Making Your Money Work

Just saving money isn't enough; you need to invest it wisely to ensure that inflation doesn't eat it away....

According to the dictionary, income that is not spent is saving. f you don’t spend ten per cent of your monthly income and just keep the cash in a box, then you are saving money, no question about that. It’s a simple concept, but by itself, it doesn’t get you very far.

The basic reason for that is that money doesn’t retain its value. Prices rise and what was worth a hundred rupees last year is probably worth ten or twenty rupees more this year. Inflation eats away at your savings, bit by bit. Historically, inflation in India has always been at a far higher level than in the developed countries. Over the last thirty years, it has varied over a wide range, but has rarely fallen below five or six per cent per year for a sustained period. The long-term average over this entire period is about eight per cent.

Eight per cent doesn’t sound all that harmful. It just means that something worth R100 becomes R108. However, that’s the annual rate. The inflation rate is a compounding rate, and the inflation of one year feeds into that of the next year, and so on. This means that if you had saved R1 lakh in 1982 and just kept it in a drawer as cash all long, then it would be worth no more thanR8,200 today, just 1/12th of its original value!

And don’t think that the future is going to be any better. Currently, despite all the efforts of the Reserve Bank, inflation has stayed above seven per cent. Economists now say that high inflation is now ‘structural’, meaning it’s integral to the Indian economy and will likely stay that way.

And that’s why we need to not just save, but also to invest our savings. Investment means putting our money into some form whereby it will yield some gains. Most of us are familiar with the ‘types of things’ that we can invest in. These ‘types of things’ could be property, gold, bank deposits, shares and deposits. Anything into which we can put in money and have it grow can be called an investment.

Of course, just matching inflation should not be the goal of any smart investor. Anyone who takes the trouble to learn some basics and applies them sensibly, should be able to earn more than enough to retain the value of their money. Investments can become an independent source of income. And if you let this sum accumulate instead of using it as income then it can grow into a serious amount of wealth.

Take the example above. Suppose that same R1 lakh had been invested in 1982 in the shares of a group of leading companies so that their value grew along the same rate as the BSE Sensex. The money would today have grown to R37 lakh! This is far ahead of the rate of inflation. A sum of R37 lakh can buy you a lot more than what R1 lakh could have bought you in 1982. Investing well over long periods of time will not just save you from inflation— it can also make you rich.

But investing can be as risky as it can be rewarding. Newcomers who start investing with over-optimistic expectations, and without enough knowledge or caution always face the biggest problems.

So, you have decided to start investing in the stock market - on your own. You have decided not to go by the mutual fund route [alone] and you want to test the waters yourself. The Indian stock market has done pretty well over the past one year, and you want to try your hand at picking stocks. Not a bad idea, I must say. Peter Lynch, the legendary stock investor, said, "Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it." So, you can indeed invest like a stock market rock star. However, there are a handful of things you must know before you dive into the stock market. You can save yourself a lot of time, effort and money if you follow the advice in this article.

Get trading and demat accounts
You will need a stock-trading account and a demat account to start investing in the stock market directly. There are many brokerage firms, and you can choose among them. One of the easiest things you can do is contact your bank. Most banks provide brokerage and demat services. Since you would already have an established relationship history with your bank, you would feel more comfortable.
Opt for an online trading account
You can place your stock-purchase orders over the phone or online. An online trading account brings a lot of transparency into your transactions. With an online account not only can you place orders yourself, you can also track what is happening to your order in real time. Also, never let the broker or anyone else trade on your behalf. You should be the only one who has access to your stock-trading account.
Be cautious of broker's advice
The moment your stock-trading account is opened, the broker would like you to opt for many services it offers, including regular stock tips and guidance. What you must appreciate is that your interests are always secondary to the broker. He has his interests in mind, which are related to your trading frequency. So, he would want you to trade more. Nassim Nicholas Taleb eloquently quoted, "Never take advice from anyone in a tie. They'll bankrupt you. Don't ask a general for advice on war, and don't ask a broker for advice on money." Never feel compelled to buy and sell as per your broker's advice. Rely on your judgment, analysis and research.
Keep records
Your broker should send you a contract note for every trade you make. You should verify it and archive it. It is the proof of the transaction. Also, you should make a note of your buying prices and dates, selling prices and dates, profits and losses, quantities bought and sold, etc., in an Excel sheet. This will not only help you track your investment results and pay taxes but will also bring discipline to your investing approach.
Start small
Start investing with a small amount of money. Since you would be learning during your initial phase in the stock market, it's better that you commit smaller sums of money. Even if you have a large corpus to invest, go slow. Once you have gathered ample experience and are confident of your ability to invest successfully, you can increase the allocation.
Invest in education
Benjamin Franklin said, "An investment in knowledge pays the best interest." You can't be successful in the market unless you invest in educating yourself about it. Knowledge about how stocks work will also prevent you from making costly mistakes. You will also learn about the right methods of investing in stocks. One of the major reasons why many stock investors don't do well is that they don't make any effort to learn. There are many good books around that you can read, such as One Up on Wall Street,The Intelligent Investor, What Works on Wall Street and so on. Learning from stock gurus is a very effective way to be successful in the stock market.
Stay away from stock trading, derivatives and stock tips
Stock trading is the pursuit of making quick profits by profiting from the fluctuations in the market. Most stock traders lose, so it is not a worthy pursuit. Invest for the long term in the stock market after doing thorough analysis and research.
Also, don't be carried away by futures and options, which are collectively called derivatives. Derivatives use leverage and can dramatically increase your returns. However, they can also wipe off your capital in a matter of moments. Most derivative traders lose, so keep away from derivatives. Derivatives have the potential of tearing down the entire financial system, which made Warren Buffett call them the 'weapons of mass destruction'.
The new stock investor should stay away from ubiquitous stock tips. The stock market sees a lot of speculation and stock tips are generally circulating around. These stock tips are generally not reliable and aren't a surefire way to make profits.
Keep an emotional check on yourself
Someone rightly said, "The best investors in the world have more of an edge in psychology than in finance." As a new investor you will experience an entire gamut of emotions when you see fluctuating stock prices. You would be tempted to book profits instantly if your stocks gain in value, and you would have a sinking feeling when your stocks fall. Many people start behaving irrationally when they see ever-changing stock prices. A fall in stock price is a normal occurrence, and you should not sell a stock in order to make a quick buck. Buying and selling stocks should be based on your stock strategy, which is the point below.
Devise a strategy
Once you start operating in the market, you will need a stock strategy that clearly tells you what to buy, when to buy, when to sell and how to track progress. In the absence of a sound strategy, your stock market career will be more like a ship that has lost its way. One day you will do this and the other day that. Your stock strategy is the ultimate filter which will safeguard you from the noise in the stock market. You can keep refining the strategy as you progress with investing. The books that you will read on stock investing will help you with your strategy. However, the major help in preparing your strategy will come with your real-life experience in the market. Since you would surely be making some mistakes, it has been advised that you start small.
Persist
Don't expect magnificent results from day 1. Initially, you may also lose some money. Yet persist in your pursuit. Combine stock investing with sound money management skills. Invest regularly. There are many people out there who know a lot about stock investing but who are never able to build wealth because they seldom have money to invest. In any form of investing, discipline and regularity are the most important determinants of success.

A Winning Attitude

Everyone wants to be a winner; at least, they think so. Unfortunately, most are not willing to perform the tasks necessary to become a consistent winner.

