Classical Bar Charting & Technical Analysis

Kenneth H. Shaleen

Section One - The ‘Bottom of the Chart’ Chapter 1 Rationale of technical analysis Chapter 2 Volume Analysis Significance Healthy Price Trends Blowoff Volume Determination of Volume Parameters Chapter 3 Open Interest in a Futures Contract Significance Healthy Price Trends Idiosyncrasies Chapter 4 General Rule for a Healthy Price Trend (on a daily futures chart) Why Total Volume & Open interest is Used Worksheet

Section Two - The Basics Chapter 5 Price Scales Arithmetic verses Logarithmic Futures Continuation Charts Chapter 6 Trending with the Trend Trendline Construction Trendline Analysis Chapter 7 Support and Resistance

Section Three - Reversal Patterns Chapter 8 Price Pattern Recognition - an Overview Chapter 9 Head & Shoulders Top and Bottom

Chapter 10 Broadening Formations Chapter 11 Double Top and Double Bottom

i

Section Four - Continuation Patterns

Chapter 12 Symmetrical Triangles As a Continuation Pattern As a Reversal Pattern Chapter 13 Right Angle Triangle Ascending Right Triangle Descending Right Triangle Chapter 14 Wedge Formations Rising Wedge Falling Wedge Chapter 15 Flags & Pennants - ‘half-way’ formations

Section Five - Gap Theory Chapter 16 Gap Theory Four Basic Types of Gaps Ex-Dividend Gap Island Formation

Section Six - Minor Trend Change Indicators Chapter 17 Minor Trend Change Indicators Key Reversal Outside/Inside Range Mid-Range Close

Section Seven - Other Forms of Technical Analysis Chapter 18 Chapter 19 Mathematical Models - Trend Following Chapter 20 Mathematical Models - Oscillators Chapter 21 Chapter 22 Spreading and Spread Charts © Kenneth H. Shaleen ii CHARTWATCH 9/08

International Futures Research

Kenneth H. Shaleen is President of CHARTWATCH, an international research firm to the futures industry. CHARTWATCH distributes weekly technical analysis at www.chartwatch.com and produces a daily telephone market update. Mr. Shaleen has instructed technical analysis courses for the Chicago Mercantile Exchange since 1976. These courses are also conducted in London, Singapore, Malaysia, Hong Kong and other locations throughout the world. Mr. Shaleen is the author of Volume & Open Interest (Irwin, 1991, 1997) and Technical Analysis & Options Strategies (Irwin, 1992), three Chicago Mercantile Exchange course book as well as numerous articles. Mr. Shaleen Joined the Northern Trust Company in Chicago in 1968 as a Management Science Analyst to develop computer models for the Bond and Trust Departments. A move to futures research was made in 1972. After supplying analysis for twelve years as Director of Research for two Chicago Board of Trade clearing member firms, he formed CHARTWATCH in 1984. Mr. Shaleen is a charter member of the Commodity Options Market (1982) at the Chicago Board of Trade. He holds a B.S. in Civil Engineering from the University of Colorado (1967) and an M.B.A. in Finance from Northwestern University (1968).

Please direct all inquires concerning videos and any of the services offered by CHARTWATCH to:

CHARTWATCH Fulton House 1604

345 North Canal Street Chicago, Il 60606 USA

Telephone: 312 454-1130

www.chartwatch.com

iii

Foreword

Earning an MBA in finance at Northwestern University in June of 1968, I was never exposed to one of the most active markets in the world - the Chicago futures exchanges - basically just down the street from the downtown Northwestern campus. After reading Commodity Speculation with Profits in Mind by L. Dee Belveal (Commodities Press, 1967), I started my first chart - Sept ‘68 Oat futures. This course manual is an ongoing compilation and refinement of all the charts and technical analysis I have encountered since this time. The majority of charts in this manual are futures charts, although the first Technical Analysis Course I conducted for the Chicago Mercantile Exchange in the Summer of 1976 used the Edwards and Magee “bible” of price pattern recognition: Technical Analysis of Stock Trends. Now the technical analysis course has come full circle with Stock Index futures charts and individual equity charts increasingly in evidence. This is the course manual. The “live” charts assigned in the early CME Technical Analysis courses were Live Cattle and Soybeans. These evolved to Deutsche Marks and Treasury Bonds - as the volume in financial futures became dominant. The simple creation of a chart also evolved with the advent of electronic “after hours” trading and the proliferation of technical analysis software. Much of what is contained in this course manual is the old fashioned “art” of drawing trendlines to construct classic price patterns. A combination of older charts and more up-to-date examples are co-mingled to show that human nature, creating the price patterns, does not change. To the 15,000+ students who have helped me analyze these charts - my thanks.

Ken Shaleen Chicago Sept 22, 2008

Classical Bar Charting

&

Technical Analysis

Prepared and Presented

by

Ken Shaleen

President, CHARTWATCH Inc.

Classical Bar Charting & Technical Analysis

Kenneth H. Shaleen

Section One - The ‘Bottom of the Chart’

Chapter 1 Rationale of technical analysis

Chapter 2 Volume Analysis SignificanceHealthy Price TrendsBlowoff VolumeDetermination of Volume Parameters

Chapter 3 Open Interest in a Futures ContractSignificanceHealthy Price TrendsIdiosyncrasies

Chapter 4 General Rule for a Healthy Price Trend (on a daily futures chart)Why Total Volume & Open interest is UsedWorksheet

Section Two - The Basics

Chapter 5 Price ScalesArithmetic verses LogarithmicFutures Continuation Charts

Chapter 6 Trending with the TrendTrendline ConstructionTrendline Analysis

Chapter 7 Support and Resistance

Section Three - Reversal Patterns

Chapter 8 Price Pattern Recognition - an Overview

Chapter 9 Head & Shoulders Top and Bottom

Chapter 10 Broadening Formations

Chapter 11 Double Top and Double Bottomi

Section Four - Continuation Patterns

Chapter 12 Symmetrical TrianglesAs a Continuation PatternAs a Reversal Pattern

Chapter 13 Right Angle TriangleAscending Right TriangleDescending Right Triangle

Chapter 14 Wedge FormationsRising WedgeFalling Wedge

Chapter 15 Flags & Pennants - ‘half-way’ formations

Section Five - Gap Theory

Chapter 16 Gap TheoryFour Basic Types of GapsEx-Dividend GapIsland Formation

Section Six - Minor Trend Change Indicators

Chapter 17 Minor Trend Change IndicatorsKey ReversalOutside/Inside RangeMid-Range Close

Section Seven - Other Forms of Technical Analysis

Chapter 18

Chapter 19 Mathematical Models - Trend Following

Chapter 20 Mathematical Models - Oscillators

Chapter 21

Chapter 22 Spreading and Spread Charts

© Kenneth H. Shaleen ii CHARTWATCH 9/08

International Futures Research

Kenneth H. Shaleen is President of CHARTWATCH, an international research firmto the futures industry. CHARTWATCH distributes weekly technical analysis at www.chartwatch.com and produces a daily telephone market update.

Mr. Shaleen has instructed technical analysis courses for the Chicago MercantileExchange since 1976. These courses are also conducted in London, Singapore,Malaysia, Hong Kong and other locations throughout the world.

Mr. Shaleen is the author of Volume & Open Interest (Irwin, 1991, 1997) andTechnical Analysis & Options Strategies (Irwin, 1992), three Chicago MercantileExchange course book as well as numerous articles.

Mr. Shaleen Joined the Northern Trust Company in Chicago in 1968 as aManagement Science Analyst to develop computer models for the Bond and TrustDepartments. A move to futures research was made in 1972. After supplyinganalysis for twelve years as Director of Research for two Chicago Board of Tradeclearing member firms, he formed CHARTWATCH in 1984.

Mr. Shaleen is a charter member of the Commodity Options Market (1982) at theChicago Board of Trade. He holds a B.S. in Civil Engineering from the University ofColorado (1967) and an M.B.A. in Finance from Northwestern University (1968).

Please direct all inquires concerning videos andany of the services offered by CHARTWATCH to:

CHARTWATCHFulton House 1604

345 North Canal StreetChicago, Il 60606 USA

Telephone: 312 454-1130

www.chartwatch.com

iii

Foreword

Earning an MBA in finance at Northwestern University in June of 1968, I was neverexposed to one of the most active markets in the world - the Chicago futuresexchanges - basically just down the street from the downtown Northwestern campus.

After reading Commodity Speculation with Profits in Mind by L. Dee Belveal(Commodities Press, 1967), I started my first chart - Sept ‘68 Oat futures. Thiscourse manual is an ongoing compilation and refinement of all the charts andtechnical analysis I have encountered since this time.

The majority of charts in this manual are futures charts, although the first TechnicalAnalysis Course I conducted for the Chicago Mercantile Exchange in the Summerof 1976 used the Edwards and Magee “bible” of price pattern recognition: TechnicalAnalysis of Stock Trends. Now the technical analysis course has come full circle withStock Index futures charts and individual equity charts increasingly in evidence. Thisis the course manual.

The “live” charts assigned in the early CME Technical Analysis courses were LiveCattle and Soybeans. These evolved to Deutsche Marks and Treasury Bonds - asthe volume in financial futures became dominant. The simple creation of a chartalso evolved with the advent of electronic “after hours” trading and the proliferationof technical analysis software.

Much of what is contained in this course manual is the old fashioned “art” of drawingtrendlines to construct classic price patterns. A combination of older charts andmore up-to-date examples are co-mingled to show that human nature, creating theprice patterns, does not change.

To the 15,000+ students who have helped me analyze these charts - my thanks.

Ken Shaleen Chicago Sept 22, 2008

iv

Chapter One

Rationale

In the long run, the price of any freely traded item is determined by the interactionof the fundamentals of supply and demand. But in the short run, the price of thatitem could move in exactly opposite direction as dictated by the fundamentals. Why? What is contained in the determination of the price? Hopes, fears, andmoods. An these moods can be rational or irrational. The technical traderfollows the price only. Price changes produce the profit or loss; as a final result,this is what is important.

It is difficult for a trader to isolate a technically derived market view from thefundamentals. The question always arises: Why is price moving the way it is andwhy should it go to a particular price level that might be predicted by technicalanalysis? A technician must try to divorce himself from these thoughts. Thisdoes not mean that a technician does not know what is going on in the “real”world. Often, a scheduled economic report will initiate the price move. Indeed, ittakes reversals of the minor price trend to create the handful of classic pricepatterns that will be studied in this course manual. A fundamental event isusually responsible for creating the minor price change. So a technical tradershould monitor the economic release calendar - and be prepared for the possibleprice moves that will result. Often these minor price moves create the necessaryconditions for a classical bar charting price pattern.

The bulk of this course manual will be devoted to the “low tech” art of pricepattern recognition. There is nothing magic about these price patterns. They arethe interaction of supply and demand variables as perceived by the marketplace. And human nature - reacting to economic events and shock variables - tends torepeat itself.

Equity Markets verses Futures Markets

The techniques investigated are applicable to equity (stock) charts and futurescharts. Each of these markets has its own unique characteristics. Thesecharacteristics are not difficult to understand - and do not pose any majorproblems for the astute technician.

1-1

The Difference between Equity and Futures Charts

The main difference between equity charts and futures charts is that equity chartscontain only price and volume statistics whereas a futures chart contains theadded variable of open interest. There is a major conceptual difference in amarket that must have a short for every long at the end of a trading session i.e., afutures market, verses the equity market where there are (predominately) longsonly, at the end of the trading session.(For purists, the concept of short interest inthe equity market will be detailed in Chapter Two, Open Interest).

The question often arises: Why should a derivative market, the futures, beanalyzed when the underlying “cash” or “spot” market is the dominant market? Afutures market that has achieved a “critical mass” becomes a microcosm -diminutive but analogous to the whole (cash market). The “basis”, the differencebetween the cash market price and the futures price, is highly arbitraged andproduces a relatively stable (although dynamic) relationship between the cashand futures market.

1-2

Chapter Two

Volume

Volume provides a “filter” for classical high, low, close, bar chartists. Volume isso important that when this internal statistic does not support the technicalconclusion derived from the analysis of price movements, the contemplated tradeis suspect and would not be initiated. In this regard, volume is often thevalidating statistic that causes a technical trader to “pull the trigger” on a newtrade.

Definition: Volume is the number of futures contracts (shares for an equity

market participants) traded each trading session.

In a futures market, a contract is consummated only when both sides of the tradeagree to the price and quantity. At the end of a trading session, the total numberof contracts bought equals the total number of contracts sold. Therefore, thefollowing equality always prevails:

Buy Volume = Sell Volume = Total Volume

Published volume figures represent one side of a futures trade only. The phrase“more buyers than sellers” is never true with respect to volume statistics. A morerepresentative phrase to explain the rise in prices during a particular tradingsession might be “more potential buyers than sellers”.

The dissemination of volume (and open interest) statistics varies widely byfutures exchange. In an open outcry trading environment the final volume totalsare not available until after the close of trading. Electronic screen based trading(and most equity exchanges) do show “on-line” volume. This is obviously a boonto technical traders.

The CME Group Clearing House releases the volume (and open interest)statistics prior to the start of open outcry trading the next morning in the U.S.See the Appendix of this manual for examples of how to obtain the statisticsdirectly from the exchange website.

Note that once each week, a technician will be able to analyze the statisticsbefore trading begins the next day. This occurs with the Saturday morningavailability of the data for the Friday trading sessions.

2-1

Significance of Volume: Volume is a measure of urgency. It is the result of the

need for traders and investors to “do something”. And nothing creates moreurgency in a market than a losing position. Since any useful chart analysisdetermines what the losers are doing, the technician will want to monitor thissense of urgency, thereby assessing the health and strength of the prevailingprice trend.

