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Trend Trading Indicators

Copyright © 2011 by John Person

Published by Marketplace Books TABLE OF CONTENTS
All rights reserved.

Reproduction or translation of any part of this work beyond that permitted

by section 107 or 108 of the 1976 United States Copyright Act without the
permission of the copyright owner is unlawful. Requests for permission or Introduction 3
further information should be addressed to the Permissions Department at
Marketplace Books. Chapter 1 : Seasonal Analysis 4
This publication is designed to provide accurate and authoritative informa-
Chapter 2 : Pivot Point Analysis 8
tion in regard to the subject matter covered. It is sold with the understand-
ing that neither the author nor the publisher is engaged in rendering legal,
Chapter 3 : Commitment of Traders Report 16
accounting, or other professional service. If legal advice or other expert
assistance is required, the services of a competent professional person
should be sought.
Chapter 4 : ADX as a Trend Strength Indicator 23

From a Declaration of Principles jointly adopted by a Committee of the Chapter 5 : Stochastics & MACD 27
American Bar Association and a Committee of Publishers.
Chapter 6 : Moving Averages 33
Charts created using TradeStation ©TradeStation Technologies, Inc., 2001 -
2011. All rights reserved. No investing or trading advice, recommendation or
Chapter 7 : Dow Theory 43
opinion is being given or intended.

TD Ameritrade, Inc. and John Person are separate and unaffiliated compa- Chapter 8 : Volume & Open Interest 48
nies and are not responsible for each others services or policies.
Chapter 9 : Trend Lines 52
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Chapter 10 : Elliott Wave 56
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In Closing 62
eISBN 978-1-59280-461-0 2
Trend Trading Indicators
the most important trend trading In addition, I will share techniques and bottoms. As a result, their
I concepts that many traders seem on how to correctly apply trend trading careers end quickly.
to either not know or completely line analysis and integrate mul-
It is a proven fact that more suc-
forget to incorporate when execut- tiple timeframe techniques. I will
Introduction ing investment decisions using real also show you some of the more
cessful traders wait for a trend
to be established and then try to
money. reliable technical indicators for
profit by trading on the right side
helping to identify trend market
1. Seasonal and intermarket of the direction of that price move
Profiting from analysis for an extended period of time.
Trend Analysis 2. Traditional trend line charting As the saying goes, “the trend is The trick here is to stay disciplined
techniques your friend”—until the trend ceas- and focused, but many trend fol-
“The trend is your friend”
es to exist. Many traders in the lowers understand the significance
3. Technical indicators
In simplest terms, trend is defined course of their careers have tried of seasonal analysis and they let
as the direction of price over a Many investors are familiar with to identify when a trend ceases historic data help them gauge how
period of time. There are many the axioms, “sell in May and go to exist and to capitalize on that long they expect a trend to last.
techniques that can be used to away,” or perhaps, “harvest lows reversal. This is often referred to
Some of the most technically
trade with the trend. Most profit- are made in the fall,” but they fail as anticipating a trend reversal, or
advanced studies are applied to
able longer-term traders choose to to either adhere to their game top or bottom picking. While it can
trend trading. As I mentioned, one
trade in the direction of the trend plan or follow through with apply- be extremely lucrative if you are
of the simplest forms of analytical
while intermediate-term traders ing seasonal tendencies of sup- right, unfortunately very few trad-
studies is understanding seasonal
will trade the longer-term trend ply and demand functions of the ers are successful at picking tops
analysis. More complex analysis
against pullbacks in the intermedi- markets. I plan on sharing secrets
that I will introduce in this book
ate term time frame. Short-term that I have also written about in
traders or daytraders will also my second book Candlestick and
use pullbacks against longer-term Pivot Point Trading Triggers, as
trends but may also incorporate well as in the Commodity Trader’s In simplest terms, trend is defined as the
countertrend techniques in their Almanac, which I co-authored with
trading decisions.
direction of price over a period of time.
Jeff Hirsch, so please consult either
of these titles if you wish to go fur-
This guide is designed to introduce
ther with your studies on trend.
you to what I consider three of 3
Trend Trading Indicators
includes pivot analysis, Elliott
wave studies, and then going back 1
to the turn of the 20th century,
the concepts of “trend phases” Seasonal
introduced by Charles Dow. All of
this will help you in your decision-
making process for not only enter-

ing trades but also holding onto
your trades. I was taught early on, he key to achieving wealth by trading the markets—other than being on the right side of the
nearly thirty years ago, to cut your trend—is good risk management and being properly positioned in a trade. It is crucial that the
losses short and let your winners individual trader fully comprehends the psychological impact trading has on one’s own psyche,
ride. Understanding and applying and more importantly, understanding how very little predictability there is in the market. That is where
some of these principles in this seasonal analysis can help prepare traders and investors for what lies ahead, and when shifts in supply
book will not only shed light on and demand functions can reverse or help accelerate trending market conditions. I believe this book will
how to do that, but we will also help you to successfully formulate a solid plan of attack in market trends.
share with you where you can
If the trader is armed with the right knowledge and can implement the application of good, sound tech-
acquire further educational mate-
nical analysis methodology to help time entries, exits, as well as to establish risk and profit objectives,
rial in order to master the tech-
the odds of success can be improved immensely.
niques that many have acquired
through the last half century. Seasonal analysis gives investors and traders an edge in capturing that elusive “predictability of the
markets.” What many traders do not realize is that most markets demonstrate seasonal price patterns;
All the best,
meaning they tend to make highs or lows near the same time period year after year.
John L. Person
Stocks, commodities, and even foreign currencies have a strong tendency to demonstrate seasonal pat-
terns. One of the greatest benefits of incorporating seasonal analysis is being able determine when a
market is in a weak or strong trend and time changes in the trend's direction.

The art of using history as a guide to predict future price moves is absolutely a mind-blowing experi-
ence, especially when you are able to profit from that knowledge. However, if it were that simple and
reliable, everyone would be doing it, and every trader would be getting rich, and quickly. Unfortunately,
this is not the case. 4
Trend Trading Indicators
Seasonal analysis cannot forecast banks’ massive printing of curren- to break down the cumulative tunity. If, for example, I see a
the outcome of each trade. Trend cies. In addition, government defi- profits, which aids in the decision- decent risk/reward opportunity
moves from a seasonal perspective cit spending was out of control. making process. of perhaps a three to one setup, I
can either be muted or magnified, Therefore, gold was being bought may diversify position tactics.
Here is where seasonal analy-
depending on economic turmoil, by any and all avenues of investing
sis helps me as a trader: I am In the case of this bullish seasonal
political events, monetary and fis- perspectives.
constantly scanning for trading trend in gold, instead of loading
cal policy (stimulus) changes, and
In the Commodity Traders opportunities. We all know we up on a long futures position, or
weather concerns that will impact
Almanac, 2010 Edition, I highlight- can not take every trade, so there just buying into a bullish option
supply and demand parameters.
ed one of the top seasonal trades must be a filtering process to strategy, I usually look to diversify
There are always unique events in August for gold: help us decide which trade has a my position in a bullish trend situ-
that will affect certain markets or higher probability, and then we ation such as spreading my trad-
sectors. A specific company can can look at the risk to reward lay- ing capital around. I may look to
influence prices. “Seasonally, this is a strong out. I like to look for a good fun- buy a highly correlated gold stock,
price period for gold until late damental situation and a market and I will look at a near-the-money
There are many times when the September or early October. Look that has a proven track record of credit call spread in the exchange
macro economic environment will to enter long positions on or somewhat high level of predict- traded fund (GLD). At the same
enhance a seasonal situation. Let’s about August 25 and holding until ability based on its past trading time, I might expand my risk capi-
examine a case study using gold. September 30. In the last 34 years history. I like to plan ahead, and tal and look at a slightly out-of-
By August of 2010, the market was this trade has worked 20 times for using seasonal analysis helps me the-money short term credit put
in turmoil over whether or not a a success rate of 58.8%. The last in that process. I can start a shop- spread option position. Finally, I
double dip recession was in the 8 years have provided an amazing ping list so-to-speak for which might just take a reduced hold-
making. Gold had been in a strong cumulative profit of $20,160 per sectors enter a period of strength ing of a long futures position. This
uptrend as it was acting on its own futures contract.” or weakness, and based on my way I am diversified in my actual
merits, meaning there was global
criteria, I can filter out which trade, which can help me survive
consumer demand and investment
areas to focus in on rather than or take advantage of multiple out-
demand as many entities were Using Seasonal Analysis acting after a market has already come scenarios, whether the trend
looking at gold as a hedge against as a Filter moved. In addition, I can start of gold continues sharply higher,
not only deflationary fears, but
Seasonal analysis can not only to lay out how much equity and mildly higher, stays flat, or drops
as a defense against longer term
help define when a trend move which strategy I want to employ first and then takes off.
inflationary fears, due to central
may take place, but can help one to take advantage of the oppor- 5
Trend Trading Indicators
I think many traders get the mar- the seasonal tendencies. The same
ket trend right at times but fail in technique enables traders to man-
their sense of timing and perhaps age their risks more appropriately
over-position themselves for a rather than going “all in” in one
trade. Then, when a slight move large overleveraged position.
occurs against them or a draw-
Figure 1.1 is a seven-year average
down happens, as is often the case
of gold’s price moves taken as of
in the real world of trading, they
the end of April 2009. Notice that
can’t afford to hang on. This often
between the August low and the
results in a loss, or they miss the
September low, the average of
move entirely. An old saying of
those lows would come in around
mine that may resonate with you if
August 25.
you have had experience in trading
markets: “The market will always The seasonal analysis indicates
let you in the losers; the mar- that this uptrend should continue
ket’s job is to keep as few winners through the end of September
around as possible.” Diversifying into early October. On average,
your trend trading strategy may the market conducts a short-
help you overcome this issue. term profit-taking correction or a
trend reversal in the third week
One has to remember that his-
of October to the first week of
tory can and does repeat itself;
November. After that, gold prices
the problem is the outcomes rather sideways, still adhering to We have many scenarios that could
have the best three month bull-
are not always the same. Let me a seasonally strong period. Rather unfold, so I believe a more pru-
ish trend period from November
explain. Perhaps the market is bull- instead of moving up in value, it dent, well-balanced trader can and
lasting into late February. Short-
ish; it could move at lightning bolt just remained the same. Now of should diversify his or her position
term traders can potentially expe-
speed to the upside, not allowing course there are the few times based on many different outcomes.
rience a period of approximately
one to enter in a position. Or the when the market will not perform By employing different strategies
five weeks of stronger prices from
market could move higher, but according to its past historic sea- with the same risk capital, one can
August 25 through October 1.
only by a small percentage. Or the sonal tendency and moves down still profit handsomely if the mar-
market may not move higher but against a long position. ket does indeed move according to 6
Trend Trading Indicators
A quick review of recent history traders uncover when the best The graph shows the weekly It was the next trading session
shows from the low made on time of the year­—on average—a Person Pivots overlaid on the where the move really started to
August 25, 2009 at 950.60, gold market trend can occur, either up charts, and you could see in the accelerate.
peaked by October 14, 2009 at or down. Commodity Traders Almanac, it
If you did not act on the 24th, but
1079.50. Two weeks later it cor- stated, “Look to enter long posi-
Take a look at Figure 1.2, which is rather waited until the 25th of
rected to a low of 1034. Back on tions on or about August 25.” The
a daily gold chart for 2010. As you August to enter a long position,
August 25, 2008, gold traded as market made a corrective pullback
can see, prior to August 24, the you obviously would have had
low as 835.6, but it did take heat on August 24, trading right down
trend was up. a better advantage from a risk/
and fell further, first to a low of to the predicted support targets.
reward perspective. This is where
754.3 by September 11. However
employing various bullish strate-
by October 11, just four weeks
gies would be instrumental, and
later, gold made a sharp rally,
help one become a more com-
posting a high of 889.5. A diver-
plete, well-balanced, diversified
sified trader may have ridden
trader trying to capture a strong
the storm out better than a fully
trending and strong bullish season-
vested, long, futures-only position
al market condition.
trader. On a side note, that high
made in October 2008 reversed Buying on the close of business
hard in just 11 trading days, post- and holding as of the date of this
ing from peak of 950.80 to a writing, gold surged to a high of
trough of approximately 695.50, 1288 by September 21. As of the
over a 250.00 dollar correction close the market, gold was at
per ounce of gold. 1279.50. Seasonal analysis was
instrumental in helping to define a
I mention this to support my pre-
strong trend condition and there-
vious statement that not all years
fore one may have enhanced trad-
are created equal from a seasonal
ing performance. Even if you did
perspective in both the exact time
not catch this trend, at the very
of markets’ moves and in price
least, seasonal analysis alerted you
swings. The key to focus in on is
to a high probability situation that
that seasonal analysis can help 7
Trend Trading Indicators
may have kept you from trading on Quick Quiz
the wrong side of the market. Or 2
1. What is the key to achieving
as we say, fighting the trend.
wealth by trading the markets? Pivot Point
In addition to helping pick out a
trend condition, seasonal analysis
a. Being on the right side of the
is absolutely instrumental in iden- b. Good risk management
tifying when a trend may cease to

