Introduction

There is a reason why there is no other comprehensive book about price action written by a trader. It takes thousands of hours, and the financial reward is meager compared to that from trading. However, with my three girls now away in grad school, I have a void to fill and this has been a very satisfying project. I originally planned on updating the first edition of Reading Price Charts Bar by Bar (John Wiley & Sons, 2009), but as I got into it, I decided instead to go into great detail about how I view and trade the markets. I am metaphorically teaching you how to play the violin. Everything you need to know to make a living at it is in these books, but it is up to you to spend the countless hours learning your trade. After a year of answering thousands of questions from traders on my website at www.brookspriceaction.com, I think that I have found ways to express my ideas much more clearly, and these books should be easier to read than that one. The earlier book focused on reading price action, and this series of books is instead centered on how to use price action to trade the markets. Since the book grew to more than four times as many words as the first book, John Wiley & Sons decided to divide it into three separate books. This first book covers price action basics and trends. The second book is on trading ranges, order management, and the mathematics of trading, and the final book is about trend reversals, day trading, daily charts, options, and the best setups for all time frames. Many of the charts are also in Reading Price Charts Bar by Bar, but most have been updated and the discussion about the charts has also been largely rewritten. Only about 5 percent of the 120,000 words from that book are present in the 570,000 words in this new series, so readers will find little duplication.

My goals in writing this series of three books are to describe my understanding of why the carefully selected trades offer great risk/reward ratios, and to present ways to profit from the setups. I am presenting material that I hope will be interesting to professional traders and students in business school, but I also hope that even traders starting out will find some useful ideas. Everyone looks at price charts but usually just briefly and with a specific or limited goal. However, every chart has an incredible amount of information that can be used to make profitable trades, but much of it can be used effectively only if traders spend time to carefully understand what each bar on the chart is telling them about what institutional money is doing.

Ninety percent or more of all trading in large markets is done by institutions, which means that the market is simply a collection of institutions. Almost all are profitable over time, and the few that are not soon go out of business. Since institutions are profitable and they are the market, every trade that you take has a profitable trader (a part of the collection of institutions) taking the other side of your trade. No trade can take place without one institution willing to take one side and another willing to take the other. The small-volume trades made by individuals can only take place if an institution is willing to take the same trade. If you want to buy at a certain price, the market will not get to that price unless one or more institutions also want to buy at that price. You cannot sell at any price unless one or more institutions are willing to sell there, because the market can only go to a price where there are institutions willing to buy and others willing to sell. If the Emini is at 1,264 and you are long with a protective sell stop at 1,262, your stop cannot get hit unless there is an institution who is also willing to sell at 1,262. This is true for virtually all trades.

If you trade 200 Emini contracts, then you are trading institutional volume and are effectively an institution, and you will sometimes be able to move the market a tick or two. Most individual traders, however, have no ability to move the market, no matter how stupidly they are willing to trade. The market will not run your stops. The market might test the price where your protective stop is, but it has nothing to do with your stop. It will only test that price if one or more institutions believe that it is financially sound to sell there and other institutions believe that it is profitable to buy there. At every tick, there are institutions buying and other institutions selling, and all have proven systems that will make money by placing those trades. You should always be trading in the direction of the majority of institutional dollars because they control where the market is heading.

At the end of the day when you look at a printout of the day's chart, how can you tell what the institutions did during the day? The answer is simple: whenever the market went up, the bulk of institutional money was buying, and whenever the market went down, more money went into selling. Just look at any segment of the chart where the market went up or down and study every bar, and you will soon notice many repeatable patterns. With time, you will begin to see those patterns unfold in real time, and that will give you confidence to place your trades. Some of the price action is subtle, so be open to every possibility. For example, sometimes when the market is working higher, a bar will trade below the low of the prior bar, yet the trend continues higher. You have to assume that the big money was buying at and below the low of that prior bar, and that is also what many experienced traders were doing. They bought exactly where weak traders let themselves get stopped out with a loss or where other weak traders shorted, believing that the market was beginning to sell off. Once you get comfortable with the idea that strong trends often have pullbacks and big money is buying them rather than selling them, you will be in a position to make some great trades that you previously thought were exactly the wrong thing to do. Don't think too hard about it. If the market is going up, institutions are buying constantly, even at times when you think that you should stop yourself out of your long with a loss. Your job is to follow their behavior and not use too much logic to deny what is happening right in front of you. It does not matter if it seems counterintuitive. All that matters is that the market is going up and therefore institutions are predominantly buying and so should you.

Institutions are generally considered to be smart money, meaning that they are smart enough to make a living by trading and they trade a large volume every day. Television still uses the term institution to refer to traditional institutions like mutual funds, banks, brokerage houses, insurance companies, pension funds, and hedge funds; these companies used to account for most of the volume, and they mostly trade on fundamentals. Their trading controls the direction of the market on daily and weekly charts and a lot of the big intraday swings. Until a decade or so ago, most of the trade decisions were made and most trading was done by very smart traders, but it is now increasingly being done by computers. They have programs that can instantly analyze economic data and immediately place trades based on that analysis, without a person ever being involved in the trade. In addition, other firms trade huge volumes by using computer programs that place trades based on the statistical analysis of price action. Computer-generated trading now accounts for as much as 70 percent of the day's volume.

Computers are very good at making decisions, and playing chess and winning at Jeopardy! are more difficult than trading stocks. Gary Kasparov for years made the best chess decisions in the world, yet a computer made better decisions in 1997 and beat him. Ken Jennings was heralded as the greatest Jeopardy! player of all time, yet a computer destroyed him in 2011. It is only a matter of time before computers are widely accepted as the best decision makers for institutional trading.

Since programs use objective mathematical analysis, there should be a tendency for support and resistance areas to become more clearly defined. For example, measured move projections should become more precise as more of the volume is traded based on precise mathematical logic. Also, there might be a tendency toward more protracted tight channels as programs buy small pullbacks on the daily chart. However, if enough programs exit longs or go short at the same key levels, sell-offs might become larger and faster. Will the changes be dramatic? Probably not, since the same general forces were operating when everything was done manually, but nonetheless there should be some move toward mathematical perfection as more of the emotion is removed from trading. As these other firms contribute more and more to the movement of the market and as traditional institutions increasingly use computers to analyze and place their trades, the term institution is becoming vague. It is better for an individual trader to think of an institution as any of the different entities that trade enough volume to be a significant contributor to the price action.

