Bullish Divergence... A lesson from hind sight with CBIP

This case study is based on the chart for CBIP, a counter listed on the Bursamalaysia.

The point of focus is bullish divergence.
This phenomenal of bullish divergence does not occur very frequently but once it appears it can be a good opportunity to act on it for profitable trade.

Look at the chart above, which is captured on 4th November 2010.
I have drawn two vertical lines to show the bullish divergence between price of CBIP and MACD
Bullish divergence here means that when the price of CBIP decline or make lower low the MACD forms higher low. Similarly there is also a bullish divergence between price of CBIP and its RSI.

Of  course, on 4th November 2010 it is already too late to use this information because from the occurrence of the divergence, which is around 22nd May 2010 , to the price level on 4th November 2010 there is a price increase of  about RM1.00. Just imagine you were looking at CBIP chart on 22nd May 2010 and a few days later you are convinced that bullish divergence has occurred and bought some CBIP shares and just hold on and wait,you would have made a handsome gain. Never mind we (including me) miss this opportunity but we should not miss the opportunity to learn the lesson of how to use the bullish divergence to trade profitably.


Any comment can be addressed to the writer, Lee Huong Sing

Lessons on balance sheet by investopedia

A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements. If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it.

The main formula behind balance sheets is: Assets = Liabilities + Shareholders' Equity
This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings. The total assets must equal the liabilities plus the equity of the company.

Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes include cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks. Cash equivalents are very safe assets that can be readily converted into cash; U.S. Treasuries are one such example. Accounts receivables consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clientsAdd caption

Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year and/or have a life-span of more than a year. They can refer to tangible assets such as machinery, computers, buildings and land. Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated. Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life 

On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet. Current liabilities are the company’s liabilities which will come due, or must be paid, within one year. This is includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan

Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account. This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other

Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company’s financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.

Case study .. Bollinger Band buy signal

Using Technical Patterns to Spot Money-Doubling Trades

Here are a few of the classic chart patterns and technical analysis tools that lead us to triple-digit winners over and over again:

Bear Flag: A sharp, strong volume decline on a negative fundamental development and several days of sideways-to-higher price action on much weaker volume followed by a second, sharp decline to new lows on strong volume. The vertical downtrend that precedes a flag may occur because of buyers' reactions to an unfavorable company announcement, such as a court case, or a sudden and unexpected departure of a CEO. The sharp price decrease is sometimes referred to as the “flagpole” or “mast.”
Bearish Pennant: A sharp, strong volume decline on a negative fundamental development and several days of narrowing price consolidation on much weaker volume followed by a second, sharp decline to new lows on strong volume.
Breakout: A period where a stock's value increases. Typically immediately follows a consolidation.
Bull Flag: A sharp, strong volume rally on a positive fundamental development, and several days of sideways-to-lower price action. The vertical uptrend that precedes a flag may occur because of buyers' reactions to a favorable company earnings announcement, or a new product launch. The sharp price increase is sometimes referred to as the “flagpole” or “mast.”
Bullish Continuation Wedge: A bullish Continuation Wedge consists of two converging trend lines. The trend lines are slanted downward. Unlike the Triangles where the apex is pointed to the right, the apex of this pattern is slanted downwards at an angle. This is because prices edge steadily lower in a converging pattern i.e. there are lower highs and lower lows. A bullish signal occurs when prices break above the upper trend line.
Over the weeks or months that this pattern forms, the trend appears downward, but the long-term range is still upward. Volume should diminish as the pattern forms.
Bullish Pennant: A sharp, strong volume rally on a positive fundamental development, and several days of narrowing price consolidation on much weaker volume, followed by a second sharp rally to new highs on strong volume.
Candlestick: A charting method used to display open, high, low and closing prices for a security, it uses the top and bottom of its bar to indicate high and low prices of the time frame indicated.
Consolidation: A period where a stock's value declines.
Cup and Handle:  Similar in appearance to Rounded Bottoms, this pattern includes an elongated U-shape. However, the pattern also includes a short period of consolidation of 1–2 weeks in duration, which tends to be down-trending. The pattern is similar in appearance to a coffee cup with a right-side handle, and indicates the potential for an uptrend.
Diamond Patterns: These patterns usually form over several months in very active markets. Volume remains high during the formation of this pattern.
Diamond Bottom:  This pattern occurs because prices create higher highs and lower lows in a broadening pattern. Then the trading range gradually narrows after the highs peak and the lows start trending upward until they break upward through the diamond formation.
Head and Shoulders Top: An extremely popular pattern among investors because it's one of the most reliable of all formations. It also appears to be an easy one to spot. Novice investors often make the mistake of seeing Head and Shoulders everywhere. Seasoned technical analysts will tell you that it is tough to spot the real occurrences.
The classic Head and Shoulders Top looks like a human head with shoulders on either side of the head. A perfect example of the pattern has three sharp high points, created by three successive rallies in the price of the financial instrument.
The first point—the left shoulder—occurs as the price of the financial instrument in a rising market hits a high and then falls back. The second point—the head—happens when prices rise to an even higher high and then fall back again. The third point—the right shoulder—occurs when prices rise again but don't hit the high of the head. Prices then fall back again once they have hit the high of the right shoulder. The shoulders are definitely lower than the head and, in a classic formation, are often roughly equal to one another.
A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting two low price points of the formation. The pattern is complete when the support provided by the neckline is broken to the downside on a closing basis.
Megaphone Bottom: Also known as a Broadening Bottom, it is considered a bullish signal, indicating that the current downtrend may reverse to form a new uptrend. This rare formation can be recognized by the successively higher highs and lower lows, which form after a downward move. Usually, two higher highs between three lower lows form the pattern, which is completed when prices break above the second higher high and do not fall below it.
Moving Average: The average price of a security over a specified time period (the most common being 20, 30, 50, 100 and 200 days), used to find pricing trends by flattening out large fluctuations.
Moving Average Convergence/Divergence: A technical analysis tool that shows the relationship between two moving averages of prices.
Resistance: Price levels where sellers have shown a better-than-average willingness to sell.
Reversal Patterns: These patterns break out in a direction opposite to the previous trend. They mark a change in direction of the price of the stock. After pausing to consider their investment strategies, investors decide to reverse an existing trend in a stock's price. Examples of this type of pattern include head-and-shoulders tops and bottoms, double-bottoms or -tops, triple-bottoms or -tops, ascending triangles, descending triangles and symmetrical triangles.
Rounded Top: This is considered a bearish signal, indicating a possible reversal of the current uptrend to a new downtrend. A Rounded Top is dome-shaped, and is sometimes referred to as an inverted bowl or a saucer top. The pattern is confirmed when the price breaks down below its moving average.
Support: Price levels where buyers have shown a better-than-average willingness to buy.
Trendline: A line constructed by connecting a series of descending peaks or ascending troughs. The more times a trendline has been touched increases the significance of a break in the trendline. A trendline can act as either a support line or a resistance line.

