Point And Figure Charting, Part Two

Point and Figure Charting

Part Two: Beyond The Basics

In Point and Figure Charting Part One we talked about the basic characteristics of point-and-figure charts: what they measure and how they're formed. We finished up with a discussion of trendline analysis, using bullish support and bearish resistance to help determine entry points. One of the nice things about those trends is that they're completely unambiguous . . . They're always at 45-degree angles!

But when you take it down to the most fundamental level, stock movement is driven by only one thing: differences in supply and demand. When buying outstrips selling (or vice versa), an equity's price changes.

This isn't always the case with a bar chart, where connecting various highs or lows in a trend can be an inexact science. Bar chart patterns often pose the same problem, because stocks rarely form textbook examples of head & shoulders, ascending wedges, and so on.

One of the advantages of point-and-figure patterns is that, like those 45-degree trendlines, there is no ambiguity. These patterns have set-in-stone definitions that don't depend on a trader's individual interpretation.

Point-and-figure chart patterns take the form of buy signals and sell signals. As we covered in Point And Figure Charting Part 1, this form of charting is used to give traders insight into key inflection points in the supply/demand relationship. A buy signal is formed when the current column of demand (X) exceeds a previous column of X. Our trusty example stock, ZZZ, should help to illustrate the point.

43     X  <- double-top
42 X   X
41 X O X
40 X O X
39 X O X

These three columns show that ZZZ had sufficient demand to move up to 42, then gave a three-box reversal with a pullback to 39. A fresh wave of buying then pushed the stock beyond its previous high, to 43. This formed a "double-top" buy signal. The move is seen as a bullish development because current demand exceeded prior demand. A "double- bottom" sell signal is the double-top's bearish counterpart, and is formed when supply (O) falls below a previous column of O.

To put it in terms that should be more familiar to bar chartists, these signals represent moves beyond support or resistance. The significance of those support/resistance levels increases with the number of previous columns. A rising stock that moves above two previous columns of X produces a "triple-top" buy signal. "Triple-bottoms" are formed when a stock moves below two previous O columns, as shown below:

42 O X
41 O X O X
40 O X O X O
39 O X O X O
38 O   O   O
37         O  <- triple-bottom

The two prior columns of O that bottomed out at 38 represented support. A breakdown through that level would be seen as a negative development. As you might imagine, triple-tops and triple-bottoms tend to be more reliable than double-tops and double-bottoms. Occasionally you'll even see quadruple tops or bottoms (X or O exceeds three previous columns). These indicate that a very solid support/resistance level has been broken.

Okay, enough with the hypothetical examples...Let's check out some real-world chart patterns.

Affymetrix (AFFX) - Point and Figure chart:

Another type of pattern - the bullish or bearish triangle - denotes a move out of consolidation. These signals aren't all that common, but they often produce explosive results. A triangle is formed by a tightening range (lower highs and higher lows) for at least 5 columns. The pattern is neutral until the stock breaks out of the range, at which point a bullish triangle buy signal or bearish triangle sell signal is created.

Duke Energy (DUK) - Point and Figure chart:

- - Bullish Percent

Point-and-figure analysis also provides a tool to gauge risk/reward: Bullish Percent. But while trendlines and chart patterns can be helpful for shorter-term traders, the Bullish Percent method is more valuable to those with a longer timeframe. Market sentiment is measured by charting the percentage of stocks giving a buy signal within a given index or sector. Any reading over 70 is considered "overbought," while a reading below 30 is viewed as "oversold.

The prior mentioned chart patterns are not used with Bullish Percent charts. Instead, sell signals are given when the indicator moves above 70, then reverses 6% (creating a column of "O"). Buy signals are given when the percentage reverses 6% -creating a column of "X" - after dropping below 30.

From a contrarian standpoint, very extreme readings are also viewed as a sign that the market is due for a reversal. A powerful example occurred following the 9/11 attacks, when the NASDAQ-100 Bullish Percent bottomed out at 2. Out of the 100 index components, only 2 stocks were on buy signals! However, the overwhelming negative sentiment was soon replaced with a bargain-hunting mentality, and the index rallied sharply in the following months.

Well, that about wraps up our introduction to the world of X's and O's. These articles should provide a good starting point for p-n-f analysis, yet they're by no means comprehensive. Traders looking for more information on the subject will find Thomas Dorsey's "Point and Figure Charting" an exellent guide. The book offers a thorough in-depth discussion and gives some interesting statistics on the rates of success for various patterns.

P-n-f charts are formed by alternating columns of "X" (rising price) and "O" (falling price), with the price axis showing the extent of the movement. For example, a stock that rose from 30.00 to 33.00 would form a column that looked like this:

35
34
33 X
32 X
31 X
30 X

This column would continue until the stock (we'll call it ZZZ) produced what's referred to as a "three-box reversal." Each "box" is a price unit. For stocks trading at 20-100, the box size is one dollar. Box size decreases to 0.50 intervals in the 5-15 range, and is bumped up to 2.00 for equities trading above 100. This difference is visible on the Intel chart, with the price axis shrinking to 50-cent divisions below 20.00.

These varying box sizes take into account the relative impact of a stock's movement, depending on its price; a 2-dollar move is a lot more significant for a stock trading at 12.00, compared to one that's trading at 43.00.

Let's return to our example. ZZZ is trading between 20 and 100, so it'll take a reversal of 3 boxes (3 dollars) to create a column of O's. Subtracting 3 from the column's high (33), we see that ZZZ will have to hit 30 in order to form a three-box reversal. But momentum is on the bulls' side. Shares only pull back to 31.75, then rise to a new high of 34.15. This adds another "X" to the column:

35
34 X
33 X
32 X
31 X
30 X

Finally, a more meaningful sell-off takes place as the stock falls from its relative high of 34.15. At this point it would take a trade at or below 31.00 to mint a three-box reversal (34 - 3 = 31). ZZZ falls to 31.02, then pauses. At this point there is still no reversal - the actual price level (31.00) has to be traded first. Finally, there's another round of selling and shares hit an intraday low of 30.93. The p-n-f chart now shows ZZZ trading in a column of O's:

35
34 X
33 X O
32 X O
31 X O
30 X

The stock would remain in a column O's until it gave a three-box reversal to the upside. For example, a decline to 25.70 would extend the column all the way down to 26. (But not 25 - it would take a tick at or below 25.00 to accomplish that). ZZZ would then have to turn around and move back to 29.00 (26 + 3 = 29) in order to create another column of "X."

Another point to keep in mind is that opening and closing price data is not used in p-n-f charting. What matters is the intraday high or low. If either of these extremes adds to a column or creates a three-box reversal, appropriate changes are made to the p-n-f chart. Any other movement is ignored. This goes a long way towards filtering out the price movements that don't have a major impact on the supply/demand relationship.

We can identify key turning points in that relationship by using trendlines, which are familiar to most bar chartists. These trends always form a 45-degree angle, and are denoted by "+" signs.

Adobe Systems (ADBE) - Point and Figure chart:

P-n-f trends are formed differently, but don't let that confuse you; approach them just like would with a conventional bar chart trend. As shown on the ADBE chart, strong reversals can take place when a downtrending stock encounters bullish support.

The same is true of an uptrending stock when it meets bearish resistance. Violations of those levels are also significant. The red arrow points out the recent breakdown below support, which is a negative sign for ADBE.

These are just one way to profit from point-and-figure analysis. In "Point and Figure Charting Part II: Profiting From Patterns" we'll delve deeper and discuss buy/sell signals (which indicate key turning points in the all-important battle between supply and demand), charting of indexes, and a useful technique to help manage risk.

Point And Figure Charting, Part One

Point and Figure Charting

Part I: The Basics

What exactly makes a stock move? You'll get a variety of answers, depending on who you ask. Investors who use fundamental analysis will point to changing business conditions or major news stories, while those with a more technical approach might focus on breaches of key trendlines or areas of support/resistance.

But when you take it down to the most fundamental level, stock movement is driven by only one thing: differences in supply and demand. When buying outstrips selling (or vice versa), an equity's price changes.

