CMT LEVEL II NOTES

2022
Prepared by
Shayan Ali from
Sharing is Caring. I have prepared these Pakistan
notes for my self during my study and I
want others to get full benefit. There is
no commercial or any other benefit
hidden. Feel free to circulate it and
encourage others for the importance of
“Sharing is Caring” (Shayan Ali)
Charts: Understanding Data Intervals
01. The opening price of the first trading day of the week is Monday but could be Sunday evening; this depends on the
market and time zone.
02. Monthly chart includes data for all the trading days of the month regardless of how many days in that month.
03. Weekly and monthly charts rarely open or close with the same daily data. They can if the first trading day of the
month is Monday and last is Friday.
04. General rule of thumb is that the data interval for the next shorter timeframe should be no more than one-quarter
of the previous data interval.
05. Not every 60 minute bar is equal. US Stock markets begins at 9:30 am and ends at 4:00 pm Eastern Time. Market is
open for 6½ hours or 390 minutes, so the last 1 hour candle captures 30 minutes.
06. Multiple time frames would not likely be used to measure a stocks volatility. There are generally better technical
analysis tools to use.
07. In a scatter plot graph, you cannot tell when a particular price combination occurred, only that those two prices
occurred simultaneously.

Additional Charting Methods

01. Point & Figure Charting
a. Price is plotted vertically on the left side.
b. The box size determines the minimum price movement (increment).
c. Increasing the box size reduces the amount of noise in the chart.
d. One Point three Box Reversal (1x3) = Every box is made of one point and a reversal is recorded after price
has reversed by at least three boxes.
e. Price is measured on y-axis and there is no time in point and figure charts.
f. Using a 3-box reversal method, a reversal is recorded only when the price has reversed by at least three
boxes from the “last price” marked on the chart.
02. Range Bars
a. Each bar has standard open, high, low and close but each bar is made of a particular price range rather than
a specific time period.
b. Dates are on the x-axis but dates are not evenly spaced on horizontal axis.
c. The high and Close is always the same price.
d. When prices rise by $5, and then another $5, followed by another $5, this is characterized as directional
volatility.
03. Volume Bars (Volume Scaled Charts)
a. It creates one bar or candlestick for a particular number of shares or contracts.
b. Price is measured on vertical axis but volume rather than time will determine the horizontal axis.
c. Equivolume charts incorporate both volume and price.
04. Tick Bars
a. A Tick Chart uses a specific number of trades to create a new bar. If each candle represents 25 Ticks then a
new candle is created for every 25 trades but may have different size or number of shares.
05. Market Profile

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 a. Price is on the vertical axis. Time is represented by Alphabets and Colors.
b. CBOT used 24 capital letters A to X and each letter means 30 minutes of trading activity. These 24 capital
letters from A to X are 12 hours representing from midnight through noon. 24 Small letters or lowercase
letters from a to x are also 12 hours from noon to midnight.
c. The less the letters the imbalance of supply and demand. More letters around any price is considered as fair
price or a balance between supply and demand or in equilibrium.
d. If an imbalance of supply and demand occurs, price will move.

Moving Averages
01. Various Types of Moving Averages
a. Simple Moving Average (Arithmetic Moving Average) = Adding a set of data and then dividing by the number
of observations.
b. Exponentially Smoothed Moving Average = Exponential does not drop off the earliest data. All data is
considered in the calculation. This is to avoid the drop-off effect where signals can be generated because of
the values removed, rather than the ones added. EMA doubles the weight of the current price and applies
the remaining weight to the previous EMA value. The preferred length of an EMA should be 17 Days which
half the length of the dominant market cycle (34 Days).
c. Linearly Weighted moving Average = Gives extra weight to the recent data. Most recent price, in a 10 period
WMA, is multiplied by 10. The previous price is multiplied by 9 and so on.
d. Geometric Moving Average = Mostly used in Indexes. It is a simple moving average of the percent changes
between the previous price and the current price.
e. Triangular Moving Average = Refers to creating moving averages of moving averages. This effectively
emphasizes the weight of the middle of the price series.
f. Variable EMAs = Same as EMA but the weighting scheme is adjusted based on the volatility of price data.
g. MAMA & FAMA = MAMA (MESA Adaptive Moving Average) and FAMA (Following Adaptive Moving
Average). These two are EMAs that adapt to volatility using Hilbert’s Transform based on phase change of a
cycle in data. A buy or sell signal is generated when MAMA crosses the FAMA.
h. KAMA = Kaufman Adaptive Moving Average = Adjusts an EMA for volatility and trend.
i. Wilder Method = It weights the more recent number more heavily.
02. Four Uses of moving Averages
i. Determining Trend
ii. Determining Support & Resistance = When two moving averages cross.
iii. Determining Price Extremes
iv. Giving specific Signals
03. Directional Movement
a. +DM = Positive Directional Movement happens when the current bar’s high is greater than previous bar’s
high.
b. -DM = Negative Directional Movement happens when the current bar’s Low is lower than previous bar’s
low.
c. Inside bars are ignored. For outside bars whichever is the larger, wins.
d. Smoothed +DM and –DM is achieved by a moving average over 14 days using wilder’s method with 14 days
ATR (Average True Range)

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 e. DI+ = Positive Directional Movement Indicator is the ratio between the smoothed +DM and Average True
Range (ATR).
f. DI- = Negative Directional Movement Indicator is the ratio between the smoothed -DM and Average True
Range (ATR).
g. When DI- crosses above DI+ it means downward trend has started. When DI+ crosses above DI- it means
upward trend has started.
h. Wilder suggested an entry stop (buy or sell stop) at the price when the two “DIs” first crosses.
i. Divergence techniques are valid in DMI (Directional Movement Indicator which is made of DI+ and DI-)
j. Negative Divergence = Negative line (Descending Trend Line) on the indicator and Positive line on Bar chart.
It shows Negative trend may start.
k. Positive Divergence = Positive line (Ascending Trend Line) on the indicator and negative line on Bar chart. It
shows Positive trend may start.
l. DX = Directional Index is created by “DIs”.
m. ADX = Average Directional Index is the smoothed value of DX. When the ADX is rising, the market is
increasingly trending in either direction. When ADX begins to rise, it is time to look for entry into the trend.
n. ADX Peaks = When ADX Peaks, it often signals a Peak or Trough in prices. ADX Peaks are used to close
trending positions.
o. ADX Troughs = When ADX Troughs, it signals dormant trend or trendless market.
04. Percentage Envelope = It is developed to reduce unprofitable signals from crossing a moving average when the
trend is sideways. It is calculated by taking a percentage of the moving average and plotting it above and below the
moving average. When price crosses the envelope, it is the trigger for a signal.
05. Bollinger Bands = Bands are also envelopes around a moving average but also adjust for the price volatility around
the moving average. The moving average in the Bollinger band should be used as trailing stop and it is also used as
retracement level for additional entry.
06. Keltner Bands = Also known as ATR Bands.
07. STARC Band = Stoller Average Range Channel also uses ATR.
08. Bands are a method of determining trend and generally not used for range trading between them.
09. Bandwidth Indicator = The difference between the high and low band and plot it as a line below the price action. It is
used for watching the volatility.
10. Donchian Channel = It is constructed by the record of the highs and lows over four weeks (20 days). It is Stop and
Reverse System.

Time-Based Trend Calculations

01. Autoregressive Functions = The technique used for evaluating the direction or tendency of prices both within ranges
or at new levels. Autoregressive function is a statistical process that uses past data to evaluate current price
direction. There is an underlying assumption that past data can be used to predict future price movement, and that
the direction of price today is most likely forecast in the direction of prices tomorrow.
02. Drop-Off Effect = A common way of expressing the abrupt change in the current value when a significant older value
is dropped from the calculation. A large change in the moving average that results from the deletion of early data
potentially generates a false signal and is called the “drop-off effect.”

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Trend Systems (Part 1)
01. Three Reasons why Trend Systems work
i. Fundamental Factors = Long term trends capture large price moves caused by Fundamental factors.
ii. Fat Tail = Prices are not normally distributed but have fat tail. A simple moving average crossover
system and results plotted as a histogram would be used to determine whether a market shows a
tendency toward a fat tail distribution. If the distribution is extended far to the right, then we can
determine that fat tails exist.
iii. Money Flow = Money moves the market. Most trends are supported by the flow of investor funds.
02. Lower frequency data leads to better performance when using a trend strategy. Lower frequency data, longer
calculation periods, and markets that are more closely linked to their underlying fundamentals all perform better.
03. Moving Average Signals:
a. Buy long when prices cross above the trend line. Sell short when prices cross below the trend line.
b. Buy and sell when prices closes above and below the trend line.
c. Buy and sell when the change in the trend line is up and down.
04. Bollinger Bands Signals:
a. Buy long and close Short and Sell short and close Buy long when the Prices close above or below the upper
and lower band.
b. Buy and Sell when prices close above or below the upper and lower band. Close out Longs and Shorts when
prices reverse and close below and above the moving average value (the center of the band).
c. Buy and Sell when prices penetrates above or below the upper and lower band. Close out Longs and Shorts
when prices reverse and penetrates below and above the moving average value (the center of the band).
05. The oil market would be most suitable for bands. Bands are more successful in trending markets and are, therefore,
more suitable for commodities markets than the stock market or other traditional markets.
06. The choice of two standard deviations equates to an 87% confidence band. If price were normally distributed, two
standard deviations would contain 95.4% of the data.
07. Period of High Volatility causes a BUBBLE.
08. 10-Day Moving Average Rule:
a. Construction: Central 10 day HLC Moving Average. Bands based on 10 day HL range.
b. Signals = Buy on penetration of upper band. Sell on penetration of lower band.
c. Positions are always reversed.

Trend Systems (Part 2)

01. The best moving average speed for institutional or commercial participants may be very different from that of an
active trader. The non-commercial trader is not concerned about the frequency of trades, only the return and risk.
For trader or speculator the right moving average is the one that produces the best performance profile.
02. If the uptrend last for 6 months, a 6 month moving average will not see any of it. Use a moving average with a
period less than one quarter of the length of the trend.
03. Tests often show that results are better when the trend line itself is used to generate the signal rather than the
penetration.
04. One benefit of the two trend method is that you are in the market only 50% of the time.

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 05. Golden Cross = When 50 day moving average crosses “ABOVE” 200 day moving average indicating bullish move in
the market.
06. Death Cross = When 50 day moving average crosses “BELOW” 200 day moving average indicating bearish move in
the market.
07. Both the Golden Cross and Death Cross signals have signaled investors of important market turns, thus avoiding
some of the worst declines, such as the damaging declines of 2008.
08. Exiting a trade rather than reversing, adds liquidity by reducing the order size and allows you to enter the next trade
in the same direction as the previous one, instead of always reversing.

