an active traders guide

7/25/2019 An Active Traders Guide

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An Active

Traders Primer Your free trading guide to learn the secretsof successful trading from the pros.

These selected trading education articles are key to makingmore money in any market. Get your Active Traders Primertoday and start building your portfolio to greater profits.


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Introduction

As anyone who makes all or part of his or her livingin the nancial markets will tell you, making moneyat it is like any other business it is dependent onwhat you put into it.

Because we have been in the business of supportingthe active trader for more than 25 years, we knowthat one of the earmarks of a successful trader isthe willingness to put time into education. Thatswhy, in addition to providing market data andprofessional decision support tools, we also offerseminars and mentoring to help you get better atwhat you do best.

In that spirit of continuous progress learning, weoffer this primer of selected trading educationarticles in four categories of topics that matter tothose who want to make more money in the market

an introduction to the markets, characteristics ofa successful trader, technical analysis techniques,money management and the psychology of trading.

To quote one of the articles authors on therecipe for success:

You need:

A reliable data provider A reliable execution service at a rate that

suits you

An understanding of how your competition op -erates in the markets you wish to trade

A methodology that allows you to approachtrading from a winners perspective

An understanding of the shortcomings ofany method you are using

Discover the data and software package preferredby thousands of active traders like you by visitingour website (http://www.esignal.com/), or see whatwe offer in trading education at:http://www.esignallearning.com/.

In the meantime, we hope you will nd in thisselection of articles we offer with our complimentsinformation that can help you make better trades.


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Contents

An Introduction to the Markets

Markets An Overview excerpted from theeSignal Learning Foundation Course , unit 1

2 Behaviors That Differentiate a SuccessfulTraders Approach to the Marketsby Ron Wheeler

Trading Styles

Technical Tradingby Nick Sudbury

Mastering Momentum Trading Using TechnicalAnalysisby Alan Farley

Technical Analysis Techniques

Analyzing and Anticipating Price Movements:Two Approaches Not Necessarily Opposingexcerpted from the eSignal Learning FoundationCourse , unit 3

The Technical Analysis Toolbox excerpted from

the eSignal Learning Foundation Course , unit 4

The Psychology of Trading

Trading and Psychologyby Bennett McDowell

Only the Zeros Are Different: How Great TradersGo Badby John A. Sarkett


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An Introduction to the Markets

In the spirit of the title of this collection of essays,these two articles are the kind of basic informationthat can help someone new to trading understandhow the markets operate, what types of markets

he or she may want to get into, as well as thetechniques that can help the trader maximize pro tswhile minimizing risk.

Markets An Overview, an excerpt from theeSignal Learning Foundation Course , unit 1 , is anexcellent summary-level view of the markets youcan trade and a helpful roadmap.

2 Behaviors That Differentiate a SuccessfulTraders Approach to the Markets providesan excellent perspective on how to determinemarket behavior that reveals reasonably predictableopportunities, as well as sound advice about moneymanagement techniques that can help minimizeyour risk when predictable turns the corner tounpredictable.

Markets An OverviewAs excerpted from theeSignal Learning Foundation Course

Theres an old saying that if you dont know whereyoure going, any road will get you there. To makesure that you get on the road thats right for you,this introduction to the markets provides you withsome guidance to help you identify where you wantto go in your nancial future and how to map outyour journey to get there.

Depending on how much you already know, youmay be able to skim through this article quickly,or you may need to take things a bit more slowly.

Either way, it provides a foundation on which tobuild an understanding of the markets, a roadmapfor what types of markets you might want to trade.

A nancial instrument is a legal document thatgrants a right or gives formal expression to acontractual relationship. Among the many differenttypes of nancial instruments are stocks, bonds,mutual funds, futures, options, and currencies.

A stock is a security that represents ownership ina company. Stocks fall into two basic categories:common stock and preferred stock.

There are two basic ways to make money throughbuying stocks. One way is to collect dividends,which are a portion of the companys pro ts that arepaid out to the shareholders. The other way is to sellyour shares for more than you paid for them.

The increase (or decrease) in the price of thesecurity since it was purchased, expressed as apercentage, is the return. A stocks performancetypically is calculated in terms of a 12-month periodand expressed in a measurement called annualreturn, or annualized return.

Stocks are often categorized and described in

different ways. They can be categorized by the sizeof the company, or market capitalization, as large-cap, mid-cap, small-cap, and microcap. In general,small-cap stocks have tended to be riskier thanlarge-cap stocks but are also considered to offermore potential for growth.

Stocks can be described according to their risk andreturn potential, as growth stocks, income stocks,blue chip stocks, and speculative stocks. Growthstocks offer a potential for higher returns, but

generally with more volatility, and generally do notoffer dividend payments. Income stocks tend to beless volatile and pay high dividends.

Blue chip stocks are companies that haveconsistently exhibited steady growth andpro tability. Speculative stocks are high-riskinvestments and tend to be very volatile.

Stocks can be described in relation to generalmarket activity. Cyclical stocks parallel the upsand downs of the economy and the business cycles.Defensive stocks are less affected by the vagaries ofthe business cycle.

A bond is a debt instrument that pays interest overa xed term. Bonds are issued by corporations andgovernments when they want to raise cash. Becausethe interest rate and amount of each payment aredetermined at the time the bond is offered, bondsare often referred to as xed-income investments.


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There are several types of government bonds.Municipal bonds (munis) are issued by cities orsometimes state government agencies or localpolitical entities. The U.S. government issuesTreasury bonds, Treasury bills (T-bills), andTreasury notes. All are considered very low risk

investments, backed by the full faith and credit ofthe U.S. government, but their return is also low.

Investors trade bonds in the hope of selling them formore than the purchase price, just as with stocks.Bond prices have an inverse relationship to interestrates: As interest rates rise, bond prices fall; and asinterest rates fall, bond prices rise.

Bonds are compared to one another in terms ofyield and rating. Bonds rated Baa or higher byMoodys and BBB or higher by Standard and Poorsare considered investment-grade bonds. The lowest-rated bonds tend to have the highest yields and areknown as high-yield bonds or junk bonds.

A mutual fund is an investment fund that managesthe money of a large number of investors who havepooled their money together. Mutual funds can becategorized according to the types of securities theyinvest in: stock funds (equity funds), bond funds,or money market funds. Some funds invest in morethan one type of security; for example, balancedfunds invest in both stocks and bonds.

There are also several different kinds of specializedfunds. Examples include international funds, globalfunds, precious metals funds, and sector funds.Mutual funds can also be categorized according totheir investment objective: current income, someincome and growth, or future growth.

Derivatives are nancial instruments whoseprices derive from an underlying item, either a

commodity or a nancial security. When youtrade in derivatives, you are not buying or sellingthe underlying item; instead, you are trading incontracts. Futures and options are consideredderivative investments.

A futures contract is an agreement to either buy orsell a certain amount of a commodity at a speci edtime at a particular price, called the exercise price.

The value of the contract is determined by openauction on a futures exchange.

When you buy a futures contract, you are goinglong, or taking a long position; when you sell, youare going short, or taking a short position. Onlya very small percentage of futures contracts aresettled by delivery. Instead, traders offset (close out)their position before the delivery date by enteringinto an equal number of the same contracts on theopposite side of the market.

An option is a right to buy or sell a certain quantityof a nancial product, called the underlyingsecurity, at a speci ed price (the strike price), up toa speci ed time (the expiration date). Underlyingsecurities can be stocks, bonds, stock or bondindexes, or futures contracts.

Options that give you the right to buy are calledcalls; options that give you the right to sell arecalled puts. When you buy a call option, you areexpecting that the price of the security will go up.When you buy a put option, you are expecting thatthe price will go down.

Trading options costs less than trading the actualsecurities. The price of trading the option is calledthe premium. For conservative investors, options

can protect their portfolios against major dropsin stock prices, to lock in a favorable purchaseprice, or even to acquire some immediate income.For more aggressive investors, options providean opportunity to leverage their investment byrealizing a much larger gain than they could byowning the underlying security.

Foreign exchange currency trading, also knownas Forex or FX, involves buying one countryscurrency while simultaneously selling another

countrys currency. A position in a currency is eithera bullish or bearish outlook versus other currencies.

If the outlook is bullish, a trader can pro t bypurchasing that currency against other currencies.However, if an outlook is bearish, a trader can pro tby selling that currency against other currencies.

The nancial markets are places where investorstrade stocks, bonds, and other nancial instruments.


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Stock exchanges started out as centralized facilitiesfor trading. The rst stock exchange organized inthe United States is the New York Stock Exchange(NYSE). The NYSE is a traditional, oor-basedexchanged, as is the American Stock Exchange(AMEX) and some smaller regional exchanges.