Point-and-figure charting is a tool that can help traders monitor significant changes in the supply/demand relationships, while filtering out the "noise" brought about by day-to-day price gyrations.

For those used to conventional bar charts, a point-and-figure chart looks more like a big game of tic-tac-toe than a typical graph of an equity's movement. And in addition to all those X's and O's, the "time" axis (or X-axis, on a bar chart) is missing completely.

Let's take a look at some of the main features of a "p-n-f" chart:

Intel (INTC) - Point and Figure chart:

This chart depicts INTC's movement from early-2002 through the first quarter of 2006. Even though there's no axis that measures time intervals, reference points show us what timeframe we're looking at. The lines extending from the "03" and "04" at the bottom denote the beginning of 2003 and 2004, while the red numbers in the various columns signify the month. Months are represented by the red numbers 1-9 (for January through September) and the capital letters A-C (for October through December).

The left-most red letter is "2", which shows up in the chart's second column. Looking below we see no year marker to the left of "03," meaning THAT column was formed in 2002. So this particular chart extends back to February 2002. There is no standard time interval for p-n-f charts - some might show activity dating back only 5-6 months, while others (like INTC) have a longer timeframe. In general, stocks that trade in wider price ranges tend to create more columns.

P-n-f charts are formed by alternating columns of "X" (rising price) and "O" (falling price), with the price axis showing the extent of the movement. For example, a stock that rose from 30.00 to 33.00 would form a column that looked like this:

35
34
33 X
32 X
31 X
30 X

This column would continue until the stock (we'll call it ZZZ) produced what's referred to as a "three-box reversal." Each "box" is a price unit. For stocks trading at 20-100, the box size is one dollar. Box size decreases to 0.50 intervals in the 5-15 range, and is bumped up to 2.00 for equities trading above 100. This difference is visible on the Intel chart, with the price axis shrinking to 50-cent divisions below 20.00.

These varying box sizes take into account the relative impact of a stock's movement, depending on its price; a 2-dollar move is a lot more significant for a stock trading at 12.00, compared to one that's trading at 43.00.

Let's return to our example. ZZZ is trading between 20 and 100, so it'll take a reversal of 3 boxes (3 dollars) to create a column of O's. Subtracting 3 from the column's high (33), we see that ZZZ will have to hit 30 in order to form a three-box reversal. But momentum is on the bulls' side. Shares only pull back to 31.75, then rise to a new high of 34.15. This adds another "X" to the column:

35
34 X
33 X
32 X
31 X
30 X

Finally, a more meaningful sell-off takes place as the stock falls from its relative high of 34.15. At this point it would take a trade at or below 31.00 to mint a three-box reversal (34 - 3 = 31). ZZZ falls to 31.02, then pauses. At this point there is still no reversal - the actual price level (31.00) has to be traded first. Finally, there's another round of selling and shares hit an intraday low of 30.93. The p-n-f chart now shows ZZZ trading in a column of O's:

35
34 X
33 X O
32 X O
31 X O
30 X

The stock would remain in a column O's until it gave a three-box reversal to the upside. For example, a decline to 25.70 would extend the column all the way down to 26. (But not 25 - it would take a tick at or below 25.00 to accomplish that). ZZZ would then have to turn around and move back to 29.00 (26 + 3 = 29) in order to create another column of "X."

Another point to keep in mind is that opening and closing price data is not used in p-n-f charting. What matters is the intraday high or low. If either of these extremes adds to a column or creates a three-box reversal, appropriate changes are made to the p-n-f chart. Any other movement is ignored. This goes a long way towards filtering out the price movements that don't have a major impact on the supply/demand relationship.

We can identify key turning points in that relationship by using trendlines, which are familiar to most bar chartists. These trends always form a 45-degree angle, and are denoted by "+" signs.

Adobe Systems (ADBE) - Point and Figure chart:

P-n-f trends are formed differently, but don't let that confuse you; approach them just like would with a conventional bar chart trend. As shown on the ADBE chart, strong reversals can take place when a downtrending stock encounters bullish support.

The same is true of an uptrending stock when it meets bearish resistance. Violations of those levels are also significant. The red arrow points out the recent breakdown below support, which is a negative sign for ADBE.

These are just one way to profit from point-and-figure analysis. In "Point and Figure Charting Part II: Profiting From Patterns" we'll delve deeper and discuss buy/sell signals (which indicate key turning points in the all-important battle between supply and demand), charting of indexes, and a useful technique to help manage risk.

The New High Dip

Profit from stocks breaking out to new highs with this effective trading tactic

A powerful yet easy to understand stock trading tactic, the New-High-Dip consists of buying the first pullback or "dip" after a stock makes a new high. What makes this setup work so well is the consistency of human nature, which is the driving force behind all market behavior.

Here's how it works. After the initial flurry of buying that occurs when a stock breaks out to a new high, prices will usually pull back for a short breather. This retreat is almost always a buy and provides a safe entry on a stock that has obviously shown strength already.

Emotional dynamics support this stock trading tactic.

One group of traders missed the first breakout and are hoping for another chance to get in before prices race off to even more new highs. They buy into the pullback and in doing so contribute their part to slowing the decline with their cash investment. They feel a sense of relief that they've made a wise choice and patiently wait for the shares to bounce.

Another group is already in the stock with profits, having bought into the stock before the breakout. They are looking for a chance to add to their positions and will take advantage of the retreat to get in at a good price.

The last gang of traders are the guys and gals who, just like the second group, bought into the stock before the breakout. But instead of holding on as prices began to retreat, they sold near the high and pocketed some profits for their efforts. Now they are waiting for the rebound to get back in and ride the "profit highway" once again.

Each of these groups of buyers will help the stock find a new support level and resume the advance to new highs again. However, there are a few things that can interrupt the stock's upward progress. If the overall market falls hard enough and long enough, trader's moods can change and more selling will occur, stopping the stock from rebounding. Negative news about the company or industry can also have an impact and keep the stock from heading higher.

To protect your trading account, always use sell stops to prevent major losses. Remember that no tactic will work 100-percent of the time, but sound risk management will ensure that any potential losses are minimal.

Just make sure that the reason for the stock's decline is due to normal profit taking and not some outside event.

Knowing the proper time to enter is very important. Usually a support zone provided by a moving average, trend line, or other technical support will provide the initial reversal setup. Knowing exactly when to pull the trigger only comes with practice and experience. The RightLine Report gives you an advantage by providing New-High-Dip trades along with specific entry, exit, and stop-loss levels for each one.

Trading With The Turnover Ratio (TRO)

Turnover Ratio (TRO)

Have you ever noticed how some stocks seem to soar for months on little or no news while other stocks can receive ongoing great news and hardly move higher at all? Today, we will review the important role of supply and demand in the stock market. More specifically, we'll concentrate on a very useful ratio for comparing the supply and demand - it is called the "turnover ratio" or TRO.

Before we discuss the TRO, let's quickly review the basics. The markets are driven by supply and demand. What really makes a stock price rise? How about "more buyers than sellers at a specific price level." On the other hand, if there are more sellers than buyers, then the price will quickly adjust down to the point where the buyers and sellers meet at an agreeable price. If there aren't sufficient sellers, the price will rise. So how can one go about comparing the supply vs. the demand of a particular stock? First let's define the elements needed to come up with this comparison.

In researching any stock you will often find the daily average volume and various share-related items, one of which is "float." You can get the information from a number of sites, but below is the site we will use for our discussion.

Go to Yahoo! Finance at http://finance.yahoo.com/? and input a stock symbol to retrieve a quote. After receiving the quote click on "Key Statistics." The following will take you directly to the statistics for eBay (EBAY): http://finance.yahoo.com/q/ks?s=ebay

Find the "Share Statistics" (right hand column) and locate these two items:

1) Daily Volume
2) Float

Though most sites only give one Daily Volume figure, Yahoo! provides two averaged over different time periods (3 months or 10 days.) We recommend using the 10-day average as it will reflect more current trading activity.

