Technical Analysis & Charting Course Ken 06-22-09[1]

Classical Bar Charting& Technical Analysis Kenneth H. Shaleen Section One Chapter 1 Chapter 2 - The ‘Bottom of the Chart’ Rationale of technical analysis Volume Analysis Significance Healthy Price Trends Blowoff Volume Determination of Volume Parameters Open Interest in a Futures Contract Significance Healthy Price Trends Idiosyncrasies General Rule for a Healthy Price Trend (on a daily futures chart) Why Total Volume & Open interest is Used Worksheet Chapter 3 Chapter 4 Section Two - The Basics Chapter 5 Price Scales Arithmetic verses Logarithmic Futures Continuation Charts Trending with the Trend Trendline Construction Trendline Analysis Support and Resistance Chapter 6 Chapter 7 Section Three - Reversal Patterns Chapter 8 Chapter 9 Chapter 10 Chapter 11 Price Pattern Recognition - an Overview Head & Shoulders Top and Bottom Broadening Formations Double Top and Double Bottom i Section Four - Continuation Patterns Chapter 12 Symmetrical Triangles As a Continuation Pattern As a Reversal Pattern Right Angle Triangle Ascending Right Triangle Descending Right Triangle Wedge Formations Rising Wedge Falling Wedge Flags & Pennants - ‘half-way’ formations Chapter 13 Chapter 14 Chapter 15 Section Five - Gap Theory Chapter 16 Gap Theory Four Basic Types of Gaps Ex-Dividend Gap Island Formation Section Six - Minor Trend Change Indicators Chapter 17 Minor Trend Change Indicators Key Reversal Outside/Inside Range Mid-Range Close Section Seven - Other Forms of Technical Analysis Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Spreading and Spread Charts Mathematical Models - Trend Following Mathematical Models - Oscillators © Kenneth H. Shaleen ii CHARTWATCH 9/08 International Futures Research Kenneth H. Shaleen is President of CHARTWATCH, an international research firm to the futures industry. CHARTWATCH distributes weekly technical analysis at www.chartwatch.com and produces a daily telephone market update. Mr. Shaleen has instructed technical analysis courses for the Chicago Mercantile Exchange since 1976. These courses are also conducted in London, Singapore, Malaysia, Hong Kong and other locations throughout the world. Mr. Shaleen is the author of Volume & Open Interest (Irwin, 1991, 1997) and Technical Analysis & Options Strategies (Irwin, 1992), three Chicago Mercantile Exchange course book as well as numerous articles. Mr. Shaleen Joined the Northern Trust Company in Chicago in 1968 as a Management Science Analyst to develop computer models for the Bond and Trust Departments. A move to futures research was made in 1972. After supplying analysis for twelve years as Director of Research for two Chicago Board of Trade clearing member firms, he formed CHARTWATCH in 1984. Mr. Shaleen is a charter member of the Commodity Options Market (1982) at the Chicago Board of Trade. He holds a B.S. in Civil Engineering from the University of Colorado (1967) and an M.B.A. in Finance from Northwestern University (1968). Please direct all inquires concerning videos and any of the services offered by CHARTWATCH to: CHARTWATCH Fulton House 1604 345 North Canal Street Chicago, Il 60606 USA Telephone: 312 454-1130 The “live” charts assigned in the early CME Technical Analysis courses were Live Cattle and Soybeans.as the volume in financial futures became dominant. To the 15. 1967). These evolved to Deutsche Marks and Treasury Bonds .the Chicago futures exchanges . Now the technical analysis course has come full circle with Stock Index futures charts and individual equity charts increasingly in evidence. This course manual is an ongoing compilation and refinement of all the charts and technical analysis I have encountered since this time. A combination of older charts and more up-to-date examples are co-mingled to show that human nature.chartwatch. The simple creation of a chart also evolved with the advent of electronic “after hours” trading and the proliferation of technical analysis software. The majority of charts in this manual are futures charts. After reading Commodity Speculation with Profits in Mind by L. although the first Technical Analysis Course I conducted for the Chicago Mercantile Exchange in the Summer of 1976 used the Edwards and Magee “bible” of price pattern recognition: Technical Analysis of Stock Trends. Dee Belveal (Commodities Press. creating the price patterns.basically just down the street from the downtown Northwestern campus.www.my thanks. I was never exposed to one of the most active markets in the world .com iii Foreword Earning an MBA in finance at Northwestern University in June of 1968. This is the course manual. I started my first chart . Ken Shaleen Chicago Sept 22. 2008 .Sept ‘68 Oat futures. does not change. Much of what is contained in this course manual is the old fashioned “art” of drawing trendlines to construct classic price patterns.000+ students who have helped me analyze these charts . CHARTWATCH Inc. .Classical Bar Charting & Technical Analysis Prepared and Presented by Ken Shaleen President. Reversal Patterns Chapter 8 Chapter 9 Chapter 10 Chapter 11 Price Pattern Recognition .an Overview Head & Shoulders Top and Bottom Broadening Formations Double Top and Double Bottom i .The ‘Bottom of the Chart’ Chapter 1 Chapter 2 Rationale of technical analysis Volume Analysis Significance Healthy Price Trends Blowoff Volume Determination of Volume Parameters Open Interest in a Futures Contract Significance Healthy Price Trends Idiosyncrasies General Rule for a Healthy Price Trend (on a daily futures chart) W hy Total Volume & Open interest is Used W orksheet Chapter 3 Chapter 4 Section Two . Shaleen Section One .Classical Bar Charting & Technical Analysis Kenneth H.The Basics Chapter 5 Price Scales Arithmetic verses Logarithmic Futures Continuation Charts Trending with the Trend Trendline Construction Trendline Analysis Support and Resistance Chapter 6 Chapter 7 Section Three . Gap Theory Chapter 16 Gap Theory Four Basic Types of Gaps Ex-Dividend Gap Island Formation Section Six .Minor Trend Change Indicators Chapter 17 Minor Trend Change Indicators Key Reversal Outside/Inside Range Mid-Range Close Section Seven . Shaleen CHARTWATCH 9/08 .Other Forms of Technical Analysis Chapter 18 Chapter 19 Mathematical Models .Oscillators Chapter 21 Chapter 22 Spreading and Spread Charts ii © Kenneth H.Continuation Patterns Chapter 12 Symmetrical Triangles As a Continuation Pattern As a Reversal Pattern Right Angle Triangle Ascending Right Triangle Descending Right Triangle W edge Formations Rising W edge Falling W edge Flags & Pennants .Trend Following Chapter 20 Mathematical Models .‘half-way’ formations Chapter 13 Chapter 14 Chapter 15 Section Five .Section Four . com and produces a daily telephone market update.International Futures Research Kenneth H. Please direct all inquires concerning videos and any of the services offered by CHARTW ATCH to: CHARTW ATCH Fulton House 1604 345 North Canal Street Chicago. After supplying analysis for twelve years as Director of Research for two Chicago Board of Trade clearing member firms.B.chartwatch. Shaleen is President of CHARTW ATCH. CHARTW ATCH distributes weekly technical analysis at www.S. Mr. Shaleen is the author of Volume & Open Interest (Irwin. Mr. 1997) and Technical Analysis & Options Strategies (Irwin. Singapore. Shaleen has instructed technical analysis courses for the Chicago Mercantile Exchange since 1976. Mr. in Finance from Northwestern University (1968). He holds a B. A move to futures research was made in 1972.chartwatch. an international research firm to the futures industry.com iii . Malaysia. three Chicago Mercantile Exchange course book as well as numerous articles. 1991. in Civil Engineering from the University of Colorado (1967) and an M. Shaleen is a charter member of the Commodity Options Market (1982) at the Chicago Board of Trade.A. Mr. 1992). Shaleen Joined the Northern Trust Company in Chicago in 1968 as a Management Science Analyst to develop computer models for the Bond and Trust Departments. These courses are also conducted in London. Hong Kong and other locations throughout the world. Il 60606 USA Telephone: 312 454-1130 www. he formed CHARTW ATCH in 1984. Foreword Earning an MBA in finance at Northwestern University in June of 1968. This course manual is an ongoing compilation and refinement of all the charts and technical analysis I have encountered since this time.as the volume in financial futures became dominant. The majority of charts in this manual are futures charts. I was never exposed to one of the most active markets in the world .the Chicago futures exchanges .000+ students who have helped me analyze these charts . 2008 iv . This is the course manual. Much of what is contained in this course manual is the old fashioned “art” of drawing trendlines to construct classic price patterns.Sept ‘68 Oat futures.my thanks. Now the technical analysis course has come full circle with Stock Index futures charts and individual equity charts increasingly in evidence.basically just down the street from the downtown Northwestern campus. although the first Technical Analysis Course I conducted for the Chicago Mercantile Exchange in the Summer of 1976 used the Edwards and Magee “bible” of price pattern recognition: Technical Analysis of Stock Trends. To the 15. I started my first chart . 1967). The simple creation of a chart also evolved with the advent of electronic “after hours” trading and the proliferation of technical analysis software. does not change. creating the price patterns. Dee Belveal (Commodities Press. After reading Commodity Speculation with Profits in Mind by L. These evolved to Deutsche Marks and Treasury Bonds . The “live” charts assigned in the early CME Technical Analysis courses were Live Cattle and Soybeans. Ken Shaleen Chicago Sept 22. A combination of older charts and more up-to-date examples are co-mingled to show that human nature. reacting to economic events and shock variables . as a final result. These characteristics are not difficult to understand .tends to repeat itself. 1-1 . fears.Chapter One Rationale In the long run.and be prepared for the possible price moves that will result. The technical trader follows the price only. Often. Price changes produce the profit or loss. Indeed. Equity Markets verses Futures Markets The techniques investigated are applicable to equity (stock) charts and futures charts. But in the short run. An these moods can be rational or irrational. And human nature . This does not mean that a technician does not know what is going on in the “real” world. a scheduled economic report will initiate the price move. and moods. The question always arises: W hy is price moving the way it is and why should it go to a particular price level that might be predicted by technical analysis? A technician must try to divorce himself from these thoughts. the price of any freely traded item is determined by the interaction of the fundamentals of supply and demand. A fundamental event is usually responsible for creating the minor price change. They are the interaction of supply and demand variables as perceived by the marketplace. the price of that item could move in exactly opposite direction as dictated by the fundamentals. this is what is important. It is difficult for a trader to isolate a technically derived market view from the fundamentals. Often these minor price moves create the necessary conditions for a classical bar charting price pattern. There is nothing magic about these price patterns. Each of these markets has its own unique characteristics. W hy? W hat is contained in the determination of the price? Hopes. So a technical trader should monitor the economic release calendar . it takes reversals of the minor price trend to create the handful of classic price patterns that will be studied in this course manual.and do not pose any major problems for the astute technician. The bulk of this course manual will be devoted to the “low tech” art of price pattern recognition. a futures market. The question often arises: W hy should a derivative market. verses the equity market where there are (predominately) longs only. There is a major conceptual difference in a market that must have a short for every long at the end of a trading session i.. the futures. the difference between the cash market price and the futures price. Open Interest). 1-2 . at the end of the trading session.e. is highly arbitraged and produces a relatively stable (although dynamic) relationship between the cash and futures market. The “basis”.The Difference between Equity and Futures Charts The main difference between equity charts and futures charts is that equity charts contain only price and volume statistics whereas a futures chart contains the added variable of open interest. the concept of short interest in the equity market will be detailed in Chapter Two.(For purists. be analyzed when the underlying “cash” or “spot” market is the dominant market? A futures market that has achieved a “critical mass” becomes a microcosm diminutive but analogous to the whole (cash market). Volume is so important that when this internal statistic does not support the technical conclusion derived from the analysis of price movements. The phrase “more buyers than sellers” is never true with respect to volume statistics. This occurs with the Saturday morning availability of the data for the Friday trading sessions. a contract is consummated only when both sides of the trade agree to the price and quantity. In a futures market. See the Appendix of this manual for examples of how to obtain the statistics directly from the exchange website. the contemplated trade is suspect and would not be initiated. 2-1 . low. Electronic screen based trading (and most equity exchanges) do show “on-line” volume. the total number of contracts bought equals the total number of contracts sold. the following equality always prevails: Buy Volume = Sell Volume = Total Volume Published volume figures represent one side of a futures trade only. This is obviously a boon to technical traders. In this regard. volume is often the validating statistic that causes a technical trader to “pull the trigger” on a new trade. At the end of a trading session. a technician will be able to analyze the statistics before trading begins the next day. Note that once each week. close.Chapter Two Volume Volume provides a “filter” for classical high. The CME Group Clearing House releases the volume (and open interest) statistics prior to the start of open outcry trading the next morning in the U. In an open outcry trading environment the final volume totals are not available until after the close of trading.S. bar chartists. Therefore. The dissemination of volume (and open interest) statistics varies widely by futures exchange. A more representative phrase to explain the rise in prices during a particular trading session might be “more potential buyers than sellers”. Definition: Volume is the number of futures contracts (shares for an equity market participants) traded each trading session. Their boundaries will fluctuate with substantial changes in open interest and/or price volatility. This relationship is shown schematically in Figure 2-1. And nothing creates more urgency in a market than a losing position. These three categories are not static. thereby assessing the health and strength of the prevailing price trend. Ideal Healthy Price Uptrend: The ideal situation for a healthy bull market is volume moving up as the bull market expands. Figure 2-1 Ideal Bull Market Price versus Volume Interaction 2-2 . than on down days when prices settle lower. average or high. It is necessary to classify the trading session’s volume into one of three categories: low. Since any useful chart analysis determines what the losers are doing.Significance of Volume: Volume is a measure of urgency. the technician will want to monitor this sense of urgency. It is the result of the need for traders and investors to “do something”. A strong price uptrend is characterized by greater volume on up days when prices close higher. The specific volume number is not important. This concept is shown schematically in Figure 2-2. The ideal situation for a healthy uptrend in prices is for volume to increase on rallies in price and decrease on selloffs. A strong price downtrend is characterized by expanding volume on days when prices close lower and increasing volume on price up days. Figure 2-2 Ideal Bear Market Price versus Volume Interaction 2-3 .