An electronic exchange is an advancedcomputerized telecommunications network. Thebest known electronic exchange is the NASDAQ.Many newer and smaller company stocks arentlisted on a traditional exchange or the NASDAQ.Instead, they are traded over-the-counter (OTC).

Electronic communications networks (ECNs)collect, display, and execute orders electronically.

An index is a mathematical composite of a markets

activity at any given hour of any trading day.Prominent indexes include the Dow Jones IndustrialAverage (DJIA), which is calculated from 30 bluechip stocks, and the S&P 500, which tracks 500U.S. large-company (large-cap) stocks.

Securities prices move in response to supply anddemand, and prices rise and fall in recurring cycles.A bull market is a time of prolonged rise in prices.A bear market is a time of prolonged fall in prices.A bear market in stocks usually results from a

widespread anticipation of declining economicactivity; a bear market in bonds is caused by risinginterest rates.

Investor emotions also in uence stock prices.Greed and fear can cause investors to act too rashly.However, knowledge and discipline can help youavoid the traps of your emotions and help you makemoney whether markets are high or low.

2 Behaviors That Differentiate aSuccessful Traders Approach to theMarketsBy Ron Wheeler, eSignal Learning

I have spent the better parts of the last 14 yearsdeveloping a unique perspective on trading andespecially the trading industry. As a member ofthe Trading Education team at eSignal Learning,

Ive had the privilege and honor of travelingaround the United States and Europe educatingthousands of traders from small groups focusedon the advanced concepts of Gann and Elliott Waveas used in the eSignal, Advanced GET Edition,software to hundreds of people at larger trade

show events.Over the course of these travels, I have spokenwith many fellow educators and speakers andlearned many things about the markets and tradingin general. Most of us while we may look atdifferent theories and patterns to nd our trades all believe, at least in part, that successful tradingcomes about as a result of consistent applicationof two essential behaviors:

1. Learning to identify predictable marketbehavior

2. Applying good money managementtechniques to your trading decisions

Lets start with that rst one, identifyingpredictable market behavior . I am abig proponent of making sure that the wordpredictable is thoroughly explained. First andforemost, no market is 100% predictable. As Imentioned earlier, in my travels, I have heard fellow

educators talk about the types of market behaviorthey believe make the most sense to target forpotential trade setups.

For example, I have heard that trading market topsand bottoms is too unpredictable and should beavoided. Yet, another educator says that tradingmarket tops and bottoms is where the most moneycan be made.

Some traders and educators like to avoid trendbreakouts; others make that a cornerstone of theirtrades. Some traders believe that the trend maynot truly be your friend. New traders nd that thisconfusion of ideas leaves them feeling that theydont know what to believe, and most importantly,whom to believe.

Most of us in the trading education eld truly haveyour best interests in mind, and we want to help youbecome successful in the market. Of course, as in


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any eld, there are a few unscrupulous people outthere, but, as you gain knowledge and experience,you will be able to spot them.

When it comes to my trading and the methods Iteach, I prefer to follow the market according to theElliott Wave theory for two important reasons. Firstand most importantly, the model is mathematicalin nature because it is derived using the Fibonaccinumber sequences and the ratios the sequencesprovide.

Second, the models we teach with the AdvancedGET system have veri ed everything of value Ihave learned from my fellow traders and lecturesover the years. For example, I spoke of hearingthat trading at market tops and bottoms can beunpredictable. Its true; it is one of the hardesttrades to master and has the highest probability forerror in our systems. On the other hand, nding the

tops and bottoms typically starts a very pro tablerun in the market that makes up for the losses yousuffered trying to nd them.

Similarly, trend breakouts are low probability butprovide a higher return on pro ts once the trendstarts. To me, trading with the trend is the easiesttype of trading you can do and has the highestdegree of accuracy. Of course, you pay for thisgreater degree of accuracy by having the smallestamount of pro ts available. I nd that the trend ismost de nitely my friend because the Elliott Wavecycle tells me when the trend is complete, and itstime to go the other way.

At the core of Elliott Wave theory is the beliefthat market trends last for 5 cycles or waves. Atthe completion of the 5-wave pattern, the markettypically ends the trend, and we see a correction or acomplete change in trend. The cycles themselves are


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de ned by Fibonacci ratios. So, Wave 2 is typicallya 68.1% retracement of Wave 1, Wave 3 is a 162-to-262% extension of Wave 1, Wave 4 is typically a25-to-68.1% retracement of Wave 3, and Wave 5 istypically a 68.1-to-100% extension of Waves 1-2-3.(See the accompanying chart for an example.)

This is what I mean when I say predictable. I amlooking for a repeatable sequence of chart patterns.As the pattern or trend grows, it becomes morepredictable because the market is following theFibonacci sequence throughout the move. For thisreason, the midpoints of Wave 3s and the endingpoints of Wave 4s are the most predictable patternsI look for in trading, and they form the core of twoof our Advanced GET strategies the eXpert TrendLocator (XTL) Breakout and the Elliott Type I

Trade.On the second chart, I have an example of thisbehavior on the 5-Minute British Pound. The Wave5 low indicates that the down trend is complete, andthe market is ready for a reversal; this is also ourElliott Type II Trade. You can try to buy into themarket at the end of the Wave 5 (higher risk) or waituntil the new trend is con rmed (lower risk).

In that second chart, we also see a new rally thatstalls at the previous Wave 4 and starts a smallpro t-taking decline. If this small decline can hold a61.8% retracement, re-rally and break the previoushigh, you have the potential for a Wave 3 rally.Essentially, you are seeing the development of theWaves 1 and 2 forming. The blue bars in AdvancedGET are our XTL study, and a second blue bar alsocon rms the trend breakout.

We would take pro ts at the projected targetsof Wave 3, but, because the market is not 100%predictable, we use a trailing stop to protect usin the event of a pattern failure. Once we fallbelow the Regression Trend Channel, we take theremainder of the position off and await our nextmove.

In addition, the black bars, as de ned by the XTLstudy, indicate a neutral or non-trending bar andcan be con rmation that the Wave 3 is complete. Atthis point, the market is ready for the 25-to-61.8%


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retracement of the Elliott Wave 4. Its important tonote that I am not looking for everything to tradeto these levels to the tick; its a range, and, if themarket starts moving in another direction beforethese levels are hit, my money management willprotect me.

The market has now moved into Wave 4 and hitour projected levels of retracement. As we cross theRegression Trend Channels, the Wave 5 is assumedto have begun, and we enter into the market at thecross of the channels. Our stop would be placedimmediately below (a few pips) the current Wave4. I prefer to use Gann Levels to predict the top ofWave 5 instead of the Fibonacci levels because,over time, they have proved to be more reliable forthis sequence than the Fibonacci levels.

In Advanced GET, the Make-or-Break (MOB) tooluses principles of Gann to nd the Wave 5 target.Of course, the more experienced trader can use aGann Box as well.

Our target has been hit, and its time to exit thetrade and prepare for a correction or a major trendreversal.

In this article featuring the British Pound, we haveseen an example of many of the kinds of patterns

that Elliott Wave can provide. While I want tore-iterate that nothing is 100% predictable, thesepatterns can help the trader nd most of the keyareas of price movement and an opportunity to getinto and out of the trend at the most predictableplaces.

Ultimately, traders have to nd out for themselveswhich trades t their personality. Some tradersprefer to trade with a higher degree of accuracyand like trading within the trend. Others have

a more aggressive style and prefer market topsand bottoms. The market provides all of uswith different opportunities to buy and sell, andunderstanding where those patterns are appearing isthe rst step to becoming a successful trader.

That leads me into the second component ofsuccessful trading, applying good moneymanagement to your trading decisions .


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As has been the theme throughout this article,nothing in trading is 100% accurate, and the tradermust prepare for those times when the patternsbreak down. Patterns can break down for amultitude of reasons that range from world events tocompany fundamentals news items. Some of these

can be anticipated, but none are 100% predictable.In my trading, my money management followstwo simple rules. I never risk more than 1% of mycapital on any trade, and I make sure the trade has atleast a 1.6:1 reward-risk ratio.

I look at all trades as the same. I dont doubleup because of multiple losses or have such goodfeelings about this pattern that it makes me breakmy rules. If I am wrong in my analysis, I admit itand take a loss.

An example of what I mean is illustrated by Wave4, which has multiple levels of support or resistance

and can occasionally give false signals of abreakout. If I get trapped in a false breakout, and themarket has not yet hit my rst pro t targets beforereversing, I simply get stopped out.

As we can see in the following example chart, Ithought we had the proper entry for the new Wave5, but the market had other ideas.

Because the market was still in the Wave 4 range,and a Wave 5 was still projected, I re-enteredthe market at the next breakout of the updatedRegression Trend Channels.