The specific volume number is not important. It is necessary to classify thetrading session’s volume into one of three categories: low, average or high. These three categories are not static; Their boundaries will fluctuate withsubstantial changes in open interest and/or price volatility.

Ideal Healthy Price Uptrend: The ideal situation for a healthy bull market is

volume moving up as the bull market expands. A strong price uptrend ischaracterized by greater volume on up days when prices close higher, than ondown days when prices settle lower. This relationship is shown schematically inFigure 2-1.

Figure 2-1

Ideal Bull MarketPrice versus Volume Interaction

2-2

Volume measures how anxious trader are to establish or close out their positions. The ideal situation for a healthy uptrend in prices is for volume to increase onrallies in price and decrease on selloffs. This configuration created the old adage- “Don’t sell a quiet market after a fall” - because a low volume selloff is actually abullish technical situation.

Monitoring volume to identify price moves as counter-trend is important. Lowvolume on price down days is telling the astute trader that there is no urgency onthe part of the longs or shorts to close out their positions - and thus the prevailingmajor price uptrend should continue.

Ideal Healthy Price Downtrend: The ideal situation for a healthy bear market is

for volume to increase a prices move lower. A strong price downtrend ischaracterized by expanding volume on days when prices close lower andincreasing volume on price up days. This concept is shown schematically inFigure 2-2.

Figure 2-2

Ideal Bear MarketPrice versus Volume Interaction

2-3

Even in a long-term bear market, prices will not continually decline. Adversemoves against the direction of the major trend will result in price rallies - somelasting several days, or erratically, over several weeks. If no urgency developsfor the shorts to cover their positions, volume should decline. This is theproverbial low volume rally. A low volume rally is bearish. Ergo, “Don’t buy aquiet market after a rise”.

Blowoff Volume - A Warning Signal: There is one amplification of the ideal

price versus volume configuration that is of paramount importance and should notbe overlooked. Losing positions, especially speculative ones (as opposed tolegitimate hedges), often create conditions that lead to excessive volume. Theurgent need to close out losing positions produces “blowoff “ volume.

Blowoff volume is volume of an extremely high magnitude which is a warningsignal that the price trend is in the process of exhausting itself.

Prices often move violently in the opposite direction after such blowoff volume. Figure 2-3 illustrates the theoretical relationships between blowoff volume andprice activity. Figure 2-7 is an actual example of this sign of exhaustion in theCorn futures market.

Figure 2-3

Theoretical Examples of Blowoff Volume

One caveat is in order. Extreme high volume is the warning signal whichindicates at least a temporary trend change. This signal does not have tocoincide with the exact extreme price day. Often blowoff volume will occur onetrading session before the ultimate high or low price posting.

2-4

Determination of Volume Parameters

Figure 2-4

A bar chartist will scan back an ‘appropriate distance, whether two weeks or twomonths, depending on the specific conditions prevailing on each chart. Hypothetical horizontal lines are drawn, representing the threshold levels of “lowand “high” volume.

One third of the volume readings should fall into each of the three categories

2-5

Volume Analysis

Figure 2-5

2-6

Volume Analysis

Figure 2-6

Note the increase in volume on price down days and reduction in volume on price rallies

2-7

Example of Blowoff Volume

Figure 2-7

2-8

Chapter Three

Open Interest

Futures trading is a zero sum game: for every dollar in - there is a dollar out. Admittedly, the exchange clearing house and member firms scoop a little off thetop; but for every open position in a futures market there has to be an oppositeposition.

Definition: Open Interest (O.I.) Is the summation of all unclosed purchases orsales at the end of a trading session. Similar to volume, the published figurerepresents one side of the transaction only. Confusion concerning the definitionof open interest can be avoided by remembering this simple equality:

Long O.I. = Short O.I. = Total O.I.

Futures technicians monitor the total open interest figure. This number representsthe summation of open positions in all the contract months traded for theparticular commodity. The reason for using total open interest is explained ingraphic detail in Chapter Four.

How Open Interest Changes: Open interest changes from one trading sessionto the next, fall into one of three categories: 1) Increase, 2) Decrease, or 3) Nochange. Each of the three situations will be examined in a hypothetical example. For this illustration, it does not matter whether prices moved up or down. What isnecessary is that a “significant” price change occurred. While no specificdefinition of what constitutes significant will be given, it is safe to assume that thedefinition begins at more than five minimum price tics. The technicalramifications of these changes will be apparent later in this chapter whendetailing the ideal healthy price uptrend or downtrend.

Example:

Prior Day’s Total Open Interest = 180,000Answer the question: Who is getting in or out of the market?

Case One: Open Interest Increases

Total O.I. now at 183,000 3,000 new long contracts opened a change of +3000 3,000 new short contracts opened

3-1

Case Two: Open Interest Decreases

Total O.I. now at 178,000 2,000 long contracts sold out a change of -2,000 2,000 short contracts bought back (covered their existing shorts)

Case Three: Open Interest Unchanged

Total O.I. now at 180,000 In this situation, the trader would not no change know exactly what changing of positions occurred.

Significance of Open Interest: There are three reasons why technically basedfutures traders monitor open interest.

Open interest:

1) Indicates the existence of a difference of opinion.

2) Provides “fuel” to sustain a price move.

3) Determines if the losers are being replaced.

There is nothing that creates a market more than a difference of opinion. This isreflected in a willingness to take an open position. Open interest is a reflection ofthis important concept. If a market was at equilibrium and the entire trading worldknew this - the open interest in a futures listed on that commodity would be zero.There would be no need for hedgers to lay off unwanted risk, or speculatorsplacing positions trying to profit from a mis-priced market.

The analogy of fuel to the market is like that of fuel to a fire. If the fuel is removedfrom a fire, the fire will go out. If fuel is removed from a price trend, the trend willchange. Fuel in a futures market is provided by the losing positions. When openinterest declines, fuel is being removed and the prevailing price trend is runningon borrowed time. For a healthy, strong price trend (either up or down) tocontinue, open interest should increase, or at least not decline. This is soimportant a concept that remembering the word fuel as a surrogate for openinterest will place a trader ahead of 80 percent of all futures traders worldwide!

3-2

Technicians do not care if a losing position is being financed by meeting margincalls and throwing more money at the market, or if a loser steps aside and newblood comes in to take the loser’s place. What matters is that the funds are beingposted at the clearinghouse. The losers are necessary to pay off the traders withthe correct market judgment. When the losers decide that they “don’t want toplay the silly game anymore” and leave the market, open interest will decline.Obviously the losers pay the price for their misjudgment, but what is ofimportance to the technician is that declining open interest means the prevailingprice trend has become very unhealthy.

Ideal Healthy Price Uptrend: In an uptrending market when open interest isgoing up, both sides are increasing their positions. The additional short sellersmay be existing shorts adding to their losing positions, or new short sellersentering the market (thinking prices are too high). Longs may be adding to theirprofitable positions, or new longs may be joining the bull bandwagon. What is ofthe most importance to the longs is the fact that the losers are being replaced andmore fuel to sustain the upmove is entering the market. This is a healthy priceuptrend and prices should continue to work higher as long as open interest doesnot begin to decline. This is shown in schematic fashion in Figure 3-1.

If open interest is declining, the underlying support is suspect. Liquidation of bothlong and short positions is occurring. Less conviction concerning probable pricemovement together with less fuel to sustain the price trend produces a definitewarning signal of an impending trend change.

Precautionary measures should be taken such as moving protective stop orders(hopefully to realize profits) closer and placing orders to liquidate existingpositions. Potential hedgers should begin to implement any previously plannedstrategies to protect inventory, lock in profit margins, etc.

Figure 3-1

Ideal Bull MarketPrice versus Open InterestInteraction

3-3

Ideal Healthy Price Downtrend: The ideal situation for a healthy pricedowntrend (price expected to continue moving lower) is open interest increasingwhen prices close lower and open interest decreasing on trading sessions whenprices close higher. This is shown in Figure 3-2.

There is often difficulty in finding the ideal technical situation of open interestincreasing during a downtrending market, especially in the metals, grains andlivestock futures. This is because “commodity” speculators are by nature bullish. They would much rather buy something than be short. Thus a short position infutures can be taken if other indicators, such as price patterns, suggest lowerprices - even though the ideal situation of increasing open interest is not present. This concept will be illustrated in many of the charts in this course manual.

Figure 3-2

Ideal Healthy Price DowntrendPrice versus Open InterestInteraction

Short Interest (Equities)

The concept of short interest in the U.S. or any equity (stock) market) iscompletely different from open interest in futures. In any equity market thatallows short sales using borrowed stock, a short interest situation might exist. Short interest is the number of shares that have not yet been purchased to covershort sales. The borrowed stock must eventually be returned to the lender. Twoschools of thought prevail as to what short interest implies:

1) Traders expecting a price decline are initiating short sales; They could be correct, or 2) By definition, the shares sold short must eventually be bought back: A bullish situation.

Increases in takeover activity and arbitrage cloud the issue of how to interpretshort interest statistics from an equity market.

3-4

IDIOSYNCRASIES

Questions quickly arise when a new trader is exposed to the concept of how openinterest should ideally interact with price changes in a futures market.

1) What happens to open interest as a market reverses price direction?2) How can open interest continually increase in the direction of the new pricetrend? This would mean that open interest would have to continually rise!

Markets in Transition: The answer is that normally open interest does decline asa new price trend initially gets underway. This is because the participants withthe correct (profitable) positions are liquidating (realizing that the trend ischanging) and the losers are closing out their positions (confused and notrealizing that the trend really is finally starting to go their way).

Open interest often declines to a “steady-state” condition - a level of opencontracts that often approximates the level that prevailed before the start of theprevious price trend. As the new price trend becomes more apparent, openinterest should then begin to increase - fueling the price move to new highs orlows as the smart money rides the trend and the skeptics fight it.

Open Interest as a Coincident Indicator: On many occasions, open interest actsas a coincident indicator with price. This occurs most often in the traditionalphysical commodity futures during a bull market. Total open interest roundsupward as a price bottom is being made and tops out as price peaks.

In general, any time open interest begins to act erratic after experiencing a steadyincrease, price is, at best, moving net sideways, and more than likely trying tochange direction.

A special case in which open interest often acts as a coincident indicator in bothbull and bear directions is the CME Group currency futures. Total open interesthas acted in a coincident fashion with price in so many instances that it cannot beattributed solely to chance. The changes in open interest in the foreign exchange(forex) futures accurately reflect how the dominant price making force is changingits market view.

3-5

Ideal Healthy Price Uptrend - and Early Warning Signal

Figure 3-3

3-6

Ideal Healthy Price Downtrend

Figure 3-4

3-7

Historical Charts

Figure 3-5

3-8

Historical Charts

Figure 3-6

Ideal Healthy Price Downtrend

Lean Hogs - Feb 1999

Note that after the January 5 price decline, a vicious short covering rally ensued.Technical traders cannot simply use the fact that an price rally is short covering -to initiate short sales. A price reason must be present.

3-9

Historical ChartsFigure 3-7

Open Interest as a Warning Signal

3-10

Historical Charts

Figure 3-8

13-11

Historical Charts

Figure 3-9

Open Interest in the Transition from a Bull to a Bear Market

3-12

Historical Charts

Figure 3-10

Open Interest Increasing in a Bear Market

Note the transition from a bear to bull market was initially accompanied by a ecrease in open interest. This is usual.

3-13

Historical Charts

Figure 3-11 A Figure 3-11B

Open Interest as a Coincident Indicator History does Repeat Itself

Deutsche Mark Sept 1998

Note how the liquidation in total open interest corresponded to the price declines. When the bulls finally had the courage of their convictions and were willing to holdlong positions overnight, price was able to move up.

Also observe the interaction of price and open interest at the price highs. Theopen interest line resembles the Head & Shoulders Top that formed on the pricechart!

3-14

Chapter Four

General Rule for a Healthy Price Trend

Volume and Open InterestShould Increase as Prices Move in the Direction

of the Major Price Trend

According to this rule, the most bullish condition on a futures chart is price movingup on increasing volume and increasing open interest; The longs are in controland the price uptrend is expected to continue. On a daily basis, this rule impliesthat on price up days (when quotes close higher than the previous tradingsession), volume should expand and open interest should increase.

In a strong bear market when quotes close lower, volume will expand and openinterest will increase. This ideal healthy price downtrend does not often occur inthose markets that the public prefers to trade from the long side. These includetraditional agricultural commodity futures and metals. Conversely, markets such

as interest rate futures (U.S. Treasury Bonds in particular) often do exhibit theideal bear market characteristics of volume and open interest up on price downdays. The most bullish and bearish technical situations are shown schematicallyin figures 4-1 and 4-2.

Figure 4-1 Figure 4-2

Ideal Healthy Bull Market Ideal Healthy Bear Market

4-1

Why Total Open Interest is Used

4-2

Volume and Open Interest Analysis - Worksheet

4-3

Ideal Healthy Price Uptrend

Volume Should: Increase on price up moves Decrease on price down moves

Open Interest Should: Increase on price up moves Decrease on price down moves

4-4

Ideal Healthy Price Downtrend

Volume Should: Increase on price down moves Decrease on price up moves

Open Interest Should: Increase on price down moves Decrease on price up moves

4-5

Ideal Healthy Price Uptrend

Volume Should: Increase on price up moves Decrease on price down moves

Open Interest Should: Increase on price up moves Decrease on price down moves

4-6

4-7

4-8

Weak Price Uptrend - Downside Reaction Likely

4-9

4-10

Chapter Five

Price Scales

One of the first decisions a prospective bar chartist must address is what type ofprice scale to use. The two choices are arithmetic or logarithmic. First, adiscussion of each type of scale - and then a recommendation.

Arithmetic scales are constructed with each small square on the chart actuallybeing a square. This referred to as rectangular coordinate chart paper.

