The Investment Club Network
www.ticn.com
The Investment Club Network
www.ticn.com
The Investment Club Network
Contents
Introduction
An Interesting Approach to the Stock Market
Chapter One
Psychology of a successful trader
2
Chapter Two
The Four Pillars of Success
5
Chapter Three
TICN in the Press
8
Chapter Four
The Basics of Stock Market Investing
How the Stock Market Works
How to read a stock Table
21
27
29
Chapter Five
Learning Options
A history of Options
The Option Players
33
33
37
Chapter Six
The Investment Club Network
What we do
TICN training Modules
42
43
45
Chapter Seven
Picking the right Companies
Quality Company scoring system
47
48
Quality Mind Map
52
Right Time to Buy
Right time to Buy scoring system
53
53
Price Mind Map
57
Chapter Nine
Profits in Graphs and Charts
59
Chapter Ten
A Gentle Introduction to Equity Option
How Options are Valued
How Option trading works
Call Buying
Covered Call selling
66
68
70
71
72
Chapter Eight
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The Investment Club Network
Fundamental Analysis
Chapter Eleven
Six Common Strategies for picking Stocks
Value Investing
Growth Investing
Momentum Investing
CANSLIM Investing
Income Investing
GARP Investing
74
75
77
79
81
83
85
Chapter Twelve
Qualitive Analysis
87
Chapter Thirteen
Quantitive Analysis
Balance Sheet
Income Statement
Cash Flow Statement
89
92
94
96
Chapter Fourteen
19 Important Financial Ratios Explained
Performance Ratios
Activity Ratios
Financing Ratios
Liquidity Ratios
Financial Ratio Index
97
97
107
109
111
114
Technical Analysis
Chapter Fifteen
Charts
What are Charts?
Different types of Charts
Introduction to Support&Resistance levels
115
115
117
122
Chapter Sixteen
Trend lines
130
Chapter Seventeen
19 Powerful Chart Patterns
An Introduction to Chart Patterns
Reversal Chart Patterns
Continuation Chart Patterns
138
138
141
173
Chapter Eighteen
The Fundamentals of Chart Indicators
Tips for using Indicators
Leading Indicators
Lagging Indicators
Oscillator Types
Centerline crossovers
198
200
201
203
204
213
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Chapter Nineteen
Chart Indicators Explained
Accumulation/Distribution Line
Aroon and Aroon Oscillator
Average Directional Index (ADX)
Average True Range (ATR)
Bollinger Bands
Commodity Channel Index (CCI)
Chaikin Money Flow
Chaikin Oscillator
MACD
Moving Averages
Percentage Volume Oscillator
Price Oscillator (including PPO)
Price Relative
Price by Volume
Relative Strength Index
Standard Deviation
Stochastic Oscillator
StochRSI
218
220
225
227
228
232
239
241
251
255
270
280
290
295
297
298
301
304
307
Chapter Twenty
Introduction to Candlestick Charts
History
Fundamentals of Candlestick Patterns
Candlestick Patterns
Blending Candlesticks
312
312
320
323
326
Chapter Twenty-one Interpreting Candlestick Chart Patterns
Candlestick Support
Candlestick Resistance
Bullish Reversals
Bearish Reversals
328
328
330
333
342
Option Trading Strategies
Chapter Twenty-two Call Options
Covered Calls
Naked Calls
Chapter Twenty-three LEAPS
LEAP Option trading strategies
Long calls
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353
354
356
358
359
362
The Investment Club Network
Chapter Twenty-four Puts
Protective Puts
Selling Naked Puts
Long Puts
LEAP Puts
Chapter Twenty-five Spread Trading
Bull Call Spreads
Bull Put Spreads
Call Backspreads
Bear Put Spreads
Bear Call Spreads
Chapter Twenty-six
Neutral Option trading Strategies
Long Straddles
Long Strangles
Short Strangles
(Also known as a Combination)
The Butterfly
The Condor
The Short Condor
Ratio Spreads
Calendar Spreads
The Collar
364
365
366
368
370
372
373
375
377
379
381
383
385
387
390
392
395
398
400
404
407
Portfolio Repair Strategies
Chapter Twenty-seven
Portfolio Repair Strategies
410
Chapter Twenty-eight
Protection against future Falls
415
Chapter Twenty-nine
Profiting while the Share Falls
421
Chapter Thirty
The Elite Investors Program
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427
The Investment Club Network
The Investment Club
Network
www.ticn.com
Freephone
1800 367 693
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The Investment Club Network
1
Introduction
An Interesting Approach to the Stock
Market.
Employing the Distillation of the Wisdom of many lifetimes
of experience.
By Owen O'Malley Founder and CEO of The Investment
Club Network.
In March of 1996 Owen O’Malley travelled half way
around the globe from a small remote part of
Donegal, Ireland to the Hilton Hotel in Kona, Hawaii
to spend time with and attend a course designed and
delivered by some of the most successful Investors
and Traders on the face of the planet at that time.
For six long days twenty four different millionaires and billionaires
compressed their decades of knowledge and experience into days.
Some of the individuals that designed and delivered the course are
well known in the investment world such as Sir John Templeton, Peter
Lynch, Beardstown Ladies and Matt Seto to name but a few that
graced the seminar stage.
Owen O’Malley then returned to Ireland to teach and share that
knowledge and experience with his fellow countrymen and women by
establishing investment clubs and creating investment seminars.
The orgainsation that was started in Ireland 8 years ago now has
15,000 members in 30 countries on 5 continents that have collectively
invested $50M over and now invest $500,000 per month.
They have an interesting and incredibly successful approach to the
stock market that they would like to share with you the reader.
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2
Chapter one
Psychology of a Successful Investor.
1. “Master your emotions and you will master the Stock Market”
This is a profound principle that is the corner stone to success and is
as essential to success as breathing is to life.
We could send you, the reader in a time machine to discover the one
company that will outperform all other companies in the World over the
next 5 years. You could return with great excitement to instruct us to
invest in that company today and tell us that we will be guarenteed
1000% price appreciation 5 years from now.
Without exception all companies fluctuate wildly in share price with the
average share price movement of +50% to –50% in any 52 week time
period including the best performing company that you discovered in
your time machine.
Even though share price fluctuation is part of the real world of the
emotional roller coaster that investors experience they tend to forget
that when they are in the game of investing and trading. Consequently
errors of judgment influenced by emotions through time lead to
ultimate fiscal failure in the stock market.
It is those that remember that all shares fluctuate and choose not to let
this interfere with their decision making process that conquer the stock
market. Emotional Mastery is the cause Financial Mastery is the effect.
2. Belief in yourself.
“What you believe you will achieve”
Belief in oneself leads to taking action which leads to results which
leads to more belief which leads to more action which leads to even
better results and so the positive reinforcement loop continues ever
upwards.
3. Develop a Positive attitude.
It’s as simple as this, positive people get positive results, negative
people get negative results so you decide what attitude that you
choose to take with you on your journey through life.
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The Investment Club Network
3
4. Develop an attitude of gratitude.
Regret of the past and fear of the future steals your present. No matter
how badly off you feel you are right now you are properly better off
than more than 90% of the world’s population. Once you choose to
accept that there is nothing wrong with where you are right now it will
give you the necessary platform to spring forward in life without regret
of the past holding you back and fear of the future stopping you going
forward. To all those people that you feel have hurt you in the past in
light and love let them go and get on with your short life taking
absolute and ultimate responsibility for the choices you take in life.
5. Who are the players in the fiscal world?
I challenge you to find out who invented money, why was it invented,
when was it invented and who has controlled the flow of money since it
was invented. What agenda do the banks, the brokers and the market
makers have,and how to you as an invester fit within this agenda. Are
you able to think like them and use this insight to outperform those that
control the market place that you find yourself in?
6. Appreciate True Value
When you evaluate a company for the purpose of investment the
company will have the book value share price which is the true value
of the company divided by the number of shares. On the other hand
there is the often wildly inflated actual market share value. Do you
know how to find out and appreciate the true value of a company? If
you don’t know true value when now would be a good time to find out?
7. Take Action
One of the most important actions to take when you learn something
new is to apply the knowledge gained. One of the greatest myths out
there is that knowledge is power. In this new so called ‘Information
Age’ that we live in knowledge is not power instead it is the application
of knowledge that is true power. So go forth and apply yourself.
Today you can open an online investment account, today you can
simulate trades with a pretend $100,000 portfolio and today for as little
a $500 you can fund and start trading a real online account.
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The Investment Club Network
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4
The Investment Club Network
5
Chapter Two
The Four Pillars of Success
The Investment Club Network.
The Investment Club Network truly have an interesting approach to
investing in the stock market.
They combine the power of clarity that comes from knowledge based
decisions with an ability to generate an income regardless of the
direction of the market or the companies that invest in.
The systematic unemotional approach taken to investing is the basis of
success with TICN.
The 4 steps of the systematic approach are as follows:
Fundamental analysis
Technical analysis
Income generating strategies.
Capital Preservation strategies.
1. Fundamental Analysis
There are ~ 300,000 companies available to invest in the world and ~
30,000 in the US Market. The Investment Club Network purchase
professional research on the top 6,000 companies traded in the US
stock market. TICN then run 21 different computer filters to produce a
batch of 2 – 300 of the best companies. Then a quantative scoring
system is applied to ensure that only a small batch of 80 – 90 quality
companies that are close to value for money to invest in are left to
choose from.
2. Technical Analysis
Professional Technical analysis is then applied to the remaining batch
of 80 – 90 companies to help crystalise the decision making process
and further refine the investment entry points.
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The Investment Club Network
6
3. Income Generation Strategies
TICN teach 20 different income producing strategies that yield a
consistant monthly return on investment regardless of the direction of
the shares or the market.
One such strategy is the Covered Call strategy that is employed to
generate monthly and bi-monthly income from the portfolio of shares.
Covered Call Strategy
Once a company is Fundamentally sound and is Technically right to
purchase then the strategy of Covered Calls can be applied as follows
provided that company trades options.
The approach taken is that the shares are like owning property and
that by consistant collection of rent (covered call income) you will
eventually recoup the cost of your initial purchase. The average house
mortgage would take 30 years to pay back if you are solely relying on
your tenants rent to pay the mortgage repayments in full. The good
news is that applying the covered call strategy you can cover your
initial purchase price of your shares in a shorter time frame of
anywhere between 12 to 24 months. In fact using some of the
advanced covered call strategies that TICN teach in some cases you
can cover the intial purchase price in as little as 6 months.
Just as in property investments once you own the property in full you
can continue to collect rent thus enabling one to purchase more
property and collect more rent and so on. One can do exactly the
same with shares in the stock market over a much shorter time frame.
4. Capital Preservation Strategies.
The most important strategy in the Equities Market is to protect your
profits and preserve your initial investments and TICN teach 4 capital
preservation strategies.
Covered Calls.
Put Insurance.
Dollar cost Averaging.
Trailing Stops.
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The Investment Club Network
7
TICN emphasise financial self reliance and are committed to break the
cycle of financial illiteracy that is prevalent in todays society. In no way
do TICN advise and prefer to teach you to fish rather than give you a
fish. TICN have a policy of teaching children under 18 for free and
actively teach their course material in Primary and Secondary Schools
as well.
To find out more about this “Interesting Approach to the Stock Market”
you can contact The Investment Club Network,
Freephone 1800 367 693
www.ticn.com
The Investment Club Network
8
Chapter Three
TICN In the press
Teenager Tops the Table
Roisin Mentor’s her 3 Clubs into the Top Performing
TICN Investment Clubs league Table!
Roisin McBride from
Carrigart, Co. Donegal
was trained by The
Investment Club Network
at the tender age of 15
just 4 years ago.
Roisin at age 17 took over the TICN Club Co-ordination role from her
father Noel McBride in 2003 (when he was elected as the local Fine
Gael County Councillor) to mentor three local TICN Investment Clubs
in North West Donegal.
These 3 Investment Clubs are now positioned 1st, 2nd and 17th in the
World on the TICN Performance League Table as updated on the
www.ticn.com website.
Here follows the story of how Roisin helped transform her three clubs
from average performing clubs to top performing TICN Investment
Clubs:
Muckish Marvel’s Investment Club
Creeslough, Co. Donegal: Ranked First
This club meets monthly upstairs in the Corncutters Rest Bar in
Creeslough. The club works very well together with a diligent research
team and a strong Trader Team who research and trade in accordance
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The Investment Club Network
9
with the TICN System. They buy only solid 4 x 4 companies and sell
covered calls looking for a consistent 7% return per covered call. Their
most successful trade to date was to buy and sell Novel making a
125% return in 2003.
Beachcombers Investment Club,
Downings, Co. Donegal: Ranked Second
This club enjoyed the most dramatic turnaround in that it had lost its
way and found itself down $16,000 and now is + $43,000. The club
now sticks to the TICN System rigidly and its best trade was to make
$11,000 on JKHY using their advanced knowledge and experience
gained from selling covered calls, understanding exactly how options
behave in the US Stock market. Recently the club made $8,000 in the
last month rolling 2,000 shares of four different 4 x 4 TICN companies.
The Investment Club members have mastered the art of using charts
and price graphs to determine and execute profitable exit and entry
points.
LYIT Investment Club, Letterkenny
Co. Donegal: Ranked 17th
This club benefited from the power of long term buy and hold of solid 4
x 4 companies for a ten month period. The Club now combines long
term buy and hold with covered call and rolling stock strategies.
The club is now determined to model the success of the other two
clubs and climb up the table.
Those clubs that follow the TICN System of careful research followed
by ‘hold, rent and roll’ succeed. The three clubs mentioned above
having achieved their first target of $100,000 are now focussed on the
next goal of $1,000,000 which is the goal of all the TICN Investment
clubs. There are 6,000 club members in 300 clubs in Ireland and TICN
remains focussed on their next goal of establishing 1,000 clubs and
20,000 club members in Ireland. TICN wish to empower all club
members with the knowledge, skills and confidence to master the
stock market. The clubs long term goal is to be in a position to pay
regular and substantial monthly dividends to its club members as soon
as possible.
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Muckish Marvels Investment Club
Beachcombers Investment Club
Castle Warriors Investment Club
Bitclub Investment Club
Deep South Investment Club
Kerry Blues Investment Club
LYIT Investors Investment Club
1
2
3
4
5
6
17
9/25/2001
3/15/2002
11/29/2001
3/20/2001
2/15/2002
8/12/2003
7/24/2001
Start
Date
$99,427.00
$101,317.0
$28,685.00
$131,539.0
$33,887.00
$103,510.0
$94,570.00
Total
Assets
$56,630.00
$58,014.00
$16,549.00
$76,921.00
$19,935.00
$60,955.00
$65,014.00
Cash
Deposits
Cash
Withdr
awals
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$42,797.00
$43,303.00
$12,136.00
$54,618.00
$13,952.00
$42,555.00
$29,556.00
Total
Profit
+75.57%
+74.64%
+73.33%
+71.01%
+69.99%
+69.81%
+69.81%
% Profit
www.ticn.com
info@ticn.com or Free phone 1800 367 693
To receive your FREE information pack from TICN to find out about the powerful education programs and / or becoming an
Investment Club member email
Visit www.ticn.com for club performance updates.
Club Name
Rank
(Top 50 clubs have an average growth of 63% compared with Dow -5.5% and NASDAQ -7.5% over the same period)
The Table below is from TICN’s Top Performance table in December 2005
The Investment Club Network 10
The Investment Club Network 11
"Shares club pays handsome returns"
by Fiona McGoran
Pat Lynch joined the Investment Club Network in 2002 and made a
62% return by the end of his first year of trading; he has made a
cumulative gain of 190% to date.
"I consider myself to be a calculated risk taker. I have all my research
done before I invest. From my experience, very few people do this," he
says.
Being an accountant, Lynch was always interested in the stock market
but he did not have the experience or knowledge to make substantial
returns. "One of the few coups I experienced was with Eircom. I was
one of the lucky punters who sold within days of the company going
public. I made a gain of 18% on my investment. With what I know now
I would never have invested in that stock," he says.
In late 2001 Lynch, 48 sold the company he had set up in 1998, giving
him a substantial amount of disposable income to invest. "I decided to
look at the stock market as a means of making returns on part of the
proceeds from the sale of my business. A friend informed me about the
Investment Club Network and I joined a share club in Cork - the Rebel
Club."
Lynch attended a weekend seminar on the basic principles of the stock
market and then took some more advanced courses.
"Within 90 days I had a deep understanding of how the stock market
worked. I found that being part o f a club meant that I was mixing with
like-minded people where we were able to share many ideas," he
says.
According to Lynch, one of the most valuable lessons he learnt was
the importance of carrying out fundamental analyses on companies.
"You need to know how much debt is in the company; what the sales
and profit growth have been for the last several years and what the
projections are going forward," he says.
Lynch chooses stocks from companies where the management owns
part of the business. He also likes to see profits reinvested in the
company.
"When you analyse all the companies out there it is surprising only a
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The Investment Club Network 12
few fit my investment criteria. The same names keep reappearing Cisco, Oracle, Pfizer, Starbucks, Dell, Home Depot, Walgreen, Nokia
and Quicksilver," he says.
Lynch then applies technical analysis to these companies. This
involves sitting down for a few minutes each day reviewing charts. He
then chooses one or two companies to invest in out of a list of about
30.
"I like to buy what I call 'fallen angels'. Sometimes a company misses
its earnings by a cent and the value of the stock falls suddenly. From
my charts I can see institutions selling shares and I usually buy on the
first day they stop selling.
He tends to buy when the stock price is at a six-month low. Within
three months the shares usually make a full recovery and then he sells
it.
"I have also learnt to trade with an online broker on the internet, which
costs me about $13 (€10) a trade and I do not pay stamp duty as I only
trade the American market. This also means I can trade from
anywhere in the world once I can get access to the Internet," he says.
During 2003, his best returns were from the following stocks: Humana
which he bought at $10 and sold at $17; Nokia bought at $15 and sold
at $20; Pfizer bought at $29 sold at $35, King Pharmaceutical bought
at $13 sold at $16 and Concord bought at $10 and sold at $15.
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The Investment Club Network 13
"PLAYING THE STOCK MARKET …IN YOUR LIVING
ROOM"
By Sinead Egan
In an ideal, your favourite hobby would also make you money - and as
many are discovering, it is possible through fast growing stock market
investment clubs, SINEAD EGAN reports.
Whether it's green fees at the golf club, membership fees at the tennis
club or costly trips to the art supplies shop, the average extra curricular
activity leaves the average Joe feeling somewhat out of pocket.
But a revolution, which started across the Atlantic, has spread to
Ireland - and more people could soon be lining their pockets on a
Sunday afternoon instead of emptying their contents into the nearest
bunker or water trap.
Stock market investment clubs are popping up all over the country,
proving that Gordon Geckos of this world are not the only ones having
fun making their money work for them.
Investment clubs are not an entirely new concept -in fact the first-ever
investment club was established in 1898 in Texas. However, in recent
years the idea has really taken off, with 40,000 separate investment
clubs across the US alone.
Not surprisingly, the fever has spread around the globe -there are
3,000 investment clubs in the UK, and estimations are that new ones
are established at a rate of 100 a month.
The set-up is simple: get together with a sizeable bunch of friends,
neighbours or colleagues, and pool your money and knowledge
together in order to make even more money through the stock market
investment. You may make a tidy profit and, more importantly you'll
have some serious fun and learn about the market in the process.
The Investment Club Network (TICN) has more than 150 separate Irish
investment clubs affiliated with it - there is at least one in every
country. The membership is diverse in age, gender of course, and
profession.
"We have one mechanic, one college student, two van drivers, two
accountants, a housewife, an engineer, two managing directors, an
operations manager, and a customer service manager," says Sile
Leahy of the cork-base Rebel investment club, which has been going
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The Investment Club Network 14
for just over a year.
The club has 20 members, who all contribute to the decision-making
process of the group. They come from all over Cork, but many of them
met at Microtech, a cleaning firm based in the city's North Point
Business Park. It is part of TICN, which gave members training in how
to maximize their investment.
"A few people had dabbled and gotten burned by the markets," says
fellow Rebel Orla O'Mahony.
But of course many, like Denis Ormond, were coming to the world of
stock market training for the first time. "Initially, I knew nothing about it.
But I thought it would be a great way to learn and it's not a huge
commitment," he says. "It's a medium commitment in terms of money
and it's a lot of fun - and I've made lots of friends."
In a weekend training courser before trading began in earnest last
year, the new club members were shown skills such as how to open a
trading account, how to analyse a company, and how to when it is the
best time to buy.
As members explained, they feel very fortunate because they were not
in the market before September 11. But now, they say they are trained
well enough that, even if the market is in a slump, they can still make
money.
Every month, each member has a homework assignment of carefully
researching information about potentially interesting companies.
"We investigate 20 companies each month," says Sile. "Then, we
would look at the '4x4 companies' and invest in the one that would
make the best return."
As Pat Lynch -who is managing director at Microtech and a member of
the Rebels -explains, a 4x4 company is quality company, which comes
at the right price.
"Were usually looking for a 'fallen angel' -that is a company that has
come down in value but whose fundamentals are still solid, with good
management and maybe a monopoly in a certain area. It has to be a
business we could relate to."
And, so far, their investment strategy has proven successful, with an
average monthly return of 6pc in line with TICN targets. So far, the
Rebels' total fund has gone up a nifty 31pc.
In clubs around the country, the membership is on average 80pc male
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The Investment Club Network 15
but, according to Pat Lynch, women are vital to the effort. "In our club
there are about six ladies," he says. "Ladies are a lot wiser as
investors. They are a lot more focused and they play by the book. I
would advise other clubs that it is important to have three or four ladies
involved in a club to make it a success."
Understandably, in every democracy there are disagreements: but the
simple answer in the investment club game is that a 75pc majority
decision rules.
"You can have strong characters in a club and not all decisions are
right," says Pat. "A successful club has to make mistakes so it can
learn."
The plan for the Rebels is to wind up after five years. In that time, each
member of the club will have invested a total of €6,000 which they
hope will have matured to the nice round figure of €50,000. This will
represent a profit of €1m fore the group pool before it is dished out
among the members.
"We're on target to do it and we're wiser investors than we were a year
ago," enthuses Pat Lynch.
With all this expertise, a few members have even set up individual
trading accounts independent of the club.
"It has given me confidence," confirms Maura Leahy (23). "I've opened
my own account, which will provide me with a future. I would definitely
advise young people to get involved -the younger the better."
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The Investment Club Network 16
"Clubbing Together to Beat the Market"
By Barry McCall
The past three years have not been kind to the majority of equity
investors. Fist came the bursting of the dot.com bubble and the end of
the so-called new economy. Then came the consequent near collapse
of the telecommunications giants, such as WorldCom, and a welter of
accounting scandals affecting companies like Enron and Tyco.
And hardly had investor’s time to recover their collective breath, and
then talk of war in the Middle East sent stocks tumbling again.
However, it is not all doom and gloom and a growing number of Irish
investors have been profiting quite handsomely from equity
investments over the past few years.
Founded in 1999, the Investment Club Network (TICN) has been
helping groups of small investors throughout the country to play the
markets and win.
TICN sets up investors clubs of 20 members in towns and villages
around Ireland. Membership is limited to 20, as that is the maximum
allowed by law for a partnership. Each member deposits €100 per
month in the club bank account and the money is then used to make
investments in U.S. equities
the clubs aren't limited to buying and selling shares, however. They
also become involved in selling options on their shareholdings thus
developing an income stream additional to the normal dividends and
capital appreciation that investors usually seek.
"The concept grew out of an investment seminar I attended in Hawaii
about eight years ago," says TICN founder Owen O'Malley. "This was
attended by some of the world's leading investors and they passed on
the benefit of their experiences over five days, I came back with the
idea of setting up an investment club. I started by setting up one here
in Donegal and we now have more than 200 clubs with almost 5,000
members around Ireland."
When a club is established members receive training in various key
aspects of equity trading - principally picking the right stocks to buy.
"We train club members in how to identify the right stocks to buy," says
Owen O'Malley. "Companies invested in must be fundamentally sound
with little or no debt and an excellent track record over the previous
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The Investment Club Network 17
eight years. They must also be in industries that are experiencing
growth and have a solid management team. We also train our
members in how to identify the true value of companies, price support
and resistance points and up to 25 different strategies for investment."
One of the most interesting aspects of the investments clubs is their
ability to "collect the rent" on their investments as O'Malley puts it.
"About 95 per cent of investors just buy and sell shares, they never
look to collect the rent on them," he says.
"Our clubs look to the Chicago Options Exchange for this. Using that
exchange they can look to see if dealers are looking to buy options in
shares they hold. This might involve the dealer agreeing to buy an
option that will allow them to buy shares currently valued at $9 for $10
in one month's time. They will do this because they might believe that
the shares will be worth more than that at the time.
"By using mechanisms such as this our clubs have been making
annual trading profits of up to 50 per cent."
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"Join the Investment Club"
By Aileen Power
"Shares are scary, and you can lose your shirt," was what flickered
through Patrick Murray's mind when a colleague suggested joining an
investment club early last year. But Murray, a healthcare manager
based in Donegal, took the plunge and joined a small group of other
amateurs with an interest in the stock market.
The investment group dealing exclusively in US shares, started in
August 2001. So far its profit is 33 per cent in a difficult market in which
the S&P 500 is down over 11 per cent in the same period. Its portfolio
is now worth almost $12,000. So how was this achieved?
The initial idea came when Murray attended a meeting hosted locally
by The Investment Club Network (TICN).
"TICN offers a supportive environment, investment advice and access
to information on how to assess whether shares you are considering
buying are of good quality and have growth potential. The comfort
cushion is that your personal financial exposure is limited to you
monthly contributions," he said.
TICN also advises members on how to gain access to the US markets.
There are 19 group members in Murray's club and each contributes
€68 per month, giving a cumulative monthly total of almost €1,300.
They meet monthly to discuss where to place their hard-earned
money.
"If Enron, Elan and Eircom have taught us anything, it is to maximize
profits and limit losses," he said.
It is a requirement for individual members of TICN to attend TICN's
weekend intensive investment training course within about six months
of joining, which costs about €1,000, according to Murray.
TICN provides an 'associate' who is part of the group (although making
no financial contribution) and provides support, advice and guidance
on investment matters. The group's objective is to create wealth over a
five-year timescale, which will be shared equally by all group
members.
The strategy is medium to long-term, with a focus on investing in
fundamentally sound stocks and accumulating benefits from buying
and selling shares and reinvesting the gains in the stock market.
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"We are active not passive investors - we are looking to make money
on market moves by trading (buying or selling) the shares rather than
just sitting on them for the next five years. That said, we're not day
trader, trying to get rich quick," said Murray.
The investment group is diverse, with a large proportion working in
healthcare industry at different levels. There are teachers and a
number of self-employed business people.
Eighty per cent of the group is male with ages ranging from early
thirties to early sixties. Some group members successfully traded
shares in the past; the majority had no previous experience but were
enthusiastic beginners.
The group chose the US market for a number of reasons. The range of
diversity of shares traded offers greater scope and liquidity (ease of
buying and selling shares) that the Iseq, FTSE or European markets.
How can you make money from selling 'covered' calls in the market?
The US market also offers the facility to trade options, or place
'covered calls' on the shares purchased, which is not available when
trading Irish Stocks. Covered calls occur when an investor sells a 'call'
option (a right to buy) to buyers in the market on a stock that they
already own.
In this case the group sold 'out-of-the-money' options which means the
buyer of the option has the choice (but not the obligation) to buy the
shares at a higher price than the price at which the group had
purchased them, at a fixed date in the future - usually the third Friday
of each month.
The group is paid a price for selling an option that adds to the return
from their shares.
For example, the members owned Oracle, a software company at
about $12.50 per share, and they sold call options on a monthly basis
with strike prices of about $15 - the price at which the owner of the call
option could buy the shares.
TICN has an affiliation with MyTrack (www.mytrack.com), which made
opening a trading account easier. It costs $12.95 per trade irrespective
of sized once you are buying or selling more than $500 worth of stock.
It costs the same to execute an option transaction but the trade size
must consist of at least 100 of the underlying shares.
"It has been a steep learning curve, and has been interesting,
educational and enjoyable. Having found my feet within a group, I am
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now ready to trade independently, albeit on a small scale," said
Murray.
(On a cautionary note, while the shares chosen are real, this article is
not designed to provide tips or advice. Patrick Murray is an
enthusiastic amateur, happy to invest money he can afford to lose in
order to enjoy the thrill of the stock market, whilst hoping to make a
profit along the way.)
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Chapter Four
The Basics of Stock Investing
An Introduction To Stocks
Unless you have been living in a hole or on Mars for the past 10 years,
chances are you've heard about stocks and the stock market. It usually
comes in the form of something like: "Bob's cousin made a killing in the
stock market with XYZ company" or "watch out for ABC stock, my
brother-in-law lost his shirt in that company!"
The fact is, most people don't truly understand what the stock market
is and many consider investing in stocks to be equivalent with
gambling. Contrary to this belief, investing in the stock market is not
gambling. Stocks should be considered a financial tool, not a roll of a
dice, and can be quite profitable if you learn the basics and understand
the rules to the game, just as anything else in life. The next few pages
will introduce you to the world of stocks and give you a basic
foundation for future lessons.
What are Stocks?
Stock is sometimes referred to as a share, security or equity. Plain and
simple, a share of stock is part ownership in a company. For every
share of stock you own in a company you "own" a part of the assets of
the company and part of the revenues those assets generate. As the
company acquires more assets and the stream of cash it generates
gets larger, the value of the business increases. This increase in the
value of the business is what drives up the value of the stock in that
business. The more shares you own, the larger the portion of the
company (and profits) you own.
You might be asking yourself why a company would want to sell stock?
Why share the profits with thousands of people when they could keep
profits for themselves. The reason companies issue stock is to raise
money (called equity financing). By selling some ownership in the
company in the form of stock they get money that they do not have to
pay back. The companies do not have to pay back the money because
it is not a loan; instead they have sold part of the company for the
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money. This capital can be used for expansion, upgrading equipment,
marketing, or whatever the company needs. The other method of
raising money is through debt financing (borrowing money from the
bank or through issuing bonds), equity is more popular for raising
money because there is not a loan to pay back and there are no
interest payments to make like there is from taking on debt.
Because shareholders own a part of the business, they get one vote
per share of stock to elect the board of directors. The board is a group
of individuals who oversee major decisions made by the company. The
board of directors normally has the most power in corporate structure.
Boards decide how to spend the money the company makes. The
board will also make decisions on whether a company will reinvest in
its self, buy other companies, pay a dividend, or repurchase stock. The
top company management that is hired and also fired by the board
give some advice, but in the end it is the board makes the final
decision.
As with most things in life, the potential reward from owning stock in a
growing business has some possible pitfalls. Shareholders also
participate in the risk inherent in operating the business. If things go
bad, their shares of stock may decrease in value - or even end up
being worthless if the company goes bankrupt.
In addition to owning part of a corporation, owning stocks for the long
term allows investors to capitalize on the power of compounding, that
is, to earn a return on top of returns. Compounding is part of the
reason that over the past several decades’ stocks have outperformed
practically every other investment tool. A great example: 1 share of
General Electric in 1928 would be worth over $500,000 today!
Different Types of Stock
There are two main types of stocks: Common Stock and Preferred
Stock.
Common stock is just that, "common". It is the standard form of stock
an investor will encounter. The majority of stocks trading today are in
this form. Common stock represents ownership in a company and a
portion of profits (dividends). Investors also have voting rights (one
vote per share) to elect the board members who oversee the major
decisions made by management. In the long term, common stock, by
means of capital growth, yield higher rewards than other forms of
investment securities. This higher return comes at a cost of higher risk
than some of the safer investments. Should a company go bankrupt
and liquidate, the common shareholders will not receive money until
the creditors, bondholders, and preferred shareholders are paid. What
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this means is simple, don't expect anything if the company goes belly
up.
Preferred Stock is a different type of stock that most investors will not
own. Preferred Stock represents some degree of ownership in a
company but the stock usually doesn't have voting rights (this may
vary depending on the company). On preferred shares investors are
guaranteed a fixed dividend forever, rather than the variable dividend
that common stocks receive. However, one advantage is in the event
of liquidation they are paid off before the common shareholder (but still
after debt holders). Preferred stock may also be callable, meaning that
the company has the option to purchase the shares from shareholders
at anytime, usually for a premium price.
Different Classes of Stock
Occasionally, companies find it necessary for various reasons to
concentrate the voting power of a company into a specific class of
stock where the majority is owned by a certain set of people. For
instance, if a family business needs to raise money by selling equity,
sometimes they will create a second class of stock that they own and
control that has ten votes per share of stock. Then they will sell a class
of stock that only has one vote per share to others. Does this sound
like a bad deal? Many investors believe it is and routinely avoid
companies where there are multiple classes of voting stock. This kind
of structure is most common in media companies and has been
around only since 1987.
When there is more than one kind of stock, the shares are often
designated as Class A or Class B shares, this is signified on the New
York Stock Exchange and American Stock Exchange by a period and
then a letter following the ticker symbol The ticker symbol is a
shorthand name for the company's shares that brokerages use to
facilitate transactions. For instance, Berkshire Hathaway Class A
shares trade as BRK.A, whereas Berkshire Class B shares trade as
BRK.B. On the NASDAQ stock market, the class of stock becomes a
fifth letter in the ticker symbol. For example, Tele-Communications,
Inc. has TCOMA, the Class A shares, and TCOMB, the Class B
shares.
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Different Categories of Stock
Professionals divide stocks into various categories attempting to
narrow the list of stocks that will meet their investment needs. Stocks
may be divided into categories such as: size or market capitalization
(large cap, mid cap, small cap, etc); some may be separated by
industry such as technology or energy, while others are divided by
relative sensitivity to the economic cycle such as growth and cyclical.
Stocks may be divided into the following common categories.
•
•
•
•
•
•
•
•
CYCLICAL STOCKS
DEFENSIVE STOCKS
INCOME STOCKS
GROWTH STOCKS
EMERGING-GROWTH STOCKS
BLUE CHIP STOCKS
SPECULATIVE STOCKS
VALUE STOCKS
As you can see by the different categories, each stock has its own set
of characteristics. Separating stocks is not always clear and precise,
because a stock may fall into several categories, such as a utility
stock, which can be classified as both a defensive and an income
stock. Below is a brief description of some of the different types of
stocks.
CYCLICAL STOCKS - Industries usually classified as cyclical stocks
include: chemical, machinery, airline, and railroad, steel, paper, and
automotive. Cyclical stocks are companies whose profits and earnings
are tied to the economy and whose stock prices fluctuate with the
business cycle. The company's profitability is increased and its stock
rises when economic conditions are good. Conversely, when the
economy worsens, the company's business falls off, with the
company's profits and stock price.
DEFENSIVE STOCKS - Defensive stocks include: electric and gas
utilities, food, beverage, and drug companies, and are characterized
by their degree of stability during periods of economic uncertainty and
decline. Anything that is considered to be in the category of human
needs and/or vices is thought of as a defensive stock. These
companies may lack the appeal of high-growth companies, but are
considered to be recession-resistant companies.
INCOME STOCKS - Some stocks are classified as income stocks,
because they pay higher than average dividends, and investors,
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especially the elderly and retired, buy these stocks for the purpose of
current income. Careful attention must be given to these stocks,
because a high dividend yield does not always insure safety. For
example, the price of a stock may have fallen over concerns about the
safety of the dividend, thus a high yield is the result. In addition, the
stock could be in an industry that is not favored and is believed to have
no future. In order to avoid mistakes, investors should buy quality
stocks that have had a steady trend in rising dividends.
GROWTH STOCKS - These are generally companies whose sales,
market share, and earnings are growing faster than the general
economy and their industry average. These companies are usually
involved in research and are more aggressive than others.
Furthermore, they reinvest their earnings back into the business to
facilitate this growth. Because investors generally place a higher value
for this above-normal growth, the price-earnings ratios of these stocks
will be higher than their counterparts and average stocks, and the
dividend if any will usually be lower.
EMERGING-GROWTH STOCKS - Technology companies are a good
example of a stock in this group. These are usually smaller companies
that are emerging and have survived their formative years. They have
entered a period of strong earnings and expanding unit Sales and
profit margins. These stocks are normally traded on the American
Stock Exchange (AMEX) or over-the-counter (NASDAQ), and their
stock prices may be more volatile, therefore having a higher risk.
BLUE CHIP STOCKS - These companies hold leading positions in
their industry and have a long, unbroken record of earnings growth and
dividend payments. These stocks are high-grade, investment-quality
issues of major companies that have the fundamental strength and
size to hold their own during a recession and enough resources to
capitalize on an economic recovery. All in all, investors who are
conservative and who seek safety and stability, will usually invest in
this group.
SPECULATIVE STOCKS - When investing in a speculative stock, an
investor needs to remember the phrase: Caveat Emptor! Buyer
Beware! These companies usually have a great story, but lack the
earnings, revenue history, and the visibility of the more established
companies. The stock price can be highly volatile because there is
uncertainty that the company can meet expectations of future earnings
and revenue. This is not to say that money cannot be made on these
stocks, we just think that an investor should gather enough information
to determine whether or not this is a stock with a high potential or a
stock with no value other than speculative appeal. Just understand the
risk involved up front before investing in a speculative stock.
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VALUE STOCKS - Value stocks are basically stocks that appear
inexpensive relative to earnings, sales, or other fundamental factors. In
the past, the demand for growth stocks and value stocks tend to
fluctuate. When value stocks are in favour, growth stocks are usually
out of favor. Conversely, when growth stocks are in demand, value
stocks lag behind.
Company Sizes - Large, Mid, Small and Micro Caps
Company size is typically based on market capitalization. Market
capitalization is the total value of the company's outstanding shares
and is defined as current price per share times the number of total
outstanding shares. For example, if a company has 1 million shares
outstanding and is trading at a price of $20 per share, it has a market
capitalization or market cap of $20 million. Stocks are usually classified
as follows:
•
•
•
•
Large Cap: $5 billion dollars or more
Mid Cap: $1 billion-$5 billion dollars
Small Cap: $100 million--$1 billion dollars
Micro Cap: $100 million or less
Large cap stocks are usually more stable, mature companies. These
generally have lower beta and are not as volatile as small caps, as
small cap companies tend to fluctuate more in price but have
historically offered higher returns for the higher volatile.
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How the Stock Market Works
Probably one of the most confusing aspects of investing is,
understanding how stocks actually trade. Words such as "bid," "ask,"
"size," "volume," and "spread" can be quite confusing if you do not
understand what they mean. Depending on which exchange a stock
trades; there are two different systems.
Listed Exchange - The New York Stock Exchange and the American
Stock Exchange are both listed exchanges, meaning that brokerage
firms contribute individuals known as "specialists" who are responsible
for all of the trading in a specific stock. With the help of technology, the
specialist quickly matches buyers with sellers. Sometimes referred to
as "an auction market," from the resemblance of all the people
throwing their arm up, waving and yelling at the local auction house.
The specialist can see who has stock to buy or sell and at what price.
He acts as the auctioneer and links them up for a small fee. The
number of shares that are traded on a given day is called the volume,
and it is the responsibility of the specialist to keep an accurate count
and relay that information to the exchange. There are many Stock
Exchanges located in hundreds of countries around the world. The
major ones are located in New York, London, and Tokyo. When people
refer to "The Market" they are usually referring to the New York Stock
Exchange (NYSE).
Over-the-Counter Market - These markets have no floor brokers
whatsoever; instead, it is basically a computer network of dealers. An
example of a computerized exchange (ECN) you've probably heard of
is the NASDAQ. In over-the-counter market, brokerages (also known
as broker-dealers) act as market makers for various stocks. The
brokerages interact over a centralized computer system managed by
the NASDAQ, providing liquidity for the market to function. One firm
represents the seller and offers an ask price (also called the offer), or
the price the seller is asking to sell the stock. Another firm represents
the buyer and gives a bid, or a price at which the buyer will buy the
stock.
For example: A particular stock might be trading at a
bid of $10 and an ask price of $10.50. If an investor
wanted to sell shares, he would get the bid price of
$10 per share; if he wanted to buy shares, he would
pay the ask price of $10.50 per share. The difference
is called the spread. This difference called the spread
is the 50 cents difference between the two firms prices
involved in the transaction. Volume on over-the-
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counter markets is often double-counted, as both the
buying firm and the selling firm report their activity.
Stock markets facilitate the exchange of stocks between buyers and
sellers thus reducing the risks of investing. Just imagine how difficult it
would be to sell shares if you had to call around the neighbourhood
trying to find a buyer. Think of the stock market as a sophisticated
farmers market linking buyers and sellers. Or say you wanted to buy or
sell a stock in a foreign company, what would you have to do? Go to
that country, find a buyer or seller, negotiate a price, and then
exchange your currency for theirs to get the transaction completed?
Well the answer could be yes unless you were to purchase an ADR of
the company.
Why do Stock Prices Change?
Stock prices are changing every moment of the trading day. Buyers
and sellers cause prices to change as they decide how valuable each
stock is at that moment in time. Basically, share prices change
because of supply and demand. If more people want to buy a stock
than sell it - the price moves up. Conversely, if more people want to
sell a stock, there would be more supply (sellers) than demand
(buyers) - the price would start to fall.
Stock as we have said represents ownership in a company. Therefore,
the price of a stock shows what investors feel the company is worth at
that point in time. Stock prices can change at any rate; some have
dramatic price swings everyday while others stay the same for days at
the time. There are hundreds of variables that drive stock prices, the
most important of which is earnings. Think of earnings as the profit of a
company, the money left after all expenses have been paid, this is
what shareholders desire.
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How to Read a Stock Table
Columns 1 & 2: 52-Week Hi and Low. These are the highest and
lowest prices that a stock has traded at over the previous 52-weeks (1
year). This typically does not include the previous day's trading.
Column 3: Company Name & Type of Stock. This column lists the
name of the company. If there are no special symbols or letters
following the name, it is common stock. Different symbols imply
different classes of shares. For example, "pf" means the shares are
preferred stock.
Column 4: Ticker Symbol. This is the unique alphabetic name that
identifies the stock on the exchange's ticker. The ticker tape will quote
the latest prices alongside this symbol. If you are looking for stock
quotes online, you always search for a company by the ticker symbol.
Column 5: Dividend Per Share. This indicates the annual dividend
payment per share. If this space is blank, the company does not
currently pay out dividends.
Column 6: Dividend Yield. The percentage return for the dividend.
Calculated as annual dividends per share divided by price per share.
Column 7: Price/Earnings Ratio. This is calculated by dividing the
current stock price by earnings per share from the last four quarters.
For more detail on how to interpret this, see our P/E Ratio tutorial.
Column 8: Trading Volume. This figure shows the total number of
shares traded for the day, listed in hundreds. To get the actual number
traded, add "00" to the end of the number listed.
Column 9 & 10: Day High & Low. This indicates the price range the
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stock has traded at throughout the day's trading. In other words, these
are the maximum and the minimum people have paid for the stock.
Column 11: Close. The close is the last trading price recorded when
the market closed on the day. If the closing price is up or down more
than 5% than the previous day's close, the entire listing for that stock is
bold-faced. Keep in mind you are not guaranteed to get this price if you
buy the stock the next day. Because a stock's price is constantly
changing (even after an exchange is closed for the day) the close
merely serves as an indicator of past performance.
Column 12: Net Change. This is the dollar value change in the stock
price from the previous day's closing price. When you hear about a
stock being: "up for the day" it means the net change was positive.
"Bulls and Bears", what's that all about?
As you invest more and more you will hear about the bulls and bears.
No, these names do not refer to farm animals; they are terms that
describe the performance of the stock market.
A bull market is when stocks are rising, people are finding jobs, GDP
(Gross Domestic Product), is growing, everything looks just plain rosy.
Picking stocks during a bull market is sometimes easier because
everything is going up. Bull markets cannot last forever though, and
sometimes lead to dangerous situations if stocks become overvalued.
If a person is an optimist, believing that stocks will go up, they are
called a "bull".
The opposite, a bear market, is when there are falling stock prices,
recession, high unemployment, and relatively high inflation. Bear
markets make it tough for investors to pick profitable stocks, one
solution to this is to make money when stocks are falling using a
technique called short selling (discussed in our short selling chapter)
Another strategy is to wait on the sidelines until you feel that the bear
market is nearing its end and start buying in anticipation of a bull
market. If a person is a pessimist, believing that stocks are going to
drop, they are called a "bear".
“No great thing is created suddenly”
Epictetus
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Types of Accounts and Orders
You've learned what a stock is and a little bit about the principles
behind the stock market, so how do you actually buy the stock? There
are two ways:
Using a Brokerage Firm The most common method to buy and sell
stocks is to use a broker. Brokerage firms come in many different
shapes and sizes. There are big well-known "full-service" brokerage
firms such as Merrill Lynch and Goldman Sacks, as well as an
incredible number of well-known "discount" brokerage firms such as ETrade and Charles Schwab. There are also a multitude of no name
brokerage firm of both full and discount services.
When you use a brokerage firm, you have the choice of setting up a
cash account or a margin account. Having a margin account meaning
you can borrow money from the brokerage firm to buy stocks.
DRIPs & DIPs Using Dividend Reinvestment Programs and Direct
Investment Plans Dividend Reinvestment Plans (DRIPs) and Direct
Investment Plans (DIPs) are the official names for what many people
refer to as Drips. These are plans in which individual companies allow
shareholders to purchase stock directly from the company with only
minimal cost or commissions. Drips are great for those who have small
amounts of money but who are willing to invest it at regular intervals.
Placing the Trade
In order to make your trade you'll have to be specific how the stock
should be traded. The following terms are common terminology you'll
encounter:
Day Order: An order that expires at the end of the business day if it
has not been filled.
GTC (Good Till Cancelled): An order either to buy or to sell a stock
that remains in effect until the customer cancels it or until it is executed
by the broker. Some brokerage firms cancel these orders after 90 days
check with you firm on their company policy.
Limit Order: An order to buy or sell at a specified price or better. This
type of order allows you to set the price you will buy or sell a stock at.
Remember the danger of a limit order is you might not get filled.
Market Order: An order that requires immediate execution. When you
place this kind of order you are saying I want to buy this stock
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immediately at its current price, or sell this stock now at the current
selling price. If you have access to real time quotes, you will have a
good idea what price you will receive with your market order. If you
don't, trading stocks with market orders is not the smartest thing to do
in most cases.
Stop Loss Order: An order that is lays dormant until the stock trades
at a specified price, once the stock trades at the specified price the
order is triggered and becomes an active market order. Remember the
danger of a market order is the buy or sell price is unknown, but the
execution is guaranteed.
Stop Limit Order: An order that is lays dormant until the stock trades
at a specified price, once the stock trades at the specified price the
order is triggered and becomes an active limit order. Remember the
danger of a limit order is that it my not get filled.
All or None (AON): A stipulation on a limit order either to buy or sell a
stock only if the broker can fill the entire order and not part of it. If the
order is not completely filled by the end of the business day it is
cancelled.
Fill-or-Kill: A stipulation on a limit order either to buy or sell a stock
only if the broker can get an immediate execution. If it cannot be filled
immediately the order is automatically cancelled.
Congratulations on taking the first step
You now know more about stocks than the average person...
Don't let it go to your head though, these chapters were meant to
provide a basic foundation for understanding what a stock is, the
general principles behind the stock market, stock exchange, and
the methods by which to purchase a shares of stock. These
chapters just scratch the surface. It is the snowflake on the tip of
the iceberg. Over the coming weeks, months, and years you will
learn more than you could ever imagine. Remember the old
saying "The journey of ten thousand miles begins with a single
step".
Join The Investment Club Network Now
Call us on 1800 367 693
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The Investment Club Network 33
Chapter five
Learning Options
A History of Options
Ancient Origins of Options
Although it isn't known exactly when the first option contract traded, it
is known that the Romans and Phoenicians used similar contracts in
shipping. There is also evidence that Thales, a mathematician and
philosopher in ancient Greece used options to secure a low price for
olive presses in advance of the harvest. Thales had reason to believe
the olive harvest would be particularly strong. During the off-season
when demand for olive presses was almost non-existent, he acquired
rights-at a very low cost-to use the presses the following spring. Later,
when the olive harvest was in full swing, Thales exercised his option
and proceeded to rent the equipment to others at a much higher price.
In Holland, trading in tulip options blossomed during the early 1600s.
At first, tulip dealers used call options to make sure they could secure
a reasonable price to meet the demand. At the same time, tulip
growers used put options to ensure an adequate selling price.
However, it wasn't long before speculators joined the mix and traded
the options for profit. Unfortunately, when the market crashed, many
speculators failed to honour their agreements. The consequences for
the economy were devastating. Not surprisingly, the situation in this
unregulated market seriously tainted the view most people had of
options. After a similar episode in London one hundred years later,
options were even declared illegal.
Early Options in America
In America, options appeared on the scene around the same time as
stocks. In the early 19th Century, call and put contracts-known as
"privileges"-were not traded on an exchange. Because the terms
differed for each contract, there wasn't much in the way of a secondary
market. Instead, it was up to the buyers and sellers to find each other.
This was typically accomplished when firms offered specific calls and
puts in newspaper ads.
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Not unlike what happened in Holland and England, options came
under heavy scrutiny after the Great Depression. Although the
Investment Act of 1934 legitimised options, it also put trading under the
watchful eye of the newly formed Securities and Exchange
Commission (SEC).
For the next several decades growth in option trading remained slow.
By 1968, annual volume still didn't exceed 300,000 contracts.
For the most part, early over-the-counter options failed to attract a
following because they were cumbersome and illiquid. In the absence
of an exchange, trading was haphazard to say the least, traders didn't
know what other traders had to buy or sell most trading was done by
calling around to find out who had what to buy, or sell. To make
matters worse, investors had no way of knowing what the real true
market price of a given contract was. Instead, the put-call dealer
functioned only to try to match up buyer and seller. Operating without a
fixed commission, the dealer simply kept the spread between the
prices paid and the price sold. There was no limit to the wide the
spread was. Worse yet, all option contracts had to be exercised in
person. If the holder (person who had bought, or owner) of the option
somehow missed the 3:15 pm deadline, the option would expire
worthless regardless of how deep in-the-money it was (its intrinsic
value).
The Chicago Board of Trade
In the late 1960s, as exchange volume for commodities began to
shrink, the Chicago Board of Trade (CBOT) explored opportunities for
diversification into the options market. Joseph W. Sullivan, Vice
President of Planning for the CBOT, studied the over-the-counter
option market and concluded that two key ingredients for success were
missing. First, Sullivan believed that existing options had too many
variables. To correct this, he proposed standardizing the strike price,
expiration date, size (number of shares in a contract), and other
relevant contract terms. Second, Sullivan recommended the creation
of an intermediary to issue contracts and guarantee settlement and
performance. This intermediary is now known as the Options Clearing
Corporation.
To replace the put-call dealers, who served only as intermediaries, the
CBOT created a system in which market makers were required to
provide a purchase price as well as a sell price (a two-sided market)
for all their options. At the same time, the presence of multiple market
makers made for a competitive atmosphere in which buyers and
sellers alike could be assured of getting the best possible price.
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The Investment Club Network 35
The Chicago Board Options Exchange
After four years of study and planning, the Chicago Board of Trade
established the Chicago Board Options Exchange (CBOE) and began
trading, options that were now trade on the exchange were called
listed options. The listed options were all standardized with contract
terms (strike prices, expiration dates, size, etc.). The first listed options
to be traded were call options, they were written on 16 different stocks
on April 26, 1973. The stock an option is written on became known as
the underlying security. The CBOE's first home was actually a
smoker's lounge at the Chicago Board of Trade. After achieving firstday volume of 911 contracts, the average daily volume skyrocketed to
over 20,000 the following year. Along the way, the new exchange
achieved several important milestones.
As the number of underlying securities (stocks) with listed options
doubled to 32, exchange membership doubled from 284 to 567. About
the same time, new laws opened the door for banks and insurance
companies to include options in their portfolios. For these reasons,
option volume continued to grow. By the end of 1974, average daily
volume exceeded 200,000 contracts. The newfound interest in options
also caught the attention of the nation's newspapers, which voluntarily
began carrying listed option prices. That's quite an accomplishment
considering that the CBOE initially had to purchase news space in The
Wall Street Journal in order to publish quotes.
The Emergence of Put Trading
After repeated delays by the SEC, put trading finally began in 1977.
Determined to monitor the situation closely, the SEC only permitted
puts to be traded on five stocks. Despite the rapid acceptance of puts
and the rising interest in options, the SEC imposed a moratorium
halting the listing of additional options. Nevertheless, annual volume at
the CBOE reached 35.4 million in 1979.
Today, more than ever, option volume and open interest continues to
climb. In 1999 alone, option volume at the CBOE doubled. By the end
of 1999, the number of open contracts reached almost 60 million.
Other Exchanges Get Into the Game
Starting in 1975, a number of other exchanges began trading listed
options. This group included the American Stock Exchange (ASE), the
Pacific Stock Exchange (PSE), and what is now known as the
Philadelphia Stock Exchange (PHE). The most recent player to enter
the game is the International Stock Exchange (ISE). Although the ISE
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The Investment Club Network 36
only trades options on a limited number of stocks, the list is literally
growing every day. Today, options on all sorts of financial instruments
are also traded at the Chicago Mercantile Exchange, the CBOT, and
other exchanges.
Employee Stock Options
With the rapid growth in Internet and Biotech companies over the past
few years and the enormous wealth created by employee stock
options, more and more people are developing an interest in the
concept of owning and trading options. Although there are fundamental
differences between the options granted to an employee by a company
and the listed options traded on the floor of an exchange, there are
important similarities.
When a company grants stock options to an employee, it gives that
person the right (not obligation) to buy a certain number of shares at a
price often well below market value. Although the options granted by a
company eventually expire, they are usually good for extended periods
(e.g., 10 years). Generally speaking, options issued by a company are
not transferable. Therefore, they cannot be sold or traded to a third
party. However, if the company is publicly traded, the employee can
exercise the options and convert it to stock. This stock can then be
sold on the open market.
For example, the person might have options to buy 1,000 shares at an
exercise (strike) price of $12 per share when the stock (in the case of a
public company) is actually trading at $50. In this case, the person
pays $12,000 for stock that is worth $50,000 on the open market. Not
a bad deal at all.
Exchange Traded Options
Although there are a variety of different types of listed options (e.g.,
stock options, index options), this section will focus exclusively on
listed stock options. Once you understand the basic principles, they
can easily be applied to the other financial instruments. Exchangetraded stock options (listed), also known as equity (stock) options,
differ from those granted to employees by their company in a number
of important ways.
First, they typically have shorter-term expirations. Options granted by
companies are often good for several years. During that period, they
can be exercised (converted to stock) at any point. However,
employee stock options cannot usually be sold or transferred. In
contrast, exchange traded options (with the exception of LEAPS) are
generally valid for 9 months or less and can be bought or sold at any
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The Investment Club Network 37
time prior to expiration. To many people, it seems odd that exchangetraded options are not issued by the companies (underlying stock)
themselves. Instead, they are issued by the Options Clearing
Corporation (OCC). By centralizing and standardizing options trading,
the OCC has created a more liquid market.
Unless otherwise specified, each option contract controls 100 shares
of stock. In simplest terms, an option holder has the right, but not the
obligation, to buy or sell a particular stock at a set price (also called
strike price or exercise price) on or before the expiration date. (Also
called assignment or exercise date). For example, the buyer (also
called holder or owner) of a Cisco September 65 Call would have the
right (not obligation) to buy 100 shares of Cisco Systems (NASDAQ:
CSCO) for $65 per share. Likewise, a Cisco September 65 Put gives
the buyer the right (not obligation) to sell 100 Shares of CSCO for $65
per share, until expiration of the option in September.
The Option Players
The exchange is a place where market makers and traders gather to
buy and sell stocks, options, bonds, futures, and other financial
instruments.
Since 1973 when the Chicago Board Options Exchange first began
trading options, a number of other players have emerged. These
include the Pacific Stock Exchange (PCX) in San Francisco, the
Philadelphia Stock Exchange (PHLX), the American Stock Exchange
(AMX) and the most recent addition, the International Stock Exchange
(ISE). At first, the exchanges each maintained separate listings and
therefore didn't trade the same contracts. In recent years this has
changed.
Now that these exchanges list and trade the same contracts, they
compete with each other. Nevertheless, even though a stock may be
listed on multiple exchanges, one exchange generally handles the bulk
of the volume. This would be considered the dominant exchange for
that particular option.
The competition between exchanges has been particularly valuable to
individual investors who have created complex computer programs to
monitor price discrepancies between exchanges. These discrepancies,
though small, can be extraordinarily profitable for traders with the
ability and speed to take advantage. More often than not, individual
investors simply use multiple exchanges to get the best prices on their
trades.
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For example, traders with access to real-time quotes on all exchanges
will see the following data and make their decisions accordingly:
XYZ Company (XYZ) Aug 75 Calls
Exchange
AMEX
Bid Price
10.35
Ask Price
10.75
CBOE
10.45
10.75
ISE
10.10
10.65*
PCX
10.45
10.90
PHLX
10.25
10.75
For individual investors, the best price (real market) for this option is
10.45 to 10.65 because it represents the best bid and offer (ask)
currently available. Thus, for an individual investor looking to sell the
August 75 calls, the Chicago Board Options Exchange (CBOE) or the
Pacific Stock Exchange (PSE) would be the best choices because they
both have 10.45 bids in the contract. Deciding between the two would
be simply a matter of choosing the exchange that does the most
trading in this contract. The more volume the exchange does, the more
liquid the contract. Greater liquidity increases the likelihood the trade
will get filled at the best price.
If the trader wanted to buy the XYZ August 75 call, the International
Stock Exchange (ISE) would be the best place to go in this case
because they offer the contract at 10.65.
Payment for Order Flow
It is becoming more common for brokerage firms and large market
making firms to accept what is called "payment for order flow." This
means the firm is paid for each order it routes to a particular exchange.
While this can help reduce customer commissions, it doesn't
necessarily guarantee the best possible execution because, at any
given moment, the exchange receiving the order may or may not have
the highest bid or lowest offer. While relatively small price
discrepancies among exchanges may not be as critical to small
traders, they can have an enormous impact on investors who trade
large numbers of contracts.
The Financial Institutions
Financial institutions are professional investment management
companies that typically fall into several main categories: banks,
hedge funds, insurance companies, mutual funds, stock funds, and
pension funds. In each case, these money managers control large
portfolios of stocks, options, and other financial instruments.
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The Investment Club Network 39
Although individual strategies differ, institutions share the same goal to
outperform the market (S&P 500). In a very real sense, their livelihood
depends on performance because the investors who make up any
fund tend to be a fickle group. When fund don't perform, investors are
often quick to move money in search of higher returns.
Where individual investors might be more likely to trade equity options
related to specific stocks, fund managers often use index options to
better approximate their overall portfolios. For example, a fund that
invests heavily in a broad range of tech stocks might use Nasdaq 100
Index options rather than separate options for each stock in their
portfolio. The Nasdaq 100 Index (Symbol: QQQQ) is known as a
tracking stock because its price is based on the cumulative value of
the top 100 stocks in the Nasdaq market. Theoretically, the
performance of this index would be relatively close to the performance
of a subset of comparable high tech stocks the fund manager might
have in his or her portfolio.
The Market Makers
Market makers are the traders on the floor of the exchanges who
create liquidity by providing two-sided (bid and ask) markets. In each
pit, the competition between market makers keeps the spread between
the bid and the offer relatively narrow. Nevertheless, it's the spread
that partially compensates market makers for the risk of willingly taking
either side of a trade (the buy side or sell side).
For market makers, the ideal situation would be to "scalp" every trade.
For example, in a busy market, one customer order may come into the
pit to sell 100 June IBM calls at the market. At the same time, another
customer may want to buy 100 June IBM calls at the market. If the
current bid-ask for the contract is 7 - 7.25 and the same market maker
fills both orders, she'll sell 100 contracts for 7.25 and buy 100 identical
contracts for 7. This way, she earns the ¼ point differential on the
spread for each contract. This works out to a quick profit of $2,500
(100 contracts x $0.25 x 100 shares).
More often than not, however, market makers don't benefit from an
endless flow of perfectly offsetting trades to scalp. As a result, they
have to find other ways to profit. In general, there are four trading
techniques that characterize how different market makers trade
options.
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The Investment Club Network 40
The same market maker depending on trading conditions may employ
any or all of these techniques.
1.
2.
3.
4.
Day Traders
Premium Sellers
Spread Traders
Theoretical Traders
Day Trader
Day traders, on or off the trading floor, tend to use small positions to
capitalize on intra-day market movement. Since their objective is not to
hold a position for extended periods, day traders generally don't hedge
options with the underlying stock. At the same time, they tend to be
less concerned about delta, gamma, and other highly analytical
aspects of option pricing.
Premium Sellers
Just like the name implies, premium sellers tend to focus their efforts
selling high priced options and taking advantage of the time decay
factor by buying them later at a lower price. This strategy works well in
the absence of large, unexpected price swings but can be extremely
risky when volatility skyrockets.
Spread Traders
Like other market makers, spread traders often end up with large
positions but they get there by focusing on spreads. In this way, even
the largest of positions will be somewhat naturally hedged. Spread
traders employ a variety of strategies buying certain options and
selling others to offset the risk. Floor traders primarily use some of
these strategies like reversals, conversions, and boxes because they
take advantage of minor price discrepancies that often only exist for
seconds. However, spread traders also use strategies like butterflies,
condors, call spreads, and put spreads that can be used quite
effectively by individual investors.
Theoretical Traders
By readily making two-sided markets, market makers often find
themselves with substantial option positions across a variety of months
and strike prices. The same thing happens to theoretical traders who
use complex mathematical models to sell options that are overpriced
and buy options that are relatively under priced. Of the four groups,
theoretical traders are often the most analytical in that they are
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The Investment Club Network 41
constantly evaluating their position to determine the effects of changes
in price, volatility, and time.
The Individual Investors (Retail Investors)
As option volume increases, the role of individual investors becomes
more important because they account for over 90% of the volume.
That's especially impressive when you consider that option volume in
February 2000 was 56.2 million contracts-an astounding 85%
increases over February 1999 (Source: Options Industry Council).
The Move to Online Trading
By mid-1999, online investors accounted for $420 billion in assets. By
2002, it is estimated that almost 14 1/2 million people will have $688
billion in online brokerage accounts.
The Psychology of the Individual Investor
From a psychological standpoint, individual investors are in interesting
group because there are probably as many strategies and objectives
as there are individuals. For some, options are a means to generate
additional income through relatively conservative strategies such as
covered calls and bull put spreads. For others, options in the form of
protective puts provide an excellent form of insurance to lock in profits
or prevent losses from new positions. More risk tolerant individuals use
options for the leverage they provide. These people are willing to trade
options for large percentage gains even knowing their entire
investment may be on the line.
In a sense, taking a position in the market automatically means that
you are competing with countless investors from the categories
described above. While that may be true, avoid making direct
comparisons when it comes to your trading results. The only person
you should compete with is yourself. As long as you are learning,
improving, and having fun, it doesn't matter how the rest of the world is
doing.
“What we have to learn to do, we learn by doing”
Aristotle
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The Investment Club Network 42
Chapter Six
The Investment Club Network
The Investment Club Network TICN provides education and training
and organizes participatory seminars to help people understand the
world of investment-shares, bonds, options, commodities, securities
and derivatives. We help you understand how their prices move, what
factors affect them and by what mechanisms the markets reflect these
changes.
Our seminars teach you how to invest wisely and trade online, sensibly
and profitably. In addition TICN provides an infrastructure (web site,
manuals, advanced seminars, ongoing training and information) to
help you increase your investment skills and knowledge and establish
your own share/stock owning club that become part of The Investment
Club Network.
Our aim is to outperform the stock market month on month thereby
giving our members real value for money, real increases in asset
values and real satisfaction. To accomplish this we combine our
proven instruction technique with your enthusiasm, drive and ambition.
All of this coupled with TICN's unique money back guarantee.
So whether you wish to learn how the stock market operates, trade
online yourself or become a member of one of our ever-expanding
number of clubs TICN can deliver it to you.
The TICN Difference
TICN we believe our members and those who attend our seminars can
best achieve their goals by learning for themselves how the markets
operate and how prices on the various exchanges move. Our
members use the knowledge they have learned and the patented
software we provide to anticipate price movements of companies with
a stock market capitalization on any of the world's leading stock
markets - the Dow Jones, Nasdaq, and the FTSE. We give them the
tools and information they need to help them achieve that level of
understanding and insight.
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The Investment Club Network 43
It is only when you comprehend how things happen and are able to act
on that knowledge yourself that you can make prudent investment
decisions that are right for you and your portfolio.
TICN is different in that it allows the investor the freedom to choose
his/her own investments according to their needs. TICN does not as a
matter of policy recommend particular stocks, bonds, options,
derivatives or securities of any kind. Ultimately all decisions are made
by you putting you in the driving seat.
TICN are so confident that you will enjoy and appreciate the value of
our seminars that we offer a unique money back guarantee to any
participant not fully satisfied with them! Now there's a difference.
The stock market by its very nature is a highly speculative arena and
consequently there is a risk of loss inherent in all trading and
investment. The Investment Club Network do not guarantee any
results or investment returns based on the information you receive.
What we do is ensure all of our participants and investment club
members have the information and skills necessary to create and
manage a well-balanced portfolio of investment stocks.
With our help and your enthusiasm, drive and ambition you can make
investment decisions wisely and knowledgably. Our aim is to
outperform the stock market month on month thereby giving you-our
member-real value for money, real increases in asset values and real
satisfaction.
What We Do
TICN teaches proven investment strategies in a manner that fits their
mission statement:
"Creating a supportive environment of investment
clubs and empowering individuals to become
abundantly wealthy"
TICN flagship seminar 'Making Money With Careful Planning' is
delivered during a 20 hour weekend session or 8 x 2 hour evening
Modules on our state of the art interactive “webinar” platform so you
can learn and train from the comfort of your own home.
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The Investment Club Network 44
TICN then provides a service to help each member to join a TICN
associated investment club or to help form a new club within their local
geographic locations. TICN will then provide members with on-going
support in the following ways:
•
Website - The TICN TOOLS club members area of the
website hosts a very powerful suite of research tools that are
live and interactive to support new inexperienced as well as
seasoned investors. Some of these research resources are
unique and specific to the proven systems that TICN teach
and that the members use. We have a weekly updated club
performance table.
•
Seminars - there are a number of different events that TICN
offer, they cater for novice investors to those who wish to trade
for a living, using vehicles like options.
