An Active

Traders Primer
Your free trading guide to learn the secrets
of successful trading from the pros.
These selected trading education articles are key to making
more money in any market. Get your Active Traders Primer
today and start building your portfolio to greater profits.

Introduction
As anyone who makes all or part of his or her living
in the financial markets will tell you, making money
at it is like any other business it is dependent on
what you put into it.
Because we have been in the business of supporting
the active trader for more than 25 years, we know
that one of the earmarks of a successful trader is
the willingness to put time into education. Thats
why, in addition to providing market data and
professional decision support tools, we also offer
seminars and mentoring to help you get better at
what you do best.
In that spirit of continuous progress learning, we
offer this primer of selected trading education
articles in four categories of topics that matter to
those who want to make more money in the market
an introduction to the markets, characteristics of
a successful trader, technical analysis techniques,
money management and the psychology of trading.

To quote one of the articles authors on the

recipe for success:
You need:
A reliable data provider

A reliable execution service at a rate that

suits you

An understanding of how your competition operates in the markets you wish to trade
A methodology that allows you to approach
trading from a winners perspective
An understanding of the shortcomings of
any method you are using

Discover the data and software package preferred

by thousands of active traders like you by visiting
our website (http://www.esignal.com/), or see what
we offer in trading education at:
http://www.esignallearning.com/.
In the meantime, we hope you will find in this
selection of articles we offer with our compliments
information that can help you make better trades.

Contents
An Introduction to the Markets
Markets An Overview excerpted from the
eSignal Learning Foundation Course, unit 1
2 Behaviors That Differentiate a Successful
Traders Approach to the Markets
by Ron Wheeler
Trading Styles
Technical Trading
by Nick Sudbury
Mastering Momentum Trading Using Technical
Analysis
by Alan Farley
Technical Analysis Techniques
Analyzing and Anticipating Price Movements:
Two Approaches Not Necessarily Opposing
excerpted from the eSignal Learning Foundation
Course, unit 3
The Technical Analysis Toolbox excerpted from
the eSignal Learning Foundation Course, unit 4
The Psychology of Trading
Trading and Psychology
by Bennett McDowell
Only the Zeros Are Different: How Great Traders
Go Bad
by John A. Sarkett

An Introduction to the Markets

In the spirit of the title of this collection of essays,
these two articles are the kind of basic information
that can help someone new to trading understand
how the markets operate, what types of markets
he or she may want to get into, as well as the
techniques that can help the trader maximize profits
while minimizing risk.
Markets An Overview, an excerpt from the
eSignal Learning Foundation Course, unit 1, is an
excellent summary-level view of the markets you
can trade and a helpful roadmap.
2 Behaviors That Differentiate a Successful
Traders Approach to the Markets provides
an excellent perspective on how to determine
market behavior that reveals reasonably predictable
opportunities, as well as sound advice about money
management techniques that can help minimize
your risk when predictable turns the corner to
unpredictable.

Markets An Overview

As excerpted from the

eSignal Learning Foundation Course

Theres an old saying that if you dont know where

youre going, any road will get you there. To make
sure that you get on the road thats right for you,
this introduction to the markets provides you with
some guidance to help you identify where you want
to go in your financial future and how to map out
your journey to get there.
Depending on how much you already know, you
may be able to skim through this article quickly,
or you may need to take things a bit more slowly.
Either way, it provides a foundation on which to
build an understanding of the markets, a roadmap
for what types of markets you might want to trade.
A financial instrument is a legal document that
grants a right or gives formal expression to a
contractual relationship. Among the many different
types of financial instruments are stocks, bonds,
mutual funds, futures, options, and currencies.
4

A stock is a security that represents ownership in

a company. Stocks fall into two basic categories:
common stock and preferred stock.
There are two basic ways to make money through
buying stocks. One way is to collect dividends,
which are a portion of the companys profits that are
paid out to the shareholders. The other way is to sell
your shares for more than you paid for them.
The increase (or decrease) in the price of the
security since it was purchased, expressed as a
percentage, is the return. A stocks performance
typically is calculated in terms of a 12-month period
and expressed in a measurement called annual
return, or annualized return.
Stocks are often categorized and described in
different ways. They can be categorized by the size
of the company, or market capitalization, as largecap, mid-cap, small-cap, and microcap. In general,
small-cap stocks have tended to be riskier than
large-cap stocks but are also considered to offer
more potential for growth.
Stocks can be described according to their risk and
return potential, as growth stocks, income stocks,
blue chip stocks, and speculative stocks. Growth
stocks offer a potential for higher returns, but
generally with more volatility, and generally do not
offer dividend payments. Income stocks tend to be
less volatile and pay high dividends.
Blue chip stocks are companies that have
consistently exhibited steady growth and
profitability. Speculative stocks are high-risk
investments and tend to be very volatile.
Stocks can be described in relation to general
market activity. Cyclical stocks parallel the ups
and downs of the economy and the business cycles.
Defensive stocks are less affected by the vagaries of
the business cycle.
A bond is a debt instrument that pays interest over
a fixed term. Bonds are issued by corporations and
governments when they want to raise cash. Because
the interest rate and amount of each payment are
determined at the time the bond is offered, bonds
are often referred to as fixed-income investments.

There are several types of government bonds.

Municipal bonds (munis) are issued by cities or
sometimes state government agencies or local
political entities. The U.S. government issues
Treasury bonds, Treasury bills (T-bills), and
Treasury notes. All are considered very low risk
investments, backed by the full faith and credit of
the U.S. government, but their return is also low.
Investors trade bonds in the hope of selling them for
more than the purchase price, just as with stocks.
Bond prices have an inverse relationship to interest
rates: As interest rates rise, bond prices fall; and as
interest rates fall, bond prices rise.
Bonds are compared to one another in terms of
yield and rating. Bonds rated Baa or higher by
Moodys and BBB or higher by Standard and Poors
are considered investment-grade bonds. The lowestrated bonds tend to have the highest yields and are
known as high-yield bonds or junk bonds.
A mutual fund is an investment fund that manages
the money of a large number of investors who have
pooled their money together. Mutual funds can be
categorized according to the types of securities they
invest in: stock funds (equity funds), bond funds,
or money market funds. Some funds invest in more
than one type of security; for example, balanced
funds invest in both stocks and bonds.
There are also several different kinds of specialized
funds. Examples include international funds, global
funds, precious metals funds, and sector funds.
Mutual funds can also be categorized according to
their investment objective: current income, some
income and growth, or future growth.
Derivatives are financial instruments whose
prices derive from an underlying item, either a
commodity or a financial security. When you
trade in derivatives, you are not buying or selling
the underlying item; instead, you are trading in
contracts. Futures and options are considered
derivative investments.
A futures contract is an agreement to either buy or
sell a certain amount of a commodity at a specified
time at a particular price, called the exercise price.

The value of the contract is determined by open

auction on a futures exchange.
When you buy a futures contract, you are going
long, or taking a long position; when you sell, you
are going short, or taking a short position. Only
a very small percentage of futures contracts are
settled by delivery. Instead, traders offset (close out)
their position before the delivery date by entering
into an equal number of the same contracts on the
opposite side of the market.
An option is a right to buy or sell a certain quantity
of a financial product, called the underlying
security, at a specified price (the strike price), up to
a specified time (the expiration date). Underlying
securities can be stocks, bonds, stock or bond
indexes, or futures contracts.
Options that give you the right to buy are called
calls; options that give you the right to sell are
called puts. When you buy a call option, you are
expecting that the price of the security will go up.
When you buy a put option, you are expecting that
the price will go down.
Trading options costs less than trading the actual
securities. The price of trading the option is called
the premium. For conservative investors, options
can protect their portfolios against major drops
in stock prices, to lock in a favorable purchase
price, or even to acquire some immediate income.
For more aggressive investors, options provide
an opportunity to leverage their investment by
realizing a much larger gain than they could by
owning the underlying security.
Foreign exchange currency trading, also known
as Forex or FX, involves buying one countrys
currency while simultaneously selling another
countrys currency. A position in a currency is either
a bullish or bearish outlook versus other currencies.
If the outlook is bullish, a trader can profit by
purchasing that currency against other currencies.
However, if an outlook is bearish, a trader can profit
by selling that currency against other currencies.
The financial markets are places where investors
trade stocks, bonds, and other financial instruments.
5

Stock exchanges started out as centralized facilities

for trading. The first stock exchange organized in
the United States is the New York Stock Exchange
(NYSE). The NYSE is a traditional, floor-based
exchanged, as is the American Stock Exchange
(AMEX) and some smaller regional exchanges.
An electronic exchange is an advanced
computerized telecommunications network. The
best known electronic exchange is the NASDAQ.
Many newer and smaller company stocks arent
listed on a traditional exchange or the NASDAQ.
Instead, they are traded over-the-counter (OTC).
Electronic communications networks (ECNs)
collect, display, and execute orders electronically.
An index is a mathematical composite of a markets
activity at any given hour of any trading day.
Prominent indexes include the Dow Jones Industrial
Average (DJIA), which is calculated from 30 blue
chip stocks, and the S&P 500, which tracks 500
U.S. large-company (large-cap) stocks.