“Don’t sell a quiet market after a fall” .because a low volume selloff is actually a bullish technical situation. Low volume on price down days is telling the astute trader that there is no urgency on the part of the longs or shorts to close out their positions . This configuration created the old adage . Ideal Healthy Price Downtrend: The ideal situation for a healthy bear market is for volume to increase a prices move lower. Monitoring volume to identify price moves as counter-trend is important.Volume measures how anxious trader are to establish or close out their positions.and thus the prevailing major price uptrend should continue. Blowoff volume is volume of an extremely high magnitude which is a warning signal that the price trend is in the process of exhausting itself. Prices often move violently in the opposite direction after such blowoff volume. Figure 2-7 is an actual example of this sign of exhaustion in the Corn futures market. Blowoff Volume . especially speculative ones (as opposed to legitimate hedges). volume should decline. This signal does not have to coincide with the exact extreme price day. The urgent need to close out losing positions produces “blowoff “ volume. Figure 2-3 Theoretical Examples of Blowoff Volume One caveat is in order. If no urgency develops for the shorts to cover their positions. This is the proverbial low volume rally. prices will not continually decline. 2-4 .Even in a long-term bear market. Losing positions. Adverse moves against the direction of the major trend will result in price rallies . over several weeks. A low volume rally is bearish. Ergo. Often blowoff volume will occur one trading session before the ultimate high or low price posting. “Don’t buy a quiet market after a rise”.A Warning Signal: There is one amplification of the ideal price versus volume configuration that is of paramount importance and should not be overlooked. Extreme high volume is the warning signal which indicates at least a temporary trend change. Figure 2-3 illustrates the theoretical relationships between blowoff volume and price activity. or erratically. often create conditions that lead to excessive volume.some lasting several days. depending on the specific conditions prevailing on each chart.Determination of Volume Parameters Figure 2-4 A bar chartist will scan back an ‘appropriate distance. Hypothetical horizontal lines are drawn. representing the threshold levels of “low and “high” volume. whether two weeks or two months. One third of the volume readings should fall into each of the three categories 2-5 . Volume Analysis Figure 2-5 2-6 Volume Analysis Figure 2-6 Note the increase in volume on price down days and reduction in volume on price rallies 2-7 Example of Blowoff Volume Figure 2-7 2-8 This number represents the summation of open positions in all the contract months traded for the particular commodity. Similar to volume. Definition: Open Interest (O.000 a change of +3000 3-1 3. = Short O. W hile no specific definition of what constitutes significant will be given.000 new long contracts opened 3.I. How Open Interest Changes: Open interest changes from one trading session to the next. or 3) No change. For this illustration.I. The reason for using total open interest is explained in graphic detail in Chapter Four.I. fall into one of three categories: 1) Increase. Example: Prior Day’s Total Open Interest = 180.) Is the summation of all unclosed purchases or sales at the end of a trading session.there is a dollar out.000 Answer the question: W ho is getting in or out of the market? Case One: Open Interest Increases Total O. it is safe to assume that the definition begins at more than five minimum price tics. Futures technicians monitor the total open interest figure. Admittedly. now at 183. 2) Decrease. Each of the three situations will be examined in a hypothetical example.Chapter Three Open Interest Futures trading is a zero sum game: for every dollar in . but for every open position in a futures market there has to be an opposite position. it does not matter whether prices moved up or down. W hat is necessary is that a “significant” price change occurred. the exchange clearing house and member firms scoop a little off the top. the published figure represents one side of the transaction only. = Total O. Confusion concerning the definition of open interest can be avoided by remembering this simple equality: Long O.I.000 new short contracts opened . The technical ramifications of these changes will be apparent later in this chapter when detailing the ideal healthy price uptrend or downtrend.I. W hen open interest declines.I. the trend will change. There is nothing that creates a market more than a difference of opinion. For a healthy. fuel is being removed and the prevailing price trend is running on borrowed time. If the fuel is removed from a fire. Significance of Open Interest: There are three reasons why technically based futures traders monitor open interest. now at 180.000 a change of -2. If a market was at equilibrium and the entire trading world knew this . There would be no need for hedgers to lay off unwanted risk. Open interest: 1) Indicates the existence of a difference of opinion. the trader would not know exactly what changing of positions occurred. 3) Determines if the losers are being replaced. The analogy of fuel to the market is like that of fuel to a fire. This is reflected in a willingness to take an open position. If fuel is removed from a price trend. 2) Provides “fuel” to sustain a price move. This is so important a concept that remembering the word fuel as a surrogate for open interest will place a trader ahead of 80 percent of all futures traders worldwide! 3-2 .I.000 no change In this situation. Fuel in a futures market is provided by the losing positions.the open interest in a futures listed on that commodity would be zero. Open interest is a reflection of this important concept. the fire will go out.000 long contracts sold out 2. or speculators placing positions trying to profit from a mis-priced market.000 2. strong price trend (either up or down) to continue. or at least not decline. now at 178.Case Two: Open Interest Decreases Total O.000 short contracts bought back (covered their existing shorts) Case Three: Open Interest Unchanged Total O. open interest should increase. W hat matters is that the funds are being posted at the clearinghouse. lock in profit margins. etc. Obviously the losers pay the price for their misjudgment. This is shown in schematic fashion in Figure 3-1. Precautionary measures should be taken such as moving protective stop orders (hopefully to realize profits) closer and placing orders to liquidate existing positions. Liquidation of both long and short positions is occurring. or new longs may be joining the bull bandwagon. Ideal Healthy Price Uptrend: In an uptrending market when open interest is going up. the underlying support is suspect. Figure 3-1 Ideal Bull Market Price versus Open Interest Interaction 3-3 . Potential hedgers should begin to implement any previously planned strategies to protect inventory. This is a healthy price uptrend and prices should continue to work higher as long as open interest does not begin to decline. open interest will decline. The losers are necessary to pay off the traders with the correct market judgment.Technicians do not care if a losing position is being financed by meeting margin calls and throwing more money at the market. The additional short sellers may be existing shorts adding to their losing positions. Longs may be adding to their profitable positions. Less conviction concerning probable price movement together with less fuel to sustain the price trend produces a definite warning signal of an impending trend change. or new short sellers entering the market (thinking prices are too high). or if a loser steps aside and new blood comes in to take the loser’s place. both sides are increasing their positions. but what is of importance to the technician is that declining open interest means the prevailing price trend has become very unhealthy. W hat is of the most importance to the longs is the fact that the losers are being replaced and more fuel to sustain the upmove is entering the market. If open interest is declining. W hen the losers decide that they “don’t want to play the silly game anymore” and leave the market. In any equity market that allows short sales using borrowed stock. a short interest situation might exist. Two schools of thought prevail as to what short interest implies: 1) Traders expecting a price decline are initiating short sales. such as price patterns. They would much rather buy something than be short. or any equity (stock) market) is completely different from open interest in futures. Figure 3-2 Ideal Healthy Price Downtrend Price versus Open Interest Interaction Short Interest (Equities) The concept of short interest in the U.Ideal Healthy Price Downtrend: The ideal situation for a healthy price downtrend (price expected to continue moving lower) is open interest increasing when prices close lower and open interest decreasing on trading sessions when prices close higher. The borrowed stock must eventually be returned to the lender. Short interest is the number of shares that have not yet been purchased to cover short sales.S. They could be correct. Thus a short position in futures can be taken if other indicators. grains and livestock futures. This is because “commodity” speculators are by nature bullish. This is shown in Figure 3-2. suggest lower prices . especially in the metals. or 2) By definition. Increases in takeover activity and arbitrage cloud the issue of how to interpret short interest statistics from an equity market. the shares sold short must eventually be bought back: A bullish situation. There is often difficulty in finding the ideal technical situation of open interest increasing during a downtrending market.even though the ideal situation of increasing open interest is not present. 3-4 . This concept will be illustrated in many of the charts in this course manual. price is.IDIOSYNCRASIES Questions quickly arise when a new trader is exposed to the concept of how open interest should ideally interact with price changes in a futures market. Total open interest rounds upward as a price bottom is being made and tops out as price peaks. The changes in open interest in the foreign exchange (forex) futures accurately reflect how the dominant price making force is changing its market view. Open Interest as a Coincident Indicator: On many occasions. This occurs most often in the traditional physical commodity futures during a bull market. Total open interest has acted in a coincident fashion with price in so many instances that it cannot be attributed solely to chance. 3-5 . 1) W hat happens to open interest as a market reverses price direction? 2) How can open interest continually increase in the direction of the new price trend? This would mean that open interest would have to continually rise! Markets in Transition: The answer is that normally open interest does decline as a new price trend initially gets underway. A special case in which open interest often acts as a coincident indicator in both bull and bear directions is the CME Group currency futures. and more than likely trying to change direction. As the new price trend becomes more apparent. open interest should then begin to increase . In general. open interest acts as a coincident indicator with price. any time open interest begins to act erratic after experiencing a steady increase. moving net sideways.fueling the price move to new highs or lows as the smart money rides the trend and the skeptics fight it.a level of open contracts that often approximates the level that prevailed before the start of the previous price trend. Open interest often declines to a “steady-state” condition . at best. This is because the participants with the correct (profitable) positions are liquidating (realizing that the trend is changing) and the losers are closing out their positions (confused and not realizing that the trend really is finally starting to go their way). Ideal Healthy Price Uptrend .and Early Warning Signal Figure 3-3 3-6 . Ideal Healthy Price Downtrend Figure 3-4 3-7 . Historical Charts Figure 3-5 3-8 . Feb 1999 Note that after the January 5 price decline. A price reason must be present. Technical traders cannot simply use the fact that an price rally is short covering to initiate short sales. a vicious short covering rally ensued.Historical Charts Figure 3-6 Ideal Healthy Price Downtrend Lean Hogs . 3-9 . Historical Charts Figure 3-7 Open Interest as a Warning Signal 3-10 . Historical Charts Figure 3-8 13-11 . Historical Charts Figure 3-9 Open Interest in the Transition from a Bull to a Bear Market 3-12 . Historical Charts Figure 3-10 Open Interest Increasing in a Bear Market Note the transition from a bear to bull market was initially accompanied by a ecrease in open interest. This is usual. 3-13 Historical Charts Figure 3-11 A Open Interest as a Coincident Indicator Figure 3-11B History does Repeat Itself Deutsche Mark Sept 1998 Note how the liquidation in total open interest corresponded to the price declines. W hen the bulls finally had the courage of their convictions and were willing to hold long positions overnight, price was able to move up. Also observe the interaction of price and open interest at the price highs. The open interest line resembles the Head & Shoulders Top that formed on the price chart! 3-14 Chapter Four General Rule for a Healthy Price Trend Volume and Open Interest Should Increase as Prices Move in the Direction of the Major Price Trend According to this rule, the most bullish condition on a futures chart is price moving up on increasing volume and increasing open interest; The longs are in control and the price uptrend is expected to continue. On a daily basis, this rule implies that on price up days (when quotes close higher than the previous trading session), volume should expand and open interest should increase. In a strong bear market when quotes close lower, volume will expand and open interest will increase. This ideal healthy price downtrend does not often occur in those markets that the public prefers to trade from the long side. These include traditional agricultural commodity futures and metals. Conversely, markets such as interest rate futures (U.S. Treasury Bonds in particular) often do exhibit the ideal bear market characteristics of volume and open interest up on price down days. The most bullish and bearish technical situations are shown schematically in figures 4-1 and 4-2. Figure 4-1 Ideal Healthy Bull Market Figure 4-2 Ideal Healthy Bear Market 4-1 Why Total Open Interest is Used 4-2 . Volume and Open Interest Analysis .Worksheet 4-3 . Ideal Healthy Price Uptrend Volume Should: Increase on price up moves Decrease on price down moves Open Interest Should: Increase on price up moves Decrease on price down moves 4-4 . Ideal Healthy Price Downtrend Volume Should: Increase on price down moves Decrease on price up moves Open Interest Should: Increase on price down moves Decrease on price up moves 4-5 . Ideal Healthy Price Uptrend Volume Should: Increase on price up moves Decrease on price down moves Open Interest Should: Increase on price up moves Decrease on price down moves 4-6 . 4-7 . 4-8 . Downside Reaction Likely 4-9 .Weak Price Uptrend . 4-10 . Downside measuring objectives will not be as low on a semi-log scale chart as compared to the target from the same bearish price pattern as reflected on an arithmetic scaled chart. This quandary obviously needs answering. What gives futures trading its allure? Answer: The high leverage or ‘gearing’. Logarithmic scales increase in a doubling of price in equal price distances.Chapter Five Price Scales One of the first decisions a prospective bar chartist must address is what type of price scale to use. This referred to as rectangular coordinate chart paper. a discussion of each type of scale . Classical bar chartists quite often use the vertical height of the price pattern to determine upside or downside measuring objectives. Obviously. Since time is recorded in linear fashion. In forty years of examining futures charts on a daily basis. the result is semi-log chart paper. It does not take a doubling or tripling of price to produce sizable percentage gains or losses. The ‘bottom line’ is that the use of an arithmetic price scale on a daily futures chart is perfectly acceptable. An upside target on a semi-log scale chart will be much higher than the same price pattern measured on an arithmetic scaled chart. 