•
TICN Club Coordinators - these are a growing band of
individuals, whose very nature is to help others. These
individuals have been highly trained in the investment
strategies that TICN teach and support. The most important
quality that these club coordinators possess is that they use
the strategies successfully for themselves. Our club cocoordinators are responsible for supporting clubs in their area
and in this way, clubs and club members get some highly
focused support attention. TICN Club members gain first level
support from a TICN club coordinator whose primary role is to
assist in the training, development and empowering of the club
members in the skills necessary to succeed in the stock
market.
•
Club formation - in the formative days of a club, we will help
the club get started by helping with formalities such as
constitution and rules, how to open brokerage accounts,
appointing officers etc. This is normally done either at our
weekend financial seminar, or through a club visit.
•
Special offers - Find powerful investment research and
trading tools such as charting services, books, trade finders
etc.
•
TICN telephone support - Each club has a TICN club cocoordinator, who will provide initial support and is able to
attend a few of the meetings.
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The Investment Club Network 45
•
TICN 12 Module Investment Education Programme - As a
condition of TICN club membership each member commits to
the following TICN 12 module investment education
programme:
TICN 12 Module Investment Education
Programme
Module Description
Costs
1
The Markets
£ 225
2
Fundamental
Analysis (Quality)
£ 225
3
Technical Analysis £ 225
4
Strategies to
create monthly
income.
5
Applied Trading(Introductory Skills for
Online Trading)
Pay total of £ 895
for 4 MMCP
Modules
£ 230
£ 135
6
Graphs and
Charts
£ 135
7
Call Options
Module
£ 180
8
Put Options
Module
£ 180
9
Leap Options
Module
£ 180
10
Basic Japanese
Candles
£ 275
11
Credit Spreads
£ 345
12
Debit Spreads
£ 345
All Prices based on
19 members per
club funded by club
account.
All 12 Modules are completed comfortably within
12-15 Months. (Prices valid until 31/12/07)
“Skill to do comes of doing”
Ralph Waldo Emerson
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The Investment Club Network 46
Welcome to The Investment Club Network!
If you become a TICN member online you will have access to:
1. TICN Member's Area which includes
o The TICN Research Sheet
o The TICN Members Chat Room
o The TICN Trader's Forum
o The TICN 4'4 Mind Map
o Access to Valueline information on ~ 8,000 companies
and 80,000 options
o TICN Educational FREE Web shops
o Covered Call Trader Finder
o Buying In-The-Money Puts Trade Finder
o Discounted books from the TICN bookstore
2. TICN Club Co-ordinator
Each club has a club co-coordinator who supports the club
and club members during the early start up days and this
individual is focused on developing and empowering the
individual members as well as the club to become successful
in the stock market. The experienced Club Coordinator under
goes continual quarterly training to add experience and value
back into the club. TICN is committed to bring the best
investors and trainers in the World to the Co-ordinators in
order to bring that worldwide experience back to the clubs.
3. A disciplined, structured, proven club success system with a
proven track record over time.
4. The potential to purchase investment $$'s wholesale instead of
retail as well as accessing more efficient electronic wire
transfer costs.
5. Continual weekly benchmarking of clubs on the web with the
sharing of best practice.
6. Online educational seminars for stay at home investment
education.
7. Thousands of dollars worth of research information per annum
negotiated down to a fraction per person per annum as a TICN
club member.
and much much more.
So what are you waiting for?
Join us now… and let's Make Money with Careful Planning.
Contact us @ enquires@ticn.com for a club near you.
Contact us on Free phone 1800 367 693
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The Investment Club Network 47
Chapter Seven
Picking the right Companies
The Investment Club Network (TICN) have an interesting and
incredibly successful approach to the stock market that they would like
to share with you the reader.
We buy for the long term: we look for value in a company and seek to
make a profit by holding onto a stock while that value grows.
We spread our investment among industries that are experiencing
growth.
We diversify our portfolio: we buy in different industries, as well as
different size companies.
Success depends largely on doing our homework and being selective.
We do not try and time the market (earn profits from the daily/hourly
fluctuations of a stock price). Instead, we invest in fundamentals stocks we believe are well priced, with the potential for steady growth.
We want the price of our stocks to appreciate at minimum 100% in the
next five years.
We look for companies that offer a product or service we understand
and can relate to.
Fundamental Analysis of a Successful Investor.
Using the reliable and dependable resource of a *Valueline Report the
TICN students carry out qualitative and quantitative fundamental
analysis of all companies before they invest.
In order to greatly enhance the prospects of success when choosing
stocks to invest in the TICN investors select a rock solid fundamental
sound quality company at the right time to buy.
The aim of the TICN researcher is to score a company out of possible
maximum score of 52 and only consider companies that score higher
than 40 out of 52 for both Quality and Right Time to Buy.
In this chapter we will explain the Quality system and in the next
chapter we explain the Right Time to Buy.
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Quality Company Scoring System:
The company information is sorted into seven headings:
Industry Rank
Timeliness
Safety
Debt
Beta
Growth Trends
Management
1.Industry Rank
This is a measure of the industry that the company is in relative to
other industries of which there are 98 industries. Industries are ranked
from 1 to 98 in terms of potential for growth and then scored from 1 to
4 as follows:
Top 1 – 25 performing industries assigned a score of 1
Next 26 – 50 performing industries assigned a score of 2
Next 51 – 75 performing industries assigned a score of 3
Last 76 – 98 performing industries assigned a score of 4.
2. Timeliness
The components of the Timeliness Ranking System are the 10-year
trend of relative earnings and prices, recent earnings and price
changes, and earnings surprises. All data are actual and known. A
computer program combines these elements into a forecast of the
price change of each stock, relative to all other approximately 1,700
stocks for the six to 12 months ahead. The Value Line Timeliness rank
measures relative probable price performance of all stocks during the
next six to 12 months on a scale from 1 (Highest) to 5 (Lowest).
Timeliness of 1 and 2 is scored of 4, Timeliness of 3 scores 2.5 and
Timeliness 4,5 is scored 1.
3. Safety
The Safety rank is a measure of the total risk of a stock compared to
others. As with Timeliness, Value Line ranks each stock from 1
(Highest) to 5 (Lowest).
The Safety rank is derived from two measurements:
•Company's Financial Strength and
•Stock's Price Stability.
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The Investment Club Network 49
Financial Strength is a measure of the company's financial condition,
and is reported on a scale of A++ (Highest) to C (Lowest). The largest
companies with the strongest balance sheets get the highest scores.
A Stock's Price Stability score is based on a ranking of the standard
deviation (a measure of volatility) of weekly percent changes in the
price of a stock over the last five years, and is reported on a scale of
100 (Highest) to 5 (Lowest) in increments of 5. Safety of 1 and 2 is
scored of 4, Safety of 3 scores 2.5 and Safety 4,5 is scored 1.
4. Debt
We look for companies that have a long-term debt of less than 33% of
capitalization.
Definition: How much long-term debt is the company carrying as a
percentage of its capitalization?
The amount of long-term debt will affect the company’s ability to grow,
survive and prosper during tough times. Too much debt will drain
profitability.
Calculation: Divide Total Debt by Market Capitalization and multiply by
100.
Belief in oneself leads to taking action, which leads to results, which
leads to more belief, which leads to more action, which leads to even
better results, and so the positive reinforcement loop continues ever
upwards.
Debt of 0 – 9% is assigned a score of 1
Debt of 10 – 30% assigned a score of 2
Debt of 31 – 50% assigned a score of 3
Debt of 51- 100% assigned a score of 4.
5. Beta
Beta = Volatility of the share price compared to the market.
Definition: Beta How closely will the fluctuation of the stock price mirror
that of the market overall?
This is rated because we invest in quality companies, not markets. For
long term investing, the market means less for longterm safety. Certain
beta’s can be advantageous in the short term.
The way in which we score Beta is the market growth rate is taken as
being equal to 1
Beta range 0.95 to 1.1 is scored as 4
Beta range 0.94 to 1.2 is scored as 3
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Beta range 0.91 to 1.49 is scored as 2
Beta range <0.91 to >1.49 scored as 1
6. Growth Trends
We measure the Sales and Earnings growth of a company for the past
5 years and future projected 5 years and we measure projections
based on a 8 year track record to establish whether the company is in
the habit of matching its projections.
The way in which we measure growth trends is as follows.
Sales and Earnings Growth rate in the past and future 5 years:
>15% per annum scored as 4
11 – 14.99% p.a. scored as 3
6.66 – 10.99% p.a. scored as 2
< 6.65% per annum scored as 1
We also measure consistency in earnings growth as follows:
Last 5 consequtive years of growth scored as 4
4 years of growth and up in last 2 years scores 3
4 years of growth but not in last 2 years scores 2
> 2 years without growth in last 5 years scores 1
7.Management
Management: We look for strong management, who anticipate future
trends and challenges to create future growth in profitability.
How strong is the management of the company, and are they
anticipating challenges and trends to create future growth in
profitability?
Management is the essence of what makes the company profitable or
not.
This is however more difficult to track with specificity. An increase in
profit on sales and percentage earned on invested capital are good
indicators of management strength.
Lastly we measure and score managment under the following
headings:
Are Profits increasing year on year? Yes is scored 1(out of a possible
4)
Is Management solid and anticipating future trends? Yes is scored as 1
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Has the Company handled past challenges? Again Yes is scored as 1
Company operating smoothly without any pending law suits? Yes = 1
Finally we add all the scores together with a weighted ranking system
that multiplies the scores by the following weight:
Industry Rank = 1
Timeliness = 2
Safety = 2
Debt = 2
Beta = 1
Growth Trends = 3
Management = 1
Next chapter we will outline the second part of the Fundamental
analysis system which quantifies again out a possible score of 52 how
to identify the Right Time to Buy a company again using the past and
projected 5 years of reliable fundamental data.
* Valueline were founded in 1931 with the express purpose of
supplying independent unbiased reports on companies to protect
investors from the dangers of favourably reporting.
The right time to buy
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TICN Ltd Quality Mind Map
© 2004
7. Company
Management Rank
(1 to 4)**
1. Industry rank
(1 to 4)*
6b. Future 5
years Sales &
Earnings
2. Timeliness
Rank (1 to 4)**
TICN
Quality Company
out of
Scored
a possible 52
6. Growth
Trends
Rank (1 to 4) ***
3. Safety Rank
(1 to 4)**
5. BETA Rank
(1 to 4)*
6a. PAST 5 YEARS in SALES &
EPS
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4. Debt / Equity
Ratio Rank (1 to 4)**
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Chapter Eight
Right Time to Buy Scoring System.
Using the reliable and dependable resource of a *Valueline Report the
TICN students carry out qualitative and quantitative fundamental
analysis of all companies before they invest.
In order to greatly enhance the prospects of success when choosing
stocks to invest in the TICN investors select a rock solid fundamental
sound quality company at the right time to buy.
The aim of the TICN researcher is to score a company out of possible
maximum score of 52 and only consider companies that score higher
than 40 out of 52 for both Quality and Right Time to Buy.
Having explained the Quality system in the last chapter let us now
explain the Right Time to Buy system.
The company information is sorted into seven headings:
Current Stock Price
Dividends versus Earnings
Estimated Price Appreciation
Sales versus Earnings
Average Annual PE Ratios
High / Medium / Low Price Ranges
Reward to Risk Ratios
1.Current Stock Price
This is used to calculate the Reward to Risk Ratio and overall score for
Right Time to Buy for a particular stock and is always changing on a
minute by minute basis in the stock market.
2. Dividends versus Earnings
This section measures the dividends of a company relative to its
earnings per share and is based upon the distribution of profits relative
to the profitability of the company. Maximum score of 4 is given to a
company that retains more than half its earnings to fuel the future
growth potential of a company and a Minimum score of 1 is given to a
company that distributes more than half its earnings / profits in the
form of annual dividends.
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3. Estimated Price Appreciation Potential
How much is the price of the stock likely to rise in the next twelve
months based on Value Line Projections. We like to find companies
that have a price appreciation potential of > 15% per annum which
over a 5 year period has the potential for 100% growth as a minimum
accepted growth rate. (>15% scores 4 and <15% = 1).
4. Sales versus Earnings
We look for companies that have earnings growth rate faster than
sales growth rate for both the past 5 years of results and future 5 years
of conservative projections.
All projections are measured against a factual 8-year track record of
matching expected earnings to actual, which includes all the data from
32 quarterly earnings reporting events in the past 8 years.
If earnings growth rates are faster than sales growth rate for both the
past 5 years and future 5 yearly projections than it will receive the
maximum score of 4
If earnings growth rate is faster for one of the 5-year periods than the
score assigned is 2.5
However if sales growth rate is outpacing earnings growth rate for both
the past 5 years and future projected 5 years than the sales growth is
not benefiting the shareholders to the degree we would like and
therefore the company only scores 1.
5. Average Annual PE Ratios
The PE ration is simply the Price divided by the companies Earnings
per Share.
The Price fluctuates on a minute by minute, hour by hour and daily
basis and is constantly changing however the Earnings per Share
figure is reported Quarterly and only changes 4 times per annum.
What we do in this section is add up the average annual PE ratios for
the past 5 years and divide by 5 to get an average five-year PE ratio.
Then we look at the current PE ratio relative to the average PE ratio for
the past 5 years.
If the current PE ratio is at or below its 5-year average PE ratio then it
receives a maximum score of 4
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If the current PE ratio is above the 5-year average annual PE ratio
then it receives a score of 2.5
If the current PE ration is twice the 5-year average annual PE ratio
then it receives the minimum score of 1.
If a stock is currently very popular than it will be trading well above its
5-year average annual PE ratio.
When the stock trading well above its 5-year average PE then it
indicates that shareholders are willing to pay more to own the
company.
Ideally we wait and invest in companies that are trading well below the
5-year average annual PE ratios.
6. High / Medium / Low Price Ranges
In this section we add up the 52-week high share price for the last 5
years and divide by 5 to get the average high share price for the past 5
years.
Then we add up the 52 week low share price for the last 5 years and
divide by 5 to get the average low share price for the past 5 years.
Then we add up the annual EPS figure for the past 5 years and divide
by 5 to get an average annual EPS figure for the past 5 years.
We then take note of the EPS for last year and the projected EPS for
the coming 5 years again based on a 8 year track record of matching
earnings expectations over a total of 32 quarterly earnings reporting.
Using all the above figures we are now able to project forward in time
over the next five years to calculate a ‘worst case scenerio’ and ‘best
case scenerio’ for the stock share price to come up with an Estimated
High Share Price and an Estimated Low Share Price.
By taking the difference between the ‘best case scerio’ share price and
the ‘worst case scenrio’ share price and dividing by 3 we can calculate
the size of the slice that will decide if the current share price is in a
HIGH range, MEDIUM range or LOW range for the next 5 years.
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7.Reward to Risk Ratio
Lastly we look at the current share price to see where it is relative to
the High Share Price or Low Share Price.
By subtracting the difference between the current price and the High
and Low Share Price we can calculate the Reward to Risk ratio of
buying that particular stock at the current share price that it is at.
We look for a Reward to Risk of greater than 3:1 to receive a
maximum score of 4 or less than 3:1 to receive the minimum score of
1.
Finally we add all the scores together with a weighted ranking system
that multiplies the scores by the following weight:
Current Stock Price
Dividends versus Earnings = 1
Estimated Price Appreciation = 3
Sales versus Earnings = 3
Average Annual PE Ratios = 3
High / Medium / Low Price Ranges
Reward to Risk Ratios = 3
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TICN Ltd Price Mind Map © 2004
7. Reward to Risk
Ratio Rank (1 to
4)*** (3>1)
1.Price used to
Calculate Score
High
Med
Low
6. High/Med./Low
Price Entry Ranges
TICN
Right Time to Buy
out of
Scored
a possible 52
2.Dividends Rank
(Rank 1 to 4)*
5. Price/ EPS Ratio
Rank (1 to 4)***
3. Estimated Price
Appreciation Rank
(1 to 4)***
4. Sales versus Earnings
Rank (1 to 4)***
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We only consider investing in companies that score greater than 40
out of a possible maximum of 52 for both Quality and Price as
explained in this chapter and the last chapter.
These companies are affectionatley known in TICN as 4 x 4
companies meaning greater than 40 out of 52 = 4 for both Quality and
Price.
Our criterion for selecting companies is so tight that at times when the
overall stock market is overpriced and over valued then the number of
4 x 4 companies are very few and far between.
The Quality and Price Fundamental Analysis is only step 1 of a 3 step
process that we use and so in the next chapter we will discuss step 2
of our process which uses Technical Analysis to further identify and
refine the entry points into companies which helps in the decision on
when to invest in a company.
Next chapter we will outline the second part of our system which is the
Technical Analysis using charts and graphs of the companies where
we explain how to identify levels of price support and resistance.
*Valueline were founded in 1931 with the express purpose of
supplying independent unbiased reports on companies to protect
investors from the dangers of favorable reporting.
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Chapter Nine
Profits in graphs and charts
Whether it is equities, currencies, property prices or commodities there
is great merit in studying a price graph over time. Prices tend to follow
patterns over time and fluctuate between points of price support and
resistance. By using these points of support and resistance one can
draw trend lines to accurately predict the most probable pivot points or
turning points on a graph.
Attempting to trade the stock market without looking at charts is similar
to driving with a blindfold on … you are not going to get to far and are
pretty certain to crash.
Once you have become comfortable with reading graphs and
identifying support and resistance and trend lines which join points of
support and resistance to form straight lines the next tool you can use
are technical indicators.
Technical indicators allow you to predict what the stock price is likely to
do in the future and are just indicators with no guarantees. How many
times have you witnessed a person driving in front of you indicating to
turn left and then they turn right!
Well technical indicators have the exact same potential to let you down
and the stock can do the opposite to what you were expecting from the
indicators.
The most common used technical indicators are:
Moving Averages
Balance of Power
Money Stream
Stochastic
MACD
RSI
Bollinger Bands
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Chart 1. Top: (Red 10 dma vs. yellow 20 dma) Middle: (BOP) Bottom:
(CMS)
1. Moving Averages as in (Top of Chart 1)
A price Moving Average or MA is calculated by adding up the average
daily prices and dividing by the number of days to work out the Daily
Moving Average or (dma).
For example if the average price of a stock was $10 yesterday and $12
today then the two-day moving average or 2dma would equal ($10 +
$12) divided by 2, which is $11.
The most commonly used moving averages are 20, 50,100 and 200
dma to predict significant pivot points or turning points on the price
chart of a stock.
It is more common to compare one moving average line on a chart to
another to identify significant turning points when one moving average
line crosses over another it confirms a movement of the share price in
one direction or the other.
In TICN we use 10 dma (red) crossing the 20 dma (yellow) as
confirmation of signals of a future price movement.
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2. Balance of Power as in (Middle of Chart 1)
This is an indicator that actually tracks the activity of significantly
abnormally large orders and separates them from the normally smaller
orders in the stock market.
It is plotted in either a histograph bar chart or colour coded price line
chart as follows:
.
Green indicates Major Institutional Buying Activity
Yellow indicates Neutral or insignificant Institutional Activity
Red indicates Major Institutional Selling Activity
There are times for companies that trade low daily volumes of less
than 500,000 shares traded per day that institutional activity can cause
the share price to move up in response to institutional buying or move
down in response to institutional selling. The way in which different
companies share price react to institutional activity can be varied so it
is important to not to make decisions to buy or sell based on Balance
of Power on its own.
3. Money Stream or (Money Flow) as in (Bottom of Chart 1)
Money Stream or Money Flow is a measure of the amount of money
flowing into our out of a company and can be reported in a line graph
or in volume bar chart.
Cumulative Money Stream (CMS) plotted as a line graph moves up
and down relative to the amount of institutional money being invested
in a particular company and on is not note worthy. However if you plot
CMS against its own 15-day moving average you can recognize
significant movements of money in and out of a stock.
When the Cumulative Money Stream line crosses its own 15dma line
and both are pointing upwards this is a strong bullish signal for the
stock and is useful to anticipate a move to the upside for a stock, as it
is the action of buying that creates share prices to move upwards.
When the Cumulative Money Stream line crosses its own 15dma line
and both are pointing downwards this is a strong bearish signal for the
stock and is useful to anticipate a move to the downside for a stock, as
it is the action of selling that creates share prices to move downwards.
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Chart 2. Top (Bollinger bands) Middle: (14 / 35 day Stoics) Bottom:
(MACD &RSI)
4.Stochastic as in (Middle of Chart 2)
In its simplified form stochastic is a measure of when a share is either
over sold and has a potential to rise in price or is over bought and has
potential to fall in price. It is simply a mathematical measure of daily
share price activity looking at the difference between the open, low,
high and closing prices of a share.
There are typically two lines plotted on a Stochastic graph which looks
at the standard deviation from the normal price activity.
The scale of the stochastic graph ranges form 0 – 100 and when the
line plotted is greater than 80 the share is said to be short term at an
unsustainable high point and hence over bought with the potential (but
not guaranteed) to fall in price.
When the line plotted is less than 20 the share is said to be short term
at an unsustainable low point and hence over sold with the potential
(but not guaranteed) to rise in price
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This indicator can be an early indicator of price movement and
requires confirmation as it can on its own lead to less than efficient
entry points into a stock.
The settings that the folks in TICN use to measure stochastic are over
both a 14 day and 35 day window of time and the best entry or exit and
entry has proved to be when both the 35 day and 14 day stochastic
lines are giving the same indication of either being overbought or over
sold.
5. Moving Average Convergence Divergence (MACD) as in
(Bottom of Chart 2)
This indicator is either plotted as two lines on a graph or as a
histogram. The graph has a neutral or zero line which be called the
zero line and there are times that it is below the line and negative and
above the line and positive.
When the share price and the peaks on the MACD lines are rising
together they are said to be in agreement with each other and no
significant signal is evident.
If the share price is rising and yet the MACD peaks are falling then
they are giving different signals and a Divergence is occurring which is
hinting at an underlying weakness in the share price, which could
signal a drop in the share price.
If the share price is falling and yet the MACD peaks are rising then
they are giving different signals and a Convergence is occurring which
is hinting at an underlying strength in the share price, which could
signal a rise in the share price.
6. RSI as in (Bottom of Chart 2)
In its simplified form RSI or Relative Strength Indicator is a measure of
the price at a point in time relative the previous price performance and
again it measures when a share is either over sold and has a potential
to rise in price or is over bought and has potential to fall in price.
There is one line plotted on a RSI graph, which compares the relative
strength of the price relative to previous price action.
The scale of the RSI graph ranges form 0 – 100 and when the line
plotted is greater than 70 the share is said to be short term at an
unsustainable high point and hence over bought with the potential (but
not guaranteed) to fall in price.
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When the line plotted is less than 30 the share is said to be short term
at an unsustainable low point and hence over sold with the potential
(but not guaranteed) to rise in price
This indicator can be an early indicator of price movement and
requires confirmation as it can on its own lead to less than efficient
entry points into a stock.
The settings that the folks in TICN use to measure stochastic are over
both a 14 day and 35 day window of time and the best entry or exit and
entry has proved to be when both the 35 day and 14 day stochastic
lines are giving the same indication of either being overbought or over
sold.
7. Bollinger Bands as in (Top of Chart 2)
Even though Bollinger Bands can help generate buy and sell signals,
they are not designed to determine the future direction of a security.
The bands were designed to augment other analysis techniques and
indicators. By themselves, Bollinger Bands serve two primary
functions:
To identify periods of high and low volatility
To identify periods when prices are at extreme, and possibly
unsustainable, levels.
Share prices can fluctuate between periods of high volatility and low
volatility. Being able to identify a period of low volatility can serve as an
alert to monitor the price action of a share. Other aspects of technical
analysis, such as momentum, moving averages and retracements, can
then be employed to help determine the direction of the potential
breakout.
Remember that buy and sell signals are not given when prices reach
the upper or lower bands. Such levels merely indicate that prices are
high or low on a relative basis. A security can become overbought or
oversold for an extended period of time. Knowing whether or not prices
are high or low on a relative basis can enhance our interpretation of
other indicators and assist with timing issues in trading.
In the next chapter we will discuss how we in TICN combine our use of
Fundamental Analysis as explained in earlier chapters, with Technical
Analysis in this chapter, to apply powerful income producing strategies
that allow you to make money regardless of the direction of your share.
Indicators allow you to predict what the stock price is likely to do in the
future and are just indicators with no guarantees. How many times
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have you witnessed a person driving in front of you indicating to turn
left and then they turn right!
Well technical indicators have the exact same potential to let you down
and the stock can do the opposite to what you were expecting from the
indicators.
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Chapter Ten
A gentle introduction to equity options.
What is an Option?
An option is a contract to buy or sell shares in a company in the future.
The option contract is very specific in that it details:
A specific price that share will be bought or sold at known as the Strike
Price
A specific time by which the option may or may not be exercised
known as the days to option expiration.
A specific date which an option contract expires worthless the
expiration date.
There are two types of options
Call options.
Put options.
1. Call Options
If you buy a call option you have the right but not the obligation to buy
a share of a specific company at a certain price known as the strike
price for a certain time known as the days to expiration between the
time of call option purchase and the expiration date.
If you sell a call option you have the obligation to sell a share of a
specific company at a certain price known as the strike price for a
certain time known as the days to expiration between the time of call
option purchase and the expiration date.
2. Put Options
If you buy a put option you have the right but not the obligation to sell a
share of a specific company at a certain price known as the strike price
for a certain time known as the days to expiration between the time of
call option purchase and the expiration date.
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If you sell a put option you have the obligation to buy a share of a
specific company at a certain price known as the strike price for a
certain time known as the days to expiration between the time of call
option purchase and the expiration date.
Option assignment occurs only to those that sell either a call or a put
option. It means that the seller of the option must now fulfil his or her
obligation to either have a share called away from or a share put to the
seller known as the writer of that option contract.
The person that owns the call or put option is known as the holder of
that option contract.
The buyer or holder of an option contract has the three choices
between the time of purchase and the expiration date:
Exercise the option contract on or before the expiration date.
Sell the option contract onto another buyer
Simply allow the option contract to expire worthless.
The seller or writer of an option contract has no control whether or not
the contract is exercised on or before the expiration date and has two
choices.
Buy back the option contract to avoid an option assignment
Simply allow the option contract to expire worthless.
How are options priced?
When an option contract is traded it has a price, which is known as the
premium.
The buyer of an option contract pays a premium for that option and so
takes a financial position in the market called a net debit position. The
only way to profit from this position is to either sell the option contract
at a profit or exercise the option contract and then trade the newly
assigned equity position for a profit.
The seller of an option contract receives a premium for that option and
so takes a financial position in the market called a net credit position. If
the option is never exercised the option is not exercised then the seller
keeps the premium and no further action is required.
If the option is exercised then assignment occurs and the seller of that
option contract is obligated to sell (in the case of a call option) or buy
(in the case of a put option) the underlying equity.
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How are options valued?
The way in which an option contract is valued to a buyer or seller is a
measure of whether the underlying equity is likely to meet the
expectations of the buyer or seller. Option contract prices vary
considerably over the time duration to expiration and are dependant on
how close or far away the market price is from the agreed strike price.
The following terms are used to describe the call option contract when
comparing market price to strike prices:
In The Money (ITM): This is where the call option strike price is below
the market price.
At The Money (ATM): This is where the call option strike price is at the
market price.
Out of the Money (OTM): This where the call option strike price is
above market price.
The following terms are used to describe the put option contract when
comparing market price to strike prices:
In The Money (ITM): This is where the put option strike price is above
the market price.
At The Money (ATM): This is where the put option strike price is at the
market price.
Out of the Money (OTM): This where the put option strike price is
below market price.
An option contract price known as the premium has two parts:
Intrinsic Value (Real Value): The amount by which an option is in the
money
Time Value: The difference between the overall premium and the real
value of the option.(The more days to expiration the greater the time
value of an option)
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For example if:
Share market price of $15 minus option strike price of $10 = Option
Real Value of $5
If Total Option Premium is $6 minus the option real value of $5 = TIME
VALUE of $1
Market Share Price = $15
Option Strike Price = $10
Total Option Premium of $6
Real Value is then
Share price of $15
- Strike price of $10
= Real value of $5
Time Value is then
Option Premium of $6
– Real value of
$5 = Time Value of
CUBE'
$1
“ICE CUBE”
The Time Value of an Option can be described as an ‘ICE CUBE’ that
‘melts’ the closer that it gets to the ‘fire’ of the expiration date. The
closer that an option contract gets to the expiration date the more time
value decay will occur with an acceleration of time decay occurring in
the last week of the expiration period. Once an option moves passed
the expiration date it effectively expires worthless, as it can no longer
be traded. US Style options typically expire at 4pm EST on the third
Friday of every month.
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Option Prices are affected by many factors such as:
Supply and demand for the option.
Price behaviour of the underlying share.
Volatility of the underlying share.
Days to expiration for the option.
Overall Market Sentiment
How option trading works
Option trading has many advantages for the investor and
would-be day trader - limited risk and limited exposure if
your options are covered; improved leverage that can give
you far better returns than stock or mutual fund investments
and the ability to profit in bull and bear markets alike
As explained in the last chapter, an option is the right to sell
or buy property, usually equity, at a predetermined price on or
before, a predetermined date. To acquire this right, the taker (buyer)
pays a premium to the writer (seller) of the contract, however while
the contract gives the right to buy or sell the property, there is no
obligation to buy or sell the property.
There are two types of options available: call options, which give the
taker the right to buy underlying shares, and put options, which give
the taker the right to sell the underlying shares. In both cases, the
purchase or the sale may take place before the predetermined date
and there is no obligation to buy or sell the shares unless the option
is exercised.
The largest market for the options is the Chicago Board of Options
Exchange (CBOE) where most of the trading used to be carried out
via open outcry on the floor of the exchange. Today, however, most
CBOE trading is now done online using computers. The advent of
the Internet has opened up the US options market and anybody can
trade US options online from a computer from any location in the
world.
In addition to the CBOE, there are five other US Exchanges where
options are bought and sold: the American Stock Exchange (AMIiX);
the International Securities Exchange (ISE); the Pacific Exchange
(PACX); the Philadelphia Stock Exchange (PHLX) and the Boston
Stock Exchange (BOSX)
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Call Buying
There are two reasons why you may purchase a call option.
The first is that you simply want to buy the right, but not the
obligation to buy the shares at a fixed price (the strike price) and by a
fixed time (expiration date)
For example, say this is January and you want to buy 1,000 shares of
company ABC for a strike price of $10 in 12 months time, because you
do not have funds now to complete the purchase but plan to have
the funds available in December.
You would buy 10 contracts (100 shares = 1 contract) of the
December $10 call option for say $2, which would then expire on the
third Friday of December at 4pm EST (New York Time).
If the share price is trading at $20 on the third Friday of December
you could exercise your right to buy the shares at $10 and either hold
onto the shares or sell the shares back to the market for $20 and
make $8 per share profit.
If you don't exercise your option on or before the third Friday of
December then you lose the opportunity to profit and consequently
lose your $2 investment.
Also, if the share price happens to be trading lower than $12 on the
third Friday it may not be worth your while to exercise your option
therefore you cut your losses and decide to lose the price of your
option.
The second reason for buying a call option is that you want to
profit from a rise in the share value without buying the share
because as the share price increases so does the option price
increase.
In the ABC example above, where the share price moves from
$10 to $20 in 12 months instead of exercising your right to the
buy the share for $10 and selling the share for $20, you can
simply sell the call option you bought for $2 for $10 and gain a
profit of $8.
If the share price moves from $10 to $20 then the option price will
move from $2 to $10 and can be sold for a $8 profit on or before
the third Friday of December.
If you forget to sell your call option for $10 on or before the third
Friday, you will lose your opportunity to profit from the increase
of the option price.
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If the share price moves from $10 down to say $8 then the option
you bought for $2 will be worth $0 and you will lose your $2
investment.
You can use the delta of an option to predict the increase of option
price in relation to the increase in share price rise — for example, if
the share price is $10 and the option price is $1 and has a delta of
50 this means that as the share price increases $1 from $10 to $11
then the option price will increase by $0.50 from $1 to $1.50.
Covered Call Selling
The term 'covered' refers to the fact that you own the shares of the
stock and are therefore covered and you can succeed with this
strategy in bullish, bearish or neutral markets by moving with the
market trends for your share using the technical analysis skills that
we discussed in an earlier chapter.
The strategy involves a two-step process - first buy the shares
and then sell the covered call option.
For example, say this is January and you predict that share price
trend sideways at $10 between now and the third Friday of
February. First you could buy 1,000 shares of company ABC for
$10 and then you could sell the right for 1,000 shares of the
company to be called away from you for a strike price of $10 any
time between now and the third Friday of February.
You would sell 10 contracts (100 shares = 1 contract) of the
February $10 call option for say $0.50, which would then expire on
the third Friday of February at 4pm EST (New York Time).
If the share price is trading at $9.50 on the third Friday of
February then the call option will not be exercised and you get to
keep your option premium of $0.50 per share, giving you a return
of $500 while keeping your shares.
Effectively, you have discounted the purchase of your shares to
$9.50
If the share price continued to trade sideways for the next 20
months and you continued to sell the $10 option every month for
20 months for $0.50, you would eventually fully recoup the cost of
your share by collecting $10 option premiums on a $10 share.
This could be termed your breakeven point in that you invested
$10 on the New York Stock Exchange (NYSE) while collected
$10 from the CBOE and still owning a $10 asset.
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If the share price is $10.50 on the third Friday of February, you
can still buy back the call you sold for $0.50 and get out of the
position on a breakeven position (remember to factor in the trading
commissions and price difference between the bid and ask of the
option price in your calculations) or you can allow the shares to be
sold and enjoy a five percent return on capital employed for the
month while having also cashed out your position.
If you anticipate that the share will rise to, say, $12.50 on the third
Friday, you can sell the $12.50 option strike and if you are called
out you will make a profit of $2.50 per share, plus your option
premium on a $10 investment, which is at least 25%.
If you believe the share will fall to $7.50, you could sell a $7.50
call option for at least $2.50 when the share price is $10 and hence
use the cover call strategy to hedge against a anticipated fall in the
value of the shares.
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Chapter Eleven
Investing In Stocks
Six Common Strategies For Picking Stocks
From throwing darts to crunching numbers, there are more methods of
picking stocks and investment strategies than we can explain here,
some of which have more success than others. In this chapter we will
dive into stock investing and explain some of the most popular
strategies used for picking stocks.
So you have decided to invest for the long term. It doesn't matter
whether you are investing for the first time or a seasoned professional
you will have to make a decision as to which investment style fits you,
your personality and your goals. Every successful investor at one time
or another has sat down and mapped out a game plan. There is no
single style that works for every investor; sometimes a combination of
different styles can produce the required results. This tutorial will
introduce you to several different Six Common Strategies For Picking
Stocks. Let's take a closer look at the different styles now.
Below is a list of the Six Common Strategies For Picking Stocks that
we cover in this chapter.
•
•
•
•
•
•
Value Investing
Growth Investing
Momentum Investing
CANSLIM Investing
Income Investing
GARP Investing
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Value Investing
The idea of value investing and looking for a bargain is one of the
oldest ways to pick stocks. Benjamin Graham and David Dodd, finance
professors at Columbia University, laid out the framework for value
investing way back in the 1930s. The concept is similar to shopping;
you look for the product that is reasonably priced without sacrificing
quality. This strategy tends to come into favour when there is
uncertainty on the horizon.
Background
A value company is one that is relatively cheap compared to its
earnings and book value. In most cases value stocks tend to
outperform other stocks during bear markets and because of this
quality they are often considered a defensive investment. In contrast, a
growth company is relatively expensive compared to its current
earnings or assets. Value stocks tend to have a P/E ratio and book
value (or tangible assets) much closer to the stock price. Furthermore,
value investing is founded on the concept of investing in companies
that have a solid history of earnings and sales. There should be little
uncertainty about a value company's operations or future performance.
Value investors pay very close attention to the price-to-earnings ratio
(P/E ratio), which is indicative of an "inexpensive" company. They also
conduct fundamental analysis using various other ratios to decide on
stocks they like, and then wait for those stocks to trade at bargain
prices before placing and order to buy.
The PEG Ratio is another common method used by value investors to
identify oversold stocks. Taking a stock’s P/E ratio and dividing it by
the stock’s projected year-over-year earnings growth rate calculate the
PEG Ratio. In other words, the ratio measures how undervalued the
stock while taking into account its earnings growth. If the company's
PEG ratio is less than one then it is considered by many to be
undervalued.
The results of value investing have been proven by one of the greatest
investors of all time, Warren Buffett. His value investing strategy has
taken the stock of his company Berkshire Hathaway from $12 a share
in 1967 to $60,900 in 2001, that's right, over $60,000 per share.
When to Buy
Value investors are always looking to capitalize on bad news and
stocks that are shunned by other investors. By examining the
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fundamentals of a company value investors decide if the tumble in
stock price was "over done". If the company meets their criteria, the
value investor will strike.
Value, Not Cheap!
The prospects of value investing may sound intriguing, but simply
buying a stock that is cheap is not the right approach. There is a
significant difference between an undervalued company and a cheap
company. Cheap companies have seen a tumble in their stock price
because there something is fundamentally wrong. Furthermore, all the
analysis in the World might not detect the fundamental problem with
the company. This is a risk that all value investors take when investing
in beaten down companies.
A perfect example of this risk is the recent tumble in Lucent's stock
price. Back in January, 2000 Lucent warned of earnings shortfall and
the stock plummeted from $70 to $50. Had you bought then, you
wouldn't have seen much upside. The stock subsequently had serveral
more earnings warnings throughout the year and is trading at the time
of writing at a pitiful $7 per share. Many value investors lost a lot of
money on Lucent because they purchased the stock each time the
price plummeted.
Things to remember about Value Investing.
•
Value is Relative, manias exist from time to time, whether
Tulips, Gold, or Internet stocks. You usually only get a bargain
when something is out of favour.
•
Enormously undervalued stocks are usually cheap for a
reason. Be wary!
•
Avoid investing in a stock that has significant uncertainty, it
could go from a value stock to a Chapter 11 (bankruptcy) stock
faster than you think.
•
Value stocks may take some time to prove their worth,
sometimes 10, to 15 years or longer! You must be patient
when value investing.
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Growth Investing
Chances are that you've heard about this strategy before. Like many of
the core strategies in use today growth investing was pioneered a long
time ago. With growth investing, investors enjoyed previously unheard
of returns in the late 1990's. But, before you jump on the bandwagon
realize this strategy isn't for everyone as there are additional risks.
Background
Growth investing is based on the concept of buying stock in companies
that tend to grow substantially faster than others. In most cases this
involves buying young companies with high potential. The idea is that
growth in earnings and/or revenues will directly correlate into growth of
the stock price. In the 90's most technology companies took on the title
of growth stocks. Because this strategy has proven viable over a long
period of time, growth investing has many followers.
What factors are involved? For the most part growth investing involves
looking at a company's earnings. Earnings per share (EPS), tells
investors how much profit is being made for each share in the
company. There are many examples of companies with astounding
growth in sales but a widening loss in earnings. For investors who
follow growth investing, a stock that has a revenue growth of 40%
annually is very good as long as the earnings have increase from year
to year. If the company's EPS has declined, then the basic principles of
growth investing have been broken.
Earnings Per Share
As mentioned above, the EPS of a firm is the main determinant of a
company's growth. But EPS growth can sometimes be tricky to
determine, and figuring out whether the growth is average or above
average can also be difficult.
Profit growth of 40% is great, but if the outstanding shares of the
company doubles because of secondary issues then EPS growth is
only 20%.
What do we compare the growth number against? 20% may seem like
a pretty decent rate, especially since the firms in the S&P 500 Index
have an average EPS growth of around 13%. Looking at the main
averages can be misleading though. It is important that investors look
at the industry that the company is in. The 20% growth rate is a
negative if the industry is growing at 30%. Another example is the oil
and gas industry whose growth is heavily dependent on the price of oil.
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In the year 2000 the price of oil has nearly tripled and as a result
energy companies are expected to show earnings growth of 250% this
year. (Many traditional industries have a steady growth of 10-12%).
Therefore, the stock with EPS growth of 20% in a traditional industry is
great, but terrible in the oil and gas industry.
It is important to remember that inevitably some of today's leading
growth companies will be tomorrow's laggards. Some of these
laggards will renew themselves and return to the fast growth, but
others will fade and become average performers. On the other hand,
there are a few companies that have been remarkably successful in
maintaining their earnings momentum year in and year out.
Things to remember about Growth Investing
•
Growth stocks are risky, and fluctuations in the stock price will
probably be more volatile than the market as a whole. Which
means the stock will have a higher beta than the market.
•
Most growth stocks have higher than average P/E ratios
because the investors as a whole have higher expectations for
the stock.
•
Fast-growing companies need their capital to finance their
expansion. Most reinvest a high portion or all of their earnings
in their own businesses therefore don't expect any dividends.
•
Growth stocks have often performed best relative to the overall
market when the economy is slowing or downright sluggish. At
such times, consistent earnings growth shines more brightly.
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Momentum Investing
Momentum investing is a relatively new strategy that has taken the
markets by storm. Momentum investors are known for moving fast and
having little patience for under-performing stocks.
Background
Momentum investors buy stocks with accelerating numbers such as a
surging share price, rising earnings or bulging revenues. At the first
sign of a dip they usually sell. The objective of a momentum investor is
to buy a stock after its rise has just begun and sell it as soon as it
begins to falter. Most are indifferent to positions and will go long or
short on a stock as long as they see significant momentum.
Cockroach Theory
The basis of the momentum strategy centres on the cockroach theory,
which states "bad (and good) news tends to be released in bunches".
Just as cockroaches tend to travel in large groups momentum
investors buy hot stocks on the way up and bail out on the first hint of
bad news, believing that one item of bad corporate news is rarely an
isolated event. A perfect example is Lucent (LU), which gave earnings
warnings back in January 2000 and has subsequently warned several
times since then. This has resulted in a decline from $70 down to $7
per share at the time of writing.
Earnings Growth
Similar to growth investing, a momentum investor wants to find
companies that are improving at a faster rate than the market.
Momentum investors also seek out average companies that are
becoming good or good companies that are becoming great. It is in
this transition that the momentum investor makes his or her money.
This "improvement" can be anything from an earnings surprise to a
drastic change in business strategy or scope.
There are four major factors that can be used to detect a company with
momentum:
1. Earnings Growth - when a company's earnings are
accelerating fast than they have previously grown.
2. Upside Earnings Surprises - when a company delivers better
earnings performance than analysts had predicted.
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3. Analyst Upgrades - when an analyst or brokerage revises the
earnings forecasts for a company to be higher.
4. Overall Strength - when a company's stock price is increasing
faster than the overall stock market.
Risks
Like all strategies that try to make big money in a small time frame,
there are additional risks. The danger of momentum investing is
that you believe in and are betting on "The Greater Fool Theory",
which basically means you are going along for the ride with these
fools hoping that someone will be a greater fool than you allowing
you to get out before them with a profit. The momentum strategy
sows the seeds of its own collapse. You buy in because of
attractive prospects for the company and move the price higher
until finally the stock price becomes so horribly overpriced that it
collapses. Sounds quite similar to the "Dot-com crash" of 2000.
Things to remember about Momentum Trading
•
This strategy is short-term and can be very risky. It is best
suited for investors with ample experience and strong risk
control discipline.
•
A momentum investor's "sell discipline" should be as strong if
not stronger than his or her "buy discipline" because a missed
trade is less painful than entering the wrong trade and not
getting out in time.
•
Successful momentum investors trade without getting
emotionally attached to a stock or company. They are
indifferent to the stock and don't fall in love with it.
•
Risk control is top priority. Momentum investing can include
buying stocks that are being driven up on speculative hype.
•
A momentum investor must know exactly how capital is at risk
and take appropriate action to control losses.
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CANSLIM Investing
CANSLIM is a philosophy of screening, purchasing, and selling
common stock as described and developed by William O'Neil (The cofounder of Investors Business Daily) in his book "How To Make Money
In Stocks".
The name may sound like some boring government agency, but this 7
letter acronym is one of the most successful investment strategies
around. What makes it different is its consideration for tangibles like
earnings, as well as intangibles like overall strength and ideas in the
company. The best part about this strategy is that it is proven, there
are countless examples over the past couple decades of companies
that have shown CANSLIM potential and gone on to increase
enormously.
Background
In a nutshell, here is a summary of seven characteristics for CANSLIM:
C = Current quarterly earnings per share. Earnings must be up at least
18-20%.
A = Annual earnings per share. They should show meaningful growth
for the last five years.
N = New Things. Buy companies with new products, new
management, or significant new changes in industry conditions. Most
important, buy stocks as they initially make new highs in price. Forget
cheap stocks, they are that way for a good reason.
S = Shares outstanding. This should be small and reasonable number.
You are not looking for an older company with a large capitalization.
L = Leaders. Buy market leaders avoid laggards.
I = Institutional sponsorship. Buy stocks, with at least a few institutional
sponsors with better than average recent performance records.
M = The general market. The market will determine whether you win or
lose, so learn to interpret the daily general market indices (price and
volume changes) and action of the individual market leaders to
determine the overall market's current direction.
Each of these characteristics are basic fundamentals of successful
stocks. History has shown that a large majority of winning companies
have these characteristics. Remember, it is important that all of these
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fundamentals are met before investing.
CANSLIM does not support investments in high-risk companies. Best
of all it takes virtually all major investment strategies into consideration.
Think of it as a conglomeration of value, growth, fundamental, and
even a little technical analysis.
Things to remember about CANSLIM Investing
•
This strategy is a mishmash of many different types of
investing.
•
All criteria for CANSLIM must be met for it to warrant your
investment.
•
The astounding success of CANSLIM has been proven back
as far as 50 years.
•
Like every stock picking strategy, CANSLIM is not perfect, so
always have an exit strategy on hand for each position.
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Income Investing
Income investing is perhaps one of the most straightforward stock
picking strategies. The goal is to pick investments, which can provide a
steady stream of income every month, quarter or year. This typically
involves buying bond, preferred shares, or common shares that pay
regular (and substantial) dividends. As a result, we end up looking at
older, more established firms, which have a very predictable earnings
stream.
Dividend Yield
Simply investing in companies with the highest dividends is not the
premise of this strategy. More important is the dividend yield, which is
calculated by dividing the annual dividends of common stock by the
current market value of common stock per share. For example, if the
company share price is $100 and a dividend of $6 per share is paid,
the result is a 6% dividend yield. The average dividend yield for
companies in the S&P 500 Index is 2-3%.
Income investors demand a much higher yield than 2-3%. At minimum
most are looking for a 5-6% yield. On a $1 million investment this
would produce $50,000-$60,000 in income (before taxes). And forget
those tech stocks, virtually none of them pay dividends.
Dividends are Not Everything
Never invest solely on the basis of dividends. Keep in mind that high
dividends don't necessarily mean a good company. Dividends are paid
out of a company's net income, the higher the dividends, the lower
retained earnings are for the company. Problems arise when a
company is paying out large amounts of their income to shareholders
when that income would have been better spent investing within the
company.
Other Options
Investing in dividend paying stocks is not the only way to become an
income investor. For example, many "A rated" corporate bonds are
currently averaging 6-8% coupon yields. Furthermore, many municipal
bonds offer 3-5% tax free returns.
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Risks
Like every stock picking strategy we have discussed, income investing
has risks too. When you buy common stock, there's a chance that the
value of your original investment could drop.
Dividend distribution and the levels of those payouts are not
guaranteed with stocks as they are with bonds. Should the firm run into
financial hardship, or if there is a great investment opportunity, which
requires significant cash outlay, you could end up without a dividend.
One last thing, income from dividends is taxed at the same rate as
ordinary income for the year, not as capital gains.
Things to remember about Income Investing
•
Income investors can use a combination of common and
preferred stocks as well as bonds.
•
It is important to look at the company's fundamentals, don't
just look at dividend yields.
•
"Income" from dividends and bonds are taxed as ordinary
income, not capital gains from price appreciation.
•
Like every stock picking strategy, income investing is not
perfect, so always have an exit strategy on hand for each
position.
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GARP Investing
GARP investing combines the two successful strategies of value and
growth investing. The name really says it all; GARP (Growth At
Reasonable Prices) investors look for a stock with growth potential, but
only if it is reasonably priced. More recently the GARP name has been
associated with another great acronym, SWAN (Sleep Well at Night).
Background
As we've mentioned, value investors search high and low for relatively
cheap stocks compared to their earnings and book value. Growth
investors are on the opposite side of the spectrum, buying stock in
companies that tend to growth substantially faster than others or firms
with high potential in hopes that earnings will come in the future.
GARP investors are somewhere in between these two, they aren't
looking for the companies in trouble or drastically undervalued, but
they also avoid the highflying growth stocks.
How to Use GARP
Practitioners of GARP are somewhat traditional. They use various
fundamental analysis ratios to search for companies with solid growth
prospects and share prices that are somewhat lower than the intrinsic
value of the business. GARP investors stop short of looking at the
companies business in great detail, they are more concerned with
historical growth and the stock price and not the qualitative factors.
Traditionally, GARP investors have sought growth in two ways, from
the firm itself, or earnings growth. An undervalued stock price is
usually detected from the low price-earnings ratio relative to its
industry. More recently, GARP investors have discovered the PEG
ratio, which has become a pillar in the strategy by only investing in
stocks with a PEG ratio less then one.
One common pitfall for GARPers is mistakenly investing in high growth
companies with high P/E's. In most cases their P/E indicates a higher
growth rate than earnings are currently showing. This means that it is
inevitable the stock price will eventually come down or remain the
same to wait for the P/E ratio to "catch up". On the other hand,
investing in a drastically undervalued stock means if the earnings
growth or turnaround does not come to be, the GARP investor's
perceived bargain will disappear.
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Who Uses GARP?
One of the biggest supporters of GARP is Peter Lynch, someone who
many of you may be familiar with. He has written several books on
sensible investing and more recently has starred in Fidelity Investment
commercials. His success in the stock market has associated him with
high profile investors like Warren Buffet. Many consider him the "The
World's Best Money Manager".
Risks
This might sound like the perfect strategy, but being the "jack" of both
growth and value investing isn't as easy as it sounds. If you don't
master both of the two strategies you could potentially find yourself
buying mediocre stocks rather than good GARPs. Furthermore, GARP
investing can depend a lot on the current market conditions. For
example, in the late 1990's people were so captivated with high tech
and Internet stocks that value and even some traditional stocks had a
tough time increasing their stock price even though fundamentally
there was nothing wrong with their company.
Things to remember about GARP Investing
•
This strategy is a combination of growth and value investing
principles.
•
Avoid buying stocks at either end of the spectrum, that is avoid
high flying stocks and those deeply undervalued.
•
The PEG ratio is one of the major tools used by GARP
investors; it should be less than one.
Different individuals will have different goals and tolerances for risk.
Your goals and tolerances are not static; they will change as your life
does. Achieving right medium between risk and return will ensure that
you achieve your financial goals while allowing you to sleep at night.
To Remember about Value Investing Things To Remember about
Value Investing
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Chapter Twelve
Fundamental Analysis
Qualitative Analysis
The success of companies such as General Electric and some of other
blue chips is amazing. Since its inception in 1878, GE has managed to
arguably become the most successful company in history. 1 share of
GE back in 1892 would be worth 4,602 shares today. A major reason
for the astounding success of GE is the story behind the numbers,
sometimes referred to as the qualities of the company called
qualitative analysis.
Management
A strong management is the backbone of any successful company.
You may have heard the old saying, "bet on the jockey not the horse".
This is not to say that employees are not important as well, but it is
management that ultimately makes the strategic decisions. One good
indicator is to see how long the CEO has been serving for the
company. In the case of GE their CEO has been around for years.
Secondly, check to see how the company and stock price has done
over the years that he or she has been leading the company. If the
company has "restructured", then it probably means that you should
take a closer look to see the reasons why.
Industry/Competition
Market share is another important factor to take a look at. For
example, Coke and Pepsi heavily dominate the battle in the soft drink
industry. Anyone trying to enter this market would face heavy
competition from these firms. GE on the other hand is extremely
diversified, owning everything from NBC to their traditional business of
selling light bulbs.
Barriers to enter the market are extremely important. A classic
example is the restaurant industry. Anybody can open up a restaurant.
Compare this to the automobile or pharmaceuticals industries. Both
have massive barriers to entry. This can come in the form of large
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capital expenditures, exclusive distribution channels, government
regulation, patents, etc. The harder it is for competition to enter an
industry the better the advantage to existing firms.
Brand Name
Ask yourself "Does this company have a valuable brand name?" This
is a very important competitive advantage that should be considered.
Coke is one of the most popular brand name in the World, and the
financial value of this is huge. Companies such as Proctor and Gamble
rely on hundreds of popular brand names such as Tide, Pampers, and
Head & Shoulders. Having a long-term portfolio of brands diversifies
risk, since under-performance of one brand can be compensated by
the performance of other brands. As such, the shareholder/stock
market value is less dependent on a single brand.
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Chapter Thirteen
Crunching the Numbers with Quantitative
Analysis
Quantitative Analysis Index
Assessing a company from a quantitative standpoint and determining
whether you should invest in it is as important as looking at the
company's management. Qualitative analysis is one of the easiest
methods for taking a quick look to determine if a company fits your
profile for the long-term. But, for an in-depth look at a firm we need to
consider tangible, measurable (quantitative) factors. This means
crunching and analysing numbers from the financial statements. If
used in conjunction with other methods, this can produce excellent
returns.
Background
Quantitative analysis has been around since the early beginnings of
the stock market. Looking at revenues, earnings, expenses, inventory,
cash flow, among other factors has been one of the traditional
strategies for picking stocks. If these factors looked good, then the
company was said to have "good fundamentals". For the most part,
this approach is alive and well today.
This strategy has not gone without snags though. Remember when the
NASDAQ had those double and triple digit rises in technology stocks,
for those only using "quantitative analysis" missed out on these
tremendous gains, because most of the companies had no
fundamentals, only potential growth prospects.
Historical Data
Common with almost every investment strategy is consideration for
historical performance. This is particularly true for quantitative analysis,
which will often look at data that dates back 5-10 years in order to
detect any trends in the numbers as well as determining if the stock
seems over or under valued compared to its historical performance.
Businesses and the economy tend to grow cyclically. With sufficient
historical data and quantitative analysis, we have the ability to
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capitalize on these changes. For example, if the economy appears to
be entering a recession the quantitative investor will look at how the
company performed the last time we entered a recession and if there
are any similarities in the fundamentals.
Factors to Consider
While there are hundreds of financial valuation ratios used by analysts,
there are a couple factors that they pay particularly close attention to.
The first factor is year-over-year earnings growth; this shows if a
company has been growing at a steady and solid rate for the past few
years. The same is true for sales revenues, which is the backbone to
earnings growth.
The P/E Ratio has historically been used to see if a stock is over or
under valued. But this is quickly being taken over by the PEG ratio,
which incorporates growth as well as the stock price and earnings.
Investors are getting pickier. Many have abandoned the P/E ratio, not
because it is worthless, but because they desire more information
about a stock potential before investing.
With all of these factors, quantitative investors will set limits as to
whether they should buy or sell a stock. For example, they may only
buy stocks with at least 20% annual earnings growth, a P/E under 20,
and a profit margin of at least 30%. Should any of these factors not be
met, then quantitative investors will not buy a stock, and if the
fundamentals are really bad they will even consider shorting the stock.
What do these figures tell us?
Looking at the fundamentals of a company is second nature for many
investors, but for others these numbers are only trivial. Some shortterm momentum investors don't put as much emphasis on quantitative
analysis because these factors are not likely to affect the stock price
over the next few minutes, days or weeks. Long-term investors take
the stance that they are able to detect inefficiencies in a stock over the
long run if the fundamentals don't support a particular price.
For quantitative analysis, setting limits is half the battle. They avoid
getting emotionally attached to a stock and set numerical limits at
which they will buy and sell stocks. The limits are always based on
value and growth principles, and these principles are not just a guide,
but also a strict law to be followed. All of these numbers can be found
in the company's annual report. Now that we know where to find the
numbers, lets take a look at the report more in detail.
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The Annual Report
As you look through a company's financial-statements the masses of
numbers can be bewildering and often intimidating. On the other hand
if you know what to look for, these financial statements can be a gold
mine of information. The Annual Report is a corporation's annual
statement of financial operations, usually a glossy and colourful
publication. Annual reports are required by law and include a balance
sheet, income statement, statement of cash flows, auditor's report,
along with a somewhat detailed description of the company's
operations and prospects for the upcoming year. The 10-K contains all
the much more detailed financial information than many annual
reports.
The information in an annual report is typically presented
in this order:
•
•
•
•
•
•
•
Summary of the previous year
Information about the company in general,
their history, products and line of business
Letter to shareholders from the President or
CEO
An in-depth discussion about the financial
results and other factors within the business
The complete set of financial statements
(balance sheet, income statement, statement
of retained earnings, and cash flow statement)
including the notes
Auditor's report telling you that the results are
accurate
Other information on the company’s management, officers,
offices, new locations, etc
The Balance Sheet
Investors often overlook the balance sheet, in fact "often overlooked" is
probably an understatement. People tend to focus more on earnings,
which are important, but they don't tell the whole story. There is a lot to
be said for this integral part of the financial statements.
First, notice that Assets = Liabilities + Equity, thus the name balance
sheet, these two figures must always equal each other.
All those numbers, now what should you be looking for - what story are
they telling? Well there are a number of things to look at here is the
balance sheets that we will be using for all 19 of our examples.
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Bubba Gump Shrimp Co. Consolidated Balance Sheet
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The Income Statement
The income statement is generally the first financial statement you'll
encounter in an annual report or SEC filing. It also contains the
information you'll most often see mentioned when a company
announces its results for the year (10-K) or a quarter (10-Q). The
income statement is the "sexy" portion of the financial report as it
includes figures such as revenue, earnings, and earnings per share, or
EPS. In essence, an income statement tells you how much money a
company brought in (its revenues), how much it spent (its expenses),
and the difference between the two (its profit) over a specified time.
The exact information presented in an income statement depends
partly on the type of business the company is in, and no company's
income statement will likely contain each and every term or in this
order for that matter.
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Bubba Gump Shrimp Co. Consolidated Income
Statement
(in millions, except per-share amounts)
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The Cash Flow Statement
The cash-flow statement is fairly new to the financial statements that
companies report, in fact it has only been a requirement since 1988.
Cash flow is somewhat similar to the income statement in that it
records a company's performance over a specified period of time,
usually over the quarter or year. But whereas the income statement
takes into account some abstract items (such as depreciation), the
cash-flow statement strips away all these and tells you how much
actual cash the company has generated.
Many of the items on this statement are also found on either the
income statement or the balance sheet, but here they're arranged to
highlight the cash generated and how it relates to reported earnings.
They can put it into savings accounts, money-market funds,
government bonds, companies, or any number of different
investments. In each, they expect a return on that investment. The
cash-flow statement is divided into three parts: cash flows from
operating activities, from investing activities, and from financing
activities
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Bubba Gump Shrimp Co.Consolidated Statement of Cash Flow
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Chapter Fourteen
19 Important Financial Ratios Explained
Financial Ratio Analysis
There is a lot to be said for valuing a company, it is no easy task. If you
have yet to discover this goldmine, the satisfaction one gets from
tearing apart a companies financial statements and analysing it on a
whole different level is great - especially if you make or save yourself
money for your efforts.
In this section we explain 19 basic fundamental analysis ratios in a
simplified manner to make them easier to understand. Each ratio
covers an important aspect of analysing a company's business. Sure
some of the ratios have different varieties, but by the end you will
understand the basic premise and reasons for fundamental analysis.
Average Interest Rate
(Interest Expense – Accounts Payable)
Liabilities
Indicates the average interest rate that a company borrows at.
Things to remember
This is a rough estimate, the ratio does not account for everything.
Using the before tax or after tax interest expense will produce different
results.
Interest Rate Analysis
There are several versions of this ratio, some people prefer to just use
interest bearing liabilities such as the bonds and other short term
loans. This formula won't give you the exact interest rate they are
paying, but it is useful in an interest rate sensitive environment. And if
you compare it to previous years then you are able to tell what rate the
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company had to take on more debt at. If you will notice on the balance
sheet, Bubba Gump's doesn't have any long-term debt - therefore you
will not find an interest expense. What a great position to be in,
practically debt free.
Book Value Per Share
(Stockholders Equity – Preferred Stock)
Average Outstanding Shares
Somewhat similar to the EPS, but it relates the stockholder's equity to
the number of shares, giving the shares a raw value
Things to remember
•
Comparing the market value to the book value can indicate
whether or not the stock in overvalued or undervalued.
•
During bull markets the stock price is more likely to trade much
higher than book value, and in a bear market the two values
may be close to equal
For Bubba Gump Shrimp Co.
$11,678 - $0
= $3.57
3271
Book Value Analysis
For the most part the Book Value really doesn't tell us a whole lot.
Bubba Gump's is trading at over $100 and the BV is only $3.57? What
is up with that? Well BV is considered to be the accounting value of
each share, drastically different than what the market is valuing the
stocks at. And the truth is that Market and Book Value's have nothing
in common. Market value is what the investment community's
expectations are and book value is based on costs and retained
earnings. One situation where BV can be useful is if the market value
is trading below the book value, this rarely happens, but if it does it
could mean that the company is undervalued and might be an
attractive buy.
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Cash Flow To Assets
Cash From Operations
Total Assets
This ratio indicates the cash a company can generate in relation to its
size.
Things to remember
•
Comparing previous years is important, if the company's ratio
is decreasing then they may eventually run into cash problems
For Bubba Gump Shrimp Co.
$4,438
= 0.30
$14,725
Cash Flow to Assets Analysis
Cash flow is often overlooked when people analyse a company. You
can be a profitable company but if you don't have cash moving around
to pay bills then you are really in trouble. It relates a company's ability
to generate cash compared to its asset size. A ratio of 0.30 is quite
good, Bubba Gump's shouldn't run into any problems generating cash.
When the ratio declines below 10% then there may be some cause for
concern.
Common Size Analysis
Entity
Total Entity
Indicates the proportion of an asset/liability/expense is as a function of
total assets/liabilities/revenue.
Things to remember
•
Compares what proportion that an expense reduces sales,
especially useful when comparing previous years.
it is also useful when comparing similar companies of different sizes to
see if they have the same financial structure
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Common Size Analysis
For Bubba Gump Shrimp Co.
1999
1998
Sales
100% 100%
COGS
35%
34%
Other Expenses
40%
41%
Net Income
17%
16%
Common Size Analysis
Looking at the chart above you wouldn't really think that there is
anything that useful to compare. Well that is because Bubba Gump's
has done an excellent job maintaining its pricing and expenditure
strategy. Ideally you would like to see Cost of Goods Sold (COGS) go
down each year because of increased efficiencies. It also tells us that
for every $1 of sales contributes 17 cents to the bottom line of Bubba
Gump's, a healthy profit margin
Dividend Payout Ratio
Yearly Dividends Per Share
Earning Per Share
Indicates the proportion of earnings that are used to pay dividends to
shareholders.
Things to remember
•
A reduction in dividends paid, is looked poorly upon by
investors, and the stock price usually depreciates as investors
seek other dividend paying stocks.
•
A stable dividend payout ratio indicates a solid dividend policy
by the company's board of directors.
Dividend Payout Analysis
Bubba Gump's payout ratio is zero, in other words they do not pay a
dividend to its shareholders. This is the case for most high growth
firms, reinvesting in the firms activities rather than a cash payout to
shareholders better spends their profits. In fact lately it seems that
corporations have elected to pay out less of their earnings as
dividends, perhaps because current corporate rates of return on
reinvested capital are higher these days, but it could also be that
dividends are doubly taxed
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Earnings Per Share
(Net Income – Dividends on Preferred Stock)
Average Outstanding Shares
The most widely used ratio, it tells how much profit was generated on a
per share basis
Things to remember
•
Diluted EPS means that the outstanding shares include any
convertibles or warrants outstanding.
•
If the company issues more shares then EPS are much harder
to compare to previous years
Earnings Per Share
For Bubba Gump Shrimp Co.
$2,096 - $0
= $0.65
3,271
Earnings Per Share Analysis
The earnings per share ratio are only useful for companies with
publicly traded shares. Most companies will quote the earnings per
share in their financial statements saving you from having to calculate
it yourself. By itself, EPS doesn't really tell you a whole lot. But if you
compare it to the EPS from a previous quarter or year it indicates the
rate of growth a companies earnings are growing on a per share basis.
Bubba Gump's have increased almost 50% since last year, and
excellent growth rate.
It should be noted that the 65 cents EPS is the "trailing" number, using
the previous 4 quarters of earnings. Some analysts like to use
"projected" EPS to analyse a stock's current value in respect to these
estimates
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Gross Profit Margin
(Revenue – Cost of Goods Sold)
Revenue
Indicates what the company's pricing policy is and what the true markup margins are.
Things to remember
•
The results may skew if the company has a very large range of
products.
•
This is very useful when comparing against the margins of
previous years.
•
A 33% gross margin means products are marked up 50% and
so on
Gross Profit Margin
For Bubba Gump Shrimp Co.
($12,154-4,240)
$12,154
= 0.65
Gross Profit Margin Analysis
The gross margin is not an exact estimate of the company's pricing
strategy but it does give a good indication of financial health. Without
an adequate gross margin, a company will be unable to pay its
operating and other expenses and build for the future. Bubba Gump's
is 65% therefore there mark-up is over 100% of the cost. In general, a
company's gross profit margin should be stable. It should not fluctuate
much from one period to another, unless the industry it is in is
undergoing drastic changes, which will affect the costs of goods sold
or your pricing policies.
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Price/Earnings Ratio (P/E Ratio)
Market Value Per Share
Earnings Per Share
One of the most widely used ratios, it compares the current price with
earnings to see if a stock is over or under valued.
Things to remember
•
Generally a high P/E ratio means that investors are
anticipating higher growth in the future.
•
The average market P/E ratio is 20-25 times earnings.
•
The P/E ratio can use estimated earnings to get the forwardlooking P/E ratio.
•
Companies that are losing money do not have a P/E ratio.
•
Use the last 4 quarters of earnings for the Earnings Per Share
figure
Price/Earnings Ratio
For Bubba Gump Shrimp Co.
$107.125
$0.65
= 164.8
Price-Earnings Analysis
Sometimes referred to as the multiple, the idea behind the P/E ratio is
that it is a prediction or more likely an expectation of the company's
performance in the future. The P/E ratio for the overall market
averages around 20, so as you can see Bubba Gump's is much higher
than this. In other words the market is expecting big things from Bubba
Gump's over the next little while.
