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The Essentials Trend Trading Techniques .pdf

Nome del file originale: The Essentials Trend Trading Techniques.pdf
Titolo: Option Trading : The Essentials Trend Trading Techniques™ √PDF √eBook ✔Download
Autore: Trend Strategist : The Technical Analysis Guidebook

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Congratulations! You are now enhancing your quest to become a successful trader. The tools and tips
you will find in this technical analysis primer will be useful to the novice and the pro alike. While there
is a wealth of information about trading available, has put together this concise, yet
powerful, compilation of the most meaningful analytical tools. You’ll learn to create and interpret the
same data that we use every day to make trading recommendations!
This course is designed to be read in sequence, as each section builds upon knowledge
you gained in the previous section. It’s also compact, with plenty of real life examples rather
than a lot of theory. While some of these tools will be more useful than others, your goal is to find
the ones that work best for you.

Technical analysis. Those words have come to have much more meaning during the bear market of
the early 2000’s. As investors have come to realize that strong fundamental data does not always
equate to a strong stock performance, the role of alternative methods of investment selection has
grown. Technical analysis is one of those methods. Once only a curiosity to most, technical analysis is
now becoming the preferred method for many. But technical analysis tools are like fireworks –
dangerous if used improperly. That’s why this book is such a valuable tool to those who read it and
properly grasp the concepts. The following pages are an introduction to many of our favorite analytical
tools, and we hope that you will learn the ‘why’ as well as the ‘what’ behind each of the indicators. In
the case of technical trading, quality is far more important than quantity.

The very essence of technical trading is really quite simple – spot trends, buy low, and sell high. The
most challenging of these is spotting the trend. Once you learn that, the buying and selling is easy.
Just as important is the ability to spot a non-trending market, so you can avoid it (or at least use
alternative strategies). To maximize profits from a trend, you’ll need to do two things. First, you want to
enter in the early stages of the trend. Second, you want to able to exit promptly when the trend is over.
To do that effectively, you must be able to spot exactly when trends start and stop. This book will show
you how to do both.

Table of Contents
Section 1 – Basic Charting
Page 4 Charting Page 6 Moving Averages Page 8 Support/Resistance Page 10
Envelopes Page 14 Bollinger Bands Page 16 Parabolic SAR Page 18 Checkpoint 1 Page 25
Checkpoint 1 Answer Key
Section 2 – Important Chart Patterns
Page 28 Inside/Outside Reversal Page 31 Hammer Page 32 Elephant Trunk (E.T.) Page 33
Cup & Handle Page 34 Head & Shoulders Page 35 Doji Page 37 Gaps Page 39 Two Bar
Tails Page 42 Checkpoint 2 Page 47 Checkpoint 2 Answer Key
Section 3 – Indicators & Interpretation
Page 49 Directional Movement Index (DMI) Page 53 Moving Average Convergence Divergence
(MACD) Page 57 Stochastics Page 61 Volume Page 63 Relative Strength Index Page 64
Relative Strength Page 69 Momentum Page 70 Acceleration Bands Page 72 Checkpoint 3
Page 79 Checkpoint 3 Answer Key
Section 4 – Sentiment
Page 84 Why sentiment? Page 85 CBOE Volatility Index (VIX) Page 88 Equity Put/Call Ratio
Page 91 Rydex Ratio Page 92 Checkpoint 4 Page 95 Checkpoint 4 Answer Key
Section 5 – Putting It All Together
Page 97 Oscillators Page 100 Momentum Indicators Page 104 Reading The Market Page 110
Checkpoint 5 – Final Exam Page 114 Checkpoint 5 Answer Key

Section 1: Charting
There are several types of stock price charts, and they all basically show the same information.
However, there are some very simple price charts that actually show much more information than just
price movement. Let’s look at a simple line chart first, and then compare that to a bar chart and a
candlestick chart. The two latter charts show you volatility, and possibly additional clues about
developing trends.
Line Charts
A simple line chart draws a line from one closing price to the next closing price. When strung together
with a line, we can see
the general price
movement of a stock over
a period of time.
Bar Charts
A bar chart also shows
closing prices, while
simultaneously showing
opening prices, as well as
the daily highs and lows.
The bottom of the vertical
bar indicates the lowest
traded price for that day,
while the top of the bar
indicates the highest price
paid that day. So, the
vertical bar indicates that
day’s trading range. The horizontal hash on the left side of the bar is the opening price, and the
right-side horizontal hash is the closing price.
Bar charts are also called “OHLC” charts, because they indicate the Open, the High, the Low, and the
Close for that particular stock.

