7 Chart Patterns
7 Chart Patterns
7 Chart Patterns
Patterns
BY
ED DOWNS
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Chart patterns form because people react to price movements in consistent ways based mostly on fear, greed, and herd mentality. Ed Downs
Copyright 2000 by Ed Downs. Published by Marketplace Books All rights reserved. Reproduction or translation of any part of this work beyond that permitted by Section 107 or 108 of the 1976 United States Copyright Act without the permission of the copyright owner is unlawful. Requests for permission or further information should be addressed to the Permissions Department at Traders Library. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers.
This book, along with other books, are available at discounts that make it realistic to provide them as gifts to your customers, clients and staff. For more information on these long-lasting, cost-effective premiums, please call John Boyer at 800-424-4550 or email him at [email protected].
Contents
Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Introduction Different Charts and How to Read Them . . . . . . . . . . 13 Chapter 1 THE POWER OF TECHNICAL ANALYSIS. . . . . . . . . . . . Trading vs. Investing: Choose One and Profit From It . . The Power of the Short Side . . . . . . . . . . . . . . . . . . . $10,000 to $1 Million in One Year . . . . . . . . . . . . . . . Do Technical Analysis and Charting Work? . . . . . . . . . The Formula for Success in Trading . . . . . . . . . . . . . . Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15 15 20 23 26 27 28
Chapter 2 THE SEVEN CHART PATTERNS FOR SUCCESSFUL TRADING . . . . . . . . . . . . . . . . . . . . . . . . 29 Computers Cant See Everything. . . . . . . . . . . . . . . 29 Chart Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Chapter 3 CHART PATTERN 1: Support and Resistance . . . . . . . . . 31 Chapter 4 CHART PATTERN 2: Trendline Break and Reversal . . . . 35 Chapter 5 CHART PATTERN 3: Saucer Formations . . . . . . . . . . . . 39 Chapter 6 CHART PATTERN 4: Fibonacci Retracements. . . . . . . . . 43
Chapter 7 CHART PATTERN 5: Gaps (Breakaway, Measured, Exhaustion) . . . . . . . . . . . . . . . 45 Chapter 8 CHART PATTERN 6: Volume Climax, Volume Trend . . . . 47 Chapter 9 CHART PATTERN 7: Consolidations (Flags and Triangles) . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Chapter 10 PREDICTING MARKET DIRECTION . About SignalWatch.com . . . . . . . . Why the Dow? . . . . . . . . . . . . . . . Consolidations Are Magic! . . . . . . . What Will the Dow Do Tomorrow? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 55 56 57 59 61 61 62 65 68 70
Chapter 11 TRADING THE MOVES WHILE MINIMIZING RISK The Golden Exit Rule . . . . . . . . . . . . . . . . . . . . Setting Stops to Minimize Risk . . . . . . . . . . . . . Maximizing Profits on Every Trade . . . . . . . . . . Put the Odds in Your Favor! . . . . . . . . . . . . . . . Closing Thoughts . . . . . . . . . . . . . . . . . . . . . . .
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Preface
here are two camps in the trading and investing world: Fundamental Analysis and Technical Analysis. If you are investing with fundamentals, you will be interested in a companys balance sheet, product focus, and other prospects for earnings growth. Fundamentals work great, but the problem is, which fundamentals? Stocks with astronomic price to earnings ratios, like Amazon, keep going higher. Stocks with bad news but sound books and products go down. Trading with such information is just downright hard especially when the market isnt going up. Since the day I first started trading some 20 years ago, Ive been fascinated and awed by the power of Technical Analysis and Charting. According to my studies and from talking with Nirvana customers, successful traders use technical methods almost exclusively. Chart patterns work! Why? Because human behavior repeats itself. There are two forces at work: greed and fear. What you see in charts is the transition between investor elation and terror. Seven Chart Patterns That Consistently Make Money is purposely not a long book. I have seen chart books that went on and on for 200 pages or more. You dont need that much information. After studying the markets for 20+ years, I have come down to these seven patterns as the key predictors of direction, in any market.
