Volume and Time

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Volume and Time

Many traders focus exclusively on price quotes, but while those are extremely important, there’s more to the market than price. Volume of transactions provides a valuable additional dimension. Joseph Granville, a pioneer of volume studies, was fond of saying “Volume is the steam that makes the choo-choo go.”

Another hugely important factor of market analysis is time. Markets live and move in different timeframes at the same time. No matter how carefully you analyze the daily chart, its trend can be upended by a move that erupts from another timeframe.

In this section we’ll focus on volume and volume-based indicators. We’ll also look into tying all market decisions to their timeframes.

■ 28. Volume

Volume reflects the activity of traders and investors. Each unit of volume represents actions of two individuals: one sells a share or a contract and another buys that share or a contract. Daily volume is the number of shares or contracts traded in one day (Figure 28.1).

Traders usually plot volume as a histogram—vertical bars whose height reflects each day’s volume. They usually draw it underneath prices. Changes in volume show how bulls and bears react to price swings and provide clues to whether trends are likely to continue or to reverse.

Some traders ignore volume. They think that prices already reflect all information known to the market. They say, “You get paid on price and not on volume.”

FIGURE 28.1 BID daily, 22-day EMA, volume. (Chart by Stockcharts.com)

Volume

Sotheby’s Holdings Inc. (BID) is the world’s biggest publicly traded auction house. It provides a window into what the world’s big money is doing in terms of their conspicuous consumption. This company’s business was buoyed in 2013 by the influx of new money from Asia, but the stock hit its head on the ceiling during that year’s last quarter.

In areas A and B, volume increased during the rally, confirming the uptrend and calling for higher prices ahead. In areas C and D, volume flashed warning signs for the bulls—it shrank during each rally attempt. Notice false upside breakouts in those areas and an atypical form of a kangaroo tail in area C. Rising volume near the right edge confirms the power of bears.

Professionals, on the other hand, know that analyzing volume can help them understand markets deeper and trade better.

Volume depends on the size of the trading crowd and the activity levels of buyers and sellers. If you compare volumes of two markets, you’ll see which is more active or liquid. You are likely to receive better fills and suffer less slippage in liquid markets than in thin, low-volume markets.

There are three ways to measure volume:

• 1. The actual number of shares or contracts traded. For example, the New York Stock Exchange reports volume this way. This is the most objective way of measuring volume.
• 2. The number of trades that took place. Some international exchanges report volume this way. This method is less objective because it doesn’t distinguish between a 100-share trade and a 5000-share trade.
• 3. Tick volume is the number of price changes during a selected period of time, such as 10 minutes or an hour. It is called tick volume because most changes equal 1 tick. Some exchanges don’t report intraday volume, forcing day traders to use tick volume as a proxy for real volume.

A note to forex traders: since that market is decentralized and reports no volume, you can use the volume of currency futures as its proxy. Futures of all major currencies, measured against the U.S. dollar, are traded in Chicago and on the electronic exchanges. We can assume that their volume trends are reasonably similar to those in the forex markets, since both respond to the same market forces.

Crowd Psychology

Volume reflects the degree of financial and emotional involvement, as well as pain, among market participants. A trade begins with a financial commitment by two persons. The decision to buy or sell may be rational, but the act of buying or selling creates an emotional commitment in most people. Buyers and sellers crave to be right. They scream at the market, pray, or use lucky talismans. The level of volume reflects the degree of emotional involvement among traders.

Each tick takes money away from losers and gives it to winners. When prices rise, longs make money and shorts lose. When prices fall, shorts gain and longs lose. Winners feel happy and elated, while losers feel depressed and angry. Whenever prices move, about half of the traders are hurting. When prices rise, bears are in pain, and when prices fall, bulls suffer. The greater the volume, the more pain in the market.

Traders react to losses like frogs to hot water. If you throw a frog into a hot pail, it’ll jump in response to sudden pain, but if you put a frog into cool water and heat it slowly, you can boil it alive. If a sudden price change hits traders, they jump from pain and liquidate losing positions. On the other hand, losers can be very patient if their losses increase gradually.

You can lose a great deal of money in a sleepy stock or a future, such as corn, where a one-cent move costs only $50 per contract. If corn goes against you just a few cents a day, that pain is easy to tolerate. If you hang on, those pennies can add up to thousands of dollars in losses. Sharp moves, on the other hand, make losing traders cut their losses in a panic. Once weak hands get shaken out, leaving behind a volume spike, the market is ready to reverse. Trends can persist for a long time on moderate volume but can expire after a burst of volume.

Who buys from a trader who is selling his losing long position? It may be a short seller who wants to cover and take profits. It may be a bargain hunter who steps in because prices are “too low.” A bottom-picker takes over the position of a loser who washed out—he either catches the bottom or becomes the next loser.

Who sells to a trader who buys to cover his losing short position? It may be a savvy investor who takes profits on his long position. It also may be a top-picker who sells short because he thinks that prices are “too high.” He assumes the position of a loser who covered his shorts, and only the future will tell whether he is right or wrong.

When shorts give up during a rally, they buy to cover and push the market higher. Prices rise, flush out even more shorts, and the rally feeds on itself. When longs give up during a decline, they sell, pushing the market lower. Falling prices flush out even more longs, and the decline feeds on itself. Losers who give up on their trades propel trends. A trend that moves on steady volume is likely to persist. It shows that new losers are replacing those who washed out.

When volume falls, it shows that the supply of losers is running low and a trend is ready to reverse. It happens after enough losers catch on to how wrong they are. Old losers keep bailing out, but fewer new ones come in. Falling volume is a sign that the trend is about to reverse.

A burst of extremely high volume also gives a signal that a trend is nearing its end. It shows that masses of losers are bailing out. You can probably recall holding a losing trade longer than you should have. Once the pain became intolerable and you got out, the trend reversed and the market went the way you expected, only without you. This happens time and again because most humans react to stress similarly and bail out at roughly the same time. Professionals don’t hang on while the market beats them up. They quickly close out losing trades and reverse or wait on the sidelines, ready to re-enter.

Volume spikes are more likely to signal an imminent reversal of a downtrend than an uptrend. Volume spikes in downtrends reflect explosions of fear. Fear is a powerful but short-term emotion—people run fast, dump shares, and then the trend is likely to reverse. Volume spikes in uptrends are driven by greed, which is a slowermoving, happy emotion. There may be a slight pause in an uptrend after a volume spike, but then the trend is quite likely to resume.

Volume usually stays relatively low in trading ranges because there is relatively little pain. People feel comfortable with small price changes, and flat markets can drag on a long time. A breakout is often marked by a dramatic increase in volume because losers run for the exits. A breakout on low volume shows little emotional commitment to a new trend. It indicates that prices are likely to return into their trading range.

Rising volume during a rally shows that more buyers and short sellers are pouring in. Buyers are eager to buy even if they have to pay up, and shorts are eager to sell to them. Rising volume shows that losers who leave are being replaced by a new crop of losers.

When volume shrinks during a rally, it shows that bulls are becoming less eager, while bears are no longer running for cover. The intelligent bears have left long ago, followed by weak bears who could not take the pain. Falling volume shows that fuel is being removed from the uptrend and it’s ready to reverse.

