Lesson 1: The Trend
A trader is only successful if he/she can identify a prevailing trend and trade in the same direction. I am sure you heard that one before. How many times did you hear the definition "Bull trend is when the market makes higher highs and higher lows"? Yet how many times did you see that happen, and when you attempted to trade, the trend reversed against you, and cost you dearly? Every single time you traded? two times out of three? Nine times out of ten? Did you think the problem lies within your trading capabilities? Well no, it’s not! It’s with the definition itself! You need to properly identify the trend, because otherwise, you’ll keep wandering in that same vicious cycle in search for a profitable trading system.
Let’s not waste more time and get into the heart of the subject, the trend. We will be approaching the market for some swing trades. However, if you want to do intraday trading, you can just use shorter time frames as we’ll see later. As for the type of market, the beauty of those tools is that they are applicable on mostly all financial markets. So regardless of whether you’re a stock trader, futures trader, FX trader, you can still apply those tools profitably.
OK. So how do we define a trend? It’s pretty simple. We’ll use a 5-period Simple Moving Average. Note: All moving averages used in the system are simple moving averages, however, you are free to experiment with weighted or exponential moving averages if they give you better results. For swing trades, we’ll be using a daily chart with a 5-day Moving Average. And yes, this sounds too simple to be true. Oh well, that’s one reality about successful trading: PLEASE keep it simple, and don’t get shocked by the results. Just keep it simple and make money. Look at the 5-day moving average, and if it’s pointing up then the trend is up. If it’s pointing down, then the trend is down. This is ALL you need to know for now as far as trend identification is concerned. Someone might ask, what if the moving average is flat? Well that’s when it’s changing from bullish to bearish or the other way around. That’s one of the cases when you should be paying extra attention to the market, as we’ll see later. But for now, please only use a 5-day moving average, and trade in its direction. We’ll be going long if the 5-day moving average is pointing up, and we’ll be going short if the 5-day moving average is pointing down.
Lesson 2: The Setup – Candlesticks
Some pre-requisites are essential before we get into the heart of successful trading. The Japanese Candlestick method is one important aspect. And by the way, Candlesticks are not complicated at all. Actually, no previous candlestick knowledge is needed to understand and follow the method. Just focus on what we have to pick from that school, and that’s all you need to know, in order to take the first steps towards successful trading. The beauty of candlesticks, is that it is the ONLY method capable of signaling a trend reversal at its earliest stages. Yes, I repeat the ONLY method capable of doing that, and therefore, we can’t ignore it if we want to be successful traders. Can we? The Japanese method was there 300 years before any other school of technical analysis.
We will only pick some major indicative candlestick patterns, memorize them by heart, and use them whenever we can in our trading. But first, we need to understand what a candle is. When you draw a Japanese Candlestick chart, you’ll realize it’s similar to candles, and hence the name. Some candles are white, others are black. And sometimes, there are lines on top and below the candle. The Candle itself is the difference between the open price and the close price at any given period. When the body of the candle is white, it means the market opened at the bottom of the candle, and closed at the top. And when the color of the body is black, it means the market opened at the top of candle and closed at the bottom, i.e. the close is lower than the open. Then what about those upper and lower lines? Those are the highs and lows at any given session. The highest price reached during a specific period is connected to the body of the candle, and is called the "upper shadow", whereas, the low of the session is connected to the body of the candle, and is called the "lower shadow". Sometimes the high is also the open/close, in which case the candle won’t have a higher shadow. And if the low is also the open/close, then in the same way, the candle won’t be having a lower shadow.
Please find below detailed description of each candle pattern we will be using :
Continuation Patterns :
- Long White Body: In a bullish trend, this candle is very healthy and confirms the continuation of the positive trend. It’s simply a candle with a white body that is longer than usual. This should be easily detectable with the eye.
- Long Black Body: In bear trend, it confirms the continuation of the negative tone.
That’s all you need to know as far as continuation patterns are concerned so stick to those until we see how to use them in conjunction with Moving Averages.
Reversal Patterns :
- Doji: That’s when the open and the close are the same, and therefore, the candle has the shape of a cross. In which case, it signals indecision in the market, and is usually followed by a trend reversal.
- Bullish Engulfing: That is when after a long bear trend comprised of several black bodies, a long white body engulfs the previous day’s black body. The market usually goes up afterwards.
