Sammy Chua's Day Trade Your Way to Financial Freedom

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Sammy Chua’s

DAY TRADE Your Way to

FINANCIAL FREEDOM 2ND EDITION

Sammy Chua

John Wiley & Sons, Inc.

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Copyright © 2007 by Sammy Chua. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. Wiley Bicentennial Logo: Richard J. Pacifico All graphics courtesy of CyberTrader. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. 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 2006 332.64′2—dc22 2005031909 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

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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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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

• 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

v


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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 INDEX

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

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PREFACE

W

HEN SAMMY CHUA ASKED ME to edit his new book on day trading, 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 capital 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 success 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 supply 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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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 prevention program. But I’ll let Sammy Chua explain this to you. He is a proven winner in the fine art of day trading. Learn and enjoy. Peter McKenna Editor

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INTRODUCTION

D

AY TRADING IS THE MIRROR OPPOSITE of the buy and hold strategy. 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 knowledge 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 markets 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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INTRODUCTION

But things turned nasty in 2000 and 2001. The tech sector collapsed and the market 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 number 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 buying 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 successfully, 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 successful 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 specialize in one strategy before moving on.


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INTRODUCTION

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.

3


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CHAPTER

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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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SAMMY CHUA’S DAY TRADE YOUR WAY TO FINANCIAL FREEDOM

THE STOCK MARKETS

D

AY 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.

You will not be able to execute these strategies

Exchange (NYSE). The NYSE is situated on Wall

unless you learn how the stock markets work.

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

Every day, millions of shares move back and forth

Board and is considered the center of the stock-

from one investor to another. How is this done?

trading universe. The NYSE was created in 1792 by

Who are the people who execute these trades for

24 traders who got together to trade a few shares in

investors? How do you get the best price on your

two small, local companies. From this humble

order? Which electronic routing systems are the

beginning, the stock market grew into the beast it

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

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

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

inside the NYSE. Including the NYSE, there are

Learn them well.

seven stock exchanges in the United States, but the

In the United States, stocks are bought and sold

NYSE is the granddaddy of them all. The others

in two different venues: stock exchanges and over-

are smaller, regional exchanges that look to the

the-counter markets (OTCs). This chapter explores

NYSE as the leader.

the differences between the two systems, particu-

An exchange is a place where buyers and sellers

larly the differences that will affect your career as a

physically get together on a central trading floor to

day trader.

buy and sell. Floor trading is essentially an auction in which price is determined by supply and

THE EXCHANGE SYSTEM

demand. The trades may be routed by computer, but they all eventually come to the market floor for

The largest stock exchange in the world, trading

execution. The exchanges are membership organi-

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

zations. The members trade securities on behalf of


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7

AN OVERVIEW

their clients or for themselves. Both individuals

TECHNOLOGICAL ADVANCES

and big securities firms are members of the NYSE. 1878 The first telephone is installed.

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.

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.

1940 Down to 750,000 shares per day for 862 companies, volume explodes.

LISTED STOCKS

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.

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

1987 Largest one day percentage drop occurs.

capitalization. To be listed on the NYSE, a company

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

usually must have a market capitalization of at

companies. 1997 Volume is 525 million shares per day for 3,028 companies. 1997 All-time record 1.2 billion shares are traded on minicrash day, October 27. 2000 Both the biggest point jump (499.19) and the biggest point slide (617.78) occur.

least $100 million. (Market capitalization is determined 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 established companies. For example, IBM, founded in

2001 Trading in fractions ends.

1911, has a market capitalization of $124.64 billion

2003 NYSE Composite Index is relaunched using revised

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

methodology. 2005 ARCA and the NYSE merge.

large-caps traded on the NYSE include DuPont, Ford, Coca-Cola, General Electric, Alcoa, and


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

There is more to a specialist’s job than matching

stocks traded on the NYSE are not as volatile as

buyers and sellers. They are expected to maintain

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

an orderly and fair market. When there is an excess

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

of buy or sell orders, making it impossible to

though they trade on the NYSE, are volatile.

match orders evenly, the specialist steps in. There

Energy stocks and pharmaceuticals are examples.

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

Before I discuss how these stocks are traded,

for example, but only 100 people who are willing

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

to pay this price. This situation, called an order

to the workings of both the NYSE and the OTC:

imbalance, sometimes causes trading to be tem-

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

porarily suspended. An opening delay usually happens when a news event or extreme imbalance of orders prevents the stock from trading when the

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

market opens. The specialist has 15 minutes from

is willing to sell it.

the opening bell to determine a price range at

Broker. One who arranges the sale of a stock.

which the stock will begin trading. A specialist can delay an opening or halt trading

Dealer. Usually a brokerage, such as Charles Schwab. Brokers sell the stocks that dealers keep in their inventories.

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

THE SPECIALIST SYSTEM

day traders try to profit from these imbalances, which occur frequently.

Exchange trading is carried out by a person called

Specialists profit from the spread, the difference

a specialist. Specialists control the auction process.

between the bid price and ask price, for each

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

market-order transaction in which a spread exists.

cialist looks at an electronic order book of bids and

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

asks and matches them according to price and

the market’s current best displayed price.

quantity. The specialist, for example, will match a

A good specialist will be assigned responsibil-

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

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

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

cialists may trade for their own firm’s accounts as

Specialists are the people you see running around

well, buying low and selling high to make a

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

profit.

her clerks are assigned responsibility for one or

Specialists are predictable. Novice day traders

two stocks. They handle all bids and offers for

who want to trade stocks on the NYSE should

these stocks.

get to know the habits of the specialists they are


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AN OVERVIEW

dealing with. There are several day trading firms

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

whose members make a good living just by follow-

see on the floor.

ing the actions of the specialists. Their aim is to capture small profits several times a day, just like the specialist.

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

WHO’S WHO ON THE EXCHANGE FLOOR

in designated spots. The clerk sits inside the post and communicates with the specialist through a

In addition to the specialist, here are the people

window. Display monitors hang above the post

who make the NYSE hum:

windows so the clerk and the specialist can watch the floor broker and the order books at the same

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

time. Huge conduits rise up from the trading floor,

They stand ready to maintain the electronic order book

carrying data lines to the exchange computers.

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

THE SUPERDOT SYSTEM

matched. Floor brokers. Brokers usually represent big-name brokerage 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

Buy and sell orders on the NYSE are routed to the exchange floor by an electronic system called Super Designated Order Turnaround, or SuperDOT. The best way to understand the miracle of this system is to compare it with the routing methods used before the SuperDOT was implemented. Figure 1.1 gives you an idea of the long process

brokers to the specialists.

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

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

see, getting a trade executed in the old days took

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

time. The trader called a stockbroker and placed the

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

order. The stockbroker called the order in to the trading desk. The desk relayed the order to a floor

Floor traders. These are independent traders. They trade for their own accounts and can represent institutions when contracted.

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-

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

mation (or trade report) would flow backward

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

through the same process until it reached the trader.


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

Customer Gets Confirmation

Trading Desk

Trading Desk

Floor Broker

Floor Broker

Floor Clerk

Floor Clerk

Specialist Executes Order 䊳

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

Every transaction required multiple pieces of paper, which were crumpled up to distinguish

Paper is still used for negotiating large and special orders.

them from paperwork that might have been acci-

SuperDOT is fast and reliable. Orders go

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

directly to the specialist. This minimizes the time

the floor of the stock exchange was littered with

involved, and trade reports are made within sec-

small scraps of paper. The SuperDOT system has

onds, except on the busiest days. Brokers who

eliminated most but not all of the paperwork.

trade on this system have what is called direct

1.2 SuperDOT System (Super Designated Order Turnaround System) Customer Places Order 䊳

Specialist Executes Order

Customer Gets Confirmation

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


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11

AN OVERVIEW

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

electronically through SuperDOT, but they are still

and your broker is a NYSE member, your order

executed by specialists. If there is an order imbal-

will most likely be delivered through SuperDOT.

ance or if you have placed a limit order, SuperDOT

A quick look at the flowchart in Figure 1.2 gives

will automatically deliver your order, but that

you an idea of how streamlined this new process

doesn’t guarantee that your order will be exe-

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

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

automatic-execution system. Orders are routed

$ filled. ●


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CHAPTER

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2

The Big Board and 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


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14


THE OVER-THE-COUNTER MARKET (OTC)

T

HE 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 trading platforms.

While the NYSE trades large-cap stocks, the OTC is home to smaller companies. Many technol-

Of these, day traders are mainly interested in corporate stock.

ogy companies with small market capitalization trade over the OTC. They are often less established than companies found on the exchanges. For

NASD AND NASDAQ

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

Market makers trade through an electronic system

with a market capitalization of $17 billion, trades

run by the National Association of Securities Deal-

on the OTC.

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

Over-the-counter trading is done by people

Securities Dealers Automated Quotation System,

called market makers. You never see these men and

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

women, because they work out of sight at com-

NYSE’s SuperDOT system.

puter terminals across the country. In contrast to

Nasdaq began operating in 1971. The purpose

the NYSE, where stocks are put up for auction,

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

market makers buy and sell from their own inven-

quotes on selected OTC stocks through its auto-

tory of stocks.

mated quotation system. This system was a major

Numerous types of securities are traded on the OTC, including but not limited to the following:

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

●

Corporate stock

●

Corporate bonds

●

Municipal bonds

Essentially, Nasdaq is a real-time classified ad.

●

U.S. government securities

Traders post their buy and sell orders for the rest of

●

U.S. government agency securities

the trading world to see. It also provides a means

$35. They had to keep calling until a buyer was found. The process was cumbersome and slow.


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15

THE BIG BOARD AND NASDAQ

to get orders executed. Nasdaq trades some of the

lowest price will likewise get a faster response

biggest names in technology, such as Intel and

from buyers. Nasdaq is automated and simplified.

Microsoft. The Nasdaq system allows large institu-

Remember, at the NYSE, stocks are sold at auction

tional buyers, market makers, brokerage houses,

by an intermediary. Nasdaq stocks are bought and

electronic day traders, and online investors to

sold on a best-price basis.

come together to communicate their trading intentions 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 ●

3 ●

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-

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

ing the spread, just like NYSE specialists. Market

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

makers also act as commissioned representatives

ization than do large caps.

for large financial firms or mutual funds. As reps,

Companies with very small market capitalization are han-

market makers become brokers acting on their

dled on the OTC Bulletin Board and the Pink Sheets.

client’s behalf to buy or sell a security. When market makers act as intermediaries for a big firm, they get

Day traders are mainly interested in the NMS tier of stocks—the large caps.

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

NASDAQ IS A NEGOTIATED MARKET

me come from a market maker’s own inventory. The term market maker refers to a securities firm

While the NYSE requires a specialist to act as an

as well as an individual. Examples are Goldman

auctioneer or intermediary, the Nasdaq allows

Sachs and Morgan Stanley, firms that are regis-

buyers and sellers to interact directly without an

tered to buy and sell specific securities. As market

intermediary. That is why Nasdaq is called a nego-

makers, they abide by Nasdaq rules when making

tiated market. The buyer who offers the best price

a market. Market makers are required by Nasdaq

will get taken care of first. The seller offering the

to maintain a two-sided market. This means they


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are required to post both a bid price and an ask

Different Types of Market Makers

price at the same time.

It is important for day traders to be aware of the

Unlike specialists and floor brokers, market makers work in offices, using computers and the

different types of market makers and understand the trading patterns they create. Here’s why.

telephone to make the market. One market maker

Market makers do the lion’s share of trading on

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

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

are approximately 60 market makers trading the

man Sachs, Paine Webber, Salomon Brothers, and

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

Merrill Lynch, represent large institutions, such as

stocks have 40 or more market makers, while the

pension funds and mutual funds. They buy and

smaller-name stocks have just a few. Tracking and

sell for these clients. They also trade for their own

understanding their methods is vitally important

retail customers and their own trading accounts.

for the day trader.

The sheer volume of this trading can have a dramatic impact on stock prices.

The Three Main Responsibilities of Market Makers 1 ●

Execute transactions for their clients. The most important function is to execute orders for clients at the best possible price. They do this by interacting with other market makers online or by telephone.

2 ●

You can watch market makers trading on what’s known as Level II computer screens. Patterns 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

Keep an orderly market. This means they must prevent

market makers do not always make the right deci-

dramatic fluctuations in the price of a stock that comes

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

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

erful than any single market maker.

uidity, market makers must provide a two-sided market

The following will help you recognize the vari-

within the market bid/ask price. Liquidity happens as

ous types of market makers as you watch Level II

market makers fulfill their obligation to make markets

screens. Trading symbols are given for each firm.

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

The information available on Level II is discussed

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

in detail later in this chapter.

a certain price. That’s why it’s called a two-sided market. 3 ●

Trade for the firm’s proprietary account. Market makers

INSTITUTIONAL FIRMS

use inside knowledge, experience, and technology to make profits on a daily basis. They take profits on the

GSCO

Goldman Sachs & Co.

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

SBSH

Salomon Smith Barney

LEHM

Lehman Brothers

MSCO

Morgan Stanley & Co.

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.


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These worldwide firms do the largest underwrit-

DAIN

Dain Bosworth Inc.

ings. They cater to big institutions like mutual

WEAT

Wheat, First Securities

funds and pension funds. They have well-financed research departments. They are the most powerful

These are smaller brokerage firms with less expo-

market makers and can set the market on fire

sure to the markets. They are cautious traders.

when they trade.

INVESTMENT BANKS 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

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.

research. They simply make a market for other firms.

Market Maker Recap

WIRE HOUSES DEAN

Dean Witter Reynolds

PAIN

Paine Webber

PRUD

Prudential Securities, Inc.

MLCO

Merrill Lynch & Co.

To 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 These are big, full-service brokerage firms. They provide financial advisors and brokers. They make

Day traders need as much information as they can

commissions from order flow and a growing cus-

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

tomer base.

ing, who is selling, and the prices offered by each buyer and seller. Both the NYSE and the OTC pro-

REGIONAL FIRMS

vide information about the trades taking place on their systems. The information is flashed on a Level

PIPR

Piper Jaffray

II computer screen. But the information provided

SWST

Southwest Securities, Inc.

on NYSE Level II screens is basic, not nearly enough


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18


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

Level II

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

Level II not only shows the size of the best bids

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

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

will see no such gaps (see Figure 2.1).

market that exists behind the best bid and offer,

Figure 2.1 compares the details shown on a

also called the outside market. Level II shows the

NYSE Level II screen with the information shown

next bids and offers for several levels up and down

on a Nasdaq Level II screen. Remember, for day

from the best price. This is very important to the

traders, who rely on Level 2 information to make

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

decisions, information is critical. The Nasdaq pro-

maps for Napoleon. It is the best crystal ball you

vides far more information than the NYSE.

can have to determine the short-term direction of a stock price.

NASDAQ SERVICE LEVELS I, II, AND III

Here’s another way of looking at the depth offered by Level II. Let’s say Buyer A is bidding

NASD is a self-regulatory organization. Its mem-

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

ber firms use Nasdaq terminals that display real-

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

time bids and offers, size of quotes, and other

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

information. Nasdaq sends this information

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

electronically to all market participants on three

side market bids and offers, the next levels of

levels.

bids and offers down from the best bids and offers. In the outside market, Buyer B is offering

Level I

to buy the same stock for $64.75 while another

Available to stockbrokers and most online

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

investors, Level I provides the following basic

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

information:

has to get filled first and stock prices have to fall

Highest bid and lowest offer at any given time (called the inside market)

to $64.75. Level II shows the names and quotes of all registered market makers in each Nasdaq security. Day

High and low for the day

traders and online traders can access Nasdaq’s

Volume for the day

Level II through electronic communications net-

Price change from previous day

works (ECNs), which are explained later in this

Direction of last trade (uptick or downtick) Size of highest bid and highest ask Last transaction price

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:


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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, spread the ratio of the sizes between the bid and ask price.

NAME OF THE STOCK If you look at the first 7 levels on the bid side and compare the two, you will notice that the prices of IBM goes from ? down to ? (a difference of $?) while INTC only drops from ? to ? (a difference of $)

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

䊱

NYSE LEVEL II SCREEN

IBM is a listed stock that is traded on the NYSE

NASDAQ LEVEL II SCREEN

INTC is an over the counter stock traded on the NASDAQ

Which market makers are playing

Level III

Which ECNs are participating

Level III permits market makers to enter bid and

Bids and offers

offer prices into Nasdaq. It also provides a means

Size of the market (for both market maker and ECN) Time that the market maker placed or refreshed a bid or offer

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-

Time of each executed trade

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

Price of each executed trade

Market makers use Level III to advertise on the

Size of each executed trade

national system (Level II).


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COMPARING THE NYSE AND NASDAQ

required to display quotes for the stocks they are making a market in. Nasdaq stocks tend to be

The NYSE is an auction house maintained by spe-

smaller-capitalization stocks with high growth

cialists who receive orders and execute them by

potential.

matching them with other orders and sometimes with orders from their own account. The special-

Which Market Is Better for Day Traders?

ist quotes at the inside bid or inside ask if the

The answer depends on the individual. Nasdaq

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

provides more price movement. This higher intra-

ist will trade from his or her own inventory. These

day volatility also generates more intraday profit

factors are apparent to the trader on the computer

opportunities. But large price fluctuations could

screen. All other factors such as strategy are not

also mean greater losses. This means that trading

apparent, but sometimes they can be deduced by

the Nasdaq requires more expertise and knowl-

watching the specialist’s trading patterns. The

edge.

orders received by the specialist flow electroni-

However, many traders prefer the NYSE. It is

cally through SuperDOT. Only under unusual

more stable and can absorb a lot more volume.

circumstances do orders flow manually through a

These traders make a good living by following the

floor broker. Price movement on the NYSE is

specialist, but due to the narrower range on NYSE

order-driven, because the specialist matches bids

stock prices, most traders take profits of less than

and asks from the order book. Movement of

$1 on their intraday trades.

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

The bottom line: If you are willing to take the

sell to buy) creates price movement. The NYSE is

risk, Nasdaq offers greater rewards. As a day

a traditional marketplace; its stocks are estab-

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

lished companies with high market capitaliza-

vides good opportunities every day.

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.

ELECTRONIC COMMUNICATIONS NETWORKS (ECNs)

Nasdaq is a negotiated marketplace without

Electronic communications networks (ECNs) are

specialists. It is totally computer-driven. Market

quasi stock markets. They are used by both NYSE

makers compete in this marketplace. If Nasdaq

traders and OTC traders. Recently, the NYSE has

is dominated by anything, it is a nationwide

allowed traders to trade directly with each other

computer bulletin board (the OTCBB), which

via electronic communications networks (ECNs).

lists all available quotes. It is a modern techno-

They function as an exchange floor, except that

logical phenomenon. Nasdaq market makers are

orders are filled electronically and there is no


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trading floor. Currently, two of these networks

me to access the Nasdaq directly. Prior to ISLD,

trade stocks that are listed on the NYSE. They are

the ability to buy and sell directly in the Nasdaq

INET and ARCA. ARCA recently merged with the

market was available only to large institutions.

NYSE. Although the future is unclear on this

Since then, many new ECNs have been estab-

merger, one thing is sure: Speed will increase and

lished. Island and Instinet joined forces to

transaction costs will decrease. Both very good

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

things for the trader.

as mentioned earlier, has merged with the NYSE.

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

Changes and consolidation will continue. (Note:

the orders match, these transactions usually take a

As of this writing the Nasdaq is awaiting regula-

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

tory approval of its proposed acquisition of

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

INET.)

have a match. The order executes almost instantaneously. Because of their speed, ECNs are very

How ECNs Work

popular. They now account for a large proportion

As mentioned earlier, ECNs function as regional

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

exchange floors. They have their own individ-

increase in the future.

ual markets and allow traders to trade directly

ECNs were introduced in 1969. They provided a

with each other. ECNs accept both trader (indi-

way for institutions to display their buy and sell

vidual) and broker (institution) orders. Do not

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

automatically assume an ECN order to be from

tronically executed trades. Prior to this, a Nasdaq

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

trader had no way of executing trades except via

maker trying to hide his or her true identity and

the telephone. ECNs sped up the process by hav-

intentions.

ing every trade executed electronically. There is a

ECNs do not provide capital to facilitate trades.

lot less handling, and transactions now occur in

They serve only as a conduit or intermediary to the

fractions of a second instead of minutes. All orders

market. They give the trader a medium for order

on ECNs are firm orders. This means the trader

placement and execution. They compete directly

who placed the order does not have the choice of

with market makers for order flow. They have no

accepting or declining a matching order. As soon

vested interest in the price of a stock. They now

as a matching order arrives into the network, the

account for a very large proportion of Nasdaq’s

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

total daily volume.

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

Traders enter bids and offers on a national system that is visible worldwide. Real-time visibility and volume equal liquidity. That’s why traders get fast results.


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22

1 ● 2 ●

3 ●

Page 22


The three main ECNs available to daytraders are:

REGULATORY FRAMEWORK

Inet (INET)

The NASD is a self-regulatory organization. It

Brut (formally owned by SunGard Data and now owned

polices Nasdaq trading and the overall OTC mar-

by Nasdaq Stock Market, Inc.)

ket. The Securities and Exchange Commission

Archipelago (ARCA), which recently merged with the NYSE

(SEC), however, has the ultimate authority to

Other ECNs, playing smaller roles, include:

enforce securities laws and regulations. The SEC also supervises and acts as a safety net for securi-

●

Bloomberg Tradebook (BTRD)

ties markets. The SEC constantly updates its poli-

●

Attain (ATTN)

cies and has the authority to mandate changes to

●

NexTrade (NTRD)

$ NASD rules and regulations. ●


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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

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

Nasdaq: (a) Is market maker territory (b) Requires high-tech equipment (c) Is made up of stocks in the OTC market (d) All of the above (e) A and B only

Which of the following statements are true concerning market makers? (a) They execute trades for their firm’s customers

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 (d) All of the above (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

(b) (c) (d) (e)

They have many different customers They are nice people Nasdaq’s Level II displays market makers’ quotes 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


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CHAPTER

Page 25

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


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SELECTING A BROKERAGE

I

F 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 characteristics and features. Full-Service Brokers

trade, then buy an index fund and consistently

These are traditional, established brokerage

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

houses. They cater to people who do not have the

will probably pay more than investing in individ-

time to research stocks or follow the market. They

ual stocks.

usually have research departments that make stock recommendations. They also provide finan-

Discount Brokers

cial and portfolio planning services. This personal

These brokers provide automated systems that

attention means high fees.

take orders through the Internet. They also take

Many brokerages provide clients with online

orders over the phone. Because there is less han-

access to their accounts. But they do not provide

dling involved, they charge lower commissions

high-speed executions. These brokerages are best

than full-service brokers.

for people who invest rather than trade.

Brokers like Charles Schwab, Quick & Reilly,

One word of caution: Full-service brokerages

Fidelity, TD Waterhouse, Scott Trade, and others

claim to have great research departments that will

have e-trading services. Customers can log on to

find good stocks for you. Based on my experience

their account through the Internet and place buy

working for a brokerage, I would not put my trust

and sell orders.

in them. The people you deal with are merely

Discount brokers also allow you to trade

sales representatives. They want to make sales

through a touch-tone telephone. This comes in

and collect commissions. They are looking after

handy when the Internet crashes. Generally, com-

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

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

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

kerages do not offer buy or sell recommendations.

think this effort could be better spent learning

Instead, they give you access to research material

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

and allow you to make your own decisions.


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BROKERAGE FIRMS

Direct Access Brokers

will be outmoded tomorrow. As a rule, I would

With the establishment of ECNs came a new breed

expect a direct access broker to consistently exe-

of brokerage firms called direct access brokers.

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

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

count brokerage, executions as long as 10 seconds

Goldman Sachs, and Datek) now have divisions

are too long.

that provide direct access to the Nasdaq and the

Direct access trading means you are responsible

other exchanges. Direct access is the fastest way to

for routing orders properly. It is not as simple as

execute a trade on both Nasdaq and the NYSE.

clicking a buy or a sell order. Unless you know

There are no intermediaries involved. Customers

what you are doing, direct access trading can be

are responsible for routing their own orders to get

more of a hindrance than a tool. Make sure you

the best possible price. Real-time charting and

understand how orders are routed before trading

software for technical analysis usually come with

with real money. Some direct access platforms

the firm’s trading platform. Commissions can

have smart order routing whereby the software

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

chooses the fastest route. Some will even let you

share basis for under half a penny a share depend-

set your preference of where the program should

ing on the volume of your trades and the firm you

look first.

use. This is the only type of brokerage I would use to day trade.

EXECUTION SPEED

RELIABILITY Fast execution is useless if the brokerage’s trading system is unreliable. Some firms use software that

Execution speed is the most important considera-

has not been debugged. This might cause a system

tion when choosing a direct access broker. High-

crash when a large number of orders are placed at

speed execution allows you to quickly get into and

the same time. Bad software could also cause con-

out of positions. This gives you control of your

stant Internet disconnects, forcing you to keep log-

trading. Please note, however, that not all direct

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

access brokerages are alike. Execution speeds vary

interact properly with your computer, the system

from firm to firm.

may constantly hang up your computer, forcing

You need to search for the broker with the latest,

you to reboot, a waste of valuable trading time.

fastest, and most reliable equipment. A delay of a

Browse trade journals and magazines to find

couple of seconds or a breakdown can cost you

evaluations of the various brokerages’ reliability.

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

Talk to other traders; most traders have used sev-

fastest and most reliable brokers. Trading technol-

eral different platforms and will give you an hon-

ogy is constantly changing, so a fast system today

est opinion on which is best.


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Sometimes the problem is your computer. You

When you trade with a direct access brokerage,

could be asking your ISP connection to download

it is important to know the following: Does the

more information than it can handle. Your com-

broker allow you to route an order to an ECN such

puter will freeze when this happens. It is your

as INET or ARCA? How many ECNs is it directly

responsibility to know the limits of your computer

connected to? Does your direct access broker have

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

a straight connection to Nasdaq, or does the order

able for trading except as backup to a cable

have to hop through several offices before it gets to

modem, DSL, or other broadband connections. You

Nasdaq?

may need to buy a new computer to get the speed

If you trade heavily, good order routing can

and performance you need for trading. If you are

save money. You want as little delay as possible

using a system with dual processors, check to see if

between you and the market. A good direct access

the trading platform you use supports them. Com-

broker will have a direct connection to several

puter memory is inexpensive today, so maximize it.

ECNs. ECNs tend to execute orders a lot quicker than market makers. The more ECNs you have

ORDER ROUTING

direct access to, the more choices you have to get your orders filled. The more choices you have, the

Here are some questions to ask your broker before

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

opening an account: Do you execute your own

brokerage should have direct access to at least the

orders or go through an intermediary? Do you sell

ARCA, INET, and BRUT ECNs, and preferably all

orders through that intermediary? Can I get price

the available ECNs should be available to you.

improvement on my orders? Does the platform

The best way to find out whether a direct access

have smart routing? Does it support multiple

broker has efficient order routing is to send a live

monitor setups?

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

Brokers who execute their own orders tend to

slow-moving stock and place it away from the

have faster executions. Brokers who sell their

inside prices. The order should show up at the

orders to intermediaries add precious seconds to

Nasdaq in less than two seconds. Many firms take

the execution time. The intermediary profits by

eight seconds or more to get an order to Nasdaq.

trading against your order. Fills are poor and price

Make sure you avoid these firms like the plague.

improvements are rare. Whatever price improve-

Order routing is getting faster and faster. Cyber-

ment the intermediary gets, the intermediary

Trader of Austin, Texas, a subsidiary of The

keeps. The easiest way to know whether a broker-

Charles Schwab Corporation, offers smart orders

age sells orders is to look at its financial statement.

using its proprietary CyberExchange order rout-

If its revenue stream includes an item called “pay-

ing system. It electronically routes orders to the

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

trading venue that offers the best price and best fill


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BROKERAGE FIRMS

speeds. These are often ECNs, which not only

saved $10 in commissions, but missed an opportu-

eliminate payment for order flow intermediaries,

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

but also frequently avoid market makers them-

missed opportunity.

selves.

We do not see a lot of good trading opportuni-

CyberTrader isn’t alone. TradeStation, RealTick

ties each day. It is imperative that we have the

and E*Trade all offer smart executions. Others

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

have a policy of not accepting order payments.

cheap commissions are not necessarily cheap.

Services are improving every year and brokers are

They usually cost you money in the long run.

constantly merging. The similarities between full-

There are two ways commissions are calculated

service brokers, Internet brokers, information

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

service providers, and ECNs are becoming more

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

apparent. Each tries to offer something unique.

trade will generally cost you at least two tickets. Commissions can range from $5 to $20 per ticket,

PRICE

depending on the brokerage. In the second method, commissions are figured

Price is not as important as speed, reliability, and

on a per-share basis. Depending on your trading

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

volume, per-share commissions can range from

cution than low commissions. A good execution

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

will ultimately save more money than a poor one.

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

I had the following experience with one of my

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

students. He had worked for a firm with a cheap

commission when you sell. Many companies that

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

charge a per-share commission also have a mini-

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

mum charge. Some firms, such as CyberTrader,

prepared to trade. He used the firm with the cheap

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

rate. I used a slightly more expensive firm with

commission.

faster executions. After searching for a while, we finally found a good opportunity.

Commissions can add up to hundreds or even thousands of dollars every month for active

At my signal, both of us started placing orders.

traders. A balance has to be struck between cheap

Our plan was to chase the entry by no more than

commissions and execution speed. There are other

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

brokerage costs involved when trading. You really

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

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

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

be a per-share charge for each share exceeding

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

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

making some nice money for me. The student

Some brokerages charge a small fee for cancel,


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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

OTHER ONLINE BROKERAGE FEATURES Other features you might consider when selecting a brokerage service include the following:

on additional ECN fees. They charge a low per-

Products available for trading. Never assume a broker-

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

age has the product you want to trade. Brokerages that

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

specialize in equities might not have futures and com-

and profit from the higher ECN fees.

modities. Many equity brokerages don’t offer options

Make sure you evaluate the whole commission structure. Do not just focus on one area.

trading. Quote services. Delayed quotes are free; real-time quotes are not. Real-time quotes make all the difference

SERVICE

in a market that changes by the minute. Find out which brokers offer real-time quotes and how much they charge.

If you trade from home and experience a computer

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

crash or a lost Internet connection, your brokerage

cost.

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 representative 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-

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.

resentative should not take more than a few min-

News and research services. Some brokerages provide

utes to answer your call.

real-time newswire services. Others provide news at their

A good online brokerage should have a toll-free service desk that can answer any technical ques-

website. Some brokerages provide extensive research databases, while others do not.

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

TYPES OF ACCOUNTS

the technical support team of the brokerage. Some

There are several types of brokerage accounts you

brokers offer online support directly from the plat-

can use to day trade. You can open a corporate

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

account, a partnership account, a retirement

unable to solve the problem, they might want to

account, or just a personal account. Most traders

log on to your computer remotely and have a look

use a personal account for simplicity, but once you

around. Check to see if that feature is available.

start making money, trading under a corporation


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BROKERAGE FIRMS

or retirement account does have tax benefits. Con-

words, someone will call you because your margin

sult with your tax advisors before you decide on

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

one or the other. There are two major types of trading accounts: margin accounts and cash accounts.

