Plotting trendlines onto a chart is one of the easiest ways for technical traders to get a quick idea of an asset's direction.
As you may know, trendlines come in a variety of different forms and they can greatly vary in length and significance. In this article, we'll take a look at an 11-month trendline that we identified on the chart of NVR Inc. (NYSE: NVR) in our June 12, 2007 ChartAdvisor newsletter, and we'll show how it affected the short-term direction of the stock's price. We'll also cover a simple stop-loss strategy that may be used when trading technical signals based on breaks of support/resistance.
What We Saw
A price move through an identified trendline is one of the most common signals of a trend reversal and, as you can see in Figure 1 below, this was exactly what happened on the chart of June 12 NVR chart. We noted that the drop below the trendline would likely be the first signal of a reversal in the trend, but also that it was important to pay attention to the lower-than-average volume because it could signal a failed break. The low volume was a concern for technical traders because it was showing that the bears were not as interested in pushing the price sharply lower as most were expecting. Given the low volume and lack of volatility, we argued that it would be a good idea to wait several days to confirm that the bulls wouldn't be able to send the stock price back above the trendline.
Figure 1
What happened?
In the case of NVR, the price started to move lower and with this came technical confirmation that the breakdown was valid. The bulls tried to step back in by pushing the price toward the newly formed resistance level, but this attempt was met with a flood of sellers. The retest of the resistance, also known as a throwback, is a common occurrence in trading and the failed move higher is usually the final piece of confirmation needed by traders looking to profit from a pullback.
When the dust settled near the end of July, volatility remained high and volume was trading at higher-than-average levels. NVR shares were hovering around the $600 mark - falling from a mid-month high of $723.
The break below the trendline was a good indication of the impending downward momentum and proved to be a profitable strategy for those who knew what to look for.
No Man's Land
The clear signal of a stock breaking through a trendline is the first step to making a highly profitable trade. However, the act of taking a profit is not quite as easy. A trader's job becomes substantially more difficult when a stock is trading midway between influential levels of support and resistance because, from a technical perspective, the stock could go either way. The questions in the trader's mind come quickly: "Should I take a profit when the downward momentum lets up?" and "Is this just a period of consolidation before the bears continue to hammer the stock lower?"
As you can see from the chart below, NVR did trend lower for the next couple of months, ending near $560. It is important to mention that the extra percentage gain from $600 to $550 comes at a substantially higher cost because the trader consciously ran the risk of giving up a healthy gain in the event that the stock was able to find some unexpected strength. Notice how in Figure 2 the stock was trading halfway between the March 2007 high and the May low from 2006. This can leave a trader uncertain about the future direction. In addition, the declining volume again suggested that traders were losing interest. If a trader does not have a defined target, it may be a wise decision to close some or all of the position at a junction like this and to look for a trade with a higher probability of success.
Figure 2
A Strategy for Managing Stop Losses
There is also a strategy that traders can consider when using trendlines as a basis for a trade. Previous swing highs/lows are a good indicator of potential areas that may influence the stock's momentum. These are levels where the price has reversed in the past and traders will often look for this situation to occur again. As you can see in Figure 3 below, there can often be many levels of support/resistance and one strategy would be to set a stop-loss order above the previous level of resistance (in the case of a short position) and trail the order behind the price as it breaks below the lower price levels. Keep in mind that traders will pay more attention to levels that have been tested several times (red lines) because of their historical influence.
Figure 3
In this example, traders with a higher level of risk aversion, or those with a long-term investment horizon, may instead prefer to trail a stop order above the resistance found two levels above the current price. This would allow the given security to have more room to fluctuate and is used to profit from prolonged downward moves. It is important to note that this version of the strategy will lead to larger losses if the stop price is reached, but can also lead to larger gains.
What We Learned
A drop below a trendline is often used by traders as a signal of a reversal in the current trend. The clear move below a trendline is often a good indicator for determining a strategic entry price. Sometimes it only takes the implementation of a simple risk-management strategy to protect the gains made from an uptake in momentum that accompanies a breakdown through a trendline.
by Casey Murphy, investopedia.com
Casey Murphy is the senior analyst at Investopedia.com and is a graduate of the University of Alberta School of Business. He specializes in technical analysis and is dedicated to uncovering profitable trading opportunities.
Channel trading is a powerful yet often overlooked form of trading that capitalizes on the tendencies of markets to trend. It combines several forms of technical analysis to provide traders with precise points from which to buy and sell, put stop-loss and take-profit levels, and much more! This article will show you how to create and effectively trade these amazing instruments.