Over the course of these travels, I have spoken

with many fellow educators and speakers and
learned many things about the markets and trading
in general. Most of us while we may look at
different theories and patterns to find our trades
all believe, at least in part, that successful trading
comes about as a result of consistent application
of two essential behaviors:
1. Learning to identify predictable market
behavior
2. Applying good money management
techniques to your trading decisions

Securities prices move in response to supply and

demand, and prices rise and fall in recurring cycles.
A bull market is a time of prolonged rise in prices.
A bear market is a time of prolonged fall in prices.
A bear market in stocks usually results from a
widespread anticipation of declining economic
activity; a bear market in bonds is caused by rising
interest rates.

Lets start with that first one, identifying

predictable market behavior. I am a
big proponent of making sure that the word
predictable is thoroughly explained. First and
foremost, no market is 100% predictable. As I
mentioned earlier, in my travels, I have heard fellow
educators talk about the types of market behavior
they believe make the most sense to target for
potential trade setups.

Investor emotions also influence stock prices.

Greed and fear can cause investors to act too rashly.
However, knowledge and discipline can help you
avoid the traps of your emotions and help you make
money whether markets are high or low.

For example, I have heard that trading market tops

and bottoms is too unpredictable and should be
avoided. Yet, another educator says that trading
market tops and bottoms is where the most money
can be made.

2 Behaviors That Differentiate a

Successful Traders Approach to the
Markets
By Ron Wheeler, eSignal Learning

I have spent the better parts of the last 14 years

developing a unique perspective on trading and
especially the trading industry. As a member of
the Trading Education team at eSignal Learning,
6

Ive had the privilege and honor of traveling

around the United States and Europe educating
thousands of traders from small groups focused
on the advanced concepts of Gann and Elliott Wave
as used in the eSignal, Advanced GET Edition,
software to hundreds of people at larger trade
show events.

Some traders and educators like to avoid trend

breakouts; others make that a cornerstone of their
trades. Some traders believe that the trend may
not truly be your friend. New traders find that this
confusion of ideas leaves them feeling that they
dont know what to believe, and most importantly,
whom to believe.
Most of us in the trading education field truly have
your best interests in mind, and we want to help you
become successful in the market. Of course, as in

any field, there are a few unscrupulous people out

there, but, as you gain knowledge and experience,
you will be able to spot them.

tops and bottoms typically starts a very profitable

run in the market that makes up for the losses you
suffered trying to find them.

When it comes to my trading and the methods I

teach, I prefer to follow the market according to the
Elliott Wave theory for two important reasons. First
and most importantly, the model is mathematical
in nature because it is derived using the Fibonacci
number sequences and the ratios the sequences
provide.

Similarly, trend breakouts are low probability but

provide a higher return on profits once the trend
starts. To me, trading with the trend is the easiest
type of trading you can do and has the highest
degree of accuracy. Of course, you pay for this
greater degree of accuracy by having the smallest
amount of profits available. I find that the trend is
most definitely my friend because the Elliott Wave
cycle tells me when the trend is complete, and its
time to go the other way.

Second, the models we teach with the Advanced

GET system have verified everything of value I
have learned from my fellow traders and lectures
over the years. For example, I spoke of hearing
that trading at market tops and bottoms can be
unpredictable. Its true; it is one of the hardest
trades to master and has the highest probability for
error in our systems. On the other hand, finding the

At the core of Elliott Wave theory is the belief

that market trends last for 5 cycles or waves. At
the completion of the 5-wave pattern, the market
typically ends the trend, and we see a correction or a
complete change in trend. The cycles themselves are

defined by Fibonacci ratios. So, Wave 2 is typically

a 68.1% retracement of Wave 1, Wave 3 is a 162to-262% extension of Wave 1, Wave 4 is typically a
25-to-68.1% retracement of Wave 3, and Wave 5 is
typically a 68.1-to-100% extension of Waves 1-2-3.
(See the accompanying chart for an example.)
This is what I mean when I say predictable. I am
looking for a repeatable sequence of chart patterns.
As the pattern or trend grows, it becomes more
predictable because the market is following the
Fibonacci sequence throughout the move. For this
reason, the midpoints of Wave 3s and the ending
points of Wave 4s are the most predictable patterns
I look for in trading, and they form the core of two
of our Advanced GET strategies the eXpert Trend
Locator (XTL) Breakout and the Elliott Type I
Trade.
On the second chart, I have an example of this
behavior on the 5-Minute British Pound. The Wave
5 low indicates that the down trend is complete, and
the market is ready for a reversal; this is also our
Elliott Type II Trade. You can try to buy into the
market at the end of the Wave 5 (higher risk) or wait
until the new trend is confirmed (lower risk).
In that second chart, we also see a new rally that
stalls at the previous Wave 4 and starts a small
profit-taking decline. If this small decline can hold a
61.8% retracement, re-rally and break the previous
high, you have the potential for a Wave 3 rally.
Essentially, you are seeing the development of the
Waves 1 and 2 forming. The blue bars in Advanced
GET are our XTL study, and a second blue bar also
confirms the trend breakout.
We would take profits at the projected targets
of Wave 3, but, because the market is not 100%
predictable, we use a trailing stop to protect us
in the event of a pattern failure. Once we fall
below the Regression Trend Channel, we take the
remainder of the position off and await our next
move.
In addition, the black bars, as defined by the XTL
study, indicate a neutral or non-trending bar and
can be confirmation that the Wave 3 is complete. At
this point, the market is ready for the 25-to-61.8%
8

retracement of the Elliott Wave 4. Its important to

note that I am not looking for everything to trade
to these levels to the tick; its a range, and, if the
market starts moving in another direction before
these levels are hit, my money management will
protect me.
The market has now moved into Wave 4 and hit
our projected levels of retracement. As we cross the
Regression Trend Channels, the Wave 5 is assumed
to have begun, and we enter into the market at the
cross of the channels. Our stop would be placed
immediately below (a few pips) the current Wave
4. I prefer to use Gann Levels to predict the top of
Wave 5 instead of the Fibonacci levels because,
over time, they have proved to be more reliable for
this sequence than the Fibonacci levels.
In Advanced GET, the Make-or-Break (MOB) tool
uses principles of Gann to find the Wave 5 target.
Of course, the more experienced trader can use a
Gann Box as well.
Our target has been hit, and its time to exit the
trade and prepare for a correction or a major trend
reversal.
In this article featuring the British Pound, we have
seen an example of many of the kinds of patterns
that Elliott Wave can provide. While I want to
re-iterate that nothing is 100% predictable, these
patterns can help the trader find most of the key
areas of price movement and an opportunity to get
into and out of the trend at the most predictable
places.
Ultimately, traders have to find out for themselves
which trades fit their personality. Some traders
prefer to trade with a higher degree of accuracy
and like trading within the trend. Others have
a more aggressive style and prefer market tops
and bottoms. The market provides all of us
with different opportunities to buy and sell, and
understanding where those patterns are appearing is
the first step to becoming a successful trader.
That leads me into the second component of
successful trading, applying good money
management to your trading decisions.
9

As has been the theme throughout this article,

nothing in trading is 100% accurate, and the trader
must prepare for those times when the patterns
break down. Patterns can break down for a
multitude of reasons that range from world events to
company fundamentals news items. Some of these
can be anticipated, but none are 100% predictable.
In my trading, my money management follows
two simple rules. I never risk more than 1% of my
capital on any trade, and I make sure the trade has at
least a 1.6:1 reward-risk ratio.
I look at all trades as the same. I dont double
up because of multiple losses or have such good
feelings about this pattern that it makes me break
my rules. If I am wrong in my analysis, I admit it
and take a loss.
An example of what I mean is illustrated by Wave
4, which has multiple levels of support or resistance

10

and can occasionally give false signals of a

breakout. If I get trapped in a false breakout, and the
market has not yet hit my first profit targets before
reversing, I simply get stopped out.
As we can see in the following example chart, I
thought we had the proper entry for the new Wave
5, but the market had other ideas.
Because the market was still in the Wave 4 range,
and a Wave 5 was still projected, I re-entered
the market at the next breakout of the updated
Regression Trend Channels.
The reason we must exit the market when the first
breakout fails is because there is no guarantee
that the market will break out again. (Remember:
Nothing is 100% predictable.) If the market does
break out again, however, you must have the
confidence to re-enter the move. As you can see in
the chart shown above, if you had, you would have

been rewarded for your effort.