Candlestick Charts
Candlestick charts show the same information as a bar chart, but in a different graphic format.
Candlestick bars still indicate the high-to-low range with a vertical line. However in candlestick charting,
the larger block in the middle indicates the range between the opening and closing prices. Traditionally,
if the block in the middle is filled or colored in, then the stock closed lower than it opened. In our
example, the ‘filled color’ is black. For our ‘filled’ blocks, the top of the block is the opening price, and
the bottom of the block is the closing price. If the closing price is higher than the opening price, then
the block in the middle will be hollow, or unfilled. In our example, you can see the consecutive
individual days of losses (filled blocks) that make up the major downtrend. When it reversed to the
upside in October, we start to see more hollow, unfilled blocks.
The purpose of candlestick charting is strictly to serve as a visual aid, since the exact same information
appears on an OHLC bar chart. The advantage of candlestick charting is that you can easily see
strength of trends
as indicated by
filled or unfilled
blocks, where the
bar charts may
be visually less

NOTE: Not all
candlestick charts
are drawn the
same. Some
charts use red
print for down
days and green
for up days. Or,
depending on the
background color
of your chart, you may see up days as filled blocks and down days as unfilled blocks – especially if
your background is a dark color.

Throughout this book, and throughout most technical analysis literature, you will see the word “bar” in
reference to a single piece of data on a candlestick or OHLC bar chart. While this usually refers to
one day on a chart, don’t assume it always does. A bar is simply one segment of time, whether it be
one day, one week, or one hour. When you see the word ‘bar’ going forward, be sure to understand
what timeframe it is referencing.

For the purpose of this workbook, we will primarily use candlestick charts to illustrate our

Moving Averages
One of the easiest ways to smooth out or “clean up” a bar chart or candlestick chart is to convert the
closing prices into a line. This is what a line chart (from section 1) does. However, this still doesn’t
help you see major trends if there are wide swings from one closing price to the next closing price,
since a line chart just shows you the progression from one day to the next. A moving average,
however, will even further smooth out a price chart to show you which direction a stock is going.
By ‘moving average’ we mean the average closing price of a stock for the last x number of days.
There are two types of moving averages: simple, and exponential.
The formula for a 3-day simple moving average would be:
Closing price 3 days ago + Closing price 2 days ago + Closing price 1 day ago

= Average 3

As each day passes by we drop the price from 3 days ago from the formula (since it becomes 4 days
old) and add the newest closing price. The result is a rolling average called the moving average. We
then plot these average prices in a line chart. The result is a much smoother (and more meaningful)
chart of a simple moving average.
By comparison, we can also use an exponential moving average. Again, we are plotting the
moving average of the last x days, but with an exponential moving average, we are giving more
weight to recent prices, and less weight to older prices. In doing this, we make the exponential
moving average move faster than a simple moving average.
A possible formula for a 3 day exponential moving average would be:
(Close from 3 days ago x 1)+(Close from 2 days ago x 2)+(Close from 1 day ago x 3) = Average 6


*(we have to change the divisor to 6 to adjust for the additional weight on more recent days)
As you may guess, these different formulas produce different results when charting their
values. Each particular method has both good and bad aspects.
Simple Moving Averages

Exponential Moving Averages

Draws a very smooth chart, Effective at showing recent price eliminating most fake-out
signals. swings.
Slow moving, which may cause lag
Subject to errant or meaningless
price swings, which can cause errant signals. (see early September in the example) In our example to
the right, we can see how the exponential moving average (solid) more closely follows the actual price
movement, where the simple moving average (dashed) is slower to respond and lags behind the
exponential average.

Using moving averages as
The most common use of
moving averages is simply to
interpret the cross above a
moving average line as a buy
signal, and a cross under a
moving average as a sell
signal. This would have given
you good results in the chart
above. The other common use
of moving averages is taking
crossovers of two moving
average lines as a buy or sell
signal. If the faster moving
exponential average line
crosses over the slower simple
moving average, that often
indicates a strong uptrend that
you want to buy into. In the
chart above, we can see that we got a crossover in late October that would have been a very good
purchase point. From the time we saw the crossover, the stock climbed from $20 to nearly $23 in a
matter of days.
Conversely, if a faster moving average crosses under a slowing moving average, then that is often a
sell signal. In our example above we can see that we received an accurate sell signal in the beginning
or March.
Timeframes of moving averages
In our sample formulas you saw how to calculate a 3-day moving average, but any number of days
could be used. The more days you use, the smoother lines you will produce, but you get lagging
signals. The fewer days you use, the sooner you will get crossovers, but at the expense of potentially
false signals. This situation is illustrated in the next example.

