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TRADING INDICATORS
By Ka Maffey Beht
Kira McCaffrey Brecht is Senior Editor of
SFO magazine. She has been writing and
analyzing the markets for more than 19 years.
Posts during her career include Chicago bureau
chief at Futures World News, derivatives reporter
and market analyst at Bridge News and technical analyst at
MMS International.
e pe: $7.95
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TRADING INDICATORS
By Ka Maffey Beht
Be Your Own Analyst:Understand Fibonacci Retracements 1Be Your Own Analyst: Understand Stochastics 5
Be Your Own Analyst:Understand Moving Averages 9
Be Your Own Analyst:Understand Japanese Candlesticks
14
Be Your Own Analyst:Understanding Cycles 20
Be Your Own Analyst:Understanding Volume 27
tis sris covr undmnls o rding indicors ws originllublisd rom Mrc o augus 2005.
2005, 2006, 2010. Sf Mgzin. all rigs rsrvd.
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TRADING INDICATORSBe Your Own Analyst:
Understand Fibonacci Retracements
While Ive always studied and utilized Fibonacci retracement
targets as part of screen-based analysis and trading, I remem-
ber well a story that a oor trader friend of mine at the Chicago
Mercantile Exchange told me years ago.
He told me that part of his trading strategy was to watch the morning
range of the market: from the high to the low or vice versa. Lets say themarket was rallying. From his experience in the pit, he noticed that a good
trade was often buying at halfway back.
As a trained technical analyst, I was stumped. Halfway-backwhat does
that mean? I asked.
You know, when the market sells off to its halfway-back point from
the high. Suddenly it hit me. My friend, who was completely unschooled
in charts or technical analysis and primarily made his living by scalping
extremely short-term trades in the pit, had coined his own term for retrace-
ment analysis.
Oh, you mean a 50-percent retracement! I said.
Whats that? he asked.I went on to explainbut it didnt really matter to him. He had discov-
ered from his years in the pit that a bull market often retreats halfway backBck o tbl o onns
and then rallies again. He didnt care what it was calledit worked!
The BASIC CONCepT
While there are many ways to utilize Fibonacci numbers, for the purposes
of this article we are going to stick to the basics and keep it simple.Well
outline the fundamentals of Fibonacci retracement analysis and how some
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fIGuRe 1: Dil Mr NyBt o r Wi fiboncci rcmn
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traders use it in both long- and short-term trading. Fibonacci analysis can
be used on any market and any timeframe. It is just as valid on a monthly
dollar/euro chart as on a daily dollar/yen chart or a 60-minute E-mini S&P
chart. The basic concept of retracement analysis stems from the fact that
markets dont move in a straight line.When a market is in an uptrend, price
rallies, hits resistances, and then retreats (or corrects) before advancing in
another up wave. Retracements can help pinpoint how far a market will
correct before resuming its prior trend.
Fibonacci retracements pinpoint specic areas between price highs and
price lows that potentially could be good spots to enter or exit a trade. Trad-
ers could trade with the existing trend or attempt to catch a counter-trend
corrective move using Fibonacci retracements: you choose.
DONT SweATThe MATh
While there are many variations on Fibonacci retracements, the three
basic levels are 38.2%, 50% and 61.8%. Dont worry. One does not have
to be a mathematician to understand or utilize Fibonacci retracement
targets in trading! These days, just about every charting package of-
fers Fibonacci retracement lines programmed right into the software.
A trader just clicks on that option and drags the cursor from the price
high to the low or conversely, from the low to the high that he wants
to measure. Presto! Magic lines will appear on his screen. And surpris-
ingly, more often than not, prices appear to gravitate toward the 38.2%,
50% and 61.8% mark.
pICk pOINTS CARefully
Many people might say, Oh, those Fibonacci numbers dont work. One
problem that beginning technical traders may encounter that may detract
from the efcacy of this strategy is picking the right points from which to
draw the lines.The rst criterion for using Fibonacci retracement targets is
that there must be a well-dened trend with a series of higher highs and
higher lows (or vice versa). It can be an uptrend or a downtrend; it doesnt
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matter. Dont forget, traders can draw retracement targets across all time-
frames from an intraday chart to a monthly chart.
Now that youve got a trend, pick the right points. Traders need to pick a
valid low to high (or vice versa) in which to draw the line. Look at the chart.
Where did the rally (or sell-off) begin? Thats where the rst line is drawn.
For an uptrend, draw the lines from the most important swing low to the
most important swing high. SeeFigure 1 for an example of how to draw the
lines. From that important swing high, prices will likely correct and retrace.
TRADING TARGeTS
Once a correction is underway, counter-trend traders could use those Fibo-
nacci targets as potential exit points, as they represent a point where the
market could run out of steam. Or for those who missed the starting point
of the rally, the retracements could offer a low-risk entry point to join the
uptrend.
Take another look at Figure 1. In late October 2004, March coffee futures
launched a strong bull move that peaked out in late December. One could
draw a Fibonacci retracement of the move; from Point A to Point B. From
top to bottom, the rst line on the chart is the 38.2% of the move; the second
line represents 50% of the rally, and the third line delineates 61.8% of the
upmove.
For those versed in pattern recognition, a double-top formation devel-
oped on this daily chart in late December, which was a warning signal that
the bulls were running out of steam (and a potential sign to take at least
partial prots on longs). From those highs, traders can see that Mar cof-
fee did indeed pull back and correct, as all markets need to do from time
to time. The contract retreated to just around the 38.2% mark, seen in the
circled area in Figure 1. This proved to be a successful stalling point for the
corrective retreat, and as of this writing in late January, prices have re-newed their upside momentum.
TRADING SpOTS
How could traders have used Fibonacci retracements in this example? As
mentioned earlier, traders can use them in a trend or counter-trend man-
ner. The rst obvious counter-trend strategy could have been to trade the
corrective pullback. Several technical negative indicators had developed
(not all shown on this chart). The bearish double top was seen in price,
bearish divergences had developed on momentum readings, and prices be-
gan to fall. Traders looking for a short-term move could have attempted to
sell after the failed double top. Right away, traders would have a rst objec-tive with the 38.2% retracement. Sometimes markets need to correct even
more and will continue lower until the 50% or the 61.8% mark. All three of
those levels could be used as valid targets for counter-trend trades.
It is important to remember, according to basic Fibonacci analysis, that as
long as the 61.8% support level holds, the prior trend (in this instance the
uptrend) will remain intact. This simply means that a market can retrace
as much as 61.8% of the move but still be in an overall uptrend (or down-
trend). Classic Fibonacci analysis says that if the 61.8% support area (in an
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uptrend) is severely violated, the uptrend is over. In that case, traders can
set their objective for a retest of the low (or the rst point that is drawn off
the Fibonacci lines).
Confused? To clarify, lets pretend that Mar coffee shown on Figure
1 failed to hold the 38.2%, 50% and 61.8% support lines on its corrective
pullback. Instead, coffee futures plunged through the 87.90 cents per pound
zone (61.8%) in January. That would have conrmed an end to the uptrend
and would have targeted a retest of the late October low around 75.00 cents.
CONfIRMATION
Technical traders often talk about the need for conrmation. This is an im-
portant theme within technical analysis and simply means that one should
not look at one chart or indicator in a vacuum. For example, technical trad-
ers often will look for conrmation across timeframes. For example, does
that support or resistance point pop up on the hourly chart and the daily
chart? If so, it is likely a more signicant price point for the market.
Conrmation also refers to the concept of utilizing several different
technical indicators in tandem. Lets say three of your favorite technical
indicators all ash buy signals that conrmation increases the odds of a
protable trading opportunity. With this in mind, it is not advisable to rely
strictly on Fibonacci retracement targets for entry or exit points. They are
an excellent tool when used in conjunction with other conrming techni-
cal indicators. A few that work well with Fibonacci numbers are stochastics,
relative strength index and candlestick chart formations. The idea is if posi-
tive readings are seen on those tools around retracement levels, the trade
idea may be looking good!
why DOeS IT wORk?