The reason we must exit the market when the rstbreakout fails is because there is no guaranteethat the market will break out again. (Remember:Nothing is 100% predictable.) If the market does

break out again, however, you must have thecon dence to re-enter the move. As you can see inthe chart shown above, if you had, you would have


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been rewarded for your effort.

Finally, the last thing I verify is that the trade hasa 1.6:1 reward-risk ratio. This simply means that,if I am risking 1 dollar on the trade, I expect a1.60 pro t. This can be done using the Fibonacciratios we talked about earlier or tools such as theAdvanced GET MOB tool.

In my trading, I prefer to use Gann Levels to locatepro t-taking levels. The reason we look to the 1.6:1ratio is that, if you are trading at 50% accuracy and

keeping true to your reward-risk tolerances, youcan and will be pro table at that rate of accuracy.Even if your accuracy were to dip (as it can duringthe course of your career), pro tability can still bemaintained.

It is important to remember that, if the trade atthe initial entry point does not t the minimumreward-risk ratio, you should not place the trade.

This means that, at the entry, you need to haveidentied on your chart both the stop and theprot targets . Do not enter a trade until you knowwhere those two points are.

As you become adept at trading and learn thedifferent signals of trend reversals and earlywarning signals of trade failures, you may noticethat your reward-risk ratio declines somewhat asyou learn to take pro ts early. This should not hurtyou because this is where your accuracy as a traderwill increase.

Even though, in my own trading, I have plans inplace to take pro ts before reaching 1.6:1, in theevent of a trade failure, I still verify that the tradehas the required distance before I enter the trade. Inother words, I am fully expecting to make my 1.6:1target, but, if the market does not cooperate, I amprepared to take less to avoid a loss and protect mygains.


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I am an advocate for developing processes tomanage my trading decisions. These processesinvolve the creation of mechanical, set trading rulesthat I do not deviate from. This helps me maintaindiscipline in choosing and taking trades on a day-to-day basis.

I mentioned at the beginning that, while tradingeducators may have different approaches to how wetrade the markets, one thing we all have in commonis the discipline to follow our patterns and avoidtaking unnecessary risk . As you advance in yourcareer, remember that successful trading revolvesaround the two key behaviors I introduced at thebeginning of the article learning to identifypredictable market behavior and applying goodmoney management rules to the trades you take.

If you can master these behaviors, you too will beon your way to becoming successful.


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Trading Styles

Technical TradingBy Nick Sudbury*

Technical analysis is widely used to augment many

different trading philosophies, but in a broad sense,can also be thought of as a trading style in its ownright.

Technical traders study price movements throughthe use of charts. By identifying particular knownpatterns, often in conjunction with technicalindicators, adherents believe it is possible to gaugethe prevailing market sentiment and, hence, gainsome insight into how the price is likely to change.

Popular PatternsOne of the best-known formations is the headand shoulders, where a high (the left shoulder) isfollowed by a higher high (the head) and then alower high forming the right shoulder. This patternoften heralds a breakout from the neckline theline linking the lows on either side of the head.

Another popular pattern to look for is a congestionarea, which is essentially a consolidation phasefollowing a move. The majority of these tend toresolve themselves in the same direction as thepreceding trend.

Technical traders generally use indicators inconjunction with the charts to help gauge thestrength and direction of the underlying pricemovement. An indicator is solely designed to helpinterpret the price movements; it is not in any wayintended to be a substitute.

Which Ones (and How Many) to Use?

Traders should not be misled by the precision and,in some cases, the complexity of the formulaeused to calculate the indicators because the nalinterpretation inevitably remains more of an art thana science. One aspect of this is learning just whichof the hundreds of indicators to actually use.

The mere fact that there are so many indicatorsreveals the truth of the matter, namely, that somework better in certain circumstances than others.

Because there is no universally accepted view as towhich ones are the best, most traders evolve theirown short list of favorites that they become familiarand con dent with.

As tempting and as easy as the technical analysissoftware makes it to keep adding extra indicatorsto the charts, it is most certainly not a case of themore the better. Few traders use more than two orthree in a single analysis because any more would

just be likely to confuse the issue.

The nal selection is largely a question of personalpreference and experience, but most wouldagree that it makes sense to pick indicators thatcomplement each other rather than those thatmeasure the same phenomena. For example, therewould be little point in using both Stochastics andRSI because both measure momentum and haveoverbought / oversold levels.

One of the most popular and intuitive indicatorsis the moving average. This simply calculates theaverage (usually closing) price of a security overa speci ed period of time. Moving averages arelagging indicators and are used to emphasize thedirection of the trend. For example, when a stockmoves below its moving average, it is a negativetrend and visa versa. Views differ as to the bestperiods to use, but, for longer-term traders, the 50-and 200- day moving averages are among the mostwidely watched.

Combining Moving Averages andthe Relative Strength Index

A chart combining two moving averages providesone of the most popular ways to identify a tradingsignal. If the shorter (faster) moving average movesabove the longer (slower) moving average, thisrepresents a buy signal, while a sell signal is givenwhen it dips below.

The number of signals generated depends on thelength of the moving averages -- the shorter, thegreater the number of signals but the more that willbe false. Because of this, moving averages are bestused in conjunction with another indicator, such asthe popular Relative Strength Index (RSI).


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The RSI compares the number of days that a stocknishes higher against the number that it ends

lower. In value, it ranges from 0 to 100 with, ingeneral, a stock being considered overbought if itreaches 70 a sign to consider selling. Similarly,if a security approaches 30, it is usually regarded

as a buy signal. In a true bull or bear market,these numbers tend to be changed to 80 and 20,respectively.

The majority of analysts use a 9- to 15-day RSI. Theshorter the number of days used, the more volatilethe indicator but, also, the more susceptible itbecomes to big surges or falls in stocks dramaticallyaffecting the RSI, potentially resulting in false buyor sell signals.

The strength of the RSI as a complementarymeasure to the moving average can be seen fromthe chart of the Dow taken from Market Center.The index crossed above its 20-day moving averageon August 18th, indicating a positive trend. TheDow continued to rise, peaking at a high of 10,363on September 7th. At this point, the nine-day RSI,which is shown along the bottom of the chart,hit the overbought level of 70.409, heralding asubsequent fall in the index back toward the laggingmoving average indicator.

*Reprinted (and modi ed) with permission from NickSudbury.

Nick Sudbury is a nancial journalist who has worked both asa fund manager and as a consultant to the industry. He has anMBA and is also a chartered accountant.

Mastering Momentum TradingUsing Technical AnalysisBy Alan Farley,Editor / Publisher, Hard Right Edge*

Outside the BoxMarkets must continuously digest new information.Cyclic impulses of stability and instability gatherforce through the pulse of this future discountmechanism . Each small event shocks the commonknowledge, building a dynamic friction that dissi -pates through volatility-driven price movement.

In its purest form, volatility generates negative feedback as price swings randomly back and forth.However, if focused into a single direction, positive

feedback awakens and generates momentum intostrong price trending. Traders recognition of theseactive-passive states will likely determine their ulti -

mate success in market speculation.Neophytes fall quickly under the spell of fast-moving markets. However, momentum is far moredif cult to trade than most participants admit. Whenan emotional crowd ignites sharp price movement,greed clouds risk awareness. The anxious traderthen chases positions just behind the big volume,where odds of a reversal quickly increase.

Obviously, the majority seek their pro t throughmomentum. But, most ultimately fail as this wickedbeast devours equity. Those who survive committhemselves to mastering the diverse skills needed toplay this dangerous game.

As traders gain experience, fresh dangers block theroad to success. The swing of negative feedbacktriggers many false alarms while real entry signals,streaming from multiple sources, remain unnoticed.In the confusion, pro table trades are missed com -pletely or entered just as the trend dies.

Either way, bad choices consume inexperiencedtrading dollars and the markets tally more losers.

Trade Momentum Swing

State Positive Feedback Negative Feedback

Strategy Reward Risk

Basis Demand Supply

Chart Trend Range

Impulse Action Reaction

Purpose Thrust Test

Condition Instability Stability

Indicator Lagging Leading

Price Change Directional Flat-Line

Like magnetic elds, polar forces drive market conditions. Alternating cycles of activity and inactivity continuously fuelthe dynamics of price movement. Traders must recognize

current axis conditions before executing positions.


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WinningMomentum trading can be mastered. Three disci -plines will break destructive habits and reprogramtrading for success:

Abandon the adrenaline rush . Forget theexcitement. Pro t is dependent on detached anddisciplined execution.

Learn the numbers . The nature of price move -ment must be ingrained deeply enough to allowspontaneous decision-making during the tradingday.

Cross-verify . Objective measurements mustlter unconscious bias.