c. Proper trade position
exist, and that is also a very valu- d. All of the above his chapter is devoted to my favorite technical tool, pivot
able piece of market knowledge, points. This is a tool that many traders either misuse or
because one needs to be able to 2. What types of securities dem-
do not understand entirely. I use pivot point analysis to
onstrate seasonal patterns?
take profits in this business. help confirm the market trend, or condition whether it is bullish
a. Stocks or bearish. Then, I use the integrated formulas to project under
In the remainder of this ebook, we
b. Commodities those assumptions as to what the next time periods’ range
will delve into more techniques to
c. Foreign currencies might be. In addition, I use pivot analysis to confirm at what
aid traders in identifying trends
d. All of the above price level a potential trend reversal level might be.
and how to tread on the right side
of the market. 3. Seasonal price patterns show
As traders, we think about what more one wants than to stay
that most markets make highs
with the trend, correct? Well, traders also need as much help in
or lows near the same time
setting risk targets as they do profit targets. Pivot analysis helps
period year after year.
me achieve both of these goals.
a. True
b. False This chapter will describe in full detail the principles behind
the mathematical calculations as well as the rationale behind
4. Seasonal analysis can help pre- the psychological impact that drives traders to make decisions
dict the outcome of each trade. around these levels.
a. True I will break it into separate sections to explain how it can be
b. False
applied for identifying support and resistance levels in trending
For the answers to this quiz, go to market conditions. This technical tool works for short and long term trend traders. It can be applied for stocks, futures, and in
the foreign currency arena. Each investment vehicle has its own 8
Trend Trading Indicators
nuances, such as trading session feel compelled not to learn about all market participants’ collective a given session out of fear that
hours, time periods in which vol- them because they seem compli- perception of value for that time they would lose more by stay-
ume flows change, contract sizes, cated. I will dispel that myth. period. I want to quote the famous ing in a long trade; they certainly
and decimal point placement so legendary trader Jesse Livermore, will respect that price point the
In my first book, A Complete
that you know how to correctly cal- who stated nearly seventy years next time the market trades back
Guide to Technical Trading Tactics,
culate the pivot point levels. First, ago this observation: “The pat- at that level. So the high and low
I illustrated many trading meth-
you need to know the foundation terns the traders and technicians are important reference points.
ods that one can apply using pivot
of the methodology of pivot point observe are simply the reflections With that said, pivot point analy-
point analysis with candlesticks
analysis; this will then allow you to of human emotional behavior.” It sis incorporates the three most
patterns, including the power of
apply it to the specific markets of rings as true today as it did then. important elements—the high, the
multiple time frames, or what is
interest that you are trading. low, and of course, the close of a
know as confluence of various The range, which is the high and
given trading session. The most
target levels. This chapter will low of a given time period, accu-
Power of Pivot Point common formulas are:
highlight those techniques as well rately reflects all market partici-
as explain how to filter out and pants’ exuberant bullishness and Pivot Point: the pivot point is the
The power in using pivot analy- narrow the field of the respective pessimistic bearishness for that high, low, and close added togeth-
sis is that the strategy works in support and resistance numbers trading session, whether it is a day, er and divided by three.
all markets that have established and divulge various formulas that a week, or a month. The high and
ranges, based on significant vol- are popular today. low of a given period is certainly P=(H+L+C)/3
ume or a large group of collective important, as it mirrors human
participants. After all, the current Resistance 2: R2 is the pivot point
What is Pivot Point emotional behavior.
market price equals the collec- number plus the high and minus
tive action of buyers and sellers. Think of it this way: the high is the low.
Pivot point analysis is a mathemat- a reference point for those who
Pivot point analysis is a robust,
ical formula designed to determine bought out of greed thinking R2=P+H-L
time-tested, and best of all, testifi-
the potential range expansion they are missing an opportunity.
able form of market analysis. This
based on a previous time period’s They certainly won’t forget how Resistance 1: R1 is the pivot point
means that you can backtest to
data, which includes the high, much they lost and how the mar- number times two minus the low.
see the accuracy of this tool’s pre-
the low, and the close or settle- ket reacted as it declined from
dictive analysis. The really unbe-
ment price. These variables from that level. The opposite is true R1=(Px2)-L
lievable aspect of pivots is who
a given time period’s range reflect for those who sold the low of
uses them. In fact, many traders 9
Trend Trading Indicators
Support 1: S1 is the pivot point Resistance 3 = H + 2x (Pivot I believe in looking at the progres- Resistance Level 3
number times two minus the high. – Low) sively higher time period’s price This is an extreme bullish market
support or resistance projections. condition generally created by
S1=(Px2)-H Support 3 = L – 2x (High – Pivot) For example, from the daily num- news-driven price shocks. This is
bers, I would look at the weekly where a market is at an overbought
Support 2: S2 is the Pivot Point figures and then from the weekly
Or condition and may offer a day trad-
number minus the high plus the R3 = (P-S1) + R2 numbers, I would look at the er a quick reversal scalp trade.
low. S3 = P- (R2 - S1) monthly numbers.

S2=P-H+L There are other variations which Resistance Level 2

include adding the opening range. The longer the time We see this level when there is a
The Next Level In this case, that would involve bullish market price objective or
simply taking the open, high, low, frame, the more target high number for a trading
Some analysts add a third level to
and close and dividing by four to session. It generally establishes
their pivot calculations to help tar- important or signif-
derive the actual pivot point. the high of a given time period.
get extreme price swings on what
has occurred on occasion, such
icant the data. The market often sees significant
P = (O, H, L, C) /4 resistance at this price level and
as a price shock resulting from a
will provide an exit target for long
news driven event. Currency mar- It is rare that the daily numbers
Price Action Reaction positions.
kets tend to experience a double will trade beyond the extreme R2
dose of price shocks, as they are Let’s see what these numbers or S2 numbers and when the mar-
mean and how price action reacts Resistance Level 1
exposed to foreign economic ket does, it is generally in a strong
developments as well as U.S. eco- with these projected target levels. This is a mild bullish to bearish
trending condition. In this case,
nomic developments that pertain Here is how the numbers would projected high target number. In
we have methods to follow the
to a specific country’s currency. break down by order, what typi- low volume or light volatility ses-
market’s flow, and we will cover
This tends to make wide trading cally occurs, and how the market sions, or consolidating trading
this in more detail in the next few
ranges. Therefore, a third level of behaves. Keep in mind, this is a periods, this often acts as the high
sections. By focusing on just a few
projected support and resistance general description and we will of a given session. In a bearish
select numbers and learning how
can be calculated. learn what to look for at these price to filter out excess information, market condition, prices will try to
points to spot reversals in order to come close to this level, but most
I eliminate the analysis paralysis
make money and reduce risk. times will fail.
from information overload. 10
Trend Trading Indicators
Pivot Point sees significant support at or near Here is how I utilize time frame in sense. If the exchanges and the
This is the focal price level or the this level in a bearish market con- my research. There are approxi- banking system use a specific time
mean, which is derived from the dition and it is a likely target level mately 22 business days, or about to settle a market, then that is the
collective market data from the to cover shorts. four weeks in any given month. time period that should be consid-
prior session’s high, low, and close. Every month there will be an estab- ered for a close. They should know
It is the strongest of the support Support Level 3 lished range—a high and a low. those are the rules that make
and resistance numbers. Prices In an extremely bearish market There are typically five trading days money move. I want to follow the
normally trade above or below condition, this level will act as the in a week. Now consider that in money flow.
this area before breaking in one projected target low or support one day of one week in one month,
direction or the other. As a gen- area. A price decline to this level a high and a low will be made. It Predicting Highs
eral guideline, if the market opens is generally created by a news- is likely that this high and low may and Lows Using the
above the primary pivot, be a driven price shock. This is where a be made in a minute or within one Calculations
buyer on dips. If the market opens market is at an oversold condition hour of a given day, of a given week I believe in keeping things simple,
below this level, look to sell rallies. and may offer a day trader a quick of that month. That is why longer- and that less is more. I use the
reversal scalp trade. term time frames such as monthly numbers and the filtering method
or weekly analysis should be includ-
Support Level 1 to help me select either the high
Value of Time Frame ed in your market analysis. or the low of a given trading ses-
This level consists of a mild bearish
to bullish projected low target num- Daily, weekly, and monthly time In the world of 24-hour trading, sion, and sometimes this works to
ber in light volume or low volatility frames can and should be utilized, the most popular question I get project both the high and the low
sessions, or in consolidating trad- as well. To understand how price from those studying and using with amazing accuracy. Therefore,
ing periods. Prices tend to reverse moves within the pivots, begin by pivot points is: “What are the it is important not to be bur-
at or near this level in bullish mar- breaking down the time frames times that you derive the high, dened with information overload.
ket conditions, but most times fall from longer term to shorter term. low, and close information?” Remember:
short of hitting this number. As traders, we should begin with a • Pivot point calculations help
There are many different people
monthly time frame, where there is determine when to enter and
telling many different stories. Here
Support Level 2 a price range or an established high exit positions.
is what I do and what seems to
At this level, we find a bearish or low for a given period and this
work the best for me. For starters, • They help as a leading price
market price objective or targeted range, including its price points.
just keep things simple and apply indicator for traders.
low number. The market often some good old-fashioned common 11
Trend Trading Indicators
• Pivot points are used to proj- not be applicable in most cases This number represents the true the preceding time frame. If they
ect support and resistance or two, three, or four days later. value of a prior session. In an are, then to help filter out unnec-
actual highs and lows of trad- uptrending market, if the market essary information or excessive
The same principle goes for the
ing sessions. gaps higher above the pivot point, support and resistance numbers
weekly and monthly calculations,
then a retracement back to the on my charts, I use the actual
• They help confirm other tech- so at the end of that time period,
pivot will attract buyers. Until that pivot point up to the R1 number
nical methods. new data must be recalculated.
pivot point is broken by prices for resistance, and then I target
• Daily, weekly, and monthly If in a given trading day, the mar- trading below that level, traders the S2 for the potential low for
time frames can and should be ket goes through my daily target will step in and buy the pullback. that time period’s trading range.
used. numbers, the importance of the Have you ever heard of the phrase
As you can see in the Figure 2.1, if
weekly and even monthly numbers “if bullish, buy breaks”? Well, using
In every week, there are five trad- I determine the market is bearish,
is what gives me an indicator for the pivot point as a price level to
ing days. In every month, there will and if I understand the relation-
the next major target levels of sup- buy helps traders define at what
be an established range—in other ship of the geometric distance of
port and resistance. price a break might occur.
words, a high and a low. In one the resistance and support targets,
day of one week in one month, a The opposite is true in an extreme- I can eliminate the R2 number,
Using the Actual ly bearish market condition; the
high and a low will be made. since in a bearish environment we
Pivot Point
pivot point will act as the target should see a lower high. If I am
It is likely that the high and the low I use the actual pivot point for high for the session. If a news- looking for a lower low, then I can
will be made in a minute or hour many things. For example, it is driven event causes the market to eliminate the S1 support number
of a given day of a given week in important to understand that gap lower, traders will then access as well, and now I have reduced
that month. That is why longer the pivot point can be used as an the news. Once prices come back the field to just three numbers.
time frames such as a monthly or actual trading number in deter- up to test the pivot point, if the
weekly analysis should be used. mining the high or low of a given Once again, I am not using the
market fails to break that level
time period, especially in strong numbers to place orders ahead of
Pivot point analysis relies on spe- and trade higher, sellers will take
bull or bear market trend con- time (even though you could); I am
cific time frames for determin- action and start pressing the mar-
ditions. In an extremely bullish using the numbers as a guide.
ing support and resistance levels ket lower again.
for that particular timing element trend condition, the pivot point These numbers work so well and
can become the target low for Technically speaking, in a bearish
only, and infers that the analysis or often act as a self-fulfilling proph-
that trading session. market, the highs should be lower
calculations for the prior day will ecy because so many institutions
and the lows should be lower than
and professional traders do use 12
Trend Trading Indicators

them. Many hold differently sized positions, and some traders may not
wait for the exact number to hit. Instead, they may start scaling out of
positions (as I do). With this method, you can use these numbers as exit
areas on your trades. As Figure 2.2 depicts, in a bullish market environ-
ment, by definition, the highs should be higher and the lows should be
higher than the preceding time period. When I have determined that we
are in a bullish trend, I target the S1 up to the pivot point for the low of
the session and the R2 for targeting the high. This will give me an idea of
what the potential trading range will be.

Take a look at Figure 2.3. It is a 15-minute chart using all five pivot cal-
culations. We have a mid-point number which is the pivot point, with
two upside resistance levels, and two downside support targets. I have
a week’s worth of data starting from Wednesday through the follow-
ing Wednesday close. This chart is from thinkorswim by TD Ameritrade
using the Person's Pivot indicator. 13
Trend Trading Indicators
monthly pivot levels. Notice when the monthly pivots were projecting
the market was in a bearish trend higher highs and higher lows? Not
in late 2008, the actual target only can pivot point analysis help
levels were projecting out a lower keep traders on the right side
high lower low scenario. Then, as of a trending market condition,
the market reversed in a bullish the support and resistance
trend throughout 2009, see how target levels help navigate price

Using a filtering method as shown Longer Time Frames

in Figure 2.4, we eliminated the When the market goes through the
excess support and resistance projected daily target numbers,
lines, so now we have one resis- I use the longer time periods to
tance and one support target give me the next reliable price
level. Doesn’t this elimination pro- objective. That is where the
cess give a better picture of what significance of the weekly and
may have happened as opposed monthly numbers comes into play.
to what the real results were? Take for example the weekly chart
on the S&P 500 Exchange Traded
Fund (SPY) in Figure 2.5 using the 14
Trend Trading Indicators
Now here is where combining different time frames can be most useful.
As you look at Figure 2.7, you will see the e-mini S&P 500 futures with
the weekly and daily pivot levels. What I like to look for is what I call
a confluence, or a synchronized setup of various time frames within a

For example, let’s say we are in a higher degree time frame bullish trend
and the market pulls back to the weekly support. I also like to see a daily
support level coincide with that weekly pivot support for a low-risk buy

extremes, allowing one to set entry and exit orders according to the
market price direction.
For those interested in commodities, the graph in Figure 2.6 is a daily
price chart of crude oil futures with a weekly pivot analysis displayed. As
you can see, the pivot levels recalibrate and give not only a confirmation
reading that the market is bullish by displaying higher highs and higher
lows, it does so with exact pricing. 15
Trend Trading Indicators
setup. Notice the price action on September Quick Quiz
23, 2010. The market pulled back to the weekly 3
support level (pink) and that day’s daily pivot
1. What is pivot point analysis?
(green) coincided at the same level. As the day
progressed, traders could not take the market
a. A mathematical formula designed to deter-
mine the potential range expansion based of Traders
any lower and by the end of the day, the lon- on a previous time period’s data.
b. A system for determining when to get into
ger-term trend stayed intact as prices contin-
a trade.

