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Classical Bar Charting

& Technical Analysis

Kenneth H. Shaleen
Section One
Chapter 1 Chapter 2

- The ‘Bottom of the Chart’

Rationale of technical analysis Volume Analysis Significance Healthy Price Trends Blowoff Volume Determination of Volume Parameters Open Interest in a Futures Contract Significance Healthy Price Trends Idiosyncrasies General Rule for a Healthy Price Trend (on a daily futures chart) Why Total Volume & Open interest is Used Worksheet

Chapter 3

Chapter 4

Section Two - The Basics
Chapter 5 Price Scales Arithmetic verses Logarithmic Futures Continuation Charts Trending with the Trend Trendline Construction Trendline Analysis Support and Resistance

Chapter 6

Chapter 7

Section Three - Reversal Patterns
Chapter 8 Chapter 9 Chapter 10 Chapter 11 Price Pattern Recognition - an Overview Head & Shoulders Top and Bottom Broadening Formations Double Top and Double Bottom i

Section Four - Continuation Patterns
Chapter 12 Symmetrical Triangles As a Continuation Pattern As a Reversal Pattern Right Angle Triangle Ascending Right Triangle Descending Right Triangle Wedge Formations Rising Wedge Falling Wedge Flags & Pennants - ‘half-way’ formations

Chapter 13

Chapter 14

Chapter 15

Section Five - Gap Theory
Chapter 16 Gap Theory Four Basic Types of Gaps Ex-Dividend Gap Island Formation

Section Six - Minor Trend Change Indicators
Chapter 17 Minor Trend Change Indicators Key Reversal Outside/Inside Range Mid-Range Close

Section Seven - Other Forms of Technical Analysis
Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Spreading and Spread Charts Mathematical Models - Trend Following Mathematical Models - Oscillators

© Kenneth H. Shaleen ii

CHARTWATCH 9/08

International Futures Research

Kenneth H. Shaleen is President of CHARTWATCH, an international research firm to the futures industry. CHARTWATCH distributes weekly technical analysis at www.chartwatch.com and produces a daily telephone market update. Mr. Shaleen has instructed technical analysis courses for the Chicago Mercantile Exchange since 1976. These courses are also conducted in London, Singapore, Malaysia, Hong Kong and other locations throughout the world. Mr. Shaleen is the author of Volume & Open Interest (Irwin, 1991, 1997) and Technical Analysis & Options Strategies (Irwin, 1992), three Chicago Mercantile Exchange course book as well as numerous articles. Mr. Shaleen Joined the Northern Trust Company in Chicago in 1968 as a Management Science Analyst to develop computer models for the Bond and Trust Departments. A move to futures research was made in 1972. After supplying analysis for twelve years as Director of Research for two Chicago Board of Trade clearing member firms, he formed CHARTWATCH in 1984. Mr. Shaleen is a charter member of the Commodity Options Market (1982) at the Chicago Board of Trade. He holds a B.S. in Civil Engineering from the University of Colorado (1967) and an M.B.A. in Finance from Northwestern University (1968).

Please direct all inquires concerning videos and any of the services offered by CHARTWATCH to:

CHARTWATCH Fulton House 1604 345 North Canal Street Chicago, Il 60606 USA Telephone: 312 454-1130

chartwatch. To the 15.my thanks. The “live” charts assigned in the early CME Technical Analysis courses were Live Cattle and Soybeans.Sept ‘68 Oat futures. creating the price patterns. Much of what is contained in this course manual is the old fashioned “art” of drawing trendlines to construct classic price patterns. I started my first chart . This is the course manual.000+ students who have helped me analyze these charts . 2008 . This course manual is an ongoing compilation and refinement of all the charts and technical analysis I have encountered since this time. Dee Belveal (Commodities Press. does not change. A combination of older charts and more up-to-date examples are co-mingled to show that human nature. although the first Technical Analysis Course I conducted for the Chicago Mercantile Exchange in the Summer of 1976 used the Edwards and Magee “bible” of price pattern recognition: Technical Analysis of Stock Trends. These evolved to Deutsche Marks and Treasury Bonds . The simple creation of a chart also evolved with the advent of electronic “after hours” trading and the proliferation of technical analysis software.www.the Chicago futures exchanges . Ken Shaleen Chicago Sept 22. 1967). The majority of charts in this manual are futures charts. After reading Commodity Speculation with Profits in Mind by L.com iii Foreword Earning an MBA in finance at Northwestern University in June of 1968. Now the technical analysis course has come full circle with Stock Index futures charts and individual equity charts increasingly in evidence.as the volume in financial futures became dominant. I was never exposed to one of the most active markets in the world .basically just down the street from the downtown Northwestern campus.

. CHARTWATCH Inc.Classical Bar Charting & Technical Analysis Prepared and Presented by Ken Shaleen President.

The ‘Bottom of the Chart’ Chapter 1 Chapter 2 Rationale of technical analysis Volume Analysis Significance Healthy Price Trends Blowoff Volume Determination of Volume Parameters Open Interest in a Futures Contract Significance Healthy Price Trends Idiosyncrasies General Rule for a Healthy Price Trend (on a daily futures chart) W hy Total Volume & Open interest is Used W orksheet Chapter 3 Chapter 4 Section Two . Shaleen Section One .an Overview Head & Shoulders Top and Bottom Broadening Formations Double Top and Double Bottom i .The Basics Chapter 5 Price Scales Arithmetic verses Logarithmic Futures Continuation Charts Trending with the Trend Trendline Construction Trendline Analysis Support and Resistance Chapter 6 Chapter 7 Section Three .Classical Bar Charting & Technical Analysis Kenneth H.Reversal Patterns Chapter 8 Chapter 9 Chapter 10 Chapter 11 Price Pattern Recognition .

Gap Theory Chapter 16 Gap Theory Four Basic Types of Gaps Ex-Dividend Gap Island Formation Section Six .Trend Following Chapter 20 Mathematical Models .Minor Trend Change Indicators Chapter 17 Minor Trend Change Indicators Key Reversal Outside/Inside Range Mid-Range Close Section Seven .Other Forms of Technical Analysis Chapter 18 Chapter 19 Mathematical Models .Oscillators Chapter 21 Chapter 22 Spreading and Spread Charts ii © Kenneth H.‘half-way’ formations Chapter 13 Chapter 14 Chapter 15 Section Five .Continuation Patterns Chapter 12 Symmetrical Triangles As a Continuation Pattern As a Reversal Pattern Right Angle Triangle Ascending Right Triangle Descending Right Triangle W edge Formations Rising W edge Falling W edge Flags & Pennants . Shaleen CHARTWATCH 9/08 .Section Four .

Hong Kong and other locations throughout the world. These courses are also conducted in London. Mr. Mr. 1997) and Technical Analysis & Options Strategies (Irwin. Please direct all inquires concerning videos and any of the services offered by CHARTW ATCH to: CHARTW ATCH Fulton House 1604 345 North Canal Street Chicago.S. Shaleen has instructed technical analysis courses for the Chicago Mercantile Exchange since 1976. Shaleen is the author of Volume & Open Interest (Irwin. Mr.com iii . A move to futures research was made in 1972. Shaleen Joined the Northern Trust Company in Chicago in 1968 as a Management Science Analyst to develop computer models for the Bond and Trust Departments. in Finance from Northwestern University (1968). 1992). Singapore. in Civil Engineering from the University of Colorado (1967) and an M. three Chicago Mercantile Exchange course book as well as numerous articles.B. an international research firm to the futures industry. He holds a B.International Futures Research Kenneth H. Shaleen is President of CHARTW ATCH.com and produces a daily telephone market update. 1991. Mr.chartwatch. After supplying analysis for twelve years as Director of Research for two Chicago Board of Trade clearing member firms. Malaysia. Shaleen is a charter member of the Commodity Options Market (1982) at the Chicago Board of Trade.chartwatch.A. Il 60606 USA Telephone: 312 454-1130 www. he formed CHARTW ATCH in 1984. CHARTW ATCH distributes weekly technical analysis at www.

the Chicago futures exchanges .as the volume in financial futures became dominant. Now the technical analysis course has come full circle with Stock Index futures charts and individual equity charts increasingly in evidence.Sept ‘68 Oat futures. To the 15. The simple creation of a chart also evolved with the advent of electronic “after hours” trading and the proliferation of technical analysis software. I started my first chart . The majority of charts in this manual are futures charts.my thanks. although the first Technical Analysis Course I conducted for the Chicago Mercantile Exchange in the Summer of 1976 used the Edwards and Magee “bible” of price pattern recognition: Technical Analysis of Stock Trends. Much of what is contained in this course manual is the old fashioned “art” of drawing trendlines to construct classic price patterns. The “live” charts assigned in the early CME Technical Analysis courses were Live Cattle and Soybeans. This is the course manual. creating the price patterns. Dee Belveal (Commodities Press. I was never exposed to one of the most active markets in the world . After reading Commodity Speculation with Profits in Mind by L. These evolved to Deutsche Marks and Treasury Bonds . Ken Shaleen Chicago Sept 22. This course manual is an ongoing compilation and refinement of all the charts and technical analysis I have encountered since this time. 2008 iv .Foreword Earning an MBA in finance at Northwestern University in June of 1968.000+ students who have helped me analyze these charts . A combination of older charts and more up-to-date examples are co-mingled to show that human nature.basically just down the street from the downtown Northwestern campus. 1967). does not change.

It is difficult for a trader to isolate a technically derived market view from the fundamentals.and be prepared for the possible price moves that will result.and do not pose any major problems for the astute technician. But in the short run. Each of these markets has its own unique characteristics. this is what is important. the price of any freely traded item is determined by the interaction of the fundamentals of supply and demand. and moods. They are the interaction of supply and demand variables as perceived by the marketplace. fears. The question always arises: W hy is price moving the way it is and why should it go to a particular price level that might be predicted by technical analysis? A technician must try to divorce himself from these thoughts. W hy? W hat is contained in the determination of the price? Hopes. A fundamental event is usually responsible for creating the minor price change. And human nature . The technical trader follows the price only.Chapter One Rationale In the long run.tends to repeat itself. There is nothing magic about these price patterns. Indeed. 1-1 . a scheduled economic report will initiate the price move. This does not mean that a technician does not know what is going on in the “real” world. Equity Markets verses Futures Markets The techniques investigated are applicable to equity (stock) charts and futures charts. as a final result. An these moods can be rational or irrational. it takes reversals of the minor price trend to create the handful of classic price patterns that will be studied in this course manual. Price changes produce the profit or loss. Often these minor price moves create the necessary conditions for a classical bar charting price pattern. So a technical trader should monitor the economic release calendar . These characteristics are not difficult to understand . the price of that item could move in exactly opposite direction as dictated by the fundamentals. Often.reacting to economic events and shock variables . The bulk of this course manual will be devoted to the “low tech” art of price pattern recognition.

at the end of the trading session. the difference between the cash market price and the futures price. 1-2 .e. the concept of short interest in the equity market will be detailed in Chapter Two. a futures market. Open Interest).The Difference between Equity and Futures Charts The main difference between equity charts and futures charts is that equity charts contain only price and volume statistics whereas a futures chart contains the added variable of open interest. The “basis”. is highly arbitraged and produces a relatively stable (although dynamic) relationship between the cash and futures market.. verses the equity market where there are (predominately) longs only. There is a major conceptual difference in a market that must have a short for every long at the end of a trading session i.(For purists. The question often arises: W hy should a derivative market. be analyzed when the underlying “cash” or “spot” market is the dominant market? A futures market that has achieved a “critical mass” becomes a microcosm diminutive but analogous to the whole (cash market). the futures.

In this regard. the following equality always prevails: Buy Volume = Sell Volume = Total Volume Published volume figures represent one side of a futures trade only. This occurs with the Saturday morning availability of the data for the Friday trading sessions. Therefore. a contract is consummated only when both sides of the trade agree to the price and quantity. The CME Group Clearing House releases the volume (and open interest) statistics prior to the start of open outcry trading the next morning in the U. the contemplated trade is suspect and would not be initiated. In a futures market. Electronic screen based trading (and most equity exchanges) do show “on-line” volume. volume is often the validating statistic that causes a technical trader to “pull the trigger” on a new trade. A more representative phrase to explain the rise in prices during a particular trading session might be “more potential buyers than sellers”. low. bar chartists. 2-1 . the total number of contracts bought equals the total number of contracts sold.Chapter Two Volume Volume provides a “filter” for classical high. Note that once each week. a technician will be able to analyze the statistics before trading begins the next day. The phrase “more buyers than sellers” is never true with respect to volume statistics. Volume is so important that when this internal statistic does not support the technical conclusion derived from the analysis of price movements.S. This is obviously a boon to technical traders. In an open outcry trading environment the final volume totals are not available until after the close of trading. The dissemination of volume (and open interest) statistics varies widely by futures exchange. See the Appendix of this manual for examples of how to obtain the statistics directly from the exchange website. At the end of a trading session. close. Definition: Volume is the number of futures contracts (shares for an equity market participants) traded each trading session.

