T

An Approach for Investors and Traders

DARYL GUPPY

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r.Jrlgbtboolls
 Daryl Guppy is also the author of:
Share Trading*
Trend Trading*
Trading Tactics*
Trading Asian Shares
Snapshot Trading*
36 Strategies of the Chinese*
and the Australian editor/contributor to:
The Day Traders Advantage* by Howard Abell
Options- Trading Strategies that Work* by William F. Eng
*Available from John Wiley & Sons Australia, Ltd

First published 1999 by Wrightbooks,

an imprint of John Wiley & Sons Australia, Ltd
42 McDougall Street, Milton, Qld 4064
Office also in Melbourne
© Daryl Guppy 1999
Internet: <china@guppytraders.com>, <www.guppytraders.com>
The moral rights of the author have been asserted
Reprinted 2000,2002,2004,2008 and 2010
National Library of Australia Cataloguing-in-Publication data:

Guppy, Daryl, 1954-.

Chart trading: an approach for investors and traders.
Includes index.
ISBN 1 876627 13 1.
1. Stocks-Australia-Charts, diagrams, etc. 2. Investment analysis. 3. Stock price
forecasting-Australia. 4. Commercial products-Australia-Charts, diagrams, etc. I. Title.
332.6320994

All rights reserved. Except as permitted under the Australian Copyright Act 1968 (for example, a fair dealing for
the purposes of study, research, criticism or review), no part of this book may be reproduced, stored in a retrieval
system, communicated or transmitted in any form or by any means without prior written permission. All inquiries
should be made to the publisher at the address above.
Cover design by Rob Cowpe
Acknowledgments: All charts created by Metastock© and Ezy Chart© using data supplied by Just Data and
Online Trading Systems.
Printed in China by Printplus Limited
10 9 8 7 6
Disclaimer
The material in this publication is of the nature of general comment only, and does not represent professional
advice. It is not intended to provide specific guidance for particular circumstances and it should not be
relied on as the basis for any decision to take action or not take action on any matter which it covers. Readers
should obtain professional advice where appropriate, before making any such decision. To the maximum extent
permitted by law, the author and publisher disclaim all responsibility and liability to any person, arising directly
or indirectly from any person taking or not taking action based upon the information in this publication.
Contents

Preface: Not Every Chart has a Pirate v

Port I: MARKET MAPS

1 Message in a Chart 3
2 Drumming up the Numbers 14
3 Punting on Prophets 28
4 The Plain Plot 41
5 Summary Plots 58

Port II: IMPROVING THE CHART

Crowd Behaviour
6 The Straight Edge 79
7 Combination Lines 95
8 Bar Set-Ups ll5

Crowd Movement
9 Average Performance 139
10 Better Than Average 157
ll Average Chaos 176

iii
Contents (cont'd)

Crowd Thinking
12 Signs of Thought 185
13 Mind Readers 196
14 The Power of Thought 206

Crowd Analysis
15 End ofEmpire 215
16 Echoes of the Crowd 228

Part Ill: THERE IS ARISK OF LOSS

17 Four-Letter Words for Traders 249
18 Counting Cash 257
19 Selecting Software 272
20 Mind Traps 279

Index 283

iv
Preface

NOT EVERY CHART HAS A PIRATE

Buried somewhere in the backyard where I grew up are several old bottles. Each
contains a treasure map, the paper authentically browned by lightly burning it with a
candle until it resembled parchment. Each map is a fantastic mythical island on the
edge of the known world. Each is marked with a childish 'X' to show the treasure
buried under a coconut palm.
The lust for buried treasure grew early and it was my first introduction to charts.
These invented charts were eventually replaced with real maps. They provided
enticement, opening my eyes to the vast and, to me, unknown regions of Australia
beyond the settled districts. Later I followed the Northern Territory roads and tracks
marked on topographic maps which themselves carried the magic words "not fully
mapped".
Working in the middle of an Australian desert I stumbled across a real treasure map:
a chart of the financial market. This is a practical map, always charting new areas as
the boundaries of exploration push forward. Charting for me has thus come full
circle, although there was no 'X' marking the buried treasure. Instead, financial charts
provide profit-making opportunities undreamt of by the child who buried the bottles.
Tradition holds that atop every treasure chest is a collection of bones. Textbooks
give you the bones of technical analysis. In this book we put some flesh on them.
Critics may suggest I, and others like myself, are still looking for buried treasure and
adventure. The long bull market at the turn of the century has attracted its fair share
of ill-equipped and inexperienced treasure hunters who are easy prey for those who
pretend to know the future or to hold the secrets to the market. The treasure I look

v
CHART TRADING

for is hard won. It takes skill to consistently extract profits from the market, and at
the end of the day the results look more like hard work than a windfall.
The 'X' on my charts and yours show opportunity and risk. There is treasure there,
but it is constructed personally by every trader from his chosen entry and exit points.
The treasure is buried in a blur of market detail and a mountain of steady work.
Finding it is a most satisfying challenge.
Navigate through outback Australia, or metropolitan Melbourne, and you soon
discover the difference between having a map and actually arriving at your destination.
Map reading takes skill. Chart reading also requires skill, so this book is written to
help you make sense of common charts, patterns and market indicators. I have a
particular understanding of the way the market operates. My interpretation and use
of indicators is a personal approach so this is not a textbook. One of the great features
of the financial markets is the unlimited room for new interpretations .

• CHARTING AND TRADING

Even basic charting software comes with over 30 indicators. Choosing the right
combination assumes you understand what they mean. This book is an introduction
to such indicators. It is not an exhaustive coverage of all the indicators available, and
as you grow in your charting skills you will develop nuances of interpretation not
covered here. This is part of your growth as a trader.
Charting sounds as if it involves maps which show past paths and future destinations.
It is more effectively considered as a record of the emotions of the crowd of buyers
and sellers who drive prices up and down every day. Our focus is on how technical
analysis and charting delivers information about the way the crowd is thinking. We
will look at the trading rules and how they grow out of the aspects of crowd behaviour
each indicator is designed to measure.
This book is written as a user's guide to make sense of the basic indicators available
on most charting programs. Where appropriate, additional reading is provided to
explore the use and application of each indicator in more detail. Readers looking for
the finer details of the history of indicator development can turn to An Encyclopedia
of Technical Analysis, or Technical Market Indicators. The study of these developments
is an interesting task in itself, but do not allow it to become a distraction from the
real task of trading the markets.
A few of the indicators included do not work particularly well in Australian markets,
but you will find them in many software packages. You need to know what works and
what does not work, preferably without losing your trading capital in finding out.

vi
 Preface/ Not Every Chart has a Pirate

Charting is a retrospective activity. Most trading decisions are based on end of day
data and displayed on end of day charts. Traders decide what action they will take
when the market opens tomorrow. They look for signs in the price activity to support,
or validate, their analysis. Perhaps they believe a stock is about to rally. If the market
opens higher than yesterday's close, their analysis is confirmed and a buy order is
placed. If it opens lower, their analysis is incorrect, and the planned action-placing
a buy order-is abandoned.
This is the difference between analysis and prediction. Unfortunately, for many people
it is also the difference between trading and investing-between active risk
management and risk control. Despite many claims of infallibility, nobody can predict
where the market is going. Better analysts will identify a range of outcomes, ranked
in order of probability. Better traders select the high probability outcomes, keenly
aware that high probability does not equal infallibility. Trading skills are much more
than just analysis. We touch only briefly on trading skills. They are covered more
completely in Share Trading.
Every treasure map includes a dotted line and significant features so the treasure
hunter knows he is on the right path. This book is divided into three sections. Follow
the path and you will have a better idea of where the 'X' is located on your personal
treasure chart.

• PART I-MARKET MAPS

Would you recognise a treasure map if you saw one? Probably not, so we start with
an exploration of the 'Message in a Chart' in Chapter l. How effectively we use the
chart depends on our purpose. Road maps do not help fishermen find the deep river
holes, so we must match form and function for effective trading and risk control. All
maps are based on observation and data and each collects topographical information
in different ways. Chapter 2, 'Drumming up the Numbers', shows what data is used
or ignored. This choice determines the accuracy of the chart.
Charts provide precise numbers for calculating risk but many reject this advantage in
favour of'Punting on Prophets'. Risk eats away at our trading or investment capital.
Although we crave certainty, it is not an antidote for risk. This chapter examines
several types of prophets so you can avoid them in favour of active risk management.
We start with the basic chart display in Chapter 4, 'The Plain Plot'. These are the
basic contour lines of the market. Some charts have specialised displays and we examine
how they are used in 'Summary Plots'.

vii
CHART TRADING

• PART II-IMPROVING THE CHART

We then move through chart applications, starting with simple concepts based on
what the chart tells us about Crowd Behaviour. Each chapter includes trading rules
and a section explaining how it is related to crowd behaviour. We consider a trading
example and a ready reference summary is provided. 'The Straight Edge' covers trend
lines and support and resistance concepts. These come together in 'Combination
Lines'-these dynamic chart patterns capture crowd behaviour and provide clues to
future directions. Some 'Bar Set-Ups' signal high probability trading opportunities.
This is basic bar chart analysis.
We take a step into the world of technical analysis in the Crowd Movement section. If
we know how the crowd has been moving in the past then we have a better opportunity
to understand where it might move in the future. The most common of these approaches
consider 'Average Performance', while others look for indicators which are 'Better
Than Average'. These technical indicators manipulate basic price data. Some use 'Average
Chaos' to venture into the uncertain world of complexity and use this to manage risk.
Traders anticipate crowd reactions more effectively when they understand Crowd
Thinking. In this section we examine those indicators which suggest 'Signs of Thought'.
Other indicator groups work as 'Mind Readers', giving the trader a glimpse into the
collective thoughts of the crowd or its leaders. The market demonstrates 'The Power
of Thought' by using relative strength concepts. We apply them to real trades.
Behaviour, movement and thought all add up to Crowd Analysis and the final section
in Part II collects some statistical tools. The 'End of Empire' is signalled not by the
activity of an individual stock, but by the character of an entire market. Watch these
signals to avoid fiddling while Rome burns. Even the 'Echoes of the Crowd' warn
the trader about the risk of market collapse. These are not traders' tools applied to
individual trades. They are survival indicators, telling us when to abandon the ship
or take extra care.

• PART Ill-THERE IS A RISK OF LOSS

Risk and fear are 'Four-Letter Words for Traders'. They do become an advantage
when understood and applied in particular ways. We show how to combine them
with charting tools in 'Counting Cash'. This is an important step in turning trading
activity into trading profits. We also include a general guide to 'Selecting Software'.
The right software for your style of trading positions you for success. Finally, we
point in the direction of true trading success. Success or failure lies in avoiding the

viii
 Preface/ Not Every Chart has a Pirate

'Mind Traps'-and until we accept this responsibility, reward remains inconsistent

and elusive.
These are traders' tools, but not a pathway to instant success. We will show you how
each indicator is used for trading. Please do not confuse this knowledge with the
skills required for successful trading .

• THE STEPS TO SUCCESS

Success most often comes in small steps, and this book has been examined at every
step in its writing. My wife Marion took on the task of final reading, fine-tuning
words and expressions. My mother Patricia surrendered yet another holiday in the
Northern Territory to gently contest my understanding of Macbeth while slashing
text and sloppy expression in the first drafts. David Barnes edited for technical accuracy
in an attempt to ensure my idiosyncratic application of indicators remained within
the mainstream. These people and others examined the work in progress, but it is the
people who send e-mail and visit www.guppytraders.com who encouraged me to
write this book.

• TRADING SKILLS

We work most effectively in the market when we accept it as an extension of ourselves.

Effective trading takes common skills and stretches them, sometimes to breaking
point. We step into a world where our competitors are skilled professionals and they
will not go easy on us just because we are learners.
While writing this book my son graduated from junior cricket to playing with the
seniors. He approached his first senior match with some trepidation. He had two
main concerns. The first was to avoid being hurt. The second was to avoid being
bowled out for no runs. His first senior appearance was a success, with a surprising
run tally gathered by ones and twos.
The novice approaches his first trade with the same feelings. He doesn't want to hurt
his capital and his focus is on not making a loss. Often success comes from small
trades returning 10% or 20%. Caution accompanies success.
The senior cricket series is drawing to a close with the end of the Dry season and my
son's batting performance has slumped steadily from the peak of his first appearance.
Made bold by early survival, he now swings for the big hit on every ball. Bowlers

ix
CHART TRADING

don't very often deliver balls suitable for smashing to the boundary-and the market
does not very often deliver trading opportunities measured in 100% returns.
Survive the first few carefully selected trades and the novice hits out for the big
returns. If 10% is achievable, then 30% is possible and 100% not beyond dreaming.
The novice abandons the very caution and focus that delivered early success. My son
drifts further down the batting order while the novice trader depletes his trading
capital.
My son has the rudiments of skill and this will improve with practice. Better equipment
makes it easier to develop skills. Better charting packages make it easier to analyse
the market. His decline in performance, however, will not be arrested with a better
bat, brand name shoes, or fierce determination alone.
The solution is in his head. His initial success came from concentrating on survival.
In trading terms, this is from the management of risk. Future success will come from
the same source. It does not come from dreams of six off every ball and wild swinging
will not make it so. Our success does not come from dreams of $30,000 profits from
a single trade. Big tallies and trading profits come from many little runs. Determination
is important but so too is survival. Concentrate on what counts rather than on counting
the results in advance.
You are not a treasure-hunting pirate just because you use charts. Focus on using the
tools well. Trading profits will come.

Daryl Guppy
Katherine
August 1999

X
Part I

MARKET
MAPS
Chapter 1

MESSAGE IN A CHART

Charts go with the treasure ships of the East Indies, with swashbuckling privateers,
and with treasure hunts where 'X' marks the spot. Unfortunately, some people think
charts of market activity are used in the same way as these shipboard charts from the
era of sail. They miss out on an invaluable aid to understanding and profiting from
the financial markets. This book will show you how to read a modern day chart so
you can navigate the shoals and reefs of financial fortune.
Charts help the investor make better decisions. Charts are essential for the trader, and
the lifeblood of the day trader. In reaching a decision to buy or sell, the market
survivor should always turn to a chart. The investor might turn to it last, while the
trader looks at it first, but each needs to know how to read a chart correctly to help
avoid disaster.
Treasure maps last forever but the market chart is constantly updated by market
activity. The position of the 'X' changes daily. Today we use computer software like
Guppy Traders Essentials charting pak, Metastock, Ezy Chart, and others to quickly
create our charts from price data supplied electronically. Here, the focus of discussion
is on end of day charts. Whether parchment or computer screen, in both cases we
should always remember the charts do not move the market any more than a treasure
chart itself digs the hole on the desert island at the spot marked 'X.'

• AN INVESTMENT IN CHARTS

Many people are frightened of the sea, and of the markets. Both environments represent
largely unknown, and completely uncontrollable, events. The nervous passenger asks

3
CHART TRADING

the captain about the size of his ship, its seaworthiness, its construction, the reliability
of its engines, the location of the life rafts and the captain's past history of successful
voyages. The landlubber in us all wants to avoid boarding the Titanic, or the Sun
Vista cruise ship which sank in the Straits of Malacca.
The novice investor approaches the market in the same way. He wants a measure of
company size; a long established company that has survived rough markets; a company
without fancy structural cross holdings like the SS Bond Corp; a product line Warren
Buffett understands; the whiff of a capital guarantee; and management with a friendly
face.
Brokerages have specialist sections designed to soothe the novice passenger in these
markets. They provide piles of updated research and opinion, analysis and conjecture
about the relative market-worthiness of one company compared to another. Some of
these specialists are accountants-the bean counters-and we meet them later. Taken
at face value, these answers help the new investor to overcome his fears, but they do
not help him to make money.
Committed to making a voyage, the frightened travellers select the largest ship in the
harbour. As an afterthought, they enquire about its destination. This is the very time
novice investors should reach for a chart, but they believe big is safe. They forget-
or choose to ignore-the multitude of big, apparently sound, ships which have
foundered and big sound companies which have collapsed with remarkable speed.
Despite this type of solid research the New Zealand corporate raider Graham Hart
found Burns Philp a dangerous stock to buy. Prices dropped from $2.33 to $0.42 in
just a few weeks after his purchase.
The investor is different from the passenger travelling tourist class on the cruise
liner. The investor buys part of the ship with a voyage thrown in. This is why he is so
concerned about the soundness of the vessel and less concerned with its precise
destination.
He is really buying a ticket for a voyage which is designed to make him money, but
too often this is forgotten in the welter of paperwork concerning the details of the
ship. The solidity of the ship is important, but so too is its destination and the course
it follows.
A chart of price history is a record of the past voyage. A chart updated daily, or even
weekly, gives the investor a way to tell when the ship is drifting away from the
destination he wants to reach. Just exactly how we use a chart to reach these conclusions
is what this book is about. It is an essential tool in managing risk.

4
 1/ Message in a Chart

• TRADING CHARTS
We could characterise the trader as a professional sailor who, in a single glance, is
able to assess the seaworthiness of the vessel for the voyage he has in mind. This
suggests the sailor has an intuitive grasp of the fundamentals of the ship. It is more
accurate to say he has a working knowledge of ships and their purposes. Uppermost
in his mind, particularly if he is an enterprising sailor, is the vessel's suitability for the
task ahead. A sleek racer is needed to win the Sydney-to-Hobart yacht race, even
though the Queen Mary might ride more smoothly in the rough seas.
The financial trader wants to know where his ship is going, how long it is likely to
take to get there, the course it is expected to take and, even more importantly, just
how effective the life boats are. He knows survival depends on how fast he can get
off the boat if need be. This gives him an advantage over the investor, who tends to
believe size has a direct relationship with the ship's ability to float. These different
attitudes to risk control are an important divide between investors and traders and
we return to these throughout the book.
A chart of market activity helps the financial trader identify opportunities and assess
them. He wants to take a particular type of voyage, but unlike the investor, he uses a
different method to decide the likely destination and the chances of the ship reaching
port. Catch a ship regularly plying the sea routes between Sydney and Singapore and
there is a strong probability you will end up at one of these ports. Climb on board a
tramp steamer and it could turn out to be a slow boat to China or a fast trip to Davey
Jones' locker.
The trader turns to a bar chart display like that in Figure 1.2 on page 10. This plots
direction, speed and shows the shoals of"outrageous fortune". Later in the book we
dress the chart with technical indicators and it becomes a more detailed explanation
of why certain directions have been chosen. This helps confirm the probabilities for
future courses and course changes.
Most importantly, however, the chart gives the trader better ways to define risk. The
ship's navigator combines chart reading skills with seamanship to steer a way through
dangerous reefs. The financial trader combines charting with money management to
minimise risk. If the investor wants to be more than an idle passenger then he too
uses a chart to manage risk. This gives him a significant advantage over his fellow
passengers, and with good chart analysis, he abandons ship before others fully
comprehend the danger and the shortage of life rafts.

5
CHART TRADING

• SHOW ME THE RISK

I choose to live on the edge of the Australian desert, which is a good guide to my
attitudes towards deep water and risk. I regard anything involving blue water as
carrying a high level of risk. I am not a candidate for cruise brochures no matter how
big the ship. I trade the market because I do not like taking uncontrolled risks. The
market allows me to aggressively manage risk and personally accept responsibility for
any failure.
The management of risk is at the very core of our relationship with the market. It is
instantly recognisable, easily calculated and completely unavoidable. Big boats do
not reduce risk in the way passengers hope, and nor do big companies. The investor
looks for a Coles Myer, a Telstra or a National Australia Bank because deep down he
believes the size of these companies will protect him. He tries to limit risk by choosing
size, which is too often equated with quality. He boards in anticipation of a long
journey. He never expects an iceberg, or an engine room fire. If the thought does
cross his mind, he certainly does not expect disaster to loom early in his journey.
When I go fishing, preferably in tidal waterways, I always expect disaster. I know the
location of every life jacket, just how far away the shore is and where the crocodiles
are basking. The trader always expects the iceberg, an engine room fire, or an attack
by pirates. He knows there will be a significant challenge to his trading profits, although
he cannot tell if it will be days, weeks or months into his journey.
When disaster does arrive, he aims to jump ship before it goes down. He knows
about the Titanic, and Burns Philp, GIO and HIH Insurance. He has heard about
Capricorn Resources, Roebuck Resources and Finemore Holdings even though he
does not trade these small companies. He understands size is no protection in itself.
He also accepts that his judgement is fallible, just like the judgement of his travel
agent or broker. He prepares for the inevitable, unknown eventuality by using chart
information, money management and stop loss techniques.
If the trader were to advise the investor, this is the one message he would deliver:
"Every relationship with the financial markets is about the management of risk." And
then he would take out a chart to show just how he manages the risk in every trade.
Our knowledge of the market is based on numbers. Unlike the ocean, or the vessels
sailing on it, we cannot see the market. We cannot gaze in wonder on Telstra. The
best we can do is see its products and marvel at the buildings housing the company,
its staff and its management. We cannot feel the market in the same way we feel the
sea. Both the market and companies are a type of virtual reality. We define and measure
this world primarily with numbers.

6
 1I Message in a Chart

The numbers grow like weeds. The market pages in the Australian Financial Review
summarise the basic price information for each trading day. Shares magazine delivers
another summary of trading numbers and associated figures. Every brokerage report
uses numbers to support its conclusions. The company annual report extracts the
significant balance sheet features. All of these numbers are more effectively displayed
as graphs or charts.
Graphs and graphics are used to make sense of numbers. They consolidate, compare,
analyse and display number relationships in a way that is quickly understood. This is
why all players in the financial markets use graphs extensively. An accountant labels
these displays as graphs. The trader calls them charts .

• GRAPHS
Every politician knows numbers are made of rubber. Every investor should be able to
distinguish between hard numbers and soft numbers. Hard numbers include those
which are verifiable-such as earnings per share, dividend payments, number of people
employed and actual sales.
The soft numbers are the analyst's estimates, or 'guesstimates', of current or future
performance based on inferred conclusions. These include future earnings growth,
projected sales figures, the impact of cost savings and the development of market
opportunities. As the real information needed to calculate these figures is not publicly
available, the analyst makes an informed guess based on published figures. Invariably
these are massaged before release, sometimes seriously as shown by the Enron collapse
in the United States. In sum, the analyst's figure is the difference between actual sales
figures and the sales forecast figures for the same period. Although some of these
guesses are quite accurate, they are not reliable.
These numbers, and more accurate ones, are often shown as graphs. Think of them as
technical drawings of the structure of the ship you are about to set sail in. Use them
to identify weaknesses, or unusual strength. Work with them to test the soundness of
one company compared to another. They are important investment tools for the
management of generalised risk. But remember that while a few of the figures show
the ship as it is, many others describe the ship as it is supposed to be after the refit.
If we were just buying a ship, or part of a ship, this analysis would be adequate. But
when we invest we buy both the ship and a slice of the voyage it is making. We want
to travel with it, sharing its profits, its fortunes, and its capital appreciation. In addition
to an ability to judge the seaworthiness of the vessel, we need the ability to chart the
intended voyage.

7
CHART TRADING

• CHARTS
Ships sail more safely in charted waters. The charts identify hazards, indicate the
occurrence of very high tidal flows, and delineate areas which are unknown, or
imperfectly mapped. They use the numbers dredged from the sea floor with depth
sounders, tidal numbers recorded by generations of fishermen and guesstimates of
depth in the bottomless abyss between the continental plates.
A chart of price history is built from the basic information available from the market.
The best charts have five components:
>- the opening price
>- the high price for the day
>- the low price for the day
>- the closing price
>- the volume for the day.
In newspaper summaries often only the closing price is shown along with the volume.
We start this foray into the financial markets with a simple line chart which tracks
the closing price for each day.
The line in such a chart is a record of closing price movements and it reflects the actual
price activity on the day. These are hard figures dredged directly from the market.
There is no room for guessing when it comes to compiling the raw trading data. Just
as the landlubber finds it difficult to understand fathoms, knots and the Beaufort
wind scale, so there is confusion in understanding just what it is that price measures.
Many investors believe the closing price-the share price-has a fairly direct
relationship with the financial health of the company. Some investment strategies
rely on identifying undervalued companies. Others believe undervaluation is fleeting
in today's competitive, transparent and information-rich markets.
This naive view of share price and value is supported by the chart of Seven Network
(SEV) in Figure l.l opposite. The sudden jump in the share price followed an
announcement that Seven had disposed of some significant liabilities. This ship had
cast off a dragging anchor. Suddenly Seven was worth more and the market price
reflects this. Such direct relationships between news and the share price appear to
support the link between fundamental value and the share price. A closer look at the
chart shows a price retreat just a few weeks later, suggesting there are other factors at
work here in the link between fundamental value and share price.

8
 1/ Message in a Chart

The Seven chart also shows the

shortcomings of the line chart Fig. 1.1 Share price and value 5.5
display. This chart suggests it
was possible to buy into this rise 5.4
at $4.35, or $4.50 or perhaps 5.3
$4.80. The bar chart, Figure 1.2
overleaf, carries more detail 5.2
because it shows the open, the 5.1
high, the low and the close for 5.0
each day, or price bar. This race
for the stars was even more 4.9
exciting than when shown by the 4.8
line chart. Miss the first rush and
4.7
the next traded price is $5.00
with no trades in between. This 4.6
level of detail is not available 4.5
from the line chart. We return
to the superior advantages of the 4.4
bar chart in later chapters. News 4.3
If the share price is linked to
Jl announcement 4.2
some sort of fundamental value. 4.1
then the links are made of elastic.
4.0
The investor looks in vain for a
non-elastic relationship with Seven Network 3.9
Publishing and Broadcasting Daily line chart
3.8
Limited (PBL). This is a well
established public company with
no more financial secrets than
any other. In the period covered
by the sharp rise in this chart, Figure 1.3 on page 11, there were no significant
announcements, no sudden additions of capital or profit, or reduction in liabilities.
Yet the share price raced dramatically upwards.
The fmancial press repeated the speculative brokerage analysis, which turned rumour
into fact. PBL had the potential to become a significant Internet player. This was a
week when Internet stocks were hot news in the United States. As a result PBL took a
short ride towards the moon. This galloping price activity is not created by a change in
the structure or the balance sheet of the company. In a fundamental sense, PBL is not
more profitable or substantially different in the week of the substantial price rise than it
was the week before. This is the same old ship with the promise of a new coat of paint.

9
CHART TRADING

So how do we explain the surge

Fig. 1.2 Better charts to - 5.5 in the share price if it is not a
understand the market - 5.4 particularly good measure of
5.3 value?

~ \l,vJl
J'' 5.2
5.1
The trader, the chartist, and the
active investor have a common
hr'I) : 5.0
answer. The share price is first
and foremost a measure of crowd

ij
No trades
11
lkt1: 1-
4.9
4.8
4.7
sentiment. The line on the PBL
chart shows us the pulse of the
market. Sometimes the pulse
races, excited by future prospects,
possible in 1- 4.6 or terrified of imagined disasters.
this area At other times the pulse shows a
1- 4.5
steady rise in anticipation of
4.4 better results, or a ho-hum
1- 4.3 boredom of everyday living.
- 4.2 Using a chart to measure
4.1 fundamental value is like using
- the tip of a knife as a screwdriver.
4.0
It is the wrong tool for the job,
SEV - 3.9 even though every now and then
Seven Network
- 3.8 it does work. A chart does not
Daily bar chart measure fundamental value. It is
~ l.o
8 ep
•
July
1 1
1Augus t.l I I I
I'
a measure of the value we place
1
on the stock. Understand this
essential point and we clear the
decks for some serious applications of charting to trading and risk management.
Every one of us is part of the market. How we think is duplicated by thousands of
other individuals. By understanding our own thoughts and reactions we understand
how the market thinks. When we decide to act there is a strong chance thousands of
other people have made a similar decision. The chart is like a diary, recording our
thoughts-the collective thoughts of the market-every day.
How much we pay for an individual stock is a very personal matter but the moment
we decide to buy we put a figure on our judgement, our analysis and our belief in the
future. This is one of the very few moments of human emotion defined with a number.
Perhaps we believe PBL is worth buying at $9.30, but its future prospects are so good

10
 1/ Message In a Chart

that we stretch a little

Fig. 1.3 Elastic fundamentals
further, prepared to pay 10.9
$9.40. We go to the market 10.8
with this figure in mind. 10.7
10.6
This is an auction, and 10.5
although we do not hear 10.4
the shout of competing 10.3
bids, we do have to 10.2
compete against others. If 10.1
we want these shares we 10.0
have to buy them from 9.9
somebody. Our decision to 9.8
buy is powerless until we 9.7
Internet 9.6
meet someone who wishes

illt~
to sell. We are also rumou<' """ ~ 9.5
powerless if other buyers 9.4
Flo•t of 9.3
shoulder past us, bidding
section announced 9.2
higher to get the stock.
9.1
The price we have in mind 9.0
is flexible. The final price 8.9
PBL 8.8
we pay is forged in the heat Publishing and Broadcasting Ltd 8.7
of the. market. When PBL Daily line chart
8.6
prices run away they leave Closing price 8.5
us, and other market
hopefuls, with three
choices:
I. Stay with our
original price and wait for the market to slow down and retreat.
2. Chase the price and collect the number of shares we have set our heart on.
3. Chase the price, but keep our dollar limit, buying a smaller number of shares
than we originally intended.
Our reaction helps shape the market for the day, and the outcome is recorded in our
portfolio and contract notes. It is also recorded on the price chart.
A few traders and investors wait for the market. Most take up the chase. They include
the day trader pursuing price on a minute-by-minute basis with a live screen, the
trader watching the end of day trading data, and the investor ringing his broker
every few days for updated information and analysis. The decision to chase the price

11
CHART TRADING

is an emotional one. The faster price moves away from us, the stronger our conviction
that we might miss out. We bid higher, clambering over other bidders. We want a
piece of this action.
Buying shares is a very personal decision made by thousands of people every day.
Together their emotional assessment of the potential future value of PBL pushes the
price up even though there is no fundamental change in PBL. What does change is
the investors', and traders', opinion ofPBL. This change is noted and valued exactly
with every price that PBL trades for on the day. It is most accurately displayed with
a chart of price activity.
Every price paid for PBL contains an estimate of the underlying value of PBL and an
estimate of the future value of PBL. It also contains a dose of emotion-sometimes
a substantial dose. The chart measures the sentiment of the crowd and when we
accept this we use a market chart in very effective ways.
Not every voyage is the same. Tourists pay little for a cruise down the south east
coast of Australia but willingly pay more for their dream holiday when the same ship
sails to the Spice Islands. They base their decisions on a chart showing the past
voyages and the proposal for the current journey.
When I buy stock it is a secret between my broker and myself-and an open secret in
the rest of the market. The market is made up of thousands of individuals all making
individual decisions. Each trader and investor watches the thousands who are his
competitors. Their decisions are shown in the last price paid for the share. We must
decide if that price is acceptable. Individually, we must decide if we will:
> wait and attempt to buy at a cheaper price;
> match the last traded price; or
> pay a little more just to be sure of getting stock.
When many individuals decide they will pay a little more we see the rapid price rise
shown with PBL, and with SEV.

• RING THE BELL

Although each trade is an individual transaction, together they make up a crowd
sentiment and a crowd reaction. Crowds behave in quite different ways from
individuals, and market crowds are quite different from individual buyers and sellers.
This behaviour sets up specific patterns which are tracked with charts. When the
school bell rings for the end of the day most of the students rush from the classroom.

12
 1/ Message In a Chart

If we chart the average of their movement at minute intervals we create a visual

record of their activity. We do not need to know the time the bell rings to understand
the reaction that follows. As soon as we hear the bell we anticipate the likely outcome
because the pattern is repeated on the chart.
The PBL chart is the equivalent of a market bell. It rang when PBL announced the
spin-off of its Internet division as Ecorp. The bell rang with Seven Network when
they announced very good news. Even without knowing exactly what happened we
see the dramatic impact on price. Our objective is to learn to trade the action.
There are a few distinct market bells, and the next section identifies some of them.
Often the noise of the bell is drowned out by the noise of the market. Later sections
concentrate on ways to amplify the first peals so we get to hear them before others.
A chart is a map of the market and it will lead us to treasure. It plots the gyrations of
crowd sentiment and provides an insight into crowd psychology. Every crowd is a
risk, but an emotional crowd carries even more risk. By understanding how the chart
captures the progress of crowd emotion we make better investment and trading
decisions because we are able to manage risk more effectively. Using charts to
understand market activity is the focus of the remainder of this book.
Turning from here the reader has a choice. If you wish to jump straight into how
charts are constructed and how they relate to crowd emotions, then please turn to
Chapter 4. Readers who are still uncertain of just where charting fits into their
investment or trading strategy should continue reading the next two chapters.
Chapter 2 considers the charting spectrum and the way different choices make use
of the market numbers. Chapter 3 looks at how charting tackles the vexed question
of prediction.

13
Chapter 2

DRUMMING UP THE NUMBERS

The market is a collection of numbers. Some analysts choose to focus on the

fundamental numbers, using a range of established fmancial ratios. Others use the
numbers generated by market activity itself. This is the most obvious difference
between the fundamental approach favoured by many brokers and the charting and
technical analysis approach favoured by many traders and investors. The market is
larger than any one of us, and there is ample room for all of types of interpretations,
including those who believe market cycles are related to lunar and stellar activity.
When we approach the market we choose between largely accepting the advice given
by others, or using our own analytical skills to verify the advice we are given. If our
doctor tells us we have an incurable disease then we know exactly what to do. We
fmd another doctor. We want a second opinion to verify the first. Many patients go
further, reading about the disease and its diagnosis because they wish to verify for
themselves the information they have been given by others. This should mirror our
approach to the market. All too often it is not our standard practice.
Of course if the doctor suggests we will live another 80 years then we do not ask for
a second opinion. We are more inclined to accept good news without question, and
this opens the door for the financial services industry. We see an advertisement for
"The Loan That Pays You Back" and are encouraged to "Think of it as a Turbo-
charged Managed Fund." This is good news so we do not always enquire closely
enough about the risk. Good news or bad, a second opinion saves lives.
For many years the investing public has been led to believe the market is too complex,
too risky, and too difficult for them to understand. It seemed rude to ask for a second
opinion, let alone to try to develop one of our own. With more than a dash of self-

14
 2/ Drumming up the Numbers

interest the financial industry offers to look after our money. Regulators encourage us
to invest with professionals rather than to talk with other investors and traders. Most of
the professional funds have succeeded in generating returns which, over several years,
are about the same as the average market index. Now we have some investment funds
whose sole objective is to match the performance of the All Ords Index. They suggest
just a "simple word on managing your superannuation: Indexing." Instead of trying to
pick winners, the funds advise clients to spread risk by participating across the market.
While public attitudes have been slow to change, many new educational tools have
hit computer desktops. These tools give the investing public access to a wider range
of information that forms the basis of decision-making. This includes end of day and
real time market data at reasonable costs, company news and reports available in a
timely fashion via the Internet, and an Australian Stock Exchange (ASX) trading
system transparent to all users. This combination of information and market transaction
transparency gives us all the ability to make better decisions. Whether we accept this
opportunity, and the responsibility that goes with it, is another matter. As a reader
of this book you have indicated your interest in exploring these ideas further.
At the very bottom of this verification process are numbers and the way we handle
them. The most important of these numbers is the closing price for a stock. The
debate about what this number represents is not something confined to the dusty
walls of academia. The debate determines how you understand the market and how
you choose to track it. Ultimately, it determines how you invest your capital and
manage the risk associated with any market activity.

• RUNNING THE NUMBERS

All market approaches come together at the closing price but we all use this in different
ways. Although it is a simplification, I will define here three main approaches to the
market. All are distinguished by the way they use the closing price.
1. The fundamental analyst takes an accounting view of the numbers.
Accountants are often referred to as 'bean counters' and that's what I call this
approach. For this group the closing market price is a reference point for the
calculation of many accounting equations such as P/E ratios, price-to-NTA,
earnings per share, debt/equity ratios and return on equity amongst others.
They believe the price on any given day is not as important as the general
price of the stock in relation to its calculated 'fair value' price derived from
the analysis of other accounting-related data. The market price is not the same
as the fundamental value of the company, but it is a rough and ready guide.
The closing price is just a small part of the overall analysis of the company.

15
CHART TRADING

2. The trader, or more active investor, puts today's closing price into the
context of prices for previous weeks or months. The price is an accurate
gauge of the market value of the stock at the moment. Capital gains, or
losses, are made when the market price fluctuates. The market price helps
establish trends, define risk, and identify trading opportunities. This group
believes the closing price is amongst the most important of the information
available about the company because it captures the psychology of the
market. This is a more active and innovative use of data, and like the name
given to the brightest accountants, I call this the 'jelly bean' approach.
3. Some system traders want to be the lords of time. They see today's closing
price as part of a continuous flow of numbers. They know hidden in every
number series is a repeated pattern. It may be a cycle, it may be a ratio, it
may be a series of repeated gains and losses. This repetitive numerical activity
allows the 'time lords' to predict future market activity as the cycle starts or
finishes. They believe today's close is a vital part of a number series. This
provides a deeper level of meaning to price activity than the daily judgements
by people about market value or company fundamentals.
The same figure-today's closing price-is understood and applied in different ways
by each ofthese groups. This is summarised in Figure 2.1 below. Each application is
valid, and each leads to successful trading and investment strategies. Just a few traders
apply only one of these techniques. Most traders use a mixture. We need to know a
little more about each approach before we decide which combination suits us best,
and just how charting is always included in the mix to achieve the best results for our
trading style.

Fig. 2.1 Understanding approaches to the market

Special charts
Time Lords

Market price data

Probability
16
 2/ Drumming up the Numbers

• BEAN COUNTERS
How do we put a value on a company? The accountants-the bean counters-have a
well established procedure. How do we translate that value into a reasonable price to
pay for a share of the company? Bean counters have an answer and many books take
you spreadsheet-by-spreadsheet through the process. We want to compare market
approaches, so here we only summarise the steps.
For most of us this leading question is the starting point when we decide to switch
from low interest savings accounts into the dramatic world of more active investment,
and perhaps trading. The obvious solution is a better understanding of the inner
operations of a company, its current profitability and its future prospects. As investors
we treat a purchase of a share in a company in much the same way as we treat the
purchase of any ongoing business, be it the corner store, a rental property, or a
franchise. We want the financial numbers.
This is an involved process, now made easier by a wealth of information from brokers,
research papers, magazines and the fmancial press. Most company research is based on
fundamental analysis. This involves many bright young people compiling volumes of
detailed accounting, earnings projections, industry oudook and other forward estimates.
This is the traditional work of accountant 'bean counters' designed to give a clear picture
of where the company is right now, or at least where it was when its most recent reports
were released to the market. Deciding the potential for future revenues and earnings is
critical to making a good estimate of the current value of the future cash flow.
These future trends are difficult to predict. Last year's balance sheet is analysed
comparatively easily, but the final investment part of the process-future financial
performance-is much more difficult.
Many books delve extensively into these evaluation processes. The classics include
Security Analysis from Benjamin Graham, and his modern disciple Warren Buffett's
approaches, discussed in Buffittology. In the Australian context, Analysing Company
Accounts by Martin Roth and Blueprint for Investment by Richard Fitzherbert are
excellent examples of this approach applied in a clear way. For the resources sector
The Mining Valuation Handbook from Victor Rudenno completes this picture. These
books are recommended as a starting point for this style of analysis. They do give the
investor a way to verify the opinion offered by the bean counters, but it is like
comparing the time on one watch with the time on another. It tells us both watches
agree, but not whether both watches are set to the correct time.
The end purpose of this analysis process is to identify stocks which are undervalued
or overvalued in terms of their current market price when compared with their future

17
CHART TRADING

value. For those who analyse the market from a fundamental basis, the closing price
is a rough guide to the fundamental value of the company on the day. Although they
recognise this market value may sometimes get ahead of, or lag behind, the
fundamental value of the company, they do acknowledge that in most cases the market
fairly values the company. Any particular closing price is less important than the
average closing price taken over perhaps a week, or even more. Typically these analysts
talk of a pricing range of fair value. Above and below these levels they refer to stocks
which are overvalued or undervalued.
The concept of under or overvalued is a small acknowledgement of the roles market
emotion and psychology play in determining market price. Bean counters treat such
factors as an annoyance. In the US, company CEOs complain when their stock price
turns volatile. They blame the new breed of day traders for disrupting what they believe
are their sound fundamentals. This is at heart an attempt to muzzle the market and
make it conform with bean counters' predictions. Just as you cannot make a silk purse
out of a sow's ear, so you cannot tie the market value of a company to a balance sheet.
If the market crowd believes future earnings and profitability are very good then
they will bid the price up in a race to get a slice of this future pie. This is reflected in
higher P /E ratios-this ratio is the calculation bringing together market price and
fundamental analysis. Companies with good earnings prospects are rewarded with
high P/E ratios.
For the bean counter the market price broadly reflects, or should reflect, the
fundamental value of the company, with some allowance for ill-informed market
participants who get carried away about future prospects. As the fundamentals change,
as more cans of soft drink are sold, or as theatre ticket sales fall, the share price will
also change in anticipation of the future value of the company. This makes the current
share price just another accountant's tool.
The accountants manage market risk in the long term convinced their analysis of the
fundamental value of the stock is correct and that, given time, the market will factor
this into the current share price. The individual share price on any given day is not
particularly important because they feel they can predict the general direction of
future priced based on fundamental analysis. Please remember the word 'prediction'
because we return to it later in the chapter.
This group looks at market price as just one in a collection of numbers churned up
by the market, the company, and the general economy. A chart of price activity is
mainly used as a convenient running record, or summary, of the past. It is no more
important than the fancy graphs showing earnings growth, production statistics and
employee sick days.

18
 2/ Drumming up the Numbers

• JELLY BEANS
Bean counters are noted for their grey understanding of the world. The brightest and
most innovative of them are sometimes referred to as 'jelly beans.' Traders who rely
on understanding and using market numbers for charting and technical analysis of
the market are the jelly beans. Their market numbers come from market activity and
track the market process rather than the company progress. The price chart is a daily
working tool defining profit and loss.
This is a switch from a pure consideration of the company to understanding how the
company fits into the market process that thrives in a continuous auction. This is
'active price discovery', which is a strange name for a process which delivers trading
profits. Price discovery sets a trading price by balancing competing bids against the
stock on offer.
Just like an auctioneer at a clearing sale, we start the auction with a question. "What
am I offered for this?" This is price discovery at its most elementary.
The clearing sale auction is a one-sided affair because although there are many bidders
there is only one seller. But even in this handicapped market there is ample room for
emotion to take over. Prices for old and used items sometimes soar above the cost of
buying the same item for new. Valuations rapidly get out of kilter in the excitement
of the bidding-the trading-floor. Taciturn farmers bid aggressively and the
auctioneer uses this charged atmosphere to lock in the best price.
The market is a more competitive auction with multiple sellers and buyers. Once this
market swings into action it starts an emotional process capable of defeating even
those who are normally rational and cool.
This is our chosen market, and although we do not duplicate the frenzy of the open
outcry trading floors, we do participate via telephone and the Internet. We do not
see our competitors face to face. Instead we see the numbers indicating the last
traded price, the bid and the ask. With ready access to depth of market screens and
course of sales information we see who is bidding with us, and against us. We see
who has stock for sale, and at what prices. Behind each order on the screen is a
person, a company, or an institution. We know them only through price.
Each trading session is capped in time so the flow of market figures has a convenient
beginning and end. From these we select the opening price, the high for the day, the
low for the day, and the closing price as significant. The closing price is often
considered to be the most important because it is most often set by the institutional
and professional traders.

19
CHART TRADING

The highest and lowest prices for the day are set by the most bullish and the most
bearish market participants on the day. If you believe a stock is on the way up then
you will chase it just to be sure of adding it to your portfolio. The only way to do
this is to get ahead of the pack, and this means bidding higher. The unfortunate
result in some cases is that you end up paying the highest price for the day. Not only
are you enthusiastic, you are the most enthusiastic person. You are bullish. If price
goes up the next day you feel vindicated. If it goes down, you may feel a little foolish.
In contrast, the low of the day is set by the person who believes the stock has gone
about as far as it is likely to go and, already, he has missed out on the best price
possible. Reluctantly he accepts a lower price, but only because he believes the stock
is going to go much lower during the day, or the next day. These are the bears and
the bear is a more complicated creature than the bull.
The bull buys because he wants to make money. The bear is always a seller. He sells
because he believes the price is going down, or that the price is about as high as it's
going to be for a while. He sells either to lock in a profit, or to lock in a small loss
before it grows into a larger loss. We have only one reason for buying, but there are
many reasons for selling. The most fearful of the bears sets the lowest price for the
day by offering to sell stock at this level.
The bull and the bear represent the emotional extremes of the market. The people who
set the open are often considered to be amateurs. They tend to be people who have
listened to the evening news and who have read the early edition of the newspaper.
They take the closing price of the stock they are interested in and make their decision
on this. They enter orders before the market opens, offering to sell at, say, $1.67 when
the opening bid is $1.80. It is these early orders which are first matched and traded
and which set the opening price. Some of these orders will come from larger, professional
players in the market as they attempt to jump on board, or off ship, before the market
gathers momentum for the day. This is most clearly seen when the Dow falls by a
significant amount. On these days those lining up to sell on the opening of Australian
trading include the institutions as well as the novices and mums and dads.
Despite this,· it is still reasonable to suggest that the opening price tends to be a less
reliable guide to market action than the closing price. The close price tends to be set
by professionals because these are the people who have the time to watch the market
during the day. They have the time to place their orders in the last 30 minutes of
trading. The novice, the amateurs, the mums and dads, usually do not have the time
for this close level of scrutiny. They are still tied to their day jobs.
The trader, or the more active investor, accepts this closing price as a reflection of
the psychological and emotional balance of the market, and of every individual who
is participating in the market. Any price is the sum total of the assessment at a point

20
 2/ Drumming up the Numbers

in time of all of the people who are involved in the market. Many will choose not to
buy or sell the stock we are involved in. This decision has an impact on price. A low
priced speculative stock is often priced as it is and poorly traded precisely because it
does not attract the interest of a wide section of the market. Price is affected as much
by inaction as it is by action.
This is where the chartists-the jelly beans-are clearly separated from the bean
counters. We accept it is impossible to know all the basic and news-related detail. We
accept there are others in the market who are much better informed, and others who
are much less informed. Our solution is to use the current market price as a basis for
trading and investment decisions because this price captures all of the available
information. Price is a second opinion about bean counter analysis.
This process is largely independent of the fundamental and basic figures constructed
by the bean counters. There is a link, but its strength ranges from fairly solid to
extremely tenuous. Many people find it difficult to accept that the bean counters'
research has little application to these market gyrations, but those who do are able to
make more effective use of charts to manage both trading and investment activity.
For these traders, and I count myself amongst them, the closing price is a summary
of the psychology of the market. It is a measure of enthusiasm, or dejection. It is a
precise statement of all that is known, that is guessed at, that is suspected about the
factors relating to the company. All market knowledge is imperfect, but the closing
price represents a point of equilibrium between the most pessimistic of stock holders-
the sellers-and the most optimistic of would-be stock holders-the buyers. The
feelings of these groups drive the market. Our concern is not to decide if they are
right or wrong. Our concern is to develop the best understanding of how they are
thinking because this allows us to decide the probability of specific future activity.
These valuations and mis-valuations, these changes in market sentiment, provide the
profit-making opportunities for traders and investors. The chart of price history is
the cornerstone of this activity and the tool for the management of risk. These traders
and investors make use of charting techniques and technical analysis techniques to
understand what is happening in the market and to identify high probability trading
or investment situations. They are distinguished from the bean counters because
they take a more active role in the management of risk based on listening to the
market rather than trying to outguess, or predict, the market.
For traders where the entry price is more critical, today's price is very important in
the context of the previous days or weeks of price history. It allows them to construct
high probability outcomes. For investors, today's price could provide better-than-
expected entry conditions.

21
CHART TRADING

These are the tools used to verify the bean counters' analysis and turn it into profit.
By using different market numbers we check both the operation of the watch and that
it shows the correct time when compared with another time signal. This is a second
opinion from an independent authority who administers a different battery of tests.

• MORE THAN PRICE

The market also throws up some additional numbers usually summarised as technical
indicators and market statistics. The latter includes data about the number of stocks
making new highs or new lows for the year and the relative percentage gains for all
stocks traded on the day. These are also useful numbers for traders.
From the four basic elements of a day's price-open, high, low and close-we extract
many relationships. Some are significant, some appear to be significant, and some
are just interesting. Many technical indicators rely on extracting these relationships
and using them to help understand what is driving the current price.
Using these numbers we get a second opinion about the correct time by pulling the
cover off the watch to make sure the mechanism is working.
Earlier we considered the way the closing price is set by the professionals and the
high for the day by the bulls. If the professionals' price is the same as the bulls' price,
then the market is likely to continue rising because even the professionals are as
enthusiastic as the most enthusiastic buyer on the day. This relationship between the
high and the close can be measured and monitored. The formula that does this, and
the screen display it generates, is classed as a technical indicator. It is one of many
indicators available.
The results of such analysis provide a snapshot of how various segments of the market
are thinking, and this is used as a guide to future emotions. All things being equal,
bullish professionals today are likely to be bullish professionals tomorrow. The
emotional balance is tipped in one direction, and this acts as a guide to high probability
outcomes on the next day.
Other market numbers give the trader a series of statistical probabilities. These are
applied to individual stocks. Bollinger bands and standard deviation techniques are a
common example of this. On a broader scale these relationships are also applied to
overall market activity. These indicators mix statistics, probability and analysis. It
helps us to decide in advance the probability of finding a defective watch when we
pull the cover off for examination. This is another independent verification of the
first opinion.

22
 2/ Drumming up the Numbers

A few traders make use of these market statistics to help in managing market risk and
combining it with the risk on individual stocks. The Australian market has a high
probability of rising in April as it has done this 10 out of the last 11 years. This is
useful in establishing particular trading frameworks. In March, Tuesday is the best
day to be a seller because on a statistical basis the market rises 48% of the time.
Others prefer to be sellers on 10 March because, on average, this date has recorded
the best March performance since 1988.
The drift away from purely market trading generated numbers to the statistical series
generated by prolonged market activity is an important pathway. It leads us towards
specific probability and entices with the prospect of prediction. The group using this
pathway sees the closing price and number series in particular ways.

• BEANS OF THE FUTURE

A third group in the market takes a more radical approach to using numbers generated
by market activity. I call this approach the 'time lords' to distinguish them from the
bean counters and jelly beans. They are fascinated by numbers and series of numbers.
Ask them the time and they want to tell you what time it will be in the future using
Grandad's pocket watch. They verify a market opinion by leapfrogging into the future
using numerical relationships.
The voyage from probability to predictability starts innocently and reflects a deepfelt
need to impose order on chaos. Enter the closing prices ofNational Australia Bank
for the last 10 years on a spreadsheet and we end up with a column of numbers. The
price history for every stock, for every commodity, for every futures contract, for
every bond issue is no more than a series of numbers. Mathematicians have been
fascinated by number series and their relationships for centuries.
This collection of people who eventually became market time lords includes the
Renaissance mathematician, Fibonacci. He is historically the first to have his work
applied to the market. The Russian Kondratieff identified long-term 54-year cyclic
waves. The later Coppock indicator is a variation and application of this approach,
but uses a 13-month calculation.
In the turbulent 1930s R. N. Elliott, described by some writers as "an impecunious
accountant", believed he had found a regular sequence of wave counts-the market
rallied in five waves and retreated in three waves. These became known as Elliott
waves and their accuracy is very dependent upon the initial point selected for the
start of the calculations. Mter the American market crash W. D. Gann claimed to

23
CHART TRADING

have discovered the secret of price and time. He published it in How to Make Profits
in Commodities and in Truth ofthe Stock Tape.
Time lords know any randomly selected number series is likely to exhibit particular
types of number relationships. Many authors have shown how there is a persistent
geometry in the natural world which determines not just the shape, but the ratios of
the spiral growth in flowers and sea shells. These are defined by precise mathematical
relationships. Tony Plummer in Forecasting Financial Markets shows how these are
applied to number series from the market.
From here is it but a short step to the application of Elliott Wave, Gann and Fibonacci
theory to a stream of market data. Most importantly, because this data appears to
follow these mathematical relationships, the time lords believe it is logical to assume
these relationships will continue in the future. Traders and investors using these
methods often rely heavily on predicting market activity.
Although time lords are philosophically a very long way from the bean counters, the
outcome of their analysis has the same predictive component. Those who use number
relationships tend to be more specific about their dates for future predictions.
Sometimes they are spectacularly successful, but more often they go out with a
whimper when their predictions fail to materialise.
Number series do exhibit repeated relationships. These relationships are a valid way
of understanding any data series that does not have an emotional content. The chart
in Figure 2.2 opposite presents several trading opportunities. This looks like a market
bar chart, but it fails on one important condition. The data has no emotional content.
It is based on a randomised record of temperature readings taken at Melbourne
Airport. Despite all the wishes of Melbourne people on a very hot day, their wishing
does not change the weather. In the market the trader can wish for a lower price, and
make it so, simply by selling his own stock at a lower price.
In trading the equity market the number series is a product of the market's
understanding, or misunderstanding, of the current and future values of a tangible
product. It is, after all, a company we buy a share in. And the company may produce
dog food, sell Internet time, or broadcast television signals. When we move to the
derivative markets we take a long step away from these market fundamentals.
Even in simple derivative markets, those closely tied to the underlying stock like the
options and warrants market, the behaviour of price more closely resembles an
independent numbers series. As we move further into complex derivatives and 'over-
the-counter' products, the link to the fundamental product on which the derivative is
based is stretched even further. In some ways, these number series become closer to
a pure number series, although they still retain an emotional content generated by

24
 2/ Drumming up the Numbers

the 'marked to market' position for each trade. Trades are marked to market when
the value of the portfolio is calculated each day based on the closing price. Winning
or losing is an emotional experience and this component is included in every over-
the-counter derivative trade.
Perhaps this weak link between fundamentals and the derivative is why the
mathematical predictive approaches favoured by Elliott waves and Gann appear to
work more successfully in these markets.

Fig. 2.2 Figures and relationships

Trend
trade?

v
I

l l
Support?
Vr
Double bottom?
r
Jl\~ Break away gap?

I have simplified and, some would say, misrepresented the time lords. If you are
looking for the certainty of prediction implied by Gann, Elliott and other similar
trading styles then this chapter is not a good place to start. I agree with Larry Williams,
the US commodity trader who is noted for turning a $10,000 stake into $1,100,00 in
less than 12 months. He notes a survey of newsletter trading approaches in Long
Term Secrets to Short Term Trading. He says the performance figures are very revealing:
"I went back three years and found that the poorest performers in 1995,
1996, and 1997 have consistently been the GannjElliott/Acarne group who,

25
CHART TRADING

as a group, have averaged a loss of close to 100% a year. This from a crowd
that claims all can be known, that you really can buy bottoms and sell exact
tops."
This is harsh criticism, yet some people do use these approaches very successfully.
Closer inspection often shows they also use good risk control techniques that would
return good trading results under almost any system. If you feel these approaches are
worth investigating then I would recommend Fibonacci For Traders and Forecasting
Profits Using Price and Time as starting points.