We use our product, OmniTrader, to prospect for trading candidates, but it doesnt matter what method you are using if you confirm your entries with these simple patterns, you will be light-years ahead of the average investor. Best of luck in all your trading endeavors. Ed Downs
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Trade Secrets
Chart 7 Patterns
That Consistently Make Money
Introduction
DIFFERENT CHARTS AND HOW TO READ THEM
efore the personal computer revolution of the 80s, technical analysis or charting was considered a black art. Today, financial news commentators often turn to their favorite market technician to find out what the charts are saying. The reason? Charts work! But before we discuss charts, we should cover a few basics about how charts are displayed. Price charts are typically drawn in one of three styles: a bar chart, a candle chart, or a line chart. Examples are shown at the right. On each day of a securitys life there are five pieces of information recorded: The Open the price the market opened at the beginning of the day The High the highest price reached during the day The Low the lowest price reached
Bar Chart
Candle Chart
Line Chart
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The Close the final price Volume the number of shares which changed hands Each price bar is represented as a vertical line from the high to low. Small lines point left and right, which are the open and close, respectively. Volume is almost always shown as a line below the bar. In a candle chart, the range between the open and close is shown as a rectangle, or body. If the day closed up, the body is hollow. If the day closed down, the body is typically filled in. A line chart is just a line connecting closing prices. This type of chart is rarely used by technical analysts. In this book, we will use candle charts where the timeframe is not too compressed. Otherwise, we will show a bar chart for ease of viewing.
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Trade Secrets
Chapter 1
THE POWER OF TECHNICAL ANALYSIS
Trading vs. Investing: Choose One and Profit From It
At the dawn of the bull market in the 80s and early 90s, the best approach for any investor was clearly buy and hold. With interest rates low and the stock market advancing slowly and steadily, one could earn a nice return on his or her nest egg by just socking money away in a mutual fund and letting it ride. The playing field has changed. We now have a Dow over 10,000 (see Figure 1-1) and a volatile NASDAQ that can gain and lose 2% -5% on any given day. Internet stocks are tripling in value in a matter of weeks, only to be thrashed when earnings dont materialize. Its an amazingly volatile time. The good news is that volatility can lead to huge profits if taken advantage of properly. Most traders start out as investors. Maybe they had some money socked away in a 401K plan, and saw the opportunities in dot com and high tech stocks, realizing that if they had invested in these stocks, they would have made huge gains in a very short time. The budding trader starts by calling a discount broker, setting up an account, and buying some shares of Amazon, Intel, or Dell Computer stocks.
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Volatility increases slow and steadily from April 1994 to December 1995
Weekly chart on the Dow, going back to 1994. Volatility has increased dramatically, particularly in the last few years.
But then, they find that the stock that was going up, suddenly takes a nosedive. Instead of making a boring 2% gain for the month, they realize a 20% loss. Ouch! Maybe they should have watched the market more closely. They start reading about different methods, Internet resources, and other ideas for determining what is going up and what is going down. And, after a while, they begin to realize that the best and simplest way to figure out what is going up, and what down, is to use technical analysis, or charting. The following charts illustrate the potential difference between trading and investing. On the next page (see Figure 1-2), we have a chart of stock Ethan Allen (ETH) for one year, from January 1998 to January 1999. If we had purchased ETH at the start of 1998 and held for one year, we would have realized a 13% gain. Not bad.
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Trade Secrets
Now, lets consider what could have happened had we traded the moves in this stock (see Figure 1-3). By going long (buying the stock) in early January 1998 and selling it in April, we would have made a 45% gain. Then, by shorting the stock1 and making money as it declined, we would have picked up another 46%. Finally, a purchase of the stock again in early October would have yielded a very nice 68% gain through January 1999. The gains were calculated by dividing the point movement by the price at the start of the move. By adding up the total percentage of gain on each trade, we ended up
__________________ 1 See The Power of the Short Side on page 20.
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Potential gains.
with over ten times the buy and hold gain netting a hefty 159% gain.
The key to this performance is staying in the market and making steady, consistent gains. While it is true that commission costs are incurred from trading, modern discount brokerages charge as little as $7 to execute a trade. In the above example, we had three trades which would have incurred six brokerage commissions (one each to buy and sell), giving us a cost of $42. If you had invested $5,000 trading this stock, you would have ended up with $12,950 in the account for a gain of $7,950. The $42 cost is negligible.
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Trade Secrets
Consolidation target #2
Here, we have marked the primary chart patterns that led us to our trades in ETH in 1999. You will be learning about these patterns in Chapters 2-11.