There are some who scoff at the concept of Fibonacci numbers, callingthem superstition or just plain old hoo-hah. Some even say they become a
self-fullling prophecy. Make no mistake about it, though. They are widely
used in the technical community, and that reason alone makes them impor-
tant to watch. Wouldnt you like to know the key levels that other traders
may be considering for entry and exit points?
Simply, the Fibonacci retracements are based off a number series: 1, 1,
2, 3, 5, 8, 13, 21, 34, 55etc. (notice that the sum of any two consecutive
numerals equals the next higher number). Leonardo Fibonacci, the son of a
Pisan merchant, in the 13th century discovered this number series and its
various properties. The percentage retracements actually are ratios of this
number series. Scientists have found that Fibonacci numbers and ratiostend to appear randomly (or maybe not so randomly throughout nature)
for example, in the number of petals on a ower and the number of spi-
rals in a pinecone.
So what does this have to do with the nancial markets? Well, there are
those that say markets move in waves. Momentum rises and swells like the
tides. Perhaps there is a relationship. Dont take my word for it. Check them
out for yourself. Form your own opinion. But as my old oor trader friend
said, he didnt care why it worked; he just observed that it did.
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TRADING INDICATORSBe Your Own Analyst:
Understand Stochastics
Beginning technical traders are confronted with a dazzling array of
indicators, chart types, wave counts and patterns.While it can be dif-
cult for the novice trader to know how to sift and sort through the
dozens of indicators now available with just the click of a nger, it could beuseful to start with an oldie, but what many technicians consider to be a
goodie stochastics.
Before diving into what this indicator does, lets take a look at what it
measures momentum.Traders have long been on the lookout for good
momentum, or strongly trending markets. And, of course, when that mo-
mentum begins to dry up, that is something traders need to know as well.
Stochastics, an oscillator popularized by George Lane, president of Invest-
ment Educators Inc., may be able to help. In an interview nearly a decade
ago, Lane told this reporter that, Stochastics measures the momentum of
price. If you visualize a rocket going up in the air before it can turn down,
it must slow down. Momentum always changes direction before price.
The IDeA BehIND STOChASTICS
One doesnt need to worry about the formula.This is a popular technical
indicator available in just about every charting software package out there.
According to John J. Murphy in his book,Technical Analysis of the Financial
Markets, stochastics are based on the observation that as prices increase,
closing prices tend to be closer to the upper end of the price range. Con-
versely, in downtrends, the closing price tends to be near the lower end of
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fIGuRe 1: Dil M Silvr wi Slow Socsics nd gulr Socsics
Sourc: fuurSourc
a bris divrgnc on slow socsics signld nd o bullis run in rl D-cmbr 2004.t rgulr socsics indicor on boom o cr rvls mnmor co nd rd-o-dcir signls.
the range.Two lines are used in the stochastic process the %K line and the
%D line.The %D line is the more important one in that it provides the major
signals.The intent is to determine where the most recent closing price is
in relation to the price range for a chosen time period. SeeFigure 1.The
blue line represents %K, while the red line is %D. Readers can see that this
chart provides a glimpse of both slow stochastics (below prices) and regular
stochastics (at the bottom of the example). But well get into the differences
between those later.
Phil Roth, chief technical analyst at Miller Tabak & Co., puts it another
way. Stochastics is concerned with how stocks close within a range. For
example, you could look at the last ve days. Did the stock close near the
highs? Accumulation is identied with strong closes. A close at the upper
end of the range is an important thing to know, he explains.Many technical traders and analysts simply use the default parameter of
14 periods (14 hours, 14 days, 14 weeks, depending on the timeframe of the
chart being used). But feel free to experiment. Fourteen is the standard.
But its not magic, comments Ken Tower, chief market strategist at Cyber-
Trader.
Stochastics, like many other technical indicators, were developed origi-
nally for use in the commodity futures markets. But, as most experienced
traders know, every market has its own personality. And for some markets, a
12-period or 15-period parameter may offer better signals.
TRADITIONAl uSeSStochastics offer traders a variety of technical signals. Of course, like other
indicators it is not a Holy Grail and does have some drawbacks. But if trad-
ers know the proper way to utilize the tool, it can be easy to avoid some
common pitfalls.
First, lets take a look at traditional buy and sell signals from stochastics.
The two lines %K and %D oscillate between a vertical scale from 0 and
100. Generally, the upper extremes, or above 80, are called overbought
readings, while under 20 are considered oversold. The K line is the faster
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line, and when %K crosses %D from overbought levels, it is considered a
traditional sell signal. On the other hand, if the %K line were to cross over
%D in oversold territory, a buy signal would be seen.
Traders need to be aware, however, that one of the drawbacks of stochas-
tics is that in a strongly trending market, overbought or oversold readings
can be seen for days, weeks or even months. So caution needs to be used,
and a simple overbought or oversold reading is not a good reason to pull
the trade trigger.
In the early stages of an uptrend, this indicator moves up to overbought
very quickly and will stay there. It isnt helpful because it can get over-
bought and stay overbought, John Murphy says.
DONT GeT OuT TOO eARly
People make an incredible mistake with this indicator because they use
it in a way you can only use it in a sideways market, says CyberTraders
Tower. He calls this tool one of his favorite technical indicators and uses it
to help time entry and exit points. If I buy a stock, I want it to get over-
bought and stay overbought. These are the stocks I want to own.
However, a lot of times novice traders will get nervous amid overbought
momentum readings and get out of the trade too early, making the criti-
cal error of failing to allow prots to run. Dont be fooled by overbought or
oversold (if you are short) readings. Unless divergences appear (well get to
those shortly), the extreme readings simply are conrming a continuation
of the strong trend.
pROfIT fROM TReNDleSS CONDITIONS: SIDewAyS MARkeTS
For those looking to trade a well-dened range, stochastics may offer
good insights for entry and exit points. When markets shift into a neutral
trend, trading back and forth between a specic resistance and sup-port zone, stochastics are a very useful tool as they are considered to
be a fast indicator. Comparing this tool to a similar type of momentum
indicator the relative strength index (RSI) Murphy says, Stochastics
are faster than RSI.
I nd that stochastics are better for short-term trading. It tends to
be a lot more volatile than the RSI, Murphy says. If you are looking for
speed and a quick entry point, yes, stochastics can be helpful, he adds.
In a sideways range, traditional buy and sell signals could appear on sto-
chastics as prices near the top of the range and the bottom of the range.
uSeful IN TReNDING SITuATIONS,TOO:BullISh AND BeARISh DIveRGeNCeS
An extremely valuable aspect of stochastics is the ability to monitor wan-
ing momentum. Readings called bearish and bullish divergences will warn
of impending tops and bottoms. See Figure 1 for an example of a bear-
ish divergence in the May silver chart. Take a look at the slow stochastics
reading. As price climbed to a new bull trend high in early December 2004,
stochastics failed to conrm that new high. Remember we said that in a
strong uptrend, this indicator would get overbought and stay overbought?
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Technicians like to see stochastics continue to make new highs, along with
price. When that fails to occur, a divergence is formed.
Also in Figure 1, as price made a new high in mid-November 2004,
stochastics made a higher high conrming that price move (seen in the
rst circle). However, heres where stochastics can really help. For those
trading May silver from the long side, a huge red warning ag emerged on
the chart with the rally to the December 2 high at $8.280. That day did in-
deed turn out to be a multi-month peak for silver. Stochastics was already
trending lower. It had turned down, and a bearish divergence had formed
(second circle). Technical clue: time to exit longs and initiate shorts!
BeST SIGNAlS
Most technicians recommend using stochastics in conjunction with an-
other technical tool for the most accurate buy and sell signals. A commonly
used tool used alongside stochastics is the relative strength index (RSI).
Technicians say that when both of these tools exhibit buy and sell signals
in tandem at major market turning points, it is likely a high-odds trading
opportunity. For important turns in the market, I like for RSI and stochas-
tics to be in overbought or oversold territory together, says Murphy.
CheCk lONGeR-TeRM ChARTS
For an additional layer of conrmation, traders doing analysis off of a
daily timeframe should check out the weekly chart as well. For example,
a buy signal on the daily stochastics, which is conrmed by a buy signal
on the weekly stochastics, is a stronger indication than just one time-
frame by itself.