This relationship is shown schematically in Figure 2-1. Figure 2-1 Ideal Bull Market Price versus Volume Interaction 2-2 . than on down days when prices settle lower. It is the result of the need for traders and investors to “do something”. the technician will want to monitor this sense of urgency. average or high. Since any useful chart analysis determines what the losers are doing. These three categories are not static. The specific volume number is not important.Significance of Volume: Volume is a measure of urgency. Their boundaries will fluctuate with substantial changes in open interest and/or price volatility. And nothing creates more urgency in a market than a losing position. It is necessary to classify the trading session’s volume into one of three categories: low. Ideal Healthy Price Uptrend: The ideal situation for a healthy bull market is volume moving up as the bull market expands. thereby assessing the health and strength of the prevailing price trend. A strong price uptrend is characterized by greater volume on up days when prices close higher.

Low volume on price down days is telling the astute trader that there is no urgency on the part of the longs or shorts to close out their positions .“Don’t sell a quiet market after a fall” . Ideal Healthy Price Downtrend: The ideal situation for a healthy bear market is for volume to increase a prices move lower. A strong price downtrend is characterized by expanding volume on days when prices close lower and increasing volume on price up days. The ideal situation for a healthy uptrend in prices is for volume to increase on rallies in price and decrease on selloffs.because a low volume selloff is actually a bullish technical situation.and thus the prevailing major price uptrend should continue.Volume measures how anxious trader are to establish or close out their positions. Monitoring volume to identify price moves as counter-trend is important. Figure 2-2 Ideal Bear Market Price versus Volume Interaction 2-3 . This configuration created the old adage . This concept is shown schematically in Figure 2-2.

especially speculative ones (as opposed to legitimate hedges). Figure 2-3 Theoretical Examples of Blowoff Volume One caveat is in order. Often blowoff volume will occur one trading session before the ultimate high or low price posting. If no urgency develops for the shorts to cover their positions. over several weeks. Blowoff Volume . This signal does not have to coincide with the exact extreme price day.some lasting several days. prices will not continually decline. Adverse moves against the direction of the major trend will result in price rallies . The urgent need to close out losing positions produces “blowoff “ volume. often create conditions that lead to excessive volume. Figure 2-7 is an actual example of this sign of exhaustion in the Corn futures market. A low volume rally is bearish. 2-4 . “Don’t buy a quiet market after a rise”. This is the proverbial low volume rally. volume should decline. Prices often move violently in the opposite direction after such blowoff volume. or erratically.A Warning Signal: There is one amplification of the ideal price versus volume configuration that is of paramount importance and should not be overlooked. Extreme high volume is the warning signal which indicates at least a temporary trend change.Even in a long-term bear market. Ergo. Blowoff volume is volume of an extremely high magnitude which is a warning signal that the price trend is in the process of exhausting itself. Figure 2-3 illustrates the theoretical relationships between blowoff volume and price activity. Losing positions.

whether two weeks or two months. depending on the specific conditions prevailing on each chart. Hypothetical horizontal lines are drawn. One third of the volume readings should fall into each of the three categories 2-5 .Determination of Volume Parameters Figure 2-4 A bar chartist will scan back an ‘appropriate distance. representing the threshold levels of “low and “high” volume.

Volume Analysis
Figure 2-5

2-6

Volume Analysis
Figure 2-6

Note the increase in volume on price down days and reduction in volume on price rallies

2-7

Example of Blowoff Volume
Figure 2-7

2-8

The technical ramifications of these changes will be apparent later in this chapter when detailing the ideal healthy price uptrend or downtrend. Definition: Open Interest (O. Example: Prior Day’s Total Open Interest = 180.I.I.000 new long contracts opened 3.000 Answer the question: W ho is getting in or out of the market? Case One: Open Interest Increases Total O. Similar to volume. Futures technicians monitor the total open interest figure.) Is the summation of all unclosed purchases or sales at the end of a trading session. The reason for using total open interest is explained in graphic detail in Chapter Four.there is a dollar out. Admittedly. Confusion concerning the definition of open interest can be avoided by remembering this simple equality: Long O. it does not matter whether prices moved up or down. = Short O. = Total O. fall into one of three categories: 1) Increase. the published figure represents one side of the transaction only. How Open Interest Changes: Open interest changes from one trading session to the next. This number represents the summation of open positions in all the contract months traded for the particular commodity. W hat is necessary is that a “significant” price change occurred. or 3) No change.Chapter Three Open Interest Futures trading is a zero sum game: for every dollar in . the exchange clearing house and member firms scoop a little off the top.I. 2) Decrease. but for every open position in a futures market there has to be an opposite position.000 new short contracts opened .I. it is safe to assume that the definition begins at more than five minimum price tics. now at 183. For this illustration.I. W hile no specific definition of what constitutes significant will be given. Each of the three situations will be examined in a hypothetical example.000 a change of +3000 3-1 3.

000 2. strong price trend (either up or down) to continue.000 a change of -2. open interest should increase.the open interest in a futures listed on that commodity would be zero. or speculators placing positions trying to profit from a mis-priced market. the trend will change. 3) Determines if the losers are being replaced. the trader would not know exactly what changing of positions occurred. For a healthy.000 short contracts bought back (covered their existing shorts) Case Three: Open Interest Unchanged Total O.Case Two: Open Interest Decreases Total O. This is reflected in a willingness to take an open position.I.I. 2) Provides “fuel” to sustain a price move. The analogy of fuel to the market is like that of fuel to a fire.000 long contracts sold out 2. This is so important a concept that remembering the word fuel as a surrogate for open interest will place a trader ahead of 80 percent of all futures traders worldwide! 3-2 . W hen open interest declines. Open interest is a reflection of this important concept. If the fuel is removed from a fire. Open interest: 1) Indicates the existence of a difference of opinion. Significance of Open Interest: There are three reasons why technically based futures traders monitor open interest. now at 178. There is nothing that creates a market more than a difference of opinion. the fire will go out.000 no change In this situation. If fuel is removed from a price trend. There would be no need for hedgers to lay off unwanted risk. fuel is being removed and the prevailing price trend is running on borrowed time. now at 180. If a market was at equilibrium and the entire trading world knew this . Fuel in a futures market is provided by the losing positions. or at least not decline.

Less conviction concerning probable price movement together with less fuel to sustain the price trend produces a definite warning signal of an impending trend change. Ideal Healthy Price Uptrend: In an uptrending market when open interest is going up. W hat matters is that the funds are being posted at the clearinghouse. The additional short sellers may be existing shorts adding to their losing positions.Technicians do not care if a losing position is being financed by meeting margin calls and throwing more money at the market. or new longs may be joining the bull bandwagon. Precautionary measures should be taken such as moving protective stop orders (hopefully to realize profits) closer and placing orders to liquidate existing positions. This is a healthy price uptrend and prices should continue to work higher as long as open interest does not begin to decline. lock in profit margins. etc. both sides are increasing their positions. or new short sellers entering the market (thinking prices are too high). open interest will decline. Liquidation of both long and short positions is occurring. Figure 3-1 Ideal Bull Market Price versus Open Interest Interaction 3-3 . Longs may be adding to their profitable positions. but what is of importance to the technician is that declining open interest means the prevailing price trend has become very unhealthy. This is shown in schematic fashion in Figure 3-1. the underlying support is suspect. W hen the losers decide that they “don’t want to play the silly game anymore” and leave the market. The losers are necessary to pay off the traders with the correct market judgment. W hat is of the most importance to the longs is the fact that the losers are being replaced and more fuel to sustain the upmove is entering the market. Obviously the losers pay the price for their misjudgment. Potential hedgers should begin to implement any previously planned strategies to protect inventory. If open interest is declining. or if a loser steps aside and new blood comes in to take the loser’s place.

Increases in takeover activity and arbitrage cloud the issue of how to interpret short interest statistics from an equity market. Figure 3-2 Ideal Healthy Price Downtrend Price versus Open Interest Interaction Short Interest (Equities) The concept of short interest in the U. Thus a short position in futures can be taken if other indicators.even though the ideal situation of increasing open interest is not present. Short interest is the number of shares that have not yet been purchased to cover short sales. Two schools of thought prevail as to what short interest implies: 1) Traders expecting a price decline are initiating short sales. or 2) By definition. The borrowed stock must eventually be returned to the lender. such as price patterns. In any equity market that allows short sales using borrowed stock. grains and livestock futures. They would much rather buy something than be short. This is because “commodity” speculators are by nature bullish. or any equity (stock) market) is completely different from open interest in futures. a short interest situation might exist. especially in the metals.Ideal Healthy Price Downtrend: The ideal situation for a healthy price downtrend (price expected to continue moving lower) is open interest increasing when prices close lower and open interest decreasing on trading sessions when prices close higher. They could be correct. This is shown in Figure 3-2. the shares sold short must eventually be bought back: A bullish situation. This concept will be illustrated in many of the charts in this course manual. suggest lower prices . 3-4 . There is often difficulty in finding the ideal technical situation of open interest increasing during a downtrending market.S.

As the new price trend becomes more apparent. Total open interest rounds upward as a price bottom is being made and tops out as price peaks. This is because the participants with the correct (profitable) positions are liquidating (realizing that the trend is changing) and the losers are closing out their positions (confused and not realizing that the trend really is finally starting to go their way). Open interest often declines to a “steady-state” condition . moving net sideways. Total open interest has acted in a coincident fashion with price in so many instances that it cannot be attributed solely to chance. and more than likely trying to change direction.IDIOSYNCRASIES Questions quickly arise when a new trader is exposed to the concept of how open interest should ideally interact with price changes in a futures market. A special case in which open interest often acts as a coincident indicator in both bull and bear directions is the CME Group currency futures. 1) W hat happens to open interest as a market reverses price direction? 2) How can open interest continually increase in the direction of the new price trend? This would mean that open interest would have to continually rise! Markets in Transition: The answer is that normally open interest does decline as a new price trend initially gets underway. 3-5 . open interest acts as a coincident indicator with price. The changes in open interest in the foreign exchange (forex) futures accurately reflect how the dominant price making force is changing its market view. This occurs most often in the traditional physical commodity futures during a bull market. open interest should then begin to increase .fueling the price move to new highs or lows as the smart money rides the trend and the skeptics fight it. Open Interest as a Coincident Indicator: On many occasions. In general.a level of open contracts that often approximates the level that prevailed before the start of the previous price trend. any time open interest begins to act erratic after experiencing a steady increase. price is. at best.

and Early Warning Signal Figure 3-3 3-6 .Ideal Healthy Price Uptrend .

Ideal Healthy Price Downtrend Figure 3-4 3-7 .

Historical Charts Figure 3-5 3-8 .

a vicious short covering rally ensued.Historical Charts Figure 3-6 Ideal Healthy Price Downtrend Lean Hogs . A price reason must be present. 3-9 .Feb 1999 Note that after the January 5 price decline. Technical traders cannot simply use the fact that an price rally is short covering to initiate short sales.

Historical Charts Figure 3-7 Open Interest as a Warning Signal 3-10 .

Historical Charts Figure 3-8 13-11 .

Historical Charts Figure 3-9 Open Interest in the Transition from a Bull to a Bear Market 3-12 .

Historical Charts
Figure 3-10

Open Interest Increasing in a Bear Market

Note the transition from a bear to bull market was initially accompanied by a ecrease in open interest. This is usual.

3-13

Historical Charts
Figure 3-11 A Open Interest as a Coincident Indicator Figure 3-11B History does Repeat Itself

Deutsche Mark Sept 1998

Note how the liquidation in total open interest corresponded to the price declines. W hen the bulls finally had the courage of their convictions and were willing to hold long positions overnight, price was able to move up. Also observe the interaction of price and open interest at the price highs. The open interest line resembles the Head & Shoulders Top that formed on the price chart!

3-14

Chapter Four General Rule for a Healthy Price Trend
Volume and Open Interest Should Increase as Prices Move in the Direction of the Major Price Trend
According to this rule, the most bullish condition on a futures chart is price moving up on increasing volume and increasing open interest; The longs are in control and the price uptrend is expected to continue. On a daily basis, this rule implies that on price up days (when quotes close higher than the previous trading session), volume should expand and open interest should increase. In a strong bear market when quotes close lower, volume will expand and open interest will increase. This ideal healthy price downtrend does not often occur in those markets that the public prefers to trade from the long side. These include traditional agricultural commodity futures and metals. Conversely, markets such as interest rate futures (U.S. Treasury Bonds in particular) often do exhibit the ideal bear market characteristics of volume and open interest up on price down days. The most bullish and bearish technical situations are shown schematically in figures 4-1 and 4-2. Figure 4-1 Ideal Healthy Bull Market Figure 4-2 Ideal Healthy Bear Market

4-1

Why Total Open Interest is Used 4-2 .

Volume and Open Interest Analysis .Worksheet 4-3 .

Ideal Healthy Price Uptrend Volume Should: Increase on price up moves Decrease on price down moves Open Interest Should: Increase on price up moves Decrease on price down moves 4-4 .

Ideal Healthy Price Downtrend Volume Should: Increase on price down moves Decrease on price up moves Open Interest Should: Increase on price down moves Decrease on price up moves 4-5 .

Ideal Healthy Price Uptrend Volume Should: Increase on price up moves Decrease on price down moves Open Interest Should: Increase on price up moves Decrease on price down moves 4-6 .

4-7 .

4-8 .

Downside Reaction Likely 4-9 .Weak Price Uptrend .

4-10 .