Using Chart patterns for profitable trades

Let’s Take a Look at a Few “Classic” Patterns

 Technical analysis is based on historical pricing patterns, so how far back do technical analysts look for patterns?

That all depends.
Some patterns can be traced back to a market's inception, some go back a number of years, some are seasonal and some chart patterns can even be seen happening by the minute or second. Because technical analysis focuses on historical prices, patterns can emerge in the pricing during any time period.
“Classic” refers to a group of patterns that typically have a longer-term horizon (greater than 12 days) and that have distinct price movements that form distinctive patterns.
In technical analysis, the names of classic patterns generally describe the shape of the formation such as the double-top, double-bottom, head-and-shoulders top, ascending triangle, etc.
But, as I stated at the beginning, there are really only two trends to technical analysis: continuations and reversals. If we can remember that trends tell us direction, then we've got the important parts down.

Ascending Triangle

You may also hear this called an ascending right triangle. It's a bullish indicator.
Technically speaking, what happens is that an ascending triangle is a rally to a new high, followed by a pullback to an intermediate support level, then a second rally to test the first peak, followed by a second decline to a level higher than the intermediate-term support level and, finally, a rally to fresh new highs on strong volume.

Descending Triangle

A descending triangle is a decline to a new low on news that's followed by a rally to an intermediate resistance level, then a second decline to test the recent low, followed by a second rally toward (but not through) intermediate resistance. Then, finally, there's a decline to new lows on strong volume.
This happens when The Street becomes extremely bearish and, subsequently, a stock looks like it's done for.
Most analysts consider descending triangles to be the most reliable of all chart patterns because it's easy to define the supply-and-demand relationship.

Technical Analysis Takes Shape

In addition to triangles, technical analysis is full of other patterns, most aptly named for the type of shape they make.
Below, I'll describe a few of the more common ones for you that are considered classic longer-term patterns.

While there are a considerable number of patterns, many of them shorter-term in nature, the following will give you a solid grasp of the basics you need to become a pro at reading the charts.

Double-Bottom

A double-bottom occurs when prices form two distinct lows on a chart. A double-bottom is only complete, however, when prices rise above the high end of the point that formed the second low.
The double-bottom is a reversal pattern of a downward trend in a stock's price. This formation marks a downtrend in the process of becoming an uptrend.
Double-bottoms are among the most common of the patterns. Because they seem to be so easy to identify, the double-bottom should be approached with caution by the investor.
A double-bottom consists of two well-defined lows at approximately the same price level. Prices fall to a support level, rally and pull back up, then fall to the support level again before increasing.

The two lows should be distinct. According to technical analysis experts Robert D. Edwards and John Magee, the second bottom can be rounded while the first should be distinct and sharp. The pattern is complete when prices rise above the highest high in the formation. The highest high is called the confirmation point.
Traders should pay close attention to volume when analyzing a double-bottom.
Generally, volume in a double-bottom is usually higher on the left bottom than the right. Volume tends to be downward as the pattern forms. However, volume picks up as the pattern hits its lows.
Volume increases again when the pattern completes, breaking through the confirmation point.


Double top

 

A double-top occurs when prices form two distinct peaks on a chart. A double-top is only complete, however, when prices decline below the lowest low—the “valley floor”—of the pattern.
The double-top is a reversal pattern of an upward trend in a stock's price. The double top marks an uptrend in the process of becoming a downtrend.
Sometimes called an “M” formation because of the pattern it creates on the chart, the double-top is one of the most frequently seen and common of the patterns. Because they seem to be so easy to identify, the double-top should be regarded very carefully.
As illustrated above, a double top consists of two well-defined, sharp peaks at approximately the same price level. A double-top occurs when prices are in an uptrend.
Prices rise to a resistance level, retreat, and return to the resistance level again before declining. The two tops should be distinct and sharp. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is called the confirmation point.
A double-top often forms in active markets that are experiencing heavy trading. A stock's price heads up rapidly on high volume. Demand falls off, and the price falls, often remaining in a trough for weeks or months.
A second run-up in the price occurs, taking the price back up to the level achieved by the first top. This time volume is heavy but not as heavy as during the first run-up. Stock prices fall back a second time, unable to pierce the resistance level.
These two sharp advances with relatively heavy volume have exhausted the buying power in the stock. Without that power behind it, the stock reverses its upward movement and falls into a downward trend.
Generally, trading volume in a double-top is usually higher on the left top than the right. Volume tends to dissipate as the pattern forms. However, it picks up as the pattern hits its peaks.
Volume increases again when the pattern completes, breaking through the confirmation point.

Cup-and-Handle

As the name would suggest, a cup-and-handle pattern includes an elongated U-shape followed by a short period of consolidation of 1–2 weeks in duration, which tends to be downtrending.
The pattern is similar in appearance to a coffee cup with a right-side handle, and indicates the potential for an uptrend.

 

The depth of the cup indicates the potential for a handle and subsequent breakout to develop. The cup should be fairly shallow.
The handle tends to be down-sloping and indicates a period of consolidation. Consolidation occurs when the price seems to bounce between an upper and lower price limit. You can track the down-sloping angle of the handle by drawing trendlines across the upper and lower price limits.
If the price ascends outside of the trendlines, then it has the potential for breakout. If the price ascends beyond the upper right side of the cup, then the pattern is confirmed, particularly if it is accompanied with a sharp increase in volume.
Volume tends to parallel the price pattern. Consequently, during the cup formation, as price descends, volume tends to decrease. Following a period of relative inactivity (at the bottom of the cup), the price pattern starts an upward turn and volume tends to increase.
During the handle formation, the volume decreases. However, you will notice an increase in volume when the price breaks out beyond the right side of the cup.
Cup-and-handles are long-term patterns that can be observed from about three weeks to several years.

POS Malaysia ... buy opportunity?

POS Malaysia chart as at 11.2.2010. Observe that price movement has become volatile for the last 10 months or so. At the moment there is a bullish divergence between price, RSI and MACD.(see chart above)
I believe that buying it at RM2.10 or below will have a good chance to make a profit in the time frame of 1 or 2 months. Just my suggestion.

