe is crical is idenfying what we say is “old resistance,” which turns into new

McDonalds (MCD), (MCD), you can see the old highs during 2008. If you draw a horizontal line across your chart as prices boom in 2009 and start the new uptrend, that old high is creang a ceiling of resistance.

a. As prices connue higher b. When prices close beneath the uptrend line c. When prices hold the trend line support . All of the above Fo te answes to tis qui, o to TaesLiba.com/TLEcone.. TaesLiba.com/TLEcone

Tren Tra ng In c ator s 10

Elliott Wave Theory 

N

o book on trends would

be complete without some introducon on the

Ellio wave theory. I do not necessarily use Ellio wave theory consistently in my trading, but I do know the principles of the waves and the theory behind the psychological aspects that drive human beings are reected in market prices, namely fear and greed. As it is oen stated, human emoon oen interferes with human intelligence. I want to share with you my experience, feelings, and observaons on this theory, as well as quote a good acquaintance who is one of the premier technicians in the world on the eecveness of  Ellio Wave, who says: “it works when it works.” This means that I do not use it all the me, and as

I disclose the principles here, you

and “M” top formaons, seasonal seasonal

thing that has been achieved and

will understand why. So I guess

analysis, pivot points, moving aver-

pracced even by Mr. Ellio him-

you are now asking yourself why

ages, trend lines, indicators like

self. His discoveries were simply a

bother sharing it in this book? The

ADX, MACD, and stochascs, and

compelling phenomenon into the

reason is because it reveals trends

volume and open interest studies.

art of forecasng price moves. I

and the trend paerns.

hISTOry ANd vALUE OF ELLIOTT WAvE

I believe it is important that traders have a complete understanding of trend analysis but also phases or waves as they are con-

will cover the basis for his discoveries and the overall strengths as well as weaknesses of his work. Keep in mind that Ellio wave is a fractal concept which works in

Ralph Nelson Ellio (1871-1948)

sidered. Ellio wave principles can

was a dedicated student of the

help you uncover just that, and

stock market. Back in the 1920s,

more specically, what phase or

he observed market moves, both

“wave” the market trend is in. As

bullish and bearish, occur in three

you may have already discovered,

disnct phases. He began to

all markets certainly do trade in

develop theories and views that

phases, from periods of consoli-

the overall prices in stock market

daons to trending modes. With

averages move in waves. This was

the knowledge of the Ellio wave

presumed to fall in line with the

principles, this informaon may

understanding of the work cred-

give you a beer understanding of 

A completed Ellio wave cycle

ited by Charles Dow as dened in

which side of the market to be on,

from bullish to bearish or bearish

the Dow Theory.

and to capture protable moves

to bullish consists of eight waves.

The purpose of this chapter is to

with surgical precision. And hope-

There are two disnct wave deni-

give an introducon as to what

fully more mes than not, trading

ons. Impulse waves are the ones

Ellio wave is and how you can

from the winning side.

termed to be moving with the

apply this method in the markets

Since many of the concepts

combined with what we have

explained already are great tools

already covered, incorporang

in and of themselves, combining

Impulse waves have ve primary

Dow Theory with “W” booms

them with Ellio wave is some-

price movements and the cor-

mulple me frames so that it can truly benet all styles of trading from day to swing to posion traders. The fractal concept is simply dened as cycles or paerns repeang in shorter me frames and developing in longer-term me periods, meaning there are waves within waves.

main trend and correcve waves are against the main trend.