Studying supply and demand on a scrolling tickeror NASDAQ Market Depth display provides asolid rst step for understanding the inner workingsof rapid price movement. Combining this with anunderstanding of time-of-day tendencies strengthensawareness of pro t and danger zones. And, under -standing all the players proffers a needed edge onthe competition.

But, the study of technical analysis uncovers greatersecrets as insider deception and herd emotions areexposed. Properly applied, patterns and indica -tors reduce the false entries associated with failure.And, they invoke natural risk management. Tech -nical analysis teaches traders when to painlesslyexit momentum positions and move on to the nextopportunity.

Action-Reaction Cycle

Prices rarely move in a straight line. As shocksdestabilize a market, a counter-force emerges torestrain price back toward its stable state. Aftereach forward impulse, a backward reaction follows.Burning the fuel of the crowds money, marketsseek equilibrium before proceeding with the next

impulse.Traders fail to consider this phenomenon when theyenter their momentum trades. Simply put, both ac -tion and reaction must be considered in developingappropriate entry-exit points. This requires morecomplex planning than most anticipate. Successfulstrategies often demand execution opposite to thenatural tendencies of the trader:

Entry on counter-trend reaction and exit on ac -celerating thrust

Entry on accelerating thrust and exit on subse -quent reaction

Exit strategy can confuse trader logic more than en -try. Effective risk management may require revers -ing the entry process entirely:

Exit on further reaction when counter-trendentry fails

Exit on accelerating impulse when thrust entrysucceeds

Choosing the wrong action-reaction trigger willproduce frustrating results. Every trader knows thepain of making a low-risk entry, riding a pro tabletrend, then losing everything on a subsequent reac -tion. This experience can be avoided using technicalanalysis to identify momentum signposts and locatenatural escape routes.

First Pullback

Buying the rst pullback following a breakout

offers very high reward:risk. Inevitably, an impul -sive crowd will be waiting to jump in on a secondchance. Use support and resistance or short-termmoving averages to identify your entry point.

(Day Traders: a 5-to 8-period SMA on a 5-minutebar is highly effective.)


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Identifying MomentumWell chosen technical analysis tools signal awaken -ing momentum and track subtle changes in strengthand duration. The power to identify these transform -ing conditions just prior to signi cant price move -ment is the key to pro table entry. All momentumstudy falls into one of two broad categories:

Trend-following indicators gaze into the rearview mirror and average price over de ned timeseries. They are most valuable early in a trendfor identifying momentum.

Trend-leading oscillators measure develop -ing range and movement from price bar to pricebar. They provide valuable information late in atrend by identifying turning points.

Effective analysis must investigate the nature of

momentum change. Physics teaches that an objectin motion tends to remain in motion. Pro tableentry-exit will capitalize on this universal tendency.With most indicators, this requires combining snap -shots of different period lengths in order to measuremomentum acceleration-deceleration.

Three types of technical tools provide complete re -sources needed to accomplish these complex tasks:

Line Tools visually illustrate rate of change andaction-reaction points:

TrendlinesTrendlines display average momentum. While aline drawn under any two lows has limited value,the addition of a third low creates order and a pre -diction point for future reversals. Combined withother chart features, trendlines uncover dynamicmomentum information.

Price ChannelsChannels predict order with only two distincttrend lows. But, these must be matched by twocorresponding highs of the same slope. Whilelogic suggests that these formations rarely occur,the opposite is true. They are easier to locate thanclean trendlines.

ArcsRounding formations are dif cult to quantify. Theevolving slope may not maintain a constant rate ofchange. This reduces its effectiveness for predic -tion. Use arcs as visual tools to estimate roundingreversal bottoms and tops.


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Fibonacci RatiosOne of the most powerful tools in technical analy -sis, Fibonacci remains poorly understood. Thisproportional force of nature measures retrace -ment and testing of trend impulses. For moves toremain intact, the 62% level must provide support.

Averaging Tools combine and smooth data setsinto directional and acceleration forecasts:

Moving Average CrossoversSimple crossovers mark key shifts in momentum.They form the foundation of many complex trad -ing strategies. But, watch out. This method hassevere limitations in sideways markets. Duringnegative feedback, moving averages will emitcontinuous false signals.

Averaging RainbowsUse of ve or more color-coded moving averagesdisplays continuous data on evolving momentumchange. In addition to targeting price strengthwithin the rainbow bands, the lines themselvesdraw complex patterns with superb predictivecapacity.

Moving Average Convergence-Divergence (MACD)

Gerald Appels classic moving average interac -tion tool found new power when expressed as ahistogram. Momentum changes accurately trackthe oscillating slopes. Create pro table entry-exitrules with this rewarding tool.


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Strength Tools measure rates of price and rangeascent-descent over different time frames:

Rate of ChangeDirectional price movement often hides withinthe twists and turns of price bars. Rate of changeindicators lter visual data into actual price pro -gression. ROC lines develop their own support/ resistance, trendlines and patterns. Key patternbreaks in advance of price can trigger importantconvergence-divergence signals.

Relative Strength IndexDont trade without this important tool. RSI meas -ures the quality of price movement by compar -ing UP days with DOWN ones. Like ROC, RSIcreates patterns that respond more quickly thanprice change. Use overbought and oversold levelsto close positions and prepare reversal strategies.

StochasticsStochastics accurately measure short-term shiftsin price momentum. But, once this indicatorpierces the extremes of its wide bands, usefulinformation ceases. As trend takes over, it wob -bles randomly until conditions change. As linesmove back into the center zone, measure strengththrough double top/bottom formations.

Bar Range AnalysisShort-term traders should closely examine smallprice bar formations. Narrow and wide range barssignal measurable change within the crowd andimpending price movement. One classic pattern isNR7, the narrowest range bar of the last 7. These

predict breakouts that can be safely traded in thedirection of the rst impulse.

Trendlines

Trendlines join three or more reaction lows or highsinto a straight line. This core element of technicalanalysis has many applications beyond its well-


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known uses. Standing alone though, trendlinescontain limited information regarding momentumshifts.

The indicator plots average momentum for the trendbeing studied and nothing else. The rate of pricechange up or down the line always remains con -stant. Trendlines will provide signi cant momentumchange feedback when compared with other chartdata. As constant ROC indicators, these straightlines will measure convergence-divergence againstany other price inputs.

Trend RelativityThe relationship between trendlines and otherchart properties shifts relative to the time frame ofeach element. The trader must properly tune time

to explore different aspects of momentum. Makecertain the time inputs match the holding periodfor the intended execution. When day trading, forexample, the plot of a 6-month trendline has nomeaning unless price touches it that day. But, thereturn of a 5-minute candlestick to a 3-hour trend -line will pinpoint an excellent entry zone.

Three common chart features will measure momen -tum change when combined with trendlines:

Other trendline(s)

Moving averages

Price bars or candlesticks

When one or more of these elements acceleratesaway from the studied line, momentum is increasingas it diverges. Conversely, as these indicators rollover to point back home, signals ash convergingdeceleration. Combining all of these features intoa single momentum system will produce powerfultrading signals.

Moving Averages

Moving averages contain more immediate feedbackon momentum change than trendlines but are bur -dened by one severe limitation. Their computationforces useful data to lag current events. By the timea simple 20-bar average curves upward to re ect ac -

celerating price, the move has already matured andmay even be over. While exponential calculations(EMAs) and other smoothing adjustments speedup signals, action bells ring way too late for mostmomentum entries.

Using multiple moving averages overcomes thistime drawback and provides timely feedback onmomentum change. The simplest tool for this studyis the Moving Average Crossover . Two averagesare chosen based on different time frames and theirconvergence is tracked. Signals are generated whenthe short average crosses above or below the longerone. The challenge with crossovers is nding thetime sequence that elicits the most pro table infor -mation about the studied market. Also, lters mustbe built to ignore crossovers in choppy conditions

when moving averages give false signals.An effective technique for studying momentumchange is the MACD Histogram , popularized by Dr.Alexander Elder in his book Trading for a Living .Using 12- and 26-period moving averages smoothedby 9 periods, MACD creates a visual momentumladder. As MACD rises, momentum increases. Azero line pinpoints the center balance zone. Posi -tive acceleration ags as columns thrust above thispoint. Likewise, down steps below the line signal

negative acceleration.Moving Average Rainbows provide multi-timeframe, multi-dimensional views of shifting mo -mentum. Rainbows combine 5 to 8 averages, color-coded by the users software program. Identi ablepatterns develop between the averages, allowing forsophisticated analysis of impending accelerationand deceleration. Like spreading ngers, rainbowaverages respond incrementally to advancing trendsand provide targeted entry-exit points.

