Classical Bar Charting

& Technical Analysis

Kenneth H. Shaleen
Section One
Chapter 1 Chapter 2

- The Bottom of the Chart

Rationale of technical analysis Volume Analysis Significance Healthy Price Trends Blowoff Volume Determination of Volume Parameters Open Interest in a Futures Contract Significance Healthy Price Trends Idiosyncrasies General Rule for a Healthy Price Trend (on a daily futures chart) Why Total Volume & Open interest is Used Worksheet

Chapter 3

Chapter 4

Section Two - The Basics

Chapter 5 Price Scales Arithmetic verses Logarithmic Futures Continuation Charts Trending with the Trend Trendline Construction Trendline Analysis Support and Resistance

Chapter 6

Chapter 7

Section Three - Reversal Patterns

Chapter 8 Chapter 9 Chapter 10 Chapter 11 Price Pattern Recognition - an Overview Head & Shoulders Top and Bottom Broadening Formations Double Top and Double Bottom i

Section Four - Continuation Patterns

Chapter 12 Symmetrical Triangles As a Continuation Pattern As a Reversal Pattern Right Angle Triangle Ascending Right Triangle Descending Right Triangle Wedge Formations Rising Wedge Falling Wedge Flags & Pennants - half-way formations

Chapter 13

Chapter 14

Chapter 15

Section Five - Gap Theory

Chapter 16 Gap Theory Four Basic Types of Gaps Ex-Dividend Gap Island Formation

Section Six - Minor Trend Change Indicators

Chapter 17 Minor Trend Change Indicators Key Reversal Outside/Inside Range Mid-Range Close

Section Seven - Other Forms of Technical Analysis

Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Spreading and Spread Charts Mathematical Models - Trend Following Mathematical Models - Oscillators

Kenneth H. Shaleen ii

CHARTWATCH 9/08

International Futures Research

Kenneth H. Shaleen is President of CHARTWATCH, an international research firm to the futures industry. CHARTWATCH distributes weekly technical analysis at www.chartwatch.com and produces a daily telephone market update. Mr. Shaleen has instructed technical analysis courses for the Chicago Mercantile Exchange since 1976. These courses are also conducted in London, Singapore, Malaysia, Hong Kong and other locations throughout the world. Mr. Shaleen is the author of Volume & Open Interest (Irwin, 1991, 1997) and Technical Analysis & Options Strategies (Irwin, 1992), three Chicago Mercantile Exchange course book as well as numerous articles. Mr. Shaleen Joined the Northern Trust Company in Chicago in 1968 as a Management Science Analyst to develop computer models for the Bond and Trust Departments. A move to futures research was made in 1972. After supplying analysis for twelve years as Director of Research for two Chicago Board of Trade clearing member firms, he formed CHARTWATCH in 1984. Mr. Shaleen is a charter member of the Commodity Options Market (1982) at the Chicago Board of Trade. He holds a B.S. in Civil Engineering from the University of Colorado (1967) and an M.B.A. in Finance from Northwestern University (1968).

Please direct all inquires concerning videos and any of the services offered by CHARTWATCH to:

CHARTWATCH Fulton House 1604 345 North Canal Street Chicago, Il 60606 USA Telephone: 312 454-1130

www.chartwatch.com
iii

Foreword

Earning an MBA in finance at Northwestern University in June of 1968, I was never exposed to one of the most active markets in the world - the Chicago futures exchanges - basically just down the street from the downtown Northwestern campus. After reading Commodity Speculation with Profits in Mind by L. Dee Belveal (Commodities Press, 1967), I started my first chart - Sept 68 Oat futures. This course manual is an ongoing compilation and refinement of all the charts and technical analysis I have encountered since this time. The majority of charts in this manual are futures charts, although the first Technical Analysis Course I conducted for the Chicago Mercantile Exchange in the Summer of 1976 used the Edwards and Magee bible of price pattern recognition: Technical Analysis of Stock Trends. Now the technical analysis course has come full circle with Stock Index futures charts and individual equity charts increasingly in evidence. This is the course manual. The live charts assigned in the early CME Technical Analysis courses were Live Cattle and Soybeans. These evolved to Deutsche Marks and Treasury Bonds - as the volume in financial futures became dominant. The simple creation of a chart also evolved with the advent of electronic after hours trading and the proliferation of technical analysis software. Much of what is contained in this course manual is the old fashioned art of drawing trendlines to construct classic price patterns. A combination of older charts and more up-to-date examples are co-mingled to show that human nature, creating the price patterns, does not change. To the 15,000+ students who have helped me analyze these charts - my thanks.

Ken Shaleen
Chicago Sept 22, 2008

Classical Bar Charting

&

Technical Analysis
Prepared and Presented by

Ken Shaleen

President, CHARTWATCH Inc.

Classical Bar Charting & Technical Analysis

Kenneth H. Shaleen
Section One - The Bottom of the Chart
Chapter 1 Chapter 2 Rationale of technical analysis Volume Analysis Significance Healthy Price Trends Blowoff Volume Determination of Volume Parameters Open Interest in a Futures Contract Significance Healthy Price Trends Idiosyncrasies General Rule for a Healthy Price Trend (on a daily futures chart) W hy Total Volume & Open interest is Used W orksheet

Chapter 3

Chapter 4

Section Two - The Basics

Chapter 5 Price Scales Arithmetic verses Logarithmic Futures Continuation Charts Trending with the Trend Trendline Construction Trendline Analysis Support and Resistance

Chapter 6

Chapter 7

Section Three - Reversal Patterns

Chapter 8 Chapter 9 Chapter 10 Chapter 11 Price Pattern Recognition - an Overview Head & Shoulders Top and Bottom Broadening Formations Double Top and Double Bottom i

Section Four - Continuation Patterns

Chapter 12 Symmetrical Triangles As a Continuation Pattern As a Reversal Pattern Right Angle Triangle Ascending Right Triangle Descending Right Triangle W edge Formations Rising W edge Falling W edge Flags & Pennants - half-way formations

Chapter 13

Chapter 14

Chapter 15

Section Five - Gap Theory

Chapter 16 Gap Theory Four Basic Types of Gaps Ex-Dividend Gap Island Formation

Section Six - Minor Trend Change Indicators

Chapter 17 Minor Trend Change Indicators Key Reversal Outside/Inside Range Mid-Range Close

Section Seven - Other Forms of Technical Analysis

Chapter 18 Chapter 19 Mathematical Models - Trend Following

Chapter 20 Mathematical Models - Oscillators Chapter 21 Chapter 22 Spreading and Spread Charts

ii

Kenneth H. Shaleen CHARTWATCH 9/08

International Futures Research

Kenneth H. Shaleen is President of CHARTW ATCH, an international research firm to the futures industry. CHARTW ATCH distributes weekly technical analysis at www.chartwatch.com and produces a daily telephone market update. Mr. Shaleen has instructed technical analysis courses for the Chicago Mercantile Exchange since 1976. These courses are also conducted in London, Singapore, Malaysia, Hong Kong and other locations throughout the world. Mr. Shaleen is the author of Volume & Open Interest (Irwin, 1991, 1997) and Technical Analysis & Options Strategies (Irwin, 1992), three Chicago Mercantile Exchange course book as well as numerous articles. Mr. Shaleen Joined the Northern Trust Company in Chicago in 1968 as a Management Science Analyst to develop computer models for the Bond and Trust Departments. A move to futures research was made in 1972. After supplying analysis for twelve years as Director of Research for two Chicago Board of Trade clearing member firms, he formed CHARTW ATCH in 1984. Mr. Shaleen is a charter member of the Commodity Options Market (1982) at the Chicago Board of Trade. He holds a B.S. in Civil Engineering from the University of Colorado (1967) and an M.B.A. in Finance from Northwestern University (1968).

Please direct all inquires concerning videos and any of the services offered by CHARTW ATCH to:

CHARTW ATCH Fulton House 1604 345 North Canal Street Chicago, Il 60606 USA Telephone: 312 454-1130

www.chartwatch.com
iii

Foreword

Earning an MBA in finance at Northwestern University in June of 1968, I was never exposed to one of the most active markets in the world - the Chicago futures exchanges - basically just down the street from the downtown Northwestern campus. After reading Commodity Speculation with Profits in Mind by L. Dee Belveal (Commodities Press, 1967), I started my first chart - Sept 68 Oat futures. This course manual is an ongoing compilation and refinement of all the charts and technical analysis I have encountered since this time. The majority of charts in this manual are futures charts, although the first Technical Analysis Course I conducted for the Chicago Mercantile Exchange in the Summer of 1976 used the Edwards and Magee bible of price pattern recognition: Technical Analysis of Stock Trends. Now the technical analysis course has come full circle with Stock Index futures charts and individual equity charts increasingly in evidence. This is the course manual. The live charts assigned in the early CME Technical Analysis courses were Live Cattle and Soybeans. These evolved to Deutsche Marks and Treasury Bonds - as the volume in financial futures became dominant. The simple creation of a chart also evolved with the advent of electronic after hours trading and the proliferation of technical analysis software. Much of what is contained in this course manual is the old fashioned art of drawing trendlines to construct classic price patterns. A combination of older charts and more up-to-date examples are co-mingled to show that human nature, creating the price patterns, does not change. To the 15,000+ students who have helped me analyze these charts - my thanks.

Ken Shaleen
Chicago Sept 22, 2008

iv

Chapter One Rationale

In the long run, the price of any freely traded item is determined by the interaction of the fundamentals of supply and demand. But in the short run, the price of that item could move in exactly opposite direction as dictated by the fundamentals. W hy? W hat is contained in the determination of the price? Hopes, fears, and moods. An these moods can be rational or irrational. The technical trader follows the price only. Price changes produce the profit or loss; as a final result, this is what is important. It is difficult for a trader to isolate a technically derived market view from the fundamentals. The question always arises: W hy is price moving the way it is and why should it go to a particular price level that might be predicted by technical analysis? A technician must try to divorce himself from these thoughts. This does not mean that a technician does not know what is going on in the real world. Often, a scheduled economic report will initiate the price move. Indeed, it takes reversals of the minor price trend to create the handful of classic price patterns that will be studied in this course manual. A fundamental event is usually responsible for creating the minor price change. So a technical trader should monitor the economic release calendar - and be prepared for the possible price moves that will result. Often these minor price moves create the necessary conditions for a classical bar charting price pattern. The bulk of this course manual will be devoted to the low tech art of price pattern recognition. There is nothing magic about these price patterns. They are the interaction of supply and demand variables as perceived by the marketplace. And human nature - reacting to economic events and shock variables - tends to repeat itself.

Equity Markets verses Futures Markets

The techniques investigated are applicable to equity (stock) charts and futures charts. Each of these markets has its own unique characteristics. These characteristics are not difficult to understand - and do not pose any major problems for the astute technician.

1-1

The Difference between Equity and Futures Charts

The main difference between equity charts and futures charts is that equity charts contain only price and volume statistics whereas a futures chart contains the added variable of open interest. There is a major conceptual difference in a market that must have a short for every long at the end of a trading session i.e., a futures market, verses the equity market where there are (predominately) longs only, at the end of the trading session.(For purists, the concept of short interest in the equity market will be detailed in Chapter Two, Open Interest). The question often arises: W hy should a derivative market, the futures, be analyzed when the underlying cash or spot market is the dominant market? A futures market that has achieved a critical mass becomes a microcosm diminutive but analogous to the whole (cash market). The basis, the difference between the cash market price and the futures price, is highly arbitraged and produces a relatively stable (although dynamic) relationship between the cash and futures market.

1-2

Chapter Two Volume

Volume provides a filter for classical high, low, close, bar chartists. Volume is so important that when this internal statistic does not support the technical conclusion derived from the analysis of price movements, the contemplated trade is suspect and would not be initiated. In this regard, volume is often the validating statistic that causes a technical trader to pull the trigger on a new trade.

Definition: Volume is the number of futures contracts (shares for an equity

market participants) traded each trading session. In a futures market, a contract is consummated only when both sides of the trade agree to the price and quantity. At the end of a trading session, the total number of contracts bought equals the total number of contracts sold. Therefore, the following equality always prevails:

Buy Volume = Sell Volume = Total Volume

Published volume figures represent one side of a futures trade only. The phrase more buyers than sellers is never true with respect to volume statistics. A more representative phrase to explain the rise in prices during a particular trading session might be more potential buyers than sellers. The dissemination of volume (and open interest) statistics varies widely by futures exchange. In an open outcry trading environment the final volume totals are not available until after the close of trading. Electronic screen based trading (and most equity exchanges) do show on-line volume. This is obviously a boon to technical traders. The CME Group Clearing House releases the volume (and open interest) statistics prior to the start of open outcry trading the next morning in the U.S. See the Appendix of this manual for examples of how to obtain the statistics directly from the exchange website. Note that once each week, a technician will be able to analyze the statistics before trading begins the next day. This occurs with the Saturday morning availability of the data for the Friday trading sessions. 2-1

Significance of Volume: Volume is a measure of urgency. It is the result of the

need for traders and investors to do something. And nothing creates more urgency in a market than a losing position. Since any useful chart analysis determines what the losers are doing, the technician will want to monitor this sense of urgency, thereby assessing the health and strength of the prevailing price trend. The specific volume number is not important. It is necessary to classify the trading sessions volume into one of three categories: low, average or high. These three categories are not static; Their boundaries will fluctuate with substantial changes in open interest and/or price volatility.