One thing to remember is that if a company has a low P/E ratio it
doesn't necessarily mean that it is undervalued. The P/E doesn't
dictate the stock price, in fact a low P/E could mean that the
company's earning are flat or slowing, they could be in financial
trouble. And in fact the P/E Ratio doesn't tell a whole lot, but it's useful
to compare the P/E Ratios of other companies in the same industry, or
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to the market in general, or against the companies own historical P/E
Ratios.
Profit Margin (Net Profit Margin)
Net Income
Revenue
Indicates what percentage of sales contributes to the income of a
company.
Things to remember
•
This ratio is not useful for companies losing money, since they
have no profit.
•
A low profit margin can indicate pricing strategy and/or the
impact competition has on margins
Profit Margin
For Bubba Gump Shrimp Co.
$2,096
$12,154
= 0.17
Profit Margin Analysis
A profit margin of 17% means that for each dollar of sales that Bubba
Gump's generates it is contributing 17 cents to its bottom line (net
income). This ties in with gross profit margin, Bubba Gump's has a
healthy pricing strategy, which is evident in both ratios. Cutthroat
pricing industries such as retail and gasoline you would expect the
profit margin much lower because of the heavy competition. We can
interpret that Bubba Gump's either has exceptional products which
customers are willing to pay a substantial premium for, or Bubba
Gump's really doesn't have much competition therefore they can
charge what they wish.
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Return On Assets
(Net Income + Interest Expense)
Total Assets
Indicates what return a company is generating on the firm's
investments/assets
Things to remember
•
The ROA is often referred to as ROI
•
We add the interest expense to ignore the costs associated
with funding those assets
Return on Assets
For Bubba Gump Shrimp Co.
$2,096
$14,725
= 0.14
Return on Assets Analysis
This is an important ratio for companies deciding whether or not to
initiate a new project. The basis of this ratio is that if a company is
going to start a project they expect to earn a return on it, well ROA is
the return they would receive. If ROA is above the rate that the
company borrows at then the project should be accepted, if not then it
is rejected. Bubba Gump's ROA is 14% - very high, this is over double
the cost of borrowing.
Return On Equity
Net Income
Shareholders Equity
Indicates what return a company is generating on the owners'
investment.
Things to remember
•
if new shares are issued then use the weighted average of the
number of shares throughout the year.
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•
for high growth companies you should expect a higher ROE.
•
Averaging ROE over the past 5-10 years can give you a better
idea of the historical growth.
Return on Equity
For Bubba Gump Shrimp Co.
$2,096
$11,678
= 0.18
Return on Equity Analysis
Sometimes ROE is referred to as Stockholder's return on investment, it
tells the rate that shareholders are earning on their shares. Bubba
Gump's is earning a very respectable 18% on shareholder's equity. But
ROE is often misunderstood, for example if the return on equity is
10%, for instance, then ten cents of assets are created for each dollar
that was originally invested. Companies that generate high returns
relative to their shareholder's equity are companies that pay their
shareholders off handsomely, creating substantial assets for each
dollar invested. These businesses are more than likely self-funding
companies that require no additional debt or equity investments.
Asset Turnover Ratio
Revenue
Total Assets
Indicates the relationship between assets and revenue
Things to remember
•
Companies with low profit margins tend to have high asset
turnover, those with high profit margins have low asset
turnover - it indicates pricing strategy.
•
This ratio is more useful for growth companies to check if in
fact they are growing revenue in proportion to sales
Asset Turnover Ratio
For Bubba Gump Shrimp Co.
$12,154
$14,725
= 0.85
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Asset Turnover Analysis
This ratio is useful to determine the amount of sales that are generated
from each dollar of assets. As noted above, companies with low profit
margins tend to have high asset turnover, those with high profit
margins have low asset turnover. Bubba Gump’s asset turnover seems
to be relatively low, meaning that it makes a high profit margin on its
products. For companies in the retail industry you would expect a very
high turnover ratio - mainly because of cutthroat pricing.
Collection Ratio
Accounts Receivable
Revenue/365
This indicates the average number of days it takes a company to
collect unpaid invoices.
Things to remember
•
A high ratio indicates that the company is having problems
getting paid for services or products.
•
The ratio is sometimes seasonally effected, rising during busy
seasons and falling during the off-season.
Collection Ratio
For Bubba Gump Shrimp Co.
$1,242
($12,154/365)
= 37.3
Collection Ratio Analysis
This ratio could perhaps be renamed as the "Thug Ratio", it explains
the average time it takes to receive payment on sales. The "Cool
Dudes" at Bubba Gump's seem to be doing their job quite well; on
average it takes 37 days for customers to clear their invoices. This is
quite reasonable since most companies clear pay all of their bills on a
monthly basis. If we were really picky we could redo this calculation
using only credit sales since cash purchases are received immediately
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Inventory Turnover
Cost of Goods Sold
Average Inventory
An important and often overlooked ratio that indicates inventory levels.
Things to remember
•
A low turnover is usually a bad sign because products tend to
deteriorate as they sit in a warehouse.
•
Companies selling perishable items have very high turnover.
Inventory Turnover
For Bubba Gump Shrimp Co.
$4,240
$642
= 6.60
Inventory Analysis
Bubba Gump’s inventory has gone up almost 100% since last year,
this could mean nothing or something. But there could be something
fundamentally wrong perhaps sales are slowing. A change of 100% is
quite substantial and should be any cause for concern if sales are
slowing. But if we look more closely at Bubba Gump’s sales it shows
that product sales have increased almost 50% since last year. In other
words the higher inventory could simply be a factor of higher demand.
Debt-to-Assets Ratio
Total Liabilities
Total Assets
Indicates what proportion of the company’s assets is being financed
through debt.
Things to remember
•
This ratio is very similar to the debt-equity ratio.
•
A ratio under 1 means a majority of assets are financed
through equity, above 1 means they are financed more by
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debt. Furthermore you can interpret a high ratio as a "highly
debt leveraged firm".
Debt-to-Assets Ratio
For Bubba Gump Shrimp Co.
$3,003
$14,725
= 0.20
Debt/Asset Analysis
Not a particularly exciting ratio, but a useful one. Bubba Gump’s
debt/asset ratio is fairly low, meaning that its assets are financed more
through equity rather than debt. And if you'll notice Bubba Gump's has
zero long-term debt and shouldn't have to worry about creditor's
getting nervous. Companies with high ratios are placing themselves at
risk, especially in an increasing interest rate market. Creditors are
bound to get worried if the company is exposed to a large amount of
debt and may demand that the company pay some of it back.
Debt-to-Equity Ratio
Total Liabilities
Shareholders Equity
Indicates what proportion of equity and debt that the company is using
to finance its assets. Sometimes investors only use long-term debt
instead of total liabilities.
Things to remember
•
A ratio greater than one means assets are mainly financed
with debt, less than one means equity provides a majority of
the financing.
•
If the ratio is high then the company is in a risky position especially if interest rates are on the rise.
Debt-to-Equity Ratio
For Bubba Gump Shrimp Co.
$3,003
$11,678
= 0.26
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Debt-to-Equity Ratio Analysis
The shareholders capital has risen quite a bit. Again this could mean a
number of things, there are a couple reasons that this could have
happened. Perhaps they've made acquisition’s, which were partially
paid for through the issue of stock, or they took on additional share
capital from another firm. Another reason is that they had to issue
more shares because they were strapped for cash. For the most part a
rise in share capital is better than a rise in debt, but too much of a rise
could be cause for alarm.
The Debt/Equity ratio is certainly far from perfect! A low ratio of 0.26
means that the company is exposing itself to a large amount of equity.
This is certainly better than a high ratio of 2 or more since this would
expose the company to risk such as interest rate increases and
creditor nervousness. One way to improve their situation would be to
issue more debt and use the cash to buyback some of its outstanding
shares. You see the problem with issuing more and more stock like
Bubba Gump's is that outstanding shares become diluted and existing
investors receive a smaller ownership portion with each additional
share issued.
Note: Some prefer to use only interest bearing long-term debt instead
of total liabilities to get a more precise calculation.
Acid Test (Quick Ratio)
(Cash + Accounts Receivables + Short term Investments)
Current Liabilities
A stringent test that indicates if a firm has enough short-term assets
(without selling inventory) to cover its immediate liabilities. It is similar
but a more strenuous version of the "working capital", indicating
whether liabilities could be paid without selling inventory.
Things to remember
•
It is an extreme version of the working capital ratio because it
only uses cash and equivalents
•
The ratio excludes inventory, which for some companies can
make up a large portion of its assets
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Acid Test (Quick Ratio)
For Bubba Gump Shrimp Co.
$827 + $1,187 + $1,242
$3,003
= 0.26
Acid Test (Quick Ratio) Analysis
This ratio is used to determine risk that is not detected by the Working
Capital ratio. Bubba Gump's seems to be all right in this area. Their
ratio of 1.08 means that they have just enough liquid assets to cover a
unexpected draw down of liabilities (people wanting their money now).
Companies with ratios of less than 1 cannot pay their current liabilities
and should be looked at with extreme care. Furthermore if the Acid
ratio is much lower than the working capital ratio it means that current
assets are highly dependent on inventory - retail stores are examples
of this type of business.
Interest Coverage Ratio
EBITDA
Interest Expense
Indicates what portion of debt interest is covered by a company's cash
flow situation.
Things to remember
•
A ratio under 1 means that the company is having problems
generating enough cash flow to pay its interest expenses.
•
Ideally you want the ratio to be over 1.
Interest Coverage Ratio Analysis
If you will notice, Bubba Gump's doesn't have any long-term debt therefore you will not find an interest expense. What a great position to
be in, practically debt free. Companies with a ratio below 1 could run
into serious trouble servicing its loan payments and a high risk of
default over the long-term. Because Bubba Gump's has no interest
expense its Interest coverage ratio is infinite...obviously the best you
could possibly have.
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Working Capital (Current Ratio)
Current Assets
Current Liabilities
Indicates if a firm has enough short-term assets to cover its immediate
liabilities.
Things to remember
•
If the ratio is less than one then they have negative working
capital.
•
A high working capital ratio isn't always a good thing, it could
indicate that they have too much inventory or they are not
investing their excess cash.
Working Capital Ratio
For Bubba Gump Shrimp Co.
$4,615
$3,003
= 1.54
Working Capital (Quick Ratio) Analysis
This ratio indicates whether a company has enough short-term assets
to cover its short-term debt. Anything below 1 indicates negative
working capital. While anything over 2 means that the company is not
investing excess assets. Most believe that a ratio between 1.2 and 2.0
is sufficient; Bubba Gump's seems to be very comfortable in this area.
If you wanted to take this ratio a step further then you could try the
Acid Test (Quick Ratio) - it is a more strenuous version of the Working
Capital Ratio (Current Ratio), indicating whether liabilities could be
paid without selling inventory
In Conclusion
There is a lot to be said for valuing a company, it is no easy task. I
hope that we have helped shed some light on this topic, and that you
will use this information to make educated investment decisions.
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Financial Ratio Index
Performance Ratios
•
•
•
•
•
•
•
•
•
•
•
Average Interest Rate
Book Value Per Share
Cash Flow To Assets
Common Size Analysis
Dividend Payout Ratio
Earnings Per Share
Gross Profit Margin
Price/Earnings Ratio
Profit Margin
Return on Assets
Return on Equity
Activity Ratios
•
•
•
Asset Turnover Ratio
Collection Ratio
Inventory Turnover
Financing Ratios
•
•
Debt-to-Assets Ratio
Debt-to-Equity Ratio
Liquidity Ratios
•
•
•
Acid Test (Quick Ratio)
Interest Coverage Ratio
Working Capital Ratio
“Give us the tools and we will finish the job”
Winston Churchill (1874-1965)
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Chapter fifteen
Technical Analysis
Technical analysis is one of the most common methods of evaluating
stocks and other securities. Technical analysis utilizes charts of market
statistics such as a stock's historical price history and volume to focus
on trends and interpret where the stock's price is most likely to move
next.
What Are Charts?
A price chart is a sequence of prices plotted over a specific timeframe.
In statistical terms, charts are referred to as time series plots.
.
On the chart, the y-axis (vertical axis) represents the price scale and
the x-axis (horizontal axis) represents the time scale. Prices are plotted
from left to right across the x-axis with the most recent plot being the
furthest right. The price plot for MMM extends from January 1, 1999 to
March 13, 2000.
Technicians, technical analysts and chartists use charts to analyse a
wide array of securities and forecast future price movements. The
word "securities" refers to any tradable financial instrument or
quantifiable index such as stocks, bonds, commodities, futures or
market indices. Any security with price data over a period of time can
be used to form a chart for analysis.
While technical analysts use charts almost exclusively, the use of
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charts is not limited to just technical analysis. Because charts provide
an easy-to-read graphical representation of a security's price
movement over a specific period of time, they can also be of great
benefit to fundamental analysts. A graphical historical record makes it
easy to spot the effect of key events on a security's price, its
performance over a period of time and whether it's trading near its
highs, near its lows, or in between.
How to Pick a Timeframe
The timeframe used for forming a chart depends on the compression
of the data: intraday, daily, weekly, monthly, quarterly or annual data.
The less compressed the data is, the more detail is displayed.
Daily data is made up of intraday data that has been compressed to
show each day as a single data point, or period. Weekly data is made
up of daily data that has been compressed to show each week as a
single data point. The difference in detail can be seen with the daily
and weekly chart comparison above. 100 data points (or periods) on
the daily chart is equal to the last 5 months of the weekly chart, which
is shown by the data marked in the rectangle. The more the data is
compressed, the longer the timeframe possible for displaying the data.
If the chart can display 100 data points, a weekly chart will hold 100
weeks (almost 2 years). A daily chart that displays 100 days would
represent about 5 months. There are about 20 trading days in a month
and about 252 trading days in a year. The choice of data compression
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and timeframe depends on the data available and your trading or
investing style.
•
Traders usually concentrate on charts made up of daily and
intraday data to forecast short-term price movements. The
shorter the time frame and the less compressed the data is,
the more detail that is available. While long on detail, shortterm charts can be volatile and contain a lot of noise. Large
sudden price movements, wide high-low ranges and price
gaps can affect volatility, which can distort the overall picture.
•
Investors usually focus on weekly and monthly charts to spot
long-term trends and forecast long-term price movements.
Because long-term charts (typically 1-4 years) cover a longer
timeframe with compressed data, price movements do not
appear as extreme and there is often less noise.
Others might use a combination of long-term and short-term charts.
Long-term charts are good for analysing the large picture to get a
broad perspective of the historical price action. Once the general
picture is analysed, a daily chart can be used to zoom in on the last
few months.
Different Types of Charts
We will be explaining the construction of line, bar, candlestick and
point & figure charts. Although there are other methods available,
these are 4 of the most popular methods for displaying price data.
Line Chart
The line chart is one of the simplest charts. It is formed by plotting one
price point, usually the close, of a security over a period of time.
Connecting the dots, or price points, over a period of time, creates the
line.
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Some investors and traders consider the closing level to be more
important than the open, high or low. By paying attention to only the
close, intraday swings can be ignored. Line charts are also used when
open, high and low data points are not available. Sometimes only
closing data are available for certain indices, thinly traded stocks and
intraday prices.
Bar Chart
Perhaps the most popular charting method is the bar chart. The high,
low and close are required to form the price plot for each period of a
bar chart. The high and low are represented by the top and bottom of
the vertical bar and the close is the short horizontal line crossing the
vertical bar. On a daily chart, each bar represents the high, low and
close for a particular day. Weekly charts would have a bar for each
week based on Friday's close and the high and low for that week.
Bar charts can also be displayed using the open, high, low and close.
The only difference is the addition of the open price, which is displayed
as a short horizontal line extending to the left of the bar. Whether or
not a bar chart includes the open depends on the data available.
Bar charts can be effective for displaying a large amount of data. Using
candlesticks, 200 data points can take up a lot of room and look
cluttered. Line charts show less clutter, but do not offer as much detail
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(no high-low range). The individual bars that make up the bar chart are
relatively skinny, which allows users the ability to fit more bars before
the chart gets cluttered. If you are not interested in the opening price,
bar charts are an ideal method for analysing the close relative to the
high and low. In addition, bar charts that include the open will tend to
get cluttered quicker. If you are interested in the opening price,
candlestick charts probably offer a better alternative.
Candlestick Chart
Originating in Japan over 300 years ago, candlestick charts have
become quite popular in recent years. For a candlestick chart, the
open, high, low and close are all required. A daily candlestick is based
on the open price, the intraday high and low, and the close. A weekly
candlestick is based on Monday's open, the weekly high-low range and
Friday's close.
Many traders and investors believe that candlestick charts are easy to
read, especially the relationship between the open and the close.
White (clear) candlesticks form when the close is higher than the open
and black (solid) candlesticks form when the close is lower than the
open. The white and black portion formed from the open and close is
called the body (white body or black body). The lines above and below
are called shadows and represent the high and low.
Point & Figure Chart
The charting methods shown below all plot one data point for each
period of time. No matter how much price movement each day or week
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represented is one point, bar or candlestick along the time scale. Even
if the price is unchanged from day to day or week to week, a dot, bar
or candlestick is plotted to mark the price action. Contrary to this
methodology, Point & Figure Charts are based solely on price
movement and do not take time into consideration. There is an x-axis
but it does not extend evenly across the chart.
The beauty of Point & Figure Charts is their simplicity. Little or no price
movement is deemed irrelevant and therefore not duplicated on the
chart. Only price movements that exceed specified levels are
recorded. This focus on price movement makes it easier to identify
support and resistance levels, bullish breakouts and bearish
breakdowns. This article has a more detailed explanation of Point &
Figure Charts.
Price Scaling
There are two methods for displaying the price scale along the y-axis:
arithmetic and logarithmic. An arithmetic scale displays 10 points (or
dollars) as the same vertical distance no matter what the price level.
Each unit of measure is the same throughout the entire scale. If a
stock advances from 10 to 80 over a 6-month period, the move from
10 to 20 will appear to be the same distance as the move from 70 to
80. Even though this move is the same in absolute terms, it is not the
same in percentage terms.
A logarithmic scale measures price movements in percentage terms.
An advance from 10 to 20 would represent an increase of 100%. An
advance from 20 to 40 would also be 100%, as would an advance from
40 to 80. All three of these advances would appear as the same
vertical distance on a logarithmic scale. Most charting programs refer
to the logarithmic scale as a semi-log scale, because the time axis is
still displayed arithmetically.
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The chart above uses the 4th-Quarter performance of Verisign to
illustrate the difference in scaling. On the semi-log scale, the distance
between 50 and 100 is the same as the distance between 100 and
200. However, on the arithmetic scale, the distance between 100 and
200 is significantly greater than the distance between 50 and 100.
Key points on the benefits of arithmetic and semi-log scales:
•
•
•
•
•
Arithmetic scales are useful when the price range is
confined within a relatively tight range.
Arithmetic scales can be useful for short-term charts and
trading. Price movements (particularly for stocks) are
shown in absolute dollar terms and reflect movements
dollar for dollar.
Semi-log scales are useful when the price has moved
significantly, be it over a short or extended timeframe
Trendlines tend to match lows better on semi-log scales.
Semi-log scales can be useful for long-term charts to
gauge the percentage movements over a long period of
time. Large movements are put into perspective.
Stocks and many other securities are judged in relative terms through
the use of ratios such as PE, Price/Revenues and Price/Book. With
this in mind, it also makes sense to analyse price movements in
percentage terms.
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Even though many different charting techniques are available, one
method is not necessarily better than the other. The data may be the
same, but each method will provide its own unique interpretation, with
its own benefits and drawbacks. A breakout on the Point & Figure
Chart may not occur in unison with a breakout in a candlestick chart.
Signals that are available on candlestick charts may not appear on bar
charts. How the security's price is displayed, be it a bar chart or
candlestick chart, with an arithmetic scale or semi-log scale, is not the
most important aspect. After all, the data is the same and price action
is price action. When all is said and done, it is the analysis of the price
action that separates successful technicians from not-so-successful
technicians. The choice of which charting method to use will depend
on personal preferences and trading or investing styles. Once you
have chosen a particular charting methodology, it is probably best to
stick with it and learn how best to read the signals. Switching back and
forth may cause confusion and undermine the focus of your analysis.
Faulty analysis is rarely caused by the chart. Before blaming your
charting method for missing a signal, first look at your analysis.
The keys to successful chart analysis are dedication, focus and
consistency.
•
Dedication: Learn the basics of chart analysis, apply your
knowledge on a regular basis and continue your development.
•
Focus: Limit the number of charts, indicators and methods you
use. Learn how to use these and learn how to use them well.
Consistency: Maintain your charts on a regular basis and study them
often (daily if possible).
An Introduction to Support and Resistance Levels
Support and resistance represent key junctures where the forces of
supply and demand meet. In the financial markets, prices are driven by
excessive supply (down) and demand (up). Supply is synonymous with
bearish, bears and selling. Demand is synonymous with bullish, bulls
and buying. These terms are used interchangeably throughout this and
other articles. As demand increases, prices advance and as supply
increases, prices decline. When supply and demand are equal, prices
move sideways as bulls and bears slug it out for control.
What is Support?
Support is the price level at which demand is thought to be strong
enough to prevent the price from declining further. The logic dictates
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that as the price declines towards support and gets cheaper, buyers
become more inclined to buy and sellers become less inclined to sell.
By the time the price reaches the support level, it is believed that
demand will overcome supply and prevent the price from falling below
support
Support does not always hold and a break below support signals that
the bears have won out over the bulls. A decline below support
indicates a new willingness to sell and/or a lack of incentive to buy.
Support breaks and new lows signal that sellers have reduced their
expectations and are willing sell at even lower prices. In addition,
buyers could not be coerced into buying until prices declined below
support or below the previous low. Once support is broken, another
support level will have to be established at a lower level.
Where is Support Established?
Support levels are usually below the current price, but it is not
uncommon for a security to trade at or near support. Technical
analysis is not an exact science and it is sometimes difficult to set
exact support levels. In addition, price movements can be volatile and
dip below support briefly. Sometimes it does not seem logical to
consider a support level broken if the price closes 1/8 below the
established support level. For this reason, some traders and investors
establish support zones.
What is Resistance?
Resistance is the price level at which selling is thought to be strong
enough to prevent the price from rising further. The logic dictates that
as the price advances towards resistance, sellers become more
inclined to sell and buyers become less inclined to buy. By the time the
price reaches the resistance level, it is believed that supply will
overcome demand and prevent the price from rising above resistance.
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Resistance does not always hold and a break above resistance signals
that the bulls have won out over the bears. A break above resistance
shows a new willingness to buy and/or a lack of incentive to sell.
Resistance breaks and new highs indicate buyers have increased their
expectations and are willing to buy at even higher prices. In addition,
sellers could not be coerced into selling until prices rose above
resistance or above the previous high. Once resistance is broken,
another resistance level will have to be established at a higher level.
Where is Resistance Established?
Resistance levels are usually above the current price, but it is not
uncommon for a security to trade at or near resistance. In addition,
price movements can be volatile and rise above resistance briefly.
Sometimes it does not seem logical to consider a resistance level
broken if the price closes 1/8 above the established resistance level.
For this reason, some traders and investors establish resistance
zones.
Establishing Support and Resistance
Support and resistance are like mirror images and have many common
characteristics.
Highs and Lows
Support can be established with the previous reaction lows.
Resistance can be established by using the previous reaction highs.
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The chart for HAL shows a large trading range between Dec-99 and
Mar-00. Support was established with the October low around 33. In
December, the stock returned to support in the mid-thirties and formed
a low around 34. Finally, in February the stock again returned to the
support scene and formed a low around 33 1/2.
After each bounce off support, the stock traded all the way up to
resistance. Resistance was first established by the September support
break at 44. After a support level is broken, it can turn into a resistance
level. From the October lows, the stock advanced to the new supportturned-resistance level around 44. When the stock failed to advance
past 44, the resistance level was confirmed. The stock subsequently
traded up to 44 two more times after that and failed to surpass
resistance both times.
Support = Resistance
Another principle of technical analysis stipulates that support can turn
into resistance and visa versa. Once the price breaks below a support
level, the broken support level can turn into resistance. The break of
support signals that the forces of supply have overcome the forces of
demand. Therefore, if the price returns to this level, there is likely to be
an increase in supply, and hence resistance.
The other turn of the coin is resistance turning into support. As the
price advances above resistance, it signals changes in supply and
demand. The breakout above resistance proves that the forces of
demand have overwhelmed the forces of supply. If the price returns to
this level, there is likely to be an increase in demand and support will
be found.
“I’m all mixed up and I can’t keep up with everything that’s happening”
Elvis Presley (1935-1977)
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In the CPQ example, the stock broke resistance at 25 Nov-99 and
traded just above this resistance level for over a month. The ability to
remain above resistance established 25 as a new support level. The
stock subsequently rose to 34, but then fell back to test support at 25.
After the second test of support at 25, this level is well established.
From the PSFT example, we can see that support can turn into
resistance and then back into support. PSFT found support at 18 from
Oct-98 to Jan-99 (green oval), but broke below support in Mar-99 as
the bears overpowered the bulls. When the stock rebounded (red
oval), there was still overhead supply at 18 and resistance was met
from Jun-99 to Oct-99.
Where does this overhead supply come from? Demand was obviously
increasing around 18 from Oct-98 to Mar-99 (green oval). Therefore,
there were a lot of buyers in the stock around 18. When the price
declined past 18 and to around 14, many of these buyers were
probably still holding the stock. This left a supply overhang (commonly
known as resistance) around 18. When the stock rebounded to 18,
many of the green-oval-buyers (who bought around 18) probably took
the opportunity to sell. When this supply was exhausted, the demand
was able to overpower supply and advance above resistance at 18.
Trading Range
Trading ranges can play an important role in determining support and
resistance as turning points or as continuation patterns. A trading
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range is a period of time when prices move within a relatively tight
range. This signals that the forces of supply and demand are evenly
balanced. When the price breaks out of the trading range, above or
below, it signals that a winner has emerged. A break above is a victory
for the bulls (demand) and a break below is a victory for the bears
(supply).
After an extended advance from 27 to 64, WCOM entered into a
trading range between 55 and 63 for about 5 months. There was a
false breakout in mid-June when the stock briefly poked its head above
62 (red oval). This did not last long and a gap down a few days later
nullified the breakout (grey arrow). The stock then proceeded to break
support at 55 in Aug-99 and trade as low as 50. Here is another
example of support turned resistance as the stock bounced off 55 two
more times before heading lower. While this does not always happen,
a return to the new resistance level offers a second chance for longs to
get out and shorts to enter the fray.
In Nov/Dec-99, the LU formed a trading range that resembled a head
and shoulders pattern (red arrow). When the stock broke support at 72
1/2, there was little or no time to exit. Even though the there is a long
black candlestick indicating an open at 71 13/16, the stock fell so fast
that it was impossible to exit above 55. In hindsight, the support line
could have been drawn as an upward sloping neckline (blue line) and
the support break would have come at 73 1/2. This is only 1 point
higher and a trader would have had to take action immediately to avoid
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a sharp fall. However, the lows match up rather nicely on the neckline
and it is something to consider when drawing support lines.
After LU declined, a trading range was established between 51 and 58
for almost two months (green oval). The resistance level of the trading
range was well marked by three reaction peaks at 58. The support
level was not as clearly marked, but appeared to be between 51 and
50. Some buying interest began to become evident around 53, in mid
to late February. Notice the array of candlesticks with long lower
shadows, or hammers as they are known. The stock then proceeded
to form two up gaps on 24-Feb and 25-Feb, and close above
resistance at 58. This was a clear indication of demand winning out
over supply. There were still two more opportunities (days) to get in on
the action. On the third day after the breakout, the stock gapped up
and moved above 70.
Support and Resistance Zones
Because technical analysis is not an exact science, it is sometimes
useful to create support and resistance zones. This is contrary to the
strategy mapped out for LU, but it is sometimes the case. Each
security has its own characteristics and the analysis should reflect the
intricacies of the security. Sometimes exact support and resistance
levels are best and sometimes zones work better. Generally, the
tighter the range, the more exact the level. If the trading range spans
less than 2 months and the price range is relatively tight, then more
exact support and resistance levels are probably best suited. If a
trading range spans many months and the price range is relatively
large, then it is probably best to use support and resistance zones.
These are only meant as general guidelines and each trading range
should be judged on its own merits.
Returning to the analysis of HAL, we can see that the November high
of the trading range (33 to 44) extended more than 20% past the low,
making the range quite large relative to the price. Because the
September support break forms our first resistance level, we are ready
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to set up a resistance zone after the November high is formed,
probably around early December. At this point though, we are still
unsure if a large trading range will develop. The subsequent low in
December, which was just higher than the October low, offers
evidence that a trading range is forming and we are ready to set the
support zone. As long as the stock trades within the boundaries set by
the support and resistance zone, we will consider the trading range to
be valid. Support may be looked upon as an opportunity to buy and
resistance as an opportunity to sell.
Identification of key support and resistance levels is an essential
ingredient to successful technical analysis. Even though it is
sometimes difficult to establish exact support and resistance levels,
being aware of their existence and location can greatly enhance
analysis and forecasting abilities. If a security is approaching an
important support level, it can serve as an alert to be extra vigilant in
looking for signs of increased buying pressure and a potential reversal.
If a security is approaching a resistance level, it can act as an alert to
look for signs of increased selling pressure and potential reversal. If a
support or resistance level is broken, it signals that the relationship
between supply and demand has changed. A resistance breakout
signals that demand (bulls) has gained the upper hand and a support
break signals that supply (bears) has won the battle.
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Chapter Sixteen
Understanding and Drawing Important
Trendlines
Technical analysis is built on the assumption that prices trend.
Trendlines are an important tool in technical analysis for both trend
identification and confirmation. A trendline is a straight line that
connects two or more price points and then extends into the future to
act as a line of support or resistance. Many of the principles applicable
to support and resistance levels can be applied to trendlines as well.
Up Trendline
An up trendline has a positive slope and is formed by connecting two
of more low points. The second low must be higher than the first for
the line to have a positive slope. Up trendlines act as support and
indicate that net-demand (demand less supply) is increasing even as
the price rises. A rising price combined with increasing demand is very
bullish and shows a strong determination on the part of the buyers. As
long as prices remain above the trendline, the up trend is considered
solid and intact. A break below the up trendline indicates that netdemand has weakened and a change in trend could be imminent
Down Trendline
A down trendline has a negative slope and is formed by connecting
two or more high points. The second high must be lower than the first
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for the line to have a negative slope. Down trendlines act as resistance
and indicate that net-supply (supply less demand) is increasing even
as the price declines. A declining price combined with increasing
supply is very bearish and shows the strong resolve of the sellers. As
long as prices remain below the down trendline, the downtrend is
considered solid and intact. A break above the down trendline
indicates that net-supply is decreasing and a change of trend could be
imminent.
Scale Settings
High points and low points appear to line up better for trendlines when
prices are displayed using a semi-log scale. This is especially true
when long-term trendlines are being drawn or there has been a large
change in price. Most charting programs allow users to set the scale
as arithmetic or semi-log. An arithmetic scale displays incremental
values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10
movement in price will look the same from $10 to $20 or from $100 to
$110. A semi-log scale displays incremental values in percentage
terms as they move up the y-axis. A move from $10 to $20 is a 100%
gain and would appear to be a much larger than a move from $100 to
$110, which is only a 10% gain.
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In the case of EMC, there was a large price change over a long period
of time. While there were not any false breaks below the up trendline
on the arithmetic scale, the rate of ascent appears smoother on the
semi-log scale. EMC doubled three times in less than two years. On
the semi-log scale, the trendline fits all the way up. On the arithmetic
scale, three different trendlines were required to keep pace with the
advance.
“Pursue worthy aims”
Solon (ca. 630-560 BC)
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In the case of BD, there were two false breaks above the down
trendline as the stock declined during 1999 and 2000. These false
break outs could have led to premature buying as the stock continued
to decline after each one. The stock lost 50% of its value three times
over a two-year period. The semi-log scale reflects the percentage loss
evenly and the down trendline was never broken.
Validation
It takes two or more points to draw a trendline. The more points used
to draw the trendline, the more validity attached to the support or
resistance level represented by the trendline. It can sometimes be
difficult to find more than 2 points from which to construct a trendline.
Even though trendlines are an important aspect of technical analysis, it
is not always possible to draw trendlines on every price chart.
Sometimes the lows or highs just don't match up and it is best not to
force the issue. The general rule in technical analysis is that it takes
two points to draw a trendline and the third point confirms the validity.
“Adversity is the midwife of genius”
Napoleon (1769-1821)
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The chart of MSFT shows an up trendline that has been touched 4
times. After the third touch in Nov-99, the trendline was considered a
valid line of support. Now that the stock has bounced off of this level a
fourth time, the soundness of the support level is enhanced even
more. As long as the stock remains above the trendline (support), the
trend will remain in control of the bulls. A break below would signal that
net-supply was increasing and a change in trend could be imminent.
Spacing of Points
The lows used to form an up trendline and the highs used to form a
down trendline should not be too far apart, or too close together. The
most suitable distance apart will depend on the timeframe, the degree
of price movement and personal preferences. If the lows (highs) are
too close together, the validity of the reaction low (high) may be in
question. If the lows are too far apart, the relationship between the two
points could be suspect. An ideal trendline is made up of relatively
evenly spaced lows (or highs). The trendline in the MSFT example
represents well-spaced low points.
On the WMT example, the second high point appears to be too close
to the first high point for a valid trendline. However, it would be feasible
to draw a trendline beginning from point 2 and extending down to the
February reaction high.
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Angles
As the steepness of a trendline increases, the validity of the support or
resistance level decreases. A steep trendline results from a sharp
advance (or decline) over a brief period of time. The angle of a
trendline created from such sharp moves is unlikely to offer a
meaningful support or resistance level. Even if the trendline is formed
with three seemingly valid points, attempting to play a trendline break
or use the support and resistance level that has been established will
often prove difficult.
The trendline for YHOO was touched four times over a 5-month period.
The spacing between the points appears OK, but the steepness of the
trendline is unsustainable and the price is more likely than not to drop
below the trendline. However, trying to time this drop or make a play
after the trendline is broken is a difficult task. The amount of data
displayed and chart size can also affect the angle of a trendline. Short
and wide charts are less likely to have steep trendlines than long and
narrow charts. Keep this in mind when assessing the validity and
sustainability of a trendline.
Internal Trendlines
Sometimes there appears to be the possibility for drawing a trendline,
but the exact points do not match up quite right. The highs or lows may
be out of whack, the angle may be too steep or the points may seem
too close together. If one or two points could be ignored, then a fitted
trendline could be formed. With the volatility present in the market,
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prices can over-react and produced spikes that may distort the highs
and lows. One method for dealing with over-reactions is to draw
internal trendlines. Even though an internal trendline ignores price
spikes, the ignoring should be within reason.
The long-term trendline for the S&P 500 extends up from the end of
1994 and passes through low points in Jul-96, Sept-98 and Oct-98.
These lows were formed with selling climaxes and represented
extreme price movements that protrude beneath the trendline. By
drawing the trendline through the lows, the line appears to be at a
reasonable angle and the other lows match up extremely well.
Sometimes there is a price cluster with a high or low spike sticking out.
A price cluster is an area where prices are grouped within a tight range
over a period of time. The price cluster can be used to draw the
trendline and the spike can be ignored. The KO chart shows an
internal trendline that is formed by ignoring price spikes and using the
price clusters instead. In October and November 1998, KO formed a
peak with the November peak just higher than the October peak (1). If
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the November peak had been used to draw a trendline, then the slope
would have been more negative and there would have appeared to be
a breakout in Dec-98 (grey line). However, this would have only been a
two point trendline because the May-June highs are too close together
(black arrows). Once the Dec-99 peak formed (green arrow), it would
have been possible to draw an internal trendline based on the price
clusters around the Oct/Nov-98 and the Dec-99 peaks (blue line). This
trendline is based on three solid touches and accurately forecast
resistance in Jan-00 (blue arrow).
Trendlines can offer great insight, but if not used properly can also
result in false signals. Other items such as horizontal support and
resistance levels or peak and trough analysis should be employed to
validate trendline breaks. While trendlines have become a very popular
aspect of technical analysis, they are merely one tool for establishing,
analysing and confirming the trend. Trendlines should not be the final
arbiter, but serve as a warning that a change in trend may be
imminent. By using trendline breaks for warnings, investors and
traders can pay closer attention to other confirming signals for a
potential change in trend.
The up trendline for VRSN was touched 4 times and seemed to be a
valid support level. Even though the trendline was broken in Jan-00,
the previous reaction low held and did not confirm the trendline break.
In addition, the stock recorded a new higher high prior to the trendline
break.
“In human affairs, the best stimulus for running ahead is to have
something to run from”
Eric Hoffer (1902-1983)
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Chapter Seventeen
19 Powerful Chart Patterns
An Introduction to Chart Patterns
There are hundreds of thousands of market participants buying and
selling securities for a wide variety of reasons: hope of gain, fear of
loss, tax consequences, short-covering, hedging, stop-loss triggers,
price target triggers, fundamental analysis, technical analysis, broker
recommendations and a few dozen more. Trying to figure out why
participants are buying and selling can be a daunting process.
Chart patterns put all buying and selling into perspective by
consolidating the forces of supply and demand into a concise picture.
As a complete pictorial record of all trading, chart patterns provide a
framework to analyse the battle raging between bulls and bears.
More importantly, chart patterns and technical analysis can help
determine who is winning the battle, allowing traders and investors to
position themselves accordingly.
Chart pattern analysis can be used to make short-term or long-term
forecasts. The data can be intraday, daily, weekly or monthly and the
patterns can be as short as one day or as long as many years. Gaps
and outside reversals may form in one trading session, while
broadening tops and dormant bottoms may require many months to
form.
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An Oldie but Goodie
Much of our understanding of chart patterns can be attributed to the
work of Richard Schabacker. His 1932 classic, Technical Analysis and
Stock Market Profits, laid the foundations for modern pattern analysis.
In Technical Analysis of Stock Trends (1948), Edwards and Magee
credit Schabacker for most of the concepts put forth in the first part of
their book. We would also like to acknowledge Messrs. Schabacker,
Edwards and Magee, and John Murphy as the driving forces behind
these articles and our understanding of chart patterns.
Pattern analysis may seem straightforward, but it is by no means an
easy task. Schabacker states:
The science of chart reading, however, is not as easy as the
mere memorizing of certain patterns and pictures and recalling
what they generally forecast. Any general stock chart is a
combination of countless different patterns and its accurate
analysis depends upon constant study, long experience and
knowledge of all the fine points, both technical and
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fundamental, and, above all, the ability to weigh opposing
indications against each other, to appraise the entire picture in
the light of its most minute and composite details as well as in
the recognition of any certain and memorized formula.
Even though Schabacker refers to "the science of chart
reading", technical analysis can at times be less science and
more art. In addition, pattern recognition can be open to
interpretation, which can be subject to personal biases.
To defend against biases and confirm pattern interpretations,
other aspects of technical analysis should be employed to
verify or refute the conclusions drawn. While many patterns
may seem similar in nature, no two patterns are exactly alike.
False breakouts, bogus reads and exceptions to the rule are
all part of the ongoing education.
Careful and constant study is required for successful chart
analysis. On the AMZN chart above, the stock broke
resistance from a head and shoulders reversal. While the
trend is now bearish, analysis must continue to confirm the
bearish trend.
Some analysts might have labelled the NVLS chart as a head and
shoulders patterns with neckline support around 17.50. Whether or not
this is robust remains open to debate. Even though the stock broke
neckline support at 17.50, it repeatedly moved back above its support
break. This refusal might have been taken as a sign of strength and
justify a reassessment of the pattern.
Two Dominant Groups
Two basic tenets of technical analysis are that prices trend and that
history repeats itself. An uptrend indicates that the forces of demand
(bulls) are in control and a downtrend that the forces of supply (bears)
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are in control. However, prices do not trend forever and as the balance
of power shifts, a chart pattern begins to emerge. Certain patterns,
such as a parallel channel, denote a strong trend. However, the vast
majority of chart patterns fall into two main groups: reversal and
continuation. Reversal patterns indicate a change of trend and can be
broken down into top and bottom formations. Continuation patterns
indicate a pause in trend and indicate that the previous direction will
resume after a period of time.
Just because a pattern forms after a significant advance or decline
does not mean it is a reversal pattern. Many patterns, such as a
rectangle, can be classified as either reversal or continuation. Much
depends on the previous price action, volume and other indicators as
the pattern evolves. This is where the science of technical analysis
becomes the art of technical analysis.
Reversal Chart Pattern: Bump and Run
As the name implies, the Bump and Run Reversal (BARR) is a
reversal pattern that forms after excessive speculation drives prices up
too far, too fast. Developed by Thomas Bulkowski, the pattern was
introduced in the June-97 issue of Technical Analysis of Stocks and
Commodities and also included in his recently published book, the
Encyclopaedia of Chart Patterns.
The pattern was originally named the Bump and Run Formation, or
BARF. Bulkowski decided that Wall Street was not ready for such an
acronym and changed the name to Bump and Run Reversal.
Bulkowski identified three main phases to the pattern: lead-in, bump
and run. We will examine these phases and also look at volume and
pattern validation.
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1. Lead-in Phase: The first part of the pattern is a lead-in phase
that can last 1 month or longer and forms the basis from which
to draw the trendline. During this phase, prices advance in an
orderly manner and there is no excess speculation. The
trendline should be moderately steep. If it is too steep then the
ensuing bump is unlikely to be significant enough. If the
trendline is not steep enough, then the subsequent trendline
break will occur too late. Bulkowski advises that an angle of 30
to 45 degrees is preferable. The size of the angle will depend
on the scaling (semi-log or arithmetic) and the size of the
chart. It is probably easier to judge the soundness of the
trendline with a visual assessment.
2. Bump Phase: The bump forms with a sharp advance, and
prices move further away from the lead-in trendline. Ideally,
the angle of the trendline from the bump's advance should be
about 50% greater than the angle of the trendline extending up
from the lead-in phase. Roughly speaking, this would call for
an angle between 45 and 60 degrees. If it is not possible to
measure the angles, then a visual assessment will suffice.
3. Bump Validity: It is important that the bump represent a
speculative advance that cannot be sustained for a long time.
Bulkowski developed what he calls an "arbitrary" measuring
technique to validate the level of speculation in the bump. The
distance from the highest high of the bump to the lead-in
trendline should be at least twice the distance from the highest
high in the lead-in phase to the lead-in trendline. These
distances can be measured by drawing a vertical line from the
highest highs to the lead-in trendline. An example is provided
below.
4. Bump rollover: After speculation dies down, prices begin to
peak and a top forms. Sometimes a small double top or a
series of descending peaks forms. Prices begin to decline
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towards the lead-in trendline and the right side of the bump
forms.
5. Volume: As the stock advances during the lead-in phase,
volume is usually average and sometimes low. When the
speculative advance begins to form the left side of the bump,
volume expands as the advance accelerates.
6. Run Phase: The run phase begins when the pattern breaks
support from the lead-in trendline. Prices will sometimes
hesitate or bounce off the trendline before breaking through.
Once the break occurs, the run phase takes over and the
decline continues.
Support turns resistance
After the trendline is broken, there is sometimes a retracement that
tests the newfound resistancelevel. Potential support-turned-resistance
levels can also be identified from the reaction lows within the bump.
The Bump and Run Reversal pattern can be applied to daily, weekly or
monthly charts. As stated above, the pattern is designed to identify
speculative advances that are unsustainable for a long period.
Because prices rise very fast to form the left side of the bump, the
subsequent decline can be just as ferocious.
Level Three Communications (LVTL) formed a Bump and Run
Reversal pattern after prices advanced in a speculative frenzy at the
beginning of 2000. Prices advanced from 72 to 132 in 2 months and
this advance ultimately proved unsustainable.
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•
•
•
•
•
The lead-in phase formed over a 3-month period from early
Oct-99 to early Jan-00. Volume during this phase was
relatively subdued and actually declined during the November
and December advance.
The trendline extending up from the lead-in phase lows formed
a 34-degree angle. A visual assessment also reveals that this
trendline is neither too steep nor too flat.
The bump phase began in early January when the advance
accelerated with a large increase in volume. A conservatively
drawn trendline formed a 51-degree angle that was exactly
50% larger than the angle from the lead-in trendline.
The distance from the lead-in phase's highest high to the
trendline was 13. The distance from the Bump Phase's highest
high to the trendline was 38. This is almost three times larger
and validates the speculative excesses in the bump.
After reaching a high around 132, prices declined sharply and
bounced off the lead-in trendline. A lower high formed around
115 (red arrow) and the trendline was soon broken.
The decline continued after the trendline break and reached 67 before
a reaction rally began. The reaction rally advanced to around 95, but
fell just short of the horizontal support line before falling back to new
lows.
Reversal Chart Pattern: Double Top
The double top is a major reversal pattern that forms after an extended
uptrend. As its name implies, the pattern is made up of two
consecutive peaks that are roughly equal, with a moderate trough in
between.
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Although there can be variations, the classic double top marks at least
an intermediate change, if not long-term change, in trend from bullish
to bearish. Many potential double tops can form along the way up, but
until key support is broken, a reversal cannot be confirmed. To help
clarify, we will look at the key points in the formation and then walk
through an example.
1. Prior Trend: With any reversal pattern, there must be an
existing trend to reverse. In the case of the double top, a
significant uptrend of several months should be in place.
2. First Peak: The first peak should mark the highest point of the
current trend. As such, the first peak is fairly normal and the
uptrend is not in jeopardy (or in question) at this time.
3. Trough: After the first peak, a decline takes place that typically
ranges from 10 to 20%. Volume on the decline from the first
peak is usually inconsequential. The lows are sometimes
rounded or drawn out a bit, which can be a sign of tepid
demand.
4. Second peak: The advance off the lows usually occurs with
low volume and meets resistance from the previous high.
Resistance from the previous high should be expected. Even
after meeting resistance, only the possibility of a double top
exists. The pattern still needs to be confirmed. The time period
between peaks can vary from a few weeks to many months,
with the norm being 1-3 months. While exact peaks are
preferable, there is some leeway. Usually a peak within 3% of
the previous high is adequate.
5. Decline from peak: The subsequent decline from the second
peak should witness an expansion in volume and/or an
accelerated descent, perhaps marked with a gap or two. Such
a decline shows that the forces of demand are weaker than
supply and a support test is imminent.
6. Support break: Even after trading down to support, the
double top and trend reversal are still not complete. Breaking
support from the lowest point between the peaks completes
the double top. This too should occur with an increase in
volume and/or an accelerated descent.
7. Support turned resistance: Broken support becomes
potential resistance and there is sometimes a test of this
newfound resistance level with a reaction rally. Such a test can
offer a second chance to exit a position or initiate a short.
8. Price Target: The distance from support break to peak can be
subtracted from the support break for a price target. This
would infer that the bigger the formation is, the larger the
potential decline.
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While the double top formation may seem straightforward, technicians
should take proper steps to avoid deceptive double tops. The peaks
should be separated by about a month. If the peaks are too close, they
could just represent normal resistance rather than a lasting change in
the supply/demand picture. Ensure that the low between the peaks
declines at least 10%. Declines less than 10% may not be indicative of
a significant increase in selling pressure. After the decline, analyse the
trough for clues on the strength of demand. If the trough drags on a bit
and has trouble moving back up, demand could be drying up. When
the security does advance, look for a contraction in volume as a further
indication of weakening demand.
Perhaps the most important aspect of a double top is to avoid jumping
the gun. Wait for support to be broken in a convincing manner, and
usually with an expansion of volume. A price or time filter can be
applied to differentiate between valid and false support breaks. A price
filter might require a 3% support break before validation. A time filter
might require the support break to hold for 3 days before considering it
valid. The trend is in force until proven otherwise. This applies to the
double top as well. Until support is broken in a convincing manner, the
trend remains up.
The double top in Ford took about 5 months to form. Even after the
support break, there was another test of newfound resistance almost 4
months later.
1. From a low near 20 in Mar-97, Ford advanced to 66 1/2 by
Dec-98. The trendline extending up from Mar-97 is an internal
trendline and Ford held above it until the break in May-99.
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2. From the first peak, the stock declined around 17% to form the
trough.
3. After reaching a low near 56 1/2 in early Feb, the trough
formed over the next 2 months and there wasn't a rally until
early April. This long drawn out low suggested tepid demand.
4. The rally from 56 1/2 to 67.88 occurred on fairly good volume,
but money flows barely surpassed +10%. The high at 67 7/8
was about 2% higher than the previous high, but within the 3%
threshold. The distance between the two peaks was about 3
months.
5. The decline from 67 7/8 occurred with two gaps down and
increased volume. Furthermore, Chaikin Money Flow promptly
moved below -10%. The speed with which money flows
deteriorated indicated a serious increase in selling pressure.
6. In late May and early June, the stock traded for about 3 weeks
at support from the previous low. During this time, money
flows declined below -20%. Even though the situation looked
ominous, the double formation would not be complete until
support was broken.
Support was broken in early June when the stock fell below 53, which
was more than 3% below support at 56. After this sharp drop, there
was an equally sharp advance back above the newfound resistance
level. While a test of broken support can be expected, it is usually not
quite this early. The advance to 58 5/8 in late June may have triggered
some unpleasant short covering for those who jumped in on the first
support break. The stock fell to 46 1/4 and then began the retracement
advance that would ultimately test support.
On the second chart, 56 marked the support turned resistance level
and 57 marked a 50% retracement of the decline from 67 7/8 to 46 1/4.
Combined with the price action in early June and early July, a
resistance zone could probably be established between 56 and 57.
The stock subsequently formed a lower high at 55 in Jan-00 and
declined to around 40 by mid-March.
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Reversal Chart Pattern: Double Bottom
The double bottom is a major reversal pattern that forms after an
extended downtrend. As its name implies, the pattern is made up of
two consecutive troughs that are roughly equal, with a moderate peak
in between.
Although there can be variations, the classic double bottom usually
marks an intermediate or long-term change in trend. Many potential
double bottoms can form along the way down, but until key resistance
is broken, a reversal cannot be confirmed. To help clarify, we will look
at the key points in the formation and then walk through an example.
1. Prior Trend: With any reversal pattern, there must be an
existing trend to reverse. In the case of the double bottom, a
significant downtrend of several months should be in place.
2. First Trough: The first trough should mark the lowest point of
the current trend. As such, the first trough is fairly normal in
appearance and the downtrend remains firmly in place.
3. Peak: After the first trough, an advance takes place that
typically ranges from 10 to 20%. Volume on the advance from
the first trough is usually inconsequential, but an increase
could signal early accumulation. The high of the peak is
sometimes rounded or drawn out a bit from the hesitation to go
back down. This hesitation indicates that demand is
increasing, but still not strong enough for a breakout.
4. Second trough: The decline off the reaction high usually
occurs with low volume and meets support from the previous
low. Support from the previous low should be expected. Even
after establishing support, only the possibility of a double
bottom exists, it still needs to be confirmed. The time period
between troughs can vary from a few weeks to many months,
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5.
6.
7.
8.
9.
with the norm being 1-3 months. While exact troughs are
preferable, there is some room to manoeuvre and usually a
trough within 3% of the previous is considered valid.
Advance from trough: Volume is more important for the
double bottom than the double top. There should clear
evidence that volume and buying pressure are accelerating
during the advance off of the second trough. An accelerated
ascent, per
haps marked with a gap or two, also indicates a potential
change in sentiment.
Resistance break: Even after trading up to resistance, the
double top and trend reversal are still not complete. Breaking
resistance from the highest point between the troughs
completes the double bottom. This too should occur with an
increase in volume and/or an accelerated ascent.
Resistance turned support: Broken resistance becomes
potential support and there is sometimes a test of this
newfound support level with the first correction. Such a test
can offer a second chance to close a short position or initiate a
long.
Price Target: The distance from the resistance breakout to
trough lows can be added on top of the resistance break to
estimate a target. This would imply that the bigger the
formation is, the larger the potential advance.
It is important to remember that the double bottom is an intermediate
to long-term reversal pattern that will not form in a few days. Even
though formation in a few weeks is possible, it is preferable to have at
least 4 weeks between lows. Bottoms usually take longer than tops to
form and patience can often be a virtue. Give the pattern time to
develop and look for the proper clues. The advance off of the first
trough should be 10-20%. The second trough should form a low within
3% of the previous low and volume on the ensuing advance should
increase. Volume indicators such as Chaikin Money Flow, OBV and
Accumulation/Distribution can be used to look for signs of buying
pressure. Just as with the double top, it is paramount to wait for the
resistance breakout. The formation is not complete until the previous
reaction high is taken out.
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After trending lower for almost a year, PFE formed a double bottom
and broke resistance with an expansion in volume.
1. From a high near 50 in April-99, PFE declined to 30 in
November-99, which was a new 52-week low.
2. The stock advanced over 20% off of its low and formed a
reaction high around 37 1/2. Volume expanded and the 13-Jan
advance (green arrow) occurred on the highest volume since
5-Nov.
3. After a short pullback, there was another attempt to break
above resistance, but this failed. Even so, volume on
advancing days was generally higher than on declining days.
The ability of the stock to remain in the mid-thirties for an
extended period of time indicated some strengthening in
demand.
4. The decline from 37 1/2 back to 30 was sharp, but downside
volume did not expand materially. There were two days when
volume on a decline exceeded the 60-day SMA and Chaikin
Money Flow dipped near -10% twice. However, money flows
indicated accumulation throughout the decline by remaining
mostly above zero with periodic movements above +10%.
5. The second trough formed with a low exactly equal to the
previous low (30) and a little over 2 months separated the
lows.
6. The advance off of the second low witnessed an accelerated
move with an expansion of volume. After the second low at 30,
5 of the next 6 advancing days saw volume well above the 60day SMA. Chaikin Money Flow, which never really weakened,
moved above +20% within 6 days of the low.
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Resistance at 37 1/2 was broken with a gap up on the open and
another volume expansion. After running from 30 to 40 in a few weeks,
the stock pulled back to the resistance break at 37 1/2, which now
turned into support. There was a brief chance to get in on the pullback
and the stock quickly advanced past 45.
Reversal Chart Pattern: Head and Shoulders Top
A head and shoulders reversal pattern forms after an uptrend, and its
completion marks a trend reversal. The pattern contains three
successive peaks with the middle peak (head) being the highest and
the two outside peaks (shoulders) being low and roughly equal. The
reaction lows of each peak can be connected to form support, or a
neckline.
As its name implies, the head and shoulders reversal pattern is made
up of a left shoulder, head, right shoulder and neckline. Other parts
playing a role in the pattern are volume, the breakout, price target and
support turned resistance. We will look at each part individually and
then put them together with some examples.
1. Prior Trend: It is important to establish the existence of a prior
uptrend for this to be a reversal pattern. Without a prior
uptrend to reverse, there cannot be a head and shoulders
reversal pattern, or any reversal pattern for that matter.
2. Left Shoulder: While in an uptrend, the left shoulder forms a
peak that marks the high point of the current trend. After
making this peak, a decline ensues to complete the formation
of the shoulder (1). The low of the decline usually remains
above the trendline, keeping the uptrend intact.
3. Head: From the low of the left shoulder, an advance begins
that exceeds the previous high and marks the top of the head.
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After peaking, the low of the subsequent decline marks the
second point of the neckline (2). The low of the decline usually
breaks the uptrend line, putting the uptrend in jeopardy.
4. Right Shoulder: The advance from the low of the head forms
the right shoulder. This peak is lower than the head (a lower
high) and usually in line with the high of the left shoulder.
While symmetry is preferred, sometimes the shoulders can be
out of whack. The decline from the peak of the right shoulder
should break the neckline.
5. Neckline: The neckline forms by connecting low points 1 and
2. Low point 1 marks the end of the left shoulder and the
beginning of the head. Low point 2 marks the end of the head
and the beginning of the right shoulder. Depending on the
relationship between the two low points, the neckline can
slope up, slope down or be horizontal. The slope of the
neckline will affect the pattern's degree of bearishness: a
downward slope is more bearish than an upward slope.
Sometimes more than one low point can be used to form the
neckline.
6. Volume: As the head and shoulders pattern unfolds, volume
plays an important role in confirmation. Volume can be
measured as an indicator (OBV, Chaikin Money Flow) or
simply by analysing volume levels. Ideally, but not always,
volume during the advance of the left shoulder should be
higher than during the advance of the head. This decrease in
volume along with new highs that form the head serve as a
warning sign. The next warning sign comes when volume
increases on the decline from the peak of the head. Final
confirmation comes when volume further increases during the
decline of the right shoulder.
7. Neckline Break: The head and shoulders pattern is not
complete and uptrend is not reversed until neckline support is
broken. Ideally, this should also occur in a convincing manner
with an expansion in volume.
8. Support turned resistance: Once support is broken, it is
common for this same support level to turn into resistance.
Sometimes, but certainly not always, the price will return to the
support break and offer a second chance to sell.
9. Price Target: After breaking neckline support, the projected
price decline is found by measuring the distance from the
neckline to the top of the head. This distance is then
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subtracted from the neckline to reach a price target. Any price
target should serve as a rough guide and other factors should
be considered as well. These factors might include previous
support levels, Fibonacci retracements or long-term
movingaverages.
Xircom (XIRC) formed a head and shoulders reversal with an upward
sloping neckline. This is not the most symmetrical of patterns, but the
neckline is well marked. Key points include:
1. The low at 46 1/4 marked the end of the left shoulder and the
beginning of the head (1).
2. During the advance to 72 5/8, volume soared. However, during
the second advance to 75 15/16, volume tapered off
significantly.
3. When the decline from 75 15/16 began, volume accelerated
(note red line on volume bars).
4. The decline from 75 15/16 to 48 1/2 broke the trendline
extending up from Apr-99 and formed the second low point (2).
5. During the decline of the right shoulder and neckline break,
volume expanded (red oval) and Chaikin Money Flow turned
negative.
6. After the initial decline, there was a return to the neckline
break (black arrow). Even during this decline, Chaikin Money
Flow remained negative. The subsequent decline took the
stock below 30.
The measurement from neckline to the top of the head was 27. With
the neckline break at 50, this would imply a move to around 23. The
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April low was 29 1/8. After a decline from 75 15/16, at least a reaction
rally can be expected.
DLJ formed a head and shoulders reversal with a horizontal neckline.
Again, it isn't the prettiest head and shoulders pattern, but neckline
support is well established. Key points include:
1. The low at 60 1/2 marked the end of the left shoulder and the
beginning of the head (1).
2. During the advance to 100 3/4, volume soared.
3. When the decline from 100 3/4 began, volume exceeded the
levels witnessed in the previous advance and Chaikin Money
Flow turned negative almost immediately.
4. The decline from 100 3/4 broke the trendline extending up
from Oct-98 and the ensuing low formed the second point of
the neckline (2).
5. Volume increased during the decline and Chaikin Money Flow
dipped below -30%, indicating serious selling pressure.
6. During the advance of the right shoulder, volume was fairly
heavy, but Chaikin Money Flow remained at level indicating
continued distribution.
7. The high of the right shoulder was just short of the previous
reaction high in late April. The decline after this lower high saw
an increase in volume as neckline support was broken.
8. The stock returned to the scene of the crime with an advance
to 61 in early July. The newfound resistance level was never
broken and the stock gapped down on heavy volume (red
arrows) to start the decline below 40.
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The head and shoulders pattern is one of the most common reversal
formations. It is important to remember that it occurs after an uptrend
and usually marks a major trend reversal when complete. While it is
preferable that the left and right shoulders be symmetrical, it is not an
absolute requirement. They can be different widths as well as different
heights. Identification of neckline support and volume confirmation on
the break can be the most critical factors. The support break indicates
a new willingness to sell at lower prices. Lower prices combined with
an increase in volume indicate an increase in supply. The combination
can be lethal and sometimes there is no second chance return to the
support break. Measuring the expected length of the decline after the
breakout can be helpful, but don't count on it for your ultimate target.
As the pattern unfolds over time, other aspects of the technical picture
are likely to take precedence.
Reversal Chart Pattern: Head and Shoulders Bottom
The head and shoulders bottom is sometimes referred to as an inverse
head and shoulders. The pattern shares many common characteristics
with its comparable partner, but relies more on volume patterns for
confirmation.
As a major reversal pattern, the head and shoulders bottom forms after
a downtrend, and its completion marks a change in trend. The pattern
contains three successive troughs with the middle trough (head) being
the deepest and the two outside troughs (shoulders) being shallower.
Ideally, the two shoulders would be equal in height and width. The
reaction highs in the middle of the pattern can be connected to form
resistance, or a neckline.
The price action forming both head and shoulders top and head and
shoulders bottom patterns remains roughly the same, but reversed.
The role of volume marks the biggest difference between the two.
Generally speaking, volume plays a larger role in bottom formations
than top formations. While an increase in volume on the neckline
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breakout for a head and shoulders top is welcomed, it is absolutely
required for a bottom. We will look at each part of the pattern
individually, keeping volume in mind, and then put the parts together
with some examples.
1. Prior Trend: It is important to establish the existence of a prior
downtrend for this to be a reversal pattern. Without a prior
downtrend to reverse, there cannot be a head and shoulders
bottom formation.
2. Left Shoulder: While in a downtrend, the left shoulder forms a
trough that marks a new reaction low in the current trend. After
forming this trough, an advance ensues to complete the
formation of the left shoulder (1). The high of the decline
usually remains below any longer trendline, thus keeping the
downtrend intact.
3. Head: From the high of the left shoulder, a decline begins that
exceeds the previous low and forms the low point of the head.
After making a bottom, the high of the subsequent advance
forms the second point of the neckline (2). The high of the
advance sometimes breaks a downtrend line, which calls into
question the robustness of the downtrend.
4. Right Shoulder: The decline from the high of the head
(neckline) begins to form the right shoulder. This low is always
higher than the head and usually in line with the low of the left
shoulder. While symmetry is preferred, sometimes the
shoulders can be out of whack and the right shoulder will be
higher, lower, wider or narrower. When the advance from the
low of the right shoulder breaks the neckline, the head and
shoulders reversal is complete.
5. Neckline: The neckline forms by connecting reaction highs 1
and 2. Reaction high 1 marks the end of the left shoulder and
the beginning of the head. Reaction high 2 marks the end of
the head and the beginning of the right shoulder. Depending
on the relationship between the two reaction highs, the
neckline can slope up, slope down or be horizontal. The slope
of the neckline will affect the pattern's degree of bullishness:
an upward slope is more bullish than downward slope.
6. Volume: While volume plays an important role in the head and
shoulders top, it plays a crucial role in the head and shoulders
bottom. Without the proper expansion of volume, the validity of
any breakout becomes suspect. Volume can be measured as
an indicator (OBV, Chaikin Money Flow) or simply by
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analysing the absolute levels associated with each peak and
trough.
Volume levels during the first half of the pattern are less
important that in the second half. Volume on the decline of the
left shoulder is usually pretty heavy and selling pressure quite
intense. The intensity of selling can even continue during the
decline that forms the low of the head. After this low,
subsequent volume patterns should be watched carefully to
look for expansion during the advances.
The advance from the low of the head should show and
increase in volume and/or better indicator readings (e.g. CMF
> 0 or strength in OBV). After the reaction high forms the
second neckline point, the right shoulder's decline should be
accompanied with light volume. It is normal to experience
profit-taking after an advance. Volume analysis helps
distinguish between normal profit taking and heavy selling
pressure. With light volume on the pullback, indicators like
CMF and OBV should remain strong. The most important
moment for volume occurs on the advance from the low of the
right shoulder. For a breakout to be considered valid, there
needs to be an expansion of volume on the advance and
during the breakout.
7. Neckline Break: The head and shoulders pattern is not
complete and the downtrend is not reversed until neckline
resistance is broken. For a head and shoulders bottom, this
must occur in a convincing manner with an expansion of
volume.
8. Resistance turned support: Once resistance is broken, it is
common for this same resistance level to turn into support.
Often, the price will return to the resistance break and offer a
second chance to buy.
9. Price Target: After breaking neckline resistance, the projected
advance is found by measuring the distance from the neckline
to the bottom of the head. This distance is then added to the
neckline to reach a price target. Any price target should serve
as a rough guide and other factors should be considered as
well. These factors might include previous resistance levels,
Fibonacci retracements or long-term moving averages.
Alaska Air (ALK) formed a head and shoulders bottom with a
downward sloping neckline. Key points include:
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1. The stock began a downtrend in early July and declined from
60 to 26.
2. The low of the left shoulder formed with a large spike in
volume on a sharp down day (red arrows).
3. The reaction rally at around 42 1/2 formed the first point of the
neckline (1). Volume on the advance was respectable with
many grey bars exceeding the 60-day SMA. (Note: grey bars
denote advancing days, black bars declining days and the thin
red horizontal is the 60-day SMA).
4. The decline from 42 1/2 to 26 (head) was quite dramatic, but
volume did not get out of hand. Chaikin Money Flow was
mostly positive when the lows around 26 were forming.
5. The advance off of the low saw a large expansion of volume
(green oval) and gap up. The strength behind the move
indicated that a significant low formed.
6. After the reaction high around 39, the second point of the
neckline could be drawn (2).
7. The decline from 39 to 33 occurred on light volume until the
final two days, when volume reached its highest point in a
month. Even though there are two long black (down) volume
bars, these are surrounded by above-average grey (up)
volume bars. Also notice how trendline resistance near 35
became support around 33 on the price chart.
8. The advance off of the low of the right shoulder occurred with
above average volume. Chaikin Money Flow was at its highest
levels and surpassed +20% shortly after neckline resistance
was broken.
9. After breaking neckline resistance, the stock returned to this
newfound support with a successful test around 35 (green
arrow).
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AT&T (T) formed a head and shoulders bottom with a flat neckline.
The shoulders are a bit shallow, but the neckline and head are well
pronounced. Key points include:
1. The stock established a 6-month downtrend with the trendline
extending down from Mar-98.
2. After a head fake above the trendline in late June, the stock
fell from 43 11/16 to 34 11/16 with a sharp increase in volume
to form the left shoulder.
3. The rally to 40 13/16 met resistance from the trendline and the
reaction high became the first point of the neckline.
4. The decline from 40 13/16 to 33 7/16 finished with a piercing
pattern to form the low of the head. Even though volume was
heavy when the long black candlestick formed, the subsequent
reversal occurred on even higher volume. This reversal was
followed with a number of strong advances and up gaps. Also
notice that Chaikin Money Flow was above +10% when the
low of the head formed.
