EXPLOSIVE STOCK TRADING STRATEGIESEXPLOSIVE STOCK TRADING STRATEGIES DR. SAMIR ELIASPublished June 2011 Copyright © 2011 by Samir Elias. All rights reserved Except as permitted under the United States copyright act of 1976, no part of this publication may be reproduced or distributed in any form or by any means or stored in a data base or retrieval system without the prior written permission of the publisher. Printed in the United States ISBN 13: 978-0-9846387-0-3 ISBN 10: 0-9846387-0-9 Published by: Lovoc Group Inc P.O. Box 12974 Wichita KS 67277TABLE OF CONTENTS Introduction... Chapter 1 Explosive volume based breakouts .. Technical requirements Practical applications Entry Strategy .. Exit strategy using technical indicators Exit strategy using trend indicators. Chapter 2 Explosive consolidation pattern breakouts. Technical indicators... Practical applications... Momentum driven breakouts .. Volatility driven breakouts Chapter 3 Explosive profits using divergent signals ... Partial basic divergences. Complex divergences Guidelines to trading divergences. Practical applications... Divergences using both price and volume indicators. Chapter 4 Explosive chart patterns Falling rectangle pattern V reversal patterns... VPV and PVP reversals Falling wedges. Multiple falling wedges. Reverse wedges .. Partial pullback ascending triangle Compressed double bottoms... Chapter 5 Explosive profits trading momentum shifts Trade entry trigger... Examples 1 & 2: Indices daily Examples 3 & 4: Stocks daily. Example 5: Weekly timeframe:Chapter 6 Explosive profits trading signal price bars. Momenta pharmaceuticals (MNTA) entry points. Secondary exit signal price bars. Chelsea Therapeutics (CHTP) Volume considerations... Three Bar Count trend reversals Trading Three Count signal bars Scripps E.W. Co a Final Word... f Chapter 7 Explosive profits from small price bars Indecision candlesticks ... Explosive moves from small bars PFSWeb (PSFW). Final Word... Chapter 8 Explosive profits trading price spikes Consolidation pattern price spikes. Ziopharm Oncology (ZIOP)... Green Plains Renewable Energy (GPRE) . Trend reversal price spikes Bollinger band width ..... Air Transport Group (ATRG Fiber Tower CO. (FTWR). Chapter 9 Explosive profits trading reverse price swings Trading reversals using price swings... ; Cliffs Natural Resources(CLF) . Reverse swings Lululemon Athletica (LULU). Trend reversals using failed price swings. Cliffs Natural Resources(CLF) . (Failed reverse swings) Chapter 10 Explosive profits trading price bar pattern Four step Uptrend. Pivot shakeout reversal Narrow range bar continuation pattern . Second day shakeout pattern Out of range three bar reversal. Overlapping wide range bars Price pattern pullbacksTriple bar high reversals... Bullish and bearish reversal zones ‘Two day bar reversal... Tight range bar continuation patter Examples trading price bar pattern Coinstar (CSTR) .. Power One (PWER F5 Networks (FFIV) Croes Inc (CROX) Netezza Corp (NZ). Price pattern classifications .. Isilion Systems (ISLN) ... Atheros Communicaions(ATH) Final Word. 7 Chapter 11 Explosive profits trading falling knives ... A123 Systems (AONE) Power One (PWER) .......- Monolithic Power (MPWR) Trading falling knife stocks using multiple time frames Atheros Communications (ATHR)..... Index reversals using falling knife signals . Dow Jones Index (DJX) . Post signal shakeouts NASDAQ Composite (COMPQ)... Short term trading using falling knife signals VM WARE (VMW).... Chapter 12 Combining fundamental and technical indicators for explosive profits...287 The myth of popular fundamental criteri The RESHE stock filtering system RESHE filtering criteria...... Bullish earning chart patterns Acme Packet (APKT) technical breakout Acme Packet (APKT) pre earnings shakeout Atheros Communications (ATHR) Final Word.. Appendix A Candlestick charting ..... Appendix B Convergence Divergence charts Closing thoughts......INTRODUCTION The question | get asked often is: can anyone learn how to become a successful trader? My answer to this question is both yes and no. Not everyone has the personality traits to be a successful short term trader but everyone can learn how to make money trading the market. If this statement appears contradictory to you, | recom- mend you read the Market Wizards book series by Jack Schwa- ger in which he profiles several highly successful traders. The only common characteristic amongst these traders is their high level of success. Other than that they are quite different in the markets they trade, the time frames they trade in, and the trading vehicles they use. Some are fundamental long term traders, oth- ers are short term scalpers, some trade stocks, others bonds and some trade futures. In essence each uses a trading system that fits their personality and style and has unwavering faith in their system to the point where they “perceive” it as a sure winner over a period of time. The key here is the trader's perception of the system or approach they use. While no trading system is one hundred per- cent profitable, the trader's perception that the system is a sure winner is more likely to give them the confidence to pull the trig- ger rather than hesitate and sit and watch. In my years of leading a local trade group, | have noticed that certain traders are able to pick up a system I present, add their own slight modifications to it, trade it and do very well. On the other hand, some traders are, for some reason, unable to be profitable using the same exact system. This observation peaked my interest especially since the ideas were presented to both at the same time in a similar manner. | wondered whether the successful group had more expe- rienced, more educated, or mathematically oriented members; but | found out that both groups had experienced and inexperi- enced traders with varying backgrounds and education levels. | have concluded after working one on one with selected struggling traders that the reason they are unable to succeed is viitheir desire to be “safe”. This is manifested by their purchase of stocks they perceive to be “sure winners” where the success story is already known to everyone. Their argument is usually as follows “1 want to buy a fun- damentally strong company so that in case | am wrong and the stock goes down, | can hold on since the fundamentals will bring the stock back up”. What | learned is that strong fundamentals mean different things to different traders. Some perceive P/E ratio as the key, others consider revenue or earnings growth, others debt ratio among many other factors. To have the correct attitude towards the market you will need to develop winning habits. You do this not by winning every trade, but by embracing the risk and realizing that you can capi- talize on market opportunities by using sound strategies. You probably heard the saying “Success breeds more success”. The best way to become a winning trader is to put yourself into a state of mind that will reward you again and again. The way to do this is by making money over and over again through rewarding your- self with taking profits as a stock moves higher. This will mini- mize the hesitation to take a trade because of the fear of losing. Remember that the psychological factors are the most im- portant aspects of trading. When you see an opportunity, do you freeze and decide to watch the stock for a period of time, taking action after the move has started?; or do you follow your system and instincts and take on the risks that the crowd is running away from? Remember what | said often, “the crowd is wrong most of the time, especially at major turns”. Actually these statements are not new and that is why many traders buy books on trading psychology to change their losing ways. However, from my experience with the struggling traders | worked with, these books offered little help except for the temporary motivational pick me up that disappeared with the first loss. | have experienced this first hand when working with trad- ers who struggled to achieve profitability using the systems | pre- sented; even though others were able to be highly profitable us- Viliing the same system. For example one trader will not pull the trigger unless the price to earnings ratio of the stock meets his criteria. For that reason he hesitates and waits since he does not perceive the trade as a sure winner unless it meets his criteria of the right P/E. In essence a trader is likely to have a perception of a certain characteristic a winning stock must possess and for that reason, he hesitates to trade stocks that do not fit these param- eters. This observation prompted me to conduct an experiment to see if by changing the trading methodology into one that fits the style of the struggling group of traders, | can improve their profitability. It was my observation, after talking to the majority of struggling traders in my group, that there is quite a bit of hesita- tion to take a trade usually because it does not meet all of their requirements of what they perceive to be a winner. In addition, they were hesitant to enter a trade since they felt a high level of anxiety in determining when to exit. This anxiety is likely to have been brought on by previous market losses that damaged their confidence. My conclusion was that this group of traders is likely to feel more comfortable with longer holding times and funda- mentally sound stocks. The longer holding times will remove the anxiety of having to exit quickly and the fundamental strength of the stock will give the trader the perception of having a “sure win- ner”. | thus formed a new group focusing on “technofundamen- tal’ trading with a holding period of few months and up to a year. In this group we implemented a simple combination of technical and fundamental criteria to take positions after a stock’s earn- ings release. The fundamental aspects are based on the RESHE system | introduce in chapter 12, in combination with three chart patterns that tend to appear near earnings. As a result of using this system, the change in traders level of confidence was phenomenal. They pulled the trigger without hesitation as soon as the technical signal appeared on the chart, since they perceived the stock as a “sure winner’ due to its fun- damental strength and the strict entry criteria. In addition, the anxiety of knowing when to get out was removed since they knew they would not have to exit until few months later in most cases. ixIn the few instances the trade did not work, they had a clear stop as well as an exit strategy included in the system. Thus, by changing the trading method to one that fits these traders personality and style better, the anxiety and hesitation were replaced by confidence that grew with each winning trade. This experiment was so successful that | kept this group going parallel to the original one. Using the methods in Chapter 12 we were able to identify huge winners such as FFIV, APKT, CRM, TSL, GMCR, ISLN, ARUN, and many more. This book offers a broad spectrum of trading techniques that fits the style of almost any type of trader. These methods were selected based on their exceptional results, ease of appli- cation and diversity of approach. | have used these methods in my local trade groups with great success and was encouraged to write this book by group members whose friends wanted to benefit from these trading systems but were unable to join these groups due to limited space. Your success as a trader highly depends on your ability to develop a system that fits your own personality and trading style. If you prefer to merge fundamental with