Next turn to "Float" which represents the number of shares outstanding (or all the shares there are for that company) minus what is owned by insiders (people in the company, like the CEO, COO, CFO, President, Vice Presidents, etc.) and what the company is holding back (treasury stock). In a nutshell, associate the float with the supply of shares available to be traded at any given time by the public.

Now having defined the elements, the "turnover ratio," or TRO, is "the average daily volume divided by the float." Consider the following:

If the float is very large relative to the average volume (lots of shares out there to be bought and sold in relationship to the average volume) we would see a low turnover rate and thus an onrush of buyers would not move the price much. However, if the float is low relative to the average volume (a lot of people wanting very few available shares,) a sudden rush of buyers could move the price of a stock dramatically.

Let's take a look at a couple of examples. The first one is the widely held GE stock. Go to http://finance.yahoo.com/q/ks?s=ge and find the following information:

Daily Volume (10-day avg) 16.2M and Float is 9.92B

*Note that "B" is for billion, "M" is for million and "K" is for thousand. This can make a lot of difference in your calculations! If you find that the statistics are in two different "denominations" you must first convert one of the numbers into the same denomination as the other. We prefer millions, as it what you will find most often.

With this in mind we will now calculate the TRO for GE:

Daily Volume (10-day avg) of 16.2M divided by 9920M of Float = 0.16%

What significance is this? It means that only 0.16% of the total outstanding shares owned by investors are traded on average per day.

In contrast, let's take a look at Sohu.com (SOHU) by going to http://biz.yahoo.com/p/S/SOHU.html

Daily Volume (10-day avg) of 3.78M divided by 12.3M of Float = 30.7%

Wow, what a difference! 307 out of every 1,000 shares of SOHU have changed hands every day over the last ten days, compared to only about 16 of every 1,000 shares of GE. Higher TRO translates into bigger price swings.

Understand that TRO is simply a relative measure of the supply and demand relationship which tells us how volatile a stock will trade given an imbalance in supply or demand either to the up or downside. During strong up trends, we would gravitate towards high TRO stocks. During choppy times, lower TRO stocks will keep the Alka Seltzer in the medicine cabinet.

Case in point, from 8/1/03 - 8/20/03 SOHU traded as high as 39.52 and as low as 30.75. During that same time period GE hit a high of 29.62 and a low of 27.18. Also look at the daily Average True Range (ATR*) and how much more dramatic price movement can be in SOHU (2.62) compared to GE (0.69). The higher the turnover, the more volatile the stock - and the greater potential for larger swings in price (both up and down!).

In summary - turnover shouldn't be used to make a decision on whether to invest in any particular stock. Rather, it should be used to quantify the relative supply and demand and how much risk/reward there may be as a result of a change in trading volume, market conditions or significant news.

Market Physics

A Master Swing Trader Explores Similarities Between Stock Market Price Action and The Classic Rules of Physics

The swing trader faces a considerable challenge mastering the puzzle of market movement.
While most of us recognize conflict and resolution within the price chart, we fail to utilize these dependable mechanics in our trading strategies. Fortunately, repeating elements of the charting landscape offer a powerful context to understand and manage these vital aspects of trend development. Through repeating dynamics of crowd behavior, price action tends to mimic classic rules that modern scientists apply to our physical universe.

his is probably no accident of nature.
Emotion and mathematics interact continuously while they draw the Fibonacci retracements that we see every day through our chart analysis. This fascinating relationship offers a glimpse into the profound order beneath common price movement. At its core, convergence-divergence between these two forces helps us to understand and trade the market swing. For example, we may search the chart for a reversal or breakout pattern that spells opportunity, but we also watch the ticker tape to gauge the crowd's emotional intensity, and to predict where it will burn out or shift gears.

Successful traders draw intuitively upon these bilateral market mechanics as they master the art of speculation.

Their advanced skills correspond with the peculiar logic required to unify left and right brain functions into a focused trading methodology. Perhaps future technicians will quantify these profound interactions between herd behavior and physical law, and even open up a new branch of technical price prediction. In the meantime, let's explore some primary characteristics of these underlying market physics.

1. AN OBJECT IN MOTION TENDS TO REMAIN IN MOTION

New trends awaken within the low volatility of a rangebound market and are characterized by directional price momentum.

During the early phases of new trends, volatility rises but inertia tends to slow down price rate of change. This often generates a series of tests or congestion mini-patterns while price tries to escape the influence of the old range. Eventually, momentum overcomes inertia and price movement takes on a more vertical appearance. This freedom of motion actually lowers volatility as friction eases and a one-sided market assumes control.

New trends can be very difficult to stop once they are underway.

As with other objects in motion, trends feed on themselves because they draw in fresh energy (from cash and emotions on the sidelines). This induces price movement to travel well beyond arbitrary barriers, such as targets set by outside forces. But no trend can last forever or travel to infinity. Just like its physical counterpart, intervening market force will eventually stop or reverse directional price movement.

Simple friction slows down a rolling ball.

Active trends experience friction in the form of market gravity. Classic trading wisdom notes that rallies take buyers, but that markets will "fall from their own weight" under the right circumstances. Unfortunately, the dynamics of this well-understood mechanism don't quite match those of Mother Earth. If they did, all markets would fall to zero as soon as buying and selling dried up. The fact that markets retain value suggests that each one has a hidden center of gravity that price development will reach if all participants step aside at the same time. This "central tendency" gently pulls market movement toward a hidden mean during quiet times, but can act with shocking intensity when price action generates strong imbalances during extreme market conditions.

The distance from the current price bar to this elusive value quantifies a level of market inefficiency at each point in time.

It also defines most opportunity for the swing trader. Bollinger Bands present a common tool to measure tension on this hidden spring. But other indicators that rely upon deviation from the mean perform an adequate job as well. And don't overlook simple chart patterns. Certain formations can reveal major inefficiency through a simple set of price bars. For example, a Shooting Star candle after a strong rally signals an invisible wall to the observant speculator.

The Pull of Central Tendency

Combine candlestick patterns and Bollinger Band extremes to uncover hidden friction that will stop or reverse a strong market trend. Note how Immunex pierces the top band on July 19th, but closes back within its boundaries in a tall Shooting Star candle.

2. FOR EVERY ACTION, THERE IS AN EQUAL AND OPPOSITE REACTION

Traders at all levels must deal with the wavelike motion on price charts. These define underlying cycles that strategies must align with, or risk failure. At their core, these waves reflect constant battles between bulls and bears, and the underlying trend-range axis. Price thrusts forward in a surge of participation but then pauses to test prior boundaries and dissipate volatility. Price bars contract, volume drops significantly, and the trend pulls against its primary direction. But just as that market returns to a stable state, the action-reaction cycle suddenly regenerates and volatility surges. Fresh momentum carries the reawakened trend toward a new price level, or reverses it back toward its origins.

But why aren't markets stuck between two horizontal extremes if trend and countertrend act with equal force, and are polar opposites?

The answer lies in how active markets dissipate directional force. Every buyer must eventually sell and every short seller must eventually cover. This induces layers of cycles that equalize price action and reaction over time. Swing traders observe this dynamic process in the trend relativity of different length charts for the same trading instrument. In other words, a single market may print a strong rally on the daily chart, a bear market on the 60-minute chart, and sideways congestion on the 5-minute chart, all at the same time. While this phasing process may seem chaotic, it actually reflects the dissipation of underlying action-reaction polarity. This 3-D trend-range axis also carries an added benefit: its alignment generates many of the setups in the swing trader's playbook.

Locate these important opportunities in the convergence of specific action-reaction imbalances through several layers of price activity.

This logical analysis also supports the contrary attitude that leads to successful swing trading. For example, while the crowd sees a buying opportunity when price surges on heavy participation, the swing trader sees selling power increasing in that market due to the entrance of a new crowd of buyers. Fortunes are made through this type of counterintuitive logic, generated by recognition of the underlying power in market physics.

Time Frame Divergence

Price action in 3 time frames generates different support-resistance considerations while Qualcomm tries to halt a sharp decline. The daily chart prints a hammer reversal near a 6-month low. The 60-minute chart shows a bearish pullback into an ugly down gap, while the 5-minute chart offers short-term traders excellent profits through a midday bounce near whole number 50.