• CHOOSE A SECOND OPINION

The market is large enough to encompass all of these approaches, and more. Although
many people feel more comfortable with one approach than another, these approaches
are not mutually exclusive. Each is used to verify the analysis of others.
Many investors use fundamental analysis to select stocks, and then apply charting
techniques to select the best buying opportunity. Many chart traders use Elliott wave
analysis to time their entry into individual stocks. Many fundamental analysts
unconsciously use Elliott wave and Dow theory concepts in selecting counter cyclical
stocks which provide buying opportunities because they are below fair value. They
draw on other approaches to verify their own analysis, but do not always acknowledge
them.
The market does not care what we do. Each day it drums up the numbers and we
arrange them in neat columns and rows in spreadsheet heaven. Which numbers we
choose to use, and how we use them, has a significant impact on the way we understand
and use the market to grow our capital. Whilst many maintain an artificial division
between the investor and the trader based on hazy notions of comparative risk, the
real difference between the two is in how each understands the relationship between
analysis and outcomes. In both cases charting provides an important verification
tool.
Those who believe any series of numbers contain inherent relationships find it very
easy to slide towards predicting market outcomes. Elliott forecasts may identify 15
October as a significant turning point on the completion of the fifth wave. Those
who believe the company numbers contain the seeds of market truth are also inclined
to slide towards prediction. They use a different language, telling the investor: "Coca
Cola is fundamentally sound and undervalued at current prices-we recommend
accumulate."

26
 2/ Drumming up the Numbers

Both these opinions are predictions. Each is taken up eagerly by traders and investors
who are anxious to reduce market risk by grasping at certainty. It may carry the
authority of a brokerage report, of a report issued by an acolyte of Gann or from the
purveyors of a market trading system, but they all offer certainty where none can
exist.
No market participant can afford to surrender his right to the aggressive management
of risk in favour of an approach that suggests risk is minimised by the certainty of
prediction. This is the basic difference between the trader and everyone else in the
market. Often this difference is highlighted by the way traders use charting and
technical analysis to verify these other opinions. These are the tools required for the
aggressive management of risk.
Trading and investing are about identifying high probability outcomes to aggressively
manage risk to protect capital and grow profits. No matter which school of thought,
or which collection of numbers it is drawn from, prediction does not reduce risk.
The differences between prediction and probability lie at the heart of risk management
and form the core of charting applications. We examine the differences in the next
chapter.

27
Chapter 3

PUNTING ON PROPHETS

The bottle-weary Macbeth stumbles across three witches on the blasted heath.
Looming from the mist, they deliver up a prophecy of Macbeth's future. The tension
in the play comes from the strange ways the prophecies are met. We experience the
same tension in trading the market.
We quickly dismiss such Elizabethan dramas as irrelevant to trading and instead turn
our attention to the latest investment magazine or trading system. Prophecies are the
stuff of legend and inventive drama. Yet this quest for certainty about the future lies
at the very core of the way many people approach the market. At heart they believe
better research means greater certainty about the future behaviour of prices.
The easiest research is provided by people, or systems, who claim to predict future
market behaviour. This is the way they control market risk. If market risk-or even
the risk in an individual stock-can be controlled by better analysis, then they believe
this reduces the risk on each individual trade.
At each further crucial turning-point in Shakespeare's plot Macbeth has a choice. Through
his own choices, his actions coincide with the prophecy of the three hags. How much is
coincidence, how much is events that would happen in any case and how much is the
result of his own actions being influenced by the anticipation of what he has been told
would happen? Separating truth from fiction and coincidence is difficult at the best of
times. Trading systems built on carefully selected hypothetical past data blur the distinction.
Those in search of certainty are most likely to mistake coincidence for prophecy.
Just like us, Macbeth is josded by greed and fear, racked by remorse but driven by
"vaulting ambition, which o'er-leaps itself". He lunges for a kingdom. We reach for
wealth and capital accumulation. He acts in two contexts-the world as he sees it

28
 3/ Punting on Prophets

and the future world as constructed by three cunning women thriving on battlefield
rumour. We work in a market defined by its activity. Some traders and investors look
for opportunity in a future market world constructed for them by analysts, brokers
and trading system promoters.
Macbeth goes to his death believing his every step was defined by the three witches.
How much is fate and how much is his own doing is the open question of the
tragedy, and of our trading. Those who choose fate look for omens, portents found
in "hours dreadful and things strange", or in the charts. Traders who need certainty
in the midst of chaos have fate delivered by modern witches reading from spreadsheets
and specialist charting approaches.
The prophecy confirmed, Macbeth fights on, bellowing "damn'd be him that first
cries, 'Hold, enough!' ", fmally taking perverse pleasure in compounding his suffering
beyond the minimum necessary to fulfil the prophecy. He hangs on to his sword. We
hang onto our losing position because the trading system says we must.
We avoid such a bloody death of our trading and investment capital when we have a
clear idea of the difference between prediction and probability. This understanding
also places charting and chart analysis into a better perspective. The ill-informed
think charting is on about the same level as the witches gathered around their cauldron
because they believe it is all about prediction. They miss the opportunity to use this
valuable tool in an effective way.

• STEPPING INTO RISK

The accumulation of capital in the market involves risk. Every sensible market approach
attempts to reduce the risk to the smallest amount possible. This is usually achieved
through extensive analysis but some prefer the shortcut offered by prophetic
approaches. This is an important first step, but many investment and trading strategies
go no further and founder as a result. The second step is the active management of
the risk entailed in every market position. Unfortunately many investors, like Macbeth,
believe risk is neutralised by good prophecy. Nothing could be further from the
truth, and the more detailed example below shows this in practice.
The analysis of market opportunities is linked to the three major approaches discussed
in the previous chapter. The accountants-the bean counters-examine the books,
study the fundamentals and try to learn as much as possible about the basics of the
business. This activity provides the basis for much of our financial industry.
The belief in the effectiveness of this approach is ingrained. Writing in the Aprill999
Shares magazine, Graeme Anderson draws a distinction between those with a "focus

29
CHART TRADING

on professional research on when to buy" and the "chartist, who essentially is a trader
by nature and looks as much for sell signals as buy signals." The implication here is
that the trader is a punter while the investor is a prophet, making investment decisions
secure in the knowledge of the future by 'choosing stocks for the long term'.
The real message of the 'sleep-easy' approaches is the suggestion that they can predict
the future and so reduce risk. By fmding the right broker, or analyst, you limit your risk
in the market because you have been shown which stocks are going to perform and
which are not. Many people who have relied on brokers' advice will quickly point to
the fallacy of this conclusion. And the brokers and other fmancial writers will just as
quickly provide the slick answer: "You need a better analyst, and do I have an opportunity
for you!" Or they ask the rhetorical question: " Looking for fmancial direction?" and
provide the answer: "Find yourself a good navigator", then provide their phone number.
The sad and irrefutable truth is that beyond certain levels, analysis is a poor guide to
the accuracy of prediction. In The Fortune Sellers Sherden devotes several chapters
to the inability of market analysts to outperform the naive forecast-which assumes
tomorrow will be much the same as today-or weather forecasters to get it right
more than two days ahead. The most effective method is the naive forecast. More
recent research about the performance of the fmancial pundits confirms this evaluation.
They are consistently too bullish, or too bearish. Personal experience adds a supporting
cast-readers should apply a simple confirming test. This, we will go through below.

• PUNTING ON PROPHETS
Select an issue of your favourite investment magazine, or broker's report, at least a
year old. Bring up a chart of the recommended stocks. The first step is to match their
predictions with the actual results. The second step is to spend some time with a
spreadsheet to work out the impact of a buy and hold strategy. If you bought at
market price on the date the report hit your office desk, what would be the result
now? Is this portfolio in profit or loss? For accuracy this exercise needs to include
every recommendation in the report or magazine you use as a starting point. It is
easy in retrospect to select just the best recommendations, but at the time we have to
assume all recommendations have an equal level of accuracy. After all, we are
encouraged to believe investment risk is reduced by better analysis.
The results of the test are very often extremely depressing. Typical results are shown
in Figure 3.1 opposite. In this selection taken from a popular investment magazine
in March 1998, over 75% of the recommendations from respected sources were just
plain wrong. Even at the highest prices achieved in the following 12 months, only
one buy recommendation showed a profit-and this in a powerful bull market.

30
 3/ Punting on Prophets

Fig. 3.1 Punting on prophets

All the Brokerage stock selections published March 1998.

Buy Price listed in Best Worst Maximum gain Maximum

publication price for price for in 12 months draw down
the year the year %of capital %of capital
TAH 7.20 11.85 7.75 65% Nil
ARG 3.65 3.56 3.00 -2.4% 18%
ANI 1.45 1.43 .66 - 1.4% 54%
IHG 1.25 .85 .50 -41% 60%

Sell Price listed in Best Worst Maximum gain Maximum

publication price for price for in 12 months draw down
the year the year %of capital %of capital
CML 7.50 9.22 6.06 22% 19%
TLS 4.67 9.20 4.81 73% Nil

The success rate for prophets is 17%

The CML sell recommendation took three months to establish the down trend so we
have not classed this as a success. The TLS sell recommendation was based on the
idea of fair value reached using discounted cash flow or adjusted P fE ratio methods.
The limited success of this small sample of brokerage recommendations is not unusual.
It is not sufficient to shrug our shoulders and say that some analysts are better than
others or that the best we can expect is a mixed bag of results. If better analysis is
supposed to be the most important step in reducing market risk and if it fails
consistently then we, and our capital, have a serious problem. We might just not live
long enough to see some of these predictions become profitable.
Can we improve this analysis, and if so, do we really reduce the risk to our investments?
More informed decisions always reduce risk, but in the market they cannot eliminate
it. Prophecy is not possible, but this does not stop us from looking for it.
One solution is to gather more information, and more quickly, than our competitors.
The Internet is seen as a vital tool in this process, feeding news as it happens onto
our screens. Understanding the impact of news takes skill. Some people are very
good at it while most of us are just overwhelmed.

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CHART TRADING

Some brokers, and regulators, are worried everyday investors will use the same information
that until recently was largely restricted to the financial industry. They believe it takes
skill to read and understand the news and they are right. They believe they have the skills
and that investors should pay them for these skills. Here the performance tables suggest
many of them are wrong or that the funds they control typically perform about as well
as the general market. Duplicating market performance is a skill but it is not the skill we
want as traders. Our objective is to outperform the market.
News and access to news does not by itself reduce market risk. Nor is risk reduced
just because one group, the financial industry, believes it has a monopoly on the skill
to interpret it.
While better analysis does reduce risk, it is difficult to sort the good analysis from the
poor. Even more importantly, because this analysis rests entirely on its predictive
ability to control risk, the trader is not encouraged to actively manage risk to protect
capital. The trader assumes risk is neutralised, and this assumption is wrong.
Another solution is to look for certainty in the charts. Here we skip the charting
approaches used by the 'jelly beans' and land squarely amongst the aficionados of
Gann, Elliott and Fibonacci. The time lords sit in front of screens running software
like HotTrader, Advanced Get, OmniTrader and others. Or they use trading systems
that come in plain brown packages with pages of fine print seeking our silence forever
and with an invoice calculated in thousands of dollars. Here the power of prediction
is put to work again because we assume better prediction reduces risk.
The witch's cauldron is replaced with a laptop and incantations with an algorithm. The
outcome is still the same. We believe the risk of an individual market position is eliminated
or reduced because the method we use assures us that we know what the future holds.
The method we choose to make this initial analysis of an investment or trading
opportunity is an important first step. But these styles of selection reduce the risk on
individual positions only marginally. We all want to avoid punting on the markets
but we duplicate this process when we punt on the prophets who want us to believe
they can predict the market.

• PROBABILITY
Our solution-the jelly bean charting solution-keeps a foot in every camp. Some
traders like myself use this as our starting point, dipping also into the bean counters'
analysis, or using the time lords' analysis for additional support. Other traders and
investors start their analysis at either of the two extremes, and then use the jelly bean
charting solution to identify, define, and manage the risk of each investment position.

32
 3/ Punting on Prophets

This is aggressive risk management and it is the key to survival in the market. This
key is delivered to us wrapped up in a chart. It opens the door to probability by
accepting that prophecy is a low probability outcome.
For readers who wish to examine probability in detail I recommend Against the
Gods. Berstein's discussion is clear and wide ranging. Trading applications of
probability are discussed more fully in Trading Tactics. For our purposes in this
chapter just a brush with these concepts is sufficient. Probability is strictly defined as
the ratio of favourable outcomes to the total number of possible combinations.
Traditionally a pair of dice is used to reveal the basic concepts. Between them they
have 12 faces and each number from 1 to 6 occurs once on each die, or twice between
the pair.
There are a total of 36 different outcomes. The Renaissance gambler and
mathematician, Girolamo Cardano, worked out the combinations and discovered there
are more ways to get to some results than to others. Throwing a 7 can be reached by
six combinations. Throwing a 12 can be only reached with a single combination.
These are the basic calculations necessary for determining the odds and probability
of any outcome. The odds of an event happening are the ratio of favourable outcomes
to unfavourable outcomes. The odds of throwing a 7 are six throws to 30. The odds
of throwing a 12 are one throw to 35.
The probability of an event occurring is the ratio of favourable outcomes to the total
number of possible combinations. The probability of throwing a 7 is six throws out
of 36. The probability of a 12 occurring is one throw out of 36.
In the market, probability is identified by the behaviour of price. At its simplest and
most powerful level, it is the tendency of prices to trend. When prices continue to
move in the same direction, day after day, a trend develops. Just as all outcomes on
the throw of a pair of dice are not 1/12, so not all outcomes for price movements up
or down are 50/50. This gives us a way to actively and aggressively manage risk.
Trending activity increases the probability that tomorrow's price will move in the
same direction as today's price. Buy a rising stock today in a rising trend, then a rising
price tomorrow is a high probability outcome. At some point we will be wrong, and
prices will fall, perhaps developing a new trend. Because we know this is one of the
probable outcomes we are prepared for it and we know in advance what action to take.
This history of time, today and tomorrow, can be stretched to include weeks or
months, or years. Later we will look at the chart tools used to help us identify trends,
their starting and ending points, and the way they develop over time.

33
CHART TRADING

Other price behaviours point us in the direction where one outcome is more probable
than another. These include simple chart patterns, such as triangles and the concepts
of support and resistance, also discussed in later chapters. The shift from prophecy to
probability transforms our understanding of risk and how it is managed. The prophet
has a focus on market risk and believes better analysis leads to better prediction of
results. With probability we focus on the range of possible outcomes so we pre-plan
our response to each. The risk that hurts us is the risk associated with the individual
position we have in the market. The market crowd can give us money, or take it
away.
For the moment the specifics are less important than the general conclusion. Crowds
behave in consistent ways. The most powerful of these is shown as a trend on a chart.
When we see certain types of patterns developing in a chart we position ourselves to
take advantage of the most probable outcomes. This includes both a way to manage
the entry into a trade, and also the exit. Against a background of market risk we take
specific action to control position risk.
There is a key difference between prophecy and a probability. A prophecy gives you
one outcome. A probability provides a choice, but suggests which outcome is most
likely. This is a much more accurate definition of risk and when this is more accurately
defined we manage it more effectively.
By accepting that potential outcomes can be ranked in order of probability, we position
ourselves more effectively for both trading and investment decisions. When we
combine an aggressive management of risk using stop loss techniques with chart
analysis we construct a better model for protecting and growing our trading capital.
The stop loss concept assumes the possibility of error. It assumes that although the
decision has a high probability of being profitable, it also has a probability of being
unprofitable. How we react in the face of the erosion of our trading or investment
capital is a significant factor in determining our financial success. The example
discussed in the Annex to this chapter details the financial consequences of each
approach. Later chapters deal more specifically with ways this risk is managed by
using chart and chart indicator information.
The stop loss concept is usually missing from the bean counters' investment advice.
This is perhaps a measure of the certainty of their analysis, which allows little room
for error. In contrast, a stop loss technique is often an integral part of the time lords'
approach. Whether this is a tacit recognition of the limitations or imperfections of
their approach or whether it is just a more advanced application of risk management
is a moot point. Either way, it puts them well ahead of the bean counters' concept of
risk management.

34
 3/ Punting on Prophets

• TRADERS MANAGE RISK

Although there is one type of risk involved in the selection of stocks, as soon as we
buy a stock we are exposed to a risk generated by the activity of the market itself.
This is the greatest risk of all, because it could destroy our trading capital just as
rapidly and more effectively than any end of the world scenario. It can also build
capital in ways unimaginable to those stuck in day jobs. Which result applies to you
depends on how you manage the active risk of market exposure.
Traders manage risk and there is no reason why investors should be exempt from
this. The time of your intended investment or trading horizon is irrelevant. While
the day trader focuses on today and tomorrow, this does not mean he is not prepared
to act just a few minutes after he opens a trade. The investor who is in for the long
term, three years or more, must be prepared to act if necessary just days after the
investment is purchased.
The investor who believes in quality advice, or quality stocks, or time in the market,
all too often does not actively exercise detailed risk management because he believes
the risk has been controlled by the actions of others. The investor, in many ways,
refuses to accept responsibility. When the investor eventually does accept responsibility,
when he does accept he is wrong, he often takes the advice of the very same broker
who got him into the losing investment in the first place. This is usually called a
'portfolio review', where poorly performing stocks are weeded out.
The investor makes a more successful investment when he understands he may be
called upon to exercise effective risk control at any stage of the investment. The trader
expects to exercise this control every day the position is open. The investor hopes he
will never have to exercise this control to get out of a losing position, and that if he
does, it will be months, or years, in the future. Perhaps he believes he will have
accumulated enough wealth to be able to take the loss. The investor gets a better return
on capital by exercising the same level of risk management and control as the trader.
Risk waits for no trader or investor. By using a chart each has a better way to
understand the risk of each trading or investment opportunity, and each has better
ways to manage the risk once a position is opened.

• PREDICTION OR FORECAST?

Chart analysis is often confused with predicting or forecasting the market. This
confusion is enhanced by those who confuse trading and investing. Chart analysis
uses the action of price and volume to clearly show how the market has behaved. For

35
CHART TRADING

traders, the past pattern of behaviour helps to identify market situations that have a
high probability of a specific action. The trading approach requires the trader to
develop a plan to cope with the probability, or equally to cope when the probability
does not eventuate.
Before crossing the road we pause at the kerb, check left, right and left, then cross.
The kerb tells us of changing conditions ahead, but it tells us nothing about the
actual events on the road. We prepare to behave in a particular way depending on
what the road reveals. In our market world the trader prepares to act one way if
certain conditions are met, and another way if different conditions are met.
Forecasting uses the higher probability situations in an attempt to project future
price action and acts in anticipation of this. It straddles the boundary between trading
and investing. Instead of a random point on the kerb, here we stand at the pedestrian
crossing, stepping out confidently when the walk sign flashes. Sometimes we get
wiped out as a car crashes through the walk signal, but most times the signal is
reliable. When we see the signal we forecast the action for a selected period of time.
Here traders act when the event occurs.
Prediction is a different beast altogether. It offers a high level of certainty about the
occurrence of events at a specific time. Some Gann and Elliott Wave analysts make
quite specific predictions. This is like saying: "I know there is a set of traffic lights at
the end of the block, and that at 10.38 am the signal will be flashing 'Walk'."
This leaves little room for probability, although there are times when such predictions
match the coincident events. Then the predictions come true. Separating the
coincidence from accurate predictive ability is difficult. The tendency with prediction
is for traders or investors to act in anticipation of the event.

• THE LOSER'S LAMENT

Losers think the market takes money from them. Later they think it is nasty individuals
who steal. They look for easy targets to blame, starting with brokers, investment
advisors and later a nebulous group of inside traders who 'really' control the market.
Few of them ever understand it is the market crowd who takes the money away and
because of this they are not able to develop effective risk control strategies.
The loser's lament starts with a prophecy-this stock is going to be really good-and
sometimes it gets twisted in a most unusual way. The twist is this: Charts are self-fulfilling.
Because everyone is looking at the same chart, and all are reading it in the same way, then
of course we expect chart predictions to come true. Written like this it looks and sounds

36
 3/ Punting on Prophets

quite silly. Dress it up little, attach the idea to a respected colunmist or commentator, and
the idea gains a counterfeit currency. Having taken one twist, another seems acceptable.
Charting becomes a black art and suddenly we are back to the three witches, the
cauldron and the laptop computer. If you are not singing the loser's lament it is easy
to see the fallacies in these opinions. We list them briefly only because the repetition
of the charges seems to give them some validity.
We start with the basic mantra. Charting records price activity. It does not cause it.
Charting reflects the activity of the market crowd, but is not responsible for it.
Although I regret it, most people do not use charts. Chartists are a small proportion
of the market crowd, and those who know how to use charts effectively are an even
smaller group. Of those who do, they have a choice of nearly 3,000 stocks, securities,
and derivatives to choose from on the ASX alone.
This book is one of hundreds about using charting and technical analysis to understand
the markets. This is powerful evidence that there is not just one way to read a chart, to
apply chart analysis and to take action based on analysis. The idea that a small group
of chartists are all watching the same chart and reading it in the same way is a nonsense.
Add to this the variation in trading and investment styles amongst chart users and
the link with reality is very thin. Toss in a variable tolerance for risk amongst traders,
investors and potential market participants who also use charts, and reality is a long
distance from the loser's lament.
Finally, consider the power of the individual to move the market. The idea of chart
patterns being self-fulfilling assumes a concerted pattern of trading by individuals
with enough cash to influence the trading activity of not just one stock, but every
stock with a promising chart pattern.
Conspiracy theories, self-fulfilling prophecies, an insider's market and predictive
analysis are all lame excuses for an inability to understand, accept and manage risk in
the stocks we choose to trade or invest in.

• RISK AND REALITY

We have an appointment with reality. Chart analysis gives us a way to understand
the activity of the market crowd based on the probability of outcomes. The market
does not owe us money, no matter what our time frame is. The market is full of
people busy trying to take money from us, and most of the time they succeed. Good
advice is better than no advice. Good stocks are better than bad stocks. Good
probabilities are better than an.y prophecy.

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CHART TRADING

Nobody can take away your responsibility for identifying, assessing, and managing
market risk. You may delegate the task, but not the responsibility. A chart of price
action gives you the tools to handle this responsibility successfully and profitably.
Risk is confronted on its terms, not on ours. When risk eats into our capital or our
profits, we must move at that very moment to neutralise it. This does not mean
being tied to a trading screen all day, but it does mean having a solid stop loss plan
in place. When we know the difference between prediction and probability we are
able to identify and manage risk. Prediction means we know when bad things will
happen and until then we do not need to monitor the market. Probability means we
know bad things can happen at any time so the market demands our attention.
Matching ambition with battlefield chaos, Macbeth willingly concludes the witches
are right. He structures his world in the light of their prophecy and pre-empts events
to hasten the predicted outcomes. Be it fate or coincidence, or direct cause and effect,
each action seems to twist to match the canny witches' fortune telling. Macbeth plays
to his destiny, giving in to his own desires. We do the same when our trading is built
on someone else's agenda.
As market survivors we will do better if we reject at least some of Macbeth's attitude.
When we reject the power of prophecy, no matter how well intentioned, we take
control of our own risk in the market. We use a chart and the tools of charting to aim
for more successful results.

Annex to Chapter 3: RISK AND NO RISK

If we want to accumulate capital growth from the market then we need a more active
approach to risk management that does not rely on prophecy and which is not a
'punt'. I suggest chart based approaches, either used alone, or as a way to verify
information and recommendations from other sources, are an effective way to manage
risk and to lock in capital returns from the market.
To illustrate the difference in these approaches we can look at WH Soul Pattinson
(SOL). At the time of the original analysis recommendation in June 1998, SOL was
listed by several brokerages as "accumulate". This suggests any existing positions should
be held and additional shares should be added as the price hovered around the then-
current levels. This recommendation was based on SOL being undervalued and, like
all of these style of 'prophecies', suggests at the very least little harm will befall the
investor and good profits will accrue as the market readjusts the value of the stock.

38
 3/ Punting on Prophets

The reality is different. Figure 3.2 below shows the application of a model
accumulation trade based on the brokerage recommendation. This shows an entry
on 1 June and an exit 10 months later. With an initial entry at $29.93 and a sale at
the highest point in April of $32.00 this investment returns a capital gain of 6. 9%. If
we used just $1,000 for the trade we walk away with $69 profit at the end of 10
months. This is about half of the rate of increase in the All Ords for the same period.
Even more disturbing is the maximum draw down, which is the amount of portfolio
capital lost at the lowest point once the trade was opened. Capital is reduced by 23%
when SOL hits a low of $23.00. Risking 23% of our capital to collect a 6.9% return
puts the balance of the risk/reward ratio very much against us.

Fig. 3.2 Accumulation trade vs 'ideal' risk management

This trend line keeps traders Accumulation
32.50 out when accumulation trade and exit

30.00

27.50

25.00
Entry point for
accumulation trade

359
SOL
179 WH Soul Patterson loss, for accumulation trade
Daily bar chart

0
[000)

The intention here is not to disparage any particular recommendation. What is

important is to understand why such 'prophet' approaches carry a higher level of risk
than is first apparent, and then to understand how other techniques are used to make

39
CHART TRADING

our trading capital work more effectively. We can choose to follow Macbeth and
prophecy, or appreciate that the market offers many other factors so each trade is just
one in a series of possible outcomes.
In this example we use perfect outcomes on the historical SOL chart. In real life it is not
possible to pick the tops and bottoms. The comparison is useful only because it shows
the dramatic difference in the results obtained through a more active management of
risk-a combined 78% return shown below in comparison to the 6.9% prophet return.
The active risk manager takes one look at the SOL chart on 1 June and stands aside
from the market because SOL is still in a down trend. This immediately saves him
money and reduces risk. He enters on the down trend breakout using just a straight
edge trend line to deliver the signal. We use the very low and the very high in this
example, so the first SOL trade is from $26.02 with an exit at $30.31. This gives a
16.5% return.
Even taking a slice of this delivers more than the 10-month performance figures
from the accumulation trade. The second trade is from the new low at $23.00 and
finishes with an exit at $30.97. This delivers a 34.6% return. Even without the
advantage of retrospect it was easy enough to collect at least a 6. 9% return in just a
few weeks instead of waiting 10 months.
The third trade, from valley low to the high peak is from $25.09 to $32.00. This is
a 27.5% return. As with the first example, we assume each trade uses only $1,000.
The first trade delivers a $165 profit. The next trade uses no new capital. Instead the
original $1,000 is recommitted to the market. At the end of three trades our original
capital has grown by $785. These three trades taken within the context of an
"accumulate" recommendation deliver an excellent 78% return. They do so by actively
managing the risk rather than by placing all faith in the prophecy of a long-term
recommendation, no matter how respected the source.
When the theoretical returns are so much better than actual returns, then we need to
examine the alternatives. Market reality will modify these returns, but they may still
be far better than the returns from the prophet approach. The alternative is not punting
but the sound application of market analysis to verify information from other sources.
The first step to survival in the market is to recognise that prophets do not exist.
Every now and then one might get it right, but they stand on the bodies of literally
thousands who got it wrong. Taking a punt on finding the right prophet is just as
dangerous as taking a punt on the market.
Between the extremes of punting and prophecy lies active risk control. Understanding
chart activity plays an important role in risk management because it deals with
possibilities and provides the power of choice.
40
Chapter 4

THE PLAIN PLOT

Every voyage starts with a chart. The chart plot arranges the information in sequence,
but does not interpret or analyse it. How useful the chart is depends on the way the
chart maker chooses to display the available information, and also the elements he
decides to include. How suitable it is depends on what he intends to do with it.
A nautical chart shows reefs, spot depths, the nature of the sea bed and other ocean
hazards. The weekend angler's chart shows the deep river holes where fish have been
caught before. Each chart is valid for its purpose. The sailor and fisherman plot with a
purpose, and so too should the investor and trader. Our choice of how we collect and
organise the information determines how accurate our chart is, and whether it is suitable
for our purposes. The chart plot is the basis of all other chart and indicator analysis.
The depth sounder replaced the lead line, and nautical charts are more accurate for it.
Electronic price information has replaced laborious market reports neatly listed in
columns of small print in the newspaper.
Few people now draw charts by hand. Like calligraphy, it is a quaint skill practised
by a few and on a limited scale. Most people reach for the computer, the spreadsheet,
and the screen chart. Choosing good software is discussed in Chapter 19. There is a
certain nostalgia for hand drawn charts but it is quickly dispelled as soon as we
actually attempt to update more than just a handful of them on a daily basis.
The price plot created on the screen by our charting software is a way of organising
the information delivered by market activity. It is as close as we can get to the market
action without actually standing on the trading floor. These screen plots generally do
not manipulate the data and this makes them different from the technical indicators
discussed later.

41
CHART TRADING

Traders need to collect updated information for the entire market very quickly. Time
spent updating the basic information is time not spent on analysis. The investor is less
harried but even he makes life easier by updating quickly. The match of electronic
information and the computer makes this possible and cheap. Now the entire market is
downloaded from somewhere in cyberspace, automatically added to your existing market
data files, and within a few seconds every chart has been updated. And all for just a few
dollars a month. We need no better reason to throw away the pencil and graph paper.
Here we are not directly concerned with the suppliers of this data. A selection of
these are listed in the Annex to this chapter. We are concerned with the content of
the data stream. Most commonly it includes seven elements:
> date
>open
>high
>low
> close
> volume
and, for some financial instruments:
> open interest.
Each is a number, and every number tells a story about the extremes of market
opinion and the time these emotional outbursts occurred. This is the sum total of the
information we work with in deciding how emotionally charged this particular crowd
is on this day.
The date tells us when the events happened. This organises today's action in the
context of previous action. Without it the chart has no chronology and reliable sequence.
The open is the first traded price for the day and the close the last traded price for the
day. We place these two events in time because they help defme the mood of particular
parts of the crowd. The other two significant points are the highest traded price for
the day, and the lowest. These relationships pinpoint emotional extremes.
The volume figure records the number of shares changing hands on the day. This has
an inconsistent relationship with price, but generally higher than normal volume
associated with a rapid change in price suggests an important change in crowd
sentiment. Volume traditionally is plotted as a histogram, usually at the bottom of
the price chart. The height of each vertical bar is a scale reading of the day's volume.

42
 4/ The Plain Plot

The open interest figure is supplied with futures contracts. It plots the number of
open contracts and is used to measure the activity and strength of a commodity.
These are figures generated by real market activity. They tell us how individuals and
groups of individuals were thinking during the day. Most importantly, they tell us
who we should believe-because those who back their opinions with money are
more believable than those who don't.
There is an exception to this direct chart link with reality. Sometimes we use artificial
figures to build a chart. The All Ordinaries Index and other indices are a running
record of average prices achieved by a selected basket of stocks. This is then converted
to a base figure and added to the running total of the index.
Indices summarise the movements in share values resulting from trading on the ASX.
They indicate current trends, provide performance benchmarks and record market
cycles and reactions to economic events. The indices are designed to reflect price
·movements resulting from share trading between 10 a.m. and 4:05 p.m. each day.
All ASX indices are described as chain linked and market capitalisation weighted. In
plain terms, the larger companies have proportionately more influence on the indices
than smaller companies. A list of which stocks are in particular indices is available
from http://www.guppytraders.com on the data suppliers and support link.
From a charting perspective, these created figures deliver information about the
emotional health of an entire market, or market segment. Investors and traders factor
this information into market decisions. Despite the slightly different construction
mechanics, we use market information in the same way as we use information about
a stock, an option, a futures contract or a currency trade .

• BY SCREEN OR BY HAND
Price data is delivered in an electronic format. Although this looks like numbers in a
spreadsheet-style format, it is really fields in a database. End of day data collected via
modem is not added to a spreadsheet. It is a database update. The chart display you
see is only as good as the information in the database. Just as inaccurate information
about the position of reefs sinks ships, so inaccurate information about price leads to
false judgements and disaster. Obtaining reliable data and updating with reliable
data are vital steps in working with charts.
With computers, electronic data and modem access, getting the information is a
breeze. Understanding it is a little more difficult. Understanding starts with the way
we plot this data, and here the newcomer finds an apparent quagmire, and a choice.

43
CHART TRADING

Hand-drawn charts have charm. There are some small advantages in learning how to
construct a chart by hand but the danger is in the way it sometimes becomes a
therapeutic distraction from trading. Good charting software is cheap and efficient.
For the novice it is better to spend time working with charts drawn on a screen
rather than wasting time mastering the skills of hand-drawn charts. Better to use the
tools than to redesign them from scratch. Cheap and nasty software is a poor
introduction to charting and should be avoided. Log onto a chat forum or
www.guppytraders.com for the latest user updates and opinions on any software you
are considering.
You do not have to slog your way through hand-drawn charts when computerised
charting programs will do it for you. There are a bewildering number of software
programs available, and ways to choose the best program to suit your needs are discussed
in Chapter 19. No matter which charting software you eventually choose, it will offer
you at least three ways to plot this electronic market information on the screen .

• ORGANISING INFORMATION-THE PLAIN PLOT

How we organise market data decides what we see. At times we want only a summary
of activity, but most times we look for all the important detail. The first choice of
screen display is a daily chart. My preference is a display showing one year of trading
action, or 260 days. This provides enough information to place today's price activity
in a general context. Fallen stocks do look attractive on a short-term display because
the total price action may be trapped between $1.00 and $1.20. This is a potential
20% return. But when the trader steps back to a 12-month view he may discover this
is a fall from grace measured from previous highs of $7.00. The current activity
could offer a trading opportunity, but the risk profile may be different from the one
suggested by the short-term chart.
Before switching to the first chart on the screen we need to choose between linear
and logarithmic displays. For most users the choice is already made as the screen
display is usually linear by default.
A linear display shows price moves as we expect them to be. This is a change from,
for example, $0.10 to $0.20, measured in $0.01 increments. A change from $0.20 to
$0.40 is also measured in $0.01 increments.
On a logarithmic chart display the distance between each point is measured in
percentage terms. The two sets of price moves used in the previous paragraph would
be shown as equal because the change is 100% in both cases. Logarithmic, or semi-
log, scaling is used to compare relative price changes rather than physical price changes.
 4/ The Plain Plot

The differences in the two displays are shown in Figure 4.1 below. Compare the
price points shown as A and B with their counterparts, Al and B1. Often price
movements appear flattened on logarithmic charts. Lines C and Cl display the same
price moves but Cl looks much smaller and slower. When the rate of change is
distorted we sometimes fail to see opportunities.

Fig. 4.1 Screen display scales - 0.20

- 0.19 fy ~
fr ~ -
h{~~~r
0.18

~ ~~(
- 0.17 - 0.15

- 0.16
Cl
- 0.15
,
- 0.14 -1,1) r- 0.10
M c - 0.13
- 0.12
- 0.11 Al
- 0.10
-'\ -

r
0.09 r- 0.05
- 0.08

A
- 0.07
- 0.06

I IMR
-
-
0.05 Bl

0.04
)

IMR

-.Jv:t-t...,
B
f-f r
- _...._1 -- _1,.
) International Mineral -
Resources
Daily bar chart
-
0.03

0.02
!-Lft
-
International Mineral
Resources
Daily bar chart
Linear scale r- 0.01 Semi-logarithmic scale

IIMarch !April IMay • •1June IJt !April !May •!June IJL

Some words of caution. Once you select a logarithmic display you start data
manipulation. No longer does the display show the numerical relationship between
current and past prices in the way measured by the market. The market does not

45
CHART TRADING

structure its bids in accordance with logarithmic rules. Each bid moves in a linear
fashion, in multiples of a cent, or fractions of a cent. Logarithmic charts are useful for
some styles of calculation, but because they manipulate the base price data I believe
they are unsuitable as a starting base for charting analysis, and for technical analysis.
Once initial analysis is completed using a linear scale chart then the logarithmic display
is useful for additional specific styles of analysis.
Certain styles of market analysis which rely on Fibonacci numbers, or on logarithmic
spirals derived from some elements of Elliott Wave analysis, make extensive use of
logarithmic plots. The Elliott Wave Principle by Prechter and Frost is one of the best
books in this area. Fibonacci analysis applied to modern markets is considered by Joe
DiNapoli in Trading With DiNapoli Levels. When traders select a logarithmic scale
chart they move away from plotting the market and towards applying a particular
technical analysis technique or indicator to interpret market activity.

• UNDERSTANDING THE LINE PLOT

Charts of price action in many newspapers and magazines show a single line based
on the closing price for the day. This is helpful, but not very useful because the price
of a stock changes during the day. The line chart shows the activity of only one part
of the crowd active at one point during the day-usually those who set the closing
price. Working with only one data point each day we build a graph of price changes
by joining the dots. A typical result is shown in Figure 4.2 opposite for the online
brokerage E-Trade (ETR).
The line accurately reflects the opinions of just one segment of the crowd and is a
summary of the day's trading. Summaries are particularly effective when the user is
already familiar with the detail. They are potentially misleading when the user never
sees the detail. The Readers Digest condensed books were masterpieces of precis but
at the sacrifice of detail. They sucked the life out of the characters. Our market lives
and breathes so we need to know it intimately before we can trade it effectively.
Who sets the closing price? Just a single group out of all the groups who traded this
stock today is represented. The answer determines how we assess the significance of
the close. In a small speculative stock with low volume the closing price for the day
might be ours. In a larger stock, such as Woolworths, the close is more likely to be
set by professional traders.
The most active trading periods during the day are the first 20 minutes after the
market opens, and the last 20 minutes before it closes. Anybody who has tried ringing
their broker in the lunch break between midday and 2 p.m. will understand why the

46
 4/ The Plain Plot

speed of trading slows in the middle of the day. Even institutional trading slows in
this period. Direct Internet trading will change this pattern of activity to some extent,
but the open of the early morning session will still be set by those chasing yesterday's
prices, and the afternoon by those anticipating tomorrow's prices.

Fig. 4.2 Building a line chart

. 10.0
9.5
10.0
9.5
9.0 9.0

..
-..........
-. .
':,. 8.5
8.0
7.5
8.5
8.0
7.5

.. .,..·. 7.0 7.0

.. 6.5
6.0
6.5
6.0
5.5 5.5

/
5.0
4.5
Compare these 4.0
points with the bar
chart display
3.5

... 3.0
2.5
ETR ETR 2.0
E-Trade E-Trade 1.5
1.5
Daily Daily
1.0 1.0
Close price only Line chart
0.5 0.5

The closing price is established in anticipation of the direction of tomorrow's market

and by the surge of trading activity. Who has the time to monitor the market at the
end of the day? Generally it is the market professionals-the full-time institutional
traders, the dealers and brokers and the active private traders. They make their living
from the screens and most of the time their evaluation of the market value of a stock

47
CHART TRADING

is accurate. These professionals do not buy expecting to lose money and they get it
right more times than they get it wrong.
This makes the closing price very important. It is the most accurate summary of the
market's feeling on that day. This section of the market crowd has weight of money
behind it, although this is no antidote to emotional extremes. Even in more detailed
screen displays, the close is a vital reference point .

• MORE THAN JUST THE CLOSE

So why is the line screen plot the least satisfactory for traders? Market data consists
of four elements, the open, high, low and close. The relationship between these
prices lets us crawl into the mind of the market crowd, and into its various sectors.
In any crowd some people are more exuberant than others. At Melbourne cricket
matches they gather in Bay 13. In market terms these are the bulls. Other spectators
disappointed with their team's performance leave early, dragging national flags behind
them. These pessimists are the bears. As well as these emotional extremes of this
crowd on this day there are those who arrive early and those who stay to the very end.
The relationship between each of these groups in the crowd-the rowdy, the well-
behaved, the meek and the wild-tells us a lot about the progress of the game. These
relationships in market terms are most effectively plotted on a bar chart, or on its
first cousin, the candlestick chart. When we know these relationships we use the line
chart more effectively as a summary of price action.
The line chart is best used as a handy summary of events. Longer-term investors
looking just for market direction find them useful. The line chart does not clutter the
screen so it is most often used in conjunction with technical indicator displays. For a
simple overview of price action it is suitable for newspapers, magazines and brokerage
reports. For traders and active investors, the line chart display is the last stop in
displaying market activity. The bar chart is our preferred starting point .

• UNDERSTANDING THE BAR CHART

Trading and investing is an emotional experience. We like to believe we reach buy or

sell decisions in a rational way, but few traders can deny the emotions associated
with riding a winning or losing trade, or missing out by just a few cents on a trade
that turns into a magnificent winner. Individually we bring these emotions with us
in every trade. Together, the crowd of buyers and sellers drown the market with

48
 4/ The Plain Plot

emotion. It is often whipped to extremes by the activity of crowd leaders pushing

and pulling at price. The bar chart shows us where those extremes are located.
Perhaps ETR closed at $5.20 one day and again the next day at the same price. A line
chart displays a level line. It doesn't show us ETR fell as low as $4.09 during the day.
Compare the line display we saw in Figure 4.2 with the bar chart display for the
same period in Figure 4.3. If we knew prices dropped as low as $4.09 we might
change our mind about this stock. A bar chart shows the significant points in the way
a stock has traded for the day. Each bar includes the open, the high for the day, the
low for the day, and the
closing price. Fig. 4.3 The bar chart display
10.0
The opening pnce is f
shown as a horizontal 'bar' 9.5
Htl
i
High
or 'tick' on the left-hand
side. This price is often set ~ao.e ~ j :,:';;"
9.0

~
by market amateurs. These 8.5
people do not trade very Open 1j )1111 ,),Ill reoc'n 8.0
much, or do not invest Low [ 1 l1 ~ 7.5
very often. They read the
paper, they listen to the tll1 I lhll 1 7.0
news, they read magazines
I l t1
and decide ETR is a good
stock to buy. They think
1 '11\1' 6.5
6.0
the price is going to go up '\ Bearish sellingl 5.5
and when they hear on the
news that it closed at $3.50 ~ A display of all daily 5.0
J data points shows price
they decide they had better 4.5
¥ action detail not available
get some. They leave a 4.0
Bullish { on a line chart

l
message for their broker,
buying !~
or ring their broker before 3.5
the start of trading. He } 3.0
tells them the current price The line chart Extreme
is now $3.60. Many other shows these closes crowd 2.5
as a straight line reaction
people have also rung their 2.0
brokers as well. Our novice 1.5
tells his broker to buy ETR ETR
at $3.65, or perhaps 'at E-Trade 1.0
market', taking whatever Daily bar chart Time scale is chronologically spaced
the current price is. May June

49
CHART TRADING

This bar-the opening slash on the left-hand side of the vertical line-clearly shows
the activity of one segment of the crowd. These are people trying to buy at yesterday's
prices. Often inexperienced buyers set the opening price for the day. Sometimes the
open is set by the professional traders working for institutions, but most times it is
set by novices. We see this when price falls back after the first 20 minutes of trading
as more experienced traders move into the market.
Price moves up and down during the day. This movement is shown as a vertical line.
The top of this vertical line is the high for the day. The high is set by the most excited
people. Perhaps they have been thinking about buying ETR around $3.50. They
listen to the lunch-time news, or watch the big board at the Stock Exchange, and see
ETR now trading at $3.60. This is exciting, and they worry they are going to miss
out, so they ring their broker and instruct him to buy ETR 'at market'.
Lots of other 'bulls' are doing the same, so the price climbs higher. In the cattle
yards, when the bull attacks he slashes upwards with his horns. In the market the
optimistic buyers slash prices upwards in the same way. Sellers do not want to sell at
$3.50 because they see all these buyers flooding the market. They know they can get
$3.65. Our bull ends up paying $3.65 and sets the high for the day. Perhaps he is
joined by a few other traders at the same price. This is one extreme of crowd emotion
on the day.
Sometimes the opposite happens. Sellers are pessimists. They have to be. They sell
because they believe the price is going to go down and they want to lock in profits
before it does. These are the 'bears' and just as the bear uses his paws to strike down
his prey, these traders push prices lower. Perhaps they would prefer to sell at $5.50,
but they missed out yesterday. Frightened they might miss out again today, they
lower their asking price to $5.00.
On very bad days nobody wants ETR at $5.00, so the frightened bears try to sell
their stock at $4.90. They are really worried the price is going to fall and that they
will miss out on any remaining profit. The lowest price for the day is set by the bears.
The lowest extremity of price tells us just how this segment of the market crowd is
thinking.
The close for the day is set by the smart money. These are traders working for the big
institutions, and big money did not get big by being dumb. These traders have a very
good idea of the best price for ETR on this particular day. They might change their
opinion tomorrow depending on what happens in New York, but today they have a
very good idea of the best price. So they buy or sell towards the end of the day,
usually setting the closing price which is shown as a horizontal bar-or slash-on the
right-hand side of the vertical price line.

50
 4/ The Plain Plot

The construction points on a price bar deliver information about the behaviour of
the crowd. When we see the relationship between the close and the other crowd
elements we make judgements about the strength of the market move in a way not
possible by using just the closing price.
When we make trading decisions it is a good idea to understand how the smart
money is thinking. If they agree with the bulls-if the close is very near the high for
the day-there is a good chance this stock will increase in price again tomorrow.
The daily bar chart shows a day's trading for each price bar. The time display along
the bottom of the chart is arranged in chronological order. Every trading day is
shown. Using this style of chart the trader or investor has a better idea of the balance
of the bulls and bears in the market. This is the basic price plot all traders use because
it identifies market risk. Investors should also refer to it because it gives early warning
of trouble in a way that a line chart does not.
In the next section we consider ways this basic price plot can be used to get into our
competitors' minds .

• UNDERSTANDING CANDLESTICK CHARTS

The bar chart display has an older cousin from Asia. This is the candlestick plot used
by Japanese rice merchants in the 18th century or earlier. Like the bar chart display,
it is a solution to the problem of capturing the mood of the market by using all the
price information available.
The open and the close figures define the body of the day. Instead of a single bar on
the left and right-hand sides as with a bar chart, these defining points are positioned
to make either end of a thin rectangular box, or body. The ETR information is
shown as a candlestick display in Figure 4.4 overleaf. Traditionally the body of the
rectangle was left white when the close was higher than the open for an up day, and
filled in with black ink when the close was lower than the open for a down day.
Computer screens usually display up days in blue or green and down days in red.
These solid bodies provide strong visual clues about the thinking of the crowd. The
trader sees the crowd surging forward, or holding back. Although the same
information is obtained from a bar chart, some people find it easier to read a candlestick
chart.
Crowds are not a single entity. In every crowd there is a ringleader, and in our market
crowds we find bullish and bearish leaders. How they are positioned in relation to the

51
CHART TRADING

body of the crowd tells the

Fig. 4.4 Candlestkk display trader about the strength
10.0 of the market. If the bulk
9.5 of the crowd agrees with
the bulls, we expect to see
9.0 the close at the same level
8.5 as the high for the day.
When the crowd runs, it is
8.0
led by the most fearful of
7.5 all. When the close equals
7.0
the low for the day, then
we know this is a really
6.5 frightened crowd. This
6.0 determines our trading
H.
strategy. Even investors
5.5 like to buy on weakness.

Close Open
5
·°
Candlestick displays
4.5 pinpoint the relationship
between the crowd and its
Open Close 40
· leaders. The highest traded
3.5 price for the day is joined
Low Low
30
to the body by a single thin
1 Up day Down day · line. This looks like a wick
2.5 on a candle, and this gave
2.0
birth to the Western name
ErR for this technique. The
E-Trade 1.5 lowest traded price is
Candlestkk Display 1.o connected by a thin line to
Daily the bottom of the body.
The price details are the
May
same as in a bar chart
display, but some people
find it easier to spot significant relationships with the candlestick display.
The most significant relationship is between the body of the crowd and its leaders.
When the leaders get too far ahead, the crowd is sometimes left behind. Strong
leaders carry the crowd with them, moving just far enough ahead to set the direction
without losing touch with their followers. When we trade we want to stay with the
smart money, with the bulk of the crowd. For many traders there is safety in numbers
and this style of display shows where those numbers congregate.

52
 4/ The Plain Plot

Other traders look for the leading edge, hoping to take early positions in developing
breakouts. The rewards are great, but so are the risks. A candlestick display helps
define risk by its clear depiction of the crowd position in relation to the crowd
leaders-the wick. These traders who want to be among the leaders feel comfortable
in buying prices along the wick if the bulk of the crowd is close behind them.
The same information is derived from a bar chart, and it is largely a matter of choice
as to which price plot you prefer. The primary advantage of the candlestick chart is
the way it highlights pattern relationships. These range from the simple series of
down days to more complex patterns indicative of crowd behaviour.
The style has attracted the attention of many end of day traders, but it is used with
more effect on intra-day charts and on weekly charts.

• CANDLES BY DAY
On intra-day five-minute and 15-minute 'tick' charts the candlestick develops
dynamically. A 'tick' records every trade and the information is added to the live
chart display. A five-minute tick chart records all the trades in every five-minute
segment. The candle grows and changes as new tick data is received. Many day traders
find the relationships highlighted by candlestick action are clearer than with a standard
bar chart display. Even when traditional bar chart patterns appear on the real time
screen, they are easier to spot in a candlestick format and this gives a vital edge in real
time trading. The body of the candlestick has a knack of capturing the substance of
market feeling in a way that the anorexic bar chart cannot.
The literature on candlestick charting includes page after page of increasingly difficult
and subtle patterns. Some charting software, such as CandlePower, is designed to
identify these patterns. The skilled candlestick trader is able to recognise many of the
hundreds of available patterns. Most traders do not have this skill or experience, and
rely either on just a few powerful patterns, or on software to highlight patterns.
Traders using real time screens look for major signals and often skip the subtlety.
Day traders use the more common candlestick patterns to assist in trading. These
include reversal patterns such as the bearish or bullish harami cross, dark cloud cover,
engulfing bearish lines, evening stars and inverted hammers.
Some investors use weekly candlestick charts to decide the long-term balance of the
bulls and the bears. These are not trading signals. By the time the weekly candlestick
is completed many trading opportunities have disappeared, or been taken up by
others. Weekly candlestick charts provide a big picture analysis, and these investors
turn to other charting techniques to get the best entry points.

53
CHART TRADING

• FOLLOW THE PLOT

Charting is a graphic record of measurements, or 'soundings', taken from the market.
The basic bar chart price plot is the starting point for all other analysis. Those who
enjoy using technical indicators, many of which are displayed without any direct
reference to price, must eventually return to the basic price plot chart display to
implement their trading decisions. Those who use the various forms of fundamental
analysis should also turn to the basic price plot. A glance at a simple chart is an
antidote for investment regret because it puts the investor in touch with market
reality.
The charting purist uses only the bar chart to understand how the crowd is thinking
and how it is likely to behave. Certain chart patterns are indicative of particular types
of crowd behaviour. The combination of patterns is wide and varied, but some of
them identify high probability trading situations. We look at these in later chapters.
The chart is a measure of crowd psychology and the plot we choose to use-bar chart
or candlestick-makes this clearer. These chart plots do not manipulate the basic
price data.
Several other styles of price plots do twist the data. These displays are very useful if
we understand where the twist is applied.

Annex to Chapter 4: DATA SUPPLIERS

The supply of market data is a very competitive field. Data prices are constantly falling
and new suppliers are entering the market. This summary is a guide only and the listings
are in alphabetical order. Those marked with an asterix (*)are data suppliers I currently
use. An updated list is maintained at http://www.guppytraders.com along with links to
many data suppliers. Some data suppliers deliver via the Internet, while others use a
dedicated dial-in telephone line with a local call facility. The difference is not important
as it usually takes about one minute to collect all data for the ASX and SFE.
In selecting a data supplier, price is not always the best guide. First establish the type
of data you need and then shop around for the best deal. Most suppliers now provide
10 years of historical data either free, or at a very low cost. You do need historical
end of day data for charting.
The most frustrating aspect of collecting electronic data is importing it, or transferring
it, into the format used by your charting software. The most common standard is a

54
 4/ The Plain Plot

Metastock format, but there are many other proprietary formats. The best data
suppliers provide free software which converts their data into the format you require.
It is a waste of time and false economy to attempt this import and update task yourself.
The time is better spent analysing the market than in fiddling with data problems.
Providing market data is the core business of the very best data suppliers. Their
survival depends on getting the job right the first time and every time. Other data
sources supply data as a added extra to their core business. They do not always
understand or care about the quality, accuracy and timeliness of their data. Nor do
they always understand the important issues of how to treat no-trade days and holidays.
They make their money from their core business and data supply comes a poor last.
The quality of data does vary. Mistakes do happen and data containing these errors is
termed 'dirty data.' Traders base their trading decisions on the data displayed as a chart.
They cannot afford dirty data, even if it is free. You cannot take on the best traders in
the Australian market when you are equipped with data of doubtful quality or accuracy.
This applies to end of day data, but also to data which claims to be real time.
A sign of a good data supplier is the way they treat name changes and capital
reconstructions. The best suppliers provide an e-mail alert to these changes. The very
best automatically include the changes in their data stream, so old data is matched to
the new name. It pays to ask the right questions before deciding on a data supplier.
All lists below are arranged alphabetically.

END OF DAY DATA

This is the open, high, low, close and volume data for each day. It is the base data
used for all the charts in this book and in most charting programs. This list is not
exhaustive.
..... AAP Financial Market Services
..... Almax Information Systems
..... Bloomberg L. P .
..... Bourse Data
..... *Just Data
..... FutureSource
..... *KeyQuotes (Asian markets)

55
CHART TRADING

~ Online Trading Systems (OTS)

~ *Paritech-includes US and UK markets
~ Park Lane Information Technology
~ *Stock Data Corp (US markets)
~ *Winrow Marketing (UK markets)

REAL TIME DATA

This is a direct live feed from the ASX showing every trade. Some real time feeds
show delayed data, so check what you are getting. Some real time feeds are very
expensive so it pays to shop around.
~ Bloomberg L. P.
~ Bourse Data
~ Bridge Information Systems
~ Charting Australia
~ *MarketCast
~ MarketSource
~ Online Trading Systems (OTS)
~ Reuters
~ Standard & Poors Comstock

REAL TIME AND END OF DAY DATA FROM BROKERAGE SERVICES

This list is a sample. Brokerages are increasingly providing this service for clients.
~ ComSecurities
~ E-Trade
~ Greenline
~ *Sanford Securities
~ *AOT Online

56
 4/ The Plain Plot

~ Todd Partners
~ L-Quay Futures

INTERNET AND FREEBIES

Remember you get the quality you pay for. This is a very small selection. A more
detailed selection is listed in The Internet for Investing and Personal Finance by Martin
Roth.
~ BigPond
~ EquityCafe
~ Excite.com
~ HotCopper
~ OzEmail
~ ShareNet
~ We bLink
~ * StockMeetingPlace

57
Chapter 5

SUMMARY PLOTS

The three styles of price display-line, bar and candlestick-mentioned in the previous
chapter plot price activity without alteration or manipulation and in all its detail. The
high for the day is the highest traded price. It is not discounted, modified or altered in
any way by a bar chart or candlestick display. What we see is what we get in the market.
Detailed charts serve us well but there are times when a summary chart is also useful.
Summary market charts manipulate the base price data to deliberately emphasise
particular price relationships. These are similar to the important spot depths and heights
shown on ocean maps. Summary plots display only the features we decide are significant.
There are three major ways to extract and display these features of price activity:
1. The first is the swing chart, which plots the direction of movement by
combining days into a single line.
2. The second captures all the aspects of swing charting, combining them into a
point and figure chart.
3. The third is the only serious attempt to incorporate volume data into price
data. Equi-volume displays give a picture of the relationship between price
and volume.
All summary plots distort time. The date axis is scrunched up, or stretched out,
depending on the needs of the price display. Here the trader wants to know something
about price behaviour, so time is less important.
Some applications of swing-style trading do rely heavily on time relationships and
this applies in particular to Gann traders. This is a specialised application of charting

58
 5/ Summary Plots

and trading techniques which we leave to the experts in this field. Good starting
points are Fibonacci for Traders, Price Pattern and Time or Gann Made Easy .