5. The advance from the low of the head broke above the
trendline extending down from Mar-98 and met resistance
around 41. This reaction high formed the second point of the
neckline.
6. The right shoulder was quite short and shallow. The low was
recorded at 37 7/16 and Chaikin Money Flow remained above
+10% the whole time. Support was found from the trendline
that offered resistance a few weeks earlier.
7. The stock advanced sharply off of lows that formed the right
shoulder and volume increased three straight days (blue
arrow). This is a bit early, but volume remained just above
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average for the neckline breakout a few days later. Also
Chaikin Money Flow remained above +10% the whole time.
8. After the break of neckline resistance, the stock tested this
newfound support twice while consolidating recent gains. The
power arrived a few weeks later with a strong move off support
and a huge increase in volume. The stock subsequently
advanced from the low forties to the low sixties.
Head and shoulder bottoms are one of the most common and reliable
reversal formations. It is important to remember that they occur after a
downtrend and usually mark a major trend reversal when complete.
While it is preferable that the left and right shoulders be symmetrical, it
is not an absolute requirement. Shoulders can be different widths as
well as different heights. Keep in mind that technical analysis is more
an art than a science. If you are looking for the perfect pattern, it may
be a long time coming.
Analysis of the head and shoulders bottom should focus on correct
identification of neckline resistance and volume patterns. These are
two of the most important aspects to a successful read, and by
extension a successful trade. The neckline resistance breakout
combined with an increase in volume indicates an increase in demand
at higher prices. Buyers are exerting greater force and the price is
being affected.
As seen from the examples, traders do not always have to chase a
stock after the neckline breakout. Many times, but certainly not always,
the price will return to this new support level and offer a second
chance to buy. Measuring the expected length of the advance after the
breakout can be helpful, but don't count on it for your ultimate target.
As the pattern unfolds over time, other aspects of the technical picture
are likely to take precedent. Technical analysis is dynamic and your
analysis should incorporate aspects of the long, medium and shortterm picture.
Reversal Chart Pattern: Falling Wedge
The falling wedge is a bullish pattern that begins wide at the top and
contracts as prices move lower. This price action forms a cone that
slopes down as the reaction highs and reaction lows converge. In
contrast to symmetrical triangles, which have no definitive slope and
no bias, falling wedges definitely slope down and have a bullish bias.
However, this bullish bias cannot be realized until a resistance
breakout.
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The falling wedge can also fit into the continuation category. As a
continuation pattern, the falling wedge will still slope down, but the
slope will be against the prevailing uptrend. As a reversal pattern, the
falling wedge slopes down and with the prevailing trend. Regardless of
the type (reversal or continuation), falling wedges are regarded as
bullish patterns.
1. Prior Trend: To qualify as a reversal pattern, there must be a
prior trend to reverse. Ideally, the falling wedge will form after
an extended downtrend and mark the final low. The pattern
usually forms over a 3-6 month period and the preceding
downtrend should be at least 3 months old.
2. Upper resistance line: It takes at least two reaction highs to
form the upper resistance line, ideally three. Each reaction
high should be lower than the previous highs.
3. Lower support line: At least two reaction lows are required to
form the lower support line. Each reaction low should be lower
than the previous lows.
4. Contraction: The upper resistance line and lower support line
converge to form a cone as the pattern matures. The reaction
lows still penetrate the previous lows, but this penetration
becomes shallower. Shallower lows indicate a decrease in
selling pressure and create a lower support line with less
negative slope than the upper resistance line.
5. Resistance Break: Bullish confirmation of the pattern does
not come until the resistance line is broken in convincing
fashion. It is sometimes prudent to wait for a break above the
previous reaction high for further confirmation. Once
resistance is broken, there can sometimes be a correction to
test the newfound support level.
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6. Volume: While volume is not particularly important on rising
wedges, it is an essential ingredient to confirm a falling wedge
breakout. Without an expansion of volume, the breakout will
lack conviction and be vulnerable to failure.
As with the rising wedge, the falling wedge can be one of the most
difficult chart patterns to accurately recognize and trade. When lower
highs and lower lows form, as in a falling wedge, a security remains in
a downtrend. The falling wedge is designed to spot a decrease in
downside momentum and alert technicians to a potential trend
reversal. Even though selling pressure may be diminishing, demand
does not win out until resistance is broken. As with most patterns, it is
important to wait for a breakout and combine other aspects of technical
analysis to confirm signals.
FCX provides a textbook example of a falling wedge at the end of a
long downtrend.
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Prior Trend: The downtrend for FCX began in the third quarter
of 1997. There was a brief advance in Mar-98, but the
downtrend resumed and the stock was trading at new lows by
Feb-99.
Upper resistance line: The upper resistance line formed with
four successively lower peaks.
Lower support line: The lower support line formed with four
successive lower lows.
Contraction: The upper resistance line and lower support line
converged as the pattern matured. Even though each low is
lower than the previous low, these lows are only slightly lower.
The shallowness of the new lows indicates that demand is
stepping almost immediately after a new low is recorded. The
supply overhang remains, but slope of the upper resistance
line is more negative than the lower support line.
Resistance break: In contrast to the three previous lows, the
late February low was flat and consolidated just above 9 for a
few weeks. The subsequent breakout in March occurred with a
series of strong advances. In addition, there was a positive
divergence in the PPO.
Volume: After the large volume decline on 24-Feb (red arrow),
upside volume began to increase. Above-average volume
continued on advancing days and when the stock broke
trendline resistance. Money flows confirmed the strength by
surpassing their Nov-98 high and moving to their highest level
since Apr-98.
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After the trendline breakout, there was a brief pullback to support from
the trendline extension. The stock consolidated for a few weeks and
then advanced further on increased volume again
Reversal Chart Pattern: Rising Wedge
The rising wedge is a bearish pattern that begins wide at the bottom
and contracts as prices move higher and the trading range narrows. In
contrast to symmetrical triangles, which have no definitive slope and
no bullish or bearish bias, rising wedges definitely slope up and have a
bearish bias.
Even though this article will focus on the rising wedge as a reversal
pattern, the pattern can also fit into the continuation category. As a
continuation pattern, the rising wedge will still slope up, but the slope
will be against the prevailing downtrend. As a reversal pattern, the
rising wedge will slope up and with the prevailing trend. Regardless of
the type (reversal or continuation), rising wedges are bearish.
1. Prior Trend: In order to qualify as a reversal pattern, there
must be a prior trend to reverse. The rising wedge usually
forms over a 3-6 month period and can mark an intermediate
or long-term trend reversal. Sometimes the current trend is
totally contained within the rising wedge; other times the
pattern will form after an extended advance.
2. Upper resistance line: It takes at least two reaction highs to
form the upper resistance line, ideally three. Each reaction
high should be higher than the previous high.
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3. Lower support line: At least two reaction lows are required to
form the lower support> line. Each reaction low should be
higher than the previous low.
4. Contraction: The upper resistance line and lower support line
converge as the pattern matures. The advances from the
reaction lows (lower support line) become shorter and shorter,
which makes the rallies unconvincing. This creates an upper
resistance line that fails to keep pace with the slope of the
lower support line and indicates a supply overhang as prices
increase.
5. Support break: Bearish confirmation of the pattern does not
come until the support line is broken in a convincing fashion. It
is sometimes prudent to wait for a break of the previous
reaction low. Once support is broken, there can sometimes be
a reaction rally to test the newfound resistance level.
6. Volume: Ideally, volume will decline as prices rise and the
wedge evolves. An expansion of volume on the support line
break can taken as bearish confirmation.
The rising wedge can be one of the most difficult chart patterns to
accurately recognize and trade. While it is a consolidation formation,
the loss of upside momentum on each successive high gives the
pattern its bearish bias. However, the series of higher highs and higher
lows keeps the trend inherently bullish. The final break of support
indicates that the forces of supply have finally won out and lower
prices are likely. There are no measuring techniques to estimate the
decline -- other aspects of technical analysis should be employed to
forecast price targets.
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ANN provides a good example of the rising wedge as a reversal
pattern that forms in the face of weakening momentum and money
flow.
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Prior Trend: From a low around 20 in Oct-98, ANN surpassed
50 in less than 7 months. The final leg up was a sharp
advance from below 35 in Feb to 53.06 in mid-April.
Upper resistance line: The upper resistance line formed with
three successively higher peaks.
Lower support line: The lower support line formed with three
successive higher lows.
Contraction: The upper resistance line and lower support line
converged as the pattern matured. A visual assessment
confirms that the slope of the lower support line is steeper than
that of the upper resistance line. Less slope in the upper
resistance line indicates that momentum is waning as the
stock makes new highs.
Support break: The stock hugged the support line for over a
week before finally breaking with a sharp decline. The
previous reaction low was broken a few days later with long
black candlestick (red arrow).
Volume: Chaikin Money Flow turned negative in late April and
was well below -10% when the support line was broken. There
was an expansion of volume when the previous reaction low
was broken.
Support from the April reaction low around 46 turned into
resistance and the stock tested this level in early July before
declining further.
Reversal Chart Pattern: Rounding Bottom
The rounding bottom is a long-term reversal pattern that is best suited
for weekly charts. It is also referred to as a saucer bottom, and
represents a long consolidation period that turns from a bearish bias to
a bullish bias.
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1. Prior Trend: In order to be a reversal pattern, there must be a
prior trend to reverse. Ideally, the low of a rounding bottom will
mark a new low or reaction low. In practice, there are
occasions when the low is recorded many months earlier and
the security trades flat before forming the pattern. When the
rounding bottom does finally form, its low may not be the
lowest low of the last few months.
2. Decline: The first portion of the rounding bottom is the decline
that leads to the low of the pattern. This decline can take on
different forms: some are quite jagged with a number of
reaction highs and lows, while others trade lower in a more
linear fashion.
3. Low: The low of the rounding bottom can resemble a "V'
bottom, but should not be too sharp and should take a few
weeks to form. Because prices are in a long-term decline, the
possibility of a selling climax exists that could create a lower
spike.
4. Advance: The advance off of the lows forms the right half of
the pattern and should take about the same amount of time as
the prior decline. If the advance is too sharp, then the validity
of a rounding bottom may be in question.
5. Breakout: Bullish confirmation comes when the pattern breaks
above the reaction high that marked the beginning of the
decline at the start of the pattern. As with most resistance
breakouts, this level can become support. However, rounding
bottoms represent long-term reversal and this new support
level may not be that significant.
6. Volume: In an ideal pattern, volume levels will track the shape
of the rounding bottom: high at the beginning of the decline,
low at the end of the decline and rising during the advance.
Volume levels are not too important on the decline, but there
should be an increase in volume on the advance and
preferably on the breakout.
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A rounding bottom could be thought of as a head and shoulders
bottom without readily identifiable shoulders. The head represents the
low and is fairly central to the pattern. The volume patterns are similar
and confirmation comes with a resistance breakout. While symmetry is
preferable on the rounding bottom, the left and right side do not have
to be equal in time or slope. The important thing is to capture the
essence of the pattern.
AMGN provides an example of a rounding bottom that formed after a
long consolidation period. Throughout 1996, the stock traded in a tight
range bound by 16.63 and 12.83. The trading range continued the first
half of 1997 and the stock broke support by falling to a low of 12 in
August.
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Prior Trend: With the break of support at 12.83, it appeared
that a downtrend had begun. Even though the decline was not
that sharp, the new reaction low represented a 52-week low.
AMGN was clearly not in an uptrend.
Decline: The stock declined from 17 to a low of 11.22 and a
pair of hammers formed in Oct-98 to mark the end of the
decline (red arrow).
Low: Prior to the hammers, the stock traded around 12 for the
previous 6 weeks. When the gap up with high volume followed
the hammers, it appeared that a low had been formed. After a
short rally, there was another test of the low and a higher low
formed at 11.66.
Advance: From the second low at 11.66, the advance began
in earnest and volume started to increase. In March, there was
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a large advance with the highest volume in 4 months (green
arrow).
May-97 resistance at 17 represented the confirmation line for
the pattern. The stock broke resistance in Jul-98 with a further
expansion of volume. This breakout was also confirmed with a
new high in OBV.
After breaking resistance, there was a test of support and the stock
actually fell back below 17. The stock had advanced from 11.66 to
19.84 in 6 months and some sort of pullback could have been
expected.
Reversal Chart Pattern: Triple Top
The triple top is a reversal pattern made up of three equal highs
followed by a break below support. In contrast to the triple bottom,
triple tops usually form over a shorter time frame and typically range
from 3 to 6 months. Generally speaking, bottoms take longer to form
than tops. We will first examine the individual parts of the pattern and
then look at an example.
1. Prior Trend: With any reversal pattern, there should be an
existing trend to reverse. In the case of the triple top, an
uptrend or long trading range should be in place. Sometimes
there will be a definitive uptrend to reverse. Other times the
uptrend will fade and become many months of sideways
trading.
2. Three Highs: All three highs should be reasonable equal, well
spaced and mark significant turning points. The highs do not
have to be exactly equal, but should be reasonably equivalent
to each other.
3. Volume: As the triple top develops, overall volume levels
usually decline. Volume sometimes increases near the highs.
After the third high, an expansion of volume on the subsequent
decline and at the support break greatly reinforces the
soundness of the pattern.
4. Support break: As with many other reversal patterns, the
triple top is not complete until a support break. The lowest
point of the formation, which would be the lowest of the
intermittent lows, marks this key support level.
5. Support turns resistance: Broken support becomes potential
resistance, and there is sometimes a test of this newfound
resistance level with a subsequent reaction rally.
6. Price Target: The distance from the support break to highs
can be measured and subtracted from the support break for a
price target. The longer the pattern develops, the more
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significant is the ultimate break. Triple tops that are 6 or more
months old represent major tops and a price target is less
likely to be effective.
Throughout the development of the triple top, it can start to resemble a
number of patterns. Before the third high forms, the pattern may look
like a double top. Three equal highs can also be found in an ascending
triangle or rectangle. Of these patterns mentioned, only the ascending
triangle has bullish overtones; the others are neutral until a break
occurs. In this same vein, the triple top should also be treated as a
neutral pattern until a breakout occurs. The inability to break above
resistance is bearish, but the bears have not won the battle until
support is broken. Volume on the last decline off resistance can
sometimes yield a clue. If there is a sharp increase in volume and
momentum, then the chances of a support break increase.
When looking for patterns, it is important to keep in mind that technical
analysis is more art and less science. Pattern interpretations should be
fairly specific, but not overly exacting as to obstruct the spirit of the
pattern. A pattern may not fit the description to the letter, but that
should not detract from its robustness. For example: it can be difficult
to find a triple top with three highs that are exactly equal. However, if
the highs are within reasonable proximity and other aspects of the
technical analysis picture jibe, it would embody the spirit of a triple top.
The spirit is three attempts at resistance, followed by a breakdown
below support, with volume confirmation. ROK illustrates an example
of a triple top that does not fit exactly, but captures the spirit of the
pattern.
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The stock was in an uptrend and remained above the trendline
extending up from Oct-98 until the break in late August 1999.
Over a period of about 4 months, the stock bounced off
resistance around 64. The first attempt happened in May, the
second in July and the third in August. The third attempt was
the most feeble and fell short of the resistance line by 1.19
points or about 1.8%.
The decline from the third high broke trendline support and the
stock continued to fall past support from the previous lows.
Triple top support should be drawn from the lowest low of the
pattern, which would be the May low around 54.50.
Volume expanded after the stock broke trendline support. The
stock paused for a few days when support at 54.50 was
reached, but volume accelerated when this support level was
broken (grey dotted line). In addition, Chaikin Money Flow
turned negative and broke below -10%.
After the support break, there was a test of the newfound
resistance a few weeks later. Money flows continued to
indicate selling pressure and volume expanded when the stock
began to fall again.
The projected decline was 9 points and the stock reached this target
soon after the resistance test.
Reversal Chart Pattern: Triple Bottom
The triple bottom is a reversal pattern made up of three equal lows
followed by a breakout above resistance. While this pattern can form
over just a few months, it is usually a long-term pattern that covers
many months. Because of its long-term nature, weekly charts can be
best suited for analysis. We will first examine the individual parts of the
pattern and then look at an example
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1. Prior Trend: With any reversal pattern, there should be an
existing trend to reverse. In the case of the triple bottom, a
downtrend or long trading range should be in place.
Sometimes there will be a definitive downtrend to reverse.
Other times the downtrend will fade away after many months
of sideways trading.
2. Three lows: All three lows should be reasonable equal, well
spaced and mark significant turning points. The lows do not
have to be exactly equal, but should be reasonably equivalent.
3. Volume: As the triple bottom develops, overall volume levels
usually decline. Volume sometimes increases near the lows.
After the third low, an expansion of volume on the advance
and at the resistance breakout greatly reinforces the
soundness of the pattern.
4. Resistance break: As with many other reversal patterns, the
triple bottom is not complete until a resistance breakout. The
highest point of the formation, which would be the highest of
the intermittent highs, marks resistance.
5. Resistance turns support: Broken resistance becomes
potential support, and there is sometimes a test of this
newfound support level with the first correction. Because the
triple bottom is a long-term pattern, the test of newfound
support may occur many months later.
6. Price Target: The distance from the resistance breakout to
lows can be measured and added to the resistance break for a
price target. The longer the pattern develops, the more
significant is the ultimate breakout. Triple bottoms that are 6 or
more months in duration represent major bottoms and a price
target is less likely to be effective.
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As the triple bottom develops, it can start to resemble a number of
patterns. Before the third low forms, the pattern may look like a double
bottom. Three equal lows can also be found in a descending triangle or
rectangle. Of these patterns mentioned, only the descending triangle
has bearish overtones; the others are neutral until a breakout occurs.
Similarly, the triple bottom should also be treated as a neutral pattern
until a breakout occurs. The ability to hold support is bullish, but
demand has not won the battle until resistance is broken. Volume on
the last advance can sometimes yield a clue. If there is a sharp
increase in volume and momentum, then the chances of a breakout
increase.
After a failed double bottom breakout, ANDW formed a large triple
bottom. While the new reaction high (black arrow) and potential double
bottom breakout seemed bullish, the stock subsequently fell back to
support.
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Technically, the downtrend ended when the stock formed a
higher low in Mar-99 and surpassed its Jan-99 high by closing
above 20 in Jul-99 (black arrow). Even though the downtrend
ended, it would have been difficult to label the trend bullish
after the third test of support around 11.
Over a 13-month timeframe, three relatively equal lows formed
in Oct-98, Mar-99 and Nov-99. When the Jul-00 high
surpassed the Jan-99 high, the possibility of a rectangle
pattern was ruled out.
Resistance at 22 1/2 was broken in Jan-00. The stock closed
above this key level for 5 consecutive weeks to confirm the
breakout.
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Even though volume expanded near the second and third
lows, the 10-day EMA of volume declined between the lows.
The advance off the third low saw a dramatic expansion of
volume that lasted many weeks. The Accumulation/Distribution
Line formed a positive divergence in 1999 and broke to new
highs with the stock in Jan-00.
After the resistance break, the stock fell below 22 1/2 twice
over the next 2 months. Based on the Feb-00 and Apr-00
lows, a new support level was established at 20 and. Because
upside movement was limited after the breakout (a high of 25
1/2), a pullback below 22 1/2 might have been expected.
Based on Oct-99 resistance, critical support could have been
marked at 18 1/2.
ANDW built a base over a 13-month period. Even though the height of
the pattern is relatively impressive, it pales in comparison to the length
of the base. The length of this pattern and subsequent breakout
suggest a long-term change of sentiment.
Continuation Chart Pattern: Cup with Handle
The Cup with Handle is a bullish continuation pattern that marks a
consolidation period followed by a breakout. It was developed by
William O'Neil and introduced in his 1988 book, How to Make Money in
Stocks.
As its name implies, there are two parts to the pattern: the cup and the
handle. The cup forms after an advance and looks like a bowl or
rounding bottom. As the cup is completed, a trading range develops on
the right hand side and the handle is formed. A subsequent breakout
from the handles trading range signals a continuation of the prior
advance.
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1. Trend: To qualify as a continuation pattern, a prior trend
should exist. Ideally, the trend should be a few months old and
not too mature. The more mature the trend, the less chance
that the pattern marks a continuation or the less upside
potential.
2. Cup: The cup should be "U" shaped and resemble a bowl or
rounding bottom. A "V" shaped bottom would be considered
too sharp of a reversal to qualify. The softer "U" shape ensures
that the cup is a consolidation pattern with valid support at the
bottom of the "U". The perfect pattern would have equal highs
on both sides of the cup, but this is not always the case.
3. Cup Depth: Ideally, the depth of the cup should retrace 1/3 or
less of the previous advance. However, with volatile markets
and over-reactions, the retracement could range from 1/3 to
1/2. In extreme situations, the maximum retracement could be
2/3, which conforms to Dow theory.
4. Handle: After the high forms on the right side of the cup, there
is a pullback that forms the handle. Sometimes this handle
resembles a flag or pennant that slopes downward, other
times just a short pullback. The handle represents the final
consolidation/pullback before the big breakout and can retrace
up to 1/3 of the cup's advance, but usually not more. The
smaller the retracement is, the more bullish the formation and
significant the breakout. Sometimes it is prudent to wait for a
break above the resistance line established by the highs of the
cup.
5. Duration: The cup can extend from 1 to 6 months, sometimes
longer on weekly charts. The handle can be from 1 week to
many weeks and ideally completes within 1-4 weeks.
6. Volume: There should be a substantial increase in volume on
the breakout above the handle's resistance.
7. Target: The projected advance after breakout can be
estimated by measuring the distance from the right peak of the
cup to the bottom of the cup.
As with most chart patterns, it is more important to capture the
essence of the pattern than the particulars. The cup is a bowl-shaped
consolidation and the handle is a short pullback followed by a breakout
with expanding volume. A cup retracement of 62% may not fit the
pattern requirements, but a particular stock's pattern may still capture
the essence of the Cup with Handle.
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Trend: EMC established the bull trend by advancing from 10
and change to above 30 in about 5 months. The stock peaked
in March and then began to pull back and consolidate its large
gains.
Cup: The April decline was quite sharp, but the lows extended
over a two-month period to form the bowl that marked a
consolidation period. Also note that support was found from
the Feb-99 lows.
Cup Depth: The low of the cup retraced 42% of the previous
advance. After an advance in June and July, the stock peaked
at 32.69 to complete the cup (red arrow).
Handle: Another consolidation period began in July to start the
handle formation. There was a sharp decline in August that
caused the handle to retrace more than 1/3 of the cup's
advance. However, there was a quick recovery and the stock
traded back up within the normal handle boundaries within a
week. I believe the essence of the formation remained valid
after this sharp decline.
Duration: The cup extended for about 3 months and the
handle for about 1 1/2 months.
Volume: In early Sept-00, the stock broke handle resistance
with a gap up and volume expansion (green arrow). In
addition, Chaikin Money Flow soared above +20%.
Target: The projected advance after breakout was estimated
at 9 points from the breakout around 32. EMC easily fulfilled
this target over the next few months.
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Continuation Chart Pattern: Flag, Pennant
Flags and Pennants are short-term continuation patterns that mark a
small consolidation before the previous move resumes. These patterns
are usually preceded by a sharp advance or decline with heavy
volume, and mark a mid-point of the move.
1. Sharp Move: To be considered a continuation pattern, there
should be evidence of a prior trend. Flags and pennants
require evidence of a sharp advance or decline on heavy
volume. These moves usually occur on heavy volume and can
contain gaps. This move usually represents the first leg of a
significant advance or decline and the flag/pennant is merely a
pause.
2. Flagpole: The flagpole is the distance from the first resistance
or support break to the high or low of the flag/pennant. The
sharp advance (or decline) that forms the flagpole should
break a trendline or resistance/support level. A line extending
up from this break to the high of the flag/pennant forms the
flagpole.
3. Flag: A flag is a small rectangle pattern that slopes against the
previous trend. If the previous move was up, then the flag
would slope down. If the move was down, then the flag would
slope up. Because flags are usually too short in duration to
actually have reaction highs and lows, the price action just
needs to be contained within two parallel trendlines.
4. Pennant: A pennant is a small symmetrical triangle that
begins wide and converges as the pattern matures (like a
cone). The slope is usually neutral. Sometimes there will not
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5.
6.
7.
8.
be specific reaction highs and lows from which to draw the
trendlines and the price action should just be contained within
the converging trendlines.
Duration: Flags and pennants are short-term patterns that can
last from 1 to 12 weeks. There is some debate on the
timeframe and some consider 8 weeks to be pushing the limits
for a reliable pattern. Ideally, these patterns will form between
1 and 4 weeks. Once a flag becomes more than 12 weeks old,
it would be classified as a rectangle. A pennant more than 12
weeks old would turn into a symmetrical triangle. The reliability
of patterns that fall between 8 and 12 weeks is debatable.
Break: For a bullish flag or pennant, a break above resistance
signals that the previous advance has resumed. For a bearish
flag or pennant, a break below support signals that the
previous decline has resumed.
Volume: Volume should be heavy during the advance or
decline that forms the flagpole. Heavy volume provides
legitimacy for the sudden and sharp move that creates the
flagpole. An expansion of volume on the resistance (support)
break lends credence to the validity of the formation and the
likelihood of continuation.
Targets: The length of the flagpole can be applied to the
resistance break or support break of the flag/pennant to
estimate the advance or decline.
Even though flags and pennants are common formations, identification
guidelines should not be taken lightly. It is important that flags and
pennants are preceded by a sharp advance or decline. Without a
sharp move, the reliability of the formation becomes questionable and
trading could carry added risk. Look for volume confirmation on the
initial move, consolidation and resumption to augment the robustness
of pattern identification.
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HWP provides an example of a flag that forms after a sharp and
sudden advance.
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Sharp move: After consolidating for three months, HWP broke
above resistance at 56 to begin a sharp advance. The 5-April
high and 16-Feb trendline marked resistance and the breakout
occurred with a volume expansion. The stock advanced from
56 to 76 in a mere 4 weeks. (Note: It is also possible that a
small pennant formed in early May with resistance around
62.25).
Flagpole: The distance from the breakout at 56 to the flag's
high at 76 formed the flagpole.
Flag: Price action was contained within two parallel trendlines
that sloped down.
Duration: From a high at 76 to the breakout at 72.25, the flag
formed over a 23-day period.
Breakout: The first break above the flag's upper trendline
occurred on 21-June without an expansion of volume.
However, the stock gapped up a week later and closed strong
with above-average volume (red arrows)
Volume: To recap -- volume expanded on the sharp advance
to form the flagpole, contracted during the flag's formation and
expanded right after the resistance breakout.
Targets: The length of the flagpole measured 20 points and
was applied to the resistance breakout at 72.25 to project a
target of 92.25.
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Continuation Chart Pattern: Symmetric Triangle
The symmetrical triangle, which can also be referred to as a coil,
usually forms during a trend as a continuation pattern. The pattern
contains at least two lower highs and two higher lows. When these
points are connected, the lines converge as they are extended and the
symmetrical triangle takes shape. You could also think of it as a
contracting wedge, wide at the beginning and narrowing over time.
While there are instances when symmetrical triangles mark important
trend reversals, they more often mark a continuation of the current
trend. Regardless of the nature of the pattern, continuation or reversal,
the direction of the next major move can only be determined after a
valid breakout. We will examine each part of the symmetrical triangle
individually and then provide an example with Consesco.
1. Trend: In order to qualify as a continuation pattern, an
established trend should exist. The trend should be at least a
few months old and the symmetrical triangle marks a
consolidation period before continuing after the breakout.
2. 4 points: At least 2 points are required to form a trendline and
two trendlines are required to form a symmetrical triangle.
Therefore, a minimum of 4 points is required to begin
considering a formation as a symmetrical triangle. The second
high (4) should be lower than the first (2) and the upper line
should slope down. The second low (3) should be higher than
the first (1) and the lower line should slope up. Ideally, the
pattern will form with 6 points (3 on each side) before a
breakout occurs.
3. Volume: As the symmetrical triangle extends and the trading
range contracts, volume should start to diminish. This refers to
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4.
5.
6.
7.
8.
9.
the quiet before the storm, or the tightening consolidation
before the breakout.
Duration: The symmetrical triangle can extend for a few
weeks or many months. If the pattern is less than 3 weeks, it is
usually considered a pennant. Typically, the time duration is
about 3 months.
Breakout Timeframe: The ideal breakout point occurs 1/2 to
3/4 of the way through the pattern's development or time-span.
The time-span of the pattern can be measured from the apex
(convergence of upper and lower lines) back to the beginning
of the lower trendline (base). A break before the 1/2 waypoint
might be premature and a break too close to the apex may be
insignificant. After all, as the apex approaches, a breakout
must occur sometime.
Breakout Direction: The future direction of the breakout can
only be determined after the break has occurred. Sound
obvious enough, but attempting to guess the direction of the
breakout can be dangerous. Even though a continuation
pattern is supposed to breakout in the direction of the longterm trend, this is not always the case.
Breakout Confirmation: For a break to be considered valid, it
should be on a closing basis. Some traders apply a price (3%
break) or time (sustained for 3 days) filter to confirm validity.
The breakout should occur with an expansion in volume,
especially on upside breakouts.
Return to Apex: After the breakout (up or down), the apex
can turn into future support or resistance. The price sometimes
returns to the apex or a support/resistance level around the
breakout before resuming in the direction of the breakout.
Price Target: There are two methods to estimate the extent of
the move after the breakout. First, the widest distance of the
symmetrical triangle can be measured and applied to the
breakout point. Second, a trendline can be drawn parallel to
the pattern's trendline that slopes (up or down) in the direction
of the break. The extension of this line will mark a potential
breakout target.
Edwards and Magee suggest that roughly 75% of symmetrical
triangles are continuation patterns and the rest mark reversals. The
reversal patterns can be especially difficult to analyse and often have
false breakouts. Even so, we should not anticipate the direction of the
breakout, but rather wait for it to happen. Further analysis should be
applied to the breakout by looking for gaps, accelerated price
movements and volume for confirmation. Confirmation is especially
important for upside breakouts.
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Prices sometimes return to the breakout point of apex on a reaction
move before resuming in the direction of the breakout. This return can
offer a second chance to participate with a better reward to risk ratio.
Potential reward price targets found by measurement and parallel
trendline extension are only meant to act as rough guidelines.
Technical analysis is dynamic and ongoing assessment is required. In
the first example above, SUNW may have fulfilled its target (42) in a
few months, but the stock gave no sign of slowing down and advanced
above 100 in the following months.
Conseco formed a rather large symmetrical triangle over a 5-month
period before breaking out on the downside.
1. The stock declined from 50 in Mar-98 to 22 in Oct-98 before
beginning to firm and consolidate. The low at 22 probably was
an over-reaction, but the long-term trend was down and
established for almost a year.
2. After the first 4 points formed, the lines of the symmetrical
triangle were draw. The stock traded within the boundaries for
another 2 months to form the last 2 points.
3. After the gap up from point 3 to point 4, volume slowed over
the next few months. There was some increase in volume in
late June, but the 60-day SMA remained in a downtrend as the
pattern took shape.
4. The red square marks the ideal breakout time-span from 50%
to 75% of the pattern. The breakout occurred a little over 2
weeks later, but proved valid nonetheless. While it is
preferable to have an ideal pattern develop, it is also quite
rare.
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5. After points 5 and 6 formed, the price action moved to the
lower boundary of the pattern. Even at this point, the direction
of the breakout was still a guess and it’s was prudent to wait.
The break occurred with an increase in volume and
accelerated price decline. Chaikin Money Flow declined past 30% and volume exceeded the 60-day SMA for an extended
period.
6. After the decline from 29 1/2 to 25 1/2, the stock rebounded,
but failed to reach potential resistance from the apex. The
weakness of the reaction rally foreshadowed the sharpness of
the decline that followed.
The widest point on the pattern extended 10 1/2 points. With a break of
support at 29 1/2, the measured decline was estimated to around 19.
By drawing a trendline parallel to the upper boundary of the pattern,
the extension estimates a decline to around 20.
Continuation Chart Pattern: Ascending Triangle
The ascending triangle is a bullish formation that usually forms during
an uptrend as a continuation pattern. There are instances when
ascending triangles form as reversal patterns at the end of a
downtrend, but they are typically continuation patterns. Regardless of
where they form, ascending triangles are bullish patterns that indicate
accumulation
Because of its shape, the pattern can also be referred to as a rightangle triangle. Two or more equal highs form a horizontal line at the
top. Two or more rising troughs form an ascending trendline that
converges on the horizontal line as it rises. If both lines were extended
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right, the ascending trendline could act as the hypotenuse of a right
triangle. If a perpendicular line were drawn extending down from the
left end of the horizontal line, a right triangle would form. Let's examine
each individual part of the pattern and then look at an example.
1. Trend: In order to qualify as a continuation pattern, an
established trend should exist. However, because the
ascending triangle is a bullish pattern, the length and duration
of the current trend is not as important. The robustness of the
formation is paramount.
2. Top Horizontal Line: At least 2 reaction highs are required to
form the top horizontal line. The highs do not have to be exact,
but should be within reasonable proximity of each other. There
should be some distance between the highs, and a reaction
low between them.
3. Lower Ascending Trendline: At least two reaction lows are
required to form the lower ascending trendline. These reaction
lows should be successively higher and there should be some
distance between the lows. If a more recent reaction low is
equal to or less than the previous reaction low, then the
ascending triangle is not valid.
4. Duration: The length of the pattern can range from a few
weeks to many months with the average pattern lasting from
1-3 months.
5. Volume: As the pattern develops, volume usually contracts.
When the upside breakout occurs, there should be an
expansion of volume to confirm the breakout. While volume
confirmation is preferred, it is not always necessary.
6. Return to breakout: A basic tenet of technical analysis is that
resistance turns into support and vice versa. When the
horizontal resistance line of the ascending triangle is broken, it
turns into support. Sometimes there will be a return to this
support level before the move begins in earnest.
7. Target: Once the breakout has occurred, the price projection
is found by measuring the widest distance of the pattern and
applying it to the resistance breakout.
In contrast to the symmetrical triangle, an ascending triangle has a
definitive bullish bias before the actual breakout. If you will recall, the
symmetrical triangle is a neutral formation that relies on the impending
breakout to dictate the direction of the next move. On the ascending
triangle, the horizontal line represents overhead supply that prevents
the security from moving past a certain level. It is as if a large sell
order has been placed at this level and it is taking a number of weeks
or months to execute, thus preventing the price from rising further.
Even though the price cannot rise past this level, the reaction lows
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continue to rise. It is these higher lows that indicate increased buying
pressure and give the ascending triangle its bullish bias.
Primus Telecom formed an ascending triangle over a 6-month period
before breaking resistance with an expansion of volume.
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From a low around 6, the stock established an uptrend by
forming a higher low at 9 3/8 and advancing to a new reaction
high early June. After recording its highest price in 10 months,
the stock met resistance at 24.
In June, the stock hit resistance at 23 a number of times and
then again at 24 in July. The stock bounced off 24 at least
three times in 5 months to form the horizontal resistance line.
It was as if portions of a large block were being sold each time
the stock neared 24.
The reaction lows were progressively higher and formed an
ascending trendline. The first low in May-99 occurred with a
large spike down to 12 1/4, but the trendline was drawn to
connect the prices grouped around 14. The ascending
trendline could have been drawn to start at 12 1/4 and this
version is shown with the grey trendline. The important thing is
that there are at least two distinct reaction lows that are
consecutively higher.
The duration of the pattern is around 6 months, which may
seem a bit long. However, all the key ingredients for a robust
pattern were in place.
Volume declined from late June until early October. There was
a huge expansion when the stock fell from 23 7/16 (point 6) to
19 3/8 on two heavy trading days in October. However, this
was only for two days and the stock found support around 20
to form a higher low. In keeping with the ideal pattern, the next
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expansion of volume occurred in late October when the stock
broke resistance at 24. The stock traded at above average
volume 7 of the 10 days surrounding the breakout, and all 7
were up days. Chaikin Money Flow dragged a bit from the two
heavy down days, but recovered to +20% five days after the
breakout. (The 10-day SMA of volume was overlaid on the
price plot; the grey volume bars are up days and the black
volume bars are down days).
The stock advanced to 30 3/4 before pulling back to around
26. Support was found above the original resistance breakout
and this indicated underlying strength in the stock.
The initial advance was projected to be 10 (24 -14 = 10) points
from the breakout at 24, making a target of 34. This target was
reached within 2 months, but the stock didn't slow down until
reaching 50 in March. Targets are only meant to be used as
guidelines and other aspects of technical analysis should also
be employed for deciding when to sell.
Continuation Chart Pattern: Descending Triangle
The descending triangle is a bearish formation that usually forms
during a downtrend as a continuation pattern. There are instances
when descending triangles form as reversal patterns at the end of an
uptrend, but they are typically continuation patterns. Regardless of
where they form, descending triangles are bearish patterns that
indicate distribution
Because of its shape, the pattern can also be referred to as a rightangle triangle. Two or more comparable lows form a horizontal line at
the bottom. Two or more declining peaks form a descending trendline
above that converges with the horizontal line as it descends. If both
lines were extended right, the descending trendline could act as the
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hypotenuse of a right triangle. If a perpendicular line were drawn
extending up from the left end of the horizontal line, a right triangle
would form. Let's examine each individual part of the pattern and then
look at an example.
1. Trend: In order to qualify as a continuation pattern, an
established trend should exist. However, because the
descending triangle is definitely a bearish pattern, the length
and duration of the current trend is not as important. The
robustness of the formation is paramount.
2. Lower Horizontal Line: At least 2 reaction lows are required
to form the lower horizontal line. The lows do not have to be
exact, but should be within reasonable proximity of each other.
There should be some distance separating the lows and a
reaction high between them.
3. Upper Descending Trendline: At least two reaction highs are
required to form the upper descending trendline. These
reaction highs should be successively lower and there should
be some distance between the highs. If a more recent reaction
high is equal to or greater than the previous reaction high, then
the descending triangle is not valid.
4. Duration: The length of the pattern can range from a few
weeks to many months, with the average pattern lasting from
1-3 months.
5. Volume: As the pattern develops, volume usually contracts.
When the downside break occurs, there would ideally be an
expansion of volume for confirmation. While volume
confirmation is preferred, it is not always necessary.
6. Return to breakout: A basic tenet of technical analysis is that
broken support turns into resistance and visa versa. When the
horizontal support line of the descending triangle is broken, it
turns into resistance. Sometimes there will be a return to this
newfound resistance level before the down move begins in
earnest.
7. Target: Once the breakout has occurred, the price projection
is found by measuring the widest distance of the pattern and
subtracting it from the resistance breakout.
In contrast to the symmetrical triangle, a descending triangle has a
definite bearish bias before the actual break. The symmetrical triangle
is a neutral formation that relies on the impending breakout to dictate
the direction of the next move. For the descending triangle, the
horizontal line represents demand that prevents the security from
declining past a certain level. It is as if a large buy order has been
placed at this level and it is taking a number of weeks or months to
execute, thus preventing the price from declining further. Even though
the price does not decline past this level, the reaction highs continue to
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decline. It is these lower highs that indicate increased selling pressure
and give the descending triangle its bearish bias.
After recording a lower high just below 60 in Dec-99, Nucor formed a
descending triangle early in 2000. In late April, the stock broke support
with a gap down, sharp break and increase in volume to complete the
formation.
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The stock declined from above 60 to the low 40s before finding
some support and mounting a reaction rally. The rally stalled
just below 50 and a series of lower reaction highs began to
form. The long-term trend was down and the resulting pattern
was classified as continuation.
Support at 45 was first established with a bounce in February.
After that, the stock touched this level two more times before
breaking down. After the second touch in March (about a
month later), the lower support line was drawn.
After each bounce off support, a lower high formed. The
reaction highs at points 2,4 and 6 formed the descending
trendline to mark the potential descending triangle pattern. I
say potential because the pattern is not complete until support
is broken.
The duration of the pattern was a little less than 3 months.
The last touch of support at 45 occurred in late April. The stock
spiked down through support, but managed to close above this
key level. The final break occurred a few days later with a gap
down, a considerable black candlestick and an expansion in
volume. The way support is broken can offer insight into the
general weakness of a security. This was not a slight break,
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but a rather convincing break. Volume jumped to the highest
level in many months and money flows broke below -10%.
After falling from 45 to 41, the stock mounted a feeble reaction
rally that only lasted three days and produced two candlesticks
with long upper shadows. Sometimes there is a test of the
newfound resistance level, and sometimes there isn't. A weak
test of support can indicate acute selling pressure.
The initial decline was projected to be 9 points (54 -45 = 9). If
this is subtracted from the support break at 45, the downside
projection is to around 36. Even though the stock exceeded
this target in late June, recent strength has brought it back
near 36. Targets are only meant to be used as guidelines and
other aspects of technical analysis should also be employed
for deciding when to cover a short or buy.
Continuation Chart Pattern: Price Channel
A price channel is a continuation pattern that slopes up or down and is
bound by an upper and lower trendline. The upper trendline marks
resistance and the lower trendline marks support. Price channels with
negative slopes (down) are considered bearish and those with positive
slopes (up) bullish. For explanatory purposes, a "bullish price channel"
will refer to a channel with positive slope and a "bearish price channel"
to a channel with negative slope.
1. Main trendline: It takes at least two points to draw the main
trendline. This line sets the tone for the trend and the slope.
For a bullish price channel, the main trendline extends up and
at least two reaction lows are required to draw it. For a bearish
price channel, the main trendline extends down and at least
two reaction highs are required to draw it.
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2. Channel line: The line drawn parallel to the main trendline is
called the channel line. Ideally, the channel line will be based
off of two reaction highs or lows. However, after the main
trendline has been established, some analysts draw the
parallel channel line using only one reaction high or low. The
channel line marks support in a bearish price channel and
resistance in a bullish price channel.
3. Bullish price channel: As long as prices advance and trade
within the channel, the trend is considered bullish. The first
warning of a trend change occurs when prices fall short of
channel line resistance. A subsequent break below main
trendline support would provide further indication of a trend
change. A break above channel line resistance would be
bullish and indicate an acceleration of the advance.
4. Bearish price channel: As long as prices decline and trade
within the channel, the trend is considered bearish. The first
warning of a trend change occurs when prices fail to reach
channel line support. A subsequent break above main
trendline resistance would provide further indication of a trend
change. A break below channel line support would be bearish
and indicate an acceleration of the decline.
5. Scaling: Even though it is a matter of personal preference,
trendlines seem to match reaction highs and lows best when
semi-log scales are used. Semi-log scales reflect price
movements in percentage terms. A move from 50 to 100 will
appear the same distance as a move from 100 to 200.
In a bullish price channel, some traders look to buy when prices reach
main trendline support. Conversely, some traders look to sell (or short)
when prices reach main trendline resistance in a bearish price
channel. As with most price patterns, other aspects of technical
analysis should be used to confirm signals.
Because technical analysis is just as much art as it is science, there is
room for flexibility. Even though exact trendline touches are ideal, it is
up to each individual to judge the relevance and placement of both the
main trendline and the channel line. By that same token, a channel line
that is exactly parallel to the main trendline is ideal.
“We have more ability than willpower; and it is often an excuse
to ourselves that we imagine that things are impossible”
La Rochefoucauld (1613-1680)
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CSCO provides an example of an 11-month bullish price channel that
developed in 1999.
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Main trendline: The January, February and March reaction
lows formed the beginning of the main trendline. Subsequent
lows in April, May and August confirmed the main trendline.
Channel line: Once the main trendline was in place, the
channel line beginning from the January high was drawn. A
visual assessment reveals that these trendlines look parallel.
More precise analysts may want to test the slope of each line,
but a visual inspection is usually enough to ensure the
"essence" of the pattern.
Bullish price channel: Subsequent touches along the main
trendline offered good buying opportunities in mid April, late
May and mid August.
The stock did not reach channel line resistance until July (red
arrow) and this marked a significant reaction high.
The September high (blue arrow) fell short of channel line
resistance, but only by a small margin that was probably
insignificant.
The break above channel line resistance in Dec-99 marked an
acceleration of the advance. Some analysts might consider the
stock overextended after this move, but the advance was
powerful and the trend never turned bearish. Price channels
will not last forever, but the underlying trend remains in place
until proven otherwise.
Chart Pattern: Measured Bear Move Continuation
The Measured Move is a three-part formation that begins as a reversal
pattern and resumes as a continuation pattern. The Measured (Bear)
Move consists of a reversal decline, consolidation/retracement and
continuation decline. Because the Measured (Bear) Move cannot be
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confirmed until after the consolidation/retracement period, I have
elected to categorize it as a continuation pattern. The pattern is usually
long-term and forms over several months.
1. Prior Trend: For the first decline to qualify as a reversal, there
must be evidence of a prior uptrend to reverse. Because the
Measured (Bear) Move can occur as part of a larger advance,
the length and severity of the prior decline may vary from a
few weeks to many months.
2. Reversal Decline: The first decline usually begins near the
established highs of the previous advance and extends for a
few weeks or many months. Sometimes this reversal pattern
can mark the initial trend change, other times a new
downtrend is established by new reaction lows or a break
below support. Ideally, the decline is fairly orderly and lengthy
with a series of declining peaks and troughs that may form a
price channel. Less erratic declines are satisfactory, but run
the risk of turning into a different pattern.
3. Consolidation/Retracement: After an extended decline,
some sort of consolidation or retracement can be expected. As
a retracement rally (or reaction rally), prices could recoup 33%
to 67% of the previous decline. Generally speaking, the bigger
the decline is, the bigger the reaction rally. Some retracement
formations might include an upward sloping flag or rising
wedge. If the formation turns out to be a consolidation, then a
continuation pattern such as a rectangle or descending
triangle could form.
4. Continuation Decline - Length: The distance from the high to
the low of the first decline can be applied to the high of the
consolidation/retracement to estimate the length of the next
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decline. Some technicians like to measure by points, others in
percentage terms. If a security declines from 60 to 40 (20
points) and the consolidation/retracement rally returns to the
security to 50, then 30 would be the target of the second
decline (50 - 20 = 30). Using the percentage method, the
decline from 60 to 40 would be -33% and projected decline
from 50 would be 16.50. (50 X 33% = 16.50 : 50 - 16.5 =
33.50). Deciding which method to use will depend on the
individual security and your analysis preferences.
5. Continuation Decline - Entry: If the
consolidation/retracement forms a continuation pattern, then
an appropriate second leg entry point can be identified using
traditional technical analysis rules. However, if there is no
readily identifiable pattern, then some other signal must be
sought. In this case, much will depend on your trading
preferences, objectives, and risk tolerance and time horizon.
One method might be to measure potential retracements
(33%, 50% or 62%) and look for short-term reversal patterns.
Another method might be to look for a break below the
reaction low set by the first decline as confirmation of
continuation. This method would make for a late entry, but the
Measured (bear) Move pattern would be confirmed.
6. Volume: Volume should increase during the reversal decline,
decrease at the end of the consolidation/retracement and
increase again during the continuation decline. This is the
ideal volume pattern, but volume confirmation for bearish
patterns is not as important as for bullish patterns.
More than one pattern can exist within the context of a Measured
(Bear) Move. A double top could mark the first reversal and decline, a
price channel could form during this decline, a descending triangle
could mark the consolidation and another price channel could form
during the continuation decline.
During multi-year bear markets (or bull markets), a series of Measured
(Bear) Moves can form. A bear move consisting of three down legs
might include a reversal and decline for the first leg, a retracement, a
decline for the second leg, a retracement and finally the third leg
decline.
While the projection targets for the continuation decline can be helpful,
they should only be used as rough guidelines. Securities can
overshoot their targets, but also fall short and technical assessments
should be ongoing.
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As illustrated in the chart above, the second decline of a Measured
(Bear) Move may not be as orderly as the first, especially when volatile
stocks are involved.
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Prior Trend: After a multi-year bull move, XIRC reached its
all-time high at 69.69 on 31-Dec-99.
Reversal Decline: The stock broke trendline support in Jan-00
and a lower low was recorded when the stock dropped below
45 in Feb-00. The decline took the stock to 29.13 in Apr-00 for
a total of 40.56 points down.
Consolidation/Correction: In April, May and June, the stock
recouped about 50% of its previous decline with a retracement
rally to 52.75. Including the spike high at 52.75, a parallel price
channel formed (resembling a large flag) with support marked
by the lower trendline. Excluding the spike high, the
interpretation could have been a rising wedge. Either way,
support was marked by the lower trendline.
Continuation Decline - Length: The estimated length of the
continuation decline was 40.56 points from the June high at
52.75, which would target 12.19. Percentage estimates can
sometimes be more applicable to Measured (Bear) Moves,
especially if the target appears unusually low. The decline
from 69.69 to 29.13 was 58%. A 58% decline from 52.75
would mark a target around 22.16 (52.75 x .58 = 30.59 : 52.75
- 30.59 = 22.16).
Continuation Decline - Entry: Because the
consolidation/retracement portion formed a continuation
pattern, entry could have been based on a break below the
support trendline line (red arrows).
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•
Volume: Volume increased just prior to the trendline support
break in Jan-00 and again when the stock broke below its
previous reaction low (blue arrows). Later when the stock
broke trendline support in July, volume also increased
significantly (red arrows).
Continuation Chart Pattern: Measured Bull Move
The Measured Move is a three-part formation that begins as a reversal
pattern and resumes as a continuation pattern. The Measured (Bull)
Move consists of a reversal advance, correction/consolidation and
continuation advance. Because the Measured (Bull) Move cannot be
properly identified until after the correction/consolidation period, I have
elected to categorize it as a continuation pattern. The pattern is usually
long-term and forms over several months.
1. Prior Trend: For the first advance to qualify as a reversal,
there must be evidence of a prior downtrend to reverse.
Because the Measured (Bull) Move can occur as part of a
larger advance, the length and severity of the prior decline
may vary from a few weeks to many months.
2. Reversal Advance: The first advance usually begins near the
established lows of the previous decline and extends for a few
weeks or many months. Sometimes a reversal pattern can
mark the initial trend change. Other times the new uptrend is
established by new reaction highs or a break above
resistance. Ideally, the advance is fairly orderly and lengthy
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3.
4.
5.
6.
with a series of rising peaks and troughs that may form a price
channel. Less erratic advances are satisfactory, but run the
risk of forming a different pattern.
Consolidation/Correction: After an extended advance, some
sort of consolidation or correction can be expected. As a
consolidation, there could be a continuation pattern such as a
rectangle or ascending triangle. As a correction, there could be
33% to 67% retracement of the previous advance and the
possible patterns include a large downward-sloping flag or
falling wedge. Generally speaking, the bigger the advance, the
bigger the correction. A 100% advance may see a 62%
correction and a 50% advance may see only a 33% correction.
Continuation Advance - Length: The distance from the low
to the high of the first advance can be applied to the low of the
consolidation/retracement to estimate a projected advance.
Some technicians like to measure by points, others in
percentage terms. If the first advance was from 30 to 50 (20
points) and the consolidation/correction was to 40, then 60
would be the target of the second advance (50 - 30 = 20 : 40 +
20 = 60). For those who prefer percentages: if the first
advance was from 30 to 50 (66%) and the
consolidation/correction was to 40, then 66.40 would be the
target of the second advance (40 X 66% = 26.40 : 40 + 26.40
= 66.40). The decision of which method to use will depend on
the individual security and your analysis style.
Continuation Advance - Entry: If the consolidation/correction
is made up of a continuation pattern, then second leg entry
points can be identified using the normal breakout rules.
However, if there is no readily identifiable pattern, then some
other continuation breakout signal must be sought. In this
case, much will depend on your trading style, objectives, and
risk tolerance and time horizon. One method might be to
measure potential retracements (33%, 50%, or 62%) and look
for short-term reversal patterns for good reward-to-risk entry
points. Another method might be to wait for a break above the
reaction high set by the first advance as confirmation of
continuation. This method would make for a late entry, but the
pattern would be confirmed.
Volume: Volume should increase at the beginning of the
reversal advance, decrease at the end of the
consolidation/correction and increase again at the beginning of
the continuation advance.
The Measured (Bull) Move can be made up of a number of patterns.
There could be a double bottom to start the reversal advance, a price
channel during the reversal advance, an ascending triangle to mark
the consolidation and another price channel to mark the continuation
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advance. During multi-year bullmarkets (or bear markets), a series of
Measured (Bull) Moves can form. While the projections for the
continuation advance can be helpful for targets, they should only be
used as rough guidelines. Securities can overshoot their targets, but
also fall short -- technical assessments should be ongoing.
Intel (INTC) broke out of a multi-year slump and began a Measured
(Bull) Move.
•
•
•
•
•
Prior Trend: After a large downward sloping trading range
throughout most of 1997 and 1998, Intel broke above
resistance in early November (blue arrows) and started the
first leg of a Measured (Bull) Move.
Reversal Advance: The breakout occurred with a strong
move above resistance at 22 with 2 weeks of strong volume
(green arrows). The advance began from 17.44 and ended at
35.92.
Consolidation/Correction: After an extended advance, the
stock declined within a set range that resembled a large
descending flag. The decline retraced about 54% of the
previous advance.
Continuation Advance - Length: The estimated length of the
advance was 18.48 points from the June low at 25.94, which
would target 44.42. The actual high was 44.75 for a 18.81
advance.
Continuation Advance - Entry: Because the
consolidation/correction portion formed a continuation pattern,
entry could have been based on a break above the resistance
line (red arrow).
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•
Volume: Volume increased in early November at the
beginning of the reversal advance. There was a decrease from
March to May 1999. And, volume increased at the beginning of
the continuation advance (green arrows).
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Chapter Eighteen
The Fundamentals of Chart Indicators
What is an Indicator?
An indicator is a series of data points that are derived by applying a
formula to the price data of a security. Price data includes any
combination of the open, high, low or close over a period of time.
Some indicators may use only the closing prices, while others
incorporate volume and open interest into their formulas. The price
data is entered into the formula and a data point is produced.
For example, the average of 3 closing prices is one data point
((41+43+43)/3=42.33). However, one data point does not offer much
information and does not an indicator make. A series of data points
over a period of time is required to create valid reference points to
enable analysis. By creating a time series of data points, a comparison
can be made between present and past levels. For analysis purposes,
indicators are usually shown in a graphical form above or below a
security’s price chart. Once shown in graphical form, an indicator can
then be compared with the corresponding price chart of the security.
Sometimes indicators are plotted on top of the price plot for a more
direct comparison
What does an Indicator Offer?
An indicator offers a different perspective from which to analyse the
price action. Some, such as moving averages, are derived from simple
formulas and the mechanics are relatively easy to understand. Others,
such as Stochastic, have complex formulas and require more study to
fully understand and appreciate. Regardless of the complexity of the
formula, indicators can provide unique perspective on the strength and
direction of the underlying price action.
A simple moving average is an indicator that calculates the average
price of a security over a specified number of periods. If a security is
exceptionally volatile, then a moving average will help to smooth the
data. A moving average filters out random noise and offers a smoother
perspective of the price action. Veritas (VRTS) displays a lot of
volatility and an analyst may have difficulty discerning a trend. By
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applying a 10-day simple moving average to the price action, random
fluctuations are smoothed to make it easier to identify a trend.
Why Use Indicators?
Indicators serve three broad functions: to alert, to confirm and to
predict.
An indicator can act as an alert to study price action a little more
closely. If momentum is waning, it may be a signal to watch for a break
of support. Or, if there is a large positive divergence building, it may
serve as an alert to watch for a resistance breakout.
Indicators can be used to confirm other technical analysis tools. If
there is a breakout on the price chart, a corresponding moving average
crossover could serve to confirm the breakout. Or, if a stock breaks
support, a corresponding low in the On-Balance-Volume (OBV) could
serve to confirm the weakness.
Some investors and traders use indicators to predict the direction of
future prices. In his column on 29-Oct, Rex Takasugi shows how the
Commodity Channel Index (CCI) can be used to generate buy signals
for the Russell 2000.
“Fortune favours the brave”
Terence (ca 190-160 B.C)
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Tips for Using Indicators
Indicators indicate. This may sound straightforward, but sometimes
traders ignore the price action of a security and focus solely on an
indicator. Indicators filter price action with formulas. As such, they are
derivatives and not direct reflections of the price action. This should be
taken into consideration when applying analysis. Any analysis of an
indicator should be taken with the price action in mind. What is the
indicator saying about the price action of a security? Is the price action
getting stronger? Weaker?
Even though it may be obvious when indicators generate buy and sell
signals, the signals should be taken in context with other technical
analysis tools. An indicator may flash a buy signal, but if the chart
pattern shows a descending triangle with a series of declining peaks, it
may be a false signal.
On the Inktomi (INKT) chart, MACD MACD improved from April to
August and formed a positive divergence in August. All the earmarks
of a MACD buying opportunity were present, but the stock failed to
break above the resistance and exceed its previous reaction high. This
non-confirmation from the stock should have served as a warning sign
against a long position. For the record, a sell signal occurred when the
stock broke support from the descending triangle in early Oct-00
As always in technical analysis, learning how to read indicators is more
of an art than a science. The same indicator may exhibit different
behavioural patterns when applied to different stocks. Indicators that
work well for IBM might not work the same for Delta Airlines. Through
careful study and analysis, expertise with the various indicators will
develop over time. As this expertise develops, certain nuances as well
as favourite set-ups will become clear.
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There are hundreds of indicators in use today, with new indicators
being created every week. Technical analysis software programs come
with dozens of indicators built in, and even allow users to create their
own. Given the amount of hype that is associated with indicators,
choosing an indicator to follow can be a daunting task. Even with the
introduction of hundreds of new indicators, only a select few really offer
a different perspective and are worthy of attention. Strangely enough,
the indicators that usually merit the most attention are those that has
been around the longest time and has stood the test of time.
When choosing an indicator to use for analysis, choose carefully and
moderately. Attempts to cover more than five indicators are usually
futile. It is best to focus on two or three indicators and learn their
intricacies inside and out. Try to choose indicators that complement
each other, instead of those that move in unison and generate the
same signals. For example, it would be redundant to use two
indicators that are good for showing overbought and oversold levels,
such as Stochastic and RSI. Both of these indicators measure
momentum and both have overbought/oversold levels.
The Challenge of Indicators
For technical indicators, there is a trade-off between sensitivity and
consistency. In an ideal world, we want an indicator that is sensitive to
price movements, gives early signals and has few false signals
(whipsaws). If we increase the sensitivity by reducing the number of
periods, an indicator will provide early signals, but the number of false
signals will increase. If we decrease sensitivity by increasing the
number of periods, then the number of false signals will decrease, but
the signals will lag and this will skew the reward-to-risk ratio.
The longer a moving average is, the slower it will react and fewer
signals will be generated. As the moving average is shortened, it
becomes faster and more volatile, increasing the number of false
signals. The same holds true for the various momentum indicators. A
14 period RSI will generate fewer signals than a 5 period RSI. The 5
period RSI will be much more sensitive and have more overbought and
oversold readings. It is up to each investor to select a time frame that
suits his or her trading style and objectives.
Leading Indicators
As their name implies, leading indicators are designed to lead price
movements. Most represent a form of price momentum over a fixed
look-back period, which is the number of periods used to calculate the
indicator. For example, a 20-day Stochastic Oscillator would use the
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past 20 days of price action (about a month) in its calculation. All prior
price action would be ignored. Some of the more popular leading
indicators include Commodity Channel Index (CCI), Momentum,
Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
Momentum Oscillators
Many leading indicators come in the form of momentum oscillators.
Generally speaking, momentum measures the rate-of-change of a
security's price. As the price of a security rises, price momentum
increases. The faster the security rises (the greater the period-overperiod price change), the larger the increase in momentum. Once this
rise begins to slow, momentum will also slow. As a security begins to
trade flat, momentum starts to actually decline from previous high
levels. However, declining momentum in the face of sideways trading
is not always a bearish signal. It simply means that momentum is
returning to a more median level.
Momentum indicators employ various formulas to measure price
changes. RSI (a momentum indicator) compares the average price
change of the advancing periods with the average change of the
declining periods. On the IBM chart, RSI advanced from October to the
end of November. During this period, the stock advanced from the
upper 60s to the low 80s. When the stock traded sideways in the first
half of December, RSI dropped rather sharply (blue lines). This
consolidation in the stock was quite normal and actually healthy. From
these lofty levels (near 70), flat price action would be expected to
cause a decline in RSI (and momentum). If RSI were trading around
50 and the stock began to trade flat, the indicator would not be
expected to decline. The green lines on the chart mark a period of
sideways trading in the stock and in RSI. RSI started from a relatively
median level, around 50. The subsequent flat price action in the stock
also produced relatively flat price action in the indicator and it remains
around 50.
Benefits and Drawbacks of Leading Indicators
There are clearly many benefits to using leading indicators. Early
signalling for entry and exit is the main benefit. Leading indicators
generate more signals and allow more opportunities to trade. Early
signals can also act to forewarn against a potential strength or
weakness. Because they generate more signals, leading indicators are
best used in trading markets. These indicators can be used in trending
markets, but usually with the major trend, not against it. In a market
trending up, the best use is to help identify oversold conditions for
buying opportunities. In a market that is trending down, leading
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indicators can help identify overbought situations for selling
opportunities.
With early signals comes the prospect of higher returns and with
higher returns comes the reality of greater risk. More signals and
earlier signals mean that the chances of false signals and whipsaws
increase. False signals will increase the potential for losses. Whipsaws
can generate commissions that can eat away profits and test trading
stamina
Lagging Indicators
As their name implies, lagging indicators follow the price action and
are commonly referred to as trend-following indicators. Rarely, if ever,
will these indicators lead the price of a security. Trend-following
indicators work best when markets or securities develop strong trends.
They are designed to get traders in and keep them in as long as the
trend is intact. As such, these indicators are not effective in trading or
sideways markets. If used in trading markets, trend-following indicators
will likely lead to many false signals and whipsaws. Some popular
trend-following indicators include moving averages (exponential,
simple, weighted, variable) and MACD.
The chart above shows the S&P 500 with the 20-day simple moving
average and the 100-day simple moving average. Using a moving
average crossover to generate the signals, there were seven signals
over the two years covered in the chart. Over these two years, the
system would have been enormously profitable. This is due to the
strong trends that developed from Oct-97 to Aug-98 and from Nov-98
to Aug-99. However, notice that as soon as the index starts to move
sideways in a trading range, the whipsaws begin. The signals in Nov97 (sell), Aug-99 (sell) and Sept-99 (buy) were reversed in a matter of
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days. Had these moving averages been longer (50- and 200-day
moving averages), there would have been fewer whipsaws. Had these
moving average been shorter (10 and 50-day moving average), there
would have been more whipsaws, more signals, and earlier signals.
Benefits and Drawbacks of Lagging Indicators One of the main
benefits of trend-following indicators is the ability to catch a move and
remain in a move. Provided the market or security in question
develops a sustained move, trend-following indicators can be
enormously profitable and easy to use. The longer the trend, the fewer
the signals and less trading involved.
The benefits of trend-following indicators are lost when a security
moves in a trading range. In the S&P 500 example, the index appears
to have been range-bound at least 50% of the time. Even though the
index trended higher from 1982 to 1999, there have also been large
periods of sideways movement. From 1964 to 1980, the index traded
within a large range bound by 85 and 110.
Another drawback of trend-following indicators is that signals tend to
be late. By the time a moving average crossover occurs, a significant
portion of the move has already occurred. The Nov-98 buy signal
occurred at 1130, about 19% above the Oct-98 low of 950. Late entry
and exit points can skew the risk/reward ratio.
Oscillator Types
An oscillator is an indicator that fluctuates above and below a
centreline or between set levels as its value changes over time.
Oscillators can remain at extreme levels (overbought or oversold) for
extended periods, but they cannot trend for a sustained period. In
contrast, a security or a cumulative indicator like On-Balance-Volume
(OBV) can trend as it continually increases or decreases in value over
a sustained period of time.
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As the indicator comparison chart shows, oscillator movements are
more confined and sustained movements (trends) are limited, no
matter how long the time period. Over the two-year period, Moving
Average Convergence Divergence (MACD) fluctuated above and
below zero, touching the zero line about twelve times. Also notice that
each time MACD surpassed +80 the indicator pulled back. Even
though MACD does not have an upper or lower limit on its range of
values, its movements appear confined. OBV, on the other hand,
began an uptrend in September 1998 and advanced steadily for the
next year. Its movements are not confined and long-term trends can
develop.
There are many different types of oscillators and some belong to more
than one category. The breakdown of oscillator types begins with two
types: centred oscillators, which fluctuate above and below a centre
point or line, and banded oscillators, which fluctuate between,
overbought and oversold extremes. Generally, centred oscillators are
best suited for analysing the direction of price momentum, while
banded oscillators are best suited for identifying overbought and
oversold levels.
Centred Oscillators
Centred oscillators fluctuate above and below a central point or line.
These oscillators are good for identifying the strength or weakness, or
direction, of momentum behind a security's move. . In its purest form,
momentum is positive (bullish) when a centred oscillator is trading
above its centre line and negative (bearish) when the oscillator is
trading below its centre line.
MACD is an example of a centred oscillator that fluctuates above and
below zero. MACD is the difference between the 12-day EMA and 26day EMA of a security. The further one moving average moves away
from the other, the higher the reading. Even though there is no range
limit to MACD, extremely large differences between the two moving
averages are unlikely to last for long.
MACD is unique in that it has lagging elements as well as leading
elements. Moving averages are lagging indicators and would be
classified as trend-following or lagging elements. However, by taking
the differences in the moving averages, MACD incorporates aspects of
momentum or leading elements. The difference between the moving
averages represents the rate of change. By measuring the rate-ofchange, MACD becomes a leading indicator, but still with a bit of lag.
With the integration of both moving averages and rate-of-change,
MACD has forged a unique spot among oscillators as both a lagging
and a leading indicator.
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Rate-of-change (ROC) is a centred oscillator that also fluctuates above
and below zero. As its name implies, ROC measures the percentage
price change over a given time period. For example: 20 day ROC
would measure the percentage price change over the last 20 days.
The bigger the difference between the current price and the price 20
days ago, the higher the value of the ROC Oscillator. When the
indicator is above 0, the percentage price change is positive (bullish).
When the indicator is below 0, the percentage price change is negative
(bearish).
ROC 20-Period
As with MACD, ROC is not bound by upper or lower limits. This is
typical of most centred oscillators and can make it difficult to spot
overbought and oversold conditions. The ROC chart indicates that
readings above +20% and below -20% represent extremes and are
unlikely to last for an extended period of time. However, the only way
to gauge that +20% and -20% are extreme readings is from past
observations. Also, +20% and -20% represent extremes for this
particular security and may not be the same for other securities.
