Technical Analysis of the Financial Markets A Comprehensive Guide to Trading Methods and Applications

Philosophy of Technical Analysis

Introduction 1

Philosophy or Rationale 2

Technical versus Fundamental Forecasting 5

Analysis versus Timing 6

Flexibility and Adaptability of Technical

Analysis 7

Technical Analysis Applied to Different Trading

Mediums 8

Technical Analysis Applied to Different Time

Dimensions 9

Economic Forecasting 10

Technician or Chartist? 10

A Brief Comparison of Technical Analysis in Stocks and

Futures 12

Less Reliance on Market Averages and Indicators 14

Some Criticisms of the Technical Approach 15

Random Walk Theory 19

Universal Principles

Dow Theory

Introduction 23

Basic Tenets 24

21

The Use of Closing Prices and the Presence of Lines 30

Some Criticisms of Dow Theory 31

Stocks as Economic Indicators 32

Dow Theory Applied to Futures Trading 32

Conclusion 33

Chart Construction

Introduction 35

Types of Charts Available

Candlesticks 37

36

Arithmetic versus Logarithmic Scale 39

Construction of the Daily Bar Chart 40

Volume 41

Futures Open Interest 42

Weekly and Monthly Bar Charts 45

Conclusion 46

ix

35

Basic Concepts of Trend 49

Definition of Trend 49

Trend Has Three Directions 51

Trend Has Three Classifications 52

Support and Resistance 55

Trendlines 65

The Fan Principle 74

The Importance of the Number Three 76

The Relative Steepness of the Trendline 76

The Channel Line 80

Percentage Retracements 85

S peed Resistance Lines 87

Gann and Fibonacci Fan Lines 90

Internal Trendlines 90

Reversal Days 90

Price Gaps 94

Conclusion 98

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Major Reversal Patterns

Introduction 99

Price Patterns 100

Two Types of Patterns: Reversal and

Continuation 100

The Head and Shoulders Reversal Pattern 103

The Importance of Volume 107

Finding a Price Objective 108

The Inverse Head and Shoulders 110

Complex Head and Shoulders 113

Triple Tops and Bottoms 115

Double Tops and Bottoms 117

Variations from the Ideal Pattern 121

S aucers and S pikes 125

Conclusion 128

Continuation Patterns

Introduction 129

Triangles 130

The Symmetrical Triangle 132

The Ascending Triangle 136

The Descending Triangle 138

The Broadening Formation 140

Flags and Pennants 141

The Wedge Formation 146

The Rectangle Formation 147

The Measured Move 151

The Continuation Head and Shoulders Pattern 153

Confirmation and Divergence 155

Conclusion 156

Volume and Open Interest

Introduction 157

Volume and Open Interest as Secondary

Indicators 158

Interpretation of Volume for All Markets 162

Interpretation of Open Interest in Futures 169

Summary of Volume and Open Interest Rules

Blowoffs and Selling Climaxes 175

Commitments of Traders Report 175

Watch the Commercials 176

Net Trader Positions 177

Open Interest In Options 177

Put/Call Ratios 178

174

Combine Option Sentiment With Technicals 179

Conclusion 179

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Long Term Charts

Introduction 181

The Importance of Longer Range Perspective 182

Construction of Continuation Charts for Futures 182

The Perpetual Contract™ 184

Long Term Trends Dispute Randomness 184

Patterns on Charts: Weekly and Monthly

Reversals 185

Long Term to Short Term Charts 185

Why Should Long Range Charts Be Adjusted for

Inflation? 186

Long Term Charts Not Intended for Trading

Purposes 188

Examples of Long Term Charts 188

Moving Averages Introduction 195 The Moving Average: A Smoothing Device with a Time Lag 197 Moving Average Envelopes 207 Bollinger Bands 209 Using Bollinger Bands as Targets 210 Band Width Measures Volatility 211 Moving Averages Tied to Cycles 212 Fibonacci Numbers Used as Moving Averages 212 Moving Averages Applied to Long Term Charts 213 The Weekly Rule 215 To Optimize or Not 220 Summary 221 The Adaptive Moving Average 222 Alternatives to the Moving Average 223 Oscillators and Contrary Opinion Introduction 225 Oscillator Usage in Conjunction with Trend 226 Measuring Momentum 228