3. THE STAR THAT BURNS BRIGHTEST BURNS OUT FASTER THAN THE STAR THAT EMITS A COOLER, DARKER LIGHT

We measure the health of a rally or weakness of a selloff by the angle of its rise or fall.

Common sense dictates that more vertical price bars reflect more powerful price moves. But how does the intensity of price change interact with the persistence of the trend itself? To answer this question, we can rely upon the characteristics of central tendency discussed earlier. If each market carries an underlying fair value at each point in time, a dynamic move should reach that price in less time (fewer bars) than a slow hike in the same direction. In other words, vertical trend bars should burn out and end their movement much sooner than slower trend bars.

Unfortunately these angles of inclination and declination are relative to the observer.

Low price distorts movement on arithmetic charts. A spectrum of growth rates distorts movement on log charts. So before we can objectively measure how bright our market star burns, we need to adopt a common system of viewing price change. Unfortunately this is more difficult than it first appears. Diverse charting types and methods force us to apply measurements that are often dependent upon the software or service that we use. The most fruitful analysis adopts a common view across an entire database, so that visual comparison of trend intensity has a point of reference. Then we can use our eyes and simple standard deviation to examine the duration and stability of price change.

Apply this charting method to locate parabolas that are ripe for strong reversals.

In the contrary view of the swing trader, vertical price movement is seen as a prelude to a reaction of the same intensity in the opposite direction. Just as a supernova signals the imminent demise of an aging star, the parabola informs the market that its trend fuel is about to run out, and likely cause a violent reaction. First set a fixed log chart percentage between 15% and 20%. Then scan the entire database for issues with the steepest angles of short-term price change. Isolate those markets with the tallest price bars and visible trends in excess of 45 degrees. Then reset the log scale to automatic for these filtered issues, so that recent price action fills the screen. Apply a standard Bollinger Band and look for bars that print well outside the upper or lower band. Find your fade entry level by dropping down to a lower time frame and locating a small-scale reversal pattern that aligns well with broader landscape features.

A trend that moves at a very shallow angle also predicts its own demise, but for different reasons.

This reversal follows the mechanics of the rising or falling wedge patterns seen on many price charts. Both traders and investors want excitement in their lives. They buy or sell so they can watch price ramp to new levels. Shallow trends never fulfill this need for gratification. For example, participants watch price rise in an uptrend to a marginal new high over and over again, but never gather enough momentum to accelerate the rate of ascent. Shareholders eventually lose interest in this type of price action and jump ship in search of a more exciting trading vehicle. The market loses broad sponsorship and finally drops off a cliff.

Locating Blowoffs

Skilled eyes uncover the most dynamic parabolic trends and then execute fading strategies at natural reversal levels. Start with a fixed log chart setting, such as the 15% in figure A. Scan your database quickly and locate the most vertical price movement that you can find, up or down. Return to a more comfortable chart scale (figure B) and apply 3-D charting landscape techniques to identify low-risk entry.

4. ENERGY SOURCES LEAVE TELLTALE SIGNATURES IN THE FORM OF EXHAUST OR RADIATION

This classic principle of physics requires little translation for the financial markets.

Real trading opportunities look like opportunities because they emit characteristics of impending directional price movement. This reveals itself in crowd participation, price action at known boundaries, the creation of recurring price patterns, and the convergence of technical indicators. Interpret these diverse market signatures correctly and book consistent profits as a swing trader.

Engineers build machinery to investigate exhaust emissions and measure their internal characteristics.

For example, a hose attached to a vehicle's exhaust pipe tells the auto mechanic the current condition of the internal machinery. Swing traders build similar measurement tools to evaluate the state of internal market activity. But just as the engineer designs instruments to examine a very narrow range of physical information, swing traders must limit data intake to specific market characteristics and filter out many noise levels that can defeat profits.

Chart patterns with true predictive power emit evidence that these market engineers can detect and measure.

The radiation of opportunity builds through convergence of diverse elements at narrow intersections of price and time. Each independent signal drawn into this small space raises the odds that a trade setup will produce a valid result. Heat builds strongly at these important levels and tells the swing trader to get on board quickly.

Reading the Charting Landscape

Highly predictive charts print well-organized patterns at expected price levels. AMCC starts with an Island Reversal (1) that ends a clear Elliott 5-Wave (2) rally. Price drops under the intermediate high at 48 and the 62% retracement (3) of the prior move. Weak congestion (4) forms under the retracement level. The bottom Bollinger Band (5) expands downward, opening the door to falling price. All signs points to an impending first failure event (6), in which price will retrace 100% or more of a prior trend leg. The swing trader measures this evidence, sells short into the congestion, and waits for the pattern to work out the expected result.

CONCLUSION

Modern traders have great difficulty organizing market movement into a manageable feedback and execution system.

Too often, they ignore important chart data because it doesn't fit into a convenient system of horizontal price boundaries. This obsession with simple-minded pattern recognition exposes a trader's inability to grasp the more powerful mechanics of price prediction. Unfortunately, concentrating on a narrow execution strategy is like trying to play music with a single note. It works only when a fleeting moment of opportunity demands a single, flat tone.

Expand your trading knowledge through the application of market physics.

Each new aspect expands your ability to profit from subtle aspects of crowd behavior. Keep in mind that these natural forces rely upon mechanics that many speculators will overlook. This lets you gain an important edge on the path to successful trading. It might take a lifetime to explore these complex interactions between evolving price and the emotional crowd. But each piece of this fascinating puzzle adds new levels of empowerment to trading performance.

Hedge Fund Index For Trading Bad Markets

Hedge Fund Index For Traders

New York, NY, September 17, 2002 - Following the general introduction of the S&P Hedge Fund Index earlier this year, Standard & Poor's, a leading global provider of indices and benchmarks, today announced the components of the index, the list of which is available at www.standardandpoors.com.

Standard & Poor's has also published a white paper that details the structure and methodology of the index, expected to be launched shortly.

"By screening for funds that demonstrate style purity and requiring that they provide daily transparency, Standard & Poor's offers a breakthrough benchmarking tool for this traditionally secretive corner of the investment universe," said Paul Aaronson, Executive Managing Director, Standard & Poor's. "The S&P Hedge Fund Index measures the performance of a diverse array of hedge fund strategies in use by managers today. The index is designed to be investable and provide a means to indexed investment in hedge funds through licensed products that replicate it."

Forty hedge funds make up the S&P Hedge Fund Index, which is divided into three "style" sub-indices, Arbitrage, Event-Driven and Directional/Tactical. The Arbitrage sub-index includes Equity Market Neutral, Fixed Income Arbitrage, and Convertible Arbitrage strategies. The Event-Driven sub-index includes Merger Arbitrage, Distressed and Special Situations strategies. The Directional/Tactical sub-index includes Long/Short Equity, Managed Futures, and Macro strategies. The index is equal weighted to ensure well-rounded representation of hedge fund investment approaches and to avoid over-representation of strategies that are in favor at the time (see pages 8-9 of the white paper for further clarification).

The hedge funds included in the S&P Hedge Fund Index have been selected by Standard & Poor's Index Committee following a rigorous due diligence process conducted along with hedge fund consultant, Albourne Partners Ltd. Funds are screened in an effort to ensure that they are appropriately managed, adhere to their stated strategy or style, and maintain all necessary risk controls and operational infrastructure. Other criteria for index inclusion include level of assets under management, length of time the fund has been in existence, tenure of the fund manager and willingness to grant daily transparency for daily index calculation. A decision to include a hedge fund as a component of the S&P Hedge Fund Index does not reflect an endorsement by Standard & Poor's or anyone else of the investment merits of the fund.

S&P Publishes Hedge Fund Research

Also released today is a white paper offering details on the index methodology and structure as well as research on the representativeness of the index.

"We believe the S&P Hedge Fund Index components include representative examples of funds in the respective strategies," said Peter Roffman, Vice President, Standard & Poor's. "The median AUM of components in the S&P Hedge Fund Index is approximately $530 million and the median track record in the strategy is six years."