Ideal Healthy Price Uptrend: The ideal situation for a healthy bull market is
volume moving up as the bull market expands. A strong price uptrend is characterized by greater volume on up days when prices close higher, than on down days when prices settle lower. This relationship is shown schematically in Figure 2-1. Figure 2-1 Ideal Bull Market Price versus Volume Interaction

2-2

Volume measures how anxious trader are to establish or close out their positions. The ideal situation for a healthy uptrend in prices is for volume to increase on rallies in price and decrease on selloffs. This configuration created the old adage - Dont sell a quiet market after a fall - because a low volume selloff is actually a bullish technical situation. Monitoring volume to identify price moves as counter-trend is important. Low volume on price down days is telling the astute trader that there is no urgency on the part of the longs or shorts to close out their positions - and thus the prevailing major price uptrend should continue.

Ideal Healthy Price Downtrend: The ideal situation for a healthy bear market is
for volume to increase a prices move lower. A strong price downtrend is characterized by expanding volume on days when prices close lower and increasing volume on price up days. This concept is shown schematically in Figure 2-2.

Figure 2-2 Ideal Bear Market Price versus Volume Interaction

2-3

Even in a long-term bear market, prices will not continually decline. Adverse moves against the direction of the major trend will result in price rallies - some lasting several days, or erratically, over several weeks. If no urgency develops for the shorts to cover their positions, volume should decline. This is the proverbial low volume rally. A low volume rally is bearish. Ergo, Dont buy a quiet market after a rise.

Blowoff Volume - A Warning Signal: There is one amplification of the ideal

price versus volume configuration that is of paramount importance and should not be overlooked. Losing positions, especially speculative ones (as opposed to legitimate hedges), often create conditions that lead to excessive volume. The urgent need to close out losing positions produces blowoff volume. Blowoff volume is volume of an extremely high magnitude which is a warning signal that the price trend is in the process of exhausting itself. Prices often move violently in the opposite direction after such blowoff volume. Figure 2-3 illustrates the theoretical relationships between blowoff volume and price activity. Figure 2-7 is an actual example of this sign of exhaustion in the Corn futures market. Figure 2-3 Theoretical Examples of Blowoff Volume

One caveat is in order. Extreme high volume is the warning signal which indicates at least a temporary trend change. This signal does not have to coincide with the exact extreme price day. Often blowoff volume will occur one trading session before the ultimate high or low price posting. 2-4

Determination of Volume Parameters

Figure 2-4

A bar chartist will scan back an appropriate distance, whether two weeks or two months, depending on the specific conditions prevailing on each chart. Hypothetical horizontal lines are drawn, representing the threshold levels of low and high volume. One third of the volume readings should fall into each of the three categories

2-5

Volume Analysis
Figure 2-5

2-6

Volume Analysis
Figure 2-6

Note the increase in volume on price down days and reduction in volume on price rallies

2-7

Example of Blowoff Volume

Figure 2-7

2-8

Chapter Three Open Interest

Futures trading is a zero sum game: for every dollar in - there is a dollar out. Admittedly, the exchange clearing house and member firms scoop a little off the top; but for every open position in a futures market there has to be an opposite position. Definition: Open Interest (O.I.) Is the summation of all unclosed purchases or sales at the end of a trading session. Similar to volume, the published figure represents one side of the transaction only. Confusion concerning the definition of open interest can be avoided by remembering this simple equality: Long O.I. = Short O.I. = Total O.I. Futures technicians monitor the total open interest figure. This number represents the summation of open positions in all the contract months traded for the particular commodity. The reason for using total open interest is explained in graphic detail in Chapter Four.

How Open Interest Changes: Open interest changes from one trading session to the next, fall into one of three categories: 1) Increase, 2) Decrease, or 3) No change. Each of the three situations will be examined in a hypothetical example. For this illustration, it does not matter whether prices moved up or down. W hat is necessary is that a significant price change occurred. W hile no specific definition of what constitutes significant will be given, it is safe to assume that the definition begins at more than five minimum price tics. The technical ramifications of these changes will be apparent later in this chapter when detailing the ideal healthy price uptrend or downtrend.

Example: Prior Days Total Open Interest = 180,000 Answer the question: W ho is getting in or out of the market?

Case One: Open Interest Increases Total O.I. now at 183,000 a change of +3000 3-1 3,000 new long contracts opened 3,000 new short contracts opened

Case Two: Open Interest Decreases Total O.I. now at 178,000 a change of -2,000 2,000 long contracts sold out 2,000 short contracts bought back (covered their existing shorts)

Case Three: Open Interest Unchanged Total O.I. now at 180,000 no change In this situation, the trader would not know exactly what changing of positions occurred.

Significance of Open Interest: There are three reasons why technically based futures traders monitor open interest. Open interest: 1) Indicates the existence of a difference of opinion. 2) Provides fuel to sustain a price move. 3) Determines if the losers are being replaced.

There is nothing that creates a market more than a difference of opinion. This is reflected in a willingness to take an open position. Open interest is a reflection of this important concept. If a market was at equilibrium and the entire trading world knew this - the open interest in a futures listed on that commodity would be zero. There would be no need for hedgers to lay off unwanted risk, or speculators placing positions trying to profit from a mis-priced market. The analogy of fuel to the market is like that of fuel to a fire. If the fuel is removed from a fire, the fire will go out. If fuel is removed from a price trend, the trend will change. Fuel in a futures market is provided by the losing positions. W hen open interest declines, fuel is being removed and the prevailing price trend is running on borrowed time. For a healthy, strong price trend (either up or down) to continue, open interest should increase, or at least not decline. This is so important a concept that remembering the word fuel as a surrogate for open interest will place a trader ahead of 80 percent of all futures traders worldwide!

3-2

Technicians do not care if a losing position is being financed by meeting margin calls and throwing more money at the market, or if a loser steps aside and new blood comes in to take the losers place. W hat matters is that the funds are being posted at the clearinghouse. The losers are necessary to pay off the traders with the correct market judgment. W hen the losers decide that they dont want to play the silly game anymore and leave the market, open interest will decline. Obviously the losers pay the price for their misjudgment, but what is of importance to the technician is that declining open interest means the prevailing price trend has become very unhealthy.

Ideal Healthy Price Uptrend: In an uptrending market when open interest is going up, both sides are increasing their positions. The additional short sellers may be existing shorts adding to their losing positions, or new short sellers entering the market (thinking prices are too high). Longs may be adding to their profitable positions, or new longs may be joining the bull bandwagon. W hat is of the most importance to the longs is the fact that the losers are being replaced and more fuel to sustain the upmove is entering the market. This is a healthy price uptrend and prices should continue to work higher as long as open interest does not begin to decline. This is shown in schematic fashion in Figure 3-1. If open interest is declining, the underlying support is suspect. Liquidation of both long and short positions is occurring. Less conviction concerning probable price movement together with less fuel to sustain the price trend produces a definite warning signal of an impending trend change. Precautionary measures should be taken such as moving protective stop orders (hopefully to realize profits) closer and placing orders to liquidate existing positions. Potential hedgers should begin to implement any previously planned strategies to protect inventory, lock in profit margins, etc. Figure 3-1 Ideal Bull Market Price versus Open Interest Interaction

3-3

Ideal Healthy Price Downtrend: The ideal situation for a healthy price downtrend (price expected to continue moving lower) is open interest increasing when prices close lower and open interest decreasing on trading sessions when prices close higher. This is shown in Figure 3-2. There is often difficulty in finding the ideal technical situation of open interest increasing during a downtrending market, especially in the metals, grains and livestock futures. This is because commodity speculators are by nature bullish. They would much rather buy something than be short. Thus a short position in futures can be taken if other indicators, such as price patterns, suggest lower prices - even though the ideal situation of increasing open interest is not present. This concept will be illustrated in many of the charts in this course manual. Figure 3-2 Ideal Healthy Price Downtrend Price versus Open Interest Interaction

Short Interest (Equities) The concept of short interest in the U.S. or any equity (stock) market) is completely different from open interest in futures. In any equity market that allows short sales using borrowed stock, a short interest situation might exist. Short interest is the number of shares that have not yet been purchased to cover short sales. The borrowed stock must eventually be returned to the lender. Two schools of thought prevail as to what short interest implies: 1) Traders expecting a price decline are initiating short sales; They could be correct, or 2) By definition, the shares sold short must eventually be bought back: A bullish situation. Increases in takeover activity and arbitrage cloud the issue of how to interpret short interest statistics from an equity market. 3-4

IDIOSYNCRASIES
Questions quickly arise when a new trader is exposed to the concept of how open interest should ideally interact with price changes in a futures market. 1) W hat happens to open interest as a market reverses price direction? 2) How can open interest continually increase in the direction of the new price trend? This would mean that open interest would have to continually rise! Markets in Transition: The answer is that normally open interest does decline as a new price trend initially gets underway. This is because the participants with the correct (profitable) positions are liquidating (realizing that the trend is changing) and the losers are closing out their positions (confused and not realizing that the trend really is finally starting to go their way). Open interest often declines to a steady-state condition - a level of open contracts that often approximates the level that prevailed before the start of the previous price trend. As the new price trend becomes more apparent, open interest should then begin to increase - fueling the price move to new highs or lows as the smart money rides the trend and the skeptics fight it. Open Interest as a Coincident Indicator: On many occasions, open interest acts as a coincident indicator with price. This occurs most often in the traditional physical commodity futures during a bull market. Total open interest rounds upward as a price bottom is being made and tops out as price peaks. In general, any time open interest begins to act erratic after experiencing a steady increase, price is, at best, moving net sideways, and more than likely trying to change direction. A special case in which open interest often acts as a coincident indicator in both bull and bear directions is the CME Group currency futures. Total open interest has acted in a coincident fashion with price in so many instances that it cannot be attributed solely to chance. The changes in open interest in the foreign exchange (forex) futures accurately reflect how the dominant price making force is changing its market view.

3-5

Ideal Healthy Price Uptrend - and Early Warning Signal

Figure 3-3

3-6

Ideal Healthy Price Downtrend

Figure 3-4

3-7

Historical Charts
Figure 3-5

3-8

Historical Charts
Figure 3-6

Ideal Healthy Price Downtrend

Lean Hogs - Feb 1999

Note that after the January 5 price decline, a vicious short covering rally ensued. Technical traders cannot simply use the fact that an price rally is short covering to initiate short sales. A price reason must be present. 3-9

Historical Charts
Figure 3-7

Open Interest as a Warning Signal

3-10

Historical Charts
Figure 3-8

13-11

Historical Charts
Figure 3-9

Open Interest in the Transition from a Bull to a Bear Market

3-12

Historical Charts
Figure 3-10

Open Interest Increasing in a Bear Market

Note the transition from a bear to bull market was initially accompanied by a ecrease in open interest. This is usual.

3-13

Historical Charts
Figure 3-11 A Open Interest as a Coincident Indicator Figure 3-11B History does Repeat Itself

Deutsche Mark Sept 1998

Note how the liquidation in total open interest corresponded to the price declines. W hen the bulls finally had the courage of their convictions and were willing to hold long positions overnight, price was able to move up. Also observe the interaction of price and open interest at the price highs. The open interest line resembles the Head & Shoulders Top that formed on the price chart!

3-14

Chapter Four General Rule for a Healthy Price Trend

Volume and Open Interest Should Increase as Prices Move in the Direction of the Major Price Trend
According to this rule, the most bullish condition on a futures chart is price moving up on increasing volume and increasing open interest; The longs are in control and the price uptrend is expected to continue. On a daily basis, this rule implies that on price up days (when quotes close higher than the previous trading session), volume should expand and open interest should increase. In a strong bear market when quotes close lower, volume will expand and open interest will increase. This ideal healthy price downtrend does not often occur in those markets that the public prefers to trade from the long side. These include traditional agricultural commodity futures and metals. Conversely, markets such as interest rate futures (U.S. Treasury Bonds in particular) often do exhibit the ideal bear market characteristics of volume and open interest up on price down days. The most bullish and bearish technical situations are shown schematically in figures 4-1 and 4-2. Figure 4-1 Ideal Healthy Bull Market Figure 4-2 Ideal Healthy Bear Market

4-1

Why Total Open Interest is Used

4-2

Volume and Open Interest Analysis - Worksheet

4-3

Ideal Healthy Price Uptrend

Volume Should: Increase on price up moves Decrease on price down moves Open Interest Should: Increase on price up moves Decrease on price down moves

4-4

Ideal Healthy Price Downtrend

Volume Should: Increase on price down moves Decrease on price up moves Open Interest Should: Increase on price down moves Decrease on price up moves

4-5

Ideal Healthy Price Uptrend

Volume Should: Increase on price up moves Decrease on price down moves Open Interest Should: Increase on price up moves Decrease on price down moves 4-6

4-7

4-8

Weak Price Uptrend - Downside Reaction Likely

4-9

4-10

Chapter Five Price Scales

One of the first decisions a prospective bar chartist must address is what type of price scale to use. The two choices are arithmetic or logarithmic. First, a discussion of each type of scale - and then a recommendation. Arithmetic scales are constructed with each small square on the chart actually being a square. This referred to as rectangular coordinate chart paper. Logarithmic scales increase in a doubling of price in equal price distances. Since time is recorded in linear fashion, the result is semi-log chart paper.