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

Margin Accounts

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

A margin account is a leveraged account. The bro-

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

kerage lends the account owner part of the pur-

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

chase price of a security. The collateral used for the

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

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

point, the capital is still higher than the mainte-

Some securities are not marginable. A security

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

priced below $5 is a good example. Because they

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

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

trigger a call.

ing to use the stock as collateral.

The buying power for a day trading account is

You must understand two concepts when using

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

a margin account: the buying power level and the

margin on day trading accounts. The trader must

margin maintenance requirement. Buying power is

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

the maximum dollar amount of stocks you can

The maintenance margin requirement on the new

purchase on a given day. The maintenance margin is

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

the amount of cash you must have in your account

trader who uses up his or her buying power and

to continue to hold a position.

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

If an account is not being used for day trading

gin call. This is because the maintenance margin is

or pattern trading, the buying power level is two

at 30 percent, while the capital available is only 25

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

percent of the buying power.

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

How does the SEC define a day trader or pat-

means you can borrow up to 100 percent of the

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

cash in the account. If the maintenance level is 30

chase and sale or sale and purchase of the same

percent of the value of the stock, you will need

security on the same day in the same account. If

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

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

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

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

the account drops below the maintenance level,

you are day trading. A day trader must trade at

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

least four times in five business days. However, if

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

this trading does not exceed 6 percent of the total


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trading activity for a five-day period, the account

profit comes from buying the stock at a low price

is not considered a day trading account.

and selling it at a higher price. Losses occur when

A margin account is needed if you want to short

the selling price is lower than the purchase price.

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

When the market heads down, traders can make

A trader who fits the definition of a day trader

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

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

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

account to day trade.

The profits and losses are no different than a long position. Losses come from paying more for the

Cash Accounts

stock than the original sale price.

In a cash account, your capital equals your buy-

The only difference between the two positions

ing power. Cash accounts are mostly used by

is the timing sequence. On a long position, the

long-term investors. Retirement accounts are cash

trader buys the stock first and sells later. With a

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

short position, the trader sells the stock first and

do not have a cash account.

buys it back later.

Certain trading products, because they are con-

Most newcomers have a hard time grasping the

sidered risky, must be traded in a cash account.

concept of shorting. They wonder how it is possi-

Options transactions are a good example. Options

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

are extremely risky. Unlike stocks, they have no

making this possible is the intermediary: your bro-

inherent value. Options are only a right to buy or

kerage.

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

To sell something they do not own, traders do

thing except that right. Options are not worth

the following: After borrowing the stock, they sell

much as collateral. Brokerages are therefore

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

unwilling to extend margin against these holdings.

debt to the brokerage. The debt is not in the form of cash. It’s in the form of the shares they borrowed.

TYPES OF POSITIONS

The only way a trader can repay this debt is to buy the shares and give them back to the brokerage. It is

There are two types of positions that a trader can

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

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

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

tion. The market allows traders to profit in either

successful short trade: You are a trader. You think

direction of the market. When the market heads

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

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

borrow 100 shares from your brokerage. You sell

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

the stock immediately, getting cash in return. You

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

still must return the 100 shares you borrowed. You

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

will do this after the price falls.


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BROKERAGE FIRMS

When you sold the stock you borrowed it was priced at $125 per share. Thus, you received

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

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

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

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

borrowing from your brokerage firm or clearing-

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

house. Stocks that are thinly traded are usually not

you buy 100 shares so you can return them. You

available for selling short. This happens because

have already sold 100 shares at $125, getting

the brokerage cannot obtain the stocks you want to

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

short. Another problem might arise after you short

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

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

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

sale, the brokerage must first borrow and then

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

lend you the securities that you sell short.

ference of $2,500. Buying the shares to return them is called covering your short.

From time to time, a brokerage will receive a recall notice on the shares it lent to you. If the bro-

To short successfully, you borrow shares, sell

kerage is unable to obtain replacement shares to

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

secure your position, it will sell the short position

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

in your account on the open market at the current

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

market price. As the account holder, you will be

severely limit your moneymaking potential.

responsible for any resulting loss or costs incurred by the brokerage.

Shorting Guidelines

A short sale is always handled as a margin

Here are the regulations for shorting. Short sales

transaction. Shorting involves borrowing stocks,

can occur only on an uptick. The Nasdaq and the

and only margin account holders are allowed to

stock exchanges define uptick in different terms.

borrow. The current margin interest rate is applied

For exchanges like the NYSE, an uptick is

for however long the short position is open.

defined by the time and sales or the last trans-

The margin maintenance requirement is a little

acted price. If the last price is higher than the

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

previous one, then you have an uptick on the

tion. Often, brokers will not charge margin interest

stock. For the Nasdaq, the uptick is determined

on short trades that are opened and closed the

by the inside bid price. If the current inside bid

same day. New issues typically cannot be shorted

price is higher than the previous inside bid price,

during their first 30 days of trading.

then you have an uptick. In both cases, short

Please note, as of this writing the SEC is proposing

sales can happen only when the stock price is ris-

to remove the uptick rule. Presently, you can short

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

on a downtick on ARCA and INET ECNs, and both

to prevent another stock crash like the one in

the Nasdaq and NYSE are testing feasibility on a


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limited list of stocks. Check with your broker for the

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

latest rules and regulations.

tions. When a stock hits my stop-loss, I get out immediately at the market price. If I wait, I could

Dangers of Short Selling

lose even more. I also use market orders at the

A widely perceived misconception is that shorting

beginning of an up move. If an uptrending stock

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

has made a nice pullback and is beginning to turn

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

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

money you paid for the stock. With short selling,

upswing.

you risk an unlimited amount of money. If the

Market orders are susceptible to slippage. Let’s

stock you shorted rises instead of dropping, you

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

will be responsible for that increase in price. This

a buying opportunity. But a lot of buyers will jump

can indeed lead to a disastrous loss.

into the stock. Because demand for the stock is

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

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

pen. Nothing should stop you from quickly clos-

filled because you have entered a market order.

ing a short position if it goes bad. Many short

But the price will be higher than you thought. This

traders do not have an exit plan. An exit plan

is called slippage, and it applies to both winning

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

and losing trades. When you want to take a profit

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

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

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

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

out an exit strategy.

traders will have the same objective. The key is to enter your market orders early. Never wait or hes-

TYPES OF TRADING ORDERS

itate. If not, the slippage can be extreme. A market order is good for the duration of the

A day trader has a variety of trading orders to

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

choose from. Two factors determine which type of

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

order should be used: timing and price. Timing is

system that works well. Never deal with a firm

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

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

leave an order open briefly for a day or longer.

trading against your order, putting you on the losing end of the trade. Market orders should be filled

The Market Order

within one or two minutes.

The simplest form of order is the market order. It is an order that must be executed at the best price

The Limit Order

available as soon as the order reaches the market

A limit order guarantees a price. You literally place

maker or trading floor. No price is specified. The

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

transaction has to be made at the current market

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


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BROKERAGE FIRMS

As you will see next, limit orders do not guarantee that your trade will be executed.

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

The Buy Limit Order

market. Once the price hits my limit price, the

This is an order to buy shares at a stipulated price.

order will be executed. I do not like placing limit

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

orders to exit a losing position if it is higher than

rent market price. I use buy limit orders to take

the market price. They tend not to get executed,

advantage of pullbacks. If a stock currently at $35

leaving me worse off than if I had simply placed a

is dropping, I place a buy limit order lower than

market sell order to get out.

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

I use limit orders when I enter a short position.

order is executed. Computerized order books send

This prevents me from getting into a stock at the

these orders to specialists and market makers, or

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

they are executed automatically on the ECN. If the

limit price is determined by how much profit I

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

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

I also use this strategy when I am exiting a short

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

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

short using a limit order that is higher than the

wait for the price to drop far enough to buy back

market price. You are simply waiting for the price

the shares I shorted. Again, you should place the

to bounce up to a resistance point before entering

order early. Do not hesitate.

your short position.

I also place buy limit orders at a higher-thanmarket 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 pullback.

Stop Order Stop 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 market. 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 market order becomes a live order only when that stop price is hit.

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

The Buy Stop Order

orders. But they set a sell or short price target

A buy stop is a buy order that becomes an active

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

market order only when the stock rises to a specified


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

for sale, protecting some of your profits. In this

rent market price.

example, you could also place a sell stop order at

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

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

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

This order will go into effect when the stock price

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

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

order starting at $45.

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

Investors use this method to buy stocks that are rising. They believe the upswing will continue and

the upside potential is not limited. Only the downside is limited with a sell stop order.

they want to buy before the price goes too high. Buy stop orders also protect profits in a short posi-

The Short Stop

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

This is an order to go short at the market price

drops to $44.50. Then Coke announces that earn-

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

ings will double in the next quarter. The price is

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

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

the selling pressure down, and buy the stock back

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

at a cheaper price.

stock hit that price. This would protect most of your hard-won profit. Buy stop orders are a safety

The Stop-Limit Order

net for short sellers.

This is a good order to use when you enter a position. It is both a stop order and a limit order. It can

The Sell Stop Order

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

Sell stops, often called stop-loss orders, are safety

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

nets for long positions. The order is always set

when a stop price is reached.

below the current market price. It is used to protect

For example, you entered the following order

profits and to limit losses in a long position. This

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

order is the opposite of the buy stop order. It

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

becomes a market order only when the price of the

you think it might go higher. If Coke finally

stock declines to your “stop” price.

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

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

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

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

than $45.15. With such restrictions on your order,

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

however, it may go past $45.15 without there being

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

enough stock at your price to fill the order. Your

order will now be as follows:

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

“Sell 1,000 Coca-Cola at $51 stop.” If the stock drops back to $51 or lower, your shares will go up

limit order prevents the trader from chasing an entry beyond a reasonable price.


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BROKERAGE FIRMS

The market is like an auction. Bidders at auction

cancellation is executed, the market may have

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

changed and you might incur a loss. Be careful

an unreasonably high price. If you set a limit price

with cancellations.

prior to the auction, you will not overpay. The

All brokerages and trading systems allow order

same is true with stocks. You will not overpay if

cancellation. Simply identify the order and hit the

you set a predetermined maximum price. The limit

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

order ensures that you have the chance to get in on

cellations, I would change brokerages. Some bro-

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

kerages will falsely tell you the Nasdaq charges a

confirmation and then enter as a run begins.

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

Bear in mind that the limit price on a buy stoplimit order does not have to be higher than the stop

age keeps the money. I trade only with firms that do not charge a fee for order cancellation.

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

Cancellation should work just as fast as the

allows the trader to buy on pullbacks, but you do

original order placement. Orders reaching an

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

exchange in seconds can be canceled in seconds.

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

But when markets and electronic trading systems

be as follows:

are caught in a traffic jam, cancellations will be

“Short 1,000 Coca-Cola stop $45, limit $44.85.” This order says when the price of Coca-Cola

slow. Be warned, your cancellation may arrive after the order is filled.

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

Market orders are executed quickly. You proba-

$44.85. This will also ensure that the trader does

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

not get filled too far away from the desired short

orders give you more time to change your mind. I

entry price.

use cancel orders to speed up market orders sent to

Again, the limit price does not have to be lower

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

or higher than the stop price. It can be anywhere

cancel order usually gets the job done. Remember,

you choose to place it. The price you choose will

specialists and market makers make money by

depend on the current bid and ask and also the

playing the spread. They want as many orders as

price action.

possible.

The Cancellation Order

More Order Terms

If you change your mind after opening a position,

Some of the following terms involve the length of

you must place a cancellation order to close out the

time an order is left open. Some involve execution.

position. A cancellation that arrives after a transac-

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

tion is completed is not valid. You will be liable

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

for the results of the transaction. By the time your

market won’t.


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

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

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

tion added to an order that requires execution at the

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

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

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

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

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

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

not filled immediately.

immediately at the open.

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

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

to be taken or it will be rejected.

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


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CHAPTER

Page 39

4

Direct Access Order Entry System • • • • • •

Nasdaq Direct SuperMontage TotalView ECNs SuperDOT Order Execution Systems Review


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T

HIS 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 frequently 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.

There are a number of electronic systems for directly buying and selling stocks within the market. The main systems are:

NASDAQ DIRECT The Nasdaq Market Center is where market makers conduct the business of buying and selling

Through the market makers participating in the

stocks. The Market Center is a fully integrated

Nasdaq Market Center

order display, execution, and trade reporting sys-

●

ECNs

tem for all securities listed on Nasdaq National

●

SuperDOT

Market®, Nasdaq SmallCap MarketSM, NYSE, and

●


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DIRECT ACCESS ORDER ENTRY SYSTEM

Amex. The Market Center offers trade executions

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

and reporting for more than 6,700 securities.

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

SuperMontage

SM

is Nasdaq’s display and order

order will execute, and the new inside bid will be

execution system designed to help reduce frag-

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

mentation, provide best execution, expand the

will be rejected, as there is no additional liquidity

number of choices to market participants, and bet-

at or above the threshold bid price.

ter handle the growth of the market. The order

Market participants are obligated to comply

routing and execution segment of SuperMontage

with the “Firm Quote Rule,” which means they

SM

replaces SuperSOES and SOES

orders. The

basics of SuperMontage are discussed next.

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.

SUPERMONTAGE

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

The SuperMontage system will attempt to match

Market makers and ECNs can post to Level II

your order with the best price available at the time

anonymously by sending nonattributed orders to

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

the market. Nonattributed orders are displayed in

grouped with other odd lots to create round lots

the Level II montage under the size identifier. For

before being executed. Dual-listed securities can

each price level, all nonattributed orders are aggre-

be round lots only if sent to SuperMontage.

gated under this identifier; however, unless you

SuperMontage does not use a tier limit system.

subscribe to Nasdaq TotalView, size will display

As such, tier limit restrictions are no longer appli-

only one quote on each side of the montage—the

cable for any Nasdaq National Market Securities

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

(NMS) or Nasdaq SmallCap Market securities

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

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

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

stocks cannot be traded via SuperMontage order

transaction is complete.

routing.

Another type of SuperMontage order is the

Any portion of a SuperMontage order that

SuperMontage Directed order. SuperMontage

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

Directed sends orders to market makers and

inside market at the time of entry will be rejected.

ECNs, either directly or broadcast to all available

For example, in stock ABCD, the current inside bid

participants at once. Order quantity must be 100

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

shares over the size the market maker is posting.

shares. There are currently 4,000 shares bidding

Otherwise, your order may be rejected. For exam-

between $8.99 and $10.00, with another 100 shares

ple, if a market maker is posting 900 shares and

available at $8.98. Based on the preceding formula

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


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

also “SIZE,” where market makers are posting

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

nonattributed orders.

a market maker who is posting 900. No counterparty is obligated to fill SuperMontage Directed orders. There is no tier limit on a SuperMontage

ECNs

Directed order. If your order is directed to a market

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

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

were created in response to a growing need to cre-

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

ate fair and efficient trading that was more accessi-

Orders cannot be canceled for 5 seconds after be-

ble to individuals. They came about after the SEC

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

passed the order handling rules of 1997.

6:30 P.M. eastern time.

ECNs allow Nasdaq customers, traders, or in4.1 Level II with Nasdaq TotalView®

TOTALVIEW Market maker activity can be viewed on all Level II screens. Level II shows each Nasdaq participant’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 participant. 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 market participant LEHM is shown at two levels on the bid side and two levels on the ask side. Notice


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vestors like you and me to trade directly with each

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

other or to place orders directly into the marketplace.

able through all direct access brokers, and the

This process eliminates the intermediaries. In the

hours may vary from broker to broker.

beginning they handled fewer than 5 percent of all OTC trades. They now control over 35 percent of

ARCA

Nasdaq volume, and that number continues to grow.

Gerald Putnam formed Archipelago in 1996 in

In 1998, the SEC passed a regulation called Alterna-

response to the new order handling rules imple-

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

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

as ARCA, REDI, and others, to become electronic

four original ECNs approved by the SEC. Archi-

securities exchanges. As for-profit exchanges, each

pelago is accessible to traders, easy to use, and

ECN has its own individual trading system and

inexpensive. It also has a great deal of liquidity.

computer algorithms. Understanding how each

Codeveloped by Townsend Analytics, Ltd., and

ECN works, and under what situations each works

Terra Nova Trading, Archipelago allows traders to

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

post bids and asks into Nasdaq Level II and on

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

some stocks in the NYSE. Archipelago also oper-

Liquidity is the ability to quickly turn stocks into

ates on a computer algorithm. Best execution is

cash. The ECN that provides the best liquidity and

facilitated by its proprietary SmartBook technol-

reliability is the one you should use. When trading

ogy, which looks for the best price for an order

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

internally or externally. This book server, the heart

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

of the Archipelago system, maintains a current

computer algorithm system is not self-contained.

real-time account of all bids and offers for each

This type of ECN will automatically search the entire

Nasdaq stock. If an incoming order crosses or

market to get the order filled. It literally helps the

locks an existing internal order, the order is exe-

trader decide where to go for liquidity.

cuted immediately. If no crosses or locks occur,

The list of available ECNs is constantly chang-

and the order reaches the top of the Archipelago

ing due to failures, consolidation, mergers, and

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

acquisitions. What is most important is which ones

bid and ask posting 100 or more shares will post on

are offered by your direct access broker. The main

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

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

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

ATTN, and BTRD. BRUT is now owned by the

time. Limit orders can be entered and will be

Nasdaq; ARCA has merged with the NYSE; and

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

INET has also been acquired by Nasdaq and is

ern time. Individual brokers may have different

awaiting regulatory approval. Following is a brief

hours of operations. For more information go to

description of the main ECNs: INET, ARCA,

ARCA’s web site at www.tradearca.com.


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INET

routing to all major destinations. In addition, all

INET is the result of a merger between Instinet and

firms, both market maker and order entry, can now

Island ECNs. Instinet is the original ECN. It was

post orders in the National Market System using

founded in 1969 and acquired by the Reuters Group

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

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

DOT router and access the Amex and regional

provide investors with an open, transparent, and

exchanges. Your DOT orders will sweep the Brut,

fully accessible marketplace. It operated on one

Nasdaq Market Center, and INET exchange-listed

simple principle: It automatically matched buy and

books before being sent to the floor if not already

sell limit orders for equities. It was inexpensive,

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

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

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

one looked at day trading. Together now as INET,

the Brut web site at www.nasdaqtrader.com/

this is one of the most powerful ECNs available.

trader/tradingservices/productservices/product-

Where the acquisition by the Nasdaq will take it is

descriptions/brutdescription.stm.

anyone’s guess, but odds are it will be good for the day trader. INET is an order matching system and

ATTN

accessible only to other INET subscribers. Orders

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

not immediately matched are added to the INET

It was founded by Harvey Houtkin, often referred

order book, a database of available orders, where

to as the father of electronic stock trading. Houtkin

they wait to be matched in price-time priority.

has long advocated the reform of investing rules

Orders will not be routed to other market partici-

and regulations. ATTN was acquired by Domestic

pants for execution. All INET subscribers are

Securities and then, more recently, by Knight Capi-

anonymous; no subscriber’s identity is disclosed

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

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

matching system. Orders that are not matched in

book bid and ask quotes are displayed on Level II

the ATTN book will be displayed on Level II if the

with the INET or CINN identifier. Currently, hours

order is for more than 100 shares and at the inside

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

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

the INET web site at www.inetats.com.

ket. Hours are 8:05 A.M. to 6:30 P.M. eastern time. At this time, ATTN accepts only limit orders.

Brut In its early phases, when it was owned by Brass Utilities, this ECN catered mostly to institutional

SUPERDOT

investors and broker-dealers. Now, after being

Electronic access to the listed markets is evolving

purchased by the Nasdaq, it is available to all

rapidly. Currently, SuperDOT is the most common

traders. Brut offers broad market access, with

way for traders using a direct access platform to


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trade listed securities. SuperDOT is an electronic

A trader trading on the Nasdaq has several order routes to

means of gaining access to the listed markets. It is

choose from.

responsible for the vast majority of all orders on the

The easiest routing method is the intelligent ECN. These

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

systems use a smart computer algorithm to help the

a time. It gives individual investor orders of less

traders send their orders properly.

than 2,100 shares priority over the large institutional orders. It links the member firms directly to the specialists who will rapidly execute orders. The specialists’ job is to pair orders, fill orders

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-

from the inventory, or place orders on the limit

puter algorithms. Each has its own individual designs.

order book. The purpose of the limit order book is

When canceling an order, the order remains active until

to give specialists time to organize the book while

actually canceled by the exchange. An order can be filled

establishing an orderly market.

even after a trader has hit the cancel button.

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

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 brokerdealer.

through these third markets. With more and more

Remember, each venue has its own characteris-

listed securities trading on ECNs, and with the

tics, rules, and risks. Commission charges may

merger of ARCA and the NYSE, things will be

vary depending on what route you choose for

changing rapidly.

your order. Some routes may be faster in different markets. Price, volume, fees, and liquidity are all

ORDER EXECUTION SYSTEMS REVIEW A market order is an order executed at current bid or ask price.

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

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

using direct access. Also remember that this infor-

ing to buy or sell.

mation is changing rapidly; make sure you have

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

$ the latest! ●


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2/2/07

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CHAPTER

Page 47

5

Elements of Successful Trading • • • •

Minimum Requirements to Begin Trading Psychology of Trading Risk Management Trading Methodology


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MINIMUM REQUIREMENTS TO BEGIN TRADING

T

HE FOLLOWING RESOURCES ARE the bare minimum that you need to begin trading for a living.

Capital

you begin. It will make your life easier. Reading

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

books and attending seminars and conventions

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

takes time. Doing research and analysis also takes

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

time.

ization is one of the keys to successful trading. Too many traders start out with inadequate capital.

Knowledge

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

Knowledge comes from books, seminars, and talk-

a living immediately. This is possible, but highly

ing with others. Many people skip the educational

unlikely.

process and jump right into trading. Most of them

It generally takes a few months for a trader to

fail. We are not built to trade. Our psychological

become successful. Adequate capitalization allows

makeup is such that we will almost always make

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

the wrong decisions. Make sure you learn how to

not to become involved with day trading if you

trade from successful traders. If you imitate their

cannot survive this period without dipping into

methods, your chances of success will greatly

reserves. It’s also wise for beginning traders to

increase. As you progress from beginner to profes-

keep their jobs until they start making money in

sional, your quest for knowledge will continue. It

day trading. This lessens the pressure to make

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

money immediately.

sion, there is always something new for us to understand and conquer.

Time You may not think that time is an important con-

Your Computer

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

Here are the minimum requirements for your

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

computer. Keep in mind that technology makes

away from your family, friends, and leisure activi-

quantum leaps every year. By the time you read

ties. Are you willing to make this sacrifice? Make

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

sure you have the support of loved ones before

anyway.


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ELEMENTS OF SUCCESSFUL TRADING

1.0-gigahertz Pentium processor

tion, because of the distance the signal is traveling,

512 megabytes of memory

a slight delay is present.

50-gig hard drive

A T1 line connection is also an option, but it is expensive. Installation and monthly maintenance

Windows XP

costs are high. Make sure your trading is profitable

Networking card

before venturing into such a connection.

CD-ROM 19-inch monitor (LCD)

PSYCHOLOGY OF TRADING

Uninterruptible power supply (UPS)

There are three key elements to trading success.

When you buy a computer, get the best you

They are psychology, risk management, and trading

can afford without hurting your trading account.

methodology. It is critical to understand how inter-

Make sure it has expansion slots so it can grow

related all three pieces are. You absolutely cannot

with your needs. As a beginner, you might start

have success without one or the other. Each ele-

out with only one monitor. Later, you might want

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

to add more memory and an extra monitor. Make

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

sure this is possible with the computer system

let’s look at the psychology of trading.

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

Trading is a psychological process. The way you

monitors on two video cards, 512 megs of RAM,

analyze the market and reach conclusions depends

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

on your past experiences. The market is an inani-

a UPS.

mate object. It has no feeling. It simply exists. People make judgments about everything. To some, a

Internet Connection

mountain is beautiful. To others, a mountain is just

Today, nothing less than cable or DSL will work. A

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

lot of traders have both for redundancy. The shear

glass of water can be half empty or half full.

amount of data that traders demand requires a broadband connection to the Internet.

The same is true in trading. If your past experience has been good, you will see the market as an

Cable modems are available in most areas of the

opportunity. You will have the confidence to act

country. These modems come from your cable TV

quickly. If your past experiences have been bad,

company. High-speed DSL Internet connections

you will see the market in a negative light. Fear

are also available in most areas. Your phone com-

and indecision will control your decisions. Your

pany usually provides this service. Two-way satel-

mind will focus on the things that could go wrong.

lite connections will work on some platforms, but

You will hesitate, waiting for more confirmation

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

that you are making the right trade. Often, you


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

place, your focus will always be on the wrong

and watch opportunities disappear.

things. You are your biggest enemy in trading.

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.

BEING RIGHT DOES NOT EQUAL MAKING MONEY.

Most traders start out confident but ignorant.

Beginning traders are more concerned with being

They have an idea and they immediately start trad-

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

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

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

after several good trades, the beginning trader usu-

ners short. Most beginners think being right equals

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

making money. When they have a winning trade,

trader steps to the side and decides to learn more

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

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

ing a profit means that they have proven to the

more information becomes a crutch instead of a tool.

world that they were right. Beginners also tend to

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

believe that if they have not closed a losing position,

have overlooked crucial information.

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

Now the trader gets back into the market and a few trades go favorably. The individual is more

It is not real. So they hang on until the pain gets too unbearable, and then they close out the position.

convinced than before that success depends on get-

The bottom line is this: Cutting profits and

ting the right information. But after a few more

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

winning trades, the trader again sustains a big loss.

right and making money are exact opposites in

The trader now enters an unending cycle of fail-

trading. Many of the good traders I know have a

ure and success that will lead him or her to stop

winning percentage of only 40 percent. But they

trading altogether. When the trader wins, he or she

make a lot of money. I also know traders whose

believes information is the key. When the trader

winning percentages are over 90 percent. And yet,

loses, he or she believes that some important infor-

they are consistent losers.

mation was missed. Following each loss, the trader

The reason is simple. They focus only on the high

goes on a more intense quest for information that

percentage of winners, thinking this equals prof-

will stop the losses. But the losses continue, and

itability. They ignore something called the reward-

the trader ultimately gives up.

to-risk ratio. This ratio measures the amount of

With trading, your success or failure begins and

profits per trade and the amount of losses per trade.

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

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

dom information the market generates. If you

about one to four. This means winning trades net

think in an orderly fashion, the market will begin

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

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

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


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

cept of trying to predict mass behavior is absurd. If

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

the market ever becomes completely predictable,

80 winning trades multiplied by a $1 profit per

we would be able to optimize a computer program

trade. Total losses are 20 losing trades multiplied by

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

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

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

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

What works well today may be useless tomorrow.

winning percentage has not made a dime.

A quick look at two intraday Nasdaq charts

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

proves this point. Figure 5.1 shows the market is

and a winning percentage of only 50 percent will make

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

money. Consider another 100-trade sample, this time

following system developed through system opti-

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

mization will make money for you. On the other

cent winning percentage translates to 50 winners

hand, an oscillation-type system will constantly be

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

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

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

trend-following system is less likely to make

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

money than an oscillation-type system. This is

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

because the market had very little trend and

this trader makes money only half the time, he is

moved sideways the whole day.

profitable. This exercise tells us one thing: Being right does not equal making money in trading.

Looking at Figure 5.1, traders who use system optimization would conclude that the trendfollowing method works. So they would customize

Avoid System Optimization

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

The compulsive need to be right has resulted in

But, as seen in Figure 5.2, the conditions that

a strategy known as system optimization. This

favored a trend-following system reversed the

involves using computers to analyze technical

very next day. This forces the traders to rethink

indicators and historical data. The data is “opti-

their strategies. Based on the information gained

mized” for current market connotations. Some

the second day, an oscillating system seems to

traders believe this data makes the market pre-

work better, so the traders reconfigure their sys-

dictable. They also believe they will make a lot of

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

money using this system.

timize a trading system, you will almost always

But system optimization does not work in real

be late.

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

Many of the optimized trading systems used

stantly changing. The market is made up of people.

10 or 20 years ago have become obsolete. They

People are not predictable. Even my longtime

worked for the markets that existed years ago, but

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

not for today’s market. However, methods using


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5.1 Nasdaq Futures on a Downtrend

䊳 This intraday chart clearly shows the market on a downtrend. A trendfollowing system works well in this type of market.

fundamental and technical analysis have withstood

The same logic applies to trading systems. We

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

cannot design a system that perfectly fits a chang-

ages. They worked before and they work today.

ing market. There is no sure thing in trading.

They will continue to work in the future. The only

Anyone who claims to have a system that works

difference is that these systems and methods were

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

never optimized to the current market conditions.

with general probabilities. The best systems work

Another way of understanding why optimiza-

on a lower probability of success but a high reward-

tion does not work is human psychology. Using

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

the most general terms, you can find similarities

two to find the right trading system for yourself.

between everyone. Based on these similarities, a psychologist can predict the most likely outcome

Accept Losses and Move On

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

Viewing losses the right way is a large part of the

a most likely outcome. Personalities vary from

trading profession. Your ability to accept losses

individual to individual. What is true for one per-

quickly and easily will have a great impact on your

son might not be true for another.

success. The most successful traders I know feel no


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5.2 Nasdaq Futures on a Sideways Move

䊳 This

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

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

traders have great trading plans, but they are

of the business. They quickly exit positions that

unable to control themselves. They get into posi-

have not gone their way, keeping losses small and

tions even though an entry signal has not been

inconsequential. These traders have setbacks, but

generated. Or they get out of positions early, even

they never go broke because of them.

though their trading system dictates otherwise. Some traders take massive risks outside their

Maintain Discipline

trading plans. They are impatient and impulsive.

Discipline is another characteristic of a successful

They do not belong in the profession of trading.

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

Sooner or later, the market will take them out of

trading opportunities. You should trade only if

this business.

there is a high probability of success and a favorable reward-to-risk ratio.

Disciplined trading can lead to consistent profitability. It is the only way to build trust in your

There is a popular saying in trading: “Plan

systems and prevent destructive tendencies from

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

taking over. Staying on course when the going gets

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

tough takes a lot of discipline. Exiting at the right


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time also takes discipline. So does waiting for the

every day and continue trading. The battle to con-

right opportunity to come along. Make sure you

trol your emotions while trading is never an easy

practice disciplined trading from the beginning.

one. It is not something you can change overnight.

Do not start this profession by developing bad

It takes work to detach yourself from the money

habits.

aspect of trading and not get emotional about losses. It takes practice and more practice. Perse-

Be Patient

vere through all the challenges, and success is but

Another characteristic of a successful trader is

a small step away.

patience. Trading is about waiting until conditions are right to trade. I frequently stay on the sidelines

Be Self-Reliant

all day without making a trade. My students have

The successful trader is self-reliant. Traders do not

asked why I stay out. My answer is always the

become successful by following the lead of some-

same. A good opportunity did not present itself.

one else. Ultimately, we are responsible for our

The conditions that I sought never arose, so I did

own actions. Blaming others for our losses lessens

nothing.

the possibility of learning from our mistakes. If you

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

take responsibility for your trades, you will begin

are expected to be busy all the time. To make

acquiring the knowledge you need to improve.