When volume dries up during a decline, it shows that bears are less eager to sell short, while bulls are no longer running for the exits. The intelligent bulls have sold long ago, and the weak bulls have been shaken out. Falling volume shows that the remaining bulls have greater pain tolerance. Perhaps they have deeper pockets or bought later in the decline, or both. Falling volume identifies an area in which a downtrend is likely to reverse.

This reasoning applies to all timeframes. As a rule of thumb, if today’s volume is higher than yesterday’s, then today’s trend is likely to continue.

Trading Pointers

The terms “high volume” and “low volume” are relative. What’s low for Amazon may be very high for a less popular stock, while what’s low for gold is high for platinum, and so on. We compare volumes of different stocks, futures, or options only when selecting higher-volume trading vehicles. Most of the time, we compare current trading volume of a stock to its average volume. As a rule of thumb, “high volume” for any given market is at least 25 percent above its average for the past two weeks, while “low volume” is at least 25 percent below average.

• 1. High volume confirms trends. If prices rise to a new peak and volume reaches a new high, then prices are likely to retest or exceed that peak.
• 2. If the market falls to a new low and the volume reaches a new high, that bottom is likely to be retested or exceeded. A very high volume “climax bottom” is almost always retested on low volume, offering an excellent buying opportunity.
• 3. If volume shrinks while a trend continues, that trend is ripe for a reversal. When a market rises to a new peak on lower volume than its previous peak, look to take profits on a long position and/or for a shorting opportunity. This technique does not work as well in downtrends because a decline can persist on low volume. There is a saying on Wall Street: “It takes buying to put prices up, but they can fall of their own weight.”
• 4. Watch volume during reactions against the trend. When an uptrend is punctuated by a decline, volume often picks up in a flurry of profit taking. When that dip continues but volume shrinks, it shows that bulls are no longer running or that selling pressure is spent. When volume dries up, it shows that the reaction is nearing its end and the uptrend is ready to resume. This identifies a good buying opportunity. Major downtrends are often punctuated by rallies that begin on heavy volume. Once weak bears have been flushed out, volume shrinks and gives a signal to sell short.

■ 29. Volume-Based Indicators

Several indicators help clarify volume’s trading signals. For example, a 5-day EMA of volume can identify volume’s trends. A rising EMA of volume affirms the current price trend, while a declining one points to the price trend’s weakness.

This and other volume-based indicators provide more precise timing signals than volume bars. They include On-Balance Volume and Accumulation/Distribution, described below. Force Index combines price and volume data to help identify areas where prices are likely to reverse.

On-Balance Volume

On-Balance Volume (OBV) is an indicator designed by Joseph Granville and described in his book, New Strategy of Daily Stock Market Timing. Granville used OBV as a leading indicator of the stock market, but other analysts applied it to futures.

OBV is a running total of volume. Each day’s volume is added or subtracted, depending on whether prices close higher or lower than on the previous day. When a stock closes higher, it shows that bulls won the day’s battle; that day’s volume is added to OBV. When a stock closes lower, it shows that bears won the day, and that day’s volume is subtracted from OBV. If prices close unchanged, OBV stays unchanged. On-Balance Volume often rises or falls before prices, acting as a leading indicator.

Crowd Psychology

Prices represent the consensus of value, but volume represents the emotions of market participants. It reflects the intensity of traders’ financial and emotional commitments, as well as pain among losers, which is what OBV helps to track.

A new high of OBV shows that bulls are powerful, bears are hurting, and prices are likely to rise. A new low of OBV shows that bears are powerful, bulls are hurting, and prices are likely to fall. When the pattern of OBV deviates from the pattern of prices, it shows that mass emotions aren’t in gear with mass consensus. A crowd is more likely to follow its gut than its mind, and that’s why changes in volume often precede price changes.

Trading Signals

The patterns of OBV tops and bottoms are much more important than the absolute levels, which depend on the starting date of your calculations. It is safer to trade in the direction of a trend that is confirmed by OBV (Figure 29.1).

• 1. When OBV reaches a new high, it confirms the power of bulls, indicates that prices are likely to continue to rise, and gives a buy signal. When OBV falls below its previous low, it confirms the power of bears, calls for lower prices ahead, and gives a signal to sell short.
• 2. OBV gives its strongest buy and sell signals when it diverges from prices. If prices rally, sell off, and then rise to a new high, but OBV rallies to a lower high, it creates a bearish divergence and gives a sell signal. If prices decline, rebound, and then fall to a new low, but OBV falls to a more shallow bottom, it traces a bullish divergence and gives a buy signal. Long-term divergences are more important than the short-term ones. Divergences that develop over the course of several weeks give stronger signals than those created over a few days.
• 3. When prices are in a trading range and OBV breaks out to a new high, it gives a buy signal. When prices are in a trading range and OBV breaks down and falls to a new low, it gives a signal to sell short.

More on OBV

One of the reasons for Granville’s success in stock market timing was that he combined OBV with two other indicators—the Net Field Trend indicator and the Climax indicator. Granville calculated OBV for each stock in the Dow Jones Industrial Average and rated its OBV pattern as rising, falling, or neutral. He called

FIGURE 29.1 MCD daily, 22-day EMA, On-Balance volume (OBV). (Chart by Stockcharts.com)

On-Balance Volume

McDonald’s Corp. (MCD) is a stable, slow-moving stock. You can see a fairly tight trading range, marked with dashed lines (two lines at the lows, one tight and the other loose). Notice the tendency of MCD towards false breakouts (bottoms A and C and tops B and D). Notice a kangaroo tail in area A.

At the right edge of the chart, the stock market is in a free-fall, but while MCD trades near its recent lows, its OBV indicator is trading near the highs. It points to strength and suggests buying rather than selling.

that a Net Field Trend of a stock: It could be +1, −1, or 0. Climax indicator was a sum of the Net Field Trends of all 30 Dow stocks.

When the stock market rallied and the Climax indicator reached a new high, it confirmed strength and gave a buy signal. If the stock market rallied but the Climax indicator made a lower top, it gave a sell signal.

You can look at the Dow Jones Industrial Average as a team of 30 horses pulling the market wagon. The Climax indicator shows how many horses are pulling uphill, downhill, or standing still. If 24 out of 30 horses pull up, 1 down and 5 are resting, then the market wagon is likely to move up. If 9 horses pull up, 7 pull down, and 14 are resting, that wagon may soon roll downhill.

Remarkably, Granville did his calculations by hand1 . Now, of course, OBV, the Net Field Trend indicator, and the Climax indicator can be easily programmed. It would be

¹ I visited Granville in 2005 in Kansas City. Not only did he do all his calculations by hand, he avoided going online, as he was suspicious of pervasive snooping—and that was years before the disclosures of government spying. He disconnected his computer from the Internet until it was time to send out his newsletter. Granville monitored intraday prices by tuning his TV into CNBC with the sound turned off and a towel draped over the upper portion of the screen, so that all he could see was the tape, running along the bottom of his screen.

worthwhile to apply them to a database that includes all stocks of the S&P 500 index. This method may produce good signals for trading the S&P 500 futures and options.