• THE SULTANS OF SWING

The objective in this style of display is to track the direction of price, usually using the
close. The Japanese use three methods called kagi, three line break and renko. In a
rising trend we know there will always be stumbles. Most of these are minor, and we
do not want to be frightened into selling when they happen. The bar chart of Magna
Pacific (MPH) in Figure 5.1 does not help us decide if the price retreat marked B is
really part of a down trend, or just a temporary dip in the up trend similar to point A.
The retreat marked C looks much the same as the others, but it really does signal a
change in trend. How do
we tell the difference?
Fig. 5.1 Retreat or trend break?
0.65

• KAGI
Many traders use a trend
line to help in this decision.
This is a line connecting at
lltI l. I!Jl -
This is th_e trade
11
t
r
0.60

0.55

0.50
least two points on a chart
to show the direction of the
opportumty we
look for on every
chart display j
l
1L
ll L _
C
1

0.45

t'-~-
trend, such as the one in the
MPH chart. While price 0.40
remains above the trend line
the trader leaves the trade 0.35
or position open. When
0.30
price moves sideways,
gaining a little and losing a 0.25
little value, some traders sell
because they are worried 0.20
about the trend. Later they
regret this because the trend 0.15
continues upwards. The
first sultan of swing, the 0.10
MPH
Japanese kagi chart, gives a
0.05
way to discount these
unimportant pauses in the
trend. In the following

59
CHART TRADING

examples we stay with MPH to make it easier to understand the impact of these different
chart displays. This includes the impact on the time scale at the base of the chart.
The kagi display shows a series of connected vertical lines. The thickness and direction
of the line depends on the price action. If price continues in the same direction today
as it did yesterday, then the vertical kagi line is extended. In a continuous up trend
without pauses or minor retracements-price falls-we would expect to see just a
single vertical line.
We know prices do not climb steadily. As long as there is only one step back for
every three steps forward, most traders are happy to stay with the trend. The kagi
chart uses a percentage figure to
Fig. 5.2 Kagi chart define just how far price can fall
Best exit
from the 0.65 before we decide it has taken two
last rally steps back instead on one. This
0.60 is called the 'reversal figure', and
/ it gives a characteristic stepped
appearance to the chart display.
0.55
Early trend
reversal signalled In an up trend if the price
0.50 retracement moves below the
lower end of the previous vertical
0.45
line the thickness changes from
thick to thin. In a down trend
0.40
the line changes from thin to
thick. Sounds complicated, but
0.35
New entry which the chart display of MPH in
turns out to be a Figure 5.2 shows the result more
0.30
rally trade clearly. This looks more like a
0.25 traditional Greek frieze than a
price chart. The time scale along
0.20 the bottom is compressed
because now the action of price
0.15 is more important than recording
Trend reversal as every tick of daily price.
~ Kagi line changes
0.10 This style of price plot brings out
MPH the balance of supply and
0.05
demand. A series of thick lines
define a rally, where demand
exceeds supply. This crowd
wants stock now, and it wants it

60
 5/ Summary Plots

at almost any price. This is a great time to be a seller. A group of thin lines tells the
reverse, with supply larger than demand. Nobody really wants these shares, and
sellers are forced to lower their prices if they want to get rid of them.
It is these changes in balance which provide the trading signals. When the kagi line
changes from thin to thick, a buy signal is generated. When it changes from thick to
thin, a sell is signalled. This swing style of charting captures the significant reversals
in market trend. The trading objective is to capture the trend, rather than to capture
the best possible price. The technique works very well in trending markets, but in a
sideways market the kagi swing chart oscillates quickly between thick and thin.
Frequent buy and sell signals in a narrow price range leave little room for profit.
Ultimately the effect may be to thin your wallet.
The key in constructing kagi charts is the reversal amount, because this controls
when the direction of the line will change, and later, when the thickness of the line
changes. The default reversal is usually 3%. This does not suit all markets and users
should verify this with back-testing on historical data. This underlines the importance
of using software that allows you to manipulate the default values. Kagi charting
uses many more advanced techniques than just the thick and thin approach. Steve
Nison in Beyond Candlesticks explores this method in more detail.
The kagi chart resembles a Gann swing chart. Please do not confuse them. Gann
swing charting uses different construction and trading rules. These are explained in
by Bill McLaren in Gann Made Easy.

• RENKO
The second sultan of swing is the renko display, which uses 'bricks' rather than
percentages in its calculations. The term 'renko' is thought to have derived from
'renga' which is Japanese for bricks.
The kagi chart plots a vertical line whenever there is a change in price. The plot
moves to a new column only when price moves on after a pause. The renko plot
doesn't believe all price changes are equally significant. Who wants to count National
Australia Bank (NAB) at $27.00 in l¢ blocks? The linear bar chart display automatically
scales the NAB price in 10¢ increments. This scaling makes it easier to fit the chart
on the screen, and makes it easier for us to place today's price action in the context of
previous action.
The renko chart uses a scale to decide which price changes are important. It preselects
a scale of significance. Each brick is given a nominal value of, for instance, l 0¢. Only

61
CHART TRADING

when price changes by at least 10¢ is a new brick added to the pile. This is intuitively
attractive when applied to a stock like National Australia Bank. For a time in early
1999 the NAB price increased by more than 10¢ a day. This went on for day after
day. When making trading decisions about NAB a move of just a cent or two was
hardly worth noting, while a move of 20¢ would attract our attention.

Fig. 5.3 Renko chart

0.65

0.60

0.55

0.50

0.45

0.40

0.35

0.30
Up trend is well defined
0.25

••I 0.20

0.15

0.10

MPH 0.05
Magna Pacific
Renko Chart Time scale is compressed

Renko charting uses these principles and the MPH chart in Figure 5.3 above is a
typical display. It looks like a child's lego construction. Each new brick is worth 5¢
and is placed to the right of the previous brick. If the rally is worth 10¢, then two
bricks are added to the teetering pile. If the rally is worth 7¢- a brick and a half-only
a single brick is added. As with all these styles of charting, the time scale is compressed.

62
 5/ Summary Plots

The selection of scale decides what the trader sees. Usually the computer will select
an appropriate scale based on the data loaded, but this will not always be the best
scale to use. We look at better ways to set the scale in the next section.
The renko chart is a trend following tool. Exits are signalled when a new brick is
added in the opposite direction. A rising trend is built with white bricks. When
prices fall by at least one brick the new box is black. The exit signal is not given until
price falls by at least one brick. When the exit is made it may not be possible to get
out just one brick below the peak trend price. An entry is signalled when the black
down brick is replaced with a new white brick at the beginning of a new up trend.
These bricks do not start off as a thin line and then grow to full size. They appear on
the chart fully formed and at full value. In a strong rally the trader might suddenly
find three bricks where yesterday there were none. In strongly trending markets this
is not a problem. In weak or sideways markets, the delayed signal might cost most of
the profit in the trade .

• THREE LINE BREAK

The final sultan in the swing family is the three line break display. The kagi chart
concentrates on the direction of price. The renko chart concentrates on the size of
each move using the closing price. The three line break chart tries to identify significant
reversals. It gets its name from the default setting of three lines.
The display in Figure 5.4 overleaf shows a series of bricks superficially similar to those
in the renko chart. In this display each new box is placed to the right of the old box and
the key feature is any group of three boxes of the same colour. When prices collapse by
more than the value of three boxes-a three line break-a new box is drawn in the
opposite direction. In an up trend this new black box is a trend reversal signal.
Minor price reversals are not shown until they exceed the value of the three lines.
This is not the same as the count back line technique discussed in Part III because the
trading signal is not generated from the high. Additionally, there is no prior warning
of the signal developing. The new box suddenly appears, fully formed.
As with its close cousins, the basic buy signal is when a white brick emerges after
three prior black bricks. The advantage with this style of display is that the reversal
does not depend on an arbitrary percentage like the kagi chart, or on the correct
selection of scale, as with the renko chart. It is the action of price itself which generates
the signal, although this is usually well after the new trend has started.
Trading signals are made more sensitive by adjusting the break criteria to two lines,
or perhaps four. Investors use larger reversal amounts, sacrificing more of the trend,

63
CHART TRADING

and carrying more risk on the exit. Steve Nison discusses these trading techniques in
more depth in Beyond Candlesticks. What is important for our purposes is the way
these various swing charts attempt to isolate a single aspect of price action and plot it.
The European approach to these problems of price direction-scale and reversal-
was to combine them into a single price plot. Point and figure charting brings together
all the advantages of these Japanese charting methods and discards many of the vices.

Fig. 5.4 Three Line Break chart

1- 0.65
0
- 0.60
3 line break ~
'bl~k bo<£1
- 0.55

E<itwh<O
appears.
- 0.50

I - 0.45

oo -
•. 0 •.• 0.40

·~
- 0.35

Docf 1- 0.30

o0
1- 0.25
1
3 ""' b=k ••·~{ __.. Enter when a white box appears.
- 0.20

- 0.15

- 0.10

MPH - 0.05
Magna Pacific
3 Line break chart Time scale is compressed
D I199BIJ lA 11999 IM AM

• POINT AND FIGURE

The construction rules for point and figure (P&F) combine the kagi chart display-
which moves up and down showing just one price direction in each line-with the
renko chart display-using bricks of equal scale-and the three line break chart-
which doesn't change until price changes by a predetermined amount.

64
 5/ Summary Plots

The point and figure chart is a skeleton of market activity capturing the bones of
price direction in a single X-ray snapshot. It uses bricks-usually called boxes-to
measure the scale of significant price movements. It uses columns to define the
movement of price in a consistent direction. It crosses to a new column when price
changes direction by a predetermined reversal amount, usually 3 boxes.
The box size used in a point and figure chart is the scale of the chart, just as the
Renko chart uses bricks of a certain size. The point and figure display plots these
bricks-boxes-as an 'X' for up moves and as an '0' for down moves. These notations
are contained in a box which was originally a square on a sheet of graph paper.
Selecting the scale for the box is sometimes confusing because few software programs
do it automatically with any intelligence. Later we look at two methods of selecting
the appropriate scale, but here we concentrate on the look and feel of the point and
figure chart, and each brick, or box, is the same size.
The kagi chart draws a continuous line, changing columns when price changes
direction. The point and figure chart does the same. A new box is added on top of
the existing pile of boxes. In point and
figure terms, a new X is added to the
existing column of Xs whenever price Fig. 5.5 Point and Figure
moves are equal to or greater than the The basics of movement
chosen scale. This creates a single column
~~. X
The same applies to falling prices. While X
price continues to drop a new box is X
added to the bottom of the column, X X
extending the line of Os downwards. X OX
At this stage of the construction, Figure X OX
5.5 presents a column of Xs showing X OX
rising prices, and a column of Os showing X OX
falling prices. This combines scale and
X 0 X Price moves up
direction and all that needs to be added
is the reversal factor. The three line break X 0 Price moves down
chart sets a condition for showing a X
change in direction. The point and figure X
chart does the same by applying a reversal
X
rule. The standard rule is that price must
change by the value of at least three boxes X Price moves up
before a new column is started.

65
CHART TRADING

This rule is designed to weed out false, or insignificant, changes in price. We eliminate
many minor fluctuations simply through our choice of scale. Instead of recording
every 1¢ move in a $20 stock like National Australia Bank we choose to only record
every 10¢ move, or price changes adding up to multiples of 10¢.
This scale weeds out most of the minor daily price changes, but not all of them.
Traders look for a way to decide if larger price changes are just stumbles, or if they
are the start of a major fall. The reversal value used with point and figure hands them
this tool.
We count NAB price moves in multiples of 10, but if price suddenly falls back by 10
we are not concerned. If price falls by 20 we pay closer attention. If price falls by 30
we start to worry this stumble has turned into a fall. When price changes direction by
three units of scale, by three boxes-bricks-we want to know about it.
The point and figure chart shows this price reversal only when it has changed by a
minimum of three boxes. Immediately a new column is created, and if price has
turned down, a new column of Os is started. If price has turned up, the column will
be filled with Xs.
Rather than draw these charts by hand most traders let the computer do the work,
and the calculations. They then run into the problem of scale.

Scale Models
The problem of setting the scale on a point and figure chart has two solutions. The
first uses our knowledge of the market. The second compares two chart styles. In
some cases the scale selected automatically by the computer software will be fairly
accurate, but when it is not, we need a method to set a better scale.
Experienced farmers estimate the number of sheep mustered into a yard, but to be
certain of full payment, they are counted out prior to loading on ships for a voyage
to the exotic Middle East. The picture of a farmer busy counting sheep with blackboard
and chalk is no longer appropriate, but the method is still useful. With an estimated
500 sheep the farmer decides to count them in groups of ten. As they gallop past the
race he makes small mark on a blackboard for every sheep. He shows the tenth sheep
as a horizontal slash. He has scaled his data in groups of ten.
Experienced traders estimate the dollar range of historical price history for a stock,
and this includes several years of price data, not just that shown on a chart covering
the last year. We scale our data for NAB in groups of ten, but we count cents, not
sheep, and we draw an X instead of a horizontal slash.

66
 5/ Summary Plots

The farmer musters as many sheep as he thinks the market will bear at his preferred
price. Our task is to identify the level of price movement we think is significant.
The most effective way is to consider the average bid size for the stock.
This task starts with a question: How do you think about the stock? If you are thinking
of buying ANZ Bank and you set an entry price of $20.00, does this mean you are
prepared to pay $20.60 on the day? Probably not. At $20.00 you might be prepared
to chase it to $20.20. But if you were trading a $0.30 stock then even an extra 5¢ is
too much to pay. Here a more appropriate chase, or bid size, is just l¢ or 2¢.
The most useful rule of thumb is to choose the point and figure box size that defines
how much you would be prepared to chase the price beyond your target entry price.
This is usually a fairly good guide to the best box size or scale.

Historical Scale
Not everybody is confident about their ability to select the best scale, so they turn to
another method to confirm their choice. By comparing a bar chart and a point and
figure chart the trader establishes the dominant turning points and matches them
on a P&F display.
The bar chart of Magna Pacific in Figure 5 .l on page 59 shows a strong trend with
a minor peak followed by a higher peak. As traders we would like to jump on the
new trend early, but after the false starts have finished. Using the bar chart we
dearly see, in retrospect, where the best entry and exit points were. This is the
point of comparison with a point and figure chart.
Print out the bar chart, then open a point and figure chart such as shown in Figure
5.6 overleaf. The objective is to adjust the box size-scale-and the reversal size-
the level of significant changes in price direction-so the point and figure chart
shows the same breakout as the bar chart, and at the same time. When these settings
are correct it is most likely they will also be correct for all past data and future data.
With MPH the box size is $0.02 with a reversal of three.
Point and figure charts are useful for dearly displaying chart patterns. These include
the two down sloping triangles and the support and resistance level shown in Figure
5.6. These chart patterns are examined in later chapters. More detailed discussion
of point and figure trading applications are included in Share Trading.
Point and figure charts are designed to manipulate the price data to emphasise
particular crowd relationships. They do this by displaying a skeleton of the market.
On these bones the trader establishes accurate support and resistance levels, and
draws effective trend lines. Just how, and what, these tell us about crowd action is
discussed in Part II.

67
CHART TRADING

Fig. 5.6 Scaling the Point and Figure chart

Box Size:- 0.020 Box Revs:- 3
Scale details
0.75

0.70

0.65

0.60

0.55

0.50

0.45

0.40

0.35

0.30
i
Support/ Resistance line

0.25

0.20

0.15

0.10

7 7 2 4 4 7 2 4 5 2 7 5 1 1 3 2 2 1 3 1 7 1 4 1 5 1 9 2
6 53 84 40 1 5387 8 8 0
number of periods in each column 4

• EQUI-VOLUME
These charting methods summarise aspects of the price data plot to extract what are,
for some traders, significant details. The third major approach plots the relationship
between price and volume. This style of chart plot stands on the boundary between
straight market data displays and the manipulation of data by technical analysis indicators.
We include it here because it is best seen as an extension of a summary price plot.

68
 5/ Summary Plots

It is easy to make general statements about price and volume. When price increases
on high volume we know the market crowd is eager to buy stock. The mad scramble
for AMP Insurance when it listed, or for Cable and Wireless, shows the way crowd
hysteria translates into a price and volume relationship. When large crowds chase
prices then, in a broad sense, demand exceeds supply.
Of course when the crowds want to go home and there is nobody who wants to buy
their shares, we see the opposite impact. Falling prices are driven rapidly lower on
high volume as the crowd runs.
These broad relationships do hold true despite the way very small orders sometimes
push up the price of illiquid, or tightly held, stocks. Moving from broad volume
relationships to tradeable detail is a more difficult task. The equi-volume display
attempts to do this by making volume an equal partner with price. The mechanics of
the forced marriage are complex so most traders concentrate on the outcome quickly
displayed on their computer screen.
The equi-volume display at first glance resembles a renko chart, but with boxes of
various sizes. The top line of the box is the high for the day, and the bottom line the low
as shown in Figure 5. 7 overleaf. The open and the close are excluded from the standard
display. The candlestick application of this technique uses the body to show the open
and close, and two wicks to show the high and the low and is a more useful application
of this particular plot. Knowing where the close is placed in relation to the high or low
is particularly useful because it tells us where the bulk of the crowd is placed.
Unlike a renko chart, the equi-volume boxes have variable width. The chart is littered
with fat squat boxes and long thin rectangles. The width of the box represents the
volume traded for the day and here lies a small but dangerous trap. The width of
each equi-volume box is based on a percentage of the total volume displayed on the
entire chart. If the chart displays 100 days with a combined total volume of 100,000,
then the size of each equi-volume box is determined by the normalised volume value.
This divides the actual volume for the day by 100,000 in this example. The width of
each box is a percentage of this 100,000.
Wizard things, these computers, but just when you begin to trust them they do the
calculation again. On the next day the total volume displayed changes to perhaps
120,000, but only 100 days are shown. The oldest day is dropped off and the newest
day is added to the display to keep the display length consistent at 100 days. This
changes the percentage relationships, and alters the width of pre-existing boxes. No
longer is the chart directly comparable to yesterday's chart, or the chart plotted three
weeks ago. The problem remains even when the chart starting date remains fixed.
Now the total volume is 120,000 but 101 days are shown.

69
CHART TRADING

Problems become serious when we are unaware of them. Other problems we live
with. My family car is too small to tow a semi-trailer, but this is not a real problem
unless I try to hitch up to a 12-wheel flat top. The changing relationships are not a
problem with equi-volume chart displays if we use them to explore the changes in
demand and supply. The dynamic alteration is an advantage because we more accurately
place today's price and volume relationships in a context of previous relationships.
What was once a major event may, in comparison, shrink to relative unimportance as
the drama of market action unfolds.

Fig. 5. i Equi-volwne c:hart

Exit signal 0.65
weak
0.60

0.55
High for
the day
l· 0.50

~
0
l r

0- ~
0.45

0.40

0.35
l~lill
L~·
0.30
Elthy signal
weak 0.25

0.20
\
0.15
MPH 0.10
Magna Pac:ifu
Equi-volwne c:hart

Traders turn to equi-volume displays to ferret out a small range of specific relationships.
Short and wide boxes show small changes in price, but very heavy volume. These
squat large boxes usually appear at turning points. At the bottom of a down trend
these show steady accumulation of shares. Experienced investors are buying quality

70
 5/ Summary Plots

at discount prices. Sometimes we infer informed traders are buying ahead of an

important news announcement. These squat boxes sometimes hide those who want
to get many shares without disturbing the market too much. Not every fat squat box
is a sign of inside, or informed, trading-but the possibility is always there.
At the top of a trend, the same pattern of squat boxes shows a steady distribution of
shares. Traders and investors are slowly selling, or unwinding, their positions to
people who are less informed. On a bar chart this shows up as a resistance level. The
addition of volume information supplies extra information about the nature of the
resistance.
When an equi-volume display is used with MPH it is difficult to identify any distinctive
signals for the entry or exit points. Traders working with equi-volume should ensure
that the display does give reliable signals so the reality of the market matches the
theory. I could have used a better example but that would be misleading. Not all
indicators work well with all stocks, or in our market. Just because it is included in
your software does not mean you have to use it.
Equi-volume plots were developed by Richard Arms and detailed in Volume Cycles
in the Stock Market. The research was based on American markets and is of less
relevance and application to Australian markets. He notes 'power boxes' where both
height and width increase substantially. When these boxes appear above a resistance
level they signal a well sustained breakout. Thin boxes starved of volume suggest
these breakouts are poorly supported. This is a significant way to verify other charting
signals, such as the breakout from an upsloping triangle. Volume feeds the market,
and equi-volume plots provide a useful way to capture the relationship in a single
chart display.

• DAILY OR WEEKLY?
The standard chart display I use shows 260 trading days. This is the chart from
which most trading and final investment decisions are made. Because these charts are
detailed but long, it is useful to select a part of them to get a closer view.
Investors are more inclined to take this standard chart as a first step, but traders
should also consider the weekly chart. The weekly chart compresses the daily price
data. It displays the high for the week, the low for the week, and the average opening
and closing prices for the five-day period. Charting software is intelligent, so it doesn't
include holidays.

71
CHART TRADING

The weekly chart, Figure 5.8 below, provides a view of the general direction of the
market. It shows the ebb and flow of the tide, while the daily chart shows the ups
and downs of each individual wave. Traders use the weekly chart to trade in the
general direction of the trend. Investors use the weekly chart to identify long-term
opportunities, some of which may be purchased on temporary price weakness.

Fig. 5.8 Weekly chart

0.65

0.60

0.55

0.50

0.45

0.40

0.35

0.30

T High for week

0.25
~ Average close

Average open i 0.20

0.15
Low for week
0.10
shown in
MPH Figure 5.1 0.05
Magna Pacific
Weekly bar chart Time scale in weeks

1997 1998 1999

Better charting software gives you the choice of floating or fixed weeks. A fixed week
always starts on the same day. This is usually Monday, but you might choose
Wednesday, or Thursday. Every time you display a weekly chart in this mode the
software goes to the most recent Monday and works back in five-day groups. In
contrast, a floating week calculation counts back from the last date on the chart. The

72
 5/ Summary Plots

weekly chart display will look different on Monday from the display starting on
Thursday. A fixed weekly display is preferred and if your charting software does not
allow this option then make sure you consistently use your weekly chart display on
the same day of the week. Weekends are good for this type of work.
Which chart time display you select to use is up to you, but for traders who are
actively involved in getting the best out of the market, a daily chart is vital. Short-
term traders and day traders use these in conjunction with a real time tick chart.
Above all else, a chart helps traders and investors to manage risk. Reliance on weekly
charts alone is not an effective way to control market risk. Technical indicators used
with weekly charts are all calculated in weekly periods. This retards the relevance of
many indicator signals.
The price plot display is simply a way of organising the daily information delivered
by the market. The basic plot shows just the open, high, low, close and volume,
while other methods take a step further in isolating particular aspects of the market
data.
As a general starting point for any analysis I find the bar chart the most useful, and
this forms the basis of all charting discussions in Part II. The chart alone guides the
ship through dangerous reefs. The chart alone tells traders and investors just what
action they can expect from the crowd.

73
Part II

IMPROVING
THE
CHART
 CROWD
BEHAVIOUR_
Chapter 6

THE STRAIGHT EDGE

Achart tellsthe ship's captain what to expect. We are captains of our own investment
and trading ships so the price chart shows us what to expect because it maps the
behaviour of the crowd. This does not tell us in detail the events of the market but it
does highlight significant turning points.
When the sailor's chart shows a rising shelf it does not always specify if the bottom is
sand or silt, reef or rock. Despite this, the sailor knows to take care. A rising triangle
does not tell the trader when a price rise will happen, or how far it will finally go. It
does, however, alert him to impending price action. This is how we approach the
tools and skills of chart reading in this section. The chart provides warning signs and
markers defining the safe channels. Sometimes the chart provides the treasure map 'X'.
The nautical chart maps the structure of the seabed. Our charts map the structure
and psychology of the market crowd. Many traders do act in anticipation of price
action. If price has a habit of coming back to a trend line we set a buy order at this
level in anticipation of the rally away from the trend line. Aggressive traders buy on
upsloping triangles in anticipation of the breakout. More conservative traders wait
for the breakout to take place. The relationship between chart patterns and the trading
action you adopt is a personal decision. The correct combination depends on your
trading character, your approach to risk and the way you trade. Every combination
can be successful, but only you can make it so.
This does not mean we set a closing price by our own action to fulfil our own
analysis. Do this and we play a dangerous game. Better trading waits for the market
to confirm our analysis before we act on it.

79
CHART TRADING

• LINES AND MARKET

Chartists are skilled in understanding price charts. They use the information from
the chart alone to understand what is happening in the market. Their most common
tools are straight edge trend lines, and this is where we start. In contrast, the technical
analyst uses a graph showing market relationships, using an indicator such as a moving
average, to analyse the market. We consider these technical approaches in the following
sections.
Not all charts yield useful information when these charting techniques are applied.
Be wary of any attempt to force charts to comply with preconceived ideas. Look hard
enough, and with enough imagination, and any chart will display fanciful patterns.
Charting skill avoids this wishful thinking and doubtful application of charting tools.
The chartist's tools dismantle crowd action. They are not tools for building a new
market in our own image.
All lines are at first tentatively plotted and we wait for further market activity to
prove, or validate, the placement of them. If this doesn't occur, then we must change,
plotting the lines again, or removing them altogether until they do define market
action. With practice the lines are plotted accurately with just a few reference points
to work from. This skill starts with straight edge lines .

• STRAIGHT EDGE TREND LINES

Some charts lend themselves to straight edge trend line analysis. Just as lines on the
road direct the traffic, straight edge lines seem to direct the market crowd. With
uncanny success, correctly placed trend lines seem to control the market.
Such control is an illusion. The line does not direct the market, but it does accurately
show us where the market action has been and, by implication, where it might pause
in the future. When prices are going up we want to know when to sell. When prices
are going down, we want to know when to buy. The straight edge trend line shows
the crowd in action and, in particular, when the crowd changes the way it values a
stock.
A sloping straight edge trend line measures changing values over time. We use a
trend line to tell us which direction prices are moving and to give us a better way to
judge this. When prices close below the up trend line it suggests the stock price is
falling. Ideally we would want to get out of this stock, selling to realise our profits
and protecting ourselves against loss. We get the exit signal with a close, or a series
of closes, below the trend line.

80
 6/ The Straight Edge

Where we put the trend line is important because it could cost us money if we get it
wrong. When a stock has been falling, many traders try to buy the stock near the
bottom just as the stock price starts to recover. They get a buy signal when the price
closes above the down trend line.
Up trend or down trend, the principles of drawing the trend line are the same. Really
accurate trend lines use the information available from a bar chart because this shows
the total price action for the day. You can use trend lines on simple line charts, but
they are not as useful because good trend lines need to use the high or low prices for
accuracy. A close beyond these extremes of past prices often signals a change in direction.
This is a very exact use of trend lines as a trading tool. We look for closes beyond the
trend line to signal an entry or an exit. The straight edge trend line records the way
the market adjusts value over time. With each new trading day the market may attach
a little more value to a stock, so it trades higher. In a down trend, the market takes
away some value, and prices continue to fall.
Using trend lines in this way is different from some other approaches which define
trend lines as a combination of time and price. This is particularly true of Gann
trading approaches. The trend line signals these traders use are slightly different and
discussed more fully in Turning Point Analysis in Price and Time by Joe Duffy.
Another trend definition uses Elliott Wave style analysis. This school of analysts
believe prices move in waves rather than proceeding straight up or down. An up
trend is when each new upward rally in price carries prices higher than previous
highs, each new rally finishes higher than the previous rally, and each correction, or
retracement, will also finish higher than its predecessor. An ideal example of this is
shown in Figure 6.1 below.

Fig. 6.1 Trends and waves

correction

Ideal Elliott Wave up trend model

81
CHART TRADING

Many traders find this combination of straight edge trend lines and Elliott Wave
analysis a useful way of understanding and identifying trends. Other traders find the
definitions lag behind real price action and fail to capture the best profit opportunities
because the signal for the end of the trend is always lower than previous retracements.
Our concern is with practical trading applications, so our rules are designed to capture
substantial trading profits based on using a straight edge trend line.

+RULES
1. The line is placed along the lows of the price bars in a rising trend. An up
trend is defined by higher lows each day. This is the price element we want
to track, so the line goes underneath. If prices fall below this then the trend
may change into a down trend.
A falling trend is defined by the failure of prices to make new highs each
day. We track this by placing the down trend line along the highs.
2. The trend line starts with the extremes of the price bars-the high or the
low. These extremes really count because a close beyond the extreme tells us
the trend might be changing. This is an entry, or an exit, signal.
3. The trend line starts at the very extreme high, or low. This is called a pivot
point. The pivot point can only be determined retrospectively.
4. The trend line should touch the maximum number of price bar extremes
from the available choices. This means we do not exclude too many
extremes, nor do we go for the maximum number of hits. We want to use
the trend line as a trading signal, so we are interested in closes beyond the
extremes of the existing trend because these give the best trading signals.
5. The more often a trend line is hit by price extremes, but not broken, the
more powerful the trend line signal. A trend line hit ten times, but not
broken, is very strong. So when price does close beyond this it is a very
strong trend change signal.

+ CROWD RULES
These construction rules work because they plot the changing nature of the crowd.
By using the price highs and lows-the bullish or bearish opinions-the trader defines
the way the crowd acts.

82
 6/ The Straight Edge

I dislike inane television cricket commentary, but my son enjoys watching, so we

compromise. He watches the television broadcast with the sound turned off. When I
walk past, just a glance at the action of the crowd tells me who is winning, or if some
significant event has occurred. I need no other information about exactly what has
happened, or what individual people are thinking. The crowd action is enough by
itself for me to decide who is winning or losing. Nobody waves national flags in the
market but the movement of traded prices shows crowd action in the same way.
Often a crowd acts no differently from us, and nor should this be surprising. A
crowd is just a wide collection of individuals. When we see a petrol station with fuel
at $0.85 instead of the normal $0.90 we think about filling up the tank. For many
reasons we might miss the opportunity. Later prices return to the old levels at $0.90
and we regret the missed opportunity. Next time fuel is on special at $0.87 we jump
in quickly, believing this is probably the best price we are going to get and we do not
want to miss out a second time.
Investors and traders watch stock prices in the same way, waiting for prices to fall.
When they believe the stock is likely to increase in price they jump in quickly on any
price weakness. Prices do not fall very far before buyers snap up the bargains. Petrol
was not reduced to $0.85 again, but we thought it was good value at $0.87 so we
bought the bargain at a slightly higher price. We may believe fuel costs are increasing
over time and if we wait for too long we will have to pay even more. A map of our
action-of the crowd action-in this case would show an upward sloping triangle
because we snap up petrol before it has time to fall back to the old bargain levels.
Buy a new car and the opposite is true. Perhaps we want the current model Holden
but we know a new model is due to hit the market very soon. If we wait we get to
buy our preferred motor car much more cheaply as soon as it becomes slightly
outdated. Many other buyers feel the same way and they put off their buying decision
until the 'old model runout' clearance sale is announced. Here we believe there is a
declining value over time. The longer we wait, the cheaper the stock becomes.
The runout clearance sale is predictable so we circle a date on the calendar in advance.
The decline in prices-the decline in our expectations-is defined by a straight edge
trend line sloping down. We plot it in advance by observing the extremes of market
behaviour using the straight edge trend line construction rules .

• USING A STRAIGHT EDGE TREND LINE

Look at Faulding FH & Co. (FHF) in Figure 6.2 overleaf. Quite clearly the price
trend is up. If we already have FHF in our portfolio purchased at $8.16 we are quite

83
CHART TRADING

happy. But if the price ofFHF falls to $8.02 should we be concerned? The trend line
gives us a way to answer these questions, but only if it is accurately drawn.
Every trend line starts life as a tentative plot with two points. We cannot know in advance
if the slope of our line is correct. Only future price action confrrms this. We watch prices
fall back towards our line, and then bounce away. The more often this happens the more
accurate the placement of the trend line. The trend line is tested and retested.

Fig. 6.2 Straight edge trend lines A Trend line

9.50

9.00
c

8.50

8.00

7.50

7.00 below the

trend line

6.50

4163

2082

0
(000)

Line A tells us about this up trend for FHF and is a correctly drawn trend line. It
touches the optimum number of price extremes available on this chart. Only one
extreme low is excluded. History confirms this line defines the level below which

84
 6/ The Straight Edge

traders and investors will not let the price fall. We use the history to project the line
into the future, and we watch the way price behaves when it comes near the values
defmed by the line. If it bounces up and away, we know the trend is still strong. The
FHF fall back to $8.02 after we purchased at $8.16 is not pleasant, but it is not an
exit signal. The price pullback is consistent with the placement of the trend line.
Because we are defining an up trend we want to know when people start thinking
this stock is not worth its current price. A close below the trend line suggests some
people-the smart people who set the dose-think this stock is beginning to lose
value. Not everyone agrees, but if we want to be smart this is one of the signals we
listen to. A close below the trend line clearly signals the beginning of a new down
trend, flashing a signal to take profits.
A correctly placed trend line gives a timely exit signal. Traders have a good opportunity
to lock in profits because they have a clear indication of the end of the trend. Using
the correctly placed trend line we get to act when prices are $9.10 and this locks in
11.5% profit.
The FHF chart also carries a trading trap. Many readers note how FHF climbed back
to the old high of $9.90. In this case the trader who did not act on the trend line
signal could have done better. In real life this trader is probably still holding on
when FHF prices hit $8.16 again. Without a sound set of exit conditions based on
something else besides greed, it is difficult to decide when the trend has really ended.
But most importantly, on the days following the break in the FHF trend line there is
no guarantee the new down trend will not continue. In many cases, the new trend
moves rapidly down, taking traders and trading profits with it. The signals may not
get you the best profit, but they will deliver a consistent profit.
The FHF chart flashes another exit signal with the double top at $9.90. We look at
double tops in the next chapter. A single chart does not just show one trading signal.
Often different types of signals appear on the same chart. When several signals flash
"Sell!" it is a good idea to take notice.
Those new to charting often plot a trend line shown as line B. This line only shows
the general direction of prices. Normally we would use a moving average for this as
it does a better job. This helps show us the direction of the trend, but it does not
define the trend with sufficient accuracy to deliver trading signals. Line B does not
give any useful trading signals because prices move above and below this line all the
time. A close above or below this trend line is meaningless as an entry or exit signal.
Unskilled analysts are tempted to place a trend line connecting the major lows in an
up trend, shown as line C. This line is invalid and lethal to trading profits. It uses

85
CHART TRADING

only two points to set the slope of the trend and ignores other significant price
action. This trend line costs the investor, and the trader, a great deal of money. The
exit is not signalled until prices fall all the way from $9.90 to $8.50. The exit signal
comes too late to save good profits.
Straight edge trend lines are a very powerful trading tool, but they must be placed
correctly for us to see the crowd in action. They are used to show the short-term
trend-perhaps days or weeks; the intermediate-term trend-perhaps weeks or
months; and the long-term trend-perhaps months or even years. Long-term down
trends are best seen on a weekly bar chart.

SUMMARY • TREND LINES

An up trend is drawn when each new high is higher than the previous high. The line
is drawn touching the lows of these bars. Why the lows? Because a close below the
lows indicate the bears have beaten the bulls.
A down trend is drawn when each new low is lower than the previous low. The line
is drawn touching the highs of these bars. Why the highs? Because a close above the
highs indicate the bulls have beaten the bears.
The more times the trend line is touched, but not broken, by price movements, the
more significant, or accurate, the line is. Trend lines are short-term over just a few
days; medium-term, lasting a few weeks or months; and long-term, extending for
months, or even years.
When prices make new lows, compared to the previous day, and fail to make a higher
high than the previous day, then a down trend exists in a daily time frame. When this
happens over five days then clearly a week-long down trend is established. Price does
not behave in an orderly fashion, so we expect this trend to be broken by spikes
above and below the trend line. In defining a longer trend over days and weeks, we
exclude these spikes and define the trend to include at least 80% of the price action.
A down trend reversal is signalled by a series of higher highs and higher lows which
continue above the line that defined the upper limits of down trend price moves.
Traders identify short-term, intermediate-term and long-term trends. Trends are
powerful and we look for increasing dominance as we move up the scale. So a short-
term trend runs into trouble when it encounters an intermediate trend. It usually
defines a stopping point and limits profits. An intermediate trend has the same
problems when it meets a long-term trend. The trend in each longer time frame acts
as a resistance or support level.

86
 6/ The Straight Edge

Trend line trading tactics include waiting for trend confirmation before taking a new
position. For instance, a collapse of a short-term trend may give entry opportunities
around levels set by the intermediate trend.
One way long-term trends are identified is by using longer averages and watching for
signals when the 50-day average crosses over the 100-day average. These are covered
in the section on Crowd Movement. Other approaches use weekly charts, applying a
10 and 30-week moving average and using the same crossover signals. This entry
technique makes for a late entry-usually some time after the trend is established-
and for a late exit-usually some considerable time after the trend has ended. Some
traders try to take a very large position at the beginning of the trend, and rely on
getting out before the trend turns. Other traders 'scale in', and take a number of new
positions as the trend develops. The choice then is to either close all positions at once
when the trend changes, or to take profits on each position as the trend progresses.
'Fading' the trend is when the trader takes a position in anticipation of a trend reversal.
This is used for breakout entries, and for exits based on trend resistance. This can be
based on a chart pattern indicating a reversal, such as the development of a down
sloping triangle, or based on the tendency of prices to move back towards the average
price. Those using this second approach use trade bands, or envelopes, to see when
prices are well away from the average. Bollinger bands are more complex, plotting
the standard deviation from the mean. Both approaches fade the trend and are discussed
in later chapters .

• HORIZONTAL SUPPORT AND RESISTANCE LINES

Markets are dynamic and sloping trend lines show changing market values over time.
But under certain circumstances the market develops a consistent value over time,
and different trend lines can be used. These cousins to the straight edge trend line are
called support and resistance lines. They define a consistent value, or series of values,
over time. These levels usually occur as independent support or resistance levels,
although sometimes they combine in a trading channel. They are defined as a straight
edge horizontal line which sometimes stretches a long way back in time. This
consistency makes support and resistance levels particularly useful because they act as
a resistance roof and a support floor for price action.
These levels dominate the market more uncannily than trend lines. Just why the
crowd has a focus on these areas is not clear, although some explanations make more

87
CHART TRADING

sense than others. Patterns of resistance are seen in all markets and existed long
before chartists and technical analysts drew attention to them.
Some people believe these levels are self-fulfilling because technical traders look for
them and act on the signals. It is unlikely there are enough technical traders to influence
the action of price in an individual, well-traded stock in this way. It is beyond belief
to suggest it occurs consistently in almost all stocks in all markets.
I prefer the explanation for this crowd action developed in the Crowd Rules section
opposite. Here our real interest is how we recognise and use these patterns of chart
activity. These lines do not control the market, but they do help to define the action
of the crowd.
Some support and resistance levels are very clear with consistent price action spanning
days or weeks. These are strong levels. Weaker levels are defined with just three or
four points, or in special circumstances, just two. Strong long-term support or
resistance is defined on weekly charts, or more effectively, on point and figure charts.
Defining and plotting them accurately is the first step towards using them effectively
for investment and trading decisions.

+RULES
1. For support levels, only the lows of price action are used. We need at least
two of these joined with a horizontal line. This activity can take place at any
time, say near the end of trends, or in the middle of trend.
2. Two points on a daily chart is barely enough. A third point is preferred. No
low should dip below the points on the horizontal line. As soon as a new
lower low occurs, the support level is invalidated.
3. On daily charts, strong support levels are tested many times. Price falls to
this exact level, then rises again. Each time price falls it reaches the projected
support level and goes no further before rising.
4. Short-term support levels are separated by days, or weeks.
5. A resistance level is defined in the same way as a support using the first four
rules. Only the highs of price action are used. We need at least two of these
joined with a horizontal line. This activity takes place at any time, near the
end of trends, or in the middle of trend. A third point is preferred. No high
should rise above the points on the horizontal line. As soon as a new higher
high occurs, the resistance level is invalidated.

88
 6/ The Straight Edge

On daily charts, strong resistance levels are tested many times. Price rises to
this exact level, then falls again. Each time price rises it reaches the projected
resistance level and goes no further before falling. Short-term resistance
levels are separated by days, or weeks.
6. Long-term levels connect price highs or lows separated by months, or years.
These are best observed on weekly charts, or point and figure charts.
7. Long-term levels need at least three points for validity. The more points, the
stronger the impact of the level. These points are often made up of clusters
of price highs or lows.
8. All levels are eventually broken. When this happens, rising prices are most
likely to pause at the next resistance level. In a falling market, the fall is likely
to pause at the next lower support level.
9. When price moves beyond the resistance level for a single day and then falls
back to the resistance level, it delivers a bullish signal. Prices are likely to
continue rising.
10. Resistance levels often become new support levels after price has finally
broken above the resistance level. Support levels often become new resistance
levels after price breaks below support.
11. The Watpac chart, Figure 6.3 overleaf, shows resistance levels as parallel
lines, and support as a single line. Many times prices meet these levels
exactly. At other times the general activity of price is strong enough to
ignore the odd price extreme beyond the line, as shown with point A. This is
acceptable towards the beginning when placing a support or resistance line.
It is not acceptable as we move towards the right-hand side of the chart
because here we want to use the line as an exact trading signal. In real time,
on the right-hand side of the chart, we treat all support and resistance line
violations as if they indicate a significant change.

+ CROWD RULES
We all belong to crowds, even though we might not gather together in the same
physical place at the same time. We become part of a virtual crowd when waiting for
prices to fall.
Buying a new computer is a good example of the way many individuals acting
independently help to define market action. At one time Apple Computers adopted

89
CHART TRADING

an entirely counter-
Fig. 6.3 Support and Resistance
productive marketing
0.55 strategy. Whenever a
0.54 new model was
0.53 released it sold at a
0.52 premium then, within
a few weeks, it was
Resistance 0.51
offered at discounted
0.50
Support prices for a short
0.49 period with limited
0.48 stock. Then prices
0.47 rose again. A few
A 0.46 months later prices
0.45 dropped back to the
0.44 same discount level,
0.43 again with limited
0.42 stock. Pricing rose and
WTP fell to predictable
0.41
WatpacLtd levels, although the
Daily bar chart 0.40
T'--:F""""""T--r.,--,.-,-,--,-~,.-,-,-.,.-r-TT--r--r-.,--F""""""Tr-ri'- 0. 39
timing was erratic.
Ju- 0.38
Loyal Apple users had
enough sense to wait
for the inevitable discounts before they bought a new system. If they missed out on
the limited stock in the first offer they knew there would be more stock at these
prices in the second offer. It was just a matter of time. Instead of encouraging
consumers to buy, this strategy encouraged clients to defer their purchases.
This fine example of how to lose market share shows a crowd in action. Imagine a
price plot of this activity. On the discount days the price would fall so low, but no
lower. In-between times price would rise, and people could buy an Apple computer
at this level, or slightly cheaper if they shopped around. On a chart this discount
price activity is defined by a support line. Apple Computers did not have to discount
any further to sell computers because they knew many buyers would enter the market
at their set discount levels.
In the stock market price is set by the crowd of buyers and sellers so why does price
sometimes seem to get stuck on a support level? It turns out it is for much the same
reason as with the Apple discounting example. Enough people think the stock, or the
product, is good value at exactly that price. When prices fall, they buy at this exact
level. Apple Computers set its floor artificially. The market sets it with a common
feeling that the asking price is just about right.

90
 6/ The Straight Edge

What is important for the trader and the investor is the repeated behaviour of this
crowd action. It is so repeatable that we build market strategies around it, although
hopefully with more personal success than Apple.
The market crowd appears to have a long memory. Major support and resistance
levels show up on long-term weekly charts. These exact levels from the distant past
appear to hold true for today's price activity. They also hold true for future activity.
Please remember the line has no connection with the real world so we can only speculate
on why some resistance levels are so strong, reliable and often exact. Our explanation
rests on common individual behaviour repeated many times in the market crowd.
Buying a computer is different from buying a stock. We expect the value of the
computer to decrease but we expect the value of our shares to increase over time. We
are disappointed if they don't and we make the profit and loss calculation based on
the price we paid for the shares. If there are many other new shareholders who
bought stock at around the same price, then they also use this price as the basis for
their profit and loss calculations.
Losses hurt, and if price goes down the new shareholders remember just how much
they paid for the stock. As prices rise back to these levels many people decide to bail
out, taking a small loss, or perhaps a small profit. They are relieved to just break even
on the trade or, in the longer term, on the investment. When lots of people bought
at about the same level, and then later sold their shares at about the same level, a
resistance line develops.
It works in reverse. Perhaps the many new buyers were right, and prices do rise.
Most of the new shareholders do not sell. They wait for even more profit. When
prices do fall back to the original purchase level many of these shareholders buy
more. Mter all, the price has rallied once, so a price fall gives them an opportunity to
buy even more. Using their original buy price as a reference point, these people are
buyers again at this level. They provide support, or a floor, under the price retreat.
The key factor in developing support and resistance levels is the way the crowd of
new stockholders use a common price point as a basis for their profit and loss
calculations. I believe this is the most effective explanation for support and resistance
patterns. We may never know the real reasons for this activity, but this does not
prevent us from using this repeated crowd action profitably.

• USING SUPPORT AND RESISTANCE LEVELS

Support and resistance lines offer several trading strategies with Boag and Son (BOA).
They include a trading channel opportunity and a trend breakout as shown in Figure

91
CHART TRADING

6.4 below. The first strategy uses the trading band established between points A and
B. This gives an entry at $0.55 and an exit on the resistance level at $0.60. This is a
9% return gained in several cases from trades lasting just a few days. They are
numbered l and 2. These style of trades were not taken in October because the
trading channel had not been developed or confirmed. To succeed, this strategy
needs the good resistance level shown as double lines at $0.60.

Fig. 6.4 Trading with support and resistance

I- 0.73
Long-term resistance D
0.72
0.71
0.70
BOA 0.69
Boag and Son
Daily bar chart I- 0.68
;- 0.67
- 0.66
Long-term support and resistance c
0.65
- 0.64
- 0.63
- 0.62
- 0.61
0.60
J - 0.59

r1~~ l-~~~ -·
- 0.58
- 0.57
- 0.56

------~--------------------~--~-------------------r~ 0.55
1 2
- 0.54

October INov 'loec 11999 February March !April IMay

Not all traders want to take these small profits. Armed with faith in BOA they believe
prices will reach for old highs around $0.73. With an entry at $0.55 on support,

92
 6/ The Straight Edge

these traders are looking for returns of around 30%. The old levels of support and
resistance provide the profit targets for this trade. They also provide the exit conditions.
All the support and resistance lines in Figure 6.4 extend to the left of the chart and
are taken from previous price action in 1997 and 1998. This style of trading relies on
price moves from one extreme to the other.
The first target for these longer-term traders is set by the resistance level at C. This
was a support level in previous years and the November price spike confirmed this as
a likely up side price target. Many traders set sell orders at this level. A trade from
$0.55 to $0.65 returns nearly 19%.
Other traders watch how price behaves around this resistance level. They have a
longer-term trading plan, so they are comfortable with prices hitting $0.65 and then
falling into a new trading channel with a low point of $0.60. They are prepared to
wait for a new breakout above the $0.65 resistance level. In this example they are
quickly rewarded with a price surge towards $0.72. They lock in profits from $0.55
to $0.72 of30%. The traders have six opportunities to exit at this price before BOA
falls below $0.72.
Traders take profits here because BOA has not traded above these levels since
September 1997. Additionally, the BOA price spent a lot of time around these price
levels from 1996 to 1997. It is unlikely to push higher in the short term.
Not all traders are confident enough to take a position at point A and hold it until an
exit at the upper resistance level, line D. Support and resistance lines offer other
trading alternatives. Cautious traders wait until the resistance level at B is broken.
Their trade uses the same exit objectives based on resistance levels at lines C and D,
but they accept a lower profit.
In all cases the traders use the old support and resistance levels to set the potential
price targets and exit conditions for their trades.

SUMMARY • SUPPORT AND RESISTANCE

A support level is created when the supply of stock runs into a wall of demand. Every
time selling pressure approaches a particular level it is supported by buyers who have
a more positive view of the stock's future. This temporarily halts the price decline. In
a positive sense, when all the buyers at that level have bought, the price has nowhere
to go but up as buyers have to bid higher to get the stock. In a negative sense, when
buyers will only bid for stock at lower levels, sellers have to lower their ask to move
their stock. With such a shortage of buyers, the price falls to new lows.

93
CHART TRADING

A resistance level is created when the demand for stock runs into a solid block of
supply of the stock. Every time buying pressure approaches a particular level it is
overwhelmed by sellers, which temporarily halts the price advance. In a positive
sense, when all the sellers at this level have sold, the price has nowhere to go but up
as buyers have to bid higher to get the stock. In a negative sense, when sellers start to
unload stock at lower levels, buyers do not have to bid as high to get the stock. With
such oversupply of sellers, the price falls to new lows.
As prices progress, these lines change character. Once broken on the up side, the old
resistance level often acts as a new support level. This is because many people have
bought at this level, and they all make similar profit and loss calculations. Resistance
levels help to set profit targets in short and long-term time frames.

SUMMARY • TRADING CHANNELS OR BANDS

The walls of a trading channel are defined by support and resistance. These walls
may be horizontal, or sloping. In either case they tend to be parallel. A support level
is created when the supply of stock runs into a wall of demand. A resistance level is
created when the demand for stock runs into a solid block of supply of that stock.
Trading channels provide trading opportunities based on the consistent price
movement between the walls of the channel. In a horizontal channel the returns are
often low, 10% to 30%. In a sloping channel the returns are often larger because the
upper point of the channel rises during the trade.
Because these bands are defined by support and resistance, traders buy at support
and sell at resistance. The most effective strategy trades from one price extreme to
the other.

94
Chapter 7

COMBINATION LINES

Resistance levels, marked as lines, act as barriers. Like crowd control devices, these
levels seem to say, "Thus far and no further." They are static forces controlling crowd
action. Trend lines, on the other hand, are dynamic because they reflect changing
value over time. With these lines we get a sense of crowd movement. The real dynamics
of crowd action are expressed by a combination of resistance levels and trend lines.
These chart patterns capture the dynamics of the crowd and help traders select powerful
movements.
Although many good trading and investment opportunities are available soon after a
new trend has started, traders in particular try to identify trend breaks early. Some
trade just these breaks, taking quick profits from significant moves. Others, the true
trend traders, book an early place on a powerful trend and stay with it until it changes.
Many traders and investors have little choice due to circumstance or cash flow. They
have to jump on established trends. By using the dynamics of resistance levels and
trend lines, they make better decisions about entry points so their capital starts working
quickly.
Crowded with many signals, with warnings and clear channels, a chart offers many
choices. Which choices you see depends on your approach to the market and the type
of vessel you are sailing through these waters. Large investment funds, like ocean
liners, avoid the narrow channels. Nippy traders brave the mud flats and shoals chasing
elusive opportunities. Others stay with the main channel, avoiding marked reefs and
rocks, content to sail with the current. How each interprets the chart depends upon
his purpose.

95
CHART TRADING

The same reef repels cautious weekend sailors, but attracts the weekend fishermen.
The same chart pattern repels superannuation investment but is a beacon to speculative
traders. Each should know how to recognise the patterns and each should know how
relevant they are to their chosen trading or investment style. No single answer suits
all.
Patterns by themselves do not necessarily lead to consistent outcomes. The
development of chart patterns alerts the trader to a selected range of more probable
outcomes. As price moves towards a well established resistance level the trader pays
more attention to the stock, ready to place a buy order if prices move a few ticks
above the level. He cannot buy until others have bought because he wants to follow
the action, not create it. When prices retreat into the body of the support and resistance
band, or other chart patterns, the trader shifts attention elsewhere. Chart patterns
signal the probability of action.
Charts do not come dressed up with trend lines, patterns and indicator overlays. We
have to dress the chart ourselves without the advantage of knowing how price action
will develop in the future. Traders who dress a chart well have an edge in anticipating
price action, or in establishing conditions that show price action is not developing as
anticipated.
While lines tend to be static, a series of individual price patterns provide pointers to
the action of the smarter elements in the crowd, usually the leaders. These are
important reversal patterns associated with a major change in the trend-they are a
starter's gun so traders listen carefully for the sound of the trigger creeping back.

• DOUBLE BOTTOM AND DOUBLE TOP

Resistance levels are usually extended lines on a chart, but solitary spots of resistance
also deliver powerful trading signals. Like a child stamping a foot before flying into
a tantrum, these resistance spots show up as exclamation marks just prior to significant
action. Often they dip substantially below the previous day's price action, standing
out as a single spike.
These are trend reversal signals found at the end of a trend. Here we concentrate on
the 'double bottom'. The same conclusion, but in reverse, is applied to a 'double top'.
The classic double bottom has quite precise construction rules, and these deliver a
very high probability of successfully selecting the future direction of price. Other
double bottom rules are less rigid, and have a lower level of probability. Which rules
you decide to use will determine how reliable the double bottom is as an indicator.

96
 71 Combination Lines

A single bottom in a falling trend is the point at which the trend reverses direction.
In trend terms this is the pivot point low shown in Figure 7.1 below. This absolute
low price is a useful reference point and many traders try to buy as close as possible
to this to make good money as the trend develops. Many strong trends do develop
from single point bottoms but many single point bottoms precede weak trends.
Sometimes prices rise and then fall back again to re-test the low. This is the beginning
of a potential double bottom. When the pullback in prices is exactly equal to the earlier
single point low, or is within
one tick, we label it a double
Fig. 7.1 Pivot point lows
bottom. This is a powerful

J~fltt
signal when the two bottoms
are separated by several weeks. 20.00
It is still a powerful signal
when separated by just a few
days, but the reliability is
19.50
j'tj)l No.t ~double bottom
reduced.
19.00
11 jf~~nuing
J
as 1t 1s part of a

ttond f\
+RULES 18.50

The rules for a classic double

bottom or top are quite
defmite and are designed to
eliminate look-alike patterns of
18.00

17.50
t~·-, 1
no significance that occur in
17.00
Not a doublo bottom"' tho \ lr
trending stocks. Some traders
modify these, accepting a
pivot pointlow i< low« I \Jl1~
pattern where prices are 16.50
almost the same, or within This is a pivot
16.00
3%. This stretches the classic point low
rules and reduces the reliability 4178
of this pattern.
2089
1. Significant double
bottoms occur in stocks
with strong trends. The 0
first bottom is a (000]
significant and clear
low. Figure 7.2
overleaf is an example.

97
CHART TRADING

A series of resistance bottoms in a stock moving sideways do not make a

double bottom. The National Mutual chart, Figure 7.3 opposite, shows
support and resistance activity. It does not include any double bottoms, or
tops, because the price action is not trending up or down.

Fig. 7.2 Double Bottom

Project this Not a double top
upwards for because no new
price target of trend has been
3.00
$3.34
~hed

2.75

348 11---t------------~F=s=e=p=ar=aLti~on==be=t=w=e=en~bo~t~to~m--~--~-----------­
points is 11 weeks
1740

0
(000) May98 Nov98
Pacific Magazines Not a double bottom because
Daily bar chart these occur during an existing trend

2. The price levels at the second bottom must be within a cent up or down of
the first bottom price.
3. The two bottoms must be separated by at least several days of price action
that rallies from the first low to a peak then retreats to the second low.
Longer patterns where the lows are separated by several weeks are much
more reliable indicators.

