wiley trading - sammy chua's day trade your way to financial freedom - 2007

Sammy Chua

John Wiley & Sons, Inc.

Sammy Chua’s

DAY TRADE Your Way to

FINANCIAL FREEDOM

2 N D E D I T I O N

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Copyright © 2007 by Sammy Chua. All rights reserved.

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Library of Congress Cataloging-in-Publication Data:

Chua, Sammy.Sammy Chua’s day trade your way to financial freedom / Sammy Chua.—2nd ed.

p. cm.Includes index.ISBN-13: 978-0-471-74558-7 (cloth)ISBN-10: 0-471-74558-8 (cloth)1. Day trading (Securities) 2. Electronic trading of securities. 3. Investment analysis.

I. Title: Day trade your way to financial freedom. II. Title.HG4515.95.C49 2006332.64′2—dc22 2005031909

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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www.wiley.com

CONTENTS

PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

CHAPTER ONE

An Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5• The Stock Markets

• The Exchange System

• NYSE Time Lines

• Listed Stocks

• The Specialist System

• Who’s Who on the Exchange Floor

• The SuperDOT System

CHAPTER TWO

The Big Board and Nasdaq . . . . . . . . . . . . . . . . . . . . . . . . . 13

• The Over-the-Counter Market (OTC)

• NASD and Nasdaq

• Nasdaq Is a Negotiated Market

• Understanding Market Makers

• Information Is Power

• Nasdaq Service Levels I, II, and III

• Comparing the NYSE and Nasdaq

• Electronic Communications Networks (ECNs)

• Regulatory Framework

• Quick Quiz

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iv CONTENTS

CHAPTER THREE

Brokerage Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25• Selecting a Brokerage

• Execution Speed

• Reliability

• Order Routing

• Price

• Service

• Other Online Brokerage Features

• Types of Accounts

• Types of Positions

• Types of Trading Orders

CHAPTER FOUR

Direct Access Order Entry System . . . . . . . . . . . . . . . . . . 39• Nasdaq Direct

• SuperMontage

• TotalView

• ECNs

• SuperDOT

• Order Execution Systems Review

CHAPTER FIVE

Elements of Successful Trading . . . . . . . . . . . . . . . . . . . . . 47• Minimum Requirements to Begin Trading

• Psychology of Trading

• Risk Management

• Trading Methodology

CHAPTER SIX

Trading Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59• Scalping

• Intraday-Trend Trading

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CONTENTS v

• Swing Trading

• Long-Term Trading

• Back Testing

CHAPTER SEVEN

Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65• Charts

• Identifying Support and Resistance

• Trading Strategies

• Trendlines

• Gaps

• Basic Chart Patterns

• Volume Analysis

CHAPTER EIGHT

Candlestick Charting Techniques . . . . . . . . . . . . . . . . . . 115• Spotting Heavy Buying and Selling Pressures

• Comparing Buying and Selling Pressures

• Spotting Indecision with Candlesticks

• Understanding Intraperiod Activity

• Candlestick Positions

• Bullish Patterns

• Bearish Patterns

CHAPTER NINE

Spotting Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151• Technical Indicators

• Key to Using Indicators

• Moving Averages

• Moving Average Convergence Divergence

• MACD Histogram

• Stochastic Oscillator

• Relative Strength Index

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vi CONTENTS

• On-Balance Volume

• Accumulation/Distribution

• Futures and Pivot Points

• Conclusion

CHAPTER TEN

Preparing for the Open . . . . . . . . . . . . . . . . . . . . . . . . . . . 177• The Trading Day

• Do the Research

• Manage Risk

• Set Alerts and Trading Screens

• Intraday Trading

• Market Indices

• Other Market Indicators

• Direction of Market Trends

• Keep a Trade Journal

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

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PREFACE

WHEN SAMMY CHUAASKED ME to edit his new book on day trad-

ing, I jumped at the chance. As a reporter for Investor’s Business

Daily, I had covered day trading for several years. Too many of the

day trading gurus I wrote about were interested only in getting novice traders into

their shop, bleeding them dry, and then shoving them out the door when their cap-

ital had run dry.

Sammy Chua was an exception. He has made a fortune using trading methods

that I believe to be superior to the many other methods I have covered. Now he

wants to teach others how to succeed in this miraculous profession. There is no

hidden agenda with Sammy. His zeal to teach is genuine and heartfelt. He wants

to teach beginners to protect their capital and to avoid the psychological traps that

often spell disaster for new traders. Sammy Chua wants you to have the same suc-

cess he has had.

Day trading has come a long way in the past 10 years. It is a risky occupation,

but a small group of talented people have developed ways of lessening the risk

and increasing the potential for profit. Sammy Chua is number one on this list.

Here’s a short version of his strategy: The controlling factor in day trading is,

according to Sammy, supply and demand. If demand for a stock is great, the sup-

ply will decrease, driving the stock price upward. If demand is poor, supply will

increase, driving the stock price down. You don’t need a broker or an army of

research analysts to tell you when the laws of supply and demand are pushing a

stock up or down. Just pay attention to what Sammy has to say in this book.

Concentrating on supply and demand is liberating. It frees the trader from the

onerous chore of picking stocks based on the industry they represent. Sammy once

drove this home to me in a phone conversation. He talked about making a good

profit the day before on Corning. I remarked that I liked Corning, because the

company was in the rapidly growing fiber optics business.

Sammy took a deep breath and said, “Pete, I don’t know what Corning does. I

don’t care what they do. I don’t know anything about any of the companies I trade.

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viii PREFACE

All I know is the stock generated a strong buy signal based on several indicators.

Institutions are jumping in big-time, which means supply is dwindling. That’s all

I care about.”

And that’s all day trading should be about. It’s about supply and demand,

learning to read indicators and volume trends, and sticking rigidly to a loss pre-

vention program. But I’ll let Sammy Chua explain this to you. He is a proven win-

ner in the fine art of day trading. Learn and enjoy.

Peter McKenna

Editor

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INTRODUCTION

DAY TRADING IS THE MIRROR OPPOSITE of the buy and hold strat-

egy. It means trading frequently, trying to capture small profits while

limiting risk. You do not buy a stock and hold it for years. Good

traders learn what makes stock prices move up or down, and they use this knowl-

edge to make money on a daily basis.

Consider, for example, just one of the important bits of knowledge this book

will teach you: the theory of supply and demand as it applies to stock prices. When

institutions such as brokerages and mutual funds buy huge amounts of a stock—

IBM, for example—the available supply of that stock will diminish. This in turn

will drive the price of IBM stock upward. A day trader who learns to spot stocks

that are under heavy accumulation can use that knowledge to catch a ride on IBM

as its price goes up. The same is true in reverse. If institutions are selling a stock,

it’s supply will increase, driving the price down. An alert day trader will short this

stock for a brief time as its price falls.

When done correctly, day trading can help investors avoid the periodic losses

that come with the traditional buy and hold strategy. Since the first stock was

traded more than 200 years ago in New York City, the overall direction of the mar-

kets has been upward. For this reason, the buy and hold strategy makes sense if

you want to hold stocks for several years.

However, the market does not make this upward climb in a straight line. There

are periods of months and sometimes years when prices come crashing down or

move sideways. This is the classic bear market. Long-term investors who get

caught in these downdrafts can be badly hurt.

Suppose, for example, that you put a lot of money into Lucent Technologies

when it was trading near $20 in 1999. The stock soared to nearly $80 by January

2000. Everything was rosy. Many long-term investors held onto tech stocks such as

Lucent, thinking they would go up forever, providing the money for retirement or

college tuition or a new car in the years ahead. Lucent was their nest egg.

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2 INTRODUCTION

But things turned nasty in 2000 and 2001. The tech sector collapsed and the mar-

ket came tumbling down. It bears repeating that the market cannot go up forever.

Something always brings it down. Lucent now trades at about $3. Investors who

bought Lucent in 1999 and held on have been left with next to nothing.

When the tech bubble burst, a day trader who understood the supply and

demand theory mentioned previously would have spotted Lucent, or any num-

ber of other tech stocks. They would have seen the selling pressure and shorted

the stock, making money immediately. The rewards and risks of the day trading

strategy are immediate; they are not long-term promises that may or may not

materialize.

This is a great time to be a day trader. Although day trading has been around for

several years, recent changes in technology and securities laws have opened it to

simple folks like you and me. Today, we can trade from any location. All we need

is an Internet connection and a computer. We also have the ability to place orders

directly into the stock exchanges, which is almost like buying a seat on the

exchange itself.

Day trading is not for everyone. To be successful, you have to love what you do.

If day trading does not fit your personality, you will not last long. For example,

day trading can be risky. You can lose money in a few seconds. Risk taking comes

naturally to some people but shakes others to the core. If you feel comfortable buy-

ing only companies with strong, long-term fundamentals, then short-term trading,

particularly day trading, is not for you. But if your desire for financial freedom is

strong enough, if you are willing to develop the discipline it takes to trade success-

fully, you have the right mentality to be a frequent trader.

Before we continue, let me make an important point: This book covers many

different trading strategies. You do not have to master all of them to be successful.

Traders who concentrate on just one or two strategies almost always become suc-

cessful faster than traders who want to know everything before they take the

plunge. The same is true in all professions. Both general practitioners and heart

surgeons, for example, are doctors. But heart surgeons are specialists and enjoy

more success than general practitioners. Be the heart surgeon and learn to special-

ize in one strategy before moving on.


INTRODUCTION 3

As you read this book, try to decide whether you have the type of personality it

takes to be a trader. Remember, trading is an ongoing process of learning. You

must be willing to constantly adapt to the ever-changing market. Trading requires

constant reading, picking the brains of those who have already succeeded, and a

bulldog tenacity to learn your craft. It can be exciting, even exhilarating, when

things go your way. There is no limit to the profits you can earn. Your success

depends on how much effort you are willing to commit to learning. Let’s get

started.


CHAPTER 1

An Overview• The Stock Markets

• The Exchange System

• NYSE Time Line

• Listed Stocks

• The Specialist System

• Who’s Who on the Exchange Floor

• The SuperDOT System

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You will not be able to execute these strategies

unless you learn how the stock markets work.

Every day, millions of shares move back and forth

from one investor to another. How is this done?

Who are the people who execute these trades for

investors? How do you get the best price on your

order? Which electronic routing systems are the

best for day traders? What does all this back-and-

forth mean to the day trader? These are the basics.

Learn them well.

In the United States, stocks are bought and sold

in two different venues: stock exchanges and over-

the-counter markets (OTCs). This chapter explores

the differences between the two systems, particu-

larly the differences that will affect your career as a

day trader.

THE EXCHANGE SYSTEM

The largest stock exchange in the world, trading

more than 3,000 stocks, is the New York Stock

6 SAMMY CHUA’S DAY TRADE YOUR WAY TO FINANCIAL FREEDOM

Exchange (NYSE). The NYSE is situated on Wall

Street in New York City. It is also known as the Big

Board and is considered the center of the stock-

trading universe. The NYSE was created in 1792 by

24 traders who got together to trade a few shares in

two small, local companies. From this humble

beginning, the stock market grew into the beast it

is today. Most day traders, however, never set foot

inside the NYSE. Including the NYSE, there are

seven stock exchanges in the United States, but the

NYSE is the granddaddy of them all. The others

are smaller, regional exchanges that look to the

NYSE as the leader.

An exchange is a place where buyers and sellers

physically get together on a central trading floor to

buy and sell. Floor trading is essentially an auction

in which price is determined by supply and

demand. The trades may be routed by computer,

but they all eventually come to the market floor for

execution. The exchanges are membership organi-

zations. The members trade securities on behalf of

THE STOCK MARKETS

DAY TRADING INVOLVES THE FINE ART of finding stocks that

will come under buying or selling pressure. This pressure makes

the stock price move significantly up or down. That’s the first

step. Knowing when these stocks are likely to make their move is the second

step. The final step is executing a trade to capture a brief portion of this

move, making a profit in the process.


AN OVERVIEW 7

their clients or for themselves. Both individuals

and big securities firms are members of the NYSE.

NYSE TIME LINES

HISTORIC MILESTONES

1865 The average daily volume is about 34,000 shares

traded for 141 companies.

1900 Volume grows to 505,000 shares per day for 369

companies.

1920 Volume is 825,000 shares per day for 689

companies.

1940 Down to 750,000 shares per day for 862

companies, volume explodes.

1960 Average daily volume rises to 3 million shares for

1,143 companies.

1980 Volume is 44 million shares per day for 1,570

companies.

1987 Largest one day percentage drop occurs.

1990 Volume is 157 million shares per day, 1,774

companies.

1997 Volume is 525 million shares per day for 3,028

companies.

1997 All-time record 1.2 billion shares are traded on mini-

crash day, October 27.

2000 Both the biggest point jump (499.19) and the

biggest point slide (617.78) occur.

2001 Trading in fractions ends.

2003 NYSE Composite Index is relaunched using revised

methodology.

2005 ARCA and the NYSE merge.

TECHNOLOGICAL ADVANCES

1878 The first telephone is installed.

1978 The first electronic linkage to other exchanges is

installed.

1984 Orders are electronically routed to the floor using

SuperDOT system.

1995 Hundreds of old TV-style monitors are replaced with

modern flat-panel displays in the world’s largest

installation of this technology to date.

1996 Floor brokers start using handheld wireless

information tools.

LISTED STOCKS

Stocks traded on the NYSE are called listed stocks.

This means the underlying company has met the

requirements necessary to list its stock on the

NYSE. One requirement, for example, is market

capitalization. To be listed on the NYSE, a company

usually must have a market capitalization of at

least $100 million. (Market capitalization is deter-

mined by multiplying the stock price times total

shares outstanding.) These rules were designed to

prevent the Mafia from getting money-laundering

companies listed on an exchange.

Stocks with a large market capitalization are

called large-cap stocks. They are usually estab-

lished companies. For example, IBM, founded in

1911, has a market capitalization of $124.64 billion

and is a large-cap stock traded on the NYSE. Other

large-caps traded on the NYSE include DuPont,

Ford, Coca-Cola, General Electric, Alcoa, and


AT&T. It is important to remember that large-cap

stocks traded on the NYSE are not as volatile as

OTC stocks. This can be an asset or a liability to the

day trader. However, some large-cap stocks, even

though they trade on the NYSE, are volatile.

Energy stocks and pharmaceuticals are examples.

Before I discuss how these stocks are traded,

here is a list of terms you should know. They apply

to the workings of both the NYSE and the OTC:

Best bid. The price a buyer is willing to pay to buy a

stock.

Best ask. The price at which someone who owns a stock

is willing to sell it.

Broker. One who arranges the sale of a stock.

Dealer. Usually a brokerage, such as Charles Schwab. Bro-

kers sell the stocks that dealers keep in their inventories.

THE SPECIALIST SYSTEM

Exchange trading is carried out by a person called

a specialist. Specialists control the auction process.

Their job is to match buyers with sellers. The spe-

cialist looks at an electronic order book of bids and

asks and matches them according to price and

quantity. The specialist, for example, will match a

person willing to buy 100 shares of IBM at $80 with

a person willing to sell 100 shares of IBM at $80.

Specialists are the people you see running around

on the floor of the NYSE. The specialist and his or

her clerks are assigned responsibility for one or

two stocks. They handle all bids and offers for

these stocks.


There is more to a specialist’s job than matching

buyers and sellers. They are expected to maintain

an orderly and fair market. When there is an excess

of buy or sell orders, making it impossible to

match orders evenly, the specialist steps in. There

may be 1,000 people who want to sell IBM at $80,

for example, but only 100 people who are willing

to pay this price. This situation, called an order

imbalance, sometimes causes trading to be tem-

porarily suspended. An opening delay usually

happens when a news event or extreme imbalance

of orders prevents the stock from trading when the

market opens. The specialist has 15 minutes from

the opening bell to determine a price range at

which the stock will begin trading.

A specialist can delay an opening or halt trading

until a proper balance of buyers and sellers is

achieved. Usually, the stock will start trading at a

price far different from its previous price. Some

day traders try to profit from these imbalances,

which occur frequently.

Specialists profit from the spread, the difference

between the bid price and ask price, for each

market-order transaction in which a spread exists.

A market order is an order to buy or sell a stock at

the market’s current best displayed price.

A good specialist will be assigned responsibil-

ity for more stocks than the usual one or two. Spe-

cialists may trade for their own firm’s accounts as

well, buying low and selling high to make a

profit.

Specialists are predictable. Novice day traders

who want to trade stocks on the NYSE should

get to know the habits of the specialists they are


AN OVERVIEW 9

dealing with. There are several day trading firms

whose members make a good living just by follow-

ing the actions of the specialists. Their aim is to

capture small profits several times a day, just like

the specialist.

WHO’S WHO ON THE EXCHANGE FLOOR

In addition to the specialist, here are the people

who make the NYSE hum:

Specialist’s clerk. The clerk sits next to the specialist.

They stand ready to maintain the electronic order book

and report executions. The order book contains buy and

sell orders at different prices, including the current market

price. These are the orders and prices that must be

matched.

Floor brokers. Brokers usually represent big-name bro-

kerage firms. They handle large (block trades) or sensitive

orders. The brokers deliver these orders to the specialists.

They are allowed to negotiate orders with the specialists or

other floor brokers in the presence of a specialist.

Floor clerks. These people deliver orders from the floor

brokers to the specialists.

Member firms. A big-name brokerage firm that has a

seat on the NYSE. If your brokerage firm is not a member,

your order will pass through another firm that is a member.

Floor traders. These are independent traders. They trade

for their own accounts and can represent institutions when

contracted.

Customer. A customer can be a day trader, an investor, or

a large institution. Generally, they are not present on the

floor, but their orders are the cause of all the activity you

see on the floor.

There are 17 trading posts on the trading floor.

Each post is semicircular and about 15 feet across.

Each post trades an average of 150 securities. The

specialists are stationed outside the trading posts

in designated spots. The clerk sits inside the post

and communicates with the specialist through a

window. Display monitors hang above the post

windows so the clerk and the specialist can watch

the floor broker and the order books at the same

time. Huge conduits rise up from the trading floor,

carrying data lines to the exchange computers.

THE SUPERDOT SYSTEM

Buy and sell orders on the NYSE are routed to the

exchange floor by an electronic system called

Super Designated Order Turnaround, or Super-

DOT. The best way to understand the miracle of

this system is to compare it with the routing meth-

ods used before the SuperDOT was implemented.

Figure 1.1 gives you an idea of the long process

needed to route orders in the old days. As you can

see, getting a trade executed in the old days took

time. The trader called a stockbroker and placed the

order. The stockbroker called the order in to the

trading desk. The desk relayed the order to a floor

broker at the NYSE. The order was then passed to a

floor clerk, who would give it to the specialist for

execution. After the order was executed, a confir-

mation (or trade report) would flow backward

through the same process until it reached the trader.


Every transaction required multiple pieces of

paper, which were crumpled up to distinguish

them from paperwork that might have been acci-

dentally dropped. That was why, in the old days,

the floor of the stock exchange was littered with

small scraps of paper. The SuperDOT system has

eliminated most but not all of the paperwork.


Paper is still used for negotiating large and special

orders.

SuperDOT is fast and reliable. Orders go

directly to the specialist. This minimizes the time

involved, and trade reports are made within sec-

onds, except on the busiest days. Brokers who

trade on this system have what is called direct

Customer Places Order

Trading Desk

Floor Broker

Floor Clerk

Customer Gets Confirmation

Trading Desk

Floor Broker

Floor Clerk

Specialist Executes Order

1.1 Historical Buy and Sell Order Routing System Used on the New York Stock Exchange

� WHEN THERE IS AN EXCESS of buy and sell orders, the specialist steps in.

Customer PlacesOrder

SpecialistExecutes Order

Customer GetsConfirmation

1.2 SuperDOT System (Super Designated Order Turnaround System)

� COMPANIES WITH SMALL MARKET CAPS are handled on the Bulletin Board and the Pink Sheets.


AN OVERVIEW 11

access to the NYSE market. If you are a day trader

and your broker is a NYSE member, your order

will most likely be delivered through SuperDOT.

A quick look at the flowchart in Figure 1.2 gives

you an idea of how streamlined this new process

is. It is important to note that SuperDOT is not an

automatic-execution system. Orders are routed

electronically through SuperDOT, but they are still

executed by specialists. If there is an order imbal-

ance or if you have placed a limit order, SuperDOT

will automatically deliver your order, but that

doesn’t guarantee that your order will be exe-

cuted. If there is no match, the trade will not be

filled. ●$


CHAPTER 2

The Big Boardand Nasdaq

• The Over-the-Counter Market (OTC)

• NASD and Nasdaq

• Nasdaq Is a Negotiated Market

• Understanding Market Makers

• Information Is Power

• Nasdaq Service Levels I, II, and III

• Comparing NYSE and Nasdaq

• Electronic Communications Networks (ECNs)

• Regulatory Framework

• Quick Quiz


While the NYSE trades large-cap stocks, the

OTC is home to smaller companies. Many technol-

ogy companies with small market capitalization

trade over the OTC. They are often less established

than companies found on the exchanges. For

example, eBay, a seven-year-old tech company

with a market capitalization of $17 billion, trades

on the OTC.

Over-the-counter trading is done by people

called market makers. You never see these men and

women, because they work out of sight at com-

puter terminals across the country. In contrast to

the NYSE, where stocks are put up for auction,

market makers buy and sell from their own inven-

tory of stocks.

Numerous types of securities are traded on the

OTC, including but not limited to the following:

● Corporate stock

● Corporate bonds

● Municipal bonds

● U.S. government securities

● U.S. government agency securities


Of these, day traders are mainly interested in cor-

porate stock.

NASD AND NASDAQ

Market makers trade through an electronic system

run by the National Association of Securities Deal-

ers (NASD). It is called the National Association of

Securities Dealers Automated Quotation System,

or Nasdaq. It is the NASD’s equivalent of the

NYSE’s SuperDOT system.

Nasdaq began operating in 1971. The purpose

of Nasdaq is to collect and provide real-time, firm

quotes on selected OTC stocks through its auto-

mated quotation system. This system was a major

advance for OTC trading. Previously, if dealers

wanted to sell a stock for $35, they had to get on

the phone and find another dealer willing to pay

$35. They had to keep calling until a buyer was

found. The process was cumbersome and slow.

Essentially, Nasdaq is a real-time classified ad.

Traders post their buy and sell orders for the rest of

the trading world to see. It also provides a means

THE OVER-THE-COUNTER MARKET (OTC)

THE OTC DIFFERS FROM THE NYSE in important ways. However,

it, too, uses a state-of-the-art computer system to route trades.

There is no central trading floor in the OTC market. Transactions

move from computer to computer, over the Internet, or over electronic trad-

ing platforms.


THE BIG BOARD AND NASDAQ 15

to get orders executed. Nasdaq trades some of the

biggest names in technology, such as Intel and

Microsoft. The Nasdaq system allows large institu-

tional buyers, market makers, brokerage houses,

electronic day traders, and online investors to

come together to communicate their trading inten-

tions in real time. It is a high-speed, state-of-the-art

computer network bazaar.

Securities traded on Nasdaq are grouped into

the following three classifications:

●1 The National Market Securities (NMS) are the highest

classification, or tier, of Nasdaq stocks. There are more

than 4,000 NMS stocks. These stocks meet the highest

standards with regard to annual net income, price per

share, number of publicly held shares, and so on. They

are considered large-cap stocks.

●2 The small-cap market is the next group, comprising more

than 1,300 securities. They have smaller market capital-

ization than do large caps.

●3 Companies with very small market capitalization are han-

dled on the OTC Bulletin Board and the Pink Sheets.

Day traders are mainly interested in the NMS

tier of stocks—the large caps.

NASDAQ IS A NEGOTIATED MARKET

While the NYSE requires a specialist to act as an

auctioneer or intermediary, the Nasdaq allows

buyers and sellers to interact directly without an

intermediary. That is why Nasdaq is called a nego-

tiated market. The buyer who offers the best price

will get taken care of first. The seller offering the

lowest price will likewise get a faster response

from buyers. Nasdaq is automated and simplified.

Remember, at the NYSE, stocks are sold at auction

by an intermediary. Nasdaq stocks are bought and

sold on a best-price basis.

UNDERSTANDING MARKET MAKERS

Market makers make day trading exciting. They

are dealers who buy and sell stocks on behalf of

their clients or for their own firm. They provide

liquidity for their customers and make the Nasdaq

market viable. When a stock is liquid, it means the

price will not be greatly changed by heavy buying

or selling.

Market makers make money by capturing

momentum moves. They also make money captur-

ing the spread, just like NYSE specialists. Market

makers also act as commissioned representatives

for large financial firms or mutual funds. As reps,

market makers become brokers acting on their

client’s behalf to buy or sell a security. When market

makers act as intermediaries for a big firm, they get

paid a commission. The commission is usually the

spread between the inside bid and the inside ask. In

most cases, small orders from traders like you and

me come from a market maker’s own inventory.

The term market maker refers to a securities firm

as well as an individual. Examples are Goldman

Sachs and Morgan Stanley, firms that are regis-

tered to buy and sell specific securities. As market

makers, they abide by Nasdaq rules when making

a market. Market makers are required by Nasdaq

to maintain a two-sided market. This means they


are required to post both a bid price and an ask

price at the same time.

Unlike specialists and floor brokers, market

makers work in offices, using computers and the

telephone to make the market. One market maker

may handle a single security or 25 at a time. There

are approximately 60 market makers trading the

6,000 securities on Nasdaq. Usually, the big-name

stocks have 40 or more market makers, while the

smaller-name stocks have just a few. Tracking and

understanding their methods is vitally important

for the day trader.

The Three Main Responsibilities of Market Makers

●1 Execute transactions for their clients. The most impor-

tant function is to execute orders for clients at the best

possible price. They do this by interacting with other mar-

ket makers online or by telephone.

●2 Keep an orderly market. This means they must prevent

dramatic fluctuations in the price of a stock that comes

under heavy buying or selling pressure. To create this liq-

uidity, market makers must provide a two-sided market

within the market bid/ask price. Liquidity happens as

market makers fulfill their obligation to make markets

throughout the trading day. They must advertise to sell at a

certain price whenever they make a bid to buy a stock at

a certain price. That’s why it’s called a two-sided market.

●3 Trade for the firm’s proprietary account. Market makers

use inside knowledge, experience, and technology to

make profits on a daily basis. They take profits on the

stocks they make a market in, but they also take specula-

tive positions on the possibility of future price movements

of those stocks—depending on the time of day, the market

conditions, and the existing order flow.


Different Types of Market MakersIt is important for day traders to be aware of the

different types of market makers and understand

the trading patterns they create. Here’s why.

Market makers do the lion’s share of trading on

the OTC. Big market-making firms, such as Gold-

man Sachs, Paine Webber, Salomon Brothers, and

Merrill Lynch, represent large institutions, such as

pension funds and mutual funds. They buy and

sell for these clients. They also trade for their own

retail customers and their own trading accounts.

The sheer volume of this trading can have a dra-

matic impact on stock prices.

You can watch market makers trading on

what’s known as Level II computer screens. Pat-

terns will emerge if you watch them over time.

They repeat certain actions throughout the day,

giving you insight into their true buy and sell

intentions and market direction. Keep in mind that

market makers do not always make the right deci-

sions. The market as a whole is always more pow-

erful than any single market maker.

The following will help you recognize the vari-

ous types of market makers as you watch Level II

screens. Trading symbols are given for each firm.

The information available on Level II is discussed

in detail later in this chapter.

INSTITUTIONAL FIRMS

GSCO Goldman Sachs & Co.

SBSH Salomon Smith Barney

LEHM Lehman Brothers

MSCO Morgan Stanley & Co.



These worldwide firms do the largest underwrit-

ings. They cater to big institutions like mutual

funds and pension funds. They have well-financed

research departments. They are the most powerful

market makers and can set the market on fire

when they trade.

WHOLESALERS

MASH Mayer & Schweitzer, Inc. (Charles Schwab)

HRZG Herzog, Hein & Geduld

SLKC Spear, Leeds & Kellogg

SHWD Sherwood

NITE Knight/Trimark

MHMY MH Meyerson & Co.

These firms do no retail business and provide no

research. They simply make a market for other

firms.

WIRE HOUSES

DEAN Dean Witter Reynolds

PAIN Paine Webber

PRUD Prudential Securities, Inc.

MLCO Merrill Lynch & Co.

These are big, full-service brokerage firms. They

provide financial advisors and brokers. They make

commissions from order flow and a growing cus-

tomer base.

REGIONAL FIRMS

PIPR Piper Jaffray

SWST Southwest Securities, Inc.

DAIN Dain Bosworth Inc.

WEAT Wheat, First Securities

These are smaller brokerage firms with less expo-

sure to the markets. They are cautious traders.

INVESTMENT BANKS

HMQT Hambrecht & Quist, Inc.

MONT Montgomery Securities

COWN Cowen & Co.

These are strictly underwriting firms. They help

companies complete initial public offerings (IPOs)

and secondary offerings. They are not primary

market makers, but they will trade stocks they

underwrite to help create market activity.

Market Maker RecapTo recap, the market maker must:

● Execute orders for their firm’s clients.

● Keep an orderly market.

● Trade for the firm’s proprietary accounts.

INFORMATION IS POWER

Day traders need as much information as they can

get. At the very least, they need to see who is buy-

ing, who is selling, and the prices offered by each

buyer and seller. Both the NYSE and the OTC pro-

vide information about the trades taking place on

their systems. The information is flashed on a Level

II computer screen. But the information provided

on NYSE Level II screens is basic, not nearly enough


to be used to day trade. If you look at a NYSE Level

II screen, for example, you will see large gaps in the

bid and ask prices. On a Nasdaq Level II screen, you

will see no such gaps (see Figure 2.1).

Figure 2.1 compares the details shown on a

NYSE Level II screen with the information shown

on a Nasdaq Level II screen. Remember, for day

traders, who rely on Level 2 information to make

decisions, information is critical. The Nasdaq pro-

vides far more information than the NYSE.

NASDAQ SERVICE LEVELS I, II, AND III

NASD is a self-regulatory organization. Its mem-

ber firms use Nasdaq terminals that display real-

time bids and offers, size of quotes, and other

information. Nasdaq sends this information

electronically to all market participants on three

levels.

Level IAvailable to stockbrokers and most online

investors, Level I provides the following basic

information:

Highest bid and lowest offer at any given time

(called the inside market)

High and low for the day

Volume for the day

Price change from previous day

Direction of last trade (uptick or downtick)

Size of highest bid and highest ask

Last transaction price


Level IILevel II not only shows the size of the best bids

and offers, it also shows the depth. Depth is the

market that exists behind the best bid and offer,

also called the outside market. Level II shows the

next bids and offers for several levels up and down

from the best price. This is very important to the

day trader. It’s like sonar for a submariner or field

maps for Napoleon. It is the best crystal ball you

can have to determine the short-term direction of a

stock price.

Here’s another way of looking at the depth

offered by Level II. Let’s say Buyer A is bidding

$65 for a stock on Nasdaq. On Level II, sellers

are offering the stock for $65.25. Buyer A’s bid

and the sellers’ offer is the best bid and offer at

the time. Also listed on the screen are the out-

side market bids and offers, the next levels of

bids and offers down from the best bids and

offers. In the outside market, Buyer B is offering

to buy the same stock for $64.75 while another

seller is offering to sell at $65.50. In order for

Buyer B’s order to be executed, Buyer A’s order

has to get filled first and stock prices have to fall

to $64.75.

Level II shows the names and quotes of all regis-

tered market makers in each Nasdaq security. Day

traders and online traders can access Nasdaq’s

Level II through electronic communications net-

works (ECNs), which are explained later in this

chapter. Each of these systems has its own name,

which appears on the Level II screen.

The following information is displayed on the

Nasdaq Level II screen:



Which market makers are playing

Which ECNs are participating

Bids and offers

Size of the market (for both market maker and ECN)

Time that the market maker placed or refreshed a bid or offer

Time of each executed trade

Price of each executed trade

Size of each executed trade

Level IIILevel III permits market makers to enter bid and

offer prices into Nasdaq. It also provides a means

by which the trades are reported to Nasdaq. Level

III is to the market maker what ECNs are to the

day trader. It’s a system by which they can adver-

tise to buy or sell securities that appear on Level II.

Market makers use Level III to advertise on the

national system (Level II).

2.1 NYSE Level II versus Nasdaq Level II Information

THIS SECTION GIVES THE ACTIVITY ON THE STOCK:The change in price from the previous day, the highest and the lowest price of the day.Previous closing price, volume, spreadthe ratio of the sizes between the bid and ask price.

NAME OF THE STOCK

If you look atthe first 7 levelson the bid sideand comparethe two, you willnotice that theprices of IBMgoes from ?down to ? (adifference of$?) while INTConly drops from? to ? (a differ-ence of $)

THIS IS THE TIME AND SALES COLUMNaka “prints.” Any transaction that occurs will show up here.

� NYSE LEVEL II SCREENIBM is a listed stock that is traded on the NYSE

� NASDAQ LEVEL II SCREENINTC is an over the counter stock traded on the NASDAQ


COMPARING THE NYSE AND NASDAQ

The NYSE is an auction house maintained by spe-

cialists who receive orders and execute them by

matching them with other orders and sometimes

with orders from their own account. The special-

ist quotes at the inside bid or inside ask if the

spread becomes too wide. In this case, the special-

ist will trade from his or her own inventory. These

factors are apparent to the trader on the computer

screen. All other factors such as strategy are not

apparent, but sometimes they can be deduced by

watching the specialist’s trading patterns. The

orders received by the specialist flow electroni-

cally through SuperDOT. Only under unusual

circumstances do orders flow manually through a

floor broker. Price movement on the NYSE is

order-driven, because the specialist matches bids

and asks from the order book. Movement of

orders from one side to the other (buy to sell, or

sell to buy) creates price movement. The NYSE is

a traditional marketplace; its stocks are estab-

lished companies with high market capitaliza-

tion. The NYSE is a stable marketplace because

specialists can stop trading if the market’s order

flow becomes extremely maladjusted or out of

balance.

Nasdaq is a negotiated marketplace without

specialists. It is totally computer-driven. Market

makers compete in this marketplace. If Nasdaq

is dominated by anything, it is a nationwide

computer bulletin board (the OTCBB), which

lists all available quotes. It is a modern techno-

logical phenomenon. Nasdaq market makers are


required to display quotes for the stocks they are

making a market in. Nasdaq stocks tend to be

smaller-capitalization stocks with high growth

potential.

Which Market Is Better for Day Traders?The answer depends on the individual. Nasdaq

provides more price movement. This higher intra-

day volatility also generates more intraday profit

opportunities. But large price fluctuations could

also mean greater losses. This means that trading

the Nasdaq requires more expertise and knowl-

edge.

However, many traders prefer the NYSE. It is

more stable and can absorb a lot more volume.

These traders make a good living by following the

specialist, but due to the narrower range on NYSE

stock prices, most traders take profits of less than

$1 on their intraday trades.

The bottom line: If you are willing to take the

risk, Nasdaq offers greater rewards. As a day

trader, my market of choice is the Nasdaq. It pro-

vides good opportunities every day.

ELECTRONIC COMMUNICATIONS NETWORKS (ECNs)

Electronic communications networks (ECNs) are

quasi stock markets. They are used by both NYSE

traders and OTC traders. Recently, the NYSE has

allowed traders to trade directly with each other

via electronic communications networks (ECNs).

They function as an exchange floor, except that

orders are filled electronically and there is no



trading floor. Currently, two of these networks

trade stocks that are listed on the NYSE. They are

INET and ARCA. ARCA recently merged with the

NYSE. Although the future is unclear on this

merger, one thing is sure: Speed will increase and

transaction costs will decrease. Both very good

things for the trader.

ECNs work on a first-come, first-served basis. If

the orders match, these transactions usually take a

fraction of a second. When a buy order at $35 hits

the network and a sell order at $35 is present, you

have a match. The order executes almost instanta-

neously. Because of their speed, ECNs are very

popular. They now account for a large proportion

of daily stock trades. I am sure this will continue to

increase in the future.

ECNs were introduced in 1969. They provided a

way for institutions to display their buy and sell

orders on the Nasdaq. It was also the start of elec-

tronically executed trades. Prior to this, a Nasdaq

trader had no way of executing trades except via

the telephone. ECNs sped up the process by hav-

ing every trade executed electronically. There is a

lot less handling, and transactions now occur in

fractions of a second instead of minutes. All orders

on ECNs are firm orders. This means the trader

who placed the order does not have the choice of

accepting or declining a matching order. As soon

as a matching order arrives into the network, the

trade is executed. In a fast market, this feature is

priceless. It allows traders to get in and out of their

positions quickly.

In 1996, the introduction of a new ECN called

Island (ISLD) allowed small traders like you and

me to access the Nasdaq directly. Prior to ISLD,

the ability to buy and sell directly in the Nasdaq

market was available only to large institutions.

Since then, many new ECNs have been estab-

lished. Island and Instinet joined forces to

become INET. Brut is the Nasdaq’s ECN. ARCA,

as mentioned earlier, has merged with the NYSE.

Changes and consolidation will continue. (Note:

As of this writing the Nasdaq is awaiting regula-

tory approval of its proposed acquisition of

INET.)

How ECNs WorkAs mentioned earlier, ECNs function as regional

exchange floors. They have their own individ-

ual markets and allow traders to trade directly

with each other. ECNs accept both trader (indi-

vidual) and broker (institution) orders. Do not

automatically assume an ECN order to be from

a trader like you and me. It could be a market

maker trying to hide his or her true identity and

intentions.

ECNs do not provide capital to facilitate trades.

They serve only as a conduit or intermediary to the

market. They give the trader a medium for order

placement and execution. They compete directly

with market makers for order flow. They have no

vested interest in the price of a stock. They now

account for a very large proportion of Nasdaq’s

total daily volume.

Traders enter bids and offers on a national sys-

tem that is visible worldwide. Real-time visibility

and volume equal liquidity. That’s why traders get

fast results.


The three main ECNs available to daytraders are:

●1 Inet (INET)

●2 Brut (formally owned by SunGard Data and now owned

by Nasdaq Stock Market, Inc.)

●3 Archipelago (ARCA), which recently merged with the NYSE

Other ECNs, playing smaller roles, include:

● Bloomberg Tradebook (BTRD)

● Attain (ATTN)

● NexTrade (NTRD)


REGULATORY FRAMEWORK

The NASD is a self-regulatory organization. It

polices Nasdaq trading and the overall OTC mar-

ket. The Securities and Exchange Commission

(SEC), however, has the ultimate authority to

enforce securities laws and regulations. The SEC

also supervises and acts as a safety net for securi-

ties markets. The SEC constantly updates its poli-

cies and has the authority to mandate changes to

NASD rules and regulations. ●$



QUICK QUIZ

Test your knowledge of the investment marketplace by taking the quick quiz that follows.