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

Taking responsibility means relying on your own

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

judgment, getting in and out of positions based on

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

your own perceptions and knowledge.

nities always arise.

Traders who search for a guru to follow will learn nothing about themselves. These traders are

Persevere

never responsible for their own losses. It is

Perseverance is also required to trade the right

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

way. During the course of your trading career,

cover your weaknesses by following someone

there will be periods in which nothing you do

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

seems right. This will have a severe impact on

dence. Unless we take responsibility and rely on

your psyche and on the way you approach trad-

our own judgments, we will not gain the confi-

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

dence needed to bridge the gap between success

ing you hesitate when you should not, and making

and failure. Confidence is especially needed dur-

you wait longer than you should before exiting a

ing times of uncertainty. It keeps you going when

losing position.

things are not working out.

It takes perseverance to get through the bad

We know there will be good times and bad

times. You need the strength to pick up the pieces

times. Your trading system will be geared toward


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making a profit, with losses factored in. You will

without risk management eventually go out of

take losses, but you will also take profits. Some

business. Proper money management means that

traders are eager to take losses because they

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

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

not put you out of the game.

That’s how confident they have become. That’s how much trust they have in their systems.

Without risk management, the best trading system in the world, one that is right 90 percent of the time, will not save you. But with good risk manage-

RISK MANAGEMENT

ment skills, you could have an inaccurate system and still get respectable returns. Studies have shown

The second key element of successful trading is

that 90 percent of the variance in fund manager per-

risk management.

formance can be attributed to risk management. Jesse Livermore was a noted trader whose

Do the Hard Work

biggest failure was lack of risk management. He is

Trading is hard work. Before you make a trade,

considered one of the greatest speculators ever. He

you must do research. You need to analyze charts.

went from being poor to being rich, from rich to

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

poor, and back again several times. He would risk

trading day and pick the stocks for a watch list.

everything he had on trading. His winning streaks

What are their entry points? What are their stop-

would make millions for him; his losing streaks

loss points? What are their profit-taking points?

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

What size position should you take?

he committed suicide. The note he left said that he

These questions need to be answered before

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

you start trading. And after the trading day, you

tion in relaying his story is to stress the importance

need to analyze your trades. Go back and check

of protecting your capital. No matter how lucky

the charts; figure out what you did right and what

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

you did wrong. Then the process starts again.

law of averages will catch up to you. There are no sure things in trading.

Stay in the Game

Here is the only way to prevent a catastrophic

Risk management includes both money manage-

loss when you trade: Make sure that the amount of

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

money you risk on each trade is so small that you

system that tells you how much you can risk on

can sustain numerous losses without having to

one trade, and it is vitally important.

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

Trading means taking risks. If you do not con-

example of good risk management. Casinos are in

trol risk, you will not be around long enough to

the gambling business. However, the casino busi-

become successful. Traders who succeed for a time

ness itself is no gamble. Casinos take few risks


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with the money you pour into their coffers. They

Avoid Psychological Barriers

watch their money like hawks. Casinos have a

A large loss is a body blow to your psyche. When

house edge. All their games are skewed in favor of

you discipline yourself not to take huge posi-

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

tions, you avoid this psychological damage.

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

Small losses do not create psychological barriers

of averages work for them. This means that if you

that keep you in a losing frame of mind. Why

play long enough, the casino will end up with the

would a trader ever take a large position? Most

other 98 cents of your dollar.

traders play big when they think they have a sure

Casinos keep their risks small. They never take

winner. But taking this type of position results in

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

a loss of objectivity. You will become emotional

That is why they have house limits. This keeps

about the trade. This means you will hang on if

their risk spread out and their losses small. Trad-

the position goes bad and claim a profit too

ing should be the same as the casino business. As

quickly. This is the very opposite of what needs to

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

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

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

trading. Sooner or later, traders who habitually

with risk management, by keeping our risk small.

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

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

ing everything. Think of the sad story of Jesse

morning I prepared a list of stocks to trade. I

Livermore.

selected one stock to trade when the market

Traders also take obscenely large positions

opened. I picked the loser every day, while the

because they have a gambler’s mentality. These

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

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

for risk management, I would not be here today,

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

writing this book and still trading. After suffering

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

many consecutive losses, my account was still

for gambling in this profession. We should take

robust enough for me to come back the next

only calculated risks. In fact, unless the variables

month. In July, everything I touched made money.

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

There is no telling when a bad streak will come.

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

But if you practice risk management, you will sur-

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

vive. You will live to play another day.

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

TRADING METHODOLOGY

not hesitate to exit a position and move on to the next trade. But when we risk large amounts, we

The third key element of successful trading is

have a tendency to want to make things work. This

methodology.

tendency is the trader’s biggest enemy. When I


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hear traders say, “I cannot afford to lose this

missions and slippage. There are two ways to use

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

the 2 percent rule.

these people, trading is very stressful. They have

First, use it to determine whether to make a

lost their objectivity. They cannot sense the market

trade or not. Many traders feel comfortable trad-

flow anymore. They are fighting themselves, not

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

the market.

ple, that you typically buy 300 shares per trade.

This battle within your mind can be easily ap-

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

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

checking the chart, you believe the entry point is

the same controlled amounts every time you trade.

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

Never break this rule, and the ups and downs of

against you and is stopped out, the loss per share

trading will never break you. As a beginner, make

would be $3. This is calculated by subtracting the

sure you take risk management seriously, very

stop-loss price from the entry price. Because you

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

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

your capital before you gain the experience neces-

share multiplied by 300 shares, or $900.

sary to be a successful trader.

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

Even as a seasoned trader, my primary concern

mum risk was 2 percent, this trade would still be

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

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

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

dictated by the 2 percent rule. You should not make

worry about making millions of dollars a year. I

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

make small, well-calculated trades, slowly build-

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

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

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

gles and doubles and stealing a few bases.

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

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.

than the maximum allowed risk per trade. This method forces the trader to look for opportunities with the least amount of loss per share. Second, use the maximum risk per trade figure to calculate the number of shares you should

Follow the 2 Percent Rule

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

Here are some good ways to manage risk. I live by

to the 2 percent risk rule. We know the maximum

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

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

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

considering a trade with an entry point of $50 and

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

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

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

would be at $5. Because the maximum loss per

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

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


58

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$5, how many shares should you trade on this

that present themselves and still maintain the

position?

same amount of risk per trade.

The answer is simple. Divide the maximum loss

In both methods of risk management, knowing

per trade by the possible loss per share and you

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

will get the maximum share size that can be

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

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

ling your losses and managing your risk. Never

and get an answer of 200 shares. This method

enter a trade without knowing your stop-loss point.

gives you flexibility. By raising and lowering the

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

number of shares, you can trade all opportunities

$ risk management principles we have just described. ●


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CHAPTER

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6

Trading Strategies • • • • •

Scalping Intraday-Trend Trading Swing Trading Long-Term Trading Back Testing


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T

RADING STRATEGIES INVOLVE A PREDEFINED SET of guidelines 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.

There are several trading styles. They include

If the commission was a penny per share, the

scalping, intraday position trading, swing trading

scalper would still make money. The scalper must

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

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

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

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

You should concentrate on the style that fits your

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

personality. Some traders love high-speed action.

ties are bad.

Scalping would probably be right for them. Many

When the market went to decimal pricing, the

traders prefer longer-term trades because they do

spread on the high-volume stocks became a penny

not want to be glued to the monitor for 6 ⁄2 hours

or less. This has made it impossible for scalpers

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

to profit. Another scalping technique involves

right for them.

momentum trading. Scalpers try to ride on the

1

back of institutional trading. They learn to spot opportunities on Level II, then jump in at the

SCALPING

beginning of a move and get out before the

Scalping is one of the toughest types of trading. It

momentum dies. On any given day, there will be

means trying to capture profits of less than $0.50

short bursts of activity when buy or sell orders

per share as fast and as often as you can.

from large institutions reach the market. The sheer

There are several ways to scalp. This first is by

size of these orders tends to move the market in

capturing the spread. The scalper tries to buy at

the direction of the order. A sell order tends to

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

move the market down, whereas a buy order

stocks with large trading volumes have become

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

smaller. Before the market converted to decimal

these activities.

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

Rather than looking for specific stocks, momen-

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

tum scalpers watch for news events, earnings

who bought at the bid and sold immediately at the

reports, and business news that can set a particular

ask would make the spread of 6.25 cents per share.

stock in motion. They watch the various queues

1


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TRADING STRATEGIES

for signs of a potential burst of activity. Usually,

Every penny saved is truly a penny earned. As the

this is done by watching the activities of the mar-

name implies, the trader follows intraday trends.

ket makers.

If the market stays in a tight range and fails to

Another method the scalper uses is “shadow-

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

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

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

that is actively participating in the movement of a

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

stock. Usually, the institution has received a large

not as hectic as scalping. It can be profitable when

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

the market moves dramatically. This is the style I

tion will employ different tactics to confuse the

like to trade. The losses are usually small and the

trading public about its true intentions. To make

gains can be substantial if the techniques are cor-

money using this strategy, scalpers need to have a

rect. I use a combination of methods when I follow

clear understanding of how each of the different

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

market-making operations act. Otherwise, they

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

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

way to identify entry and exit points. I like to

cuss all the various scalping tactics here, but now

enter long positions when a stock is pulling back a

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

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

stantly watch the Level II screen and quickly react

short trades on bounces that hit a resistance level.

to the information it provides. Unfortunately, the

Reading Level II can give you these levels before

screen does not slow down and allow the scalper

they actually form. I use technical analysis to find

to interpret the information. Decisions must be

intraday-trend trading candidates. Rotating posi-

made in less than a second. Once a decision has

tions every day involves a lot of research, but the

been made, scalpers must react before the price

payoff can be good. Fundamental analysis does

moves away from them. Execution skills come

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

into play. Scalpers with less than optimum execu-

and can be based purely on technical analysis.

tion skills will not succeed. They will always be

Watch out for overtrading. It is better to deal with

late, unable to get the shares they want. Scalping

only a few well-chosen candidates. Trade them

is not for everyone.

during the day and then continue to perfect your technique.

INTRADAY-TREND TRADING Intraday-trend traders trade a slightly longer

SWING TRADING

period of time than the scalper. Their profit objec-

The swing trader holds a position for one to five

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

days. The biggest mistake swing traders make is

not critical, but they are nonetheless important.

holding a losing position too long. This is the


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biggest difference between a successful swing

and commissions are minor factors with long-term

trader and a struggling one. The only reason to

trading.

hold a losing position is because it never hits the

After settling on a style of trading, pick the type

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

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

factor for exiting trades. Price action alone should

nical, a mix of technical and fundamental analysis,

determine when you exit.

or 100 percent fundamental analysis. That choice is

Technical analysis plays a key role in this style

yours. The longer the trading time frame, the better

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

fundamental analysis will work. The best system is

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

still a mix of fundamental and technical analysis.

plan to carry positions overnight. This often puts

Setting conditions and specific trade guidelines

me on the right side of the trade.

forces traders to narrow their trading choices.

Some swing traders have found success by combining technical analysis with fundamental

Narrowing choices does not automatically mean success.

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

BACK TESTING

holding time may be sufficient to correct the

There is a way to test your trading style before

inefficiency.

making live trades. It involves using historical data to determine the profitability of the style. It is called

LONG-TERM TRADING

back testing. Some trading platforms, like TradeStation and CyberTrader, come with this feature

The long-term trader has the longest time frame of

built in. Or you can buy software programs that

all. Trades can range from one month to six

access historical data and test certain combinations

months. Technical analysis plays a big role, but

of technical and fundamental data. The cost is

fundamental analysis can also help. A few things

cheap relative to the risk you would take if you

add risk to this style of trading. Usually, traders

were to test an idea by actually trading a position.

hold positions through a company’s earnings

Scalping cannot be back tested. Usually, histori-

announcement. This works if earnings come in

cal data does not cover the intricacies of Level II.

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

With this method, the key is experience. Many

Whenever a company misses estimates, long-term

scalpers start by trading only 100 shares. Their

traders stand to lose money. If you hold positions

intention is to learn how to react quickly to

for the long term, the likelihood of getting stung

momentum changes. Profit is not the main objec-

by bad news increases. Unlike with scalping, intra-

tive. Once they can consistently capitalize on

day trading, and swing trading, execution skills

momentum runs, they will increase the share size.


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TRADING STRATEGIES

6.1 Testing Strategies

䊳

BACK TESTING IS AN IMPORTANT PART of developing a sound system. This is a simple back test of the MACD crossover

using CyberTraders Strategy Tester.

Most scalpers will lose money during this learning

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

process. Some do not survive the steep learning

wise, I would continue on the search. Figure 6.1

curve and lose their money. Those who survive

shows the results of a simple back test of an

often make a nice living.

MACD crossover strategy. Back testing is an

After back testing the trading system, you need

important part of developing a sound system, but

to adjust and improve it. I like trading systems that

remember, markets exist because the future is unpre-

produce successful signals of at least 60 percent

$ dictable. ●


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CHAPTER

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7

Technical Analysis • • • • • • •

Charts Identifying Support and Resistance Trading Strategies Trendlines Gaps Basic Chart Patterns Volume Analysis


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T

ECHNICAL ANALYSIS IS THE STUDY of past price movement to determine possible future price direction. The primary tool for technical analysis is the price chart. Charles Dow originated this method

of analysis around 1900.

Price movement provides an understanding of

produce more gasoline during the summer

the underlying forces at work on a stock. The price

months, the gasoline supply remains constant. If

of a security represents a consensus between buyer

demand grows while the supply is constant, prices

and a seller. It also shows when supply and

will rise. During winter months, people travel a lot

demand is at equilibrium. When price is plotted on

less. The demand for gasoline also drops. When

a chart, a trader can get an understanding of where

this happens, there will be a corresponding drop in

the overall sentiment lies. When the trading public

the price of gasoline. Another example is the

is selling a particular security, the equilibrium

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

price tends to head downward. When traders are

mothers were willing to pay exorbitant prices to get

accumulating and holding a security, the equilib-

them. After Christmas was over, prices dropped as

rium price tends to head upward. The rise and fall

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

of prices gives the trader an idea of ongoing senti-

goes on sale several times a year; the demand is

ment shifts. Waves of buying push prices up and

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

waves of selling push prices down. A technical

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

analyst wants to know which wave is the

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

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,

Charles Dow developed the following three concepts: 1 ●

available information.

prices tend to go up. On the other hand, if the sellers are in control, there is a lot more supply. When

2 ●

negative. When sentiment is mixed, prices tend to move

A quick look at gas prices demonstrates how this

sideways.

works. People travel more in the summer than in gasoline. Because gasoline manufacturers do not

Price movements are not random. They reflect a shift in market sentiment. Sentiment can shift from positive to

supply is strong, prices tend to go down.

the winter. This produces an added demand for

Price discounts everything. The current price reflects all

3 ●

Trends are formed when sentiment shifts. Trends are predictable. A technical analyst should be more


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TECHNICAL ANALYSIS

concerned with the current price than with the history

Types of Charts

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

There are several types of charts to choose from.

counts everything. If all information is already reflected in

The most popular are bar charts, candlesticks, line

the current price, it is unnecessary to understand why a

charts and point and figure charts.

certain price has been reached.

Bar Charts The bar chart is the most popular charting

CHARTS

method. There are two variations. Figure 7.1, for

A price chart is a series of prices plotted over

example, shows only the high, low, and closing

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

prices. Each bar represents a time period. In this

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

case, one trading day. Each bar also shows three

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

pieces of information. The top of the vertical bar is

term trends. A chartist using a brief period, such

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

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

represents the lowest price of the day. The little

opportunities.

horizontal line that sticks out to the right of the

7.1 S&P Bar Chart

䊳

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


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vertical bar represents the closing price. In this

They pay attention to the closing price because it

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

was determined by professionals.

range (see Figure 7.2). The next variation adds another piece of infor-

Candlesticks

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

This method of charting originated in Japan more

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

than 300 years ago. Its use has recently gained

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

popularity. Candlesticks plot the open, high, low,

slight difference in the way the bars are drawn.

and close. They show how these prices relate to

Here’s how to interpret the information on this

each other in a manner that can be understood at a

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

glance (see Figure 7.4).

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

In a white or open candlestick, the opening

The horizontal bar to the right is also the closing

price is lower than the closing price. This means

price. The only difference is the horizontal bar to

the professionals were able to move the price up

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

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

ure 7.3).

dlestick, the opening price is higher than the clos-

Many technicians discount the importance of

ing price. This means that during the period

the opening price. Usually, the opening price is

covered by the candlestick, the price closed below

determined by amateur orders placed the night

the open. Sellers were able to drive the prices

before, which are considered of little significance.

down.

7.2 Bar Chart

7.3 Bar Chart

䊳

䊳

THIS BAR CHART SHOWS only the high, low, and

closing price.

THIS BAR CHART SHOWS high, low, and closing price

plus the open price.


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TECHNICAL ANALYSIS

7.4 The Candlestick Chart

䊳

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

In some cases, you will find that the pattern

period to period. Some traders also plot the open,

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

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

These are doji patterns. Doji patterns mean the

to be consistent. Do not plot the closing price one

opening and closing prices were the same (see

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

Figure 7.5).

plotting multiple numbers, you need to plot a line

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.

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

Line Charts

ting them any other way is impossible. Figure 7.7

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

shows an example of a simple line chart. The line

plotting the closing prices. All you need to do is

tracks only the closing price of the index as it

draw a line that connects the closing prices from

moves up and down.


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7.5 & 7.6 Candlestick Patterns

䊳

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

Point and Figure Charts

does not take time into consideration. This makes

Point and figure charts are different from all other

it easy to identify support and resistance levels. It

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

also allows you to effortlessly see breakouts or

one candlestick for each period of time, this

breakdowns of these levels. Thus it allows you to

method is based solely on price movements. It

quickly recognize the underlying trend.


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7.7 Line Chart

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

This method of charting is very simple. Prices that fail to move significantly are not considered

Not all charting software offers point and figure charting.

relevant, and therefore are not plotted. It is only when the price movement exceeds a certain level

Types of Price Scaling

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

There are two ways to display the price scale along

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

the y-axis: arithmetic or logarithmic.

more Xs are marked onto the same column. When

An arithmetic scale simply means that each price

the price movement is downward, you plot it as an

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

O. Before you start plotting anything onto a new

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

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

example, each level could represent a $5 increase

determined “reversal amount” in the opposite

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

direction. The reversal amount is your wiggle

and another at $15.

room. It takes out all the noise and smoothes out

A logarithmic scale displays price movement in

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

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

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

percent increase. The next 100 percent level from


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7.8 Point and Figure Chart

䊳

THIS POINT AND FIGURE CHART OF THE S&P 500 is based solely on price movement. 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.

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

stuff out there. They are a lot more reliable and

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

tend to produce the most profit if used properly.

chart as percentage of price movement, it is easier

Many of the complicated indicators do not work

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

well intraday.

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

The most notable ones are those that include

$40 stock, because both have a 25 percent price

volume in their analysis. These tend to produce

move.

poor results when used intraday, mainly because of the lunch period. During the lunch period, vol-

Basic Charting Techniques

ume usually drops as traders take off to grab

Basic charting is a time-tested technique. It has

lunch. This practice leads to false signals. Under-

been around for a long time. When it comes to

standing how each of the indicators work before

intraday trading, I find that basic techniques are

putting them into use will reduce the problem of

even more important than the more complicated

false signals.


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TECHNICAL ANALYSIS

There are several basic techniques that traders

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

must know before they venture into the world of

Elder contends that support and resistance exist

trading. They are as follows:

because people have memories. They have memo-

Identifying support and resistance

ries of pain and regret. When you buy a stock and make money, you will remember the price you

Identifying a trend and a trading range

paid for the stock. When the stock drops to that

Understanding different types of gaps

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

Recognizing basic chart patterns

rebound. And there are memories of regret. People

Understanding volume

regret not getting into a stock at a certain price. They sat on the sidelines as the price soared. Once

Beyond basic techniques, I believe the following

the prices drop down again, they buy aggressively

indicators are of importance to the trader. They are

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

discussed in later chapters.

port levels come from.

Candlestick patterns and combinations

Resistance levels exist because people also remember where prices turned around and started

Moving averages

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

Moving average convergence divergence (MACD)

around level, investors start thinking of selling.

Relative strength index

Traders who are not in a long position might start

On-balance volume (OBV)

thinking about going short. There are also people who were caught holding onto losing positions on

Accumulation/distribution

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

Time segmented volume (TSV)

get out without a loss. They contribute to selling pressures.

IDENTIFYING SUPPORT AND RESISTANCE

I believe support and resistance levels also have a lot to do with how people perceive value. If a

Identifying support and resistance levels on a

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

chart is the first thing you should learn. When a

investors think it is cheap. But if the price goes

stock price hits a support level, buying pressure is

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

stronger than selling pressure. Support levels

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

interrupt a price decline. Prices usually bounce

our dependency on financial analysts. They are

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

responsible for this perception of value we have on

selling pressure is strong enough to interrupt a

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

price advance. Prices tend to hit these levels on

dependent on supply and the demand. If there is a

the way up.

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


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

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

ply, prices can go to the moon.

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

Nothing is cheap in the stock market. Prices fall

start considering a short position.

for one simple reason: There is more supply than

A break of a key resistance level is a sign that

demand. No one can predict where a stock finds its

buyers have become aggressive. There is an in-

equilibrium. A friend once called to tell me about a

crease of demand, and prices are likely to go

company he was familiar with. The stock had

higher. Exit short positions and enter long posi-

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

tions when the buying strength follows through.

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

There are two schools of thought on how to

good the management was, how much cash the

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

company had, and how strong the fundamentals

support and resistance levels across congestion

were. He could not believe the stock was selling at

areas. The other contends that drawing them at the

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

extreme edges works better. Both have their merits

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

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

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

pose these lines serve.

$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.

Extremes mark areas where support and resistance 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

On the other hand, how expensive is expensive?

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

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

ter than placing them in congestion areas. This is

companies were losing money and had astronomi-

even more true when it comes to intraday trading.

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

On the other hand, for the purpose of technical

saw no reason not to short these companies, and

analysis, marking them over congestion areas

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

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

tually, before the bubble burst, many big hedge

tality. Extreme points tend to mark levels of panic

funds had to declare bankruptcy.

among the weakest traders.

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

In Figure 7.9, notice how I drew the support and

of this. We need to separate ourselves from the

resistance lines. Going from left to right, the first

crowd and respect the information that charts give

top marked a resistance point. Then it came down

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

to a low and reversed. The low marked the support

ing pressures have overwhelmed buying activi-

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

ties. Demand has lessened and there is a lot more

powerful enough to break past the resistance.

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

Notice how the resistance now became the support.


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TECHNICAL ANALYSIS

7.9 Support and Resistance

䊳

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

Prices could not go below it significantly, and

port and resistance area relative to the price of the

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

security. The taller the height, the stronger you will

another resistance was hit. Prices came back down

find the support and resistance levels. In the exam-

and established another support level higher than

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

our previous one. The resistance is tested three

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

times before a breakout occurs. Again, notice how

support levels of chart A are going to be stronger

the roles of resistance and support changed.

than those of chart B. This is because the distance between the levels found in A is greater than in B.

Strength of Support and Resistance

The width refers to the amount of time the price

Three things govern the strength of support and

stays within the support and resistance level. The

resistance levels. They are height, width, and

longer the period, the stronger those levels are

volume.

going to be (see Figure 7.10B).

The height refers to the price range of the sup-

Finally, volume is another indicator of strength


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7.10 Strength of Support and Resistance

䊳

THE HEIGHT OF THE SUPPORT AND RESISTANCE would determine the strength of those levels. The support and resistance levels for chart A would be stronger than those for chart B because the height is greater on chart A. The width of the support and resistance levels would also determine the strength. The wider the channel, the stronger the support and resistance level.

on the support and resistance levels. The more vol-

your position. As the position goes in your favor,

ume occurring on those levels, the stronger the

meaning that price keeps heading up, you should

levels of support and resistance will be.

continue to hold the position. The only time you should move your stop-loss order up is when it

TRADING STRATEGIES The support and resistance levels explained in the

breaks another resistance level. Keep doing this until your position gets stopped out, meaning price has declined to your stop-loss level.

previous section comprise the best tool for letting

Let’s take NTMD as a trade example (see Figure

your profits run and cutting your losses short. If

7.11). The double bottom pattern (discussed later in

you get into a long position, the first thing you

this chapter) on the lower left corner suggests a pos-

should do is place a stop-loss order just slightly

sible trend reversal. The confirmation comes when

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

it breaks out of resistance 1. A long position should

nals a turn for the worse and you should get out of

be entered at around $18.45. After entering the long


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TECHNICAL ANALYSIS

7.11 NTMD Trade Example

䊳

THIS CHART SHOWS that if you entered a trade on NTMD after it broke resistance 1, and just use the support levels as your trailing stop, you would have capitalized very nicely on the run.

position, the stop-loss point should be at support 1.

broke resistance 2 fairly easily. At this point, you

You really do not want to see the price go below the

can choose to move the stop-loss order to that

support. Make sure to exit the long position then.

minor support located at resistance 1, or you can

Notice how resistance 1 also became a minor

choose to stick with your original stop-loss point at

support level. Prices came down slightly and

support 1. My choice would be to move it up and

moved up even more. It hesitated just a little, but

protect my capital.


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After breaking resistance 2, the price continued upward until it found another resistance at 3. It

NTMD go below our stop-loss point at any time during the trade, we would exit the position.

came down and found support just a little bit

For the short position, the trading strategy

above the previous resistance level at 2. The price

should be reversed. After entering a short position,

went up to test the resistance again on the second

the first place to put your stop-loss order would be

try; then it broke it. Keep this in mind and practice

the prior resistance. A break of this resistance level

it diligently: The only time you want to move your

tells us that the security is stronger than we

stop-loss point is after prices break out of a resist-

expected and we should exit the position. In the

ance level. After a significant break of the resist-

case of shorts, you should move your stop-loss

ance level, your stop-loss point should be moved

point down to the next resistance level when

to the support level below it. This is the best way to

another level of support is broken.

let your profits run while controlling your losses.

Now let’s take VRSN as an example (see Figure

After the price breaks resistance 3 at $20.40, your

7.12). A break of support 1 triggered an entry on

stop should be moved to support 2 at around

the short trade at $45. The stop-loss point should

$19.55. Once again, it finds another resistance (4) at

be initially set at resistance point 1. The price

$21.10 and pulls back. Again that prior resistance

should not rise that far at all. If it is weak, then the

area turned into a support level and the selling pres-

decline should follow through rather quickly.

sure turned back. Prices went up to break resistance

Another support level later established itself at

4, so the stop-loss point should be moved up again

support 2. A break of this level calls for a move of

to support 3. The same process is repeated again.

your stop-loss point to resistance 2. Support 3

Price movement on the market is never a

quickly sets up. When prices drop below this level,

straight-line event. It is more like a stairway. It

it would be time to move the stop-loss point again.

goes up and levels off. It gains more support

This time, it should be moved to resistance 3. It

while leveling off, and then it surges upward

took a little time for the price to find support at

again. On this trade, we went from a breakout

level 4. It took awhile for the price to reverse and

price of $18.45 per share to a high run of $22.40;

come back down and break the support.

and we are still in the trade. Already our profit is

After the break of support 4, there were two

$3.95, or +21 percent! There is still no telling when

choices for setting the stop-loss point. It could be

this run will end.

either resistance 4 or resistance 5. Both will work. I

The process we just described, of moving up

usually prefer the lower level, as it protects more

our stop-loss point to protect profits and minimize

profit. VRSN hit a low of $36.40, for a total possible

losses, is called the trailing stop. You are trailing or

profit of $8.60, or 19 percent.

following the trend up. It is only when it stops

It is impossible to tell how big a run any trade

going up that you get out. Should the price of

will give us. Traders who trade with a set profit


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TECHNICAL ANALYSIS

7.12 VRSN Short Trade Example

䊳

A BREAK OF SUPPORT 1 triggered an entry for a short trade. Using resistance 1 as the initial stop-loss point and our trailing stop method, we were able to capture a very large part of this run.

objective in mind have a tendency to cut their prof-

TRENDLINES

its short. Let the market tell you where it is headed.

Trendlines are an important tool in technical

You’d be surprised how much you leave on the

analysis. They serve to identify and confirm the

table if you have a target in mind. Learn to base

existence of trends. A trendline is simply a straight

your trailing stops on support and resistance lev-

line that connects two or more price points. To

els, and your trading will improve.

draw a trendline, connect support points to sup-


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port points or resistance points to resistance points

ply. A break below the bottom line tells us that

(see Figure 7.13).

demand could be decreasing and supply could be

When the slope of the lines is positive, the

increasing. It is a signal that a possible trend

security is said to be on an uptrend. An uptrend is

change is coming. A test of the most recent sup-

characterized by a series of higher highs and

port level is a sign that a price could be going into

higher lows. Each rally breaks the last resistance

a trading range. A break of the most recent sup-

and goes higher. Each pullback gains support

port level would confirm a new trend direction.

before the last support is reached. Hence, you

However, a breakout of the resistance level tells

have the saying “higher highs and higher lows.”

us that the uptrend might still be intact. A new

When a security is trending up, the bottom line is

trendline should be drawn to incorporate the last

more significant. If the price continues to stay

support (see Figure 7.14).

above this line, the trend is considered intact. It

When the slope is negative, then a security is said

indicates increasing demand and decreasing sup-

to be on a downtrend. Downtrends are characterized

7.13 Stock on an Uptrend

䊳

CONNECTING THE SUPPORTS AND RESISTANCE POINTS WITH A LINE would give us the trendline. A stock on an uptrend is characterized by a series of higher highs and higher lows in price. The slope of the trendlines is also up.