Accumulation/Distribution

This indicator was developed by Larry Williams and described in his 1973 book, How I Made One Million Dollars. It was designed as a leading indicator for stocks, but several analysts applied it to futures. The unique feature of Accumulation/Distribution (A/D) is that it tracks the relationship between opening and closing prices, in addition to volume. Its concept is similar to that of Japanese candlesticks, which at the time Williams wrote his book weren’t known to Western traders.

Accumulation/Distribution is more finely calibrated than OBV because it credits bulls or bears with only a fraction of each day’s volume, proportionate to the degree of their win for the day.

$$A/D = \frac{Close - Open}{High - Low} \cdot Volume$$

If prices close higher than they opened, then bulls won the day, and A/D is positive. If prices close lower than they opened, then the bears won, and A/D is negative. If prices close where they opened, then nobody won, and A/D is zero. A running total of each day’s A/D creates a cumulative A/D indicator.

For example, if today’s high-low spread was five points but the distance from the open to the close was two points, then only 2/5 of today’s volume is credited to the winning camp. Just as with OBV, the pattern of A/D highs and lows is important, while its absolute level simply depends on the starting date.

When the market rises, most people focus on new highs, but if prices open higher and close lower, then A/D, which tracks their relationship, turns down. It warns that the uptrend is weaker than it appears. If, on the other hand, A/D ticks up while prices are down, it shows that bulls are gaining strength.

Crowd Behavior

Opening prices reflect pressures that have built up while the market was closed. Openings tend to be dominated by amateurs who read their news in the evening and trade in the morning.

Professional traders are active throughout the day. They often trade against the amateurs. As the day goes on, waves of buying and selling by amateurs as well as slow-moving institutions gradually subside. Professionals tend to dominate the markets at closing time. Closing prices are especially important because the settlement of trading accounts depends on them.

A/D tracks the outcomes of daily battles between amateurs and professionals. It ticks up when prices close higher than they opened—when professionals are more bullish than amateurs. It ticks down when prices close lower than they opened when professionals are more bearish than amateurs. It pays to bet with the professionals and against the amateurs.

Trading Rules

When the market opens low and closes high, it moves from weakness to strength. That’s when A/D rises and signals that market professionals are more bullish than amateurs, and the upmove is likely to continue. When A/D falls, it shows that market professionals are more bearish than amateurs. When the market weakens during the day, it’s likely to reach a lower low in the days to come.

The best trading signals are given by divergences between A/D and prices.

• 1. If prices rally to a new high but A/D reaches a lower peak, it gives a signal to sell short. This bearish divergence shows that market professionals are selling into the rally.
• 2. A bullish divergence occurs when prices fall to a new low but A/D bottoms out at a higher low than during its previous decline. It shows that market professionals are using the decline for buying, and a rally is coming (Figure 29.2).

FIGURE 29.2 GOOG daily, Accumulation/Distribution Index. (Chart by Stockcharts.com)

Accumulation/Distribution

“Coming events cast their shadows before” is an old proverb with a lot of meaning for technical analysts. Google Inc. (GOOG) was trending lower for months, but the uptrend of the Accumulation/Distribution Index (A/D) showed that big money was buying. The stock has fallen lower at point B than at A, but the A/D Index traced out a much higher bottom. Just as important, it broke out to a new high (marked with a vertical green arrow) before prices gapped up following a surprisingly good earnings announcement. Somebody knew what was coming, and their massive buying was identified by the A/D accumulation pattern and its upside breakout. Technical analysis helps even out the imbalance of knowledge between outsiders and insiders.

More on Accumulation/Distribution

When you go long or short, following a divergence between A/D and price, remember that even market professionals can go wrong. Use stops and protect yourself by following the Hound of the Baskervilles rule (see Chapter 23).

There are important parallels between A/D and Japanese candlestick charts, since both focus on the differences between opening and closing prices. A/D goes further than candlesticks by taking volume into account.

■ 30. Force Index

Force Index is an oscillator developed by this author. It combines volume with prices to discover the force of bulls or bears behind every rally or decline. Force Index can be applied to any price bar for which we have volume data: weekly, daily, or intraday. It brings together three essential pieces of information—the direction of price change, its extent, and the volume during that change. It provides a practical way of using volume for making trading decisions.2

Force Index can be used in its raw form, but its signals stand out much more clearly if we smooth it with a moving average. Using a short EMA of Force Index helps pinpoint entry and exit points. Using a longer EMA helps confirm trends and recognize important reversals.

How to Construct Force Index

The force of every move is defined by three factors: direction, distance, and volume.

• 1. If prices close higher than the close of the previous bar, the force is positive. If prices close lower than the close of the previous bar, the force is negative.
• 2. The greater the change in price, the greater the force.
• 3. The bigger the volume, the greater the force.

$$Force Index = Volume_{today} \cdot (Close_{today} - Close_{yesterday})$$

A raw Force Index can be plotted as a histogram, with a horizontal centerline at a zero level. If the market closes higher, Force Index is positive and rises above the centerline. If the market closes lower, Force Index is negative and extends below the centerline. If the market closes unchanged, Force Index is zero.

The histogram of a raw Force Index is very jagged. This indicator gives much better trading signals after being smoothed with a moving average (see Chapter 22).

² Remember, we’re talking about the force of market crowds, not the formula in physics.

A 2-day EMA of Force Index provides a minimal degree of smoothing. It is useful for finding entry points into the markets. It pays to buy when the 2-day EMA is negative and sell when it’s positive, as long as you trade in the direction of the trend.

A 13-day EMA of Force Index tracks longer-term changes in the force of bulls and bears. When the 13-day EMA crosses above the centerline, it shows that bulls are in control and suggests trading from the long side. When the 13-day EMA turns negative, it shows that bears are in control and suggests trading from the short side. Divergences between a 13-day EMA of Force Index and prices identify important turning points.

Trading Psychology

When the market closes higher, it shows that bulls won the day’s battle, and when it closes lower, it shows that bears carried the day. The distance between today’s and yesterday’s closing prices reflects the margin of victory by bulls or bears. The greater this distance, the larger the victory achieved.

Volume reflects the degree of emotional commitment by market participants (see Chapter 28). High-volume rallies and declines have more inertia and are more likely to continue. Prices moving at high volume are like an avalanche that gathers speed as it rolls. Low volume, on the other hand, shows that the supply of losers is thin, and a trend is probably nearing an end.

Prices reflect what market participants think, while volume reflects the strength of their feelings. Force Index combines price and volume—it shows whether the head and the heart of the market are in gear with each other.

When Force Index rallies to a new high, it shows that the force of bulls is high and the uptrend is likely to continue. When Force Index falls to a new low, it shows that the force of bears is intense and the downtrend is likely to persist. If the change in prices is not confirmed by volume, Force Index flattens and warns that a trend is about to reverse. It also flattens and warns of a nearing reversal if high volume generates only a small price move.

Trading Rules

Short-Term Force Index

A 2-day EMA of Force Index is a highly sensitive indicator of the short-term force of bulls and bears. When it swings above its centerline, it shows that bulls are stronger, and when it falls below the centerline, it shows that bears are stronger.

Since the 2-day EMA of Force Index is a sensitive tool, we can use it to fine-tune signals of other indicators. When a trend-following indicator identifies an uptrend, the declines of the 2-day EMA of Force Index below zero pinpoint the best buying points: buying pullbacks during a long-term rally (Figure 30.1). When a trendfollowing tool identifies a downtrend, rallies of a 2-day EMA of Force Index mark the best shorting areas.

