Chapter 7
Getting Technical Without Getting Tense
In This Chapter
Embracing the purpose and uses of technical analysis
Choosing a good charting service
Adopting specific charts and interpreting chart patterns
I’m a visual person, and my first experience with trading came from reading a chart in 1988, right before Memorial Day weekend, when I made my first stock trade: 100 shares of Quanex Corp. (NYSE:NX), a steel pipe and tube maker. I bought the stock for around $12 and sold it at essentially the same price a few days later, at which point it hadn’t done much of anything. I was most unhappy with the commissions I had to pay and the fact that the stock didn’t do what I had expected it to do — rise substantially in price.
I bought the stock based on a chart that exhibited a cup-and-handle pattern, a chart pattern made famous by Investor’s Business Daily founder William O’Neil. This pattern isn’t very useful in futures trading, but it can be helpful in trading stocks. It shows up when a stock forms a rounded base and then trades sideways in a narrow range, giving the appearance or impression of a cup and a handle.
In my first trade, I identified such a pattern from an Investor’s Business Daily chart. I was lucky. My first stock trade cost me only a hundred bucks, and I had enough money left to keep on trading. But that failure within my small account — breaking even and paying a $50 commission on the purchase and the sale — is what prompted me to find out more about charts and how they work together with the fundamentals of the markets.
What I didn’t realize at the time was that Quanex had only recently come out of some major difficulties and was restructuring. A longer-term view of the chart would’ve revealed that trading was volatile and that the stock was, in fact, stuck in a trading range and not in a significant up, down, or breakout trend.
I also discovered that I didn’t know anything about the state of the steel industry at the time, the company’s management, or its plans for the future. All are important when trading futures, options, and their underlying equities.
My mistake was that the cup-and-handle pattern, although genuine, was only a snapshot of the trading action over a few months. Had I known better — as I do now — I would’ve looked at a multiyear chart, and put the cup-and-handle pattern from the newspaper in its proper context.
The major lesson that I brought home during that relatively traumatic experience was that a chart pattern is only a beginning — a tool that leads you toward exploring more information about why the pattern suggests that you need to buy, sell, or sell short the underlying instrument.
In this chapter, I introduce you to the basics of recognizing interesting chart patterns that can lead you either to more study of the situation or to plug in what you already know about a market that is giving you a visual signal. See Chapters 8 and 12 for speculating strategies and using technical analysis for trading stock index futures.
Picturing a Thousand Ticks: The Purpose of Technical Analysis
I like to think of stock or futures charts as summaries of the collective opinions of all the participants in a market. In essence, a chart is a tick-by-tick history of those opinions as they evolve over time, factoring in everything that market participants know, think they know, and expect to happen with regard to the asset for which the chart was compiled.
And although a picture is worth a thousand words to most people, to a trader, a chart is worth a chance to make some money. Technical analysis, or the use of price charts, moving averages, trend lines, volume relationships, and indicators for identifying trends and trading opportunities in underlying financial instruments, is the key to success in the futures market. The more you know about reading charts, the better your trading results are likely to be.
After you become better acquainted with the basic drivers and influences of a particular market and how that information — key market moving reports, the major players involved, and the general fundamentals of supply and demand — fits into the big picture of the marketplace in general, the next logical step is to become acquainted with how the fundamentals are combined with the data that is compiled in price charts.
By becoming proficient at reading the charts of various security prices, you gain quick access to significant amounts of information, such as prices, general trends, and info about whether a market is sold out and ready to rally or overbought, meaning few buyers are left and prices can fall. By combining your knowledge of the markets and trading experiences with excellent charting skills, you vastly improve your market reaction time and your ability to make informed trades.
Technical Analysis For Dummies by Barbara Rockefeller (Wiley)
Trading For Dummies by Michael Griffis and Lita Epstein (Wiley)
Technical Analysis of the Financial Markets by John J. Murphy (New York Institute of Finance)
Candlestick Charting Explained: Timeless Techniques for Trading Stocks and Futures by Gregory L. Morris (McGraw-Hill)
By reading the information in this book and the books in the preceding list, you can build a foundation for technical analysis. However, as you gain trading experience, technical analysis will become more of an individualized endeavor for you because you’ll find that you gravitate to some areas more than others.