Banded oscillators offer a better alternative to gauge extreme price
levels.
Banded Oscillators
Banded oscillators fluctuate above and below two bands that signify
extreme price levels. The lower band represents oversold readings
and the upper band represents overbought readings. These set bands
are based on the oscillator and change little from security to security,
allowing the users to easily identify overbought and oversold
conditions. The Relative Strength Index (RSI) and the Stochastic
Oscillator are two examples of banded oscillators. (Note: The formulas
and rationale behind RSI and the Stochastic Oscillator are more
complicated than those for MACD and ROC, As such, calculations are
addressed in separate articles.)
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For RSI, the bands for overbought and oversold are usually set at 70
and 30 respectively. A reading greater than 70 would be considered
overbought and a reading below 30 would be considered oversold. For
the Stochastic Oscillator, a reading above 80 is overbought and a
reading below 20 oversold. Even though these are the recommended
band settings, certain securities may not adhere to these ranges and
might require more fine-tuning. Making adjustments to the bands is
usually a judgment call that will reflect a trader's preferences and the
volatility of the security.
Many, but not all, banded oscillators fluctuate within set upper and
lower limits. The Relative Strength Index (RSI) is range-bound by 0
and 100 and will never go higher than 100 nor lower than zero. The
Stochastic Oscillator is another oscillator with a set range and is bound
by 100 and 0 as well. However, the Commodity Channel Index (CCI) is
a banded oscillator that is not range bound.
CCI
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Summary
Centred oscillators are best used to identify the underlying strength or
direction of momentum behind a move. Broadly speaking, readings
above the centre point indicate bullish momentum and readings below
the centre point indicate bearish momentum. The biggest difference
between centred oscillators and banded oscillators is the latter's ability
to identify extreme readings. While it is possible to identify extreme
readings with centred oscillators, they are not ideal for this purpose.
Banded oscillators are best suited to identify overbought and oversold
conditions.
Oscillator Signals
Oscillators generate buy and sell signals in various ways. Some
signals are geared towards early entry, while others appear after the
trend has begun. In addition to buy and sell signals, oscillators can
signal that something is amiss with the current trend or that the current
trend is about to change. Even though oscillators can generate their
own signals, it is important to use these signals in conjunction with
other aspects of technical analysis. Most oscillators are momentum
indicators and only reflect one characteristic of a security's price
action. Volume, price patterns and support/resistance levels should
also be taken into consideration.
Positive and Negative Divergences
Divergence is a key concept behind many signals for oscillators as well
as other indicators. Divergences can serve as a warning that the trend
is about to change or set up a buy or sell signal. There are two types of
divergences: positive and negative. In its most basic form, a positive
divergence occurs when the indicator advances and the underlying
security declines. A negative divergence occurs when an indicator
declines and the underlying security advances.
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On the Merrill Lynch (MER) chart, MACD formed a positive divergence
in late October. While MER was trading below its previous reaction
low, MACD had yet to penetrate its previous low (green arrows).
However, MACD had not turned up and the positive divergence was
still just a possibility. When MACD turned up and traded above its 9day EMA, a positive divergence was confirmed. At this point, other
signals came together to create a buy signal. Not only had the stock
reached support and gapped up, but there was also a MACD positive
divergence and a MACD bullish crossover. (Note: The thick line and
the thin line is the 9-day EMA of MACD, which acts as a trigger line. A
bullish crossover occurs when MACD moves above its 9-day EMA and
a bearish crossover occurs when MACD moves below its 9-day EMA.)
After these MACD signals, the stock gapped up the very next day on a
huge increase in volume.
Intel
On the Intel (INTC) chart, the ROC Oscillator formed a negative
divergence just prior to the decline that began in September. When
INTC recorded a record high in early September, the ROC Oscillator
failed to surpass its previous high. The stock then began to decline
and the ROC Oscillator turned lower as well, thus completing the lower
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high and the negative divergence. As there was little else to go on at
the time, this negative divergence should have been taken as a
warning signal. However, when the ROC Oscillator continued to
deteriorate and broke below 0 (centreline), it was clear that the stock
was weak and vulnerable to a further decline.
Overbought and Oversold Extremes
Banded oscillators are designed to identify overbought and oversold
extremes. Since these oscillators fluctuate between extremes, they
can be difficult to use in trending markets. Banded oscillators are best
used in trading ranges or with securities that are not trending. In a
strong trend, users may see many signals that are not really valid. If a
stock is in a strong uptrend, buying on oversold conditions will work
much better than selling on overbought conditions.
In a strong trend, oscillator signals against the direction of the
underlying trend are less robust than those with the trend. The trend is
your friend and can be dangerous to fight it. Even though securities
develop trends, they also fluctuate within those trends. If a stock is in a
strong uptrend, buying when oscillators reach oversold conditions (and
near support tests) will work much better than selling on overbought
conditions. During a strong downtrend, selling when oscillators reach
overbought conditions would work much better. If the path of least
resistance is up (down), then acting on only bullish (bearish) signals
would be in harmony with the trend. Attempts to trade against the trend
carry added risk.
When the trend is strong, banded oscillators can remain near
overbought or oversold levels for extended periods. An overbought
condition does not indicate that it is time to sell, nor does an oversold
condition indicate that it is time to buy. In a strong uptrend, an
oscillator can reach an overbought condition and remain so as the
underlying security continues to advance. A negative divergence may
form, but a bearish signal against the uptrend should be considered
suspect. In a strong downtrend, an oscillator can reach an oversold
condition and remain so as the underlying security continues to
decline. Similarly, a positive divergence may form, but a bullish signal
against the downtrend should be considered suspect. This does not
mean counter-trend signals won't work, but they should be viewed in
proper context and considered with other aspects of technical analysis.
The first step in using banded oscillators is to identify the upper and
lower bands that mark the extremities. For RSI, anything below 30 and
above 70 represents an extremity. For the Stochastic Oscillator,
anything below 20 and above 80 represents an extremity. We know
that when RSI is below 30 or the Stochastic Oscillator is below 20, an
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oversold condition exists. By that same token, when RSI is above 70
and the Stochastic Oscillator is above 80, an overbought condition
exists. Identification of an overbought or oversold condition should
serve as an alert to monitor other technical aspects (price pattern,
trend, support, resistance, candlesticks, volume or other indicators)
with extra vigilance.
The simplest method to generate signals is to note when the upper
and lower bands are crossed. If a security is overbought (above 70 for
RSI and 80 for the Stochastic Oscillator) and moves back down below
the upper band, then a sell signal is generated. If a security is oversold
(below 30 for RSI and 20 for the Stochastic Oscillator) and moves back
above the lower band, then a buy signal is generated. Keep in mind
that these are the simplest methods.
Simple signals can also be combined with divergences and moving
average crossovers to create more robust signals. Once a stock
becomes oversold, traders may look for a positive divergence to
develop in the RSI and then a cross above 30. With the Stochastic
Oscillator overbought, traders may look for a negative divergence and
combine that with a moving average crossover and a break below 80
to generate a signal. (Note: The Stochastic Oscillator is usually plotted
with a 3-day simple moving average that acts as the trigger line. When
the Stochastic Oscillator crosses above the trigger line it is a bullish
moving average crossover, and when it crosses below it is bearish).
Cisco Systems
The Cisco (CSCO) chart shows that the Stochastic Oscillator can
change from oversold to overbought quite quickly. Much depends on
the number of time periods used to calculate the oscillator. A 10-day
Slow Stochastic Oscillator will be more volatile than a 20-day. The thin
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green lines indicate when the Stochastic Oscillator touched or crossed
the oversold line at 20. The thin red lines indicate when Stochastic
Oscillator touched or crossed the overbought line. CSCO was in a
strong up trend at the time and experiencing little selling pressure.
Therefore, trying to sell when the oscillator crossed back below 80
would have been against the uptrend and not the proper strategy.
When a security is trending up or has a bullish bias, traders would be
better off looking for oversold conditions to generate buying
opportunities.
We can also see that much of the upside for the stock occurred after
the Stochastic Oscillator advanced above 80 (thin red lines). The
green circle in August shows a buy signal that was generated with
three separate items: one, the oscillator moved above 20 from
oversold conditions; two, the oscillator moved above its 3-day MA; and
three, the oscillator formed a positive divergence. Confirmation from
these three items makes for a more robust signal. After the buy signal,
the oscillator was in overbought territory a mere 4 days later. However,
the stock continued its advance for 2-3 weeks before reaching its high.
Airborne Freight
The Airborne Freight (ABF) chart reveals trading opportunities with the
Relative Strength Index (RSI). Because a 14-period RSI rarely moved
below 30 and above 70, a 10-period RSI was chosen to increase
sensitivity. With the intermediate-term and long-term trends decidedly
bearish, savvy traders could have sold short each time RSI reached
overbought (black vertical lines). More aggressive traders could have
played the long side each time RSI dipped below 30 and then moved
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back above this oversold level. The first two buy signals were
generated with a positive divergence and a move above 30 from
oversold conditions. The third buy signal came after RSI briefly dipped
below 30. Keep in mind that these three signals were against the
larger downtrend and trading strategies should be adjusted
accordingly.
Centreline Crossovers
As the name implies, centreline crossover signals apply mainly to
centred oscillators that fluctuate above and below a centreline. Traders
have been also known to use centreline crosses with RSI in order
validate a divergence or signal generated from an overbought or
oversold reading. However, most banded oscillators, such as RSI and
Stochastic, rely on divergences and overbought/oversold levels to
generate signals. The middle ground is a bit of a no man's land for
banded oscillators and is probably best left to other tools. For our
purposes, the analysis of centreline crossovers will focus on centred
oscillators such as Chaikin Money Flow, MACD and Rate-of-Change
(ROC).
A centreline crossover is sometimes interpreted as a buy or sell signal.
A buy signal would be generated with a cross above the centreline and
a sell signal with a cross below the centreline. For MACD or ROC, a
cross above or below zero would act as a signal.
Movements above or below the centreline indicate that momentum has
changed from either positive to negative or negative to positive. When
a centred momentum oscillator advances above its centreline,
momentum turns positive and could be considered bullish. When a
centred momentum oscillator declines below its centreline, momentum
turns negative and could be considered bearish.
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Intel
On this Intel chart with MACD and ROC, there have been a number of
signals generated from the centreline crossover. There were a couple
of excellent signals, but there were also plenty of false signals and
whipsaws. This highlights some of the challenges associated with
trading oscillator signals. Also, it stresses the importance of combining
various signals in order to create more robust buy and sell signals.
Some traders also criticize centreline crossover signals as being too
late and missing too much of the move.
A centreline crossover can also act as a confirmation signal to validate
a previous signal or reinforce the current trend. If there were a positive
divergence and bullish moving average crossover, then a subsequent
advance above the centreline would confirm the previous buy signal.
Failure of the oscillator to move above the centreline could be seen as
a non-confirmation and act as an alert that something was amiss.
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Intel
On the Intel chart with MACD, the centreline crossover acts as the
third in a series of bullish signals. Even after the third signal, Intel still
has plenty of upside left.
1. There was the higher low forming that signalled a potential
positive divergence.
2. There was the bullish moving average crossover to confirm the
positive divergence.
3. And finally, there was the bullish centreline crossover.
Some traders would worry about missing too much of the move by
waiting for the third and final confirmation. However, this can be a
more reliable signal and help to avoid whipsaws and false signals. It is
true that waiting for the third signal will reduce profits, but it can also
help reduce risk.
“Skill to do comes of doing”
Ralph Waldo Emerson
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IBM
Chaikin Money Flow is an example of a centred oscillator that places
importance on crosses above and below the centreline. Divergences,
overbought levels and oversold levels are all secondary to the absolute
level of the indicator. The direction of the oscillator's movement is
important, but needs to be placed in the context of the absolute level.
The longer the oscillator is above zero, the more evidence of
accumulation. The longer the oscillator is below zero, the more
evidence of distribution. Hence, Chaikin Money Flow is considered to
be bullish when the oscillator is trading above zero and bearish when
trading below zero.
On the IBM chart, Chaikin Money Flow began to turn down in July. At
this time, the stock was declining with the market and the decline in the
oscillator was normal. However, in the second half of August, concerns
began to grow when the oscillator failed to continue up with the stock
and fell below zero. As the stock advanced further, Chaikin Money
Flow continued to deteriorate. This served as a signal that something
was amiss.
Oscillator Signals Conclusion
Banded oscillators are best used to identify overbought and oversold
conditions. However, overbought is not meant to act a sell signal and
oversold is not meant to act as a buy signal. Overbought and oversold
situations serve as an alert that conditions are reaching extreme levels
and close attention should be paid to the price action and other
indicators.
To improve the robustness of oscillator signals, traders can look for
multiple signals. The criteria for a buy or sell signal could depend on
three separate yet confirming signals. A buy signal might be generated
with an oversold reading, positive divergence and bullish moving
average crossover. Conversely, a sell signal might be generated from
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a negative divergence, bearish moving average crossover and bearish
centreline crossover.
Traditional chart pattern analysis can also be applied to oscillators.
This is a bit trickier, but can help to identify the strength behind an
oscillator's move. Looking for higher highs or lower lows can help
confirm previous analysis. A trendline breakout can signal that a
change in the direction of the momentum is imminent.
It is dangerous to trade an oscillator signal against the major trend of
the market. In bull moves, it is best to look for buying opportunities
through oversold signals, positive divergences, bullish moving average
crossovers and bullish centreline crossovers. In bear moves, it is best
to look for selling opportunities through overbought signals, negative
divergences, bearish moving average crossovers and bearish
centreline crossovers.
And finally, oscillators are most effective when used in conjunction with
pattern analysis, support/resistance identification, trend identification
and other technical analysis tools. By being aware of the broader
picture, oscillator signals can be put into context. It is important to
identify the current trend or even to ascertain if the security is trending
at all. Oscillator readings and signals can have different meaning in
differing circumstances. By using other analysis techniques in
conjunction with oscillator reading, the chances of success can be
greatly enhanced.
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Chapter Nineteen
Chart Indicators Explained.
Accumulation/Distribution Line
A volume indicator, the A/D Line was developed by Marc Chaikin to
assess the cumulative flow of money into and out of a security.
Aroon and Aroon Oscillator
A set of oscillators similar to the ADX system. They help determine the
strength and direction of the current trend.
Average Directional Index (ADX)
An oscillator that assesses the strength of current trends, and can also
be used to identify potential changes in a market from trending to nontrending.
Average True Range (ATR)
An indicator that measures a security's volatility, but gives no indication
of price or duration.
Bollinger Bands
An indicator that allows users to compare volatility and relative price
levels over a period of time.
Commodity Channel Index (CCI)
An oscillator used to identify changes and strengths in a trend, and find
buy or sell signals.
Chaikin Money Flow
An indicator that allows users to compare volatility and relative price
levels over a period of time.
Chaikin Oscillator
Technically an indicator of an indicator, the Chaikin Oscillator gives
momentum characteristics to the Accumulation/Distribution Line.
MACD
One of the simplest and most reliable indicators available, MACD uses
moving averages, which are lagging indicators, to include some trendfollowing characteristics.
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Moving Averages
One of the most popular and easy to use tools, available to the
technical analyst. By using an average of prices, moving averages
smooth a data series and make it easier to spot trends.
Percentage Volume Oscillator
The percentage difference between two moving averages of volume.
The PVO can be used to identify periods of expanding or contracting
volume.
Price Oscillator (including PPO)
An indicator based on the difference between two moving averages,
expressed as either a percentage or in absolute terms.
Price Relative
Compares the performance of one security to another. It is often used
to compare the performance of a particular stock to a market index,
usually the S&P 500 Index.
Price by Volume
Indicates the volume that occurred at various price levels on a chart.
Relative Strength Index
A momentum oscillator that compares the magnitude of gains against
the magnitude of losses.
Standard Deviation
A statistical term that provides a good indication of volatility. It
measures how widely.
Stochastic Oscillator
A momentum indicator that shows the location of the current close
relative to the high/low range over a set number of periods
StochRSI
An oscillator that measures the level of RSI relative to its range, over a
set period of time by applying the formula behind Stochastic
Accumulation/Distribution Line
A volume indicator, the A/D Line was developed by Marc Chaikin to
assess the cumulative flow of money into and out of a security
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Volume and the Flow of Money
There are many indicators available to measure volume and the flow of
money for a particular stock, index or security. One of the most popular
volume indicators over the years has been the
Accumulation/Distribution Line.
The basic premise behind volume indicators, including the
Accumulation/Distribution Line, is that volume precedes price. Volume
reflects the amount of shares traded in a particular stock and is a direct
reflection of the money flowing into and out of a stock. Many times
before a stock advances, there will be period of increased volume just
prior to the move. Most volume or money flow indicators are designed
to identify early increases in positive or negative volume flow to gain
an edge before the price moves. (Note: the terms "money flow" and
"volume flow" are essentially interchangeable.)
Methodology
The Accumulation/Distribution Line was developed by Marc Chaikin to
assess the cumulative flow of money into and out of a security. In
order to fully appreciate the methodology behind the
Accumulation/Distribution Line, it may be helpful to examine one of the
earliest volume indicators and see how it compares.
In 1963, Joe Granville developed On Balance Volume (OBV), which
was one of the earliest and most popular indicators to measure
positive and negative volume flow. OBV is a relatively simple indicator
that adds the corresponding period's volume when the close is up and
subtracts it when the close is down. A cumulative total of the positive
and negative volume flow (additions and subtractions) forms the OBV
line. This line can then be compared with the price chart of the
underlying security to look for divergences or confirmation.
In developing the Accumulation/Distribution Line, Chaikin took a
different approach. OBV uses the change in closing price from one
period to the next to value the volume as positive or negative. Even if a
stock opened on the low and closed on the high, the period's OBV
value would be negative as long as the close was lower than the
previous period's close. Chaikin choose to ignore the change from one
period to the next and instead focused on the price action for a given
period (day, week, month). He derived a formula to calculate a value
based on the location of the close, relative to the range for the period.
We will call this value the "Close Location Value" or CLV. The CLV
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ranges from plus one to minus one with the centre point at zero. There
are basically five combinations:
1. If the stock closes on the high, the absolute top of the range,
then the value would be plus one.
2. If the stock closes above the midpoint of the high-low range,
but below the high, then the value would be between zero and
one.
3. If the stock closes exactly halfway between the high and the
low, then the value would be zero.
4. If the stock closes below the midpoint of the high-low range,
but above the low, then the value would be negative.
5. If the stock closes on the low, the absolute bottom of the
range, then the value would be minus one.
The CLV is then multiplied by the corresponding period's volume and
the cumulative total forms the Accumulation/Distribution Line.
Cienna
The daily chart of CIEN gives a breakdown of the
Accumulation/Distribution Line and shows how different closing levels
affect the value. The top section shows the price chart for CIEN. The
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closing level relative to the high-low range is clearly visible. The
second section with a black histogram is the Closing Location Value
(CLV). The CLV is multiplied by volume and the result appears in the
green histogram. Finally, at the bottom, is the
Accumulation/Distribution Line.
1. The close is on the low and the CLV = -1. Volume, however,
was relatively light and the Accumulation/Distribution Value for
that period is only moderately negative.
2. The close is very near the high and the CLV = +.9273. Volume
is relatively high and the resulting Accumulation/Distribution
Value is high.
3. The close is near the low and the CLV = -.75. Volume is
moderately high and the resulting Accumulation/Distribution
Value is moderately high as well.
4. The close is about half way between the mid-point of the highlow range and the high, and the CLV = +.51. Volume is very
heavy and the Accumulation/Distribution Value is also very
high.
Accumulation/Distribution Line Signals
The signals for the Accumulation/Distribution Line are fairly
straightforward and centre around the concepts of divergence and
confirmation.
Bullish Signals
A bullish signal is given when the Accumulation/Distribution Line forms
a positive divergence. Be wary of weak positive divergences that fail to
make higher reaction highs or those that are relatively young. The
main issue is to identify the general trend of the
Accumulation/Distribution Line. A two-week positive divergence may
be a bit suspect. However, a multi-month positive divergence deserves
serious attention
.
“Goodness is the only investment that never fails”
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Henry David Thoreau
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Alcoa
On the chart for AA, the Accumulation/Distribution Line formed a huge
positive divergence that was over 4 months in the making. Even
though the stock fell from above 35 to below 30, the
Accumulation/Distribution Line continued on a relentless march north.
If one did not know better, it would seem that the two plots did not
belong together. However, the stock finally caught up with the
Accumulation/Distribution Line when it broke resistance in November.
Another means of using the Accumulation/Distribution Line is to
confirm the strength or sustainability behind an advance. In a healthy
advance, the Accumulation/Distribution Line should keep up or at the
very least move in an uptrend. If the stock is moving up at a rapid clip,
but the Accumulation/Distribution Line has trouble making higher highs
or trades sideways, it should serve as an indication that buying
pressure is relatively weak.
Wal-Mart
WMT began a sharp advance in August that was accompanied by an
equally strong move in the Accumulation/Distribution Line. In fact, the
Accumulation/Distribution Line was stronger than the stock in early
September. After a bit of a consolidation, both again started higher and
recorded new reaction highs in early October. Volume flows were
behind this advance from the very beginning and continued
throughout. The stock ended up advancing from 40 to 60 in about 3
months. Interestingly, as of this writing (December 1999) the
Accumulation/Distribution Line has started to move sideways and is
indicating that buying pressure is beginning to wane.
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Bearish Signals
The same principles that apply to positive divergences apply to
negative divergences. The key issue is to identify the main trend in the
Accumulation/Distribution Line and compare it to the underlying
security. Young negative divergences, or those that are relatively flat,
should be looked upon with a healthy dose of scepticism.
The WMT chart shows a relatively flat negative divergence that is just
over a month old. This negative divergence has yet to make a lower
low and should probably be given a little more time to mature. The
relative weakness in the Accumulation/Distribution Line should serve
as a sign that buying pressure is diminishing while the stock remains at
lofty levels.
Delta Airlines
The DAL chart shows a negative divergence that developed within the
confines of a clear downtrend. The stock had clearly broken down and
the Accumulation/Distribution Line was declining in line with the stock.
A deteriorating Accumulation/Distribution Line confirmed weakness in
the stock. During the June-July rally, the stock recorded a new reaction
high, but the Accumulation/Distribution Line failed, thus setting up the
negative divergence.
Conclusion
The Accumulation/Distribution Line is good means to measure the
volume force behind a move.
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•
As a volume indicator, the Accumulation/Distribution Line will
help to determine if the volume in a security is increasing on
the advances or declines.
•
The Accumulation/Distribution Line can be used to gauge the
general flow of money. An uptrend indicates that buying
pressure is prevailing and a downtrend indicates that selling
pressure is prevailing.
•
The Accumulation/Distribution Line can be used to spot
divergences, both positive and negative
•
The Accumulation/Distribution Line can be used to confirm the
strength and sustainability behind a move.
There are some drawbacks to the Accumulation/Distribution Line,
though.
•
The indicator does not take gaps into consideration. A stock
that gaps up and closes midway between the high and the low
will not receive any credit for the advance off of the gap. A
series of gaps could go largely undetected.
•
Because the Accumulation/Distribution Line is clearly tied to
price movement, specifically the close, it will sometimes move
in step with the underlying security and yield few divergences.
•
It sometimes difficult to detect subtle changes in volume flows.
The rate of change in a downtrend could be slowing, but it may
be impossible to detect until the Accumulation/Distribution Line
turns up. This drawback has been addressed in the form of the
Chaikin Oscillator or Chaikin Money Flow, which are next in
the education series.
Aroon and Aroon Oscillator
Developed by Tushar Chande in 1995, the Aroon is an indicator
system that can be used to determine whether a stock is trending or
not and how strong the trend is. "Aroon" means "Dawn's Early Light" in
Sanskrit and Chande choose that name for this indicator since it is
designed to reveal the beginning of a new trend.
The Aroon indicator consists of two lines, Aroon(up) and Aroon(down).
The Aroon Oscillator is a single line that is defined as the difference
between Aroon(up) and Aroon(down). All three take a single
parameter, which is the number of time periods to use in the
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calculation. Since Aroon(up) and Aroon(down) both oscillate between
0 and +100, the Aroon Oscillator ranges from -100 to +100 with zero
serving as the crossover line.
Aroon(up) for a given time period is calculated by determining how
much time (on a percentage basis) elapsed between the start of the
time period and the point at which the highest closing price during that
time period occurred. When the stock is setting new highs for the time
period, Aroon(up) will be 100. If the stock has moved lower every day
during the time period, Aroon(up) will be zero. Aroon(down) is
calculated in just the opposite manner, looking for new lows instead of
new highs.
Technically, the formula for Aroon(up) is [ (# of periods) - (# of periods
since highest close during that time) ] / (# of periods) x 100. The
formula for Aroon(down) is [ (# of periods) - (# of periods since lowest
close during that time) ] / (# of periods) x 100.
For example, consider plotting a 10-period Aroon(up) line on a daily
chart. If the highest closing price for the past ten days occurred 6 days
ago (4 days since the start of the time period), Aroon(up) for today
would be equal to ((10-6)/10) x 100 = 40. If the lowest close in that
same period happened yesterday (i.e. on day 9), Aroon(down) for
today would be 90.
Interpretation Guidelines: Chande states that when Aroon(up) and
Aroon(down) are moving lower in close proximity, it signals a
consolidation phase is under way and no strong trend is evident. When
Aroon(up) dips below 50, it indicates that the current trend has lost its
upward momentum. Similarly, when Aroon(down) dips below 50, the
current downtrend has lost its momentum. Values above 70 indicate a
strong trend in the same direction as the Aroon (up or down) is under
way. Values below 30 indicate that a strong trend in the opposite
direction is underway.
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The Aroon Oscillator signals an upward trend is underway when it is
above zero and a downward trend is underway when it falls below
zero. The farther away the oscillator is from the zero line, the stronger
the trend.
Average Directional Index (ADX)
J. Welles Wilder Jr. developed the Average Directional Index (ADX) in
order to evaluate the strength of the current trend, be it up or down. It's
important to determine whether the market is trending or trading
(moving sideways), because certain indicators give more useful results
depending on the market doing one or the other.
ADX is an oscillator that fluctuates between 0 and 100. Even though
the scale is from 0 to 100, readings above 60 are relatively rare. Low
readings, below 20, indicate a weak trend and high readings, above
40, indicate a strong trend. The indicator does not grade the trend as
bullish or bearish, but merely assesses the strength of the current
trend. A reading above 40 can indicate a strong downtrend as well as
a strong uptrend.
ADX can also be used to identify potential changes in a market from
trending to non-trending. When ADX begins to strengthen from below
20 and/or moves above 20, it is a sign that the trading range is ending
and a trend could be developing.
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When ADX begins to weaken from above 40 and/or moves below 40, it
is a sign that the current trend is losing strength and a trading range
could develop.
ADX is derived from two other indicators, also developed by Wilder,
called the Positive Directional Indicator (sometimes written +DI) and
the Negative Directional Indicator (-DI).
More on ADX can be found in Wilder's book, New Concepts In
Technical Trading Systems, written in 1978. Wilder's indicators remain
some of the best and most popular indicators today
Average True Range (ATX)
Developed by J. Welles Wilder and introduced in his book, New
Concepts in Technical Trading Systems (1978), the Average True
Range (ATR) indicator measures a security's volatility. As such, the
indicator does not provide an indication of price direction or duration,
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simply the degree of price movement or volatility.
As with most of his indicators, Wilder designed ATR with commodities
and daily prices in mind. In 1978, commodities were frequently more
volatile than stocks. However, recent Nasdaq price action may belie
that notion. In addition, commodities were (and still are) often subject
to gaps and limit moves. A limit move occurs when a commodity opens
up or down its maximum allowed move and does not trade again until
the next session. The resulting bar or candlestick would simply be a
small dash. In order to accurately reflect the volatility associated with
commodities, Wilder sought to account for gaps, limit moves and small
high/low ranges in his calculations. A volatility formula based on only
the high/low range would fail to capture the actual volatility created by
the gap or limit move.
Wilder defined the true range (TR) as the greatest of the following:
•
•
•
The current high less the current low.
The absolute value of: current high less the previous close.
The absolute value of: current low less the previous close.
If the current high/low range is large, chances are it will be used as the
TR. If the current high/low range is small, it is likely that one of the
other two methods would be used to calculate the TR. The last two
possibilities usually arise when the previous close is greater than the
current high (signalling a potential gap down and/or limit move) or the
previous close is lower than the current low (signalling a potential gap
up and/or limit move). To ensure positive numbers, absolute values
were applied to differences
The example above shows three potential situations when the TR
would not be based on the current high/low range. Notice that all three
examples have small high/low ranges and two examples show a
significant gap.
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A. A small high/low range formed after a gap up. The TR was
found by calculating the absolute value of the difference
between the current high and the previous close.
B. A small high/low range formed after a gap down. The TR was
found by calculating the absolute value of the difference
between the current low and the previous close.
C. Even though the current close is within the previous high/low
range, the current high/low range is quite small. In fact, it is
smaller than the absolute value of the difference between the
current high and the previous close, which is used to value the
TR.
Typically, the Average True Range (ATR) is based on 14 periods and
can be calculated on an intraday, daily, weekly or monthly basis. For
this example, the ATR will be based on daily data. Because there must
be a beginning, the first TR value in a series is simply the high minus
the low and the first 14-day ATR is found by averaging the daily ATR
values for the last 14 days. After that, Wilder sought to smooth the
data set, by incorporating the previous period's ATR value. The second
and subsequent 14-day ATR value would be calculated with the
following steps:
1. Multiply the previous 14-day ATR by 13.
2. Add the most recent day's TR value.
3. Divide by 14.
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In the Excel spread sheet example above, the first TR value (1.9688)
equals the high minus the low. The first 14-day ATR value (3.6646)
was calculated by finding the average of first 14 TR values. The
second ATR value started the smoothing process by using the
previous value.
The chart above corresponds with the Excel spreadsheet calculations
for Sun Microsystems from 23-Oct 2000 to 7-Dec 2000.
•
•
Day 15: (( 3.6646 x 13 ) + 4.3437 ) / 14 = 3.7131
Day 16: (( 3.7131 x 13 ) + 4.2812 ) / 14 = 3.7536
For those trying this at home, here are a few cautionary notes on
calculations.
•
•
•
•
There is always a beginning and the first calculations may not
conform exactly with the formula. The first TR value is simply
the high minus the low and the first ATR is a simple average of
the first 14 TR values.
Second, many indicators involve a smoothing process. In this
example, the previous period's ATR is used to form the current
ATR.
This example only contains a small portion of total available
price data. The size of the data set will affect the final
outcome. Although the difference is not likely to be huge, a
data set of 33 days will produce a different ATR value than a
data set of 500 days.
If you wish to replicate this formula, first try and duplicate the
example provided using the same open/high/low/close data.
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Once your formulas produce answers that match the example,
you can then plug in your desired open/high/low/close data.
Due to rounding issues and decimal places, an exact match may not
be possible. Also, discrepancies in the open/high/low/close data can
produce different indicator values.
Example: The IBM chart provides an example of the 14-day ATR in
action. Extreme levels (both high and low) can mark turning points or
the beginning of a move. As a volatility-based indicator like Bollinger
Bands, the ATR cannot predict direction or duration, simply activity
levels. Low levels indicate quiet trading (small ranges) and high levels
indicate violent trading (large ranges). A prolonged period of low ATR
readings might indicate consolidation and the beginning of a
continuation move or reversal. High ATR readings usually result from a
sharp advance or decline and are unlikely to be sustained for extended
periods.
Bollinger Bands
Developed by John Bollinger, Bollinger Bands are an indicator that
allows users to compare volatility and relative price levels over a
period time. The indicator consists of three bands designed to
encompass the majority of a security's price action.
1. A simple moving average in the middle
2. An upper band (SMA plus 2 standard deviations)
3. A lower band (SMA minus 2 standard deviations)
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The centreline is the 20-day simple moving average. The upper band
is the 20-day simple moving average plus 2 standard deviations. The
lower band is the 20-day simple moving average less 2 standard
deviations.
Settings
Closing prices are most often used to compute Bollinger Bands. Other
variations, including typical and weighted prices, can also be used.
•
•
Typical Price = (high + low + close)/3
Weighted Price = (high + low + close + close)/4
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Bollinger recommends using a 20-day simple moving average for the
centre band and 2 standard deviations for the outer bands. The length
of the moving average and number of deviations can be adjusted to
better suit individual preferences and specific characteristics of a
security.
Trial and error is one method to determine an appropriate moving
average length. A simple visual assessment can be used to determine
the appropriate number of periods. Bollinger Bands should encompass
the majority of price action, but not all. After sharp moves, penetration
of the bands is normal. If prices appear to penetrate the outer bands
too often, then a longer moving average may be required. If prices
rarely touch the outer bands, then a shorter moving average may be
required.
A more exact method to determine moving average length is by
matching it with a reaction low after a bottom. For a bottom to form and
a downtrend to reverse, a security needs to form a low that is higher
than the previous low. Properly set Bollinger Bands should hold
support established by the second (higher) low. If the second low
penetrates the lower band, then the moving average is too short. If the
second low remains above the lower band, then the moving average is
too long. The same logic can be applied to peaks and reaction rallies.
The upper band should mark resistance for the first reaction rally after
a peak.
The centreline is the 20-day simple moving average. The upper band
is the 20-day simple moving average plus 2 standard deviations. The
lower band is the 20-day simple moving average less 2 standard
deviations.
Settings
Closing prices are most often used to compute Bollinger Bands. Other
variations, including typical and weighted prices, can also be used.
•
•
Typical Price = (high + low + close)/3
Weighted Price = (high + low + close + close)/4
Bollinger recommends using a 20-day simple moving average for the
centre band and 2 standard deviations for the outer bands. The length
of the moving average and number of deviations can be adjusted to
better suit individual preferences and specific characteristics of a
security.
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Trial and error is one method to determine an appropriate moving
average length. A simple visual assessment can be used to determine
the appropriate number of periods. Bollinger Bands should encompass
the majority of price action, but not all. After sharp moves, penetration
of the bands is normal. If prices appear to penetrate the outer bands
too often, then a longer moving average may be required. If prices
rarely touch the outer bands, then a shorter moving average may be
required.
A more exact method to determine moving average length is by
matching it with a reaction low after a bottom. For a bottom to form and
a downtrend to reverse, a security needs to form a low that is higher
than the previous low. Properly set Bollinger Bands should hold
support established by the second (higher) low. If the second low
penetrates the lower band, then the moving average is too short. If the
second low remains above the lower band, then the moving average is
too long. The same logic can be applied to peaks and reaction rallies.
The upper band should mark resistance for the first reaction rally after
a peak.
The centreline is the 20-day simple moving average. The upper band
is the 20-day simple moving average plus 2 standard deviations. The
lower band is the 20-day simple moving average less 2 standard
deviations.
Settings
Closing prices are most often used to compute Bollinger Bands. Other
variations, including typical and weighted prices, can also be used.
•
•
Typical Price = (high + low + close)/3
Weighted Price = (high + low + close + close)/4
Bollinger recommends using a 20-day simple moving average for the
centre band and 2 standard deviations for the outer bands. The length
of the moving average and number of deviations can be adjusted to
better suit individual preferences and specific characteristics of a
security.
Trial and error is one method to determine an appropriate moving
average length. A simple visual assessment can be used to determine
the appropriate number of periods. Bollinger Bands should encompass
the majority of price action, but not all. After sharp moves, penetration
of the bands is normal. If prices appear to penetrate the outer bands
too often, then a longer moving average may be required. If prices
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rarely touch the outer bands, then a shorter moving average may be
required.
A more exact method to determine moving average length is by
matching it with a reaction low after a bottom. For a bottom to form and
a downtrend to reverse, a security needs to form a low that is higher
than the previous low. Properly set Bollinger Bands should hold
support established by the second (higher) low. If the second low
penetrates the lower band, then the moving average is too short. If the
second low remains above the lower band, then the moving average is
too long. The same logic can be applied to peaks and reaction rallies.
The upper band should mark resistance for the first reaction rally after
a peak.
Wal-Mart
For WMT, a 20-period simple moving average proved to be a bit too
long for the Bollinger Bands. Notice the wide gap between the lower
band and the higher low in March. Through trial and error, a 12-period
simple moving average appears to offer a better fit.
For general timeframes, Bollinger recommends a 10-day moving
average for the short term, a 20-day moving average for the
intermediate term and 50-day moving average for the long term.
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Use
In addition to identifying relative price levels and volatility, Bollinger
Bands can be combined with price action and other indicators to
generate signals and foreshadow significant moves.
Double bottom buy: A double bottom buy signal is given when prices
penetrate the lower band and remain above the lower band after a
subsequent low forms. Either low can be higher or lower than the
other. The important thing is that the second low remains above the
lower band. The bullish set-up is confirmed when the price moves
above the middle band, or simple moving average.
AT&T
AT&T provides an example of a double bottom buy signal. The stock
penetrated the lower band in late September (red arrow) and then held
above on the subsequent test in October. The October breakout above
the middle band (green circle) provided the bullish confirmation.
Double top sell: A sell signal is given when prices peak above the
upper band and a subsequent peak fails to break above the upper
band. The bearish set-up is confirmed when prices decline below the
middle band.
Sharp price changes can occur after the bands have tightened and
volatility is low. In this instance, Bollinger Bands do not give any hint as
to the future direction of prices. Direction must be determined using
other indicators and aspects of technical analysis. Many securities go
through periods of high volatility followed by periods of low volatility.
Using Bollinger Bands, these periods can be easily identified with a
visual assessment. Tight bands indicate low volatility and wide bands
indicate high volatility. Volatility can be important for options players
because options prices will be cheaper when volatility is low.
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Starbucks
SBUX provides an example of the bands tightening before a big move.
In November, the bands were relatively wide and began to tighten over
the next 2 months. By early January, the bands were the tightest in
over 4 months (red circle). A little over a week later, the stock exploded
for a 10+ point gain in less than 2 weeks.
Conclusion
Even though Bollinger Bands can help generate buy and sell signals,
they are not designed to determine the future direction of a security.
The bands were designed to augment other analysis techniques and
indicators. By themselves, Bollinger Bands serve two primary
functions:
•
•
To identify periods of high and low volatility
To identify periods when prices are at extreme, and possibly
unsustainable, levels.
As stated above, securities can fluctuate between periods of high
volatility and low volatility. Being able to identify a period of low
volatility can serve as an alert to monitor the price action of a security.
Other aspects of technical analysis, such as momentum, moving
averages and retracements, can then be employed to help determine
the direction of the potential breakout.
Remember that buy and sell signals are not given when prices reach
the upper or lower bands. Such levels merely indicate that prices are
high or low on a relative basis. A security can become overbought or
oversold for an extended period of time. Knowing whether or not prices
are high or low on a relative basis can enhance our interpretation of
other indicators and assist with timing issues in trading.
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Commodity Channel Index (CCI)
Developed by Donald Lambert, the Commodity Channel Index (CCI)
was designed to identify cyclical turns in commodities. The assumption
behind the indicator is that commodities (or stocks or bonds) move in
cycles, with highs and lows coming at periodic intervals. Lambert
recommended using 1/3 of a complete cycle (low to low or high to
high) as a time frame for the CCI. (Note: Determination of the cycle's
length is independent of the CCI.) If the cycle runs 60 days (a low
about every 60 days), then a 20-day CCI would be recommended. For
the purpose of this example, a 20-day CCI is used. There are 4 steps
involved in the calculation of the CCI:
1. Calculate the last period's Typical Price (TP) = (H+L+C)/3
where H = high, L = low, and C = close.
2. Calculate the 20-period Simple Moving Average of the
Typical Price (SMATP).
3. Calculate the Mean Deviation. First, calculate the absolute
value of the difference between the last period's SMATP and
the typical price for each of the past 20 periods. Add all of
these absolute values together and divide by 20 to find the
Mean Deviation.
4. The final step is to apply the Typical Price (TP), the Simple
Moving Average of the Typical Price (SMATP), the Mean
Deviation and a Constant (.015) to the following formula:
Dell Computer
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For scaling purposes, Lambert set the constant at .015 to ensure that
approximately 70 to 80 percent of CCI values would fall between -100
and +100. The CCI fluctuates above and below zero. The percentage
of CCI values that fall between +100 and -100 will depend on the
number of periods used. A shorter CCI will be more volatile with a
smaller percentage of values between +100 and -100. Conversely, the
more periods used to calculate the CCI, the higher the percentage of
values between +100 and -100.
Lambert's trading guidelines for the CCI focused on movements above
+100 and below -100 to generate buy and sell signals. Because about
70 to 80 percent of the CCI values are between +100 and -100, a buy
or sell signal will be in force only 20 to 30 percent of the time. When
the CCI moves above +100, a security is considered to be entering into
a strong uptrend and a buy signal is given. The position should be
closed when the CCI moves back below +100. When the CCI moves
below -100, the security is considered to be in a strong downtrend and
a sell signal is given. The position should be closed when the CCI
moves back above -100.
Since Lambert's original guidelines, traders have also found the CCI
valuable for identifying reversals. The CCI is a versatile indicator
capable of producing a wide array of buy and sell signals.
•
•
CCI can be used to identify overbought and oversold levels. A
security would be deemed oversold when the CCI dips below 100 and overbought when it exceeds +100. From oversold
levels, a buy signal might be given when the CCI moves back
above -100. From overbought levels, a sell signal might be
given when the CCI moved back below +100.
As with most oscillators, divergences can also be applied to
increase the robustness of signals. A positive divergence
below -100 would increase the robustness of a signal based
on a move back above -100. A negative divergence above
+100 would increase the robustness of a signal based on a
move back below +100.
Trendline breaks can be used to generate signals. Trendlines can be
drawn connecting the peaks and troughs. From oversold levels, an
advance above -100 and trendline breakout could be considered
bullish. From overbought levels, a decline below +100 and a trendline
break could be considered bearish. Rex Takasugi has used this type of
system to trade the Russell 2000.
Traders and investors use the CCI to help identify price reversals,
price extremes and trend strength. As with most indicators, the CCI
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should be used in conjunction with other aspects of technical analysis.
CCI fits into the momentum category of oscillators. In addition to
momentum, volume indicators and the price chart may also influence a
technical assessment.
Brooktrout
The 25-day CCI for Brooktrout (BRKT) provides an example using
Lambert's guidelines. Even though a few signals are good, using
crosses above and below +100/-100 resulted in plenty of whipsaws. In
January, the stock broke resistance at 20 and proceeded to double in
the next few weeks. The CCI moved above and below +100 several
times, but the stock remained in a strong uptrend. The CCI did
manage to remain above +50 for about 7 weeks (blue oval), but the
whipsaws below +100 could have caused an early exit. Whipsaws do
not make an indicator bad. However, traders and investors should
learn to use the CCI in conjunction with other indicators and chart
analysis. In addition, various time frames for the CCI should be tested
as well as buy and sell points. For Brooktrout, a buy point on a cross
above and below +50 may have worked better. What works for one
stock may not necessarily work for another stock.
Chaikin Money Flow
Developed by Marc Chaikin, the Chaikin Money Flow oscillator is
calculated from the daily readings of the Accumulation/Distribution
Line. The basic premise behind the Accumulation Distribution Line is
that the degree of buying or selling pressure can be determined by the
location of the close relative to the high and low for the corresponding
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period (Closing Location Value). There is buying pressure when a
stock closes in the upper half of a period's range and there is selling
pressure when a stock closes in the lower half of the period's trading
range. The Closing Location Value multiplied by volume forms the
Accumulation/Distribution Value for each period. (See our Chart
School article for a detailed analysis of the Accumulation/Distribution
Line.)
Cienna
Methodology
The CIEN chart details the breakdown of the daily
Accumulation/Distribution Values and how they relate to Chaikin
Money Flow. The formula for Chaikin Money Flow is the cumulative
total of the Accumulation/Distribution Values for 21 periods divided by
the cumulative total of volume for 21 periods.
On the CIEN chart, the purple box encloses 21 days of
Accumulation/Distribution Values. The total of these 21 days divided
by the total for the 21 days of volume forms the value of Chaikin
Money Flow at the end of that day (purple arrow). To calculate the next
day, the Accumulation/Distribution Value from the first day is removed
and the value for the next day is entered into the equation.
The number of periods can be changed to best suit a particular
security and timeframe. The 21-day Chaikin Money Flow is a good
representation of the buying and selling pressure for the past month. A
month is long enough to filter out the random noise. By using a longer
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timeframe, the indicator will be less volatile and be less prone to
whipsaws. For weekly and monthly charts, a shorter timeframe is
usually suitable.
Generally speaking, Chaikin Money Flow is considered bullish when it
is positive and bearish when it is negative. The next item to assess is
the length of time Chaikin Money Flow has remained positive or
negative. Even though divergences are not an intricate part of the
strategy behind Chaikin Money Flow, the absolute level and general
direction of the oscillator can be important.
Accumulation Indicators
The Chaikin Money Flow oscillator generates bullish signals by
indicating that a security is under accumulation. There are three items
that determine if a security is under accumulation and the strength of
the accumulation.
•
The first and most obvious signal to look for: is Chaikin Money
Flow greater than zero? It is an indication of buying pressure
and accumulation when the indicator is positive
•
The second item: determine how long the oscillator has been
able to remain above zero. The longer the oscillator remains
above zero, the more evidence there is that the security is
under sustained accumulation. Extended periods of
accumulation or buying pressure are bullish and indicate that
sentiment towards the security remains positive.
•
The third indication: the actual level of the oscillator. Not only
should the oscillator remain above zero, but it should also be
able to increase and attain a certain level. The more positive
the reading is, the more evidence of buying pressure and
accumulation. There is such a thing as weak buying! This is
usually a judgment call, based on prior levels for the oscillator.
“All things are difficult before they are easy”
Thomas Fuller
(1608-1661)
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Alcoa
On the chart for AA, Chaikin Money Flow actually strengthened while
the stock continued to decline. For most of October, the stock traded
flat while Chaikin Money Flow remained positive and continued to
strengthen. The accumulation levels, as evidenced by Chaikin Money
Flow, were very strong in October. The stock fell at the end of October
and Chaikin Money Flow declined in November. When the stock fell,
distribution levels never surpassed -.10, indicating that selling pressure
was not that intense. In late November, the stock managed a
comeback and broke resistance at 64. Chaikin Money Flow formed a
higher low and returned to positive territory to confirm the breakout.
Selling pressure dried up quickly and Chaikin Money Flow was able to
bounce back in strong fashion. The evidence is clearly bullish, but to
capitalize a trader would have had to act fast.
AOL
The chart for AOL is a bit different. The stock formed a double bottom
in August and September while Chaikin Money Flow formed a rather
large positive divergence. This divergence was not a signal, but would
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have served as an alert that the selling pressure was decreasing.
Divergences can be difficult to act on and should be used in
conjunction with other aspects of technical analysis. By the time the
stock broke resistance at 52, Chaikin Money Flow has moved from a
mildly bearish levels just above -.10 to moderately bullish levels just
above +.13. The interesting point about AOL is the period from 28-Sept
to 22-Oct (grey lines). During this period, the stock traded sideways,
but Chaikin Money Flow continued to strengthen as buying pressure
intensified. The oscillator moved from +.1208 on 28-Sept to +.2377 on
22-Oct. Buying pressure has nearly doubled. This was a clearly bullish
indication and the stock soon obliged with an advance from the low
fifties to over 90.
The Chaikin Money Flow oscillator generates bearish signals by
indicating that a security is experiencing selling pressure, or is perhaps
under distribution. As with the bullish signals, there are three items
used to determine whether or not a security is experiencing selling
pressure and the degree of selling pressure.
•
The first and most obvious bearish signal is when Chaikin
Money Flow is less than zero. A negative reading indicates
that the security in question is under selling pressure or
experiencing distribution.
•
The second potentially bearish signal is the length of time that
Chaikin Money Flow has remained negative. The longer the
oscillator remains negative, the greater the evidence of
sustained selling pressure or distribution. Extended periods
below zero indicate that sentiment towards the underlying
security is bearish and there is likely to be downward pressure
on the price as well. The length of time can be determined by
measuring the percentage of time that the indicator remains
below zero. If Chaikin Money Flow is negative to 3 out of 4
weeks, then it would be experiencing selling pressure 75% of
the time.
•
The third potentially bearish signal is the degree of selling
pressure or distribution. This can be determined by the
oscillator's absolute level. Readings on either side of the zero
line or within 10 percent of both sides (plus or minus .10) are
usually not considered strong enough to warrant a bullish or
bearish signal. Once the indicator moves below -.10, the
degree selling pressure begins to warrant a bearish signal. (A
move above .10 would be significant enough to warrant a
bullish signal). Any further movement would increase the
degree of selling pressure and the bearish or bullish
inclination. Marc Chaikin considers a reading below 25 percent
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(.25) to be indicative of strong selling pressure. Conversely, a
reading above .25 is considered to be indicative of strong
buying pressure. These levels are general guidelines and
establishing important levels will depend on the characteristics
of the individual security and past readings for Chaikin Money
Flow.
J.C. Penney
J. C. Penny (JCP) is an example of a stock that experienced
distribution for many weeks before the price actually fell. Once the
price began to fall, the indicator remained in negative territory for an
extended period of time. From March to May, Chaikin Money Flow had
been positive (green). On 18-May, the stock gapped up on the open,
but the indicator abruptly fell and turned negative (red arrows). The
stock advanced intraday on the 18th, but fell by the close to end the
day near the lows. Based on the previous close, the stock advanced.
However, from the perspective of Chaikin Money Flow, the stock
closed near the low for the day on heavy volume, which is regarded as
selling pressure.
“Excessive fear is always powerless”
Aeschylus
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J.C. Penney
To prove that this abrupt change was not a fluke, the indicator declined
further over the next several weeks and remained negative for almost
3 months, indicating that selling pressure was strong in the stock. Not
only did the selling pressure remain for an extended period, but also
the degree of selling pressure increased. Chaikin Money Flow reached
a low of -.468 (negative 46.8 percent) while the stock was near its
highs around 50. The stock began to confirm the selling pressure and
worked its way down in June and July.
There were a few weeks in August when the indicator turned positive.
This might have been seen as bullish, but it lasted a mere 3 weeks and
Chaikin Money Flow only managed to get as high as +.1270.
Furthermore, the price action of the stock never confirmed this strength
and it is likely that other price and momentum indicators were bearish
as well. The positive readings did not last long and by early
September, Chaikin Money Flow was trading below -.25 and the stock
was trading around 36. This was a solid signal that selling pressure in
the stock remained heavy and there would likely be downward
pressure on the price before long. The stock subsequently declined
below 20 and Chaikin Money Flow has not been positive since late
August.
All three indications of selling pressure were prevalent in JCP:
•
•
•
Chaikin Money Flow turned negative before the stock
declined.
The indicator remained negative for 6 out of 7 months (85% of
the time).
Almost all of the negative readings were below -.10 and many
times the indicator dipped below -.25.
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IBM
IBM provides an excellent example of a reaction rally that had failure
written all over it. When the stock peaked in July, Chaikin Money Flow
was already well off of its highs. The indicator was still positive and
mildly bullish, but could not surpass +.10 to even partially confirm the
high. The indicator formed a double top in July with both peaks well
below +.10. After the decline in late July, the stock began to find
support and rallied in August, but Chaikin Money Flow would have
none of it. The indicator broke below -.10 twice and remained negative
for almost the entire month. When the stock reached its September
reaction high, Chaikin Money Flow was still negative.
After the September high in the stock, things began to fall apart. On
17-Sept, the stock declined with heavy volume and Chaikin Money
Flow recorded a new reaction low. Each of these items is marked with
a blue arrow on the chart. By this time, selling pressure had been
evident for over a month. Chaikin Money Flow had been negative the
whole time and had progressively weakened. The sharp decline in the
stock on the heaviest volume in over 4 months indicated something
was not right. The final straw came when support at 118.5 was broken
and Chaikin Money Flow was trading below -.20.
Chaikin Money Flow and Other Indicators
It is best to choose indicators that complement each other. In a recent
interview with Technical Analysis of Stocks and Commodities
magazine, Marc Chaikin advises against using indicators that have
common characteristics. It would be redundant to analyse both
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Momentum and MACD. These are both momentum oscillators that are
based on the closing price and reflect the rate of change. Their signals
will not be exactly the same, but it would be a waste of valuable time to
analyse both. Chaikin singles out the Stochastic Oscillator, CCI and
RSI as similar indicators. All three are banded momentum oscillators
that are good for detecting overbought and oversold conditions. Buy
and sell signals are also generated in much the same fashion. All three
are excellent indicators, but it would be a waste of time to follow all
three when one will be sufficient.
Chaikin Money Flow can be used to identify the tradable trend. If
Chaikin Money Flow has been above zero for most of the past three
months, then prudence would dictate that the tradable trend is up. The
oscillator is indicating that buying pressure prevails. It would not be
sensible to attempt a short sale if the tradable trend is up. By
identifying the tradable trend, traders can ignore bearish signals and
only pay attention to signals that concur. If Chaikin Money Flow
indicates that buying pressure prevails, then positive divergences,
bullish moving average crossovers, bullish centreline crossovers and
bullish oversold crossovers would be potential buy signals. (A bullish
oversold crossover occurs when an indicator advances above the
oversold line. This would be a move from below 30 to above 30 for
RSI). All bearish signals would be ignored, at least as long as Chaikin
Money Flow indicated that buying pressure reigned.
One possible combination of indicators would be the following:
•
•
•
•
Chaikin Money Flow - A non-trend-following volume indicator
to identify buying and selling pressure.
RSI - A momentum indicator used to identify potential
overbought and oversold levels.
Moving averages - A trend-following indicator to identify the
underlying trend in the stock.
Price relative - A comparative indicator to identify the strength
of the stock relative to a major index.
These four indicators have little in common and complement each
other very well.
Conclusion
Chaikin Money Flow is an indicator that is best used in conjunction
with other aspects of technical analysis. This is usually the case with
indicators, but probably even more so in this case. The oscillator is
unlike a momentum oscillator and is not influenced by the price change
from day to day. Instead, the indicator focuses on the location of the
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close relative to the range for the period (daily or weekly). This is the
strength of Chaikin Money Flow, but can also be its weakness.
Because Chaikin Money Flow does not reflect the change in price from
day to day or week to week, large opening gaps are sometimes not
reflected in the indicator. Sometimes the indicator moves in the
opposite direction of the gap and creates a misleading picture.
Starbucks
Starbucks (SBUX) formed a large down gap on 1-July with extremely
heavy volume. Even though the stock opened more than 10 points
lower, it managed to close on the high for the day. Strong closes
indicate accumulation and the heavy volume amplified this message to
cause a large jump in the indicator. The strength was a bit misleading
and the indicator slowly declined over the next 20 days. On the 21st
day, the data from 1-July was removed and the current day's data
added. This caused an immediate drop in the indicator. Chaikin Money
Flow was well below zero the next day and more accurately reflected
the selling pressure taking place in the stock.
Even though Chaikin Money Flow can be used on an intraday, daily or
weekly basis, it was designed with daily data in mind. One day is an
unambiguous time period with measurable volume and a specific
open, high, low and close. This definability may lessen in the future,
with the proliferation of after-hours trading, but determining the location
of the close relative to the high and low is still fairly straightforward.
When dealing with weekly or monthly data, the beginning and end are
less precise. This imprecision can affect the location of the close
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relative to the high and low for the period. Weekly is obviously more
definable than monthly, but less definable than daily. This is something
to consider when analysing Chaikin Money Flow with periods other
than daily.
Chaikin advocated a 21-day time frame for Chaikin Money Flow. If
Chaikin Money Flow is to be used on a weekly chart, a shorter time
frame will probably work better. A 21-day period represents about one
month of trading and will allow for some smoothing. A shorter
timeframe may prove too choppy, but a longer time frame may lag too
much. Each security will have its own optimum time frame.
Keep in mind that the short-term trend is not as important as the
absolute level. As long as the indicator remains above zero, it is
considered bullish. It is also important to gauge the length of time that
the indicator remains positive. If the indicator is positive for 7 out of 9
weeks, then buying pressure is the order of the day. The two negative
weeks are a blip on the radar, and should not be taken out of context.
Chaikin Oscillator
The Accumulation/Distribution Line was covered in a previous chapter:
here we will examine an indicator that stems from the concept behind
the Accumulation/Distribution Line: the Chaikin Oscillator or Chaikin
A/D Oscillator as it is sometimes called, named after its creator, Marc
Chaikin. Before reading this article, you may want to become familiar
with the concepts behind the Accumulation/Distribution Line.
The basic premise of the Accumulation/Distribution Line is that the
degree of buying or selling pressure can be determined by the location
of the close, relative to the high and low for the corresponding period.
There is buying pressure when a stock closes in the upper half of a
period's range and there is selling pressure when a stock closes in the
lower half of the period's trading range.
“The man who makes no mistakes does not usually make
anything”
Bishop W.C Maggee (1821-1899)
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The CIEN chart shows the relationship among each period's
Accumulation/Distribution Value, Accumulation/Distribution Line, and
Chaikin Oscillator. The same four points noted in the
Accumulation/Distribution Line article have been noted in this example
for reference as well.
Methodology
The Chaikin Oscillator is simply the Moving Average Convergence
Divergence indicator (MACD) applied to the Accumulation/Distribution
Line. The formula is the difference between the 3-day exponential
moving average and the 10-day exponential moving average of the
Accumulation/Distribution Line. Just as the MACD-Histogram is an
indicator to predict moving average crossovers in MACD, the Chaikin
Oscillator is an indicator to predict changes in the
Accumulation/Distribution Line.
Many of the same signals that apply to MACD are also applicable to
the Chaikin Oscillator. Keep in mind though, that these signals relate to
the Accumulation/Distribution Line, not directly to the stock itself.
Readers may want to refer to our MACD series for more detailed
information on various signals such as positive divergences, negative
divergences and centreline crossovers.
Just as MACD injects momentum characteristics into moving
averages, the Chaikin Oscillator gives momentum characteristics to
the Accumulation/Distribution Line, which can be a bit of a laggard
sometimes. By adding momentum features, the Chaikin Oscillator will
lead the Accumulation/Distribution Line. The CIEN chart confirms that
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movements in the Accumulation/Distribution Line are usually preceded
by corresponding divergences in the Chaikin Oscillator.
1. The July negative divergence in the Chaikin Oscillator
foreshadowed the impending weakness in the
Accumulation/Distribution Line. This was a slant type
divergence that is characterized by its lack of distinctive peaks
to form the divergence. The Chaikin Oscillator peaked about a
week before the Accumulation/Distribution Line and formed a
bearish centreline crossover 2 weeks later. When the oscillator
is negative, it implies that momentum for the
Accumulation/Distribution Line is negative or bearish, which
would ultimately be a negative reflection on the stock.
2. The August positive divergence in the Chaikin Oscillator
foreshadowed a sharp advance in the
Accumulation/Distribution Line. This divergence was longer
and could have been referred to as a trough divergence. In a
trough divergence there are two noticeable troughs, one
higher than the other, that form the divergence. The bullish, or
positive, momentum was confirmed when the Chaikin
Oscillator formed a bullish moving average crossover in late
August.
Bullish Signals
There are two bullish signals that can be generated from the Chaikin
Oscillator: positive divergences and centreline crossovers. Because
the Chaikin Oscillator is an indicator of an indicator, it is prudent to look
for confirmation of a positive divergence, by a bullish moving average
crossover for example, before counting this as a bullish signal. The
chart for KO is an excellent example of a positive divergence that has
been confirmed by a centreline crossover.
Coca Cola Co
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1. The positive divergence is sharp and pronounced. When using
an indicator of an indicator, it is preferable to take only strong
signals. Note the steepness of the positive divergence.
2. The bullish centreline crossover occurred in the Chaikin
Oscillator before the Accumulation/Distribution Line broke to a
new reaction high.
3. At the point of the centreline crossover (green dotted line), the
stock also broke resistance and the bullish signal was further
validated.
Bearish Signals
In direct contrast to the bullish signals, there are two bearish signals
that can be generated from the Chaikin Oscillator: a negative
divergence and a bearish centreline crossover. Allow a negative
divergence to be confirmed by a bearish centreline crossover, before a
bullish signal is rendered. The chart for MRK shows a recent bearish
signal that coincided with a support break in the stock.
Coca Cola Co.
1. The negative divergence is not as sharp and pronounced at
the positive divergence in KO, but it is detectable none the
less. Divergences that cover long time spans are sometimes
difficult to time for a trade.
2. It is easy to see the effects of price action on the Chaikin
Oscillator and the Accumulation/Distribution Line in this
example. The blue lines mark a period when the stock traded
basically flat for 13 days. However, many of the closes for this
period were below the midway point and some were near the
intraday lows. Note the action of the Chaikin Oscillator and
Accumulation/Distribution Line during this period; both
declined markedly.
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3. The bearish centreline crossover to confirm the divergence
occurred just recently and coincided with a break of support in
the stock and a trendline break in the
Accumulation/Distribution Line.
Conclusion
The Chaikin Oscillator is good for adding momentum to the
Accumulation/Distribution Line, but can sometimes add a little too
much momentum and be difficult to interpret. The moving averages are
both relatively short and will therefore be more sensitive to changes in
the Accumulation/Distribution Line. Sensitivity is important, but one
must also be able to interpret the indicator. Those with the software
and resources may try different moving averages to further smooth the
fluctuations. This indicator should definitely be used in conjunction with
other aspects of technical analysis.
Chaikin Money Flow is one answer to the volatility that has been
created from the Chaikin Oscillator.
MACD
The Combination Oscillator
Developed by Gerald Appel, Moving Average Convergence
Divergence (MACD) is one of the simplest and most reliable indicators
available. MACD uses moving averages, which are lagging indicators,
to include some trend-following characteristics. These lagging
indicators are turned into a momentum oscillator by subtracting the
faster moving average from the slower moving average. The resulting
plot forms a line that oscillates above and below zero, without any
upper or lower limits. MACD is a centred oscillator and the guidelines
for using centred oscillators apply.
MACD Formula
The most popular formula for the "standard" MACD is the difference
between a security's 26-day and 12-day exponential moving averages.
This is the formula that is used in many popular technical analysis
programs, including SharpCharts, and quoted in most technical
analysis books on the subject. Appel and others have since tinkered
with these original settings to come up with a MACD that is better
suited for faster or slower securities. Using shorter moving averages
will produce a quicker, more responsive indicator, while using longer
moving averages will produce a slower indicator, less prone to
whipsaws. For our purposes in this article, the traditional 12/26 MACD
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will be used for explanations. Later in the indicator series, we will
address the use of different moving averages in calculating MACD.
Of the two moving averages that make up MACD, the 12-day EMA is
the faster and the 26-day EMA is the slower. Closing prices are used
to form the moving averages. Usually, a 9-day EMA of MACD is
plotted as a along side to act as a trigger line. A bullish crossover
occurs when MACD moves above its 9-day EMA and a bearish
crossover occurs when MACD moves below its 9-day EMA. The Merrill
Lynch chart below shows the 12-day EMA (thin green line) with the 26day EMA (thin blue line) overlaid the price plot. MACD appears in the
box below as the thick black line and its 9-day EMA is the thin blue
line. The histogram represents the difference between MACD and its
9-day EMA. The histogram is positive when MACD is above its 9-day
EMA and negative when MACD is below its 9-day EMA.
Merrill Lynch
What does MACD do?
MACD measures the difference between two moving averages. A
positive MACD indicates that the 12-day EMA is trading above the 26day EMA. A negative MACD indicates that the 12-day EMA is trading
below the 26-day EMA. If MACD is positive and rising, then the gap
between the 12-day EMA and the 26-day EMA is widening. This
indicates that the rate-of-change of the faster moving average is higher
than the rate-of-change for the slower moving average. Positive
momentum is increasing and this would be considered bullish. If
MACD is negative and declining further, then the negative gap
between the faster moving average (green) and the slower moving
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average (blue) is expanding. Downward momentum is accelerating
and this would be considered bearish. MACD centreline crossovers
occur when the faster moving average crosses the slower moving
average.
Merrill Lynch
This Merrill Lynch chart shows MACD as a solid black line and its 9day EMA as the thin blue line. Even though moving averages are
lagging indicators, notice that MACD moves faster than the moving
averages. In this example with Merrill Lynch, MACD also provided a
few good trading signals as well.
•
•
•
In March and April, MACD turned down ahead of both moving
averages and formed a negative divergence ahead of the price
peak.
In May and June, MACD began to strengthen and make higher
lows while both moving averages continued to make lower
lows.
And finally, MACD formed a positive divergence in October
while both moving averages recorded new lows.
MACD Bullish Signals
MACD generates bullish signals from three main sources:
•
•
•
Positive divergence
Bullish moving average crossover
Bullish centreline crossover
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Positive Divergence
Novellus
A positive divergence occurs when MACD begins to advance and the
security is still in a downtrend and makes a lower reaction low. MACD
can either form as a series of higher lows or a second low that is
higher than the previous low. Positive divergences are probably the
least common of the three signals, but are usually the most reliable
and lead to the biggest moves.
Bullish Moving Average Crossover
Novellus
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A bullish moving average crossover occurs when MACD moves above
its 9-day EMA or trigger line. Bullish moving average crossovers are
probably the most common signals and as such are the least reliable.
If not used in conjunction with other technical analysis tools, these
crossovers can lead to whipsaws and many false signals. Moving
average crossovers are sometimes used to confirm a positive
divergence. The second low or higher low of a positive divergence can
be considered valid when it is followed by a bullish moving average
crossover.
Sometimes it is prudent to apply a price filter to the moving average
crossover in order to ensure that it will hold. An example of a price filter
would be to buy if MACD breaks above the 9-day EMA and remains
above for three days. The buy signal would then commence at the end
of the third day.
Bullish Centreline Crossover
Apple
A bullish centreline crossover occurs when MACD moves above the
zero line and into positive territory. This is a clear indication that
momentum has changed from negative to positive, or from bearish to
bullish. After a positive divergence and bullish moving average
crossover, the centreline crossover can act as a confirmation signal. Of
the three signals, moving average crossover are probably the second
most common signals.
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Using a Combination of Signals
Halliburton
Even though some traders may use only one of the above signals to
form a buy or a sell signal, using a combination can generate more
robust signals. In the Halliburton example, all three bullish signals were
present and the stock still advanced another 20%. The stock formed a
lower low at the end of February, but MACD formed a higher low, thus
creating a potential positive divergence. MACD then formed a bullish
crossover by moving above its 9-day EMA. And finally, MACD traded
above zero to form a bullish centreline crossover. At the time of the
bullish centreline crossover, the stock was trading at 32 1/4 and went
above 40 immediately after that. In August, the stock traded above 50.