5-1 . First. Ken Shaleen has found that futures charts plotted with an arithmetic scale do meet the standard vertical height measuring objective dictated by the pattern. Note that this objective could be calculated mathematically . The two choices are arithmetic or logarithmic. the choice of price scale will generate much different price objectives. Arithmetic scales are constructed with each small square on the chart actually being a square.and then a recommendation.and arrive at the same price target as the ‘graphic’ method of taking the height and physically moving it over to the breakout level. After a large price move has occurred on a daily chart. 5-2 .In general. The ‘bottom line’ is that individual equity traders should find semi-log scale charts very useful. 1. 2. In addition. This is the stock that an equity investor wants to find.where a long term bull market existed. They will have an easier time finding such a buy-and-hold candidate on a semi-log scale chart. individual equities (stocks) move slower than anything listed as a futures contract. Two exceptions There are several situations in which a futures chartist might find changing the price scale from arithmetic to logarithmic. And the equity market is dominated by ‘buy-and-hold’ type investors who do not use margin accounts to leverage their holdings. the universe of equities to choose from is huge compared to the 60-80 actively traded futures contracts. helpful. The measuring objective in a Bull Flag pattern can be far surpassed using an arithmetic scale. the price blowoff to the upside in the physical commodity futures in 2007-08 can be kept in context by using a log scale. And. This is especially true for the stock index futures . Determining the graphic objective using a log scale will result in a much more aggressive (higher) target. This is a very dynamic price pattern. This would happen if a valid Flag pattern forms. An upsloping trendline on a semi-log scale chart is increasing at a constant percentage increase. Looking a long term (weekly or monthly) continuation chart of the nearest-toexpire future over a long time period (years) might be better viewed with a log scale for price. They are looking for individual stocks that are increasing in price at a good rate. This type of market participant also tends to be on the long side of the market. Example of Semi-Log Scale Figure 5-1 London Gold .monthly 5-3 . Monthly Chart nearest-to-expire future Figure 5-2A Figure 5-2B Price drop off the March 2008 high (1033.90 on the near-by future) ‘seems’ much larger on the arithmetic scale chart. 5-4 .Comparison of Arithmetic and Logarithmic Price Scales Gold . Sometimes these trends last several years. Yes. Higher and higher price highs and higher and higher price lows is the basic definition of an uptrend.down to seconds and minutes. Figure 6-1 Price Uptrend 6-1 . A position trader is an investor who wants to ride a price trend. there might be some sizable moves against the major trend. The investor desires to hold the position and therefore has a much longer time frame.up or down. but the long term trend continues. ascertaining its health (strength). Even a casual observation of historic charts indicates the presence of many sustained price trends . They have the best chance of making a profit by identifying the direction of the major price trend. Figure 6-1 is a plot of this definition. scalper.Chapter Six Trading with the Trend A ‘trader’ is different from an ‘investor’. market maker. Trendline Construction Defining a price trend is easy. For the day trader. The trader is operating in a very short time frame . and trading with it. Each upmove extends to new high price territory while the selloffs do not decline as far as the price drop on previous selloffs. trading with it is not so easy. it is the speed of execution and small commissions that produces their profits. the uptrend line is the one drawn across (tangent to) the low of the price bar at each of the relative price lows. In a downtrend it is possible to construct a straight line tangent to two price highs.) Is being used. Figure 6-3 Uptrend Lines 6-2 . It only takes two points to determine a straight line.Downtrends are characterized by lower highs and lower lows. The trendline takes on much greater significance. days. This line is referred to as the downtrend line. If a third point lies on any trendline. Typically these are the highs of the price bars on whatever time frame chart (minutes. etc. See figure 6-2. hours. a significant charting event occurs. The trend direction has much greater validity. Figure 6-2 Price Downtrend In a bull market. This is shown twice in figure 6-3. Figure 6-4 Three Point Downtrend Line Note that the 1 st trendline was only constructed using two points.and obviously has to when the trend changes. A three point trendline is infinitely greater in its technical significance than a two point line. The trend will continue until a close beyond the trendline occurs. It did not hold. Subsequent price action (after the trendline has been drawn) may cut thru prices . should not cut thru prices. It is not enough evidence to completely reverse direction. A trader strives to find the technical situation where a market is residing above or below a three point trendline. 6-3 . it changes the trend to sideways. Violating a three point trendline is cause for exiting an existing position. Even then. when initially drawn. Addition technical corroboration is needed.Any trendline. Figure 6-4 shows a three point downtrend line on the Dec 2008 Crude Oil future. The line must be tangent to two relative highs or lows. the trend does not completely reverse. This is the cardinal rule of trendline construction. Still. Figure 6-5 Trend Channel on a Weekly Continuation Chart 6-4 .and turned the market to neutral.A chartist never erases a properly drawn trendline once it has been constructed. The weekly continuation chart of the nearest-to-expire British Pound future in figure 6-5 is a good example. Trend Channels Although not as common as most traders might think. it is a ‘reasonable’ line to place on the chart. Another aspect of trendline construction is the use of a line constructed parallel to the trendline. Some chartists construct this line as a reasonable price target for the extent of the next move.even if the ensuing price move proved the analysis incorrect. This is especially true for shorter trendlines used to delineate the boundary lines of an orthodox price pattern. this upper line is often exceeded as the price up move goes into a greater vertical angle of ascent. Reference to the chart months or years later will allow the technician to see what the prevailing price configuration implied . Knowledge of the technical personalities of each market will be gained by review of the success or failure of each identifiable price pattern.where the trendline and parallel objective line contain the price swings. markets sometimes do trend within a well defined channel . Violation of the three point upsloping trendline with a weekly close below the line would signal that the major price uptrend has stopped . In bull markets. It is known as a parallel objective line or a return line. rather than reverse. 3. Figure 7-1 . Determine if a price trend is present. This seems logical because the previous price rally did stop at that level once before. In the process of defining support and resistance. And Double Top formations would be much more prevalent. and the overwhelming majority would state that the highest point on the graph is resistance. but least understood aspects of technical analysis. . . would change. The concept of support and resistance is one of the most talked about. . the following observation is useful: Ask 100% of all the would-be ‘technicians’ in the trading world where overhead resistance is located on the following line graph (Figure 7-1) . . The ‘double’ formation is not a common reversal pattern. Set entry points for new positions.Chapter Seven Analysis of Support and Resistance Locating support and resistance is probably the most important part of any classical bar charting analysis. 7-1 . . Properly locating the price levels where support or resistance would be expected. . Locate where the prevailing trend. . 2. 4. if any. the price upmove would turn down when approaching that level again. if a simple price high was overhead resistance. But. Markets tend to trend most of time. An uptrending market would never materialize. Place protective stop orders. allows the trader to: 1. Giving a price high on a chart a name. Position traders do not operate as close to the market as these highly active traders. a price low on a chart (Figure 7-3) should be referred to as a “Benchmark Low” and should not automatically be labeled as support. Figure 7-3 Market makers in equities.. The operative word is temporary. 7-2 . It is usually impossible for all but the most active day traders to make money by ‘fading’ a market as it reaches a benchmark high or low. The daily and 10-minute charts (Figures 7-8 & 9) of the Dow Jones Industrial Average illustrates how a benchmark low can act as temporary support. The June 16 low of 8570 on the daily high low close bar chart was well known and easily seen by all traders. and scalpers on an open outcry futures floor do notice that price often temporarily stops in the area of a previous price high or low. a technician should simply refer to it as a “Benchmark High”. Figure 7-2 Similarly. e.g. Look at what happened during the trading session in which the price decline again approached 8570 seven weeks later. foreign exchange dealers. This is illustrated in Figure 7-2. support. . A former price high (or top) should be underlying support in the ensuing price uptrend.overhead resistance. Figure 7-4 Support is: a Former Top 7-3 . See Figure 7-4. this low will be taken out . W hat then. The selloff had reached “support”! (not really). if any. if any. . Resistance. If an aggressive short term trader wants to label a benchmark low price as possible temporary support . is above the current price. a chartist looks down and to the left on a chart and locates the closest former price high. The chartist’s “bible” Technical Analysis of Stock Trends. resides below the current price level. The next time down the Dow moved thru 8570 like a knife thru warm butter.The supposed “support” was only slightly violated with the 8562 low on a 10minute price bar (Figure 7-9). Specifically.underlying support. is a more classical definition of support and resistance? First.fine. This trader must realize that if a healthy price downtrend trend is in progress. Think of support in two words .usually quite dramatically. Resistance is always . . by Edwards and Magee is still the best source of a definition. To find support. The next time down on the 10-minute chart the cash Dow stopped exactly at 8570. Quotes may have to eat into support or resistance until they get to a level where a sufficient amount of prior trading occurred . See Figure 7-5. 7-4 . To find resistance. should be directly proportional to the amount of dealing previously done at that particular price level. Relating volume to this concept: The lower the volume on the price sell-off to test support. a chartist looks up and to the left on a chart and locates the closest former price low.to finally produce the friction necessary to stop the price move. in theory. Figure 7-5 Resistance is: a Former Bottom Traders are obviously interested in what will happen as quotes ‘test’ a benchmark high or low.or that a price sell-off has to bounce off a price level that stopped a sell-off previously. the more likely the resistance will hold. The lower the volume on the rally to test resistance.A former price low (or bottom) on a chart should be overhead resistance in the ensuing price downtrend. the more likely the support will hold. It is important not to harbor a preconceived notion that a price rally has to stop at a price level that it (temporarily) stopped at before . The strength (ability to halt the price move) of the support or resistance. Putting support and resistance into practice: Traders wishing to initiate a new long position would place the order to buy at a price slightly above the support price. the stock index futures in particular. Another important note: Simply violating support or resistance (with a close into it) does not automatically change the direction of the prevailing price trend 180 degrees. It changes the trend to neutral. Make any buy order end with a price of 1 or 6. It is an excellent place to begin the analysis of any new chart. 7-5 . Protective stop orders should be entered far enough into support or resistance so the price move would have to inflict an inordinate amount of damage to the support or resistance before the trader would get knocked out of the market. the price should not end in zero. A good definition of “slightly’ is two minimum price fluctuations. prices ending with zeros. Locating support and resistance on a chart is an age-old technique. Additional technical evidence must be present to warrant entering a new position. all too common. Every market has it’s daily ‘noise’. Traders wishing to initiate a new short position would place the sell order at a price just below (2 tics) the resistance price. Some markets. The public gravitates to common. And. The stop must be placed beyond this noise. The proliferation of undercapitalized day-traders makes for this phenomena. It is far easier to make this statement than to quantify it. It does not require a sophisticated computer package. Make any sell order end with a price of 4 or 9. are notorious for eating farther into support or resistance than any other market. Example of Underlying Support Airtouch Communications Common Stock Daily Chart Figure 7-6 7-6 . Example of Overhead Resistance Figure 7-7 7-7 . Daily Figure 7-8 7-8 .Dow Jones industrial Average (cash) . Dow Jones industrial Average (cash) .10 Minute Figure 7-9 7-9 . Blank 7-10 . Price Pattern Recognition Price patterns that tend to appear regularly on a classical bar chart are one of the most valuable tools for a technical trader.and. The rationale behind the use of price charts is that all the supply and demand information has to be synthesized into a single piece of information . fears. Also affecting the price movement is activity by speculators who utilized information other than fundamental supply/demand data. These market moving decisions are also reflected in the price. the ‘opening’ price is also recorded on the graph. is an important aspect of any chart . most importantly. such as psychological judgements. 8-1 . If fundamental forces are at work moving the market. They divide themselves into two distinct groups: Reversal patterns or continuation patterns. Open interest on a daily futures chart is also a helpful aid in assessing the validity of a price pattern. such as candle charts. Chapters 9 thru 17 detail these formations. In specialized forms of charting. greed.Chapter Eight Price Pattern Recognition Overview The high. low. by Edwards & Magee. the price will show it. Only a handful of orthodox price patterns exist. they repeat themselves often enough to allow the technician to make a future forecast based upon past price patterns. often carry specific measuring objectives . These patterns indicate the high probability direction of the major price trend.especially a daily high. if available. In the move toward 24-hour electronic dealing. low and last price for a specified time period are the basic inputs for a classical bar chartist. This course manual primarily contains examples of futures charts.price. Volume. Reader desiring more illustrations of individual equity charts are referred to the classic: Technical Analysis of Stock Trends. there is some question about the benefit of the next day’s open when it happens a nanno-second later than the previous day’s close. Although some of the decisions may be based on hopes. close bar chart. alert a trader where things are going wrong. often this is best accomplished when the market is not open. diversify the analysis. 3. Do not try to force a conclusion via assuming that a reasonable risk / reward trade must be present. 