The most famous stock exchange is the NYSE.

Securities sold on the Big Board are called:

(a) M1-6

(b) Listed securities

(c) VIP securities

(d) All of the above

(e) None of the above

Nasdaq:

(a) Is market maker territory

(b) Requires high-tech equipment

(c) Is made up of stocks in the OTC market


(e) A and B only

Which of the following statements are true

regarding market makers and their

responsibilities?

(a) They fulfill their firm’s customer order flow

(b) They have limited resources and do not do much

trading

(c) They are required to keep a two-sided (bid and

offer) market at all times


(e) A and C only

A specialist is:

(a) An assassin for the CIA

(b) A market maker who specializes in trading one stock

(c) An individual who is assigned a listed security on an

exchange

(d) Somebody who knows a lot of secret stuff

(e) A and D only

Which statements about the OTC market are

correct?

(a) The OTC market is a negotiated marketplace

(b) You can buy OTC securities at Kmart during the

blue-light special

(c) It employs stealth Ninjas to eliminate opponents

(d) OTC stocks come with a money-back guarantee

Which of the following statements are true

concerning market makers?

(a) They execute trades for their firm’s customers

(b) They have many different customers

(c) They are nice people

(d) Nasdaq’s Level II displays market makers’ quotes

(e) A, B, and D only

Which of the following types of market makers

are considered to be the most powerful?

(a) Wholesale firms like Sherwood

(b) Wire houses like Paine Webber

(c) Institutional firms like Goldman Sachs

(d) Investment banks like Montgomery

Which of the following are not market makers’

responsibilities (and which one is a trick)?

(a) To keep an orderly, two-sided market

(b) To trade for the firm’s proprietary account

(c) To instigate program trading when markets drop too

low or rise too high

(d) To never quote both a bid and an offer on the same

stock at the same time

(e) To advertise as a seller when they are really buyers

of a specific stock


CHAPTER 3

Brokerage Firms• Selecting a Brokerage

• Execution Speed

• Reliability

• Order Routing

• Price

• Service

• Other Online Brokerage Features

• Types of Accounts

• Types of Positions

• Types of Trading Orders


Full-Service BrokersThese are traditional, established brokerage

houses. They cater to people who do not have the

time to research stocks or follow the market. They

usually have research departments that make

stock recommendations. They also provide finan-

cial and portfolio planning services. This personal

attention means high fees.

Many brokerages provide clients with online

access to their accounts. But they do not provide

high-speed executions. These brokerages are best

for people who invest rather than trade.

One word of caution: Full-service brokerages

claim to have great research departments that will

find good stocks for you. Based on my experience

working for a brokerage, I would not put my trust

in them. The people you deal with are merely

sales representatives. They want to make sales

and collect commissions. They are looking after

their interests, not yours. It takes effort to find a

broker who truly has your well-being in mind. I

think this effort could be better spent learning

how to day trade. If you don’t have the time to


trade, then buy an index fund and consistently

put money into it. In the long run, this strategy

will probably pay more than investing in individ-

ual stocks.

Discount BrokersThese brokers provide automated systems that

take orders through the Internet. They also take

orders over the phone. Because there is less han-

dling involved, they charge lower commissions

than full-service brokers.

Brokers like Charles Schwab, Quick & Reilly,

Fidelity, TD Waterhouse, Scott Trade, and others

have e-trading services. Customers can log on to

their account through the Internet and place buy

and sell orders.

Discount brokers also allow you to trade

through a touch-tone telephone. This comes in

handy when the Internet crashes. Generally, com-

missions range from $7 to $20 per trade. These bro-

kerages do not offer buy or sell recommendations.

Instead, they give you access to research material

and allow you to make your own decisions.

SELECTING A BROKERAGE

IF YOU HAVE THE MONEY AND THE TIME to trade, and if you are

willing to learn this profession, it’s time to select a brokerage house. You

will use the facilities provided by the brokerage to make your trades.

There are several types of brokerages. They have the following characteris-

tics and features.


BROKERAGE FIRMS 27

Direct Access BrokersWith the establishment of ECNs came a new breed

of brokerage firms called direct access brokers.

Several large brokerages (e.g., Charles Schwab,

Goldman Sachs, and Datek) now have divisions

that provide direct access to the Nasdaq and the

other exchanges. Direct access is the fastest way to

execute a trade on both Nasdaq and the NYSE.

There are no intermediaries involved. Customers

are responsible for routing their own orders to get

the best possible price. Real-time charting and

software for technical analysis usually come with

the firm’s trading platform. Commissions can

range from $5 to $25 per trade or may be on a per-

share basis for under half a penny a share depend-

ing on the volume of your trades and the firm you

use. This is the only type of brokerage I would use

to day trade.

EXECUTION SPEED

Execution speed is the most important considera-

tion when choosing a direct access broker. High-

speed execution allows you to quickly get into and

out of positions. This gives you control of your

trading. Please note, however, that not all direct

access brokerages are alike. Execution speeds vary

from firm to firm.

You need to search for the broker with the latest,

fastest, and most reliable equipment. A delay of a

couple of seconds or a breakdown can cost you

money. I can’t give you an up-to-date list of the

fastest and most reliable brokers. Trading technol-

ogy is constantly changing, so a fast system today

will be outmoded tomorrow. As a rule, I would

expect a direct access broker to consistently exe-

cute trades within two seconds or less. For a dis-

count brokerage, executions as long as 10 seconds

are too long.

Direct access trading means you are responsible

for routing orders properly. It is not as simple as

clicking a buy or a sell order. Unless you know

what you are doing, direct access trading can be

more of a hindrance than a tool. Make sure you

understand how orders are routed before trading

with real money. Some direct access platforms

have smart order routing whereby the software

chooses the fastest route. Some will even let you

set your preference of where the program should

look first.

RELIABILITY

Fast execution is useless if the brokerage’s trading

system is unreliable. Some firms use software that

has not been debugged. This might cause a system

crash when a large number of orders are placed at

the same time. Bad software could also cause con-

stant Internet disconnects, forcing you to keep log-

ging back on. If the firm’s software does not

interact properly with your computer, the system

may constantly hang up your computer, forcing

you to reboot, a waste of valuable trading time.

Browse trade journals and magazines to find

evaluations of the various brokerages’ reliability.

Talk to other traders; most traders have used sev-

eral different platforms and will give you an hon-

est opinion on which is best.


Sometimes the problem is your computer. You

could be asking your ISP connection to download

more information than it can handle. Your com-

puter will freeze when this happens. It is your

responsibility to know the limits of your computer

system. Today, a telephone-line modem isn’t suit-

able for trading except as backup to a cable

modem, DSL, or other broadband connections. You

may need to buy a new computer to get the speed

and performance you need for trading. If you are

using a system with dual processors, check to see if

the trading platform you use supports them. Com-

puter memory is inexpensive today, so maximize it.

ORDER ROUTING

Here are some questions to ask your broker before

opening an account: Do you execute your own

orders or go through an intermediary? Do you sell

orders through that intermediary? Can I get price

improvement on my orders? Does the platform

have smart routing? Does it support multiple

monitor setups?

Brokers who execute their own orders tend to

have faster executions. Brokers who sell their

orders to intermediaries add precious seconds to

the execution time. The intermediary profits by

trading against your order. Fills are poor and price

improvements are rare. Whatever price improve-

ment the intermediary gets, the intermediary

keeps. The easiest way to know whether a broker-

age sells orders is to look at its financial statement.

If its revenue stream includes an item called “pay-

ments for order flow,” it is selling its orders.


When you trade with a direct access brokerage,

it is important to know the following: Does the

broker allow you to route an order to an ECN such

as INET or ARCA? How many ECNs is it directly

connected to? Does your direct access broker have

a straight connection to Nasdaq, or does the order

have to hop through several offices before it gets to

Nasdaq?

If you trade heavily, good order routing can

save money. You want as little delay as possible

between you and the market. A good direct access

broker will have a direct connection to several

ECNs. ECNs tend to execute orders a lot quicker

than market makers. The more ECNs you have

direct access to, the more choices you have to get

your orders filled. The more choices you have, the

better your fills will be. At the very minimum, a

brokerage should have direct access to at least the

ARCA, INET, and BRUT ECNs, and preferably all

the available ECNs should be available to you.

The best way to find out whether a direct access

broker has efficient order routing is to send a live

order to the Nasdaq. Usually, I send the order on a

slow-moving stock and place it away from the

inside prices. The order should show up at the

Nasdaq in less than two seconds. Many firms take

eight seconds or more to get an order to Nasdaq.

Make sure you avoid these firms like the plague.

Order routing is getting faster and faster. Cyber-

Trader of Austin, Texas, a subsidiary of The

Charles Schwab Corporation, offers smart orders

using its proprietary CyberExchange order rout-

ing system. It electronically routes orders to the

trading venue that offers the best price and best fill


BROKERAGE FIRMS 29

speeds. These are often ECNs, which not only

eliminate payment for order flow intermediaries,

but also frequently avoid market makers them-

selves.

CyberTrader isn’t alone. TradeStation, RealTick

and E*Trade all offer smart executions. Others

have a policy of not accepting order payments.

Services are improving every year and brokers are

constantly merging. The similarities between full-

service brokers, Internet brokers, information

service providers, and ECNs are becoming more

apparent. Each tries to offer something unique.

PRICE

Price is not as important as speed, reliability, and

order routing. It is more important to get a fast exe-

cution than low commissions. A good execution

will ultimately save more money than a poor one.

I had the following experience with one of my

students. He had worked for a firm with a cheap

commission rate. I went to his home with my lap-

top. I hooked up to a 56-kilobyte modem line and

prepared to trade. He used the firm with the cheap

rate. I used a slightly more expensive firm with

faster executions. After searching for a while, we

finally found a good opportunity.

At my signal, both of us started placing orders.

Our plan was to chase the entry by no more than

$0.25. If the stock moved past our entry by $0.25,

we would cancel our orders. I bought 3,000 shares

of the stock, while my student ended up with noth-

ing. The position moved about $1.50 in my favor,

making some nice money for me. The student

saved $10 in commissions, but missed an opportu-

nity to make $1.50 a share. The worst part was the

missed opportunity.

We do not see a lot of good trading opportuni-

ties each day. It is imperative that we have the

tools to capitalize on those that we see. That is why

cheap commissions are not necessarily cheap.

They usually cost you money in the long run.

There are two ways commissions are calculated

in this industry. The first method is per ticket. A buy

order is one ticket. A sell order is another ticket. A

trade will generally cost you at least two tickets.

Commissions can range from $5 to $20 per ticket,

depending on the brokerage.

In the second method, commissions are figured

on a per-share basis. Depending on your trading

volume, per-share commissions can range from

$0.005 to $0.02 a share. If you buy 200 shares and

your per-share commission is $0.02, your commis-

sion will be $4.00. Don’t forget that you also pay a

commission when you sell. Many companies that

charge a per-share commission also have a mini-

mum charge. Some firms, such as CyberTrader,

will let you choose either a per-share or per-trade

commission.

Commissions can add up to hundreds or even

thousands of dollars every month for active

traders. A balance has to be struck between cheap

commissions and execution speed. There are other

brokerage costs involved when trading. You really

need to read the fine print. For example, there may

be a per-share charge for each share exceeding

1,000 shares if you are on a per-ticket commission.

Some brokerages charge a small fee for cancel,


limit, and stop orders. Manually assisted trades

usually cost more than electronic trades.

Direct access brokers have varying costs for

real-time quotes. Some direct access brokers tack

on additional ECN fees. They charge a low per-

ticket fee, but have costlier ECN fees. Their inten-

tion is to draw you in with the low per-ticket fee

and profit from the higher ECN fees.

Make sure you evaluate the whole commission struc-

ture. Do not just focus on one area.

SERVICE

If you trade from home and experience a computer

crash or a lost Internet connection, your brokerage

should come to the rescue without much delay.

Here’s what you should expect in the form of

backup help: You should be able to call a represen-

tative and execute the trade “by hand.” A good

online broker will reduce the price of the trade if

the problem occurred with the brokerage. The rep-

resentative should not take more than a few min-

utes to answer your call.

A good online brokerage should have a toll-free

service desk that can answer any technical ques-

tion. Even in this day and age, there will be

glitches. The last thing I want to do is become a

computer expert just so I can trade. I leave that to

the technical support team of the brokerage. Some

brokers offer online support directly from the plat-

form using “text chat.” If the support team is

unable to solve the problem, they might want to

log on to your computer remotely and have a look

around. Check to see if that feature is available.


OTHER ONLINE BROKERAGE FEATURES

Other features you might consider when selecting

a brokerage service include the following:

Products available for trading. Never assume a broker-

age has the product you want to trade. Brokerages that

specialize in equities might not have futures and com-

modities. Many equity brokerages don’t offer options

trading.

Quote services. Delayed quotes are free; real-time

quotes are not. Real-time quotes make all the difference

in a market that changes by the minute. Find out which

brokers offer real-time quotes and how much they charge.

You also want to know if Level II access is available and its

cost.

Charts. Many brokers provide charts or links to charts.

Find out whether the charts are interactive and whether

you can set the parameters. Also, find out whether the

charts are current, whether they load quickly, and whether

they are real-time or 15-minute-delayed.

News and research services. Some brokerages provide

real-time newswire services. Others provide news at their

website. Some brokerages provide extensive research

databases, while others do not.

TYPES OF ACCOUNTS

There are several types of brokerage accounts you

can use to day trade. You can open a corporate

account, a partnership account, a retirement

account, or just a personal account. Most traders

use a personal account for simplicity, but once you

start making money, trading under a corporation


BROKERAGE FIRMS 31

or retirement account does have tax benefits. Con-

sult with your tax advisors before you decide on

one or the other.

There are two major types of trading accounts:

margin accounts and cash accounts.

Margin AccountsA margin account is a leveraged account. The bro-

kerage lends the account owner part of the pur-

chase price of a security. The collateral used for the

loan is the stock itself; no credit check is necessary.

Some securities are not marginable. A security

priced below $5 is a good example. Because they

tend to be high-risk issues, brokerages are unwill-

ing to use the stock as collateral.

You must understand two concepts when using

a margin account: the buying power level and the

margin maintenance requirement. Buying power is

the maximum dollar amount of stocks you can

purchase on a given day. The maintenance margin is

the amount of cash you must have in your account

to continue to hold a position.

If an account is not being used for day trading

or pattern trading, the buying power level is two

to one. If you have $10,000 in the account, you

can buy up to $20,000 of marginable stocks. This

means you can borrow up to 100 percent of the

cash in the account. If the maintenance level is 30

percent of the value of the stock, you will need

$6,000 in cash to keep the $20,000 position.

If the value of the stock drops, and the cash in

the account drops below the maintenance level,

the owner will be asked to put in more cash or sell

a portion of the stock. This is a margin call. In other

words, someone will call you because your margin

is insufficient. This is not a call I like to receive.

Here’s an example of how a margin call could

occur: You buy 100 shares of a $200 stock using

your margin account. The price drops from $200 to

$150. This is a $50 loss per share and a $5,000 loss

of capital. The account now has $5,000 left ($10,000

original capital − $5,000 loss), and the total stock

value is $15,000 ($150 × 100 shares). The mainte-

nance margin is $4,500 ($15,000 × 30%). At this

point, the capital is still higher than the mainte-

nance margin, so a margin call will not be gener-

ated. Any further drop in the price of the stock will

trigger a call.

The buying power for a day trading account is

even greater. New regulations allow a four-to-one

margin on day trading accounts. The trader must

have a minimum balance of $25,000 in the account.

The maintenance margin requirement on the new

four-to-one margin rule has not changed. A day

trader who uses up his or her buying power and

does not sell stock to generate cash will get a mar-

gin call. This is because the maintenance margin is

at 30 percent, while the capital available is only 25

percent of the buying power.

How does the SEC define a day trader or pat-

tern trader? The SEC defines a day trade as a pur-

chase and sale or sale and purchase of the same

security on the same day in the same account. If

you go long on a position and close it the same day

or go short on a position and close it the same day,

you are day trading. A day trader must trade at

least four times in five business days. However, if

this trading does not exceed 6 percent of the total


trading activity for a five-day period, the account

is not considered a day trading account.

A margin account is needed if you want to short

stocks. (Shorting is explained in the next section.)

A trader who fits the definition of a day trader

must have $25,000 minimum equity in his or her

account to day trade.

Cash AccountsIn a cash account, your capital equals your buy-

ing power. Cash accounts are mostly used by

long-term investors. Retirement accounts are cash

accounts. If you want to day trade, make sure you

do not have a cash account.

Certain trading products, because they are con-

sidered risky, must be traded in a cash account.

Options transactions are a good example. Options

are extremely risky. Unlike stocks, they have no

inherent value. Options are only a right to buy or

to sell. The owner of an option does not own any-

thing except that right. Options are not worth

much as collateral. Brokerages are therefore

unwilling to extend margin against these holdings.

TYPES OF POSITIONS

There are two types of positions that a trader can

have. They are the long position and the short posi-

tion. The market allows traders to profit in either

direction of the market. When the market heads

up, a trader can go long on a position and profit

from it. The trader buys the stock, holds it, and

sells it later at a higher price. Thus, traders are to

be long on a position if they own the stock. Their


profit comes from buying the stock at a low price

and selling it at a higher price. Losses occur when

the selling price is lower than the purchase price.

When the market heads down, traders can make

money by going short. A trader sells the stock at a

high price and later buys it back at a lower price.

The profits and losses are no different than a long

position. Losses come from paying more for the

stock than the original sale price.

The only difference between the two positions

is the timing sequence. On a long position, the

trader buys the stock first and sells later. With a

short position, the trader sells the stock first and

buys it back later.

Most newcomers have a hard time grasping the

concept of shorting. They wonder how it is possi-

ble to sell something you do not own. The key to

making this possible is the intermediary: your bro-

kerage.

To sell something they do not own, traders do

the following: After borrowing the stock, they sell

the stock, getting cash in return. But they still owe a

debt to the brokerage. The debt is not in the form of

cash. It’s in the form of the shares they borrowed.

The only way a trader can repay this debt is to buy

the shares and give them back to the brokerage. It is

only after the debt is repaid that a profit is realized.

To clarify this concept, here’s an example of a

successful short trade: You are a trader. You think

IBM, currently trading at $125, is going to fall. You

borrow 100 shares from your brokerage. You sell

the stock immediately, getting cash in return. You

still must return the 100 shares you borrowed. You

will do this after the price falls.


BROKERAGE FIRMS 33

When you sold the stock you borrowed it was

priced at $125 per share. Thus, you received

$12,500 in cash. Remember, you think IBM is going

to fall. You do not return the shares to the broker-

age right away. You let it fall. When it hits $100,

you buy 100 shares so you can return them. You

have already sold 100 shares at $125, getting

$12,500. Now you buy 100 shares at $100, spend-

ing $10,000. Remember, you sold 100 shares for

$12,500. Then you bought 100 shares for $10,000

and returned them to the lender. You keep the dif-

ference of $2,500. Buying the shares to return them

is called covering your short.

To short successfully, you borrow shares, sell

them at a high price, and then buy them back at a

lower price. It is sell first, buy later.As a trader, short-

ing has to be part of your strategy. If it is not, you will

severely limit your moneymaking potential.

Shorting GuidelinesHere are the regulations for shorting. Short sales

can occur only on an uptick. The Nasdaq and the

stock exchanges define uptick in different terms.

For exchanges like the NYSE, an uptick is

defined by the time and sales or the last trans-

acted price. If the last price is higher than the

previous one, then you have an uptick on the

stock. For the Nasdaq, the uptick is determined

by the inside bid price. If the current inside bid

price is higher than the previous inside bid price,

then you have an uptick. In both cases, short

sales can happen only when the stock price is ris-

ing, even if just briefly. This is a safety measure

to prevent another stock crash like the one in

1987. If stocks could be shorted as they fall, chaos

would follow.

In order to short a stock, it must be available for

borrowing from your brokerage firm or clearing-

house. Stocks that are thinly traded are usually not

available for selling short. This happens because

the brokerage cannot obtain the stocks you want to

short. Another problem might arise after you short

a stock. As you know, in order to facilitate a short

sale, the brokerage must first borrow and then

lend you the securities that you sell short.

From time to time, a brokerage will receive a

recall notice on the shares it lent to you. If the bro-

kerage is unable to obtain replacement shares to

secure your position, it will sell the short position

in your account on the open market at the current

market price. As the account holder, you will be

responsible for any resulting loss or costs incurred

by the brokerage.

A short sale is always handled as a margin

transaction. Shorting involves borrowing stocks,

and only margin account holders are allowed to

borrow. The current margin interest rate is applied

for however long the short position is open.

The margin maintenance requirement is a little

higher for selling short than it is for a long posi-

tion. Often, brokers will not charge margin interest

on short trades that are opened and closed the

same day. New issues typically cannot be shorted

during their first 30 days of trading.

Please note, as of this writing the SEC is proposing

to remove the uptick rule. Presently, you can short

on a downtick on ARCA and INET ECNs, and both

the Nasdaq and NYSE are testing feasibility on a


limited list of stocks. Check with your broker for the

latest rules and regulations.

Dangers of Short SellingA widely perceived misconception is that shorting

can lead to disaster. This is true, but only if you let

it be true. When you buy a stock, you risk the

money you paid for the stock. With short selling,

you risk an unlimited amount of money. If the

stock you shorted rises instead of dropping, you

will be responsible for that increase in price. This

can indeed lead to a disastrous loss.

But again, this will happen only if you let it hap-

pen. Nothing should stop you from quickly clos-

ing a short position if it goes bad. Many short

traders do not have an exit plan. An exit plan

means setting an exit point. If you short a stock at

$35, plan to get out of the position if it rises to a cer-

tain point, say $36. Do not attempt shorting with-

out an exit strategy.

TYPES OF TRADING ORDERS

A day trader has a variety of trading orders to

choose from. Two factors determine which type of

order should be used: timing and price. Timing is

the length of time an order is left open. You can

leave an order open briefly for a day or longer.

The Market OrderThe simplest form of order is the market order. It is

an order that must be executed at the best price

available as soon as the order reaches the market

maker or trading floor. No price is specified. The

transaction has to be made at the current market


price. I use market orders to get out of losing posi-

tions. When a stock hits my stop-loss, I get out

immediately at the market price. If I wait, I could

lose even more. I also use market orders at the

beginning of an up move. If an uptrending stock

has made a nice pullback and is beginning to turn

up, I use a market order to catch a ride on the

upswing.

Market orders are susceptible to slippage. Let’s

say the stock is moving up after a pullback. This is

a buying opportunity. But a lot of buyers will jump

into the stock. Because demand for the stock is

high, the price will move up quickly. You will get

filled because you have entered a market order.

But the price will be higher than you thought. This

is called slippage, and it applies to both winning

and losing trades. When you want to take a profit

on a winning trade, others will be doing the same.

When you want to get out of a losing trade, other

traders will have the same objective. The key is to

enter your market orders early. Never wait or hes-

itate. If not, the slippage can be extreme.

A market order is good for the duration of the

trading day. An order placed after the close of trad-

ing is good for the next trading day. It’s a simple

system that works well. Never deal with a firm

that takes too long to fill a market order. It could be

trading against your order, putting you on the los-

ing end of the trade. Market orders should be filled

within one or two minutes.

The Limit OrderA limit order guarantees a price. You literally place

a limit on the buy or sell price. If a better price than

your limit price is available, you’ll get that price.


BROKERAGE FIRMS 35

As you will see next, limit orders do not guaran-

tee that your trade will be executed.

The Buy Limit OrderThis is an order to buy shares at a stipulated price.

The limit price can be higher or lower than the cur-

rent market price. I use buy limit orders to take

advantage of pullbacks. If a stock currently at $35

is dropping, I place a buy limit order lower than

that price. When the stock hits the lower price, the

order is executed. Computerized order books send

these orders to specialists and market makers, or

they are executed automatically on the ECN. If the

price you set is not reached, there is no execution.

I also use this strategy when I am exiting a short

position. I place a below-the-market order and

wait for the price to drop far enough to buy back

the shares I shorted. Again, you should place the

order early. Do not hesitate.

I also place buy limit orders at a higher-than-

market price when I am opening a position. Here’s

an example of this strategy: A stock is trading at

$35. I expect the stock to run to $36, giving me a

profit of $1. I send a buy limit order at $35.25. The

order will be filled only at $35.25 or lower. If the

price goes above $35.25, my order will not be

filled. This keeps me from paying too much, and

thus I make a small profit. If the stock runs up

quickly, I will cancel the order and wait for a pull-

back.

The Sell or Short Limit OrderSell or short limit orders are similar to buy limit

orders. But they set a sell or short price target

instead of a buy price target. Again, the limit price

can be either higher or lower than the market. If I

have a long position and the stock is climbing, I

place a limit order to sell at a price higher than the

market. Once the price hits my limit price, the

order will be executed. I do not like placing limit

orders to exit a losing position if it is higher than

the market price. They tend not to get executed,

leaving me worse off than if I had simply placed a

market sell order to get out.

I use limit orders when I enter a short position.

This prevents me from getting into a stock at the

end of a run, leaving me with little or no profit. My

limit price is determined by how much profit I

expected, but I tend to limit my price to $0.25 away

from my entry point. Don’t forget, you can also

short using a limit order that is higher than the

market price. You are simply waiting for the price

to bounce up to a resistance point before entering

your short position.

Stop OrderStop orders are the most important type of order.

They can get you into favorable positions and out

of losing positions when you can’t watch the mar-

ket. They allow traders to let profits run on the

upside and limit losses on the downside. Stop

orders say, in effect, when the market hits a certain

price, “Stop here” and enter a market order. A mar-

ket order becomes a live order only when that stop

price is hit.

The Buy Stop OrderA buy stop is a buy order that becomes an active

market order only when the stock rises to a specified


stop price. The stop price is always above the cur-

rent market price.

A sample order is as follows: “Buy 1,000 Coca-

Cola at $45 stop.” This does not mean you’ll get

Coke at $45. It means that it will become a market

order starting at $45.

Investors use this method to buy stocks that are

rising. They believe the upswing will continue and

they want to buy before the price goes too high.

Buy stop orders also protect profits in a short posi-

tion. Let’s say you sold Coke short at $47 and it

drops to $44.50. Then Coke announces that earn-

ings will double in the next quarter. The price is

going to skyrocket. If you had set a buy stop order

$45, you would be out of the position when the

stock hit that price. This would protect most of

your hard-won profit. Buy stop orders are a safety

net for short sellers.

The Sell Stop OrderSell stops, often called stop-loss orders, are safety

nets for long positions. The order is always set

below the current market price. It is used to protect

profits and to limit losses in a long position. This

order is the opposite of the buy stop order. It

becomes a market order only when the price of the

stock declines to your “stop” price.

For example, you bought Coke at $45 and it’s

now gone up to $54. You want to make sure it

doesn’t drop while you’re not watching, so you

place a sell stop at $51 to protect your profit. Your

order will now be as follows:

“Sell 1,000 Coca-Cola at $51 stop.” If the stock

drops back to $51 or lower, your shares will go up


for sale, protecting some of your profits. In this

example, you could also place a sell stop order at

any price below your entry price of $45, say $41.

This order will go into effect when the stock price

drops to $41. At that point, it becomes a market

order to sell. This limits your loss. With this order

the upside potential is not limited. Only the down-

side is limited with a sell stop order.

The Short StopThis is an order to go short at the market price

when the stock falls to a certain level. The idea is to

go short on a stock that is declining in price, ride

the selling pressure down, and buy the stock back

at a cheaper price.

The Stop-Limit OrderThis is a good order to use when you enter a posi-

tion. It is both a stop order and a limit order. It can

be used for a buy order or a short order. When a

stop-limit order is used, a limit order is triggered

when a stop price is reached.

For example, you entered the following order

for Coca-Cola: “Buy 1,000 Coca-Cola stop $45,

limit $45.15.” Coke is floundering at $44.50, but

you think it might go higher. If Coke finally

“breaks resistance” and moves up to $45 or higher,

then you’ll buy at $45.15 or lower, but not higher

than $45.15. With such restrictions on your order,

however, it may go past $45.15 without there being

enough stock at your price to fill the order. Your

order might not get filled. But overall, the stop-

limit order prevents the trader from chasing an

entry beyond a reasonable price.


BROKERAGE FIRMS 37

The market is like an auction. Bidders at auction

can get caught up in the hype and buy an item at

an unreasonably high price. If you set a limit price

prior to the auction, you will not overpay. The

same is true with stocks. You will not overpay if

you set a predetermined maximum price. The limit

order ensures that you have the chance to get in on

a run, while the stop order allows you to wait for

confirmation and then enter as a run begins.

Bear in mind that the limit price on a buy stop-

limit order does not have to be higher than the stop

price. It can be lower than the stop price. This

allows the trader to buy on pullbacks, but you do

run the risk of not getting a fill when these restric-

tions are placed. For a short order, the order would

be as follows:

“Short 1,000 Coca-Cola stop $45, limit $44.85.”

This order says when the price of Coca-Cola

declines to $45, send a short limit order out at

$44.85. This will also ensure that the trader does

not get filled too far away from the desired short

entry price.

Again, the limit price does not have to be lower

or higher than the stop price. It can be anywhere

you choose to place it. The price you choose will

depend on the current bid and ask and also the

price action.

The Cancellation OrderIf you change your mind after opening a position,

you must place a cancellation order to close out the

position. A cancellation that arrives after a transac-

tion is completed is not valid. You will be liable

for the results of the transaction. By the time your

cancellation is executed, the market may have

changed and you might incur a loss. Be careful

with cancellations.

All brokerages and trading systems allow order

cancellation. Simply identify the order and hit the

cancel button. If your broker charges a fee for can-

cellations, I would change brokerages. Some bro-

kerages will falsely tell you the Nasdaq charges a

$0.25 cancellation fee. This is not true! The broker-

age keeps the money. I trade only with firms that

do not charge a fee for order cancellation.

Cancellation should work just as fast as the

original order placement. Orders reaching an

exchange in seconds can be canceled in seconds.

But when markets and electronic trading systems

are caught in a traffic jam, cancellations will be

slow. Be warned, your cancellation may arrive

after the order is filled.

Market orders are executed quickly. You proba-

bly will not have the time to cancel the order. Limit

orders give you more time to change your mind. I

use cancel orders to speed up market orders sent to

the NYSE. If a specialist is ignoring my order, a

cancel order usually gets the job done. Remember,

specialists and market makers make money by

playing the spread. They want as many orders as

possible.

More Order TermsSome of the following terms involve the length of

time an order is left open. Some involve execution.

Good-till-canceled order. A GTC order stays on the

books until it’s executed. You might forget about it, but the

market won’t.


Good-for-the-day order. A GTD order stays open until the

end of the day. It is automatically canceled if it is not exe-

cuted during the day. This is a good strategy, because you

have no idea what the market will do the next day.

Fill-or-kill order. An FOK order is killed or canceled if it is

not filled immediately.

All-or-none order. For an AON order, the whole order has

to be taken or it will be rejected.


Immediate-or-cancel order. An IOC order is an instruc-

tion added to an order that requires execution at the

stated price for as many shares as can be filled immedi-

ately. The order for shares that are not filled is canceled.

Market-at-open order. This is an order to buy or to sell

immediately at the open.

Market-at-close order. This is an order to buy or sell as

close to the end of the trading day as possible. ●$


CHAPTER 4

Direct AccessOrder EntrySystem

• Nasdaq Direct

• SuperMontage

• TotalView

• ECNs

• SuperDOT

• Order Execution Systems Review


There are a number of electronic systems for

directly buying and selling stocks within the mar-

ket. The main systems are:

● Through the market makers participating in the

Nasdaq Market Center

● ECNs

● SuperDOT


NASDAQ DIRECT

The Nasdaq Market Center is where market mak-

ers conduct the business of buying and selling

stocks. The Market Center is a fully integrated

order display, execution, and trade reporting sys-

tem for all securities listed on Nasdaq National

Market®, Nasdaq SmallCap MarketSM, NYSE, and

THIS CHAPTER CONCERNS ONLY THOSE with a direct access

trading account. With direct access, there is no intermediary between

you and the market. Some trading platforms, like CyberTrader Pro,

will select the best venue for your order automatically, using “smart routing.”

With others, you need to do the work manually. Either way, you need to

know, at a minimum, the basics if you want to use direct access brokerages.

Remember, confirmations through the direct access system can take as little as

0.5 seconds! Each venue has its own rules, risks, and characteristics. A fre-

quently asked question is, “Which venue is best overall, and which works

best in a fast-moving market?” Unfortunately there are no cut-and-dried

answers, which is why it is a must to familiarize yourself with all the venues

that are available to you through your broker. The more knowledge you have

about direct access, the better off you will be. Again, keep in mind that things

are changing rapidly in this business. As always, check with your broker for

the latest. As of this writing, Nasdaq is awaiting regulatory approval for its

purchase of INET; you should expect this to bring more changes.


DIRECT ACCESS ORDER ENTRY SYSTEM 41

Amex. The Market Center offers trade executions

and reporting for more than 6,700 securities.

SuperMontageSM is Nasdaq’s display and order

execution system designed to help reduce frag-

mentation, provide best execution, expand the

number of choices to market participants, and bet-

ter handle the growth of the market. The order

routing and execution segment of SuperMontage

replaces SuperSOES and SOESSM orders. The

basics of SuperMontage are discussed next.

SUPERMONTAGE

The SuperMontage system will attempt to match

your order with the best price available at the time

it is received. Odd lots are accepted, but will be

grouped with other odd lots to create round lots

before being executed. Dual-listed securities can

be round lots only if sent to SuperMontage.

SuperMontage does not use a tier limit system.

As such, tier limit restrictions are no longer appli-

cable for any Nasdaq National Market Securities

(NMS) or Nasdaq SmallCap Market securities

(SC). Over-the-Counter Bulletin Board (OTCBB)

stocks cannot be traded via SuperMontage order

routing.

Any portion of a SuperMontage order that

attempts to execute “10% + $.01” away from the

inside market at the time of entry will be rejected.

For example, in stock ABCD, the current inside bid

is $10.00. You enter a market sell order for 5,000

shares. There are currently 4,000 shares bidding

between $8.99 and $10.00, with another 100 shares

available at $8.98. Based on the preceding formula

[$10.00 −($10.00 × .10) − $.01 = $8.99], the threshold

price will be $8.99. Therefore, 4,000 shares of your

order will execute, and the new inside bid will be

$8.98. The remaining 1,000 shares of your order

will be rejected, as there is no additional liquidity

at or above the threshold bid price.

Market participants are obligated to comply

with the “Firm Quote Rule,” which means they

must execute an order presented at a price at least

as favorable as its displayed quote, up to its

quoted size. This is also called a liability order.

Transaction hours are 9:30 A.M. to 4:00 P.M. eastern

time.

Market makers and ECNs can post to Level II

anonymously by sending nonattributed orders to

the market. Nonattributed orders are displayed in

the Level II montage under the size identifier. For

each price level, all nonattributed orders are aggre-

gated under this identifier; however, unless you

subscribe to Nasdaq TotalView, size will display

only one quote on each side of the montage—the

best-priced, nonattributable bid and ask in the sys-

tem. If your order is filled by a nonattributed par-

ticipant, you will see the participant’s ID when the

transaction is complete.

Another type of SuperMontage order is the

SuperMontage Directed order. SuperMontage

Directed sends orders to market makers and

ECNs, either directly or broadcast to all available

participants at once. Order quantity must be 100

shares over the size the market maker is posting.

Otherwise, your order may be rejected. For exam-

ple, if a market maker is posting 900 shares and

you wish to purchase 1,000, you may send your


order for 1,000. If the market maker is posting

1,000, you must send your order for 1,100, or find

a market maker who is posting 900. No counter-

party is obligated to fill SuperMontage Directed

orders. There is no tier limit on a SuperMontage

Directed order. If your order is directed to a market

maker at its posted price, it has 15 seconds to fill the

order, reject the order, or move off of the price.

Orders cannot be canceled for 5 seconds after be-

ing placed. The transaction hours are 9:00 A.M. to

6:30 P.M. eastern time.

TOTALVIEW

Market maker activity can be viewed on all

Level II screens. Level II shows each Nasdaq par-

ticipant’s best bid and ask and the size available.

Some brokers charge a fee for Level II. Besides just

basic Level II, some offer a new product from

Nasdaq called TotalView. TotalView shows up to

five quotes per market participant per side. (Note

that participants are not obligated to post five

quotes, but they do have the option.) In other

words, TotalView has the same data as Level II,

plus up to four more quotes per side per partici-

pant. TotalView also includes an aggregate of the

first five price levels and the total number of shares

at each price.

Figure 4.1 shows a Level II screen with

TotalView for Netease.com Inc. At the top of the

actual Level II montage you can see the five levels

of aggregated quotes. Below that, notice that mar-

ket participant LEHM is shown at two levels on

the bid side and two levels on the ask side. Notice


also “SIZE,” where market makers are posting

nonattributed orders.

ECNs

It’s time to discuss ECNs in greater detail. They

were created in response to a growing need to cre-

ate fair and efficient trading that was more accessi-

ble to individuals. They came about after the SEC

passed the order handling rules of 1997.

ECNs allow Nasdaq customers, traders, or in-

4.1 Level II with Nasdaq TotalView®



vestors like you and me to trade directly with each

other or to place orders directly into the marketplace.

This process eliminates the intermediaries. In the

beginning they handled fewer than 5 percent of all

OTC trades. They now control over 35 percent of

Nasdaq volume, and that number continues to grow.

In 1998, the SEC passed a regulation called Alterna-

tive Trading Systems (ATS). This allows ECNs, such

as ARCA, REDI, and others, to become electronic

securities exchanges. As for-profit exchanges, each

ECN has its own individual trading system and

computer algorithms. Understanding how each

ECN works, and under what situations each works

best, will enable you to get in and out of positions

quickly. As a trader, my biggest concern is liquidity.

Liquidity is the ability to quickly turn stocks into

cash. The ECN that provides the best liquidity and

reliability is the one you should use. When trading

on an order-matching ECN, volume is critical. Oth-

erwise, there will be little liquidity for the trader. A

computer algorithm system is not self-contained.

This type of ECN will automatically search the entire

market to get the order filled. It literally helps the

trader decide where to go for liquidity.

The list of available ECNs is constantly chang-

ing due to failures, consolidation, mergers, and

acquisitions. What is most important is which ones

are offered by your direct access broker. The main

ECNs as of this writing are ARCA, INET, BRUT,

ATTN, and BTRD. BRUT is now owned by the

Nasdaq; ARCA has merged with the NYSE; and

INET has also been acquired by Nasdaq and is

awaiting regulatory approval. Following is a brief

description of the main ECNs: INET, ARCA,

BRUT, and ATTN. Not all the order types are avail-

able through all direct access brokers, and the

hours may vary from broker to broker.

