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.