One of the basic technical signals is a cross above or below a moving average line. Using Accredo
Health (ACDO) in our example below, let’s assume that we’ll buy when shares move above the 10-day
exponential moving average, and we’ll sell when it falls below the 10-day exponential moving average.
As you can see, using the 10-day line may have resulted in a few errant signals.
In this next chart, after changing the 10-day exponential moving average to 20-day exponential moving
averages, we get a smoother line. Therefore, we see fewer crossovers, but the quality of the signal

Support /Resistance
In the chart below there are two straight lines plotted in relation to the price of the stock. The line above
the bar plots is the resistance line, which serves as a ceiling. The idea is that prices are not likely to
go through the ceiling, and when they do, it often is the beginning of a strong trend. The line drawn
below the prices is the support line, which serves as a floor. Prices aren’t likely to go below that line,
but when they do it often signals the beginning of a big downtrend. This is very evident in the case of
Lockheed Martin (LMT), when it fell under the support line at 64.50, and continued to drop. These
support and resistance lines can be broadly called trend lines.
There is no formula for support or resistance lines; they are almost always drawn manually. In the

examples above and on the next page we can see that, over time, the price movement will make its
own lines with highs and lows. The key is to connect prior important highs for resistance lines, while
support lines should be drawn using prior significant lows.

Here’s another example of support and resistance. The trend lines here are based on a much
shorter timeframe, but the effect is still the same. After the second close above the resistance line,
we saw that BBOX had plenty of strength, and enough buyers, to move upward.

The more times a stock’s price hits a support or resistance line and turns back the other way, the more
meaningful those trend lines become. Usually, the longer a stock stays inside support and resistance
lines, the stronger the breakout is when it does occur. It is recommended to use at least three points to
draw a trend line.
Trader’s Tip: Not all support and resistance lines have to be straight. Although conventional trend
lines are straight, support and resistance levels may fluctuate to reflect price changes. Many
analysts use moving average lines as support and resistance lines.

We can reasonably expect a stock price to mildly fluctuate over any given length of time. But how
much fluctuation should we allow? One of the most effective ways to determine how much fluctuation
is normal is to establish price boundaries, or an envelope, that the price of a stock will usually be
inside. What you are looking for, then, are the points that the price begins to move outside the
envelope. When the envelope line is pierced, that often serves as a signal of a new trend.
To establish this envelope, we simply plot a moving average (as we did in a previous section). Then
we plot two more lines that will serve as the boundaries of our envelope. The first line will be the top
portion of our envelope, which is plotted at x percentage greater than the moving average. The
second line is the bottom portion of our envelope, which is plotted x percentage less than the moving
average. Since the moving average will change from day to day, so too will the two moving average
envelope lines. The result is a moving average envelope.
In our example of a moving average envelope, we can see the 20-day moving average line in the
middle. The line on top is the upper portion of our moving average envelope, and is drawn at points
that are 5% higher than the actual moving average. The lower boundary of the envelope is plotted at
points 5% less than the moving average line. As you can see, the price of Aetna Inc. (AET) shares is
usually inside this envelope. But in area 1, you can see what happens when the closing price starts to
pierce the upper portion of the envelope. It doesn’t just touch it and reverse; it continues to move
above it. As the price moves up, so will the moving average, and therefore, the envelope will move
higher too. The fact that the closing price continually breaks through the upper envelope is a
testament to the strength of that trend.

(cont.) That strong trend doesn’t end until the price reversal you see in area 2. While we were mildly
concerned that the price of the stock fell back inside the envelope in area 2, we didn’t necessarily
consider that a time to sell. After all, we saw the same occurrence just a few days before that, when
the price dropped back inside the envelope and almost closed below the moving average. However, at
that time it just bounced off of the moving average line for one more surge higher.
In area 2 we can see that this time, the moving average line would not act a support, and the closing
price would fall below it. This confirmed the end of the uptrend. Remember, we saw the potential end
of the trend in area 2 with a few closes back inside the envelope, and we confirmed the end of the

trend when the price broke below the moving average line.

In our other example of moving average envelopes, we can see in area 1 that shares of Adeptec
(ADPT) broke under the lower boundary in June on its way to about a 30% decline. It showed signs of
a reversal in area 2. But there, instead of staying above the moving average, it met resistance at that
moving average and continued downward. Even in area 3 we saw the price move back above the
upper envelope boundary, but when it came back inside the envelope again it did not find support.
Rather, it fell through it, and went on to further losses.

