March 2004

Trading Tip:

The year 2000 will be remembered in the financial history books as the year of the top of the greatest bull market in stocks in the United States.  However there was another event with far less fan fare that occurred in the spring of 2000!  Business Week in its April 17^th issue published an article titled "This Alchemy can yield gold."  The article summarized the research work of Dr. Andrew Lo and his colleagues from the school of applied mathematics at Massachusetts Institute of Technology (MIT).  Dr. Lo examined over 30 years of chart patterns (over 60,000) from 1962 to 1996 in an attempt to prove or disprove the mystery of technical analysis of chart patterns.

Lo’s theory was based on the premise that certain price patterns repeat in actively traded markets.  The results of the study were nothing short of amazing.  Indeed, the classical chart patterns such as head and shoulders, double tops and bottoms, pennants, flags and other popular chart patterns were not only identifiable but highly predictive of future price movement.

These accolades from academia were heralded in the financial press as finally giving the technicians an equal playing field with the fundamental trader.  Statistically, the study proved that reading chart patterns can yield startling results in portfolio performance.

Price movements in actively traded markets are chaotic in nature.  One can never predict what the next price movement will be; up or down.  Nor can anyone ever know how much they will make on a trade (or if it will even be profitable).  So why even bother to try and predict price movement?  The answer lies in the control of risk.  Risk is the only factor in the risk reward equation that a trader can control.  Great traders learn the lesson early in their careers.  "Take care of your losses and the profits will take care of themselves" was the trading advice of Amos Barr Hostetter, founder of Commodity Corporation and a mentor to many of the Market Wizards.

Within the chaos of market activity are non-random patterns that repeat and are also identifiable.  This happens because markets can only do three things; go up, go down or go sideways.  Unfortunately they sometimes do all on the same day.  However, there are certain patterns that occur on an almost daily basis allowing the pattern recognition trader a valuable window of positive probability.  Probability is the key word here!  Traders deal in probabilities – never in certainties.  Only two professions deal in certainties – tax accountants and morticians.

Ensign Software has developed a pattern recognition tool that automatically calculates the exact ratios from previous price swings.  Non random patterns occur because all price swings in the past have an effect to future price swings.  This is why pattern recognition trading is predictive and acts as a leading indicator as opposed to oscillators and moving average systems that are lagging indicators.

Knowing the ratios is the first step in pattern recognition.  Ensign’s tool "Pesavento Patterns" does the work instantly for the trader.  It allows the trader to select the price swings over any time frame from tick charts to monthly charts.  The trader must then select the pattern recognition trade that fits his own "psyche".  Pattern recognition is the key!  Head and shoulders, pennants and flags and many other patterns have those important ratios needed to confirm the validity of the pattern.

Personally, I think the Pesavento Pattern is a very valuable new tool for swing traders.  The value resides in its graphic presentations of all past price swings.  Each price swing repeats at some future point in time.  The index allows the trader to see not only the ratio of all swings but the exact number of points in the swing.  Knowing the intrinsic harmony of each or commodity is necessary to understanding future price swings.  Markets expand and contract in relationships that are illustrated by the Fibonacci summation series.

When using the Pesavento Pattern it is best to wait for the multiple patterns and ratios to form and complete as shown on the examples in this summary.  It takes time to understand the significance but it is time well spent.  Each stock chart has its own pattern and harmony.  Find stocks and commodities that have symmetrical patterns that are easy to understand.  That assumes that you study pattern recognition in depth.

Time is most elusive of all technical indicators.  From the words of the great New Your Yankee Yogi Berra – "It ain’t over till it’s over".  This certainly applies to trading stocks and commodities.

The Ensign Software Ensign Map has been quite successful in locating key times for trend reversals when day trading.  Based on the principle that markets can only go up, go down or go sideways the Map searches for similar patterns that have repeated over the past several days and then defines a trading "Map" for the next several trading hours.  The "Map" is not a stand alone trading plan but must be used with support and resistance points and strong money management rules.  I use the default settings provided by Ensign and I do not change them at any time.  My experience using the Map has been helpful in the first hour of trading. The first hour of trading is sometimes referred to as "Amateur hour" by the financial press.  The map has a tendency to give better entry signals after the first hour of trading.  The Map can also be helpful on strong trending days, which occur about 15% of the time.

These 2 charts show the Ensign Map I used for trading ES M4 on March 23rd.   The Map is the red line.  My time objective was 10:30 and my price objective was the 0.618 retracement marked by the green line.  Pretty good I think!

Taking a combination of the Pesavento Patterns and the Ensign Map is probably the best use of these tools.  When the map is indicating a price reversal and several key Fibonacci ratios are present an ideal trading set up is in play.  But it is only a probability, never a certainty.  Money management and risk control is of paramount importance in trading.  The use of these two tools is no exception and I urge all traders to practice with paper trading before using real capital.

If you trade currency with the Interactive Brokers (IB) feed, you might miss a nice Index available from NYBOT.  The Dollar Index futures ($DX) is composed of a basket of six major currencies (Euro, Yen, British Pound, Canadian Dollar, Swiss Franc and Swedish Krona) http://www.nybot.com/specs/dx.htm

I use Ensign Windows to recreate a currency index as a custom symbol, with one exception.  The basket currency Swedish Krona is not available from IB.  But the Australian Dollar is available and having seen the nice move the Australian Dollar futures made and seeing the average volume in the futures is comparable to the CAD or CHF, I have replaced the Swedish Krona with the AUD in my new Dollar Index.  Here is my setup:

1. Click menu Set-Up | Customs symbol:

2. Enter the following information (For the June series use M4.  For the March series use H4).

Only difference to the "real" DX index is that the Swedish Krona has been replaced with the Australian Dollar.  This was necessary since IB does not carry the Swedish Krona futures.  Of course this change makes the value you get for this $DX custom symbol different from the real dollar index.  But, you don't want to trade it, you just want a currency index, which might move faster than the currency you are trading.

Click Add/Resave and close the Custom Symbols window.

3. Add the new $DX H4 to a custom quote page in Ensign Windows.

4. Open a chart for your new $DX H4 index symbol.