Since these buy and sell programs generate most of the volume, they are the most important contributor to the appearance of every chart and they create most of the trading opportunities for individual investors. Yes, it's nice to know that Cisco Systems (CSCO) had a strong earnings report and is moving up, and if you are an investor who wants to hold stock for many months, then do what the traditional institutions are doing and buy CSCO. However, if you are a day trader, ignore the news and look at the chart, because the programs will create patterns that are purely statistically based and have nothing to do with fundamentals, yet offer great trading opportunities. The traditional institutions placing trades based on fundamentals determine the direction and the approximate target of a stock over the next several months, but, increasingly, firms using statistical analysis to make day trades and other short-term trades determine the path to that target and the ultimate high or low of the move. Even on a macro level, fundamentals are only approximate at best. Look at the crashes in 1987 and 2009. Both had violent sell-offs and rallies, yet the fundamentals did not change violently in the same short period of time. In both cases, the market got sucked slightly below the monthly trend line and reversed sharply up from it. The market fell because of perceived fundamentals, but the extent of the fall was determined by the charts.

There are some large patterns that repeat over and over on all time frames and in all markets, like trends, trading ranges, climaxes, and channels. There are also lots of smaller tradable patterns that are based on just the most recent few bars. These books are a comprehensive guide to help traders understand everything they see on a chart, giving them more opportunities to make profitable trades and to avoid losers.

The most important message that I can deliver is to focus on the absolute best trades, avoid the absolute worst setups, use a profit objective (reward) that is at least as large as your protective stop (risk), and work on increasing the number of shares that you are trading. I freely recognize that every one of my reasons behind each setup is just my opinion, and my reasoning about why a trade works might be completely wrong. However, that is irrelevant. What is important is that reading price action is a very effective way to trade, and I have thought a lot about why certain things happen the way they do. I am comfortable with my explanations and they give me confidence when I place a trade; however, they are irrelevant to my placing trades, so it is not important to me that they are right. Just as I can reverse my opinion about the direction of the market in an instant, I can also reverse my opinion about why a particular pattern works if I come across a reason that is more logical or if I discover a flaw in my logic. I am providing the opinions because they appear to make sense, they might help readers become more comfortable trading certain setups, and they might be intellectually stimulating, but they are not needed for any price action trades.

The books are very detailed and difficult to read and are directed toward serious traders who want to learn as much as they can about reading price charts. However, the concepts are useful to traders at all levels. The books cover many of the standard techniques described by Robert D. Edwards and John Magee (Technical Analysis of Stock Trends, AMACOM, 9th ed., 2007) and others, but focus more on individual bars to demonstrate how the information they provide can significantly enhance the risk/reward ratio of trading. Most books point out three or four trades on a chart, which implies that everything else on the chart is incomprehensible, meaningless, or risky. I believe that there is something to be learned from every tick that takes place during the day and that there are far more great trades on every chart than just the few obvious ones; but to see them, you have to understand price action and you cannot dismiss any bars as unimportant. I learned from performing thousands of operations through a microscope that some of the most important things can be very small.

I read charts bar by bar and look for any information that each bar is telling me. They are all important. At the end of every bar, most traders ask themselves, “What just took place?” With most bars, they conclude that there is nothing worth trading at the moment so it is just not worth the effort to try to understand. Instead, they choose to wait for some clearer and usually larger pattern. It is as if they believe that the bar did not exist, or they dismiss it as just institutional program activity that is not tradable by an individual trader. They do not feel like they are part of the market at these times, but these times constitute the vast majority of the day. Yet, if they look at the volume, all of those bars that they are ignoring have as much volume as the bars they are using for the bases for their trades. Clearly, a lot of trading is taking place, but they don't understand how that can be and essentially pretend that it does not exist. But that is denying reality. There is always trading taking place, and as a trader, you owe it to yourself to understand why it's taking place and to figure out a way to make money off of it. Learning what the market is telling you is very time-consuming and difficult, but it gives you the foundation that you need to be a successful trader.

Unlike most books on candle charts where the majority of readers feel compelled to memorize patterns, these three books of mine provide a rationale for why particular patterns are reliable setups for traders. Some of the terms used have specific meaning to market technicians but different meanings to traders, and I am writing this entirely from a trader's perspective. I am certain that many traders already understand everything in these books, but likely wouldn't describe price action in the same way that I do. There are no secrets among successful traders; they all know common setups, and many have their own names for each one. All of them are buying and selling pretty much at the same time, catching the same swings, and they all have their own reasons for getting into a trade. Many trade price action intuitively without ever feeling a need to articulate why a certain setup works. I hope that they enjoy reading my understanding of and perspective on price action and that this gives them some insights that will improve their already successful trading.

The goal for most traders is to maximize trading profits through a style that is compatible with their personalities. Without that compatibility, I believe that it is virtually impossible to trade profitably for the long term. Many traders wonder how long it will take them to be successful and are willing to lose money for some period of time, even a few years. However, it took me over 10 years to be able to trade successfully. Each of us has many considerations and distractions, so the time will vary, but a trader has to work though most obstacles before becoming consistently profitable. I had several major problems that had to be corrected, including raising three wonderful daughters who always filled my mind with thoughts of them and what I needed to be doing as their father. That was solved as they got older and more independent. Then it took me a long time to accept many personality traits as real and unchangeable (or at least I concluded that I was unwilling to change them). And finally there was the issue of confidence. I have always been confident to the point of arrogance in so many things that those who know me would be surprised that this was difficult for me. However, deep inside I believed that I really would never come up with a consistently profitable approach that I would enjoy employing for many years. Instead, I bought many systems, wrote and tested countless indicators and systems, read many books and magazines, went to seminars, hired tutors, and joined chat rooms. I talked with people who presented themselves as successful traders, but I never saw their account statements and suspect that most could teach but few, if any, could trade. Usually in trading, those who know don't talk and those who talk don't know.

This was all extremely helpful because it showed all of the things that I needed to avoid before becoming successful. Any nontrader who looks at a chart will invariably conclude that trading has to be extremely easy, and that is part of the appeal. At the end of the day, anyone can look at any chart and see very clear entry and exit points. However, it is much more difficult to do it in real time. There is a natural tendency to want to buy the exact low and never have the trade come back. If it does, a novice will take the loss to avoid a bigger loss, resulting in a series of losing trades that will ultimately bust the trader's account. Using wide stops solves that to some extent, but invariably traders will soon hit a few big losses that will put them into the red and make them too scared to continue using that approach.

Should you be concerned that making the information in these books available will create lots of great price action traders, all doing the same thing at the same time, thereby removing the late entrants needed to drive the market to your price target? No, because the institutions control the market and they already have the smartest traders in the world and those traders already know everything in these books, at least intuitively. At every moment, there is an extremely smart institutional bull taking the opposite side of the trade being placed by an extremely smart institutional bear. Since the most important players already know price action, having more players know it will not tip the balance one way or the other. I therefore have no concern that what I am writing will stop price action from working. Because of that balance, any edge that anyone has is always going to be extremely small, and any small mistake will result in a loss, no matter how well a person reads a chart. Although it is very difficult to make money as a trader without understanding price action, that knowledge alone is not enough. It takes a long time to learn how to trade after a trader learns to read charts, and trading is just as difficult as chart reading. I wrote these books to help people learn to read charts better and to trade better, and if you can do both well, you deserve to be able to take money from the accounts of others and put it into yours.

