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Alexander Elder - Trading For A Living | ||||
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free download links about online stock trading, forex, futures, stock investing, market, trading systems The patterns you see on your chart or computer screen are the trails left by bulls and bears. A chartist is a hunter who follows subtle signs, visible only to those who know what to look for. Chart patterns can help you decide when a trend is likely to continue or to reverse. There are two main groups of patterns: continuation and reversal. Continuation patterns include flags and pennants. They suggest trading in the direction of the current trend. Reversal patterns include head and shoulders, inverse head and shoulders, and double tops and bottoms. They indicate it is time to take profits on existing positions. Some patterns can serve as either continuation or reversal formations. Triangles and rectangles are notorious for doing that double duty. When several chart patterns point in the same direction, their signals are reinforced. For example, if an uptrendline gets broken when a head-and- shoulders top is being completed, they both confirm that the uptrend is ending. When different patterns give conflicting messages, their signals cancel one another, and it is better not to trade. Head-and-Shoulders Tops A healthy uptrend moves up in steps. Most rallies reach higher peaks than the preceding rally and declines stop at a higher level than the previous decline. When an uptrend fails to reach a higher high or a decline falls below the previous low, it shows that bulls are losing their grip. Head-and-shoulders tops mark the ends of uptrends (Figure 23-1). The "head" is a price peak surrounded by two lower peaks, or "shoulders." A neckline connects the lows of declines from the left shoulder and the head. The neckline does not have to be horizontal — it may be flat, rising, or falling. A downsloping neckline is especially bearish —it shows that bears are becoming stronger. When prices fail to rally above the head, they confirm that a head-and-shoulders top is developing. The right shoulder may be higher or lower than the left and may be shorter or longer. The decline from the right shoulder breaks the neckline. When that happens, the uptrend is dead. After breaking the neckline, prices sometimes pull back to it on low volume. This feeble rally offers an excellent shorting opportunity, with a logical stop just above the neckline. Head-and-shoulders tops often have typical volume patterns. Volume is often lower on the head than on the left shoulder. It is even lower on the right shoulder. Volume tends to increase when prices break the neckline. When prices pull back to it, volume is very thin. A head-and-shoulders pattern provides an approximate target for the new downtrend. You can obtain it by measuring the distance from the top of the head to the neckline and projecting this down from the neckline
An uptrend remains healthy as long as e ach new rally reaches a n ew high. Rising volume confirmsT^TnesTVoiumelalls when prices reach the "Tiead (H) and flashes a warning to tighten stops on long positions. The decline from the head breaks the uptrendline and signals that the uptrend is over. The head, in this case, is an "island reversal" (see "Gaps," Section 22)-a very bearish pattern. Volume shoots up ominously during the decline from the head. The right shoulder (RS) is much smaller than the left-another sign of weakness. Low volume on the right shoulder also points to a good shorting opportunity. The decline from the right shoulder breaks the neckline. This completes the head-and-shoulders pattern. There is an excellent shorting opportunity when prices pull back to the neckline from below on low volume. The distance from the top of the head to the neckline (A) provides a target for the decline (B). At the right edge of the chart, hold shorts because prices continue to fall on rising volume and have not reached their target; place a protective stop at the top of the past 5 days' range. Trading Rules Once you identify a head-and-shoulders top, you need to make two trading decisions: what to do about your long position and how to go about shorting. You have three choices for managing your longs: sell them outright, tighten your stops, or sell some and hold the rest. Many traders take the fourth choice — they simply freeze and do nothing. Trading is a complex, nontrivial game that demands making decisions in an atmosphere of uncertainty. Your decision depends on how certain you feel about the pattern. It also depends on the size of your account. A large account allows you to buy and sell gradually. Having to trade a single contract in a small account demands precise timing—it is a good school for a beginning trader. You must analyze your charts in more than one timeframe (see Section 36). If weekly charts are toppy, a head-and-shoulders pattern on the dailies should prompt you to run for the exit. If weeklies are strong, then it is often better to simply tighten the stops. Technical indicators can also help you decide how urgent it is to sell. Markets often are more volatile at tops, with wide swings between short- term highs and lows. Selling short and placing a stop above the latest high may expose you to more risk than the maximum amount allowed per contract in your account (see Chapter 10). You may have to pass up the trade or buy puts to keep your monetary risk within allowed limits. • Sell when you recognize the head or the right shoulder of a head-and- • The decline from the head establishes a neckline. If you still hold a • The rally to the right shoulder is usually marked by low volume and Once the neckline is broken, a pullback on low volume offers an excellent shorting opportunity, with a protective stop slightly above the neckline. The Hound of the Baskervilles This signal occurs when a reliable chart or indicator pattern does