Ken Shaleen has found that futures charts plotted with an arithmetic scale do meet the standard vertical height measuring objective dictated by the pattern. Downside measuring objectives will not be as low on a semi-log scale chart as compared to the target from the same bearish price pattern as reflected on an arithmetic scaled chart. This referred to as rectangular coordinate chart paper.and then a recommendation. An upside target on a semi-log scale chart will be much higher than the same price pattern measured on an arithmetic scaled chart. Classical bar chartists quite often use the vertical height of the price pattern to determine upside or downside measuring objectives.and arrive at the same price target as the ‘graphic’ method of taking the height and physically moving it over to the breakout level. First. 5-1 . It does not take a doubling or tripling of price to produce sizable percentage gains or losses. Obviously. a discussion of each type of scale . What gives futures trading its allure? Answer: The high leverage or ‘gearing’. Since time is recorded in linear fashion. The ‘bottom line’ is that the use of an arithmetic price scale on a daily futures chart is perfectly acceptable. The two choices are arithmetic or logarithmic. Arithmetic scales are constructed with each small square on the chart actually being a square. Logarithmic scales increase in a doubling of price in equal price distances. This quandary obviously needs answering. Note that this objective could be calculated mathematically . the result is semi-log chart paper. In forty years of examining futures charts on a daily basis. the choice of price scale will generate much different price objectives.Chapter Five Price Scales One of the first decisions a prospective bar chartist must address is what type of price scale to use.

And the equity market is dominated by ‘buy-and-hold’ type investors who do not use margin accounts to leverage their holdings. The ‘bottom line’ is that individual equity traders should find semi-log scale charts very useful.where a long term bull market existed. This is especially true for the stock index futures .In general. helpful. They will have an easier time finding such a buy-and-hold candidate on a semi-log scale chart. This is a very dynamic price pattern. individual equities (stocks) move slower than anything listed as a futures contract. Two exceptions There are several situations in which a futures chartist might find changing the price scale from arithmetic to logarithmic. 5-2 . In addition. This would happen if a valid Flag pattern forms. Determining the graphic objective using a log scale will result in a much more aggressive (higher) target. And. the universe of equities to choose from is huge compared to the 60-80 actively traded futures contracts. Looking a long term (weekly or monthly) continuation chart of the nearest-toexpire future over a long time period (years) might be better viewed with a log scale for price. The measuring objective in a Bull Flag pattern can be far surpassed using an arithmetic scale. An upsloping trendline on a semi-log scale chart is increasing at a constant percentage increase. 2. 1. This type of market participant also tends to be on the long side of the market. They are looking for individual stocks that are increasing in price at a good rate. After a large price move has occurred on a daily chart. This is the stock that an equity investor wants to find. the price blowoff to the upside in the physical commodity futures in 2007-08 can be kept in context by using a log scale.

monthly 5-3 .Example of Semi-Log Scale Figure 5-1 London Gold .

5-4 .Comparison of Arithmetic and Logarithmic Price Scales Gold .90 on the near-by future) ‘seems’ much larger on the arithmetic scale chart.Monthly Chart nearest-to-expire future Figure 5-2A Figure 5-2B Price drop off the March 2008 high (1033.

A position trader is an investor who wants to ride a price trend.Chapter Six Trading with the Trend A ‘trader’ is different from an ‘investor’. Yes. Figure 6-1 Price Uptrend 6-1 . Trendline Construction Defining a price trend is easy. Figure 6-1 is a plot of this definition. They have the best chance of making a profit by identifying the direction of the major price trend. Even a casual observation of historic charts indicates the presence of many sustained price trends . but the long term trend continues. Each upmove extends to new high price territory while the selloffs do not decline as far as the price drop on previous selloffs. The trader is operating in a very short time frame . For the day trader. ascertaining its health (strength).up or down. market maker. Higher and higher price highs and higher and higher price lows is the basic definition of an uptrend. trading with it is not so easy. Sometimes these trends last several years.down to seconds and minutes. there might be some sizable moves against the major trend. scalper. it is the speed of execution and small commissions that produces their profits. and trading with it. The investor desires to hold the position and therefore has a much longer time frame.

It only takes two points to determine a straight line. This line is referred to as the downtrend line.Downtrends are characterized by lower highs and lower lows. The trendline takes on much greater significance. The trend direction has much greater validity. This is shown twice in figure 6-3. Figure 6-3 Uptrend Lines 6-2 . See figure 6-2. Typically these are the highs of the price bars on whatever time frame chart (minutes. etc. days.) Is being used. the uptrend line is the one drawn across (tangent to) the low of the price bar at each of the relative price lows. a significant charting event occurs. hours. If a third point lies on any trendline. Figure 6-2 Price Downtrend In a bull market. In a downtrend it is possible to construct a straight line tangent to two price highs.

It is not enough evidence to completely reverse direction. Subsequent price action (after the trendline has been drawn) may cut thru prices .Any trendline. This is the cardinal rule of trendline construction. Even then. Figure 6-4 shows a three point downtrend line on the Dec 2008 Crude Oil future. when initially drawn. A trader strives to find the technical situation where a market is residing above or below a three point trendline. The line must be tangent to two relative highs or lows. Figure 6-4 Three Point Downtrend Line Note that the 1 st trendline was only constructed using two points. A three point trendline is infinitely greater in its technical significance than a two point line. 6-3 . Violating a three point trendline is cause for exiting an existing position. Addition technical corroboration is needed. It did not hold. it changes the trend to sideways. should not cut thru prices.and obviously has to when the trend changes. the trend does not completely reverse. The trend will continue until a close beyond the trendline occurs.

it is a ‘reasonable’ line to place on the chart. Violation of the three point upsloping trendline with a weekly close below the line would signal that the major price uptrend has stopped . this upper line is often exceeded as the price up move goes into a greater vertical angle of ascent. This is especially true for shorter trendlines used to delineate the boundary lines of an orthodox price pattern. The weekly continuation chart of the nearest-to-expire British Pound future in figure 6-5 is a good example.A chartist never erases a properly drawn trendline once it has been constructed. Trend Channels Although not as common as most traders might think. It is known as a parallel objective line or a return line.where the trendline and parallel objective line contain the price swings. Some chartists construct this line as a reasonable price target for the extent of the next move.and turned the market to neutral. Still. Another aspect of trendline construction is the use of a line constructed parallel to the trendline. Figure 6-5 Trend Channel on a Weekly Continuation Chart 6-4 .even if the ensuing price move proved the analysis incorrect. Reference to the chart months or years later will allow the technician to see what the prevailing price configuration implied . markets sometimes do trend within a well defined channel . In bull markets. Knowledge of the technical personalities of each market will be gained by review of the success or failure of each identifiable price pattern.

. But. . rather than reverse. The concept of support and resistance is one of the most talked about. . the price upmove would turn down when approaching that level again. The ‘double’ formation is not a common reversal pattern. Set entry points for new positions. would change. Markets tend to trend most of time. 7-1 . .Chapter Seven Analysis of Support and Resistance Locating support and resistance is probably the most important part of any classical bar charting analysis. allows the trader to: 1. Place protective stop orders. In the process of defining support and resistance. 2. Determine if a price trend is present. if a simple price high was overhead resistance. and the overwhelming majority would state that the highest point on the graph is resistance. This seems logical because the previous price rally did stop at that level once before. but least understood aspects of technical analysis. the following observation is useful: Ask 100% of all the would-be ‘technicians’ in the trading world where overhead resistance is located on the following line graph (Figure 7-1) . 4. . Properly locating the price levels where support or resistance would be expected. Figure 7-1 . And Double Top formations would be much more prevalent. Locate where the prevailing trend. if any. 3. . . An uptrending market would never materialize.

7-2 . and scalpers on an open outcry futures floor do notice that price often temporarily stops in the area of a previous price high or low. e.g. It is usually impossible for all but the most active day traders to make money by ‘fading’ a market as it reaches a benchmark high or low.Giving a price high on a chart a name. Figure 7-3 Market makers in equities. Position traders do not operate as close to the market as these highly active traders. foreign exchange dealers. This is illustrated in Figure 7-2. The June 16 low of 8570 on the daily high low close bar chart was well known and easily seen by all traders. Look at what happened during the trading session in which the price decline again approached 8570 seven weeks later. The operative word is temporary. a price low on a chart (Figure 7-3) should be referred to as a “Benchmark Low” and should not automatically be labeled as support. Figure 7-2 Similarly.. a technician should simply refer to it as a “Benchmark High”. The daily and 10-minute charts (Figures 7-8 & 9) of the Dow Jones Industrial Average illustrates how a benchmark low can act as temporary support.

Figure 7-4 Support is: a Former Top 7-3 . The next time down on the 10-minute chart the cash Dow stopped exactly at 8570. support.The supposed “support” was only slightly violated with the 8562 low on a 10minute price bar (Figure 7-9). The chartist’s “bible” Technical Analysis of Stock Trends. this low will be taken out .overhead resistance.fine. Specifically. . Think of support in two words . by Edwards and Magee is still the best source of a definition.underlying support. is above the current price. This trader must realize that if a healthy price downtrend trend is in progress. If an aggressive short term trader wants to label a benchmark low price as possible temporary support . if any. is a more classical definition of support and resistance? First. Resistance is always . . The next time down the Dow moved thru 8570 like a knife thru warm butter. if any.usually quite dramatically. . Resistance. The selloff had reached “support”! (not really). A former price high (or top) should be underlying support in the ensuing price uptrend. See Figure 7-4. resides below the current price level. To find support. a chartist looks down and to the left on a chart and locates the closest former price high. W hat then.

See Figure 7-5. the more likely the resistance will hold. in theory. Quotes may have to eat into support or resistance until they get to a level where a sufficient amount of prior trading occurred . To find resistance. should be directly proportional to the amount of dealing previously done at that particular price level. the more likely the support will hold.to finally produce the friction necessary to stop the price move. The strength (ability to halt the price move) of the support or resistance. Figure 7-5 Resistance is: a Former Bottom Traders are obviously interested in what will happen as quotes ‘test’ a benchmark high or low.A former price low (or bottom) on a chart should be overhead resistance in the ensuing price downtrend. 7-4 . a chartist looks up and to the left on a chart and locates the closest former price low.or that a price sell-off has to bounce off a price level that stopped a sell-off previously. It is important not to harbor a preconceived notion that a price rally has to stop at a price level that it (temporarily) stopped at before . The lower the volume on the rally to test resistance. Relating volume to this concept: The lower the volume on the price sell-off to test support.

7-5 .Putting support and resistance into practice: Traders wishing to initiate a new long position would place the order to buy at a price slightly above the support price. A good definition of “slightly’ is two minimum price fluctuations. The stop must be placed beyond this noise. It does not require a sophisticated computer package. It changes the trend to neutral. Protective stop orders should be entered far enough into support or resistance so the price move would have to inflict an inordinate amount of damage to the support or resistance before the trader would get knocked out of the market. Another important note: Simply violating support or resistance (with a close into it) does not automatically change the direction of the prevailing price trend 180 degrees. It is far easier to make this statement than to quantify it. Locating support and resistance on a chart is an age-old technique. And. the stock index futures in particular. Traders wishing to initiate a new short position would place the sell order at a price just below (2 tics) the resistance price. It is an excellent place to begin the analysis of any new chart. The proliferation of undercapitalized day-traders makes for this phenomena. are notorious for eating farther into support or resistance than any other market. the price should not end in zero. The public gravitates to common. all too common. Make any sell order end with a price of 4 or 9. Make any buy order end with a price of 1 or 6. Some markets. Additional technical evidence must be present to warrant entering a new position. Every market has it’s daily ‘noise’. prices ending with zeros.

Example of Underlying Support Airtouch Communications Common Stock Daily Chart Figure 7-6 7-6 .

Example of Overhead Resistance Figure 7-7 7-7 .

Daily Figure 7-8 7-8 .Dow Jones industrial Average (cash) .

10 Minute Figure 7-9 7-9 .Dow Jones industrial Average (cash) .

Blank 7-10 .

alert a trader where things are going wrong. close bar chart. 8-1 . These market moving decisions are also reflected in the price. In the move toward 24-hour electronic dealing. low. if available. the price will show it. is an important aspect of any chart . they repeat themselves often enough to allow the technician to make a future forecast based upon past price patterns. Also affecting the price movement is activity by speculators who utilized information other than fundamental supply/demand data. the ‘opening’ price is also recorded on the graph. This course manual primarily contains examples of futures charts.Chapter Eight Price Pattern Recognition Overview The high. often carry specific measuring objectives . If fundamental forces are at work moving the market. Price Pattern Recognition Price patterns that tend to appear regularly on a classical bar chart are one of the most valuable tools for a technical trader. The rationale behind the use of price charts is that all the supply and demand information has to be synthesized into a single piece of information . Volume. They divide themselves into two distinct groups: Reversal patterns or continuation patterns. most importantly. Open interest on a daily futures chart is also a helpful aid in assessing the validity of a price pattern.especially a daily high. Although some of the decisions may be based on hopes. Only a handful of orthodox price patterns exist. by Edwards & Magee. greed. low and last price for a specified time period are the basic inputs for a classical bar chartist.price. such as psychological judgements. there is some question about the benefit of the next day’s open when it happens a nanno-second later than the previous day’s close. These patterns indicate the high probability direction of the major price trend. such as candle charts.and. Chapters 9 thru 17 detail these formations. In specialized forms of charting. Reader desiring more illustrations of individual equity charts are referred to the classic: Technical Analysis of Stock Trends. fears.

often this is best accomplished when the market is not open. Create a trading plan based on the bar charting conditions that exist. 4. 6. sometimes no trade is the best trade. A chartist need not get married to a single market. diversify the analysis.Hierarchy of Bar Charting Analysis 1. 8-2 . 7. determine the measuring objective and the stop-out price level. 8. Locate the closest underlying support and overhead resistance price levels. 3. Look for the possibility that an orthodox price pattern may be present . 5. If an active price pattern is present.or in the process of forming. Do not try to force a conclusion via assuming that a reasonable risk / reward trade must be present. Identify the direction (if any) of the major price trend 2. Check the internal health of the trend by using volume and open interest.