Winners generally achieve success by being focused on a goal. Being focused allows winners to remain committed to the tasks at hand. Most winners perform a lot of hard work; including a willingness to deal with sometimes mundane duties. Most of all, winners perform with an "I am responsible for both my failures and successes" attitude.

So, where does the would-be trader start to become a success? By focusing on the tasks at hand. Most of all, treat trading as a business. And, as in any business, money management is critical.

Money management, next to trend, is probably the aspect of trading most overlooked by smaller investors. Man, by nature, is an optimistic creature and the amateur trader often acts instinctively. Unfortunately, this instinct or optimism is often the undoing of the smaller trader.

When a person enters a trade, he does so with the hope it will be a winner. When the position goes against him, he keeps thinking (or hoping) "it will come back." He knows he should have a stop in place, but hope keeps telling him to stay just a little longer since everybody knows "you always get stopped out the day the market turns." Eventually, hope turns into frustration, desperation and, finally, panic, prompting the trader to issue a GMO (get me out) order.

If the trader hasn't learned his lesson by this point, he develops the "I have to get it back" syndrome. He generally rushes into another poorly planned trade, throwing good money after bad.

Winners show several different characteristics. They enter the market knowing they can be wrong and, in fact, are wrong as often as they are right. They have learned markets don't run on hope. They understand markets tell them when they are right or wrong. When a trade is losing money and getting worse, the market is telling them to get out. A bad trade is like a dead fish: The longer you keep it, the worse it smells.

When a trade is making money, the market is telling them they are right and to let the position ride. Winners don't add to, or "average", losing positions. They dump the trade and go looking for a new opportunity. Successful investors may add to the winning trades. When ahead, they press their advantage while remembering that at any time the market can turn on them and prove them wrong.

The Psychology of Commodity Price Movement

The price of a futures contract is the result of a decision on the part of both a buyer and a seller. The buyer believes prices will go higher; the seller feels prices will decline. These decisions are represented by a trade at an exact price.

Once the buyer and seller make their trade, their influence in the market is spent — except for the opposite reaction they will ultimately have when they close the trade. Thus, there are two aspects to every trade: 1) each trade must ultimately have an opposite reaction on the market, and 2) the trade will influence other traders.

Each trader's reaction to price movements can be generalized into the reactions of three basic groups of traders who are always present in the market: 1) traders who have long positions; 2) those who hold short positions; and 3) those who have not taken a position but soon will. Traders in the third group have mixed views on the market's probable direction. Some are bullish while others are bearish, but a lack of positive conviction has kept them out of the market. Therefore, they also have no vested interest in the market's direction.

The impact of human nature on futures prices can perhaps best be seen by examining changing market psychology as a typical market moves through a complete cycle from price low to price low.

Classic price pattern

Assume prices trade within a relatively narrow trading range (between points A and B on the chart). Recognizing the sideways price movement, the "longs" might buy additional contracts if the price advances above the recent trading range. They may even enter stop orders to buy at B, to add to their position if they should get some confirmation the trend is higher. But by the same token, recognizing prices might decline below the recent trading range and move lower, they might also enter stop loss orders below the market at A to limit their loss.

The "shorts" have exactly the opposite reaction to the market. If the price advances above the recent trading range, many of them might enter stop loss orders to buy above point B to limit losses. But they, too, may add to their position if the price should decline below point A with orders to sell additional contracts on a stop below point A.

The third group is not in the market, but they are watching it for a signal either to go long or short. This group may have stop orders to buy above point B, because presumably the price trend would begin to indicate an upward bias if point B were penetrated. They may also have standing orders to sell below point A for converse reasons.

Assume the market advances to point C. If the trading range between points A and B has been relatively narrow and the time period of the lateral movement relatively long, the accumulated buy stops above the market could be quite numerous. Also, as the market breaks above point B, brokers contact their clients with the news, and this results in a stream of market orders. As this flurry of buyers becomes satisfied and profit-taking from previous long positions causes the market to dip from the high point of C to point D, another distinct attitude begins working in the market.

Part of the first group that went long between points A and B did not buy additional contracts as the market rallied to point C. Now they may be willing to add to their position "on a dip." Consequently, buy orders trickle in from these traders as the market drifts down.

The second group of traders with short positions established in the original trading range have now seen prices advance to point C, then decline to move back closer to the price at which they originally sold. If they did not cover their short positions on a buy stop above point B, they may be more than willing to "cover on any further dip" to minimize the loss.

Those not yet in the market will place price orders just below the market with the idea of "getting in on a dip."

The net effect of the rally from A to C is a psychological change in all three groups. The result is a different tone to the market, where some support could be expected from all three groups on dips. (Support on a chart is denned as the place where the buying of a futures contract is sufficient demand to halt a decline in prices.) As this support is strengthened by an increase in market orders and a raising of buy orders, the market once again advances toward point C. Then, as the market gathers momentum and rallies above point C toward point E, the psychology again changes subtly.

The first group of long traders may now have enough profit to pyramid additional contracts with their profits. In any case, as the market advances, their enthusiasm grows and they set their sights on higher price objectives. Psychologically, they have the market advantage.

The original group who sold short between A and B and who have not yet covered are all carrying increasing losses. Their general attitude is negative because they are losing money and confidence. Their hopes fade as their losses mount. Some of this group begin liquidating their short positions either with stops or market orders. Some reverse their position and go long.

The group which has still not entered the market — either because their orders to buy the market were never reached or because they had hesitated to see whether the market was actually moving higher — begins to "buy at the market."

Remember that even if a number of traders have not entered the market because of hesitation, their attitude is still bullish. And perhaps they are even kicking themselves for not getting in earlier. As for those who sold out previously-established long positions at a profit only to see the market move still higher, their attitude still favors the long side. They may also be among those who are looking to buy on any further dip.

So, with each dip the market should find the support of 1) traders with long positions who are adding to their positions; 2) traders who are short the market and want to buy back their shorts "if the market will only back down some"; and 3) new traders without a position in the market who want to get aboard what they consider a full-fledged bull market.

This rationale results in price action that features one prominent high after another and each prominent reactionary low is higher than the previous low. In a broad sense, it should appear as an upward series of waves of successively higher highs and higher lows.

But at some point the psychology again subtly shifts. The first group with long positions and fat profits is no longer willing to add to its positions. In fact they are looking for a place to "take profits." The second group of battered traders with short positions has finally been worn down to a nub of die-hard shorts who absolutely refuse to cover their short positions. They are no longer a supporting element, eagerly waiting to buy the market on dips.

The third group of those who never quite got aboard the up-move become unwilling to buy because they feel the greatest part of the upside move has been missed. They consider the risk on the downside too great when compared to the now-limited upside potential. In fact, they may be looking for a place to "short the market and ride it back down."

When the market demonstrates a noticeable lack of support on a dip that "carries too far to be bullish," this is the first signal of a reversal in psychology. The decline from point I to point J is the classic example of such a dip. This decline signals a new tone to the market. The support on dips becomes resistance on rallies, and a more two-sided market action develops. (Resistance is the opposite of support. Resistance on a chart is the price level where selling pressure is expected to stop advances and possibly turn prices lower.)

The downturn

Now the picture has changed. As the market begins to advance from point J to point K, traders with previously-established long positions take profits by selling out. Most of the hard-nosed traders with short positions have covered their shorts, so they add no significant new buying impetus to the market. In fact, having witnessed the recent long decline, they may be adding to their short positions.

