The longer the trend has been in place, the higher the chance that it can turn the other way.
After you get comfortable with this process, you can advance to looking for the charting patterns that I describe in the sections that follow.
Analyzing textbook base patterns
Bases, whether tops or bottoms, are sideways patterns on price charts; they’re pauses in the uptrends or downtrends in security prices. Bases are formed as
some traders take profits and other traders establish new positions in the other direction.
In futures markets, someone always buys, and someone always sells. So a baseis what happens when the number of buyers and sellers is in fairly good balance and prices remain steady.
Bases, in general, are points in the pricing of a security at which the market takes a break before deciding what to do next. A base can come before the market turns up or down, and it can last for a long time, even years. If, after it forms a base, the market decides that more selling is called for, a new down- turn, or falling prices, can start on a candlestick chart, despite the fact that the market has based after a decline. When the base forms after a rally, it can either resolve as a top, and the market can fall, or indicate only a pause in a continuing uptrend. You can’t, however, predict with full certainty which way the markets will break after they pause (in either direction).
Figure 7-4 (later in this chapter) shows some key technical terms, including price tops and bottoms and basing patterns.
A base and a bottom accomplish the same thing, except that they can occur at different places. A base can be seen after the market climbs, after the market falls, or even during an uptrend or downtrend. A bottom usually is seen in retrospect, after the market rallies from the basing pattern. Similarly, a topusually is seen in retrospect, after the market declines from a basing pattern.
Although you can’t predict tops and bottoms with 100 percent certainty, some reliable indicators can help you make better guesses. These indicators are
Specific patterns seen in price oscillators, such as when the RSI and MACD indicators move in different directions than the price of the security (see Chapters 8 and 13).
Major turns in market sentiment (see Chapter 9).
Key price movements above and below important price areas, such as resistance or support points (see Figure 7-4 and the section “Using lines of resistance and support to place buy and sell orders,” later in the chapter).
Downtrends
Here are some important factors to remember about a base at the bottom of a downtrend:
A good trading bottom usually comes when everyone thinks that the market will never rise again.
Downtrends can die in two ways: in a major selling frenzy or over a long period of time in which a base forms.
At some point, all markets become oversold, and they bounce. Any such bounce can be the beginning of a new bullish uptrend in the market.
After a long time of falling prices, you have to be ready to trade all turns in the market, even if you get taken out as the downtrend reasserts itself.
The most important area of a chart that is making a bottom is known as sup- port. Supportis a chart point, or series of points, that puts a floor under prices. That’s where the buyers come in.
Uptrends
Here are some important factors to remember about a base at the top of an uptrend:
Most participants at the top in the market are bullish, which is why three or four failures often occur before the market breaks toward the downside.
Downturns that follow long-term rallies tend to spiral downward for a long time. That’s exactly what happened with the multiyear chart of the dollar index shown in Figure 7-5, later in the chapter.
Tops are more likely to lead to reflex rallies, meaning that long-term downtrends are likely to be more volatile than are uptrends. For short sellers, it’s a very rough ride, no matter which market you’re trading.
The most important area of a chart that is making a top is known as resis- tance. Resistanceis a chart point, or series of points, that puts a ceiling above prices. That’s where sellers come in.
Using lines of resistance and support to place buy and sell orders
Drawing lines of resistance and support for a particular market or security (see Figure 7-4) can help you maintain your focus when placing your buy, sell, and short-sell orders. Buy orders usually are placed above resistance lines, and sell orders and sell-short orders are placed below support levels. One thing you can count on in the futures markets is the disciplined way by which traders respond to the signals. That’s what makes technical analysis ideal for futures trading.
Support and resistance lines define a trading range.In Figure 7-4 (later in the chapter), the trading range is called a basing pattern, because it precedes a breakout.
Support and resistance levels can be fluid, flowing up and down within the trading range. When combined with a moving average (see the next section), they provide a useful tool that indicates how market exit and entry points are progressing in relationship to the price of the security.