technical param- eters in your trading then Chapters 1 and 12 are for you. Chapter 1 makes use of simple information such as insider ownership, share float etc., while Chapter 12 uses more elaborate balance sheet information. These fundamental criteria are then combined with technical indicators to complete the trading system. For traders whose objective is to scalp in short time frames, | have included several chapters that employ price bar sequenc- es to determine entry and exit points in and out of a trade. These include: Chapter 6 (signal price bars), Chapter 7 ( Small price bars), Chapter 8 (Price Spikes), and Chapter 9 (Reverse price swings). The focus of these chapters is to use open and close prices, price bar ranges, and bar sequences to scalp in short term time frames between few days to a couple of weeks. Price bar formations are also used to determine stops and exit points. lf your preferred trading style is exclusively using technical indicators, | have included several chapters that focus on special setups using unique combinations of technical signals that can xdeliver explosive profits. These include : Chapter 2 (Consolida- tion pattern breakouts), Chapter 3 ( Divergent Signals), Chapter 5 (Momentum Shifts), and Chapter 11 ( Falling Knives). These chapters focus on setups that are well known to deliver big prof- its, and then shows you how to recognize the pattern and time the entry within a short period from an explosive move. For those traders who are fascinated by chart patterns and geometrical shapes such as triangles, rectangles, wedges, etc, | have included two chapters: Chapter 4 (Chart patterns) and Chapter 10 (Price bar patterns). The first chapter focuses on geometrical shapes such as falling rectangles, single and mul- tiple wedges, ascending and reverse ascending triangles and many other powerful not so common shapes. The chapter on price bar patterns discusses powerful major bullish and bearish price pattern sequences and the minor patterns embedded within them. One of my trading group members came up with an idea to use price bar patterns as a litmus test to predict whether a geo- metrical shape chart pattern is likely to result in a price move as expected. For example if you see a bullish ascending triangle pattern, but a bearish micro price bar pattern is embedded within the macro chart pattern, failure of the ascending triangle is very likely. This idea was so successful that | decided to use in my own trading and was able to reduce geometrical shape failures from over 30 percent to below 10 percent. One of the members in my original group had a problem trading stocks he did not perceive as “cheap”. He focused on find- ing stocks that have fallen precipitously, hoping to take a position just before they reversed delivering substantial profits. Unfortu- nately he racked up one loss after another until his confidence was damaged to the point where he could not pull the trigger. He would watch the stock, sit and wait for it to get cheaper, just to see it reverse before he established a position. Essentially, this person was trying to catch a falling knife. After trying without success to convince him to trade with the trend, | decided to put together a system that fits his trading style. This is summarized in Chapter 11 “Explosive profits trading xifalling knives”, and it involves using three technical indicators. It introduces an interesting concept of a narrow channel formation between two of the indicators giving clear entry and exit signals when combined with the third indicator. This method had clear entry and exit criteria and it delivered consistent profits, but most importantly it fit the trader's style by requiring that the stock has dropped at least forty percent from its last peak. This allowed the trader to stay within his comfort zone of trading “cheap” stocks. After using this approach for few months, the trader's confidence improved significantly, due to the consistent profits delivered by this approach. To benefit from this book, | recommend you become pro- ficient in the concepts that fit your own trading style and comfort zone. Learn these concepts well, first by paper trading, and then by trading them in real market conditions. xiiChapter 1 Explosive Volume Based Breakouts Most traders are aware of the importance of volume as a trading tool. A price increase accompanied by heavy volume is seen as an indication of potential further uptrend. Unfortunately, in most cases, volume increases are temporary as are accompanying price increases. How then can we tell whether a volume spike accompanied by a price increase is a sign of a short term sustain- able uptrend? My experience has shown that one of the most important factors is the behavior of the stock before a volume spike oc- curs. Itis essential that the stock shows a flat price and volume behavior before the spike. This is an indication that the stock drew little attention until the volume spike signaling an imbalance between buy and sell interest. This is where my favorite saying in stock market language “from small bars come big moves” comes from. The main reason why most traders miss big moves is that they are asleep not watching when a stock is listless until a sud- den move occurs, at which point they believe they have missed the boat and take no action. While in many cases this may be the right decision, in others, when the right technical and fundamen- tal conditions are present, such a move may just be the tip of the iceberg. In this chapter | will present the conditions that are required for a volume spike to be considered as a real precursor to a com- ing short term move. Some of the conditions | will present are based on logic while others are based on experience.Fundamental requirements can be justified by common sense while technical conditions are mostly based on my trading experi- ence. | will thus explain the reasons behind some, while | will ask that you trust others based on the extensive actual trading over a long period of time. When a stock is under the radar trading low volume with little price movements, there is no way to tell when a high level of interest occurs until a volume spike appears. It is thus not wise to enter a position before such a spike occurs since you can never tell when or if it ever will. The focus of this chapter is to answer whether and under what conditions an entry is justified. Fundamental and “technofundamental” requirements Many traders follow insider buying and selling as a guide to which stocks to trade on either the long or short side. This technique has become quite prevalent to the point where some advisory services are dedicated to following insider moves and then giving recommendations accordingly. The problem with this strategy is twofold: (1) Insiders can at times be wrong and (2) Insiders have a much longer time frame than the average trader. Having said that, insider Participation is still important and we factor that into our criteria by requiring that 10% or more of the company shares are held by insiders. We thus do not care who buys or sells as long as insiders maintain at least a 10% ownership in the 3 months before the volume spike. This is the one purely fundamental requirement necessary for an explosive volume breakout trade. For sudden buying interest to significantly move a stock, there has to be what we call a “share squeeze”. In other words there isn’t enough available shares to buy when sudden inter- est develops, so the price has to be bid up to entice holders to sell. This necessitates that the company has a small number of shares available to trade or a “low float”; ideally the float should be below 35 million shares. A sudden move in a stock on large volume is on occasiona result of news; good earnings report, drug approval, buyout rumors, or analyst upgrade. In most cases smart money has bought before the news and is likely to sell after the news at least resulting in a temporary correction. We thus prefer that the vol- ume spike occurs on no news and is a result of hidden interest by big players in anticipation of things to come. In summary, the fundamental and “technofundamental” require- ments are: (1) Insider ownership of 10% or more of the company’s shares. (2) Low float of no more than 35 million shares. (3) Volume spike occurring on no news. Technical Requirements The effectiveness of this system lies in its simplicity since most indicators are volume and price related with no complex technical signals used. Thus even beginners can apply this sys- tem with the help of a basic scanning software. For sudden buying interest to result in a volume spike that is a precursor to a continued advance, it is essential that any resistance above the spike is low volume. In other words “low overhead” resistance. We require that there is no overhead re- sistance with volume higher than twice the 50 day simple mov- ing average during the last 12 months. We also require that the volume spike results in a price higher than the high in the last 60 days. This is necessary to insure that any significant resistance in the short term is broken. To facilitate the satisfaction of the two conditions above we require that the stock trades low volume, so that even a mod- erate amount of buying will result in a significant volume increase and a price break above the 60 day high. It is preferred that the 50 day moving average of volume before the spike is below 300,000 shares. Such stocks are usually of little interest to big market players, and the only reason they will buy into them is an expectation of a major move as a result of an anticipated change to company fundamentals. This can be in the form of a new prod- uct, a major alliance, coming drug FDA approval or other reasons.In such stocks with low liquidity it is impossible for big players to buy without showing their hand and alerting savvy small traders on what is to come. In summary the technical requirements discussed up to this point are: (1) Low overhead resistance in the past 12 months with maximum traded volume no more than twice the 50 day moving average. (2) Price on spike day above 60 day price high. (3) 50 day volume moving average is 300,000 shares or less. Other technical volume and price requirements listed be- low are based on my experience trading this pattern for over 4 years with great success, these are: (4) Closing price on spike day is above the opening price on the same day. (5) Closing price on spike day is above the closing price ‘on the day before the spike. (6) Closing price on spike day is above $2.00. (7) Closing price on spike day is below $25. (8) Volume after the spike is at least three times the vol- ume traded the day before the spike. (9) 50 day exponential moving average of the volume traded before the spike day is no more than 50% higher than the simple 50 day moving average of that volume. ALERT1: Condition (9) points to a gradual volume increase in most recent days before the spike. This increase was not enough to push the stock above the 60 day high, nonetheless it indicated increased interest in the stock. This assures us that once a vol- ume spike occurs it is unlikely to be temporary due to the build up of buying interest in the recent days. The heavier weighting placed on the most recent time frames is the reason for using the exponential moving average. ALERT2: When scanning for “explosive volume breakout stocks” use your scanning software to narrow the field as much as pos-sible by entering as many of the criteria as the software will allow. Then check each stock and pick the one that satisfies most of the