Measuring Rate of Change (ROC) 234 Constructing an Oscillator Using Two Moving Averages 234 Commodity Channel Index 237 The Relative Strength Index (RSI) 239 Using the 70 and 30 Lines to Generate Signals 245 Stochastics (K%D) 246 Larry Williams %R 249 The Importance of Trend 251 When Oscillators are Most Useful 251 Moving Average Convergence/Divergence (MACD) 252 MACD Histogram 255 Combine Weeklies and Dailies 256 The Principle of Contrary Opinion in Futures 257 Investor Sentiment Readings 261 Investors Intelligence Numbers 262 Point and Figure Charting Introduction 266 The Point and Figure Versus the Bar Chart 270 Construction of the Intraday Point and Figure Chart 270 The Horizontal Count 274 Price Patterns 275Measuring Rate of Change (ROC) 234 Constructing an Oscillator Using Two Moving Averages 234 Commodity Channel Index 237 The Relative Strength Index (RSI) 239 Using the 70 and 30 Lines to Generate Signals 245 Stochastics (K%D) 246 Larry Williams %R 249 The Importance of Trend 251 When Oscillators are Most Useful 251 Moving Average Convergence/Divergence (MACD) 252 MACD Histogram 255 Combine Weeklies and Dailies 256 The Principle of Contrary Opinion in Futures 257 Investor Sentiment Readings 261 Investors Intelligence Numbers 262 Point and Figure Charting Introduction 266 The Point and Figure Versus the Bar Chart 270 Construction of the Intraday Point and Figure Chart 270 The Horizontal Count 274 Price Patterns 275

Measuring Rate of Change (ROC) 234 Constructing an Oscillator Using Two Moving Averages 234 Commodity Channel Index 237 The Relative Strength Index (RSI) 239 Using the 70 and 30 Lines to Generate Signals 245 Stochastics (K%D) 246 Larry Williams %R 249 The Importance of Trend 251 When Oscillators are Most Useful 251 Moving Average Convergence/Divergence (MACD) 252 MACO Histogram 255 Combine Weeklies and Dailies 256 The Principle of Contrary Opinion in Futures 257 Investor Sentiment Readings 261 Investors Intelligence Numbers 262 Point and Figure Charting Introduction 266 The Point and Figure Versus the Bar Chart 270 Construction of the Intraday Point and Figure Chart 270 The Horizontal Count 274 Price Patterns 2753 Box Reversal Point and Figure Charting 277 Construction of the 3 Point Reversal Chart 278 The Drawing of Trendlines 282 Measuring Techniques 286 Trading Tactics 286 Advantages of Point and Figure Charts P&F Technical Indicators 292 Computerized P&F Charting 292 P&F Moving Averages 294 Conclusion 296 r- Japanese Candlesticks Introduction 297 Candlestick Charting 297 Basic Candlesticks 299 Candle Pattern Analysis 301 Filtered Candle Patterns 306 Conclusion 308 Candle Patterns 309 Elliott Wave Theory Historical Background 319 288 The Basic Tenets of the Elliott Wave Principle 320Connection Between Elliott Wave and Dow Theory 324 Corrective Waves 324 The Rule of Alternation 331 Channeling 332 Wave 4 as a Support Area 334 Fibonacci Numbers as the Basis of the Wave Principle 334 Fibonacci Ratios and Retracements 335 Fibonacci Time Targets 338 Combining All Three Aspects of Wave Theory 338 Elliott Wave Applied to Stocks Versus Commodities 340 Summary and Conclusions 341 Reference Material Time Cycles Introduction 343 Cycles 344 342 How Cyclic Concepts Help Explain Charting Techniques 355 Dominant Cycles 358 Combining Cycle Lengths 361 The Importance of Trend 361 Left and Right Translation 362 How to Isolate Cycles 363Seasonal Cycles 369 Stock Market Cycles 373 The January Barometer 373 T he Presidential Cycle 373 Combining Cycles with Other Technical Tools 374 Maximum Entropy Spectral Analysis 374 Cycle Reading and Software 375 Computers and Trading Systems 377 Introduction 377 Some Computer Needs 379 Grouping Tools and Indicators 380 Using the Tools and Indicators 380 Welles Wilder's Parabolic and Directional Movement Systems 381 Pros and Cons of System Trading 387 Need Expert Help? 389 Test Systems or Create Your Own 390 Conclusion 390 \ Money Management and Trading Tactics Introduction 393 T he Three Elements of Successful Trading 393Money Management Reward to Risk Ratios 394 397 Trading Multiple Positions: Trending versus Trading Units 398 What to Do After Periods of Success and Adversity 399 Trading Tactics 400 Combining Technical Factors and Money Management 403 Types of Trading Orders 403 From Daily Charts to Intraday Price Charts 405 The Use of Intraday Pivot Points 407 Summary of Money Management and Trading Guidelines 408 Application to Stocks 409 Asset Allocation 409 Managed Accounts and Mutual Funds 410 Market Profile 411 The Link Between Stocks and Futures: Contents Intermarket Analysis 413 Intermarket Analysis 414 Program Trading: The Ultimate Link 415 The Link Between Bonds and Stocks 416 The Link Between Bonds and Commodities 418 The Link Between Commodities and the Dollar 419