The reason why the patterns that we all see do unfold as they do is because that is the appearance that occurs in an efficient market with countless traders placing orders for thousands of different reasons, but with the controlling volume being traded based on sound logic. That is just what it looks like, and it has been that way forever. The same patterns unfold in all time frames in all markets around the world, and it would simply be impossible for all of it to be manipulated instantaneously on so many different levels. Price action is a manifestation of human behavior and therefore actually has a genetic basis. Until we evolve, it will likely remain largely unchanged, just as it has been unchanged for the 80 years of charts that I have reviewed. Program trading might have changed the appearance slightly, although I can find no evidence to support that theory. If anything, it would make the charts smoother because it is unemotional and it has greatly increased the volume. Now that most of the volume is being traded automatically by computers and the volume is so huge, irrational and emotional behavior is an insignificant component of the markets and the charts are a purer expression of human tendencies.

Since price action comes from our DNA, it will not change until we evolve. When you look at the two charts in Figure I.1, your first reaction is that they are just a couple of ordinary charts, but look at the dates at the bottom. These weekly Dow Jones Industrial Average charts from the Depression era and from World War II have the same patterns that we see today on all charts, despite most of today's volume being traded by computers.

Figure I.1 Price Action Has Not Changed over Time

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If everyone suddenly became a price action scalper, the smaller patterns might change a little for a while, but over time, the efficient market will win out and the votes by all traders will get distilled into standard price action patterns because that is the inescapable result of countless people behaving logically. Also, the reality is that it is very difficult to trade well, and although basing trades on price action is a sound approach, it is still very difficult to do successfully in real time. There just won't be enough traders doing it well enough, all at the same time, to have any significant influence over time on the patterns. Just look at Edwards and Magee. The best traders in the world have been using those ideas for decades and they continue to work, again for the same reason—charts look the way they do because that is the unchangeable fingerprint of an efficient market filled with a huge number of smart people using a huge number of approaches and time frames, all trying to make the most money that they can. For example, Tiger Woods is not hiding anything that he does in golf, and anyone is free to copy him. However, very few people can play golf well enough to make a living at it. The same is true of trading. A trader can know just about everything there is to know and still lose money because applying all that knowledge in a way that consistently makes money is very difficult to do.

Why do so many business schools continue to recommend Edwards and Magee when their book is essentially simplistic, largely using trend lines, breakouts, and pullbacks as the basis for trading? It is because it works and it always has and it always will. Now that just about all traders have computers with access to intraday data, many of those techniques can be adapted to day trading. Also, candle charts give additional information about who is controlling the market, which results in a more timely entry with smaller risk. Edwards and Magee's focus is on the overall trend. I use those same basic techniques but pay much closer attention to the individual bars on the chart to improve the risk/reward ratio, and I devote considerable attention to intraday charts.

It seemed obvious to me that if one could simply read the charts well enough to be able to enter at the exact times when the move would take off and not come back, then that trader would have a huge advantage. The trader would have a high winning percentage, and the few losses would be small. I decided that this would be my starting point, and what I discovered was that nothing had to be added. In fact, any additions are distractions that result in lower profitability. This sounds so obvious and easy that it is difficult for most people to believe.

I am a day trader who relies entirely on price action on the intraday Emini S&P 500 Futures charts, and I believe that reading price action well is an invaluable skill for all traders. Beginners often instead have a deep-seated belief that something more is required, that maybe some complex mathematical formula that very few use would give them just the edge that they need. Goldman Sachs is so rich and sophisticated that its traders must have a supercomputer and high-powered software that gives them an advantage that ensures that all the individual traders are doomed to failure. They start looking at all kinds of indicators and playing with the inputs to customize the indicators to make them just right. Every indicator works some of the time, but for me, they obfuscate instead of elucidate. In fact, without even looking at a chart, you can place a buy order and have a 50 percent chance of being right!

I am not dismissing indicators and systems out of ignorance of their subtleties. I have spent over 10,000 hours writing and testing indicators and systems over the years, and that probably is far more experience than most have. This extensive experience with indicators and systems was an essential part of my becoming a successful trader. Indicators work well for many traders, but the best success comes once a trader finds an approach that is compatible with his or her personality. My single biggest problem with indicators and systems was that I never fully trusted them. At every setup, I saw exceptions that needed to be tested. I always wanted every last penny out of the market and was never satisfied with a return from a system if I could incorporate a new twist that would make it better. You can optimize constantly, but, since the market is always changing from strong trends to tight trading ranges and then back again and your optimizations are based on what has recently happened, they will soon fail as the market transitions into a new phase. I am simply too controlling, compulsive, restless, observant, and untrusting to make money in the long term off indicators or automated systems, but I am at the extreme in many ways and most people don't have these same issues.

Many traders, especially beginners, are drawn to indicators (or any other higher power, guru, TV pundit, or newsletter that they want to believe will protect them and show their love and approval of them as human beings by giving them lots of money), hoping that an indicator will show them when to enter a trade. What they don't realize is that the vast majority of indicators are based on simple price action, and when I am placing trades, I simply cannot think fast enough to process what several indicators might be telling me. If there is a bull trend, a pullback, and then a rally to a new high, but the rally has lots of overlapping bars, many bear bodies, a couple of small pullbacks, and prominent tails on the tops of the bars, any experienced trader would see that it is a weak test of the trend high and that this should not be happening if the bull trend was still strong. The market is almost certainly transitioning into a trading range and possibly into a bear trend. Traders don't need an oscillator to tell them this. Also, oscillators tend to make traders look for reversals and focus less on price charts. These can be effective tools on most days when the market has two or three reversals lasting an hour or more. The problem comes when the market is trending strongly. If you focus too much on your indicators, you will see that they are forming divergences all day long and you might find yourself repeatedly entering countertrend and losing money. By the time you come to accept that the market is trending, you will not have enough time left in the day to recoup your losses. Instead, if you were simply looking at a bar or candle chart, you would see that the market is clearly trending and you would not be tempted by indicators to look for trend reversals. The most common successful reversals first break a trend line with strong momentum and then pull back to test the extreme, and if traders focus too much on divergences, they will often overlook this fundamental fact. Placing a trade because of a divergence in the absence of a prior countertrend momentum surge that breaks a trend line is a losing strategy. Wait for the trend line break and then see if the test of the old extreme reverses or if the old trend resumes. You do not need an indicator to tell you that a strong reversal here is a high-probability trade, at least for a scalp, and there will almost certainly be a divergence, so why complicate your thinking by adding the indicator to your calculus?