Bollinger Bands
Moving average envelopes allow for normal fluctuations in price. But how can we be sure that a
breakout is actually a breakout, and not just a temporary shift in price? Bollinger bands can solve that
problem, because Bollinger bands adjust for volatility. Moving average envelopes do not adjust for
The application of Bollinger bands is the same as a moving average envelope, in that closing prices
outside of the upper or lower bands can signal the beginning of a new trend. To avoid an errant signal
generated by a closing price outside of the bands, Bollinger bands incorporate the daily highs and lows
of stock prices. If there is a wide gap between the high and the low, then that stock is very volatile, and
Bollinger bands will expand. If there is very little difference between the daily high and low price, then
there is very little volatility, and the Bollinger bands will contract. The result is fewer closing prices
outside of the bands, but those closes outside of the bands are better signals.
In our example below, you can see that the upper and lower Bollinger bands are contracting until
mid-April, when shares of Compuware (CPWR) start to accelerate higher. At that point where
Compuware shares move high enough to close above the upper Bollinger band, the bands start to
separate. Yet, shares continued to close above the upper Bollinger band, even though the widening
bands made it increasingly difficult. This is an illustration of the principle of acceleration, and you can
see why closes outside the bands are often good buy signals
Obviously not all closes outside of Bollinger bands signal a breakout, but when they do, the price

movement can be explosive. A close under the lower Bollinger band can serve equally well as sell

We see another example of Bollinger bands below. In area 1, we can see that the first close below the
lower band leads to many more consecutive closes below the lower band. We almost got a sustained
reversal in area 1, but the exponential moving average failed to act as support in late July after we
made three closes above the moving average line. In area 2 we can see that the first close above the
upper band preceded many more consecutively higher closes. It almost appeared that we would see a
reversal of that uptrend at the beginning of September, but the stock bounced up off of the moving
average line. We finally did get a confirmed reversal in area 3, when the closing price broke below the
exponential moving average.
There are two key differences between Bollinger bands and a moving average envelope. Moving

average envelopes are plotted based on a specific percentage above and below a simple moving
Bollinger bands, on the other hand, are based on an exponential moving average, and are drawn a
specific number of standard deviations above and below the exponential moving average,
incorporating price volatility into their calculation. A standard deviation is simply a unit of any given
measurement. For instance, since most stock charts plot prices in terms of dollars, one standard
deviation unit would equal one dollar

So far we’ve looked at what the beginning of a trend looks like on a chart. But is there a way to spot the
reversal of a trend? A chart pattern called a parabolic stop-and-reversal (or ‘SAR’ for short) can do just
that. The parabolic SAR places dots, or points, on a chart that indicate a potential reversal in the price
movement. In the chart below, you can see the parabolic points that coincide with a new trend.
In August, the parabolic point moves below the actual price, indicating the reversal. As the trend
develops strength through August, the parabolic points move closer together and eventually
intercept the price. In October, we see the reversal of the previous trend when the parabolic point
moves above the candlesticks, indicating that the trend has lost momentum, and prices are
beginning to fall again.
As you can see, when the parabolic marker moves from above the price bar to below it, it is a buy
signal. Conversely, when the marker jumps from below the price bar to above it, it serves as a sell
signal. What exactly causes the shift of the parabolic point? If you look closely at the chart above, you

can see that the SAR marker switches placement the day after the price bar intercepts (or touches) the
SAR marker for that day. The formula used to calculate the placement of the parabolic SAR marker is
too complex for our purposes in this workbook, but fortunately, you don’t have master it to use this
indicator effectively. We’ll see another example on the following page.

The best feature of a parabolic stop-and-reversal is that it is easy to interpret, because there can only
be bullish or bearish signals. It assumes that either a stock is moving up, or moving down, and that you
want to be in the market, either long or short, at all times. As stated previously, a buy signal is
generated when the parabolic dot moves below the price information on a stock chart and begins to
climb along with the stock itself. Likewise, a sell signal is generated when the price of a stock hits a
top, loses momentum, and begins to fall.

As you can see in this
example, the parabolic
marker switches whenever
there is an intra-day price
that pierces that line of
parabolic points. In area 1
we can see that the day
prior to the dot being
placed below the
candlesticks, the intraday
high was greater than the
parabolic plot line. The
inverse is the case in area
2, when the parabolic SAR
switched to bearishness.
The parabolic SAR
method is a very useful
tool in a trending market
that can make sustained
rallies and downturns. This technique, however, is more difficult to use in a choppy, indecisive market.
As you may notice in the examples, the parabolic SAR did not switch positions until a few days into a
new trend. In a back-and-forth market, you may get signals right around the point in time when the
market turns the other direction. All the same, the parabolic SAR indicator is a great tool.