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Trade Secrets
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pent-up selling pressure, just waiting to be unleashed anytime bad news enters the market. Selling short is something every trader should do. The market has ebbs and flows. And, ferocious declines happen often, typically once a quarter. On a smaller scale, they happen every day to certain issues and contracts (futures). Trading the short side is a very profitable habit. Below (see Figure 1-6), we see another great example of a short trade that made big money. In early April of 1999, Pfizer, Inc. (PFE) had a breakaway gap down, and broke a trendline. You are going to be reading about both these patterns soon!
Breakaway gap
After the gap in April, Pfizer, Inc. dropped 30%, down to the volume climax in late May. Again, notice the buy and sell signals generated by OmniTrader.
Volume climax
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Trade Secrets
Look again at the chart and analyze what happened. On April 15, the stock plummeted from 144 to 129 in one trading session. If you had gone short on April 14, you would have realized a gain of 10%, in ONE DAY! If you had held your short position in this stock until the volume climax that occurred on May 25, you would have made 25% on the trade. You will read about gaps, trendline breaks, and volume climaxes in the next eight chapters. After you have read Chapters 2-9, come back to this chart and the patterns will be much more obvious. One more note you can see buy and sell signals below the chart. These were generated by OmniTrader2 using other technical trading systems. While having a tool like OmniTrader can help you find great candidates (like this one), the patterns we will soon study can be applied to any chart discovered by any method.
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Back in the 60s, when Mr. Hurst wrote his book, we didnt have the volatility we have today. We are now seeing stocks that move 2%, 4%, even 10% in a single day. And, it is possible to turbo-charge your trading through the use of margin. If you are trading on margin with your broker, you can trade twice your account balance. That is, if you have $10,000 in your account you can actually take $20,000 in positions in the market. So, a 1% gain in a fully margined account is like 2% in a non-margined account. By the way, the interest the broker will charge you for borrowing these funds is negligible something like .02% per day. If you start with $10,000 and earn just 2% a day for 250 trading days in a year, your $10,000 would grow to $1.4 million. I started thinking, If you actually made 2% a day (1% on margin), what would happen to an initial stake of $10,000? I stayed up late one night and wrote a little program to calculate compound rates of return given different assumptions. Heres what I found:
If you start with $10,000 and earn just 2% a day for 250 trading days in a year, your $10,000 would grow to $1.4 million. Again, going back to the lesson from Mr. Hurst, the trick is to stay invested at all times and make small, consistent gains. And remember, we really only need to clear 1% if we are trading on margin.
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Trade Secrets
Thats why we created OmniTrader, to help us with the task of finding great trading opportunities each day in the market. The next chart (see Figure 1-7) shows two signals from OmniTrader Real Time. One chart had a buy signal with a beakaway gap, and the other had a sell confirmed by a trendline break at the same time. You would have made money on both chartsthe one on the left by taking a short position. Both trades exceeded our 1% per day requirement, after deducting the spread between the bid and ask, and also deducting a typical $8-$12 commission. Can you see the sheer power of todays markets? How many investors are aware of this? After reading this book, 30% a year is going to seem very boring. The point is, these moves are everywhere. And, the market gives us great confirming chart patterns every day, on thousands of opportunities!
Short
Long
Recent buy and sell signals from OmniTrader Real Time version.
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Trade Secrets
Each of these traders said they use technical methods, almost exclusively. Did these gentlemen discover the secret to riches? Not according to them. If you read the interviews, you will find that each trader said basically the same thing: develop a trading system that matches your trading style, and maintain discipline in sticking to your system.
1 2 3
You may want to focus on the general market trend, or may feel more confident trading short-term opportunities against the trend. Almost any method will work, if it matches your personality and incorporates good money management principles. Van K. Tharp, one of the traders interviewed by Schwagger for Market Wizards, has since written the book Trade Your Way to Financial Freedom, which is devoted to developing your own trading style.