Average Directional Movement Index

Although the average directional movement index (ADX) isn't used as frequently as some of the popular technical indicators, the ADX line has definite advantages because it filters out a lot of the false oscillator signals which are frequently given early in a move.
A longer-term trader can stay with trending positions longer by following the simple guidelines for the ADX line. According to research by computer trading expert Bruce Babcock, a climb by the ADX line above 40 followed by a downturn signals an imminent end to the current trend (whether up or down). When this signal is given, traders should take profits on existing positions. More aggressive traders can use this signal to consider taking positions for a possible move in the opposite direction.

The charts on this page show how the ADX works. The ADX line on the feeder cattle chart gave two signals during the year. The first downturn accurately marked the top in February, and the second downturn above the 40 level signaled a bottom in late summer. Note that the signal in late July was actually more than a month ahead of the actual bottom in September. The ADX warns you of an end to the trend. In this case, it gave you more than a month's warning.

Like the feeder cattle signals, crude oil's ADX gave two signals during the year, one at the summer low and the second at the winter high. Both signals were given by climbing above 40 and turning down.

The ADX signals by feeder cattle and crude oil signaled the end of one trend and the beginning of a new trend. But the ADX is not designed to signal a trend reversal. It only signals the end of the existing trend.  A good example of not signaling a trend reversal is T-Bonds. The end of the strong spring rally was accurately marked by the ADX signal in June. Then T-Bonds consolidated in a coil until the upside breakout in the fall. An ADX climb above 40 and downturn in November signaled another consolidation.
Usually, a commodity gives no more than a couple ADX signals during a year, unless the market has particularly volatile price action. The ADX is less helpful during sideways markets. During extended consolidation periods, the ADX line will slip toward 10. When ADX approaches 10, a major move is usually about to take place. But the ADX line doesn't tell you which direction it will go. You have to rely on other indicators for the probable direction of the next move.
The ADX is part of the direction movement system introduced by J.Welles Wilder in his book, New Concepts in Technical Trading Systems. Wilder introduced a 14-day ADX, and Babcock has not found any good reason to vary this time period.
In summary, if the market is trending (whether up or down), the ADX line should be rising. During an extended consolidation period, the ADX line will slip toward a low number.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.

Finding A Friend In The Trend

"The trend is your friend" is an important trading guideline.
Because trends persist for long periods, a position taken with the trend will more likely be successful than one taken randomly or against the trend. Trading with the trend in a bull market means buying on dips; in a bear market, selling on rallies.
On a bar chart, each vertical line connects the day's, week's, or month's high and low. The horizontal tick to the right of the line indicates that time period's closing price.
A trend is easily spotted on a bar chart. An uptrend is a series of higher lows and higher highs. Uptrend lines are drawn under the lows of the market and give support. A downtrend is a series of lower lows and lower highs. Downtrend lines are drawn across the highs and give resistance to the market. The soybean chart shown below has both uptrend lines and a downtrend line.

Lows and highs vs. closes

A trendline can be drawn when two points are available. The more times a trendline is touched, the more technically significant this support or resistance line becomes.
While some chartists draw trendlines through lows and highs, others may prefer drawing lines through closes in hopes of detecting a change in trend more quickly.
Trendlines may change angles, requiring another line drawn through new high or low points. For example, the sideways trading action in March and April broke the steeper uptrend line connecting the Feb. 13 and March 20 lows. But when the uptrend resumed in early May, a more shallow uptrend line can be drawn connecting the February and late-April lows.
The most reliable trendlines are those near a 45° angle. If about four weeks have elapsed between the two connecting points, this increases the trendline's validity. However, steep trendlines that don't fit these guidelines, like the uptrend line in the early portion of the soybean chart, may be just as useful.
Often, minor uptrends or downtrends will confuse the beginner. It may seem the market has turned around. However, sharp chartists will see these minor trends as small ripples within a major wave. Remember, if the trendline isn't broken, that trend remains intact. Two closes outside the trendline are the criteria for detecting a change in trend. However, very seldom do markets go directly from uptrend to downtrend. At the end of a move, traders become less aggressive and prices may swing in a sideways pattern or consolidation period.
Many times, markets break into an uptrend or downtrend out of a sideways trading pattern or consolidation period. In the soybean chart, prices traded in a 50
Because traders need time to be convinced that they should put their money into the market, sideways patterns are more likely to occur near the bottom of a move. The beginning of a downtrend often will be sharp and sudden as investors pull money out of the market.

False breakouts

Another way beginners might be fooled is seeing false breakouts of tops and bottoms. As prices begin to make their move in switching from a downtrend to an uptrend, traders with short positions will "cover." This buying many times will cause the market to rally above the downtrend line. This short covering rally seldom holds, and prices may drop back to the breakout point. The uptrend is confirmed when prices close above the high of the short rally.
On a topping formation, long liquidation takes prices through the uptrend line on a short break. Before the downtrend begins, the market sometimes rallies back to "test" the uptrend line as shown on the soybean chart in September. As the downtrend unfolds, the second reaction rally could not top the highs of the first rally.
Channel lines are an extension of the trendline theory. The October through January downtrend on the soybean chart shows prices staying in a "channel" between the downtrend line and a line drawn parallel to it, connecting the lows. A channel line in a downtrending market helps identify where support may be found.
Speedlines are another line which show where prices may find support or resistance. Frequently, speedlines and trendlines will overlap, emphasizing that line's importance to the market.
The speedline on the soybean chart starts from the June 29 low. To find the points to connect with the low, divide the range between the low ($6.40) and the high($9.94) into thirds and subtract from the high.
Plot the point obtained by subtracting one-third of the range from the high on the day the high was made. A line drawn between this point ($8.76) and thelow established the 1/3 speedline. The 2/3 speedline is drawn through the point that is two-thirds of the range subtracted from the high ($7.58) plotted on the day the high was made.
Another way to detect a change in trend is by looking for a price from which the market reacts two or three times.

A double bottom, such as the one on the T-Bill chart, indicated the 87.10 to 87.20 area gave support to the market. Although a recovery had begun from the late-May low, prices broke the short-term uptrend in mid-June. The question then became: Will aggressive short-selling and long liquidation overwhelm the short-covering and new buying that come from support at the May low?
The soybean chart displays a triple top, where prices met resistance in approximately the same area three times before falling. Just the inverse of making the double bottom goes through traders' minds as the market makes a top: Will new buying and short-covering be able to overwhelm the new selling and long liquidation coming from the triple-top resistance area?
As with trendlines, the more time that elapses between the tests of support and resistance in double or triple tops or bottoms, the more valid the formation becomes. Also, the greater the reaction between tests of the support or resistance, the more likely the point will hold.
Though these examples are from daily bar charts, technical analysis works just as well on weekly and monthly charts. Because the longer-term charts cover more time, their trendlines are more important in identifying areas of support and resistance to the market.