- Bearish Engulfing: That is when after a long bull trend comprised of several white bodies, a long black body engulfs the previous day’s white body. The market should be expected to fall afterwards.
- Piercing Line: When after a long bear trend, the market hits a new low, and then ends up penetrating (but not engulfing) the previous day’s black body. The market usually goes up afterwards.
- Dark Cloud Cover: When after a long bull trend, the market hits a new high, but then closes lower, penetrating (but not engulfing) the previous day’s white body. The market usually falls afterwards.
- Hammer: When after a long bear trend, the market opens almost neutral, then falls sharply, before coming up again and closing near its open. In this case, we only have a long lower shadow (no upper shadow). The market usually rallies afterwards.
- Shooting Star: When after a long bull trend, the market opens almost flat, then rallies to new highs, before coming down again and closing near its open. In this case, we only have a long upper shadow (no lower shadow). The market usually falls afterwards.
- Morning Star: When after a long bear trend, a steep decline in the first day, is followed by small body gaping below the first day’s body, and then finally on the third day the market opens up and rallies forming a long white candle. In this case, we have a long black body + a small body + a long white body. The market usually rallies afterwards.
- Evening Star: When after a long bull trend, a steep rally in the first day, is followed by a small body gaping above the first day’s body, then finally on the third day the market opens lower and falls sharply forming a long black body. In this case, we have a long white body + small body + a long black body. The market usually falls afterwards.
- Bullish Harami: When after a long bear trend, a long black body is followed by a small body that is engulfed inside it. The market usually rallies afterwards.
- Bearish Harami: When after a long bull trend, a long white body is followed by a small body that is engulfed inside it. The market usually falls afterwards.
- Spinning Tops: This is when after a long trend, bullish or bearish, one or several candles are comprised of small bodies and small shadows. The market usually reverses afterwards.
But please note, that we only need to memorize 14 patterns: Two continuation patterns, and 12 reversal patterns.
You only need to properly understand the logic behind those 14 candle patterns. And that’s what we did in this chapter. So please visit the link provided, and memorize those patterns by heart. Look at them one by one, see how the market behaved, where it started and where it ended, and hence why the pattern became bullish or bearish. That is ALL for now. Later on, we will see how to use those candle patterns in trading.
Lesson 3: The Entry – Leading Method
In this chapter we’ll see when to enter a trade using the Leading Method. The Leading Method, is used whenever an early signal is generated by ANY candlestick reversal pattern discussed in lesson 2, "The Setup". Someone might wonder that in a bear trend the 5-day moving average might still be pointing down when a reversal signal is generated by a candlestick pattern, so how are we suppose to enter long when the trend is down? Very good question! Well this would be the ONLY exception, and it would have some strict criteria to allow its application :
1) In a Bear trend, the candlestick reversal signal must be generated AT or BELOW the 5-day moving average, or otherwise, it would be too late and too risky to enter, and vice versa.
2) The candlestick reversal signal must be associated with AVERAGE to HIGH volume, or otherwise it’s unreliable.
3) The trade should be entered at the very end of the session, and since we’re planning a swing trade and working on a daily chart, then we’ll have to enter the trade before the session closes. It’s better to wait till the very last minutes, preferably the last 5 minutes to make sure the candle pattern doesn’t change at the close.
Let’s have an example and see how this practically works. We picked the NDX since most people seem to trade it. So let’s draw a daily candlestick NDX chart, with a 5-day moving average, and see how signals were generated. (you can use yahoo or any other free online charting service)
Let’s examine the last three months and see how candlestick patterns accurately signaled most bounces against the trend, as well as the resumption of the bear trend:
1) May 7, 2002: A combination of a Hammer & Bullish Harami saw the index rebound from a low of 1,142 to a high of 1,350 six days later. Please note how both signals were generated way below the 5-day moving average.
2) May 15, 2002: That same move ended six days later at 1,350 with a Shooting Star. See how the signal was generated way above the 5-day moving average. The market tried to resume higher during the following two days, but failed, and resumed sharply lower.
3) June 12, 2002: A Piercing Line just below the 5-day moving average caused the market to rally three days later.
4) June 18, 2002: A Doji + Bearish Harami ended that upward move and forced another sell-off.
5) July 3rd, 2002: A bullish Engulfing forced another rally.