Momentum and Oscillators

01. Momentum = Leading indicator of price direction. It is used to identify when the current trend is no longer
maintaining its same level of strength; that is, they show when an upward move is decelerating. And vice versa. One
key advantage of momentum is that it does not have the lag that exists in a moving average. Relative price strength
or momentum is characterized by buying winning stocks and selling losing stocks. Momentum is often used in
countertrend strategies. The market is oversold when the momentum lower bound is penetrated. RSI, MACD and
Stochastics are momentum oscillators. Moving average is “NOT”. Momentum indicators are leading indicators.
02. Rate of Change (ROC) = The change in momentum is called as rate of change. It is also used to describe acceleration,
an increase or decrease in speed. When the rate of change is zero, we are talking about speed and momentum.
03. MACD (Moving Average Convergence/Divergence) = It uses the difference between a 12-day and 26-day exponential
smoothing.
a. MACD Line (faster) = 26 day – 12 day (Exponential Smoothing)
b. Signal Line (slower) = The signal line is a 9-day smoothing of the MACD line (faster) to produce trading
recommendations.
c. MACD Histogram = Signal Line (Slower) – MACD Line (Faster). It is created by subtracting slower signal line
from MACD line (faster). When the histogram is above zero, it confirms the uptrend.
d. The MACD line and Signal Line leads the moving averages.
e. Signals:
i. Buy when MACD Line (Faster) crosses upwards through the Signal Line (Slower)
ii. Sell when MACD Line(Faster) crosses downwards through the Signal Line (Slower)
iii. An equally important use of MACD is for Divergence signals.
iv. To remove whipsaws of sideways market, first let the MACD line (Faster) penetrate the lower band;
then it must signal a new uptrend before a long position can be entered. And vice versa.
v. Divergence Index = The volatility-adjusted difference between two moving averages.
04. RSI (Relative Strength Index)
a. RSI = 100-(100/(1+RS))
b. RSI makes a high above 70 and then forms a low and then makes a second high and if that second high fails
and breaks the neckline, it is a sell point.
05. A positive divergence occurs when price makes a new low while the oscillator makes a higher low.
06. A negative divergence occurs when price makes a new high, but the oscillator refuses to confirm by making a lower
high.
07. Stochastics = One of the few oscillators that uses High, Low and close prices (others use closes). No smoothing to lag.
a. %K (Fastest Calculation) = raw ratio of price in the high/low range. Not used due to its instability.

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 b. %D-Fast (%K-Slow) = Moving Average of %K
c. %D-Slow = Moving Average of %D
d. %D and %D-Slow crossovers at the extremes.
e. The most practical solution is to combine the stochastic signal with the trend.
f. Left Crossover = The Faster %K-Slow which is %D-Fast will usually change direction sooner than the %D-Slow.
g. Right Crossover = When %D-Slow turns first, indicates a slow, stable change of direction and is a more
favorable pattern.
h. Long Signal = Enter Buy Long after the trend has turned up on the first stochastic buy signal.
i. Short signal = Enter a Sell Short after the trend has turned down on the first stochastic sell signal.
08. TRIX = It is a Triple Smoothed exponential used as an oscillator.
a. Signal as a Trend indicator:
i. Buy when the value of TRIX crosses above zero.
ii. Sell when the value of TRIX crosses below zero.

Price Trends and Volume

01. Four Phases of Price-Volume Trends:
i. Strong Demand = When Volume tends to increase during price advances (Bullish)
ii. Weak Demand = When Volume tends to decrease during price advances (Bearish)
iii. Strong Supply = When Volume tends to increase during price declines (Bearish)
iv. Weak Supply = When Volume tends to decrease during price declines (Bullish)
02. Volume analysis is identifying where money is flowing.
03. A lengthy, lackluster downward trend is a characteristic that shows up differently in a weak-supply phase during a
primary secular trend as opposed to any shorter time period. Because buyer and seller apathy grow during the final
phase of the downward trend, the price action doesn’t move much lower. During the closing stages of weak supply,
few holders remain who are willing to sell.
04. Uptrend = State of Accumulation
05. Downtrend = State of Distribution
06. The birth of a new Bull market often begins with wild price swings, mostly to the upside.
07. The lack of supply is a strong indication the security is bottoming. Which implies a bullish outlook.
08. Volume spikes are usually at the end of a trend.

Volume and Breadth

01. On Balance Volume (OBV) = On days when prices close higher, it is assumed that all volume represents the buyers;
on lower days, the volume is controlled by the sellers. Volume is then either added or subtracted from the previous
value. We can look for divergences and we can also use OBV in a moving average as a trend indicator. An upward
trend in Volume is interpreted as a confirmation of the current price direction, while a downturn in Volume can be
liquidation or uncertainty. On Balance Volume is a running total of volume.

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 02. Accumulation Distribution = A concept of buying pressure and selling pressure. Adds (or subtracts) volume based on
the ratio of (Open/Close range) to (High/Low range). This compares the strength of the close compared to the open
divided by the trading range.
03. Volume Weighted Average Price (VWAP) = Examines every tick in the period. Prices are weighted by the total
volume at that price. Large funds or Hedge Funds trade at this price to not “alert” others on what they are doing.
Hedge funds that do not want to force prices higher by placing an excessively large buy order at one point during the
day or even on the close.
04. Breadth = It measures the imbalance between the number of advancing and declining stocks on a given day. It is the
percentage of rising stocks to the total number of stocks traded. In general more advancing issues should add
confidence to an upward price move in the same way that volume confirms price. A net increase in the S&P 500
while more issues are declining should generate concern that the upwards move is poorly supported.
05. Breadth Indicators:
a. Advance-Decline Index = Adding the net of the number of advancing and declining stocks each day.
b. McClellan Oscillator = It starts with the NET Advances (NA) and then creates an oscillator by subtracting two
smoothed trends, 19 and 39 days, based on the net advances, in a manner similar to MACD.
06. Breadth Indicators that combine Volume:
a. Arms Index (TRIN) = TRIN is Trader’s Index. It divides the number of advancing and declining stocks by the
ratio of the volume of the advancing and declining stocks.
i. TRIN = Advancing Stocks / Declining Stocks (Divided by) Advancing Volume / Declining Volume
b. Thrust Oscillator = It is created by multiplying the number of Advancing stocks by the volume of advancing
stocks and subtracting the Declining stocks multiplied by Volume of declining stocks (Divided by) multiplying
the number of Advancing stocks by the volume of advancing stocks and adding to the Declining stocks
multiplied by Volume of declining stocks. The bands of plus minus 30give short term indication of
overbought and oversold period.
07. Interpreting Volume and Breadth Systematically
a. High volume confirms a new price direction; extreme volume on the other hand, is more likely to be a
reversal signal.
b. A volume spike is a day when the volume is at least twice that of other days over a period generally longer
than one month, most likely longer than three months. The volatility spike marks the end of the current
move.
c. Advance-Decline System
i. CHADTP (Connors-Hayward Advance Decline Trading Patterns)
1. CHADTP = [Sum(Advancing NYSE, 5) – Sum(Declining NYSE, 5)] / 5
2. Buy when CHADTP < -400 and the S&P Futures trade 10 basis points above the high of the
previous day.
3. Sell when CHADTP > +400 and the S&P Futures trade 10 basis point below the low of the
previous day.
08. Triple Witching Day = When futures on the S&P, options on futures, and options on individual stocks all expire at the
same time.
09. Force Index = It is constructed using price and volume and is the change in price multiplied by daily volume. When
the Force Index is constructed using the 13-day EMA the signals are given when it crosses above and below zero. The
13-day value is treated as a trend.
10. Patterns in volume have a dominant W pattern throughout the day. They begin high, drop quickly, increase
modestly near midday, fall again, and then increase significantly as the trading day draws to a close.

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 11. Along with the day before a holiday and during the summer, volume can be expected to decline on the first day of
the week.
12. Tick Volume = It can be described as the number of recorded price changes, regardless of volume or size of the price
change that occurs during any time interval. Tick volume is related directly to actual volume because as the market
becomes more active, prices move from bid to ask and from ask to bid more often. Tick volume shows the level of
liquidity and can be used as a substitute for volume.
13. Volume spikes = They are a good example of extremes and the clearest cases for trading. A volume spike is a
warning that something has happened, most likely the result of a surprising news release or new economic data. It is
a very clear, positive action by investors and possibly the public, suggesting that they all hold the same opinion and
feel compelled to act on that opinion at the same time and in the same direction. When there is a volume spike it
generally means everyone has entered the market, there is no one left to buy or sell and prices must reverse.
14. High volume = High volume for any given market is at least 25% above average for the past two weeks.
15. Volume Interpretation:
a. A general rule for interpreting volume data is to watch volume reactions against the trend. Volume reactions
against the trend, in a consolidation will generally be on lower volume.
b. Volume is always higher at the end of the day. Therefore, to use volume to confirm a buy signal, you must
compare volume today against the normal volume for that time of the day.
c. When prices rise, and volume and open interest falls the interpretation is short sellers are covering
positions, causing a rally. Money is leaving the market.

Bar Chart Patterns

01. Generally shorter patterns are more common and less reliable. Longer patterns are more complex and less frequent.
The more complicated and more frequent a pattern, the less likely it will be profitable. The best patterns seem to be
in the middle of complexity and frequency. Once a pattern is widely recognized and acted upon, its effectiveness is
also likely to diminish. Because of this patterns in widely traded securities tend to be less accurate than in those
quiet trading securities that few traders watch.
02. Pattern = A pattern is simply a configuration of price action that is bounded, above and below, by some form of
either a line or curve.
03. Pattern Entry & Exit = The entry describes preceding the formation, and the exit is usually the signal for action.
04. Bar chart patterns are fractal which means they can occur in any bar chart period (time frame).
05. Breakout = A false breakout is one that breaks out in the direction opposite from the direction of the final breakout.
A premature breakout will break in the same direction as the eventual exit breakout.
06. Pullback = It occurs when price break out downward and then “pull back” to their breakout level. More volume is
preferred on downward breakout.
07. Throwback = It occurs when price breakout upward and then “throw back” to their breakout level. Less volume is
preferred on upward breakout.
08. Price Patterns (Bar chart Patterns) = Bar chart patterns form by combining support and resistance zones and trend
lines. In all cases, a pattern finalizes when a breakout occurs from the pattern. Two types of patterns: Continuation
& Reversal.
09. Price Patterns (Set Price Targets) = The target is calculated by taking the height of the pattern and adding it to the
breakout price.

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 10. Double Top & Double Bottom = It consists of only three reversal points: two peaks separated by a trough. Double
bottoms are more orderly than double tops. They are less volatile because double bottoms often represent prices
reaching a level which is low enough for the average investor to realize that there is little additional downside
potential.

11. Rectangle = It much touch roughly the same price level at least twice. During the formation of a rectangle chart
pattern, and there is a shortfall, this would be interpreted as a warning as to the direction of the eventual breakout.

Rectangle with Entry Up and Breakout Up.

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 12. Triple Top & Triple Bottom = Number of touches to the support or resistance line is three.

Triple Top with Breakout Down.

Triple Bottom with Breakout Up.

13. Standard Triangles

a. Apex (Cradle) = the point at which the two lines extend and cross over each other.
b. Base = The distance the first high reversal point and the first low reversal point.

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 14. Descending Triangle = Price should touch each line at least twice.

Descending Triangle with Breakout Down.

Descending Triangle with Breakout Up.

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 15. Ascending Triangle

Ascending Triangle with Breakout Down.

16. Symmetrical Triangle (Coil or Isosceles Triangle) = Price must touch each border trend line at least twice and
meanwhile cover the area of the triangle with price action. Initial target for these patterns is calculated by adding
the base distance to the price where the breakout occurred. A symmetrical triangle is most likely to occur at the
beginning of a trend when there is greater uncertainty about direction. The breakout from the symmetrical triangle
will often mark the beginning of a longer-term trend.