ARCAGerald Putnam formed Archipelago in 1996 in

response to the new order handling rules imple-

mented by the SEC. It began in 1997 as one of the

four original ECNs approved by the SEC. Archi-

pelago is accessible to traders, easy to use, and

inexpensive. It also has a great deal of liquidity.

Codeveloped by Townsend Analytics, Ltd., and

Terra Nova Trading, Archipelago allows traders to

post bids and asks into Nasdaq Level II and on

some stocks in the NYSE. Archipelago also oper-

ates on a computer algorithm. Best execution is

facilitated by its proprietary SmartBook technol-

ogy, which looks for the best price for an order

internally or externally. This book server, the heart

of the Archipelago system, maintains a current

real-time account of all bids and offers for each

Nasdaq stock. If an incoming order crosses or

locks an existing internal order, the order is exe-

cuted immediately. If no crosses or locks occur,

and the order reaches the top of the Archipelago

book, it will be sent to Nasdaq for display. The best

bid and ask posting 100 or more shares will post on

Level II if it does not cross or lock the market.

Hours of operation are 4:00 A.M. to 9:30 P.M. eastern

time. Limit orders can be entered and will be

queued until the limit order auction at 4 A.M. east-

ern time. Individual brokers may have different

hours of operations. For more information go to

ARCA’s web site at www.tradearca.com.


INETINET is the result of a merger between Instinet and

Island ECNs. Instinet is the original ECN. It was

founded in 1969 and acquired by the Reuters Group

in 1987. Established in 1997, Island’s mission was to

provide investors with an open, transparent, and

fully accessible marketplace. It operated on one

simple principle: It automatically matched buy and

sell limit orders for equities. It was inexpensive,

easy, reliable, and liquid. It changed the way every-

one looked at day trading. Together now as INET,

this is one of the most powerful ECNs available.

Where the acquisition by the Nasdaq will take it is

anyone’s guess, but odds are it will be good for the

day trader. INET is an order matching system and

accessible only to other INET subscribers. Orders

not immediately matched are added to the INET

order book, a database of available orders, where

they wait to be matched in price-time priority.

Orders will not be routed to other market partici-

pants for execution. All INET subscribers are

anonymous; no subscriber’s identity is disclosed

before, during, or after an execution. The top INET

book bid and ask quotes are displayed on Level II

with the INET or CINN identifier. Currently, hours

are 7:00 A.M. to 8:00 P.M. For more information, go to

the INET web site at www.inetats.com.

BrutIn its early phases, when it was owned by Brass

Utilities, this ECN catered mostly to institutional

investors and broker-dealers. Now, after being

purchased by the Nasdaq, it is available to all

traders. Brut offers broad market access, with


routing to all major destinations. In addition, all

firms, both market maker and order entry, can now

post orders in the National Market System using

Brut. Firms can use Brut to access the NYSE via its

DOT router and access the Amex and regional

exchanges. Your DOT orders will sweep the Brut,

Nasdaq Market Center, and INET exchange-listed

books before being sent to the floor if not already

filled. For more in-depth information on the vari-

ety of Brut order types your broker may offer, go to

the Brut web site at www.nasdaqtrader.com/

trader/tradingservices/productservices/product-

descriptions/brutdescription.stm.

ATTNAttain (ATTN) was introduced in 1988 by All-Tech.

It was founded by Harvey Houtkin, often referred

to as the father of electronic stock trading. Houtkin

has long advocated the reform of investing rules

and regulations. ATTN was acquired by Domestic

Securities and then, more recently, by Knight Capi-

tal Group, Inc. Like INET, Attain is strictly an order

matching system. Orders that are not matched in

the ATTN book will be displayed on Level II if the

order is for more than 100 shares and at the inside

bid or ask and if it does not cross or lock the mar-

ket. Hours are 8:05 A.M. to 6:30 P.M. eastern time. At

this time, ATTN accepts only limit orders.

SUPERDOT

Electronic access to the listed markets is evolving

rapidly. Currently, SuperDOT is the most common

way for traders using a direct access platform to



trade listed securities. SuperDOT is an electronic

means of gaining access to the listed markets. It is

responsible for the vast majority of all orders on the

NYSE. SuperDOT can handle up to 99,999 shares at

a time. It gives individual investor orders of less

than 2,100 shares priority over the large institu-

tional orders. It links the member firms directly to

the specialists who will rapidly execute orders.

The specialists’ job is to pair orders, fill orders

from the inventory, or place orders on the limit

order book. The purpose of the limit order book is

to give specialists time to organize the book while

establishing an orderly market.

In recent times, third markets like the Chicago,

Philadelphia, and the Pacific Stock Exchanges

have entered the picture by guaranteeing to fill

orders at the best price on the NYSE. Day trading

firms across the country can access the specialists

through these third markets. With more and more

listed securities trading on ECNs, and with the

merger of ARCA and the NYSE, things will be

changing rapidly.

ORDER EXECUTION SYSTEMS REVIEW

A market order is an order executed at current bid or ask

price.

A limit order sets a limit on the price that the trader is will-

ing to buy or sell.

The SuperDOT system is for executing a trade on the NYSE.

A trader trading on the Nasdaq has several order routes to

choose from.

The easiest routing method is the intelligent ECN. These

systems use a smart computer algorithm to help the

traders send their orders properly.

INET ECN has plenty of volume to provide good liquidity,

but it does not work on a smart computer algorithm.

ECNs such as ARCA, Brut, and NTRD work on smart com-

puter algorithms. Each has its own individual designs.

When canceling an order, the order remains active until

actually canceled by the exchange. An order can be filled

even after a trader has hit the cancel button.

Pay close attention to the spread between bid and ask,

especially if you are placing a market order.

Make sure you know the fee structure at your broker-

dealer.

Remember, each venue has its own characteris-

tics, rules, and risks. Commission charges may

vary depending on what route you choose for

your order. Some routes may be faster in different

markets. Price, volume, fees, and liquidity are all

things that have to be considered, sometimes very

rapidly as you make your trading decisions. Make

sure you understand all these concepts completely

to prevent any surprises as you begin trading

using direct access. Also remember that this infor-

mation is changing rapidly; make sure you have

the latest! ●$


CHAPTER 5

Elements ofSuccessfulTrading

• Minimum Requirements to Begin Trading

• Psychology of Trading

• Risk Management

• Trading Methodology


CapitalTo trade, of course, you need money, or capital, as

it’s called. If you want to trade stocks, you will

need from $30,000 to $100,000. Adequate capital-

ization is one of the keys to successful trading. Too

many traders start out with inadequate capital.

They start with less than $30,000 and hope to make

a living immediately. This is possible, but highly

unlikely.

It generally takes a few months for a trader to

become successful. Adequate capitalization allows

the trader to survive this learning curve. It’s best

not to become involved with day trading if you

cannot survive this period without dipping into

reserves. It’s also wise for beginning traders to

keep their jobs until they start making money in

day trading. This lessens the pressure to make

money immediately.

TimeYou may not think that time is an important con-

sideration, but I urge you not to overlook this fac-

tor. Trading takes a lot of time. It will take you

away from your family, friends, and leisure activi-

ties. Are you willing to make this sacrifice? Make

sure you have the support of loved ones before


you begin. It will make your life easier. Reading

books and attending seminars and conventions

takes time. Doing research and analysis also takes

time.

KnowledgeKnowledge comes from books, seminars, and talk-

ing with others. Many people skip the educational

process and jump right into trading. Most of them

fail. We are not built to trade. Our psychological

makeup is such that we will almost always make

the wrong decisions. Make sure you learn how to

trade from successful traders. If you imitate their

methods, your chances of success will greatly

increase. As you progress from beginner to profes-

sional, your quest for knowledge will continue. It

never ends. Isn’t that wonderful? In this profes-

sion, there is always something new for us to

understand and conquer.

Your ComputerHere are the minimum requirements for your

computer. Keep in mind that technology makes

quantum leaps every year. By the time you read

this list, it could be outdated—but we’ll include it

anyway.

MINIMUM REQUIREMENTS TO BEGIN TRADING

THE FOLLOWING RESOURCES ARE the bare minimum that you

need to begin trading for a living.


ELEMENTS OF SUCCESSFUL TRADING 49

1.0-gigahertz Pentium processor

512 megabytes of memory

50-gig hard drive

Windows XP

Networking card

CD-ROM

19-inch monitor (LCD)

Uninterruptible power supply (UPS)

When you buy a computer, get the best you

can afford without hurting your trading account.

Make sure it has expansion slots so it can grow

with your needs. As a beginner, you might start

out with only one monitor. Later, you might want

to add more memory and an extra monitor. Make

sure this is possible with the computer system

that you buy. My current system has four 21-inch

monitors on two video cards, 512 megs of RAM,

a networking card, cable access, CD-ROM, and

a UPS.

Internet ConnectionToday, nothing less than cable or DSL will work. A

lot of traders have both for redundancy. The shear

amount of data that traders demand requires a

broadband connection to the Internet.

Cable modems are available in most areas of the

country. These modems come from your cable TV

company. High-speed DSL Internet connections

are also available in most areas. Your phone com-

pany usually provides this service. Two-way satel-

lite connections will work on some platforms, but

usually won’t be supported by the broker; in addi-

tion, because of the distance the signal is traveling,

a slight delay is present.

A T1 line connection is also an option, but it is

expensive. Installation and monthly maintenance

costs are high. Make sure your trading is profitable

before venturing into such a connection.

PSYCHOLOGY OF TRADING

There are three key elements to trading success.

They are psychology, risk management, and trading

methodology. It is critical to understand how inter-

related all three pieces are. You absolutely cannot

have success without one or the other. Each ele-

ment has to play a part in the way you trade. Oth-

erwise, you are building a house of cards. First,

let’s look at the psychology of trading.

Trading is a psychological process. The way you

analyze the market and reach conclusions depends

on your past experiences. The market is an inani-

mate object. It has no feeling. It simply exists. Peo-

ple make judgments about everything. To some, a

mountain is beautiful. To others, a mountain is just

a big rock. Depending on your point of view, a

glass of water can be half empty or half full.

The same is true in trading. If your past experi-

ence has been good, you will see the market as an

opportunity. You will have the confidence to act

quickly. If your past experiences have been bad,

you will see the market in a negative light. Fear

and indecision will control your decisions. Your

mind will focus on the things that could go wrong.

You will hesitate, waiting for more confirmation

that you are making the right trade. Often, you


will not trade at all. You will sit on the sidelines

and watch opportunities disappear.

To trade successfully, you must rise above your

past experiences. If not, they will govern the way

you trade. And they will cause your downfall.

Most traders start out confident but ignorant.

They have an idea and they immediately start trad-

ing. The first few trades turn out to be winners. Then,

after several good trades, the beginning trader usu-

ally takes a big loss. Now fear comes into play. The

trader steps to the side and decides to learn more

about the market. But the more he or she learns, the

more information becomes a crutch instead of a tool.

The trader is unable to act, afraid that he or she might

have overlooked crucial information.

Now the trader gets back into the market and a

few trades go favorably. The individual is more

convinced than before that success depends on get-

ting the right information. But after a few more

winning trades, the trader again sustains a big loss.

The trader now enters an unending cycle of fail-

ure and success that will lead him or her to stop

trading altogether. When the trader wins, he or she

believes information is the key. When the trader

loses, he or she believes that some important infor-

mation was missed. Following each loss, the trader

goes on a more intense quest for information that

will stop the losses. But the losses continue, and

the trader ultimately gives up.

With trading, your success or failure begins and

ends in your mind. You have to prioritize the ran-

dom information the market generates. If you

think in an orderly fashion, the market will begin

to make sense. But if your mind is all over the


place, your focus will always be on the wrong

things. You are your biggest enemy in trading.

BEING RIGHT DOES NOT EQUAL MAKING MONEY.

Beginning traders are more concerned with being

right about a trade than the trade itself. This leads to

a natural tendency to hold on to losers and cut win-

ners short. Most beginners think being right equals

making money. When they have a winning trade,

they take their profit quickly. To the beginners, tak-

ing a profit means that they have proven to the

world that they were right. Beginners also tend to

believe that if they have not closed a losing position,

they have not yet lost. The losses are only on paper.

It is not real. So they hang on until the pain gets too

unbearable, and then they close out the position.

The bottom line is this: Cutting profits and

hanging on to losers is a sure way to failure. Being

right and making money are exact opposites in

trading. Many of the good traders I know have a

winning percentage of only 40 percent. But they

make a lot of money. I also know traders whose

winning percentages are over 90 percent. And yet,

they are consistent losers.

The reason is simple. They focus only on the high

percentage of winners, thinking this equals prof-

itability. They ignore something called the reward-

to-risk ratio. This ratio measures the amount of

profits per trade and the amount of losses per trade.

The reward-to-risk ratio of a beginning trader is

about one to four. This means winning trades net

them an average of $1. But they lose $4 on their los-

ing trades. Let’s take a sample of 100 trades with



this type of ratio. Of the 100 trades, 80 are winners

and 20 are losers. The total profits would be $80, or

80 winning trades multiplied by a $1 profit per

trade. Total losses are 20 losing trades multiplied by

a $4 loss per trade. This also equals $80! The net

result in this case is zero! The trader with a high

winning percentage has not made a dime.

But a trader with a reward to risk ratio of two to one

and a winning percentage of only 50 percent will make

money. Consider another 100-trade sample, this time

with a reward-to-risk ratio of two to one. A 50 per-

cent winning percentage translates to 50 winners

and 50 losers. Of the 50 winners, the trader makes $2

on each trade, or a total of $100. Of the 50 losers, this

trader loses $1 on each trade, or a total of $50. The

net result in this case is a profit of $50. Even though

this trader makes money only half the time, he is

profitable. This exercise tells us one thing: Being

right does not equal making money in trading.

Avoid System OptimizationThe compulsive need to be right has resulted in

a strategy known as system optimization. This

involves using computers to analyze technical

indicators and historical data. The data is “opti-

mized” for current market connotations. Some

traders believe this data makes the market pre-

dictable. They also believe they will make a lot of

money using this system.

But system optimization does not work in real

life. It does not work because the market is con-

stantly changing. The market is made up of people.

People are not predictable. Even my longtime

friends often act in ways that surprise me. The con-

cept of trying to predict mass behavior is absurd. If

the market ever becomes completely predictable,

we would be able to optimize a computer program

that would make us rich. But in real life, conditions

change day by day, week by week, month by month.

What works well today may be useless tomorrow.

A quick look at two intraday Nasdaq charts

proves this point. Figure 5.1 shows the market is

clearly on a downtrend. On a day like this, a trend-

following system developed through system opti-

mization will make money for you. On the other

hand, an oscillation-type system will constantly be

stopped out. In Figure 5.2, the reverse is true. The

trend-following system is less likely to make

money than an oscillation-type system. This is

because the market had very little trend and

moved sideways the whole day.

Looking at Figure 5.1, traders who use system

optimization would conclude that the trend-

following method works. So they would customize

the system’s indicators to fit this type of market.

But, as seen in Figure 5.2, the conditions that

favored a trend-following system reversed the

very next day. This forces the traders to rethink

their strategies. Based on the information gained

the second day, an oscillating system seems to

work better, so the traders reconfigure their sys-

tem again. It is a vicious cycle. When you op-

timize a trading system, you will almost always

be late.

Many of the optimized trading systems used

10 or 20 years ago have become obsolete. They

worked for the markets that existed years ago, but

not for today’s market. However, methods using


fundamental and technical analysis have withstood

the test of time. They have been in use for ages and

ages. They worked before and they work today.

They will continue to work in the future. The only

difference is that these systems and methods were

never optimized to the current market conditions.

Another way of understanding why optimiza-

tion does not work is human psychology. Using

the most general terms, you can find similarities

between everyone. Based on these similarities, a

psychologist can predict the most likely outcome

of an event. Even so, it is still not a sure thing, just

a most likely outcome. Personalities vary from

individual to individual. What is true for one per-

son might not be true for another.


The same logic applies to trading systems. We

cannot design a system that perfectly fits a chang-

ing market. There is no sure thing in trading.

Anyone who claims to have a system that works

100 percent of the time is lying. We can only work

with general probabilities. The best systems work

on a lower probability of success but a high reward-

to-risk ratio. As a trader, you need to balance the

two to find the right trading system for yourself.

Accept Losses and Move OnViewing losses the right way is a large part of the

trading profession. Your ability to accept losses

quickly and easily will have a great impact on your

success. The most successful traders I know feel no

5.1 Nasdaq Futures on a Downtrend

� This intraday chart clearly shows the market on a downtrend. A trend-following system works well in this type of market.



remorse when they take a loss. They know it is part

of the business. They quickly exit positions that

have not gone their way, keeping losses small and

inconsequential. These traders have setbacks, but

they never go broke because of them.

Maintain DisciplineDiscipline is another characteristic of a successful

trader. As a trader, your objective is to find the best

trading opportunities. You should trade only if

there is a high probability of success and a favor-

able reward-to-risk ratio.

There is a popular saying in trading: “Plan

your trades and trade your plan.” The idea is sim-

ple, but it is not an easy task to complete. Many

traders have great trading plans, but they are

unable to control themselves. They get into posi-

tions even though an entry signal has not been

generated. Or they get out of positions early, even

though their trading system dictates otherwise.

Some traders take massive risks outside their

trading plans. They are impatient and impulsive.

They do not belong in the profession of trading.

Sooner or later, the market will take them out of

this business.

Disciplined trading can lead to consistent prof-

itability. It is the only way to build trust in your

systems and prevent destructive tendencies from

taking over. Staying on course when the going gets

tough takes a lot of discipline. Exiting at the right

5.2 Nasdaq Futures on a Sideways Move

� This intraday chart clearly shows the market on a sideways move. A systemthat uses an oscillation-type indicator works well in this type of market.


time also takes discipline. So does waiting for the

right opportunity to come along. Make sure you

practice disciplined trading from the beginning.

Do not start this profession by developing bad

habits.

Be PatientAnother characteristic of a successful trader is

patience. Trading is about waiting until conditions

are right to trade. I frequently stay on the sidelines

all day without making a trade. My students have

asked why I stay out. My answer is always the

same. A good opportunity did not present itself.

The conditions that I sought never arose, so I did

nothing.

Sitting on the sidelines is a strategy. At a job, we

are expected to be busy all the time. To make

money in trading, you need to be busy at the right

time. When conditions are not right, your job is to

do nothing. Just sit and wait. Be patient. Opportu-

nities always arise.

PerseverePerseverance is also required to trade the right

way. During the course of your trading career,

there will be periods in which nothing you do

seems right. This will have a severe impact on

your psyche and on the way you approach trad-

ing. It will introduce fear into your trading, mak-

ing you hesitate when you should not, and making

you wait longer than you should before exiting a

losing position.

It takes perseverance to get through the bad

times. You need the strength to pick up the pieces


every day and continue trading. The battle to con-

trol your emotions while trading is never an easy

one. It is not something you can change overnight.

It takes work to detach yourself from the money

aspect of trading and not get emotional about

losses. It takes practice and more practice. Perse-

vere through all the challenges, and success is but

a small step away.

Be Self-ReliantThe successful trader is self-reliant. Traders do not

become successful by following the lead of some-

one else. Ultimately, we are responsible for our

own actions. Blaming others for our losses lessens

the possibility of learning from our mistakes. If you

take responsibility for your trades, you will begin

acquiring the knowledge you need to improve.

Taking responsibility means relying on your own

judgment, getting in and out of positions based on

your own perceptions and knowledge.

Traders who search for a guru to follow will

learn nothing about themselves. These traders are

never responsible for their own losses. It is

always the guru who is at fault. You can’t dis-

cover your weaknesses by following someone

else. The vital piece that is missing here is confi-

dence. Unless we take responsibility and rely on

our own judgments, we will not gain the confi-

dence needed to bridge the gap between success

and failure. Confidence is especially needed dur-

ing times of uncertainty. It keeps you going when

things are not working out.

We know there will be good times and bad

times. Your trading system will be geared toward



making a profit, with losses factored in. You will

take losses, but you will also take profits. Some

traders are eager to take losses because they

“know” a profitable trade is just around the corner.

That’s how confident they have become. That’s

how much trust they have in their systems.

RISK MANAGEMENT

The second key element of successful trading is

risk management.

Do the Hard WorkTrading is hard work. Before you make a trade,

you must do research. You need to analyze charts.

You need to read news. You also need to plan your

trading day and pick the stocks for a watch list.

What are their entry points? What are their stop-

loss points? What are their profit-taking points?

What size position should you take?

These questions need to be answered before

you start trading. And after the trading day, you

need to analyze your trades. Go back and check

the charts; figure out what you did right and what

you did wrong. Then the process starts again.

Stay in the GameRisk management includes both money manage-

ment and risk control. It is the part of your trading

system that tells you how much you can risk on

one trade, and it is vitally important.

Trading means taking risks. If you do not con-

trol risk, you will not be around long enough to

become successful. Traders who succeed for a time

without risk management eventually go out of

business. Proper money management means that

one bad trade, or even a series of bad trades, can-

not put you out of the game.

Without risk management, the best trading sys-

tem in the world, one that is right 90 percent of the

time, will not save you. But with good risk manage-

ment skills, you could have an inaccurate system

and still get respectable returns. Studies have shown

that 90 percent of the variance in fund manager per-

formance can be attributed to risk management.

Jesse Livermore was a noted trader whose

biggest failure was lack of risk management. He is

considered one of the greatest speculators ever. He

went from being poor to being rich, from rich to

poor, and back again several times. He would risk

everything he had on trading. His winning streaks

would make millions for him; his losing streaks

would completely bust him. In the end, flat broke,

he committed suicide. The note he left said that he

considered his life to be a total failure. My inten-

tion in relaying his story is to stress the importance

of protecting your capital. No matter how lucky

you are or how good you are, sooner or later the

law of averages will catch up to you. There are no

sure things in trading.

Here is the only way to prevent a catastrophic

loss when you trade: Make sure that the amount of

money you risk on each trade is so small that you

can sustain numerous losses without having to

quit and get a job. The casino business is a good

example of good risk management. Casinos are in

the gambling business. However, the casino busi-

ness itself is no gamble. Casinos take few risks


with the money you pour into their coffers. They

watch their money like hawks. Casinos have a

house edge. All their games are skewed in favor of

the casino. The casino keeps 2 cents for every dol-

lar you put into a slot machine. Casinos let the law

of averages work for them. This means that if you

play long enough, the casino will end up with the

other 98 cents of your dollar.

Casinos keep their risks small. They never take

on a gambler who has the ability to break the bank.

That is why they have house limits. This keeps

their risk spread out and their losses small. Trad-

ing should be the same as the casino business. As

traders, we can gain a house edge and we can let

the law of averages work in our favor. We do this

with risk management, by keeping our risk small.

In June of 2000, I ran into a bad streak. Every

morning I prepared a list of stocks to trade. I

selected one stock to trade when the market

opened. I picked the loser every day, while the

other stocks on my list worked out fine. Were it not

for risk management, I would not be here today,

writing this book and still trading. After suffering

many consecutive losses, my account was still

robust enough for me to come back the next

month. In July, everything I touched made money.

There is no telling when a bad streak will come.

But if you practice risk management, you will sur-

vive. You will live to play another day.

TRADING METHODOLOGY

The third key element of successful trading is

methodology.


Avoid Psychological BarriersA large loss is a body blow to your psyche. When

you discipline yourself not to take huge posi-

tions, you avoid this psychological damage.

Small losses do not create psychological barriers

that keep you in a losing frame of mind. Why

would a trader ever take a large position? Most

traders play big when they think they have a sure

winner. But taking this type of position results in

a loss of objectivity. You will become emotional

about the trade. This means you will hang on if

the position goes bad and claim a profit too

quickly. This is the very opposite of what needs to

be done. As we all know, there is no sure thing in

trading. Sooner or later, traders who habitually

risk the whole wad on one trade will end up los-

ing everything. Think of the sad story of Jesse

Livermore.

Traders also take obscenely large positions

because they have a gambler’s mentality. These

traders think trading is a get-rich-quick scheme,

that free money is there for the taking. In the end,

they are the ones who get taken. There is no place

for gambling in this profession. We should take

only calculated risks. In fact, unless the variables

are completely in our favor, there is no sense trad-

ing at all. Gamblers might win some of the time,

but never all the time. I don’t care to gamble with

my business.

When we keep it small, we stay objective. We do

not hesitate to exit a position and move on to the

next trade. But when we risk large amounts, we

have a tendency to want to make things work. This

tendency is the trader’s biggest enemy. When I



hear traders say, “I cannot afford to lose this

money,” I know they have risked too much. For

these people, trading is very stressful. They have

lost their objectivity. They cannot sense the market

flow anymore. They are fighting themselves, not

the market.

This battle within your mind can be easily ap-

peased. All you need to do is make sure you risk

the same controlled amounts every time you trade.

Never break this rule, and the ups and downs of

trading will never break you. As a beginner, make

sure you take risk management seriously, very

seriously. If you fail to do this, you will deplete

your capital before you gain the experience neces-

sary to be a successful trader.

Even as a seasoned trader, my primary concern

is to be here tomorrow! If I can guarantee tomor-

row, I know I am going to make money. I don’t

worry about making millions of dollars a year. I

make small, well-calculated trades, slowly build-

ing my account. I am trying to win by hitting sin-

gles and doubles and stealing a few bases.

I am not a home run hitter; they strike out too

much. If I make just 3 percent a day, my account

will compound to a whopping 80 percent return in

a month! Time becomes my best friend.

Follow the 2 Percent RuleHere are some good ways to manage risk. I live by

what I call the “2 percent rule.” I never risk more

than 2 percent of my capital on any trade. If my ini-

tial capital is $50,000, I will not risk more than 2

percent, or $1,000. My maximum risk per trade is

no more than $1,000. This amount includes com-

missions and slippage. There are two ways to use

the 2 percent rule.

First, use it to determine whether to make a

trade or not. Many traders feel comfortable trad-

ing a particular share size. Let’s assume, for exam-

ple, that you typically buy 300 shares per trade.

You pick a stock that you believe will go up. After

checking the chart, you believe the entry point is

$35 and the stop-loss point is $32. If the trade goes

against you and is stopped out, the loss per share

would be $3. This is calculated by subtracting the

stop-loss price from the entry price. Because you

bought 300 shares, the total risk exposure is $3 per

share multiplied by 300 shares, or $900.

If your account size was $50,000 and your maxi-

mum risk was 2 percent, this trade would still be

acceptable because it is below your limit of $1,000,

dictated by the 2 percent rule. You should not make

the trade with a lower loss point. For example, if the

loss point was $31 instead of $32, the loss would be

$4 per share. This is because $4 per share multiplied

by 300 shares equals $1,200. And $1,200 is greater

than the maximum allowed risk per trade.

This method forces the trader to look for oppor-

tunities with the least amount of loss per share.

Second, use the maximum risk per trade figure

to calculate the number of shares you should

trade. Suppose you have $50,000 and you adhere

to the 2 percent risk rule. We know the maximum

loss per trade should not exceed $1,000. You’re

considering a trade with an entry point of $50 and

a stop-loss point of $45. The possible loss per share

would be at $5. Because the maximum loss per

trade is $1,000 and the possible loss per share is at


$5, how many shares should you trade on this

position?

The answer is simple. Divide the maximum loss

per trade by the possible loss per share and you

will get the maximum share size that can be

traded. In this case, you would divide $1,000 by $5,

and get an answer of 200 shares. This method

gives you flexibility. By raising and lowering the

number of shares, you can trade all opportunities


that present themselves and still maintain the

same amount of risk per trade.

In both methods of risk management, knowing

the stop-loss point is critical. Without it, you should

never take on a trade. This is the first step in control-

ling your losses and managing your risk. Never

enter a trade without knowing your stop-loss point.

Without a stop-loss point, it is impossible to apply the

risk management principles we have just described. ●$


CHAPTER 6

TradingStrategies

• Scalping

• Intraday-Trend Trading

• Swing Trading

• Long-Term Trading

• Back Testing


There are several trading styles. They include

scalping, intraday position trading, swing trading

and even long-term trading. These styles are cov-

ered in detail in this chapter. But keep this in mind:

You should concentrate on the style that fits your

personality. Some traders love high-speed action.

Scalping would probably be right for them. Many

traders prefer longer-term trades because they do

not want to be glued to the monitor for 61⁄2 hours

every trading day. A more laid-back style would be

right for them.

SCALPING

Scalping is one of the toughest types of trading. It

means trying to capture profits of less than $0.50

per share as fast and as often as you can.

There are several ways to scalp. This first is by

capturing the spread. The scalper tries to buy at

the bid and sell at the ask. These days, spreads on

stocks with large trading volumes have become

smaller. Before the market converted to decimal

pricing, the standard spread was 1⁄16 of a dollar or a

“teenie.” A “teenie” equals 6.25 cents. A scalper

who bought at the bid and sold immediately at the

ask would make the spread of 6.25 cents per share.


If the commission was a penny per share, the

scalper would still make money. The scalper must

be right more often than not. Three things can hap-

pen: The stock can go against you, stay the same,

or move in your favor. Two of the three possibili-

ties are bad.

When the market went to decimal pricing, the

spread on the high-volume stocks became a penny

or less. This has made it impossible for scalpers

to profit. Another scalping technique involves

momentum trading. Scalpers try to ride on the

back of institutional trading. They learn to spot

opportunities on Level II, then jump in at the

beginning of a move and get out before the

momentum dies. On any given day, there will be

short bursts of activity when buy or sell orders

from large institutions reach the market. The sheer

size of these orders tends to move the market in

the direction of the order. A sell order tends to

move the market down, whereas a buy order

moves the market up. It takes effort to learn to spot

these activities.

Rather than looking for specific stocks, momen-

tum scalpers watch for news events, earnings

reports, and business news that can set a particular

stock in motion. They watch the various queues

TRADING STRATEGIES INVOLVE A PREDEFINED SET of guide-

lines for entering and exiting a trade. These guidelines can be based

on technical or fundamental analysis. They determine what stocks

you should trade and when you should trade them.


TRADING STRATEGIES 61

for signs of a potential burst of activity. Usually,

this is done by watching the activities of the mar-

ket makers.

Another method the scalper uses is “shadow-

ing the ax.” The “ax” is a large institutional player

that is actively participating in the movement of a

stock. Usually, the institution has received a large

buy or sell order. To get it delivered, the institu-

tion will employ different tactics to confuse the

trading public about its true intentions. To make

money using this strategy, scalpers need to have a

clear understanding of how each of the different

market-making operations act. Otherwise, they

can get on the wrong side of the trade. I do not dis-

cuss all the various scalping tactics here, but now

you have the basic idea. A scalper has to con-

stantly watch the Level II screen and quickly react

to the information it provides. Unfortunately, the

screen does not slow down and allow the scalper

to interpret the information. Decisions must be

made in less than a second. Once a decision has

been made, scalpers must react before the price

moves away from them. Execution skills come

into play. Scalpers with less than optimum execu-

tion skills will not succeed. They will always be

late, unable to get the shares they want. Scalping

is not for everyone.

INTRADAY-TREND TRADING

Intraday-trend traders trade a slightly longer

period of time than the scalper. Their profit objec-

tives are a minimum of $1, so execution skills are

not critical, but they are nonetheless important.

Every penny saved is truly a penny earned. As the

name implies, the trader follows intraday trends.

If the market stays in a tight range and fails to

form a trend, the trader will sustain a loss. The key

is to make good money on the days when the mar-

ket moves in a strong trend. This type of trading is

not as hectic as scalping. It can be profitable when

the market moves dramatically. This is the style I

like to trade. The losses are usually small and the

gains can be substantial if the techniques are cor-

rect. I use a combination of methods when I follow

a trend. I do not scalp, but I use scalping tech-

niques for entry and exit points. Level II is a great

way to identify entry and exit points. I like to

enter long positions when a stock is pulling back a

bit and reaching a support level. I like to enter my

short trades on bounces that hit a resistance level.

Reading Level II can give you these levels before

they actually form. I use technical analysis to find

intraday-trend trading candidates. Rotating posi-

tions every day involves a lot of research, but the

payoff can be good. Fundamental analysis does

not matter to me at all. Day trading is short term

and can be based purely on technical analysis.

Watch out for overtrading. It is better to deal with

only a few well-chosen candidates. Trade them

during the day and then continue to perfect your

technique.

SWING TRADING

The swing trader holds a position for one to five

days. The biggest mistake swing traders make is

holding a losing position too long. This is the


biggest difference between a successful swing

trader and a struggling one. The only reason to

hold a losing position is because it never hits the

stop-loss point. Otherwise, time should never be a

factor for exiting trades. Price action alone should

determine when you exit.

Technical analysis plays a key role in this style

of trading. It can be used to improve the chances of

a successful trade. I focus on the longer trend if I

plan to carry positions overnight. This often puts

me on the right side of the trade.

Some swing traders have found success by

combining technical analysis with fundamental

analysis. I believe that technical analysis should

be at least 70 percent of the equation. If there are

inefficiencies in the market, the one- to five-day

holding time may be sufficient to correct the

inefficiency.

LONG-TERM TRADING

The long-term trader has the longest time frame of

all. Trades can range from one month to six

months. Technical analysis plays a big role, but

fundamental analysis can also help. A few things

add risk to this style of trading. Usually, traders

hold positions through a company’s earnings

announcement. This works if earnings come in

better than expected. But what if the news is bad?

Whenever a company misses estimates, long-term

traders stand to lose money. If you hold positions

for the long term, the likelihood of getting stung

by bad news increases. Unlike with scalping, intra-

day trading, and swing trading, execution skills


and commissions are minor factors with long-term

trading.

After settling on a style of trading, pick the type

of analysis you want to use. It could be purely tech-

nical, a mix of technical and fundamental analysis,

or 100 percent fundamental analysis. That choice is

yours. The longer the trading time frame, the better

fundamental analysis will work. The best system is

still a mix of fundamental and technical analysis.

Setting conditions and specific trade guidelines

forces traders to narrow their trading choices.

Narrowing choices does not automatically mean

success.

BACK TESTING

There is a way to test your trading style before

making live trades. It involves using historical data

to determine the profitability of the style. It is called

back testing. Some trading platforms, like Trade-

Station and CyberTrader, come with this feature

built in. Or you can buy software programs that

access historical data and test certain combinations

of technical and fundamental data. The cost is

cheap relative to the risk you would take if you

were to test an idea by actually trading a position.

Scalping cannot be back tested. Usually, histori-

cal data does not cover the intricacies of Level II.

With this method, the key is experience. Many

scalpers start by trading only 100 shares. Their

intention is to learn how to react quickly to

momentum changes. Profit is not the main objec-

tive. Once they can consistently capitalize on

momentum runs, they will increase the share size.


TRADING STRATEGIES 63

Most scalpers will lose money during this learning

process. Some do not survive the steep learning

curve and lose their money. Those who survive

often make a nice living.

After back testing the trading system, you need

to adjust and improve it. I like trading systems that

produce successful signals of at least 60 percent

with a reward-to-risk ratio of at least 2 to 1. Other-

wise, I would continue on the search. Figure 6.1

shows the results of a simple back test of an

MACD crossover strategy. Back testing is an

important part of developing a sound system, but

remember, markets exist because the future is unpre-

dictable. ●$

6.1 Testing Strategies

� BACK TESTING IS AN IMPORTANT PART of developing a sound system. This is a simple back test of the MACD crossoverusing CyberTraders Strategy Tester.


CHAPTER 7

TechnicalAnalysis

• Charts

• Identifying Support and Resistance

• Trading Strategies

• Trendlines

• Gaps

• Basic Chart Patterns

• Volume Analysis


Price movement provides an understanding of

the underlying forces at work on a stock. The price

of a security represents a consensus between buyer

and a seller. It also shows when supply and

demand is at equilibrium. When price is plotted on

a chart, a trader can get an understanding of where

the overall sentiment lies. When the trading public

is selling a particular security, the equilibrium

price tends to head downward. When traders are

accumulating and holding a security, the equilib-

rium price tends to head upward. The rise and fall

of prices gives the trader an idea of ongoing senti-

ment shifts. Waves of buying push prices up and

waves of selling push prices down. A technical

analyst wants to know which wave is the

strongest. If buying pressure is strong, the chance

of a rise in price is high. This is simply the law of

supply and demand. When buyers snap up a

stock, its supply declines. When supply is limited,

prices tend to go up. On the other hand, if the sell-

ers are in control, there is a lot more supply. When

supply is strong, prices tend to go down.

A quick look at gas prices demonstrates how this

works. People travel more in the summer than in

the winter. This produces an added demand for

gasoline. Because gasoline manufacturers do not


produce more gasoline during the summer

months, the gasoline supply remains constant. If

demand grows while the supply is constant, prices

will rise. During winter months, people travel a lot

less. The demand for gasoline also drops. When

this happens, there will be a corresponding drop in

the price of gasoline. Another example is the

“Tickle Me Elmo” toy. When it was in demand,

mothers were willing to pay exorbitant prices to get

them. After Christmas was over, prices dropped as

demand subsided. Now the once-hard-to-find toy

goes on sale several times a year; the demand is

gone. All commodities are subject to the law of sup-

ply and demand, be it a car, a head of lettuce, a

house or a stock. Even your time is a commodity.

Charles Dow developed the following three

concepts:

●1 Price discounts everything. The current price reflects all

available information.

●2 Price movements are not random. They reflect a shift in

market sentiment. Sentiment can shift from positive to

negative. When sentiment is mixed, prices tend to move

sideways.

●3 Trends are formed when sentiment shifts. Trends are

predictable. A technical analyst should be more

TECHNICAL ANALYSIS IS THE STUDY of past price movement to

determine possible future price direction. The primary tool for tech-

nical analysis is the price chart. Charles Dow originated this method

of analysis around 1900.


TECHNICAL ANALYSIS 67

concerned with the current price than with the history

behind the price. This follows the idea that price dis-

counts everything. If all information is already reflected in

the current price, it is unnecessary to understand why a

certain price has been reached.

CHARTS

A price chart is a series of prices plotted over

a period of time. The period can be as long as a

month or as short as a second. A chartist using a

long period, such as a month, is plotting long-

term trends. A chartist using a brief period, such

as a tick-by-tick chart, is plotting short-term

opportunities.

Types of ChartsThere are several types of charts to choose from.

The most popular are bar charts, candlesticks, line

charts and point and figure charts.