Before a chartist should be looking for any reversal pattern. 2. Before discussing the pattern in detail. there will much less confusion whether the trader is talking about price topping or price bottoming.so there is something to reverse.Chapter Nine Head & Shoulders Reversal Pattern The Head & Shoulders (H&S) price pattern is the most reliable reversal pattern. By using this terminology. technicians should use the phrase H&S Bottom rather than ‘inverse Head & Shoulders’. there are several overall observations: 1. there must be a definite price trend in place . Figure 9-1 clearly shows these five reversals. For clarity. Five obvious reversals of the minor price trend must be present on the chart to form the pattern. This classical bar charting price pattern physically resembles a head & shoulders when found at a market top. when referring to a bottoming of a price trend. It can occur as either a Head & Shoulders Top or a Head & Shoulders Bottom. Figure 9-1 9-1 .

W hen this occurs. It is especially bearish if the volume on this developing right shoulder takes place on volume readings lower than what occurred on the rally for the left shoulder. the chart is really telling the technician that the market is in the process of trying to reverse the major price uptrend. The price decline does not have to stop exactly at the same price level of reversal point two. A price decline that violates support is the first important sign that a reversal pattern could be developing. At this time. the definition of a bull market will continue to be present. And if the item being charted is a futures contract. Note that because the pattern has not been officially activated (with a close below the neckline). total open interest might decline on this final rally. This price decline below the support (which is in the process of becoming the high of the left shoulder) can halt anywhere in the vicinity of reversal point two. Ideally this rally will occur on lower or declining volume. Symmetry (more on this later) would suggest that the high of the right shoulder will be in the general price area of the top of the left shoulder. These first two reversals of the minor price trend will create what will be the ‘left shoulder’ of the completed pattern. The highest price in the pattern will be called the ‘head’. The ability of a technician to properly locate where support should be present is of paramount importance. It is quite possible that extremely high (blowoff) volume might be present on the price move up to form the head. At this juncture in the development of an H&S Top (at a price level near the high of the head). 9-2 . a corrective selloff (from reversal point one) and the subsequent rally to a new price high (off the low of reversal point two) implies that the uptrend is firmly entrenched. the proverbial ‘early warning signal’ will have been flashed. If not. any long positions should be closed out. This is a sign of weakness in the major price uptrend. a classical bar chartist begins to study the graph in earnest. that the selloff from the high of the head must violate the support level. a conservative chartist should not be attempting to pick the high of the right shoulder and trade it via a new short sale. there is no overhead resistance present . If so. Next.Development of a Head & Shoulders Top: In a price uptrend. a price rally (off reversal point four) must occur.only underlying support. If so. It cannot be emphasized enough. This last price rally in the developing H&S Top must stop below the high of the head.

One of the helpful aspects of classical bar charting price patterns is that a definite measuring objective can be derived. Any classical bar charting price pattern is not officially activated until a close outside the pattern is posted. but do these books ever detail how to determine this ratio? Answer: No. W ith this in mind a trader should take partial profits when the minimum measuring objective is reached and look for additional technical signs that a greater percentage of the open trade (short) should be closed. Sounds good.the pattern has worked as expected. 9-3 For sure. the technical trader will know where the pattern breaks down i.Activating a Head & Shoulders Top: The neckline is the 2-point minor trendline drawn tangent to the lows of the price bars at reversal points two and four. Traders should try to follow the old adage of “letting profits run and cutting losses”. What to do at the Measuring Objective: A close below the minimum downside measuring objective in an H&S Top is not required. Once this occurs. most importantly. How Far Will Prices Move: Elementary textbooks about trading often refer to establishing a risk to reward ratio. In the case of a Head & Shoulders Top this must be a close below the neckline. a trader should have been following the market down with trailing .. given the expected price move.e. it is the price at which the neckline was broken. This enables a chartist to gain insight as to what the risk is. Note that this distance is not measured from the close beyond the neckline. price is expected to move a minimum of the vertical distance from the extreme of the head to the neckline as measured from where price penetrated the neckline. And. W ith any active H&S formation (Top or Bottom). As long as price trades below the objective any time during the international 24-hour trading day . These two price lows are the reactions on either side of the head. The style convention for drawing this boundary line of the pattern is a dashed line. fails. the chartist has strong technical evidence that the longer term trend has changed direction.

a decline in open interest (futures only).and additional directional positions can be established. Symmetry: It is amazing how often the Head & Shoulders formation exhibits symmetry with respect to the magnitude of the two shoulders (figure 9-2). to form.protective buy-stop orders. 9-4 When to Enter a Position: After monitoring a market closely and seeing a potential Head & Shoulders . or the posting of one of the four minor trend change indicators (see Chapter 17). time spent during the development of the two shoulders. Pay attention to what happens on the ‘left’ side on the chart because it could be duplicated on the ‘right’ side of the chart. The chartist will also be looking for one of the classical continuation patterns. Additional signs that more open trades should be removed would be blowoff volume. More than one shoulder on each side of the head produces a complex H&S formation (more on this later). If a right shoulder develops. it is the first price signal that H&S Top may be forming. Figure 9-2 If a selloff penetrates this former ² price high. Ideally. Triangle or W edge. Then note the magnitude and duration of the previous reaction. the protective stop would be located well into or above the top of the closest overhead resistance. This would indicate the existing price trend has further to travel . it may prove to be very similar. and the number of shoulders.

might see price trading beyond a neckline within the price bar.88% reliable). 1. 9-5 Additional considerations: It takes time to reverse a price trend. An aggressive short term trader. A sharp reaction then takes price back within the pattern. Since the close of the price bar was not beyond the neckline. whipsaw. The suggestion is to construct a ‘failsafe trendline’ to gauge where a chartist should become worried about the pattern not working. This line is drawn tangent to the extreme of the head and the right shoulder. the less likely a pullback will occur. It takes discipline to wait for the penetration of the neckline and the confirmation of high volume if it was an upside breakout from an H&S Bottom. it is very tempting to ‘lead off’ and establish a position prior to the official breaking (close below) the neckline.pattern developing. W hether or not a corrective price pullback (rally in the case of the H&S Top) will take place is the age old question that causes difficulty for a chartist. A pullback to the closest overhead resistance. A look at the various possible shapes of a Head & Shoulders formation (Figure 94) shows that it is impossible to make a blanket statement concerning when and where to establish an initial position. Note that the protection slides down (is tightened) with time. Where to Place the Protective Stop: Any H&S formation is not destroyed until the extreme of the head is taken out. 2. This is as it should be with any protective stop order. Establish a 50% position on any closing penetration of a valid neckline. Read. slightly worse than one to one. the formation was not set off. Even though the H&S formation is a highly reliable pattern (86 . The five reversals of the minor price trend . But. The higher the volume associated with any breakout. A pullback to just below (2 minimum price tics) the neckline. this is not an attractive risk to reward ratio. placing a protective stop higher than the high of the head in a Head & Shoulders Top results in a risk to reward that is. Establish the remaining 50% position on: A. The following is a reasonable strategy. The protective buy-stop would be placed just above this downsloping line on a Head & Shoulders Top pattern. Volume can be a useful aid. monitoring intra-bar price activity. by definition. This is a dangerous practice. or B.

It pictures the influx of new information or moods that are necessary to change the direction of the trend. This time frame is most suited for the interpretation of volume and open interest on a futures chart. not the dutiful analysis of volume and open interest (the latter being impossible on an intra-day chart). volume is not usually a consideration.in a Head & Shoulders formation represent the battle between the forces of supply and demand. Most of the charts in this manual are daily. For the day trader. And for the long term position trader. The H&S formation ‘works’ on any time frame chart . the new fundamental inputs are what drive prices. Figure 9-3 H&S Top 9-6 Every Head & Shoulders has a Different Shape .from minutes to months. For the extreme time frames of minutes or months. it is the speed of execution that is important. high-low-close bar charts.

Figure 9-4 9-7 Head Shoulders Top & on a Weekly Chart .

9-8 Head & Shoulders Bottom . Believing the pattern on the Zinc chart produced the correct directional view for this metal.LME It is interesting to note that Zinc was in a major bear market during the same time frame that Gold and Silver were setting new all-time highs.Figure 9-5 Zinc .

2. total open interest would ideally increase on the upside breakout. the sophisticated fundamental traders doing enough buying such that. in combination with any technically based traders. The Swiss Franc future in figure 9-6 is an example of a Head & Shoulders Bottom on a daily chart and figure 9-7 is an H&S Bottom on an hourly (Gold) chart. 9-9 Figure 9-6 Head & Shoulders Bottom . should occur on a noticeable increase in volume during that trading session (or price bar). Declining open interest would mean that the price rally was due to net short covering. the minimum upside measuring objective of a bottom is determine in exactly the same fashion. The vertical distance from the head up to the neckline is graphically added to the neckline when a closing price is posted above the neckline. a close above the neckline. Needed is the ‘smart money’. As with the H&S Top. An apparent upside breakout that has been engineered solely by technical traders will not usually generate enough volume to be valid. A classical bar chartist does not trust an upside breakout of any price pattern or 2-point trendline that occurs on less than high volume. Ideally volume on the price selloff to form the right shoulder will be ‘low’ or declining.A valid Head & Shoulders Bottom formation contains two important volume considerations: 1. W ith specific regard to a daily futures chart. Short covering on an upside breakout does not automatically invalidate the breakout. volume will escalate to a distinctively higher level. it does imply a high likelihood of a price pullback (decline) toward the neckline. The upside breakout.

9-10 Figure 9-7 Head & Shoulders Bottom on an Hourly Chart .

Not e the symmetry of three shoulders on either side of the low of the head. 9-11 .

The Fed stopped pegging interest rates and tightened the money supply. The large H&S Bottom depicts this process of increasing long term interest rates and then a bull run in price that continued to set new price highs as late at September 2008 (124-24) on this notional 6% coupon bond.and the back of inflation was broken. Paul Volker was the chairman of the US Federal Reserve Bank at the time when inflation was running rampant.Figure 9-8 Head & Shoulders Bottom on a Monthly Chart This multi-year Head & Shoulders Bottom occurred in the years just after the TBond future began trading. 9-12 Complex Head & Shoulders Formations . Volume is not normally analyzed on a weekly or monthly chart. The left shoulder selloff began with the “October Massacre” in 1979. The prime rate reached a high of 21 1/2% . The ‘growth curve’ upward in volume can be seen as this future gained in popularity as a trading and hedging vehicle.

symmetry. Figure 9-9 Possible Complex Head & Shoulders Top 913 . Most complex H&S formations tend to exhibit symmetry in the number of price gyrations seen on either side of the head.The term complex refers to the fact that ‘two or more of something’ is found in the pattern. Or it could be Double Top for the head. A chartist does have to be aware that any H&S formation cannot be expected to retrace more than the price move that preceded it. This was the problem with measuring objective on the Copper chart at the end of this Chapter. Multiple measuring objectives are possible if several necklines exist. There is no technical reason that the largest obtainable objective should not be considered viable. This could be two sets of shoulders on either side of the head. A chartist should always be thinking .

Figure 9-10 Complex Head & Shoulders Top on an Hourly Chart 9-14 .

Historic Charts Figure 9-11 H&S Top ‘failure to form’ “The most widely advertised (possible) Head & Shoulders Top since Edwards and Magee wrote their book” Quote from a member of the Chicago Board of Trade on the trading floor in 1982 9-15 .

Can Technical Analysis be used in a manipulated market? 9-16 .

Manipulation ended badly Bre-X common stock . Wednesday May 7. Ltd.” 9-17 .in Canadian Dollars Suspended May 8. 1997: “Bre-X Minerals. 1977 Quote from the Wall Street Journal. shares staged a spectacular collapse to near-worthless levels in frantic trading as investors reacted to the news that the company’s supposedly huge gold discovery is really a highly engineered fraud.

Example of a Head & Shoulders Failure 9-18 .

In contrast.Historical Chart The severity of the price pullbacks are what make stock index futures trading so difficult. Often price moves much farther into classical support or resistance levels than any other futures contract. individual equities chart very well. 9-19 Multi-year Head & Shoulders Top .

9-20 Failure of a Head & Shoulders Bottom to Reach .on a Monthly Chart of a U. 2008.S. Equity Index The Dow Jones Industrial Average and the S&P 500 Index also met a Head & Shoulders Top objective on their monthly charts during the week ending October 10.

cannot be expected to re-trace more than the price move that preceded it. the traditional objective at 105. to the neckline break.62 daily high.at 104.Its Measuring Objective . Copper .10 with the 103. The May Copper did ‘attack’ 104. This price extreme is the limiting factor if application of the standard height objective results in a price beyond where the previous price move began. 5.04 was never reached.04. This was higher than where the previous price downmove began . Top or Bottom.May 1992 92 1 Notes .and Why Any H&S formation. resulted in a conservative (arithmetic) upside price target of 105.10.04. Adding the vertical height of the pattern. 100. This was the case in the Copper chart below. But.00.

9-22 .

