Kramer's Bottom Call

I take heart in the fact that Kramer has called a bottom.Although there is a lot of volatility I am hoping that over time I'll be able to build and protect a sizable AUDJPY position. You see, as you get positions in profit and place stop losses in to protect them, you get to start again with respect to risk. Also, as the profits rise, you can start to get positions that are funded by locked in

Fed Cuts Another 50 Bps

The Fed has released the FOMC statement for this month and voted to reduce the overnight lending rate 50 basis points to 3%.

This reflects the lowest rates have been since June of 2005. The move was made easier after GDP numbers came out this morning lower than expected, mostly on negative housing growth.

The Fed felt it had to lower rates because inflation is not a concern, the economy is spiralling into recession (out of fear, possibly), the market had already priced it in, and today's GDP numbers proved that the economy needs a shot in the arm to pull out of a recession quickly.

You can argue that a little recession would be good, but you can't convince Wall Street of that, and obvious signs of fear and lack of confidence there made the Fed's decision fairly easy.

Proton Saga Red Concept Design

Here are some photos of the Proton Saga "RED" Concept by Proton Design, which will let some of you soon to be new Proton Saga owners know what modifications could be possible with the car's aesthetics. Having a special kitted up version of each new model launch has been a tradition now, and I hope this continues.
The Proton Saga "RED" Concept features a nice metallic red paintwork, a black roof, nice light grey grill surrounds, and large wheels, complete with a minimal tyre to fender gap. The interior gets a two-tone black and grey design, with red door trim, red seats and a grey-red trimmed steering wheel.

Forex Trading Wish List

Well, once again it is Saturday. There is no trading at all today so I have some time to reflect on wider issues. So, as someone who wants to trade full time for a living, I am feeling the need for the following:A nice large workstation including a comfortable reclining chair. As an active trader I can find myself sitting at the keyboard for many hours at a time so I might as well be

Forex Trading Review

So, I've been practicing my strategy using a micro-account for months, and it's time to up my game and start trading for real.I capitalized my account on Thursday evening and have been playing the AUDJPY with a more serious dollar value for the last two days. Here is a summary of the mistakes I noticed myself making over this period:Discipline breakdown. I broke discipline and acquired too many

Double Top Warning

It isn't here yet, and that means it may never arrive, but we are currently looking at a potential double top on the AUDJPY.This means that the DOW could also be poised to give up some recent gains.Obviously, the DOW can do what it wants, but if you are seeing gains right now and are thinking of jumping in, be wary.Personally, I'm hoping for the downturn. If it happens according to "my" chart

Trade Out

At the time of writing I am somewhere in Putrajaya. Its sound proof and no mobile phone can get a signal in here.

Trade gone bad. EU has actually hit my 1st target but I didnt close it. Now every trade has hit SL. No more trade for now.

Im going back to Kota Kinabalu this afternoon. My flight is at 3pm. See you later

Earning While Sleeping or Catching The Top

This morning I wake up to verify that I've made about 30% of the NAV (net asset value) of my downside trading sub-account. Sweet!How did I do this?I have been charting the AUDJPY for several days. There is a clear down trend and at 7:30pm last night the price touched the top of the trend. From there I'd been able to accumulate short positions, setting protective stop losses before opening up

US Fed Cuts

US Fed has cut benckmark Fed Fund rates by 75 basis points to 3.50% and it has cut the Discount rates by 75 basis points as well.

This cut has managed to bring immediate immediate relief to carry-trades and the stock indices.

The statement with the rate cut is given below...

The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Eric S. Rosengren; and Kevin M. Warsh. Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week. Absent and not voting was Frederic S. Mishkin.

In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis.

Effect:
I was up 3k on the demo account but now its -1.6k. This is something unexpected and market is trying to find a new balance point. At the moment that point is still unknown. EurUsd was dropping like WWII plane shot down now its going up again. In another angle what we see here is a correction. An act done by US Fed to slow down the drop by EurUsd.

Beauty about forex market is it will not turn on you in an instant. At the moment trend is still intact eventhough UsdChf has turn but with out support from other pairs it may not go very far.

Monday Forex Thoughts

Well, I was able to successfully navigate the downward movement of the AUDJPY overnight. It's always a pleasure to wake up to a large degree of pippage! Of course, I sunk a few positions with protective stop losses before retiring for the evening.This morning, the AUDJPY is bouncing around the 91.36 resistance point. However, a double top has formed on the bounces, so I'm starting to suspect

System Testing

Ive open a demo account to test my final system. Final coz I dont see anyway I can improve it somemore. It has been the same in the last 3 months with no more room to improve.

Its a medium term trade system. Trade between 2-4 times a month only with target of doubling capital each month.

For those of you who like to monitor the trade can login to investors account as below:

Metatrader 4 Terminal
Login : 112328
Investor : qjxx1rm (read only password)
Server : 74.86.131.115:443 or 88.85.79.65:443

You are welcome to monitor. Any idea on improvement is much appreciated.

Is It Bigger Than A Breadbox?

This was gold!Poulson, while trying to avoid questions about the exact size of a proposed stimulus package, answered "I don't want to play 'is it bigger than a breadbox?'"It's hard to say what the DOW (and hence the AUDJPY) is going to do with this. Obviously, it's better for the economy than not having incentives, so it must have some impact. It also shows the government is serious about the

Finicky Forex Friday

Well, in a while the president will be talking about some type of economic stimulus package.The question is, will the market think this is meaningful?So far, the market is up a bit but moving sideways. I guess we are all waiting to see if anything important is going to come out of this.My guess is that the market will rise a bit before the details arrive, but then fall in disappointment when the

Thursday's Bernanke Dive

Well, as per my previous post, Bernanke maintains his negative signal status.I'm happy to say I was trading the AUDJPY downwards today. I don't usually trade the downside, as I don't like the chance of being caught in a negative interest income position, but with Bernanke on the microphone, I just couldn't resist.I also had some very well behaving trend lines on the 1hr and the 5min charts.

The Bernanke Signal

If you haven't noticed, Bernanke has turned into a Forex signal.The market will rise, anticipating that he'll say something useful, or helpful, but then he actually starts speaking and we get a precipitous drop in prices.Of course, when rate cuts are announced we will get a momentary spike, but it will only be lasting if the rate cuts are deeper than the market has already built into prices.Keep

Trend is broken

At last the trend is broken. EU is changing direction but unfortunately that last dip was too much. A correction is coming before we can consider a short entry.

Same story with Uchf. Long entry on next low

Dow Theory

$ INTRODUCTION $
Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Most technicians and students of the markets concur that much of what we call technical analysis today has its origins in theories first proposed by Dow around the turn of the century. Dow published his ideas in a series of editorials he wrote for the Wall Street Journal. Most technicians today recognize and assimilate Dow's basic ideas, whether or not they recognize the source. Dow Theory still forms the cornerstone of the study of technical analysis, even in the face of today's sophisticated com­puter technology, and the proliferation of newer and supposedly better technical indicators.
On July 3, 1884, Dow published the first stock market aver­age composed of the closing prices of eleven stocks: nine railroad companies and two manufacturing firms. Dow felt that these eleven stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health, and created a 12 stock industrial index and a 20 stock rail index. By 1928 the industrial
index had grown to include 30 stocks, the number at which it stands today. The editors of The Wall Street Journal have updated the list numerous times in the ensuing years, adding a utility index in 1929. In 1984, the year that marked the one hundredth anniversary of Dow's first publication, the Market Technicians Association presented a Gorham-silver bowl to Dow Jones & Co. According to the MTA, the award recognized "the lasting contri­bution that Charles Dow made to the field of investment analy­sis. His index, the forerunner of what today is regarded as the leading barometer of stock market activity, remains a vital tool for market technicians 80 years after his death."
Unfortunately for us, Dow never wrote a book on his the­ory. Instead, he set down his ideas of stock market behavior in a series of editorials that The Wall Street Journal published around the turn of the century. In 1903, the year after Dow's death, S.A. Nelson compiled these essays into a book entitled The ABC of Stock Speculation. In that work, Nelson first coined the term "Dow's Theory." Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theo­ry with Freud's contribution to psychiatry. In 1922, William Peter Hamilton (Dow's associate and successor at the Journal) catego­rized and published Dow's tenets in a book entitled The Stock Market Barometer. Robert Rhea developed the theory even further in the Dow Theory (New York: Barron's), published in 1932.
Dow applied his theoretical work to the stock market aver­ages that he created; namely the Industrials and the Rails. However, most of his analytical ideas apply equally well to all market averages. This chapter will describe the six basic tenets of Dow Theory and will discuss how these ideas fit into a modern study of technical analysis. We will discuss the ramifications of these ideas in the chapters that follow.
BASIC TENETS
1. The Averages Discount Everything.
The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street's knowl‑
edge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluc­tuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things (Hamilton, pp. 40-41).
Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for "acts of God." While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action.
2. The Market Has Three Trends.
Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis.
Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote, "Records of trading show that in many cases when a stock reach­es top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance" (Nelson, page 43).
Dow considered a trend to have three parts, primary, sec­ondary, and minor, which he compared to the tide, waves, and rip­ples of the sea. The primary trend represents the tide, the sec­ondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.
An observer can determine the direction of the tide by not­ing the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each succes­sive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years.
The secondary, or intermediate, trend represents correc­tions in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.
According to Dow, the minor (or near term) trend usually lasts less than three weeks. This near term trend represents fluc­tuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4, "Basic Concepts of Trends," where you will see that we continue to use the same basic concepts and terminology today.
3. Major Trends Have Three Phases.
Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has assimi­lated all the so-called "bad" news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public partic­ipation increase. During this last phase the same informed investors who began to "accumulate" near the bear market bot­tom (when no one else wanted to buy) begin to "distribute" before anyone else starts selling.
Students of Elliott Wave Theory will recognize this divi­sion of a major bull market into three distinct phases. R. N. Elliott elaborated upon Rhea's work in Dow Theory,to recognize that a bull market has three major, upward movements. In Chapter 13, "Elliott Wave Theory," we'll show the close similari­ty between Dow's three phases of a bull market and the five wave Elliott sequence.
4. The Averages Must Confirm Each Other.
Dow, in referring to the Industrial and Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but rec­ognized that a shorter length of time between the two signals pro­vided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. (Elliott Wave Theory only requires that signals be generated in a single average.) Chapter 6, "Continuation Patterns," will cover the key concepts of confirmation and diver­gence. (See Figures 2.1 and 2.2.)
5. $ Volume Must Confirm the Trend $.
Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, vol­ume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on clos­ing prices. In Chapter 7, "Volume and Open Interest," we'll cover the subject of volume and build on Dow's ideas. Today's sophisti­cated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this infor­mation to price action to see if the two are confirming each other.

