March 2007

Trading Tip:

Types of Traders
by Howard Arrington

Classifications:

Most traders can be classified in the three groups which I refer to as Formations, Studies and Fundamentals.   The following table shows resources sorted into the three groups.

Larry Pesavento, as an example, is very much a Formations trader.  He is very vocal in his seminar presentations in pointing out that he does not use any studies.  He also avoids the News and includes in his seminar classic examples of market moves ending just when some major magazine promotes the trend on its front page.   Larry has honed his skills to focus on the following set of Formations tools:  Ensign Map, Pesavento Patterns, AB=CD, Harmonics, Fibonacci Levels, Opening Price Principle, Gartley and Butterfly Patterns.  See a review of Larry's seminar and methodology  in the November 2006 Trading Tips issue.

Ken Wood (Woodie) has honed his skills to focus on the Commodity Channel Index study and understanding its nuances.   Although his methodology includes Support and Resistance levels, his primary focus is on the CCI Study, so he and his patronage would be classified as Studies users.

Judy Mackeigan (Buffy in the B-Line chat room) focuses on the Stochastic, Keltner Channel, and MACD studies.   Her methodology is augmented with Heikin-Ashi bars, Pesavento Patterns, and recognizing patterns named Money on Floor and Sling Shot.   Though she uses tools from the Formations groups, she and her patronage probably would be classified with the Studies group.

I would classify myself as a Formations trader because Draw Tools speak to me more than do Studies.  In fact, I have favorite draw tools but no favorite studies.  I scan lots of charts looking for the next 'train about to depart the station'.  I do not need to know the fundamentals such as supply and demand, P/E ratios, corporation management, competition, weather patterns, government policies and interest rates.  Supposedly all that information is already factored into the present price of a security.  I use the chart as a road map of the trend and behavior of a security because embedded in the chart are characteristics that help identify a trade opportunity.

My expertise from the past 26 years has been in the development of analytical software.  Yet, having been there and done that, having dug through the mathematics of dozens of popular studies, having back tested various ideas in search of the holy grail, what I am about to say may surprise most of my clients.  Though the software I use (Ensign Windows) has a broad arsenal of fantastic technical analysis studies and tools, I personally concentrate on analyzing chart patterns.

So just what is it that I use when I analyze a chart?  I use:

• trend lines
• parallel lines
• Fibonacci bar counts
• Fibonacci price levels
• basic Elliott wave counts
• pennants, gaps, and break-out formations

There are literally hundreds of ways to analyze the markets, and dozens of software programs available to assist in the process.  You will want to acquire and use analysis software that fits the following criteria:

• fast and efficient
• easy to learn and use
• inexpensive
• rock solid reliable
• excellent support
• flexible
• powerful
• works with a real-time data feed
• works with the Internet
• has a programming language for developing new trading ideas

Technical Analysis Tips

The six tips illustrated in this section are effective techniques for finding winning trades and maximizing profits.  I cut through the fog and show you how to spot winning trades without needing to be a technical whiz.  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 principles.

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.  Ensign Windows even has a tool to draw the trend lines automatically.  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.

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 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, such as the one in this example, 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 trading days, and then reverse direction.  This tip can be used to develop patience, and know with greater accuracy on which day 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.

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 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.

Summary

The various tips I have mentioned are used in the complete analysis, and when there is good correlation or fulfillment, I make the trade.  If the chart pattern is confusing, I leave it alone and look for another symbol that shows an opportunity.  My ego is not such that I have to have all the answers to all the complexities than might exist.  I only have to satisfy my own comfort level.  I don't need to be a guru to the world.

Use these tools to spot opportunities.  The best use of your time will be to print a set of quality charts using Ensign Windows or similar software, sit down with a straight edge and colored pencil, and draw trend lines, parallel lines, count bars in waves, and count wave patterns.  Draw horizontal lines from all previous key trend tops and bottoms. Use Fibonacci Price Levels as price objectives.  You will find Fibonacci price and time relationships present on every chart.  Using this information, I can frequently predict with good accuracy a pattern, time and price objective.  At the forecast time and price, I draw a circle on the chart using a dime for the circle template.  A chart studied and marked in this manner serves as a road map, and confidence develops as price movement unfolds, confirming your analysis.

I teach a class each Wednesday afternoon in the Support chat room built into Ensign Windows or accessed with the free eChat program.  Click this link to learn more about the chat room.  Click any of the links in the article for additional reading material and examples.