Symmetrical Triangle with Breakout Up.

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 17. Broadening Patterns = Also known as megaphone, funnel, reverse triangle, and inverted triangle. Very risky pattern
due to wide protective stop level because breakout lines are constantly moving away from each other.

Broadening Formation with Breakout Up.

18. Diamond Top = One of the less frequent but profitable. It is combination of Symmetrical Triangle and Broadening
Pattern. It is rare at bottoms. Upward breakouts from a diamond top have a poor performance and should be
avoided. The price objective is usually the distance that the entry price traveled to reach the diamond.

Diamond Pattern with Breakout Down.

19. Wedge & Climax = It is a triangle pattern with both trend lines heading in the same direction. It is a reversal pattern.
Volume declines during the formation of wedges. It requires at least five reversal points be touched to qualify the
pattern as wedge. At a climax peak, when the test is a rising wedge, the odds are extremely high that the breakout
will be downward. A rising wedge suggests that sellers have become more anxious and therefore that the trend line
will soon be broken. Wedges are one of a few patterns that can be consolidation patterns against the prevailing

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 trend, consolidation patterns with the trend, or topping patterns, especially when accompanying a climax. They
occur more often during consolidations but are more dramatic after a climax.

Rising Wedge with Breakout Down from a Climax Peak.

Declining Wedge with Breakout Up from Climax Trough.

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 20. Rounding Top & Bottom (Also known as Saucer, Bowl, or Cup) = Rounding bottoms are more common than
rounding tops. Rounding patterns are longer-term patterns, more easily identified in weekly or even monthly charts.
Short term rounded formations are known as scallops.

Cup or Bowl and Handle Variety of a Rounding Bottom with Breakout Up.

21. Head-and-Shoulders =
a. It combines all three characteristics of a pattern: 1. Trend lines 2. Support or Resistance lines 3. Rounding.
Left shoulder is slightly higher than right shoulder.
b. Upward sloping neckline in top formation produces better performance than the horizontal one.
c. Volume is usually highest on the left shoulder and decreases throughout the formation.
d. Price target is calculated by taking the height from peak of the head to where it intersects with the neckline
and projecting it up or down from the breakout price. When a head-and-shoulders pattern is completed and
a breakout through the neckline occurs, enter the trade and place a protective stop above the peak of the
right shoulder.
e. If the head-and-shoulders top pattern fails before a breakdown through the neckline, then the top of the
head and the top of the right shoulder form the descending resistance line. The support line is the horizontal
lower line which is touched by the bottoms between the peaks. In this case, the failed head-and-shoulders
which has become a descending triangle pattern breaks to the upside when a head-and-shoulder pattern
fails.
f. When price moves above the neckline in a head-and-shoulders top, the pattern has failed. Activity after the
formation of the pattern must confirm the pattern. Failure means that the market has refused to follow
through and therefore it should be traded in the opposite direction. Schwager (1996) has suggested that the
profitability from a failed pattern is often greater than from successful patterns.

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 Head-and-Shoulders Top with Breakout Down.

Head-and-Shoulders Bottom with Breakout Up.

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 22. Flags and Pennants (Shorter Continuation Patterns Also Half-Mast Formation) = The flag is a short channel that
usually slopes in the opposite direction from the trend. The pennant is a short triangle that also slopes in the
opposite direction from the trend. Flag formation occurs over a few days to a few weeks. The best flag is less than 15
days. The breakout of flags and pennants should be expected steep and sharp in the direction of the preceding
trend. The price target is calculated by taking the distance from the beginning of the sharp trend to the first reversal
in the pattern.

Flag and Pennant in Upward Trend.

The Measured Rule (X—U.S. Steel, daily: June 4—December 2, 2013).

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Short-Term Patterns
01. Short Term means a small number of bars. Frequent patterns often give false signals. Short term patterns are useful
for entering and exiting longer term positions at more favorable prices.
02. A “Setup” occurs when certain known factors needed to establish the pattern have occurred and trader is waiting
for the “action signal” to occur. For example if a triangle formation has occurred by rules and correctly it is a setup.
Now we wait for the breakout which is the action signal.
03. A top pattern in a downward trend is meaning less and can be disregarded from consideration during down trend.
And vice versa.
04. A short term reversal pattern should be considered necessary when prices are at some support, resistance or trend
line.
05. Gaps = Gaps occur when either the low of the current bar is above the high for the previous bar OR the high for the
current bar is lower than the low of the previous bar. Gaps often do not occur in market averages that are not
themselves traded for example DJIA but DJIA futures may show gaps because it is a traded security. A sudden failure
in a gap is often followed by a large move in the opposite direction. Spikes are similar to gaps except that instead of
an empty space, a spike has a solid line (in a bar chart).

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 a. Breakaway Gaps (Breakout Gaps) = The most Profitable gaps are those that occur at the beginning of a
trend, called breakaway gaps. It shows that a pattern is completed and a boundary penetrated. Heavy
volume on the upward gap but not necessarily on the downward gap. The Breakaway gap can be a false gap
and that if it is filled, the odds of it being false increase. The best manner of trading breakaway gaps is to
wait a short while for the initial fading or profit taking by the professionals to see if the gap is filled. We want
a breakaway gap to establish a new high for at least the past 20 days and for the subsequent retracement
not to fill the gap. If either of these requirements is not met, the gap is ignored. A buy stop entry is placed
above the high of the next bar from the pivot low. When trading a breakaway gap, a pivot low is the low of a
bar that is surrounded on both sides by a bar with a higher low.

Explosion Gap Pivot. Explosion Gap Pivot.

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 b. Opening Gap = When the opening price for the day is outside the range of the range of the previous day. It
can be recognized and traded immediately. In downward opening gaps, a fill is not as common. If the gap is
not filled usually within the first 30 minutes, the odds of the trend continuing in the direction of the gap
increase. One potential way to profit from an opening gap is to watch the first 3 bars of five minutes and
determine the high and low of this range. If price breaks the 3 bar range toward the fill, the previous day’s
close, the fill line will be the target. If price breaks the 3 bar range in the direction of the gap, it indicates
that the trend will continue in the gap direction.

Opening Down Gap.

c. Runaway gaps (measuring gaps) = Gaps that occur along a trend are called runaway gaps. They appear in
the middle of a price run and the initial distance to them can be projected above them for a price target just
like pennants and flags target calculation. A runaway gap should not retrace back into the gap, or it is not a
runaway.
d. Exhaustion Gaps = Exhaustion gaps occur at the end of moves but are not recognized at the time because
they have the same characteristics as runaway gaps. If a gap is later closed, it is likely an exhaustion gap.
e. Other minor Gaps:
i. Common Gaps = They occur frequently in illiquid trading vehicles. They are of no consequence. A
common gap would be traded by taking a position counter to the direction of the gap, and expecting
the move to reverse and fill the gap. The position should be liquidated if the gap is not filled in a few
days. A common gap is likely to fill and not continue in the direction of the trend. Common gaps are

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 small and they usually occur on low volume for no specific reason. Since they will usually be filled
within a few days, it is possible to trade counter to the direction of the gap.
ii. Pattern Gaps = Appear occasionally within the formation of larger patterns and generally they are
filled. Their only significance is to suggest that a congestion area is forming.
iii. Ex-Dividend Gaps = Appear sometimes in stock prices when the dividend is paid and the stock price
is adjusted the following day. They have no significance.
iv. Suspension Gaps = They occur in 24-hour futures trading when one market closes and other opens,
especially if one is electronic and the other is open outcry. They are meaningless.

Case Study: Apple Computer.

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 06. Spike (Wide-Range or Large-Range Bar) = It is like a gap except that the empty space associated with a gap is a solid
line in a bar chart. It usually occurs intraday. The daily bar would not show the discontinuity from the gap. Spikes
represent the beginning or the end of a trend. At the end of an accelerated trend, the last bar within the trend is
often a spike called “Climax”.

Spike Peak and Buying Climax (X—U.S. Steel, weekly: November 8, 2013– June 26, 2015).

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 07. Dead Cat Bounce = It is a failed rally after a sharp decline. It is easily recognized after a large downward breakaway
gap or breakaway spike. The sudden downward motion is called as “Event Decline”. Ideally the rally should follow an
event decline of more than 20%. The second decline is less intense but equally deceiving. To trade DCB, wait for the
initial sell-off volume to decline and then look for a rally on lesser volume, sometimes back as far as the lower edge
of the breakaway gap. The Short Selling trading requirement then is for a topping of the bounce. For those wanting
to purchase the stocks, the odds are against profiting from a purchase for at least 6 months.

Dead Cat Bounce (HPQ—Hewlett Packard, daily: October 13, 2014– March 12, 2015).

08. Island Reversal = It requires two gaps at roughly the same price. The first in the direction of the trend (Exhaustion
Gap) and the second in the reverse direction (Breakaway Gap). Island reversal can occur at either Top or Bottom of
the trend.
09. One-Bar Reversal = When the trading bar high is greater than the previous bar high and the close is down from the
previous bar close. Also when the trading bar low is lower than the previous bar low and the close is above from the
previous bar close.

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 10. Two-Bar Reversal (Pipe Formation) = Same like one bar reversal but it extends the reversal over two bars. The
second bar closes near its high. The formation in weekly bars is more reliable than daily bars.

Two-Bar Reversal Bottom (or pipe bottom).

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 11. Horn Pattern = It is almost identical to Pipe formation except a smaller bar separates the two lengthy bars.

The Horn Pattern.

12. Two Bar Breakout = If today’s low is less than yesterday’s low and today’s high is less than yesterday’s high and
today’s close is less than today’s open then Buy on a stop one tick above today’s high. Exit on a stop at the then
current day’s low. The sell side is just opposite.

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 13. Inside Bar = An inside bar is a bar with a range that is smaller than and within the previous bar’s range.

Inside Bar.

14. Outside Bar = An outside bar occurs when the high is higher than the high of the previous bar and the low is lower
than the low of the previous bar. When an outside bar closes near a high or low and above or below the previous
close and its current opening, it suggest further action in the direction of the close.

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 15. Hikkake = It is an inside bar signal that fails and becomes a signal itself. Hikake means trap or trick.

Hikkake Buy Failure.

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 16. Knockout Pattern = The first requirement is that an extremely strong and persistent trend must be present. The
stock must have risen at least 10 points in past 20 days. If we think about a linear regression line, the bars should
have a small deviation from that line. Buy after two days of lower lows. Place a buy entry stop at the high of the bar
with the second low. If the next bar is lower, move the entry buy stop to its high until the position is executed. Place
a protective stop below the last low.

Landry KO Pattern.

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 17. Oops! = When the opening price on today’s bar is outside the previous day’s range. A buy stop is then placed just
inside the yesterday’s range in case the market closes the gap, indicating a reversal. Place stop at the second day’s
opening.

Oops! Buy Pattern.

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 18. Shark = it is a 3 bar pattern. It is a small triangle or pennant. It is like finlike shape of the Shark. Buy when the base of
the triangle is exceeded and exit is a trailing stop or a reversal on the opposite signal.

Shark Pattern with Break to the Upside.

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 19. Volatility Patterns:
a. Wide-Range Bar = Its range is VERY wider than the normal bar due to volatility. Emotional spikes and Two
Bar reversals are often wide-range bars.
b. Narrow-range Bar = It indicates low volatility. If the current day has a narrower range than the past three
days, it is called NR4 day.