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TECHNICAL ANALYSIS

7.14 Stock on a Downtrend

䊳 CONNECTING THE SUPPORT AND RESISTANCE POINTS WITH A TRENDLINE on the Nasdaq Composite Index allows us to easily identify the downtrend that it is in. Downtrending stocks are also characterized by a series of lower highs (resistance) and lower lows (support).

by a series of lower highs and lower lows. Each

change is on the horizon. Should the price rise to

decline breaks the last support, with prices going

test the most recent resistance level without break-

lower than the last low. Each rally is met with sell-

ing above it, a trading range could be forming. If

ers at a lower price than the previous high. Hence,

the price breaks above the most recent resistance

you have the saying “lower lows and lower highs.”

level, then the direction has probably turned

When a security is trending down, the top line is

upward. However, another breakdown of a sup-

more significant. While prices continue to stay

port level tells us that the downtrend might still be

below this line, the downtrend is considered intact.

intact. A new trendline should be drawn to incor-

It indicates that demand is still weak and there is

porate the last resistance (see Figure 7.15).

plenty of supply. A break above the top line tells us

A security is said to be in a trading range if there

that demand is on the rise and supply could be on

is no trend. The trendline would be flat. Rallies end

the decline. It is also a sign that a possible trend

at the same resistance levels, and declines stop at


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7.15 Stock in a Trading Range

䊳

THE DOW JONES INDUSTRIES 30 INDEX was in a trading range for several months. Notice how the slope of trendlines that connects the support and resistance points are flat.

the same support levels. Another name for a mar-

completely opposite of each other. Without first

ket in a trading range is a sideways market. It is

identifying what period the market is in, there is no

descriptive of what the market is doing. Within this

way a trader will know which strategy to use.

period, the market is basically doing nothing

Also, the indicators that you would use during

except moving sideways. It is important to learn to

these two periods will be very different. Most

identify trends and trading ranges. Markets spend

traders would use trend-following indicators,

the majority of their time in trading ranges instead

such as MACD or the moving averages, if the mar-

of in trends. Trading techniques are very different

ket is in a trend. These indicators work best at

during these two periods.

those times. While the market is in a trading range,

While the market is in a trading range, it is better

oscillating indicators work better. They identify

to go short at the resistance levels and go long at

overbought and oversold conditions, which is usu-

the support levels. If the market is in a trend, then

ally a good time to go short or long.

you should go long at the resistance points and go

As a trader, it is better and easier to trade when

short at the support points. These two strategies are

the market is in a trend. When the market is in a


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TECHNICAL ANALYSIS

trading range, trading tends to be choppy. I find

7.16). When a security is on an uptrend, start by

that I often get shaken out of a trade when the mar-

drawing a line connecting the lowest low (A) to the

ket is indecisive and directionless. It pays to wait

low of the last minor support (B). You do not want

for a clear trend to establish itself before taking on

to see any price action below this trendline. A

a position.

break of the trendline at point 1 gives the first signal that a possible trend reversal is in the making.

1-2-3 Reversal Method

A successful test at point 2 of that high set at resis-

Learning to recognize the beginning of a new

tance level C gives the second signal of a trend

trend is a big key to nice profits when the market

change. This is a good place to go short on the

starts trending. In his book, Trader Vic, Victor

security. A break of support level D at point 3 con-

Sperandeo describes a method that has helped him

firms that the trend has, in fact, reversed.

catch major trend reversals. The method is called the 1-2-3 reversal.

For a security on a downtrend (see Figure 7.17), draw a line connecting the highest high (A) to the

Let’s start with an uptrend reversal (see Figure

high of the last minor resistance (B) that came

7.16 1-2-3 Reversal Method

䊳

THE 1-2-3 REVERSAL METHOD allows us to quickly identify when a trend has reversed. This is an example of an uptrend reversal. At point 1, you have to identify a break of the trendline. At point 2, you have a failed test of the previous high. The Nasdaq Composite was unable to breakout of the previous resistance at level C. At point 3, the Nasdaq composite confirms a trend reversal when it broke the support level D.


84

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7.17 1-2-3 Reversal Method

䊳 THE 1-2-3 METHOD can also identify a downtrend reversal. At point 1, you have a break of the trendline between points A and B. At point 2, you have a successful test of the lows. LUME was unable to go below the resistance level C. Confirmation of the trend direction change came at point 3 when price broke past resistance level D.

before the lowest low (C). Make sure there isn’t

make very little. It is not a good way to trade. Here

any price activity above this trendline. The signals

are some guidelines when trading with trendlines.

will come as follows. First, a break (1) of the trendline signals a possible direction change. The sec-

Angle or Slope

ond signal is a successful test (2) of the support of

The most important feature to watch on a trendline

the lowest low (C). This is good place to be long on

is the slope. It identifies which side is in control of

the security. The last signal is a break (3) through of

the market. If the slope is up, buyers are in control.

the last resistance level (D). This serves as a con-

Demand is high and supplies are low. The direc-

firming signal that the trend has turned around.

tion of the trade should be only long. If the slope is

The trend is your friend. For intraday trading,

down, sellers are in control. Supplies are high and

there is nothing better than following the trend.

demand is low. Take only short positions. You

Whether you want to scalp or swing trade, make

need to watch the angle of a trendline. A security

sure that you trade on the side of the trend. Many

with a very steep angle of ascent has a very high

traders love to trade against the trend. They try to

possibility of running out of steam quickly. This is

catch the bottom or the top. They risk a lot and

the same when it comes to the angle of decline. A


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TECHNICAL ANALYSIS

very steep decline is a signal of panic selling.

tance levels and trendlines. While prices stay

Sooner rather than later, the selling will be done

above the trendline, it acts as a support level. Once

and the rebound will be just as hard. When the

there is a significant break of the trendline, it will

angles of the trendlines begin to accelerate, it is a

often turn into the resistance level. This gives

good sign that the trend might soon be coming to

traders a good opportunity to exit long positions

an end. Many astute traders would begin to look

and enter short positions.

for points to exit their positions (see Figure 7.18).

For traders who like to “short the tops,” here is

As you look at Figure 7.18, check the difference

a better way to trade. It is a lot better to wait until

between the angle of the incline on trendline A ver-

there is a trendline break before going short. I

sus the one on trendline B. Notice how much

would then wait for the price to rebound back or

steeper the angle is on this newer trendline. Once

just close to the trendline and then enter the short

the prices break (C) below the trendline B, it

position. This increases the odds of your success

turned back up again to hit the trendline from

tremendously. The reversals at these points are

below before heading back down.

usually a lot more powerful. The reward-to-risk

Notice the similarities between support/resis-

ratio is also a lot better at those points.

7.18 When the Slope of Trendlines Increase

䊳

INCREASING TRENDLINE SLOPE can mark the possibility of an uptrend reversal. The slope of trendline B was a lot steeper than trendline A. Prices were unable to sustain themselves and made a 1-2-3 reversal afterward. Once trendline B was broken at point C; this line later became the resistance at point D. Point D was a good place to initiate a short position on this stock.


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This process is the same when a stock or secu-

three-minute or the five-minute chart may work

rity is on a decline. Let’s take a look at the S&P 500

best. If you are intermediate term, you should use

index (see Figure 7.19). Again, pay attention to the

the daily chart.

increasing slope between trendline A and trend-

You will find smaller trends within all the dif-

line B. After the steep drop, prices rebounded back

ferent time frames. Some of them may conflict

and broke the trendline at point C. The next

with the bigger trend, while others might confirm

decline came in very close to the trendline before

it. To put it another way, a weekly chart might

reversing and heading up.

show an uptrend, but the trend could be down in one or two of those five days that make up the

Different Time Frames

information on that week. You can further break

Different time frames can and will produce differ-

this down into a trading day. The fact that the day

ent results. That is why it is necessary to begin

ended up does not mean the trend for the whole

your trading career by deciding what type of trad-

day was up. You could have several smaller trends

ing you want to do. If it is scalping, you should

working against each other to form the end result

pay attention to the trend on a tick chart or a one-

of the day.

minute chart. With intraday trend trades, the

What time frame should you use? If I were

7.19 When the Slope of Trendlines Decrease

䊳

WHEN THE SLOPE OF A TRENDLINE DECREASES, it can mark the possible coming of a downtrend reversal. Comparing the slope of trendline A and B, we can easily see that the slope has decreased significantly. Again, we can see how 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.


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TECHNICAL ANALYSIS

intraday-trend trading, I would first use the bigger

the chart. The more points these lines connect to,

trend on the daily chart. Usually, the moves tend to

the more valid the trend. This is the same school of

be stronger when the intraday trend goes in the

thinking as the theory of support or resistance.

same direction as the daily trend. If I were scalp-

Trendlines also act as a support or resistance area.

ing, then the trend on the five-minute chart mat-

When the price pulls back down to the trendline,

ters more than the trend on the daily chart. My

traders who have missed the initial run are waiting

trend concerns are focused on the next bigger time

on the sidelines for pullbacks or bounces. If a lot of

frame. If the two trends match up, then the trade

these pullbacks or bounces are bought or sold into,

usually goes a lot better for me. The chances of a

then the trend is confirmed and it is a lot more

successful trade are also increased.

valid. What we do not want to see when marking trendlines is the acceleration away from the lines.

Logarithmic versus Arithmetic Scaling

This is a signal that panic buying or selling is

Logarithmic or arithmetic scaling makes a differ-

occurring and that a reversal may be imminent.

ence in trendlines. Should you go for logarithmic or arithmetic scaling? Again, the answer depends on your style of trading. For shorter time frames,

GAPS

arithmetic scaling seems to work better than loga-

A gap occurs when the opening price is signifi-

rithmic scaling. This is because the range usually is

cantly different from the closing price. The gap

not big enough to make much of a difference to be

could be up or down depending on the buying or

scaling otherwise. I have always kept an arith-

selling pressures that built up between trading

metic scale on my intraday trading activities. It has

periods.

worked for me and I am sure it will work for you.

More often than not, gaps are news-driven. Pos-

For longer-term trading, logarithmic scaling is

itive news generates buying interests and negative

probably the way to go. It allows the trader to com-

news brings in sellers. If a company reports good

pare the rise and fall as a percentage. It puts every-

earnings that beat estimates after the market

thing into a better perspective instead of

closed, buying interest will be generated overnight.

magnifying it as arithmetic scaling would. As you

If a company misses estimates, selling interests will

can see in Figure 7.20, a view of Qualcomm toward

come in overnight. Winning a large contract is pos-

the end of the Internet bubble, stocks with big ver-

itive news. When a biotech company fails to get

tical moves are better viewed in logarithmic scale.

FDA approval for a drug, it is very negative news. So is bankruptcy. As technical analysts, you do not

Trendline Validity

need to read every piece of news on the wire. The

In order to draw a trendline, you need to connect

news itself does not matter much. Price action tells

at least two (2) low points or two (2) high points in

it all. What matters is whether the opening price


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7.20 Trendlines on Logarithmic and Arithmetic Scale

䊳

LOGARITHMIC AND ARITHMETIC SCALING affect the slope of the trendline you draw. Both of these charts are of the same period on QCOM. The only difference is the scaling. Notice how much steeper the trendlines are on the arithmetic scale. For analysis over longer periods, it is better to use the logarithmic scale.

gaps up or down and whether a news event is

market makers and specialists are faced with an

behind this gap. The most powerful and reliable

order imbalance. There are more orders to buy

signals that gaps can generate are those that come

than to sell. In order to find equilibrium, they need

without any news.

to move prices higher to find more sellers. This

When buying pressures build up overnight,

way, they can transact all the buy orders they have.


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TECHNICAL ANALYSIS

Prices open at a much higher price than the previ-

common gaps, breakaway gaps, continuation

ous close. If the opening price is higher than the

gaps, and exhaustion gaps. Learn to distinguish

high of the previous session, then it is considered a

each of their characteristics early and you can get

full gap up. Otherwise, it is known as a partial gap

in early on powerful trends.

up. Depending on your trading style, full gaps and partial gaps present their own unique trading

Common Gaps

opportunities. Long-term traders concern them-

As the name implies, common gaps occur more

selves with full gaps, while the short-term traders

frequently than other gaps. They tend to show up

benefit from both partial gaps and the full gaps.

a lot more during a sideways market. For trading,

When selling pressures build up overnight,

they are considered the least important of all the

market makers and specialists are faced with sell

gaps. There is no follow-through; prices tend to

order imbalances. More orders to sell than to buy

return to the gap; and the gap is quickly closed

have come in while the market was closed. To bal-

within a few days.

ance these orders and get them executed, the mar-

You can spot these gaps by checking volume.

ket maker or specialist brings the price down to

Volume usually increases, but is never extremely

attract more buyers. This is why prices open at a

high. This slight increase shows the gap’s failure to

lower price than the previous session. If the open-

generate buying interest. Buyers and sellers are

ing price is lower than the previous session’s low,

indifferent. This is confirmed by the lack of follow-

then it is considered as a full gap down. An opening

through to a new high or new low.

price that is higher than the previous session’s low

Most professionals would trade against the

will be considered a partial gap down. Short- and

direction of common gaps. Because prices tend to

long-term traders can also find opportunities in

return and close the gap, a nice profit can be made

these gaps.

by trading against the gap. The practice of trading

The types of gap that interest me more are the

against the gap is also called fading the gap. When

full gaps. They can be up or down. A full gap up

you fade the gap, wait for confirmation of the

has to open above the previous session’s high, and

directional change. Then act on it. It is never a

a full gap down has to open below the previous

good idea to jump in without proof. Use the 1-2-3-

session’s low. These generate more powerful sig-

reversal method or the break of support or resis-

nals and can be traded with much better reliability

tance levels to enter these trades. Remember, the

and success. With more than 9,000 different stocks

trade should be against the direction of the gap. If

available to trade in the United States, you will

the gap is up, then your trade should be to go

find these gaps occurring on a daily basis. Concen-

short. If the gap is down, then your trade should

trating on these setups alone can be profitable.

be long.

There are several types of full gaps. They are

The Intel chart in Figure 7.21 shows many


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7.21 Common Gaps

䊳 COMMON GAPS HAPPEN VERY OFTEN. They show up more often on a sideways market. INTC is in a trading range. In this chart, I have identified five of these gaps. Notice how little change there is on the volume on these gaps. It either shrank or stayed basically the same.

common gaps. On all the common gaps, volume

low for several days in a row. Getting in on these

either shrank or stayed the same. Increases were

gaps early can result in a nice profit.

slight and insignificant.

Volume levels are the best confirmation of these gaps. They should be high on the day of the gap. I

Breakaway Gaps

like to see a minimum 100 percent increase in vol-

Breakaway gaps are one of the most powerful sig-

ume. There is no maximum volume number. The

nals in trading. They occur when prices take off

higher the volume, the more powerful the move

from an area of congestion and start a new trend.

will be. Heavy volume comes only with institu-

Heavy volume confirms the move. This gap can

tional participation. With an upside gap, heavy

remain open for a long time. Prices usually follow

volume means that institutions are buying aggres-

through to the direction of the gap within a short

sively. Institutions such as mutual funds tend to

period of time.

hold onto their positions for the long term. If

A breakaway gap to the upside is usually fol-

mutual funds are buying and holding, you will

lowed by new highs for a few days in a row. A

have decreasing supply. If demand stays constant,

breakaway gap to the downside establishes a new

then prices should head up soon.


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TECHNICAL ANALYSIS

On a downside gap, heavy volume is a good

with the gap. If the gap is to the upside, go long

indication that institutions are selling aggressively.

early and place a protective stop at the lower rim

There probably has been a fundamental change in

of the gap. Once it is profitable, use a trailing stop

the security, and institutions are unloading their

to exit the position.

positions. When mutual funds get rid of their

In the IBM example shown in Figure 7.22, the

shares, supplies to the public will rise. A rising

breakaway gap took the stock from a price of $96

supply with constant demand is a good recipe for

to a high of more than $130 in a few months.

the price to drop.

Notice that the gap was confirmed in the next few

On the days following the breakaway gap, vol-

days by a higher high and above-average volume.

ume should remain higher than normal for several

This came with a more than 100 percent increase

days in a row. It is a good sign of continuing pres-

in volume. Getting in early on the long side is ben-

sures around the security. Professionals do not

eficial.

trade against the direction of a breakaway gap.

Our next example is a company called Copper

Once volume confirms the gap, they will trade

Mountain Networks (CMTN), another high flyer

7.22 Bullish Breakaway Gaps

䊳

THIS CHART SHOWS A BULLISH BREAKAWAY GAP on IBM. There are two confirmations for this type of gap. The first is the heavy volume found on the first day of the gap. The second is the follow-through on the prices. IBM established higher prices on the next two trading sessions.


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during the Internet bubble. A breakaway gap

attention to losers is important. The next example,

marked the end of the uptrend and the beginning

eBay, shows a case of failure.

of a long, long downtrend, as shown in Figure 7.23.

As shown in Figure 7.24, eBay had a break-

An early short trade on CMTN would have made

away gap on October 19. Volume confirmed the

a lot of money. From a gap down price of $105.88,

move early in the day. It ended with nearly dou-

the stock eventually ran down to $0.65. New lows

ble the average volume. However, volume fell on

and above-average volume validated the break-

the days following the breakaway gap. Newer

away gap. With a breakaway gap to the downside,

lows were not established. Instead, the price

the initial stop-loss point should be placed just

moved up to fill and close the gap. This position

above the low of the previous day. A valid break-

should have been exited when the price failed to

away gap should never close the gap and get that

establish newer lows. At the least, the position

far up in price. Once the position becomes prof-

should have been stopped-out once it broke the

itable, I would use a trailing stop to maximize

rim of the gap (marked by the stop-loss point on

profits.

chart). It is better to exit this position and reeval-

Although I love to talk about winners, paying

uate the opportunity.

7.23 Bearish Breakaway Gaps

䊳

THIS IS AN EXAMPLE OF A BEARISH BREAKAWAY GAP. Heavy volume and a downward follow-through in price are the confirming signals you are looking for. CMTN reversed its uptrend on this breakaway gap and completely collapsed in price in the following months. Note the placement of the stop-loss point if you had entered a short trade on the breakaway.


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TECHNICAL ANALYSIS

7.24 Failed Breakaway Gap

䊳 NOT ALL BREAKAWAYS WORK OUT AS EXPECTED. This chart of eBay is just a quick reminder that they can fail. Even though we had volume and price confirmation on this eBay trade, the stock rose and hit our stop-loss point. This trade was exited with a loss. If we held on longer (hoping that things would turn), the small loss would have become a lot greater as the price of eBay rose to over $65.

As you can see from this example, breakaway

breakaway gap. A stock with a 50 percent increase

gaps can still fail. That is the nature of trading.

in volume qualifies as a possible continuation gap

There is only one sure thing in this business: You

candidate.

will, from time to time, take a loss. As long as the

The last confirmation comes when prices reach

loss is controlled, you stand to make a lot of

new highs or new lows for several days after a gap.

money, especially if you let your winners run.

An exhaustion gap might be in the works if prices fail to follow through. Once confirmed, continua-

Continuation Gaps

tion gaps provide a good target for how far the

Continuation gaps occur much like breakaway

trend is likely to go. First, measure the initial move

gaps. The main difference is that they occur in the

from the base of the reversal to the gap. Then pro-

middle of a powerful trend instead of at the begin-

ject this from the gap in the direction of the trend

ning. Volume is also a confirming factor, but usu-

to get your profit-taking point.

ally the increase is not as heavy as in the

Professionals trade continuation gaps like a


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breakaway gap. They trade with the trend, in the

to stay high and actually surged by 100 percent on

same direction of the gap. If the gap is to the

the second day after the gap. The price also con-

upside, they go long. A stop-loss order is placed

firmed the move with new highs.

just under the high of the previous day. If the gap

You would go long on this position. Your stop-

is to the downside, they go short. A stop-loss order

loss point would be slightly below the rim. Prices

should be placed just above the low of the previ-

should not drop that far down. To get your initial

ous day. A valid continuation gap should follow

profit target, measure the distance between point

through in the same direction quickly. Bounces

A and point B. Project this value to arrive at point

and pullbacks should never get that far up or

C. The two distances should be equal. Once the

down (see Figure 7.25).

price gets to your projected profit point, tighten

The chart on eBay shows a continuation gap on

your stop. While buying momentum remains

April 18. Volume had a slight increase of 50 per-

strong, hold the long position. Maximize your

cent. Confirmation came when volume continued

profits with the use of a trailing stop to exit.

7.25 Continuation Gap

䊳

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 the distance between points A and B and projecting that upward. This should allow you to get the price target at point C.


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TECHNICAL ANALYSIS

Exhaustion Gaps

gap. If the direction of an exhaustion gap is down,

Exhaustion gaps appear at the end of a trend.

the trader would go long once prices break back

Prices do not follow through to a new high during

into the gap. A protective stop should be placed

an uptrend; or, during a downtrend, the price fails

slightly below the most recent low. If the direction

to establish new lows. Instead, the direction turns

of an exhaustion gap were up, go short once the

around and the gap is closed. At first glance,

price breaks below and starts filling the gap. Place

exhaustion gaps look like continuation gaps. Vol-

a stop-loss order slightly above the most recent

ume comes in at a high level. But the price fails to

high. The chart of IBM in Figure 7.26 shows an

follow through to the direction of the gap. Confir-

exhaustion gap. After the gap, the price failed to

mation comes when the price reverses back into

establish new lows except for the day after. Price

the gap and closes the gap.

then went sideways. This tells us that the bears

Exhaustion gaps offer excellent trading oppor-

have lost control of the market and the bulls are

tunities. They mark the end of a trend. Profession-

now evenly matched. A break to the upside con-

als would trade in the opposite direction of the

firms the exhaustion gap.

7.26 Exhaustion Gap

䊳

THIS TYPE OF GAP occurs at the end of a trend. On a downtrend, prices are unable to follow through to the downside. Instead, they consolidate and begin to close the gap. Enter a long trade when prices move back into the gap, and place a stop-loss at the last support.


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A long position should be entered once it breaks

7.27 Double Top Pattern

back and starts filling the gap at $105. A stop-loss order should be placed just below the low established 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

䊳

DOUBLE TOP PATTERNS are usually bearish, occurring at the end of an uptrend.

All traders should have the ability to recognize basic chart patterns. They are popular and widely

●

There is a clear uptrend.

●

Two peaks were formed.

●

Volume on the second peak dried up, which means

followed. Because they are widely followed, the patterns have a tendency to follow through. The following are some of the most basic patterns.

buyers could be exhausted.

Double Top and Double Bottom

The most popular way to trade this pattern is to

Double top and double bottom patterns are gener-

go short after the price breaks below the neckline.

ally found at the end of a trend. They are also

The maximum stop-loss point would be at the

called trend-reversal patterns. The double top pattern is considered bearish. It

7.28 Double Top Trade Setup

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).

䊳

A DOUBLE TOP PATTERN should be traded on the short side. Enter into a short position once the prices have broken the neckline. Place a stop-loss order slightly above the second peak.


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TECHNICAL ANALYSIS

7.29 Nasdaq Composite Double Top

䊳

SPOTTING THE NASDAQ COMPOSITE DOUBLE TOP would have saved a lot of heartache 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 the buyers were completely exhausted. They did not have the strength to move the prices up any further.

7.31 Double Bottom Trade Setup 7.30 Double Bottom Pattern

䊳䊳

DOUBLE BOTTOM PATTERNS are bullish patterns. They occur very often at the end of a downtrend.

A DOUBLE BOTTOM PATTERN should be traded on the long side. Enter a long position when the price breaks the neckline. Place a stop-loss order slightly below the second bottom.


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second peak (see Figure 7.28). Double bottom pat-

neckline with a stop below the second bottom (see

terns are bullish. They are found at the end of

Figure 7.31).

downtrends. A double bottom looks like the letter W (see Figure 7.30). The two lows, or “bottoms,” in

The example CTXS chart in Figure 7.32 shows a classic double bottom.

pricing characterize this pattern. Volume on the

●

There is a general decline in pricing.

second bottom is usually a lot lower than on the

●

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

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 price has broken past the neckline.

the break of the last resistance, also called the neckline. The most popular way to trade a double bottom pattern is to go long after prices break the

●

The maximum stop-loss point would be at the second bottom.

7.32 CTXS Classic Double Bottom

䊳

(1) AN INITIAL DOWNTREND, (2) TWO CLEAR BOTTOMS, AND (3) DECREASING VOLUME between the first and second bottoms make this a classic example of

a double bottom pattern. Go long when prices get past the neckline.


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TECHNICAL ANALYSIS

Triangles

ability of resolving to the upside. This is why sym-

There are several types of triangles, including

metrical triangles are often called continuation pat-

symmetrical triangles, ascending triangles, and

terns and can be bullish or bearish, depending on

descending triangles.

the trend prior to the pattern formation.

A symmetrical triangle pattern can be both a

There are two ways to trade triangles. The first is

bullish and a bearish pattern. It is an area of inde-

to determine whether the stock was in an uptrend

cision where buying and selling pressures are

or a downtrend prior to the pattern formation.

almost equal. Each wave of buying is met with

With an uptrend, enter on a break of the trend-

sellers, and waves of selling are met with buyers.

line. The stop-loss point should be at the last sup-

The effect is that the most recent high is lower than

port. The initial target is a break of the highest

the previous high and the most recent low is

resistance (see Figure 7.34A).

higher than the previous low. In effect, there is no

With a downtrend, also enter on a break of the

trend to follow. The shape formed during this

trendline. The stop-loss point should be at the last

period is a sideways triangle. Typically, volume

resistance. The initial target is a break of the lowest

diminishes during this period (see Figure 7.33).

support (see Figure 7.34B).

Eventually, the period of indecision is resolved.

Ascending triangles are considered bullish

Prices move out of the formation on heavy volume.

because they typically resolve to the upside. They

These patterns are likely to end up in the direction

are more reliable when found in an uptrend. Price

of the original trend. If the price was in a downtrend

resistance causes the top part of the triangle to be

prior to this pattern, it will probably explode to the

formed. Buyers become exhausted when the price is

downside. If it was in an uptrend, it has a high prob-

reached. However, the selling pressure weakened

7.33 Symmetrical Triangle Pattern

䊳

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, then this pattern is bullish. If they were on a downtrend, then this pattern is bearish.


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7.34 Symmetrical Triangle Trade Setup

A

B

䊳

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.

every time, causing a higher low to be formed.

For the ascending triangle, make sure of the

These higher lows cross the upward-slanting line

trend prior to its formation. Unless it was on an

when you connect the lows.

uptrend, it is best not to trade this pattern. If it is on

The price eventually breaks through the resist-

an uptrend, enter a trade if the stock breaks the last

ance, and the price goes up. It should be noted that

resistance. The stop-loss point should be at the last

volume usually decreases while it is moving side-

support (see Figure 7.35B).

ways and resurfaces again on the breakout (see Figure 7.35A).

Descending triangles are generally considered bearish. They are more reliable to trade when

7.35 Ascending Triangle Pattern and Trade Setup

A 䊳

B

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.


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TECHNICAL ANALYSIS

found on a downtrending stock. Unlike the

Head and Shoulders Top

ascending triangle, it is the bottom that appears

This is generally regarded as a reversal pattern. It

flat. The top part of the triangle slants downward.

is a bearish pattern. You often see these patterns at

The initial drop attracts buyers at the support

the end of an uptrend. They tend to be more reli-

level, and the selling pressure ends. Price reverses

able when found there. The left shoulder is started

and is later met with selling.

on a normal breakout with heavy volume. At the

The selling pressure ends around the support

peak of the left shoulder, sellers were able to

level, but this time, the buying pressure ends up a

reverse the trend and push the prices back down.

lot weaker. It does not go as far as the previous

The support that it finds on the sell-off marks the

run. This establishes the lower high. Eventually,

beginning neckline. (See Figure 7.37.)

the selling pressure breaks the support level,

From the support area, buyers were able to

bringing in a new wave of sellers as traders exit

push the price to a new high. This marks the top of

their positions. Like the previous triangle forma-

the “head.” The head is usually formed on

tions, volume tends to diminish, and it forms the

decreasing volume. This indicates that there were

pattern and returns on the breakdown of the sup-

not as many buyers on this last wave. The head is

port (see Figure 7.36A).

formed when the selling pressure is strong enough

With descending triangles, make sure the trend

to break the uptrend line. It reverses only at an

prior to formation was down. My entry would be

area of previous support. The point of reversal

after the stock breaks the price-support level. The

marks the continuing neckline. (Connect the

stop-loss point should be at the last resistance (see

beginning neckline and the continuing neckline to

Figure 7.36B).

determine the trendline.)

7.36 Descending Triangle Pattern and Trade Setup

A 䊳

B

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.


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7.37 Head and Shoulders Top Pattern

䊳

THIS PATTERN IS GENERALLY BEARISH, and can signal a downside reversal. Three peaks characterize it. They are the left shoulder, the head, and the right shoulder. Notice the lower right shoulder. This tells us that buyers were exhausted even before prices rose to the previous high.

However, this next rally fails to take out the pre-

The good thing about a head and shoulders for-

vious high. The peak of this rally marks the right

mation is that it gives you an idea of the possible

shoulder. A break of the neckline would complete

depth of the run. Your profit target can easily be

the right shoulder formation and the head and

estimated by measuring the distance between the

shoulders pattern. Volume on the right shoulder is

head and the neckline. If A is the distance from the

usually lighter than at the head. This indicates that

head and the neckline, then you should see an

buyers are exhausted. A break of the neckline usu-

approximate price decline of B, where B is the

ally brings in more sellers and an increase in vol-

same value as A.

ume, as buyers are now getting out of their positions (see Figure 7.37).

Suppose the head has a price of $50 and the neckline is at $45. The value of A would be $50

How do you trade this pattern? The best trade is

minus $45, or $5. Research has shown that the

usually to go short when the price breaks the neck-

probability of decline B equaling the value of A is

line. If you miss the first entry, the pattern often

very high. If we entered at the neckline $45, we can

gives you another chance by pulling back to the

hold until it gets near the $40 mark. This is because

neckline once more. The stop in both cases would

when B equals A, a value of $5, then $45 minus $5

be placed at the high on the right shoulder.

will give us a target price of $40 (see Figure 7.38).


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TECHNICAL ANALYSIS

7.38 Head and Shoulders Top Trade Setup

䊳

YOU CAN ENTER THIS TRADE AT TWO POINTS. The first is on the break of the neckline. Usually, prices will give you a second entry on this trade when it bounces back up. The neckline (previously a support level) will now become the resistance. In both cases, enter a short position. Place a stop-loss order at the last minor resistance. Your profit target can be calculated by measuring distance A between the head and the neckline and projecting it down. The distance between A and B should be equal.

Reverse Head and Shoulders

quickly turned back. In this case, the buying pres-

The reverse head and shoulders pattern is also

sures are strong enough to break the trendline and

known as an inverted head and shoulders pattern,

test the last resistance. Selling pressures reemerge

or the head and shoulders bottom. This is a reversal

and the market falls again.

pattern. It is, however, a bullish pattern. These pat-

This time, however, the selling pressure fails to

terns are most reliable when found at the end of a

take out the last low. This higher low forms the

downtrend. Buyers enter the picture at the low

right shoulder. The neckline is drawn from the

found on the left shoulder. The point that selling

points of the last two resistance levels. A break of

pressure overpowers the buyers again marks the

the neckline completes the reverse head and shoul-

beginning neckline. The return of sellers to the

ders pattern. Volume in this case would be heaviest

market ultimately pushes the price to a new low

on the left shoulder and decline into the head, and

“head” (see Figure 7.39). However, this new low is

it would decline even more into the right shoulder.


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7.39 Reverse Head and Shoulders Pattern

䊳

THIS PATTERN IS GENERALLY BULLISH. You will find three bottoms on this pattern. 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 selling pressures were unable to bring the prices down as hard as in the prior session.

This shows that sellers are getting weaker and

them. The stop-loss point in both cases would be at

weaker. They are completely exhausted at the right

the last support (see Figure 7.40).

shoulder and unable to bring the price to a new

The target is measured the same way as the

low. It should be noted that volume usually comes

head and shoulders pattern. The distance between

in during the rally off the low. Pushed by this

the neckline and the head gives you a good idea of

added volume, the buying pressure breaks the

how far it will run.

trendline. Finally, volume comes in again at the break of the neckline.