My own experience is that the simpler the analysis, the better, so my analytical style relies on moving averages, trend lines, and a few oscillators and indicators. Your style will develop as you gain experience.
These guidelines can help organize your expectations about reading charts:
Charting, in my opinion, isn’t meant to replace fundamental analysis. In my trading, charts are meant to complement and enhance it, enabling you to make better decisions. That’s not to say that there aren’t those very talented people out there who make millions as pure chartists, because there are. Just keep an open mind on this.
Understanding the fundamentals of supply and demand in your par-ticular segment of the futures market is necessary for you to be able to trade futures based on charted technical signals. Knowing both the fundamentals of what you are trading and combining the knowledge with technical analysis makes investing your hard-earned money easier.
You have to be flexible, so becoming familiar with more than one set of indicators and being able to combine them gives you more than one perspective from which to view the markets. I use different combinations of indicators for different types of trading to find more ways of looking at the markets. Narrow-minded traders don’t go too far.
Mastering the basics of following moving averages, identifying trend reversals, and drawing trend lines is important so you can add new layers of analysis, such as moving average crossover systems, and other more sophisticated techniques as you gain more experience.
Continuing to expand your knowledge of technical analysis is important. You can do so by reading magazines like Technical Analysis of Stocks & Commodities (www.traders.com), Futures (www.futuresmag.com), and Active Trader (www.activetradermag.com) magazines, which are excellent sources of interesting articles. Investor’s Business Daily (www.investors.com), is a chart reader’s paradise for stock and futures traders.
Exercising care so that you avoid clutter in your charts, even as you become more sophisticated in your approach to trading futures, is important. The simpler your charts, the better the picture you get and the better your decisions will be.
First Things First: Getting a Good Charting Service
You need a reliable charting service — a provider of quotes, charts, and market data — either one that your broker provides or an independent one such as Barchart (www.barchart.com), and you need a reliable set of software tools to be able to trade well. Many such services, programs, and combinations of the two are available.
Some online trading houses offer a range of services on their respective Web sites. Software and charting services are available as on websites, downloads, or as individually boxed packages that are Web-ready. They range from the bare minimum with basic charts and indicators to very complex systems used by professionals. A good way to start is with a bare-bones charting system or the next step up. You can move up to progressively more elaborate systems as your trading skills become more sophisticated.
Some brokers charge you extra for using their in-house, more sophisticated charting and software services, but others let you use them as part of a package deal, especially if you’re an active trader placing trades through the sponsoring trading house. Extra charges vary, but a difference of $30 to $40 per month or more between the low- and the high-end packages is not uncommon. You need to check with each individual service before deciding on a charting service.
No matter what, you’re obligated to pay exchange fees to get real-time quotes from the exchanges, and those fees can add up to hundreds of dollars per month, depending on the number of exchanges from which you get quotes.
Here are the characteristics that a charting service/online brokerage must have:
Reliability: The service must be up and running when you want to place trades, and the data it provides must be accurate. If your service tells you to come back later because it’s unavailable anytime when the markets are open — in other words, during peak trading times — you need to quit the unreliable service, demand a refund, and find another more-reliable service. A good way to find out whether a service is reliable is to locate users’ groups, either online, where you can read their bulletin boards, or in your town, where you can attend a meeting or two and listen to any complaints. You also need to sign up for a trial period so you can see how you like the system before you pay for it. Most services offer free trials.
Accessibility: The service needs to be available to you virtually anywhere, either online or by the use of a convenient online interface. You need to be able to check your quotes, open positions, and make your decisions from home, work, or elsewhere — even on your laptop, PDA, or smart phone at the airport, or at your favorite hangout that has Wi-Fi.
Support: Make sure the service offers both a toll-free telephone number to call for support and online support. The toll-free number may or may not be better than the online support, so you need to try both of them out to see which works better. Call the toll-free number, log in to the support chat room, or e-mail customer support before you purchase the software, just to test the availability and level of support that you’ll be getting. If your software or charting service malfunctions and you have to wait 30 minutes before anyone responds to your query, think about what effect that kind of delay may have on your investments, especially if you’re trying to place a trade when a big economic release is moving the markets.