Finally, the last thing I verify is that the trade has
a 1.6:1 reward-risk ratio. This simply means that,
if I am risking 1 dollar on the trade, I expect a
1.60 profit. This can be done using the Fibonacci
ratios we talked about earlier or tools such as the
Advanced GET MOB tool.
In my trading, I prefer to use Gann Levels to locate
profit-taking levels. The reason we look to the 1.6:1
ratio is that, if you are trading at 50% accuracy and
keeping true to your reward-risk tolerances, you
can and will be profitable at that rate of accuracy.
Even if your accuracy were to dip (as it can during
the course of your career), profitability can still be
maintained.
It is important to remember that, if the trade at
the initial entry point does not fit the minimum
reward-risk ratio, you should not place the trade.

This means that, at the entry, you need to have

identi ed on your chart both the stop and the
pro t targets. Do not enter a trade until you know
where those two points are.
As you become adept at trading and learn the
different signals of trend reversals and early
warning signals of trade failures, you may notice
that your reward-risk ratio declines somewhat as
you learn to take profits early. This should not hurt
you because this is where your accuracy as a trader
will increase.
Even though, in my own trading, I have plans in
place to take profits before reaching 1.6:1, in the
event of a trade failure, I still verify that the trade
has the required distance before I enter the trade. In
other words, I am fully expecting to make my 1.6:1
target, but, if the market does not cooperate, I am
prepared to take less to avoid a loss and protect my
gains.
11

I am an advocate for developing processes to

manage my trading decisions. These processes
involve the creation of mechanical, set trading rules
that I do not deviate from. This helps me maintain
discipline in choosing and taking trades on a day-today basis.
I mentioned at the beginning that, while trading
educators may have different approaches to how we
trade the markets, one thing we all have in common
is the discipline to follow our patterns and avoid
taking unnecessary risk. As you advance in your
career, remember that successful trading revolves
around the two key behaviors I introduced at the
beginning of the article learning to identify
predictable market behavior and applying good
money management rules to the trades you take.
If you can master these behaviors, you too will be
on your way to becoming successful.

12

Trading Styles
Technical Trading
By Nick Sudbury*

Technical analysis is widely used to augment many

different trading philosophies, but in a broad sense,
can also be thought of as a trading style in its own
right.
Technical traders study price movements through
the use of charts. By identifying particular known
patterns, often in conjunction with technical
indicators, adherents believe it is possible to gauge
the prevailing market sentiment and, hence, gain
some insight into how the price is likely to change.
Popular Patterns
One of the best-known formations is the head
and shoulders, where a high (the left shoulder) is
followed by a higher high (the head) and then a
lower high forming the right shoulder. This pattern
often heralds a breakout from the neckline the
line linking the lows on either side of the head.
Another popular pattern to look for is a congestion
area, which is essentially a consolidation phase
following a move. The majority of these tend to
resolve themselves in the same direction as the
preceding trend.
Technical traders generally use indicators in
conjunction with the charts to help gauge the
strength and direction of the underlying price
movement. An indicator is solely designed to help
interpret the price movements; it is not in any way
intended to be a substitute.
Which Ones (and How Many) to Use?
Traders should not be misled by the precision and,
in some cases, the complexity of the formulae
used to calculate the indicators because the final
interpretation inevitably remains more of an art than
a science. One aspect of this is learning just which
of the hundreds of indicators to actually use.
The mere fact that there are so many indicators
reveals the truth of the matter, namely, that some
work better in certain circumstances than others.

Because there is no universally accepted view as to

which ones are the best, most traders evolve their
own short list of favorites that they become familiar
and confident with.
As tempting and as easy as the technical analysis
software makes it to keep adding extra indicators
to the charts, it is most certainly not a case of the
more the better. Few traders use more than two or
three in a single analysis because any more would
just be likely to confuse the issue.
The final selection is largely a question of personal
preference and experience, but most would
agree that it makes sense to pick indicators that
complement each other rather than those that
measure the same phenomena. For example, there
would be little point in using both Stochastics and
RSI because both measure momentum and have
overbought / oversold levels.
One of the most popular and intuitive indicators
is the moving average. This simply calculates the
average (usually closing) price of a security over
a specified period of time. Moving averages are
lagging indicators and are used to emphasize the
direction of the trend. For example, when a stock
moves below its moving average, it is a negative
trend and visa versa. Views differ as to the best
periods to use, but, for longer-term traders, the 50and 200- day moving averages are among the most
widely watched.
Combining Moving Averages and
the Relative Strength Index
A chart combining two moving averages provides
one of the most popular ways to identify a trading
signal. If the shorter (faster) moving average moves
above the longer (slower) moving average, this
represents a buy signal, while a sell signal is given
when it dips below.
The number of signals generated depends on the
length of the moving averages -- the shorter, the
greater the number of signals but the more that will
be false. Because of this, moving averages are best
used in conjunction with another indicator, such as
the popular Relative Strength Index (RSI).
13

The RSI compares the number of days that a stock

finishes higher against the number that it ends
lower. In value, it ranges from 0 to 100 with, in
general, a stock being considered overbought if it
reaches 70 a sign to consider selling. Similarly,
if a security approaches 30, it is usually regarded
as a buy signal. In a true bull or bear market,
these numbers tend to be changed to 80 and 20,
respectively.

In its purest form, volatility generates negative

feedback as price swings randomly back and forth.
However, if focused into a single direction, positive
feedback awakens and generates momentum into
strong price trending. Traders recognition of these
active-passive states will likely determine their ultimate success in market speculation.

Neophytes fall quickly under the spell of fastmoving markets. However, momentum is far more
The majority of analysts use a 9- to 15-day RSI. The difficult to trade than most participants admit. When
shorter the number of days used, the more volatile
an emotional crowd ignites sharp price movement,
the indicator but, also, the more susceptible it
greed clouds risk awareness. The anxious trader
becomes to big surges or falls in stocks dramatically then chases positions just behind the big volume,
affecting the RSI, potentially resulting in false buy
where odds of a reversal quickly increase.
or sell signals.
Obviously, the majority seek their profit through
The strength of the RSI as a complementary
momentum. But, most ultimately fail as this wicked
measure to the moving average can be seen from
beast devours equity. Those who survive commit
the chart of the Dow taken from Market Center.
themselves to mastering the diverse skills needed to
The index crossed above its 20-day moving average play this dangerous game.
on August 18th, indicating a positive trend. The
As traders gain experience, fresh dangers block the
Dow continued to rise, peaking at a high of 10,363
road to success. The swing of negative feedback
on September 7th. At this point, the nine-day RSI,
triggers many false alarms while real entry signals,
which is shown along the bottom of the chart,
streaming from multiple sources, remain unnoticed.
hit the overbought level of 70.409, heralding a
In the confusion, profitable trades are missed comsubsequent fall in the index back toward the lagging
pletely or entered just as the trend dies.
moving average indicator.
Either way, bad choices consume inexperienced
*Reprinted (and modified) with permission from Nick
trading dollars and the markets tally more losers.
Sudbury.
Nick Sudbury is a financial journalist who has worked both as
a fund manager and as a consultant to the industry. He has an
MBA and is also a chartered accountant.

Mastering Momentum Trading

Using Technical Analysis
By Alan Farley,
Editor / Publisher, Hard Right Edge*

Outside the Box

Markets must continuously digest new information.
Cyclic impulses of stability and instability gather
force through the pulse of this future discount
mechanism. Each small event shocks the common
knowledge, building a dynamic friction that dissipates through volatility-driven price movement.
14

Trade

Momentum

Swing

State

Positive Feedback

Negative Feedback

Basis

Demand

Supply

Impulse

Action

Reaction

Condition

Instability

Stability

Price Change

Directional

Flat-Line

Strategy
Chart

Purpose

Indicator

Reward
Trend

Thrust

Lagging

Risk

Range
Test

Leading

Like magnetic fields, polar forces drive market conditions.

Alternating cycles of activity and inactivity continuously fuel
the dynamics of price movement. Traders must recognize
current axis conditions before executing positions.

Winning
Momentum trading can be mastered. Three disciplines will break destructive habits and reprogram
trading for success:

Abandon the adrenaline rush. Forget the

excitement. Profit is dependent on detached and
disciplined execution.

Learn the numbers. The nature of price movement must be ingrained deeply enough to allow
spontaneous decision-making during the trading
day.
Cross-verify. Objective measurements must
filter unconscious bias.

