October 2004

The six tips illustrated this month are effective techniques for finding winning trades and maximizing profits.  Even though my illustrations make it look easy, the process of analyzing charts and trading is still hard work.  Also, I have the benefit of hindsight in selecting a good example to use to illustrate these tips.

The Power of Trend Lines

I am frequently asked which is the best study or tool to use to trade the markets.  I think the best analytical tool is drawing a straight line on a chart beneath the lows of bars to show a rising trend, and above the highs of bars to show a falling trend.  A tool this simple does not require a computer.  Yet, because traders have computers, they overlook the power of a trend line, and number crunch massive quantities of data through complex formulas searching for a secret methodology no one has discovered.  Forget it.  I have been there and done that.  I keep coming back to the simplicity of manually drawing trend lines on a chart.  When the chart trend reverses and breaks through the trend line, a new position is taken.  This is the primary tool I use, and everything else you learn is just an enhancement to the power of the trend line.

Ensign Windows has a very powerful and unique tool called Auto Trends, which is illustrated on the chart above.   The trend lines are calculated and drawn automatically by the software, in real-time.   The tool has proven to be very helpful and greatly appreciated by many day traders.   The Auto Trends tool has several options that increase its value.  These options can be seen on the property window for the tool.

An Alarmed trend line will display an alert message box in green when price action breaks upward through a descending trend line, and display an alert message box in red when prices break below the ascending trend line.

Average Trend uses the principle of Parallelism in trends, and suggests the next trend based on the average slopes of prior trend lines.    This feature is illustrated in the next chart.

The red trend lines are the average trend lines and show the typical slope seen in earlier trends.

Channel Lines and 50% Lines (mid-channel) can be added by checking the boxes for those options.

The Gann 1x1 option will automatically place the 1x1 line on the chart from the swing points.  This is similar to placing a Gann fan on the chart to show the 1x1 line.   The slope for the Gann 1x1 line is determined by the proprietary technique Ensign Windows uses to square price and time.

The last two options for the Auto Trends tool can be used to show Support and Resistance and Break Out trend lines, as illustrated in this chart.

The Power of Parallel Lines

The first analysis principle is that prices move in trends, but the trends do not last forever.  Eventually price movement changes direction and breaks through the trend line.  The second principle I use is observing that up trend lines are frequently parallel to each other.  This means there is a repeatable chart characteristic in the rate at which price movement advances.  Likewise, down trend lines are frequently parallel to each other.  I use this principle of parallel lines to give me an idea of what would be a typical up trend or typical down trend when price movement changes direction, and a new trend starts.

The Power of Pennants

Pennant formations indicate the balancing of opposing market forces.  The pennant is a narrowing triangle where prices are making subsequent lower-highs and higher-lows.  Prices usually break out of a pennant pattern rapidly with the frequent presence of a gap, increased bar range and increased volume.  Join the move in the direction of the break-out. Odds favor a breakout to the upside from an ascending pennant, and to the downside from a descending pennant.  A smaller variation to a pennant is a flag where price movement pauses and moves sideways after a steep move.  Odds favor a break away from the flag to resume in the same direction.

The Power of Fibonacci Price Levels

Fibonacci price levels are constructed by drawing horizontal lines at the top and bottom of a recent trend.  The band is then sub-divided with additional horizontal lines at significant percentages.  The three retracement sub-division percentages I use the most are 38.2 percent, 50 percent, and 61.8 percent.  These percentages are members of a set of Fibonacci Price levels.  When a trend is being used to forecast the size of a subsequent larger trend, the significant percentage I use is 161.8 percent.

Prices often extend or retrace to these Fibonacci price levels, and then reverse direction.  Confidence is increased that a trend has fulfilled itself when its slope is parallel to other trends, the number of bars in the trend is a Fibonacci count, and the price is near a Fibonacci price level.  Fibonacci Price Levels are easily constructed on an Ensign Windows' chart using the trend top and bottom I select.

Another principle of horizontal lines is that previous resistance becomes future support, and past support becomes future resistance.  Always consider significant support and resistance levels from the past and extend horizontal lines at these levels into the future.  Note in the example that the pennant point consolidated on the horizontal line I labeled as Fibonacci Bottom for the first 5 wave down trend.  Also, this horizontal line was resistance to a couple of the wave tops I labeled with 4 and diamond 4.