Wedges

Here’s the best method of trading a reverse

The wedge formation appears similar to the sym-

head and shoulders formation: Go long on the

metrical triangle. Both patterns have trendlines

stock after it breaks the neckline. Again, these pat-

that intersect or converge. However, the difference

terns have a tendency to pull back for a second

between the two patterns is a noticeable slant,

entry. Usually, this shakes out weak traders who

which can be upward or downward in direction.

are not sure of the position. They get shaken out on

If the slant is downward, it is considered a

this pullback only to see the price go away from

falling wedge. A falling wedge is generally a


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TECHNICAL ANALYSIS

7.40 Reverse Head and Shoulders Trade Setup

䊳

THERE ARE ALSO TWO ENTRY POINTS FOR THIS TRADE. The first is on the break of the neckline and the second entry is when prices pull back down to the neckline. Notice how the prior resistance level now becomes a support. In both cases, 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 neckline and project it up. The distance between A and B should be equal.

bullish pattern, whether found on an uptrend or a

downside. Go long on a falling wedge or go short

downtrend. This pattern is characterized by a

on a rising wedge once a break occurs. Your stop-

series of lower highs and lower lows.

loss point should be at the last support for a falling

An upward slant is considered a rising wedge

wedge and at the last resistance for a rising wedge.

(see Figure 7.41A). The rising wedge is considered a bearish pattern whether it is found on an uptrend

Flags and Pennants

or a downtrend. This pattern is marked by its

Flags and pennants are usually considered contin-

series of higher highs and higher lows.

uation patterns. They typically occur right after a

As with triangles, volume usually falls during

big, quick surge or a big drop in price. The market

the period of sideways movement (see Figure

at this point is pausing and consolidating. It is get-

7.41B). It generally returns on the breakout or a

ting ready for the next move. Research has shown

breakdown of the formation. The best way to trade

that flags and pennants are reliable continuation

wedges is to wait for a break to the upside or

patterns.


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7.41 Rising and Falling Wedge Pattern

A

B

䊳

THE FALLING WEDGE IS A BULLISH TRIANGLE PATTERN whether found in a downtrend or an uptrend. Notice the downward slant 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.

Bullish flags are formed by a series of lower

Rectangles

tops and lower bottoms, with a pattern slanting

Rectangle patterns contain price movements

against the trend. However, unlike wedges, their

within two parallel trendlines, or a channel. The

trendlines run parallel to each other. On the other

price stays within the channel because buyers and

hand, bearish flags are made up of a series of high

sellers are evenly matched. The upper line of the

tops and higher bottoms, and their trendlines also

rectangle represents resistance, where the sellers

run parallel to each other (see Figure 7.42).

turn back the buyers. The lower line represents

Pennants look like symmetrical triangles. The

support, where the buyers turn back the sellers.

only difference is that pennants are usually smaller

Rectangles are also a type of continuation pat-

in size and much shorter in duration. The market

tern. They tend to move to the original direction of

is merely taking a brief pause from its rapid rise or

the trend. The longer the rectangle, the more pow-

rapid fall.

erful the move will be (see Figure 7.43).

The trade for both pennants and flags has to be

There are two ways to trade rectangles. The first

in the original direction of the large move. If the

method involves trading while the issue is still

prior move is up, get ready to go long when it

within the channel. Look at the trend. If the origi-

breaks the trendline. If the prior move is down, get

nal trend is up, go long at the support area with a

ready to go short when the price breaks the trend-

stop just below this area. Your initial target is to

line. Volume is a big indicator of this pattern. For

sell the position when it gets to the resistance level.

both pennants and flags, it should contract on the

However, if there is a lot of buying momentum,

sideways move and increase again on the breakout.

consider holding the position a little longer to see


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TECHNICAL ANALYSIS

7.42 Flags and Pennants Pattern

䊳

TWO THINGS DEFINE THE FLAGS PATTERNS. The first is the large “pole,” and second is the short period of consolidation. The consolidation period looks like a 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 consolidation period. However, in this case, the consolidation period resembles a small symmetrical triangle.

if it will break out of the channel. If the original

The second method is to wait for a break of the

trend was down, go short at the resistance level

support or resistance, then enter on the pullback or

with a stop just above that level. The initial target

the bounce. It is common to see support and resis-

would be the support level. If the position gets to

tance areas swap duties once a break occurs. A

the support level with increasing volume, you

support area usually becomes the resistance, while

might consider holding a little longer to see

a resistance area turns into the support area. This is

whether the selling momentum is able to break the

where I would enter the trade.

support level (see Figure 7.44).

Once I enter the trade, my stop-loss point


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7.43 Rectangle Pattern

䊳 THE RECTANGLE IS A CONTINUATION PATTERN. It can signal either accumulation or distribution. If the prior trend was up, then this pattern is bullish. If it was down, then this pattern is bearish.

would be set just slightly below the breakout or

The price rise B should equal the height of the

breakdown point. If the break is valid, the price

channel.

should not move back into the rectangle. The easi-

There is also a way to project the maximum

est way to project the initial price target would be

price rise (see Figure 7.46). It is done by measuring

to measure the height of channel A in Figure 7.45.

the length of the rectangle (C) and projecting it

7.44 Rectangle Trade Setup Number 1

䊳

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 the resistance level. If the stock is previously on a downtrend, go short when prices bounce off the resistance level. Place a stop just above the resistance. Take profits when it falls to the support level.


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TECHNICAL ANALYSIS

7.45 Rectangle Trade Setup Number 2

䊳

THE SECOND WAY TO TRADE A RECTANGLE is to wait for it to break the support or resistance level. Go long once it breaks the resistance level. Place a stop just below the last resistance. If prices were to break a support, go short on the bounce back to the support level. Place a stop-loss order just slightly above the support level. Calculate your initial price target by measuring distance A between the support and resistance levels. Project up or down, depending on long or short, to get your target. Distance A should be equal to distance B.

vertically (D) from the breakpoint (support line if

ways move in which the pattern resembles the

bullish and resistance line if bearish). Remember,

shape of a saucer, called the saucer pattern.

in this case, this is the maximum price rise you can

As a reversal pattern, the duration has to be a lot

expect. The probability of the price reaching this

longer. It is a period of consolidation in which sen-

point is not as high as the probability of it reaching

timent turns from bearish to bullish. Ideally, the

the initial price target (see Figure 7.46).

low established on the rounded bottom is a signif-

With these patterns, volume tends to decrease

icant low. The low of the pattern should not equal

while the stock is moving sideways. A break of the

more than a 50 percent retracement of the run. As a

support or the resistance is usually followed by a

rule, the lower the value of the pullback, the faster

marked increase in volume. If volume failed to

it will break out. In both cases, the wider the con-

materialize on the breakout, the move is more sus-

solidation period, the harder and longer the secu-

ceptible to failure.

rity will tend to run. The rounded top is basically an upside-down

Rounded Bottoms and Rounded Tops

pattern of the rounded bottom. It is a bearish pat-

A rounded bottom can be a bullish reversal pattern

tern whether found on an uptrend or on a down-

or a continuation pattern. It consists of a long side-

trend (see Figure 7.47). The best way to trade a


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7.46 Rectangle—Estimating Maximum Price Targets

䊳

TO ESTIMATE THE MAXIMUM PRICE TARGET, measure width C. Rotate the measurement up and project this up or down from the support and resistance levels. This gives you the optimistic projections of a breakout or breakdown run.

rounded top is to go short on a breakdown of the

Stocks. It is considered a bullish continuation pat-

rim. With a rounded bottom, go long on a breakout

tern. A prior uptrend must exist. It is better if the

of the rim. The initial target point would be the dis-

trend is not extended. An extended run decreases

tance between the rim and the high or the low,

the upside potential of the breakout.

depending on the pattern. The breakout or break-

The pattern consists of two parts: a cup and a

down should be accompanied by strong volume.

handle. The cup is a consolidation area that forms

The stop-loss point should be slightly inside the

after an advance in price. It can look like a deep

support or resistance level or the rim. Like the rec-

bowl or a rounded bottom. It should resemble the

tangle, a valid break should not come back too far

letter U, not the letter V.

into the pattern.

Ideally, the depth of the cup should be no more than 38 percent of the prior advance. In extreme

Cup with Handle

cases, the retracement can be as much as 62 per-

William O’Neil, founder of Investor’s Business

cent. As a rule, the lesser the retracement percent-

Daily, popularized the concept of the “cup with

age, the more powerful the run will be on the

handle” in his 1988 book, How to Make Money in

breakout. The handle forms after a test of the prior


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TECHNICAL ANALYSIS

7.47 Rounded Bottoms and Rounded Tops Pattern

䊳

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.

resistance. It can be a flag or a pennant. The depth

has a clear uptrend and it has formed a nice cup.

of the handle is usually a lot shallower than the

The pullback low on the cup is just below the 38

cup depth. Maximum depth is about 38 percent. A

percent mark. It has also formed a nice flag.

breakout of the resistance signals a continuation on the uptrend.

After you identify this pattern, go long on the breakout. The initial stop should be at the last sup-

Figure 7.48 shows an example of this pattern.

port. Your target can be obtained by measuring the

You have all three key components. The pattern

distance between the right side of the cup (A) and


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7.48 Cup with Handle Pattern

the low of the cup. This same distance can be projected from the breakout point to calculate the initial 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 levels have to be followed with heavier volume. Gaps

䊳

WILLIAM O’NEIL POPULARIZED THE CUP WITH HANDLE PATTERN. The pattern looks exactly like its name: a cup

are also confirmed by heavy volume. A common

with a small handle on it. It is a bullish pattern.

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

7.49 Cup with Handle Pattern Trade Setup

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

䊳

TRADE THIS PATTERN ON THE LONG SIDE once it has

broken out of the resistance area. Place a stop-loss slightly below the last support. Calculate your initial profit target by measuring the depth (A) of the cup and adding this value to your entry price. Initial profit target amount B should be the same as the amount A.

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


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TECHNICAL ANALYSIS

7.50 Volume Analysis

䊳

VOLUME IS A VERY IMPORTANT INDICATOR. Decreasing volume places the direction of the trend in doubt, while increasing volume supports the direction of the price movement. Flat volume neither confirms nor disputes the move. It is considered neutral.

the head and shoulders pattern. This is also the

Always keep an eye on volume. It reveals the

case when the stock is in a trading range. Volume

underlying strength of a move better than price

usually decreases when it gets near a support or

action itself. Weak volume means momentum

resistance area, signaling that interest has waned.

could end soon. Strong volume confirms the

It picks up again when it reverses and heads in the

momentum. Pay attention to climactic volume.

opposite direction (see Figure 7.50).

This usually comes at the end of a hard run. It

Volume bars are the easiest way to analyze

could be after a big rise in price or an extreme sell-

volume. They compare volume on a given day

off. Climactic volume is at least 100 percent more

with volume on previous days. Take note of the

than the average daily volume on the security. The

trend. Is volume increasing or decreasing? If vol-

higher volume serves to confirm a possible rever-

ume bars are getting taller and taller, then vol-

sal of the short-term trend.

ume is increasing. This confirms the direction of

Let’s take the chart of CECO in Figure 7.51 as an

the move. If volume bars are shrinking, then vol-

example. There were two periods in which volume

ume is decreasing. This means the direction of

surged a lot higher than normal. In period A, vol-

the current move could be in jeopardy. Volume

ume was more than 10 times higher than the daily

bars can also be flat. They neither confirm nor

average. However, this is not climactic volume

refute the trend. They are considered neutral.

because of its location in relation to the trend. In

Usually, the trend will stay intact when you see

the early part of a trend, heavy volume serves as a

flat bars.

confirmation of the strength of that direction. In


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7.51 Climactic Volume

䊳 THE CHART OF CECO SHOWS two high-volume days. However, only at point B is it considered climactic volume. This is because it occurred at the end of a run. All the weak hands were flushed out from the run. This allowed the prices of CECO to recover from $25 to around $33.

this case, it was down. Prices fell afterward to a

high volumes flush out weak traders. Nervous

low of $22.

investors are getting out. Those who remain are

The scenario for period B is different. It already

fully committed to the security. After the sell-

had eight prior days of decline before heavy

ers are gone, only buyers are left. The price will

volume came in. This is climactic volume. Such

$ rise. ●


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8

Candlestick Charting Techniques • • • • • • •

Spotting Heavy Buying and Selling Pressures Comparing Buying and Selling Pressures Spotting Indecision with Candlesticks Understanding Intraperiod Activity Candlestick Positions Bullish Patterns Bearish Patterns


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I

T IS BELIEVED THIS CHARTING METHOD was started by the Japanese 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 patterns are formed using four price points. They are the opening price, the highest 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 candlestick pattern. The body is normally displayed as

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.

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 periods of heavy selling pressures.

SPOTTING HEAVY BUYING AND SELLING PRESSURES The white marubozu candlestick can quickly identify periods of heavy buying. This pattern is sometimes 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 throughout the whole period.


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CANDLESTICK CHARTING TECHNIQUES

8.1 Different Types of Candlestick Patterns

䊳

THE NAME OF THE CANDLESTICK DEPENDS ON the location of the close in relation to the open. For open candlesticks, the close is higher than the open. For closed candlesticks, the close is lower than the open. For doji candlesticks, the close is the same as the open.

Of the two patterns shown in Figure 8.2, the can8.2 Definition of a White Marubozu

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 considered 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

䊳

TO QUALIFY AS A WHITE MARUBOZU, the open has to

be located at the bottom 20 percent of the candlestick range and the close has to be above the top 20 percent of the candlestick range. Both patterns shown here would qualify.

reversing. A follow-through of the bullish momentum is likely the next day. However, if this pattern is found after a long advance, it could signal an overbought situation. Buyers have become too aggressive and too optimistic. A reversal could be at hand.


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The black marubozu candlestick identifies periods of heavy selling activity. It is also referred to as

the high price, and the closing price is the same as the low price.

a 20/20 candlestick. But with this candlestick, the

Black marubozus are generally considered bear-

opening price should be on the top 20 percent of

ish patterns. It shows that sellers were in full con-

the candlestick range and the closing price should

trol of the period. Usually, when found at the early

be below the bottom 20 percent of the candlestick

stages of a decline, they signal more selling pres-

range (see Figure 8.3).

sure ahead. After a long advance, a black mar-

Long black candlesticks show heavy selling

ubozu will mark a possible resistance area. The

pressure. The longer the black candlestick, the

bears now have control of the market. After several

lower the closing price relative to the open. It indi-

periods of decline, black marubozu candlesticks

cates that sellers were aggressive during this

can indicate panic selling or capitulation. Climactic

period, causing a significant drop in price at the

selling can be a signal of a possible turning point.

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-

COMPARING BUYING AND SELLING PRESSURES

ers were in control the whole period. They began

Candlesticks make it easy to compare similar or

selling at the open and sold until the close of the

contrasting pressures. When you place candle-

period. That is why the open price is the same as

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, the

8.3 Definition of a Black Marubozu 8.4 Comparing Selling Pressures

䊳

TO QUALIFY AS A BLACK MARUBOZU, the close has to be located at the bottom 20 percent of the candlestick range and the open has to be above the top 20 percent of the candlestick range. Both patterns shown here would qualify.

䊳

IT IS EASY TO TELL THAT THE CANDLESTICK on the right had a lot more selling pressure. The bigger the black body on a candlestick, the heavier the selling pressure.


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8.5 Comparing Buying Pressures

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 combination 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

IT IS EASY TO TELL THAT THE CANDLESTICK on the right

bullish or bearish directions. It all depends on the

had a lot more buying pressure. The bigger the white body on a candlestick, the heavier the buying pressure.

price action that came before it and the confirming

䊳

candlestick that follows it. In the ideal doji, the open and close are equal in price, and the upper

wider the price range in the period. If sellers were

and lower wicks are of essentially the same length.

aggressive throughout the entire period, the clos-

Within this period, prices moved up and then

ing price will be far lower than the open price and

down, or they moved down and then up from the

the range will be wide. If selling pressures were

open. In both cases, it closed at or near the opening

not as hard, the closing price will not be far away

level. The result is a standoff. Neither buyers nor

from the open price. This creates a smaller body

sellers were able to gain control. The market is

than the previous scenario.

indecisive (see Figure 8.6).

In Figure 8.4, there is little doubt which period

The long-legged doji (see Figure 8.7) is the big

had more selling pressures. The length of the bod-

brother of the pattern in Figure 8.6. It also has

ies tell the story. The same applies to open candle-

upper and lower wicks that are roughly the same

sticks. The longer the length of the body, the

length. But the wicks are a lot longer. These pat-

stronger the buying pressure in that period. In Fig-

terns suggest indecision within the period: Prices

ure 8.5, the buyers were a lot more aggressive dur-

traded well above the open. They also traded well

ing the period on the right.

below the open. The end result, however, was the same. It closed at or near the opening price. Again,

SPOTTING INDECISION WITH CANDLESTICKS

neither buyers nor sellers had control of the market in that session. They might have had control

Two patterns indicate indecision within the period.

within certain segments, but overall, the market

They are doji patterns and spinning tops.

ended in a tie.

Dojis are formed when opening and closing

Spinning tops also suggest indecision. They are


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8.6, 8.7, and 8.8 Spotting Indecision

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 indicate 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 closing 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 䊳

THESE THREE CANDLESTICK PATTERNS INDICATE INDECISION. Buyers and sellers were unable to gain an

upper hand. Prices essentially stayed the same at the end of the period. These patterns often mark reversal points.

important indications given by candlesticks: White marubozu or long white candlestick. These indicate that buyers were aggressive and in control for the whole or most of the period (see Figure 8.9).


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Black marubozu or long black candlestick. These indi-

and were able to push the price up considerably from the

cate that sellers were aggressive and in control for the

low (see Figure 8.12).

whole or most of the period (see Figure 8.10).

Inverted hammer or shooting star. A long upper wick

Dojis or spinning tops. These candlesticks with small

indicates that buyers controlled the market for part of the

bodies tell us that neither buyers nor sellers were in con-

session, but lost control by the end as sellers were able to

trol. Prices finished about where they started (see Figure

aggressively push the market back down (see Figure 8.13).

8.11).

Long-legged dojis or spinning tops. A long upper and

Hammer or hanging man pattern. The long lower tail

lower wick indicates that both buyers and sellers had their

indicates sellers had control of the market for part of the

moments during the trading session, but neither could

period, but lost it by the end. Buyers made a comeback

claim a significant victory in the end. The result was a tie (see Figure 8.14).

8.9 White Marubozus

䊳 WHITE MARUBOZUS, or long white candlesticks, indicate that buyers were aggressive and in control for the whole or most of the period.

8.10 Black Marubozus

䊳

8.13 Inverted Hammer

䊳

THESE CANDLESTICKS WITH SMALL BODIES tell

䊳

A LONG UPPER WICK INDICATES that buyers

us that neither buyers nor sellers were in control. Prices finished about where they started. 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.

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.

BLACK MARUBOZUS

indicate that sellers were aggressive and in control for the whole or most of the period.

8.11 Dojis or Spinning Tops

䊳

8.12 Hammer Pattern

THESE CANDLESTICKS WITH SMALL BODIES tell us that neither buyers nor sellers were in control. Prices finished about where they started.


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8.14 Long-Legged Dojis or Spinning Tops

䊳 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.

What Candlesticks Can’t Tell You

sequence could have been the other way around.

Candlesticks can give you an idea of the end result

The buyers could have come in first, followed by

of the session, but they have limitations. They do

sellers. And at the end of the period, buyers came

not reflect the sequence of events between the

in again.

open and close. They show the relationship

Both scenarios would produce the same pat-

between the open and the close. They also show

tern. The missing information could be vital

the relationship of these two to the high and the

because buyers and sellers might not have been

low of the session.

totally exhausted at the end of the period. The

We can’t tell whether buyers stepped in first or

market might have closed before they were able to

sellers stepped in first in a doji pattern unless we

complete their trades. This is why technical analy-

reduce the time frame. Let’s take a long-legged

sis of candlesticks is never based on just one can-

doji pattern as an example. The activity within the

dlestick pattern. Complete analysis is done in

period could be reflected by either one of the

combination with other periods and other factors.

charts shown in Figure 8.15. Perhaps sellers

Candlesticks do not reflect volatility (see Figure

stepped in first and pushed the price down, which

8.15). Looking at a white marubozu candlestick,

created the low. Then buyers stepped in and

most traders would simply assume that prices

pushed it up hard, which created the high. Later

advanced most of the session. However, if you

on, sellers stepped in again to push the price back

break the pattern down, the sequence of price

down to close at or near the open price. Or the

movements could be different than normally


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8.15 What Candlesticks Cannot Tell You

A

B 䊳

CANDLESTICKS CANNOT TELL YOU THE SEQUENCE OF EVENTS within the period. Both intraperiod activity charts shown here would result in the same longlegged doji pattern. Candlesticks also cannot tell you the volatility within the period. Both intraperiod activity charts shown here would result in the same white marubozu pattern. Notice the greater volatility of the period on the right.

expected. The market could have been volatile,

More Candlesticks

with price pressure shifting several times.

Here are some additional patterns you should

The trading activity that forms a particular can-

learn to recognize.

dlestick can vary. That is why candlestick patterns work best when you use combinations and not just

Dragonfly Doji

a single candlestick. The example in Figure 8.15

This pattern forms when the open, high, and close

also shows two different price movements that

are equal and the low creates a long tail. The result

could have formed a white marubozu candlestick.

is a candlestick that looks like a T, with a long tail

During the first session, there was a small decline

only on the bottom. This pattern indicates that sell-

off the open to form the low, a sharp advance to

ers dominated the early part of the period and

form the high, and a small decline to form the

drove the price lower. But they were not able to

close. The second session shows three sharp

keep up the pressure. By the end of the session,

moves instead of just one. As you can see, the sec-

buyers had pushed the price back to the opening

ond session was a lot more volatile than the first.

level.


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The reversal implications of this pattern depend

The candlestick looks like an upside-down T.

on the previous price action and what happens dur-

Gravestone dojis indicate that buyers dominated

ing the next period. The long wick provides proof of

the early part of the trading session. They drove

buying pressure, but the low indicates that plenty of

prices higher during the session. However, they

sellers could still be around. If this pattern is found

were unable to hold their gains. Sellers resurfaced

after a long downtrend, it could signal a potential

and were able to push the prices back down to the

bullish reversal or bottom. A bullish confirmation

open price.

would come in the form of a follow-through to the

As with the dragonfly doji and other patterns,

upside the next period. After a long uptrend, the

the reversal implications of a gravestone doji will

long tail could suggest a potential bearish reversal

depend on the previous price movement and also

or top. Bearish confirmation will come in the form

on how the next period confirms this movement.

of a closed candle the next period (see Figure 8.16).

After a long downtrend, it could signal a possible bullish reversal. After a long uptrend, they can

Gravestone Doji

indicate a possible bearish reversal. Both need to

This pattern forms when the open, low, and close

be confirmed with a follow-through to the upside

are the same and the high has a long upper wick.

(if bullish) or downside (if bearish) to confirm the validity of this interpretation.

8.16 Doji Candlestick Patterns

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 nonexistent 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

Dragonfly Doji

Gravestone Doji

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

䊳

THE HIGH, THE OPEN, AND THE CLOSE ARE ALL AT THE SAME PRICE FOR THE DRAGONFLY DOJI, and the low, the

open, and the close are all at the same price for the gravestone doji.

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


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8.17 Candlestick Patterns

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 hanging 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 candlestick 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 hammer came in after a price decline. The hanging man marked the resistance level, and the hammer

䊳

THE HAMMER AND THE HANGING MAN both have the

marked the support.

same patterns. Their names depend on the preceding price movement.

Inverted Hammer and Shooting Star implies that although sellers drove prices lower

These patterns look like the hammer and hanging

during the session, they were unable to sustain the

man patterns turned upside down. The long tail is

pressure. Buyers stepped in and forced the price

now located above the body, and there is little or

back up at the end of the session. Like many of the

no tail below the body. These patterns also mark

patterns we have discussed, hammers require fur-

potential trend reversals, and they also require

ther bullish confirmation. Confirmation can come

confirming price movement during the following

in the form of a gap up or white marubozu candle-

period (see Figure 8.20).

stick the next period. Another confirmation would

Like their counterparts, their names come from

be from increasing volume on the way up. Ham-

their location on the chart and the preceding price

mers are like climactic sell-offs, and heavy volume

action. If this pattern forms after an advance, it is

serves to validate the reversal even more.

called a shooting star. The ideal position is a star

If the same pattern you saw earlier formed after

position (to be discussed later), hence the name.

an advance, then it is called a hanging man (see Fig-

This pattern marks a potential trend reversal. The

ure 8.18). The hanging man is a bearish reversal

high usually marks a significant resistance level.


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8.18 Hammer and the Hanging Man

䊳

BOTH THE CIRCLED PATTERNS LOOK THE SAME. The one that occurred at the end of a move up is called a hanging man, and the one that occurred after a downward price move is called a hammer.

8.19 Hammer as a Reversal Indicator

䊳

THIS CHART OF EBAY SHOWS two circled hammer patterns. Both mark the reversal points of the downtrend. They were good signals for initiating a long position. Can you find the third one?

126


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8.20 Candlestick Patterns

The inverted hammer looks exactly like a shooting 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 sustained through the entire session, the presence of this pressure should not be ignored. It should raise a caution flag on any short position. The

䊳

THE INVERTED HAMMER AND THE SHOOTING STAR both

have the same patterns. Their names depend on the preceding price movement.

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.

This candlestick pattern forms when prices

The examples shown in Figures 8.21 and 8.22

open higher than the previous period’s high. It

show how to identify an inverted hammer or a

then advances during the session. But somewhere

shooting star. Both patterns look alike. Note the rela-

within the session, selling pressure occurs and

tionship to the prior price movement. The inverted

pushes the price back down. The close is well off

hammer came in after a price decline, whereas

the high. The result is a candlestick that has a long

the shooting star came in after a price advance. The

upper tail and small black or white body. It can

shooting star marked the resistance level, and the

have a small lower tail or none at all.

inverted hammer marked the support. Take note of

The ability of sellers to force the price down should raise a caution flag in any situation. In this

the confirming candlestick on the period that followed these patterns (see Figures 8.21 and 8.22).

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-

CANDLESTICK POSITIONS

tion is required after the shooting star. It can come

Whereas patterns are a series of candlesticks, posi-

from a gap down or black marubozu candlestick

tions define a single candlestick in relation to the

on heavy volume.

previous candlesticks (i.e., in relation to its pattern).


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8.21 Inverted Hammer and the Shooting Star

䊳

BOTH THE PATTERNS CIRCLED HERE LOOK THE SAME. The one that occurred at the end of a move down is called an inverted hammer, and the one that occurred after an upward price move is called a shooting star.

Star Position

parties. That is why we see the smaller range the

A candlestick is said to be in a star position when it

next day. Bear in mind that for a candlestick to be

gaps away from the previous candlestick. The first

in a star position, it does not have to have a small

candlestick usually has a large body, while the sec-

range. It just needs a small body and it needs to

ond candlestick in star position has a small body.

gap above the prior day’s high. In shooting stars

Due to the gap, a candlestick in a star position

and hammers, the range is fairly wide, but the

appears to be isolated from the rest. It could be

body is small. Figure 8.23A gives you a better idea

from a gap down or a gap up. If it is a gap up, it is

of a candlestick in a star position.

usually preceded by a white marubozu. If it is a gap down, it is usually preceded by a black maru-

Harami Position

bozu. This occurs because either buying or selling

A candlestick is said to be in a harami position when

momentum carried over to the next day. This

it forms within the body of the previous candlestick.

caused the gap. However, the gap absorbed a lot of

The first candlestick usually has a large body, while

those pressures and almost balanced out the two

the second candlestick in harami has a smaller body


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8.22 Inverted Hammer as a Reversal Indicator

䊳

NOTICE HOW THE INVERTED HAMMER shown here marked a big turnaround in prices the next day. Savvy traders who spotted this could have capitalized on the move.

8.23 Candlestick Positions

A

B

䊳 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 the following period on a harami position is all within the body of the first period.


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than the first. Harami means pregnant in Japanese.

Piercing pattern

If you imagine the first candlestick as being preg-

Bullish harami

nant with the second candlestick, you can remember the harami position easily. Preferably, the upper

Three white soldiers

and lower tails of the second candlestick should be

Bullish engulfing harami

within the first, but it is not necessary. Dojis and

Morning star

spinning tops are just some of the patterns that can

Bullish abandoned baby

form in the harami position. Figure 8.23B gives you a better idea of the harami position.

The hammer and inverted hammer were covered earlier. This section focuses on the other seven

Combination Patterns

patterns. For a complete list of bullish (and bear-

It must be stressed that candlestick analysis should

ish) reversal patterns, see Greg Morris’s Candlestick

never be based on a single candle. It should always

Charting Explained. With all bullish patterns, a bull-

be combined with previous price action and a con-

ish confirmation has to occur. These patterns are

firming candle. Learning to recognize combina-

still considered neutral. No clear direction has

tion patterns is a must for the candlestick chartist.

been established. Action should not be taken. Bull-

Combinations provide a better picture of possible

ish confirmation has to occur within a short

future price movements and are more reliable than

period. Maximum effectiveness of these patterns is

a single candlestick. These combinations fall into

only about two weeks. More often, it is a lot less

two categories:

time. Bullish confirmation has to occur within one

1 ● 2 ●

Bullish patterns Bearish patterns

BULLISH PATTERNS

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 Pattern

There are many bullish combination patterns. I

A bullish engulfing pattern consists of two candle-

have chosen the more popular and common ones

sticks (see Figure 8.24). The first candlestick,

for discussion here. They occur often and should

which is a period earlier, is a closed pattern, mean-

be part of the basic understanding of any candle-

ing the close was lower than open. It should be a

stick chartist.

black candlestick. The upper and lower tails are

Hammer

usually fairly short, although this is not necessary. This indicates a small range compared with the

Inverted hammer

opening and closing price. The second candlestick

Bullish engulfing

is an open pattern, or a white candlestick, mean-


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8.24 Bullish Combination Patterns

A B 䊳

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 the first candlestick. To make it easier to remember this combination, try merging the two candles together. The result is an open hammer pattern.

ing the close was higher than the open. The white

means buying pressure must be strong enough to

body of this second candlestick is larger than the

bring the price back above the open price, closing

black body of the first candlestick. The white body

above it. Note that it does not necessarily have to

of the second candlestick has to completely cover

break the high of the first candle. Figure 8.24A is an

the black body of the previous candlestick for it to

illustration of the bullish engulfing pattern.

qualify as a bullish engulfing pattern. Ideally, the

As the name implies, this pattern is bullish. It

white body of the second candlestick should also

indicates that buyers have seized control from sell-

engulf the upper and lower tails of the first can-

ers. The first candlestick is closed. It indicates that

dlestick.

sellers were in control and forced the price to close

A couple of things must happen in this pattern

lower than the open. In the next period, the control

for it to form. The open of the second candlestick

of the sellers was short-lived. Buyers were able to

must be lower than the previous close. This means

push the price up. This rally proved so powerful

that the price gapped down at the open on the sec-

that the price went past the previous open and

ond period. The close of the second candlestick

closed above this price. The resulting candlestick is

must be higher than the previous open. This

one in which the white body completely “engulfs”


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that of the previous candlestick, hence the name bullish engulfing pattern.