If the rally back toward the contract highs fails to establish new highs, this failure is quickly noticed by professional traders as a signal the bull market has run its course. This is even more true if the rally carries only up to the approximate level of the rally top at point G.

If the open interest also declines during the rally from J to K, it is another sign it was not new buying that caused the rally but short covering.

As profit-taking and new short-selling forces the market to decline from point K, the next critical point is the reactionary low point at J. A major bear signal is flashed if the market penetrates this prominent low (support) following an abortive attempt to establish new contract highs.

In the vernacular of chartists, a head-and-shoulders reversal pattern has been completed. But rather than simply explaining away price patterns with names, it is important to understand how the psychology of the market action at different points causes the market to respond as it does. It also explains why certain points are quite significant.

In a bear market, the attitudes of the traders would be reversed. Each decline would find the bears more confident and prosperous and the bulls more depressed and threadbare. With the psychology diametrically opposite, the pattern completely reverses itself to form a series of lower highs and lower lows.

But at some point, the bears become unwilling to add to their previously-established short positions. Those who were already long the market and had refused to sell higher would eventually be reduced to a hard core of traders who had their jaws set and refused to sell out. Traders not in the market who were perhaps unsuccessfully attempting to short the market at higher levels will begin to find the long side of the market more attractive. The first rally that "carries too high to be bearish" signals another possible trend reversal.

With this basic understanding of market psychology through three phases of a market, a trader is better equipped to appreciate the significance of all technical price patterns. No one expects to establish short positions at the high or long positions at the low, but development of a feel for market psychology is the beginning of the quest for trades that even hindsight could not improve upon.

When you analyze charts, approach them with the idea that they reflect human ideas about prices that are the result and the struggle between supply and demand forces. Your attitude and ability to judge market psychology will determine your success at chart analysis. Unexpected occurrences can change price trends abruptly, and without warning. Also, some of the chart formations may be hard to visualize. You'll sometimes need a good imagination as well.

Finding A Friend In The Trend

"The trend is your friend" is an important trading guideline.

Because trends persist for long periods, a position taken with the trend will more likely be successful than one taken randomly or against the trend. Trading with the trend in a bull market means buying on dips; in a bear market, selling on rallies.

On a bar chart, each vertical line connects the day's, week's, or month's high and low. The horizontal tick to the right of the line indicates that time period's closing price.

A trend is easily spotted on a bar chart. An uptrend is a series of higher lows and higher highs. Uptrend lines are drawn under the lows of the market and give support. A downtrend is a series of lower lows and lower highs. Downtrend lines are drawn across the highs and give resistance to the market. The soybean chart shown below has both uptrend lines and a downtrend line.

Lows and highs vs. closes

A trendline can be drawn when two points are available. The more times a trendline is touched, the more technically significant this support or resistance line becomes.

While some chartists draw trendlines through lows and highs, others may prefer drawing lines through closes in hopes of detecting a change in trend more quickly.

Trendlines may change angles, requiring another line drawn through new high or low points. For example, the sideways trading action in March and April broke the steeper uptrend line connecting the Feb. 13 and March 20 lows. But when the uptrend resumed in early May, a more shallow uptrend line can be drawn connecting the February and late-April lows.

The most reliable trendlines are those near a 45° angle. If about four weeks have elapsed between the two connecting points, this increases the trendline's validity. However, steep trendlines that don't fit these guidelines, like the uptrend line in the early portion of the soybean chart, may be just as useful.

Often, minor uptrends or downtrends will confuse the beginner. It may seem the market has turned around. However, sharp chartists will see these minor trends as small ripples within a major wave. Remember, if the trendline isn't broken, that trend remains intact. Two closes outside the trendline are the criteria for detecting a change in trend. However, very seldom do markets go directly from uptrend to downtrend. At the end of a move, traders become less aggressive and prices may swing in a sideways pattern or consolidation period.

Many times, markets break into an uptrend or downtrend out of a sideways trading pattern or consolidation period. In the soybean chart, prices traded in a 50

Because traders need time to be convinced that they should put their money into the market, sideways patterns are more likely to occur near the bottom of a move. The beginning of a downtrend often will be sharp and sudden as investors pull money out of the market.

False breakouts

Another way beginners might be fooled is seeing false breakouts of tops and bottoms. As prices begin to make their move in switching from a downtrend to an uptrend, traders with short positions will "cover." This buying many times will cause the market to rally above the downtrend line. This short covering rally seldom holds, and prices may drop back to the breakout point. The uptrend is confirmed when prices close above the high of the short rally.

On a topping formation, long liquidation takes prices through the uptrend line on a short break. Before the downtrend begins, the market sometimes rallies back to "test" the uptrend line as shown on the soybean chart in September. As the downtrend unfolds, the second reaction rally could not top the highs of the first rally.

Channel lines are an extension of the trendline theory. The October through January downtrend on the soybean chart shows prices staying in a "channel" between the downtrend line and a line drawn parallel to it, connecting the lows. A channel line in a downtrending market helps identify where support may be found.

Speedlines are another line which show where prices may find support or resistance. Frequently, speedlines and trendlines will overlap, emphasizing that line's importance to the market.

The speedline on the soybean chart starts from the June 29 low. To find the points to connect with the low, divide the range between the low ($6.40) and the high($9.94) into thirds and subtract from the high.

Plot the point obtained by subtracting one-third of the range from the high on the day the high was made. A line drawn between this point ($8.76) and thelow established the 1/3 speedline. The 2/3 speedline is drawn through the point that is two-thirds of the range subtracted from the high ($7.58) plotted on the day the high was made.

Another way to detect a change in trend is by looking for a price from which the market reacts two or three times.

A double bottom, such as the one on the T-Bill chart, indicated the 87.10 to 87.20 area gave support to the market. Although a recovery had begun from the late-May low, prices broke the short-term uptrend in mid-June. The question then became: Will aggressive short-selling and long liquidation overwhelm the short-covering and new buying that come from support at the May low?

The soybean chart displays a triple top, where prices met resistance in approximately the same area three times before falling. Just the inverse of making the double bottom goes through traders' minds as the market makes a top: Will new buying and short-covering be able to overwhelm the new selling and long liquidation coming from the triple-top resistance area?

As with trendlines, the more time that elapses between the tests of support and resistance in double or triple tops or bottoms, the more valid the formation becomes. Also, the greater the reaction between tests of the support or resistance, the more likely the point will hold.

Though these examples are from daily bar charts, technical analysis works just as well on weekly and monthly charts. Because the longer-term charts cover more time, their trendlines are more important in identifying areas of support and resistance to the market.

How do I know?

In identifying the trend in a market, it is wise to start with the longer term charts to identify the long-term trend. The daily charts offer trends for the shorter-run.

Technical analysis is more an art than a science. The answer to your question, "How do I know where to draw the trendlines?" is, "They're your charts, draw them wherever they seem to work best for you."

Technical Price Objectives

Traders who believe in price charts make them work.

Chartists try to find repetitive price patterns which have a high degree of accuracy and usually are self-fulfilling. Gaps and specific formations frequently meet these criteria.

Gaps are one of the most easily recognizable technical indicators. A gap is simply an empty spot formed on a chart when price lines don't overlap the previous day's price action. Sometimes market psychology changes overnight or over a weekend. That change in psychology forces prices to open and stay above or below the previous day's range.