Classical bar chartists quite often use the vertical height of the price pattern to determine upside or downside measuring objectives. Obviously, the choice of price scale will generate much different price objectives. An upside target on a semi-log scale chart will be much higher than the same price pattern measured on an arithmetic scaled chart. Downside measuring objectives will not be as low on a semi-log scale chart as compared to the target from the same bearish price pattern as reflected on an arithmetic scaled chart. This quandary obviously needs answering. What gives futures trading its allure? Answer: The high leverage or gearing. It does not take a doubling or tripling of price to produce sizable percentage gains or losses. In forty years of examining futures charts on a daily basis, Ken Shaleen has found that futures charts plotted with an arithmetic scale do meet the standard vertical height measuring objective dictated by the pattern. Note that this objective could be calculated mathematically - and arrive at the same price target as the graphic method of taking the height and physically moving it over to the breakout level. The bottom line is that the use of an arithmetic price scale on a daily futures chart is perfectly acceptable.

5-1

In general, individual equities (stocks) move slower than anything listed as a futures contract. And the equity market is dominated by buy-and-hold type investors who do not use margin accounts to leverage their holdings. This type of market participant also tends to be on the long side of the market. They are looking for individual stocks that are increasing in price at a good rate. An upsloping trendline on a semi-log scale chart is increasing at a constant percentage increase. This is the stock that an equity investor wants to find. They will have an easier time finding such a buy-and-hold candidate on a semi-log scale chart. In addition, the universe of equities to choose from is huge compared to the 60-80 actively traded futures contracts. The bottom line is that individual equity traders should find semi-log scale charts very useful.

Two exceptions There are several situations in which a futures chartist might find changing the price scale from arithmetic to logarithmic, helpful. 1. After a large price move has occurred on a daily chart. This would happen if a valid Flag pattern forms. This is a very dynamic price pattern. The measuring objective in a Bull Flag pattern can be far surpassed using an arithmetic scale. Determining the graphic objective using a log scale will result in a much more aggressive (higher) target. 2. Looking a long term (weekly or monthly) continuation chart of the nearest-toexpire future over a long time period (years) might be better viewed with a log scale for price. This is especially true for the stock index futures - where a long term bull market existed. And, the price blowoff to the upside in the physical commodity futures in 2007-08 can be kept in context by using a log scale.

5-2

Example of Semi-Log Scale

Figure 5-1 London Gold - monthly

5-3

Comparison of Arithmetic and Logarithmic Price Scales Gold - Monthly Chart

nearest-to-expire future

Figure 5-2A

Figure 5-2B

Price drop off the March 2008 high (1033.90 on the near-by future) seems much larger on the arithmetic scale chart.

5-4

Chapter Six Trading with the Trend

A trader is different from an investor. The trader is operating in a very short time frame - down to seconds and minutes. For the day trader, scalper, market maker, it is the speed of execution and small commissions that produces their profits. The investor desires to hold the position and therefore has a much longer time frame. A position trader is an investor who wants to ride a price trend. They have the best chance of making a profit by identifying the direction of the major price trend, ascertaining its health (strength), and trading with it. Even a casual observation of historic charts indicates the presence of many sustained price trends - up or down. Sometimes these trends last several years. Yes, there might be some sizable moves against the major trend, but the long term trend continues. Trendline Construction Defining a price trend is easy; trading with it is not so easy. Higher and higher price highs and higher and higher price lows is the basic definition of an uptrend. Figure 6-1 is a plot of this definition. Each upmove extends to new high price territory while the selloffs do not decline as far as the price drop on previous selloffs.

Figure 6-1 Price Uptrend

6-1

Downtrends are characterized by lower highs and lower lows. See figure 6-2. In a downtrend it is possible to construct a straight line tangent to two price highs. Typically these are the highs of the price bars on whatever time frame chart (minutes, hours, days, etc.) Is being used. This line is referred to as the downtrend line. Figure 6-2 Price Downtrend

In a bull market, the uptrend line is the one drawn across (tangent to) the low of the price bar at each of the relative price lows. This is shown twice in figure 6-3. It only takes two points to determine a straight line. If a third point lies on any trendline, a significant charting event occurs. The trendline takes on much greater significance. The trend direction has much greater validity. Figure 6-3 Uptrend Lines

6-2

Any trendline, when initially drawn, should not cut thru prices. This is the cardinal rule of trendline construction. The line must be tangent to two relative highs or lows. Subsequent price action (after the trendline has been drawn) may cut thru prices - and obviously has to when the trend changes. A three point trendline is infinitely greater in its technical significance than a two point line. A trader strives to find the technical situation where a market is residing above or below a three point trendline. The trend will continue until a close beyond the trendline occurs. Even then, the trend does not completely reverse; it changes the trend to sideways. Violating a three point trendline is cause for exiting an existing position. It is not enough evidence to completely reverse direction. Addition technical corroboration is needed. Figure 6-4 shows a three point downtrend line on the Dec 2008 Crude Oil future. Figure 6-4 Three Point Downtrend Line

Note that the 1 st trendline was only constructed using two points. It did not hold.

6-3

A chartist never erases a properly drawn trendline once it has been constructed. This is especially true for shorter trendlines used to delineate the boundary lines of an orthodox price pattern. Reference to the chart months or years later will allow the technician to see what the prevailing price configuration implied - even if the ensuing price move proved the analysis incorrect. Knowledge of the technical personalities of each market will be gained by review of the success or failure of each identifiable price pattern. Another aspect of trendline construction is the use of a line constructed parallel to the trendline. It is known as a parallel objective line or a return line. Some chartists construct this line as a reasonable price target for the extent of the next move. In bull markets, this upper line is often exceeded as the price up move goes into a greater vertical angle of ascent. Still, it is a reasonable line to place on the chart. Trend Channels Although not as common as most traders might think, markets sometimes do trend within a well defined channel - where the trendline and parallel objective line contain the price swings. The weekly continuation chart of the nearest-to-expire British Pound future in figure 6-5 is a good example. Violation of the three point upsloping trendline with a weekly close below the line would signal that the major price uptrend has stopped - and turned the market to neutral. Figure 6-5 Trend Channel on a Weekly Continuation Chart

6-4

Chapter Seven Analysis of Support and Resistance

Locating support and resistance is probably the most important part of any classical bar charting analysis. Properly locating the price levels where support or resistance would be expected, allows the trader to: 1. Set entry points for new positions. 2. Place protective stop orders. 3. Determine if a price trend is present. 4. Locate where the prevailing trend, if any, would change.

The concept of support and resistance is one of the most talked about, but least understood aspects of technical analysis. In the process of defining support and resistance, the following observation is useful: Ask 100% of all the would-be technicians in the trading world where overhead resistance is located on the following line graph (Figure 7-1) . . . . Figure 7-1

. . . . . and the overwhelming majority would state that the highest point on the graph is resistance. This seems logical because the previous price rally did stop at that level once before. But, if a simple price high was overhead resistance, the price upmove would turn down when approaching that level again. An uptrending market would never materialize. And Double Top formations would be much more prevalent. Markets tend to trend most of time, rather than reverse. The double formation is not a common reversal pattern. 7-1

Giving a price high on a chart a name, a technician should simply refer to it as a Benchmark High. This is illustrated in Figure 7-2. Figure 7-2

Similarly, a price low on a chart (Figure 7-3) should be referred to as a Benchmark Low and should not automatically be labeled as support. e.g., Figure 7-3

Market makers in equities, foreign exchange dealers, and scalpers on an open outcry futures floor do notice that price often temporarily stops in the area of a previous price high or low. The operative word is temporary. Position traders do not operate as close to the market as these highly active traders. It is usually impossible for all but the most active day traders to make money by fading a market as it reaches a benchmark high or low. The daily and 10-minute charts (Figures 7-8 & 9) of the Dow Jones Industrial Average illustrates how a benchmark low can act as temporary support. The June 16 low of 8570 on the daily high low close bar chart was well known and easily seen by all traders. Look at what happened during the trading session in which the price decline again approached 8570 seven weeks later. 7-2

The supposed support was only slightly violated with the 8562 low on a 10minute price bar (Figure 7-9). The next time down on the 10-minute chart the cash Dow stopped exactly at 8570. The selloff had reached support! (not really). The next time down the Dow moved thru 8570 like a knife thru warm butter. If an aggressive short term trader wants to label a benchmark low price as possible temporary support - fine. This trader must realize that if a healthy price downtrend trend is in progress, this low will be taken out - usually quite dramatically. W hat then, is a more classical definition of support and resistance? First, support, if any, resides below the current price level. Think of support in two words - underlying support. Resistance, if any, is above the current price. Resistance is always - overhead resistance. The chartists bible Technical Analysis of Stock Trends, by Edwards and Magee is still the best source of a definition. Specifically, . . .

A former price high (or top) should be underlying support in the ensuing price uptrend. To find support, a chartist looks down and to the left on a chart and locates the closest former price high. See Figure 7-4. Figure 7-4 Support is: a Former Top

7-3

A former price low (or bottom) on a chart should be overhead resistance in the ensuing price downtrend. To find resistance, a chartist looks up and to the left on a chart and locates the closest former price low. See Figure 7-5. Figure 7-5 Resistance is: a Former Bottom

Traders are obviously interested in what will happen as quotes test a benchmark high or low. It is important not to harbor a preconceived notion that a price rally has to stop at a price level that it (temporarily) stopped at before - or that a price sell-off has to bounce off a price level that stopped a sell-off previously.

Relating volume to this concept: The lower the volume on the price sell-off to test support, the more likely the support will hold. The lower the volume on the rally to test resistance, the more likely the resistance will hold. The strength (ability to halt the price move) of the support or resistance, in theory, should be directly proportional to the amount of dealing previously done at that particular price level. Quotes may have to eat into support or resistance until they get to a level where a sufficient amount of prior trading occurred - to finally produce the friction necessary to stop the price move.

7-4

Putting support and resistance into practice:

Traders wishing to initiate a new long position would place the order to buy at a price slightly above the support price. A good definition of slightly is two minimum price fluctuations. Traders wishing to initiate a new short position would place the sell order at a price just below (2 tics) the resistance price. And, the price should not end in zero. Make any buy order end with a price of 1 or 6. Make any sell order end with a price of 4 or 9. The public gravitates to common, all too common, prices ending with zeros. Protective stop orders should be entered far enough into support or resistance so the price move would have to inflict an inordinate amount of damage to the support or resistance before the trader would get knocked out of the market. It is far easier to make this statement than to quantify it. Every market has its daily noise. The stop must be placed beyond this noise. Some markets, the stock index futures in particular, are notorious for eating farther into support or resistance than any other market. The proliferation of undercapitalized day-traders makes for this phenomena. Another important note: Simply violating support or resistance (with a close into it) does not automatically change the direction of the prevailing price trend 180 degrees. It changes the trend to neutral. Additional technical evidence must be present to warrant entering a new position. Locating support and resistance on a chart is an age-old technique. It does not require a sophisticated computer package. It is an excellent place to begin the analysis of any new chart.

7-5

Example of Underlying Support

Airtouch Communications Common Stock Daily Chart
Figure 7-6

7-6

Example of Overhead Resistance

Figure 7-7

7-7

Dow Jones industrial Average (cash) - Daily

Figure 7-8

7-8

Dow Jones industrial Average (cash) - 10 Minute

Figure 7-9

7-9

Blank

7-10

Chapter Eight Price Pattern Recognition

Overview
The high, low and last price for a specified time period are the basic inputs for a classical bar chartist. In specialized forms of charting, such as candle charts, the opening price is also recorded on the graph. In the move toward 24-hour electronic dealing, there is some question about the benefit of the next days open when it happens a nanno-second later than the previous days close. Volume, if available, is an important aspect of any chart - especially a daily high, low, close bar chart. Open interest on a daily futures chart is also a helpful aid in assessing the validity of a price pattern. This course manual primarily contains examples of futures charts. Reader desiring more illustrations of individual equity charts are referred to the classic: Technical Analysis of Stock Trends, by Edwards & Magee.

Price Pattern Recognition

Price patterns that tend to appear regularly on a classical bar chart are one of the most valuable tools for a technical trader. These patterns indicate the high probability direction of the major price trend, often carry specific measuring objectives - and, most importantly, alert a trader where things are going wrong. The rationale behind the use of price charts is that all the supply and demand information has to be synthesized into a single piece of information - price. If fundamental forces are at work moving the market, the price will show it. Also affecting the price movement is activity by speculators who utilized information other than fundamental supply/demand data, such as psychological judgements. These market moving decisions are also reflected in the price. Although some of the decisions may be based on hopes, fears, greed, they repeat themselves often enough to allow the technician to make a future forecast based upon past price patterns. Only a handful of orthodox price patterns exist. They divide themselves into two distinct groups: Reversal patterns or continuation patterns. Chapters 9 thru 17 detail these formations. 8-1

Hierarchy of Bar Charting Analysis

1. Identify the direction (if any) of the major price trend

2. Check the internal health of the trend by using volume and open interest.

3. Locate the closest underlying support and overhead resistance price levels.

4. Look for the possibility that an orthodox price pattern may be present - or in the process of forming.

5. If an active price pattern is present, determine the measuring objective and the stop-out price level.

6. Create a trading plan based on the bar charting conditions that exist; often this is best accomplished when the market is not open.