ued higher. By identifying the support targets
in advance, one was keen to the idea to at least c. An exit-planning technique. here are many indicators and tech-
look to “buy the dip,” or at the very least, not d. All of the above nical tools that can be used to help
sell at the low of a retracement. 2. What is the most important element to gain an edge in the market, espe-
pivot point analysis? cially in identifying the strength of a trend,
Conclusion or more importantly, helping to time a
a. The high trend reversal. You may be familiar with
Pivot point analysis is a valuable trading tool.
b. The low
Of course, there is no holy grail of indicators, my “Person’s Pivots” and proprietary buy
c. The close
but combining correlated technical tools to and sell signals, but believe me, I use other
d. All of these points are vital to pivot point
help you plan your trades will certainly give you indicators and this chapter is focused on
an edge in the markets, especially if you are the “grand-daddy” of the consensus or
looking to trade both with a trend and looking 3. The basic formula for the pivot point is: contrarian indicators. I have been using
for clues as to when or at what price level the this indicator since my start in the indus-
a. P+H-L
trend may end. If you are interested in further- b. (P x 2) – L try as a commodity trader back in the
ing your education on the use of pivot point c. (H + L + C)/3 early 1980s. The tool I am talking about is
analysis, including how to construct a trading d. (P x 2) – H none other than the Commodity Futures
methodology using a pivot point moving aver- Trading Commission (CFTC) Commitment
4. To understand how price moves within the of Traders report (COT).
age, take a look at my home study course from
pivots, examine time frames from:
Traders’ Library, Candlesticks and Pivot Point
The data is like an insider information
Strategies. a. Longer term to shorter term
report, but it is legal. It acts like a true
b. Shorter term to longer term
consensus of who literally “owns” the
For the answers to this quiz, go to market. A trader can use this data to determine if market participants are too 16
Trend Trading Indicators
heavily positioned on one side of gate of all long open interest is tions are added to the trader’s long ally represents 70 to 90 percent
the market in a long-term trend equal to the aggregate of all short and short futures positions to give of the total open interest in any
run, especially when we are enter- open interest. ‘combined-long’ and ‘combined- given market. From time to time,
ing a seasonally strong or weak short’ positions. Open interest, as the Commission will raise or lower
The terms and definition can be
time period from a supply and reported to the Commission and the reporting levels in specific mar-
found at the CFTC’s website, but
demand perspective. This chapter as used in the COT report, does kets to strike a balance between
for ease of explanation, I will
will provide a quick synopsis of not include open futures contracts collecting sufficient information to
quote it here:
where to find and how to use this against which notices of deliver- oversee the markets and minimiz-
report. ies have been stopped by a trader ing the reporting burden on the
or issued by the clearing organi- futures industry. “
“Open interest held or controlled
When by a trader is referred to as that
zation of an exchange. Clearing
First, let’s discuss when this report members, futures commission mer- The data is collected as of the
trader’s position. For the COT
is released and how you can use it. chants, and foreign brokers (col- close each Tuesday from each
The COT reports provide a break- lectively called reporting firms) file clearing firm by the corresponding
report, option open interest and
down of each Tuesday’s open daily reports with the Commission. exchange where a particular com-
traders’ option positions are com-
interest for markets, but they are Those reports show the futures modity is traded. It is then turned
puted on a futures-equivalent basis
not released until Friday at 3:30 and option positions of traders over to the Commodity Futures
using delta factors supplied by the
p.m. EST. Current and historical that hold positions above spe- Trading Commission (CFTC). They
exchanges. Long-call and short-
Commitments of Traders data is cific reporting levels set by CFTC release the data each Friday at
put open interest are converted to
available as is historical COT data regulations. If, at the daily mar- 3:30 p.m. EST.
long futures-equivalent open inter-
going back to 1986 for futures- ket close, a reporting firm has a
est. Likewise, short-call and long-
trader with a position at or above I should point out that it is logical
only reports, and to 1995 for com- put open interest are converted
the Commission’s reporting level in to watch for any major directional
bined options and futures reports. to short futures-equivalent open
any single futures month or option price changes in the market that
interest. For example, a trader
The information is based on the expiration, it reports that trader’s you are analyzing from the time
holding a long put position of 500
open interest figures. Open inter- entire position in all futures and when the data was collected on
contracts with a delta factor of
est is the total of all futures and options expiration months in that Tuesday to the close of business
0.50 is considered to be holding a
option contracts entered into and commodity, regardless of size. The on Friday to watch for any drastic
short futures-equivalent position
not yet offset by a transaction, aggregate of all traders’ positions prices changes that may alter the
of 250 contracts. A trader’s long
delivery, or exercise. The aggre- reported to the Commission usu- position size of traders.
and short futures-equivalent posi- 17
Trend Trading Indicators
Key Categories to enter trades accordingly. Keep Interpretation and the non-reportable positions
There are three categories to in mind that the commercials are Here are some general guidelines category are net long, look at sell-
pay attention to: non-commer- not always right; they are not in for interpreting the information ing opportunities.
cials (professional traders, hedge the market to time market turns. presented in the Commitment of Examine Figure 3.1 on the e-mini
funds), commercials (banks and They are hedging their risk expo- Traders report that I wrote about S&P 500 index. See point “A,”
institutions, producers, or end sure in a cash position. in my first book, A Complete Guide where the non-commercials are
users), and non-reportable posi- Since money moves the market, to Technical Trading Tactics and in significantly net long, and then
tions holders (small speculators). banks and large professional trad- The Commodity Traders Almanac. point “B,” which shows the small
Many people ask if the large ers are a bit savvier when it comes speculators net short. This was
A. If non-commercials are net
speculators and commercials have to their business. After all, one the reading that was released on
long, commercials are net long and
reportable positions, then how do would think a bank has a good March 6, 2009 from data collected
the non-reportable positions cat-
they figure out the small specu- idea of what direction interest on March 3, 2009. The actual bot-
egory are net short, look at buying
lator’s position? The answer is rates are going to go once a cen- tom on the March e-mini S&P
opportunities. In other words, go
simple; the long and short open tral bank meeting occurs, right? contract was on March 6, 2009 at
long with the pros.
interest calculated as “non-report- This report reveals what the pro- 662.50. The market proceeded to
able positions” is derived by sub- fessionals are doing in relation- B. If non-commercials are net rally at the close of business on
tracting total long and short open ship to the small speculators. If short, commercials are net short March 31, 2009 at 827.25, which
interest from the total “reportable 80 percent of small speculators
positions” category. That is one are accused of losing their money
more reason why there is no avail- trading, then it would stand to rea-
able information for the number son that you would not want to be
of traders that exist in the “non- in the market on the side of the
reportable positions” category. small speculator.
This report helps uncover pos- Therefore, in the short term, the
sible imbalances in markets that non-commercials, professional
have been in a trending market speculators, or hedge funds are
condition for quite some time, and considered the smart money.
therefore can help you develop a
game plan to look for timing clues 18
Trend Trading Indicators

was priced in the June futures con- Examine the chart Figure 3.3, professional trader category, the cials or large professional traders
tract, up almost 25 percent from which is also on the e-mini S&P. black line represents the commer- (blue) and the small speculator or
the lows. The small speculators This shows my TradeStation indi- cials’ positions, and the gray bars general public, as highlighted in
were net short into that rally. cators with a zero line histo- represents the small speculator gray.
gram color coded to identify the net position.
Figure 3.2 using TradeStation The chart starts from January
three classes of traders and their
shows my Person COT indicator Without going into exact details of 2008, and as you can tell, it was
respective net positions as mea-
reflecting that the small specula- this indicator or the exact figure a very bearish market environ-
sured against the open interest
tors were short as the profession- of each category’s net position, I ment. Notice that the gray his-
numbers. The blue bars represent
al traders were long since early want to focus on the overall con- togram lines are above the zero
the non-commercial position or
February of 2009. sensus between the non-commer- line, showing the small speculators 19
Trend Trading Indicators
were net long all the way down. posted a low right at one of my the CFTC Commitment of Traders added to their net short position.
The blue bars are below the zero predicted pivot support levels and Report, many small speculators did Commercials were less short and
histogram line showing the large set off a buy signal. not follow that rule. In fact, notice professional traders added to their
professional traders were net that they finally threw in the towel net long position.
The market did recover in what
short. In fact, you can even see and went net long darn close
turned out to become an amaz- At that point, we had a weekly
that by late June of 2008, the com- to both a seasonally weak time
ing rally. Professional traders held buy signal intact, with the infor-
mercials also committed to the period and also near a predicted
a net long position (blue) right mation that small speculators are
short side. Person Pivot Point resistance tar-
through early April. Commercials building a new net short position.
get level (the red horizontal line on
Now let’s focus on late February (black) grazed a neutral position, This could be the ammunition the
this chart).
of 2009, when the media and bouncing between a small net long market needed to bring the mar-
headline news proclaimed the end and net short the entire rally. It This brings me to an interesting ket back to test the June high near
of the stock market and that the was the small speculators (gray) point—the summer of 2010 was no 1130. In any event, the CFTC report
economy as we knew it was com- that committed to the short side doubt a choppy and volatile mar- is a strong contrarian indicator.
ing to an end. It was a very difficult all the way up. ket. Granted, we traded to these
time; housing prices plunged, jobs predicted support and resistance “Japan Sells Yen for First
So let’s review. The small specu-
were lost, foreclosures skyrocket- levels quite well, which helped me Time in Six Years”
lators were net long all the way
ed, and the stock market plunged. identify trading opportunities, but Here is another example of how
down and net short all the way
look back at how the small specu- this report can help time major
On an interesting note, see how up. Wow—not a pretty picture,
lators were net long on the sum- market reversals: the front
professional traders (blue) were especially if you were a small
mer break. A low was made in the page business news showed the
mounting a net long position and speculator.
last week of August at the 1037 Japanese government intervened
the commercials (black) were
level, the small speculators made on behalf of the Yen’s value, the
beginning to shed shorts? Now Summer 2010 Example a net short position, commercials headlines stated.
look at the gray histogram bars Here is where it gets interest- were reducing shorts, and the
see how the small speculators ing, though. Seasonally speaking, One article as the story hit the
professional traders were holding
threw in the towel, and after a stocks tend to weaken in late April newswires read as if the mar-
a net long position. In fact, dur-
long losing battle being net long in through the May time period. I am ket price action was a shock. The
ing the first week of September,
a bear market finally went short, sure you are familiar with the say- only real shock was the fact that
before the monthly employment
darn near the bottom or “in the ing, “sell in May and go away.” I the Japanese government actu-
report was released and the Labor
hole,” as we say. March of 2009 can assure you that according to ally intervened. I would argue
Day holiday, small speculators 20
Trend Trading Indicators
that their government most likely situation, it is exactly what hap- trader should make? After all, sell- ket temperature reading. If the
was aware that there were a large pened; speculators who were net ing Yen futures could be costly, folks who trade their own as well
number of speculators holding long needed to liquidate their long especially with the increased vola- as other people’s money need
long positions, and that is why positions by selling, forcing the tility; the leverage would kill you to book a profit on a trade, it
they chose to intervene in the first price of the Yen versus the U.S. if you were early on such a trade. stands to reason if one is long,
place—in order to gain maximum dollar lower. Another consideration would be they would have to sell to get out,
results with minimal effort. In this the use of the CME’s electronic and if they are short, they have
Was this move predictable?
situation, the Yen was primed for mini Yen futures contract, or put to cover or buy back those short
Seasonally speaking, yes. The yen
a sharp correction; all it needed options on the Yen futures. A trad- positions, right? Well, the non-
has a tendency to peak against
was a push off a cliff, so to speak. er could employ a combination of commercial traders are considered
these products to take advantage hedge funds or professional trad-
of a strong seasonal tendency. ers, and if they manage money
then they look to take a percent-
If you were a stock trader and did
age of profits on a quarterly basis.
not have a futures account, you
As with the Yen setup, the reason
could take an options position
I was excited about this trade and
on an exchange traded fund—
was selling futures and buying put
the Japanese Yen Trust (FXY).
options was simple. The stars had
But again, timing is everything.
all lined up.
If you sold too early, you risk the
chance of adverse risk on a futures A. Seasonally, the Yen
contract, since options premi- peaks against the dollar in
ums could lose value as theta or mid-September.
time decay impacts the option
B. Large speculators were holding
the U.S. dollar in mid-September. premium.
If you were a speculator taking a a substantial net long position in
Armed with only that information,
percentage of profits, you would the market.
be forced to sell in order to act
one would most likely not want to Market Temperature
go long at a multi-year high. In fact Readings C. The Yen had been in a defined
quickly before all profits eroded.
one would most likely would want Here is where the CFTC COT uptrend for several months and
That is what typically causes an
to look for a shorting opportunity. report can help. I call it a mar- was ripe for a correction.
avalanche of sell orders. In this
So how to decide what choices a 21
Trend Trading Indicators
D. The end of the quarter was speculators started to build a long
within two weeks. position around the first week of
July and were fully committed to
Take a look at the chart in Figure
this uptrend.
3.4 showing the Person Histogram
COT report. As you can see, the Now let’s examine the actual
commercials were net short and report to see the complete break-
the speculators were net long. The down of the CFTC’s numbers.

The non-commercials (profession- you can start to explore selling

al speculators) were long 66,038 opportunities. Just remember, if
contracts versus short 13,995, you are using options, select strike
which was a whopping 40.9 per- prices that are within the realm of
cent of the open interest of the reality and select the expiration
market. The commercials were month that will give you time for
long 60,724 versus short 108,489. the trade to mature.
The non-reportable position trad-
You can find this report at nation-
ers (small speculators) were more
or less neutral as they were long
29,390 versus short 33,669 posi-
tions. If a market is entering a
seasonally weak period and is fully
loaded on the long side, as con-
firmed with the COT report, then 22
Trend Trading Indicators
Quick Quiz 4
1. The total of all futures and options contracts entered into and not
yet offset by a transaction, delivery, or exercise is referred to as:
ADX as a
a. Consensus
Trend Strength
Open Interest
Commitment of Traders

d. Market Participation
s previously discussed, a trend can be identified by using
2. The Commitment of Traders report: trend lines to identify either a series of higher highs
a. Acts as a true consensus of who literally owns the market. and higher lows, or lower highs and lower lows. Moving
b. Is published by the New York Stock Exchange. average ribbons and moving average channels can also help
c. Is an insider information report. traders gauge the market’s direction along with the strength of
d. All of the above the trend.