criteria which should be easily done since most of the require- ments are straightforward. Practical Applications First let me stress that stocks that meet all the required conditions do not appear often. In a strong up trending market you can expect to find a solid candidate every couple of weeks, while in a weak market, you may come across only one stock every couple of months. This is why it is critical that you run the screen on daily basis when the market is up trending, while in a downtrend you can use a different scan. The scan | ran on September 15, 2009 produced one ide- al candidate namely Clearfield (CLFD). This was picked from around 10 stocks that came up. Although all of them satisfied the scan parameters, this was the only one that satisfied all fun- damental requirements too. | will thus use this stock to illustrate how this setup is traded under real market conditions. | will also demonstrate how to pick your entry point and when to exit the trade. Trade Candidate (CLFD) Data Shares Float: 8,210,000 (less than 35 million) Total shares outstanding: 11,983,131 Percent owned by insiders: 25.92% (above 10%) Percent owned by institutions: 10.10% Average daily volume traded: 70,500 (less than 300,000) Volume traded day before spike: 90,163 Volume traded spike day: 1,787,182 (more than 3 times 90,163) 50 Day volume exponential moving average: 105,000 (less than 1.5 times 90,163) 60 day price high: $3.46 on 9/2/2009 12 month overhead resistance after spike: None Open price day of spike: $3.17 on 9/15/2009 Closing price day before spike: $3.09 on 9/14/2009 Closing price on spike day: $4.11 on 9/15/2009. (This is greaterthan $3.46 which is the 60 day high. It is also greater than the opening price $3.17 and the closing price the day before $3.09) Price high on day of spike: $4.55 on 9/15/2009 Mid point on day of spike: ($3.17+$4.55)/2 = $3.86 on 9/15/2009 Entry Strategy As can be seen from the chart on page 7 the spike oc- curred on September 15, 2009 and is marked by an X. If as we believe this spike is a precursor to a strong short term move the stock should remain under accumulation. This im- plies that even an intraday drop should not push the stock much below the middle of the price range on the day of the spike. The best way to get a reasonable entry into the stock without “chas- ing” it is to place a limit at 5% above the mid point of the price range on the spike day. This order should be kept open for 3 days. ALERT1: You are probably thinking why not wait for a pullback to a lower price. The stock just moved from $3.17 to above $4 in one day which is a large move by any standard. This in fact is why this trade is called an “explosive volume breakout”. There is little resistance above the spike and even an intraday pullback much below the midpoint is unlikely. Considering that such trades are rare and have a high reward to risk ratio, an entry 5% above the midpoint of the spike insures we get a fill without chasing the stock, With the mid point on spike day at $3.86 we will thus place a limit buy order the next day at 5% above this point or at $4.05. This order was executed on 9/16/2009 or the day after the spike. As common with heavy volume breakouts, the advance continues few days after the spike followed by a correction. In this case CLFD moves above $6 on an intraday spike, and then falls into a corrective pattern. It is thus important to exit the trade while the momentum is pushing the price higher even though we may not exit at the top. For this reason | am proposing the exit strategy below.CLED (Clearfield inc.) Nasdaq OM #eSep2000 0.424 H5.10 L420 C502 V 10M Chg +0.99G20.10%) + W CLED (Daily) 5.02 én ims | sevohine 1015.82 x S z AoExit Strategy using technical indicators Exiting volume based breakout trades is tricky since this is in essence a momentum play. Such trades can reverse quickly with profit dwindling and often turning into a loss. In formulating an exit strategy for such trades, it is critical to keep it simple so a quick decision can be made. Even if some profit may be left on the table, it is better to get out while momen- tum is on our side rather than risk a violent reversal. Technical Indicator Signals After experimenting with several technical indicators, | found that the Commodity Channel Index (CCI) divergent signals are best in deciding when to exit an explosive volume breakout trade. The Commodity Channel Index (CCl) is a momentum indi- cator that measures the location of price in relation to its moving average. The formula for CCI is: CCI = (NP- SMANP)/(0.15*MD) Where: NP = Normalized Price = (High +Low + Close)/3 SMANP = 20 period simple moving average (SMA) of Normalized price MD = Mean Deviation = Sn-1.20(Abs(( SMANP)n — (NP)n)/20 Where: Abs = absolute value n= period 1 to 20. Imagine that the price and its moving average are con- nected by a rubber band. When the price deviates significantly from the moving average due to a strong momentum move, the rubber band becomes over stretched and is likely to snap back. When the CCI moves above +200 the rubber band is over stretched, meaning that the price has deviated significantly from its moving average. Thus a down reversal in price to bring it closer to its moving average is likely. On the other hand when the CCI drops below -200, the rubber band is over stretched to the downside and a reversal to the upside is likely thus snapping back the price closer to its moving average. When the price moves to a higher peak but the CCI formsa lower peak, a negative divergence has taken place. As the price moves higher and deviates away from its mov- ing average, the numerator of the CCI equation becomes larger. If the value of the CCI is to be lower, this requires higher values of the MD. This implies that the sum of the 20 period difference between the simple moving average of the normalized price and the price has a higher value. In other words the price has to be moving closer to its moving average or the over stretched rubber band has to snap back. As you will see in the following examples, CCI divergences are effective exit indicators for momentum trades since they are able to point to a coming price drop before it takes place. Example 1: Clearfield (CLFD) exit strategy 1 As discussed in the entry strategy section, we bought CLFD the day after the spike at $4.05. This was on 9/16/2009, the day after the volume breakout occurred marked by an X on the chart page 7. The CCI / price chart on page 10 clearly demonstrates a negative divergence between CCI and price. Notice that as the price moves from point 1 to point 2 forming a new high, the CCI moves from corresponding point A to point B forming a lower high. Pay attention also to the fact that at point A, CCl > 200 sig- naling an overbought condition and a possible reversal. Our exit should be made the day after a negative CCI divergence occurs at point B. Using this timing technique would have allowed us to sell over $6.00 for a profit over 50%. Example 2: Biotime (BTIM) By studying the CCI / price chart on page 11, it can be seen that the price moved higher from point 1 to point 2 and to an even higher peak at point 3. The price move from point 1 to point 2 was accompanied by a confirming move in the CCI from point A to a higher point B. On the other hand the price move from point 2 to the price peak at point 3 resulted in a CCI negative divergence between points B and C. This is an indication that the price at point 3 has diverged enough from the moving average signaling a likely coming correction.CLED (Clearfield inc.) Nasteq om SHazIOd 9416 H4s0 L390 C401 ¥ 119.9 Chg0.11 62.87%) {dit CCT(20) -56.60 bd B 3 10BTUM GioTine, nc.) Nasdaq 0082000 ‘Oaoe hae Laz? carr ‘¥oroon che. o.7 aes, 1An entry at around $4.00 on a heavy volume breakout and a sell after the CCI divergence signal at around $5.50 would have resulted in a profit of around 40%. Please note that this example was not used as a candi- date in this chapter since all the required criteria were not met. My reason for using it is to demonstrate the effectiveness of the CCI divergence based exit strategy on momentum trades. Exit strategy using trend indicators In my book “Generate thousands in cash on your stocks before buying or selling them” | have presented the three day dif- ference of the five day oscillator as a method to measure short term strength and direction of a price move of a stock. In this section | will demonstrate the utility of this method in exiting mo- mentum type trades. ALERT: | may be repeating some material from the aforemen- tioned book in this section. The reason for this is that my inten- tion is for this book to stand alone, and a trader should not be required to buy the other book just to learn this concept. Momentum trades are notorious for changing direction quickly with profit turning into a loss if a momentum trade is not exited in a timely manner. To avoid getting caught in an often quick and violent pullback, a reliable method for measuring the short term strength and the directional move of a stock is need- ed. This is where the five day oscillator and its three day differ- ence come into play. The five day oscillator generates numbers between zero and 100. Results between zero and 30 are bear- ish, 30 and 70 are neutral and above 70 are bullish. The formula for the five day oscillator is: Oscillator = [(A+B)100]/[(highest price - Lowest Price)2] Where: A= Highest price in 5 days - Open 5 days ago B = Last Day’s close — Lowest price in 5 days To time our exit from a momentum trade accurately, we need to know the direction and speed of the coming move. This is where 12the three day difference of the 5 day oscillator proves its useful- ness. The formula for the three day difference is: Three day difference = value of the five-day oscillator today - value of the oscillator three days ago. A positive value of the three-day difference indicates that the price momentum is still positive while a negative number in- dicates negative momentum. A large number indicates that a substantial move is likely to occur in the future, the direction of which depends on whether the three-day difference is negative or positive. A high positive number decreasing in magnitude as the days pass, indicates that the rally is slowing down and the likeli- hood of the stock entering a consolidation pattern or reversing di- rection. A warning signal is given when the three-day difference changes from positive to negative. A sell signal is given with a second negative reading of the three day difference. ALERT: With momentum trades it is possible that few days of moderate strength are left in the stock after the first negative read- ing occurs. Often you will see low number positive readings for a day or two after the first negative three day difference number is produced. For this reason, and to take advantage of a further moderate price advance, we will wait for a second negative read- ing before executing the sell order. The use of this method will be clearer by studying the fol- lowing example. Example 3: Clearfield (CLFD) exit strategy 2 As indicated in a previous section of this chapter we entered the trade on 9/16/09 at $4.05. To calculate the three-day difference of the five-day oscillator for that day we will need oscillator data starting 9/14/09. This in turn requires price data starting five days before or on 9/08/09. 