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Summary
In Chapter 1, we have covered the following, important points as a prelude to our study of chart patterns in the markets: Trading is superior to investing in terms of potential gains for the same amount of time. Trading the short side can be extremely profitable. It is possible to make 1%-4% each and every day in the market. If you can make just 2% a day or just 1% on margin a $10,000 account will grow to $1.4 million in one year. Technical Analysis and Charting work, provided you find a method or pattern that you are comfortable with, and stay with it. As you study this book, some patterns will jump out at you as being totally obvious. Focus on those. As a great trader once said, You only need one pattern to be successful.3 With this background behind us, were ready to dive right into our main topic the seven chart patterns for successful trading! These patterns have proven themselves over and over to be tremendous predictors of tomorrows market, and the individual stocks and futures that comprise it.
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Master trader Chris Manning presents proven, reliable chart patterns that pinpoint buy/sell signals for short and longer-term investors - plus precise indicators for developing each pattern. Manning's clear, comprehensive style is easy enough, even for those new to technical analysis. With a focus on using chart patterns to profit from today's markets and seizing market turns before the 'crowd' does, Manning highlights Broad-based patterns vs. those that work for specific stocks How trading-range systems compare to trending systems A less is more approach focusing in on a select few indicators Clean signals vs. messy signals interpreting the nuances of moving averages and other indicators The importance of double bottoms, triple tops and other confirmations Reducing FALSE signals by two-thirds
Chapter 2
THE SEVEN CHART PATTERNS FOR SUCCESSFUL TRADING
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Chart Patterns
In my 20 years of charting experience, I have distilled the most successful chart patterns down to the following seven (see Figure 2-1). These patterns are classified into two basic types: momentum (breakout) and exhaustion (reversal). By the term breakout we mean measuring situations where a security has or is acquiring momentum, meaning it will move further in a given direction. Patterns which fall in this category have an X in the B column. By reversal we mean detecting that a move is ending, so we can avoid getting in at just the wrong time or, trade in the other direction. These patterns are marked under R.
Figure 2-1. SEVEN CHART PATTERNS FOR SUCCESS
# 1 2 3 4 5 6 7
CHART PATTERN Support and Resistance Trendline Break and Reversal Saucer Formations Fibonacci Retracements Price Gaps Volume Climax and Volume Trend Consolidations
B X X X
R X X
X X X X X X
The seven chart patterns are classified as either breakout (B) or reversal (R) type patterns, or both.
Chapters 3-9 cover these chart patterns, starting with Support and Resistance, which can serve as either a breakout or reversal type of pattern.
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Trade Secrets
Chapter 3
CHART PATTERN 1: SUPPORT AND RESISTANCE
upport and resistance have been used for a very long time by technicians and anyone who watches markets even fundamentalists! Support is a level or area on the chart under the market where buying interest is sufficiently strong to overcome selling pressure. As a result, a decline is A support level is halted and prices turn back up usually identified again. A support level is usually identified beforehand by a previbeforehand by a ous reaction low or trough. Reprevious reaction sistance is the opposite of support low or trough. and represents a price level or area over the market where sellA resistance level ing pressure overcomes buying is usually pressure and a price advance is identified by a turned back. A resistance level is previous peak. usually identified by a previous peak. When a solid support level forms, the psychology of this level becomes more important the more times price approaches it and retreats. More buying will continue to come
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into the security because the participants expect price to reverse off the line (see Figure 3-1), and try to anticipate it. The chart for General Motors (GM) shows important support and resistance breaks (see Figure 3-2). It is often difficult to determine whether a support level will hold or be broken. That is why we are discussing this pattern first it is the weakest and most difficult to use. However, when you see a clear support line form, and it is broken, that usually means price will continue down lower. If it bounces off the level, it will likely continue high-
Resistance
Support
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Trade Secrets
Resistance broken
Support broken
Support and resistance pointed the way to nice breakouts on General Motors (GM).
er. When looking for a support break, you want to see major strength such as a gap or heavy volume accompanying the break.