Tren Tra ng In c ator s recve waves are seen as having

posed of eight price moves, ve

For more experienced charsts,

wave one count for the weekly

three primary price moves, which

up and three down, as you can see

they would of course recognize

me period. We can also see a ve

are leered and run in the oppo-

in Figure 10.1. Incidentally, three,

that the end of a bullish move’s

wave count on a ve minute chart

site direcon of the main trend.

ve, and eight are contained in

h point could possibly be con-

that composes just wave one on

A healthy long-term trend follows

the Fibonacci series of numbers.

sidered the number one point of 

a daily chart. Ellio wave theory

the indicaon of heavier volume

The fundamental concept behind

a one-two-three formaon, or the

combines the best of tradional

during the impulse waves (one,

Ellio’s Ellio’s theory is that bull markets

top of a head and shoulders for-

charng techniques and price pat-

three, and ve).

have a tendency to follow a basic

maon. The one thing Ellio most

tern formaons such as triangles

ve-wave advance, followed by

wanted charsts to recognize is

and wedges. These are simply con-

a three-wave decline. The exact

that his wave theory worked on

solidaon paerns within trends.

opposite is true for bear markets.

long-term charts as well as intra-

These trends’ phases are consid-

day charts.

ered waves.

It is assumed that Ellio used some of Fibonacci’s work because a complete wave cycle is com-

A WAvE IS A WAvE

Price objecves from predicting possible highs or lows can

It does not maer what me

be determined through the use

frame you trade in; a wave is a

of Fibonacci raos and the cor-

wave. The idea here is that each

responding rules associated with

wave is simply a subset of another

each wave descripon. I also have

wave just to a lesser degree. Each

had tremendous success iden-

wave is itself part of the higher

fying turning points as indicated

degree wave. We can dene

by the maturity of a price move.

this by saying waves of one me

For example, if it is the boom of 

frame can be expanded to relate

wave two or four, I may look for

to a higher me period, and one

support targets using the Fibonacci

me frame can be subdivided

raos as well as the pivot point

into a shorter term me frame.

support targets. When I see a

For example, we might see a ve

conuence or mulple cluster of 

wave count on a 60-minute chart

support targets from using both

that, when converted to a daily

techniques, it heightens my asser-

or weekly chart, counts as a full

on to go with a posion because

Tren Tra ng In c ator s I understand which direcon to

forms, Fibonacci correcon, and

The Ellio wave principle was

is referred to as a proporonate

trade from. I will admit there are

projecon raos and has a me

originally applied for the stock

and alternate relaonship with the

mes when an Ellio wave pat-

element as magnitudes of each

market, but the core foundaon

measurement of the waves.

tern is crystal clear and helps me

waves are concerned.

of its decipherable use was based on the premise of mass human

Wae One

psychology. Due to the exorbitant

The rst wave is the base or start-

extent of trading on a global scale

ing point derived from a con-

ysis can work with all markets

in foreign currency, I nd it works

solidaon trading phase aer a

well when the paerns jump out

prolonged price decline. It usually

on the charts. In a world of cha-

appears to be simply a small cor-

and time frames; whether it is stocks,

oc and turbulent volality, Ellio

recve bounce from a previous

wave aempts to give a trader

trend. It is the smallest in price

a beer chance of interpreng

moves as compared to the three

what phase a market is in, price

impulse waves. This stage or wave

objecves, and me duraons to

is what technicians have discov-

expect a move to last. It is highly

ered to be an accumulaon phase.

subjecve, and I strongly suggest

Using what we have learned with

scking to the rules I will outline

Fibonacci calculaons so far, we

Trading is not about being rigid

when applying these principles in

can apply the rao numbers to

and scking with just one sin-

your trading.

develop a technique to give price

trade on the winning side, and then there are mes when I do not have a clue and can not make out any clear or disnct paern. That is when I rely on other techniques such as trading in a short term me frame within the direcon of a higher degree me frame. For instance, if the 15-minute trend is up, classied by the market trading above a set of moving averages (namely pivot point aver-

 Elliott  Elli ott wave analanal-

 ETFs, futures,  ETFs, f utures, or  Forex.  For ex.

ages), then I look for buy signals as dened by a series of higher highs, higher lows, and higher closing highs as prices trade above a set of  moving averages on the ve-min-

gle method. Market condions

projecons for a typical ve wave

of tools to improve your market

rULES FOr TrAdINg WITh ELLIOTT WAvE

The key in understanding Ellio Ellio

forecasng abilies. Because it is

Each wave has its own set of char-

wave move, we can use several

wave is that it can work with all

a complete and comprehensive

acteriscs or personalies and

techniques.