Time-tested rule

Gaps are filled is another time-tested rule of the market. That is why gaps become future price objectives. Quite often, prices retreat to fill a gap in a bull market before continuing the move. Likewise, prices often rally in a bear market to fill gaps.

Gaps may serve one of three purposes. They are used to spot the beginning of a move, to measure a move and to signal the end. There are four different kinds of gaps: common or temporary, breakaway, measuring or runaway, and exhaustion.

The most frequently occurring gap is the common gap. When this gap occurs because of a slight change in psychology, traders expect it to be filled soon. Once a gap is filled, it no longer has significance.

The early portion of the soybean chart on this page shows common gaps during the December and January period which were later filled.

The breakaway gap on this chart occurred on May 7 and begins a major bull move. Breakaway gaps often occur after a stretch of sideways trading and in the leading days of an uptrend or downtrend. This type of gap remains unfilled for a long time.

It sometimes is difficult to tell right away that it's a breakaway gap and not a common gap. When the market fails to fill this gap after a couple of weeks, this confirms the breakaway gap.

Additional gaps

A measuring gap typically occurs in the middle of a price move and predicts how much farther the move will go. It is also called a midpoint gap and a runaway gap.

On this soybean chart, the measuring gap, which occurred on June 8, left an empty spot from $6.16 to $6.26. The April 5 low at $4.90 marked the beginning of this move. The distance from the low at $4.90 to the measuring gap is $1.26 to $1.36. Adding this distance to the measuring gap projects a move to at least $7.50. Whether you add the distance to the top, bottom or middle of the measuring gap depends on your preference.

An exhaustion gap shows frustrated bears giving up and aggressive bulls trying to make the market go their way. It is the first sign of sputtering before the end.

Though prices may go higher after an exhaustion gap at the top, the rally will not last long before the market dies. An extreme exhaustion gap may form an island reversal.

What about gaps that remain unfilled? They become future chart objectives.If gaps are unfilled when a futures contract expires, there are usually corresponding gaps on the charts of subsequent contract months.

Gaps also appear on longer-term charts such as weekly commodity charts, but gaps on monthly charts are rare because they generally are constructed to avoid gaps caused by contract changeover. Like those on the daily charts, gaps on weekly charts are also "made to be filled".

A downtrend may slide to a slow, gradual halt in the saucer bottom formation. Open interest and volume follow the same pattern as prices in this formation, reflecting speculator disinterest in a market with little action and little profit potential. Our example on the monthly cocoa chart took three years to form. Saucer bottoms on daily charts may take at least four weeks to become visible.

Although this bottom formation doesn't meet the requirements of other bottom formations, it's just as significant in signaling a trend change. Usually, the longer it takes to form a saucer bottom, the more violently prices will rise out of their lows.

Key reversals

One of the most easily recognizable technical signals in trend change is the key reversal. A key reversal often has an unusually wide trading range. Its requirements are a day's range outside the previous day's range with a close higher than the previous close for an upward turnaround and a lower close for a downward turn.

Here again, this chart formation reflects market psychology. A key reversal is the climax of a period of buying or selling fever. In extremely volatile markets, two or more key reversals may occur. The key reversal on the silver chart defined the top of its rally and signaled a fall in prices.

To be a valid key reversal top, trading volume must be heavy and the daily trading range should be wide. Prices first surge to new highs, but fall back and close lower for the day.

For a key reversal bottom, the characteristics are the same. The selling climax has to have heavy volume with a wide trading range which first breaks to new lows, rebounds above the previous day's high and closes higher. Frequently, the highest trading volume and the highest or lowest price of the year will be set on a key reversal day.

An island reversal takes gaps to the extreme. It receives its name for obvious reasons. An island reversal can be only one day or a few days of trading above (or below) the previous and following day's trading activity The action is isolated by gaps on both sides. Thus, it leaves a day or a few days of price action surrounded by empty space.

The Japanese yen chart shows two island reversals. The 1-day island top of marked the climax of a bull move and the beginning of falling prices. The 3-day island reversal bottom in mid-May signaled a halt to the decline and the Island reversal beginning of a bear market rally.

Island reversals occur less frequently than key reversals. The exhaustion gap which marks the beginning of the island reversal will remain unfilled for a lengthy period because the island reversal is usually the climax to an existing trend.

Technical analysis is not an absolute tool. Because it is more an art than a science, individuals will interpret formations and trends differently.

"Thin markets" — those with very low open interest and trading volume — will create false technical signals. These markets, as well as deferred contracts which also have low open interest, should be avoided by inexperienced traders.

Despite these cautions, technical analysis is a powerful tool and if used with common sense, can enhance a trader's perspective and profits

Picturing Technical Objectives

When prices form pictures on charts, you can obtain realistic objectives for later moves. One of the most reliable chart formations is the head-and-shoulders top or bottom. This easily recognizable chart pattern signals a major turn in trend.

The main advantage of the head-and-shoulders pattern is it gives you a clear-cut objective of the price move after breaking out of the formation. Measure the price distance between the head and the neckline and add it to the price where the neckline is broken. This projects the minimum objective. Although the head-and-shoulders gives no time projection, it predicts a very strong trend in the future.

In most cases, a head-and-shoulders formation will be symmetrical, with the left and right shoulders equally developed. Although the neckline doesn't have to be horizontal, the most reliable formations stray only a little.

Flags and pennants are consolidation patterns which give objectives for further moves. As the formation develops, price action in an uptrending market will look like a flag flying from a flagpole as prices tend to form a parallelogram after a quick, steep upmove. Flags "fly at half-staff." The more vertical the flagpole, the better.

A price objective is obtained by measuring the flagpole and adding it to the breakout point of the formation. The flagpole should begin at the point from which it broke away from a previous congestion area, or from important support or resistance lines. Flags in a downtrending market look like they are defying gravity and slant upward.

Continuation patterns

A pennant also starts with a nearly vertical price rise or fall. But, instead of having equal move reactions in the consolidation phase like a flag, pennant reactions gradually decrease to form short uptrend and downtrend lines from the flagpole.

The same measuring tools used in flags are used in pennants. Add the length of the flagpole to the breakout point to get the minimum objective. Remember,flags and pennants are usually continuation patterns in an overall trend which resumes after the breakout of the consolidation area.

Also, the coil formation, or symmetrical triangle, appears while prices trade in continually narrower ranges, forming uptrend and downtrend lines. This pattern doesn't tell you much about the direction of the next move. After breaking one of the trendlines, the objective is found by adding the width of the coil's base to the breakout point.

Springing from coils

The formation gets its name from the way prices contract and suddenly spring out of this pattern like a tight coil spring. One caution about this formation: It's best if prices break out of the formation while halfway to three-quarters of the way to the triangle's apex. If prices reach the apex, a strong move in either direction is less likely.

Ascending and descending triangles are similar to coils but are much better at predicting the direction prices will take. Prices should break to the flat side of the triangle.

Price objectives from ascending and descending triangles can be obtained two ways. The easiest is to add the length of the left side of the triangle to the triangle's flat side.

Another method of projecting price is to draw a line parallel to the sloping line from the beginning of the triangle. Expect prices to rise or fall out of the triangle formation until they reach this parallel line.