Some pundits recommend a combination of time frames, indicators, wave counting, and Fibonacci retracements and extensions, but when it comes time to place the trade, they will do it only if there is a good price action setup. Also, when they see a good price action setup, they start looking for indicators that show divergences, different time frames for moving average tests, wave counts, or Fibonacci setups to confirm what is in front of them. In reality, they are price action traders who are trading exclusively off price action on only one chart but don't feel comfortable admitting it. They are complicating their trading to the point that they certainly are missing many, many trades because their overanalysis takes too much time for them to place their orders and they are forced to wait for the next setup. The logic just isn't there for making the simple so complicated. Obviously, adding any information can lead to better decision making and many people might be able to process lots of inputs when deciding whether to place a trade. Ignoring data because of a simplistic ideology alone is foolish. The goal is to make money, and traders should do everything they can to maximize their profits. I simply cannot process multiple indicators and time frames well in the time needed to place my orders accurately, and I find that carefully reading a single chart is far more profitable for me. Also, if I rely on indicators, I find that I get lazy in my price action reading and often miss the obvious. Price action is far more important than any other information, and if you sacrifice some of what it is telling you to gain information from something else, you are likely making a bad decision.

One of the most frustrating things for traders when they are starting out is that everything is so subjective. They want to find a clear set of rules that guarantee a profit, and they hate how a pattern works on one day but fails on another. Markets are very efficient because you have countless very smart people playing a zero-sum game. For a trader to make money, he has to be consistently better than about half of the other traders out there. Since most of the competitors are profitable institutions, a trader has to be very good. Whenever an edge exists, it is quickly discovered and it disappears. Remember, someone has to be taking the opposite side of your trade. It won't take them long to figure out your magical system, and once they do, they will stop giving you money. Part of the appeal of trading is that it is a zero-sum game with very small edges, and it is intellectually satisfying and financially rewarding to be able to spot and capitalize on these small, fleeting opportunities. It can be done, but it is very hard work and it requires relentless discipline. Discipline simply means doing what you do not want to do. We are all intellectually curious and we have a natural tendency to try new or different things, but the very best traders resist the temptation. You have to stick to your rules and avoid emotion, and you have to patiently wait to take only the best trades. This all appears easy to do when you look at a printed chart at the end of the day, but it is very difficult in real time as you wait bar by bar, and sometimes hour by hour. Once a great setup appears, if you are distracted or lulled into complacency, you will miss it and you will then be forced to wait even longer. But if you can develop the patience and the discipline to follow a sound system, the profit potential is huge.

There are countless ways to make money trading stocks and Eminis, but all require movement (well, except for shorting options). If you learn to read the charts, you will catch a great number of these profitable trades every day without ever knowing why some institution started the trend and without ever knowing what any indicator is showing. You don't need these institutions’ software or analysts because they will show you what they are doing. All you have to do is piggyback onto their trades and you will make a profit. Price action will tell you what they are doing and allow you an early entry with a tight stop.

I have found that I consistently make far more money by minimizing what I have to consider when placing a trade. All I need is a single chart on my laptop computer with no indicators except a 20-bar exponential moving average (EMA), which does not require too much analysis and clarifies many good setups each day. Some traders might also look at volume because an unusually large volume spike sometimes comes near the end of a bear trend, and the next new swing low or two often provide profitable long scalps. Volume spikes also sometimes occur on daily charts when a sell-off is overdone. However, it is not reliable enough to warrant my attention.

Many traders consider price action only when trading divergences and trend pullbacks. In fact, most traders using indicators won't take a trade unless there is a strong signal bar, and many would enter on a strong signal bar if the context was right, even if there was no divergence. They like to see a strong close on a large reversal bar, but in reality this is a fairly rare occurrence. The most useful tools for understanding price action are trend lines and trend channel lines, prior highs and lows, breakouts and failed breakouts, the sizes of bodies and tails on candles, and relationships between the current bar to the prior several bars. In particular, how the open, high, low, and close of the current bar compare to the action of the prior several bars tells a lot about what will happen next. Charts provide far more information about who is in control of the market than most traders realize. Almost every bar offers important clues as to where the market is going, and a trader who dismisses any activity as noise is passing up many profitable trades each day. Most of the observations in these books are directly related to placing trades, but a few have to do with simple curious price action tendencies without sufficient dependability to be the basis for a trade.

I personally rely mainly on candle charts for my Emini, futures, and stock trading, but most signals are also visible on any type of chart and many are even evident on simple line charts. I focus primarily on 5 minute candle charts to illustrate basic principles but also discuss daily and weekly charts as well. Since I also trade stocks, forex, Treasury note futures, and options, I discuss how price action can be used as the basis for this type of trading.

As a trader, I see everything in shades of gray and am constantly thinking in terms of probabilities. If a pattern is setting up and is not perfect but is reasonably similar to a reliable setup, it will likely behave similarly as well. Close is usually close enough. If something resembles a textbook setup, the trade will likely unfold in a way that is similar to the trade from the textbook setup. This is the art of trading and it takes years to become good at trading in the gray zone. Everyone wants concrete, clear rules or indicators, and chat rooms, newsletters, hotlines, or tutors that will tell them when exactly to get in to minimize risk and maximize profit, but none of it works in the long run. You have to take responsibility for your decisions, but you first have to learn how to make them and that means that you have to get used to operating in the gray fog. Nothing is ever as clear as black and white, and I have been doing this long enough to appreciate that anything, no matter how unlikely, can and will happen. It's like quantum physics. Every conceivable event has a probability, and so do events that you have yet to consider. It is not emotional, and the reasons why something happens are irrelevant. Watching to see if the Federal Reserve cuts rates today is a waste of time because there is both a bullish and bearish interpretation of anything that the Fed does. What is key is to see what the market does, not what the Fed does.

If you think about it, trading is a zero-sum game and it is impossible to have a zero-sum game where rules consistently work. If they worked, everyone would use them and then there would be no one on the other side of the trade. Therefore, the trade could not exist. Guidelines are very helpful but reliable rules cannot exist, and this is usually very troubling to a trader starting out who wants to believe that trading is a game that can be very profitable if only you can come up with just the right set of rules. All rules work some of the time, and usually just often enough to fool you into believing that you just need to tweak them a little to get them to work all of the time. You are trying to create a trading god who will protect you, but you are fooling yourself and looking for an easy solution to a game where only hard solutions work. You are competing against the smartest people in the world, and if you are smart enough to come up with a foolproof rule set, so are they, and then everyone is faced with the zero-sum game dilemma. You cannot make money trading unless you are flexible, because you need to go where the market is going, and the market is extremely flexible. It can bend in every direction and for much longer than most would ever imagine. It can also reverse repeatedly every few bars for a long, long time. Finally, it can and will do everything in between. Never get upset by this, and just accept it as reality and admire it as part of the beauty of the game.