Narrow-Range Bar.

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 20. Intraday Patterns = The Opening Range Breakout is a popular method. The opening range is the range of a daily bar
that forms in the first few minutes or hour of the trading day.

Opening Range.

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 The ACD Method of Determining Opening Range.

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 21. Candlestick Patterns = These are short term of only one to five bars. Candlestick patterns are often reversal
patterns.
a. Doji = Its performance statistics are low.

Doji Candlestick.

b. Windows = These are simply the western gaps.

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 c. Harami = It is similar to Inside bar pattern. The second candlestick in the Harami is spinning top and if it’s a
Doji, it is known as harami Cross.

Harami Candlestick Pattern.

d. Hammer and Hanging Man = The lower wick is at least twice to three times as long as the body and the
upper wick is small or nonexistent.

Hanging Man and Hammer.

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 e. Shooting Star and Inverted Hammer

Shooting Star and Inverted Hammer.

f. Engulfing = It is similar to an Outside Day Reversal in Bar Patterns.

Candle Engulfing Pattern.

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 g. Dark Cloud Cover and Piercing Line = The pattern resembles the Oops! Pattern in bar chart.

Dark Cloud Cover and Piercing Line.

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 h. Morning and Evening Star = these are Three-bar candlestick pattern. The middle bar is known as a star. The
star has a small body that lies outside the range of the body before it and does not overlap the previous
body at all. A Doji can also be a star called a Doji star. The evening star is similar to the island reversal bar
pattern without the necessary second gap. The third bar closes well within the range of the first candlestick.

Evening Star and Morning Star Candlestick Patterns.

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 i. Three Black Crows and Three White Soldiers = At the time they are recognized, a large portion of the new
trend has already occurred. These are reversal patterns.

Three Black Crows and Three White Soldiers’ Candlestick Patterns.

j. Three Inside Up and Three Inside Down = It starts with Harami pattern.

Inside Down and Inside Up Candlestick Patterns.

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 k. Three Outside Up and Outside Down = It starts with an Engulfing Pattern.

Outside Down and Outside Up Candlestick Patterns.

Single Candle Lines

01. Remember
a. Candle signals give you early reversal or change signals, but they don’t predict future price targets.
b. Doji and candles with small bodies indicate indecision.
c. High wave candles indicate confusion.
d. Candle charting tends to provide earlier signals than those derived from bar charts.
02. High Wave candle = These candle lines must have small real bodies and also long upper and lower shadows.
03. Spinning Tops = It is a small real body wither black or white.

Spinning Tops and High Wave Candles.

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 04. Three Candle lines that contain Spinning Tops
i. Hammer
ii. Hanging Man
iii. Shooting Star

Hammer, Hanging Man, and Shooting Star.

05. Dangerous Doji

Doji.

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 06. Bullish Belt Hold = It is a tall, white candle that opens on (or very near) the low of the session and closes at, or near
the high of the session. When it appears in a decline, it forecast a potential rally. If it appears during an uptrend, it
keeps the bull trend intact.
07. Bearish Belt Hold = It is a long, black candle that opens at, or near the high of the session and closes at, or near the
low of the session. If Doji or spinning top appears, it’s a warning but after that if bearish belt hold appears, it will
confirm the reversal.

Belt-Hold Lines.

Multi-Candle Patterns
01. A two candle pattern begins with the topping or bottoming candles and the next candle confirms the reversal. A
three candle pattern may start with the formation of a candle in the context of a trend, followed by the topping or
bottoming candle. The third candle’s appearance verifies the reversal signal.
02. Piercing Pattern and Dark Cloud Cover = Dark cloud cover forms a top reversal pattern and the bullish piercing
pattern appears in the context of a decline or a downtrend.

Piercing Pattern and Dark Cloud Cover.

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 03. Bullish & Bearish Engulfing Patterns = If the market is solid, the lows of the bullish engulfing pattern should be the
support and place a stop under the lows of the pattern.

Engulfing Patterns.

04. Bullish & Bearish Counterattack pattern = The Bullish counterattack line does not move up into the prior candle’s
real body. Instead it returns to the prior candle’s close. The bearish counterattack line does not move down into the
prior candle’s real body. Instead it returns to the prior candle’s close.

Counterattack Patterns.

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 05. Harami

Harami.

06. Harami Cross (Doji)

Harami Crosses.

Morning Star & Evening Star (Morning Doji Star & Evening Doji Star) Morning and Evening Stars.

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 07. Tweezers = Tweezers consists of two or more candle lines with matching highs or lows. Tweezer tops occur in rising
market when two or more consecutive highs match each other thus giving the two prongs of a tweezers so that
tweezers pinch the trend. Tweezer bottoms take place in a declining market, when two successive lows are equal. As
opposed to the shorter time frames of intraday and daily charts, tweezers tops and bottoms that appear on weekly
and monthly charts potentially indicate important reversal signals.

Tweezers Tops and Tweezers Bottoms.

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 08. Three Black Crows & Three White Soldiers = These are continuation patterns and each candle should close at or
near its high or low.

Three Black Crows.

Three White Soldiers.

09. Windows = These are continuation pattern and same like western gap. A rising window is a bullish signal and a
falling window is a bearish signal. With Rising and Falling windows, there must be a space where candle highs and
lows do not intersect. If shadows or wick intersects, there is no window. The entire space of the rising window is
considered a support and if market closes below the windows bottom, then support has been broken but if price
does not close below the bottom, the support has not been broken. The most important area of a rising window is
the bottom of that window. Same applies to falling windows too.

Rising and Falling Windows.

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Candle Pattern Forecasting and Trading Techniques
01. Tick charts and daily mutual funds can’t have candle charts, since both only have closes.
02. Candles don’t give price targets. If a candle signal confirms a western technical signal. It is like the right hand helping
the left. This is the power of merging Candle and Western charting techniques.
03. Doji = A tall white candle breaks the resistance but after that a Doji, one should consider taking profits, moving up
protective sell stops, or selling calls. For second picture, look at the gravestone Doji which confirms the top and a
trader should consider selling short with that signal with a target to the bottom end of the box range.

Oil Service Index: Daily. (Using candle charts to preserve capital.)

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 Semiconductor Index: Daily. (Using candle charts to confirm resistance.)

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 04. Bullish Engulfing Pattern = the lows of the bullish engulfing pattern confirmed a potential support level set by the
lows made in late January.

Dow Jones Industrials: Daily. (Using candle charts to confirm support.)

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 05. Falling Window with Confluence of Candles = The bearish Falling Window is the resistance zone. At Point B look at
small real bodies (Spinning Tops and Doji). These small bodies tell us that the bulls were tired.

American Express: 60-Minute. (Confluence of candles.)

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 Converse Technology: Daily. (Using candle signals to enter or exit trades.)

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 H and R Block: Daily. (Using intraday candle signals.)

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 H and R Block: 5-Minute. (Using intraday candle signals.) The concept of using a longer time frame (daily) to obtain
support or resistance and then a shorter time frame’s candle (5 minute chart) to place the trade.

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Concepts in Cycle Theory
01. Cause of Mid Cycle Dip is Summation of two cycles.
02. Mid cycle Dip and Dominant cycle develops ¾ Cycle high.
03. Explanation of inversion is amplitude of 2nd harmonic is decreasing and / or amplitude of a larger harmonic is
increasing.
04. Explanation of Inversion is the presence of 3rd harmonic of a dominant cycle.
05. Synchronizing of cycle lows creates V-bottom capitulation price action. The bull goes up the stairs and the bear
jumps out of the window means market tops take more time and take hold resulting in rounded tops and produce
capitulation price action in form of V-Bottoms.
06. 2nd harmonic is half the amplitude of the dominant cycle.
07. Price bottoming early = left translation relative to an expected cycle low. A cycle low in a bull market.
08. Price bottoming late = right translation relative to an expected cycle low. A cycle low in a bear market.
09. Phasing = Process of matching actual price lows to theoretical cycle troughs.
10. Falling VTLs are used to identify when a cycle low has passed.
11. If you drew a VTL connecting two consecutive 25-week cycle highs, a break above this trend line would suggest the
lowest price low within the last 25 weeks is the trough of the 75-week cycle. According to Garrett's model, the larger
harmonic of a 25-week cycle is the 75-week cycle. For connecting two consecutive 10 weeks cycle highs, a break
above this trend line suggests the 20 weeks cycle trough within past 10 weeks.
12. There is no principle of inversion in J.M Hurst seven principles of Commonality.

Applied Cycle Analysis

01. Visual Analysis > Spectrogram > Phasing Dominant Cycle > Phasing Harmonics > Completed Phasing (VSPPC)
02. Cycles are mean reversion tools. Cyclical analysis is more effective in consolidation or trading range.
03. Finding Cycles Tools = Visual Analysis & spectrogram
04. Phasing Cycles Tools = CMA Envelopes
05. Visual Analysis = Highlight Sine Waves by looking for ¾ Cycle highs.
06. Spectrogram = Labeling taller and skinnier Spikes which indicates stronger cycles (The more harmonics are present)
(Dominant Cycle is verified by 2nd & 3rd Harmonics)
07. Phasing larger harmonics is more challenging than phasing smaller harmonics because there is more than one
dominant cycle low that can potentially sync up with the larger harmonic's trough.
08. After phasing the dominant cycle, an analyst can begin to phase harmonics. Smaller harmonics are easier to work
with than larger harmonics because their lows must sync up with the dominant cycle low, per the Principle of
Harmonicity.

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Options
01. Purpose of Options = Hedging, Portfolio Protection
02. Benefit of Options = Leverage
03. American Style = Options that may be exercised at any time up to the expiration date and including the expiration
date.
04. European Style = Options that may be exercised only at expiration.
05. Greeks
a. Delta = measures how much an option price changes from one point move in the underlying. Value ranges
between 0 and 1 for Calls and between -1 and 0 for puts.
b. Gamma = measures the rate of change in Delta
c. Vega = measures the risk from changes in implied volatility
d. Theta = measures the rate of time value decay and always a negative number because time moves in one
direction.
e. Rho = measures the impact of changes in interest rate on Option’s price.
06. Implied Volatility = estimated volatility of a security’s price.
07. Long Straddle Position = utilizing both Call and Put.

Understanding Implied Volatility

01. Implied Volatility reacts to the supply and demand of the market place.
02. Option contracts usually reacts in advance.
03. Implied volatility is not dictated by price of underlying security but dictated by buying and selling of Options contract
(Price of options Contract)
04. If Put prices increase, because of fear of a fall in prices, Calls must also rise. This is Put Call Parity. If the Call did not
rise in value, there would be an arbitrage opportunity.
05. Combining a long stock position with a long put position results in a payoff similar to a call option because it results
in a call option with the same strike price as the put option.
06. One Standard Deviation gives us the range that we are 68.2% certain that the price will be within, in one year’s time.
07. With stock trading at $50 and the underlying option price indicating 20% implied Volatility, the result is “a one
standard deviation price move” equal to $10 which is 20 percent of 50. In other words, the stock is expected to close
between $40 (down $10) and $60 (up $10) with 68.2% certainty a year from today.
08. Single Day Implied Volatility = Implied volatility / Square Root of 252
09. One week Implied Volatility = Implied volatility / Square Root of 50
10. One Month Implied Volatility = Implied volatility / Square Root of 12
11. One Year Implied Volatility = Daily Volatility X square Root of 252
12. If VIX is 11.47%, daily expected move is 11.47 / √252 = 0.72%
Multiply the current value of SPX by daily Implied Volatility
Expected change in the SPX is 2,367 ∓ 17.10
13. According to put-call parity, put and call prices are linked together through the underlying asset price.