10-1 . The price volatility associated with any Broadening formation is more likely at a top in any of the physical commodity futures. There is a reversal formation known as a Broadening Formation that contains five reversals of the minor price trend . a. On the currency futures or spot foreign exchange charts the volatility could be at either extreme.. there is no specific measuring objective. Although.i. According to the old Edwards & Magee textbook. it would be at high rates . This can be seen on the TBill chart in figure 10-4. One further note. Because the fifth reversal of the minor price trend takes place beyond the extreme of a possible ‘head’. There is no way to know beforehand that a Broadening Formation might be developing.a.just like the Head & Shoulders pattern.e. Patience and knowing that such a pattern does exist (although not frequently) is the first step. a downward sloping neckline when a possible H&S Top might be forming and an upward sloping neckline when a possible H&S Bottom might be forming is a big clue. in an interest rate future.k. Carrying on the notion of where price volatility would be expected. Ken Shaleen. This is what happened on the Yen future in figure 10-3. Price bottoms on the physical commodity future tend to be more ‘rounding’. CHARTW ATCH will suggest using a standard ‘double’ measuring objective using the last two price extremes. A well thought out game plan for an entry into a new position is a must. low prices. it keeps the technician ‘honest’ in not jumping to the premature conclusion that an H&S is forming every time four reversals of the minor trend are in place. This is why it is unusual to find this formation at a price bottom on this type of chart. the pitfalls associated with each particular price pattern are encountered.Chapter Ten Broadening Formations As a chartist gains experience. This technique worked out to the exact point in the Japanese Yen example in Figure 10-3. A theoretical example of a Broadening Top can be seen in figure 10-1 and an actual example in figure 10-2.

Figure 10-1 Theoretical Broadening Top Figure 10-2 Broadening Top 10-2 .

Figure 10-3 Broadening Bottom 10-3 .

Figure 10-4 Broadening Bottom and Complex H&S Top 10-4 .

But what trading usefulness does this have? Should a short (or long in the case of a possible Double Bottom) be taken? The answer is no. CHARTW ATCH must share some historical observations: 1. This negative does not automatically mean that a technician trading this pattern will suffer a loss. Prices must decline below and close below the low point established in-between the two price highs before a Double Top pattern has been officially activated.but the minimum objective is not reached.k. Top or Bottom. Ken Shaleen a. 11-1 .Chapter Eleven Double Top and Double Bottom Double Top The definition is simple. The pattern is more prevalent on a cash or spot market chart where the basis convergence in a futures contract is not continually pulling the future toward the cash price. A ‘double’ formation is not all that reliable price pattern. A new position should not be initiated until the pattern has been activated. Figure 11-1 Double Top Many traders see a price move stop in the same general area of a previous price reversal. Before proceeding with examples. ‘Two price highs at approximately the same price level’ is only one-half of the definition. Often the pattern is activated and some price progress toward the measuring objective is made .a. Proper money management and the movement of a protective stop order can mitigate the poor performance of the pattern. yet the misunderstanding involved with the Double Top is extraordinary. 2. A ‘double’ formation. is not a common pattern on a future or forward chart.

rally in the case of a Double Top. a straight line (a 2-point trendline) is drawn tangent to the two price highs. After the breakout there may be a price pullback. it is easy for a chartist to determine the location of overhead resistance. In a Double Top the vertical height of the pattern is subtracted from the price low in-between the two highs or lows. If so. This is a method of ‘graphically averaging’ the two highs if they are not exactly the same price. The height of the pattern is from the low point in-between the twin highs up to the line. Figure 11-2 11-2 .The measuring objective of a Double formation is straight-forward. To determine the height of the pattern. It is the now former price low in-between the twin highs. This is schematically shown in Figure 11-1. A conservative trader might wish to wait before initiating a new short until a pullback to test the overhead resistance is posted. Note that there was no pullback on the weekly Euro-fx chart in Figure 11-2.

the pullback might not happen. It is always difficult to know whether a pullback is going to be posted. it must occur on a noticeable increase in volume. Price should rally to as far above the high point as the vertical distance inbetween the twin price lows. Because this is an upside breakout. Thus. As usual. A chartist should not trust any upside breakout that takes place on substandard volume.such that a pullback would have to do an inordinate amount of damage to the expected resistance or support level. Once an official upside breakout is posted. a trader has to weight the opportunity loss of not initiating a new long on the breakout.Double Bottom In a Double Bottom. a protective stop should be placed far enough beyond where the classical resistance or support begins . This is schematically shown in Figure 11-3. price must close above the high point in-between the two (approximately equal) price lows before a trading decision can be made. the risk / reward of a new long placed only a pullback is better but. W ith either the Double Top or Bottom. there may or may not be a price pullback following the upside breakout. Yes. the upside measuring objective is clear. Figure 11-3 Double Bottom 11-3 .

Double Bottom and H&S Bottom on ‘non-storable’ commodity futures charts 11-4 .

look at where the pullback stopped . After the downside breakout from the Double Top. Note the typical open interest action in the transition from a bull to bear market.This is a classic chart. 11-5 .at the overhead resistance.

11-6 . Time erosion caused the price of the 70 strike T-Bond Call option to decline much farther than the pullback after the price decline into the Double Bottom occurred on the chart of the underlying instrument. A trader should do all the technical work on the chart of the underlying instrument .No Because an option is a ‘wasting asset’ the bar charts do not lend themselves to classical price pattern analysis.Should Price Pattern Recognition be Applied to Options Charts? Price plot of June 70 Call option Price plot of underlying instrument June 1985 T-Bond future The answer to the question posed above is .and then pick an options strategy suitable for trading that pattern.

continues. a significant directional price move ensues. Valid Symmetrical Triangles In the ‘art’ of classical bar charting. the Symmetrical Triangle formation is the premier continuation pattern. This means that the prevailing price trend that was in progress prior to the triangle forming. after which. Note that this new price move can be in either direction . 10-1 . It is created by a net sideways price movement on the chart.Chapter Twelve Continuation Patterns The Symmetrical Triangle Formation Figure 12-1.but there is an overwhelming tendency for a valid triangle to act as a continuation pattern.

Valid Symmetrical Triangles shows the ideal bearish and bullish formations. Remembering this simple rule will keep a trader from incorrectly assuming that a valid triangle is present. Any triangle is not an active pattern until a closing tic mark is posted beyond one of the boundary lines.Most of the time markets are trending. 5 minutes to monthly. The lower boundary line must slope up. (More on this later.although this occurs in less than 25% of the cases. Shape: It only takes two points to define a straight line. the upper boundary line must slope down. It ‘works’ on all time frame charts . The major price trend is not continually reversing from bullish to bearish and then reversing again. Two converging line segments form a proper Symmetrical Triangle. it is not surprising that this pattern is the most common of all bar charting formations. Four reversals of the ‘minor’ price trend are necessary to create the two converging boundary lines..e. An Incorrect Interpretation shows how a bad mistake can be made. It is the lower probability case where the triangle acts as a reversal pattern that keeps a chartist ‘honest’ by not always taking a directional position within the pattern prior to the breakout. The more likely outcome in Figure 12-2 is a Head & Shoulders Top rather than a Symmetrical Triangle as a bullish continuation pattern. the word symmetry is important. Figure 12-1. Figure 12-2. Note that this pattern can be a reversal pattern .) Where to Locate Reversal Point One: The first reversal point (1) in any valid triangle is always at a relative price high in a bull market or at a relative price low in a bear market. If the Symmetrical Triangle is best classified as a continuation pattern. 12-2 . it leads to a continuation of the prevailing price trend approximately 75+% of the time. Directional Considerations: W hen this formation occurs on a high-low-close bar chart.i. The two lines intersect at the apex of the triangle. Although the definition of a Symmetrical Triangle is not so strict as to require that the triangle be equal lateral (line segments of the same length) or equal angular (same angle for each converging line). One side of a valid Symmetrical Triangle should not even approach twice the length of the other side. Each line must slope in a different direction.

A chartist should not use a microscope. This is common sense. Because the price swing near reversal points 1 and 2 are greater than the price swings near reversal points 3 and 4 it is not surprising that volume would typically be greater at the beginning of the net side ways price movement. 12-3 . looking for nuances in volume within the consolidation pattern. The downsloping line overlaying the volume in the chart of Exelon common stock (Figure 12-3) is a reasonable example of how volume contracts within a symmetrical triangle. An Incorrect Interpretation Volume Within the Triangle: A general statement can be made with respect to volume within any triangle: It usually moves irregularly lower.Figure 12-2.

Figure 12-3. Exelon Common Stock 10-4 .

Breakout Volume: One of the first things that any novice bar chartist learns is that
a valid upside breakout from any price pattern should occur on a noticeable increase in volume. This is due to the idiosyncrasy of the trading public to prefer to be on the buy side rather than on the sell side. A low volume upside breakout is not to be trusted. Figure 12-3, Exelon Common Stock shows volume of 2,807,400 shares on the ‘second breakout’. Although this was not a major jump in volume, it was higher than the ‘first breakout’ from the inner Symmetrical Triangle. The section on Re-drawing the boundary lines later in this chapter explains what happened with the two triangles that formed.

Downside chart breakouts (a close beyond the lower boundary line of the triangle) do not have to occur on increased volume. Often volume increases a trading session or two after a downside breakout. This is because the market is making it painfully aware to the bulls that they are ‘long and wrong’. The undercapitalized longs are forced to liquidate their losings positions; volume increases during this panic exit.

Location of the Breakout: Another vital consideration of any triangle breakout
is its location with respect to time The breakout cannot occur too far into the pattern. Too far is defined as more than 3/4 of the horizontal distance from reversal point one to the apex. If a breakout is posted beyond this 3/4 distance, the triangle loses its’ effectiveness. Anything can happen. Price could move up, down, or sideways.

Measuring Implication: The majority of classical bar charting price patterns
utilize the vertical height of the pattern to gauge the future extent of the price move. This convention is also applied to the triangle formation. The vertical height of any triangle is always measured at reversal point 2 to the opposite boundary line. This is true whether the triangle is found in a bull or bear market. This distance is added to or subtracted from the price of the boundary line on the price bar which posted a close outside the triangle. This is minimum distance price is expected to move. Figure 12-3, Exelon Common Stock shows that the vertical height of the largest Symmetrical Triangle measured straight up from the 59.75 low was 1.87. Adding this distance to the 60.76 breakout price yielded an upside measuring objective of 62.63. This arithmetic objective was met.

10-5

Old time chartists often use a graphic method of obtaining an objective. This takes the vertical height of the pattern and moves it over to the breakout. Note that this method of obtaining an objective will result in the same objective if the price scale used is arithmetic. Use of a logarithmic scale for price will result in higher absolute upside objectives and not as aggressive downside objectives compared to an arithmetic scale chart. Futures traders use arithmetic price scales and equity chartists tend to use logarithmic scales.

Pullback?: The question of whether or not a price pullback (after a valid breakout)
will occur is always difficult for a chartist to answer. Volume may provide some insight. For sure, a technical trader must keep the size of any position small enough to withstand the adversity if a substantial price pullback occurs. After a valid breakout, underlying support (for an upside breakout) is created at the price level of the breakout. Additional support should be present at the boundary line just penetrated (Note that this line is moving farther away during a pullback). Support should also be present at the price level of the apex. There is nothing special about the location of the apex in time, after a breakout. The last bastion of support (again, in the case of an active bullish pattern) is the opposite (lower) boundary line of the triangle. A violation of the opposite boundary line or its extension beyond the apex, even intra-price bar, officially destroys the triangle. This last support (line) gives the technical trader a worst case scenario for the triangle - with it still ‘working’ as expected. Thus, in theory, the protective stop order should be placed just beyond the opposite boundary line. The good news is that this stop order is continually ‘tightened’ as time passes.

Reliability: An educated guess as to the reliability of an active Symmetrical
Triangle meeting it’s minimum measuring objective is 76 - 78%. This probability is about 10 percentage points below the reliability of a valid Head & Shoulders formation. The H&S pattern (top or bottom) is the most reliable of all classical bar charting price patterns.

10-6

Redrawing the Boundary Lines: A ‘fact of life’ concerning the triangle formation
is that sometimes reversal points 3 and 4 have to be relocated. This usually happens when the two boundary lines of a possible triangle converge too quickly. This is shown in Figure 12-4, Re-drawing the Boundary Lines.

