Technical Indicators - 34 Page Article

8/3/2019 Technical Indicators - 34 Page Article

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TRADING INDICATORS

By Ka Maffey Beht

Kira McCaffrey Brecht is Senior Editor of

SFO magazine. She has been writing and

analyzing the markets for more than 19 years.

Posts during her career include Chicago bureau

chief at Futures World News, derivatives reporter

and market analyst at Bridge News and technical analyst at

MMS International.

e pe: $7.95


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TRADING INDICATORS

By Ka Maffey Beht

Be Your Own Analyst:Understand Fibonacci Retracements 1Be Your Own Analyst: Understand Stochastics 5

Be Your Own Analyst:Understand Moving Averages 9

Be Your Own Analyst:Understand Japanese Candlesticks

14

Be Your Own Analyst:Understanding Cycles 20

Be Your Own Analyst:Understanding Volume 27

tis sris covr undmnls o rding indicors ws originllublisd rom Mrc o augus 2005.

2005, 2006, 2010. Sf Mgzin. all rigs rsrvd.


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TRADING INDICATORSBe Your Own Analyst:

Understand Fibonacci Retracements

While Ive always studied and utilized Fibonacci retracement

targets as part of screen-based analysis and trading, I remem-

ber well a story that a oor trader friend of mine at the Chicago

Mercantile Exchange told me years ago.

He told me that part of his trading strategy was to watch the morning

range of the market: from the high to the low or vice versa. Lets say themarket was rallying. From his experience in the pit, he noticed that a good

trade was often buying at halfway back.

As a trained technical analyst, I was stumped. Halfway-backwhat does

that mean? I asked.

You know, when the market sells off to its halfway-back point from

the high. Suddenly it hit me. My friend, who was completely unschooled

in charts or technical analysis and primarily made his living by scalping

extremely short-term trades in the pit, had coined his own term for retrace-

ment analysis.

Oh, you mean a 50-percent retracement! I said.

Whats that? he asked.I went on to explainbut it didnt really matter to him. He had discov-

ered from his years in the pit that a bull market often retreats halfway backBck o tbl o onns

and then rallies again. He didnt care what it was calledit worked!

The BASIC CONCepT

While there are many ways to utilize Fibonacci numbers, for the purposes

of this article we are going to stick to the basics and keep it simple.Well

outline the fundamentals of Fibonacci retracement analysis and how some

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fIGuRe 1: Dil Mr NyBt o r Wi fiboncci rcmn

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traders use it in both long- and short-term trading. Fibonacci analysis can

be used on any market and any timeframe. It is just as valid on a monthly

dollar/euro chart as on a daily dollar/yen chart or a 60-minute E-mini S&P

chart. The basic concept of retracement analysis stems from the fact that

markets dont move in a straight line.When a market is in an uptrend, price

rallies, hits resistances, and then retreats (or corrects) before advancing in

another up wave. Retracements can help pinpoint how far a market will

correct before resuming its prior trend.

Fibonacci retracements pinpoint specic areas between price highs and

price lows that potentially could be good spots to enter or exit a trade. Trad-

ers could trade with the existing trend or attempt to catch a counter-trend

corrective move using Fibonacci retracements: you choose.

DONT SweATThe MATh

While there are many variations on Fibonacci retracements, the three

basic levels are 38.2%, 50% and 61.8%. Dont worry. One does not have

to be a mathematician to understand or utilize Fibonacci retracement

targets in trading! These days, just about every charting package of-

fers Fibonacci retracement lines programmed right into the software.

A trader just clicks on that option and drags the cursor from the price

high to the low or conversely, from the low to the high that he wants

to measure. Presto! Magic lines will appear on his screen. And surpris-

ingly, more often than not, prices appear to gravitate toward the 38.2%,

50% and 61.8% mark.

pICk pOINTS CARefully

Many people might say, Oh, those Fibonacci numbers dont work. One

problem that beginning technical traders may encounter that may detract

from the efcacy of this strategy is picking the right points from which to

draw the lines.The rst criterion for using Fibonacci retracement targets is

that there must be a well-dened trend with a series of higher highs and

higher lows (or vice versa). It can be an uptrend or a downtrend; it doesnt

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matter. Dont forget, traders can draw retracement targets across all time-

frames from an intraday chart to a monthly chart.

Now that youve got a trend, pick the right points. Traders need to pick a

valid low to high (or vice versa) in which to draw the line. Look at the chart.

Where did the rally (or sell-off) begin? Thats where the rst line is drawn.

For an uptrend, draw the lines from the most important swing low to the

most important swing high. SeeFigure 1 for an example of how to draw the

lines. From that important swing high, prices will likely correct and retrace.

TRADING TARGeTS

Once a correction is underway, counter-trend traders could use those Fibo-

nacci targets as potential exit points, as they represent a point where the

market could run out of steam. Or for those who missed the starting point

of the rally, the retracements could offer a low-risk entry point to join the

uptrend.

Take another look at Figure 1. In late October 2004, March coffee futures

launched a strong bull move that peaked out in late December. One could

draw a Fibonacci retracement of the move; from Point A to Point B. From

top to bottom, the rst line on the chart is the 38.2% of the move; the second

line represents 50% of the rally, and the third line delineates 61.8% of the

upmove.

For those versed in pattern recognition, a double-top formation devel-

oped on this daily chart in late December, which was a warning signal that

the bulls were running out of steam (and a potential sign to take at least

partial prots on longs). From those highs, traders can see that Mar cof-

fee did indeed pull back and correct, as all markets need to do from time

to time. The contract retreated to just around the 38.2% mark, seen in the

circled area in Figure 1. This proved to be a successful stalling point for the

corrective retreat, and as of this writing in late January, prices have re-newed their upside momentum.

TRADING SpOTS

How could traders have used Fibonacci retracements in this example? As

mentioned earlier, traders can use them in a trend or counter-trend man-

ner. The rst obvious counter-trend strategy could have been to trade the

corrective pullback. Several technical negative indicators had developed

(not all shown on this chart). The bearish double top was seen in price,

bearish divergences had developed on momentum readings, and prices be-

gan to fall. Traders looking for a short-term move could have attempted to

sell after the failed double top. Right away, traders would have a rst objec-tive with the 38.2% retracement. Sometimes markets need to correct even

more and will continue lower until the 50% or the 61.8% mark. All three of

those levels could be used as valid targets for counter-trend trades.

It is important to remember, according to basic Fibonacci analysis, that as

long as the 61.8% support level holds, the prior trend (in this instance the

uptrend) will remain intact. This simply means that a market can retrace

as much as 61.8% of the move but still be in an overall uptrend (or down-

trend). Classic Fibonacci analysis says that if the 61.8% support area (in an

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uptrend) is severely violated, the uptrend is over. In that case, traders can

set their objective for a retest of the low (or the rst point that is drawn off

the Fibonacci lines).

Confused? To clarify, lets pretend that Mar coffee shown on Figure

1 failed to hold the 38.2%, 50% and 61.8% support lines on its corrective

pullback. Instead, coffee futures plunged through the 87.90 cents per pound

zone (61.8%) in January. That would have conrmed an end to the uptrend

and would have targeted a retest of the late October low around 75.00 cents.

CONfIRMATION

Technical traders often talk about the need for conrmation. This is an im-

portant theme within technical analysis and simply means that one should

not look at one chart or indicator in a vacuum. For example, technical trad-

ers often will look for conrmation across timeframes. For example, does

that support or resistance point pop up on the hourly chart and the daily

chart? If so, it is likely a more signicant price point for the market.

Conrmation also refers to the concept of utilizing several different

technical indicators in tandem. Lets say three of your favorite technical

indicators all ash buy signals that conrmation increases the odds of a

protable trading opportunity. With this in mind, it is not advisable to rely

strictly on Fibonacci retracement targets for entry or exit points. They are

an excellent tool when used in conjunction with other conrming techni-

cal indicators. A few that work well with Fibonacci numbers are stochastics,

relative strength index and candlestick chart formations. The idea is if posi-

tive readings are seen on those tools around retracement levels, the trade

idea may be looking good!

why DOeS IT wORk?