5. Create a trading plan based on the bar charting conditions that exist. determine the measuring objective and the stop-out price level. 4. sometimes no trade is the best trade. 6. A chartist need not get married to a single market. Identify the direction (if any) of the major price trend 2. 8.or in the process of forming.Hierarchy of Bar Charting Analysis 1. Check the internal health of the trend by using volume and open interest. 8-2 . Look for the possibility that an orthodox price pattern may be present . Locate the closest underlying support and overhead resistance price levels. 7. If an active price pattern is present. there will much less confusion whether the trader is talking about price topping or price bottoming. there must be a definite price trend in place .so there is something to reverse. It can occur as either a Head & Shoulders Top or a Head & Shoulders Bottom. Figure 9-1 9-1 . when referring to a bottoming of a price trend.Chapter Nine Head & Shoulders Reversal Pattern The Head & Shoulders (H&S) price pattern is the most reliable reversal pattern. Before a chartist should be looking for any reversal pattern. Figure 9-1 clearly shows these five reversals. This classical bar charting price pattern physically resembles a head & shoulders when found at a market top. For clarity. Before discussing the pattern in detail. Five obvious reversals of the minor price trend must be present on the chart to form the pattern. there are several overall observations: 1. technicians should use the phrase H&S Bottom rather than ‘inverse Head & Shoulders’. 2. By using this terminology. The price decline does not have to stop exactly at the same price level of reversal point two.only underlying support. This is a sign of weakness in the major price uptrend. If so. the proverbial ‘early warning signal’ will have been flashed. A price decline that violates support is the first important sign that a reversal pattern could be developing. The highest price in the pattern will be called the ‘head’. At this time. Symmetry (more on this later) would suggest that the high of the right shoulder will be in the general price area of the top of the left shoulder.Development of a Head & Shoulders Top: In a price uptrend. Note that because the pattern has not been officially activated (with a close below the neckline). 9-2 . This last price rally in the developing H&S Top must stop below the high of the head. At this juncture in the development of an H&S Top (at a price level near the high of the head). If not. W hen this occurs. a classical bar chartist begins to study the graph in earnest. a conservative chartist should not be attempting to pick the high of the right shoulder and trade it via a new short sale. Ideally this rally will occur on lower or declining volume. If so. that the selloff from the high of the head must violate the support level. It is quite possible that extremely high (blowoff) volume might be present on the price move up to form the head. Next. a corrective selloff (from reversal point one) and the subsequent rally to a new price high (off the low of reversal point two) implies that the uptrend is firmly entrenched. there is no overhead resistance present . It is especially bearish if the volume on this developing right shoulder takes place on volume readings lower than what occurred on the rally for the left shoulder. the definition of a bull market will continue to be present. total open interest might decline on this final rally. the chart is really telling the technician that the market is in the process of trying to reverse the major price uptrend. It cannot be emphasized enough. These first two reversals of the minor price trend will create what will be the ‘left shoulder’ of the completed pattern. any long positions should be closed out. The ability of a technician to properly locate where support should be present is of paramount importance. This price decline below the support (which is in the process of becoming the high of the left shoulder) can halt anywhere in the vicinity of reversal point two. And if the item being charted is a futures contract. a price rally (off reversal point four) must occur. Once this occurs. These two price lows are the reactions on either side of the head. W ith this in mind a trader should take partial profits when the minimum measuring objective is reached and look for additional technical signs that a greater percentage of the open trade (short) should be closed. As long as price trades below the objective any time during the international 24-hour trading day . the chartist has strong technical evidence that the longer term trend has changed direction.Activating a Head & Shoulders Top: The neckline is the 2-point minor trendline drawn tangent to the lows of the price bars at reversal points two and four. This enables a chartist to gain insight as to what the risk is. And.. W ith any active H&S formation (Top or Bottom). it is the price at which the neckline was broken. Traders should try to follow the old adage of “letting profits run and cutting losses”. fails. Note that this distance is not measured from the close beyond the neckline. 9-3 For sure.e. a trader should have been following the market down with trailing . In the case of a Head & Shoulders Top this must be a close below the neckline. The style convention for drawing this boundary line of the pattern is a dashed line. most importantly. One of the helpful aspects of classical bar charting price patterns is that a definite measuring objective can be derived. What to do at the Measuring Objective: A close below the minimum downside measuring objective in an H&S Top is not required. How Far Will Prices Move: Elementary textbooks about trading often refer to establishing a risk to reward ratio. the technical trader will know where the pattern breaks down i. price is expected to move a minimum of the vertical distance from the extreme of the head to the neckline as measured from where price penetrated the neckline.the pattern has worked as expected. but do these books ever detail how to determine this ratio? Answer: No. given the expected price move. Sounds good. Any classical bar charting price pattern is not officially activated until a close outside the pattern is posted. 9-4 When to Enter a Position: After monitoring a market closely and seeing a potential Head & Shoulders . The chartist will also be looking for one of the classical continuation patterns. it is the first price signal that H&S Top may be forming. and the number of shoulders. Figure 9-2 If a selloff penetrates this former ² price high. Ideally. If a right shoulder develops. Triangle or W edge. it may prove to be very similar.and additional directional positions can be established. time spent during the development of the two shoulders. More than one shoulder on each side of the head produces a complex H&S formation (more on this later). Pay attention to what happens on the ‘left’ side on the chart because it could be duplicated on the ‘right’ side of the chart. a decline in open interest (futures only). Additional signs that more open trades should be removed would be blowoff volume. to form. Symmetry: It is amazing how often the Head & Shoulders formation exhibits symmetry with respect to the magnitude of the two shoulders (figure 9-2).protective buy-stop orders. Then note the magnitude and duration of the previous reaction. the protective stop would be located well into or above the top of the closest overhead resistance. This would indicate the existing price trend has further to travel . or the posting of one of the four minor trend change indicators (see Chapter 17). A pullback to the closest overhead resistance. This is as it should be with any protective stop order. whipsaw. 2. Read. this is not an attractive risk to reward ratio. Volume can be a useful aid. This line is drawn tangent to the extreme of the head and the right shoulder. 9-5 Additional considerations: It takes time to reverse a price trend. placing a protective stop higher than the high of the head in a Head & Shoulders Top results in a risk to reward that is. the less likely a pullback will occur. by definition. But. Even though the H&S formation is a highly reliable pattern (86 . The following is a reasonable strategy. A sharp reaction then takes price back within the pattern. A look at the various possible shapes of a Head & Shoulders formation (Figure 94) shows that it is impossible to make a blanket statement concerning when and where to establish an initial position. it is very tempting to ‘lead off’ and establish a position prior to the official breaking (close below) the neckline. monitoring intra-bar price activity. This is a dangerous practice. 1.pattern developing. A pullback to just below (2 minimum price tics) the neckline.88% reliable). slightly worse than one to one. It takes discipline to wait for the penetration of the neckline and the confirmation of high volume if it was an upside breakout from an H&S Bottom. or B. The protective buy-stop would be placed just above this downsloping line on a Head & Shoulders Top pattern. the formation was not set off. An aggressive short term trader. W hether or not a corrective price pullback (rally in the case of the H&S Top) will take place is the age old question that causes difficulty for a chartist. Note that the protection slides down (is tightened) with time. The suggestion is to construct a ‘failsafe trendline’ to gauge where a chartist should become worried about the pattern not working. Since the close of the price bar was not beyond the neckline. might see price trading beyond a neckline within the price bar. The higher the volume associated with any breakout. The five reversals of the minor price trend . Establish a 50% position on any closing penetration of a valid neckline. Where to Place the Protective Stop: Any H&S formation is not destroyed until the extreme of the head is taken out. Establish the remaining 50% position on: A. It pictures the influx of new information or moods that are necessary to change the direction of the trend. And for the long term position trader. the new fundamental inputs are what drive prices. high-low-close bar charts. it is the speed of execution that is important.in a Head & Shoulders formation represent the battle between the forces of supply and demand. volume is not usually a consideration. This time frame is most suited for the interpretation of volume and open interest on a futures chart. Figure 9-3 H&S Top 9-6 Every Head & Shoulders has a Different Shape . Most of the charts in this manual are daily.from minutes to months. not the dutiful analysis of volume and open interest (the latter being impossible on an intra-day chart). For the extreme time frames of minutes or months. The H&S formation ‘works’ on any time frame chart . For the day trader. Figure 9-4 9-7 Head Shoulders Top & on a Weekly Chart . Figure 9-5 Zinc . Believing the pattern on the Zinc chart produced the correct directional view for this metal. 9-8 Head & Shoulders Bottom .LME It is interesting to note that Zinc was in a major bear market during the same time frame that Gold and Silver were setting new all-time highs. A classical bar chartist does not trust an upside breakout of any price pattern or 2-point trendline that occurs on less than high volume. The vertical distance from the head up to the neckline is graphically added to the neckline when a closing price is posted above the neckline.A valid Head & Shoulders Bottom formation contains two important volume considerations: 1. in combination with any technically based traders. 9-9 Figure 9-6 Head & Shoulders Bottom . total open interest would ideally increase on the upside breakout. The upside breakout. it does imply a high likelihood of a price pullback (decline) toward the neckline. should occur on a noticeable increase in volume during that trading session (or price bar). Needed is the ‘smart money’. the minimum upside measuring objective of a bottom is determine in exactly the same fashion. the sophisticated fundamental traders doing enough buying such that. Short covering on an upside breakout does not automatically invalidate the breakout. Declining open interest would mean that the price rally was due to net short covering. An apparent upside breakout that has been engineered solely by technical traders will not usually generate enough volume to be valid. a close above the neckline. As with the H&S Top. The Swiss Franc future in figure 9-6 is an example of a Head & Shoulders Bottom on a daily chart and figure 9-7 is an H&S Bottom on an hourly (Gold) chart. Ideally volume on the price selloff to form the right shoulder will be ‘low’ or declining. W ith specific regard to a daily futures chart. 2. volume will escalate to a distinctively higher level. 9-10 Figure 9-7 Head & Shoulders Bottom on an Hourly Chart . 9-11 .Not e the symmetry of three shoulders on either side of the low of the head. and the back of inflation was broken.Figure 9-8 Head & Shoulders Bottom on a Monthly Chart This multi-year Head & Shoulders Bottom occurred in the years just after the TBond future began trading. Paul Volker was the chairman of the US Federal Reserve Bank at the time when inflation was running rampant. The Fed stopped pegging interest rates and tightened the money supply. The ‘growth curve’ upward in volume can be seen as this future gained in popularity as a trading and hedging vehicle. The large H&S Bottom depicts this process of increasing long term interest rates and then a bull run in price that continued to set new price highs as late at September 2008 (124-24) on this notional 6% coupon bond. 9-12 Complex Head & Shoulders Formations . The prime rate reached a high of 21 1/2% . The left shoulder selloff began with the “October Massacre” in 1979. Volume is not normally analyzed on a weekly or monthly chart. The term complex refers to the fact that ‘two or more of something’ is found in the pattern. This was the problem with measuring objective on the Copper chart at the end of this Chapter. Multiple measuring objectives are possible if several necklines exist. This could be two sets of shoulders on either side of the head. Or it could be Double Top for the head. Most complex H&S formations tend to exhibit symmetry in the number of price gyrations seen on either side of the head. A chartist should always be thinking . Figure 9-9 Possible Complex Head & Shoulders Top 913 .symmetry. A chartist does have to be aware that any H&S formation cannot be expected to retrace more than the price move that preceded it. There is no technical reason that the largest obtainable objective should not be considered viable. Figure 9-10 Complex Head & Shoulders Top on an Hourly Chart 9-14 . Historic Charts Figure 9-11 H&S Top ‘failure to form’ “The most widely advertised (possible) Head & Shoulders Top since Edwards and Magee wrote their book” Quote from a member of the Chicago Board of Trade on the trading floor in 1982 9-15 . Can Technical Analysis be used in a manipulated market? 9-16 . shares staged a spectacular collapse to near-worthless levels in frantic trading as investors reacted to the news that the company’s supposedly huge gold discovery is really a highly engineered fraud. 1977 Quote from the Wall Street Journal. 1997: “Bre-X Minerals. Ltd.Manipulation ended badly Bre-X common stock .in Canadian Dollars Suspended May 8.” 9-17 . Wednesday May 7. Example of a Head & Shoulders Failure 9-18 . Often price moves much farther into classical support or resistance levels than any other futures contract. individual equities chart very well. 9-19 Multi-year Head & Shoulders Top .Historical Chart The severity of the price pullbacks are what make stock index futures trading so difficult. In contrast. 9-20 Failure of a Head & Shoulders Bottom to Reach .on a Monthly Chart of a U. 2008.S. Equity Index The Dow Jones Industrial Average and the S&P 500 Index also met a Head & Shoulders Top objective on their monthly charts during the week ending October 10. 10. This price extreme is the limiting factor if application of the standard height objective results in a price beyond where the previous price move began. This was the case in the Copper chart below. 5. to the neckline break. This was higher than where the previous price downmove began . Top or Bottom. 100. resulted in a conservative (arithmetic) upside price target of 105.at 104. the traditional objective at 105.04. cannot be expected to re-trace more than the price move that preceded it.62 daily high.10 with the 103.and Why Any H&S formation.04.04 was never reached. Copper .00. Adding the vertical height of the pattern. But.May 1992 92 1 Notes . The May Copper did ‘attack’ 104.Its Measuring Objective . 