markets and me frames, whether

analycal tool, I believe studying

rules. Besides wave counts and the

it is stocks, ETFs, futures, or Forex.

and using Ellio wave will improve

interacon with Fibonacci exten-

It is a valuable technical tool

your chances for success.

sion and correcon relaonships, relaonships,

ute me period.

because it is comprised of wave

change, requiring an assortment

there is a me element and what

paern. In order to help determine the top or peak of a ve

Using soware that includes a Fibonacci correcon and expansion tool, we can easily determine a price objecve with fairly good

Tren Tra ng In c ator s

accuracy. If your charng soware

higher frequency of the 2.618 per-

The one drawback in using this

included examples of integrang

program does not have this fea-

cent rao work as well. See Figure

method is the consideraon of 

longer-term pivot point analysis

ture, my website, NaonalFutures.

10.2 for illustraon.

how much me it takes for a swing

such as weekly and monthly me

measurement measurement to reach its objec-

periods. These seem to be more

ve. Using Fibonacci extensions

eecve in predicng both me

 just gives us an idea of a poten-

and price turning points.

com,, provides a free pivot point com and Fibonacci calculator.

Another method to predict the peak for wave ve is to take the

Once we determine the overall

measurement measurement from the boom of 

measurement or amplitude of 

wave one to the top of wave three

wave one, extend that amount by

and mulply out by 1.618 percent.

3.236 and add that sum to the bot-

See Figure 10.3.

tom of wave one. I have seen a

al move; it does not give us a me frame in which the move

Wae Two

will occur. The move could take

As you can see in Figure 10.4, the

days, weeks, or months to meet

second wave usually retraces .618

the objecve. That is why I have

percent of the sum of wave one.

Tren Tra ng In c ator s Wae Tee

needs to be followed is to make

The third wave is one of the most

sure the third wave is a true wave;

important because this is where

it cannot be the shortest of the

you will see your trend conrma-

ve waves.

on occur. This wave is the largest

Wave two can at mes retrace

in the chapter on Dow Theory.

100 percent of the enre previous

These are commonly referred to

trend or wave one, but not beyond

as 1-2-3 paerns and resemble a

the beginning of that wave. This

head and shoulder chart paern.

means that if it is a bullish cycle,

Traders have also been able to use

wave two will not make a lower

the number two point to predict

low, and if it is a bearish cycle, it

the top of wave ve by taking the

will not make a higher high. This is

sum of the price move in wave

what technicians generally consid-

one, mulply that amount out by

er the makings of “W” paerns or

1.618 percent and then add that

double booms or “M” paerns

gure to the price point of the bot-

or double tops. This was discussed

tom of wave two.

of the three impulse waves. It is

Wae Fou

accustomed with heavy volume.

The fourth wave is the correcve

From a fundamental aspect, this is

wave. It usually gives back some of 

where you will start to hear more

the advancement from the third

and more bullish news, which will

wave. One may see measuring

in turn support the move upward.

chart paerns like triangles, pen-

Generally speaking, the top of 

nants, or ags during the fourth

wave three equals a measurement

wave. Triangles, pennants, and

of the length of wave one mul-

ags are connuaon paerns and

plied out by a factor of 1.618 per-

generally break out in the same

cent. Another way to determine

direcon as the overall trend. The

or predict the top of wave three

most important rule to remember

is to take the overall length of 

about the fourth wave is that the

wave one, mulply that amount by

low of the fourth wave can never

2.168, and then take that sum and

overlap the top of the rst wave.

add it to the price point of the low

Here is where we will nd tremen-

of wave two. Technicians jump on

dous trading opportunies once

the trend and place market orders

you can idenfy the fourth wave.

to enter a posion from the break-

As the principle applies, applies, old highs

out above the number one wave.