98
 71 Combination Lines

4. Trading volume must be

steady and consistent. Fig. 7.3 Identifying double bottoms
Double bottoms in thin 1.35
markets are not strong
indicators. These are resistance
levels, not triple tops
5. These are bottom
patterns. They do not
1.30
/
~
occur in the middle of up
trends or down trends.
1.25
These construction rules
are tough and designed
to weed out look-alike
price is
imitations. The classic 1.20
sideways
double bottom is an NMP ~
infrequent pattern. National Mutual These are support levels,
6. Significant double tops Daily bar chart not double bottoms
occur in stocks with 7779
strong trends. The first
3889
top is a significant and
clear high. The price
levels at the second top 0
must be within a cent up (000)
or down of the first top
price. The two tops must
be separated by at least several days of price action falling from the first high
to a low point then rising to the second high. The Faulding FH chart in
Figure 6.2 on page 84 shows this pattern.
Longer patterns where the highs are separated by several weeks are much
more reliable indicators. Trading volume must be steady and consistent.
Double tops in thin markets are not strong indicators. These are top
patterns. They do not occur in the middle of up trends or down trends.
7. Triple bottoms or tops are constructed in the same way as double bottom or
top patterns. The triple bottom includes another failed rally with a price
retreat to the same levels, followed by another up trend. Although many
traders feel these triple patterns are more reliable, they sometimes signal the
start of a channel trading opportunity. Cautious traders wait for the trend
break from these triple patterns to be fully confirmed before taking action.

99
CHART TRADING

+ CROWD RULES
The first definite bottom in a falling trend is a bargain buying opportunity. Traders
and investors wait on the sidelines, watching the price collapse at a steady rate over
weeks and months. Eventually, company fortunes change. The actual reason is not as
important as the action it initiates from buyers waiting in the wings. Now the stock
is a true bargain, not because it is historically low, but because it is potentially
undervalued in relation to its future prospects. This turnaround in fortune is rapid,
and buyers drive prices upwards in a scramble to get stock. These smart traders and
investors jump on the trend break very early.
The less informed have given up hope long ago. They have read, and believed, every
good news story put out by company management during the long price decline.
They stop looking at the stock price every day because it is so depressing. These
stockholders are hurting and avoidance is one way to ease the pain. When prices do
move, they miss out. They are literally asleep at the wheel.
When they do wake up they take action. Prices are higher than the last time they
dared to look. Some sell very quickly, frightened the down trend will resume. Others
hang off, trying for better prices so their level of loss is reduced to something they
can tell their partner about without collecting too much grief and recrimination.
Early buying is beaten down by investors who already hold the stock and who are
eager to get rid of it as the price rises. Some of the early inexperienced buyers see
this, and worry they have made a mistake. They begin to sell, and gradually the price
is forced down, overwhelmed by nervous sellers.
The final result has several possible outcomes. At worst, prices continue to fall below
the previous low. If so, this rally turns out to be just an excited blip in a longer down
trend. The most useful outcome is when prices fall to exactly the same low level as in
the past, and then begin to rise again. Traders look for this second rally to build from
a double bottom. When prices bounce off the same old level it suggests many more
people have decided this is a good buying opportunity.
The double bottom can become a self-fulfilling pattern, as many traders watch for
this type of chart pattern. When the second bottom is confirmed they pile on, adding
to the buying pressure and pushing prices higher. Does this matter? Probably not.
Traders use the pattern to get in early on solid new up trends. Exactly who creates
the pattern is not as important as making money from it.

100
 7I Combination Lines

• USING DOUBLE BOTTOMS

Although some significant double bottoms take just a few days, generally the period
between the two points is much longer. With Pacific Magazines (PMP) the first
bottom occurred in May. Figure 7.2 on page 98 shows the second II weeks later in
August. The second low was confirmed, or tested, over three days.
The double bottom is significant for two reasons. The first is because it signals a
change in the direction of the long-term trend. PMP stopped its long-term fall in
May, but did not start a new long-term up trend until August.
The second is the way the pattern is used to project potential price targets. The low
point in this pattern is at $2.50. The highest point in the middle of the pattern is at
$2.92-a difference of $0.42. Adding this to the high gives a price target of $3.34
which was first met six months later in March I999. This long-term pattern delivers
long-term results. Because it is a reliable pattern, traders buy on the second low at
$2.50 and aim for a 33% return with an exit at the projected target price. The
developing trend took prices as high as $3.56, offering a return of 42% to skilled
traders.
In some trades, these target prices are reached in just a few weeks, as with Normandy
Mining, or with United Energy (UEL) as shown in Figure 7.4 overleaf. The second
point in this double bottom is one tick higher tllar1 the first point. Sometimes the
trend will carry prices much higher. With UEL the final trend high was $2.5 7. Double
bottom targets are reliably achieved, and frequently exceeded.
The same projection techniques are applied to double tops. Here the price is projected
downwards, setting targets for new lows.

SUMMARY • DOUBLE BOTTOMS AND TOPS

The classic double bottom or double top is a very reliable reversal pattern. The rules
are quite firm and this weeds out other similar patterns of less significance. When the
two low, or high, points are separated by several days, or weeks, the market has an
opportunity to confirm the strength of the new trend direction. These are powerful
trading signals but remember they do not occur in the middle of trends or congestion
activity. Other technical indicators help confirm the potential for a change in trend
direction. The double bottom, or top, puts precise prices on these reversals.
The triple bottom is a comparatively rare chart formation. It is formed when prices
make a bottom, rally, come back to the same support level again, rally, and then drop
back to the support level for a third time. The strong support, confirmed over many

101
CHART TRADING

price moves, makes this a very bullish signal. This signal rarely requires confirmation
and it leads many other indicator signals.
The triple top uses a resistance level in the same way. The strong resistance, confirmed
over many price moves, makes this a very bearish signal. This signal rarely requires
confirmation and it leads many other indicator signals. These patterns are not formed
when prices spend three consecutive days at the same level.

Fig. 7.4 Double bottom price projections

2.30

2.20
2.20

2.10

2.00

1.90

1.80
3444 UEL
United Energy
1722 Daily bar chart

0
(000) ALlg98 Oct98

+ + + + +

• UP SLOPING TRIANGLES
Market tantrums often set off new trends in the market, but these are comparatively
rare events. More common is the clash between those with rising expectations, defined

102
 71 Combination Lines

by an up sloping trend line, and those who are set in their ways, defined by a horiwntal
resistance level. These two lines eventually define a perfect point of contradiction.
Sellers firmly believe the stock is worth a particular amount. This belief is so strong
that a solid resistance level forms, extending usually for days or weeks, although
sometimes for months. Buyers believe they know better. They sense future value in
this stock, and effectively push prices higher. Each time price retreats, they bid a
little higher just to make sure they get stock. This builds a rising trend line.
Where these two lines intersect they form a triangle, and ultimately the end point of
conflict between two substantial and active groups in the market. Who wins-the
crowd of buyers or the crowd of sellers-is not a forgone conclusion, although the
probabilities are weighted in particular ways with up sloping triangles. What we do
say with a high level of certainty is-here is a point where the crowd is involved in
some serious action.
Just like a school-yard fight, this action draws more spectators, and more participants.
It quickly becomes a brawl, and in market terms, we want to be on the winning side.
The triangle points the way to the victor.

+RULES
1. The resistance level is plotted according to the resistance line construction
rules in the previous chapter.
2. The up sloping trend line must be accurately plotted and conform to the
trend line construction rules in the previous chapter.
3. Single days spiking above the resistance line are ignored. These are a good
sign of building strength and are a guide to price targets for any breakout.
4. Use the height of the base of the triangle to project up side price targets.
Breakouts often meet these targets, and pause at this level before new
trending action develops. Figure 7.5 on page 106 shows how this is applied.
The same techniques are used to establish down side targets. More accurate
down side targets are determined by starting the projection from the trend
line slope at the actual breakout point.
5. Short-term triangles lasting just a few days have low reliability. Triangles
developing over ten days, or several weeks, are more reliable. Very long-term
triangles, constructed over three or four months, or sometimes even longer
periods, have a low level of success.

103
CHART TRADING

6. The horizontal edge of the triangle is divided into thirds starting at the base
and ending where the sloping trend line intersects the horizontal line. Price
breakouts starting in the middle third of the triangle tend to be very strong.
7. Price breakouts from the last third towards the triangle tip tend to be weaker
than middle triangle breakouts.
8. The up sloping triangle is very bullish when the entire market, or market
segment, is also trending upwards.

+ CROWD RULES
This chart pattern forms when a sloping trend line meets a horizontal resistance
level. A sloping trend line represents the market changing its valuation of a stock
over time. It is created because people are worried about missing out on a stock.
Consider Telstra. When people saw it trading for $5.83 many regretted they had not
bought Telstra at $5.57. Telstra continued to climb and many decided to buy Telstra
again when the price dropped back to $5.83, but they were worried about missing out.
To get extra Telstra they set their buy price a bit higher at $5.84-just to be sure. Many
buyers still missed out, and Telstra's price went up again. A few days later it slipped back,
giving another buying opportunity. Some of the people who had been prepared to pay
$5.84 just a few days ago, now offered $5.90-just to be sure of getting some shares.
Th1s psychological crowd action develops a clear chart pattern shown as an upward
sloping trend line. Prices appear to fall back to the line, then bounce off it again.
There is nothing magic about the line. It is just an aid to show us how the crowd is
thinking about Telstra.
In some up trends the price rise seems to run into an area of resistance. When prices
get to a particular level, a large number of sellers come into the market with stock to
offer at one price. Buyers do not have to bid higher to get stock, so the price rise
stalls. This is defined as a horizontal line. This shows a consistent value over time.
People sell shares for many reasons. Sometimes it is to take a profit. Often it is
people who bought the shares on the way down, and now they are selling to break
even on the trade on the way back up. We cannot understand all the individual
reasons that help create a resistance level. We do not need to know them. But we use
our knowledge of this price action to make better trading decisions based on the
evidence of a resistance level.
These horizontal and sloping lines are initially placed tentatively on the chart. We
watch for future price action to confirm the placement of these lines. These lines
offer us a glimpse into a potential future. If they are accurately placed then we
reasonably expect price action to react away from each of the lines. Prices will bounce

104
 71 Combination Lines

off the rising trend line, and ricochet off the horizontal resistance level. By projecting
these lines to the right of the chart-by projecting these lines into the future-we
build a picture of future price action. The trader defines a point in time by which he
expects certain action to have taken place. If it has not taken place, then the trade is
abandoned on this basis alone.
The triangle formations are one of the few chart patterns pinpointing a deadline or
timetable for price action. Crowds are excitable, and when rising expectations meet a
barrier the crowd tries to push through it. This barrier is created by a wave of sellers.
While the crowd can throw more money at the barrier it is inevitable that the sellers
will start to disperse. Most leave because they have been paid. Gradually the others
realise they can get more for their stock, so they shift their section of the barrier,
asking higher prices. Using a depth of market screen, traders watch these tactical
withdrawals. Beyond the current frontline of trades, new resistance levels are prepared
as sellers dig in at even higher prices. The order stream grows at these levels.
Finally even the most dedicated seller realises better returns are available, and when
the last sell order is withdrawn from the old resistance level, the line crumbles. This is
a triangle breakout. Flushed with success and pushed from behind, buyers surge forward,
chasing the last of the sellers. A decisive breakout happens when price closes consistently
higher than the old resistance level. Everyone believes price can only increase. An
indecisive, or weak, breakout sees traded prices pull back to the old resistance level, or
even below it. There are still sellers who are not entirely convinced the rally is for real.
Every market crowd has its bullies, its weaklings, its fearless idiots armed with more
money than sense, and the nervous losers who refuse to believe their own good luck.
The triangle formation captures all these elements in a crowd, and it captures them
in action. This makes the triangle one of the most useful chart patterns.
Traders use these chart patterns to understand how the crowd is thinking. They try
to get in ahead of the crowd because they know there is a high probability prices will
go even higher. Investors use these patterns to confirm a stock is likely to increase in
price. They add to existing shareholdings with a higher level of confidence. The up
sloping triangle pattern is very bullish in rising trends. There is an increased probability
of prices continuing to rise above the pattern. This pattern is not as useful in falling
trends. In this situation the trader looks for other confirming chart indicators.

• USING UP SLOPING TRIANGLES

The up sloping triangle has a horizontal face formed by a resistance level as shown
with Australian Foundation (AFI) in Figure 7.5 overleaf. The length of the horizontal

105
CHART TRADING

face is determined by
Fig. 7.5 Up sloping triangles projecting it to the right
2.90 Price tar et until it intersects the up
sloping trend line. This
2.80 horizontal face is then
divided into three equal
sections as shown.
2.70
Breakouts from the middle
section are most reliable,
2.60 but good breakouts also
take place from the last
2.50 third of the triangle.
triangle divided into
thirds shown by «<> The height of the base of
AFI
the triangle is projected
17SS
Australian Foundation upwards to give a price
883 Daily bar chart target. With AFI the base
is $0.18 high, and this
gives a target of $2.88.
0 Aggressive traders enter as
(000)
prices pull back towards
the trend line. They collect
around 9% for this trade. Conservative traders wait for a close above the horizontal
face. In this trade the return is reduced to 6%.

SUMMARY • UP SLOPING TRIANGLES

The up sloping triangle is formed when a horizontal resistance line is intersected by
a rising trend line. Price rises to the resistance level, where sustained selling forces
the price back. Buyers bid less and still pick up stock. However, on each pullback,
the fall is reduced. Buyers have to bid slightly higher to get the stock. This creates
the rising trend line as each new low is higher than the previous one. When there are
no more sellers at the resistance level buyers have to bid higher to get stock. Often
this means bidding substantially higher and the breakout takes place. This is a strong
chart pattern and breakouts from the last third of the triangle can be very powerful.

• • • • •
106
 71 Combination Lines

• DOWN SLOPING TRIANGLES

This chart pattern is an accurate measure of growing fear of loss. It shows the trader
exactly what the crowd is thinking, and if he holds an open position-if he owns
stock-then he contributes to the development of the pattern with his own selling.
The down sloping triangle is a bearish pattern, and even more so in a falling market.
True believers hold up the floor with dollar bills. Every time price falls they jump in,
buying whatever stock is offered. Nervous sellers like this because they have an
apparently guaranteed price from buyers who stand firmly in the order line and build
this support level.
Very nervous traders worry about this, and.although prices do bounce up, they sell a
little early just to be certain of getting out of the stock. This is a falling trend line,
and when it meets the horizontal support level traders look for crowd action.

+RULES
1. The support level is plotted according to the resistance line construction
rules in the previous chapter.
2. The down sloping trend line must be accurately plotted and conform to the
trend line construction rules in the previous chapter.
3. Single days dipping or spiking below the support line are important warning
signals, although they are ignored in terms of placing the line. These spikes
are an accurate sign of developing weakness and are used to project the level
of any future price fall.
4. The height of the vertical base of the triangle is used to project down side
price targets as shown in Figure 7.6 on page 109. Breakouts often meet these
targets, and pause at this level before new trending action develops.
These projections are also used to project up side targets, but these are less
reliable when applied to down sloping triangles. The up side targets are
determined by starting the projection from the actual breakout point on the
trend line.
5. Prices tend to fall more easily than they rise. Short-term down sloping
triangles lasting just a few days have reasonable reliability. Triangles
developing over ten days, or several weeks, are more reliable. Very long-term
triangles, constructed over three or four months, or sometimes even longer
periods, have a low level of reliability.

107
CHART TRADING

6. The horizontal edge of the triangle is divided into thirds starting at the base
and ending where the sloping trend line intersects the horizontal line. Price
breakouts in the middle and end third of the triangle tend to be very strong.
7. The down sloping triangle is very bearish when the entire market, or market
segment, is also trending down.

+ CROWD RULES
We believe we are more rational than the market crowd, but reality suggests many of
us act in very similar ways. It is these individual actions, each rational in its own way,
that build crowd action. The down slopi.ng triangle captures our fear.
Imagine we own QAZX purchased earlier for $7.00. Prices have risen and we have
been thinking about selling it. Yesterday it climbed to $10.00. Today we instruct our
broker to sell at yesterday's high of $10.00. Instead QAZX falls to $9.50 and our sell
order is unfilled. A few days later QAZX climbs towards $10.00 and we watch the
closing prices eagerly, but the price only gets to $9.96 before falling back again to
$9.50. This rise and fall is repeated over several days, but the most recent rises are
consistently lower.
We turn to a chart of price activity and see a changing downward value over time
defined by a short-term straight edge down trend line. Prices appear to move up to
the line, then they fall away from it. Because we hold stock in QAZX we are worried
by this. It is clear we cannot get $10.00 for it as we had hoped, so we join the sellers.
Because we don't want to be left holding QAZX and because we don't want to lose
too much profit, we place a sell order just a little lower than yesterday's close, perhaps
at $9.75 instead of $9.80.
When our stock is sold we are quite relieved because we have collected a profit even
though prices have been steadily falling for the past few days.
Our reaction is the same as for many other traders. They see prices falling and they
worry. They join the rush to sell, and in their haste to get out, offer stock at lower
prices. Buyers do not need to bid higher for the stock. This process accelerates the
down trend.
The downward sloping triangle forms when this sloping trend line intersects a
horizontal support line or level. Initially other people believe QAZX has a good
future. When they see prices falling back to $9.50 they decide to buy. Some even pay
$9.51. They expect the price to go up so initially there may be quite a few buyers. As
price falls back to $9.50 these people buy more stock because QAZX is a bargain
compared to what they think it is going to be worth in the future.
108
 71 Combination Lines

But as days and weeks go past, and prices just can't seem to make new highs, these
buyers begin to leave the market. When prices do fall back to $9.50 there are just a
few buyers left, and even they stop buying when QAZX continues to build a strong
down trend. They realise if they wait the price will probably fall lower.
When the last of the buyers at $9.50 leaves the market there is no support left, and
prices fall even further. Now the sellers
are desperate, and they go looking for
Fig. 7.6 Down sloping triangles
buyers, for any buyers, and so QAZX ends
up selling for perhaps $9.00. 2.70
Traders see this pattern developing and
move quickly to lock in profits. Investors
also use these chart signals, particularly 2.60
when they confirm other down trend
signals. The development of a down
sloping triangle in a down trend is a 2.50
strong continuation signal, suggesting the
down trend is likely to continue. This
prevents investors from buying 'bargains'
2.40
at inappropriate levels.
Down sloping triangles in up trends act
as caution signs. Here the price collapse 2.30
\1
is likely to be limited by other support
areas and the general strength of the
trend. The downward sloping triangle
defines crowd action and, like the up
2.20 Price projection ]1j1ljl J
sloping triangle, allows the trader to
anticipate how the action might develop.
2.10 Aluminium
Daily bar chart
• USING DOWN SLOPING 4917
TRIANGLES Short-term triple bottom
2459
The Capral Aluminium (CAA) chart
extract in Figure 7.6 is a clear indication
of the way down sloping triangles are 0
used to identify the end of an up trend. (000)
The same techniques are used when down
sloping triangles appear in down trends.

109
CHART TRADING

For most traders these patterns tell them to resist the temptation to buy stock at
what looks like bargain prices.
The CAA triangle base extends from $2.47 to $2.72. This is $0.25 high and this
figure provides a down side target of $2.22 for any price collapse. When prices break
below the horizontal support floor, prices rapidly fall to $2.17 in just ten days.
Using triangle price projections means the trader is ready to consider buying CAA as
it bounces up from this very short-term triple bottom formed at $2.17.
Wider analysis of the trending activity for CAA will decide if the bounce is likely to
be part of a new up trend, or just a short-lived rally. The real importance of this
down sloping triangle is to signal a sell for traders already holding positions in CAA.

SUMMARY • DOWN SLOPING TRIANGLES

The down sloping triangle is formed when a horizontal support line is intersected by
a falling trend line. Price falls to the support level, where weak buying forces the
price back up. Buyers bid less and still pick up stock. However, on each pullback, the
fall is increased. Buyers bid slightly lower to get the stock. This creates the falling
trend line as each new low is lower than the previous one. When there are no more
buyers at the support level, sellers have to lower their asking price to sell stock. Often
this means asking substantially lower prices and the down side breakout takes place.
This is a strong chart pattern and breakouts from the last two thirds of the triangle
can be very powerful.

• • • • •
• EQUILATERAL OR SYMMETRICAL TRIANGLES

The equilateral or symmetrical triangle should be the most dynamic pattern of all. It
combines two opposing sloping trend lines, each representing the way the crowd
changes its idea of value over time. Instead, this pattern shows weak indecision. No
single group gains the upper hand and what initially looks a sensible trading decision
turns into a prolonged attempt to get out with some dignity, and perhaps even a
little profit.
The equilateral triangle with its contradictory sloping trend lines is a model of market
indecision. Traders and investors are trapped. It usually takes an external shock-an
event not directly related to the stock itself-to open the floodgates to an escape

110
 71 Combination Lines

route. When the crowd surges through the gap, prices often move very quickly in a
new direction.
This indecisiveness is not a fruitful ground for traders. The classic equilateral triangle
is symmetrical. Triangles that slope slightly up or down are labelled wedges. The
direction of the dominant slope is a guide to the direction of any breakout, but these
are still weak patterns looking for leadership.

+RULES
1. The up sloping trend line is plotted according to the rules in the previous
chapter.
2. The down sloping trend line is plotted using the rules in the previous
chapter.
3. The potential fall or rise is plotted using the height of the triangle base, and
projecting it away from the tip of the pattern. Better targets are determined
by starting the projection from the breakout point on the upper or lower
trend line. These targets are indicative only because the pattern shows market
weakness.
4. The break in the same direction as the general market is likely to be much
stronger than a break going against the market direction.

+ CROWD RULES
This is a restless crowd, milling in anticipation of an event. Some are convinced the
outcome is going to be good, so they buy early, snapping up shares at lower prices.
Prices do rise, and these early buyers feel vindicated. They are concerned when prices
start to fall again, but others are starting to think the same way, so prices do not fall
quite as far. The next wave of buyers is prepared to pay a little more. This is the
classic buying pattern establishing an up trend.
What is remarkable about the wider chart pattern is the way sellers are almost as
equally pessimistic. As prices rise they take the opportunity to sell, locking in profits
from trades initiated many weeks or months previously. Significant numbers of
shareholders grow increasingly nervous and sell at slightly lower prices, just to lock
in their profits. Frightened they might miss out, they lower their asking price.

111
CHART TRADING

These contradictory trends start to feed on each other. Smart traders who bought
early watch the developing down sloping trend line with some concern. By the time
the pattern is clear, usually about a third of the way through the projected development
of the equilateral triangle, some of these early buyers become sellers. Their selling
reflects their indecision, and helps build the broader market indecision.
When the pattern first starts to develop, buyers and sellers are both firmly convinced
that they are right and the other is wrong. By the time the last third of the triangle is
reached, buyers and sellers are not quite as certain of their correctness as they were a
few weeks previously.
This confused and increasingly worried crowd has nowhere to go. They wait for an
external shock, a jolt delivered by an event not directly related to the stock. This is
most frequently delivered by a move in the general market, such as a fall in the All
Ords, but it may be triggered by some other, comparatively minor, event.
This is a crowd waiting to run. All they need is a starter's gun. Occasionally there is
a false start and then the pattern just dribbles along trapping traders, investors, and
capital.

• USING EQUILATERAL TRIANGLES

Equilateral triangles highlight the difficulty in deciding just where to place a short-
term trend line. Both the upper and lower trend lines shown with the Bank ofWestern
Australia (BWA) chart in Figure 7.7 opposite make sense. Neither group is dominant
so we cannot be sure in which direction prices will break out from this pattern. The
price projections provide a guide to possible targets. These targets may be exceeded,
as did happen with BWA, but initially they provide a target area. The trader uses this
to calculate the risks and rewards for the trade.
Because the direction of the breakout is often determined by an external shock, such
as unexpected company announcements, or a change in the general market, these
trading positions carry a high level of risk. Unless the trader has a good idea of the
nature of the external shock, he is really trading on hope. Unlike the other triangle
patterns, the trader has not tilted the balance of probability in favour of one direction.
Traders holding BWA use this weak chart pattern as an exit signal. Leaving the exit
decision until after the down side break is confirmed often costs a lot of open profits.
With BWA the fall takes the trader from a close of $3.38 to an exit at $3.25 on the
day after the down side break-or even more if he hesitates.

112
 71 Combination Lines

Traders considering entering

BWA delay their decision until Fig. 7.7 Equilateral triangle targets
the breakout determines the

!
Up side
direction of the new trend. price
Unlike an up sloping triangle, projection
this pattern does not enhance the 3.40
probability of a price rise.

l!
3.30 Down side
SUMMARY• price
EQUILATERAL TRIANGLES 3.20 projection

Some trends are ambiguous.

Prices do make higher lows,
setting the conditions for placing
3.10 ~~11l .
an up trend line. Sometimes the
price activity on the day also
3.00 Each short-term trend line 1~
is valid, but it is difficult
makes a lower high. More often
to tell which is dominant
prices work their way above the 2.90
up trend line, but fail to make
new highs. This trend meets the BWA
2.80
conditions for placing a down Bank of Western
trend line. Both lines are valid, Australia
and they define an equilateral 2.70 Daily bar chart
triangle. The market is uncertain
as to the correct pricing for the
stock. Both sellers and buyers 1853
revise their valuations over time,
but in opposite directions.
927
Breakouts tend to be driven by
external factors, hitching a ride
with broader market conditions. 0
(000)
Triangle patterns point the way
to high probability trading. The
results are summarised in Figure 7.8 overleaf. As with all chart patterns, the trader
must avoid the temptation to build patterns where no patterns really exist. Creating
castles in the sky from wind driven clouds is good recreation for children. Using
your time to build imaginary chart patterns from market data is a fatal trading error.

113
CHART TRADING

These chart patterns are valid when they are clear. If you cannot see the pattern in
the first glance at the chart, then it is probably not there.
Triangles map crowd activity. They do not map your hopes and desires. Correcdy
identified and used, these patterns return trading profits. If you chase imaginary
chart patterns be prepared to watch your trading capital disappear in a very real way.

Fig. 7.8 Triangle summary

Prevailing market conditions

UP DOWN

Breakouts Limited up side

tend to be up breakouts

Limited up side Breakouts tend

breakouts to be down

Any up move is Any down move is

likely to be weak likely to be weak

114
Chapter 8

BAR SET-UPS

The danger of filling a chart with attractive but meaningless lines is avoided when
we look for chart set-ups as a guide to the action of the crowd. Despite the term, a
'set-up' is not a form of market manipulation. It is a pattern of bar chart activity
revealing action taken by the crowd.
The distinction between action and the reason for the action is important. We are
not trying to read the collective mind of the crowd, or even the minds of a few key
individuals. Instead we look for signs the crowd is stirring, either reacting negatively
to something, such as price fall when a managing director resigns, or positively towards
something, perhaps new business acquisitions.
Watching a cricket match with the sound off, the first sign of one team's defeat is
when the national flags are furled and the standard bearers start leaving the stands.
In a wider sense, this action is a prelude to the end of the match. I look for this 'set-
up' because it means I can soon switch channels without my son complaining.
In the market we look for the same clues to crowd action. These set-ups show when
the crowd is arriving, when it is preparing to depart, and when it is jostling for the
best seats ahead of the next rally. Recognising these set-ups gives us a trading edge.
With experience, many set-ups are easily spotted in a single glance and they become
a very efficient way of weeding out trading candidates.
Generally these patterns of bars are easily defined. More complex patterns and
relationships can be explored, and Edwards and Magee, in Technical Analysis of Stock
Trends, provide a good coverage. Magee also wrote Analyzing Bar Charts for Profit,
which concentrates almost exclusively on chart reading.

115
CHART TRADING

Other authors use computers to fine-tune the many hundreds of pattern set-ups they
believe lead certain types of price action. On a practical level Larry Williams covers
some of these in Long Term Secrets of Short Term Trading. Larry Connors includes a
selection in Investment Secrets ofa Hedge Fund Manager, while Tom De Mark covers
an unnecessarily confusing array of set-ups in The New Science of Technical Analysis.
We do not want to delve into this level of detail. As our skills grow, these methods may
be appropriate. Until then we start with the most visible of these set-ups-the gap.

•GAPS
Gaps are calculated from the extremes of price activity-the high and the low. The
chart display shows as a clear space-a gap-between one day and the next that is not
filled with any part of a price bar. Gaps do not show up on line charts.
All gaps show a significant overnight shift in the mood of the crowd. For reasons
which might not be clear to the individual trader, the market crowd has fallen in love
with this stock, or recoiled in horror. These are extreme reactions and we should
evaluate them carefully.
This simple chart observation is complicated by division into four types:
:> congestion gaps;
:> exhaustion gaps;
:> break away gaps; and
:> runaway or continuation gaps.
Edwards and Magee discuss these and other nuances of gaps in depth in Technical
Analysis of Stock Trends. Regina Meani includes them in her book Charting-An
Australian Investor] Guide.
Congestion gaps are found when a stock is locked into a trading range, or consolidation
pattern. Prices move in a defmed band, first bouncing off the bottom then ricocheting
off the top. The band is frequently defined by resistance levels. These gaps dot the
recent price activity of the stock so we see they have no significance. Congestion
gaps are consistent with ongoing price activity. These should be ignored.
With thinly traded stocks, usually speculative issues and small gold miners, the chart
is full of gaps. Eventually some of these turn out to be significant, but it is difficult to
tell which is which at the time. These gaps are created by the lack of trading activity
and low volume. When the chart is full of price gaps most of them are unimportant.

116
 8/ Bar Set-Ups

Break away gaps are much more interesting. Traders look for these. They reflect a
dramatic change in the market for this stock. Often they are marked by above-average
volume. This is the crowd at its most active. The large break away gap happens because
the crowd opinion has changed. It is as if all bets are cleared.
An initial gap followed quickly by another gap day is called a continuation gap. As
this develops, we set targets for the eventual limits of the rally or decline, based on
the first break away gap. We look at this below. This second gap is caused because
the momentum of the crowd accelerates so rapidly that all buy and sell orders are
quickly outdated and abandoned. These are usually very fast markets, with furious
activity in the face of calamity or unexpected windfalls.
When crowds run quickly they run out of breath, or in this case, money. Markets
adapt very quickly, so although the sell-off, or the rally, may continue for some time,
it is likely to slow down. The next gap is most likely to be an exhaustion gap-a last
gasp of crowd action. When it occurs at about the projected target level of the rally
it is most likely a signal of the end of the rally or retreat. The next day is often
marked with low volume. This market is tired and has stopped running. For the
moment all it wants to do is get its bearings before either correcting some of its
recent excesses, or continuing on, but at a more measured pace.
There are benefits in recognising continuation gaps and exhaustion gaps. Unfortunately
some of these distinctions are more easily made well after the event, than in real
time. Traders and investors work in real time. There is intellectual satisfaction in
being able to retrospectively define and identify an exhaustion gap, but unless there
is a trading advantage, this skill does not add to profits.
Gaps have many features in common and these may be more significant than the
differences in classification. Just how you decide to incorporate gaps into your trading
strategies will determine the relevance of these differences. We need to know when
the crowd moves, but we do not always need to know which particular exit they are
heading for.

+RULES
All Gaps
1. Today's low must be higher than yesterday's high for rising gaps. For falling
gaps, today's high must be lower than yesterday's low.
2. The gap is not important if it is consistent with the normal recent behaviour
of price, or if it is within an established trading range.

117
CHART TRADING

Congestion Gaps
I. Today's low must be higher than yesterday's high for rising gaps. For falling
gaps, today's high must be lower than yesterday's low. These gaps are
consistent with the ordinary behaviour of this stock. They tend to be part of
a consolidation pattern.

Break Away Gaps

I. Today's low must be higher than yesterday's high for rising gaps. For falling
gaps, today's high must be lower than yesterday's low. This gap is large
enough to be out of the ordinary for this stock. It usually happens when
other indicators are also signalling the end of the trend.
2. They break well beyond any previous chart pattern, such as a resistance level
or congestion area.
3. Volume is usually greater than average.

Runaway or Continuation Gaps

I. Today's low must be higher than yesterday's high for rising gaps. For falling
gaps, today's high must be lower than yesterday's low. This gap is large
enough to be out of the ordinary for this stock.
2. They break well beyond any temporary pause in the previous price
movement. Usually these gaps occur within a few days of the first break
away gap. Together these two gaps form a single continuous pattern.
3. Potential targets are set by measuring the distance of the break away gap.
This is then projected from the beginning of the second continuation gap.
This helps define the total move, including any exhaustion gaps.

Exhaustion Gaps
I. Today's low must be higher than yesterday's high for rising gaps. For falling
gaps, today's high must be lower than yesterday's low.
2. This is often the last gap in a continuous series of gaps and is characterised
by a decline in volume. Generally it is smaller than the preceding gaps. When
the gap price finishes at about the same level as target price projected by
other analysis methods, then it is most likely to signal the end of the current
price move. Usually the close is below the open. This is often a reversal
signal and traders look for it as an entry signal into the new trend.

118
 8/ Bar Set-Ups

3. Sometimes exhaustion means the trend pauses and then resumes the same
direction, but more slowly. Exhaustion gaps are not stand-alone trading
signals. They tell the trader to use other indicators to confirm if the current
trend has ended, or just paused.

+ CROWD RULES
Most of the time the crowd is relatively orderly. It mills around and moves slowly,
generally in a single direction. These are slow trends, or extended sideways movements.
Most of the time life is not too exciting so the emotions of the crowd mirror our
own, locked into a steady routine.
When extraordinary events happen crowds get restless very quickly. A sudden collapse
of the Australian dollar encourages us to bring forward the purchase of a totally
imported vehicle while old stock is still on the showroom floor. A sudden rise in the
dollar brings us to the Internet quickly to cancel any outstanding book orders with
Amazon.com because the next shipment will be cheaper.
When markets, which are lots of individuals, believe there has been a change in the
way they should evaluate a stock, they often rush into action. This analysis does not
have to be in-depth. It is sometimes as simple as a government announcement,
comments on a breakfast TV show, or the release of new information to the exchange.
These items do not have to move markets. They need only move the market for an
individual stock.
A gap appears when most of the crowd hears the same information at about the same
time, usually overnight. In a rising market sellers lift their selling prices, perhaps by
a few cents, perhaps by a great deal more. Buyers are frantic at the prospect of
missing out. Many just know they should have bought yesterday instead of hanging
back. In this excitement buyers bid higher than what the sellers ask on the order
screens just before the open. The bid is $2.50 and the ask is $2.40.
Trading does not get much better than this-if you are already holding stock. Buyers
chasing stock must decide if this surge in buying is part of a new wave of buying, or
just a bubble of enthusiasm. Only in the last minutes of trade for the day do they decide
if the price action qualifies as a gap day. As in real life, hindsight is always 20/20.
The crowd surges forward, or draws back. We do not need to know the specific
reason why, although for larger stocks this is generally common knowledge through
the news media. In smaller stocks the reasons may be more difficult to pinpoint. For
traders the action itself provides the trading advantage. While avoiding panic, we do
want to run with this crowd because it offers fast-moving opportunities.

119
CHART TRADING

Crowds come in all sizes so sheer numbers, or volume, is not a useful guide to the
importance of a gap. A gap occurs because the crowd milling around a particular
stock believes there has been a major change. If the crowd numbers in the thousands,
such as W estpac traders and investors, then the result is a gap in price activity on the
chart. There is a region where no trades take place. If the crowd is small, perhaps just
a few hundred gathered to celebrate the success of Biota, then the impact is the same
for that market. Price shoots up, leaving a gap on the chart. Later, when they hear
the new drug has failed to gain approval from the US, they gather again to dump the
stock. In both cases the action of the crowd with an interest in the stock is shown by
a price gap on the chart.

• USING GAPS
Gaps are useful tools in certain situations. They are not a useful guide to trading
opportunities when they are created by low and erratic trading volume. Hillcrest
Resources is a small and
struggling miner at a
Fig. 8.1 Insignificant gaps time when gold is
0.045
reaching 20-year lows.
0.040 Although good profits
around 60% are
0.035 available in price moves
from $0.025 to $0.04
0.030 the volume of trading is
low and slow. The
0.025 result is the chart
---~- ___________
~·----~"P""""'""""'~~ --~--.e-a
display shown in Figure
r:rn 8.1. These price gaps
HLL
are unimportant. The
20000
Hillcrest Resources 15000
market doesn't care
10000 about this stock.
·'·' .1.1 • Daily bar chart 5000
11 1 Price charts dominated
1.. , • .•. I x100
by this type of spotted
gap activity are not
candidates for gap
trading and are avoided by traders wanting to apply gap trading techniques.
Congestion gaps develop when a stock is locked into a long-term trading pattern.
Schroders Property Fund (SCH), presented in Figure 8.2 opposite, spent six months

120
 8/ Bar Set-Ups

trapped in a trading band between $2.35 and $2.50. About once a month prices
gapped up or down, usually by around 2¢. This activity provides no clues to trading
opportunity. It takes place within the confines of a steady consolidation, or sideways,
price pattern. When a stock gaps away from the upper resistance level or the lower
support base, then we take notice.

Fig. 8.2 Congestion gaps Gaps are shown with arrows

2.55

2.50

2.45

2.40

SCH
2.35
Schroders Property Fund
Daily bar chart
3907

1954

0
(000] Feb99 Apr99 Ma}l99 Jun99 Jul99

The break away gap is a clear change in the valuation of the stock. WA Newspapers
(WAN) shows a 10¢ opening gap in Figure 8.3 overleaf. Traders interested in WAN
because of the breakout past the short-term down trend line use the gap as a bullish
confirmation signal. This stock is going places. The trading volume is higher than
previous days, and higher than average. Traders are confident this rally is likely to
continue and are prepared to buy WAN at $5.30. The size of the gap and the increase
in volume are all bullish indications of a break away gap.

121
CHART TRADING

Many traders are frightened by

Fig. 8.3 Break away gap gaps. Mter extensive end of day
5.80 analysis they are prepared to pay
up to $5.16 for WAN, so when
it opens at $5.26 they think they
5.70 {1m have missed the boat. Break
away gaps are a positive trading
signal confirming strength in the
5.60 new rally, or trend.
When these are combined with
5.50 a continuation or runaway gap
on the next day, or series of days,
Short-term then the outlook is very bullish.
5.40 down trend These gap days are characteristic
of volatile stocks like News Corp

5.30 j (NCP) shown in Figure 8.4

opposite. They are generally
associated with mid cap and
~ speculative stocks. The key
5.20 Gap of $0.10
trading message is the way the
rJ crowd keeps bidding higher in a
desperate attempt to get hold of
1695 WAN stock.
W A Newspapers volume These trends are strong while the
848 Daily bar chart
i crowd is able to close the day
above the open, and at or near
the highs for the day. The first
0 warning sign of a weakening
(000) Feb99 rally is a close below the open.
As NCP shows, this does not
mean the next day will not also
gap above, but it does suggest
the rally is not as strong. There are still people prepared to pay high prices but the
crowd of willing buyers is getting smaller.
The NCP rally fails on the next day. Traders heeding the first sign of rally weakness
were well prepared to sell around $13.50. When trading gaps we rely on momentum
and this is particularly true in today's markets where many traders focus on short-
term trends.

122
 8/ Bar Set-Ups

Exhaustion gaps appear at the end

of a trend or rally. They do not have Fig. 8.4 Continuation gaps
to be part of a series of gaps. They Rally failure
indicate a last burst of crowd 13.50 confirmed
enthusiasm as more experienced by lower
traders sell to less experienced close
buyers. The National Foods (NFD)
chart, Figure 8.5 overleaf, shows this 13.00
gap appearing at the end of a sharp
rally. The key confirming indicator
is the extremely low volume when
compared to the previous few days. 12.50
Only a few people are prepared to
chase prices and although we don't
want to call them fools, it is clear
they are just a small, eager section 12.00
of the crowd. This price rise does I

L-- =~~away
not enjoy strong support.
These exhaustion gaps are not stand- 11.50
alone signals. Sometimes, as with J-..r

1
NFD, they do signal a trend reversal.
At other times, they show a slowing NCP
of the trend. In such cases the market 11.00
News Corp
pauses for a while before resuming
the trend. We tell the difference by Daily bar chart
applying other trend analysis tools, 10407
such as the straight edge trend line.
Exhaustion gaps are most easily 5708
identified in retrospect and this makes
them an imprecise trading tool.
1010
(000] Jun98 .Jul98
• COVERED GAPS

Edwards and Magee completed the

first comprehensive study of gaps and they believed every gap was eventually 'covered.'
Some still hold dear the belief that the gap must be covered or closed as if this is
some immutable law of the universe or the market. A gap appears on a screen display
when price bars are separated vertically. A gap is covered when some future price
action fills in the blank space. The new price bar covers the vertical gap in prices.

123
CHART TRADING

This is shown in Figure 8.5. Certainly gaps are frequently filled, but such action is
more likely to be coincidental with the activity of the market, rather than an inevitable
relationship. Some gaps are filled within a few days, others take weeks, while others
take many years. Strong rising stocks like National Australia Bank have many unfilled
gaps. Some of these gaps are unlikely to be filled unless we experience a major market
downturn of crisis proportions.
Traders need to distinguish between statements about the market which are useful,
and which improve trading, and those which are general or rely too heavily on
coincidental relationships. In all probability the gap will be filled, but this is not
tradeable information.

Fig. 8.5 Exhaustion gaps

3.20

3.10

3.00

2.90

2.80

2.70

3891
Very low
1946 volume

0
(000) May98

124
 8/ Bar Set-Ups

SUMMARY • GAPS
A gap occurs when today's open is higher than yesterday's high, or when the open is
lower than yesterday's low. An up side gap-higher open-tells us buyers are
impatient. They want this stock and they will bid ahead of the market, sometimes by
considerable amounts. The larger the gap, the stronger the buying pressure. Gap
opens provide good buying signals, but only if you jump on board quickly. Gaps are
only significant in stocks with steady volume. Gaps in low volume stocks are
unimportant because they are caused by lack ofliquidity, not by an excess of enthusiasm
or pessimism.

.. .. .. .. ..
• INSIDE DAYS
Many set-up patterns rely on discrepancies in the range of today's price activity
compared to a previous day. Range is the difference between the low and the high
for the day. While gaps and trends show us the way prices move in a single direction
below or above the previous day, the inside day is a pause before action.
Every day prices range between the very low for the day and the absolute high of the
day. This range is also defined as volatility and later in the section on Crowd M07Jement
we will look at the way we can use indicators to measure this. Changes in volatility
are also tracked just by looking at the chart. When the range narrows the volatility
decreases. When the range expands, volatility expands because at any time during the
day prices could be anywhere between the two wide extremes.
When the price range narrows it is like a compressed spring, ready to explode into
action. We see this in all the triangle patterns, where decreasing range increases the
probability of a significant market move. By comparing just two bars, the current
and the previous day's, traders also identify increasing probability.
With an inside day all the price action takes place within the extremes established by
the day before. In exceptional circumstances this pattern may repeat several days,
building a very sharp equilateral triangle, but with very different results than those
delivered by the long-term equilateral triangle. The sudden decrease in volatility is
the lull before the storm. In most cases the trader has already taken a position consistent
with the direction of the expected trend. When the storm breaks it is most likely to
continue the trend, but at increased speed. The inside day is a short-term trading
pattern.

125
CHART TRADING

An outside day has extremes below and above the extremes of the previous day. They
are not particularly useful indicators of immediate market reaction and are usually
considered in the wider context of the trend.

+RULES
1. This is a two-day pattern, but sometimes extends for up to four days. It
occurs anywhere, at the top and bottom of trends, or in mid-trend.
2. Today's high must be lower than yesterday's high. Today's low must be
higher than yesterday's low. This plots a bar smaller than the previous day's
bar, and positioned inside the extremes of yesterday's bar.
3. If one of today's price extremes is equal to yesterday's, the pattern is not an
inside day.

+ CROWD RULES
This is the crowd in action on an intimate level. Yesterday people chased this stock,
but today there is an air of expectation in the market. Inside days commonly form
ahead of major news announcements, such as profit releases, drill reports, or other
news significant for the company. Ahead of this news, nobody wants to take a chance
either way. People who hold the stock already don't want to sell in case the news is
very, very good. Potential buyers begin to doubt the certainty of the previous day.
Perhaps the news will not be as good but, like runners poised on the starting block,
they are ready to explode into action when given the signal.
The inside day shows the crowd taking a collective, deep calming breath in preparation
for an explosive reaction to an expected news event. When news is released it is
assessed instantaneously, and the market is off. Unlike the runner who can only go in
a single direction, this crowd has a choice. It can chase price very quickly, or sell off
with horrifying speed.
Traders using this pattern as a trading signal also keep an eye on the depth of market
and the order line. By defmition, the inside day is an end of day pattern. It is the day
after the inside day that delivers on the promise of explosive action. The news event
is often released prior to the opening of trading, and good traders with open positions
watch the order lines carefully. The balance of buying and selling is usually weighted
one way. They join the side with the largest numbers because this sets the direction
of the day's action.

126
 8/ Bar Set-Ups

The inside day shows a crowd

poised for action, and like any
Fig. 8.6 Inside days
race, those with the fastest
reflexes-or brokerage order
systems-win. Proposed entry on pullback to
1.00
30-day moving average

• USING INSIDE DAYS

1.90
These signals are of more
practical use once an entry
1.80
decision has been made based on
other factors. Although not
common, inside days do appear 1.70
relatively frequently. Search any
chart and a few inside days are
bound to occur. They are most 1.60
useful when they turn up on the Inside
day you have already decided to day
buy the stock. Oil Search (OSH) 1.50
in Figure 8.6 attracts our
attention because of the change
1.40
in trend direction indicated by
the moving average crossover, moving average
discussed further in Chapter 9. 3675 OSH
Rather than chase prices, we are
Oil Search
prepared to wait for price to 4337 Daily bar
move back towards the value of
the 30-day moving average.
0
Price does this and the next day (000)
is an inside day. This acts as a
warning. Aggressive traders buy
just on the close of the trading day, picking up OSH at $1.56. The conservative
trader waits until the next day for the market to confirm the direction of the price
move. His actual entry point is around $1.61.
The trading decision is based on the moving average crossover. It relies on a pullback
to the 30-day moving average to signal a better entry point for the trade. An inside
day suggests a market preparing for a larger move so the trader adds this information
as confirmation of a trading decision already reached.

127
CHART TRADING

SUMMARY • INSIDE DAYS

Inside days form when today's price action falls within the high and low set by the
previous day's price action. They show a market waiting for a market-moving news
event or announcement. Not everyone may be aware of this, but a significant group
of traders do know. Inside days provide important clues to the potential for future
price action for every other trader or investor.
Inside days are most significant in the stocks where they occur infrequently. Stocks
which are traded frequently usually show a wide difference between the high and
low for the day, and individual bars peak above or below the previous day's activity-
here, inside days are unusual and this attracts our attention.
Stocks with low trading volumes often show inside days but these are not important.
They just reflect a thin market, usually in speculative stocks.

• HEAD AND SHOULDERS

The head and shoulders chart pattern is a distinctive reversal pattern. When it forms
it usually signals the top of the current trend and the start of a down move. The
height of the pattern is used to project a downwards target. Like many chart patterns,
the trader either acts in anticipation of the pattern completion, or waits until the
pattern is confirmed, or fully developed, before taking any action.
The head and shoulders pattern is both one of the most useful, and the most useless
of chart set-ups. It is useful because it provides an accurate way to project future
price action, and to set down side price targets. It is a major reversal pattern, suggesting
the current trend has finished and a new trend is about to start.
I fmd it is one of the most useless chart set-ups because it is most easily seen in
retrospect. It is a very difficult set-up to identify as it develops, or even towards the
very end of the pattern. It is also a very subjective pattern. While triangles, gaps,
inside days and other chart patterns are very well defined and quite clear-cut, the
head and shoulders is definitely subjective.
One man's head is another's shoulder. Some shoulders have bumps that look like
heads, but which later prove to be unimportant. Drawing the neckline is an
approximation in real time. There is a narrow boundary between sheer skilled artistry
and guesswork, and not all traders are able to tell the difference.

128
 8/ Bar Set-Ups

Despite this, and unfortunately, the head and shoulders is often one of the primary
patterns discussed by analysts and the media. It sounds exotic and fits the mystique
of charting. I prefer to banish mystique and replace it with sound analysis combining
the strengths and weakness of each method to build a better trading result.
Head and shoulders patterns are most useful for measuring the extent of the trend
reversal. Used this way it does
not matter if the pattern is Fig. 8.7 Head and shoulders This rally should
already completed-unless of not break the
Head
course we are still holding
shares we should have sold. 7.00 3
By setting potential targets the
trader and investor are able to 6.75
decide the best entry points,
or choose probable exit
targets to maximise profits. 6.50

Traders with open positions- 6.25

those who already hold stock-
use the head and shoulders as
a last resort. By the time the 6.00
right-hand shoulder forms,
other chart signals-such as 5.75
trend line breaks-or other
indicators-such as moving
5.50
averages-will have already
sounded a warning. The head
and shoulders is a confirming 5.25
indicator, a last warning before
the fall. 5.00 Leighton Holdings
Daily bar chart
4519 Volume Volume
+RULES
In using these rules, remember 2259
the head and shoulders pattern
develops slowly. It may take 0
weeks or months to emerge. (000) .98
The Leighton Holdings
example in Figure 8. 7 takes
nearly five months.

129
CHART TRADING

1. Head and shoulders patterns develop in well established trends and signal a
change in trend direction. The pattern develops at the end of a rising trend.
2. A retreat from the first peak-the left shoulder-is a minor change in the
direction of the trend. This is consistent for at least four or five days, but
sometimes extends for longer. This establishes the first shoulder pivot point
low. From this low, the trend changes direction again in a sustained rally.
3. Prices rally from the first pivot point low and reach new highs-the head.
Sometimes this will be a blow-off high where prices surge rapidly on large
volume, but then close near the lows for the day. The rise to the head takes
at least five days, and often two or three trading weeks. It is this combined
action, the trend rise, retreat, then resumption of the trend that forms the
left-hand side of the head.
4. Prices retreat from the head and dip towards the level of the first pivot point
low established by the retreat from the first shoulder. This takes around five
days or more. This establishes the 'neckline'.
5. Prices make a second pivot point low before rallying again. This rally fails to rise
as high as the high created by the head. Mter at least a few days, and sometimes
longer, the rally collapses. This rally and decline form the right-hand shoulder.
6. To confirm a head and shoulders pattern there are three conditions relating
to the neckline:
(a) We need a close below the neckline. The neckline is plotted by drawing
a line under the two pivot point lows that form the low points of the
shoulders.
(b) The volume traded usually decreases as the right-hand shoulder is formed.
The volume in this period is lower than the volume in the first and
second stages. Once there is a close below the neckline, the volume tends
to increase as the new trend gathers momentum. This relationship is not
always present because prices tend to fall more easily than they rise.
(c) Any rally in this new down trend after the first close below the neckline
must fail before it reaches the neckline. The neckline acts as a resistance
level. If it does not, then it is more likely this potential head and
shoulders pattern is just a prelude to a prolonged sideways movement.
7. The distance from the top of the head to the neckline is measured. It is projected
downwards from the point where the right-hand shoulder crosses the neckline.
This gives a potential target for the price collapse. When prices reach this level,
the trader watches for evidence of a trend continuation, or a trend reversal.

130
 8/ Bar Set-Ups

8. The same rules are used in establishing a head and shoulders pattern at the
bottom of a down trend. The pivot point lows become pivot point highs as
shown with News Corp in Figure 8.8 below. The head dips below the
shoulders to make a new low. Price targets are projected in the same way,
but upwards instead of downwards.
The main difference is in volume. As the right-hand shoulder forms there is
an increase in volume, and this continues once the neckline is broken. This is
very important because it takes committed buyers to push these prices up
and we need this commitment to reverse a down trend.

Fig. 8.8 Inverted head and shoulders

Price projection
14.00

13.00

12.00

1100

10.00

NCP
9.00 News Corp
Daily bar chart

33065 Head

16533

0
[000]

131
CHART TRADING

+ CROWD RULES
The peak of the left-hand shoulder is formed in the first rush of excitement. Skilled
or lucky traders get in early, and as others join, the market runs up. Imagine you got
in early and are sitting on good profits. You mention this to your friends, and although
it is not investment advice, they decide to join the party.
This initial up trend is driven by experienced traders and investors and they are also
the very people who decide to bail out when the market runs up to an almost
unbelievable peak. They start selling to lock in full or partial profits. Potential investors
are frightened by the high prices, and put off committing to the market. Your friends
decide to wait to see if the market pulls back. These reactions are repeated
independently by individuals across the nation. This is what builds the market
psychology.
When prices do fall back, they create the first point of the neckline. On this retreat
your friends decide it is time to start buying, and they begin to chase the price up. As
the rally gains pace your friend tells his friends how well he is doing in the market.
They know less about the market so they tend to like buying stocks that are going
up. This rally forms one side of the head in this head and shoulder pattern.
It is capped by both stratospheric high valuations and by experienced traders taking
profit. Even these relative newcomers aren't fools so there is a limit to how much
they are prepared to pay. People start to shy away from the high prices, and sellers,
keen to lock in a profit, start to chase the buyers by lowering their prices.
Consider the right-hand shoulder and the way this is created by your friends. Some
of them have never been in the market before and they are annoyed they didn't take
your advice. They watched prices pull back and then, in disbelief, watched as the
market took off again. Determined not to miss out and eager for a bargain, they start
buying as prices move towards the old lows.
Lots of people thinking the same way tend to act in the same way. This shows up as
a repeated market pattern reflecting the crowd psychology. This last gasp rally gives
slower traders an opportunity to unload their stocks at better-than-expected prices,
but the supply of inexperienced buyers is limited. This second rally, forming the
right-hand shoulder, has limited potential.

• USING HEAD AND SHOULDERS

This is a subjective pattern, and Leighton Holdings (LEI) shown in Figure 8.7 on
page 129 illustrates some of the problems. The pattern is not confirmed until the

132
 8/ Bar Set-Ups

right-hand shoulder is formed and this involves a close below the neckline. For traders
with open positions in LEI this signal sacrifices a lot of potential profit. Other methods,
such as the count back line discussed in Chapter 18, would signal an exit at $6.84
rather than around $6.30.
The head and shoulders pattern is more useful as a tool for projecting down side
targets. This uses the distance between the head and the neckline to set a down side
price projection, in this case around $5.30. When prices reach these levels the trader
is alert for new up trends. The accuracy of these down side projections depends upon
the accurate placement of the neckline.
Line A is the best fit because it captures the end of the left-hand shoulder and the
low point that begins the formation of the right-hand shoulder. Necklines are defined
by the base of the neck, not by the base of the shoulder. Line B is incorrectly placed
because it uses the base of the shoulder rather than the neck.
Just which peak is the real left-hand shoulder? The trader has a choice of peak 1 or
peak 2. His selection determines the placement of the neckline, and subsequently the
down side price projection. We use peak 1 because it is the first peak in this head and
shoulders formation. Other traders will use peak 2 because it is the most recent peak
before the development of the head.
Some readers might suggest peak 3 is the left-hand shoulder because it is the closest
peak and retreat to the fmal development of the head. This might be used as a tentative
shoulder, but the development of the right-hand shoulder at lower levels invalidates
this. Necklines are horizontal, or generally slope upwards from left to right. Using
peak 3 as a shoulder gives a sharp down sloping neckline.
To conform with all the rules of head and shoulder construction, the last rally after
the formation of the right-hand shoulder should not close above the neckline. In this
example it does. The trader must decide if this break in the rules is sufficient to
exclude LEI from head and shoulder analysis. In the market few stocks are perfect
examples. Most resemble LEI-showing a close, but not perfect, relationship with
the rules. Trading reality comes with warts and blemishes unknown to the carefully
chosen examples selected for many trading books.
This is one of the most subjective patterns in chart analysis, although Figure 8. 9
overleaf shows an almost perfect example. The selection of the shoulder is subjective.
The placement of the neckline is subjective. It is too easy to use an historical chart
and justify almost any price projection and target. I find this pattern is most often
based on hope and imagination rather than on clear, repeatable events.