SlOw veRSuS ReGulAR
In Figure 1, both slow stochastics and regular stochastics are shown.Readers can see that regular stochastics are choppier and more difcult
from which to ascertain signals. Many technicians recommend utiliz-
ing slow stochastics, which is calculated in a slightly different or slower
fashion. The result is a smoother indicator, with less whipsaw type of
readings.
Traders in all markets may nd stochastics to be a useful tool. It is a
momentum indicator, somewhat similar in concept to Bollinger bands,
Keltner bands or the RSI. Every trader needs to nd the tools that he or
she likes best. Its a good idea to monitor charts with various indicators
to see what feels comfortable for you.
While stochastics originally were developed for the commodity futuresarena, this tool can be applied to forex markets, individual stocks and ex-
change traded funds (ETFs). Its a universal indicator, comments Murphy.
However, like all technical tools, it has its drawbacks. For the best success
with stochastics, understand its limitations and strengths. Look for conrma-
tion with the RSI at major turning points, and also check out varying time-
frames for another layer of conrmation. Looking for the end of a trend or
a good sell signal in a trading range environment? Stochastics may be the
indicator for you.
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TRADING INDICATORSBe Your Own Analyst:
Understand Moving Averages
n this third installment of the "Trading the Indicators" series, we've
chosen to tackle moving averages. In an issue partially dedicated to
trend following, moving averages are the perfect indicator to study.
While everyone has heard the old saying the trend is your friend, howdoes one actually identify trend? Moving averages are a simple tool that
can pinpoint whether a market is in an uptrend or a downtrend and can
signal when a trend is turning.
hMMMDOeS ThAT lOOk lIke A heAD AND ShOulDeRS TOp TO yOu?
Within the eld of technical analysis, which includes some very subjective
forms of looking at the market (such as pattern identication, Elliott wave
counts, etc.), moving averages offer an objective manner to view price and
trend.
The rst job of a technician is to identify trend, says Ralph Acampora,
well-known technical guru and former head of technical research at Pruden-tial.The simplest way to do that is to identify higher highs and higher lows
and draw a trend line.And he adds,The problem with that is that my trends
might be a little different from your trends because we might draw the line a
little differently.A moving average, by denition, is a mathematical trend line.
The MAjOR MOvING AveRAGeS
The basic concept is that if price is above the 10-day moving average,
then the short-term trend is up (just ip that example on its head for
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a downtrend). Remember that there are three basic time frames to
which technical traders refer: the short-, medium- and long-term
trend. And unless one is doing very short-term intraday trading, it is
worth knowing where all three trends stand (and all actually can be
different).
Moving on, if price is above the 50-day moving average, then the
medium-term trend is generally considered to be up. Finally, the big
mama of all moving averages is the 200-day moving average. Most
technical traders and analysts consider this moving average to be
a proxy for the long-term trend its the key line in the sand. Are
prices above the 200-day moving average? Then the dominant, major
trend is up. If prices are below the 200-day moving average, it would
signal that the longer-term trend is down.
Just a little note on time frames traders can adjust moving aver-
ages to any period, which could be a 10-, 20- or 50-period moving
average. Its called a period because if one is looking at an hourly
chart, it would be a 10-hour moving average, or on a weekly chart,
a 10-week moving average. It all depends on the time frame of your
chart. Also good to know, moving averages are a universal tool, which
can be used on any market including foreign exchange, individual
stocks, crude oil futures or the S&P E-mini contract.
hOw ARe They fORMeD?
Moving averages can signal when a new trend has started or when
a trend is completed. However, because of the way it is constructed,
moving average signals are lagging, not leading, indicators.
So how are they formed? Actually, they are very simple to com-
pute. Lets say one is trying to calculate the 20-day moving average
of closing prices. Add up the last 20 days and divide the total by 20 todetermine the moving average. The average moves because every
day the oldest day is dropped off as the current days information is
added. And dont worry; you dont have to do the math yourself. This
technical tool is widely available in all standard charting software
packages. Simply click on the moving average option and voil! It
appears. There will be a function to change the parameter of periods,
such as a 20-day or 10-hour (depending on chart time frame) for the
moving average.
wheNS The BeST TIMe TO pull ThIS TRICk OuT Of The BAG?
Technical traders generally rely on a number of technical tools intheir trading arsenals. The more one learns about technical analy-
sis, the better they will understand the concept of confirmation. For
example, the more technical tools that are flashing the same signal at
the same time, the better the odds that a trading idea would be suc-
cessful.
But traders also need to know how and when to apply different
technical tools to maximize their usefulness, and moving averages are
most useful in trending market environments.
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Says Acampora, When the market is going sideways, you can get
many false signals. Avoid whiplash! If a market has shifted into a
well-dened sideways consolidation band, the best advice is dont use
moving averages.
However, there is a caveat. For extremely short-term swing traders,
moving averages can help pinpoint turning points in sideways markets.
If there is a well-dened price ceiling and price oor for the sideways
band, traders could use shorter lengths of moving averages to pick off
short-term swings in the longer-term context of going sideways, accord-
ing to John Bollinger, president of Bollinger Capital Management.
The CRySTAl BAll, MeDIA hype OR Self-fulfIllING pROpheCy
While traders have heard over and over again that there is no Holy
Grail, in the world of technical analysis, where do moving averages t
in? They are not the answer within the crystal ball, but the big and wide-
ly watched moving averages do attract some media hype and perhaps,
at least to some extent, can become a self-fullling prophecy, at least for
the short-term. CNBC may proclaim, XYZ stock has been trading above
its 50-day moving average for months now, but today fell to that level.
Will it hold? A media buzz is created around the 50-day or 200-day
moving averages. And for the most part, those are the averages ashing
on many individual and institutional traders screens every day. When
prices fail to hold a certain moving average, it can have a pronounced
psychological impact on the community, Bollinger notes. And by now,
readers must be well aware how much psychology plays into price
movement!
BuIlD yOuR OwN SySTeM
For those who dont understand the basics of a moving average cross-over system, its actually very simple. One could easily construct a mov-
ing-average system that issues buy and sell signals. If a trader is using
just one moving average, a buy signal is triggered when the closing price
moves above the moving average. Conversely, a sell signal is ashed
when the closing price moves below the moving average.
Many technical traders will rely on the crossover method as an at-
tempt to reduce false signals and noise. Using the crossover strategy,
a trader might pick the 20-day and the 50-day moving average. When
the shorter average (in this case the 20-day) crosses above the longer
average, a buy signal is seen. Sell signals are produced in the opposite
fashion. Fewer whipsaws are seen when traders rely on this type ofmethodology. See Figure 1 for an example. A circle signals a buy signal
when the 10-day crossed over the 20-day moving average in late Janu-
ary. Cocoa prices rallied substantially from that signal, roughly from the
$1,580 dollars per metric ton level to the mid-March peak (at this writing
in late March) at $1,850.
While moving averages can be helpful, traders need to do their home-
work when using them. If it were as simple as this example, everybody
would be using this system to make millions, and Id be sitting at the
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fIGuRe 1: Dil Nw york Bord o trd M oco
Sourc: fuurSourc Xr
t 10-d moving vrg is sn in grn nd 20-d moving vrg in rd.
oor-to-ceiling windows of my mansion overlooking Lake Michigan,
with French champagne in one hand and hors doeuvres in the other.
Some of the drawbacks that traders need to consider are that the buy
signal isnt formally issued until after the close, which means the entry
point is the next day. Also, as evidenced by this example, moving-average
signals dont get you in at the bottom of the trend. Nor do they get you
out at the top. But you may be able to catch a good part of the middle of
the trend (which should be enough to be protable, if proper discipline
and money management techniques are rmly in place).In late March, as seen inFigure 1, cocoa prices plunged sharply in an
apparent bull trap failure. But as of this writing, a sell signal has not yet
been seen. A trader, who faithfully follows buy and sell signals would
still be sitting in this trade watching his prots erode. Despite this, how-
ever, there is value in moving averages. They can be used as part of a
discretionary methodology or as part of a mechanical, systematic trading
system.