13The table below shows price data starting on this date: Date Open High Low Close 9/08/09 2.97 3.11 2.63 2.69 9/09/09 2.66 2.91 2.66 2.80 9/10/09 2.86 3.08 2.84 2.90 9/11/09 2.97 3.00 2.79 2.84 9/14/09 2.78 3.09 2.78 3.09 9/15/09 3.17 4.55 3.17 4.11 9/16/09 4.49 4.72 4.25 4.55 9/17/09 4.60 5.20 3.71 4.18 9/18/09 4.24 5.10 4.20 5.02 9/21/09 5.05 5.64 4.89 5.48 9/22/09 5.75 6.09 4.90 5.09 9/23/09 5.24 5.58 5.21 5.52 9/24/09 5.45 5.49 4.60 4.88 9/25/09 4.91 5.48 4.90 5.16 The first step after our entry into the stock is to calculate the five- day oscillator and the three-day difference after the market closes on the trade entry day. Date: 9/16/09 A=4.72 — 2.86 = 1.86 B= 4.55 — 2.78 = 1.77 Oscillator = (1.86+1.77)100/(4.72 - 2.78)2 = 93% As you can see this is a bullish reading . The next step is to calculate the three-day difference for the day of interest. This requires oscillator readings for 9/14/09 and 9/15/09 Date: 9/14/09 A=3.09 — 2.97 = 0.12 B = 3.09 — 2.63 = 0.46 Oscillator = (0.12 + 0.46)100/(3.09 — 2.63)2 = 63% 14Date: 9/15/09 A= 4.55 - 2.66 = 1.89 B=4.11 - 2.66 =1.45 Oscillator = (1.89 + 1.45)100/(4.55 — 2.66)2 = 88% This provides the data to calculate the three-day difference of the five day oscillator for the day of interest or 9/16/09: Three day difference for 9/16/09 = 93 — 63 = 30 We will repeat the above calculation for each closing day after 9/16/09 while we are holding the stock. We will watch for the three day difference moving below 10 or turning negative which is our signal to get ready to exit. Date 9/17/09 A= 5.20 - 2.97 = 2.23 B= 4.18 — 2.78 = 1.40 Oscillator = (2.33 + 1.40)100/(5.20 — 2.78)2 = 77% Three day difference for 9/17/09 = 77 — 88 = -11 Date: 9/18/09 A=5.20 — 2.78 = 2.42 B = 5.02 — 2.78 = 2.24 Oscillator = (2.42 + 2.24)100/(5.20 — 2.78)2 = 96% Three day difference for 9/18/09 = 96 - 93 =3 a 9/21/09 Oscillator = — (2. 47+ 2. 31)100/(5.64 — 3.17)2 = 97% Three day difference for 9/21/09 = 97 — 77 = 20 Date 9/22/09 A=6.09 — 4.49 = 1.60 B=5.09-3.71 = 1.38 Oscillator = (1.60 + 1.38)100/(6.09 — 3.71)2 = 62% Three day difference for 9/22/09 = 62 — 96 = -34Date 9/23/2009 A=6.09 — 4.60 = 1.49 B=5.52 —3.71 = 1.81 Oscillator = (1.49 + 1.81)100/(6.09 — 3.71)2 = 69% Three day difference for 9/22/09 = 69 — 97 = -28 We can represent the data in the following table : Date 5 Day oscillator 3 day difference 9/14/09 63 9/15/09 88 9/16/09 93 +30 9/17/09 7 “11 9/18/09 96 +3 9/21/09 97 +20 9/22/09 62 “34 9/23/09 69 -28 Notice that the first negative reading was registered on 9/17/09 giving a warning signal to be ready to sell after another negative reading occurs. For two consecutive days after that we had a positive reading indicating that there is still carry over mo- mentum strength likely to push the price higher. However on 9/22/09 the three day difference turned highly negative giving us a confirmed sell signal on 9/23/09. Assuming we exited at the day's average price, our exit would have been at $5.40 which is a 33% profit from our entry point at $4.05 in 6 trading days. 16Chapter 2 Explosive Consolidation Pattern Breakouts Everything good must come to an end and it is no different with stocks. A trending stock is likely to eventually run out of steam and reverse or settle into a non trending or consolidation pattern. It is these patterns that offer the astute trader a significant profit opportunity. Breakouts from consolidation patterns are usually quite powerful and last for a good amount of time. The key to profiting from consolidation pattern breakouts is dependent on being able to predict the direction and timing of the move. A consolidation pattern can be a pause before the previous trend continues or a warning of a reversal and start of a new trend. Furthermore, a stock can remain in a consolidation or basing pattern for weeks or months before any significant break- out occurs. In this chapter | will present a combination of technical in- dicators that can predict the timing and direction of an impending breakout with a high degree of accuracy. Introduction It is essential for this approach to work that the stock be in anon trending state. In other words it should continually oscillate between support and resistance never breaching them by any significant amount. An example of a trendless stock is MTXX with the chart shown on page 18. Notice that after a large gap down, the stock setiled between two lines, defining support and resistance. It is also worth noting that the stock has been stuck in this pattern for 17: MEO alate be) 2} Rasdaq Rootaninae cop tha dco niles 8% 22 Jub 13 20 27 Aug 10 18 "F248 =e 1a 2over three months. This emphasizes the importance of a reason- ably accurate timing tool to avoid your trades turning into dead money for a while. In addition, the conditions | present in this chapter are suf- ficient but not necessary for a breakout to occur. In other words a breakout can materialize without these technical signals being present, however, a consolidation pattern breakout will almost certainly take place if these signals are triggered. In the last chapter | showed how a trader can capitalize on breakouts from a non trending base by recognizing and trading volume spike breakouts. While this is a useful technique it does have inherent limitations. These are: (1) Breakouts that occur without a volume spike are com- pletely missed. Considering such breakouts are com- mon, it is important for any serious trader to be prepared to capitalize on them. (2) Volume based breakouts decrease the time spent in a trade and thus offer the advantage of quicker profits. This, however, comes at a cost of giving up a percentage of the return which can be at times quite high. (3) the number of candidates found is limited due to the highly restrictive fundamental and technical conditions imposed. While these conditions are essential to avoid getting into a false volume breakout, they tend to signifi- cantly limit the number of trading opportunities. The techniques in this chapter can spot non volume based breakouts and thus offer more trading opportunities. This comes at the price of having to stay a few weeks longer in the trade. Thus the strategies in this chapter should be viewed as an ad- dition to your trading arsenal and complementary to the volume based breakout discussed earlier, rather than a replacement for it. To be a successful trader you need as many arrows in your trading arsenal as possible, to be able to identify trading op- portunities in any kind of market. You should keep this in mind as you continue reading the remaining chapters in this book. 19Technical Indicators As | discussed previously, to successfully trade consolida- tion breakouts we need to: (1) Accurately predict the direction of the breakout and (2) Predict timing of the breakout within a reasonable time window, prefer- ably within no more than few weeks of its occurrence. It is logical to assume that as more and more money flows into a stock in a consolidation pattern; it is more likely that a break out of the pattern to the upside will occur. The flow of money is the product of price and volume and shows the demand of a security at a certain price. There are several types of money flow indica- tors including: Chaikin Money Flow (CMF), Money Flow(MF) and Money Flow Index ( MFI) among others. Based on my trading experience the technical indicator most useful in assessing the direction of the breakout from a con- solidation pattern is the Money Flow Index (MFI). The MFI is a volume weighted relative strength index. It compares today’s average price to yesterday’s average price then weights the average price by volume to calculate the money flow. The ratio of the cumulative positive and negative money flows are then normalized to be in a scale of 1 to 100. The Money Flow Index MFI formula is: MFI = 100 — (1/(1+MR)) Where MR= Money Ratio MR = Positive Money Flow / Negative Money Flow Where: Positive Money Flow = Sum of money flow for the specified periods where the normalized price increased. Negative Money Flow: Sum of money flow for the specified periods where the normalized price decreased. Normalized Price = (( Day high + Day open + Day Close)) / 3 The MFI is available on most stock trading software and on many free stock charting websites. The technique | use is an MFI trend line break signaling a reversal. This will be clearer as you read the trade examples later in this chapter. One of the most difficult challenges a trader faces is to be 20able to predict the timing of a move before it actually occurs. Stock movements are never one hundred percent predictable and they will never be as long as peoples’ emotions are involved. What | will present here is a timing indicator that has demonstrated its effectiveness in predicting consolidation pattern breakouts within few weeks of their occurrence. This indicator is especially potent when combined with the MFI as a directional signal. The indicator of choice is the Mass Index (MI) which is the 25 day moving sum of the ratio of two moving averages. The first moving average is an exponentially smoothed moving average of the daily close. The second is the first moving average smoothed a second time. Values over 25 indicate a widening range while values below 25 indicate a narrowing range. The calculations for the Mass Index (MI) are as follows MI = En=1...25 (Rn/Ln) Where Rn = 0.8(Rn-1) + 0.2(PR) Ln = 0.8(Ln-1 ) + 0.2(Rn) PR = Today’s price high — Price Low Rn-1 = Yesterday’s Rn Ln-1 = Yesterday’s Ln The mass index measures the narrowing and widening of the average range between the high and low prices. When the value of daily ranges begins to increase the value of the numera- tor increases faster than the denominator and the ratio will be larger than 1. The 25 day moving sum will then become larger than 25. As the range narrows the opposite happens and the de- nominator increases faster than the numerator allowing the sum- mation to start moving below 25. Thus as the range widens the MI increases, and it decreases as the range narrows. A “reversal bulge” occurs when a 25 period MI moves above 27 and then falls below 26.5. The signal of an approaching trend reversal is triggered when the MI moves below 26.5 after the formation of the bulge. Combining the Mass Index timing signal with the Money flow index directional signal, permits the trader to anticipate the direction and timing of breakouts from consolidation patterns with 21reasonable degree of accuracy. A trading signal is usually triggered within few days to few weeks of an explosive move allowing the trader profits of more than 50%-300%+ in a relatively short time. | do realize that this combination of technical indicators may not be common, however, | have used it in my trading for many years with highly profitable results. As a result | strongly recommend you add this strategy to your trading arsenal. Practical Applications Before discussing specific trade applications, it is impor- tant to re-emphasize two points | discussed earlier in this chap- ter: (1) Breakout from consolidation patterns can still take place without the signals discussed in this chapter being triggered. (2) After a trade signal is triggered, the breakout may ma- terialize within few days to few weeks of trade entry. In most cases the high reward to risk ratio, as well as the significant profits achieved justify the wait. One way to find such stocks is to program the Mass Index and Money Flow Index trigger conditions into a scanning soft- ware. Unfortunately, except for few selected screening programs, such capabilities are not readily accessible. An easier way, which is the one | use, is to place any stocks you find in your scan that are in a non trending pattern on awatch list. Once the conditions in this chapter are satisfied, you can enter your trade. Three Easy Steps to a trade (1) Get ready Once you find a