6) July 11, 2002: Another Piercing Line was behind the last upward move.
Isn’t that impressive? All moves signaled a day or more prior to their start? Well, no! If you don’t know where to take your profit, then it doesn’t make a difference, and you’ll end up losing money. We’ll learn everything about profit-taking later in a separate lesson.
Lesson 4: The Entry – Lagging Method
In this chapter we’ll learn the Lagging entry method. It’s called so, because the entry takes place at a later stage than that of the Leading method. In other words, the market would have already reversed course when you enter the trade. It’s pretty straight forward, and is applied in the following conditions :
1) The market crosses above the 5-day moving average, the 5-day moving average is pointing up, you enter long. The only exception is if the market crosses way above the 5-day moving average, in which case, you’d wait for the first pull-back as we’ll see in case 3.
2) The market crosses below the 5-day moving average, the 5-day moving average is pointing down, you enter short. The only exception is when the market crosses way below the 5-day moving average, in which case you wait for the first reaction as we’ll see in case 4.
3) The 5-day moving average is pointing up, the market is already above the 5-day moving average but is pulling back towards it. As the market closes near the 5-day moving average (but doesn’t cross below it), you enter long.
4) The 5-day moving average is pointing down, the market is already below the 5-day moving average but is picking up towards it. As the market closes near the 5-day moving average (but doesn’t cross above it), you enter short.
That’s it plain and simple!
Now let’s see the Lagging Method in action. Let’s examine once again the 3-month daily candlestick chart of the NDX, and note the following lagging signals:
1) April 30, 2002: The market is coming up from below the 5-day bearish moving average and closes right on it. As the moving average is pointing down, you go short, and five days later the index is down 140 points.
2) May 13, 2002: The market crosses above the 5-day moving average. The 5-day moving average is pointing up, you go long. Four days later, the market is up 80 points.
3) May 23, 2002: The market comes up from below the negative 5-day moving average, and closes right on it. You go short, and 15 days later, the market is down almost 180 points.
4) June 19, 2002: The market crosses below the negative 5-day moving average, you go short, and 5 days later, it’s down another 100 points.
5) July 1st, 2002: The market crosses below the negative 5-day moving average, you go short, and 2 days later, it’s down 50 points.
6) July 19, 2002: The market crosses below the negative 5-day moving average, you go short, and 3 days later, it’s down 100 points.
Sometimes the Leading Method would help you enter the market at an early stage, but if no leading signals are generated, you can still trade the market using the lagging method and make money. Next we learn about stops.
Lesson 5 : The Stop
It should come as no surprise that we’ll be discussing stops before targets. Why? Because that’s your risk factor. That’s how much money you could lose in a single trade. That’s the one MAJOR difference between technical analysis and the regular "Buy & Hold". That’s how you can’t go bankrupt. That’s your peace of mind, and invaluable wisdom.
The stop is simply the level above/below which, if the market moves harshly against you, you would be taking your loss and getting out of the market. That simply means, that if you enter long, the stop would be below your entry level. And in the same way, if you enter short, the stop would be above your entry level. At least until you start trailing them.
So far it’s easy I suppose. However, the hard part is the level where you are supposed to place that stop. Many people, think they’re applying stops, when in reality, they’re actually killing their trades, and giving their money generously to the market. How? By placing wrong stops. Is there a correct stop and a wrong stop? Of course! A wrong stop, is when the market knocks you out of your trade, and then reverses and goes to where you always wanted it to go. How many times did you suffer that horrible experience? You buy, you place a stop, the market breaks your stop, you take your loss and get out of the market, and at the end of the day your stock is way above your targets? You don’t want to live that experience again, do you? Hence you need to apply a correct stop. And here is how:
1) If a Leading Buy signal is generated, the stop should be placed right BELOW the LOW of the candle pattern. Then as the market moves up and crosses above the 5-day moving average, the stop should be TRAILED right below the 5-day moving average. Therefore, no matter the direction of the 5-day moving average, you’d sell and get out of the market WHENEVER the market breaks below the 5-day moving average.
2) If a Leading Sell signal is generated, the stop should be placed right above the HIGH of the candle pattern. Then as the market starts falling and crosses below the 5-day moving average, the stop should be TRAILED right above the 5-day moving average. Therefore, no matter the direction of the 5-day moving average, you’d cover and get out of the market WHENEVER the market breaks above the 5-day moving average.