The most difficult task for a Dow theorist, or any trend-fol- lower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the first leg of a new trend in the opposite direction. Dow theorists often disagree as to when the market gives an actual reversal signal. Figures 2.3a and 2.3b show how this disagreement manifests itself.
Figures 2.3a and 2.3b illustrate two different market sce- narios. In Figure 2.3a, notice that the rally at point C is lower than the previous peak at A. Price then declines below point B. The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is bro- ken (point S). This reversal pattern is sometimes referred to as a "failure swing."
In Figure 2.3b, the rally top at C is higher than the previous peak at A. Then price declines below point B. Some Dow theorists would not consider the clear violation of support, at S1, to be a bona fide sell signal. They would point out that only lower lows exist in this case, but not lower highs. They would prefer to see a rally to point E which is lower than point C. Then they would look for another new low under point D. To them, S2 would represent the actual sell signal with two lower highs and two lower lows.
The reversal pattern shown in Figure 2.3b is referred to as a "nonfailure swing." A failure swing (shown in Figure 2.3a) is a much weaker pattern than the nonfailure swing in Figure 2.3b. Figures 2.4a and 2.4b show the same scenarios at a market bottom.
THE USE OF CLOSING PRICES AND THE PRESENCE OF LINES
Dow relied exclusively on closing prices. He believed that averages had to close higher than a previous peak or lower than a previous trough to have significance. Dow did not consider intraday pene­trations valid.
When traders speak of lines in the averages, they are refer­ring to horizontal patterns that sometimes occur on the charts. These sideways trading ranges usually play the role of corrective phases and are usually referred to as consolidations. In more mod­ern terms, we might refer to such lateral patterns as "rectangles."
SOME CRITICISMS OF DOW THEORY
Dow Theory has done well over the years in identifying major bull and bear markets, but has not escaped criticism. On average, Dow Theory misses 20 to 25% of a move before generating a sig­nal. Many traders consider this to be too late. A Dow Theory buy signal usually occurs in the second phase of an uptrend as price penetrates a previous intermediate peak. This is also, incidentally, about where most trend-following technical systems begin to identify and participate in existing trends.
In response to this criticism, traders must remember that Dow never intended to anticipate trends; rather he sought to rec­ognize the emergence of major bull and bear markets and to cap­ture the large middle portion of important market moves.
Available records suggest that Dow's Theory has performed that function reasonably well. From 1920 to 1975, Dow Theory signals captured 68% of the moves in the Industrial and Transportation Averages and 67% of those in the S&P 500 Composite Index (Source: Barron's). Those who criticize Dow Theory for failing to catch actual market tops and bottoms lack a basic understanding of the trend-following philosophy.
STOCKS AS ECONOMIC INDICATORS
Dow apparently never intended to use his theory to forecast the direction of the stock market. He felt its real value was to use stock market direction as a barometric reading of general business con­ditions. We can only marvel at Dow's vision and genius. In addi­tion to formulating a great deal of today's price forecasting methodology, he was among the first to recognize the usefulness of stock market averages as a leading economic indicator.
DOW THEORY APPLIED TO FUTURES TRADING
Dow's work considered the behavior of stock averages. While most of that original work has significant application to com­modity futures, there are some important distinctions between stock and futures trading. For one thing, Dow assumed that most investors follow only the major trends and would use intermedi­ate corrections for timing purposes only. Dow considered the minor or near term trends to be unimportant. Obviously, this is not the case in futures trading in which most traders who follow trends trade the intermediate instead of the major trend. These traders must pay a great deal of attention to minor swings for timing purposes. If a futures trader expected an intermediate uptrend to last for a couple of months, he or she would look for short term dips to signal purchases. In an intermediate down­trend, the trader would use minor bounces to signal short sales. The minor trend, therefore, becomes extremely important in futures trading.

NEW WAYS TO TRADE THEDOW AVERAGESFor the first 100 years of its existence, the Dow Jones Industrial Average could only be used as a market indicator. That all changed on October 6, 1997 when futures and options began trading on Dow's venerable average for the first time. The Chicago Board of Trade launched a futures contract on the Dow Jones Industrial Average, while options on the Dow (symbol: DJX) started trading at the Chicago Board Options Exchange. In addition, options were also launched on the Dow Jones Transportation Average (symbol: DJTA) and the Dow Jones Utility Index (symbol: DJUA). In January 1998, the American Stock Exchange started trading the Diamonds Trust, a unit investment trust that mimics the 30 Dow industrials. In addition, two mutual funds were offered based on the 30 Dow benchmark. Mr. Dow would probably be happy to know that, a century after their creation, it would now be possible to trade his Dow averages, and actually put his Dow Theory into practice

CONCLUSION
This chapter presented a relatively quick review of the more important aspects of the Dow Theory. It will become clear, as you continue through this book, that an understanding and apprecia­tion of Dow Theory provides a solid foundation for any study of technical analysis. Much of what is discussed in the following chapters represents some adaptation of Dow's original theory. The standard definition of a trend, the classification of a trend into three categories and phases, the principles of confirmation and divergence, the interpretation of volume, and the use of percent­age retracements (to name a few), all derive, in one way or anoth­er, from Dow Theory.
In addition to the sources already cited in this chapter, an excellent review of the principles of Dow Theory can be found in Technical Analysis of Stock Trends (Edwards & Magee).