3. What is the key category to pay attention to when examining the Because of the lag factor, it is often more difficult for the trader
COT report? to be prepared for a trend change or a period of non-trending
a. Non-reportable position holders action. This can turn a profitable trade into a losing one and
b. Non-commercials frustrate beginning traders who may start questioning their stop
c. Commercials strategy. They may conclude that their stop was too tight and
d. All of the above use a much wider stop next time, thereby increasing the risk.
They might alternatively decide that their stop was too wide
4. How is the small speculator’s position determined?
and therefore use too tight of a stop on their next trade and get
a. By subtracting total open interest from the total reportable positions chopped up.
b. It is derived from the short open interest.
c. There is no available information for the small speculator’s position. The ADX Indicator
d. By subtracting the short open interest from the long open interest.
Traders can use the ADX indicator to determine whether a mar-
For the answers to this quiz, go to ket is trending or not, as well as the strength of a trend. The
ADX indicator is part of the Directional Movement Index devel-
oped by Welles Wilder and discussed in his 1978 book, New
Concepts in Technical Trading Systems. Since the ADX is available 23
Trend Trading Indicators
in most charting platforms, I will Sugar prices remained in a trading
concentrate on the interpreta- range for the next eight weeks.
tion of the ADX, not the formula
In trading stocks and providing
by which it is calculated. Other
advice for clients through PA Stock
analysts like Chuck LeBeau, who
Alerts, the ADX analysis can be
won the coveted Traders’ Library
important. The strongest signals
Traders Hall of Fame award, pro-
from the ADX occur when it drops
vides in-depth detail on how to
down to low levels in the 10 to
effectively, and most importantly,
15 range and then crosses back
correctly use this indicator in his
above the 20 level. This is because
DVD course.
the very low ADX readings indi-
It should first be noted that the cate that the market has reached
ADX is not a timing indicator as it an extreme level of non-trending
does not identify whether a mar- behavior.
ket is moving up or down but is
instead is designed to determine Using a 21-Period Moving
whether a market is trending or Average
the time frame, the more reli- to turn higher. This coincided with
not. When the ADX is rising, then To the chart of Apple (AAPL) in
able the signals. Sugar was one of the crossing of the 20-period MA
the market is trending either up Figure 4.2, I have added a 21-peri-
the strongest trending markets in moving above the 50 period. By
or down, and conversely a declin- od moving average of the ADX
2009, as it more than doubled in a the end of May, the ADX was clear-
ing ADX suggests a non-trending as well as a dotted line at the 20
single year. ly rising, indicating that sugar was
market. Remember the direction level. In both December 2008 and
now trending. It continued to rise
of the ADX is more important than In Figure 4.1, we have the weekly February 2009, AAPL was unable
during the summer and early fall,
its value. chart of the continuous sugar to move through resistance at
but in the middle of October 2009,
futures contract to which I have $103.75, but on March 23, 2009
Like other methods discussed in the ADX had turned lower (see
added the 20- and 50-period mov- this resistance was overcome. The
this book, the ADX can be applied arrow). This indicated that sugar
ing averages discussed earlier ADX line dropped below the 20
to weekly, daily, or intraday data. was no longer trending, but this
along with the 14-period ADX. The level in December and dropped
It is generally agreed upon by should not have been taken as a
ADX was in a gradual downtrend below 15 several times in the next
most technicians that the longer sign that sugar prices had peaked.
into April of 2009 when it started 24
Trend Trading Indicators
average has proven to be useful. In was still below its 21-day weighted
a trending market, traders can use moving average. Several days later,
a wider stop with more confidence the $52 level was overcome before
than is advised in a non-trending MOS has a sharp pullback that
market. For my advisory service, lasted several days.
PA Stock Alerts, my analysis sug-
From a trading standpoint, this
gested buying Mosaic (MOS) at
pullback could have made some
$45.68 (see Figure 4.3) and this
traders consider closing out their
level was reached on July 21, 2010.
long positions, but the movement
Just over a week later on August
of the ADX above its moving aver-
2, 2010, MOS closed above next
age indicated that MOS was in the
resistance in the $47.65 area. The
trending mode, so a wider stop
20- and 50-day moving averages
was a better idea. A week later,
had turned positive, but the ADX
MOS was trading close to $60.

three months. As AAPL moved that AAPL was starting to trend.

through resistance, the ADX The 20- and 50-day moving aver-
moved above its moving average ages were also positive and the
as well as the 20 level. gap between the moving averages
had begun to widen. For the next
As discussed before, if a resis-
month, both AAPL and the ADX
tance level is overcome, it then
continued to move higher as AAPL
becomes support and several days
rose from $103.75 to over $130
after the breakout, AAPL declined
per share.
back to test support (former resis-
tance) as indicated by the dashed Understanding whether the ADX
vertical line. On this pullback, the is rising or falling is of key impor-
ADX line was rising and above the tance and to help better identify
20-day moving average, indicating the trend, a 21-period moving 25
Trend Trading Indicators
Interpreting Strength The best way to determine whether the ADX can help your trading is to
As I have stressed earlier in this chapter, a rising ADX line does not give study it, and run it on your existing positions as well as those trades you
you any indication on what direction a market is moving, but helps you are considering. In this way, you should have a better idea whether or
determine the strength of a rally or a decline. Figure 4.4 shows British not the ADX can help you in your trading.
Petroleum (BP) when its price started to decline during the latter part
Quick Quiz
of April as support at $51.90 was broken at the end of the month.
Remember, this support now becomes resistance. BP stock tested this 1. The ADX indicator identifies:
resistance and moved sideways (see box in Figure 4.4) for nine days
a. Trade timing opportunities
before resuming its decline. Even though prices were locked in a trad-
b. The direction of a market’s movement
ing range, the ADX was rising strongly. It had previously dropped below c. If a market is trending or not
the 15 level and then moved strongly above 20. Towards the latter part d. The lag factor
of May, the rise in the ADX slowed as BP prices continued to plunge. The
ADX did not drop below its moving average until early July as BP started 2. Trend lines can be used to identify a series of:
to rally and eventually moved from a low near $27 to over $41 per share. a. Higher highs and lower lows, or lower highs and higher lows
b. Lower highs and lower lows, or higher highs and higher lows

3. Moving average ribbons and channels help to identify:

a. The presence of a trend

b. The market’s direction
c. The strength of a trend
d. Both b & c

4. The strongest ADX signals occur when:

a. The indicator drops to the 10 to 15 range.

b. The indicator crosses the 20 level.
c. There is no trend.
d. Both a & b

For the answers to this quiz, go to 26
Trend Trading Indicators
make higher highs and the settle- Fast Versus Slow
5 ment price usually tends to be in
The second calculation is the %D
(3 period), and it is the moving Stochastics
Stochastics & the upper end of that time peri-
od’s trading range.
average of %K. There are other techniques asso-
ciated when using stochastics,
It is calculated as follows:
MACD When the momentum starts to including fast stochastics and slow
slow, the settlement prices will %D=100(Hn/Ln) stochastics.

eorge C. Lane is credited start to fade from the upper Hn= the n period sum of (c-Ln). The difference is how the param-
with creating the formula boundaries of the range and the
eters are set to measure the
for stochastics, a range- stochastics indicator will show It is important to understand the change in price. This is referred to
based momentum oscillator indica- that the bullish momentum is rules of how to interpret buy or as a gauge in sensitivity. A higher
tor. His indicator is a popular tech- starting to change. The exact sell signals. When the readings are rate of sensitivity will require the
nical tool used to help determine opposite is true for bear or down- above 80 percent, and %K crosses number of periods in the calcula-
whether a market is overbought, trending markets. over the %D line and both lines are tion to be decreased. This is what
meaning prices have advanced too pointing down, a “hook” sell signal “fast” stochastics does; it enables
There are two lines that are
far, too soon, and are due for a is generated. A confirmed sell sig- one to generate faster and higher-
referred to as %K and %D. These
downside correction. Stochastics nal is triggered once both %K and frequency trading signals in a short
are plotted on a horizontal axis for
can also help to identify oversold %D close back beneath the 80 per- time period.
a given time period and the verti-
markets, meaning prices have cent line.
cal axis is plotted on a scale from
declined too far, too soon, and are Markets need volatility in order
zero to 100. The exact opposite is true to gen-
due for an upside correction. The to move and we need markets to
erate a buy signal when %K cross- move in order to trade. We also
indicator itself is based on a math- The formula to calculate the first
es above %D. When the reading is need to base our trading plans on
ematical formula that is computed component, %K (14 period) is as
below 20 percent, and both lines reliable signals. Not all times do
to compare the settlement price of follows:
are pointing up, a “hook” buy sig- the setups that trigger an entry
a specific time period to the price nal is generated. A confirmed buy
range of a specific number of past The value of %K =c-Ln/Hn-Ln*100 work as perfectly as in Figure 5.1,
signal is triggered once both %K which is why I use other confirm-
periods. c=closing price of current period, and % D close back above the 20
Ln= lowest low during n period ing signals to corroborate trad-
The theory is based only on the percent line. ing signals. I also like to see if the
of time, Hn=highest high during n
assumption that in a bull, or period of time and n=number of methodology works in a diverse
uptrending market, prices tend to periods. group or non-correlated markets. 27
Trend Trading Indicators

To test how robust, or how well a signal responds in different markets low from a previous low, but the underlying stochastic pattern makes a
helps validate the reliability of that signal. higher low. This indicates that the low is a “false bottom” and can resort
to a turnaround for a price reversal.
Figure 5.2 is a Spot FOREX Euro Currency chart that demonstrates the
same setup and trigger that would enter a long position with the %K and Market prices can and usually do vacillate around the actual pivot point
%D crossover above the 20 percent line with a confirming higher closing number before making a decision on a directional price move. It is at
high candle pattern. The sell signal also works well as confirmed when these points, or market conditions, that you want to use a indicator to
%K and %D both cross over and close back below the 80 percent line. help measure the true strength or weakness of the price action. That is
what the Stochastics indicator does. In Figure 5.3, we see how a second-
Bullish Convergence ary low is marked with a higher indicator low.
One other method to use the stochastic indicator is trading with a pat- Once we draw the corresponding lines, it appears as if prices and the
tern called bullish convergence, seen in Figure 5.3. It is used in identify- indicator are actually converging. This is hinting that the secondary low
ing market bottoms. This is where the market price itself makes a lower is not as bearish as it seems, and that a market rally can occur. 28
Trend Trading Indicators

In essence, this is exactly what happens, and as prices trade above both The example in Figure 5.4 shows how the market makes a secondary
moving average values, we have a nice trigger to go long for a quick high, but the corresponding high in the stochastics is at a lower level
profitable scalp. then the primary high point. This pattern can alert you that if the mar-
ket appears to be ready for a new bull trend, the stochastics readings
Bearish Divergence should be equal to or higher than the primary peak level.
Another signal is a trading pattern called bearish divergence, seen in Likewise, a higher high that is accompanied with a lower stochastics
Figure 5.4. It is used in identifying market tops. This is where the mar- reading indicates a potential trend reversal, especially when prices are
ket price itself makes a higher high from a previous high, but the under- near a pivot resistance level. Notice the lower closing low off the sec-
lying stochastic pattern makes a lower high. This indicates that the sec- ondary peak, and then as %K and %D both cross over and are beneath
ond high is a “weak” high and can resort to a turnaround for a lower the 80 percent line. This helps confirm the sell signal, which was trig-
price reversal. gered with the moving average crossovers and the lower closing lows. 29
Trend Trading Indicators
Bearish divergence signals warn • If the secondary stochastics were the difference between a two exponential moving aver-
you that there is an impend- peak is less than or under the 12-day and a 26-day exponen- ages, which then compares that to
ing downtrend of a substantial 80 percent level, this signals a tial smoothed average. The signal the 9-period exponential moving
amount. Therefore, it is impor- stronger sell signal. line used is a 9-day smoothing of average. What we get is a moving
tant to monitor for divergence today’s MACD value, subtracted average crossover feature and a
• Prices should make a lower
patterns. from today’s, or the last time zero line oscillator, and that helps
closing low to confirm a trigger
count’s MACD value. Most chart- us to identify overbought and
The bearish divergence pattern to enter a short position. Enter
ing packages give the 12-period, oversold market conditions. The
signals or forecasts that there is on the close of the first lower
26-period, and the smoothed chart in Figure 5.5 shows how the
an impending reversal in prices closing low or the next open.
average of a 9-period for the sig- MACD helps to confirm buy and
and that one is ready to occur. As The protective stop should ini-
nal line. sell signals.
I mentioned previously, one can tially be placed above the high
anticipate and get ready to place of the secondary high. There are many variations and I might add that since traders are
an order to act on the signal, but most charting software packages now more computer savvy than
you should not act until the con- Moving Average allow you to change the parame- ever before, many charting soft-
firmation of a lower closing low Convergence/Divergence ters. Just remember, the less time ware packages allow changing or
triggers the entry, which is on MACD in its simplest terms is an periods you input, the more sensi- optimizing the settings or param-
the close or the next open. Here indicator that shows when a short- tive the indicator will be to price eters. In other words, it is easy to
are rules to guide you to trading term moving average crosses over changes. Therefore, with fewer change or “tweak” the variables in
a stochastics bearish divergence a longer-term moving average. time periods, an indicator will gen- Appel's original calculations.
pattern: Gerald Appel developed this indi- erate more signals. Longer time
Traders can increase the time peri-
cator as we know it today for the periods help smooth out the false
• The first peak in prices should ods in the moving average calcu-
purpose of stock trading. It is now cross-over signals. Some varia-
correspond with a peak in the lations to generate less trade sig-
widely used for short-term trad- tions to consider are a 10-period,
%K and %D readings above the nals and shorten the time periods
ing signals in stocks, futures, and a 24-period, and for the smoothed
80 percent level. to generate more trade signals.
Forex markets, as well as for swing average signal line, use an 8-peri-
The 15-minute chart in Figure 5.6
• The second peak must corre- and position traders. od input.
shows many signals generated.
spond to a significant higher
It is composed of three expo- The concept behind this indica- Just as is the case for most indica-
secondary price high point.
nential moving averages. The tor is to calculate a value, which tors, the higher the time periods
initial inputs for the calculations is the difference between the 30
Trend Trading Indicators

used, the less sensitive the indicator will be to changes in price MACD also has a zero base line component, called the histogram, which
movements. is created by subtracting the slower signal line from the MACD line. If
the MACD line is above the zero line, prices are usually trending higher.
MACD signals react quickly to changes in the market and that is why a
The opposite is true if MACD is declining below the zero line.
lot of analysts including myself use it. It helps clear the picture when
moving average crossovers occur. It measures the relative strength MACD is a lagging indicator since it is based off of moving averages. We
between current prices as compared to past time frames, giving a short want to look for the zero line crossovers to identify market changes and
term perspective relative to a longer term perspective. help confirm trade entries or to trigger action to exit a position.