(resistance) once broken will later

You usually see a large increase

turn into a new low (support) on a

in volume and open interest at

re-test as we covered in our chap-

that point. This is where break-

ter on trend line analysis.

away gaps will occur. One rule that

Tren Tra ng In c ator s Wae Fie

the Extraordinary Value of the

beyond Wave A, then another

nal rather than chase the market

The h wave is usually the stron-

Ellio Wave Model  , both of which

cycle begins in the opposite

as it declines and sell short right as

gest for some commodies, such

can be found at www.tradersli-

direcon.

it starts building an upside reversal

as coon, soybeans, gold, and cur-

brary.com.. brary.com

rencies. This is where the longest

To summarize what we’ve learned

“leg” of the waves will be formed.

in this chapter, here are the main

It is also during this nal phase that the price advance begins to slow. From the rule of “mulple

that forms forms into wave wave ve. Beer

SUBJECTIvITy IN ELLIOTT WAvE

yet, with the knowledge of what

principles that you should focus

There are more observaons to

might look like you can:

on when working with Ellio Wave

understand which are quite sub-

•

project a prot objecve

Theory:

 jecve rather than absolute rules •

lter a trading system to look

regarding Ellio wave theory.

techniques,” other indicators and Wave A is usually mistaken

Having the ability to look at a

for beer triggers to sell short

cs begin to show signs of being

as a regular pullback in the

chart and being capable of seeing

as the maturity of a long-term

overbought in a bullish trend, or

trend, but this is where you

the corresponding trends or waves

trend starts to dissipate. dissipate.

oversold in a bearish trend. We

could possibly start seeing the

in the market will help you deter-

This will also help you not to sck

noce during this period that

makings of “W” or “M” pat-

mine which side of the market to

terns(1-2-3 paerns), double

around in a trade too long.

the market is beginning to lose

trade on.

momentum and that the trend

tops or booms, or a head and

may be exhausng itself.

shoulders chart paern.

oscillators oscillators like MACD and stochas-

•

the characteriscs of a h wave

One such setup is idenfying a higher right side double bot-

•

Wave B is a small retrace-

CONCLUSION

tom form as wave two forms.

ment back towards the high of 

Remember, it will look like a dou-

Robert Prechter of Ellio of Ellio Wave

wave ve, but it does not quite

ble boom or correct near the

Internaonal is one of the world’s

reach that point. This is where

.618 percent retracement level.

foremost leading experts on Ellio

traders will exit their posion

Wave two can also retrace 100

wave. If you see yourself wanng

or begin seng up their posi-

percent of wave one, so armed

to learn more into this subject, he

on for a move in the opposite

with this informaon, you will

has wrien several books on this

direcon.

have a beer idea of how much

Wave C conrms the end of 

to risk on a trade. For example, as

subject, and I would would recommend that you explore them, along with and his video courses Trading the Ellio Waves and Understanding

•

the uptrend and when conrmaon is made by going

you see a fourth wave develop, it will be beer to wait for a buy sig-

QUICk QUIz 1. Ellio wae analsis can wo in all maets an all me fames. a. True b. False 2. A complete Ellio wae ccle consists of ow man waes? a. b. c. .

5 3 8 13

Tren Tra ng In c ator s 3. Wat in of waes ae sai to moe wit te main ten? a. b. c. .

Correcve Fractal Dow Impulse

4. In wic wae will a tae see a ten conmaon occu? a. b. c. .

Wave one Wave two Wave three Wave four

Fo te answes to tis qui, o to TaesLiba.com/TLEcone.. TaesLiba.com/TLEcone

C

In Closing

ABOUT ThE AUThOr

cal analysis, his trading style, and

John Person is a 32-year veteran

system development. John devel-

of the futures and opons trad-

oped the Person’s Pivots and the

ing industry. He started

PPS indicator, both of which

on the oor of the

are on TD Ameritrade’s

Chicago Mercanle

Thinkorswim trad-

Exchange back

ing plaorm. He

I hope you found this book use-

in 1979. This

also has devel-

ful in increasing your knowledge

was the premier

oped indicators

and understanding of trend and

exchange which

for TradeNavigator

its eect on the market. With

launched foreign

and TradeStaon

the tools and indicators we cov-

currency trading.