Charting tools: The charts provided by your charting service must be easy to read and user-friendly. You shouldn’t have to punch five or ten keys or toggle your mouse for ten minutes to make your chart look right. Sure, you can expect a learning curve with most programs, but if you can’t make the software do what you want (and what the provider says it will do) after a few days, it isn’t the right setup for you, and you need to consider getting a new program.
Real-time quotes: Trading futures without real-time quotes is a sure path down the road to ruin. Real-time quotes are up-to-the-minute market prices, as they happen. They provide you with up-to-the-minute pricing for your particular security, futures contract, or option, thus enabling you to make timely decisions. Without them, the prices you get from your charting service may be subject to a standard 20-minute delay, during which markets can move to their limits (or even reverse course), leaving you faced with a margin call or a big loss.
Live charts: If you’re going to trade, you need access to live charts that actually change with every tick (up or down movement) of the market. You can set them up to update the bars or candlesticks in your charts over a broad range of different time frames. The key: You want your chart to be updated to reflect the direction in which the market is trading.
Time-frame analysis: Make sure your charting service enables you to produce intraday charts. You want to be able to look at different time frames simultaneously. For example, if the long-term trend in the S&P futures is headed up on a six-month chart, but you see that a top is building on your intraday chart, your strategy for your S&P 500 Index fund may not be affected. But if you have two S&P 500 long contracts open and a few call options, you may need to adjust the strategies on your futures positions. For example, you may want to consider moving a sell stop closer to the current price if you’re concerned about remaining in the position. Or you may want to sell the position outright.
Multiple indicators: Make sure the service to which you subscribe lets you plot price charts and multiple indicators at the same time. A standard page may include prices, a combination of moving averages, stochastics, and MACD and RSI oscillators. I go into more details on these indicators and how to use them in Chapter 8. Chapter 13 features a great example of how to use RSI in the energy markets. But for now, you need to concentrate on the charting information you need for technical analysis.
Also important is the amount of data that you can get on one chart and having the ability to save it as a template. Set up your charts the way you like them when the market is closed, and then save them as your favorites. Most services will let you set up different sets of charts. That way when you start trading you won’t waste time setting up your indicators when you should be pulling the trigger on your trade.
Deciding What Types of Charts to Use
Security analysis relies on these four basic types of charts: line charts, bar charts, candlestick charts, and point-and-figure charts. Line charts almost never are used in trading. Bar and candlestick charts commonly are used in stocks and futures trading, and point-and-figure charts have a smaller but loyal following as trading tools.
I don’t use point-and-figure charts, so I won’t include them in this discussion. However, for a nice short overview of point-and-figure charting, check out Technical Analysis For Dummies (Wiley). If you like what you read there and want even more information about it, I also recommend John Murphy’s Technical Analysis of the Financial Markets (New York Institute of Finance).
In general, I concentrate on bar and candlestick charting, but the bulk of my explanation in this chapter is based on candlestick charts, because they’re the most commonly used charts in futures trading. They offer the best information for shorter holding periods (like the ones common to day trading) or for longer trading periods where you have open positions that you may stay with for a few days.
Confused? Don’t be. Both types of price charts are useful, and you’ll develop your own style and preferences for the ones that work best for you. At this point, however, you merely need to be aware of what these charts are, how to recognize them, and how you can start thinking about putting them to use. Both sets of charts offer the same basic kind of information — price, volume, and general direction of the market.
Bar charts are made up of thin single bars that define the movement of a price over a period of time. You can use one for analyzing a longer period of the market. I like them for this purpose because they’re a bit less cluttered.
Candlestick charts, on the other hand, are made up of thin- and thick-bodied candles, such as in Figure 7-1, which shows how they basically look like candles with wicks at both ends. Figure 7-3 shows how you can incorporate candlestick patterns with key indicators, such as moving averages and oscillators.
Stacking up bar charts
Bar charts used to be the most commonly displayed charts on most trading software programs. The bars displayed low and high prices for the specific time frame of the chart, with the body of the bar representing the range of trading action during that time frame. The time frame of a bar chart can be set according to whatever time period the user wants to use, regardless of whether it’s for part of a day, a day, a week, a month, a year, or longer.
