Chart Formations
CHAPTER 8 Fortune Telling 101 131
Figure 8-6.
was reversing, only to see the entity move lower. They now have losing positions, and they would be happy to get out of the trade at breakeven or the old support price. These traders offset (sell in this case) their losing positions, causing the up- trend to stall and making the old support level a resistance level. It works from the other direction as well. A resistance level penetrated by an uptrending move be- comes a support level when the stock or other entity’s price retraces. It is easy to understand why a trader holding a losing position for a while gives up on his or her original analysis and is happy as a bull in a pasture full of heifers to get out whole.
Closely related to support and resistance formations are multiple tops and bot- toms. Take the double top as an example (see Figure 8-7). A market rallies, reaches an area of resistance, stalls, and begins to decline. After a short retracement, it ral- lies again, only to stall at the exact same resistance area. The chartist would call this a double top or “M” formation and consider it a sign of weakness. It would be a signal to buy puts. The risk, of course, is that a triple top could develop. The trader who shorted the double top would be whipsawed by the market. Whipsawing is
Figure 8-7.
Figure 8-8.
First, they are generally considered very reliable by professional chartists for cer- tain stocks and futures contracts. Furthermore, they foretell a major reversal in trend and can predict the length of the next move or the reversal.
A head-and-shoulders formation usually consists of the following four key phases:
1. Left shoulder 2. Head
3. Right shoulder 4. Neckline penetration
Prices often retrace and bounce off the neckline before heading toward the first price objective. This provides a second opportunity to short the stock or futures contract.
The first price objective is measured from the top of the head to the neckline and projected downward from the point at which the neck is broken. A second and even a third objective of the same distance can be projected, depending on the ve- locity of the market as it reaches the first objective. An inverted head-and- shoulders works in just the opposite way.
A formation I particularly find reliable is the rounded bottom (see Figure 8-10).
These are long-drawn-out formations that can take months to mature. They are
CHAPTER 8 Fortune Telling 101 133
what happens when you reverse your position, only to have the market turn against you. You lose twice, once on your original position and again on your reversal.
Multiple bottoms are the opposite of multiple tops (see Figure 8-8).
A more complex version of the multiple top or bottom is the head-and-shoulders and inverted head-and-shoulders formation (see Figure 8-9). These formations resemble the silhouette of a person and are very important for several reasons.
Figure 8-9.
often called “saucer” bottoms because of their shape. When a saucer bottom ma- tures, it signals a long-term uptrend. Remember back in the section of this chapter on fundamental analysis where I was describing the problem of determining, after a bottom was obviously in place, when to begin buying calls? If you bought too soon, the option would expire and you would have to roll over into the next option.
A fundamental trader with some knowledge of TA would see the bottom as a rounded bottom. And when the price turned up and penetrated the rounded bottom, it would be time to begin putting on a call position. That is one of the ways that TA and FA can work together.
The reason a long-term uptrend follows a rounded bottom is that while the rounded bottom is maturing, the price of the stock or commodity is relatively low.
It is at the bottom of its price range for a long time. While this is occurring, it is common for the company behind the stock to correct the problems that precipi- tated the decline or, in the case of a commodity, for new uses to be developed to increase demand. While corn was making a rounded bottom in 1986–87, new uses for it, as gasohol and corn sweeteners, were developed. When corn’s price finally began to rise, it had a stronger demand base, and a long-term bull move developed.
Also, at times of high inflation, a stock or commodity can look cheap after being in the cellar for a while.
There are hundreds of other bar chart patterns, such as triangles, boxes, key re- versal days, and so on, but I cannot cover them all. If you are serious about trading, you need to spend some time studying all the formations—so that you will at least know what other traders are likely to do.
At the start of this section, I said there are two and one-half schools of thought on the best way to predict price trends. The two obviously are FA and TA. The half is the combination of the two. FA has one serious flaw: it does not have a good mechanism to tell you when to cut a losing trade loose. If a stock is a good buy at $10 per share or corn at $2.50 per bushel, according to FA, both must be even better
Figure 8-10.
buys at $5 or $1.25 if the fundamentals are right, except for the fact that you have lost half your money. TA, on the other hand, has self-correcting mechanisms. For example, if you are trading an uptrend and the price declines, penetrating the trendline, this is a clear signal to immediately exit the trade.
Another positive of TA is that it gives you signals of when to enter trades, as well as when to exit them. The rounded bottom is a good example, the way support and resistance tell the trader when a stock is over- or underpriced works. The price point at which the neck of a head and shoulders is broken is another reliable indicator for action. Many traders use fundamental analysis for their overall direction and tech- nical analysis for timing. Together, they are stronger than either one alone.
This is where the art of trading blends with the science. As you will see as you get deeper into this book, trading is as much intuition as discipline and training.
Intuition translates as education reinforced with experience. Intuition, discipline, and training are like the three legs of a milking stool, which tips over if any one is missing or weak.
One last thought: I’ve used the word reliabilitymany times in this section re- garding the use of fundamental and technical tools and signals. Burn the terms re- liableand reliabilityinto your mind. The basic principle underlying all analysis, whether fundamental or technical, is degrees of reliability. Thousands and thou- sands of studies have been done to find the most reliable indicators for the pricing of stocks, futures, and options. As you might guess, nothing has been found to be 100 percent reliable. If any does turn up perfect, someone will break the bank and close all the markets down. That will end the financial world as we know it, and we will all go home sad. Don’t panic yet; I sure do not see it coming. Meanwhile, the operative words are “degrees of reliability,” not fail-safe systems.