Logarithmic scales increase in a doubling of price in equal price distances. Since time is recorded in linear fashion, the result is semi-log chart paper.

Classical bar chartists quite often use the vertical height of the price pattern todetermine upside or downside measuring objectives. Obviously, the choice ofprice scale will generate much different price objectives.

An upside target on a semi-log scale chart will be much higher than the sameprice pattern measured on an arithmetic scaled chart.

Downside measuring objectives will not be as low on a semi-log scale chart ascompared to the target from the same bearish price pattern as reflected on anarithmetic scaled chart.

This quandary obviously needs answering.

What gives futures trading its allure?Answer: The high leverage or ‘gearing’. It does not take a doubling or tripling of price to produce sizable percentage gainsor losses. In forty years of examining futures charts on a daily basis, Ken Shaleenhas found that futures charts plotted with an arithmetic scale do meet thestandard vertical height measuring objective dictated by the pattern. Note thatthis objective could be calculated mathematically - and arrive at the same pricetarget as the ‘graphic’ method of taking the height and physically moving it over tothe breakout level.

The ‘bottom line’ is that the use of an arithmetic price scale on a daily futureschart is perfectly acceptable.

5-1

In general, individual equities (stocks) move slower than anything listed as afutures contract. And the equity market is dominated by ‘buy-and-hold’ typeinvestors who do not use margin accounts to leverage their holdings. This type ofmarket participant also tends to be on the long side of the market. They arelooking for individual stocks that are increasing in price at a good rate.

An upsloping trendline on a semi-log scale chart is increasing at a constantpercentage increase. This is the stock that an equity investor wants to find. Theywill have an easier time finding such a buy-and-hold candidate on a semi-logscale chart. In addition, the universe of equities to choose from is hugecompared to the 60-80 actively traded futures contracts.

The ‘bottom line’ is that individual equity traders should find semi-log scale chartsvery useful.

Two exceptions

There are several situations in which a futures chartist might find changing theprice scale from arithmetic to logarithmic, helpful.

1. After a large price move has occurred on a daily chart. This would happen if avalid Flag pattern forms. This is a very dynamic price pattern. The measuringobjective in a Bull Flag pattern can be far surpassed using an arithmetic scale. Determining the graphic objective using a log scale will result in a much moreaggressive (higher) target.

2. Looking a long term (weekly or monthly) continuation chart of the nearest-to-expire future over a long time period (years) might be better viewed with a logscale for price. This is especially true for the stock index futures - where a longterm bull market existed. And, the price blowoff to the upside in the physicalcommodity futures in 2007-08 can be kept in context by using a log scale.

5-2

Example of Semi-Log Scale

Figure 5-1 London Gold - monthly

5-3

Comparison of Arithmetic and Logarithmic Price Scales

Gold - Monthly Chart nearest-to-expire future

Figure 5-2A Figure 5-2B

Price drop off the March 2008 high (1033.90 on the near-by future) ‘seems’ muchlarger on the arithmetic scale chart.

5-4

Chapter Six

Trading with the Trend

A ‘trader’ is different from an ‘investor’.

The trader is operating in a very short time frame - down to seconds and minutes. For the day trader, scalper, market maker, it is the speed of execution and smallcommissions that produces their profits.

The investor desires to hold the position and therefore has a much longer timeframe. A position trader is an investor who wants to ride a price trend. They havethe best chance of making a profit by identifying the direction of the major pricetrend, ascertaining its health (strength), and trading with it.

Even a casual observation of historic charts indicates the presence of manysustained price trends - up or down. Sometimes these trends last several years. Yes, there might be some sizable moves against the major trend, but the longterm trend continues.

Trendline Construction

Defining a price trend is easy; trading with it is not so easy. Higher and higherprice highs and higher and higher price lows is the basic definition of an uptrend. Figure 6-1 is a plot of this definition. Each upmove extends to new high priceterritory while the selloffs do not decline as far as the price drop on previousselloffs.

Figure 6-1 Price Uptrend

6-1

Downtrends are characterized by lower highs and lower lows. See figure 6-2.In a downtrend it is possible to construct a straight line tangent to two price highs. Typically these are the highs of the price bars on whatever time frame chart(minutes, hours, days, etc.) Is being used. This line is referred to as thedowntrend line.

Figure 6-2 Price Downtrend

In a bull market, the uptrend line is the one drawn across (tangent to) the low ofthe price bar at each of the relative price lows. This is shown twice in figure 6-3.

It only takes two points to determine a straight line. If a third point lies on anytrendline, a significant charting event occurs. The trendline takes on muchgreater significance. The trend direction has much greater validity.

Figure 6-3 Uptrend Lines

6-2

Any trendline, when initially drawn, should not cut thru prices. This is the cardinalrule of trendline construction. The line must be tangent to two relative highs orlows. Subsequent price action (after the trendline has been drawn) may cut thruprices - and obviously has to when the trend changes.

A three point trendline is infinitely greater in its technical significance

than a two point line.

A trader strives to find the technical situation where a market is residing above orbelow a three point trendline. The trend will continue until a close beyond thetrendline occurs. Even then, the trend does not completely reverse; it changesthe trend to sideways. Violating a three point trendline is cause for exiting anexisting position. It is not enough evidence to completely reverse direction. Addition technical corroboration is needed. Figure 6-4 shows a three pointdowntrend line on the Dec 2008 Crude Oil future.

Figure 6-4

Three Point

Downtrend Line

Note that the 1st

trendline was onlyconstructed usingtwo points. It didnot hold.

6-3

A chartist never erases a properly drawn trendline once it has been constructed. This is especially true for shorter trendlines used to delineate the boundary linesof an orthodox price pattern. Reference to the chart months or years later willallow the technician to see what the prevailing price configuration implied - even ifthe ensuing price move proved the analysis incorrect.

Knowledge of the technical personalities of each market will be gained by reviewof the success or failure of each identifiable price pattern.

Another aspect of trendline construction is the use of a line constructed parallel tothe trendline. It is known as a parallel objective line or a return line. Some chartists construct this line as a reasonable price target for the extent ofthe next move. In bull markets, this upper line is often exceeded as the price upmove goes into a greater vertical angle of ascent. Still, it is a ‘reasonable’ line toplace on the chart.

Trend Channels

Although not as common as most traders might think, markets sometimes dotrend within a well defined channel - where the trendline and parallel objectiveline contain the price swings.

The weekly continuation chart of the nearest-to-expire British Pound future infigure 6-5 is a good example. Violation of the three point upsloping trendlinewith a weekly close below the line would signal that the major price uptrend hasstopped - and turned the market to neutral.

Figure 6-5 Trend Channel on a Weekly Continuation Chart

6-4

Chapter Seven

Analysis of Support and Resistance

Locating support and resistance is probably the most important part of anyclassical bar charting analysis. Properly locating the price levels where support orresistance would be expected, allows the trader to:

1. Set entry points for new positions.

2. Place protective stop orders.

3. Determine if a price trend is present.

4. Locate where the prevailing trend, if any, would change.

The concept of support and resistance is one of the most talked about, but leastunderstood aspects of technical analysis. In the process of defining support andresistance, the following observation is useful:

Ask 100% of all the would-be ‘technicians’ in the trading world where overheadresistance is located on the following line graph (Figure 7-1) . . . .

Figure 7-1

. . . . . and the overwhelming majority would state that the highest point on thegraph is resistance.

This seems logical because the previous price rally did stop at that level oncebefore. But, if a simple price high was overhead resistance, the price upmovewould turn down when approaching that level again. An uptrending market wouldnever materialize. And Double Top formations would be much more prevalent. Markets tend to trend most of time, rather than reverse. The ‘double’ formation isnot a common reversal pattern.

7-1

Giving a price high on a chart a name, a technician should simply refer to it as a “Benchmark High”. This is illustrated in Figure 7-2.

Figure 7-2

Similarly, a price low on a chart (Figure 7-3) should be referred to as a“Benchmark Low” and should not automatically be labeled as support. e.g.,

Figure 7-3

Market makers in equities, foreign exchange dealers, and scalpers on an openoutcry futures floor do notice that price often temporarily stops in the area of aprevious price high or low. The operative word is temporary. Position traders donot operate as close to the market as these highly active traders. It is usuallyimpossible for all but the most active day traders to make money by ‘fading’ amarket as it reaches a benchmark high or low.

The daily and 10-minute charts (Figures 7-8 & 9) of the Dow Jones IndustrialAverage illustrates how a benchmark low can act as temporary support. TheJune 16 low of 8570 on the daily high low close bar chart was well known andeasily seen by all traders. Look at what happened during the trading session inwhich the price decline again approached 8570 seven weeks later.

7-2

The supposed “support” was only slightly violated with the 8562 low on a 10-minute price bar (Figure 7-9). The next time down on the 10-minute chart thecash Dow stopped exactly at 8570. The selloff had reached “support”! (notreally). The next time down the Dow moved thru 8570 like a knife thru warmbutter.

If an aggressive short term trader wants to label a benchmark low price aspossible temporary support - fine. This trader must realize that if a healthy pricedowntrend trend is in progress, this low will be taken out - usually quitedramatically.

What then, is a more classical definition of support and resistance?

First, support, if any, resides below the current price level. Think of support intwo words - underlying support. Resistance, if any, is above the current price. Resistance is always - overhead resistance.

The chartist’s “bible” Technical Analysis of Stock Trends, by Edwards and Mageeis still the best source of a definition. Specifically, . . .

A former price high (or top) should be underlying support in the ensuing priceuptrend. To find support, a chartist looks down and to the left on a chart andlocates the closest former price high. See Figure 7-4.

Figure 7-4 Support is: a Former Top

7-3

A former price low (or bottom) on a chart should be overhead resistance in theensuing price downtrend. To find resistance, a chartist looks up and to the left ona chart and locates the closest former price low. See Figure 7-5.

Figure 7-5 Resistance is: a Former Bottom

Traders are obviously interested in what will happen as quotes ‘test’ a benchmarkhigh or low. It is important not to harbor a preconceived notion that a price rallyhas to stop at a price level that it (temporarily) stopped at before - or that a pricesell-off has to bounce off a price level that stopped a sell-off previously.

Relating volume to this concept:

The lower the volume on the price sell-off to test support, the more likely the support will hold.

The lower the volume on the rally to test resistance, the more likely the resistance will hold.

The strength (ability to halt the price move) of the support or resistance, in theory,should be directly proportional to the amount of dealing previously done at thatparticular price level. Quotes may have to eat into support or resistance until they get to a level where a sufficient amount of prior trading occurred - to finallyproduce the friction necessary to stop the price move.

7-4

Putting support and resistance into practice:

Traders wishing to initiate a new long position would place the order to buy at aprice slightly above the support price. A good definition of “slightly’ is twominimum price fluctuations.

Traders wishing to initiate a new short position would place the sell order at aprice just below (2 tics) the resistance price.

And, the price should not end in zero. Make any buy order end with a price of 1 or6. Make any sell order end with a price of 4 or 9. The public gravitates tocommon, all too common, prices ending with zeros.

Protective stop orders should be entered far enough into support or resistance sothe price move would have to inflict an inordinate amount of damage to thesupport or resistance before the trader would get knocked out of the market. It isfar easier to make this statement than to quantify it. Every market has it’s daily‘noise’. The stop must be placed beyond this noise.

Some markets, the stock index futures in particular, are notorious for eating fartherinto support or resistance than any other market. The proliferation ofundercapitalized day-traders makes for this phenomena.

Another important note: Simply violating support or resistance (with a close into it)does not automatically change the direction of the prevailing price trend 180degrees. It changes the trend to neutral. Additional technical evidence must bepresent to warrant entering a new position.

Locating support and resistance on a chart is an age-old technique. It does notrequire a sophisticated computer package. It is an excellent place to begin theanalysis of any new chart.

7-5

Example of Underlying Support

Airtouch CommunicationsCommon Stock

Daily Chart

Figure 7-6

7-6

Example of Overhead Resistance

Figure 7-7

7-7

Dow Jones industrial Average (cash) - Daily

Figure 7-8

7-8

Dow Jones industrial Average (cash) - 10 Minute

Figure 7-9

7-9

Blank

7-10

Chapter Eight

Price Pattern Recognition

Overview

The high, low and last price for a specified time period are the basic inputs for aclassical bar chartist. In specialized forms of charting, such as candle charts, the‘opening’ price is also recorded on the graph. In the move toward 24-hourelectronic dealing, there is some question about the benefit of the next day’sopen when it happens a nanno-second later than the previous day’s close.

Volume, if available, is an important aspect of any chart - especially a daily high,low, close bar chart. Open interest on a daily futures chart is also a helpful aid inassessing the validity of a price pattern.

This course manual primarily contains examples of futures charts. Readerdesiring more illustrations of individual equity charts are referred to the classic:Technical Analysis of Stock Trends, by Edwards & Magee.

Price Pattern Recognition

Price patterns that tend to appear regularly on a classical bar chart are one of themost valuable tools for a technical trader. These patterns indicate the highprobability direction of the major price trend, often carry specific measuringobjectives - and, most importantly, alert a trader where things are going wrong.

The rationale behind the use of price charts is that all the supply and demandinformation has to be synthesized into a single piece of information - price. Iffundamental forces are at work moving the market, the price will show it.

Also affecting the price movement is activity by speculators who utilizedinformation other than fundamental supply/demand data, such as psychologicaljudgements. These market moving decisions are also reflected in the price.Although some of the decisions may be based on hopes, fears, greed, theyrepeat themselves often enough to allow the technician to make a future forecastbased upon past price patterns.

Only a handful of orthodox price patterns exist. They divide themselves into twodistinct groups: Reversal patterns or continuation patterns. Chapters 9 thru 17detail these formations.