9-22 . Carrying on the notion of where price volatility would be expected. The price volatility associated with any Broadening formation is more likely at a top in any of the physical commodity futures. Because the fifth reversal of the minor price trend takes place beyond the extreme of a possible ‘head’. A well thought out game plan for an entry into a new position is a must. the pitfalls associated with each particular price pattern are encountered. 10-1 . in an interest rate future.k. One further note. Although. This is why it is unusual to find this formation at a price bottom on this type of chart. a downward sloping neckline when a possible H&S Top might be forming and an upward sloping neckline when a possible H&S Bottom might be forming is a big clue. A theoretical example of a Broadening Top can be seen in figure 10-1 and an actual example in figure 10-2. low prices. On the currency futures or spot foreign exchange charts the volatility could be at either extreme. it would be at high rates . a.i.. There is no way to know beforehand that a Broadening Formation might be developing. there is no specific measuring objective. CHARTW ATCH will suggest using a standard ‘double’ measuring objective using the last two price extremes. There is a reversal formation known as a Broadening Formation that contains five reversals of the minor price trend . This can be seen on the TBill chart in figure 10-4. According to the old Edwards & Magee textbook. Price bottoms on the physical commodity future tend to be more ‘rounding’. it keeps the technician ‘honest’ in not jumping to the premature conclusion that an H&S is forming every time four reversals of the minor trend are in place.Chapter Ten Broadening Formations As a chartist gains experience.just like the Head & Shoulders pattern.e. This is what happened on the Yen future in figure 10-3.a. This technique worked out to the exact point in the Japanese Yen example in Figure 10-3. Ken Shaleen. Patience and knowing that such a pattern does exist (although not frequently) is the first step. Figure 10-1 Theoretical Broadening Top Figure 10-2 Broadening Top 10-2 . Figure 10-3 Broadening Bottom 10-3 . Figure 10-4 Broadening Bottom and Complex H&S Top 10-4 . The pattern is more prevalent on a cash or spot market chart where the basis convergence in a futures contract is not continually pulling the future toward the cash price. ‘Two price highs at approximately the same price level’ is only one-half of the definition. A new position should not be initiated until the pattern has been activated.Chapter Eleven Double Top and Double Bottom Double Top The definition is simple.a. Often the pattern is activated and some price progress toward the measuring objective is made . Proper money management and the movement of a protective stop order can mitigate the poor performance of the pattern. 2. Before proceeding with examples. This negative does not automatically mean that a technician trading this pattern will suffer a loss. Figure 11-1 Double Top Many traders see a price move stop in the same general area of a previous price reversal. Prices must decline below and close below the low point established in-between the two price highs before a Double Top pattern has been officially activated.k. is not a common pattern on a future or forward chart. Top or Bottom. A ‘double’ formation is not all that reliable price pattern. But what trading usefulness does this have? Should a short (or long in the case of a possible Double Bottom) be taken? The answer is no. 11-1 . yet the misunderstanding involved with the Double Top is extraordinary. Ken Shaleen a.but the minimum objective is not reached. CHARTW ATCH must share some historical observations: 1. A ‘double’ formation. To determine the height of the pattern. After the breakout there may be a price pullback. The height of the pattern is from the low point in-between the twin highs up to the line. This is a method of ‘graphically averaging’ the two highs if they are not exactly the same price. It is the now former price low in-between the twin highs. Note that there was no pullback on the weekly Euro-fx chart in Figure 11-2. it is easy for a chartist to determine the location of overhead resistance. This is schematically shown in Figure 11-1. If so. In a Double Top the vertical height of the pattern is subtracted from the price low in-between the two highs or lows. rally in the case of a Double Top.The measuring objective of a Double formation is straight-forward. A conservative trader might wish to wait before initiating a new short until a pullback to test the overhead resistance is posted. Figure 11-2 11-2 . a straight line (a 2-point trendline) is drawn tangent to the two price highs. such that a pullback would have to do an inordinate amount of damage to the expected resistance or support level. there may or may not be a price pullback following the upside breakout. It is always difficult to know whether a pullback is going to be posted. This is schematically shown in Figure 11-3. Because this is an upside breakout. Yes. a trader has to weight the opportunity loss of not initiating a new long on the breakout. the upside measuring objective is clear. As usual. price must close above the high point in-between the two (approximately equal) price lows before a trading decision can be made. W ith either the Double Top or Bottom. Price should rally to as far above the high point as the vertical distance inbetween the twin price lows. Figure 11-3 Double Bottom 11-3 . A chartist should not trust any upside breakout that takes place on substandard volume. a protective stop should be placed far enough beyond where the classical resistance or support begins .Double Bottom In a Double Bottom. Thus. the risk / reward of a new long placed only a pullback is better but. the pullback might not happen. Once an official upside breakout is posted. it must occur on a noticeable increase in volume. Double Bottom and H&S Bottom on ‘non-storable’ commodity futures charts 11-4 . After the downside breakout from the Double Top. Note the typical open interest action in the transition from a bull to bear market. look at where the pullback stopped .This is a classic chart. 11-5 .at the overhead resistance. 11-6 . A trader should do all the technical work on the chart of the underlying instrument .Should Price Pattern Recognition be Applied to Options Charts? Price plot of June 70 Call option Price plot of underlying instrument June 1985 T-Bond future The answer to the question posed above is . Time erosion caused the price of the 70 strike T-Bond Call option to decline much farther than the pullback after the price decline into the Double Bottom occurred on the chart of the underlying instrument.No Because an option is a ‘wasting asset’ the bar charts do not lend themselves to classical price pattern analysis.and then pick an options strategy suitable for trading that pattern. Chapter Twelve Continuation Patterns The Symmetrical Triangle Formation Figure 12-1. Note that this new price move can be in either direction . Valid Symmetrical Triangles In the ‘art’ of classical bar charting. continues. the Symmetrical Triangle formation is the premier continuation pattern. It is created by a net sideways price movement on the chart. This means that the prevailing price trend that was in progress prior to the triangle forming. a significant directional price move ensues. after which. 10-1 .but there is an overwhelming tendency for a valid triangle to act as a continuation pattern. It is the lower probability case where the triangle acts as a reversal pattern that keeps a chartist ‘honest’ by not always taking a directional position within the pattern prior to the breakout. The major price trend is not continually reversing from bullish to bearish and then reversing again.i. it is not surprising that this pattern is the most common of all bar charting formations. Shape: It only takes two points to define a straight line. Valid Symmetrical Triangles shows the ideal bearish and bullish formations. Each line must slope in a different direction. Remembering this simple rule will keep a trader from incorrectly assuming that a valid triangle is present. Although the definition of a Symmetrical Triangle is not so strict as to require that the triangle be equal lateral (line segments of the same length) or equal angular (same angle for each converging line). One side of a valid Symmetrical Triangle should not even approach twice the length of the other side. 5 minutes to monthly.although this occurs in less than 25% of the cases. Figure 12-2. it leads to a continuation of the prevailing price trend approximately 75+% of the time. An Incorrect Interpretation shows how a bad mistake can be made. Any triangle is not an active pattern until a closing tic mark is posted beyond one of the boundary lines.e. Note that this pattern can be a reversal pattern . If the Symmetrical Triangle is best classified as a continuation pattern. Four reversals of the ‘minor’ price trend are necessary to create the two converging boundary lines. Figure 12-1. It ‘works’ on all time frame charts . the word symmetry is important. 12-2 . The two lines intersect at the apex of the triangle.Most of the time markets are trending.. the upper boundary line must slope down.) Where to Locate Reversal Point One: The first reversal point (1) in any valid triangle is always at a relative price high in a bull market or at a relative price low in a bear market. Two converging line segments form a proper Symmetrical Triangle. The lower boundary line must slope up. (More on this later. The more likely outcome in Figure 12-2 is a Head & Shoulders Top rather than a Symmetrical Triangle as a bullish continuation pattern. Directional Considerations: W hen this formation occurs on a high-low-close bar chart. An Incorrect Interpretation Volume Within the Triangle: A general statement can be made with respect to volume within any triangle: It usually moves irregularly lower. 12-3 . Because the price swing near reversal points 1 and 2 are greater than the price swings near reversal points 3 and 4 it is not surprising that volume would typically be greater at the beginning of the net side ways price movement. This is common sense. The downsloping line overlaying the volume in the chart of Exelon common stock (Figure 12-3) is a reasonable example of how volume contracts within a symmetrical triangle.Figure 12-2. looking for nuances in volume within the consolidation pattern. A chartist should not use a microscope. Figure 12-3. Exelon Common Stock 10-4 . Breakout Volume: One of the first things that any novice bar chartist learns is that a valid upside breakout from any price pattern should occur on a noticeable increase in volume. This is due to the idiosyncrasy of the trading public to prefer to be on the buy side rather than on the sell side. A low volume upside breakout is not to be trusted. Figure 12-3, Exelon Common Stock shows volume of 2,807,400 shares on the ‘second breakout’. Although this was not a major jump in volume, it was higher than the ‘first breakout’ from the inner Symmetrical Triangle. The section on Re-drawing the boundary lines later in this chapter explains what happened with the two triangles that formed. Downside chart breakouts (a close beyond the lower boundary line of the triangle) do not have to occur on increased volume. Often volume increases a trading session or two after a downside breakout. This is because the market is making it painfully aware to the bulls that they are ‘long and wrong’. The undercapitalized longs are forced to liquidate their losings positions; volume increases during this panic exit. Location of the Breakout: Another vital consideration of any triangle breakout is its location with respect to time The breakout cannot occur too far into the pattern. Too far is defined as more than 3/4 of the horizontal distance from reversal point one to the apex. If a breakout is posted beyond this 3/4 distance, the triangle loses its’ effectiveness. Anything can happen. Price could move up, down, or sideways. Measuring Implication: The majority of classical bar charting price patterns utilize the vertical height of the pattern to gauge the future extent of the price move. This convention is also applied to the triangle formation. The vertical height of any triangle is always measured at reversal point 2 to the opposite boundary line. This is true whether the triangle is found in a bull or bear market. This distance is added to or subtracted from the price of the boundary line on the price bar which posted a close outside the triangle. This is minimum distance price is expected to move. Figure 12-3, Exelon Common Stock shows that the vertical height of the largest Symmetrical Triangle measured straight up from the 59.75 low was 1.87. Adding this distance to the 60.76 breakout price yielded an upside measuring objective of 62.63. This arithmetic objective was met. 10-5 Old time chartists often use a graphic method of obtaining an objective. This takes the vertical height of the pattern and moves it over to the breakout. Note that this method of obtaining an objective will result in the same objective if the price scale used is arithmetic. Use of a logarithmic scale for price will result in higher absolute upside objectives and not as aggressive downside objectives compared to an arithmetic scale chart. Futures traders use arithmetic price scales and equity chartists tend to use logarithmic scales. Pullback?: The question of whether or not a price pullback (after a valid breakout) will occur is always difficult for a chartist to answer. Volume may provide some insight. For sure, a technical trader must keep the size of any position small enough to withstand the adversity if a substantial price pullback occurs. After a valid breakout, underlying support (for an upside breakout) is created at the price level of the breakout. Additional support should be present at the boundary line just penetrated (Note that this line is moving farther away during a pullback). Support should also be present at the price level of the apex. There is nothing special about the location of the apex in time, after a breakout. The last bastion of support (again, in the case of an active bullish pattern) is the opposite (lower) boundary line of the triangle. A violation of the opposite boundary line or its extension beyond the apex, even intra-price bar, officially destroys the triangle. This last support (line) gives the technical trader a worst case scenario for the triangle - with it still ‘working’ as expected. Thus, in theory, the protective stop order should be placed just beyond the opposite boundary line. The good news is that this stop order is continually ‘tightened’ as time passes. Reliability: An educated guess as to the reliability of an active Symmetrical Triangle meeting it’s minimum measuring objective is 76 - 78%. This probability is about 10 percentage points below the reliability of a valid Head & Shoulders formation. The H&S pattern (top or bottom) is the most reliable of all classical bar charting price patterns. 10-6 Redrawing the Boundary Lines: A ‘fact of life’ concerning the triangle formation is that sometimes reversal points 3 and 4 have to be relocated. This usually happens when the two boundary lines of a possible triangle converge too quickly. This is shown in Figure 12-4, Re-drawing the Boundary Lines. Figure 12-4, Re-drawing the Boundary Lines The more difficult case (of having to relocate the boundary lines) is contained in Figure 12-3, Exelon Common Stock. Exelon did experience what looked like a valid price breakout to the upside on October 10. Admittedly, volume at only 2,268,300 shares was not impressive. The price move up after the breakout did not exceed the first point in the triangle. Then, a severe price pullback(decline) occurred; the pullback entered the triangle and destroyed the formation by violating the opposite(lower) boundary line. However, the extent of the pullback did not take out reversal point two (59.75). An ensuing price move in the direction of the major price trend (up) created the conditions where a second set of reversal point 3 and 4 were present. 