How do I know?

In identifying the trend in a market, it is wise to start with the longer term charts to identify the long-term trend. The daily charts offer trends for the shorter-run.
Technical analysis is more an art than a science. The answer to your question, "How do I know where to draw the trendlines?" is, "They're your charts, draw them wherever they seem to work best for you."

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.

Stochastics

Like the Relative Strength Index (RSI), stochastics is another popular oscillator to gauge price momentum and judge the age of a price move. Stochastics is not a new oscillator. The idea was originated by a Czechoslavakian and perfected by Dr. George Lane, editor and publisher of Investment Educators in Skokie, Illinois.
But unlike the RSI, which measures momentum based on the changes in daily settlement prices, stochastics has two lines and the calculations are based on the rate of change in the daily high, low, and close. The concept for stochastics is based on the tendency that as prices move higher, the daily closes will be closer to the high of the daily range. The reverse is true in downtrends. As prices decrease, the daily closes tend to accumulate closer to the lows of the daily trading range. This concept also holds true on daily, weekly and monthly charts.
Stochastics can be calculated for any time period. Choosing the right time period for the stochastics is similar to choosing the right number of days for a moving average. In effect, stochastics is a trend-following method since its lines will cross after tops and bottoms have been made. Choosing too short a time period will make the stochastics so sensitive that it becomes virtually worthless. If the time period is too long, it is too slow to turn and too insensitive to be useful.

Stochastics signals

Both bearish and bullish divergence are shown on the accompanying S&P chart. There's bearish divergence in late February when S&P prices make a new high but the %D line stays far below its winter high. This divergence accurately warned that a top was forming. An equally good signal of a bottom was the bullish divergence during the spring. The S&P was making new lows into early May, but the %D line held above the lows made during March.

Overbought/oversold zones

Markets seldom go straight in one direction without a pause or correction. When prices move up and appear to be ready to correct, the market is called overbought. When prices have been moving down and appear to be ready to rebound, the market is oversold. As a mathematical representation of a market's overbought or oversold condition, stochastics tells you when prices have gone too far in one direction.
Values above 75 (in the shaded area) indicate the overbought zone. Values below 25 (also shaded) indicate the oversold zone. (Some traders prefer using 80 and 20 as the parameters for overbought and oversold markets.) In sustained moves, stochastics values may remain in these shaded areas for extended lengths of time.

Buy/Sell signals

There are at least two popular ways traders use stochastics for buy and sell signals. A conservative approach is to wait for both the %K and %D to come out of the shaded area to issue the signal. For sell signals, a conservative trader waits for both lines to rise into the overbought zone and then fall below 75 again. An opposite pattern is followed for a buy signal. After both lines drop below 25, the buy signal is given when the stochastics lines climb above 25 again. This is a more conservative approach because you will be slower in taking a position, but it may eliminate some false signals.
For more aggressive traders, the buy and sell signals on the stochastics charts are generated when the two lines cross. For most traders the buy and sell signals are flashed when %K crosses %D, as long as both lines have first gone into the overbought or oversold zones. This is similar to the buy and sell signals of two moving averages.
Waiting for the stochastics lines to come out of the shaded area will sometimes prevent false - signals. For example, If you,were watching for a buy signal on the stochastics chart for the NYSE composite index during the August-September period, %K crossed the %D line in early August and at least five more buy signals were given before the trend finally turned up in early October. An aggressive trader who went with the first crossing of the lines would have been stopped out at least a couple times before finally getting on board for a good move up. But the more conservative trader would have been waiting for both lines to climb out of the oversold area before buying, thus avoiding the whipsaw signals in August and September.
Oscillators are notoriously unreliable in signaling trades against the trend. For good stochastics signals, you'll need to trade with the longer-term trend (Giant Footprints) . Follow only the buy signals in uptrends and only the sell signals in bear markets. However, in a trading range market, stochastics will give good buy and sell signals.
Buy and sell signals are shown on S&P 500 chart. With stock indexes in an overall uptrending pattern, the stochastics buy signal would have helped traders establish long positions on the buy signals in November, December and March. The sell signals in February, June and July could have been used to take profits on long positions.
Some traders prefer to see the %K line cross the %D line on the right side. This is called a right-hand crossing. In other words, %K is crossing %D after %D has bottomed or topped. When the %K crosses the %D line before the %D has bottomed or topped, it is referred to as left-hand crossing. Of course, this can only be seen in hindsight because, at the time the two lines intersect, you don't know if the %D has reached its ultimate top or bottom.
Left-hand crossings are not as common as right-hand crossings. You can see a left-hand crossing on the S&P chart in early February. The %K dipped below the %D before the %D had reached its ultimate peak.
Stochastics is a very useful technical indicator which helps you with your timing, especially when it is used in conjunction with the other trading tools.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.

How To Use The Relative Strength Index

One of the most useful tools employed by many technical commodity traders is a momentum oscillator which measures the velocity of directional price movement.
When prices move up very rapidly, at some point the commodity is considered overbought; when they move down very rapidly, the commodity is considered oversold at some point. In either case, a reaction or reversal is imminent. The slope of the momentum oscillator is directly proportional to the velocity of the move, and the distance traveled up or down by this oscillator is proportional to the magnitude of the move.
The momentum oscillator is usually characterized by a line on a chart drawn in two dimensions. The vertical axis represents magnitude or distance the indicator moves; the horizontal axis represents time. Such a momentum oscillator moves very rapidly at market turning points and then tends to slow down as the market continues the directional move. Suppose we are using closing prices to calculate the oscillator and the price is moving up daily by exactly the same increment from close to close. At some point, the oscillator begins to flatten out and eventually becomes a horizontal line. If the price begins to level out, the oscillator will begin to descend.