The chart of NVDA (see Figure 8.25) is an example of a bullish engulfing pattern. Notice that there

As with most candlesticks, prior price action

are two of these patterns. The first combination

and ensuing price action need to be taken into con-

clearly shows the increased strength of the buyers.

sideration. These patterns tend to work best dur-

There was a tremendous amount of buying pres-

ing a decline or a downtrend. If you add the other

sure. It caused the range to be almost twice that of

aspects of technical analysis to this pattern, an

the normal daily range. The confirming bullish

even better trade signal can be generated.

candlestick came in the next day. This tells us that

The easiest way to remember this pattern is to imagine a marriage of the two candlesticks into

on a short-term basis, we can expect the stock to head up.

one. If you use the opening price of the first candle,

Three days later, the stock showed signs that

the highest and lowest price between the two peri-

buying momentum had stopped and sellers had

ods, and the close of the second candle, you should

again controlled the session. This is evidenced by

get an open hammer (see Figure 8.24B).

the down candlestick. But that was short-lived, as

8.25 NVDA Bullish Engulfing Pattern

䊳 THE FIRST BULLISH ENGULFING PATTERN on this chart of NVDA marked a significant turning point in the direction for this stock. Notice how it followed through again to the upside on another bullish engulfing pattern.


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the next day another bullish engulfing pattern

trend. The pattern itself is not a strong enough sig-

appeared. This was followed by a bullish confir-

nal. A bullish confirmation is needed for trading. It

mation. The stock gapped up the next day and

can come in the form of a gap up or another white

went higher, and later the stock went significantly

marubozu following the pattern. Strong or increas-

higher.

ing volume must follow these moves to the upside. Again, the best way to remember these patterns

Piercing Pattern

is to imagine a marriage of the two candlesticks.

Two candlesticks are required to form a piercing

Using the open of the first, the highest and lowest

pattern. The first candlestick is a relatively long

price of the two periods, and the closing price of

black marubozu. The second candlestick is a white

the second period, you will find that the pattern

marubozu that opens below the previous period’s

transforms into a closed hammer.

closing price and closes above the midpoint of the

Bullish Harami Pattern

black marubozu. The charts in Figure 8.26 illustrate the bullish

The bullish harami pattern is made up of two can-

piercing pattern. Piercing patterns are bullish for-

dlesticks. The first has a large body and the second

mations. You usually find them after a decline.

a small body. The second candlestick has to be in

They mark a potential reversal point or change in

a harami position, so the body of the first has to


A 䊳

B

THESE TWO CANDLESTICKS MAKE UP THIS COMBINATION PATTERN. Notice how the open on the second candlestick is below the close of the first candlestick and the close on the second candlestick is above the midpoint of the first candlestick. To make it easier to remember this combination, try merging the two candles together. The result is a closed hammer pattern.


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completely encompass the second. These patterns

possible capitulation. The ensuing candlestick is

are also called inside range days, or IRDs, because the

formed with a gap up at the open. This indicates

range of the second day is completely found within

that buying pressures increased between sessions,

that of the first. There are four possible combina-

and it could signal a possible reversal.

tions in this pattern: white/white, white/black, black/white, and black/black (see Figure 8.27).

One similarity between the four combinations stands out. The color of the first candlestick does not

In Beyond Candlesticks, Steve Nison asserts that

really matter. What is more important is the body of

any of the four combinations of colors can be con-

the second candlestick. The smaller the body of the

sidered a harami. He believes the most bullish are

second candlestick, the more likely it is to reverse.

those that form with a white/black or white/white

The best second candlestick you can find is a doji. It

combination. The large body of the first candlestick

has a very small body or none at all. The chances

implies strong buying pressure throughout the

of a reversal are greatly increased whenever this

period. The smaller candlestick indicates a consoli-

occurs. It tells us that, after a period of heavy decline

dation period. The white/white and white/black

(black marubozu), sellers were unable to push the

bullish harami are likely to occur instead of the

price down. Hence the narrower range. On the

black/black or black/white harami.

other hand, after a prior period of heavy advance

If the prior trend was on a decline, a black/black

(white marubozu), sellers were also unable to move

or black/white combination is regarded as a bull-

the price down, even though the price had gapped

ish harami. The first long black candlestick tells us

against the previous upward direction.

that sellers were aggressive, but it could signal a

Look at the chart in Figure 8.28. Pay attention to


䊳

THIS ILLUSTRATES THE FOUR POSSIBLE COMBINATIONS FOR THE BULLISH HARAMI. Two candlesticks make up this combination pattern. Notice how the

range of the second candlestick is always within that of the first candlestick.


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8.28 Bullish Harami Pattern

䊳

THE SERIES OF THREE BULLISH HARAMI PATTERN (circled) on this stock

marked a nice turnaround in price.

the following: the downtrend and the occurrence

combine the three candlesticks, you form one giant

of the harami pattern. At this point, we still do not

white marubozu. This shows the power the bulls

know whether it is bullish or bearish. It is with the

have over the market (see Figure 8.29).

gap upward that a long candlestick confirmed the

Two things affect the bullish nature of this combi-

bullishness. Two more harami patterns followed.

nation pattern. First is the past price action. Second

They are white/white and white/black combina-

is the range or size of the three candlesticks. If this

tions. These patterns are considered bullish and a

combination occurs at the beginning of a reversal

sign of possible continuation of strength.

and just below a resistance level, then chances of the bullish action continuing are greatly increased. This

Three White Soldiers

is a good scenario for a possible break of resistance.

The three white soldiers pattern is made up of

When the range is shrinking as it gets close to resis-

three white marubozu candlesticks formed in con-

tance, however, you should be cautious. It suggests

secutive periods. In and of itself, the white

that buying momentum is losing steam. While sell-

marubozu candlestick pattern indicates a lot of

ers never really controlled the session, the strength

buying pressure throughout the period. When

behind these two pressures is now starting to bal-

three of these occur side by side, the buying has

ance out. Soon, it could tip to the side of the sellers

become urgent. Every move up brings in more

again. Do not initiate a long position when you see

buyers, as short sellers cover their positions. If you

this pattern. Although this combination is also bull-


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䊳

THIS PATTERN IS MADE UP OF THREE WHITE MARUBOZU CANDLESTICKS.

Combining all three candlesticks together gives you one big marubozu candlestick. It gives you an idea of how strong the buying pressures were on this stock.

ish when it occurs after a breakout of resistance,

ing pattern. However, the two pillars that frame the

caution should be taken when entering into a long

pattern on the two sides have to be white maru-

position. If the ranges of the three candlesticks are

bozus (see Figure 8.31). The first combination

roughly equal, the chances of the buying momen-

found on the bullish engulfing pattern is a harami

tum continuing in the next period are a lot better.

pattern. Of the four possible harami combinations,

However, if the range is increasing or decreasing,

only two are shown here, the white/white and the

then it is preferable not to enter a long position. Wait

white/black combinations. The initial move on this

for a pullback to enter. If the range is gradually

combination has to be a big surge in buying inter-

decreasing, then buying momentum is definitely

est. Usually, this is caused by news or some new

waning. On the other hand, if the range is increas-

development pertaining to the stock.

ing rapidly between the three candlesticks, the action could be caused by panic (see Figure 8.30).

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-

Bullish Engulfing Harami

sticks can be of any possible combination. The best

As the name suggests, the bullish engulfing harami

ones are those where the range of all candlesticks

pattern consists of two combination patterns. The

is low. It tells us that buyers are present, absorbing

first is a harami pattern and the second an engulf-

the selling pressure.


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8.30 Three White Soldiers

䊳

THE RANGE AND LOCATION OF THIS PATTERN would affect the bullish nature of this pattern. This is an illustration of what increasing range, decreasing range, and constant range would look like for this combination pattern.


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 Star THE BULLISH ENGULFING HARAMI PATTERN is made

The morning star pattern consists of three candle-

up of two separate combination patterns. The first combination is the bullish harami pattern. The second combination is the bullish engulfing pattern.

sticks. They are usually formed after a decline and

䊳

can mark a support and a possible trend reversal area. The first candlestick is a closed pattern and


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should have a relatively long body. The middle

After a downtrend, the dojis and spinning tops

candlestick is a doji or spinning top that forms

indicate a tie between the bulls and bears. Neither

after a gap down at the open. The last candlestick

the buyers nor sellers scored a decisive victory in

is an open pattern, with a relatively long body (see

the session. This standoff is resolved when a long

Figure 8.32).

white candlestick forms to indicate a reversal of

The first candlestick should be in the direction of the current trend, which should be down. The

trend. It is preferable but not necessary to see a gap up on the long white candlestick.

closed pattern shows that sellers are still in control

A close relative to this pattern is the bullish

and were able to push the price down to close

abandoned baby. It consists of the same three can-

below the opening price. The gap on the second

dlesticks, and in the same order. Here’s the only

candlestick indicates that selling pressure contin-

difference between the morning star and the bull-

ued at the open. However, these pressures were

ish abandoned baby: On the bullish abandoned

weak and did not persist throughout the session.

baby, gaps are found on both sides of the doji or

Buyers stepped in and were able to push the price

spinning top (see Figure 8.33).

back up to end at or near the opening price.

The gap between the first and second candle-

8.33 Bullish Combination Patterns 8.32 Bullish Combination Patterns

䊳

THE MORNING STAR PATTERN is a three-candlestick

combination pattern. The most important aspect about this combination is the “star” position of the middle candlestick.

䊳

THE BULLISH ABANDONED BABY PATTERN looks very much like the morning star pattern. The only difference is that the high of the middle candlestick is lower than the low of the first and third candlesticks.


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stick indicates that significant selling pressure remains. However, the gap absorbed a lot of the selling pressure, and the security trades in a narrow range. It closes at or near the open price, creating 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 confirmation is required.

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 complete list of bearish patterns in Candlestick Charting Explained, by Greg Morris. Here are some of the key bearish patterns. Shooting star

The chart in Figure 8.34 is that of eBay. Notice the decline that preceded the doji pattern. It was in

Hanging man

a star position because of the gap. Finally, the gap-

Bearish engulfing pattern

up confirmed the pattern on the next candlestick.

Dark cloud cover

8.34 Morning Star Pattern: eBay

䊳

THE CIRCLED DOJI PATTERN is in a morning star pattern. Notice how nicely eBay’s prices reversed from the downtrend after this combination occurred.


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Bearish harami pattern

stick begins to form when residual buying pres-

Three black cows

sure causes the security to open above the previ-

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. Sellers are now in control of the market. Without the bearish confirmations, these patterns are considered neutral. There is no clear direction for the market yet. All these patterns do is signal a potential resistance point. Bearish confirmation comes in the form of a gap down or a downside followthrough. Understand that candlestick pattern analysis is short-term analysis. Maximum effectiveness is only about two weeks, sometimes less. Bearish confirmation has to occur within one to three days.

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 completely engulfs the previous day’s body. This indicates a possible reversal. A bearish confirmation is needed before any action is taken (see Figure 8.35A). 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 periods, and the close of the second 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

Bearish Engulfing Pattern

chart in Figure 8.36, the bearish engulfing pattern

The bearish engulfing pattern consists of two

marked the end of the uptrend and signaled a

candlesticks. The first is a small white or open

change of direction.

candlestick and the second is a large black or

Figure 8.37 shows another example of a bearish

closed candlestick. The bigger it is, the more

engulfing pattern. On the left side of the chart, you

bearish the reversal. The black body must totally

will notice that NVDA was in a downtrend. It then

engulf the body of the first white candlestick.

reversed up to where we now find the bearish

Ideally, the black body should engulf the shad-

engulfing pattern. The gap down on the next day

ows as well. Shadows are permitted, but they are

was the bearish confirmation. Price subsequently

usually small or nonexistent on both candle-

dropped from $25 to $20, where another engulfing

sticks. After an advance, the second black candle-

pattern marked the reversal.


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8.35 Bearish Combination Patterns

A

B

䊳 THESE TWO CANDLESTICKS MAKE UP THIS COMBINATION PATTERN. Notice how the open on the second candlestick is above the close of the first candlestick and the close on the second candlestick is below the open of the first candlestick. To make it 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

䊳

EARLIER WE SAW HOW THE BULLISH HARAMI PATTERN marked the reversal of the downtrend. This time the bearish engulfing pattern (circled) marked the reversal back down.


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8.37 NVDA Bearish Engulfing Pattern

䊳

HERE’S ANOTHER EXAMPLE of how the bearish engulfing pattern marked the reversal of the small uptrend.

Dark Cloud Cover

in the next session. However, sellers stepped in

This pattern comprises two candlesticks. The first

soon after the open and pushed prices lower. Sell-

is a white candlestick and the second a black can-

ing pressures were strong enough to drive prices

dlestick. Both candlesticks should have fairly large

below the midpoint of the white candlestick’s body,

bodies with small or nonexistent upper and lower

but not strong enough to drive it past the previous

wicks. The black candlestick must open above the

sessions open. Bearish confirmation in the next

previous close. It should also close below the mid-

period would validate the reversal (see Figure

point of the white candlestick’s body. If it closes

8.38A). Again, the best way to remember these pat-

above the midpoint, it is not considered as bearish

terns is to blend together the two candlesticks.

and may not necessarily qualify as a reversal com-

Using the open of the first, the highest and lowest

bination.

price of the two periods, and the closing price of the

Look at Figure 8.38. In this pattern, buying

second period, you will find that the pattern trans-

momentum carried over from the first session to

forms into an open shooting star (see Figure 8.38B).

the next. It caused the price to gap and open higher

The chart of ENZN in Figure 8.39 shows the


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B

A 䊳

TWO CANDLESTICKS MAKE UP THE DARK CLOUD COVER PATTERN. Notice how the open on the second candlestick is above the close of the first candlestick and the close on the second candlestick is below the midpoint of the first candlestick. To make it easier to remember this combination, try merging the two candles together. The result is an open shooting star pattern.

8.39 ENZN Dark Cloud Cover

䊳

THE DARK CLOUD COVER PATTERN shown here on ENZN marked the reversal of a very short uptrend. This stock’s price dropped severely afterward.


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value of recognizing this pattern. Price action on

White/white

ENZN remains sideways for many sessions. Trad-

White/black

ing this action within the rectangle formation would

Black/white

be choppy and tough. The formation of the dark cloud cover pattern signaled a possible change. The

Black/black

bearish confirmation that came afterward was a big

Whether they are bullish or bearish in nature,

black marubozu candlestick, which is the most

all harami patterns look the same. Their bullish or

bearish of all patterns. There were no upper or

bearish nature depends on two things, the preced-

lower tails in the pattern. This shows that sellers

ing trend and the confirming candlestick (see Fig-

were in complete control during the entire session.

ure 8.40).

The move also broke a key support level of the rec-

Steve Nison asserts in Beyond Candlesticks that

tangle. The price dropped from $62.50 down to $44.

any combination of colors can form a harami. The most bearish are those that form with a black/white

Bearish Harami Pattern

or black/black combination. The large black body

The bearish harami pattern is made up of two can-

indicates the presence of strong selling pressure that

dlesticks. It is a harami pattern. To qualify, the first

was sustained until the session ended. The small

candlestick has to have a large body and the body

candlestick afterward is considered to be a period

of the second candlestick has to be completely

of consolidation before continuation. After an ad-

encompassed by the first. This means that the body

vance, black/white or black/black bearish harami

of the second candlestick also has to be smaller

are not as common as white/black or white/white

than the first. There are four possible combinations:

combinations.

8.40 Four Possible Combinations for the Bearish Harami

䊳

TWO CANDLESTICKS MAKE UP THIS COMBINATION PATTERN. Notice how the range of the second candlestick is always within that of the first candlestick.


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A white/black or white/white combination is

pattern. The stock had a nice uptrend, with a big

still regarded as a bearish harami and can signal a

white marubozu candlestick marking the end. The

potential reversal. The first long white candlestick

next day, the stock gapped down and closed

usually follows the direction of the trend. It shows

down, producing the black candlestick pattern.

that plenty of buying pressure remains. The sec-

The next day, bearish confirmation came in the

ond candlestick that follows begins with a gap

form of a gap down. The price later dropped about

down on the open. This indicates a change of con-

a dollar in a few days, and JDSU eventually

trol between sessions from buyers to sellers. The

dropped well below $2.00.

struggle that followed in the second candlestick ends with an indecision or a tie, giving us further

Three Black Cows

proof that buyers are losing control.

The three black cows pattern is made up of three

A bearish confirmation on the next period

black marubozu candlesticks that formed in con-

should bring action on your part. If you are long,

secutive periods (see Figure 8.42A). In and of itself,

you should exit quickly. If you are not long, con-

a black marubozu candlestick pattern indicates a

sider shorting the security. The chart of JDSU in

lot of selling pressure throughout the period. If

Figure 8.41 is a good example of a bearish harami

three of these occur side by side, it means the sell-

8.41 JDSU Bearish Harami Pattern

䊳

THE BEARISH HARAMI PATTERN (circled) marked the start of a double top pattern and the reversal of the uptrend.


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8.42 Three Black Cows Pattern

A B 䊳 THE THREE BLACK COWS PATTERN is made up of three black marubozu candlesticks. Combining all three candlesticks together gives you one big black marubozu candlestick. It gives you an idea of how strong the selling pressures were on this stock.

ing is urgent. Fear is probably a factor. Every move

action will continue to improve greatly. You will

down in price brings in more sellers. This intensity

likely see a break of the support level. The only

points to opportunities on the short side. Hope-

range condition that lessens this likelihood is when

fully, you are not in a long position as it happens.

the range is shrinking as it gets close to a support.

Combining the three candlesticks together forms

This suggests that selling momentum is losing

one giant black marubozu. This shows the power

steam. While buyers have yet to gain control of the

the bears have over the market (see Figure 8.42B).

session, the strength behind these two pressures is

Like the three white soldiers, two things affect

now starting to balance out. It could tip to the side of

the bearish nature of this combination pattern. First

the buyers soon, a bad time to open a short position.

is the past price action. Second is the range or size of

Although this combination is also bearish when

the three candlesticks. If this combination occurs at

it occurs after a breakdown of support, caution

the beginning of a reversal to the downside and just

should be taken when entering into a short posi-

above a support level, chances are that the bearish

tion. If the ranges of the three candlesticks are


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roughly equal, the chances that selling momentum

with a long white body. The second is a small can-

will continue into the next period are a lot better.

dlestick that gaps above the close of the first. This

However, if the range is increasing or decreasing,

candlestick can be an open or closed spinning top

it is preferable not to enter a short position.

pattern. It can also be a doji. If it is a doji, the pat-

If the range is gradually decreasing, selling momentum is definitely waning. On the other

tern is called an evening star doji. The last is a closed candlestick with a long black body.

hand, this might be a case of panic selling if the

The long body of the white candlestick tells us

range is increasing rapidly between the three can-

that buying pressure remains strong. The gap up at

dlesticks. When the panic ends, buyers can bring

the open of the second candlestick provides fur-

the price up with ease (see Figure 8.43).

ther evidence of buying pressure. However, a lot of the pressure is absorbed in the gap. The upward

Evening Star

momentum loses steam and the range becomes

The evening star pattern consists of three candle-

narrow. A small candlestick forms. The battle for

sticks. The first candlestick is an open candlestick

control ends in a tie, indicating indecision and a

8.43 Three Black Cows

䊳

THE RANGE AND LOCATION OF THIS PATTERN would affect the bearish nature of this pattern. This is an illustration of what increasing range, decreasing range, and constant range would look like for this combination pattern.


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possible reversal of the trend. The chances of a

The first gap up confirms that strong buying

reversal increase even more if the small candle-

pressure carried into the next session. However,

stick is a doji. The third long black candlestick pro-

buying pressure subsides after the gap up and the

vides bearish confirmation of the reversal (see

security closes at or near the open. This creates

Figure 8.44).

the doji.

A close relative of this pattern is the bearish

Following the second candlestick, the price

abandoned baby pattern. The difference is the gap

gaps down below the low of the doji. The gap indi-

found on either side of the second candlestick. The

cates strong selling pressure, and the long black

open of the second candlestick has to gap above the

candlestick confirms it. The strong and sustained

high of the first candlestick. Plus, the open of the

selling pressure on the third candlestick completes

third candlestick has to gap below the low of

the reversal. Further bearish confirmation is not

the second candlestick. The end result is a candle-

required.

stick that is isolated from the rest of the patterns on the chart (see Figure 8.45).

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

Evening Star 䊳

Bearish Abandoned Baby

THIS IS A THREE-CANDLESTICK COMBINATION PATTERN. The most important aspect about this combination is the “star” position of the middle candlestick. The bearish abandoned baby pattern looks very much like the evening star pattern. The only difference is that the low of the middle candlestick is higher than the high of the first and third candlesticks.


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8.46 Evening Star Pattern: eBay

䊳

THE EVENING STAR PATTERN on eBay marked a short-term trend reversal.

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 Harami The 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

䊳

THE BEARISH ENGULFING HARAMI PATTERN is made up of two separate combination patterns. The first combination is the bearish harami pattern. The second combination is the bearish engulfing pattern.


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of a big surge in selling pressure. Usually, this is

These patterns are found at major reversals. The

caused by bad news, a downgrade, a missed esti-

initial surge usually is a good indication of a possi-

mate, or news concerning the overall sector.

ble change of trend direction. However, the public

The next two or three candlesticks serve as a

mistakes it for a pullback buying opportunity and

distribution period as the market works through

pushes it back up. But it fails to break the last

the initial selling spree of the first day. These can-

resistance and sellers step back in, completing the

dlesticks can be of any possible combination. The

pattern (see Figure 8.47).

best ones show a low range of all candlesticks. This

If you can identify these patterns at the early

tells us the market was deadlocked and ended

stages, the possibility of a profit is high. The

with little or no move in price.

trade in this case involves getting into a short

After the buying pressures are absorbed, a new

position after it breaks the low of the first candle.

surge in selling pressure comes in. Sellers become

You should see bearish confirmations when this

aggressive again and bring the price back down to

happens. Volume should pick up as buyers

the closing level of the first candlestick. This forms

from the previous two or three sessions head for

the second part of the combination, the bearish

the exits. This is on top of those who went long

engulfing pattern. No confirmation is necessary

on the position prior to the formation of the

after this pattern is completed.

$ pattern. ●


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CHAPTER

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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


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TECHNICAL INDICATORS

W

HAT 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. Technical indicators are great tools when used

stays on an uptrend, go long and stay long. If the

properly. They offer a perspective from which we

intraday trend is down, go short and stay short. Do

can analyze price action. They help identify trends

this until the market tells you otherwise. You do

and their reversal points. They serve to confirm or

not need a multitude of indicators to figure out

refute certain price actions. When they confirm,

where the market might go. Simply follow the cur-

we can hold onto the trade a little longer. When

rent microtrend.

they refute, it is time to get out. There are three types of indicators: trendfollowing indicators, oscillators, and miscellaneous indicators. This section will concentrate on

KEY TO USING INDICATORS

trend-following indicators and oscillators. Many

Make sure you understand what indicators mea-

of the miscellaneous indicators are used to analyze

sure and under what conditions they work best.

the stock market in general. I believe day traders

Trend-following indicators work best when the

should ignore those indicators. This applies to

market is in an up or a down trend. They tend to

swing traders who hold positions from one to five

give false signals in a sideways market. Oscillators

days.

work best when the market is in a trading range.

For day traders, the short-term trend is the most

They catch turning points when the market is

important. Even in the bear market of 2000, there

moving sideways, but when the market is in a

were ample opportunities to go long for a few

trend, they produce false signals.

days. On any given day, short-term traders should

You can combine different indicators to capital-

follow the current microtrend. If the intraday trend

ize on positive features and eliminate negative

is up, do not enter short positions. If the market

features. The best possible combination is an


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SPOTTING TRENDS

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. Suppose 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

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:

make sure there is a break of the rectangle, with

P + P1 + P2 + P3 . . . + P(N − 1) SMA (N) = ᎏᎏᎏ N

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 indicators. There are more than 100 technical analysis

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

indicators, with more being built every day. There is even technical analysis software that allows

On most occasions, traders calculate the SMA

traders to create their own indicators. However

using the closing price, but there are also complex

the oldest indicators still work the best. They have

strategies that calculate them from the high, the

withstood the test of time. Most traders use the

low, or the open. This also goes for the EMA and

older indicators. This alone increases the likeli-

WMA. It depends on the trader. The trader also

hood of a successful trade. This section discusses

has to choose the number of periods to be used,

only these time-tested indicators. Don’t forget:

which is covered later in this section.

The specialist makes more money than the gen-

An exponential moving average is calculated dif-

eral practitioner. Be a specialist, not a general

ferently than the simple moving average. It assigns

practitioner.

a greater weight to the data on the latest period.


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Thus it responds faster to current events. The for-

erate false signals. I suggest that beginners stay

mula for the EMA is as follows:

away from this moving average.

EMA (N) = (P × K) − (EMA1 × (1 − K))

Choosing the Number of Periods The number of periods to use depends on the

where

K = 2/(N + 1)

underlying sentiment you are trying to measure and

N = periods in the moving average

the trend you are trying to catch. A short time frame

P = price of current period

gives you the average sentiment of that short time

EMA1 = EMA of 1 period before

frame. It changes direction more frequently than a long time frame. A long time frame smoothes out

To calculate this formula manually, do the fol-

the noise, but reacts slowly to directional changes.

lowing: Determine how many periods you want to

Long time frames are used when you want to catch

use for the EMA. Then calculate the value of the

long-term trends. The more popular settings are 10-,

coefficient K. Then calculate a SMA to use as EMA1

20-, 50-, 100-, and 200-period moving averages.

for the first EMA. Use the preceding formula to get EMA (N). Repeat the last step to obtain the EMA

Uses of Moving Averages

for the next period. Computers are available to do

Moving averages can be used to identify trends.

all this dirty work. One press of a button and out

There are several ways to do this. The first is to

come the results.

determine the slope of the moving average line. If

A weighted moving average is also designed to put

the slope is rising, the stock is on an uptrend. You

more weight on recent data and less on past data. It

should go long. If the slope points downward, the

is calculated much like the simple moving average,

stock is on a downtrend. You should short the

except that each period is multiplied by a weighting

stock (see Figure 9.1).

factor. The weighting factor used depends on the

The second method involves finding the current

number of periods chosen. Suppose you want a

price location. If the stock price is above the mov-

three-period WMA. Multiply the most current price

ing average line, the trend is bullish. If it is below

by 3, the price from the prior period by 2, and the

the moving average line, it is bearish (see Figure

price from a couple of periods ago by 1. Add the

9.2). Based on this method, old mechanical sys-

three together and divide by the sum of those peri-

tems would trade the security the following way:

ods. In this case, the sum would be 3 plus 2 plus 1,

Every time the price crosses from below the MA

or a total of 6.

line and closes above the MA line, it generates a

A weighted moving average causes an even

buy signal. Sell the stock if the price closes below

greater reaction to the current price than the expo-

the MA line. A short signal is generated when the

nential moving average. However, it tends to gen-

stock crosses the MA line to close below it. Cover


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9.1 Identifying Trends with Moving Averages

䊳 THE SLOPE OF THE MOVING AVERAGE determines the trend of the stock. If the slope is up, then the trend is up. If the slope is down, then the trend is down.

9.2 Trading Signals from Moving Averages

䊳

THIS CHART ILLUSTRATES the different buy and sell signals generated if you were trading the crossovers.


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the position only when the price closes above the

average is above the long-term moving average,

MA line. The number of periods to use depends on

the stock is said to be on an uptrend (see Figure 9.3).

the trend you are trying to catch. Longer trends

If the short-term moving average is below the

mean using longer periods.

long-term moving average, the stock is said to be

One last note, shorter time periods will generate

on a downtrend.

more signals than longer periods, because they are

Moving averages also identify support and

more sensitive to price movement. In a sideways

resistance levels. If a stock price is above the mov-

market, you get a little whiplash. Look at the

ing average line, a pullback to this line could be a

MSFT chart in Figure 9.2 for a three-month period.

chance to add to a long position. A break below the

It crossed back and forth over the MA line several

moving average line could be a trigger to exit long

times during that period, making it tough for the

positions and go short. If the stock price is below the

trader to follow.

moving average line, a bounce to this line could be

The location of the short moving average line in

a chance to enter a short position or add to an exist-

relation to the long moving average line is another

ing position. A break above the line could serve as a

way to identify a trend. If the short-term moving

trigger to exit a short position and go long.

9.3 Identifying Trends with Moving Averages

䊳

THIS IS ANOTHER METHOD whereby you can use moving averages to identify trends. In our example, MSFT is considered to be on an uptrend when the short-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) moving average.


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SMA versus EMA

turning points on the chart in Figure 9.4, you will

EMA puts more weight on the most current period

notice that the EMA line (dashed line) almost

than the SMA and gradually fades the last period

always turned before the SMA line (solid line)

away. On the other hand, SMA assigns equal

turned. It did not matter whether the change in

weight to each period. In reality, current news and

direction was from up to down or from down to

sentiment should have the most weight. For the

up. The reaction was always faster and earlier.

purpose of day trading, exponential moving aver-

For short-term traders, this slight edge is of

ages work best. Day traders are concerned with

prime importance. The last thing I want is to be

short time frames. Recent news on a security is

stuck in a long position when the trend has already

important in short-term trading. An EMA does the

started to change to the downside.

job, and SMA does not. I suggest that short-term traders use the EMA instead of the SMA (see Fig-

Advantages and Disadvantages

ure 9.4).

Moving averages smooth out the prices, filter out

Using the same periods we had on MSFT ear-

the interperiod noise, and help identify the under-

lier, I removed the candlestick patterns and left

lying trend. They are great trend-following indica-

only the EMA (20) and SMA (20). If you look at the

tors. When the market is in a trend, whether an

9.4 EMA versus SMA

䊳

ALTHOUGH THE EMA AND SMA LINES SHOWN HERE are both calculated based on 20 periods, notice how the slope of the EMA always turns before the slope of the SMA does. This tells us that the EMA reacts to current events a lot quicker than the SMA.


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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.

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, overbought and oversold conditions, and divergences.

Traders should be aware of market conditions before using this indicator. In a sideways market, it

Crossovers

is best to leave this indicator alone. Another disad-

MACD is plotted as two lines on a chart. One is a

vantage of this indicator is the way signals are gen-

solid line and the other a dashed line. The solid

erated. MA traders receive signals only when

line is the MACD line. It is also called the fast line.

prices have crossed over to the other side of the

The dashed line is the signal line. It is also called

MA. The problem is that MA lines are always

the slow line. Trading signals are generated when

drawn from historical data. For this reason, it is

these lines cross each other.

considered a lagging indicator. It lacks the predictive powers of the other indicators we have here.