Bar Charts

The bar chart is the most popular charting

method. There are two variations. Figure 7.1, for

example, shows only the high, low, and closing

prices. Each bar represents a time period. In this

case, one trading day. Each bar also shows three

pieces of information. The top of the vertical bar is

the highest price of the day. The bottom of the bar

represents the lowest price of the day. The little

horizontal line that sticks out to the right of the

7.1 S&P Bar Chart

� THIS IS A BAR CHART OF S&P 500 INDEX. Each bar will give you informationon the high, low, and closing price of each day.


vertical bar represents the closing price. In this

case, it closed about in the middle of the day’s

range (see Figure 7.2).

The next variation adds another piece of infor-

mation to the bar, the opening price, as shown in

Figure 7.3. The bars on the chart show the open,

high, low, and closing prices. Notice that there is a

slight difference in the way the bars are drawn.

Here’s how to interpret the information on this

type of bar chart: The top and bottom of the verti-

cal bar represent the high and low price of the day.

The horizontal bar to the right is also the closing

price. The only difference is the horizontal bar to

the left, which marks the opening price (see Fig-

ure 7.3).

Many technicians discount the importance of

the opening price. Usually, the opening price is

determined by amateur orders placed the night

before, which are considered of little significance.


They pay attention to the closing price because it

was determined by professionals.

Candlesticks

This method of charting originated in Japan more

than 300 years ago. Its use has recently gained

popularity. Candlesticks plot the open, high, low,

and close. They show how these prices relate to

each other in a manner that can be understood at a

glance (see Figure 7.4).

In a white or open candlestick, the opening

price is lower than the closing price. This means

the professionals were able to move the price up

after the market opened. In a black or closed can-

dlestick, the opening price is higher than the clos-

ing price. This means that during the period

covered by the candlestick, the price closed below

the open. Sellers were able to drive the prices

down.

7.2 Bar Chart

� THIS BAR CHART SHOWS only the high, low, andclosing price.

7.3 Bar Chart

� THIS BAR CHART SHOWS high, low, and closing priceplus the open price.



In some cases, you will find that the pattern

has no body. All you see is a straight line across.

These are doji patterns. Doji patterns mean the

opening and closing prices were the same (see

Figure 7.5).

The wicks of the candlestick mark the high and

low of the day. Sometimes, you will not find wicks

on the top or the bottom. Figure 7.6 shows samples

of these patterns and their interpretations.

Line Charts

The simplest chart is the line chart. It’s formed by

plotting the closing prices. All you need to do is

draw a line that connects the closing prices from

period to period. Some traders also plot the open,

high, and low prices on line charts. It is important

to be consistent. Do not plot the closing price one

day and the opening price the next day. If you are

plotting multiple numbers, you need to plot a line

for each. Use one for open price, another for clos-

ing price, and so on.

Line charts are most commonly used when the

open, high, and low prices are not available. Some

securities provide only the closing prices, so plot-

ting them any other way is impossible. Figure 7.7

shows an example of a simple line chart. The line

tracks only the closing price of the index as it

moves up and down.

7.4 The Candlestick Chart

� THIS IS A CANDLESTICK CHART OF THE S&P 500 INDEX, which has all theinformation a bar chart offers. It also shows at a glance how these pricesrelate to each other.


Point and Figure Charts

Point and figure charts are different from all other

charts. Instead of plotting one point, one bar, or

one candlestick for each period of time, this

method is based solely on price movements. It


does not take time into consideration. This makes

it easy to identify support and resistance levels. It

also allows you to effortlessly see breakouts or

breakdowns of these levels. Thus it allows you to

quickly recognize the underlying trend.

7.5 & 7.6 Candlestick Patterns

� DEPICTED HERE ARE OPEN, CLOSED, AND DOJI CANDLESTICKS. Note that a doji candlestick indicates that the open and close price were the same. Thecandlestick wicks show how candlesticks mark the high and low stock price of the day.



This method of charting is very simple. Prices

that fail to move significantly are not considered

relevant, and therefore are not plotted. It is only

when the price movement exceeds a certain level

that it is recorded. If the price of a security is rising,

it is plotted as an X. While it continues to increase,

more Xs are marked onto the same column. When

the price movement is downward, you plot it as an

O. Before you start plotting anything onto a new

column, the price movement has to go over a pre-

determined “reversal amount” in the opposite

direction. The reversal amount is your wiggle

room. It takes out all the noise and smoothes out

the trend. What you end up with is a series of X

and O columns, like the one shown in Figure 7.8.

Not all charting software offers point and figure

charting.

Types of Price ScalingThere are two ways to display the price scale along

the y-axis: arithmetic or logarithmic.

An arithmetic scale simply means that each price

along the y-axis is a fixed distance from the next

price on the scale. It is also called linear scaling. For

example, each level could represent a $5 increase

in price. You would see a level at $5, another at $10,

and another at $15.

A logarithmic scale displays price movement in

terms of percentages. Between $5 and $10 is a 100

percent increase. The next 100 percent level from

7.7 Line Chart

� THIS IS A SIMPLE LINE CHART OF THE S&P 500. Note that the line tracks onlythe closing price of the index as it moved up and down.


$10 would be at $20. In logarithmic scaling, the

levels would read $5, $10, and $20. By scaling the

chart as percentage of price movement, it is easier

to compare different securities. A $5 move on a $20

stock would now look the same as a $10 move on a

$40 stock, because both have a 25 percent price

move.

Basic Charting TechniquesBasic charting is a time-tested technique. It has

been around for a long time. When it comes to

intraday trading, I find that basic techniques are

even more important than the more complicated


stuff out there. They are a lot more reliable and

tend to produce the most profit if used properly.

Many of the complicated indicators do not work

well intraday.

The most notable ones are those that include

volume in their analysis. These tend to produce

poor results when used intraday, mainly because

of the lunch period. During the lunch period, vol-

ume usually drops as traders take off to grab

lunch. This practice leads to false signals. Under-

standing how each of the indicators work before

putting them into use will reduce the problem of

false signals.

7.8 Point and Figure Chart

� THIS POINT AND FIGURE CHART OF THE S&P 500 is based solely on pricemovement. A rising price is plotted as an X, a falling price is plotted as an O.This makes it easy to spot support and resistance levels.



There are several basic techniques that traders

must know before they venture into the world of

trading. They are as follows:

Identifying support and resistance

Identifying a trend and a trading range

Understanding different types of gaps

Recognizing basic chart patterns

Understanding volume

Beyond basic techniques, I believe the following

indicators are of importance to the trader. They are

discussed in later chapters.

Candlestick patterns and combinations

Moving averages

Moving average convergence divergence (MACD)

Relative strength index

On-balance volume (OBV)

Accumulation/distribution

Time segmented volume (TSV)

IDENTIFYING SUPPORT AND RESISTANCE

Identifying support and resistance levels on a

chart is the first thing you should learn. When a

stock price hits a support level, buying pressure is

stronger than selling pressure. Support levels

interrupt a price decline. Prices usually bounce

up from there. When a stock hits a resistance level,

selling pressure is strong enough to interrupt a

price advance. Prices tend to hit these levels on

the way up.

In his book, Trading for a Living, Dr. Alexander

Elder contends that support and resistance exist

because people have memories. They have memo-

ries of pain and regret. When you buy a stock and

make money, you will remember the price you

paid for the stock. When the stock drops to that

price, you buy it again, hoping to profit from a

rebound. And there are memories of regret. People

regret not getting into a stock at a certain price.

They sat on the sidelines as the price soared. Once

the prices drop down again, they buy aggressively

to avoid missing the next run. This is where sup-

port levels come from.

Resistance levels exist because people also

remember where prices turned around and started

to fall. When a stock price goes up to this turn-

around level, investors start thinking of selling.

Traders who are not in a long position might start

thinking about going short. There are also people

who were caught holding onto losing positions on

the last advance. They are waiting for a rally just to

get out without a loss. They contribute to selling

pressures.

I believe support and resistance levels also have

a lot to do with how people perceive value. If a

stock comes down to $30 from a high of $50, many

investors think it is cheap. But if the price goes

from $50 to $80, investors think it is expensive and

will not buy it. I guess part of the problem lies in

our dependency on financial analysts. They are

responsible for this perception of value we have on

a stock. In reality, the price of a stock is totally

dependent on supply and the demand. If there is a

lot of supply and little demand, prices can get a lot


cheaper. If there is a lot of demand and little sup-

ply, prices can go to the moon.

Nothing is cheap in the stock market. Prices fall

for one simple reason: There is more supply than

demand. No one can predict where a stock finds its

equilibrium. A friend once called to tell me about a

company he was familiar with. The stock had

recently declined from a high of $125 to about $12.

My friend thought it was a steal. He told me how

good the management was, how much cash the

company had, and how strong the fundamentals

were. He could not believe the stock was selling at

just $12. When he finished, I asked him a question.

Did he own the stock? His answer was a resound-

ing yes. The last time I checked, the price was

$1.12. My friend’s analysis was right on the money.

But there was no demand for the stock.

The question, then, is: How cheap is cheap? I will

never know the answer, nor will I try to find out.

On the other hand, how expensive is expensive?

During the tech craze, 9 out of every 10 dot-com

companies were losing money and had astronomi-

cal price-earnings (P/E) ratios. The hedge funds

saw no reason not to short these companies, and

for a time their prices went through the roof. Even-

tually, before the bubble burst, many big hedge

funds had to declare bankruptcy.

As traders, we are not here to make sense of all

of this. We need to separate ourselves from the

crowd and respect the information that charts give

us. A break of a key support level is a sign that sell-

ing pressures have overwhelmed buying activi-

ties. Demand has lessened and there is a lot more

supply in the market. If we are long on a position,


we need to exit the position as soon as this weak-

ness is confirmed. If we are not in any position,

start considering a short position.

A break of a key resistance level is a sign that

buyers have become aggressive. There is an in-

crease of demand, and prices are likely to go

higher. Exit short positions and enter long posi-

tions when the buying strength follows through.

There are two schools of thought on how to

draw these levels. One says it is better to draw the

support and resistance levels across congestion

areas. The other contends that drawing them at the

extreme edges works better. Both have their merits

and faults. I believe their use depends on the pur-

pose these lines serve.

Extremes mark areas where support and resis-

tance have to exist. If prices fail to turn around

before these extreme levels, they usually follow

through in that direction. I have found that placing

my stop-loss points at extremes tends to work bet-

ter than placing them in congestion areas. This is

even more true when it comes to intraday trading.

On the other hand, for the purpose of technical

analysis, marking them over congestion areas

tends to give you a better picture of the mass men-

tality. Extreme points tend to mark levels of panic

among the weakest traders.

In Figure 7.9, notice how I drew the support and

resistance lines. Going from left to right, the first

top marked a resistance point. Then it came down

to a low and reversed. The low marked the support

level. The next run on the S&P 500 futures was

powerful enough to break past the resistance.

Notice how the resistance now became the support.



Prices could not go below it significantly, and

instead went up even more. On this next leg up,

another resistance was hit. Prices came back down

and established another support level higher than

our previous one. The resistance is tested three

times before a breakout occurs. Again, notice how

the roles of resistance and support changed.

Strength of Support and ResistanceThree things govern the strength of support and

resistance levels. They are height, width, and

volume.

The height refers to the price range of the sup-

port and resistance area relative to the price of the

security. The taller the height, the stronger you will

find the support and resistance levels. In the exam-

ple in Figure 7.10, if we first assume that the price

of charts A and B are the same, the resistance and

support levels of chart A are going to be stronger

than those of chart B. This is because the distance

between the levels found in A is greater than in B.

The width refers to the amount of time the price

stays within the support and resistance level. The

longer the period, the stronger those levels are

going to be (see Figure 7.10B).

Finally, volume is another indicator of strength

7.9 Support and Resistance

� IDENTIFYING SUPPORT AND RESISTANCE LEVELS, as shown in this chart, is thefirst skill a day trader should learn. The lows mark the support, and the highsmark the resistance.


on the support and resistance levels. The more vol-

ume occurring on those levels, the stronger the

levels of support and resistance will be.

TRADING STRATEGIES

The support and resistance levels explained in the

previous section comprise the best tool for letting

your profits run and cutting your losses short. If

you get into a long position, the first thing you

should do is place a stop-loss order just slightly

below a support level. Any break of this level sig-

nals a turn for the worse and you should get out of


your position. As the position goes in your favor,

meaning that price keeps heading up, you should

continue to hold the position. The only time you

should move your stop-loss order up is when it

breaks another resistance level. Keep doing this

until your position gets stopped out, meaning

price has declined to your stop-loss level.

Let’s take NTMD as a trade example (see Figure

7.11). The double bottom pattern (discussed later in

this chapter) on the lower left corner suggests a pos-

sible trend reversal. The confirmation comes when

it breaks out of resistance 1. A long position should

be entered at around $18.45. After entering the long

7.10 Strength of Support and Resistance

� THE HEIGHT OF THE SUPPORT AND RESISTANCE would determine the strengthof those levels. The support and resistance levels for chart A would be strongerthan those for chart B because the height is greater on chart A. The width ofthe support and resistance levels would also determine the strength. The widerthe channel, the stronger the support and resistance level.



position, the stop-loss point should be at support 1.

You really do not want to see the price go below the

support. Make sure to exit the long position then.

Notice how resistance 1 also became a minor

support level. Prices came down slightly and

moved up even more. It hesitated just a little, but

broke resistance 2 fairly easily. At this point, you

can choose to move the stop-loss order to that

minor support located at resistance 1, or you can

choose to stick with your original stop-loss point at

support 1. My choice would be to move it up and

protect my capital.

7.11 NTMD Trade Example

� THIS CHART SHOWS that if you entered a trade on NTMD after it broke resistance 1, and just use the support levels asyour trailing stop, you would have capitalized very nicely on the run.


After breaking resistance 2, the price continued

upward until it found another resistance at 3. It

came down and found support just a little bit

above the previous resistance level at 2. The price

went up to test the resistance again on the second

try; then it broke it. Keep this in mind and practice

it diligently: The only time you want to move your

stop-loss point is after prices break out of a resist-

ance level. After a significant break of the resist-

ance level, your stop-loss point should be moved

to the support level below it. This is the best way to

let your profits run while controlling your losses.

After the price breaks resistance 3 at $20.40, your

stop should be moved to support 2 at around

$19.55. Once again, it finds another resistance (4) at

$21.10 and pulls back. Again that prior resistance

area turned into a support level and the selling pres-

sure turned back. Prices went up to break resistance

4, so the stop-loss point should be moved up again

to support 3. The same process is repeated again.

Price movement on the market is never a

straight-line event. It is more like a stairway. It

goes up and levels off. It gains more support

while leveling off, and then it surges upward

again. On this trade, we went from a breakout

price of $18.45 per share to a high run of $22.40;

and we are still in the trade. Already our profit is

$3.95, or +21 percent! There is still no telling when

this run will end.

The process we just described, of moving up

our stop-loss point to protect profits and minimize

losses, is called the trailing stop. You are trailing or

following the trend up. It is only when it stops

going up that you get out. Should the price of


NTMD go below our stop-loss point at any time

during the trade, we would exit the position.

For the short position, the trading strategy

should be reversed. After entering a short position,

the first place to put your stop-loss order would be

the prior resistance. A break of this resistance level

tells us that the security is stronger than we

expected and we should exit the position. In the

case of shorts, you should move your stop-loss

point down to the next resistance level when

another level of support is broken.

Now let’s take VRSN as an example (see Figure

7.12). A break of support 1 triggered an entry on

the short trade at $45. The stop-loss point should

be initially set at resistance point 1. The price

should not rise that far at all. If it is weak, then the

decline should follow through rather quickly.

Another support level later established itself at

support 2. A break of this level calls for a move of

your stop-loss point to resistance 2. Support 3

quickly sets up. When prices drop below this level,

it would be time to move the stop-loss point again.

This time, it should be moved to resistance 3. It

took a little time for the price to find support at

level 4. It took awhile for the price to reverse and

come back down and break the support.

After the break of support 4, there were two

choices for setting the stop-loss point. It could be

either resistance 4 or resistance 5. Both will work. I

usually prefer the lower level, as it protects more

profit. VRSN hit a low of $36.40, for a total possible

profit of $8.60, or 19 percent.

It is impossible to tell how big a run any trade

will give us. Traders who trade with a set profit



objective in mind have a tendency to cut their prof-

its short. Let the market tell you where it is headed.

You’d be surprised how much you leave on the

table if you have a target in mind. Learn to base

your trailing stops on support and resistance lev-

els, and your trading will improve.

TRENDLINESTrendlines are an important tool in technical

analysis. They serve to identify and confirm the

existence of trends. A trendline is simply a straight

line that connects two or more price points. To

draw a trendline, connect support points to sup-

7.12 VRSN Short Trade Example

� A BREAK OF SUPPORT 1 triggered an entry for a short trade. Using resistance 1 as the initial stop-loss point and ourtrailing stop method, we were able to capture a very large part of this run.


port points or resistance points to resistance points

(see Figure 7.13).

When the slope of the lines is positive, the

security is said to be on an uptrend. An uptrend is

characterized by a series of higher highs and

higher lows. Each rally breaks the last resistance

and goes higher. Each pullback gains support

before the last support is reached. Hence, you

have the saying “higher highs and higher lows.”

When a security is trending up, the bottom line is

more significant. If the price continues to stay

above this line, the trend is considered intact. It

indicates increasing demand and decreasing sup-


ply. A break below the bottom line tells us that

demand could be decreasing and supply could be

increasing. It is a signal that a possible trend

change is coming. A test of the most recent sup-

port level is a sign that a price could be going into

a trading range. A break of the most recent sup-

port level would confirm a new trend direction.

However, a breakout of the resistance level tells

us that the uptrend might still be intact. A new

trendline should be drawn to incorporate the last

support (see Figure 7.14).

When the slope is negative, then a security is said

to be on a downtrend. Downtrends are characterized

7.13 Stock on an Uptrend

� CONNECTING THE SUPPORTS AND RESISTANCE POINTS WITH A LINE would giveus the trendline. A stock on an uptrend is characterized by a series of higherhighs and higher lows in price. The slope of the trendlines is also up.



by a series of lower highs and lower lows. Each

decline breaks the last support, with prices going

lower than the last low. Each rally is met with sell-

ers at a lower price than the previous high. Hence,

you have the saying “lower lows and lower highs.”

When a security is trending down, the top line is

more significant. While prices continue to stay

below this line, the downtrend is considered intact.

It indicates that demand is still weak and there is

plenty of supply. A break above the top line tells us

that demand is on the rise and supply could be on

the decline. It is also a sign that a possible trend

change is on the horizon. Should the price rise to

test the most recent resistance level without break-

ing above it, a trading range could be forming. If

the price breaks above the most recent resistance

level, then the direction has probably turned

upward. However, another breakdown of a sup-

port level tells us that the downtrend might still be

intact. A new trendline should be drawn to incor-

porate the last resistance (see Figure 7.15).

A security is said to be in a trading range if there

is no trend. The trendline would be flat. Rallies end

at the same resistance levels, and declines stop at

7.14 Stock on a Downtrend

� CONNECTING THE SUPPORT AND RESISTANCE POINTS WITH A TRENDLINE on theNasdaq Composite Index allows us to easily identify the downtrend that it isin. Downtrending stocks are also characterized by a series of lower highs(resistance) and lower lows (support).


the same support levels. Another name for a mar-

ket in a trading range is a sideways market. It is

descriptive of what the market is doing. Within this

period, the market is basically doing nothing

except moving sideways. It is important to learn to

identify trends and trading ranges. Markets spend

the majority of their time in trading ranges instead

of in trends. Trading techniques are very different

during these two periods.

While the market is in a trading range, it is better

to go short at the resistance levels and go long at

the support levels. If the market is in a trend, then

you should go long at the resistance points and go

short at the support points. These two strategies are


completely opposite of each other. Without first

identifying what period the market is in, there is no

way a trader will know which strategy to use.

Also, the indicators that you would use during

these two periods will be very different. Most

traders would use trend-following indicators,

such as MACD or the moving averages, if the mar-

ket is in a trend. These indicators work best at

those times. While the market is in a trading range,

oscillating indicators work better. They identify

overbought and oversold conditions, which is usu-

ally a good time to go short or long.

As a trader, it is better and easier to trade when

the market is in a trend. When the market is in a

7.15 Stock in a Trading Range

� THE DOW JONES INDUSTRIES 30 INDEX was in a trading range for severalmonths. Notice how the slope of trendlines that connects the support andresistance points are flat.



trading range, trading tends to be choppy. I find

that I often get shaken out of a trade when the mar-

ket is indecisive and directionless. It pays to wait

for a clear trend to establish itself before taking on

a position.

1-2-3 Reversal MethodLearning to recognize the beginning of a new

trend is a big key to nice profits when the market

starts trending. In his book, Trader Vic, Victor

Sperandeo describes a method that has helped him

catch major trend reversals. The method is called

the 1-2-3 reversal.

Let’s start with an uptrend reversal (see Figure

7.16). When a security is on an uptrend, start by

drawing a line connecting the lowest low (A) to the

low of the last minor support (B). You do not want

to see any price action below this trendline. A

break of the trendline at point 1 gives the first sig-

nal that a possible trend reversal is in the making.

A successful test at point 2 of that high set at resis-

tance level C gives the second signal of a trend

change. This is a good place to go short on the

security. A break of support level D at point 3 con-

firms that the trend has, in fact, reversed.

For a security on a downtrend (see Figure 7.17),

draw a line connecting the highest high (A) to the

high of the last minor resistance (B) that came

7.16 1-2-3 Reversal Method

� THE 1-2-3 REVERSAL METHOD allows us to quickly identify when a trend hasreversed. This is an example of an uptrend reversal. At point 1, you have toidentify a break of the trendline. At point 2, you have a failed test of theprevious high. The Nasdaq Composite was unable to breakout of the previousresistance at level C. At point 3, the Nasdaq composite confirms a trendreversal when it broke the support level D.


before the lowest low (C). Make sure there isn’t

any price activity above this trendline. The signals

will come as follows. First, a break (1) of the trend-

line signals a possible direction change. The sec-

ond signal is a successful test (2) of the support of

the lowest low (C). This is good place to be long on

the security. The last signal is a break (3) through of

the last resistance level (D). This serves as a con-

firming signal that the trend has turned around.

The trend is your friend. For intraday trading,

there is nothing better than following the trend.

Whether you want to scalp or swing trade, make

sure that you trade on the side of the trend. Many

traders love to trade against the trend. They try to

catch the bottom or the top. They risk a lot and


make very little. It is not a good way to trade. Here

are some guidelines when trading with trendlines.

Angle or SlopeThe most important feature to watch on a trendline

is the slope. It identifies which side is in control of

the market. If the slope is up, buyers are in control.

Demand is high and supplies are low. The direc-

tion of the trade should be only long. If the slope is

down, sellers are in control. Supplies are high and

demand is low. Take only short positions. You

need to watch the angle of a trendline. A security

with a very steep angle of ascent has a very high

possibility of running out of steam quickly. This is

the same when it comes to the angle of decline. A

7.17 1-2-3 Reversal Method

� THE 1-2-3 METHOD can also identify a downtrend reversal. At point 1, youhave a break of the trendline between points A and B. At point 2, you have asuccessful test of the lows. LUME was unable to go below the resistance levelC. Confirmation of the trend direction change came at point 3 when pricebroke past resistance level D.



very steep decline is a signal of panic selling.

Sooner rather than later, the selling will be done

and the rebound will be just as hard. When the

angles of the trendlines begin to accelerate, it is a

good sign that the trend might soon be coming to

an end. Many astute traders would begin to look

for points to exit their positions (see Figure 7.18).

As you look at Figure 7.18, check the difference

between the angle of the incline on trendline A ver-

sus the one on trendline B. Notice how much

steeper the angle is on this newer trendline. Once

the prices break (C) below the trendline B, it

turned back up again to hit the trendline from

below before heading back down.

Notice the similarities between support/resis-

tance levels and trendlines. While prices stay

above the trendline, it acts as a support level. Once

there is a significant break of the trendline, it will

often turn into the resistance level. This gives

traders a good opportunity to exit long positions

and enter short positions.

For traders who like to “short the tops,” here is

a better way to trade. It is a lot better to wait until

there is a trendline break before going short. I

would then wait for the price to rebound back or

just close to the trendline and then enter the short

position. This increases the odds of your success

tremendously. The reversals at these points are

usually a lot more powerful. The reward-to-risk

ratio is also a lot better at those points.

7.18 When the Slope of Trendlines Increase

� INCREASING TRENDLINE SLOPE can mark the possibility of an uptrendreversal. The slope of trendline B was a lot steeper than trendline A. Priceswere unable to sustain themselves and made a 1-2-3 reversal afterward. Oncetrendline B was broken at point C; this line later became the resistance atpoint D. Point D was a good place to initiate a short position on this stock.


This process is the same when a stock or secu-

rity is on a decline. Let’s take a look at the S&P 500

index (see Figure 7.19). Again, pay attention to the

increasing slope between trendline A and trend-

line B. After the steep drop, prices rebounded back

and broke the trendline at point C. The next

decline came in very close to the trendline before

reversing and heading up.

Different Time FramesDifferent time frames can and will produce differ-

ent results. That is why it is necessary to begin

your trading career by deciding what type of trad-

ing you want to do. If it is scalping, you should

pay attention to the trend on a tick chart or a one-

minute chart. With intraday trend trades, the


three-minute or the five-minute chart may work

best. If you are intermediate term, you should use

the daily chart.

You will find smaller trends within all the dif-

ferent time frames. Some of them may conflict

with the bigger trend, while others might confirm

it. To put it another way, a weekly chart might

show an uptrend, but the trend could be down in

one or two of those five days that make up the

information on that week. You can further break

this down into a trading day. The fact that the day

ended up does not mean the trend for the whole

day was up. You could have several smaller trends

working against each other to form the end result

of the day.

What time frame should you use? If I were

7.19 When the Slope of Trendlines Decrease

� WHEN THE SLOPE OF A TRENDLINE DECREASES, it can mark the possiblecoming of a downtrend reversal. Comparing the slope of trendline A and B, wecan easily see that the slope has decreased significantly. Again, we can seehow nicely the 1-2-3 reversal method identified the trend reversal afterward.Notice how trendline B turned from being a resistance into a support later on.



intraday-trend trading, I would first use the bigger

trend on the daily chart. Usually, the moves tend to

be stronger when the intraday trend goes in the

same direction as the daily trend. If I were scalp-

ing, then the trend on the five-minute chart mat-

ters more than the trend on the daily chart. My

trend concerns are focused on the next bigger time

frame. If the two trends match up, then the trade

usually goes a lot better for me. The chances of a

successful trade are also increased.

Logarithmic versus Arithmetic ScalingLogarithmic or arithmetic scaling makes a differ-

ence in trendlines. Should you go for logarithmic

or arithmetic scaling? Again, the answer depends

on your style of trading. For shorter time frames,

arithmetic scaling seems to work better than loga-

rithmic scaling. This is because the range usually is

not big enough to make much of a difference to be

scaling otherwise. I have always kept an arith-

metic scale on my intraday trading activities. It has

worked for me and I am sure it will work for you.

For longer-term trading, logarithmic scaling is

probably the way to go. It allows the trader to com-

pare the rise and fall as a percentage. It puts every-

thing into a better perspective instead of

magnifying it as arithmetic scaling would. As you

can see in Figure 7.20, a view of Qualcomm toward

the end of the Internet bubble, stocks with big ver-

tical moves are better viewed in logarithmic scale.

Trendline ValidityIn order to draw a trendline, you need to connect

at least two (2) low points or two (2) high points in

the chart. The more points these lines connect to,

the more valid the trend. This is the same school of

thinking as the theory of support or resistance.

Trendlines also act as a support or resistance area.

When the price pulls back down to the trendline,

traders who have missed the initial run are waiting

on the sidelines for pullbacks or bounces. If a lot of

these pullbacks or bounces are bought or sold into,

then the trend is confirmed and it is a lot more

valid. What we do not want to see when marking

trendlines is the acceleration away from the lines.

This is a signal that panic buying or selling is

occurring and that a reversal may be imminent.

GAPS

A gap occurs when the opening price is signifi-

cantly different from the closing price. The gap

could be up or down depending on the buying or

selling pressures that built up between trading

periods.

More often than not, gaps are news-driven. Pos-

itive news generates buying interests and negative

news brings in sellers. If a company reports good

earnings that beat estimates after the market

closed, buying interest will be generated overnight.

If a company misses estimates, selling interests will

come in overnight. Winning a large contract is pos-

itive news. When a biotech company fails to get

FDA approval for a drug, it is very negative news.

So is bankruptcy. As technical analysts, you do not

need to read every piece of news on the wire. The

news itself does not matter much. Price action tells

it all. What matters is whether the opening price


gaps up or down and whether a news event is

behind this gap. The most powerful and reliable

signals that gaps can generate are those that come

without any news.

When buying pressures build up overnight,


market makers and specialists are faced with an

order imbalance. There are more orders to buy

than to sell. In order to find equilibrium, they need

to move prices higher to find more sellers. This

way, they can transact all the buy orders they have.

7.20 Trendlines on Logarithmic and Arithmetic Scale

� LOGARITHMIC AND ARITHMETIC SCALING affect the slope of the trendline you draw. Both of these charts are of the same period on QCOM. The onlydifference is the scaling. Notice how much steeper the trendlines are on thearithmetic scale. For analysis over longer periods, it is better to use thelogarithmic scale.



Prices open at a much higher price than the previ-

ous close. If the opening price is higher than the

high of the previous session, then it is considered a

full gap up. Otherwise, it is known as a partial gap

up. Depending on your trading style, full gaps and

partial gaps present their own unique trading

opportunities. Long-term traders concern them-

selves with full gaps, while the short-term traders

benefit from both partial gaps and the full gaps.

When selling pressures build up overnight,

market makers and specialists are faced with sell

order imbalances. More orders to sell than to buy

have come in while the market was closed. To bal-

ance these orders and get them executed, the mar-

ket maker or specialist brings the price down to

attract more buyers. This is why prices open at a

lower price than the previous session. If the open-

ing price is lower than the previous session’s low,

then it is considered as a full gap down. An opening

price that is higher than the previous session’s low

will be considered a partial gap down. Short- and

long-term traders can also find opportunities in

these gaps.

The types of gap that interest me more are the

full gaps. They can be up or down. A full gap up

has to open above the previous session’s high, and

a full gap down has to open below the previous

session’s low. These generate more powerful sig-

nals and can be traded with much better reliability

and success. With more than 9,000 different stocks

available to trade in the United States, you will

find these gaps occurring on a daily basis. Concen-

trating on these setups alone can be profitable.

There are several types of full gaps. They are

common gaps, breakaway gaps, continuation

gaps, and exhaustion gaps. Learn to distinguish

each of their characteristics early and you can get

in early on powerful trends.

Common GapsAs the name implies, common gaps occur more

frequently than other gaps. They tend to show up

a lot more during a sideways market. For trading,

they are considered the least important of all the

gaps. There is no follow-through; prices tend to

return to the gap; and the gap is quickly closed

within a few days.

You can spot these gaps by checking volume.

Volume usually increases, but is never extremely

high. This slight increase shows the gap’s failure to

generate buying interest. Buyers and sellers are

indifferent. This is confirmed by the lack of follow-

through to a new high or new low.

Most professionals would trade against the

direction of common gaps. Because prices tend to

return and close the gap, a nice profit can be made

by trading against the gap. The practice of trading

against the gap is also called fading the gap. When

you fade the gap, wait for confirmation of the

directional change. Then act on it. It is never a

good idea to jump in without proof. Use the 1-2-3-

reversal method or the break of support or resis-

tance levels to enter these trades. Remember, the

trade should be against the direction of the gap. If

the gap is up, then your trade should be to go

short. If the gap is down, then your trade should

be long.

The Intel chart in Figure 7.21 shows many


common gaps. On all the common gaps, volume

either shrank or stayed the same. Increases were

slight and insignificant.

Breakaway GapsBreakaway gaps are one of the most powerful sig-

nals in trading. They occur when prices take off

from an area of congestion and start a new trend.

Heavy volume confirms the move. This gap can

remain open for a long time. Prices usually follow

through to the direction of the gap within a short

period of time.

A breakaway gap to the upside is usually fol-

lowed by new highs for a few days in a row. A

breakaway gap to the downside establishes a new


low for several days in a row. Getting in on these

gaps early can result in a nice profit.

Volume levels are the best confirmation of these

gaps. They should be high on the day of the gap. I

like to see a minimum 100 percent increase in vol-

ume. There is no maximum volume number. The

higher the volume, the more powerful the move

will be. Heavy volume comes only with institu-

tional participation. With an upside gap, heavy

volume means that institutions are buying aggres-

sively. Institutions such as mutual funds tend to

hold onto their positions for the long term. If

mutual funds are buying and holding, you will

have decreasing supply. If demand stays constant,

then prices should head up soon.

7.21 Common Gaps

� COMMON GAPS HAPPEN VERY OFTEN. They show up more often on a sidewaysmarket. INTC is in a trading range. In this chart, I have identified five of thesegaps. Notice how little change there is on the volume on these gaps. It eithershrank or stayed basically the same.



On a downside gap, heavy volume is a good

indication that institutions are selling aggressively.

There probably has been a fundamental change in

the security, and institutions are unloading their

positions. When mutual funds get rid of their

shares, supplies to the public will rise. A rising

supply with constant demand is a good recipe for

the price to drop.

On the days following the breakaway gap, vol-

ume should remain higher than normal for several

days in a row. It is a good sign of continuing pres-

sures around the security. Professionals do not

trade against the direction of a breakaway gap.

Once volume confirms the gap, they will trade

with the gap. If the gap is to the upside, go long

early and place a protective stop at the lower rim

of the gap. Once it is profitable, use a trailing stop

to exit the position.

In the IBM example shown in Figure 7.22, the

breakaway gap took the stock from a price of $96

to a high of more than $130 in a few months.

Notice that the gap was confirmed in the next few

days by a higher high and above-average volume.

This came with a more than 100 percent increase

in volume. Getting in early on the long side is ben-

eficial.

Our next example is a company called Copper

Mountain Networks (CMTN), another high flyer

7.22 Bullish Breakaway Gaps

� THIS CHART SHOWS A BULLISH BREAKAWAY GAP on IBM. There are twoconfirmations for this type of gap. The first is the heavy volume found on thefirst day of the gap. The second is the follow-through on the prices. IBMestablished higher prices on the next two trading sessions.


during the Internet bubble. A breakaway gap

marked the end of the uptrend and the beginning

of a long, long downtrend, as shown in Figure 7.23.

An early short trade on CMTN would have made

a lot of money. From a gap down price of $105.88,

the stock eventually ran down to $0.65. New lows

and above-average volume validated the break-

away gap. With a breakaway gap to the downside,

the initial stop-loss point should be placed just

above the low of the previous day. A valid break-

away gap should never close the gap and get that

far up in price. Once the position becomes prof-

itable, I would use a trailing stop to maximize

profits.

Although I love to talk about winners, paying


attention to losers is important. The next example,

eBay, shows a case of failure.

As shown in Figure 7.24, eBay had a break-

away gap on October 19. Volume confirmed the

move early in the day. It ended with nearly dou-

ble the average volume. However, volume fell on

the days following the breakaway gap. Newer

lows were not established. Instead, the price

moved up to fill and close the gap. This position

should have been exited when the price failed to

establish newer lows. At the least, the position

should have been stopped-out once it broke the

rim of the gap (marked by the stop-loss point on

chart). It is better to exit this position and reeval-

uate the opportunity.

7.23 Bearish Breakaway Gaps

� THIS IS AN EXAMPLE OF A BEARISH BREAKAWAY GAP. Heavy volume and adownward follow-through in price are the confirming signals you are lookingfor. CMTN reversed its uptrend on this breakaway gap and completelycollapsed in price in the following months. Note the placement of the stop-loss point if you had entered a short trade on the breakaway.



As you can see from this example, breakaway

gaps can still fail. That is the nature of trading.

There is only one sure thing in this business: You

will, from time to time, take a loss. As long as the

loss is controlled, you stand to make a lot of

money, especially if you let your winners run.

Continuation GapsContinuation gaps occur much like breakaway

gaps. The main difference is that they occur in the

middle of a powerful trend instead of at the begin-

ning. Volume is also a confirming factor, but usu-

ally the increase is not as heavy as in the

breakaway gap. A stock with a 50 percent increase

in volume qualifies as a possible continuation gap

candidate.

The last confirmation comes when prices reach

new highs or new lows for several days after a gap.

An exhaustion gap might be in the works if prices

fail to follow through. Once confirmed, continua-

tion gaps provide a good target for how far the

trend is likely to go. First, measure the initial move

from the base of the reversal to the gap. Then pro-

ject this from the gap in the direction of the trend

to get your profit-taking point.

Professionals trade continuation gaps like a

7.24 Failed Breakaway Gap

� NOT ALL BREAKAWAYS WORK OUT AS EXPECTED. This chart of eBay is just aquick reminder that they can fail. Even though we had volume and priceconfirmation on this eBay trade, the stock rose and hit our stop-loss point. Thistrade was exited with a loss. If we held on longer (hoping that things wouldturn), the small loss would have become a lot greater as the price of eBay rose to over $65.


breakaway gap. They trade with the trend, in the

same direction of the gap. If the gap is to the

upside, they go long. A stop-loss order is placed

just under the high of the previous day. If the gap

is to the downside, they go short. A stop-loss order

should be placed just above the low of the previ-

ous day. A valid continuation gap should follow

through in the same direction quickly. Bounces

and pullbacks should never get that far up or

down (see Figure 7.25).

The chart on eBay shows a continuation gap on

April 18. Volume had a slight increase of 50 per-

cent. Confirmation came when volume continued


to stay high and actually surged by 100 percent on

the second day after the gap. The price also con-

firmed the move with new highs.

You would go long on this position. Your stop-

loss point would be slightly below the rim. Prices

should not drop that far down. To get your initial

profit target, measure the distance between point

A and point B. Project this value to arrive at point

C. The two distances should be equal. Once the

price gets to your projected profit point, tighten

your stop. While buying momentum remains

strong, hold the long position. Maximize your

profits with the use of a trailing stop to exit.

7.25 Continuation Gap

� A CONTINUATION GAP occurs after a stock has already raised off its bottom.Volume and price follow-through are the confirmations you are looking for.You can easily estimate the move on a continuation gap by measuring thedistance between points A and B and projecting that upward. This should allowyou to get the price target at point C.



Exhaustion GapsExhaustion gaps appear at the end of a trend.

Prices do not follow through to a new high during

an uptrend; or, during a downtrend, the price fails

to establish new lows. Instead, the direction turns

around and the gap is closed. At first glance,

exhaustion gaps look like continuation gaps. Vol-

ume comes in at a high level. But the price fails to

follow through to the direction of the gap. Confir-

mation comes when the price reverses back into

the gap and closes the gap.