1. Buy when a 2-day EMA of Force Index turns negative during uptrends.

Even a fast and furious uptrend has occasional pullbacks. If you delay buying until the 2-day EMA of Force Index turns negative, you’ll buy closer to a shortterm bottom. Most people chase rallies and then get hit by drawdowns they find hard to tolerate. Force Index helps find buying opportunities with lower risks.

When a 2-day EMA of Force Index turns negative during an uptrend, place a buy order above the high price of that day. When the uptrend resumes and prices rally, you’ll be stopped in on the long side. If prices continue to decline, your

FIGURE 30.1 ADBE daily, 26-day EMA, 2-day Force Index. (Chart by Stockcharts.com)

Short-Term Force Index

Later in this book we’ll return to the all-important topic of using multiple timeframes to make trading decisions. For example, you may make your strategic decision—to be a bull or a bear—on a weekly chart and then make your tactical decisions on where to buy or sell short using a daily chart.

In the case of Adobe Systems, Inc. (ADBE), there is a steady uptrend on the weekly chart, confirmed by its rising EMA (not shown). When the weekly trend is up, a 2-day Force Index on the daily chart provides an ongoing series of signals that identify buy points. Instead of chasing strength and buying high, it’s better to buy during short-term pullbacks, when a wave goes against the tide. Those waves are marked by the 2-day Force Index dropping below zero. Once the 2-day Force Index goes negative, it makes sense to start placing buy orders above the latest bar’s high. This will ensure you’ll be stopped into a long trade as soon as the downwave loses it power.

order will not be executed. Keep lowering your buy order to near the high of the latest bar. Once your buy stop is triggered, place a protective stop below the latest minor low. This tight stop is seldom touched in a strong uptrend, but it’ll get you out early if the trend is weak.

2. Sell short when a 2-day EMA of Force Index turns positive in a downtrend.

When trend-following indicators identify a downtrend, wait until the 2-day EMA of Force Index turns positive. It reflects a quick splash of bullishness—a shorting opportunity. Place an order to sell short below the low of the latest price bar.

If the 2-day EMA of Force Index continues to rally after you place your sell order, raise your order the next day to near the previous bar’s low. Once prices slide and you enter a short trade, place a protective stop above the latest minor peak. Move your stop down to a break-even level as early as possible.

Additionally, a 2-day EMA of Force Index helps decide when to pyramid positions. You can add to longs in uptrends each time Force Index turns negative; you can add to shorts in downtrends whenever Force Index turns positive.

Force Index even provides a glimpse into the future. When a 2-day EMA of Force Index falls to its lowest low in a month, it shows that bears are strong and prices are likely to fall even lower. When a 2-day EMA of Force Index rallies to its highest level in a month, it shows that bulls are strong and prices are likely to rise even higher.

A 2-day EMA of Force Index helps decide when to close out a position. It does it by identifying short-term splashes of mass bullishness or bearishness. A short-term trader who bought when this indicator was negative can sell when it turns positive. A short-term trader who went short when this indicator was positive can cover when it turns negative. A longer-term trader should get out of his position only if a trend changes (as identified by the slope of a 13-day EMA of price) or if there is a divergence between the 2-day EMA of Force Index and the trend.

• 3. Bullish divergences between the 2-day EMA of Force Index and price give strong buy signals. A bullish divergence occurs when prices fall to a new low while Force Index makes a more shallow low.
• 4. Bearish divergences between the 2-day EMA of Force Index and price give strong sell signals. A bearish divergence occurs when prices rally to a new high while Force Index traces a lower second top.
• 5. Whenever the 2-day EMA of Force Index spikes down to five times or more its usual depth and then recoils from that low, expect prices to rally in the coming days.

Markets fluctuate between overbought and oversold, and when they recoil from a down spike, we can expect a rally. Note that this signal doesn’t work well in uptrends—markets recoil from down spikes but not from up spikes. Spikes that point down reflect intense fear, which doesn’t persist for very long. Spikes that point up reflect excessive enthusiasm and greed, which can persist for quite a long time.

A 2-day EMA of Force Index fits well into the Triple Screen trading system (see Chapter 39). Its ability to find short-term buying and selling points is especially useful when you combine Force Index with a longer-term trend-following indicator.

Intermediate-Term Force Index

A 13-day EMA of Force Index identifies longer-term changes in the balance of power between bulls and bears. When it rises above zero, the bulls are stronger, and when

FIGURE 30.2 SSYS daily, 26-day EMA, 13-day Force Index. (Chart by Stockcharts.com)

Long-Term Force Index

Stratasys, Inc. (SSYS) is one of the two leading companies in the rapidly emerging additive manufacturing (AM) market. In the two years since I wrote the world’s first popular e-book on investing in this technology, AM stocks have become investors’ favorites. A technical pattern has emerged, with rallies driven by amateurs piling in and sharp declines as they panic and bail out. The 13-day Force Index does a good job of catching those waves.

When the 13-day Force Index crosses above its zero line (marked by vertical green arrows), it shows that buying volume is coming in. That’s where a longer-term trader buys and holds. When the 13-day Force declines below its zero line and stays there, it shows that bears predominate.

Near the right edge of the screen, we see a record low of Force Index, but then bears begin to weaken, as Force Index starts inching towards zero. Keep your powder dry as you wait for an accumulation pattern to emerge and be confirmed by Force Index crossing above zero. This see-saw movement of stocks passing from strong hands into weak ones near the tops and back again near the lows goes on forever. Force Index can help you position yourself with the right group.

it falls below zero, the bears are in charge. Its divergences from prices identify intermediate and even major turning points (Figure 30.2). Its spikes, especially near the bottoms, mark approaching trend reversals.

The raw Force Index identifies the winning team in the battle between bulls and bears in any price bar, be it weekly, daily, or intraday. We get much clearer signals by smoothing the raw Force Index with a moving average.

1. When a 13-day EMA of Force Index is above the centerline, bulls are in control of the market. When it is below the centerline, bears are in charge.

When a rally begins, prices often jump on heavy volume. When a 13-day EMA of Force Index reaches a new high, it confirms the uptrend. As an uptrend grows older, prices tend to rise more slowly, and volume becomes thinner. That’s when a 13-day EMA of Force Index starts tracing lower tops. When it drops below its zero line, it signals that the back of the bull has been broken.

2. A new peak of the 13-day EMA of Force Index shows that bulls are very strong and a rally is likely to continue. A bearish divergence between a 13-day EMA of Force Index and price gives a strong signal to sell short. If prices reach a new high but this indicator traces a lower peak, it warns that bulls are losing power and bears are ready to take control.

Note that for a divergence to be legitimate, this indicator must make a new peak, then fall below its zero line, and then rise above that line again, but tracing a lower peak, which creates a divergence. If there is no crossover, then there is no legitimate divergence.

3. A new low in the 13-day EMA of Force Index shows that a downtrend is likely to continue. If prices fall to a new low but this indicator rallies above zero and then falls again, but to a more shallow low, it completes a bullish divergence. It reveals that bears are losing power and gives a buy signal.