stock in a consolidation pattern for more than 15 trading days place it on your watch list. The chart for stocks on this list should be revisited every other trading day. (2) Get Set When the Mass Index (Ml) crosses over 27, place the stock on a daily watch. Look for the formation of the characteristic “reversal 22bulge” and the subsequent MI crossing below 26.5 (3) Trade or drop Once the MI drops below 26.5 after forming the “reversal bulge” check if the Money Flow index (MFI) has broken above its down- trend line. If that occurred, then enter the trade otherwise look for another candidate. These steps will be clearer once you study the following exam- ples. Example 1 : Clearfield (CLFD) | have intentionally picked the same example used in the previous chapter to demonstrate volume based breakouts. This will permit comparing the two trading strategies and highlighting the features of each. The chart on page 24 shows the price in the middle sec- tion with the Mass Index (Ml) on the top part and the Money Flow Index (MFI) on the bottom part. To time trade entry we will follow the three easy steps outlined in the previous section. Get Ready: The stock is obviously a good candidate since it has been in a non trending pattern for at least 15 trading days. Dependent on when the stock was identified, it could have been placed on a watch list anytime from the beginning of May to late June 2009. Get Set: The Mass Index (MI) crossed over 27 early July at point A, at which time the stock should be placed on a daily watch. Few days later the “reversal bulge” formed at point B. A couple of weeks later around the middle of July, the stock cross- es Ml=26.5 near point C. At this point the Mass Index conditions have been satisfied and the attention should shift to the Money Flow Index. Trade trigger: The Money Flow Index (MFI) downtrend line was broken at point D which occurred right after the Mass Index (MI) crossed below 26.5. This triggers a trade at the cor- responding price X near the end of July. Our entry point is at $1.65. As you can see the stock took almost 30 days to get to 23Clesrtintd(eAto) 1260 Prev Closess i th 6.9-Me5.A9 14.60 054.09 ¥e 706947 | ees 24$2.50, but then the advance accelerated quickly and the stock eventually hit $6.00 before pulling back. ALERT1: This clearly shows the trade off between the method described in the last chapter and this one. Using the volume based breakout we entered around $3.85 with a move to $6 in four days. Using the concepts in this chapter we entered at $1.65 but had to wait almost two months to get to $6.00. ALERT2: Remember that the strategies in this chapter can iden- tify consolidation pattern breakouts that DO NOT show a volume spike. In such cases the strategies discussed in the first chapter will fail to identify such moves and thus limit the choice to strate- gies discussed here. Example 2: Dataram Corp (DRAM) This example was chosen to demonstrate the high degree of reliability of this trading strategy. As this example will demon- strate, the Money Flow Index (MFI) can oscillate between positive and negative after our trade entry without affecting the outcome of the trade. As long as you stick to the rules of entry you will be in a high reward to risk trade. The chart on page 26 shows the price in the middle sec- tion with the Mass Index (Ml) on the top part and the Money Flow Index (MFI) on the bottom part. To time trade entry we will follow the three easy steps outlined in the previous section. Get Ready: The stock was stuck in a trading range bound by defined support and resistance starting the beginning of May and until middle of June. It is a good candidate to place on our watch list within this time frame. Get Set: The mass Index (MI) crossed 27 at point A, at which time the stock should be placed on daily watch. The “reversal bulge” was formed at point B, and subsequently the MI crossed below 26.5 near point C. This satisfies all MI conditions for the trade setup and our focus should now shift to the Money Flow Index. Trade Trigger: The money flow index (MFI) broke the downtrend 2526line few days before the point D. It is important however to wait until the MI crosses the 26.5 mark (just below the 27 line) to take the trade. For this reason our entry point is few days after the MFI trend line was broken. Our entry point is at the correspond- ing price X around $1.50 in mid July. Again as you can see we had to wait 45 days for the price to move to $2.50. As occurred in the previous example the price advance accelerated moving above $4 within a couple of weeks after that. From our initial entry in mid July at $1.50 until the stock moved above $4 required that we stay in the trade for 9 weeks. While this may seem long if you are a swing trader, in most cases the profits realized are well worth it. | bet many traders will wish they can find few trades that can deliver a 250% profit in 9 weeks. Notice that after our entry the money flow went through a couple of up and down cycles. The price however was not affected much and the price advance continued. This is a testimony to the high level of reliability of this strategy. lam sure you are wondering whether this strategy is 100% reliable. As | said before there are no holy grails in the market and this is no different. If the Money flow index breaks an uptrend line after trade entry, this is only a sell signal if the Mass Index has passed through 27.00 formed a reversal bulge and then crossed the 26.5 mark. If you have entered a trade and see this then you should exit. Notice however, that in our second example, the two occa- sions DRAM breaks the MFI uptrend line were not accompanied by the MI reversal bulge described above. This dictated that we stay in the trade and the result was a profit of over 250%. In my experience trading this pattern for many years, | have come across no more than a handful of situations where an exit was necessary. Momentum Driven Breakouts As indicated in the beginning of this chapter, a consolida- tion pattern is essentially flat with the bottom defined by a horizon- tal trend line. While prices may be higher for few days and lower for few others, they are essentially confined to a trading range 27within a boundary limited by two flat horizontal trend lines. In es- sence, the desire to own a stock by some investors is balanced by the unwillingness of others to sell unless the price reaches the upper boundary. Conversely, the desire to sell the stock by some participants is matched by others unwillingness to buy unless the price is close to the lower boundary. An early indication that a stock may be a momentum driv- en breakout trade candidate, is a steady accumulation as prices rise slowly resulting in a trend line slope change. The trend line previously flat is now climbing steadily at around a 30 degree angle indicating that smart money believes that some good news is on the horizon. This is the accumulation phase and can last from as little as a week to as much as a year. As accumulation continues and the rise slowly accelerates, momentum players enter propelling the stock higher. This is usually triggered by news of better earnings, drug approval, or an important business deal. The trend line turns up with a steeper angle of ascent at 45 to 60 degrees on heavy volume. This is usually the start of the momentum driven consolidation pattern breakout. As short to intermediate level traders, entering during the accumulation phase, while profitable, may require a long time in the trade before a significant rise occurs. Our goal is to enter the trade as soon as an imminent signal of a momentum based breakout appears on the chart. This is usually indicated by a significant increase in volume with a pull away from the original trend line eventually establishing the 45-60 degree angle trend line previously alluded to. We should enter the trade on a pull back from the initial momentum spike to the newly established trend line. As any trader knows, momentum trades tend to be highly rewarding since the profits are usually quick after entry. This is the case as long as the profits are taken before a momentum shift against the trade takes place. It is thus essential to have a simple exit strategy to get out with near maximum possible profits. Dur- ing my experience trading momentum moves, | have found that using a simple exit technique with three parallel trend lines serves this purpose well. Even though a trader is not likely to catch the 28high, exit is usually signaled within few percent of the high giving the trader the bulk of the profits. The first trend line is drawn at the beginning of the forma- tion and often coincides with the 45-60 degree sloping trend line during the initial stages of the momentum break out phase. The second trend line is drawn parallel to the first by connecting two of the highest price points before the major momentum spike oc- curs. These points occur within the first quarter of the formation due to initial small price spikes after which the trend line is tested. The third trend line, also known as the sell signal line, is drawn above the second trend line and parallel to it. The distance be- tween the third or sell signal line and the second should be the same as that between the second and the first. Note that the third line is determined by just measuring the distance between the first two lines, extrapolating it from the second line, and then drawing a parallel line. This is independent of what price points the sell line intersects. The sell signal is given when strong momentum drives the price above the third, or sell signal line, and then back towards it. Trading momentum based consolidation breakouts will be clearer when studying the following examples. Example 3 : Clearfield Inc (CLFD) This is the third time | have used this example to show that when a stock is likely to make a strong move, there are many ways an astute trader can recognize the potential and enter the trade. In this case recognizing a likely momentum breakout would have allowed an entry at the early stages of the advance resulting in a handsome profit. As can be seen on the chart page 30, the slow accumula- tion phase defined by the lowest trend line lasted for almost three months. Suddenly a volume spike V on the chart resulted in a price spike to point 2 and a subsequent pullback. Another vol- ume spike in early June with a pullback took place followed by a third volume spike in late June resulting in a price move to point 8 and a retest of the new steeper trend line. This trend line has a 29CLED (Clearfield inc.) Masdaq ob 46-Oetznng ©0468 H490 L452 € 4.90 V 207.0K Chg +021 445%) WECLED (Daily) 4.90 (50) 344 30steeper angle of ascent than the original line indicating the start of a momentum move. Our entry point will be on a pullback from the spike at point 8 to the trend line defined by points 1, 4 or at around $1.50 in early July. It is important to note that the volume spikes defined by points V on the chart may seem small, but they are significant as a percentage of the volume traded on the prior day. As an example, the volume traded on June 24 was 3900 shares, but on June 26 it was 36,780 shares and on June 29 it was 31,501 shares, which is almost a 900% increase. This is a clear indica- tion that there is something about this stock, that normally trades only few thousand shares a day, attracting buyers. Days of low volume followed by days of higher volume then a pullback to the trend line with low trading volume again, are a clear sign of ac- cumulation by smart money. The new trend line 1, 4 now defines the momentum ad- vance