Exhaustion gaps offer excellent trading oppor-

tunities. They mark the end of a trend. Profession-

als would trade in the opposite direction of the

gap. If the direction of an exhaustion gap is down,

the trader would go long once prices break back

into the gap. A protective stop should be placed

slightly below the most recent low. If the direction

of an exhaustion gap were up, go short once the

price breaks below and starts filling the gap. Place

a stop-loss order slightly above the most recent

high. The chart of IBM in Figure 7.26 shows an

exhaustion gap. After the gap, the price failed to

establish new lows except for the day after. Price

then went sideways. This tells us that the bears

have lost control of the market and the bulls are

now evenly matched. A break to the upside con-

firms the exhaustion gap.

7.26 Exhaustion Gap

� THIS TYPE OF GAP occurs at the end of a trend. On a downtrend, prices areunable to follow through to the downside. Instead, they consolidate and beginto close the gap. Enter a long trade when prices move back into the gap, andplace a stop-loss at the last support.


A long position should be entered once it breaks

back and starts filling the gap at $105. A stop-loss

order should be placed just below the low estab-

lished on July 6 at around $99. Use the trailing stop

techniques described earlier in the support and

resistance section to maximize profits on this trade.

Note that IBM rose to a high of $134 after the trend

reversed on an exhaustion gap (see Figure 7.26).

BASIC CHART PATTERNS

All traders should have the ability to recognize

basic chart patterns. They are popular and widely

followed. Because they are widely followed, the

patterns have a tendency to follow through. The

following are some of the most basic patterns.

Double Top and Double BottomDouble top and double bottom patterns are gener-

ally found at the end of a trend. They are also

called trend-reversal patterns.

The double top pattern is considered bearish. It

is usually found at the end of an uptrend and looks

like the letter M. The two peaks, or “tops,” in price

characterize this pattern. Volume on the second

peak is usually lower than on the first peak. This

gives you a clue to the possible formation. Interest

has waned. Buyers are not pushing the price up on

the second run. This pattern is formed with the

break of the last support, also called the neckline

(see Figures 7.27 and 7.28).

A good example of the double top pattern was

formed by the Nasdaq Composite in 2000 (see the

chart in Figure 7.29).


● There is a clear uptrend.

● Two peaks were formed.

● Volume on the second peak dried up, which means

buyers could be exhausted.

The most popular way to trade this pattern is to

go short after the price breaks below the neckline.

The maximum stop-loss point would be at the

7.27 Double Top Pattern

� DOUBLE TOP PATTERNS are usually bearish, occurringat the end of an uptrend.

7.28 Double Top Trade Setup

� A DOUBLE TOP PATTERN should be traded on the shortside. Enter into a short position once the prices havebroken the neckline. Place a stop-loss order slightlyabove the second peak.



7.29 Nasdaq Composite Double Top

� SPOTTING THE NASDAQ COMPOSITE DOUBLE TOP would have saved a lot ofheartache for the average investor. It had a great uptrend going at point 1. But,it formed the two peaks at point 2. Volume confirmed this pattern at point 3.Notice how much lower volume was on the second peak. This tells us that thebuyers were completely exhausted. They did not have the strength to move theprices up any further.

7.30 Double Bottom Pattern

� DOUBLE BOTTOM PATTERNS are bullish patterns. Theyoccur very often at the end of a downtrend.

7.31 Double Bottom Trade Setup

� A DOUBLE BOTTOM PATTERN should be traded on thelong side. Enter a long position when the price breaksthe neckline. Place a stop-loss order slightly below thesecond bottom.



neckline with a stop below the second bottom (see

Figure 7.31).

The example CTXS chart in Figure 7.32 shows a

classic double bottom.

● There is a general decline in pricing.

● Two bottoms have formed.

● Volume dries up on the second bottom

● Note, volume returns on the breakout.

● In the case of a double bottom pattern, go long once

the price has broken past the neckline.

● The maximum stop-loss point would be at the second

bottom.

7.32 CTXS Classic Double Bottom

� (1) AN INITIAL DOWNTREND, (2) TWO CLEAR BOTTOMS, AND (3) DECREASINGVOLUME between the first and second bottoms make this a classic example ofa double bottom pattern. Go long when prices get past the neckline.

second peak (see Figure 7.28). Double bottom pat-

terns are bullish. They are found at the end of

downtrends. A double bottom looks like the letter

W (see Figure 7.30). The two lows, or “bottoms,” in

pricing characterize this pattern. Volume on the

second bottom is usually a lot lower than on the

first. This means selling interest was not as strong

as during the first run. The sellers are unable to

break past the last support level. Buyers have

pushed the price up. This pattern is formed with

the break of the last resistance, also called the neck-

line. The most popular way to trade a double bot-

tom pattern is to go long after prices break the


ability of resolving to the upside. This is why sym-

metrical triangles are often called continuation pat-

terns and can be bullish or bearish, depending on

the trend prior to the pattern formation.

There are two ways to trade triangles. The first is

to determine whether the stock was in an uptrend

or a downtrend prior to the pattern formation.

With an uptrend, enter on a break of the trend-

line. The stop-loss point should be at the last sup-

port. The initial target is a break of the highest

resistance (see Figure 7.34A).

With a downtrend, also enter on a break of the

trendline. The stop-loss point should be at the last

resistance. The initial target is a break of the lowest

support (see Figure 7.34B).

Ascending triangles are considered bullish

because they typically resolve to the upside. They

are more reliable when found in an uptrend. Price

resistance causes the top part of the triangle to be

formed. Buyers become exhausted when the price is

reached. However, the selling pressure weakened


TrianglesThere are several types of triangles, including

symmetrical triangles, ascending triangles, and

descending triangles.

A symmetrical triangle pattern can be both a

bullish and a bearish pattern. It is an area of inde-

cision where buying and selling pressures are

almost equal. Each wave of buying is met with

sellers, and waves of selling are met with buyers.

The effect is that the most recent high is lower than

the previous high and the most recent low is

higher than the previous low. In effect, there is no

trend to follow. The shape formed during this

period is a sideways triangle. Typically, volume

diminishes during this period (see Figure 7.33).

Eventually, the period of indecision is resolved.

Prices move out of the formation on heavy volume.

These patterns are likely to end up in the direction

of the original trend. If the price was in a downtrend

prior to this pattern, it will probably explode to the

downside. If it was in an uptrend, it has a high prob-

7.33 Symmetrical Triangle Pattern

� THIS PATTERN MARKS A PERIOD OF INDECISION. It can be bullish or bearish.Its nature depends on the prior price action. If prices were on an uptrend, thenthis pattern is bullish. If they were on a downtrend, then this pattern is bearish.


every time, causing a higher low to be formed.

These higher lows cross the upward-slanting line

when you connect the lows.

The price eventually breaks through the resist-

ance, and the price goes up. It should be noted that

volume usually decreases while it is moving side-

ways and resurfaces again on the breakout (see

Figure 7.35A).


For the ascending triangle, make sure of the

trend prior to its formation. Unless it was on an

uptrend, it is best not to trade this pattern. If it is on

an uptrend, enter a trade if the stock breaks the last

resistance. The stop-loss point should be at the last

support (see Figure 7.35B).

Descending triangles are generally considered

bearish. They are more reliable to trade when

7.34 Symmetrical Triangle Trade Setup

� WITH AN UPTREND, enter the trade on a break of the trendline; stop-loss should be at the last support. On a downtrend,also enter the trade on a break of the trendline; stop-loss should be at the last resistance.

7.35 Ascending Triangle Pattern and Trade Setup

� THIS BULLISH PATTERN is characterized by a series of higher lows, with the highs ending in the same resistance level.Enter a long trade once the price has broken through the resistance. Place a stop-loss order slightly below the last minor support.

A B

A B



found on a downtrending stock. Unlike the

ascending triangle, it is the bottom that appears

flat. The top part of the triangle slants downward.

The initial drop attracts buyers at the support

level, and the selling pressure ends. Price reverses

and is later met with selling.

The selling pressure ends around the support

level, but this time, the buying pressure ends up a

lot weaker. It does not go as far as the previous

run. This establishes the lower high. Eventually,

the selling pressure breaks the support level,

bringing in a new wave of sellers as traders exit

their positions. Like the previous triangle forma-

tions, volume tends to diminish, and it forms the

pattern and returns on the breakdown of the sup-

port (see Figure 7.36A).

With descending triangles, make sure the trend

prior to formation was down. My entry would be

after the stock breaks the price-support level. The

stop-loss point should be at the last resistance (see

Figure 7.36B).

Head and Shoulders TopThis is generally regarded as a reversal pattern. It

is a bearish pattern. You often see these patterns at

the end of an uptrend. They tend to be more reli-

able when found there. The left shoulder is started

on a normal breakout with heavy volume. At the

peak of the left shoulder, sellers were able to

reverse the trend and push the prices back down.

The support that it finds on the sell-off marks the

beginning neckline. (See Figure 7.37.)

From the support area, buyers were able to

push the price to a new high. This marks the top of

the “head.” The head is usually formed on

decreasing volume. This indicates that there were

not as many buyers on this last wave. The head is

formed when the selling pressure is strong enough

to break the uptrend line. It reverses only at an

area of previous support. The point of reversal

marks the continuing neckline. (Connect the

beginning neckline and the continuing neckline to

determine the trendline.)

7.36 Descending Triangle Pattern and Trade Setup

� THIS BEARISH PATTERN is characterized by a series of lower highs, with the lows ending in the same support level.Enter a short trade once prices have broken through the support. Place a stop-loss order slightly above the last minor resistance.

A B


However, this next rally fails to take out the pre-

vious high. The peak of this rally marks the right

shoulder. A break of the neckline would complete

the right shoulder formation and the head and

shoulders pattern. Volume on the right shoulder is

usually lighter than at the head. This indicates that

buyers are exhausted. A break of the neckline usu-

ally brings in more sellers and an increase in vol-

ume, as buyers are now getting out of their

positions (see Figure 7.37).

How do you trade this pattern? The best trade is

usually to go short when the price breaks the neck-

line. If you miss the first entry, the pattern often

gives you another chance by pulling back to the

neckline once more. The stop in both cases would

be placed at the high on the right shoulder.


The good thing about a head and shoulders for-

mation is that it gives you an idea of the possible

depth of the run. Your profit target can easily be

estimated by measuring the distance between the

head and the neckline. If A is the distance from the

head and the neckline, then you should see an

approximate price decline of B, where B is the

same value as A.

Suppose the head has a price of $50 and the

neckline is at $45. The value of A would be $50

minus $45, or $5. Research has shown that the

probability of decline B equaling the value of A is

very high. If we entered at the neckline $45, we can

hold until it gets near the $40 mark. This is because

when B equals A, a value of $5, then $45 minus $5

will give us a target price of $40 (see Figure 7.38).

7.37 Head and Shoulders Top Pattern

� THIS PATTERN IS GENERALLY BEARISH, and can signal a downside reversal.Three peaks characterize it. They are the left shoulder, the head, and the rightshoulder. Notice the lower right shoulder. This tells us that buyers wereexhausted even before prices rose to the previous high.



Reverse Head and ShouldersThe reverse head and shoulders pattern is also

known as an inverted head and shoulders pattern,

or the head and shoulders bottom. This is a reversal

pattern. It is, however, a bullish pattern. These pat-

terns are most reliable when found at the end of a

downtrend. Buyers enter the picture at the low

found on the left shoulder. The point that selling

pressure overpowers the buyers again marks the

beginning neckline. The return of sellers to the

market ultimately pushes the price to a new low

“head” (see Figure 7.39). However, this new low is

quickly turned back. In this case, the buying pres-

sures are strong enough to break the trendline and

test the last resistance. Selling pressures reemerge

and the market falls again.

This time, however, the selling pressure fails to

take out the last low. This higher low forms the

right shoulder. The neckline is drawn from the

points of the last two resistance levels. A break of

the neckline completes the reverse head and shoul-

ders pattern. Volume in this case would be heaviest

on the left shoulder and decline into the head, and

it would decline even more into the right shoulder.

7.38 Head and Shoulders Top Trade Setup

� YOU CAN ENTER THIS TRADE AT TWO POINTS. The first is on the break of theneckline. Usually, prices will give you a second entry on this trade when itbounces back up. The neckline (previously a support level) will now becomethe resistance. In both cases, enter a short position. Place a stop-loss order atthe last minor resistance. Your profit target can be calculated by measuringdistance A between the head and the neckline and projecting it down. Thedistance between A and B should be equal.


This shows that sellers are getting weaker and

weaker. They are completely exhausted at the right

shoulder and unable to bring the price to a new

low. It should be noted that volume usually comes

in during the rally off the low. Pushed by this

added volume, the buying pressure breaks the

trendline. Finally, volume comes in again at the

break of the neckline.

Here’s the best method of trading a reverse

head and shoulders formation: Go long on the

stock after it breaks the neckline. Again, these pat-

terns have a tendency to pull back for a second

entry. Usually, this shakes out weak traders who

are not sure of the position. They get shaken out on

this pullback only to see the price go away from


them. The stop-loss point in both cases would be at

the last support (see Figure 7.40).

The target is measured the same way as the

head and shoulders pattern. The distance between

the neckline and the head gives you a good idea of

how far it will run.

WedgesThe wedge formation appears similar to the sym-

metrical triangle. Both patterns have trendlines

that intersect or converge. However, the difference

between the two patterns is a noticeable slant,

which can be upward or downward in direction.

If the slant is downward, it is considered a

falling wedge. A falling wedge is generally a

7.39 Reverse Head and Shoulders Pattern

� THIS PATTERN IS GENERALLY BULLISH. You will find three bottoms on thispattern. They are also called the left shoulder, the head, and the right shoulder.In this case, the right shoulder is higher than the head. This tells us the sellingpressures were unable to bring the prices down as hard as in the priorsession.



bullish pattern, whether found on an uptrend or a

downtrend. This pattern is characterized by a

series of lower highs and lower lows.

An upward slant is considered a rising wedge

(see Figure 7.41A). The rising wedge is considered

a bearish pattern whether it is found on an uptrend

or a downtrend. This pattern is marked by its

series of higher highs and higher lows.

As with triangles, volume usually falls during

the period of sideways movement (see Figure

7.41B). It generally returns on the breakout or a

breakdown of the formation. The best way to trade

wedges is to wait for a break to the upside or

downside. Go long on a falling wedge or go short

on a rising wedge once a break occurs. Your stop-

loss point should be at the last support for a falling

wedge and at the last resistance for a rising wedge.

Flags and PennantsFlags and pennants are usually considered contin-

uation patterns. They typically occur right after a

big, quick surge or a big drop in price. The market

at this point is pausing and consolidating. It is get-

ting ready for the next move. Research has shown

that flags and pennants are reliable continuation

patterns.

7.40 Reverse Head and Shoulders Trade Setup

� THERE ARE ALSO TWO ENTRY POINTS FOR THIS TRADE. The first is on the breakof the neckline and the second entry is when prices pull back down to theneckline. Notice how the prior resistance level now becomes a support. In bothcases, enter a long position. Place a stop-loss order at the last minor support.To get a profit target, calculate distance A between the head and the necklineand project it up. The distance between A and B should be equal.


Bullish flags are formed by a series of lower

tops and lower bottoms, with a pattern slanting

against the trend. However, unlike wedges, their

trendlines run parallel to each other. On the other

hand, bearish flags are made up of a series of high

tops and higher bottoms, and their trendlines also

run parallel to each other (see Figure 7.42).

Pennants look like symmetrical triangles. The

only difference is that pennants are usually smaller

in size and much shorter in duration. The market

is merely taking a brief pause from its rapid rise or

rapid fall.

The trade for both pennants and flags has to be

in the original direction of the large move. If the

prior move is up, get ready to go long when it

breaks the trendline. If the prior move is down, get

ready to go short when the price breaks the trend-

line. Volume is a big indicator of this pattern. For

both pennants and flags, it should contract on the

sideways move and increase again on the breakout.


RectanglesRectangle patterns contain price movements

within two parallel trendlines, or a channel. The

price stays within the channel because buyers and

sellers are evenly matched. The upper line of the

rectangle represents resistance, where the sellers

turn back the buyers. The lower line represents

support, where the buyers turn back the sellers.

Rectangles are also a type of continuation pat-

tern. They tend to move to the original direction of

the trend. The longer the rectangle, the more pow-

erful the move will be (see Figure 7.43).

There are two ways to trade rectangles. The first

method involves trading while the issue is still

within the channel. Look at the trend. If the origi-

nal trend is up, go long at the support area with a

stop just below this area. Your initial target is to

sell the position when it gets to the resistance level.

However, if there is a lot of buying momentum,

consider holding the position a little longer to see

7.41 Rising and Falling Wedge Pattern

� THE FALLING WEDGE IS A BULLISH TRIANGLE PATTERN whether found in a downtrend or an uptrend. Notice the downwardslant of both trendlines. The rising wedge is a bearish triangle pattern. It does not matter if the prior trend is up or down.Notice how both trendlines are slanted upward.

A B



if it will break out of the channel. If the original

trend was down, go short at the resistance level

with a stop just above that level. The initial target

would be the support level. If the position gets to

the support level with increasing volume, you

might consider holding a little longer to see

whether the selling momentum is able to break the

support level (see Figure 7.44).

The second method is to wait for a break of the

support or resistance, then enter on the pullback or

the bounce. It is common to see support and resis-

tance areas swap duties once a break occurs. A

support area usually becomes the resistance, while

a resistance area turns into the support area. This is

where I would enter the trade.

Once I enter the trade, my stop-loss point

7.42 Flags and Pennants Pattern

� TWO THINGS DEFINE THE FLAGS PATTERNS. The first is the large “pole,” andsecond is the short period of consolidation. The consolidation period looks likea rectangle but is slanted. For bull flags, the slant is downward. For bear flags,the slant is upward. Pennants are also defined with a pole and a consolidationperiod. However, in this case, the consolidation period resembles a smallsymmetrical triangle.


would be set just slightly below the breakout or

breakdown point. If the break is valid, the price

should not move back into the rectangle. The easi-

est way to project the initial price target would be

to measure the height of channel A in Figure 7.45.


The price rise B should equal the height of the

channel.

There is also a way to project the maximum

price rise (see Figure 7.46). It is done by measuring

the length of the rectangle (C) and projecting it

7.43 Rectangle Pattern

� THE RECTANGLE IS A CONTINUATION PATTERN. It can signal eitheraccumulation or distribution. If the prior trend was up, then this pattern isbullish. If it was down, then this pattern is bearish.

7.44 Rectangle Trade Setup Number 1

� ONE OF THE WAYS YOU CAN TRADE THE RECTANGLE is to capture the range it is in. If the stock is previously on an uptrend,go long when prices fall to the support level. Place a stop just below the support. Take profits when it goes back up to theresistance level. If the stock is previously on a downtrend, go short when prices bounce off the resistance level. Place astop just above the resistance. Take profits when it falls to the support level.



vertically (D) from the breakpoint (support line if

bullish and resistance line if bearish). Remember,

in this case, this is the maximum price rise you can

expect. The probability of the price reaching this

point is not as high as the probability of it reaching

the initial price target (see Figure 7.46).

With these patterns, volume tends to decrease

while the stock is moving sideways. A break of the

support or the resistance is usually followed by a

marked increase in volume. If volume failed to

materialize on the breakout, the move is more sus-

ceptible to failure.

Rounded Bottoms and Rounded TopsA rounded bottom can be a bullish reversal pattern

or a continuation pattern. It consists of a long side-

ways move in which the pattern resembles the

shape of a saucer, called the saucer pattern.

As a reversal pattern, the duration has to be a lot

longer. It is a period of consolidation in which sen-

timent turns from bearish to bullish. Ideally, the

low established on the rounded bottom is a signif-

icant low. The low of the pattern should not equal

more than a 50 percent retracement of the run. As a

rule, the lower the value of the pullback, the faster

it will break out. In both cases, the wider the con-

solidation period, the harder and longer the secu-

rity will tend to run.

The rounded top is basically an upside-down

pattern of the rounded bottom. It is a bearish pat-

tern whether found on an uptrend or on a down-

trend (see Figure 7.47). The best way to trade a

7.45 Rectangle Trade Setup Number 2

� THE SECOND WAY TO TRADE A RECTANGLE is to wait for it to break the support or resistance level. Go long once it breaksthe resistance level. Place a stop just below the last resistance. If prices were to break a support, go short on the bounceback to the support level. Place a stop-loss order just slightly above the support level. Calculate your initial price target bymeasuring distance A between the support and resistance levels. Project up or down, depending on long or short, to getyour target. Distance A should be equal to distance B.


rounded top is to go short on a breakdown of the

rim. With a rounded bottom, go long on a breakout

of the rim. The initial target point would be the dis-

tance between the rim and the high or the low,

depending on the pattern. The breakout or break-

down should be accompanied by strong volume.

The stop-loss point should be slightly inside the

support or resistance level or the rim. Like the rec-

tangle, a valid break should not come back too far

into the pattern.

Cup with HandleWilliam O’Neil, founder of Investor’s Business

Daily, popularized the concept of the “cup with

handle” in his 1988 book, How to Make Money in


Stocks. It is considered a bullish continuation pat-

tern. A prior uptrend must exist. It is better if the

trend is not extended. An extended run decreases

the upside potential of the breakout.

The pattern consists of two parts: a cup and a

handle. The cup is a consolidation area that forms

after an advance in price. It can look like a deep

bowl or a rounded bottom. It should resemble the

letter U, not the letter V.

Ideally, the depth of the cup should be no more

than 38 percent of the prior advance. In extreme

cases, the retracement can be as much as 62 per-

cent. As a rule, the lesser the retracement percent-

age, the more powerful the run will be on the

breakout. The handle forms after a test of the prior

7.46 Rectangle—Estimating Maximum Price Targets

� TO ESTIMATE THE MAXIMUM PRICE TARGET, measure width C. Rotate the measurement up andproject this up or down from the support and resistance levels. This gives you the optimisticprojections of a breakout or breakdown run.



resistance. It can be a flag or a pennant. The depth

of the handle is usually a lot shallower than the

cup depth. Maximum depth is about 38 percent. A

breakout of the resistance signals a continuation

on the uptrend.

Figure 7.48 shows an example of this pattern.

You have all three key components. The pattern

has a clear uptrend and it has formed a nice cup.

The pullback low on the cup is just below the 38

percent mark. It has also formed a nice flag.

After you identify this pattern, go long on the

breakout. The initial stop should be at the last sup-

port. Your target can be obtained by measuring the

distance between the right side of the cup (A) and

7.47 Rounded Bottoms and Rounded Tops Pattern

� A ROUNDED BOTTOM ON A DOWNTRENDING STOCK is a bullish signal. A rounded top on an uptrending stock is also bullish.Note that breakout points are found at the rim. Rounded tops on both downtrending and uptrending stocks are bearish.The rim shows the point where stock should break downward.



the low of the cup. This same distance can be pro-

jected from the breakout point to calculate the ini-

tial target point (B). Distance A should be the same

as distance B (see Figure 7.49).

VOLUME ANALYSIS

Volume is an important part of basic technical

analysis. It serves to refute or confirm certain price

movements. Breaks of support and resistance lev-

els have to be followed with heavier volume. Gaps

are also confirmed by heavy volume. A common

gap does not have volume, while the other types

have higher-than-average volume. Heavy volume

is also necessary in the days following the gap. If

not, a failure could be in the works.

When a stock is in a trend, volume should

increase when prices are going in the direction of

the trend. If the trend is up, then volume should be

higher on days when prices are going up and

lighter on the days when it heads down. A stock on

a downtrend should have the opposite volume

effects. Down days should be marked by higher

volume, while up days should be marked by lower

volume. This makes sense if you think of the

underlying reasons for an uptrend. A stock can

sustain an uptrend only if there continue to be

more buyers than sellers. For it to continue on a

downtrend, it must continue to have more sellers

than buyers.

If volume fails to materialize in the direction of

the trend, it will serve as a signal that the trend

could be reversing. You often find this situation

with double top and double bottom patterns and

7.48 Cup with Handle Pattern

� WILLIAM O’NEIL POPULARIZED THE CUP WITH HANDLEPATTERN. The pattern looks exactly like its name: a cupwith a small handle on it. It is a bullish pattern.

7.49 Cup with Handle Pattern Trade Setup

� TRADE THIS PATTERN ON THE LONG SIDE once it hasbroken out of the resistance area. Place a stop-lossslightly below the last support. Calculate your initialprofit target by measuring the depth (A) of the cup andadding this value to your entry price. Initial profit targetamount B should be the same as the amount A.



the head and shoulders pattern. This is also the

case when the stock is in a trading range. Volume

usually decreases when it gets near a support or

resistance area, signaling that interest has waned.

It picks up again when it reverses and heads in the

opposite direction (see Figure 7.50).

Volume bars are the easiest way to analyze

volume. They compare volume on a given day

with volume on previous days. Take note of the

trend. Is volume increasing or decreasing? If vol-

ume bars are getting taller and taller, then vol-

ume is increasing. This confirms the direction of

the move. If volume bars are shrinking, then vol-

ume is decreasing. This means the direction of

the current move could be in jeopardy. Volume

bars can also be flat. They neither confirm nor

refute the trend. They are considered neutral.

Usually, the trend will stay intact when you see

flat bars.

Always keep an eye on volume. It reveals the

underlying strength of a move better than price

action itself. Weak volume means momentum

could end soon. Strong volume confirms the

momentum. Pay attention to climactic volume.

This usually comes at the end of a hard run. It

could be after a big rise in price or an extreme sell-

off. Climactic volume is at least 100 percent more

than the average daily volume on the security. The

higher volume serves to confirm a possible rever-

sal of the short-term trend.

Let’s take the chart of CECO in Figure 7.51 as an

example. There were two periods in which volume

surged a lot higher than normal. In period A, vol-

ume was more than 10 times higher than the daily

average. However, this is not climactic volume

because of its location in relation to the trend. In

the early part of a trend, heavy volume serves as a

confirmation of the strength of that direction. In

7.50 Volume Analysis

� VOLUME IS A VERY IMPORTANT INDICATOR. Decreasing volume places thedirection of the trend in doubt, while increasing volume supports the directionof the price movement. Flat volume neither confirms nor disputes the move. Itis considered neutral.


this case, it was down. Prices fell afterward to a

low of $22.

The scenario for period B is different. It already

had eight prior days of decline before heavy

volume came in. This is climactic volume. Such


high volumes flush out weak traders. Nervous

investors are getting out. Those who remain are

fully committed to the security. After the sell-

ers are gone, only buyers are left. The price will

rise. ●$

7.51 Climactic Volume

� THE CHART OF CECO SHOWS two high-volume days. However, only at point Bis it considered climactic volume. This is because it occurred at the end of arun. All the weak hands were flushed out from the run. This allowed the pricesof CECO to recover from $25 to around $33.


CHAPTER 8

CandlestickChartingTechniques

• Spotting Heavy Buying and Selling Pressures

• Comparing Buying and Selling Pressures

• Spotting Indecision with Candlesticks

• Understanding Intraperiod Activity

• Candlestick Positions

• Bullish Patterns

• Bearish Patterns


Candlestick patterns are formed using four

price points. They are the opening price, the high-

est price of the period, the lowest price of the

period, and the closing price. If the closing price

is above the opening price, you have an open can-

dlestick pattern. The body is normally displayed as

white. Lately, many traders are using green

instead of white. If the closing price is below the

opening price, then you have a closed candlestick

pattern. The body is normally displayed as black,

although the use of red has recently grown in

popularity. The lines above and below the body

represent the range that prices have traveled

through the time period. They are called wicks,

tails, or shadows. The top of the upper wick marks

the high price of the period, and the bottom of the

lower wick marks the low price of the period (see

Figure 8.1).

Traders believe candlestick charts are easier to

interpret than traditional bar charts. Because of the

way they are drawn, candlesticks make it easy to

do the following:

Visually spot periods of heavy buying pressure and peri-

ods of heavy selling pressures.


Compare these buying and selling pressures from period

to period.

Visually spot periods of indecision, marking a possible

direction reversal.

Get an idea of what transpired within the period.

SPOTTING HEAVY BUYING AND SELLING PRESSURES

The white marubozu candlestick can quickly iden-

tify periods of heavy buying. This pattern is some-

times referred to as the 20/20 candlestick. The

reason is simple. For the candlestick to qualify as a

20/20 candle, the opening price has to be located

below the bottom 20 percent of the candlestick

range. The closing price has to be above the top 20

percent of the candlestick range. Both patterns you

see in Figure 8.2 qualify as white marubozus.

Long white candlesticks show heavy buying

pressures. The longer the white candlestick, the

higher the closing price compared with the open.

This indicates that prices rose significantly from

open to close. The buyers were aggressive through-

out the whole period.

IT IS BELIEVED THIS CHARTING METHOD was started by the Japa-

nese to trade rice in the seventeenth century. Homma, a legendary rice

trader from Sakata, is credited with its further development and popu-

larity. Today, the candlestick charting technique has become a standard for

day trading.


CANDLESTICK CHARTING TECHNIQUES 117

Of the two patterns shown in Figure 8.2, the can-

dlestick on the right is the most bullish. This shows

buyers pushing the price up from the open to the

close. That is why there are no wicks on either end.

The high of the period is the same as the close, and

the low of the period is the same as the open.

White marubozu candlesticks are generally con-

sidered bullish indications. When found at the end

of a decline, they mark a strong support level. They

are great indications that bearish sentiment could be

reversing. A follow-through of the bullish momen-

tum is likely the next day. However, if this pattern is

found after a long advance, it could signal an over-

bought situation. Buyers have become too aggres-

sive and too optimistic. A reversal could be at hand.

8.1 Different Types of Candlestick Patterns

� THE NAME OF THE CANDLESTICK DEPENDS ON the location of the close in relation to the open. For open candlesticks, theclose is higher than the open. For closed candlesticks, the close is lower than the open. For doji candlesticks, the close isthe same as the open.

8.2 Definition of a White Marubozu

� TO QUALIFY AS A WHITE MARUBOZU, the open has tobe located at the bottom 20 percent of the candlestickrange and the close has to be above the top 20percent of the candlestick range. Both patterns shownhere would qualify.


The black marubozu candlestick identifies peri-

ods of heavy selling activity. It is also referred to as

a 20/20 candlestick. But with this candlestick, the

opening price should be on the top 20 percent of

the candlestick range and the closing price should

be below the bottom 20 percent of the candlestick

range (see Figure 8.3).

Long black candlesticks show heavy selling

pressure. The longer the black candlestick, the

lower the closing price relative to the open. It indi-

cates that sellers were aggressive during this

period, causing a significant drop in price at the

close of the period.

Of the two patterns shown in Figure 8.3, the one

on the right is the most bearish. It shows that sell-

ers were in control the whole period. They began

selling at the open and sold until the close of the

period. That is why the open price is the same as


the high price, and the closing price is the same as

the low price.

Black marubozus are generally considered bear-

ish patterns. It shows that sellers were in full con-

trol of the period. Usually, when found at the early

stages of a decline, they signal more selling pres-

sure ahead. After a long advance, a black mar-

ubozu will mark a possible resistance area. The

bears now have control of the market. After several

periods of decline, black marubozu candlesticks

can indicate panic selling or capitulation. Climactic

selling can be a signal of a possible turning point.

COMPARING BUYING AND SELLING PRESSURES

Candlesticks make it easy to compare similar or

contrasting pressures. When you place candle-

sticks of different periods side by side, you get a

quick sense of the urgency or the aggressiveness of

the buying or selling. The longer the candles, the8.3 Definition of a Black Marubozu

� TO QUALIFY AS A BLACK MARUBOZU, the close has tobe located at the bottom 20 percent of the candlestickrange and the open has to be above the top 20 percentof the candlestick range. Both patterns shown herewould qualify.

8.4 Comparing Selling Pressures

� IT IS EASY TO TELL THAT THE CANDLESTICK on the righthad a lot more selling pressure. The bigger the blackbody on a candlestick, the heavier the selling pressure.



wider the price range in the period. If sellers were

aggressive throughout the entire period, the clos-

ing price will be far lower than the open price and

the range will be wide. If selling pressures were

not as hard, the closing price will not be far away

from the open price. This creates a smaller body

than the previous scenario.

In Figure 8.4, there is little doubt which period

had more selling pressures. The length of the bod-

ies tell the story. The same applies to open candle-

sticks. The longer the length of the body, the

stronger the buying pressure in that period. In Fig-

ure 8.5, the buyers were a lot more aggressive dur-

ing the period on the right.

SPOTTING INDECISION WITH CANDLESTICKS

Two patterns indicate indecision within the period.

They are doji patterns and spinning tops.

Dojis are formed when opening and closing

prices are almost the same. They are important

candlesticks to note on their own, but they provide

an even more powerful signal when found in com-

bination with other patterns. We will discuss these

combinations later in this section.

The length of the upper and lower wicks can

differ. This makes the candlestick look like a cross,

an inverted cross, or a plus sign. On their own, doji

patterns give us a clue to the indecision area. They

are neutral patterns. They can be biased to either

bullish or bearish directions. It all depends on the

price action that came before it and the confirming

candlestick that follows it. In the ideal doji, the

open and close are equal in price, and the upper

and lower wicks are of essentially the same length.

Within this period, prices moved up and then

down, or they moved down and then up from the

open. In both cases, it closed at or near the opening

level. The result is a standoff. Neither buyers nor

sellers were able to gain control. The market is

indecisive (see Figure 8.6).

The long-legged doji (see Figure 8.7) is the big

brother of the pattern in Figure 8.6. It also has

upper and lower wicks that are roughly the same

length. But the wicks are a lot longer. These pat-

terns suggest indecision within the period: Prices

traded well above the open. They also traded well

below the open. The end result, however, was the

same. It closed at or near the opening price. Again,

neither buyers nor sellers had control of the mar-

ket in that session. They might have had control

within certain segments, but overall, the market

ended in a tie.

Spinning tops also suggest indecision. They are

8.5 Comparing Buying Pressures

� IT IS EASY TO TELL THAT THE CANDLESTICK on the righthad a lot more buying pressure. The bigger the whitebody on a candlestick, the heavier the buying pressure.



cousins of the doji pattern. They are candlesticks

with a long upper shadow, long lower shadow,

and small body. The small body is what separates

spinning tops from dojis. I have also heard these

patterns referred to as hi-waves. Activity within

this period also shows indecision. The small body

shows that the close was not that far from the

open, while the wicks indicate that buyers and

sellers were active in the session. As with a doji,

the result is much like a standoff. Neither the bulls

nor the bears were able to gain the upper hand.

After a long advance, a spinning top can indi-

cate a possible change of direction. After a long

decline, a spinning top indicates that sellers are not

as strong as before. It could signal a potential

change in trend (see Figure 8.8).

UNDERSTANDING INTRAPERIOD ACTIVITY

A candlestick shows the struggle between buyers

and sellers over a given period of time. The top of

the candlestick represents the winning zone for

buyers, and the bottom represents the winning

zone for sellers. The mark, in this case, is the clos-

ing price. The closer to the high the mark gets at

the end of the period, the closer the buyers are to

claiming victory. On the other hand, sellers can

claim victory if the mark is down near the bottom.

Candlesticks indicate how the struggle between

buyers and sellers might end. Here are the most

important indications given by candlesticks:

White marubozu or long white candlestick. These indi-

cate that buyers were aggressive and in control for the

whole or most of the period (see Figure 8.9).

8.6, 8.7, and 8.8 Spotting Indecision

� THESE THREE CANDLESTICK PATTERNS INDICATEINDECISION. Buyers and sellers were unable to gain anupper hand. Prices essentially stayed the same at the endof the period. These patterns often mark reversal points.



Black marubozu or long black candlestick. These indi-

cate that sellers were aggressive and in control for the

whole or most of the period (see Figure 8.10).

Dojis or spinning tops. These candlesticks with small

bodies tell us that neither buyers nor sellers were in con-

trol. Prices finished about where they started (see Figure

8.11).

Hammer or hanging man pattern. The long lower tail

indicates sellers had control of the market for part of the

period, but lost it by the end. Buyers made a comeback

and were able to push the price up considerably from the

low (see Figure 8.12).

Inverted hammer or shooting star. A long upper wick

indicates that buyers controlled the market for part of the

session, but lost control by the end as sellers were able to

aggressively push the market back down (see Figure 8.13).

Long-legged dojis or spinning tops. A long upper and

lower wick indicates that both buyers and sellers had their

moments during the trading session, but neither could

claim a significant victory in the end. The result was a tie

(see Figure 8.14).

8.9 White Marubozus

� WHITE MARUBOZUS, orlong white candlesticks,indicate that buyers wereaggressive and in controlfor the whole or most ofthe period.

8.10 Black Marubozus

� BLACK MARUBOZUSindicate that sellers wereaggressive and in controlfor the whole or most ofthe period.

8.11 Dojis or Spinning Tops

� THESE CANDLESTICKS WITH SMALL BODIES tell us thatneither buyers nor sellers were in control. Prices finishedabout where they started.

8.12 Hammer Pattern

� THESE CANDLESTICKSWITH SMALL BODIES tellus that neither buyers norsellers were in control.Prices finished aboutwhere they started. Thelong lower tail indicatessellers had control of themarket for part of theperiod, but lost it by theend. Buyers made acomeback and were ableto push the price upconsiderably from the low.

8.13 Inverted Hammer

� A LONG UPPER WICKINDICATES that buyerscontrolled the market forpart of the session, butlost control by the end assellers were able toaggressively push themarket back down.


What Candlesticks Can’t Tell YouCandlesticks can give you an idea of the end result

of the session, but they have limitations. They do

not reflect the sequence of events between the

open and close. They show the relationship

between the open and the close. They also show

the relationship of these two to the high and the

low of the session.

We can’t tell whether buyers stepped in first or

sellers stepped in first in a doji pattern unless we

reduce the time frame. Let’s take a long-legged

doji pattern as an example. The activity within the

period could be reflected by either one of the

charts shown in Figure 8.15. Perhaps sellers

stepped in first and pushed the price down, which

created the low. Then buyers stepped in and

pushed it up hard, which created the high. Later

on, sellers stepped in again to push the price back

down to close at or near the open price. Or the


sequence could have been the other way around.

The buyers could have come in first, followed by

sellers. And at the end of the period, buyers came

in again.

Both scenarios would produce the same pat-

tern. The missing information could be vital

because buyers and sellers might not have been

totally exhausted at the end of the period. The

market might have closed before they were able to

complete their trades. This is why technical analy-

sis of candlesticks is never based on just one can-

dlestick pattern. Complete analysis is done in

combination with other periods and other factors.

Candlesticks do not reflect volatility (see Figure

8.15). Looking at a white marubozu candlestick,

most traders would simply assume that prices

advanced most of the session. However, if you

break the pattern down, the sequence of price

movements could be different than normally

8.14 Long-Legged Dojis or Spinning Tops

� A LONG UPPER AND LOWER WICK INDICATES that both buyers and sellers hadtheir moments during the trading session, but neither could claim a significantvictory in the end. The result was a tie.



expected. The market could have been volatile,

with price pressure shifting several times.