When a downtrend begins, prices usually drop on heavy volume. When a 13-day EMA of Force Index falls to a new low, it confirms the decline. As the downtrend grows old, prices fall more slowly or volume dries up—that’s when a reversal is in the cards.

Adding an envelope to the chart of Force Index can help you detect its extreme deviations from the norm, which tend to lead to price trend reversals. This method for catching deviations and potential reversals works well with weekly charts, but not with the daily and intraday charts. This is truly a longer-term tool.

■ 31. Open Interest

Open interest is the number of contracts held by buyers or owed by short sellers in any derivative market, such as futures or options. If you are unfamiliar with futures or options, skip this chapter and return to it after you have read Chapters 44 on options and 46 on futures.

Stock market shares are traded for as long as the company that listed them stays in business as an independent unit. Most shares are held as long positions, with only a small percentage of shorts. In futures and options, on the other hand, the total size of long and short positions is always identical, due to the fact that they are contracts for future delivery. When someone wants to buy a contract, someone else has to sell it to them, i.e., go short. If you want to buy a call option for 100 shares of Google, another trader has to sell you that option; in order for you to be long, someone else has to be short. Open interest equals the total long or the total short positions.

Futures and options contracts are designed to last for only a set period of time. A futures or options buyer who wants to accept delivery and a seller who wants to deliver have to wait until the first delivery day. This waiting period ensures that the numbers of contracts held long and short are always equal. In any case, very few futures and options traders plan to deliver or accept delivery. Most traders close out their positions early, settling in cash long before the first notice day. We’ll return to the topic of futures and options in Part Eight of this book on trading vehicles.

Open interest rises when new positions are being created and falls when positions are being closed. For example, if open interest in April COMEX gold futures is 20,000 contracts, it means that bulls are long and bears short 20,000 contracts. If open interest rises to 20,200, it means that the net of 200 new contracts have been created: both bought and sold short.

Open interest falls when a bull who is long sells to a bear who is short but wants to cover his short position. As both of them get out, open interest falls by the size of their trade, since one or more contracts disappear from that market.

If a new bull buys from an old bull that is getting out of his long position, open interest remains unchanged. Nor does the open interest change when a new bear sells to an old bear who wants to buy to cover his short position. In summary, open interest rises when “fresh blood” enters that market and falls as current bulls and bears start leaving that market, as illustrated in the table below:

Buyer	Seller	Open Interest
New buyer	New seller	Increases
New buyer	Former buyer sells	Unchanged
Former seller buys to cover	New seller	Unchanged
Former seller buys to cover	Former buyer sells	Decreases

Technicians usually plot open interest as a line below price bars (Figure 31.1). Open interest in any market varies from season to season because of massive hedging by industrial users and producers at different stages of the annual production cycle. Open interest gives important messages when it deviates from its seasonal norm.

Crowd Psychology

It takes one bull and one bear to create a futures or options contract. A bull who believes that prices will rise buys a contract. A bear who thinks that prices are going to drop goes short by selling a contract for future delivery. With a trade between a

FIGURE 31.1 TYH14 daily, 13-day EMA, open interest. (Chart by TradeStation)

Open Interest

Open interest (OI) reflects the number of all short or long positions in any futures or options market. Since the two are equal in the derivatives markets, OI reflects the degree of conviction among bulls and bears.

Rising OI shows that the conflict between bulls and bears is becoming more intense and confirms the exiting trend. Falling OI, on the other hand, shows that losers are leaving the market, while the winners are cashing in—it signals that the trend is nearing its end.

Near the left edge of this chart of March 2014 Treasury Notes futures (TYH14), the trend is down, but the declining OI warns bears not to overstay the downtrend. OI bottomed out in area A, T-Notes in area B, and in area C, both were in clear uptrends, with rising OI calling for higher prices ahead. OI topped out in area D, and while prices continue to rise in area E, the new downtrend of OI serves up a warning to the bulls near the right edge of the chart.

Not all charts of open interest look as smooth and clear as this one. Serious traders don’t expect to find a magic tool of a single indicator—they use several indicators and act only when their messages confirm one another.

new bull and a new bear, open interest rises by the number of contracts they traded. A single trade is unlikely to move any market, but when thousands of traders make similar trades, they propel or reverse market trends.

Open interest reflects the intensity of conflict between bulls and bears. It depends on their willingness to maintain long and short positions. When bulls and bears don’t expect the market to move in their favor, they close out their positions, reducing open interest.

There are two people on the opposite sides of every trade, and one of them will be hurt when prices change. In a rally, bears will get hurt, and in a decline, bulls will suffer. As long as the losers hold on, hoping and hanging on to their positions, open interest doesn’t change.

A rise in open interest shows that a crowd of confident bulls is facing down a crowd of equally confident bears. It points to a growing disagreement between the two camps. One group is sure to lose, but as long as potential losers keep pouring in, the trend will continue. These ideas have been clearly put forth in L. Dee Belveal’s classic book, Charting Commodity Market Price Behavior.

It takes conviction among both bulls and bears to maintain a trend. Rising open interest shows that both camps keep adding to their positions. If they strongly disagree about the future course of prices, then the supply of losers is growing, and the current trend is likely to persist. An increase in open interest gives a green light to the existing trend.

If open interest rises during an uptrend, it shows that longs are buying while bears are shorting because they believe that the market is overvalued. They are likely to run for cover when the uptrend squeezes them harder—and their buying will propel prices higher.

If open interest rises during a downtrend, it shows that shorts are aggressively selling, while bottom pickers are buying. Those bargain hunters are likely to bail out when falling prices hurt them, and their selling will push prices even lower.

When a bull is convinced that prices are going higher and decides to buy, but a bear is afraid to sell short, that bull can buy only from another bull who bought earlier and now wants to cash out. Their trade creates no new contract, and open interest stays unchanged. When open interest goes flat during a rally, it shows that the supply of losers has stopped growing.

When a bear is convinced that prices are going lower and wants to sell short, but a bull is afraid to buy from him, that bear can sell only to another bear who shorted earlier and now wants to cover, take profits and leave. Their trade creates no new contract, and open interest does not change. When open interest stays flat during a decline, it shows that the supply of bottom pickers isn’t growing. Whenever open interest flattens out, it flashes a yellow light—a warning that the trend is aging and the best gains are probably behind.

When a bull decides to get out of his long position, a bear decides to cover his short position, and the two trade with one another, a contract disappears, and open interest shrinks. Falling open interest shows that losers are bailing out, while winners are taking profits. When the disagreement between bulls and bears decreases, the trend is ripe for a reversal. Falling open interest shows that winners are cashing in and losers are giving up hope. It signals that the trend is approaching its end.

Trading Rules

1. When open interest rises during a rally, it confirms the uptrend and gives a green light to add to long positions. It shows that more short sellers are coming into the market. When they bail out, their short covering is likely to push the rally higher.

When open interest rises as prices fall, it shows that bottom pickers are active in the market. It gives a green light to shorting because those bargain hunters are likely to push prices lower when they throw in the towel.

If open interest rises when prices are in a trading range, it’s a bearish sign. Commercial hedgers are much more likely to sell short than speculators. A sharp increase in open interest while prices are flat shows that savvy hedgers are probably shorting the market. You want to avoid trading against those who likely have better information than you.

