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62

b. Sell on the first rally after the neckline is broken. (Although more conservatrve, the lost opportunities usually outweigh the improved entry prices.) Use the same stops as in Step la.

2a. Sell when the right shoulder is being fiarmed. A likely place would be when prices have retraced their way half of the distance to the head. A stop-loss can be placed above the top of the head.

b. Wait until the top of the right shoulder is formed and sell with a stop either above the high of the right shoulder or above the high of the head.

Both steps 2a and 2b allow positions to be taken well in advance of the neckline penetration with logical stop-loss points. Using the high of the head for a protective stop is conservative

3. Sell when the right part of the head is forming, with a stop-loss at about the high of the move. Although this represents a small ride it has less chance of success, it is for traders who prefer to find tops and are willing to suffer frequent small losses

to do il. Even if the current prices become the head of the formation, there may be numerous small corrections that will look like atsolute tops to an anxious seller.

Other Top and Bottom Formations

The experienced trader is most successful when prices are testing a major support or resistance level, usually a contract or seasonal high or low. The more often those levels are tested the clearer they become and the less likely prices will break through to a new level without a change in the ftindamental supply and demand factors.

Repeated tests of tops are visually clearer, but not as exact as bottoms because of the added volatility of higher prices. The double top is a more speculative trade than successive multiple tops; it is more frequent than the other formations and is the first opportunity for picking the top of a bull move. It is also easj to position a stop-loss above the previous highs. As with other chart pattems, declining volume would be a welcome confinnation after the formation of the first top and accompanjing each additional test of the top (Figure 9-3).

Triple tops are frequently used as opportunities for selling. Because they are easily seen, there is anticpation that causes the ttiird top to look similar to a right shoulder, lower than the previous highs. Traders waiting for a near-test of the highs to enter a trade with less risk could find themselves without any position at all Among professionals, the fourth top is considered the final test; whichever direction prices tum at that time will determine the new major trend.

Double and triple bottoms also occur but are generally of lesser magnitude than tops. Because low prices can be sustained at value or cost-of-production levels, it is not necessarj for the new upward trend to begin in the near ftiture. In most markets, the profitability associated with these bottom formations is much lower and is proportional to the lower risk. With the exception of the financial markets, for which bottoms are really tops (peak interest rates), double and triple bottom formations are most often found in the currency and catUe markets

When using top formations, we must consider why a three- or four- combination is so rare. There are two possibilities. When it is evident that the previous peaks occurred under extreme conditions, such as a temporarj supply shortage, or demand caused by a news-related item, the following tests of the high are met with active selling. This causes any attempt at an upward move to be sha ly halted. The greater the conviction that the rally is over, the greater the selling

Multiple tops also fail to appear because prices simply move higher. The market does not see the previous tops as significant, and new buying renews the upward trend. If you see a single, interim top on a chart, formed by a pullback within a trend, there must have been a potential double top when prices resumed their direction, it may be ttiat two or

FIGURE 9-3 Double and ttiple tops.



three peaks at very similar prices are very unusual and a poor way to trade. A perfect test of the top means that there is uncertainty at that moment and significant selling developed after the fact

Now You See It, Now You Dont!

The "V"-top (actually an mverted V), or spike, is the most difficult top formation to anticipate and trade. Its frequency in the 1974 and 1980 maikets tended to deceive a generation of new apeculators. V-tops are caused by critical shortage and demand and magnified by public awareness. In 1974, it was a combination of domeatic crop shortage, severe pressure on the U.S. dollar abroad, and foreign purchases of U.S. grain that combined to draw public attention. The news was so well publicized that novice commodity traders withdrew their funds from their declining stock portfolios and bought any commodity available as a hedge against infiation.

It could not continue for long. When the top came in soybeans, silver, and most other commodities, there was no frading for dajs in locked-limit maikets: paper profits dwindled faster than they were made, and the latecomers found their inveshnents unrecoverable. The public often seems to enter at the wrong time The case of cattle is an example.

Live cattle prices are based on a combination of consumer demand, substitute foods, current health news, and the price of various feed grains. During 1973 as the price of feed increased, cattle prices rose steadily from under 40c per pound to almost 54c in August. Prior to that, live beef prices had never been over 37c (in 1952). The price of soybean meal, used as a high-protein feed, continued to move prices higher. How high could it go Between August and October, live-cattle prica; formed a V-top and declined bad; to under 40,c, giving up the 8-month gain in 2 months. How could the supply-and-demand fadors change so quicklj? They cant. Fast rises are ahvajs followed by fast, usually extensive declines.