There are some who scoff at the concept of Fibonacci numbers, callingthem superstition or just plain old hoo-hah. Some even say they become a

self-fullling prophecy. Make no mistake about it, though. They are widely

used in the technical community, and that reason alone makes them impor-

tant to watch. Wouldnt you like to know the key levels that other traders

may be considering for entry and exit points?

Simply, the Fibonacci retracements are based off a number series: 1, 1,

2, 3, 5, 8, 13, 21, 34, 55etc. (notice that the sum of any two consecutive

numerals equals the next higher number). Leonardo Fibonacci, the son of a

Pisan merchant, in the 13th century discovered this number series and its

various properties. The percentage retracements actually are ratios of this

number series. Scientists have found that Fibonacci numbers and ratiostend to appear randomly (or maybe not so randomly throughout nature)

for example, in the number of petals on a ower and the number of spi-

rals in a pinecone.

So what does this have to do with the nancial markets? Well, there are

those that say markets move in waves. Momentum rises and swells like the

tides. Perhaps there is a relationship. Dont take my word for it. Check them

out for yourself. Form your own opinion. But as my old oor trader friend

said, he didnt care why it worked; he just observed that it did.

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Understand Stochastics

Beginning technical traders are confronted with a dazzling array of

indicators, chart types, wave counts and patterns.While it can be dif-

cult for the novice trader to know how to sift and sort through the

dozens of indicators now available with just the click of a nger, it could beuseful to start with an oldie, but what many technicians consider to be a

goodie stochastics.

Before diving into what this indicator does, lets take a look at what it

measures momentum.Traders have long been on the lookout for good

momentum, or strongly trending markets. And, of course, when that mo-

mentum begins to dry up, that is something traders need to know as well.

Stochastics, an oscillator popularized by George Lane, president of Invest-

ment Educators Inc., may be able to help. In an interview nearly a decade

ago, Lane told this reporter that, Stochastics measures the momentum of

price. If you visualize a rocket going up in the air before it can turn down,

it must slow down. Momentum always changes direction before price.

The IDeA BehIND STOChASTICS

One doesnt need to worry about the formula.This is a popular technical

indicator available in just about every charting software package out there.

According to John J. Murphy in his book,Technical Analysis of the Financial

Markets, stochastics are based on the observation that as prices increase,

closing prices tend to be closer to the upper end of the price range. Con-

versely, in downtrends, the closing price tends to be near the lower end of

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a bris divrgnc on slow socsics signld nd o bullis run in rl D-cmbr 2004.t rgulr socsics indicor on boom o cr rvls mnmor co nd rd-o-dcir signls.

the range.Two lines are used in the stochastic process the %K line and the

%D line.The %D line is the more important one in that it provides the major

signals.The intent is to determine where the most recent closing price is

in relation to the price range for a chosen time period. SeeFigure 1.The

blue line represents %K, while the red line is %D. Readers can see that this

chart provides a glimpse of both slow stochastics (below prices) and regular

stochastics (at the bottom of the example). But well get into the differences

between those later.

Phil Roth, chief technical analyst at Miller Tabak & Co., puts it another

way. Stochastics is concerned with how stocks close within a range. For

example, you could look at the last ve days. Did the stock close near the

highs? Accumulation is identied with strong closes. A close at the upper

end of the range is an important thing to know, he explains.Many technical traders and analysts simply use the default parameter of

14 periods (14 hours, 14 days, 14 weeks, depending on the timeframe of the

chart being used). But feel free to experiment. Fourteen is the standard.

But its not magic, comments Ken Tower, chief market strategist at Cyber-

Trader.

Stochastics, like many other technical indicators, were developed origi-

nally for use in the commodity futures markets. But, as most experienced

traders know, every market has its own personality. And for some markets, a

12-period or 15-period parameter may offer better signals.

TRADITIONAl uSeSStochastics offer traders a variety of technical signals. Of course, like other

indicators it is not a Holy Grail and does have some drawbacks. But if trad-

ers know the proper way to utilize the tool, it can be easy to avoid some

common pitfalls.

First, lets take a look at traditional buy and sell signals from stochastics.

The two lines %K and %D oscillate between a vertical scale from 0 and

100. Generally, the upper extremes, or above 80, are called overbought

readings, while under 20 are considered oversold. The K line is the faster

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line, and when %K crosses %D from overbought levels, it is considered a

traditional sell signal. On the other hand, if the %K line were to cross over

%D in oversold territory, a buy signal would be seen.

Traders need to be aware, however, that one of the drawbacks of stochas-

tics is that in a strongly trending market, overbought or oversold readings

can be seen for days, weeks or even months. So caution needs to be used,

and a simple overbought or oversold reading is not a good reason to pull

the trade trigger.

In the early stages of an uptrend, this indicator moves up to overbought

very quickly and will stay there. It isnt helpful because it can get over-

bought and stay overbought, John Murphy says.

DONT GeT OuT TOO eARly

People make an incredible mistake with this indicator because they use

it in a way you can only use it in a sideways market, says CyberTraders

Tower. He calls this tool one of his favorite technical indicators and uses it

to help time entry and exit points. If I buy a stock, I want it to get over-

bought and stay overbought. These are the stocks I want to own.

However, a lot of times novice traders will get nervous amid overbought

momentum readings and get out of the trade too early, making the criti-

cal error of failing to allow prots to run. Dont be fooled by overbought or

oversold (if you are short) readings. Unless divergences appear (well get to

those shortly), the extreme readings simply are conrming a continuation

of the strong trend.

pROfIT fROM TReNDleSS CONDITIONS: SIDewAyS MARkeTS

For those looking to trade a well-dened range, stochastics may offer

good insights for entry and exit points. When markets shift into a neutral

trend, trading back and forth between a specic resistance and sup-port zone, stochastics are a very useful tool as they are considered to

be a fast indicator. Comparing this tool to a similar type of momentum

indicator the relative strength index (RSI) Murphy says, Stochastics

are faster than RSI.

I nd that stochastics are better for short-term trading. It tends to

be a lot more volatile than the RSI, Murphy says. If you are looking for

speed and a quick entry point, yes, stochastics can be helpful, he adds.

In a sideways range, traditional buy and sell signals could appear on sto-

chastics as prices near the top of the range and the bottom of the range.

uSeful IN TReNDING SITuATIONS,TOO:BullISh AND BeARISh DIveRGeNCeS

An extremely valuable aspect of stochastics is the ability to monitor wan-

ing momentum. Readings called bearish and bullish divergences will warn

of impending tops and bottoms. See Figure 1 for an example of a bear-

ish divergence in the May silver chart. Take a look at the slow stochastics

reading. As price climbed to a new bull trend high in early December 2004,

stochastics failed to conrm that new high. Remember we said that in a

strong uptrend, this indicator would get overbought and stay overbought?

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Technicians like to see stochastics continue to make new highs, along with

price. When that fails to occur, a divergence is formed.

Also in Figure 1, as price made a new high in mid-November 2004,

stochastics made a higher high conrming that price move (seen in the

rst circle). However, heres where stochastics can really help. For those

trading May silver from the long side, a huge red warning ag emerged on

the chart with the rally to the December 2 high at $8.280. That day did in-

deed turn out to be a multi-month peak for silver. Stochastics was already

trending lower. It had turned down, and a bearish divergence had formed

(second circle). Technical clue: time to exit longs and initiate shorts!

BeST SIGNAlS

Most technicians recommend using stochastics in conjunction with an-

other technical tool for the most accurate buy and sell signals. A commonly

used tool used alongside stochastics is the relative strength index (RSI).

Technicians say that when both of these tools exhibit buy and sell signals

in tandem at major market turning points, it is likely a high-odds trading

opportunity. For important turns in the market, I like for RSI and stochas-

tics to be in overbought or oversold territory together, says Murphy.

CheCk lONGeR-TeRM ChARTS

For an additional layer of conrmation, traders doing analysis off of a

daily timeframe should check out the weekly chart as well. For example,

a buy signal on the daily stochastics, which is conrmed by a buy signal

on the weekly stochastics, is a stronger indication than just one time-

frame by itself.