Strength IndicatorsAnalysis of a closing bars contribution to recentprice action creates a variety of strength indicators.These important tools range from simple compari -sons with prior values to complex pattern analysisbased on expansion and contraction of high-low barlengths. Their common theme identi es the momen -tum pulse in the relative strength of closing price.


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While endless techniques accomplish this sametask, several contain all the horsepower needed tobeat the momentum monster.

Price Rate of Change offers an elementary compu -tation for tracking momentum. Price bar patternsoften hide developing directional movement. ROCcompares current price with the value x periods agoand plots it below the bar chart on a line graph. Asmomentum escalates, ROC often curves upwardahead of a breakout. And, this versatile indicatorworks just as well signaling impending breakdownsand plunges.

Stochastics and RSI are well known for targetingoverbought-oversold zones in constricted ranges.These popular oscillators also have tremendousvalue in charting momentum. Plotting their valueson a chart reveals pattern characteristics similar toprice bar ascent and descent.

These tools differ from price due to the extremezones they cannot pass. In theory, price can go up -ward to in nity. Oscillators can go no further than0% or 100% before turning back. But, as their direc -tional movement follows price swings, patterns ofacceleration-deceleration quickly reveal themselves.

Futures markets have used range bar analysis for

years. A classic on the subject, Toby Crabels DayTrading with Short Term Price Patterns and Open-ing Range Breakouts , investigates how expandingcandle and bar patterns characterize momentumin many commodities and indices. The emotionalcrowd provides fuel as bar range stretches in the di -rection of the prevailing trend. Finally, a climax barprints a sharp reversal under surging volume.

Computation indicators (such as stochastics) meas -ure bar range indirectly. By going straight to the

bars themselves, visual analysis yields pro tableshort-term prediction. However, not all marketscan be accurately examined through range changes.Low volume stocks, for example, carry high spreadsthat will distort signals. Limit bar analysis to highlyliquid markets with low spreads and high averagedaily movement.

The Momentum PulseMomentum generates force as increasing volatil -ity resolves itself into directional movement. Thisdynamic trending state invokes a measurable shiftfrom negative to positive feedback. While subse -quent thrusts may appear chaotic, price movementcontains many cyclical features. Pulses will oftenbe proportional in time duration and length. Thistendency allows traders to calculate reward:riskthrough measured move analysis. As an addedbene t, these expected reversal points can also bewatched for pro table swing entries.

Markets inhale and exhale. Each burst of market ex -citement alternates with extended periods of relativeinactivity. Prices trend only 10% to 20% of the time.The balance is spent absorbing instability createdfrom a momentum thrust. The interface between theend of an inactive period and the start of the nextsurge often hosts a quiet neutral point. Paradoxi -cally, this Empty Zone will ignite well-tuned entrysignals.

Prior to beginning each new breath, the body expe -riences a moment of silence as the last exhalationcompletes. The markets regenerate momentum in asimilar manner. The Empty Zone emerges as the re -turn to stability concludes. Because instability alonewill change that condition, volatility then sparks anew action cycle.

Cross-Verification

Momentum change indicators work best whencombined with other technical tools. This process ofcross-veri cation searches for repeated con rmationof any signal through other methods of technicalanalysis. But, watch out. Many indicators are builton top of better-known calculations. Accidentallyusing one of these derivative measurements carriessubstantial risk. It will automatically con rm your

ndings just by recalculating a tool already usedand give false con dence to the trade.

Verify technical conditions using dissimilar formsof analysis. For example, after seeing momentumsurge on stochastics, try duplicating that observationusing a line tool. Or, when multiple moving aver -ages suggest an impending thrust, analyze the recent


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short-term price bars to locate narrow-range days.

Fibonacci ratios offer the most powerful form ofcross-veri cation in all of technical analysis. Priceimpulses faithfully retrace similar percentages of acompleted move before nally reversing or continu -ing the prevailing trend. Examining the price actionnear these support / resistance zones will identifysigni cant bounce reversal opportunities when otherindicators offer support.

Using Fibonacci requires only a calculator or FibLine Grid (available with most charting analysissoftware). Hidden support / resistance exist at 38,50 and 62% of the prior trend. Price will oftenbounce like a pool ball back and forth across thismarvel of mathematics.

ExitTraders fail when they dont manage their losses.The lure of the big gain disables unbiased evalua -tion. Danger increases signi cantly when trading ina high momentum environment. The wide swingsensure price will move through a 10 to 40% rangein a very short time frame. While position traderscan consider well-placed stops, many short-termand day trading vehicles dont allow limit manage -ment.

Positions should never be entered without anticipat -ing an appropriate escape route. Winning is a toughgame. Each trader must compete against all otherparticipants and take their money. And, exchangerules always favor market insiders highly skilled inshaking small players out of their positions. To ndan edge, remote traders must replace mechanicalself-control (stops) with strong mental discipline.

Use technical analysis and drill key price swingnumbers of favored markets into memory. Target anacceptable tick loss average. If the average tick gainisnt larger, the winning percentage will need to bewell above 70% to turn acceptable pro ts. Improveresults by getting your loss average down beforeconsidering how to let your pro ts run further. And,keep current, accurate records. Relying on memoryto determine results allows the mind to play crueltricks.

Finally, consider the real nature of your tradingaccount size and leverage. The well-greased com -petition can overcome transaction costs by movinglarge blocks. Balance the leverage of your accountagainst the costs of taking positions. And, use draw -downs as a signal to lighten up and slow down.

*Reprinted (and modi ed) with permission from Alan Farley.


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Technical Analysis TechniquesBecause you conduct your trading as a business,you are aware of the importance analysis plays in it

just as it does in any successful venture. Let thesetwo excerpts from the Foundations course manual

used by the trader-instructors of eSignal Learninggive you a glimpse into the world of analysisas it relates to the components of the marketsmovements and how it informs your trade decisions.

Analyzing and Anticipating Price Movements:Two Approaches Not Necessarily Opposingexcerpted from the eSignal Learning FoundationCourse , unit 3 , compares the two basic types ofanalysis fundamental and technical not so muchfrom an either-or perspective, but an and point

of view that allows for combining the best of both.The Technical Analysis Toolbox excerptedfrom the eSignal Learning Foundation Course ,unit 4 , provides an overview of some of themoving parts involved in the market data fed tothe charts you use to analyze the markets. It givesyou something of a Cliff Notes for both thepicture part of the charts (patterns) and the formulas(math-based indicators) that can help you see how amarket youre following may be trending.

Analyzing and Anticipating PriceMovements: Two Approaches NotNecessarily OpposingAs excerpted from theeSignal Learning Foundation Course

Fundamental analysis and technical analysis aretwo approaches that investors use to anticipate pricemovements in the overall market and in individualsecurities.

Fundamental analysts, or fundamentalists, believethat factors or conditions within the overalleconomy and within individual companies arewhat drive prices. Fundamentalists concentrateon macroeconomic factors and conditions, calledfundamentals, that cause market moves and changesin stock prices, and they seek to identify keyindicators of the stocks real value.

Fundamentalists, in general, take a long-term view,whereas technicians tend to look at short-term pricemovements. However, the two approaches are notnecessarily incompatible. Many investors meet withsuccess by using both.

The central principle of technical analysis is thatprices are determined by factors or conditionswithin the market itself. Technical analysts, alsocalled technicians, seek to identify patterns in pricesthat they can use to predict future movement.

FundamentalsFundamental measures of valuing stocks includeearnings per share (EPS), price-earnings (P-E) ratio,book value (shareholders equity per share), price-to-book ratio, return on equity (ROE), price-salesratio, and revenue growth rate.

Most fundamentalists base their stock valuationsand predictions of price trends on earnings. Acompanys earnings per share (EPS) are its netincome or pro t divided by the number of shares ofstock outstanding. Earnings are generally stated astrailing earnings over the past 12 months.

The price-earnings ratio, or P-E ratio, is a stockscurrent market price divided by its annual earnings.

The P-E ratio is not an absolute indicator of thevalue of a stock; rather, it expresses the relationshipof a stocks price to its earnings.

Book value, also called shareholders equity pershare, is the companys net assets divided by thenumber of shares of stock outstanding. In bullmarkets, fundamentalists often look for companiesselling below book value.

A companys quick assets represent what thecompany would be worth if it were liquidatedimmediately. The relationship between a stocksmarket share price and the companys quick assetvalue per share is called the price-to-book ratio. Aprice-to-book ratio less than 1 means that stock isselling at a discount to the companys ready cash.

Return on equity (ROE) is calculated by dividinga companys trailing earnings to its shareholdersequity (total assets minus total liabilities).