The trading activity that forms a particular can-

dlestick can vary. That is why candlestick patterns

work best when you use combinations and not just

a single candlestick. The example in Figure 8.15

also shows two different price movements that

could have formed a white marubozu candlestick.

During the first session, there was a small decline

off the open to form the low, a sharp advance to

form the high, and a small decline to form the

close. The second session shows three sharp

moves instead of just one. As you can see, the sec-

ond session was a lot more volatile than the first.

More CandlesticksHere are some additional patterns you should

learn to recognize.

Dragonfly Doji

This pattern forms when the open, high, and close

are equal and the low creates a long tail. The result

is a candlestick that looks like a T, with a long tail

only on the bottom. This pattern indicates that sell-

ers dominated the early part of the period and

drove the price lower. But they were not able to

keep up the pressure. By the end of the session,

buyers had pushed the price back to the opening

level.

8.15 What Candlesticks Cannot Tell You

� CANDLESTICKS CANNOT TELL YOU THE SEQUENCE OF EVENTS within the period.Both intraperiod activity charts shown here would result in the same long-legged doji pattern. Candlesticks also cannot tell you the volatility within theperiod. Both intraperiod activity charts shown here would result in the samewhite marubozu pattern. Notice the greater volatility of the period on the right.

A

B


The reversal implications of this pattern depend

on the previous price action and what happens dur-

ing the next period. The long wick provides proof of

buying pressure, but the low indicates that plenty of

sellers could still be around. If this pattern is found

after a long downtrend, it could signal a potential

bullish reversal or bottom. A bullish confirmation

would come in the form of a follow-through to the

upside the next period. After a long uptrend, the

long tail could suggest a potential bearish reversal

or top. Bearish confirmation will come in the form

of a closed candle the next period (see Figure 8.16).

Gravestone Doji

This pattern forms when the open, low, and close

are the same and the high has a long upper wick.


The candlestick looks like an upside-down T.

Gravestone dojis indicate that buyers dominated

the early part of the trading session. They drove

prices higher during the session. However, they

were unable to hold their gains. Sellers resurfaced

and were able to push the prices back down to the

open price.

As with the dragonfly doji and other patterns,

the reversal implications of a gravestone doji will

depend on the previous price movement and also

on how the next period confirms this movement.

After a long downtrend, it could signal a possible

bullish reversal. After a long uptrend, they can

indicate a possible bearish reversal. Both need to

be confirmed with a follow-through to the upside

(if bullish) or downside (if bearish) to confirm the

validity of this interpretation.

Hammer and Hanging Man

These patterns look exactly the same. Their names

depend on the preceding price movement. Both

have small bodies. Both can be black or white. Both

need to have a long lower tail and a short or non-

existent upper tail. Finally, the lower tail must be at

least two times the length of the body (see Figure

8.17). As with most candlestick formations, the

hammer and hanging man require confirmation

before action.

If the pattern you see in Figure 8.18 formed after

a decline, then it is called a hammer. A hammer is a

bullish reversal pattern. It points to a possible

trend reversal. It will often mark support levels.

After a decline, hammers signal a possible return

of the buyers. The low of the long lower wick

8.16 Doji Candlestick Patterns

� THE HIGH, THE OPEN, AND THE CLOSE ARE ALL AT THESAME PRICE FOR THE DRAGONFLY DOJI, and the low, theopen, and the close are all at the same price for thegravestone doji.

Dragonfly Gravestone Doji Doji



implies that although sellers drove prices lower

during the session, they were unable to sustain the

pressure. Buyers stepped in and forced the price

back up at the end of the session. Like many of the

patterns we have discussed, hammers require fur-

ther bullish confirmation. Confirmation can come

in the form of a gap up or white marubozu candle-

stick the next period. Another confirmation would

be from increasing volume on the way up. Ham-

mers are like climactic sell-offs, and heavy volume

serves to validate the reversal even more.

If the same pattern you saw earlier formed after

an advance, then it is called a hanging man (see Fig-

ure 8.18). The hanging man is a bearish reversal

pattern. It points to a possible trend reversal. It will

often mark resistance levels. The long tail on this

pattern is a clue that sellers are now around after

the long price advance. They were able to push it

down at one point. Although they failed to keep

the price down, an action like this makes buyers

nervous. If you see this after an advance, it should

raise a caution flag on your long positions. A hang-

ing man also requires a bearish confirmation

before any action is taken. Such confirmation can

come in the form of a gap down or long black can-

dlestick on heavy volume. The chart in Figure 8.19

shows how we can identify a hanging man or a

hammer. Both patterns look alike. The hanging

man came in after a price advance, while the ham-

mer came in after a price decline. The hanging man

marked the resistance level, and the hammer

marked the support.

Inverted Hammer and Shooting Star

These patterns look like the hammer and hanging

man patterns turned upside down. The long tail is

now located above the body, and there is little or

no tail below the body. These patterns also mark

potential trend reversals, and they also require

confirming price movement during the following

period (see Figure 8.20).

Like their counterparts, their names come from

their location on the chart and the preceding price

action. If this pattern forms after an advance, it is

called a shooting star. The ideal position is a star

position (to be discussed later), hence the name.

This pattern marks a potential trend reversal. The

high usually marks a significant resistance level.

8.17 Candlestick Patterns

� THE HAMMER AND THE HANGING MAN both have thesame patterns. Their names depend on the precedingprice movement.


126

8.18 Hammer and the Hanging Man

� BOTH THE CIRCLED PATTERNS LOOK THE SAME. The one that occurred at theend of a move up is called a hanging man, and the one that occurred after adownward price move is called a hammer.

8.19 Hammer as a Reversal Indicator

� THIS CHART OF EBAY SHOWS two circled hammer patterns. Both mark thereversal points of the downtrend. They were good signals for initiating a longposition. Can you find the third one?



This candlestick pattern forms when prices

open higher than the previous period’s high. It

then advances during the session. But somewhere

within the session, selling pressure occurs and

pushes the price back down. The close is well off

the high. The result is a candlestick that has a long

upper tail and small black or white body. It can

have a small lower tail or none at all.

The ability of sellers to force the price down

should raise a caution flag in any situation. In this

case, it comes after a big move up. To qualify as a

substantial reversal, the upper tail must be at least

two times the length of the body. Bearish confirma-

tion is required after the shooting star. It can come

from a gap down or black marubozu candlestick

on heavy volume.

The inverted hammer looks exactly like a shoot-

ing star. However, the pattern is given this name

only if it forms after a decline or a downtrend. It

represents a potential trend reversal and usually

marks support levels. The long upper tail indicates

that buyers were present during the session. They

were able to push the price up, but were unable to

sustain this buying pressure. Sellers came in and

pushed the price back down. Prices closed well off

of their highs and created the long upper tail.

Although buying pressure could not be sus-

tained through the entire session, the presence of

this pressure should not be ignored. It should

raise a caution flag on any short position. The

possibility of a reversal could be in the works,

depending on the confirmation candlestick in the

next period. Bullish confirmation comes in the

form of a gap up or a white marubozu candlestick

with heavy volume.

The examples shown in Figures 8.21 and 8.22

show how to identify an inverted hammer or a

shooting star. Both patterns look alike. Note the rela-

tionship to the prior price movement. The inverted

hammer came in after a price decline, whereas

the shooting star came in after a price advance. The

shooting star marked the resistance level, and the

inverted hammer marked the support. Take note of

the confirming candlestick on the period that fol-

lowed these patterns (see Figures 8.21 and 8.22).

CANDLESTICK POSITIONS

Whereas patterns are a series of candlesticks, posi-

tions define a single candlestick in relation to the

previous candlesticks (i.e., in relation to its pattern).

8.20 Candlestick Patterns

� THE INVERTED HAMMER AND THE SHOOTING STAR bothhave the same patterns. Their names depend on thepreceding price movement.


Star PositionA candlestick is said to be in a star position when it

gaps away from the previous candlestick. The first

candlestick usually has a large body, while the sec-

ond candlestick in star position has a small body.

Due to the gap, a candlestick in a star position

appears to be isolated from the rest. It could be

from a gap down or a gap up. If it is a gap up, it is

usually preceded by a white marubozu. If it is a

gap down, it is usually preceded by a black maru-

bozu. This occurs because either buying or selling

momentum carried over to the next day. This

caused the gap. However, the gap absorbed a lot of

those pressures and almost balanced out the two


parties. That is why we see the smaller range the

next day. Bear in mind that for a candlestick to be

in a star position, it does not have to have a small

range. It just needs a small body and it needs to

gap above the prior day’s high. In shooting stars

and hammers, the range is fairly wide, but the

body is small. Figure 8.23A gives you a better idea

of a candlestick in a star position.

Harami PositionA candlestick is said to be in a harami position when

it forms within the body of the previous candlestick.

The first candlestick usually has a large body, while

the second candlestick in harami has a smaller body

8.21 Inverted Hammer and the Shooting Star

� BOTH THE PATTERNS CIRCLED HERE LOOK THE SAME. The one that occurred atthe end of a move down is called an inverted hammer, and the one thatoccurred after an upward price move is called a shooting star.



8.22 Inverted Hammer as a Reversal Indicator

� NOTICE HOW THE INVERTED HAMMER shown here marked a big turnaround inprices the next day. Savvy traders who spotted this could have capitalized onthe move.

8.23 Candlestick Positions

� THIS ILLUSTRATES THE DIFFERENCE BETWEEN A STAR POSITION AND A HARAMI POSITION. Notice that in the star position,the price action on the following period is outside the body of the first period. On the other hand, the price action of thefollowing period on a harami position is all within the body of the first period.

A B


than the first. Harami means pregnant in Japanese.

If you imagine the first candlestick as being preg-

nant with the second candlestick, you can remem-

ber the harami position easily. Preferably, the upper

and lower tails of the second candlestick should be

within the first, but it is not necessary. Dojis and

spinning tops are just some of the patterns that can

form in the harami position. Figure 8.23B gives you

a better idea of the harami position.

Combination PatternsIt must be stressed that candlestick analysis should

never be based on a single candle. It should always

be combined with previous price action and a con-

firming candle. Learning to recognize combina-

tion patterns is a must for the candlestick chartist.

Combinations provide a better picture of possible

future price movements and are more reliable than

a single candlestick. These combinations fall into

two categories:

●1 Bullish patterns

●2 Bearish patterns

BULLISH PATTERNS

There are many bullish combination patterns. I

have chosen the more popular and common ones

for discussion here. They occur often and should

be part of the basic understanding of any candle-

stick chartist.

Hammer

Inverted hammer

Bullish engulfing


Piercing pattern

Bullish harami

Three white soldiers

Bullish engulfing harami

Morning star

Bullish abandoned baby

The hammer and inverted hammer were cov-

ered earlier. This section focuses on the other seven

patterns. For a complete list of bullish (and bear-

ish) reversal patterns, see Greg Morris’s Candlestick

Charting Explained. With all bullish patterns, a bull-

ish confirmation has to occur. These patterns are

still considered neutral. No clear direction has

been established. Action should not be taken. Bull-

ish confirmation has to occur within a short

period. Maximum effectiveness of these patterns is

only about two weeks. More often, it is a lot less

time. Bullish confirmation has to occur within one

to three days. Move on to another security if you

do not see confirmation quickly. The longer it takes

to confirm, the weaker the setup.

Bullish Engulfing PatternA bullish engulfing pattern consists of two candle-

sticks (see Figure 8.24). The first candlestick,

which is a period earlier, is a closed pattern, mean-

ing the close was lower than open. It should be a

black candlestick. The upper and lower tails are

usually fairly short, although this is not necessary.

This indicates a small range compared with the

opening and closing price. The second candlestick

is an open pattern, or a white candlestick, mean-



ing the close was higher than the open. The white

body of this second candlestick is larger than the

black body of the first candlestick. The white body

of the second candlestick has to completely cover

the black body of the previous candlestick for it to

qualify as a bullish engulfing pattern. Ideally, the

white body of the second candlestick should also

engulf the upper and lower tails of the first can-

dlestick.

A couple of things must happen in this pattern

for it to form. The open of the second candlestick

must be lower than the previous close. This means

that the price gapped down at the open on the sec-

ond period. The close of the second candlestick

must be higher than the previous open. This

means buying pressure must be strong enough to

bring the price back above the open price, closing

above it. Note that it does not necessarily have to

break the high of the first candle. Figure 8.24A is an

illustration of the bullish engulfing pattern.

As the name implies, this pattern is bullish. It

indicates that buyers have seized control from sell-

ers. The first candlestick is closed. It indicates that

sellers were in control and forced the price to close

lower than the open. In the next period, the control

of the sellers was short-lived. Buyers were able to

push the price up. This rally proved so powerful

that the price went past the previous open and

closed above this price. The resulting candlestick is

one in which the white body completely “engulfs”

8.24 Bullish Combination Patterns

� THESE TWO CANDLESTICKS MAKE UP THIS COMBINATION PATTERN. Notice how the open on the second candlestick (on the left) is below the close of the first candlestick and the close on the second candlestick is above the open of thefirst candlestick. To make it easier to remember this combination, try merging the two candles together. The result is an open hammer pattern.

A

B


that of the previous candlestick, hence the name

bullish engulfing pattern.

As with most candlesticks, prior price action

and ensuing price action need to be taken into con-

sideration. These patterns tend to work best dur-

ing a decline or a downtrend. If you add the other

aspects of technical analysis to this pattern, an

even better trade signal can be generated.

The easiest way to remember this pattern is to

imagine a marriage of the two candlesticks into

one. If you use the opening price of the first candle,

the highest and lowest price between the two peri-

ods, and the close of the second candle, you should

get an open hammer (see Figure 8.24B).


The chart of NVDA (see Figure 8.25) is an exam-

ple of a bullish engulfing pattern. Notice that there

are two of these patterns. The first combination

clearly shows the increased strength of the buyers.

There was a tremendous amount of buying pres-

sure. It caused the range to be almost twice that of

the normal daily range. The confirming bullish

candlestick came in the next day. This tells us that

on a short-term basis, we can expect the stock to

head up.

Three days later, the stock showed signs that

buying momentum had stopped and sellers had

again controlled the session. This is evidenced by

the down candlestick. But that was short-lived, as

8.25 NVDA Bullish Engulfing Pattern

� THE FIRST BULLISH ENGULFING PATTERN on this chart of NVDA marked asignificant turning point in the direction for this stock. Notice how it followedthrough again to the upside on another bullish engulfing pattern.



the next day another bullish engulfing pattern

appeared. This was followed by a bullish confir-

mation. The stock gapped up the next day and

went higher, and later the stock went significantly

higher.

Piercing PatternTwo candlesticks are required to form a piercing

pattern. The first candlestick is a relatively long

black marubozu. The second candlestick is a white

marubozu that opens below the previous period’s

closing price and closes above the midpoint of the

black marubozu.

The charts in Figure 8.26 illustrate the bullish

piercing pattern. Piercing patterns are bullish for-

mations. You usually find them after a decline.

They mark a potential reversal point or change in

trend. The pattern itself is not a strong enough sig-

nal. A bullish confirmation is needed for trading. It

can come in the form of a gap up or another white

marubozu following the pattern. Strong or increas-

ing volume must follow these moves to the upside.

Again, the best way to remember these patterns

is to imagine a marriage of the two candlesticks.

Using the open of the first, the highest and lowest

price of the two periods, and the closing price of

the second period, you will find that the pattern

transforms into a closed hammer.

Bullish Harami PatternThe bullish harami pattern is made up of two can-

dlesticks. The first has a large body and the second

a small body. The second candlestick has to be in

a harami position, so the body of the first has to


� THESE TWO CANDLESTICKS MAKE UP THIS COMBINATION PATTERN. Notice how the open on the second candlestick is belowthe close of the first candlestick and the close on the second candlestick is above the midpoint of the first candlestick. Tomake it easier to remember this combination, try merging the two candles together. The result is a closed hammer pattern.

A B


completely encompass the second. These patterns

are also called inside range days, or IRDs, because the

range of the second day is completely found within

that of the first. There are four possible combina-

tions in this pattern: white/white, white/black,

black/white, and black/black (see Figure 8.27).

In Beyond Candlesticks, Steve Nison asserts that

any of the four combinations of colors can be con-

sidered a harami. He believes the most bullish are

those that form with a white/black or white/white

combination. The large body of the first candlestick

implies strong buying pressure throughout the

period. The smaller candlestick indicates a consoli-

dation period. The white/white and white/black

bullish harami are likely to occur instead of the

black/black or black/white harami.

If the prior trend was on a decline, a black/black

or black/white combination is regarded as a bull-

ish harami. The first long black candlestick tells us

that sellers were aggressive, but it could signal a


possible capitulation. The ensuing candlestick is

formed with a gap up at the open. This indicates

that buying pressures increased between sessions,

and it could signal a possible reversal.

One similarity between the four combinations

stands out. The color of the first candlestick does not

really matter. What is more important is the body of

the second candlestick. The smaller the body of the

second candlestick, the more likely it is to reverse.

The best second candlestick you can find is a doji. It

has a very small body or none at all. The chances

of a reversal are greatly increased whenever this

occurs. It tells us that, after a period of heavy decline

(black marubozu), sellers were unable to push the

price down. Hence the narrower range. On the

other hand, after a prior period of heavy advance

(white marubozu), sellers were also unable to move

the price down, even though the price had gapped

against the previous upward direction.

Look at the chart in Figure 8.28. Pay attention to


� THIS ILLUSTRATES THE FOUR POSSIBLE COMBINATIONS FOR THE BULLISHHARAMI. Two candlesticks make up this combination pattern. Notice how therange of the second candlestick is always within that of the first candlestick.



the following: the downtrend and the occurrence

of the harami pattern. At this point, we still do not

know whether it is bullish or bearish. It is with the

gap upward that a long candlestick confirmed the

bullishness. Two more harami patterns followed.

They are white/white and white/black combina-

tions. These patterns are considered bullish and a

sign of possible continuation of strength.

Three White SoldiersThe three white soldiers pattern is made up of

three white marubozu candlesticks formed in con-

secutive periods. In and of itself, the white

marubozu candlestick pattern indicates a lot of

buying pressure throughout the period. When

three of these occur side by side, the buying has

become urgent. Every move up brings in more

buyers, as short sellers cover their positions. If you

combine the three candlesticks, you form one giant

white marubozu. This shows the power the bulls

have over the market (see Figure 8.29).

Two things affect the bullish nature of this combi-

nation pattern. First is the past price action. Second

is the range or size of the three candlesticks. If this

combination occurs at the beginning of a reversal

and just below a resistance level, then chances of the

bullish action continuing are greatly increased. This

is a good scenario for a possible break of resistance.

When the range is shrinking as it gets close to resis-

tance, however, you should be cautious. It suggests

that buying momentum is losing steam. While sell-

ers never really controlled the session, the strength

behind these two pressures is now starting to bal-

ance out. Soon, it could tip to the side of the sellers

again. Do not initiate a long position when you see

this pattern. Although this combination is also bull-

8.28 Bullish Harami Pattern

� THE SERIES OF THREE BULLISH HARAMI PATTERN (circled) on this stockmarked a nice turnaround in price.


ish when it occurs after a breakout of resistance,

caution should be taken when entering into a long

position. If the ranges of the three candlesticks are

roughly equal, the chances of the buying momen-

tum continuing in the next period are a lot better.

However, if the range is increasing or decreasing,

then it is preferable not to enter a long position. Wait

for a pullback to enter. If the range is gradually

decreasing, then buying momentum is definitely

waning. On the other hand, if the range is increas-

ing rapidly between the three candlesticks, the

action could be caused by panic (see Figure 8.30).

Bullish Engulfing HaramiAs the name suggests, the bullish engulfing harami

pattern consists of two combination patterns. The

first is a harami pattern and the second an engulf-


ing pattern. However, the two pillars that frame the

pattern on the two sides have to be white maru-

bozus (see Figure 8.31). The first combination

found on the bullish engulfing pattern is a harami

pattern. Of the four possible harami combinations,

only two are shown here, the white/white and the

white/black combinations. The initial move on this

combination has to be a big surge in buying inter-

est. Usually, this is caused by news or some new

development pertaining to the stock.

The next two or three candlesticks serve as a

consolidation period as the market tries to absorb

the buying pressure of the first day. These candle-

sticks can be of any possible combination. The best

ones are those where the range of all candlesticks

is low. It tells us that buyers are present, absorbing

the selling pressure.


� THIS PATTERN IS MADE UP OF THREE WHITE MARUBOZU CANDLESTICKS.Combining all three candlesticks together gives you one big marubozucandlestick. It gives you an idea of how strong the buying pressures were onthis stock.



After the selling pressures are absorbed, a new

surge in interest comes in as buyers become

aggressive again. This forms the second part of the

combination, the bullish engulfing pattern.

You find these patterns at major reversals. News

concerning the stock can cause the initial surge. As

the trading community grasps the news, a surge in

buying pressure takes hold and the price goes up

again. A breakout of the high with volume is a big

confirmation.

Morning StarThe morning star pattern consists of three candle-

sticks. They are usually formed after a decline and

can mark a support and a possible trend reversal

area. The first candlestick is a closed pattern and

8.30 Three White Soldiers

� THE RANGE AND LOCATION OF THIS PATTERN would affect the bullish nature of this pattern. This is an illustration of whatincreasing range, decreasing range, and constant range would look like for this combination pattern.


� THE BULLISH ENGULFING HARAMI PATTERN is made up of two separate combination patterns. The firstcombination is the bullish harami pattern. The secondcombination is the bullish engulfing pattern.



After a downtrend, the dojis and spinning tops

indicate a tie between the bulls and bears. Neither

the buyers nor sellers scored a decisive victory in

the session. This standoff is resolved when a long

white candlestick forms to indicate a reversal of

trend. It is preferable but not necessary to see a gap

up on the long white candlestick.

A close relative to this pattern is the bullish

abandoned baby. It consists of the same three can-

dlesticks, and in the same order. Here’s the only

difference between the morning star and the bull-

ish abandoned baby: On the bullish abandoned

baby, gaps are found on both sides of the doji or

spinning top (see Figure 8.33).

The gap between the first and second candle-

should have a relatively long body. The middle

candlestick is a doji or spinning top that forms

after a gap down at the open. The last candlestick

is an open pattern, with a relatively long body (see

Figure 8.32).

The first candlestick should be in the direction

of the current trend, which should be down. The

closed pattern shows that sellers are still in control

and were able to push the price down to close

below the opening price. The gap on the second

candlestick indicates that selling pressure contin-

ued at the open. However, these pressures were

weak and did not persist throughout the session.

Buyers stepped in and were able to push the price

back up to end at or near the opening price.


� THE MORNING STAR PATTERN is a three-candlestickcombination pattern. The most important aspect aboutthis combination is the “star” position of the middlecandlestick.


� THE BULLISH ABANDONED BABY PATTERN looks verymuch like the morning star pattern. The only differenceis that the high of the middle candlestick is lower thanthe low of the first and third candlesticks.



stick indicates that significant selling pressure

remains. However, the gap absorbed a lot of the

selling pressure, and the security trades in a nar-

row range. It closes at or near the open price, creat-

ing the spinning top or the doji. Between the

second and third candlesticks, the gap up indicates

strong buying pressure built-up between the two

periods. A long white candlestick on the next

period confirms the reversal. No further confirma-

tion is required.

The chart in Figure 8.34 is that of eBay. Notice

the decline that preceded the doji pattern. It was in

a star position because of the gap. Finally, the gap-

up confirmed the pattern on the next candlestick.

BEARISH PATTERNS

There are also many bearish combination patterns.

Again, I have chosen to narrow the field. I have

selected the most popular and common patterns

for more detailed discussion. You can find a com-

plete list of bearish patterns in Candlestick Charting

Explained, by Greg Morris. Here are some of the

key bearish patterns.

Shooting star

Hanging man

Bearish engulfing pattern

Dark cloud cover

8.34 Morning Star Pattern: eBay

� THE CIRCLED DOJI PATTERN is in a morning star pattern. Notice how nicelyeBay’s prices reversed from the downtrend after this combination occurred.


Bearish harami pattern

Three black cows

Evening star

Bearish engulfing harami

The shooting star and the hanging man patterns

were covered earlier. The focus here is on the other

six patterns. Remember that bearish confirmations

are needed in all bearish reversal patterns. The

actual reversal signals the change in direction. Sell-

ers are now in control of the market. Without the

bearish confirmations, these patterns are consid-

ered neutral. There is no clear direction for the

market yet. All these patterns do is signal a poten-

tial resistance point. Bearish confirmation comes in

the form of a gap down or a downside follow-

through. Understand that candlestick pattern

analysis is short-term analysis. Maximum effec-

tiveness is only about two weeks, sometimes less.

Bearish confirmation has to occur within one to

three days.

Bearish Engulfing PatternThe bearish engulfing pattern consists of two

candlesticks. The first is a small white or open

candlestick and the second is a large black or

closed candlestick. The bigger it is, the more

bearish the reversal. The black body must totally

engulf the body of the first white candlestick.

Ideally, the black body should engulf the shad-

ows as well. Shadows are permitted, but they are

usually small or nonexistent on both candle-

sticks. After an advance, the second black candle-


stick begins to form when residual buying pres-

sure causes the security to open above the previ-

ous close. However, sellers step in soon after this

opening gap up and begin to drive the price

down. The selling pressure proves to be so

intense that the price ends the session below the

previous open. The resulting candlestick com-

pletely engulfs the previous day’s body. This

indicates a possible reversal. A bearish confirma-

tion is needed before any action is taken (see Fig-

ure 8.35A). The easiest way to remember this

pattern is to imagine a marriage of the two can-

dlesticks into one. If you use the opening price of

the first candle, the highest and lowest price

between the two periods, and the close of the sec-

ond candle, you should get a closed shooting star

(see Figure 8.35B).

In the example we used earlier in Figure 8.28, a

bullish harami pattern marked the reversal of the

downtrend. After entering into that trade, another

combination pattern would have alerted you to

a possible bearish reversal. This is the bearish

engulfing pattern. As you see from the NVDA

chart in Figure 8.36, the bearish engulfing pattern

marked the end of the uptrend and signaled a

change of direction.

Figure 8.37 shows another example of a bearish

engulfing pattern. On the left side of the chart, you

will notice that NVDA was in a downtrend. It then

reversed up to where we now find the bearish

engulfing pattern. The gap down on the next day

was the bearish confirmation. Price subsequently

dropped from $25 to $20, where another engulfing

pattern marked the reversal.



8.35 Bearish Combination Patterns

� THESE TWO CANDLESTICKS MAKE UP THIS COMBINATION PATTERN. Notice how the open on the second candlestick is abovethe close of the first candlestick and the close on the second candlestick is below the open of the first candlestick. To makeit easier to remember this combination, try merging the two candles together. The result is a closed shooting star pattern.

8.36 NVDA Bearish Engulfing Pattern

� EARLIER WE SAW HOW THE BULLISH HARAMI PATTERN marked the reversal of the downtrend. This time the bearishengulfing pattern (circled) marked the reversal back down.

A B



8.37 NVDA Bearish Engulfing Pattern

� HERE’S ANOTHER EXAMPLE of how the bearish engulfing pattern marked the reversal of the small uptrend.

Dark Cloud CoverThis pattern comprises two candlesticks. The first

is a white candlestick and the second a black can-

dlestick. Both candlesticks should have fairly large

bodies with small or nonexistent upper and lower

wicks. The black candlestick must open above the

previous close. It should also close below the mid-

point of the white candlestick’s body. If it closes

above the midpoint, it is not considered as bearish

and may not necessarily qualify as a reversal com-

bination.

Look at Figure 8.38. In this pattern, buying

momentum carried over from the first session to

the next. It caused the price to gap and open higher

in the next session. However, sellers stepped in

soon after the open and pushed prices lower. Sell-

ing pressures were strong enough to drive prices

below the midpoint of the white candlestick’s body,

but not strong enough to drive it past the previous

sessions open. Bearish confirmation in the next

period would validate the reversal (see Figure

8.38A). Again, the best way to remember these pat-

terns is to blend together the two candlesticks.

Using the open of the first, the highest and lowest

price of the two periods, and the closing price of the

second period, you will find that the pattern trans-

forms into an open shooting star (see Figure 8.38B).

The chart of ENZN in Figure 8.39 shows the




� TWO CANDLESTICKS MAKE UP THE DARK CLOUD COVER PATTERN. Notice how the open on the second candlestick is abovethe close of the first candlestick and the close on the second candlestick is below the midpoint of the first candlestick. Tomake it easier to remember this combination, try merging the two candles together. The result is an open shooting starpattern.

8.39 ENZN Dark Cloud Cover

� THE DARK CLOUD COVER PATTERN shown here on ENZN marked the reversalof a very short uptrend. This stock’s price dropped severely afterward.

A B


value of recognizing this pattern. Price action on

ENZN remains sideways for many sessions. Trad-

ing this action within the rectangle formation would

be choppy and tough. The formation of the dark

cloud cover pattern signaled a possible change. The

bearish confirmation that came afterward was a big

black marubozu candlestick, which is the most

bearish of all patterns. There were no upper or

lower tails in the pattern. This shows that sellers

were in complete control during the entire session.

The move also broke a key support level of the rec-

tangle. The price dropped from $62.50 down to $44.

Bearish Harami PatternThe bearish harami pattern is made up of two can-

dlesticks. It is a harami pattern. To qualify, the first

candlestick has to have a large body and the body

of the second candlestick has to be completely

encompassed by the first. This means that the body

of the second candlestick also has to be smaller

than the first. There are four possible combinations:


White/white

White/black

Black/white

Black/black

Whether they are bullish or bearish in nature,

all harami patterns look the same. Their bullish or

bearish nature depends on two things, the preced-

ing trend and the confirming candlestick (see Fig-

ure 8.40).

Steve Nison asserts in Beyond Candlesticks that

any combination of colors can form a harami. The

most bearish are those that form with a black/white

or black/black combination. The large black body

indicates the presence of strong selling pressure that

was sustained until the session ended. The small

candlestick afterward is considered to be a period

of consolidation before continuation. After an ad-

vance, black/white or black/black bearish harami

are not as common as white/black or white/white

combinations.

8.40 Four Possible Combinations for the Bearish Harami

� TWO CANDLESTICKS MAKE UP THIS COMBINATION PATTERN. Notice how therange of the second candlestick is always within that of the first candlestick.



A white/black or white/white combination is

still regarded as a bearish harami and can signal a

potential reversal. The first long white candlestick

usually follows the direction of the trend. It shows

that plenty of buying pressure remains. The sec-

ond candlestick that follows begins with a gap

down on the open. This indicates a change of con-

trol between sessions from buyers to sellers. The

struggle that followed in the second candlestick

ends with an indecision or a tie, giving us further

proof that buyers are losing control.

A bearish confirmation on the next period

should bring action on your part. If you are long,

you should exit quickly. If you are not long, con-

sider shorting the security. The chart of JDSU in

Figure 8.41 is a good example of a bearish harami

pattern. The stock had a nice uptrend, with a big

white marubozu candlestick marking the end. The

next day, the stock gapped down and closed

down, producing the black candlestick pattern.

The next day, bearish confirmation came in the

form of a gap down. The price later dropped about

a dollar in a few days, and JDSU eventually

dropped well below $2.00.

Three Black CowsThe three black cows pattern is made up of three

black marubozu candlesticks that formed in con-

secutive periods (see Figure 8.42A). In and of itself,

a black marubozu candlestick pattern indicates a

lot of selling pressure throughout the period. If

three of these occur side by side, it means the sell-

8.41 JDSU Bearish Harami Pattern

� THE BEARISH HARAMI PATTERN (circled) marked the start of a double toppattern and the reversal of the uptrend.



8.42 Three Black Cows Pattern

� THE THREE BLACK COWS PATTERN is made up of three black marubozu candlesticks. Combining all three candlestickstogether gives you one big black marubozu candlestick. It gives you an idea of how strong the selling pressures were onthis stock.

ing is urgent. Fear is probably a factor. Every move

down in price brings in more sellers. This intensity

points to opportunities on the short side. Hope-

fully, you are not in a long position as it happens.

Combining the three candlesticks together forms

one giant black marubozu. This shows the power

the bears have over the market (see Figure 8.42B).

Like the three white soldiers, two things affect

the bearish nature of this combination pattern. First

is the past price action. Second is the range or size of

the three candlesticks. If this combination occurs at

the beginning of a reversal to the downside and just

above a support level, chances are that the bearish

action will continue to improve greatly. You will

likely see a break of the support level. The only

range condition that lessens this likelihood is when

the range is shrinking as it gets close to a support.

This suggests that selling momentum is losing

steam. While buyers have yet to gain control of the

session, the strength behind these two pressures is

now starting to balance out. It could tip to the side of

the buyers soon, a bad time to open a short position.

Although this combination is also bearish when

it occurs after a breakdown of support, caution

should be taken when entering into a short posi-

tion. If the ranges of the three candlesticks are

AB



roughly equal, the chances that selling momentum

will continue into the next period are a lot better.

However, if the range is increasing or decreasing,

it is preferable not to enter a short position.

If the range is gradually decreasing, selling

momentum is definitely waning. On the other

hand, this might be a case of panic selling if the

range is increasing rapidly between the three can-

dlesticks. When the panic ends, buyers can bring

the price up with ease (see Figure 8.43).

Evening StarThe evening star pattern consists of three candle-

sticks. The first candlestick is an open candlestick

with a long white body. The second is a small can-

dlestick that gaps above the close of the first. This

candlestick can be an open or closed spinning top

pattern. It can also be a doji. If it is a doji, the pat-

tern is called an evening star doji. The last is a closed

candlestick with a long black body.

The long body of the white candlestick tells us

that buying pressure remains strong. The gap up at

the open of the second candlestick provides fur-

ther evidence of buying pressure. However, a lot of

the pressure is absorbed in the gap. The upward

momentum loses steam and the range becomes

narrow. A small candlestick forms. The battle for

control ends in a tie, indicating indecision and a

8.43 Three Black Cows

� THE RANGE AND LOCATION OF THIS PATTERN would affect the bearish nature of this pattern. This is an illustration of whatincreasing range, decreasing range, and constant range would look like for this combination pattern.


possible reversal of the trend. The chances of a

reversal increase even more if the small candle-

stick is a doji. The third long black candlestick pro-

vides bearish confirmation of the reversal (see

Figure 8.44).

A close relative of this pattern is the bearish

abandoned baby pattern. The difference is the gap

found on either side of the second candlestick. The

open of the second candlestick has to gap above the

high of the first candlestick. Plus, the open of the

third candlestick has to gap below the low of

the second candlestick. The end result is a candle-

stick that is isolated from the rest of the patterns on

the chart (see Figure 8.45).


The first gap up confirms that strong buying

pressure carried into the next session. However,

buying pressure subsides after the gap up and the

security closes at or near the open. This creates

the doji.

Following the second candlestick, the price

gaps down below the low of the doji. The gap indi-

cates strong selling pressure, and the long black

candlestick confirms it. The strong and sustained

selling pressure on the third candlestick completes

the reversal. Further bearish confirmation is not

required.

The chart of eBay in Figure 8.46 started off with

an uptrend. It ended with an evening star. The

8.44 and 8.45 Bearish Combination Patterns

� THIS IS A THREE-CANDLESTICK COMBINATION PATTERN. The most importantaspect about this combination is the “star” position of the middle candlestick.The bearish abandoned baby pattern looks very much like the evening starpattern. The only difference is that the low of the middle candlestick is higherthan the high of the first and third candlesticks.

Evening Star Bearish Abandoned Baby



black confirming candlestick completes the rever-

sal. The white candlestick that followed should be

an opportunity to exit a long position or enter a

short position.

Bearish Engulfing HaramiThe bearish engulfing harami pattern consists of

two combination patterns. The first is a harami

pattern and the second is an engulfing pattern. The

end result is a pattern whose two sides are black

marubozu candlesticks.

The first combination found on the bearish

engulfing pattern is a harami pattern. Of the four

possible harami combinations, only the black/white

and the black/black combination are discussed here.

The initial move on this combination has to be that

8.46 Evening Star Pattern: eBay

� THE EVENING STAR PATTERN on eBay marked a short-term trend reversal.


� THE BEARISH ENGULFING HARAMI PATTERN is madeup of two separate combination patterns. The firstcombination is the bearish harami pattern. The secondcombination is the bearish engulfing pattern.



of a big surge in selling pressure. Usually, this is

caused by bad news, a downgrade, a missed esti-

mate, or news concerning the overall sector.

The next two or three candlesticks serve as a

distribution period as the market works through

the initial selling spree of the first day. These can-

dlesticks can be of any possible combination. The

best ones show a low range of all candlesticks. This

tells us the market was deadlocked and ended

with little or no move in price.

After the buying pressures are absorbed, a new

surge in selling pressure comes in. Sellers become

aggressive again and bring the price back down to

the closing level of the first candlestick. This forms

the second part of the combination, the bearish

engulfing pattern. No confirmation is necessary

after this pattern is completed.

These patterns are found at major reversals. The

initial surge usually is a good indication of a possi-

ble change of trend direction. However, the public

mistakes it for a pullback buying opportunity and

pushes it back up. But it fails to break the last

resistance and sellers step back in, completing the

pattern (see Figure 8.47).

If you can identify these patterns at the early

stages, the possibility of a profit is high. The

trade in this case involves getting into a short

position after it breaks the low of the first candle.

You should see bearish confirmations when this

happens. Volume should pick up as buyers

from the previous two or three sessions head for

the exits. This is on top of those who went long

on the position prior to the formation of the

pattern. ●$


CHAPTER 9

Spotting Trends• Technical Indicators

• Key to Using Indicators

• Moving Averages

• Moving Average Convergence Divergence

• MACD Histogram

• Stochastic Oscillator

• Relative Strength Index

• On-Balance Volume

• Accumulation/Distribution

• Futures and Pivot Points

• Conclusion


Technical indicators are great tools when used

properly. They offer a perspective from which we

can analyze price action. They help identify trends

and their reversal points. They serve to confirm or

refute certain price actions. When they confirm,

we can hold onto the trade a little longer. When

they refute, it is time to get out.

There are three types of indicators: trend-

following indicators, oscillators, and miscella-

neous indicators. This section will concentrate on

trend-following indicators and oscillators. Many

of the miscellaneous indicators are used to analyze

the stock market in general. I believe day traders

should ignore those indicators. This applies to

swing traders who hold positions from one to five

days.