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Chapter 4
CHART PATTERN 2: TRENDLINE BREAK AND REVERSAL
rendlines are perhaps the oldest tools known to chartists. Trendlines form across peaks and valleys called pivot points relative highs and lows in a chart. As more points form along a line, it becomes more established. This means that, when the line is broken, it will likely follow Trendlines form through with a strong move in the across peaks and new direction. valleys called After a trendline has formed, pivot points we look for reversals when price relative highs and moves in proximity to the trendlows in a chart. line and pulls back, but also watch for breaks through it. As more points Either event can be significant form along a line, and predict the next price move it becomes more (see Figure 4-1). established. When you draw a trendline, you should be aware of the approximate cycle for the peaks and valleys. In his book The Profit Magic of Stock Transaction Timing, J.M. Hurst proved that stocks fall in 16, 32, and 64 period cycles (which we will call
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Break Reversal
Trendline
Trendline
Reversal Break
short, medium, and long term).4 These measurements are the approximate valley-to-valley or peak-to-peak distances in each time frame that you see a reversal (pivot point). It is important to understand which time frame you are working when you use a trendline, because you may want to set your target exit point at approximately the halfway point. That is, if you are using a medium-term trendline, you would expect price to reach an extreme point and reverse approximately 32/2 = 16 periods from the previous pivot.
__________________ 4 Our experiments indicate the same cycles work on futures as well.
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Trade Secrets
Break
Break
Break
The trendlines in Figure 4-1 are based on medium-term pivots, as are the ones in the chart above (see Figure 4-2). Again, if you measure the approximate distance from peak to peak or valley to valley for each trendline, you would see about 6-7 weeks (30-35 trading days) of price action forming these cycles. The chart (see Figure 4-3) for Air Touch Communication (ATI) shows trendline pivots in the short-term time frame. Indeed, you can see that the measurement from peak to peak or valley to valley is approximately 3-4 weeks, or about 16 trading periods. And, the next relative peak or valley is typically 7-9 periods from the previous valley or peak, respectively.
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One last note on trendlines the best angle on a line for breaks is 45 degrees. The shallower the angle, the less pronounced any breaks are likely to be. Conversely, for trendline reversals, you want to see a shallow angle formed by the trendline 20 to 30 degrees or so is best.
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Trade Secrets
Chapter 5
CHART PATTERN 3: SAUCER FORMATIONS
aucer patterns are fairly rare, but are usually very predictive. The saucer pattern shows a gradual change in trend as it develops (see Figure 5-1). It is important that the formation show a clear arc with tight trading ranges at The saucer the bottom of the arc. This patpattern shows a tern can be traded for short-term gradual change moves, but is much better if held for a long period of time. Set in trend as it stops just below the saucer botdevelops. It is tom (the lows of the formation). important that A stop is used to exit a position if the formation a certain price level is broken. show a clear Generally, they are set below the arc with tight current market price. trading ranges at In Figure 5-1 on the next page, the bottom of Hunt JB Transport Services Inc the arc. (JBHT) formed a saucer bottom and rallied over the next year to double in price. Saucers can occur in short or long time frames.
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This saucer pattern formed over a long time framenearly a year and a half.
Another, more pronounced saucer, can be seen on the Columbia/HCA Healthcare Corp (COL) chart on the next page (see Figure 5-2). We have marked another confirming pattern, a breakaway gap, indicating the saucer has completed and the stock will rally considerably from that point.
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Trade Secrets
This saucer pattern occurred in a short time frame of just six months.
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Chapter 6
CHART PATTERN 4: FIBONACCI RETRACEMENTS
ann was probably the first trader to use Fibonacci retracement ratios. The Fibonacci number sequence occurs in nature frequently (1, 3, 5, 8, 13, 21, . . .). Ratios of these numbers to each other form the values 38%, 50%, and 62%. As it turns out, these are very close to the Gann numbers 3/8 (37.5%), 4/8 (50%), and 5/8 (62.5%), which he used over and over in his chart calculations. Figure 6-1 shows 50% retracements occurring in three places. By the word retracement we mean price retreated from a high, to the 50% point of the prior move. You can see, for example, that in August we formed a low point for Mobile (MOB), and in September we formed a high. If you take half the distance between these two points, you get the approximate point at which price reversed in mid-November. The Fibonacci retracement phenomenon happens over and over in markets of all kinds. Essentially, you look at the most recent significant low and high, and make measurements on a move between these points. Measure the 3/8 point (38% of the distance from the last pivot) and look for a reversal there. If it doesnt happen, move on to the 4/8 (50%) point and finally the 5/8 (62%) point.