Checkpoint 1
At this point you should be able to identify each type of price chart, as well as functionally use price
chart data, such as moving average envelopes, Bollinger bands, and others. To get the most from this
workbook, it is important that you understand these basic concepts before moving on to the next
section. It is recommended that you be able to answer all questions correctly before moving on to the
next section “Important Chart Patterns”.
1. The following chart is a ____________ (type) chart.
2. This type of chart (above) plots which daily data?

a. Opening price
b. Average price
c. Closing price
d. High price

3. The following chart is a _____________ (type) chart.

4. The four letters marked on the chart (above) point to which price data?
5. The following chart is a _____________(type) chart.
6. The four letters marked on the previous chart point to which price data?
7. What is the benefit of using moving average lines over raw price data?
8. Which of these two lines is more likely to be an exponential moving average?_______
9. Why?
10. What is the primary drawback of using exponential moving averages instead of simple moving
11. What is the primary drawback of using simple moving averages instead of exponential moving

12. On the following chart draw a support line (Hint: It will not be perfect)

13. On the following chart draw a resistance line (Hint: It will not be perfect)

14. Why are support and resistance lines useful?

15. How many points on a chart should be used to draw support and resistance lines? __
16. Moving average envelope lines are plotted a certain ___ above and below a simple moving
average line.
a. standard deviation
b. percentage
c. volatility factor
17. Why wouldn’t the last bar you see below necessarily be a good buy signal, based on its
relationship with its Bollinger band?

18. Based on the last information you can see below, what is the next likely direction for this

19. Why?

20. Correctly identify the following three occurrences on the chart with the appropriate description
below: 1) _____ Resistance at moving average line 2) _____ Support at moving average line 3)
_____ Moving Average Crossover

21. True/False. Bollinger bands reflect volatility by incorporating the daily high and low prices into the

22. True/False. Bollinger bands are less likely to draw smooth lines compared to moving average
envelope lines.

23. True/False. Bollinger band lines are drawn a certain percentage above and below an exponential
moving average line.

24. On the chart below, based on the last information you can see, what direction would you expect
this stock to go next? ___________________

25. On the chart below, why are the Bollinger bands narrow in “area a” but widened in “area b”?


26. In the most current portion of the chart below, is the parabolic stop-and-reversal
showing bearishness or bullishness? ________________


Stop! You have completed section 1. You may check your answers with the answer key. We
recommend that you be able to answer all questions correctly before proceeding to the next

Checkpoint 1 Answer Key

1. Line
2. c: closing price
3. OHLC, or open-high-low-close
4. a. close
b. open
c. high
d. low
5. candlestick
6. a. high
b. low
c. open
d. close
7. The price change is smoothed into discernible directions. Trends appear clearly.
8. a
9. It moves faster. The other one moves noticeably slower.
10. They may move too fast. Being more reactive to recent price changes, they are also more subject
to volatility.
11. They may move too slow. If a new trend is established quickly, the simple moving average may not
reflect it in a timely manner.


You could have also drawn a resistance line from March’s high to the high of the day right
before the big gap in July.
14. They indicate likely points where a stock will either reverse or begin a breakout.
15. 3, at least. (2 can be used, but at least 3 are recommended)
16. b. percentage
17. It didn’t close above the upper band. Rather, it reversed intra-day.
18. Lower
19. A close under the lower acceleration band is an indication of a downtrend.
assume the trend will continue until it has a reason not to.
20. 1) a 2) c 3) b
21. True
22. True
23. False. They are plotted using standard deviations.

In general,

24. Higher. Breaking above the upper Bollinger band is bullish.


Bollinger bands adjust for volatility. If the high-to-low range is greater, then Bollinger
bands will expand. If the stock’s trading range is narrower, the Bollinger bands will be too.
2. Bearish. If the marker is above the price bar, it’s bearish.

Section 2: Important Chart Patterns
We’ve seen how charts are drawn. Now let’s take a look at the interpretation of some of these chart
patterns. While we will highlight some of the most common chart patterns, this is by no means an
exhaustive list of useful chart interpretations.
Inside/Outside Reversal.
On a candlestick chart (or an OHLC bar chart), we can see the daily trading range (high to low) in the
height of the bar. What does it mean when there is a change in the trading range from one day to the
next? While this is not an absolute rule, a significant change in the high-to-low range often indicates a
reversal of a trend. This concept is better explained with the charts below.
A smaller trading range than the previous day indicates that traders have become much stricter about
price levels at
which they are
willing to buy
and sell. In the
circled area to
the right, we
see that the
first day had a
wide gap
between the
open and the
close, and an
even wider
trading range
(high to low).
The following
day we saw a
much narrower
range, and a
smaller gap
between the
open and close. This pattern coincided with the short-term reversal. This is called an inside day
reversal, because the high-to-low range of the second day was contained inside the high-to-low range
of the previous day. Something significantly changed about the stock on that day, and it caused a
raised amount of discretion.