When people rst come to technical analysis and look at moving
averages, they seem to offer great buy signals, says Bollinger. But when
traders do a little work, the reality turns out not as rosy as they had
hoped it would be. Yet he admits that moving averages can be good ina carefully constructed trading system, provided one tests carefully with
extensive out-of-sample testing, and avoids optimization. With proper
system testing and proper system construction, such systems can work.
OTheR uSeS Of MOvING AveRAGeS
Linda Bradford Raschke, CTA and president of LBR Group, says moving
averages can pinpoint good buying spots during a trend. For shorter-term
discretionary traders, who are trading a trending market, pullbacks to the
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moving average can be good buy
spots, she explains. Markets dont
go straight up or down. For ex-
ample, lets say the S&P contract is
rallying, but intraday price stages
a pullback to the 20-period moving
average on the hourly chart. That
level could offer a good buy spot.
However, warns Raschke, Buy-
ing on the rst or second retracement is OK. But be careful as the trend
matures. If you see a buy or sell climax, dont buy the pullback.
DIffeReNT TypeS
Looking at a basic technical analysis books, youll notice different types
of moving averages: simple, exponential and linearly weighted. While
they are slightly different, experienced traders suggest not getting bogged
down in the details, as they all basically work the same and offer the same
type of signals. For the record, however, the simple moving average is the
one we dened above.
A criticism to the simple moving average concept is that each days
action carries equal weight. The linearly weighted moving average gives
greater weight to more recent closes, as the calculation would multiply
the closing price on the 20th day (for a 20-day moving average) by 20 and
the 19th day by 19, and so on. The total then is divided by the sum of the
multipliers. The exponential moving average also assigns greater weight
to more recent data, but also includes in its formula all of the data in the
history of that instrument (in order to take into account the importance
of data that may have occurred before the specied period). Traders also
actually can dene what percentage weighting to be given to the last daysprice.
Many traders seem to use either the simple or the exponential, but its
worth trying the various indicators to see which ts best for you. Person-
ally, I like exponential moving averages, says Raschke. They give more
weight to the data on the front end. But you can start splitting hairs on
this stuff. It comes down to what tickles your eye. The crux of the matter
is that traders need to experiment or test on their own to determine which
moving average and what type ts best with their trading style and time
frame.
Many technical tools, such as moving average convergence divergence
(MACD), moving average envelopes, and Bollinger bands are more ad-vanced indicators, which in some way borrow from the moving-average
concept. But those are all topics for another day. Understanding the basics
of moving averages, however, will allow one to delve further into the
technical arena. Moving averages can be a useful tool for those looking
to identify what type of trend the market is in and when a turning point
has occurred. Again, traders will never catch exact tops or bottoms with
moving averages, as they are lagging indicators, but they can catch a lions
share of a major market move.
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TRADING INDICATORSBe Your Own Analyst:
Understand Japanese Candlesticks
D
o the terms, dark cloud cover, gravestone doji or morning star
sound like something out of a science ction movie? To seasoned
candle readers, these terms actually identify key candlestickcharting formations that have been used for hundreds of years in Japan,
developed initially by those trading the rice markets there. In recent
years, western technicians have come to appreciate the subtleties and
additional insights that this unique visual display of price action reveals
about underlying market forces.
GeTTING STARTeD
The most basic tool of any technical trader is, of course, the chart, and
one of the rst decisions he or she must make is what type of chart to
use the traditional bar chart, point and gure charts, the market prole
graphic, line charts or Japanese candlestick charts. Each type of chart hasits own advantages and disadvantages, and it is worth taking the time to
experiment with each to see which works best for you.
This article, aimed at those with little experience with candles, will offer
up some of the pros and cons of using these charts.
Candlestick charts are much more visually appealing [than bar
charts], says Joe Palmisano, technical strategist at Ideaglobal. They lay
out an immediately recognizable graphic that reveals the underlying
forces of the market participants.
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A lITTle hISTORy
Candlestick charting is one of the oldest forms of technical analysis, evolving from
methods utilized by 18th century rice traders, according to Steve Nisons book Japa-
nese Candlestick Charting Techniques.
After 1710, the Dojima Rice Exchange, founded in the late 1600s, began to issue
and accept rice warehouse receipts essentially futures on rice. Roughly 1,300
rice dealers participated in this exchange, and because no currency standard had
developed at this time, these rice coupons became the medium for exchange.
Legendary trader Munehisa Homma was given control of his family business
in 1750, and he began trading at the local rice exchange. Throughout the years,
Homma amassed a huge fortune through his rice trading. He also developed his
own system for analyzing the markets, which included analyzing rice prices since
trading began and keeping detailed records of yearly weather conditions. His trad-
ing principles evolved into the candlestick methodology, which became extremely
popular in Japan.
While candle charts have been used for hundreds of years in Japan, they were
only introduced to traders and analysts in the western hemisphere in the early
1980s. Steve Nison is widely credited for bringing awareness of this unique charting
method to the West.
Nison first was introduced to Japanese candlesticks when he noticed some
strange-looking charts in the office of a Japanese broker who worked down the hall
from him at the then Shearson Lehman Hutton. He was instantly attracted to this
charting method and wanted to learn more. Consequently, Nison began doing ma-
jor research on candlesticks and read every book he could find on the topic. In the
late 1980s, Nison ultimately compiled some of his research into a booklet on candle
charts, which was distributed through Merrill Lynch, where he was then working as
a senior technical analyst.
Other proponents of candlestick analysis say these formations offer
traders clues to better entry and exit points and the ability to spot market
turns faster than on a traditional bar chart. While some may shrug off
candlestick analysis as funny-looking charts with a lot of odd terminol-
ogy, the formation of the candles offer traders a great deal of additional
information about who is in control of price.
Palmisano says that candlestick charts offer traders a better read onthe power of the buyers and sellers in the market than do traditional bar
charts. Candlesticks and their patterns tell a story.
Candlesticks can be used across many time frames, just like traditional
bar charts. Traders can look at a monthly, weekly, daily or even an intraday
candlestick chart. The difference between a traditional high-low-close bar
chart and a candlestick is the way the price action is presented.
Candlesticks are composed of what is known as the real body and the
shadows. The real body represents the range between the sessions open
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and close. If the close is lower than the open, the real body is black (or
some other color based on ones charting provider). If the close is higher
than the open, the real body is pictured in white. The thin lines above and
below the real body are called shadows. The peak of the upper shadow is
the high of the session, and the bottom of the lower shadow is the low of
the session. Generally, analysts look to the close and the length of the real
body to determine whether the bulls or the bears are in charge.
Traders will still nd all the same high-low-close information that is
found on a bar chart, but says Steve Nison, author, technician and presi-
dent of candlecharts.com, With candlesticks you get the candle and bar
chart signals. Its a no-lose proposition. Additionally, Candlesticks are
very simple to construct. But, dont let the simplicity fool you; they are
very powerful.
Pointing to an old Japanese proverb, Nison adds, He who sits in the
well can see little of the sky. When you look at a bar chart you are only
seeing part of the picture.
The DOwNSIDe?There are not a lot of naysayers when it comes to using candlestick charts.
Traders arent losing any data or information they would have found on a
bar chart; instead they gain additional information via the candle forma-
tions. And traders can utilize candlesticks along with all of their favor-
ite western indicators. So using a candlestick chart is not a this-or-that
proposition.
When pressed for some cons, analysts did note that those who are
not well-versed or educated in candle sticks could trade off them in
an incorrect manner, which could be devastating to your capital base.
Additionally, as some of the candle formations take several days for a
pattern to develop, one may need to wait until that candle is complet-ed for confirmation of a market bottom or top. Another disadvantage
for those using the daily time frame is that one does need to wait until
after the final bell in order to see the days final pattern. This means a
trader could have to wait until the next days open to get in the mar-
ket, based on a signal.
uSING CANDleSTICkS
For those who are interested in using candles in their trading analysis,
some study is advisable. There are many books and websites available
that can offer novice candle readers background and education.