8-1

Hierarchy of Bar Charting Analysis

1. Identify the direction (if any) of the major price trend

2. Check the internal health of the trend by using volume and open interest.

3. Locate the closest underlying support and overhead resistance price levels.

4. Look for the possibility that an orthodox price pattern may be present - or in the process of forming.

5. If an active price pattern is present, determine the measuring objective and the stop-out price level.

6. Create a trading plan based on the bar charting conditions that exist; often this is best accomplished when the market is not open.

7. Do not try to force a conclusion via assuming that a reasonable risk / reward trade must be present; sometimes no trade is the best trade.

8. A chartist need not get married to a single market; diversify the analysis.

8-2

Chapter Nine

Head & Shoulders Reversal Pattern

The Head & Shoulders (H&S) price pattern is the most reliable reversal pattern. It can occur as either a Head & Shoulders Top or a Head & Shoulders Bottom. This classical bar charting price pattern physically resembles a head & shoulderswhen found at a market top.

For clarity, when referring to a bottoming of a price trend, technicians should usethe phrase H&S Bottom rather than ‘inverse Head & Shoulders’. By using thisterminology, there will much less confusion whether the trader is talking aboutprice topping or price bottoming.

Before discussing the pattern in detail, there are several overall observations:

1. Before a chartist should be looking for any reversal pattern, there must be adefinite price trend in place - so there is something to reverse.

2. Five obvious reversals of the minor price trend must be present on the chart toform the pattern. Figure 9-1 clearly shows these five reversals.

Figure 9-1

9-1

Development of a Head & Shoulders Top:

In a price uptrend, a corrective selloff (from reversal point one) and thesubsequent rally to a new price high (off the low of reversal point two) impliesthat the uptrend is firmly entrenched. These first two reversals of the minor pricetrend will create what will be the ‘left shoulder’ of the completed pattern.

The highest price in the pattern will be called the ‘head’. It is quite possible thatextremely high (blowoff) volume might be present on the price move up to formthe head. And if the item being charted is a futures contract, total open interestmight decline on this final rally. If so, the proverbial ‘early warning signal’ willhave been flashed.

At this juncture in the development of an H&S Top (at a price level near the highof the head), there is no overhead resistance present - only underlying support. The ability of a technician to properly locate where support should be present isof paramount importance. A price decline that violates support is the firstimportant sign that a reversal pattern could be developing. This is a sign ofweakness in the major price uptrend. When this occurs, a classical bar chartistbegins to study the graph in earnest.

It cannot be emphasized enough, that the selloff from the high of the head mustviolate the support level. If not, the definition of a bull market will continue to bepresent. This price decline below the support (which is in the process ofbecoming the high of the left shoulder) can halt anywhere in the vicinity ofreversal point two. The price decline does not have to stop exactly at the sameprice level of reversal point two.

Next, a price rally (off reversal point four) must occur. Ideally this rally will occuron lower or declining volume. It is especially bearish if the volume on thisdeveloping right shoulder takes place on volume readings lower than whatoccurred on the rally for the left shoulder. If so, the chart is really telling thetechnician that the market is in the process of trying to reverse the major priceuptrend.

This last price rally in the developing H&S Top must stop below the high of thehead. Symmetry (more on this later) would suggest that the high of the rightshoulder will be in the general price area of the top of the left shoulder.

At this time, any long positions should be closed out. Note that because thepattern has not been officially activated (with a close below the neckline), aconservative chartist should not be attempting to pick the high of the rightshoulder and trade it via a new short sale.

9-2

Activating a Head & Shoulders Top:

The neckline is the 2-point minor trendline drawn tangent to the lows of the pricebars at reversal points two and four. These two price lows are the reactions oneither side of the head. The style convention for drawing this boundary line of thepattern is a dashed line.

Any classical bar charting price pattern is not officially activated until a closeoutside the pattern is posted. In the case of a Head & Shoulders Top this mustbe a close below the neckline. Once this occurs, the chartist has strongtechnical evidence that the longer term trend has changed direction.

How Far Will Prices Move:

Elementary textbooks about trading often refer to establishing a risk to rewardratio. Sounds good, but do these books ever detail how to determine this ratio? Answer: No.One of the helpful aspects of classical bar charting price patterns is that adefinite measuring objective can be derived. And, most importantly, the technicaltrader will know where the pattern breaks down i.e., fails. This enables a chartistto gain insight as to what the risk is, given the expected price move.

With any active H&S formation (Top or Bottom), price is expected to move aminimum of the vertical distance from the extreme of the head to the neckline asmeasured from where price penetrated the neckline. Note that this distance isnot measured from the close beyond the neckline; it is the price at which theneckline was broken.

What to do at the Measuring Objective:

A close below the minimum downside measuring objective in an H&S Top is notrequired. As long as price trades below the objective any time during theinternational 24-hour trading day - the pattern has worked as expected.

Traders should try to follow the old adage of “letting profits run and cuttinglosses”. With this in mind a trader should take partial profits when the minimummeasuring objective is reached and look for additional technical signs that agreater percentage of the open trade (short) should be closed.

9-3

For sure, a trader should have been following the market down with trailing

protective buy-stop orders. Ideally, the protective stop would be located well intoor above the top of the closest overhead resistance.

Additional signs that more open trades should be removed would be blowoffvolume, a decline in open interest (futures only), or the posting of one of the fourminor trend change indicators (see Chapter 17).

The chartist will also be looking for one of the classical continuation patterns,Triangle or Wedge, to form. This would indicate the existing price trend hasfurther to travel - and additional directional positions can be established.

Symmetry:

It is amazing how often the Head & Shoulders formation exhibits symmetry withrespect to the magnitude of the two shoulders (figure 9-2), time spent during thedevelopment of the two shoulders, and the number of shoulders.More than one shoulder on each side of the head produces a complex H&Sformation (more on this later).

Pay attention to what happens on the ‘left’ side on the chart -

because it could be duplicated on the ‘right’ side of the chart.

Figure 9-2

If a selloff penetrates this former ² price high, it is the first price signal that H&S Top may be forming.

Then note the magnitude and duration of the previous reaction. If a right shoulder develops, it

may prove to be very similar.

9-4

When to Enter a Position:

After monitoring a market closely and seeing a potential Head & Shoulders

pattern developing, it is very tempting to ‘lead off’ and establish a position prior tothe official breaking (close below) the neckline. This is a dangerous practice.An aggressive short term trader, monitoring intra-bar price activity, might seeprice trading beyond a neckline within the price bar. A sharp reaction then takesprice back within the pattern. Since the close of the price bar was not beyond theneckline, the formation was not set off. Read, whipsaw.

It takes discipline to wait for the penetration of the neckline and the confirmationof high volume if it was an upside breakout from an H&S Bottom.

Whether or not a corrective price pullback (rally in the case of the H&S Top) willtake place is the age old question that causes difficulty for a chartist. Volume canbe a useful aid. The higher the volume associated with any breakout, the lesslikely a pullback will occur.

A look at the various possible shapes of a Head & Shoulders formation (Figure 9-4) shows that it is impossible to make a blanket statement concerning when andwhere to establish an initial position. The following is a reasonable strategy.

1. Establish a 50% position on any closing penetration of a valid neckline.

2. Establish the remaining 50% position on:A. A pullback to just below (2 minimum price tics) the neckline, orB. A pullback to the closest overhead resistance.

Where to Place the Protective Stop:

Any H&S formation is not destroyed until the extreme of the head is taken out. But, placing a protective stop higher than the high of the head in a Head &Shoulders Top results in a risk to reward that is, by definition, slightly worse thanone to one. Even though the H&S formation is a highly reliable pattern (86 - 88%reliable), this is not an attractive risk to reward ratio.

The suggestion is to construct a ‘failsafe trendline’ to gauge where a chartistshould become worried about the pattern not working.This line is drawn tangent to the extreme of the head and the right shoulder.The protective buy-stop would be placed just above this downsloping line on aHead & Shoulders Top pattern. Note that the protection slides down (istightened) with time. This is as it should be with any protective stop order.

9-5

Additional considerations:

It takes time to reverse a price trend. The five reversals of the minor price trend

in a Head & Shoulders formation represent the battle between the forces ofsupply and demand. It pictures the influx of new information or moods that arenecessary to change the direction of the trend.

Most of the charts in this manual are daily, high-low-close bar charts. This timeframe is most suited for the interpretation of volume and open interest on afutures chart. The H&S formation ‘works’ on any time frame chart - from minutesto months.

For the extreme time frames of minutes or months, volume is not usually aconsideration. For the day trader, it is the speed of execution that is important,not the dutiful analysis of volume and open interest (the latter being impossible onan intra-day chart). And for the long term position trader, the new fundamentalinputs are what drive prices.

Figure 9-3

H&S Top

9-6

EveryHead &Shouldershas a Different Shape

Figure 9-4

9-7

Head &Shoulders Top on a Weekly Chart

Figure 9-5

Zinc - LME

It is interesting to note that Zinc was in a major bear market during the same timeframe that Gold and Silver were setting new all-time highs. Believing the patternon the Zinc chart produced the correct directional view for this metal.

9-8

Head & Shoulders Bottom

A valid Head & Shoulders Bottom formation contains two important volumeconsiderations:

1. Ideally volume on the price selloff to form the right shoulder will be ‘low’ ordeclining.

2. The upside breakout, a close above the neckline, should occur on a noticeableincrease in volume during that trading session (or price bar).

A classical bar chartist does not trust an upside breakout of any price pattern or2-point trendline that occurs on less than high volume. An apparent upsidebreakout that has been engineered solely by technical traders will not usuallygenerate enough volume to be valid. Needed is the ‘smart money’, thesophisticated fundamental traders doing enough buying such that, in combinationwith any technically based traders, volume will escalate to a distinctively higherlevel.

With specific regard to a daily futures chart, total open interest would ideallyincrease on the upside breakout. Declining open interest would mean that theprice rally was due to net short covering. Short covering on an upside breakoutdoes not automatically invalidate the breakout; it does imply a high likelihood of aprice pullback (decline) toward the neckline.

As with the H&S Top, the minimum upside measuring objective of a bottom isdetermine in exactly the same fashion. The vertical distance from the head up tothe neckline is graphically added to the neckline when a closing price is postedabove the neckline. The Swiss Franc future in figure 9-6 is an example of a Head& Shoulders Bottom on a daily chart and figure 9-7 is an H&S Bottom on anhourly (Gold) chart.

9-9

Figure 9-6 Head & Shoulders Bottom

9-10

Figure 9-7 Head & Shoulders Bottom on an Hourly Chart

Notethe symmetry of three shoulders on either side of the low of the head.

9-11

Figure 9-8 Head & Shoulders Bottom on a Monthly Chart

This multi-year Head & Shoulders Bottom occurred in the years just after the T-Bond future began trading. Volume is not normally analyzed on a weekly ormonthly chart. The ‘growth curve’ upward in volume can be seen as this futuregained in popularity as a trading and hedging vehicle.

Paul Volker was the chairman of the US Federal Reserve Bank at the time wheninflation was running rampant. The left shoulder selloff began with the “OctoberMassacre” in 1979. The Fed stopped pegging interest rates and tightened themoney supply. The prime rate reached a high of 21 1/2% - and the back ofinflation was broken. The large H&S Bottom depicts this process of increasinglong term interest rates and then a bull run in price that continued to set new pricehighs as late at September 2008 (124-24) on this notional 6% coupon bond.

9-12

Complex Head & Shoulders Formations

The term complex refers to the fact that ‘two or more of something’ is found in thepattern. This could be two sets of shoulders on either side of the head. Or itcould be Double Top for the head.

A chartist should always be thinking - symmetry. Most complex H&S formationstend to exhibit symmetry in the number of price gyrations seen on either side ofthe head.

Multiple measuring objectives are possible if several necklines exist. There is notechnical reason that the largest obtainable objective should not be consideredviable. A chartist does have to be aware that any H&S formation cannot beexpected to retrace more than the price move that preceded it. This was theproblem with measuring objective on the Copper chart at the end of this Chapter.

Figure 9-9 Possible Complex Head & Shoulders Top

9-13

Figure 9-10 Complex Head & Shoulders Top on an Hourly Chart

9-14

Historic Charts

Figure 9-11 H&S Top ‘failure to form’

“The most widely advertised (possible) Head & Shoulders Topsince Edwards and Magee wrote their book”

Quote from a member of the Chicago Board of Trade on the trading floor in 1982

9-15

Can Technical Analysis be used in a manipulated market?

9-16

Manipulation ended badly

Bre-X common stock - in Canadian DollarsSuspended May 8, 1977

Quote from the Wall Street Journal, Wednesday May 7, 1997:

“Bre-X Minerals, Ltd. shares staged a spectacular collapse to near-worthlesslevels in frantic trading as investors reacted to the news that the company’ssupposedly huge gold discovery is really a highly engineered fraud.”

9-17

Example of a Head & Shoulders Failure

9-18

Historical Chart

The severity of the price pullbacks are what make stock index futures trading sodifficult. Often price moves much farther into classical support or resistance levelsthan any other futures contract. In contrast, individual equities chart very well.

9-19

Multi-year Head & Shoulders Top

on a Monthly Chart of a U.S. Equity Index

The Dow Jones Industrial Average and the S&P 500 Index also met a Head &

Shoulders Top objective on their monthly charts during the week ending October10, 2008.

9-20

Failure of a Head & Shoulders Bottom to Reach

Its Measuring Objective - and Why

Any H&S formation, Top or Bottom, cannot be expected to re-trace more than theprice move that preceded it. This price extreme is the limiting factor if applicationof the standard height objective results in a price beyond where the previous pricemove began. This was the case in the Copper chart below.

Adding the vertical height of the pattern, 5.04, to the neckline break, 100.00,resulted in a conservative (arithmetic) upside price target of 105.04. This washigher than where the previous price downmove began - at 104.10.