SlOw veRSuS ReGulAR

In Figure 1, both slow stochastics and regular stochastics are shown.Readers can see that regular stochastics are choppier and more difcult

from which to ascertain signals. Many technicians recommend utiliz-

ing slow stochastics, which is calculated in a slightly different or slower

fashion. The result is a smoother indicator, with less whipsaw type of

readings.

Traders in all markets may nd stochastics to be a useful tool. It is a

momentum indicator, somewhat similar in concept to Bollinger bands,

Keltner bands or the RSI. Every trader needs to nd the tools that he or

she likes best. Its a good idea to monitor charts with various indicators

to see what feels comfortable for you.

While stochastics originally were developed for the commodity futuresarena, this tool can be applied to forex markets, individual stocks and ex-

change traded funds (ETFs). Its a universal indicator, comments Murphy.

However, like all technical tools, it has its drawbacks. For the best success

with stochastics, understand its limitations and strengths. Look for conrma-

tion with the RSI at major turning points, and also check out varying time-

frames for another layer of conrmation. Looking for the end of a trend or

a good sell signal in a trading range environment? Stochastics may be the

indicator for you.

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Understand Moving Averages

n this third installment of the "Trading the Indicators" series, we've

chosen to tackle moving averages. In an issue partially dedicated to

trend following, moving averages are the perfect indicator to study.

While everyone has heard the old saying the trend is your friend, howdoes one actually identify trend? Moving averages are a simple tool that

can pinpoint whether a market is in an uptrend or a downtrend and can

signal when a trend is turning.

hMMMDOeS ThAT lOOk lIke A heAD AND ShOulDeRS TOp TO yOu?

Within the eld of technical analysis, which includes some very subjective

forms of looking at the market (such as pattern identication, Elliott wave

counts, etc.), moving averages offer an objective manner to view price and

trend.

The rst job of a technician is to identify trend, says Ralph Acampora,

well-known technical guru and former head of technical research at Pruden-tial.The simplest way to do that is to identify higher highs and higher lows

and draw a trend line.And he adds,The problem with that is that my trends

might be a little different from your trends because we might draw the line a

little differently.A moving average, by denition, is a mathematical trend line.

The MAjOR MOvING AveRAGeS

The basic concept is that if price is above the 10-day moving average,

then the short-term trend is up (just ip that example on its head for

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a downtrend). Remember that there are three basic time frames to

which technical traders refer: the short-, medium- and long-term

trend. And unless one is doing very short-term intraday trading, it is

worth knowing where all three trends stand (and all actually can be

different).

Moving on, if price is above the 50-day moving average, then the

medium-term trend is generally considered to be up. Finally, the big

mama of all moving averages is the 200-day moving average. Most

technical traders and analysts consider this moving average to be

a proxy for the long-term trend its the key line in the sand. Are

prices above the 200-day moving average? Then the dominant, major

trend is up. If prices are below the 200-day moving average, it would

signal that the longer-term trend is down.

Just a little note on time frames traders can adjust moving aver-

ages to any period, which could be a 10-, 20- or 50-period moving

average. Its called a period because if one is looking at an hourly

chart, it would be a 10-hour moving average, or on a weekly chart,

a 10-week moving average. It all depends on the time frame of your

chart. Also good to know, moving averages are a universal tool, which

can be used on any market including foreign exchange, individual

stocks, crude oil futures or the S&P E-mini contract.

hOw ARe They fORMeD?

Moving averages can signal when a new trend has started or when

a trend is completed. However, because of the way it is constructed,

moving average signals are lagging, not leading, indicators.

So how are they formed? Actually, they are very simple to com-

pute. Lets say one is trying to calculate the 20-day moving average

of closing prices. Add up the last 20 days and divide the total by 20 todetermine the moving average. The average moves because every

day the oldest day is dropped off as the current days information is

added. And dont worry; you dont have to do the math yourself. This

technical tool is widely available in all standard charting software

packages. Simply click on the moving average option and voil! It

appears. There will be a function to change the parameter of periods,

such as a 20-day or 10-hour (depending on chart time frame) for the

moving average.

wheNS The BeST TIMe TO pull ThIS TRICk OuT Of The BAG?

Technical traders generally rely on a number of technical tools intheir trading arsenals. The more one learns about technical analy-

sis, the better they will understand the concept of confirmation. For

example, the more technical tools that are flashing the same signal at

the same time, the better the odds that a trading idea would be suc-

cessful.

But traders also need to know how and when to apply different

technical tools to maximize their usefulness, and moving averages are

most useful in trending market environments.

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Says Acampora, When the market is going sideways, you can get

many false signals. Avoid whiplash! If a market has shifted into a

well-dened sideways consolidation band, the best advice is dont use

moving averages.

However, there is a caveat. For extremely short-term swing traders,

moving averages can help pinpoint turning points in sideways markets.

If there is a well-dened price ceiling and price oor for the sideways

band, traders could use shorter lengths of moving averages to pick off

short-term swings in the longer-term context of going sideways, accord-

ing to John Bollinger, president of Bollinger Capital Management.

The CRySTAl BAll, MeDIA hype OR Self-fulfIllING pROpheCy

While traders have heard over and over again that there is no Holy

Grail, in the world of technical analysis, where do moving averages t

in? They are not the answer within the crystal ball, but the big and wide-

ly watched moving averages do attract some media hype and perhaps,

at least to some extent, can become a self-fullling prophecy, at least for

the short-term. CNBC may proclaim, XYZ stock has been trading above

its 50-day moving average for months now, but today fell to that level.

Will it hold? A media buzz is created around the 50-day or 200-day

moving averages. And for the most part, those are the averages ashing

on many individual and institutional traders screens every day. When

prices fail to hold a certain moving average, it can have a pronounced

psychological impact on the community, Bollinger notes. And by now,

readers must be well aware how much psychology plays into price

movement!

BuIlD yOuR OwN SySTeM

For those who dont understand the basics of a moving average cross-over system, its actually very simple. One could easily construct a mov-

ing-average system that issues buy and sell signals. If a trader is using

just one moving average, a buy signal is triggered when the closing price

moves above the moving average. Conversely, a sell signal is ashed

when the closing price moves below the moving average.

Many technical traders will rely on the crossover method as an at-

tempt to reduce false signals and noise. Using the crossover strategy,

a trader might pick the 20-day and the 50-day moving average. When

the shorter average (in this case the 20-day) crosses above the longer

average, a buy signal is seen. Sell signals are produced in the opposite

fashion. Fewer whipsaws are seen when traders rely on this type ofmethodology. See Figure 1 for an example. A circle signals a buy signal

when the 10-day crossed over the 20-day moving average in late Janu-

ary. Cocoa prices rallied substantially from that signal, roughly from the

$1,580 dollars per metric ton level to the mid-March peak (at this writing

in late March) at $1,850.

While moving averages can be helpful, traders need to do their home-

work when using them. If it were as simple as this example, everybody

would be using this system to make millions, and Id be sitting at the

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fIGuRe 1: Dil Nw york Bord o trd M oco

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t 10-d moving vrg is sn in grn nd 20-d moving vrg in rd.

oor-to-ceiling windows of my mansion overlooking Lake Michigan,

with French champagne in one hand and hors doeuvres in the other.

Some of the drawbacks that traders need to consider are that the buy

signal isnt formally issued until after the close, which means the entry

point is the next day. Also, as evidenced by this example, moving-average

signals dont get you in at the bottom of the trend. Nor do they get you

out at the top. But you may be able to catch a good part of the middle of

the trend (which should be enough to be protable, if proper discipline

and money management techniques are rmly in place).In late March, as seen inFigure 1, cocoa prices plunged sharply in an

apparent bull trap failure. But as of this writing, a sell signal has not yet

been seen. A trader, who faithfully follows buy and sell signals would

still be sitting in this trade watching his prots erode. Despite this, how-

ever, there is value in moving averages. They can be used as part of a

discretionary methodology or as part of a mechanical, systematic trading

system.