2. If open interest falls while prices are in a trading range, it identifies short covering by major commercial interests and gives a buy signal. When commercials start covering shorts, they show that they expect the market to rise.

When open interest falls during a rally, it shows that winners and losers alike are becoming cautious. Longs are taking profits, and shorts are covering. Markets discount the future, and a trend that is accepted by the majority is ready to reverse. If open interest falls during a rally, consider selling and getting out.

When open interest falls during a decline, it shows that shorts are covering and buyers are taking losses and bailing out. If open interest falls while prices slide, take profits on short positions.

3. When open interest goes flat during a rally, it shows that the uptrend is getting old and the best gains have already been made. This gives you a signal to tighten stops on long positions and avoid new buying. When open interest goes flat during a decline, it warns you that the downtrend is mature and it is best to tighten stops on short positions. Flat open interest in a trading range does not contribute any new information.

More on Open Interest

The higher the open interest, the more active the market, and the less slippage you risk when getting in and out of positions. Short-term traders should focus on the contracts with the highest open interest. In the futures markets, the highest open interest tends to be in the front months. As the first notice day approaches and open interest of the front month begins to drop, while open interest in the next month begins to rise, it signals to roll over your position into the next month.

■ 32. Time

Most people conduct their lives as if they will live forever — repeating the same mistakes, not learning from the past, and hardly ever planning for the future. Freud showed that the unconscious mind doesn’t have the notion of time. Our deep-seated wishes remain largely unchanged throughout our lives.

When people join crowds, their behavior becomes even more primitive and impulsive. Individuals may be ruled by the calendar and the clock, but crowds pay no attention to time. They act out their emotions as if they had all the time in the world.

Most traders focus only on changing prices but pay little attention to time. That’s just another sign of being caught up in mass mentality.

The awareness of time is a sign of civilization. A thinking person is aware of time, while someone who is acting impulsively is not. A market analyst who pays attention to time becomes aware of a dimension hidden from the market crowd.

Cycles

Long-term price cycles are a fact of economic life. For example, the U.S. stock market tends to run in approximately four-year cycles. They exist because the ruling party inflates the economy going into the presidential election every four years. The party that wins the election deflates the economy when voters can’t take revenge at the polls. Flooding the economy with liquidity lifts the stock market, while draining liquidity pushes it down3 .

Major cycles in agricultural commodities are due to weather and fundamental production factors, coupled with the mass psychology of producers. For example, when livestock prices rise, farmers breed more animals. When those animals reach the market, prices fall and producers cut back. When the supply is absorbed, scarcity pushes prices up, breeders go to work again, and the bull/bear cycle repeats. This cycle is shorter in hogs than in cattle because pigs breed faster than cows.

Long-term cycles can help traders identify market tides. Instead, many traders get themselves in trouble by trying to use short-term cycles to predict minor turning points.

Price peaks and valleys often seem to flow in an orderly manner. Traders measure distances between neighboring peaks, and project them into the future to forecast the next top. Then they measure distances between bottoms and extend them into the future to forecast the next low. Cycles put bread and butter on the tables of analysts who sell forecasts. Few of them realize that what appears like a cycle on the charts is often a figment of the imagination. If you analyze price data using a mathematically rigorous program, such as John Ehlers’s MESA (Maximum Entropy Spectral Analysis), you’ll find that approximately 80 percent of what looks like cycles is simply market noise. A human mind looks for order—and even an illusion of order is good enough for many people.

If you look at any river from the air, it appears to have cycles, swinging right and left. Every river meanders in its valley because water flows faster in its middle than near the shores, creating turbulences that force the river to turn. Looking for short-term market cycles with a ruler and a pencil is like searching for water with a divining rod. Profits from an occasional success are erased by many losses due to unsound methods.

Indicator Seasons

A farmer sows in spring, harvests in late summer, and in the fall, lays in supplies for the winter. There is a time to sow and a time to reap, a time to bet on a warm trend and a time to get ready for a frost. We can apply the concept of seasons to financial markets. Taking a farmer’s approach, a trader should look to buy in spring, sell in summer, go short in the fall, and cover in winter.

Martin Pring developed the model of seasons for prices, but this concept works even better with technical indicators. Their seasons help recognize the current stage

³ Thiscycle was grossly distorted by the Fed’s “quantitative easing” following the 2008 debacle, but it’s likely to return, once we crawl out of the Great Recession.

of the market cycle. This simple but effective model helps you buy when prices are low and sell short when they are high, setting you apart from the market crowd.

We can define the seasons of many indicators by two factors: their slope as well as their position above or below the centerline. For example, let’s apply the concept of indicator seasons to MACD-Histogram (see Chapter 23). We define the slope of MACD-Histogram as the relationship between two neighboring bars. When MACD-Histogram rises below its centerline, it is spring; when it rises above its centerline, it is summer; when it falls above its centerline, it is autumn; and when it falls below its centerline, it is winter. Spring is the best season for going long, and autumn is the best season for selling short (Figure 32.1).

Indicator Slope	Position Relative to Centerline	Season	Preferred Action
Rising	Below	Spring	Go long
Rising	Above	Summer	Start selling
Falling	Above	Fall	Go short
Falling	Below	Winter	Start covering

When MACD-Histogram is below its centerline but its slope is rising, it is spring in the market. The weather is cool but turning warmer. Most traders expect the winter to return and are afraid to buy. Emotionally, it is hard to buy because the memories of a downtrend are still fresh. In fact, spring is the best time for buying, with the highest profit potential, while risks are relatively small because we can place a protective stop slightly below the market.

When MACD-Histogram rises above its centerline, it’s summer in the market and by now most traders recognize the uptrend. It’s emotionally easy to buy in summer because bulls have plenty of company. In fact, profit potential in summer is lower than in spring, while the risks are higher because stops have to be farther away from the market due to heightened volatility.

When MACD-Histogram is above its centerline but its slope turns down, it’s autumn in the market. Few traders recognize that change and keep buying, expecting summer to return. Emotionally, it’s hard to sell short in autumn—it requires you to stand apart from the crowd. In fact, autumn is the best time for selling short.

When MACD-Histogram falls below its centerline, it’s winter in the market. By then, most traders recognize the downtrend. It is emotionally easy to sell short in winter, joining many vocal bears. In fact, the risk/reward ratio is rapidly shifting against bears, as potential rewards are becoming smaller and risks higher because stops have to be placed relatively far away from prices.

Just as a farmer must pay attention to the vagaries of weather, a trader needs to stay alert. An autumn on the farm can be interrupted by an Indian summer, and a market can stage a strong rally in the autumn. A sudden freeze can hit the fields in spring, and the market can drop early in a bull move. A trader needs to use several indicators and techniques to avoid getting whipsawed.

The concept of indicator seasons focuses a trader’s attention on the passage of time. It helps you plan for the season ahead instead of mindlessly following other people.

FIGURE 32.1 VRTX daily, MACD-Histogram 12-26-9. (Chart by Stockcharts.com)

Indicator Seasons

We can apply the concept of seasons to most indicators and timeframes, including intraday. This can be done with a multitude of trading vehicles, even though this example focuses on the daily MACD-Histogram of Vertex Pharmaceuticals, Inc. (VRTX), a stock in the Nasdaq 100.