Plotting the oscillator

Let's look at this concept using a simple oscillator expressed in terms of the price today minus the price "x" number of days ago — let's say 10 days ago, for example.
The easiest way to illustrate the interaction between price movement and oscillator movement is to take a straight line price relationship and plot the oscillator points used on this relationship, as shown on this page's chart.
In our illustration, we begin on Day 10 when the closing price is 48.50. The price 10 days ago on Day 1 is 50.75. So with a 10-day oscillator, today's price of 48.50 subtracted from the price 10 days ago of 50.75 results in an oscillator value of - 2.25, which is plotted below the zero line. By following this procedure each day, we develop an oscillator curve.
The oscillator curve developed by using this hypothetical situation is very interesting. As the price moves down by the same increment each day between Days 10 and 14, the oscillator curve is a horizontal line. On Day 15, the price turns up by 25 points, yet the oscillator turns up by 50 points. The oscillator is going up twice as fast as the price. The oscillator continues this rate of movement until Day 23 when its value becomes constant, although the price continues to move up at the same rate.
On Day 29, another very interesting thing happens. The price levels out at 51.00, yet the oscillator begins to go down. If the price continues to move horizontally, the oscillator will continue to descend until the 10th day, at which time both the oscillator and the price will be moving horizontally
Note the interaction of the oscillator curve and the price curve. The oscillator appears to be one step ahead of the price. That's because the oscillator, in effect, is measuring the rate of change of price movement. Between Days 14 and 23, the oscillator shows the rate of price change is very fast because the direction of the price is changing from down to up. Once the price has bottomed out and started up, then the rate of change slows down because the increments of change are measured in one direction only.

Three problems

The oscillator can be an excellent technical tool for the trader who understands its inherent characteristics. However, there are three problems encountered in developing a meaningful oscillator:

1. Erratic movement within the general oscillator configuration. Suppose that 10 days ago the price moved limit down from the previous day.Now, suppose that today the price closed the same as yesterday. When you subtract the price 10 days ago from today's price, you get an erroneously high value for the oscillator today. To overcome this, there must be some way to dampen or smooth out the extreme points used to calculate the oscillator.
2. The second problem with oscillators is the scale to use on the horizontal axis. How high is high, and how low is low? The scale will change with each commodity. To overcome this problem, there must be some common denominator to apply to all commodities so the amplitude of the oscillator is relative and meaningful.
3. Calculating enormous amounts of data. This is the least of the three problems.

A solution to these three problems is incorporated in the indicator which we call the Relative Strength Index (RSI):

RSI = 100 – [100 / (1 + RS)]
RS = Average of 14 days' closes UP / Average of 14 days' closes DOWN

For the first calculation of the Relative Strength Index (RSI), we need closing prices for the previous 14 days. From then on, we need only the previous day's data. The initial RSI is calculated as follows:

1. Obtain the sum of the UP closes for the previous 14 days and divide this sum by 14. This is the average UP close.
2. Obtain the sum of the DOWN closes for the previous 14 days and divide this sum by 14. This is the average DOWN close.
3. Divide the average UP close by the average DOWN close. This is the Relative Strength (RS).
4. Add 1.00 to the RS.
5. Divide the result obtained in Step 4 into 100.
6. Subtract the result obtained in Step 5 from 100. This is the first RSI.

Smoothing effect

From this point on, it is necessary to use only the previous average UP close and the previous average DOWN close in calculating the next RSI.
This procedure incorporates the dampening or smoothing factor into the equation:

1. To obtain the next average UP close, multiply the previous average UP close by 13, add to this amount today's UP close (if any) and divide the total by 14.

Steps 3 to 6 are the same as for the initial RSI.
The RSI approach surmounts the three basic problems of oscillators:

1. Erroneous erratic movement is eliminated by the averaging technique. However, the RSI is amply responsive to price movement because an increase of the average UP close is automatically coordinated with a decrease in the average DOWN close and vice versa.
2. The question, "How high is high and how low is low?" is answered because the RSI value must always fall between 0 and 100. Therefore, the daily momentum of any number of commodities can be measured on the same scale for comparison to each other and to previous highs and lows within the same commodity.
3. The problem of having to keep up with mountains of previous data is also solved. After calculating the initial RSI, only the previous day's data is required for the next calculation.

Just one tool

The Relative Strength Index, used in conjunction with a bar chart, can provide a new dimension of interpretation for the chart reader. No single tool, method, or system is going to produce the right answers 100 of the time. However, the RSI can be a valuable input into this decision-making process.
Commodity Price Charts plots the 14-day RSI, updating the chart through Thursday of each week. Contrary to popular opinion, the choice of the number of market days used in calculating the RSI doesn't really matter because the smoothing nature of the exponential averages reduces the effect of the early days as more data is included.
To help you update the RSI values until the next issue of the charts arrives, we list the "up average" and "down average" as of Thursday on each RSI chart.

Simplified formula

The procedure outlined earlier for beginning and updating RSIs is from J. Welles Wilder's book and his 1978 Futures Magazine story, which made the RSI a popular technical tool. The following is a simpler and faster method of computing the RSI. The results are the same as Wilder's more complicated method.
To begin a new RSI, just list the changes for 14 consecutive trading days and total the changes. Divide these totals by 14, and you will have the new up and down average. Then proceed with this formula:

RSI = 100 x U / (U + D)
U = up average; D = down average.

The example below is for T-bills.

Date	Up	Down
1/28	+41
1/29		-2
2/1		-60
2/2		-7
2/3	+2
2/4	+1
2/5	+6
2/8		-26
2/9	+11
2/10	+14
2/11	0	0
2/12		-11
2/16	+28
2/17		-18
Total	103	124

1.03 / 14 = .074 = Up ave.
1.24 / 14 = .089 = Down ave.
RSI= 100 x (.074 /.163) = 45.39

To calculate the next day's RSI, multiply the up average (.074) by 13. Add the change for the day, if it is up. Divide the total by 14. Do the same for the new down average. Multiply the new down average (.089) by 13. Add the change for the day, if it is down. Divide total by 14.
Then, proceed with the formula:
RSI = 100 x U / (U + D)
For example, if T-Bills closed up 25 points the next day, calculate the new RSI as follows:

New Up ave. = .074(13) + .25/14 = .087
New Down ave. = .089(13) + 0/14 = .083
New RSI = 100 x .087 / (.087 + .083)
RSI = 51.2