Studying supply and demand on a scrolling ticker

or NASDAQ Market Depth display provides a
solid first step for understanding the inner workings
of rapid price movement. Combining this with an
understanding of time-of-day tendencies strengthens
awareness of profit and danger zones. And, understanding all the players proffers a needed edge on
the competition.
But, the study of technical analysis uncovers greater
secrets as insider deception and herd emotions are
exposed. Properly applied, patterns and indicators reduce the false entries associated with failure.
And, they invoke natural risk management. Technical analysis teaches traders when to painlessly
exit momentum positions and move on to the next
opportunity.
Action-Reaction Cycle

Prices rarely move in a straight line. As shocks

destabilize a market, a counter-force emerges to
restrain price back toward its stable state. After
each forward impulse, a backward reaction follows.
Burning the fuel of the crowds money, markets
seek equilibrium before proceeding with the next
impulse.
Traders fail to consider this phenomenon when they
enter their momentum trades. Simply put, both action and reaction must be considered in developing
appropriate entry-exit points. This requires more
complex planning than most anticipate. Successful
strategies often demand execution opposite to the
natural tendencies of the trader:

Entry on counter-trend reaction and exit on accelerating thrust

Entry on accelerating thrust and exit on subsequent reaction

Exit strategy can confuse trader logic more than entry. Effective risk management may require reversing the entry process entirely:

Exit on further reaction when counter-trend

entry fails

Exit on accelerating impulse when thrust entry

succeeds

Choosing the wrong action-reaction trigger will

produce frustrating results. Every trader knows the
pain of making a low-risk entry, riding a profitable
trend, then losing everything on a subsequent reaction. This experience can be avoided using technical
analysis to identify momentum signposts and locate
natural escape routes.
First Pullback
Buying the first pullback following a breakout
offers very high reward:risk. Inevitably, an impulsive crowd will be waiting to jump in on a second
chance. Use support and resistance or short-term
moving averages to identify your entry point.
(Day Traders: a 5-to 8-period SMA on a 5-minute
bar is highly effective.)

15

Identifying Momentum
Well chosen technical analysis tools signal awakening momentum and track subtle changes in strength
and duration. The power to identify these transforming conditions just prior to significant price movement is the key to profitable entry. All momentum
study falls into one of two broad categories:

Trend-following indicators gaze into the rear

view mirror and average price over defined time
series. They are most valuable early in a trend
for identifying momentum.
Trend-leading oscillators measure developing range and movement from price bar to price
bar. They provide valuable information late in a
trend by identifying turning points.

Effective analysis must investigate the nature of

momentum change. Physics teaches that an object
in motion tends to remain in motion. Profitable
entry-exit will capitalize on this universal tendency.
With most indicators, this requires combining snapshots of different period lengths in order to measure
momentum acceleration-deceleration.
Three types of technical tools provide complete resources needed to accomplish these complex tasks:

Line Tools visually illustrate rate of change and

action-reaction points:

Trendlines
Trendlines display average momentum. While a
line drawn under any two lows has limited value,
the addition of a third low creates order and a prediction point for future reversals. Combined with
other chart features, trendlines uncover dynamic
momentum information.

16

Price Channels
Channels predict order with only two distinct
trend lows. But, these must be matched by two
corresponding highs of the same slope. While
logic suggests that these formations rarely occur,
the opposite is true. They are easier to locate than
clean trendlines.

Arcs
Rounding formations are difficult to quantify. The
evolving slope may not maintain a constant rate of
change. This reduces its effectiveness for prediction. Use arcs as visual tools to estimate rounding
reversal bottoms and tops.

Fibonacci Ratios
One of the most powerful tools in technical analysis, Fibonacci remains poorly understood. This
proportional force of nature measures retracement and testing of trend impulses. For moves to
remain intact, the 62% level must provide support.

Averaging Tools combine and smooth data sets

into directional and acceleration forecasts:

Moving Average Crossovers

Simple crossovers mark key shifts in momentum.
They form the foundation of many complex trading strategies. But, watch out. This method has
severe limitations in sideways markets. During
negative feedback, moving averages will emit
continuous false signals.

Averaging Rainbows
Use of five or more color-coded moving averages
displays continuous data on evolving momentum
change. In addition to targeting price strength
within the rainbow bands, the lines themselves
draw complex patterns with superb predictive
capacity.

Moving Average ConvergenceDivergence (MACD)

Gerald Appels classic moving average interaction tool found new power when expressed as a
histogram. Momentum changes accurately track
the oscillating slopes. Create profitable entry-exit
rules with this rewarding tool.

17

Strength Tools measure rates of price and range

ascent-descent over different time frames:

Rate of Change
Directional price movement often hides within
the twists and turns of price bars. Rate of change
indicators filter visual data into actual price progression. ROC lines develop their own support
/ resistance, trendlines and patterns. Key pattern
breaks in advance of price can trigger important
convergence-divergence signals.

Relative Strength Index

Dont trade without this important tool. RSI measures the quality of price movement by comparing UP days with DOWN ones. Like ROC, RSI
creates patterns that respond more quickly than
price change. Use overbought and oversold levels
to close positions and prepare reversal strategies.

Stochastics
Stochastics accurately measure short-term shifts
in price momentum. But, once this indicator
pierces the extremes of its wide bands, useful
information ceases. As trend takes over, it wobbles randomly until conditions change. As lines
move back into the center zone, measure strength
through double top/bottom formations.

Bar Range Analysis

Short-term traders should closely examine small
price bar formations. Narrow and wide range bars
signal measurable change within the crowd and
impending price movement. One classic pattern is
NR7, the narrowest range bar of the last 7. These
predict breakouts that can be safely traded in the
direction of the first impulse.

Trendlines
Trendlines join three or more reaction lows or highs
into a straight line. This core element of technical
analysis has many applications beyond its well18

known uses. Standing alone though, trendlines

contain limited information regarding momentum
shifts.
The indicator plots average momentum for the trend
being studied and nothing else. The rate of price
change up or down the line always remains constant. Trendlines will provide significant momentum
change feedback when compared with other chart
data. As constant ROC indicators, these straight
lines will measure convergence-divergence against
any other price inputs.
Trend Relativity
The relationship between trendlines and other
chart properties shifts relative to the time frame of
each element. The trader must properly tune time
to explore different aspects of momentum. Make
certain the time inputs match the holding period
for the intended execution. When day trading, for
example, the plot of a 6-month trendline has no
meaning unless price touches it that day. But, the
return of a 5-minute candlestick to a 3-hour trendline will pinpoint an excellent entry zone.
Three common chart features will measure momentum change when combined with trendlines:

Other trendline(s)
Moving averages

Price bars or candlesticks

When one or more of these elements accelerates

away from the studied line, momentum is increasing
as it diverges. Conversely, as these indicators roll
over to point back home, signals flash converging
deceleration. Combining all of these features into
a single momentum system will produce powerful
trading signals.
Moving Averages
Moving averages contain more immediate feedback
on momentum change than trendlines but are burdened by one severe limitation. Their computation
forces useful data to lag current events. By the time
a simple 20-bar average curves upward to reflect ac-

celerating price, the move has already matured and

may even be over. While exponential calculations
(EMAs) and other smoothing adjustments speed
up signals, action bells ring way too late for most
momentum entries.
Using multiple moving averages overcomes this
time drawback and provides timely feedback on
momentum change. The simplest tool for this study
is the Moving Average Crossover. Two averages
are chosen based on different time frames and their
convergence is tracked. Signals are generated when
the short average crosses above or below the longer
one. The challenge with crossovers is finding the
time sequence that elicits the most profitable information about the studied market. Also, filters must
be built to ignore crossovers in choppy conditions
when moving averages give false signals.
An effective technique for studying momentum
change is the MACD Histogram, popularized by Dr.
Alexander Elder in his book Trading for a Living.
Using 12- and 26-period moving averages smoothed
by 9 periods, MACD creates a visual momentum
ladder. As MACD rises, momentum increases. A
zero line pinpoints the center balance zone. Positive acceleration flags as columns thrust above this
point. Likewise, down steps below the line signal
negative acceleration.
Moving Average Rainbows provide multi-time
frame, multi-dimensional views of shifting momentum. Rainbows combine 5 to 8 averages, colorcoded by the users software program. Identifiable
patterns develop between the averages, allowing for
sophisticated analysis of impending acceleration
and deceleration. Like spreading fingers, rainbow
averages respond incrementally to advancing trends
and provide targeted entry-exit points.
Strength Indicators
Analysis of a closing bars contribution to recent
price action creates a variety of strength indicators.
These important tools range from simple comparisons with prior values to complex pattern analysis
based on expansion and contraction of high-low bar
lengths. Their common theme identifies the momentum pulse in the relative strength of closing price.
19