• Autumn—The indicator is above the centerline but falling. This is the best season for establishing shorts.
• Winter—The indicator drops below its centerline. Use weakness to take profits on short positions.
• Spring—The indicator turns up from below its centerline. It is the best time to establish longs.
• Summer—The indicator rises above its centerline. As the weather gets hot, use strength to take profits on long positions.

MACD-Histogram looks very smooth in this example, but be prepared for brief fluctuations, both above and below the centerline. Spring can be interrupted by a frost, there can be a warm spell in winter, etc.

Market Time

We measure time using calendars and watches, but seldom stop to think that our own perceptions of time are far from universal. We keep track of time in human terms, while huge areas of life move on vastly different timelines.

For example, we think that the ground under our feet is stable, while in fact continents move constantly. They traverse only a few inches per year, but this is enough to radically change the face of the globe over millions of years. Within shorter timeframes, weather patterns change over centuries. Ice ages and warming periods alternate with one another.

At the other end of the scale, there are physical particles that survive only a tiny fraction of a second. There are insects that are born, mature, procreate, and die within a single day.

Turning to trading, let’s keep in mind that time flows at a different speed in the market than it does for us as individuals. The market, composed of huge masses of human beings, moves at a much slower speed. The patterns you recognize on your charts may have predictive value—but the turns they anticipate are likely to occur much later than you expect.

The relative slowness of crowds can bedevil even experienced traders. Time and again we find ourselves entering trades too early. Beginners are typically late. By the time they recognize a trend or a reversal, that move had been underway for so long that they miss most, if not all of it. Newbies tend to chase old trends, but the more experienced analysts and traders tend to run into an opposite problem. We recognize approaching reversals and emerging new trends from far away—and jump in too soon. We often buy before the market finishes tracing a bottom or sell short well before it completes a top. By getting in too early we can end up losing money in trends that are too slow to turn.

What should we do? First of all, you need to become aware that the market time is much slower than your own. Second, consider not putting on a trade when you notice an early reversal signal. A better signal may well emerge later, especially at market tops, which take longer to form than bottoms.

It pays not to be greedy and trade a smaller size. A smaller position is easier to hold while a reversal is taking its sweet time. Be sure to use multiple timeframes for market analysis: this is the essence of Triple Screen, the system we’ll review in a future chapter.

The Factor of Five

Most beginners casually pick a timeframe that looks good to them—it can be a daily or a 10-minute chart, or any other—and ignore others. Few are aware of the fact that the market lives in multiple timeframes. It moves simultaneously on monthly, weekly, daily, and intraday charts—often in opposite directions.

The trend may be up on the daily charts but down on the weeklies, and vice versa. Which of them will you follow? And what will you do about the intraday charts, which may well contradict either the weeklies or the dailies? Most traders ignore all timeframes except for their own—until a sudden move from outside of their timeframe hits their account.

Keep in mind that neighboring timeframes are linked by the factor of approximately 5. If you start with a monthly chart and proceed to the weekly, you’ll notice that there are 4.5 weeks to a month. As you switch from a weekly to a daily chart, you know that there are 5 trading days to a week. Turning to intraday analysis, you may look at an hourly chart—and there are approximately 5–6 hours to a trading day. Day traders can proceed even further and look at 10-minute charts, followed by 2-minute charts. Each is related to its neighboring timeframes by approximately the factor of five.

The proper way to analyze any market is to review at least two neighboring timeframes. You must always start with the longer timeframe for a strategic view and then switch to the shorter timeframe for tactical timing. If you like using daily charts, you must first examine weekly charts, and if you want to day-trade using 10-minute charts, you first need to analyze hourly charts. This is one of the key principles of the Triple Screen trading system (see Chapter 39).

■ 33. Trading Timeframes

How long do you plan to hold your next trade? Do you think it’ll be a year, a week, or an hour? A serious trader plans the expected duration of every trade. Various timeframes offer different opportunities and carry different risks. We can roughly divide all trades into three groups:

1. Long-term trading or investing—The expected duration of a position is measured in months, sometimes years.

Advantages: requires little day-to-day attention and may lead to spectacular gains. Disadvantage: drawdowns can be intolerably severe.

2. Swing trading—The expected duration of a trade is measured in days, sometimes weeks.

Advantages: a wealth of trading opportunities, fairly tight risk control.

Disadvantage: will miss major trends.

3. Day-trading—The expected duration of a trade is measured in minutes, rarely hours.

Advantages: great many opportunities, no overnight risk.

Disadvantages: demands instant reflexes; transaction costs become a factor.

If you decide to operate in more than one timeframe, consider making those trades in different accounts. This will allow you to evaluate your performance in each timeframe rather than lump together apples and oranges.

Investing

The decision to invest or trade for the long term is almost always based on some fundamental idea. You may recognize a new technological trend or an exciting product that can greatly increase the value of a company. Investing demands a firm conviction and a great supply of patience if you are to hold that position through the inevitable pullbacks and periods of flat prices. These tough challenges make successful investing extremely hard.

Major trends that are easily seen on long-term charts appear uncertain and foggy in real time, especially when a stock enters a drawdown. When your investment drops 50% or more, wiping out the bulk of paper profits—a common development for long-term positions—few of us have enough conviction and fortitude to continue to hold. Let me illustrate this using an example of Apple Inc. (AAPL), a darling of several bull markets (Figure 33.1).

AAPL survived its near-death experience in 2003, when its battered stock was rumored to be a takeover candidate, and grew to become the highest-capitalized, publicly traded company in the world, before collapsing from that top in 2012. Its uptrend looks grand in retrospect, but ask yourself, honestly, would you have been able to hold though multiple drawdowns, some of them exceeding 50%. Remember that such drawdowns often mark the ends of uptrends.

A sensible way to deal with the challenge of investing is to implement your fundamental idea with the help of technical trading tools. When you decide to buy, check out technical signals to ensure you’re getting a relative bargain rather than paying full price. If your investment soars, use technical tools to identify overvalued zones; take your profits there and be ready to repurchase during the inevitable pullbacks. This plan demands a high degree of attention, focus, and perseverance. Figure 33.2 is an example that was taken from my trading diary.

FIGURE 33.1 AAPL weekly. (Chart by Stockcharts.com)

Investing

The tremendous challenges of holding an investment, even a market leader like Apple Inc. (AAPL), can be seen on this 10-year chart:

• 1. 2003—AAPL collapses below $10. Company’s survival in question. Would you buy?
• 2. 2006—AAPL rallies to $86, then sinks to $51. If you had a thousand shares, would you hold? Would you sell when it got back above $80 and appeared to stall?
• 3. 2008—AAPL rallies to $202, drops to $115. If you had a thousand shares, showing an $87,000 drawdown, would you hold or sell?
• 4. 2009—AAPL recovers to $192, sinks to $78, below its previous low. Your drawdown is over 50%. Are you holding or cashing out?