Appendix D: Continuous Futures Contracts

With a clean database of "raw" commodity data, there are numerous types of contracts that can be gleaned from the raw data, such as: Nearest Contracts, Next Contracts, Gann Contracts, and Continuous Contracts. Following, are ideas for constructing these futures contracts derivatives. The symbols used are for illustration purposes only. These continuous con­tracts can be created through the Dial Data Service (56 Pine Street, New York, NY 10005, [212] 422-1600.)
$$ NEAREST CONTRACT $$
A nearest contract is primarily used by traders who just want a large file of continuous data made up of actual trading prices. They are content with the data going to expiration and then rolling over automatically.
It is quite probable that no one trades the nearest contract within 15 to 30 days of expiration. This is because the liquidity dries up very fast in the latter days of a contract. The number of days before expiration that an individual rolls over to the next contract is a function of the commodity that is being traded (the number of months till the next contract), and the individual's trading style. It is quite conceivable that the same individual will rollover at different times for different commodities.
When to rollover to the next contract will more than like­ly be based upon the current contract's volume. When it begins to erode, that is the time to roll forward.
Therefore, one should have available a choice as to when to rollover his Nearest Contract. Remember, Nearest Contracts are made up of actual data. Here are some examples: Portfolio Manager A is content to rollover at expiration; so all he wants is the "standard" Nearest Contract with symbol TRNE00 (Treasury Bonds). Manager A is probably managing money and needs equi­ty calculations which he can derive from the data. Trader B feels that trading in the month of expiration is not liquid enough for him; so he wants his Nearest Contract to roll over 15 days prior to expiration—the symbol could be TRNE15. Analyst C would like to evaluate different roll-over dates, so he might like to download multiple Nearest Contracts, such as: TRNE00, TRNE05, TRNE12, and TRNE21 (which roll-over 5, 12, and 21 days before expiration.
Keep in mind that all of these contracts are Nearest Contracts and contain actual contract data. The only difference is which actual contract the data comes from.
$ NEXT CONTRACT $
A Next Contract is a unique offspring of the Nearest Contract. It is exactly the same as the Nearest Contract except that it is always
the contract that follows the Nearest Contract. In other words, if the Nearest Contract is using December data for T-Bonds (TR), then the Next Contract is using data from the March T-Bond con­tract. When the December contract expires, the Nearest rolls to the March and the Next rolls to the June contract. This is defined as the Next-1 contract.
From this concept, another Next Contract is available, called a Next-2. Here, the data is always coming from the contract that is two contracts away from the Nearest Contract. Keeping with the above example, if the Nearest is using data from the December contract, the Next-2 Contract is using data from the June contract. When the December contract expires, the Nearest begins to use data from the March contract and the Next-2 Contract uses data from the September contract and so on.
Ticker symbols for the Next contracts are: TRNXT1 and TRNXT2. Of course, the actual futures ticker will be used instead of the TR used in this example.
$ GANN CONTRACT $
Gann Contracts refer to the use of a specific contract month and rolling over only to the same contract in the next year. For exam­ple, July Wheat would be used until the July contract expires, then the Gann Contract would start using data from the July Wheat contract of the next year.
Examples of ticker symbols for Gann Contracts are: WO7GN, GC04GN, JY12GN, etc. (representing July Wheat, April gold, December Japanese yen).
CONTINUOUS CONTRACTS
Continuous Contracts were developed to help analysts overcome the problem of liquidity dry up and premium (or discount) gaps in futures data. This becomes a problem whenever an analyst is testing a trading model or system over many years of data. It allows for a continuous stream of data with compensation being made for rollover jumps in price trends.
CONSTANT FORWARD CONTINUOUS CONTRACTSA Constant Forward Continuous Contract looks a constant length of time into the future. It uses more than one contract to do this. A common method is to use the nearest two contracts and do a linear extrapolation of the data
One possibility is to give the futures trader (as with the Nearest Contracts) the ability to construct his own Constant Forward Continuous Contract. Three things are needed to do this: The commodity symbol, the number of contracts he wants used in the calculation, and the number of weeks into the futures he wants to look. For instance, if he wanted T-Bonds, using 3 of the
nearest contracts, and looking 14 weeks into the future, the sym­bol could be: TRCF314. TR is the symbol, CF is for Continuous (Forward Looking), 3 is the number of contracts used, and 14 is the number of weeks the price is projected.
The mechanics of this are fairly simple. First, a fixed rollover date would need to be set for each commodity. A good one to start with could be 10 days prior to expiration. What is important is that there is a rollover sometime prior to actual expiration. Second, the number of contracts used will never be less than 2 and probably never greater than 4. The number of weeks used should probably always be greater that 3 and could go up to 40 in some cases.
Example: This is the method used by Commodity Systems, Inc. (See Perpetual Contract in Chapter 8.)
T-Bonds will be used again, because they have a uniform expiration cycle of every 3 months. Let's say a trader wants a Continuous Contract of T-Bonds using the 2 nearest months and looking 12 weeks into the future (symbol = TRCF212). Today's date is December 1. A graphical portrayal makes this easier to understand (see Figure D.1). The vertical axis is price and the hor­izontal axis is time. Today's date is marked on the horizontal axis and the expiration dates of the two nearest contracts (December and March), are also marked. He wants to look 12 weeks into the future so a mark is made 12 weeks from today which is about February 25. The close price of the December contract was 88.25 and the close of the March contract was 87.75 These points are then put above their expiration dates at the corresponding prices. Then a linear extrapolation is made by merely drawing a line between the two points. The slope of this line will vary up and down depending upon the outlook for long term interest rates (in this T-Bond example). In this particular example the outlook is for higher rates because the March futures price is lower than the December price.
To find the value of the TRCF212 close price for today, find the point on the horizontal axis that is 12 weeks from today (Feb 25th) and go up to the line drawn on the chart. Then from the line go to the right and that is the price of the close for this Constant Forward Continuous Contract (about 87.91). You can 510
$ Appendix D $
also visually see from the chart that the March contract is carry­ing more weight than the December contract because the point of interception is closer to March. This method can be done on the Open, High, Low, and Close in the exact manner. Of course, a computer does it mathematically; this is just a visual explanation of how a Perpetual Contract is constructed.