For day traders, the short-term trend is the most

important. Even in the bear market of 2000, there

were ample opportunities to go long for a few

days. On any given day, short-term traders should

follow the current microtrend. If the intraday trend

is up, do not enter short positions. If the market


stays on an uptrend, go long and stay long. If the

intraday trend is down, go short and stay short. Do

this until the market tells you otherwise. You do

not need a multitude of indicators to figure out

where the market might go. Simply follow the cur-

rent microtrend.

KEY TO USING INDICATORS

Make sure you understand what indicators mea-

sure and under what conditions they work best.

Trend-following indicators work best when the

market is in an up or a down trend. They tend to

give false signals in a sideways market. Oscillators

work best when the market is in a trading range.

They catch turning points when the market is

moving sideways, but when the market is in a

trend, they produce false signals.

You can combine different indicators to capital-

ize on positive features and eliminate negative

features. The best possible combination is an

TECHNICAL INDICATORS

WHAT ARE TECHNICAL INDICATORS? A technical indicator is

a series of data points that are computed using the price and

volume actions for a given period. Indicators use several

pieces of data: the open, the close, and the high and low of each period. Some

indicators also consider the volume of each period. Each indicator uses a

specific formula to arrive at the data points.


SPOTTING TRENDS 153

oscillator and a trend-following indicator. Never

combine two indicators of the same type. If you

use two trend-following indicators, price action

that goes with or against the trend will cause the

same results on both indicators. The best results

are usually gained when conflicting indicators

both generate the same signals, whether it is a buy

or a sell signal. Make sure to use an indicator from

the trend-following group and another from the

oscillator group.

Never ignore the price action of a stock. Sup-

pose an indicator has generated a buy signal.

When you look at the chart, you realize the stock is

still trading within a channel or rectangle. The

mere fact that a signal has been generated should

not result in immediate action. Wait for confirming

price actions before taking a position. I would

make sure there is a break of the rectangle, with

volume, before I entered a long position. This is

why the most basic understanding of technical

analysis is necessary.

One final word before we get started with indi-

cators. There are more than 100 technical analysis

indicators, with more being built every day. There

is even technical analysis software that allows

traders to create their own indicators. However

the oldest indicators still work the best. They have

withstood the test of time. Most traders use the

older indicators. This alone increases the likeli-

hood of a successful trade. This section discusses

only these time-tested indicators. Don’t forget:

The specialist makes more money than the gen-

eral practitioner. Be a specialist, not a general

practitioner.

MOVING AVERAGES

There are three main types of moving averages:

the simple moving average (SMA), the exponential

moving average (EMA), and the weighted moving

average (WMA). All three show the average price

of a security over a specific number of periods.

However, the formulas used to arrive at these

averages are different.

A simple moving average shows the average price

of a security over a specified number of periods. A

10-period moving average is the average price of

the last 10 periods. The period could be a day, a

week, a month, or just minutes. Connecting each

period’s SMA value gives you the moving average

line. The formula for simple moving average is as

follows:

SMA (N) =

where P = price of current period

P1 = price of 1 period before

P2 = price of 2 periods before

N = number of periods in the moving average

On most occasions, traders calculate the SMA

using the closing price, but there are also complex

strategies that calculate them from the high, the

low, or the open. This also goes for the EMA and

WMA. It depends on the trader. The trader also

has to choose the number of periods to be used,

which is covered later in this section.

An exponential moving average is calculated dif-

ferently than the simple moving average. It assigns

a greater weight to the data on the latest period.

P + P1 + P2 + P3 . . . + P(N − 1)��

N


Thus it responds faster to current events. The for-

mula for the EMA is as follows:

EMA (N) = (P × K) − (EMA1 × (1 − K))

where K = 2/(N + 1)

N = periods in the moving average

P = price of current period

EMA1 = EMA of 1 period before

To calculate this formula manually, do the fol-

lowing: Determine how many periods you want to

use for the EMA. Then calculate the value of the

coefficient K. Then calculate a SMA to use as EMA1

for the first EMA. Use the preceding formula to get

EMA (N). Repeat the last step to obtain the EMA

for the next period. Computers are available to do

all this dirty work. One press of a button and out

come the results.

A weighted moving average is also designed to put

more weight on recent data and less on past data. It

is calculated much like the simple moving average,

except that each period is multiplied by a weighting

factor. The weighting factor used depends on the

number of periods chosen. Suppose you want a

three-period WMA. Multiply the most current price

by 3, the price from the prior period by 2, and the

price from a couple of periods ago by 1. Add the

three together and divide by the sum of those peri-

ods. In this case, the sum would be 3 plus 2 plus 1,

or a total of 6.

A weighted moving average causes an even

greater reaction to the current price than the expo-

nential moving average. However, it tends to gen-


erate false signals. I suggest that beginners stay

away from this moving average.

Choosing the Number of PeriodsThe number of periods to use depends on the

underlying sentiment you are trying to measure and

the trend you are trying to catch. A short time frame

gives you the average sentiment of that short time

frame. It changes direction more frequently than a

long time frame. A long time frame smoothes out

the noise, but reacts slowly to directional changes.

Long time frames are used when you want to catch

long-term trends. The more popular settings are 10-,

20-, 50-, 100-, and 200-period moving averages.

Uses of Moving AveragesMoving averages can be used to identify trends.

There are several ways to do this. The first is to

determine the slope of the moving average line. If

the slope is rising, the stock is on an uptrend. You

should go long. If the slope points downward, the

stock is on a downtrend. You should short the

stock (see Figure 9.1).

The second method involves finding the current

price location. If the stock price is above the mov-

ing average line, the trend is bullish. If it is below

the moving average line, it is bearish (see Figure

9.2). Based on this method, old mechanical sys-

tems would trade the security the following way:

Every time the price crosses from below the MA

line and closes above the MA line, it generates a

buy signal. Sell the stock if the price closes below

the MA line. A short signal is generated when the

stock crosses the MA line to close below it. Cover


SPOTTING TRENDS 155

9.1 Identifying Trends with Moving Averages

� THE SLOPE OF THE MOVING AVERAGE determines the trend of the stock. If theslope is up, then the trend is up. If the slope is down, then the trend is down.

9.2 Trading Signals from Moving Averages

� THIS CHART ILLUSTRATES the different buy and sell signals generated if youwere trading the crossovers.


the position only when the price closes above the

MA line. The number of periods to use depends on

the trend you are trying to catch. Longer trends

mean using longer periods.

One last note, shorter time periods will generate

more signals than longer periods, because they are

more sensitive to price movement. In a sideways

market, you get a little whiplash. Look at the

MSFT chart in Figure 9.2 for a three-month period.

It crossed back and forth over the MA line several

times during that period, making it tough for the

trader to follow.

The location of the short moving average line in

relation to the long moving average line is another

way to identify a trend. If the short-term moving


average is above the long-term moving average,

the stock is said to be on an uptrend (see Figure 9.3).

If the short-term moving average is below the

long-term moving average, the stock is said to be

on a downtrend.

Moving averages also identify support and

resistance levels. If a stock price is above the mov-

ing average line, a pullback to this line could be a

chance to add to a long position. A break below the

moving average line could be a trigger to exit long

positions and go short. If the stock price is below the

moving average line, a bounce to this line could be

a chance to enter a short position or add to an exist-

ing position. A break above the line could serve as a

trigger to exit a short position and go long.

9.3 Identifying Trends with Moving Averages

� THIS IS ANOTHER METHOD whereby you can use moving averages to identifytrends. In our example, MSFT is considered to be on an uptrend when theshort-term (20-period) moving average is above the long-term (50-period)moving average. It is considered to be on a downtrend when the short-term(20-period) moving average is below the long-term (50-period) movingaverage.


SPOTTING TRENDS 157

SMA versus EMAEMA puts more weight on the most current period

than the SMA and gradually fades the last period

away. On the other hand, SMA assigns equal

weight to each period. In reality, current news and

sentiment should have the most weight. For the

purpose of day trading, exponential moving aver-

ages work best. Day traders are concerned with

short time frames. Recent news on a security is

important in short-term trading. An EMA does the

job, and SMA does not. I suggest that short-term

traders use the EMA instead of the SMA (see Fig-

ure 9.4).

Using the same periods we had on MSFT ear-

lier, I removed the candlestick patterns and left

only the EMA (20) and SMA (20). If you look at the

turning points on the chart in Figure 9.4, you will

notice that the EMA line (dashed line) almost

always turned before the SMA line (solid line)

turned. It did not matter whether the change in

direction was from up to down or from down to

up. The reaction was always faster and earlier.

For short-term traders, this slight edge is of

prime importance. The last thing I want is to be

stuck in a long position when the trend has already

started to change to the downside.

Advantages and DisadvantagesMoving averages smooth out the prices, filter out

the interperiod noise, and help identify the under-

lying trend. They are great trend-following indica-

tors. When the market is in a trend, whether an

9.4 EMA versus SMA

� ALTHOUGH THE EMA AND SMA LINES SHOWN HERE are both calculated basedon 20 periods, notice how the slope of the EMA always turns before the slopeof the SMA does. This tells us that the EMA reacts to current events a lotquicker than the SMA.


uptrend or a downtrend, moving averages help

the trader maximize gains. On an uptrend, a trader

should keep long positions while the stock stays

above the MA line. On a downtrend, a trader

should keep short positions while the stock stays

below the MA line. However, moving averages are

ineffective when the market is in a trading range.

They generate false signals and cause whipsaws.

Traders should be aware of market conditions

before using this indicator. In a sideways market, it

is best to leave this indicator alone. Another disad-

vantage of this indicator is the way signals are gen-

erated. MA traders receive signals only when

prices have crossed over to the other side of the

MA. The problem is that MA lines are always

drawn from historical data. For this reason, it is

considered a lagging indicator. It lacks the predic-

tive powers of the other indicators we have here.

MOVING AVERAGE CONVERGENCE DIVERGENCE

The moving average convergence divergence

(MACD) indicator is another trend-following indi-

cator. It was invented by Gerald Appel, a New

York analyst and money manager. It consists of

three exponential moving averages. To plot the

MACD indicator, you need to do the following:

Calculate a 12-period EMA of the closing prices.

Calculate a 26-period EMA of the closing prices

Subtract the 26-period EMA from the 12-period EMA.

Plot the difference as a solid line. This is called the

MACD line.

Calculate a 9-period EMA of the MACD line.


Plot the result as a dashed line. This is called the

signal line.

The 12, 26, and 9 periods are the most widely used

numbers. Some traders like to optimize these

numbers by linking them to market cycles. MACD

provides three main signals: crossovers, over-

bought and oversold conditions, and divergences.

CrossoversMACD is plotted as two lines on a chart. One is a

solid line and the other a dashed line. The solid

line is the MACD line. It is also called the fast line.

The dashed line is the signal line. It is also called

the slow line. Trading signals are generated when

these lines cross each other.

A buy signal is generated when the MACD line

crosses over the signal line from below to close

above the signal line. When the MACD line crosses

the signal line to close below it, a sell signal is gen-

erated (see Figure 9.5).

Looking at the KLAC chart in Figure 9.5, we see

four trade signals generated by the MACD. The

first is a buy signal when the MACD line (solid)

crossed the signal line (dashed). Notice that the

MACD line was below the signal line before the

signal was generated. Only when it closes above

the line will the entry be triggered. While the

MACD line continues to stay above the signal line,

do not enter or exit a position. Simply continue to

hold the position. A sell order is triggered only

when the MACD line crosses the signal line and

closes below it. This indicates a sell-to-close or sell-

short-to-open position.


SPOTTING TRENDS 159

Notice that the MACD came down several times

but never crossed the signal line following the sec-

ond buy entry. No action should be taken. It finally

did break below the signal line on the fifth try. This

is the only time a sell order should be entered.

Overbought and Oversold ConditionsOverbought and oversold conditions are indica-

tions of extreme optimism and extreme pessimism

in the market. The market is like a big rubber band.

It can be stretched only so far. Sooner or later, it has

to snap back. The longer it’s stretched, the harder

the snapback will be. In an overbought condition,

buyers have been too aggressive. Soon, the momen-

tum will end and a sell-off will occur quickly. In an

oversold condition, sellers have been too aggres-

sive. Once the selling momentum ends, only buyers

are left. They will push the price up rapidly. To

determine whether an MACD indicates an over-

bought or oversold condition, watch the distance

between the MACD line and the signal line. If the

MACD line starts pulling away dramatically from

the signal line, it is possible that the security is

overextended. Prices could snap back soon.

DivergencesThe most powerful signal the MACD can generate

is a divergence. A bearish divergence occurs when

9.5 Moving Average Convergence Divergence

� A BUY SIGNAL IS GENERATED when the MACD line (solid line) crosses abovethe signal line (dashed line). A sell signal is given when the MACD line crossesbelow the signal line. Look at how MACD signals help catch a major part of thetrends on KLAC.


the indicator fails to confirm that a new high has

been established. This means that while the price

has hit a new high, MACD stayed at the same levels

or lower than the previous high. A bullish diver-

gence occurs when a new low is established and the

indicator fails to confirm the move with a new low.

Let’s analyze the KLAC chart to see whether a

bearish divergence has occurred. Pay no attention

to the crossover trade signals that it is generating.

Simply look at the three price peaks I have circled

in Figure 9.6. Each of these peaks has a correspon-

ding MACD reading. To find out what the read-

ings are, follow the long line down to the bottom of

the chart.


Between point A and point B, you will notice the

following: Point B is a new high price. MACD at

point B is also higher than it was at point A.

MACD has confirmed this price move. It is vali-

dating a new peak in price. Chances are the price

will move higher again in the future.

Between point B and point C, things are differ-

ent. Point C is a new high in price. However,

MACD has not established another high. It has

now fallen below the MACD high set at point B.

This is when a divergence is said to have occurred.

As you can see in Figure 9.6, the signal foretold

the big decline that ensued the next month. The

stock dropped from around $95 to below $50.

9.6 MACD Divergences

� THE CHART OF KLAC HERE SHOWS that, although prices broke to a new highbetween points B and C, MACD failed to confirm to move with a new high. Abearish divergence signal was triggered as soon as the slope of the MACDturned down.


SPOTTING TRENDS 161

MACD HISTOGRAM

The MACD indicator can also be plotted into a his-

togram. The MACD histogram measures the dif-

ference between the MACD line and the signal

line. To calculate this difference, subtract the value

of the signal line from the value of the MACD line.

The MACD histogram is plotted into vertical

bars. They are much like volume bars, except there

is a zero line in the middle. If the MACD line is

above the signal line, the result is positive and a

vertical bar would appear above the zero line. If

the MACD line is below the signal line, the result

would be negative and a vertical bar would then

appear below the zero line.

Two trading signals are generated when using

the histogram. The first is generated when the

slope of the histogram changes direction. The sec-

ond, an extremely strong signal, occurs when there

is a price divergence with the MACD histogram.

Slope Direction ChangeThe most important part of the MACD histogram

is the slope. If the slope is up, then consider long

positions. If the slope is down, consider short posi-

tions. Trading signals are generated when the fol-

lowing conditions apply: For buy signals, the

MACD histogram has to be below the zero line. A

trading signal is generated once the slope of the

histogram changes. Once a position is entered, a

stop-loss order should be placed just slightly

below the last support.

For sell signals, the MACD histogram has to be

above the zero line. A trading signal is generated

when the slope turns downward. Once a short

position is opened, place a stop-loss order just

slightly above the last high.

The chart of E-mini Nasdaq 100 futures in Fig-

ure 9.7 shows how trading signals are generated.

While the slope of the MACD remains positive or

neutral, long positions should be kept. Exit only

when the slope turns negative. This is also the

point where a short position can be entered. In the

case of short, stay in the position until the slope

turns positive. Observe the stop-loss point if it is

violated. Exit the position and reevaluate.

Point A is the only point at which you would

not hold any contracts of the E-mini Nasdaq 100

futures. The long position was stopped out. A

word of warning: These signals tend to occur fre-

quently. They are for traders with a high tolerance

for loss. Try to get in at the beginning of a trend

and ride it for as long as possible. Traders who fol-

low this method will find themselves stopped out

several times until they finally catch a big run. The

big runs usually pay for the losses. Unfortunately,

there are times when the market does not have a

strong trend and losses are substantial. A better

way is to use different time frames. A long-term

trader should use a weekly MACD chart. A short-

term trader can use the daily charts for intraday

trade signals. Never use the same period as the one

you are trading. Back away and look at the bigger

picture.

DivergencesMACD histograms also generate divergence sig-

nals. This signal does not occur often, but it is a


strong trading signal. Divergences tell us that the

bulls are losing momentum in an uptrend. The

stock is due for a reversal. On a downtrend, diver-

gences also suggest that sellers are losing momen-

tum. They are getting weaker. A possible reversal

could be in the works. Bullish divergences occur

when the MACD histogram fails to confirm a new

low in price, and bearish divergences occur when

the histogram fails to confirm a new high in price.

Let’s take a look at the chart of BRCM in Figure

9.8 and discuss the divergence trade signals. Pay

attention to the slope change for signs of trend

direction change.


Two bullish divergence signals were generated.

The first occurred between point A and point B.

Point B established a new low for BRCM. The

MACD histogram failed to confirm this signal.

This set up an entry point when the slope

turned upward. The stop-loss point should be

placed just slightly below the low of point B. After

a small rally, sellers again stepped in and forced

the price down. The stop-loss point was hit and the

trade was closed for a loss. The sell-off ended at

point C, and another bullish divergence signal was

triggered. Point C was a new low in price, but the

histogram failed to confirm it.

9.7 MACD Histogram

� BUY AND SELL SIGNALS ARE GIVEN on this indicator when the direction of theslope changes. When the slope of the MACD histogram turns up, it generates abuy signal. A sell signal is given when the slope of the MACD histogram turnsdown.


SPOTTING TRENDS 163

The strongest bullish signals are those in which

point C is higher than both points B and A. These

double divergence formations are rare and are

among the most powerful signals you will ever get

with indicators. It shows that the bears have com-

pletely lost momentum. They present a fantastic

long opportunity. When these double divergences

are found on the bearish end, do not hesitate to go

long. The second long entry on BRCM (see Figure

9.8) proved to be profitable. The stock ran from $35

to $44. This more than covered the small loss sus-

tained on the first trade.

STOCHASTIC OSCILLATOR

George Lane popularized the use of the stochastic

oscillator as a technical indicator. It compares the

relationship between the closing price and its price

range over a given period of time. The stochastic

oscillator consists of two lines: the fast line, called

%K, and the slow line, called %D.

The formula for %K is as follows:

%K = � � × 100

where C = close of today

C − L(N)��H(N) − L(N)

9.8 MACD Histogram Divergences

� DIVERGENCES BETWEEN THE MACD HISTOGRAM AND THE PRICES can identifymajor trend reversals. As prices on BRCM declined to new lows between pointsA to B and B to C, this indicator makes a slightly higher low each time. This isa bullish divergence signal. BRCM made a very powerful move once the slopeon the MACD histogram turned up (which was your buy entry signal).


L(N) = lowest point within the number of periods

selected

H(N) = highest point within the number of periods

selected

The %D is obtained by calculating a moving

average of %K. The number of periods for this

moving average usually differs from the number

of periods used for %K. The standard number of

periods for %K is five, with a smoothing period of

three. I have also seen a 5/3, a 10/3, and a 14/8

combination used successfully. A shorter %K

period catches more turning points, while a longer

%K period (14 to 21) will help identify significant

turning points.

It is impossible to get a negative number as a

result. Since it is calculated as a percentage of the

periods’ high and low range, the result would

fluctuate between 0 and 100. A reading of 100 per-

cent indicates that the price closed at its highest

level within the selected number of periods. A

reading of 0 percent tells us that the price closed

at its lowest level within the selected number of

periods.

On the chart, the %K is plotted on a solid line

and the %D is plotted on a dashed line. Reference

lines are drawn at the 20 percent and 80 percent

levels. When stochastic reaches the 80 percent

level, the market is considered overbought. When

it goes below the 20 percent level, the market is

considered oversold.

Stochastic oscillators generate three popular

trading signals: overbought and oversold levels,

crossovers, and divergence.


Overbought and Oversold LevelsThe first signal is based on the overbought and

oversold levels at 20 percent and 80 percent. A buy

signal is generated when the stochastic oscillator

(either %K or %D) falls below the 20 percent level

and then rises above that level. A sell signal is gen-

erated when the stochastic oscillator (either %K or

%D) rises above the 80 percent level and later falls

below it.

The chart of BRCD in Figure 9.9 shows the buy

and sell signals generated using the first method.

Protective stops on a long position should be

placed just under the most recent low, while a pro-

tective stop on a short position should be placed

just above the most recent high. For long positions,

tighten stops on the position once it gets close to

the overbought level. For shorts, tighten stops on

the position once it gets close to the oversold level.

Notice that BRCD (see Figure 9.9) started to form a

downtrend toward the end. Buy 4 would have

been stopped out for a loss. Stochastic oscillators

work well in a sideways market, but they generate

a lot of false signals when the market is in a trend.

CrossoversThe second trading signal generated by the sto-

chastic oscillator is the crossover. A long entry is

generated when the %K line rises above the %D

line, and a short is generated when the %K line

drops below the %D line. In this case, you would

also use a crossover as an exit signal. Most traders

are always in a position. They cover their short

positions and go long, and later they sell the long

and go short at the same time. During a sideways


SPOTTING TRENDS 165

market, this strategy can produce good profits for

traders.

The chart of QLGC in Figure 9.10 makes the

idea a little clearer. In this method, the stochastic

trader would always be in a position. Every buy

marks a point where the trader is covering a short

position and reversing it to go long. Every sell

marks the point where the trader sells to close the

long position and also sells to open a short posi-

tion. In this case, the only time the trader takes a

loss is when the trend continues down on the sec-

ond to the last buy signal.

DivergenceDivergence signals in stochastic oscillators are also

powerful signals. A bullish divergence occurs when

prices establish a new low but stochastic fails to

follow suit. A strong buy signal is given as soon as

stochastic turns up from its second bottom. The

best buy signals are those in which the first bottom

is below the 20 percent reference line and the sec-

ond is above it.

A bearish divergence occurs when the price estab-

lishes a new high but stochastic manages to stay

below the previous high. A strong sell or short sig-

9.9 Stochastic Overbought and Oversold Trade Signals

� STOCHASTIC BUY SIGNALS ARE GENERATED when this indicator falls below the20 percent level and then rises above it again. A sell signal is given when thisindicator rises above the 80 percent level and then falls below it again. Thechart here shows you all the different signals that would have been generatedon BRCD using this indicator.


nal is generated as soon as stochastic turns down

from the second top. The best signals are those in

which the first top is above the 80 percent refer-

ence line and the second top is below it.

Agoodexampleofabearishstochasticdivergence

is ITWO, shown in Figure 9.11. The price at point B

managed to break to a new high, a bullish sign. How-

ever, when compared with point A, stochastic tells a

different story. It refutes the move and is unable to go

along with the new high. Stochastic declined

between period A and period B. The uptrend was in

jeopardy. The reverse followed almost immediately,

and prices later dropped severely.


RELATIVE STRENGTH INDEX

Welles Wilder introduced the relative strength

index in 1978. It is an oscillator that measures the

strength of a stock by tracking changes in its clos-

ing price. It is a good leading indicator. It never

lags behind. This is one of the reasons its popular-

ity has grown. The formula for RSI is as follows:

RSI = 100 − � �where U = average of upward price change in the selected

period

100�1 + ��

DU

��

9.10 Stochastic Crossover Trade Signals

� BUY AND SELL SIGNALS ARE ALSO GENERATED when the two lines cross. Lookto take a long position when the %K line (solid line) rises above the %D line(dashed line). Take a short position when the %K line falls below the %D line.The chart of QLGC shows all the signals that would have been generated if youwere trading the crossovers.


SPOTTING TRENDS 167

D = average of downward price change in the

selected period

Six steps need to be taken to calculate this oscil-

lator:

●1 Separate the days with a closing price higher than the

previous period and the days with a closing price lower

than the previous period.

●2 Figure the upward price change for each closing price

that went higher by subtracting the closing price from the

preceding closing price within the selected period.

●3 Calculate the average upward price change by adding

all upward price changes within the period and dividing

the result by the selected number of periods.

●4 Figure the downward price change for each closing

price that went lower by subtracting the preceding closing

price from the closing price within the selected period.

●5 Calculate the average downward price change by

adding the downward price change within the period and

dividing it by the selected number of periods.

●6 Finally, calculate the RSI by plugging in the values

obtained in steps 3 and 5.

Isn’t it great that we have computers to do all that

calculating for us?

The results are then plotted in a separate study.

RSI results will fall between 0 and 100. Like the sto-

chastic oscillator, reference lines are also drawn to

9.11 Stochastic Divergences

� THE MOST POWERFUL SIGNAL THIS INDICATOR CAN GENERATE is thedivergence signal. This chart shows a bearish divergence on ITWO. Althoughprices rose to a new high, the stochastic line failed to confirm the move.Instead, this indicator established a lower high.


indicate overbought and oversold conditions. For

RSI, they are often drawn at the 30 and 70 levels.

Some traders change these levels according to

market conditions. For bear markets, they use a 20

and 60 level. For bull markets, they draw the lines

at the 40 and 80 levels. When you vary the levels of

your reference lines, make sure that RSI has spent

less than 5 percent of the time at those levels for

the past 80 to 100 periods. Otherwise, you need to

redraw them to better fit the conditions.

When Wilder introduced this oscillator, he rec-

ommended using a 14-period RSI. The 9- and 25-

period RSIs have since gained a wide following.

The lowest period I recommend on RSI is seven.

You should experiment with different periods to

find out which works best for you. Keep in mind

that the lower the number, the more volatile the

indicator tends to be. Volatile indicators generate

more trading signals than less volatile ones. For

short-term traders, volatile is better, because they

catch short runs. Long-term traders should work

with a higher number of periods.

In his book, New Concepts in Technical Trading

Systems, Wilder discusses five uses for the RSI.

However, the most common uses are for over-

bought and oversold conditions, chart patterns,

and divergences.

RSI LevelsThe relative strength index usually turns around

when it goes above the upper reference line at 70

percent. It also bottoms below the lower reference

line at 30 percent. Buy signals are generated when

RSI declines below the lower reference line and


then rises above it. Sell signals are generated when

RSI goes above the upper reference line and then

crosses back below it (see Figure 9.12).

The chart in Figure 9.12 shows the buy and sell

signals generated if you were trading HPQ using

RSI levels. Stop-loss points on these trades should

be at the most recent low for a long position and

the most recent high for a short position. In the

case of HPQ, the second sell signal would have

resulted in a loss when the price surged upward.

After exiting the position, sit on the sidelines and

reevaluate the opportunity before reentering. The

third sell signal proved to be profitable after RSI

declined below the reference line again.

This method of entering into a long and short

position is best combined with the trend of the big-

ger picture. If you first check the trend on the

weekly chart, entering on an RSI-level trigger usu-

ally produces better results. For intraday trading,

make sure the direction of your RSI trade coincides

with the trend on the daily chart.

Just to be clear on this issue, if the stock is on an

uptrend on the daily chart (bigger picture), the only

trade I would take based on the RSI level intraday

is a long. In order for it to trigger an entry, intraday

price has to meet the preceding conditions. On the

other hand, if the stock is on a downtrend on the

daily chart, the only trade I would take based on

RSI level intraday is a short. Again, RSI level condi-

tions also have to be met before I would trade.

Chart PatternsClassical technical analysis works better with the

relative strength index than with any other indica-


SPOTTING TRENDS 169

tor. Trendlines, supports and resistance, triangles,

and head and shoulders patterns will all work

with RSI.

The RSI will often complete patterns or a trend-

line break before the charts. If you see an ascend-

ing triangle breakout on RSI, chances are the price

of the stock will also break out to new highs. This

prepares you for the upcoming move.

Another example would be a trendline break.

When RSI breaks an uptrend line, get ready to go

short when the uptrend line of the stock is broken.

DivergencesDivergences between RSI and prices also give the

best signals for this indicator. A bullish divergence

occurs when a new low price is established and the

RSI indicator fails to confirm the move with a new

low. The best bullish RSI divergence setup is when

the first RSI bottom is below the lower reference

line and the shallower second RSI bottom is above

the lower reference line. When a bullish diver-

gence occurs, enter long as soon as RSI turns up

from the second bottom. Place a stop-loss order

9.12 Relative Strength Index

� RSI BUY AND SELL SIGNALS ARE GENERATED much like stochastic signals. Theonly difference is that RSI uses the 30 percent and 70 percent levels. Whenthis indicator rises above the 70 percent level and falls back below it, a sellsignal is generated. When this indicator falls below the 30 percent level andrises back above it, a buy signal is given. The chart of HPQ shows the differentRSI buy and sell signals that would have been generated.


slightly below the latest low. Trail to exit the posi-

tion to maximize profits.

A bearish divergence occurs when the price

makes a new high but the RSI indicator makes a

lower top. This signal is strongest when the first

RSI top is above the 70 percent reference line. On a

bearish divergence, sell short as soon as RSI heads

downward from the second top. Place a stop-loss

order slightly above the latest high. As always,

trail to exit this position to maximize profits.

The chart of AMZN in Figure 9.13 shows an RSI

setting of nine. It is showing a bearish divergence.

The price hit a new peak at point B, but the RSI


made a lower top. A sell-short signal was gener-

ated when RSI turned down below the 70 percent

level. A stop-loss order should be placed above the

peak at point B. The stock turned around from

there and headed south more than 40 points.

ON-BALANCE VOLUME

Joseph Granville developed this indicator. It was

originally presented in his book, New Strategy of

Daily Stock Market Timing for Maximum Profits. On-

balance volume (OBV) is a leading indicator that

relates volume to price change. It keeps a running

9.13 RSI Divergences

� THE CHART OF AMZN SHOWS A BEARISH DIVERGENCE between points A and B.Prices rose to a new high between points A and B. On the other hand, RSImade a lower high. It was not able to confirm the breakout. A short positiontaken once this indicator turned would have profited handsomely.


SPOTTING TRENDS 171

total of volume, rising and falling depending on

the changes in the closing price. If the price closed

higher than the previous period, volume for the

period is added to OBV. If the price closed lower

than the previous period, volume is subtracted

from OBV. If the price closed the same as the previ-

ous period, then OBV stays the same. The most

basic assumption regarding OBV analysis is that

OBV moves before the price. That is why it is con-

sidered a leading indicator.

The OBV movement gives us an idea of what

the large institutions are doing. If it is rising,

money is flowing into this security. If it is falling,

chances are the institutions are cashing out of this

security.

One of the trading signals OBV generates is

based on this condition. A buy signal is generated

if OBV breaks out and reaches a new high. The

breakout confirms the buying strength and indi-

cates that prices are likely to go higher. On the

other hand, a sell signal is generated if OBV breaks

down and reaches a new low. The breakdown con-

firms that sellers are in control of the market and

prices are likely to decline further.

The OBV gives a second trading signal when it

diverges from prices. If the price rallies to a new

high, but OBV does not, then a bearish divergence

signal is triggered. You should sell to close long

positions or sell to open a short position. An OBV

bullish divergence occurs when the price hits a

new low while OBV establishes a higher bottom.

This generates a strong buying signal.

The IDTI chart in Figure 9.14 shows an OBV

bullish divergence. In the early part of July, the

price broke slightly lower than the low established

in the middle of June. However, OBV failed to con-

firm the move. If you compare the OBV level

between the two lows at point A and point B, you

will notice that OBV was higher at point B. To con-

firm the price breakdown, OBV should be lower at

point B than at point A. In this case, it was not. A

bullish divergence is said to have occurred.

The trade would be to go long once OBV turned

up. Place a protective stop just slightly below the

low of point B. Entry on this trade would be some-

where around $28. The stock ran all the way past

$40, for a nice gain of over $12.

ACCUMULATION/DISTRIBUTION

This leading indicator, called accumulation/distri-

bution (A/D) was developed by Larry Williams in

1972. He described it in his book, How I Made a Mil-

lion Dollars. Like OBV, this indicator also incorpo-

rates volume into its analysis. However, instead of

just tracking volume’s relationship to changes in

closing prices, this indicator also tracks volume’s

relationship to the high-low range.

The A/D line is calculated by adding and sub-

tracting part of each period’s volume from a

cumulative total. The amount of volume added or

subtracted depends on the relationship between

the close and the high-low range. More volume

would be added to the cumulative total if the secu-

rity closed at or near its high.

Conversely, if the security were to close near its

low, a lot more volume will be subtracted from the

cumulative total. If the closing price was exactly in


the middle of the period’s range, then nothing is

added to the cumulative total.

The formula for A/D is as follows:

A/D = × V

where C = closing price

L = lowest price

H = highest price

V = volume

Interpretation of the A/D line is basically the

same as OBV. The A/D line should be leading an

(C − L) − (H − C)��

(H − L)


uptrend while the market is strong. The A/D line

should also be leading the downtrend in a weak

market. This is because of institutional money

going in and out of the security.

Trading signals are generated in the same two

ways as OBV. First, trading signals occur when

there is a break of previous support and resis-

tance levels on the A/D line. A break out of the

A/D line to a new high is a signal that higher

prices are coming. Go long as soon as price action

confirms the signal. A breakdown of the A/D line

to a new low is a signal that prices will be declin-

9.14 On-Balance Volume Divergences

� BULLISH OR BEARISH DIVERGENCES on this indicator rarely occur, so they arevery powerful signals. This chart of IDTI shows a bullish divergence signalbetween points A and B. Notice how the OBV indicator failed to confirm thebreakdown in price. Sellers did not have any power at all to move the pricesdown. Prices turned up and the trend reversed.


SPOTTING TRENDS 173

ing soon. Go short as soon as price action con-

firms the signal.

Second, a stronger signal occurs when the A/D

line diverges from prices. A bearish divergence

occurs when a new high in price is not confirmed

by a new high on the A/D line, and a bullish diver-

gence occurs when a new low in price fails to see a

new low on the A/D line. Bullish divergence gives

strong buy signals while bearish divergence gives

a strong sell signal.

FUTURES AND PIVOT POINTS

The candlestick chart in Figure 9.15 shows a lot of

information: stochastic %D, volume, MACD his-

togram, and three moving averages. All of these

have been discussed previously. What is new is

that pivot point lines have been added. The E-mini

futures are very useful in spotting trends. Remem-

ber, both the Nasdaq and S&P futures contracts are

based on the Nasdaq 100 and the S&P 500 Indices.

The old saying “A rising tide lifts all boats” (and

vice versa) is very true. If, for example, you are in

a long trade and futures are trending upward, it’s

like having the wind at your back: The odds will

be increased in your favor. Futures will tend to

lead the market, so watching them closely will

help your trading.

Adding pivot points adds one more piece to

puzzle. As you can see in the chart in Figure 9.15

showing S&P E-minis, the market hit resistance

and support right on the S1 line and also on the PP

line. The calculation of pivot points is fairly sim-

ple. Most of the better trading platforms include

them in their technical studies that you can add to

your charts. If not, a simple spreadsheet can be set

up to do the calculation for you, and you can then

draw the lines manually on most charting pack-

ages. Pivot points are based on the prior day’s

high, low, and close. These values suggest where

the futures will pivot up or down and hit levels of

support or resistance. You can also apply them to

individual stocks, but they work best on futures

contracts.

To calculate the pivot point support and resist-

ance levels, you need yesterday’s high, low, and

close. The pivot point is simply the average of the

high plus low plus close, or (H + L + C) ÷ 3. Sup-

port level 1 is calculated by multiplying the pivot

by 2 and then subtracting the day’s high. Resis-

tance level 1 is calculated by multiplying the

pivot by 2 and then subtracting the day’s low.

Finally, the secondary support (S2) and resistance

(R2) levels are calculated by using the numbers (P,

S1, and R1) created in step one. This is how they

are calculated:

Pivot (P) =

where Resistance level 1 = (2 × P) − L

Support level 1 (S1) = (2 × P) − H

Resistance level 2 (R2) = (P − S1) + R1

Support level 2 (S2) = P − (R1 − S1)

Once you have made these calculations, it is

best to plot them on your intraday futures chart.

These lines will often alert you to areas where the

market is likely to turn. There are three ways you

H + L + C�

3


can take advantage of this information. First, let’s

suppose you are in a trade that is on the same

direction as the market. As the market gets close to

a pivot point, my suggestion is to watch your posi-

tion a little closer. Should the market reverse at the

pivot point, you might want to tighten your stop a

bit or even choose to take some profits on the posi-


tion. The reason is because as the market turns and

goes against your trade, it is very likely that your

position will also move against you. Second, let’s

suppose you are looking to get into a position. If

the market is nearing a pivot point and the direc-

tion it traveled before is the same as the direction

of your trade, my suggestion is to hold off on the

9.15 Futures with Pivot Points

� THE E-MINI FUTURES WITH PIVOT POINTS are a valuable tool for determining trend and support and resistance.


SPOTTING TRENDS 175

entry. It is better to wait until the pivot point is bro-

ken before entering the position. Third, if the mar-

ket is nearing a pivot point and the direction it

traveled before is opposite the direction of your

trade, my suggestion is to get in immediately on

the trade once you see prices on the futures bounce

off the pivot point. The reverse would put your

trade in the same direction as the market and

should help your trade.

CONCLUSION

Trend-following indicators work well when the

market is in a trend, and oscillators work better

when the market is in a trading range. Make sure

you know what the current market conditions are

before using an indicator to trade.

For the purpose of short-term trading, it is not

necessary to learn the whole encyclopedia of

trading indicators. The most basic technical

analysis tools, the most basic charting methods,

and the most commonly used technical indicators

are all you need to succeed. It is more important

to learn how to use each of these tools properly

than to learn more tools. Mastering the basic tech-

niques will give you the edge you want. The rest

depends on your discipline and dedication. Trade

only when you have developed a solid plan. ●$


CHAPTER 10

Preparing forthe Open

• The Trading Day

• Do the Research

• Manage Risk

• Set Alerts and Trading Screens

• Intraday Trading

• Market Indices

• Other Market Indicators

• Direction of Market Trends

• Keep a Trade Journal


Be prepared. The first step is to be prepared. This

means following methodology and risk manage-

ment disciplines. Never step into day trading if

you are not prepared.

Here is the step-by-step preparation process

that I go through.

DO THE RESEARCH

What you need to research depends on the

methodology you choose. In Chapter 9, I outlined

several good trading signals and opportunities.

Each and every day I rank the stocks on my watch

list according to the type, strength, and number of

signals they have generated. Each signal is

assigned a value depending on the strength of

those signals. Stocks that are mildly bullish will

have a value of +1. They show a breakout of a

resistance, an uptrend above the 20-day moving

average, and an RSI crossover above the lower ref-

erence line. The more powerful signals are

assigned bigger values. All bullish divergences

will have a value of +5.

Bearish stocks will have negative values rang-


ing from −1 to −5. Bearish divergences rank the

highest while bearish reading generated by basic

technical analysis would have a value of just −1.

