Technical analysis of the Futures markets
John-j-Murphy
Chapter 1
1. Introduction to Technical Analysis
Definition: Technical analysis is the study of market action (price, volume, and open interest) primarily through charts to forecast future price trends.
Market action refers to price movements, and for futures and options markets, it also includes volume and open interest.
Goal: Identify market trends to make informed trading decisions.
2. Core Philosophical Premises There are three fundamental premises that technical analysis is based upon:
Market Action Discounts Everything
This principle suggests that all relevant information (political, economic, psychological, etc.) is reflected in the price.
Technicians believe that the study of price action is sufficient to forecast future market behavior because prices reflect supply and demand dynamics.
The price chart essentially becomes a shortcut to fundamental analysis since price action already factors in fundamental data.
Prices Move in Trends
The central goal of chart analysis is to identify market trends early and trade accordingly.
A trend in motion is more likely to continue than to reverse, following Newton's first law of motion applied to market dynamics.
Traders aim to ride trends as long as they persist, only considering exit when signs of reversal appear.
History Repeats Itself
Market patterns, often driven by human psychology, tend to recur over time.
Historical price movements, reflected in chart patterns, are expected to play out similarly in the future, as human behavior and market reactions remain consistent over time.
3. Technical vs. Fundamental Analysis
Fundamental Analysis: Focuses on economic forces of supply and demand to determine the intrinsic value of a security.
If the market price is below the intrinsic value, it is considered undervalued and a buy signal is generated. If above, it's overvalued and a sell signal.
Fundamentalists study why the price changes.
Technical Analysis: Concerned with the effect of market movements, rather than the cause. Technicians believe the reasons behind market action (fundamentals) are irrelevant, as all necessary information is already priced into the market.
Both methods aim to predict future price movement, but the approaches differ: fundamentalists study the causes, while technicians study the effects.
4. Analysis vs. Timing
Analysis: Determining the general trend of the market can be approached through both fundamental and technical methods.
Timing: Timing the market (entry and exit points) is critical and almost entirely reliant on technical analysis.
Correct timing is especially crucial in futures markets due to high leverage, where even small timing errors can lead to significant financial losses.
5. Flexibility and Adaptability of Technical Analysis
Technical analysis can be applied across various markets (stocks, futures, options) and time frames (short-term, medium-term, long-term).
Traders can apply these techniques whether trading intra-day, weekly, or even monthly trends. It allows flexibility in different markets and time dimensions.
6. Technical Analysis in Economic Forecasting
Commodity prices (like gold or oil) provide clues about inflation and economic strength.
Rising commodity prices suggest inflationary pressure and a strong economy, while falling prices may signal economic weakness.
Futures markets often predict economic trends before they show up in traditional indicators, making them useful tools for forecasting.
7. Technician or Chartist?
Technician and Chartist are terms often used interchangeably, though they may differ in application.
Traditional chartists rely heavily on price charts to make decisions, while statistical technicians quantify and optimize market data, often developing mechanical trading systems.
Both types of technicians study market action but may differ in the tools and approaches used.
8. Criticisms of Technical Analysis
Self-Fulfilling Prophecy: One common criticism is that if enough traders act on the same chart patterns, they can cause the predicted price movements to occur.
Random Walk Theory: This theory challenges the idea that prices move in trends, suggesting that market prices are random and cannot be predicted. Technical analysts reject this theory, pointing to market trends as evidence of predictability.
9. Conclusion
Chapter 1 establishes the philosophical underpinnings of technical analysis, contrasting it with fundamental analysis and defending it against common criticisms.
Understanding these principles is crucial for applying technical analysis in real-world trading contexts.
Chapter 2 "Dow Theory"
1. Introduction to Dow Theory
Founders: Charles Dow and Edward Jones, founders of Dow Jones & Company in 1882, laid the foundation for modern technical analysis.
Application: Dow applied his theories primarily to stock market averages, specifically focusing on the Dow Industrials and the Rails (later known as the Dow Transportation Index).
Significance: Even though Dow never formally wrote a book on his theory, his work was posthumously compiled, and his principles remain a cornerstone of technical analysis today.
2. Basic Tenets of Dow Theory
The Averages Discount Everything
Similar to the central philosophy of technical analysis, Dow believed that stock market averages reflect all known information, including political, economic, and social factors.
This tenet implies that studying price action alone can provide insight into the market’s future behavior.
The Market Has Three Trends
Dow identified three types of trends in the market:
Primary Trend: The main movement, lasting more than a year and representing a significant shift in market direction.
Secondary Trend: Temporary corrections within the primary trend, lasting a few weeks to a few months, often retracing one-third to two-thirds of the previous move.
Minor Trend: Short-term fluctuations within the secondary trend, usually lasting less than three weeks.
These trends are likened to the tide, waves, and ripples of the sea.
Major Trends Have Three Phases
Each primary trend typically goes through three phases:
Accumulation Phase: Informed investors begin buying while the general public is pessimistic.
Public Participation Phase: The broader market begins to participate as prices rise.
Distribution Phase: Smart investors start selling as the market becomes overbought and optimistic sentiment peaks.
The Averages Must Confirm Each Other
Dow believed that signals from one average (e.g., Dow Industrials) should be confirmed by another average (e.g., Dow Transports).
A bull or bear market is only confirmed when both averages break through significant levels.
Volume Must Confirm the Trend
While Dow considered volume a secondary indicator, it plays a critical role in confirming price signals.
In an uptrend, volume should increase as prices rise and decrease during corrections. In a downtrend, volume should rise during declines and diminish during rallies.
A Trend Is Assumed to Be in Effect Until a Reversal Is Signaled
This tenet applies Newton’s law of inertia to markets, suggesting that a trend remains in place until there is clear evidence of reversal.
Identifying reversals is a challenge for analysts, but it often involves studying support and resistance levels, price patterns, and technical indicators.
3. Interpretation and Criticism
Lines in the Averages: Sideways trading ranges in market averages can signify consolidation phases, often referred to as "lines" or "rectangles" in modern chart analysis.
Criticism: Dow Theory has been criticized for being slow to identify trends, often missing 20-25% of the move before issuing a signal. However, Dow intended his theory to capture the significant middle portion of market moves, not the tops or bottoms.
Stock Market as an Economic Indicator: Dow Theory wasn’t initially intended to predict stock prices but to gauge the general direction of the economy. Even today, market averages are used as leading indicators of economic conditions.
4. Dow Theory Applied to Futures Markets
Differences from Stocks: In futures trading, minor trends are more important for timing trades than in stock markets, where investors typically follow major trends.
Relevance: The principles of Dow Theory can still be applied to commodity futures, though with adjustments to account for differences between stock and futures markets.
5. Conclusion
Dow Theory forms the basis for many concepts in technical analysis, such as trend classification, confirmation, volume analysis, and retracement levels.
While some critics find it slow to react to market moves, the theory has proven effective at identifying the core of major market trends over long periods.
These principles set the foundation for much of modern technical analysis, influencing everything from trendlines and chart patterns to volume and momentum indicators .
Chapter 3 "Chart Construction"
1. Introduction
The chapter introduces various chart types, with an emphasis on the daily bar chart.
These charts are the primary tools used in technical analysis for tracking market trends and forecasting future price movements.
2. Types of Charts Available
Daily Bar Chart:
Most commonly used: Each vertical bar represents one day’s price action, showing the high, low, open, and close.
The bar chart displays time on the horizontal axis and price on the vertical axis. A tic to the right of the vertical bar indicates the closing price, and a tic to the left represents the opening price.
Line Chart:
Only closing prices are plotted for each day, which some analysts prefer as it focuses on the most critical price of the day.
A line chart provides a simplified visual representation compared to bar charts.
Point and Figure Chart:
A compressed format compared to bar charts.
Alternating columns of 'X' and 'O' show price increases and decreases, respectively.
It allows easier identification of buy and sell signals.
Candlestick Chart:
A Japanese version of the bar chart, growing in popularity among Western traders.
The real body shows the price difference between the open and close. A black body indicates the close is lower than the open, while a white body indicates the close is higher.
Shadows represent the price range from high to low.
3. Arithmetic vs. Logarithmic Scale
Arithmetic Scale:
Equal distances on the price axis represent equal price changes.
Used for shorter-term analysis, where price unit changes are relatively small.