More objectives

In the chapter on trends, we mentioned double and triple tops and bottoms. These formations also provide us with objectives. Once a double bottom is completed, prices should rise at least as far as the distance from the bottom of the "W" to the breakout point.

A double bottom is confirmed when prices close above the center of the "W" formation. This is referred to as the breakout. The difference from the bottom of the formation to the top gives a price objective. Targets for price declines from double tops are figured the same way.

Often, prices will retest the breakout point after completing the formation. After a double top is completed, prices may briefly rebound to test the resistance, which is the same point where the original double top was completed.

Trending With Moving Averages

Moving averages are one tool to help you detect a change in trend. They measure buying and selling pressures under the assumption that no commodity can sustain an uptrend or downtrend without consistent buying and selling pressure.

A moving average is an average of a number of consecutive prices updated as new prices become available. The moving average swallows temporary price aberrations but tells you when prices begin moving consistently in one direction.

Trading with moving averages will never position you in the market at precisely the right time. They are intended to help you take profits from the middle of the trend and hold losses to a minimum.

The risks and the magnitude are intrinsic to the speed of the moving averages. Professional traders lean toward the faster averages and portfolio managers generally prefer slower signaling moving average approaches.

Moving averages are a simple way to gauge the direction the tide is flowing in a commodity market. They are not always right, but they provide a wide variety of possible uses.

Lag prices

Moving averages lag prices because of their makeup. You can make a moving average for any number of days you choose, but remember that the more days you average, the more sluggish the moving average becomes. Most commodity traders find a 3-day moving average alone is too volatile. However, 4-day and 5-day moving averages are common as short-term indicators.

To start a 4-day moving average, add the last four days' closing prices and divide by four, The next day, drop off the oldest price, add the new close, and divide by four again. The result is the new moving average. Use the same system for any moving average you might want to develop.

Moving averages give signals when different averages cross one an- other. For example, in using 4-day, 9-day and 18-day moving averages, a buy signal would be given when the 9-day average crosses the 18-day. However, to avoid false signals, the 4-day average should be higher than the 9-day.

Just the opposite is true for sell signals. To sell, the 4-day average must be below the 9-day. The sell signal is triggered when the 9-day average crosses the 18-day.

There are other conditions you might wish to place on your averages to avoid false signals. One possible requirement is to make the 4-day exceed the 9-day by a certain percentage before acting on the appropriate buy or sell signal.

The caveat to moving averages is that although they work well in trending markets, they may whipsaw you in a sideways, choppy market.

It helps to "tune" the moving averages to a particular market. A bit of brainwork is necessary to use a moving average. You can use the moving average studies on MarketClub streaming charts to find whether a fast or slow moving average is best for your trading style.

Some traders who use moving averages follow the slower moving average signals to initiate a position but a faster moving average to exit the trade, especially if substantial profits have been built up.

A linearly-weighted moving average also could help eliminate false signals. A 4-day linearly-weighted moving average multiplies the oldest price by four, the next oldest price by three, etc., and divides the total by 10.

This weighted average is more sensitive to recent prices than a standard average. The term, "linearly-weighted," comes from the fact that each day's contribution diminishes by one digit.

The rules for trading a weighted moving average are the same as using a combination of three moving averages. The weighted average must be above or below the other moving averages, or the signal is ignored.

A more sophisticated average is the exponential moving average, which is weighted nonlinearly by using a specific smoothing constant derived for each commodity to allocate the weight exponentially back over prior trading days.

However, it requires high mathematics and a computer to determine each optimum smoothing constant.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders!

Point-and-Figure Charts

You know what point-and-figure charts look like: an elongated version of tic-tac-toe. Yet, they provide another means of determining a trend. In fact, their advantage over a bar chart is the specific buy and sell signals — no personal interpretation is needed.

The pork belly chart is shown for the same time period in both bar chart and point-and-figure form. The differences in appearance are striking. This is due mainly to the lack of a time scale on the point-and-figure chart. Time is irrelevant; price movements are charted only when they occur. On days when no new high or low is made, no additional entries are made on the chart.

Also, on a point-and-figure chart, the price scale marks the space between the lines rather than on the lines as bar charts are marked.

Upward price action in a point-and-figure chart is indicated by X's; downward movement by 0's.

The point-and-figure chart gives a simple buy signal when an X in the latest column has filled a box that is one box higher than the preceding column of X's. A simple sell signal appears when the latest column is in 0's, and the 0's fill the box below the previous column of 0's. These simple signals are marked on the pork belly point-and-figure chart on this page.

Each point-and-figure chart you see will have a box size and reversal number. In this case, it is 40 x 6, which means each box is worth 40 points, and it takes a price change of six full boxes in the opposite direction to start a new column. When beginning a new column, the box adjacent to the last entry is always left empty.

Rules for plotting

When plotting X's, wait for the price to rise to fill the entire box before adding another X to the current column. Likewise, when working with a down trending column of 0's, wait for prices to drop to fill the whole box before adding another 0 to the column.
Based on a single day's price action, you don't add to the current column and then plot a reversal. If you continued the current column of X's or 0's, don't start a new column based on one day's price action.

For example, if the most recent column is X's, look at the daily high first. If the high is high enough to require drawing one or more additional X's in the current column, the daily low is ignored, regardless of how low it might be. If the trend has truly reversed, it will be revealed the following day Only if you can't add an X do you check the low to see if you can fill the required number of boxes for a reversal.

A similar procedure is used when the current column is 0's. Look at the daily low first and ignore the high if you can add to the 0 column. As before, only if you can't add an 0 do you check the high to determine if you can add enough X's for a reversal. A flow chart for plotting a 3-box reversal chart is below.

Each vertical column will always have at least the number of X's or Os needed for a reversal. For example, the pork belly illustration of a 40 by 6 box size and reversal will always have at lease six X's or 0's in each column.

There are many formations on point-and-figure charts, but breakouts of double or triple tops or bottoms are probably the most reliable ones. The last rally (the June rally) on the pork belly point-and-figure chart to just over the 70 f level was a breakout of a triple top.

Trendlines can also be used on point-and-figure charts. Most traders agree that the 45-degree trendline, which cuts each box diagonally, is more useful than connecting highs or lows as you do on a bar chart.

An uptrend line is started at the lower right hand comer of the box with an 0 and drawn up to the right at a 45-degree angle. A downtrend line begins at the upper right hand comer of a box with an X and is drawn down at a 45-degree angle to the right.

Selective use

Breakouts of point-and-figure formations must completely clear the 45-degree line, and, if applicable, move one box higher or lower than the previous column of like letters.

The disadvantage of point-and-figure charts is that they may be slow to signal trend changes. Since point-and-figure traders are buying and selling breakouts, follow through is needed for a profitable trade. Similar to moving averages, they don't work well in sideways markets.

One way to use the point-and-figure selectively is to ignore minor trend reversals when a new column is started. Some whipsaws may be reduced by ignoring minor signals unless they are in tune with the major trendline on the point-and-figure chart.

How To Use The Relative Strength Index

One of the most useful tools employed by many technical commodity traders is a momentum oscillator which measures the velocity of directional price movement.

When prices move up very rapidly, at some point the commodity is considered overbought; when they move down very rapidly, the commodity is considered oversold at some point. In either case, a reaction or reversal is imminent. The slope of the momentum oscillator is directly proportional to the velocity of the move, and the distance traveled up or down by this oscillator is proportional to the magnitude of the move.