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It should be noted that the 50% retracement is the most common, followed by the 38%, and last the 62% level. That is, you should always expect a 50% retracement, but be prepared for a 38% or 62%. A good rule of thumb is to enter a trade on 50% retracement but exit a trade at 38%. This is done to preserve profits at the nearest retracement point (if we wait for 50%, we may not get it). These methods work particularly well on the Dow and on futures contracts. It would seem that any market which is liquid (has reasonable volume) works well with this technique.
50% 50%
50%
We have marked three 50% retracements in this chart. Can you find more?
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Trade Secrets
Chapter 7
CHART PATTERN 5: GAPS (BREAKAWAY, MEASURED, EXHAUSTION)
ur fifth pattern is one of my absolute favorites. Gaps are basically points of high or low demand. Usually, the pent-up buying or selling pressure that forms the gap will follow through in the general market with more buying or selling. Hence, the pattern is powerful in predicting a Gaps are continuation move. There are basically points many technical trading books that describe gaps. There are three of high or low basic kinds: breakaway gap, meademand. sured gap and exhaustion gap (see Figure 7-1). Breakaway gaps occur at the ends of moves, in the opposite direction. They are usually the most profitable and easiest to trade. Measured gaps occur at (approximately) the 50% point of moves, and are more difficult to identify when they happen. But as price moves away in the direction of the gap, it can become apparent that the gap has likely marked the 50% point, giving us a target for the end of the move.
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Finally, the exhaustion gap occurs at the end of a move. Exhaustion gaps are differentiated from measured gaps by observing what price does after the gap forms. If it reverses to move into the zone of the gap, you probably have exhaustion. Figure 7-1 had a gap in May 1997, near the long signal shown. This served to confirm the long as a higher probability signal. These examples are taken from our product, OmniTrader. But regardless of what product you use, or how you get the initial signal, you can quickly see if you have a gap near a signal you are considering trading.
B E
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Trade Secrets
Chapter 8
CHART PATTERN 6: VOLUME CLIMAX, VOLUME TREND
olume climaxes are beautiful patterns that are about 90% accurate in terms of predicting a reversal move tomorrow. When they occur, the market will likely move in the opposite direction we just dont know how much. A climax occurs when a market has been trending down (or up) for an extended period of time, usually for several months.
In this example (see Figure 8-1) of AllState Corp (ALL) you can see several great examples of volume climaxes, and several lesser ones. Particularly, the climax in late June and early August were powerful. It is interesting to note that stocks (or futures) that exhibit volume climaxes typically repeat the pattern a number of
Volume climaxes are beautiful patterns that are about 90% accurate in terms of predicting a reversal move tomorrow. Volume trend, the inverse pattern to a volume climax, looks like a climax except the price does not retreat.
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This example of volume climaxes illustrates three lower and one upper.
times. So, when you find a security that exhibits a volume climax, bookmark it and wait for the next one to form! Volume climaxes are characterized by sudden increases in volume. Suddenly, the market moves quickly in the same direction as it was previously moving, on heavy volume. Then price retreats on lighter volume. Volume climaxes are particularly accurate at the end of long moves, near significant market tops or bottoms, or near Fibonacci retracement points (38%, 50%, 62%).
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Trade Secrets
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Chapter 9
CHART PATTERN 7: CONSOLIDATIONS (FLAGS AND TRIANGLES)
consolidation is a place where buyers and sellers are very closely matched in numbers (see Figure 9-1). As the battle ensues, others (on the sidelines) notice that the market is consolidating, and begin considering getting on A consolidation board. As soon as a breakout to is the price the upside (or downside) occurs, movement in a the latent buyers (or sellers) usually begin taking positions. You trading range want to look for places where between two price moves outside the trading trendlines it range that forms the consolidacan appear in the tion, on increasing volume. formation of a triangle or a flag. In Figure 9-1, we see several consolidations set up as the stock declines. And, we see several different kinds. The first two marked consolidations are triangles and the third and fourth are flags. The time frame of the consolidation is used to determine the target. That is, if the consolidation lasts two weeks, you
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Consolidations
Consolidations imply a continued price move in the same direction. The first two marked consolidations are triangles and the third and fourth are flags.
should go back on the chart approximately two weeks to measure the recent high or low. The distance of the next move is also in direct proportion to the size of the consolidation. Look at the second consolidation that started in January of 1998 and continued until about May. The approximate size of the consolidation, then, is four months. If you go back four months from the start of the consolidation, you can find a peak at that point, in the September/October time frame. And, the end of the move measured by that consolidation was about four months later, in October of 1998.