phase. The second trend line shown as 2, 8, 5 is drawn connecting points 2 and 8, which are the price advances result- ing from the corresponding volume spikes. These sudden price moves are followed by a retest of the new trend line 1, 4. The third or sell signal line is drawn parallel to the line 2, 8, 5 with the distance from point 2 to point 3 equal to that from 1 to 2. The sell signal is activated as the price passes the sell line at point 6 and then reverses back towards it. This takes place near point 7 at a price of around $4.50 for a profit of 300%. While we did not get out at the top near $6.00 we made a handsome profit using a very simple sell strategy. If we have held the stock not knowing when to get out, most of our profits would have evaporated since as of the day of writing this section the price was around $2.60. Many traders shy away from such low volume stocks since they believe that these stocks are easily manipulated by big in- stitutions. While this is true in some cases, trading such stocks can be highly profitable if you can recognize legitimate signs of accumulation by smart money. This kind of accumulation is char- acterized by multiple volume spikes with accompanying price in- creases followed by pullbacks to an established positive sloping 31trend line. This is smart money’s way of slowly accumulating shares without being detected. On the other hand, extreme volume increases with a para- bolic price spike is usually a trap to get small investors to buy into a stock while smart money is selling. It is thus advisable not to trade such stocks on the long side and wait for a pullback. If this is a setup to distribute shares to unsuspecting small investors, the pullback is likely to break below the pre established trend line. In such cases the trade is better avoided. Volatility Driven Breakouts Another approach to trading consolidation pattern break- outs is by recognizing the changes in volatility and the ensuing breakout. When a stock settles into a consolidation pattern, a significant reduction in volatility is evident. Volatility increases as a potential breakout gets closer. A common indicator that measures volatility is the Aver- age True Range (ATR) which is briefly discussed below. Average True Range (ATR) Average true range (ATR) is the average of true ranges (TR) over a specified period. The true range for a specified period is de- fined as the greatest of the following: (1) (H)p- (L)p (2) Abs[(H)p — (C)p-1] (3) Abs[(L)p — (C)p-1] Where H = high, L = low, C = close, P = current period, Abs = Absolute Value In cases (2) and (3 ) it was necessary to use absolute val- ues to insure a positive number. Such situations arise with either a gap down or up, whereby the previous close is greater than the current high in case of a gap down or lower than the current low in case of a gap up. The Average True Range (ATR) reflects the volatility of a stock which usually decreases during a consolidation period, but does not provide information on the direction or timing of the break. 32To be able to predict the direction of the break we will use Chaikin Money Flow (CMF). For a bullish breakout we require that the Chaikin Money Flow show the following properties: (1) CMF remains above the zero line for at least seventy five percent of the duration of the consolidation period. (2) CMF shows a clear uptrend starting at the beginning of the consolidation period and until the breakout occurs. (3) CMF is at 0.1 or higher at the breakout point signifying heavy accumulation. As indicated previously, the volatility as measured by the Average True Rage (ATR) trends downward during the major part of the consolidation period. At some point during the latter stages of consolidation, the ATR starts trending higher indicating a nearing breakout. This is the first signal that a viable trade en- try is close, The final trigger is given when the price breaks above the 30 period price channel with CMF at or above 0.1. The trade is taken on the first close above the channel assuming the ATR and CMF conditions are also satisfied. Trading consolidation pattern breakouts using volatility shifts is best used in cases where the consolidation pattern is more likely to be in a pause before the previous trend resumes. Based on my trading experience this method is less effective in cases where the consolidation pattern is more likely to be a trend reversal. Also this strategy is more likely to yield significant and sustainable profits when utilized in the longer or weekly time frame. As will be demonstrated in the following example, profits of more than one hundred percent are often possible. Example 4: Green Mountain Coffee Inc (GMCR) By examining the chart page 34, it can be clearly seen that volatility as represented by the Average True Range (ATR) is trending down between points A and B corresponding to price points 1 and 2. Notice that the chart between points 1 and 2 falls within the 30 week price channel defining the consolidation pat- tern. While the volatility was trending lower, the money flow as represented by the Chaikin Money Flow (CMF) was moving high- 33SED Koren ere tng.) Nasdaq GS. 56.4) Volume 4.1m Chg +295 4.94%) eMay2000 “ATREA4) 4,296 46. 35 SWGMCR (Weekly) 55.49 e 5.4 Ace CHANG) 1.55 ~ $6.23 ~ 55 aie 0 46 ad 23er between points D and E corresponding to the consolidation pattern. Between points B and C corresponding to price points 2 and 3, the ATR started trending higher indicating an increase in volatility signaling that a price breakout from the 30 week chan- nel is imminent. The breakout from this channel on closing basis occurs at point 3 with CMF reading around 0.2 at corresponding point F. This gives the final signal to pull the trigger at around $30. As with such types of trades, the stock moved quickly to $55 and kept moving steadily higher, although at a lower pace. At the time of this writing (1/6/2010), the stock is trading at $83. 3536Chapter 3 Explosive Profits Trading Divergent Signals Technical indicators are divided into two major kinds: price based indicators and volume based indicators. Price based indicators include simple and exponential moving averages (SMA and EMA), Moving average convergence di- vergence (MACD) and its histogram, Average directional Move- ment (ADX), Stochastics (STO) and Relative strength index (RSI) among several others. Most of these type indicators involve some form of math- ematical manipulation of price and/or its moving averages. Volume based indicators include Chaikin Money Flow (CMF), Williams accumulation/distribution (A/D), On Balance Vol- ume (OBV), Finite elements volume indicator (FVE), and Money flow index (MFI) among others. These are usually a mathemati- cal representation of intraday or from one day to the next price volume relationship. Price based indicators are themselves divided into two ma- jor types: Ones that use some form of the Simple moving average in their formulas such as Stochastics (STO), and others that are based on exponential moving average such as Moving average convergence divergence (MACD) and its histogram. Volume indicators are also divided into two major classifi- cations: One that uses intraday price action in combination with volume to decide whether money is flowing in or out of a stock. Such indicators include Chaikin money flow (CMF), Williams ac- cumulation distribution (A/D) and Finite elements volume indicator (FVE). The other types of volume indicators use price variations 37from one day to the next in combination with volume to decide the direction of money flow. Such indicators include On balance volume (OBV) and Money flow index (MFI) among others. In es- sence these indicators use today’s price relative to yesterday's to decide whether money is flowing in or out of a security, while ignoring intraday price fluctuations. Most traders are familiar with complete basic divergent sig- nals which occur when a technical indicator is trending in the op- Posite direction to that of price. A bullish divergence takes place when the indicator is forming higher lows or shallower valleys, while the corresponding price is forming lower lows or deeper valleys. A bearish divergence occurs when the indicator is form- ing lower highs or shallower peaks, while the corresponding price is forming higher highs or higher peaks. Thus when the price makes a new high but the indicator forms a lower high, this indi- cates a pending down reversal. An impending upward reversal is signaled when the price establishes a new low but the indicators form a higher low. In addition to the above well recognized divergences, there are partial basic divergences and full as well as partial complex divergences that offer profitable trading opportunities but are not often recognized by the average trader. The following section touches on such divergent signals. Partial basic divergences The two conditions below signal a down reversal after an advance: (1) Price makes a new high but the indicator forms a dou- ble top, where the indicator’s new peak is equivalent in height to the prior peak. (2) Price forms a double top but the indicator forms a low- er high rather than a double top or a higher high. The two conditions below signal an upward reversal after a decline: (1) Price makes a new low but the indicator forms a dou- ble bottom. The indicator’s new valley is equivalent in 38depth to the prior valley. (2) The price makes a double bottom but the indicator forms a higher low rather than a double bottom or a lower low. A schematic of Partial Basic Divergences is presented on page 40. Complex Divergences As in the case of basic divergences, there are complete as well as partial complex divergences. Some of these divergences are commonly encountered while others are uncommon or rarely seen. Common complex divergences (1) The price makes triple new highs while the indictor makes a double top then a lower third high. This is a signal that the advance is about to come to an end and reversal is in the cards. (2) The price makes triple new lows while the indicator forms a double bottom followed by a third higher low. This is an indication of an ending decline phase and likely upward reversal. (3) The price makes a first new high followed by a higher double top while the indicator forms three lower highs. This is an indication that the uptrend is becoming exhausted with potential downward reversal. (4) Price makes a first new low followed by a double bottom while the indicator forms three lows with each forming a higher valley than the one before. This is an indication that sellers are getting exhausted and an upward reversal is likely. (5) Price makes a first new high followed by a double top while the indicator forms a first double top followed by a lower high. This is a warning of a possible down reversal. (6) Price makes a first new low followed by a lower double bottom while the oscillator forms a double bottom 39Partial Basic Divergences Price NM Price j~ 2. Indicator [* Indicator VN Bearish Price Price VV 1. 