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

MOVING AVERAGE CONVERGENCE DIVERGENCE

the signal line to close below it, a sell signal is generated (see Figure 9.5).

The moving average convergence divergence

Looking at the KLAC chart in Figure 9.5, we see

(MACD) indicator is another trend-following indi-

four trade signals generated by the MACD. The

cator. It was invented by Gerald Appel, a New

first is a buy signal when the MACD line (solid)

York analyst and money manager. It consists of

crossed the signal line (dashed). Notice that the

three exponential moving averages. To plot the

MACD line was below the signal line before the

MACD indicator, you need to do the following:

signal was generated. Only when it closes above

Calculate a 12-period EMA of the closing prices. Calculate a 26-period EMA of the closing prices

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

Subtract the 26-period EMA from the 12-period EMA.

hold the position. A sell order is triggered only

Plot the difference as a solid line. This is called the

when the MACD line crosses the signal line and

MACD line. Calculate a 9-period EMA of the MACD line.

closes below it. This indicates a sell-to-close or sellshort-to-open position.


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9.5 Moving Average Convergence Divergence

䊳

A BUY SIGNAL IS GENERATED when the MACD line (solid line) crosses above the signal line (dashed line). A sell signal is given when the MACD line crosses below the signal line. Look at how MACD signals help catch a major part of the trends on KLAC.

Notice that the MACD came down several times

tum will end and a sell-off will occur quickly. In an

but never crossed the signal line following the sec-

oversold condition, sellers have been too aggres-

ond buy entry. No action should be taken. It finally

sive. Once the selling momentum ends, only buyers

did break below the signal line on the fifth try. This

are left. They will push the price up rapidly. To

is the only time a sell order should be entered.

determine whether an MACD indicates an overbought or oversold condition, watch the distance

Overbought and Oversold Conditions

between the MACD line and the signal line. If the

Overbought and oversold conditions are indica-

MACD line starts pulling away dramatically from

tions of extreme optimism and extreme pessimism

the signal line, it is possible that the security is

in the market. The market is like a big rubber band.

overextended. Prices could snap back soon.

It can be stretched only so far. Sooner or later, it has to snap back. The longer it’s stretched, the harder

Divergences

the snapback will be. In an overbought condition,

The most powerful signal the MACD can generate

buyers have been too aggressive. Soon, the momen-

is a divergence. A bearish divergence occurs when


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the indicator fails to confirm that a new high has

Between point A and point B, you will notice the

been established. This means that while the price

following: Point B is a new high price. MACD at

has hit a new high, MACD stayed at the same levels

point B is also higher than it was at point A.

or lower than the previous high. A bullish diver-

MACD has confirmed this price move. It is vali-

gence occurs when a new low is established and the

dating a new peak in price. Chances are the price

indicator fails to confirm the move with a new low.

will move higher again in the future.

Let’s analyze the KLAC chart to see whether a

Between point B and point C, things are differ-

bearish divergence has occurred. Pay no attention

ent. Point C is a new high in price. However,

to the crossover trade signals that it is generating.

MACD has not established another high. It has

Simply look at the three price peaks I have circled

now fallen below the MACD high set at point B.

in Figure 9.6. Each of these peaks has a correspon-

This is when a divergence is said to have occurred.

ding MACD reading. To find out what the read-

As you can see in Figure 9.6, the signal foretold

ings are, follow the long line down to the bottom of

the big decline that ensued the next month. The

the chart.

stock dropped from around $95 to below $50. 9.6 MACD Divergences

䊳

THE CHART OF KLAC HERE SHOWS that, although prices broke to a new high between points B and C, MACD failed to confirm to move with a new high. A bearish divergence signal was triggered as soon as the slope of the MACD turned down.


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161

MACD HISTOGRAM

when the slope turns downward. Once a short

The MACD indicator can also be plotted into a histogram. The MACD histogram measures the difference 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 second, an extremely strong signal, occurs when there is a price divergence with the MACD histogram.

position is opened, place a stop-loss order just slightly above the last high. The chart of E-mini Nasdaq 100 futures in Figure 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 frequently. 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 follow this method will find themselves stopped out several times until they finally catch a big run. The

Slope Direction Change

big runs usually pay for the losses. Unfortunately,

The most important part of the MACD histogram

there are times when the market does not have a

is the slope. If the slope is up, then consider long

strong trend and losses are substantial. A better

positions. If the slope is down, consider short posi-

way is to use different time frames. A long-term

tions. Trading signals are generated when the fol-

trader should use a weekly MACD chart. A short-

lowing conditions apply: For buy signals, the

term trader can use the daily charts for intraday

MACD histogram has to be below the zero line. A

trade signals. Never use the same period as the one

trading signal is generated once the slope of the

you are trading. Back away and look at the bigger

histogram changes. Once a position is entered, a

picture.

stop-loss order should be placed just slightly below the last support.

Divergences

For sell signals, the MACD histogram has to be

MACD histograms also generate divergence sig-

above the zero line. A trading signal is generated

nals. This signal does not occur often, but it is a


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9.7 MACD Histogram

䊳

BUY AND SELL SIGNALS ARE GIVEN on this indicator when the direction of the slope changes. When the slope of the MACD histogram turns up, it generates a buy signal. A sell signal is given when the slope of the MACD histogram turns down.

strong trading signal. Divergences tell us that the

Two bullish divergence signals were generated.

bulls are losing momentum in an uptrend. The

The first occurred between point A and point B.

stock is due for a reversal. On a downtrend, diver-

Point B established a new low for BRCM. The

gences also suggest that sellers are losing momen-

MACD histogram failed to confirm this signal.

tum. They are getting weaker. A possible reversal

This set up an entry point when the slope

could be in the works. Bullish divergences occur

turned upward. The stop-loss point should be

when the MACD histogram fails to confirm a new

placed just slightly below the low of point B. After

low in price, and bearish divergences occur when

a small rally, sellers again stepped in and forced

the histogram fails to confirm a new high in price.

the price down. The stop-loss point was hit and the

Let’s take a look at the chart of BRCM in Figure

trade was closed for a loss. The sell-off ended at

9.8 and discuss the divergence trade signals. Pay

point C, and another bullish divergence signal was

attention to the slope change for signs of trend

triggered. Point C was a new low in price, but the

direction change.

histogram failed to confirm it.


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9.8 MACD Histogram Divergences

䊳 DIVERGENCES BETWEEN THE MACD HISTOGRAM AND THE PRICES can identify major trend reversals. As prices on BRCM declined to new lows between points A to B and B to C, this indicator makes a slightly higher low each time. This is a bullish divergence signal. BRCM made a very powerful move once the slope on the MACD histogram turned up (which was your buy entry signal).

The strongest bullish signals are those in which

STOCHASTIC OSCILLATOR

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 completely 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

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: C − L(N) %K = ᎏᎏ × 100 H(N) − L(N)

9.8) proved to be profitable. The stock ran from $35

冢

to $44. This more than covered the small loss sustained on the first trade.

where

C = close of today

冣


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L(N) = lowest point within the number of periods selected H(N) = highest point within the number of periods selected

Overbought and Oversold Levels The 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

The %D is obtained by calculating a moving

and then rises above that level. A sell signal is gen-

average of %K. The number of periods for this

erated when the stochastic oscillator (either %K or

moving average usually differs from the number

%D) rises above the 80 percent level and later falls

of periods used for %K. The standard number of

below it.

periods for %K is five, with a smoothing period of

The chart of BRCD in Figure 9.9 shows the buy

three. I have also seen a 5/3, a 10/3, and a 14/8

and sell signals generated using the first method.

combination used successfully. A shorter %K

Protective stops on a long position should be

period catches more turning points, while a longer

placed just under the most recent low, while a pro-

%K period (14 to 21) will help identify significant

tective stop on a short position should be placed

turning points.

just above the most recent high. For long positions,

It is impossible to get a negative number as a

tighten stops on the position once it gets close to

result. Since it is calculated as a percentage of the

the overbought level. For shorts, tighten stops on

periods’ high and low range, the result would

the position once it gets close to the oversold level.

fluctuate between 0 and 100. A reading of 100 per-

Notice that BRCD (see Figure 9.9) started to form a

cent indicates that the price closed at its highest

downtrend toward the end. Buy 4 would have

level within the selected number of periods. A

been stopped out for a loss. Stochastic oscillators

reading of 0 percent tells us that the price closed

work well in a sideways market, but they generate

at its lowest level within the selected number of

a lot of false signals when the market is in a trend.

periods. On the chart, the %K is plotted on a solid line

Crossovers

and the %D is plotted on a dashed line. Reference

The second trading signal generated by the sto-

lines are drawn at the 20 percent and 80 percent

chastic oscillator is the crossover. A long entry is

levels. When stochastic reaches the 80 percent

generated when the %K line rises above the %D

level, the market is considered overbought. When

line, and a short is generated when the %K line

it goes below the 20 percent level, the market is

drops below the %D line. In this case, you would

considered oversold.

also use a crossover as an exit signal. Most traders

Stochastic oscillators generate three popular

are always in a position. They cover their short

trading signals: overbought and oversold levels,

positions and go long, and later they sell the long

crossovers, and divergence.

and go short at the same time. During a sideways


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SPOTTING TRENDS

9.9 Stochastic Overbought and Oversold Trade Signals

䊳

STOCHASTIC BUY SIGNALS ARE GENERATED when this indicator falls below the 20 percent level and then rises above it again. A sell signal is given when this indicator rises above the 80 percent level and then falls below it again. The chart here shows you all the different signals that would have been generated on BRCD using this indicator.

market, this strategy can produce good profits for

Divergence

traders.

Divergence signals in stochastic oscillators are also

The chart of QLGC in Figure 9.10 makes the

powerful signals. A bullish divergence occurs when

idea a little clearer. In this method, the stochastic

prices establish a new low but stochastic fails to

trader would always be in a position. Every buy

follow suit. A strong buy signal is given as soon as

marks a point where the trader is covering a short

stochastic turns up from its second bottom. The

position and reversing it to go long. Every sell

best buy signals are those in which the first bottom

marks the point where the trader sells to close the

is below the 20 percent reference line and the sec-

long position and also sells to open a short posi-

ond is above it.

tion. In this case, the only time the trader takes a

A bearish divergence occurs when the price estab-

loss is when the trend continues down on the sec-

lishes a new high but stochastic manages to stay

ond to the last buy signal.

below the previous high. A strong sell or short sig-


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9.10 Stochastic Crossover Trade Signals

䊳

BUY AND SELL SIGNALS ARE ALSO GENERATED when the two lines cross. Look to 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 you were trading the crossovers.

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 reference line and the second top is below it. Agood example of a bearish stochastic divergence is ITWO, shown in Figure 9.11. The price at point B managed to break to a new high, a bullish sign. However, when compared with point A, stochastic tells a

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 closing price. It is a good leading indicator. It never lags behind. This is one of the reasons its popularity has grown. The formula for RSI is as follows:

different story. It refutes the move and is unable to go

RSI = 100 −

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.

where

冢

冢冣冣

100 ᎏ U 1 + ᎏᎏ D

U = average of upward price change in the selected period


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SPOTTING TRENDS

D = average of downward price change in the

4 ●

selected period

price that went lower by subtracting the preceding closing price from the closing price within the selected period.

Six steps need to be taken to calculate this oscil5 ●

lator:

Figure the downward price change for each closing

Calculate the average downward price change by adding the downward price change within the period and

● 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 ●

3 ●

dividing it by the selected number of periods. 6 ●

Finally, calculate the RSI by plugging in the values obtained in steps 3 and 5.

Figure the upward price change for each closing price that went higher by subtracting the closing price from the

Isn’t it great that we have computers to do all that

preceding closing price within the selected period.

calculating for us?

Calculate the average upward price change by adding

The results are then plotted in a separate study.

all upward price changes within the period and dividing

RSI results will fall between 0 and 100. Like the sto-

the result by the selected number of periods.

chastic oscillator, reference lines are also drawn to

9.11 Stochastic Divergences

䊳

THE MOST POWERFUL SIGNAL THIS INDICATOR CAN GENERATE is the divergence signal. This chart shows a bearish divergence on ITWO. Although prices rose to a new high, the stochastic line failed to confirm the move. Instead, this indicator established a lower high.


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indicate overbought and oversold conditions. For

then rises above it. Sell signals are generated when

RSI, they are often drawn at the 30 and 70 levels.

RSI goes above the upper reference line and then

Some traders change these levels according to

crosses back below it (see Figure 9.12).

market conditions. For bear markets, they use a 20

The chart in Figure 9.12 shows the buy and sell

and 60 level. For bull markets, they draw the lines

signals generated if you were trading HPQ using

at the 40 and 80 levels. When you vary the levels of

RSI levels. Stop-loss points on these trades should

your reference lines, make sure that RSI has spent

be at the most recent low for a long position and

less than 5 percent of the time at those levels for

the most recent high for a short position. In the

the past 80 to 100 periods. Otherwise, you need to

case of HPQ, the second sell signal would have

redraw them to better fit the conditions.

resulted in a loss when the price surged upward.

When Wilder introduced this oscillator, he rec-

After exiting the position, sit on the sidelines and

ommended using a 14-period RSI. The 9- and 25-

reevaluate the opportunity before reentering. The

period RSIs have since gained a wide following.

third sell signal proved to be profitable after RSI

The lowest period I recommend on RSI is seven.

declined below the reference line again.

You should experiment with different periods to

This method of entering into a long and short

find out which works best for you. Keep in mind

position is best combined with the trend of the big-

that the lower the number, the more volatile the

ger picture. If you first check the trend on the

indicator tends to be. Volatile indicators generate

weekly chart, entering on an RSI-level trigger usu-

more trading signals than less volatile ones. For

ally produces better results. For intraday trading,

short-term traders, volatile is better, because they

make sure the direction of your RSI trade coincides

catch short runs. Long-term traders should work

with the trend on the daily chart.

with a higher number of periods.

Just to be clear on this issue, if the stock is on an

In his book, New Concepts in Technical Trading

uptrend on the daily chart (bigger picture), the only

Systems, Wilder discusses five uses for the RSI.

trade I would take based on the RSI level intraday

However, the most common uses are for over-

is a long. In order for it to trigger an entry, intraday

bought and oversold conditions, chart patterns,

price has to meet the preceding conditions. On the

and divergences.

other hand, if the stock is on a downtrend on the daily chart, the only trade I would take based on

RSI Levels

RSI level intraday is a short. Again, RSI level condi-

The relative strength index usually turns around

tions also have to be met before I would trade.

when it goes above the upper reference line at 70 percent. It also bottoms below the lower reference

Chart Patterns

line at 30 percent. Buy signals are generated when

Classical technical analysis works better with the

RSI declines below the lower reference line and

relative strength index than with any other indica-


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SPOTTING TRENDS

9.12 Relative Strength Index

䊳 RSI BUY AND SELL SIGNALS ARE GENERATED much like stochastic signals. The only difference is that RSI uses the 30 percent and 70 percent levels. When this indicator rises above the 70 percent level and falls back below it, a sell signal is generated. When this indicator falls below the 30 percent level and rises back above it, a buy signal is given. The chart of HPQ shows the different RSI buy and sell signals that would have been generated.

tor. Trendlines, supports and resistance, triangles,

Divergences

and head and shoulders patterns will all work

Divergences between RSI and prices also give the

with RSI.

best signals for this indicator. A bullish divergence

The RSI will often complete patterns or a trend-

occurs when a new low price is established and the

line break before the charts. If you see an ascend-

RSI indicator fails to confirm the move with a new

ing triangle breakout on RSI, chances are the price

low. The best bullish RSI divergence setup is when

of the stock will also break out to new highs. This

the first RSI bottom is below the lower reference

prepares you for the upcoming move.

line and the shallower second RSI bottom is above

Another example would be a trendline break.

the lower reference line. When a bullish diver-

When RSI breaks an uptrend line, get ready to go

gence occurs, enter long as soon as RSI turns up

short when the uptrend line of the stock is broken.

from the second bottom. Place a stop-loss order


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slightly below the latest low. Trail to exit the posi-

made a lower top. A sell-short signal was gener-

tion to maximize profits.

ated when RSI turned down below the 70 percent

A bearish divergence occurs when the price

level. A stop-loss order should be placed above the

makes a new high but the RSI indicator makes a

peak at point B. The stock turned around from

lower top. This signal is strongest when the first

there and headed south more than 40 points.

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

ON-BALANCE VOLUME

order slightly above the latest high. As always,

Joseph Granville developed this indicator. It was

trail to exit this position to maximize profits.

originally presented in his book, New Strategy of

The chart of AMZN in Figure 9.13 shows an RSI

Daily Stock Market Timing for Maximum Profits. On-

setting of nine. It is showing a bearish divergence.

balance volume (OBV) is a leading indicator that

The price hit a new peak at point B, but the RSI

relates volume to price change. It keeps a running

9.13 RSI Divergences

䊳

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, RSI made a lower high. It was not able to confirm the breakout. A short position taken once this indicator turned would have profited handsomely.


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SPOTTING TRENDS

total of volume, rising and falling depending on

price broke slightly lower than the low established

the changes in the closing price. If the price closed

in the middle of June. However, OBV failed to con-

higher than the previous period, volume for the

firm the move. If you compare the OBV level

period is added to OBV. If the price closed lower

between the two lows at point A and point B, you

than the previous period, volume is subtracted

will notice that OBV was higher at point B. To con-

from OBV. If the price closed the same as the previ-

firm the price breakdown, OBV should be lower at

ous period, then OBV stays the same. The most

point B than at point A. In this case, it was not. A

basic assumption regarding OBV analysis is that

bullish divergence is said to have occurred.

OBV moves before the price. That is why it is considered a leading indicator.

The trade would be to go long once OBV turned up. Place a protective stop just slightly below the

The OBV movement gives us an idea of what

low of point B. Entry on this trade would be some-

the large institutions are doing. If it is rising,

where around $28. The stock ran all the way past

money is flowing into this security. If it is falling,

$40, for a nice gain of over $12.

chances are the institutions are cashing out of this security. One of the trading signals OBV generates is

ACCUMULATION/DISTRIBUTION

based on this condition. A buy signal is generated

This leading indicator, called accumulation/distri-

if OBV breaks out and reaches a new high. The

bution (A/D) was developed by Larry Williams in

breakout confirms the buying strength and indi-

1972. He described it in his book, How I Made a Mil-

cates that prices are likely to go higher. On the

lion Dollars. Like OBV, this indicator also incorpo-

other hand, a sell signal is generated if OBV breaks

rates volume into its analysis. However, instead of

down and reaches a new low. The breakdown con-

just tracking volume’s relationship to changes in

firms that sellers are in control of the market and

closing prices, this indicator also tracks volume’s

prices are likely to decline further.

relationship to the high-low range.

The OBV gives a second trading signal when it

The A/D line is calculated by adding and sub-

diverges from prices. If the price rallies to a new

tracting part of each period’s volume from a

high, but OBV does not, then a bearish divergence

cumulative total. The amount of volume added or

signal is triggered. You should sell to close long

subtracted depends on the relationship between

positions or sell to open a short position. An OBV

the close and the high-low range. More volume

bullish divergence occurs when the price hits a

would be added to the cumulative total if the secu-

new low while OBV establishes a higher bottom.

rity closed at or near its high.

This generates a strong buying signal.

Conversely, if the security were to close near its

The IDTI chart in Figure 9.14 shows an OBV

low, a lot more volume will be subtracted from the

bullish divergence. In the early part of July, the

cumulative total. If the closing price was exactly in


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9.14 On-Balance Volume Divergences

䊳

BULLISH OR BEARISH DIVERGENCES on this indicator rarely occur, so they are very powerful signals. This chart of IDTI shows a bullish divergence signal between points A and B. Notice how the OBV indicator failed to confirm the breakdown in price. Sellers did not have any power at all to move the prices down. Prices turned up and the trend reversed.

the middle of the period’s range, then nothing is

uptrend while the market is strong. The A/D line

added to the cumulative total.

should also be leading the downtrend in a weak

The formula for A/D is as follows: (C − L) − (H − C) A/D = ᎏᎏ × V (H − L) where

C = closing price L = lowest price H = highest price V = volume

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 resistance 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

Interpretation of the A/D line is basically the

confirms the signal. A breakdown of the A/D line

same as OBV. The A/D line should be leading an

to a new low is a signal that prices will be declin-


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SPOTTING TRENDS

ing soon. Go short as soon as price action con-

them in their technical studies that you can add to

firms the signal.

your charts. If not, a simple spreadsheet can be set

Second, a stronger signal occurs when the A/D

up to do the calculation for you, and you can then

line diverges from prices. A bearish divergence

draw the lines manually on most charting pack-

occurs when a new high in price is not confirmed

ages. Pivot points are based on the prior day’s

by a new high on the A/D line, and a bullish diver-

high, low, and close. These values suggest where

gence occurs when a new low in price fails to see a

the futures will pivot up or down and hit levels of

new low on the A/D line. Bullish divergence gives

support or resistance. You can also apply them to

strong buy signals while bearish divergence gives

individual stocks, but they work best on futures

a strong sell signal.

contracts. To calculate the pivot point support and resist-

FUTURES AND PIVOT POINTS

ance levels, you need yesterday’s high, low, and close. The pivot point is simply the average of the

The candlestick chart in Figure 9.15 shows a lot of

high plus low plus close, or (H + L + C) ÷ 3. Sup-

information: stochastic %D, volume, MACD his-

port level 1 is calculated by multiplying the pivot

togram, and three moving averages. All of these

by 2 and then subtracting the day’s high. Resis-

have been discussed previously. What is new is

tance level 1 is calculated by multiplying the

that pivot point lines have been added. The E-mini

pivot by 2 and then subtracting the day’s low.

futures are very useful in spotting trends. Remem-

Finally, the secondary support (S2) and resistance

ber, both the Nasdaq and S&P futures contracts are

(R2) levels are calculated by using the numbers (P,

based on the Nasdaq 100 and the S&P 500 Indices.

S1, and R1) created in step one. This is how they

The old saying “A rising tide lifts all boats” (and

are calculated:

vice versa) is very true. If, for example, you are in H+L+C Pivot (P) = ᎏ 3

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

where

Resistance level 1 = (2 × P) − L

lead the market, so watching them closely will

Support level 1 (S1) = (2 × P) − H

help your trading.

Resistance level 2 (R2) = (P − S1) + R1

Adding pivot points adds one more piece to

Support level 2 (S2) = P − (R1 − S1)

puzzle. As you can see in the chart in Figure 9.15 showing S&P E-minis, the market hit resistance

Once you have made these calculations, it is

and support right on the S1 line and also on the PP

best to plot them on your intraday futures chart.

line. The calculation of pivot points is fairly sim-

These lines will often alert you to areas where the

ple. Most of the better trading platforms include

market is likely to turn. There are three ways you


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9.15 Futures with Pivot Points

䊳

THE E-MINI FUTURES WITH PIVOT POINTS are a valuable tool for determining trend and support and resistance.

can take advantage of this information. First, let’s

tion. The reason is because as the market turns and

suppose you are in a trade that is on the same

goes against your trade, it is very likely that your

direction as the market. As the market gets close to

position will also move against you. Second, let’s

a pivot point, my suggestion is to watch your posi-

suppose you are looking to get into a position. If

tion a little closer. Should the market reverse at the

the market is nearing a pivot point and the direc-

pivot point, you might want to tighten your stop a

tion it traveled before is the same as the direction

bit or even choose to take some profits on the posi-

of your trade, my suggestion is to hold off on the


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SPOTTING TRENDS

entry. It is better to wait until the pivot point is bro-

when the market is in a trading range. Make sure

ken before entering the position. Third, if the mar-

you know what the current market conditions are

ket is nearing a pivot point and the direction it

before using an indicator to trade.

traveled before is opposite the direction of your

For the purpose of short-term trading, it is not

trade, my suggestion is to get in immediately on

necessary to learn the whole encyclopedia of

the trade once you see prices on the futures bounce

trading indicators. The most basic technical

off the pivot point. The reverse would put your

analysis tools, the most basic charting methods,

trade in the same direction as the market and

and the most commonly used technical indicators

should help your trade.

are all you need to succeed. It is more important to learn how to use each of these tools properly

CONCLUSION

than to learn more tools. Mastering the basic techniques will give you the edge you want. The rest

Trend-following indicators work well when the

depends on your discipline and dedication. Trade

market is in a trend, and oscillators work better

$ only when you have developed a solid plan. ●


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CHAPTER

Page 177

10

Preparing for the 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


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THE TRADING DAY

G

ETTING 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.

Be prepared. The first step is to be prepared. This

ing from −1 to −5. Bearish divergences rank the

means following methodology and risk manage-

highest while bearish reading generated by basic

ment disciplines. Never step into day trading if

technical analysis would have a value of just −1.

you are not prepared.

After assigning these values, I add everything

Here is the step-by-step preparation process that I go through.

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-

DO THE RESEARCH

itive. For example, a stock on an uptrend (+1) that is breaking out of resistance (+1) will have a value

What you need to research depends on the

of +2. It will rank higher than a stock that is just on

methodology you choose. In Chapter 9, I outlined

an uptrend and that has a value of +1. A stock on a

several good trading signals and opportunities.

downtrend (−1) will not be as negative as a stock

Each and every day I rank the stocks on my watch

on a downtrend (−1) that is breaking a support

list according to the type, strength, and number of

level (−1). This is because the second stock has a

signals they have generated. Each signal is

total value of −2. The best trading candidates are

assigned a value depending on the strength of

those at the two extremes, the most bullish and the

those signals. Stocks that are mildly bullish will

most bearish. I recommend following just a few

have a value of +1. They show a breakout of a

until you are comfortable handling more. I have

resistance, an uptrend above the 20-day moving

followed as many as 40 stocks on a given day, 20 of

average, and an RSI crossover above the lower ref-

the most bullish and 20 of the most bearish.

erence line. The more powerful signals are

Here are a few things to watch out for when you

assigned bigger values. All bullish divergences

are assigning values. Do not follow two indicators

will have a value of +5.

of the same type. They tend to give the same signals

Bearish stocks will have negative values rang-

and skew the results according to their advantages.


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PREPARING FOR THE OPEN

When using the oscillator and volume indicators,

at what price point you will consider entering into

follow just one indicator. This goes for trend-

a position. One of the most common entry points

following indicators, too. Do not forget that some of

for short-term traders is a break of the previous

these indicators can generate more than one trading

day’s high or the previous day’s low. A break of

signal. When both signals are triggered, both of

the previous day’s high triggers a signal to go

their values have to be added to the running total

long. A break of the previous day’s low triggers a

for the stock. Finally, the values you place on each of

signal to go short. This is because the high and low

these bullish and bearish signals should be adjusted

of the previous day were the resistance and sup-

based on your trading experience. If you have had

port levels that day.

successes with breaks of support and resistance lev-

Other entry points are those called for on the

els, assign a higher positive and negative value to

chart patterns you found—such as breakout or

these indicators so they come to the top of your list

breakdown prices on a rectangle formation. The

more often. It makes sense to trade the combina-

choice should be based on the methodology or sys-

tions that have made money for you in the past.

tem that generated the trading signals. Whatever your entry points are, you need to note them on your trading candidate list. Then fig-

MANAGE RISK

ure the stop-loss point for each of these candidates.

The next step is to work on risk management. To

Again, their location depends on the methodology

use risk management effectively, you must know

that generated the signal. A bearish divergence sig-

TABLE 10.1

Sample Risk Management Table

Account size: $50,000 Percentage 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

7.52

490

CKFR 20.76 17.66

323

MERQE 25.52 27.39

267

6.50


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nal usually has a stop above the latest minor high.

systems. This is an area you want to research

A rectangle would have the stop placed slightly on

when picking a trading platform, because it

the inside of the rectangle. Each of the methods we

becomes an important part of most trading sys-

described in the earlier chapter has its own stop-

tems. An alert is a software function that will at a

loss point. It is important that you follow them.

minimum alert you when a price has been hit.

They have already been time-tested, so you do not

The better platforms take this function much fur-

have to reinvent the wheel. Next, calculate the

ther. Some will alert you, place orders, cancel

appropriate number of shares to take in the posi-

orders, load stocks in the order entry window,

tion. Divide the risk per trade by the per-share

and more. Figure 10.1A shows you an example

stop-loss amount to arrive at the number of shares

of the alert entry window on CyberTrader Pro.

to trade for each candidate. You end up with some-

After alerts are entered you need a way to keep

thing similar to Table 10.1, which should be pre-

track of them and modify them. Figure 10.1B

pared before the market opens. Mark your long

shows the Alert tab in CyberTrader that lists all

candidates on one side of the sheet and the short

of the active and inactive alerts. Placing an alert

candidates on the other side. Then list the number

on all candidates helps you in a number of ways.

of shares you want to trade. When the entry signal

It is impossible to follow all candidates all the

is triggered intraday, all that is left is to get the

time. Loading all the trade candidates into a

order executed.

Market View window (see Figure 10.2) will reduce your workload by allowing you to organ-

SET ALERTS AND TRADING SCREENS

ize them and check the status of the alert (high and low) for the day, change from open and

After the preceding steps, set your alerts and

close, review the 52-week high, switch industry

trading screens. It will be obvious after a few

sectors, and so on.

days that you do not trade the same stocks all the

Traders who continually miss opportunities

time. When you trade with a ranking system, the

have a tendency to force their trades. They get into

candidates will rotate from day to day. Today,

trades late, or, fearful of missing the next opportu-

QCOM might be one of the strongest candidates,

nity, they get into a trade early, before a confirma-

and the next day it may not be. The trading

tion has been generated. When your entry is late,

screen on your computer must be changed man-

the risk is higher because the stop-loss point is fur-

ually as new trading candidates emerge. Do this

ther away. Both cases will lead to poor results.

before the market opens. Now set your alerts.

Another tendency is to try to make the late entry

Most real-time trading software programs come

work by holding it. This means you let your losers

with alert functions. Some platforms offer only

run. This fear of missing opportunities does not

very basic functions; others offer very elaborate

breed confidence. It is a never-ending cycle that


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10.1 Alert Entry Window 䊳

THE ADD ALERT WINDOW, where an alert for BIDU is being set, and the Alert tab in the Account Manager, where all the alerts are listed and can be edited, removed, activated, or deactivated.


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10.2 The Market View

䊳

HERE IS THE PLACE to keep track of all trading candidates.

can easily be broken by simply setting alerts. It

trade entries, what will become of their open posi-

does not take a lot of effort or time, and the results

tions?

can be dramatic.

A large part of trading involves trade manage-

Placing an alert also frees the trader to do other

ment. After getting into a trade, your first concern

things. Many professional traders take on multiple

is to control losses. You need to place an order to

positions. If their attention is devoted to catching

exit at the stop-loss point. If the trade goes your


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way, you still have to manage your trade. You need

plants” and constantly calculate the indices with

to take steps to protect profits. You need to watch

very little lag time, usually just seconds. Futures

the market. You need to watch the stock. You need

indices are considered leading indicators. Index

to move your trailing stops. There is always some-

futures are very actively traded. They tend to

thing to do, especially if you carry multiple posi-

move before the underlying stocks. More discus-

tions. Don’t forget that you can set an alert for

sion of futures follows.

stop-loss orders, or on some platforms just go

Keep in mind that you need only follow either

ahead and place the order where it is held on the

the cash indices or the futures indices. It is not nec-

server. A little extra safety just in case you have

essary to follow both.