To understand how to use this indicator, always remember that when Watching for clues that identify shifts in momentum as the market
the fast line crosses above the slow line, a buy signal is generated. The moves from one extreme to another or overbought to oversold to trig-
opposite is true for sell signals. ger a trading opportunity can be identified with the aid of MACD read-
ings in both the moving average and the histogram component. While 31
Trend Trading Indicators
Currency, the MACD histogram that the high close doji (HCD) trig-
helps identify both bearish and gers a buy that is confirmed and is
bullish divergence patterns. in sync with the stochastics signal.
The MACD triggers six days later a
You may have the impression I
whopping 237 pips difference.
prefer the stochastics over the
MACD study, and for the most This frequently occurs where
part, I do. The fast stochastics indi- MACD lags other indicators, how-
cator generally gives confirmation ever, it is most helpful as a trend
on my triggers earlier than the momentum confirmation tool.
MACD studies. In Figure 5.8, notice

it is more profitable in buying the Buy and sell signals with a bull-
absolute bottom, that is a haphaz- ish and bearish divergence as
ard guessing game to play. Trading described in the last chapter
based on a set of rules and being can also be found using MACD.
able to use a confirming indicator However, with the MACD, we can
to identify a change in price direc- see the convergence and diver-
tion and then following that price gence in the moving average lines,
movement is the essence of how and it is more reliable when they
to make money in the markets. appear in the histogram bars. In
Figure 5.7 with the chart for Euro 32
Trend Trading Indicators
As you follow the flow of the 3. A “weak high” is often revealed
market, you may notice where by what stochastic indicator 6
the MACD triggers a false sell sig- pattern?
nal, but the stochastics does not. a. Bullish convergence
However, once the stochastics %K
and %D close below the 80 per-
b. Bearish convergence Averages
c. Bearish divergence
cent level, MACD helps to confirm d. Bullish divergence

the exit.
4. The moving average conver- simple way to determine the trend is to draw trend lines.
Quick Quiz gence/divergence indicator: In an uptrend, we should see a sequence of higher highs
a. Shows when a short-term mov- and higher lows. So we would draw a line against the
1. The stochastics indicator is
ing average crosses over a lon- lows and extend it outward to forecast a support level sometime
used to determine if:
ger-term moving average. in the future. In a downtrend, as the sequence of events shows
a. a market is overbought or b. Is composed of three exponen- lower highs and lower lows, we would draw a line against the top
oversold tial moving averages. of the highs and extend it outward to help predict a resistance
b. prices have moved too far, too c. Identifies overbought and point in the future. Another method used in determining trend
soon oversold market conditions. line support and resistance is through the use of moving averag-
c. a correction is due d. All of the above. es. The moving average is generally calculated by taking the aver-
d. all of the above
age of the closing price of a defined number of sessions.
For the answers to this quiz, go to
2. A “false bottom” is often The moving average is one of the most widely utilized indicators
revealed by what stochastic indi-
in technical analysis. The reason that this is the case is that the
cator pattern?
moving average is easily identifiable and easy to backtest. Many
a. Bullish convergence automated trend trading systems use moving averages or some
b. Bearish convergence derivation of a moving average method to generate buy and sell
c. Bearish divergence signals. Moving averages are considered classic indicators and
d. Bullish divergence are very popular with traders today. Most technicians view the
moving average as a way to signal a change in the direction of
the trend, and even for identifying levels of support and resis-
tance. They can also be used as a way to smooth out the volatil-
ity of the market. 33
Trend Trading Indicators
Traders can use just one moving indexes versus the futures stock As we have discussed previously given number of time periods and
average or combine a few differ- index products. So when using in this book, all traders, analysts, dividing the sum by the number
ent ones and overlay these on moving averages, it is important to and technicians have equal access of time periods. A 10-day simple
their charts. By using short-term, understand that the variables and to the most important common moving average is the 10-day sum
intermediate-term and a longer- parameter settings of one instru- denominators. Those are the open, of closing prices, divided by 10.
term moving average overlaid ment may be more or less sensi- the high, the low, and the close. As the name implies, a moving
on top of the chart, you can see tive to another due to liquidity and This chapter is dedicated to vari- average moves or is considered
the trend direction of market trading hours. ous moving average types, which a rolling indicator because as a
prices from a different perspec- includes examining these four vari- new date emerges, you remove
tive. Different markets such as What are Moving ables. Most traders use the close or drop the old date in your con-
futures, stocks, exchange-traded Averages? as their price input for calculating a tinuously rolling new data as it
funds, and foreign currencies all In its simplest terms, a moving moving average. There are advan- becomes available.
have their own particular nuances average takes a measurement of tages and disadvantages to only
By averaging the price data, a
such as trading hours and trad- past price action to help smooth using a close variable input as your
smoother line is produced and the
ing time frames. So it is impor- out price data. As the calculation is moving average. But first let’s dis-
trend is much easier to recognize.
tant to understand that one set formulated with each new date as cuss the various types of moving
The disadvantages of the simple
of parameters in the moving aver- the name implies, the sum moves averages, and then we will discuss
moving average is that it only
age may not work as efficiently in as an older date is dropped. Since the parameter inputs to use and
takes into account the time period
one market versus another. For we are using past data to calculate the reasons and purposes for mea-
of the sessions covered in the cal-
example, in the spot foreign cur- the formula, moving averages are suring these values.
culation and it gives equal weight
rency markets, such as the euro considered a trend following or to each day’s price.
currency, the trading hours are vir- confirmation indicator. Since mov- Simple Moving Average
tually around the clock five days a ing averages are based on past There are two main types of mov-
week, compared to trading in the
Exponential Moving
price action, they simply cannot be ing averages. The first is a simple Average
Euro Currency Exchange Traded leading price indicators. When we moving average (SMA), which is
Fund (FXE), where we have a lim- The next calculation is using what
discuss past price action, remem- defined as dividing the sum of
ited trading session from 9:30 a.m. is known as an exponential mov-
ber the shorter the time frame, two or more figures by the num-
to 4:15 p.m. EST. This relationship ing average (EMA). Exponential
the more sensitive the moving ber of figures. When we apply
of time trading differences even moving averages are calculated
average will be to price changes. this to market analysis, it means
exists between the cash stock from complex formulas and have
adding up the price inputs for a 34
Trend Trading Indicators
become the most common aver- the subject. One such article was Multiple Moving pare one time frame versus anoth-
ages used today by many quote by Frank Hochheimer who wrote Averages er. Usually it is a short-term versus
vendors, analysts, and traders an article way back in the 1978 The use of multiple moving aver- a longer-term outlook. Figure 6.1
since they are weighted to give Commodity Yearbook entitled, ages gives a trader read of the shows a daily chart of the Russell
more importance to the newest “Computers Can Help You Trade market from different perspec- 2000. The white dotted line is a 20
data from current market condi- the Futures Markets.” He con- tives. Generally speaking, when day simple moving average based
tions as older data becomes less ducted a study on 13 different we use more than one moving on the close, as compared to the
important as time passes and is commodity markets to find the average, we are looking to com- solid black line, which is a 50-day
eventually filtered out. optimal moving averages between
simple, weighted, and exponen-
Calculating all these numbers by
tial in order to determine the best
hand or even with a calculator is
and most consistent cumulative
tedious and time-consuming, but
net profits.
fortunately computers can now
figure all this out for us. A simple One of his findings was that each
moving average is straightforward individual market had its own
and has minimal mathematical optimal moving average settings.
requirements. Another of his findings was that
simple moving averages outper-
History of Moving formed both linear weighted and
Averages exponential moving averages. As
We have the aerospace industry the computer era emerged, more
to thank for the use of simple, and more traders have developed
weighted, and exponential mov- their own backtest studies to opti-
ing averages. The formula was mize their settings for individual
originally used as a way of calcu- markets for their individual trad-
lating the trajectory of missiles. ing needs. In this chapter, we will
As for applying moving averages reveal various methods and combi-
to trading, many books and maga- nations from parameter settings to
zine articles have been written on the use of multiple simple moving
average time frames. 35
Trend Trading Indicators
simple moving average based on 30-, 40-, 50-, 60-, 70-, and 80-peri-
the close. Buy signals are gener- od moving average system over-
ated when the short-term moving laid on your price chart. Ribbons
average is above the longer-term can be used to determine a weak
moving average. An additional fil- or strong trend. With all the mov-
ter can be used to go along when ing averages pointing in the same
the current price is trading above direction, the trend is said to be
both moving averages. You will strong. Price reversals are con-
notice that by mid March of 2010, firmed when all the moving aver-
a strong uptrend had developed ages have crossed over each other
and the shorter-term 20-day mov- and start to move in the oppo-
ing average acted as support until site direction. Figure 6.2 uses the
mid-May, when prices broke below e-mini S&P futures contract, illus-
both the 20- and then 50-day trating an exponential weighted
moving average. A reversal sell sig- 8-period moving average ribbon
nal would have occurred by early combined with the 20- and 50-day
June. The short-term moving aver- simple moving average.
age was below the longer-term
A good bullish setup to determine
moving average, and as an addi-
a high quality trade is not only
tional filter, current prices were
when the shorter-term moving
trading beneath both moving aver-
averages cross up over the inter-
age values.
mediate and longer-term settings;
in addition, we look for prices to
Moving Average Ribbons lengths. Since most computers and by a specific time period, or by a close above all moving averages.
Moving beyond the use of two or trading software platforms have percentage. To create a simple
three different time period mov- advanced graphics cards, the rib- moving average ribbon for exam- An additional filter would be if the
ing averages is the moving average bons are mostly seen using gra- ple, you start by using a 10-period market closed at least two con-
ribbon. The ribbon as it is called is dient colors. The ribbon moving moving average, using 8 moving secutive time periods above the
created by using a series of expo- average method starts with one averages increasing by 10 periods, moving average settings, as this
nential moving averages of various time frame and increases either so that you will have a 10-, 20-, would reduce the likelihood of a 36
Trend Trading Indicators
reversal failure. Since most failed high, and the low. For this section,
market reversals or false breakouts we want to focus on taking a mov-
occur almost immediately, waiting ing average of both the high and
for confirmation by multiple closes the low. In doing so, we will form
reduces the likelihood of a failed a moving average channel. The
breakout. The downside to this fil- rationale here is that if we are in
tering method is that we increase a strong uptrend, prices will con-
the risk factor because prices have tinue to close above past or prior
moved higher from the lows and highs and will continue to move up
we reduce the potential lion’s until the market or current prices
share of the profits since the trend close below the average of past or
in this trade will have been suffi- prior lows.
ciently intact.
In Figure 6.3, we have an e-mini
Another filter I use is if the real S&P chart based on a five-minute
body (open, close relationship) is time interval. We took a seven-
above the moving average settings period simple moving average of
for two or more periods. Others the highs and a seven-period sim-
have used the entire range to help ple moving average of the lows.
filter higher quality setups to enter As you can see from this example,
positions when trend trading using a strong uptrend developed once
moving averages. the market closed above the upper
channel or the seven-period mov-
Moving Average ing averages of the highs. Notice
identifying positive or negative od to calculate than using volatility
Channels that once the market closed below
the lower band or the seven peri- momentum or strong trending bands such as the more popular
As we discussed previously, there
od moving averages of the lows, market conditions. and famous technical tool known
are four main variables that we
the market entered a defined as Bollinger bands. Bollinger
all have equal access to and can
downtrend. The moving average Bollinger Bands bands are made up of three mov-
use to input for moving averages.
channel method helps traders stay The moving average channel is a ing average components in which
These are the open, the close, the
on the right side of the market by simple and less complicated meth- the width of the bands expand or 37
Trend Trading Indicators
contract as price volatility increas- the lower Bollinger band, one may Confirming Indicators is intact is not only when prices
es and decreases. The bands are look to take a buying opportunity. A word of warning when it comes close outside of the bands, but
measured based off of the center But when prices close below the to using indicators for confirma- also when the Bollinger bands
moving average component using lower Bollinger band, traders can tion—make sure they are not widen and point in the direction
a 20-day simple moving average. develop either an exit strategy similar in nature or related in of that trend. In addition, Bollinger
The upper band is calculated by on long positions, or start to sell parameter settings. Remember; bands can act as a gauge of vola-
multiplying the standard deviation short, anticipating that prices will avoid collinearity when using tility when the bands contract or
by two and the lower band is cal- continue lower. additional technical indicators for come together; it shows when
culated by subtracting the 20-day confirmation. the market is in a period of low
On the other hand, as prices reach
moving average by two standard volatility or a consolidation phase.
towards the upper band, traders
deviations. The benefit to traders here is that
can start to look at exit strate-
• Middle Band = 20-day simple gies from long positions or start
Make sure that once you understand that markets
go through phases of volatility or
moving average to implement short trades. It is indicators used trend phases and then pause into
important to note that in strong
• Upper Band = 20-day SMA +
trending periods, prices will “walk for confirmation consolidation periods, it is the
(20-day standard deviation of Bollinger bands that can help iden-
price x 2)
the band,” meaning they will con-
are not similar in tify these different cycles or phas-
tinue to move up or down when
es by examining the narrowing or
• Lower Band = 20-day SMA - settlement prices occur outside of nature or related in widening of the bands.
(20-day standard deviation of the bands averages. Just because
price x 2) prices “tag” the Bollinger bands, parameter settings. Figure 6.4 shows a daily candle
meaning they are drawn either chart on Google (GOOG) with a
Simply put, two standard devia-
to the upper or lower band, this For example, avoid following 20-period simple moving average,
tions means that 87 percent of
in itself is not a buy or sell signal. any indicator that uses an 18- to using the standard deviation from
all prices will close inside the
In order to improve the quality 22-day simple moving average set- the formula mentioned above. In
Bollinger bands. The Bollinger
of the trade signal, one needs an ting, because Bollinger bands use early April 2010, prices broke out
bands try to help us uncover
additional indicator for a trade the 20-day simple moving aver- to the upside of the top band, but
whether prices are too high or too
confirmation. age for the middle band. A really experienced a large gap lower in
low in relative terms.
good sequence of events to watch price as the market trended lower.
A simple trading plan can be exe- for to confirm that a strong trend Notice the direction of the three
cuted so that when price touches moving average components all 38
Trend Trading Indicators
cators or trading techniques for confirmation before entering trades,
and Bollinger bands are no exceptions.