No hard-and-fast rules govern whether one type of chart is better than another. For example, bar charts and candlestick charts can be used for trading during any time span that you like, whether day trading or trading intermediate-term positions in which you stay with the underlying asset as long as the trend remains in your favor.
I prefer to use candlestick charts for intraday charts, because the color tells me what I want to know rapidly. For longer-term charts from which I just want to get the big picture about whether I want to buy or sell the underlying asset, I tend to use bar charts. The best thing to do is work with both kinds of charts when you are a beginner and develop your own tendencies.
Bar charts are useful when
You’re looking for a quick snapshot of a particular instrument, sector, or market, or when you’re doing basic trend analysis.
You’re trading individual stocks or mutual funds, and you’re looking at a long-term chart, such as a five-year time span.
Weighing the benefits of candlestick charts
Candlestick charts provide the same sort of information as bar charts, but they’re better for making trading decisions because they take the guesswork out of the overall trend in the underlying contract by the use of color-coding. They’re especially suited for the short-term trading that’s common in the futures markets.
Candlestick charts can be broken down into several parts, including the following:
Real body: The real body is the box between the opening and closing prices depicted by the candlestick. The body can be white or black. White bodies are bullish, meaning that the price depicted is rising. Black bodies are bearish, meaning that the price depicted by the candlestick is falling.
Lower and upper shadows: The thin lines that extend above and below the real body (the candlewicks) are the lower and upper shadows. The shadows, or wicks, extend to the high and low prices for the time frame.
Figure 7-1 summarizes the basic anatomy of candlestick charting.
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Figure 7-1: The anatomy of a candlestick. |
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Although bearish candlesticks traditionally are solid black, many software programs and charting services have replaced the black color with red to correspond with the standard method of displaying falling prices on quote systems. They’ve also replaced normally white bullish candlesticks with green ones, again to conform to the quote systems standards. In fact, many software programs will even let you decide which color you want to use for bullish or bearish charts. In this chapter, though, green and white refer to bullish conditions, and red and black mean bearish.
When a candlestick has no body but only vertical and horizontal shadows, meaning that it is a line with no box, it forms what is known as a doji pattern. Doji patterns are a sign of indecision in the market. The three types of doji patterns (see Figure 7-2) are
Plain: A plain doji looks like a cross and may just be a sign of a short-term pause. Other kinds of doji bars can be important signs of a trend reversal.
Dragonfly: A dragonfly doji has a long lower shadow, or single-line body — the dragonfly appears to be flying upward. If you see this kind of pattern, it means that sellers were not successful in closing the contract at the lows of the day. When that happens as the price is bottoming out, it can mean that buyers are gaining an upper hand. If a dragonfly doji occurs after a big rally, it can mean that buyers are not able to take prices any higher.
Gravestone: A gravestone doji looks like an upside-down dragonfly, with a longer upper shadow — the dragonfly appears to be flying downward. Gravestone dojis occur when buyers push prices higher but can’t get prices to close at those higher levels. If a gravestone doji appears after a rally, it can signal that a reversal is coming.
On the other hand, a gravestone doji in a downtrend may mean that a bottom is forming.
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Figure 7-2: The three basic doji bars. |
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Candlesticks can be superior to bar charts for the following reasons:
Trends are easier to spot. For example, a sea of rising green (or white), meaning a large grouping of bullish candles on a candlestick chart, is hard to mistake for anything other than a strong uptrend. Because candlesticks tend to have a body in most cases, the overall trend of the market often is easier to identify.
Trend changes are easier to spot. Candlestick patterns can be dramatic and can help you identify trend changes before you can recognize them on bar charts. Some candlestick patterns are reliable at predicting future prices.
Shifts in momentum are easy to spot. Conditions in which a security is oversold and overbought, along with trends and other kinds of indicators, may be easier to spot on candlestick charts than on bar charts because of the presence of doji candles and color. For example, an engulfing pattern (see Figures 7-3 and 7-6 and the section “Engulfing the trend,” later in this chapter), which can be either negative or positive, is easier to spot in a candlestick chart.