When people rst come to technical analysis and look at moving

averages, they seem to offer great buy signals, says Bollinger. But when

traders do a little work, the reality turns out not as rosy as they had

hoped it would be. Yet he admits that moving averages can be good ina carefully constructed trading system, provided one tests carefully with

extensive out-of-sample testing, and avoids optimization. With proper

system testing and proper system construction, such systems can work.

OTheR uSeS Of MOvING AveRAGeS

Linda Bradford Raschke, CTA and president of LBR Group, says moving

averages can pinpoint good buying spots during a trend. For shorter-term

discretionary traders, who are trading a trending market, pullbacks to the

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moving average can be good buy

spots, she explains. Markets dont

go straight up or down. For ex-

ample, lets say the S&P contract is

rallying, but intraday price stages

a pullback to the 20-period moving

average on the hourly chart. That

level could offer a good buy spot.

However, warns Raschke, Buy-

ing on the rst or second retracement is OK. But be careful as the trend

matures. If you see a buy or sell climax, dont buy the pullback.

DIffeReNT TypeS

Looking at a basic technical analysis books, youll notice different types

of moving averages: simple, exponential and linearly weighted. While

they are slightly different, experienced traders suggest not getting bogged

down in the details, as they all basically work the same and offer the same

type of signals. For the record, however, the simple moving average is the

one we dened above.

A criticism to the simple moving average concept is that each days

action carries equal weight. The linearly weighted moving average gives

greater weight to more recent closes, as the calculation would multiply

the closing price on the 20th day (for a 20-day moving average) by 20 and

the 19th day by 19, and so on. The total then is divided by the sum of the

multipliers. The exponential moving average also assigns greater weight

to more recent data, but also includes in its formula all of the data in the

history of that instrument (in order to take into account the importance

of data that may have occurred before the specied period). Traders also

actually can dene what percentage weighting to be given to the last daysprice.

Many traders seem to use either the simple or the exponential, but its

worth trying the various indicators to see which ts best for you. Person-

ally, I like exponential moving averages, says Raschke. They give more

weight to the data on the front end. But you can start splitting hairs on

this stuff. It comes down to what tickles your eye. The crux of the matter

is that traders need to experiment or test on their own to determine which

moving average and what type ts best with their trading style and time

frame.

Many technical tools, such as moving average convergence divergence

(MACD), moving average envelopes, and Bollinger bands are more ad-vanced indicators, which in some way borrow from the moving-average

concept. But those are all topics for another day. Understanding the basics

of moving averages, however, will allow one to delve further into the

technical arena. Moving averages can be a useful tool for those looking

to identify what type of trend the market is in and when a turning point

has occurred. Again, traders will never catch exact tops or bottoms with

moving averages, as they are lagging indicators, but they can catch a lions

share of a major market move.

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Understand Japanese Candlesticks

D

o the terms, dark cloud cover, gravestone doji or morning star

sound like something out of a science ction movie? To seasoned

candle readers, these terms actually identify key candlestickcharting formations that have been used for hundreds of years in Japan,

developed initially by those trading the rice markets there. In recent

years, western technicians have come to appreciate the subtleties and

additional insights that this unique visual display of price action reveals

about underlying market forces.

GeTTING STARTeD

The most basic tool of any technical trader is, of course, the chart, and

one of the rst decisions he or she must make is what type of chart to

use the traditional bar chart, point and gure charts, the market prole

graphic, line charts or Japanese candlestick charts. Each type of chart hasits own advantages and disadvantages, and it is worth taking the time to

experiment with each to see which works best for you.

This article, aimed at those with little experience with candles, will offer

up some of the pros and cons of using these charts.

Candlestick charts are much more visually appealing [than bar

charts], says Joe Palmisano, technical strategist at Ideaglobal. They lay

out an immediately recognizable graphic that reveals the underlying

forces of the market participants.

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A lITTle hISTORy

Candlestick charting is one of the oldest forms of technical analysis, evolving from

methods utilized by 18th century rice traders, according to Steve Nisons book Japa-

nese Candlestick Charting Techniques.

After 1710, the Dojima Rice Exchange, founded in the late 1600s, began to issue

and accept rice warehouse receipts essentially futures on rice. Roughly 1,300

rice dealers participated in this exchange, and because no currency standard had

developed at this time, these rice coupons became the medium for exchange.

Legendary trader Munehisa Homma was given control of his family business

in 1750, and he began trading at the local rice exchange. Throughout the years,

Homma amassed a huge fortune through his rice trading. He also developed his

own system for analyzing the markets, which included analyzing rice prices since

trading began and keeping detailed records of yearly weather conditions. His trad-

ing principles evolved into the candlestick methodology, which became extremely

popular in Japan.

While candle charts have been used for hundreds of years in Japan, they were

only introduced to traders and analysts in the western hemisphere in the early

1980s. Steve Nison is widely credited for bringing awareness of this unique charting

method to the West.

Nison first was introduced to Japanese candlesticks when he noticed some

strange-looking charts in the office of a Japanese broker who worked down the hall

from him at the then Shearson Lehman Hutton. He was instantly attracted to this

charting method and wanted to learn more. Consequently, Nison began doing ma-

jor research on candlesticks and read every book he could find on the topic. In the

late 1980s, Nison ultimately compiled some of his research into a booklet on candle

charts, which was distributed through Merrill Lynch, where he was then working as

a senior technical analyst.

Other proponents of candlestick analysis say these formations offer

traders clues to better entry and exit points and the ability to spot market

turns faster than on a traditional bar chart. While some may shrug off

candlestick analysis as funny-looking charts with a lot of odd terminol-

ogy, the formation of the candles offer traders a great deal of additional

information about who is in control of price.

Palmisano says that candlestick charts offer traders a better read onthe power of the buyers and sellers in the market than do traditional bar

charts. Candlesticks and their patterns tell a story.

Candlesticks can be used across many time frames, just like traditional

bar charts. Traders can look at a monthly, weekly, daily or even an intraday

candlestick chart. The difference between a traditional high-low-close bar

chart and a candlestick is the way the price action is presented.

Candlesticks are composed of what is known as the real body and the

shadows. The real body represents the range between the sessions open

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and close. If the close is lower than the open, the real body is black (or

some other color based on ones charting provider). If the close is higher

than the open, the real body is pictured in white. The thin lines above and

below the real body are called shadows. The peak of the upper shadow is

the high of the session, and the bottom of the lower shadow is the low of

the session. Generally, analysts look to the close and the length of the real

body to determine whether the bulls or the bears are in charge.

Traders will still nd all the same high-low-close information that is

found on a bar chart, but says Steve Nison, author, technician and presi-

dent of candlecharts.com, With candlesticks you get the candle and bar

chart signals. Its a no-lose proposition. Additionally, Candlesticks are

very simple to construct. But, dont let the simplicity fool you; they are

very powerful.

Pointing to an old Japanese proverb, Nison adds, He who sits in the

well can see little of the sky. When you look at a bar chart you are only

seeing part of the picture.

The DOwNSIDe?There are not a lot of naysayers when it comes to using candlestick charts.

Traders arent losing any data or information they would have found on a

bar chart; instead they gain additional information via the candle forma-

tions. And traders can utilize candlesticks along with all of their favor-

ite western indicators. So using a candlestick chart is not a this-or-that

proposition.

When pressed for some cons, analysts did note that those who are

not well-versed or educated in candle sticks could trade off them in

an incorrect manner, which could be devastating to your capital base.

Additionally, as some of the candle formations take several days for a

pattern to develop, one may need to wait until that candle is complet-ed for confirmation of a market bottom or top. Another disadvantage

for those using the daily time frame is that one does need to wait until

after the final bell in order to see the days final pattern. This means a

trader could have to wait until the next days open to get in the mar-

ket, based on a signal.

uSING CANDleSTICkS

For those who are interested in using candles in their trading analysis,

some study is advisable. There are many books and websites available

that can offer novice candle readers background and education.

Nison warns that many traders misinterpret candle signals. One com-mon mistake surrounds the appearance of a doji, which forms when the

open and the close are the same (or nearly the same). People see that

and think, Oh, I should sell short, but thats not right. The Japanese

would say the market is tired when a doji appears. The trend has gone

from up to neutral. A doji shows equilibrium between buyers and sellers,

Nison explains. In order to combat incorrect interpretation, traders need

to take their time to study, learn and watch candle charts before trading

off of them.