The May Copper did ‘attack’ 104.10 with the 103.62 daily high. But, the traditionalobjective at 105.04 was never reached.

Copper - May 1992

9-21

Notes

9-22

Chapter Ten

Broadening Formations

As a chartist gains experience, the pitfalls associated with each particular pricepattern are encountered. There is a reversal formation known as a BroadeningFormation that contains five reversals of the minor price trend - just like the Head& Shoulders pattern. A theoretical example of a Broadening Top can be seen infigure 10-1 and an actual example in figure 10-2.

Because the fifth reversal of the minor price trend takes place beyond theextreme of a possible ‘head’, it keeps the technician ‘honest’ in not jumping to thepremature conclusion that an H&S is forming every time four reversals of theminor trend are in place.

There is no way to know beforehand that a Broadening Formation might bedeveloping. Although, a downward sloping neckline when a possible H&S Topmight be forming and an upward sloping neckline when a possible H&S Bottommight be forming is a big clue.

Patience and knowing that such a pattern does exist (although not frequently) isthe first step. A well thought out game plan for an entry into a new position is amust.

According to the old Edwards & Magee textbook, there is no specific measuringobjective. Ken Shaleen, a.k.a. CHARTWATCH will suggest using a standard‘double’ measuring objective using the last two price extremes. This techniqueworked out to the exact point in the Japanese Yen example in Figure 10-3.

One further note. The price volatility associated with any Broadening formation ismore likely at a top in any of the physical commodity futures. This is why it isunusual to find this formation at a price bottom on this type of chart. Pricebottoms on the physical commodity future tend to be more ‘rounding’.

Carrying on the notion of where price volatility would be expected, in an interestrate future, it would be at high rates - i.e., low prices. This can be seen on the T-Bill chart in figure 10-4.

On the currency futures or spot foreign exchange charts the volatility could be ateither extreme. This is what happened on the Yen future in figure 10-3.

10-1

Figure 10-1 Theoretical

Broadening Top

Figure 10-2 Broadening Top

10-2

Figure 10-3 Broadening Bottom

10-3

Figure 10-4 Broadening Bottom and Complex H&S Top

10-4

Chapter Eleven

Double Top and Double Bottom

Double Top

The definition is simple, yet the misunderstanding involved with the Double Top isextraordinary. ‘Two price highs at approximately the same price level’ is onlyone-half of the definition. Prices must decline below and close below the lowpoint established in-between the two price highs before a Double Top pattern hasbeen officially activated.

Figure 11-1

Double Top

Many traders see a price move stop in the same general area of a previous pricereversal. But what trading usefulness does this have? Should a short (or long inthe case of a possible Double Bottom) be taken? The answer is no. A newposition should not be initiated until the pattern has been activated.

Before proceeding with examples, Ken Shaleen a.k.a. CHARTWATCH mustshare some historical observations:

1. A ‘double’ formation, Top or Bottom, is not a common pattern on a future orforward chart. The pattern is more prevalent on a cash or spot market chart -where the basis convergence in a futures contract is not continually pulling thefuture toward the cash price.

2. A ‘double’ formation is not all that reliable price pattern. Often the pattern isactivated and some price progress toward the measuring objective is made - butthe minimum objective is not reached. This negative does not automaticallymean that a technician trading this pattern will suffer a loss. Proper moneymanagement and the movement of a protective stop order can mitigate the poorperformance of the pattern.

11-1

The measuring objective of a Double formation is straight-forward. In a DoubleTop the vertical height of the pattern is subtracted from the price low in-betweenthe two highs or lows.

To determine the height of the pattern, a straight line (a 2-point trendline) isdrawn tangent to the two price highs. The height of the pattern is from the lowpoint in-between the twin highs up to the line. This is a method of ‘graphicallyaveraging’ the two highs if they are not exactly the same price. This isschematically shown in Figure 11-1.

After the breakout there may be a price pullback, rally in the case of a DoubleTop. If so, it is easy for a chartist to determine the location of overheadresistance. It is the now former price low in-between the twin highs. Aconservative trader might wish to wait before initiating a new short until a pullbackto test the overhead resistance is posted. Note that there was no pullback on theweekly Euro-fx chart in Figure 11-2.

Figure 11-2

11-2

Double Bottom

In a Double Bottom, price must close above the high point in-between the two(approximately equal) price lows before a trading decision can be made.Because this is an upside breakout, it must occur on a noticeable increase involume. A chartist should not trust any upside breakout that takes place on sub-standard volume.

Once an official upside breakout is posted, the upside measuring objective isclear. Price should rally to as far above the high point as the vertical distance in-between the twin price lows. This is schematically shown in Figure 11-3.

As usual, there may or may not be a price pullback following the upside breakout. It is always difficult to know whether a pullback is going to be posted. Thus, atrader has to weight the opportunity loss of not initiating a new long on thebreakout. Yes, the risk / reward of a new long placed only a pullback is better -but, the pullback might not happen.

With either the Double Top or Bottom, a protective stop should be placed farenough beyond where the classical resistance or support begins - such that apullback would have to do an inordinate amount of damage to the expectedresistance or support level.

Figure 11-3

Double Bottom

11-3

Double Bottom and H&S Bottomon ‘non-storable’ commodity futures charts

11-4

This is a classic chart. Note the typical open interest action in the transition froma bull to bear market. After the downside breakout from the Double Top, look atwhere the pullback stopped - at the overhead resistance.

11-5

Should Price Pattern Recognition be Applied to Options Charts?

Price plot of June 70 Call option

Price plot ofunderlyinginstrument - June 1985T-Bond future

The answer to thequestion posed above is - No

Because an option is a ‘wasting asset’ the bar charts do not lend themselves toclassical price pattern analysis. A trader should do all the technical work on thechart of the underlying instrument - and then pick an options strategy suitable fortrading that pattern.

Time erosion caused the price of the 70 strike T-Bond Call option to decline muchfarther than the pullback after the price decline into the Double Bottom occurredon the chart of the underlying instrument.

11-6

Chapter Twelve

Continuation Patterns

The Symmetrical Triangle Formation

Figure 12-1, Valid Symmetrical Triangles

In the ‘art’ of classical bar charting, the Symmetrical Triangle formation is the premiercontinuation pattern. It is created by a net sideways price movement on the chart,after which, a significant directional price move ensues. Note that this new pricemove can be in either direction - but there is an overwhelming tendency for a validtriangle to act as a continuation pattern. This means that the prevailing price trendthat was in progress prior to the triangle forming, continues.

10-1

Most of the time markets are trending. The major price trend is not continuallyreversing from bullish to bearish and then reversing again. If the SymmetricalTriangle is best classified as a continuation pattern, it is not surprising that thispattern is the most common of all bar charting formations. It ‘works’ on all timeframe charts - i.e., 5 minutes to monthly.

Directional Considerations: When this formation occurs on a high-low-close bar

chart, it leads to a continuation of the prevailing price trend approximately 75+% ofthe time. Note that this pattern can be a reversal pattern - although this occurs inless than 25% of the cases.

It is the lower probability case where the triangle acts as a reversal pattern thatkeeps a chartist ‘honest’ by not always taking a directional position within the patternprior to the breakout.

Shape: It only takes two points to define a straight line. Two converging line

segments form a proper Symmetrical Triangle. Four reversals of the ‘minor’ pricetrend are necessary to create the two converging boundary lines. Each line mustslope in a different direction. The lower boundary line must slope up; the upperboundary line must slope down. The two lines intersect at the apex of the triangle.

Although the definition of a Symmetrical Triangle is not so strict as to require that thetriangle be equal lateral (line segments of the same length) or equal angular (sameangle for each converging line), the word symmetry is important. One side of a validSymmetrical Triangle should not even approach twice the length of the other side.

Figure 12-1, Valid Symmetrical Triangles shows the ideal bearish and bullishformations. Any triangle is not an active pattern until a closing tic mark is postedbeyond one of the boundary lines. (More on this later.)

Where to Locate Reversal Point One: The first reversal point (1) in any valid

triangle is always at a relative price high in a bull market or at a relative price low ina bear market. Remembering this simple rule will keep a trader from incorrectlyassuming that a valid triangle is present. Figure 12-2, An Incorrect Interpretationshows how a bad mistake can be made. The more likely outcome in Figure 12-2 isa Head & Shoulders Top rather than a Symmetrical Triangle as a bullish continuationpattern.

12-2

Figure 12-2, An Incorrect Interpretation

Volume Within the Triangle: A general statement can be made with respect to

volume within any triangle: It usually moves irregularly lower. This is commonsense. Because the price swing near reversal points 1 and 2 are greater than theprice swings near reversal points 3 and 4 it is not surprising that volume wouldtypically be greater at the beginning of the net side ways price movement.

A chartist should not use a microscope, looking for nuances in volume within theconsolidation pattern. The downsloping line overlaying the volume in the chart ofExelon common stock (Figure 12-3) is a reasonable example of how volumecontracts within a symmetrical triangle.

12-3

Figure 12-3, Exelon Common Stock

10-4

Breakout Volume: One of the first things that any novice bar chartist learns is that

a valid upside breakout from any price pattern should occur on a noticeable increasein volume. This is due to the idiosyncrasy of the trading public to prefer to be on thebuy side rather than on the sell side. A low volume upside breakout is not to betrusted.

Figure 12-3, Exelon Common Stock shows volume of 2,807,400 shares on the‘second breakout’. Although this was not a major jump in volume, it was higher thanthe ‘first breakout’ from the inner Symmetrical Triangle. The section on Re-drawingthe boundary lines later in this chapter explains what happened with the two trianglesthat formed.

Downside chart breakouts (a close beyond the lower boundary line of the triangle)do not have to occur on increased volume. Often volume increases a tradingsession or two after a downside breakout. This is because the market is making itpainfully aware to the bulls that they are ‘long and wrong’. The undercapitalizedlongs are forced to liquidate their losings positions; volume increases during thispanic exit.

Location of the Breakout: Another vital consideration of any triangle breakout

is its location with respect to time The breakout cannot occur too far into the pattern. Too far is defined as more than 3/4 of the horizontal distance from reversal point oneto the apex. If a breakout is posted beyond this 3/4 distance, the triangle loses its’effectiveness. Anything can happen. Price could move up, down, or sideways.

Measuring Implication: The majority of classical bar charting price patterns

utilize the vertical height of the pattern to gauge the future extent of the price move. This convention is also applied to the triangle formation.

The vertical height of any triangle is always measured at reversal point 2 to theopposite boundary line. This is true whether the triangle is found in a bull or bearmarket. This distance is added to or subtracted from the price of the boundary lineon the price bar which posted a close outside the triangle. This is minimum distanceprice is expected to move.

Figure 12-3, Exelon Common Stock shows that the vertical height of the largestSymmetrical Triangle measured straight up from the 59.75 low was 1.87. Addingthis distance to the 60.76 breakout price yielded an upside measuring objective of62.63. This arithmetic objective was met.

10-5

Old time chartists often use a graphic method of obtaining an objective. This takesthe vertical height of the pattern and moves it over to the breakout. Note that thismethod of obtaining an objective will result in the same objective if the price scaleused is arithmetic. Use of a logarithmic scale for price will result in higher absoluteupside objectives and not as aggressive downside objectives compared to anarithmetic scale chart.

Futures traders use arithmetic price scales and equity chartists tend to uselogarithmic scales.

Pullback?: The question of whether or not a price pullback (after a valid breakout)

will occur is always difficult for a chartist to answer. Volume may provide someinsight. For sure, a technical trader must keep the size of any position small enoughto withstand the adversity if a substantial price pullback occurs.

After a valid breakout, underlying support (for an upside breakout) is created at theprice level of the breakout. Additional support should be present at the boundaryline just penetrated (Note that this line is moving farther away during a pullback).

Support should also be present at the price level of the apex. There is nothingspecial about the location of the apex in time, after a breakout.

The last bastion of support (again, in the case of an active bullish pattern) is theopposite (lower) boundary line of the triangle. A violation of the opposite boundaryline or its extension beyond the apex, even intra-price bar, officially destroys thetriangle.

This last support (line) gives the technical trader a worst case scenario for thetriangle - with it still ‘working’ as expected. Thus, in theory, the protective stop ordershould be placed just beyond the opposite boundary line. The good news is that thisstop order is continually ‘tightened’ as time passes.

Reliability: An educated guess as to the reliability of an active Symmetrical

Triangle meeting it’s minimum measuring objective is 76 - 78%. This probability isabout 10 percentage points below the reliability of a valid Head & Shouldersformation. The H&S pattern (top or bottom) is the most reliable of all classical barcharting price patterns.

10-6

Redrawing the Boundary Lines: A ‘fact of life’ concerning the triangle formation

is that sometimes reversal points 3 and 4 have to be relocated. This usuallyhappens when the two boundary lines of a possible triangle converge too quickly. This is shown in Figure 12-4, Re-drawing the Boundary Lines.

Figure 12-4, Re-drawing the Boundary Lines

The more difficult case (of having to relocate the boundary lines) is contained inFigure 12-3, Exelon Common Stock. Exelon did experience what looked like a validprice breakout to the upside on October 10. Admittedly, volume at only 2,268,300shares was not impressive. The price move up after the breakout did not exceed thefirst point in the triangle. Then, a severe price pullback(decline) occurred; thepullback entered the triangle and destroyed the formation by violating theopposite(lower) boundary line. However, the extent of the pullback did not take outreversal point two (59.75). An ensuing price move in the direction of the major pricetrend (up) created the conditions where a second set of reversal point 3 and 4 werepresent.

10-7

Re-drawing the two boundary lines on the Exelon chart, continuing to use the originalpoints 1 and 2, resulted in a larger triangle. It became a viable SymmetricalTriangle.