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Trade Secrets
V2
L T1 T2
The diagram above (see Figure 9-2) illustrates the structure which usually forms around consolidations5. The consolidation is shown in the middle of the drawing, representing price movement in a trading range between two trendlines the definition of a consolidation. After the consolidation completes and reaches its target, you will usually find that T1 = T2 and V1 = V2. We also usually note that the previous low, marked L, is typically found from the start of the consolidation back into the past, an amount of time equal to the width of the consolidation. That is, most consolidations form such that C = D. As consolidations form, you want to look back on the chart to the previous, probable significant low, approximately the same distance as the width of the consolidation,
__________________ 5 Turn this diagram upside-down for a short trade. The examples on the previous page are all shorts.
7 Chart Patterns That Consistently Make Money 53
and then expect any continuation move out of the consolidation to last the same amount of time into the future. Typically, the entry point will be at E (see diagram) after the consolidation forms. By making these measurements, you can quickly assess how far the stock is likely to go from that point, by just measuring T1 and V1 and projecting T2 and V2 into the future. Look at some charts and verify this for yourself. It works.
Summary
We have presented the 7 Chart Patterns in Chapters 3-9. All of these patterns can predict moves in any tradeable security (stocks, futures contracts, etc.). Just grab a chart, sit down, and start marking patterns. They will soon begin to jump out at you! These same seven patterns can be used to predict market direction. Thats exactly what I do on SignalWatch, as you will see in Chapter 10.
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Chapter 10
PREDICTING MARKET DIRECTION
echnical analysis works! I have been running my daily SignalWatch commentary since September 1998. In Chapter 10, we will look at how you can use the patterns we have discussed to predict the Dow for tomorrow.
About SignalWatch.com
SignalWatch was launched in an interesting way. We recently took on the task of educating our website designers on trading and using OmniTrader. After showing them how to use the software to pinpoint opportunities, and then read simple patterns on charts to improve odds, they suggested starting a website to help educate our customers. We implemented their suggestion, and SignalWatch was born at www.signalwatch.com. The goal of SignalWatch is to provide technical analysis education for our customers. To fulfill this goal, we provide a number of resources, including market commentary, trading lessons, and daily charts.
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Each day, we isolate chart patterns to determine probable direction of the Dow for the next day. SignalWatch is all about charting learning to identify the key components that make a good opportunity a really great trade. It is through careful isolation of only the best candidates, plus matching the direction of the market, that we beat the odds in our trading.
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K A G 6 B 1 C E 2 4 F 5 J H I 7
The Dow Industrials from July 1998 to January 1999. Numbered boxes are drawn around the consolidations. Letters indicate consolidation centers and pivots.
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When consolidation 2 formed, the move from C to D was likely, because of the distance from A to C (that is, AC ~ CD). You can see from the other consolidations on the chart that the next move (continuation in trend) was very predictable from this sort of measurement. Any time you see a consolidation form, ask yourself, Where is the nearest significant high or low? Now, measure the same distance in the direction of trend. Seventy percent of the time, a continuation will occur to that price. In fact, if you measure the distances on the chart between all the consolidation centers and extreme points, you find that distances tend to match: AB ~ BC EF ~ FG AC ~ CD GH ~ HI DE ~ EF IJ ~ JK Another way to say this is, consolidations measure the 50% point of moves. That is, when you see a consolidation form, you can usually measure the distance to the previous high (or low) and be fairly confident that the market will continue in that direction the same distance. However, consolidations are not perfect. In Figure 10-1 at Consolidation #3, it appeared the market would move down the distance from A-D, or about 600 points. When it broke to the upside to form Consolidation #4, we knew that we had seen a double bottom rather than a consolidation. So, the important rule for consolidations is: Wait for the breakout. The consolidation phenomenon repeats itself over and over in charts of all types, including indexes like the Dow, individual stocks, and futures contracts.