Getting the Hang of Basic Charting Patterns
Charting patterns can get out of control if you’re not careful, so I like to keep it simple. That means that if you understand the basic tenets of charting and the most important, easy-to-spot patterns, you can make solid trading decisions as long as you remember that charting is most useful to you when you couple it with fundamental and situational analysis of the markets.
So before you start looking for patterns, follow this three-step rule:
1. Get the feel for whether the basic trend is up or down.
Just look at the chart. If the price starts low and rises, it’s an uptrend. If the opposite is true, it’s a downtrend.
2. Gauge how long that trend has been in place.
Using longer-term charts sometimes can help you spot just how long the trend has been in place.
3. Consider the potential for a reversal.
The longer the trend has been in place, the higher the chance that it can turn the other way.
After you get comfortable with this process, you can advance to looking for the charting patterns that I describe in the sections that follow.
Analyzing textbook base patterns
Bases, whether tops or bottoms, are sideways patterns on price charts; they’re pauses in the uptrends or downtrends in security prices. Bases are formed as some traders take profits and other traders establish new positions in the other direction.
Bases, in general, are points in the pricing of a security at which the market takes a break before deciding what to do next. A base can come before the market turns up or down, and it can last for a long time, even years. If, after it forms a base, the market decides that more selling is called for, a new downturn, or falling prices, can start on a candlestick chart, despite the fact that the market has based after a decline. When the base forms after a rally, it can either resolve as a top, and the market can fall, or indicate only a pause in a continuing uptrend. You can’t, however, predict with full certainty which way the markets will break after they pause (in either direction).
Figure 7-4 (later in this chapter) shows some key technical terms, including price tops and bottoms and basing patterns.
Specific patterns seen in price oscillators, such as when the RSI and MACD indicators move in different directions than the price of the security (see Chapters 8 and 13).
Major turns in market sentiment (see Chapter 9).
Key price movements above and below important price areas, such as resistance or support points (see Figure 7-4 and the section “Using lines of resistance and support to place buy and sell orders,” later in the chapter).
Downtrends
Here are some important factors to remember about a base at the bottom of a downtrend:
A good trading bottom usually comes when everyone thinks that the market will never rise again.
Downtrends can die in two ways: in a major selling frenzy or over a long period of time in which a base forms.
At some point, all markets become oversold, and they bounce. Any such bounce can be the beginning of a new bullish uptrend in the market. After a long time of falling prices, you have to be ready to trade all turns in the market, even if you get taken out as the downtrend reasserts itself.
The most important area of a chart that is making a bottom is known as support. Support is a chart point, or series of points, that puts a floor under prices. That’s where the buyers come in.
Uptrends
Here are some important factors to remember about a base at the top of an uptrend:
Most participants at the top in the market are bullish, which is why three or four failures often occur before the market breaks toward the downside.
Downturns that follow long-term rallies tend to spiral downward for a long time. That’s exactly what happened with the multiyear chart of the dollar index shown in Figure 7-5, later in the chapter.
Tops are more likely to lead to reflex rallies, meaning that long-term downtrends are likely to be more volatile than are uptrends. For short sellers, it’s a very rough ride, no matter which market you’re trading.
The most important area of a chart that is making a top is known as resistance. Resistance is a chart point, or series of points, that puts a ceiling above prices. That’s where sellers come in.
Using lines of resistance and support to place buy and sell orders
Drawing lines of resistance and support for a particular market or security (see Figure 7-4) can help you maintain your focus when placing your buy, sell, and short-sell orders. Buy orders usually are placed above resistance lines, and sell orders and sell-short orders are placed below support levels. One thing you can count on in the futures markets is the disciplined way by which traders respond to the signals. That’s what makes technical analysis ideal for futures trading.
Support and resistance lines define a trading range. In Figure 7-4 (later in the chapter), the trading range is called a basing pattern, because it precedes a breakout.
Support and resistance levels can be fluid, flowing up and down within the trading range. When combined with a moving average (see the next section), they provide a useful tool that indicates how market exit and entry points are progressing in relationship to the price of the security.
Moving your average
Moving averages are lines that are formed by a series of consecutive points that smooth out the general price trend. Moving averages are a form of a trend line.