Logarithmic Scale:
More appropriate for long-range trend analysis, where percentage changes are of more interest.
Equal distances represent equal percentage changes, so larger price levels have smaller physical distances.
4. Construction of the Daily Bar Chart
Price and Time:
The vertical axis represents price, and the horizontal axis represents time. The trader marks each day’s high and low prices on the chart, with the closing price marked by a tic to the right of the bar.
The bar chart provides a detailed view of daily price movements, enabling traders to visualize the range of trading activity.
5. Volume
Volume represents the total trading activity in a market for a given day, displayed as a vertical bar at the bottom of the chart.
Heavier volume often confirms a price move, while lighter volume suggests a lack of conviction in the market’s direction.
Interpreting Volume:
Increasing volume during an upward price movement typically signals strength, while rising volume during a downward price move indicates weakness in the market.
6. Open Interest in Futures
Open Interest: The total number of futures contracts outstanding at the end of the trading day, reflecting the market’s commitment.
Open interest increases when more contracts are being entered into than closed.
This information is critical in futures markets and is plotted as a solid line at the bottom of the chart above the volume bars.
7. Weekly and Monthly Bar Charts
Weekly Bar Chart:
Each bar represents a week’s price range, enabling longer-term trend analysis, typically covering up to five years.
Monthly Bar Chart:
Each bar represents a month’s trading activity, compressing data further to observe trends over decades, up to 20 years.
These charts offer a longer-range perspective, which can often be lost when focusing solely on daily charts.
8. Conclusion
Chart construction is the foundation of technical analysis. Understanding how to plot price data using various chart types, including bar, line, and point-and-figure charts, is essential.
Alongside price, traders must also track volume and open interest, especially in futures markets, as these metrics offer insight into the strength or weakness of market trends.
This chapter serves as an introduction to charting techniques and prepares the reader for more advanced analytical tools in later chapters. It emphasizes that while charts themselves are simple, their interpretation requires skill and experience.
Chapter 4 Basic Concepts of Trend"
1. Definition of Trend
Trend refers to the general direction of the market, and it’s defined by the movement of peaks and troughs.
Uptrend: Characterized by higher highs (peaks) and higher lows (troughs).
Downtrend: Defined by lower lows and lower highs.
Sideways Trend: Known as a trendless market, where peaks and troughs are more horizontal in nature.
Market trends are rarely straight and usually manifest in zigzags, with periods of correction or consolidation within broader trends.
2. Support and Resistance
Support: A price level where buying pressure is strong enough to halt a price decline.
Identified by previous lows where the market "bounced back".
In an uptrend, each low should be higher than the previous one to maintain the trend.
Resistance: A price level where selling pressure is sufficient to stop a price advance.
Identified by previous highs where the market reversed direction.
In a downtrend, resistance levels form descending peaks.
Reversal of Roles: Once broken, support often becomes resistance and vice versa. This is a key concept in determining trend direction and reversals .
3. Trend Classifications
Major Trend: Lasts over six months to a year and represents the primary direction of the market.
Intermediate Trend: Lasts from three weeks to several months and often represents corrections within the major trend.
Near-term Trend: Covers shorter periods (less than three weeks) and represents minor market fluctuations.
These trends often exist simultaneously, with short-term trends occurring within larger intermediate and major trends .
4. Trendlines
Trendlines help identify the direction of a trend by connecting a series of reaction highs (resistance) in a downtrend or reaction lows (support) in an uptrend.
A valid trendline requires at least two points to draw, but it becomes more reliable after a third touch.
Trendlines act as support in an uptrend and resistance in a downtrend.
Breaking a trendline is often one of the first signals of a potential reversal .
5. Channels
A Channel is formed when price moves between two parallel lines: the trendline and the channel line.
Channels provide traders with additional insights about potential profit-taking zones or places to enter countertrend positions.
Upward Channels: Prices oscillate between the rising trendline (support) and the upper channel line (resistance).
Downward Channels: Prices fluctuate between the falling trendline and the lower channel line.
Channels are valuable as they offer measuring implications: once a breakout occurs from a channel, prices often move by a distance equal to the width of the channel .
6. Percentage Retracements
After a significant price move, markets often retrace a portion of the move. The most common retracement levels are:
33% (1/3)
50%
66% (2/3)
These levels are used by traders to identify potential entry points during corrections in an ongoing trend. A retracement between 33% and 50% is often seen as a buying or selling opportunity in the direction of the major trend .
7. The Fan Principle
After a trendline is broken, prices may rally back to the original trendline, now acting as resistance.
Successive trendlines (fan lines) are drawn, each steeper than the last. The breaking of the third trendline is considered a strong signal of a trend reversal .
8. Key Reversal Patterns
Reversal Days: A key reversal day signals a change in trend. In an uptrend, it occurs when prices open higher but close lower than the previous day. In a downtrend, it occurs when prices open lower but close higher.
Gaps:
Breakaway Gap: Signals the beginning of a new trend.
Runaway Gap: Appears in the middle of a trend, confirming the strength of the current direction.
Exhaustion Gap: Occurs near the end of a trend and signals a potential reversal .
9. Conclusion
Understanding trends, support, and resistance, and how to use trendlines and channels is essential for technical analysis.
The tools introduced here form the foundation of more advanced techniques in market analysis .
These basic principles of trend help traders identify the direction of the market and make informed decisions about when to enter or exit trades.
Chapter 5 "Major Reversal Patterns"
1. Introduction to Reversal Patterns
Reversal patterns signal that a major change in trend is occurring.
Reversals can happen at market tops and bottoms, indicating shifts from bullish to bearish (or vice versa).
Volume plays a critical role in confirming reversal patterns.
2. Common Reversal Patterns
Head and Shoulders Pattern:
Structure: The head and shoulders pattern is one of the most well-known reversal patterns.
It consists of three peaks: a higher middle peak (the "head") and two lower peaks (the "shoulders").
Confirmation: The pattern is confirmed when the neckline (the line connecting the troughs between the peaks) is broken.
Volume: A decrease in volume during the formation of the pattern, with an increase at the breakout, is a key confirmation.
Triple Tops and Bottoms:
Structure: Similar to the head and shoulders pattern, but all three peaks (in a top) or troughs (in a bottom) are at the same level.
Confirmation: The pattern completes when prices break through the support level (for tops) or resistance level (for bottoms).
Volume: Volume decreases at each successive peak or trough and rises on the breakout.
Double Tops and Bottoms:
Structure: Features two peaks (in a double top) or troughs (in a double bottom) at roughly the same level.
Volume: Like the triple pattern, volume tends to decrease during the formation and increases on the breakout.
Rounding (Saucer) Bottom:
Structure: A long-term reversal pattern that forms slowly and gradually as a rounded bottom.
Volume: Volume is typically low during the decline and rises as prices turn upward.
V (Spike) Tops and Bottoms:
Structure: Sudden and sharp reversals that occur with little warning.
Volume: A dramatic surge in volume accompanies these patterns, but they are hard to predict in advance.
3. General Characteristics of Reversal Patterns
Prerequisite of a Prior Trend:
A reversal pattern requires a well-established trend (either up or down) to be present.
Breaking Trendlines:
The first indication of a reversal often comes with the breaking of a major trendline. This break could signal either a reversal or a consolidation phase.
Larger Patterns Indicate Greater Potential Moves:
The bigger the pattern (both in height and width), the more significant the price movement after the breakout.
Tops vs. Bottoms:
Topping patterns are generally more volatile and quicker to form than bottoms.
Bottoming patterns take longer to develop but are less volatile.
Importance of Volume:
Volume should increase in the direction of the trend. It is more crucial during bottoming patterns than topping ones.
4. Measuring Implications
A common measuring technique involves calculating the height of the pattern (the distance between the peak and the trough) and projecting that distance from the breakout point.
This method provides a minimum target for price movement.
5. Key Considerations for Traders
Pattern Failures: Occasionally, a head and shoulders or other pattern may fail, where prices recross the neckline after a breakout, signaling a bad trade signal.
Anticipatory Trades: Aggressive traders often initiate positions during the formation of the pattern (e.g., the right shoulder of a head and shoulders), but caution is advised.
6. Conclusion
Reversal patterns, such as head and shoulders, double/triple tops and bottoms, and saucers, are essential tools in technical analysis.