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Chapter 11
TRADING THE MOVES WHILE MINIMIZING RISK
Here Are Some Situations That May Invoke The Golden Exit Rule:
You enter a position because the stock was lagging behind the market. However, the market begins declining as a whole, and appears to be correcting. You see your stock get-
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ting hit as well. Get out. Your reason for entering is no longer valid. You saw a consolidation on a chart, and entered a long position on a breakout to the upside. However, the stock retraces back into the consolidation, thus proving that it may not have been a consolidation at all, but rather a resistance. Exit that trade! You bought stock XYZ because it broke a resistance level. The next few days it trades back through the resistance level and looks weak. Just get out. We have all fallen victim to the it will come back sort of thinking. We dont like admitting we are wrong, but trading is the one pursuit where being wrong is a necessary condition to the activity. It is a game of odds, and what we are trying to do is get the odds in our favor not delude ourselves into thinking that every event will be a success.
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In the chart below (see Figure 11-1), IBM consolidated for four months a rather long period of time before breaking out. (It just so happened, OmniTrader fired a beautiful long signal at the same time.) If we set a stop just below the lower bounds of the consolidation, at about 160, we will know if the breakout was false as soon as price gets to this level. Stops based on consolidation ranges are perhaps the simplest, yet most effective stops available to technical analysts.
Consolidation
Stop
Entry
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$1 $5 S1 S2
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Obviously, if you only take trades where your loss risk is 5% to 10%, but your profit potential is 10% to 20%, you only have to be right half the time to do well! That is, if you place ten trades and lose 10% on five, but make 20% on the other five, your net gain is still 5% overall. Of course, our goal is to do better than 50%, but the point is that you should create situations where your gains are larger than your losses. If you do that, you will win.
Retracement Targets
You can define targets based on Fibonacci retracement levels of 38%, 50%, and 62% (see Figure 11-3). Particularly in markets that oscillate and form waves, this can be a powerful exit technique. Set your exit point at the next retracement level. If price barrels through the level you have set, then set it at the next level and set an exit stop at the prior level.
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B Trade
Target
To illustrate this point, look again at Figure 11-3. After going short at point A, we waited until price moved through a retracement level, and then exited on the reversal.
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Entry
Consolidation Targets
The fourth exhaustion pattern, the consolidation target, also deserves some discussion. Remember from our discussion earlier, we pointed out how well consolidations mark the 50% points of moves. Obviously, if consolidations measure the 50% point, we can tell when to get out by looking at the double point. Using our previous example of IBM, the chart on the next page (see Figure 11-5) shows a trade we entered on the back
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Target
Consolidation
50%
Entry
side of a consolidation (on the breakout). Now, we are sitting at the 2x (double) point target, and should tighten stops in anticipation of an exit.
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The table below shows four hypothetical trades that yielded a 2% daily gain, even though only half of the trades were successful. Note also that the gains are not quite twice the losses.
Trade # 1 2 3 4 Total G/L on Trade +10% +9% -5% -6% +8% G/L on Account +2.5% +2.25% -1.25% -1.5% +2.0%
Clearly, you will expect to be more than 50% correct in your trading, but by always trying to select candidates that exhibit stop and target levels consistent with a 2:1 ratio, you are ahead of the game and have a good chance of meeting our 2% per day requirement.
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Closing Thoughts . . .
hart patterns form because people react to price movements in consistent ways based mostly on fear, greed, and herd mentality. Knowing this, we can then focus our attention on chart pattern formations and take advantage of the resulting opportunities including those detailed in this book. A stock is never so low that it cant go lower, nor so high it cant go higher. Edwin LeFevre, Reminiscences of a Stock Operator
The key to being successful as a trader is not losing money in between the big moves, but staying in the market so you are there when the big move comes. Wise Trader (Anonymous) You only need ONE pattern to be successful. Linda Bradford Raschke, Market Wizard
One percent a day is all you need! Good luck in your quest . . .
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Point and Figure Charting: Essential Applications for Forecasting and Tracking Market Prices
by Thomas J. Dorsey Now, the first new work on point and figure in thirty years. Todays leading expert shows how to use point and figure to chart price movements on stocks, options, futures, and mutual funds. Also covers how to combine point and figure with technical analysis for unbeatable success. $65.00 Item #2365.
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Many of these books along with hundreds of others are available at a discount from Traders Library. To place an order, or find out more, visit us at
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7 Chart Patterns That Consistently Make Money 77
Many of these books along with hundreds of others are available at a discount from Traders Library. To place an order, or find out more, visit us at
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or call us at
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