Figure 12-4, Re-drawing the Boundary Lines

The more difficult case (of having to relocate the boundary lines) is contained in Figure 12-3, Exelon Common Stock. Exelon did experience what looked like a valid price breakout to the upside on October 10. Admittedly, volume at only 2,268,300 shares was not impressive. The price move up after the breakout did not exceed the first point in the triangle. Then, a severe price pullback(decline) occurred; the pullback entered the triangle and destroyed the formation by violating the opposite(lower) boundary line. However, the extent of the pullback did not take out reversal point two (59.75). An ensuing price move in the direction of the major price trend (up) created the conditions where a second set of reversal point 3 and 4 were present. 10-7

It is this sometime problem of re-locating reversal points 3 and 4 that drops the reliability of the triangle formation below that of a Head & Shoulders reversal pattern. Another Method of Obtaining a Measuring Objective: A chartist can also construct a ‘parallel objective line’ to construct a reasonable triangle measuring objective. The line begins at reversal point one and increases/decreases at the same angle as the opposite boundary line of the triangle. The market would then be followed by a trailing protective stop order. Figure 12-5. a chartist could plot both targets. existing positions can be partially liquidated. W hen the closest target is reached. Another method of obtaining a Triangle measuring objective 10-8 . This is shown in Figure 12-5. It became a viable Symmetrical Triangle. Another method of obtaining a Triangle measuring objective. This line is derived from a point and an angle. The assumption is that price will touch this parallel objective line. To resolve the dual techniques of obtaining a triangle measuring objective. It is a secondary objective. continuing to use the original points 1 and 2.Re-drawing the two boundary lines on the Exelon chart. resulted in a larger triangle.

long or short only trader must wait for the breakout before entering a new position. The price move could go much farther. If the next two reversal points create the proper conditions for a Symmetrical Triangle . If both lines slope in the same direction. Other Continuation Patterns: If either boundary line is horizontal. The market must simply trade at or beyond the objective any time during the international 24-hour trading day. the pattern that forms is a relatively rare variation of the triangle. This results in an Ascending (bullish) or Descending (bearish) continuation pattern. Note that a close beyond the objective is not required.the risk / reward parameters for a directional trade appear. There should be a profitable trade ahead . declining open interest (for a futures contract) or a Key Reversal price posting (a minor trend change indicator) would prompt a trader to remove 100% of all directional positions. The Right Angle (90E) form of triangle is found more frequently on cash (spot) market charts than on futures charts. This is due to basis convergence that is constantly occurring on any futures chart. A trader is trying to follow the old adage of letting some profits run. W hen two reversals of the minor price trend are present. They are both continuation patterns. Conclusion: The Symmetrical Triangle is a common bar chart pattern.but patience is required. the technical trader receives a ‘get ready’ signal. And. the resulting pattern is a Rising or Falling W edge.What to do when the Measuring Objective is Reached: As the economists say “all other things being equal”. A ‘plain vanilla’. The reason that 1/4 of the trade should be kept open is because of the word ‘minimum’ used in conjunction with the measuring objective. Examples of right angle formations and wedges are located in chapters 13 and 14. The market ‘wants’ to penetrate the horizontal line. food for thought: A trader equipped with a knowledge of option strategies has a much larger arsenal of positioning techniques within a Symmetrical Triangle prior to the breakout. 3/4 of the long or short position should be closed out when the height measuring objective is met. Sometimes two entities that tend to move in the same direction with one another will exhibit a Symmetrical Triangle on one chart and a W edge pattern on the other. all or nothing. This is the narrowing of the difference between the cash price and the futures price as time passes. a 90 degree angle is present. 10-9 . Additional technical factors such as blowoff volume. yet still converge.

NYMEX 10-10 .Example of a Symmetrical Triangle Crude Oil .Dec 2008 Light .

a right angle. . Figure 13-1A Ascending Right Triangle . The expected direction of the breakout is thru the horizontal boundary line of the pattern. . the same number of reversals of the minor trend (four) are necessary before the two converging boundary lines of a Right Triangle can be constructed. . The two forms of Right Triangles are shown in Figures 13-1A&B. As a variation of a Symmetrical Triangle.Chapter Thirteen Right Angle Triangles A Right Triangle is so named because one of the boundary lines is horizontal. is a bullish pattern (price will ascend out of it) Figure 13-1B Descending Right Triangle . and a 90-degree angle is present . is a bearish pattern (price will descend out of it) 13-1 .

This idiosyncracy is based on the outside public tending to favor trades on the long side of any market. Assessing the theoretical risk in any new trade is of paramount importance. as usual. If not. could then lead to the measuring objective being met . This is such a favorable ratio. The risk parameter in a trade based on any active Triangle pattern is a price move beyond the opposite boundary line.where constant basis convergence between the futures and cash market is not present. the initial protective stop loss order would ideally be placed slightly (say 2 minimum price tics) beyond the sloping boundary line. It will be a risk of 1 to a reward of 3. a gap down.on the same price bar as the breakout! 13-2 . figure the approximate risk to reward of taking a directional position within a Right Triangle prior to the breakout.to the other side of the Triangle. In a Right Triangle. The reward parameter of any Triangle pattern is the same. that a trader will want to place this position every time a Right Triangle is present. Because the expectation is that price will breakout thru the horizontal boundary line. Right Triangles are likely to be more prevalent on a cash or spot chart . by the vertical height of the pattern. Be careful. And. As an experiment. Note that this is in contrast to waiting for the breakout from a Symmetrical Triangle . markets tend to fall faster than they move up in price.The risk and reward parameters in a Right Triangle are distinctly defined. Thus. a chartist / trader can ‘lead-off’ by placing a directional position within the Right Triangle prior to the breakout. As with the Double Top or Bottom formation. Right Triangle are relatively rare patterns on forward or futures charts. Price is expected to move beyond the boundary line penetrated. This height is always measured from reversal point two . it is important to place short positions within a possible Descending Right Triangle prior to the breakout.even though the high probability (75-80%) is for the Symmetrical Triangle to act as a continuation pattern. thru the lower boundary line.

cending Right Triangle Eurodollar Time Deposit Futures June 1989 (Objective was met) 13-3 .

13-4 .Ascending Right Triangle US Treasury Bond future Dec 1982 The time period during which the Symmetrical Triangle formed is examined on Point & Figure chart in Chapter 18.

A chartist can place both objective on the chart .but the traditional height measuring objective was met. 13-5 .Descending Right Triangle The parallel objective line on the Cotton chart was not reached .and begin removing positions when the first objective is reached.

Notes

13-6

Chapter Fourteen Wedge Formations

A W edge formation is a continuation pattern. Price is expected to continue in the same direction it was going when the W edge began to form. As with the premiere continuation pattern, the Symmetrical Triangle, a W edge requires four reversals of the minor trend for the two converging boundary lines to be constructed. A W edge begins its development in similar fashion to the Triangle; however, the fourth minor reversal of the trend is such that both boundary lines slope either up or down.

Rising Wedge
A Rising W edge is a bearish pattern. Both converging boundary lines slope up. A close below the lower boundary line of the Rising W edge activates the pattern. The objective is to take out the lowest point in the formation (reversal point one). A schematic diagram of a Rising W edge is shown in Figure 14-1.

Figure 14-1 Rising Wedge

14-1

Figure 14-2

Rising Wedge - Gold, Dec 2008 NY

14-2

Figure 14-3 is a schematic diagram of a Falling W edge. A close above reversal point one is not required . A high volume close above the upper boundary line is necessary to activate the pattern.Falling Wedge A Falling W edge is a bullish pattern.only an intra price bar move above it. Both converging boundary lines slope down. Figure 14-3 Falling Wedge Figure 14-4 Falling Wedge Plywood futures 14-3 . Note that high volume is necessary to validate the upside breakout from the Falling W edge but is not necessary (although ideal) on a downside breakout from a Rising W edge. The minimum upside measuring objective of a Falling W edge is to take out the highest point in the pattern (reversal point one).

Falling Wedge on the Gold / Silver Ratio Monthly Chart 14-4 .

14-5 .Rising Wedge Soybean Oil March 1981 Note the quote from the Edwards and Magee book. The Rising W edge is a very powerful sign that a bear market is in progress.

14-6 .What if a boundary line is very close to being horizontal? W hen a boundary line is so close to horizontal that there is a question of what pattern is developing. additional charts of markets that are thought to move in concert must be analyzed.

In an uptrend. Flags occur within the course of a ‘rapid. the Flag is composed of several narrow range price up days.Chapter Fifteen Flags & Pennants ‘The Flag Flies at Half Mast’ A Flag is a dynamic and potentially very profitable price pattern. Figure 15-1A Flag in a Bull Market Figure 15-1B Flag in a Bear Market 15-1 . the ‘body’ of the Flag slopes downward. In a price downtrend. straight-line’ price move. several low volume small range down days produce the body of the Flag. They mark a half-way. resting place before the prevailing trend resumes. Figures 15-1A&B show a theoretical Bull and Bear Flag. breath-catching. Flags normally slope against the trend.

Notice this nuance in figure15-1B and the actual application on the Silver chart in fig. The beauty of a Flag is that the risk is small compared to the expected reward.On a daily futures chart. it is not a common pattern. This because a limit move that trading session is frequently the result. The suggestion is not to look for this formation on intra-day charts. This will make the 10 minute chart ‘look’ like a possible flag pole is present. Therefore. Three caveats: 1. the body of the Flag seldom lasts more than five trading sessions before a resumption of the trend occurs. 3. One hundred percent of all existing positions predicated on the Flag pattern should be removed once it has reached its minimum measuring objective of duplicating the rapid straight-line price move that preceded it. Historical observation has shown that once a Flag objective has been reached. Everything moves faster when the item is listed as a futures contract. Therefore. 15-3. Any trailing protective stop order would more than likely be executed. ideally there will no price activity in the price range of the Flag for quite some time. the trader will know quickly if the newly placed position is a winner or loser. Be careful. a 10 minute chart. Flags work best on daily time frame charts. Because of the dynamic nature of a Flag pattern. a quick trading decision is necessary. On an individual equity chart. a violent price move in the opposite direction often occurs. A proper Flag will not be found within a trading range. and is not faced with an agonizing wait for confirmation of the wisdom of the trade. There should never be a ‘pullback’ (reaction) back into a Flag pattern after a valid breakout. Look to the left on the chart. 2. After moving net sideways for several price bars is there another shock variable to sent the market an equal distance away? Usually not. In addition. The reason is that a shock variable (from an economic report) will cause a financial future to move swiftly on say. a conservative method of obtaining a downside measuring objective is to measure down from the high in the body of the Flag instead of from the Flag breakout. the body of the Flag can extend up to weeks in duration. 15-2 . A Flag should really only ‘fly’ in new life-of–contract high or low ground. W hen an apparent breakout is occurring. No market can go below zero to the downside. a trader should take profits at the objective and try not to give back the significant gains that were made in so short a time period. a chartist will ‘want’ to find this pattern as often as possible.

Also note that because this commodity is bounded by zero on the downside.Dec 2008 New York Figure 15-3 Note that the start of the flag pole on the Silver chart in figure 15-3 began at the breaking of a 2-pont trend (the two points used to construct the line are off the chart to the left). The measurement always starts at a previous breakout. The measurement did not start at the relative price high of 1809. 15-3 .Bear Flag Silver .80 point flag pole distance from the 1523 high in the body of the Flag on this arithmetic scale chart. a conservative measuring objective subtracts the 265.50.

Example of a Flag Failure Four trading sessions later 15-4 .

Bull Flag 15-5 .

S.Comparison of Hourly and Daily Charts U. Treasury Bond futures June 1985 Hourly Daily 15-6 .

Chapter Sixteen Gap Theory 16-1 .

Four Types of Gaps 16-2 .

16-3 .

Graphical Summary 16-4 .Gap Theory .

Suspension Gap 16-5 .

Dividend Gap 16-6 .Ex.

Island Formation 16-7 .

Island Top Chesapeake Energy Corp (CHK) 16-8 .

Gap Theory Exercise Gilts Dec 1995 Classify this gap See the next page for the answer and ‘how it came out’. 16-9 .

How it Came Out Gilts Dec 1995 (Two days later) Because the close was within the trading range. 16-10 . It was closed the next trading session. the gap was a Pattern Gap.

Suspension Gaps Suspension Gaps.until the chart package programmers add a considerable amount of sophistication to their algorithms. 16-11 . within a 24-hour bar will only appear on a hand constructed chart . See page 2-7 for a mechanically reproduced Corn chart.

it had to be re-classified as a Measuring Gap. Also see the Corn chart on the previous page and the mechanical version on page 2-7.Nov 1999 Because the Triangle objective had been met. 16-12 . W hen it wasn’t quickly filled .Gap Analysis Soybeans . the gap between 435 and 440 initially looked like it could be an Exhaustion Gap.

If one of these one-bar indicators is then posted. and a minor trend change indicator appears. If the minor price trend is down (three consecutive lower highs). Key Reversal Inside Range Outside Range Mid-Range Close It must be emphasized that these configurations are helpful in gauging only what might happen the next trading session. 3. In fact. a higher high is expected. the expectation is that the next price bar will register a lower low than the indicator’s price bar low. If there are three higher highs. 17-1 Key Reversal . There are four of them: 1. often ask: How can bar charts be utilized for their type of dealing? One of the answers to their query lies in the short term forecasting significance of minor trend change indicators. e.Chapter Seventeen Minor Trend Change Indicators Market participants with short term trading horizons.g. 2. day traders. The first step in applying any of these indicators is the identification of the direction of the ‘minor’ price trend.but this assumption must not be given too much weight. Note that nothing is being predicted for the location of the next price bar’s close. A technician will examine the previous three price bars. the minor trend is considered to be up. the next trading session could even be the next major world time zone! As such. they change the minor trend in the opposite direction for as little as one price bar. Figure 17-1 Key Reversal. The end of a major price move could be signaled by one of the minor trend change indicators . 4.