Trader’s Tip: The inside day does not in itself indicate a reversal, as there are many times the pattern
occurs. Use the inside day pattern as added support for other indicators, or in conjunction with
fundamental data.

Above we see an example of an outside day reversal. The circled area shows that the first day had a
very narrow high-to-low range. The following day, however, indicates a higher high and a lower low
than the first day. In the other words, the high and the low of that second day were outside of the high
and low levels set on the first day. Again, this pattern coincided with a reversal. What we are seeing is
a sudden need to sell, and/or a willingness to take any price to do so. It is likely that there was bad
news announced that day, and the panic resulted in a volatile day that started a sell-off lasting several

A simple way to spot a possible reversal of a bear trend on a candlestick chart is finding a bar
formation that resembles a hammer. On the marked candlestick below, you can see that this stock
opened near its high, traded very low, but ended up closing near where it opened. Like hammer that
has a long wooden handle with a perpendicular metal head at one end, this candlestick pattern has a
long ‘handle’, and a perpendicular ‘hammer head’ near the top.

The psychology of this
interpretation is that there were
willing buyers for this stock. They
were just waiting to purchase on
the low end of the trading range.
Ironically, while someone did
actually purchase the stock at the
low end of the bar, we can see that
buyers ended up paying a price
near where the stock opened. That
willingness to forego a bargain
price indicates that there may be
many more buyers out there.

Here we see another example of a
hammer formation.

Elephant Trunk
The Elephant Trunk (or ‘ET’) sell signal is a signal developed here at It derives its
name because the sell signal bar formation literally looks like an elephant trunk. To officially be an ‘ET’
sell signal, the opening price for the first down day must be lower than the closing price of the previous
up day, and the closing price for that same day must be lower than the previous opening price. There
must also be a trade on that first down day that is lower than the low of the previous day.
A lower low and an opening price lower than the previous close does not automatically constitute an
ET sell signal. The ET sell
signal is best applied after an
excessive run-up that caused
a price to go too high. The ET
signal indicates that investors
have caught their mistake or
are taking profits. In either
case, it’s best to take the
signal as a sign of worse
things to come, as in our

Cup and Handle
One of the more interesting interpretations of a longer term chart is the “cup and handle” formation.
While the specifics of what constitutes an actual cup and handle formation are always debated, suffice
it to say that the pattern does indeed look like a cup with a handle. In our example below, we can see
that the stock makes a new term high in August, and then sells off sharply on much higher volume. It’s
not until late on 2000/early 2001 that the price is trading at the same levels that we saw before the
downturn in September. To complete the other side of the cup, we need to see trades at prices we see
in August, and we need to see those trades on higher volume. The final piece of the puzzle is the
handle. To properly develop the handle, we have to see another reclamation of those August prices
after a pullback, and then new highs on higher volume.
This formation usually takes weeks to actually develop, although you may see it occasionally form over

a period of several days. It is recommended to use cup and handle charts for intermediate term or
longer term strategies.
As you may guess, there will never be a perfect cup and handle formation. Nor will any two cup and
handle patterns looks the same. All the same, the price and volume data can be very telling when
charts start to look similar to the one above.

Head and Shoulders
Another longer-term chart pattern worth knowing is called a “head and shoulders” pattern. The price
chart literally looks like a head with a shoulder on either side of it, and typically occurs right before a
significant decline. In the example below, you can see how this three peak pattern developed right
before the Nasdaq fell about 100 points.
To understand the psychology behind this pattern, see the sample below. Essentially, the first surge
(the shoulder on the left) indicates a possibility of an uptrend. After a pullback, people are acting on
the bullishness they saw in that first surge and rush into the market. This stronger buying spree
creates the head. At this point some investors begin taking what profits they may have, and a sell-off
begins. Shortly thereafter, there is one more buying surge from the last hopefuls who are still bullish.
That last surge creates the shoulder on the right. If the third rally fails and prices fall back below the
neckline, that is usually a set up for a sell-off.
The degree of decline after the formation occurs is usually about the same as the degree of ascent

between the bottom of the first shoulder formation and the top of the ‘head’. In other words, you can
reasonably expect the market to fall about as much as it grew (in terms of total points) between
neckline and the top of the head.