Learning to use this index is a lot like learning to read a chart. The more you study the interaction between chart movement and the Relative Strength Index, the more revealing the RSI will become. If used properly, the RSI can be a very valuable tool in interpreting chart movement. Some of its uses
RSI points are plotted daily on a bar chart and, when connected, form the RSI line. Here are some things the index indicates as shown by examples from the silver chart:
Tops and bottoms — These are often indicated when the index goes above 70 or below 30. The index will usually top out or bottom out before the actual market top or bottom, giving an indication a reversal or at least a significant reaction is imminent.
The major bottom of Aug. 15 was accompanied by an RSI value below 30. The major top of Nov. 9 was preceded by an RSI value above 70. The top made on Jan. 24 was preceded by an RSI value of less than 70. This would indicate this top is less significant than the previous one and either a higher top is in the making or the long-term uptrend is running out of steam.
Chart formations — The index will display graphic chart formations which may not be obvious on a corresponding bar chart. For instance, head-and-shoulders, tops or bottoms, pennants or triangles often show up on the index to indicate breakouts and buy and sell points.
A descending triangle was formed on the RSI chart during October and early November that is not evident on the bar chart. A breakout of this triangle indicates and intermediate move in the direction of the breakout. Note also the long-term coil on the RSI chart with the large number of support points.
Failure swings — Failure swings above 70 or below 30 are very strong indications of a market reversal.
After the RSI exceeded 70 during October, the immediate downswing carried to 65. When this low point of 65 was penetrated the following week, the failure swing was completed.
After the low of Aug. 15, the RSI shot up to 41. After two downswings, this point was penetrated on the upside on Aug. 26, completing the failure swing.
Support and resistance — Areas of support and resistance often show up clearly on the index before becoming apparent on the bar chart. Trendlines on the bar chart often show up as support lines on the RSI. The mid-November break penetrated the uptrend line on the bar chart at the same time as the support level on the RSI chart.
Divergence — Divergence between price action and the RSI is a very strong indicator of a market turning point and is the single most indicative characteristic of the Relative Strength Index. Divergence occurs when the RSI is increasing and price movement is either flat or decreasing. Conversely, divergence occurs when the RSI is decreasing and price movement is either flat or increasing. Divergence does not occur at every turning point.
On the silver chart, there was divergence between the bar chart and RSI at every major turning point. The top made in November was "warned" by the RSI exceeding 70, a failure swing and divergence with the RSI turning sideways while prices continued to climb higher.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.

AEON

AEON chart as at 27/1/2001. There was a very good opportunity for buying when a bullish divergence occured Febuary 2009. Currently it is trading within a channel. If you have the stock, it will be an opportunity to sell off when it reaches the upper channel or when RSI >70.
Just my suggestion.

Trading with Triangle (7)

Here is another, and yes, the profit objective was real close to the actual market turn. Using the predetermined profit objective, you were stopped out with 7000 in profits! Had you not used it you would be near breakeven now.
Since most commodity markets are in up trends in 2008, you'll see more of these triangles develop as trends continue. 

Trading with Triangle (6)

Take a look at the lean hogs chart below for another example of this
Even though the lean hog market is in a down trend a small triangle developed and signaled a buy (long) trade entry.  You place your entry order just outside the triangle, and project the profit objective higher and bam you made $1200 in four-days.
Had you not used the predetermined profit objective and let greed or hearsay keep you in the trade, you would have been stopped out for a loss.
What I want to show you how to do is learn to take profits, because you can't lose money that way!

Trading with Triangle (5)

Using the predetermined profit objective determined by measuring the triangle then projecting that amount higher or lower depending on which direction prices take is more powerful than you might think! Just look at the July coffee chart to see how prices reversed just after our profit objective was met!
Don't overlook the power of these chart patterns and their incredible accuracy!
Just like in gold, the coffee market took a break then moved higher once again. We didn't worry about fundamentals or why the market made its move, we just knew that it would because triangle chart patterns always do produce a price move and we were ready to profit from it.

Trading with Triangle (4 )

Here is another great triangle in April gold. Notice how your stop loss order was never in jeopardy of being touched! In my course I show you exactly how to trade triangles and many other chart patterns.
More importantly, I place these same charts, only full size, in our member's only Ultimate Trader's Resource private web site for all to see as these formations as they develop.
My members know very little about any given market. In fact, you don't need to know about market fundamentals or be a market guru to make money; it's just a few simple rules to follow for trading chart patterns.
The triangle in gold is simply a period of time where prices take a break after moving up. Once the break is over the market moves up to the next level. Once it begins its move you place your order for a long futures contract or purchase a call option.
It's like coiling a spring and when it's released the market moves to the next level. There's nothing secret about it; just common sense!

Trading with Triangle (3)

Are you beginning to see why we like triangles so much? Here is one in December cotton. Here is what you don't need to make profits from this triangle:

• No technical indicators.
• No black box software or some fancy named trading system.
• None of those 'can't lose' trading recommendations.

It's just not necessary or even recommended that you try to learn everything there is to know up front. Get enough knowledge to start making money and then slowly increase your knowledge of the markets if you like.

One successful trade creates a hunger inside for more and if you grow slowly and not fall victim to greed, you'll increase your knowledge slowly and naturally. And this translates into more profits.

You'll have trades that don't go your way, but by planning for them first with stop loss orders they are easily managed with minimal losses.

Trading with Triangle (2)

Here is the same type triangle in December corn.

Notice that once prices broke out of the triangle, the stop loss order was never threatened and prices met the profit objective in about three weeks.

Not a big gainer, but when your risk is low and there is no input from you needed after you place your orders, it becomes a low-risk profitable trade.

Here is what you need to make these trades happen:

• Red pencil, ruler, free charts from the Internet
• Learn how to spot triangles and other chart formations. It's not rocket science!
• Learn how to place orders.
• A minimum size broker account (no minimum size for some option trading accounts.)

Why would you listen to other's advise or buy expensive software when all you need is right there on your charts?

Trade with Triangle (1)

This is a small triangle in soybean oil. Triangles form most often in trending markets. You simply look for a triangle in the developing stage and place your orders.

The goal is to place orders or buy options at a price just outside the triangle to catch the price direction either way because we really don't know which way prices will go, and we don't need to know!

The profit potential is determined by measuring the triangle and projecting that amount in the direction that prices take. When one order is filled, the other order becomes your stop loss order in case prices reverse.

You place your orders with your broker or through online trading, and you are off doing what you normally do during the day. Your orders have you protected so there is no more interaction on your part!

Your stop loss order was never threatened in this trade and the profit objective was hit in two weeks!

Trending With Moving Averages

Moving averages are one tool to help you detect a change in trend. They measure buying and selling pressures under the assumption that no commodity can sustain an uptrend or downtrend without consistent buying and selling pressure.
A moving average is an average of a number of consecutive prices updated as new prices become available. The moving average swallows temporary price aberrations but tells you when prices begin moving consistently in one direction.
Trading with moving averages will never position you in the market at precisely the right time. They are intended to help you take profits from the middle of the trend and hold losses to a minimum.
The risks and the magnitude are intrinsic to the speed of the moving averages. Professional traders lean toward the faster averages and portfolio managers generally prefer slower signaling moving average approaches.
Moving averages are a simple way to gauge the direction the tide is flowing in a commodity market. They are not always right, but they provide a wide variety of possible uses.