The momentum oscillator is usually characterized by a line on a chart drawn in two dimensions. The vertical axis represents magnitude or distance the indicator moves; the horizontal axis represents time. Such a momentum oscillator moves very rapidly at market turning points and then tends to slow down as the market continues the directional move. Suppose we are using closing prices to calculate the oscillator and the price is moving up daily by exactly the same increment from close to close. At some point, the oscillator begins to flatten out and eventually becomes a horizontal line. If the price begins to level out, the oscillator will begin to descend.

Plotting the oscillator

Let's look at this concept using a simple oscillator expressed in terms of the price today minus the price "x" number of days ago — let's say 10 days ago, for example.

The easiest way to illustrate the interaction between price movement and oscillator movement is to take a straight line price relationship and plot the oscillator points used on this relationship, as shown on this page's chart.

In our illustration, we begin on Day 10 when the closing price is 48.50. The price 10 days ago on Day 1 is 50.75. So with a 10-day oscillator, today's price of 48.50 subtracted from the price 10 days ago of 50.75 results in an oscillator value of - 2.25, which is plotted below the zero line. By following this procedure each day, we develop an oscillator curve.

The oscillator curve developed by using this hypothetical situation is very interesting. As the price moves down by the same increment each day between Days 10 and 14, the oscillator curve is a horizontal line. On Day 15, the price turns up by 25 points, yet the oscillator turns up by 50 points. The oscillator is going up twice as fast as the price. The oscillator continues this rate of movement until Day 23 when its value becomes constant, although the price continues to move up at the same rate.

On Day 29, another very interesting thing happens. The price levels out at 51.00, yet the oscillator begins to go down. If the price continues to move horizontally, the oscillator will continue to descend until the 10th day, at which time both the oscillator and the price will be moving horizontally

Note the interaction of the oscillator curve and the price curve. The oscillator appears to be one step ahead of the price. That's because the oscillator, in effect, is measuring the rate of change of price movement. Between Days 14 and 23, the oscillator shows the rate of price change is very fast because the direction of the price is changing from down to up. Once the price has bottomed out and started up, then the rate of change slows down because the increments of change are measured in one direction only.

Three problems

The oscillator can be an excellent technical tool for the trader who understands its inherent characteristics. However, there are three problems encountered in developing a meaningful oscillator:

Erratic movement within the general oscillator configuration. Suppose that 10 days ago the price moved limit down from the previous day.Now, suppose that today the price closed the same as yesterday. When you subtract the price 10 days ago from today's price, you get an erroneously high value for the oscillator today. To overcome this, there must be some way to dampen or smooth out the extreme points used to calculate the oscillator.
The second problem with oscillators is the scale to use on the horizontal axis. How high is high, and how low is low? The scale will change with each commodity. To overcome this problem, there must be some common denominator to apply to all commodities so the amplitude of the oscillator is relative and meaningful.
Calculating enormous amounts of data. This is the least of the three problems.

A solution to these three problems is incorporated in the indicator which we call the Relative Strength Index (RSI):

RSI = 100 – [100 / (1 + RS)]
RS = Average of 14 days' closes UP / Average of 14 days' closes DOWN

For the first calculation of the Relative Strength Index (RSI), we need closing prices for the previous 14 days. From then on, we need only the previous day's data. The initial RSI is calculated as follows:

Obtain the sum of the UP closes for the previous 14 days and divide this sum by 14. This is the average UP close.
Obtain the sum of the DOWN closes for the previous 14 days and divide this sum by 14. This is the average DOWN close.
Divide the average UP close by the average DOWN close. This is the Relative Strength (RS).
Add 1.00 to the RS.
Divide the result obtained in Step 4 into 100.
Subtract the result obtained in Step 5 from 100. This is the first RSI.

Smoothing effect

From this point on, it is necessary to use only the previous average UP close and the previous average DOWN close in calculating the next RSI.

This procedure incorporates the dampening or smoothing factor into the equation:

To obtain the next average UP close, multiply the previous average UP close by 13, add to this amount today's UP close (if any) and divide the total by 14.

Steps 3 to 6 are the same as for the initial RSI.

The RSI approach surmounts the three basic problems of oscillators:

Erroneous erratic movement is eliminated by the averaging technique. However, the RSI is amply responsive to price movement because an increase of the average UP close is automatically coordinated with a decrease in the average DOWN close and vice versa.
The question, "How high is high and how low is low?" is answered because the RSI value must always fall between 0 and 100. Therefore, the daily momentum of any number of commodities can be measured on the same scale for comparison to each other and to previous highs and lows within the same commodity.
The problem of having to keep up with mountains of previous data is also solved. After calculating the initial RSI, only the previous day's data is required for the next calculation.

Just one tool

The Relative Strength Index, used in conjunction with a bar chart, can provide a new dimension of interpretation for the chart reader. No single tool, method, or system is going to produce the right answers 100 of the time. However, the RSI can be a valuable input into this decision-making process.

Commodity Price Charts plots the 14-day RSI, updating the chart through Thursday of each week. Contrary to popular opinion, the choice of the number of market days used in calculating the RSI doesn't really matter because the smoothing nature of the exponential averages reduces the effect of the early days as more data is included.

To help you update the RSI values until the next issue of the charts arrives, we list the "up average" and "down average" as of Thursday on each RSI chart.

Simplified formula

The procedure outlined earlier for beginning and updating RSIs is from J. Welles Wilder's book and his 1978 Futures Magazine story, which made the RSI a popular technical tool. The following is a simpler and faster method of computing the RSI. The results are the same as Wilder's more complicated method.

To begin a new RSI, just list the changes for 14 consecutive trading days and total the changes. Divide these totals by 14, and you will have the new up and down average. Then proceed with this formula:

RSI = 100 x U / (U + D)
U = up average; D = down average.

The example below is for T-bills.
Date	Up	Down
1/28	+41
1/29		-2
2/1		-60
2/2		-7
2/3	+2
2/4	+1
2/5	+6
2/8		-26
2/9	+11
2/10	+14
2/11	0	0
2/12		-11
2/16	+28
2/17		-18
Total	103	124

1.03 / 14 = .074 = Up ave.
1.24 / 14 = .089 = Down ave.
RSI= 100 x (.074 /.163) = 45.39

To calculate the next day's RSI, multiply the up average (.074) by 13. Add the change for the day, if it is up. Divide the total by 14. Do the same for the new down average. Multiply the new down average (.089) by 13. Add the change for the day, if it is down. Divide total by 14.

Then, proceed with the formula:

RSI = 100 x U / (U + D)

For example, if T-Bills closed up 25 points the next day, calculate the new RSI as follows:

New Up ave. = .074(13) + .25/14 = .087
New Down ave. = .089(13) + 0/14 = .083
New RSI = 100 x .087 / (.087 + .083)
RSI = 51.2

Learning to use this index is a lot like learning to read a chart. The more you study the interaction between chart movement and the Relative Strength Index, the more revealing the RSI will become. If used properly, the RSI can be a very valuable tool in interpreting chart movement. Some of its uses

RSI points are plotted daily on a bar chart and, when connected, form the RSI line. Here are some things the index indicates as shown by examples from the silver chart:

Tops and bottoms — These are often indicated when the index goes above 70 or below 30. The index will usually top out or bottom out before the actual market top or bottom, giving an indication a reversal or at least a significant reaction is imminent.