The psjchologj of the runaway maiket is fascinating. In some way. even- V-top shares a similarity with the exanples in Mackays Extraordinarj, Popular Delusions and the Madness of Crowds. With beef, the consumers do not tend to consider pork. fowl, or fish as an adequate subatitute and will bear increased costs longer than expeded. As prices neared the top, the following changes occurred:

The cost became an increasing fador in the standard household budget.

Rising prices received more publicitj

Movements for public beef boycotts began.

Grain prices declined due to the new harvest.

This becomes a matter explained by the Elastic Theory,, it can be applied to the 19-3 soybean and 1980 silver markets as well. The Elastic Theory is based on the principle that when prices get hieh enough, a number of phenomena occur:

1 .Previously higher-priced substitutes become pradical (sj-nthetics for cotton, reclaimed silver).

2. Competition becomes more feasible (corn sweetener as a sugar substitute, alternate eneigj).

3. Inadive operations start up (Southwest gold mines, marginal production of oil).

4. Consumers avoid the products (beef, bacon, silver).



Consequently, the demand suddenly disappears (the same conclusion arrived at by economists). Announcements of additional production, more acreage, new products, boycotts, and a cancellation of orders all coming at once cause highly inflated prices to reverse sha ly.

These factors form a V-top that is impossible to anticipate with reasonable risk. There is a natural reluctance to take profits while they are atill growing. Further impetus is given to the reversal because of the scramble to liquidate after the first reversal dsy. This is followed by those latecomers or pjTamiders who entered their most recent positions near the top and caimot afford a continued adverse move. The rush to close out long positions, put on new shorts, and liquidate deficit accounts only prolongs the sharpness of the V-top, causing a liquidity void at many points during the decline.

Quantifjing Spikes

A apike is often the focal point of a trade. Most often it represents a severe reaction to an event, but it may be an island reversal representing a new direction. A spike is important because it alwajs indicates high volatility and exceptional rid; and cannot be ignored. A apike has only one dominant feature, a price high or low much higher or lower than recent prices. This must result in volatility that is equally extreme. The easiest way to identifj an upside apike is to compare the days trading range with previous ranges and to the next day. This can be done by using the average true range and satisfjing both the following conditions:

High today - (ahighest(high,n) : = x average true range(n)

High today - high tomorrow := x average true range (n)

Todays spike high must be higher than the highs of the previous n-dajs by a multiple, K, of the average true range; it must also be higher than tomorrows high if it is to stand out as a apike

A gap is a formation caused by a jump in price from one point to the next and can be calculated as Gap = (aAbsValue(open - close[l])

Gaps are phenomena that make sense only when trading is restricted to local business hours. A currency trader with 24-hour capability has, theoretically, a very small chance of confronting a gap. Most gaps are overnight moves, where continuous events cause changes in price levels; when the exchange or banks open for business the price immediately jumps to the new level. A market with very large relative gaps is the Japanese yen trading in Chicago During the Japanese business day, when most relevant news occurs, the International Monetarj Market (IMM) is closed; when die IMM is open, most businesses in japan are closed. The Chicago market is therefore always trjing to catdi up to the price of the dollar/jen as seen by the Japanese.

There is also a technical situation associated with price gaps. Traders place more orders to buy at a point near or just above a resistance level; similarly, they place sell orders just below support lines. This causes fast moves and a void of orders when resistance and support are pendrated. Gaps also occur after a price shock or any unexpected new release or economic report.

A gap appears as an open area on a chart created by prices trading entirely above or below the prior trading range. Gaps will usually occur at the opening of the day, a news release, or where prices break out of a clearlj identified formation, such as a long-term trendline, a consolidation area, or during a prolonged major price move. Regardless of the reason, it is the consequence of a lack of apeculators willing to take the opposing position causing a thinly traded or illiquid market. In the most interesting situations, the breakaway gap is the name given to the result of many stop-loss orders placed at new hiehs or

lows, at major trendlines as protection against unfavorable breakouts with respect to existing positions, or as an entry to a new position. The breakaway gap usually signifies a change from the previous, well-established pattem.

The common gap is die least glamorous. It occurs within a wen-defined trading range or pattem, and is not



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