It is this sometime problem of re-locating reversal points 3 and 4 that drops thereliability of the triangle formation below that of a Head & Shoulders reversal pattern.

Another Method of Obtaining a Measuring Objective: A chartist can also

construct a ‘parallel objective line’ to construct a reasonable triangle measuringobjective. This line is derived from a point and an angle. The line begins at reversalpoint one and increases/decreases at the same angle as the opposite boundary lineof the triangle. This is shown in Figure 12-5, Another method of obtaining a Trianglemeasuring objective.

The assumption is that price will touch this parallel objective line. It is a secondaryobjective. To resolve the dual techniques of obtaining a triangle measuringobjective, a chartist could plot both targets. When the closest target is reached,existing positions can be partially liquidated. The market would then be followed bya trailing protective stop order.

Figure 12-5, Another method of obtaining a Triangle measuring objective

10-8

What to do when the Measuring Objective is Reached: As the economists

say “all other things being equal”, 3/4 of the long or short position should be closedout when the height measuring objective is met. Note that a close beyond theobjective is not required. The market must simply trade at or beyond the objectiveany time during the international 24-hour trading day.

The reason that 1/4 of the trade should be kept open is because of the word‘minimum’ used in conjunction with the measuring objective. The price move couldgo much farther. A trader is trying to follow the old adage of letting some profits run.

Additional technical factors such as blowoff volume, declining open interest (for afutures contract) or a Key Reversal price posting (a minor trend change indicator)would prompt a trader to remove 100% of all directional positions.

Other Continuation Patterns: If either boundary line is horizontal, the pattern

that forms is a relatively rare variation of the triangle; a 90 degree angle is present. This results in an Ascending (bullish) or Descending (bearish) continuation pattern. The market ‘wants’ to penetrate the horizontal line.

The Right Angle (90E) form of triangle is found more frequently on cash (spot)market charts than on futures charts. This is due to basis convergence that isconstantly occurring on any futures chart. This is the narrowing of the differencebetween the cash price and the futures price as time passes.

If both lines slope in the same direction, yet still converge, the resulting pattern is aRising or Falling Wedge. Sometimes two entities that tend to move in the samedirection with one another will exhibit a Symmetrical Triangle on one chart and aWedge pattern on the other. They are both continuation patterns. Examples of right angle formations and wedges are located in chapters 13 and 14.

Conclusion: The Symmetrical Triangle is a common bar chart pattern. When two

reversals of the minor price trend are present, the technical trader receives a ‘getready’ signal. There should be a profitable trade ahead - but patience is required. If the next two reversal points create the proper conditions for a SymmetricalTriangle - the risk / reward parameters for a directional trade appear.

And, food for thought: A trader equipped with a knowledge of option strategies hasa much larger arsenal of positioning techniques within a Symmetrical Triangle priorto the breakout. A ‘plain vanilla’, all or nothing, long or short only trader must waitfor the breakout before entering a new position.

10-9

Example of a Symmetrical Triangle

Crude Oil - Dec 2008Light - NYMEX

10-10

Chapter Thirteen

Right Angle Triangles

A Right Triangle is so named because one of the boundary lines is horizontal,and a 90-degree angle is present - a right angle.

As a variation of a Symmetrical Triangle, the same number of reversals of theminor trend (four) are necessary before the two converging boundary lines of aRight Triangle can be constructed. The expected direction of the breakout is thruthe horizontal boundary line of the pattern. The two forms of Right Triangles areshown in Figures 13-1A&B.

Figure 13-1A

Ascending Right Triangle . . . is a bullish pattern (price will ascend out of it)

Figure 13-1B

Descending Right Triangle . . is a bearish pattern (price will descend out of it)

13-1

The risk and reward parameters in a Right Triangle are distinctly defined.Assessing the theoretical risk in any new trade is of paramount importance. Therisk parameter in a trade based on any active Triangle pattern is a price movebeyond the opposite boundary line. In a Right Triangle, the initial protective stoploss order would ideally be placed slightly (say 2 minimum price tics) beyond thesloping boundary line.

The reward parameter of any Triangle pattern is the same. Price is expected tomove beyond the boundary line penetrated, by the vertical height of the pattern. This height is always measured from reversal point two - to the other side of theTriangle.

Because the expectation is that price will breakout thru the horizontal boundaryline, a chartist / trader can ‘lead-off’ by placing a directional position within theRight Triangle prior to the breakout. Note that this is in contrast to waiting for thebreakout from a Symmetrical Triangle - even though the high probability (75-80%)is for the Symmetrical Triangle to act as a continuation pattern.

As an experiment, figure the approximate risk to reward of taking a directionalposition within a Right Triangle prior to the breakout. It will be a risk of 1 to areward of 3. This is such a favorable ratio, that a trader will want to place thisposition every time a Right Triangle is present.

Be careful, Right Triangle are relatively rare patterns on forward or futures charts. As with the Double Top or Bottom formation, Right Triangles are likely to be moreprevalent on a cash or spot chart - where constant basis convergence betweenthe futures and cash market is not present.

And, as usual, markets tend to fall faster than they move up in price. Thisidiosyncracy is based on the outside public tending to favor trades on the longside of any market. Thus, it is important to place short positions within a possibleDescending Right Triangle prior to the breakout. If not, a gap down, thru the lowerboundary line, could then lead to the measuring objective being met - on thesame price bar as the breakout!

13-2

cending Right TriangleEurodollar Time Deposit Futures

June 1989

(Objective was met)

13-3

Ascending Right TriangleUS Treasury Bond future

Dec 1982

The time period during which the Symmetrical Triangle formed is examined onPoint & Figure chart in Chapter 18.

13-4

Descending Right Triangle

The parallel objective line on the Cotton chart was not reached - but the traditionalheight measuring objective was met. A chartist can place both objective on the chart - and begin removing positionswhen the first objective is reached.

13-5

Notes

13-6

Chapter Fourteen

Wedge Formations

A Wedge formation is a continuation pattern. Price is expected to continue in thesame direction it was going when the Wedge began to form.

As with the premiere continuation pattern, the Symmetrical Triangle, a Wedgerequires four reversals of the minor trend for the two converging boundary lines tobe constructed.

A Wedge begins its development in similar fashion to the Triangle; however, thefourth minor reversal of the trend is such that both boundary lines slope either upor down.

Rising Wedge

A Rising Wedge is a bearish pattern.

Both converging boundary lines slope up. A close below the lower boundary lineof the Rising Wedge activates the pattern. The objective is to take out the lowestpoint in the formation (reversal point one). A schematic diagram of a RisingWedge is shown in Figure 14-1.

Figure 14-1

Rising Wedge

14-1

Figure 14-2

Rising Wedge - Gold, Dec 2008 NY

14-2

Falling Wedge

A Falling Wedge is a bullish pattern.

Both converging boundary lines slope down. A high volume close above theupper boundary line is necessary to activate the pattern. Note that high volume isnecessary to validate the upside breakout from the Falling Wedge but is notnecessary (although ideal) on a downside breakout from a Rising Wedge.

The minimum upside measuring objective of a Falling Wedge is to take out thehighest point in the pattern (reversal point one). A close above reversal point oneis not required - only an intra price bar move above it. Figure 14-3 is a schematicdiagram of a Falling Wedge.

Figure 14-3

Falling Wedge

Figure 14-4

Falling WedgePlywood futures

14-3

Falling Wedge on the Gold / Silver Ratio

Monthly Chart

14-4

Rising Wedge

Soybean OilMarch 1981

Note the quote from the Edwards and Magee book. The Rising Wedge is a verypowerful sign that a bear market is in progress.

14-5

What if a boundary line is very close to being horizontal?

When a boundary line is so close to horizontal that there is a question of whatpattern is developing, additional charts of markets that are thought to move inconcert must be analyzed.

14-6

Chapter Fifteen

Flags & Pennants

‘The Flag Flies at Half Mast’

A Flag is a dynamic and potentially very profitable price pattern. Flags occurwithin the course of a ‘rapid, straight-line’ price move. They mark a half-way,breath-catching, resting place before the prevailing trend resumes.

Flags normally slope against the trend. In an uptrend, the ‘body’ of the Flagslopes downward; several low volume small range down days produce the bodyof the Flag. In a price downtrend, the Flag is composed of several narrow rangeprice up days. Figures 15-1A&B show a theoretical Bull and Bear Flag.

Figure 15-1AFlag in a Bull Market Figure 15-1B Flag in a Bear Market

15-1

On a daily futures chart, the body of the Flag seldom lasts more than five tradingsessions before a resumption of the trend occurs. When an apparent breakout isoccurring, a quick trading decision is necessary. This because a limit move thattrading session is frequently the result. On an individual equity chart, the body ofthe Flag can extend up to weeks in duration. Everything moves faster when theitem is listed as a futures contract.

The beauty of a Flag is that the risk is small compared to the expected reward. In addition, the trader will know quickly if the newly placed position is a winner orloser, and is not faced with an agonizing wait for confirmation of the wisdom ofthe trade. There should never be a ‘pullback’ (reaction) back into a Flag patternafter a valid breakout.

One hundred percent of all existing positions predicated on the Flag patternshould be removed once it has reached its minimum measuring objective ofduplicating the rapid straight-line price move that preceded it. Historicalobservation has shown that once a Flag objective has been reached, a violentprice move in the opposite direction often occurs. Any trailing protective stoporder would more than likely be executed. Therefore, a trader should take profitsat the objective and try not to give back the significant gains that were made in soshort a time period.

Three caveats:

1. Because of the dynamic nature of a Flag pattern, a chartist will ‘want’ to findthis pattern as often as possible. Be careful, it is not a common pattern. A Flagshould really only ‘fly’ in new life-of–contract high or low ground. A proper Flagwill not be found within a trading range. Look to the left on the chart; ideally therewill no price activity in the price range of the Flag for quite some time.

2. Flags work best on daily time frame charts. The suggestion is not to look forthis formation on intra-day charts. The reason is that a shock variable (from aneconomic report) will cause a financial future to move swiftly on say, a 10 minutechart. This will make the 10 minute chart ‘look’ like a possible flag pole ispresent. After moving net sideways for several price bars is there another shockvariable to sent the market an equal distance away? Usually not.

3. No market can go below zero to the downside. Therefore, a conservativemethod of obtaining a downside measuring objective is to measure down fromthe high in the body of the Flag instead of from the Flag breakout. Notice thisnuance in figure15-1B and the actual application on the Silver chart in fig. 15-3.

15-2

Bear Flag

Silver - Dec 2008 New York

Figure 15-3

Note that the start of the flag pole on the Silver chart in figure 15-3 began at thebreaking of a 2-pont trend (the two points used to construct the line are off thechart to the left). The measurement did not start at the relative price high of1809.50. The measurement always starts at a previous breakout.

Also note that because this commodity is bounded by zero on the downside, aconservative measuring objective subtracts the 265.80 point flag pole distancefrom the 1523 high in the body of the Flag on this arithmetic scale chart.

15-3

Example of a Flag Failure

Four trading sessions later

15-4

Bull Flag

15-5

Comparison of Hourly and Daily Charts

U.S. Treasury Bond futuresJune 1985

Hourly Daily

15-6

Chapter Sixteen

Gap Theory

16-1

Four Types of Gaps

16-2

16-3

Gap Theory - Graphical Summary

16-4

Suspension Gap

16-5

Ex- Dividend Gap

16-6

Island Formation

16-7

Island Top

Chesapeake Energy Corp (CHK)

16-8

Gap Theory Exercise

Gilts Dec 1995

Classify this gap

See the next page for the answer and ‘how it came out’.

16-9

How it Came Out

Gilts Dec 1995

(Two days later)

Because the close was within the trading range, the gap was a Pattern Gap.

It was closed the next trading session.

16-10

Suspension Gaps

Suspension Gaps, within a 24-hour bar will only appear on a hand constructedchart - until the chart package programmers add a considerable amount ofsophistication to their algorithms.

See page 2-7 for a mechanically reproduced Corn chart.

16-11

Gap Analysis

Soybeans - Nov 1999

Because the Triangle objective had been met, the gap between 435 and 440initially looked like it could be an Exhaustion Gap. When it wasn’t quickly filled - ithad to be re-classified as a Measuring Gap. Also see the Corn chart on the previous page and the mechanical version on page2-7.

16-12

Chapter Seventeen

Minor Trend Change Indicators

Market participants with short term trading horizons, e.g. day traders, often ask: How can bar charts be utilized for their type of dealing? One of the answers totheir query lies in the short term forecasting significance of minor trend changeindicators. There are four of them:

1. Key Reversal2. Inside Range3. Outside Range4. Mid-Range Close

It must be emphasized that these configurations are helpful in gauging only whatmight happen the next trading session. In fact, the next trading session couldeven be the next major world time zone! As such, they change the minor trend inthe opposite direction for as little as one price bar. The end of a major pricemove could be signaled by one of the minor trend change indicators - but thisassumption must not be given too much weight.

The first step in applying any of these indicators is the identification of thedirection of the ‘minor’ price trend. A technician will examine the previous threeprice bars. If there are three higher highs, the minor trend is considered to be up. If one of these one-bar indicators is then posted, the expectation is that the nextprice bar will register a lower low than the indicator’s price bar low.Note that nothing is being predicted for the location of the next price bar’s close.If the minor price trend is down (three consecutive lower highs), and a minortrend change indicator appears, a higher high is expected.

Figure 17-1

Key Reversal.

17-1

Key Reversal

The definition of a Key Reversal High, after a series of higher price activity, is anew high and a lower close. It forecasts a lower price low. A Key Reversal Low, after a series of lower price activity, implies that a higherhigh should be set. Figure 17-1 depicts both of these conditions.

The Key Reversal on a daily chart is one of the most widely known yet leastunderstood reversal pattern. A high percentage of traders jump to the erroneousconclusion that a Key Reversal marks the end of a major price move. It might,but this is asking for too much. Regarding it as minor trend change indicator willallow for the construction of a much safer trading plan.