7. Do not try to force a conclusion via assuming that a reasonable risk / reward trade must be present; sometimes no trade is the best trade.

8. A chartist need not get married to a single market; diversify the analysis.

8-2

Chapter Nine Head & Shoulders Reversal Pattern

The Head & Shoulders (H&S) price pattern is the most reliable reversal pattern. It can occur as either a Head & Shoulders Top or a Head & Shoulders Bottom. This classical bar charting price pattern physically resembles a head & shoulders when found at a market top. For clarity, when referring to a bottoming of a price trend, technicians should use the phrase H&S Bottom rather than inverse Head & Shoulders. By using this terminology, there will much less confusion whether the trader is talking about price topping or price bottoming. Before discussing the pattern in detail, there are several overall observations: 1. Before a chartist should be looking for any reversal pattern, there must be a definite price trend in place - so there is something to reverse. 2. Five obvious reversals of the minor price trend must be present on the chart to form the pattern. Figure 9-1 clearly shows these five reversals. Figure 9-1

9-1

Development of a Head & Shoulders Top: In a price uptrend, a corrective selloff (from reversal point one) and the subsequent rally to a new price high (off the low of reversal point two) implies that the uptrend is firmly entrenched. These first two reversals of the minor price trend will create what will be the left shoulder of the completed pattern. The highest price in the pattern will be called the head. It is quite possible that extremely high (blowoff) volume might be present on the price move up to form the head. And if the item being charted is a futures contract, total open interest might decline on this final rally. If so, the proverbial early warning signal will have been flashed. At this juncture in the development of an H&S Top (at a price level near the high of the head), there is no overhead resistance present - only underlying support. The ability of a technician to properly locate where support should be present is of paramount importance. A price decline that violates support is the first important sign that a reversal pattern could be developing. This is a sign of weakness in the major price uptrend. W hen this occurs, a classical bar chartist begins to study the graph in earnest. It cannot be emphasized enough, that the selloff from the high of the head must violate the support level. If not, the definition of a bull market will continue to be present. This price decline below the support (which is in the process of becoming the high of the left shoulder) can halt anywhere in the vicinity of reversal point two. The price decline does not have to stop exactly at the same price level of reversal point two. Next, a price rally (off reversal point four) must occur. Ideally this rally will occur on lower or declining volume. It is especially bearish if the volume on this developing right shoulder takes place on volume readings lower than what occurred on the rally for the left shoulder. If so, the chart is really telling the technician that the market is in the process of trying to reverse the major price uptrend. This last price rally in the developing H&S Top must stop below the high of the head. Symmetry (more on this later) would suggest that the high of the right shoulder will be in the general price area of the top of the left shoulder. At this time, any long positions should be closed out. Note that because the pattern has not been officially activated (with a close below the neckline), a conservative chartist should not be attempting to pick the high of the right shoulder and trade it via a new short sale. 9-2

Activating a Head & Shoulders Top: The neckline is the 2-point minor trendline drawn tangent to the lows of the price bars at reversal points two and four. These two price lows are the reactions on either side of the head. The style convention for drawing this boundary line of the pattern is a dashed line. Any classical bar charting price pattern is not officially activated until a close outside the pattern is posted. In the case of a Head & Shoulders Top this must be a close below the neckline. Once this occurs, the chartist has strong technical evidence that the longer term trend has changed direction.

How Far Will Prices Move: Elementary textbooks about trading often refer to establishing a risk to reward ratio. Sounds good, but do these books ever detail how to determine this ratio? Answer: No. One of the helpful aspects of classical bar charting price patterns is that a definite measuring objective can be derived. And, most importantly, the technical trader will know where the pattern breaks down i.e., fails. This enables a chartist to gain insight as to what the risk is, given the expected price move. W ith any active H&S formation (Top or Bottom), price is expected to move a minimum of the vertical distance from the extreme of the head to the neckline as measured from where price penetrated the neckline. Note that this distance is not measured from the close beyond the neckline; it is the price at which the neckline was broken.

What to do at the Measuring Objective: A close below the minimum downside measuring objective in an H&S Top is not required. As long as price trades below the objective any time during the international 24-hour trading day - the pattern has worked as expected. Traders should try to follow the old adage of letting profits run and cutting losses. W ith this in mind a trader should take partial profits when the minimum measuring objective is reached and look for additional technical signs that a greater percentage of the open trade (short) should be closed.

9-3

For sure, a trader should have been following the market down with trailing

protective buy-stop orders. Ideally, the protective stop would be located well into or above the top of the closest overhead resistance.

Additional signs that more open trades should be removed would be blowoff volume, a decline in open interest (futures only), or the posting of one of the four minor trend change indicators (see Chapter 17). The chartist will also be looking for one of the classical continuation patterns, Triangle or W edge, to form. This would indicate the existing price trend has further to travel - and additional directional positions can be established.

Symmetry: It is amazing how often the Head & Shoulders formation exhibits symmetry with respect to the magnitude of the two shoulders (figure 9-2), time spent during the development of the two shoulders, and the number of shoulders. More than one shoulder on each side of the head produces a complex H&S formation (more on this later).

Pay attention to what happens on the left side on the chart because it could be duplicated on the right side of the chart.

Figure 9-2

If a selloff penetrates this former price high, it is the first price signal that H&S Top may be forming. Then note the magnitude and duration of the previous reaction. If a right shoulder develops, it may prove to be very similar.

9-4 When to Enter a Position: After monitoring a market closely and seeing a potential Head & Shoulders

pattern developing, it is very tempting to lead off and establish a position prior to the official breaking (close below) the neckline. This is a dangerous practice. An aggressive short term trader, monitoring intra-bar price activity, might see price trading beyond a neckline within the price bar. A sharp reaction then takes price back within the pattern. Since the close of the price bar was not beyond the neckline, the formation was not set off. Read, whipsaw. It takes discipline to wait for the penetration of the neckline and the confirmation of high volume if it was an upside breakout from an H&S Bottom. W hether or not a corrective price pullback (rally in the case of the H&S Top) will take place is the age old question that causes difficulty for a chartist. Volume can be a useful aid. The higher the volume associated with any breakout, the less likely a pullback will occur. A look at the various possible shapes of a Head & Shoulders formation (Figure 94) shows that it is impossible to make a blanket statement concerning when and where to establish an initial position. The following is a reasonable strategy. 1. Establish a 50% position on any closing penetration of a valid neckline. 2. Establish the remaining 50% position on: A. A pullback to just below (2 minimum price tics) the neckline, or B. A pullback to the closest overhead resistance.

Where to Place the Protective Stop: Any H&S formation is not destroyed until the extreme of the head is taken out. But, placing a protective stop higher than the high of the head in a Head & Shoulders Top results in a risk to reward that is, by definition, slightly worse than one to one. Even though the H&S formation is a highly reliable pattern (86 - 88% reliable), this is not an attractive risk to reward ratio. The suggestion is to construct a failsafe trendline to gauge where a chartist should become worried about the pattern not working. This line is drawn tangent to the extreme of the head and the right shoulder. The protective buy-stop would be placed just above this downsloping line on a Head & Shoulders Top pattern. Note that the protection slides down (is tightened) with time. This is as it should be with any protective stop order. 9-5 Additional considerations:

It takes time to reverse a price trend. The five reversals of the minor price trend

in a Head & Shoulders formation represent the battle between the forces of supply and demand. It pictures the influx of new information or moods that are necessary to change the direction of the trend. Most of the charts in this manual are daily, high-low-close bar charts. This time frame is most suited for the interpretation of volume and open interest on a futures chart. The H&S formation works on any time frame chart - from minutes to months. For the extreme time frames of minutes or months, volume is not usually a consideration. For the day trader, it is the speed of execution that is important, not the dutiful analysis of volume and open interest (the latter being impossible on an intra-day chart). And for the long term position trader, the new fundamental inputs are what drive prices. Figure 9-3 H&S Top

9-6

Every Head & Shoulders has a Different Shape

Figure 9-4

9-7

Head Shoulders Top

& on a Weekly Chart

Figure 9-5

Zinc - LME

It is interesting to note that Zinc was in a major bear market during the same time frame that Gold and Silver were setting new all-time highs. Believing the pattern on the Zinc chart produced the correct directional view for this metal.

9-8

Head & Shoulders Bottom

A valid Head & Shoulders Bottom formation contains two important volume considerations: 1. Ideally volume on the price selloff to form the right shoulder will be low or declining. 2. The upside breakout, a close above the neckline, should occur on a noticeable increase in volume during that trading session (or price bar). A classical bar chartist does not trust an upside breakout of any price pattern or 2-point trendline that occurs on less than high volume. An apparent upside breakout that has been engineered solely by technical traders will not usually generate enough volume to be valid. Needed is the smart money, the sophisticated fundamental traders doing enough buying such that, in combination with any technically based traders, volume will escalate to a distinctively higher level. W ith specific regard to a daily futures chart, total open interest would ideally increase on the upside breakout. Declining open interest would mean that the price rally was due to net short covering. Short covering on an upside breakout does not automatically invalidate the breakout; it does imply a high likelihood of a price pullback (decline) toward the neckline. As with the H&S Top, the minimum upside measuring objective of a bottom is determine in exactly the same fashion. The vertical distance from the head up to the neckline is graphically added to the neckline when a closing price is posted above the neckline. The Swiss Franc future in figure 9-6 is an example of a Head & Shoulders Bottom on a daily chart and figure 9-7 is an H&S Bottom on an hourly (Gold) chart.

9-9 Figure 9-6 Head & Shoulders Bottom

9-10 Figure 9-7 Head & Shoulders Bottom on an Hourly Chart

Not e the symmetry of three shoulders on either side of the low of the head. 9-11

Figure 9-8 Head & Shoulders Bottom on a Monthly Chart

This multi-year Head & Shoulders Bottom occurred in the years just after the TBond future began trading. Volume is not normally analyzed on a weekly or monthly chart. The growth curve upward in volume can be seen as this future gained in popularity as a trading and hedging vehicle. Paul Volker was the chairman of the US Federal Reserve Bank at the time when inflation was running rampant. The left shoulder selloff began with the October Massacre in 1979. The Fed stopped pegging interest rates and tightened the money supply. The prime rate reached a high of 21 1/2% - and the back of inflation was broken. The large H&S Bottom depicts this process of increasing long term interest rates and then a bull run in price that continued to set new price highs as late at September 2008 (124-24) on this notional 6% coupon bond. 9-12

Complex Head & Shoulders Formations

The term complex refers to the fact that two or more of something is found in the pattern. This could be two sets of shoulders on either side of the head. Or it could be Double Top for the head. A chartist should always be thinking - symmetry. Most complex H&S formations tend to exhibit symmetry in the number of price gyrations seen on either side of the head. Multiple measuring objectives are possible if several necklines exist. There is no technical reason that the largest obtainable objective should not be considered viable. A chartist does have to be aware that any H&S formation cannot be expected to retrace more than the price move that preceded it. This was the problem with measuring objective on the Copper chart at the end of this Chapter. Figure 9-9 Possible Complex Head & Shoulders Top

913

Figure 9-10 Complex Head & Shoulders Top on an Hourly Chart

9-14

Historic Charts
Figure 9-11 H&S Top failure to form

The most widely advertised (possible) Head & Shoulders Top since Edwards and Magee wrote their book
Quote from a member of the Chicago Board of Trade on the trading floor in 1982

9-15

Can Technical Analysis be used in a manipulated market?

9-16

Manipulation ended badly Bre-X common stock - in Canadian Dollars Suspended May 8, 1977

Quote from the Wall Street Journal, Wednesday May 7, 1997: Bre-X Minerals, Ltd. shares staged a spectacular collapse to near-worthless levels in frantic trading as investors reacted to the news that the companys supposedly huge gold discovery is really a highly engineered fraud.

9-17

Example of a Head & Shoulders Failure

9-18

Historical Chart

The severity of the price pullbacks are what make stock index futures trading so difficult. Often price moves much farther into classical support or resistance levels than any other futures contract. In contrast, individual equities chart very well. 9-19

Multi-year Head & Shoulders Top

on a Monthly Chart of a U.S. Equity Index

The Dow Jones Industrial Average and the S&P 500 Index also met a Head &

Shoulders Top objective on their monthly charts during the week ending October 10, 2008.