The market gravitates toward uncertainty. During most of the day, every market has a directional probability of 50–50 of an equidistant move up or down. By that I mean that if you don't even look at a chart and you buy any stock and then place a one cancels the other (OCO) order to exit on a profit-taking limit order X cents above your entry or on a protective stop at X cents below your entry, you have about a 50 percent chance of being right. Likewise, if you sell any stock at any point in the day without looking at a chart and then place a profit-taking limit order X cents lower and a protective stop X cents higher, you have about a 50 percent chance of winning and about a 50 percent chance of losing. There is the obvious exception of X being too large relative the price of the stock. You can't have X be $60 in a $50 stock, because you would have a 0 percent chance of losing $60. You also can't have X be $49, because the odds of losing $49 would also be minuscule. But if you pick a value for X that is within reasonable reach on your time frame, this is generally true. When the market is 50–50, it is uncertain and you cannot rationally have an opinion about its direction. This is the hallmark of a trading range, so whenever you are uncertain, assume that the market is in a trading range. There are brief times on a chart when the directional probability is higher. During a strong trend, it might be 60 or even 70 percent, but that cannot last long because it will gravitate toward uncertainty and a 50–50 market where both the bulls and bears feel there is value. When there is a trend and some level of directional certainty, the market will also gravitate toward areas of support and resistance, which are usually some type of measured move away, and those areas are invariably where uncertainty returns and a trading range develops, at least briefly.

Never watch the news during the trading day. If you want to know what a news event means, the chart in front of you will tell you. Reporters believe that the news is the most important thing in the world, and that everything that happens has to be caused by their biggest news story of the day. Since reporters are in the news business, news must be the center of the universe and the cause of everything that happens in the financial markets. When the stock market sold off in mid-March 2011, they attributed it to the earthquake in Japan. It did not matter to them that the market began to sell off three weeks earlier, after a buy climax. I told the members of my chat room in late February that the odds were good that the market was going to have a significant correction when I saw 15 consecutive bull trend bars on the daily chart after a protracted bull run. This was an unusually strong buy climax, and an important statement by the market. I had no idea that an earthquake was going to happen in a few weeks, and did not need to know that, anyway. The chart was telling me what traders were doing; they were getting ready to exit their longs and initiate shorts.

Television experts are also useless. Invariably when the market makes a huge move, the reporter will find some confident, convincing expert who predicted it and interview him or her, leading the viewers to believe that this pundit has an uncanny ability to predict the market, despite the untold reality that this same pundit has been wrong in his last 10 predictions. The pundit then makes some future prediction and naïve viewers will attach significance to it and let it affect their trading. What the viewers may not realize is that some pundits are bullish 100 percent of the time and others are bearish 100 percent of the time, and still others just swing for the fences all the time and make outrageous predictions. The reporter just rushes to the one who is consistent with the day's news, which is totally useless to traders and in fact it is destructive because it can influence their trading and make them question and deviate from their own methods. No one is ever consistently right more than 60 percent of the time on these major predictions, and just because pundits are convincing does not make them reliable. There are equally smart and convincing people who believe the opposite but are not being heard. This is the same as watching a trial and listening to only the defense side of the argument. Hearing only one side is always convincing and always misleading, and rarely better than 50 percent reliable.

Institutional bulls and bears are placing trades all the time, and that is why there is constant uncertainty about the direction of the market. Even in the absence of breaking news, the business channels air interviews all day long and each reporter gets to pick one pundit for her report. What you have to realize is that she has a 50–50 chance of picking the right one in terms of the market's direction over the next hour or so. If you decide to rely on the pundit to make a trading decision and he says that the market will sell off after midday and instead it just keeps going up, are you going to look to short? Should you believe this very convincing head trader at one of Wall Street's top firms? He obviously is making over a million dollars a year and they would not pay him that much unless he was able to correctly and consistently predict the market's direction. In fact, he probably can and he is probably a good stock picker, but he almost certainly is not a day trader. It is foolish to believe that just because he can make 15 percent annually managing money he can correctly predict the market's direction over the next hour or two. Do the math. If he had that ability, he would be making 1 percent two or three times a day and maybe 1,000 percent a year. Since he is not, you know that he does not have that ability. His time frame is months and yours is minutes. Since he is unable to make money by day trading, why would you ever want to make a trade based on someone who is a proven failure as a day trader? He has shown you that he cannot make money by day trading by the simple fact that he is not a successful day trader. That immediately tells you that if he day trades, he loses money because if he was successful at it, that is what he would choose to do and he would make far more than he is currently making. Even if you are holding trades for months at a time in an attempt to duplicate the results of his fund, it is still foolish to take his advice, because he might change his mind next week and you would never know it. Managing a trade once you are in is just as important as placing the trade. If you are following the pundit and hope to make 15 percent a year like he does, you need to follow his management, but you have no ability to do so and you will lose over time employing this strategy. Yes, you will make an occasional great trade, but you can simply do that by randomly buying any stock. The key is whether the approach makes money over 100 trades, not over the first one or two. Follow the advice that you give your kids: don't fool yourself into believing that what you see on television is real, no matter how polished and convincing it appears to be.

As I said, there will be pundits who will see the news as bullish and others who will see it as bearish, and the reporter gets to pick one for her report. Are you going to let a reporter make trading decisions for you? That's insane! If that reporter could trade, she would be a trader and make hundreds of times more money than she is making as a reporter. Why would you ever allow her to influence your decision making? You might do so only out of a lack of confidence in your ability, or perhaps you are searching for a father figure who will love and protect you. If you are prone to be influenced by a reporter's decision, you should not take the trade. The pundit she chooses is not your father, and he will not protect you or your money. Even if the reporter picks a pundit who is correct on the direction, that pundit will not stay with you to manage your trade, and you will likely be stopped out with a loss on a pullback.