The ability to recognize these patterns and confirm them using volume and other technical indicators allows traders to make informed decisions during major market transitions.
This chapter emphasizes the importance of understanding both the formation and confirmation of reversal patterns, which can help traders identify significant market reversals early and trade accordingly.
Chapter 6 "Continuation Patterns"
1. Introduction to Continuation Patterns
Continuation patterns indicate a pause in an existing trend, rather than a reversal. These patterns suggest that after a brief consolidation, the trend is likely to resume in the same direction.
Continuation patterns tend to be shorter in duration compared to reversal patterns.
2. Types of Continuation Patterns
Triangles:
Symmetrical Triangle:
Formed by two converging trendlines: one descending and one ascending.
Indicates that the market is in consolidation, and the breakout could be in the direction of the previous trend.
Volume tends to decrease during the formation of the triangle and increases on the breakout.
Ascending Triangle:
A flat upper trendline with a rising lower trendline, typically considered a bullish pattern.
Breakouts usually occur to the upside.
Descending Triangle:
The opposite of the ascending triangle, with a descending upper trendline and flat lower trendline.
This pattern is typically bearish, with the breakout often occurring to the downside.
Flags and Pennants:
Flags: Resemble a small rectangle sloping against the prevailing trend. They are short-term continuation patterns that indicate a brief pause in a strong trend.
Volume should decrease during the formation and increase upon the breakout.
Pennants: Similar to flags but shaped like a small symmetrical triangle. These also indicate brief consolidations before the trend resumes.
Both patterns are usually followed by sharp price moves, and they often occur at the midpoint of a price movement.
Rectangles:
Rectangles form when prices move sideways between two parallel horizontal lines, indicating a consolidation phase.
The breakout from a rectangle could go either way, though it usually follows the direction of the prior trend.
Volume plays a significant role in confirming whether the rectangle is a continuation or reversal pattern.
Wedges:
Rising Wedge: Slants upward and usually occurs in a downtrend, making it a bearish continuation pattern.
Falling Wedge: Slants downward and typically occurs in an uptrend, making it a bullish continuation pattern.
These patterns indicate a narrowing trading range before the breakout.
Measured Move:
A measured move consists of three phases:
The initial trend.
A correction, which retraces about one-third to one-half of the previous move.
A continuation of the initial trend, with the second leg being roughly equal in size to the first.
Continuation Head and Shoulders:
A variation of the head and shoulders pattern that can act as a continuation rather than a reversal. The pattern’s middle peak or trough is more pronounced, resembling a sideways rectangular pattern.
Like other continuation patterns, the breakout often resumes the previous trend.
3. Importance of Volume
Volume is a critical confirming factor for continuation patterns.
In bullish patterns, volume should increase during the breakout.
In bearish patterns, volume should increase during the breakdown.
The lack of volume confirmation can suggest that the breakout is weak and may fail.
4. Measuring Techniques
For most continuation patterns, the measuring technique involves projecting the height of the pattern (the distance between the highest and lowest points) from the breakout point to estimate the target price move.
5. Conclusion
Continuation patterns like triangles, flags, pennants, rectangles, and wedges provide valuable insights into trend pauses and potential price breakouts.
By recognizing and confirming these patterns with volume, traders can anticipate the resumption of the existing trend and position themselves accordingly.
These patterns are essential for traders looking to capitalize on market consolidations within a prevailing trend and to identify the likely continuation of the price direction after a brief pause .
Chapter 7: Volume and Open Interest
Key Concepts:
Volume and open interest are critical indicators in futures markets that help in analyzing market behavior, spotting trends, and confirming price movements.
Volume Analysis:
Volume refers to the number of contracts traded during a specific period (e.g., a day). It helps gauge the level of activity and interest in a market.
Increasing volume generally supports the direction of the current price trend. If prices are rising and volume increases, this typically indicates the trend is strong. Conversely, a decline in volume while prices rise could signal a potential reversal.
Volume analysis is commonly applied across all financial markets, including futures, stocks, and options.
Open Interest:
Open interest is the total number of outstanding contracts that have not been settled. It shows the liquidity and the level of market participation.
Increases in open interest suggest new participants are entering the market, which often indicates a continuation of the trend. Conversely, declining open interest can suggest a waning trend or market consolidation.
Volume and Open Interest Relationship:
Both volume and open interest are used together to confirm market trends. A new price trend that is accompanied by both increasing volume and open interest is considered more reliable.
A declining volume or open interest, particularly at the end of a trend, often signals a potential reversal.
Summary of Volume and Open Interest Rules:
Volume is a significant indicator across all markets, while open interest is more relevant in futures.
Rising volume and open interest typically confirm a price trend, while declining volume and open interest may suggest a trend reversal.
Sudden changes in volume often precede price changes, making it a leading indicator in some cases.
Put/Call Ratios:
Volume in options markets is split into call volume (bullish) and put volume (bearish).
The put/call ratio is a sentiment indicator used to assess market psychology. A high put/call ratio signals an oversold market (a potential buying opportunity), while a low ratio suggests an overbought market (a potential selling opportunity).
The ratio is typically used as a contrarian indicator: extreme values indicate that the majority sentiment may be wrong.
Blowoffs and Selling Climaxes:
A blowoff occurs at major market tops, where prices rally sharply on heavy volume and then peak suddenly.
A selling climax happens at market bottoms, where prices drop sharply on large volume but rebound quickly.
These events often signal the end of a trend and are usually accompanied by changes in open interest.
Commitments of Traders (COT) Report:
The COT Report, released bi-monthly by the Commodity Futures Trading Commission (CFTC), breaks down open interest by:
Large hedgers (commercials) – primarily involved in hedging.
Large speculators – typically rely on trend-following systems.
Small traders – the general public, often on the wrong side of market moves.
Hedgers are usually considered the “smart money,” and their positions are watched closely by traders to identify market turning points. For instance, if commercial traders are net long and speculators are net short, it may signal a market bottom.
Combining Option Sentiment with Technicals:
Open interest and volume figures for options, such as put/call ratios, are often used alongside traditional technical analysis methods like support, resistance, and trend lines to gauge market sentiment and potential reversals.
Conclusion:
Volume and open interest are crucial indicators used to confirm trends, spot reversals, and measure market participation across futures, stocks, and options markets.
While volume is applicable to all financial markets, open interest is particularly valuable in futures and options, providing insights into market sentiment and potential trend strength or reversals.
These notes encapsulate the major topics from Chapter 7, summarizing how volume and open interest function as core technical analysis tools in futures trading.
Chapter 8: The Moving Average
Key Concepts:
Moving averages are one of the most widely used tools in technical analysis. They help smooth out price action by filtering out the noise from random price fluctuations, making it easier to identify the direction of the trend.
Types of Moving Averages:
Simple Moving Average (SMA):
Calculated by summing the closing prices over a set number of periods and then dividing by the number of periods.
Each price has an equal weight in the calculation.
Common periods include 10, 20, 50, 100, and 200 days.
Exponential Moving Average (EMA):
Similar to the SMA, but with greater weight given to more recent prices.
More responsive to new information.
Useful in fast-moving markets where recent price changes are more relevant.
Applications of Moving Averages:
Trend Identification:
A rising moving average suggests an upward trend, while a declining moving average suggests a downward trend.
If prices are above the moving average, it indicates a bullish market, and if below, it indicates a bearish market.
Crossover Signals:
A bullish crossover occurs when a shorter-term moving average crosses above a longer-term moving average.
A bearish crossover happens when a shorter-term moving average crosses below a longer-term moving average.
These crossovers are key signals for traders to enter or exit trades.
Support and Resistance:
Moving averages can act as dynamic support or resistance levels. In an uptrend, the price may find support at the moving average, while in a downtrend, it may act as resistance.
Combining Moving Averages:
Traders often use combinations of moving averages (e.g., 50-day and 200-day) to confirm trends.
The Golden Cross: Occurs when a short-term moving average (e.g., 50-day) crosses above a long-term moving average (e.g., 200-day), signaling a bullish trend.
The Death Cross: Occurs when a short-term moving average crosses below a long-term moving average, signaling a bearish trend.
Adjusting Moving Average Periods:
Shorter moving averages (e.g., 10-day) are more sensitive and provide more signals, but they can also generate more false signals.
Longer moving averages (e.g., 200-day) provide fewer signals but are generally more reliable, reflecting longer-term trends.