Channel Characteristics
In the context of technical analysis, a channel is defined as the area between two parallel trendlines and is often taken as a measure of a trading range. The upper trendline connects price peaks (highs) or closes, and the lower trendline connects lows or closes. An example of a channel is shown below.Breakout points in channels indicate bullish (on upward trends) or bearish (on downward trends) signals.
Channels are useful for short-to medium-term trading - not long-term trading or investing. The technique often works best on stocks with a medium amount of volatility. Remember, the volatility determines your profit per trade. Channeling also tend to work best when the technique is combined with other forms of technical analysis, at which we take a closer look below.
Finding an Equity
Not all equities can utilize this technique as it requires that the underlying equity has an existing channel in its chart. Generally, a channel consisting of four contact points is necessary for the channel to be considered “trade-able”. There are three ways to locate an equity to which this strategy can be applied:
1. Manually look through charts to locate channel patterns.
2. Utilize software or a service that automatically recognizes channel patterns.
3. Subscribe to a company that provides you with a list of equities to which this technique can be applied.
Creating a Channel
Channels are relatively easy to create using these four simple steps:
1. Locate a relative high and a relative low in the past from which to begin the channel.
2. Locate another subsequent high and low that follows one of the three following patterns (see table below):
a. Ascending channel - higher high and higher low.
b. Descending channel- lower low and lower high.
c. Horizontal channel- horizontal highs and lows.
3. Draw two trend lines - one connecting the two highs, and one connecting the two lows. Note that these two lines should be near parallel.
4. These two lines form your basic channel after there are at least two contact points with the upper channel and two with the lower channel. More contact points enhance the reliability of the channel.
Trading the Channel
Channels provide a clear, systematic way to trade. In fact, these simple instruments can show you when to buy and sell, where to place your stop-loss and take-profit points, how to determine the reliability of the trade and how long you should expect the trade to take! Let's look at how these can be done...
Locating Buy and Sell Points
Channels help locate optimal buying and selling points. Here are the standard channel trading rules:
• When the price hits the top of the channel, sell your existing position and/or take a short position.
• When the price is in the middle of the channel, hold.
• When the price hits the bottom of the channel, add to your existing position, cover your short and/or buy.
Two exceptions to these rules:
1. If the price breaks through the top or bottom of the channel, then the channel play ends until a new channel is established.
2. If the price drifts between the channels for a prolonged period of time, a new narrower channel may be established.
There may be times when other forms of technical analysis are needed to enhance the accuracy of the channel plays, and verify the overall strength of the channel. Using other techniques in conjunction with channeling can also help you avoid the side-effects of the two exceptions listed above. A few useful ones to keep in mind are:
• Moving average convergence divergence - These can be used to confirm channel movements, especially after a contact is made.
• Stochastics - These are useful to confirm channel movements.
• Volume - Analyzing volume ratios can also help you determine the strengths of different channel movements, which determine the overall channel strength.
• Short-term moving averages - These can provide you with a short-term outlook on a channel play. They are most useful after a contact is made to confirm the change in direction.
• Candlestick patterns - These are useful for spotting channel breakouts.
Determining Stop-Loss and Take-Profit Levels
Channels provide built-in money-management capabilities in the form of stop-loss and take-profit points. Here are the standard rules for determining these points:
• If you have bought at the bottom of the channel, set a (moving) take-profit point at the top of the channel. Also, set a (moving) stop-loss point slightly below the bottom of the channel, allowing room for regular volatility (taking the beta into consideration).
• If you have taken a short position at the top of the channel, set a (moving) take-profit point at the bottom of the channel. Also, set a (moving) stop-loss slightly above the top of the channel, allowing room for regular volatility (taking the beta into consideration).
Determining Trade Reliability
Channels provide the ability to determine how likely your trade is to be successful. This is done through something known as confirmations. Confirmations represent the number of times the price has rebounded from the top or bottom of the channel - in essence confirming the accuracy of the channel. Here are the important confirmation levels to remember:
• 1-2 - Weak channel (non-trade-able).
• 3-4 - Adequate channel (trade-able).
• 5-6 - Strong channel (reliable).
• 6+ - Very strong channel (very reliable).
Estimating Trade Length
The amount of time a trade takes to reach a sell point from a buy point can also be calculated using channels. This is done by recording the amount of time it has taken for trades to execute in the past, then averaging the amount of time for the future. This strategy relies on the theory that channel price movements tend to be nearly equal in time and price.
Conclusion
Channels provide one of the most accurate methods from which to trade in any market. By “encasing” an equities price movement into two parallel trend lines, this simple chart can provide the exact points from which to buy and sell, create stop-loss and take-profit points, check channel strength and even estimate how long the trade will take. This technique is a valuable asset to any trader.