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 14. The earnings announcement would cause the implied volatility to be high relative to other periods of time, so a
comparison to the implied volatility behavior around past earnings announcements would be the best way to
determine whether options are cheap or expensive.

About the VIX index

01. When the VIX is quoted at 20, this can be interpreted as SPX options pricing in an annualized move, up or down, of
20 percent over the next 30 days.
02. VIX is the implied volatility of synthetic option created for S&P 500 that expires in 30 days.
03. Inverse relationship between implied volatility (Demand for Put Options) and the direction of S&P 500
04. 30 day movement = VIX / Square Root of 12
05. The put–call parity exists because combining a stock and a put position can result in the same payoff as a position in
a call option with the same strike price as the put.
06. If the VIX is below the SMA by 5% and the market is above its 200-day moving average the odds favor a continuing
upward trend but not necessarily a good time to buy except on throwbacks.
07. This increase in demand is not necessarily the purchase of either all call or all put options but just net buying of
option contracts.
08. The VIX is the 30 day implied volatility of the S&P 500 but it is also expressed as annual figure.

Prospect Theory
01. Utility Theory = If an individual gained $500 and then lost $500, traditional utility would suggest that there was no
change in the individual’s happiness. (NOT Path Dependent)
02. Prospect Theory = If there was enough time between the transactions so that the individual reset their reference
point, they would feel a sense of loss. (Path Dependent)
03. The prospect theory says that investors value gains and losses differently, placing more weight on perceived gains
versus perceived losses because losses cause a greater emotional impact.
04. The Prospect theory describes how people make decisions when faced with conditions of uncertainty.
05. Expected Utility theory assumes individuals will choose the outcome which gives maximum utility given the
probability of outcomes.
06. A problem with wealth-based utility theory is that it is not path dependent. This means that if an individual gains
$500 and then loses $500, traditional wealth-based utility theory predicts that there will be no change in the
individual's level of happiness after both transactions have taken place. Wealth-based utility theory only looks at the
net change in wealth over the course of all decisions to assess the overall impact on utility.
07. Prospect Theory is path dependent.
08. Prospect theory does provide insight into loss aversion and it is a key concept of prospect theory.
09. Loss Aversion = People treat gains and losses differently and are more sensitive to losses than gains. An investor
who feels a significantly larger pain from a $5,000 loss than the benefit from a $5,000 gain exhibits loss aversion.
(Aversion means Dislike)
10. Loss Aversion Ratio = 1.5 to 2.5 which means people feel the pain of loss 1.5 to 2.5 times more than the pleasure of
gains.

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 11. The biggest single limitation of Prospect’s theory is its inability to provide insight into general asset pricing theory.
12. The failure to deal with the emotions of disappointments and regrets are major limitations of prospect’s theory.
13. The S-Curve = Concave (Risk Averse) & Convex (Risk Seeking)
14. For gains an individual’s utility function is concave representing Risk Aversion.
15. For Losses an individual’s utility function is convex representing Risk Seeking.

Perception Bias
01. A perception bias arises when an individual has difficulty figuring out what the problem is that needs to be solved.
02. Saliency = If an event hasn't happened recently, then the perceived probability is zero. If an event has occurred
recently, then the perceived probability becomes overstated. Investors can be fooled into thinking a long-term trend
will continue forever. They downplay the probabilities of a crash because it was so long ago.
03. Framing = The answer to a question changes as it is asked differently, even though it is materially the same
question. Framing exploits our attitude towards bad news/losses. Study shows that all people give different
responses based on framing. A “well” written investment document can influence investor’s perceptions.
04. Anchoring = Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first
piece of information offered (the "anchor") when making decisions. It is a perception bias that arises when you are
attempting to make a guess at something about which you have limited information. Investors that are examining an
indicator signal believe that the few charts that they reviewed are representative of the whole market.
05. Sunk-Cost Bias = The bias from the regret stops the trader from making rational decisions. They will hope the price
goes back down so that they can get back in at the price they exited. After time, the regret fades. Investors fail to
react to clear changes in trend because it would galvanize the mistake of not getting in sooner. An individual who
paid $300 for a theater ticket, realizes that he is no longer interested in attending, but sees the performance anyway
is exhibiting sunk-cost bias. Sunk-cost bias involves feelings of regret.

Inertial Effects
01. Endowment Effect = People ascribe more value to things merely because they own them. Sellers will often value
things at twice what buyers will. Investors refuse to sell an investment that they have held for a long time. Their
valuation of that investment is usually double what the market would pay.
02. Status Quo Effect = A preference for the current state. When there are too many options, & one is the default, they
will choose the default. Investors fail to close out current positions to take advantage of new opportunities. They
prefer to maintain their current holdings.
03. Disposition Effect = The tendency of investors to sell shares whose price has increased, while keeping assets that
have dropped in value. Investors hold onto losing positions while liquidating winners as they do not want to lock in
the loss. They are risk loving with their losers. This is the tendency investors have to close out winning positions
before closing out losers, even if the winning stocks have more potential for future gains than the losing ones.

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Analyzing Sentiment in the Stock Market
01. Insider Activity = Insider buying is more significant than insider selling. Several insiders selling all of their holdings
could be an important bearish signal. Cluster of activity in which three or more insiders either buy or sell are
important signals.
02. A senior executive of the firm increasing his holdings in the stock by 10% over the last three quarters is likely a
bullish indicator when coming from insider activity.
03. The CEO of a listed company increasing his holdings by 40% as he is awarded shares by the firm is not likely a bullish
indicator when coming from insider activity. This increase was part of the compensation plan of the CEO and has
nothing to do with any insider activity.
04. Company policy generally restrict insiders from trading before the release of the earnings to protect insiders from
criminal investigation.
05. The SEC requires corporate insiders and any beneficial owner of more than 10% of a class of the company’s equity
securities – to notify the SEC of all their purchases and sales.
06. Short Interest = It is the total number of shares of a security that have been sold short by customers and securities
firms that have not yet been repurchased to settle out-standing short positions in the market.
07. Short Interest Ratio = An indicator known as “Days to Cover”. It is calculated as aggregate short interest for the
month divided by the average daily share volume.
08. Short Interest Ratio is the sentiment indicator. It is interpreted in a contrarian manner. If short interest ratio is very
high, that means investors are shorting a large share of a company’s outstanding stock.
09. Some analysts view a high short interest ratio as a bullish indicator.
10. Survey Data = The most beneficial way of interpreting data from a sentiment indicator is anticipating a rally when
there are high neutral views. The best contrarian signal occurred not when investors were unusually optimistic or
pessimistic, but rather when they described themselves as being neutral (defined by the survey as expecting stock
prices to be unchanged over the next six months).

Analyzing Sentiment in Derivatives Markets

01. Open interest is the total number of outstanding futures contracts that have not yet been settled by an offsetting
trade or by delivery.
02. Increase in Open Interest indicates the trend is likely to continue.
03. Decrease in Open Interest indicates the trend is likely to reverse.
04. Steady Open Interest is an early warning and not an urgent call to action.
05. P/C Ratio (Put Call ratio) is a sentiment indicator.
06. Put Call Ratio compares the volume or the open interest of Puts to Calls.
07. Put Call Ratio is interpreted in Contrarian manner.
08. An increase in Put Call Ratio will always indicate an increase in put volume and that’s very bearish but is considered
to be bullish in short term. Falling ratios, indicating a reduction in put trading relative to calls, is bearish in the short
run.
09. Put Call Ratio is an indicator that measures sentiment through action rather than surveys.
10. VIX is also called Fear Index. Higher levels of VIX imply that greater volatility is expected within the next 30 days.

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 11. The VIX can identify increases in volatility which could indicate that an option selling strategy is likely to be more
profitable, or volatility levels and changes in volatility levels may impact the calculations used for exit stops in a
trend-following strategy.

Inferential Statistics
01. Descriptive Statistics = It is about describing or summarizing data using quantitative or visual tools.
02. Inferential Statistics = It is built on descriptive statistics to draw conclusions or inferences based on that data.
03. Null Hypothesis (H0) = It is conventional wisdom or status quo at the time of hypothesis test.
04. Alternate Hypothesis (HA) = It is the hypothesis we are trying to prove.
05. We prove our Alternate Hypothesis by disproving the base case (Null Hypothesis).
06. Hypothesis testing is one way of using inferential statistics. The higher burden of proof is always on alternate
hypothesis.
07. Confidence Interval = It is the level of probability that the true value of the parameter falls inside a given interval. An
estimate of the range of possible values for a parameter. If we test our example investment strategy using a 95%
confidence interval, we are setting a bar so that there is at most a 5% chance that a strategy that truly produces zero
excess returns would have produce the same results or better due to randomness in the market.
08. When we reject null hypothesis, the result is considered statistically significant.
09. A usable investment strategy should have both statistical and economic significance.
10. Base Rate Fallacy = Suppose you randomly select a strategy from the database and the test indicates that it is a valid
strategy using a 95% confidence level. What is the probability that it is actually valid? 95% is the wrong answer this
mistake is known as Base Rate Fallacy or Base Rate Bias. Actually there is only 2% probability that it is actually a valid
strategy.
11. Correlation = Association between two variables. -1 for negative 1 for positive correlation and zero for no
correlation.
12. Causation = There is an extremely strong correlation between Amazon and Alphabet shares but Amazon’s move
does not “CAUSE” the price moves of Alphabet or vice versa. It is more likely a third unseen factor that is causing the
price moves in both stocks.
13. Autocorrelation = It describes how a variable correlates itself over time.
14. Regression analysis = It gives us the tools to estimate values for yet unseen data points.

Correlation
01. Correlation = Regression describes the relationship but Correlation describes the strength of the relationship.
02. Correlation Coefficient = measures the strength and direction of correlation or correlation between two variables.
The best method is Pearson’s Correlation denoted by “r” which is obtained by dividing the covariance of the two
variables by the product of their standard deviations. The covariance is the combined variance of x and y from their
averages.
03. Coefficient of Determination = r2 is the square of Pearson’s correlation coefficient. If r = 0.922, then r2 = 0.850 which
means that 85% of the actual variation in y can be explained by the linear relationship between x and y. The other
15% of the total variation in y is unexplained. Higher r2 is better.