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fIGuRe 1: Dil Jun rud il ndlsick r

Sourc: fuurSourc Xr

Greg Morris, author of Candlestick Charting Explained, says one of the

initial insights that candlestick charts can offer a trader by simply look-

ing at the chart is a take on the quality of the trend. A candlestick jumps

out at you, says Morris. You can easily see if the close is above the open

for the day. Or if the recent candles are predominantly white, you are in

a strong trend. If an uptrend is sprinkled with black days, then the daily

candles are not reecting a strong uptrend.

MAjOR Buy AND Sell SIGNAlS

There are numerous candlestick formation and patterns that generally

range from one-day signals to ve-day patterns. Many of the important

reversal signals tend to be three-day patterns. These reversal signals tendto offer earlier clues that the market trend may be shifting over many

price-based technical indicators. While there are many different patterns

to study and learn, once a trader gains familiarity with the formations,

they are quickly and easily identiable and, indeed, do jump right out at

the trader.

Candlesticks are notoriously useful for identifying reversals in trend.

Two-day patterns that appear frequently in many markets are bullish and

bearish engulng patterns. For a bearish engulng pattern, Nison says

that on the rst day of the white candle, the bulls are in charge. The next

day, the market opens higher and then closes very weak. The bears are

grabbing control from the bulls.A bearish engulng pattern is a top reversal pattern that reects over-

whelming selling pressure seen as the long, black real body engulfs a

small, white real body in an uptrend. SeeFigure 1 for an example. Point

A reveals a bearish engulng pattern, which quickly identied a trend

reversal in the June crude oil contract.

No need for a long description on the inverse a bullish engulfing

pattern is simply the opposite type of formation that occurs during a

downtrend.

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Lets take a look at a couple

of other basic and simple pat-

terns that occur frequently. In

Figure 1, point B highlights a

hammer formation. This is an

important bottoming candlestick

line and takes only one day to

signal that a bottom has likely

formed, at least for the short-

term. The hammer signaled a

bottom and presaged a decent

rally in crude oil futures. Point C

in Figure 1 highlights a bear-

ish shooting star formation, also

a one-day pattern. A shooting

star forms when there is a long

upper shadow, with little or no

lower shadow. The real body

forms near the lows of a session.

When this occurs in an uptrend,

it reveals that prices opened in

the lower third of the range, ral-

lied intraday, but the bulls were

unable to defend the new high

territory. The bears assert control

by the close, leaving prices to settle near the days open. The actual

shape of the candlestick reveals the psychology behind the intraday

action.

There are dozens more candlestick patterns to learn and study.The best way to get started is to pick a book and then start looking at

charts. Turn the candles on whatever market you are watching, and try

incorporating them into your market analysis.

MIx IT up

One of the major advantages of candlestick charts is that traders are still

able to use their other favorite technical indicators. Go ahead, draw a

trendline on a candlestick chart and add stochastics, Bollinger bands or

moving averages. Nison believes that candlesticks are a tool, not a sys-

tem. He is a proponent of combining candles with Western signals.

Its like the right hand helping the left. If a group of signals are allsay the same thing, the odds of a turn are higher, Nison says. Point-

ing to the example of a bearish engulfing pattern (but true for all

patterns), he notes, The odds of a market turn are increased if it is

confirmed by a Western moving average or resistance area.

Nisons personal favorite tool to combine with candlesticks is vol-

ume. Candles show the force behind a move. But I always look at vol-

ume as part of my analysis, he says. For example, a tall white candle

on high volume is potentially a positive signal.

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pICkING A TIMe fRAMe

There has been a debate over appropriate time frame usage for can-

dlestick charts. Historically, traders used candle charts on a daily or

longer basis. The Japanese used the daily period. They believe that

the time period of the close from one day to the open of the next day

was a very important decision-making period, says Morris.

However, in recent years, candlestick charts have gained popular-

ity even among the day-trading crowd. Traders use them on time

frames as short as three- and five-minutes. On very short-term

charts, however, Nison advises that traders rely not just on a one-

line formation. Instead, use formations that are comprised of two or

three candles together for more accurate signals. Or try very short-

term intraday candles in conjunction with major support or resis-

tance areas.

Some very short-term traders simply use the color of the candle as

confirmation to get into a trade. For example, lets say someone uti-

lizes a 20-period exponential moving average and retracements. If

price retreats to the 20-period EMA that coincides with a Fibonacci

retracement, the trader may enter a short-term position on the next

white (up) candle. But there are many different strategies and ways

to use candlesticks.

Nison recommends that short-term intraday traders first de-

termine the overall longer-term trend. Then, for example, If the

longer-term trend on the daily chart is bullish and a bullish signal is

confirmed, go long [and] initiate new positions only in the direction

of the longer-term trend, Nison says. Conversely, if a bearish signal

were to emerge on an intraday chart in which the daily trend was

up, Nison suggests only using that to liquidate posit ions or to takeprofits not as a signal for a fresh short position.

A few MORe TIpS

Candlestick analysis can work well in just about any market as long as

there is liquidity. For markets that are not actively traded, the candle-

sticks will not offer an accurate picture of market action. For those

trading foreign exchange, in which there is no official open or close,

it is wise to rely on the same quote provider that has, for example, a

standard 5 p.m. EST settlement. As candlesticks rely heavily on the

open and the close in order to provide clues to market action, one

needs to use consistent open-close data for forex.Each market has its own unique feel. It can take some time to watch

that market with a candle chart to get into that particular markets

rhythm. The Japanese say the personality of a market is like a per-

sons face. No two are alike, says Nison. Get comfortable with four to

eight markets and get to know their personalities, he advises.

If you know how to read the candles and heed what they say, you

will be more equipped to successfully participate in the market, con-

cludes Ideaglobals Palmisano.

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TRADING INDICATORSBe Your Own Analyst:Understanding Cycles

for pure cycle analysts, time not price is the most important

aspect in studying charts.

This is an important theoretical difference when it comes to

analyzing the markets, as the bulk of the eld of technical analysisfocuses on price as the main indicator. Cycle advocates say that both

long- and short-term repetitive patterns can be identied via time,

which can help predict market turns before they happen. Instead of

waiting for a price breakdown or a momentum buy or sell signal, cycles

can help pinpoint areas of time where potential tops or bottoms may be

forming in a market.

Whats the basic rationale behind this approach? A true cycle, by

my denition, is one that goes from a time of extreme pessimism to

extreme optimism and then back to extreme pessimism, says 33-year

market veteran Glen Ring, editor of View on Futures. A cycle simply

measures the mood of participants in the marketplace and is reectedby the price behavior however long it takes.

We see rhythms perpetuate themselves time and time again in all

markets. Rhythms are a natural phenomenon, says Stan Ehrlich, author

of The Ehrlich Report. Traditionally, all cycle denitions or counts

are from market bottom to market bottom. Many cycle analysts point to

J.M. Hurst, author of The Prot Magic of Stock Transaction Timing, as

the pioneer of stock market cycles, and many using this form of analysis

bring some elements of Hursts concepts into their work.

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ChART 1: Monl Dow Jons ndusril avrg r

Sourc: fuurSourc Xr

juSTTAke A lOOkTake out a longer-term chart of the stock market and study it. You just

cant look at a historical chart of the stock market and not see them there,

says Ken Tower, chief market strategist at Cybertrader, Inc. There is am-

ple evidence of cycles within crowd behavior. There are business cycles,

and there are cycles in nature. There are cycles everywhere, so its not too

surprising to nd them in the stock market, he adds.