Moving Averages and Oscillators:
Moving averages are often combined with oscillators like the Moving Average Convergence Divergence (MACD) to confirm trend strength and signal potential reversals.
The MACD uses two moving averages (a fast and a slow) to create a momentum oscillator. When the MACD line crosses above its signal line, it generates a buy signal, and when it crosses below, it generates a sell signal.
Moving Average Envelopes and Bands:
Moving average envelopes are plotted a fixed percentage above and below a moving average to form bands that help measure volatility.
Bollinger Bands use a standard deviation to plot bands above and below a moving average, adjusting dynamically based on price volatility.
Key Considerations:
Lagging Nature:
Moving averages are lagging indicators, which means they react to price changes after they have occurred. They are better at confirming trends than predicting them.
Market Suitability:
Moving averages are most effective in trending markets and less useful in sideways markets, where they can generate false signals.
Conclusion:
Moving averages are versatile tools for identifying trends, signaling entry and exit points, and providing dynamic support and resistance. Combining them with other technical indicators can improve their effectiveness in both trending and volatile markets.
These notes summarize the primary concepts of moving averages from Chapter 8, focusing on their types, applications, and limitations within technical analysis.
Chapter 9: Moving Averages
Introduction to Moving Averages:
Moving averages are one of the most versatile and widely used technical indicators. They help smooth out price action to reveal the underlying trend.
Moving averages are used in trend-following systems and can generate specific buy and sell signals.
They do not predict market movements but follow the market, signaling trends only after they have begun.
Types of Moving Averages:
Simple Moving Average (SMA):
Averages the closing prices over a set period, giving equal weight to each period.
It is the most commonly used moving average but is criticized for not giving more weight to recent prices.
Linearly Weighted Moving Average:
Weights more recent prices more heavily, which addresses the issue of giving equal weight to older prices.
Exponentially Smoothed Moving Average (EMA):
This type assigns more weight to recent data but also includes all price data from the past.
EMAs are useful in reducing the lag present in simple moving averages by reacting more quickly to price changes.
Application of Moving Averages:
Single Moving Average Method:
Signals are generated when prices cross above or below the moving average.
For example, a buy signal occurs when the price crosses above the moving average, and a sell signal is triggered when it falls below.
Double Crossover Method:
Involves using two moving averages, such as a 5-day and a 20-day moving average.
A buy signal occurs when the shorter average (5-day) crosses above the longer average (20-day), and a sell signal is generated when the shorter average falls below the longer one.
Triple Crossover Method:
Uses three moving averages, such as the 4-day, 9-day, and 18-day moving averages.
A buying alert occurs when the shortest average (4-day) crosses above the 9-day and 18-day averages. The buy signal is confirmed when the 9-day crosses above the 18-day average.
Conversely, a sell signal is generated when the 4-day average crosses below the other two moving averages.
Bollinger Bands:
Bollinger Bands are a type of volatility band plotted at standard deviations above and below a moving average.
When prices touch the outer bands, it signals potential extremes in price movements. Prices moving between the upper band and the 20-day average in an uptrend indicate a strong trend.
Pros and Cons of Moving Averages:
Advantages:
Moving averages force traders to follow trends, helping them stay with a trend as long as it persists.
They help traders avoid premature exits by cutting losses short and letting profits run.
Disadvantages:
Moving averages are lagging indicators, which means they perform poorly in choppy, non-trending markets.
The system may generate several false signals in sideways markets, leading to "whipsaws."
Moving Averages and Cycles:
Moving averages can be adjusted to match dominant market cycles. For example, a 20-day moving average corresponds to the monthly cycle (20-21 trading days in a month).
Common combinations like the 5, 10, 20, and 40-day moving averages are related to the monthly cycle and its harmonics.
Adaptive Moving Average (AMA):
Developed by Perry Kaufman, this technique adjusts the speed of the moving average based on market conditions.
The Efficiency Ratio compares price direction to volatility. In a trending market, the AMA moves quickly, but in a sideways market, it slows down to avoid whipsaws.
Conclusion:
Moving averages are essential in technical analysis for trend-following, but they are not foolproof and must be applied with an understanding of their limitations.
In trending markets, moving averages work exceptionally well, while in sideways markets, alternative techniques like oscillators (discussed in Chapter 10) may be more effective.
These notes encapsulate the core concepts of Chapter 9, focusing on different types of moving averages, their application, and their strengths and weaknesses .
Chapter 10: Oscillators and Contrary Opinion
Introduction to Oscillators:
Oscillators are valuable tools in technical analysis, particularly during non-trending (sideways) markets. They help traders profit in environments where trend-following systems struggle by identifying overbought or oversold conditions.
Oscillators can also be used in trending markets to highlight potential market extremes or trend reversals.
Oscillator Basics:
Oscillators fluctuate within a bounded range and are plotted beneath the price chart, coinciding with market peaks and troughs.
Some oscillators have a midpoint (often zero) that separates the upper and lower halves of their range. Values close to these extremes signal overbought (upper) or oversold (lower) conditions.
General Rules for Oscillators:
Overbought and Oversold Levels:
When an oscillator reaches an extreme value near the upper boundary, the market is considered overbought and vulnerable to a correction.
Conversely, if the oscillator is near the lower boundary, the market is oversold, signaling potential upside.
Divergences:
A divergence occurs when the price action and the oscillator move in opposite directions at an extreme level. This is a strong warning that a trend may soon reverse.
Zero Line Crossings:
The oscillator’s crossing of the midpoint line is another important signal. A move above the zero line in an uptrend is a buy signal, while a move below in a downtrend signals a sell.
Types of Oscillators:
Relative Strength Index (RSI):
Developed by J. Welles Wilder, the RSI is one of the most popular momentum oscillators. It fluctuates between 0 and 100 and helps identify overbought and oversold conditions.
A reading above 70 is generally considered overbought, and a reading below 30 indicates an oversold market.
Divergences between RSI and price action are strong reversal signals.
Stochastics:
The Stochastic Oscillator compares a security's closing price to its price range over a specified period.
It generates buy and sell signals when the %K line crosses the %D line at extreme levels (above 80 for overbought and below 20 for oversold conditions).
Moving Average Convergence Divergence (MACD):
The MACD uses two moving averages of different lengths to identify momentum changes.
Signals are generated when the MACD line crosses the signal line, and divergences between the MACD and price can indicate trend reversals.
The MACD Histogram helps identify when a trend may be losing strength.
Commodity Channel Index (CCI):
Developed by Donald Lambert, the CCI measures the variation of a security’s price from its average price.
Values above +100 indicate an overbought condition, and values below -100 signal oversold conditions. It’s often used in commodity and index trading.
Momentum and Rate of Change (ROC):
Momentum measures the rate of price changes over a set period by subtracting a past price from the current price.
ROC is a similar concept but expressed as a percentage. Both indicators highlight the speed and direction of price changes, helping identify overbought and oversold conditions.
Oscillators in Conjunction with Trends:
Oscillators work best when used in conjunction with trend analysis. They should not be relied upon solely, especially at the beginning of major trends.
During the early stages of a breakout, oscillators may reach extreme levels quickly and should be subordinated to basic trend-following analysis.
In mature trends, oscillators gain importance as they help identify potential exhaustion points.
Contrary Opinion:
The principle of Contrary Opinion posits that the majority of traders are often wrong at key turning points. This means that extreme sentiment, whether bullish or bearish, can be a signal to take the opposite position.
Tools like the Bullish Consensus Index track market sentiment by polling traders. Readings above 75% suggest an overbought market (likely a top), and readings below 25% suggest an oversold market (likely a bottom).
Conclusion:
Oscillators are powerful tools for identifying market extremes and potential reversals, but they should always be used in conjunction with broader trend analysis.
Relying too heavily on oscillators can lead to premature trades, particularly in trending markets. When used with tools like moving averages and contrary opinion, oscillators can significantly improve trading decisions.
These notes summarize the key points from Chapter 10, covering oscillators, their practical applications, and their role in contrary opinion analysis.
Chapter 11: Point and Figure Charting
Introduction to Point and Figure Charting:
Point and Figure (P&F) Charting is one of the oldest charting techniques, tracing back to the late 19th century.
Unlike bar or candlestick charts, which include time and price, P&F charts focus solely on price movement and ignore time.