Securies.. He has Securies

ered, you’re well on your way to

He then had the privi-

being able to harness the power

lege of working with George

of a trend and using it to improve

Lane , the innovator of the sto-

bers of the largest exchanges. He

your trades.

chasc indicator.

is the author of three naonally

All the best in your connued

John has worked his way through-

ing books as well as three trad-

educaon and trading endeavors.

out the industry as an inde-

ing courses and a DVD seminar

pendent trader, broker, analyst

series. His latest book series, The

and branch manager for one

Commodity Trader's Almanac, Almanac, is

of Chicago's largest discount

instrumental instrumental in trading the sea-

/ full service rms under the

sonal aspects of the commodity

direct supervision of a former

markets and the correlated ETFs

Chairman of the Chicago Board

and stocks of those markets.

taught thousands of  traders, including mem-

and internaonally popular trad-

John Person

of Trade. John is the founder of  NaonalFutures.com , an online

The naon’s most respected busi-

educaon website.

ness journalists call John Person for his market opinions. He is

John has shared his wealth of 

widely quoted by CBS Market

knowledge in the eld of techni-

Watch, Reuters, Dow Jones

Tren Tra ng In c ator s Newswires, Newswires, and appears regu-

rECOMMENdEd rEAdINg

larly on CNBC. He is a sought aer

Te Tee Secets to Tain Momentum Inicatos

speaker for many professional organizaons organizaons such as the Market

By David Penn

Technicians Associaon (MTA ) ,

You can't predict the future, but if you see a car going 100 miles an hour toward a

the Internaonal Federaon of 

picket fence, you have a prey good idea. In trading, this concept is called momen-

Technical Technical Analyst Society (IFTA)

tum and it is one of the most widely used factors in creang eecve, protable

and delivers keynote speeches and

technical indicators.

seminars at some of the country's

This eBook not only shows the three secrets that allow you to capitalize on the

top naonal investment expos.

power of momentum indicators, the digitally integrated features make it easier for

John’s thorough understanding of 

you to see the charts and click right through to the glossary and addional infor-

the futures industry makes him

maon. Momentum indicators are excellent for geng on the right side of the

qualied to oer his clients a bal-

trend and spong the reversal before it happens. With a mastery of momentum,

anced perspecve of the trading

traders can put this predictability to work making them money.

industry. In addion, the personal

Item #7781726 - more info...

contacts he has developed around the world and in the nancial industry have been instrumental instrumental in helping him gain an edge on informaon pertaining to the markets.

Te denie guie to Momentum Inicatos By Marn Pring Momentum, oen caused by fast-breaking fast-breaking news or big-money investors taking or dumping posions, is one of today's most valuable technical analysis tools for spong trends and catching turning points. Now, Marn Pring delivers the most comprehensive volume available on the subject. The Ulmate Guide to Momentum Indicators is a unique combinaon of  text and audio-visual CD tutorial. It is an excellent teaching tool for in-depth research, instant reference, reference, and interacve review. It provides technical traders with remarkably remarkably accurate methods—proven eecve in today's fast-moving fast-moving markets—for ancipang and exploing trends. Item #6220328 - more info...

Tren Tra ng In c ator s volalit Inicatos: Tecniques fo Pon fom te Maet's Moes By Lee Leibfarth & Jean Folger You have probably been hearing a lot about volality in today’s nancial nancial markets, and that’s because it is such a crucial factor in trading. Fluctuaons in trading acvity can be used to establish ming for trade that will yield maximum results—if you know what to look for. In this new eBook, Jean Folger and Lee Leibfarth, authors of  Make Money Trading, help you to understand volality and the indicators that can help to harness its power. Volality indicators provide predicve insight into the price movements of the market and are powerful technical analysis tools that can be used to nd protable trades. This new eBook format makes everything you need to know about volality indicators—from indicators—from a history of the most popular volality indicators to experimental applicaon, applicaon, to nding unique opportunies for short and long-term traders—just a click away! It’s a breeze to get right to the informaon you’re looking for and even tap into answers that go beyond the book! Item #10353118 - more info...