Standard & Poor's, a division of The McGraw-Hill Companies, provides independent financial information, analytical services and credit ratings to the world's financial markets. Among the company's many products are the S&P Global 1200, the world's first real-time, investable global equity index, the S&P 500, the premier U.S. portfolio index, and credit ratings on more than 220,000 securities and funds worldwide. With more than 5,000 employees located in 18 countries, Standard & Poor's is an integral part of the global financial infrastructure. For more information, you can visit www.standardandpoors.com.

ETFs, Exchange Traded Funds

Exchange Traded Funds may offer a simple solution.

Exchange Traded Funds, or ETFs, are similar to mutual funds, but are traded on a stock exchange just like a stock. Exchange traded index investments have become very popular in the past few years, and are now available to track many broad indexes. The S&P 500, the Nasdaq 100, and the Dow Jones Industrial Average are all offered, as well as many narrowly defined sectors and specialty indexes.

ETFs represent shares of ownership in a fund, unit investment trust, or depository receipts. These instruments own portfolios of stocks that closely track the performance of specific indexes that correspond with either broad market indexes or sectors. ETFs give investors the opportunity to buy or sell an entire portfolio of stocks in a single security in a single transaction.

ETFs offer a wide range of investment opportunities. While they closely resemble index mutual funds, ETFs differ from mutual funds in a number of ways. Unlike Index mutual funds, ETFs are priced and can be bought and sold throughout the trading day. They can also be bought on margin and sold short. There is an ever-increasing number of ETFs that can be categorized into three types of funds:

Broad-Based - This category tracks a broad group of stocks from different industries and market sectors. For example, iShares S&P 500 index fund (symbol IVV) is a broad based ETF that tracks the S&P 500.

Sector - These ETFs track companies represented in related industries. For example, iShare Dow Jones U.S. Healthcare sector Index Fund (symbol IYH) is a sector ETF that tracks the Dow Jones Healthcare sector.

International - Tracks a group of stocks from a specific country. For example, iShares MSCI- Australia (symbol EWA) tracks the Morgan Stanley Capital International index for Australian stocks.

ETFs are bought and sold through your broker of your choice - the same way you buy a stock. Most ETFs have no minimum purchase requirements, and you can buy as little as one share at a time. However, some ETFs, like the Merrill Lynch HOLDRS, must be bought or sold in round-lot amounts of 100. All ETFs may be purchased on margin, and are usually subject to the same terms that apply to all common stocks.

It's clear that ETFs offer several advantages to traders and investors. Unlike open-end mutual funds that can only be redeemed at the end of the day, ETFs are priced throughout the day and can be bought or sold at any time during the trading session - just like a stock. They provide instant exposure to a portfolio of stocks of your choice. You can choose a fund that either represents a broad-based market index, a specific industry sector or an international sector.

ETFs can be bought on margin, and sold short. Although brokerage commissions do apply, there are no sales loads, management or sponsor fees typically associated with mutual funds. There are also positive tax implications. Both ETFs and open-end mutual funds provide low stock turnover, which is tax efficient because capital gains are not realized. However, ETFs provide a tax advantage not available with mutual funds.

Mutual funds sell securities to cover redemptions, creating capital gains, while ETFs transfer securities out to redeeming shareholders instead of selling the securities, thus minimizing taxable capital gains. There is also lower risk due to the diversification aspect of ETFs. Proper investment diversification is intended to reduce the risk inherent in particular securities. It is the acquisition of a group of assets in which returns on the assets are not directly related over time. By containing the stocks in an index, an investor has a broader number of companies, which provides a degree of protection in case the price of one company in the index goes lower.

In summary, ETFs provide a convenient way to trade or invest in the overall market or specific sectors. Their performance matches the return of the overall market or individual sectors as a whole. They are usually less volatile than the individual stocks that make up the sector, and provide a relatively low-risk way to trade volatile markets. If you are interested in trading specific sectors, indices, or mutual fund type equities, you should definitely consider Exchange Traded Funds as a part of your stock trading and investing strategy.

Online Trading - Stock Buybacks Can Signal Good Days Ahead

Stock Buybacks

During times when the stock market is declining there will often be an increase in the number of companies announcing a stock buyback. Although a stock buyback is fairly common, the investing public often overlooks the potential value of these announcements that can be used in their investing or trading analysis.

What Is A Stock Buyback?

When a corporation buys its own stock on the open stock market, it is considered a "stock buyback" and the shares purchased are re-titled "treasury stock." Before examining some of the potential benefits and pitfalls of a stock buyback, let's first review a couple of terms that will be used in this discussion:

Authorized Shares - the number of shares of stock a corporation is "authorized" to issue per their articles of incorporation. Additional shares can be "authorized" by the Board of Directors with approval of shareholders.

Outstanding Shares - the number of shares of stock that are held by investors (including employees and executives of the corporation). Treasury and Authorized-not-Issued shares are not included in this figure.

Treasury Shares - the number of shares of previously outstanding stock that has been repurchased by the corporation. Treasury stock can later be sold or retired based on a shareholder vote.

Float - the number of shares outstanding minus what is owned by insiders (people in the company, like the CEO, COO, CFO, President, Vice Presidents, etc.) and treasury stock.

Earnings Per Share (EPS) - Earnings divided by the number of outstanding shares of stock.

Now that we've defined a few terms, let's move on to take a closer look at the effect a buyback can have - both positive and negative.

Benefits of Stock Buybacks

Increased Shareholder Value - There are many ways to value a profitable company but the most common measurement is Earnings Per Share (EPS). If earnings are flat but the number of outstanding shares decreases. . Voila! . . A magical increase in period-to-period EPS will result.

Higher Stock Prices - An increase in EPS will often alert investors that a stock is undervalued or has the potential for increasing in value. The most common result is an increase in demand and an upward movement in the price of a stock.

Increased Float - As the number of outstanding shares decreases, the shares remaining represent a larger percentage of the float. If demand increases and there is less supply, then fuel is added to a potential upward movement in the price of a stock.

Excess Cash - Companies usually buy back their stock with excess cash. If a company has excess cash, then at a minimum you can bank that it doesn't have a cash flow problem. More importantly, it signals that executives feel that cash re-invested in the corporation will get a better return than alternative investments.

Income Taxes - When excess cash is used to buyback company stock, in lieu of increasing or paying dividends, shareholders often have the opportunity to defer capital gains AND lower their tax bill if the stock price increases. Remember that dividends are taxed as ordinary income in the year they are received whereas the sale of appreciated stock is taxed when sold. Also, if the stock is held for more than one year the gain will be subject to lower capital gain rates.

Price Support - Companies with buyback programs in place use market weakness to buy back shares more aggressively during market pullbacks. This reflects confidence that a company has in itself and alerts investors that the company believes that the stock is cheap. Frequently you will see a company announce a buyback after its stock has taken a hit, which is merely an overt action to take advantage of the discount on the shares. This lends support to the price of the stock and ultimately provides security for long-term investors during rough times.

Now that we've shown a few reasons to be bullish on "buyback stocks," should you go out and buy every buyback you can find? Definitely not. Not all buybacks are equal and some buybacks seem to be nothing more than an attempt to manipulate the stock price.

Potential Pitfalls

Manipulation of Earnings - Above we described how a buyback improves the earnings per share number. Analysts rate stocks on many factors, but one of the most important numbers is the Earnings Per Share. Assume that an analyst estimates earnings using a higher number of outstanding shares existing before a buyback is executed. If the timing is right, companies could buyback shares and appear to beat consensus estimates that were based on a larger number of outstanding shares. So, watch out for announcements just prior to earnings.

Buyback Percentage - The higher the percentage of the buyback, the greater the potential for profits. Unfortunately, the buyback percentage is not typically part of an announcement so in order to determine if there is any significance to the announcement you'll need to do some research. Don't assume that a large number of shares is necessarily a large percentage.

Execution of Buyback - There is a difference between announcing a buyback and actually purchasing the stock. A buyback announcement may initially boost the price of a stock, but this phenomenon (when it occurs) is usually short lived. Don't be fooled into believing that all announcements are implemented. A good portion of announced buybacks are not executed in full.