Financial news stations do not exist to provide public service. They are in business to make money, and that means they need as large an audience as possible to maximize their advertising income. Yes, they want to be accurate in their reporting, but their primary objective is to make money. They are fully aware that they can maximize their audience size only if they are pleasing to watch. That means that they have to have interesting guests, including some who will make outrageous predictions, others who are professorial and reassuring, and some who are just physically attractive; most of them have to have some entertainment value. Although some guests are great traders, they cannot help you. For example, if they interview one of the world's most successful bond traders, he will usually only speak in general terms about the trend over the next several months, and he will do so only weeks after he has already placed his trades. If you are a day trader, this does not help you, because every bull or bear market on the monthly chart has just about as many up moves on the intraday chart as down moves, and there will be long and short trades every day. His time frame is very different from yours, and his trading has nothing to do with what you are doing. They will also often interview a chartist from a major Wall Street firm, who, while his credentials are good, will be basing his opinion on a weekly chart, but the viewers are looking to take profits within a few days. To the chartist, that bull trend that he is recommending buying will still be intact, even if the market falls 10 percent over the next couple of months. The viewers, however, will take their losses long before that, and will never benefit from the new high that comes three months later. Unless the chartist is addressing your specific goals and time frame, whatever he says is useless. When television interviews a day trader instead, he will talk about the trades that he already took, and the information is too late to help you make money. By the time he is on television, the market might already be going in the opposite direction. If he is talking while still in his day trade, he will continue to manage his trade long after his two-minute interview is over, and he will not manage it while on the air. Even if you enter the trade that he is in, he will not be there when you invariably will have to make an important decision about getting out as the market turns against you, or as the market goes in your direction and you are thinking about taking profits. Watching television for trading advice under any circumstances, even after a very important report, is a sure way to lose money and you should never do it.

Only look at the chart and it will tell you what you need to know. The chart is what will give you money or take money from you, so it is the only thing that you should ever consider when trading. If you are on the floor, you can't even trust what your best friend is doing. He might be offering a lot of orange juice calls but secretly having a broker looking to buy 10 times as many below the market. Your friend is just trying to create a panic to drive the market down so he can load up through a surrogate at a much better price.

Friends and colleagues freely offer opinions for you to ignore. Occasionally traders will tell me that they have a great setup and want to discuss it with me. I invariably get them angry with me when I tell them that I am not interested. They immediately perceive me as selfish, stubborn, and close-minded, and when it comes to trading, I am all of that and probably much more. The skills that make you money are generally seen as flaws to the layperson. Why do I no longer read books or articles about trading, or talk to other traders about their ideas? As I said, the chart tells me all that I need to know and any other information is a distraction. Several people have been offended by my attitude, but I think in part it comes from me turning down what they are presenting as something helpful to me when in reality they are making an offering, hoping that I will reciprocate with some tutoring. They become frustrated and angry when I tell them that I don't want to hear about anyone else's trading techniques. I tell them that I haven't even mastered my own and probably never will, but I am confident that I will make far more money perfecting what I already know than trying to incorporate non-price-action approaches into my trading. I ask them if James Galway offered a beautiful flute to Yo-Yo Ma and insisted that Ma start learning to play the flute because Galway makes so much money by playing his flute, should Ma accept the offer? Clearly not. Ma should continue to play the cello and by doing so he will make far more money than if he also started playing the flute. I am no Galway or Ma, but the concept is the same. Price action is the only instrument that I want to play, and I strongly believe that I will make far more money by mastering it than by incorporating ideas from other successful traders.

The charts, not the experts on television, will tell you exactly how the institutions are interpreting the news.

Yesterday, Costco's earnings were up 32 percent on the quarter and above analysts’ expectations (see Figure I.2). COST gapped up on the open, tested the gap on the first bar, and then ran up over a dollar in 20 minutes. It then drifted down to test yesterday's close. It had two rallies that broke bear trend lines, and both failed. This created a double top (bars 2 and 3) bear flag or triple top (bars 1, 2, and 3), and the market then plunged $3, below the prior day's low. If you were unaware of the report, you would have shorted at the failed bear trend line breaks at bars 2 and 3 and you would have sold more below bar 4, which was a pullback that followed the breakout below yesterday's low. You would have reversed to long on the bar 5 big reversal bar, which was the second attempt to reverse the breakout below yesterday's low and a climactic reversal of the breakout of the bottom of the steep bear trend channel line.

Figure I.2 Ignore the News

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Alternatively, you could have bought the open because of the bullish report, and then worried about why the stock was collapsing instead of soaring the way the TV analysts predicted, and you likely would have sold out your long on the second plunge down to bar 5 with a $2 loss.

Any trend that covers a lot of points in very few bars, meaning that there is some combination of large bars and bars that overlap each other only minimally, will eventually have a pullback. These trends have such strong momentum that the odds favor resumption of the trend after the pullback and then a test of the trend's extreme. Usually the extreme will be exceeded, as long as the pullback does not turn into a new trend in the opposite direction and extend beyond the start of the original trend. In general, the odds that a pullback will get back to the prior trend's extreme fall substantially if the pullback retraces 75 percent or more. For a pullback in a bear trend, at that point, a trader is better off thinking of the pullback as a new bull trend rather than a pullback in an old bear trend. Bar 6 was about a 70 percent pullback and then the market tested the climactic bear low on the open of the next day.

Just because the market gaps up on a news item does not mean that it will continue up, despite how bullish the news is.

As shown in Figure I.3, before the open of bar 1 on both Yahoo! (YHOO) charts (daily on the left, weekly on the right), the news reported that Microsoft was looking to take over Yahoo! at $31 a share, and the market gapped up almost to that price. Many traders assumed that it had to be a done deal because Microsoft is one of the best companies in the world and if it wanted to buy Yahoo!, it certainly could make it happen. Not only that—Microsoft has so much cash that it would likely be willing to sweeten the deal if needed. Well, the CEO of Yahoo! said that his company was worth more like $40 a share, but Microsoft never countered. The deal slowly evaporated, along with Yahoo!'s price. In October, Yahoo! was 20 percent below the price where it was before the deal was announced and 50 percent lower than on the day of the announcement, and it continues to fall. So much for strong fundamentals and a takeover offer from a serious suitor. To a price action trader, a huge up move in a bear market is probably just a bear flag, unless the move is followed by a series of higher lows and higher highs. It could be followed by a bull flag and then more of a rally, but until the bull trend is confirmed, you must be aware that the larger weekly trend is more important.

Figure I.3 Markets Can Fall on Bullish News

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The only thing that is as it seems is the chart. If you cannot figure out what it is telling you, do not trade. Wait for clarity. It will always come. But once it is there, you must place the trade and assume the risk and follow your plan. Do not dial down to a 1 minute chart and tighten your stop, because you will lose. The problem with the 1 minute chart is that it tempts you by offering lots of entries with smaller bars and therefore smaller risk. However, you will not be able to take them all and you will instead cherry-pick, which will lead to the death of your account because you will invariably pick too many bad cherries. When you enter on a 5 minute chart, your trade is based on your analysis of the 5 minute chart without any idea of what the 1 minute chart looks like. You must therefore rely on your five-minute stops and targets, and just accept the reality that the 1 minute chart will move against you and hit a one-minute stop frequently. If you watch the 1 minute chart, you will not be devoting your full attention to the 5 minute chart and a good trader will take your money from your account and put it into his account. If you want to compete, you must minimize all distractions and all inputs other than what is on the chart in front of you, and trust that if you do you will make a lot of money. It will seem unreal but it is very real. Never question it. Just keep things simple and follow your simple rules. It is extremely difficult to consistently do something simple, but in my opinion, it is the best way to trade. Ultimately, as a trader understands price action better and better, trading becomes much less stressful and actually pretty boring, but much more profitable.

