INDICATORS

By Kira Mccaffrey Brecht

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.

TRADING the

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INDICATORS

By Kira Mccaffrey Brecht Be Your Own Analyst:

Understand Fibonacci Retracements
Be Your Own Analyst: Understand Stochastics Be Your Own Analyst: Understand Moving Averages Be Your Own Analyst:
Understand Japanese Candlesticks
Be Your Own Analyst:Understanding Cycles Be Your Own Analyst: Understanding Volume 1 5 9

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this series cover the fundamentals of trading the indicators was originally published from March to august 2005. 2005, 2006, 2010. Sfo Magazine. all rights reserved.

TRADING the INDICATORS

Be Your Own Analyst:

Understand Fibonacci Retracements

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 the market 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 retracement 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 discovered from his years in the pit that a bull market often retreats halfway back and then rallies again. He didnt care what it was calledit worked!

hile Ive always studied and utilized Fibonacci retracement targets as part of screen-based analysis and trading, I remember well a story that a floor trader friend of mine at the Chicago

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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: Daily Mar NyBot coffee chart With fibonacci retracement

Source: futureSource

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 specific areas between price highs and price lows that potentially could be good spots to enter or exit a trade. Traders could trade with the existing trend or attempt to catch a counter-trend corrective move using Fibonacci retracements: you choose.

DONT SweAT The 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 offers 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 surprisingly, 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 efficacy of this strategy is picking the right points from which to draw the lines. The first criterion for using Fibonacci retracement targets is that there must be a well-defined 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 timeframes 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 first line is drawn. For an uptrend, draw the lines from the most important swing low to the most important swing high. See Figure 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 Fibonacci 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 first 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 developed 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 profits on longs). From those highs, traders can see that Mar coffee 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 renewed 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 manner. The first 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 began 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 first objective 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 downtrend). 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 first 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 confirmed 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 confirmation. This is an important theme within technical analysis and simply means that one should not look at one chart or indicator in a vacuum. For example, technical traders often will look for confirmation 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 significant price point for the market. Confirmation also refers to the concept of utilizing several different technical indicators in tandem. Lets say three of your favorite technical indicators all flash buy signals that confirmation increases the odds of a profitable 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 confirming technical indicators. A few that work well with Fibonacci numbers are stochastics, relative strength index and candlestick chart formations. The idea is if positive 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, calling them superstition or just plain old hoo-hah. Some even say they become a self-fulfilling prophecy. Make no mistake about it, though. They are widely used in the technical community, and that reason alone makes them important 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 ratios tend to appear randomly (or maybe not so randomly throughout nature) for example, in the number of petals on a flower and the number of spirals in a pinecone. So what does this have to do with the financial 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 floor trader friend said, he didnt care why it worked; he just observed that it did.
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TRADING the INDICATORS

Be Your Own Analyst:

Understand Stochastics

dozens of indicators now available with just the click of a finger, it could be useful 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 momentum begins to dry up, that is something traders need to know as well. Stochastics, an oscillator popularized by George Lane, president of Investment 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.

eginning technical traders are confronted with a dazzling array of indicators, chart types, wave counts and patterns. While it can be difficult for the novice trader to know how to sift and sort through the

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. Conversely, in downtrends, the closing price tends to be near the lower end of
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fIGuRe 1: Daily May Silver with Slow Stochastics and regular Stochastics

a bearish divergence on slow stochastics signaled the end of the bullish run in early December 2004.the regular stochastics indicator on the bottom of the chart reveals many more choppy and hard-to-decipher signals.
Source: futureSource

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. See Figure 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 five days. Did the stock close near the highs? Accumulation is identified 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 CyberTrader. Stochastics, like many other technical indicators, were developed originally 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 uSeS
Stochastics 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 traders 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 stochastics 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 overbought 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 overbought 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 critical error of failing to allow profits 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 confirming a continuation of the strong trend.

pROfIT fROM TReNDleSS CONDITIONS: SIDewAyS MARkeTS

For those looking to trade a well-defined range, stochastics may offer good insights for entry and exit points. When markets shift into a neutral trend, trading back and forth between a specific resistance and support 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 find 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 stochastics 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 waning momentum. Readings called bearish and bullish divergences will warn of impending tops and bottoms. See Figure 1 for an example of a bearish 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 confirm 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 confirming that price move (seen in the first circle). However, heres where stochastics can really help. For those trading May silver from the long side, a huge red warning flag emerged on the chart with the rally to the December 2 high at $8.280. That day did indeed 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 another 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 stochastics to be in overbought or oversold territory together, says Murphy.