A failure would mean that a higher high was set. however.as long as the pattern is not destroyed. It might. 17-2 Why should these price configurations work? . a trader should not overlook their significance on an hourly or weekly chart. but this is asking for too much. should be posted. is a new high and a lower close. The example continues with the second price bar after the Key Reversal setting the expected lower low. Regarding it as minor trend change indicator will allow for the construction of a much safer trading plan. It forecasts a lower price low. It must be noted. But neither did this next price bar cause the K-R to ‘fail’. This means that several price bars could be posted before the objective is achieved . figure 17-2 contains a Key Reversal (K-R) at a price high. The Inside Range that was posted after the Key Reversal simply perpetuated the original indicator. after a series of lower price activity. A Key Reversal Low. But. The Key Reversal on a daily chart is one of the most widely known yet least understood reversal pattern.The definition of a Key Reversal High. A high percentage of traders jump to the erroneous conclusion that a Key Reversal marks the end of a major price move. As an example. Note that the next price bar. Figure 17-2 Key Reversal that ‘worked as expected These one price bar reversal indicators tend to work best on daily bar charts. after a series of higher price activity. implies that a higher high should be set. The expectation was that a lower low. did not achieve this objective. the minimum measuring objective inferred by any of the four minor trend change indicators is fulfilled during the next price bar. Figure 17-1 depicts both of these conditions. that a more rigorous definition of ‘worked as expected’ means that the objective was reached before the one-bar pattern is destroyed. The pattern worked. In most cases. after the K-R. than the K-R.

In the old open outcry environment in the futures markets this required access to a knowledgeable source down on the trading floor for a guesstimate of volume activity during the trading session. W hen using a daily high-low-close bar chart.for at least one price bar. Key Reversal on a Daily Chart Several additional criteria are important to the understanding of the Key Reversal phenomenon. then down and then finally up in the last hour of trading. The analogy of a ‘see-saw’ is applicable. The forces previously in control of the market are losing momentum but opposing forces have not gathered enough strength to turn the trend.before the late move in the opposite direction. evidence of a Key Reversal early in the day is more likely to result in prices making another violent move to a new low or high .They all indicate that the forces of the bulls and bears have reached an equilibrium. Price was down. with on-line volume. trading off a presumed Key Reversal early in the trading day can be extremely hazardous. 17-3 Anatomy of a Key Reversal . a technician does not trust a Key Reversal that occurs on ‘average’ or ‘low’‘ volume. More often. has made the interpretation of this valuable internal variable much easier. Thus. Seldom does a Key Reversal make itself evident early in the dealing day. 2008 in Figure 17-3. then up. Note the “anatomy of a Key Reversal” on the daily & hourly charts of the NASDAQ-100 future on October 10. The move to electronic trading. high volume will result. but the rival forces are about to gain the heavier weight to move prices in the opposite direction . Thus. the price move to a higher or lower close occurs in the last 20 minutes of trading. Both sides are in balance (temporarily). Volume Considerations By generating the wicked price gyrations. the tide will turn in the next price bar. often expanding the range for the day several times in both directions.

NASDAQ-100 eMini Dec 2008 future October 10. 2008 Figure 17-3A Daily Chart Figure 17-3B Hourly Chart 17-4 Open Interest Considerations W hy does a Key Reversal take place? Because the losers are finally giving up! .

This situation results in open interest declining. By the same token. The change in open interest will not be known during the trading session. For example. This is shown in the diagram on the left in figure 17-4. the bears have not gathered enough strength to reverse price to the downside by generating a lower low.so price plummets. In the example above. after three or more higher highs. Both sides liquidate. the silence is deafening” There are no more buyers . This will take prices down the next price bar. and finally surrender . The forces are in balance. the loser is getting to the sidelines. The participants with the correct market judgement going into that trading session are taking profits. It is likely that the momentum will shift to the bears for as short a duration as one price bar.usually the next price bar. he old adage on an open outcry trading floor was that: “When the last weak short is finished buying. an Inside Range appears. the next bar’s low is expected to be lower than the price bar that formed the Inside Range. Inside Range W hen an entire price bar’s activity is contained within the previous bar’s price range. Thus. The prior minor tend direction is expected to be reversed . it generates an Inside Range.at any price. Confirmation of the drop in total open interest will not be known until the next day. resulting in a lower low than the Inside Range price bar.They are forced to wait (sweat) almost all day with their losing positions. The rationale is as explained previously. the bulls have been in control of the market but cannot force price to a higher high during the Inside Range. a technician does not trust a Key Reversal if open interest increases. 17-5 Figure 17-4 Inside Range . just to get out.

Outside ange A widely swinging market resulting in a price range where the high is higher and the low is lower than the previous price bar’s activity is known as an Outside Range. This is shown in figure 17-5.usually the following price bar. if only temporarily. It is expected to reverse prices . R Both supply and demand forces are evident. Figure 17-5 Outside Range 17-6 Mid-Range Close . but it appears that the forces are becoming more balanced and the prior trend will be interrupted.

Figure 17-6 contains examples of Mid-Range Closes.W hen prices close equidistant between the high and low of the price bar. say. W hen it does happen. An example would be the Eurodollar Time Deposit futures. the trend previously in progress was not dominant going into the end of trading for this time period. This is ok. Figure 17-6 Mid Range Close Ther e some markets in which it is ‘too easy’ to post a Mid-Range Closes . W hat if the close is. An exact Mid-Range Close is impossible.at least for one price bar . a MidRange Close is formed. by default. Seldom does the close of the day land in the middle of the range. Often the daily range is so small that.and therefore the indicator should not be trusted as much as normally would be expected.via moving prices in the appropriate direction beyond the range of the Mid-Range Close price bar. the close is close to a mid-range. the indecision that surfaced that trading session is likely to result in a reversal of the minor trend. The opposite type of market would be the stock indices. And the market trades in one-tic minimum increments. The theory that the market is trying to change its short term direction should still hold. A technician should look for the opposing forces to gain the stronger hand . 17-7 Locate the Minor Trend Change Indicators on this Chart . 24 tics under the high of the price bar and 25 tics above the low of the same price bar. Traders did not know where to close prices. There is an excellent probability that an adverse move against the minor trend is about to occur.

daily 1 78 17-8 .and record whether or not they ‘worked’ as expected Nickel. LME 3-month.

Oscillators. Try to be aboard every new emerging price trend. How could a single trading advisor be knowledgeable about the fundamentals affecting the 40+ actively traded futures contracts at that time? The answer is that he could not.Chapter Nineteen Mathematical Models . There are two diametrically opposed mathematical approaches the directional traders could use: Trend Following vs. the next chapter will discuss the Oscillator concepts. Unlike the next influx of commodity funds just after 2000 that were long only ‘index funds’ touting physical commodities as an asset class. The rational is: 1. A good estimate is that 90% of all managed money in the futures market that is traded as a fund uses a Trend Following system. Relative Strength. 2. They could be long or short. Momentum. 3. Follow the old adage of allowing profits to run while cutting losses. This chapter will discuss trend following techniques. Utilize diversification to limit risk. 19-1 . Their proliferation was of such magnitude that hundreds of millions of US Dollars was being traded by these funds.Trend Following Historical Overview The mid-1970's saw the creation of ‘commodity funds’. the first crop of funds were ‘directional’. This latter category has numerous additional subtitles such as Over Bought / Over Sold. and Stochastics. The trading advisors turned to mathematical models for entry and exit signals for the futures in their portfolio. Often the traditional commodity funds were operated by a very small number of traders.

the slower the average moves relative to the market itself (because each individual piece of data has less impact). because stock indexes have. plot each day’s moving average calculation (or whatever time period is being used) on a bar chart. a 200-day moving average has traditionally been popular in analyzing stock market trends. For example.or shortterm view of the market. such as 5. Price data from the oldest day (or period) in the average is dropped (i. moved rather slowly and stayed in long-term trends. for a simple 10-day moving average. Although traders could use computers to calculate moving averages based on every single price quote for a desired time period. and resulting in an easier-to-read picture of price direction A Simple Moving Average A simple moving average is merely the arithmetic average of price data during a pre-determined period of trading. add all the closes for that period (10 data points) and divide by 10. intermediate. and connect each point with a line to get a smoothed version of the price action.or 10-minutes.e. A moving average distills market action into a single line on the chart. and the average "moves" or fluctuates with the market (but at a slower pace). smoothing out the sharp peaks and valleys that usually occur in futures (or equity) price movement. Then. and that time frame would be of little value if the goal is identifying current trends. not used in the new calculation) and the new day’s data is used instead. technical trend indicators can help confirm that a market is in a trend. Thus.. 19-2 . until recently. A moving average is recalculated every day. most just use the closing price. The more data included in the average (generally meaning the longer the trading period). For example. Analysts determine the time period. One of the best and most commonly used trend indicators is the moving average. although they can be calculated for very short time periods. But 200 days are an eternity for the futures markets.to 40-day range. to calculate a simple 10-day moving average. only the most recent ten days’ closing prices are used.Trend Following Even though it’s possible to see sustained price trends just by looking at a chart. or the amount of data. The most popular futures moving averages generally fall in the 10. The time frame also depends on the type of markets being studied. used to calculate a moving average based on whether they’re seeking a long-. the eleventh day is dropped.

a downtrend is broken if prices close above the moving average.The plot of a simple 10-day moving average using the daily closing price has been placed on the daily chart of the Dec 2007 Euro-fx future. Identifying Trends Analysts have come up with all sorts of rules and conditions to determine whether a market is in a trend — but. An uptrend is considered broken if prices close below the moving average. This provides the basis for a ‘trading system’. basically. 19-3 . It’s the opposite for a downtrend. a market can be considered in an uptrend if prices are above the moving average line and the moving average itself is trending higher.

" For example. however. a practice that is called "optimizing. this tells the analysts that in this market a 40-day moving average is a better trend indicator. W hen that happens a moving average that had been giving fairly accurate trend signals might suddenly become "obsolete" while another moving average based on a different time period could exhibit a better fit. Traders must keep in mind that markets often change character and volatility. in an uptrending market. 19-4 . prices might consistently bounce off of the 40-day average but consistently violate the 20-day average. They occurred when the long term price downtrend was in the process of changing to a long term price uptrend. This type of "optimization" is not without pitfalls.In practice. In nicely trending markets such as the June 2007 Canadian Dollar future. Note what happened to the simple 10-day moving average on the Dec 2007 Euro-f`x futures chart when price moved net sideways in a triangular consolidation. a 40-day moving average only had two whipsaws. technical analysts often experiment with more than one moving average (computers make this easy) to see which one "fits" the price action best.

If all three averages are moving higher. it’s a good bet that the market is in an uptrend.Using Multiple Averages Since a single moving average doesn't always give a clear indication of the trend. and a trend follower might trade less aggressively or stay out of the market until all the averages come into agreement. 19-5 .and long-term trends. 18. If there is divergence among the moving averages. An example of a chart with three moving averages plotted on it is the June 2007 Swiss Franc future. intermediate. Analysts commonly work simultaneously with a 9-. for example two are moving higher but one is headed lower.and 40-day average to track short-. then some judgment is required. technical analysts often use a combination of two or three averages that move at different speeds (calculated based on different time periods).

but suffers the disadvantage of signaling positions to be taken well after a trend has begun. and this can create a false trend reversal signal. even if this is not warranted by the fundamentals. and often a component of trend-following systems used by futures fund managers. one that indicates a trend change sooner but with fewer false cross-overs. technical analysts have tried to diminish the error potential by weighting the averages. a violation of the 40-day moving average can trigger significant liquidation of trend-following positions. W ith this approach. such as the ones mentioned above. they attach more importance to the most recent price data. Traders. this approach does involve a fair number of incorrect signals and whipsaw losses. that the averages themselves can become the source of significant support and resistance. Using longer term averages (say a 20. before deciding which moving averages to track. For example. Deciding which two averages to use is up to the individual trader and also poses a dilemma. must be very clear on whether they’re looking to capture short-. All of these methods attempt to shift the position of the moving average relative to the actual price movement so as to get a better trading signal. Weighted Moving Average Since any combination of moving averages will result in erroneous signals to varying degrees. Other techniques for limiting error include exponential "smoothing. However. intermediate.and a 40 day) generates fewer false signals and fewer whip-saws. accordingly. the 40-day moving average is so popular as a trend indicator. and calculating an average of averages. Conversely. Using two shorter term averages to generate cross-over signals (say a 4.or long-term price moves and how much risk they’re willing to take. Always keep in mind that a moving average is a lagging indicator which gives a signal after the underlying market has embarked on a new trend.and 8-day moving average) has the advantage of signaling quick changes in market direction and enabling a trader to take a position early in a trend.So many traders follow some of the moving averages. that prices often rebound or fall from that average due to the sheer number of traders entering positions against that level. and this choice poses a larger risk per trade than the shorter-term approach. believing that "what's happening now" is more significant than what happened previously. 19-6 ." offsetting the averages (shifting the moving average line to the right on the chart).

In practice. Already discussed is the fact that analysts/traders often "optimize" moving averages. an optimized average may not work well beyond the "test" period. a fairly simple process with computers and one that can help limit the number of false trading signals over a selected period of price action.The dashed line on the Dec 2007 Japanese Yen future is a weighted 10-day moving average. But because markets are volatile (exhibit large or small price swings). Notice how it reacts slightly faster to price changes than the simple 10 day average. simple moving averages can work just as well as jazzed-up versions. 19-7 .

it’s considered a double indication that the trend is changing. 19-8 . Note the chart example of the Sept ‘07 New Zealand Dollar future. This line was broken at the same time as the downward crossover of the price and moving averages.Moving Averages & Trendlines Analysts also use moving averages with other trend indicators such as trend lines or oscillators to improve the reliability of the trading signals they get from the averages. If prices violate a trend line and the moving averages also give a crossover signal in the same direction. It contains an important 3-point upsloping trendline.