Lag prices

Moving averages lag prices because of their makeup. You can make a moving average for any number of days you choose, but remember that the more days you average, the more sluggish the moving average becomes. Most commodity traders find a 3-day moving average alone is too volatile. However, 4-day and 5-day moving averages are common as short-term indicators.
To start a 4-day moving average, add the last four days' closing prices and divide by four, The next day, drop off the oldest price, add the new close, and divide by four again. The result is the new moving average. Use the same system for any moving average you might want to develop.
Moving averages give signals when different averages cross one an- other. For example, in using 4-day, 9-day and 18-day moving averages, a buy signal would be given when the 9-day average crosses the 18-day. However, to avoid false signals, the 4-day average should be higher than the 9-day.
Just the opposite is true for sell signals. To sell, the 4-day average must be below the 9-day. The sell signal is triggered when the 9-day average crosses the 18-day.
There are other conditions you might wish to place on your averages to avoid false signals. One possible requirement is to make the 4-day exceed the 9-day by a certain percentage before acting on the appropriate buy or sell signal.
The caveat to moving averages is that although they work well in trending markets, they may whipsaw you in a sideways, choppy market.
It helps to "tune" the moving averages to a particular market. A bit of brainwork is necessary to use a moving average. You can use the moving average studies on MarketClub streaming charts to find whether a fast or slow moving average is best for your trading style.

Some traders who use moving averages follow the slower moving average signals to initiate a position but a faster moving average to exit the trade, especially if substantial profits have been built up.
A linearly-weighted moving average also could help eliminate false signals. A 4-day linearly-weighted moving average multiplies the oldest price by four, the next oldest price by three, etc., and divides the total by 10.
This weighted average is more sensitive to recent prices than a standard average. The term, "linearly-weighted," comes from the fact that each day's contribution diminishes by one digit.
The rules for trading a weighted moving average are the same as using a combination of three moving averages. The weighted average must be above or below the other moving averages, or the signal is ignored.
A more sophisticated average is the exponential moving average, which is weighted nonlinearly by using a specific smoothing constant derived for each commodity to allocate the weight exponentially back over prior trading days.
However, it requires high mathematics and a computer to determine each optimum smoothing constant.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.

Picturing Technical Objectives

When prices form pictures on charts, you can obtain realistic objectives for later moves. One of the most reliable chart formations is the head-and-shoulders top or bottom. This easily recognizable chart pattern signals a major turn in trend.

The main advantage of the head-and-shoulders pattern is it gives you a clear-cut objective of the price move after breaking out of the formation. Measure the price distance between the head and the neckline and add it to the price where the neckline is broken. This projects the minimum objective. Although the head-and-shoulders gives no time projection, it predicts a very strong trend in the future.

In most cases, a head-and-shoulders formation will be symmetrical, with the left and right shoulders equally developed. Although the neckline doesn't have to be horizontal, the most reliable formations stray only a little.

Flags and pennants are consolidation patterns which give objectives for further moves. As the formation develops, price action in an uptrending market will look like a flag flying from a flagpole as prices tend to form a parallelogram after a quick, steep upmove. Flags "fly at half-staff." The more vertical the flagpole, the better.

A price objective is obtained by measuring the flagpole and adding it to the breakout point of the formation. The flagpole should begin at the point from which it broke away from a previous congestion area, or from important support or resistance lines. Flags in a downtrending market look like they are defying gravity and slant upward.

Continuation patterns

A pennant also starts with a nearly vertical price rise or fall. But, instead of having equal move reactions in the consolidation phase like a flag, pennant reactions gradually decrease to form short uptrend and downtrend lines from the flagpole.

The same measuring tools used in flags are used in pennants. Add the length of the flagpole to the breakout point to get the minimum objective. Remember,flags and pennants are usually continuation patterns in an overall trend which resumes after the breakout of the consolidation area.

Also, the coil formation, or symmetrical triangle, appears while prices trade in continually narrower ranges, forming uptrend and downtrend lines. This pattern doesn't tell you much about the direction of the next move. After breaking one of the trendlines, the objective is found by adding the width of the coil's base to the breakout point.

Springing from coils

The formation gets its name from the way prices contract and suddenly spring out of this pattern like a tight coil spring. One caution about this formation: It's best if prices break out of the formation while halfway to three-quarters of the way to the triangle's apex. If prices reach the apex, a strong move in either direction is less likely.

Ascending and descending triangles are similar to coils but are much better at predicting the direction prices will take. Prices should break to the flat side of the triangle.

Price objectives from ascending and descending triangles can be obtained two ways. The easiest is to add the length of the left side of the triangle to the triangle's flat side.

Another method of projecting price is to draw a line parallel to the sloping line from the beginning of the triangle. Expect prices to rise or fall out of the triangle formation until they reach this parallel line.

More objectives

In the chapter on trends, we mentioned double and triple tops and bottoms. These formations also provide us with objectives. Once a double bottom is completed, prices should rise at least as far as the distance from the bottom of the "W" to the breakout point.

A double bottom is confirmed when prices close above the center of the "W" formation. This is referred to as the breakout. The difference from the bottom of the formation to the top gives a price objective. Targets for price declines from double tops are figured the same way.

Often, prices will retest the breakout point after completing the formation. After a double top is completed, prices may briefly rebound to test the resistance, which is the same point where the original double top was completed.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.

The Psychology of Commodity Price Movement

The price of a futures contract is the result of a decision on the part of both a buyer and a seller. The buyer believes prices will go higher; the seller feels prices will decline. These decisions are represented by a trade at an exact price.

Once the buyer and seller make their trade, their influence in the market is spent — except for the opposite reaction they will ultimately have when they close the trade. Thus, there are two aspects to every trade: 1) each trade must ultimately have an opposite reaction on the market, and 2) the trade will influence other traders.

Each trader's reaction to price movements can be generalized into the reactions of three basic groups of traders who are always present in the market: 1) traders who have long positions; 2) those who hold short positions; and 3) those who have not taken a position but soon will. Traders in the third group have mixed views on the market's probable direction. Some are bullish while others are bearish, but a lack of positive conviction has kept them out of the market. Therefore, they also have no vested interest in the market's direction.