CheCk lONGeR-TeRM ChARTS

For an additional layer of confirmation, 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 confirmed by a buy signal on the weekly stochastics, is a stronger indication than just one timeframe 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 difficult from which to ascertain signals. Many technicians recommend utilizing 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 find 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 find 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 futures arena, this tool can be applied to forex markets, individual stocks and exchange 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 confirmation with the RSI at major turning points, and also check out varying timeframes for another layer of confirmation. 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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TRADING the INDICATORS

Be Your Own Analyst:

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, how does 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 field of technical analysis, which includes some very subjective forms of looking at the market (such as pattern identification, Elliott wave counts, etc.), moving averages offer an objective manner to view price and trend. The first job of a technician is to identify trend, says Ralph Acampora, well-known technical guru and former head of technical research at Prudential. 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 definition, is a mathematical trend line.

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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 flip 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 averages 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 compute. 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 to determine 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 in their trading arsenals. The more one learns about technical analysis, 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 successful. 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-defined 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-defined price ceiling and price floor 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, according 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 fit in? They are not the answer within the crystal ball, but the big and widely watched moving averages do attract some media hype and perhaps, at least to some extent, can become a self-fulfilling 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 flashing 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 crossover system, its actually very simple. One could easily construct a moving-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 flashed when the closing price moves below the moving average. Many technical traders will rely on the crossover method as an attempt 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 of methodology. 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 January. 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 homework 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: Daily New york Board of trade May cocoa

the 10-day moving average is seen in green and the 20-day moving average in red.
Source: futureSource Xtra

floor-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 profitable, if proper discipline and money management techniques are firmly in place). In late March, as seen in Figure 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 profits erode. Despite this, however, 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 first 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 in a 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.

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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 example, 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, Buying on the first 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 defined 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 specified period). Traders also actually can define what percentage weighting to be given to the last days price. Many traders seem to use either the simple or the exponential, but its worth trying the various indicators to see which fits best for you. Personally, 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 fits 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 advanced 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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TRADING the INDICATORS

Be Your Own Analyst:

Understand Japanese Candlesticks

charting 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.

o the terms, dark cloud cover, gravestone doji or morning star sound like something out of a science fiction movie? To seasoned candle readers, these terms actually identify key candlestick

GeTTING STARTeD
The most basic tool of any technical trader is, of course, the chart, and one of the first decisions he or she must make is what type of chart to use the traditional bar chart, point and figure charts, the market profile graphic, line charts or Japanese candlestick charts. Each type of chart has its 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 Japanese 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 trading 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 major 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 terminology, 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 on the 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 find all the same high-low-close information that is found on a bar chart, but says Steve Nison, author, technician and president 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 formations. And traders can utilize candlesticks along with all of their favorite 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 completed 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 market, 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 common 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: Daily June crude oil candlestick chart

Source: futureSource Xtra

Greg Morris, author of Candlestick Charting Explained, says one of the initial insights that candlestick charts can offer a trader by simply looking 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 reflecting a strong uptrend.

MAjOR Buy AND Sell SIGNAlS

There are numerous candlestick formation and patterns that generally range from one-day signals to five-day patterns. Many of the important reversal signals tend to be three-day patterns. These reversal signals tend to 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 identifiable 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 engulfing patterns. For a bearish engulfing pattern, Nison says that on the first 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 engulfing pattern is a top reversal pattern that reflects overwhelming selling pressure seen as the long, black real body engulfs a small, white real body in an uptrend. See Figure 1 for an example. Point A reveals a bearish engulfing pattern, which quickly identified 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 patterns 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 shortterm. The hammer signaled a bottom and presaged a decent rally in crude oil futures. Point C in Figure 1 highlights a bearish 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, rallied 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 system. He is a proponent of combining candles with Western signals. Its like the right hand helping the left. If a group of signals are all say the same thing, the odds of a turn are higher, Nison says. Pointing 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 volume. Candles show the force behind a move. But I always look at volume 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 candlestick 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 popularity 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 oneline formation. Instead, use formations that are comprised of two or three candles together for more accurate signals. Or try very shortterm intraday candles in conjunction with major support or resistance 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 utilizes 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 determine 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 positions or to take profits 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 candlesticks 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 persons 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, concludes Ideaglobals Palmisano.
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TRADING the INDICATORS

Be Your Own Analyst:

Understanding Cycles

or 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 field of technical analysis focuses on price as the main indicator. Cycle advocates say that both long- and short-term repetitive patterns can be identified 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 definition, 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 reflected by 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 definitions or counts are from market bottom to market bottom. Many cycle analysts point to J.M. Hurst, author of The Profit 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: Monthly Dow Jones industrial average chart

Source: futureSource Xtra

juST TAke A lOOk

Take 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 ample 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 find 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 influences practically all stock and commodity prices. However, his theory proved controversial both then and now, and many economists and traders have discredited Kondratieffs 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-fashioned. 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, however, 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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Most cycle advocates say that this type of analysis offers them a backdrop or framework for looking at a market. Cycle signals are not a stand-alone tool.

printed out daily price data going back at least a year. For those looking to find 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 significant lows. Count forward to find out where the next significant low is, and over time you may have enough observations to define a cycle. Ring agrees. I just start with a low. I count forward and backward, and just see if I start picking 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 find a simplistic way to get a feel for when we can get some sort of turnaround, Zukowski explains.

uSING CyCleS IN yOuR TRADING

Most cycle advocates say that this type of analysis offers them a backdrop or framework for looking at a market. Cycle signals are not a standalone 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 sparingly 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 mid May.) 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 find 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
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that a low may be on the way. Then, once they see confirmation of this low via their other favored technical indicators, they can be more confident 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 oscillators 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 looking 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 difficult 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 psychologically 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 methodologies, too. Most discretionary traders develop a number of favorite analytical and technical tools upon which they rely. When the majority 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 cycle in 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 ignore. 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 fouryear 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 analysts note that this is allowable.

ITS NOT exACT

In Rings cycle work, he allows for cycle bottoms to form plus or minus five 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, readers 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 most variations 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 shorterterm 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 the same 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.

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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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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 difficult 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 19822000),

saw an unbelievable 18 consecutive years in which the low for the year was above the previous 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 together. 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 least one to two years, you have specific cycles that arent going to add anything 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 bull markets 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 long25 > >

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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 severe 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 benefit 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 identifiable patterns. It is human nature to always chase what is hot at the time, notes Ring. Cycles reflect the need of a market to constantly purge the excess pessimism 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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TRADING the INDICATORS

Be Your Own Analyst:

Understanding Volume

any 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 blue or red line at the bottom of ones chart. But volume is a completely different 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 significant 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 first law of motion reflects the concept underlying volume analysis in the financial 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 confirm 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 confirm 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 find 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 bullishness. 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 resistance, 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 trading and analysis. He says volume is second only to price. Price is what pays, and volume lets us know about the emotional condition of the buyers and sellers. Shannon highlights a couple of his favorite reflections 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 first day, a million the second day and a million-five the third day. Price pullbacks should see successively lower volume, such as 900,000, 600,000 then 450,000" to reflect 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 traders 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 opportunity for a trend move.

DIveRGeNCe
Themes that come up over and over again in the field of technical analysis are the concepts of confirmation 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 flag 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 example, 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 flag time.

BlOw-Off AND ClIMAx

Now 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 reflect 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 psychology 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 BReAkOuTS

Another 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 confirming indicator for double bottom or top, flag, 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 confirmation 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 downside of that triangle, blasting below the lower triangle line at the final bell. On that day, traders could look for a highvolume day, a large and long volume bar, relative to the recent sessions. A high-volume day would be viewed as confirmation to the downside breakout of that pattern.

DRIll A lITTle DeepeR

For 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 relationship 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, is known 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 Murphy. He also notes that OBV could actually be a leading indicator. OBV can 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 analysis and trading, Granville advises students to pick a stock, preferably 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 outstanding 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 popularity 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 MISTAke

According to Marketwises Shannon, one of the biggest misuses of volume is an interpretation when a stock is declining. Lets say a trader is long a stock and price begins to pull back. People convince themselves to hold on because it [the pullback] is on light volume, Shannon 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 first 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 Shannon. 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 finish 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 profits, take them during the first 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 profits in that trade, may slowly watch that profit 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 profits 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 scanning thousands of stocks looking for a good trading opportunity, volume can help distinguish between those that are in an uptrend or downtrend (depending on whether one is looking for long or short trades). How? Those stocks with the best volume profile 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. Volume analysis is most useful when compared to previous sessions. Some like to say volume is simply a reflection of supply and demand. A highvolume day simply reflects more demand in the marketplace. But overall, traders and analysts note that volume should be used as a confirming indicator. Most still agree that price remains the most important factor to consider while trading. Volume may offer up warning signals, red flags 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 important. You cant do good technical analysis without looking at volume, concludes Murphy.
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