9-20

Failure of a Head & Shoulders Bottom to Reach

Its Measuring Objective - and Why

Any H&S formation, Top or Bottom, cannot be expected to re-trace more than the price move that preceded it. This price extreme is the limiting factor if application of the standard height objective results in a price beyond where the previous price move began. This was the case in the Copper chart below. Adding the vertical height of the pattern, 5.04, to the neckline break, 100.00, resulted in a conservative (arithmetic) upside price target of 105.04. This was higher than where the previous price downmove began - at 104.10. The May Copper did attack 104.10 with the 103.62 daily high. But, the traditional objective at 105.04 was never reached. Copper - May 1992

92 1

Notes

9-22

Chapter Ten Broadening Formations

As a chartist gains experience, the pitfalls associated with each particular price pattern are encountered. There is a reversal formation known as a Broadening Formation that contains five reversals of the minor price trend - just like the Head & Shoulders pattern. A theoretical example of a Broadening Top can be seen in figure 10-1 and an actual example in figure 10-2. Because the fifth reversal of the minor price trend takes place beyond the extreme of a possible head, it keeps the technician honest in not jumping to the premature conclusion that an H&S is forming every time four reversals of the minor trend are in place. There is no way to know beforehand that a Broadening Formation might be developing. Although, a downward sloping neckline when a possible H&S Top might be forming and an upward sloping neckline when a possible H&S Bottom might be forming is a big clue. Patience and knowing that such a pattern does exist (although not frequently) is the first step. A well thought out game plan for an entry into a new position is a must. According to the old Edwards & Magee textbook, there is no specific measuring objective. Ken Shaleen, a.k.a. CHARTW ATCH will suggest using a standard double measuring objective using the last two price extremes. This technique worked out to the exact point in the Japanese Yen example in Figure 10-3. One further note. The price volatility associated with any Broadening formation is more likely at a top in any of the physical commodity futures. This is why it is unusual to find this formation at a price bottom on this type of chart. Price bottoms on the physical commodity future tend to be more rounding. Carrying on the notion of where price volatility would be expected, in an interest rate future, it would be at high rates - i.e., low prices. This can be seen on the TBill chart in figure 10-4. On the currency futures or spot foreign exchange charts the volatility could be at either extreme. This is what happened on the Yen future in figure 10-3. 10-1

Figure 10-1 Theoretical Broadening Top

Figure 10-2

Broadening Top

10-2

Figure 10-3 Broadening Bottom

10-3

Figure 10-4 Broadening Bottom and Complex H&S Top

10-4

Chapter Eleven Double Top and Double Bottom

Double Top
The definition is simple, yet the misunderstanding involved with the Double Top is extraordinary. Two price highs at approximately the same price level is only one-half of the definition. Prices must decline below and close below the low point established in-between the two price highs before a Double Top pattern has been officially activated. Figure 11-1 Double Top

Many traders see a price move stop in the same general area of a previous price reversal. But what trading usefulness does this have? Should a short (or long in the case of a possible Double Bottom) be taken? The answer is no. A new position should not be initiated until the pattern has been activated. Before proceeding with examples, Ken Shaleen a.k.a. CHARTW ATCH must share some historical observations: 1. A double formation, Top or Bottom, is not a common pattern on a future or forward chart. The pattern is more prevalent on a cash or spot market chart where the basis convergence in a futures contract is not continually pulling the future toward the cash price. 2. A double formation is not all that reliable price pattern. Often the pattern is activated and some price progress toward the measuring objective is made - but the minimum objective is not reached. This negative does not automatically mean that a technician trading this pattern will suffer a loss. Proper money management and the movement of a protective stop order can mitigate the poor performance of the pattern. 11-1

The measuring objective of a Double formation is straight-forward. In a Double Top the vertical height of the pattern is subtracted from the price low in-between the two highs or lows. To determine the height of the pattern, a straight line (a 2-point trendline) is drawn tangent to the two price highs. The height of the pattern is from the low point in-between the twin highs up to the line. This is a method of graphically averaging the two highs if they are not exactly the same price. This is schematically shown in Figure 11-1. After the breakout there may be a price pullback, rally in the case of a Double Top. If so, it is easy for a chartist to determine the location of overhead resistance. It is the now former price low in-between the twin highs. A conservative trader might wish to wait before initiating a new short until a pullback to test the overhead resistance is posted. Note that there was no pullback on the weekly Euro-fx chart in Figure 11-2. Figure 11-2

11-2

Double Bottom
In a Double Bottom, price must close above the high point in-between the two (approximately equal) price lows before a trading decision can be made. Because this is an upside breakout, it must occur on a noticeable increase in volume. A chartist should not trust any upside breakout that takes place on substandard volume. Once an official upside breakout is posted, the upside measuring objective is clear. Price should rally to as far above the high point as the vertical distance inbetween the twin price lows. This is schematically shown in Figure 11-3. As usual, there may or may not be a price pullback following the upside breakout. It is always difficult to know whether a pullback is going to be posted. Thus, a trader has to weight the opportunity loss of not initiating a new long on the breakout. Yes, the risk / reward of a new long placed only a pullback is better but, the pullback might not happen. W ith either the Double Top or Bottom, a protective stop should be placed far enough beyond where the classical resistance or support begins - such that a pullback would have to do an inordinate amount of damage to the expected resistance or support level.

Figure 11-3 Double Bottom

11-3

Double Bottom and H&S Bottom on non-storable commodity futures charts

11-4

This is a classic chart. Note the typical open interest action in the transition from a bull to bear market. After the downside breakout from the Double Top, look at where the pullback stopped - at the overhead resistance. 11-5

Should Price Pattern Recognition be Applied to Options Charts?

Price plot of June 70 Call option

Price plot of underlying instrument June 1985 T-Bond future

The answer to the question posed above is - No Because an option is a wasting asset the bar charts do not lend themselves to classical price pattern analysis. A trader should do all the technical work on the chart of the underlying instrument - and then pick an options strategy suitable for trading that pattern. Time erosion caused the price of the 70 strike T-Bond Call option to decline much farther than the pullback after the price decline into the Double Bottom occurred on the chart of the underlying instrument. 11-6

Chapter Twelve Continuation Patterns

The Symmetrical Triangle Formation

Figure 12-1, Valid Symmetrical Triangles

In the art of classical bar charting, the Symmetrical Triangle formation is the premier continuation pattern. It is created by a net sideways price movement on the chart, after which, a significant directional price move ensues. Note that this new price move can be in either direction - but there is an overwhelming tendency for a valid triangle to act as a continuation pattern. This means that the prevailing price trend that was in progress prior to the triangle forming, continues.

10-1

Most of the time markets are trending. The major price trend is not continually reversing from bullish to bearish and then reversing again. If the Symmetrical Triangle is best classified as a continuation pattern, it is not surprising that this pattern is the most common of all bar charting formations. It works on all time frame charts - i.e., 5 minutes to monthly.

Directional Considerations: W hen this formation occurs on a high-low-close bar

chart, it leads to a continuation of the prevailing price trend approximately 75+% of the time. Note that this pattern can be a reversal pattern - although this occurs in less than 25% of the cases. It is the lower probability case where the triangle acts as a reversal pattern that keeps a chartist honest by not always taking a directional position within the pattern prior to the breakout.

Shape: It only takes two points to define a straight line. Two converging line
segments form a proper Symmetrical Triangle. Four reversals of the minor price trend are necessary to create the two converging boundary lines. Each line must slope in a different direction. The lower boundary line must slope up; the upper boundary line must slope down. The two lines intersect at the apex of the triangle.

Although the definition of a Symmetrical Triangle is not so strict as to require that the triangle be equal lateral (line segments of the same length) or equal angular (same angle for each converging line), the word symmetry is important. One side of a valid Symmetrical Triangle should not even approach twice the length of the other side.

Figure 12-1, Valid Symmetrical Triangles shows the ideal bearish and bullish formations. Any triangle is not an active pattern until a closing tic mark is posted beyond one of the boundary lines. (More on this later.)

Where to Locate Reversal Point One: The first reversal point (1) in any valid
triangle is always at a relative price high in a bull market or at a relative price low in a bear market. Remembering this simple rule will keep a trader from incorrectly assuming that a valid triangle is present. Figure 12-2, An Incorrect Interpretation shows how a bad mistake can be made. The more likely outcome in Figure 12-2 is a Head & Shoulders Top rather than a Symmetrical Triangle as a bullish continuation pattern.

12-2

Figure 12-2, An Incorrect Interpretation

Volume Within the Triangle: A general statement can be made with respect to
volume within any triangle: It usually moves irregularly lower. This is common sense. Because the price swing near reversal points 1 and 2 are greater than the price swings near reversal points 3 and 4 it is not surprising that volume would typically be greater at the beginning of the net side ways price movement. A chartist should not use a microscope, looking for nuances in volume within the consolidation pattern. The downsloping line overlaying the volume in the chart of Exelon common stock (Figure 12-3) is a reasonable example of how volume contracts within a symmetrical triangle.

12-3

Figure 12-3, Exelon Common Stock

10-4

Breakout Volume: One of the first things that any novice bar chartist learns is that
a valid upside breakout from any price pattern should occur on a noticeable increase in volume. This is due to the idiosyncrasy of the trading public to prefer to be on the buy side rather than on the sell side. A low volume upside breakout is not to be trusted. Figure 12-3, Exelon Common Stock shows volume of 2,807,400 shares on the second breakout. Although this was not a major jump in volume, it was higher than the first breakout from the inner Symmetrical Triangle. The section on Re-drawing the boundary lines later in this chapter explains what happened with the two triangles that formed.

Downside chart breakouts (a close beyond the lower boundary line of the triangle) do not have to occur on increased volume. Often volume increases a trading session or two after a downside breakout. This is because the market is making it painfully aware to the bulls that they are long and wrong. The undercapitalized longs are forced to liquidate their losings positions; volume increases during this panic exit.

Location of the Breakout: Another vital consideration of any triangle breakout

is its location with respect to time The breakout cannot occur too far into the pattern. Too far is defined as more than 3/4 of the horizontal distance from reversal point one to the apex. If a breakout is posted beyond this 3/4 distance, the triangle loses its effectiveness. Anything can happen. Price could move up, down, or sideways.

Measuring Implication: The majority of classical bar charting price patterns

utilize the vertical height of the pattern to gauge the future extent of the price move. This convention is also applied to the triangle formation. The vertical height of any triangle is always measured at reversal point 2 to the opposite boundary line. This is true whether the triangle is found in a bull or bear market. This distance is added to or subtracted from the price of the boundary line on the price bar which posted a close outside the triangle. This is minimum distance price is expected to move. Figure 12-3, Exelon Common Stock shows that the vertical height of the largest Symmetrical Triangle measured straight up from the 59.75 low was 1.87. Adding this distance to the 60.76 breakout price yielded an upside measuring objective of 62.63. This arithmetic objective was met.

10-5

Old time chartists often use a graphic method of obtaining an objective. This takes the vertical height of the pattern and moves it over to the breakout. Note that this method of obtaining an objective will result in the same objective if the price scale used is arithmetic. Use of a logarithmic scale for price will result in higher absolute upside objectives and not as aggressive downside objectives compared to an arithmetic scale chart. Futures traders use arithmetic price scales and equity chartists tend to use logarithmic scales.

Pullback?: The question of whether or not a price pullback (after a valid breakout)
will occur is always difficult for a chartist to answer. Volume may provide some insight. For sure, a technical trader must keep the size of any position small enough to withstand the adversity if a substantial price pullback occurs. After a valid breakout, underlying support (for an upside breakout) is created at the price level of the breakout. Additional support should be present at the boundary line just penetrated (Note that this line is moving farther away during a pullback). Support should also be present at the price level of the apex. There is nothing special about the location of the apex in time, after a breakout. The last bastion of support (again, in the case of an active bullish pattern) is the opposite (lower) boundary line of the triangle. A violation of the opposite boundary line or its extension beyond the apex, even intra-price bar, officially destroys the triangle. This last support (line) gives the technical trader a worst case scenario for the triangle - with it still working as expected. Thus, in theory, the protective stop order should be placed just beyond the opposite boundary line. The good news is that this stop order is continually tightened as time passes.

Reliability: An educated guess as to the reliability of an active Symmetrical

Triangle meeting its minimum measuring objective is 76 - 78%. This probability is about 10 percentage points below the reliability of a valid Head & Shoulders formation. The H&S pattern (top or bottom) is the most reliable of all classical bar charting price patterns.

10-6

Redrawing the Boundary Lines: A fact of life concerning the triangle formation
is that sometimes reversal points 3 and 4 have to be relocated. This usually happens when the two boundary lines of a possible triangle converge too quickly. This is shown in Figure 12-4, Re-drawing the Boundary Lines.

Figure 12-4, Re-drawing the Boundary Lines

The more difficult case (of having to relocate the boundary lines) is contained in Figure 12-3, Exelon Common Stock. Exelon did experience what looked like a valid price breakout to the upside on October 10. Admittedly, volume at only 2,268,300 shares was not impressive. The price move up after the breakout did not exceed the first point in the triangle. Then, a severe price pullback(decline) occurred; the pullback entered the triangle and destroyed the formation by violating the opposite(lower) boundary line. However, the extent of the pullback did not take out reversal point two (59.75). An ensuing price move in the direction of the major price trend (up) created the conditions where a second set of reversal point 3 and 4 were present. 10-7

Re-drawing the two boundary lines on the Exelon chart, continuing to use the original points 1 and 2, resulted in a larger triangle. It became a viable Symmetrical Triangle. It is this sometime problem of re-locating reversal points 3 and 4 that drops the reliability of the triangle formation below that of a Head & Shoulders reversal pattern.