They consist of columns of Xs and Os:
X columns represent rising prices.
O columns represent falling prices.
Key Characteristics of Point and Figure Charts:
No Time Element: Price changes are recorded, but time is ignored. If there is no price movement, nothing is plotted.
Reversal Criteria: The key concept is the reversal. A move in the opposite direction requires a minimum number of boxes (e.g., 3 boxes), representing a reversal threshold.
No Volume Data: Unlike bar charts, point and figure charts do not include volume. However, the number of price changes itself can reflect market activity indirectly.
Basic Construction of a Point and Figure Chart:
Box Size: Each box represents a specific price movement (e.g., $1 per box).
Reversal Criteria: A minimum number of boxes (e.g., 3) is required for a column of Xs to reverse into a column of Os, or vice versa.
Plotting:
If the price rises by at least the box size, Xs are plotted.
If the price falls by at least the box size, Os are plotted.
No new column is formed unless the reversal criteria are met.
Advantages of Point and Figure Charts:
Clarity of Trends: P&F charts filter out insignificant price movements, making trends clearer and helping to avoid "market noise."
Ease of Use: They make it easy to identify buy and sell signals through specific patterns like breakouts.
Flexibility: The box size and reversal size can be adjusted to suit different time frames and volatility conditions.
Types of Point and Figure Charts:
1-Box Reversal Chart: Shows every single price movement above the box size. Often used for very short-term trading.
3-Box Reversal Chart: Commonly used for intermediate trend analysis.
5-Box Reversal Chart: Best suited for identifying long-term trends as it condenses data more significantly.
Trendlines in Point and Figure Charts:
45-Degree Lines: Unlike traditional trendlines, P&F charts use 45-degree lines:
An uptrend line is drawn at a 45-degree angle upward from the bottom of a column of Os.
A downtrend line is drawn at a 45-degree angle downward from the top of a column of Xs.
Measuring Techniques:
Horizontal Count (Price Targeting):
Used to calculate price targets based on the width of a consolidation or base.
The greater the width (i.e., number of columns), the greater the projected move.
Vertical Count:
The height of the first column in a new trend is multiplied by the reversal number to estimate the potential price move.
Common Patterns in Point and Figure Charts:
Double Top and Bottom:
A double top forms when an X column breaks above a previous column of Xs, signaling a buy.
A double bottom occurs when an O column breaks below a previous O column, signaling a sell.
Triangles:
A consolidation pattern that suggests accumulation or distribution before a breakout.
Bullish triangles point toward an upward breakout, while bearish triangles signal a potential downward breakout.
Breakouts:
A buy signal is generated when an X column rises above a previous X column, while a sell signal occurs when an O column falls below a previous O column.
Logarithmic Point and Figure Charting:
A more advanced method that uses percentage-based box sizes instead of fixed values.
Helpful for markets where percentage changes are more relevant than absolute price movements, such as for stocks with wide price ranges.
Conclusion:
Point and figure charting provides a simple yet effective method for analyzing pure price movement, identifying key support and resistance levels, and measuring potential price objectives.
It is especially useful in determining long-term trends and eliminating market noise, offering a clear perspective on market direction without the influence of time or volume.
These study notes cover the essentials of Chapter 11, focusing on the mechanics, patterns, and applications of Point and Figure Charting.
Chapter 12: Japanese Candlesticks
Introduction to Japanese Candlestick Charting:
Japanese candlestick charting is an ancient technique developed in Japan centuries ago, but only recently adopted in Western markets.
Candlestick charts provide the same information as traditional bar charts, but they are more visually appealing and easier to interpret.
Candlestick charts display the open, high, low, and close prices for a specific period, with the body of the candlestick representing the difference between the open and close prices.
Basic Candlestick Structure:
The body of the candlestick shows the price range between the opening and closing prices.
A white (empty) body indicates that the close is higher than the open (bullish).
A black (filled) body indicates that the close is lower than the open (bearish).
Shadows (wicks) above and below the body represent the highest and lowest prices during the period.
The upper shadow represents the high of the day, and the lower shadow represents the low.
Basic Candlestick Patterns:
Long Days and Short Days:
Long days have a significant difference between the open and close prices, showing strong market activity.
Short days have a small body, indicating indecision or little price movement.
Spinning Tops:
Candlesticks with small bodies and long shadows, indicating indecision between buyers and sellers.
Doji Candlesticks:
Doji occur when the open and close prices are virtually the same, indicating market indecision.
Types of Doji include:
Gravestone Doji: Bearish reversal signal with a long upper shadow.
Dragonfly Doji: Bullish reversal signal with a long lower shadow.
Long-legged Doji: Indicates significant indecision with long upper and lower shadows.
Popular Reversal Candlestick Patterns:
Dark Cloud Cover:
A bearish reversal pattern occurring in an uptrend.
The first day is a long white candlestick, followed by a black candlestick that opens above the previous high but closes below the midpoint of the white body.
Piercing Line:
A bullish counterpart to the Dark Cloud Cover.
It consists of a long black candlestick followed by a white candlestick that opens below the previous low but closes above the midpoint of the black body.
Evening Star and Morning Star:
Evening Star: A bearish reversal pattern with a long white candlestick, followed by a small real body (the "star"), and a long black candlestick that closes below the midpoint of the first candlestick.
Morning Star: A bullish reversal pattern with a long black candlestick, a star, and a white candlestick that closes above the midpoint of the first candlestick.
Continuation Candlestick Patterns:
Continuation patterns help confirm that the current trend is likely to continue:
Rising Three Methods: A bullish continuation pattern where three short black candlesticks are followed by a long white candlestick in an uptrend.
Falling Three Methods: A bearish continuation pattern in a downtrend.
Using Candlestick Patterns with Technical Indicators:
Candlestick patterns are often combined with technical indicators such as moving averages or oscillators to increase their predictive power.
For example, using candlestick patterns alongside stochastics or RSI can help filter out weak signals.
Conclusion:
Japanese candlestick patterns offer a unique and insightful way to visualize market psychology and anticipate reversals and continuations.
Candlestick analysis should be used in conjunction with other technical tools to identify the overall trend and market sentiment, enhancing the ability to make informed trading decisions.
These notes provide a comprehensive overview of Chapter 12, focusing on the basics of candlestick charting, key reversal and continuation patterns, and how they can be applied to market analysis .
Chapter 13: Elliott Wave Theory
Introduction to Elliott Wave Theory:
The Elliott Wave Theory was developed by Ralph Nelson Elliott in the 1930s. It is based on the idea that financial markets move in predictable cycles, which are the result of investor psychology.
Elliott believed that markets follow a repetitive rhythm of five-wave advances followed by three-wave declines during a complete bull market cycle.
Basic Tenets of the Elliott Wave Theory:
Five-Wave Advance:
The basic structure of a market advance consists of five waves in the direction of the main trend.
Waves 1, 3, and 5 are called impulse waves because they move in the direction of the primary trend.
Waves 2 and 4 are corrective waves, moving against the main trend.
Three-Wave Decline:
After the five-wave advance, a market correction typically occurs in a three-wave pattern labeled A-B-C.
Wave A and Wave C move in the direction of the correction, while Wave B is a temporary reversal.
Key Aspects of Elliott Wave Theory:
Wave Degrees:
Elliott classified market cycles into nine degrees of trend, ranging from long-term supercycles to short-term patterns that can last only a few hours.
Regardless of the time frame, the five-wave advance and three-wave correction remain constant.
Subwaves and Fractals:
Each wave in an Elliott Wave structure can be subdivided into smaller waves of lesser degree.
These smaller waves exhibit the same 5-3 pattern, making the structure fractally consistent across different time scales.
Corrective Waves:
Corrections, which counter the prevailing trend, occur in three main forms: zig-zags, flats, and triangles.
Zig-zags are sharp corrections, consisting of a 5-3-5 structure.
Flats are sideways corrections, usually in a 3-3-5 format.
Triangles are consolidations that precede the final movement of a trend and contain five waves.
Fibonacci Numbers:
Elliott believed that market waves followed Fibonacci sequences, which are a mathematical basis for understanding price movements.
Common Fibonacci retracement levels used to determine price targets include 38%, 50%, and 62%.
Impulse Waves and Extensions:
Occasionally, one of the impulse waves (usually Wave 3) is extended, meaning it is significantly longer than Waves 1 and 5.