3) If a Lagging Buy signal is generated, the stop should always be trailed below the 5-day moving average regardless of its direction.
4) If a Lagging Sell signal is generated, the stop should always be trailed above the 5-day moving average regardless of its direction.
Now two VERY important things :
1) The market has to CLOSE above/below the 5-day moving average in order to validate your stop. Otherwise, intra-day breaks should be DISREGARDED.
2) The market has to break and close decisively above/below the 5-day moving average in order to validate your stop. A slight break above/below the 5-day moving average should also be disregarded. Therefore, please do not automate your stops, and please wait till the very last second of the session before validating your stop. As for the penetration level, please judge that with your eyes and don’t base it on any percentages. Always use 3-month charts, you can use shorter periods, but no longer than 3 month charts in order to clearly view any cross-overs and degree of penetration.
Now let’s see the stop in action. We’ll get back to the 3-month NDX daily chart, and note the following:
1) May 15, 2002: A Leading Sell signal was generated through a "Shooting Star" pattern. The market goes up for two consecutive days, but fails to break above the high of the candle (The Stop). On the fourth day, the market falls and breaks below the 5-day moving average. Consequently, the stop is trailed from the high of "Shooting Star" down to the 5-day moving average. The market fails to break above the 5-day moving average for one full month, and falls 200 points before finally breaking above the 5-day moving average on June 17. Two days later you’d short again, but at least you avoided the upward correction.
2) June 19, 2002: A Lagging Sell signal is generated as the market breaks below the negative 5-day moving average. You short again, and you trail your stop above the 5-day moving average. Please note the intra-day break on June 25, as the market opened above the 5-day moving average before closing sharply below it. This is a case where you should have ignored the intra-day break. Also note the SLIGHT penetrations on June 27 and June 28, two other cases where you would ignore the signals. Finally, on July 3rd a "Bullish Engulfing" reverses the trade.
Remember our latest Buy signal generated on July 24? That was another Leading Buy signal generated by another "Bullish Engulfing". Our stop is currently placed right below the candle’s low at 869. Therefore, we’re still long, and despite yesterday’s drop, our stop still holds, unless the market decisively breaks below it.
Next we look at targets.
Lesson 6: The Targets
In this chapter we look at targets, and learn how to close our trade. Sometimes well be forced to take profit, and some other times well let the trade roll for more profits. This process is VERY important, and makes all the difference when applied properly, because just like the stop, there are correct targets and incorrect ones. You don’t want to close a long position when the market still has steep upward potential. And seemingly, you wouldn’t wanna cover a short trade when the market later on could free fall. Having said that, you need to understand that in our system, there is no such thing as buying the bottom and selling the peak or vice versa. We don’t even buy high and sell higher, or sell low and cover lower. Please forget all that guru nonsense. We rather attempt to trade whenever there is a good trading opportunity, no matter where we are in the market. So one day, we may buy near a bottom and sell near high, another day we may buy high and sell higher, a third day we may buy a dip and sell the resumption of the trend, and so on and so forth. There is no such thing as the ONE rule which guides all trades, or otherwise, you’d be missing a lot of opportunities, and hence fall in the famous category of UNSUCCESSFUL traders. You gotta take advantage of EVERY single opportunity in the market if you wanna become a successful trader.
So? Where are our targets once we enter a trade? Simple! First, we need to plot TWO more moving averages: the 20-day and the 40-day moving averages. Do we use these to generate more buy/sell signals? NO! We rather use them to find targets and take profit! Therefore, whenever you enter a trade, the 20-day moving average becomes your primary target, i.e. whenever the market hits the 20-day moving average, you gotta square a portion of your trade, ideally a third. The fact that we’re using moving averages as target levels destroys a golden rule in TA, which is that targets are placed at fixed levels. Forget about that! Targets change, and they do so on daily basis. So there are no fixed levels, and there is no way of knowing in advance where you’ll be closing your trade. You gotta monitor the 20-day moving average on a daily basis in order to leave the proper order in the market.
Once the market hits the 20-day moving average and a third of the position is squared, two scenarios are possible. First, the market might reverse and break above/below the 5-day moving average, in which case you’d have to close the whole trade, and depending on the direction of the 5-day moving average, might have to reverse the trade. Second, the market might proceed higher/lower towards the 40-day moving average, in which case you’d have to square another portion of the trade, ideally another third.