Resources
Voodoo Trader (http://www.chart.nu) - A free service that automatically locates stocks that are compatible with channel trading.
ChartAdvisor (http://www.chartadvisor.com) - A paid service that identifies chart patterns.
Tradecision (http://www.tradecision.com) - Trading software that automatically generates various technical formations, including channels.
by Justin Kuepper
Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.
In 1977, long before investment analysis software made testing strategies a painless process, market researcher Arthur Merrill manually tested the idea of "filtered waves". Several years later, Martin Zweig popularized the concept as a trading model in his 1986 book, "Winning on Wall Street". In this article, we'll introduce you to this simple trading strategy and illustrate why every active trader should consider paddling out to catch these waves.
What are Filtered Waves?
Very few people read Merrill's short book, "Filtered Waves, Basic Theory: A Tool for Stock Market Analysis", when he completed it, but this work clearly demonstrated that legendary trader Jesse Livermore's swing trading methods worked. A Wall Street legend, Livermore had detailed his methods of swing trading late in his trading career and was able to make a complex subject understandable to all.
While Livermore traded on a short time frame, Merrill discovered that with an appropriate filter, this strategy could form the backbone of long-term investing strategies. Swing trading is a strategy that involves holding a stock overnight, and at times for longer periods. With filtered waves, trades can last for months, and occasionally years. The goal of both methods is to take the low-risk gains from the middle of a trend, rather than trying to pick bottoms and tops. The idea is shown in Figure 1. The swing trader would hold this stock during the time indicated by the dashed line, buying after the bottom is confirmed and selling after the top is confirmed.
Figure 1: A wave
In Figure 1, the buy signal occurs when the price moves above the previous high. The sell signal is tougher to define; it can be a rule that sells after three days without a new high, or a decline equal to a percentage retracement of the previous move (for example, selling when the stock gives back half of the gains made on the upside).
Livermore defined swing buying and selling signals in percentage terms. First, Livermore identified the trend as up or down. An uptrend is a series of higher highs and higher lows; a downtrend is marked by lower lows and lower highs. During an uptrend, Livermore's system only takes long trades. The specific buy and sell points are illustrated in Figure 2. As the uptrend runs its course, prices will eventually experience a decline of at least 4% from a high (Point A in Figure 2). This is the signal to close long trades.
When price penetrates the previous swing low by 2% (B), Livermore entered short position. Shorts were closed when prices rose 4% from a recent low (C) and new longs were initiated only after the previous swing high was exceeded by 2% (D). This is also the point where Figure 2 started, with the buy signal shown on the left side of the chart.
Figure 2 - Trading the waves
However, Livermore never offered proof that his tactics worked. Merrill picked up where Livermore left off, and quantitatively tested the idea of buying and selling based on percentage moves. He simplified the rules, backtesting on the Dow Jones Industrial Average, switching from long to short whenever price rose or fell by 5%. Merrill's results showed that despite a lot of losing trades in trendless markets, these rules beat a buy-and-hold strategy.
The name filtered waves comes from the idea that the market moves in waves. These waves ebb and flow just like ocean waves. Up waves are followed by down waves and they all come in different sizes and strengths. Merrill ignored the minor waves, filtering out any moves of less than 5%. The filter allowed him to identify the long-term trend, and formed the basis of a trend following trading system.
Building a Trading Strategy
Zweig extended the work of Merrill by providing a complete trading history in his book, crediting Ned Davis with developing the trading rules. Using the Value Line Index, a popular trading vehicle at that time, buy signals were generated whenever prices closed 4% above the most recent low. Sells occurred when prices declined 4% from previous highs.
From 1966 until 1993, the period Zweig tested in his book, the strategy significantly outperformed the buy-and-hold investor. Taking both short and long trades, Zweig reported that this simple rule posted a 12.6% annualized gain, compared to a 2.7% gain for the index. The system was also profitable on long-only trades, switching to cash instead of shorting the market.
Of course, this system can still lose. For example, if we take a trade at the beginning of a bull market, the averages may increase by 20%. This would lead to a trade with a profit of 12%, because entry is delayed until the market has gained 4% and an additional 4% of profits are given back before the sell signal is taken.
While this would be a respectable trade, most swing moves are smaller than that. On a 10% move, the trader would show a profit of only 2% before trading costs are considered. On a 5% move, the trader would actually lose 3% or more after trading costs are considered.
Advanced Trading Strategies
Traders can think of filtered waves as a trend identification tool rather than a standalone trading strategy. While the results are certainly impressive, in a trading range market, the patience and equity of most traders will suffer. Simple modifications to the basic idea should help reduce the risks of being caught in a series of whipsaw trades.