In most cases, the minimum measuring objective inferred by any of the four minortrend change indicators is fulfilled during the next price bar. It must be noted,however, that a more rigorous definition of ‘worked as expected’ means that theobjective was reached before the one-bar pattern is destroyed. This means thatseveral price bars could be posted before the objective is achieved - as long asthe pattern is not destroyed.

As an example, figure 17-2 contains a Key Reversal (K-R) at a price high. Theexpectation was that a lower low, than the K-R, should be posted. Note that thenext price bar, after the K-R, did not achieve this objective. But neither did thisnext price bar cause the K-R to ‘fail’. A failure would mean that a higher high wasset. The example continues with the second price bar after the Key Reversalsetting the expected lower low. The pattern worked. The Inside Range that wasposted after the Key Reversal simply perpetuated the original indicator.

Figure 17-2Key Reversal that ‘worked as expected

These one price bar reversal indicatorstend to work best on daily bar charts. But, a trader should not overlook theirsignificance on an hourly or weeklychart.

17-2

Why should these price configurations work?

They all indicate that the forces of the bulls and bears have reached anequilibrium. The forces previously in control of the market are losing momentumbut opposing forces have not gathered enough strength to turn the trend; the tidewill turn in the next price bar.

The analogy of a ‘see-saw’ is applicable. Both sides are in balance (temporarily),but the rival forces are about to gain the heavier weight to move prices in theopposite direction - for at least one price bar.

Key Reversal on a Daily Chart

Several additional criteria are important to the understanding of the Key Reversalphenomenon. When using a daily high-low-close bar chart, trading off a presumedKey Reversal early in the trading day can be extremely hazardous. Seldom does aKey Reversal make itself evident early in the dealing day. More often, the pricemove to a higher or lower close occurs in the last 20 minutes of trading. Thus,evidence of a Key Reversal early in the day is more likely to result in pricesmaking another violent move to a new low or high - before the late move in theopposite direction.

Note the “anatomy of a Key Reversal” on the daily & hourly charts of theNASDAQ-100 future on October 10, 2008 in Figure 17-3. Price was down, thenup, then down and then finally up in the last hour of trading.

Volume Considerations

By generating the wicked price gyrations, often expanding the range for the dayseveral times in both directions, high volume will result. Thus, a technician doesnot trust a Key Reversal that occurs on ‘average’ or ‘low’‘ volume. In the old openoutcry environment in the futures markets this required access to a knowledgeablesource down on the trading floor for a guesstimate of volume activity during thetrading session. The move to electronic trading, with on-line volume, has madethe interpretation of this valuable internal variable much easier.

17-3

Anatomy of a Key Reversal

NASDAQ-100 eMini Dec 2008 futureOctober 10, 2008

Figure 17-3A Daily Chart Figure 17-3B Hourly Chart

17-4

Open Interest Considerations

Why does a Key Reversal take place? Because the losers are finally giving up!

They are forced to wait (sweat) almost all day with their losing positions, andfinally surrender - at any price, just to get out. he old adage on an open outcry trading floor was that:

“When the last weak short is finished buying, the silence is deafening”

There are no more buyers - so price plummets. This situation results in openinterest declining. The participants with the correct market judgement going intothat trading session are taking profits; the loser is getting to the sidelines. Bothsides liquidate.

Thus, a technician does not trust a Key Reversal if open interest increases. Thechange in open interest will not be known during the trading session. Confirmation of the drop in total open interest will not be known until the next day.

Inside Range

When an entire price bar’s activity is contained within the previous bar’s pricerange, it generates an Inside Range. The prior minor tend direction is expected tobe reversed - usually the next price bar. For example, after three or more higherhighs, an Inside Range appears; the next bar’s low is expected to be lower thanthe price bar that formed the Inside Range.

The rationale is as explained previously. In the example above, the bulls havebeen in control of the market but cannot force price to a higher high during theInside Range. By the same token, the bears have not gathered enough strengthto reverse price to the downside by generating a lower low. The forces are inbalance. It is likely that the momentum will shift to the bears for as short aduration as one price bar. This will take prices down the next price bar, resultingin a lower low than the Inside Range price bar. This is shown in the diagram onthe left in figure 17-4.

17-5

Figure 17-4

Inside Range

Outside Range

A widely swinging market resulting in a price range where the high is higher andthe low is lower than the previous price bar’s activity is known as an OutsideRange. It is expected to reverse prices - usually the following price bar.

Both supply and demand forces are evident, but it appears that the forces arebecoming more balanced and the prior trend will be interrupted, if only temporarily. This is shown in figure 17-5.

Figure 17-5

Outside Range

17-6

Mid-Range Close

When prices close equidistant between the high and low of the price bar, a Mid-Range Close is formed. Traders did not know where to close prices; the trendpreviously in progress was not dominant going into the end of trading for this timeperiod. There is an excellent probability that an adverse move against the minortrend is about to occur.

A technician should look for the opposing forces to gain the stronger hand - atleast for one price bar - via moving prices in the appropriate direction beyond therange of the Mid-Range Close price bar.

What if the close is, say, 24 tics under the high of the price bar and 25 tics abovethe low of the same price bar. And the market trades in one-tic minimumincrements. An exact Mid-Range Close is impossible. This is ok. The theory thatthe market is trying to change its short term direction should still hold. Figure 17-6contains examples of Mid-Range Closes.

Figure 17-6

Mid Range Close

Ther esome markets in which it is ‘too easy’ to post a Mid-Range Closes - and thereforethe indicator should not be trusted as much as normally would be expected. Anexample would be the Eurodollar Time Deposit futures. Often the daily range isso small that, by default, the close is close to a mid-range.

The opposite type of market would be the stock indices. Seldom does the close ofthe day land in the middle of the range. When it does happen, the indecision thatsurfaced that trading session is likely to result in a reversal of the minor trend.

17-7

Locate the Minor Trend Change Indicators on this Chart

and record whether or not they ‘worked’ as expected

Nickel,

LME 3-month, daily

17-8

17-8

Chapter Nineteen

Mathematical Models - Trend Following

Historical Overview

The mid-1970's saw the creation of ‘commodity funds’. Their proliferation was ofsuch magnitude that hundreds of millions of US Dollars was being traded bythese funds. Unlike the next influx of commodity funds just after 2000 that werelong only ‘index funds’ touting physical commodities as an asset class, the firstcrop of funds were ‘directional’. They could be long or short.

Often the traditional commodity funds were operated by a very small number oftraders. How could a single trading advisor be knowledgeable about thefundamentals affecting the 40+ actively traded futures contracts at that time? The answer is that he could not. The trading advisors turned to mathematicalmodels for entry and exit signals for the futures in their portfolio.

There are two diametrically opposed mathematical approaches the directionaltraders could use: Trend Following vs. Relative Strength. This latter category hasnumerous additional subtitles such as Over Bought / Over Sold, Momentum,Oscillators, and Stochastics.

A good estimate is that 90% of all managed money in the futures market that istraded as a fund uses a Trend Following system. The rational is:

1. Try to be aboard every new emerging price trend.2. Follow the old adage of allowing profits to run while cutting losses.3. Utilize diversification to limit risk.

This chapter will discuss trend following techniques, the next chapter will discussthe Oscillator concepts.

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Trend Following

Even though it’s possible to see sustained price trends just by looking at a chart,technical trend indicators can help confirm that a market is in a trend. One of thebest and most commonly used trend indicators is the moving average. A movingaverage distills market action into a single line on the chart, smoothing out thesharp peaks and valleys that usually occur in futures (or equity) price movement,

and resulting in an easier-to-read picture of price direction

A Simple Moving Average

A simple moving average is merely the arithmetic average of price data during apre-determined period of trading. The more data included in the average(generally meaning the longer the trading period), the slower the average movesrelative to the market itself (because each individual piece of data has lessimpact). Although traders could use computers to calculate moving averagesbased on every single price quote for a desired time period, most just use theclosing price.

For example, to calculate a simple 10-day moving average, add all the closes forthat period (10 data points) and divide by 10. Then, plot each day’s movingaverage calculation (or whatever time period is being used) on a bar chart, andconnect each point with a line to get a smoothed version of the price action.

A moving average is recalculated every day. Price data from the oldest day (orperiod) in the average is dropped (i.e., not used in the new calculation) and thenew day’s data is used instead. Thus, for a simple 10-day moving average, onlythe most recent ten days’ closing prices are used, the eleventh day is dropped,and the average "moves" or fluctuates with the market (but at a slower pace).

Analysts determine the time period, or the amount of data, used to calculate amoving average based on whether they’re seeking a long-, intermediate- or short-term view of the market. The most popular futures moving averages generally fallin the 10- to 40-day range, although they can be calculated for very short timeperiods, such as 5- or 10-minutes. The time frame also depends on the type ofmarkets being studied. For example, a 200-day moving average has traditionallybeen popular in analyzing stock market trends, because stock indexes have, untilrecently, moved rather slowly and stayed in long-term trends. But 200 days are aneternity for the futures markets, and that time frame would be of little value if thegoal is identifying current trends.

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The plot of a simple 10-day moving average using the daily closing price has beenplaced on the daily chart of the Dec 2007 Euro-fx future.

Identifying Trends

Analysts have come up with all sorts of rules and conditions to determine whethera market is in a trend — but, basically, a market can be considered in an uptrend ifprices are above the moving average line and the moving average itself is trendinghigher. It’s the opposite for a downtrend. An uptrend is considered broken if pricesclose below the moving average; a downtrend is broken if prices close above themoving average. This provides the basis for a ‘trading system’.

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In practice, technical analysts often experiment with more than one movingaverage (computers make this easy) to see which one "fits" the price action best,a practice that is called "optimizing." For example, in an uptrending market, pricesmight consistently bounce off of the 40-day average but consistently violate the20-day average; this tells the analysts that in this market a 40-day moving averageis a better trend indicator. This type of "optimization" is not without pitfalls,however. Traders must keep in mind that markets often change character andvolatility. When that happens a moving average that had been giving fairlyaccurate trend signals might suddenly become "obsolete" while another movingaverage based on a different time period could exhibit a better fit. Note whathappened to the simple 10-day moving average on the Dec 2007 Euro-f`x futureschart when price moved net sideways in a triangular consolidation.

In nicely trending markets such as the June 2007 Canadian Dollar future, a 40-daymoving average only had two whipsaws. They occurred when the long term pricedowntrend was in the process of changing to a long term price uptrend.

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Using Multiple Averages

Since a single moving average doesn't always give a clear indication of the trend,technical analysts often use a combination of two or three averages that move atdifferent speeds (calculated based on different time periods). Analysts commonlywork simultaneously with a 9-, 18- and 40-day average to track short-,intermediate- and long-term trends. If all three averages are moving higher, it’s agood bet that the market is in an uptrend. If there is divergence among themoving averages, for example two are moving higher but one is headed lower,then some judgment is required, and a trend follower might trade lessaggressively or stay out of the market until all the averages come intoagreement. An example of a chart with three moving averages plotted on it is theJune 2007 Swiss Franc future.

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So many traders follow some of the moving averages, such as the onesmentioned above, that the averages themselves can become the source ofsignificant support and resistance. For example, the 40-day moving average isso popular as a trend indicator, and often a component of trend-followingsystems used by futures fund managers, that prices often rebound or fall from

that average due to the sheer number of traders entering positions against thatlevel. Conversely, a violation of the 40-day moving average can trigger significantliquidation of trend-following positions, even if this is not warranted by thefundamentals, and this can create a false trend reversal signal.

Always keep in mind that a moving average is a lagging indicator which gives asignal after the underlying market has embarked on a new trend.

Deciding which two averages to use is up to the individual trader and also posesa dilemma. Using two shorter term averages to generate cross-over signals (saya 4- and 8-day moving average) has the advantage of signaling quick changes inmarket direction and enabling a trader to take a position early in a trend.However, this approach does involve a fair number of incorrect signals and whip-saw losses. Using longer term averages (say a 20- and a 40 day) generatesfewer false signals and fewer whip-saws, but suffers the disadvantage ofsignaling positions to be taken well after a trend has begun, and this choiceposes a larger risk per trade than the shorter-term approach. Traders,accordingly, must be very clear on whether they’re looking to capture short-,intermediate- or long-term price moves and how much risk they’re willing to take,before deciding which moving averages to track.

Weighted Moving Average

Since any combination of moving averages will result in erroneous signals tovarying degrees, technical analysts have tried to diminish the error potential byweighting the averages. With this approach, they attach more importance to themost recent price data, believing that "what's happening now" is more significantthan what happened previously. Other techniques for limiting error includeexponential "smoothing," offsetting the averages (shifting the moving averageline to the right on the chart), and calculating an average of averages. All ofthese methods attempt to shift the position of the moving average relative to theactual price movement so as to get a better trading signal, one that indicates atrend change sooner but with fewer false cross-overs.

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The dashed line on the Dec 2007 Japanese Yen future is a weighted 10-daymoving average. Notice how it reacts slightly faster to price changes than thesimple 10 day average.

Already discussed is the fact that analysts/traders often "optimize" movingaverages, a fairly simple process with computers and one that can help limit thenumber of false trading signals over a selected period of price action. Butbecause markets are volatile (exhibit large or small price swings), an optimizedaverage may not work well beyond the "test" period. In practice, simple moving

averages can work just as well as jazzed-up versions.

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Moving Averages & Trendlines

Analysts also use moving averages with other trend indicators such as trend linesor oscillators to improve the reliability of the trading signals they get from theaverages. If prices violate a trend line and the moving averages also give a cross-over signal in the same direction, it’s considered a double indication that the trendis changing.

