|
Tools for every
trader’s toolbox
By Jim Wyckoff
Most successful
veteran futures traders agree that sound money management is more
important than methodology when it comes to trading. In other words,
a trading method cannot produce sustained profits without applying
sound money management principles.
Nevertheless, many
traders, especially those with little experience or those with
experience and little success, keep searching for specific trading
methods used by successful traders. And with good reason. While
money management is the key to real trading success, you still need
to start with a reliable approach to analyzing the markets.
Here are some most
important tools needed for a comprehensive approach to market
analysis and trading. Remember, the primary trading tools are solid
technical or fundamental analysis – or preferably both – but these
tools can be helpful to have around for traders who are looking for
ways to continue their education and sharpen their trading
methodology.
Spotting the
trend
No matter how many tools you have, you will find most success
trading in the direction of the trend. One accurate definition of a
trend might be that it’s something you know when you see it on a
chart in hindsight. It is not always easy to recognize a trend in
its formative stages. Identifying a trend early and then having the
perseverance to stick with it as prices move up or down a trend-
line is critical for successful trading.
Where you place a
trendline depends on your methodology – there really are no hard and
fast rules. Like much of technical analysis, drawing trendlines is
more art than science.
However, one
reliable rule for the violation of trendlines is that prices must
penetrate the trendline resistance or support level and then
demonstrate follow-through strength or weakness during the next
trading session (see “When it’s not broken…” right). However, if
prices make a big push above or below a trendline, then that
trendline is violated without needing follow-through confirmation.
WHEN IT’S NOT BROKEN…
Often, when a trendline is broken, a new, equally
significant trend can take it’s place.
|
 |
| Source:
TraderTech.com |
Collapse in
volatility
A collapse in market price volatility occurs when trading ranges
(price bars) suddenly get smaller (bars can be daily, hourly or
minute). There should be at least three smaller price bars in a row,
but they do not necessarily need to get progressively smaller with
each bar.
This collapse in
volatility usually sets off a significantly bigger price move,
either up or down (see “Playing with ranges,” right). There
generally is no relationship between the number of bars and the
strength of the subsequent move. In other words, more smaller price
bars on the chart does not necessarily indicate a larger breakout.
There is no set
number of bars that will set off the bigger price move. It could be
three bars, or it could be 10 bars or more before the bigger price
action is set off.
Outside days
Outside days or bars for, say, hourly or weekly breakdowns,
occur when the last price bar is bigger than the previous bar on the
chart.
If the close (last
trade of the bar's time frame) is higher than the previous bar's
last trade, then that is considered a bullish "outside day" up move.
A bearish outside day down move occurs when the close of the bar is
lower than the previous bar's close or last trade.
Subsequent price
action is expected to move, generally, in the direction of that
indicated by the outside day.
Inside days
Inside days occur when the most recent price bar range is smaller
than that of the previous bar. The trading range is smaller and
inside the previous bar's trading range.
Inside days signal
that the market is taking a break after a busy period. Inside days
also can be a sign a collapse in volatility may be setting up and
that yet another bigger price move could be on the horizon.
After a big price
bar and busy trading day, the next session is often an inside rest
day.
PLAYING WITH RANGES
Here, we can see how a bullish outside day marked
the beginning of a new price move, and how the market
busted high after a series of smaller range days.
|
 |
| Source:
TraderTech.com |
Key reversals
Because they signal a potential market top or bottom, key reversals
are important chart signals that occur less frequently than most
others in this feature. A key reversal occurs when a
new-for-the-move high or low occurs and then during that same day
(or trading bar), the price sharply reverses direction to form an
outside day up or down move. These are called bullish or bearish
“engulfing patterns” on candlestick charts.
Some analysts call
this one-bar pattern alone a key reversal. But for more
significance, a key reversal must be confirmed by follow-through
strength or weakness the next trading session (or trading bar).
Follow-through greatly helps eliminate false signals and makes a
market prove itself after a bigger move.
Exhaustion tails
Exhaustion tails occur when either buying or selling apparently is
exhausted after prices make a fresh high or low for that move and
that creates a bigger price bar on the chart. Then prices reverse
course to close at the other extreme of the bar's earlier move (see
“Mercy!” page 44). Thus, you get the bigger bar that creates a tail
(or shadow in candlestick lingo).