133
CHART TRADING

Fig. 8.9 Developing head and shoulders Head

30.00 Right
shoulder

27.50

25.00

22.50
Price projection

20.00
Rio Tinto
Daily bar chart
17.50
9300--~--------------~--------------------

4650

0
(000)

SUMMARY • HEAD AND SHOULDERS AND ROUNDING TOPS

This popular chart pattern helps to give technical analysis a bad name. First, it is easy
to see head and shoulders almost anywhere. Real head and shoulders patterns are
very clear on historical charts after the event. They are not so clear as events unfold
because the recognition is too subjective.
Because of this retrospective clarity some people try to use the developing pattern as
a predictive reversal indicator. This creates many problems. The pattern, when
completed, is very useful for establishing limits to the price collapse and this is the
best way to use it.

134
 8/ Bar Set-Ups

This pattern is created by a series of rallies. An up trend stock often proceeds with
one rally following another, each separated by a retracement. Each new rally offers
the potential to form a head. This cannot be confirmed until it is followed by a rally
that fails to rise above the previous rally. The same applies in a down trend stock
with an inverted head and shoulders pattern. Both are strong trend reversal signals.
A close cousin to this pattern is the rounding top, and price projection targets are
also set with this pattern. A rounding top is defined by a series of lower highs at the
top of a trend. The Normandy Mining chart in Figure 8.10 overleaf shows a rounding
top and the down side price projections. This is a long-term distribution pattern
caused by stockholders selling into the market. The market is weaker, and does not
absorb the selling, so prices try to make new highs, but are unsuccessful.
The rounding top sometimes looks like a head and shoulders pattern, but the difference
is in the way the lows cluster around a single level every time the price retreats. This
creates a quite definite support level. Prices consistently test this level, but when they
bounce up they do not create new highs. The collapse of a rounding top is sometimes
quite sudden so traders try to sell into any rallies once the pattern has been confirmed.

135
w
,...
a"\
- ::c
,.
;Ia
Fig. 8.10 Rounding top
Price action here is best described with
....
an arc, rather than straight lines
....
;Ia
,.
c
.]1 j~t z
1.50 Ci)

1f). •1,1
140 -1\ r ,y-,] .l ~~,J\~,~~ IJ\
1.30 ~~~~ .I Base .

1.20 ~ \ll
1.10 J
v\ .!'I Price projection l~
1.00

37780

18890

0
(000) Mav99 JL
 CROWD
MOVEMENT_
Chapter 9

AVERAGE PERFORMANCE

Here we sail into deeper water, leaving behind the world defined solely by the lines
on charts. The screen displays look the same, and are still referred to as charts, but
they are really close relatives to graphs. These are the charts used by the explorers to
fill in the blank bits on the treasure map. Their technical indicators form the basis of
technical analysis as distinct from the chartists and their chart reading.
We stay with nautical charts for a moment. In the shallow, shoal scarred deltas of
Australia's north, powerful rivers gouge channels through the mud flats. At high tide
the water beckons with good fishing but as the tide drops the unwary are trapped on
the mud banks along with basking crocodiles. The charts show these features and
leave it to the fishermen to decide how best to use them.
The better fishermen understand how the predatory barramundi hang along the
channel edges waiting for a feed as the tide changes. They know the mangrove jacks
cruise the edges of the draining swamps on the falling tide, feasting on the small fish
heading for deeper water. These fishermen watch for the turn of the tide and position
themselves over the deep holes where the jewfish spend their time.
None of this information is provided directly by the chart, but all of it is inferred
from the chart display. By using what we do know about the seascape and the
behaviour of fish we make informed decisions about events we do not know about
directly, but which we suspect. When the tide changes the current in the single channel
through the mud flats will really race. We suspect this, and look for the tidal action
to confirm our suspicions.

139
CHART TRADING

Or we tackle the problem from the other end. Armed with tide charts showing a 2.5
metre fall between the high and the low we know to expect fast currents where the
tidal river narrows across the rocky bars. Few fishermen would call these processes
technical analysis but they are no different from the way we combine price and
chart information.
Technical analysts use price information to make inferences about the behaviour of
prices and the attitudes of the crowd. These changing emotional states are graphed
-or charted-with a series of lines telling us something about price, but these lines
are not actual prices themselves. A moving average of price shows us the average
value on any day and rarely does it show the actual closing price on the day. A more
complicated indicator, the Relative Strength Index, displays a value not directly
related to price on the day-but it does tell us if the price is reasonable compared to
past prices.
Technical analysis is as simple, or as complicated, as you wish to make it. We start
with the simplest of approaches which concentrates on understanding the movement
of the crowd. Later we look at more complex inferences about crowd thinking and
analysis. This first step is just a small shuffle away from the world of the chartist,
but as soon as we start dealing with calculated numbers and a graphical display of
the results we touch the edges of a new world. And there is treasure here as well.
To explore the new world you do need a computer and charting software such as
Guppy Traders Essential charting pak or Ezy Chart. To explore it in much greater
detail you turn to Metastock, SuperCharts and their competitors. To go where no
man has gone before requires more powerful packages like TradeStation. Of course,
you could always take a short cut guided tour using a black-box style trading system
which promises to do all the work for you. These tend to be very expensive to buy
and to run. Some of the suppliers of such systems end up in receivership, having
spent all your money without delivering on their promises. We step into a world of
chaos-so better to control what we can with a charting package than to surrender
decision-making to others .

• WORKING WITH A SINGLE MOVING AVERAGE

Simple Moving Average

We rub shoulders with this new world beyond charting by starting with just a single
moving average of prices. A moving average tells the trader where today's prices
are in relation to prices, on average, in the past. This gives us a way to decide if a
stock is cheap or expensive compared to its average price. It smooths out the price
fluctuations and reveals the general direction of price increases or price falls.

140
 9/ Average Performance

These averages can be calculated by hand, or on a spreadsheet, but most charting

software does this automatically. It is a relief to forget the mathematics and just
concentrate on the results, but this also provides a trap for the unwary.
There are three main ways to calculate an average price. If we have three closing prices,
106, 109, 104, then the simple average of these is the total, 319, divided by three. This
gives an average closing price of 106.3. This simple average calculation gives a good
answer to our question about the position of today's prices compared with the past
average, but if we want a 100-day moving average, the answer may not be as useful.

Exponential Moving Average

Perhaps in the last 100 days prices did stay around 106 to 109. What happens if on
just one day there was a price spike to 180? This very high close distorts the average
price because a simple moving average calculation 'counts' this day at full value for
the entire 100 days. It is like a cartoon snake swallowing a rabbit. This big bulge
travels from the mouth to the tail, and never gets any smaller.
Some traders say this is not how the market works. They believe today's price is
more significant than the price of 10 days ago, or 50, or 90 days ago. They use an
exponential moving average.
A 10-day exponential moving average calculation applies a percentage of today's
closing price to yesterday's moving average value. The objective is to give more
weight to the recent price action and less weight to the oldest price action.

Weighted Moving Average and Others

The third common calculation method is the weighted moving average which
multiplies each of the previous days' data by a weight. A 10-day weighted moving
average gives 10 times more weight to the most recent price than to the price 10 days
ago. A triangular moving average assigns more weight to the middle third of the
data series. In a nine-day triangular moving average the middle three days are
considered the most important.

Traders have a choice of several other methods for calculating moving averages, and
each of them is designed to reflect a particular view of the way the market behaves.
Sometimes the difference between a simple moving average and an exponential moving
average, or some other form of calculation, is not very large. Sometimes it is very
significant, particularly when we use two moving averages.

141
CHART TRADING

Despite appearances, this is not just playing with numbers. Later, when we combine
two moving averages as shown on page 147, we compare the delays in the trading
signals. Traders calculate these differences in dollars of lost profit. Eventually you
need to decide which calculation method gives the best results for your trading
approach. I prefer an exponential moving average based on the close.
No matter how you decide to calculate the moving average, we all use it in the same
way. The moving average helps us to decide the average direction of price movements.
The moving average gives the trader confidence to buy the price dips because he has
a good way to decide if the up trend is strong and the weakness just temporary.
The moving average also gives the trader a way to get out of the stock. If the average
line turns down it suggests the trend is weakening, and that prices might fall much
lower. If today's price is a long way below a moving average that is also turning
down, then the trader could watch his profits disappear if he holds onto the stock. In
this case the simple average gives a sell signal. The longer the calculation period for
the simple average, say 100 days, the more reliable itis in correctly signalling the end
of the trend. Unfortunately, by the time you are sure of the trend change you have
also lost much of the profit in the trade. The shorter the calculation period, say three
days, the less reliable it is. The three-day average moves up and down, often giving
buy and sell signals very close together. However, when it is correct you get to keep
most of your profit.
Traders use moving averages in contradictory ways. First they use them to smooth
out the random, unimportant and insignificant price changes that do not alter the
direction of the trend. Later they combine two moving averages of different lengths
and look for crossover signals to time an entry or an exit. This introduces a problem
of 'lag' where the signals lag behind the time of the actual trend change. There is a
constant search to find the combination that smooths price action, but which catches
a change quickly enough to reduce the lag. We look at some interesting and innovative
solutions in later sections.

+RULES
1. Select the moving average calculation style that matches your view of the
market.
2. Long-term moving averages are more reliable, but the signals lag behind the
market too much for trading.
3. Short-term moving averages fluctuate more, but lag the market less and so
provide useful trading signals.

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 9/ Average Performance

4. The single moving average tells us if today's price is cheaper or more

expensive than it has been in the past, on average.
5. In a rising trend, shown by a rising average, a cheaper entry is made when
prices dip below the average. Once prices close above the moving average
line, use the value of the line as a stop loss.
6. In a falling trend, shown by a falling average line, a better exit is made when
prices spike above the average line.
7. When the moving average flattens out, the market has stopped trending. This
is often a good exit point after a rally, although traders should use other
tools to determine if the pause is temporary, prior to another rally, or fatal,
prior to a new falling trend.

+ CROWD RULES
The single moving average moves in whatever time frame the user selects-whether
that be 10, 20, 35, 40 or 100 days. Each calculation point is a snapshot of a crowd in
action, but combined they show the crowd in movement and often the direction they
are headed.
Every crowd is a complex mix of bravado and fear, or agitated leadership and milling
followers. While the police try to identify the ringleaders in cricket crowds and political
demonstrations, we are more interested in the smart organisers. They propel others
forward, or sound the retreat. In our market this is the smart money. As we noted
earlier, the smart money is most active on the close, so we use the close in all our
moving average calculations.
Some traders choose to follow the crowd leaders-the bulls, or highs, in a rising
trend, and the bears in a falling trend. They use a moving average of the high, or the
low, to track this section of the crowd.
Which group you decide to track is a personal choice, but in all cases we look for the
direction of crowd movement. Inevitably we also look for an indication of the strength
of the movement, a measure of the determination and commitment of the crowd.
The single moving average gives us two clues. Other indicators, discussed later, give
better information.
The first clue about the movement of the crowd is the steepness and persistence of
the moving average slope. It is difficult to put an exact figure or value on which
slope constitutes gentle, or steep, or slumbering, but traders find it easy to make
these judgements looking at a chart. Although I generally suggest a 45° slope is

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CHART TRADING

gentle, and a 30° line is described as slumbering, these are broad figures. The gentle
slope does not exclude trends with 47° or 40° slopes.
On a gentle, sustained upward slope, or trend, the crowd gathers around the centre
line. This is a mature crowd which knows where it wants to go, and is content to
travel at a reasonable pace. They know their destination and they believe nothing is
going to stand in their way or rob them of future profits. Like a crowd lined up for
a football match, they are calm and relatively ordered-knowing the gates will not
close early, seats will be available, and although the match might have started, there
are still three quarters left to play.
We could draw a line through the middle of this crowded column of people waiting
to pass the turnstile. Many people would stand on the line in the middle, and others
are only a few paces away. This crowd dusters close to this single moving average.
Crowds are always potentially dangerous, and this one will ignite into mayhem if the
gates close early. This constitutes a market rally, a mad scramble to get the last seats
at a reasonable price. Fail here, and we pay scalper's prices. People move away from
the centre line, widening the gap. In this mad scramble, we calculate the average
position of people in the new queue every few minutes. By the time we finish each
calculation, the crowd has changed position again.
This second clue about the movement of the crowd lies in the distance between the
moving average and the current price. When prices cluster consistently above and beyond
the moving average the crowd is excited. The rally feeds on the excitement, jumping and
leaping ahead of yesterday's average consensus of opinion about the value of this stock.
The gap increases and the steepness of the moving average slope also increases. The
single moving average of the crowd's position moves sharply. This widening gap and
steep slope tell us the crowd is working itself into a frenzy, and this sounds a warning.
Excited crowds yelling at the top of their lungs for tickets, pushing and shoving to
get to the front of the pack, cannot keep it up for long. Extreme rallies always slow
down, pulling back to the line of average value. The relationship between today's
price and the average tells us how quickly this crowd is moving, and we infer from
this the probability of the crowd weakening. Selling into this exhilarated strength
locks in good profits. Buying ties up capital in declining positions as the crowd
comes back to its senses. Some football fans are just not that dedicated, and refuse to
pay the scalper's price. They leave the stadium gates, or in our case, the market.
The single moving average captures the movement of the crowd in a series of snapshots.
Traders get a more accurate fix using two moving averages, and we look at these
later in the chapter.

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 9/ Average Performance

• USING A SINGLE MOVING AVERAGE

The National Australia Bank (NAB) chart in Figure 9.1 below highlights the difficulties
in using just a single moving average. We show two for comparison purposes. In
retrospect, both moving average lines do give a clear indication of the trend. They
turn up on the left-hand side of the chart, and down on the right-hand side. Using
this information in real time is much more difficult.

Fig. 9.1 Moving average trading signals 31.0

30.5
30.0
29.5
Difficult to decide which dip below the moving
average is really the beginning of the trend change
29.0
28.5
28.0
27.5
27.0
26.5
26.0
25.5
25.0
24.5
The moving average line turns
24.0
down. Is this an exit signal?
23.5
A close below the moving average 23.0
line. Is this an exit signal? 22.5
22.0
21.5
21.0
20.5
.....___ _ _ _ 10-day simple moving average
20.0
NAB 19.5
National Australia Bank 19.0
Daily bar chart 18.5

In this example, the entry signal is clear. The 10-day moving average turns up in
October very soon after the NAB price jumps from $19.00 to $20.00. The trader buys
as prices pull back to $19.50. The lag between the market turn and the entry signal is
just a few days.

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CHART TRADING

If we relied on a longer 60-day moving average to signal an entry then the upturn
does not happen until December. Enter here at around $23.00 and we miss a lot of
profit from this solid up trend.
The real problems start in December when the NAB price closes below the value of
the moving average. Rule 5 tells us that once we have made an entry we use the
moving average line as a stop loss level. A close below this line signals an exit. At the
very time when the 10-day moving average suggests an exit, the longer-term moving
average is signalling an entry.
Rule 6 calls for an exit when the moving average line turns down. This happens in
January. By this time the trader has collected two exit signals. Acting on either one
of them takes him out of a trend when it still has a long way to go. These are false
signals. We only know this days or weeks after the event. Using just a single moving
average, we do not have any other way to verify the reliability of the signal.
The significant price dip in February looks dangerous, but the trend recovers. The dip
in April looks no different from the dip in February, so the trader ignores it. By the time
prices take him down to $26.00 he realises he should have acted on the April sell signal.
This is the major shortcoming of a single moving average. We cannot tell at the time
which price moves are significant and signal the end of the trend, and which are just part
of a developing trend. Many traders use the crossover of two moving averages as a solution.

SUMMARY • MOVING AVERAGE CALCULATIONS

A single price tells us nothing until it is compared with other prices. Moving averages
compare prices over a period established by the trader. Averages are a little like a
trend line, but instead of a straight line joining the highs or lows, the line joins price
points calculated by the software. Moving averages are lagging indicators. They are
not very useful for projecting price action into the future. By providing a context for
price action, moving averages allow the trader to assess the most recent price action
against a different time frame.
To calculate a simple moving average, add the closing price for the selected number
of periods, for example five, and divide the result by five. Each day has equal weight
in the calculation.
An exponential moving average is calculated by applying a percentage of today's closing
price to yesterday's moving average value. Most programs display the percentage value
automatically once the moving average period is chosen. The percentage applied to
yesterday's moving average value depends on the length of the moving average selected.

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 9/ Average Performance

The weighted moving average calculates a weighting for each day in the data series.
In a five-day series today's price has five times more weight than the data from five
days ago. This is similar to the exponential moving average.
The variable moving average is an exponential moving average but the smoothing
factor depends on the volatility of the market. The aim is to adjust the sensitivity of
the moving average so it does not give misleading signals in volatile markets.
A triangular moving average shifts most weight in the calculation to the middle
portions of the data series. It is really a double smoothed moving average, as is the
same process used in stochastic calculations for %D.
The volume adjusted moving average uses changes in volume to modify the variable
weighting used in the moving average calculation. The day with the most volume
gets the highest weighting.
A moving average is plotted by connecting calculated price points. How these price
points are calculated affects the placement of the line. Different calculation methods
are a response to the different significance placed on the most recent price action.
The calculation uses today's price and the average price of a predetermined period.
Today's price is modified in accordance with the construction rules used for the
predetermined period. This gives a new point on the plotted moving average line.
The significance the trader attaches to recent price action should be reflected in the
method used to calculate the moving average.
Moving averages compare prices over a period established by the trader. The trader
compares the relationship ofprice today with the average of price for another period.
The longer the period, the more reliable, on average, the relationship. Conversely,
the longer the period, the less useful are the trading signals. Using a selected range of
moving averages is one way to overcome this problem. Crossover strategies are used
to increase the timeliness of signals while confirming the general trend.

+ + + + +

• WORKING WITH TWO MOVING AVERAGES

When early navigators used a chart they had no choice but to verify their position by
a single sighting on the pole star. Using a staff, they computed their movement in a
single dimension and frequently got themselves lost. This is a disadvantage of a
single moving average.

147
CHART TRADING

Navigation became a precise skill with the invention of reliable clocks, or chronometers,
because now the star sight was matched with another dimension-time. This allowed
the navigator to calculate both longitude and latitude and the position of the ship in
two dimensions. Now movement was plotted accurately and a charted course was
more than just a sail and a prayer.
Two moving averages provide similar precision in the market. The margin for error
is not eliminated, but is more easily manipulated. A single moving average lets the
trader see where today's prices are in relation to prices, on average, in the past. A
short moving average, 10 days for instance, moves up and down too quickly. It is
good for helping the trader to get the best entry price, but by itself it gives too many
exit signals. A long-term moving average, 30 days for instance, is good for showing
the long-term trend and telling us when the long-term trend has changed.
Many traders combine these two moving averages, a short-term and a long-term
average, to get a better idea of how strong the trend is and when it might be changing.
It helps them decide when it is a good time to worry, and when they do not have to
worry about price falls because they are temporary.
For entry and exit purposes, we use a moving average crossover. When the shorter
moving average crosses above the longer moving average it tells us prices are better,
on average, both in the short term and in the long term. This means when we buy
today's price there is a strong probability the value of the stock will increase. Daily
prices will rise and fall, but the average calculations smooth out these bumps so we
have a better idea of the general direction of the price rise.
Of course, when the short moving average drops below the longer moving average it
suggests the up trend is coming to an end and that a new down trend is about to
start. For traders this is an exit signal, telling them it is time to sell and lock in profits.
Using two averages gives the trader another level of comfort. While prices stay above
the long-term average the trader is confident the long-term trend is up. When prices
fall below the short-term average, the trader starts to get worried. He watches the
stock price more closely so if the short-term moving average also falls below the
long-term moving average he is ready to sell straight away.
Two moving averages provide a simple way to use a chart to manage a trade because
they more accurately show the movement of the crowd. The following charts also
show the impact of the different calculation methods. Some combinations deliver
trading profits while others take them away.
For comparison we stay with National Australia Bank and apply a 10-day and 30-day
moving average. The up trend starts on 13 October, but the best moving average

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 9/ Average Performance

crossover does not generate an entry signal until, at earliest, 23 October. This is
typical of the inherent lag in all moving average techniques.
The charts in Figure 9.2 below show a simple and exponential moving average display.
The dates of the crossover entry and exit signals are shown. The same charts and
signal dates are shown in Figure 9.3 on page 150 using a weighted and triangular
moving average calculation. Those in Figure 9.4 on page 151 use a variable and
volume adjusted calculation.

Fig. 9.2 Comparing simple and exponential moving averages

30
29
28
27
26
25
24
23
22
21
20
19

- - -
~-- ----- --~----- -- - - - -
20 7 99
--
Ml"ii- -£S
-

NAB 30
National Australia Bank -~~- 1 29
28
DaUyba•ebart ~ 615 \\ 27
26

~<Hhy oxponontial moving ave<age

25
24
23
""' _ ,,~.< -I<Hhy exponential moving ave"'"'
22
21
"1~~10 20
19

Ma

The exponential moving averages provide the best trading solution. They get the
trader into the new trend fairly early and do not generate any false exits. They flash

149
CHART TRADING

a defmitive exit signal before any other moving average combination. The othe1
have flashed false signals so the trader treats later exit signals from these with cautior
waiting for proof they are correct.
Depending on your style of trading, the differences in the entry and exit signal date
may be very important. These minor differences are multiplied by more complc
indicators which rely on moving average calculations. These include the stochasti•
relative strength and momentum indicators discussed in later chapters. Some calculatio
methods generate just a few signals which keep the trader in this NAB trend. Othe1
take the trader in and out of the trend, or provide many points where the trader neec
to watch price action carefully. No matter which calculation method you select, tl1
crossover signals using two moving averages are applied according to the rules belov

Fig. 9.3 Comparing weighted and triangular moving averages

30
29
28
27
26
25
24
30-day weighted moving average 23
22
21
20
19

30
National Australia Bank 29
Daily bar chart 28
27
26
25
24
30-day triangular moving average
23
22
21
triangular moving average
20
19

150
 9/ Average Performance

Fig. 9.4 Comparing variable and volume adjusted moving averages

30
29
28
27
26
25
24
23
22
21
20
19

20-7-99 FR ES
NAB
30
National Australia Bank
29
Daily bar chart 28
27
26
25
24
30-day volume adjusted moving average 23
22
21
20
19

+RULES
1. Select the moving average calculation style that matches your view of the
market.
2. Long-term moving averages are more reliable, but the signals lag behind the
market too much for trading.
3. Short-term moving averages fluctuate more, but lag the market less and so
provide useful trading signals.

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CHART TRADING

4. A rising trend is indicated when the short-term moving average crosses

above the long-term moving average.
5. The crossover above the longer moving average is a buy signal. Traders can
chase the price, or set a buy order on the value of the short-term moving
average. Investors set orders on the value of the longer moving average. These
orders are changed each day to match the new value of the moving average.
6. Some traders use the value of the long-term moving average as a trailing stop
loss level. Because investors use the long-term moving average as a buy
signal, they use other methods as a trailing stop loss.
7. A falling trend is signalled when the short-term moving average crosses
below the long-term moving average.
8. The crossover below the longer moving average is a sell signal for traders
and investors. The hopeful set sell orders based on the value of the long-term
moving average. Traders use the value of the short-term moving average, or
sell into every minor rally.
9. Using a moving average crossover as a sell signal does reduce profits,
sometimes to unacceptable levels because of the inherent lag in moving
averages. Traders who use moving averages for entry do not often use them
as exit signals.

+ CROWD RULES
Over time we change, the child becoming an adolescent, then an adult. Played in
sequence, the baby videos show different movement to yesterday's action shot of the
adolescent cricketer, which are different again from the teenager slumped in the
chair watching the video replay. Movement alone does not capture character.
Individuals are complex, and we cannot adequately defme their growth and movement
with historical videos, but they do provide points of comparison. Where we have
been does have an impact on where we are going.
Crowds are more complex. To avoid being overwhelmed by the data they generate,
we extract just the significant highlights-in this case two moving averages. This
captures movement and a glimpse of character. Although the analogy is not perfect,
the first moving average guides us to the way the crowd morphs into the second
moving average and from there, to how it shifts into its current form.
Two moving averages give us a better idea of how this crowd is developing. When
both averages are close together the crowd is changing slowly. Growth spurts of

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 9/ Average Performance

volatility are captured when the averages move apart. Often today's price is a long
way from yesterday's average. How we decide to trade these growth stages depends
on our intentions.
By using two moving averages we capture two slices of time. Not only do we get a
better trading position, but we get a better understanding of how the crowd is moving
and developing.

• TWO MOVING AVERAGES APPLICATION

Two simple averages will give false signals-an entry signal today, and then an exit
signal just a few days later. Many stocks give very clear trading signals using two
moving averages and if they have done this in the past then there is a good probability
they will give clear signals in the future. We stay with the NAB example in Figure
9.5 overleaf to show how two exponential moving averages are used to identify the
trading opportunity and lock in profits.

The Entry
Initially we want to know if the price rise in October is a change in the trend, or just
a short lived rally. By waiting for a moving average crossover we confirm current
prices are better than average on both a 10-day and 30-day time frame. This calls for
an entry, which we cannot make until the day after the crossover signal. This costs us
some potential profits, but in return we have the added security of joining an
established trend rather than a potential trend. Our entry is at $20.60.

Trade Management
This is a comfortable trade for over 20 weeks, but in February prices dip towards the
30-day moving average. As this happens we pay close attention to the daily price
chart. When the close is below the 30-day moving average we are ready to sell NAB
on the next day. We could place a sell order in anticipation of a moving average
crossover, or we could watch the depth of market for NAB.
This means watching how price behaves when the market opens. On this day it
opens, drops quickly lower, and then rises steadily as other buyers chase what they
believe is a bargain. This buying pressure drives prices up and we defer our selling
decision. The driving up of prices eliminates the threat of a moving average crossover.
When price action approaches our sell conditions, we watch the market more carefully.
This is a time when we must be ready to act. This does not mean we should watch a

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CHART TRADING

real time trading screen all day. It does mean we should monitor NAB several times
during the day, either by checking prices on the Internet, or talking to our broker.

Fig. 9.5 Trading with two moving averages

Clear break below the 30-day 30.5

30.0
29.5
29.0
28.5
28.0
27.5
27.0
26.5
26.0
25.5
30-day exponential 25.0
24.5
24.0
old level, so exit is 23.5
delayed 23.0
22.5
22.0
No action until the day after the 21.5
close below the moving average
21.0
20.5
20.0
the crossover signal
19.5
NAB
19.0
National Australia Bank
Daily bar chart
18.5

The Exit
At the end of April the NAB price again drops below the 30-day moving average
line. Unlike the price action in February, prices continue to fall on the next day.
Additionally, the two moving averages move quickly towards each other. This watch
signal turns into a defmite sell signal. We are ready to sell without hesitation on the

154
 9/ Average Performance

day after the moving average crossover. This exit decision is supported by a close
below the 30-day moving average and the confirmation of a moving average crossover.
The exit is taken at $26.99 as soon as trading opens. Using the trading signals from
two moving averages delivers a 31% profit in this example. This trading technique is
not always so successful. It works most effectively with stocks which have a history
of strong trends. It does not work well with stocks trapped in sideways patterns, or
trading bands.

SUMMARY • TWO MOVING AVERAGES

Moving averages compare prices over a period established by the trader. The trader
compares the relationship of price today with the average of price for another period.
The longer the period, the more reliable, on average, the relationship. Conversely,
the longer the period, the less useful are the trading signals. Using a selected range of
moving averages is one way to overcome this problem. Crossover strategies are used
to increase the timeliness of signals while confirming the general trend.
A single price tells us nothing until it is compared with other prices. Moving averages
compare prices over an established period. By using a long-term average we get a feel
for the general direction of the stock. Overlaying this with a shorter-term moving
average gives us a way of comparing the short-term price action with the long-term
action. The crossover generates a trading signal. This is the foundation of conservative
trading strategies and of many 'trading' programs, and makes for solid, but delayed,
entries. The primary problem with using averages in this way is exit delay. This
sometimes leaves a lot of profit behind.
Ezy Chart offers two options for finding moving average crossovers. First is a visual
search of just the selected market segment. The segment is selected by using a preselect
option, such as All Industrials, and saving these as 'Live Charts'. Any personal selection
of stocks, such as those with warrants attached, can be saved as a live chart group.
Save the charts with a 10-day and 30-day moving average overlay. When the charts
are flipped through using auto display, the trader quickly notes the best trading
candidates.
The other way to find these crossover candidates is to use Ezy Analyser to search the
entire database, or a selected index, looking for crossovers in the past three or five
days. This just shows those stocks where the 10-day average is over the 30-day average.
Metastock users do the same, and by choosing 'Edit' and then 'Options', they can
also limit the number of days involved in the search. Metastock users are not able to

155
CHART TRADING

search by industry grouping, so each search is of the entire database. The search
results will come back as+ or- numbers, or as 0. The 0 and+ numbers measure the
difference between the two averages. These are the stocks where the 10-day average
is above the 30-day average.
Moving average crossovers are easily scanned by most software.
The Metastock MA Crossover search formula is:
(Mov(Close, 10,E) )-(Mov( close,30,E))
Ranking criteria look for readings around 0.1 as this means the crossover has just
taken place.
The Ezy Analyser formula is:
The price oscillator of today is greater than 0 AND the price oscillator has
been less than 0 in the last 5 days.
Conservative traders looking for confirmed breakouts use:
The price oscillator of today is less than 0 AND the price oscillator has been
greater than 0 in the last 5 days.

156
Chapter 10

BETTER THAN AVERAGE

In direct contradiction to the physicist's laws of the universe where solutions strive
for simplicity, technical analysis sometimes strives for complexity. Or perhaps it is
because a simple observation about the market sometimes requires a great deal of
complex mathematics to explain. The relationships between two moving averages
start out simply enough. When the lines cross, a buy or sell signal is generated. The
disadvantage is the way the signals lag the market. They come too late for really
good entries, and so late that profits are lost on the exit. Finding ways to cut out the
lag is a challenge taken up by amateurs and professionals.
They navigate towards a solution with impeccable logic and reasoning. If the crossover
generates signals, then traders should be able to anticipate the crossover as the distance
between the closing values of the two averages begins to narrow. The spread between
the two lines of average value gives the trader information about the strength of the
trend and the potential for change. When the short-term average dips towards the
long-term average in an up trend, a buying signal is generated. These observations
lead us directly to the world of exotic moving averages.
These quite straightforward observations are difficult to quantify. Experienced traders
drawing on years of experience take one glance at a chart with moving averages and
make a good judgement about the strength of the trend, and the value of the trading
opportunity. The novice is locked out of this world. His key lies in mathematics and,
in particular, in the programming logic of technical indicators designed to formalise,
categorise and display these relationships. The Moving Average Convergence
Divergence (MACD) indicator is his tool of choice.

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CHART TRADING

• DEGREES OF SEPARATION

The original Moving Average Convergence Divergence indicator was developed by

Gerald Appel. It consists of two lines that do not look much different from a standard
plot of two moving averages. The real difference is hidden in the calculation, because
the MACD is a moving average of a moving average.
The line plot usually includes a solid MACD line and a dashed or dotted line-the
signal or trigger line. The solid MACD attempts to quantify the trader's observations
about the degree of separation between a long-term and short-term moving average.
In the original calculations 12-day and 26-day Exponential Moving Averages (EMAs)
were used. Each day the difference between the short-term and long-term EMA
values are calculated and plotted as a single line. Instead of visually judging the
degree of separation this line plot gives the trader an accurate value on a daily basis.
In using moving averages, traders want to identify the direction of the trend by using
the average consensus of crowd opinion over a selected period. The way the degree
of separation moves up and down is not, by itself, a useful trading signal because it is
difficult to identify the significant changes.
Appel's solution was to take the value of the MACD and calculate a 9-day EMA. This
he called the signal line. In some charting packages it is called the trigger line. Like
any combination of moving averages, the signals are generated by the crossover points.
This average value of the daily value of separation identifies shifts in the balance of
the bulls and the bears. The signal line, or slow MACD, shows how the crowd is
thinking over a longer period. When the fast, or solid, MACD line rises above the
slow signal line it shows the bulls are running the market. This is a buy signal.
Trading in the direction of the crossover keeps the trader in tune with the direction
of the market crowd. Using this indicator, he recognises the tune sooner than others.
The MACD reflects a shift towards subtlety, reducing the lag inherent in moving
average signals. The chart of Orica, Figure 10.1 on page 160, shows how MACD
crossover signals initiate the trade several days before the plain moving average crossover
delivers a signal. This makes money for the trader and on the other end of the trade,
the MACD saves profits by signalling an earlier and often more effective exit.

+RULES
1. The MACD lines show trend direction.
2. When the MACD line crosses above the signal or trigger line it gives an
entry signal in the direction of the trend.

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 10/ Better Than Average

3. When the MACD line crosses below the signal or trigger line, an exit signal
is generated.
4. Traders who short the market reverse these signals. A crossover below the
MACD signal line is an entry, and a crossover above the MACD signal line is
an exit. This is particularly useful for warrant, options and futures traders.
5. These crossover signals are most effective in stocks with strong trends. They
are ineffective with stocks locked in a consolidation or sideways pattern as
they generate too many buy and sell signals without delivering a reasonable
profit.

+ CROWD RULES
Each moving average captures a consensus of crowd movement showing how it has
changed over the selected period. This is a raw and obvious measure. The MACD
line makes it easier to put a value on the relationship already visible on the bar chart.
This is the general direction of the crowd, but every action contains within it the
seeds of change.
Crowds do not suddenly stop and change direction. They slow, uncertain about their
intentions. Perhaps they mill about for a while until, driven by a market-moving
event, they start to move solidly in a single direction with renewed vigour. This may
be a continuation of their previous direction, or a change in direction. Most traders
look for trend reversals.
As the crowd slows, perceptive observers spot those ringleaders who change direction
first. Traders use the market charting tools discussed in earlier sections to track the
smart money. Other observers watch for the change in balance between the bulls and
the bears. They want to know when more people are looking back than are looking
forward. The MACD gives this observation a value, and with two continuous
snapshots, shows how the crowd is moving in relation to its longer-term values.
Traders and investors get early warning of the shift in the balance of the market, and
the direction of the shift. The distinction is important, because not every shift is a
change in direction .

• USING THE MACD

At first glance on a perfect example, the MACD appears to provide a better trading
solution than just a combination of moving averages. The chart of Orica (ORI) price

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action in Figure 10.1 below signals an entry in February very near the trend lows for
ORI. The signal gets the trader in around $8.00 when the dotted signal line crosses
the MACD line. The clear exit signal is given a few weeks later and the trader gets
out around $8.50 or a little better. This exit does not coincide with the ORI top
above $9.00. The second MACD trade on the right-hand side of the chart also fails
to lock in maximum profits.

Fig. 10.1 MACD

9.5

9.0

8.5

8.0

Signal line
0.20

I 0.15
0.10
0.05
0.00
-0.05
MACD line
-0.1 0
Enter -0.15
-0.20
ORI
Orica -0.25
Daily bar chart and MACD -0.30

This does not diminish the usefulness of MACD signals. Indicators very useful for
selecting entries are not always so good at identifying exits. A good exit locks in close

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to maximum profits from the trend move. Traders often use a different set of indicators
to help manage exits.
The MACD is a more effective trading tool than the combination of 12-day and 26-
day exponential moving averages. Using just a simple crossover signal, the EMAs
signal an entry six days after the MACD. The exit is delayed by 22 days. Although the
exit price is higher than when using the MACD in this example, the delay exposes the
trader to a much higher level of risk. The market could collapse heavily in this time.
The MACD smooths out false signals generated by the underlying moving averages
and also helps to reduce the lag. The entry and exit signals are closer to the valleys
and peaks of price activity.
However, the MACD is not immune from whipsaws. On the left-hand side of the
ORI chart the indicator has generated several whipsaws. Follow these signals and the
trader is whipped into the trade, then taken out again in just a few days for little
return. False entries and exits are a hazard of trading, but they are more common in
sideways, or non-trending markets. The MACD is a trend analysis tool, so avoid
using it in sideways markets.

SUMMARY• MACD
The MACD smooths out daily price fluctuations. This indicator takes two averages.
The short-term lets us compare today's price with recent price history. The long-
term lets us compare today's price with the average over a longer period. This gives
us a feeling for the context of today's price. The MACD plots the average of these as
a solid line. The signal line smooths the first line by applying another moving average
to the data in the first line. This is plotted as a dotted line. The line crossovers
generate trading signals.

• • • • •
• HISTOGRAM PLOTS
Traders show an unusual desperation to be first to know about trend changes, probably
because this is where significant trading profits are found. They buy better charting
software just to play with indicator values and improve them. The MACD is no exception.
The MACD is an effective tool for describing crowd movement at an early stage, but
traders by nature are fiddlers. Could they make the MACD better? Apart from the

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obvious twiddling with the MACD values, using 10-day and 30-day EMAs for the
fast MACD line, or perhaps a 15-day value for the signal line, there are further
possibilities with the degree of separation.
Traders thought perhaps there were advantages in charting the degree of separation
between the MACD line and the signal line. Elder gave this approach a popularity
boost in Trading For a Living with his MACD Histogram (MACD _H).
This chart displays moves above and below a zero line and overcomes one of the
most significant dangers in charting and chart analysis. A clear and present danger
with all charting is the problem of perception. Optical illusion tricks in children,s
books are amusing, but they are fatal in the market. Many traders are unaware of the
way parallel lines are distorted when displayed against a background of bars. Trusting
their eyes, they overlay line indicators on bar charts, and fail to see distortions. Some
believe they see relationships which really do not stand up to later objective analysis.
The MACD uses the separation of the two lines to build trading signals. Trying to
judge the degree of separation of two lines, neither of which is straight, against the
background of a bar chart is difficult. It is a task best left to the computer, or to a
different style of display.
Enter the MACD _H. This makes it easier to see the way the separation between the
MACD line and signal line is changing and also highlights the trend of the change.
We are interested in the way these histogram bars group above and below the zero
line. When used with a weekly chart they smooth out the unimportant daily fluctuations.
Here is a new way to consider trend action. What looks like a steady fall is revealed as
a weakening trend because the separation value between the MACD values rises towards
zero. The MACD _H gives warning of a weakening up trend as the bars move towards
zero. The MACD crossover signal is used as an early warning of trend change. The
MACD _H is used as an early warning of the probability of a crossover.
The problem of market lag is attacked head-on because it identifies hidden strength,
or weakness, in advance.
Elder believes the MACD H "is one of the best tools available to the market
technician.,, When used as a weekly display to find divergences, the MACD_H is a
very powerful leading indicator of building trend changes.

• DIVERGENCE
Divergence signals apply to all oscillator-style indicators. The MACD_H is an oscillator
because it moves above and below a zero line. The MACD _H takes a step away from

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showing us how the crowd is moving to suggesting how the crowd is thinking. This
conclusion is reached by inference based on the divergence between two separate
events.
When two lines move towards each other they converge. When they move apart,
they diverge. When the two lines are moving averages then the measurement of this
convergence and divergence is at the heart of the MACD concept. Consider the
concept from a different angle and a different relationship emerges. When the lines
converge they move in a similar direction. When they diverge they move in
contradictory, or opposite, directions.
Occasionally the MACD _H groups move in an opposite direction to the market.
This divergence is most obvious and significant at market tops and market bottoms.
In a rising trend prices make many new highs. We are interested in the peaks created
by this trending process. When the market makes a new high it is shown as a new
peak on the bar chart. If the trend is strong then we expect the MACD _H group of
histogram bars to also make a new high. This confirms the direction and strength of
the trend. On a chart display we see a new higher peak on the bar chart, and a new
higher peak on the MACD _H group.
Mter the rally the market may fall again for a few days or weeks. Later it rallies again,
making a new price peak. This time if the MACD _H group fails to make a new high
and the slope of the MACD _H moves down-if it contradicts or diverges from the
new high peak on the bar chart-it suggests a weakening trend. Courage is turning
to bravado. This price rise is a last hurrah, and the MACD _H divergence exposes it.
This is not best judged on a bar-by-bar daily histogram basis. This action is too
spasmodic to form a reliable base for action. Divergence is best determined on a
weekly chart. When traders search for divergences they use a rolling week, calculating
back in five-day blocks from the most recent date. While a stock is being tracked in
this way, a new weekly chart is created by the charting software every trading day.

+RULES
1. The slope of the MACD _H shows the direction of the trend.
2. The daily MACD_H gives many false signals. Use a weekly MACD_H, but
recalculate this every day.
3. When the MACD _H stops falling and starts to move up, an early buy is
signalled. Use a stop loss one tick below the most recent low.

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CHART TRADING

4. When the MACD _H stops rising and starts to fall, a sell signal is generated.
This is not a reliable sell signal by itself, so other indicators or trailing stop
loss methods should be used to confirm the exit.
5. Traders who short the market reverse these signals. The entry is signalled
when the slope of the MACD _H changes to down. Use a stop loss one tick
above the most recent high.
6. When prices make a new high, look for a new high on the weekly MACD _H.
Mter a retreat, if prices make another new high on the next rally, look for a
new high on the MACD near or above the zero line. This confirms the trend.
A lower MACD _H high suggests the trend is weakening, giving an exit signal.
7. When prices make a new low, look for a new low on the weekly MACD_H.
Mter a rally, if prices make another new low, look for a new low on the
MACD near or below the zero line. This confirms the trend. A higher
MACD _H low suggests the trend is weakening. This is an entry signal.
8. These divergence signals are most effective in stocks with strong trends using
a weekly chart display. They are ineffective with stocks locked in a
consolidation or sideways pattern.

+ CROWD RULES
Crowds get exhausted. Mter a surge in any direction, up or down, the crowd just
runs out of energy, or in market terms, it runs out of money. In a rising trend there
comes a time when even the most optimistic buyers have no money left. Already they
have committed all their cash to a portfolio of stocks. They have scraped up borrowed
funds, trading on the margin, to add further to their portfolio. The only way to get
more cash is to realise a profit by selling some of their portfolio. When the money
runs out, the bull run slows and collapses.
When the market declines, most people lose money. Those who bought near the top
bail out, capturing a small profit, or perhaps taking a loss. The profit-takers move in,
which is really just a nasty term for traders and investors who bought low and are
now selling high. As prices continue to fall fear dominates. Sellers overwhelm the
market, desperate to dump their stock. Buyers, sensing the same fear, are reluctant to
buy it. Bargain sales become fire sales as the building burns and the crowd runs for
the exit. When the bear arrives, money runs away from the market.
When something large is moving below the surface of the market it sends ripples of
fear and greed through the crowd. The MACD _H tracks the causes of those ripples by
highlighting the shift in balance between the bulls and bears. The slope of the MACD_H
shows the power of the move and gives early warning of any shift in balance.

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 10/ Better Than Average

When courage turns to bravado the market makes new highs but with less conviction.
Few in the crowd participate or want to participate. This is a MACD _H divergence
signal. Tracking this feature of crowd behaviour is a strong point for the MACD _H.

• USING MACD_H
The basic application of MACD _H is based on crossover signals and peaks. There
are several combinations of this technique and the Orica (ORI) chart in Figure 10.2
below illustrates how they are applied.

Fig.10.2 MACD_H Trading peaks and crossovers

r- 9.5

r- 8.0

E r- 0.20

r- 0.15
c D
- 0.10

-
1 1 1' ' 1~1 1 1 1 1 ' 1
0.05

- 0.00

- -0.05

ORI - -0.1 0
Orica
Daily bar chart and MACD Histogram
v Auaust 'lsep !october Nov 'loec 11999 IFebruc;

165
CHART TRADING

The first trade in the chart, based on moves above or below the zero reference line,
starts at Band ends at F. The trader waits for the MACD_H to move into positive
values. This introduces a lag because the entry is not made until the day after the first
close above the reference line. This gets the trader in around $8.10. The same lag
applies to the exit.
On the completed chart we see the close below the reference line at F, but we cannot
act on it until the next day. On the day it happens we cannot build the MACD _H
chart until after the market has closed. The indicator may give timely signals, but
when we use end of day data we have to wait until the next trading day before we can
act. This delivers an exit at $8.60 and returns 6%.
Traders are always looking for better trading solutions, comparing what is with what
could have been. In this case an exit at the peak of $9.10 would have returned 12%
for a trade based on the same entry signal. The solution is to use the MACD _H peak
marked E.
This is good theory, but bad practice. We cannot know if pointE is the highest peak
until the MACD _H has moved clearly lower. Unlike the crossover below the reference
line, the trader has to wait several days to confirm point E as the peak. By then prices
have fallen. Just waiting two days brings prices back to $8.60.
The other problem with the peak approach is deciding which peak is the correct one.
As price action develops we have a choice of peaks at C and D. At the time the trader
has sound reasons for assuming each of these is the highest peak in the series. Only
future action proves him wrong. The MACD _H does not give the trader sufficient
information to make accurate exit decisions based on MACD _H peaks. The same
limitations apply to techniques which use the MACD _H valleys as an entry signal.
In real time the same problems apply to MACD _H moves above or below the reference
line. It is difficult to decide immediately if the move is substantial, as in area B, or if
it is a false start, as with area A. Few traders would act on the MACD _H signal at
area A because the bar chart gives no indication of a trend reversal. The down trend
is intact. All indicator signals are moderated against the action of the bar chart. In
most cases traders look for independent confirmation of any indicator signal.
In assessing an indicator for incorporation in your trading system try to separate the
ideal signals from the action you are able to take in reality. A signal that is clear
retrospectively on a chart may be much more difficult to see as it develops day by day.
One solution to this problem uses divergence signals. We stay with ORI in Figure
10.3 opposite. Here two divergence signals are generated. The first is the series A-B,
and the second C-D.

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 10/ BeHer Than Average

9.5

9.0

8.5

8.0
Valle)

c ~lr D r- 0.20
Divergence ~·
r- 0.15
A B
r- 0.1 0

t- 0.05
~

IIIII '"1111111111~ ,I
r- 0.00

r- -0.05

II/
1
VoRI Orica
t- -0.10

Daily bar chart and MACD_Histogram

3C !1999 February !March JApril !May

Consider the bar chart with its falling trend. The first bar chart valley is matched
with a very low valley on the MACD_H. They are joined by line A. The down trend
rallies and then continues making a new lower bar chart valley. The corresponding
MACD _H valley is not as low. They are joined by line B.

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CHART TRADING

The divergence signal is clear because the MACD _H does not mirror the bar chart
action. The entry around $8.20 is delayed by a few days until the trader confirms the
valley pattern. Even with this delay the entry is initiated several days before an
MACD _H crossover signal.
The potential exit signals are separated by 50 days. The first up trend peak on the bar
chart is matched by the peak on the MACD_H. Unless the following price retreat
falls below the valley low at $8.00 this trade remains open. We wait for the next
higher peak on the bar chart. For this trade to remain open we need a higher MACD_H
peak. Instead the peak connected by line D is slightly lower than the first peak at C.
This is a divergence signal. The bar chart has moved in one direction, but the
MACD_H has not acted in the same way. The horizontal line drawn from point C
confirms this divergence. The divergence is not very much. It does not have to be.
Divergence is the failure to reach a new high so the position is closed with an exit at
$9.40. This returns 14% and is a more effective trade than those based on the
MACD_H crossover and peak approaches shown in Figure 10.2.
Although MACD _H divergences do appear on daily charts they tend to be more
useful and reliable on weekly charts. This does delay the entry and exit, but the
longer time frame tends to capture more substantial trends. Divergence signals are
reliable, but they are not infallible.

SUMMARY• MACD_H
The MACD plots the average of two averages as a solid line. The signal line smooths
the first line by applying another moving average to the data in the first line. The
MACD_H plots the difference between the MACD and signal lines. Bullish activity
is plotted above zero, and bearish below zero. The slope of the MACD _H shows the
dominant market group and when it moves in the same direction as prices, the trend
is confirmed.
Constructing an MACD _H display in Metastock requires some work. The Metastock
formula is MACD()-Mov(MACD(),9,E). The figure 9 in the formula is the default
for the MACD_H. Change this ifyou wish. When this indicator is plotted it appears
as a line. To turn the display into a histogram click on the MACD _H line and select
'Properties'. Choose the display option as a histogram. This shows the familiar
MACD _H display. Use the 'Save as a template' command to save the screen for later
use with any stock.
Ezy Chart users simply click the MDH button or select MACD _H from the indicator
menu.

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 10/ Better Than Average

• • • • •
• FINDING DIRECTION WITH ADX
The MACD and MACD _H measure the separation between two averages. Traders
are also interested in the way the relationships change between the low and the high
for each trading day, and on average over several days. This led to the development
of a group of directional indicators often referred to by the single name ADX. They
are designed to identify changes in the direction of the market.
The ADX is a complex collection of calculations using moving averages to track
relationships between price behaviour. It is a directional system. In comparison the
MACD is child's play. The ADX was developed by Welles Wilder, Jr in the mid
1970s and has been modified by many analysts ever since. Like many indicators that
try to ferret out the truth about crowd movement, this indicator is based on some
common observations about crowd behaviour and the way this changes over time. In
particular, the ADX concentrates on how far the crowd is able to push prices up or
down each day.
Although we have labelled this section ADX, in fact it is a combination of five
indicators, which when assembled together have the generic name of ADX. We
consider just the three most useful of these for trading stocks:
> Plus directional indicators (DI +)
> Minus directional indicators (DI-)
> Average directional movement (ADX).
It is not my intention to duplicate the construction calculations in detail, or to consider
the ADXR and DX indicators which are more appropriate for futures markets. Your
computer software completes all these calculations in a fraction of a second. We do
need to know what the ADX is measuring, though, because then we more effectively
apply the analysis to our trading opportunities.
To establish the directional movement on up days compare today's price range-
high to low value-with the range of the previous day. The Direction of Movement
(DM) is that part of the price action greater than yesterday's. If the difference is
higher the result is called DM +. The value being measured is shown more clearly in
Figure 10.4 overleaf. If today's price action ranges below yesterday's price action,
then the same calculation is used, but the result is called DM- to show the direction
of movement is downwards. Some days the calculation returns a zero value.

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CHART TRADING

Fig.10.4 Defining directional movement

DM+

1
Value of Value of
-r-ralueof

r·--- t- - -
directional directional directional
movement - movement movement

r-

DM-

r-

t-
*Value of
........ directional
movement
] Value of
directional
movement -t....
Value of
directional
movement

Days where DM =0

tnD~tional 11·1 D~ional

movement =0 movement =0

These results are divided by the true range of the data being analysed to create the
daily Directional Indicators (DI). These are usually referred to as Dl+ and DI- and
these results are eventually plotted on the screen.
As raw values they tell the trader how today's price movement above yesterday's
close is related to the previous day's full price range. If today was 50% higher than
yesterday we have a strong day, but not necessarily a strong trend. To measure the
strength of the trend the Dl+ and the DI- are recalculated as moving averages. This
is the display most commonly used by charting software, with blue for DI + and red
for DI-. The default, or most common, value for the moving average is 13 days.

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These two values are useful, but just like the original two line MACD plot this indicator
is made more useful when we include information about the way these values change.
In a bullish market we expect to see a series of higher closes in a rising trend. This is
reflected in a rising DI + line. The bears are in retreat, so the DI- line should fall.
The spread, or difference, between the two lines increases. Instead of showing this as
a histogram, the ADX indicator displays it as another line expressed as a percentage.
This line provides the trader's signals. When the trend is healthy and growing, the
ADX line is rising, reflecting the growing strength of one section of the market over
the other.
When the up trend begins to weaken, the bears start to have more success. The
spread between the DI + and the DI- begins to decelerate, and eventually weaken.
The ADX line first moves sideways, and then as the trend weakness and the separation
between the DI lines decreases, the ADX loses value. The ADX line declines.
As the bears dominate the market, driving prices down in a powerful new trend, the
separation between the DI + and the DI- increases. The ADX line starts to rise as the
falling trend accelerates. A rising ADX tells us the trend is strong, but it does not tell
us the direction of the trend.
When the ADX rises the trend is strengthening. When the ADX declines, the trend is
weakening. The ADX delivers timely warnings about a change in the trend. It confirms
the strength of the trend and tells the trader when the movement of the crowd is slowing.

+RULES
1. The direction of the ADX tells the strength of the trend. Rising ADX is a
strong trend. Falling ADX is a weakening trend. Sideways ADX is a strong
trend failing.
2. A rising DI + is a bullish signal. Trade from the long side, buying low and
selling high.
This is confirmed when the ADX is also rising because the up trend is
gaining strength.
3. A rising DI- is a bearish signal. Close long positions, and think about
opening short positions. These trades are implemented using put warrants or
options to trade a falling trend.
This is confirmed when the ADX is also rising because the down trend is
gaining strength.

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CHART TRADING

4. When the DI + is above the DI- the market is generally bullish. When the
DI- is above the DI + the market is generally bearish. We know who is in
control of the market, but not how firm their grip is on power. These are
general signals which need confirmation from the ADX. A rising ADX
confirms the strength of the bullish or bearish trend.
5. When DI + crosses above DI- but the ADX is still flat, or falling, then the
rally is likely to be weak and short lived. This suggests a cautious long side
entry.
When DI- crosses above the DI + and the ADX is still flat or falling, then
the price decline is likely to be weak. This gives the trader another
opportunity to exit long positions at slightly higher prices. It is early
warning of a trend change so rather than hanging out for a new high, the
trader tries to exit on the next, and weaker, rally.
6. When the ADX values are low, the market is moving sideways. Do not use
trend following methods in trading. A strong ADX chart is shown in Figure
10.5 on page 174. Weak ADX values have peaks that cluster below the mid-
levels.

+ CROWD RULES
Every crowd faces barriers. Angry or excited crowds push the barrier over, spilling
into new areas of action. The Indonesian protest movement in 1998 was at first
confined to student campuses. Crowds were unruly, but were not a major threat to
the existing status quo established by Suharto and associates.
When the crowd pushed past the campus barriers, spilling into the streets, it was
both a signal of increasing momentum, and a rally point for further momentum.
Each day more people joined the students, and new police lines were broken, pushed
back to re-form at more distant points. The size and nature of the crowd told outside
observers more about the stability of the Suharto government than any official
government or news agency report.
In market terms, the bulls are in charge, driving a new trend. Each day old boundaries
are overturned. The separation between the bulls and the bears increases as the bulls
win. The ADX rises.
In Indonesia the end of the rally was signalled when Suharto resigned, preventing an
open civil war. Most of the angry crowd went home. The students remained, calling
for even more reforms. Still noisy, still vibrant and colourful on the news reports, the

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students became increasingly ineffective as they lost the support of the broader crowd.
They toppled no new barriers.
In market terms, the bulls weaken. They trade loudly, perhaps even making occasional
new highs, but most of the crowd is ignoring them. The bears are gaining strength
and confidence. First the ADX turns down, telling us the bulls and their trend are a
spent force. Later the ADX turns up again. This, and the DI-line, tell us the bears
are setting the new, stronger trend. First they counterbalanced the bulls, and later
they overturn them completely. The ADX tells us the strength of this crowd, but not
who is in charge.
The ADX identifies the dominant trend in the crowd, and more importantly, when
the dominance begins to erode. This provides both entry and exit signals in advance
of the general crowd. Traders move before the rest of the crowd realises the good
times are over .