High Stock Prices - Beware of a buyback program announced when a stock is at or nearing an all-time high. A stock buyback can be used to manipulate less than desirable EPS expectations. One way of investigating this is to compare the P/E (Price/Earnings) ratio relative to other stocks in the sector or industry. If a higher than normal P/E ratio exists, then it doesn't make a whole lot of sense for a company to buy it's stock at a premium unless there is something in the works that will add substantially to earnings.

The Bottom Line

Stock buyback programs take advantage of supply and demand by reducing the number of shares outstanding, increasing EPS shareholder value, float and ultimately the price of stock. In addition, they are often a wise use of excess cash and can create tax opportunities for the investor. However, not all buybacks are actually implemented so caution and research is advisable.

Online Trading - Short Sales Make Money When The Stock Market Drops

Short Selling: How To Win When Stocks Go Down

Most all of us grow up with a fundamental and innate sense of optimism. We tend to feel good when things are just right, and conversely, in down times we collectively maintain a sense of "hope" that a better future lies ahead. For certain, the attitude is almost tangible throughout the halls of Wall Street. In the options market, the number of traders wagering on rising stocks (call buyers) clearly outnumbers those betting on the down side (put buyers), even in extended bear markets.

And while this innate sense of optimism may be good in a societal sense, trading accounts don't always benefit, especially for those stuck in "hoping" their stocks will go back up. No, reality - and prudence - dictates a wiser course.

We should already be aware that economic cycles have periods were various sectors fall in and out of favor. In down markets, contraction - complete with falling stock prices - ensues as a natural course of events. And for traders, it's imperative to recognize this contraction. We must immediately and decisively take action to protect profits, minimize risk, and plan for new opportunities. That's what this business is all about!

Today we'll focus on a few of the profit opportunities and tactics applicable to Short Selling. The idea is to remove some of the "mystery" surrounding this supposed "black art." It's our goal to arm readers with basic knowledge of this potentially profitable stock trading tactic. Be forewarned, however, that Selling Short, like anything else we'd like to excel at, takes practice, practice, practice!

Here's how it works.

Most investors buy stock with the intention that it will go up in value. On the other hand, short sellers sell stock they DON'T own because they believe that the stock will drop in price. For those familiar with short selling, that last sentence probably made sense. But for those of you new to the idea of shorting, you are probably asking, "How do you sell something you don't own?"

Well, in order to sell shares that you don't own, you must borrow them from your broker, sell them, and then replace the shares by purchasing them at some point in the future - hopefully at a lower price. This is where the phrase "selling short" comes from. You are "short" the shares that you've sold. You don't own them. There are a few rules to keep in mind with this tactic.

1. No Shorting in IRAs

Shorting is not allowed in IRA accounts. One of the rules imposed on Individual Retirement Accounts is that you can't borrow within the account, or you risk having the account disqualified as an IRA. Therefore, for those of you who trade within your IRA account, shorting probably isn't an option under the current tax rules.

2. Dividends

Second, dividends paid to you during the time that you are short a stock need to be repaid to the lender of the stock. The actual shares borrowed have since been sold to a new owner who receives the dividends for those shares. However, the lender is also entitled to dividends on the shares they lent, and it's the short seller's responsibility to make it up to the lender. Again, your broker's computer system will keep up with the details, but it's a good idea to be aware when dividend payments are scheduled.

3. Calling Your Shorts

Third, the broker who lent the shares that you sold short may ask for the shares back at any time, in which case you will have to buy shares to cover those you borrowed from him. A broker has the right and sole discretion to require a short seller to cover, even if it's at an inopportune time.

When you buy a stock long and it goes down instead of up, you have the option of waiting for it to recover over the long term. However, if you are short the stock and it goes up instead of down as you had planned, the broker that loaned you the shares could require that you cover them (meaning you'll have to buy them back NOW).

Fortunately, this doesn't happen that often, but it is still important for short sellers to use buy stops to avoid letting a trade move too far against them. Technically, the potential loss from selling short is unlimited because the stock price has the potential to go up forever. Of course, as one trader put it, "you would have to be in a coma to let something like that happen!"

When Should You Consider Shorting?

regularly includes suggestions for short sales that are based on a variety of setups with strong potential for profits. For example, companies who issue earnings warnings or lower than expected results are often punished by disappointed shareholders who immediately sell the stock. There is a way to profit from the situation by shorting the actual stock, or an even larger group that we refer to as "sympathy stocks" that are in some way related to the company. When a company announces an earnings warning or reports less than favorable results, look to other stocks in the same industry group or sector to be dragged down as well.

Look To The Charts

Learning to sell short allows you to take profits when the market is going down. If you are accustomed to buying, or going long, on breakouts above resistance when the market is strong, you can apply the same procedure to shorting breakdowns below support when the market is weak. You may find it helpful to flip your graph upside down and look for breakout entry points. As always, increased volume confirms a trend - up or down. Getting used to trading "upside down" requires lots of practice, so be patient with yourself and use a smaller than normal position size while you are learning.

And don't forget those stops!

Just like with long plays, a complete trading plan includes the use of trailing stops to protect profits.

More on Shorting ...

Is there a downside to shorting?

The most common objection has to do with the so-called "unlimited risk" of shorting. The idea here is that if you place a short sale and then permanently ignore it, the stock could theoretically increase in price forever. As a result, you would accumulate greater and greater losses over time - hypothetically to infinity. When you compare this scary interpretation of "unlimited risk" to the "limited risk" of buying stocks whose value can only drop to zero, it seems like a reasonable argument against shorting. A closer look reveals the truth.

Basically, anyone who enters a position whether long OR short, then walks away and ignores it is asking for serious trouble. Every trade should be entered with a planned exit, and then monitored for performance. If the trade moves in the wrong direction, you have to get out. But let's suppose that someone DOES enter a short position and then just walks away from it. There is a limit to the amount of loss they may incur, for if the losing short-trade reaches a level that puts their margin status in jeopardy, the brokerage firm will attempt to contact the trader. If they get no response, the broker will close the trade to protect their margin.

Far more traders lose money in long trades than short trades. In reality short sellers tend to have better results because they have taken the time to learn how to trade both sides of the market. What this really means is that educated traders do better . . . period.

Can you short stocks long-term?

Although you can hold a short position for as long as the stock is available to borrow, shorting has recently been primarily a shorter-term strategy. Some rules do apply, so see your broker for details. Shorting in a non-trending or up-trending market can be difficult. When bad news or sector rotation takes a stock out of favor, the company and brokers do everything in their power to buoy the stock. Most investors want the market to move higher. They invest in the hopes that individual stock prices will go higher as well. Only shorters hope that stock prices drop, and shorters are relatively few in number.

Companies release positive news stories and brokers do their infamous upgrades. These actions become forces that tend to drive the price back up in a bull market. In a bear market, it doesn't matter what brokers or companies say - they rarely have the power to drive stock prices back up for very long.

Why would someone want to loan their shares to a shorter?

Well, the truth is that shorting generally takes place without the stockholder's knowledge. Under certain conditions stockholders can instruct a broker not to allow their shares to be shorted, but this is rarely done.

Why would a brokerage want to allow shorting?

Because brokers make a commission on the transactions. The shorter pays a commission to sell short AND to buy to cover. In addition, the person who buys the shares from the shorter pays a commission for the purchase. It's all about the money!

Gap-Open Trading Tips

Tips For Trading Stocks Online: The Gap-Open Tactic

The Gap Open Online Stock Trading Strategy

The "Gap-Open Trading Strategy" is a popular online stock trading technique that we use whenever a stock gaps open beyond our planned entry price. For example if we plan to enter a stock long at $50, but it opens the next morning higher at $52, we will then apply the Gap-Open strategy.

Here's how it works. Instead of entering immediately at $52, we wait until the stock has been trading for thirty minutes. We then check the highest price that the stock traded at during that time, and re-set our entry point to just above that level; usually .25 to .375 of a point is enough. Once the price is reached, we enter our trade.