Trend Following Funds Managed money has become a major factor in commodity markets since the late 1970's. Even though fund managers know this and try to design trading systems using different trend indicators (including some pretty esoteric stuff). These types of charts are easy to construct by hand. whenever a trend changes. implying that the trend is healthy and may have further to go. It provides a pretty good proxy for fund-trend following buy and sell activity.e. since momentum usually shifts before the trend does a change in momentum can help anticipate a change in trend. everyone gets a signal regardless of the technical method they’re using and the rush of buying or selling that occurs often creates a big move in the market. but the math-challenged need not worry since moving average divergence indicators are included with most charting software packages. i. Moving average divergence is sometimes tracked on a type of chart called a histogram (a type of bar chart) but is more often plotted against a zero line. Thus. if the value of the fast moving average is above the slow moving average. The impact of the collective actions of the trend following funds can be particularly pronounced when a market is changing trend. the difference between them (subtract the value of the slow moving average from the fast moving average) is a positive number and is plotted above the zero line. traders can get a feel for where concentrated fund activity might take place by watching the 40-day moving average. This difference. the price momentum is increasing to the upside. These managers typically use technically-based trend following systems (unless they are a ‘long only’ commodity index fund). If the fast moving average is below the slow one. For example. In other words. Moving Average Divergence Another way to use moving averages is to keep track of the difference between two averages. if a market is in an uptrend and a short-term moving average is rising at a faster pace than a longer term average. they still often enter and exit markets at about the same time.. or "divergence". Large sums that are now invested with fund managers. is an indicator of a market’s momentum. More importantly. the divergence is a negative number and is plotted below the zero line. Although most managed funds use sophisticated technical systems. 19-9 . the difference between the short-term and long-term average is widening.

19-10 .The Sept 2007 British Pound futures chart contains a simple 10 day and 21 day moving average. At the bottom of the chart the difference between the two averages is plotted as a histogram.

The trader is looking for a reversal of the price trend. 13 hours or 13 days to calculate the resulting number. short) position. 20-1 . The indicator can be calculated over any number of discrete periods. In general.. An active futures trader rarely uses more than 13 periods . There is nothing magic in these threshold levels. W elles W ilder. the trader will want to take an opposite (i.g. Momentum.e. This output from the RSI or Stochastic model will be a number that can vary between 0 and 100 but it will never reach either extreme. Personal computers and plotting packages have made their use widespread. A technician has to back test the model to determine suitable parameters. Note that the RSI remained in neutral territory while the price of the British Pound moved net sideways within a triangular consolidation. The theory is that if a trader can identify a market that is in an overbought condition. Overbought / Oversold. The ‘trick’ is to set the parameters that constitute overbought and oversold. a category exists that tries to locate price levels where the existing price trend could be in the process of exhausting itself. W ilder suggested a 14 day period and parameters of 70 for overbought and 30 oversold in the equity market examples. The calculation of these indicators is simple arithmetic. Using threshold levels of 80 and 30 on the 9-day Relative Strength Index for the Dec 2007 British Pound future produced a successful short sale (when the Index when above 80) and a buy (when the Index went below 30). Pioneering work in the field of mathematical models was the book New Concepts in Technical Trading Systems.e.as the markets change their characteristics. In it. Stochastic. And even these are unlikely to be optimal . They strive to locate ‘overbought’ and oversold’ levels on a price chart.Chapter Twenty Mathematical Models . Note that this type of model is diametrically opposed to the trend following models. The Relative Strength (RSI) and Stochastic models are two of the most popular.Oscillators Among the myriad of mathematical models. by J. Some of the specific names for these models are Relative Strength Index. this type of model can be referred to as an oscillator.

20-2 .

moved up above 84. technicians have worked with not pulling the trigger on a new position unless a ‘failure swing’ occurs. Rather.A Caveat Simply shorting a market when an indicator breeches a supposedly overbought level is a path to ruin. 20-3 . Note that the Dec Euro set a new price high . The 9-bar RSI moved above the overbought threshold of 84.but it was not capable of pulling the 9-hour RSI above the level marked ‘A’ on the chart. W hen this signal occurs it is not unusual to have a divergence between what price is doing and what the indicator is doing. The next push by the indicator into ‘over’ territory is watch very closely. and then moved down below 84. it is difficult to determine an effective stop loss point when a market is in a runaway mode. The entry signal just detailed was present on the hourly chart of the Dec 2007 Euro-fx future after the price run up. dropped back below 84. A general observation can be made: 17 consecutive profitable trades could be wiped out in one huge loss . This last move down was the short sale entry signal. the trader watches for a pullback in the indicator back into neutral territory. And. If the indicator fails to go to a new extreme and then moves back into neutral territory again . In an attempt to create a safer entry into a position.where the value of the indicator continues to move farther into extreme overbought territory as a price move of unprecedented proportion takes place. This means that a trader does not automatically place a new position when the indicator enters ‘over’ territory.this is the time to enter.

20-4 . Traders are always trying to refine their ability to construct risk and reward parameters. And unlike classical bar charting where a measuring objective is present from an orthodox price pattern.W hether this does provide a safer entry signal is open to conjecture. an RSI or Stochastic model does not provide a price target.

Relative Strength Example Hourly Chart 20-5 .

How it Came Out 20-6 .

A ‘Get Ready’ Signal on a 9-Week RSI 20-7 .

‘How it Came Out’ The failure swing and divergence led to a sizable price rally. 20-8 .

Chapter Twenty-Two Spreads & Spread Trading The bailiwick of old time commodity futures traders were the grain and oilseed spreads. lent itself to spreading . yes C. W hy trade spreads? A. That is: All the hopes. The price of one arbitrary item cannot be subtracted from the price of another arbitrary item and expect that the plot of the spread differential would/should act in classical fashion. A trader has to do a minimal amount of fundamental analysis . Before listing some spreading considerations in the form of an outline. B. the overwhelming premise for a chartist must be stated.most of which contain a price pattern.the price. Lower risk? Not necessarily. ‘Staying power’? .where the trader was long something as well as short something. Attractive margins? .in futures. The reader is encouraged to examine the chapters that follow.and come to the conclusion that enough traders are paying attention to the specific relationship between the two items in question. I. The different seasonal factors plus the fact that distinct crop years existed. In the case of a spread. on classical bar charting and then return to this chapter and then look at the various spread charts . Overview 1. and moods are reflected in once single item . traders must be paying attention to the specific differential between two prices. This form of trading also has a place in the modern markets. fears.Sometimes 22-1 . If so. the spread should be charted.

ever! II. W hat is a cross? A division. Do not spread to protect a loss . different location 4. may imply only a temporary ‘technical’ bull move is occurring. Aid in trading outright positions? . Spread indicating tightness of supply (or the opposite) ii . Proper mentality toward profiting from a spread = think the difference only 3. Perishable Futures Contracts 1. Definitions A. 2. W hat is arbitrage? Exactly the same product. W hat is a straddle? A spread B W hat is a switch? A spread C. 22-2 .and be eligible without re-inspection for delivery. Bull spread not working.Definitely i. the futures must be one which can be accepted on delivery when the near-by (long) contract matures . one currency into another. when the more distant contract which was sold. Storable vs. neither being the US Dollar E. Definition of a ‘storable’ futures contract To be considered storable. matures.D. W hat is pairs trading? A spread using individual equities D. Picking the best month for an outright position iii.

. Can / should a spread be charted? A. W eighting the legs differently . 2 Gasoline & 1 Heating Oil 22-3 . An example of a spread that should not be charted: the Canadian Bacon spread (Canadian Dollar . Some minimal fundamental analysis must be done to determine the answer.e. Charting a Spread 1. W hat did the NY Merc trade in the ‘old days’? Potatoes ii. Does the plotting software support spread definitions? A. Spreading mentality of old-time CBOT vs. W hy did Crude Oil futures flourish on the New York Mercantile Exchange (and not the CBOT)? i. 4 Hogs B. Soybeans vs. W hich Chicago futures exchange traded predominantly storable commodities and which traded perishable commodities (according to the definition stated above)? The Chicago Board of Trade = storable. Is there a close in the cash foreign exchange markets? No 3. Meal & Oil ii. B.g. 2. 3 Crude Oil vs.Pork Bellies). Three items i. Use close-only prices A.2. B. B. 3 Cattle vs. Is Crude Oil (futures) a storable commodity? No III. W hich futures close to use? ‘Pit’ close. CME members A.

Spreads tend to ‘trend’ vs. Order Entry 1. A ‘flat’ on spread chart = a minor trend change indicator. Backwardation = inverted market V. Indicate a specific (limited) spread differential B. ‘Inverted’ market: Near-by trading above back month 3. Near-by minus more distant month (inter-delivery spread) B. C. Difference in Dollar value: Second named item is subtracted from the first named item (inter-commodity spread) 5. Contango = normal market B. See any of the various ‘current’ charts IV. Do not ‘leg’ out of a spread 22-4 . ‘Normal’ market: Near-by trading below back month 2 . Place order as a spread order: A.4. Do not ‘leg’ into a spread. British terms: A. Plot: A. create classical price patterns 6. Definitions 1.

Stop placed on the volatile leg vs.if calling the CBOT open outcry floor (‘Buy’ is on the left side of the order pad) 3. execution is at 17. State long leg first .g.July Corn spread is quoted as 16 ½ to 17 (premium July) B. Market order to buy Dec .dangerous but necessary B. C. Last trade prices vs.. Interest rate traders (at the introduction of T-Bond futures) used negative numbers (if applicable) 6. Use of protective stop (loss) orders A. Spread chart C.2.sell July arrives. enter limited order at 16 3/4 (split the difference) 7. W hen to exit . CBOT floor traders traditionally used positive numbers (‘or better’ is always implied) See Order Entry Example 4. Money management ii. Electronic spread entry places premium or discount on near-by contract. 5. e. ‘Mental’ stop . Market order to buy July . ‘dead leg’ of the spread D. A. Determined location of stop based on: i.sell Dec arrives. D. Better strategy for either side. execution is at 16 ½. Dec .when the trendline is broken or (partially) when objective met 22-5 . where the spread is really trading.

Do not buy last market to trade limit-up D. How to compute ‘full carry’ i. Limit price moves (future is locked limit up or down) A. 2. short deferred A.negligible.very low for an exchange member v. Storage cost (0. Interest cost Could be bankers acceptance rate. B. Can use options to determine where futures are trading.if applicable 22-6 . Reward is unlimited 3. Forward pricing A.2% or prime. Insurance cost . fed funds + 1 3/4 . Commissions . “most often ignored” iv. Available only in storable futures contracts where calculation of carrying charges is possible. C. Limited Risk Spreads 1.as of April 2008) iii. Risk is limited to move to ‘full carry’ B. Do not sell last market to trade limit-down VI. The ‘basis’ = cash price minus futures price (Basis in grains was unusually unstable (wide) when strong inflow of ‘Index Fund’ money occurred in 2007/08) B. Inspection / handling . Limited risk spread = long near-by vs. or prime +1% ii.8. Can a spread to exit from locked limit position (if any of the other futures contracts are freely traded).15 cent/bu/day or 4 ½ cents/bu/month for a 30 day month .

49. Fallacy of using ‘newspaper’ cash prices . 100 years = 32. Question: How could (did) futures traders speculate on interest rate changes prior to the introduction of short term interest rate futures? (Answer: Storable commodity spreads trading near full carry) 4.C. 48. Obtaining commodity that is not re-deliverable (KC W heat. on a ‘bounce’ 22-7 .19 (Dec 2008 futures). Gold / Silver ratio A.82 (cash) and moving downward on monthly chart ii. Buying cash commodity & unable to get it into position ‘regular’ for delivery vi.ceiling on near-by future Unlikely . Ratio on March 12.as maturity approaches ii. 2008 i. Greater than limit move (down) by expiring future vii. Lumber) v. Tendency for discounts to widen (toward full carry) with the passage of time . Long term ratio (approx. Price rise increases total value of contract & thus financing costs increases full carry iii. Interest rate increase (full carry increases) iv.5 B. Government intervention .don’t do it.but it has happened 3. VII. Some Specific Spreads 1 . Risks in a limited risk spread i.

10% of normal outright initial margin 3. Dow Jones Industrial Average A.C. ‘Ratio’ the spread = “dollar neutral” 5 x 6 or 10 x 11 (using 2007 year end prices) iii. 2 Gasoline & 1 Heating Oil vs. Dollar value of contracts should be approximately equal i. blue chip stocks C.E-mini Dow i. Crack spread: i. Spread = [{Gasoline price x 42} x 2 + Heating Oil price x 42 minus (Crude Oil price x 3)] divided by 3 iii. 95% correlation during majority of trading days B. Could weight the legs and/or plot a Dollar difference chart 2. Spread margin = approx. Spread result is in Dollars/barrel 22-8 . E-mini S&P 500 . CBOT 1000 oz Silver future = close enough to equal Dollar values. ii. CBOT one Kilo Gold vs. One-to-One ii. 3 Crude Oil ii. Both dominated by large capitalization. S&P 500 Index vs.

Soybean Spreads New Crop .New Crop Old Crop .New Crop 22-9 .

A Cross Chart The old Sterling / D-Mark Cross W henever a horizontal line is present on a chart .that is the line that the market ‘wants’ to go thru. 22-10 .

Falling Wedge on the Gold / Silver Ratio Monthly Chart 22-11 .

Notes 22-12 .