Nison warns that many traders misinterpret candle signals. One com-mon mistake surrounds the appearance of a doji, which forms when the
open and the close are the same (or nearly the same). People see that
and think, Oh, I should sell short, but thats not right. The Japanese
would say the market is tired when a doji appears. The trend has gone
from up to neutral. A doji shows equilibrium between buyers and sellers,
Nison explains. In order to combat incorrect interpretation, traders need
to take their time to study, learn and watch candle charts before trading
off of them.
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fIGuRe 1: Dil Jun rud il ndlsick r
Sourc: fuurSourc Xr
Greg Morris, author of Candlestick Charting Explained, says one of the
initial insights that candlestick charts can offer a trader by simply look-
ing at the chart is a take on the quality of the trend. A candlestick jumps
out at you, says Morris. You can easily see if the close is above the open
for the day. Or if the recent candles are predominantly white, you are in
a strong trend. If an uptrend is sprinkled with black days, then the daily
candles are not reecting a strong uptrend.
MAjOR Buy AND Sell SIGNAlS
There are numerous candlestick formation and patterns that generally
range from one-day signals to ve-day patterns. Many of the important
reversal signals tend to be three-day patterns. These reversal signals tendto offer earlier clues that the market trend may be shifting over many
price-based technical indicators. While there are many different patterns
to study and learn, once a trader gains familiarity with the formations,
they are quickly and easily identiable and, indeed, do jump right out at
the trader.
Candlesticks are notoriously useful for identifying reversals in trend.
Two-day patterns that appear frequently in many markets are bullish and
bearish engulng patterns. For a bearish engulng pattern, Nison says
that on the rst day of the white candle, the bulls are in charge. The next
day, the market opens higher and then closes very weak. The bears are
grabbing control from the bulls.A bearish engulng pattern is a top reversal pattern that reects over-
whelming selling pressure seen as the long, black real body engulfs a
small, white real body in an uptrend. SeeFigure 1 for an example. Point
A reveals a bearish engulng pattern, which quickly identied a trend
reversal in the June crude oil contract.
No need for a long description on the inverse a bullish engulfing
pattern is simply the opposite type of formation that occurs during a
downtrend.
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Lets take a look at a couple
of other basic and simple pat-
terns that occur frequently. In
Figure 1, point B highlights a
hammer formation. This is an
important bottoming candlestick
line and takes only one day to
signal that a bottom has likely
formed, at least for the short-
term. The hammer signaled a
bottom and presaged a decent
rally in crude oil futures. Point C
in Figure 1 highlights a bear-
ish shooting star formation, also
a one-day pattern. A shooting
star forms when there is a long
upper shadow, with little or no
lower shadow. The real body
forms near the lows of a session.
When this occurs in an uptrend,
it reveals that prices opened in
the lower third of the range, ral-
lied intraday, but the bulls were
unable to defend the new high
territory. The bears assert control
by the close, leaving prices to settle near the days open. The actual
shape of the candlestick reveals the psychology behind the intraday
action.
There are dozens more candlestick patterns to learn and study.The best way to get started is to pick a book and then start looking at
charts. Turn the candles on whatever market you are watching, and try
incorporating them into your market analysis.
MIx IT up
One of the major advantages of candlestick charts is that traders are still
able to use their other favorite technical indicators. Go ahead, draw a
trendline on a candlestick chart and add stochastics, Bollinger bands or
moving averages. Nison believes that candlesticks are a tool, not a sys-
tem. He is a proponent of combining candles with Western signals.
Its like the right hand helping the left. If a group of signals are allsay the same thing, the odds of a turn are higher, Nison says. Point-
ing to the example of a bearish engulfing pattern (but true for all
patterns), he notes, The odds of a market turn are increased if it is
confirmed by a Western moving average or resistance area.
Nisons personal favorite tool to combine with candlesticks is vol-
ume. Candles show the force behind a move. But I always look at vol-
ume as part of my analysis, he says. For example, a tall white candle
on high volume is potentially a positive signal.
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pICkING A TIMe fRAMe
There has been a debate over appropriate time frame usage for can-
dlestick charts. Historically, traders used candle charts on a daily or
longer basis. The Japanese used the daily period. They believe that
the time period of the close from one day to the open of the next day
was a very important decision-making period, says Morris.
However, in recent years, candlestick charts have gained popular-
ity even among the day-trading crowd. Traders use them on time
frames as short as three- and five-minutes. On very short-term
charts, however, Nison advises that traders rely not just on a one-
line formation. Instead, use formations that are comprised of two or
three candles together for more accurate signals. Or try very short-
term intraday candles in conjunction with major support or resis-
tance areas.
Some very short-term traders simply use the color of the candle as
confirmation to get into a trade. For example, lets say someone uti-
lizes a 20-period exponential moving average and retracements. If
price retreats to the 20-period EMA that coincides with a Fibonacci
retracement, the trader may enter a short-term position on the next
white (up) candle. But there are many different strategies and ways
to use candlesticks.
Nison recommends that short-term intraday traders first de-
termine the overall longer-term trend. Then, for example, If the
longer-term trend on the daily chart is bullish and a bullish signal is
confirmed, go long [and] initiate new positions only in the direction
of the longer-term trend, Nison says. Conversely, if a bearish signal
were to emerge on an intraday chart in which the daily trend was
up, Nison suggests only using that to liquidate posit ions or to takeprofits not as a signal for a fresh short position.
A few MORe TIpS
Candlestick analysis can work well in just about any market as long as
there is liquidity. For markets that are not actively traded, the candle-
sticks will not offer an accurate picture of market action. For those
trading foreign exchange, in which there is no official open or close,
it is wise to rely on the same quote provider that has, for example, a
standard 5 p.m. EST settlement. As candlesticks rely heavily on the
open and the close in order to provide clues to market action, one
needs to use consistent open-close data for forex.Each market has its own unique feel. It can take some time to watch
that market with a candle chart to get into that particular markets
rhythm. The Japanese say the personality of a market is like a per-
sons face. No two are alike, says Nison. Get comfortable with four to
eight markets and get to know their personalities, he advises.
If you know how to read the candles and heed what they say, you
will be more equipped to successfully participate in the market, con-
cludes Ideaglobals Palmisano.
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TRADING INDICATORSBe Your Own Analyst:Understanding Cycles
for pure cycle analysts, time not price is the most important
aspect in studying charts.
This is an important theoretical difference when it comes to
analyzing the markets, as the bulk of the eld of technical analysisfocuses on price as the main indicator. Cycle advocates say that both
long- and short-term repetitive patterns can be identied via time,
which can help predict market turns before they happen. Instead of
waiting for a price breakdown or a momentum buy or sell signal, cycles
can help pinpoint areas of time where potential tops or bottoms may be
forming in a market.
Whats the basic rationale behind this approach? A true cycle, by
my denition, is one that goes from a time of extreme pessimism to
extreme optimism and then back to extreme pessimism, says 33-year
market veteran Glen Ring, editor of View on Futures. A cycle simply
measures the mood of participants in the marketplace and is reectedby the price behavior however long it takes.
We see rhythms perpetuate themselves time and time again in all
markets. Rhythms are a natural phenomenon, says Stan Ehrlich, author
of The Ehrlich Report. Traditionally, all cycle denitions or counts
are from market bottom to market bottom. Many cycle analysts point to
J.M. Hurst, author of The Prot Magic of Stock Transaction Timing, as
the pioneer of stock market cycles, and many using this form of analysis
bring some elements of Hursts concepts into their work.
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ChART 1: Monl Dow Jons ndusril avrg r
Sourc: fuurSourc Xr
juSTTAke A lOOkTake out a longer-term chart of the stock market and study it. You just
cant look at a historical chart of the stock market and not see them there,
says Ken Tower, chief market strategist at Cybertrader, Inc. There is am-
ple evidence of cycles within crowd behavior. There are business cycles,
and there are cycles in nature. There are cycles everywhere, so its not too
surprising to nd them in the stock market, he adds.