Confirming Patterns
Other means of confirming indicators can be the use of just simple pat-
terns such as “M” top and “W” bottom formations. By definition, a “W”
bottom is a series of higher highs and higher lows, and an “M” top for-
mation is a series of lower highs and lower lows. In Figure 6.5, we see a

pointed down and prices hugged or “tagged’ the lower band. This illus-
trated a bearish market turn and downtrend. It wasn’t until late July that
prices traded back up above the middle band, which by early August
acted as support. Besides identifying support and resistance targets,
Bollinger bands can also aid traders in uncovering directional trend
changes. As with most indicators, traders should incorporate other indi- 39
Trend Trading Indicators
daily chart on Wells Fargo (WFC). ful to actually take the average is that traders can focus on the act as resistance. This is one idea
As you can see, right around July of moving averages. Instead of signal and the price to moving that may help you start to devel-
5, we have a series of lows and having excess information or mul- average relationship. If the market op your own automated trading
closes beneath the lower Bollinger tiple moving averages overlaid on truly is in a sell mode or bearish system using moving averages to
band. Five days later, we suddenly charts, you can more easily work trend condition, then the average identify trends.
find the market piercing through with one moving average overlaid of both moving averages should
the middle band, almost closing in on prices. The benefit here is if
on the upper band. As the market you have a charting program that
pulls back, notice it forms a sec- can give indications of when mov-
ondary low on July 20, which is a ing averages cross over, generating
higher low. This is what starts to buy and sell signals, and you can
form the “W” pattern. use the moving average as a direc-
tional moving trend line. It will not
In addition, the secondary low is
burden you with information over-
above or inside the lower Bollinger
load and clog up your graphs.
band. To take one step further,
you will also see that the July 20 In essence, with software program
low is formed with a higher close such as Genesis, TradeStation,
than open sequence. Swing trad- or Thinkorswim’s charts, trad-
ers can look to buy near the close ers can have indicators built-in
of this bar at 25.91, placing stops to give alerts or arrows when a
below the low formed on July 5 at crossover of two moving averages
24.60. The profit objective would actually occurs. As you can see in
be near the top of the Bollinger Figure 6.6, you only have to have
band at 28.55. one moving average overlaid on
prices, but as the arrow pointing
Averaging Moving down shows, you have a sell sig-
Averages nal that develops from the point
When you are using a series of of intersection of the crossover
moving averages, it can be help- from the hidden moving average.
Once again, the advantage here 40
Trend Trading Indicators
Pivot Point Moving my favorite moving average con- This information provides a clear when markets are in a trending
Averages cepts is using the typical price for picture of the “average true price” phase, and when applied correctly,
We have not discussed calculat- a specific time period—otherwise as a gauge of bullish or bearish they allow the trader to let profits
ing a moving average using a known as the pivot point—which is market conditions for that time run and cut short their losses. That
combination of the four common derived from taking the sum of the period. In Figure 6.7, we have a is, if one devises a specific trading
denominators (open, high, low, high, low, and close and dividing daily chart on the e-mini S&P. plan with buy and sell signals that
and close) or averaging out one or by three. The formula again is: Notice that the pivot point mov- have incorporated the use of mul-
more of these components. One of ing average “hugs” prices closely tiple moving averages.
(H+L+C) / 3 = Pivot Point
when we are in a trend mode. The
As the saying goes, “the trend is
moving average acts as a support
your friend,” but the age-old ques-
in an uptrend phase and this mov-
tion begs, so when does the trend
ing average acts as a good resis-
end? To help answer this question,
tance line in a downtrend phase.
savvy technicians and computer
Always remember that the shorter
geeks who like to develop their
the time frame, the more sensi-
own indicators can devise an oscil-
tive the moving average will be
lator to compare the difference
to directional price changes. The
between two moving averages,
moving average used here is a sim-
as well as closing price to the dis-
ple moving average using a five-
tance of those moving averages.
period pivot point setting rather
Based on moving average values,
than the close.
it is very relevant and possible to
develop a histogram component
Moving Average
by setting a standard deviation of
Oscillators and
where a closing price is located to
the last known value of the mov-
If I have not stated it already, let ing average.
me make sure we cover this sub-
ject now—because moving aver- Based on a historical viewpoint,
ages are trend-following mecha- an oscillator like this can be used
nisms, they obviously work best to help determine the strength 41
Trend Trading Indicators
or weakness of a trend. In other I created this histogram, I under-
words, this method can be used stand and have more confidence
to determine if prices have more in what it’s trying to tell me, and
room to run, or if they have therefore it helps me make a bet-
reached an overbought or over- ter educated and informed trading
sold condition by looking at the decision.
values of the current market price
and the moving averages. Moving Averages
As prices depart too far from the
means or the short-term moving In summary, moving averages can
average starts to aggressively pull be used in a variety of ways other
too far from the longer-term mov- than just looking at a 200-day
ing average, one can construct a moving average based on the close
histogram to help illustrate this (which is the normal setting that
relationship. It is even possible to most stock pundits or the media
trade a convergence or divergence will quote), as you can see from
based off of the pattern in the this chapter. You have now learned
histogram, similar to what is used that there are a variety of param-
with MACD. eter settings you can utilize in dif-
age oscillator, which helps me a higher low. We call this bullish
ferent ways in order to capture
generate buy and sell signals, and convergence. What this indica-
Figure 6.8 shows a 15-min- a reading of what these moving
gives me clues to when the market tor has identified is that the price
ute intraday chart on the Euro averages are telling us about the
has reached an oversold or over- has departed too far from the
Currency FX using my TradeStation condition, and more importantly,
bought condition. means and that this downtrend
platform. I have a simple moving the trend of the market.
that started approximately at 6:30
average overlaid on the chart to Look at the low at the 7:30 a.m.
a.m. has likely exhausted itself.
help me identify trending mar- time frame; now look at the corre-
This is a very valuable tool in my
ket conditions. As you can see, sponding histogram reading. Then,
trading because it helps me make
the bottom section of the chart take a look at the low at approxi-
the determination of entering and
has what is labeled the Person mately 9:45 a.m., and you should
exiting trades. Due to the fact that
Histogram. This is a moving aver- see that the histogram reading has 42
Trend Trading Indicators
Quick Quiz 7
1. The simple moving average is calculated:

a. From complex formulas

b. By summing the price inputs for a given time period and dividing
Dow Theory
that sum by the number of time periods
c. By dropping old price data as new price data emerges

d. From a series of weighted averages
harles Dow was one of America’s most famous stock
2. When calculating the exponential moving average, market observers. His reputation revolved around the
a. Past market conditions must be taken into consideration. fact that the market made continued gyrations. He
b. More weight is given to newer data. observed that the stock market moved in three phases. His
c. Backtesting confirms accuracy. observations included that the market had short-term daily
d. A calculator should be used. fluctuations, an intermediate-term trend called a secondary
wave, and a longer-term trend called the primary wave. The
3. To help determine the strength of a trend, use:
primary uptrend was characterized by three upward swings. It
a. Moving average channels was the work of Charles Dow that Ralph Elliott incorporated to
b. Exponential moving averages create the Elliott wave theory.
c. Moving average ribbons
d. 50-day moving averages Back in 1897, the Wall Street Journal printed out two main
indexes. One was the Industrial Average and the other one
4. The Person histogram helps a trader to: was the railroads, which is now what we call the Dow Jones
a. Make the determination of entering and exiting trades. Industrial Average, and the transportation index. Back in the
b. Generate buy and sell signals. early 1900s, it was very easy to manipulate an individual stock.
c. Identify market conditions as overbought or oversold. It was nearly impossible to manipulate a group of stocks, and
d. All of the above. that was what Charles Dow believed would be a better way to
gauge the strength of the economy, by looking at the overall
For the answers to this quiz, go to trend of these indexes. That way, it gave him a better idea of
the bigger picture of the trend of the market. There was a third
index added called the Dow Jones Utility Index, and it helped to
confirm a boom or bust cycle. 43
Trend Trading Indicators
Charles Dow had certain principles of confirmation—if two of the three Dow’s Bullish Phase Theory
sectors were rising, this would be good confirmation that the economy Dow believed an overall bull or bear market was created by three dis-
was in a bullish market trend condition, and therefore one could look tinct phases. A bullish buy signal was established once the market trad-
at buying stocks. If the industrial and the transportation indexes were ed above the high of a previous rally after a definitive downtrend (see
declining, that would signal an overall weakness in the economy and Figure 7.1). Once prices trade above a previous high after forming a dou-
that one may want to look to take profits in the markets. These were ble bottom, or what is known as a “W” pattern, a buy signal is initiated.
known as simple but strong confirming index tools. Through time, we
have seen many changes, including newer indexes, like the technology If you examine the graph in Figure 7.2, you will see the distinct “W”
sector as represented by the NASDAQ. Now we also have exchange pattern or the double bottom. Once the market trades back above the
traded funds (ETFs) on indexes like the S&P 500 called the SPDRs (SPY) first swing high, a buy signal was initiated. This is a weekly chart on
or the NASDAQ (QQQQs). To take matters further, we now have ETFs on
the top sectors such as financials (XLF), material stocks (XLB), the ener-
gy sector (XLE), and even consumer staples (XLP) just to name a few. 44
Trend Trading Indicators
the e-mini NASDAQ 100 futures. comprise the market’s makeup is the bull market. They just want high, the feeling that one can’t
When combining this setup with are in my opinion: precautionary to get in something before missing lose prompts the need to borrow
an understanding of Dow three fear, lack of discipline, and greed. the move. This is when we witness money or become heavily lever-
wave phase theory, it is amazing The beginnings of a bull phase are a lack of discipline; investors buy aged in the market. This was the
to see this action as recently as as markets are forming bottoms just to get in, and they lose sight of case in 2000 as the “tech wreck,”
the low in March of 2009. It’s been known to be in accumulation phas- their trading plans. as it was called, posted the top in
approximately 100 years since es; this is known as Phase One. the stock market, in particular the
Dow first published his work, and Investors who are cautious buy Phase Three technology sector as represented
we still see these setups working. high-quality, beaten-down stocks Phase Three is generally when by the NASDAQ. My theory is that
Identifying and trading a newly and limit purchases. In other the irrational exuberance state or due to the massive infliction of
discovered trend requires a bit of words, they are just nibbling at extreme speculation takes place. monetary loss on a large audience
knowledge in what to look for, as this point. Typically, investors start Investors will do anything to get of speculators, it my take years if
well as patience and discipline. The buying utility stocks or high divi- in on the action, greed takes not another decade or a terrific
setups are there and they work, dend yielding stocks. They want to over, and this is where you find bull market to attract those who
if you know what to look for and make money, but are afraid of los- increases in margin trading. Many lost money in that event to come
how to apply these principles. ing, thus they are being cautious. will borrow money to buy stocks back into the market again.
As the fear of loss prevails, there is to not only get in on the action, In Figure 7.2, the price action
Beginnings of a Bull little in the way of courage. but also with real hopes to “get showed a steady stream of rising
Market rich quick.” Stock picking based on prices after the confirmation buy
Once you have identified a bull- Phase Two value or positive earnings is usually signal. Prices continued steadi-
ish setup, applying the concept Then as the trend matures, we not important at this stage of the ly higher throughout 2009 and
of Dow’s theory can help you not enter into what is known as Phase game. People just get in believing into early 2010. Certainly by mid
only potentially ride a trend a bit Two. As the market starts to prove stocks will keep going up. February of 2010, phase one and
longer, but his theories can help itself by displaying higher prices, two were completed. As Figure
This is the ultimate state of greed;
you correctly identify when a volume starts to increase as more 7.2 shows, we had not yet expe-
all levels of logic are abandoned,
trend may be exhausting itself. and more investors buy as their rienced a typical phase three bull
emotions rule, and there is no lon-
confidence level rises. Investors will market condition since prices did
ger that precautionary level of fear
Phase One start buying lower grade and small not escalate to an irrational exu-
that existed as it did in phase one.
The principles behind the emo- cap stocks, just to get in the mar- berance state. In fact, we had yet
The confidence level is excessively
tional state of the masses who ket before what they now believe 45
Trend Trading Indicators
to experience any criteria for the beginnings of a bear market which I
will explain now.

Dow’s Bearish Phase Theory

A bear market or bullish reversal move is commonly identified once
prices break below an important support level or old low. I like to sell
against a failed double top as prices trade below the old low for confir-
mation. In Figure 7.3 below, a sell signal occurs as prices trade below the
low of what is also known as an “M” top pattern.

I just mentioned the “tech wreck” that occurred in late 2000, and the
graph in Figure 7.4 is a monthly chart on the e-mini NASDAQ 100 futures
contract that shows a text book case of the “M” top pattern that initi-
ated not only a substantial sell signal but also the end of that bull mar-

ket’s trend. The three phases of the bullish side were very prominent in
the rally preceding the bear market. As of this writing, we have still not
even come close to the highs made back then. In fact, many companies
are either out of business or were acquired by others.

Now, let’s look at Figure 7.5, a daily chart on the U.S. dollar index. Here
is a classic double top or “M” top pattern that initiated a significant bear
market move. Granted, this index was not around when Charles Dow
stated his theories. However, when applying his theories on a bear mar- 46
Trend Trading Indicators
Phase One: Distribution
Dow believed that like a bull market, there were three parts to a bear
market, beginning with the distribution phase. This is where there is a
longer battle between bulls and bears, mainly when the general public
is buying as professionals are selling to unload their long position. Have
you heard the phrase, “tops take longer to form than bottoms?” Notice
in Figure 7.5 that the top lasted over one month before the sell signal
was generated as the market entered a significant bear trend.

Phase Two: Panic

Phase two is what was termed the “panic” period. This is where prices
accelerate rapidly to the downside, usually without any upside correc-
tion. This could be a period where the media may be publicizing the fact
that the bull market has ended and traders who were long might look to
liquidate their longs to stop the bleeding.