Note the chart example of the Sept ‘07 New Zealand Dollar future. It contains animportant 3-point upsloping trendline. This line was broken at the same time asthe downward crossover of the price and moving averages.

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Trend Following Funds

Managed money has become a major factor in commodity markets since the late1970's. Large sums that are now invested with fund managers. These managerstypically use technically-based trend following systems (unless they are a ‘longonly’ commodity index fund). The impact of the collective actions of the trendfollowing funds can be particularly pronounced when a market is changing trend.Even though fund managers know this and try to design trading systems usingdifferent trend indicators (including some pretty esoteric stuff), they still oftenenter and exit markets at about the same time. Thus, whenever a trend changes,everyone gets a signal regardless of the technical method they’re using and therush of buying or selling that occurs often creates a big move in the market.

Although most managed funds use sophisticated technical systems, traders canget a feel for where concentrated fund activity might take place by watching the40-day moving average. It provides a pretty good proxy for fund-trend following

buy and sell activity.

Moving Average Divergence

Another way to use moving averages is to keep track of the difference betweentwo averages. This difference, or "divergence", is an indicator of a market’smomentum. In other words, if a market is in an uptrend and a short-term movingaverage is rising at a faster pace than a longer term average, the pricemomentum is increasing to the upside, i.e., the difference between the short-termand long-term average is widening, implying that the trend is healthy and mayhave further to go. More importantly, since momentum usually shifts before thetrend does a change in momentum can help anticipate a change in trend.

Moving average divergence is sometimes tracked on a type of chart called a

histogram (a type of bar chart) but is more often plotted against a zero line. Forexample, if the value of the fast moving average is above the slow movingaverage, the difference between them (subtract the value of the slow movingaverage from the fast moving average) is a positive number and is plotted abovethe zero line. If the fast moving average is below the slow one, the divergence isa negative number and is plotted below the zero line. These types of charts areeasy to construct by hand, but the math-challenged need not worry since movingaverage divergence indicators are included with most charting softwarepackages.

19-9

The Sept 2007 British Pound futures chart contains a simple 10 day and 21 daymoving average.

At the bottom of the chart the difference between the two averages is plotted as ahistogram.

19-10

Chapter Twenty

Mathematical Models - Oscillators

Among the myriad of mathematical models, a category exists that tries to locateprice levels where the existing price trend could be in the process of exhaustingitself. The trader is looking for a reversal of the price trend. In general, this typeof model can be referred to as an oscillator. Some of the specific names forthese models are Relative Strength Index, Stochastic, Momentum, Overbought /Oversold. Note that this type of model is diametrically opposed to the trendfollowing models.

The Relative Strength (RSI) and Stochastic models are two of the most popular. They strive to locate ‘overbought’ and oversold’ levels on a price chart. Thetheory is that if a trader can identify a market that is in an overbought condition,the trader will want to take an opposite (i.e., short) position.

The calculation of these indicators is simple arithmetic. Personal computers andplotting packages have made their use widespread. The indicator can becalculated over any number of discrete periods. An active futures trader rarelyuses more than 13 periods - e.g. 13 hours or 13 days to calculate the resultingnumber.

This output from the RSI or Stochastic model will be a number that can varybetween 0 and 100 but it will never reach either extreme. The ‘trick’ is to set the parameters that constitute overbought and oversold. Pioneering work in the field of mathematical models was the book New Conceptsin Technical Trading Systems, by J. Welles Wilder. In it, Wilder suggested a 14day period and parameters of 70 for overbought and 30 oversold in the equitymarket examples. There is nothing magic in these threshold levels. A technicianhas to back test the model to determine suitable parameters. And even these areunlikely to be optimal - as the markets change their characteristics.

Using threshold levels of 80 and 30 on the 9-day Relative Strength Index for theDec 2007 British Pound future produced a successful short sale (when the Indexwhen above 80) and a buy (when the Index went below 30).Note that the RSI remained in neutral territory while the price of the British Poundmoved net sideways within a triangular consolidation.

20-1

20-2

A Caveat

Simply shorting a market when an indicator breeches a supposedly overboughtlevel is a path to ruin. A general observation can be made: 17 consecutiveprofitable trades could be wiped out in one huge loss - where the value of theindicator continues to move farther into extreme overbought territory as a pricemove of unprecedented proportion takes place. And, it is difficult to determinean effective stop loss point when a market is in a runaway mode.

In an attempt to create a safer entry into a position, technicians have worked withnot pulling the trigger on a new position unless a ‘failure swing’ occurs. Thismeans that a trader does not automatically place a new position when theindicator enters ‘over’ territory. Rather, the trader watches for a pullback in theindicator back into neutral territory. The next push by the indicator into ‘over’territory is watch very closely. If the indicator fails to go to a new extreme andthen moves back into neutral territory again - this is the time to enter.

The entry signal just detailed was present on the hourly chart of the Dec 2007Euro-fx future after the price run up. The 9-bar RSI moved above the overboughtthreshold of 84, dropped back below 84, moved up above 84, and then moveddown below 84. This last move down was the short sale entry signal.

When this signal occurs it is not unusual to have a divergence between whatprice is doing and what the indicator is doing. Note that the Dec Euro set a newprice high - but it was not capable of pulling the 9-hour RSI above the levelmarked ‘A’ on the chart.

20-3

Whether this does provide a safer entry signal is open to conjecture. Traders arealways trying to refine their ability to construct risk and reward parameters. Andunlike classical bar charting where a measuring objective is present from anorthodox price pattern, an RSI or Stochastic model does not provide a pricetarget.

20-4

Relative Strength ExampleHourly Chart

20-5

How it Came Out

20-6

A ‘Get Ready’ Signal on a 9-Week RSI

20-7

‘How it Came Out’

The failure swing and divergence led to a sizable price rally.

20-8

Chapter Twenty-Two

Spreads & Spread Trading

The bailiwick of old time commodity futures traders were the grain and oilseedspreads. The different seasonal factors plus the fact that distinct crop yearsexisted, lent itself to spreading - where the trader was long something as well asshort something. This form of trading also has a place in the modern markets.

Before listing some spreading considerations in the form of an outline, theoverwhelming premise for a chartist must be stated. That is:

All the hopes, fears, and moods are reflected in once single item - the price.

In the case of a spread, traders must be paying attention to the specificdifferential between two prices. The price of one arbitrary item cannot besubtracted from the price of another arbitrary item and expect that the plot of thespread differential would/should act in classical fashion.

A trader has to do a minimal amount of fundamental analysis - and come to theconclusion that enough traders are paying attention to the specific relationshipbetween the two items in question. If so, the spread should be charted.

The reader is encouraged to examine the chapters that follow, on classical barcharting and then return to this chapter and then look at the various spread charts- most of which contain a price pattern.

I. Overview

1. Why trade spreads?

A. Lower risk? Not necessarily.

B. Attractive margins? - in futures, yes

C. ‘Staying power’? - Sometimes

22-1

D. Aid in trading outright positions? - Definitely

i. Spread indicating tightness of supply (or the opposite)

ii . Picking the best month for an outright position

iii. Bull spread not working, may imply only a temporary ‘technical’ bull move is occurring.

2. Proper mentality toward profiting from a spread = think the difference only

3. Definitions

A. What is a straddle? A spread

B What is a switch? A spread

C. What is pairs trading? A spread using individual equities

D. What is a cross? A division, one currency into another, neither being the US Dollar

E. What is arbitrage? Exactly the same product, different location

4. Do not spread to protect a loss - ever!

II. Storable vs. Perishable Futures Contracts

1. Definition of a ‘storable’ futures contract To be considered storable, the futures must be one which can be

accepted on delivery when the near-by (long) contract matures - and be eligible without re-inspection for delivery, when the more distant contract which was sold, matures.

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2. Spreading mentality of old-time CBOT vs. CME members

A. Which Chicago futures exchange traded predominantly storable commodities and which traded perishable commodities (according to

the definition stated above)? The Chicago Board of Trade = storable.

B. Why did Crude Oil futures flourish on the New York Mercantile Exchange (and not the CBOT)?

i. What did the NY Merc trade in the ‘old days’? Potatoesii. Is Crude Oil (futures) a storable commodity? No

III. Charting a Spread

1. Can / should a spread be charted?

A. Some minimal fundamental analysis must be done to determine the answer.

B. An example of a spread that should not be charted: the Canadian Bacon spread (Canadian Dollar - Pork Bellies).

2. Use close-only prices

A. Which futures close to use? ‘Pit’ close.

B. Is there a close in the cash foreign exchange markets? No

3. Does the plotting software support spread definitions?

A. Weighting the legs differently - e.g., 3 Cattle vs. 4 Hogs

B. Three items

i. Soybeans vs. Meal & Oil

ii. 3 Crude Oil vs. 2 Gasoline & 1 Heating Oil

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4. Plot:

A. Near-by minus more distant month (inter-delivery spread)

B. Difference in Dollar value: Second named item is subtracted from the first named item (inter-commodity spread)

5. Spreads tend to ‘trend’ vs. create classical price patterns

6. A ‘flat’ on spread chart = a minor trend change indicator. See any of the various ‘current’ charts

IV. Definitions

1. ‘Normal’ market: Near-by trading below back month

2 . ‘Inverted’ market: Near-by trading above back month

3. British terms:

A. Contango = normal market

B. Backwardation = inverted market

V. Order Entry

1. Place order as a spread order:

A. Indicate a specific (limited) spread differential

B. Do not ‘leg’ into a spread.

C. Do not ‘leg’ out of a spread

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2. State long leg first - if calling the CBOT open outcry floor (‘Buy’ is on the left side of the order pad)

3. CBOT floor traders traditionally used positive numbers (‘or better’ is always implied) See Order Entry Example

4. Electronic spread entry places premium or discount on near-by contract.

5. Interest rate traders (at the introduction of T-Bond futures) used negative numbers (if applicable)

6. Last trade prices vs. where the spread is really trading, e.g.,

A. Dec - July Corn spread is quoted as 16 ½ to 17 (premium July)

B. Market order to buy Dec - sell July arrives; execution is at 16 ½.

C. Market order to buy July - sell Dec arrives; execution is at 17.

D. Better strategy for either side; enter limited order at 16 3/4 (split the difference)

7. Use of protective stop (loss) orders

A. ‘Mental’ stop - dangerous but necessary

B. Determined location of stop based on:

i. Money management

ii. Spread chart

C. Stop placed on the volatile leg vs. ‘dead leg’ of the spread

D. When to exit - when the trendline is broken or (partially) when objective met

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8. Limit price moves (future is locked limit up or down)

A. Can a spread to exit from locked limit position (if any of the other futures contracts are freely traded). B. Can use options to determine where futures are trading.

C. Do not buy last market to trade limit-up

D. Do not sell last market to trade limit-down

VI. Limited Risk Spreads

1. Available only in storable futures contracts where calculation of carrying charges is possible.

2. Limited risk spread = long near-by vs. short deferredA. Risk is limited to move to ‘full carry’B. Reward is unlimited

3. Forward pricing

A. The ‘basis’ = cash price minus futures price (Basis in grains was unusually unstable (wide) when strong inflow of ‘Index Fund’ money occurred in 2007/08)

B. How to compute ‘full carry’

i. Interest cost Could be bankers acceptance rate, fed funds + 1 3/4 - 2% or prime, or prime +1%

ii. Storage cost (0.15 cent/bu/day or 4 ½ cents/bu/month for a 30 day month - as of April 2008)

iii. Insurance cost - negligible, “most often ignored”

iv. Commissions - very low for an exchange member

v. Inspection / handling - if applicable22-6

C. Risks in a limited risk spread

i. Tendency for discounts to widen (toward full carry) with the passage of time - as maturity approaches

ii. Price rise increases total value of contract & thus financing costs increases full carry

iii. Interest rate increase (full carry increases)

iv. Obtaining commodity that is not re-deliverable (KC Wheat, Lumber)

v. Buying cash commodity & unable to get it into position ‘regular’ for delivery

vi. Greater than limit move (down) by expiring future

vii. Government intervention - ceiling on near-by future Unlikely - but it has happened

3. Question: How could (did) futures traders speculate on interest rate changes prior to the introduction of short term interest rate futures? (Answer: Storable commodity spreads trading near full carry)

4. Fallacy of using ‘newspaper’ cash prices - don’t do it.

VII. Some Specific Spreads

1 . Gold / Silver ratio

A. Long term ratio (approx. 100 years = 32.5

B. Ratio on March 12, 2008

i. 48.82 (cash) and moving downward on monthly chart

ii. 49.19 (Dec 2008 futures), on a ‘bounce’

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C. Dollar value of contracts should be approximately equal

i. CBOT one Kilo Gold vs. CBOT 1000 oz Silver future = close enough to equal Dollar values.

ii. Could weight the legs and/or plot a Dollar difference chart

2. S&P 500 Index vs. Dow Jones Industrial Average

A. 95% correlation during majority of trading days

B. Both dominated by large capitalization, blue chip stocks

C. E-mini S&P 500 - E-mini Dowi. One-to-One

ii. ‘Ratio’ the spread = “dollar neutral” 5 x 6 or 10 x 11 (using 2007 year end prices)

iii. Spread margin = approx. 10% of normal outright initial margin

3. Crack spread:

i. 2 Gasoline & 1 Heating Oil vs. 3 Crude Oil

ii. Spread = [{Gasoline price x 42} x 2 + Heating Oil price x 42 minus (Crude Oil price x 3)] divided by 3

iii. Spread result is in Dollars/barrel

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Soybean Spreads

New Crop - New Crop

Old Crop - New Crop

22-9

A Cross Chart

The old Sterling / D-Mark Cross

Whenever a horizontal line is present on a chart - that is the line that the market ‘wants’ to go thru.

22-10

Falling Wedge on the Gold / Silver Ratio

Monthly Chart

22-11

Notes

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