2. Indicator \a/ Indicator \W Bullish 40followed by a higher valley. This is an indication of a potential upward reversal. A schematic of Common Complex Divergences is pre- sented on page 42. Uncommon Complex Divergences (1) Price forms three new highs while the indicator forms three lower highs resulting in a triple negative diver- gence. This is an indication of a strong bearish trend reversal. (2) Price forms three new lows while the indicator forms three higher lows resulting in a triple positive divergence. This is an indication of a possible strong bullish reversal. Triple positive and negative divergences are very power- ful reversal signals as will be demonstrated in the exam- ples later in this chapter. This is especially the case when such divergences are seen in both price and vol- ume based indicators for the same stock. (3) Price makes three new highs while the indicator forms three peaks of the same height or a triple top. This is an indication of a likely bearish reversal. (4) Price makes three new lows while the indicator forms three valleys of the same depth or a triple bottom. This is a signal of a likely bullish reversal. (5) Price forms three new highs while the indicator forms anew high followed by a lower double top. This is an indication that the advance is getting over extended and is likely to reverse. (6) Price forms three new lows while the indicator forms a new low followed by a higher double bottom. This is a signal that the price decline is nearing an end anda potential advance is in the cards. Conditions 3-6 occur very infrequently but if you recognize them when they do, you are likely to be rewarded with a hand- some profit. 4Common Complex Divergences ‘nae we * Price ‘ z indicator JW, Indicator Indicator Price Ae: ay 5. a. indicator JN moe £5 42% § Bearish Bullen 42A schematic of uncommon complex divergences is pre- sented on page 44. Many different books discuss such divergences, each fo- cusing on a specific indicator often claiming that it gives more teliable divergent signals than others. On many occasions such claims are expected to be taken at face value without being sub- stantiated with logical explanations and supported using real trad- ing examples. This chapter focuses on how to appropriately select com- binations of technical indicators to insure a high probability of explosive profits. In addition the importance of using multiple divergences within the same indicators to avoid false signals are discussed. Guidelines to trading divergences for explosive profits As | indicated previously, many books discuss using diver- gences of selected indicators as trading tools. In this chapter the focus is on appropriately selecting the right combinations to zero in on trade setups that insure a high degree of profitability while at the same time minimizing whipsaws and false signals. The guidelines below are derived from my trading experi- ence using divergences for many years. Not surprising these guidelines are supported by logical interpretations of the indica- tors used. Follow these rules and you will increase your batting average significantly trading divergences: (1) Trade when two appropriately selected indicators trend in an opposite direction to that of price. One indica- tor divergences are prone to false signals and using a well selected second confirming indicator significantly reduces such occurrences. (2) When using price based indicators trade only triple divergences where both indicators form three consecu- tive peaks or valleys trending in the opposite direction to that of price. Double divergences are notorious for failures often resulting in a third divergence. Remember the “rule of threes” mentioned in my previous book “gen- erate thousands in cash on your stocks before buying or 43Uncommon Complex Divergences Price We Brice Mn, 1 2. Indicator \WV Indicator NAA Price we c" Any 3. Indicator pe Indicator \AWV ee oo Wa, 5. a: indicator tacaton A, \JVWV Bearish Bullish 44selling them, Third edition“. A similar argument can be made here in that it is very unlikely a triple divergence will fail resulting in a fourth divergence. Although triple diver- gences do not occur often, trading them will result in an extremely high reward risk ratio and a high probability of a significant amount of profit. (3) When using volume based indicators look for trend di- vergence from price. Most volume based indicators do not form well defined peaks and valleys as price based indicators do, so your goal is to find the indicator trend line moving in the opposite direction of the price trend line. A bullish divergence is formed when a price down- trend line is countered by a volume indicator uptrend line. A bearish divergence is formed when a price uptrend is countered by a down trending indicator. (4) Do not use volume based indicators alone in trading divergences. To avoid false signals, combine a volume based indicator such as Chaikin Money Flow (CMF) with a price based indicator such as MACD histogram. First look for a trend line in the volume indicator opposite to that of price, then use the triple price divergence as confirmation. (5) Avoid using indicators that give similar information. As an example, Stochastics (STO), Williams %R, and Relative strength index (RSI) are permutations of the same kind of indicator. It is thus important when selecting indicators to review the mathematical formulas to be sure you are not in effect using the same indicator twice. Al- though there are scores of indicators, many of them are similar in nature or use similar price parameters. It is thus essential for successful trading, especially when using divergences, to check the formulas out that are readily available in most cases. (6) Avoid using indicators that emphasize similar time pe- riods. In other words combine one leading indicator with another that lags behind it. 45To understand this rule better, when looking at a price based indicator, you can think of an exponential moving aver- age based price indicator as a leading indicator. While a Simple moving average (SMA) based indicator is a lagging indicator. Re- member that the EMA places more weight on recent data while the SMA places equal weight on all data in the period of interest. All volume based indicators are considered leading indica- tors when compared to price based indicators. The reason for this is that volume signals often precede price movements. Within volume indicators, the ones that are based on in- traday price data are considered leading indicators while those based on today’s price data in relation to yesterday's (inter day) price data are lagging indicators. Examples of leading indicators include Chaikin money flow (CMF) which bases calculations on the intraday price midpoint to decide whether the stock is under accumulation or distribution. Finite volume element indicator is another leading indicator that uses the arithmetic average of the intraday high, low and close, known as typical price, to decide whether money is flowing in or out of a security. Examples of lagging indicators are On balance volume (OBV) and Money flow Index (MFI), both of which base money flow calculations on inter day price comparisons, i.e, to- day’s price in relation to yesterday's. Practical Applications In the remainder of this chapter | will present examples from my trading diary on how these concepts are used. Most of the technical indicators used are common with information and mathematical formulas on them available on numerous free inter- net sites. Divergences Using Price Based Indicators In this section | will present a couple of examples on how triple divergences using two well known price based indicators can predict price movement. As mentioned in the previous guide- lines, it is necessary that the two indicators used are: a leading in- dicator usually based on the exponential moving average (EMA) 46and a lagging indicator usually based on the Simple moving av- erage (SMA). The following examples clearly demonstrate the usefulness of this approach utilizing MACD histogram as leading indicator and Stochastics (STO) as lagging indicator. ALERT1: The descriptors leading and lagging are usually used in relation to price, meaning that a leading indicator would give a signal before a price move occurs, while a lagging indicator gives a signal after the price move takes place. My use of these terms is in relation to the time period being stressed by the indica- tor. The MACD histogram is leading in time since it places more weight on most recent data thus signaling the move earlier. On the other hand stochastics lags in that all data points in the period of interest are equally weighted. Example 1: Ballard Power Systems (BLDP) The chart page 48 shows the price trending down between mid July and early September 2009. The top portion of the chart displays the Stochastics (STO) showing higher lows at points 1, 2 and 3. The MACD histogram is represented in the lower part of the chart showing less negative values or shallower valleys at points A, B and C. Thus while the price was trending down we had both indi- cators the MACD histogram leading indicator and the Stochastics lagging indicator showing triple bullish divergences from the price. Three consecutive higher lows were formed by both indicators as the price trended lower. As you can see from the chart the price advance acceler- ated once the downtrend was broken. If we entered when both indicators showed the third divergence at points 3 and C corre- sponding to a price of around $1.75, we would have a significant profit in less than 10 trading days. 477 hag 2 24 Sapo 4 2 2 a ACD(A2.26,5) Hist 0.069” 48Example 2: Cousins Properties Inc (CUZ) By examining the chart page 50 you can clearly see the triple divergence between Stochastics (STO) shown on the top portion of the chart and price. The lower arm of the triangle on the price chart is trending down while the STO is forming higher lows at points 1, 2 and 3. A similar situation is manifested by the MACD histogram at points A, B and C forming a triple divergence in relation to price. As the price moved down, the valleys at A, B, and C became shallower. Notice that our entry price corresponding to point C on the MACD histogram is around $7.5 which is slightly lower than the price corresponding to point 3 on the STO chart. The reason is that the MACD histogram is based on EMA calculations that stress recent data and thus signals a possible move earlier. If we entered at $7.5 based on the triple divergence signal we would have achieved a profit of near 15% in eight trading days. My experience shows that more than 90% of the trades using triple MACD and histogram divergences are profitable. Also, almost 60% of the trades result in significant price moves giving explosive profits of more than 50% within two to three trad- ing weeks. Be sure you are always looking out for such trade setups. Divergences using both Price and Volume indicators In my discussion earlier this chapter, | pointed out that volume based indicators are considered leading indicators when compared to price based indicators. This creates a powerful trad- ing too! since combining both volume and price based indicators enables the trader to use the first as a signal and the second as confirmation triggering a trade entry. To accomplish this it is important to follow the guidelines for trading divergences discussed earlier in this chapter. When you see the volume indicator trending in an opposite direction to that of price, the stock should be placed on daily watch. The trade is triggered when the price based indicator completes a triple divergence. This occurrence often is close in time to a price breakout from a downtrend. Applying this concept will be clearer 49CE einoins Pragati a 50when reading the following example. Example 3: Columbia Banc Corp ( CBBO) By examining the chart page 52, it is clear that the CMF is moving in an opposite direction to price. Notice that the CMF was very negative (almost at -0.5) corresponding to the point V1 on the price chart. Between points V1 and V2 the correspond- ing CMF trended higher becoming less negative and eventually reaching close to the zero line. This indicates that