When one wave extends, the other two impulse waves tend to be of similar length and duration.
Alternation:
Elliott's rule of alternation states that if Wave 2 is a sharp correction, Wave 4 will likely be a flat or complex correction, and vice versa.
Fibonacci Ratios and Retracements:
Fibonacci ratios play a critical role in predicting the length of waves:
Wave 3 often extends 1.618 times the length of Wave 1.
Wave 5 may extend by 1.618 times the length of Wave 1, or it could equal the length of Wave 1 or Wave 3.
Corrective waves (A-B-C) typically retrace a Fibonacci portion of the previous five-wave advance, with common retracement levels at 38%, 50%, and 62%.
Price Channels and Targets:
Elliott Wave analysis uses price channels to predict price movements. A channel is created by connecting the extremes of Waves 1 and 2, and projecting a parallel line through the peak of Wave 3 to define the boundaries of the trend.
Price targets can also be calculated by measuring the height of corrective patterns like triangles and projecting that distance from the breakout point.
Application of Elliott Wave Theory:
Stock Market:
Elliott originally applied his theory to stock market averages, particularly the Dow Jones Industrial Average.
The theory works best on stock indices and large, widely traded markets because it relies on collective investor psychology.
Commodities:
The rules are slightly different for commodities. For example, Wave 5 tends to be stronger and extended in commodities markets.
Commodities markets also experience "contained" bull markets, where a completed five-wave move may not exceed previous highs.
Using Elliott Wave with Other Tools:
Elliott Wave Theory is most effective when combined with other technical analysis tools, such as Fibonacci retracements, moving averages, and oscillators.
Traders should avoid relying solely on Elliott Wave counts, as wave patterns are not always clear, and subjective interpretation can lead to errors.
Conclusion:
Elliott Wave Theory provides a structured framework for understanding market movements through recurring patterns of five-wave advances and three-wave corrections.
It combines price patterns, Fibonacci ratios, and market psychology to forecast future price trends.
However, Elliott Wave analysis should be used alongside other tools and techniques to improve accuracy and reliability.
These notes summarize the core elements of Chapter 13, emphasizing the principles of Elliott Wave Theory, corrective patterns, and how to apply the theory in both stock and commodity markets .
Chapter 14: Time Cycles
Introduction to Time Cycles:
Time cycles are an important but often overlooked aspect of technical analysis. While price movement is widely analyzed, time plays a critical role in market trends.
Cyclic analysts believe that time cycles are a determining factor in bull and bear markets, and incorporating time cycles can improve the effectiveness of other technical tools like trendlines and moving averages.
Key Cyclic Principles:
Principle of Summation:
Price movements are seen as the sum of several underlying cycles. If the individual cycles can be isolated, it is possible to predict future price movements by summing their effects.
Principle of Harmonicity:
Neighboring cycles are usually related by small whole numbers, typically a ratio of 2. For instance, a 20-day cycle may have shorter related cycles of 10 and 5 days.
Principle of Synchronicity:
Cycles of different lengths often bottom around the same time, especially in related markets. This alignment of cycles is useful for forecasting market turns.
Principle of Proportionality:
Cycles with longer periods tend to have larger amplitudes (the height of the wave). This means that the price swings in longer cycles will be larger than those in shorter cycles.
Types of Cycles:
Long-Term Cycles:
These span two or more years and have a significant influence on market direction. For instance, the Kondratieff Wave is a 54-year cycle that affects long-term economic trends.
Seasonal Cycles:
These are one-year cycles that repeat annually, such as agricultural market cycles that peak or trough around harvest times. Commodities like grains, oil, and copper exhibit strong seasonal patterns.
Intermediate or Primary Cycles:
These cycles last between 9 to 26 weeks and often correspond with intermediate trends. The primary cycle is crucial for determining which side of the market to trade.
Trading Cycle:
The 4-week trading cycle can be broken down into two shorter alpha and beta cycles, each lasting around two weeks. These cycles help with the timing of entries and exits in the market.
The 28-Day Trading Cycle:
Many commodity markets are influenced by a 28-day cycle which may be related to the lunar cycle. This cycle is most apparent in short-term trends, and traders often use 5, 10, and 20-day moving averages to track its effects.
Richard Donchian's 4-Week Rule is based on this 28-day cycle. Buy signals are generated when prices exceed the previous 4-week high, while sell signals occur when prices break below the 4-week low.
Left and Right Translation:
Translation refers to the shifting of cycle peaks to the left or right of the cycle’s midpoint:
Right translation (bullish): Peaks occur after the midpoint of the cycle, indicating that prices spend more time rising than falling.
Left translation (bearish): Peaks occur before the midpoint, meaning prices decline more than they rise.
Translation helps traders assess the strength of the underlying trend. Right-translated cycles indicate an uptrend, while left-translated cycles point to a downtrend.
Seasonal Cycles in Commodities:
Agricultural commodities like grains exhibit strong seasonal patterns, with seasonal lows often occurring around harvest time.
Other markets such as copper, silver, and oil also follow seasonal trends. For example:
Soybeans tend to peak in May and bottom in October.
Copper often bottoms in February and peaks between March and May.
Combining Time Cycles with Other Technical Tools:
Moving Averages and Oscillators can be more effective if their time spans are tied to the market's dominant cycles. For example, a 20-day cycle would suggest using a 10-day oscillator to track short-term swings.
Walt Bressert’s Work: Cycles are integrated with technical indicators like the Relative Strength Index (RSI) and Commodity Channel Index (CCI) to refine their effectiveness in timing market entries and exits.
Kondratieff Wave:
The Kondratieff Cycle is a 54-year long economic cycle that affects major trends in commodity prices, stock markets, and interest rates. It has been studied across various markets and is considered a key long-term cycle.
Conclusion:
Understanding time cycles can greatly enhance market forecasting and the precision of technical tools.
Long-term cycles provide a broad view of market direction, while shorter cycles assist in timing trades. The key is to align analysis with the dominant cycle to improve accuracy in predicting market tops and bottoms.
These notes summarize the key concepts and tools discussed in Chapter 14, emphasizing the role of time cycles in market analysis and their integration with other technical indicators .
Chapter 15: Computers and Trading Systems
Introduction to Computers in Technical Analysis:
The rise of computers has significantly simplified the task of technical analysis by providing easy access to complex studies and indicators that would have been labor-intensive just a few decades ago.
While computers enhance efficiency, a deep understanding of the tools they offer is necessary for successful trading. Computers alone will not make a poor trader into a successful one.
Charting Software:
Charting software provides various technical tools that allow traders to automate technical studies, backtest strategies, and even create their own indicators and systems without needing advanced programming knowledge.
Traders can test strategies for profitability and run simulations to assess how a system might have performed in different market environments.
Key Technical Systems:
Welles Wilder's Systems:
Directional Movement Index (DMI) and Parabolic SAR are two of the most popular trend-following systems developed by Wilder.
Directional Movement System (DMI):
Uses two lines, +DI and -DI, to measure the strength of upward and downward movements. A crossover between these lines generates buy and sell signals.
Parabolic System (SAR):
The SAR stands for Stop and Reverse, which always keeps a position open. Once a stop is hit, the system reverses the trade direction. It performs best in trending markets, but struggles in ranging markets.
Pros and Cons of Mechanical Systems:
Advantages:
Removes emotions from trading, ensuring consistency and discipline.
Trades are taken in line with the prevailing trend, and losses are minimized while profits are allowed to run.
The system ensures participation in every important trend.
Disadvantages:
Most mechanical systems rely on trends to be profitable, and they tend to generate poor results in sideways markets.
Mechanical systems cannot detect major market reversals and are not flexible enough to account for market nuances like oscillators or divergences.
System Trading and Trend Identification:
A critical component of mechanical system trading is determining whether the market is trending or in a range. Wilder's Average Directional Index (ADX) is useful for this:
A rising ADX line indicates a trending market.
A falling ADX suggests a non-trending environment where oscillators are more effective.
Automating System Signals:
Modern trading platforms allow traders to automate signals generated by their systems, alerting them when certain conditions are met. This feature is especially valuable for traders who monitor multiple markets or securities simultaneously.
System signals can also serve as an excellent screening device, providing traders with a quick way to identify potential trades without having to manually analyze numerous charts.