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 04. Spearman’s p = The best nonparametric correlation coefficient. The main advantage is that it is not sensitive to
outliers.
05. Pearson vs Spearman = Unlike Pearson’s correlation Spearman’s correlation does not require the assumption that
the variables are normally distributed but like Pearson’s correlation, linearity is still an assumption.
06. Spearman’s correlation looks at ranks as opposed to actual values.
07. Neither Pearson’s nor Spearman’s correlation coefficient are appropriate for non-linear assumptions.
08. Linearity = The formula used when calculating the correlation coefficient between two variables makes the implicit
assumption that a linear relationship exist between them.
09. Normality = Pearson’s Correlation makes the implicit assumption that the two variables are jointly distributed. When
the assumption that the two variables are jointly normally distributed is not justified, Spearman rank correlation
coefficient is more appropriate.
10. Outliers = A single outlier is capable of changing the slope of the regression line and the value of the correlation.
11. Homoscedasticity = A set of random variables having the same variance is called homoscedastic.
12. Means of determining whether a linear relationship exists is to look at a scatterplot of the two variables.
13. Bonds and stocks are positively correlated most of the time. They tend to rise and fall together.
14. Crude oil futures and the S&P Index are usually negatively correlated.
15. Stock prices and interest rates are negatively correlated.
16. The price of gold and the dollar are negatively correlated

Regression
01. Regression = Involves the use of the concept of correlation in predicting future values of one security (dependent
variable), in terms of another (independent or predictor variable).
02. Simple Linear Regression formula is y = bx + a
y = dependent variable b = regression coefficient x = independent variable a = regression constant
03. The regression equation to predict the dollar index in terms of gold is:
y(Dollar) = -0.314 X x(Gold) + 0.083
04. If there is high correlation between the S&P 500 and the Euro Stoxx 50 index (or another index such as the Russell
2000) we can use the linear regression equation to predict future values of the S&P by extending the least squares
or linear regression line into the future.
05. Multiple Regression = In a single regression we fitted a straight line to the scatterplot of points in a two dimensional
graph. In multiple regression, we involve fitting a plane in multi-dimensional space. We want to include predictor
variables that are highly correlated with the dependent variable but have low correlation among themselves.
Intercorrelation among the independents above 0.80 is a problem and may cause system to become unstable.
06. Tolerance = It is (1-r2) one minus the coefficient of determination for the regression of each independent variable on
all other independent variables, ignoring the dependent. There will be as many tolerance coefficients as there are
independents. The higher the Intercorrelation of the independents, the more the tolerance will approach ZERO. If
tolerance is less than 0.20, a problem with multicollinearity is indicated.
07. Assumption of Linearity = Substantial violation of linearity means regression results may be more or less UNUSABLE.
08. Coefficient of determination, r squared, which is the proportion of variance.

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Regression Analysis
01. ARIMA Method = Autoregressive Integrated Moving Average. ARIMA process automatically applies the most
important features of regression analysis in a preset order and continues to reanalyze results until an optimum set
of parameters or coefficients is found. Because it is used to recalculate the BEST FIT each time a new piece of data
appears, it may be thought of as an adaptive process.
02. Autoregression in ARIMA = it is the use of same data to self-predict, for example, using only gold prices to arrive at a
gold price forecast.
03. Moving Average in ARIMA = This process uses an exponential smoothing technique.
04. Autocorrelation in ARIMA = It is used to determine to what extent past prices will forecast future prices.
05. Success of ARIMA = It depends on two factors. 1. High correlation in the Autoregression. 2. Low variance in the final
forecast errors.
06. If the ARIMA process forecasts an uptrend and prices fall below the forecast value, the market can be bought with
added confidence.
07. A natural application of linear regression is to measure and compare the strength of one market against another.
The slope of the linear regression, measured over the same time period as the market we are comparing, is the
perfect tool for ranking or comparing a set of markets.
08. The slope of the regression is a component of a linear regression that allows for ranking a set of markets. The
strongest and weakest stocks are determined by the slope of the regression. The strategy should be to buy the
strongest stocks and sell short the weakest, or sell short the strongest and buy the weakest.
09. Because the linear regression line passes through the center of price movement during a steady period of rising or
falling prices, a lot of buy and sell signals could occur. Therefore, to reduce the frequency of signals, and also to
avoid being whipsawed by changes in direction due to market noise, confidence bands can be drawn on either side
of the regression line.

Selection of Markets and Issues: Trading and Investing

01. Four general categories or Styles of trading = 1. Day Trading 2. Swing Trading 3. Position Trading 4. Buy-and-hold.
02. Day Trading = Transaction costs are a factor in day trading, and are a disadvantage.
03. Swing Trading = It offers a higher frequency of opportunities and fairly tight risk control, which can be an advantage
of swing trading.
04. Buy and Hold = A fundamental exercise in company and economy analysis, can be done once a year or more likely
once a month.
05. Long Term Trading = A disadvantage of long-term trading is that this approach can experience severe drawdowns.
06. Slippage = the difference between quote price and execution price.
07. A stock's alpha of 1.50 implies that the stock has outperformed the market by 1.5%. Alpha relates to a stock's
outperformance relative to the market. It is a method for measuring relative strength.
08. A stock's beta of 1.50 implies that the stock will move 50% more than the market. Beta represents how volatile the
stock is relative to the market. It is not a method for measuring relative strength.
09. Selection in Futures Markets = It is based on ratio analysis of each futures versus a basket of futures or against
another investment vehicle.

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 10. Selection in Stock market = The first method is Top Down method. The second method is Bottom Up method.
11. Top-Down Analysis =
a. Asset Classes > Sectors > Industry Groups > Individual Securities.
b. Starts at Asset Classes which has the highest probability of profit.
c. Then look at Sectors and Industry Groups within the asset classes.
d. GICS categorizes US Stocks in to 11 Sectors, 24 Industry groups and
1. Equities (Asset Class) >>> Sectors (Finance) >>> Industry group (Banks) >>> Bank of America
2. Forex >>> Industrial, Resource or Emerging?
3. Bonds >>> Length to maturity, Country, Currency and level of default risk.
12. Sector Rotation = It is the movement of money invested in stocks from one industry to another as investors and
traders anticipate the next stage of the economic cycle. Stock investors try to anticipate the next cycle months in
advance. They move their money into the industries that tend to perform best in the next cycle.
13. The economy moves in reasonably predictable cycles. Various industries and the companies that dominate them
thrive or languish depending on the cycle.
14. Ratio Analysis = To determine a market's relative attractiveness to another market, a technician would use Ratio
Analysis. It is merely the ratio between two investments, sectors, industry groups, averages, commodities to see
which is outperforming the other.
15. Secular = It is a term used for any period longer than the business cycle. Business cycle is 4-5 years long.
16. Hard Assets = Commodities such as Gold Silver
17. Soft Assets = Stocks and Bonds
18. Correlation = The US Dollar leads the industrial raw material, which in turn generally leads the bonds market, which
in turn leads the stock market.
a. When Gold is declining, Interest rates are usually declining too.
b. When Gold rise, Stocks and Bonds are declining.
c. When USD decline, Gold rise.
d. When USD decline, Stocks decline.
e. When USD decline, Oil rise.
f. When Interest Rate rise, Stocks and Bonds are declining.
g. When Crude Oil decline, S&P rise.
h. When Bonds rise, Stocks rise too.
i. When US Dollar declines, it makes Gold and other commodities cheap in foreign currencies but expensive in
dollar terms.
j. Utility stocks, in an inflationary environment, will generally decline because they are interest-rate-related
stocks.
19. Secular Stocks = These are companies that are not as sensitive to economic cycles. When the economy is doing very
well, Secular Stocks are likely to be in line with the market. But when the economy is struggling, Secular Stocks will
generally outperform the market or will not fall more than the index. Healthcare utilities, food and beverage
producers or consumption companies are examples of Secular companies. There is a logic behind this even when the
economy is struggling you will buy milk, visit the doctor, and pay for your gas and electric. And when the economy
improves, you will still continue doing the above. The result is the profit of secular companies which will end up
being much more consistent. Thus such companies are consistent dividend payers to their shareholders.
20. Cyclical Stocks = These are Stocks that are sensitive to economic cycles. When the economy is doing well Cyclical
Stocks outperforms the market. But when the economy is doing poorly Cyclical Stocks performs worst in the market.
Examples of cyclical companies would be cement, sugar and metal companies. Once again there is a logic behind

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 this. If the economy is booming you’re likely to buy houses that need cement. But if the economy is doing poorly
people generally hold off on such large purchases to save for the future. Profits of cyclical companies undergo
variations as they are affected by economic cycles.
21. Bottom-Up analysis = Selecting Stocks by their Relative Strength. Stocks are selected based on their price behavior,
on their earnings, cash flows and general business prospects.
22. Relative Strength = A method of stock selection in Bottom-Up method. It provides evidence that a particular stock is
out-performing the market and is likely in a strong, upward trend. Relative Strength is the primary argument against
Efficient Market Hypothesis and random walk theory.
23. Ratio Method = It is merely the ratio between two investments, sectors, industry groups, averages, commodities to
see which is outperforming the other.
24. Measuring Relative Strength =
a. Percentage Change Method = ranking based on 6 months percentage change of the RS line.
b. Alpha method = using the regression of 1 week returns compared to the returns of the benchmark to
calculate Beta (Slope) and Alpha (y-intercept).
c. Trend Slope Method = take the slope of the line using linear regression.
d. Levy method = Ratio of stocks to 131 day MA. Then rank results.
25. The law of percentages states that in investing all absolute losses must be kept to a minimum. An absolute loss of
20% requires a 25% gain to break even, which is why all absolute losses must be kept to a minimum in investing.
26. The required gain to recover from an absolute 30% is calculated as follows: % gain necessary = 30% ÷ (1 – 30%) =
42.9%

Intermarket Analysis
01. In a typical business cycle, near the end of an economic cycle, bonds usually turn down before stocks and
commodities. US Dollar follows commodities.
02. During periods of a negative stock returns, commodities (except industrial metal futures) dominate the portfolio
return acting as a hedge.
03. Correlation coefficient is essential for the analysis of multiple markets.
04. Linear regression is used to predict the future price trend of a market based on its correlation with multiple related
markets.
05. A free reserve position usually indicates that the Federal Reserve's monetary policy is easy. Banks are required to
keep on deposit with the Federal Reserve Bank a certain percentage of their deposits. Banks have a free reserve
position when they have excess reserves. Excess reserves are the total reserves less required reserves. A free
reserve position is when their excess reserves are greater than borrowed reserves.

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Relative Strength Strategies for Investing
01. Momentum based strategies = Trend following and Relative strength
02. Biggest drawback of Relative Strength System is that the portfolio is long-only and fully invested, thus leaving the
risks of that particular asset beta.
03. To control for the losses and drawdowns while using a relative strength rotation system, there are two possible
solutions: 01. Hedging 02. Adding non-correlated asset classes.
04. Static Hedge = It always hedges a percentage of the portfolio or the entire portfolio (market neutral).
05. Dynamic Hedge = It attempts to hedge when conditions are more favorable to market decline. Using a long term
moving average to hedge a portfolio results in reduction in volatility and drawdown versus buy and hold.