Many traders may have heard of the Kondratieff wave, an economic
cycle discovered by Nikolai D. Kondratieff back in the 1920s. Basically,
Kondratieff believed that the world economy moves in 40- to 60-year
waves, or cycles, with the average being 52 years. According to his theory,
this overriding cycle of economic activity inuences practically all stockand commodity prices. However, his theory proved controversial both
then and now, and many economists and traders have discredited Kon-
dratieffs work, saying it had little or no merit. And realistically, for day
traders or investors, a 60-year cycle doesnt offer much help in terms
of shorter-term buying or selling spots. But, advocates of cycle theory
note that cycles can be found even on intraday, daily and longer-term
charts.
fINDING CyCleS
In this day and age of split-second, computerized charting software,
counting cycles by hand on a chart may seem outdated and old-fash-ioned. But that is how analysts from the old school began identifying
these cycles years ago. Counting out cycles is a roll up your sleeves and
get your hands dirty kind of approach, explains Ring. These days, how-
ever, there are computerized cycle tools available on charting software
packages. Yet some analysts still prefer to do the work themselves.
Rob Zukowski, technical analyst at 4CAST Inc. in New York, uses cycles
as one of the many technical tools in his analytical approach. In looking for
cycles in the Treasury bond futures market several years back, he simply
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printed out daily price data going
back at least a year. For those
looking to nd cycles on their
own, he advises, You want to look
at a years worth of data, if not
two years. And then, just pick
out what you think are signicant
lows. Count forward to nd out
where the next signicant low
is, and over time you may have
enough observations to dene a
cycle.
Ring agrees. I just start with a
low. I count forward and back-
ward, and just see if I start pick-
ing up a rhythmical pattern.
In recent years, Zukowski had
found an 11-day time cycle in
the U.S. T-bond futures market,
which moved from low to low. He
allowed that cycle to have a plus
or minus one-day time window.
While he warns against trading
off time cycles alone, Zukowski
had found them to be useful as a time predictor. What Im trying to do
here is to nd a simplistic way to get a feel for when we can get some
sort of turnaround, Zukowski explains.
uSING CyCleS IN yOuR TRADINGMost cycle advocates say that this type of analysis offers them a back-
drop or framework for looking at a market. Cycle signals are not a stand-
alone tool. This is an example of what is even more important than
the tool is how you use the tool, says Ring. You want to integrate cycle
work with the trend and other tools.
While CyberTraders Tower admits that he uses cycles only spar-
ingly in his technical work, he says they are a great guideline, and they
helped him identify the U.S. stock market bottom in 2002. (The Dow
Jones Industrial Average posted a strong bottom at 7,197 in October
2002. Since then, prices have rallied to the March 2005 peak at 10,984
and have not revisited the October 2002 low, as of this writing in midMay.) See Chart 1. In the spring/summer 2002, I looked at my historical
cycle chart, and said Im looking for the market to bottom. But, I needed
to see some evidence of a bottom, says Tower.
I nd the U.S. stock four-year cycle to be very helpful in providing a
framework; it is not a deterministic thing, says Tower. This is similar to
what other cycle analysts say. One shouldnt use a cycle-timing trigger
simply to jump into a trade. But it can be a guideline that a low may be
coming. Perhaps, traders can view cycle analysis as a warning system
Most cycle
advocates say
that this type
of analysisoffers them a
backdrop or
framework for
looking at a
market. Cycle
signals are not
a stand-alone
tool.
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that a low may be on the way. Then, once they see conrmation of this
low via their other favored technical indicators, they can be more con-
dent about taking advantage of that information.
This will not be the Holy Grail. It is not something that you strictly
place a trade on. Use your other analysis tools. It is a timing guide, says
Zukowski. For those using shorter-term cycles they may have found in
commodity futures, he notes it could be possible to use the next low as
an opportunity to add to your long. Or, if you are just a day trader, start
looking for an opportunity to buy [around the next low], but use oscilla-
tors to help set up for the trade, he explains.
From a psychological perspective, those using cycle analysis could
be viewed as contrarians. After all, cycle advocates are actually look-
ing to pick bottoms. Market sentiment into important lows tends to be
extremely bearish, as bottoms form when everyone is so bearish that
there is no one left to buy. And that is how cycle analysis can help.
Because at those times, it is very difcult to even think of being bullish!
Shifting to current market conditions, which have seen U.S. stocks in a
decent rally phase off the 2002 low, when you tell people the market
is going to top out, they look at you like you are a crazy person, says
Tower. But, as market historians know well, bull markets dont go on
forever.
The bottom line is that the analysis of rhythms sets you up psycho-
logically in advance for when you should be looking for a turn, says
Ehrlich.
The CRITICS SAy
One of the main criticisms of cycle analysis is that they are not reliable
enough to trade off of. Indeed even arch proponents of cycle analysis
say that they dont rely on them alone in making trading decisions. But,of course, this is true of many other technical indicators and method-
ologies, too. Most discretionary traders develop a number of favorite
analytical and technical tools upon which they rely. When the major-
ity of their favored indicators line up in one direction, it may indicate a
high-odds trading opportunity. Cycle analysis may just be another useful
checkpoint on ones checklist.
fOuR-yeAR STOCk CyCle
While cycle analysts say that cycles occur in all markets including
foreign exchange, various commodity markets and the bond market,
there is a particularly well-known and widely watched four-year cyclein the U.S. stock market. The idea behind this particular cycle is that
by looking at a longer-term chart one can see an easily identifiable
series of important lows every four years in the Dow Jones Industrial
Average.
Where I find cycles most valuable is with the major trend in the
stock market, says CyberTraders Tower. Whether you call it the
presidential cycle or the four-year cycle, its too strong a cycle to ig-
nore. There is incredible evidence that this exists.
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Looking back over the past 60-plus years, analysts say, there has
been a strong tendency for the U.S. stock market to bottom on a four-
year cycle basis. Starting with the most recent low, these bottoms have
been seen in 2002, 1998, 1994, 1990, 1987, 1982, 1978, 1974, 1970, 1966,
1962, 1957, 1953, 1949, 1946 and 1942. Readers may have noticed that a
couple of those important market bottoms were a year off. Cycle ana-
lysts note that this is allowable.
ITS NOT exACT
In Rings cycle work, he allows for cycle bottoms to form plus or minus
ve percent in the overall time of cycle. CyberTraders Tower likens the
minor discrepancies to longer-term weather patterns. Weather cycles
on a long-term basis seem very predictable. In the Northeast in March
and April, we know it warms up. However, there is the issue of exact
timing. If Im a farmer, figuring out what day to plant my tomato seeds
will vary from year to year, Tower says.
However, shifting back to the four-year stock market cycle, read-
ers also may have noticed that the 2002 bottom means that the next
major bottom is coming for U.S. stocks next year in 2006. In an ideal
four-year cycle, the stock market would go up for two years and down
for two years. But that rarely happens, notes Peter Eliades, editor of
Stock Market Cycles for the past 30 years.
IS IT The lefT OR The RIGhT?
This brings us to the concept of left and right translation within cycle
analysis. That simply refers to the movement of cycle highs either to
the left or right of the ideal cycle midpoint. For example, the four-year
stock market cycles mid-point high would be the two-year mark, in
between the lows seen every four years. Analysts have found that mostvariations in cycles develop at the highs, not at the bottoms, which is
why market watchers count from the lows.
If the top comes to the right of where it should have, it is called
right translation, says Eliades. Longer-term cycles, such as 25- or
30-year cycles may have an overriding impact on shorter-term cycles,
such as the four-year. For example, if left translation is seen in the
four-year stock cycle, theoretically longer-term negative cycles are
weighing on the market.
Tower again likens the influence of longer-term cycles over shorter-
term cycles to the weather. If the real long-term trend is up, it will
bias all the short-term trends just as a cold day in summer is not thesame as a cold day in winter. The point is that longer-term cycles may
have an influence on whether left or right translation will likely occur
in shorter-term cycles.
lOOkING BACk
Looking back at some recent U.S. stock market history, many investors
are well aware that one of the greatest and most historic bull markets
of all time began in the early 1980s. From 1982, the U.S. stock market
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saw an unbelievable 18 consecu-
tive years in which the low for
the year was above the previ-
ous years low. That has never
before happened in the history
of the market , notes Eliades.
Within a two-year period
around 1982, Eliades explains,
several major long-term stock
market cycles, including the
60-year, 30-year and 25-year
cycles, all bottomed together.