10-7 This is shown in Figure 12-5. resulted in a larger triangle. Figure 12-5. To resolve the dual techniques of obtaining a triangle measuring objective. The market would then be followed by a trailing protective stop order. It became a viable Symmetrical Triangle. Another Method of Obtaining a Measuring Objective: A chartist can also construct a ‘parallel objective line’ to construct a reasonable triangle measuring objective. Another method of obtaining a Triangle measuring objective. It is a secondary objective. The assumption is that price will touch this parallel objective line. It is this sometime problem of re-locating reversal points 3 and 4 that drops the reliability of the triangle formation below that of a Head & Shoulders reversal pattern. continuing to use the original points 1 and 2. The line begins at reversal point one and increases/decreases at the same angle as the opposite boundary line of the triangle.Re-drawing the two boundary lines on the Exelon chart. Another method of obtaining a Triangle measuring objective 10-8 . existing positions can be partially liquidated. a chartist could plot both targets. This line is derived from a point and an angle. W hen the closest target is reached. W hen two reversals of the minor price trend are present. A ‘plain vanilla’. a 90 degree angle is present. Other Continuation Patterns: If either boundary line is horizontal. This is due to basis convergence that is constantly occurring on any futures chart. The market ‘wants’ to penetrate the horizontal line. The price move could go much farther. They are both continuation patterns.the risk / reward parameters for a directional trade appear. food for thought: A trader equipped with a knowledge of option strategies has a much larger arsenal of positioning techniques within a Symmetrical Triangle prior to the breakout. Sometimes two entities that tend to move in the same direction with one another will exhibit a Symmetrical Triangle on one chart and a W edge pattern on the other. the pattern that forms is a relatively rare variation of the triangle. the resulting pattern is a Rising or Falling W edge. the technical trader receives a ‘get ready’ signal. 3/4 of the long or short position should be closed out when the height measuring objective is met. declining open interest (for a futures contract) or a Key Reversal price posting (a minor trend change indicator) would prompt a trader to remove 100% of all directional positions. This results in an Ascending (bullish) or Descending (bearish) continuation pattern. long or short only trader must wait for the breakout before entering a new position. Conclusion: The Symmetrical Triangle is a common bar chart pattern. Examples of right angle formations and wedges are located in chapters 13 and 14. The market must simply trade at or beyond the objective any time during the international 24-hour trading day. The Right Angle (90E) form of triangle is found more frequently on cash (spot) market charts than on futures charts. This is the narrowing of the difference between the cash price and the futures price as time passes. And. 10-9 . The reason that 1/4 of the trade should be kept open is because of the word ‘minimum’ used in conjunction with the measuring objective. If both lines slope in the same direction. If the next two reversal points create the proper conditions for a Symmetrical Triangle . all or nothing. A trader is trying to follow the old adage of letting some profits run.What to do when the Measuring Objective is Reached: As the economists say “all other things being equal”. Note that a close beyond the objective is not required. Additional technical factors such as blowoff volume.but patience is required. There should be a profitable trade ahead . yet still converge. Dec 2008 Light .Example of a Symmetrical Triangle Crude Oil .NYMEX 10-10 . The expected direction of the breakout is thru the horizontal boundary line of the pattern. The two forms of Right Triangles are shown in Figures 13-1A&B. the same number of reversals of the minor trend (four) are necessary before the two converging boundary lines of a Right Triangle can be constructed. is a bearish pattern (price will descend out of it) 13-1 .Chapter Thirteen Right Angle Triangles A Right Triangle is so named because one of the boundary lines is horizontal. As a variation of a Symmetrical Triangle. is a bullish pattern (price will ascend out of it) Figure 13-1B Descending Right Triangle . Figure 13-1A Ascending Right Triangle .a right angle. . . . and a 90-degree angle is present . And. As an experiment. figure the approximate risk to reward of taking a directional position within a Right Triangle prior to the breakout. Note that this is in contrast to waiting for the breakout from a Symmetrical Triangle .where constant basis convergence between the futures and cash market is not present. could then lead to the measuring objective being met . This idiosyncracy is based on the outside public tending to favor trades on the long side of any market. Assessing the theoretical risk in any new trade is of paramount importance. a chartist / trader can ‘lead-off’ by placing a directional position within the Right Triangle prior to the breakout. If not. a gap down. Right Triangles are likely to be more prevalent on a cash or spot chart . This height is always measured from reversal point two . it is important to place short positions within a possible Descending Right Triangle prior to the breakout. It will be a risk of 1 to a reward of 3. This is such a favorable ratio. Because the expectation is that price will breakout thru the horizontal boundary line.even though the high probability (75-80%) is for the Symmetrical Triangle to act as a continuation pattern. The risk parameter in a trade based on any active Triangle pattern is a price move beyond the opposite boundary line. thru the lower boundary line. Thus. markets tend to fall faster than they move up in price. Be careful.to the other side of the Triangle. that a trader will want to place this position every time a Right Triangle is present. Price is expected to move beyond the boundary line penetrated. The reward parameter of any Triangle pattern is the same.on the same price bar as the breakout! 13-2 . by the vertical height of the pattern. As with the Double Top or Bottom formation. as usual. In a Right Triangle.The risk and reward parameters in a Right Triangle are distinctly defined. Right Triangle are relatively rare patterns on forward or futures charts. the initial protective stop loss order would ideally be placed slightly (say 2 minimum price tics) beyond the sloping boundary line. cending Right Triangle Eurodollar Time Deposit Futures June 1989 (Objective was met) 13-3 . 13-4 .Ascending Right Triangle US Treasury Bond future Dec 1982 The time period during which the Symmetrical Triangle formed is examined on Point & Figure chart in Chapter 18. and begin removing positions when the first objective is reached. 13-5 .Descending Right Triangle The parallel objective line on the Cotton chart was not reached . A chartist can place both objective on the chart .but the traditional height measuring objective was met. Notes 13-6 Chapter Fourteen Wedge Formations A W edge formation is a continuation pattern. Price is expected to continue in the same direction it was going when the W edge began to form. As with the premiere continuation pattern, the Symmetrical Triangle, a W edge requires four reversals of the minor trend for the two converging boundary lines to be constructed. A W edge begins its development in similar fashion to the Triangle; however, the fourth minor reversal of the trend is such that both boundary lines slope either up or down. Rising Wedge A Rising W edge is a bearish pattern. Both converging boundary lines slope up. A close below the lower boundary line of the Rising W edge activates the pattern. The objective is to take out the lowest point in the formation (reversal point one). A schematic diagram of a Rising W edge is shown in Figure 14-1. Figure 14-1 Rising Wedge 14-1 Figure 14-2 Rising Wedge - Gold, Dec 2008 NY 14-2 Figure 14-3 is a schematic diagram of a Falling W edge. A close above reversal point one is not required . Note that high volume is necessary to validate the upside breakout from the Falling W edge but is not necessary (although ideal) on a downside breakout from a Rising W edge.only an intra price bar move above it. Both converging boundary lines slope down.Falling Wedge A Falling W edge is a bullish pattern. The minimum upside measuring objective of a Falling W edge is to take out the highest point in the pattern (reversal point one). A high volume close above the upper boundary line is necessary to activate the pattern. Figure 14-3 Falling Wedge Figure 14-4 Falling Wedge Plywood futures 14-3 . Falling Wedge on the Gold / Silver Ratio Monthly Chart 14-4 . Rising Wedge Soybean Oil March 1981 Note the quote from the Edwards and Magee book. The Rising W edge is a very powerful sign that a bear market is in progress. 14-5 . additional charts of markets that are thought to move in concert must be analyzed. 14-6 .What if a boundary line is very close to being horizontal? W hen a boundary line is so close to horizontal that there is a question of what pattern is developing. Flags occur within the course of a ‘rapid. the Flag is composed of several narrow range price up days. resting place before the prevailing trend resumes. Flags normally slope against the trend. the ‘body’ of the Flag slopes downward. In a price downtrend. Figure 15-1A Flag in a Bull Market Figure 15-1B Flag in a Bear Market 15-1 . They mark a half-way. straight-line’ price move.Chapter Fifteen Flags & Pennants ‘The Flag Flies at Half Mast’ A Flag is a dynamic and potentially very profitable price pattern. Figures 15-1A&B show a theoretical Bull and Bear Flag. In an uptrend. breath-catching. several low volume small range down days produce the body of the Flag. a 10 minute chart. Be careful. a trader should take profits at the objective and try not to give back the significant gains that were made in so short a time period. No market can go below zero to the downside. 2. Historical observation has shown that once a Flag objective has been reached. the trader will know quickly if the newly placed position is a winner or loser. Any trailing protective stop order would more than likely be executed. On an individual equity chart. Therefore. ideally there will no price activity in the price range of the Flag for quite some time. The suggestion is not to look for this formation on intra-day charts. After moving net sideways for several price bars is there another shock variable to sent the market an equal distance away? Usually not. One hundred percent of all existing positions predicated on the Flag pattern should be removed once it has reached its minimum measuring objective of duplicating the rapid straight-line price move that preceded it. 15-3. Therefore. A proper Flag will not be found within a trading range. This will make the 10 minute chart ‘look’ like a possible flag pole is present. Because of the dynamic nature of a Flag pattern. a quick trading decision is necessary. it is not a common pattern. There should never be a ‘pullback’ (reaction) back into a Flag pattern after a valid breakout. Flags work best on daily time frame charts. 3. In addition. The reason is that a shock variable (from an economic report) will cause a financial future to move swiftly on say. Notice this nuance in figure15-1B and the actual application on the Silver chart in fig. a conservative method of obtaining a downside measuring objective is to measure down from the high in the body of the Flag instead of from the Flag breakout. a chartist will ‘want’ to find this pattern as often as possible. Three caveats: 1. 15-2 . the body of the Flag can extend up to weeks in duration. The beauty of a Flag is that the risk is small compared to the expected reward. Everything moves faster when the item is listed as a futures contract. and is not faced with an agonizing wait for confirmation of the wisdom of the trade.On a daily futures chart. Look to the left on the chart. the body of the Flag seldom lasts more than five trading sessions before a resumption of the trend occurs. A Flag should really only ‘fly’ in new life-of–contract high or low ground. a violent price move in the opposite direction often occurs. W hen an apparent breakout is occurring. This because a limit move that trading session is frequently the result. a conservative measuring objective subtracts the 265. Also note that because this commodity is bounded by zero on the downside.80 point flag pole distance from the 1523 high in the body of the Flag on this arithmetic scale chart. 15-3 . The measurement always starts at a previous breakout.Bear Flag Silver .50.Dec 2008 New York Figure 15-3 Note that the start of the flag pole on the Silver chart in figure 15-3 began at the breaking of a 2-pont trend (the two points used to construct the line are off the chart to the left). The measurement did not start at the relative price high of 1809. Example of a Flag Failure Four trading sessions later 15-4 . Bull Flag 15-5 . Treasury Bond futures June 1985 Hourly Daily 15-6 .S.Comparison of Hourly and Daily Charts U. Chapter Sixteen Gap Theory 16-1 . Four Types of Gaps 16-2 . 16-3 . Gap Theory .Graphical Summary 16-4 . Suspension Gap 16-5 . Ex.Dividend Gap 16-6 . Island Formation 16-7 . Island Top Chesapeake Energy Corp (CHK) 16-8 . 16-9 .Gap Theory Exercise Gilts Dec 1995 Classify this gap See the next page for the answer and ‘how it came out’. the gap was a Pattern Gap.How it Came Out Gilts Dec 1995 (Two days later) Because the close was within the trading range. 16-10 . It was closed the next trading session. 16-11 . within a 24-hour bar will only appear on a hand constructed chart . See page 2-7 for a mechanically reproduced Corn chart.Suspension Gaps Suspension Gaps.until the chart package programmers add a considerable amount of sophistication to their algorithms. 16-12 . Also see the Corn chart on the previous page and the mechanical version on page 2-7.it had to be re-classified as a Measuring Gap. W hen it wasn’t quickly filled .Gap Analysis Soybeans .Nov 1999 Because the Triangle objective had been met. the gap between 435 and 440 initially looked like it could be an Exhaustion Gap. the minor trend is considered to be up. a higher high is expected.Chapter Seventeen Minor Trend Change Indicators Market participants with short term trading horizons. 3. 17-1 Key Reversal . the expectation is that the next price bar will register a lower low than the indicator’s price bar low. and a minor trend change indicator appears. A technician will examine the previous three price bars. There are four of them: 1. e. If one of these one-bar indicators is then posted. In fact. they change the minor trend in the opposite direction for as little as one price bar. 4. Note that nothing is being predicted for the location of the next price bar’s close. If there are three higher highs. day traders.g. often ask: How can bar charts be utilized for their type of dealing? One of the answers to their query lies in the short term forecasting significance of minor trend change indicators. Figure 17-1 Key Reversal. the next trading session could even be the next major world time zone! As such. If the minor price trend is down (three consecutive lower highs). The end of a major price move could be signaled by one of the minor trend change indicators . 2. Key Reversal Inside Range Outside Range Mid-Range Close It must be emphasized that these configurations are helpful in gauging only what might happen the next trading session.but this assumption must not be given too much weight. The first step in applying any of these indicators is the identification of the direction of the ‘minor’ price trend. It might. 