A Stock Market Model

01. A rapidly expanding economy is BAD for the stock market.
02. Environmental Model = It is called the “Fab 5” and is what he calls an environmental model. It uses what he calls
Modes. It uses Internal and External Indicators.
03. Fab Five Model = Four components
a. Tape (Double Weight)
i. Seven Indicators make up the Tape Component. Each is assigned +1. 0, -1
1. Golden Cross (SMA 50 > SMA 200)
2. Stochastic (85/5) with two zones
3. Volume Advance Decline (Advancing Volume is Demand, Declining Volume is Supply)
4. AD Ratio
5. High Low Logic Indicator (52 weeks High or Low)
6. Diffusion Index (How many of the worlds stocks markets are above their 50 day MA.
>71% = +1, <41 = -1
7. Go with Mo (A Diffusion Index of individual trend and momentum indicators 96 sub-industry
indices

b. Sentiment
i. Valuation like PE
ii. Advisors
iii. Asset flows (COT Data)
iv. Overbought / Oversold)
v. Volatility (Implied and Historical)
vi. Put / Call Ratios
c. Monetary Component
i. Price of Money (Interest Rate)
ii. Supply of Money
d. Combo
i. Composed of 6 Stock market Models
ii. Models are combined to create a single value (>67 = +1, <50 = -1)

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 04. Fab Five is a model that can keep risk at arm's length without sacrificing too much on the long side.
05. 5 points any Environmental Model should take into account: 1.What the Fed is doing 2.What Smart Money is
doing 3.How are speculators feeling 4.What interest rates & inflation are doing 5.What is the primary trend

A Simple Model for Bonds

01. Four Indicators in the Bonds Model by Marty Zweig
a. Short-term slope of the Dow Jones 20 Bond Index
i. +1 when the index rises from bottom by 0.6 percent
ii. -1 when index falls from a peak by 0.6 percent
b. The long-term slope of the Dow Jones 20 Bond Index
i. +1 when the index rises from a bottom by 1.8 percent
ii. -1 when the index falls from a peak by 1.8 percent
c. The Target Rate the Fed sets for Fed Funds
i. +1 when it drops of at least one half of a percentage point
ii. -1 when it rises of at least one half of a percentage point
d. The Yield Curve (Based on the difference between the yields on AAA corporate bonds & 90-day commercial
paper)
i. +1 when the spread crosses above 0.6 of a percentage point
ii. -1 when spread crosses below -0.2
iii. Go Neutral between -0.2 and 0.6
e. (Added) Simple trend indicator to minimize losses (50-day (10-week) Moving Average with 1-percent bands)
i. +1 when price crosses above 1% of the 50-day Moving Average
ii. -1 when price crosses below 1% of the 50-day Moving Average

Perspectives on Active and Passive Money Management

01. Passive Investors = Buy and hold for the long term. They choose investments that minimize costs. Typical
investments are Index Funds, Mutual Funds and ETFs. The aim is to imitate the returns of an index like S&P 500.
Passive is more popular because the majority of active investors underperform.
02. Active Investors = Seek to outperform the indexes by identifying individual stocks to buy and sell. Usually incur
higher transaction costs.
03. Active Investing = It is further divide into:
a. Relative Return Vehicle
i. Relative Return Vehicles seek to outperform an index by increased returns, or by decreased risk
exposure. A relative fund is evaluated in terms of its outperformance of the benchmark.
b. Absolute Return Vehicle
i. Absolute return is an investment objective focused on Reward-Risk rather than bench mark tracking.
Absolute Return Vehicles seek to deliver returns that are less risky but are also usually lower than
the returns of most index benchmarks. Examples are Equity hedge funds like long/short funds. A

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 long-short hedge fund seeks to deliver returns that are less risky but are also usually lower than the
returns of most index benchmarks.
04. Alpha = It refers to the returns earned by a relative return investor. Positive or Negative Alpha if the fund beats or
underperforms the benchmark.
05. Beta = It is a measure of risk that can apply to an individual stock or a portfolio of stocks. Average Market Beta = 1.0
which means that a 1% move in the market should result in a 1% move in the stock. Beta is also a measure of
volatility contributed to the portfolio by an individual security. Beta is calculated from a Regression. It quantifies the
historical reaction of the stock or portfolio to changes in the market.
06. Top-Down Fundamental Analysis Process =
a. We begin by looking at the economy with the emphasis on discerning where we are in the business cycle.
b. Analysts divide the stock market into ten sectors.
c. “Economic Analysis” Determines stage of the “Business Cycle” >>> Business Cycle Stage determines “Sector”
Over weight and Underweight >>> Fundamental Analysis determines Active weights of “Individual stocks”
within each sector >>> Performance Attribution Analysis identifies why a Portfolio Under or Outperformed
its Benchmark.
d. Different sectors are expected to outperform at different times in the Business Cycle.
07. Portfolio Allocation = Based on the analysis, we adjust the size of the holdings. Stocks that the PM has a high
conviction will be more heavily weighted. This is obviously different to the allocations within the Index. The
weighting scheme is called active portfolio weights.
08. Intrinsic Value = After we determine the financial health and stability of a company, we will conduct a valuation
analysis to determine if the company’s stock is trading above or below what we will call its intrinsic value. It involves
forecasting the company’s future revenues, expenses, and a variety of other income statement and balance sheet
items.
09. Market Inefficiency = When information is not accurately reflected in a stock’s price, there may be an opportunity to
buy or sell the mispriced security and earn excess returns.
10. Market Efficiency = A market is informationally efficient when news is rapidly and accurately reflected in the prices
of financial securities. EMH emphasizes a high degree of rationality in the market pricing mechanism.
11. The Three Levels of Market Efficiency =
a. Weak form / Historical
i. Market prices reflect ONLY historical information. So it not useful to study historical information.
Technical Analysis is useless.
b. Semi Strong form / Current and Publicly Available
i. Market prices reflect historical and current publicly available information. So it is not useful to study
historical, current and publicly available information. Technical and Fundamental both are useless.
c. Strong Form / Private or Inside
i. Market prices reflect all historical, publicly available and privately or inside information. So it is not
useful to study, Technicals, Fundamentals, and Insider Information.
12. Anomalies that EMH cannot explain
a. Correlations in security returns = Consistent correlation patterns exist on different time horizons. That
would not happen in an “efficient market”.
b. Mean Reversion or a Reversal effect in Securities Prices = Portfolios with best stocks over 2-3 years
underperform and vice versa.
c. Under-Reaction to News = Significant short-term drift in prices following both good and bad news.

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 d. The Size Effect = Small caps outperform Large caps by more than adjusting for their volatility. 50 Smallest
outperformed 50 largest from 1931 to 1975.
e. The Price-To-Earnings Ratio (PE) or Value Stock Effect. = Risk-adjusted returns of the lowest PE stock
portfolios are as much as 7% per year larger than risk-adjusted returns of the highest PE stocks portfolios.
f. The January Effect = Small cap companies experience unusually high returns in the first two weeks of
January, then revert to an average for the rest of the year
g. Patterns in Volatility = Returns are more volatile during bear markets .Market Volatility is greater at the
open and the close than during the trading day. Overall Market Volatility is excessive relative to changes in
the fundamentals affecting stock's’ intrinsic values.
13. Individual security returns are negatively correlated on a daily basis, positively correlated over intermediate-term
horizons, and are negatively correlated over long horizons. The correlations in security returns are one of the
anomalies the EMH cannot explain. These correlation patterns are consistent and should not exist if markets were
highly efficient.
14. After a strong earnings announcement, the stock increases for several weeks. This is an example of the under
reaction to news anomaly. Under reaction to news is an anomaly that shows that there is a significant short-term
drift in prices following both good- and bad-news announcements (drift is the tendency for stock prices to keep
moving in the same direction).
15. Outperformance of low P/E stocks is known as the value stock effect anomaly. The value stock effect is an anomaly
the EMH cannot explain, and shows that the risk-adjusted return of low-P/E stocks is 7% per year larger than that of
high-P/E stocks.
16. The paradox inherent in using fundamental analysis to determine which stocks to under- or overweight in a
portfolio. Identifying mispricing without also identifying the catalyst that will cause that mispricing to cease in the
future. This is step three of the top-down process. After determining the financial health and stability of a company,
a valuation analysis is next conducted to determine the intrinsic value of the company. If an analyst finds that a
stock's price is over- or undervalued, then the analyst is actually saying that the market is making a mistake in the
way that it is valuing the stock. If that mispricing actually exists today, then why should this mispricing not persist
into the future? It is here that a logical inconsistency or paradox resides. Just identifying the mispricing will not
correct it; the analyst must also identify the catalyst that will cause the mispricing to cease in the future, otherwise
the over- or undervalued stock could stay over- or undervalued.
17. A trader predicts that oil prices will rise significantly in the near future; thus he wants to start buying energy stocks.
This analysis is considered TOP-DOWN ANALYSIS. The trader started with a study of oil prices, and then decided on
buying energy stocks. Top-down analysis begins with a study of the major markets such as interest rates, currencies,
commodities, and stock market to determine which market has the highest possibility of profit in the future.
18. Behavioral Finance = Expressly recognizes that investors commit numerous cognitive errors and that these mistakes
can affect market prices.
19. Adaptive Market Hypothesis (AMH) = Views markets as a complex evolutionary system. Investors aren’t concerned
with being irrational or rational, just figuring out if what worked yesterday is working today. If not, quickly move on
and find new competitive advantages.
20. Investment Policy Statement = It makes clear statements about an investor’s or fund’s objectives, return
expectations, risk tolerance, time horizon, and portfolio allocation that inform the decisions of stock analysts and
portfolio managers.
21. John Maynard Keynes was an early critic of the efficient markets hypothesis.

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The Statistics of Back Testing
01. Four Important Statistical features of Time-Series Price Data
a. Non-Normality of Returns
i. Price returns do not follow normal distribution.
b. Path Dependence and Serial Correlation
i. Price data exhibits high level of serial correlation. Price moves often have some reliance on what has
happened in past. The occurrence of some event may drive price behavior in a way that
meaningfully differs from the way that stock acted before the event.
c. Heteroscedasticity
i. Price returns are heteroscedastic. It is very problematic when using standard deviation to describe
risk because the risk measure is changing.
d. Self-Correcting
i. The mere act of buying or selling a stock impacts its price. Exploitable market opportunities are also
self-correcting.
02. Solving the issues with price data
a. Log Returns
i. Instead of using RAW price returns, use Logarithm of price returns.
ii. Benefits are time additivity, handling of compounding and distribution.
b. Non Normality Cures
i. Not to use normal distribution. Not to make any assumption of the price data at all.
03. Difference between Signal Testing and Back Testing. Signal Testing is research tool and Back Testing is Validation
tool.
04. Statistical concerns in Back Testing
a. Multiple Testing Fallacy
i. If you make multiple testing (either in the same study or compare multiple studies), say 20 or more
where there is a 95% confidence level, you are likely to get a false conclusion. This becomes a fallacy
when that false conclusion is seen as significant rather than a statistical probability.
ii. For Signal testing the simplest adjustment to make to a significance level is the Bonferroni
Correction. The Bonferroni correction takes the original significance level and divides by the number
of tests.
iii. For back test performance results, the solution is the Deflated Sharpe Ratio. The DSR measures risk-
adjusted return while correcting for multiple testing and non-normal return distributions.
b. Trading System complexity and Bias-Variance-Tradeoff
i. The Simple systems like Buy and Hold are considered as Biased because it cannot capture different
turning points of market.
ii. The complex systems like extremely sophisticated are considered as Variance because it is so over fit
to the historical data that it cannot generalize well if introduce to unseen data.
c. Meta-Look-Ahead-Bias
i. It is the trader’s own preexisting knowledge of the dataset.
05. Signal testing focuses on putting the statistical inference tools to work in order to identify important causal and
predictive relationships in historical data.
06. Back testing is the final step in the system development process, one that comes long after signal testing.