Internet connection problems or computer breakdowns.

INTRADAY TRADING

MARKET INDICES In the business world, nothing is truly independent from the rest of the world. Economies are

Ding! Ding! Ding! The market is now open for

interrelated. The economy of Europe can affect the

business! What do you do next?

economy of Asia. The same is true in the stock

The first step is to watch the market indices. A

market. If the general market is bullish, a large per-

market index is a moving average of a group of

centage of stocks will head up. In a general market

stocks, either within a specific sector or encompass-

decline, most stocks will head down. Traders who

ing all sectors. The market index acts as a barome-

forget this fact have a hard time making a profit.

ter for either a specific sector or the entire market.

They struggle because they are fighting the gen-

The most well-known indices are the Dow Jones

eral sentiment of the market.

Industrial 30, the Nasdaq Composite, the NYSE Composite, the S&P 100, and the Nasdaq 100.

The Nasdaq Composite charts in Figures 10.3 and 10.4 show that going long on stocks between

There are two types of market indices—cash

October and March in 2000 would have generated

and futures. The cash indices are a compilation of

good profits. Both investors and traders made a lot

the data gathered from all the stocks in the index.

of money holding onto their stocks during that

For example, the cash index of the Dow Jones 30 is

period (see Figure 10.3).

based on the stock prices of those 30 underlying

Going long during the period shown in Figure

stocks. But the index changes only after the stock

10.4 would have resulted in disaster. The market

prices have already changed. That is why they are

declined more than 50 percent from September to

called lagging indicators. The results are always

March in 2001.

after the fact, although today some brokerages,

These two charts cover a long time period. But

CyberTrader being one, have their own “ticker

the relationship between market direction and the


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10.3 Market Trend

䊳

THE TREND ON THIS NASDAQ CHART is clearly up. Taking long positions on individual stocks offers a much better chance of success during these times.

10.4 Market Trend

䊳

THE TREND ON THIS NASDAQ CHART here is down. During these times, it is better to be trading short positions on individual stocks. The market weakness dragged almost all the stock prices down with it.


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direction of individual stocks is also true in the

capitalization-weighted. The S&P 500 is made up

short term. In the short term, a high percentage of

of 500 large- and mid-cap stocks, and the S&P 100

stocks will follow the market. If the market is

(OEX) is made up of the 100 largest stocks from

strong, long positions on individual stocks have a

the S&P 500.

good likelihood of success. If the market is weak, short positions would be a better choice.

The S&P 500 represents all major industries, including 400 industrial stocks, 20 transportation

Make sure you know the general market direction

stocks, 40 financial stocks, and 40 utility stocks.

before making a trade. Here are some of the cash

Because of the larger number of companies

market indices that traders should follow.

involved and its wider scope, this index is one of the better barometers of where the market is

Dow Jones Industrial Average

headed. This index is also widely used to measure

The most famous market index and the one most

the performance of money managers. Mutual

associated with the stock market is the Dow Jones

fund managers and institutional investors are

Industrial Average (the Dow). The Dow is made

often graded by their ability to beat this index.

up of 30 industrial stocks. They represent the

Fund managers who have produced gains less

largest companies in America. The current list of

than this index often find investors moving their

companies on the Dow can be found on most

capital to index funds, which have lower fees.

financial web sites.

This makes it the most closely watched index of them all.

NYSE Composite Index The NYSE Composite Index is made up of all 3,300

Nasdaq Composite and Nasdaq 100 Index

stocks listed on the NYSE. This index is weighted

Nasdaq comprises more than 5,000 securities and

based on capitalization. Companies with large

has a high concentration of technology stocks. The

capitalization have more weight in the index than

Nasdaq Composite Index is generally considered a

smaller companies. Large-capitalization stocks

good barometer of technology stocks. Nasdaq is a

move the market more than their smaller counter-

two-tiered structure consisting of the Nasdaq

parts. This index works better than the Dow Jones

National Market (NNM) and the Nasdaq Small-

30 Index to determine the strength or weakness of

Cap Market.

the NYSE.

The Nasdaq National Market is made up of larger companies with actively traded securities.

S&P 500 and S&P 100

The Nasdaq Small-Cap Market is made up of com-

Standard and Poor’s (S&P) has two indices that

panies with assets of less than $12 million. Within

have become barometers of the market: the S&P

these two tiers there are more than a dozen differ-

500 and the S&P 100. Both of these indices are

ent Nasdaq indices.


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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

OTHER MARKET INDICATORS Here are several other indicators you should be aware of.

www.nasdaq.com on the web. The Nasdaq 100 consists of the largest Nasdaq

Arms Index (TRIN)

stocks. It is a good barometer for the overall

The Arms Index, more commonly known as the

Nasdaq market and is closely watched by many

TRIN, is a ratio calculated by first dividing advanc-

day traders.

ing issues by declining issues and then dividing the resulting number by up volume divided by down

Other Indices

volume. A falling Arms signals a strong market, and a rising Arms suggests weakness.

There 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)

VIX/VXN The VIX is the Chicago Board Options Exchange (CBOE) Volatility Index, which reflects the market 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

Dow Jones Utility Index (UTIL)

declines. It tends to be low when the market is

Networking Index (DOT)

less volatile, usually during extreme up moves

Oil Services (OSX)

and sideways movement. As a result, high readings usually signify too much bearishness, while

Retailers (RLX)

low readings signify complacency. The VIX can

Gas Index (XNG)

be used to measure market sentiment. When

Cyclicals Index (CYC) Healthcare (HCX)

combined with additional timing triggers, it offers

the

opportunity

to

identify

market

extremes and likely reversal points.

Broker/Dealers Index (XBD) Insurance (IUX)

Advance/Decline Line The advance/decline line gives you a good idea of

Semiconductor Index (SOX)

the true breadth of the market. It indicates how

Biotech Index (BTK)

many stocks are up for every stock that is down. If


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more stocks are down than up, then we should be

sidered oversold when the oscillator is below −100

wary of any attempted rally. It indicates a weak

and overbought when it is above +100.

market. A strong market would have more stocks up than down.

This indicator is not a precise market-timing tool. Overbought readings can often become even more overbought. Oversold readings can become

McClellan Oscillator

even more oversold, especially in a trending mar-

The McClellan Oscillator is a market breadth indi-

ket. Therefore, we strongly recommend using the

cator based on the smoothed difference between

McClellan Oscillator in conjunction with other

advancing and declining issues. Markets are con-

market bias indicators.

10.5 Identifying a Trade Candidate (ADVP)

䊳

SEVERAL POINTS MADE ADVP A TRADE CANDIDATE. Point A shows that this stock is in a downtrend. Point B shows the stock price crossing over from above the short-term MA line back down. Point C shows a bearish engulfing pattern. Finally, point D shows RSI rising above the 70 percent line and coming back down below it (a sell signal).


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DIRECTION OF MARKET TRENDS

nothing. This method makes a lot of sense. Think of what it means to have the market in your favor.

When day trading, the intraday direction of the

It means you will trade only candidates with a

market should be your number one concern. If the

high demand or a high supply. If the stochastic

trend is up, trade only the long candidates on your

trader, the trend trader, the pattern trader, and the

list. If the trend is down, trade only the short candi-

breakout trader all get into the same stock at the

dates on your list.

same time, the price will most assuredly go up. On

This idea seems ridiculously simple, but it is the

the other hand, if the RSI trader, the MACD trader,

most powerful way to trade. There will be occa-

the breakdown trader, and the chart pattern trader

sions when the market does not have any trend.

all get sell signals at the same time, the price will

These are the days to sit on your hands and do

most assuredly go down.

10.6 ADVP Intraday Trade

䊳

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.


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Traders take a short ride on the up or down

in a clear downtrend. It crossed over the 20-period

side, take their profit, and move on to the next

EMA to close below it. For short-term trading, this

trade. This way of trading, coupled with proper

is a bearish indication. It has a bearish engulfing

risk management, makes success a possibility, not

pattern. The only thing missing is the bearish con-

just an empty dream. A few examples of this type

firmation. The seven-period RSI was crossed and

of trading follow.

closed below it.

I spotted ADVP as short. If you look at the daily

All of this made ADVP more attractive than the

chart in Figure 10.5, several factors favored a short

rest of the candidates. It showed up at the bottom

position. I marked each of these on the chart in Fig-

of the ranking system.

ure 10.5. They are the following: The stock is now

On the intraday front, here is what happened.

10.7 Identifying a Trade Candidate (MERQE)

䊳

FOUR POINTS MADE MERQE AN INTERESTING TRADE CANDIDATE. First, point A shows a symmetrical triangle. With the trend up, this is a good continuation pattern. Point B shows a bullish harami pattern with a confirming candlestick besides 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 the same time.


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The first confirmation came at the open. The stock

this pattern was a continuation of the weakness

closed at $30.73 and opened the next day at $30.29.

because of the downtrend at location B from the

We have a downside gap at point A in Figure 10.6.

previous period.

We earlier discussed this candlestick pattern as one of the bearish confirmations.

Our entry would be at point D, once the price broke the support level E at 30.05. The stock con-

The next confirmation came when the stock

tinued its decline and formed a double bottom

formed a rounded top pattern on location C, a

chart pattern at F. A break of the resistance G at

bearish formation. Your entry point would be

$28.60 would have signaled an exit. Total profit is

based on the entry of a rounded top pattern,

$1.45, a 5 percent run.

which is a break of the support level. In this case,

Now let’s look at a long candidate. I spotted

10.8 MERQE Intraday Trade

䊳 A BREAK OF THE SYMMETRICAL TRIANGLE (A) triggered a long entry of this stock intraday at 26.85 (B). Using our trailing stop method described earlier, we moved our stop from support level D all the way to support level J. Trade was exited at 29.65 when it broke support level J. Total profit on this trade was $2.80, more than a 10 percent run in two days!


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MERQE for a possible long position trade from my

price broke out and established a new high, we

research the previous day. The daily chart in Fig-

would move our stop-loss up. Our exit price

ure 10.7 shows several things favoring a long posi-

would be moved from C to D, and the D to E, all

tion if intraday conditions were right. I marked

the way to J.

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 confirmation candlestick the next day.

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.

It crossed over the 20-period EMA to close above it. For short-term trading, this is a bullish indication. Trend has

KEEP A TRADE JOURNAL

just turned up. The MACD histogram has also turned up. All of this made MERQE more attractive than the

Keeping a journal of your successes and failures can help you learn. Unless you study your mistakes, it is impossible for you to know which

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. Confirmation came when MERQE formed symmetrical 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 symmetrical triangle pattern, we should enter on a trendline 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

Your Trade Journal

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


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aspects of trading you need to improve. A large

Even losing money can be part of correct behavior.

part of trading is simply minimizing mistakes. If

Remember, taking losses is part of the profession.

you make just 20 percent fewer mistakes and cal-

Never blame yourself for a loss if you used a

culate that into your trading, you will be amazed

proper stop-loss point. The market just failed to

at the results.

go as planned. It simply went into the lower-

There are many possible mistakes in trading.

probability scenario.

You can trade late, missing an opportunity, or exit

Your goal is to find consistent profitability.

too late, sustaining a loss. Your positions can be too

What conditions existed on your good trades?

large. Knowing your weaknesses is vital to your

What were the confirmation signals? These intri-

progress. What methodology generated the sig-

cate details are important because they can form

nals you used? Have these signals been weak in

the basis of future trading. Pay attention to the sig-

the past? Do you need to adjust their values or stop

nals that generated the winning trades. What

trading them?

methodology or what indicator worked? Should

You can eliminate mistakes only if you know

you consider assigning a higher value to it? Strate-

what they are. If you keep getting in late, set your

gies that have consistently made money for you

alerts a little earlier. This gives you time to place

should have a greater value. Move them to the top

the order. Sometimes a mistake might not be your

of your watch list.

fault. It could be the system. Maybe your informa-

All this work will ultimately lay the foundation

tion provider is late. It might be time to change to

of a successful day trading career. Evaluate your

a new data provider. Question everything.

trades every day and continue to improve your

The other major purpose of a trading journal is

techniques and methods. Once all of this is done,

to identify correct behavior. Did you trade cor-

the process repeats itself. Keep your discipline and

rectly? Did you make money? Did you lose money?

$ continue trading your plan. Success will be yours. ●


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Conclusion We 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 trading, 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, finding your financial freedom.


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14762_Chua_2p_bindex.j.qxp

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INDEX A Accumulation/distribution (A/D) indicator, 171–173 formula, 172 Advance/decline line, 186–187 Alerts: placement, 182 setting, 180–183 All-or-none (AON) order, 38 American Stock Exchange (Amex), 40–41 Angle/slope, importance. See Trendlines Appel, Gerald, 158 Archipelago (ARCA), 21, 22, 43, 45 ECN, 28 Arithmetic scale, 71 Arithmetic scaling, contrast. See Logarithmic scaling Arms Index (TRIN), 186 Ascending triangles, 99–101 Attain (ATTN), 22, 43, 44 Average downward price change, calculation, 167 Average upward price change, calculation, 167 Ax, shadowing, 61

B Back testing, 62–63 Bar charts, 67–68 Bearish abandoned baby pattern, 148 Bearish divergence, 165–166, 170 Bearish engulfing harami patterns, 149–150 Bearish engulfing patterns, 140–142 Bearish harami pattern, 144–145 combinations, 144 Bearish patterns, 105, 139–150 Bearish reversal, 140 Bearish stochastic divergence, 166 Bearish stocks, negative values, 178

Best ask, 8 Best bid, 8 Bid/ask spread, 45 Black marubozu, 118, 121, 134 midpoint, 133 Black/black combinations, 144–145, 149–150 Black/white combinations, 144–145, 149–150 Bloomberg Tradebook (BTRD), 22, 43 Breakaway gaps, 90–93 confirmation, volume levels (usage), 90 Breakdown/breakout point, 108 Brokerage firms: accounts, types, 30–32 execution speed, 27 features (see Online brokerage firm features) price, importance, 29–30 reliability, 27–28 selection, 26–27 service, importance, 30 Broker-dealer fee structure, 45 Brokers. See Direct access brokers; Discount brokers; Full-service brokers definition, 8 Brut (Brass Utilities) (SunGard Data), 22, 43, 44 ECN, 28 BTRD. See Bloomberg Tradebook Bullish abandoned baby, 138 Bullish divergence, 165 Bullish engulfing harami pattern, 136–137 Bullish engulfing pattern, 130–133 Bullish harami pattern, 133–135, 140 Bullish patterns, 130–139 Bullish reversal, 124 Buy limit order, 35

Buy stop order, 35–36 Buying momentum, 94, 135 Buying /selling pressures: comparison, 118–119 identification (see Heavy buying /selling pressures

C Cancellation order, 37 Candlesticks, 68–69. See also 20/20 candlestick; Long black candlestick; Long white candlestick; Open candlestick; White candlestick capability, limitations, 122–123 charting techniques, 116 patterns, 123–127 (see also Closed candlestick pattern; Open candlestick pattern) positions, 127–130 usage (see Indecision) wicks, 69 Capital, usage. See Trading Cash accounts, 31, 32 Cash indices, 183 Charles Schwab Corporation, 26, 28 Charting techniques, 72–73 Charts, 30. See Bar charts; Line charts; Point/figure charts patterns, 96–112 (See also Relative strength index) types, 67–71 usage, 67–73 (See also Tick-by-tick chart) Chicago Board Options Exchange (CBOE), 186 CINN identifier, 44 Closed candlestick pattern, 116 Closing price, 87, 119 Combination patterns, 130 Commissions, per-share basis, 29 Common gaps, 89–90


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196

Continuation gaps, 93–94 Corporate stock/bonds, trading, 14 Crossovers, 158–159. See also Stochastic oscillator strategy (see Moving average convergence divergence) Cup with handle pattern, 110–112 Customers, 9 CyberExchange, 28–29 CyberTrader, 28, 29 CyberTrader Pro, 180

D Dark cloud cover pattern, 142–144 Day traders: NYSE/Nasdaq usefulness, comparison, 20 SEC definition, 31 Day trading: overview, 5 personality fit, 2–3 usefulness, 1 Dealers: definition, 8 fee structure (see Broker-dealer fee structure) Decimal pricing, 60 Descending triangles, 99–101 Designated Order Turnaround (DOT): orders, 44 system (see Super Designated Order Turnaround system) Direct access brokers, 27 costs, 30 order routing efficiency, 28 Direct access order entry system, 40 Discipline, maintenance. See Trading Discount brokers, 26 Divergences, 159–160. See also Bearish divergence; Bullish divergence; Moving average convergence divergence; Price; Relative strength index; Stochastic oscillator DJIA. See Dow Jones Industrial Average

INDEX

Dojis (spinning tops), 119–121, 138. See also Dragonfly doji; Gravestone doji; Long-legged dojis Domestic Securities, 44 Double bottom pattern, 76–77 Double top/bottom patterns, 96–98 Dow, Charles (concepts), 66 Dow Jones Industrial, 30, 183 Dow Jones Industrial Average (DJIA), 185 Downside gap, 91 Downtrends, 80–83, 135, 138, 156 Downward price change: calculation (see Average downward price change) determination, 167 Dragonfly doji, 123–124

E Elder, Alexander, 73 Electronic communications networks (ECNs), 20–22 discussion, 42–43 establishment, 27 introduction, 21 list, 43 process, explanation, 21–22 usage, 18 usefulness, 45 E-Mini Nasdaq 100 futures, 161 Entry points, 179 E*Trade, 29 E-trading services, 26 Evening star doji, 147 Evening star pattern, 147–149 Exchange floor, personnel, 9 Exhaustion gaps, 93, 95–96 Exponential moving average (EMA), 153 contrast (see Simple moving average) formula, 154

F Fading the gaps. See Gaps Fast line (%K), 158, 163–164 Fidelity, 26 Fill-or-kill (FOK) order, 38

Firm Quote Rule, 41 Flags, 105–106, 111 Floor: brokers, 9 clerks, 9 traders, 9 Full gap down, 89 Full gap up, 89 Full-service brokers, 26 Fundamental analysis, 62 Futures, 173–174

G Gap down, 127, 128, 148. See also Full gap down; Partial gap down Gap up, 125, 128, 133, 148. See also Full gap up; Partial gap up Gaps. See Breakaway gaps; Common gaps; Continuation gaps; Downside gap; Exhaustion gaps confirmation, volume (usage), 112 fading, 89 occurrence, 87–96 selling pressure, absorption, 139 types, 89 Gerald Putnam, 43 Good-for-the-day (GTD) order, 38 Good-till-canceled (GTC) order, 37 Granville, Joseph, 170 Gravestone doji, 124

H Hammer pattern (hanging man pattern), 121, 124–125. See also Inverted hammer pattern Harami pattern. See Bearish engulfing harami patterns; Bearish harami pattern; Bullish engulfing harami pattern; Bullish harami pattern Harami position, 128–130 Head/shoulders pattern, 103 Head/shoulders top pattern, 101–102 Heavy buying/selling pressures, identification, 116–118 Height, 75


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197

INDEX

Histogram. See Moving average convergence divergence Hi-waves, 120 Houtkin, Harvey, 44

I Immediate-or-cancel (IOC) order, 38 Indecision (identification), candlesticks (usage), 119–120 Indicators. See Technical indicators usage, 152–153 INET, 21, 44 ECN, 28, 45 purchase, 40 Information power, 17–18 Inside range days (IRDs), 134 Instinet, 44 Institutional firms, examples, 16 Internet connection. See Trading Internet Service Provider (ISP) connection, 28 Interperiod noise, 157–158 Intraday Nasdaq charts, 52 Intraday trading, 183 Intraday-trend trading, 61, 87 Intraperiod activity, understanding, 120–127 Inverted hammer pattern (shooting star pattern), 121, 125–127 Investment banks, examples, 17 IRDs. See Inside range days Island ECNs, 44

K Knight Capital Group, 44

L Lagging indicators, 183 Lane, George, 163 Large-cap stocks, 7–8 Limit order, 34–35, 45. See also Buy limit order; Sell limit order; Short limit order; Stop-limit order usage, 35 Line charts, 69

Livermore, Jesse (failure), 55 Logarithmic scale, 71–72 Logarithmic scaling, arithmetic scaling (contrast), 87 Long black candlestick, 121 Long positions, 32–33 Long white candlestick, 116, 120 Long-legged dojis, 119, 121 Long-term trading, 62

M MACD. See Moving average convergence divergence Margin accounts, 31–32 Margin call, occurrence, 31 Market: direction, 185 indicators, 186–187 indices, 183–186 intraday direction, 188 order, 34, 45 orderliness, maintenance, 16 trading range, 82 trends, direction, 188–191 Market markers: responsibilities, 16 types, 16–17 understanding, 15–17 Market-at-close order, 38 Market-at-open order, 38 Marubozu. See Black marubozu; White marubozu candlestick, 191 MAs. See Moving averages McClelland Oscillator, 187 Member firms, 9 Momentum. See Buying momentum; Selling momentum confirmation, 113 scalpers, 60–61 Morning star pattern, 137–139 Morris, Greg, 130 Moving average convergence divergence (MACD), 158–160 crossover strategy, 63

histogram, 161 divergences, 161–163 slope direction change, 161 usage, 82 Moving averages (MAs), 153–158. See also Exponential moving average; Simple moving average; Weighted moving average advantages/disadvantages, 157–158 line, position, 158 periods, number (selection), 154 usage, 82 uses, 154–156 Municipal bonds, trading, 14

N National Association of Securities Dealers Automated Quotation System (Nasdaq), 14–15 100 Index, 183, 185–186 comparison. See New York Stock Exchange Composite, 183, 185–186 Market Center, 40–41, 44 National Market (NNM), 40, 185 National Market Securities (NMS), 15, 41 negotiated market, 15 quiz, 23 service level I, 18 service level II, 18–19, 42 service level III, 19 SmallCap Market, 40, 41 traded securities, classification, 15 trading, 45 National Association of Securities Dealers (NASD), 14–15 quiz, 23 regulatory framework, 22 Negotiated market. See National Association of Securities Dealers Automated Quotation System


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198

New York Stock Exchange (NYSE), 6 Composite Index, 183, 185 level II screens, information, 17–18 listed stocks, 7–8 Nasdaq, comparison, 20 quiz, 23 technological advances, 7 time lines, 7 News/research services, 30 NexTrade (NTRD), 22, 45 Nison, Steve, 134, 144 NMS. See National Association of Securities Dealers Automated Quotation System NNM. See National Association of Securities Dealers Automated Quotation System

O OEX, 185 On-balance volume (OBV), 170–171 O’Neil, William, 110 1-2-3 reversal method, 83–84 Online brokerage firm features, 30 Open candlestick, 68 pattern, 116 Opening price, 87 Optimization: avoidance (see Trading) understanding, 51, 52 Options transactions, 32 Order: books, computerization, 35 cancellation, 45 execution systems, review, 45 routing, 28–29 Order-driven price movement, 20 Oscillators, 152. See also Stochastic oscillator Outside market, 18 Overbought/oversold conditions, 159 Overbought/oversold levels, 164

INDEX

Over-the-counter bulletin board (OTCBB), 20, 41 Over-the-counter (OTC): market, 6, 14 trades, 43

Q

P

Rectangle patterns, 106–109 Regional firms, examples, 17 Relative strength index (RSI), 166–170 calculation, 167 chart patterns, 168–169 day separation, 167 divergences, 169–170 formula, 166–167 levels, 168 prices, divergences, 169 Resistance: area, 118 breaking, 78 identification (see Support/resistance) levels, 73, 103 break, 74 breakout, 80 support level, 77 Reversal amount, 71 Reversal method. See 1-2-3 reversal method Reversal points, 186 Reverse head/shoulders pattern, 103–104 Reward-to-risk ratio, 50–51, 85 Risk management, 49, 55–56, 179–180 work, 55 Rounded bottoms/tops, 109–110 RSI. See Relative strength index

Partial gap down, 89 Partial gap up, 89 Patterns. See Bearish patterns; Bullish patterns; Charts; Combination patterns; Piercing pattern Pennants, 105–106, 111 Periods, number (selection). See Moving averages Per-share stop loss, 180 Piercing pattern, 133 Pivot points, 173–174 calculation, 173 Point /figure charts, 70–71 Positions. See Candlesticks; Harami position; Long positions; Short positions; Star position shorting guidelines, 33–34 types, 32–34 Price: advance, 125 change calculation (see Average downward price change; Average upward price change) determination (see Downward price change; Upward price change) decline, 127 discounts, importance, 66 divergence, 161 importance. See Brokerage firms movements, 71 movements, predictability, 66 scaling, types, 71–72 support level, 101 Proprietary accounts, trading, 16 Pullback, 136

Quick & Reilly, 26 Quote services, 30

R

S Saucer pattern, 109 Scaling, contrast. See Logarithmic scaling Scalping, 60–61 backtesting, inability, 62–63 Scott Trade, 26


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199

INDEX

Sector indices, 186 Securities and Exchange Commission (SEC) enforcement, 22 Self-reliance. See Trading Sell limit order, 35 Sell stop order, 36 Selling momentum, 146 Sell-off marks, 101 Service, importance. See Brokerage firms Shadowing the ax. See Ax Shares (number) trading, calculation, 51–52 Shooting star pattern. See Inverted hammer pattern Short limit order, 35 Short positions, 32–33, 84 Short selling, dangers, 34 Short stop, 36 Short the tops. See Tops Short-term analysis, 140 Shoulder: formation, 102 pattern (see Head/shoulders top pattern; Reverse head/shoulders pattern) Sideways movement, 105 Simple moving average (SMA), 153 EMA, contrast, 157 Slippage, 34 Slow line (%D), 158, 163–164, 173 Small-cap market, 15 SOES orders, 41 S&P. See Standard and Poor’s Spearandeo, Victor, 83 Specialist: clerk, 9 definition, 8 system, 8–9 Spinning tops. See Dojis Spread, capture, 60 Standard and Poor’s: 100 (S&P100), 183, 185 500 (S&P500), 185 index, 86

Star position, 128 Stochastic oscillator, 163–166 crossovers, 164–165 divergence, 165–166 Stock, price action, 153 Stock exchanges, 6 system, 6–7 Stock liquidity, 15 Stock markets: expensiveness, 74 overview, 6 Stop order, 35. See also Buy stop order; Sell stop order Stop price, 36 Stop-limit order, 36–37 Stop-loss order, 76 placement, 94, 95, 170 Stop-loss point, 52–53, 78, 92, 99 hit, 162 setting, 107–108, 110 Super Designated Order Turnaround (SuperDOT) system, 9–11, 44–46 usage, 20 SuperMontage, 41–42 SuperSOES orders, 41 Support level, 73 break, 190 breakdown, 81 establishment, 78 Support/resistance: area, price range, 75 identification, 73–76 strength, 75–76 Swing trading, 61–62 Symmetrical triangles, 99–101, 191

T TD Waterhouse, 26 Technical analysis, 62, 66 Technical indicators, 152 Teenie, 60 Terra Nova Trading, 43 Text chat, usage, 30 Three black cows pattern, 145–147

Three white soldiers pattern, 135–136, 146 Tick-by-tick chart, usage, 67 Time frames, impact, 86–87 Timing sequence, 32 Tops, shorting, 85 TotalView, 42 Townsend Analytics, Ltd., 43 Trade execution, 30 Trade journal, keeping, 191–192 Trading. See Intraday-trend trading; Long-term trading; Swing trading activity, 123 capital, usage, 48 computer, usage, 48–49 days, 178 discipline, maintenance, 53–54 Internet connection, 49 knowledge, impact, 48 losses, acceptance, 52–53 methodology, 49, 56–58 patience, 54 perseverance, 54 products, 30, 32 psychological barriers, avoidance, 56–57 psychology, 49–55 range. See Market requirements, 48–49 research, 178–179 risks, 55 screens, setting, 180–183 self-reliance, 54–55 signals, 179 generation, 172–173 strategies, 60, 76–79 success, 50 elements, 48 system optimization, avoidance, 51–52 time, importance, 48 Trading orders: selection, 34 terms, 37–38 types, 34–38


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200

Trailing stop, 78 Transactions, execution, 16 Trend reversal area, 137–138 Trend-following indicators, 152–153, 174, 179 usage, 82 Trend-following system, 51 Trendlines, 79–87, 106 angle/slope, importance, 84–86 break, signal, 84 validity, 87 Trend-reversal patterns, 96 Trends: formation, 66 identification, 152 Triangles. See Ascending triangles; Descending triangle; Symmetrical triangles patterns, 99–101 trading, 99

INDEX

TRIN. See Arms Index 20/20 candlestick, 116, 118 2 percent rule, usage, 57–58

U Uptick: definition, 33 rule (removal), SEC proposal, 33–34 Uptrends, 80, 148–149, 156 Upward price change: calculation (see Average upward price change) determination, 167 U.S. government securities/agency securities, trading, 14

V Volatility Index (VIX/VXN), 186 Volume, 75–76 analysis, 112–114 bars, 113

W Wedge formation, 104–105 Weighted moving average (WMA), 153 White candlestick, 68 White marubozu, 116, 120, 134 candlestick, 116–117, 122, 135 White/black combinations, 144–145 White/white combinations, 144–145 Wholesalers, examples, 17 Width, 75 Wilder, Welles, 166, 168 Williams, Larry, 171 Wire houses, examples, 17

Sammy Chua's Day Trade Your Way to Financial Freedom

The Real Deal: Property Invest Your Way to Financial Freedom!

The Way To Trade

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The Way to Trade: Discover Your Successful Trading Personality

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a Day to Pick Your Own Cotton

Abundant Life Day Book: 365 Blessings to Begin Your Day

Complete Bladesmith: Forging Your Way To Perfection

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Present Your Way to the Top

Take Your Teddy to Work Day

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Rewire Your Brain: Think Your Way to a Better Life

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Rewire Your Brain: Think Your Way to a Better Life

It's All in Your Head: Thinking Your Way to Happiness

Sammy Chua's Day Trade Your Way to Financial Freedom

The Real Deal: Property Invest Your Way to Financial Freedom!

The Way To Trade

The Way to Trade: Discover Your Successful Trading Personality

The Way to Trade: Discover Your Successful Trading Personality

Spend Your Way to Wealth

Sammy Sosa: Slammin' Sammy (Superstar Series Baseball)

Sammy Dane

Safe Strategies for Financial Freedom

The Day Trade Forex System

Day Trade Online (Wiley Trading)

Sammy Dane

Sammy Dane

Way to Go!: Finding Your Way with a Compass

Take Your Teddy to Work Day

a Day to Pick Your Own Cotton

Abundant Life Day Book: 365 Blessings to Begin Your Day

Complete Bladesmith: Forging Your Way To Perfection

Getting Them to See It Your Way

Present Your Way to the Top

Take Your Teddy to Work Day

A Day to Pick Your Own Cotton

A day to pick your own cotton

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Rewire Your Brain: Think Your Way to a Better Life

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