Moving your average
Moving averagesare lines that are formed by a series of consecutive points that smooth out the general price trend. Moving averages are a form of a trend line.
In terms of a security’s closing price, for example, a 50-day moving average is a line of points that represent the average of the closing prices of the security during each of the previous 50 days of trading.
Figure 7-3 shows two classic moving averages that are frequently used in technical analysis, the 50-day and 200-day moving averages. This particular figure shows a bullish long-term trend in which the bond fund is trading above the 200-day moving average and a crossover in which the price of the bond fund began trading above the 50-day moving average, a sign that prices were moving higher.
TLT Daily MA(50) 91.43 MA(200) 88.29
3-Jun-2005 0:96.90 H:97.00 L:95.20 C:95.25 V:5.6M Chg:-0.79 Engulfing
50-day moving average and bullish cross-over
200-day moving average Harami
RSI(14) 66.9
MACD(12.28.9) 1.11
Dec 2005 Feb Mar Apr May Jun
EMA(60)
70 50 30
-.50 85.0 5M
4M 3M 2M 1M
95.0
92.5
90.0
MACD Figure 7-3:
Moving averages point to a bullish trend in 20-year
T-bonds, while engulfing and harami patterns point to trend changes.
The MACD indicator confirms the shift.
Moving averages come in many different types, but for illustrative purposes, I use these four:
20 days:The 20-day moving average traditionally is thought of as a short-term indicator.
50 days: The 50-day moving average is considered a measure of the intermediate-term trend of the market.
100 days:More pros are starting to use the 100-day average. The 100- day average gives the pros an edge over the public, as most people tend to follow the 20- and 50-day lines. The 100-day average gives you a chance to participate in the market’s action sandwiched between the very long-term trend measured by the 200-day average and the shorter term periods measured by the 20- and 50-day lines.
200 days: The 200-day moving average is considered the dividing line between long-term bull and bear markets. Use this average to make very long-term decisions about the trend of the market.
As a general rule, when a market trades above its 200-day moving average, the path of least resistance is toward higher prices; however, no hard-and-fast rules exist. Some traders prefer to use a 21-day moving averagerather than the 20-day average, while others think moving averages are useless altogether.
I personally like using them to define dominant trends in the markets but not necessarily as guides to placing buy or sell stops.
Short-term charts, such as the charts used for day trading, where one price bar can equal as short a period of time as 15 minutes, have moving averages that measure minutes rather than days. The same decision rules apply, though.
The exception for me is when a market has been in a major uptrend or down- trend for an extended period, and it suddenly breaks below or above the 200- day average. This can signal that the long-term trend in that market has made a drastic change in the opposite direction.
Most trading software programs offer moving averages as part of their default charting systems. You may have to adjust these moving averages to your par- ticular trading style or delete them if you decide that you don’t like them.
Also, remember that the averages I describe here are good places to start. As you gain experience, you’ll find that shaving off or adding a day or two to the commonly used moving averages may give your trading a slight edge at times. The important thing is to remember the main concept first, and then you can start to add your own wrinkles.
The moving averages that you use in futures trading more than likely will be defined in terms of minutes or hours rather than days or weeks — depending, of course, on the time frame you use to make your trades. Nevertheless, knowing the longer-term trends of the markets in which you’re trading is essential for knowing when to make trades with the trend rather than against it. The basic rules are the same.
You can give your position more room to maneuver by using longer-term moving averages. In the futures markets, however, that strategy is not always the best, because some markets are more volatile than others. If you’re using moving-average trading methods, your best bet is to back test several differ- ent combinations of moving averages for each specific market.