Phase Three: Capitulation

Phase Three is what I call the capitulation period. We will see larger
down days than before, and volatility is extremely high as measured by
wide price swings. But overall volume starts to dry up as extreme pessi-
mism reigns supreme.
ket condition combined with the failed double top pattern, one would
be able to ride this bear trend for a substantial profit. The similarities I believe it is due to the mass psychological aspect of human behavior
between these two markets are simply too strong to ignore. Both the that has proven the Dow Theory again and again. It has certainly not
NASDAQ 100 and the U.S. Dollar were highly visible in the media, but it only stood the test of time, but it is applicable in markets that did not
is the “M” top pattern that is consistent with creating a significant bear even exist in his own day. Apart from imbalances in supply and demand,
market trend. Let’s review Dow’s bear market theories. it is the understanding of the three principles of precautionary fear, lack
of discipline, and greed that will help you define a trend. Truly success-
ful trend traders plan out their trades, from when to enter to where 47
Trend Trading Indicators
to place their stops. They have faith in their methodology and act with
courage when it is time to place an order. Greed does not dictate their 8
trades, price action does.
Volume and
Quick Quiz
Open Interest
1. Dow’s theory on the market’s gyrations included:

a. Short-term, intermediate-term, and long-term trends

b. Daily, secondary, and primary waves rend analysis comes in many forms and indicators. After
c. Elliott, Gann, and Dow fluctuations understanding and examining the direction of price,
d. Both a & b which includes the close as well as the current close as
2. According to Dow, the three phases of a bearish market are: compared to past price action (old highs, lows, opens, and clos-
es), the next best confirming indicator for trend traders is vol-
a. Distribution, panic, and capitulation ume. There is one more exclusive indicator for futures traders
b. Precautionary fear, lack of discipline, and greed and that is open interest.
c. Irrational exuberance, extreme speculation, and accumulation
d. Lower high, lower low, double bottom These are important tools which will give clues to the strength
or weakness of a trend, or as we technicians say, the health of
3. During a bull market, you are most likely to find traders expecting
the trend—so let’s review the basics.
to “get rich quick” in which of Dow’s phases?

a. Phase One Volume

b. Phase Two
The definition of volume is the number of trades for all shares
c. Phase Three
in stocks, or for commodities, the total amount of trades for all
d. None of the above
contract months of a given futures contract both long and short,
4. According to Dow, confirming an overall trend among various index- combined. For example, stock index futures like the e-mini S&P’s
es enables one to gauge the strength of the economy. or the foreign currency contracts all trade on quarterly expi-
a. True rations, which include March, June, September, and December
b. False contract months. The volume will represent the total for all the
trades in each contract month.
For the answers to this quiz, go to 48
Trend Trading Indicators
Most technical analysts believe that volume is an indicator of the • Decreasing volume while prices are climbing may indicate a plateau,
strength of a market trend. It is also a relative measure of the dominant and can be used to predict a reversal.
behavior of the market. Volume is the measurement of the market’s
• Decreasing volume with a weaker price environment shows that
acceptance or rejection of price at a specific level and point in time.
fresh sellers are reluctant to enter the market and could be a sign of
There are several theories and so-called rules when using volume analy- a future downtrend.
sis on price charts. The first rule to remember is: if a market is increas-
• Excessive volume while prices are high indicates that traders are sell-
ing in price and the volume is increasing, the market is said to be in a
ing into strength and often creates a price ceiling.
bullish mode and can indicate further price appreciation.
• Excessively low volume while prices are low indicates that traders
are buying on weakness and often creates a floor. 
If a market is increasing in price and the In Chapter Six, we discussed the use of moving averages. One technique
that many traders use is taking a moving average of daily volume. This
volume is increasing, the market is said helps examine the overall trend of volume as well as filter and pinpoint
to be in a bullish mode and can indicate abnormal decreases or increases in trading volume activity.

further price appreciation. The opposite Let’s examine the graph below in Figure 8.1. This is a weekly chart on
the stock Netflix, Inc. (NFLX), which as you can see experienced a strato-
is true for a declining market. spheric price increase starting in early 2010. The upper portion of the
chart shows the candlestick price chart and the bottom portion reflects
the bar histogram of weekly volume with a 20-week simple moving
The exact opposite is true for a declining market. However, if a substan-
average overlaid on the volume graph.
tial daily market price increase or decrease occurs after a long steady
uptrend or downtrend, especially on unusually daily high volume, it is The low made in February of that year was marked by a bullish rever-
considered to be a “blow-off top or bottom,” and can signal a market sal on—at that time—the heaviest weekly volume. As the price trend
turning point or trend reversal. Here are some guidelines to use when climbed higher, notice that the direction of volume also increased, con-
using volume analysis: firming the rally was real and sustainable. This shows there was an accu-
mulation of shares, or as we identified in the first bullet point, increasing
• Increasing volume in a rising price environment signals excessive
volume in a rising price environment. It signals excessive buying pres-
buying pressure and could lead to a substantial advance.
sure and in this case it did lead to a substantial price advance.
• Increasing volume while prices are falling may signal a bear move. 49
Trend Trading Indicators
ket and more new money is flow- Identifying Opportunity
ing into the market. This reflects This information can be used to
why the price increases. identify an opportunity when
Of course, the exact opposite there is a major top or bottom in
is true on a declining market. the futures markets. If you are a
Chartists combine both the price stock trader, you may also want to
movement and the data from vol- pay attention to this data, espe-
ume and open interest to evalu- cially if you are trading high beta,
ate the “condition” of the mar- or stocks highly correlated to
ket. If there is a price increase on underlying commodity markets.
strong volume and open interest For example, in the graph in Figure
increases, then this is a signal that 8.2, we have a daily chart on corn
there could be a continued trend futures. There are several compa-
advance. The opposite is true for a nies that come to mind that have
bear market when prices decline. a vested interest in what happens
If price increases, volume stays to the trend in corn prices; one is
relatively flat or is little changed, Archer Daniels Midland (ADM) and
and open interest declines, this another is Bunge (BG).
reflects a weakening market con- A good question to ask would be:
dition. This is considered to be a can higher corn prices help or hurt
bearish situation because if open a company’s bottom line? To a
Open Interest short, and for every buyer there is interest is declining and prices are stock trader, it would be important
On the other hand, open inter- a seller. The open interest figure rising, then this shows that shorts on a price advance to ascertain
est reveals the total amount of represents the longs or shorts, but are covering by buying back their if the move was sustainable and
open positions that are outstand- not the total of both. So the gener- positions rather than new longs accompanied by widespread accu-
ing in existence and not offset or al theory for open interest is that entering the market. That would mulation, rather than a short lived
delivered upon. Remember that in when prices rise and open interest give a trader a clue that there is a price spike. Here is where volume
futures trading, this is a zero sum increases, this reveals that more potential trend reversal coming. and open interest would help one
game. For every long there is a new longs have entered the mar- gather further evidence. 50
Trend Trading Indicators

Notice in Figure 8.3, we have three price advance, accompanied with a there could be a sustainable price Hecla Mining (HL). Now whether
separate panes. The top section rise in open interest, revealing that advance over time. you are a futures trader or a stock
is a candlestick, the middle is the traders are adding to longs with trader, here is where volume and
Let’s examine the graph in Figure
open interest data, and the bot- an increase in trading volume. This open interest analysis can help
8.3 further. Gold can be traded as
tom section is a volume histogram indicates that traders are accu- traders understand the overall
a futures contract, or stock traders
with a 20-day moving average mulating positions and that the health of the trend. This informa-
can trade an exchange traded fund
study overlaid on the bar graph. health of this trend is very strong. tion may help traders stay with
(GLD), or highly correlated stocks
From late June of 2010, we see the This helps one to understand that the trend a bit longer. Like the
such as Newmont Mining (NEM) or 51
Trend Trading Indicators
old saying goes, “ride the winners and cut your Quick Quiz
losses,” using these technical tools may help 9
1. Volume is an indicator of the health of a
you to see if the price advance or the trend is
market trend.
a. True
Trend Lines
As the chart shows, once again as prices start
b. False Trend Line Analysis
to bottom in late July of 2010, the open inter-
est figures shown in the middle section start 2. If volume is increasing in a rising price envi-

to increase. This is also accompanied by an ronment, then:
was taught nearly 30 years ago, the
increase in volume. Together, this signals that a. The market is in a bullish mode most profitable way to trade is with
the start of the new bullish trend is healthy and b. The market is in a bearish mode the trend. So naturally, it’s impor-
sustainable. c. Further price appreciation can be expected tant to identify what the trend is and in
d. Both a & c what market condition you are trading.
Conclusion Unfortunately, many people do not adhere
3. Decreasing volume in a weaker price
There are many indicators that rely and are environment: to this advice, either by trying to outsmart
built based upon prices, but very few are the market or letting their intelligence or
derived using volume studies, and as far as a. Indicates a plateau.
ego interfere with a simple rationale of
b. Can be used to predict a reversal.
commodities are concerned, the open interest identifying the current market condition.
c. Could be a sign of a future downtrend.
data. Both tools are instrumental for the trad-
d. Indicates a bear market. In this chapter, I will disclose some of the
ers who want to stay on the right side of the
more proper methods for identifying the
trend and are easy to access. Remember, these 4. When prices rise and open interest
increases: market condition, or what we call the
tools help confirm the overall health of the
trend, by simple line drawing techniques
market trend.
a. New longs have entered the market. and ways to help identify when a mar-
b. New shorts have entered the market. ket trend is potentially exhausting itself
c. Money is flowing out of the market. or running out of steam. I will also show
d. Traders are taking profits.
some of the techniques that I learned
For the answers to this quiz, go to early in my career on how to correctly use trend line analysis to help me implement
trades. Most importantly, based on these
techniques, I will cover how to look for 52
Trend Trading Indicators
initial entry points of interest, stop placement levels, spots to add on First Things First
positions once a trend is maturing, and places to move protective stop I was always taught if you are going to analyze the market, you need to
orders based on the use of drawing lines on my charts. figure out where prices can go. To do that requires you to look at where
Throughout the history of the trading industry, many phrases and cli- prices have been. Start with looking at the longer-term picture. Drop
chés have evolved due to past human errors and successes. From my down to the intermediate term and then to the short-term time frame.
30-plus year career, I would like to share with you some of the tech- For longer-term investing requiring more than one month, I will start
niques and tactics for successful trend trading based on some of those with the monthly chart. Drop down to a weekly chart and use my daily
phrases. or end-of-day charts. For swing trading, I will still look at the weekly and
daily time frames, but include a 60-minute chart. For day traders, I like
The Top Five Secrets to Remember When Trend to look at the weekly and daily market direction and then take trades
Trading based off of the 5- and 15-minute time frame.
1. The trend is your friend.
As for drawing trend lines, the important thing here is to identify the
2. The trend is your friend until it ends. pivotal swing points, both highs and lows, and then extend a line out
to help identify the trend’s direction. Let’s examine Figure 9.1. This is a
3. Never anticipate when a new trend will begin; markets have a habit of
chart on Potash (POT). I have purposefully made a black and white chart
moving further than traders expect.
so that if you print this page out, it will be seen clearly. From the low
4. When in a bullish trend, buy pullbacks. marked point “A,” which was created by a “W” bottom pattern as the
right side low was formed by a hammer candlestick, the market moved
5. When in a bearish trend, sell rallies.
up to the first pullback low, or swing low. This is where we would con-
In this chapter, we will go over the proper techniques for drawing trend nect the trend line and extend out in the future. As the saying goes,
lines such as lines drawn from lows, from highs, and from range mid- “the trend is your friend until it ends.” Here is how correctly drawing
points. We will discuss the importance of the condition and location of trend lines can help you identify a change in a trend’s direction.
those trend lines specifically, the angle, degree, and separation from
Once prices have traded beneath the longer term extension, say for two
price to the trend line.
consecutive closes below the trend line, one can argue that the trend
has changed direction. After the peak at point “B,” the trend started to
If you are going to analyze the market, you reverse and change direction. So does one look to buy the pullback as
prices start to close back in on the line extension? If one did not enter at
need to figure out where prices can go. the beginning phase of this “W” bottom pattern, then one could look for 53
Trend Trading Indicators

a low risk trade setup by buying small loss. As you can see, prices Let’s examine the next graph in towards this support line, that
a test of the trend line extension. continued lower. Once a reversal Figure 9.2; this is a weekly chart would be a targeted area to look
However, once prices fail to con- occurs, traders wait for “bounces” on McDonald’s (MCD). Another to enter a long position. As we
tinue higher and close beneath the or rallies to sell against. One such double bottom forms, creating say, this defines buying pullbacks
uptrend line; in other words, fail rally occurs in early May as the the “W” pattern from point “A” to in a bullish environment. Point “C”
to hold the trend line support, the chart shows. To determine future point “B.” If one wanted to draw intersects right at the trend line
trader should exit the long posi- overhead resistance, one would a textbook upward sloping trend extension. Notice that the candle
tion. This would result in a loss, draw a line against the high at line, it would exist at a nearly 45 formation is a bullish engulfing
but as the example here shows, a point “B” and extend out. degree angle. Once prices retrace pattern, which may help to con- 54
Trend Trading Indicators
However, once prices break out Quick Quiz
and above that level, if the mar-
1. Proper trend line analysis can
ket is to prove itself to be bullish,
help traders identify:
prices should not trade back under
that line. The line of old resistance a. Initial entry points
should prove to become the new b. Stop placement levels
line of support. Instead of buying c. Add-on positions
the market on the first breakout d. All of the above
of old resistance, most conser- 2. When in a bullish trend, buy
vative traders will wait until the pullbacks.
market pulls back to the horizon-
tal line and then they will go long a. True
b. False
with close stops because the price
action should hold based on the 3. When in a bearish trend, sell
theory that old resistance should pullbacks.
act as new support. In this exam-
a. True
ple, trend line “B” has acted under
b. False
that old axiom.
4. A trader should exit the long

a. As prices continue higher

firm the positive momentum as support. Figure 9.3 helps to illus- b. When prices close beneath the
prices bounce off of the newly trate this technique. In Figure 9.3, uptrend line
constructed support trend line. using the same weekly chart on c. When prices hold the trend
line support
McDonalds (MCD), you can see the
We have addressed how to prop- d. All of the above
old highs during 2008. If you draw
erly identify bullish trend lines,
a horizontal line across your chart For the answers to this quiz, go to
one area that I believe is critical
as prices bottom in 2009 and start
is identifying what we say is “old
the new uptrend, that old high is
resistance,” which turns into new
creating a ceiling of resistance. 55
Trend Trading Indicators
I disclose the principles here, you and “M” top formations, seasonal thing that has been achieved and
10 will understand why. So I guess analysis, pivot points, moving aver- practiced even by Mr. Elliott him-
you are now asking yourself why ages, trend lines, indicators like self. His discoveries were simply a
Elliott Wave bother sharing it in this book? The ADX, MACD, and stochastics, and compelling phenomenon into the

