If the trend is up (the slope a := 0) and the next price is below the projected lower band, then the trend has tumed from up to down. If the frend is down (a =: 0) and the 1 price is greater than the proj ected upper band, then the frend has tumed up. When the slope, a, is very near 0, we have a sidewajs channel and the same riUes still apply.

Because a major channel is considered a shong chart formation, prices that approach the channel, but have not penetrated the band, would be candidates for frades. For example, if the frend is down and prices come within ISo of the upper band, we would want additional short positions (see Figure 12-8). We do not necessarily want to lift those existing shorts at the bottom of the channel, especially if the downfrend is severe; however, this

FIGURE 12-8 Entering near the top of a declining channel. Points A, 8, and define the new channel.Trades can be entered at point E I, exited at XI, then entered at E2 and E3 and exited at X2.

technique offers a clear and safe way to scale into a trade with more than one entry point, if the frend is sidewajs (the slope is near zero), then exiting shorts and reversing your position could work well

A minor channel can also be used to signal bujs and sells within a major channel. By finding swing points using a small minimum swing value, we can wait for a break of the minor channel to signal a frend direction within the major channel. This gives an added confirmation that prices are moving in your direction before entering.

MOVING CHANNELS

As computers have become common, channels are frequently constructed as moving bands around prices. Some of these, such as those using a standard deviation, can claim statistical significance (these are discussed in Chapter 5). A simple mathematical way of representing a channel might use the average of the high, low, and close to designate the center and a band based on the highs and lows. The midpoint of the price move M and height or range R of the move can be calculated

Then, the upper and lower channel bands forecasted for tiie next day are tf,.. = JM, + (JM, - JM, 0 + wft i*i=M,+ W,~M,-,}- wRj

The bands are created by extrapolating the average midpoint and adding or subtracting the average daiiy range R multiplied by a scaling factor w. A iong position is taken when the new price P, 1 :*U, 1; a short is taken when P, ~, -- L, if a channel profit objective is needed, it can be calculated at a point equal in distance to the channel width from the channel breakout as follows

Long objective UO,i = UUi + 2 /?, Short objective LO,+1 = 1?+, - 2wR,

Because the value wR, represents one-half the band width, 2wR, the objective is an equal band width above or below the breakout point on any day. The objective may remain fixed at the price level determined on the day of the breakout, or preferably, will change each day to remain one bandwidth from the new channel value (Figure 12-9). This method relates closely to volatility measures and more examples can be found in Chapter 20.

An alternate way of defining a channel wouid be to forecast 1 day ahead using the slope of a regression analjsis (linear for a straight channel, log for a curved one) and use the standard deviation of the price changes to define the band. The other riUes wouid remain the same."

COMBINING TECHNIQUES

Richard D. Wyckoff, popular in the earty 1930s, relied solely on charts to determine the motives behind price behavior. He combined the three most popular methods, bar chart

" For a fiirUier discussion of channels, see Donald Lambert, "Commodity Channel Index: Tool for Trading Cjciic Trends," Tecimical Analjsis of Stocks & Commodities (October 1980), and John E Ehiers, "Trading Channels," Tecimical Analysis of Stocks & Commodities (April 1986)

ing, point charts (the predecessor of point-and-figure charts), and waves to identifj the direction, extent, and timing of price behavior, respectively. 16

To Wyckoff, the bar chart combined price and volume to show the direction of the price movement. In general terms, it shows the trading ranges in which supply and demand are balanced. The volume complemented this by giving the intensity of trading, which relates to the quality of the iong or short position. Wyckoff used group charts, or indices, in the manner of Chartes Dow, to select the stocks with the most potential, rather than looking oniy at individual stock price movement. This assures that the move is based on the broader nature of the business, rather than on company politics.

Point-and-figure charts are used to condense price action, ff prices move from lower to higher levels due to events, the time it takes to reach the new level is unimportant. Pointand-figure charts record events, not time. As iong as prices rise without a significant reversal, the chart uses oniy one column, when prices change direction, a new column is posted (see the point-and-figure section of Chapter 9 as well as the swing trading section of this chapter). Price objectives can be determined from formations in a point-and-figure chart usually related to the length of the sidewajs periods or horizontal formations. These objectives are very different and normally closer than objectives found using similar bar chart formations.

The wave chart, similar to Elliotts theories, represents the behavior of investors and the natural rhjUim of the market. Wyckoff uses these waves to determine the points of bujing and selling within the limitations defined by both the bar chart and point-and-figure charts. He considered it essential to use the wave charts as a leading indicator of price movement.

Wyckoff used many technical tools but not rigidly. He did not believe in unconfirmed fundamentals bul insisted that the market action was ali you needed-the maikets primarj forces of supply and demand couid be found in charts. He did not use triangles, fiags, and other formations, which he considered to be a tjpe of Rorschach test, bul limited his analjsis to the most basic pattems-lhe horizontal or congestion areas. He used time

1*, - Hu»(c. "EleemeCCiime, Analysis .1 . - & ...luodities (M.-*,cl, lEW,

FIGURE 12-9 Channel calculation.

based and event-based charts to find the direction and forecast, then relied on human behavior (in the form of Elliott waves) for timing. His trading was successful and his principles have survived.

COMPLEX PATTERNS

Most charting sjstems involve a few simple riUes, trjing to model a price pattem that seems to have repeatedlj resulted in a profitable move. The most popular sjstems are simply a breakout of a previous high or low, either a horizontal pattern or a trend channel. Over the years these approaches have proved to be steadj performers. Another group of traders might argue that it is better to be more selective about each trade and increase the expectation of a larger profit, than to take many trades to win with the long-term probabilities.

DeMariis Sequential

Tom DeMark has created a strategj, called a sequential, that finds a very overextended price move, one that is likely to change direction, and takes a countertrend position.- His selling objective is to identifj the place where the last buyer has bought. His riUes use counting and retracements rather than mathematical formulas or trendlines. To gel a buy signal, the following steps are applied to daily data:

1. Setup. To begin, there must be a decline of at least nine or more consecutive closes that are lower than the corresponding closes 4 dajs eartier (close - close [41 =: 0). In the case where todays close is equal or greater than the close 4 dajs before, the setiqa must begin again.

2. Intersection. To assure that prices are declining in an orderly fadiion, rather than plunging, the high of any day on or after the 8th day of the setup must be greater than the low of any day 3 or more dajs eartier. Note that there can be a delay before the intersection occurs provided that the pattem is not negated by the following riUes.

3. Countdown. Once the setup and mtersection have been satisfied, we count the number of dajs in which the close was lower than the close 2 dajs ago (close =: close[2]). The dajs that satisfj this countdown requirement do not need to be continuous. When the countdown reaches 13 we get a buy signal unless one of the following conditions occurs:

a. There is a close that exceeds the highest intraday high that occurred during the setup stage.

b. A sell setup occurs (nine consecutive closes above the corresponding closes 4 dajs eartier).

c. Another buy setup occurs before the buy countdown is complete. In this case, the riUes begin again at Step 2, the intersection. This condition is called recycling.