Back testingis a trading method by which you review or test your proposed strategy over a period of time by using historic charts. For example, if you want to see how a market relates to its 20-day moving average, you can look at a five-year chart that includes the 20-day moving average and gauge what prices do when that market is priced above or below that average. When back testing, you’re better off looking at many different indicators and combinations of them. You usually can find a combination that works best for any particular market. When you back test your strategy, you improve your chances of finding the best combination of indicators to keep you on the right side of the trend.
Breaking out
A breakout happens when buyers overwhelm sellers and prices begin to rise.
Breakouts usually follow some kind of basing pattern or sideways movement in the market. A good rule is that the longer the base, the higher the likelihood of a good move after the underlying security breaks out of its trading range.
Figure 7-4 shows a great example of a chart breakout coming out of a head- and-shoulders pattern, a basic and easy-to-find pattern that can be found in all markets. Notice the almost perfect head-and-shoulders bottom in the crude oil contract marked H for the headand S for the left and right shoul- ders,as it forms the basing pattern that precedes the crude-oil price breakout in textbook fashion.
Some of the characteristics of a head-and-shoulders base are that it
Is a common but not always reliable technical pattern. It doesn’t always point to a breakout the way it does in Figure 7-4.
Always is shaped like a head and shoulders. Arrows in Figure 7-4 illus- trate how the volume drops off as the shoulders are being formed, a textbook characteristic of the head-and-shoulders bottom. Head-and- shoulder tops are the same formation turned upside down. When they happen, they can lead to a breakdown in the underlying asset.
Indicates that any resulting breakout will take out the resistance at the neckline of the head-and-shoulders pattern.
Results in an increase in share volume as the price breaks out above the head-and-shoulders bottom (see the five-pointed star in Figure 7-4). The volume increase is another important characteristic of a chart breakout.
It indicates that many buyers are interested in the security and that prices are likely to go higher.
Using trading ranges to establish entry and exit points
Markets often trade in channels. As is what happens when a market trades up or down within defined borders. It is sort of a trading range, except usually trading ranges are defined as markets that move sideways, which are in fact horizontal channels. Don’t get too bogged down in the finer points, though.
Just remember that markets tend to move within upper and lower limits.
Sometimes the upper and lower limits are horizontal (trading ranges) and sometimes the upper and lower limits slant (channels.) Figure 7-5 shows a rising or uptrending channel. The upper line defines the top of the channel, and the lower line defines the bottom of the channel.
Regardless of whether the trend is up or down, channel lines can point to great places to set trading entry and exit points for these reasons:
The longer the channel holds in place, the more important a break above or below it becomes for a particular market or security.
Channel lines can indicate a multiyear bear market if the breakout occurs below the rising channel. (That’s what happened to the dollar in the late 1990s in Figure 7-5.)
Channel lines can indicate that a major bottom is in place and that a bear market has come to an end if a downtrend line is broken. (That’s what happened to the dollar in 1985 and 2005 in Figure 7-5.)
56 52 48 44 40 37 3534 33 32 1826 1500 1250 1000 750 500 250
56 52 48 44 40 37 3534 33 32 1826 1500 1250 1000 750 500 250 Jul
Jun Aug Sep Oct Nov Dec Jan Feb Mar Apr May
Resistance Breakout
Support
Basing pattern Figure 7-4:
Here’s a good look at lines of resistance and support, a breakout, a base pattern, and a classic head-and- shoulders pattern.
Resistance is the opposite of support, because it’s a price point on a chart above which prices cannot move higher. It’s also the place where sellers are lurking and a place where breakdowns ultimately occur. A breakdown is a point in the market when sellers overwhelm buyers and prices begin to fall.
A breakdown usually comes after a market forms a top. Figure 7-5 shows the U.S. Dollar Index making a multiyear top. In this case, the top actually is indi- cated by a triple top formation, because the dollar failed to move higher in three separate attempts. (The numbers 1, 2,and 3correspond to the three tops, or failures, before the breakdown began in Figure 7-5.)
As with most definitive bases at the top of an uptrend, the crucial signal is the failure to make a new high for the move. Note how the number 3top is lower than the number 2top and then is followed by fast and furious selling.