Many traders may have heard of the Kondratieff wave, an economic

cycle discovered by Nikolai D. Kondratieff back in the 1920s. Basically,

Kondratieff believed that the world economy moves in 40- to 60-year

waves, or cycles, with the average being 52 years. According to his theory,

this overriding cycle of economic activity inuences practically all stockand commodity prices. However, his theory proved controversial both

then and now, and many economists and traders have discredited Kon-

dratieffs work, saying it had little or no merit. And realistically, for day

traders or investors, a 60-year cycle doesnt offer much help in terms

of shorter-term buying or selling spots. But, advocates of cycle theory

note that cycles can be found even on intraday, daily and longer-term

charts.

fINDING CyCleS

In this day and age of split-second, computerized charting software,

counting cycles by hand on a chart may seem outdated and old-fash-ioned. But that is how analysts from the old school began identifying

these cycles years ago. Counting out cycles is a roll up your sleeves and

get your hands dirty kind of approach, explains Ring. These days, how-

ever, there are computerized cycle tools available on charting software

packages. Yet some analysts still prefer to do the work themselves.

Rob Zukowski, technical analyst at 4CAST Inc. in New York, uses cycles

as one of the many technical tools in his analytical approach. In looking for

cycles in the Treasury bond futures market several years back, he simply

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printed out daily price data going

back at least a year. For those

looking to nd cycles on their

own, he advises, You want to look

at a years worth of data, if not

two years. And then, just pick

out what you think are signicant

lows. Count forward to nd out

where the next signicant low

is, and over time you may have

enough observations to dene a

cycle.

Ring agrees. I just start with a

low. I count forward and back-

ward, and just see if I start pick-

ing up a rhythmical pattern.

In recent years, Zukowski had

found an 11-day time cycle in

the U.S. T-bond futures market,

which moved from low to low. He

allowed that cycle to have a plus

or minus one-day time window.

While he warns against trading

off time cycles alone, Zukowski

had found them to be useful as a time predictor. What Im trying to do

here is to nd a simplistic way to get a feel for when we can get some

sort of turnaround, Zukowski explains.

uSING CyCleS IN yOuR TRADINGMost cycle advocates say that this type of analysis offers them a back-

drop or framework for looking at a market. Cycle signals are not a stand-

alone tool. This is an example of what is even more important than

the tool is how you use the tool, says Ring. You want to integrate cycle

work with the trend and other tools.

While CyberTraders Tower admits that he uses cycles only spar-

ingly in his technical work, he says they are a great guideline, and they

helped him identify the U.S. stock market bottom in 2002. (The Dow

Jones Industrial Average posted a strong bottom at 7,197 in October

2002. Since then, prices have rallied to the March 2005 peak at 10,984

and have not revisited the October 2002 low, as of this writing in midMay.) See Chart 1. In the spring/summer 2002, I looked at my historical

cycle chart, and said Im looking for the market to bottom. But, I needed

to see some evidence of a bottom, says Tower.

I nd the U.S. stock four-year cycle to be very helpful in providing a

framework; it is not a deterministic thing, says Tower. This is similar to

what other cycle analysts say. One shouldnt use a cycle-timing trigger

simply to jump into a trade. But it can be a guideline that a low may be

coming. Perhaps, traders can view cycle analysis as a warning system

Most cycle

advocates say

that this type

of analysisoffers them a

backdrop or

framework for

looking at a

market. Cycle

signals are not

a stand-alone

tool.

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that a low may be on the way. Then, once they see conrmation of this

low via their other favored technical indicators, they can be more con-

dent about taking advantage of that information.

This will not be the Holy Grail. It is not something that you strictly

place a trade on. Use your other analysis tools. It is a timing guide, says

Zukowski. For those using shorter-term cycles they may have found in

commodity futures, he notes it could be possible to use the next low as

an opportunity to add to your long. Or, if you are just a day trader, start

looking for an opportunity to buy [around the next low], but use oscilla-

tors to help set up for the trade, he explains.

From a psychological perspective, those using cycle analysis could

be viewed as contrarians. After all, cycle advocates are actually look-

ing to pick bottoms. Market sentiment into important lows tends to be

extremely bearish, as bottoms form when everyone is so bearish that

there is no one left to buy. And that is how cycle analysis can help.

Because at those times, it is very difcult to even think of being bullish!

Shifting to current market conditions, which have seen U.S. stocks in a

decent rally phase off the 2002 low, when you tell people the market

is going to top out, they look at you like you are a crazy person, says

Tower. But, as market historians know well, bull markets dont go on

forever.

The bottom line is that the analysis of rhythms sets you up psycho-

logically in advance for when you should be looking for a turn, says

Ehrlich.

The CRITICS SAy

One of the main criticisms of cycle analysis is that they are not reliable

enough to trade off of. Indeed even arch proponents of cycle analysis

say that they dont rely on them alone in making trading decisions. But,of course, this is true of many other technical indicators and method-

ologies, too. Most discretionary traders develop a number of favorite

analytical and technical tools upon which they rely. When the major-

ity of their favored indicators line up in one direction, it may indicate a

high-odds trading opportunity. Cycle analysis may just be another useful

checkpoint on ones checklist.

fOuR-yeAR STOCk CyCle

While cycle analysts say that cycles occur in all markets including

foreign exchange, various commodity markets and the bond market,

there is a particularly well-known and widely watched four-year cyclein the U.S. stock market. The idea behind this particular cycle is that

by looking at a longer-term chart one can see an easily identifiable

series of important lows every four years in the Dow Jones Industrial

Average.

Where I find cycles most valuable is with the major trend in the

stock market, says CyberTraders Tower. Whether you call it the

presidential cycle or the four-year cycle, its too strong a cycle to ig-

nore. There is incredible evidence that this exists.

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Looking back over the past 60-plus years, analysts say, there has

been a strong tendency for the U.S. stock market to bottom on a four-

year cycle basis. Starting with the most recent low, these bottoms have

been seen in 2002, 1998, 1994, 1990, 1987, 1982, 1978, 1974, 1970, 1966,

1962, 1957, 1953, 1949, 1946 and 1942. Readers may have noticed that a

couple of those important market bottoms were a year off. Cycle ana-

lysts note that this is allowable.

ITS NOT exACT

In Rings cycle work, he allows for cycle bottoms to form plus or minus

ve percent in the overall time of cycle. CyberTraders Tower likens the

minor discrepancies to longer-term weather patterns. Weather cycles

on a long-term basis seem very predictable. In the Northeast in March

and April, we know it warms up. However, there is the issue of exact

timing. If Im a farmer, figuring out what day to plant my tomato seeds

will vary from year to year, Tower says.

However, shifting back to the four-year stock market cycle, read-

ers also may have noticed that the 2002 bottom means that the next

major bottom is coming for U.S. stocks next year in 2006. In an ideal

four-year cycle, the stock market would go up for two years and down

for two years. But that rarely happens, notes Peter Eliades, editor of

Stock Market Cycles for the past 30 years.

IS IT The lefT OR The RIGhT?

This brings us to the concept of left and right translation within cycle

analysis. That simply refers to the movement of cycle highs either to

the left or right of the ideal cycle midpoint. For example, the four-year

stock market cycles mid-point high would be the two-year mark, in

between the lows seen every four years. Analysts have found that mostvariations in cycles develop at the highs, not at the bottoms, which is

why market watchers count from the lows.

If the top comes to the right of where it should have, it is called

right translation, says Eliades. Longer-term cycles, such as 25- or

30-year cycles may have an overriding impact on shorter-term cycles,

such as the four-year. For example, if left translation is seen in the

four-year stock cycle, theoretically longer-term negative cycles are

weighing on the market.

Tower again likens the influence of longer-term cycles over shorter-

term cycles to the weather. If the real long-term trend is up, it will

bias all the short-term trends just as a cold day in summer is not thesame as a cold day in winter. The point is that longer-term cycles may

have an influence on whether left or right translation will likely occur

in shorter-term cycles.

lOOkING BACk

Looking back at some recent U.S. stock market history, many investors

are well aware that one of the greatest and most historic bull markets

of all time began in the early 1980s. From 1982, the U.S. stock market

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saw an unbelievable 18 consecu-

tive years in which the low for

the year was above the previ-

ous years low. That has never

before happened in the history

of the market , notes Eliades.

Within a two-year period

around 1982, Eliades explains,

several major long-term stock

market cycles, including the

60-year, 30-year and 25-year

cycles, all bottomed together.