Theory reason is because it reveals trends

and the trend patterns.
volume and open interest studies. art of forecasting price moves. I
will cover the basis for his discov-
I believe it is important that trad-

eries and the overall strengths as
o book on trends would ers have a complete understand-
History and Value of well as weaknesses of his work.
be complete without ing of trend analysis but also
Elliott Wave Keep in mind that Elliott wave is
some introduction on the phases or waves as they are con-
Ralph Nelson Elliott (1871-1948) a fractal concept which works in
Elliott wave theory. I do not nec- sidered. Elliott wave principles can
was a dedicated student of the multiple time frames so that it
essarily use Elliott wave theory help you uncover just that, and
stock market. Back in the 1920s, can truly benefit all styles of trad-
consistently in my trading, but I do more specifically, what phase or
he observed market moves, both ing from day to swing to position
know the principles of the waves “wave” the market trend is in. As
bullish and bearish, occur in three traders. The fractal concept is sim-
and the theory behind the psycho- you may have already discovered,
distinct phases. He began to ply defined as cycles or patterns
logical aspects that drive human all markets certainly do trade in
develop theories and views that repeating in shorter time frames
beings are reflected in market phases, from periods of consoli-
the overall prices in stock market and developing in longer-term
prices, namely fear and greed. As dations to trending modes. With
averages move in waves. This was time periods, meaning there are
it is often stated, human emo- the knowledge of the Elliott wave
presumed to fall in line with the waves within waves.
tion often interferes with human principles, this information may
understanding of the work cred- give you a better understanding of A completed Elliott wave cycle
ited by Charles Dow as defined in which side of the market to be on, from bullish to bearish or bearish
I want to share with you my expe- the Dow Theory. and to capture profitable moves to bullish consists of eight waves.
rience, feelings, and observations with surgical precision. And hope- There are two distinct wave defini-
The purpose of this chapter is to
on this theory, as well as quote fully more times than not, trading tions. Impulse waves are the ones
give an introduction as to what
a good acquaintance who is one from the winning side. termed to be moving with the
Elliott wave is and how you can
of the premier technicians in the main trend and corrective waves
apply this method in the markets Since many of the concepts
world on the effectiveness of are against the main trend.
combined with what we have explained already are great tools
Elliott Wave, who says: “it works
already covered, incorporating in and of themselves, combining Impulse waves have five primary
when it works.” This means that I
Dow Theory with “W” bottoms them with Elliott wave is some- price movements and the cor-
do not use it all the time, and as 56
Trend Trading Indicators
rective waves are seen as having posed of eight price moves, five For more experienced chartists, wave one count for the weekly
three primary price moves, which up and three down, as you can see they would of course recognize time period. We can also see a five
are lettered and run in the oppo- in Figure 10.1. Incidentally, three, that the end of a bullish move’s wave count on a five minute chart
site direction of the main trend. five, and eight are contained in fifth point could possibly be con- that composes just wave one on
A healthy long-term trend follows the Fibonacci series of numbers. sidered the number one point of a daily chart. Elliott wave theory
the indication of heavier volume The fundamental concept behind a one-two-three formation, or the combines the best of traditional
during the impulse waves (one, Elliott’s theory is that bull markets top of a head and shoulders for- charting techniques and price pat-
three, and five). have a tendency to follow a basic mation. The one thing Elliott most tern formations such as triangles
five-wave advance, followed by wanted chartists to recognize is and wedges. These are simply con-
It is assumed that Elliott used
a three-wave decline. The exact that his wave theory worked on solidation patterns within trends.
some of Fibonacci’s work because
opposite is true for bear markets. long-term charts as well as intra- These trends’ phases are consid-
a complete wave cycle is com-
day charts. ered waves.

Price objectives from predict-

A Wave is A Wave
ing possible highs or lows can
It does not matter what time be determined through the use
frame you trade in; a wave is a of Fibonacci ratios and the cor-
wave. The idea here is that each responding rules associated with
wave is simply a subset of another each wave description. I also have
wave just to a lesser degree. Each had tremendous success identi-
wave is itself part of the higher fying turning points as indicated
degree wave. We can define by the maturity of a price move.
this by saying waves of one time For example, if it is the bottom of
frame can be expanded to relate wave two or four, I may look for
to a higher time period, and one support targets using the Fibonacci
time frame can be subdivided ratios as well as the pivot point
into a shorter term time frame. support targets. When I see a
For example, we might see a five confluence or multiple cluster of
wave count on a 60-minute chart support targets from using both
that, when converted to a daily techniques, it heightens my asser-
or weekly chart, counts as a full tion to go with a position because 57
Trend Trading Indicators
I understand which direction to forms, Fibonacci correction, and The Elliott wave principle was is referred to as a proportionate
trade from. I will admit there are projection ratios and has a time originally applied for the stock and alternate relationship with the
times when an Elliott wave pat- element as magnitudes of each market, but the core foundation measurement of the waves.
tern is crystal clear and helps me waves are concerned. of its decipherable use was based
trade on the winning side, and on the premise of mass human Wave One
then there are times when I do not psychology. Due to the exorbitant The first wave is the base or start-
have a clue and can not make out Elliott wave anal- extent of trading on a global scale ing point derived from a con-
any clear or distinct pattern. ysis can work in foreign currency, I find it works solidation trading phase after a
well when the patterns jump out prolonged price decline. It usually
That is when I rely on other tech-
niques such as trading in a short
with all markets on the charts. In a world of cha- appears to be simply a small cor-
otic and turbulent volatility, Elliott
term time frame within the direc- and time frames; wave attempts to give a trader
rective bounce from a previous
tion of a higher degree time frame. trend. It is the smallest in price
For instance, if the 15-minute whether it is stocks, a better chance of interpreting moves as compared to the three
what phase a market is in, price impulse waves. This stage or wave
trend is up, classified by the mar-
ETFs, futures, or objectives, and time durations to is what technicians have discov-
ket trading above a set of moving
expect a move to last. It is highly
averages (namely pivot point aver- Forex. subjective, and I strongly suggest
ered to be an accumulation phase.
ages), then I look for buy signals as Using what we have learned with
sticking to the rules I will outline Fibonacci calculations so far, we
defined by a series of higher highs,
Trading is not about being rigid when applying these principles in can apply the ratio numbers to
higher lows, and higher closing
and sticking with just one sin- your trading. develop a technique to give price
highs as prices trade above a set of
gle method. Market conditions projections for a typical five wave
moving averages on the five-min-
change, requiring an assortment Rules for Trading with pattern. In order to help deter-
ute time period.
of tools to improve your market Elliott Wave mine the top or peak of a five
The key in understanding Elliott forecasting abilities. Because it is Each wave has its own set of char- wave move, we can use several
wave is that it can work with all a complete and comprehensive acteristics or personalities and techniques.
markets and time frames, whether analytical tool, I believe studying rules. Besides wave counts and the
it is stocks, ETFs, futures, or Forex. Using software that includes a
and using Elliott wave will improve interaction with Fibonacci exten-
It is a valuable technical tool Fibonacci correction and expan-
your chances for success. sion and correction relationships,
because it is comprised of wave sion tool, we can easily determine
there is a time element and what
a price objective with fairly good 58
Trend Trading Indicators

accuracy. If your charting software higher frequency of the 2.618 per- The one drawback in using this included examples of integrating
program does not have this fea- cent ratio work as well. See Figure method is the consideration of longer-term pivot point analysis
ture, my website, NationalFutures. 10.2 for illustration. how much time it takes for a swing such as weekly and monthly time
com, provides a free pivot point measurement to reach its objec- periods. These seem to be more
Another method to predict the
and Fibonacci calculator. tive. Using Fibonacci extensions effective in predicting both time
peak for wave five is to take the
just gives us an idea of a poten- and price turning points.
Once we determine the overall measurement from the bottom of
tial move; it does not give us a
measurement or amplitude of wave one to the top of wave three
time frame in which the move Wave Two
wave one, extend that amount by and multiply out by 1.618 percent.
will occur. The move could take As you can see in Figure 10.4, the
3.236 and add that sum to the bot- See Figure 10.3.
days, weeks, or months to meet second wave usually retraces .618
tom of wave one. I have seen a
the objective. That is why I have percent of the sum of wave one. 59
Trend Trading Indicators
Wave Three needs to be followed is to make
The third wave is one of the most sure the third wave is a true wave;
important because this is where it cannot be the shortest of the
you will see your trend confirma- five waves.
tion occur. This wave is the largest
of the three impulse waves. It is Wave Four
accustomed with heavy volume. The fourth wave is the corrective
From a fundamental aspect, this is wave. It usually gives back some of
where you will start to hear more the advancement from the third
and more bullish news, which will wave. One may see measuring
in turn support the move upward. chart patterns like triangles, pen-
Generally speaking, the top of nants, or flags during the fourth
wave three equals a measurement wave. Triangles, pennants, and
of the length of wave one multi- flags are continuation patterns and
plied out by a factor of 1.618 per- generally break out in the same
cent. Another way to determine direction as the overall trend. The
or predict the top of wave three most important rule to remember
is to take the overall length of about the fourth wave is that the
Wave two can at times retrace in the chapter on Dow Theory.
wave one, multiply that amount by low of the fourth wave can never
100 percent of the entire previous These are commonly referred to
2.168, and then take that sum and overlap the top of the first wave.
trend or wave one, but not beyond as 1-2-3 patterns and resemble a
add it to the price point of the low Here is where we will find tremen-
the beginning of that wave. This head and shoulder chart pattern.
of wave two. Technicians jump on dous trading opportunities once
means that if it is a bullish cycle, Traders have also been able to use
the trend and place market orders you can identify the fourth wave.
wave two will not make a lower the number two point to predict
to enter a position from the break- As the principle applies, old highs
low, and if it is a bearish cycle, it the top of wave five by taking the
out above the number one wave. (resistance) once broken will later
will not make a higher high. This is sum of the price move in wave
You usually see a large increase turn into a new low (support) on a
what technicians generally consid- one, multiply that amount out by
in volume and open interest at re-test as we covered in our chap-
er the makings of “W” patterns or 1.618 percent and then add that
that point. This is where break- ter on trend line analysis.
double bottoms or “M” patterns figure to the price point of the bot-
away gaps will occur. One rule that
or double tops. This was discussed tom of wave two. 60
Trend Trading Indicators
Wave Five the Extraordinary Value of the beyond Wave A, then another nal rather than chase the market
The fifth wave is usually the stron- Elliott Wave Model, both of which cycle begins in the opposite as it declines and sell short right as
gest for some commodities, such can be found at www.tradersli- direction. it starts building an upside reversal
as cotton, soybeans, gold, and cur- that forms into wave five. Better
rencies. This is where the longest Subjectivity in Elliott yet, with the knowledge of what
To summarize what we’ve learned
“leg” of the waves will be formed. Wave the characteristics of a fifth wave
in this chapter, here are the main
It is also during this final phase There are more observations to might look like you can:
principles that you should focus
that the price advance begins to on when working with Elliott Wave understand which are quite sub- • project a profit objective
slow. From the rule of “multiple Theory: jective rather than absolute rules
techniques,” other indicators and regarding Elliott wave theory. • filter a trading system to look
oscillators like MACD and stochas- • Wave A is usually mistaken Having the ability to look at a for better triggers to sell short
tics begin to show signs of being as a regular pullback in the chart and being capable of seeing as the maturity of a long-term
overbought in a bullish trend, or trend, but this is where you the corresponding trends or waves trend starts to dissipate.
oversold in a bearish trend. We could possibly start seeing the in the market will help you deter- This will also help you not to stick
notice during this period that makings of “W” or “M” pat- mine which side of the market to around in a trade too long.
the market is beginning to lose terns(1-2-3 patterns), double trade on.
momentum and that the trend tops or bottoms, or a head and Quick Quiz
shoulders chart pattern. One such setup is identifying
may be exhausting itself.
a higher right side double bot- 1. Elliott wave analysis can work
• Wave B is a small retrace- tom form as wave two forms. in all markets and all time frames.
Conclusion ment back towards the high of Remember, it will look like a dou-
Robert Prechter of Elliott Wave wave five, but it does not quite a. True
ble bottom or correct near the
b. False
International is one of the world’s reach that point. This is where .618 percent retracement level.
foremost leading experts on Elliott traders will exit their position Wave two can also retrace 100 2. A complete Elliott wave cycle
wave. If you see yourself wanting or begin setting up their posi- percent of wave one, so armed consists of how many waves?
to learn more into this subject, he tion for a move in the opposite with this information, you will a. 5
has written several books on this direction. have a better idea of how much b. 3
subject, and I would recommend to risk on a trade. For example, as
• Wave C confirms the end of c. 8
that you explore them, along with you see a fourth wave develop, it d. 13
the uptrend and when con-
and his video courses Trading the will be better to wait for a buy sig-
firmation is made by going
Elliott Waves and Understanding 61
Trend Trading Indicators
3. What kind of waves are said to About the Author cal analysis, his trading style, and
move with the main trend? C John Person is a 32-year veteran system development. John devel-
of the futures and options trad- oped the Person’s Pivots and the
a. Corrective
PPS indicator, both of which
In Closing ing industry. He started
on the floor of the are on TD Ameritrade’s
d. Impulse Chicago Mercantile Thinkorswim trad-
Exchange back ing platform. He
4. In which wave will a trader see also has devel-
I hope you found this book use- in 1979. This
a trend confirmation occur?
ful in increasing your knowledge was the premier oped indicators
a. Wave one and understanding of trend and exchange which for TradeNavigator
b. Wave two its effect on the market. With launched foreign and TradeStation
c. Wave three the tools and indicators we cov- currency trading. Securities. He has
d. Wave four ered, you’re well on your way to taught thousands of
He then had the privi-
being able to harness the power lege of working with George traders, including mem-
For the answers to this quiz, go to bers of the largest exchanges. He
of a trend and using it to improve Lane , the innovator of the sto-
your trades. chastic indicator. is the author of three nationally
and internationally popular trad-
All the best in your continued John has worked his way through- ing books as well as three trad-
education and trading endeavors. out the industry as an inde- ing courses and a DVD seminar
pendent trader, broker, analyst series. His latest book series, The
and branch manager for one Commodity Trader's Almanac, is
John Person of Chicago's largest discount instrumental in trading the sea-
/ full service firms under the sonal aspects of the commodity
direct supervision of a former markets and the correlated ETFs
Chairman of the Chicago Board and stocks of those markets.
of Trade. John is the founder of, an online The nation’s most respected busi-
education website. ness journalists call John Person
for his market opinions. He is
John has shared his wealth of widely quoted by CBS Market
knowledge in the field of techni- Watch, Reuters, Dow Jones 62
Trend Trading Indicators
Newswires, and appears regu- Recommended Reading
larly on CNBC. He is a sought after The Three Secrets to Trading Momentum Indicators
speaker for many professional
By David Penn
organizations such as the Market
Technicians Association (MTA ) , You can't predict the future, but if you see a car going 100 miles an hour toward a
the International Federation of picket fence, you have a pretty good idea. In trading, this concept is called momen-
Technical Analyst Society (IFTA) tum and it is one of the most widely used factors in creating effective, profitable
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Trend Trading Indicators
Volatility Indicators: Techniques for Profiting from the Market's Moves
By Lee Leibfarth & Jean Folger
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