Customization and Flexibility:
Most charting and system software allow users to modify existing indicators or create new ones. Software like Omega Research's TradeStation provides a language called EasyLanguage, enabling traders to write and customize their systems without needing advanced programming skills.
Testing different strategies, optimizing parameters, and backtesting are essential to ensure a system’s robustness before applying it in live trading.
Conclusion:
Computers have revolutionized trading by offering powerful tools for technical analysis, system testing, and automation.
While computers can make a competent trader more efficient, they cannot replace the need for sound judgment and a well-thought-out strategy.
Trend-following systems like the Directional Movement Index and Parabolic SAR are effective in trending markets but need to be supplemented with other tools during non-trending conditions.
These study notes summarize the use of computers in trading, Welles Wilder’s popular systems, and the benefits and limitations of mechanical systems as discussed in Chapter 15.
Chapter 16: Money Management and Trading Tactics
Introduction:
This chapter highlights the three critical elements of successful trading:
Price Forecasting: Identifies market direction (covered in previous chapters).
Timing: Determines entry and exit points, crucial in futures trading due to high leverage and low margin.
Money Management: Covers fund allocation, risk management, and position sizing, ensuring survival in the long run.
Money Management Guidelines:
Capital Allocation:
No more than 50% of total capital should be invested, with the rest in reserve (e.g., in Treasury bills).
Commitment in a single market should be 10-15% of total equity, ensuring diversification.
Risk per trade should be limited to 5% of total equity, allowing for manageable losses.
Diversification:
Important but shouldn't be overdone. Over-diversifying across too many markets can dilute profits.
It's essential to avoid placing large positions in correlated markets, e.g., multiple foreign currencies moving similarly against the U.S. dollar.
Using Protective Stops:
Protective stops are crucial for limiting losses but need careful placement.
Stops placed too close to entry might result in premature exits due to market noise. Stops too far risk larger losses.
Reward-to-Risk Ratios:
Successful traders often lose more trades than they win, but the key to profitability is maintaining a favorable reward-to-risk ratio.
The 3:1 reward-to-risk ratio is a standard guideline. The potential profit should be at least three times the possible loss for any trade to be considered.
Trading Tactics:
Breakouts:
Traders can anticipate a breakout, act during the breakout, or wait for a pullback afterward.
Each approach has its risks and rewards. Multiple positions can mitigate risk by dividing them across these strategies.
Trendline Breaks:
Breaking of a trendline serves as an important entry or exit signal. Trendlines can also be used as support or resistance points for entry positions.
Support and Resistance:
Support and resistance levels provide excellent entry and exit points.
Stops can be placed just below support in an uptrend or above resistance in a downtrend.
Percentage Retracements:
Retracements of 40-60% of prior moves provide excellent buying or selling opportunities. For example, a pullback in an uptrend might offer a good buying point at a 40% retracement.
Gaps:
Gaps serve as support in uptrends and resistance in downtrends. Traders can use gaps for entries and place stops just beyond them.
Handling Success and Adversity:
After a winning streak, resist the temptation to increase trade size aggressively. Increasing commitments after a losing streak might provide better timing.
Equity charts for a trader are like market price charts with peaks and troughs. Increasing trade size during a dip in equity can ensure better returns when the market turns around.
Summary of Key Guidelines:
Trade in the direction of the trend: Buy dips in uptrends, sell rallies in downtrends.
Cut losses short, let profits run.
Use stops to limit losses.
Diversify, but don’t overdo it.
Apply at least a 3:1 reward-to-risk ratio on trades.
Add to winning positions (pyramiding) but never add to a losing one.
Use intraday charts for fine-tuning entries and exits.
Be comfortable being in the minority when trading.
Application to Stocks:
While these tactics are applicable to futures trading, they can be adjusted slightly for the stock market, which focuses more on intermediate to long-term trends and uses less intraday analysis.
Conclusion:
Proper money management and trading tactics are as critical as price forecasting. A combination of sound risk management, disciplined trading, and strategic timing ensures survival and success in the financial markets.
These notes encapsulate the major points of Chapter 16, emphasizing the importance of risk management and strategic trading in volatile futures markets .
Chapter 17 of intermarket analysis,
a method that examines the relationships between different financial markets such as stocks, bonds, commodities, and currencies. Here's a breakdown of key points from the chapter:
1. Introduction to Intermarket Analysis
Intermarket analysis helps understand how various markets influence each other.
It looks at the ripple effect across asset classes: changes in the U.S. dollar can impact commodities, which in turn affect bonds and stocks.
Analyzing intermarket trends provides insights into economic conditions and potential market movements .
2. Key Market Relationships
Bonds and Stocks: Stock markets often react to changes in interest rates, which are reflected in bond prices. Rising bond prices (falling yields) tend to be positive for stocks, while falling bond prices (rising yields) are negative .
Bonds and Commodities: Commodities like gold and oil are influenced by inflation expectations. When commodity prices rise (inflationary pressure), bond prices tend to fall. Conversely, falling commodity prices usually lead to higher bond prices .
Commodities and the U.S. Dollar: The U.S. dollar’s strength or weakness affects commodity prices. A strong dollar usually depresses commodity prices because commodities are dollar-denominated, making them more expensive globally .
3. Sector and Industry Analysis
By understanding intermarket relationships, traders can identify which sectors and industries will perform better under certain conditions. For example:
When bond prices are strong and commodities are weak, interest rate-sensitive stocks such as utilities and financials tend to perform well.
Conversely, when commodities are strong, inflation-sensitive sectors like energy and gold mining stocks outperform .
Sector rotation within the stock market can also be observed through intermarket analysis .
4. Application to Mutual Funds
Intermarket analysis is useful in choosing mutual funds, particularly sector-oriented funds. Understanding how different markets interact can help in selecting the right sectors to invest in at the right time.
Relative strength analysis is a simple method to compare the performance of different market sectors and asset classes .
5. The Role of Neural Networks
Neural network technology has been introduced to intermarket analysis to track and identify complex relationships between markets.
VantagePoint software, developed by Louis Mendelsohn, is one example that uses neural networks to trade interest rates, stock indexes, and commodities .
This chapter highlights how a comprehensive approach, incorporating multiple markets, enhances trading decisions and economic forecasting. Intermarket analysis helps traders to predict market trends and sector performance by understanding the correlations between asset classes.
Chapter 18 Stock Market Indicators,
with a primary focus on how to measure market breadth and use various indicators to assess the overall health of the stock market. Below are the detailed study notes:
1. Measuring Market Breadth
Market breadth refers to how many stocks are participating in a market trend, which helps gauge the strength or weakness of the market.
Key market breadth indicators include the Advance-Decline Line, new highs-new lows, and upside-downside volume.
2. Advance-Decline Line
The Advance-Decline (A-D) Line is the most widely used breadth indicator. It’s constructed by subtracting the number of declining stocks from advancing ones on the New York Stock Exchange (NYSE) each day.
A cumulative total is maintained, and the A-D Line is plotted alongside market indexes like the Dow Industrials. In a healthy market, both the A-D Line and market averages should be trending in the same direction (Figure 18.1)【12:0†source】.
The positive or negative values are added to the cumulative A-D Line to create the chart. It’s a simple, yet powerful, tool for confirmation or divergence analysis.
3. New Highs-New Lows Indicator
This indicator tracks the number of stocks making new highs and new lows. It’s a reliable indicator of market trends.
The relationship between new highs and new lows helps in confirming bullish or bearish market conditions.
A divergence between the number of new highs and a rising stock market index suggests weakness. Conversely, an increasing number of new highs compared to new lows points to a robust upward trend.
4. Upside-Downside Volume
Upside volume represents the volume of shares traded in advancing stocks, while downside volume measures those traded in declining stocks.
By comparing upside to downside volume, traders can assess the strength of a trend. High upside volume during rallies is a sign of a strong market, while significant downside volume during declines signals strong bearish sentiment.
5. Breadth Thrust
This term refers to an explosive move in market breadth within a short period, often indicating the start of a new market trend.
A breadth thrust often precedes a major market rally, signifying that a broad number of stocks are participating in the upward movement.
6. Confirmation and Divergence
Confirmation occurs when both stock market indexes and market breadth indicators are moving in the same direction, indicating a strong trend.
Divergence occurs when stock indexes and breadth indicators show opposing trends. For example, a market index may be making new highs, but if the A-D Line is not, it signals a weakening market.