MACD Bearish Signals
MACD generates bearish signals from three main sources. These
signals are mirror reflections of the bullish signals.
•
•
•
Negative divergence
Bearish moving average crossover
Bearish centreline crossover
Negative Divergence
A negative divergence forms when the security advances or moves
sideways and MACD declines. The negative divergence in MACD can
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take the form of either a lower high or a straight decline. Negative
divergences are probably the least common of the three signals, but
are usually the most reliable and can warn of an impending peak.
Federal Express
The FDX chart shows a negative divergence when MACD formed a
lower high in May and the stock formed a higher high at the same time.
This was a rather blatant negative divergence and signalled that
momentum was slowing. A few days later, the stock broke the uptrend
line and MACD formed a lower low.
There are two possible means of confirming a negative divergence.
First, the indicator can form a lower low. This is traditional peak-andtrough analysis applied to an indicator. With the lower high and
subsequent lower low, the up trend for MACD has changed from
bullish to bearish. Second, a bearish moving average crossover, which
is explained below, can act to confirm a negative divergence. As long
as MACD is trading above its 9-day EMA or trigger line, it has not
turned down and the lower high is difficult to confirm. When MACD
breaks below its 9-day EMA, it signals that the short-term trend for the
indicator is weakening, and a possible interim peak has formed.
Bearish moving average crossover
The most common signal for MACD is the moving average crossover.
A bearish moving average crossover occurs when MACD declines
below its 9-day EMA. Not only are these signals the most common, but
they also produce the most false signals. As such, moving average
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crossovers should be confirmed with other signals to avoid whipsaws
and false readings.
Merck
Sometimes a stock can be in a strong uptrend and MACD will remain
above its trigger line for a sustained period of time. In this case, it is
unlikely that a negative divergence will develop. A different signal is
needed to identify a potential change in momentum. This was the case
with MRK in February and March. The stock advanced in a strong up
trend and MACD remained above its 9-day EMA for 7 weeks. When a
bearish moving average crossover occurred, it signalled that upside
momentum was slowing. This slowing momentum should have served
as an alert to monitor the technical situation for further clues of
weakness. Weakness was soon confirmed when the stock broke its
uptrend line and MACD continued its decline and moved below zero.
Bearish centreline crossover
A bearish centreline crossover occurs when MACD moves below zero
and into negative territory. This is a clear indication that momentum
has changed from positive to negative, or from bullish to bearish. The
centreline crossover can act as an independent signal, or confirm a
prior signal such as a moving average crossover or negative
divergence. Once MACD crosses into negative territory, momentum, at
least for the short term, has turned bearish.
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Unisys
The significance of the centreline crossover will depend on the
previous movements of MACD as well. If MACD is positive for many
weeks, begins to trend down and then crosses into negative territory, it
would be considered bearish. However, if MACD has been negative for
a few months, breaks above zero and then back below, it may be seen
as more of a correction. In order to judge the significance of a
centreline crossover, traditional technical analysis can be applied to
see if there has been a change in trend, higher high or lower low.
The UIS chart depicts a bearish centreline crossover that preceded a
25% drop in the stock. Although there was little time to act once this
signal appeared, there were other warnings signs just prior to the
dramatic drop.
•
•
•
•
After the drop to trendline support , a bearish moving average
crossover formed.
When the stock rebounded from the drop, MACD did not even
break above the trigger line, indicating weak upside
momentum.
The peak of the reaction rally was marked by a shooting star
candlestick (blue arrow) and a gap down on increased volume
(red arrows).
After the gap down, the trendline extending up from Apr-98
was broken.
In addition to the signal mentioned above, the bearish centreline
crossover occurred after MACD had been above zero for almost two
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months. Since 20-Sept, MACD had been weakening and momentum
was slowing. The break below zero acted as the final straw of a long
weakening process.
Combining Signals
As with bullish MACD signals, bearish signals can be combined to
create more robust signals. In most cases, stocks fall faster than they
rise. This was definitely the case with UIS and only two bearish MACD
signals were present. Using momentum indicators like MACD,
technical analysis can sometimes provide clues to impending
weakness. While it may be impossible to predict the length and
duration of the decline, being able to spot weakness can enable
traders to take a more defensive position.
Compaq
After issuing a profit warning in late Feb-00, CPQ dropped from above
40 to below 25 in a few months. Without inside information, predicting
the profit warning would be pretty much impossible. However, it would
seem that smart money began distributing the stock before the actual
warnings. Looking at the technical picture, we can spot evidence of
this distribution and a serious loss of momentum.
•
•
•
In January, a negative divergence formed in MACD.
Chaikin Money Flow turned negative on January 21.
Also in January, a bearish moving average crossover occurred
in MACD (black arrow).
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•
•
•
The trendline extending up from October was broken on 4Feb.
A bearish centreline crossover occurred in MACD on 10-Feb
(green arrow).
On 16, 17 and 18-Feb, support at 41 1/2 was violated (red
arrow).
A full 10 days passed in which MACD was below zero and continued
to decline (thin red lines). The day before the gap down, MACD was at
levels not seen since October. For those waiting for a recovery in the
stock, the continued decline of momentum suggested that selling
pressure was increasing, and not about to decrease. Hindsight is
20/20, but with careful study of past situations, we can learn how to
better read the present and prepare for the future.
MACD Benefits
One of the primary benefits of MACD is that it incorporates aspects of
both momentum and trend in one indicator. As a trend-following
indicator, it will not be wrong for very long. The use of moving
averages ensures that the indicator will eventually follow the
movements of the underlying security. By using exponential moving
averages, as opposed to simple moving averages, some of the lag has
been taken out.
As a momentum indicator, MACD has the ability to foreshadow moves
in the underlying security. MACD divergences can be key factors in
predicting a trend change. A negative divergence signals that bullish
momentum is waning and there could be a potential change in trend
from bullish to bearish. This can serve as an alert for traders to take
some profits in long positions, or for aggressive traders to consider
initiating a short position.
MACD can be applied to daily, weekly or monthly charts. MACD
represents the convergence and divergence of two moving averages.
The standard setting for MACD is the difference between the 12 and
26-period EMA. However, any combination of moving averages can be
used. The set of moving averages used in MACD can be tailored for
each individual security. For weekly charts, a faster set of moving
averages may be appropriate. For volatile stocks, slower moving
averages may be needed to help smooth the data. No matter what the
characteristics of the underlying security, each individual can set
MACD to suit his or her own trading style, objectives and risk
tolerance.
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MACD Drawbacks
One of the beneficial aspects of MACD may also be a drawback.
Moving averages, be they simple, exponential or weighted, are lagging
indicators. Even though MACD represents the difference between two
moving averages, there can still be some lag in the indicator itself. This
is more likely to be the case with weekly charts than daily charts. One
solution to this problem is the use of the MACD-Histogram.
MACD is not particularly good for identifying overbought and oversold
levels. Even though it is possible to identify levels that historically
represent overbought and oversold levels, MACD does not have any
upper or lower limits to bind its movement. MACD can continue to
overextend beyond historical extremes.
MACD calculates the absolute difference between two moving
averages and not the percentage difference. MACD is calculated by
subtracting one moving average from the other. As a security
increases in price, the difference (both positive and negative) between
the two moving averages is destined to grow. This makes its difficult to
compare MACD levels over a long period of time, especially for stocks
that have grown exponentially.
Amazon
The AMZN chart demonstrates the difficult in comparing MACD levels
over a long period of time. Before 1999, AMZN's MACD is barely
recognizable and appears to trade close to the zero line. MACD was
indeed quite volatile at the time, but this volatility has been dwarfed
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since the stock rose from below 20 to almost 100.
An alternative is to use the Price Oscillator, which find the percentage
difference between two moving averages:
(12 day EMA - 26 day EMA) / (12 day EMA)
(20 - 18) / 20 = .10 or +10%
The resulting percentage difference can be compared over a longer
period of time. On the AMZN chart, we can see that the Price
Oscillator provides a better means for a long-term comparison. For the
short term, MACD and the Price Oscillator are basically the same. The
shape of the lines, the divergences, moving average crossovers and
centreline crossovers for MACD and the Price Oscillator are virtually
identical.
MACD Histogram
In 1986, Thomas Aspray developed the MACD-Histogram. Some of his
findings were presented in a series of articles for Technical Analysis of
Stocks and Commodities. Aspray noted that MACD would sometimes
lag important moves in a security, especially when applied to weekly
charts. He first experimented by changing the moving averages and
found that shorter moving averages did indeed speed up the signals.
However, he was looking for a means to anticipate MACD crossovers.
One of the answers he came up with was the MACD-Histogram.
MACD
On the chart above, we can see that MACD-Histogram movements are
relatively independent of the actual MACD. Sometimes MACD is rising
while the MACD-Histogram is falling. At other times, MACD is falling
while MACD-Histogram is rising. MACD-Histogram does not reflect the
absolute value of MACD, but rather the value of MACD relative to its 9-
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day EMA. Usually, but not always, a move in MACD is preceded by a
corresponding divergence in MACD-Histogram.
•
The first point shows a sharp positive divergence in MACDHistogram that preceded a bullish moving average crossover.
•
On the second point, MACD continued to new highs, but
MACD-Histogram formed two equal highs. Although not a
textbook positive divergence, the equal high failed to confirm
the strength seen in MACD.
•
A positive divergence formed when MACD-Histogram formed
a higher low and MACD continued lower.
A negative divergence formed when MACD-Histogram formed a lower
high and MACD continued higher.
Definition and Construction
The MACD-Histogram represents the difference between MACD and
the 9-day EMA of MACD, which can also be referred to as the signal or
trigger line. The plot of this difference is presented as a histogram,
making centreline crossovers and divergences are easily identifiable. A
centreline crossover for the MACD-Histogram is the same as a moving
average crossover for MACD. If you will recall, a moving average
crossover occurs when MACD moves above or below the signal line.
If the value of MACD is larger than the value of its 9-day EMA, then the
value on the MACD-Histogram will be positive. Conversely, if the value
of MACD is less than its 9-day EMA, then the value on the MACDHistogram will be negative.
Further increases or decreases in the gap between MACD and its 9day EMA will be reflected in the MACD-Histogram. Sharp increases in
the MACD-Histogram indicate that MACD is rising faster than its 9-day
EMA and bullish momentum is strengthening. Sharp declines in the
MACD-Histogram indicate that MACD is falling faster than its 9-day
EMA and bearish momentum is increasing.
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MACD
Usage
Thomas Aspray designed the MACD-Histogram as a tool to anticipate
a moving average crossover in MACD. Divergences between MACD
and the MACD-Histogram are the main tool used to anticipate moving
average crossovers. A positive divergence in the MACD-Histogram
indicates that MACD is strengthening and could be on the verge of a
bullish moving average crossover. A negative divergence in the
MACD-Histogram indicates that MACD is weakening and can act to
foreshadow a bearish moving average crossover in MACD.
In his book, Technical Analysis of the Financial Markets, John Murphy
asserts that the MACD-Histogram is best used to identify periods when
the gap between MACD and its 9-day EMA is either widening or
shrinking. Broadly speaking, a widening gap indicates strengthening
momentum and a shrinking gap indicates weakening momentum.
Usually a change in the MACD-Histogram will precede any changes in
MACD.
Signals
The main signal generated by the MACD-Histogram is a divergence
followed by a moving average crossover. A bullish signal is generated
when a positive divergence forms and there is a bullish centreline
crossover. A bearish signal is generated when there is a negative
divergence and a bearish centreline crossover. Keep in mind that a
centreline crossover for the MACD-Histogram represents a moving
average crossover for MACD.
Divergences can take many forms and varying degrees. Generally
speaking, two types of divergences have been identified: the slant
divergence and the peak-trough divergence.
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Unisys
A slant divergence forms when there is a continuous and relatively
smooth move in one direction (up or down) to form the divergence.
Slant divergences generally cover a shorter timeframe than
divergences formed with two peaks or two troughs. A slant divergence
can contain some small bumps (peaks or troughs) along the way. The
world of technical analysis is not perfect and there are exceptions to
most rules and hybrids for many signals.
General Electric
A peak-trough divergence occurs when at least two peaks or two
troughs develop in one direction to form the divergence. A series of
two or more rising troughs (higher lows) can form a positive divergence
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and a series of two or more declining peaks (lower highs) can form a
negative divergence. Peak-trough divergences usually cover a longer
timeframe than slant divergences. On a daily chart, a peak-trough
divergence can cover a timeframe as short as two weeks or as long as
several months.
Usually, the longer and sharper the divergence is, the better any
ensuing signal will be. Short and shallow divergences can lead to false
signals and whipsaws. In addition, it would appear that peak-trough
divergences are a bit more reliable than slant divergences. Peaktrough divergences tend to be sharper and cover a longer time frame
than slant divergences.
MACD-Histogram Benefits
The main benefit of the MACD-Histogram is its ability to anticipate
MACD signals. Divergences usually appear in the MACD-Histogram
before MACD moving average crossovers. Armed with this knowledge,
traders and investors can better prepare for potential trend changes.
MACD-Histogram can be applied to daily, weekly or monthly charts.
(Note: This may require some tinkering with the number of periods
used to form the original MACD; shorter or faster moving averages
may be required for weekly and monthly charts.) Using weekly charts,
the broad underlying trend of a stock can be determined. Once the
broad trend has been determined, daily charts can be used to time
entry and exit strategies.
In Technical Analysis of the Financial Markets, John Murphy
advocates this type of two-tiered approach to investing in order to
avoid making trades against the major trend. The weekly MACDHistogram can be used to generate a long-term signal in order to
establish the tradable trend. Then only short-term signals that jibe with
the major trend are eligible for use. If the long-term trend were bullish,
only positive divergences with bullish centreline crossovers would be
considered valid for the MACD-Histogram. If the long-term trend were
bearish, only negative divergences with bearish centreline crossovers
would be considered valid.
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IBM
On the IBM weekly chart, the MACD-Histogram generated four signals.
Before each moving average crossover in MACD, a corresponding
divergence formed in the MACD-Histogram. To make adjustments for
the weekly chart, the moving averages have been shortened to 6 and
12. This MACD is formed by subtracting the 6-week EMA from the 12week EMA. A 6-week EMA has been used as the trigger. The MACDHistogram is calculated by taking the difference between MACD (6/12)
and the 6-day EMA of MACD (6/12).
•
The first signal was a bearish moving average crossover in
Jan-99. From its peak in late Nov-98, the MACD-Histogram
formed a negative divergence that preceded the bearish
moving average crossover in MACD.
•
The second signal was a bullish moving average crossover in
April. From its low in mid-February, the MACD-Histogram
formed a positive divergence that preceded the bullish moving
average crossover in MACD.
•
The third signal was a bearish moving average crossover in
late July. From its May peak, the MACD-Histogram formed a
negative divergence that preceded a bearish moving average
crossover in MACD.
•
The final signal was a bullish moving average crossover,
which was preceded by a slight positive divergence in MACDHistogram.
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The third signal was based on a peak-trough divergence. Two readily
identifiable and consecutive lower peaks formed to create the
divergence. The peaks and troughs on the previous divergences,
although identifiable, do not stand out as much.
MACD-Histogram Drawbacks
The MACD-Histogram is an indicator of an indicator or a derivative of a
derivative. MACD is the first derivative of the price action of a security
and the MACD-Histogram is the second derivative of the price action
of a security. As the second derivative, the MACD-Histogram is further
removed from the actual price action of the underlying security. The
further removed an indicator is from the underlying price action, the
greater the chances of false signals. Keep in mind that this is an
indicator of an indicator. MACD-Histogram should not be compared
directly with the price action of the underlying security.
Because MACD-Histogram was designed to anticipate MACD signals,
there may be a temptation to jump the gun. The MACD-Histogram
should be used in conjunction with other aspects of technical analysis.
This will help to alleviate the temptation for early entry. Another means
to guard against early entry is to combine weekly signals with daily
signals. There will of course be more daily signals than weekly signals.
However, by using only the daily signals that agree with the weekly
signals, there will be fewer daily signals to act on. By acting only on
those daily signals that are in agreement with the weekly signals, you
are also assured of trading with the longer trend and not against it.
Be careful of small and shallow divergences. While these may
sometimes lead to good signals, they are also more apt to create false
signals. One method to avoid small divergences is to look for larger
divergences with two or more readily identifiable peaks or troughs.
Compare the peaks and troughs from past action to determine
significance. Only peaks and troughs that appear to be significant
should warrant attention.
MACD Conclusion
Since Gerald Appel developed MACD, there have been hundreds of
new indicators introduced to technical analysis. While many indicators
have come and gone, MACD is an oscillator that has stood the test of
time. The concept behind its use is straightforward and its construction
simple, yet it remains one of the most reliable indicators around. The
effectiveness of MACD will vary for different securities and markets.
The lengths of the moving averages can be adapted for a better fit to a
particular security or market. As with all indicators , MACD is not
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infallible and should be used in conjunction with other technical
analysis tools.
Moving Averages
Moving averages are one of the most popular and easy to use tools
available to the technical analyst. By using an average of prices,
moving averages smooth a data series and make it easier to spot
trends. This can be especially helpful in volatile markets.
Simple Moving Averages (SMA)
A simple moving average is formed by finding the average price of a
security over a set number of periods. Most often, the closing price is
used to compute the moving average. For example: a 5-day moving
average would be calculated by adding the closing prices for the last 5
days and dividing the total by 5.
A moving average moves because as the newest period is added, the
oldest period is dropped. If the next closing price in the average is 15,
then this new period would be added and the oldest day, which is 10,
would be dropped. The new 5-day moving average would be
calculated as follows:
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Over the last 2 days, the moving average moved from 12 to 13. As
new days are added, the old days will be subtracted and the moving
average will continue to move over time.
In the example above, using closing prices from Eastman Kodak (EK),
day 10 is the first day possible to calculate a 10-day moving average.
As the calculation continues, the newest day is added and the oldest
day is subtracted. The 10-day moving average for day 11 is calculated
by adding the prices of day 2 through day 11 and dividing by 10. The
averaging process then moves on to the next day where the 10-day
moving average for day 12 is calculated by adding the prices of day 3
through day 12 and dividing by 10.
The chart above is a plot that contains the data sequence in the table.
The moving average begins on day 10 and continues.
This simple illustration highlights the fact that moving averages are
lagging indicators and will always be behind the price. The price of EK
is trending down, but the moving average, which is based on the
previous 10 days of data, remains above the price. If the price were
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rising, the moving average most likely be below. Because moving
averages are lagging indicators, they fit in the category of trend
following. When prices are trending, moving averages work well.
However, when prices are not trending, moving averages do not work.
Exponential Moving Average (EMA)
In order to reduce the lag in simple moving averages, technicians
sometimes use exponential moving averages, or exponentially
weighted moving averages. Exponential moving averages reduce the
lag by applying more weight to recent prices relative to older prices.
The weighting applied to the most recent price depends on the length
of the moving average. The shorter the exponential moving average is,
the more weight that will be applied to the most recent price. For
example: a 10-period exponential moving average weighs the most
recent price 18.18% and a 20-period exponential moving average
weighs the most recent price 9.52%. The method for calculating the
exponential moving average is fairly complicated. The important thing
to remember is that the exponential moving average puts more weight
on recent prices. As such, it will react quicker to recent price changes
than a simple moving average. For those who wish to see an example
formula for an exponential moving average, one is provided below.
Others may prefer to skip this section and move on the comparison of
the moving averages.
Exponential Moving Average Calculation
The formula for an exponential moving average is:
X = (K x (C - P)) + P
X = Current EMA
C = Current Price
P = Previous period's EMA*
K = Smoothing constant
(*A SMA is used for first period's calculation)
The smoothing constant applies the appropriate weighting to the most
recent price relative to the previous exponential moving average. The
formula for the smoothing constant is:
K = 2/(1+N)
N = Number of periods for EMA
For a 10-period EMA, the smoothing constant would be .1818.
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The EMA formula works by weighting the difference between the
current period's price and the previous period's EMA and adding the
result to the previous period's EMA. There are two possible outcomes:
the weighted difference is either positive or negative.
1. If the current price (C) is higher than the previous
period's EMA (P), the difference will be positive (C P). The positive difference is weighted by multiplying it
by the constant ((C - P) x K) and the answer is added
to the previous period's EMA, resulting in a new EMA
that is higher ((C - P) x K) + P.
2. If the current price is lower than the previous period's
EMA, the difference will be negative (C - P). The
negative difference is weighted by multiplying it by the
constant ((C - P) x K) and the final result is added to
the previous period's EMA, resulting in a new EMA
that is lower ((C - P) x K) + P.
Below is a table with the results of an exponential moving average
calculation for Eastman Kodak. For the first period's exponential
moving average, the simple moving average was used as the previous
period's exponential moving average (yellow highlight for the 10th
period). From period 11 onwards, the previous period's EMA was
used. The calculation in period 11 breaks down as follows:
1. (C - P)= (73.81 - 74.28) = -.47
2. (C - P) x K= -.47 x .1818 = -.08
3. ((C - P) x K) + P= -.08 + 74.28 = 74.20
The current price was 71.81, which was lower than the previous
period's EMA. In order to pull it closer to the EMA, .08 of a point was
shaved off of the previous period's EMA and the new EMA was 74.20.
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*The 10-period simple moving average is used for the first calculation
only. After that the previous period's EMA is used.
Simple Versus Exponential
From afar, it would appear that the difference between an exponential
moving average and a simple moving average is minimal. For this
example, which uses only 20 trading days, the difference is minimal,
but a difference nonetheless. The exponential moving average is
consistently closer to the actual price. On average, the EMA is 3/8 of a
point closer to the actual price than the SMA.
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EK
From day 10 to day 20, the EMA was closer to the price than the SMA
9 out of 10 times. The only time the SMA was closer was in period
number 18 (yellow highlight), and this did not last long. The average
absolute difference between the exponential moving average and the
current price was 1 and the simple moving average had an average
absolute difference of 1.33. This means that on average, the
exponential moving average was 1 point above or below the current
price and the simple moving average was 1.33 points above or below
the current price.
When EK stopped falling and started to trade flat, the SMA kept on
declining. During this period, the SMA was closer to the actual price
than the EMA. The EMA began to level out with the actual price and
remain further away. This was because the actual price started to level
out. Because of its lag, the SMA continued to decline and even
touched the actual price on 13-Dec.
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CMQ
A comparison of a 50-day EMA and a 50-day SMA for Compaq also
shows that the EMA picks up on the trend quicker than the SMA. The
blue arrows mark points when the stock started a strong trend. By
giving more weight to recent prices, the EMA reacted quicker than the
SMA and remained closer to the actual price. The grey circle shows
when the trend began to slow and a trading range developed. When
the change from trend to trading began, the SMA was closer to the
price. As the trading range continued into the latter part of 1999, both
moving averages converged. In later 1999, CPQ started to trend up
and the EMA was quicker to pick up on the recent price change and
remain closer to the price.
Which is better?
Which moving average you use will depend on your trading and
investing style and preferences. The simple moving average obviously
has a lag, but the exponential moving average may be prone to
quicker breaks. Some traders prefer to use exponential moving
averages for shorter time periods to capture changes quicker. Some
investors prefer simple moving averages over long time periods to
identify long-term trend changes. In addition, much will depend on the
individual security in question. A 50-day SMA might work great for
identifying support levels in the Nasdaq, but a 100-day EMA may work
better for the Dow Transports. Moving average type and length of time
will depend greatly on the individual security and how it has reacted in
the past.
The initial thought for some is that greater sensitivity and quicker
signals are bound to be beneficial. This is not always true and brings
up a great dilemma for the technical analyst: the trade off between
sensitivity and reliability. The more sensitive an indicator is, the more
signals that will be given. These signals may prove timely, but with
increased sensitivity comes an increase in false signals. The less
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sensitive an indicator is, the fewer signals that will be given. However,
less sensitivity leads to fewer and more reliable signals. Sometimes
these signals can be late as well.
For moving averages, the same dilemma applies. Shorter moving
averages will be more sensitive and generate more signals. The EMA,
which is generally more sensitive than the SMA, will also be likely to
generate more signals. However, there will also be an increase in the
number of false signals and whipsaws. Longer moving averages will
move slower and generate fewer signals. These signals will likely
prove more reliable, but they also may come late. Each investor or
trader should experiment with different moving average lengths and
types to examine the trade-off between sensitivity and signal reliability.
Trend-Following Indicator
Moving averages smooth out a data series and make it easier to
identify the direction of the trend. Because past price data is used to
form moving averages, they are considered lagging, or trend following,
indicators. Moving averages will not predict a change in trend, but
rather follow behind the current trend. Therefore, they are best suited
for trend identification and trend following purposes, not for prediction.
When to Use
Because moving averages follow the trend, they work best when a
security is trending and are ineffective when a security moves in a
trading range. With this in mind, investors and traders should first
identify securities that display some trending characteristics before
attempting to analyse with moving averages. This process does not
have to be a scientific examination. Usually, a simple visual
assessment of the price chart can determine if a security exhibits
characteristics of trend.
In its simplest form, a security's price can be doing only one of three
things: trending up, trending down or trading in a range. An uptrend is
established when a security forms a series of higher highs and higher
lows. A downtrend is established when a security forms a series of
lower lows and lower highs. A trading range is established if a security
cannot establish an uptrend or downtrend. If a security is in a trading
range, an uptrend is started when the upper boundary of the range is
broken and a downtrend begins when the lower boundary is broken
“What we have to learn to do, we learn by doing”
Aristotle
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In the Ford example, it is evident that a stock can go through both
trending and trading phases. The red circles indicate trading range
phases that are interspersed among trending periods. It is sometimes
difficult to determine when a trend will stop and a trading range will
begin or when a trading range will stop and a trend will begin. The
basic rules for trends and trading ranges laid out above can be applied
to Ford. Notice the trading range periods, the breakouts (both up and
down) and the trending periods. The moving average worked well in
times of trend, but faired poorly in times of trading. Also note how the
moving average lags behind the trend: it is always under the price
during an uptrend and above the price during a downtrend. A 50-day
simple moving average was used for this example. However, the
number of periods is optional and much will depend on the
characteristics of the security as well as an individual's trading and
investing style.
If price movements are choppy and erratic over an extended period of
time, then a moving average is probably not the best choice for
analysis. The chart for MMM shows a security that moved from 70 to
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90 in a few weeks in late April. Prior to this advance, the price gyrated
above and below its moving average. After the advance, the stock
continued its erratic behaviour without developing much of a trend.
Trying to analyse this security based on a moving average is likely to
be a lesson in futility.
A quick look at the chart for AOL shows a different picture than for
MMM. Over the same time period, AOL has shown the ability to trend.
There are 3 distinct trends or price movements that extend for a
number of months. Once the stock moves above or below the 70-day
SMA, it usually continues in that direction for a little while longer.
MMM, on the other hand, broke above and below its 70-day SMA
numerous times and would have been prone to numerous whipsaws. A
longer moving average would probably work better for MMM, but it is
clear that there are fewer characteristics of trend than in AOL.
Moving Average Settings
Once a security has been deemed to have enough characteristics of
trend, the next task will be to select the number of moving average
periods and type of moving average. The number of periods used in a
moving average will vary according to the security's volatility, trendiest
and personal preferences. The more volatility there is, the more
smoothing that will be required and hence the longer the moving
average. Stocks that do not exhibit strong characteristics of trend may
also require longer moving averages. There is no one set length, but
some of the more popular lengths include 21, 50, 89, 150 and 200
days as well as 10, 30 and 40 weeks. Short-term traders may look for
evidence of 2-3 week trends with a 21-day moving average, while
longer-term investors may look for evidence of 3-4 month trends with a
40-week moving average. Trial and error is usually the best means for
finding the best length. Examine how the moving average fits with the
price data. If there are too many breaks, lengthen the moving average
to decrease its sensitivity. If the moving average is slow to react,
shorten the moving average to increase its sensitivity. In addition, you
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may want to try using both simple and exponential moving averages.
Exponential moving averages are usually best for short-term situations
that require a responsive moving average. Simple moving averages
work well for longer-term situations that do
Uses for Moving Averages
There are many uses for moving averages, but three basic uses stand
out:
•
•
•
Trend identification/confirmation
Support and Resistance level identification/confirmation
Trading Systems
Trend Identification/Confirmation
There are three ways to identify the direction of the trend with moving
averages: direction, location and crossovers.
The first trend identification technique uses the direction of the moving
average to determine the trend. If the moving average is rising, the
trend is considered up. If the moving average is declining, the trend is
considered down. The direction of a moving average can be
determined simply by looking at a plot of the moving average or by
applying an indicator to the moving average. In either case, we would
not want to act on every subtle change, but rather look at general
directional movement and changes.
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In the case of Disney, a 100-day exponential moving average (EMA)
has been used to determine the trend. We do not want to act on every
little change in the moving average, but rather significant upturns and
downturns. This is not a scientific study, but a number of significant
turning points can be spotted just based on visual observation (red
circles). A few good signals were rendered, but also a few whipsaws
and late signals. Much of the performance would depend on your entry
and exit points. The length of the moving average influences the
number of signals and their timeliness. Moving averages are lagging
indicators. Therefore, the longer the moving average is, the further
behind the price movement it will be. For quicker signals, a 50-day
EMA could have been used.
The second technique for trend identification is price location. The
location of the price relative to the moving average can be used to
determine the basic trend. If the price is above the moving average,
the trend is considered up. If the price is below the moving average,
the trend is considered down.
This example is pretty straightforward. The long-term for ENE is
determined by the location of the stock relative to its 100-day SMA.
When ENE is above its 100-day SMA, the trend is considered bullish.
When the stock is below the 100-day SMA, the trend is considered
bearish. Buy and sell signals are generated by crosses above and
below the moving average. There was a brief sell signal generated in
Aug-98 and a false buy signal in Nov-99. Both of these signals
occurred when Enron's trend began to weaken. For the most part
though, this simple method would have kept an investor in throughout
most of the bull move.
The third technique for trend identification is based on the location of
the shorter moving average relative to the longer moving average. If
the shorter moving average is above the longer moving average, the
trend is considered up. If the shorter moving average is below the
longer moving average, the trend is considered down.
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For Xircom, a 30/100 moving average crossover was used to
determine the trend. When the 30-day moving average moves above
the 100-day moving average, the trend is considered bullish. When the
30-day moving average declines below the 100-day moving average,
the trend is considered bearish. A plot of the 30/100 differential is
plotted below the price chart by using the Percentage Price Oscillator
(PPO) set to (30,100,1). When the differential is positive the trend is
considered up -- when it is negative the trend is considered down. As
with all trend-following systems, the signals work well when the stock
develops a strong trend, but are ineffective when the stock is in a
trading range. Also notice that the signals tend to be late and after the
move has begun. Again, trend following indicators are best for
identification and following, not predicting.
Support and Resistance Levels
Another use of moving averages is to identify support and resistance
levels. This is usually accomplished with one moving average and is
based on historical precedent. As with trend identification, support and
resistance level identification through moving averages works best in
trending markets.
“I never did anything worth doing by accident; nor did any of my
inventions come by accident; they came by work”
Thomas Edison
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SUN
After breaking out of a trading range, Sun Microsystems successfully
tested moving average support in late July and early August. Also
notice that the June resistance breakout near 18 turned into support.
Therefore, the moving average acted as a confirmation of resistanceturned-support. After this first test, the 50-day moving average went on
to 4 more successful support tests over the next several months. A
break of support from the 50-day moving average would serve as a
warning that the stock may move into a trading range or may be about
to change the direction of the trend. Such a break occurred in Apr-00
and the 50-day SMA turned into resistance later that month. When the
stock broke above the 50-day SMA in early Jun-00, it returned to a
support level until the Oct-00 break. In Oct-00, the 50-day SMA
became a resistance level and that held for many months.
Conclusions
Moving averages can be effective tools to identify and confirm trend,
identify support and resistance levels, and develop trading systems.
However, traders and investors should learn to identify securities that
are suitable for analysis with moving averages and how this analysis
should be applied. Usually, an assessment can be made with a visual
examination of the price chart, but sometimes it will require a more
detailed approach. The ADX, Average Directional Index, is one tool
that can help identify securities that are trending and those that are
not.
The advantages of using moving averages need to be weighed against
the disadvantages. Moving averages are trend following, or lagging,
indicators that will always be a step behind. This is not necessarily a
bad thing though. After all, the trend is your friend and it is best to
trade in the direction of the trend. Moving averages will help ensure
that a trader is in line with the current trend. However, markets, stocks
and securities spend a great deal of time in trading ranges, which
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render moving averages ineffective. Once in a trend, moving averages
will keep you in, but also give late signals. Don't expect to get out at
the top and in at the bottom using moving averages. As with most tools
of technical analysis, moving averages should not be used on their
own, but in conjunction with other tools that complement them. Using
moving averages to confirm other indicators and analysis can greatly
enhance technical analysis.
Percentage Volume Oscillator (PVO)
The Percentage Volume Oscillator (PVO) is the percentage difference
between two moving averages of volume. The indicator is calculated
with the following formula:
Volume Oscillator (%) - PVO = (Vol 12-day EMA - Vol
26-day EMA)/Vol 12-day EMA) x 100
The 12-day exponential moving average (EMA) and 26-exponential
moving average were used as examples. Typically, these can be
changed to suit longer or shorter time periods. Because of its formula,
the PVO has a maximum value of +100, but no minimum value. For
example: if the 12-day EMA equals 2000 and the 26-day EMA equals
8000, then the PVO would equal -300 (((2000 - 8000)/2000) x 100) = 300. The absolute value is not as important as the direction or the
crosses above and below the zero line.
Uses
The PVO can be used to identify periods of expanding or contracting
volume in three different ways:
•
•
•
Centreline Crossovers: like the PPO, the PVO oscillates
above and below the zero line. When PVO is positive, the
shorter EMA of volume is greater than the longer EMA of
volume. When PVO is negative, the shorter EMA of volume is
less than the longer EMA of volume. A PVO above zero
indicates that volume levels are generally above average and
relatively heavy. When the PVO is below zero, volume levels
are generally below average and light.
Directional Movement: General directional movement of the
PVO can offer a quick visual assessment of volume patterns.
A rising PVO signals that volume levels are increasing and a
falling PVO signals that volume levels are decreasing.
Moving average crossovers: The last variable in the PVO
forms the signal line. For example: PVO(12,26,9) would
include a 9-day EMA of PVO as well as a histogram
representing the difference between the PVO and its 9-day
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EMA. When PVO moves above its signal line, volume levels
are generally increasing. When PVO moves below its signal
line, volume levels are generally decreasing.
Movements in the PVO are completely separate from price
movements. As such, movements in PVO can correlated with price
movements to assess the degree of buying or selling pressure.
Advances combined with strength in the PVO would be considered
strong. Should the PVO decline while a security's price fell, it would
indicate decreasing volume on the decline.
In the example above, FILE is shown with two PVO settings: PVO
(12,26,9) in the top window and PVO (5,60,1) in the bottom window.
When the final variable is set at 1, as with PVO(5,60,1) there is no
signal line or histogram. During August and September, the stock
traded between 15 and 21, and the PVO remained mostly below zero.
There was a small bounce above zero with the late August advance,
but the stock remained confined to its trading range. When the stock
began to advance off of its low in October, the PVO moved into
positive territory with a sharp rise (green line). The advance was
confirmed with expanding volume and the stock broke resistance. The
breakout with expanding volume signalled exceptionally strong buying
pressure.
“Problems are only opportunities in work clothes”
Henry J Kaiser (1882-1967)
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In the example above, the PVO is set in the top window at the default
setting (12,26,9) and in the bottom window at (5,60,1). Even though
the line shapes for both PVO settings are almost identical, the scales
on the right reflect different ranges and crossover points.
•
•
•
PVO (12,26,9) surpassed +20 in late October, while PVO
(5,60,1) surpassed +50.
In early October (red line #1), PVO (5,60,1) crossed below
zero, but PVO (12,26,9) remained above.
At the beginning of December (red line #2), PVO (5,60,1)
moved above zero before PVO (12,26,9) did.
Much of this difference can be attributed to the short EMA of volume in
both PVO settings. The 5-day EMA of volume is much more sensitive
than the 12-day EMA of volume. Shorter moving averages are more
volatile and more likely to have centreline crossovers. Above-average
volume periods can also be confirmed by watching for volume bars
that exceed the 60-day EMA (green oval in October). Notice that both
PVOs shot up in the second half of October as volume spiked above
60m shares.
Price Oscillator (including PPO)
The Price Oscillator is an indicator based on the difference between
two moving averages, and is expressed as either a percentage or in
absolute terms. According to user preferences, the moving averages
used to calculate the Price Oscillator can be exponential, weighted or
simple and the number of time periods can vary. For daily data, longer
moving averages might be preferred to filter out some of the
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randomness associated with daily prices. For weekly data, which will
have already filtered out some of the randomness, shorter moving
averages may be deemed more appropriate. In addition, a moving
average of the ensuing plot can be overlaid to act as a trigger line,
much like is done with MACD. In our charts and commentary, we will
use the abbreviation PPO to refer to the Percentage Price Oscillator
and APO to refer to the Absolute Price Oscillator.
Absolute Price Oscillator (APO)
The Absolute Price Oscillator is calculated by subtracting the longer
moving average from the shorter moving average. For example:
10-period exponential moving average (EMA) minus 30-period EMA
The resulting plot forms an oscillator that fluctuates above and below
zero according to the differences in the moving averages. If the shorter
moving average is above the longer moving average, then the
indicator will be positive. If the shorter moving average is below the
longer moving average, then the indicator will be negative.
Note: MACD is also calculated by finding the absolute difference.
Theoretically, MACD can be calculated with any two user-defined
moving averages. However, it is typically calculated by subtracting the
26-day exponential moving average from the 12-day exponential
moving average.
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Percentage Price Oscillator (PPO)
The Percentage Price Oscillator is found by subtracting the longer
moving average from the shorter moving average and then dividing the
result by the shorter moving average. For example:
{(10-period EMA minus 30-period EMA) divided by the 10-period EMA}
This formula displays the difference between the two moving averages
as a percentage of the shorter moving average.
Absolute versus Percentage
The Percentage Price Oscillator (PPO) and the Absolute Price
Oscillator (APO) generate many of the same signals and have
basically the same shape. All centreline crossovers, which represent
the shorter moving average crossing above or below the longer
moving average, occur at the same time. However, because the shape
of the lines are not exactly identical, there will likely be discrepancies.
This analysis of the Nasdaq Composite illustrates some of the
differences that may crop up.
“A traveller without knowledge is a bird without wings”
Mosharref Sa’di, Persian classical poet (ca. 1213-1292)
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1. The green circle shows that the PPO formed a lower high in
December while the APO formed a higher high.
2. Later in December, the APO continued higher and the PPO
began to flatten out. (red arrows)
3. In early January, the PPO recorded a lower low, which was a
day earlier than the APO.
There are two main reasons for using the PPO versus the APO.
With the Percentage Price Oscillator, it is possible to compare Price
Oscillator levels from one security to the next. A PPO reading of +5%
means that the shorter moving average is 5% higher than the longer
moving average. This percentage reading is comparable against
another security, regardless of the price of a security. The Percentage
Price Oscillator (PPO) for SLB only reached 3% for its highs while that
of the Nasdaq Composite rose above 7%.
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The Percentage Price Oscillator is a better representation of the two
moving averages relative to each other. The difference between the
two moving averages is shown in relation to the shorter moving
average. This allows for comparisons across time periods, regardless
of the price of the stock. With the Absolute Price Oscillator, the higher
the price of the stock, the greater the extremes of the oscillator. With
the Percentage Price Oscillator, a comparison of Amazon over time is
possible regardless of whether the stock is at 10 or 100.
PPO-Histogram
The daily Percentage Price Oscillator, using 12 and 26-day EMAs, is
very similar to the standard MACD, which also uses the 12 and 26-day
EMAs. The Percentage Price Oscillator measures the difference
between the two moving averages as a percentage of the shorter
moving average.
Because the Price Oscillator and MACD are so similar, the concept of
the MACD-Histogram has been applied to the PPO. The PPOHistogram shows the difference between the PPO and the 9-day EMA
of the PPO. The plot is presented as a histogram so that centreline
crossovers and divergences are easily identifiable. The same
principles that apply to the MACD-Histogram are also applicable to the
PPO-Histogram. The Absolute Price Oscillator (APO) is exactly the
same as the MACD.
A centreline crossover for the PPO-Histogram is the same as a moving
average crossover for the PPO. If the value of the PPO is larger than
the value of its 9-day EMA, then the value on the PPO-Histogram will
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be positive. Conversely, if the value of the PPO is less than its 9-day
EMA, then the value of the PPO-Histogram will be negative.
Further increases or decreases in the gap between the PPO and its 9day EMA will be reflected in the PPO-Histogram. Sharp increases in
the PPO-Histogram indicate that the PPO is rising faster than its 9-day
EMA -- bullish momentum is strengthening. Sharp declines in the
PPO-Histogram indicate that the PPO is falling faster than its moving
average -- bearish momentum is increasing.
Price Relative
The Price Relative compares the performance of one security against
that of another. It is often used to compare the performance of a
particular stock to a market index, usually the S&P 500. Because the
goal of many portfolio managers is to outperform the S&P 500, they
are usually interested in the strongest stocks. The price relative offers
a straightforward and accurate portrayal of a stock's performance
relative to the market.
The price relative is calculated by dividing the security's price by the
value of the S&P 500. If WMT were trading at 60 and the S&P 500
were 1400, then the price relative would be 60/1400, which equals
.0428. Should WMT advance to 70 and the S&P 500 to 1450, the price
relative would be .0482 (70/1450). The advance from .0428 to .0482
shows the WMT is stronger than the S&P 500. This number is then
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plotted along the Y-axis to form a line chart. The price relative can be
calculated on a daily, weekly or monthly basis; closing prices are
normally used.
Traditional technical analysis techniques can be used to analyse the
plot of the price relative. Support, resistance, trendlines, moving
averages and pattern analysis can all be applied. Some analysts even
apply indicators to the price relative in an attempt to identify changes.
In the WMT chart, we can see that the price relative peaked on 16-Dec
(red line), about two weeks earlier than the stock. A series of lower
highs ensued, and short-term support was broken in mid-January. A
few days later, the price relative broke its trendline extending up from
early August (blue line). The support and trendline breaks in the stock
occurred later than those in the price relative. A sharp decline in the
stock was foreshadowed by weakness in the price relative.
“If you wish to reach the highest, begin at the lowest”
Publilius Syrus
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In the 1998 chart for SUNW, the price relative recorded a higher low in
August and a new reaction high in September (black arrow). This
created a positive divergence and signalled that SUNW was much
stronger than the overall market. When the October-1998 rally kicked
in, SUNW was one of the top performers over the next 17 months.
Rotation among sectors and stocks plays a big part in today's market.
By applying the price relative to industry groups and stocks, traders
and investors can identify pockets of relative strength and relative
weakness. As with most indicators and analysis techniques, the price
relative is just one tool and should be used in conjunction with other
aspects of technical analysis.
Price By Volume
"Price By Volume" is a horizontal histogram that overlays a price chart.
The histogram bars stretch from left to right starting at the left side of
the chart. The length of each bar is determined by the cumulative total
of all volume bars for the periods during which the closing price fell
within the vertical range of the histogram bar.
In the chart below, each Price By Volume bar covers a vertical range
of 5 points. The longest bar covers the range from 27.5 to 32.5. The
length of that bar was determined by adding up all of the volume bars
on the days during which the price closed anywhere between 27.5 and
32.5.
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Relative Strength Index (RSI)
Developed by J. Welles Wilder and introduced in his 1978 book, New
Concepts in Technical Trading Systems, the Relative Strength Index
(RSI) is an extremely useful and popular momentum oscillator. The
RSI compares the magnitude of a stock's recent gains to the
magnitude of its recent losses and turns that information into a number
that ranges from 0 to 100. It takes a single parameter, the number of
time periods to use in the calculation. In his book, Wilder recommends
using 14 periods.
The RSI's full name is actually rather unfortunate as it is easily
confused with other forms of Relative Strength analysis such as John
Murphy's "Relative Strength" charts and IBD's "Relative Strength"
rankings. Most other kinds of "Relative Strength" stuff involve using
more than one stock in the calculation. Like most true indicators, the
RSI only needs one stock to be computed. In order to avoid confusion,
many people avoid using the RSI's full name and just call it "the RSI."
RSI Formula
To simplify the formula, the RSI has been broken down into its basic
components, which are the Average Gain, the Average Loss, the First
RS, and the subsequent Smoothed RS's.
For a 14-period RSI, the Average Gain equals the sum total all gains
divided by 14. Even if there are only 5 gains (losses), the total of those
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5 gains (losses) is divided by the total number of RSI periods in the
calculation (14 in this case). The Average Loss is computed in a
similar manner.
Calculation of the First RS value is straightforward: divide the Average
Gain by the Average Loss. All subsequent RS calculations use the
previous period's Average Gain and Average Loss for smoothing
purposes. See the "Smoothed RS" formula above for details. The table
below illustrates the formula in action.
Here's how lines 14 and 15 were calculated:
Note: It is important to remember that the Average Gain and Average
Loss are not true averages! Instead of dividing by the number of
gaining (losing) periods, total gains (losses) are always divided by the
specified number of time periods - 14 in this case.
When the Average Gain is greater than the Average Loss, the RSI
rises because RS will be greater than 1. Conversely, when the
average loss is greater than the average gain, the RSI declines
because RS will be less than 1. The last part of the formula ensures
that the indicator oscillates between 0 and 100.
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Use
Overbought/Oversold
Wilder recommended using 70 and 30 and overbought and oversold
levels respectively. Generally, if the RSI rises above 30 it is considered
bullish for the underlying stock. Conversely, if the RSI falls below 70, it
is a bearish signal. Some traders identify the long-term trend and then
use extreme readings for entry points. If the long-term trend is bullish,
then oversold readings could mark potential entry points.
Divergences
Buy and sell signals can also be generated by looking for positive and
negative divergences between the RSI and the underlying stock. For
example, consider a falling stock who’s RSI rises from a low point of
(for example) 15 back up to say, 55. Because of how the RSI is
constructed, the underlying stock will often reverse its direction soon
after such a divergence. As in that example, divergences that occur
after an overbought or oversold reading usually provide more reliable
signals.
Centreline Crossover
The centreline for RSI is 50. Readings above and below can give the
indicator a bullish or bearish tilt. On the whole, a reading above 50
indicates that average gains are higher than average losses and a
reading below 50 indicates that losses are winning the battle. Some
traders look for a move above 50 to confirm bullish signals or a move
below 50 to confirm bearish signals.
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Example
The DELL example shows a number of extreme readings as well as a
negative divergence. In Oct-99, RSI reached oversold for a brief
moment to mark the low around 38. The next extreme reading
(overbought) occurred after a large advance that peaked in Dec-99.
RSI reached overbought levels in late Dec-99 and moved below 50 by
the second week of Jan-00. The next oversold reading occurred in Feb
for another brief moment and marked the low around 35. By the end of
Feb-00, RSI moved back above 50 and into overbought territory in
March. A negative divergence formed in March and marked the high in
the upper fifties.
Standard Deviation (Volatility)
Standard deviation is a statistical term that provides a good indication
of volatility. It measures how widely values (closing prices for instance)
are dispersed from the average. Dispersion is difference between the
actual value (closing price) and the average value (mean closing
price). The larger the difference between the closing prices and the
average price, the higher the standard deviation will be and the higher
the volatility. The closer the closing prices are to the average price, the
lower the standard deviation and the lower the volatility.
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The calculation for the standard deviation is based on the number of
periods chosen. 20 days, which represents about a month, is a popular
number of periods to use and will be used in the example below.
The steps for a 20-period standard deviation formula are as follows:
1. Calculate the mean price. Sum the 20 periods and divide by
20. This is also the average price over 20 periods. (2246.06/20
= 112.30)
2. For each period, subtract the mean price from the close. This
gives us the deviation for each period (-3.30, -9.24….).
3. Square each period's deviation (10.91, 85.38…).
4. Add together the squared deviations for periods 1 through 20
(921.28).
5. Divide the sum of the squared deviations by 20 (921.28/20 =
46.06).
6. Calculate the square root of the sum of the squared
deviations. The square root of 46.06 equals 6.787.
The standard deviation for the 20 periods is 6.787. This example was
formed with a price series for IBM. The chart below shows how the
standard deviation can change over time.
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After extended periods of consolidation, the standard deviation (or
volatility) dropped. Notice that in late December the stock traded in a
tight range and volatility dropped. Later in mid-March, the stock also
traded in a tight range and volatility dropped. When the stock took off
in the second half of March, volatility also rose.
VSTR, which is in the same price range as IBM, has a higher standard
deviation. Until late December, the standard deviation was below 5.
With the sharp advance in late December, the standard deviation rose
from 5 to above 15. Since then it levelled out around 10 and has
recently risen above 17. This is quite a volatile stock and its options
will have more premium than IBM options. The higher the volatility for
a particular stock, the higher the option premiums. The lower the
volatility is for a particular stock, the lower the option premiums.
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Stochastic Oscillator
Developed by George C. Lane in the late 1950s, the Stochastic
Oscillator is a momentum indicator that shows the location of the
current close relative to the high/low range over a set number of
periods. Closing levels that are consistently near the top of the range
indicate accumulation (buying pressure) and those near the bottom of
the range indicate distribution (selling pressure).
Formula
A 14-day %K (14-period Stochastic Oscillator) would use the most
recent close, the highest high over the last 14 days and the lowest low
over the last 14 days. The number of periods will vary according to the
sensitivity and the type of signals desired. As with RSI, 14 are a
popular number of periods for calculation.
%K tells us that the close (115.38) was in the 57th percentile of the
high/low range, or just above the mid-point. Because %K is a
percentage or ratio, it will fluctuate between 0 and 100. A 3-day simple
moving average of %K is usually plotted alongside to act as a signal or
trigger line, called %D.
Slow versus Fast versus Full
There are three types of Stochastic Oscillator: Fast, Slow, and Full.
The Full Stochastic is discussed later. For now, let's look at Fast
versus Slow. As shown above, the Fast Stochastic Oscillator is made
up of %K and %D. In order to avoid confusion between the two, I'll use
%K (fast) and %D (fast) to refer to those used in the Fast Stochastic
Oscillator, and %K (slow) and %D (slow) to refer to those used in the
Slow Stochastic Oscillator. The driving force behind both Stochastic
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Oscillators is %K (fast), which is found using the formula provided
above.
In the CSCO example, the Fast Stochastic Oscillator is plotted in the
box just below the price plot. The thick black line represents %K (fast)
and the thin red line represents %D (fast). Also called the trigger line,
%D (fast) is a smoothed version of %K (fast). One method of
smoothing data is to apply a moving average. To smooth %K (fast)
and create %D (fast), a 3-period simple moving average was applied
to %K (fast). Notice how the %K (fast) line pierces the %D (fast) line a
number of times during May, June and July. To alleviate some of these
false breaks and smooth %K (fast), the Slow Stochastic Oscillator was
developed.
The Slow Stochastic Oscillator is plotted in the lower box: the thick
black line represents %K (slow) and the thin red line represents %D
(slow). To find %K (slow) in the Slow Stochastic Oscillator, a 3-day
SMA was applied to %K (fast). This 3-day SMA slowed (or smoothed)
the data to form a slower version of %K (fast). A close examination
would reveal that %D (Fast), the thin red line in the Fast Stochastic
Oscillator, is identical to %K (Slow), the thick black line in the Slow
Stochastic Oscillator. To form the trigger line, or %D (slow) in the Slow
Stochastic Oscillator, a 3-day SMA was applied to %K (Slow).
The Full Stochastic Oscillator takes three parameters. Just as in the
Fast and Slow versions, the first parameter is the number of periods
used to create the initial %K line and the last parameter is the number
of periods used to create the %D (full) signal line. What's new is the
additional parameter, the one in the middle. It is a "smoothing factor"
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for the initial %K line. The %K (full) line that gets plotted is a n-period
SMA of the initial %K line (where n is equal to the middle parameter).
The Full Stochastic Oscillator is more advanced and more flexible than
it's Fast and Slow cousins. You can even use it to duplicate the other
versions. For example, a (14, 3) Fast Stochastic is equivalent to a (14,
1, 3) Full Stochastic and a (12, 2) Slow Stochastic is equal to a (12, 3,
2) Full Stochastic.
%K and %D Recap
•
•
•
•
•
•
%K (fast) = %K formula presented above using x periods
%D (fast) = y-day SMA of %K (fast)
%K (slow) = 3-day SMA of %K (fast)
%D (slow) = y-day SMA of %K (slow)
%K (full) = y-day SMA of %K (fast)
%D (full) = z-day SMA of %K (full)
where x is the first parameter, y is the second parameter and (in the
case of Full stochastic), z is the third parameter. In the case of Fast
and Slow Stochastic, x is typically 14 and y is usually set to 3.
Use
Readings below 20 are considered oversold and readings above 80
are considered overbought. However, Lane did not believe that a
reading above 80 was necessarily bearish or a reading below 20
bullish. A security can continue to rise after the Stochastic Oscillator
has reached 80 and continue to fall after the Stochastic Oscillator has
reached 20. Lane believed that some of the best signals occurred
when the oscillator moved from overbought territory back below 80 and
from oversold territory back above 20.
Buy and sell signals can also be given when %K crosses above or
below %D. However, crossover signals are quite frequent and can
result in a lot of whipsaws.
One of the most reliable signals is to wait for a divergence to develop
from overbought or oversold levels. Once the oscillator reaches
overbought levels, wait for a negative divergence to develop and then
a cross below 80. This usually requires a double dip below 80 and the
second dip results in the sell signal. For a buy signal, wait for a positive
divergence to develop after the indicator moves below 20. This will
usually require a trader to disregard the first break above 20. After the
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positive divergence forms, the second break above 20 confirms the
divergence and a buy signal is given.
In the IBM example above, it is clear that acting solely on overbought
and oversold crossovers can generate false signals. Using crossovers
of %D (slow) by %K (slow) can result in some good signals, but there
are still whipsaws. By looking for divergences and overbought/oversold
crossovers together, the 14-day Slow Stochastic Oscillator can
produce fewer yet more reliable signals. The Slow Stochastic
Oscillator produced 2 solid signals in IBM between Aug-99 and Mar99. In Nov-99, a buy signal was given when the indicator formed a
positive divergence and moved above 20 for the second time. Note
that the double top in Nov-Dec (grey circle) was not a negative
divergence -- the stock continued higher after this formed. In Jan-00, a
sell signal was given when a negative divergence formed and the
indicator dipped below 80 for the second time
StochRSI
Developed by Tushard Chande and Stanley Kroll, StochRSI is an
oscillator that measures the level of RSI relative to its range, over a set
period of time. The indicator uses RSI as the foundation and applies to
it the formula behind Stochastic. The result is an oscillator that
fluctuates between 0 and 1.
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In their 1994 book, The New Technical Trader, Chande and Kroll
explain that RSI sometimes trades between 80 and 20 for extended
periods without reaching overbought and oversold levels. Traders
looking to enter a stock based on an overbought or oversold reading in
RSI might find themselves continuously on the sidelines. To increase
the sensitivity and provide a method for identifying overbought and
oversold levels in RSI, Chande and Kroll developed StochRSI.
Developed by Welles Wilder, RSI is a momentum oscillator that
compares the magnitude of gains to the magnitude of losses over a
period of time. Developed by George Lane, Stochastics is a
momentum oscillator that compares the closing level to the high/low
range over a given period of time.
Formulas
From the formula above, it can be seen that StochRSI is the Stochastic
formula applied to RSI; that is, it's an indicator of RSI. StochRSI
measures the value of RSI relative to its high/low range over a set
number of periods. When RSI records a new low for the period,
StochRSI will be at 0. When RSI records a new high for the period,
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StochRSI will be at 100. A reading of .20 would mean that the current
RSI was 20% above the lowest level of the period, or 80% below the
highest level. A reading of .80 would mean that the current RSI was
80% above the lowest level of the period, or 20% below the highest
level.
Signals
•
•
•
•
•
Overbought and Oversold Crossovers: If an uptrend has
been identified in the underlying security, then a buy signal
would be generated when StochRSI advances from oversold
(below .20) to above .20. Conversely, if a downtrend has been
identified, then a sell signal would be generated when
StochRSI declines from overbought (above .80) to below .80.
Centreline Crossovers: Some traders look for moves above
or below .50 (the centreline) to confirm signals and reduce
whipsaws. A move from oversold to above .50 could constitute
a buy signal and would remain in place until a decline below
.50. Conversely, a move from overbought to below .50 would
could act as a sell signal that would remain in place until an
advance back above .50.
Positive and Negative Divergences: A positive divergence
followed by a confirming advance above .20 could constitute a
buy signal and a negative divergence followed by a decline
below .80 could act as a sell signal.
Failures: Chande and Kroll also note that moves back past
the trigger lines would indicate a failed signal. An advance
back above .80 would indicate a failed signal and traders
would be advised to close positions.
Strong Trend: As with many oscillators, StochRSI can
become overbought (or oversold) and remain overbought (or
oversold) for an extended period. A move above .80 may imply
overbought, but it can also indicate a strong up trend and
remain above .80 for a prolonged period. Conversely, a quick
move below .20 could indicate the beginning of a strong
downtrend. Moves to 1 are considered very strong and moves
to 0 very weak.
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Example
In the WCOM example above, the stock peaked in Jun-99 and was in
a well-established downtrend. A series of lower lows and lower highs
confirmed the primary trend as bearish. According to Chande and
Kroll, these conditions would best suit StochRSI for identifying
overbought levels from which to short the stock. Each time StochRSI
advances above .80, an overbought situation would occur. When the
indicator declined from its overbought level back below .80, a sell
signal would have been given.
From March to June, the indicator gave 4 sell signals, or one per
month. The July sell signal was not recognized because there was a
possible change in trend. As long as the series of lower highs and
lower lows continued, the downtrend remained intact. A higher low in
late June was followed by a higher high in July to call into question the
strength and validity of the downtrend. Once the higher high arrived,
the signals for StochRSI may have required adjustments to protect
against whipsaws.
Trying to buy the stock on advances from oversold levels back above
.20 would have proved difficult. There were whipsaws in March and
May that would have resulted in some bad trades. This choppy action
around .20 could have also led to some premature exits from profitable
short positions. When a stock is trending lower, it is sometimes
prudent to raise the level in order to close short positions (or to
generate buy signals). In this case, a trader could have required
StochRSI to move from oversold to above .50 before closing short
positions. This would have eliminated the March and May whipsaws.
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Conclusions
It is important to remember that StochRSI is an indicator of an
indicator. It is designed to predict extreme readings in RSI before the
actual RSI reaches these extremities. As an indicator of an indicator, it
is further removed from the actual price of the underlying security.
Because it is actually predicting RSI, but being used to predict price
changes in the underlying security, it will have greater sensitivity and
be prone to false signals, especially if used incorrectly. As with other
indicators, StochRSI should be used in conjunction with other
indicators and aspects of technical analysis.
“Knowledge is not power, it’s the application of knowledge
that’s power”
Owen O’Malley. CEO TICN Ltd.
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Chapter Twenty
An Introduction To Candlestick Charts
History
The Japanese began using technical analysis to trade rice in the 17th
century. While this early version of technical analysis may have been
different from the US version initiated by Charles Dow around 1900,
many of the guiding principles were very similar.
•
The "what" (price action) is more important than the "why"
(news, earnings, and so on).
•
All known information is reflected in the price.
•
Buyers and sellers move markets based on expectations and
emotions (fear and greed).
•
Markets fluctuate.
•
The actual price may not reflect the underlying value.
According to Steve Nison, candlestick charting came later and
probably began sometime after 1850. Much of the credit for
candlestick development and charting goes to Homma, a legendary
rice trader from Sakata. Even though it is not exactly clear "who"
created candlesticks, Nison notes that they likely resulted from a
collective effort developed over many years of trading.
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Formation
Candlesticks are formed using the open, high, low and close. Without
opening prices, candlestick charts are impossible to draw. If the close
is above the open, then a hollow candlestick (usually displayed as
white) is drawn. If the close is below the open, then a filled candlestick
(usually displayed as black) is drawn. The hollow or filled portion of the
candlestick is called the body (also referred to as the "real body"). The
long thin lines above and below the body represent the high/low range
and are called shadows (also referred to as wicks and tails). The high
is marked by the top of the upper shadow and the low by the bottom of
the lower shadow.
Compared to traditional bar charts, many traders consider candlestick
charts more visually appealing and easier to interpret. Each
candlestick provides an easy-to-decipher picture of price action.
Immediately a trader can see and compare the relationship between
the open and close as well as the high and low. The relationship
between the open and close is considered vital information and forms
the essence of candlesticks. White candlesticks, where the close is
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greater than the open, indicate buying pressure. Black candlesticks,
where the close is less than the open, indicate selling pressure.
Long versus Short Bodies
Generally speaking, the longer the body is, the more intense the
buying or selling pressure. Conversely, short candlesticks indicate little
price movement and represent consolidation.
Long white candlesticks show strong buying pressure. The longer the
white candlestick is, the further the close is above the open. This
indicates that prices advanced significantly from open to close and
buyers were aggressive. While long white candlesticks are generally
bullish, much depends on their position within the broader technical
picture. After extended declines, long white candlesticks can mark a
potential turning point or support level. If buying gets too aggressive
after a long advance, it can lead to excessive bullishness.
Long black candlesticks show strong selling pressure. The longer the
black candlestick is, the further the close is below the open. This
indicates that prices declined significantly from the open and sellers
were aggressive. After a long advance, a long black candlestick can
foreshadow a turning point or mark a future resistance level. After a
long decline a long black candlestick can indicate panic or capitulation.
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Even more potent long candlesticks are the Marubozu brothers, Black
and White. Marubozu do not have upper or lower shadows and the
high and low are represented by the open or close. A White Marubozu
forms when the open equals the low and the close equals the high.
This indicates that buyers controlled the price action from the first trade
to the last trade. Black Marubozu form when the open equals the high
and the close equals the low. This indicates that sellers controlled the
price action from the first trade to the last trade.
Long versus Short Shadows
The upper and lower shadows on candlesticks can provide valuable
information about the trading session. Upper shadows represent the
session high and lower shadows the session low. Candlesticks with
short shadows indicate that most of the trading action was confined
near the open and close. Candlestick with long shadows show that
traded extended well past the open and close.
Candlesticks with a long upper shadow and short lower shadow
indicate that buyers dominated during the session and bid prices
higher. However, sellers later forced prices down off of their highs and
the weak close created a long upper shadow. Conversely, candlesticks
with long lower shadows and short upper shadows indicate that sellers
dominated during the session and drove prices lower. However,
buyers later resurfaced to bid prices higher by the end of the session
and the strong close created a long lower shadow.
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Candlesticks with a long upper shadow, long lower shadow and small
real body are called spinning tops. One long shadow represents a
reversal of sorts; spinning tops represent indecision. The small real
body (whether hollow or filled) shows little movement from open to
close, and the shadows indicate that both bulls and bears were active
during the session. Even though the session opened and closed with
little change, prices moved significantly higher and lower in the mean
time. Neither buyers nor sellers could gain the upper hand and the
result was a standoff. After a long advance or long white candlestick, a
spinning top indicates weakness among the bulls and a potential
change or interruption in trend. After a long decline or long black
candlestick, a spinning top indicates weakness among the bears and a
potential change or interruption in trend.
Doji Explained
Doji (pronounced DoeJee) are important candlesticks that provide
information on their own and also feature in a number of important
patterns. Doji form when a security's open and close are virtually
equal. The length of the upper and lower shadows can vary and the
resulting candlestick looks like a cross, inverted cross or plus sign.
Alone, doji are neutral patterns. Any bullish or bearish bias is based on
preceding price action and future confirmation. The word "Doji" refers
to both the singular and plural form.
Ideally, but not necessarily, the open and close should be equal. While
a doji with an equal open and close would be considered more robust,
it is more important to capture the essence of the candlestick. Doji
convey a sense of indecision or tug-of-war between buyers and
sellers. Prices move above and below the opening level during the
session, but close at or near the opening level. The result is a standoff.
Neither bulls nor bears were able to gain control and a turning point
could be developing.
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Different securities have different criteria for determining the
robustness of a doji. A $20 stock could form a doji with a 1/8 point
difference between open and close, while a $200 stock might form one
with a 1 1/4 point difference. Determining the robustness of the doji will
depend on the price, recent volatility and previous candlesticks.
Relative to previous candlesticks, the doji should have a very small
body that appears as a thin line. Steven Nison notes that a doji that
forms among other candlesticks with small real bodies would not be
considered important. However, a doji that forms among candlesticks
with long real bodies would be deemed significant.
Doji and Trend
The relevance of a doji depends on the preceding trend or preceding
candlesticks. After an advance, or long white candlestick, a doji signals
that the buying pressure is starting to weaken. After a decline, or long
black candlestick, a doji signals that selling pressure is starting to
diminish. Doji indicate that the forces of supply and demand are
becoming more evenly matched and a change in trend may be near.
Doji alone are not enough to mark a reversal and further confirmation
may be warranted.
After an advance or long white candlestick, a doji signals that buying
pressure may be diminishing and the uptrend could be nearing an end.
Whereas a security can decline simply from a lack of buyers,
continued buying pressure is required to sustain an uptrend.
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Therefore, a doji may be more significant after an uptrend or long white
candlestick. Even after the doji forms, further downside is required for
bearish confirmation. This may come as a gap down, long black
candlestick, or decline below the long white candlestick's open. After a
long white candlestick and doji, traders should be on the alert for a
potential evening doji star.
After a decline or long black candlestick, a doji indicates that selling
pressure may be diminishing and the downtrend could be nearing an
end. Even though the bears are starting to lose control of the decline,
further strength is required to confirm any reversal. Bullish confirmation
could come from a gap up, long white candlestick or advance above
the long black candlestick's open. After a long black candlestick and
doji, traders should be on the alert for a potential morning doji star.
Long-legged Doji
Long-legged doji have long upper and lower shadows that are almost
equal in length. These doji reflect a great amount of indecision in the
market. Long-legged doji indicate that prices traded well above and
below the session's opening level, but closed virtually even with the
open. After a whole lot of yelling and screaming, the end result showed
little change from the initial open.