not lead to the action you expect and prices move in the opposite direction. A head-and-shoulders pattern indicates that the uptrend is over. If prices continue to rise, they give the Hound of the Baskervilles signal. This signal is named after the story by Sir Arthur Conan Doyle in which Sherlock Holmes was called to solve a murder at a country estate. He found the essential clue when he realized that the family dog did not bark while the murder was being committed. That meant the dog knew the criminal and the murder was an inside job. The signal was given by the lack of expected action — by the lack of barking! When the market refuses to bark in response to a perfectly good signal, it gives you the Hound of the Baskervilles signal. This shows that something is fundamentally changing below the surface. Then it is time to get in gear with the new powerful trend. A head-and-shoulders pattern gives a strong sell signal. If the market refuses to collapse but rallies from the right shoulder, it gives you its Hound of the Baskervilles signal. When pieces rise above the head, it is time to cover shorts, reverse, and go long. An aborted head-and-shoulders top often leads to a very strong rally. Buy the upside breakout, and place a protective stop slightly below the top of the head. Inverse Head and Shoulders Some traders call this pattern a head-and-shoulders bottom—a mirror image of a head-and-shoulders top. It looks like a silhouette of a person upside down: the head at the lowest point, surrounded by two shoulders. This pattern develops when a downtrend loses its force and gets ready to reverse (Figure 23-2). In a valid downtrend, each new low falls lower than the previous low, and each rally stops at a lower level. A strong rally from the head allows you to draw a neckline. When a decline from the neckline fails to reach the level of the head, it creates the right shoulder. When prices rally from the right shoul- der above the neckline on increased volume, they complete the head-and- shoulders bottom and a new uptrend begins. Sometimes a head-and-shoulders bottom is followed by a pullback to the neckline on low volume, offering an excellent buying opportunity. Measure the distance from the bottom of the head to the neckline and project it upward from the point where the neckline was broken. This gives you a minimum measurement for a rally, which is frequently exceeded. The tactics for trading inverse head and shoulders is similar to head-and- shoulders tops. You risk less money trading at bottoms because prices are less volatile, and you can use closer stops. Rectangles A rectangle is a chart pattern that contains price movements between two parallel lines. They are usually horizontal but can sometimes slant up or down (see "Lines and Flags," later in this section). Rectangles and triangles can serve as continuation or reversal patterns. You need four points to draw a rectangle: The upper line connects two rally tops, and the lower line connects two bottoms (Figure 23-3). These lines should be drawn through the edges of congestion areas rather than across the extreme highs and lows (see Section 19). The upper line of a rectangle identifies resistance, while the lower line identifies support. The upper line shows where bulls run out of steam; the lower line shows where bears become exhausted. A rectangle shows that bulls and bears are evenly matched. The key question is whether bulls or bears will eventually win the battle within this pattern. If volume swells when prices approach the upper border of a rectangle, an upside breakout is more likely. If volume increases when prices approach the lower border, a downside breakout is more likely. A valid breakout from a rectangle is usually confirmed by an increase in volume — one-third to one- half higher than the average of the previous five days. If volume is thin, it is likely to be a false breakout. Rectangles tend to be wider in uptrends and narrower in downtrends. The longer a rectangle, the more significant a breakout. Breakouts from rectangles on weekly charts are especially important because they mark important victories for bulls or bears. There are several techniques for projecting how far a breakout is likely to go. Measure the height of a rectangle and project it from the broken wall in Trading Rules Floor traders can profit from trading short-term swings between a rectangle's walls, but the big money is made by trading in the direction of a breakout. 1. When trading within a rectangle, buy at the lower boundary and sell If you buy at the lower border of a rectangle, place your protective stop slightly below that rectangle. If you sell short near the upper wall of a rectangle, place a protective stop slightly above that border. You have to be very nimble and take profits at the first sign of a reversal. It is dangerous to hold on for a few extra ticks within a rectangle. • To find out whether an upside or a downside breakout is more likely, • Once you buy an upside breakout or sell short a downside breakout, Lines and Flags A line is a kind of a rectangle — a lengthy congestion area. In Dow theory, a line is a correction against the primary trend. It is a congestion zone whose height is approximately 3 percent of current stock market value. When the stock market "draws a line" instead of reacting more deeply against its major trend, it shows a particularly strong primary trend. A flag is a rectangle whose boundaries are parallel but slant up or down. Breakouts tend to go against the slope of the flag. If a flag slants upward, a downside breakout is more likely. If the flag slants down, an upside breakout is more likely. If you see a downsloping flag in an uptrend, place a buy order above the latest peak of the flag to catch an upside breakout. A rising flag in an uptrend marks distribution, and a downside breakout is more likely. Place an order to sell short below the latest low of that flag. Reverse the procedure in downtrends. Triangles