The major bottom of Aug. 15 was accompanied by an RSI value below 30. The major top of Nov. 9 was preceded by an RSI value above 70. The top made on Jan. 24 was preceded by an RSI value of less than 70. This would indicate this top is less significant than the previous one and either a higher top is in the making or the long-term uptrend is running out of steam.

Chart formations — The index will display graphic chart formations which may not be obvious on a corresponding bar chart. For instance, head-and-shoulders, tops or bottoms, pennants or triangles often show up on the index to indicate breakouts and buy and sell points.

A descending triangle was formed on the RSI chart during October and early November that is not evident on the bar chart. A breakout of this triangle indicates and intermediate move in the direction of the breakout. Note also the long-term coil on the RSI chart with the large number of support points.

Failure swings — Failure swings above 70 or below 30 are very strong indications of a market reversal.

After the RSI exceeded 70 during October, the immediate downswing carried to 65. When this low point of 65 was penetrated the following week, the failure swing was completed.

After the low of Aug. 15, the RSI shot up to 41. After two downswings, this point was penetrated on the upside on Aug. 26, completing the failure swing.

Support and resistance — Areas of support and resistance often show up clearly on the index before becoming apparent on the bar chart. Trendlines on the bar chart often show up as support lines on the RSI. The mid-November break penetrated the uptrend line on the bar chart at the same time as the support level on the RSI chart.

Divergence — Divergence between price action and the RSI is a very strong indicator of a market turning point and is the single most indicative characteristic of the Relative Strength Index. Divergence occurs when the RSI is increasing and price movement is either flat or decreasing. Conversely, divergence occurs when the RSI is decreasing and price movement is either flat or increasing. Divergence does not occur at every turning point.

On the silver chart, there was divergence between the bar chart and RSI at every major turning point. The top made in November was "warned" by the RSI exceeding 70, a failure swing and divergence with the RSI turning sideways while prices continued to climb higher.

Stochastics

Like the Relative Strength Index (RSI), stochastics is another popular oscillator to gauge price momentum and judge the age of a price move. Stochastics is not a new oscillator. The idea was originated by a Czechoslavakian and perfected by Dr. George Lane, editor and publisher of Investment Educators in Skokie, Illinois.

But unlike the RSI, which measures momentum based on the changes in daily settlement prices, stochastics has two lines and the calculations are based on the rate of change in the daily high, low, and close. The concept for stochastics is based on the tendency that as prices move higher, the daily closes will be closer to the high of the daily range. The reverse is true in downtrends. As prices decrease, the daily closes tend to accumulate closer to the lows of the daily trading range. This concept also holds true on daily, weekly and monthly charts.

Stochastics can be calculated for any time period. Choosing the right time period for the stochastics is similar to choosing the right number of days for a moving average. In effect, stochastics is a trend-following method since its lines will cross after tops and bottoms have been made. Choosing too short a time period will make the stochastics so sensitive that it becomes virtually worthless. If the time period is too long, it is too slow to turn and too insensitive to be useful.

Stochastics signals

Both bearish and bullish divergence are shown on the accompanying S&P chart. There's bearish divergence in late February when S&P prices make a new high but the %D line stays far below its winter high. This divergence accurately warned that a top was forming. An equally good signal of a bottom was the bullish divergence during the spring. The S&P was making new lows into early May, but the %D line held above the lows made during March.

Overbought/oversold zones

Markets seldom go straight in one direction without a pause or correction. When prices move up and appear to be ready to correct, the market is called overbought. When prices have been moving down and appear to be ready to rebound, the market is oversold. As a mathematical representation of a market's overbought or oversold condition, stochastics tells you when prices have gone too far in one direction.

Values above 75 (in the shaded area) indicate the overbought zone. Values below 25 (also shaded) indicate the oversold zone. (Some traders prefer using 80 and 20 as the parameters for overbought and oversold markets.) In sustained moves, stochastics values may remain in these shaded areas for extended lengths of time.

Buy/Sell signals

There are at least two popular ways traders use stochastics for buy and sell signals. A conservative approach is to wait for both the %K and %D to come out of the shaded area to issue the signal. For sell signals, a conservative trader waits for both lines to rise into the overbought zone and then fall below 75 again. An opposite pattern is followed for a buy signal. After both lines drop below 25, the buy signal is given when the stochastics lines climb above 25 again. This is a more conservative approach because you will be slower in taking a position, but it may eliminate some false signals.

For more aggressive traders, the buy and sell signals on the stochastics charts are generated when the two lines cross. For most traders the buy and sell signals are flashed when %K crosses %D, as long as both lines have first gone into the overbought or oversold zones. This is similar to the buy and sell signals of two moving averages.

Waiting for the stochastics lines to come out of the shaded area will sometimes prevent false - signals. For example, If you,were watching for a buy signal on the stochastics chart for the NYSE composite index during the August-September period, %K crossed the %D line in early August and at least five more buy signals were given before the trend finally turned up in early October. An aggressive trader who went with the first crossing of the lines would have been stopped out at least a couple times before finally getting on board for a good move up. But the more conservative trader would have been waiting for both lines to climb out of the oversold area before buying, thus avoiding the whipsaw signals in August and September.

Oscillators are notoriously unreliable in signaling trades against the trend. For good stochastics signals, you'll need to trade with the longer-term trend (Giant Footprints) . Follow only the buy signals in uptrends and only the sell signals in bear markets. However, in a trading range market, stochastics will give good buy and sell signals.

Buy and sell signals are shown on S&P 500 chart. With stock indexes in an overall uptrending pattern, the stochastics buy signal would have helped traders establish long positions on the buy signals in November, December and March. The sell signals in February, June and July could have been used to take profits on long positions.

Some traders prefer to see the %K line cross the %D line on the right side. This is called a right-hand crossing. In other words, %K is crossing %D after %D has bottomed or topped. When the %K crosses the %D line before the %D has bottomed or topped, it is referred to as left-hand crossing. Of course, this can only be seen in hindsight because, at the time the two lines intersect, you don't know if the %D has reached its ultimate top or bottom.

Left-hand crossings are not as common as right-hand crossings. You can see a left-hand crossing on the S&P chart in early February. The %K dipped below the %D before the %D had reached its ultimate peak.

Stochastics is a very useful technical indicator which helps you with your timing, especially when it is used in conjunction with the other trading tools.

Average Directional Movement Index

Although the average directional movement index (ADX) isn't used as frequently as some of the popular technical indicators, the ADX line has definite advantages because it filters out a lot of the false oscillator signals which are frequently given early in a move.

A longer-term trader can stay with trending positions longer by following the simple guidelines for the ADX line. According to research by computer trading expert Bruce Babcock, a climb by the ADX line above 40 followed by a downturn signals an imminent end to the current trend (whether up or down). When this signal is given, traders should take profits on existing positions. More aggressive traders can use this signal to consider taking positions for a possible move in the opposite direction.

The charts on this page show how the ADX works. The ADX line on the feeder cattle chart gave two signals during the year. The first downturn accurately marked the top in February, and the second downturn above the 40 level signaled a bottom in late summer. Note that the signal in late July was actually more than a month ahead of the actual bottom in September. The ADX warns you of an end to the trend. In this case, it gave you more than a month's warning.

Like the feeder cattle signals, crude oil's ADX gave two signals during the year, one at the summer low and the second at the winter high. Both signals were given by climbing above 40 and turning down.