The Essentials of Building a Trading

Trading system development is part art, part science, and part common sense. Our goal is not to develop a system that achieves the highest returns using historical data, but to formulate a sound concept that has performed reasonably well in the past and can be expected to continue to perform reasonably well in the future.
Ideally, we would prefer an approach that is 100% mechan­ical, increasing the odds that past performance can be replicated in the future. Mechanical means objective: if 10 people follow the same rules and achieve the same results, those rules are said to be objective. It does not matter whether a mechanical system is writ­ten on paper or entered into a computer.
*This appendix was prepared by Fred G. Schutzman.
Here, however, we'll assume that we are using a comput­er and will use the terms "mechanical" and "computerized" interchangeably. This does not imply that a computer is mandatory for trading system development, although it cer­tainly helps.
The mechanical approach offers us three main benefits:
· We can back test ideas before trading them. A computer allows us to test ideas on historical data rather than on hard earned cash. By helping us see how a system would have per­formed in the past, it allows us to make better decisions when it really counts—in the present.
· We can be more objective and less emotional. Most peo­ple have trouble applying their objective analysis to actual trading situations. Analysis (where we have no money at risk) is easy, trading (where we have money at risk) is stress­ful. Therefore, why not let the computer pull the trigger for us? It is free of human emotion and will do exactly what we had instructed it to do at the time when we developed our system.
· We can do more work, increasing our opportunities. A mechanical approach takes less time to apply than a sub­jective one, which allows us to cover more markets, trade more systems, and analyze more time frames each day. This is especially true for those of us who use a computer, since it can work faster and longer than we can, without losing its concentration.
5 STEP PLAN
1. Start with a concept
2. Turn it into a set of objective rules
3. Visually check it out on the charts
4. Formally test it with a computer 5. Evaluate the results
STEP 1: START WITH A CONCEPT (AN IDEA)
Develop your own concepts of how markets work. You can begin by looking at as many charts as you can, trying to identify mov­ing average crossovers, oscillator configurations, price patterns or other pieces of objective evidence which precede major market moves. Also attempt to recognize clues that provide advance warning on moves that are likely to fail. I studied chart after chart after chart in the hope of finding such answers. This "visual" approach has worked for me, and I highly recommend it.
In addition to studying price charts and reading books such as this one, I suggest you read about trading systems and study what others have done. Although no one is going to reveal the "Holy Grail" to you, there is a great deal of useful informa­tion out there. Most importantly, think for yourself. I have found that the most profitable ideas are rarely original, but frequently our own.
Most of the successful trading systems are trend following. Counter trend systems should not be overlooked, however, because they bring a degree of negative correlation to the table. This means that when one system is making money, the other is losing money, resulting in a smoother equity curve for the two systems combined, than for either one alone.
Principles of Good Concept Design
Good concepts usually make good sense. If a concept seems to work, but makes little sense, you may be sliding into the realm of coincidence, and the odds of this concept continuing to work in the future diminishes considerably. Your concepts must fit your personality in order to give you the discipline to follow them even when they are losing money (i.e. during periods of drawdown). Your concepts should be straightforward and objective, and if trend following, should trade with the major trend, let profits run and cut losses short. Most importantly, your concepts must make money in the long run (i.e. they must have a positive expectation).
Designing entries is hard, but designing exits is harder and more important. Entry logic is fairly straightforward, but exits have to take various contingencies into account, such as how fast to cut losses or what to do with accumulated profits. I prefer sys­tems that do not reverse automatically—I like to exit a trade first, before putting on another trade in the opposite direction. Work hard to improve your exits, and your returns will improve relative to your risk.
Another suggestion—try to optimize as little as possible. Optimization using historical data often leads one to expect unre­alistic returns that cannot be replicated in real trading. Try to use few parameters and apply the same technique across a number of different markets. This will improve your chances of long run suc­cess, by reducing the pitfalls of over optimization.
The three main categories of trading systems are:
· Trend following. These systems trade in the direction of the major trend, buying after the bottom and selling after the top. Moving averages and Donchian's weekly rule are popular methodologies among money managers.
· Counter trend
- Support/Resistance. Buy a decline into support; sell a rally into resistance.
- Retracements. Here we buy pullbacks in a bull market and sell rallies in a bear market. For example, buy a 50% pullback of the last advance, but only if the major trend remains up. The danger of such systems is that you never know how far a retracement will go and it becomes difficult to implement an acceptable exit technique.
- Oscillators. The idea is to buy when the oscillator is oversold and to sell when it is overbought. If divergence between the price series and the oscillator is also pre­sent, a much stronger signal is given. However, it is usu­ally best to wait for some sign of a price reversal before buying or selling.
• Pattern recognition (visual and statistical). Examples include the highly reliable head and shoulders formation (visual), and seasonal price patterns (statistical).
STEP 2: TURN YOUR IDEA INTO A SET OF OBJECTIVE RULES
This is the most difficult step in our 5 step plan, much more dif­ficult than many of us would at first expect! To complete this step successfully, we must express our idea in such objective terms that 100 people following our rules will all arrive at exactly the same conclusions.
Determine what our system is supposed to do and how it will do it. It is with this step that we produce the details needed to accomplish the programming task. We need to take the overall problem and break it down into more and more detail until we finalize all the details.
STEP 3: VISUALLY CHECK IT OUT ON THE CHARTS
Following the explicit rules we just determined in Step 2, let us visually check the trading signals that are produced on a price chart. This is an informal process, meant to achieve two results: first, we want to see whether our idea has been stated properly; and second, before writing complicated computer code, we want some proof that the idea is a potentially profitable one.
STEP 4: FORMALLY TEST IT WITH A COMPUTER
Now its time to convert our logic into computer code. For my own work, I use a program called TradeStation®, Omega Research, Inc. in Miami, FL. TradeStation is the most compre‑
hensive technical analysis software package available for formu­lating and testing trading systems. It brings together everything from the visualization of your idea, to assistance in trading your system in real time.
Writing code in any computer language is no easy task and TradeStation's EasyLanguageTM is no exception. The job with EasyLanguage, however, is greatly simplified because of the pro­gram's user friendly editor and the inclusion of many built in functions and plenty of sample code. See Figure C.1.
Once our program has been written, we then move into the testing phase. To begin with, we must choose one or more data series to test. For stock traders this is an easy task. Futures traders, however, are faced with contracts that expire after a rela­tively short period of time. I like to do my initial testing using a continuous (spread adjusted) price series popularized by Jack
Schwager. (Schwager on Futures: Technical Analysis, Wiley, 1996.) If
those results look promising, I then move on to actual contracts.
Next, we must decide how much data to use when build­ing our system. I use the entire data series, without saving any for out-of-sample testing (building your system on part of the data and then testing it on the remaining "unseen" data). Many experts would disagree with this approach, but I believe it to be the best with my methodology that relies on good solid concepts, virtually no optimization, and a testing procedure that covers a wide range of parameter sets and markets. I start with a method­ology that I believe to be sound and then test it to either prove or disprove my theory. I have found that most individuals do the reverse, they test a data series to arrive at a trading system.
I do not account for transaction costs (slippage and com­missions) when testing systems, but instead factor them in at the end. I believe that this keeps the evaluation process more pure and allows my results to remain useful should certain assump­tions change in the future.
I require my systems to work across:
• Different sets of parameters. If I were considering using a 5/20 moving average crossover system, then I would expect 6/18, 6/23, 4/21, and 5/19 to also perform reasonably well. If not, I immediately become skeptical of the 5/20 results.
· Different periods of time (e.g. 1990-95 and 1981-86). A system that tests well in the Japanese Yen over a recent five year period should also test reasonably well over any other five year interval. This is another area where I appear to hold the minority point of view.
· Many different markets. A system that has worked well in crude oil should also work well in heating oil and unlead­ed gasoline over the same period of time. If not, I will look for an explanation and will usually discard the system. I go even further than this, however, and test that same system across my entire database of markets, expecting it to per­form well in the majority of them.
Once our testing is complete, let us visually inspect the computer generated trading signals on a price chart to ensure that the system does what we intended it to do. TradeStation facilitates this process by placing buy and sell arrows directly on the chart for us! If the system does not do what it is supposed to do, we need to make the necessary corrections to the code and test it again. Keep in mind that very few ideas will test out profitably, usually less than 5%. And, for one reason or another, most of these "successful" ideas will not even be tradable.
STEP 5: EVALUATE RESULTS
Let us try to understand the concept behind our trading system. Does it make sense or is it just a coincidence? Analyze the equity curve. Can we live through the drawdowns? Evaluate the system on a trade-by-trade basis. What happens if a signal is a bad one? How quickly does the system exit from losers? How long does it stay with the winners? Make sure we are completely comfortable with the test results, otherwise we will not be able to trade this system in real time.
Three key TradeStation statistics to analyze are:
· Profit factor. Equals Gross profit on winning trades/Gross loss on losing trades. This statistic tells us how many dol­lars our system made for every $1 it lost, and is a measure
of risk. Long term traders should aim for profit factors of 2.00 or higher. Short term traders can accept slightly lower numbers.
· Avg trade (win & loss). This is our system's mathematical expectation. It should at least be high enough to cover transaction costs (slippage and commissions); otherwise we will be losing money.
· Max intraday drawdown. This is the biggest drop, in dol­lar terms, from an equity peak to an equity trough. I prefer to do this calculation on a percentage basis. I also differen­tiate between drawdowns from a standing start (where I am losing money from my own pocket) versus drawdowns from an equity peak (where I am giving back profits taken from the markets). I am usually more lenient with the latter.
MONEY MANAGEMENT
Money management, while outside the scope of this appendix, is an extremely important topic. It is the key to profitable trading, every bit as important as a good trading system.
Money management techniques should be well thought out. Accept the fact that losses are part of the game. Control your downside and profits will take care of themselves.
In this area, practice diversification as much as possible. Diversification will enable you to increase your returns while hold­ing your risk constant, or decrease your risk while holding your returns constant. Diversify among markets, systems, parameters, and time frames.
CONCLUSION
We have discussed the basic philosophy of trading systems and why objective is better than subjective. We covered the three main benefits of a computerized approach and designed a 5 step plan for building a trading system. And last, but not least, we touched upon the importance of money management and diversification.Trading systems can improve your performance and help to make you a successful trader. The reasons for that are clear:
· they force you to do your homework before making a trade
· they provide a disciplined framework, making it easier for you to follow the rules
· they enable you to increase your level of diversificationWith lots of hard work and dedication, anyone can build a successful trading system. It is not easy, but it certainly is within reach. As with most things in life, what you get out of this effort will be directly related to what you put into it.