The impact of human nature on futures prices can perhaps best be seen by examining changing market psychology as a typical market moves through a complete cycle from price low to price low.
Classic price pattern

Assume prices trade within a relatively narrow trading range (between points A and B on the chart). Recognizing the sideways price movement, the "longs" might buy additional contracts if the price advances above the recent trading range. They may even enter stop orders to buy at B, to add to their position if they should get some confirmation the trend is higher. But by the same token, recognizing prices might decline below the recent trading range and move lower, they might also enter stop loss orders below the market at A to limit their loss.

The "shorts" have exactly the opposite reaction to the market. If the price advances above the recent trading range, many of them might enter stop loss orders to buy above point B to limit losses. But they, too, may add to their position if the price should decline below point A with orders to sell additional contracts on a stop below point A.


The third group is not in the market, but they are watching it for a signal either to go long or short. This group may have stop orders to buy above point B, because presumably the price trend would begin to indicate an upward bias if point B were penetrated. They may also have standing orders to sell below point A for converse reasons.

Assume the market advances to point C. If the trading range between points A and B has been relatively narrow and the time period of the lateral movement relatively long, the accumulated buy stops above the market could be quite numerous. Also, as the market breaks above point B, brokers contact their clients with the news, and this results in a stream of market orders. As this flurry of buyers becomes satisfied and profit-taking from previous long positions causes the market to dip from the high point of C to point D, another distinct attitude begins working in the market.

Part of the first group that went long between points A and B did not buy additional contracts as the market rallied to point C. Now they may be willing to add to their position "on a dip." Consequently, buy orders trickle in from these traders as the market drifts down.

The second group of traders with short positions established in the original trading range have now seen prices advance to point C, then decline to move back closer to the price at which they originally sold. If they did not cover their short positions on a buy stop above point B, they may be more than willing to "cover on any further dip" to minimize the loss.

Those not yet in the market will place price orders just below the market with the idea of "getting in on a dip."

The net effect of the rally from A to C is a psychological change in all three groups. The result is a different tone to the market, where some support could be expected from all three groups on dips. (Support on a chart is denned as the place where the buying of a futures contract is sufficient demand to halt a decline in prices.) As this support is strengthened by an increase in market orders and a raising of buy orders, the market once again advances toward point C. Then, as the market gathers momentum and rallies above point C toward point E, the psychology again changes subtly.

The first group of long traders may now have enough profit to pyramid additional contracts with their profits. In any case, as the market advances, their enthusiasm grows and they set their sights on higher price objectives. Psychologically, they have the market advantage.

The original group who sold short between A and B and who have not yet covered are all carrying increasing losses. Their general attitude is negative because they are losing money and confidence. Their hopes fade as their losses mount. Some of this group begin liquidating their short positions either with stops or market orders. Some reverse their position and go long.

The group which has still not entered the market — either because their orders to buy the market were never reached or because they had hesitated to see whether the market was actually moving higher — begins to "buy at the market."

Remember that even if a number of traders have not entered the market because of hesitation, their attitude is still bullish. And perhaps they are even kicking themselves for not getting in earlier. As for those who sold out previously-established long positions at a profit only to see the market move still higher, their attitude still favors the long side. They may also be among those who are looking to buy on any further dip.

So, with each dip the market should find the support of 1) traders with long positions who are adding to their positions; 2) traders who are short the market and want to buy back their shorts "if the market will only back down some"; and 3) new traders without a position in the market who want to get aboard what they consider a full-fledged bull market.

This rationale results in price action that features one prominent high after another and each prominent reactionary low is higher than the previous low. In a broad sense, it should appear as an upward series of waves of successively higher highs and higher lows.

But at some point the psychology again subtly shifts. The first group with long positions and fat profits is no longer willing to add to its positions. In fact they are looking for a place to "take profits." The second group of battered traders with short positions has finally been worn down to a nub of die-hard shorts who absolutely refuse to cover their short positions. They are no longer a supporting element, eagerly waiting to buy the market on dips.

The third group of those who never quite got aboard the up-move become unwilling to buy because they feel the greatest part of the upside move has been missed. They consider the risk on the downside too great when compared to the now-limited upside potential. In fact, they may be looking for a place to "short the market and ride it back down."

When the market demonstrates a noticeable lack of support on a dip that "carries too far to be bullish," this is the first signal of a reversal in psychology. The decline from point I to point J is the classic example of such a dip. This decline signals a new tone to the market. The support on dips becomes resistance on rallies, and a more two-sided market action develops. (Resistance is the opposite of support. Resistance on a chart is the price level where selling pressure is expected to stop advances and possibly turn prices lower.)
The downturn

Now the picture has changed. As the market begins to advance from point J to point K, traders with previously-established long positions take profits by selling out. Most of the hard-nosed traders with short positions have covered their shorts, so they add no significant new buying impetus to the market. In fact, having witnessed the recent long decline, they may be adding to their short positions.

If the rally back toward the contract highs fails to establish new highs, this failure is quickly noticed by professional traders as a signal the bull market has run its course. This is even more true if the rally carries only up to the approximate level of the rally top at point G.

If the open interest also declines during the rally from J to K, it is another sign it was not new buying that caused the rally but short covering.

As profit-taking and new short-selling forces the market to decline from point K, the next critical point is the reactionary low point at J. A major bear signal is flashed if the market penetrates this prominent low (support) following an abortive attempt to establish new contract highs.

In the vernacular of chartists, a head-and-shoulders reversal pattern has been completed. But rather than simply explaining away price patterns with names, it is important to understand how the psychology of the market action at different points causes the market to respond as it does. It also explains why certain points are quite significant.

In a bear market, the attitudes of the traders would be reversed. Each decline would find the bears more confident and prosperous and the bulls more depressed and threadbare. With the psychology diametrically opposite, the pattern completely reverses itself to form a series of lower highs and lower lows.

But at some point, the bears become unwilling to add to their previously-established short positions. Those who were already long the market and had refused to sell higher would eventually be reduced to a hard core of traders who had their jaws set and refused to sell out. Traders not in the market who were perhaps unsuccessfully attempting to short the market at higher levels will begin to find the long side of the market more attractive. The first rally that "carries too high to be bearish" signals another possible trend reversal.

With this basic understanding of market psychology through three phases of a market, a trader is better equipped to appreciate the significance of all technical price patterns. No one expects to establish short positions at the high or long positions at the low, but development of a feel for market psychology is the beginning of the quest for trades that even hindsight could not improve upon.

When you analyze charts, approach them with the idea that they reflect human ideas about prices that are the result and the struggle between supply and demand forces. Your attitude and ability to judge market psychology will determine your success at chart analysis. Unexpected occurrences can change price trends abruptly, and without warning. Also, some of the chart formations may be hard to visualize. You'll sometimes need a good imagination as well.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.