Another Method of Obtaining a Measuring Objective: A chartist can also

construct a parallel objective line to construct a reasonable triangle measuring objective. This line is derived from a point and an angle. The line begins at reversal point one and increases/decreases at the same angle as the opposite boundary line of the triangle. This is shown in Figure 12-5, Another method of obtaining a Triangle measuring objective. The assumption is that price will touch this parallel objective line. It is a secondary objective. To resolve the dual techniques of obtaining a triangle measuring objective, a chartist could plot both targets. W hen the closest target is reached, existing positions can be partially liquidated. The market would then be followed by a trailing protective stop order. Figure 12-5, Another method of obtaining a Triangle measuring objective

10-8

What to do when the Measuring Objective is Reached: As the economists

say all other things being equal, 3/4 of the long or short position should be closed out when the height measuring objective is met. Note that a close beyond the objective is not required. The market must simply trade at or beyond the objective any time during the international 24-hour trading day. The reason that 1/4 of the trade should be kept open is because of the word minimum used in conjunction with the measuring objective. The price move could go much farther. A trader is trying to follow the old adage of letting some profits run.

Additional technical factors such as blowoff volume, declining open interest (for a futures contract) or a Key Reversal price posting (a minor trend change indicator) would prompt a trader to remove 100% of all directional positions.

Other Continuation Patterns: If either boundary line is horizontal, the pattern

that forms is a relatively rare variation of the triangle; a 90 degree angle is present. This results in an Ascending (bullish) or Descending (bearish) continuation pattern. The market wants to penetrate the horizontal line. The Right Angle (90E) form of triangle is found more frequently on cash (spot) market charts than on futures charts. This is due to basis convergence that is constantly occurring on any futures chart. This is the narrowing of the difference between the cash price and the futures price as time passes. If both lines slope in the same direction, yet still converge, the resulting pattern is a Rising or Falling W edge. Sometimes two entities that tend to move in the same direction with one another will exhibit a Symmetrical Triangle on one chart and a W edge pattern on the other. They are both continuation patterns. Examples of right angle formations and wedges are located in chapters 13 and 14.

Conclusion: The Symmetrical Triangle is a common bar chart pattern. W hen two
reversals of the minor price trend are present, the technical trader receives a get ready signal. There should be a profitable trade ahead - but patience is required. If the next two reversal points create the proper conditions for a Symmetrical Triangle - the risk / reward parameters for a directional trade appear. And, food for thought: A trader equipped with a knowledge of option strategies has a much larger arsenal of positioning techniques within a Symmetrical Triangle prior to the breakout. A plain vanilla, all or nothing, long or short only trader must wait for the breakout before entering a new position. 10-9

Example of a Symmetrical Triangle Crude Oil - Dec 2008

Light - NYMEX

10-10

Chapter Thirteen Right Angle Triangles

A Right Triangle is so named because one of the boundary lines is horizontal, and a 90-degree angle is present - a right angle. As a variation of a Symmetrical Triangle, the same number of reversals of the minor trend (four) are necessary before the two converging boundary lines of a Right Triangle can be constructed. The expected direction of the breakout is thru the horizontal boundary line of the pattern. The two forms of Right Triangles are shown in Figures 13-1A&B. Figure 13-1A

Ascending Right Triangle . . . is a bullish pattern

(price will ascend out of it)

Figure 13-1B

Descending Right Triangle . . is a bearish pattern (price will descend out of it)

13-1

The risk and reward parameters in a Right Triangle are distinctly defined. Assessing the theoretical risk in any new trade is of paramount importance. The risk parameter in a trade based on any active Triangle pattern is a price move beyond the opposite boundary line. In a Right Triangle, the initial protective stop loss order would ideally be placed slightly (say 2 minimum price tics) beyond the sloping boundary line. The reward parameter of any Triangle pattern is the same. Price is expected to move beyond the boundary line penetrated, by the vertical height of the pattern. This height is always measured from reversal point two - to the other side of the Triangle. Because the expectation is that price will breakout thru the horizontal boundary line, a chartist / trader can lead-off by placing a directional position within the Right Triangle prior to the breakout. Note that this is in contrast to waiting for the breakout from a Symmetrical Triangle - even though the high probability (75-80%) is for the Symmetrical Triangle to act as a continuation pattern. As an experiment, figure the approximate risk to reward of taking a directional position within a Right Triangle prior to the breakout. It will be a risk of 1 to a reward of 3. This is such a favorable ratio, that a trader will want to place this position every time a Right Triangle is present. Be careful, Right Triangle are relatively rare patterns on forward or futures charts. As with the Double Top or Bottom formation, Right Triangles are likely to be more prevalent on a cash or spot chart - where constant basis convergence between the futures and cash market is not present.

And, as usual, markets tend to fall faster than they move up in price. This idiosyncracy is based on the outside public tending to favor trades on the long side of any market. Thus, it is important to place short positions within a possible Descending Right Triangle prior to the breakout. If not, a gap down, thru the lower boundary line, could then lead to the measuring objective being met - on the same price bar as the breakout!

13-2

cending Right Triangle Eurodollar Time Deposit Futures

June 1989 (Objective was met)

13-3

Ascending Right Triangle US Treasury Bond future

Dec 1982

The time period during which the Symmetrical Triangle formed is examined on Point & Figure chart in Chapter 18. 13-4

Descending Right Triangle

The parallel objective line on the Cotton chart was not reached - but the traditional height measuring objective was met. A chartist can place both objective on the chart - and begin removing positions when the first objective is reached. 13-5

Notes

13-6

Chapter Fourteen Wedge Formations

A W edge formation is a continuation pattern. Price is expected to continue in the same direction it was going when the W edge began to form. As with the premiere continuation pattern, the Symmetrical Triangle, a W edge requires four reversals of the minor trend for the two converging boundary lines to be constructed. A W edge begins its development in similar fashion to the Triangle; however, the fourth minor reversal of the trend is such that both boundary lines slope either up or down.

Rising Wedge
A Rising W edge is a bearish pattern. Both converging boundary lines slope up. A close below the lower boundary line of the Rising W edge activates the pattern. The objective is to take out the lowest point in the formation (reversal point one). A schematic diagram of a Rising W edge is shown in Figure 14-1.

Figure 14-1 Rising Wedge

14-1

Figure 14-2

Rising Wedge - Gold, Dec 2008 NY

14-2

Falling Wedge
A Falling W edge is a bullish pattern. Both converging boundary lines slope down. A high volume close above the upper boundary line is necessary to activate the pattern. Note that high volume is necessary to validate the upside breakout from the Falling W edge but is not necessary (although ideal) on a downside breakout from a Rising W edge. The minimum upside measuring objective of a Falling W edge is to take out the highest point in the pattern (reversal point one). A close above reversal point one is not required - only an intra price bar move above it. Figure 14-3 is a schematic diagram of a Falling W edge. Figure 14-3 Falling Wedge

Figure 14-4 Falling Wedge Plywood futures

14-3

Falling Wedge on the Gold / Silver Ratio

Monthly Chart

14-4

Rising Wedge Soybean Oil March 1981

Note the quote from the Edwards and Magee book. The Rising W edge is a very powerful sign that a bear market is in progress. 14-5

What if a boundary line is very close to being horizontal?

W hen a boundary line is so close to horizontal that there is a question of what pattern is developing, additional charts of markets that are thought to move in concert must be analyzed. 14-6

Chapter Fifteen Flags & Pennants

The Flag Flies at Half Mast

A Flag is a dynamic and potentially very profitable price pattern. Flags occur within the course of a rapid, straight-line price move. They mark a half-way, breath-catching, resting place before the prevailing trend resumes. Flags normally slope against the trend. In an uptrend, the body of the Flag slopes downward; several low volume small range down days produce the body of the Flag. In a price downtrend, the Flag is composed of several narrow range price up days. Figures 15-1A&B show a theoretical Bull and Bear Flag.

Figure 15-1A Flag in a Bull Market

Figure 15-1B Flag in a Bear Market

15-1

On a daily futures chart, the body of the Flag seldom lasts more than five trading sessions before a resumption of the trend occurs. W hen an apparent breakout is occurring, a quick trading decision is necessary. This because a limit move that trading session is frequently the result. On an individual equity chart, the body of the Flag can extend up to weeks in duration. Everything moves faster when the item is listed as a futures contract. The beauty of a Flag is that the risk is small compared to the expected reward. In addition, the trader will know quickly if the newly placed position is a winner or loser, and is not faced with an agonizing wait for confirmation of the wisdom of the trade. There should never be a pullback (reaction) back into a Flag pattern after a valid breakout. One hundred percent of all existing positions predicated on the Flag pattern should be removed once it has reached its minimum measuring objective of duplicating the rapid straight-line price move that preceded it. Historical observation has shown that once a Flag objective has been reached, a violent price move in the opposite direction often occurs. Any trailing protective stop order would more than likely be executed. Therefore, a trader should take profits at the objective and try not to give back the significant gains that were made in so short a time period.

Three caveats: 1. Because of the dynamic nature of a Flag pattern, a chartist will want to find this pattern as often as possible. Be careful, it is not a common pattern. A Flag should really only fly in new life-ofcontract high or low ground. A proper Flag will not be found within a trading range. Look to the left on the chart; ideally there will no price activity in the price range of the Flag for quite some time. 2. Flags work best on daily time frame charts. The suggestion is not to look for this formation on intra-day charts. The reason is that a shock variable (from an economic report) will cause a financial future to move swiftly on say, a 10 minute chart. This will make the 10 minute chart look like a possible flag pole is present. After moving net sideways for several price bars is there another shock variable to sent the market an equal distance away? Usually not. 3. No market can go below zero to the downside. Therefore, a conservative method of obtaining a downside measuring objective is to measure down from the high in the body of the Flag instead of from the Flag breakout. Notice this nuance in figure15-1B and the actual application on the Silver chart in fig. 15-3.

15-2

Bear Flag Silver - Dec 2008

New York Figure 15-3

Note that the start of the flag pole on the Silver chart in figure 15-3 began at the breaking of a 2-pont trend (the two points used to construct the line are off the chart to the left). The measurement did not start at the relative price high of 1809.50. The measurement always starts at a previous breakout. Also note that because this commodity is bounded by zero on the downside, a conservative measuring objective subtracts the 265.80 point flag pole distance from the 1523 high in the body of the Flag on this arithmetic scale chart. 15-3

Example of a Flag Failure

Four trading sessions later

15-4

Bull Flag

15-5

Comparison of Hourly and Daily Charts U.S. Treasury Bond futures June 1985 Hourly Daily

15-6

Chapter Sixteen Gap Theory

16-1

Four Types of Gaps

16-2

16-3

Gap Theory - Graphical Summary

16-4

Suspension Gap

16-5

Ex- Dividend Gap

16-6

Island Formation

16-7

Island Top Chesapeake Energy Corp (CHK)

16-8

Gap Theory Exercise Gilts Dec 1995

Classify this gap

See the next page for the answer and how it came out.

16-9

How it Came Out Gilts Dec 1995 (Two days later)

Because the close was within the trading range, the gap was a Pattern Gap. It was closed the next trading session.

16-10

Suspension Gaps

Suspension Gaps, within a 24-hour bar will only appear on a hand constructed chart - until the chart package programmers add a considerable amount of sophistication to their algorithms. See page 2-7 for a mechanically reproduced Corn chart. 16-11

Gap Analysis Soybeans - Nov 1999

Because the Triangle objective had been met, the gap between 435 and 440 initially looked like it could be an Exhaustion Gap. W hen it wasnt quickly filled - it had to be re-classified as a Measuring Gap. Also see the Corn chart on the previous page and the mechanical version on page 2-7. 16-12

Chapter Seventeen Minor Trend Change Indicators

Market participants with short term trading horizons, e.g. day traders, often ask: How can bar charts be utilized for their type of dealing? One of the answers to their query lies in the short term forecasting significance of minor trend change indicators. There are four of them: 1. 2. 3. 4. Key Reversal Inside Range Outside Range Mid-Range Close

It must be emphasized that these configurations are helpful in gauging only what might happen the next trading session. In fact, the next trading session could even be the next major world time zone! As such, they change the minor trend in the opposite direction for as little as one price bar. The end of a major price move could be signaled by one of the minor trend change indicators - but this assumption must not be given too much weight. The first step in applying any of these indicators is the identification of the direction of the minor price trend. A technician will examine the previous three price bars. If there are three higher highs, the minor trend is considered to be up. If one of these one-bar indicators is then posted, the expectation is that the next price bar will register a lower low than the indicators price bar low. Note that nothing is being predicted for the location of the next price bars close. If the minor price trend is down (three consecutive lower highs), and a minor trend change indicator appears, a higher high is expected. Figure 17-1 Key Reversal.

17-1

Key Reversal

The definition of a Key Reversal High, after a series of higher price activity, is a new high and a lower close. It forecasts a lower price low. A Key Reversal Low, after a series of lower price activity, implies that a higher high should be set. Figure 17-1 depicts both of these conditions. The Key Reversal on a daily chart is one of the most widely known yet least understood reversal pattern. A high percentage of traders jump to the erroneous conclusion that a Key Reversal marks the end of a major price move. It might, but this is asking for too much. Regarding it as minor trend change indicator will allow for the construction of a much safer trading plan.