Seeing gaps and forming triangles
Gaps and triangles are two of the more common occurrences on price charts.
Each has its own meaning and importance.
Triangles,or wedge formations, can predict future price actions more reliably than gaps, but gaps can also be useful.
The three basic triangle shapes found on price charts are
Ascending triangles: These triangles point upward and can be good signs of a price pattern with an upward bias (refer to Figure 7-5). In that
1990s 2000s
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128 124 120 116 112 108 104 100 96 92 88 84 81
Runaway 79
gap
Ascending triangle
Down trend line Rising channel Upper
channel Exhaustion line
gap Bullish breakaway
gap Figure 7-5:
Gaps, channels, trend lines, triangles, and other basic technical analysis patterns.
example, the Dollar Index uses the lower rising channel line as support to build an ascending triangle. A horizontal line (above the triangle) marks the resistance point that completes the triangle.
Descending triangles: These triangles point downward and are the opposite of ascending triangles, usually coming before downtrends.
Symmetrical triangles: These triangles are symmetrical in that they show neither an upward nor downward trend and thus are unpre- dictable price formations.
Gaps,on the other hand, are unfilled points on price charts. They are more frequently visible and therefore less important in the price charts of thinly traded instruments, such as obscure futures contracts and some small stocks. However, when they occur in more common contracts and more heavily traded stocks, they can be much more important and have the follow- ing effects (Figure 7-5 shows all three such gaps):
Breakaway gap:This gap happens when an underlying security gets out of the gate very strongly at the start of the trading day. Breakaway gaps often come after the release of economic indicators, such as the monthly employment report. They are signs of a strong market.
Breakaway gaps are more meaningful when they are bigger than the usual trading range of a security. For example, if you know that a futures contract usually trades within a range of three point ticks and it opens ten ticks higher or lower, the result is a major breakaway gap.
Runaway gap:This gap occurs when a second gap appears on a price chart in the same direction as a breakaway gap. Runaway gaps are signs of continuing and accelerating price trends.
Exhaustion gap:This gap is a sign that a market has run out of buyers or sellers and indicates almost a last gasp in the market before the trend is reversed. Some exhaustion gaps may have telltale candlestick patterns associated with them, such as a doji, cross, or hanging man (see the sec- tion “Hammering and hanging for traders, not carpenters” later in this chapter).
Seeing through the Haze: Common Candlestick Patterns
Even though candlestick patterns are not 100 percent reliable, they certainly are worth paying attention to. As you gain more and more experience, you’ll come to know many different patterns. In this section, I concentrate on the more common and meaningful patterns that can serve as signals that a market is starting to reverse course.
Engulfing the trend
An engulfing pattern is what you see when the second (or next) day’s real body, or candlestick, completely covers the prior day’s candlestick.
An engulfing pattern signals a potential reversal. Figure 7-6 shows a schematic of bullish and bearish engulfing patterns, and Figure 7-3 shows a real-time engulfing pattern. Note that the body of the second candle is larger than the first candle and that it predicts a change of the trend. The bullish engulfing pattern predicts a trading bottom, and the bearish engulfing pattern, a top. Action on the third day often is key to whether the pattern will hold.
Engulfing patterns are characterized by a second-day candlestick that is larger than, or engulfs, the first day’s candlestick. The larger candlestick predicts a potential change in the trend of the underlying security’s price.
For example, a bullish engulfing patternusually appears at or near a trading bottom and predicts an upturn in prices, while a bearish engulfing pattern appears at or near the trading top and predicts a downturn in prices.
In Candlestick Charting Explained(McGraw-Hill), Greg Morris, a mutual fund manager (PMFM funds), software designer, and an early proponent of candle- stick charting, offers several important rules of recognition for engulfing patterns:
Engulfing
Bullish Bearish
Figure 7-6:
The engulfing pattern.