• USINGADX
Indicator displays using ADX look complicated. The dotted DI-line in Figure 10.5,
overleaf, on the left of the display defines the strength of the bears. Initially the bears
determine the price of Oil Search (OSH). This line is above the solid DI + line and
the thick ADX line. The thick ADX line is sloping upwards, confirming a strong
trend is in place. In this case it is a strong down trend and this is also clear on the bar
chart. This is not a stock we want to trade.
As the bar chart begins to flatten out we want to know if it is a good time to enter
OSH in anticipation of a new up trend. Although the first rallies look promising we
do not trade them. The ADX is showing a weakening trend and the bears are still
dominant in this period. The dotted DI- line is still above the solid DI + line.
This changes at point A on the bar chart. This rally is a candidate for a new up trend
because the solid DI + line crosses above the dotted DI- line. Within a few days the
thick ADX line also starts to move upwards. The upmove tells us a new strong trend
is developing. It does not tell us the direction of the trend. For this information we
turn to the relationship between the DI- and the DI + lines.
In May the thick ADX line shows trend weakness by turning down. This does not
necessarily mean the end of the trend, but it does put the trader on alert for a potential
exit. While the solid DI + line remains above the dotted DI- line the bulls are still in
charge. Mter a pause and consolidation period, the bulls regain full control. The
thick ADX line resumes an upward slope, reflecting the strength of the new trend.

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CHART TRADING

This combination of directional tools provides the trader with a clear understanding
of the strength of the bulls and the bears. When the directional indicator lines are
combined with the ADX line the trader is able to weed out false rallies and trend
breaks. The exit is signalled when the ADX line turns down and the DI + line moves
below the DI- line.

Fig. 10.5 ADX indicator

2.5

2.0

Oil Search 1.5

Daily bar chart and ADX

Shows strong 60
ADX shows trend 55
weakness but Dl+ 50
45
40
35
30
25
20
15
10

Jul

SUMMARY•ADX
We use the ADX as a combination of three indicators.
The DI + line shows when prices have closed higher. By taking the difference between
the previous close and the current, higher, close, it creates a value. This is then

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recalculated to get an average value over the past, usually, 13 periods. This becomes
the DI + line.
The DI- works the same way, but uses the difference between the previous close and
the current, lower, close.
The ADX line plots the average of the DI + and the DI-line over, usually, 13 periods.
Although we could use just the ADX line-which reveals the strength of the trend,
but not its direction-the other two lines help confirm the strength and show the
direction of the trend. A rising ADX indicates a strong trend. A falling ADX indicates
a weak trend. The ADX is not useful in non-trending markets.

175
Chapter 11

AVERAGE CHAOS

Moving overages are lagging indicators. The entry signals come after the breakout
happens and exit signals come after the trend collapses. Despite these limitations
moving averages are very powerful analytical tools. The most common application of
the moving average uses the crossover points as signals. These crossover points also
deliver important additional signals about the way the market is valuing the stock,
and are quite independent of the current price of the stock.
When these averages are combined as a Guppy multiple moving average indicator
they deliver powerful messages about the movement of the crowd and its strength.
This indicator tells us how the crowd is thinking and provides a powerful tool for the
analysis of the crowd and its intentions. I include it here because it is a logical
development of the moving averages.
The Guppy Multiple Moving Average (GMMA) indicator starts with the difference
between price and value. Price is what we pay for a stock, and price is clearly shown
on a bar chart. Value is what we think the stock is worth at some time in the future.
Generally, we try to pay a price that is less than our idea of future value. In plain
terms, we want price to go up so we can make a profit.
Chartists take their lead from what the market reveals about current price and future
value. The technical analyst starts with past value, and this is usually shown effectively
by a moving average. All the calculations in this chapter use an exponentially calculated
moving average as this takes more notice of recent price action.
A moving average of price tells us the average value of price over a user-determined
period, for instance the last 10 days. The calculation is made every day, and the value

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plotted on the computer screen. The value of the previous calculations do not change,
so the moving average line snakes its way across the screen, adding a new segment
each day. Our objective as traders is to buy at a market price and to sell at an increased
value.
We are not alone in this. Every other market player is doing the same, and many of
them are better at it than we are, so it is useful if we can fmd a way to read their
intentions. We know the moving average line shows, for instance, a 10-day and a 30-
day value. The crossover of these two values is often used as a trading entry and exit
signal because it confirms the stock is being revalued in two different time frames.
The first observation is that when the averages cross, price usually rises. By combining
a group of short-term moving averages-3, 5, 7, 10, 12 and 15 days-we see a
relationship develop, and the relationship is more important than the numerical value
of the crossover. This group of short-term averages is indicative of the activity of
short-term traders and market speculators.
The key relationships are the points of maximum separation in this group of short-
term averages, and the points of convergence. The narrow points tell us there is an
agreement about the value of the stock. At the widest point, there is a disagreement
about the value of the stock. When there is agreement there is a strong probability of
disagreement to follow, and when there is disagreement, this is usually reflected in a
fairly dramatic change in prices. We want to trade this future disagreement because if
we buy at the point where most short-term players agree, we later sell for a profit at
the point of maximum disagreement, where prices are driven upwards by short-term
traders speculating on future value.
The short-term group is a proxy for the inferred activity of short-term traders. When
we turn to the long-term group-30, 35, 40, 45, 50 and 60-day moving averages-
we see the same characteristics developing over a longer time frame. This is the
inferred activity of investors, and they supply the floor, or the roof, for speculative
trading activity.
Out of the chaotic activity of the market comes an order. This convergence and
separation pattern is repeated across all time frames. By selecting just a few groups
we clearly see the fractal repetition of this activity across these time frames. When
investors agree on value it is a signal for disagreement. This cycle is longer than that
used by short-term traders, but the characteristics remain the same.
When we bring these two groupings together we plot the activities of both traders
and investors on a single screen display. As with most moving average applications,
the primary signals are the convergence and crossover. When both long-term and
short-term groups narrow down, and cross over, there is a major trend change taking

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place. The MMA generates many other signals about the crowd and its intentions.
They are explored in greater detail in Trading Tactics, where this indicator was first
introduced, and in Bear Trading. Here we consider just the basic trading signals.
When the market reaches agreement on the value of a security in both time frames
then stand by for explosive action. Contrary to our intuitive understanding, the long-
term averages do not lag very far behind the short-term averages. They do provide
timely trading signals. At explosive market points the revaluation of stock, as reflected
by price, is so fundamental that every calculation is affected. When each group comes
into agreement and when both groups simultaneously cross within a single narrow
window of time, then we are confident the balance of probability is very much on
our side in this trade. This trade is going to move, and move soon.

+RULES
1. When the two groups of moving averages converge they identify a point
where there is a high probability of increased market and price volatility.
2. A convergence of both groups of averages does not mean a trend reversal.
The trend may gather new strength and continue in its previous direction.
Use other trend indicators for confirmation.
3. Trade in the direction of the crossover. Go long if the crossover is on the up
side. Go short with down side crossovers.
4. The width of the long-term group of averages is a guide to the strength of
the trend. Broad width suggests strong, well supported trends. Narrow
bands show weakness with a high potential for a trend change.
5. When the bands from both groups begin to narrow down and converge,
prepare for price action as the agreement of valuation collapses. A
combination of long and short positions could straddle the potential price
action. When prices do surge, close the losing position and ride the winner.
6. The long-term averages confirm the direction of the trend.
7. The bubbles, shown on page 181, created by the short-term group of
averages show the favourable exit point.

+ CROWD RULES
A crowd has a common purpose created by coincidental agreement. All the people
assemble in the one place at the one time to express their opinion about an event. This

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may be as passive as watching a game of cricket, or as active as chanting "Reformasi"

in front of the Malaysian parliament. When the crowd disperses its members pursue a
myriad of unrelated personal activities. The point of convergence of interest creates
the crowd, bringing people together in a single common purpose. This appears as a
motivating force. The crowd we are interested in comes together with a conscious
common objective--everyone wants to make money based on their idea of value.
Despite this common purpose there are divisions about the best way to make money.
In market terms we broadly split these groups into the traders and the investors. For
convenience, I suggest the traders have a short-term view of the market while investors
have a much longer view. Their approaches may at first glance appear to have little in
common, but in their united desire to make money they are required to make
assessments about the relative value of a stock compared to its current price.
The crowd is an extension of ourselves. Instead of assembling outside the parliament
buildings, we gather around computer screens displaying the market. The market is
a continuous auction where opportunity is fleeting.
Imagine if every reader of this page today believed the Internet company, Etrik.com,
was worth $10.00, but it was only selling for $5.00 in the market. By some trick of
communication, every reader is aware that every other reader has the same information.
In the market this common information is delivered by newspapers, news reports and
the Internet. Some readers are investors, some are traders. Every one of them has the
same unshakeable belief that Etrik.com is worth $10.00. Each has reached this
conclusion by quite different means. What concerns us here is the agreement on value.
Convinced about value, how many readers will be prepared to pay market price-
$5.00-for Etrik.com stock when the market opens tomorrow morning? The traders
bid the stock up, eager to get ahead of everyone else. The day's close might be as
high as $5.30. The investors do not follow this lead. They are more inclined to wait
for prices to pull back to more reasonable levels. If this does not happen and they
still believe Etrik.com is good future value, they may bid higher in a few day's time.
They slowly chase the stock price up, adding more to their portfolio. The long-term
group of averages begin to converge.
The activity of this crowd is reflected in the way the two groups of moving averages
behave. The multiple moving average identifies the points where the crowd is poised
for action. These are high probability points, just like the lull in the crowd prior to
an explosion of activity. When both long and short-term groups in the crowd agree
about value we know it is fleeting. Other traders, suspecting an advantage, bid up or
down. For this crowd the only option for action is disagreement and this means
price changes.

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CHART TRADING

Standing in front of a 'reformasi' crowd, the police watch those individuals who
have rocks in their hands. We watch those individuals with money in their fists.
They set and maintain the market direction .

• USING THE GUPPY MULTIPLE MOVING AVERAGE

Traders make choices about how they trade the trend. Many trade with the trend.
Others trade in anticipation of a trend break, attempt to trade the trend break or
enter during weakness in the trend. All these tactics rest on good trend analysis tools.
The multiple moving average is a more powerful trend analysis tool than just two
moving averages because it gives us information about the strength of the trend and
the degree of support it enjoys from the market. The Fletcher Challenge Energy
Services (FLCES) chart in Figure ll.l opposite shows how the compression of both
groups of moving averages at point A provided a clear signal at the beginning of the
trend break.
Traders looking at the chart and the price pullback at area B see an established
trend well supported by long-term investors. Although the price pullback at point B
may look frightening on a bar chart, the GMMA indicator signals a safe entry. This
is shown with the long-term group of moving averages. They are well separated
and show no signs of beginning to narrow down.
The short-term traders are impressed with FLCES. They have bid this stock well
above values supported by investors. This creates a bubble effect, where prices move
well beyond the idea of value established by the long-term group. This bubble activity
provides high volatility and several different types of trading opportunities.
For short-term traders the objective is to enter the stock as the short-term group
compresses. They want to get out of it when the short-term group reaches its maximum
separation and then begins to turn down. This is bubble trading.
From the investor's perspective they also prefer to enter on this weakness when the
bubble has collapsed as shown at point B. This type of chart display gives investors
the confidence to enter FLCES on the price dip because of the solid support indicated
by the long-term group of averages. Because the stock is volatile, in the short term,
traders are prepared to take advantage of temporary price spikes down.
These are buying opportunities because the multiple moving average gives traders
and investors the confidence to buy. It puts price activity into the context of a trend.
Once this initial analysis is made, based on this trend strength, traders return to the
bar chart and apply their preferred technique for the entry.

180
 11/ Average Chaos

The exit is handled in a similar fashion using signals from the MMA indicator. The
first is the way the short-term group compresses in area C, and then begins to widen
out. This is not a bubble collapse similar to those at point B. This is more likely to be
the start of a new down trend. Confirmation of this is delivered by the long-term
group of moving averages. They have begun to move sideways. Traders are on alert
for further signals which suggest the trend is ending.
End of trend signals include a narrowing, or compression, of the long-term group of
averages. Traders also look for the price spike that dips below the bottom of the
long-term group. Any penetration of the long-term group by the short-term group
of averages is a sign of bearish strength. These signals suggest the up trend is, at best,
preparing to move sideways and, at worst, starting a new down trend.

Fig. 11.1 Using the Guppy multiple moving average Compression

4.75

4.50

4.25 c
Maximum
4.00

3.75

3.50

3.25
\ Entry into tho •trong trend
3.00

Long-term group
2.75
A
2.50 Entry at start of trend

3209
Fletcher Challenge Energy Services
1605 Daily bar chart with multiple moving averages

0
(000)

181
CHART TRADING

SUMMARY • GUPPY MULTIPLE MOVING AVERAGES

A simple moving average tells us where the current price is when compared to the
average of, say, five days ago. When we combine multiple moving averages, a short-
term group and a long-term group, we see when the market has reached an agreement
about the value of the stock. All the averages narrow down into a band. When buyers,
or sellers, know something the market generally does not know, the short-term
averages move away from the long-term averages. Eventually the averages converge.
However, the maximum point of spread between the two groups signals the best
selling opportunity. When the averages cross over, it signals a change in market
valuation, and a good buying opportunity.
Sustained activity of the short-term averages above the long-term group confirms a
strong trend. The short-term group fluctuates, but while the long-term group is in a
well spread band it suggests long-term support. Signs of a weakening of the trend
are when both groups of averages begin to narrow down and fluctuate more than is
normal given their past recent activity. If both groups converge towards a crossover
a trend reversal is signalled.
(A more detailed analysis and application of the Guppy Multiple Moving Average is
included in Trend Trading by Daryl Guppy.)

182
 CROWD
THINKING_
Chapter 12

SIGNS OF THOUGHT

Understanding the movement of the crowd allows the trader to position himself with
safety. We move ahead of the crowd, anticipating when they are going to move, and
in what direction, or we leave the crowd as they change to an unfavourable direction.
We join the trend or jump off it with a higher degree of certainty when we use charts
and the first group of technical indicators discussed in the previous section. For
many traders this is all the information they need to make a successful living.
Top American trader Richard Dennis and his 'Turtle Traders' used this style of trend
trading very successfully. Dennis believed trading skills could be taught to anyone,
and the Turtles, as they became known, were literally plucked from the street and
trained in trend following methods favoured by Dennis. The result was very successful
and Jack Schwager's interview with Dennis in Market Wizards explores this in more
depth. Here we just note that the Turtles are powerful evidence of the success of just
a simple concept in trading the market.
These methods concentrate on detecting movement and its strength. For many traders
this is not enough. They want to understand how the crowd thinks. Noting movement
is one skill, but understanding what drives that movement is another issue. If we
understand what the crowd is thinking now, then we take a significant step towards
understanding what the crowd has thought in the past, and what it may think in the
future.
The market is not a game of blind chance. The distribution of prices is not random.
Each traded price is the result of an agreement between two market participants.
Each transaction is the product of serious and prolonged thinking. Understanding
what our opponents-the sellers-are thinking is very useful. Understanding what

185
CHART TRADING

our current competitors-the buyers-are thinking is also important. We are not

team players so our objective is to find a dealing edge to get ahead of our competitors
and take a point from the opposition.

• OSCILLATORS
The oscillator-style indicator resembles a market lie detector. It is based on the idea
of extremes of movement, and a return to normalcy. Extremes move the crowd away
from its comfort zone, suggesting any current pessimism or optimism is a lie-or as
the fundamental analysts suggest, borrowing terms from technical analysis, overdone.
Oscillators plot the readings as a series of lines superimposed on a chart like contour
levels, or in a separate panel displaying a cross-section of the market.
In using this style of indicator it is important to distinguish between normalcy and
equilibrium. Prices fluctuate up and down within a range. Even in a rising stock,
prices move up and down every day, although they tend to trend upwards. The trend
is defined with a moving average, or a straight edge trend line. Most of the time
prices cluster around these lines of average value. This is a point of normalcy, and is
defined by reference to the changing extreme highs and lows of price behaviour.
In a sideways consolidation pattern this behaviour is usually more evident. Prices
drift along, moving slightly above and below a centre point. Some indicators, such as
the ADX group in the previous section of Part II, work on measuring the degree of
shift away from the current normal behaviour. Essentially this is a statistical measure.
Sometimes it is a precise statistic, while at other times it is a rule of thumb observation.
In both cases traders develop an idea of normal price behaviour, and are alert to
changes which suggest the normal has been exceeded.
In contrast, equilibrium is not a statistical measure. It is a dynamic concept suggesting
a pressure to return to a state of rest. Prices cluster around a mid point because they
retreat from the extremes. Like a ball resting at the base of a round-bottomed bucket,
the tendency is to return to the exact centre point. When the ball is pushed up one
side of the bucket, it tends to fall back to the centre point at the bottom.
Equilibrium is where two opposing forces are equally balanced so neither gains a
lasting advantage. This is a long way from a statistical observation because it implies
that any variation from the norm is only temporary. Traders are eager to jump ahead
of these extreme moves away from equilibrium with strategies which 'fade the trend'.
Here they buy when prices are unusually depressed, believing prices will rebound up
to the equilibrium.

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 12/ Signs of Thought

The hedge fund group, Long Term Capital Management, used this concept as the
core of its trading strategy in 1998. In extreme markets it banked on a return to
equilibrium and used leveraged derivatives as its trading tool. Markets refused to
come back to the equilibrium, forcing Long Term Capital Management beyond the
point of bankruptcy and threatening much of the US financial system. Its expensive
bailout by banks and the US Treasury suggests the application of oscillator-style
indicators based on equilibrium requires careful management.
It is not easy to apply a concept of equilibrium to raw price data, nor to a statistical
measure of normal, because these constantly change. How do we deal with a constantly
moving target? The first solution is the idea of Bollinger bands, and we explore some
application of this below.
The second solution is found in oscillator-style indicators used to measure changes
within boundaries created by converting data into percentage readings. When readings
approach 100% they nudge a natural boundary, as they do when values approach
1%. General observations confirm that crowds oscillate between the extremes of
excitement and disappointment. In the middle lies boredom. In market terms, the
extremes are defined by the bulls and the bears, but for much of the time the crowd
is largely passive and content to be carried on a general trend, or to lie becalmed.
The oscillator-style indicators provide the trader with an opportunity to understand
how the crowd is thinking. Earlier indicators provided information about crowd
movement. This group of indicators points to way to understanding why the crowd is
moving. This is an inferred conclusion, and used with appropriate caution and applied
in conjunction with other market signals, oscillators provide important trading signals.
Their strength lies in the identification of turning points in trends. Because they look
for changes in equilibrium, the change in the balance of forces sending the bulls into
retreat, they tend to be leading or coincident indicators. The moving average tells the
trader where the crowd has been, and from this he decides on the probability of the
crowd continuing to move in the same direction. The oscillator tells the trader when
an extreme is reached. It is up to the trader to determine the probability of a return
towards equilibrium.
The novice looks at an oscillator-style indicator and dreams of the profits lodged
between 5% and 95%. The trader looks for the profit between 5% and 50%, or the
mid-point of the oscillator. Unlike a pendulum, the oscillator does not swing evenly
between the extremes, nor does it take the same time for each swing. The 'time lords'
will take issue here because the idea of defined and repeatable cycles is central to
some of their market approaches. In working with oscillators please be on the alert
for the appearance of coincidence and wishful thinking.

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CHART TRADING

No doubt the tendency in this dynamic system is to return to the point of equilibrium,
and most times the market is successful in achieving this. How we use the system and
trade it is a more individual decision. Here the objective is to examine the tools,
starting with Bollinger bands.

• BOLLINGER BANDS
The statistical measures of normal price are a launching point for oscillator indicators.
John Bollinger decided normal price was set by the simple average of prices over a selected
period. Using this as a reference point he determined the statistical spread of prices.
It is a short step from the probability of a return to a central value, to defining
extremes, and from there a dynamic equilibrium. Although it is convenient to group
indicators into crowd movement and crowd thinking, in reality it is an incremental
process as some indicators push the boundaries of definition and break into new
areas. Bollinger bands straddle this divide.
These bands are named after John Bollinger, who popularised the concept originally
developed by Perry Kaufman in The New Commodity Trading Systems and Methods.
They have no relationship to the champagne of the same name and they are not
shaped like champagne glasses. Sometimes they do deliver trading opportunities which
encourage traders to open a bottle of Bollinger.
To use this indicator we need to briefly revisit some high school mathematics and in
particular the concept of standard deviation. Start the revision with a set of random
numbers. Plot them as data points on a chart. In any collection we could draw a
median line through the plot. A variety of methods are available, and the 'least squares'
approach is commonly used. This technique fits a curve close to the given points by
minimising the sum of the squares of the deviations of the given points from the
curve. We skip the intensive mathematics involved here because charting software
completes all these calculations for us. Our focus is on the final chart and not the
day-to-day problems of the survey work.
Start with the median line drawn through these randomly distributed data points.
Now draw another two lines, each one standard deviation above and below the median
line. This captures 67% of the historical spread of random numbers. That is, 67% of
the numbers fall within this one standard deviation area. A second series of lines
plotted two standard deviations away captures 95% of the historical spread. Using
these figures we project forward for a limited time and expect the next random
number has a 67% chance of falling within one standard deviation and a 95% chance
of falling within two standard deviations.

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 12/ Signs of Thought

High school mathematics overlooks two major problems in applying standard

deviation concepts to the market. First is the non-random nature of the data. Prices
are not random. Trending behaviour is evident on any chart. Although each price is
not dependent on the previous price, it is nevertheless related to the previous price.
This is not a random number set. Prices are established by you and me, by buyers
and sellers. The price we pay today is based on our analysis of yesterday's price and
our understanding of tomorrow's potential price. The result is a trending market
where price-or data-is neither outrageously random nor predetermined.
The second problem with high school mathematics is the way our data expands.
Each day new material is added. The least squares method of drawing a reference line
finds it difficult to cope with a constant flow of new data. When the reference line
changes slope, all previous standard deviation calculations are altered. Linear regression
and other related techniques are one solution to containing and defining these changes.
Despite these difficulties, the idea of being able to define the potential range of
prices for tomorrow and attach some measure of probability to the outcomes is a
very attractive lure for most traders. The mathematics rapidly moves beyond our
rusty memory of Year 12 classrooms. Fortunately charting and analysis software
executes these calculations flawlessly, leaving us to decide which screen displays really
do help us to trade better.
Because the market is not a random set of figures, the Bollinger bands use a 20-
period simple moving average of the median price to set the calculation point for the
standard deviation value. The result is more than just a measure of trading ranges-
of crowd movement-but not quite a measure of crowd thinking. It is a statistical
measure of the probable limits of tomorrow's price moves. Now the trader has a way
to decide if the actual price move is unusual.
Bollinger bands tantalise with trading opportunities between the lower and upper
band levels. These opportunities are most useful when traders use leveraged
instruments, such as commodities and futures. The leverage provides ample return,
but in ordinary shares the dollar returns between these two points are often too small
to be worth trading.

+RULES
1. Bollinger bands map the volatility of the market. When volatility is high,
Bollinger bands are well spread apart. When volatility is low, the bands are
close together.

189
CHART TRADING

2. The bands provide short-term limits to price action. When price clusters
beyond either of the two standard deviation lines it implies a continuation of
the trend. Prices falling outside of these limits are most likely to pull back
towards the median, or middle line, value. They are less likely to pull back to
the opposite extreme.
3. When the Bollinger bands narrow down it often leads into a very rapid
change in prices. Narrow Bollinger bands do not tell us the direction of the
price change-up or down-but they alert the trader to a potential change.
4. Profitable leveraged trading opportunities arise when a new rally starts from
the lower Bollinger band and drives past the median point. Trading from the
bottom band to the top band is a useful strategy, but difficult in practice. It
is easier to identify the rally retrospectively than it is in real time. Trading
from the bottom to the top is the least effective way to use Bollinger bands.

+ CROWD RULES
Crowds tend to be slothful. The normal state of affairs is a fairly comfortable rest.
Unless the crowd is stirred up by agitators, it is most often content to amble along at
about the same pace and in more or less the same direction. This is a point of dynamic
equilibrium. As the crowd inches forward, the equilibrium point also changes.
Unless crowds are agitated it is difficult to push them much beyond the old equilibrium
points. But once the movement has started, it is easier. It is a little like pushing a
vehicle out of a bog. The first push doesn't go very far, but with each roll back, the
next push is able to get a little further. Eventually there is enough push to free the
vehicle, or in this case the crowd, from its lethargy.
The Bollinger band measures how far the next push is likely to go, based on a probable
distribution. It also is a guide to how this crowd is thinking. Is it likely to give up or
keep going? As the range of standard deviation decreases-as the bands narrow-it
becomes easier to reverse direction, or for the crowd to change its collective mind.
This suggests the crowd is growing restless. We don't know what the crowd is thinking,
but we do know it is thinking more actively than in recent times.
Can we really tell what the crowd is thinking? This is not possible, except in a very
broad sense. As a new trend develops we see a greater commitment of traders to be
on the correct side of the new trend. This carries prices further away from the
equilibrium point. This crowd is thinking positively.
As the up trend matures the continued dominance of the bulls over the bears, as
shown with successive price activity near or beyond the upper regions of a two standard

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 12/ Signs of Thought

deviations Bollinger band, is an exhausting activity. It takes an extraordinary effort

to continue to propel prices to these levels. We look for a return to equilibrium, and
when other indicators suggest a weakness in the trend we use the Bollinger bands to
set the levels where the pullback is likely to pause.
The Bollinger band concept draws from the field of probability. It plots potential
limits to price moves and acts as a guide to the way the crowd might act in the very
near future. It is tempting to take each of the Bollinger band lines and project them
forward into the future for days or weeks to define future price activity. They do not
work like this. They give the trader no more than a glimpse of the way the crowd is
thinking. True oscillator indicators catch the collective thought as it forms, and we
look at these in the next chapter.

• USING BOLLINGER BANDS

National Foods (NFD) trades in an up trend for most of the chart extract in Figure
12.1 overleaf. Although the trader could simply enter at the starting point for trade A
and later exit around $3.25 this approach does not make the best use of Bollinger band
trading signals. When we turn to a chart display like this, the first item we look for is
a guide to volatility. Low volatility delivers low risk-as shown where the bands compress
near the left-hand side of the chart. Low volatility does mean a higher level of agreement
about prices, so this is used as a guide to increased volatility in the near future.
The price plunge to $2.60 increases NFD volatility. The upper Bollinger band defines
the level capturing 95% of potential price highs above the median price. This entices
some traders to use this indicator as a base and top for the trade. In Trade A, marked
with a double-headed arrow, this is a successful strategy as the trade moves from the
bottom band to the top band. The same strategy is successful in trades I and J.
Although NFD is in an up trend, the chart does show how prices tend to return
more frequently from the extremes to the median level. This style of trading is captured
in the opportunities shown as B to H. To avoid confusion we have not shown these
with individual lines. The captions indicate the areas where these trades were possible.
Additionally, trades A, I and J all provide opportunities to trade from the lower band
to the median level, and from this level to the upper band.
We now have 13 possible trades instead of the three based purely on moves from one
extreme band value to the other.
In group 1, tradeD entered around $2.85 does not end until the first close below the
upper Bollinger band at $3.16. The others in group 1 are closed when price dips below

191
CHART TRADING

the upper Bollinger band. The same applies with trade H in group 2 which moves
from $3.02 to $3.32. In each case the entry is based on the Bollinger band value and
the exit on the best price available after a close below the upper Bollinger band.
Bollinger bands should be used along with other trend following indicators, such as
a straight edge trend line. This makes for better longer-term trade management. When
we manage a trade only with Bollinger bands we tend to look at short-term objectives.

Fig. 12.1 Bollinger band trading 3.40

3.35
3.30
3.25
3.20
3.15
Low
3.10
3.05
3.00
2.95
2.90
2.85
2.80
2.75
2.70
2.65
2.60
High volatility 2.55
NFD
National Foods 2.50
Daily bar chart 2.45
Bollinger bands 20-day
simple moving average
2.40

April

Bollinger bands are also used as a stop loss technique with derivatives such as warrants
and commodities. This helps to establish profit targets and stop loss conditions for
short-term derivative trades over one to five days. In longer-term position trades the
same approach is used to manage the trade.

192
 12/ Signs of Thought

This approach is applied to National Foods in Figure 12.2 below. In this case the entry
is usually based on some other factor, such as a close above a short-term trend line.
Once the trade is taken, the exit is managed with reference to the lower Bollinger band
placed one standard deviation below the median line. This allows prices to run upwards
without generating any exit signals, but it limits the amount of any pullback. This is a
volatility stop which signals an exit when prices close more than one standard deviation
below the median line. Although the technique is applied to a stock in this example, it
is primarily used in derivative markets. The full application is discussed in Bear Trading.
The Bollinger band approach is quite different from the trading channels discussed
in Chapter 6. There the bands are defined by support and resistance. Traders buy at
support and sell at resistance trading from one price extreme to the other.

Fig. 12.2 Modified BoUinger band trading

3.40
3.35
3.30
3.25
3.20
3.15
2 standard
3.10
3.05
3.00
2.95
2.90
2.85
2.80
2.75
deviation 2.70
2.65
2.60
2.55
2.50
NFD
2.45
National Foods
2.40

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CHART TRADING

SUMMARY • BOLLINGER BANDS

Bollinger bands are calculated using standard deviations-usually two-from a 20-
period moving average based on the close. Adjust these parameters if you wish but
remember that the default settings are based on extensive testing and deliver the best
results in most cases. The bands define short-term limits to price action. Prices falling
near these outer limits are most likely to pull back towards the median, or middle
line.
Some trading approaches are based on trading from the bottom to the top of the
band. Better trading approaches build the trade around a move from one extreme
towards the median value. In leveraged equities, such as commodities and futures,
the leverage provides ample return, but in equities dollar returns are reduced.
To apply Bollinger bands as a stop loss technique Ezy Chart users simply change the
properties of the Bollinger band display.
Metastock users need to set up a template for future use. First select the stock you
wish to study. Apply the standard Bollinger band indicator. Click on the upper line
in the display to bring up the 'Properties' box. Change the parameters to one standard
deviation. Select the upper line and median lines and make them white. This way
they cannot be seen.
Drag down the second set of Bollinger bands, and set them on two standard deviations.
White out the lower band by using the 'Properties' box. This display will now show
a median price and an upper band two standard deviations away, and a lower band
one standard deviation below.
Save as a Metastock template. Choose 'Save as' from the menu, then select 'Save as
type - Template' from the screen dialog box. Next time you want to apply this
template, just right click on any chart to bring up a list of templates.

SUMMARY • LINEAR REGRESSION

This is derived from scatter plots. The objective is to plot a line as close to as many of
the points as possible. This gives a measure of the potential to return to the line.
The line is plotted using the least squares fit method. This 'fits' a trend line to the
data in the chart by minimising the distance between the selected data points to plot
the linear regression trend line. This makes the line more responsive than a moving
average line. The linear regression line shows where prices statistically are expected
to be.

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 12/ Signs of Thought

Linear regression plots also deliver an R-squared figure. This is the percentage of
price movement explained by linear regression. If the R-squared value over 14 days
is 80% it tells us that 80% of the price movement is explained by linear regression.
The other 20% is market activity as traders jostle to reach agreement on price and
value. It is largely meaningless noise in terms of the trend.
The R-squared value tells us the probability of the trend continuing. This is related
to the number of periods used in the calculations. These are statistically significant
values. Readings below these show no statistically significant trend.

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Chapter 13

MIND READERS

Oscillator-style indicators provide a way for the trader to understand how the crowd
is thinking. Calculations are based on price data and the results are used as messages
about the strength of the market. The way market strength waxes and wanes is used
to reach inferred conclusions about market thinking. We cannot really understand
how the market is thinking, but we do use repetitive market behaviour to make well
informed judgements about the potential outcomes in the future.
The position of each day's reading on the plot display gives the trader an indication
of the strength, or weakness, of the existing price trend. The stochastic is a common
indicator included in most charting packages and is based on moving averages. It
plots the relationship of closing price to the high-low range of a user-determined set
time period. It captures more than just movement, because extreme movement implies
a reaction in the opposite direction. The more extreme the movement, the greater
the probability of a counter-reaction. It's not quite Newtonian physics, but the
principles broadly hold true. For every market over-reaction there is a counter-reaction,
often of equal force .

• FAST STOCHASTIC
The stochastic plots this movement as a result of several calculations. We start with
the fast stochastic used to catch short-term turning points. The first calculation
compares where the price closed today relative to its trading range over, usually, five
previous periods. The trading range is determined by the lowest low and the highest
high over the specified period. We use five periods and other default settings in the
discussion below-these are the standard settings used by most software packages.

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 13/ Mind Readers

Extensive development and testing by many traders show these settings are broadly
accurate with most stocks and commodities. Sometimes a small advantage is gained
by adjusting these values, but this often applies to just a small selection of stocks.
The result of this first fast stochastic calculation is expressed as a percentage. The
%K line plot shows where today's close is as a percentage of the trading range over
the last five days. The %Kline is confusingly called the fast line. This tells the trader
if today's close is near the upper or lower extremes of previous average price activity.
Essentially we get a reading in percentage terms of the degree of bullishness or
bearishness in the market. When one group pushes prices up and keeps them in the
upper section of the previous trading range, then that group is dominant. This fast
stochastic result is useful, but it sometimes gives false signals.
Any short-term average jumps up and down, so it is useful to smooth out these
fluctuations. Some traders use a longer-term moving average for this smoothing, as
shown in the earlier section on using two moving averages in Chapter 9. They watch
for crossover signals.
The stochastic tackles this problem in a different way, smoothing the first average by
averaging it again. A moving average of the first indicator value, %K, is calculated.
This provides data points for a second line. Essentially the five-day moving average is
slowed down by calculating the three-day moving average of these values. This is
often called the slow line, or %D, because it slows down the fast moving %Kline.
Stand by for confusion. When short-term averages are used in the first calculation of
the %Kline the entire construction is called a 'fast stochastic'. The 'fast line' is one part
of this fast stochastic. Like all short-term calculations, this stochastic catches more
turning points than long-term calculations, but fails to rank them. Minor turning points
look the same as major turning points. Only future activity confirms the difference.

• SLOW STOCHASTIC
The solution is a slow stochastic. This bundles all the previous calculations-
smoothing, or slowing, them further-with more average calculations. The new display
continues to use the terms %K and %D. The value of the %D calculation used in the
fast stochastic becomes the %K of the slow stochastic. It is further smoothed by
using a three-day average and plotting the value as a second line, again called %D.
The formula for this is embedded in your charting software so it is not shown here.
Many traders claim the slow stochastic does a better job of eliminating market noise.
The Metastock stochastic default is a slow stochastic. The default setting uses a five-
bar slow stochastic smoothed, or slowed, over a five-day period to plot the %K line.

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CHART TRADING

The %D line is a three-day average of %K. Ezy Chart gives users the choice of
displaying the slow and fast stochastic as separate indicators.
Is this just playing with numbers? For some traders, using stochastics and other complex
indicators does become a numbers game like a university mathematical challenge.
Successful traders concentrate on what the indicator can do for them. In evaluating
any indicator we look for an historical match between the turning points identified
by the indicator, and the turning points evident on the bar chart. In the final analysis,
the indicator must be sufficiently accurate to make money for us, and preferably
consistently. If the oscillator turning points do not match the trend changes in the
stock we are following, then this indicator is not a useful trading tool. Use the same
test with any indicator or chart pattern.
The confusion is not complete until we introduce long-term stochastic oscillators.
These are designed to identify more significant market turns. Their success should be
judged on their ability in the past to match the historical trend changes. The starting
value of five days is replaced with 15, 20 or even more days. The fast and slow
stochastics calculations remain the same, although some traders modify the smoothing
values to reflect the longer time frame.
Numbers games are sometimes interesting, but our objective is to make them
profitable. The stochastic is useful for showing when markets reach extremes. Because
the calculations are all based on percentages the indicator commonly uses a 20% line
to indicate oversold, and an 80% line to indicate overbought. Depending on the type
of stochastic used-short-term or long-term-the trader is able to identify rally turning
points, or trend turning points. In certain circumstances, these turning points are
identified before they appear on the bar chart.
This understanding of how the crowd thinks sometimes helps the trader become a
mind reader. Use this power with a great deal of caution.

+RULES
When stocks are trapped in a trading range, consolidation patterns, or an extended
sideways movement, traders apply these rules. The stochastic does not work well in
new trends.
1. Buy stock when both stochastic lines cross above the 20%-oversold-line
because this suggests the market has realised it has overdone the selling.
When %K rises above the %D line in the area below the 20% line a buy
signal also appears. These stocks are cheap and the market is beginning to
realise this.

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 13/ Mind Readers

2. Sell when the stochastic falls below the 80%-overbought-line because now
the market realises it has paid too much for the stock. When %K falls below
the %D line in the area above the 80% line a sell signal also appears. These
stocks are overpriced.
3. A stochastic spends most of its time around the 45% to 55% band. Many
good trading opportunities exist for traders who buy the low points and sell
when the stochastic reaches the 50% area. This does not mean a 50% return.
Actual returns may be larger or smaller depending on the type of stock.
4. Some traders also act when the fast stochastic line crosses the slow stochastic
line. This is rarely a profitable strategy with equities. It is a profitable
strategy when trading leveraged derivatives like high volume warrants,
futures contracts, or speculative stocks.

Modifications
The stochastic indicator, and all oscillator-style indicators, do not work well with
trending markets when they reverse. When a strong down trend reverses and becomes
a new strong up trend, oscillator indicators perform poorly. When a stock develops a
new strong up trend the stochastic continues to give overbought signals while the
market rallies. Applying the basic stochastic trading signals takes the trader out of
profitable trends. In a trending stock the stochastic signals are modified with a long-
term trend following indicator, such as a weekly MACD histogram, two moving
averages, or signals from the Guppy multiple moving averages indicator.
S. In an established up trend, buy when the stochastic moves below the 20%
line. This method generates buy signals as prices make temporary retreats
despite the general trend upwards. In a down trend, better exits are made
when the stochastic peaks above the 80% line.

Better Signals
In previous chapters we explored the concept of divergence, applying it to the MACD
histogram. Divergence signals occur when the indicator moves in one direction, and
the price moves in the opposite direction. Divergence is a powerful trading signal
with all oscillator indicators because it suggests a difference between what we see on
the price chart and what the crowd is thinking.
6. Bearish divergences occur when prices create a new peak, which is not
matched with a new stochastic peak. This is not a signal generated during a
rally. It is only observed after the price rally has started to decline. This lags

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CHART TRADING

price action by several days. Even still, it is a leading indication of a market

preparing for a downturn.
7. Bullish divergences are noted when prices dip to new lows, before a rally.
The stochastic follows the same pattern, but the low point is not as low as
the previous stochastic low point. When the stochastic turns up from the
second bottom, a strong buy signal is generated.

+ CROWD RULES
Movement reveals character in individuals. We make these judgements every day as
we walk down the street. Unfortunately in many places a comfortable walk down the
street encounters a hazard imposed by public drunkenness. Instinctively we use the
movement of individuals as a guide to their character, and their likely action. Some
drunks are no more than a nuisance, easily avoided. Others are aggressive and a
potential threat. Some look happy, while others are dangerous. Without pausing in
our stride to make a detailed analysis, we catch enough of their movement to make a
working judgement. Do we walk past or make a wide detour? We use movement to
give us clues about the way others are thinking.
City dwellers make the same style of judgements when confronted with potential
muggers, drug addicts, skateboard riders and rowdy youths. Traders also make these
kinds of judgements about the behaviour of the market crowd. The stochastic
formalises those observations in a consistent way. In particular, we understand when
the market is overbought or oversold. From these points we make better judgements
about the potential for the crowd to change its mind. As markets move towards
being oversold we anticipate a change in direction based on the extreme thinking
which sells down stock, pushing prices below any reasonable assessment of value.
Any stochastic gives two types of trading signals. The first group is overbought or
oversold signals. For instance, when many people are really disgusted with a stock,
they tend to sell it even though it may still be a very good company. This action
includes the short-term panic days in October when everything is sold down.
On the other side of the crowd equation, regarding the second type of signal-
sometimes people get so carried away that they will pay whatever it takes to get hold
of stock in what they believe is a good company. Examine the initial price action of
any new company listing with '.com' in its name in the late 1990s. Some traders, and
many novice market players, were carried away easily.
Overbought or oversold, or just carried away-in both cases the stochastic provides
a guide to the way the crowd is thinking. A crowd so carried away with the rush of

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 13/ Mind Readers

movement to buy or dump stock does not have time to stand back and evaluate their
thoughts. Traders use the stochastic oscillator to delve into the crowd consciousness
so they can get out before the crowd changes their mind.
Recognising extremes of crowd behaviour does not sound difficult, but when we are
part of the crowd of buyers or sellers it takes skill to remain objective. It takes even
more skill to recognise when the crowd has been quietly abandoned by its leaders.
These divergence signals are easily drowned out by crowds chanting 'sell' or 'buy'.
In Indonesia the student-led Reformasi movement failed to note the difference. Those
who shout the loudest are sometimes the least well informed. The leaders are
sometimes the first to retreat when the situation gets out of hand. They make a quiet
withdrawal while their most ardent supporters continue to man the barricades, shout
the slogans, and taunt the forces opposing them. When the opposing forces do attack,
it is the followers who are slaughtered. The leaders made a tactical retreat hours or
days before because they thought the cause was weakening.
Divergence signals generated by stochastic tops and bottoms provide the same insight
into the thinking of the crowd. The crowd is still shouting strongly but the bearish
divergence tells the astute trader the leaders are already in retreat. When the bears
attack, they roll back the noisy but ineffectual crowd of bulls. As traders we need
tools to understand this part of crowd thinking. Stochastic divergences do the job.

• USING STOCHASTICS
In the textbooks the stochastic oscillator delivers clear results, but in real world trading
the display is much more confusing. When the up trend starts in the Freedom Furniture
(FFL) price the stochastic moves from the oversold area in Figure 13.1 overleaf.
This is marked A and the lines rapidly move above the overbought line. Applying a
simple crossover technique, the entry is signalled at $1.10 and the exit at $1.30. The
exit is based on the crossover signal when it takes place above the overbought reference
line. This classic stochastic trade captures an 18% return. On the day of the exit the
trader is happy, but within a week he is displeased and at the end of several months,
very annoyed. A new up trend is established and the stochastic indicator has taken
him out of the trade early.
As the up trend continues in November and December the stochastic continues to
show overbought conditions. A potential entry signal flashes at point B as the %K line
dips into oversold. Eager traders enter the established up trend on this price weakness.
They may make reference to the stochastic, but they cannot validly use the stochastic
as a signal because there is no crossover signal generated below the oversold line. The

201
CHART TRADING

next valid buy signal does not come until point C. A rigorous application of stochastic
trading rules keeps the trader out of most of the FFL rise from $1.10 to $2.00.
The same rigorous application encourages the trader to buy at point C but history
shows point Dis a more accurate match for a temporary low. It is tempting to ignore
point C and tell you point D is the ideal entry point. It is also dishonest. The stochastic
does generate false signals and we have to live with them. A combination of stochastic
and other charting techniques will confirm a better entry.

2.0
1.9
1.8
1.7
1.6
1.5
1.4
1.3
1.2
FFL
Start of up trend Freedom Furniture 1.1
Daily bar chart and stochastic 1.0
---~- -----~ ~--- ·-- ---------------~---

- - P.r.J-

100
90
80
F
70
60
50
40
30
20
10

C D
tober

This entry in this example gets the trader in at $1.65. The classic stochastic exit based
on the %K and %D crossover above the overbought line takes the trader out at
$2.00 for a 21% return.

202
 13/ Mind Readers

Perhaps I should have chosen a better example? I certainly could have, but only at
the risk of deceiving the reader. In certain circumstances the stochastic does give
useful signals, but for much of the time the action is not helpful in making trading
decisions. Separating the good signals from the bad signals takes time and experience.
In trending markets the stochastic performs well when it is used to verify trading
signals generated by other analysis tools. The best FFL trade makes an entry at the
start of the up trend signalled by a trend line break and confirmed by the move above
the oversold area. The trade is closed around $1.80 as the trend line break is confirmed
by the stochastic move below the overbought area marked F.
Sorting the good signals from the bad is easy on an historical chart. Hardman Resources
(HDR) ends up trapped in a sideways consolidation pattern in Figure 13.2 below. Once
this is established, the stochastic signals several useful trading opportunities. As HDR
comes out of the down trend the stochastic flashes misleading signals. Point A looks like
a buy signal, but point B coincides with the low of the down trend and the start of the
consolidation pattern. Remember, stochastics are not good tools to use as trends change.

Fig. 13.2 Stochastic consolidation trading

HDR
Hardman Resources 0.065
Daily bar chart and stochastic
0.060
0.055
0.050
0.045
0.040

···- -· ·- .. -· - - - -,------~-- ----- - . ---

0.035
·-[;I~-

--------
Exit 1
100
90
Overbought
80
70
60
50
40
30
20
Oversold
10
Entry 1
A

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CHART TRADING

The first entry is made several months into the consolidation pattern. The exit does
not match the high at point C and unless the trader is careful the exit is at $0.044
rather than $0.046. These are slim trades, and a few cents makes a difference. The
best result based on an entry at $0.039 returns 18% while the worst is 13%.
The second trade entry is signalled at $0.045 when the %K and %D line cross over
and turn above the 20% oversold line. Although we take an exit when the same
conditions occur above the 80% line at $0.052, we should note the false signals. We
do not take an exit at point D because only the %K line moves above the overbought
level. More difficult are the signals generated at the points marked E. Acting on these
signals takes the trader out at $0.045 and then back in just a day or so later at
$0.045. The whipsaws cost additional brokerage fees and sap confidence in the
accuracy of the stochastic. In either case the trade returns 15% before deducting
brokerage costs.
In a sideways market the stochastic generates fewer signals but they allow the trader
to make better trades which capture a good slice of the price action. We watch the
battle between the bulls and the bears and the stochastic helps us decide which side is
winning in the current fight.
Trades built around stochastic signals work effectively in leveraged markets, such as
warrants and futures, or with low priced speculative stocks. They are often less
successful with other equities on a daily chart. A weekly view often gives more tradeable
results, and we consider this approach with another oscillator indication, the Relative
Strength Index, in the next chapter. Traders working with stochastics must be careful
to avoid seeing what they want to see in preference to rigorously applying stochastic
trading rules.

SUMMARY • STOCHASTIC$
The stochastic oscillator compares where the price closed today relative to its previous
trading range over, usually, five periods. The trading range is the lowest low and the
highest high over the specified period.
The range is the distance between the low and the high for the day. Prices tend to
oscillate by about the same amount for extended periods because buyers and sellers
are fairly evenly matched. When the range is greater than normal it tells us there is an
imbalance between buyers and sellers. If the direction of the imbalance is upwards it
suggests buyers will bid higher to satisfy the demand because the supply of sellers is
limited. If the supply was greater then all buyers would be able to buy at lower
prices.

204
 13/ Mind Readers

The %K line plot is a smoothed line and shows where today's close is as a percentage
of the trading range over a specified number of periods. A moving average of the
indicator values is overlaid to give a second line. Because all results are expressed as
percentages, the indicator commonly uses a 20% line to indicate oversold, and an
80% line to indicate overbought. A shortcoming is when a prolonged trend is in
place. Here the stochastic consistently shows overbought or oversold.

205
Chapter 14

THE POWER OF THOUGHT

Achart in the hands of a Sunday sailor is an instrument of safety when compared to

the chart held by Captain Aheb. The chart he created started off as an ordinary plot
of his voyage. It grew to reflect his own obsession with the path of Moby Dick, and
later the white whale sinks Aheb. Market charts sometimes show obsession.
If we fail to see the drift from normal crowd behaviour to madness then the crowd
will sink our trading. We want strong commitment to a stock because it supports a
steady trend. When prices move to extremes we look for warnings and, in particular,
any sign of people quietly deserting. When traders explore the way the crowd thinks
they look for clues to the strength of commitment.
The Relative Strength Index (RSI) is a leading, or coincident, indicator based on
measuring the strength of a stock by tracking changes in closing prices. It uses only
those changes where the close is higher, or lower than the previous close.
The user defines the period to study-either a 7, 9, or 14-day period-in the relative
strength calculation. The default is 14. We are interested in the higher closes in this
period because they tells us the crowd is getting more excited. The total increase in
the 14 days is added and then averaged. The same calculation is applied to days
which closed lower in the past 14 days. The average of the up days is divided by the
average of the down days and converted to a percentage result.
The results are used to deliver messages about the strength of the market. This indicator
is an oscillator because the readings are converted into percentage results which range
from 0% to 100%. The position of each day's reading gives the trader an indication
of the strength, or weakness, of the existing price trend.

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 14/ The Power of Thought

In this sense the RSI is very similar to a stochastic and uses similar principles. Where
the stochastic quantifies the ability of the market to close near the high or the low of
the day, the RSI quantifies the strength of movement higher or lower. The overbought
and oversold signals are the same as for any oscillator, although with an RSI they are
traditionally set at 70% and 30%.
The most significant trading signal delivered by any oscillator-style indicator is a
divergence signal-for example, in an up trend a new price high is not matched with
a new RSI high. The same divergence signals are given at the end of a down trend
when the stock makes a new low, but the RSI does not.
Divergence signals do not occur with every trend change, but when they do occur,
they deliver a strong trading signal. The RSI is one of the very few oscillator-style
indicators where trend lines and support and resistance lines can be applied to the
screen plot. Use these as confirming signals. When other chart patterns suggest action
then the RSI trend line might also confirm this.
The RSI comes with an important warning. The accuracy of this indicator was challenged
by the behaviour of the Australian market in late 1998. While the market made new
highs, the RSI showed declining peaks. This classic divergence signal proved useless as
the market continued to make new highs well into 1999. These divergence signals
came from the daily RSI chart. This failure does not mean the RSI should be discarded.
Like any indicator, the RSI is a guide to understanding the market. No indicator
comes with a 100% guarantee. When we use indicators we only shift the balance of
probability in our favour. Traders are always prepared for the market to prove them
wrong. They improve the probability of a correct market call by using several different
indicators to confirm the results. One might measure movement, another the way
the crowd is thinking, a third helps them understand why the crowd is acting this
way, and the last might provide specific entry or exit prices. No indicator is used as
a single stand-alone trading signal.
No indicator is totally accurate. Although we use them to suggest high probability
outcomes, always remember that some of the low probability outcomes will also
prove to be true some of the time. We trade with the balance of probability on our
side, but also with an eye open for failure. When the market fails to move as we
anticipate, then trading positions are closed and the situation re-evaluated.

+RULES
1. Bullish divergences-a new valley low with price matched by a lesser valley
low on the RSI-generate a buy signal. The signal has a higher probability

207
CHART TRADING

of success if the first RSI valley low was below the 30% line and the second
RSI valley low is above 30%.
2. Bearish divergences-when a new rally peak is not matched by a new rally
peak on the RSI-give a sell signal. The signal has a higher probability of
success if the first RSI peak is above 70% line and the next RSI peak is
below 70%.
3. All RSI divergence signals have a higher probability of success when applied
to weekly charts. When both daily and weekly RSI divergence signals agree
there is a high probability of a trend change.
Many traders believe the probability of success is improved when divergence
is confirmed with stochastic indicators.
4. Straight edge trend lines can be applied to the RSI-although with caution.
Some traders use RSI trend line breaks as a leading indicator of a trend
change. In stocks where this method has been accurate in the past it can
usually be usefully applied to future price action. In many stocks this
approach offers no clear advantages over other trend break techniques.
5. Like all oscillator-style indicators, the RSI spends most of its time around
the 45% to 55% band. Many good trading opportunities exist for traders
who buy the low points and sell when the RSI reaches the 50% area. This
does not mean a 50% return. Actual returns may belarger or smaller
depending on the type of stock.

+ CROWD RULES
It is difficult to pinpoint the moment of change from spirited criticism to an ugly
crowd throwing bottles at the umpire. We do observe the way the crowd avoids a
riot by refusing to follow the bottle throwing leaders. The instant the first missile
lands, some of the crowd are repulsed. As more bottles are thrown, the crowd turns
its anger on the culprits.
Generally the bottle throwers are isolated. They do not have crowd support. Their
influence relative to the crowd is weak even though they attract a lot of media coverage.
In our terms there is a divergence between what we see on the TV coverage and the
general behaviour of the crowd.
Some countries take sport to extremes. Here the bottle throwers do have the support
of the crowd and it is just a short step to a full scale riot. When the crowd follows the
leaders .the relative strength of the bottle throwers is confirmed by the crowd action.

208
 14/ The Power of Thought

The RSI does no more than indicate the relative ability of the bulls to continue
closing prices higher-of the bottle throwers to incite the crowd. It does provide us
with clues about the internal strength of the segment of the crowd most influential in
setting the closing price.
Which part of the crowd makes money? The closing price provides a good guide to
this mainly because this is usually substantially set by the smart money. When the
market closes higher the bulls overcome the bears. The winning margin tells us how
strong they are. Growing strength means we know it is safe to stay with the bulls.
But if the bulls are losing strength-if they cannot push as far today as they have, on
average, over the past 14 days, then we ought to think about switching sides. In
practice this means selling profitable positions.
When we first start to trade, our objective is to remain on the side of the big guns so
we look for trend following indicators. As we gain more trading experience, we try to
second-guess the crowd. Some traders look for leading indicators. Others look for
signs the crowd is weakening in its resolve, that the trend is slowing, or where hysteria
has replaced common sense. The RSI assists in these searches for the fatal weakness in
all crowd activity, delivering signals which allow us to act in anticipation of the crowd.

• USING THE RELATIVE STRENGTH INDEX

The most powerful RSI signals are generated by divergence. The first step in applying
these signals is to identify the price peaks on the bar chart. The National Foods
(NFD) chart in Figure 14.1 overleaf shows how these peaks are defmed. They stand
above the surrounding price action marking the end of significant rallies. Significant
is, of course, a relative term. The small peak at point 1 is not significant because it is
part of a continuing up trend. Peak A is a turning point followed by a sustained price
retreat, Peak B has the same characteristics. It is also higher than price peak A.
Divergence appears in the relationship between these higher peaks and peaks on the
RSI display. Assuming the trader purchased NFD at lower prices many months ago,
the divergence generates an RSI sell signal taking the trader out at around $3.25.
The RSI peak corresponding to price peak B is lower than the preceding RSI peak.
Although the price peaks have moved higher, the RSI peaks have moved lower,
exposing weakness in the market. It would be useful to act on this signal as soon as
it appears, but in practice we wait for confirmation of the price action around peak
B. We cannot define this as a peak until prices retreat from this new high. The
divergence signal is usually reliable, but it is not always timely. This observation
applies even more strongly to weekly charts.