That created a convergence
of longer-term upward cycle
pressure on the market to-
gether. However, now in 2005,
the next five years should see
downside pressure from all of
these longer-term stock market
cycles, according to
Eliades.
GOING fORwARD
Longer-term cycles are going to
be putting downside pressure on
the market over the next several
years, Eliades predicts. He points
to the four-year cycle due to bottom in 2006, the 25-year cycle due to
bottom in 2007 and the 30-year cycle due to bottom in 2010. For at leastone to two years, you have specic cycles that arent going to add any-
thing to the market, he says.
CuRReNT RAlly phASe
Counting out the current rally days into mid May, CyberTraders Tower
notes that U.S. stocks already have exceeded the average short bull
market (592 trading days), starting from the October 2002 bottom.
We are heading toward the average length of all bull markets (797
trading days) that would take us up to Thanksgiving. Unless one can
envision an acceleration of the economic expansion, it is difficult to
envision this advance extending into the longer-than-average bullmarkets that tend to occur during the big expansionary phases of
the economy (such as 1949-1968 and 1982-2000), Tower says.
Looking out over the next year and a half, Tower forecasts a nasty
bear market into the next four-year bottom, which is due in 2006.
Tower points to the March 2005 high and says it is quite possible
that was the end of the current bull market. It could be severe, he
says, given the overriding pressure of the very long-term sideways
pattern. (The market is no longer benefiting from the huge long-
We are heading toward
the average length of all
bull markets (797 trading
days) that would take us
up to Thanksgiving 2005.
Unless one can envision
an acceleration of the
economic expansion, it
is difcult to envision this
advance extending into
the longer-than-average
bull markets that tend
to occur during the big
expansionary phases
of the economy (such
as 1949-1968 and 1982-
2000),
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term up cycles, which supported overall activity during the 1980s and
1990s).
For example, says Tower, when you are in a really big, longer-term
uptrend, you have very short bear markets. He pointed to the 3-1/2-year
bull period into the October 1987 market crash. Then, although October
1987-early December 1987 was short in terms of time, it was extremely se-
vere in terms of price retracement. Unfortunately, for current longer-term
buy and hold investors, Tower believes that the market had broken the
short bear market pattern after the 1998 low. In the current environment,
the bull market periods no longer will see added benet or lift from any
longer-term secular uptrends. The longer-term trends have shifted either
sideways or down, depending on who is telling the story.
wheRe DO They COMe fROM AND why DO They wORk?
One of the tougher issues to understand is where cycles come from and
why they work.
It could be the same as if you had asked me if there is a God. Does he
exist and why does it work? ponders Eliades.
4Casts Zukowski takes a more pragmatic approach to the question.
Being a technician, patterns do tend to repeat. I think of it more as a
repeating factor. These markets are made up of emotions, and people tend
to trade off of emotions, whether it is a triangle or a cycle low. That is what
we do in technical analysis, he says. After all, technicians say that history
repeats itself as buying and selling and greed and fear create identiable
patterns.
It is human nature to always chase what is hot at the time, notes Ring.
Cycles reect the need of a market to constantly purge the excess pes-
simism and restore excess optimism. Think of a crowd running from one
side of the boat to another.But those who are cycle advocates simply have seen over time that they
do work, and that is enough for them. However, those who need a little
more proof may have a tough time digesting the concept of cycles. Some
cycle advocates point out that cycles are everywhere in the natural and
physical world. After all, scientists have found accurate and repeating
sunspot cycles, and the planets have reliable cycles during which they
revolve around the sun.
Be A STep AheAD Of The CROwD
For those interested in incorporating cycle analysis into their trading
decisions, as always it pays to invest some time learning and studying.For starters, simply reading some books and articles to help understand
the basic concepts and then poring over a variety of stock or commodity
charts can be very insightful.
People learn things too late. Some take no historical notice of the
fact that there are cycles out there. Now we are in a trading market.
But everybody wants to behave like it is a buy-and-hold market. If you
study cycles and history, maybe you can be a step ahead of the crowd,
concludes Tower.
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TRADING INDICATORSBe Your Own Analyst:
Understanding Volume
Many technical traders will tell you that price is king. Everything
comes down to price, and price is the most important indicator
in and of itself. Experienced traders know that many technical
indicators are simply price massaged, oiled and spit out into a fancy blueor red line at the bottom of ones chart. But volume is a completely differ-
ent animal. While youd have to travel far and wide before youd chance
upon a trader who would say that volume readings are more important
than price, they are useful and signicant raw data readings that measure
the amount of action and psychology of the market players.
Volume, of course, simply is the measure of the number of shares of Intel
or Qualcomm or any stock traded during a day. In the futures arena, volume
measures how many corn contracts or S&P E-minis changed hands that
session. For those who are trading on an intraday basis, 5-minute volume
bars can be found, or for traders more comfortable with a longer-term view,
weekly or monthly volume data can be called up just as easily.
NewTONS lAw
Remember back to high school physics. Newtons rst law of motion
reects the concept underlying volume analysis in the nancial markets.
This law says that an object in motion will stay in motion unless acted
upon by an unbalanced force.
Thus, many technical traders call volume the fuel behind a market
move. Is the gas tank full and providing powerful momentum for that
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Porsche speeding down the Autobahn? Or is the gas tank nearing empty,
which means the engine is likely sputtering, and the driving machine is
slowing and limping toward the shoulder of the road? For a trader who is
looking to put on a stock trade from the long side, knowing how much gas
is likely left in the tank is an important variable. After all, how many smart
drivers set off for a long trip with only a gallon of gas left in the tank?
Joe Granville, editor of the Granville Market Letter and developer of
the popular volume tool called on balance volume (OBV) [well get to this
later], puts it another way and says that volume is the steam in the
boiler that makes the Choo Choo go down the tracks.
uSe IT TO CONfIRM
Generally speaking, volume has to conrm price, explains John Murphy,
author and chief technician at Stockcharts.com. When price breaks out to
the upside [or downside], we normally like to see a nice pickup in volume
to conrm that.
One of the basic rules of thumb for traditional volume analysis is that a
healthy uptrend would see expanding volume on up days and contracting
volume on down days. Just the opposite would be true for a downtrend.
When you get an exception to that, it can be a sign that trend is changing,
says Phil Roth, chief technical analyst at Miller Tabak & Co. Daily volume
data is easy to nd and can even be tracked via the Wall Street Journal, and
most charting software packages offer an option for volume bars across the
bottom of the chart.
A market rallying on light volume is a sign there isnt as much bullish-
ness. It is a hesitant market, says Murphy. When we dont get volume, we
get more suspicious.
Or another subtlety for which to be on the lookout is big volume in an
uptrend, but no price progress. That could be a signal that youve hit resis-tance, adds Roth. The idea is that an unusual change in a volume pattern
could signify a possible reversal.
MORe RuleS Of ThuMB
Some other basic rules of thumb in relation to volume are that bull markets
tend to have bigger volume, while bear markets tend to have lighter volume.
Markets must be pushed up but can sink on their own weight, notes Roth.
In a downtrend, traders would like to see increasing volume on down days
and decreasing volume on up days.
Independant trader and analyst Brian Shannon uses volume in his trad-
ing and analysis. He says volume is second only to price. Price is whatpays, and volume lets us know about the emotional condition of the buyers
and sellers.
Shannon highlights a couple of his favorite reections on volume:
Big volume without further upside equals distribution;
Big volume without further downside equals accumulation;
Volume tends to peak at turning points;
Volume often precedes price movement;
Volume is a relative study.
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Shannon outlines an example for a stock that is rallying. "You'd like to
see that stock advancing on increasing volume each day, say 600,000 the
rst day, a million the second day and a million-ve the third day. Price
pullbacks should see successively lower volume, such as 900,000, 600,000
then 450,000" to reect a healthy advance.
One of the old market adages says that once a trend is established, it
is more likely to continue than to reverse. "That is even more likely to
be true if pullbacks are on declining volume," says Shannon. For trad-
ers who may have missed an entry opportunity on a breakout, if a stock
posts a retreat on declining volume, that may offer a second entry op-
portunity for a trend move.