17-2 Why should these price configurations work? . did not achieve this objective. It forecasts a lower price low. But. Note that the next price bar. should be posted. the minimum measuring objective inferred by any of the four minor trend change indicators is fulfilled during the next price bar. however. A high percentage of traders jump to the erroneous conclusion that a Key Reversal marks the end of a major price move. after a series of lower price activity. Figure 17-2 Key Reversal that ‘worked as expected These one price bar reversal indicators tend to work best on daily bar charts. In most cases. Regarding it as minor trend change indicator will allow for the construction of a much safer trading plan. implies that a higher high should be set. than the K-R. The Key Reversal on a daily chart is one of the most widely known yet least understood reversal pattern. but this is asking for too much. after a series of higher price activity. The pattern worked. is a new high and a lower close. The expectation was that a lower low. As an example. figure 17-2 contains a Key Reversal (K-R) at a price high. a trader should not overlook their significance on an hourly or weekly chart. It must be noted. The example continues with the second price bar after the Key Reversal setting the expected lower low. that a more rigorous definition of ‘worked as expected’ means that the objective was reached before the one-bar pattern is destroyed.as long as the pattern is not destroyed. But neither did this next price bar cause the K-R to ‘fail’. This means that several price bars could be posted before the objective is achieved . The Inside Range that was posted after the Key Reversal simply perpetuated the original indicator. Figure 17-1 depicts both of these conditions. after the K-R. A Key Reversal Low.The definition of a Key Reversal High. A failure would mean that a higher high was set. then up. but the rival forces are about to gain the heavier weight to move prices in the opposite direction . Both sides are in balance (temporarily). often expanding the range for the day several times in both directions.before the late move in the opposite direction.for at least one price bar. More often. The analogy of a ‘see-saw’ is applicable. evidence of a Key Reversal early in the day is more likely to result in prices making another violent move to a new low or high . The forces previously in control of the market are losing momentum but opposing forces have not gathered enough strength to turn the trend. 2008 in Figure 17-3. Key Reversal on a Daily Chart Several additional criteria are important to the understanding of the Key Reversal phenomenon. 17-3 Anatomy of a Key Reversal .They all indicate that the forces of the bulls and bears have reached an equilibrium. has made the interpretation of this valuable internal variable much easier. then down and then finally up in the last hour of trading. Thus. the tide will turn in the next price bar. W hen using a daily high-low-close bar chart. a technician does not trust a Key Reversal that occurs on ‘average’ or ‘low’‘ volume. Note the “anatomy of a Key Reversal” on the daily & hourly charts of the NASDAQ-100 future on October 10. Thus. Price was down. The move to electronic trading. In the old open outcry environment in the futures markets this required access to a knowledgeable source down on the trading floor for a guesstimate of volume activity during the trading session. with on-line volume. the price move to a higher or lower close occurs in the last 20 minutes of trading. Seldom does a Key Reversal make itself evident early in the dealing day. high volume will result. Volume Considerations By generating the wicked price gyrations. trading off a presumed Key Reversal early in the trading day can be extremely hazardous. 2008 Figure 17-3A Daily Chart Figure 17-3B Hourly Chart 17-4 Open Interest Considerations W hy does a Key Reversal take place? Because the losers are finally giving up! .NASDAQ-100 eMini Dec 2008 future October 10. It is likely that the momentum will shift to the bears for as short a duration as one price bar. Inside Range W hen an entire price bar’s activity is contained within the previous bar’s price range.usually the next price bar. By the same token. the silence is deafening” There are no more buyers . it generates an Inside Range.at any price. the next bar’s low is expected to be lower than the price bar that formed the Inside Range. Both sides liquidate. This is shown in the diagram on the left in figure 17-4. after three or more higher highs. 17-5 Figure 17-4 Inside Range .so price plummets. For example. he old adage on an open outcry trading floor was that: “When the last weak short is finished buying. the bears have not gathered enough strength to reverse price to the downside by generating a lower low. a technician does not trust a Key Reversal if open interest increases. This will take prices down the next price bar. the bulls have been in control of the market but cannot force price to a higher high during the Inside Range. and finally surrender . In the example above.They are forced to wait (sweat) almost all day with their losing positions. an Inside Range appears. Thus. just to get out. The change in open interest will not be known during the trading session. The prior minor tend direction is expected to be reversed . The participants with the correct market judgement going into that trading session are taking profits. the loser is getting to the sidelines. Confirmation of the drop in total open interest will not be known until the next day. The forces are in balance. This situation results in open interest declining. The rationale is as explained previously. resulting in a lower low than the Inside Range price bar. R Both supply and demand forces are evident. if only temporarily.Outside ange A widely swinging market resulting in a price range where the high is higher and the low is lower than the previous price bar’s activity is known as an Outside Range. but it appears that the forces are becoming more balanced and the prior trend will be interrupted. It is expected to reverse prices .usually the following price bar. Figure 17-5 Outside Range 17-6 Mid-Range Close . This is shown in figure 17-5. W hen it does happen. And the market trades in one-tic minimum increments. by default. a MidRange Close is formed.via moving prices in the appropriate direction beyond the range of the Mid-Range Close price bar. 17-7 Locate the Minor Trend Change Indicators on this Chart . Traders did not know where to close prices. the indecision that surfaced that trading session is likely to result in a reversal of the minor trend. the trend previously in progress was not dominant going into the end of trading for this time period. Figure 17-6 Mid Range Close Ther e some markets in which it is ‘too easy’ to post a Mid-Range Closes . There is an excellent probability that an adverse move against the minor trend is about to occur.at least for one price bar . A technician should look for the opposing forces to gain the stronger hand . This is ok.W hen prices close equidistant between the high and low of the price bar. The opposite type of market would be the stock indices. Often the daily range is so small that. Figure 17-6 contains examples of Mid-Range Closes. The theory that the market is trying to change its short term direction should still hold. 24 tics under the high of the price bar and 25 tics above the low of the same price bar. W hat if the close is. Seldom does the close of the day land in the middle of the range. An example would be the Eurodollar Time Deposit futures. say.and therefore the indicator should not be trusted as much as normally would be expected. the close is close to a mid-range. An exact Mid-Range Close is impossible. LME 3-month. daily 1 78 17-8 .and record whether or not they ‘worked’ as expected Nickel. Oscillators. How could a single trading advisor be knowledgeable about the fundamentals affecting the 40+ actively traded futures contracts at that time? The answer is that he could not. Momentum. This chapter will discuss trend following techniques.Trend Following Historical Overview The mid-1970's saw the creation of ‘commodity funds’. Try to be aboard every new emerging price trend. The trading advisors turned to mathematical models for entry and exit signals for the futures in their portfolio. the first crop of funds were ‘directional’. They could be long or short. Relative Strength.Chapter Nineteen Mathematical Models . Often the traditional commodity funds were operated by a very small number of traders. 2. Their proliferation was of such magnitude that hundreds of millions of US Dollars was being traded by these funds. The rational is: 1. and Stochastics. Utilize diversification to limit risk. 19-1 . 3. This latter category has numerous additional subtitles such as Over Bought / Over Sold. Follow the old adage of allowing profits to run while cutting losses. A good estimate is that 90% of all managed money in the futures market that is traded as a fund uses a Trend Following system. There are two diametrically opposed mathematical approaches the directional traders could use: Trend Following vs. the next chapter will discuss the Oscillator concepts. Unlike the next influx of commodity funds just after 2000 that were long only ‘index funds’ touting physical commodities as an asset class. and resulting in an easier-to-read picture of price direction A Simple Moving Average A simple moving average is merely the arithmetic average of price data during a pre-determined period of trading.or 10-minutes. 19-2 . and that time frame would be of little value if the goal is identifying current trends. only the most recent ten days’ closing prices are used. until recently. One of the best and most commonly used trend indicators is the moving average. technical trend indicators can help confirm that a market is in a trend. because stock indexes have. although they can be calculated for very short time periods. not used in the new calculation) and the new day’s data is used instead. the slower the average moves relative to the market itself (because each individual piece of data has less impact).Trend Following Even though it’s possible to see sustained price trends just by looking at a chart.e. a 200-day moving average has traditionally been popular in analyzing stock market trends. the eleventh day is dropped. intermediate. The time frame also depends on the type of markets being studied. smoothing out the sharp peaks and valleys that usually occur in futures (or equity) price movement. for a simple 10-day moving average. Thus. to calculate a simple 10-day moving average. Although traders could use computers to calculate moving averages based on every single price quote for a desired time period. A moving average distills market action into a single line on the chart.or shortterm view of the market. The more data included in the average (generally meaning the longer the trading period).to 40-day range. For example. Then. and connect each point with a line to get a smoothed version of the price action.. used to calculate a moving average based on whether they’re seeking a long-. such as 5. most just use the closing price. The most popular futures moving averages generally fall in the 10. or the amount of data. For example. plot each day’s moving average calculation (or whatever time period is being used) on a bar chart. Price data from the oldest day (or period) in the average is dropped (i. add all the closes for that period (10 data points) and divide by 10. moved rather slowly and stayed in long-term trends. But 200 days are an eternity for the futures markets. A moving average is recalculated every day. Analysts determine the time period. and the average "moves" or fluctuates with the market (but at a slower pace). Identifying Trends Analysts have come up with all sorts of rules and conditions to determine whether a market is in a trend — but. An uptrend is considered broken if prices close below the moving average. This provides the basis for a ‘trading system’. basically. 19-3 . a market can be considered in an uptrend if prices are above the moving average line and the moving average itself is trending higher. a downtrend is broken if prices close above the moving average.The plot of a simple 10-day moving average using the daily closing price has been placed on the daily chart of the Dec 2007 Euro-fx future. It’s the opposite for a downtrend. 19-4 .In practice. This type of "optimization" is not without pitfalls. technical analysts often experiment with more than one moving average (computers make this easy) to see which one "fits" the price action best. Traders must keep in mind that markets often change character and volatility. In nicely trending markets such as the June 2007 Canadian Dollar future. a 40-day moving average only had two whipsaws. this tells the analysts that in this market a 40-day moving average is a better trend indicator. in an uptrending market. a practice that is called "optimizing." For example. however. prices might consistently bounce off of the 40-day average but consistently violate the 20-day average. W hen that happens a moving average that had been giving fairly accurate trend signals might suddenly become "obsolete" while another moving average based on a different time period could exhibit a better fit. Note what happened to the simple 10-day moving average on the Dec 2007 Euro-f`x futures chart when price moved net sideways in a triangular consolidation. They occurred when the long term price downtrend was in the process of changing to a long term price uptrend. 19-5 . then some judgment is required. for example two are moving higher but one is headed lower. Analysts commonly work simultaneously with a 9-. intermediate. technical analysts often use a combination of two or three averages that move at different speeds (calculated based on different time periods). it’s a good bet that the market is in an uptrend. and a trend follower might trade less aggressively or stay out of the market until all the averages come into agreement. 18. An example of a chart with three moving averages plotted on it is the June 2007 Swiss Franc future. If all three averages are moving higher.and long-term trends.Using Multiple Averages Since a single moving average doesn't always give a clear indication of the trend. If there is divergence among the moving averages.and 40-day average to track short-. Always keep in mind that a moving average is a lagging indicator which gives a signal after the underlying market has embarked on a new trend. before deciding which moving averages to track. that prices often rebound or fall from that average due to the sheer number of traders entering positions against that level. Using longer term averages (say a 20. For example. Deciding which two averages to use is up to the individual trader and also poses a dilemma. However. Using two shorter term averages to generate cross-over signals (say a 4.or long-term price moves and how much risk they’re willing to take. accordingly. and this choice poses a larger risk per trade than the shorter-term approach. and this can create a false trend reversal signal. and often a component of trend-following systems used by futures fund managers. a violation of the 40-day moving average can trigger significant liquidation of trend-following positions. believing that "what's happening now" is more significant than what happened previously. must be very clear on whether they’re looking to capture short-. Other techniques for limiting error include exponential "smoothing. one that indicates a trend change sooner but with fewer false cross-overs. they attach more importance to the most recent price data. 19-6 ." offsetting the averages (shifting the moving average line to the right on the chart). even if this is not warranted by the fundamentals. technical analysts have tried to diminish the error potential by weighting the averages. W ith this approach. All of these methods attempt to shift the position of the moving average relative to the actual price movement so as to get a better trading signal.and a 40 day) generates fewer false signals and fewer whip-saws. Conversely.and 8-day moving average) has the advantage of signaling quick changes in market direction and enabling a trader to take a position early in a trend. intermediate. the 40-day moving average is so popular as a trend indicator. but suffers the disadvantage of signaling positions to be taken well after a trend has begun. such as the ones mentioned above. Weighted Moving Average Since any combination of moving averages will result in erroneous signals to varying degrees. Traders.So many traders follow some of the moving averages. and calculating an average of averages. this approach does involve a fair number of incorrect signals and whipsaw losses. that the averages themselves can become the source of significant support and resistance. Already discussed is the fact that analysts/traders often "optimize" moving averages. 