Market Profile

$ INTRODUCTION $ The purpose of this writing is to illustrate what Market Profile is and to define its underlying principles. Before the early 1980s, the only technical tools available were the bar chart and the point and figure chart. Since then Market Profile®1 was intro­duced to expand the arsenal of technical tools. Market Profile is essentially a statistical approach to the analysis of price data.2 For those without a statistics background, a familiar example may be helpful. Consider a group of students taking an exam. Typically, some score very high (say 90 or higher), some score very low 60 or lower), but most scores tend to be clustered around the average score (say 75). A histogram can be used to depict the fre­quency distribution of these test scores in a "statistical picture" (Figure B.1).As can be seen, the most frequent score, or modal score, is 75 (6 students) while the range of scores is defined by the low­est and highest scores (55 and 95). Note how the scores distrib­ute evenly around the modal score. For a perfectly symmetric distribution, the modal score will be equal to the mean, or aver­age score. Next observe that the distribution is "bell-shaped," the telltale sign of a normal distribution. For a perfect normal distribution, specific standard deviation intervals correlate to specific numbers of observations. For example, if the test scores are, in fact, perfectly normally distributed, then 68.3% of these scores will fall within one (1) standard deviation of the mean. While actual data is unlikely to form a perfect normal distri­bution, it is often close enough that these relationships can be employed.Prices, like other physical measurements (e.g., school test grades, population heights, etc.), distribute around a mean price level as well. What is the Market Profile graphic? Visualize it as simply, a frequency distribution of prices displayed as a price his­togram turned on its side
The centerpiece of the Market Profile graphic is the (bell‑shaped) normal curve used to display the evolving price distribu‑tion. Once the normal curve assumption is acknowledged, amodal or average price can be identified, a price dispersion (stan‑dard derivation) can be computed and probability statements canbe made regarding the price distribution. For example, virtuallyall values fall within three (3) standard deviations of the averagewhile about 70% (68.3% to be exact) fall within one (1) standarddeviation of the average (see Figure B.3).
Market Profile provides a picture of what's happening here and now in the marketplace. In its pursuit of promoting trade, the market is either in equilibrium or moving toward it. The profile's natur­al tendency toward symmetry defines, in a simple way, the degree of balance (equilibrium) or imbalance (disequilibri­um) that exists between buyers and sell­ers. As the market is dynamic, the profile graphic portrays equilibrium as periods of market balance—when price distribu­tions are symmetric, and represents dise­quilibrium as periods of market imbal­ance—when price distributions are not symmetric or are skewed.
Market Profile is not a trading system nor does it provide trade recommendations. The aim of the profile graphic is to allow the user to witness a market's developing value on price reoccur­rence over time. As such, Market Profile is a decision support tool requiring the user to exercise personal judgment in the trading process.
MARKET PROFILE GRAPHIC
The Market Profile format organizes price and time into a visual representation of what happens over the course of a single ses­sion. It provides a logical framework for observing market behav­ior in the present tense displaying price distributions over a period of time. The price range evolves both vertically and horizontally throughout the session. How is a profile graphic constructed?
Consider a 4 period bar chart (see Figure B.3a). This tradi­tional bar chart can be converted to a profile graphic as follows: (1) assign a letter for each price within each period's price range, letter A for the 1st period, B for the 2nd, and so on (see Figure B.3b) and then (2) collapse each price range to the leftmost or first col­umn (see Figure B.3c). The completed profile graphic reflects prices on the left and period frequency of price occurrence on the right, represented by the letters A through D.‑
sents a Time Price Opportu­nity or TPO to identify a specific price at which the market traded during a specific time period (e.g., in B period prices traded between 163 and 166). These TPOs are the basic units of analysis for the day's activity. In other words, each TPO is an opportunity created by the
market at a certain time Figure B.3c
and certain price. Market
Profile distributions are
constructed of TPOs. The Chicago Board of Trade (CBOT) assigns a letter to each half-hour trading period on a 24 hour basis; upper­case letters A through X represent the half-hour periods from midnight to noon while lowercase letters from a through x repre­sent the half-hour periods from noon to midnight.3
MARKET STRUCTURE
When you visit a commodities trading pit on a busy day, you observe what is best described as "controlled chaos." Beneath the screaming and gesturing locals and other traders, there is a describable process. Think of the market as a place where partici­pants with differing price needs and time constraints compete with each other to get business done. Emotions can run high as anxiety levels soar.
The Market Profile concept was introduced by Mr. Steidlmayer in an attempt to help describe this process. As a..
CBOT floor trader (local) and student of market behavior, he observed recurring patterns of market activity, which ultimately lay the foundation for his understanding of the market. Since the CBOT trading floor conducts trade in an auction-like man­ner, he defined Market Profile principles in auction terms. For example, an off-the-floor trader would describe an advancing market as one that is rallying or trading up, whereas Mr. Steidlmayer would instead say something like, "the market con­tinues to auction up, advertising for sellers to appear in order to shut off buying."
To explain why a trading pit auction process works the way it does, he invented some new terms unfamiliar to off-the­floor traders. He began with a definition of a market's purpose, which is to facilitate trade. Next, he defined some operational procedures, namely that the market operates in a dual auction mode as prices rotate around a fair or mean price area (i.e., sim­ilar to the way school grades were distributed). Lastly, he defined the behavior characteristics of market participants, namely that traders with a short term time frame seek a fair price, while traders with a longer term time frame seek an
advantageous price.
MARKET PROFILE ORGANIZING PRINCIPLES
Auction Setting: The purpose of the marketplace is to facilitate or promote trade. All market activity occurs within this auction setting. Initially, as price moves higher, more buying comes in, as price moves lower, more selling comes in. The market moves up to shut off buying (i.e., auctioning up until the last buyer buys) and moves down to shut off selling (i.e., auctioning down until the last seller sells). The market actually operates through a dual auction process. When price moves up and more buying comes in, the up-move advertises for an opposite response (i.e., selling) to stop the directional move. The opposite is true when price moves down.
Continuous Negotiation: When a mar­ket moves directionally it establishes price parameters, an unfair high and an unfair low, and then trades between them to establish a fair value area. All trade takes place through this negotiating process and remains within these parame­ters until one side or the other side is eventually taken out (i.e., a new high or new low is formed). (see Figure B.4.)
Market Balance and Imbalance: The market is either in equilibrium or working toward equilibrium between buyers and sellers. To facilitate trade, the market moves from a state of balance (equilibrium) to one of imbalance (dise­quilibrium ) and back to balance again. This pattern of market behavior occurs in all times frames, from intraday ses­sion activity to single session activity to aggregated or consolidated sessions Figure B.4 activity which form the longer term
auction.
Time Frames and Trader Behavior: The concept of differ­ent time frames was introduced to help explain the behavioral patterns of market participants. Market activity is divided into two timeframe categories, short term and longer term. The short term activity is defined as day time frame activity where traders are forced to trade today (e.g., locals, day traders and options traders on expiration day fall into this category). With limited time to act, the short term trader is seeking a fair price. Short term buyers and sellers do trade with each other at the same time and at the same price. Longer term activity is defined by all other timeframe activity (e.g., commercials, swing traders, and all other position traders fall into this category). Not forced to trade today and with time as an ally, these traders can seek a more advantageous price. In pursuit of their interests, longer term buyers seek lower prices
while longer term sellers seek higher prices. As their price objec­tives differ, longer term buyers and sellers generally do not trade with each other at the same price and at the same time. It is the behavioral interaction between these two distinct timeframe types of activity that causes the profile to develop as it does.
The Short Term Trader and Longer Term Trader Play Different Roles: Short term and longer term traders play key, but different, roles in facilitating trade. A market's initial balance (i.e., a place where two-sided trade can occur) is usually estab­lished in the first hour of trade by short term buyers and sellers (day timeframe activity) in their pursuit of a fair price. Most of the day's activity occurs in the fair price or value area. Prices above and below this developed fair value area offer opportuni­ty and are advantageous to longer term traders. With time on their side, longer term traders can either accept or reject prices away from fair value. By entering the market with large enough volume, longer term buyers and sellers can upset the initial bal­ance, thereby extending the price range higher or lower. The longer term trader is responsible for the way the day's range develops and for the duration of the longer term auction. In other words, the role of the longer term trader is to move the market directionally.