In most cases, the minimum measuring objective inferred by any of the four minor trend change indicators is fulfilled during the next price bar. It must be noted, however, that a more rigorous definition of worked as expected means that the objective was reached before the one-bar pattern is destroyed. This means that several price bars could be posted before the objective is achieved - as long as the pattern is not destroyed. As an example, figure 17-2 contains a Key Reversal (K-R) at a price high. The expectation was that a lower low, than the K-R, should be posted. Note that the next price bar, after the K-R, did not achieve this objective. But neither did this next price bar cause the K-R to fail. A failure would mean that a higher high was set. The example continues with the second price bar after the Key Reversal setting the expected lower low. The pattern worked. The Inside Range that was posted after the Key Reversal simply perpetuated the original indicator. Figure 17-2 Key Reversal that worked as expected

These one price bar reversal indicators tend to work best on daily bar charts. But, a trader should not overlook their significance on an hourly or weekly chart.

17-2 Why should these price configurations work?

They all indicate that the forces of the bulls and bears have reached an equilibrium. The forces previously in control of the market are losing momentum but opposing forces have not gathered enough strength to turn the trend; the tide will turn in the next price bar. The analogy of a see-saw is applicable. Both sides are in balance (temporarily), but the rival forces are about to gain the heavier weight to move prices in the opposite direction - for at least one price bar.

Key Reversal on a Daily Chart Several additional criteria are important to the understanding of the Key Reversal phenomenon. W hen using a daily high-low-close bar chart, trading off a presumed Key Reversal early in the trading day can be extremely hazardous. Seldom does a Key Reversal make itself evident early in the dealing day. More often, the price move to a higher or lower close occurs in the last 20 minutes of trading. Thus, evidence of a Key Reversal early in the day is more likely to result in prices making another violent move to a new low or high - before the late move in the opposite direction. Note the anatomy of a Key Reversal on the daily & hourly charts of the NASDAQ-100 future on October 10, 2008 in Figure 17-3. Price was down, then up, then down and then finally up in the last hour of trading.

Volume Considerations By generating the wicked price gyrations, often expanding the range for the day several times in both directions, high volume will result. Thus, a technician does not trust a Key Reversal that occurs on average or low volume. In the old open outcry environment in the futures markets this required access to a knowledgeable source down on the trading floor for a guesstimate of volume activity during the trading session. The move to electronic trading, with on-line volume, has made the interpretation of this valuable internal variable much easier.

17-3

Anatomy of a Key Reversal

NASDAQ-100 eMini Dec 2008 future October 10, 2008

Figure 17-3A

Daily Chart

Figure 17-3B

Hourly Chart

17-4

Open Interest Considerations W hy does a Key Reversal take place? Because the losers are finally giving up!

They are forced to wait (sweat) almost all day with their losing positions, and finally surrender - at any price, just to get out. he old adage on an open outcry trading floor was that: When the last weak short is finished buying, the silence is deafening

There are no more buyers - so price plummets. This situation results in open interest declining. The participants with the correct market judgement going into that trading session are taking profits; the loser is getting to the sidelines. Both sides liquidate. Thus, a technician does not trust a Key Reversal if open interest increases. The change in open interest will not be known during the trading session. Confirmation of the drop in total open interest will not be known until the next day.

Inside Range
W hen an entire price bars activity is contained within the previous bars price range, it generates an Inside Range. The prior minor tend direction is expected to be reversed - usually the next price bar. For example, after three or more higher highs, an Inside Range appears; the next bars low is expected to be lower than the price bar that formed the Inside Range. The rationale is as explained previously. In the example above, the bulls have been in control of the market but cannot force price to a higher high during the Inside Range. By the same token, the bears have not gathered enough strength to reverse price to the downside by generating a lower low. The forces are in balance. It is likely that the momentum will shift to the bears for as short a duration as one price bar. This will take prices down the next price bar, resulting in a lower low than the Inside Range price bar. This is shown in the diagram on the left in figure 17-4.

17-5

Figure 17-4 Inside Range

Outside ange
A widely swinging market resulting in a price range where the high is higher and the low is lower than the previous price bars activity is known as an Outside Range. It is expected to reverse prices - usually the following price bar.

Both supply and demand forces are evident, but it appears that the forces are becoming more balanced and the prior trend will be interrupted, if only temporarily. This is shown in figure 17-5. Figure 17-5 Outside Range

17-6

Mid-Range Close

W hen prices close equidistant between the high and low of the price bar, a MidRange Close is formed. Traders did not know where to close prices; the trend previously in progress was not dominant going into the end of trading for this time period. There is an excellent probability that an adverse move against the minor trend is about to occur. A technician should look for the opposing forces to gain the stronger hand - at least for one price bar - via moving prices in the appropriate direction beyond the range of the Mid-Range Close price bar. W hat if the close is, say, 24 tics under the high of the price bar and 25 tics above the low of the same price bar. And the market trades in one-tic minimum increments. An exact Mid-Range Close is impossible. This is ok. The theory that the market is trying to change its short term direction should still hold. Figure 17-6 contains examples of Mid-Range Closes. Figure 17-6 Mid Range Close

Ther e some markets in which it is too easy to post a Mid-Range Closes - and therefore the indicator should not be trusted as much as normally would be expected. An example would be the Eurodollar Time Deposit futures. Often the daily range is so small that, by default, the close is close to a mid-range. The opposite type of market would be the stock indices. Seldom does the close of the day land in the middle of the range. W hen it does happen, the indecision that surfaced that trading session is likely to result in a reversal of the minor trend.

17-7

Locate the Minor Trend Change Indicators on this Chart

and record whether or not they worked as expected

Nickel,

LME 3-month, daily

1 78

17-8

Chapter Nineteen Mathematical Models - Trend Following

Historical Overview

The mid-1970's saw the creation of commodity funds. Their proliferation was of such magnitude that hundreds of millions of US Dollars was being traded by these funds. Unlike the next influx of commodity funds just after 2000 that were long only index funds touting physical commodities as an asset class, the first crop of funds were directional. They could be long or short. Often the traditional commodity funds were operated by a very small number of traders. How could a single trading advisor be knowledgeable about the fundamentals affecting the 40+ actively traded futures contracts at that time? The answer is that he could not. The trading advisors turned to mathematical models for entry and exit signals for the futures in their portfolio. There are two diametrically opposed mathematical approaches the directional traders could use: Trend Following vs. Relative Strength. This latter category has numerous additional subtitles such as Over Bought / Over Sold, Momentum, Oscillators, and Stochastics. A good estimate is that 90% of all managed money in the futures market that is traded as a fund uses a Trend Following system. The rational is: 1. Try to be aboard every new emerging price trend. 2. Follow the old adage of allowing profits to run while cutting losses. 3. Utilize diversification to limit risk. This chapter will discuss trend following techniques, the next chapter will discuss the Oscillator concepts.

19-1

Trend Following

Even though its possible to see sustained price trends just by looking at a chart, technical trend indicators can help confirm that a market is in a trend. One of the best and most commonly used trend indicators is the moving average. A moving average distills market action into a single line on the chart, smoothing out the sharp peaks and valleys that usually occur in futures (or equity) price movement, and resulting in an easier-to-read picture of price direction A Simple Moving Average A simple moving average is merely the arithmetic average of price data during a pre-determined period of trading. The more data included in the average (generally meaning the longer the trading period), the slower the average moves relative to the market itself (because each individual piece of data has less impact). Although traders could use computers to calculate moving averages based on every single price quote for a desired time period, most just use the closing price. For example, to calculate a simple 10-day moving average, add all the closes for that period (10 data points) and divide by 10. Then, plot each days moving average calculation (or whatever time period is being used) on a bar chart, and connect each point with a line to get a smoothed version of the price action. A moving average is recalculated every day. Price data from the oldest day (or period) in the average is dropped (i.e., not used in the new calculation) and the new days data is used instead. Thus, for a simple 10-day moving average, only the most recent ten days closing prices are used, the eleventh day is dropped, and the average "moves" or fluctuates with the market (but at a slower pace). Analysts determine the time period, or the amount of data, used to calculate a moving average based on whether theyre seeking a long-, intermediate- or shortterm view of the market. The most popular futures moving averages generally fall in the 10- to 40-day range, although they can be calculated for very short time periods, such as 5- or 10-minutes. The time frame also depends on the type of markets being studied. For example, a 200-day moving average has traditionally been popular in analyzing stock market trends, because stock indexes have, until recently, moved rather slowly and stayed in long-term trends. But 200 days are an eternity for the futures markets, and that time frame would be of little value if the goal is identifying current trends. 19-2

The plot of a simple 10-day moving average using the daily closing price has been placed on the daily chart of the Dec 2007 Euro-fx future.

Identifying Trends Analysts have come up with all sorts of rules and conditions to determine whether a market is in a trend but, basically, a market can be considered in an uptrend if prices are above the moving average line and the moving average itself is trending higher. Its the opposite for a downtrend. An uptrend is considered broken if prices close below the moving average; a downtrend is broken if prices close above the moving average. This provides the basis for a trading system. 19-3

In practice, technical analysts often experiment with more than one moving average (computers make this easy) to see which one "fits" the price action best, a practice that is called "optimizing." For example, in an uptrending market, prices might consistently bounce off of the 40-day average but consistently violate the 20-day average; this tells the analysts that in this market a 40-day moving average is a better trend indicator. This type of "optimization" is not without pitfalls, however. Traders must keep in mind that markets often change character and volatility. W hen that happens a moving average that had been giving fairly accurate trend signals might suddenly become "obsolete" while another moving average based on a different time period could exhibit a better fit. Note what happened to the simple 10-day moving average on the Dec 2007 Euro-f`x futures chart when price moved net sideways in a triangular consolidation. In nicely trending markets such as the June 2007 Canadian Dollar future, a 40-day moving average only had two whipsaws. They occurred when the long term price downtrend was in the process of changing to a long term price uptrend.

19-4

Using Multiple Averages

Since a single moving average doesn't always give a clear indication of the trend, technical analysts often use a combination of two or three averages that move at different speeds (calculated based on different time periods). Analysts commonly work simultaneously with a 9-, 18- and 40-day average to track short-, intermediate- and long-term trends. If all three averages are moving higher, its a good bet that the market is in an uptrend. If there is divergence among the moving averages, for example two are moving higher but one is headed lower, then some judgment is required, and a trend follower might trade less aggressively or stay out of the market until all the averages come into agreement. An example of a chart with three moving averages plotted on it is the June 2007 Swiss Franc future.

19-5

So many traders follow some of the moving averages, such as the ones mentioned above, that the averages themselves can become the source of significant support and resistance. For example, the 40-day moving average is so popular as a trend indicator, and often a component of trend-following systems used by futures fund managers, that prices often rebound or fall from that average due to the sheer number of traders entering positions against that level. Conversely, a violation of the 40-day moving average can trigger significant liquidation of trend-following positions, even if this is not warranted by the fundamentals, and this can create a false trend reversal signal. Always keep in mind that a moving average is a lagging indicator which gives a signal after the underlying market has embarked on a new trend. Deciding which two averages to use is up to the individual trader and also poses a dilemma. Using two shorter term averages to generate cross-over signals (say a 4- and 8-day moving average) has the advantage of signaling quick changes in market direction and enabling a trader to take a position early in a trend. However, this approach does involve a fair number of incorrect signals and whipsaw losses. Using longer term averages (say a 20- and a 40 day) generates fewer false signals and fewer whip-saws, but suffers the disadvantage of signaling positions to be taken well after a trend has begun, and this choice poses a larger risk per trade than the shorter-term approach. Traders, accordingly, must be very clear on whether theyre looking to capture short-, intermediate- or long-term price moves and how much risk theyre willing to take, before deciding which moving averages to track. Weighted Moving Average Since any combination of moving averages will result in erroneous signals to varying degrees, technical analysts have tried to diminish the error potential by weighting the averages. W ith this approach, they attach more importance to the most recent price data, believing that "what's happening now" is more significant than what happened previously. Other techniques for limiting error include exponential "smoothing," offsetting the averages (shifting the moving average line to the right on the chart), and calculating an average of averages. All of these methods attempt to shift the position of the moving average relative to the actual price movement so as to get a better trading signal, one that indicates a trend change sooner but with fewer false cross-overs.

19-6

The dashed line on the Dec 2007 Japanese Yen future is a weighted 10-day moving average. Notice how it reacts slightly faster to price changes than the simple 10 day average.

Already discussed is the fact that analysts/traders often "optimize" moving averages, a fairly simple process with computers and one that can help limit the number of false trading signals over a selected period of price action. But because markets are volatile (exhibit large or small price swings), an optimized average may not work well beyond the "test" period. In practice, simple moving averages can work just as well as jazzed-up versions. 19-7

Moving Averages & Trendlines Analysts also use moving averages with other trend indicators such as trend lines or oscillators to improve the reliability of the trading signals they get from the averages. If prices violate a trend line and the moving averages also give a crossover signal in the same direction, its considered a double indication that the trend is changing. Note the chart example of the Sept 07 New Zealand Dollar future. It contains an important 3-point upsloping trendline. This line was broken at the same time as the downward crossover of the price and moving averages.