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The price-sales ratio (PSR) is the current marketvalue of the company (current share price timesshares outstanding) divided by the revenues (sales)over the previous 12 months. PSR is often usedto value new companies in hot industries or tocompare companies to other companies in the same

sector.Companies whose sales are growing faster thanthe economy as a whole tend to be very attractive,so some fundamentalists look for revenue growthrate that is higher than the expected increase in thegross domestic product (GDP).

Fundamental measures are not helpfulin valuing a new company without anestablished track record, and new companies areoften the ones that offer signi cant investmentopportunities.

Technical AnalysisTechnical analysis began more than 100 years agowith the use of charts; for that reason, techniciansare often called chartists. Technical analysis thusinvolves identifying and interpreting stock pricemovements over short periods and taking advantageof the ndings to lock in gains.

According to the principles of technical analysis,stock prices move in a cycle that involves vephases: accumulation, recovery, speculation,distribution, and readjustment. Technicians believethat chart formations indicate when the marketis about to turn up, turn down, or trade in a narrowrange.

There are two basic types of stock charts. (1)Bar charts (also called vertical line charts)involve plotting price ranges for the period under

consideration, with each new period (usually aday) plotted to the right of the previous one. Priceis plotted on the vertical (y) axis, and time on thehorizontal (x) axis. (2) Reversal charts (also calledpoint-and- gure charts) show price changes only,without concern for time.

Trendlines (also called trading channels) show thecurrent price range of a stock. Upper and lower

trendlines indicate resistance levels, the price atwhich holders sell in rising markets, and supportlevels, the price at which buyers buy in marketsthat are trending down. A breakout occurs whenthe price penetrates a resistance or support level.

A basic principle of technical analysis is that once atrend is established it is more likely to continue than

to reverse. The moving average is considered anearly warning signal of a trend.

Many technicians believe that in a bull market,increased volume indicates a rally, whereas declinesin volume signal a pullback. The opposite is truein a bear market: volume increases on reactionsand declines on rallies. The end of a trend (a pricereversal) is also marked by heavy volume.


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Technical analysis can also involve examiningindicators that indicate the overall strength of themarket. These indicators include the advance-decline ratio, the number of new highs and lows forthe year set in a day, various short sale ratios, andthe ratio of low- to high-priced stocks.

So, Which One Is Better?

In one sense, you might think of the distinctionbetween the fundamental approach and the technicalapproach as equivalent to the distinction betweeninvesting and trading. Fundamentalists, in general,take a long-term view; technicians tend to keeptheir eye on the short term. However, the twoapproaches dont have to be incompatible, any morethan investing and trading are. Most techniciansare aware of and may take into consideration fundamental conditions.

And most fundamentalists also pay attention to atleast some of the technical indicators. In fact, manyinvestors have met with success by using both. Forexample, they use fundamental analysis to identifypromising stocks, and they then turn to technicalanalysis to time their purchases and sales.

Other fundamentalists hold that stock prices arebased on investors emotions. Proponents of

the market psychology theory of stock pricemovements point out that it accounts for why stockprices sometimes rise when economic conditionsare weak and why they sometimes fall even wheneconomic conditions are strong.

These fundamentalists also point out that wheninvestors become optimistic about a companysprospects, they buy its stock, sometimes even whenprices climb beyond what the fundamentals support.Conversely, investors sell when they become

pessimistic, even when the fundamentals are stillgood. And technicians try to recognize marketparticipants attitudes by identifying patterns oncharts.

In the long run, what strategies you choose in agiven situation, and how you carry them out, willdepend on where you think market prices and / orthe price of an individual stock are heading.

The Technical Analysis ToolboxAs excerpted from theeSignal Learning Foundation Course

Technical analysis is based on a number ofunderlying concepts:

Securities prices move in trends much, though notall, of the time.

Trends can be identi ed with patterns that tend torepeat themselves.

Primary trends, which generally last monthsto years, are interrupted by secondary minormovements, called pullbacks or corrections, inthe opposite direction that last generally weeks tomonths.

Once a trend is established, it is more likely tocontinue than to reverse; generally it remains inplace until a major event stops it.

The price bar, or bar, is the basic building blockof technical analysis. It is a visual depiction of thetrading action in a security for a given period oftime, often a single trading day.

Each price bar is a visual depiction of four values:the open, high, low, and close. The height of the bar

indicates the range of price activity the taller thebar, the greater the range.


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A line chart shows only the closing prices plottedfor each day.

Candlestick charting was developed in Japan over150 years ago and has become popular amongtechnicians over the last 15 years, especially inshort-term trading. Candlesticks record the sameinformation that price bars record but allow foreasier interpretation and analysis. The open andclose mark off the top and bottom of a box, calledthe real body. If the close is higher than the open,the real body is white; if the close is lower than theopen, the real body is black.

Volume indicates the total amount of tradingactivity. Volume is also recorded on a chart,represented by a vertical bar at the bottom under

that days price bar. Volume is considered importantin interpreting the signi cance of a price move.

The core of technical analysis is that the price barrepresents all the dynamics of supply and demandfor a given security for the day (or other given timeperiod) and that a series of bars on a chart showshow the dynamics evolve over time.

The trend is the direction of the market. Allthe tools you will use in technical analysis arededicated to identifying and measuring the trend sothat you can participate in it.

Some con gurations of a series of price bars (e.g.,three to ve bars) are moves that may foretell anew trend, continuation of an existing trend or the


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reversal of an existing trend.

A series of closes on the high is a bullish sign that anew trend may be starting or that an existing trendis probably going to continue. A series of closes onthe low suggests that a down trend is forming oraccelerating.

An inside bar is a price bar in which (1) the high islower than the previous days high and (2) the lowis higher than the previous days low. An inside baris generally believed to re ect indecision amongtraders.

An outside bar is a bar in which the range betweenhigh and low is outside the range of the precedingbar. If the open is at the low and the close is at thehigh, its a bullish sign. If the open is at the high andthe close is at the low, its a bearish sign.

A close that is at or near the open is generallybelieved to indicate indecision in the market. Butwhen it occurs at one extreme of the range, it cansignal that a trend is about to continue or reverse.

Markets sometimes move sideways in a at,

horizontal pattern that is called the trading range.Periods of trendless, or sideways, movement arereferred to as consolidation.

The support level is the price at which tradersconsistently step in to hold up the price and preventit from dropping any further. It is also know as areaction low.

The resistance level is the price at which traderscant resist selling and taking pro ts, or higher than

which they will resist buying. It is also called a rallyhigh.

Whenever a support or resistance level is brokenby a signi cant amount, it reverses role: That is,a resistance level becomes a support level, and asupport level becomes a resistance level.

A trendline is a straight line that starts at thebeginning of the trend and stops at the end.Trendlines are used to con rm or refute that asecurity is trending.

To draw an up trendline, you need to be able toidentify at least three lows. The more lows thattouch the trendline, the more valid it is.


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A channel is marked by a pair of trendlines, onedrawn along the highs, the other along the lows.

Chart patterns are among the most powerfulindicators in the technicians toolbox. They can bebroadly categorized as continuation patterns andreversal patterns.

Examples of continuation patterns (patterns thatindicate that a trend is continuing) are ascendingtriangles (bullish) and descending triangles(bearish), ags, and pennants. Flags and pennantsgenerally signal a pullback a minor move in thedirection opposite the primary trend before themain trend resumes.

Reversal patterns signal that a trend is about toreverse itself. Three of the most notable reversalpatterns are the double bottom (bullish), doubletop (bearish), and head-and-shoulders formation(bearish).

To determine whether a pattern is, for example, atrue double bottom, look for the following:

The price must rise above the conrmation line , ahorizontal line drawn from the highest high in themiddle of the W. (The point where the price risesabove that line is the conrmation point .)

The two lows are spaced at least 10 days apart,sometimes several months.

The price variation between the two lows is small,only a few percentage points.

The center peak of the W is at least 10% higher thanthe lower of the two bottoms.

A large increase in volume takes place after theprice exceeds the con rmation point.

Pullbacks occur after the price exceeds thecon rmation point.

The ideal double bottom is easy to spot, but in reallife, it can be tough. As noted earlier, sometimes thebottoms are separated by several months. Moreover,one or both bottoms can have a rounded, ratherthan pointed appearance, and there may be severalpullbacks that obscure the pattern.

Analyzing trendlines and charts is often dif cult,and interpretations tend to be subjective; forexample, what one technician calls a triangle,another may see as a wedge. Moving averages,however, are objective and precise. In fact, one useof moving averages is to con rm your interpretationof chart patterns that you believe you are seeing.

The moving average (MA) is an average of acertain number of prices, generally closing prices.A moving average is used to identify the beginningof a new trend or the end or reversal of an existingtrend. Because it follows market activity, rather thananticipating it, the moving is known as a laggingindicator.