It's as simple as that. If the stock is really strong, it will first gap up at the open, dip down as some traders grab a quick profit, then turn around and move higher. By waiting until the first thirty minutes of trading is past, we avoid buying at what is often the high of the day.

Opening Gaps Can Present Profitable Online Stock Trading Setups

Opening price gaps can be up or down, and the size of the gap often has an impact on subsequent price activity. For example, if a gap is relatively wide, many traders will enter positions in the opposite direction of the gap - a tactic called "fading the gap."

A large gap usually indicates that investors have overreacted, and the market will either close the gap, or at the very least move back in a counter reaction to the opening direction. This tendency provides very short-term stock traders a chance to take quick profits when trading the opening gap online.

Gap Trading Tactic When Selling Short

The Gap Open Tactic works as well when we sell short as it does when we buy a stock. If the stock gaps down at the open, wait for it to take out its low of the first half-hour then enter a quarter point below that point.

Fading The Gap

Often, news can dramatically impact the price of a stock after the close or prior to the next session's open. This is often reflected in the opening price being much different than the price at the previous close. The difference between the closing and opening price is commonly referred to as a gap.

"Fading the gap" is a trader's tactic that involves trading in the opposite direction of a gap at the market open. For example, the market has a tendency to pullback after a strong open. This usually happens because of an imbalance between buy and sell orders. Once Market Makers and Specialists work through their overnight and pre-market orders, they will usually either drop their bids or go short. As the price begins to drop, many traders will also sell short, or "fade the gap" in anticipation that the gap will fill. Whenever you see a considerable gap up or down in price at the open, expect the first major move to be in the opposite direction of the gap.

Filling The Gap

Experienced traders are likely familiar with the term "filling the gap" but it's a term worth reviewing. If a stock moves against you, gapping open sharply higher or lower (as a result, for example, of earnings from a "sympathy stock"), consider removing stop orders momentarily and watching the trade very closely. Many times shares will reverse from the extremes of the gap, moving back toward the previous day's closing price, before setting a clear direction for the day.

This is termed "Filling the Gap." Being aware of this technique can really limit losses! Just remember to get out of the way if the gap DOESN'T fill, and simply continues the opening trend. For practice, carefully watch the intra-day charts of a few stocks that show a large gap open, and follow the subsequent trading price action. Good luck!

Gap Adjusted Entries To Increase Trading Profits

Gap Adjusted Entries

The "Gap Adjusted Entry" is a technique we use to reset our entries when a stock gaps open beyond or through the recommended RightLine entry price. For those who aren't familiar with the term, a "gap open" is simply the difference between the price of a stock at the open compared to the previous day's close - either up or down.

Here's how the Gap Adjusted Entry works.

Let's say that a stock closes at $30, and we plan to buy it IF it reaches $32. However, the next morning it gaps higher - beyond our entry price of $32, and opens at $33. We can then apply the gap open tactic. Instead of entering immediately at $33, we wait until the stock has traded for thirty minutes. We then check the highest price that the stock traded at during that thirty minutes, and re-set our entry point to just above that level.

How Much to Adjust.

The amount to adjust the entry is usually 0.25 for stocks priced up to $50, 0.50 for stocks from $50.01 to $100, and 1.00 for stocks over $100. Once the price is reached, we enter our trade. It's as simple as that. If the stock has "real" buying behind it, prices will first gap up at the open, dip down as day-traders grab a quick profit, then turn around and move higher. By waiting until the first thirty minutes of trading is past, we avoid buying at what is very often the high of the day.

Example of a Buy Entry - (Long)

Take a look at the example below. The original entry price is set at $32.46. On March 28 GIVN closes at $32.20 - beneath the planned entry level. The next morning GIVN gaps open above the planned entry level. This is where the Gap Adjusted Entry technique comes in. The high for the first 30 minutes of trading on March 29 is $33.77, so the original planned entry is adjusted to just above that level. The new Gap Adjusted Entry is set at 34.02. Later in the session price moves up to the new entry level, triggering the trade.

A Common Misinterpretation

On several occasions we've received feedback from traders who have applied the Gap Open Tactic incorrectly. To help clarify what NOT to do, let's review a common error.

Here's the mistake. Buyers noted the high of the first 30 minutes and then immediately placed a bid to buy at 1/4 point higher then the high of the day - even though the stock had dropped and was currently trading much lower. See the problem? This meant that their open order was filled immediately at the higher price, WAY over the current bid and ask price. You can bet that some seller was very pleased!

There is an easy way to avoid this - just wait to see if the stock continues to go higher BEFORE placing the order. If you are unable to wait for the market to move higher, just enter a "buy stop order" using the Gap Adjusted Entry price. A "buy stop order" is held by your broker until the stock price rises to your specified stop price, at which point it is executed at the market price.

Gap Adjusted Entries for Shorting

For traders who like to sell short, the Gap Open Tactic can also be used effectively when stocks gap lower. Simply wait 30-minutes, then adjust the entry level to just BELOW the suggested short entry price. Subtract the same adjustment amount that we used with long positions - 0.25 for stocks priced up to $50, 0.50 for stocks from $50.01 to $100, and 1.00 for stocks over $100.

Example of a Short Sale Entry - (Short)

Take a look at the chart of IGT below. In this example the original entry price - a short - is set at $46.14. On April 21 IGT closes at $46.57 - beneath the planned entry level. The next morning IGT gaps open below the planned entry level. This is where the Gap Adjusted Entry technique comes in. The low for the first 30 minutes of trading on April 22 is 44.09, so the original planned entry is adjusted to just beneath that level. The new Gap Adjusted Entry is set at $43.84. Later in the session price moves down to the new short entry level, triggering the trade.

Summary

RightLine traders have found that the Gap Adjusted Entry method helps avoid being "top Picked" on long entries - buying into a reversal near the session high. It also reduces the likelihood of being "bottom picked" when going short. Like any system, method, tactic or strategy, the Gap Adjusted Entry doesn't work all of the time. However, it does offer traders and investors an intelligent alternative when your original entry is lost in the gap.

Trading The Bounce Play

Playing The Stock Bounce

Many of the best stock trades come from playing "the bounce." When it comes to balancing risk and reward, we've found that entering a stock bounce trade near a support level can be a great way to go. No tactic will always work perfectly, but stock bounce plays give us a low risk entry and a clearly defined point at which to set our stops. Below are some tips that can help traders to navigate this stock trade and increase the probability of success.

Take a look at daily charts for a number of stocks, and you'll notice that some show steady, trending price movement. Minus any news events, these stocks normally cycle up and down as buying momentum builds and fades. On many stocks the cycles occur between support and resistance levels. These "predictable" looking stocks are the most appropriate for playing the bounce.

Support and Resistance

In order to understand how to play stock bounces, we need to quickly review support and resistance. The book "Trading For A Living" by Alex Elder gives a simple, but effective image of support and resistance - "A ball hits the floor and bounces. It drops after it hits the ceiling. Support and resistance are like a floor and a ceiling, with prices sandwiched between them."

When a stock's price has fallen to a level where demand at that price increases and buyers begin to buy, this creates a "floor" or support level. When a stock price rises to a level where demand decreases and owners begin to sell to lock in their profits, this creates the "ceiling" or resistance level.

Why? Because investors and traders are people and they have memories! Those that follow a particular stock just "know" that it rarely falls below xx" or rises above yy". The "floor" and the "ceiling" are not fixed barriers you can touch. They are psychological barriers built by stock traders.

How To Recognize Support and Resistance

You can identify support and resistance levels by studying a stock chart. Look for a series of low points where a stock falls to this level, but then doesn't fall any further. This is a support level. When you find that a stock rises to a certain high, but no higher, you have found a resistance level. We like to use the 22, 50 and 200 Day Moving Averages (DMA) because they often provide reliable support or resistance levels for stocks. (Note that we use exponential DMAs for the 22 and 50 DMAs, a simple DMA for the 200.)

