From the January 01, 2006 issue of Futures Magazine • Subscribe!

Tools for every trader’s toolbox

Most successful veteran traders agree that sound money management is more important than methodology when it comes to trading. In other words, a trading method cannot produce sustained profits without applying sound money management principles.

Nevertheless, many traders, especially those with little experience or those with experience and little success, keep searching for specific trading methods used by successful traders. And with good reason. While money management is the key to real trading success, you still need to start with a reliable approach to analyzing the markets.

Here are some important tools needed for a comprehensive approach to market analysis and trading. Remember, the primary trading tools are solid technical or fundamental analysis — or preferably both — but these tools can be helpful to have around for traders who are looking for ways to continue their education and sharpen their trading methodology.

SPOTTING THE TREND

No matter how many tools you have, you will find most success trading in the direction of the trend. One accurate definition of a trend might be that it’s something you know when you see it on a chart in hindsight. It is not always easy to recognize a trend in its formative stages. Identifying a trend early and then having the perseverance to stick with it as prices move up or down a trendline is critical for successful trading.

Where you place a trendline depends on your methodology — there really are no hard and fast rules. Like much of technical analysis, drawing trendlines is more art than science.

However, one reliable rule for the violation of trendlines is that prices must penetrate the trendline resistance or support level and then demonstrate follow-through strength or weakness during the next trading session (see “When it’s not broken...” below). However, if prices make a big push above or below a trendline, then that trendline is violated without needing follow-through confirmation.

COLLAPSE IN VOLATILITY

A collapse in market price volatility occurs when trading ranges (price bars) suddenly get smaller (bars can be daily, hourly or minute). There should be at least three smaller price bars in a row, but they do not necessarily need to get progressively smaller with each bar.

This collapse in volatility usually sets off a significantly bigger price move, either up or down. There generally is no relationship between the number of bars and the strength of the subsequent move. In other words, more smaller-price bars on the chart does not necessarily indicate a larger breakout.

There is no set number of bars that will set off the bigger price move. It could be three bars, or it could be 10 bars or more before the bigger price action is set off.

OUTSIDE DAYS

Outside days or bars for, say, hourly or weekly breakdowns, occur when the last price bar is bigger than the previous bar on the chart.

If the close (last trade of the bar’s time frame) is higher than the previous bar’s last trade, then that is considered a bullish “outside day” up move. A bearish outside day down move occurs when the close of the bar is lower than the previous bar’s close or last trade.

Subsequent price action is expected to move, generally, in the direction of that indicated by the outside day.

INSIDE DAYS Inside days occur when the most recent price bar range is smaller than that of the previous bar. The trading range is smaller and inside the previous bar’s trading range.

Inside days signal the market is taking a break after a busy period. Inside days also can be a sign a collapse in volatility may be setting up and that yet another bigger price move could be on the horizon.

After a big price bar and busy trading day, the next session is often an inside rest day.

KEY REVERSALS

Because they signal a potential market top or bottom, key reversals are important chart signals that occur less frequently than most others in this feature. A key reversal occurs when a new-for-the-move high or low occurs and then during that same day (or trading bar), the price sharply reverses direction to form an outside day up or down move. These are called bullish or bearish “engulfing patterns” on candlestick charts.

Some analysts call this one-bar pattern alone a key reversal. But for more significance, a key reversal must be confirmed by follow-through strength or weakness the next trading session (or trading bar). Follow through greatly helps eliminate false signals and makes a market prove itself after a bigger move.

EXHAUSTION TAILS

Exhaustion tails occur when either buying or selling apparently is exhausted after prices make a fresh high or low for that move and that creates a bigger price bar on the chart. Then prices reverse course to close at the other extreme of the bar’s earlier move. Thus, you get the bigger bar that creates a tail (or shadow in candlestick lingo).

These tails are important guideposts because they show price levels that traders do not want to pursue and become an important resistance or support level on the chart.

CLOSING PRICES

Most traders agree the most important price of the trading session is not the open, high or low but the closing or settlement price. This is true for markets with set opens and closes as opposed to 24-hour markets, though some forex traders rely on the old New York closing time (4 p.m. EST) as a technical input.

After an entire session of buyers and sellers doing business, the price at the close could be called the “right” value that the market decided on for that day. Some technicians don’t consider a breach above or below an important support resistance level a violation of a trendline unless it is maintained through a close.

Trading above or below these price points during the session, only to pull back before the close, doesn’t carry the same weight as a close beyond those levels.

Also, if a market closes near the session high or at the weekly high close, that’s a sign of market strength and suggests there will be at least some follow-through strength in the next trading session (or price bar). A close near the daily low or a weekly low close suggests market weakness and follow-through selling that could occur in the next trading session.

GAPS

Gaps on a chart appear when a price bar pushes well above or below the previous bar to produce an area where no trading occurs on the chart. The last bar’s low is higher than the previous bar’s high for a gap-higher move. The last bar’s high is lower than the previous bar’s low to form a gap-lower move.

As with closing prices, traders in 24-hour markets won’t be able to use gaps as a tool because gaps usually occur in markets that have a day session and react to some overnight or after-hours development.

Price gaps indicate a strong market move and many times serve as important support or resistance levels on a chart (see “Gap in time,” below). They have a number of names:

• Breakaway gap: occurs at the beginning of a move that reverses the previous market action.

• Measuring gap: occurs at about the 50% mark of a projected move.

• Exhaustion gap: occurs at the end of a move and suggests traders are making one last gasp to extend an existing trend.

Not all gaps have such messages, but they can be an effective tool if you rely on probabilities.

CONTRARY OPINION

One of the best methods to trade a market traditionally has been to jump on board when prices break out of a congestion or basing area and begin a new trend. It is well known that one of the most risky and least successful trading methods is trying to pick tops and bottoms in markets. So, let’s muddy the waters just a bit.

Contrary opinion goes counter the prevailing wisdom in the marketplace. This notion of going against the grain of popular market opinion is difficult, especially when there is a steady drumbeat of fundamental information that seems to corroborate the popular opinion but remember that many of the best traders are contrarians.

Consider this: A market is most bullish when the highest high on the chart is scored; it’s downhill for prices from there. A market is most bearish when the lowest low is reached. This suggests traders are most bullish at market tops and most bearish at market bottoms! Because there is no Holy Grail to trade markets and most traders lose money, you don’t want to join them and should possibly do some contrary thinking.

A trader should never be swayed by the opinion of the masses. You should develop a trading plan and stick with it throughout the trade. In other words, don’t be swayed or influenced by the opinions of others in the middle of a trade. Popular opinion many times is not the right opinion when it comes to market direction.

INTERMARKET ANALYSIS

Trading veterans know that markets are interdependent, with some markets more heavily influenced by certain markets than others.

These patterns may be hard to detect but can be found through a detailed study of charts and the help of technology.

Based on changes in the value of these comparisons from one trading session to the next, some software develop leading indicators that forecast whether a market will be choppy, maintain its trend or change trend direction.

Of course, you still have to use your other trading tools to place trades, but intermarket analysis adds another important tool to a trader’s toolbox and can augment an already good trading methodology.

All these tools can aid you in becoming a better trader. However, as stated earlier, the best methodology may be for naught without proper money management. The basics of good money management will be covered in future articles.

Jim Wyckoff is the editor of the Trends in Futures market analysis and trading advisory newsletter and is also a market analyst for www.tradingeducation.com. FM

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