A triangle is a congestion area whose upper and lower boundaries converge on the right (Figure 23-4). It can serve either as a reversal or, more often, as a continuation pattern. Some technicians call triangles coils. The market winds up and the energy of traders becomes compressed, ready to spring from a triangle. A small triangle whose height is 10 to 15 percent of the preceding trend is more likely to serve as a continuation pattern. Many uptrends and downtrends are punctuated by these triangles, as sentences are punctuated by commas. Large triangles whose height equals a third or more of the preceding trend are more likely to serve as reversal patterns. Finally, some triangles simply fizzle out into listless trading ranges. Triangles can be divided into three major groups, depending on their angles. The upper and lower lines of symmetrical triangles converge at the same angles. If the upper line is inclined 30 degrees to the horizontal, then the lower line is also inclined 30 degrees. Symmetrical triangles reflect a fair balance of power between bulls and bears and are more likely to serve as continuation patterns. An ascending triangle has a relatively flat upper boundary and a rising lower boundary. Its flat upper boundary shows that bulls are maintaining their strength and can lift prices to the same level, while bears are losing their ability to drive prices lower. An ascending triangle is more likely to result in an upside breakout. A descending triangle has a relatively flat lower boundary, while its upper boundary slants down. Its flat lower boundary shows that bears are maintaining their strength and continue to drive prices down, while bulls are losing their capacity to lift prices. A descending triangle is more likely to lead to a downside breakout. Volume tends to shrink as triangles get older. If volume jumps on a rally toward the upper boundary, an upside breakout is more likely. If volume becomes heavier when prices fall toward the lower boundary, a downside breakout is more likely. Valid breakouts are accompanied by a burst of volume — at least 50 percent above the average for the past 5 days. Valid breakouts occur during the first two thirds of a triangle. It is better not to trade breakouts from the last third of a triangle. If prices stagnate all the way into the apex, they are likely to remain flat. A triangle is like a fight between two tired boxers who keep leaning on each other. An early breakout shows that one of the fighters is stronger. If prices stay within a triangle all the way into the apex, that shows that both boxers are exhausted and no trend is likely to emerge. Charts of related markets often show triangles at the same time. If gold, silver, and platinum all trace triangles and gold breaks out to the upside, then platinum and silver are likely to follow. This approach works well with currencies, especially with closely related ones, such as the German Mark and Swiss Franc. It also works with stocks in the same group—compare General Motors to Ford but not to IBM. Triangles provide a minimum target for a move following a breakout. Measure the height of a triangle at its base and project vertically from the point where the triangle was broken. If you are dealing with a small triangle in the midst of a dynamic trend, that minimum measurement is likely to be exceeded. You can also use the Fibonacci projections mentioned earlier. Trading Rules It's better not to trade minor swings within a triangle unless that triangle is very large. As a triangle grows older, the swings become narrower. Profit potential shrinks, while slippage and commissions continue to take just as bad a bite from your account as before. • If you trade inside a triangle, use oscillators such as Stochastic (see • In trying to decide whether a triangle on a daily chart is likely to lead • When you want to buy an upside breakout, place a buy order slightly torn can be slightly above or below the first. This often confuses beginning analysts. Savvy traders use technical indicators to identify double tops and bottoms. They are often marked by bullish and bearish divergences. Buying at double bottoms and selling short at double tops offer some of the best trading opportunities. Double Tops and Bottoms Double tops occur when prices rally to the area of the previous high. Double bottoms occur when prices fall near the previous low. The second top or bot- out, place a sell order slightly below the lower boundary. Keep raising it as the triangle becomes narrower. Once you are in a trade, place a protective stop slightly inside the triangle. Prices may pull back to the wall, but they should not return deep inside a triangle following a valid breakout. • When a breakout from a triangle is followed by a pullback, pay atten • When prices approach the last third of a triangle, cancel your buy or Atypical Triangles A pennant is a small triangle whose lines are slanted in the same direction. Pennants that slant against the trend serve as continuation patterns. There is an old saying "The pennant flies at half-mast" — a rally is likely to travel as far after the pennant as it did before. A pennant that slants in the direction of the trend indicates exhaustion — a trend is nearing a reversal. A widening triangle occurs when prices set a series of higher highs and lower lows. This pattern shows that the market is becoming hysterically volatile, with bulls and bears pouring in. The fight between bulls and bears becomes too hot for the uptrend to continue —a widening triangle kills an uptrend. A diamond starts out as a widening triangle and ends as a symmetrical triangle. You have to squint very hard to recognize it. Diamonds are prime examples of Rorschach-type patterns for chartists. If you look long enough, you will find them, but their trading usefulness is minimal. I used to look for diamonds ... and most of them were fake zirconium. |
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