Classic Dilemma

The use of bands around a trendline is more popular than the use of the trendline alone because price movement is not clean. Laiger bands produce more reliable trend signals;

FIGURE9-I Basic trading rules, (a) Line signals, (b) Bands.

however, they need more time to generate a signal resulting in smaller profits and laiger rid;. This produces a classic dilemma for the trader, one that cannot be resolved except by personal choice.

Rxperienced traders often wait for the first pullbacl; after the Isreakout before entering their position. This technique results in a higher percentage of profitable trades. The position is set when the new direction is confirmed following a test of the old support or resistance levels (and the theoretic stoploss). If the test fails, which frequently occurs, the trade is not entered and a loss is prevented (Figure 9-lb). Unfortunately, most of the biggest profits result from breakouts that never pull bad;. Catching only one of these breakouts can compensate for all the small losses due to false signals. Many professional fraders may be steadj winners, but they do not often profit from the biggest moves.

Identifjing Direction from Consolidation Pattems

it is said that maikets move sidewajs about 80°o of the time, which means that diredional breakouts do not occur often, or that most breakouts are false and fail to identifj a new maiket diredion. Classic accumulation and dishibution formations, which occur at longterm lows and highs, attempt to find evolving changes in maiket sentiment. Because these formations occur only at extremes, and may extend for a long time, they represent the most obvious consolidation of price movement. Even a rounded, or saucer, bottom may have a number of false starts; it may seem to rum up in a uniform pattem, then fall back and begin another slow move up. In the long run the pattem lools as if it is a somewhat irregular but extended rounded bottom; however, using this pattem to enter a trade in a timely fadiion can

be disappointing and has resulted in the safe-but conservative technique

Most other consolidation formations are best viewed in the same way as a simply horizontal sidewajs pattem, bounded above by a resistance line and below by a support line. If this pattem occurs at reasonably low prices, we can eventually expect a breakout upward when the ftindamentals change. Occasionally prices seem to become less volatile within the sidewajs pattem, and chartists take this opportunity to redefine the support and resistance levels so that thef are narrower. Breakouts based on these more sensitive lines tend to be less reliable because they represent a tenporary quiet period inside the normal level of market noise.

Market Noise

AW markets have a normal level of noise. The stock index markets have the greatest amount of irregular movement due to its extensive participation, the high level of anticipation built into the prices, and because it is an index. This is contrasted to short-term interest rates, which have large participation but htUe anticipation and a strong tie to the underljing cash market. In comparison, long-term rates allow for greater movement away from the cash market. The normal level of noise can be seen as the consistent daily or weekly trading range on a chart of the DJIA or S&P When volatihty declines below the normal level of noise, the market is experiencing short-term inactivity An increase in volatility back to normal levels of noise should not be contused with a leakout.

This same situation can be apphed to a triangular formation, which has traditionally been interpreted as a pause within a trend. This pattem often follows a fast rise and represents a short period of dechning volatihty. If volatihty dechnes in a consistent fashion, it appears as a triangle; however, if the point of the triangle is smaller than the normal level of market noise, then a breakout from this point is hkely to restore price movement to a range tjpical of noise, resulting in a flag or pennant formation. Both of these latter pattems have uniform height that can include a normal level of noise.

TOPS ) BOTTOMS

Most of the formations important to bar charting can be traded using a penetration of one of the support oi resistance hues as a signal. The most interesting and potentially profitable trades occur on breakouts from major top or bottom formations. The simplest of all bottom formations, as well as one that offers great opportunities, is the extended rectangle at contract lows. Fortunes have been made by appljing patience, some available capital, and the foUowing plan:

I Find a market with a long consolidating base and low volatihty (with ftitures it should also have increasing open interest). When evaluating interest rates, use the yield rather than the price, and avoid currencies that have no base price; that is, they have no level considered low, but instead have a point of equihbrium.

2. Buy whenever there is a test of its major support level, placing a stop-loss to hquidate all positions on a new. low price.

3. After the initial breakout, buy again when prices puU back to the original resistance hne (now a supporl level). Close out all positions if prices penehate bad; into the consohdation area, and start again at st 2.

4. Buy whenever there is a major price adjustment m the buU move. These adjustments, or puUbacks, wiU become shorter and less frequent as the move develops. They wiU usually be proportional to current volatilitj or the size of the price as measured from the original breakout.

5. Liquidate all positions at a prior major resistance point, a top formation, or the breaking of a major buUish support hne.

Buildmg positions m this way can be done with a relatively small amount of capital and risk. The closer the price comes to major support, the shorter the distance from the stoploss; however, fewer positions can be placed. In his book. The Professional Commodity Trader ( & Row), Stanley KroU discussed "The Copper Caper-How Were Going to Make a Milhon," using a similar technique for building positions. It can be done, but it requires patience, planning, and capital. The opportunities continue to be there.

This example of patiently building a large position does not usually apply to bear markets. Although there is a great deal of money to be made on the short side of the market, prices move faster and may not permit the

accumulation of a large position. There is also exceptionally high rid; and the increased risk of false signals caused by greater volatility. Within consolidation areas at low levels, there is an underljing demand for a product, the cost of production, govemment price support (for agricultural products), and low volatility. There is also a well-defined trendline that may have been tested many times. A carefiil trader will not enter a large short-sale position at an anticipated top, but will join the buyers who contribute to the growing volume and open interest at a well-defined majoi support level.

Head and Shoulders

The classic top and bottom formation is the bead and shoulders, accepted as a major reversal indicator. This pattem, well-known to chartists, appears as a left shoulder, a head, and a right shoulder (Figure 9-2).

The head-and-shoulders top is developed in the following manner:

1. A strong upward breakout reaching new highs on increased volume. The move appears to be the continuation of a long-term bull move.

2. A consolidation area formed with diminishing volume. This can look much like a descending fiag predicting an upward breakout, or a descending triangle indicating a downward breakout.

FIGURE 9-2 Head-and-shoulders formation. Head

Right shoulder

3. Another upward breakout on continued reduced volume forms the head. This is the key point of the formation. The new high is not confirmed by increased volume, and prices fall off quickly.

4. Another descending fiag or triangle is formed on further reduced volume followed by a minor breakout without increased volume. This last move forms the right shoulder and is the third attempt at new highs for the move.

5. The lowest points of the two fiags, pennants, or triangles become the neckline of the formation. A sale is indicated when this neckline is broken.

Trading Rules for Head and Shoulders

There are three approaches to trading a head-and-shoulders top formation involving increasing degrees of anticipation:

la. Sell when the final dip of the right shoulder penetrates the neckline. This represents the completion of the head-and-shoulders formation. Place a stop-loss just above the entry if the trade is to be held only for a fasl profit, or place the stop-loss above the right shoulder or above the head to liquidate on new strength, allowing a longer holding period.