The head and shoulders patterns works upside down too. If you see an inverted head and shoulders
pattern, that is often a set up for a bullish rally. These are just as common, yet may be more difficult to
spot since we usually don’t mentally view heads and shoulders as upside down. However, it would be
wise make this effort, as they often coincide with bullish reversals of bear trends.
Trader’s Tip: Don’t assume that you’re seeing a head and shoulders pattern in development. The
first two peaks in the three peak pattern occur naturally on their own and don’t necessarily lead to
the third peak being formed. Rather, wait for the market to confirm that it won’t be able to rally after
three attempts. By then there will be enough bearish sentiment to drive a downturn.

As we had mentioned earlier in this workbook, candlestick charting was originally developed by the
Japanese. The word ‘doji’ specifically refers to a single candlestick formation. While doji interpretations
often depend on other circumstances, the formation of the doji itself is always the same. To constitute
a doji pattern, the opening price and the closing price are essentially equal, resulting in a single
candlestick that simply appears to be two crossed lines.
The doji formation is not as
important as the meaning
behind it. Think of a doji as a
battle between bulls and bears
that ended in a stalemate. Like
most stalemates, it often
coincides with a change in
momentum, or is the result of
uncertainty. If people are
collectively confused about
whether to buy or sell a stock,
that is a signal of significant

To the left we see two
examples of a doji. Example A
signaled a market top, while
example B indicates that
people were waiting to buy
this stock in a slight price
dip. In both cases, we see
that the doji correctly
signaled a reversal of some

In your interpretations of doji
formations, recognize that
the pattern is simply an
equilibrium. The buyers are
satisfied that day with the
price they are paying, and
the sellers are satisfied that
day with the price they are receiving. It just so happens that for that day, all the buyers and sellers met
in the middle at the beginning of the day as well as the end of the day. When both the buyers and
sellers are simultaneously satisfied, you may be seeing an opportunity.

Again, the doji itself is not as important as the meaning behind it. Let’s look at a couple of
noteworthy doji patterns to explain how we can see important clues in the shape of the
A ‘dragon-fly doji’ has a high that
is not any higher than the open or
the closing price, but has a low
that is lower than the open/close
level. The implication is that there
was plenty of selling of this stock
during the day, but buyers came
in before the close and were
willing to pay prices right up to
the very levels where the stock
opened. Hence the stock closed
where it opened, and then
reversed the downtrend. As the
recovery on the chart indicates,
this type of doji can be bullish.
A “gravestone doji” is essentially
an upside down dragonfly doji.
The open, the close, and the
daily low trade are all essentially
the same, although there were
trades much higher than that.
The implication is that the
sellers weren’t going to take
any less than the opening
price, yet buyers finished the
day unwilling to pay any more
than that same price. The
stocks failure to stay at the
higher trading range ultimately
spelled trouble, as you can see
three days after the gravestone

Dojis are also referred to as
‘tails’, do to their shape. We’ll
look at other types of tail
reversal patterns in an upcoming section.

We’ve seen important single-candlestick formations. Now let’s look at some important multiple-bar
formations. By that, we mean that we are looking for important chart patterns that occur over a period
of two or more bars. A “gap” occurs when there is a price range where no trades have been executed
between two bars. For instance, if XYZ shares trade as high as $26 for one bar, and then the low for
the next bar is $27, the stock is said to have “gapped up” between $26 and $27. No trades have been
made at that $26 to $27 range. This is better explained on the chart below.
As you can see, these shares never traded between 14.00 and
14.60 as they rose in a
strong trend. There was
another bullish gap
between 17.10 and
17.40. Upward gaps are
very bullish, while
downward gaps are

While individual gaps are
important to note, you
will also find that there
are patterns of gaps that
often occur within a
trend. While no two trends are alike, you may see three or four gaps occur at different intervals in the
lifecycle of a trend. We’ll look at an example chart in a moment, but first let’s define each of these
1. Breakaway gap: This is the first gap of a new trend. It is usually a very clear gap with strong
follow-through the next day, and typically occurs on much higher volume. This is the signal that
there are plenty of buyers available who are willing to drive the price up.
2. Measuring gap(s): Measuring gaps are called so because they can often be used to gauge the
length of a trend. They usually come in the middle of a trend, so you can expect that the number of
days between the breakaway gap and the measuring gap will also be about the same number of
days between that measuring gap and last gap of the trend. However, there may be several
measuring gaps in a trend, and there’s not always a clear definition about which one signals the
“middle” of a trend. Measuring gaps should occur on moderate volume. If you see a gap on
extremely high volume, that gap may be due to volatility rather than trend pressure.
3. Exhaustion gap: This is the last gap of a trend, and typically occurs on rising volume (volume
higher than the previous day), although this is not crucial. Exhaustion gaps are named so because
it is usually the last gasp for a trend. Momentum has been lost, but there are still investors who are
(erroneously) acting on the trend.