In terms of a security’s closing price, for example, a 50-day moving average is a line of points that represent the average of the closing prices of the security during each of the previous 50 days of trading.
Figure 7-3 shows two classic moving averages that are frequently used in technical analysis, the 50-day and 200-day moving averages. This particular figure shows a bullish long-term trend in which the bond fund is trading above the 200-day moving average and a crossover in which the price of the bond fund began trading above the 50-day moving average, a sign that prices were moving higher.
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Figure 7-3: Moving averages point to a bullish trend in 20-year T-bonds, while engulfing and harami patterns point to trend changes. The MACD indicator confirms the shift. |
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Moving averages come in many different types, but for illustrative purposes, I use these four:
20 days: The 20-day moving average traditionally is thought of as a short-term indicator.
50 days: The 50-day moving average is considered a measure of the intermediate-term trend of the market.
100 days: More pros are starting to use the 100-day average. The 100-day average gives the pros an edge over the public, as most people tend to follow the 20- and 50-day lines. The 100-day average gives you a chance to participate in the market’s action sandwiched between the very long-term trend measured by the 200-day average and the shorter term periods measured by the 20- and 50-day lines.
200 days: The 200-day moving average is considered the dividing line between long-term bull and bear markets. Use this average to make very long-term decisions about the trend of the market.
As a general rule, when a market trades above its 200-day moving average, the path of least resistance is toward higher prices; however, no hard-and-fast rules exist. Some traders prefer to use a 21-day moving averagerather than the 20-day average, while others think moving averages are useless altogether. I personally like using them to define dominant trends in the markets but not necessarily as guides to placing buy or sell stops.
Short-term charts, such as the charts used for day trading, where one price bar can equal as short a period of time as 15 minutes, have moving averages that measure minutes rather than days. The same decision rules apply, though.
The exception for me is when a market has been in a major uptrend or downtrend for an extended period, and it suddenly breaks below or above the 200-day average. This can signal that the long-term trend in that market has made a drastic change in the opposite direction.
Back testing is a trading method by which you review or test your proposed strategy over a period of time by using historic charts. For example, if you want to see how a market relates to its 20-day moving average, you can look at a five-year chart that includes the 20-day moving average and gauge what prices do when that market is priced above or below that average. When back testing, you’re better off looking at many different indicators and combinations of them. You usually can find a combination that works best for any particular market. When you back test your strategy, you improve your chances of finding the best combination of indicators to keep you on the right side of the trend.
Breaking out
A breakout happens when buyers overwhelm sellers and prices begin to rise. Breakouts usually follow some kind of basing pattern or sideways movement in the market. A good rule is that the longer the base, the higher the likelihood of a good move after the underlying security breaks out of its trading range.
Figure 7-4 shows a great example of a chart breakout coming out of a head-and-shoulders pattern, a basic and easy-to-find pattern that can be found in all markets. Notice the almost perfect head-and-shoulders bottom in the crude oil contract marked H for the head and S for the left and right shoulders, as it forms the basing pattern that precedes the crude-oil price breakout in textbook fashion.
Some of the characteristics of a head-and-shoulders base are that it
Is a common but not always reliable technical pattern. It doesn’t always point to a breakout the way it does in Figure 7-4.
Always is shaped like a head and shoulders. Arrows in Figure 7-4 illustrate how the volume drops off as the shoulders are being formed, a textbook characteristic of the head-and-shoulders bottom. Head-and-shoulder tops are the same formation turned upside down. When they happen, they can lead to a breakdown in the underlying asset.
Indicates that any resulting breakout will take out the resistance at the neckline of the head-and-shoulders pattern.
Results in an increase in share volume as the price breaks out above the head-and-shoulders bottom (see the five-pointed star in Figure 7-4). The volume increase is another important characteristic of a chart breakout. It indicates that many buyers are interested in the security and that prices are likely to go higher.