CHAPTER 8 Fortune Telling 101 135
1. Analysis of the option, stock, or futures market (a) is simple and reliable.
(b) can only be done using fundamental analysis.
(c) can only be done using technical analysis.
(d) relies on human nature and its repetitious patterns.
2. Fundamental analysis uses the following to reach its conclusions.
(a) Price chart formations (b) Economic data (c) Rumors
(d) Econometric modeling
Quiz
3. Describing the markets as random means what?
(a) It is possible to analyze the market to predict price trends.
(b) There are some price patterns that are more important than others.
(c) Investors should be satisfied with index funds.
(d) It is possible to get an edge on the market.
4. What does EMH mean?
(a) Efficient market hypothesis.
(b) Extra money helps.
(c) The market knows more than any trader, and trying to beat it is foolhardy.
(d) The keys to trading success are energy, money, and hope.
5. The seven cornerstones of Warren Buffett’s successful investment philoso- phy are:
(a) Easy-to-understand businesses (b) Low debt levels
(c) Profitability and return on equity (d) Managerial expertise
(e) Intrinsic value, margin of safety, and valuation (f) Economic moats
(g) Free cash flow and owner’s earnings (h) All of the above
(i) None of the above
6. What does technical analysis have its roots in?
(a) Black magic
(b) People’s attempts to measure and quantify the world around them
(c) Attempting to find patterns where none exist (d) The work of Eugene Fama
7. A head-and-shoulder top forecasts (a) much higher markets.
(b) increased volatility.
(c) an opportunity to make some money buying puts.
(d) that it is time to buy calls.
8. A trendline on which of the following charts would be considered most reli- able?
(a) 5-minute (b) 5-day
(c) 5-week (d) 5-quarter (e) 5-year
9. Using technical analysis correctly helps you avoid which of the following?
(a) A major gain (b) A small gain (c) A major loss (d) A small loss 10. Which came first?
(a) Fundamental analysis (b) Technical analysis
CHAPTER 8 Fortune Telling 101 137
Answers
1. d; 2. b and d; 3. c; 4. a and c; 5. h; 6. b; 7. c; 8. e; 9. c; 10. a.
Just Trade It!
139
CHAPTER 9
Buying Calls Buying Puts Spreads Evaluations Profits Losses Breakeven
Can you become a scratch golfer by reading books, reading magazines, watching webcasts, visiting the Golfer’s Hall of Fame, or paying regular visits to a sports psychologist? Think about what it takes to become a professional golfer and pass Qualifying School. How many hours must one train and how many hundreds of practice and tournament rounds must a rookie play before winning his or her first pro tournament, not to mention a major?
Never forget that when you open a trading account and place your first order, you are matching your wits and experience against all the professional traders as
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well as all the amateurs trading that particular stock, futures contract, or option. It is somewhat like entering the U.S. Open. Anyone can enter; all you need to do is pay the fee. If you win locally, you move up to sectional and regional tournaments.
And up and up until you qualify. Along the fairways to the Open, you must beat the very best amateurs, the top club pros, and all the local and regional champions.
You are finally in the U.S. Open, after all that work and competition, and you are ranked dead last behind the big money winners who qualified by winning pro events. The odds makers give you a 1 in 1,000 chance of making the cut and 1 in 10,000 odds of winning the Open.
What does all this have to do with trading options? First, to learn how to trade, you have to trade, just as you must play golf to become a golfer. You won’t become a competent trader by reading books or attending classes. These are very impor- tant for providing you with an overview. They help you learn what has worked for others and the mechanics of trading, but this is only the beginning. Second, you must practice all the shots required to become a competent trader and work hard on handling the unusual, the unexpected, and the pressure. For practice rounds, I recommend that you make simulated trades, or paper trade, using one of the free computer programs available. The day you place your first trade, you will probably be as bad, and as nervous, a trader as you will ever be. So be careful on day one, rookie.
The market puts you in as many unplayable lies and sand traps and on as many lightning-fast greens as a round at Augusta National. And never underestimate the competition. You are doing battle with institutional money managers with giant staffs of MBAs handling billions of dollars; professional traders like Victor Niederhoffer, who is a Harvard grad with a Ph.D. in finance from the University of Chicago; hundreds of market makers and specialists; trading firms with unlimited computer power; and individual professionals like Warren Buffett or George Soros, not to mention amateurs in the tens of thousands. It is heady competition, and you must be prepared to take on all comers. If all this were not tough enough, the secu- rities industry does everything it can to rig the game in its favor. Never assume for a New York minute that you are playing on a level course.
Just for the record, some native talent and the right psychological disposition won’t hurt. Just like golf, once you learn the basic strokes, it becomes a mental game. I delve more into the mental aspects of trading later; for now, I will discuss some strategies that you may want to begin using. This is by no means an exhaus- tive discussion. It is only a brief overview of some basic strategies to give you a feel for the sport and a place to tee off on your first round.
As mentioned earlier, the most basic option strategies are buying calls and buy- ing puts. These strategies are good ones to begin trading because the reward can be substantial, while the risk is limited to the premium and transaction costs (com- missions and fees). The negative side is that the vast majority of long options expire