The moving average crossover rule is to buy atthe point where the price crosses above the movingaverage line, and to sell where it falls below themoving average line. At rst, this simple rule seemsclear and powerful because the result is that you


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buy at a low and sell at a high.

To overcome the potential of whipsaw losses,technicians have devised a number of additionaltests, or lters.

The moving average convergence-divergence(MACD) indicator uses two exponentially adjustedmoving averages. The MACD line is calculatedby subtracting the long-term MA from the short-term MA. When the MACD line is rising, the twoaverages are converging; when it is falling, theaverages are diverging. If the difference betweenthe two is 0, a crossover is taking place. The secondline is the trigger, or signal line. It is a movingaverage of the MACD line so its an indicator ofan indicator.

When the two lines cross, you have a buy or sellsignal. When the MACD line crosses above the

signal line, its a buy signal. When the MACD linecrosses below the signal line, its a sell signal.

Many people nd it dif cult to read the MACDindicator, except when the signal line is actuallycrossing the MACD line. The MACD histogramprovides the same information in a way that is moreeasily interpreted by the eye. Histogram changes aregenerally used to spot early signals to get out of aposition.

Analyzing moving averages is most useful when themarket is uptrending or downtrending. They are notvery helpful during trendless phases.

Technicians believe that you can determine whenthe market becomes overbought or oversold byfollowing momentum the rate at which prices

change. Momentum indicators reveal nothing aboutthe direction of a trend; they are concerned onlywith speed, or rate of change.

Because momentum is a leading indicator, it canadd important information to the data generated bylagging indicators, such as moving averages.

Most technical traders measure momentum bybasing it on the number 100.

Multiplying by 100 to benchmark an indicator is

called oscillation. Oscillators show values relativeto a starting point. The Relative Strength Index(RSI) is one type of oscillator; it has a range of0 to 100. When the RSI hits 70%, the security isconsidered overbought; at 30%, the security isconsidered oversold. RSI is more often used to


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con rm buy or sell signals generated by otherindicators.

The stochastic oscillator differs from otheroscillators in that it examines not just the closingprice, but also the entire trading range. It looksfor the high-low range over a particular numberof trading days or periods, and the relationship ofthe close to the low over the same time frame. Thestochastic oscillator generally is most effective in asideways market.

The Fibonacci sequence of numbers, rst identi edby 13th-century mathematician, Leonardo

Fibonacci, forms the basis of one indicator thattechnicians use to determine the extent of marketpullbacks, or retracements. During retracements,Fibonacci numbers can be used to anticipate supportlevels in an up trend) or resistance levels (in adown trend). The most commonly used Fibonacci

numbers in retracement analysis are 62, 38 and50%.

Technical analysis is a visual pursuit for thetechnician, a world of information lies in what theuntutored eye may see as an incomprehensible massof dots, squiggles, and lines on a chart. To revealand interpret the information that these picturescontain, you need to begin at the beginning: withthe individual components. We hope that this articlehas given you a good start in understanding thesebuilding blocks that make up technical analysis.


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The Psychology of Trading

Trading and PsychologyBy Bennett McDowell, Founder and President,TradersCoach.com*

I am often asked, How important is psychology intrading the nancial markets? The answer, VERYIMPORTANT!

Most traders, when analyzing charts and backtesting trading systems, fail to realize how differentthe results would be if they were actually tradingwith real money as the market is unfolding insteadof looking at the market after the fact. This is whyI am not a back testing fan because the resultsare usually nowhere near the reality of how YOU

would actually trade.Most new traders fall victim to their own fear andgreed when trading, which causes them to exitpro table trades prematurely or enter trades caughtup in the excitement of the moment.

We have all felt the anxiety that can creep into oursouls as a trade becomes pro table in a short periodof time. That anxiety wants us to exit the trade nowand take the quick pro t. Taking the quick pro twill relieve the anxiety and make us feel good.

Maybe the cause of the anxiety is the greed to takethe quick pro t or the fear that the market will turnagainst us and cause a loss. Whatever the reason,exiting the trade because of anxiety makes it anemotional trade, and good traders do NOT trade onemotions.

Or, perhaps you have trouble pulling the triggerand entering trades when your trading systemindicates you should. Most often, fear is at work

here. The trader fears another loss! Not trustingyour trading approach and yourself can make you avictim of fear.

Or, perhaps you live in the past and not the present,and you are, again, afraid of reliving past losses oreven failures.

Or, perhaps you dont like using stops or correcttrade size or dont adhere to stops you have

already set. Dig deep enough into your psyche, andyou will uncover the reasons.

This is why I say that I could give a good solidtrading system to 100 traders, and almost all ofthem would trade it slightly differently based onhow their emotions caused them to trade. In theend, only those traders who can best manage theiremotions will have a chance to win consistently.

So, while a trading system or approach is important,so is money management and learning howto manage your psychology. It will take time,experience and dedication to overcome yourhuman shortcomings, something we all have todeal with. This is why 90 percent of the traders losein the nancial markets. We are all subject to fearand greed, but only a small percentage of traderscan manage their emotions well enough to letthemselves win.

Bennett McDowell provides private consultation / coachingservices to traders throughout the world and has beenpublished in numerous newsletters and magazines, includingTradersworld.com magazine and The Long And Short Of It , aTradersCoach.com member newsletter.Website: www.traderscoach.com.

*Reprinted (and modi ed) with permission from BennettMcDowell

Only the Zeros Are Different:How Great Traders Go BadBy John A. Sarkett, Developer, Option Wizard*

Like a pilot, a police of cer or a trapeze artist, aprofessional trader knows he or she must follow therules just to stay alive. Usually, this bracing thoughtis enough to focus the mind. Usually, this awarenesssuf ces.

But, occasionally, the realization is lost.Mistakes follow.

Losses mount.

An otherwise great trader succumbs.

A great trader goes bad.

How to avoid that tragic circumstance was


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the subject of a Futures Industry Associationpresentation in Chicago by Ray Kelly, professionaltrader and trading coach.

Large traders trade more zeros than small traders,but the process is the same, Kelly says. Both onthe upside and the downside.

The catalyst for destruction, Kelly says, is mostoften ego.

Ego is the Ebola virus to the active trader.

There is an antidote, however balance, humilityand the ability to accept being wrong.

Can you or I become infected? Of course we can!

What can be done to protect against ego and its

devastating effects?Kelly says pay close, introspective attention tothe following four areas: Self-knowledge, marketknowledge, trading strategy and risk management.Answer the hard questions for yourself, before themarket does. Like meditation, or exercise, attentionmust be paid each day for maximum effectiveness.

Self-KnowledgeFirst, when you come into your trading room, leaveyour ego entirely outside the door. Kelly de nes egoas the sense of who we believe we are: A trader, areligious person, a father, a spouse, etc.

When the over-in ated ego gains the throne, rulesgo out the door. Egotism consumes natural andhealthy caution, replacing it with an illusion ofinvincibility. An overdeveloped ego fells even themost successful, sometimes especially the mostsuccessful trader.

Expecting occasional failure, the trapeze artistpractices with a net. He or she knows that the bodyis not more durable than the concrete below. Thetrapeze artist knows that he or she can only exist inthe high- ying environment by following the rules.

Trouble is, ego is not software that can be easilyre-installed in the trader psyche. It is hardware. Youand I are hard-wired with ego. Ego is self-identity.

Ego never wants to be ignored, left out, left behind.But, sometimes it gets out of control and becomesself-absorbed and unrealistic. Sometimes, you haveto decide not to run with the crowd. But, to do so,you have to go against your wiring.

There is something in the human that wants tobelieve in the hero, the guru, the champion, and,for many, that belief is coupled with a desire tobecome that person. If you cant become the hero, itis almost as good to run with him or her a dreamcome true!

Usually, you cant. You may only watch the herofrom the stands or the balcony. But, in the nancialmarkets, you have the opportunity to participatedirectly or partner with the prospective hero. His orher glory becomes your glory. This prospect is soappealing, so motivating, it will cause some of us toleave sense, common or otherwise, far, far behind.

Watch out!

In the 1980s, I participated in a risk arbitragemanaged account program at a major brokerage

rm, supposedly run by supertraders. Ascending tothe heros podium, my account executive disclosedthat returns were expected to be 60 to 100 percent,but, if only mediocre returns were generated, the

return might be as low as 30 percent or so.Hundreds of trades (and commissions) later, I wentthrough the laborious task of reconstructing thetrading history and actual return of my account. Itwas 12 percent, exactly the money market rate ofthe day.

Contrast the swashbuckling image of the wanna-be trading hero with the wry and self-deprecatingwords of $1.5 billion Chesapeake Capital CEOand former Turtle Trader Jerry Parker (another FIAspeaker), who says, We know we dont know whatwere doing.