The Power of Counting Waves

Underlying forces cause markets to move work in ways that create identifiable patterns, or a series of waves.  Big trends are called impulse waves, and each impulse is followed by a correction wave.  The theory named after Ralph Nelson Elliott, is basically expressed that there will be 5 waves in the main trend, followed by 3 waves in the corrective reaction.

I keep it simple. I look for trends with 5 waves, and corrections with 3 waves.  If I see the pattern, my confidence is increased that the current price movement is due for a reversal.  I also look at longer term daily, weekly and monthly charts to consider the direction of the security in its bigger picture.  Trade with the trend and use corrections as opportunities to join the direction of the main trend.

The Power of Counting Bars

Over and over again, I am amazed at the repetition when I count the number of bars in a trend.  The count frequently is one of the following numbers: 3, 5, 8, 13, 21, 34, or 55.  These numbers are members of a set of numbers called the Fibonacci number sequence.  Take any chart and use a straight edge to mark the trends.  Count the number of bars in each trend and label the trend line with the bar count.  Each chart will have a characteristic that starts to appear.  I have seen charts that with regularity move up and down for either 5 or 8 or 13 bars, and then reverse direction.  This tip can be used to develop patience, and know with greater accuracy on which bar  the trend top or bottom will be put in place.  For example, there are 8 bars in the trend from the point labeled diamond 4 to point diamond 5.

I hope you enjoyed this review of 6 simple yet effective tools to use in analyzing your charts.  Keep it simple, and stay on the right side by trading with the trend.

This is the October update of the paper trading model based on Bill Hatch's July article  Straddle-Strangle-Swap.  The model is selling near term options in Dell Computers (DELL), Home Depot (HD), Office Depot (OPD),  and Disney (DIS), and holding longer term options as an insurance policy.   The plan is to execute a calendar roll-out each month by buying back the short options on the day before expiration, and selling short options one month out.   The roll-out of replacing the October options with November options was carried out on Thursday, October 14th, 2004.  The November roll-out will be carried out on Thursday, November 18th.  This is where the model stands.

DELL continued to trend upward in October which hurt HDJG.X.   Also, Disney decided to trend upward away from $22.50 and that contributed to a loss for the month in Disney.   Since DELL and HD had strangle legs expiring in October, those two symbols will be closed out and the model will continue with just ODP and DIS for the balance of 2004.

The $22.50 strike in DIS which lost $1425 in October will be resold in the November option.  There is a good chance that DIS will return to a more average range price, which would recoup the October DISJX.X loss.

Summary:

• Dell:    - 375 - 425 + 175 + 775 + 825 + 425  =    $1400 net gain, position closed

• HD:     +1375 - 475 - 2025 + 225 - 625 + 75 =   -$1450 net loss, position closed

• ODP:  - 625 - 175 + 1175 - 175 + 425 - 75   =     $  550 net gain

• DIS:    +525 - 525 - 25 + 525 - 1425 + 325   =    -$  600 net loss

DELL and ODP basically traded sideways and produced a profit for the model.   HD and DIS trended upward and produced losses, which is unfortunate yet something that happens.  The model is fulfilling its educational objective by illustrating both the reward and the risk.

Here are the net trades for the options I traded last month....

Home Depot:  I did some evaluating of the HDJG.X and selling a calendar spread would not bring me more than $0.50, so I sold a "diagonal".   I bought back my HDJE.X and sold my November $37.50 Call (HDKU.X).  My net cost on this was $1.80.  That was less than it would have been to sell a November call and settling up for the $2.50 next month.  I was in this position long enough before your time trial that it did not cost me anything, but I did not make the money I expected to make.  I will not
trade HD again unless I see some reliable variability and start trading calls and puts in expectation
of directional movement.

Dell Computer:  I bought back the October $35.00 Calls and sold November $35.00 Calls
(DLQJG.X and DLQKG.X respectively) for $0.95.  Similarly, I bought back my October 35.00 Puts and sold the November Put (DLQVG.X and DLQWG.X respectively) for $0.90.  That gives a net of +$1.85 to roll the straddle over one month.

Office Depot:  The $15 Calls (ODPJC.X and ODPKC.X) sold for $0.50.  The $15 Puts (ODPVC.X and ODPWC.X) sold for $0.70 for a net $1.25 to roll into next month.

I netted $1.70 rolling MOT (Motorola, Inc.), and $1.20 rolling DIS (Walt Disney Co.).  My personal profits on these are marred by the Home Depot.  The others have all returned a good profit.