Price and Value: The distinction between price and value defines a market-generated opportunity. There are two kinds of prices: 1) those that are accepted—defined as a price area where the market trades over time and 2) those that are rejected—defined as a price area where the market spends very little time. A rejected price is considered excessive in the market—defined as an unfair high or unfair low. Price and value are all but synony­mous for short term traders as they ordinarily trade in the fair value area. For longer term traders, however, the concept that price equals value is often inaccurate. Price is observable and objective while value is perceived and subjective, depending upon the particular needs of longer term traders. For example, a price at the top of today's range, while excessive or unfair for today, is cheap to the longer term trader who believes that prices next week will be much higher (i.e., today's price is below next week's anticipated value).The longer term trader distinguishes between price and value by accepting or rejecting current prices away from his per­ception of fair value. Recall that rising prices advertise for sellers while falling prices advertise for buyers. When the longer term trad­er responds to an advertised price, this behavior is expected and is referred to as responsive. On the other hand, if the longer term trad­er did the opposite (i.e., buy after prices rose or sell after prices declined), then this unexpected activity is referred to as initiating. Classifying longer term activity as responsive or initiating relative to yesterday's or today's evolving value area provides anecdotal evi­dence of longer term trader confidence. The more confident the trader becomes, the more likely he is to take initiating action.RANGE DEVELOPMENT AND PROFILE PATTERNS
Since market activity is not arbitrary, it's not surprising that over time recognizable price patterns reveal themselves. A skillful trad­er able to anticipate such pattern development in its early stage may be able to capitalize. Mr. Steidlmayer loosely identifies the following daily range development patterns:
1. A normal day occurs when the longer term trader is rela­tively inactive. The day's range is established in the pioneer range (defined as the first column of prices) during the ses­sion's first half-hour period of trade. The short term trader establishes the initial balance, the unfair high and low, and then prices rotate between these parameters for balance of the day (see Figure B.6: Panel #1—Orange Juice).
2. A normal variation day occurs when the longer term trad­er is more active and extends the range beyond the initial balance. In this instance, the short term traders initial bal­ance parameters do not hold and there is some directional movement which extends the range and sets a new high or new low parameter. As a rule, the range extension beyond the initial balance can be anywhere from a couple of ticks to double the initial balance. This profile type is probably the most common (see Figure B.6: Panel #2—Dow Jones Industrial Average).
3. A trend day occurs when the longer term trader extends the range successively further. In this instance, the range is considerably more than double the initial balance with the longer term trader controlling direction as the market con­tinues its search for a fair price. Here the market moves in one direction and closes at or near the directional extreme (see Figure B.6: Panel #3—Japanese Yen).
4. A neutral day occurs when the longer term trader extends the range after the initial balance in one direction, then reverses and extends the range in the opposite direction. Neutral days indicate trader uncertainty and occur when the market probes or tests for price trend continuation or change TRACKING LONGER TERM MARKET ACTIVITY
With the exception of option sellers who profit when prices remain static, the profit strategy of most traders requires direc­tional price movement. The trader wins when he gets the direc­tion right and loses when he is incorrect. Because the longer term trader is responsible for determining the market's directional movement, we monitor this activity to help detect evidence of a price trend. After identifying and evaluating longer term trader activity, an educated conclusion regarding price direction can be reached. We begin the process by identifying the longer term trad­er's influence in today's session and then considering how that influence extends into the future.
• Influence in day's range development: The profile graph­ic helps identify longer term trader behavior during daily range development. By monitoring longer term activity throughout the range, particularly at the extremes, at range extension, and after value area completion, we can deter­mine whether longer term buyers or sellers are more active and hence control market direction. Activity at the extremes provides the clearest indication of longer term trader influence, followed by range extension and then value area buying and selling.1. Extremes are formed when the longer term trader com­petes with the short term trader for opportunities at a par­ticular price level (which later becomes either the session high or low). A minimum of two single prints is required to establish an extreme. The more eager the longer term trader is in this price competition, the more the single prints and the longer the single print extreme. Anything less than two prints suggests that the longer term trader is not very interested in competing at that price. A local top or bottom is formed when only one single print defines the top or bottom of the range. This condition implies that the market offered a price opportunity which no one really wanted (i.e., no evidence of competition.
2. Range Extension occurs when the longer term trader enters the market with enough volume to tip the initial balance and extend the range up or down. Range exten­sion up indicates longer term buying while range exten­sion down indicates longer term selling. However, there are occasions when both the longer term buyer and sell­er are active at a range extreme, but not at the same price and time (recall that longer term buyers and sellers gen­erally do not trade with each other). For example, if an extreme is formed after a range extension up, the market moves up first to shut off buying and then moves down to shut off selling. This is an example of both longer term buyers and sellers trading in the same price area but at different times. Both kinds of activity at the extremes are identified to evaluate the impact of longer term buying and selling (see Figure B.7: Panel #2—Coffee).
3. The Value Area is determined each trading session by price rotations around the modal price (i.e., the price with the highest TPO count or the fairest price). The value area is computed by counting 70% of all TPOs sur­rounding the fairest price. In other words, the value area is an estimate of fair value which is approximated by one standard deviation of the session's trading volume (recall the student example earlier). When a longer term trader makes a trade in the value area, he is buying low or selling high in relation to a longer term view, not in relation to today's value. This behavior creates an imbal­ance in today's value area. Longer term trader activity is measured by counting TPOs. The following procedure can be used to determine which side contains the longer term imbalance, 1) a line is drawn through the fairest price, and 2) TPOs are counted on either side of the fairest price until a single print is encountered. The imbalance is assigned to the side with the smaller num­ber of TPOs because the longer term trader activity rep­resents the smaller percentage of total trade in the value area. For example, if the TPO count was 22 above and 12
below the fairest price, that would indicate net TPO sell­ing with a mild bias toward lower prices (see Figure B.7: Panel #3—S&P 500 Index). Note that TPO buying and selling in the value area is not applicable on trend days, as the market is still in search of a fair value area.
After identifying and evaluating longer term trader activi­ty correctly in today's profile graphic, the user can readily deter­mine whether longer term buyers or sellers were in control of the current trading session.
• Influence beyond today: The profile graphic also helps identify longer term trader behavior beyond today's range development. A key goal of the trader is to determine whether the current market price trend will continue or is likely to change. A change in market direction is a reversal of the current price trend. The standard technical approach to trend assessment, without Market Profile, is to draw an appropriate trendline and monitor subsequent price action against it. Unless the trendline is violated, the current price trend is expected to continue. Trendline analysis is the most important of basic technical tools, particularly given its uni­versal usage and applicability to different time intervals (i.e., hourly, daily, weekly, monthly, etc.).
Market Profile, on the other hand, offers an alternative approach to traditional trend analysis by evaluating market activity over different time periods. In its simplest form, an evaluation of the profile graphic on consecutive days can help define the start or continuation of the short term price trend. For example, if today's value area is higher than yes­terday's value area, then the current market price trend is up. Moreover, if tomorrow's value area is higher than today's, then the current market uptrend has continued. By monitoring market activity in this fashion, the trader is able to readily identify trend continuation or change. Similarly by combining daily consecutive profile graphics into a larger cumulative profile graphic, an evolving picture of longer term balance or imbalance emerges. The profile graphic in Figure B.5 (Sugar) on page 483 illustrate this
point. A cursory review of the individual sessions (2/10­2/13) in the upper panel suggest an uptrending market without a hint of reversal. When these four (4) consecutive sessions are combined (lower panel), however, a cumulative balanced picture springs forth. Once balanced, a market moves to a state of imbalance which, more often than not, begins after a final test at the fairest price.
CONCLUSION
The Market Profile method can be used to analyze any price data series for which continuous transaction activity is available. This includes listed and unlisted equities, U.S. government notes and bonds (prices or yields), commodity futures and options, where applicable. The profile graphic presents the movement of prices, per unit of time, in two dimensions—vertically (i.e., directionally) and horizontally (i.e., frequency of occurrence). When price action is viewed in this way, a picture of price discovery unfolds which is unavailable in the traditional one dimensional (vertical) bar chart.
The profile graphic offers unique advantages over the stan­dard bar chart:
· The symmetry attribute of the profile graphic allows the trader to assess the market's state of balance (or imbalance) in any timeframe. When a market is symmetric, a condi­tion of balance or equilibrium exists between buyers and sellers. A market imbalance implies price trend continua­tion, as the market works toward a new equilibrium. Market balance, however, is fleeting and implies market change or a directional move (either up or down) is likely to occur, a signal for traders to consider employing trend fol­lowing methodologies.
· Every trend change occurs at a single moment in time, not conveniently at the end of the hour, day, week or month. The profile graphic can be used to more accurately identify that specific time where control changed hands between
buyers and sellers. By pinning down such control shifts, the profile graphic allows the trader to identify key support and resistance levels.
In short, the profile graphic provides a substantial amount of price information per unit of time, allowing the trader to iden­tify patterns and dynamics which would not be readily apparent using other methods.