In this particular rally from $31 to $44, we can see four price gaps. The first (breakaway) gap is on
much higher volume, while there are two measuring gaps. The last gap is the exhaustion gap. There is
no clear rule for defining why one gap would be an exhaustion gap while another would be a
measuring gap, but volume is an important clue. The first measuring gap occurred on the same volume
as the previous day, while the second measuring gap occurred on relatively average volume. The other
key characteristic of this exhaustion gap is when it occurred. If you look closely, it occurred thirteen
days after the first measuring gap. The first measuring gap occurred fourteen days after the breakaway
gap. This is a very good example of how a measuring gap can provide clues about the length of a
trend – a measuring gap is usually right in the middle of a trend.

You can even use gaps to spot a reversal. If you see a bullish gap soon followed by a bearish gap, that
often signals a major
reversal of a trend.
On a price chart, if a
bullish gap and a
bearish gap leave a
section of bars away
from the general price
flow, then you have an
“island” formation. These
islands, unconnected to
any other bars due to
gapping, usually
coincide with a major
change or reversal in
price momentum.

Two-Bar Tails
Our final chart pattern we’ll discuss are often called ‘tails’. Again, you will need to use an OHLC or
candlestick chart to make this analysis, as you will be looking at the highs and lows, along with
opening and closing prices. The relationship of these four pieces of data on one price bar can signal a
potential reversal, and a particular structure of two consecutive price bars can confirm the likelihood of
a reversal.
This particular pattern is called a ‘tail’, since the chart appears to have along, isolated extension similar
to the tail of a cat, dragonfly, or any other long-tailed animal. In fact, the ‘dragonfly doji’ is a one-bar
example of a long-tail reversal pattern (so is the ‘gravestone doji’ – just the other direction). Since we
have already seen examples of these one-bar tail patterns, let’s focus now on the two-bar tail patterns
that can also signal a reversal. We can still consider these tails, since the pattern of a long, isolated
extension is visible on the chart.
What we are looking for when attempting to spot pivot (reversal) points are indications that buying or
selling has been exhausted. In other words, we want to see a panic in buying and selling. This is
often the case when you see an open at one end of the price bar, and a close at the other end of the
price bar. And we don’t mean near the top or bottom of the price bar – we mean at the end of the
price bar (ideally).
When you have an opening at the high for the day, and a close at the low, that’s an indication that
investors rushed out of a stock over the entire day. But often, it’s an indication that ALL of the sellers
have sold their positions that day. As a result, the following day, a rally is sparked and the bargain
hunters push the stock higher. While the first day’s bar is a decent indication that selling has exhausted
itself, the reversal can be confirmed on the next day by a mirror image of that first bar. The second bar
shows that the buyers really wanted the stock, and were in something of a panic to buy it, pushing the
stock up to close at the high.
An example appears on the following page.

Here we see an example of this type of reversal signaled by a tail. On the first day we opened at the
high and closed at the low, and made the opposite pattern on the next day. The more symmetrical the
pattern is, the more meaningful it is. In other words, we want to see an open on the second day right
where it closed on the first day. And, we want to see a close on the second day right at east as high as
we opened at the first day. In this example, we got a very high trade on the second day, but the overall
pattern was largely intact. No chart pattern will ever appear perfect.

In the next example you’ll see the opposite situation, where we set up a bearish reversal after a bullish
run. On the first day we’ll see a close at the high for the day, and an open at the high for the second
day. While not as crucial, we’d also like to see an opening price right at the low of the first day, and a
closing price right at the low of the second day
Here we didn’t get
the open and close
at the lowest part
of the bars for the
two circled days,
but we clearly got
the close and the
open at the top of
the bars.
It’s important that
you open the
second day where
(or at least very
near where) you
closed the first day.

Trader’s Tip: It
would be rare to get a perfectly set-up tail indicating a reversal. There’s almost always one component
that doesn’t quite appear as you would like. All the same, the principle is broadly applicable, and very
One idea to keep in mind is that the taller the price bars for both of the days, the stronger the signal. In
other words, if the trading range jumps from an average of a 50 cent range to a
1.00 range for the 2 days in question, the chart pattern is that much more meaningful. Look for the
long tails to be better indications of a reversal.

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