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Figure 7-4: Here’s a good look at lines of resistance and support, a breakout, a base pattern, and a classic head-and-shoulders pattern. |
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Using trading ranges to establish entry and exit points
Markets often trade in channels. As is what happens when a market trades up or down within defined borders. It is sort of a trading range, except usually trading ranges are defined as markets that move sideways, which are in fact horizontal channels. Don’t get too bogged down in the finer points, though. Just remember that markets tend to move within upper and lower limits. Sometimes the upper and lower limits are horizontal (trading ranges) and sometimes the upper and lower limits slant (channels.) Figure 7-5 shows a rising or uptrending channel. The upper line defines the top of the channel, and the lower line defines the bottom of the channel.
The longer the channel holds in place, the more important a break above or below it becomes for a particular market or security.
Channel lines can indicate a multiyear bear market if the breakout occurs below the rising channel. (That’s what happened to the dollar in the late 1990s in Figure 7-5.)
Channel lines can indicate that a major bottom is in place and that a bear market has come to an end if a downtrend line is broken. (That’s what happened to the dollar in 1985 and 2005 in Figure 7-5.)
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Figure 7-5: Gaps, channels, trend lines, triangles, and other basic technical analysis patterns. |
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As with most definitive bases at the top of an uptrend, the crucial signal is the failure to make a new high for the move. Note how the number 3 top is lower than the number 2 top and then is followed by fast and furious selling.
Seeing gaps and forming triangles
Gaps and triangles are two of the more common occurrences on price charts. Each has its own meaning and importance.
Triangles, or wedge formations, can predict future price actions more reliably than gaps, but gaps can also be useful.
The three basic triangle shapes found on price charts are
Ascending triangles: These triangles point upward and can be good signs of a price pattern with an upward bias (refer to Figure 7-5). In that example, the Dollar Index uses the lower rising channel line as support to build an ascending triangle. A horizontal line (above the triangle) marks the resistance point that completes the triangle.
Descending triangles: These triangles point downward and are the opposite of ascending triangles, usually coming before downtrends.
Symmetrical triangles: These triangles are symmetrical in that they show neither an upward nor downward trend and thus are unpredictable price formations.
Gaps, on the other hand, are unfilled points on price charts. They are more frequently visible and therefore less important in the price charts of thinly traded instruments, such as obscure futures contracts and some small stocks. However, when they occur in more common contracts and more heavily traded stocks, they can be much more important and have the following effects (Figure 7-5 shows all three such gaps):
Breakaway gap: This gap happens when an underlying security gets out of the gate very strongly at the start of the trading day. Breakaway gaps often come after the release of economic indicators, such as the monthly employment report. They are signs of a strong market.
Breakaway gaps are more meaningful when they are bigger than the usual trading range of a security. For example, if you know that a futures contract usually trades within a range of three point ticks and it opens ten ticks higher or lower, the result is a major breakaway gap.
Runaway gap: This gap occurs when a second gap appears on a price chart in the same direction as a breakaway gap. Runaway gaps are signs of continuing and accelerating price trends.
Exhaustion gap: This gap is a sign that a market has run out of buyers or sellers and indicates almost a last gasp in the market before the trend is reversed. Some exhaustion gaps may have telltale candlestick patterns associated with them, such as a doji, cross, or hanging man (see the section “Hammering and hanging for traders, not carpenters” later in this chapter).
Seeing through the Haze: Common Candlestick Patterns
Even though candlestick patterns are not 100 percent reliable, they certainly are worth paying attention to. As you gain more and more experience, you’ll come to know many different patterns. In this section, I concentrate on the more common and meaningful patterns that can serve as signals that a market is starting to reverse course.
Engulfing the trend
An engulfing pattern is what you see when the second (or next) day’s real body, or candlestick, completely covers the prior day’s candlestick. An engulfing pattern signals a potential reversal. Figure 7-6 shows a schematic of bullish and bearish engulfing patterns, and Figure 7-3 shows a real-time engulfing pattern. Note that the body of the second candle is larger than the first candle and that it predicts a change of the trend. The bullish engulfing pattern predicts a trading bottom, and the bearish engulfing pattern, a top. Action on the third day often is key to whether the pattern will hold.
Engulfing patterns are characterized by a second-day candlestick that is larger than, or engulfs, the first day’s candlestick. The larger candlestick predicts a potential change in the trend of the underlying security’s price. For example, a bullish engulfing pattern usually appears at or near a trading bottom and predicts an upturn in prices, while a bearish engulfing pattern appears at or near the trading top and predicts a downturn in prices.