That created a convergence

of longer-term upward cycle

pressure on the market to-

gether. However, now in 2005,

the next five years should see

downside pressure from all of

these longer-term stock market

cycles, according to

Eliades.

GOING fORwARD

Longer-term cycles are going to

be putting downside pressure on

the market over the next several

years, Eliades predicts. He points

to the four-year cycle due to bottom in 2006, the 25-year cycle due to

bottom in 2007 and the 30-year cycle due to bottom in 2010. For at leastone to two years, you have specic cycles that arent going to add any-

thing to the market, he says.

CuRReNT RAlly phASe

Counting out the current rally days into mid May, CyberTraders Tower

notes that U.S. stocks already have exceeded the average short bull

market (592 trading days), starting from the October 2002 bottom.

We are heading toward the average length of all bull markets (797

trading days) that would take us up to Thanksgiving. Unless one can

envision an acceleration of the economic expansion, it is difficult to

envision this advance extending into the longer-than-average bullmarkets that tend to occur during the big expansionary phases of

the economy (such as 1949-1968 and 1982-2000), Tower says.

Looking out over the next year and a half, Tower forecasts a nasty

bear market into the next four-year bottom, which is due in 2006.

Tower points to the March 2005 high and says it is quite possible

that was the end of the current bull market. It could be severe, he

says, given the overriding pressure of the very long-term sideways

pattern. (The market is no longer benefiting from the huge long-

We are heading toward

the average length of all

bull markets (797 trading

days) that would take us

up to Thanksgiving 2005.

Unless one can envision

an acceleration of the

economic expansion, it

is difcult to envision this

advance extending into

the longer-than-average

bull markets that tend

to occur during the big

expansionary phases

of the economy (such

as 1949-1968 and 1982-

2000),

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term up cycles, which supported overall activity during the 1980s and

1990s).

For example, says Tower, when you are in a really big, longer-term

uptrend, you have very short bear markets. He pointed to the 3-1/2-year

bull period into the October 1987 market crash. Then, although October

1987-early December 1987 was short in terms of time, it was extremely se-

vere in terms of price retracement. Unfortunately, for current longer-term

buy and hold investors, Tower believes that the market had broken the

short bear market pattern after the 1998 low. In the current environment,

the bull market periods no longer will see added benet or lift from any

longer-term secular uptrends. The longer-term trends have shifted either

sideways or down, depending on who is telling the story.

wheRe DO They COMe fROM AND why DO They wORk?

One of the tougher issues to understand is where cycles come from and

why they work.

It could be the same as if you had asked me if there is a God. Does he

exist and why does it work? ponders Eliades.

4Casts Zukowski takes a more pragmatic approach to the question.

Being a technician, patterns do tend to repeat. I think of it more as a

repeating factor. These markets are made up of emotions, and people tend

to trade off of emotions, whether it is a triangle or a cycle low. That is what

we do in technical analysis, he says. After all, technicians say that history

repeats itself as buying and selling and greed and fear create identiable

patterns.

It is human nature to always chase what is hot at the time, notes Ring.

Cycles reect the need of a market to constantly purge the excess pes-

simism and restore excess optimism. Think of a crowd running from one

side of the boat to another.But those who are cycle advocates simply have seen over time that they

do work, and that is enough for them. However, those who need a little

more proof may have a tough time digesting the concept of cycles. Some

cycle advocates point out that cycles are everywhere in the natural and

physical world. After all, scientists have found accurate and repeating

sunspot cycles, and the planets have reliable cycles during which they

revolve around the sun.

Be A STep AheAD Of The CROwD

For those interested in incorporating cycle analysis into their trading

decisions, as always it pays to invest some time learning and studying.For starters, simply reading some books and articles to help understand

the basic concepts and then poring over a variety of stock or commodity

charts can be very insightful.

People learn things too late. Some take no historical notice of the

fact that there are cycles out there. Now we are in a trading market.

But everybody wants to behave like it is a buy-and-hold market. If you

study cycles and history, maybe you can be a step ahead of the crowd,

concludes Tower.

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Understanding Volume

Many technical traders will tell you that price is king. Everything

comes down to price, and price is the most important indicator

in and of itself. Experienced traders know that many technical

indicators are simply price massaged, oiled and spit out into a fancy blueor red line at the bottom of ones chart. But volume is a completely differ-

ent animal. While youd have to travel far and wide before youd chance

upon a trader who would say that volume readings are more important

than price, they are useful and signicant raw data readings that measure

the amount of action and psychology of the market players.

Volume, of course, simply is the measure of the number of shares of Intel

or Qualcomm or any stock traded during a day. In the futures arena, volume

measures how many corn contracts or S&P E-minis changed hands that

session. For those who are trading on an intraday basis, 5-minute volume

bars can be found, or for traders more comfortable with a longer-term view,

weekly or monthly volume data can be called up just as easily.

NewTONS lAw

Remember back to high school physics. Newtons rst law of motion

reects the concept underlying volume analysis in the nancial markets.

This law says that an object in motion will stay in motion unless acted

upon by an unbalanced force.

Thus, many technical traders call volume the fuel behind a market

move. Is the gas tank full and providing powerful momentum for that

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Porsche speeding down the Autobahn? Or is the gas tank nearing empty,

which means the engine is likely sputtering, and the driving machine is

slowing and limping toward the shoulder of the road? For a trader who is

looking to put on a stock trade from the long side, knowing how much gas

is likely left in the tank is an important variable. After all, how many smart

drivers set off for a long trip with only a gallon of gas left in the tank?

Joe Granville, editor of the Granville Market Letter and developer of

the popular volume tool called on balance volume (OBV) [well get to this

later], puts it another way and says that volume is the steam in the

boiler that makes the Choo Choo go down the tracks.

uSe IT TO CONfIRM

Generally speaking, volume has to conrm price, explains John Murphy,

author and chief technician at Stockcharts.com. When price breaks out to

the upside [or downside], we normally like to see a nice pickup in volume

to conrm that.

One of the basic rules of thumb for traditional volume analysis is that a

healthy uptrend would see expanding volume on up days and contracting

volume on down days. Just the opposite would be true for a downtrend.

When you get an exception to that, it can be a sign that trend is changing,

says Phil Roth, chief technical analyst at Miller Tabak & Co. Daily volume

data is easy to nd and can even be tracked via the Wall Street Journal, and

most charting software packages offer an option for volume bars across the

bottom of the chart.

A market rallying on light volume is a sign there isnt as much bullish-

ness. It is a hesitant market, says Murphy. When we dont get volume, we

get more suspicious.

Or another subtlety for which to be on the lookout is big volume in an

uptrend, but no price progress. That could be a signal that youve hit resis-tance, adds Roth. The idea is that an unusual change in a volume pattern

could signify a possible reversal.

MORe RuleS Of ThuMB

Some other basic rules of thumb in relation to volume are that bull markets

tend to have bigger volume, while bear markets tend to have lighter volume.

Markets must be pushed up but can sink on their own weight, notes Roth.

In a downtrend, traders would like to see increasing volume on down days

and decreasing volume on up days.

Independant trader and analyst Brian Shannon uses volume in his trad-

ing and analysis. He says volume is second only to price. Price is whatpays, and volume lets us know about the emotional condition of the buyers

and sellers.

Shannon highlights a couple of his favorite reections on volume:

Big volume without further upside equals distribution;

Big volume without further downside equals accumulation;

Volume tends to peak at turning points;

Volume often precedes price movement;

Volume is a relative study.

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Shannon outlines an example for a stock that is rallying. "You'd like to

see that stock advancing on increasing volume each day, say 600,000 the

rst day, a million the second day and a million-ve the third day. Price

pullbacks should see successively lower volume, such as 900,000, 600,000

then 450,000" to reect a healthy advance.

One of the old market adages says that once a trend is established, it

is more likely to continue than to reverse. "That is even more likely to

be true if pullbacks are on declining volume," says Shannon. For trad-

ers who may have missed an entry opportunity on a breakout, if a stock

posts a retreat on declining volume, that may offer a second entry op-

portunity for a trend move.