Take a look at a daily stock chart of HCBK (Hudson City Bancorp). If you don't have a charting service that you use for trading, you should take advantage of RightLine Charts. They are realtime, and you can select a wide range of Moving Averages, plus draw resistance and support lines. For more information go to RightLine Charts

You will see a stock chart showing the effect of support at the 22 DMA (red line) going all the way back into November 2001. Note that the chart looks a little like a ball bouncing up the upward trending 22 DMA. That's why we call this tactic, "playing the bounce."

Note that moving averages are not the only places to find support and resistance. Horizontal lines and trend lines also provide support and resistance. The best way to measure the strength of support or resistance is to look and see which method appears most obvious. The most obvious levels of support and resistance are the most significant.

When a stock's movement trades within certain dollar amounts we have horizontal support and resistance. When we talk about stocks trading in a range, you can normally see these horizontal lines that seem to bind the stock between support below and resistance above. Once a stock breaks above major resistance, the resistance level can often become a support level. Once a stock breaks below a major support level, the former support level becomes the new resistance level.

Playing the Bounce

Our goal is to buy (go long) as the stock bounces upward off support. Conversely, we can sell short on a bounce down (reversal) from resistance. Sounds simple enough when we are comfortably looking in the rearview mirror, but it can be quite a bit more challenging to pull the trigger on an actual trade.

When is a Stock Bounce Really a Bounce & When is it Just a Head Fake?

Actually, you never really know until after the fact. That's why we use stops as part of our Risk Control strategy. We don't have a crystal ball, but we do have tactics that allow us to trade successfully. One of the most important tactics is to use "stops." When you buy a reasonable number of shares of a stock at a critical turning point and set your stop a reasonable distance below your entry, then the amount you risk is reasonable.

Using The RightLine Report To Play The Stock Bounce

In almost every issue of the Report you will find stocks with bounce play instructions similar to this: "If the stock weakens, plan to enter long on a bounce upward near 50-DMA support at 31." Let's assume that you are interested in this trade. What should you do?

Start by opening up a daily chart of the stock to locate the support level. As you look at the chart, use the stock write-up in the Report to determine exactly what is providing support at this time. We typically include this information - usually a key Daily Moving Average like the 22, 50 or 200 DMA, a trend line, or a specific horizontal price level. Once you are comfortable that you understand the type and location of the specific support, you will want to monitor the price action, preferably by setting an alert to let you know when the stock price drops to near the support level. Once the price action gets within this "hot" zone, things begin to get interesting.

Bounce entries are more subjective than many other types of plays. Each trader has to make the call as to whether a bounce is indeed underway, and when to enter. The specific price point where you enter the bounce is determined in large part by the time frame you prefer and your tolerance for risk. Using our daily chart example from above, there are several good ways to set your specific entry point. First understand that every trade you enter should have two key ingredients - a setup and a trigger. This principle applies not only to bounce trades, but to every trade that you enter. The setup in our example is obvious - a potential bounce from support. Choosing the trigger requires that we set an entry based on price action that confirms a bounce is underway. This is where knowing our time frame and tolerance for risk comes in.

Very short term, aggressive buyers trading five minute bar charts will often jump into a stock on a very small uptick of a few cents, while more conservative daily or weekly chart traders prefer to wait until they are certain that a bounce is underway. Though the two approaches may seem to be in conflict, they really aren't. A shorter-term trader needs to set a quick trigger because the profit target in points is smaller and will be reached within a matter of minutes or a few hours. On the other hand, a longer-term trader will set a higher trigger, raising the odds that the bounce will continue over a longer period - perhaps several days or even longer.

There are numerous ways to decide on the best trigger for your trade. When using charts to determine your entry point, always take a look at the previous bar action. The open, close, high and low of the prior bar each present a trigger level that can be used to confirm that a bounce is underway and can be safely entered. For example, if you are trading daily charts and a bounce occurs at 31 as planned, a price move a quarter point above the previous day's high might be the trigger a conservative trader prefers, while a more aggressive trader might use the previous days low as a trigger. In these instances there is no right or wrong - one is just more aggressive than the other. In every case, always use initial stops to protect against losses, and then apply trailing stops to lock in profits as the trade moves favorably.

Just because a stock drops to the support level, hesitates and then temporarily falls below support doesn't mean the bounce entry is no longer valid. Bounces don't always occur exactly at the support level. If a stock drops below the support level, keep an eye on it. Stocks will often dip below support, only to rebound back above the support level and give traders a nice entry. Again, refer to the chart for prior bar(s) action to set your entry point (trigger).

Getting back to our example "to enter long on a bounce upward near 50- DMA support at 31." Let's say the stock drops as expected, but doesn't make it all the way down to 31. Instead, it only falls to 32, then begins to move higher. Volume looks strong, and you are convinced it is a "real" bounce. What do you do? It's okay to enter as long as you have set a trigger based on reasonable criteria, such as previous bar action. Just remember to set a stop.

Once in the position, you may see the stock move quickly higher. If it does, move up your stops to protect a portion of your profits and continue trailing the stops as it moves higher. The longer you expect to hold a stock, the looser you should set your stop so you won't get stopped out too quickly. A stop amount between one and a half to three times the 14-bar Average True Range (ATR) will often work quite well.

"Anticipating Stock Bounce Plays Near Moving Averages"

We often suggest that readers watch for a potential "bounce near" entry into a stock based on an anticipated bounce off a moving average. If a stock is trending up, the support may be at a different price by the time you trade the stock than it was when we set the expected bounce level. You can still play the bounce, even if it isn't bouncing off the exact same price level that we mentioned in the report. Always be sure that you understand the reason for the expected bounce, and check the chart to see if the support level has changed.

RightLine Tracking Criteria for "Bounce Near" Setups and Triggers

To determine what constitutes "near" when tracking plays that anticipate bounces from Moving Averages - we use a defined "bounce zone" ('reversal zone' for shorts). The mid-point of the zone is the specified Moving Average. The zone extends away from the mid-point in both directions by a set amount.

Use the amounts below to set the "bounce near" zone boundaries.

Use 0.11 for stocks priced up to $10, 0.16 for stocks from $10.01 to $20, 0.26 for stocks from $20.01 to $50.01, 0.51 for stocks from $51.01 to $100, 1.01 for stocks over $100

Long Example: If the Moving Average (mid-point) for a bounce is at $20, then the zone boundaries are placed 0.16 above and 0.16 below the mid-point (Upper boundary: 20.16 / Lower boundary: 19.84). If price penetrates the zone, then reverses and moves beyond the upper boundary by 0.16, the entry is triggered.

Setup Criteria: The "bounce near" Setup is considered complete when the price action penetrates the "bounce zone."

Trigger Criteria: The entry is Triggered when price reverses and moves beyond the zone boundary by the specified amount (ex: 0.16 for a $20 stock).

Good Until: The setup is good for up to 2 weeks.

Void Setup: The setup is void if price enters the zone and then exits thru the other side of the zone within the 2-week limit. The setup is also void is price enters the bounce zone but doesn't reverse enough to reach the trigger within the 2-week limit.

The Difference Between a "Bounce Near Play" and a "Bullish Bounce Play"

There is a major difference between a "Bounce Near" setup and a "Bullish Bounce" setup. When you read about a Bullish Bounce setup in the RightLine Report, the Setup has already occurred and the entry Trigger has been determined - though not yet reached. On the other hand, a "bounce near" trade simply anticipates a potential bounce setup - neither the setup nor the trigger have yet been reached. In a "bounce near" play, it is up to the reader to anticipate the setup, define it when it occurs, and establish a Trigger for entering.

Remember:

*In this article we focused primarily on buying stocks on bounces off support. However, we often recommend shorting stocks as they bounce downward - reverse - from resistance. The concepts are the same, but instead of looking at it like a ball bouncing up off the floor, it is more like a ball bouncing down off the ceiling.

* When it appears that a stock has "over-reacted" to a news event it can be good time to look for a bounce, especially if the stock is approaching a key support level. But remember, if you get your entry, set your stop and trail it higher to avoid getting stung.

*Anticipating stock bounces near moving averages requires a bit more thought than just entering trades using specific RightLine entry points, but it can be an excellent way to pick up quick profits on lower risk stock trades.