209
CHART TRADING

Some stocks offer consistent

Fig. 14.1 Relative Strength Index divergence signals volatility and many trading
Price peak B J.4
opportunities. News Corp
(NCP) is noted for this
3.3
behaviour and the RSI gives
3.2 us a way to trade it. Rather
3.1 than using movements from
3.0
one extreme to the other, this
approach trades the return to
2.9
equilibrium. This is shown
2.8 with two horizontal lines
2.7 placed at 45% and 55%.
divergence
2.6 Five entry points are shown
2.5 as A to E in Figure 14.2
opposite. Enter as soon as the
RSI begins to turn up from
the extreme. This does not
70 rely on RSI values moving
65 below the 30% reference line.
60 Only two of these trades, B
55 and C, start from this level.
50
45 Exits are taken immediately
40 following the first peak above
35 the mid-level value at 55%.
30 Each trade starts at the
25 extreme and aims for an exit
20 near the equilibrium area
;::.::;.::;..:;:::;...::;=r-:.r.:.:;:..::.;::.:r-,-,--r-T--,-,rT'""T'"n-,.-,-,-f---- defined by the band between
45% and 55%. Only trade E1
has an exit signal above the
70% reference line.
These trades do not return a fortune. In order of execution the returns are 11%,
13%, 32%, 14% and 20%. By using this approach toRSI trading the trader is able
to profit from the volatility of this stock. Trend based traders have difficulty because
traditional tools lag the market too much. With this volatility the entry is too late
and the exit fails to capture the maximum level of profit. In this chart sequence a
moving average crossover approach captures just one trade with a 14% return.

210
 14/ The Power of Thought

Applying a trend line to the RSI display, as shown by the lines with arrows, delivers
inconsistent results. While trade C provides a close match to the preferred entry and
exits points, trades A and B signal an exit well behind the price action. Trend lines
are applied with caution to RSI displays in most cases.
Divergence signals are the most useful of RSI trading applications. Trading from
extremes to the equilibrium point provides a good way to trade volatile stocks, and
to trade leveraged derivative and commodity contracts where small moves translate
into good profits.

Fig. 14.2 Relative Strength Index - trading the extremes

13.5
13.0
12.5
12.0
11.5
11.0
10.5
10.0
9.5
NCP
9.0
News Corp
Daily bar chart with RSI
8.5
- --- --- ------- ·- --- -- - - - - - - - - - - . ~- -----R n
85
80
Cl 75
AI Bl Dl 70
13% 65
60
55
50
45
40
35
30
25

SUMMARY • RELATIVE STRENGTH INDEX

The Relative Strength Index compares the internal strength of a stock by looking at
the average of the upwards price changes and comparing this with average of the

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CHART TRADING

downward price changes. The results are expressed as a percentage, providing the
upper and lower boundaries-70% and 30%. The plotted results oscillate between
these two levels and give traders information about the speed and acceleration of the
changes. Trading signals are given when prices and speed diverge-for example a
new price high but not a new RSI high. RSI is also used to show tops and bottoms
before the tops and bottoms appear on a price plot.

212
 CROWD
ANALYSIS_
Chapter 15

END OF EMPIRE

Traders always try to understand, and then second-guess, the market. They search
for evidence of repeated behaviour, for indications of movement and clues to the
way the market is thinking. All traders are fascinated by strength and in particular by
the way every crowd contains the seeds of the next trend. They want to "look into
the seeds of time and tell which grains will grow and which will not." Macbeth turns
to the three witches for this information. Traders often turn to general statistical
measures.
Every empire comes to an end, and every trend declines. In The Decline and Fall of
the Roman Empire, historian Edward Gibbon identifies the leading indicators of
collapse. Traders use a census gathered from general market data. This statistical
analysis of the crowd identifies strength and weakness.
These statistics are not technical indicators in the same way as those discussed in
previous chapters. We do not take price data, dissect it and reassemble it in new ways
to discover clues to the way the crowd is thinking. The indicators we will look at
here are census measures of crowd activity. Like a census, the results are not generally
applied to individual stocks. These graphs, or plots, show us the relationship between
all the individual listed companies in the market.
These include New High_New Low and Advance_Decline data. The information
comes from the entire market. This is a daily census, electronically gathered and
compiled by the end of each trading day. Gibbon used the number of Roman circuses
as a guide to decadence and decline. We are more exact.

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CHART TRADING

• NEW HIGH_NEW LOW INDEX

The New High_New Low data is usually referred to as an 'index'. It tracks those
stocks which are making new 12-month highs or new 12-month lows. In the bull
market of the latter parts of the 1990s, many stocks made new 12-month highs. The
stocks on this list are trading at the highest price they have ever been in the 12-
month period. These are strong stocks.
This data collection is most useful when the 12-month calculation is made based on
a rolling year. Each day is taken as the starting point, and the previous 12 months
scanned. If the stock has made a new high, then it is added to the list. The same
applies to those stocks making new lows.
This New High_Low index list tracks the strongest and the weakest individual stocks
in the market. It measures the balance of power between the group of weakest stocks
and the group of strongest stocks. Where the strong stocks are dominant, then the
general market is rising in a bullish trend. While the New High_Low index is above
the centre line on a screen display we know the market is bullish.
The general public is accustomed to using the All Ords, or the Dow Jones, as a guide
to market strength. Good times in a bull market are confirmed when the market
index rallies to a new high. The All Ordinaries Index measures the performance of
just a few hundred stocks on the ASX, based on market capitalisation. The Dow
Jones similarly records the activity of around 30 stocks on the New York Stock
Exchange. Although commonly used as yardsticks of market performance, they are
both poor indicators of the broader market.
The New High_Low index measures the performance of all stocks and selects just
those which are performing much better-on an annual basis-or much worse than the
rest of the market. The New High_Low index concentrates on the real market leaders.
This index gives us a way to verify the performance of the All Ords. Although the
biggest stocks in the Australian market may be performing quite well, this is sometimes
misleading when compared with the rest of the market. When the market slows in an
up trend the rate of new highs also slows. This does not mean price rises collapse,
but it does mean fewer of the rises establish new 12-month highs.
This divergence signal is the most useful application of the New High_Low index.
Traders look for the divergence signals created when the market index, such as the
All Ords, makes new highs but the New High_Low index fails to make new highs.
Like many of these styles of indicators, daily action is sometimes deceptive. Once a
divergence is suspected on a daily chart it is useful to verify this on a weekly chart. In

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 15/ End of Empire

particular we look for divergence between the peaks of price activity, rather than
between individual daily bars. While individual bars may vary in a period, what is
more useful is the way the bars form a series of peaks and valleys. We look for
divergence between the peaks of the All Ords index activity and the peaks of the New
High_Low index.
When this divergence occurs, it suggests the market is travelling higher without
widespread support from the broader market. This is a sign of trend weakness, and it
encourages traders to consider individual positions with more attention.

+RULES
1. Divergence. This is the most useful application of the New High_New Low
index and is best applied on a weekly chart. When the All Ords completes a
new higher peak, and the New High_Low index fails to complete a new
higher peak, then the up trend is in trouble.
The reverse signals are taken in a down trend where the market shows new
lows but the New High_Low index makes a higher low. This suggests the
down trend is slowing and ready to change direction.
2. These divergence signals are leading signals. They may lead the markets by
weeks, or sometimes even months. It is unwise to use these signals as timing
signals for individual trades because of the time lag involved. When the head
is lopped from a snake, the body continues to lash about for some time.
When New High_Low divergence signals the end of a trend, the trend might
not reverse for some weeks after the signal. Use these as warning signals.
They give traders time to subject their open positions and intended positions
to closer scrutiny.
3. Some traders use the New High_Low line in conjunction with a straight
edge trend line. While the trend line is up the market is bullish. Traders who
wish to follow this application should verify the trend signals on the New
High_Low index with the direction of the trend on the All Ords, or other
market index they are using. In many cases the relationship is not strong and
delivers many false signals. This encourages traders to close positions while
in fact the market trend continues upwards for extended periods.
4. The position of the New High_Low index above or below the trend line is a
broad market indicator. Above the line suggests the bulls are in charge, and
below the line shows the bears are in charge. This type of broad movement is
rarely in advance of signals from other trend change indicators.

217
CHART TRADING

By the time the New High_Low index moves above the centre line into
positive territory the general All Ords Index has usually already flashed new
trend signals across a range of more easily applied indicators, such a moving
averages.

+ CROWD RULES
Each year my son flies south to Melbourne to attend the cricket. His grandfather
picks him up at the airport and they go to the Melbourne Cricket Ground (MCG).
Sometimes they go with assorted cousins and relations, or friends. They form a small
crowd within a much larger crowd. Within this small group there are disagreements
about where to sit, when to eat, and who gets the best seat.
Just like an individual stock, we track these disagreements and the impact they have
on the behaviour of this small group.
If this group of friends decided to join the larger crowd in Bay 13-which popular
media has us believe is the last refuge of the Australian larrikin-then we have two
crowds to assess. The first is the small group. The second is the crowd jammed into
Bay 13. Now the group dynamics change. Our little crowd is not free to choose
exactly where it sits, or who gets the best seat. They take this action within the
context of the larger crowd in Bay 13. In anticipating how the little group is likely to
behave it is useful to understand how the larger group-Bay 13-is behaving.
In evaluating an individual stock we also take into account the behaviour of the
index it is related to. Westpac is assessed against the banking index, Normandy Mining
against the gold index, and News Corp against the media index.
The MCG crowd is bigger than Bay 13 so, despite the antics of this group of rowdies,
the larger crowd usually goes in quite a different direction. Although the larger
crowd rarely controls Bay 13, it can act to calm it down, or to inflame it. Bay 13 may
capture some media attention for a few moments, but the final reports are based on
the general crowd behaviour rather than the activity of Bay 13.
The All Ordinaries Index fills this role in the marketplace. Statistical measures prove
an additional way to understand this wider crowd. They do not replace the other
indicators we have discussed as they are best applied only to the entire market group.
They rely on understanding and recording the activity of the small crowds which
together make up the market.

218
 15/ End of Empire

• USING THE NEW HIGH_NEW LOW INDEX

Divergence is the most useful signal and Figure 15.1 below displays two complete
sets of divergence signals. The first is a short-term signal starting with line A. Traders
expect the market to fall in a heap in June as a direct result of an outdated taxation
system that rewards losses and punishes profits. Using a daily chart, traders take
advantage of the divergence pattern developed after points A and Al. The new low
at B is not matched by a new low at Bl. The recovery in mid-June is a trading
opportunity confirmed by the way the histogram fails to match the new lows. Active
traders take advantage of this to enter early and trade the July rally.

Fig. 15.1 New High_Low index

300
200
100
0
-100
-200
-300
-400
-500
-600
-700
-800
AI Bl -900
-1000
- - - - - - - - - - - - - - - - - - - --- r:I F.I
XAO 3200
All Ords
3100
Daily bar chart
3000

c D
2900
2800
2700
2600
2500
2400

219
CHART TRADING

The second divergence signal is in a longer time frame. September threatened a

market shake-out. A few days of panic gripped the market and the pessimists projected
a continued decline towards the traditionally regarded 'horror' month of October.
Instead the early September madness transformed itself into a solid up trend. Traders
with the courage to enter in early September were well rewarded. The New High_New
Low index helped confirm the entry decision.
The major divergence in Figure 15.1 is between the two significant lows shown by
lines C and D. The new All Ords low in September is not matched with a new major
New High_Low. The divergence is not great. It does not have to be. Even a small
divergence is significant and gives traders an edge.
Conservative traders were given another sound entry opportunity in October.
Although not a new low, the valley at point 2 did not cause a significant decline in
the New High_Low index. It is easy to be mislead by the All Ords. It represents a
handful of stocks while the New High_Low index measures the performance of the
entire market. Sometimes the leaders are pushed from behind and the New High_Low
index is a good measure of just who is leading and who is pushing.
The New High_Low index does confirm the weakness of the Australian market. When
it comes time to run away, Australian investors tend to overdo it. The histogram retreat
values reach 1,000 on what really are minor retreats. When it comes to being part of a
bull market and a substantial rising trend, we are less eager. Advancing values peak out
at less than half the declining values. This type of chart display provides a background
safety margin exposing the underlying weakness in the midst of market hype.

SUMMARY • NEW HIGH_LOW INDEX

This statistical index is usually plotted around a zero line. Moves below the line show
the bears are in command, and above the line show the bulls are leading. The New
High_Low data is automatically calculated by several data services. It is delivered
and updated in the same way as for any other stock. When displayed the screen is
filled with dots. The line display joins the dots, and many traders use this style of
display. I find a histogram plot more useful, but this is purely a personal preference.
To construct a histogram in Metastock first display the New High_New Low data as
a line chart. Select the data display and delete it. This removes the display, but the
data is still readable.
Plot a one-day simple moving average of the data. This effectively transfers the data into
a different display format without changing its values. The display will look exactly the
same as the original line display but the calculation now allows Metastock to manipulate

220
 15/ End of Empire

and display the data in a different way. Double click on the moving average to bring up
the 'Properties' box. In the 'Colour/Style' section choose histogram as the style.
Save this screen as a template by choosing 'Save as' from the file menu, then select
'Template' from the 'Save as Type' box. Whenever the New High_Low chart is opened,
a simple right click will allow you to display the information as a histogram .

• • • • •
• ADVANCE AND DECLINE
A broader statistical measure of the market is the number of advancing stocks compared
with the number of declining stocks. In any market some stocks go up and others go
down. Very rarely do these balance. Usually there are more stocks heading one way
than the other. In rising markets the number of rises may outnumber falls by three to
one, or even more.
Statistics are a curse specially designed for economics, and working with market
statistics is no different. The Advance_Decline calculation starts as a simple calculation
where the number of declining stocks for the day is subtracted from the number of
advancing stocks for the day. The results are added to the previous day's total to
build a cumulative Advance Decline line.
This simple process is complicated by the choice of starting date. This calculation
could be started at any time so the resulting values vary depending on the starting
point. Advance_Decline charts of the same market can look quite different. This is
disconcerting, but not significant because we look at relationships rather than an
absolute value when using the Advance_Decline line.
An Advance_Decline plot starting in June 1997 has different values from an
Advance_Decline plot commencing in December 1997. Rather than start their own
plots, most traders would prefer to construct Advance_Decline data from information
provided by their data supplier. This is derived from the ASX advance and decline
information, but it must be combined into an Advance_Decline plot. This is not
easy. The construction steps are detailed in the summary notes.
This is one indicator we do not want to use in a short-term time frame because it is
difficult to decide what constitutes an extreme reading.
Most observers believe that when the ratio of rising to falling stocks is very high the
market is a safe place to be. Traders are worried by high ratios because they indicate

221
CHART TRADING

conditions on the edge of extremity. Because all market turns start, by definition, at
points of extremes where the market is too high, or too low, it is understandable why
traders become concerned about high Advance_Decline numbers.
Like any use of statistics, we look for a normal ratio of rises to falls as an indication
the trend is intact. Unfortunately, market conditions do change so the concept of
normal is very flexible. The Advance_Decline line is a broad tool which helps the
trader to identify crowd sentiment, but it is less useful in identifying exact turning
points in the market.
We look for a preponderance of stocks moving upwards because this tells us the
market generally is rising. Although this does not help us select individual stocks, it
does help us to be on the right side of the market. For much of the time the
Advance_Decline is a standby tool.

+RULES
All these rules are based on relative readings of the Advance_Decline indicator. The
exact values depend on the starting date for the indicator.
1. Broadly based market rallies or declines are more likely to turn into solid
trends. This is shown by high positive readings above the zero line.
2. New highs in a stock which coincide with new highs in the Advance_Decline
line are a bullish signal. This is a stock riding on the back of a general market
move.
3. New stock highs in the face of declines in the Advance_Decline line are less
bullish. This stock is bucking the general market trend. Fewer stocks are
participating in this market rise so the rally, or the trend, may be nearing its
end.
4. When the market falls to a new low but the Advance Decline line does not
make a new low it shows a divergence. The market decline is losing its
momentum. This is a leading signal, often weeks or months in advance of
the market reversal. It is not useful for specific timing, but it is a guide to the
trend reversal. In a rising market, this divergence encourages traders to
concentrate on taking profits. In a falling market they prepare for buying
opportunities.
5. Advance_Decline lines are more useful on a weekly chart than a daily chart.
This helps to smooth out short-lived rallies and declines by establishing the
general trend of the market.

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 15/ End of Empire

+ CROWD RULES
Every crowd includes firebrand leaders and lukewarm followers. While the leaders
and followers continue in the same direction, the crowd is strong. The Advance_Decline
line gives us a way to measure just how many followers are behind the leaders. While
the number of followers is high the odd defection of a few stragglers is not a problem.
But when the crowd begins to lose momentum, when segments of the crowd drift
away in increasing numbers, then the rest of the crowd is likely to follow the retreat.
This is a problem if our trade depends on finding buyers at high prices.
The Advance_Decline line shows us a measure of this, and by implication, a measure
of the crowd strength. When only the leaders are left shouting slogans then we know
this crowd has had its day. When crowds desert their leaders it does not matter how
loud the leaders are, they cannot bring their followers back.
The Advance_Decline line shows us which side of the market is winning-those
going forward, or those running away. This sounds like the supply and demand
argument invoked by economists, but the Advance_Decline numbers are slightly
different. Here we rely on the market itself to reveal the balance of supply and demand.
Buyers push prices up, while sellers push prices down. When one side predominates,
the market tends to travel in that direction. The Advance Decline shows us market
strength, and reveals market weakness.
Our objective is to stay with the strong crowd in an up trend and to grow more
cautious as the crowd begins to weaken. This means we look more carefully at
individual open positions, assessing them as possible exits to lock in profits before
the crowd turns nasty and costs us money .

• USING THE ADVANCE_DECLINE

The Advance_Decline line is a tool for understanding the general feel of the market.
In a broad sense the All Ordinaries rallied into a new up trend in October 1998. This
continued until the end of Aprill999. The up trend then reversed, losing around 8%
before a weak recovery in July. At the time it was difficult to tell if this was a
consolidation period in the market prior to a resumption of the up trend, or if it was
the beginning of a new bear market.
Many traders observed a weakness in the market. Good news no longer drove stocks
as high. Lower than expected earnings and other bad news hurried the market lower.
Bull markets rampage on good news and still gallop on bad news. These anecdotal
observations counselled caution. The Advance Decline line echoed this.

223
CHART TRADING

While the market rose early in 1999 the A_D line remained consistently positive as
shown in Figure 15.2 below. In mid-March the market went flat, but more importantly
the A_D line dipped towards the zero level. The number of advancing stocks began
to fall. Even the final All Ordinaries peak at the end of April was not well supported.
This is an important divergence between the A_D line and the All Ords index.
The A_D provides evidence of a weakening market. The new All Ordinaries high in
April was supported by just a handful of stocks. The general market lagged behind.
This general evidence provides a background to specific trading tactics encouraging
traders and investors to take profits.

Fig. 15.2 Advance_Decline line, start January 1999, base 500

'I UUU
900
Strong market 800
700
600
500
~
XAO moves
400
300
sideways from here 200
100
0
-1 00
-200
-300
-400
-500
-600
-700
-800
-900
-1000
-11 00
-1200
-1300
-1400
-1500
Weak market -1600
-1700
-1800
XAO!ow
-1900

999

224
 15/ End of Empire

SUMMARY • ADVANCE_DECLINE LINE AND CALCULATIONS

The Advance_Decline line is calculated each day by subtracting the number of declining
stocks from the number of rising stocks. Unchanged stocks are ignored. If 2,000
stocks were traded today, and 400 closed lower than yesterday, and 500 closed higher,
then the Advance_Decline value equals+ 100 (500- 400). Stocks that did not trade,
or traded but closed at the same price as yesterday, are ignored. The new
Advance_Decline value, 100, is added or subtracted from the value of yesterday's
Advance_Decline line. The absolute value of the Advance_Decline line depends on
when the calculations started so traders look for peaks and valleys.
Combined Advance_Decline data is not automatically calculated and provided by
Australian data services, although individual advance and decline data is. The challenge
is to combine this information to build a single Advance_Decline line.
Ezy Chart users construct an automatic Advance_Decline line using the Market
Statistics section of Ezy Analyser. This is very good if you are just collecting ASX
stocks. It is not so good if you are also collecting indices, warrants, some overseas
contracts, etc. because the statistical scan reads all of these, not just the ASX stocks.
Metastock users have a real challenge to set up an Advance_Decline display. Start
with a standard data feed giving ASX advances. Bring up the chart on screen. Click on
the chart display and select 'Copy' from the 'File' menu. Then open an Excel spreadsheet
and select 'Paste'. This pastes all the date and underlying data for advances. Delete all
except Column A and B. Go back to Metastock. Open the ASX decline chart. Repeat
the process and paste in the Excel spreadsheet starting from column C. Then delete
the column C dates and also all the other decline data apart from the first column.
You should be left with:
Column A: Dates Column B: Advances Column C: Declines
In column D install the formula:
=sum(b1-cl)
This gives the difference between the advances and declines. Use the 'Fill Down'
command to install this formula all the way down to the bottom of your data.
The combined Advance_Decline line uses a running total. Start this in Column E2
by adding your selected start figure, i.e. 500, and the first result in Column D2, i.e.
30, in the example shown in Figure 15.3 overleaf. On the line below in Column E1
insert the formula:
=sum(El+D2)

225
CHART TRADING

to give a running total as shown. Use the 'Fill Down' command to install this formula
down to the bottom of your data.

Fig. 15.3 Advance_Decline calculations

Declines Difference Total

272 30
23.1 173
387 59
337 -43

We have two choices in charting this. The first takes the easy way out. Select the
results in Column E and display them as a standard Excel line chart. This is quite
satisfactory and with a bit of juggling you get a reasonable date display. Remember
it is the rise and fall of the Advance_Decline line that counts, rather than the precise
date.
Other users want to transfer this data into Metastock as a permanent reference file.
This is a more difficult task mainly because of the date range. Excel displays the dates
as formulas and columns D and E are also read as formulas, even though they are
displayed as figures. Trying to import this into Metastock, we run into all sorts of
trouble.
My solution is inelegant, but it works. There are three groups of steps. First is a file
management issue. Create a new Folder called A_D and place it in your existing data
directory or folder. We will need to use this later.
Then use the Metastock Downloader to make a copy of an existing stock file with a
date range about the same as your Advance_Decline data selection. It is better if the
selected existing stock file starts later than your Advance_Decline file, i.e. 10 Jan
instead of l Jan. It is easier to select the correct date range from your Excel
Advance_Decline file than it is to alter the starting date for the Metastock file.
Once the existing stock file is selected use the Downloader 'Tools' to make a 'Copy'
of the stock file. Place this in the new directory called A_D. This file will carry the

226
 15/ End of Empire

same name and data as the original stock data file, but because it is in a different
directory folder, it is not updated when you download.
The next step is to copy the Excel Advance_Decline information into the stock file in
the A_D folder. First we must change the Excel data into a non-formula format
suitable for a Metastock file. Open the Advance_Decline Excel data file, and then
open another blank spreadsheet. Highlight all the data in the Excel spreadsheet and
'Copy' it. Move to the new spreadsheet and choose 'Edit' then select 'Paste Special'.
Select the box 'Paste Values'. This strips out all the formulas and just leaves the
number results behind. In Column F add a 0 to fill the volume field. Use the 'Fill
Down' command to distribute this to the bottom of your data list. Now your
spreadsheet resembles the Metastock data sheet with columns for date, open, high,
low, close and volume. The next step is to copy this data into the stock file in the
A_D folder using the Downloader.
Open the Downloader and use 'File' then 'Open' to find and open the stock data file
in the A_D folder. Once this is displayed, move to the first data entry in this file.
Then switch back to the Excel spreadsheet which contains values only. Highlight and
'Copy' all of these except the date column. It is easier to use the date structure in the
original Metastock file.
Click the first cell in the open column in the Metastock stock file and select 'Paste'
from the Downloader 'Edit' menu. The new Advance_Decline data will replace the
old stock data and the dates will match up.
To display this Advance_Decline file, just follow the standard Metastock chart display
steps. When the chart comes up, select the 'Properties' option by clicking on the
display, and choose line display. This automatically reads the 'Close' column which
holds the results of the spreadsheet column E.
When adding new data, just use the Downloader to select the Advance_Decline file
and add the data manually. Remember, in either case-Excel or Metastock-once
the data file is set up you will need to keep it up-to-date yourself each day. This
means manual entry, so in some ways it is easier to use just the Excel line chart
display every now and then based on freshly imported data.
It takes time to set up the A_D file in Metastock and the only advantage is that you
are able to show this chart as a display beneath the All Ords chart. If this is not
important, then the Excel line chart is the easiest solution.

227
Chapter 16

ECHOES OF THE CROWD

When the crowd shouts we listen. When the crowd whimpers, we listen very carefully
because their pain could become ours. The trader uses many tools to detect the shout
of victory and the whisper of sedition. These echoes of crowd activity are tracked by
volume indicators.
Words are not the only way to convey meaning. The spoken word adds meaning by
tone, inflection, volume and dialect. There are tools to help us understand any
language. These are dictionaries and phrase books. Land on a foreign shore and we
suspect volume has an impact on what the words mean. Hotels are full of travellers
explaining their problems in slow, clear, simple and very loud English.
We have concentrated on market price, using charting tools as a dictionary and
indicators to identify the nuances of language. Many traders feel volume aids clear
understanding of the language of price. They want to separate the loud cry of fear
from the shout of victory.
I want to be clear on my bias before you start to read this section. Although much
has been written about volume, notably by Martin Pring in Martin Pring on Market
Momentum, I find it unprofitable to move beyond the very broad applications of
volume relationships in charting and trading. Except in very special circumstances, I
do not use volume as a trading tool. The exceptions are in trading new floats and
trading warrants. These are covered in more detail in Bear Trading. Most of this
volume analysis work comes from the United States where markets are substantially
different from Australia. They have more depth, more volume of trading, than ever
experienced by the ASX. In these conditions specific volume relationships are accurate.

228
 16/ Echoes of the Crowd

Earlier we looked at the equivolume price display, which is an attempt to plot the
relationship between price and volume. Until now we have all but ignored this concept
in the discussions of the various indicators and combinations. At the root of this avoidance
is the way volume is often an unreliable or inconsistent indicator of price behaviour.
Throughout this book each indicator has been displayed and matched with significant
movements on the price chart. This is the most basic, and most effective, way of
testing the relevance of indicators. On an historical bar chart we easily spot the trend
change and the trading opportunity we would like to have been able to trade.
With an indicator displayed beneath this chart, such as a stochastic, we look for the
times when the indicator signals coincide with the historical trading action. At best,
we look for the indicators to lead the development of this new trend because in real
life this allows us to jump on board quickly before the trend starts. This is where the
big profits lie, and this is why we spend so much time trying to find this holy grail of
indicator combinations and trading approaches. Extensive research suggests this
combination offers only fleeting success, but the general principle remains sound.
If an indicator cannot call a trend change, then it is not particularly useful. If the
indicator can call a trend change some, or even half, of the time, then it is still not
useful. An indicator that is half-right and half-wrong gives us no better a trading
strategy than tossing a coin. We need a higher level of probability of indicator success.
When we act on its signals, we want to have the balance of probability on our side.
This is a core test and when applied to volume we fmd the results are not encouraging.
The test is simply applied. Expand your charting screen to show only volume, or print
the display to examine just the volume. Select whichever stock you think is most suited
to volume analysis. Your task is to identify the turning points in the market from the
volume chart. If even simple volume analysis is correct, then the points where significant
volume changes occur should coincide with the significant changes in the market price.
Apply this test to a daily or weekly volume chart. The weekly extract in Figure 16.1
overleaf is a typical starting point. Our objective is to identify market action, not the
direction of the action. We look at this in various ways below. Feel free to apply a
smoothing average over the volume chart, and to manipulate the volume figures in
whichever way you feel is appropriate.
Once you have identified and marked the turning points and those which should be
significant trading signals as indicated by volume alone, then move back to the split
screen mode and display the bar chart for the same period. We expect to see a close
correlation between volume changes and significant changes in price activity for the
stock. Even more, we expect these changes to be tradeable, perhaps generating entry
and exit signals.

229
CHART TRADING

=
Fig. 16.1 Volume turning points §- 70000
=- 65000
r- 60000
::- 55000
§- 50000
::- 45000
""""40000
::- 35000
~ 30000
::- 25000
~ 20000
=-15000
~ 10000

I I I
loct
I I I I I
I
I I I I
j1ggg
II II
Feb
I I
IIApr
I J;iOoiOOO
Sep I I
Nov Dec I I
Mar I I
May

The results are erratic. The primary peak in Figure 16.2 opposite identifies a blow-
off top and appears to confirm the price volume relationship. However, the two
other significant turning points shown at A and Bin Figure 16.2 are not accompanied
by any volume clues. The second surge in volume in May comes nearly a month after
the new rally has started.
In a handful of stocks the most obvious of volume and price relationships do signal
trading opportunities. In the majority of stocks, these volume relationships provide
few useful trading signals because there is little correlation between volume and the
trading activity of the stock. This suggests an unreliable and dangerous indicator.
Sometimes it is right, but most times it is not. The only way to tell the difference is
retrospectively, and this is not useful for trading in real life.
Despite the difficulty in establishing a close relationship between volume changes
and price changes, the broad relationship between volume and price is important.
For a price rise to be sustained in a trend it must be fed with new buyers. When price
and volume increases, then the rally is likely to continue just because more buyers are
chasing the stock.
Volume reflects the financial involvement of market participants. These people have
opinions about the market and they back their opinions with cash. Their opinions
count. The trading cycle has three elements: the buy, the hold and the sell.
Buyers back their opinion with cash because they believe the stock they buy this morning
is going to increase in value in the future. The seller has the opposite point of view.

230
 16/ Echoes of the Crowd

There are many reasons for selling, including the need for cash to pay tax bills. We are
not concerned with forced selling. Most sellers believe the stock is going to lose value
in the future, so they want to lock in profits now. In every transaction the balance of
buyers and sellers is exacdy even. Traders on each side of the trade believe they are
winners-the buyers, because they are going to make future profits; and the sellers,
because they are taking profits, or limiting a loss, before the price falls further.
Those people who bought stock and have not yet sold it are in the holding crowd
with open positions. They have not yet decided if the profit is big enough to take, or
if the loss is so large that they can no longer bear to hold it. These people are quite
different from those who are outside the market. This crowd already have open
positions. They have a financial interest in the outcome.

Fig.l6.2 Volume turning points

0.25

0.20

}ttth ttl 0.15

F} PtH
t~Jll lJlJ-,_-r B 0.10

-rl-r Blow off top

0.05
A
--- - - ------ . -- - ·- .. - - ------ . . . --- .. -· R rt
~ -- -- - -
70000
SOA
60000
50000
Solace
40000
Weekly bar chart and volume 30000
20000
x100 000

231
CHART TRADING

When a trend rises on increased volume it signals two events in the market. Firstly,
many buyers are eager to obtain the stock so they push the price up in an attempt to
get ahead of their competition. Secondly, sellers are aware of this surge in buying so
they move their prices away from the buyers because they know they will make even
better profits. Despite this, there are still sellers at every level for every completed
trade. Why do they sell if they are aware buyers are chasing the prices higher?
They sell because they are frightened the buying pressure will disappear and they will
miss out on profits. The most frightened of all sell early in the rally or trend break.
The least frightened hang on until their profit targets are reached, or until they can
resist no longer because profits are so unbelievably large. Those who like to label
themselves investors refuse to sell because they are in for the long term. This sometimes
means they have a long time to go back over the events of this trend and study in
detail their regrets at not having traded more actively.
Unless there are enough new buyers in the market to keep driving prices up, the
rally, and later the trend, will stall. As it slows, more sellers come into the market and
they offer stock for sale at slightly lower prices in an attempt to encourage the last of
the buyers to take their stock. The buying pressure slides into selling pressure. Prices
begin to fall. This does not mean a reversal of the trend. This is where the holders
come into play. Just because buying has slowed it does not follow that selling will
automatically increase. Mter all, all through the fall in prices, the increasing number
of sellers matched the exact number of buyers. What changes is the expectation of
the buyers and sellers.
The buyers no longer anticipate energetic price rises, and the sellers do not anticipate
dramatic price falls. The stock drifts sideways, with little buying or selling taking
place. The volume declines, but the price does not. It remains comparatively steady.
When a stock moves up on comparatively few buyers, we normally call this a weak
trend change, or rally. In Australian markets where small speculative stocks gallop
with just a few buyers chasing tightly held issues, this observation is sometimes
wrong, locking traders out of some very profitable trades.
Volume cannot be ignored, nor can it be applied with the level of accuracy and
precision suggested by some writers. With this in mind we can establish broad rules
for using volume in chart and trading analysis.

+RULES
1. Volume is relative. The idea of high, or low, volume is related to the
previous behaviour of volume for a stock. These relationships are best

232
 16/ Echoes of the Crowd

established visually by using the standard volume histogram display. A

moving average of volume is also useful.
2. Trends are confirmed by high volume. When prices make a new high on good
volume there is a strong probability prices will go higher in the short term.
3. A climax high is a new high made on low volume. This trend has lost
enthusiasm and is supported by less people. A climax low is a new low made
on low volume. This trend has lost enthusiasm and is supported by less
people. Both are often a reversal signal.
4. In up trends declining volume suggests weakness in the trend. When new
peaks are made on lower volumes then the trend may be running out of
supporters. This is best considered on a weekly chart, as daily volume varies
too much to make consistent decisions.
5. Rallies or trends supported by steady or increasing volume are good trades in
short-term time frames of three to five days.
6. Average volume determines the position size for individual trades. If the
average volume is 30,000 then our position size should be no larger than
this. If it is then we need at least two buyers when it comes time to sell. In a
slowing, or falling, market it is not always easy to find two buyers when you
need them. You usually find at least one buyer and most likely he will be
trading at about the average size.
7. When a volume display has one massive day out of all proportion to previous
volume activity, consider zooming in on the volume display to exclude the
out-of-character day. This 'expands' the following volume detail and reveals
useful signals.

+ CROWD RULES
Volume is a broad gauge of crowd emotions, but it is not a guide to specific actions.
An angry crowd is not always a violent one. It does not always tear up the paving
stones, crash down police barriers, or erupt into an orgy of looting. An angry crowd
could go home, simmering and seething with tension. Participants in an angry crowd
all have individual ways of dealing with their anger. As traders we need to be aware
of this crowd anger, but this awareness does not always define specific trading actions.
In applying volume analysis to understanding the crowd we are particularly interested
in the relationship between the direction of price and the number of completed trades.
When price is rising and still pursued by many traders, we look for a solid rally, and
perhaps a sustained trend if the volume of buying remains steady.

233
CHART TRADING

It is difficult to move with any certainty beyond these broad crowd rules when considering
the impact of volume. Traders need other active traders in the market to trade with. The
type, direction and tactics of the trade are determined by applying many other indicators.
Volume is most usefully applied in deciding the eventual position size for the trade.

• USING VOLUME
What works and what does not? Traders fail if they accept unsupported assertions
about market behaviour and relationships, so we test them against the stocks we
trade. The examples below examine the results of typical price and volume searches.
There are advantages in duplicating this examination with your preferred stocks.
The relationship between volume and a continued trend is very inconsistent. The
relationship between volume and a single day's price is quite strong. Here we use the
Metastock formula to identify price and volume relationships. Ezy Chart users do
the same with Ezy Analyser. Our objective is to examine how these results translate
into potential trading opportunities. Running this search throws up many candidates.
First we rank them by percentage price performance as shown in Figure 16.3 below.

Fig. 16.3 Selection by maximum % price increase

0.0080 0.0050 60.0000 1020401 .

0.0320 0.0200 60.0000 411983.
* 0.0900
0.0090
0.0600
0.0060
50.0000
50.0000
128780.
6085762.
* 0.0350
0.0160
0.0250
0.0120
40.0000
33.3333
133000.0000
576500.0000 .
0.1600 0.1200 33.3333 1oooo. oooo-
* 0.0400
0.0600
0.0300
0.0470
33.3333
27.6596 214~~~~~:~~~~ ;:~: '
* 0.1550
0.5700
0.1250
0.4750
24.0000
20.0000
215085.0000 .~.
707660.0000 :' .
0.1250 0.1050 19.0476 435941. OOO(); '
0.4200 0.3550 18.3099 5771
0.1300 0.1100 18.1818 21

234
 16/ Echoes of the Crowd

The ones at the top of the list should contain some stocks that will continue with the
trading momentum. Those at the bottom may be candidates for accelerating
momentum. We verify the outcomes by analysing the bar charts. We have selected a
middle four at random from this screen of top performers. In this and the following
ranking extracts these choices are marked with an asterix, i.e. *. Charts and analysis
for each are shown below in Figure 16.4 below.

Fig. 16.4 Testing volume search results with charts

[~ Chart 1
--~------ -- --~
EJ i;;;l Chart
II( (iii---
- -·
~
2
- - -- -. ------
lll'ifil £1
----~--

A,K - 0.20 0.08

0.07
0.06
0.05
0.04

~1 Chart 4 R~ EJ
---------------

0.30 0.06
0.25 t- - - 0.05
0.20
~~
r Tr!L[l----r.:u 0.04
0.15 r- - - 0.03
0.10 l_..L-:_...T:
0.02

235
CHART TRADING

Chart 1 in Figure 16.4 is an erratic chart and is difficult to trade with a consistent
strategy. The best move, point A, has no significant change in volume. There is a low
correlation between volume and price so no trade is indicated. Chart 2 is in a down
trend and an unlikely stock to trade from the long side buying low and selling high.
There is no immediate indication of a trend break. No distinct volume pattern is
observable. No trade is suggested.
Chart 3 has potential as a momentum trade, and perhaps later as a trend trade. This
merits closer inspection. Steady volume makes trading easy and this is the best of these
candidates. The real problem is that the same style of volume pattern in area B is also
present in area C. The first pattern did not lead to a significant change in prices. Here the
volume pattern is used to confirm a price change, but cannot be used to foretell a price
change. The danger in chart 4 is the erratic volume. Price is trapped in a broad band
between $0.03 and $0.04. This is a very speculative trade in a broad sideways pattern.
Selecting those candidates with the best percentage price increase consistent with increases
in volume tends to bring up stocks with erratic volume. Few provide good trading
opportunities-and the few good opportunities do not show distinctive volume patterns.
An alternative approach looks at those stocks with median price increases. These may
be stocks which are just beginning to move. We do not expect momentum
opportunities, but we anticipate breakout trades. The results of this selection are
shown in Figure 16.5 below.

Fig. 16.5 Selection by median % price change

GOLDEN STATE RES 0.0570 0.0510 11 .7647 216000.0000

DEFIANCE MINING *0.0290 0.0260 11 .5385 1926978.0000
SKANSEN HOLDINGS 0.2000 0.1800 11 .1111 200423.0000
STONE GROUP ASIA . 0.2000 0.1800 11 .1111 40000.0000
SIROCCO RESOURCE 0.0600 0.0540 11.1111 1191732. 0000

991500.0000~
MONTAGUE GOLD NL * 0.0310 0.0280 10.7143
CLUFF RESOURCES 0.0110 0.0100 10.0000 805622.0000 >>
t;,f
TAMO TANAMI GOLD 0.0450 0.0410 9.7561 100000.0000 J, •
SINO CONSOLIDATE * 0.1700 0.1550 9.6774 170000.0000 . .
SUNDOWNER GROUP 0.6900 0.6300 9.5238 355500.0000 .; :
GME RESOURCES NL 0.0960 0.0880 9.0909 298333.0000
RESOURCE EXPLORA 0.0600 0.0550 9.0909 100000.0000
NOVUS PETROLEUM * 1.7000 1.5600 8.9744 592261 .0000
REEF CASINO TAUS 0.0900 0.0830 8.4337 514141 .0000

236
 16/ Echoes of the Crowd

Again we select four as candidates for closer examination. They are the charts numbered
5 to 8 in Figure 16.6 below.

Fig. 16.6 Testing volume search results

~ Chart 5 l!!lliJ
- - -£J [;;j Chart 6 II'~ £i
--- -- ----
0.30

0.25

0.20

0.15

0.06

-Jr
. _Ji-J--'r J.h.
0.06
0.05
~--
0.05
- l \1 0.04
"""!.} . . -__- -
-)
0.03

Chart 5 shows a reasonably volatile stock with several past rally opportunities, shown as
A and B. Here the volume chart is not helpful. The rally at A is accompanied by a general
fall in volume at Al. The rally at B has a mid-point peak in volume as shown by Bl. The

237
CHART TRADING

current price move is accompanied by quite a different volume pattern shown as C. This
stock is a good rally trade, but it is best assessed using tools other than volume.
In contrast, chart 6 is an uninspiring chart. The general trend is down, with erratic
rallies driven by unusually high volume. These are difficult trading signals to follow.
The lack of consistent volume makes speculative trading ,approaches more appropriate.
Volume is a confirming indicator for speculative trades.
Chart 7 has a repeated volume pattern at D and at E, but the impact on price is not
repeated. Traders will make use of this level of trading to get the best-sized positions,
but volume provides little guide to the activity of price. Chart 8 is clearly in a down
trend and only the most optimistic of traders would consider it, despite its appearance
in the price volume search results.
Again, the key problem with applying a price and volume relationship is the
inconsistency of the results. No clear relationship exists to support a trend and volume
connection. Volume and price are not necessarily linked in the high price achievers
for the day, and where the link does exist, it provides little guidance to the next day's
price or volume activity.
Changes in price are not always matched by changes in volume, so perhaps the answer
lies in turning this relationship on its head. The next search rankings are based on
stocks which have a significantly higher than average volume. The results are shown
in Figure 16.7 below.

Fig. 16.7 Candidates with highest volume.changes

50.0000 128780.0000 8238.7393 1463.1031 MOD

50.0000 6085762.0000 463142.5625 1214.0148 SROOB
60.0000 1020401 .0000 87434.2344 1067.0497 AS GOA
6.2500 1270958.0000 132077.0625 862.2852 MSC *
11.1111 200423.0000 26014.0371 670.4418 SKN
27.6596 21411240.0000 3031338.5000 606.3296 ASG *
12.5000 241266.0000 35316.5703 583.1525 GHR
7.6923 561900.0000 91065.5938 51 7.0278 ARC
9.5238 355500.0000 61693.6367 476.2345 SDR *
11 .5385 1926978.0000 347215.8438 454.9799 DEF
5.8824 4891 43.0000 94926.7578 415.2846 PEM
18.3099 577120.0000 133935.7031 330.8933 SGCOA
5.8823 707995.0000 174593.9844 305.5094 AGA *
7.6923 345000.0000 86244.6719 300.0247 MMDO

238
 16/ Echoes of the Crowd

Extraordinary volume may identify stocks where heavy buying is taking place. Those
at the lower end of the scale may be in the early stages of a buying spree. Again, we
verify the outcomes with the bar charts.
Our chart selection in Figure 16.8 below groups four of the stocks showing the
highest increase in volume compared to the average.

Fig. 16.8 Selections with the highest change in volume

[;;j Chart 9
---- - --------- ~--
P-lf~ f.3
-
' :;;;;: Chart 10
- - - - --
fliffif
-- - -
E1;
- -

\1N-.I,_.- 0.15
0.06
0.05

1ff"T'r~
0.10 i 0.04
..-'-1: :f~ f~ 0.03
f-1..:_-
-- 0.05
--=--- 1 - 0.02

0.85
0.80
0.75
0.10
0.70
0.05 0.65
0.60
-- V••!om•
L.:__
- - - --
-
--- - - - -
[;J-F!'j
------

10000

239
CHART TRADING

Chart 9 in Figure 16.8 shows selling volume and a good situation to avoid from the
long side. The chart shows few volume clues to the most recently completed $0.05
to $0.15 rally. Volume in the period A1 is steady even though the trend marked A is
quite dramatic.
The trend in chart 10 presents a trading opportunity for momentum traders. The
first volume pattern, A1, did reflect the development of the new trend shown at A on
the bar chart. The further rise at B did not see a repeat of the same volume pattern.
The volume trend at B1 is a sharp rally rather than a sustained rise. Above-average
volume does not provide the trader with the early identification tools he needs to get
on board this trend, and nor does a decline in volume provide a useful exit signal.
Chart 11 is consistent with a long-term accumulation pattern. Many shares are
changing hands with little variation in price. Neither of the volume peaks, A or B,
really correspond with significant trading opportunities.
Chart 12 provides no useful clues from volume activity. The motivation of the market
is guesswork. There is little to guide traders from either price activity or volume
activity, to help them identify tradable moves with this stock. The relationship appears
almost random.
We anticipate significant changes in volume will be associated with significant changes
in price. In smaller stocks, such large volume can have a very powerful effect on the
stock price, but this is not always so. Using only volume clues, traders of Armourglass
in chart 11 would be left wondering just what was going on. High volume by itself
appears to be an unreliable guide to current price action, and has little relationship
with future price action.
If we accept that high volume is not always a good guide, then perhaps we should
examine those stocks where the current volume is about half as great as the average.
These may be stocks just beginning to move. Buying these may be a good way to get
on board early and substantial trends. I have selected stocks shown in Figure 16.9
opposite, ranging from 56% to 89% less volume than the 50-day average volume.
If we select stocks with much lower than average values, perhaps 10% or 20% of
average volume, then we tacitly acknowledge the main problem with using volume
for trading. Lower selection values means more stocks are included because the
relationship between volume and the trend is reduced. To make these type of price
and volume searches we need to be able to select consistently significant values,
usually towards the extremes, or the mid-point. These provide fewer candidates for
study, and should provide those stocks where the relationships are the strongest.

240
 16/ Echoes of the Crowd

Fig. 16.9 Selecting srnaUer volume changes

8.4337 514141 .0000 271313.5625 89.5007 ACT *

8.3333 50000.0000 26422.0176 89.2361 MSG *
7.6923 5760.0000 3077.7007 87.1527 RDFO
33.3333 22000.0000 11781.7188 86.7300 LGO
7.5000 11815347.0000 6329561 .5000. 86.6693 IMRO
7.6923 950000.0000 523289.9688 81.5437 WS G0
7.1429 4000.0000 2374.3403 68.4678
67.3034
SKY
MKA
*
13.7931 115000.0000 68737.3828
60.0000 411983.0000 250371 .5469 64.5486 PRECA
7.1038 47000.0000 29430.8086 59.6966 PLF
16.6667 916886.0000 585542.7500 56.5874 ELA * ~- rc
9.0909 298333.0000 192384.3750 55.0713 -~ME _ . ~-~
' . ' , . f~ ~~~·;;$

As with all indicator based searches, we turn to the charts in Figure 16.10 overleaf as
the next step. We want to find consistent, repeatable relationships to help us identify
new trends, or the beginning of strong rallies. If the results do not give us these
conditions, then the search parameters are not useful.
We start with chart 13 where the high volume day A is aligned with a high price day.
The signal is too late to trade, and although the subsequent volume is still higher
than average we know these 'finger' trades are very rarely the start of major trends. A
trading opportunity does exist, but it is limited.
Volume in chart 14 confirms the down trend. This is not a good trading opportunity.
A glance at the chart keeps the trader away and out of trouble.
Chart 15 is the most promising of the charts, although we mix a lot of hope with the
analysis. The big jump in volume at A did not lead to trading profits in the following
weeks. Profits were available for those who bought the retracement and traded the
volume rise B l. The big jump in volume shown as C may potentially lead to a rise in
price in potential trend D, related to the rise in volume at Dl. This is a trade based
on hope. Volume is used here as a confirming indicator. It is unwise to use it as an
initiating indicator for the trade. This is the best of the four charts, but hardly a
brilliant trading opportunity.

241
CHART TRADING

Fig.16.10 Median volume and charts

0.20

0.15

• Volume [;]' EJ ..-vol_u_m_e- - - - - - - - - - r ; : r rn

.L .. ,, .1.1111

~] Chart 15 ~~ EJ
0.20

h 0.15 0.30

0.10 0.25
f'~,;~~ D 0.05
0.20
- . - · ............ .. -
~Volume
-·--~- ,_,_,,~

~--~--------
8~

Chart 16 shows an up trend. It starts in November with few volume clues, and the
trend's progress is marked by erratic price activity. This stock spends a lot of time at
the same price which is typical of these upper-level speculative stocks. The volume
trend is defined first by a rise, trend line A. Later the volume in area B provides few
consistent clues to price activity. The current volume trend is clearly down, line C.
Yet the overall trend for the stock, shown by lineD, has been upwards. Forget for

242
 16/ Echoes of the Crowd

the moment that this is a stock we would probably not want to trade anyway because
of its erratic price activity. The volume pattern certainly does not provide any useful
guide to the activity of this stock.
Do price and volume searches by themselves deliver useful trading solutions? In a
very few cases there does appear to be a relationship between volume and trending
activity. This relationship is infrequent and unreliable. As traders we need better
search tools than this to help boost our trading success. This area of analysis provides
opportunities for advances in market research.

SUMMARY • VOLUME
Volume is the fuel driving the market. It is usually shown as a histogram, with solid
bars. Volume charts yield clues when volume is out of character-unusually high, or
unusually low.
High volume on a lower close indicates selling pressure-people want to get out and
nobody is eager to buy so the price falls. High volume on a higher close indicates
buying pressure-people want to get in, but nobody will sell so they have to bid
higher. Volume becomes erratic as the liquidity of the stock falls. Large blue chips
have high liquidity, with large-scale trades every day. A small speculative stock has
low liquidity, sometimes with no trades for days on end. Volume significance depends
on the normal liquidity of the stock.
A trend must be nourished by new buyers to survive, so consistent average volume is
important. A long-term average of volume is more useful than a daily volume chart.
Volume oscillators compare the average volume over a long period with the average
volume over a recent period. By extending the definition of recent, to say 20 periods,
and by taking 60 as a long period, and by using percentage movements we distil the
general direction of volume. An up trend starts from below the centre line and finishes
when it peaks above the centre line. This is a confirming indicator and should not be
used to time exact entries or exits.
Exhaustion patterns are created by volume and price as the trend weakens. Price struggles
to make new highs after a trend breakout or long-term up trend. Each new high has
reduced volume. Fewer people are prepared to pay the asking price and buyers pull
out of the market, waiting for a return to more reasonable prices. This typically follows
a rapid breakout, and prices often retrace between 50% and 70% of their gains. This
develops fmger pattern trading opportunities. With long-term trends, these exhaustion
patterns include rounding tops. A few sellers take lower prices and this slowly accelerates.
Exhaustion occurs when people are no longer willing to chase prices.

243
CHART TRADING

Volume is usually displayed as a histogram because a line chart display is too disjointed.
The histogram makes it easy to compare one day's volume with previous days. Volume
data like any number series is often smoothed or manipulated to clarify the volume
activity. A weekly histogram shows the trend of volume more clearly, but cannot be
plotted on the same screen as a daily bar chart. An alternative is to use an average
volume indicator with a histogram display. The Metastock formula is:
Mov(Volume,5,exponential)
Further smoothing may bring out the trend more effectively.
Traders use their software to identify price and volume relationships. There is often a
strong relationship between volume and price in the short term. This is less so in the
speculative market, where volume sometimes rockets from nowhere and disappears just
as quickly. The key to using volume is continued volume, rather than just a single day.
Metastock users turn to the Metastock Explorer screen to find securities where the
price has increased 5% and the volumt is 50% above the 50-day moving average.
The formula is:
ColA CLOSE
ColB REF (CLOSE, -1)
ColC ROC(CLOSE,l,PERCENT)
ColD VOLUME
ColE MOV(VOLUME,50,EXPONENTIAL)
CoiF ((VOLUME-MOV (VOLUME,50,EXPONENTIAL}}/
MOV(VOLUME,50,EXPONENTIAL))*l00
Filter WHEN (ColC>=5) AND WHEN(ColD>=ColE*l.5)
Traders using Ezy Analyser choose Volume Trend with Highest Close or use the
Performance Rating screen.
Traders who want to examine volume more closely usually transfer the data to a
spreadsheet. Ezy Chart users should first create an Export folder within the EC Folder.
Then open Ezy Chart and select 'Export, from the file menu. Type in the code of the
stock data to be exported, e.g. 'AAN, select it, and select the 'Export' folder as its
destination. Click 'Ok, and the information is transferred in a text format into the
Export Folder.
Locate the AAA text flle in the Export folder and open it. Select all the contents,
copy, and paste them into a Microsoft Works spreadsheet. They are very difficult to

244
 16/ Echoes of the Crowd

paste into an Excel spreadsheet. With Works each price element is automatically
placed in a separate column. Use the formula =sum(Gl:Glxxx) to add up the total
volume. (Glxxx =the last cell in the column of volume data.)
Metastock users who want to transfer volume data first open the bar chart of the
stock they want to work with. Click the chart display to select it. Then choose 'Copy'
from the 'Edit' menu. Open a new Excel spreadsheet. Highlight cell Al then select
'Paste' from the 'Edit' menu. All data fields are displayed.
Once the data is in a spreadsheet, use the formula =sum(Fl:Flxxx) to add up the
total volume. (Flxxx =the last cell in the column of volume data.)

245
Part Ill

THERE
ISA
RISK OF
LOSS
Chapter 17

FOUR-LETTER WORDS FOR TRADERS

We start this chapter with a bundle of $50 notes, 200 in all, and a box of matches.
This is our $10,000 of trading capital. Take $50 from the top of the pile, strike a
match and burn the note. That is discount brokerage taken care of. Could you take
another three notes, or 20, or 40 notes and watch a stranger apply a match to each
without flinching? It happens in the market every day. This is trading risk-and no
wonder it is one of the trader,s four-letter words.
Fear is the other four-letter word. Combine the two and they are a powerful curse
which can often paralyse every trader. Every market position involves risk. & soon
as we trade, we open the door to risk. How we close the door depends on how we
handle fear. On paper, trading looks easy. On a price chart-in retrospect-it looks
very easy, with the entry and exit points quite clear. In real time trading, however,
our judgements are clouded by the fear of taking a loss.
The market is the product of crowd reactions and in the first part of this book we
considered the way chart patterns are a development of our own reactions duplicated
by those of many other individual traders. It is easy to lose touch with this relationship
when exploring technical indicators as we did in Part II. They are designed to understand
the crowd in general. When we take a trade it is an individual decision. Although we
are moving in a crowded marketplace and must be aware of the crowd around us, at
the point of entering or exiting a trade, what really counts is the way we handle risk.
Risk in the market includes many factors, but in the final analysis risk is quantified
by the amount of money we lose, or stand to lose, in a trade. The fancy definitions all
come down to a single figure in a trading ledger, written in red or black. How we
react to this figure defines our ability to handle risk, and ultimately our ability to

249
CHART TRADING

trade. If we let small losses grow into large losses we cannot trade. If we let large
profits become small profits we do not trade effectively.
Our relationship with risk is very personal. It starts with the fear of loss and we look
at stop loss techniques below. These are designed to protect trading capital. Later,
risk is about protecting profits. We use an extension of the stop loss techniques to do
this, although they really should be called 'protect profit' strategies. In both cases a
chart of price activity is an essential tool in risk management.
Every trade has two powerful loss conditions. The first is when the trade is opened. The
second is when the trade is successful. In both cases fear is the driving emotion and many
traders have difficulty in coping with it. Normally we also add greed, but in the market
greed is often a subset of fear. Once we have a paper profit we hang on, not because we
necessarily want more, but because we are frightened oflosing what we have accumulated.