DIveRGeNCe

Themes that come up over and over again in the eld of technical analy-

sis are the concepts of conrmation and divergence. Divergence often

is used in the world of oscillator readings with such tools as stochastics

or the relative strength index. Simply, the idea with those tools is that

with a bullish trend, one should see rising oscillator readings. When that

doesnt occur, a divergence occurs, and that is an important red ag

warning signal that trend could be about to change. Example? if a price

made a new high in an uptrend, but stochastics failed to make a new

oscillator high and actually turned lower. That would represent a bearish

divergence.

Take that concept and apply the same principle to volume. For ex-

ample, in a bull trend, does a stock or a commodity price hit a new high

for the rally move, but declining volume is seen for that session? Red

ag time.

BlOw-Off AND ClIMAxNow for the exciting stuff: blow-offs and climaxes. Blow-offs tend to

occur at major market peaks, while climaxes emerge at market bottoms.

These terms simply reect a huge amount of volume that emerges late

in a market rally (or decline) with a sudden peak. Prices then abruptly

reverse.

Volume tells me where the action is. It shows me the collective psy-

chology of the participants if they are fearful or overly optimistic, says

Shannon. However, its tough to say what a climax or blow-off is until

after it is over.

CONfIRM pATTeRN BReAkOuTSAnother use of volume analysis is to incorporate volume readings

along with pattern breakouts. For those schooled in traditional pattern

analysis, volume can be a helpful conrming indicator for double bottom

or top, ag, triangle or any type of pattern breakout. How does it work?

Jordan Kotick, global head of technical analysis at Barclays Capital says

that for him, Volume shows conviction. Is there conviction in a move?

Combining a price breakout with a volume conrmation simply helps

a trader to see if there is conviction behind that price breakout. Lets

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say that corn futures have been in a

downtrend. But because markets dont

ever simply go straight up or down,

the bear trend takes a pause, prices

consolidate for several weeks, and a

continuation triangle develops on the

daily chart. Then one day, traders wake

up and corn breaks out to the down-

side of that triangle, blasting below the

lower triangle line at the nal bell. On

that day, traders could look for a high-

volume day, a large and long volume

bar, relative to the recent sessions. A

high-volume day would be viewed as

conrmation to the downside break-

out of that pattern.

DRIll A lITTle DeepeRFor those wanting to take volume

analysis to the next step, traders could

study what is called upside volume,

versus downside volume, when analyzing the major U.S. stock averages.

Just as it sounds, the upside/downside ratio simply reveals the relation-

ship between the total volume of advancing shares, versus the total

volume of declining issues.

ON BAlANCe vOluMe

There are a variety of tools and ratios based on volume, but one of the

early volume indicators, developed by Joe Granville in the early 1960s, isknown as OBV. This tool can help traders avoid the subjective nature of

eyeballing those volume bars streaming across the bottom of the chart.

(Is that one slightly bigger or smaller?) The OBV indicator turns the

volume data into a line graph, which can be displayed across the bottom

of ones chart. Traders actually can draw trendlines on the OBV indicator

just like a price chart. When the OBV turns and breaks that trendline, it

can signal a potential turning point in price. It also can be used like an

oscillator to help pinpoint divergences between price highs and volume

peaks or price lows and volume troughs.

If price is moving up, OBV should be moving up, too, explains Mur-

phy. He also notes that OBV could actually be a leading indicator. OBVcan break out before the stock does, Murphy says.

The calculation behind the OBV is extremely easy to understand even

for those who are as math-challenged as this author. The total volume

for a session is given a plus or minus value depending on whether

prices closed higher or lower that day. A higher close would result in

the volume to be counted as a plus, while a lower close would result in

a minus value. Thus, a running total is achieved by simply adding or

subtracting volume depending on direction of the market close.

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For those who are just beginning to use volume as part of their anal-

ysis and trading, Granville advises students to pick a stock, prefer-

ably a well-known stock. Follow it every day in the newspaper. Keep a

running total of volume. If it closes up, add all the volume of the stock

traded that day. If it closes down, subtract the volume of that day from

the previous figure. Youll see a running commentary on the action

of the stock. Youll see the evidence that volume precedes the price

trend.

equIvOluMe ChARTS

Volume analysis has spawned a range of indicators and even a new

type of charting technique, called equivolume bars. This type of chart

actually combines price and volume into one bar or box. For those

familiar with Japanese candlestick charts, the concept is somewhat

similar. Basically, the top of the equivolume box represents the days

price high, while the low is seen at the bottom of the box. The width

of the box represents the days volume. The wider the box, the heavier

the volume during that session. By just glancing at the bars, you can

tell which days have heavier volume, explains Murphy.

ADD OpeN INTeReST TO The MIx

Traditionally, some technical analysts have combined volume with the

study of open interest, which simply refers to the number of outstand-

ing contracts still open at the end of the trading day in the futures

markets. With the advent of 24-hour markets and the rise in popular-

ity of foreign exchange trading among individual traders, the study of

open interest appears to have waned somewhat. But for those wanting

to understand the basic rules of thumb, they still apply.

Traditional Open Interest and Volume Guidelines:

If prices are rising and volume and open interest are increasing, it

represents a strong market;

If prices are rising while volume and open interest are falling, it

reveals a weakening market;

If prices are falling while volume and open interest are increasing,

it represents a weak market;

If prices are falling while volume and open interest are falling, it

represents a strong market.

DONT MAke ThIS MISTAkeAccording to Marketwises Shannon, one of the biggest misuses of vol-

ume is an interpretation when a stock is declining. Lets say a trader

is long a stock and price begins to pull back. People convince them-

selves to hold on because it [the pullback] is on light volume, Shan-

non says. But that may not be the best way to manage a trade. Would

you rather lose ten percent of your money on light volume or big

volume? asks Shannon. He instead advises traders to exit a position

based on price action.

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Another common mistake is that many traders could point to a heavy

volume day and be convinced that it is a climax or blow-off day. Most

people end up misreading big volume, says Shannon. Just because it is

the biggest volume in three days, doesnt mean the move is over. Volume

could be even bigger the next day.

TIMING IS eveRyThING

Typically, trading in the stock market (and the futures on the major stock

indexes) sees the heaviest volume during the rst hour-and-a-half of

the day and then the last hour-and-a-half of the day. Traders can use this

generality to help them in their intraday trading. The midday doldrums

occur because institutional traders are waiting you out, warns Shan-

non. Often times, major institutional players will execute large portions

of orders in the morning, and then wait for heavy volume and renewed

trending action late in the day to nish orders.

This can be helpful information for those who are trading very short

term on an intraday basis. If you are a hyperactive trader and have to

take your prots, take them during the rst move in the morning, says

Shannon. There may be another opportunity during the second late-day

wave of action. Otherwise a trader who bought, say, the S&P E-mini early

in the day and saw some prots in that trade, may slowly watch that prot

erode during the lunchtime doldrums, as prices simply tick slowly lower.

For those who get spooked on pullbacks or dont have the patience to wait

for the afternoon move, it may be wise to simply book the prots early on.

ClOSING ThOuGhTS

Here are a few more tidbits on incorporating volume into your trading and

analysis.

Use volume simply as a screening tool. For those who are scanningthousands of stocks looking for a good trading opportunity, volume can

help distinguish between those that are in an uptrend or downtrend (de-

pending on whether one is looking for long or short trades). How? Those

stocks with the best volume prole or pattern can help weed out the

stocks most likely to continue with that trend.

Barclays Kotick closes with another tip for beginning volume followers.

Its not the level of volume that is key, it is the trend of volume. Look at it

over a range of time. One day of volume cant be viewed in a vacuum. Vol-

ume analysis is most useful when compared to previous sessions. Some

like to say volume is simply a reection of supply and demand. A high-

volume day simply reects more demand in the marketplace. But overall,traders and analysts note that volume should be used as a conrming

indicator. Most still agree that price remains the most important factor to

consider while trading. Volume may offer up warning signals, red ags or

generate trading ideas. But use it as a supplementary tool.

If youve havent incorporated volume readings or analysis into your

trading, it may be worth exploring. Volume is very useful and impor-

tant. You cant do good technical analysis without looking at volume,

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