most sellers have been exhausted and buyers are gaining the upper hand. In the bottom section of the chart the MACD histogram is forming a triple divergence at points 1, 2 and 3 relative to price points V1, V2 and V3. Notice that the MACD histogram is form- ing a shallower valley as the price is making lower lows. The CMF, considered a leading indicator, alerted us that a directional price change is coming as soon as it started trending in the opposite direction to that of price. Notice, however, that an early entry in the vicinity of points V1 and V2 before triple diver- gence confirmation would have resulted in an immediate loss. Of course since we expected the price to reverse, this may not seem as a problem. Remember, however, that the market is unpredict- able and there is no way to tell how much further the stock will drop before reversal. The best strategy is to wait for the MACD histogram triple divergence at point V3, corresponding to price point 3, and enter the trade then at $1.25. This would have resulted in a significant profit almost immediately. It is critical to realize that on occasions the stock reverses after a double divergence, or even without any MACD /CMF sig- nal. In other words if one of the setups presented in this chapter occurs, you are likely to have a high profit trade, but such trades can still materialize without these setups being present. As a trader, your goal should be to have a set of tools that have a high percentage of success and trade those setups. This is how order is made from an unpredictable market, by ignoring stocks that do not meet your trading setups and trading only the ones that do. 51(CBBO (Cotumbin Bancorp) Nasdan 08 BOs O207 W221 List C221 VoI7k Chgs0.19.600N) ‘M4 CHF(20) 0.463 fptrending CMF Downtrending price with valleys V1, V2, and V3 52Chapter 4 Explosive Chart Patterns In my previous book “Generate Thousands in Cash on Your Stocks Before Buying or Selling Them”, | have dedicated a chap- ter to discuss chart patterns that are likely to result in profitable trades. My goal in this book is to focus on specific chart patterns that can deliver explosive profits. | will also present more detailed parameters that define these patterns to avoid errors in recogniz- ing them. In addition, | will show how specific technical indicators are combined with these patterns to determine strategic entry points. These entry points insure that the trader gets in a short time before an explosive move occurs, while still benefiting from the bulk of the move. Falling Rectangle Pattern Based on my trading experience the bullish Falling Rect- angles and the closely related bearish Rising Rectangles are the most profitable chart patterns. If you are able to recognize and trade one of these patterns, you are likely to be rewarded by no less than fifty percent profit in a short period of time. A rectangle is defined by an upper resistance boundary line and a lower support boundary line. Prices remain most of the time between these two lines thus forming a rectangular pattern. A falling rectangle is formed when prices trace lower highs and lower lows but remain confined within a narrow range. In the case of rising rectangles prices form higher highs and higher lows while remaining within a narrow range. During the formation of a falling or rising rectangle pattern 53prices should remain mostly within a narrow range defined by 5 percent standard deviation above or below the 20 period Simple Moving Average. This is defined by the Moving Average Enve- lope parameters (20, 5), resulting in two curves outlining the up- per and lower boundaries. Prices are required to fall within these boundaries most of the time for a falling rectangle pattern to be established. The stock should be non trending in technical terms during the formation of a falling rectangle. Although the establishment of lower highs and lower lows indicates a visual down trend, the stock should have an Average Directional Movement of below 20 (ADX <20) during the formation of the rectangle. The duration in time of the falling rectangle formation should be at least 15 trading days. The longer the time a stock stays in a falling rectangle formation, the more explosive and profitable the move is likely to be. ALERT1: The moving average envelopes are an enhanced por- trayal of a simple moving average line. This is done by surround- ing the line pattern with curves or envelopes that deviate from the moving average line by a set percentage. This allows the trader to determine when prices have strayed from the moving average by that percentage. In the case of a falling rectangle we require that prices do not stray more than five percent from the moving average at least 70% of the time. The Average Directional Indicator (ADX) is a function of True Range (TR) and is built on the premise that a trend is a series of price ranges extending in a specific direction. Positive directional movement (+DM) is indicated if a day’s trading range is higher than the one before it. If a day’s trading range is lower than the one preceding it then negative directional movement (-DM) results. A more complex situation arises if the second day’s trading range partially overlaps the first, that is, it is both higher and lower than the first day’s trading range. In this case the larger part of a day’s range extending beyond the prior day's trading range is used to identify the directional movement. If the larger part is higher then the directional movement is positive, 54while if the larger part of a day’s range is lower the directional movement is negative. The True range (TR) is the largest of the following: (1) The difference between today’s high and today’s low. (2) The difference between today’s high and today’s close. (3) The difference between today’s low and yesterday's close. The Figure page 56 shows different examples of the av- erage directional movement indicator. Notice that the average directional movement in examples A and C is positive since most of the second day’s range is above the first day’s range. B & D show negative directional movement since the larger part of day two’s trading range is below day one. In example E, the aver- age directional movement is zero since the second day’s trading range is within the first day's range. In other words, the first day's Tange overlaps the second. ALERT2: The Average Directional Movement or ADX measures the strength of a trend. ADX is on a scale from zero to 100, with numbers below 20 indicating a technically non trending stock and numbers above 30 indicating that a trend is established and strengthening. Note that ADX does not tell the direction of the breakout. It is common to see ADX values below 20 and moving lower during the formation of a falling rectangle. In summary the requirements for a falling rectangle pattern are: (1) Prices forming lower highs and lower lows. (2) The upper and lower price boundaries of the rectan- gle remain more than 70% of the time bound by a 5% envelope from the 20 day simple moving average. (3) The stock is non trending in technical terms defined by an ADX<20 during the formation of the rectangle. (4) The formation of the rectangle is of at least 15 day duration. Entry Signals The entry trigger is given in two steps: (1) ADX starts mov- ing higher indicating a possible start of a new trend. (2) The 55positive directional indicator +DI crosses the negative directional indicator —DI establishing an upward direction for the move. How falling rectangles are traded will be clarified in the fol- lowing actual examples. Example 1: Power One (PWER) As can be seen from the chart page 58, a rectangular shaped pattern is evident between points 1 and 3 on the chart. This rectangle is also characterized by lower lows and lower highs on the price chart, indicating a likelihood of a falling rectangle pat- tern provided conditions listed previously are satisfied. The pattern had a duration starting late July 2009 and con- tinuing to mid September 2009 or almost 50 trading days. This meets our time restriction of at least 15 trading days for the for- mation of the pattern. It is also evident that most of the rectangular pattern be- tween points 1 and 3 lies within 5% deviation from the 20 day mov- ing average. This is clearly seen by constructing the ENV(20, 5) on the chart forming the two curves defining the upper and lower envelope boundaries. Notice also that points A and B on the ADX chart cor- respond to readings below 20 and the ADX was slowly moving lower during the formation of the falling rectangle between points 1 and 2. Take note also that as the prices increased from 2 to 3 the ADX value moved higher between points B and C indicating a possible new trend starting. Also near point C on the ADX chart the positive directional indicator +DI crosses the negative direc- tional indicator —DI triggering an entry signal around $1.40. As you can see such trade was rewarded by over 100% profit within a short period of time. Example 2: Ballard Power (BLDP) This example has been used in the previous chapter to demonstrate trading divergences. | have decided to use it again here to make a couple of general points regarding trading: (1) Two traders using different systems can still identify the same winning trade (2) To be successful in trading, you only need to 57PWER (Power-One, inc.) Nasdag obt Bow 2000 0p508 Hi220 Loans C1206 Vol 1am. Chg-008 1.91%) —AON(L4) 95.20 451 96.99 -D1 14,64. MWPWER (Paity) 3.08 (32 ERGO S.A) Zab - 26 f adaohrne Lae i am ON 22 22 a6 is an He om ey mt Bed “S a Coe Ss eu MM eee ea eres Oct 12 10 25 tov 58learn few profitable setups. Once you are able to recognize such setups easily with a glance at the chart, you are on your way to being a consistent winner. Can you recognize the falling rectangle formation on the chart page 60? If not then read the previous pages in this chap- ter once again. As you can see a rectangular shaped pattern is formed between points 1 and 2 on the chart page 60. This rectangle is forming lower highs and lower lows as evident in the downward slant. In addition, the prices are confined within 5% standard de- viation from the 20 day moving average as demonstrated by the moving average envelopes ENV(20, 5) depicted on the chart. As you can see most prices fall within the boundaries of the moving average envelopes. The corresponding points A and B on the ADX chart show an ADX value near 20 at point A and decreasing as one gets closer to point B. Decreasing ADX values are a trademark of fall- ing rectangles formations until a trade trigger gets close. The trade entry is triggered at the price corresponding to point X on the chart where the positive directional indicator +DI! crosses the negative directional indicator —DI. By constructing an imaginary vertical line from point X on the ADX chart down to the price chart, you can see that the corresponding price is around $1.80 in early September. This setup delivered a profit of over 70% in less than 45 days. To exit falling rectangle trades, you can use any of the techniques described in previous chapters. In this example | will present another simple exit strategy that will allow you to capture a significant portion of the profits. This strategy can only be used if the following conditions are met: (1) Two distinct peaks must be visible with the second price peak equal or higher than the first. (2) The two peaks must be separated by a V or U shaped valley resulting in a closing price pullback to near the up- per moving average envelope. (4) The second price peak must be formed with lower trading volume than the first peak. 59