While endless techniques accomplish this same

task, several contain all the horsepower needed to
beat the momentum monster.
Price Rate of Change offers an elementary computation for tracking momentum. Price bar patterns
often hide developing directional movement. ROC
compares current price with the value x periods ago
and plots it below the bar chart on a line graph. As
momentum escalates, ROC often curves upward
ahead of a breakout. And, this versatile indicator
works just as well signaling impending breakdowns
and plunges.
Stochastics and RSI are well known for targeting
overbought-oversold zones in constricted ranges.
These popular oscillators also have tremendous
value in charting momentum. Plotting their values
on a chart reveals pattern characteristics similar to
price bar ascent and descent.
These tools differ from price due to the extreme
zones they cannot pass. In theory, price can go upward to infinity. Oscillators can go no further than
0% or 100% before turning back. But, as their directional movement follows price swings, patterns of
acceleration-deceleration quickly reveal themselves.
Futures markets have used range bar analysis for
years. A classic on the subject, Toby Crabels Day
Trading with Short Term Price Patterns and Opening Range Breakouts, investigates how expanding
candle and bar patterns characterize momentum
in many commodities and indices. The emotional
crowd provides fuel as bar range stretches in the direction of the prevailing trend. Finally, a climax bar
prints a sharp reversal under surging volume.
Computation indicators (such as stochastics) measure bar range indirectly. By going straight to the
bars themselves, visual analysis yields profitable
short-term prediction. However, not all markets
can be accurately examined through range changes.
Low volume stocks, for example, carry high spreads
that will distort signals. Limit bar analysis to highly
liquid markets with low spreads and high average
daily movement.

20

The Momentum Pulse

Momentum generates force as increasing volatility resolves itself into directional movement. This
dynamic trending state invokes a measurable shift
from negative to positive feedback. While subsequent thrusts may appear chaotic, price movement
contains many cyclical features. Pulses will often
be proportional in time duration and length. This
tendency allows traders to calculate reward:risk
through measured move analysis. As an added
benefit, these expected reversal points can also be
watched for profitable swing entries.
Markets inhale and exhale. Each burst of market excitement alternates with extended periods of relative
inactivity. Prices trend only 10% to 20% of the time.
The balance is spent absorbing instability created
from a momentum thrust. The interface between the
end of an inactive period and the start of the next
surge often hosts a quiet neutral point. Paradoxically, this Empty Zone will ignite well-tuned entry
signals.
Prior to beginning each new breath, the body experiences a moment of silence as the last exhalation
completes. The markets regenerate momentum in a
similar manner. The Empty Zone emerges as the return to stability concludes. Because instability alone
will change that condition, volatility then sparks a
new action cycle.
Cross-Verification
Momentum change indicators work best when
combined with other technical tools. This process of
cross-verification searches for repeated confirmation
of any signal through other methods of technical
analysis. But, watch out. Many indicators are built
on top of better-known calculations. Accidentally
using one of these derivative measurements carries
substantial risk. It will automatically confirm your
findings just by recalculating a tool already used
and give false confidence to the trade.
Verify technical conditions using dissimilar forms
of analysis. For example, after seeing momentum
surge on stochastics, try duplicating that observation
using a line tool. Or, when multiple moving averages suggest an impending thrust, analyze the recent

short-term price bars to locate narrow-range days.

Fibonacci ratios offer the most powerful form of
cross-verification in all of technical analysis. Price
impulses faithfully retrace similar percentages of a
completed move before finally reversing or continuing the prevailing trend. Examining the price action
near these support / resistance zones will identify
significant bounce reversal opportunities when other
indicators offer support.

Finally, consider the real nature of your trading

account size and leverage. The well-greased competition can overcome transaction costs by moving
large blocks. Balance the leverage of your account
against the costs of taking positions. And, use drawdowns as a signal to lighten up and slow down.
*Reprinted (and modified) with permission from Alan Farley.

Using Fibonacci requires only a calculator or Fib

Line Grid (available with most charting analysis
software). Hidden support / resistance exist at 38,
50 and 62% of the prior trend. Price will often
bounce like a pool ball back and forth across this
marvel of mathematics.
Exit
Traders fail when they dont manage their losses.
The lure of the big gain disables unbiased evaluation. Danger increases significantly when trading in
a high momentum environment. The wide swings
ensure price will move through a 10 to 40% range
in a very short time frame. While position traders
can consider well-placed stops, many short-term
and day trading vehicles dont allow limit management.
Positions should never be entered without anticipating an appropriate escape route. Winning is a tough
game. Each trader must compete against all other
participants and take their money. And, exchange
rules always favor market insiders highly skilled in
shaking small players out of their positions. To find
an edge, remote traders must replace mechanical
self-control (stops) with strong mental discipline.
Use technical analysis and drill key price swing
numbers of favored markets into memory. Target an
acceptable tick loss average. If the average tick gain
isnt larger, the winning percentage will need to be
well above 70% to turn acceptable profits. Improve
results by getting your loss average down before
considering how to let your profits run further. And,
keep current, accurate records. Relying on memory
to determine results allows the mind to play cruel
tricks.
21

Technical Analysis Techniques

Because you conduct your trading as a business,
you are aware of the importance analysis plays in it
just as it does in any successful venture. Let these
two excerpts from the Foundations course manual
used by the trader-instructors of eSignal Learning
give you a glimpse into the world of analysis
as it relates to the components of the markets
movements and how it informs your trade decisions.
Analyzing and Anticipating Price Movements:
Two Approaches Not Necessarily Opposing
excerpted from the eSignal Learning Foundation
Course, unit 3, compares the two basic types of
analysis fundamental and technical not so much
from an either-or perspective, but an and point
of view that allows for combining the best of both.
The Technical Analysis Toolbox excerpted
from the eSignal Learning Foundation Course,
unit 4, provides an overview of some of the
moving parts involved in the market data fed to
the charts you use to analyze the markets. It gives
you something of a Cliff Notes for both the
picture part of the charts (patterns) and the formulas
(math-based indicators) that can help you see how a
market youre following may be trending.

Analyzing and Anticipating Price

Movements: Two Approaches Not
Necessarily Opposing
As excerpted from the
eSignal Learning Foundation Course

Fundamental analysis and technical analysis are

two approaches that investors use to anticipate price
movements in the overall market and in individual
securities.
Fundamental analysts, or fundamentalists, believe
that factors or conditions within the overall
economy and within individual companies are
what drive prices. Fundamentalists concentrate
on macroeconomic factors and conditions, called
fundamentals, that cause market moves and changes
in stock prices, and they seek to identify key
indicators of the stocks real value.
22

Fundamentalists, in general, take a long-term view,

whereas technicians tend to look at short-term price
movements. However, the two approaches are not
necessarily incompatible. Many investors meet with
success by using both.
The central principle of technical analysis is that
prices are determined by factors or conditions
within the market itself. Technical analysts, also
called technicians, seek to identify patterns in prices
that they can use to predict future movement.
Fundamentals
Fundamental measures of valuing stocks include
earnings per share (EPS), price-earnings (P-E) ratio,
book value (shareholders equity per share), priceto-book ratio, return on equity (ROE), price-sales
ratio, and revenue growth rate.
Most fundamentalists base their stock valuations
and predictions of price trends on earnings. A
companys earnings per share (EPS) are its net
income or profit divided by the number of shares of
stock outstanding. Earnings are generally stated as
trailing earnings over the past 12 months.
The price-earnings ratio, or P-E ratio, is a stocks
current market price divided by its annual earnings.
The P-E ratio is not an absolute indicator of the
value of a stock; rather, it expresses the relationship
of a stocks price to its earnings.
Book value, also called shareholders equity per
share, is the companys net assets divided by the
number of shares of stock outstanding. In bull
markets, fundamentalists often look for companies
selling below book value.
A companys quick assets represent what the
company would be worth if it were liquidated
immediately. The relationship between a stocks
market share price and the companys quick asset
value per share is called the price-to-book ratio. A
price-to-book ratio less than 1 means that stock is
selling at a discount to the companys ready cash.
Return on equity (ROE) is calculated by dividing
a companys trailing earnings to its shareholders
equity (total assets minus total liabilities).