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Dragon Fly Doji
Dragon fly doji form when the open, high and close are equal and the
low creates a long lower shadow. The resulting candlestick looks like a
"T" with a long lower shadow and no upper shadow. Dragon fly doji
indicate that sellers dominated trading and drove prices lower during
the session. By the end of the session, buyers resurfaced and pushed
prices back to the opening level and the session high.
The reversal implications of a dragon fly doji depend on previous price
action and future confirmation. The long lower shadow provides
evidence of buying pressure, but the low indicates that plenty of sellers
still loom. After a long downtrend, long black candlestick or at support,
a dragon fly doji could signal a potential bullish reversal or bottom.
After a long uptrend, long white candlestick or at resistance, the long
lower shadow could foreshadow a potential bearish reversal or top.
Bearish or bullish confirmation is required for both situations.
Gravestone Doji
Gravestone doji form when the open, low and close are equal and the
high creates a long upper shadow. The resulting candlestick looks like
an upside down "T" with a long upper shadow and no lower shadow.
Gravestone doji indicate that buyers dominated trading and drove
prices higher during the session. However, by the end of the session,
sellers resurfaced and pushed prices back to the opening level and the
session low.
As with the dragon fly doji and other candlesticks, the reversal
implications of gravestone doji depend on previous price action and
future confirmation. Even though the long upper shadow indicates a
failed rally, the intraday high provides evidence of some buying
pressure. After a long downtrend, long black candlestick or at support,
focus turns to the evidence of buying pressure and a potential bullish
reversal. After a long uptrend, long white candlestick or at resistance,
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focus turns to the failed rally and a potential bearish reversal. Bearish
or bullish confirmation is required for both situations.
The Fundamentals of Candlestick Patterns
Before turning to the single and multiple candlestick patterns, there are
a few general guidelines to cover.
Bulls vs. Bears
A candlestick depicts the battle between Bulls (buyers) and Bears
(sellers) over a given period of time. An analogy to this battle can be
made between two football teams, which we can also call the Bulls and
the Bears. The bottom (intra-session low) of the candlestick represents
a touchdown for the Bears and the top (intra-session high) a
touchdown for the Bulls. The closer the close is to the high, the closer
the Bulls are to a touchdown. The closer the close is to the low, the
closer the Bears are to a touchdown. While there are many variations,
I have narrowed the field to 6 types of games (or candlesticks):
1. Long white candlesticks indicate that the Bulls controlled the
ball (trading) for most of the game.
2. Long black candlesticks indicate that the Bears controlled the
ball (trading) for most of the game.
3. Small candlesticks indicate that neither team could move the
ball and prices finished about where they started.
4. A long lower shadow indicates that the Bears controlled the
ball for part of the game, but lost control by the end and the
Bulls made an impressive comeback.
5. A long upper shadow indicates that the Bulls controlled the ball
for part of the game, but lost control by the end and the Bears
made an impressive comeback.
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6. A long upper and lower shadow indicates that the both the
Bears and the Bulls had their moments during the game, but
neither could put the other away, resulting in a standoff.
What Candlesticks Don't Tell You
Candlesticks do not reflect the sequence of events between the open
and close, only the relationship between the open and the close. The
high and the low are obvious and indisputable, but candlesticks (and
bar charts) cannot tell us which came first.
With a long white candlestick, the assumption is that prices advanced
most of the session. However, based on the high/low sequence, the
session could have been more volatile. The example above depicts
two possible high/low sequences that would form the same
candlestick. The first sequence shows two small moves and one large
move: a small decline off the open to form the low, a sharp advance to
form the high and a small decline to form the close. The second
sequence shows three rather sharp moves: a sharp advance off the
open to form the high, a sharp decline to form the low and a sharp
advance to form the close. The first sequence portrays strong
sustained buying pressure and would be considered more bullish. The
second sequence reflects more volatility and some selling pressure.
These are just two examples and there are hundreds of potential
combinations that could result in the same candlestick. Candlesticks
still offer valuable information on the relative positions of the open,
high, low and close. However, the trading activity that forms a
particular candlestick can vary.
Prior Trend
In his book, Candlestick Charting Explained, Greg Morris notes that for
a pattern to qualify as a reversal pattern, there should be a prior trend
to reverse. Bullish reversals require a preceding downtrend and
bearish reversals require a prior uptrend. The direction of the trend can
be determined using trendlines, moving averages, peak/trough
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analysis or other aspects of technical analysis. A downtrend might
exist as long as the security was trading below its down trendline,
below its previous reaction high or below a specific moving average.
The length and duration will depend on individual preferences.
However, because candlesticks are short-term in nature, it is usually
best to consider the last 1-4 weeks of price action.
Candlestick Positioning
Star Position
A candlestick that gaps away from the previous candlestick is said to
be in star position. The first candlestick usually has a large real body,
but not always, and the second candlestick in star position has a small
real body. Depending on the previous candlestick, the star position
candlestick gaps up or down and appears isolated from previous price
action. The two candlesticks can be any combination of white and
black. Doji, hammers, shooting stars and spinning tops have small real
bodies and can form in the star position. Later we will examine 2- and
3-candlestick patterns that utilize the star position.
Harami Position
A candlestick that forms within the real body of the previous
candlestick is in Harami position. Harami means pregnant in Japanese
and the second candlestick is nestled inside the first. The first
candlestick usually has a large real body and the second a smaller real
body than the first. The shadows (high/low) of the second candlestick
do not have to be contained within the first, though it's preferable if
they are. Doji and spinning tops have small real bodies and can form in
the harami position as well. Later we will examine candlestick patterns
that utilize the harami position.
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Candlestick Patterns
Long Shadow Reversals
There are two pair of single candlestick reversal patterns made up of a
small real body, one long shadow and one short or non-existent
shadow. Generally, the long shadow should be at least twice the
length of the real body, which can be either black or white. The
location of the long shadow and preceding price action determine the
classification.
The first pair, hammer and hanging man, are identical with small
bodies and long lower shadows. The second pair, shooting star and
inverted hammer, is also identical with small bodies and long upper
shadows. Only preceding price action and further confirmation
determine the bullish or bearish nature of these candlesticks. The
hammer and inverted hammer form after a decline and are bullish
reversal patterns, while the shooting star and hanging man form after
an advance and are bearish reversal patterns.
“Growth is the only evidence of life”
John Henry Newman (1801-1890)
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Hammer and Hanging Man
The hammer and hanging man look exactly alike, but have different
implications based on the preceding price action. Both have small real
bodies (black or white), long lower shadows and short or non-existent
upper shadows. As with most single and double candlestick
formations, the hammer and hanging man require confirmation before
action.
The hammer is a bullish reversal pattern that forms after a decline. In
addition to a potential trend reversal, hammers can mark bottoms or
support levels. After a decline, hammers signal a bullish revival. The
low of the long lower shadow implies that sellers drove prices lower
during the session. However, the strong finish indicates that buyers
regained their footing to end the session on a strong note. While this
may seem enough to act on, hammers require further bullish
confirmation. The low of the hammer shows that plenty of sellers
remain. Further buying pressure, and preferably on expanding volume,
is needed before acting. Such confirmation could come from a gap up
or long white candlestick. Hammers are similar to selling climaxes and
heavy volume can serve to reinforce the validity of the reversal.
The hanging man is a bearish reversal pattern that can also mark a top
or resistance level. Forming after an advance, a hanging man signals
that selling pressure is starting to increase. The low of the long lower
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shadow confirms that sellers pushed prices lower during the session.
Even though the bulls regained their footing and drove prices higher by
the finish, the appearance of selling pressure raises the yellow flag. As
with the hammer, a hanging man requires bearish confirmation before
action. Such confirmation can come as a gap down or long black
candlestick on heavy volume.
Inverted Hammer and Shooting Star
The inverted hammer and shooting star look exactly alike, but have
different implications based on previous price action. Both candlesticks
have small real bodies (black or white), long upper shadows and small
or non-existent lower shadows. These candlesticks mark potential
trend reversals, but require confirmation before action.
The shooting star is a bearish reversal pattern that forms after an
advance and in the star position, hence its name. A shooting star can
mark a potential trend reversal or resistance level. The candlestick
forms when prices gap higher on the open, advance during the session
and close well off their highs. The resulting candlestick has a long
upper shadow and small black or white body. After a large advance
(the upper shadow), the ability of the bears to force prices down raises
the yellow flag. To indicate a substantial reversal, the upper shadow
should relatively long and at least 2 times the length of the body.
Bearish confirmation is required after the shooting star and can take
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the form of a gap down or long black candlestick on heavy volume.
The inverted hammer looks exactly like a shooting star, but forms after
a decline or downtrend. Inverted hammers represent a potential trend
reversal or support levels. After a decline, the long upper shadow
indicates buying pressure during the session. However, the bulls were
not able to sustain this buying pressure and prices closed well off of
their highs to create the long upper shadow. Because of this failure,
bullish confirmation is required before action. An inverted hammer
followed by a gap up or long white candlestick with heavy volume
could act as bullish confirmation.
Blending Candlesticks
Candlestick patterns are made up of one or more candlesticks and
these can be blended together to form one candlestick. This blended
candlestick captures the essence of the pattern and can be formed
using the following:
•
•
•
The open of first candlestick
The close of the last candlestick
The high and low of the pattern
By using the open of the first candlestick, close of the second
candlestick and high/low of the pattern, a bullish engulfing or piercing
pattern blends into a hammer. The long lower shadow of the hammer
signals a potential bullish reversal. As with the hammer, both the
bullish engulfing and piercing pattern require bullish confirmation
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Blending the candlesticks of a bearish engulfing or dark cloud pattern
creates a shooting star. The long upper shadow of the shooting star
indicates a potential bearish reversal. As with the shooting star,
bearish engulfing and dark cloud cover patterns require bearish
confirmation.
More than two candlesticks can be blended using the same guidelines:
open from the first, close from the last and high/low of the pattern.
Blending three white soldiers creates a long white candlestick and
blending three black crows creates a long black candlestick.
In Conclusion
While we have covered a lot of material on candlesticks in this chapter,
we have just touched the tip of the iceberg. We will cover more indepth candlestick topics in our further studies of candlestick charting.
“Never is work without reward, or reward without work”
Livy
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Chapter Twenty-one
Interpreting Candlestick Chart
Patterns
Interpreting Candlestick Charts
Candlestick charts can be used to interpret a wide variety of market
scenarios. In this tutorial we will use candlesticks to analyse support,
resistance, bullish and bearish reversals
Candlestick Support
Single candlesticks and candlestick patterns can be used to confirm or
mark support levels. Such a support level could be new after an
extended decline or confirm a previous support level within a trading
range. In a trading range, candlesticks can help choose entry points for
buying near support and selling near resistance. The list below
contains some, but not all, of the candlesticks and candlestick patterns
that can be used to together with support levels. The bullish reversal
patterns are marked (R).
•
•
•
•
•
•
•
•
•
•
Bullish Engulfing (R)
Bullish Harami (R)
Doji (Normal, Long Legged, Dragon Fly)
Hammer (R)
Inverted Hammer (R)
Long White candlestick or White Marubozu
Morning Star or Bullish Abandoned Baby (R)
Piercing Pattern (R)
Spinning Top
Three White Soldiers (R)
Bullish reversal candlesticks and patterns suggest that early selling
pressure was overcome and buying pressure emerged for a strong
finish. Such bullish price action indicates strong demand and that
support may be found.
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The inverted hammer, long white candlestick and marubozu show
increased buying pressure rather than an actual price reversal. With its
long upper shadow, an inverted hammer signifies intra-session buying
interest that faded by the finish. Even though the security finished well
below its high, the ability of buyers to push prices higher during the
session is bullish. The long white candlestick and white marubozu
signify sustained buying pressure in which prices advanced sharply
from open to close. Signs of increased buying pressure bode well for
support.
The doji and spinning top denote indecision and are generally
considered neutral. These non-reversal patterns indicate a decrease in
selling pressure, but not necessarily a revival of buying pressure. After
a decline, the appearance of a doji or spinning top denotes a sudden
letup in selling pressure. A standoff has developed between buyers
and sellers, and a support level may form.
Electronic Data Systems (EDS) traded in a range bound by 58 and 75
for about 4 months at the beginning of 2000. Support at 58 was first
established in early January and resistance at 75 in late January. The
stock declined to its previous support level in early March, formed a
long legged doji and later a spinning top (red circle). Notice that the
doji formed immediately after a long black Marubozu (long black
candlestick without upper or lower shadows). This doji marked a
sudden decrease in relative selling pressure and support held. Support
was tested again in April and this test was also marked by a long
legged doji (blue arrow).
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Broadcom (BRCM) formed a bullish engulfing pattern to mark a new
support level just below 210 (green oval) in late July 2000. A few days
later a long white candlestick formed and engulfed the previous 4
candlesticks. The combination of the bullish engulfing and long white
candlestick served to reinforce the validity of support around 208. The
stock has since tested support around 208 once in early September
and twice in October. A piercing pattern (red arrow) formed in early
October and a large hammer in late October.
Medtronic (MDT) established support around 46 in late February with a
spinning top (red arrow) and early March with a harami. The stock
declined sharply in April and formed a hammer to confirm support at
46 (green arrow). After a reaction rally to resistance around 57, the
stock again declined sharply and again found support around 46 (blue
arrow). The black candlestick with the long lower shadow marked
support, but the body was too big to qualify as a hammer.
Candlestick Resistance
Single candlesticks and candlestick patterns can be used to confirm or
mark resistance levels. Such a resistance level could be new after an
extended advance, or an existing resistance level confirmed within a
trading range. In a trading range, candlesticks can help identify entry
points to sell near resistance or buy near support. The list below
contains some, but not all, of the candlesticks and candlestick patterns
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that can be used to identify or confirm resistance levels. The bearish
reversal patterns are marked (R).
•
•
•
•
•
•
•
•
•
Bullish Engulfing (R)
Bullish Harami (R)
Dark Cloud Cover (R)
Doji (Normal, Long Legged, Gravestone)
Evening Star or Bearish Abandoned Baby (R)
Hanging Man (R)
Long Black Candlestick or Black Marubozu
Spinning Top
Three Black Crows (R)
Bearish reversal candlesticks and patterns suggest that buying
pressure was suddenly overturned and selling pressure prevailed.
Such a quick reversal of fortune indicates overhead supply and a
resistance level may form.
The hanging man, long black candlestick and black marubozu signify
increased selling pressure rather than an actual reversal. After an
advance, the hanging man's long lower shadow indicates intra-session
selling pressure that was overcome by the end of the session. Even
though the security finished above its low, the ability of sellers to drive
prices lower raises a yellow flag. The long black candlestick and black
marubozu signify sustained selling pressure that moved prices
significantly lower from beginning to end. Such intense selling pressure
signals weakness among buyers and a resistance level may be
established.
The doji and spinning top show indecision and are generally
considered neutral. These non-reversal patterns indicate decreased
buying pressure, but no noticeable increase in selling pressure. For an
advance to continue, new buyers must be willing to pay higher prices.
As noted by the spinning top and doji, a standoff shows lack of
conviction among buyers and a possible resistance level.
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In late May, Veritas (VRTS) advanced from 90 to 140 in about two
weeks. The final jump came with a gap up and two doji. These doji
marked a sudden stalemate between buyers and sellers, and a
resistance level subsequently formed. After a resistance test in mid
June, another doji formed to indicate that buyers lacked conviction.
This led to a decline and subsequent reaction rally in early July. The
advance carried the stock from 105 to 140, where another doji formed
to confirm resistance set in early June.
Lucent (LU) traded in a range bound by 65 and 52 for about 4 months.
Resistance was first established in late April with a shooting star and
dark cloud cover. Both of these bearish reversals were confirmed with
a gap down two days later and a test of support at 52. As the stock
neared support at 52, candlesticks with long lower shadow started to
form and a reversal occurred at the end of May. After a sharp advance,
resistance was met at 65 and another dark cloud cover formed at
resistance in early June. Buyers clearly lacked conviction near 65 and
sellers were all too eager to unload their stock. A final resistance test
occurred in mid July. After a one-day breakout above 65, the stock
reversed course and closed back below 65. The rest is history.
After a spring advance, DAL first established resistance at 57 in early
April with the high of a shooting star. The stock declined sharply, but
rebounded to test resistance at 57 again in May. While at resistance in
May, a whole slew of shooting stars formed as well as the odd
spinning top and long legged doji. The decline that broke below 56
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confirmed these as bearish and the stock tested support around 50.
After another advance to 57, the stock appeared to be on the verge of
a breakout. However, a small white candlestick formed in mid July
(black circle). The gap up may have been a positive, but the lack of
follow-through signalled by the small white candlestick raised the
yellow flag. The subsequent gap down formed a bearish evening star
and the stock fell back to support again
Bullish Reversals
There are dozens of bullish reversal candlestick patterns. I have
elected to narrow the field by selecting the most popular for detailed
explanations. Below are some of the key bullish reversal patterns with
the number of candlesticks required in parentheses.
•
•
•
•
•
•
•
Bullish Engulfing (2)
Piercing Pattern (2)
Bullish Harami (2)
Hammer (1)
Inverted Hammer (1)
Morning Star (3)
Bullish Abandoned Baby (3)
Before moving on to individual patterns, certain guidelines should be
established:
•
•
•
Most patterns require bullish confirmation.
Bullish reversal patterns should form within a downtrend.
Other aspects of technical analysis should be used as well.
Bullish Confirmation
Patterns can form with one or more candlesticks; most require bullish
confirmation. The actual reversal indicates that buyers overcame prior
selling pressure, but it remains unclear whether new buyers will bid
prices higher. Without confirmation, these patterns would be
considered neutral and merely indicate a potential support level at
best. Bullish confirmation means further upside follow-through and can
come as a gap up, long white candlestick or high volume advance.
Because candlestick patterns are short-term and usually effective for
only 1 or 2 weeks, bullish confirmation should come within 1 to 3 days
after the pattern.
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Existing Downtrend
To be considered a bullish reversal, there should be an existing
downtrend to reverse. A bullish engulfing at new highs can hardly be
considered a bullish reversal pattern. Such formations would indicate
continued buying pressure and could be considered a continuation
pattern. In the Ciena example below, the pattern in the red oval looks
like a bullish engulfing, but formed near resistance after about a 30point advance. The pattern does show strength, but is more likely a
continuation at this point than a reversal pattern.
The existence of a downtrend can be determined by using moving
averages, peak/trough analysis or trendlines. A security could be
deemed in a downtrend based on one of the following:
•
•
•
The security is trading below its 20-day exponential moving
average (EMA).
Each reaction peak and trough is lower than the previous.
The security is trading below its trendline.
These are just examples of possible guidelines to determine a
downtrend. Some traders may prefer shorter downtrends and consider
securities below the 10-day EMA. Defining criteria will depend on your
trading style and personal preferences.
Other Technical Analysis
Candlesticks provide an excellent means to identify short-term
reversals, but should not be used alone. Other aspects of technical
analysis can and should be incorporated to increase reversal
robustness. Below are three ideas on how traditional technical analysis
might be combined with candlestick analysis.
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1. Support: Look for bullish reversals at support levels to
increase robustness. Support levels can be identified with
moving averages, previous reaction lows, trendlines or
Fibonacci retracements. Juniper Networks (JNPR) advanced
from 75 to 175 in less than two months. The stock retraced
about 50% of this 100-point advance and formed a large
bullish engulfing pattern around 125. This pattern was
confirmed with two subsequent advances above the down
trendline.
2. Momentum: Use oscillators to confirm improving momentum
with bullish reversals. Positive divergences in MACD, PPO,
Stochastic, RSI, StochRSI or Williams’s %R would indicate
improving momentum and increase the robustness behind a
bullish reversal pattern.
3. Money Flows: Use volume-based indicators to access buying
and selling pressure. On Balance Volume (OBV), Chaikin
Money Flow (CMF) and the Accumulation/Distribution Line can
be used in conjunction with candlesticks. Strength in any of
these would increase the robustness of a reversal.
For those that want to take it one step further, all three aspects
could be combined for the ultimate signal. Look for bullish
candlestick reversal in securities trading near support with positive
divergences and signs of buying pressure.
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A number of signals came together for Compaq (CPQ) in early July.
After a steep decline in late June, the stock formed a series of spinning
tops near support at 25. A bullish engulfing pattern formed in early July
and this was confirmed three days later with a strong advance above
27. The 10-day Slow Stochastic Oscillator formed a positive
divergence and moved above its trigger line just before the stock
advanced above 27. Although not in the green yet, CMF showed
constant improvement and moved into positive territory a week later.
Bullish Engulfing
The bullish engulfing pattern consists of two candlesticks, the first
black and the second white. The size of the black candlestick is not
that important, but it should not be a doji, which would be relatively
easy to engulf. The second should be a long white candlestick -- the
bigger it is, the more bullish. The white body must totally engulf the
body of the first black candlestick. Ideally, though not necessarily, the
white body would engulf the shadows as well. Although shadows are
permitted, they are usually small or nonexistent on both candlesticks.
After a decline, the second white candlestick begins to form when
selling pressure causes the security to open below the previous close.
Buyers step in after the open and push prices above the previous open
for a strong finish and potential short-term reversal. Generally, the
larger the white candlestick and the greater the engulfing, the more
bullish the reversal. Further strength is required to provide bullish
confirmation of this reversal pattern.
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In Jan-00, Sun Microsystems (SUNW) formed a pair of bullish
engulfing patterns that foreshadowed two significant advances. The
first formed in early January after a sharp decline that took the stock
well below its 20-day exponential moving average (EMA). An
immediate gap up confirmed the pattern as bullish and the stock raced
ahead to the mid eighties. After correcting to support, the second
bullish engulfing pattern formed in late January. The stock declined
below its 20-day EMA and found support from its earlier gap up. This
also marked a 2/3 correction of the prior advance. A bullish engulfing
pattern formed and was confirmed the next day with a strong follow-up
advance.
Piercing Pattern
The piercing pattern is made up of two candlesticks, the first black and
the second white. Both candlesticks should have fairly large bodies
and the shadows are usually, but not necessarily, small or nonexistent.
The white candlestick must open below the previous close and close
above the midpoint of the black candlestick's body. A close below the
midpoint might qualify as a reversal, but would not be considered as
bullish.
Just as with the bullish engulfing pattern, selling pressure forces the
security to open below the previous close, indicating that sellers still
have the upper hand on the open. However, buyers step in after the
open to push the security higher and it closes above the midpoint of
the previous black candlestick's body. Further strength is required to
provide bullish confirmation of this reversal pattern.
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In late March and early April 2000, Ciena (CIEN) declined from above
80 to around 40. The stock first touched 40 in early April with a long
lower shadow. After a bounce, the stock tested support around 40
again in mid April and formed a piercing pattern. The piercing pattern
was confirmed the very next day with a strong advance above 50.
Even though there was a setback after confirmation, the stock
remained above support and advanced above 70. Also notice the
morning doji star in late May.
Bullish Harami
The bullish harami is made up of two candlesticks. The first has a large
body and the second a small body that is totally encompassed by the
first. There are four possible combinations: white/white, white/black,
black/white and black/black. Whether they are bullish reversal or
bearish reversal patterns, all harami look the same. Their bullish or
bearish nature depends on the preceding trend. Harami are
considered potential bullish reversals after a decline and potential
bearish reversals after an advance. No matter what the colour of the
first candlestick, the smaller the body of the second candlestick is, the
more likely the reversal. If the small candlestick is a doji, the chances
of a reversal increase.
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In his book Beyond Candlesticks, Steve Nison asserts that any
combination of colours can form a harami, but that the most bullish are
those that form with a white/black or white/white combination. Because
the first candlestick has a large body, it implies that the bullish reversal
pattern would be stronger if this body were white. The long white
candlestick shows a sudden and sustained resurgence of buying
pressure. The small candlestick afterwards indicates consolidation.
White/white and white/black bullish harami are likely to occur less often
than black/black or black/white.
After a decline, a black/black or black/white combination can still be
regarded as a bullish harami. The first long black candlestick signals
that significant selling pressure remains and could indicate
capitulation. The small candlestick immediately following forms with a
gap up on the open, indicating a sudden increase in buying pressure
and potential reversal.
Micromuse (MUSE) declined to the mid sixties in Apr-00 and began to
trade in a range bound by 65 and 100 over the next few weeks. After a
6-day decline back to support in late May, a bullish harami (red oval)
formed. The first day formed a long white candlestick, and the second
a small black candlestick that could be classified as a doji. The next
day's advance provided bullish confirmation and the stock
subsequently rose to around 150.
Hammer
The hammer is made up of one candlestick, white or black, with a
small body, long lower shadow and small or nonexistent upper
shadow. The size of the lower shadow should be a least twice the
length of the body and the high/low range should be relatively large.
Large is a relative term and the high/low range should be large relative
to range over the last 10-20 days.
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After a decline, the hammer's intraday low indicates that selling
pressure remains. However, the strong close shows that buyers are
starting to become active again. Further strength is required to provide
bullish confirmation of this reversal pattern.
Nike (NKE) declined from the low fifties to the mid thirties before
starting to find support in late February. After a small reaction rally, the
stock declined back to support in mid March and formed a hammer.
Bullish confirmation came two days later with a sharp advance.
Morning Star
The morning star consists of three candlesticks:
1. A long black candlestick.
2. A small white or black candlestick that gaps below the close of
the previous candlestick. This candlestick can also be a doji, in
which case the pattern would be a morning doji star.
3. A long white candlestick.
The black candlestick confirms that the decline remains in force
and selling dominates. When the second candlestick gaps down, it
provides further evidence of selling pressure. However, the decline
ceases or slows significantly after the gap and a small candlestick
forms. The small candlestick indicates indecision and a possible
reversal of trend. If the small candlestick is a doji, the chances of a
reversal increase. The third long white candlestick provides bullish
confirmation of the reversal.
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After declining from above 180 to below 120, Broadcom (BRCM)
formed a morning doji star and subsequently advanced above 160 in
the next three days. These are strong reversal patterns and do not
require further bullish confirmation, beyond the long white candlestick
on the third day. After the advance above 160, a two-week pullback
followed and the stock formed a piecing pattern (red arrow) that was
confirmed with a large gap up.
Bullish Abandoned Baby
The bullish abandoned baby resembles the morning doji star and also
consists of three candlesticks:
1. A long black candlestick.
2. A doji that gaps below the low of the previous candlestick.
3. A long white candlestick that gaps above the high of the doji.
The main difference between the morning doji star and the bullish
abandoned baby are the gaps on either side of the doji. The first gap
down signals that selling pressure remains strong. However, selling
pressure eases and the security closes at or near the open, creating a
doji. Following the doji, the gap up and long white candlestick indicate
strong buying pressure and the reversal is complete. Further bullish
confirmation is not required.
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In April, Genzyme (GENZ) declined below its 20-day EMA and began
to find support in the low thirties. The stock began forming a base as
early as 17-Apr, but a discernable reversal pattern failed to emerge
until the end of May. The bullish abandoned baby formed with a long
black candlestick, doji and long white candlestick. The gaps on either
side of the doji reinforced the bullish reversal.
Bearish Reversals
There are dozens of bearish reversal patterns. I have elected to
narrow the field by selecting a few of the most popular patterns for
detailed explanations. For a complete list of bearish and bullish
reversal patterns, see Greg Morris' book, Candlestick Charting
Explained. Below are some of the key bearish reversal patterns, with
the number of candlesticks required in parentheses.
•
•
•
•
•
•
Bearish Abandoned Baby (3)
Bearish Engulfing (2)
Bearish Harami (2)
Dark Cloud Cover (2)
Evening Star (3)
Shooting Star (1)
I believe in certain guidelines relating to bearish reversal patterns:
•
•
•
Most patterns require further bearish confirmation.
Bearish reversal patterns should form within an uptrend.
Other aspects of technical analysis should be used as well.
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Bearish Confirmation
Bearish reversal patterns can form with one or more candlesticks;
most require bearish confirmation. The actual reversal indicates that
selling pressure overwhelmed buying pressure for one or more days,
but it remains unclear whether or not sustained selling or lack of
buyers will continue to push prices lower. Without confirmation, many
of these patterns would be considered neutral and merely indicate a
potential resistance level at best. Bearish confirmation means further
downside follow-through, such as a gap down, long black candlestick
or high volume decline. Because candlestick patterns are short-term
and usually effective for 1-2 weeks, bearish confirmation should come
within 1-3 days.
AOL advanced from the upper fifties to the low seventies in less than
two months. The long white candlestick that took the stock above 70 in
late March was followed by a long-legged doji in the harami position. A
second long-legged doji immediately followed and indicated that the
uptrend was beginning to tire. The dark cloud cover (red oval)
increased these suspicions and bearish confirmation was provided by
the long black candlestick (red arrow).
Existing Uptrend
To be considered a bearish reversal, there should be an existing
uptrend to reverse. It does not have to be a major uptrend, but should
be up for the short term or at least over the last few days. A dark cloud
cover after a sharp decline or near new lows is unlikely to be a valid
bearish reversal pattern. Bearish reversal patterns within a downtrend
would simply confirm existing selling pressure and could be considered
continuation patterns.
There are many methods available to determine the trend. An uptrend
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can be established using moving averages, peak/trough analysis or
trendlines. A security could be deemed in an uptrend based on one or
more of the following:
•
•
•
The security is trading above its 20-day exponential moving
average (EMA).
Each reaction peak and trough is higher than the previous.
The security is trading above a trendline.
These are just three possible methods. Some traders may prefer
shorter uptrends and qualify securities that are trading above their 10day EMA. Defining criteria will depend on your trading style, time
horizon and personal preferences.
Other Technical Analysis
Candlesticks provide an excellent means to identify short-term
reversals, but should not be used alone. Other aspects of technical
analysis can and should be incorporated to increase the robustness of
bearish reversal patterns.
Resistance
Look for bearish reversals near resistance levels to increase
robustness. Resistance levels can be determined using moving
averages, previous reaction highs or trendlines.
In Jan-00, Nike (NKE) gapped up over 5 points and closed above 50.
A candlestick with a long upper shadow formed and the stock
subsequently traded down to 45. This established a resistance level
around 53. After an advance back to resistance at 53, the stock formed
a bearish engulfing pattern (red oval). Bearish confirmation came when
the stock declined the next day, gapped down below 50 and broke its
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short-term trendline two days later.
Momentum
Use oscillators to confirm weakening momentum with bearish
reversals. Negative divergences in MACD, PPO, Stochastic, RSI,
StochRSI or Williams’s %R indicate weakening momentum and can
increase the robustness of a bearish reversal pattern. In addition,
bearish moving average crossovers in the PPO and MACD can
provide confirmation, as well as trigger line crossovers for the Slow
Stochastic Oscillator.
Money Flows
Use volume-based indicators to assess selling pressure and confirm
reversals. On Balance Volume (OBV), Chaikin Money Flow and the
Accumulation/Distribution Line can be used to spot negative
divergences or simply excessive selling pressure. Signs of increased
selling pressure can improve the robustness of a bearish reversal
pattern.
For those that want to take it one step further, all three aspects could
be combined for the ultimate signal. Look for a bearish candlestick
reversal in securities trading near resistance with weakening
momentum and signs of increased selling pressure. Such signals
would be relatively rare, but could offer above average profit potential
A number of signals came together for RadioShack (RSH) in early Oct00. The stock traded up to resistance at 70 for the third time in two
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months and formed a dark cloud cover pattern (red oval). In addition,
the long black candlestick had a long upper shadow to indicate an
intraday reversal. Bearish confirmation came the next day with a sharp
decline. The negative divergence in the PPO and extremely weak
money flows also provided further bearish confirmation.
Bearish Engulfing
The bearish engulfing pattern consists of two candlesticks; the first is
white and the second black. The size of the white candlestick is not
that important, but should not be a doji, which would be relatively easy
to engulf. The second should be a long black candlestick. The bigger it
is, the more bearish the reversal. The black body must totally engulf
the body of the first, white candlestick. Ideally, the black body should
engulf the shadows as well, but this is not a requirement. Shadows are
permitted, but they are usually small or nonexistent on both
candlesticks.
After an advance, the second black candlestick begins to form when
residual buying pressure causes the security to open above the
previous close. However, sellers step in after this opening gap up and
begin to drive prices down. By the end of the session, selling becomes
so intense that prices move below the previous close. The resulting
candlestick engulfs the previous day's body and creates a potential
short-term reversal. Further weakness is required for bearish
confirmation of this reversal pattern.
After meeting resistance around 35 in mid-January, Ford (F) formed a
bearish engulfing (red oval). The pattern was immediately confirmed
with a decline and subsequent support break.
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Dark Cloud Cover
The dark cloud cover pattern is made up of two candlesticks; the first is
white and the second black. Both candlesticks should have fairly large
bodies and the shadows are usually small or nonexistent, though not
necessarily. The black candlestick must open above the previous close
and close below the midpoint of the white candlestick's body. A close
above the midpoint might qualify as a reversal, but would not be
considered as bearish.
Just as with the bearish engulfing pattern, residual buying pressure
forces prices higher on the open, creating an opening gap above the
white candlestick's body. However, sellers step in after the strong open
and push prices lower. The intensity of the selling drives prices below
the midpoint of the white candlestick's body. Further weakness is
required for bearish confirmation of this reversal pattern.
After a sharp advance from 37 1/2 to 45 in about 2 weeks, Citigroup
(C) formed a dark cloud cover pattern (red oval). This pattern was
confirmed with two long black candlesticks and marked an abrupt
reversal around 45.
Shooting Star
The shooting star is made up of one candlestick (white or black) with a
small body, long upper shadow and small or nonexistent lower
shadow. The size of the upper shadow should be a least twice the
length of the body and the high/low range should be relatively large.
Large is a relative term and the high/low range should be large relative
to the range over the last 10-20 days.
For a candlestick to be in star position, it must gap way from the
previous candlestick. In Candlestick Charting Explained, Greg Morris
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indicates that a shooting star should gap up from the preceding
candlestick. However, in Beyond Candlesticks, Steve Nison provides a
shooting star example that forms below the previous close. There
should be room to manoeuvre, especially when dealing with stocks
and indices, which often open near the previous close. A gap up would
definitely enhance the robustness of a shooting star, but the essence
of the reversal should not be lost without the gap
After an advance that was punctuated by a long white candlestick,
Chevron (CHV) formed a shooting star candlestick above 90 (red
oval). The bearish reversal pattern was confirmed with a gap down the
following day.
Bearish Harami
The bearish harami is made up of two candlesticks. The first has a
large body and the second a small body that is totally encompassed by
the first. There are four possible combinations: white/white,
white/black, black/white and black/black. Whether a bullish reversal or
bearish reversal pattern, all harami look the same. Their bullish or
bearish nature depends on the preceding trend. Harami are
considered potential bearish reversals after an advance and potential
bullish reversals after a decline. No matter what the colour of the first
candlestick, the smaller the body of the second candlestick is, the
more likely the reversal. If the small candlestick is a doji, the chances
of a reversal increase.
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In his book, Beyond Candlesticks, Steve Nison asserts that any
combination of colours can form a harami, but the most bearish are
those that form with a black/white or black/black combination. Because
the first candlestick has a large body, it implies that the bearish
reversal pattern would be stronger if this body were black. This would
indicate a sudden and sustained increase in selling pressure. The
small candlestick afterwards indicates consolidation before
continuation. After an advance, black/white or black/black bearish
harami are not as common as white/black or white/white variations.
A white/black or white/white combination can still be regarded as a
bearish harami and signal a potential reversal. The first long white
candlestick forms in the direction of the trend. It signals that significant
buying pressure remains, but could also indicate excessive
bullishness. Immediately following, the small candlestick forms with a
gap down on the open, indicating a sudden shift towards the sellers
and a potential reversal.
After a gap up and rapid advance to 30, Ameritrade (AMTD) formed a
bearish harami (red oval). This harami consists of a long black
candlestick and a small black candlestick. The decline two days later
confirmed the bearish harami and the stock fell to the low twenties.
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Merck (MRK) formed a bearish harami with a long white candlestick
and long black candlestick (red oval). The long white candlestick
confirmed the direction of the current trend. However, the stock
gapped down the next day and traded in a narrow range. The decline
three days later confirmed the pattern as bearish.
Evening Star
The evening star consists of three candlesticks:
1. A long white candlestick.
2. A small white or black candlestick that gaps above the close
(body) of the previous candlestick. This candlestick can also
be a doji, in which case the pattern would be a evening doji
star.
3. A long black candlestick.
The long white candlestick confirms that buying pressure remains
strong and the trend is up. When the second candlestick gaps up, it
provides further evidence of residual buying pressure. However, the
advance ceases or slows significantly after the gap and a small
candlestick forms, indicating indecision and a possible reversal of
trend. If the small candlestick is a doji, the chances of a reversal
increase. The third long black candlestick provides bearish
confirmation of the reversal.
“The absurd man is he who never changes”
Auguste Barthelemy (1809-1876)
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After advancing from 45 to 60 in about two weeks, AT&T (T) formed an
evening star (red oval). The middle candlestick is a spinning top, which
indicates indecision and possible reversal. The gap above 60 was
reversed immediately with a long black candlestick. Even though the
stock stabilized in the next few days, it never exceeded the top of the
long black candlestick and subsequently fell below 50.
Bearish Abandoned Baby
The bearish abandoned baby resembles the evening doji star and also
consists of three candlesticks:
1. A long white candlestick.
2. A doji that gaps above the high of the previous candlestick.
3. A long black candlestick that gaps below the low of the doji.
The main difference between the evening doji star and the bearish
abandoned baby are the gaps on either side of the doji. The first gap
up signals a continuation of the uptrend and confirms strong buying
pressure. However, buying pressure subsides after the gap up and the
security closes at or near the open, creating a doji. Following the doji,
the gap down and long black candlestick indicate strong and sustained
selling pressure to complete the reversal. Further bearish confirmation
is not required.
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AT&T (T) formed an abandoned baby to mark a sharp reversal that
carried the stock from 57 1/2 to 47 1/2. Although the open and close
are not exactly equal, the small white candlestick in the middle
captures the essence of a doji. Indecision is reflected with the small
body and equal upper and lower shadows. In addition, the middle
candlestick is separated by gaps on either side, which add emphasis
to the reversal.
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Chapter Twenty-two
Option Trading Strategies
Bullish Option Strategies
When investors are "bullish" on a stock they
believe the price of the stock is going to go
up. The option strategies below are bullish
strategies, meaning that they are most
profitable when the stock price rises.
Neutral Option Strategies
When investors are "neutral" on a stock
they are undecided about whether the price
of the stock is going to go up or down. The
option strategies below are neutral
strategies which have neither an upside or
downside bias.
Bearish Option Strategies
When investors are "bearish" on a stock
they believe the price of the stock is going
to go down. The option strategies below are
bearish strategies, meaning that they are
most profitable when the stock price
decline.
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Call Options
Covered Calls
For conservative investors, selling calls against a long stock position
can be an excellent way to generate income without assuming the
risks associated with uncovered calls. In this case, investors would sell
one call contract for each 100 shares of stock they own.
Naked Calls
Selling naked calls is a very risky strategy, which should be utilized
with extreme caution. By selling calls without owning the underlying
stock, you collect the option premium and hope the stock either stays
steady or declines in value. If the stock increases in value this strategy
has unlimited risk
Covered
Calls
For conservative investors, selling calls
against long stock position can be an
excellent way to generate income.
Example
Buy stock
sell call
Increase in Volatility
Little impact on position
Time Erosion
Helps position
Earning Income on Your Portfolio
Let's imagine that you've owned Bubba Gump's stock for years. After
multiple stock splits, you now have 1,000 shares. Pleased with the
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overall growth rate, you decide to hold the stock rather than sell it.
Rather than just sitting back in a traditional buy and hold position, you
decide to use options to generate some additional income (cash flow)
at very little risk to you. For example, with the stock at $31 you could
sell five 35 calls for the current month at $2. Actually, you could sell as
many as ten 35 calls and still be covered (you own 1000 shares), but
for this example let's be conservative and sell only five.
Knowing the stock price hasn't fluctuated much; you might have
confidence that it isn't going to move higher than $35 in the before
expiration. After all, that would be a more than 10% move. At
expiration, if the stock is still below $35, you keep the $1,000 you
received by selling the calls, as well as your stock. At that point, you
might decide to write (sell) a few more calls for the next month.
Should the stock rise unexpectedly above $35, and stay above $35 on
expiration, you will have two choices. You can either buy the calls back
and keep the stock. Or, you can let the stock be called away and sell
500 shares (5 contracts x 100 shares) at the strike price of $35. The
good news, in this case, is that you still own 500 shares and you
participated in the rise from $31 to $35 on the 500 shares you sold at
35. In doing so, you locked in an additional $2,000 in profit.
Stock Price
Position at
Expiration*
Position Value
at Expiration
$29
Long 1,000 shares
30,000**
$32
Long 1,000 shares
33,000**
$35
Long 1,000 shares
36,000**
$38
Long 500 shares
37,500***
$41
Long 500 shares
39,000***
This example does not factor in commissions, interest or tax
consequences.
* Above $35, this assumes that the options were assigned and 500
shares were sold at $35.
**Includes $1,000 from the initial sale of calls.
*** Includes $18,500 in cash. $17,500 from selling 500 shares at $35
and $1,000 from the initial sale of calls.
Using Current Month Options
When writing covered calls, most investors tend to sell current (near)
month options for two reasons. First, the earlier the expiration, the less
opportunity the stock has to trade through the strike price. Second, and
equally important, is the role time decay plays in the value of the
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options. Like all out-of-the-money options, the 35 calls in the example
above have no intrinsic value. As such, the only value is the time
premium or time value which, in the final month of expiration, decays
more and more rapidly. For these reasons, investors often sell options
that have one month remaining until expiration
Naked Calls
Selling naked calls is one of the riskiest
strategies of all. The potential loss is
UNLIMITED.
Example
Increase in Volatility
Time Erosion
buy call
hurts position
helps position
Leveraging your buying power for the big move
Unlike covered calls, where the option seller owns the underlying
stock, the writer of naked calls remains completely exposed to upside
risk. Nevertheless, if you are comfortable using this strategy, it is most
effective using current (near-term) month options because they decay
more rapidly. And that's what you want. The faster these options
become worthless, the better.
To see how this works, consider the following:
Stock price: $87
90 call: $6
By selling the 90 call at 6, you would receive the $600 option premium,
your maximum profit. At expiration, if the stock is at or below $90, you
keep the full $600. However, your profit disappears as the stock climbs
toward $96. Above $96, your loss grows without limit.
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Value at Expiration
Stock Price
Profit (Loss)
$80
$600
$90
$600
$96
0
$100
($400)
$110
($1,400)
$120
($2,400)
$130
($3,400)
Given the mounting losses apparent in the table above, it
should be clear the naked call writing is an extremely risky
strategy. Even the most bearish investor would do well to
convert this position to a bear call spread by buying an out-ofthe money call. This would limit upside losses.
“What is more mortifying than to feel that you have missed the
plum for want of courage to shake the tree”?
Logan Pearsall Smith
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Chapter Twenty-three
Long-term Equity AnticiPation
Securities
(LEAPS)
Long-term Equity AnticiPation Securities (LEAPS) are longterm option contracts that allow investors to establish positions
that can be maintained for a period of up to three years.
The development and introduction of LEAPS by CBOE in 1990
added a whole new range of options possibilities, many suited
for conservative stock investors. Current options investors are
using LEAPS, as are stock investors, because of the
similarities between LEAPS and shares of stock, and the more
conservative nature afforded to LEAPS by their long-term
expirations.
Benefits of Equity and Index LEAPS:
Equity LEAPS Benefits:
•
•
•
Equity LEAPS calls can provide long-term stock market
investors an opportunity to benefit from the growth of large
capitalization companies without having to make outright stock
purchases
Equity LEAPS puts can provide a hedge for stock investors
against substantial declines in underlying equities
Current equity options users may also find LEAPS appealing if
they desire to take a longer term position of up to three years
in some of the same options they currently trade
Index LEAPS Benefits
•
•
Index LEAPS let you trade, hedge or invest in the "entire"
stock market or select industry sectors for a time that can be
measured in years
Index options let you take a bullish or bearish position on the
entire market
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•
•
Index options let you hedge your investments against adverse
market moves
Index LEAPS let you do all this over a longer time period
LEAPS Option Strategies
Buying Equity LEAPS Calls To Anticipate A Rally
Stock Assumption:
Bullish
Situation:
An investor anticipates an advance in the
stock of one of the LEAPS issues over the
next two years.
Possible Market
Action:
Buy Equity LEAPS Calls
An investor anticipates an advance in the price of a stock underlying a
LEAPS issue over the next two years. He would like to profit from a
rise in the stock without having to purchase the shares.
ZYX is currently trading at $50.50 and a 2 year LEAPS call with a $50
strike price is trading for $8.50. The investor purchases five of these
for $4,250. These five calls give him the right to buy 500 shares of ZYX
between now and expiration at $50 no matter how high the stock
should rise. The break-even level in this example is $58.50 (strike
price + premium paid)
If ZYX advances to $65 by this date, the individual has the choice of
exercising the five calls and taking delivery of the stock by paying $50
per share or selling the LEAPS for a profit. At expiration, the LEAPS
will be trading for at least 15 with ZYX at $65.
Buy Five LEAPS ZYX $50 Calls
Closing Sale Price (5 x 100 x 15): $7,500
Less premium paid (5 x 100 x 8.50): $4,250
Profit in this situation: $3,250
The risk is only the total cost of the calls, $4,250 plus commissions if
ZYX does not rise above $50 by the expiration date.
The LEAPS may trade somewhat higher than the difference between
the $50 strike price and actual stock price due to the possibility that the
stock price may increase over the time remaining to expiration. This is
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known as time value and the amount of time value contained in an
options premium will decrease as expiration approaches.
Commissions, dividends, margins, taxes and other transaction charges
have not been included. However, they will affect the outcome of
option transactions and should be considered. The strategy discussed
above is for illustrative and educational purposes only and should not
be construed as an endorsement, recommendation or solicitation to
buy or sell any particular security.
Buying Equity LEAPS Calls As A Stock Alternative
Buying deep in-the-money LEAPS can represent an alternative to
owning stock. Purchasing a LEAPS call can lower cost, reduce risk,
and provide a return similar to owning shares outright. There are
important differences, discussed below.
Example: An investor wishes to buy shares of stock XYZ, which is
trading at 56. In order to conserve capital the investor thinks about
buying the shares on margin, putting up half the cost of 100 shares
($2800) and borrowing the balance ($2800) at a margin rate of 9%.
The investor could instead think about purchasing a LEAPS call on
XYZ expiring in Jan 2000 with a strike price of 35 paying an option
premium of $24.25 ($2425).
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Alternative 1
Buy 100 XYZ (margin) @ $56
Cash down:
Borrow:
Carry Cost:
Less dividends:
Net carry cost:
Breakeven:
RISK:
$2,800
$2800
388 ($2800 X 9% X 80 wk.)
- $198
$190
57.9 / share
$5,600 (+ margin int. -dividends)
Alternative 2
Buy 1 XYZ Jan (00) 35 call 24.25
Cash down:
Borrow:
Carry Cost:
Less dividends:
Net carry cost:
Breakeven:
RISK:
$2,425
-0325 (LEAPS time premium)
-0$325
59.25 / share
$2,425
If held to LEAPS expiration, a comparison of these two strategies
shows the following:
The investor now owns a deep-in-the-money LEAPS call on XYZ
which should perform almost the same as owning the shares, due to
the option's relatively high delta. The total risk of owning the LEAPS
call is $2425 (without commissions) versus total risk of stock
ownership of $5,600.
The "carry cost" of buying a LEAPS is $135 more than the "carry cost"
of purchasing the stock on margin. But the "cash down" payment for
the LEAPS is lower.
Breakeven stock price for the LEAPS call is slightly higher than that of
the margined stock purchase.
Remember: LEAPS have no dividends or votes, unlike stock. LEAPS
expire, stock shares do not.
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Commissions, dividends, margins, taxes and other transaction charges
have not been included. However, they will affect the outcome of
option transactions and should be considered. The strategy discussed
above is for illustrative and educational purposes only and should not
be construed as an endorsement, recommendation or solicitation to
buy or sell any particular security.
Long Calls
For aggressive investors who are bullish about the short-term
prospects for a stock, buying calls can be an excellent way to capture
the upside potential with limited downside risk.
Long
Calls
For aggressive investors, buying calls can be
an excellent way to capture the upside
potential of a stock with limited downside risk.
Example
Increase in Volatility
Time Erosion
Buy call
Helps position
Hurts position
Leveraging your buying power for the big move
Let's imagine you have a strong feeling a particular stock is about to
move higher. You can either purchase the stock, or purchase "the right
to purchase the stock" (but not the obligation), otherwise known as a
call option. Buying a call is similar to the concept of leasing. Like a
lease, a call gives you the benefits of owning a stock, yet requires less
capital than actually purchasing the stock. Just as a lease has a fixed
amount of time, a call has a limited amount of time as well and can
expire worthless.
Let's look at an example. XYZ stock is trading at $90; it would take
$9,000 to buy 100 shares. If you buy the stock, your ultimate downside
risk, is $9,000. Should the stock drop to $70, your investment will only
be worth $7,000. On the other hand, if the stock goes to $110, your
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investment will be worth $11,000. Either way, there is a lot of money at
risk.
Now, let's see what would happen if you bought call options instead of
the stock. In early July, you decide to buy one September 90 Call for
$7. Since each contract controls 100 shares, you bought the rights (but
not the obligation) to purchase 100 shares for $90 per share. The
price, $7, is quoted on a per share basis. As such, the cost of this
contract is $700 ($7 x 100 shares).
If the stock stays at or below $90 before the options expire, $700 is the
most you could lose. On the other hand, if the stock rises to $110 at
expiration, the options will be trading around $20 (current price: $110 strike price: $90). Thus, your $700 investment will be worth $2,000
($20 x 100 shares x 1 contract).
If the stock price increases, the option gives you two choices: sell or
exercise. Many investors choose to sell because it avoids the
substantial cash outlay of buying the shares. In the example above,
you would pay $9,000 ($90 x 100 shares) to buy the stock when you
exercise the options. At a market price of $110, your shares would
actually be worth $11,000. Not including commissions, you would have
made a $1,300 profit on your $700 investment ($2,000 - $700).
By selling the options, you realize the same profit without spending the
money to buy the shares. With the stock at $110, the 90 calls would be
worth $20 each. Thus, each option contract would have a value of
$2,000 ($20 x 100 shares). Not a bad return for a $700 investment!
Selling rather than exercising also avoids the extra commission
incurred by buying the shares. For example, when you sell the options,
you pay a commission. When you exercise the options and buy the
shares, you pay a commission to buy the shares. Later, when you sell
the shares, you pay another commission.
The scenario described above is a great example of the leverage
that options provide. Just look at the returns on a percentage
basis.
Purchase Price
Sale Price
Profit (Loss)
% Gain (Loss)
Stock Price
$90
$110
$20
22.2%
100 shares of stock
$9,000
$11,000
$2,000
22.2%
One 90 call
$700
$2,000
$1,300
$186%
As the chart above demonstrates, if you bought 100 shares of stock at
$90, you would be putting $9,000 at risk. If you sold the stock when it
$110, you make $2,000 on your $9,000 investment, a 22.2% return. In
contrast, investing $700 in call options only puts $700 at risk. In this
case, the return is 186%.
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Now, let's see what happens when the stock drops.
Purchase Price
Sale Price
Profit (Loss)
% Gain (Loss)
Stock Price
$90
$70
($20)
(22.2%)
100 shares of stock
$9,000
$7,000
($2,000)
(22.2%)
One 90 call
$700
$0
($700)
(100%)
While this scenario looks scary on a percentage basis, when you look
at the raw profit/loss numbers, it's clearly relative. If the stock drops,
your call may expire worthless, but your loss is limited to your initial
investment, in this case $700. In contrast, the stockholder sustains a
far larger dollar loss of $2,000. When you compare the limited
downside and the unlimited upside potential of call options, it is easy to
see why they are such an attractive investment for bullish investors.
“A man must make his opportunity as oft as find it”
Francis Bacon
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Chapter Twenty-four
Puts
Protective Puts
For investors who want to protect the stocks in their portfolio from
falling prices, protective puts provide a relatively low-cost method of
portfolio insurance. In this case, investors would purchase one put
contract for each 100 shares of stock they own.
Selling Naked Puts
For bullish investors who are interested in buying a stock at a price
below the current market price, selling naked put can be an excellent
strategy. In this case, however, the risk is substantial because the
writer of the option is obligated to purchase the stock at the strike price
regardless of where the stock is trading.
Long Puts
For aggressive investors who have a strong feeling that a particular
stock is about to move lower, long puts are an excellent low risk, high
reward strategy. Rather than opening yourself to enormous risk of
short selling stock, you could buy puts (the right to sell the stock).
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Protective Puts
For both conservative and aggressive
investors, buying protective puts can be an
excellent way to hedge downside risk of
bullish positions.
Example
Buy stock
buy put
Increase in Volatility
Time Erosion
Helps position
Hurts position
An insurance policy for your stocks
With the market volatility we've seen over the past few years, more
investors are recognizing the value of using puts as part of their
everyday trading strategy.
For investors who put money in the volatile Internet or biotech sectors,
the rewards can be enormous. But so can the risks--if the stock price
rises instead of falls, this strategy may limit the upside potential by the
cost of the put. By adding put options to their overall investment
strategy, investors can better position themselves for any direction the
market may head.
Using protective puts is simple and can be relatively inexpensive given
the insurance value. For each 100 shares of stock you buy, buy one
protective put at a strike price or two below
the current market price. For example, if you buy a stock at $87, you'd
buy either the 85 put or the 80 put. That way, if the stock plummets,
you'll be able to sell the stock for close to what you paid for it.
On the other hand, if the stock jumps as you hope, you'll participate
fully in the upswing less the small amount you paid for the protective
puts. In this way, the puts act as an insurance policy. To see how this
works, consider the following example.
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Long 100 shares @ $87
Long 1 put @ $4
Total Cost
Stock Price
$70
$80
$90
$91
$100
$110
$8,700
$400
$9,100
Stock Value
$7,000
$8,000
$9,000
$9,100
$10,000
$11,000
Put Value (Loss)
$1,500
$500
$0
Break Even Price
$0
$0
Combined Value
$8,500
$9,000
$9,000
$9,100
$10,000
$11,000
No matter how far the stock drops, as long as there is a protective put,
the combined value of your stock and option position will be worth
$8,500.
Adjusting Your Options
As the stock moves higher, you might want to adjust the puts up by
selling the contracts you own and buying more at a higher strike price.
This way, you can lock in profit from the move higher. Too many
investors have learned the hard way that what goes up rapidly can
drop with equal momentum. So, if the stock jumps from $87 to $132,
the 85 puts won't provide much downside protection. That's why it
would be advisable to lock in profits by purchasing puts at the 125 or
130 strike.
Selling
Naked Puts
For bullish investors who are
interested in buying a stock at a price
below the current market.
Example
Sell put
Increase in Volatility
Time Erosion
Hurts position
Helps position
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Buying stocks at a discount
Let's take the case of selling naked puts. When a put option is "put'
(assigned), the seller (writer) is obligated to buy stock at a fixed price,
regardless of the current market of the stock. For example, the stock
might be trading at $20, but if the seller sold the 45 put (strike price of
the option is $45), the option seller must buy the stock for $45 per
share.
Given this scenario, it's easy to see why an individual investor would
probably view selling naked puts as having limited reward and
unlimited risk. The reality however is that the risk is limited, yes that's
correct the stock can only fall to zero so in this case the risk would be
limited to 45 (minus the premium received). This is a great way to buy
stock wholesale.
By selling slightly out of the money puts, one is able to buy the stock at
a discount (if the stock is put to them) relative to where it currently
trades if the stock moves down in price. At the same time, the position
would have earned additional income from the premium associated
with the options. If the stock advances, naked put writers keep the
premium collected from the options that expire worthless. Selling
Naked puts as use in the latter way is often used to create monthly
cash flow.
To truly appreciate this strategy, let's look at the following hypothetical
example. Imagine that you want to buy Bubba Gump's stock (XYZ) but
think it is due for a slight correction from its current price, $87. By
selling the $85 puts at $5, you collect $500 ($5 x 100 shares) per
contract. If the stock drops to $81 and the stock is "put" to you
"assigned to you", you will pay $85 for the stock. However, your net
cost is really $80 per share ($85 strike - $5 premium)-a relative bargain
compared to buying the stock outright at $87!
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Long
Puts
For aggressive investors who have a
strong feeling that a particular stock is
about to move lower, long puts are an
excellent low risk, high reward strategy.
Example
Increase in Volatility
Time Erosion
Buy put
Helps position
Hurts position
Making money as prices fall
Now let's imagine that you have a strong feeling a particular stock is
about to move lower. Before puts came into existence, your only
alternative was to sell the stock short. Short selling stock is a risky
strategy. Should the stock move higher, your loss would be
theoretically unlimited. Rather than opening yourself to this risk, you
could buy puts (the right to "put" (sell) the stock). Lets suppose XYZ
stock is trading @ $90. The 90 puts might be trading for $5. For $500
you could buy one 90 put (100 shares x $5).
Since each contract controls 100 shares, you now have the right to sell
100 shares at $90 per share. If the stock stays at or above $90 before
the options expire, the most you could lose is your initial investment of
$500. On the other hand, if the stock falls to $60 at expiration, the 90
put will be worth $30 (strike price: $90 - current stock price: $60). At
this point, the puts are worth $3,000 ($30 x 100 shares). Before
commissions, this represents a 500% gain on your investment. To
achieve the same percentage gain on a typical stock trade, a $100
stock would have to increase in value to $600. Needless to say, that
doesn't happen every day.
To better see the leverage of options, let's look again at the returns on
a percentage basis.
Opening Trade Closing Trade Profit (Loss) % Gain (Loss)
Stock Price
$90
$60
$30
33%
Short 100 shares of stock
$9,000
($6,000)
$3,000
33%
Long one 90 put
($500)
$3,000
$2,500
$500%
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Now, let's see what happens when the stock rises.
Opening Trade Closing Trade Profit (Loss) % Gain (Loss)
Stock Price
$90
$120
($30)
(33%)
Short 100 shares of stock
$9,000
($12,000)
($3,000)
(33%)
Long one 90 put
($500)
$0
($500)
($100%)
If you sold the stock short at $90 thinking it would go down and it rose
quickly to $120, you would be forced to buy the stock and limit your
losses. In this case, you would lose $3,000 (100 shares x $30 share).
It's also easy to see that this could get worse. The stock could continue
climbing indefinitely. Had you purchased the puts rather than sold the
stock short, your loss would be limited to the price of the puts-in this
case $500.
Risks
With both puts and calls, the risks fall into the same categories, time
and market direction. To make a profit, the buyer of these options has
to be right about the price movement of the stock and the time frame in
which it will occur. If the stock doesn't make its move before the
options expire, they will expire worthless. While a stockholder is
concerned with market direction, the timeframe isn't as critical because
stock doesn't have an expiration date. You can hold a stock for
decades. You can't do the same with options. With the exception of
LEAPS (longer-term option contracts), most options expire in a matter
of months.
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LEAP Puts
Buying Equity LEAPS Puts To Hedge The Value Of Stock
Owned
Stock Assumption:
Bearish
Situation:
Investor believes prices on certain stocks will
decline over the next two years
Possible Market
Action:
Buy LEAPS Puts to hedge the value of stock
owned
An investor has purchased stocks in many individual companies over
time and has substantial paper profits but is now concerned about a
decrease in price over the next two years. He does not want to be
forced to sell these stocks and also is not sure when a softening in
price will occur. LEAPS offer a means to maintain ownership as well as
protect a defined amount of the value of a stock.
ZYX is trading at 110 and the 2 year January, 95 LEAPS® put is
trading at 4. The individual owns 500 shares which were purchased at
an average price of 75. He is hoping the stock will continue to
appreciate but would like to lock in a profit without putting a cap on
how high ZYX can be sold. Purchasing the 2 year January, 95 LEAPS
puts gives him the right to sell this stock at a price of 95 until the
expiration date irrespective of how much of a decline might occur.
Should the price of ZYX decline, the value of the puts would generally
increase and therefore cover some of the decline in value of the stock.
The investor buys five LEAPS puts for $2,000. He is risking this
amount plus commissions if ZYX is not below 95 at expiration.
If ZYX declines to 90 within a year, the value of the LEAPS will be
approximately 6.875. They can be sold for a profit, which will offset
some of the recent paper loss on the stock, or they can be held as
continued insurance for the remainder of the two-year term.
Buy Five LEAPS ZYX 95 Puts
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Closing Sale Price (5 x 100 x
6.875):
$3,437.50
Less premium paid (5 x 100 x 4):
$2,000.00
Profit on the LEAPS® puts in this
situation:
$1,437.50
Commissions, dividends, margins, taxes and other transaction charges
have not been included. However, they will affect the outcome of
option transactions and should be considered. The strategy discussed
above is for illustrative and educational purposes only and should not
be construed as an endorsement, recommendation or solicitation to
buy or sell any particular security.
To business that we love we rise betime
And go to’t with delight.
William Shakespeare (1564-1616)
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Chapter Twenty-five
Spread Trading
Bull Call Spreads
Also known as Debit Spreads. For bullish investors who want a nice
low risk, limited return strategy without buying or selling the underlying
stock, bull call spreads are a great alternative. This strategy involves
buying and selling the same number of calls at different strike prices to
minimize the cash outlay and the overall risk.
Bull Put Spreads
Also known as Credit Spreads. For bullish investors who want a nice
low risk, limited return strategy, bull put spreads are another
alternative. Like the bull call spread, the bull put spread involves
buying and selling the same number of put options at different strike
prices. Since puts with the higher strike price are sold, the trade is
initiated for a credit
Call Backspreads
For bullish investors who expect big moves in already volatile stocks,
call back spreads are a great limited risk, unlimited reward strategy.
The trade itself involves selling a call (or calls) at a lower strike and
buying a greater number of calls at a higher strike price.
Bear Put Spreads
Also known as a Debit Spread. For bearish investors who want a nice
low risk, limited return strategy, bear put spreads are another
alternative. The bear put spread involves buying and selling the same
number of put options at different strike prices. Since puts with the
higher strike price are bought, the bear put spread trade is initiated for
a debit.
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Bear Call Spreads
Also known as a Credit Spread. For investors who maintain a generally
negative feeling about a stock, bear spreads are a nice low risk, low
reward strategy. This trade involves selling a lower strike call, usually
at or near the current stock price, and buying a higher strike, out-ofthe-money call. This spread profits when the stock price decreases
and both calls expire worthless
Bull Call
Spreads (Debit
Spreads)
For investors who are generally bullish
about a stock, and are looking for a low
risk strategy.
Example
Increase in Volatility
Time Erosion
Buy call (lower strike)
sell call (higher strike)
Helps position as long as stock price
increases
Hurts
position
Buy call (lower strike)
sell call (higher strike)
Helps position as long as stock price
increases
Hurts
position
Earning Income on Your Portfolio
When your feeling on a stock is generally positive, Bull Call Spreads
represent a nice low risk, limited reward strategy. To create a Bull Call
Spread you will use call options at or near the current market price of
the stock. If the underlying stock is trading at $50, you could buy the
50 calls and sell the same number of 55 calls.
By selling the 55 calls, you lower your exposure, but you also lower
your upside potential. Let's say that you paid $4 for the 50 calls and
sold the 55 calls for $3. In this case, your total cost-and the most you
could lose-would be $100 ($4 x 100 - $3 x 100).
Your maximum profit is $400, the difference between the strike prices
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less the $100 you paid to put on the position. Even if the stock goes to
80, you still only stand to make $400 because while your 50 call is
worth $30, the 55 call you sold is worth $25. To close the position, you
would have to pay $25 for the 55 call when you sell the 50 call for $30.
This limited upside is the price you pay for lowering your exposure
(from $400 to $100) through the spread.
If you like the idea behind the bull call spread, be sure to check out bull
put spreads. Bull put spreads are credit spread and requires only two
commissions as compared to the bull call spread which is a debit
spread and requires four commissions to complete the trade with
maximum profit.
Stock: $50
Buy one 50 call @ 4
($400)
Sell 1 55 call @ 3
$300
Total Cost
Maximum Profit
Maximum Loss
$100
$400
$100
Stock Price at
Expiration
$45
$50
$51
$52
$53
$54
$55
$60
Profit
(Loss)
($100)
($100)
$0
$100
$200
$300
$400
$400
Return on
Investment*
(100%)
(100%)
0%
100%
200%
300%
400%
400%
*This example does not factor in commissions, interest or tax
consequences.
“Every master knows that the material teaches the artist”
Ilya Ehrenburg
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Put
Spreads
(Credit
The Investment Club Network 375
For investors who are generally bullish about
a stock and are looking for a low risk, limited
reward strategy.
Example
Buy put (lower
strike)
sell put (higher
strike)
Increase in Volatility
Helps position as long as stock price
increases
Time
Erosion
Helps
position
Earning Income on Your Portfolio
When your feeling on a stock is generally positive, bull put spreads are
great low risk, limited reward strategies. To create a bull put spread by
using put options at or near the current market price of the stock.
For example, if you have a bullish short-term feeling about XYZ when it
is trading at $46, you enter a bull put spread by selling the 45 put @ 7
and buying the 40 put for 3. In this case, the maximum profit would be
the $400 you received when you initiated the position.
Stock: $46
Buy one 40 put @ 3
Sell 1 45 put @ 7
($300)
$700
The maximum loss would be the difference between strike prices less
the $400 credit you received for putting on the trade. In this example,
the maximum loss would be $100 ((45 - 40)
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Stock: $46
Buy one 40 put @ 3
Sell 1 45 put @ 7
Total Credit
Maximum Profit
Maximum Loss
Stock Price at
Expiration
$35
$40
$41
$42
$43
$44
$45
$46
$50
($300)
$700
$400
$400
$100
Profit
(Loss)
($100)
($100)
$0
$100
$200
$300
$400
$400
$400
Return on
Investment*
(80%)
(80%)
0%
20%
40%
60%
80%
80%
80%
*This example does not factor in commissions, interest or tax
consequences.
**The Return on Investment is calculated based on the maximum loss
of the position before including the initial credit received. The
maximum loss in this case is $500.
“A man must make his opportunity as oft as find it”
Francis Bacon
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Call
backspreads
For bullish investors who expect big moves in
already volatile stocks, call back spreads are a
great limited risk, unlimited reward strategy.
The trade itself involves selling a call (or calls)
at a lower strike and buying a greater number
of calls at a higher strike price.