Advanced Technical Indicators

$$Technical Indicators $$
This appendix introduces several more advanced technical meth­ods that can be used by themselves or with other technical stud­ies. As with any technical approach, it is always recommended that investors do their own independent testing and research before actually investing.
DEMAND INDEX (DI)
Most technicians will agree that volume analysis is an important ingredient in determining a market's direction. The Demand Index (DI) is one of the early volume indicators that was developed in the 1970s by James Sibbett. The formula is quite complex (see end of this appendix). The Demand Index is the ratio of buying pres‑sure to selling pressure. When the buying pressure is greater than the selling pressure, the DI is above the zero line, which is posi­tive. Greater selling pressure means the DI is below zero, which implies prices will move lower. Most traders also look for diver­gences between the DI and prices.
Figure A.1 is a weekly chart of T-Bond futures from early 1994 until late 1997. From April to November 1994, the DI was mostly below the zero line as bonds declined from 104 to the 96 area. While prices made lower lows (line A), the DI formed high­er lows (line B). This is a classic positive, or bullish divergence, which suggested that bond prices were bottoming. The diver­gence was confirmed when the DI moved above the zero line at point 1. The DI reached its highest level for this rally in late May 1995 at point 2, and then dropped for the next six weeks before crossing below the zero line at point 3. It stayed negative for five weeks before it again turned positive. On the next rally the DI formed a significantly lower high in late November at point 4. While the DI was lower (line D), the bond contract was almost six points higher (line C). This negative or bearish divergence warned of a price peak.This indicator can also be used with stocks. The weekly chart of General Motors (Figure A.2) shows the DI plotted as a line rather than a histogram. This allows for trendlines to more easily be drawn on the indicator. I have personally found trend-line analysis of indicators to be quite valuable. Indicator trend-lines are often broken ahead of price trendlines. This was the case in late 1995 as the downtrend in the DI (line A) was broken a week before the corresponding price downtrend (line B). As this chart indicates, buying just one week earlier could have sig­nificantly improved the entry price. The DI also warned of a price high in mid-April 1996. While GM was making a new price high (line C), the DI had formed lower highs (line D). This warn­ing signal came well ahead of the serious price decline in June and July.
HERRICK PAYOFF INDEX (HPI)
This indicator was developed by the late John Herrick as a way of analyzing commodity futures through changes in the open inter­est. As discussed in Chapter 7, changes in the open interest can give traders important clues as to whether a market trend is well supported or not.
The Herrick Payoff Index uses price, volume, and open inter­est to determine money flow into or out of a given commodity. This helps the trader spot divergences between the price action and the open interest. This is often quite important as buying or selling panics can often be identified through analysis of the open interest by the Herrick Payoff Index.
The most basic interpretation of the HPI is whether it is above or below the zero line. A positive value means that the HPI is projecting higher prices and that open interest is rising along with prices. Conversely, negative readings suggest that funds are flowing out of the commodity being analyzed.
One of the more volatile commodity markets is coffee, fea­tured in Figure A.3. During March and April of 1997, the HPI had four crossings of the zero line with the last positive signal in early April (B) lasting until early June. The HPI dropped below zero in June, and even though prices were well below the highs, coffee dropped another 70 cents. Once again the HPI turned positive in late July very close to the lows. Over the next two months there were two short term signals and then another longer term sell sig­nal. This is characteristic of the HPI when used on the daily data as it will cross above and below the zero line several times before a longer lasting buy or sell signal is given.The HPI, like the Demand Index, is most effective when used on the weekly data, as fewer false signals are evident. Divergence analysis can also be used to warn the trader of a change from positive to negative money flow. There are several good examples on the weekly T-Bond futures charts (Figure A.4) that covers approximately six years of trading. The HPI stayed positive from late 1992 until late 1993. The HPI peaked in early 1993 and, when bonds were almost 10 points higher (line A), the HPI was forming a lower high (line B). This negative diver­gence warned bond traders of the decline in prices that took place in 1994. The HPI violated the zero line in late October of 1993, but then turned slightly positive in early 1994 before plunging back below the zero line. The HPI reached its lowest
level in the first half of 1994 and bottomed well ahead of prices. As prices were making lower lows (line C), the HPI was forming higher lows and therefore a positive divergence (line D). The HPI moved back into positive territory in December 1994 as bonds were very close to their lows. A negative divergence was formed in late 1995 (line F), after bonds had rallied over 25 points from the late 1994 lows. The zero line was crossed several times in 1996 and early 1997 before the HPI moved firmly into positive territory. These two examples should illustrate why the HPI and its analysis of open interest can be helpful in analyzing a com­modity market's direction.
STARC BANDS AND KELTNER CHANNELS
As discussed in Chapter 9, banding techniques have been used for many years. Two types that I prefer are based on the Average True Range. Despite this common factor, these two types of bands are used in very different ways. Average True Range is the average of true price ranges over x periods. True Range is the greatest distance from today's high to low, yesterday's close to today's high, or yes­terday's close to today's low. See Welles Wilder's New Concepts in Technical Trading Systems.
Manning Stoller, a well known expert in the commodity business, developed the Stoller Average Range Channels or starc bands. In his formula the 15 period Average True Range is doubled and added to or subtracted from a 6 period moving average (MA). The upper band is starc+; the lower is starc-. Movement outside of these bands is uncommon and indicates an extreme situation. In this manner they can be used as trading filters. When prices are near or above the starc+ band, it is a high risk time to buy and a low risk time to sell. Conversely, if prices are at or below the starc- band, then it is a high risk selling zone and a more favorable point to buy.
The weekly continuation chart of gold futures (Figure A.5) is plotted with both the starc+ and starc- bands. In Feb. 1997 at point 1, gold prices slightly overshot the starc- band. Though the price action was weak, the starc bands indicated that this was not a good time to sell. By waiting, a better selling opportunity was likely to occur. Just three weeks later gold was $22 higher and at the starc+ band (point 2). Point 2 was a low risk selling opportunity. In July (point 3), gold prices dropped well below the starc-band, but instead of declining further, prices moved sideways for the next 12 weeks. Gold prices then started to move lower from November to December 1997 and touched the starc- band three times (points 4). In all instances prices did stabilize or move higher for 1-2 weeks. These bands work well in all time frames even as short as 5 to 10 minute bar charts. Starc bands can help the trader avoid chasing the market, which almost always results in a poor entry price.
The Kellner channels were originally developed by Chester Keltner in his 1960 book How to Make Money in Commodities. Linda Raschke, a very successful commodity trader, has reintro­duced them to technicians. In her modification, the bands are also based on the average true range (ATR), but the ATR is calculat­ed over 10 periods. This ATR value is then doubled and added to a 20 period exponential moving average for the plus band and subtracted from it for the minus band.
The recommended use of the Keltner channels is much dif­ferent from the starc bands. When prices close above the plus band, a positive signal is given as it indicates a breakout in upward volatility. Conversely, when prices close below the lower band, it is negative and indicates prices will move lower. In many respects, this is just a graphical representation of a four week channel breakout system discussed in Chapter 9.Figure A-6 is a daily chart of March 1998 copper futures. Prices closed below the minus band in late October 1997 at point 1. This indicated that prices should begin a new downtrend and copper prices dropped 16 cents in the next two months There were many other closes below the minus band dur­ing this period. Until prices close above the plus band, the nega­tive signal will stay in effect. The second chart is March 1998 cof­fee prices (Figure A.7) and illustrates a positive signal at point 1. After two consecutive closes above the plus band, prices then declined to the 20 period EMA. In a rising market the 20 period EMA should act as support. Several days after the EMA was touched (point 2), coffee prices began a dramatic 30 cent rise in just a few weeks.
Both of these techniques offer an alternative approach to either percentage envelopes or standard deviation bands (like Bollinger Bands). Neither is presented as a stand-alone trading system but should be considered as additional tools of the trade.
FORMULA FOR DEMAND INDEX
The Demand Index (DI) calculates two values, Buying Pressure (BP) and Selling Pressure (SP), and then takes a ratio of the two. DI is BP/SP. There are some slight variations in the formula. Here's one version:
If prices rise:
BP = V or Volume
SP = V/P where P is the % change in price
If prices decline:
BP = V/P where P is the % change in price SP = V or Volume
Because P is a decimal (less than 1), P is modified by mul­tiplying it by the constant K.
P = P(K)
K = (3 x C)/VA
Where C is the closing price and VA (Volatility Average) is the 10 day average of a two day price range (highest high — lowest low).
If BP > SP then DI = SP/BPThe Demand Index is included on the MetaStock charting menu