The price-sales ratio (PSR) is the current market

value of the company (current share price times
shares outstanding) divided by the revenues (sales)
over the previous 12 months. PSR is often used
to value new companies in hot industries or to
compare companies to other companies in the same
sector.
Companies whose sales are growing faster than
the economy as a whole tend to be very attractive,
so some fundamentalists look for revenue growth
rate that is higher than the expected increase in the
gross domestic product (GDP).
Fundamental measures are not helpful
in valuing a new company without an
established track record, and new companies are
often the ones that offer significant investment
opportunities.
Technical Analysis
Technical analysis began more than 100 years ago
with the use of charts; for that reason, technicians
are often called chartists. Technical analysis thus
involves identifying and interpreting stock price
movements over short periods and taking advantage
of the findings to lock in gains.

trendlines indicate resistance levels, the price at

which holders sell in rising markets, and support
levels, the price at which buyers buy in markets
that are trending down. A breakout occurs when
the price penetrates a resistance or support level.
A basic principle of technical analysis is that once a
trend is established it is more likely to continue than

According to the principles of technical analysis,

stock prices move in a cycle that involves five
phases: accumulation, recovery, speculation,
distribution, and readjustment. Technicians believe
that chart formations indicate when the market
is about to turn up, turn down, or trade in a narrow
range.
There are two basic types of stock charts. (1)
Bar charts (also called vertical line charts)
involve plotting price ranges for the period under
consideration, with each new period (usually a
day) plotted to the right of the previous one. Price
is plotted on the vertical (y) axis, and time on the
horizontal (x) axis. (2) Reversal charts (also called
point-and-figure charts) show price changes only,
without concern for time.
Trendlines (also called trading channels) show the
current price range of a stock. Upper and lower

to reverse. The moving average is considered an

early warning signal of a trend.
Many technicians believe that in a bull market,
increased volume indicates a rally, whereas declines
in volume signal a pullback. The opposite is true
in a bear market: volume increases on reactions
and declines on rallies. The end of a trend (a price
reversal) is also marked by heavy volume.

23

Technical analysis can also involve examining

indicators that indicate the overall strength of the
market. These indicators include the advancedecline ratio, the number of new highs and lows for
the year set in a day, various short sale ratios, and
the ratio of low- to high-priced stocks.
So, Which One Is Better?
In one sense, you might think of the distinction
between the fundamental approach and the technical
approach as equivalent to the distinction between
investing and trading. Fundamentalists, in general,
take a long-term view; technicians tend to keep
their eye on the short term. However, the two
approaches dont have to be incompatible, any more
than investing and trading are. Most technicians
are aware of and may take into consideration
fundamental conditions.
And most fundamentalists also pay attention to at
least some of the technical indicators. In fact, many
investors have met with success by using both. For
example, they use fundamental analysis to identify
promising stocks, and they then turn to technical
analysis to time their purchases and sales.
Other fundamentalists hold that stock prices are
based on investors emotions. Proponents of
the market psychology theory of stock price
movements point out that it accounts for why stock
prices sometimes rise when economic conditions
are weak and why they sometimes fall even when
economic conditions are strong.
These fundamentalists also point out that when
investors become optimistic about a companys
prospects, they buy its stock, sometimes even when
prices climb beyond what the fundamentals support.
Conversely, investors sell when they become
pessimistic, even when the fundamentals are still
good. And technicians try to recognize market
participants attitudes by identifying patterns on
charts.
In the long run, what strategies you choose in a
given situation, and how you carry them out, will
depend on where you think market prices and / or
the price of an individual stock are heading.
24

The Technical Analysis Toolbox

As excerpted from the
eSignal Learning Foundation Course

Technical analysis is based on a number of

underlying concepts:
Securities prices move in trends much, though not
all, of the time.
Trends can be identified with patterns that tend to
repeat themselves.
Primary trends, which generally last months
to years, are interrupted by secondary minor
movements, called pullbacks or corrections, in
the opposite direction that last generally weeks to
months.
Once a trend is established, it is more likely to
continue than to reverse; generally it remains in
place until a major event stops it.
The price bar, or bar, is the basic building block
of technical analysis. It is a visual depiction of the
trading action in a security for a given period of
time, often a single trading day.
Each price bar is a visual depiction of four values:
the open, high, low, and close. The height of the bar
indicates the range of price activity the taller the
bar, the greater the range.

A line chart shows only the closing prices plotted

for each day.

Volume indicates the total amount of trading

activity. Volume is also recorded on a chart,
represented by a vertical bar at the bottom under
that days price bar. Volume is considered important
in interpreting the significance of a price move.
The core of technical analysis is that the price bar
represents all the dynamics of supply and demand
for a given security for the day (or other given time
period) and that a series of bars on a chart shows
how the dynamics evolve over time.

Candlestick charting was developed in Japan over

150 years ago and has become popular among
technicians over the last 15 years, especially in
short-term trading. Candlesticks record the same
information that price bars record but allow for
easier interpretation and analysis. The open and
close mark off the top and bottom of a box, called
the real body. If the close is higher than the open,
the real body is white; if the close is lower than the
open, the real body is black.

The trend is the direction of the market. All

the tools you will use in technical analysis are
dedicated to identifying and measuring the trend so
that you can participate in it.
Some configurations of a series of price bars (e.g.,
three to five bars) are moves that may foretell a
new trend, continuation of an existing trend or the
25

reversal of an existing trend.

A series of closes on the high is a bullish sign that a
new trend may be starting or that an existing trend
is probably going to continue. A series of closes on
the low suggests that a down trend is forming or
accelerating.

The resistance level is the price at which traders

cant resist selling and taking profits, or higher than
which they will resist buying. It is also called a rally
high.

An inside bar is a price bar in which (1) the high is

lower than the previous days high and (2) the low
is higher than the previous days low. An inside bar
is generally believed to reflect indecision among
traders.
An outside bar is a bar in which the range between
high and low is outside the range of the preceding
bar. If the open is at the low and the close is at the
high, its a bullish sign. If the open is at the high and
the close is at the low, its a bearish sign.
A close that is at or near the open is generally
believed to indicate indecision in the market. But
when it occurs at one extreme of the range, it can
signal that a trend is about to continue or reverse.
Markets sometimes move sideways in a flat,
horizontal pattern that is called the trading range.
Periods of trendless, or sideways, movement are
referred to as consolidation.
The support level is the price at which traders
consistently step in to hold up the price and prevent
it from dropping any further. It is also know as a
reaction low.

26

Whenever a support or resistance level is broken

by a significant amount, it reverses role: That is,
a resistance level becomes a support level, and a
support level becomes a resistance level.
A trendline is a straight line that starts at the
beginning of the trend and stops at the end.
Trendlines are used to confirm or refute that a
security is trending.
To draw an up trendline, you need to be able to
identify at least three lows. The more lows that
touch the trendline, the more valid it is.

To determine whether a pattern is, for example, a

true double bottom, look for the following:
The price must rise above the con rmation line, a
horizontal line drawn from the highest high in the
middle of the W. (The point where the price rises
above that line is the con rmation point.)
The two lows are spaced at least 10 days apart,
sometimes several months.
The price variation between the two lows is small,
only a few percentage points.
A channel is marked by a pair of trendlines, one
drawn along the highs, the other along the lows.
Chart patterns are among the most powerful
indicators in the technicians toolbox. They can be
broadly categorized as continuation patterns and
reversal patterns.
Examples of continuation patterns (patterns that
indicate that a trend is continuing) are ascending
triangles (bullish) and descending triangles
(bearish), flags, and pennants. Flags and pennants
generally signal a pullback a minor move in the
direction opposite the primary trend before the
main trend resumes.
Reversal patterns signal that a trend is about to
reverse itself. Three of the most notable reversal
patterns are the double bottom (bullish), double
top (bearish), and head-and-shoulders formation
(bearish).

The center peak of the W is at least 10% higher than

the lower of the two bottoms.
A large increase in volume takes place after the
price exceeds the confirmation point.
Pullbacks occur after the price exceeds the
confirmation point.
The ideal double bottom is easy to spot, but in real
life, it can be tough. As noted earlier, sometimes the
bottoms are separated by several months. Moreover,
one or both bottoms can have a rounded, rather
than pointed appearance, and there may be several
pullbacks that obscure the pattern.
Analyzing trendlines and charts is often difficult,
and interpretations tend to be subjective; for
example, what one technician calls a triangle,
another may see as a wedge. Moving averages,
however, are objective and precise. In fact, one use
of moving averages is to confirm your interpretation
of chart patterns that you believe you are seeing.
The moving average (MA) is an average of a
certain number of prices, generally closing prices.
A moving average is used to identify the beginning
of a new trend or the end or reversal of an existing
trend. Because it follows market activity, rather than
anticipating it, the moving is known as a lagging
indicator.
The moving average crossover rule is to buy at
the point where the price crosses above the moving
average line, and to sell where it falls below the
moving average line. At first, this simple rule seems
clear and powerful because the result is that you
27

signal line, its a buy signal. When the MACD line

crosses below the signal line, its a sell signal.
Many people find it difficult to read the MACD
indicator, except when the signal line is actually
crossing the MACD line. The MACD histogram
provides the same information in a way that is more
easily interpreted by the eye. Histogram changes are
generally used to spot early signals to get out of a
position.
Analyzing moving averages is most useful when the
market is uptrending or downtrending. They are not
very helpful during trendless phases.
buy at a low and sell at a high.
To overcome the potential of whipsaw losses,
technicians have devised a number of additional
tests, or filters.
The moving average convergence-divergence
(MACD) indicator uses two exponentially adjusted
moving averages. The MACD line is calculated
by subtracting the long-term MA from the shortterm MA. When the MACD line is rising, the two
averages are converging; when it is falling, the
averages are diverging. If the difference between
the two is 0, a crossover is taking place. The second
line is the trigger, or signal line. It is a moving
average of the MACD line so its an indicator of
an indicator.