After assigning these values, I add everything

together. I find that the more negative the number,

the more bearish the stock will be. I also find the

stock to be more bullish if the number is more pos-

itive. For example, a stock on an uptrend (+1) that

is breaking out of resistance (+1) will have a value

of +2. It will rank higher than a stock that is just on

an uptrend and that has a value of +1. A stock on a

downtrend (−1) will not be as negative as a stock

on a downtrend (−1) that is breaking a support

level (−1). This is because the second stock has a

total value of −2. The best trading candidates are

those at the two extremes, the most bullish and the

most bearish. I recommend following just a few

until you are comfortable handling more. I have

followed as many as 40 stocks on a given day, 20 of

the most bullish and 20 of the most bearish.

Here are a few things to watch out for when you

are assigning values. Do not follow two indicators

of the same type. They tend to give the same signals

and skew the results according to their advantages.

THE TRADING DAY

GETTING READY FOR EACH TRADING DAY is invaluable for

the successful day trader. Investing your time in a number of

basic procedures that I discuss in this chapter will improve your

chances to persevere and succeed each trading day.


PREPARING FOR THE OPEN 179

When using the oscillator and volume indicators,

follow just one indicator. This goes for trend-

following indicators, too. Do not forget that some of

these indicators can generate more than one trading

signal. When both signals are triggered, both of

their values have to be added to the running total

for the stock. Finally, the values you place on each of

these bullish and bearish signals should be adjusted

based on your trading experience. If you have had

successes with breaks of support and resistance lev-

els, assign a higher positive and negative value to

these indicators so they come to the top of your list

more often. It makes sense to trade the combina-

tions that have made money for you in the past.

MANAGE RISK

The next step is to work on risk management. To

use risk management effectively, you must know

at what price point you will consider entering into

a position. One of the most common entry points

for short-term traders is a break of the previous

day’s high or the previous day’s low. A break of

the previous day’s high triggers a signal to go

long. A break of the previous day’s low triggers a

signal to go short. This is because the high and low

of the previous day were the resistance and sup-

port levels that day.

Other entry points are those called for on the

chart patterns you found—such as breakout or

breakdown prices on a rectangle formation. The

choice should be based on the methodology or sys-

tem that generated the trading signals.

Whatever your entry points are, you need to

note them on your trading candidate list. Then fig-

ure the stop-loss point for each of these candidates.

Again, their location depends on the methodology

that generated the signal. A bearish divergence sig-

Account size: $50,000Percentage risk: 2%Risk per trade: $1,000

Long Entry S/L Shares Short Entry S/L Shares

ABGX 27.94 24.88 327 HGSI 31.66 35.11 145

BRCD 19.65 17.78 535 IDPH 48.48 50.61 235

BRCM 26.86 24.40 407 IDTI 23.11 24.97 269

CIEN 12.75 11.14 621 JDSU 6.50 7.52 490

CKFR 20.76 17.66 323 MERQE 25.52 27.39 267

TABLE 10.1 Sample Risk Management Table


nal usually has a stop above the latest minor high.

A rectangle would have the stop placed slightly on

the inside of the rectangle. Each of the methods we

described in the earlier chapter has its own stop-

loss point. It is important that you follow them.

They have already been time-tested, so you do not

have to reinvent the wheel. Next, calculate the

appropriate number of shares to take in the posi-

tion. Divide the risk per trade by the per-share

stop-loss amount to arrive at the number of shares

to trade for each candidate. You end up with some-

thing similar to Table 10.1, which should be pre-

pared before the market opens. Mark your long

candidates on one side of the sheet and the short

candidates on the other side. Then list the number

of shares you want to trade. When the entry signal

is triggered intraday, all that is left is to get the

order executed.

SET ALERTS AND TRADING SCREENS

After the preceding steps, set your alerts and

trading screens. It will be obvious after a few

days that you do not trade the same stocks all the

time. When you trade with a ranking system, the

candidates will rotate from day to day. Today,

QCOM might be one of the strongest candidates,

and the next day it may not be. The trading

screen on your computer must be changed man-

ually as new trading candidates emerge. Do this

before the market opens. Now set your alerts.

Most real-time trading software programs come

with alert functions. Some platforms offer only

very basic functions; others offer very elaborate


systems. This is an area you want to research

when picking a trading platform, because it

becomes an important part of most trading sys-

tems. An alert is a software function that will at a

minimum alert you when a price has been hit.

The better platforms take this function much fur-

ther. Some will alert you, place orders, cancel

orders, load stocks in the order entry window,

and more. Figure 10.1A shows you an example

of the alert entry window on CyberTrader Pro.

After alerts are entered you need a way to keep

track of them and modify them. Figure 10.1B

shows the Alert tab in CyberTrader that lists all

of the active and inactive alerts. Placing an alert

on all candidates helps you in a number of ways.

It is impossible to follow all candidates all the

time. Loading all the trade candidates into a

Market View window (see Figure 10.2) will

reduce your workload by allowing you to organ-

ize them and check the status of the alert (high

and low) for the day, change from open and

close, review the 52-week high, switch industry

sectors, and so on.

Traders who continually miss opportunities

have a tendency to force their trades. They get into

trades late, or, fearful of missing the next opportu-

nity, they get into a trade early, before a confirma-

tion has been generated. When your entry is late,

the risk is higher because the stop-loss point is fur-

ther away. Both cases will lead to poor results.

Another tendency is to try to make the late entry

work by holding it. This means you let your losers

run. This fear of missing opportunities does not

breed confidence. It is a never-ending cycle that



10.1 Alert Entry Window

� THE ADD ALERT WINDOW, where an alert forBIDU is being set, and the Alert tab in theAccount Manager, where all the alerts arelisted and can be edited, removed, activated,or deactivated.


can easily be broken by simply setting alerts. It

does not take a lot of effort or time, and the results

can be dramatic.

Placing an alert also frees the trader to do other

things. Many professional traders take on multiple

positions. If their attention is devoted to catching


trade entries, what will become of their open posi-

tions?

A large part of trading involves trade manage-

ment. After getting into a trade, your first concern

is to control losses. You need to place an order to

exit at the stop-loss point. If the trade goes your

10.2 The Market View

� HERE IS THE PLACE to keep track of all trading candidates.



way, you still have to manage your trade. You need

to take steps to protect profits. You need to watch

the market. You need to watch the stock. You need

to move your trailing stops. There is always some-

thing to do, especially if you carry multiple posi-

tions. Don’t forget that you can set an alert for

stop-loss orders, or on some platforms just go

ahead and place the order where it is held on the

server. A little extra safety just in case you have

Internet connection problems or computer break-

downs.

INTRADAY TRADING

Ding! Ding! Ding! The market is now open for

business! What do you do next?

The first step is to watch the market indices. A

market index is a moving average of a group of

stocks, either within a specific sector or encompass-

ing all sectors. The market index acts as a barome-

ter for either a specific sector or the entire market.

The most well-known indices are the Dow Jones

Industrial 30, the Nasdaq Composite, the NYSE

Composite, the S&P 100, and the Nasdaq 100.

There are two types of market indices—cash

and futures. The cash indices are a compilation of

the data gathered from all the stocks in the index.

For example, the cash index of the Dow Jones 30 is

based on the stock prices of those 30 underlying

stocks. But the index changes only after the stock

prices have already changed. That is why they are

called lagging indicators. The results are always

after the fact, although today some brokerages,

CyberTrader being one, have their own “ticker

plants” and constantly calculate the indices with

very little lag time, usually just seconds. Futures

indices are considered leading indicators. Index

futures are very actively traded. They tend to

move before the underlying stocks. More discus-

sion of futures follows.

Keep in mind that you need only follow either

the cash indices or the futures indices. It is not nec-

essary to follow both.

MARKET INDICES

In the business world, nothing is truly indepen-

dent from the rest of the world. Economies are

interrelated. The economy of Europe can affect the

economy of Asia. The same is true in the stock

market. If the general market is bullish, a large per-

centage of stocks will head up. In a general market

decline, most stocks will head down. Traders who

forget this fact have a hard time making a profit.

They struggle because they are fighting the gen-

eral sentiment of the market.

The Nasdaq Composite charts in Figures 10.3

and 10.4 show that going long on stocks between

October and March in 2000 would have generated

good profits. Both investors and traders made a lot

of money holding onto their stocks during that

period (see Figure 10.3).

Going long during the period shown in Figure

10.4 would have resulted in disaster. The market

declined more than 50 percent from September to

March in 2001.

These two charts cover a long time period. But

the relationship between market direction and the



10.3 Market Trend

� THE TREND ON THIS NASDAQ CHART is clearly up. Taking long positions onindividual stocks offers a much better chance of success during these times.

10.4 Market Trend

� THE TREND ON THIS NASDAQ CHART here is down. During these times, it isbetter to be trading short positions on individual stocks. The market weaknessdragged almost all the stock prices down with it.



direction of individual stocks is also true in the

short term. In the short term, a high percentage of

stocks will follow the market. If the market is

strong, long positions on individual stocks have a

good likelihood of success. If the market is weak,

short positions would be a better choice.

Make sure you know the general market direction

before making a trade. Here are some of the cash

market indices that traders should follow.

Dow Jones Industrial AverageThe most famous market index and the one most

associated with the stock market is the Dow Jones

Industrial Average (the Dow). The Dow is made

up of 30 industrial stocks. They represent the

largest companies in America. The current list of

companies on the Dow can be found on most

financial web sites.

NYSE Composite IndexThe NYSE Composite Index is made up of all 3,300

stocks listed on the NYSE. This index is weighted

based on capitalization. Companies with large

capitalization have more weight in the index than

smaller companies. Large-capitalization stocks

move the market more than their smaller counter-

parts. This index works better than the Dow Jones

30 Index to determine the strength or weakness of

the NYSE.

S&P 500 and S&P 100Standard and Poor’s (S&P) has two indices that

have become barometers of the market: the S&P

500 and the S&P 100. Both of these indices are

capitalization-weighted. The S&P 500 is made up

of 500 large- and mid-cap stocks, and the S&P 100

(OEX) is made up of the 100 largest stocks from

the S&P 500.

The S&P 500 represents all major industries,

including 400 industrial stocks, 20 transportation

stocks, 40 financial stocks, and 40 utility stocks.

Because of the larger number of companies

involved and its wider scope, this index is one of

the better barometers of where the market is

headed. This index is also widely used to measure

the performance of money managers. Mutual

fund managers and institutional investors are

often graded by their ability to beat this index.

Fund managers who have produced gains less

than this index often find investors moving their

capital to index funds, which have lower fees.

This makes it the most closely watched index of

them all.

Nasdaq Composite and Nasdaq 100 IndexNasdaq comprises more than 5,000 securities and

has a high concentration of technology stocks. The

Nasdaq Composite Index is generally considered a

good barometer of technology stocks. Nasdaq is a

two-tiered structure consisting of the Nasdaq

National Market (NNM) and the Nasdaq Small-

Cap Market.

The Nasdaq National Market is made up of

larger companies with actively traded securities.

The Nasdaq Small-Cap Market is made up of com-

panies with assets of less than $12 million. Within

these two tiers there are more than a dozen differ-

ent Nasdaq indices.


The Nasdaq Index is roughly valued at about

one-fifth of the Dow, which means that a one-point

change in the Nasdaq equals a five-point change in

the Dow. To research other Nasdaq indices, visit

www.nasdaq.com on the web.

The Nasdaq 100 consists of the largest Nasdaq

stocks. It is a good barometer for the overall

Nasdaq market and is closely watched by many

day traders.

Other IndicesThere are many other sector indices that you can

follow. Intraday, I would pay attention to only

those sectors that include my trading candidates.

Here’s a partial list of the different sector indices

and their symbols.

Banks and Financial Index (BKX)

Dow Jones Transportation Average (TRANS)

Dow Jones Utility Index (UTIL)

Networking Index (DOT)

Oil Services (OSX)

Retailers (RLX)

Gas Index (XNG)

Cyclicals Index (CYC)

Healthcare (HCX)

Broker/Dealers Index (XBD)

Insurance (IUX)

Semiconductor Index (SOX)

Biotech Index (BTK)


OTHER MARKET INDICATORS

Here are several other indicators you should be

aware of.

Arms Index (TRIN)The Arms Index, more commonly known as the

TRIN, is a ratio calculated by first dividing advanc-

ing issues by declining issues and then dividing the

resulting number by up volume divided by down

volume. A falling Arms signals a strong market,

and a rising Arms suggests weakness.

VIX/VXNThe VIX is the Chicago Board Options Exchange

(CBOE) Volatility Index, which reflects the mar-

ket consensus estimate of future volatility by

measuring the implied volatility of OEX options.

The VIX tends to be high when the market is

extremely volatile, especially during market

declines. It tends to be low when the market is

less volatile, usually during extreme up moves

and sideways movement. As a result, high read-

ings usually signify too much bearishness, while

low readings signify complacency. The VIX can

be used to measure market sentiment. When

combined with additional timing triggers, it

offers the opportunity to identify market

extremes and likely reversal points.

Advance/Decline LineThe advance/decline line gives you a good idea of

the true breadth of the market. It indicates how

many stocks are up for every stock that is down. If



more stocks are down than up, then we should be

wary of any attempted rally. It indicates a weak

market. A strong market would have more stocks

up than down.

McClellan OscillatorThe McClellan Oscillator is a market breadth indi-

cator based on the smoothed difference between

advancing and declining issues. Markets are con-

sidered oversold when the oscillator is below −100

and overbought when it is above +100.

This indicator is not a precise market-timing

tool. Overbought readings can often become even

more overbought. Oversold readings can become

even more oversold, especially in a trending mar-

ket. Therefore, we strongly recommend using the

McClellan Oscillator in conjunction with other

market bias indicators.

10.5 Identifying a Trade Candidate (ADVP)

� SEVERAL POINTS MADE ADVP A TRADE CANDIDATE. Point A shows that thisstock is in a downtrend. Point B shows the stock price crossing over fromabove the short-term MA line back down. Point C shows a bearish engulfingpattern. Finally, point D shows RSI rising above the 70 percent line andcoming back down below it (a sell signal).


DIRECTION OF MARKET TRENDS

When day trading, the intraday direction of the

market should be your number one concern. If the

trend is up, trade only the long candidates on your

list. If the trend is down, trade only the short candi-

dates on your list.

This idea seems ridiculously simple, but it is the

most powerful way to trade. There will be occa-

sions when the market does not have any trend.

These are the days to sit on your hands and do


nothing. This method makes a lot of sense. Think

of what it means to have the market in your favor.

It means you will trade only candidates with a

high demand or a high supply. If the stochastic

trader, the trend trader, the pattern trader, and the

breakout trader all get into the same stock at the

same time, the price will most assuredly go up. On

the other hand, if the RSI trader, the MACD trader,

the breakdown trader, and the chart pattern trader

all get sell signals at the same time, the price will

most assuredly go down.

10.6 ADVP Intraday Trade

� A TRADE WAS TAKEN ON ADVP once it broke the support of the rounded top pattern. The entry point(C) was at 30.05. An exit signal (H) was generated when a bullish reversal pattern (double bottom)confirmed at 28.60. Total profit for the trade was $1.45.



Traders take a short ride on the up or down

side, take their profit, and move on to the next

trade. This way of trading, coupled with proper

risk management, makes success a possibility, not

just an empty dream. A few examples of this type

of trading follow.

I spotted ADVP as short. If you look at the daily

chart in Figure 10.5, several factors favored a short

position. I marked each of these on the chart in Fig-

ure 10.5. They are the following: The stock is now

in a clear downtrend. It crossed over the 20-period

EMA to close below it. For short-term trading, this

is a bearish indication. It has a bearish engulfing

pattern. The only thing missing is the bearish con-

firmation. The seven-period RSI was crossed and

closed below it.

All of this made ADVP more attractive than the

rest of the candidates. It showed up at the bottom

of the ranking system.

On the intraday front, here is what happened.

10.7 Identifying a Trade Candidate (MERQE)

� FOUR POINTS MADE MERQE AN INTERESTING TRADE CANDIDATE. First, point Ashows a symmetrical triangle. With the trend up, this is a good continuationpattern. Point B shows a bullish harami pattern with a confirming candlestickbesides it. Point C shows a moving average crossover from below to above.This is another buy signal. Finally, the slope of MACD also turned up at thesame time.


The first confirmation came at the open. The stock

closed at $30.73 and opened the next day at $30.29.

We have a downside gap at point A in Figure 10.6.

We earlier discussed this candlestick pattern as

one of the bearish confirmations.

The next confirmation came when the stock

formed a rounded top pattern on location C, a

bearish formation. Your entry point would be

based on the entry of a rounded top pattern,

which is a break of the support level. In this case,


this pattern was a continuation of the weakness

because of the downtrend at location B from the

previous period.

Our entry would be at point D, once the price

broke the support level E at 30.05. The stock con-

tinued its decline and formed a double bottom

chart pattern at F. A break of the resistance G at

$28.60 would have signaled an exit. Total profit is

$1.45, a 5 percent run.

Now let’s look at a long candidate. I spotted

10.8 MERQE Intraday Trade

� A BREAK OF THE SYMMETRICAL TRIANGLE (A) triggered a long entry of this stock intraday at 26.85 (B). Using our trailingstop method described earlier, we moved our stop from support level D all the way to support level J. Trade was exited at29.65 when it broke support level J. Total profit on this trade was $2.80, more than a 10 percent run in two days!


MERQE for a possible long position trade from my

research the previous day. The daily chart in Fig-

ure 10.7 shows several things favoring a long posi-

tion if intraday conditions were right. I marked

each of these on the chart in Figure 10.8. They are

as follows:

Stock is in a nice symmetrical triangle pattern.

It has a bullish harami pattern. It also had a bullish confir-

mation candlestick the next day.

It crossed over the 20-period EMA to close above it. For

short-term trading, this is a bullish indication. Trend has

just turned up.

The MACD histogram has also turned up.

All of this made MERQE more attractive than the

other candidates. It showed up at the top of the

ranking system.

On the intraday front, here is what happened.

Keep in mind what happened the day before.

We had a marubozu candlestick, which tells us

the stock probably had a nice uptrend all day. Con-

firmation came when MERQE formed symmetri-

cal triangle A on the intraday charts (see Figure

10.8). When found after an initial uptrend, this

confirms that the uptrend is still intact and is likely

to continue.

According to the trading signals of the symmet-

rical triangle pattern, we should enter on a trend-

line break. This would be at entry point B, at

$26.85. The stop-loss point should be at the low of

the day or at the last minor support (C).

Using the trailing stop method described in the

support and resistance section, every time the

price broke out and established a new high, we

would move our stop-loss up. Our exit price

would be moved from C to D, and the D to E, all

the way to J.

A break of the support at K triggered our exit at

K. The trade went from $26.85 to $29.65 in two

days. Note that while a position is going in your

favor, it is best to just observe the stop-loss points

and keep the position. Profit in this case was $2.80,

a 10 percent run.

KEEP A TRADE JOURNAL

Keeping a journal of your successes and failures

can help you learn. Unless you study your mis-

takes, it is impossible for you to know which


Here is the information to record in your journal:

• Date

• Symbol

• Entry price

• Number of shares

• Exit price

• Trade signals

• Market conditions

• Profit/loss per share

• Total profit/loss

• Lessons

Your Trade Journal

14762_Chua_2p_c10.j.qxp 2/5/07 2:07 PM Page 191

aspects of trading you need to improve. A large

part of trading is simply minimizing mistakes. If

you make just 20 percent fewer mistakes and cal-

culate that into your trading, you will be amazed

at the results.

There are many possible mistakes in trading.

You can trade late, missing an opportunity, or exit

too late, sustaining a loss. Your positions can be too

large. Knowing your weaknesses is vital to your

progress. What methodology generated the sig-

nals you used? Have these signals been weak in

the past? Do you need to adjust their values or stop

trading them?

You can eliminate mistakes only if you know

what they are. If you keep getting in late, set your

alerts a little earlier. This gives you time to place

the order. Sometimes a mistake might not be your

fault. It could be the system. Maybe your informa-

tion provider is late. It might be time to change to

a new data provider. Question everything.

The other major purpose of a trading journal is

to identify correct behavior. Did you trade cor-

rectly? Did you make money? Did you lose money?


Even losing money can be part of correct behavior.

Remember, taking losses is part of the profession.

Never blame yourself for a loss if you used a

proper stop-loss point. The market just failed to

go as planned. It simply went into the lower-

probability scenario.

Your goal is to find consistent profitability.

What conditions existed on your good trades?

What were the confirmation signals? These intri-

cate details are important because they can form

the basis of future trading. Pay attention to the sig-

nals that generated the winning trades. What

methodology or what indicator worked? Should

you consider assigning a higher value to it? Strate-

gies that have consistently made money for you

should have a greater value. Move them to the top

of your watch list.

All this work will ultimately lay the foundation

of a successful day trading career. Evaluate your

trades every day and continue to improve your

techniques and methods. Once all of this is done,

the process repeats itself. Keep your discipline and

continue trading your plan. Success will be yours. ●$


ConclusionWe have covered many things throughout this book. We touched on the differences between the

exchanges. Some of you will favor the fast pace of the over-the-counter market, and some will

choose to trade the slower auction markets. Either one is fine. The key is to be comfortable in the

environment you choose.

Next, we discussed the different types of orders and brokerages. Although most of you might

think it trivial, your success depends on these important aspects. Even your Internet connection is

important. You do not want your computer to hang up while you are in a position that is going

against you. Make sure you take care of these little details at the start, so you can spend your time

trading and not worrying.

Finally, we covered the other elements needed to become successful. We discussed technical

analysis, candlestick patterns, different indicators, risk management, and trading preparation. All

of them are of equal importance. To pay attention to one and forget the other is like going to war

without the proper preparations and the proper tools. It is foolhardy. You may win a few battles,

but never the war. And believe me, trading is war. You struggle every day against other traders that

have the same intentions as you do, and that is to take money from you.

If you want to succeed, you must be better than the rest. You must be better prepared. You must

have the best tools. You must have a solid plan. You must be more disciplined and more patient.

And you must work harder than the rest. That is how you rise above the other 98% who constantly

fail in this endeavor.

For those of you who want to learn more and are serious about starting a new career in day trad-

ing, please go to my website at www.sammychua.com for more information. I would love to help

guide you step-by-step in reaching your goal as a professional day trader, and in the process, find-

ing your financial freedom.


AAccumulation/distribution (A/D)

indicator, 171–173formula, 172

Advance/decline line, 186–187Alerts:

placement, 182setting, 180–183

All-or-none (AON) order, 38American Stock Exchange (Amex), 40–41Angle/slope, importance. See TrendlinesAppel, Gerald, 158Archipelago (ARCA), 21, 22, 43, 45

ECN, 28Arithmetic scale, 71Arithmetic scaling, contrast. See

Logarithmic scalingArms Index (TRIN), 186Ascending triangles, 99–101Attain (ATTN), 22, 43, 44Average downward price change,

calculation, 167Average upward price change,

calculation, 167Ax, shadowing, 61

BBack testing, 62–63Bar charts, 67–68Bearish abandoned baby pattern, 148Bearish divergence, 165–166, 170Bearish engulfing harami patterns,

149–150Bearish engulfing patterns, 140–142Bearish harami pattern, 144–145

combinations, 144Bearish patterns, 105, 139–150Bearish reversal, 140Bearish stochastic divergence, 166Bearish stocks, negative values, 178

INDEXBuy stop order, 35–36Buying momentum, 94, 135Buying /selling pressures:

comparison, 118–119identification (see Heavy

buying /selling pressures

CCancellation order, 37Candlesticks, 68–69. See also 20/20

candlestick; Long black candle-stick; Long white candlestick; Opencandlestick; White candlestick

capability, limitations, 122–123charting techniques, 116patterns, 123–127 (see also Closed

candlestick pattern; Opencandlestick pattern)

positions, 127–130usage (see Indecision)wicks, 69

Capital, usage. See TradingCash accounts, 31, 32Cash indices, 183Charles Schwab Corporation, 26, 28Charting techniques, 72–73Charts, 30. See Bar charts; Line charts;

Point/figure chartspatterns, 96–112 (See also Relative

strength index)types, 67–71usage, 67–73 (See also Tick-by-tick

chart)Chicago Board Options Exchange

(CBOE), 186CINN identifier, 44Closed candlestick pattern, 116Closing price, 87, 119Combination patterns, 130Commissions, per-share basis, 29Common gaps, 89–90

Best ask, 8Best bid, 8Bid/ask spread, 45Black marubozu, 118, 121, 134

midpoint, 133Black/black combinations, 144–145,

149–150Black/white combinations, 144–145,

149–150Bloomberg Tradebook (BTRD), 22, 43Breakaway gaps, 90–93

confirmation, volume levels (usage),90

Breakdown/breakout point, 108Brokerage firms:

accounts, types, 30–32execution speed, 27features (see Online brokerage firm

features)price, importance, 29–30reliability, 27–28selection, 26–27service, importance, 30

Broker-dealer fee structure, 45Brokers. See Direct access brokers;

Discount brokers; Full-service brokersdefinition, 8

Brut (Brass Utilities) (SunGard Data), 22,43, 44

ECN, 28BTRD. See Bloomberg TradebookBullish abandoned baby, 138Bullish divergence, 165Bullish engulfing harami pattern,

136–137Bullish engulfing pattern, 130–133Bullish harami pattern, 133–135, 140Bullish patterns, 130–139Bullish reversal, 124Buy limit order, 35

14762_Chua_2p_bindex.j.qxp 2/2/07 11:37 AM Page 195

Continuation gaps, 93–94Corporate stock/bonds, trading, 14Crossovers, 158–159. See also

Stochastic oscillatorstrategy (see Moving average

convergence divergence)Cup with handle pattern, 110–112Customers, 9CyberExchange, 28–29CyberTrader, 28, 29CyberTrader Pro, 180

DDark cloud cover pattern, 142–144Day traders:

NYSE/Nasdaq usefulness,comparison, 20

SEC definition, 31Day trading:

overview, 5personality fit, 2–3usefulness, 1

Dealers:definition, 8fee structure (see Broker-dealer fee

structure)Decimal pricing, 60Descending triangles, 99–101Designated Order Turnaround (DOT):

orders, 44system (see Super Designated Order

Turnaround system)Direct access brokers, 27

costs, 30order routing efficiency, 28

Direct access order entry system, 40Discipline, maintenance. See TradingDiscount brokers, 26Divergences, 159–160. See also Bearish

divergence; Bullish divergence; Movingaverage convergence divergence;Price; Relative strength index;Stochastic oscillator

DJIA. See Dow Jones Industrial Average

Dojis (spinning tops), 119–121, 138.See also Dragonfly doji; Gravestonedoji; Long-legged dojis

Domestic Securities, 44Double bottom pattern, 76–77Double top/bottom patterns, 96–98Dow, Charles (concepts), 66Dow Jones Industrial, 30, 183Dow Jones Industrial Average (DJIA), 185Downside gap, 91Downtrends, 80–83, 135, 138, 156Downward price change:

calculation (see Average downwardprice change)

determination, 167Dragonfly doji, 123–124

EElder, Alexander, 73Electronic communications networks

(ECNs), 20–22discussion, 42–43establishment, 27introduction, 21list, 43process, explanation, 21–22usage, 18usefulness, 45

E-Mini Nasdaq 100 futures, 161Entry points, 179E*Trade, 29E-trading services, 26Evening star doji, 147Evening star pattern, 147–149Exchange floor, personnel, 9Exhaustion gaps, 93, 95–96Exponential moving average (EMA), 153

contrast (see Simple moving average)formula, 154

FFading the gaps. See GapsFast line (%K), 158, 163–164Fidelity, 26Fill-or-kill (FOK) order, 38

Firm Quote Rule, 41Flags, 105–106, 111Floor:

brokers, 9clerks, 9traders, 9

Full gap down, 89Full gap up, 89Full-service brokers, 26Fundamental analysis, 62Futures, 173–174

GGap down, 127, 128, 148. See also Full

gap down; Partial gap downGap up, 125, 128, 133, 148. See also

Full gap up; Partial gap upGaps. See Breakaway gaps; Common

gaps; Continuation gaps; Downsidegap; Exhaustion gaps

confirmation, volume (usage), 112fading, 89occurrence, 87–96selling pressure, absorption, 139types, 89

Gerald Putnam, 43Good-for-the-day (GTD) order, 38Good-till-canceled (GTC) order, 37Granville, Joseph, 170Gravestone doji, 124

HHammer pattern (hanging man pattern),

121, 124–125. See also Invertedhammer pattern

Harami pattern. See Bearish engulfingharami patterns; Bearish haramipattern; Bullish engulfing haramipattern; Bullish harami pattern

Harami position, 128–130Head/shoulders pattern, 103Head/shoulders top pattern, 101–102Heavy buying/selling pressures,

identification, 116–118Height, 75

196 INDEX


INDEX 197

Histogram. See Moving averageconvergence divergence

Hi-waves, 120Houtkin, Harvey, 44

IImmediate-or-cancel (IOC) order, 38Indecision (identification), candlesticks

(usage), 119–120Indicators. See Technical indicators

usage, 152–153INET, 21, 44

ECN, 28, 45purchase, 40

Information power, 17–18Inside range days (IRDs), 134Instinet, 44Institutional firms, examples, 16Internet connection. See TradingInternet Service Provider (ISP)

connection, 28Interperiod noise, 157–158Intraday Nasdaq charts, 52Intraday trading, 183Intraday-trend trading, 61, 87Intraperiod activity, understanding,

120–127Inverted hammer pattern (shooting star

pattern), 121, 125–127Investment banks, examples, 17IRDs. See Inside range daysIsland ECNs, 44

KKnight Capital Group, 44

LLagging indicators, 183Lane, George, 163Large-cap stocks, 7–8Limit order, 34–35, 45. See also Buy

limit order; Sell limit order; Shortlimit order; Stop-limit order

usage, 35Line charts, 69

Livermore, Jesse (failure), 55Logarithmic scale, 71–72Logarithmic scaling, arithmetic scaling

(contrast), 87Long black candlestick, 121Long positions, 32–33Long white candlestick, 116, 120Long-legged dojis, 119, 121Long-term trading, 62

MMACD. See Moving average convergence

divergenceMargin accounts, 31–32Margin call, occurrence, 31Market:

direction, 185indicators, 186–187indices, 183–186intraday direction, 188order, 34, 45orderliness, maintenance, 16trading range, 82trends, direction, 188–191

Market markers:responsibilities, 16types, 16–17understanding, 15–17

Market-at-close order, 38Market-at-open order, 38Marubozu. See Black marubozu; White

marubozucandlestick, 191

MAs. See Moving averagesMcClelland Oscillator, 187Member firms, 9Momentum. See Buying momentum;

Selling momentumconfirmation, 113scalpers, 60–61

Morning star pattern, 137–139Morris, Greg, 130Moving average convergence divergence

(MACD), 158–160crossover strategy, 63

histogram, 161divergences, 161–163slope direction change, 161

usage, 82Moving averages (MAs), 153–158. See

also Exponential moving average;Simple moving average; Weightedmoving average

advantages/disadvantages,157–158

line, position, 158periods, number (selection),

154usage, 82uses, 154–156

Municipal bonds, trading, 14

NNational Association of Securities

Dealers Automated QuotationSystem (Nasdaq), 14–15

100 Index, 183, 185–186comparison. See New York Stock

ExchangeComposite, 183, 185–186Market Center, 40–41, 44National Market (NNM), 40, 185National Market Securities (NMS), 15,

41negotiated market, 15quiz, 23service level I, 18service level II, 18–19, 42service level III, 19SmallCap Market, 40, 41traded securities, classification,

15trading, 45

National Association of Securities Dealers (NASD), 14–15

quiz, 23regulatory framework, 22

Negotiated market. See NationalAssociation of Securities DealersAutomated Quotation System


New York Stock Exchange (NYSE), 6Composite Index, 183, 185level II screens, information,

17–18listed stocks, 7–8Nasdaq, comparison, 20quiz, 23technological advances, 7time lines, 7

News/research services, 30NexTrade (NTRD), 22, 45Nison, Steve, 134, 144NMS. See National Association of

Securities Dealers AutomatedQuotation System

NNM. See National Association ofSecurities Dealers AutomatedQuotation System

OOEX, 185On-balance volume (OBV), 170–171O’Neil, William, 1101-2-3 reversal method, 83–84Online brokerage firm features, 30Open candlestick, 68

pattern, 116Opening price, 87Optimization:

avoidance (see Trading)understanding, 51, 52

Options transactions, 32Order:

books, computerization, 35cancellation, 45execution systems, review, 45routing, 28–29

Order-driven price movement, 20Oscillators, 152. See also Stochastic

oscillatorOutside market, 18Overbought/oversold conditions,

159Overbought/oversold levels, 164

Over-the-counter bulletin board (OTCBB),20, 41

Over-the-counter (OTC):market, 6, 14trades, 43

PPartial gap down, 89Partial gap up, 89Patterns. See Bearish patterns; Bullish

patterns; Charts; Combinationpatterns; Piercing pattern

Pennants, 105–106, 111Periods, number (selection). See Moving

averagesPer-share stop loss, 180Piercing pattern, 133Pivot points, 173–174

calculation, 173Point /figure charts, 70–71Positions. See Candlesticks; Harami

position; Long positions; Shortpositions; Star position

shorting guidelines, 33–34types, 32–34

Price:advance, 125change

calculation (see Average downwardprice change; Average upwardprice change)

determination (see Downward price change; Upward pricechange)

decline, 127discounts, importance, 66divergence, 161importance. See Brokerage firmsmovements, 71movements, predictability, 66scaling, types, 71–72support level, 101

Proprietary accounts, trading, 16Pullback, 136

QQuick & Reilly, 26Quote services, 30

RRectangle patterns, 106–109Regional firms, examples, 17Relative strength index (RSI), 166–170

calculation, 167chart patterns, 168–169day separation, 167divergences, 169–170formula, 166–167levels, 168prices, divergences, 169

Resistance:area, 118breaking, 78identification (see

Support/resistance)levels, 73, 103

break, 74breakout, 80

support level, 77Reversal amount, 71Reversal method. See 1-2-3 reversal

methodReversal points, 186Reverse head/shoulders pattern,

103–104Reward-to-risk ratio, 50–51, 85Risk management, 49, 55–56,

179–180work, 55

Rounded bottoms/tops, 109–110RSI. See Relative strength index

SSaucer pattern, 109Scaling, contrast. See Logarithmic scalingScalping, 60–61

backtesting, inability, 62–63Scott Trade, 26

198 INDEX


INDEX 199

Sector indices, 186Securities and Exchange Commission

(SEC) enforcement, 22Self-reliance. See TradingSell limit order, 35Sell stop order, 36Selling momentum, 146Sell-off marks, 101Service, importance. See Brokerage firmsShadowing the ax. See AxShares (number) trading, calculation,

51–52Shooting star pattern. See Inverted

hammer patternShort limit order, 35Short positions, 32–33, 84Short selling, dangers, 34Short stop, 36Short the tops. See TopsShort-term analysis, 140Shoulder:

formation, 102pattern (see Head/shoulders top

pattern; Reverse head/shoulderspattern)

Sideways movement, 105Simple moving average (SMA), 153

EMA, contrast, 157Slippage, 34Slow line (%D), 158, 163–164, 173Small-cap market, 15SOES orders, 41S&P. See Standard and Poor’sSpearandeo, Victor, 83Specialist:

clerk, 9definition, 8system, 8–9

Spinning tops. See DojisSpread, capture, 60Standard and Poor’s:

100 (S&P100), 183, 185500 (S&P500), 185

index, 86

Star position, 128Stochastic oscillator, 163–166

crossovers, 164–165divergence, 165–166

Stock, price action, 153Stock exchanges, 6

system, 6–7Stock liquidity, 15Stock markets:

expensiveness, 74overview, 6

Stop order, 35. See also Buy stop order;Sell stop order

Stop price, 36Stop-limit order, 36–37Stop-loss order, 76

placement, 94, 95, 170Stop-loss point, 52–53, 78, 92, 99

hit, 162setting, 107–108, 110

Super Designated Order Turnaround (SuperDOT) system, 9–11, 44–46

usage, 20SuperMontage, 41–42SuperSOES orders, 41Support level, 73

break, 190breakdown, 81establishment, 78

Support/resistance:area, price range, 75identification, 73–76strength, 75–76

Swing trading, 61–62Symmetrical triangles, 99–101, 191

TTD Waterhouse, 26Technical analysis, 62, 66Technical indicators, 152Teenie, 60Terra Nova Trading, 43Text chat, usage, 30Three black cows pattern, 145–147

Three white soldiers pattern, 135–136,146

Tick-by-tick chart, usage, 67Time frames, impact, 86–87Timing sequence, 32Tops, shorting, 85TotalView, 42Townsend Analytics, Ltd., 43Trade execution, 30Trade journal, keeping, 191–192Trading. See Intraday-trend trading;

Long-term trading; Swing tradingactivity, 123capital, usage, 48computer, usage, 48–49days, 178discipline, maintenance, 53–54Internet connection, 49knowledge, impact, 48losses, acceptance, 52–53methodology, 49, 56–58patience, 54perseverance, 54products, 30, 32psychological barriers, avoidance,

56–57psychology, 49–55range. See Marketrequirements, 48–49research, 178–179risks, 55screens, setting, 180–183self-reliance, 54–55signals, 179

generation, 172–173strategies, 60, 76–79success, 50

elements, 48system optimization, avoidance, 51–52time, importance, 48

Trading orders:selection, 34terms, 37–38types, 34–38


Trailing stop, 78Transactions, execution, 16Trend reversal area, 137–138Trend-following indicators, 152–153,

174, 179usage, 82

Trend-following system, 51Trendlines, 79–87, 106

angle/slope, importance,84–86

break, signal, 84validity, 87

Trend-reversal patterns, 96Trends:

formation, 66identification, 152

Triangles. See Ascending triangles; Descending triangle; Symmetricaltriangles

patterns, 99–101trading, 99

TRIN. See Arms Index20/20 candlestick, 116, 1182 percent rule, usage, 57–58

UUptick:

definition, 33rule (removal), SEC proposal, 33–34

Uptrends, 80, 148–149, 156Upward price change:

calculation (see Average upward pricechange)

determination, 167U.S. government securities/agency

securities, trading, 14

VVolatility Index (VIX/VXN), 186Volume, 75–76

analysis, 112–114bars, 113

WWedge formation, 104–105Weighted moving average (WMA),

153White candlestick, 68White marubozu, 116, 120, 134

candlestick, 116–117, 122, 135White/black combinations,

144–145White/white combinations,

144–145Wholesalers, examples, 17Width, 75Wilder, Welles, 166, 168Williams, Larry, 171Wire houses, examples, 17

200 INDEX


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