Although I never gamble (because the combination of odds, risk, and reward are against me, and I never want to bet against math), there are some similarities with gambling, especially in the minds of those who don't trade. Gambling is a game of chance, but I prefer to restrict the definition to situations where the odds are slightly against you and you will lose over time. Why this restriction? Because without it, every investment is a gamble since there is always an element of luck and a risk of total loss, even if you buy investment real estate, buy a home, start a business, buy a blue-chip stock, or even buy Treasury bonds (the government might choose to devalue the dollar to reduce the real size of our debt, and in so doing, the purchasing power of the dollars that you will get back from those bonds would be much less than when you originally bought the bonds).

Some traders use simple game theory and increase the size of a trade after one or more losing trades (this is called a martingale approach to trading). Blackjack card counters are very similar to trading range traders. The card counters are trying to determine when the math has gone too far in one direction. In particular, they want to know when the remaining cards in the deck are likely overweighed with face cards. When the count indicates that this is likely, they place a trade (bet) based on the probability that a disproportionate number of face cards will be coming up, increasing the odds of winning. Trading range traders are looking for times when they think the market has gone too far in one direction and then they place a trade in the opposite direction (a fade).

I tried playing poker online a few times without using real money to find similarities to and differences from trading. I discovered early on that there was a deal breaker for me: I was constantly anxious because of the inherent unfairness due to luck, and I never want luck to be a large component of the odds for my success. This is a huge difference and makes me see gambling and trading as fundamentally different, despite public perception. In trading, everyone is dealt the same cards so the game is always fair and, over time, you get rewarded or penalized entirely due to your skill as a trader. Obviously, sometimes you can trade correctly and lose, and this can happen several times in a row due to the probability curve of all possible outcomes. There is a real but microscopic chance that you can trade well and lose 10 or even 100 times or more in a row; but I cannot remember the last time I saw as many as four good signals fail in a row, so this is a chance that I am willing to take. If you trade well, over time you should make money because it is a zero-sum game (except for commissions, which should be small if you choose an appropriate broker). If you are better than most of the other traders, you will win their money.

There are two types of gambling that are different from pure games of chance, and both are similar to trading. In both sports betting and poker, gamblers are trying to take money from other gamblers rather than from the house, and therefore they can create odds in their favor if they are significantly better than their competitors. However, the “commissions” that they pay can be far greater than those that a trader pays, especially with sports betting, where the vig is usually 10 percent, and that is why incredibly successful sports gamblers like Billy Walters are so rare: they have to be at least 10 percent better than the competition just to break even. Successful poker players are more common, as can be seen on all of the poker shows on TV. However, even the best poker players do not make anything comparable to what the best traders make, because the practical limits to their trading size are much smaller.

I personally find trading not to be stressful, because the luck factor is so tiny that it is not worth considering. However, there is one thing that trading and playing poker share, and that is the value of patience. In poker, you stand to make far more money if you patiently wait to bet on only the very best hands, and traders make more when they have the patience to wait for the very best setups. For me, this protracted downtime is much easier in trading because I can see all of the other “cards” during the slow times, and it is intellectually stimulating to look for subtle price action phenomena.

There is an important adage in gambling that is true in all endeavors, and that is that you should not bet until you have a good hand. In trading, that is true as well. Wait for a good setup before placing a trade. If you trade without discipline and without a sound method, then you are relying on luck and hope for your profits, and your trading is unquestionably a form of gambling.

One unfortunate comparison is from nontraders who assume that all day traders, and all market traders for that matter, are addicted gamblers and therefore have a mental illness. I suspect that many are addicted, in the sense that they are doing it more for excitement than for profit. They are willing to make low-probability bets and lose large sums of money because of the huge rush they feel when they occasionally win. However, most successful traders are essentially investors, just like an investor who buys commercial real estate or a small business. The only real differences from any other type of investing are that the time frame is shorter and the leverage is greater.

Unfortunately, it is common for beginners to occasionally gamble, and it invariably costs them money. Every successful trader trades on the basis of rules. Whenever traders deviate from those rules for any reason, they are trading on hope rather than logic and are then gambling. Beginning traders often find themselves gambling right after having a couple of losses. They are eager to be made whole again and are willing to take some chances to make that happen. They will take trades that they normally would not take, because they are eager to get back the money they just lost. Since they are now taking a trade that they believe is a low-probability trade and they are taking it because of anxiety and sadness over their losses, they are now gambling and not trading. After they lose on their gamble, they feel even worse. Not only are they even further down on the day, but they feel especially sad because they are faced with the reality that they did not have the discipline to stick to their system when they know that discipline is one of the critical ingredients to success.

Interestingly, neurofinance researchers have found that brain scan images of traders about to make a trade are indistinguishable from those of drug addicts about to take a hit. They found a snowball effect and an increased desire to continue, regardless of the outcome of their behavior. Unfortunately, when faced with losses, traders assume more risk rather than less, often leading to the death of their accounts. Without knowing the neuroscience, Warren Buffett clearly understood the problem, as seen in his statement, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The great traders control their emotions and constantly follow their rules.

One final point about gambling: There is a natural tendency to assume that nothing can last forever and that every behavior regresses toward a mean. If the market has three or four losing trades, surely the odds favor the next one being a winner. It's just like flipping a coin, isn't it? Unfortunately, that is not how markets behave. When a market is trending, most attempts to reverse fail. When it is in a trading range, most attempts to break out fail. This is the opposite of coin flips, where the odds are always 50–50. In trading, the odds are more like 70 percent or better that what just happened will continue to happen again and again. Because of the coin flip logic, most traders at some point begin to consider game theory.

Martingale techniques work well in theory but not in practice because of the conflict between math and emotion. That is the martingale paradox. If you double (or even triple) your position size and reverse at each loss, you will theoretically make money. Although four losers in a row is uncommon on the 5 minute Emini chart if you choose your trades carefully, they will happen, and so will a dozen or more, even though I can't remember ever seeing that. In any case, if you are comfortable trading 10 contracts, but start with just one and plan to double up and reverse with each loss, four consecutive losers would require 16 contracts on your next trade and eight consecutive losers would require 256 contracts! It is unlikely that you would place a trade that is larger than your comfort zone following four or more losers. Anyone willing to trade one contract initially would never be willing to trade 16 or 256 contracts, and anyone willing to trade 256 contracts would never be willing to initiate this strategy with just one. This is the inherent, insurmountable, mathematical problem with this approach.