When the two lines cross, you have a buy or sell

signal. When the MACD line crosses above the
28

Technicians believe that you can determine when

the market becomes overbought or oversold by
following momentum the rate at which prices
change. Momentum indicators reveal nothing about
the direction of a trend; they are concerned only
with speed, or rate of change.
Because momentum is a leading indicator, it can
add important information to the data generated by
lagging indicators, such as moving averages.
Most technical traders measure momentum by
basing it on the number 100.
Multiplying by 100 to benchmark an indicator is
called oscillation. Oscillators show values relative
to a starting point. The Relative Strength Index
(RSI) is one type of oscillator; it has a range of
0 to 100. When the RSI hits 70%, the security is
considered overbought; at 30%, the security is
considered oversold. RSI is more often used to

confirm buy or sell signals generated by other

indicators.

numbers in retracement analysis are 62, 38 and

50%.

The stochastic oscillator differs from other

oscillators in that it examines not just the closing
price, but also the entire trading range. It looks
for the high-low range over a particular number
of trading days or periods, and the relationship of
the close to the low over the same time frame. The
stochastic oscillator generally is most effective in a
sideways market.

Technical analysis is a visual pursuit for the

technician, a world of information lies in what the
untutored eye may see as an incomprehensible mass
of dots, squiggles, and lines on a chart. To reveal
and interpret the information that these pictures
contain, you need to begin at the beginning: with
the individual components. We hope that this article
has given you a good start in understanding these
building blocks that make up technical analysis.

The Fibonacci sequence of numbers, first identified

by 13th-century mathematician, Leonardo
Fibonacci, forms the basis of one indicator that
technicians use to determine the extent of market
pullbacks, or retracements. During retracements,
Fibonacci numbers can be used to anticipate support
levels in an up trend) or resistance levels (in a
down trend). The most commonly used Fibonacci

29

The Psychology of Trading

Trading and Psychology

By Bennett McDowell, Founder and President,

TradersCoach.com*

I am often asked, How important is psychology in

trading the financial markets? The answer, VERY
IMPORTANT!
Most traders, when analyzing charts and back
testing trading systems, fail to realize how different
the results would be if they were actually trading
with real money as the market is unfolding instead
of looking at the market after the fact. This is why
I am not a back testing fan because the results
are usually nowhere near the reality of how YOU
would actually trade.
Most new traders fall victim to their own fear and
greed when trading, which causes them to exit
profitable trades prematurely or enter trades caught
up in the excitement of the moment.
We have all felt the anxiety that can creep into our
souls as a trade becomes profitable in a short period
of time. That anxiety wants us to exit the trade now
and take the quick profit. Taking the quick profit
will relieve the anxiety and make us feel good.
Maybe the cause of the anxiety is the greed to take
the quick profit or the fear that the market will turn
against us and cause a loss. Whatever the reason,
exiting the trade because of anxiety makes it an
emotional trade, and good traders do NOT trade on
emotions.
Or, perhaps you have trouble pulling the trigger
and entering trades when your trading system
indicates you should. Most often, fear is at work
here. The trader fears another loss! Not trusting
your trading approach and yourself can make you a
victim of fear.
Or, perhaps you live in the past and not the present,
and you are, again, afraid of reliving past losses or
even failures.
Or, perhaps you dont like using stops or correct
trade size or dont adhere to stops you have
30

already set. Dig deep enough into your psyche, and

you will uncover the reasons.
This is why I say that I could give a good solid
trading system to 100 traders, and almost all of
them would trade it slightly differently based on
how their emotions caused them to trade. In the
end, only those traders who can best manage their
emotions will have a chance to win consistently.
So, while a trading system or approach is important,
so is money management and learning how
to manage your psychology. It will take time,
experience and dedication to overcome your
human shortcomings, something we all have to
deal with. This is why 90 percent of the traders lose
in the financial markets. We are all subject to fear
and greed, but only a small percentage of traders
can manage their emotions well enough to let
themselves win.
Bennett McDowell provides private consultation / coaching
services to traders throughout the world and has been
published in numerous newsletters and magazines, including
Tradersworld.com magazine and The Long And Short Of It, a
TradersCoach.com member newsletter.
Website: www.traderscoach.com.
*Reprinted (and modified) with permission from Bennett
McDowell

Only the Zeros Are Different:

How Great Traders Go Bad

By John A. Sarkett, Developer, Option Wizard*

Like a pilot, a police officer or a trapeze artist, a

professional trader knows he or she must follow the
rules just to stay alive. Usually, this bracing thought
is enough to focus the mind. Usually, this awareness
suffices.
But, occasionally, the realization is lost.
Mistakes follow.
Losses mount.
An otherwise great trader succumbs.
A great trader goes bad.
How to avoid that tragic circumstance was

the subject of a Futures Industry Association

presentation in Chicago by Ray Kelly, professional
trader and trading coach.
Large traders trade more zeros than small traders,
but the process is the same, Kelly says. Both on
the upside and the downside.
The catalyst for destruction, Kelly says, is most
often ego.
Ego is the Ebola virus to the active trader.
There is an antidote, however balance, humility
and the ability to accept being wrong.
Can you or I become infected? Of course we can!
What can be done to protect against ego and its
devastating effects?
Kelly says pay close, introspective attention to
the following four areas: Self-knowledge, market
knowledge, trading strategy and risk management.
Answer the hard questions for yourself, before the
market does. Like meditation, or exercise, attention
must be paid each day for maximum effectiveness.
Self-Knowledge
First, when you come into your trading room, leave
your ego entirely outside the door. Kelly defines ego
as the sense of who we believe we are: A trader, a
religious person, a father, a spouse, etc.
When the over-inflated ego gains the throne, rules
go out the door. Egotism consumes natural and
healthy caution, replacing it with an illusion of
invincibility. An overdeveloped ego fells even the
most successful, sometimes especially the most
successful trader.
Expecting occasional failure, the trapeze artist
practices with a net. He or she knows that the body
is not more durable than the concrete below. The
trapeze artist knows that he or she can only exist in
the high-flying environment by following the rules.
Trouble is, ego is not software that can be easily
re-installed in the trader psyche. It is hardware. You
and I are hard-wired with ego. Ego is self-identity.

Ego never wants to be ignored, left out, left behind.

But, sometimes it gets out of control and becomes
self-absorbed and unrealistic. Sometimes, you have
to decide not to run with the crowd. But, to do so,
you have to go against your wiring.
There is something in the human that wants to
believe in the hero, the guru, the champion, and,
for many, that belief is coupled with a desire to
become that person. If you cant become the hero, it
is almost as good to run with him or her a dream
come true!
Usually, you cant. You may only watch the hero
from the stands or the balcony. But, in the financial
markets, you have the opportunity to participate
directly or partner with the prospective hero. His or
her glory becomes your glory. This prospect is so
appealing, so motivating, it will cause some of us to
leave sense, common or otherwise, far, far behind.
Watch out!
In the 1980s, I participated in a risk arbitrage
managed account program at a major brokerage
firm, supposedly run by supertraders. Ascending to
the heros podium, my account executive disclosed
that returns were expected to be 60 to 100 percent,
but, if only mediocre returns were generated, the
return might be as low as 30 percent or so.
Hundreds of trades (and commissions) later, I went
through the laborious task of reconstructing the
trading history and actual return of my account. It
was 12 percent, exactly the money market rate of
the day.
Contrast the swashbuckling image of the wannabe trading hero with the wry and self-deprecating
words of $1.5 billion Chesapeake Capital CEO
and former Turtle Trader Jerry Parker (another FIA
speaker), who says, We know we dont know what
were doing.
Far from true, (he meant that we cant predict rate
cuts, market movements, the future), but this kind of
modesty contrasts sharply with what is said by those
promising spectacular returns and is undoubtedly
a better and safer way to sail the market oceans.
His trading methodology is to take trend-following
31

positions across many markets, expecting a few

large gains to outweigh numerous losses.
Defining Success
While the psyche is often looking for others to
admire and emulate, it is not taking the time and
effort to define success for itself. This is usually too
much hard work. Easier and more fun to soak up the
vibes from the hero or try to be one yourself.
What is success? For speaker, Ray Kelly, it has been
earning 200K to 300K each year, 40 percent returns,
no drawdowns and the opportunity to spend time
with his wife and children, he says.
To define your own success, you must answer these
questions.