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The Scientific Method and Technical Analysis
01. Null hypothesis = The timid hypothesis that nothing new had been discovered is null hypothesis. If evidence can be
produced that falsifies the null hypothesis, it generates a big gain in knowledge. Every time a bold new hypothesis is
put forward, it generates an opposing claim (the null hypothesis). The null hypothesis is as timid as the new
hypothesis is bold. EMH (Weak) is the hardest version to falsify and is thus the least likely to be proven false.
02. Five Stages of Hypothetico-Deductive Method
a. Observation
b. Hypothesis
c. Prediction
d. Verification
e. Conclusion
03. Three consequences of adopting the scientific method in technical analysis
a. The elimination of subjective TA
b. Elimination of meaningless forecasts
c. Paradigm shift

Theories of Nonrandom Price Motion

01. Efficient Market = It is a market that cannot be beaten. In such a market, no fundamental or technical analysis
strategy, formula, or system can earn a risk-adjusted rate of return that beats the market defined by a benchmark
index. Efficient markets are very good for economy as a whole but very bad for Technical Analysis.
02. Smart Vs Dumb Paradox = In an efficient market, there is no competitive advantage to being smart or dumb. This
conflicts with another EMH assumption that the arbitrage activities of smart rational investors drive prices towards
rational levels. Either prices are set by the smartest, richest participants or they are not. EMH implies both!
03. Cost of Information Paradox = EMH contends that information is instantly reflected in prices and no matter how
wide or deep the research effort, whatever is discovered will be of no value. On the other hand EMH requires that
information seekers be compensated for their efforts and simultaneously denies that they will be. One way for the
rational investor to gain would be if there were a delay between the time information is discovered and the time it is
reflected in prices, but EMH denies the possibility of gradual price adjustments.
04. Assumptions of EMH = There are three weaker assumptions of EMH:
a. Investors are rational.
b. Investors’ pricing errors are random. Investor errors are uncorrelated.
c. There are always “rational arbitrage investors” to catch any pricing errors.
05. Behavioral Finance = Explains why investors depart from full rationality and there why markets depart from full
efficiency.
06. Pillars of Behavioral Finance:
i. Limited ability of arbitrage to correct pricing errors.
1. Limited capital.
ii. Limits of human rationality.

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 1. EMH says that prices depart from rational levels randomly and briefly. Behavioral finance
says some departures are systematic and last long enough to be exploited by certain
investment strategies.
07. Psychological Factors (Cognitive Errors):
a. Conservatism Bias
i. The tendency to give too little weight to new information. Adjusts slower than it should to new
information.
b. Confirmation Bias
i. Overreaction to new information which confirms the prior belief and under reaction to the new
information which contradicts prior beliefs.
c. Belief Inertia (Strengthening of prior beliefs)
d. Anchoring (Sticking or get stuck)
i. Anchoring to Numbers
ii. Anchoring to Stories
e. Optimism and Overconfidence
f. The Crime of Small Numbers (Sample Size Neglect) Why investors may over react to a short sequence of
good earning. Forming a conclusion from sample and neglecting the sample size. It can cause two
judgmental errors:
i. The Gambler’s Fallacy (A streak of positive price changes will lead naïve observers to falsely
conclude that a trend reversal is due. The false expectation of a reversal is called the gambler’s
fallacy)
ii. The Clustering Illusion (It is the misperception of order (nonrandomness) in data that is actually a
random walk)
08. Social Factors:
a. Imitative Behavior - Herding (Herd behavior stops the diffusion of information throughout a group)
b. Information Cascades = It is a chain of imitative behavior that was initiated by one or few individuals.
Imitation gives rise to “Information Cascades”.
09. Role of Feedback in systematic Price movements:
a. Financial markets rely on a healthy balance between negative and positive feedback.
b. Prices that are too high or too low trigger arbitrage trading that pushes back toward rational levels.
c. Positive feedback occurs when investor decisions are dominated by imitative behavior rather than
independent choices. Positive feedback has amplifying effect.
d. Negative feedback has the effect of dampening system behavior, driving the output back toward a level of
equilibrium.
10. Hypothesis of Behavioral Finance
a. Biased Interpretation of Public Information (BSV Hypothesis)
i. BSV asserts two cognitive errors. BSV model accounts for systematic price movement that corrects
both forms of errors:
1. Conservatism Bias (Existing opinions are sticky. New information is given too little weight)
Investors will often overreact to information which confirms beliefs they already hold and
underreact to information which contradicts beliefs they currently hold.
2. Sample Size Neglect (Drawing too grand conclusion from a small sample of observations.
New information is given too much weight) It also gives a feedback loop.
b. Biased Interpretation of Private Information (DHS Hypothesis)

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 i. DHS suggests a different explanation for systematic price movements such as trend reversals and
trend persistence (momentum) as a result of Confirmation Bias and Self-Attribution Bias. DHS
hypothesis is founded upon investors’ biased interpretation of private research. DHS emphasizes
three cognitive errors:
1. Endowment Bias Investors will be overly confident about the quality of their private
research and tend to overreact to it, placing too high a value on what they produce.
2. Confirmation Bias News or price moves confirming their beliefs will be given more weight,
and if contradicts, it will be given too-little weight.
3. Self-Attribution Bias People take credit for outcomes and deny responsibility for bad
outcomes (attribute it to bad luck rather than to poor research).
c. News Trader and Momentum Traders (HS Hypothesis)
i. HS Hypothesis explains three phenomenon:
1. Momentum
2. Over Reaction
3. Under Reaction
ii. HS Hypothesis postulates two classes of investors:
1. News Watchers (Fundamentalists)
2. Momentum Traders (Technicians)
iii. HS Hypothesis assert that the overshooting of rational price levels, resulting from the positive
feedback of momentum traders, sets up the conditions for the trend reversal back toward rational
levels based on fundamentals.
11. An option premium is not a type of financial market “risk” premium. It is the amount an investor pays for an option.
Once the option is paid for that represents the total amount of risk, no further risk is implied. This would not
necessarily be considered a risk premium offered by financial markets.
12. Arbitrageurs have limited power to push prices to rational levels because of the lack of perfect substitute securities.
An ideal arbitrage transaction involves the simultaneous purchase and sale of a pair of securities with identical
future cash flows and identical risk characteristics. This should make the transaction riskless. But the absence of
perfect substitute securities means that the arbitrageurs have to take on more risk and reduces their power to push
prices to rational levels.

Case Study of Rule Data Mining for the S&P 500

01. Data Mining in testing trading rules = A process in which the profitability of many rules is compared so that one or
more superior rules can be selected.
02. Data Mining Bias in testing trading rules = The observed performance of the best rule(s) in the back test over states
its (their) expected performance in the future. This bias complicates the evaluation of statistical significance and
may lead a data miner to select a rule with no predictive power. This problem can be minimized by two methods: 1.
Enhanced version of White’s reality check and 2. Masters’s Monte-Carlo permutation method.
03. Data Snooping Bias in testing trading rules = It refers to using the results of prior rules studies reported by other
researchers.
04. Population = the population at issue is the set of daily returns that would be earned by a rule if its signals were to
applied to the S&P 500 over all possible realizations of the immediate practical future.
05. Population Parameter = It is the rule’s expected average annualized return in the immediate practical future.

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System Design and Testing
01. Discretionary Systems = entries and exits are determined by intuition or gut-feel. The trader makes the decision to
enter or exit.
02. Non-Discretionary Systems = entries and exits are determined by algorithmic rules.
03. Partial Discretionary Systems = entries and exits are acted upon by the investor based on personal confidence and
experience in them.
04. The constructs:
a. Rules are the structure of a system. E.g. Buy when close crosses above MA(Bars=5)
b. Variables are the numerical inputs into the system. E.g. moving average value.
c. Parameters are the actual values used in the variables. E.g. 5 period moving average.
05. FIVE Initial Decisions for constructing a Trading system:
i. Type of tested model (Fundamental or Technical)
ii. Selection of Markets (Diversification)
iii. Time Horizon (Scalp, Swing, Short term or Long term)
iv. Risk control (Protective & Trailing Stops, Profit targets, Leverage and Volatility Adjustments)
v. Time Routine (system updating, planning new trades etc.)
06. FOUR types of Technical Trading systems:
i. Trend following
1. Moving Average System
2. Breakout Systems
ii. Pattern Recognition
iii. Reversion to the Mean
iv. Exogenous Signal
07. Optimization = It is simply changing the parameters of a system to achieve the best results. Curve fitting is over
optimization.
08. Methods of Optimization:
a. Whole Sample = It uses All the Data (entire price sample). It is closest to curve-fitting.
b. Out of Sample Optimization = This method optimizes the In-Sample data and then tests it on the Out of
Sample data. One way is 70%-80% being the In-Sample data and the remaining 20%-30% being the Out of
Sample data. The sample must include Bull, Bear and Consolidation periods. For reducing the curve fitting is
to use more than one market as the out of sample test.
c. Walk Forward optimization = It is also an Out-of-Sample method. It is to optimize a small portion of the data
(In-Sample data) and then test it on a small period of subsequent data (Out of Sample data).
09. Robustness = It simply means how strong and healthy our results are; it refers to how well our results will hold upto
changing market conditions.
10. Profit Measures:
a. Outlier Adjusted Profit
i. It is a profit factor that has been adjusted for the largest profit. If the system is depending on one
large profit, the system is a bust. The largest winning trade should not exceed 40% to 50% of total
profit.
b. Payoff Ratio
i. It is ratio of the average winning trade to average losing trade. For trend following systems it should
be greater than 2.0.

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 c. Efficiency Factor
i. It is Net Profit divided by the Gross Profit. Successful systems usually are in the range of 38% to 69%.
The higher the better.
d. Profit Factor
i. Ratio of Gross Profit to Gross Loss. Preferably above 2.0 and greater than 10 is a warning that the
system has been curve-fitted.
e. Percent Profitable
i. The percent of all trades that were profitable.
f. Average Trade Net Profit
i. Average profit received per trade. Sum of all Profit divided by number of trades. It can be in positive
or negative.
11. Risk Measures:
a. Maximum Drawdown
i. The maximum loss from an equity peak.
b. MAR Ratio (Managed Accounts Reports) (Recovery Ratio)
i. It is the ratio of Net Profit Percent to Maximum Drawdown percent. The ratio should be above 1.0.
c. System MAR
i. It is the ratio of annual percentage net gain for the system to the maximum percentage Drawdown.
d. Return Retracement Ratio
i. Average Annualized Compounded Return divided by Maximum Retracement.
e. Risk-Adjusted Performance Metrics
i. Sharpe Ratio
1. The ratio of excess return. Portfolio return minus T-Bill rate of return divided by the
standard deviation of return. As the risk-free rate increases, the excess return decreases,
which reduces the Sharpe ratio.
ii. Sterling Ratio
1. (Over Three Years) Arithmetic Average Annual Net profit divided by Average Annual
Maximum Drawdown. Similar to Gain to Pain Ratio.
iii. Sortino Ratio
1. Similar to Sharpe Ratio but it considers only downside volatility. It is calculated as the ratio
of the monthly expected return minus the risk free rate of return to the standard deviation
of negative returns. It is more realistic than Sharpe Ratio.
f. Maximum Favorable Excursion = It is what was the maximum profit that the trade had before the trade
closed.
g. Maximum Adverse Excursion = It is what was the maximum loss that the trade had before the trade closed.

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