Once the market hits the 40-day moving average and another third of the position is squared, two scenarios and foreseen. First, the market might reverse and break above/below the 5-day moving average, in which case you’d have to close the whole trade, and depending on the direction of the 5-day moving average, might have to reverse the trade. Second, the market might proceed above/below the 40-day moving average, in which case you’d wait until it reverses course and breaks above/below the 5-day moving average to close the whole trade, and once again depending on the direction of the 5-day moving average, might have to reverse.
But what if you go long, and the market is already above all three moving averages? And what if you go short and the market is already below all three moving averages? In this case, you simply ignore the 20-day and 40-day moving averages, and base the whole trade on the 5-day moving as well see in the following examples.
Lets see targets in action. Please re-examine the daily candlestick NDX chart and note the following:
1) May 13, 2002: The market broke above a positive 5-day moving average, generating a lagging Buy signal. The following day, it was already above the 20-day moving average. Consequently, you automatically sell a third of the position. A day later, it hits the 40-day moving average, you sell another third. Later that day, the market closes lower, below the 40-day moving average. You wait. Two days later, it re-tests the 40-day moving average for the second time, and again fails to break above it. You’re still waiting. The next day, on May 20, it breaks below the 5-day moving average. You close the whole trade gaining 65.11 points on the NDX in matter of five days.
2) May 24, 2002: The market pulls back from a negative 5-day moving average. You go short, and the market is already below all three moving averages. Therefore, you cant base you targets on the 20-day or 40-day moving averages since they’re trading higher while you anticipate the market to go lower. Consequently, you base the whole trade on the 5-day moving average, whereby you’d trail a stop at the 5-day moving average, and close the whole trade ONLY when the market breaks above it, i.e. on June 17 gaining 120 points on the NDX in a matter of 15 days.
3) July 3, 2002: A Bullish Engulfing generates a leading Buy signal. You go long. Two days later the market hits the 20-day moving average. You square a third. See how the market fails exactly at the 20-day moving average before coming lower and breaking below the 5-day moving average. You’re stopped. A gain of 18 NDX points in a matter of three days.
4) July 11, 2002: A Piercing Line generates a leading Buy signal. You go long. Three days later the market hits the 20-day moving average. You square a third. See how the market fails to close above the 20-day moving average and instead comes down and breaks below the 5-day moving average. You’re stopped. A gain of 8 NDX points in a matter of five days.
Next we reach the end of the trading system, with the Fine Tuning session.
Lesson 7 : The Fine Tuning
In this chapter we’ll fine tune our system for the sake of better trading decisions. So far the system has been very straight forward, and almost leaves no room for wrong doing. However, when as a trader, you are obliged to take action in the middle or at the end of a trading session, some mistakes may be committed, which could ruin the whole system.
First, please pay extra attention to the 5-day moving average. Most wrong doing is committed when traders ignore the direction of the 5-day moving average, and confuse its trading signals.
Leading entry signals (candlestick signals), are the only signals where the direction of the 5-day moving average is ignored, provided the market has closed near the moving average. Otherwise, you’d have to wait for a pullback/rebound.
For lagging entry signals, you only go long when the market closes above a positive 5-day moving average and pretty close to it, and you only go short when the market closes below a negative 5-day moving average and pretty close to it. Otherwise, you just DON’T trade! When you see the market oscillating above and below the 5-day moving average, you automatically conclude that this is a confused market, which offers no trading opportunities. Please take a look at the daily NDX candlestick chart from July 5 to July 16 2002, and note how the market oscillated three times above and below the 5-day moving. If you had traded based on those signals, you would have lost money in every single trade.
You also have to differentiate between a stop signal and a stop and reverse signal. A stop signal for a long trade is generated when the market breaks below a positive or a flat moving average. A stop and reverse signal for a long trade is generated when the market breaks below a negative moving average, and in most cases youd have to stop and wait for the rebound to reverse as usually when the market does this, it closes far below the 5-day moving average forcing you to await the rebound. On May 20, you only got stopped out of a long trade as the market broke below a positive 5-day moving. Three days later, you reversed as the market pulled back towards a now negative 5-day moving average.