These tails are
important guideposts because they show price levels that traders do
not want to pursue and become an important resistance or support
level on the chart.
MERCY!
Sometimes, the market will tell you when it has had
enough – that’s the message exhaustion tails give.
|
 |
Closing prices
Most traders agree that the most important price of the trading
session is not the open, high or low but the closing or settlement
price. This is true for markets with set opens and closes as
opposed to 24-hour markets, though some forex traders rely on the
old New York closing time (4p.m. EST) as a technical input.
After an entire
session of buyers and sellers doing business, the price at the close
could be called the “right” value that the market decided on for
that day. Some technicians don’t consider a breach above or below
an important support resistance level a violation of a trendline
unless it is maintained through a close.
Trading above or
below these price points during the session, only to pull back
before the close, doesn’t carry the same weight as a close beyond
those levels.
Also, if a market
closes near the session high or at the weekly high close, that's a
sign of market strength and suggests there will be at least some
follow-through strength in the next trading session (or price bar).
A close near the daily low or a weekly low close suggests market
weakness and follow-through selling that could occur in the next
trading session.
Gaps
Gaps on a chart appear when a price bar pushes well above or below
the previous bar to produce an area where no trading occurs on the
chart. The last bar's low is higher than the previous bar's high for
a gap-higher move. The last bar's high is lower than the previous
bar's low to form a gap-lower move.
As with closing
prices, traders in 24-hour markets won’t be able to use gaps as a
tool because gaps usually occur in markets that have a day session
and react to some overnight or after-hours development.
Price gaps indicate
a strong market move and many times serve as important support or
resistance levels on the chart (see “Gap in time,” left). They have
a number of names:
-
Breakaway gap:
occurs at the beginning of a move that reverses the previous
market action.
-
Measuring gap:
occurs at about the 50% mark of a projected move.
-
Exhaustion gap:
occurs at the end of a move and suggests traders are making one
last gasp to extend an existing trend.
Not all gaps have
such messages, but they can be an effective tool if you rely on
probabilities.
GAP
IN TIME
Sometimes gaps don’t tell you much. Other times,
they mark significant price moves. If you go with the
probabilities, gaps usually won’t let you down.
|
 |
| Source:
TraderTech.com |
Contrary opinion
One of the best methods to trade a market traditionally has been to
jump on board when prices break out of a congestion or basing area
and begin a new trend. It is well known that one of the most risky
and least successful trading methods is trying to pick tops and
bottoms in markets. So, let’s muddy the waters just a bit.
Contrary opinion
goes counter the prevailing wisdom in the marketplace. This notion
of going against the grain of popular market opinion is difficult,
especially when there is a steady drumbeat of fundamental
information that seems to corroborate the popular opinion but
remember that many of the best traders are contrarians.
Consider this: A
market is most bullish when the highest high on the chart is scored;
it's downhill for prices from there. A market is most bearish when
the lowest low is reached. This suggests traders are most bullish at
market tops and most bearish at market bottoms! Because there is no
Holy Grail to trade markets and most traders lose money, you don’t
want to join them and should possibly do some contrary thinking.
A tracer should
never be swayed by the opinion of the masses. You should develop a
trading plan and stick with it throughout the trade. In other
words, don’t be swayed or influenced by the opinions of others in
the middle of a trade. Popular opinion many times is not the right
opinion when it comes to market direction.
Intermarket
analysis
Trading veterans know that markets are interdependent, with some
markets more heavily influenced by certain markets than others.
These patterns may
be hard to detect but can be found through a detailed study of
charts and the help of technology.
Based on changes in
the value of these comparisons from one trading session to the next,
some software develop leading indicators that forecast whether a
market will be choppy, maintain its trend or change trend direction.
Of course, you
still have to use your other trading tools to place trades, but
intermarket analysis adds another important tool to a trader's
toolbox and can augment an already good trading methodology.
All these tools can
aid you in becoming a better trader. However, as stated earlier,
the best methodology may be for naught without proper money
management. The basics of good money management will be covered in
future articles.
Jim Wyckoff is
the editor of the Trends in Futures market analysis and trading
advisory newsletter and is also a market analyst for
www.tradingeducation.com. |