The ADX signals by feeder cattle and crude oil signaled the end of one trend and the beginning of a new trend. But the ADX is not designed to signal a trend reversal. It only signals the end of the existing trend. A good example of not signaling a trend reversal is T-Bonds. The end of the strong spring rally was accurately marked by the ADX signal in June. Then T-Bonds consolidated in a coil until the upside breakout in the fall. An ADX climb above 40 and downturn in November signaled another consolidation.

Usually, a commodity gives no more than a couple ADX signals during a year, unless the market has particularly volatile price action. The ADX is less helpful during sideways markets. During extended consolidation periods, the ADX line will slip toward 10. When ADX approaches 10, a major move is usually about to take place. But the ADX line doesn't tell you which direction it will go. You have to rely on other indicators for the probable direction of the next move.

The ADX is part of the direction movement system introduced by J.Welles Wilder in his book, New Concepts in Technical Trading Systems. Wilder introduced a 14-day ADX, and Babcock has not found any good reason to vary this time period.

In summary, if the market is trending (whether up or down), the ADX line should be rising. During an extended consolidation period, the ADX line will slip toward a low number.

How To Use Cycles

Everything in nature moves in cycles. . . the cycles of the seasons ... night and day... tides... phases of the moon. Each year animals hibernate... geese migrate... salmon swim upstream to spawn... and every seven years lemmings run into the ocean.

While nature's cycles are very visible, there are many cycles in the futures markets that are not quite as obvious. Often the reason some cycles are not easily seen is because the interaction of many large and small cycles makes individual cycles harder to see.

Cycles are the tendency for events to repeat themselves at more or less uniform intervals. One of the easiest cycles to see and understand is the seasonal cycle. Agricultural commodities have a repetitive annual price pattern called the seasonal price cycle. More than 70 of the time, the lowest cash prices of the year for corn, cotton and soybeans occur during the fall harvest period. Due to increased marketings, cattle and hogs also have price weakness during the fall. Wheat and oats tend to make seasonal lows during their summer harvest. Seasonal price trends are a reflection of regular annual changes in supply and demand factors caused by weather, production and demand.

After a seasonal cycle has bottomed, a trader knows prices should not drop below the seasonal low until after the seasonal high has been made, normally several months later. After the seasonal cycle has topped, the uptrend is over and prices should move lower until the seasonal cycle bottoms. Traders who know the direction of the seasonal cycle are able to follow the profitable maxim of trading with the trend.

Keep in mind there are sometimes some surprising differences in the seasonal pattern of cash and futures prices for agricultural markets.Futures markets try to anticipate the cash market due to expected production and expected demand. Therefore, futures market may bottom as much as two months ahead of the cash market. For example, the hog futures market may bottom in August, anticipating the fall low for the cash market, but the cash hog market may not bottom until October.

While the causes of seasonal cycles are known, the causes of other cyclical patterns are not always known. The Foundation for the Study of Cycles (124 South Highland Ave., Pittsburgh, PA 15206), a nonprofit organization, has cataloged thousands of cycles using detrending processes. Some of the longer-term cycles they have identified include the 9-year wheat cycle, the 5'/2-year corn cycle, the 5'/2-year cycle for precious metals, the 25-month and 38-month soybean cycles, the 11-year cattle cycle, and the 4-year business cycle.

The theory of cyclical analysis is that events will occur within a cycle to move prices in the expected direction of the cycle. The basic drawback of fundamental analysis is that the events causing changes in supply and demand are not known until after the fact ? well after tops and bottoms have occurred. All fundamental information relative to supply and demand is in the market each trading day. But the market usually moves before the fundamental reasons are known. Cycles help traders pick the direction of price moves before the news comes out.

To analyze a futures market based on cycles, it is necessary to isolate the dominant cycles affecting price activity. Once these dominant cycles have been identified, future price expectations can be established by combining the effects of these dominant cycles. Long-term cycles, such as the yearly cycles identified by the Foundation for the Study of Cycles, tell you the direction of the overall price trend. Shorter cycles, weekly and daily, can then be used to determine when long-term cycles have topped or bottomed and when to enter and exit a market.

Most markets have a dominant short-term daily cycle which may be as short as 14 calendar days or as long as 35 days. Most of the meats and grains, for example, have a short-term cycle averaging 28 calendar days. Combing two or more of these short-term daily cycles forms a dominant intermediate-term weekly cycle which runs 6 to some 20 weeks from low to low, depending on the futures market. When the short-term cycles are combined with a larger cycle, the smaller cycles will look like the drawing at the bottom of this page.

Cycles are seldom symmetrical, and their patterns differ in bull and bear markets. In a bull market, the crest of the cycle tends to lean to the right because the highs are to the right of the midpoint of the cycle. This is called right translation. In strong bull markets, the length of the cycles tend to contract (shorten) slightly.

Just the opposite is true in a bear market. In bear markets, the cycles tend to be slightly longer than they were during bull markets. Cycles in bear markets tend to peak early in the cycle to the left of the midpoint - called left translation. Note the 13-week cycle from August to November on the K.C. May wheat had right translation up to the seasonal high and left translation coming down from the winter seasonal high. Right translation quickly followed by left translation is often the way a longer-term cycle high is made. Seasonal lows are often made the way Dec. hogs bottomed in September with extreme left translation followed by extreme right translation.

Trendlines are also an important tool to confirm cyclical tops and bottoms. Penetration of a trendline drawn from the crest of two cycles of similar length confirms that the next longer cycle has bottomed. In bull markets, breaking an uptrend line connecting the lows of two similar length cycles will confirm that the next longer-term cycle has crested.

The wheat charts on these pages are a good example of repetitive patterns which are helpful in profitably trading a market. For the long-term perspective, these charts show wheat when it was declining toward the 9-year cycle low, which is expected the next summer. The current seasonal cycle began in August, topped in December and is expected to bottom with the 9-year cycle the following summer.

Near the 13-week cycle low in February, intermediate-term traders would be taking profits with plans to sell again as the next 13-week cycle crests. The next cycle high is likely to come early (left translation) because the dominant 9-year and seasonal cycles are pointing down. The crest of the 13-week cycle may be made with the crest of the first 28-day cycle out of the February low. This 13-week cycle should bottom again about 13 weeks from the February low, which would put the expected low in May (plus or minus 15). The next 13-week cycle low would be due in another 13 weeks in August, which would be the most likely time for the seasonal cycle lows.

On the Chicago July wheat chart, three 28-calendar-day cycles make up the 13-week wheat cycle. Breaking the uptrend line connecting 28-day cycle lows confirmed the 13-week cycle high in November. The winter seasonal high was confirmed during the January collapse when prices dropped below the previous 13-week low (Nov. 25 low). The 13-week cycle low in February was confirmed by breaking the downtrend line connecting 28-day cycle highs. Shorter-term traders would be trading the 28-day cycle highs and lows in the direction of the intermediate-term cycle.

Cycles are most accurately measured from low to low. It is not unusual for a cycle to have a variation of plus or minus 15 of the length of the cycle, and expectations should be established accordingly While the most probable times for cycles to top and bottom can be established, cycles do sometimes stretch, shrink and, on occasion, disappear. It is a common feature of cycles to correct themselves as time passes. A cycle that runs too short, for example, might then make an adjustment by running longer on its next repetition. Chicago July wheat had two short cycles in September and October, which was followed by a cycle that ran more than five weeks from mid-October to late November.

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