19-7 . But because markets are volatile (exhibit large or small price swings).The dashed line on the Dec 2007 Japanese Yen future is a weighted 10-day moving average. In practice. a fairly simple process with computers and one that can help limit the number of false trading signals over a selected period of price action. Notice how it reacts slightly faster to price changes than the simple 10 day average. an optimized average may not work well beyond the "test" period. simple moving averages can work just as well as jazzed-up versions. 19-8 . This line was broken at the same time as the downward crossover of the price and moving averages. It contains an important 3-point upsloping trendline. If prices violate a trend line and the moving averages also give a crossover signal in the same direction.Moving Averages & Trendlines Analysts also use moving averages with other trend indicators such as trend lines or oscillators to improve the reliability of the trading signals they get from the averages. Note the chart example of the Sept ‘07 New Zealand Dollar future. it’s considered a double indication that the trend is changing. Large sums that are now invested with fund managers. The impact of the collective actions of the trend following funds can be particularly pronounced when a market is changing trend. These types of charts are easy to construct by hand. If the fast moving average is below the slow one. the divergence is a negative number and is plotted below the zero line. Moving average divergence is sometimes tracked on a type of chart called a histogram (a type of bar chart) but is more often plotted against a zero line. if the value of the fast moving average is above the slow moving average. i. Thus. everyone gets a signal regardless of the technical method they’re using and the rush of buying or selling that occurs often creates a big move in the market.Trend Following Funds Managed money has become a major factor in commodity markets since the late 1970's. In other words. 19-9 . is an indicator of a market’s momentum. Although most managed funds use sophisticated technical systems. Even though fund managers know this and try to design trading systems using different trend indicators (including some pretty esoteric stuff). or "divergence". It provides a pretty good proxy for fund-trend following buy and sell activity. the difference between them (subtract the value of the slow moving average from the fast moving average) is a positive number and is plotted above the zero line. they still often enter and exit markets at about the same time. Moving Average Divergence Another way to use moving averages is to keep track of the difference between two averages. the difference between the short-term and long-term average is widening. the price momentum is increasing to the upside. whenever a trend changes. traders can get a feel for where concentrated fund activity might take place by watching the 40-day moving average. if a market is in an uptrend and a short-term moving average is rising at a faster pace than a longer term average. More importantly.. since momentum usually shifts before the trend does a change in momentum can help anticipate a change in trend. implying that the trend is healthy and may have further to go. For example.e. This difference. but the math-challenged need not worry since moving average divergence indicators are included with most charting software packages. These managers typically use technically-based trend following systems (unless they are a ‘long only’ commodity index fund). At the bottom of the chart the difference between the two averages is plotted as a histogram.The Sept 2007 British Pound futures chart contains a simple 10 day and 21 day moving average. 19-10 . by J. 13 hours or 13 days to calculate the resulting number. There is nothing magic in these threshold levels. W elles W ilder. This output from the RSI or Stochastic model will be a number that can vary between 0 and 100 but it will never reach either extreme. Note that the RSI remained in neutral territory while the price of the British Pound moved net sideways within a triangular consolidation. The ‘trick’ is to set the parameters that constitute overbought and oversold. The trader is looking for a reversal of the price trend. The theory is that if a trader can identify a market that is in an overbought condition.. They strive to locate ‘overbought’ and oversold’ levels on a price chart.as the markets change their characteristics.Chapter Twenty Mathematical Models . Pioneering work in the field of mathematical models was the book New Concepts in Technical Trading Systems.e. a category exists that tries to locate price levels where the existing price trend could be in the process of exhausting itself.g. In it. W ilder suggested a 14 day period and parameters of 70 for overbought and 30 oversold in the equity market examples. The indicator can be calculated over any number of discrete periods.Oscillators Among the myriad of mathematical models. Using threshold levels of 80 and 30 on the 9-day Relative Strength Index for the Dec 2007 British Pound future produced a successful short sale (when the Index when above 80) and a buy (when the Index went below 30). In general. Some of the specific names for these models are Relative Strength Index. Overbought / Oversold. Note that this type of model is diametrically opposed to the trend following models. A technician has to back test the model to determine suitable parameters. An active futures trader rarely uses more than 13 periods .e. Personal computers and plotting packages have made their use widespread. this type of model can be referred to as an oscillator. Momentum. 20-1 . short) position. Stochastic. And even these are unlikely to be optimal . the trader will want to take an opposite (i. The Relative Strength (RSI) and Stochastic models are two of the most popular. The calculation of these indicators is simple arithmetic. 20-2 . If the indicator fails to go to a new extreme and then moves back into neutral territory again . The next push by the indicator into ‘over’ territory is watch very closely.this is the time to enter. the trader watches for a pullback in the indicator back into neutral territory. dropped back below 84. Note that the Dec Euro set a new price high . This last move down was the short sale entry signal.where the value of the indicator continues to move farther into extreme overbought territory as a price move of unprecedented proportion takes place. Rather. technicians have worked with not pulling the trigger on a new position unless a ‘failure swing’ occurs.but it was not capable of pulling the 9-hour RSI above the level marked ‘A’ on the chart. The entry signal just detailed was present on the hourly chart of the Dec 2007 Euro-fx future after the price run up. A general observation can be made: 17 consecutive profitable trades could be wiped out in one huge loss . moved up above 84. 20-3 . it is difficult to determine an effective stop loss point when a market is in a runaway mode. And. In an attempt to create a safer entry into a position.A Caveat Simply shorting a market when an indicator breeches a supposedly overbought level is a path to ruin. This means that a trader does not automatically place a new position when the indicator enters ‘over’ territory. and then moved down below 84. W hen this signal occurs it is not unusual to have a divergence between what price is doing and what the indicator is doing. The 9-bar RSI moved above the overbought threshold of 84. 20-4 . an RSI or Stochastic model does not provide a price target. And unlike classical bar charting where a measuring objective is present from an orthodox price pattern. Traders are always trying to refine their ability to construct risk and reward parameters.W hether this does provide a safer entry signal is open to conjecture. Relative Strength Example Hourly Chart 20-5 . How it Came Out 20-6 . A ‘Get Ready’ Signal on a 9-Week RSI 20-7 . 20-8 .‘How it Came Out’ The failure swing and divergence led to a sizable price rally. on classical bar charting and then return to this chapter and then look at the various spread charts . Overview 1.in futures. The reader is encouraged to examine the chapters that follow. W hy trade spreads? A. I. The price of one arbitrary item cannot be subtracted from the price of another arbitrary item and expect that the plot of the spread differential would/should act in classical fashion. the spread should be charted. A trader has to do a minimal amount of fundamental analysis .most of which contain a price pattern. the overwhelming premise for a chartist must be stated. Attractive margins? . Before listing some spreading considerations in the form of an outline. fears. yes C. If so. lent itself to spreading .the price. B. In the case of a spread. ‘Staying power’? . Lower risk? Not necessarily.where the trader was long something as well as short something.Chapter Twenty-Two Spreads & Spread Trading The bailiwick of old time commodity futures traders were the grain and oilseed spreads. and moods are reflected in once single item . traders must be paying attention to the specific differential between two prices.and come to the conclusion that enough traders are paying attention to the specific relationship between the two items in question. That is: All the hopes. This form of trading also has a place in the modern markets. The different seasonal factors plus the fact that distinct crop years existed.Sometimes 22-1 . Do not spread to protect a loss . may imply only a temporary ‘technical’ bull move is occurring. Proper mentality toward profiting from a spread = think the difference only 3. neither being the US Dollar E. one currency into another. Spread indicating tightness of supply (or the opposite) ii . W hat is a straddle? A spread B W hat is a switch? A spread C. Definitions A. W hat is a cross? A division. when the more distant contract which was sold. Perishable Futures Contracts 1. W hat is pairs trading? A spread using individual equities D.Definitely i. Storable vs. Aid in trading outright positions? . different location 4.and be eligible without re-inspection for delivery. 22-2 . 2. matures.ever! II. the futures must be one which can be accepted on delivery when the near-by (long) contract matures . Definition of a ‘storable’ futures contract To be considered storable. Picking the best month for an outright position iii. W hat is arbitrage? Exactly the same product. Bull spread not working.D. Is there a close in the cash foreign exchange markets? No 3. Some minimal fundamental analysis must be done to determine the answer. W hich futures close to use? ‘Pit’ close. Use close-only prices A. An example of a spread that should not be charted: the Canadian Bacon spread (Canadian Dollar . Charting a Spread 1. Does the plotting software support spread definitions? A. W hy did Crude Oil futures flourish on the New York Mercantile Exchange (and not the CBOT)? i. 3 Crude Oil vs. 2.g. 3 Cattle vs. W hat did the NY Merc trade in the ‘old days’? Potatoes ii.e. W eighting the legs differently . 2 Gasoline & 1 Heating Oil 22-3 . Is Crude Oil (futures) a storable commodity? No III. Soybeans vs. B. Meal & Oil ii. 4 Hogs B. B. B. CME members A. Can / should a spread be charted? A.2.. Spreading mentality of old-time CBOT vs.Pork Bellies). Three items i. W hich Chicago futures exchange traded predominantly storable commodities and which traded perishable commodities (according to the definition stated above)? The Chicago Board of Trade = storable. British terms: A. ‘Inverted’ market: Near-by trading above back month 3. See any of the various ‘current’ charts IV. Contango = normal market B. A ‘flat’ on spread chart = a minor trend change indicator.4. Do not ‘leg’ out of a spread 22-4 . ‘Normal’ market: Near-by trading below back month 2 . Do not ‘leg’ into a spread. Order Entry 1. create classical price patterns 6. C. Backwardation = inverted market V. Difference in Dollar value: Second named item is subtracted from the first named item (inter-commodity spread) 5. Spreads tend to ‘trend’ vs. Definitions 1. Place order as a spread order: A. Near-by minus more distant month (inter-delivery spread) B. Indicate a specific (limited) spread differential B. Plot: A. 5. Interest rate traders (at the introduction of T-Bond futures) used negative numbers (if applicable) 6. ‘Mental’ stop . Better strategy for either side..if calling the CBOT open outcry floor (‘Buy’ is on the left side of the order pad) 3. CBOT floor traders traditionally used positive numbers (‘or better’ is always implied) See Order Entry Example 4. D.2. ‘dead leg’ of the spread D. Stop placed on the volatile leg vs. execution is at 17. Money management ii. where the spread is really trading. Use of protective stop (loss) orders A.July Corn spread is quoted as 16 ½ to 17 (premium July) B. Dec . e. C. enter limited order at 16 3/4 (split the difference) 7.sell Dec arrives. Market order to buy July .dangerous but necessary B. A. Last trade prices vs. Determined location of stop based on: i.when the trendline is broken or (partially) when objective met 22-5 . State long leg first . Market order to buy Dec . W hen to exit . Spread chart C. execution is at 16 ½.sell July arrives. Electronic spread entry places premium or discount on near-by contract.g. Storage cost (0. Inspection / handling . Can use options to determine where futures are trading. “most often ignored” iv. B. Commissions . Forward pricing A. Limited Risk Spreads 1. 2. The ‘basis’ = cash price minus futures price (Basis in grains was unusually unstable (wide) when strong inflow of ‘Index Fund’ money occurred in 2007/08) B. C.8. Can a spread to exit from locked limit position (if any of the other futures contracts are freely traded). Limited risk spread = long near-by vs. Do not sell last market to trade limit-down VI.as of April 2008) iii. Risk is limited to move to ‘full carry’ B. Available only in storable futures contracts where calculation of carrying charges is possible. Interest cost Could be bankers acceptance rate.15 cent/bu/day or 4 ½ cents/bu/month for a 30 day month . How to compute ‘full carry’ i.2% or prime.very low for an exchange member v. short deferred A. or prime +1% ii.negligible. fed funds + 1 3/4 . Do not buy last market to trade limit-up D.if applicable 22-6 . Reward is unlimited 3. Insurance cost . Limit price moves (future is locked limit up or down) A. 48.ceiling on near-by future Unlikely . VII. 49. 2008 i. Long term ratio (approx. 100 years = 32.C.as maturity approaches ii.19 (Dec 2008 futures). Lumber) v. Gold / Silver ratio A. Fallacy of using ‘newspaper’ cash prices . Risks in a limited risk spread i. on a ‘bounce’ 22-7 .5 B. Government intervention . Interest rate increase (full carry increases) iv.don’t do it. Ratio on March 12. Price rise increases total value of contract & thus financing costs increases full carry iii. Tendency for discounts to widen (toward full carry) with the passage of time . Greater than limit move (down) by expiring future vii. Question: How could (did) futures traders speculate on interest rate changes prior to the introduction of short term interest rate futures? (Answer: Storable commodity spreads trading near full carry) 4. Obtaining commodity that is not re-deliverable (KC W heat.82 (cash) and moving downward on monthly chart ii. Buying cash commodity & unable to get it into position ‘regular’ for delivery vi.but it has happened 3. Some Specific Spreads 1 . One-to-One ii. Dow Jones Industrial Average A. Both dominated by large capitalization. 10% of normal outright initial margin 3. 95% correlation during majority of trading days B. Dollar value of contracts should be approximately equal i. ii.C. 2 Gasoline & 1 Heating Oil vs. blue chip stocks C. CBOT one Kilo Gold vs. 3 Crude Oil ii. ‘Ratio’ the spread = “dollar neutral” 5 x 6 or 10 x 11 (using 2007 year end prices) iii. Spread = [{Gasoline price x 42} x 2 + Heating Oil price x 42 minus (Crude Oil price x 3)] divided by 3 iii. CBOT 1000 oz Silver future = close enough to equal Dollar values. Crack spread: i. Spread result is in Dollars/barrel 22-8 . Could weight the legs and/or plot a Dollar difference chart 2.E-mini Dow i. E-mini S&P 500 . S&P 500 Index vs. Spread margin = approx. Soybean Spreads New Crop .New Crop 22-9 .New Crop Old Crop . that is the line that the market ‘wants’ to go thru.A Cross Chart The old Sterling / D-Mark Cross W henever a horizontal line is present on a chart . 22-10 . Falling Wedge on the Gold / Silver Ratio Monthly Chart 22-11 . Notes 22-12 .