Who am I?

Why do I trade?

How do I prepare?

 hat are my beliefs about myself?

W
About trading?

Am I ready to handle the pressures of trading?

Sound too easy? Have you ever actually done it?

Kelly says, Great truths unfold at the level of the
student. As a student learns more, these questions
become deeper and more profound.
Ray Kellys own introspection involved working
through a family background that included an
alcoholic father and a very religious Catholic
background. The religious background left him
believing that it was evil to be rich. The instability
in his home made him feel that, somehow, all
the tension and insecurity was because of him.
Therefore, he was not worthy of success.
These powerful subconscious beliefs limited his
success, that is, until he worked through them.
When he resolved his own conflicts, he was able to
progress to a higher level of trading success.
Do these subconscious messages really sabotage
your trading? Kelly relates the story of a trading
associate. His son died in a tragic accident. Blaming
himself, he started losing significant sums the very
next week.
32

Kelly further cites a university study that indicates

a high degree of unresolved guilt among prisoners.
The study concludes that prisoners committed
crimes so that external activity would match internal
guilt, not the other way around.
Other enemies of trading success: Divorce,
employment change, trauma, illness or anything that
creates emotional distractions or pain.
If you owned a Testarossa, you wouldnt think
anything of having it checked and tuned on a
regular basis, Kelly says. Many trader egos are
too big for a regular tuneup, however.
What to do? Often you do not realize that you are
laboring under the weight of conflict. It shows up
as poor performance or an inability to follow your
rules. Losses are the inevitable by-product.
What to do? It depends on the person and the
severity of the problem. The best course to take is
to do introspective exercises constantly. Know the
resources you need before you need them.
If you are already in the fire? Walk away. Take time
off. Get counseling. Dont trade in the financial
markets until your conflicts are resolved. Do not
make the expensive mistake of thinking that,
whatever it is, it will go away if you ignore it.
Other questions to ask yourself about your state of
mind, according to Kelly, are:

Do others comment on my personality traits

negatively?
Do I suffer extremes in emotion?

Is my body sending me a message?

Am I uncomfortable with this subject?

Do I take responsibility for my actions?

Society teaches us to places blame, to externalize

our failures, Kelly says. Bad system. Bad broker.
Bad quotes. Introspection is just too painful for
most.
But to be a successful trader, you must go against
the grain and do the heavy lifting of introspection.

Approach the Markets with Equanimity

Kelly says to incorporate a bottlecap mentality
into your trading. Like Laverne & Shirley on
the TV sitcom at the Schotts Brewery, you put
one bottlecap on after another, and then you go
home and plan your excitement after work, he
says. Dont seek excitement from the markets, or,
unhappily, you may find it.

trading.
Part of market knowledge is defining how much
you expect to make in the markets. If youre a
typical newcomer, you may be looking to double
your money. There is, for example, a popular phrase
in options trading: percent to double (i.e., the
percent your underlying must move to generate a
doubling of your options price). For a pro like Jerry
Parker, CEO of Chesapeake Capital, the answer is
much more modest. His goal: 2 percent per month.

Similarly, R. Jerry Parker says trading is a brickupon-brick enterprise, but that Commodity Trading
Advisor (CTA) clients prefer a rock star approach.
Trading Strategy
They want magic, he says.
Third, develop your trading system. For Chesapeake
Trading in some 70 of the most liquid 150
Capital, the system is rule-based, trend-following,
futures markets, patiently seeking break-outs, the
diversified, no bias short or long.
Chesapeake system is a technical, trend-following
system. The system will generate 200 trades per
This flies in the face of what clients want:
year, of which some six will pay for losses and
Graduates of fancy schools, huge research, an
generate returns, he says. Obviously, if you invest
intuitive approach that knows whats going to
too much negative emotion in the 194 losers, you
happen before it happens (e.g., be overweight in the
likely wont be around for the six big winners.
stock market before an interest rate cut), Parker
says. But, obviously you cant know whats going
to happen before it happens, and maybe the rate cut
Market Knowledge
is the start of a major trend, and maybe its o.k. to
Market knowledge is the second major pillar you
get in after. Thats our approach.
must depend on to avoid a market catastrophe.
You must ask yourself, continuously:

What affects markets?

How? How might things be changing?

When do you know you are wrong?

What are you trying to extract from the markets?

Kelly cites as a successful example trader David

Druz, who runs the Tactical Asset Management
Fund.
Druz defines exactly what his system does: My
trading system captures the capital that hedgers
use to defend positions. He has back tested and
quantified it, and so he knows and expects that his
system will generate 30 percent drawdowns. But,
over time, he has achieved excellent results because
he is focused, he understands his markets, he has
good money management rules and he looks to a
realistic time horizon within which he plans his

Kelly also advises traders to develop a trading

system that they can actually follow. A system that
is geared to their own personality and financial
means. Kelly says, If you have abstract ideas
of what you want and how you are going to
accomplish it, that is what you will get, an abstract
result.
Test your system, he says.

What are the characteristics of the system?

Is it consistent?

Do you understand why it works?

Does it work in all markets?
Does it fit your personality?

Then, attend to business: Do your homework every

night. Your competitors do. Determine your answers
the night before the market.

33

Risk Management
Fourth, and most importantly, you must manage
risk. No matter how great your knowledge of
yourself and the markets is or how sound your
system is, if you dont manage risk, you wont last.

would put them out of business, and the goal is to

stay in business.

Kelly says the successful, long-term trader must

answer:

Kelly notes that, when losing, amateurs increase

bet size, but professionals decrease size. Dont try
to catch up on one trade. If your system is sound,
it will make money over time. You will recapture
losses over time. And, thats okay. Because you are
looking for 2 percent a month, correct? Not a fast
double play.

How much risk per trade?

(Various traders risk .05 to 5 percent of capital
per trade. You must fit this figure to your system.)
Do I understand my risk?

Is my system discretionary or systematic?

(A systematic approach takes all signals generated by a trading system. A discretionary system
does not mean haphazard trading but, rather,
allows the trader to make exceptions to what he
or she buys or sells within the framework of the
signals generated.)
Where are my stops, what is the meaning of my
stops?
Quantify risk. Two words that separate the
world of success and the world of failure.

Losses are expected. You are not a bad trader if

you experience them. Options broker Jerry Kopf,
Benjamin & Jerold, Chicago, puts it this way, Its
okay to be wrong. Its not okay to stay wrong.
Kelly makes a distinction between what some
people call drawdowns and what he calls losses
A drawdown is a loss taken within a defined
strategy. It is part of the strategy.
If you do not have a strategy, it is a loss. People
misname the loss in the hope of avoiding the pain
and to deceive themselves. A drawdown is not a
personal statement about you; it is an expected part
of the business plan.
Unwilling to take a small loss? For those involved
in the spectacular blow-ups of recent times, small
losses no longer were acceptable, so they were
forced to accept disastrous losses. Keep losses
predetermined and small. At best, professional
traders are right 50 percent of the time or less, so
they must take only small losses. A few large losses
34

Money management is crucial, Kelly says. This

is why the exchanges have revolving doors for
those who dont master this critical skill.

Two Last Questions: The Bottom Line

Am I profitable?
And
Am I as profitable as I could be at my full
potential?
If not, you must discover the reasons and make
changes.
Ray Kelly repeated one message over and over at
the presentation: If you want to keep getting what
you are getting, keep doing what you are doing.
Like the pilot, policeman or trapeze artist, you
respect the rules of the game, you respect the
boundaries, you respect how hard the concrete
is, and how soft you are, and so you survive. The
alternative is too costly in every way.
Ray Kelly was a veteran trader, financial consultant and
seminar speaker.
R. Jerry Parker is CEO of Chesapeake Capital, Richmond,
Virginia.
David Druz is CEO of Tactical Investment Management Fund.
Jerry Kopf is a partner in Benjamin & Jerold Discount Stock
and Options Brokers
John Sarkett writes on and trades in the financial markets.
Developer of Option Wizard software (option-wizard.com), he
can be reached at [email protected].
*Reprinted (and modified) with permission from John A.
Sarkett