Far from true, (he meant that we cant predict ratecuts, market movements, the future), but this kind ofmodesty contrasts sharply with what is said by thosepromising spectacular returns and is undoubtedlya better and safer way to sail the market oceans.His trading methodology is to take trend-following


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positions across many markets, expecting a fewlarge gains to outweigh numerous losses.

Defining SuccessWhile the psyche is often looking for others toadmire and emulate, it is not taking the time and

effort to de ne success for itself. This is usually toomuch hard work. Easier and more fun to soak up thevibes from the hero or try to be one yourself.

What is success? For speaker, Ray Kelly, it has beenearning 200K to 300K each year, 40 percent returns,no drawdowns and the opportunity to spend timewith his wife and children, he says.

To de ne your own success, you must answer thesequestions.

Who am I? Why do I trade?

How do I prepare?

What are my beliefs about myself?About trading?

Am I ready to handle the pressures of trading?

Sound too easy? Have you ever actually done it?Kelly says, Great truths unfold at the level of thestudent. As a student learns more, these questions

become deeper and more profound.Ray Kellys own introspection involved workingthrough a family background that included analcoholic father and a very religious Catholicbackground. The religious background left himbelieving that it was evil to be rich. The instabilityin his home made him feel that, somehow, allthe tension and insecurity was because of him.Therefore, he was not worthy of success.

These powerful subconscious beliefs limited hissuccess, that is, until he worked through them.When he resolved his own con icts, he was able toprogress to a higher level of trading success.

Do these subconscious messages really sabotageyour trading? Kelly relates the story of a tradingassociate. His son died in a tragic accident. Blaminghimself, he started losing signi cant sums the verynext week.

Kelly further cites a university study that indicatesa high degree of unresolved guilt among prisoners.The study concludes that prisoners committedcrimes so that external activity would match internalguilt, not the other way around.

Other enemies of trading success: Divorce,employment change, trauma, illness or anything thatcreates emotional distractions or pain.

If you owned a Testarossa, you wouldnt thinkanything of having it checked and tuned on aregular basis, Kelly says. Many trader egos aretoo big for a regular tuneup, however.

What to do? Often you do not realize that you arelaboring under the weight of con ict. It shows upas poor performance or an inability to follow your

rules. Losses are the inevitable by-product.What to do? It depends on the person and theseverity of the problem. The best course to take isto do introspective exercises constantly. Know theresources you need before you need them.

If you are already in the re? Walk away. Take timeoff. Get counseling. Dont trade in the nancialmarkets until your con icts are resolved. Do notmake the expensive mistake of thinking that,whatever it is, it will go away if you ignore it.

Other questions to ask yourself about your state ofmind, according to Kelly, are:

Do others comment on my personality traitsnegatively?

Do I suffer extremes in emotion?

Is my body sending me a message?

Am I uncomfortable with this subject?

Do I take responsibility for my actions?

Society teaches us to places blame, to externalizeour failures, Kelly says. Bad system. Bad broker.Bad quotes. Introspection is just too painful formost.

But to be a successful trader, you must go againstthe grain and do the heavy lifting of introspection.


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Approach the Markets with EquanimityKelly says to incorporate a bottlecap mentalityinto your trading. Like Laverne & Shirley onthe TV sitcom at the Schotts Brewery, you putone bottlecap on after another, and then you gohome and plan your excitement after work, hesays. Dont seek excitement from the markets, or,unhappily, you may nd it.

Similarly, R. Jerry Parker says trading is a brick-upon-brick enterprise, but that Commodity TradingAdvisor (CTA) clients prefer a rock star approach.They want magic, he says.

Trading in some 70 of the most liquid 150futures markets, patiently seeking break-outs, theChesapeake system is a technical, trend-following

system. The system will generate 200 trades peryear, of which some six will pay for losses andgenerate returns, he says. Obviously, if you investtoo much negative emotion in the 194 losers, youlikely wont be around for the six big winners.

Market Knowledge

Market knowledge is the second major pillar youmust depend on to avoid a market catastrophe.

You must ask yourself, continuously:

What affects markets?

How? How might things be changing?

When do you know you are wrong?

What are you trying to extract from the mar -kets?

Kelly cites as a successful example trader DavidDruz, who runs the Tactical Asset ManagementFund.

Druz de nes exactly what his system does: Mytrading system captures the capital that hedgersuse to defend positions. He has back tested andquanti ed it, and so he knows and expects that hissystem will generate 30 percent drawdowns. But,over time, he has achieved excellent results becausehe is focused, he understands his markets, he hasgood money management rules and he looks to arealistic time horizon within which he plans his

trading.

Part of market knowledge is de ning how muchyou expect to make in the markets. If youre atypical newcomer, you may be looking to doubleyour money. There is, for example, a popular phrasein options trading: percent to double (i.e., thepercent your underlying must move to generate adoubling of your options price). For a pro like JerryParker, CEO of Chesapeake Capital, the answer ismuch more modest. His goal: 2 percent per month.

Trading StrategyThird, develop your trading system. For ChesapeakeCapital, the system is rule-based, trend-following,diversi ed, no bias short or long.

This ies in the face of what clients want:Graduates of fancy schools, huge research, anintuitive approach that knows whats going tohappen before it happens (e.g., be overweight in thestock market before an interest rate cut), Parkersays. But, obviously you cant know whats goingto happen before it happens, and maybe the rate cutis the start of a major trend, and maybe its o.k. toget in after. Thats our approach.

Kelly also advises traders to develop a trading

system that they can actually follow. A system thatis geared to their own personality and nancialmeans. Kelly says, If you have abstract ideasof what you want and how you are going toaccomplish it, that is what you will get, an abstractresult.

Test your system, he says.

What are the characteristics of the system?

Is it consistent?

Do you understand why it works? Does it work in all markets?

Does it t your personality?

Then, attend to business: Do your homework everynight. Your competitors do. Determine your answersthe night before the market.


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Risk ManagementFourth, and most importantly, you must managerisk. No matter how great your knowledge ofyourself and the markets is or how sound yoursystem is, if you dont manage risk, you wont last.

Kelly says the successful, long-term trader mustanswer:

How much risk per trade? (Various traders risk .05 to 5 percent of capitalper trade. You must t this gure to your sys -tem.)

Do I understand my risk?

Is my system discretionary or systematic?(A systematic approach takes all signals gener -ated by a trading system. A discretionary systemdoes not mean haphazard trading but, rather,allows the trader to make exceptions to what heor she buys or sells within the framework of thesignals generated.)

Where are my stops, what is the meaning of mystops?

Quantify risk. Two words that separate theworld of success and the world of failure.

Losses are expected. You are not a bad trader ifyou experience them. Options broker Jerry Kopf,Benjamin & Jerold, Chicago, puts it this way, Itsokay to be wrong. Its not okay to stay wrong.

Kelly makes a distinction between what somepeople call drawdowns and what he calls lossesA drawdown is a loss taken within a de nedstrategy. It is part of the strategy.

If you do not have a strategy, it is a loss. Peoplemisname the loss in the hope of avoiding the painand to deceive themselves. A drawdown is not apersonal statement about you; it is an expected part

of the business plan.Unwilling to take a small loss? For those involvedin the spectacular blow-ups of recent times, smalllosses no longer were acceptable, so they wereforced to accept disastrous losses. Keep lossespredetermined and small. At best, professionaltraders are right 50 percent of the time or less, so

would put them out of business, and the goal is tostay in business.

Money management is crucial, Kelly says. Thisis why the exchanges have revolving doors forthose who dont master this critical skill.

Kelly notes that, when losing, amateurs increasebet size, but professionals decrease size. Dont tryto catch up on one trade. If your system is sound,it will make money over time. You will recapturelosses over time. And, thats okay. Because you arelooking for 2 percent a month, correct? Not a fastdouble play.

Two Last Questions: The Bottom Line

Am I pro table?

And

Am I as pro table as I could be at my fullpotential?

If not, you must discover the reasons and makechanges.

Ray Kelly repeated one message over and over atthe presentation: If you want to keep getting whatyou are getting, keep doing what you are doing.

Like the pilot, policeman or trapeze artist, yourespect the rules of the game, you respect theboundaries, you respect how hard the concreteis, and how soft you are, and so you survive. Thealternative is too costly in every way.

Ray Kelly was a veteran trader, nancial consultant andseminar speaker.

R. Jerry Parker is CEO of Chesapeake Capital, Richmond,Virginia.

David Druz is CEO of Tactical Investment Management Fund.

Jerry Kopf is a partner in Benjamin & Jerold Discount Stockand Options Brokers

John Sarkett writes on and trades in the nancial markets.Developer of Option Wizard software (option-wizard.com), hecan be reached at [email protected].

*Reprinted (and modi ed) with permission from John A.Sarkett

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