• OPENING FEAR
Fear and risk combine when we first open a trade or a position. From the very
moment we buy a stock there is the ever-present possibility we are wrong, and any
adverse price movement will destroy our trading capital. As soon as we buy we make
a loss because we have to pay for brokerage on the purchase, and on the sale. To just
break even the share price must rise slightly. If it falls, our trading capital starts to
disappear. Watching money burn is a paralysing experience.
Good trading overcomes this fear by planning, and even better trading is possible
when traders act on their trading plans. Without a trading plan, there is little hope of
survival. With a trading plan the chances of survival are increased, but they are not
certain. Planning is one task, acting on it is another. When we buy a stock we use a
stop loss technique to help decide in advance the point at which we are proven wrong.
The idea is to take action to protect our trading capital when prices reach a certain
level. It is unrealistic to expect every trade to move in our favour, becoming
immediately profitable. Many times the trade moves against us, starting with a small
loss. We need to know in advance just how much loss we can afford to take before
we have to exit the position. This is the first of the stop loss techniques, and we look
at its application in greater detail later in the chapter.

• CLOSING FEAR
In good trades the price does rise and soon we happily sit on an open profit. The
stock we bought is showing a paper profit-an open profit-but we have not yet

250
 17/ Four-Letter Words for Traders

turned this paper profit into hard cash. The only way to do this is to sell the stock
and take the money. This sounds an easy problem to solve and many new traders
wish this was the full extent of their problems. This delightful situation gives us the
opportunity to pretend that fear has become greed. As prices rise we calculate just
how much each additional!¢ rise in the share price adds to our overall worth. Portfolio
management tools are designed to meet this need.
Real traders reserve a particular type of pity for the want-to-be traders and investors
who fail to understand the difference between paper profits and real cash. If it does
not fold or crinkle it is not real. Paper profits cannot be banked but they can disappear
with terrifying speed.
When prices fall, and more particularly, when prices fall into what becomes a trend
reversal, these novice traders come face to face with fear again. No longer are they
worried about losing their trading capital. Now they worry about losing open profits.
Their portfolio is not worth as much as yesterday, and they regret not having sold at
yesterday's prices. Fuelled by profit nostalgia, they hang on, hoping yesterday's prices
will come back again. This looks like greed in action, but more often it is fear. The
novice traders and investors are frightened of losing the profit they once held.
Market risk is controlled by a variation of the stop loss technique used when the
trade was first opened. It is called a 'trailing' stop loss. This tells us when we should
be out of the trade if we wish to lock in profits. This does not lock in the best
possible profits, but it does help us to lock in the best profit possible given the
trading circumstances.
Many traders do not have the discipline to act on these signals. Even more frequently,
many want-to-be traders and investors have no method of controlling the profit risk
in an open position. These people fall victim to an even more persuasive aspect of
trading fear. In the first situation they may claim greed held them hostage in the
position because they were sitting on good profits. This explanation is not effective
in the latter stages of a trading collapse. Now good profits shrink and sometimes
disappear entirely. Greed is no longer a factor. Now the battle is about accepting
very much lower profits from a trade that was once very good.
This is a different manifestation of fear. Greed has long since vanished and now the
trader bewails miserable profit. What he really fears is a loss of self respect because
he has made a serious trading error. He has turned a large profit into a small one. By
selling the position he must admit to this mistake. This fear works against his ability
to sell. It clutches at him when he first realises the trend has changed and that he
should have sold. It prevents him from taking what profits are available. Later, this
fear grips him harder, tightening as prices fall further and further.

251
CHART TRADING

The lower prices go, the smaller his profits become, the less likely he is to take the
loss. Paradoxically he is most likely to confront his fear when all profits are lost and
his trading capital is substantially eroded. This is panic selling at the bottom of down
trends. Other frightened sellers join in and we plot their activity on the chart as a
single downward spike on high volume. They mark the sign of a trend reversal. Later
the novice kicks himself for having sold out at the bottom when, if he had waited, he
could have got it all back.
Fear magnifies risk because it interferes with the way we trade the market. Overcoming
fear is a personal challenge, but we make it easier if we put into place a good stop
loss system. Ideally this should first protect our trading capital. Later, we use the
same system to protect our open profits.

• STOP LOSS CONCEPTS

Stop loss systems are usually based on a percentage figure, a dollar figure, or on the
activity of price itself. The last option usually includes a percentage figure in the
early stages of the trade. Any stop loss system is better than no stop loss system, but
some approaches are more effective than others.
All stop loss systems rely on traders exercising the discipline to act on the exit signal.
Remember the stack of $50 notes at the beginning of the chapter. At some point the
loss becomes so great that we cannot take any action to stop it. Fear paralyses us, and
although the notes keep burning one by one, we cannot stop them. There are ways to
decide if you have nerves of steel, or of chicken wire, and these are discussed in detail
in Trading Tactics. Traders do need to know how much pain they can bear before
paralysis sets in. Any successful stop loss technique uses this as a base figure.
When we use a dollar figure, or a percentage figure, often referred to as a 'floating'
stop loss, we must make a judgement independent of the price activity of the market.
In effect, we decide what we think is our level of risk, and then try to impose it on
the market. Perhaps we feel we can stand a $500 loss, but not $600. When we take a
position we make a firm rule to get out if we lose $500 based on the closing price of
the stock.
This sounds quite useful, but apply it to a large position with NAB and even small
slips in the stock price quickly add up to a $500 loss. Instead of staying with the
strong trend we are shaken out of the trade by small, insignificant price moves.
Shaken out of good trends not just once, but several times, the novice decides stop
losses are a waste of time. Next time the price falls he stays with the trade. Sometimes he

252
 17/ Four-Lefler Words for Traders

is lucky, and prices do rise later, but eventually using this approach he will ride a profitable
trade into a loss. Without a stop loss he has no way to decide when a small price dip
becomes a large price dip. Nor has he developed the skill and discipline to take an exit.
The same limitations apply to trades based on a percentage floating stop loss. When
the individual trade loses 4% of its value, then we exit the trade. But why choose 4%,
or $500 for that matter? These are arbitrary figures which have little relationship to
the behaviour of the stock we are trading. Additionally, as trades do move against us,
there is a strong temptation to stretch the exit from $500 to $600, or from 4% to
5%. Without some rigorous ways of deciding exit conditions the choice of almost
any figure appears as good as any other. Using these types of stop loss methods gives
the illusion of risk control, but all too often they give the trader latitude to surrender
to fear.
I favour using a charting technique based on the count back line for all stop loss and
protect profit strategies. The construction and application of this is covered in the
next chapter. None of these techniques are useful unless they are combined with
basic money management. Risk is about the loss of trading capital and this is defmed
before we fine-tune the application to a specific price in the market.

•THE2%RULE
It is not enough just to trade well. The private trader must also know something
about money management. There are many options when it comes to money
management but we can use the 2% rule as the base for all of them. The rule is that
no single trade should put at risk more than 2% of our total trading equity.
This is not a complex rule but it often seems to cause a great deal of confusion. It has
two parts:
1. Trading capital
2. A percentage figure.
The trading capital is the total amount of capital we intend to use for trading. The
aim is to have this entire amount exposed to the market in open positions most of
the time. Capital not in open positions takes a temporary rest in a cash management
trust account. When we calculate 2% we use the total of our intended trading capital
rather than the total currently committed to the market. When we add profits to our
trading pile the 2% calculation changes. It also changes when we take losses.
The second part deals with an apparently arbitrary percentage figure. The 2% rule
states no single trade should put at risk more than 2% of our total trading equity.

253
CHART TRADING

The rule does not mean that, if we have $100,000 in trading capital we must allocate
only $2,000, or 2%, to each position.
It does mean, however, that when the trade is marked to market, if loss is equal to
$2,000 then we must exit the trade. Portfolio management software marks to market.
We do the same when we take the current closing price and multiply it by the number
of shares we own. This is the value of our position on the day.
The 2% rule does not apply to the stock price. We do not exit when the price falls by
2%, perhaps from $10.00 to $9.80. The rule uses the current stock price as a calculation
point.
The rule specifies that risk, in terms of realised loss, must not exceed 2% of our total
trading equity. If we use a total of $100,000 in trading equity and have one open
position with a purchase value of $50,000, then the maximum loss we carry is $2,000.
Two open positions with a total purchase value of $50,000 each put at risk a total of
$4,000 overall. Each position puts at risk no more than 2% of our total trading capital.
Obviously 2% is too large for traders working with a larger capital base and in
these cases the figure is reduced to 1% or 0.5%, or less. Only in very exceptional
circumstances, such as when a trader starts out with a very small account, is the 2%
figure increased beyond 2%. Some strategies for this are discussed in Share Trading.
The 2% rule is designed to give the trader time to learn. With trading capital of
$100,000 the novice could make 193 mistakes, one after another, losing just 2% of
his capital each time before he is washed out of the market. Mter 193 errors only
$2,025 remains and this is the bare minimum needed for any trade. Even the worst
novice soon realises something is wrong with his trading technique after a string of
20 or 30 losing trades. He may even decide trading is not a good way to make
money.
The gruesome details are shown in Figure 17.1 opposite. Stretch the loss on each
trade to 5% and washout happens after 76 trades. Let losses grow to 10% and washout
looms after just 37 trades. By the time we reduce trading capital to around $2,000
we reach the minimum effective trading size. Risk is directly related to our survival
as traders.
When we manage risk our search starts with a bar chart, and we complete the risk
calculations by referring back to the bar chart. Spreadsheet calculations put the figures
in place. We assume a total trading capital of $100,000 and a trading opportunity
described as so good that we are advised to just "Buy it and leave it in the bottom
drawer." No investor should ever manage risk in this way, but the novice does not
understand this until he loses money, and sometimes a great deal of money.

254
 17/ Four-Letter Words for Traders

Fig. 17.1 Traders' risk of washout

$100,000

$80,000

$60,000

$40,000

$20,000

Trading
capital

37 76 128 193
Number of trades

This blue ribbon opportunity has us commit $86,000 to the position at $8.60. This
buys 10,000 shares. In setting a stop loss we need to know the dollar value of 2%
when applied to this trade. Lose more than $2,000 and we are out of the trade. The
spreadsheet calculations give a stop loss figure of $8.40. If the share price falls below
$8.40 then we are out of this trade because we have lost 2% of our total trading
equity of $100,000. The basic stop loss calculations for this are shown in Figure
17.2 overleaf.
Many novice traders get to this point and ring their broker to place the order, believing
the stop loss problem is solved. Setting a stop loss is not this simple. Unless it is
related to the chart itself, to the history of price action, it is ineffective. The stop loss
level has to be set at logical levels and the chart tells us where these are.

255
CHART TRADING

Fig. 17.2 Basic stop loss calculations

Equity name Position 1

Number of shares 10,000
Purchase price $8.60
Full cost 86,000.00
RISK P .ARAMETERS
Equity risk @ 2% 2,000.00
Stop loss exit price $8.40

Before the stack of $50 notes can grow we must know how to stop strangers from
burning too many. The count back line is the fire extinguisher.

256
Chapter 18

COUNTING CASH

Keeping a stack of cash intact, and adding to it, is the primary objective of trading.
Some people find the exploration of charting and technical analysis an interesting
study in itself. Our purpose is to match this theory with a practical reality to put cash
in our pockets. This means managing risk. The tools and chart methods considered
in previous chapters all help the trader identify trading opportunities with a high
probability of success. These are based on understanding the movement, the mood
and the thinking of the market crowd.
But when it comes to actually buying a stock we need a method to identify the best
price to pay. For this we use a count back line. The count back line is derived from a
US Treasury Bond trading technique developed by Joe Stowell which he calls a 3 Bar
Nett line. The count back line is different in some very important aspects. It has two
separate roles to play in our trading method. It is mainly used as a trading entry tool,
and this is discussed fully in Share Trading.
The count back line is also used as a more sophisticated risk management tool. This
role is inseparable from its trading application-but not everyone marries this trading
tool aspect with aggressive risk management. We consider the count back line here
in its role as a tool for managing the risk of entry and exit. Get this right with a
higher level of probability and we reduce our trading risk because we don't make a.'i
many errors.
When we turn to managing trading risk we look for both an effective entry tool and
an effective exit tool related directly to the activity of the market. The count back line
meets both of these conditions because it is based on the ranging activity of the stock
price. It uses the movement between the low and the high for the day as a means of

257
CHART TRADING

calculating specific entry and exit values. With these points the trader is able to
calculate risk, and establish parameters to control it. A practical example is included
at the end of this chapter.
The count back line is designed to follow the existing short-term trend and to confirm
when the trend changes. We can apply this on a short-term basis, to trends lasting
days or weeks, or we could step back from the market and use it on a longer-term
investing basis. For this we use weekly charts, apply the count back line in exactly the
same way, and make the same style of calculations.
The count back line works by using the ranging activity of price to establish a hurdle
which must be overcome before we believe the current up tick is really a trend break
rather than just part of a normal up and down movement within the existing trend.
Prices move up and down all the time and not every up tick, nor every low, is
important. Our task is to identify those which are.
The standard entry condition on a breakout trade is established when the closing
price is above the count back line. This count back line value is calculated by selecting
the most recent low in the current down trend. Move to the top of this bar, then
travel directly to the left until you intercept the next bar. Move up this bar to the top,
then travel to the left until you intercept the next bar. Travel to the top of this bar.
The value at the top of this bar gives the count back line value. We show this by
projecting a line to the right across the chart. Prices must close above this count back
line before we assume the trend has changed.
The count back line, along with associated calculations, is shown in Figure 18.1
opposite. We discuss this chart fully starting on page 262. The purpose here is to use
the countback line to control risk. Readers interested in the full construction rules
will find them in Share Trading. Traders using the Guppy Traders Essentials charting
pak or Ezy Chart have a count back line breakout tool included in the program.
Users of other charting programs have to make the calculations by hand.
In calculating the placement of the line we ignore any price gaps in the current trend.
Instead we move to the next highest bar in the current trend.
When used as an entry tool the count back line is combined with other indicators.
The Guppy multiple moving average indicator identifies the potential trend break.
The count back line entry technique is applied only when this signal is given by the
multiple moving average. Other signals of trend breaks include closes above the
straight edge trend line, an ADX signal, or a moving average crossover. When the
entry signal is given by one indicator, or group of indicators, then the count back
line is applied. The count back line is not generally useful as a stand-alone entry
indicator.

258
 18/ Counting Cash

Fig. 18.1 Count back line entry

2.40
ARL
A us trim
2.35 Daily bar chart

2.30

2.25
Entry signal
Maximum chase line 2.21
2.20

2.15

2.10

1293
Two equal lows
Pivot point low 2.05

89
[000) Sep98 Oct98

Once the trade is open, the count back line is often used as a stand-alone trade
management tool for protecting capital and protecting profits. This is a stop loss
application of the technique. The construction principles are the same as for the
breakout, except they reverse the process.
The starting point is the most recent high in the current trend. Select this, and move
to the bottom of the bar, then to the left until you hit the next highest bar. Again,
move to the bottom of this bar, and across to the left to the next highest bar. Move
to the bottom of this third selected bar, and project a line to the right. This is the
trailing stop loss line as shown in Figure 18.2 overleaf. We examine this chart further
starting on page 263. A collapse below this level suggests the up trend is failing and
signals an exit.

259
CHART TRADING

Fig. 18.2 Count back line stop loss

3.50

*
J ln-•1'/1.
j~
3.25 ARL
Austrim
Daily bar chart
~
3.00
Most recent high is J)iJ Trailing
J
__. stop
used for calculation
2.75 rl}r J
~~ 11-tt~UJ
J1
loss 2.90

2.50 A-..-+.! Trailing stop ...

-l}ul loss 2.54

2.25
.rl * J
~ 1h~i l,.n~1.{..)
1406 Stop loss on day
of entry 2.05
703

0
(000)

Here the calculation is used to keep us in a trade until such time as the trade reverses
direction from an up trend to a down trend. Sometimes the count back line will give
very early signals. At others times it is a little slower, and other indicators give better
signals. The MMA is often very useful here, because as the short-term group of averages
begins to turn down, the trader exits. This is particularly useful for rally traders. It is
less useful for trend traders, as these short-term changes are of less importance. The
count back line is an important tool in managing the trade and managing risk.

+RULES
1. The count back line is not a stand-alone indicator. Act on the entry and exit
signals in conjunction with confirmation signals from other trend break

260
 18/ Counting Cash

indicators such as the Guppy multiple moving average and a straight edge
trend line.
2. The count back line signals are normally based on end of day data.
3. Enter the trade on the first day after a close above the count back line.
4. Exit the trade on the first day after a close below the count back line used as
a trailing stop loss.

+ CROWD RULES
Even crowds with a strong single purpose show different levels of volatility. A mainland
Chinese crowd surging down a narrow street towards the American embassy after
the destruction of their embassy in Yugoslavia spreads out when it hits a wider
boulevard. This change in the shape of the crowd has little relationship to the final
objective. The crowd is still moving towards the American embassy but its speed is
checked by the width of the streets.
Market crowds have a single objective-to make money-and this purpose remains
solid. Not all people in the crowd want to make money in the same way, and not all
of them want to make the same amount. Some take a small profit, and leave the
crowd. Others discover they are losing money, and depart silently up a side street.
Others hang on, hoping for more. They are united by a single purpose, but their
precise action depends on both the circumstances of the market-the width of the
street-and their commitment to the objective. This is reflected in the price ranging
activity on any day.
While this ranging activity-the distance between the high and the low-remains
relatively confined in relation to the previous activity of the crowd, we assume the
purpose and objective of the crowd is still intact. Everybody is still intent on reaching
the American embassy, or in the case of the market, believes there is a good chance of
profit ahead. The count back line provides a relative measure of this crowd activity
by placing a trip wire just above or below the current price extremes defined by three
significant price bars. When the trip wire is crossed we get an alert signal. The crowd
might be changing its behaviour, and its objectives.
When the crowd loses its purpose and begins to disperse we see people drifting
down side streets. Instead of the crowd being constricted by a narrow street and
ignoring the alleyways, more people take these exits. It is difficult to tell exactly
when the purposeful crowd turns into a retreating rabble. In retrospect we see it
clearly, as people stop moving in the same direction as the rest of the crowd. As these
turncoats begin to outnumber the followers, the crowd loses momentum and direction.

261
CHART TRADING

Every day in the market people run away, taking their loot or their losses with them.
Just as we expect every crowd to have its deserters, we expect every market to have
its sellers. When enough of them run, the trend changes direction. The count back
line measures the rate of desertion and decides if it is within normal attrition rates, or
if it is indicative of a general retreat. The count back line gives stock prices room to
breathe, but sets limits on just how deep each breath can be.

• USING THE COUNT BACK LINE

The count back line has three separate applications. It is used:
1. For the entry.
2. As a stop loss.
3. For the trade exit.
All of these aspects are shown in the course of a complete trend with Austrim (ARL).
The first application of the count back line, as a trade entry tool, establishes the entry
conditions in Figure 18.1 on page 259. Every time ARL makes a new low in the
falling trend a new count back line is calculated. We cannot know the ultimate pivot
point low- the ultimate low point of the falling trend-in advance. Mter it is formed,
prices begin to rise. Only future price action will confirm this. In this chart the pivot
point low is at $2.05. The count back line calculation uses the most recent of the two
equal lows, marked as A.
Move up the first bar above point A, then across to the left to the next highest bar.
Immediately to the left of this bar is another bar with an equal high. This bar is
ignored as we move left again to the next highest bar. The top of this third significant
bar gives a count back line entry level of$2.13. A count back line is plotted extending
to the right at this level.
We need a close above the count back line value before a trend change is signalled.
This happens three days after the pivot point low is created. The count back line uses
end of day price data so our entry is made the next day at favourable prices. We take
a midpoint entry at $2.11.
Even if we miss this entry signal we still have eight days before ARL prices are
carried above the maximum chase line at $2.21. If we pay more than $2.21 and the
rally turns out to be short lived then we could lose money. The maximum chase line
helps us manage risk. The position of this line is decided by a percentage calculation.
Take the percentage difference between the pivot point low and the count back line.

262
 18/ Counting Cash

It is 3.9% in this trade. Calculate this same percentage above the count back line to
find the value of the maximum chase line.
Although we show just the count back line, please remember that this technique is
used in conjunction with other trend indicators, such as the multiple moving average.
Traders who waited six days for multiple moving average confirmation of the trend
break in this case were also able to enter around $2.11.
The second application of the count back line technique is as a trailing stop loss.
Figure 18.2 on page 260 shows this applied on the original entry, and also at several
points during the developing trade. The stop loss calculation point for the first entry
is marked with an asterix (*).It has a value of $2.05. In this example this is the same
value as the pivot point low. If prices fall below $2.05 then we exit the trade because
there is a strong probability of a new down trend.
This stop loss value is a very important figure for three reasons:
> It protects our trading capital
> It tells us when the up trend is changing into a down trend.
> It determines our maximum position size. In the next section we show how
this figure is used to set a limit on the amount of money we allocate to this
trade.
The entry into this trade is safe. If prices fall below the value of the trailing stop
loss, then the trade is closed on the next day. This same process is applied as the
trend develops. Whenever a new high is made, the calculation is done again. Guppy
Traders Essentials Charting pak or Ezy Chart users do this automatically by selecting
the count back line tool. Metastock users have to make the calculation by hand.
We show just a few of these calculation points marked with an asterix (*) in Figure
18.2. The second point shown is the third bar in a series of bars of equal height.
When the first bar in the series appeared the trailing stop loss calculation value was
set at line A. The second equal bar in the series raised the trailing stop loss level to
$2.54. The most recent calculation in this series still places the stop loss at $2.54.
The third application of this technique uses the count back line to signal an exit from
the trade, shown in Figure 18.3 overleaf. When prices close below the value of the
trailing stop loss we exit to protect our profits. We ignore the dose exactly on the
value of the trailing stop loss value calculated from the high marked with the asterix
(*).The count back line exit signal is generated the next day with a close below the
trailing stop loss at $3.43. This is an end of day signal so we take an exit the next day
at $3.45.

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CHART TRADING

Fig. 18.3 Count back line exit signal

* Exit at $3.45

3.70
I Close is on the

3.60

NewCBL
3.50 entry level

3.40

3.30
Exit signal

3.20

Pivot point?
3.10

994

497

0
(000) Feb99 Mar99

Perhaps we pause for a moment to gloat. The development of this technique has
been shown across three charts and it captured almost the entire ARL up trend, with
an entry at $2.11 and an exit at $3.45, for a 63% return.
Trading life is rarely perfect, and ARL is no exception. The day after prices close below
the trailing stop loss we start a new count back line calculation, looking for the pivot
point low in the new down trend. This appears just one day after our exit and generates
a new entry signal five days later. The new count back line entry is marked on Figure
18.3. Do we take this signal? Readers have an advantage because the rest of the chart
is shown. With hindsight we know it is a false signal, but how do we know at the time?
The count back line technique is not designed as a stand-alone entry or exit signal. It
is employed only once trend break signals have been generated by other indicators.

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 18/ Counting Cash

We take the exit on this chart because the Guppy multiple moving average is also
suggesting a collapse in the trend. We ignore the new count back line entry signal for
the same reasons. We trade with the trend by using the count back line to develop
precise entry and exit conditions. In the next section I will show how these figures
are used to identify and manage risk.

SUMMARY• COUNT BACK LINE

The count back line is a short-term resistance or support line calculated, in a falling
trend, by counting back two higher highs, and then projecting a horizontal resistance
line to the right. A close above this resistance line suggests the intermediate down
trend has changed. Closes above or below the line are used to fine-tune entry and
exit points. To reduce whipsaws the technique is used when a trend break has been
signalled initially by other trend indicators.
The count back line stop loss rule uses the range activity of the stock to set a stop loss
point. The range is the distance between the high and the low for the day. The stop
loss is calculated using the count back line approach. Taking the most recent highest
high in the intermediate-term trend, the stop loss point is calculated by counting
back three lower bars. The horizontal line drawn at the bottom of the third bar is the
stop loss point. This stop loss is not related to the 2% rule. The line suggests the
conditions where the trend may be weakening. When used with open profits, it
provides an exit signal to protect those profits.
The count back line is also used to trade the short side of the market-selling high
and buying low. It is used as a signal on the parent stock, alerting traders to put
warrant opportunities. Here it is used as a short-term support line calculated, in a
rising trend, by counting back two lower highs, and then projecting a horizontal line
to the right. A close below this support line suggests the intermediate trend has
changed. This is a short-selling signal. We could act on this by buying put warrants.
As the market falls, the value of the puts rise. Using the long side count back line
technique described above, we monitor the down trend, and the put position is sold
when there is a close above the new count back line. Closes below or above the line
are used to fine-tune entry and exit points. These more complex techniques and
detailed applications of the count back line are explored in Trend Trading .

• STOP LOSS ACTION

Managing risk is a combination of the 2% rule and the count back line signals. The
ARL chart provides a starting point, but spreadsheet calculations put the exact figures

265
CHART TRADING

in place. We stay with ARL for this example and we assume a total trading capital of
$100,000. We believe this is a good trade so we are prepared to commit $84,400 to
the position. This buys 40,000 shares at our entry price of $2.11. We need to know
the dollar value of 2% when measured on this trade. The basic stop loss spreadsheet
calculations in Figure 18.4 below show the result. This uses the same structure as
Figure 17.2 in the previous chapter.

Fig. 18.4 Basic stop loss calculations

Equity name Austrim

Number of shares 40~000
Purchase price $2.11
Full cost 84,400.00
RISK P ARAlVIE TERS
Equity risk@ 2% 2,000.00
Stop loss exit price $2.06

These calculations tell us that if the ARL price falls below $2.06 then we are out of
this trade, because we would lose 2% of our total trading equity of $100,000. This
calculation uses rounded figures and excludes brokerage.
Many novice traders stop here, believing the stop loss is taken care of. They move
straight on to calculating profits. Such traders see nothing wrong with this process
and they go on to lose a great deal of their trading capital.
Setting a stop loss must be related to the chart itself, to the history of price action.
The stop loss level has to be set at logical levels and the count back line tells us where
these are by identifying a trailing stop loss figure. If prices fall below this level then
the logic of the count back line suggests the trend has changed direction. We no
longer want to be in this trade.
Turning back to ARLin Figure 18.2 on page 260, we plotted our proposed entry
point at $2.11 and, according to our original stop loss calculation, a proposed stop
loss exit point at $2.05 based on the pivot point low at the time of entry.

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 18/ Counting Cash

With a proposed $84,400 position, the stop loss at $2.06 is not related to any activity
in the market. It is a purely financial calculation. The count back line trailing stop
loss at $2.05 is directly related to market activity. On this calculation the $0.01
difference between the proposed stop loss and the count back line stop loss does not
sound like much. In this trade it represents $400 or-when added to the $2,000 stop
loss-a total of 2.4% of our total trading equity. We need to join the financial and
market calculations.
Confusing financial and market calculations kills the private trader and this is how it
happens. Assume our stop loss is at $2.06, or $0.01 above the count back line trailing
stop loss at $2.05. Prices do fall, and they do not pause at $2.06. What is our response?
Too many times we sit there, mesmerised and paralysed by falling prices. We know
we should have exited at $2.06 but the market fell straight past this level to the count
back line trailing stop loss. Although we were mentally prepared to take a loss of
$2,000 at $2.06 we are not mentally prepared to take a loss of $2,400 when prices
do pause at $2.05.
This may look like nit picking in this example. In some cases, however, the difference
between the proposed exit and the pivot point low may come to thousands of dollars.
The error is the same, but the consequences are more severe.
This saps our will to act. We are hostage to the market, holding out against the
torture of falling prices. But instead of giving just our name, rank and serial number
as prisoners of war do in the movies, we end up giving our name, the name of our
broker and our brokerage account number. The problem is that we haven't planned
realistically so our financial stop loss bears no relationship to market activity.
Technical analysis principles identify the breakout conditions, and the stop loss levels
confirm the trend breakout has failed. A logical stop loss will coincide with these
levels. A pause at this level gives us a chance to exit at this price, or a few ticks lower.
From a trade management perspective the challenge is to match position size with
the logical stop loss point and the dollar value as it relates to our total trading equity.
In our ARL example the difference between entry and stop loss exit must be no more
than $2,000. This defmes our risk. We match this risk figure with the pivot point
low by manipulating the position size as shown in Figure 18.5 overleaf. By changing
our position size we match the size of the dollar loss with the appropriate stop loss
level at $2.05. If we chose to work with a lower risk figure on this trade, perhaps
$1,500, then the result is shown in Figure 18.6 overleaf.
Looking at Figure 18.5, by reducing position size from $84,400 to $70,685 and
only buying 33,500 ARL shares, the potential loss stays within the 2% limit. Brokerage
is excluded and the figures rounded down. If prices do fall to the $2.05level we have

267
CHART TRADING

a chance to exit with dignity and effectively manage risk. Remember, this is the
maximum permissible trading size. It does not mean you have to trade at this dollar
value, but it does mean you should not trade any larger than this.

Fig. 18.5 Stop loss detailed calculations

EQUITY DETAJLS
Equity name Austrim Maximum
permissible
Nwnber of shares 33,500 trading size
Purchase price 2.110
Full cost 70,685.00
RISK PARAMETERS Risk based on
trading capital
Equity risk @ 2o/o 2,000.00
Risk on this trade 2,000.00 Risk selected
for this trade
Stop loss exit price $2.05
Value of pivot point
low or support level

Fig. 18.6 Stop loss, reduced risk, detailed calculations

EQUITY DETAJLS
Equity name Austrim Maximum
Nwnber of shares 25,000 permissible
trading size
Purchase price 2.110
Full cost 52,750.00
RISK PARAMETERS Risk based on
Equity risk @ 2% 2,000.00 trading capital

Risk on this trade 1,500.00 Risk selected

for this trade
Stop loss exit price $2.05
Value of pivot point
low or support level

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 18/ Counting Cash

This process of matching stop loss with logical chart points and then manipulating
position size so the dollar loss is consistent with the 2% rule is an essential part of
trade planning. This is just a brief introduction to the practical application of these
techniques. They are covered in more depth in Share Trading, Trading Tactics and
Bear Trading. These books also explore the relationship between risk control, money
management and trade planning. Excel spreadsheet templates are available from
www.guppytraders.com for a small charge.
In setting stop loss points in the ARL example we could also have made good use of
support and resistance concepts to set the stop loss levels. Alternatively the trader
could use an indicator value, or reading, such as a close below the 21-day moving
average. It is important to choose a stop loss combination based on chart and indicator
values before the first share is purchased. Every trade calls for a specific trading plan.
Every successful trader devises a management plan for every trade.
Our task in this book is to consider the way charting and technical analysis tools are
combined to understand market behaviour. The path is convoluted because it soon
splits into many choices at each stage. An outline of just where charting fits into the
task of trading is shown in Figure 18.7 overleaf. Better understanding increases the
probability that our selected trading opportunities will be profitable. Using chart
analysis to identify risk control enhances the profitability of individual trades and
our total trading activity. This puts cash in the bank.

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CHART TRADING

Fig. 18.7 Levels and steps in developing a trading plan

TODAY

I
Market up
I
Market down
I
Market choppy
I
Don't understand
I
Trade Surjive Standlside
1
Monitor trades Monitor mlrket Open new t!ades Close t~ades
SELECT STOCK

Pers~nal Magazmebp
1••
Tip f~om Brok~rli
preference friends recommendation

Sector Indicator Fundamental

search search analysis

Visuallessment

I
Too late
CurreLt trading
opportunities
I
Future trad"mg
opportunities

ANALYSIS
METHODS

I
CHARTING OSCIL~ATORS I
TREND FOLLOWING OTHER INDICATORS
I
CHARTING
Double top Double bottom
Triangles Rectangles
Trend lines Head and Shoulders
Support Island reversal
Resistance Exhaustion gaps
Flags Pennants
Common gaps Cup and handle

Candlestick! chart BarJhart Point and Jigure chart

270
 18/ Counting Cash

Fig. 18.7 Levels and steps in developing a trading plan Cont'd

OSC~LLATORS TREND JOLLOWING OTHER INDICATORS

I
Relative Strength Bollinger Bands Count Back Line
Index ADX Price% and Volume
Stochastic MACD Advance Decline line
Rate of Change Moving average Smart money
WiUiams %R 2 moving Averages % retracement
Multiple Moving Average New high .low index
On Balance Volume
Trading Bands
Average True Range

EVALUATION

I
Trade
I
No Trade Uncertain
I I
Proceed no further
I
STYLE OF TRADE
I I I
Aggressive Speculative Conservative Defensive

I
TYPE OF TRADE
I s1"de
Trend - long
I
Trend • short side
Ra~ly
Momentum
1 SwJng
I
Finger
Island in !he sun

I
SET ENTRY PRICE

At~arket .
Indicator value
I I
Chart value
ENTRY/EXIT CONDITIONS
Establish profit targets Establish stop loss points

Financial targets Financial stop loss

Chart based targets Chart based stop loss

Indicator targets Indicator based stop loss

EVALUATION
I
I Profi~OK
Improve Profits

Analyse warrants
I IRisk OK
I Profits too small

Proceed no further

271
Chapter 19

SELECTING SOFTWARE

By this stage in the book you either own charting software, are using Internet charts
or are thinking about buying charting software. This chapter is designed as a general
guide to charting and analysis software. Like all software the advances are frequent
and dramatic, so we look at general principles and some of the major packages. I
use the Guppy Traders Essentials charting pak, Ezy Chart and Metastock. Many
traders end up with several charting and analysis packages because each has particular
strengths.
Selecting market software is difficult. A bewildering array of products all claim to
offer the best. Fighting through this maze is the first task confronting the private
trader, and first choices are not always the best. Sales people too often just want to
make the sale. They do not trade, they do not use the product, and they do not
understand the market. Before buying software, talk to users. They will tell you the
strengths and weaknesses of each package. You can use the Internet for this. Links to
trading chat groups are updated regularly on http://www.guppytraders.com and links
to demonstration copies of programs are also available.
Market software falls into five broad categories. In order of complexity, these are:

> charting
> analysis
> indicator and systems development
> systems
> portfolio management.

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 19/ Selecting Software

Each software package has specific strengths. No single package will meet all your
needs. Deciding which is most appropriate for you depends on how you want to
track market and price activity. Each category concentrates on a different aspect.
Having chosen your focus, personal preference decides if you are more comfortable
with Windows-style software, or something fully Microsoft Office compatible .

• DATA SUPPLY
I do not include data supply software here because each of these charting programs
is designed to read a database of information built and maintained quite
independently of the charting software. This is an important distinction. Market
data is a stream of numbers. They are arranged and stored in a single folder, or
directory. The folder may contain sub-folders arranged alphabetically. Each stock is
a separate document within the folder. The accuracy of each stock document depends
on the accuracy of the data supplied.
Charting software cannot operate without data. It is like trying to create a graph in
an Excel spreadsheet that contains no numbers. Charting software reads the base
data files provided by the data supplier, some of whom were listed on page 56.
Often you must initially direct the charting software to look for the data in a specific
folder. I track six local and international markets and have a choice of six folders.
If you get strange results, missing days, data gaps and other problems in the chart
display then the most likely cause is your data supplier. Do not blame your charting
software. All charting and analysis programs are only as good as the data they have
to work with.
Avoid being locked into proprietary data formats. These formats suit only a single
program and often lock you into a single, and expensive, data provider where you
can become the victim of predatory pricing. Charting software with open data
platform solutions leaves you free to switch data suppliers at any time in search of
the cheapest rates.
Cheap data does cost money-and it is often your trading capital, and time. It is
false economy to collect free data and then spend many frustrating hours converting
it into a format suitable for your charting package. Better data suppliers provide
data in the correct format-not just ASCII. Otherwise they provide easy-to-use
downloading software to automatically collect and convert data into the correct
format in just a few minutes. Subscription based services include Paritech. Software
that provides access to quality free data is provided by Bohdi Freeway.
When data supply is the core business of the data supplier there is a guarantee of
accurate and 'clean' data. 'Dirty' data includes non-standard treatment of no-trade

273
CHART TRADING

days, incorrect prices, inconsistent calculation of continuous contracts and other errors.
Cheap data may use the last traded price rather than the settlement price, or the
preliminary volume figures rather than the final volume for the day. Often these
differences are minor, but sometimes they are significant. It is your trading capital at
risk so it pays to have absolute confidence in the quality of your data. We take on the
professional traders so it pays to meet a reasonable cost for quality end of day data.
I use up to five different charting programs and four different data suppliers to
follow six different national and international markets. My multiple charting
programs all read a single common database, providing the data format is
compatible. With a single ASX database there are no problems running the Guppy
Traders Essentials charting pak, Ezy Charts, Metastock, OmniTrader, SuperCharts
or TradeStation .

• CHARTING
Charting is the primary requirement for investors and traders. The software reads
the database of price history, and plots the results in a graphic form. Display options
usually include a line plot, bar charts, candlestick plots and a point and figure display.
Even basic charting software allows for a moving average and trend line plots.
There are an increasing number of cheap, low-end charting and analysis programs
designed to capture the unwary and the unskilled. Many make you work unnecessarily
to translate market data into their format. They are generally available at your
corner computer store for around $150 or less. Treat them as an introduction to
charting because you most likely outgrow them very quick!).
Poor charting packages just provide chart displays and pay little regard to the settings
used in the calculations. Don't buy them. Good charting software reveals the defaults,
or parameters, used for all charts. For just a few dollars more this is real charting.
Better chart programs give users control of the default indicator settings, allowing
them to fine-tune them to their personal needs. Programs with these features are
found on computers used by serious traders and investors. One of them should be
on your desk top.
The Guppy Traders Essentials charting pak and Ezy Chart are good examples of
mid-range trading software combining charting and analysis options in multiple
windows. Over 40 indicator choices are offered, ranging from MACD and stochastic,
to Gann and Fibonacci projections. It also includes automatic count back line
calculations and the Multiple Moving Average (MMA) indicator. For many traders
this style of package offers enough features for successful trading. This style of
package is like a handi-van. Just as the handi-van keeps many businesses operating
on a day-to-day basis, this software handles day-to-day functions.

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 19/ Selecting Software

I use the Guppy Traders Essentials charting pak in this way. The count back line
function speeds my daily analysis. The live chart function allows me to group selected
stocks into easily managed sub-folders, accessible in an instant .

• SOPHISTICATED CHARTING
As our trading skills develop we want to delve deeper into analysis to include speed
searches of the database for stocks meeting specific conditions. Mid-range software
meets this need with added modules, such as Ezy Analyser. Sophisticated high-
range software such as Metastock bundles this in a single powerful package.
High-range expensive software usually delivers over 100 indicators, multiple windows
and full Microsoft Office compatibility. Metastock includes a powerful indicator
builder and a useful systems testing capacity. The Explorer function facilitates database
searches looking for matches against a range of conditions, and against any of the
indicator results. This software goes a significant step beyond the mid-range offerings,
but it comes with a ten-fold increase in complexity. Make sure you do not buy a ten-
tonne flatbed truck when a simple handi-van will meet all your needs.
This complexity comes at a cost. Many features of mid-range programs speed up
daily trading but cannot be duplicated with the high-end programs. However, high-
end programs perform many functions beyond the capacity of the mid-range
programs. This includes the ability to more finely manipulate the settings for all
indicators; to develop new indicators; more sophisticated analysis; and limited system
testing.
Eventually even 100 indicators are not enough. Traders want to fiddle-maybe to
develop variations on trading ideas, or to build new indicators, and then use the
charting capacity of the program to plot the results. This capacity is found in high-
range and top-end softward. Metastock offers this but the programming language
it uses imposes some unexpected limits.
Here SuperCharts shine. The built-in programming tools are very powerful. Those
who want to push the boundaries even further look to its stablemate, TradeStation.
This is systems development and testing at its best. The charting and analysis
functions are less intuitive to use than Metastock with its Microsoft Office
compatibility. Many users find the need to learn a new program command structure
a disadvantage. Users get multiple window displays but the command structure still
suffers from a DOS hangover. Despite this these programs constitute a fully
equipped semi-trailer and demand a higher level of skill to operate the system to
achieve optimal results.

275
CHART TRADING

You would reasonably expect these top-end programs to offer everything the mid-
range programs have and more. This is incorrect. Neither SuperCharts nor
TradeStation easily plot an MMA indicator because the program has trouble plotting
such a large number of indicators all at once on a single screen. The construction
instructions cover many pages while the instructions for a Metastock template take
just a few paragraphs. Nor are all top-end programs able to automatically plot a
count back line. There is no super program, but there are programs that are particularly
good in selected areas.

• TRADING SYSTEMS
Analysis and indicator development sounds like hard work. The idea of a pre-developed
trading system appeals to some. They want to go straight to the core of trading
opportunities by using software designed to find good trades. They could buy a very
expensive trading system costing several thousand dollars, but there are cheaper options
available.
Some software, such as OmniTrader, HotTrader, Advanced GET and others let you
take a shortcut. These programs are designed to implement a specific trading strategy
or system. They do come equipped with good charting, but mainly so they can display
the results of their preferred approach. All their analysis tools and indicators are
skewed towards a single trading strategy. They might be based on Gann, Elliott
Wave, or market cycles. These are powerful tools for exploring dedicated trading
approaches, but they do lock you into a particular strategy.
Some software distributors are eager for the sale and recommend software which
delivers a high retail margin for them. Others are locked into a favourite market
approach so they attempt to sell just one style of trading, such as Gann, to all customers.
Popular finance media often run misleading and ill-informed articles based on
information supplied by software sellers rather than information from software users.
The novice trader should look for a toolbox with the widest possible range of choices.
Later he may develop an interest in market cycles, in Elliott waves or Gann swings. If
this interest is strong then it makes sense to pay the extra money to buy a specific
charting package for this purpose.

• PORTFOLIO MANAGEMENT
Success, or even failure, demands a paper trail. Portfolio management software
completes the circle. Some, like Ezy Portfolio Manager, include trading alerts, but

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 19/ Selecting Software

most concentrate on good record keeping. Most of them graph portfolio results
and a few permit simple line charting of individual stocks. Their functions are so
different from charting and analysis that this is usually stand-alone software, or an
additional module for a charting package. Do not expect your charting software to
be a portfolio and record manager.

• MIX AND MATCH

So why not simply go out and buy the most powerful market program available?
Each has its strengths, and careful selection will match individual program strengths
with your areas of interest, often at a more reasonable cost. Some traders, like myself,
end up with several different programs, using each for its particular strong points.
I use the Guppy Traders Essentials pak for its speed and automatic plotting of the
count back line entry and stop loss signals. I use Metastock as a workhorse for
detailed analysis and indicator development. Multiple open windows and Microsoft
Office compatibility are a plus. I turn to SuperCharts for systems testing. Portfolio
management is handled by Ezy Portfolio Manager. These are my choices and they
fit my needs in the market. Your needs will be different. If you have a clear idea
before you go shopping for software you will end up with software that will do the
required job for many years.
When you buy software you might look for the following:

~ Data compatibility with either the Metastock format, or ASCII. Avoid

programs where you have to spend time manipulating data into or out of a
proprietary format. Avoid the potential for predatory pricing by your data
supplier.
~ A good support base of users and a business support base for the software.
This means help is available from sources other than the product help desk.
~ A steady stream of updates to improve the charting and analysis capabilities
in line with developing industry trends.
~ Personally, I want full compatibility with Windows, and a totally mouse-
driven interface.
~ The power to easily explore and test new trading ideas. You might not need
this power now but as your trading skills improve these features grow in
importance.

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CHART TRADING

.,.... Personally, I buy specialised software for just one or two additional features
even if the rest of the indicators are already included in my existing software
packages. Guppy Traders Essentials charting falls into this category. It plots
the count back line and count back stop loss line automatically. This saves
me considerable time. It also allows me to easily search the database by
segment, i.e. small industrial stocks only.
Cost is the least important factor in choosing software. Some novices hunt for
software under $100 because they are unwilling to buy anything better. They want
to trade against the professionals armed with toy guns. No wonder the failure rate
is so high.
Other novices believe more expensive equates with better. Faced with so many choices,
they spend so much time trying to understand the indicators and the program that
they forget to trade. Eventually they focus on just a handful of indicators and leave
much of the program's capacity unused. They face the professionals with the fire
power of an armed infantry brigade, hoping at least some of the shots will hit home.
Some novices are enticed into buying specialised software which takes just one view
of the market. Usually promoted as a buy and sell system so simple than an idiot can
use it, the novice takes the short cut and misses the irony. This weapon gives them a
choice. Fire and hope for the best, or read and understand the complex instruction
manual. Most shoot and hope, and miss. In the hands of a skilled operator it is a
powerful weapon.
Trading is not easy money. More expensive tools will not make you a better trader
and you cannot buy trading success. Good software provides excellent tools but in
the hands of the unskilled the result is still messy. Successful trading is a combination
of tools, skill, money management and risk control.

278
Chapter 20

MIND TRAPS

Risk is always certain and it can be measured. Reward is only ever possible. Trading
the financial markets puts us directly at the vortex of risk and reward. It is an exciting
place, but survival depends less on the tools we assemble than it does on our
psychological strength. This is a journey into the mind where consequences turn as
easily to dreams as to screams.
How we measure risk depends on how we carve it up. Forget for the moment the
risks associated with the nature of the financial markets. Concentrate on just two
aspects because failure here destroys everything. The first is methodology risk. The
second is execution risk, often referred to as pulling the trigger-a term capturing the
fatal pause between thought and action. Mastery here changes the nature of risk in
the market. When risk is defmed by the entry and exit, rather than time in the market,
we find a spot of stability in the vortex.
This book has dealt with ways to reduce methodology risk by developing a better
understanding of the tools of the trade. From charts to indicators, from patterns to
relationships, we have explored the foundations of the better tools now available to all.
We met briefly with fear and greed. Do not forget because they will become our
constant companions. They guide, or stay, our hands when it comes to execution of
trading strategies. Skill in using the tools is not enough. Macbeth, the powerful
warrior chieftain in Shakespeare's play, explores the clash between will and skill.
When Macbeth decides to kill Duncan, his king, he chooses to use a dagger. On his
way to commit the murder his willpower falters. He sees before him "a dagger of the
mind" and on the way to the point of optimal execution, he pauses. It does not

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CHART TRADING

matter if Macbeth is equipped with a dagger, a broadsword, or a machine gun. His

failure is in the mind.
The breakout pattern we have waited for does not necessarily mean we have the
willpower to pick up the phone and place an order. The opportunity on the screen
display makes it no easier to click the mouse button to send the buy order over the
Internet.
Macbeth does go on to commit the crime, his timing altered by his indecision. He
lets "I dare not wait upon I would", and botches the killing. Instead of taking the
king by surprise he catches him as he wakes. Instead of a calm, planned killing stab,
Macbeth breaks into a frenzy of slashing, killing not only the king, but the grooms as
well.
Would decisive action have solved Macbeth's problems? Probably not. The play
explores a much more complex plot and we are only interested in a small aspect of it.
Ill-considered decisive action will not wive our own trading problems, but we do
know trading indecision does create unnecessary problems.
This collapse of planning has nothing to do with the dagger Macbeth uses. When we
miss trading opportunities it is not usually our tools which are at fault. Like Macbeth,
our hesitation causes devastation.
And this is only in the first part of the trade-the entry. Managing, and later closing
the trade, is even more demanding. Unlike Macbeth, we do not have Lady Macbeth
to act as a powerful stop loss, cleaning up the mess we leave behind. Our resolve is
entirely in our own hands.
Lady Macbeth is surprised for "who would have thought the old man to have had so
much blood in him?" In turn, we are unpleasantly surprised to find just how much of
our capital is consumed in just a few days as falling prices slash the value of our
portfolio. We cannot stop this but we could resolve to take early action to limit the
damage.
Trading success is more than just a selection of the right tools or combination of
tools. It is more than just a skilful application of the tools to the market. Most
importantly, trading success rests on how you play the mind game. It is not a dagger
you see before you. It is the prospect of loss and if it stays your hand at vital points
in opening and developing a trade then it has the capacity to destroy you as surely as
Macbeth is destroyed.
The best traders draw on experience. Macbeth drew on his fearsome ability as a
warrior, and still failed to manage the consequences of his acts. You cannot buy

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 20/ Mind Traps

trading experience in a package. It is purchased by time payment directly from the

market, lesson by painful lesson. How much you pay for each lesson depends largely
on your attitude. There are hundreds, if not thousands, of indicators, variations on
indicators, chart patterns and accidental statistical relationships available for research.
You cannot master them all and the best traders master just a handful. We should
emulate them. Knowledge grows slowly. It rarely comes fully formed and the world
of trading is no different.
Some writers flippantly suggest trading is a way to lose a lot of money and have a lot
of fun doing it. Losing money, losing esteem, losing status is never enjoyable. Macbeth
reaches for glory and too late becomes aware that the abyss beneath him cannot be
crossed on the strength of the witches' predictions. We also reach for glory, but our
tools give us a way to skirt the abyss with better risk management constructed around
probability rather than prediction.
Like an amateur trader, who considers reward before he examines risk, Macbeth
challenges the hags to "look into the seeds of time, and say which grain will grow,
and which will not."
Which grain will grow? We do not know and we do not need to know. Better analysis
skills help select those which may grow with greater certainty and consistency. But
when it comes down to it, we know not in advance which trade will be successful and
which a failure.
We ask only for the opportunity to watch the trades develop so we can select the
strongest. Each trade is just one of a series of probabilities and success lies in the way
we manage risk.
Better tools help, but in this mind game never underestimate your own ability for
self-destruction. Macbeth loses. At the vortex of risk and reward vertigo is the most
destructive force. We want to succeed, so take these tools and trade well by avoiding
the mind traps.

281
Index

2% rule 253 bulls 20, 50 derivatives 24

buy and hold 30 divergence 163, 168,
A buying pressure 232 199,207,209,217
accountants 17 double bottom 96, 97,
accumulation pattern 39, c 100
240 candlestick display 51 double top 96
Advance_Decline 215, census measure 215 Dow theory 26
221,222,225 chart patterns 67, 96 down trend 40
ADX 169, 171 Charting - An Australian draw down 39
Against the Gods 33 Investor's Guide 116
An Encyclopedia of chartist 21 E
Technical Analysis vi charts, self fulfilling 36 Elliott 23, 26, 32, 36
Analysing Bar Charts for coincidental relationships Elliott wave 25, 81
Profit 115 124 Elliott Wave Principle,
Analysing Company convergence 177 The 46
Accounts 17 Coppock 23 end of day data 15, 55
at market 49 count back line 253, equi-volume 58, 69
257,260 equilibrium 186, 211
B crossover signals 165 exhaustion pattern 243
bar chart 49 crowd behaviour 12, 13 exit conditions 85
Bay 13 48, 218 crowd emotion 50 Ezy Chart 3, 155, 168,
bean counters 15 crowd psychology 13, 79 194,225,234,244,272
Bear Trading 178, 228 crowd sentiment l 0
bears 20, 50 F
Beyond Candlesticks 61, 64 D false signals 202
blow off top 230 daily chart 44 fear 249
Blueprint for Investment data, dirty 55, 271 Fibonacci 23, 32, 274
17 data, end of day 15, 55 Fibonacci for Traders 26,
Bollinger bands 187, 189 data supply 54, 273 59
box size 67 day traders 53 financial calculations 267
breakout 91, 106 Decline and Fall of the Forecasting Profits Using
Buffettology 17 Roman Empire 215 Price and Time 26

283
CHART TRADING

fractal repetition 177 L N

fundamental analysis 15 lag 142, 146, 157 neckline 13 3
fundamental ratios 18 line chart 8, 46 New High_New Low
fundamentals 9, 29 linear display 44 215,216,217
linear regression 194 New Science of Technical
G logarithmic 44, 46 Analysis, The 116
Gann23, 25, 32, 36, 58, long-term averages 177 news 32
274 Long Term Secrets of novice 20
Gann Made Easy 59, 61 Short Term Trading number relationships 24
gaps 116, 117 25, 116
-breakaway 117, 118 0
-congestion 116, 118, M oscillator 186, 198
120 Macbeth 28, 29, 215, overdone 186
-continuation 117, 118 279
-covered 123 MACD 158 p
-exhaustion 118 MACD_H 162, 163 pivot point 97
graphs 7 market data 48 point and figure 58, 64
market psychology 21, position size 26 7
H 132 prediction 18, 27, 29, 35
head and shoulders 128, Market Wizards 185, 228 price and volume 230,
130 Metastock 3, 55, 155, 243
How to Make Profits in 168, 194, 220, 225, price data 43
Commodities 24 234,244,272 price discovery 19
Metastock downloader Price, Pattern and Time
226 59
inside day 125, 126 Mining Valuation price peak 166, 209
Internet trading 4 7 Handbook, The 17 price plot 41
Investment Secrets of a momentum 236, 240 price range 125, 169,
Hedge Fund Manager money management 5 258,261
116 moving average 140, price targets 101, 128,
investor 4, 30, 35, 179 142, 151 133
-crossover 127, 148 probability 21, 22, 33,
-exponential 141 34~37,96, 103,112,
J -simple 146
jelly bean 16, 19 113, 179, 187, 191,
-triangular 14 7 207,229
-variable 14 7 prophecy 28, 34
K -volume adjusted 14 7 protect capital 259
kagi chart 59 -weighted 141, 147 protect profit 259
Kondratieff 23 multiple moving average
176,178

284
 Index

R -floating percentage trend, fading the 87

random price 189 253 trend line 81, 84
real time data 15 -logical267 trend rules 82
Relative Strength Index -trailing 251, 263 triangle breakout 105
(RSI) 140, 206, 207 straight edge trend line triangle patterns 105
renko display 61 80 triangle, downsloping
resistance l 04 summary chart 58 107, llO
reversal amount 60, 65 SuperCharts 275 triangle, equilateralllO,
reversal pattern 101, 128 support and resistance lll
risk 18, 21, 26, 27, 28, 87, 88, 93 triangle, sloping 103
29, 31, 35, 249, 258, swing chart 58, 61 triangle, summary 114
279 triangle, symmetrical ll 0
-management 6, 33 T triangle, up sloping 103
-position 34 technical analysis 140 triple bottom 99, 101
-washout 255 Technical Analysis of Truth ofthe Stock Tape
rounding top 134 Stock Trends 115 24
technical indicator 5, 22, Turning Point Analysis in
Price and Time 81
s 54
scale 66 Technical Market
Security Analysis 17 Indicators vi v
set-ups US three line break display valuations 12, 21
Share Trading 67, 254, 63 value, fair 18
257 tick charts 53 value over time 80, 87,
short-term averages 177 time lords 16, 23 95
sideways consolidation trade entry 15 3 value, under/over 17
186,204 trade exit 154 volatility 125, 211
signal line 15 8 trade management 153 volume 42, 69, 120,
smart money 50, 209 trader 16, 20, 72, 179 131,228
smart traders ll2 -aggressive 106, 127 Volume Cycles in the
standard deviation 188, -conservative 127, 220 Stock Market 71
194 TradeStation 276 volume rules 232
statistics 23, 187, 188, trading channel 91, 94
215 Trading for a Living 162 w
stochastic, fast 196 trading, short-term 125 warrants 24
stochastic, rules 198 Trading Tactics 33, 178, wedges Ill
stochastic, slow 197 252 week, fixed 72
stop loss 34, 38, 250, Trading with DiNapoli week, floating 72
265 Levels 46 weekly charts 71, 88
-floating 252 trend break 232 whipsaw 161
trend change 229

285