FIGURE 33.2 F monthly, 26- and 13-months EMA with the Impulse system, Autoenvelope, MACD Lines and MACD-Histogram (12-26-9), and Force Index 13-months EMA with ATR channels. (Chart by Tradestation)

Technical Analysis with Fundamentals

• 1. 2007—Ford was on the ropes when the new CEO arrived—the man who earlier spearheaded saving Boeing. In the heady atmosphere of a bull market, Ford seemed to have a shot at recapturing its $30 high. I saw a false downside breakout coupled with a bullish divergence and bought. I then grimly held through the bear market.
• 2. 2011—Ford spiked above its monthly channel, which was narrower at that time, tracing a kangaroo tail, while monthly MACD weakened. I took profits.
• 3. 2011—as monthly prices stabilized in their value zone, I repurchased my position.

Fundamental analysis can help you find a stock that may be worth buying. Use technical analysis to time your entries and exits. Be prepared to buy and sell more than once during a major uptrend.

Swing Trading

While major trends and trading ranges can last for years, all are punctuated by short-term upswings and downswings. Those moves create multiple trading opportunities, which we can exploit. Many charting examples in this book feature swing trades.

I especially recommend swing trading for beginning and intermediate traders. The more trades you make, the more you learn, provided you manage risk and keep good records. Swing trading teaches you faster than long-term investing, whose lessons take years to complete. Swing trading gives you time to think, unlike day-trading, which demands instant reactions. Day-trading is too fast for beginners.

Short-term swings can be substantial enough to generate meaningful profits, without the gut-wrenching drawdowns of position trades. Swing trades don’t require watching the screen all day. In SpikeTrade.com, where hundreds of traders compete, most trades last a few days. Some members carry their trades for weeks and even months, while others hop in and out within hours—but the holding period for most members is measured in days. Swing trading hits the sweet spot among time horizons.

I piggyback one or more of the Spiketrade group’s picks almost every week. The chart of HES in Figure 33.3 comes from my diary of one of those trades.

My profit in the HES trade was $1.92 per share. You can calibrate the amount of risk you accept and the size of potential profit by deciding how many shares to trade. We’ll address this essential question in chapter 50, in the section on the Iron Triangle of risk control.

FIGURE 33.3 HES daily, 26- and 13-day EMA with 4% envelope, MACD Lines and MACD-Histogram (12-26-9), the Impulse system, and 2-day Force Index. (Chart by Stockcharts.com)

A Swing Trade

Professional traders are just as comfortable selling short as buying. The signals are similar but the action quicker—stocks fall twice as fast as they rise.

This chart shows where I shorted the stock of Hess Corporation (HES) as it was tracing a short-term double top, with bearish divergences in all indicators. I covered and took profits, as prices appeared to stall just below the value zone between the two EMAs, while the indicators became oversold.

One of the best learning techniques involves returning to your closed-out trades two months later and replotting their charts. Trading signals that looked foggy when you saw them at the right edge of the screen become clear when you see them in the middle of your chart. Now, with the passage of time, you can easily see what worked and what mistakes you may have made. Creating these follow-up charts teaches you what to repeat and what to avoid in the future. Updating the charts of closed trades turns you into your own instructor.

The chart and text in Figure 33.4 come from SpikeTrade.com. Each week the Spiker who won that week’s competition posts a diary of his trade. Different people use different indicators and parameters.

Peter’s trade gained almost 11% in three days. Of course, we can’t allow ourselves to get intoxicated by such numbers. A beginner looks at them, multiplies them

A Swing Trade near the Bottom

This trade was submitted by Peter D., a long-term Spiker from the Netherlands. His post was headlined “Fishing near the Lows.”

“Weekly conditions: Indicators don’t show much movement. MACD very shallow but positive and RSI slowly improving. Daily: MACD was about to confirm a positive divergence, and so was RSI. Prices dove last week but stopped near support.

“I set the initial entry at $3.02, in line with recent lows. It was hit on Monday morning, which turned out to be one cent above the low for the day and the week. Price closed near the high of the day and continued surging on Tuesday and Wednesday. My target was hit on Wednesday, on the way up. The rest of the day saw some pulling back, but price kept in range to close the week on a relatively high note.”

by the number of weeks in a year, and goes crazy throwing his money at the markets. Such spectacular gains are inevitably interspersed with losses. A professional trader carefully manages his money, quickly cuts losing trades and protects his capital to allow his equity to grow.

If investing is like hunting the big game, swing trading is like rabbit hunting. If your livelihood depends on hunting, shooting rabbits is a much more reliable way of putting meals on the table. Carefully entering and exiting swing trades, while cautiously managing money, is a realistic way of surviving and prospering in the markets.

Day-Trading

Day-trading means entering and exiting trades within a single market session. Rapid buying and selling in front of a flashing screen demands the highest levels of concentration and discipline. Paradoxically, it attracts the most impulsive and gamblingprone people.

Day-trading appears deceptively easy. Brokerage firms hide customer statistics from the public, but in 2000, state regulators in Massachusetts subpoenaed brokerage house records, which showed that after six months only 16% of day-traders made money.

Whatever gaps you may have in your knowledge or discipline, day-trading will find them fast and hit you hard in your weak spots. In swing trading, you have the luxury of being able to stop and think, but not in day-trading.

The person who is learning to trade is much better off using end-of-day charts. After you grow into a consistently profitable swing trader, you may wish to explore day-trading. You’ll use your already developed skills and will only need to adjust to a faster game. A market newbie who stumbles into day-trading is a gift to the pros.

Make sure to write down your action plan for day-trading: what will prompt you to enter or exit, to hold or cut. Be prepared to invest plenty of time: day-trading chews up long hours in front of multiple screens.

Another difficulty of day-trading is that you shoot at much smaller targets. This is reflected in the height of price channels. Elsewhere in this book, you’ll read that a good measure of a trader’s performance is the percentage of the channel or an envelope he captures in a trade. Taking 30% or more of a channel’s height earns you an A grade, while capturing 10% of that channel earns you a C (see Chapter 55). Let’s apply these ratings to several stocks that are popular with day traders. The exact figures will change by the time you read this book, but today I get the following numbers for channel heights on the daily and 5-minute charts:

	Daily Channel	“A” Trader	“C” Trader	5-Min Channel	“A” Trader	“C” Trader
AAPL	55	16.5	5.5	2.5	0.75	0.25
AMZN	27	8.1	2.7	2.2	0.66	0.22
MON	7	2.1	0.7	0.6	0.18	0.06

A swing trader who uses daily charts can do very well in these active stocks. He can really clean up if he is an A level trader, but even if he is a C trader, taking only 132 VOLUME AND TIME

10% out of a channel, he can stay comfortably ahead of the game while learning to trade. On the other hand, a person who day-trades the very same stocks must be a straight A trader in order to survive. Anything less and his account will be ground up by slippage, commissions, and expenses.

If, after developing a successful track record as a swing trader, you decide to daytrade, you’ll be able to use most of the tools and techniques you’ve already learned. You’ll find an example of using Triple Screen in day-trading in Chapter 39.

When a friend who is an Olympic rowing coach taught me to row, he focused on developing the correct stroke. A competent rower always moves his oars exactly the same way, whether it’s a leisurely weekend row or the final stretch of a race. What changes are power and speed. The same with day-trading: the technique is the same, but the speed is different. If you learn to swing trade, you can apply your technique to day-trading. And then you can go in reverse, and apply day-trading techniques to swing-trade entries and exits.

Day-trading can be a profitable pursuit, but keep in mind that it’s a highly demanding professional game and most definitely not a casual activity for beginners.