Example
Increase in Volatility
Time Erosion
Sell Calls (lower strike)
Buy Calls (higher strike)
Helps position
Hurts position
Call backspreads are great strategies when you are expecting big
moves in already volatile stocks. The trade itself involves selling a call
(or calls) at a lower strike and buying a greater number of calls at a
higher strike price. Ideally, this trade is initiated for a minimal debit or
possibly a small credit. This way, if the stock heads south, you won't
suffer much either way. On the other hand, if the stock takes off, the
profit potential will be unlimited because you have more long than
short calls.
To maximize the potential for this position, many traders use in-themoney options because they have a higher likelihood of finishing inthe-money. Using XYZ, a company that historically has been quite
volatile, we can create a ratio backspread using in-the-money options.
Strike Price
Stock Price
August 22.5 Call
August 25.0 Call
Call Price
$25.50
$4.50
$2.50
In this case, you might sell two of the 22.50 calls at 4.50 and buy three
25.0 calls at 2.50.
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Sell two 22.5 Calls @ $4.50 for a credit of $9.00
Buy three 25.0 calls @ 2.50 for a debit of $7.50
Position would net a credit of $1.50 (9.00 - 7.50)
In this case, you would receive $150 ((9.00 - 7.50) x 100 shares) for
putting on the trade. If the stock dropped below $22.50, you would
keep the $150. However, the real money would be made if the stock
made a huge move to the upside. The upside breakeven for this trade
would be $28.50 ($3/share higher than its current price). At this price,
the two 22.5 calls would be worth $1,200 (600 x 2) each while the
three 25 calls would be worth $1,050 (350 x 3). Factoring in the initial
$150 credit, the ROI at this price would be 0. Above $28.50, the profit
potential is unlimited.
Values at Expiration
Stock
Price
20
22
23
24
25
26
27
28
28.50
29.00
30.00
35.00
Two 22.50
calls
(sold)
0
0
(100)
(300)
(500)
(700)
(900)
(1,100)
(1,200)
(1,300)
(1,500)
(2,500)
Three 25.0
calls
(bought)
0
0
0
0
0
300
600
900
1,050
1,200
1,500
3,000
Original
Credit
(Debit)
150
150
150
150
150
150
150
150
150
150
150
150
Total
Profit
(Loss)
150
150
50
(150)
(350)
(250)
(150)
(50)
0
50
150
650
Calculating the Breakeven
The easiest way to calculate the upside breakeven is by using the
following formula:
Upside Breakeven = Long strike price + [(Long strike short strike) x # of short contracts] - (net credit/100)
**(or + net debit)
Using the data for this example, the breakeven calculation looks like
this:
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(25 + [(25 - 22.5) x 2] - (150/100)
Simplified, the equation becomes:
(25 + 5 - 1.50) = 28.5
The maximum loss for this trade would occur with the stock at 25
because the long calls would be worthless and the two short calls
would be worth $250 each. Factoring in the initial credit of $150, the
maximum loss on this trade would be $350 (2 contacts x $2.50 x 100
shares - $150 credit).
Bear Put
Spreads
(Debit
Spreads)
For investors who are generally bearish
about a stock an are looking for a low risk
strategy that has a net debit
Example
Increase in Volatility
buy put (higher strike) Increase in implied volatility hurts position
sell put (lower strike)
unless stock price drops at the same time.
Time
Erosion
hurts
position
When your feeling on a stock is generally negative, Bear Put Spreads
are nice low risk, limited reward strategies. To create a Bear Put
Spread you will use put options at or near the current market price of
the stock.
Like bear call spreads, bear put spreads profit when the price of the
underlying stock decreases. Typically buying near the money puts and
selling out-of-the-money puts creates the bear put spread. Going back
to the Bubba Gump example, if you have a bearish short-term feeling
when the stock is trading at $46, you might initiate a bear put spread
by buying the 45 put @ 7 and selling the 40 put for 3.
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Stock: $46
Buy one 45 put @ 7
Sell 1 40 put @ 5
Net Debit
($700)
$500
($200)
Maximum Profit
Maximum Loss
$300
$200
In this case, the maximum profit would be the difference between the
strike prices less the $200 it cost to put on the position. In this case,
the maximum profit works out to be $300 ((45 - 40 x 100) - $200).
In contrast, the maximum loss would be limited to the $200 spent
initiating the trade. Once again, this is a debit spread, and in order for
this trade to see it maximum profit it will require four commissions.
If you like the idea behind the bear put spread, be sure to check out
bear call spreads, as this type of spread is a credit spread and
requires only two commissions to accomplish your objectives.
Stock Price at Expiration Profit (Loss) Return on Investment*
$50
($200)
(100%)
$45
($200)
(100%)
$44
($100)
(50%)
$43
$0
0%
$42
$100
50%
$41
$200
100%
$40
$300
150%
$30
$300
150%
*This example does not factor in commissions, interest or tax
consequences.
“Never is work without reward, or reward without work”
Livy
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Bear Call
Spreads
(Credit
Spreads)
For investors who are generally bearish
about a stock and are looking for a low risk
strategy that has a net credit.
Example
Increase in Volatility
Increase in implied volatility hurts
sell call (lower strike)
position
buy call (higher strike) unless stock price decreases at the same
time.
Time Erosion
helps
position
When your feeling on a stock is generally negative, Bear Call Spreads
are nice low risk, limited reward strategy. To create a Bear Call Spread
you will use call options at or near the current market price of the
stock.
Like bear put spreads, bear call spreads profit when the price of the
underlying stock decreases. Selling slightly out-of-the-money calls and
then buying a little further out-of-the-money calls are typically the way
bear call spreads are constructed.
With the underlying stock trading near $50, you'd sell the 50 calls for
$5 and buy the 55 calls for $2. This way, you'd initiate the spread for a
credit of $300, your maximum profit. If you are correct and the stock
moves lower, both calls will expire worthless and you'll keep the $300
premium you collected when you initiated the position.
Stock: $50
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Sell one 50 call @ 5
Buy 1 55 call @ 2
$500
($200)
Net Credit
$300
Maximum Profit
Maximum Loss
$300
$200
Now, let's image the stock moves unexpectedly higher to $70. To close
the position at that price, you would have to buy the 50 calls for $20
and sell the 55 calls for $15. With the underlying stock at or above 55,
the will bring about the maximum loss of $200 ($500 - $300 credit
received when the position was opened).
The ROI for this position is calculated using the $200 maximum
possible loss for the spread, not including the initial credit, because
this is the amount of money that must remain available in the account
until either expiration or a closing trade, whichever comes first.
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Chapter Twenty-six
Neutral Option Strategies
When investors are "neutral" on a stock
they are undecided about whether the
price of the stock is going to go up or
down. The option strategies below are
neutral strategies which have neither an
upside or downside bias.
Long Straddles
For aggressive investors who expect short-term volatility yet have no
bias up or down (i.e., a neutral bias), the long straddle is an excellent
strategy. This position involves buying both a put and a call with the
same strike price, expiration, and underlying. The potential loss is
limited to the initial investment. The potential profit is unlimited as the
stock moves up or down.
Short Straddles
For aggressive investors do don't expect much short-term volatility, the
short straddle can be a risky, but profitable strategy. This strategy
involves selling a put and a call with the same strike price, expiration
and underlying. In this case, the profit is limited to the initial credit
received by selling options. The potential loss is unlimited as the
market moves up or down
Long strangles
For aggressive investors who expect short-term volatility yet have no
bias up or down, the long strange is another excellent strategy. This
strategy typically involves buying out-of-the-money calls and puts with
the same strike price, expiration and underlying. The potential loss is
limited to the initial investment while the potential profit is unlimited as
the underlying security moves in either direction
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Short Strangles
For aggressive investors who don't expect much short-term volatility,
the short strangle can be a risky, but profitable strategy. This strategy
typically involves selling out-of-the-money puts and calls with the same
strike price, expiration, and underlying. The profit is limited to the credit
received by selling options. The potential loss is unlimited as the
market moves up or down.
The Butterfly
Ideal for investors who prefer limited risk, limited reward strategies.
When investors expect stable prices, they can buy the butterfly by
selling two options at the middle strike and buying one option at the
higher and lower strikes. The options, which must be all calls or all
puts, must also have the same expiration and underlying.
The Condor
Ideal for investors who prefer limited risk, limited reward strategies.
The condor takes the body of the butterfly - two options at the middle
strike - and splits between two middle strikes. In this sense, the condor
is basically a butterfly stretched over four strike prices instead of three.
Ratio Spread
For aggressive investors who don't expect much short-term volatility,
ratio spreads are a limited reward, unlimited risk strategy. Put ratio
spreads, which involve buying puts at a higher strike price and selling
a greater number of puts at a lower strike, are neutral in the sense that
market movement hurts them.
Calendar spreads
Calendar spreads are also known as time or horizontal spreads
because they involve options with different expiration months. Because
they are not exceptionally profitable on their own, traders who maintain
large positions often use calendar spreads. Typically, a long calendar
spread involves buying an option with a long-term expiration and
selling an option with the same strike price and short-term expiration
The Collar
For bullish investors who want a nice low risk, limited return strategy to
use in conjunction with a long stock position, collars are a great
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alternative. In this case, combining covered calls creates the collar and
protective puts.
Long
Straddles
(also known as a Combination)
For aggressive investors who expect short-term
volatility yet have no bias up or down (i.e., a neutral
bias), the long straddle is an excellent strategy.
Example
Buy call
buy put
Increase in Volatility
Time Erosion
Helps position
Hurts position
A Word on Straddles as Neutral Strategies
Although long and short straddles differ in their response to market
movement, we have chosen to list both as neutral strategies. In a pure
sense, the short straddle is a neutral strategy because it achieves
maximum profit in a market that moves sideways. In contrast, the long
straddle benefits from market movement in either direction. However,
since a $10 move in either direction will have the same impact on
profit, the trader doesn't necessarily have a preference, which way the
market moves. In this sense, the trader is neutral about market
direction--as long as movement occurs.
Long Straddles
Have you ever had the feeling that a stock was about to make a big
move, but you weren't sure which way? For stockholders, this is
exactly the kind of scenario that creates ulcers. For option traders,
these feelings in the stomach are the butterflies of opportunity. By
simultaneously buying the same number of puts and calls at the
current stock price, option traders can capitalize on large moves in
either direction.
Here's how this works. Let's imagine a stock is trading around $80 per
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share. To prepare for a big move in either direction, you would buy
both the 80 calls and the 80 puts. If the stock drops to $50 by
expiration, the puts will be worth $30 and the calls will be worth $0. If
the stock gaps up to $110, the calls will be worth $30 and the puts will
be worth $0. The greatest risk in this case is that the stock remains at
$80 where both options expire worthless.
Here's what the trade might look like:
Long one 80 call @ 7.50
Long one 80 put @ 7
At these prices, every straddle will cost about 14.50. Since you are
buying two options, a call and a put, you might get a slightly better
price than the offer for each individual option. But, to keep it simple,
we'll assume the prices listed above are the best available for the
straddle. The 14.50 or $1,450 you pay for the straddle will also be the
most you can lose if the price remains close to $80.
Since the position profits from big moves in either direction, it has both
an up and a downside breakeven point calculated as follows:
Upside breakeven: Straddle Strike + Cost of Straddle
(80 + 14.50 = 94.50)
Downside breakeven: Straddle Strike - Cost of
Straddle (80 - 14.50 = 65.50)
Given this, the position will show a profit as long as the stock moves
above 94.50 or below 65.50. Between those prices, the position will
show a range of losses with the maximum lost right at the strike price
where neither option has any value.
Stock Price at
Expiration
$50
$60
$65.5
$70
$80
$90
$94.5
$100
$110
Profit
(Loss)
Return on
Investment*
$1,650
$550
$0
($450)
($1,450)
($450)
$0
$550
$1,650
114%
40%
0%
(31%)
(100%)
(31%)
0%
40%
114%
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•
The profit/loss above does not factor in commissions, interest,
or tax considerations.
Long
Strangles
For aggressive investors who expect shortterm volatility yet have no bias up or down,
the long strangle is another excellent
strategy.
Example
Buy Call (higher strike)
Buy Put (lower strike)
Increase in Volatility
Time Erosion
Helps position
Hurts position
A Word on Strangles as Neutral Strategies
Although long and short strangles differs in their response to market
movement, we have chosen to list both as neutral strategies. In a pure
sense, the short strangle is a neutral strategy because it achieves
maximum profit in a market that moves sideways. In contrast, the long
strangle benefits from market movement in either direction. However,
since a $10 move in either direction will have the same impact on
profit, the trader doesn't necessarily have a preference, which way the
market moves. In this sense, the trader is neutral about market
direction--as long as movement occurs.
Long Strangles
long strangles are comparable to long straddles in that they profit from
market movement in either direction. From a cash outlay standpoint,
strangles is less risky than straddles because they are usually initiated
with less expensive, near-the-money rather than at-the-money options.
Like long straddles, they have unlimited profit potential on both the
upside and downside. For example, let's imagine that a particular stock
is trading at $65 per share. The following chart shows where the nearthe-money and at-the-money options are trading.
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Strike Price
$60
$65
$70
Calls
7.00
5.25
2.50
Puts
2.25
5.00
6.75
* Calls and puts used in strangles have the same expiration.
Long Strangle
Current Stock Price: 65
Buy one 60 put @ 2.25
Buy one 70 call @ 2.50
If we opted for the strangle, we could buy the 60 put for 2.25 and the
70 call for 2.50. Thus, our out-of-pocket cost-and maximum loss-would
be 4.75 plus commissions. With the stock anywhere between $60 and
$70, we would incur the maximum loss of $475 (4.75 x 100). Anywhere
below $55 or above $75, the position will begin to show a profit.
Stock Price at Expiration Profit (Loss) Return on Investment*
$50
$525
111%
$55.25
$0
0%
$60
($475)
(100%)%
$65
($475)
(10%)
$70
($475)
(100%)
$74.75
$0
0%
$80
$525
0%
* The profit/loss above does not factor in commissions, interest, or tax
considerations.
The long strangle can also be created using in-the-money options.
Using the example above, this would involve the following:
Long Strangle (less common alternative)
Buy one 60 call: 7
Buy one 70 put: 6.75
This is an interesting position for a number of reasons. First, it's
guaranteed to have some value at expiration because at any price at
least one of the options will have intrinsic value. More specifically, with
the stock between $60 and $70, the position will be worth $10. Thus,
the maximum loss will be 3.75 (13.75 - 10).
It's also worth noticing that the maximum loss using in-the-money
options is lower (3.75 vs. 4.75) even though the out-of-pocket cost to
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initiate the position is much higher. The reason for this is that generally
speaking, the time premium for in-the-money options is lower than it is
for out-of-the money options. In the first example, neither the 70 call
nor the 60 put had any intrinsic value with the stock at $65. Thus, the
price of the options was primarily time premium.
In the second example, the 60 call and the 70 put each had $5 of
intrinsic value with the stock at $65. When you subtract the intrinsic
value from the total price of the options, you see that the time premium
for these in-the-money options is lower than the time premium for
options equidistant from the current stock price but out-of-the-money.
Option Price
Intrinsic Value
Out-of-the-Money Options
70 call
2.50
0
60 put
2
0
In-the-Money Options
60 call
7
5
70 put
6.75
5
Time Premium
2.50
2
2
1.75
“Nothing ever comes to one that is worth having,
except as a result of hard work”
Booker T. Washington(1856-1915)
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Short
Strangles
(Also known as a Combination)
For aggressive investors who don't expect
much short-term volatility, the short strangle
can be a risky, but profitable strategy.
Example
Sell Call (higher strike)
Sell Put (lower strike)
Increase in Volatility
Time Erosion
Hurts position
Helps position
Short Strangle
Short strangles are comparable to short straddles in that they profit in
stagnant markets with little price change. Like short straddles, they
have unlimited loss potential on both the upside and downside.
Strangles is slightly less risky than straddles, but the position is far
from risk less. In fact, the strangle got its name in 1978 when a number
of IBM option traders holding this position lost everything as a result of
wide, unexpected price swings.
Let's imagine that a particular stock is trading at $65 per share. The
following chart shows where the near-the-money and at-the-money
options are trading.
Strike Price
$60
$65
$70
Calls
Puts
7.00
5.25
2.50
2.25
5.00
6.75
* Calls and puts used in strangles have the same expiration.
Long Strangle
Current Stock Price: 65
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Sell one 60 put @ 2.25
Sell one 70 call @ 2.50
If we opted for the strangle, we could sell the 60 put for 2.25 and the
70 call for 2.50. Thus, our maximum profit would be 4.75 less
commissions. With the stock anywhere between $60 and $70, we
would keep the 4.75 premium we collected by initiating the position.
Anywhere below $55.25 or above $74.75, the position will begin to
show a loss.
Stock Price at Expiration
$50
$55.25
$60
$65
$70
$74.75
$80
Profit (Loss)
($525)
$0
$475
$475
$475
$0
($525)
* The profit/loss above does not factor in commissions, interest, or tax
considerations.
The short strangle can also be created using in-the-money options.
This particular type of strangle is sometimes referred to as a "guts."
Using the example above, this would involve the following:
Short Strangle (less common alternative)
Sell one 60 call: 7
Sell one 70 put: 6.75
This is an interesting position for a number of reasons. First, the
position is guaranteed to have some value at expiration because at
any price at least one of the options will have intrinsic value. More
specifically, with the stock between $60 and $70, the options will be
worth $10. Thus, the maximum profit will be 3.75 (13.75 - 10) or $375.
However, the person who sells this strangle would have the benefit of
the interest earned on the entire $1,375 premium collected.
70 call
60 put
In-the-Money Options
60 call
70 put
2.50
2
0
0
2.50
2
7
6.75
5
5
2
1.75
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The
Butterfly
Ideal for investors who prefer limited risk,
limited reward strategies.
Example
Sell 2 calls (middle strike)
Buy 1 call (lower strike)
Buy 1 call (higher strike)
Increase in Volatility
Hurts position
Time Erosion
Helps position
The Long Butterfly
When your feeling on a stock is generally neutral because it's been
trading in a narrow range, the long butterfly can be a great strategy to
use. Like many spreads, the long butterfly is a limited risk, limited
reward strategy. What makes the position interesting is its ability to
profit in stagnant markets.
Imagine that a stock trading at $75 has been relatively flat for some
time. If you think the situation is unlikely to change, you can sell two 75
calls. At the same time, you'd buy one 70 call and one 80 call as a
hedge in case the market moved against you. This combination of
options creates the long butterfly. The position is considered "long"
because it requires a net cash outlay to initiate.
Stock: $75
Sell: Two 75 calls @ $6 for a credit of $1,200 (the
body of the butterfly)
Buy: One 70 call @ $9 for a debit of $900 (one wing)
Buy: One 80 call @ $4 for a debit of $400 (other wing)
Total Credits: $1,200
Total Debits: $1,300
Net Debit or Cost of Position: $100 ($1,300 - 1,200)
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Note: The same position can be established using puts.
However you establish it, all options must have the same
expiration and be the same price--i.e. calls or puts.
In this case, the maximum profit is achieved at expiration with
the stock at $75. At $75, the 75 and 80 calls would expire
worthless, and the 70 calls would be worth $500. Thus, you
would achieve your maximum profit of $400 ($500 - $100 initial
debit). At any price above $80 or below $70, you would
experience the maximum loss of $100.
Value At Expiration
Stock Price Profit (Loss)
$65
(100)
$70
(100)
$71
0
$75
400
$79
0
$80
(100)
$85
(100)
$90
(100)
Return on Investment**
(100%)
(100%)
0%
400%
0%
(100%)
(100%)
(100%)
*The profit/loss above does not factor in commissions, interest or tax
considerations.
**The ROI is calculated based on the maximum loss of the position.
Now, let's see what happens when you sell the butterfly.
The Short Butterfly
Example
Buy 2 calls (middle strike)
Sell 1 call (lower strike)
Sell 1 call (higher strike)
Increase in Volatility
Time Erosion
Helps position
Hurts position
Let's imagine that a stock is trading at $75. You have a feeling the
stock is going to make a moderate move, but you aren't sure which
way. In this sense, your market sentiment is neutral.
In this case, you might sell the butterfly. Like its counterpart the long
butterfly, the short butterfly is a limited risk, limited reward strategy.
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Stock: $75
Buy: Two 75 calls @ $5 for a debit of $1,000 (the body
of the butterfly)
Sell: One 70 call @ $9 for a credit of $900 (one wing)
Sell: One 80 call @ $2 for a credit of $200 (other wing)
Total Credits: $1,100
Total Debits: $1,000
Net Credit: $100 ($1,100 - 1,000)
Note: The same position can be established using puts.
By rearranging the options, it's easy to see that the butterfly is nothing
more than the combination of a bull and bear spread.
Bull Call Spread: Long one 75 call, short one 80 call
Bear Call Spread: Short one 70 call, long one 75 call
Either way you look at it, the body of the butterfly (the inside strike
price) is purchased and the wings or outer strike prices are sold. It's
considered a short position because you receive a credit of $100 for
initiating the trade. This is also the maximum profit. In this case, the
maximum profit is achieved at expiration with the stock above $80 or
below $70.
Below $70, all of the calls expire worthless and you keep the $100
credit received when you established the position. Above $80, the
profit from the 75 calls is exactly offset by the loss from the 70 and 80
calls. Here again, you keep the $100 credit and the rest would be a
wash (less commissions of course.)
The maximum loss for this position would occur with the stock at $75.
Here, the 75 calls you paid $1,000 for would expire worthless, as
would the 80 call you sold for 2. To close the position, you'd have to
buy the 70 call for 5 (current price - strike price). Given this possibility,
the margin requirements for this position typically require you to have
at least $500 available in your account. This amount is also the basis
for calculating return on investment even though the maximum loss is
only $400 ($500 - $100 initial credit).
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Value At Expiration
Stock Price Profit (Loss)
$65
100
$70
100
$71
0
$75
(400)
$79
0
$80
100
$85
100
$90
100
Return on Investment**
20%
20%
0%
80%
0%
20%
20%
20%
*The profit/loss above does not factor in commissions, interest or tax
considerations.
**The ROI is calculated based on the maximum loss of the position not
including the credit received.
The
Condor
Ideal for investors who prefer limited risk,
limited reward strategies.
Example
Increase in Volatility
Time Erosion
Buy 1 Call (in-the-money)
Sell 2 Calls (at consecutive strikes near
the money)
Buy 1 call (out-of-the-money)
Hurts position
Helps position
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The Long Condor
The condor takes the body of the butterfly - two options at the middle
strike - and split it between two middle strikes rather than just one. In
this sense, the condor is basically a butterfly stretched over four strike
prices instead of three.
Long (Buy) 70 Call
Short (Sell) 75 Call
Short (Sell) 80 Call
Long (Buy) 85 Call
You can also view a condor as a combination of a bull and bear call
spread.
Long (buy) 70 call, short (sell) 75 call (bull call spread)
Short (sell) 80 call, long (buy) 85 call (bear call spread)
The long condor can be a great strategy to use when your feeling on a
stock is generally neutral because it's been trading in a narrow range.
Like the butterfly, the condor is a limited risk, limited reward strategy
that profits in stagnant markets.
Imagine that a stock trading at $75 has been relatively flat for some
time. If you think the situation is unlikely to change, you can sell one 75
call and one 80 call. At the same time, you'd buy one 70 call and one
85 call as a hedge in case the market moved against you. This
combination of options creates the long condor. The position is
considered "long" because it requires a net cash outlay to initiate.
Stock: $75
Sell: One 75 call @ $6 for a credit of $600 (condor
body)
Sell: One 80 call @ $4 for a credit of $400 (condor
body)
Buy: One 70 call @ $9 for a debit of $900 (one wing)
Buy: One 85 call @ $2 for a debit of $200 (other wing)
Total Credits: $1,000
Total Debits: $1,100
Net Debit or Cost of Position: $100 ($1,100 - 1,000)
Note: The same position can be established using puts.
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In this case, the maximum profit is achieved at expiration with the
stock between 75 and 80. At $75, the 75, 80, and 85 calls would expire
worthless and the 70 calls would be worth $500. Thus, you would
achieve your maximum profit of $400 ($500 - $100 initial debit).
Between 75 and 80, the loss on the short 75 calls is more than offset
by the 70 calls. Since the 80 and 85 calls would again expire
worthless, the value at expiration is the same as the value of the
70/75-bull call spread ($5). At any price above $85 or below $70, you
would experience the maximum loss of $100.
Value At Expiration
Stock
Price
$65
$70
$71
$75
$80
$84
$85
$90
Profit
(Loss)
Return on
Investment**
(100)
(100)
0
400
400
0
(100)
(100)
(100%)
(100%)
0%
400%
400%
0%
(100%)
(100%)
*The profit/loss above does not factor in commissions, interest or tax
considerations.
**The ROI is calculated based on the maximum loss of the position.
Now, let's see what happens when you sell the Condor.
“I walk firmer and more secure uphill than down”
Montaigne (1533-1592)
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The Short
Condor
When your feeling on a stock is that it's about
to move one way or the other, but you're not
sure which way, the short condor can be an
effective strategy.
Example
Sell 1 Call (in the money)
Buy 2 Calls (at consecutive strikes near the
money)
Sell 1 call (out of the money)
Increase in
Volatility
Time Erosion
Helps position
Hurts
position
Like the long condor and long butterfly, the short condor is a
limited risk, limited reward strategy. In this case, you would
buy one 75 call and one 80 call. At the same time, you'd sell
one 70 call and one 85 call as a hedge in case the market
moved against you. This combination of options creates the
short condor. The position is considered "short" because you
will collect a credit for making the trade.
Stock: $75
Buy: One 75 call @ $6 for a debit of $600 (condor body)
Buy: One 80 call @ $4 for a debit of $400 (condor body)
Sell: One 70 call @ $9 for a credit of $900 (one wing)
Sell: One 85 call @ $2 for a credit of $200 (other wing)
Total Credits: $1,100
Total Debits: $1,000
Net Credit: $100 ($1,100 - 1,000)
Note: The same position can be established using puts.
With this spread, the maximum profit is limited to the $100
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credit received when this trade was initiated. At expiration, if
the stock is above $85 or below $70, you'll keep the $100. The
$400 maximum loss for this position will occur between $75
and $80 where the profit on the 75 call is more than offset by
the loss on the short 70 call. Meanwhile, the 80 and 85 calls
would expire worthless.
Value At Expiration
Stock
Price
$65
$70
$71
$75
$80
$84
$85
$90
Profit
(Loss)
(100)
100
0
(400)
(400)
0
100
100
Return on
Investment**
20%
20%
0%
(80%)
(80%)
0%
20%
20%
*The profit/loss above does not factor in commissions, interest or tax
considerations.
**The ROI is calculated based on the maximum loss of the position not
including the credit received.
If you like the idea behind the condor, be sure to check out long
butterflies and short iron butterflies. These can be comparable
strategies depending on your objectives.
“What is more mortifying than to feel that you have missed the
plum for want of courage to shake the tree”?
Logan Pearsall Smith
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Ratio
Spreads
For aggressive investors who don't expect much
short-term volatility, ratio spreads are a limited
reward, unlimited risk strategy.
Example
Buy 1 Put (lower strike)
Sell 2 Puts (higher strike)
Increase in Volatility
Time Erosion
Hurts position
Helps position
Ratio spreads are neutral in the sense that you don't want the market
to move much either way once you make the trade.
While call and put ratio spreads can be effective strategies when you
are expecting relatively stable prices over the short term, they are not
without risk. By definition, a ratio spread involves more short than long
options. If the trade moves against you, the extra short option(s)
expose you to unlimited risk.
Put Ratio Spreads
To create a put ratio spread, you would buy puts at a higher strike and
sell a greater number of puts at a lower strike. Ideally, this trade will be
initiated for a minimal debit or, if possible, a small credit. This way, if
the stock jumps, you won't suffer much because all of the puts will
expire worthless. However, if the stock plummets, you have unlimited
risk to the downside because you will have sold more options than you
bought. For maximum profitability, you want the stock price to stay at
the strike price where you are short options.
Using Bubba Gump's stock (XYZ) with a price of $42, we can create a
ratio spread using in-the-money options.
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Strike Price
Put Price
$60
$55
$50
$45
25.50
20.60
15.75
10.00
In this case, you might buy one 60 put at 25.50 and sell three 45 puts
at 10.
Short 3 45 puts @ 10: ($30)
Long 1 60 puts @ 25.50: 25.50
In this case, you would receive a $450 credit for putting on the trade. If
the stock jumped above 60, you would keep the $450. However, the
real money would be made if the stock stayed right around $45. Here,
the short 45 puts would expire worthless and the long 60 put would be
worth $15. The value of the 60 put, combined with the initial $450
credit would bring the net profit up to $1,950.
A big move to the downside in this case would spell trouble. The
downside breakeven for this trade is $35.25. At this price, the short 45
puts would be worth 29.25 (9.75 x 3) while the long 60 put would be
worth 24.75. Factoring in the initial credit of $450, the position would
be worth zero. Below $35.25, the risk is unlimited.
Value at Expiration
Strike Price
$25
$30
$35
$40
$45
$50
$55
$60
Profit (Loss)
($2,050)
($1,050)
(50)
$950
$1,950
$1,450
$950
$450
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Calculating the Breakeven
The easiest way to calculate the downside breakeven is by using the
following formula:
[# Of short puts x (short strike - short put price) - # of
long puts x (long strike - long put price)]
(# Of short puts - # of long puts)
Using the data for this example, the breakeven calculation looks like
this:
[3 x (45 - 10) - 1 x (60 - 25.50)] / (3-1)
Simplified, the equation becomes:
(105 - 34.50) / 2 or 35.25
Thus, the downside breakeven is $35.25.
Call Ratio Spreads
Like the put ratio spread, call ratio spreads are great strategies when
you are expecting relatively stable prices over the short term. To
create this position, you would buy calls at a lower strike price and sell
a greater number of calls at a higher strike price. Here again, do your
best to initiate the trade for a minimal debit or even a small credit. This
way, if the stock drops, you won't suffer much because all of the calls
will expire worthless. However, if the stock takes off, you will have
unlimited risk to the upside because you will have sold more options
than you bought.
Using Bubba Gump's stock (XYZ) at a price of $42, we can create a
ratio spread using in-the-money options.
Strike Price
Put Price
$30
$35
$40
15.50
10.60
5.75
In this case, you might buy one of the 30 calls at 15.50 and sell three
40 calls at 5.75.
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Short 3 40 calls @ 5.75: ($1725)
Long 1 30 call @ 15.50: $1550
You would receive a $175 credit for putting on the trade. If the stock
dropped below 30, you would keep the $175. However, the real money
would be made if the stock stayed right around $40. Here, the short 40
calls would expire worthless and the long 30 call would be worth $10.
The 30 call, combined with the initial $175 credit would bring the net
profit up to $1,225.
A big move to the upside in this case would spell trouble. The upside
breakeven for this trade would be $ 45.90. At this price, you'd have to
buy the short 40 calls for 17.60 (5.90 x 3). At the same time, you'd sell
the long 30 call for 15.90. The $175 debit from this trade would be
exactly offset by the $175 credit you received for putting on the trade
(not including commissions.)
above 45.90; your potential loss would be unlimited.
Value at Expiration
Strike Price
$25
$30
$35
$40
$45
$50
$55
$60
Profit (Loss)
$225
$225
$725
$1,225
$225
($775)
($1,775)
($2,775)
Calculating the Breakeven
The easiest way to calculate the downside breakeven is by using the
following formula:
[# Of short calls x (short strike + short call price) - # of
long calls x (long strike + long put price)]
(# Of short calls - # of long calls)
Using the data for this example, the breakeven calculation looks like
this:
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[3 x (40 + 5.75) - 1 x (30 + 15.50)] / (3-1)
Simplified, the equation becomes:
(137.25 - 45.50) / 2 or 45.90
Thus, the downside breakeven is 45.90 or 45.90.
Calendar
Spreads
Calendar spreads are also known as time or
horizontal spreads because they involve options
with different expiration months.
Example
Sell Near Term Position
Buy Far Term Position
Increase in Volatility
Time Erosion
Hurts position
Helps position
Calendar spreads are also known as time or horizontal spreads
because they involve options with different expiration months. In this
case, "horizontal" refers to the fact that option months were originally
listed on the board at the exchange from left to right. At the same time,
strike prices were listed from top to bottom. For this reason, options
with different strike prices and the same expiration are often referred to
as vertical spreads.
In simplest terms, a long calendar spread involves buying an option
with a longer expiration and selling an option with the same strike price
and a shorter expiration. For example, imagine that Bubba Gump's
(XYZ) is trading for $45 per share. To initiate a calendar spread, you
might sell the Bubba Gump June 45 calls and buy the July 45 calls.
XYZ 45 Calls
Time to Expiration
June
4.50
2 months
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July
6.50
3 months
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Spread Value: $2 (6.50 - 4.50)
Like most long positions, there is a cost to put on this trade. In this
case, the cost is $2. For the time spread to work, the June option must
lose its time premium faster than the July option. If the stock price
remains relatively stable as the June expiration approaches, the value
of the spread should increase. With only one month remaining before
the June expiration, the option prices might look like this.
XYZ 45 Calls
Time to Expiration
June
1.50
1 months
July
4.50
2 months
Spread Value: $3 (4.50 - 1.50)
In this case, the position could be closed for a one-point profit by
selling the July calls and buying back the June calls.
For long calendar spreads to work, the underlying stock price must
remain relatively stable. Any swings in either direction will negatively
impact the time value of both options causing the spread to lose value.
Short Calendar Spreads
Example
Buy Near Term Position
Sell Far Term Position
Increase in Volatility
Time Erosion
Hurts position
Helps position
A short calendar spread involves selling an option with a longer
expiration and buying an option with the same strike price and a
shorter expiration. For example, imagine that Bubba Gump's (XYZ)
was trading for $45 per share. To initiate a short calendar spread, you
might buy the Bubba Gump June 45 calls and sell the July 45 calls.
XYZ 45 Calls
Time to Expiration
June
4.50
2 months
Spread Value: $2 (6.50 - 4.50)
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July
6.50
3 months
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Like all short positions, you receive a credit for putting on this trade. In
this case, you receive $2 ($200). For this spread to work, the stock
must move enough in either direction to cause both options to rapidly
lose their time value. For example, if the stock dropped to $25, the
spread might only be worth five cents.
XYZ 45 Calls
Time to Expiration
June
0.05
1 months
July
0.10
2 months
Spread Value: $0.05 (0.10 - 0.50)
In this case, you could close the position by buying the spread for .5
and earning a 1.95 profit less commission. On the other hand, if the
stock climbed to $65, the spread value might still decrease, as time
value is often less for in-the-money options.
XYZ 45 Calls
Time to Expiration
June
21.50
1 months
July
22.25
2 months
Spread Value: $0.75 (22.25 - 21.50)
In this case, you could buy the spread for .75 to close out your position
at a 1.25-point profit ($2 - .75) less commission. For short calendar
spreads to work, the underlying stock price must make a significant
move in either direction. Otherwise, lack of market movement will
cause the spread to become unprofitable if the option with the earlier
expiration loses time value at a faster rate than the other option.
“We must always change, renew, rejuvenate ourselves; otherwise
we harden”
Goethe (1749-1832)
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The
Collar
For bullish investors who want a nice low
risk, limited return strategy to use in
conjunction with a long stock position, collars
are a great alternative.
Example
Increase in Volatility
Time Erosion
Little impact
Hurts position
Buy Stock
Sell Call
Buy Put
Protecting a Long Stock Position
When the stock position is long, combining covered calls creates the
collar and protective puts. From a profitability standpoint, the collar
behaves just like a bull spread. The upside potential is limited beyond
the strike price of the short call while the downside is protected by the
long put.
The position might look like this:
Long: Buy 100 shares of stock @ $50: $5,000
Short: Sell one 60 call @3: ($300)
Long: Buy one 40 put @ 2.50: $250
Total Cost: $4,950
Between 40 and 60, the long stock behaves the same as any
long stock position--it gains when the stock goes up and it
loses when the stock drops. However, the maximum profit is
achieved when the stock is at $60. Above 60, the profit on the
stock is exactly offset by the loss on the call. On the downside,
the maximum loss occurs with the stock at or below $40.
There, the profit from the put offsets the loss from the stock.
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Value At Expiration
Stock Price Profit (Loss) Return on Investment**
$35
(950)
(19%)
$40
(950)
(19%)
$45
(450)
(9%)
$50
50
1%
$55
550
11%
$60
1050
21%
$65
1050
21%
*The profit/loss above does not factor in commissions, interest or tax
considerations.
Now let's see how the same principle can be used to protect a short
stock position.
Protecting a Short Stock Position
Example
Sell Stock
Buy Call
Sell Put
Increase in Volatility
Time Erosion
Helps position
Hurts position
To create a bear fence, traders buy out-of-the-money calls and sell
out-of-the-money puts. When these options are combined with a short
stock position, the new position behaves just like a bear spread.
The position might look like this:
Short: Sell 100 shares of stock @ $50
Long: Buy one 60 call @ 3
Short: Sell one 40 put @ 2.50
Like most bearish positions, this fence makes money when the
stock price drops. However, the profit potential as the stock
price moves down is limited beyond the strike price of the
short put while the upside loss is limited by the long call.
In this case, the maximum profit is achieved when the stock is
at $40. Below 40, the profit on the short stock is exactly offset
by the loss on the short put. Although this might seem
confusing, just remember that as the stock price drops, the
short stock makes money the same way a long put would.
However, in this case, the put is a short put. As a result, the
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short put loses money as the stock drops and exactly offsets
whatever profit the short stock would realize below $40.
If this is still confusing, the adjacent chart may make it more
understandable. Below 40, the pink line, which represents the
short put, loses value at exactly the same rate that the blue
line (short stock) increases in value. The yellow line, which
represents the long 60 call, has no impact on the shape of the
curve below $60 because it is worthless at expiration. For this
reason, the only impact the call has on the combined position
is to lower the overall profitability of the position by $300 (the
cost of the call). Thus, the combined position is represented by
the green line that flattens at a maximum profit of $950 at a
stock
price
of
$40
or
below
Without the call, the position would have a maximum profit of
$1,250 on the downside. However, it would also have
unlimited risk on the upside. With the call as protection if the
stock rises unexpectedly, the maximum loss on the upside is
limited to $1,050. This loss would occur with the stock at or
above $60. Above that point, the profit from the long call
(yellow line) exactly offsets the loss from the stock (blue line).
Again, the combined position is represented by the green line,
which flattens at a maximum loss of $1,050.
Value At Expiration
Stock Price
$35
$40
$45
$50
$55
$60
$65
Profit (Loss)
950
950
450
(50)
(550)
(1050)
(1050)
*The profit/loss above does not factor in commissions, interest or tax
considerations.
“Know your opportunity”
Pitticus (ca. 650-570 BC)
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Chapter twenty-seven
Portfolio Repair Strategies
Now that we have explained the various option strategies to you over
the previous chapters you are now ready to understand the powerful
repair strategies that we teach at TICN
(The Investment Club Network) www.ticn.com
We are going to take 3 (A, B, C) examples of shares that have
dropped significantly in the past year and show you the reader how to
recover your position much quicker than the normal buy, hold and
hope strategy that must people employ. (And we all know what hope
rhymes with)
These are only examples of potential strategies and are not to be
taken as advice as we in The Investment Club Network specifically
educate our members in, fundamental analysis, technical analysis and
strategies and we do not advise our members.
A. If you were unfortunate enough to invest in a well-known
pharmaceutical company that was trading at a peak of $30 per share
in February of 2005. It then dropped as low as $3 per share in April
2005.
So if you bought 1,000 shares at $30 per share your $30,000
investment went as low as $3,000.
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In this chapter we will show you how:
1. You could have repaired your position at the time of the fall
2. How you can repair your position now.
Repair Strategy in April 2005
Let say you bought 1,000 shares at $30 = $30,000
Step 1. Buy same amount of shares again at $3 x 1,000 = $3,000
Average cost of 2,000 shares = $16.5 per share ($33,000 / 2,000)
The shares are now worth $6,000 and you must recover the $27,000
loss (33,000 – 6,000)
Step 2. Buy 20 contracts of the Jan ’06 $2.50 Call Option @ 1.75 = $3,500
Step 3. Sell 40 contracts of the Jan ’06 $5 Call Option @ $0.90 = +
$3,600
CREDIT = $100
Notice that this is a credit trade in that the $100 credit covers all your
costs
If price moves up to $5 then the increase in share value is $4,000
and then the option position value increases in dollar value by $5,000
therefore a $2 increase in the underlying share value yields $9,000.
Where as the buy and hope model only yields $2,000 for a $2 increase
in the share price.
Repair Strategy in August 2005
Let say you bought 1,000 shares at $30 = $30,000
Share price is now $8 so you are still down $22,000
Step 1. Buy same amount of shares again at $8 x 1,000 = $8,000
Average cost of 2,000 shares = $19 per share ($38,000 / 2,000)
The shares are now worth $16,000 and you must recover the $22,000
loss (38,000 – 16,000)
Step 2. Buy 20 contracts of the Jan ’06 $7.50 Call Option @ 1.95 = $3,900
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Step 3. Sell 40 contracts of the Jan ’06 $10 Call Option @ $1.00 = +
$4,000
CREDIT = $100
Notice that this is a credit trade in that the $100 credit covers all your
costs
If price moves up to $10 then the increase in share value is $4,000
and then the option position value increases in dollar value by $5,000
therefore a $2 increase in the underlying share value yields $9,000.
Where as the buy and hope model only yields $2,000 for a $2 increase
in the share price.
Example B. If you were unfortunate enough to invest in a well known
insurance company that was trading at a peak of $50 per share in
October of 2004. It then dropped as low as $20 per share in Oct 2004.
So if you bought 1,000 shares at $50 per share your $50,000
investment went as low as $20,000.
Repair Strategy in August 2005
Let say you bought 1,000 shares at $50 = $50,000
Share price is now $27.50 so you are still down $22,500
Step 1. Buy same amount of shares again at $27.50 x 1,000 = $27,500
Average cost of 2,000 shares = $38.75 per share ($77,500 / 2,000)
The shares are now worth $55,000 and you must recover the $22,500
loss (77,500 – 55,000)
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Step 2. Buy 20 contracts of the Jan ’07 $25 Call Option @ $5.4 = $10,800
Step 3. Sell 40 contracts of the Jan ’07 $30 Call Option @ $2.85 = +
$11,400
CREDIT = $600
Notice that this is a credit trade in that the $600 credit covers all your
costs
If price moves up to $30 then the increase in share value is $5,000
and then the option position value increases in dollar value by $10,000
therefore a $2.5 increase in the underlying share value yields $15,000.
Where as the buy and hope model only yields $2,500 for a $2.5
increase in the share price.
Example C. If you were unfortunate enough to invest in a well known
pharmaceutical company that was trading at a peak of $50 per share
in June 2004. It then dropped as low as $25 per share in Oct 2004.
So if you bought 1,000 shares at $50 per share your $50,000
investment went as low as $25,000.
Repair Strategy in August 2005
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Let say you bought 1,000 shares at $50 = $50,000
Share price is now $27.50 so you are still down $22,500
Step 1. Buy same amount of shares again at $27.50 x 1,000 = $27,500
Average cost of 2,000 shares = $38.75 per share ($77,500 / 2,000)
The shares are now worth $55,000 and you must recover the $22,500
loss (77,500 – 55,000)
Step 2. Buy 20 contracts of the Apr ’06 $27.50 Call Option @ $2.30 = $4,600
Step 3. Sell 40 contracts of the Apr ‘06 $30 Call Option @ $1.25 = +
$5,000
CREDIT = $400
Notice that this is a credit trade in that the $400 credit covers all your
costs
If price moves up to $30 then the increase in share value is $5,000
and then the option position value increases in dollar value by $5,000
therefore a $2.5 increase in the underlying share value yields $10,000.
Where as the buy and hope model only yields $2,500 for a $2.5
increase in the share price.
All the above strategies are credit trades and there is no harm done if
the share continues to fall as the trade has no net cost and you do not
have to buy any more shares to employ this strategy.
In the next chapter we will show you how you could:
Have protected yourself and profited from the fall in the share price.
How you can protect yourself from any share price fall in the future.
For more information go to www.ticn.com or Free phone
1 800 367 693
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Chapter Twenty-eight
How you can protect your positions now and
in the future.
In last chapter we explained Portfolio Repair Strategies to help you
quickly recover from a dramatic fall from the value of your equity
portfolio, OWEN O’MALLEY, the CEO of The Investment Club
Network, demonstrates how you can pro-actively protect yourself from
dramatic falls in the future. Not only will you be protected you will many
times profit from a fall in the value of your stock.
We are going to take three examples of shares (let’s call them A, B
and C) that have dropped significantly in the past year, and show you
how you could have protected yourself before the fall and how you can
now protect yourself even if you are still in a stock that has fallen
dramatically and may fall some more.
Note that these are only examples of potential strategies and are not to
be taken as advice. The Investment Club Network educates members
in fundamental analysis, technical analysis and strategies, rather than
offering direct financial advice.
If you were unfortunate enough to invest in a well-known
pharmaceutical company that was trading at a peak of $30 per share
in February of 2005, you will know that it then dropped as low as $3
per share in April 2005. So if you bought 1,000 shares at $30 per
share your $30,000 investment went as low as $3,000.
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In this chapter we will show you how:
1.You could have protected your position before the fall
and then actual profit from the fall.
2.How you can protect your positions now and in the
future.
Protection Strategy in February 2005
Let say you bought 1,000 shares at $30 = $30,000.
Step 1. Now you bought 10 contracts of the March $30 put option $0.5
x 1,000 = $500.
This is like insurance on your stock and what you have bought is the
right (but not the obligation) to sell the stock at a guaranteed price of
$30 and receive $30,000 even though the stock is priced at $3.
Step 2. Exercise your option to sell the stock at $30 and receive
£30,000 in your account.
So now all you have lost is your $500 insurance cost and you have
preserved $29,500 capital in your equity account.
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Note
You would have to had call your broker to exercise this trade and you
rd
had until the close of market on the 3 Friday of March to exercise
your option to receive $30,000 back into your account.
Protection Strategy in October 2005
Let say you happen to be unfortunate enough not to have protected
your position before the fall and you are still in the stock today at $9. If
there is some uncertain earnings announcement coming up and you
are nervous about the fact that the stock could fall back down to $3
where it fell to before then here is how you could protect your position
now:
Step 1.
Buy 10 contracts of the October 2005 $10 Put Option @ $1.20 x 1,000
= $1,200.
If the earnings announcement was bad news and the stock fell back to
$3 you can:
Step 2.
Exercise your option to sell your shares at $10 and receive $10,000
back into your account.
Your insurance will have only cost you $200 instead of a $6,000 loss if
the share falls from $9 to $3 on the announcement of the bad news.
Again you have to call your broker to exercise the option and you have
rd
until 3 Friday of October 2005 to exercise the option.
Example B. Now, say you were unfortunate enough to invest in a wellknown insurance company that was trading at a peak of $50 per share
in October of 2004. The price of these shares dropped as low as
$22.50 per share in October 2004. So if you bought 1,000 shares at
$50 per share your $50,000 investment went as low as $22,500.
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Protection Strategy in October 2004
Let say you bought 1,000 shares at $50 = $50,000 in October 2004.
Step 1. Now you buy 10 contracts of the October $50 put option $0.75
x 1,000 = $750.
This is like insurance on your stock and you bought the right (but not
the obligation) to sell the stock at a price of $50 and receive $50,000
even though the stock is priced at $22.5.
Step 2. Exercise your option to sell the stock at $50 and receive
£50,000 in your account.
So now all you have lost is your $500 insurance cost and you have
preserved $49,250 capital in your equity account.
Protection Strategy in October 2005
Let say you happen to be unfortunate enough not to have protected
your position before the fall and you are still in the stock today at
$27.50. If there is some uncertain earnings announcement coming up
and you are nervous about the fact that the stock could fall back down
to $22.50 where it fell to before then here is how you can protect your
position now:
Step 1.Buy 10 contracts of the October 2005 $27.50 Put Option @
$0.60 x 1,000 = $600.
Step 2.Exercise the option to sell the shares at $27.5 and receive
$27,500 into your account.
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Your insurance will have only cost you $600 instead of a $5,000 loss if
rd
the share falls from $27.50 to $22.50 after bad news (you have until 3
Friday of Oct to exercise the option).
Example C. Finally, if you were unfortunate enough to invest in a wellknown pharmaceutical company that was trading at a peak of $50 per
share in June 2004, you will be aware that the price dropped as low as
$25 per share in October 2004. So if you bought 1,000 shares at $50
per share your $50,000 investment went as low as $25,000.
Protection Strategy in September 2004
Let say you bought 1,000 shares at $50 = $50,000 in September 2004.
Step 1. Now you buy 10 contracts of the October $50 put option $0.75
x 1,000 = $750.
This is like insurance on your stock and you bought the right (but not
the obligation) to sell the stock at a price of $50 and receive $50,000
even though the stock is priced at $25.
Step 2. Exercise your option to sell the stock at $50 and receive
£50,000 in your account.
So now all you have lost is your $500 insurance cost and you have
preserved $49,250 capital in your equity account.
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Protection Strategy in October 2005
Let say you happen to be unfortunate enough not to have protected
your position before the fall and you are still in the stock today at
$27.50. If there is some uncertain earnings announcement coming up
and you are nervous about the fact that the stock could fall back down
to $25 where it fell to before then here is how you can protect your
position now:
Step 1.Buy 10 contracts of the October 2005 $27.50 Put Option @
$0.60 x 1,000 = $600.
Step 2.Exercise the option to sell the shares at $27.5 and receive
$27,500 into your account.
Your insurance will have only cost you $600 instead of a $2,500 loss if
rd
the share falls from $27.50 to $25 after bad news (you have until 3
Friday of Oct to exercise the option).
In the next chapter we will show you how you could have made a
profit while your shares were falling and how you can now protect your
portfolio position now against any future drop in share value.
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Chapter twenty-nine
Making a profit while the share falls
In the last chapter we explained to you how to repair your equity
positions if you experience a sudden drop in the value of your portfolio.
Now that we will explain to you how to pro-actively protect your
positions and even profit from a sudden fall in the value of your shares.
We will show you how to use some of the various put option strategies
that were explained to you over the previous articles.
You are now ready to understand the powerful protection strategies
that we teach at TICN
(The Investment Club Network) www.ticn.com
In this chapter we will show you how:
1. How you could have made a profit while your shares were
falling.
2. How you can now protect your portfolio position now against
any future drop in share value.
These are only examples of potential strategies and are not to be
taken as advice as we in The Investment Club Network specifically
educate our members in, fundamental analysis, technical analysis and
strategies and we do not advise our members.
We are going to take 3 (A,B,C) examples of shares that have dropped
significantly in the past year and show you the reader how you could
have profited from the fall of the shares and how to protect your
portfolio positions from now on.
A. If you were unfortunate enough to invest in a well-known
pharmaceutical company that was trading at a peak of $30 per share
in February of 2005. It then dropped as low as $3 per share in April
2005.
So if you bought 1,000 shares at $30 per share your $30,000
investment went as low as $3,000.
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Protection Strategy in February 2005
Let say you bought 1,000 shares at $30 = $30,000
Now it would then be time to insure your shares against a fall which be
considered as a form of insurance so:
Step 1. Sell 10 contracts of the Feb $30 Call option for $1 and receive
$1,000
Step 2. Buy 10 contracts of the May $30 put option for $1 and spend
$1,000
This is known as a cashless collar in that the trade costs little or
nothing to place.
This bought you the right to put the shares to the market and receive
$30 per share any time between then which was February 2005 and
rd
the 3 Friday of May 2005
So when the shares fell all the way to $3 per share in April 2005 you
could sell the shares for $30 and put $30,000 cash back into you
account.
So even if you did not complete Step 1. above the trade would cost
$1,000 instead of $27,000.
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Repair Strategy in August 2005
Let say you bought 1,000 shares at $30 = $30,000
Share price is now $8 so you are still down $22,000
Step 1. Buy same amount of shares again at $8 x 1,000 = $8,000
Average cost of 2,000 shares = $19 per share ($38,000 / 2,000)
The shares are now worth $16,000 and you must recover the $22,000
loss (38,000 – 16,000)
Step 2. Buy 20 contracts of the Jan ’06 $7.50 Call Option @ 1.95 = $3,900
Step 3. Sell 40 contracts of the Jan ’06 $10 Call Option @ $1.00 = +
$4,000
CREDIT = $100
Notice that this is a credit trade in that the $100 credit covers all your
costs
If price moves up to $10 then the increase in share value is $4,000
and then the option position value increases in dollar value by $5,000
therefore a $2 increase in the underlying share value yields $9,000.
Where as the buy and hope model only yields $2,000 for a $2 increase
in the share price.
Example B. If you were unfortunate enough to invest in a well known
insurance company that was trading at a peak of $50 per share in
October of 2004. It then dropped as low as $20 per share in Oct 2004.
So if you bought 1,000 shares at $50 per share your $50,000
investment went as low as $20,000.
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Repair Strategy in August 2005
Let say you bought 1,000 shares at $50 = $50,000
Share price is now $27.50 so you are still down $22,500
Step 1. Buy same amount of shares again at $27.50 x 1,000 = $27,500
Average cost of 2,000 shares = $38.75 per share ($77,500 / 2,000)
The shares are now worth $55,000 and you must recover the $22,500
loss (77,500 – 55,000)
Step 2. Buy 20 contracts of the Jan ’07 $25 Call Option @ $5.4 = $10,800
Step 3. Sell 40 contracts of the Jan ’07 $30 Call Option @ $2.85 = +
$11,400
CREDIT = $600
Notice that this is a credit trade in that the $600 credit covers all your
costs
If price moves up to $30 then the increase in share value is $5,000
and then the option position value increases in dollar value by $10,000
therefore a $2.5 increase in the underlying share value yields $15,000.
Where as the buy and hope model only yields $2,500 for a $2.5
increase in the share price.
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Example C. If you were unfortunate enough to invest in a well known
pharmaceutical company that was trading at a peak of $50 per share
in June 2004. It then dropped as low as $25 per share in Oct 2004.
So if you bought 1,000 shares at $50 per share your $50,000
investment went as low as $25,000.
Repair Strategy in August 2005
Let say you bought 1,000 shares at $50 = $50,000
Share price is now $27.50 so you are still down $22,500
Step 1. Buy same amount of shares again at $27.50 x 1,000 = $27,500
Average cost of 2,000 shares = $38.75 per share ($77,500 / 2,000)
The shares are now worth $55,000 and you must recover the $22,500
loss (77,500 – 55,000)
Step 2. Buy 20 contracts of the Apr ’06 $27.50 Call Option @ $2.30 = $4,600
Step 3. Sell 40 contracts of the Apr ‘06 $30 Call Option @ $1.25 = +
$5,000
CREDIT = $400
Notice that this is a credit trade in that the $400 credit covers all your
costs
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If price moves up to $30 then the increase in share value is $5,000
and then the option position value increases in dollar value by $5,000
therefore a $2.5 increase in the underlying share value yields $10,000.
Where as the buy and hope model only yields $2,500 for a $2.5
increase in the share price.
All the above strategies are credit trades and there is no harm done if
the share continues to fall as the trade has no net cost and you do not
have to buy any more shares to employ this strategy.
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Chapter Thirty
The Elite Investors Program
At TICN our learning philosophy is driven by three distinct aims
Making it SIMPLE
One of the core values of TICN is the commitment to making investment
education simple, fun, and easily accessible to anyone. Knowledge in itself
has little value, unless it is understood well and used effectively. At TICN we
are constantly on the lookout for new and better ways to learn, retain and
reuse our knowledge. We use the latest technologies, products and
solutions wherever possible to simplify the process of learning and to allow
more people and clubs to benefit from our education.
Making it REAL
Our educational programs are designed to bridge the gap between theory and
the real world through extensive use of real-life scenarios and actual
examples. Well-respected professionals and experts with years of real world
experience in the field teach all of our educational offerings. Our curriculum is
"Designed by Investors, for Investors" to ensure that we deliver the right
content at the right levels to the right audience. Our philosophy of "Making it
Real" for the customer means the experience you get at our training is as
close as you can get to the real thing.
Making it HAPPEN
At TICN we aim to go over and beyond the boundaries of delivering "pure
theory" training to our members. Our goal is to really empower our members
to be successful, smart, confidant and thinking investors. Investing is a
serious business and our philosophy of "Making it Happen" means we
aim to provide our members with a comprehensive spectrum of tools,
products and services that will enable any investor to get started quickly and
easily, and to be ultimately successful in their investments.
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Who's Steering Your Stock Market Investments?
Why Not YOU?
Making Money with Careful Planning In the stock
market.
The MMCP, as it has come to be known, has now been delivered to over 8,000
students in 18 countries, it is acknowledged as an excellent education to on-line
equity and options trading, using state-of-the-art internet technology together
with user-friendly broker software to bring the benefits of investing and trading to
individuals and clubs around the world at keenly affordable prices. This intensive
two-and-a-half day course gives students its excellent practical grounding in
evaluating and selecting companies, understanding share price charts and
technical analysis together with the fundamentals of trading options. Students
also learn how to open and operate on-line trading accounts and simulate trading
prior to the real thing. This is the FOUNDATION to TICNs Stock Market Investing
Education.
WEALTH Creation Through EDUCATION
Online Trading
Doing your own trades direct with the markets is both simple and very cost
effective. Keeping commissions and charges to a minimum by doing your
trading on your computer is the very latest in personally investing. Letting
your online trading platform do the work 24/7 is now at your fingertips with
many excellent and valuable built-in features constantly monitoring your
portfolio.
Training Tomorrows Investors TODAY
“When a man does not know what harbour he is sailing for, no
wind is a right wind”
Senaca (ca. 4-65 BC)
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Graphs and Charts
Technical analysis of share movements is vital to our decisions. Graphs and charts
and learning how to utilize all the signals and indicators available on your charting
package is like mapping the most likely future of a share. There are many powerful
indicators on good charting programs and being able to follow these adds
significant power to your decisions. In this area we can also build filters which
will find shares performing to our requirements - this saves us many hours of
searching.
The Choices with OPTIONS.
CALL Options
An ongoing income from your shares portfolio can be generated using
covered CALL writing. Learning the other strategies we can use to capitalize on
a consistent income can be very profitable. Buying options can also be very
profitable but is extremely risky for the uneducated - in this module we
cover in detail the positives and the negatives of option trading.
PUT Options
The markets and shares go down as well as up. PUT options allow us to
trade the downside as well as protecting our positions. Trading PUTs is the
opposite of trading CALLs where we want the share price to fail. These are
a great way of insuring our long positions also -just in case!!
LEAP Options
LEAPS are long-term options, which give us cheaper positions with huge
LEVERAGE. We can accumulate a portfolio with equal potential as if we owned
the share but with a lot less money, while being able to leverage the returns
significantly. LEAPs often become the favoured way of trading for many
investors.
Spread Trading
Generating profits with no outlay!!! A very lucrative strategy, in any type of market.
Once you have become familiar with the trading of OPTIONS, many new strategies
become available to you as an investor. One of the most lucrative is SPREAD
trading. The outlay in monetary terms is zero, and the risk is minimalised
significantly. This final module in this series covers in detail how you the investor
source, devise and execute these trades.
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Take your training to the next level with TICN's Japanese Candlesticks
Trading Seminars.
"Technically Japanese" Candlestick Trading
The candlestick is the foundation for all images, sentiment and interpretations of
candlestick charting. The basic candlestick can take on many forms. It is
essential to learn what an individual candlestick means. In the TICN "Technically
Japanese" Candlesticks Seminar our presenters teach an in-dept course on using
eastern Japanese candle sticks with western technicals. Here you learn the secrets
to successful utilization of one of the most POWERFUL trading tools in any
Investors Education. It doesn't matter if you are experienced or new at
investing or a sophisticated trader, you can learn new Japanese Candlestick trading
techniques to dramatically improve your investment returns. These signals provide
powerful insights into the direction of a share trend.
If you can see, you can learn the candlestick method.
Japanese Candlesticks is one of the MOST POWERFUL Trading Tools
Available.
On Completion
On completion of this series of the12 stock market investing education modules you
will have both the knowledge and the experience to becoming an accomplished
shares trader. Combine this with the experience from your investment club as well as
the backup, support and service of the TICN company and you are now in the
TOP 1%of stock market investors.
“Why is it we define ourselves and what we can do with our
lives only by what we are currently doing, or by what we’ve
done in the past”?
Joan Lunden (b. 1950)
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For any information regarding Investment clubs in your area or
Investment training Modules
Simply contact
Lee Brennan
TICN London
0208 864 8540
07795 411 417
lee.brennan@ticn.com
For more information go to www.ticn.com
Contact us on free phone 1 800 367 693
“Adversity is the midwife of genius”
Napoleon (1769-1821)
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What the press are saying about TICN
"DO YOUR HOMEWORK BEFORE YOU INVEST"
...The Investment Club Network (TICN) is an organisation that helps
members who are new to stock market investment...
The Sunday Business Post, May 28th 2000.
"IRISH CAN ENJOY FUN OF THE MARKET"
.. Clubs break down myths for those not used buying shares, allowing
them
to dip in before going alone ...The Investment Club Network in Ireland ....
Is on track to have 100 (clubs) by the end of the year....
The Sunday Times, October 22nd 2000.
"DONEGAL BASED COMPANY EXPERIENCES RAPID GROWTH"
...In one short year they have initiated 100 clubs and grown by 2,000
members and have established 25 clubs in Donegal.... The club deals
direct
with the stock market online via an internet connection and hence by
passing all the middlemen costs associated with the buying and
selling of shares with a conventional broker over the phone...
Letterkenny Leader, July 2001.
"MAKING MONEY IS CHILDS PLAY WITH THE PROPER KNOW - HOW"
/ found the (TICN) seminar to be full of useful information .... How to pick
stocks for your portfolio .... I would personally recommend it to
anyone who even has a passing interest in investing...
Limerick Leader, 14th December 2001.
"JOIN THE INVESTMENT CLUB"
777e investment group dealing exclusively in US shares, started in August
2001. So far its profit is 33 percent in a difficult market in which the S & P
500 is down over 11 percent in the same period....
TICN offers a supportive environment...
Sunday Business Post, February 24th 2002.
"INVESTMENT CLUB TRADING DIARY"
...total investment for period Aug 01 to Feb 02 inclusive equals
$9,000...value of the ..account stands at $12,000....
producing a profit of 33 per cent.. Sunday
Business Post, February 24th 2002.
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"INVESTMENT CLUBS DON'T FEAR THE BEAR"
....Since September 2001, the club has mado a profit of 18 per cent on
cumulative savings of just over $10,000. The majority of the members had
little or no stock market experience prior to joining TICN......
The Sunday Business Post, June 9th 2002.
"INVESTMENT CLUB BUCKS STOCK TREND"
.... While others are losing their shirts some people like those in Maura
Leahy's investment club, have managed an excellent return on shares...
38.4% on her money, in n year when the
unlucky ones lost their life's savings....
Irish Examiner, 13th September 2002.
"MY FAVOURITE SHARE" SEAN O'ROURKE
... They (TICN) provide training on how to identify strong companies and
investment opportunities; how to trade, read charts ...-all with the aim
of outperforming the stock market month on month .....
Sunday Independent, September 29th 2002.
"PLAY THE STOCK MARKET .... IN YOUR LIVINGROOM "
The Investment Club Network (TICN) has more than 150 separate Irish
investment clubs affiliated with it - there is at least one in every county.
The membership is diverse in age, gender of course, and profession .......
Irish Independent, 25th November 2002.
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Quotations from some of the TICN seminar
attendees
(MMCP is TICN's Making Money with Careful Planning
Seminar)
Declan O'Connor BA,MBA,MMII,IIE Tribal
Traders Investment Club, Galway
"The MMCP TICN Seminar proved to be very powerful in clarifying
all of my previous MBA and other financial lessons to date...
a very worthwhile experience." MMCP May, 2001.
CEO of Business Quality Assurance International.
Ian McKibbin B.Sc. Dip Ed., Tyrone Tycoon Investment Club,
Dungannon, Co. Tyrone.
"After completing the MMCP in April 2000 and paper trading in May I
commenced investing with $5,000 in June 2000 and by Dec 2000
I had turned my investment into $10,000 using the TICN
strategies as taught to me at the seminar." MMCP April, 2000.
Head of School of Mathematics, Laurel Hill Community College, Lisburn.
John Moylan, The Wise Guys Investment Club, Nenagh, Co.
Tipperary.
" / attended the TICN MMCP Investment Seminar and have made
more money in the Market in the last 5 months than I have in my
previous 5 years experience in the Market just applying what was
taught to me by TICN "
MMCP April, 2002 Qualified Financial Advisor, and CEO of Moylan
Financial Services.
Pat Lynch FCCA., MBA., The Rebel Investment Club, Cork.
In my first year trading with TICN strategies I made 62% using the
TICN
strategies and I expect to do better in the coming year due to the
advanced courses done with TICN. I can now make more on the
market than I ever could as a PAYE worker" MMCP Nov, 2001.
Certified Accountant / Managing Director of
Microtech Cleanroom Services, Cork.
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Sean O'Rourke, The Sporting Speculators Investment Club, Dublin
"They (TICN) provide training on how to identify strong companies
and investment opportunities; how to trade, read charts and cut
losses. They can teach you about financial concepts like covered
calls, leaps and in-the-money calls - all with the aim of
outperforming the stock market month on month. A few people
have done so well that they've been able to pack in their jobs to
trade for a living." MMCP Nov, 2000.
Sean O'Rourke is the presenter of the 'News at One' on RTE Radio
Sam Jennings, Erne Earners Investment Club, Enniskillen, Co.
Fermanagh
"/ began online investing with $2,000 dollars in July 2000 and within
6 months I had turned this into $4,400 representing a return on
investment of 110% in my first 6 months using the TICN strategies"
MMCP April, 2000.
Personal Success Coach.
Dolores Burke, Castlebar Classics Investment Club,
Castlebar, Co. Mayo.
"Within the first month of attending the MMCP TICN Seminar I had
covered the cost of the course in the profit from my first trade"
MMCP March, 2001.
Restaurant Owner.
Willie Carey FCAA., The Castle Warriors Investment Club, Limerick.
"/ would personally recommend The MMCP TICN Seminar to anyone
thathas even a passing interest in investing. I found the seminar to
be full ofuseful information and tips on how the stock market works
and how topick the correct stocks for your portfolio" MMCP Nov,
2001.
Chartered Accountant and Director of Ernst & Young, Limerick.
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The Investment Club
Network
www.ticn.com
Freephone
1800 367 693
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