DIveRGeNCe
Themes that come up over and over again in the eld of technical analy-
sis are the concepts of conrmation and divergence. Divergence often
is used in the world of oscillator readings with such tools as stochastics
or the relative strength index. Simply, the idea with those tools is that
with a bullish trend, one should see rising oscillator readings. When that
doesnt occur, a divergence occurs, and that is an important red ag
warning signal that trend could be about to change. Example? if a price
made a new high in an uptrend, but stochastics failed to make a new
oscillator high and actually turned lower. That would represent a bearish
divergence.
Take that concept and apply the same principle to volume. For ex-
ample, in a bull trend, does a stock or a commodity price hit a new high
for the rally move, but declining volume is seen for that session? Red
ag time.
BlOw-Off AND ClIMAxNow for the exciting stuff: blow-offs and climaxes. Blow-offs tend to
occur at major market peaks, while climaxes emerge at market bottoms.
These terms simply reect a huge amount of volume that emerges late
in a market rally (or decline) with a sudden peak. Prices then abruptly
reverse.
Volume tells me where the action is. It shows me the collective psy-
chology of the participants if they are fearful or overly optimistic, says
Shannon. However, its tough to say what a climax or blow-off is until
after it is over.
CONfIRM pATTeRN BReAkOuTSAnother use of volume analysis is to incorporate volume readings
along with pattern breakouts. For those schooled in traditional pattern
analysis, volume can be a helpful conrming indicator for double bottom
or top, ag, triangle or any type of pattern breakout. How does it work?
Jordan Kotick, global head of technical analysis at Barclays Capital says
that for him, Volume shows conviction. Is there conviction in a move?
Combining a price breakout with a volume conrmation simply helps
a trader to see if there is conviction behind that price breakout. Lets
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say that corn futures have been in a
downtrend. But because markets dont
ever simply go straight up or down,
the bear trend takes a pause, prices
consolidate for several weeks, and a
continuation triangle develops on the
daily chart. Then one day, traders wake
up and corn breaks out to the down-
side of that triangle, blasting below the
lower triangle line at the nal bell. On
that day, traders could look for a high-
volume day, a large and long volume
bar, relative to the recent sessions. A
high-volume day would be viewed as
conrmation to the downside break-
out of that pattern.
DRIll A lITTle DeepeRFor those wanting to take volume
analysis to the next step, traders could
study what is called upside volume,
versus downside volume, when analyzing the major U.S. stock averages.
Just as it sounds, the upside/downside ratio simply reveals the relation-
ship between the total volume of advancing shares, versus the total
volume of declining issues.
ON BAlANCe vOluMe
There are a variety of tools and ratios based on volume, but one of the
early volume indicators, developed by Joe Granville in the early 1960s, isknown as OBV. This tool can help traders avoid the subjective nature of
eyeballing those volume bars streaming across the bottom of the chart.
(Is that one slightly bigger or smaller?) The OBV indicator turns the
volume data into a line graph, which can be displayed across the bottom
of ones chart. Traders actually can draw trendlines on the OBV indicator
just like a price chart. When the OBV turns and breaks that trendline, it
can signal a potential turning point in price. It also can be used like an
oscillator to help pinpoint divergences between price highs and volume
peaks or price lows and volume troughs.
If price is moving up, OBV should be moving up, too, explains Mur-
phy. He also notes that OBV could actually be a leading indicator. OBVcan break out before the stock does, Murphy says.
The calculation behind the OBV is extremely easy to understand even
for those who are as math-challenged as this author. The total volume
for a session is given a plus or minus value depending on whether
prices closed higher or lower that day. A higher close would result in
the volume to be counted as a plus, while a lower close would result in
a minus value. Thus, a running total is achieved by simply adding or
subtracting volume depending on direction of the market close.
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For those who are just beginning to use volume as part of their anal-
ysis and trading, Granville advises students to pick a stock, prefer-
ably a well-known stock. Follow it every day in the newspaper. Keep a
running total of volume. If it closes up, add all the volume of the stock
traded that day. If it closes down, subtract the volume of that day from
the previous figure. Youll see a running commentary on the action
of the stock. Youll see the evidence that volume precedes the price
trend.
equIvOluMe ChARTS
Volume analysis has spawned a range of indicators and even a new
type of charting technique, called equivolume bars. This type of chart
actually combines price and volume into one bar or box. For those
familiar with Japanese candlestick charts, the concept is somewhat
similar. Basically, the top of the equivolume box represents the days
price high, while the low is seen at the bottom of the box. The width
of the box represents the days volume. The wider the box, the heavier
the volume during that session. By just glancing at the bars, you can
tell which days have heavier volume, explains Murphy.
ADD OpeN INTeReST TO The MIx
Traditionally, some technical analysts have combined volume with the
study of open interest, which simply refers to the number of outstand-
ing contracts still open at the end of the trading day in the futures
markets. With the advent of 24-hour markets and the rise in popular-
ity of foreign exchange trading among individual traders, the study of
open interest appears to have waned somewhat. But for those wanting
to understand the basic rules of thumb, they still apply.
Traditional Open Interest and Volume Guidelines:
If prices are rising and volume and open interest are increasing, it
represents a strong market;
If prices are rising while volume and open interest are falling, it
reveals a weakening market;
If prices are falling while volume and open interest are increasing,
it represents a weak market;
If prices are falling while volume and open interest are falling, it
represents a strong market.
DONT MAke ThIS MISTAkeAccording to Marketwises Shannon, one of the biggest misuses of vol-
ume is an interpretation when a stock is declining. Lets say a trader
is long a stock and price begins to pull back. People convince them-
selves to hold on because it [the pullback] is on light volume, Shan-
non says. But that may not be the best way to manage a trade. Would
you rather lose ten percent of your money on light volume or big
volume? asks Shannon. He instead advises traders to exit a position
based on price action.
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Another common mistake is that many traders could point to a heavy
volume day and be convinced that it is a climax or blow-off day. Most
people end up misreading big volume, says Shannon. Just because it is
the biggest volume in three days, doesnt mean the move is over. Volume
could be even bigger the next day.
TIMING IS eveRyThING
Typically, trading in the stock market (and the futures on the major stock
indexes) sees the heaviest volume during the rst hour-and-a-half of
the day and then the last hour-and-a-half of the day. Traders can use this
generality to help them in their intraday trading. The midday doldrums
occur because institutional traders are waiting you out, warns Shan-
non. Often times, major institutional players will execute large portions
of orders in the morning, and then wait for heavy volume and renewed
trending action late in the day to nish orders.
This can be helpful information for those who are trading very short
term on an intraday basis. If you are a hyperactive trader and have to
take your prots, take them during the rst move in the morning, says
Shannon. There may be another opportunity during the second late-day
wave of action. Otherwise a trader who bought, say, the S&P E-mini early
in the day and saw some prots in that trade, may slowly watch that prot
erode during the lunchtime doldrums, as prices simply tick slowly lower.
For those who get spooked on pullbacks or dont have the patience to wait
for the afternoon move, it may be wise to simply book the prots early on.
ClOSING ThOuGhTS
Here are a few more tidbits on incorporating volume into your trading and
analysis.
Use volume simply as a screening tool. For those who are scanningthousands of stocks looking for a good trading opportunity, volume can
help distinguish between those that are in an uptrend or downtrend (de-
pending on whether one is looking for long or short trades). How? Those
stocks with the best volume prole or pattern can help weed out the
stocks most likely to continue with that trend.
Barclays Kotick closes with another tip for beginning volume followers.
Its not the level of volume that is key, it is the trend of volume. Look at it
over a range of time. One day of volume cant be viewed in a vacuum. Vol-
ume analysis is most useful when compared to previous sessions. Some
like to say volume is simply a reection of supply and demand. A high-
volume day simply reects more demand in the marketplace. But overall,traders and analysts note that volume should be used as a conrming
indicator. Most still agree that price remains the most important factor to
consider while trading. Volume may offer up warning signals, red ags or
generate trading ideas. But use it as a supplementary tool.
If youve havent incorporated volume readings or analysis into your
trading, it may be worth exploring. Volume is very useful and impor-
tant. You cant do good technical analysis without looking at volume,