And in the same way, a stop signal for a short trade is generated when the market breaks above a negative or a flat moving average. Whereas, a stop and reverse signal for a short trade is generated when the market breaks above a positive moving average, in which case, you’d have to stop and wait for the pullback before reversing as usually when the market does that, it closes far above the 5-day moving average forcing you to await the pullback. On June 17, you only got stopped out of a short trade as the market broke above a flat 5-day moving average.
Finally, for targets and entry levels in general, you gotta pay attention to some specific chart patterns. Please note that we haven’t mentioned stops here, for stops are a matter of discipline, and we should leave no room to change or manipulate them. But we can afford to do that with entry and target levels, as long as its gonna help us make more money. But what type of chart patterns should we focus on? As usual, VERY FEW.
Mainly, you should pay attention to combinations of 20-day or 40-day moving averages with Gaps, Support (previous troughs) and Resistance (previous peaks) levels. Gaps are known to form tough resistance/support zones, and therefore, you should give your trade some special attention whenever the market approaches one, and especially if a 20-day or a 40-day moving average happens to pass across the same area. Please look at the daily NDX candlestick chart once more, and check the market on May 15 2002 as it hit its 40-day moving average. If you look at the left side of the chart, you’d realize that 3 weeks earlier, the market had placed two Gaps in this same area. As a result, the market is not only facing the resistance of the 40-day moving average, but also that of a double gap. Wouldn’t that tip you to reduce a little more than one third of your trade as the market approaches this critical area? Well if you do, it would have saved you a lot of money!
Look again at the same chart on July 5 and July 8 2002, two consecutive trading days where the market approached your primary target (the 20-day moving average). Look five days earlier! Do you see that previous peak? Its a resistance level, and it combines with the 20-day moving average against the market. A day earlier, you went long thanks to a Bullish Engulfing. Now wouldn’t you reduce more than one third of the trade in front of that tough alliance?
Depending on the nature of the pattern, and the coalition formed, one might decide to manipulate the trading model a little bit, in order to be on the safe side. Please check the chart once again on June 16 2002 as the market approaches the 20-day moving average, but fails to hit it. You aren’t initially long as no signals were generated at the time, but can you tell why the market failed to reach the 20-day moving average? Ten days earlier, on June 4, there was a bottom, and if you look further to the left, you’d notice a previous bottom placed at almost the same level on May 7 2002. The two bottoms, previously a tough support area, now form a strong resistance zone, preventing the market from reaching its 20-day moving average.
It’s this type of information, which helps fine tune the whole trading system. You can, if you want, automate the whole model and sit watching as trades open and close automatically, but if you do, you gotta be sure all inputs are stored, or otherwise, you risk messing the whole system.
Next we conclude the trading system.
Lesson 8: The Conclusion
Did you digest the whole system? Do you fully understand the logic behind it? Did it sound simple enough to you? Most important, do you think it makes money? Would it help you become a better trader?
Well, we have been trying our very best to give you every single bit of it, and present it in the most easy format possible. So we suppose by now the system is fully digested and understood. As for whether it makes money or not, we would just say that one of the beauties of technical analysis, is the ability to backtest any given system. Now having worked on a 3-month chart, you clearly saw for yourself that the system works and indeed makes money. And you can even back-test it on 6-month, 12-month and 2-year charts, and it would impress you even more. But watch out, you won’t become a successful trader unless you fully abide by the rules of the system.
We have been testing the system on the NDX just to prove that it works on the whole market, and therefore, is applicable on individual stocks as well. Someone might ask: Are we allowed to change the periods of the moving averages? And use an 8-day, 25-day and 50-day moving averages instead. Good question! Of course you can, but ONLY if you can prove to yourself that those would give better results than the ones used in the system. If the 5-day, 20-day and 40-day moving averages have been giving better results on the general market index, then most probably individual stocks would follow suit. Change the moving averages period if you want, but NEVER change their use! NEVER break a stop rule! NEVER break a profit rule! NEVER break an entry rule! Take advantage of every single opportunity the market presents. Listen to NO ONE! Once you know the system works, IGNORE the crowd, and keep reminding yourself that the best trading decisions are the ones taken against the crowds inclination. You’re not there to please anyone other than yourself. You’re there to make money, and the market is consistently trying to take it away from you, so pay attention to the market and ignore the crowd.