Using asymmetrical signals is one way to limit the size of drawdowns. This means setting the buy and sell points at different percentages. Ned Davis Research has published impressive results for the S&P 500. The rules are to buy when the index rises by 8.4% from an extreme low closing price, and sell when it falls by 7.2% from a top. Long-only, this system returned 11.5% per year between 1969 and 2001, easily beating the market return of 7.9%.
More advanced students of the market can consider substituting a multiple of the average true range (ATR) instead of percentage changes to define the strategy. The ATR indicator was designed to change with market volatility by measuring the absolute level of change within the market over a certain time. As an example of this approach, traders could use a filter of three times the 10-day ATR as the trigger for buy and sell signals. From a high or low, the ATR calculation would be completed and added or subtracted to identify the trade trigger.
Using ATRs as the wave filter would have the benefit of accommodating market conditions, allowing a trader to stay with the trend longer during volatile times. Unfortunately, it can also increase the amount given back by traders during those volatile times. As such, this approach might be better suited for short-term, risk-tolerant traders.
Conclusion
No matter how it's applied, filtered waves are a valuable addition to an investor's toolbox. With them, traders are guaranteed to always be on the right side of the trend without being overrun by the crashing wave. With refinements, this versatile technique can be useful as part of a long-term trading strategy and can be applied to mutual funds, ETFs, or volatile stocks.
by Michael Carr , investopedia.com
Mike Carr, CMT, is a member of the Market Technicians Association and editor of the MTA's newsletter, Technically Speaking. He is a full-time trader and writer.
Figure 1
What happened?
In the case of NVR, the price started to move lower and with this came technical confirmation that the breakdown was valid. The bulls tried to step back in by pushing the price toward the newly formed resistance level, but this attempt was met with a flood of sellers. The retest of the resistance, also known as a throwback, is a common occurrence in trading and the failed move higher is usually the final piece of confirmation needed by traders looking to profit from a pullback.
When the dust settled near the end of July, volatility remained high and volume was trading at higher-than-average levels. NVR shares were hovering around the $600 mark - falling from a mid-month high of $723.
The break below the trendline was a good indication of the impending downward momentum and proved to be a profitable strategy for those who knew what to look for.
No Man's Land
The clear signal of a stock breaking through a trendline is the first step to making a highly profitable trade. However, the act of taking a profit is not quite as easy. A trader's job becomes substantially more difficult when a stock is trading midway between influential levels of support and resistance because, from a technical perspective, the stock could go either way. The questions in the trader's mind come quickly: "Should I take a profit when the downward momentum lets up?" and "Is this just a period of consolidation before the bears continue to hammer the stock lower?"
As you can see from the chart below, NVR did trend lower for the next couple of months, ending near $560. It is important to mention that the extra percentage gain from $600 to $550 comes at a substantially higher cost because the trader consciously ran the risk of giving up a healthy gain in the event that the stock was able to find some unexpected strength. Notice how in Figure 2 the stock was trading halfway between the March 2007 high and the May low from 2006. This can leave a trader uncertain about the future direction. In addition, the declining volume again suggested that traders were losing interest. If a trader does not have a defined target, it may be a wise decision to close some or all of the position at a junction like this and to look for a trade with a higher probability of success.
Figure 2
A Strategy for Managing Stop Losses
There is also a strategy that traders can consider when using trendlines as a basis for a trade. Previous swing highs/lows are a good indicator of potential areas that may influence the stock's momentum. These are levels where the price has reversed in the past and traders will often look for this situation to occur again. As you can see in Figure 3 below, there can often be many levels of support/resistance and one strategy would be to set a stop-loss order above the previous level of resistance (in the case of a short position) and trail the order behind the price as it breaks below the lower price levels. Keep in mind that traders will pay more attention to levels that have been tested several times (red lines) because of their historical influence.
Figure 3
In this example, traders with a higher level of risk aversion, or those with a long-term investment horizon, may instead prefer to trail a stop order above the resistance found two levels above the current price. This would allow the given security to have more room to fluctuate and is used to profit from prolonged downward moves. It is important to note that this version of the strategy will lead to larger losses if the stop price is reached, but can also lead to larger gains.
What We Learned
A drop below a trendline is often used by traders as a signal of a reversal in the current trend. The clear move below a trendline is often a good indicator for determining a strategic entry price. Sometimes it only takes the implementation of a simple risk-management strategy to protect the gains made from an uptake in momentum that accompanies a breakdown through a trendline.
by Casey Murphy, investopedia.com
Casey Murphy is the senior analyst at Investopedia.com and is a graduate of the University of Alberta School of Business. He specializes in technical analysis and is dedicated to uncovering profitable trading opportunities.