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Trend Following Funds

Managed money has become a major factor in commodity markets since the late 1970's. Large sums that are now invested with fund managers. These managers typically use technically-based trend following systems (unless they are a long only commodity index fund). The impact of the collective actions of the trend following funds can be particularly pronounced when a market is changing trend. Even though fund managers know this and try to design trading systems using different trend indicators (including some pretty esoteric stuff), they still often enter and exit markets at about the same time. Thus, whenever a trend changes, everyone gets a signal regardless of the technical method theyre using and the rush of buying or selling that occurs often creates a big move in the market. Although most managed funds use sophisticated technical systems, traders can get a feel for where concentrated fund activity might take place by watching the 40-day moving average. It provides a pretty good proxy for fund-trend following buy and sell activity.

Moving Average Divergence Another way to use moving averages is to keep track of the difference between two averages. This difference, or "divergence", is an indicator of a markets momentum. In other words, if a market is in an uptrend and a short-term moving average is rising at a faster pace than a longer term average, the price momentum is increasing to the upside, i.e., the difference between the short-term and long-term average is widening, implying that the trend is healthy and may have further to go. More importantly, since momentum usually shifts before the trend does a change in momentum can help anticipate a change in trend. Moving average divergence is sometimes tracked on a type of chart called a histogram (a type of bar chart) but is more often plotted against a zero line. For example, if the value of the fast moving average is above the slow moving average, the difference between them (subtract the value of the slow moving average from the fast moving average) is a positive number and is plotted above the zero line. If the fast moving average is below the slow one, the divergence is a negative number and is plotted below the zero line. These types of charts are easy to construct by hand, but the math-challenged need not worry since moving average divergence indicators are included with most charting software packages. 19-9

The Sept 2007 British Pound futures chart contains a simple 10 day and 21 day moving average. At the bottom of the chart the difference between the two averages is plotted as a histogram.

19-10

Chapter Twenty Mathematical Models - Oscillators

Among the myriad of mathematical models, a category exists that tries to locate price levels where the existing price trend could be in the process of exhausting itself. The trader is looking for a reversal of the price trend. In general, this type of model can be referred to as an oscillator. Some of the specific names for these models are Relative Strength Index, Stochastic, Momentum, Overbought / Oversold. Note that this type of model is diametrically opposed to the trend following models. The Relative Strength (RSI) and Stochastic models are two of the most popular. They strive to locate overbought and oversold levels on a price chart. The theory is that if a trader can identify a market that is in an overbought condition, the trader will want to take an opposite (i.e., short) position. The calculation of these indicators is simple arithmetic. Personal computers and plotting packages have made their use widespread. The indicator can be calculated over any number of discrete periods. An active futures trader rarely uses more than 13 periods - e.g. 13 hours or 13 days to calculate the resulting number. This output from the RSI or Stochastic model will be a number that can vary between 0 and 100 but it will never reach either extreme. The trick is to set the parameters that constitute overbought and oversold. Pioneering work in the field of mathematical models was the book New Concepts in Technical Trading Systems, by J. W elles W ilder. In it, W ilder suggested a 14 day period and parameters of 70 for overbought and 30 oversold in the equity market examples. There is nothing magic in these threshold levels. A technician has to back test the model to determine suitable parameters. And even these are unlikely to be optimal - as the markets change their characteristics.

Using threshold levels of 80 and 30 on the 9-day Relative Strength Index for the Dec 2007 British Pound future produced a successful short sale (when the Index when above 80) and a buy (when the Index went below 30). Note that the RSI remained in neutral territory while the price of the British Pound moved net sideways within a triangular consolidation. 20-1

20-2

A Caveat
Simply shorting a market when an indicator breeches a supposedly overbought level is a path to ruin. A general observation can be made: 17 consecutive profitable trades could be wiped out in one huge loss - where the value of the indicator continues to move farther into extreme overbought territory as a price move of unprecedented proportion takes place. And, it is difficult to determine an effective stop loss point when a market is in a runaway mode.

In an attempt to create a safer entry into a position, technicians have worked with not pulling the trigger on a new position unless a failure swing occurs. This means that a trader does not automatically place a new position when the indicator enters over territory. Rather, the trader watches for a pullback in the indicator back into neutral territory. The next push by the indicator into over territory is watch very closely. If the indicator fails to go to a new extreme and then moves back into neutral territory again - this is the time to enter.

The entry signal just detailed was present on the hourly chart of the Dec 2007 Euro-fx future after the price run up. The 9-bar RSI moved above the overbought threshold of 84, dropped back below 84, moved up above 84, and then moved down below 84. This last move down was the short sale entry signal. W hen this signal occurs it is not unusual to have a divergence between what price is doing and what the indicator is doing. Note that the Dec Euro set a new price high - but it was not capable of pulling the 9-hour RSI above the level marked A on the chart.

20-3

W hether this does provide a safer entry signal is open to conjecture. Traders are always trying to refine their ability to construct risk and reward parameters. And unlike classical bar charting where a measuring objective is present from an orthodox price pattern, an RSI or Stochastic model does not provide a price target.

20-4

Relative Strength Example

Hourly Chart

20-5

How it Came Out

20-6

A Get Ready Signal on a 9-Week RSI

20-7

How it Came Out

The failure swing and divergence led to a sizable price rally.

20-8

Chapter Twenty-Two Spreads & Spread Trading

The bailiwick of old time commodity futures traders were the grain and oilseed spreads. The different seasonal factors plus the fact that distinct crop years existed, lent itself to spreading - where the trader was long something as well as short something. This form of trading also has a place in the modern markets. Before listing some spreading considerations in the form of an outline, the overwhelming premise for a chartist must be stated. That is: All the hopes, fears, and moods are reflected in once single item - the price. In the case of a spread, traders must be paying attention to the specific differential between two prices. The price of one arbitrary item cannot be subtracted from the price of another arbitrary item and expect that the plot of the spread differential would/should act in classical fashion. A trader has to do a minimal amount of fundamental analysis - and come to the conclusion that enough traders are paying attention to the specific relationship between the two items in question. If so, the spread should be charted. The reader is encouraged to examine the chapters that follow, on classical bar charting and then return to this chapter and then look at the various spread charts - most of which contain a price pattern.

I. Overview
1. W hy trade spreads? A. Lower risk? Not necessarily. B. Attractive margins? - in futures, yes C. Staying power? - Sometimes

22-1

D. Aid in trading outright positions? - Definitely i. Spread indicating tightness of supply (or the opposite)

ii . Picking the best month for an outright position iii. Bull spread not working, may imply only a temporary technical bull move is occurring.

2. Proper mentality toward profiting from a spread = think the difference only

3. Definitions A. W hat is a straddle? A spread B W hat is a switch? A spread

C. W hat is pairs trading? A spread using individual equities D. W hat is a cross? A division, one currency into another, neither being the US Dollar E. W hat is arbitrage? Exactly the same product, different location

4. Do not spread to protect a loss - ever!

II. Storable vs. Perishable Futures Contracts

1. Definition of a storable futures contract To be considered storable, the futures must be one which can be accepted on delivery when the near-by (long) contract matures - and be eligible without re-inspection for delivery, when the more distant contract which was sold, matures. 22-2

2. Spreading mentality of old-time CBOT vs. CME members A. W hich Chicago futures exchange traded predominantly storable commodities and which traded perishable commodities (according to the definition stated above)? The Chicago Board of Trade = storable. B. W hy did Crude Oil futures flourish on the New York Mercantile Exchange (and not the CBOT)? i. W hat did the NY Merc trade in the old days? Potatoes ii. Is Crude Oil (futures) a storable commodity? No

III. Charting a Spread

1. Can / should a spread be charted? A. Some minimal fundamental analysis must be done to determine the answer. B. An example of a spread that should not be charted: the Canadian Bacon spread (Canadian Dollar - Pork Bellies).

2. Use close-only prices A. W hich futures close to use? Pit close. B. Is there a close in the cash foreign exchange markets? No

3. Does the plotting software support spread definitions? A. W eighting the legs differently - e.g., 3 Cattle vs. 4 Hogs B. Three items i. Soybeans vs. Meal & Oil ii. 3 Crude Oil vs. 2 Gasoline & 1 Heating Oil

22-3

4. Plot: A. Near-by minus more distant month (inter-delivery spread) B. Difference in Dollar value: Second named item is subtracted from the first named item (inter-commodity spread)

5. Spreads tend to trend vs. create classical price patterns

6. A flat on spread chart = a minor trend change indicator. See any of the various current charts

IV. Definitions
1. Normal market: Near-by trading below back month

2 . Inverted market: Near-by trading above back month

3. British terms: A. Contango = normal market B. Backwardation = inverted market

V. Order Entry
1. Place order as a spread order: A. Indicate a specific (limited) spread differential B. Do not leg into a spread. C. Do not leg out of a spread 22-4

2. State long leg first - if calling the CBOT open outcry floor (Buy is on the left side of the order pad)

3. CBOT floor traders traditionally used positive numbers (or better is always implied) See Order Entry Example

4. Electronic spread entry places premium or discount on near-by contract.

5. Interest rate traders (at the introduction of T-Bond futures) used negative numbers (if applicable)

6. Last trade prices vs. where the spread is really trading, e.g., A. Dec - July Corn spread is quoted as 16 to 17 (premium July) B. Market order to buy Dec - sell July arrives; execution is at 16 . C. Market order to buy July - sell Dec arrives; execution is at 17. D. Better strategy for either side; enter limited order at 16 3/4 (split the difference)

7. Use of protective stop (loss) orders A. Mental stop - dangerous but necessary B. Determined location of stop based on: i. Money management ii. Spread chart C. Stop placed on the volatile leg vs. dead leg of the spread

D. W hen to exit - when the trendline is broken or (partially) when objective met 22-5

8. Limit price moves (future is locked limit up or down) A. Can a spread to exit from locked limit position (if any of the other futures contracts are freely traded). B. Can use options to determine where futures are trading. C. Do not buy last market to trade limit-up D. Do not sell last market to trade limit-down

VI. Limited Risk Spreads

1. Available only in storable futures contracts where calculation of carrying charges is possible.

2. Limited risk spread = long near-by vs. short deferred A. Risk is limited to move to full carry B. Reward is unlimited

3. Forward pricing A. The basis = cash price minus futures price (Basis in grains was unusually unstable (wide) when strong inflow of Index Fund money occurred in 2007/08)

B. How to compute full carry i. Interest cost Could be bankers acceptance rate, fed funds + 1 3/4 - 2% or prime, or prime +1% ii. Storage cost (0.15 cent/bu/day or 4 cents/bu/month for a 30 day month - as of April 2008) iii. Insurance cost - negligible, most often ignored iv. Commissions - very low for an exchange member v. Inspection / handling - if applicable 22-6

C. Risks in a limited risk spread i. Tendency for discounts to widen (toward full carry) with the passage of time - as maturity approaches ii. Price rise increases total value of contract & thus financing costs increases full carry iii. Interest rate increase (full carry increases) iv. Obtaining commodity that is not re-deliverable (KC W heat, Lumber) v. Buying cash commodity & unable to get it into position regular for delivery vi. Greater than limit move (down) by expiring future vii. Government intervention - ceiling on near-by future Unlikely - but it has happened

3. Question: How could (did) futures traders speculate on interest rate changes prior to the introduction of short term interest rate futures? (Answer: Storable commodity spreads trading near full carry) 4. Fallacy of using newspaper cash prices - dont do it.

VII. Some Specific Spreads

1 . Gold / Silver ratio A. Long term ratio (approx. 100 years = 32.5

B. Ratio on March 12, 2008 i. 48.82 (cash) and moving downward on monthly chart ii. 49.19 (Dec 2008 futures), on a bounce

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C. Dollar value of contracts should be approximately equal i. CBOT one Kilo Gold vs. CBOT 1000 oz Silver future = close enough to equal Dollar values. ii. Could weight the legs and/or plot a Dollar difference chart

2. S&P 500 Index vs. Dow Jones Industrial Average A. 95% correlation during majority of trading days B. Both dominated by large capitalization, blue chip stocks C. E-mini S&P 500 - E-mini Dow i. One-to-One ii. Ratio the spread = dollar neutral 5 x 6 or 10 x 11 (using 2007 year end prices) iii. Spread margin = approx. 10% of normal outright initial margin 3. Crack spread: i. 2 Gasoline & 1 Heating Oil vs. 3 Crude Oil ii. Spread = [{Gasoline price x 42} x 2 + Heating Oil price x 42 minus (Crude Oil price x 3)] divided by 3 iii. Spread result is in Dollars/barrel

22-8

Soybean Spreads
New Crop - New Crop

Old Crop - New Crop

22-9

A Cross Chart The old Sterling / D-Mark Cross

W henever a horizontal line is present on a chart - that is the line that the market wants to go thru.

22-10

Falling Wedge on the Gold / Silver Ratio

Monthly Chart

22-11

Notes

22-12