The Dow Theory is also based on confirmation between different market averages like the Dow Industrials and Dow Transports【12:2†source】.
7. Conclusion
A study of market breadth and related indicators provides traders with crucial insight into the underlying strength or weakness of the stock market.
In general, the greater the number of stock market averages and breadth indicators trending in the same direction, the higher the probability of that trend continuing.
These tools and concepts are essential for evaluating the overall stock market's health and predicting potential market movements through breadth analysis.
Chapter 19 of "Technical Analysis of the Futures Markets" by John J. Murphy focuses on providing a Technical Checklist for market analysis, combining different aspects of technical tools to create a thorough market evaluation.
Here are detailed study notes:
1. Importance of a Technical Checklist
Market analysis requires multiple layers of information to detect the direction and strength of a trend.
Traders are encouraged to systematically go through this checklist to touch all the critical bases before making any trading decisions.
2. Key Components of the Checklist
Overall Market Direction: Assess whether the general market trend is up, down, or sideways.
Sector Trends: Understanding how different market sectors (e.g., technology, energy, etc.) are performing can provide valuable insight into market momentum.
Charts: Utilize weekly and monthly charts to understand long-term trends in addition to daily charts.
Trend Analysis: Determine whether the major, intermediate, and minor trends are aligned.
Support and Resistance Levels: Identify crucial price levels where the market might encounter difficulty moving higher (resistance) or lower (support).
Trendlines and Channels: Trendlines help identify support and resistance zones, while channels represent the potential path of price movement.
Volume and Open Interest: Ensure that volume trends are confirming the price direction. High volume during upward movements supports the price action, while a decrease during a rise signals weakness.
Retracement Levels: Retracement percentages (33%, 50%, and 66%) are important for spotting areas where a trend might reverse or continue.
3. Advanced Trading Tactics
Traders must consider money management principles and not rely solely on technical indicators for decision-making.
Diversification is crucial but should not be excessive. Each added position should contribute positively to the portfolio.
Adopting a reward-to-risk ratio of at least 3:1 can help traders optimize their success over the long term.
Pyramiding: This technique involves adding to winning positions but requires strict adherence to the rule that each additional position should be smaller than the previous one.
Protective Stops: Adjust protective stops to breakeven levels once a trade moves in the trader’s favor.
4. Avoiding Emotional Trading
Trading should be systematic and planned out beforehand to avoid impulsive decisions.
Major decisions should be made outside of market hours when emotions are less likely to affect judgments.
5. Summary
The Technical Checklist is not an exhaustive list but includes the primary factors necessary for sound market analysis.
Traders should use the checklist to increase the chances of identifying the right market direction and entry/exit points.
Experience helps traders know when to emphasize specific tools from the checklist based on current market conditions.
This chapter emphasizes the comprehensive and methodical approach needed for successful trading, stressing the importance of technical analysis and trading discipline.
Chapter 20 The Elliott Wave Principle,
which focuses on understanding the market movements through wave patterns. Below are the detailed study notes from this chapter:
1. Historical Background of Elliott Wave Theory
The Elliott Wave Principle was introduced by Ralph Nelson Elliott in the 1930s.
Elliott's work drew upon the Dow Theory and recognized that stock markets follow a pattern of repetitive cycles or waves.
Elliott's analysis was influenced by the idea that markets are driven by mass psychology and human behavior, which repeat over time.
2. The Basic Tenets of the Elliott Wave Principle
Wave Patterns: The market moves in repetitive cycles of five waves upward followed by three waves downward, completing one full cycle of eight waves.
Impulsive and Corrective Waves:
Impulsive waves: The first, third, and fifth waves in the five-wave structure are the ones that follow the main market trend.
Corrective waves: The second and fourth waves are corrective, moving in the opposite direction of the prevailing trend.
Fibonacci Sequence: Elliott observed that wave formations follow Fibonacci ratios (such as 61.8%, 38.2%, etc.) in their retracement and extension phases. The Fibonacci sequence is integral to calculating price targets within the Elliott Wave structure【16:17†source】.
3. Wave Degrees
The market contains waves of various degrees, from very short-term to extremely long-term.
Elliott categorized these into nine degrees of waves, ranging from Grand Supercycle (lasting centuries) to subminuette (lasting minutes or hours).
Each wave of one degree is composed of smaller waves of a lower degree.
4. Key Concepts in Elliott Wave Theory
Channeling: Elliott’s method suggests drawing trendlines to form channels around the wave patterns, helping to predict the completion of wave cycles.
Wave Alternation: Waves alternate between complex and simple structures. If wave 2 is simple, wave 4 is often complex, and vice versa.
Fibonacci Retracements: Waves often retrace a prior wave’s movement by specific Fibonacci ratios (38.2%, 50%, 61.8%).
5. Rules of Elliott Wave Analysis
Rule 1: Wave 2 cannot retrace more than 100% of wave 1.
Rule 2: Wave 3 is never the shortest wave among waves 1, 3, and 5.
Rule 3: Wave 4 does not overlap with the price territory of wave 1, except in a diagonal triangle【16:17†source】.
6. Application of Elliott Wave to Stocks and Commodities
Elliott Wave Theory applies to both stock markets and commodities. However, it tends to be more reliable in more liquid and widely followed markets.
The theory provides a framework for predicting market behavior in both bull and bear markets.
7. Challenges and Criticism
One of the main criticisms is that wave interpretation can be subjective. Correct identification of waves can sometimes be unclear.
Elliott Wave analysis requires practice, and different analysts may interpret waves differently based on their experience and skill level.
8. Summary
Elliott Wave Theory offers traders a structured way to analyze market cycles and price movements.
When applied properly, it can predict significant market turning points and trends, although its effectiveness depends on accurate interpretation and experience.
These notes summarize Elliott Wave Theory, an important technical analysis tool that helps traders understand market cycles through repetitive wave patterns【16:17†source】.
Chapter 21 Time Cycles
1. Introduction to Cycles:
Time cycles refer to repeating patterns or regular intervals that affect market behavior.
Analysts use time cycles to predict when market tops and bottoms will occur.
Time cycles are relevant in both short-term and long-term analysis, ranging from intraday fluctuations to multi-decade trends.
2. Dominant Cycles:
Markets are influenced by several different cycles simultaneously.
Dominant cycles are the most significant or strongest cycles impacting the market at a given time.
Each cycle can range from minutes to years. It’s crucial to recognize which cycles are most influential.
3. Types of Cycles:
Seasonal Cycles: Commonly seen in agricultural and energy commodities, where prices fluctuate according to planting, harvesting, or energy consumption patterns.
Stock Market Cycles: The January Barometer and the Presidential Cycle are examples of cycles specific to stock markets.
The January Barometer suggests that stock performance in January can predict the market's direction for the year.
The Presidential Cycle observes that U.S. stock markets tend to perform differently depending on the year of a president's term.
4. Key Concepts in Cycles:
Left and Right Translation: In cycle analysis, left translation occurs when the peak of the cycle happens early, signaling weakness. Right translation occurs when the peak happens later, indicating strength in the market.
Combining Cycles: Analysts combine multiple cycles of varying lengths to refine predictions. The interaction between short-term and long-term cycles can either amplify or cancel each other out.
5. Harmonic Relationships:
Cycles are often harmonically related to one another. The length of one cycle might be a fraction or a multiple of another.
For example, a 20-day cycle may be half the length of a 40-day cycle, and both cycles can influence market behavior simultaneously.
6. Maximum Entropy Spectral Analysis (MESA):
MESA is a statistical tool used to identify dominant cycles. It helps in distinguishing real cycles from noise.
This advanced method uses modern computer software to perform cycle analysis and is commonly used in technical analysis to forecast turning points in markets.
7. Combining Cycles with Technical Tools:
Technical indicators such as moving averages and oscillators are often adjusted according to the dominant cycles in the market.
By aligning technical tools with cyclical behavior, traders can better predict price movements.
8. Conclusion:
Cycles play a crucial role in market analysis. Traders must identify dominant cycles and adjust their strategies accordingly.
When used correctly, cycle analysis offers a valuable perspective on market timing and trend forecasting.
These study notes summarize the significance of time cycles in market analysis and how they help traders forecast future price movements by recognizing patterns【16:17†source】【16:18†source】.
Last updated