Pulling It All Together—A Checklist

Pullin
A ChecAs this book has demonstrated, technical analysis is a blend of many approaches. Each approach adds something to the analyst's knowledge of the market. Technical analysis is much like putting together a giant jigsaw puzzle. Each technical tool holds a piece of the puzzle. My approach to market analysis is to combine as many techniques as possible. Each works better in certain market situa­tions. The key is knowing which tools to emphasize in the current situation. That comes with knowledge and experience.
All of these approaches overlap to some extent and com­plement one another. The day the user sees these interrelation­ships, and is able to view technical analysis as the sum of its parts, is the day that person deserves the title of technical analyst. The following checklist is provided to help the user touch all the bases, at least in the early going. Later on, the checklist becomes second nature. The checklist is not all-inclusive, but does have most of the more important factors to keep in mind. Sound mar‑
ket analysis seldom consists of doing the obvious. The technician is constantly seeking clues to future market movement. The final clue that leans the trader in one direction or the other is often some minor factor that has gone largely unnoticed by others. The more factors the analyst considers, the better the chances of find­ing that right clue.
TECHNICAL CHECKLIST
1. What is the direction of the overall market?
2. What is the direction of the various market sectors?
3. What are the weekly and monthly charts showing?
4. Are the major, intermediate, and minor trends up, down,
or sideways?
5. Where are the important support and resistance levels?
6. Where are the important trendlines or channels?
7. Are volume and open interest confirming the price action?
8. Where are the 33%, 50%, and 66% retracements?
9. Are there any price gaps and what type are they?
10. Are there any major reversal patterns visible?
11. Are there any continuation patterns visible?
12. What are the price objectives from those patterns?
13. Which way are the moving averages pointing?
14. Are the oscillators overbought or oversold?
15. Are any divergences apparent on the oscillators?
16. Are contrary opinion numbers showing any extremes?
17. What is the Elliot Wave pattern showing?
18. Are there any obvious 3 or 5 wave patterns?
19. What about Fibonacci retracements or projections?
20. Are there any cycle tops or bottoms due? 21. Is the market showing right or left translation?
22. Which way is the computer trend moving: up, down, or sideways?
23. What are the point and figure charts or candlesticks showing?
After you've arrived at a bullish or bearish conclusion, ask yourself the following questions.
1. Which way will this market trend over the next several months?
2. Am I going to buy or sell this market?
3. How many units will I trade?
4. How much am I prepared to risk if I'm wrong?
5. What is my profit objective?
6. Where will I enter the market?
7. What type of order will I use?
8. Where will I place my protective stop?
Going through the checklist won't guarantee the right conclusions. It's only meant to help you ask the right ques­tions. Asking the right questions is the surest way of finding the right answers. The keys to successful trading are knowledge, dis­cipline, and patience. Assuming that you have the knowledge, the best way to achieve discipline and patience is doing your homework and having a plan of action. The final step is putting that plan of action to work. Even that won't guarantee success, but it will greatly increase the odds of winning in the financial markets.
HOW TO COORDINATE TECHNICAL AND
FUNDAMENTAL ANALYSIS
Despite the fact that technicians and fundamentalists are often at odds with one another, there are ways they can work together for
mutual benefit. Market analysis can be approached from either direction. While I believe that technical factors do lead the known fundamentals, I also believe that any important market move must be caused by underlying fundamental factors. Therefore, it simply makes sense for a technician to have some awareness of the fundamental condition of a market. If nothing else, the tech­nician can inquire from his or her fundamental counterpart as to what would have to happen fundamentally to justify a significant market move identified on a price chart. In addition, seeing how the market reacts to fundamental news can be used as an excel­lent technical indication.
The fundamental analyst can use technical factors to con­firm an analysis or as an alert that something important may be happening. The fundamentalist can consult a price chart or use a computer trend-following system as a filter to prevent him or her from assuming a position opposite an existing trend. Some unusual action on a price chart can act as an alert for the funda­mental analyst and cause him or her to examine the fundamental situation a bit closer. During my years in the technical analysis department of a major brokerage firm, I often approached our fundamental department to discuss some market move that seemed imminent on the price charts. I often received responses like "that can never happen" or "no way." Very often, that same person was scrambling a couple of weeks later to find fundamen­tal reasons to explain a sudden and "unexpected" market move. There's obviously room for much more coordination and cooper­ation in this area.
CHARTERED MARKET TECHNICIAN (CMT)
A lot of people use technical analysis and offer opinions on the technical condition of the various markets. But are they really qualified to do so? How would you know? After all, you wouldn't go to a doctor who didn't have a medical degree on the wall. Nor
would you consult a lawyer who hadn't passed the bar exam. Your accountant is undoubtedly a CTA. If you asked a security analyst for an assessment on a common stock, you would certainly make sure that he or she was a Chartered Financial Analyst (CFA). Why wouldn't you take the same precautions with a technical analyst?
The Market Technicians Association (MTA) resolved this question by instituting a Chartered Market Technician (CMT) pro­gram. The CMT program is a three step examination process that qualifies the analyst to carry the CMT letters after his or her name. Most professional technical analysts have gone through the pro­gram. The next time someone offers you his or her technical opin­ion, ask to see the CMT.
MARKET TECHNICIANS ASSOCIATION (MTA)
The Market Technicians Association (MTA) is the oldest and best known technical society in the world. It was founded in 1972 to encourage the exchange of technical ideas, educate the public and the investment community, and establish a code of ethics and pro­fessional standards among technical analysts. (On March 11, 1998 the MTA celebrated the 25th birthday of its incorporation. The event was highlighted by a special presentation at the New York monthly meeting by three of the organization's founding mem­bers—Ralph Acampora, John Brooks, and John Greeley.) MTA membership includes full-time technical analysts and other inter­ested parties (called affiliates). Monthly meetings are held in New York (Market Technicians Association, Inc., One World Trade Center, Suite 4447, New York, NY 10048 (212) 912-0995, e-mail: shelleymta@aol.com), and an annual seminar is held each May at various locations around the country. Members have access to the MTA library and a computer bulletin board. A monthly newsletter and a periodic MTA Journal are published. Some regional chapters have even been formed. MTA members also become colleagues of the International Federation of Technical Analysts (IFTA).
THE GLOBAL REACH OF TECHNICAL ANALYSIS
During the fall of 1985, a meeting was held in Japan with techni­cal representatives of several different countries to draft a consti­tution for the International Federation of Technical Analysts (IFTA, Post Office Box 1347, New York, NY 10009 USA). Since then, the organization has grown to include technical analysis organizations from more than twenty countries. One of the nice things about being a member is that annual meetings are held in places like Australia, Japan, Paris, and Rome since a different national organization hosts each seminar. I'm proud to say that in 1992 I received the first award ever given at an IFTA conference for "outstanding contribution to global technical analysis."
TECHNICAL ANALYSIS BY ANY NAME
After a century of use in this country (and 300 years in Japan), technical analysis is more popular than ever. Of course, it's not always called technical analysis. In my book, The Visual Investor, I called it visual analysis. That was simply an attempt to get people beyond the intimidating title of technical analysis and to get them to examine this valuable approach more closely. Whatever you want to call it, technical analysis is practiced under many names. A lot of financial organizations employ analysts whose job it is to number-crunch market prices to find stocks or stock groups that are expensive (overbought) or cheap (oversold). They're called quantitative analysts, but the numbers they crunch are often the same ones the technicians are crunching. The financial press has written about a "new" class of trader called "momen­tum" players. These traders move funds out of stocks and stock groups that are showing poor momentum and into those that are showing good momentum. They use a technique called relative strength. Of course, we recognize "momentum" and "relative strength" as technical terms.
Then there are the brokerage firms' "fundamental" upgrades and downgrades. Have you noticed how often these
"fundamental" changes take place the day after a significant "chart" breakout or breakdown? Economists, who certainly don't consider themselves technical analysts, use charts all the time to measure the direction of inflation, interest rates, and all sorts of economic indicators. And they talk about the "trend" of those charts. Even fundamental tools like the price/earnings ratio have a technical side to them. Anytime you introduce price into the equation, you're moving into the realm of technical analysis. Or when security analysts say the dividend yield of the stock market is too low, aren't they saying prices are too high? Isn't that the same thing as saying a market is overbought?
Finally, there are the academics who have reinvented technical analysis under the new name of Behavioral Finance. For years, the academics espoused the Efficient Market Hypothesis to prove that technical analysis simply didn't work. No less an authority than the Federal Reserve Board has thrown some doubt on those ideas.
FEDERAL RESERVE FINALLY APPROVES
During August of 1995, the Federal Reserve Bank of New York published a Staff Report under the title: "Head and Shoulders: Not Just a Flaky Pattern." The report was intended to examine the validity of the head and shoulders pattern in foreign exchange trading. (The first edition of this book was cited as one of the pri­mary sources on technical analysis.) The opening sentence in the introduction reads:
Technical analysis, the prediction of price movements based on past price movements, has been shown to gen­erate statistically significant profits despite its incompat­ibility with most economists' notions of "efficient mar­kets." (Federal Reserve Bank of New York, C.L. Osler and P.H. Kevin Chang, Staff Report No. 4, August 1995.)
A more recent report, published in the fall of 1997 by the Federal Reserve Bank of St. Louis, also addresses the use of tech‑
nical analysis and the relative merits of the Efficient Market
Hypothesis. (Technical Analysis of the Futures Markets was again
cited as a primary source of information on technical analysis.) Under the paragraph titled, "Rethinking the Efficient Markets Hypothesis," the author writes:
The success of technical trading rules shown in the pre­vious section is typical of a number of later studies show­ing that the simple efficient market hypothesis fails in important ways to describe how the foreign exchange market actually functions. While these results did not surprise market practitioners, they have helped persuade economists to examine features of the market ... that might explain the profitability of technical analysis. (Neely)
CONCLUSION
If imitation is the sincerest form of flattery, then market techni­cians should feel very flattered. Technical analysis is practiced under many different names, and often by those who may not realize they're using it. But it is being practiced. Technical analy­sis has also evolved. The introduction of intermarket analysis, for example, has changed the focus away from "single market" analysis to a more interdependent view of the financial markets. The idea that all global markets are linked isn't questioned much anymore either. That's why the universal language of technical analysis makes it especially useful in a world where the financial markets, here and abroad, have become so intertwined. In a world where computer technology and lightning-fast communi­cations require quick responses, the ability to read the market's signals is more crucial than ever. And reading market signals is what technical analysis is all about. Charles Dow introduced technical analysis at the start of the twentieth century. As the twentieth century draws to a close, Mr. Dow would be proud of what he started.