Since trading is fun and competitive, it is natural for people to compare it to games, and because wagering is involved, gambling is usually the first thing that comes to mind. However, a far more apt analogy is to chess. In chess, you can see exactly what your opponent is doing, unlike in card games where you don't know your opponent's cards. Also, in poker, the cards that you are dealt are yours purely by chance, but in chess, the location of your pieces is entirely due to your decisions. In chess nothing is hidden and it is simply your skill compared to that of your opponent that determines the outcome. Your ability to read what is in front of you and determine what will likely follow is a great asset both to a chess player and to a trader.

Laypeople are also concerned about the possibility of crashes, and because of that risk, they again associate trading with gambling. Crashes are very rare events on daily charts. These nontraders are afraid of their inability to function effectively during extremely emotional events. Although the term crash is generally reserved for daily charts and applied to bear markets of about 20 percent or more happening in a short time frame, like in 1927 and 1987, it is more useful to think of it as just another chart pattern because that removes the emotion and helps traders follow their rules. If you remove the time and price axes from a chart and focus simply on the price action, there are market movements that occur frequently on intraday charts that are indistinguishable from the patterns in a classic crash. If you can get past the emotion, you can make money off crashes, because with all charts, they display tradable price action.

Figure I.4 (from TradeStation) shows how markets can crash in any time frame. The one on the left is a daily chart of GE during the 1987 crash, the middle is a 5 minute chart of COST after a very strong earnings report, and the one on the right is a 1 minute Emini chart. Although the term crash is used almost exclusively to refer to a 20 percent or more sell-off over a short time on a daily chart and was widely used only twice in the past hundred years, a price action trader looks for shape, and the same crash pattern is common on intraday charts. Since crashes are so common intraday, there is no need to apply the term, because from a trading perspective they are just a bear swing with tradable price action.

Figure I.4 Crashes Are Common

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Incidentally, the concept that the same patterns appear on all time frames means that the principles of fractal mathematics might be useful in designing trading systems. In other words, every pattern subdivides into standard price action patterns in smaller time frame charts, and trading decisions based on price action analysis therefore work in all time frames.

HOW TO READ THESE BOOKS

I tried to group the material in the three books in a sequence that should be helpful to traders.

Book 1: Trading Price Action Trends: Technical Analysis of Price Charts Bar by Bar for the Serious Trader

Book 2: Trading Price Action Trading Ranges: Technical Analysis of Price Charts Bar by Bar for the Serious Trader

Book 3: Trading Price Action Reversals: Technical Analysis of Price Charts Bar by Bar for the Serious Trader

If you come across an unfamiliar term, you should be able to find its definition in the List of Terms at the beginning of the book.

Some books show charts that use the time zone of the location of the market, but now that trading is electronic and global, that is no longer relevant. Since I trade in California, the charts are in Pacific standard time (PST). All of the charts were created with TradeStation. Since every chart has dozens of noteworthy price action events that have not yet been covered, I describe many of them immediately after the primary discussion under “Deeper Discussion of This Chart.” Even though you might find this incomprehensible when you first read it, you will understand it on a second reading of the books. The more variations of standard patterns that you see, the better you will be able to spot them as they are developing in real time. I also usually point out the major one or two trades on the chart. If you prefer, you can ignore that supplemental discussion on your first read and then look at the charts again after completing the books when the deeper discussion would be understandable. Since many of the setups are excellent examples of important concepts, even though not yet covered, many readers will appreciate having the discussion if they go through the books again.

At the time of publication, I am posting a daily end-of-day analysis of the Emini and providing real-time chart reading during the trading day at www.brookspriceaction.com.

All of the charts in the three books will be in a larger format on John Wiley & Sons’ site at www.wiley.com/go/tradingranges. (See the “About the Website” page at the back of the book.) You will be able to zoom in to see the details, download the charts, or print them. Having a printout of a chart when the description is several pages long will make it easier to follow the commentary.

SIGNS OF STRENGTH: TRENDS, BREAKOUTS, REVERSAL BARS, AND REVERSALS

Here are some characteristics that are commonly found in strong trends:

The more of the following characteristics that a bull breakout has, the more likely the breakout will be strong:

The more of the following characteristics that a bear breakout has, the more likely the breakout will be strong:

The best-known signal bar is the reversal bar and the minimum that a bull reversal bar should have is either a close above its open (a bull body) or a close above its midpoint. The best bull reversal bars have more than one of the following:

The minimum that a bear reversal bar should have is either a close below its open (a bear body) or a close below its midpoint. The best bear reversal bars have:

Here are a number of characteristics that are common in strong bull reversals:

Here are a number of characteristics that are common in strong bear reversals:

BAR COUNTING BASICS: HIGH 1, HIGH 2, LOW 1, LOW 2

A reliable sign that a pullback in a bull trend or in a trading range has ended is when the current bar's high extends at least one tick above the high of the prior bar. This leads to a useful concept of counting the number of times that this occurs, which is called bar counting. In a sideways or downward move in a bull trend or a trading range, the first bar whose high is above the high of the prior bar is a high 1, and this ends the first leg of the sideways or down move, although this leg may become a small leg in a larger pullback. If the market does not turn into a bull swing and instead continues sideways or down, label the next occurrence of a bar with a high above the high of the prior bar as a high 2, ending the second leg.

A high 2 in a bull trend and a low 2 in a bear trend are often referred to as ABC corrections where the first leg is the A, the change in direction that forms the high 1 or low 1 entry is the B, and the final leg of the pullback is the C. The breakout from the C is a high 2 entry bar in a bull ABC correction and a low 2 entry bar in a bear ABC correction.

If the bull pullback ends after a third leg, the buy setup is a high 3 and is usually a type of wedge bull flag. When a bear rally ends in a third leg, it is a low 3 sell setup and usually a wedge bear flag.

Some bull pullbacks can grow further and form a high 4. When a high 4 forms, it sometimes begins with a high 2 and this high 2 fails to go very far. It is instead followed by another two legs down and a second high 2, and the entire move is simply a high 2 in a higher time frame. At other times, the high 4 is a small spike and channel bear trend where the first or second push down is a bear spike and the next pushes down are in a bear channel. If the high 4 fails to resume the trend and the market falls below its low, it is likely that the market is no longer forming a pullback in a bull trend and instead is in a bear swing. Wait for more price action to unfold before placing a trade.

When a bear trend or a sideways market is correcting sideways or up, the first bar with a low below the low of the prior bar is a low 1, ending the first leg of the correction, which can be as brief as that single bar. Subsequent occurrences are called the low 2, low 3, and low 4 entries. If the low 4 fails (a bar extends above the high of the low 4 signal bar after the low 4 short is triggered), the price action indicates that the bears have lost control and either the market will become two-sided, with bulls and bears alternating control, or the bulls will gain control. In any case, the bears can best demonstrate that they have regained control by breaking a bull trend line with strong momentum.