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Figure 7-6: The engulfing pattern. |
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A definite trend must be underway.
The second-day candlestick’s body must completely engulf the prior day’s candle. In other words, the high and low prices of the second-day candlestick must be higher and lower than the respective high and low for the previous day. Morris points out the subtleties of engulfing patterns by indicating that if the tops and bottoms of both candlesticks are identical, the pattern isn’t engulfing, but if one or the other is equal and the second-day candle still engulfs the previous day’s candle on the other end, the pattern is valid.
The color of the first day’s candle must reflect the trend. So if prices are trending upward, and the first candle is red, the pattern doesn’t hold.
The second day’s candle must be the opposite color of the prevailing trend. This rule is the corollary to the preceding rule. If the first day’s candle is red or black, showing a downtrend in prices, the second day’s candle must be green or white.
Figure 7-3 (earlier in the chapter) offers a great example of a real-life engulfing pattern that meets all criteria. Notice the following:
The bar started out at a higher opening price, but clearly closed at a lower level, a sign of a clear reversal.
The engulfing bar was huge compared to the prior day.
Hammering and hanging for traders, not carpenters
The hammer and the hanging man also are common patterns. A hammer is a small white candlestick with a long shadow, while a hanging man is a small black candlestick with a long shadow (see Figure 7-7).
Making sense of these patterns is difficult, because they can appear virtually anywhere on just about any chart. They are best used after a long series of bars of the same color and are most reliable as indicators of a possible reversal.
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Figure 7-7: Hammer and hanging man patterns. |
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Seeing the harami pattern
A harami pattern is an excellent example of a reversal pattern. It forms when a long candlestick of one color is followed by a smaller candlestick of another color. The color of the second candle indicates which way the market is likely to go. You can see it in a real-world example back in Figure 7-3.
The harami is an excellent pattern for indicating a trend change or pause. The stock needs to be in a strong trend, and for the harami to be a valid pattern, the second real body must form completely inside the first. The color of the second candle needs to be the opposite of the first. Confirmation of this pattern is recommended.
Say, for example, that you’ve been selling bonds (I use the exchange traded fund TLT in this example, but it is equally applicable to bond futures) short for several days and suppose that you’re starting to get comfortable with a downtrend when you spot a long red (black) candle on your chart. Your initial response, especially if you’re using bar charts, is to think that the downtrend is extending and that you’re going to make more money in the next few days.
However, on the next day, prices reverse and close higher after other short sellers have covered their short positions.
Although the bar for the second day is green (white), it’s nevertheless smaller as new short sellers come into the market at the end of the day. They’re thinking that the downtrending security is a good opportunity to initiate new short sales after missing out on the last move.
You gain a more accurate picture of the situation by looking at the volume on the two days, as shown by the down-pointing arrow in Figure 7-3. Average volume on the long black day followed by higher volume on the short white day suggests that the trend is about to change, and you indeed have a harami pattern.
The action on day three tells you whether the harami pattern will hold true and send prices higher.
Several important technical-analysis-related points to get out of the harami pattern in Figure 7-3 include
The arrow shows the close correlation between the low-volume red or down day and the higher volume up day and clearly conforms to the rules laid out by Morris where a low-volume down day is followed by a higher volume up day.
Day three is an up day, confirming the trend change.
The harami was followed by more selling until the market hit a lower bottom.
The MACD indicator also correctly correlated the bottom by crossing over a few days after the harami pattern occurred.
This is a perfect example of how you can use candlestick charts and standard indicators together to form accurate buy and sell signals.
Bears, bulls, and a bunch of crazy names
According to John Murphy’s Technical Analysis of the Financial Markets (New York Institute of Finance), 68 different candlestick patterns are commonly used by futures traders. Murphy lists 8 bullish continuation patterns, 8 bearish continuation patterns, and 26 bullish and bearish reversal patterns. Some candlestick patterns are composed of two, three, four, and five candlesticks. Some of my favorite names for patterns are
Abandoned baby
Dark cloud cover
Concealing swallow
Three white soldiers
Three black crows