Financial times guide to technical analysis how to trade like a professional

About the author Jacinta Chan is a trader and an equity and futures broker She has worked as a senior vice president of derivatives sales and likes to share the knowledge and skills that she has gained on professional dealing desks She is the author of a number of technical analysis books including Everything Technical Analysis, published by Prentice Hall Contents About the Author Acknowledgements Publisher’s acknowledgements Preface: what makes an exceptional trader Some traders’ terms PART WHAT DO TRADERS KNOW? Introduction: the market technicians Know the market: how to read and construct charts History has a habit of repeating itself Spot the bubbles and win Follow the winners: trading with the trend The tools that professionals use Leading technical indicators in the market The profit opportunities Wave after wave Booms and busts: risks and returns 10 The secret Conclusion: leave the random walkers busy with their arguments – the market technicians are busy making money PART TRADING WITH PROFESSIONAL TECHNICAL SYSTEMS Introduction: the trading game plan 11 Technical indicators to use 12 Principles of a technical algorithm trading system 13 Understanding market characteristics and what to 14 Simple formulas to design your own trading models 15 Programming trading rules into your system 16 How to write a good trading plan 17 Losing a little to gain your capital 18 Practise stop loss 19 Fine tuning the trading wheel 20 The total trader – winning trading psychology Conclusion: the complete trading set-up kit Getting started Glossary Bibliography Index Acknowledgements The body of technical analysis knowledge did not happen overnight It is built up over a century by great traders and technicians who have put together their knowledge to form what we know today as technical analysis Therefore, the first acknowledgement goes to the founder of technical analysis, Charles Dow, whose observations still hold true today and benefit many traders such as myself There are many great contributors to technical analysis, too many to be mentioned individually here However, there are some authors whose works must be mentioned: H.M Gartley (1935) for Profits in the Stock Markets, Richard Arms Jr (1999) for Profits in Volume: Equivolume Chart and Gerald Appel, the originator of Moving Average Convergence and Divergence (MACD) One of the greatest technical indicators contributor of all time is Welles Wilder, the author of New Concepts in Technical Trading Systems and originator of the Resistance Strength Index (RSI), Directional Movement Index (DMI) and Parabolic Stop-And-Reverse (Parabolic SAR) Other leading technical indicator contributors whose works are mentioned here are George Lane, the originator of Stochastics; Woods, Vignolia and Granville, the developers of On Balance Volume; and Ralph Elliott, the originator of Elliott Waves Other great technical analysis teachers of all time whose work greatly influenced my thesis and work are John Bollinger (Bollinger on Bollinger), Larry Williams (The Definitive Guide to Futures Market (Volumes I and II)) and Perry Kaufman (Trading Systems and Methods) Credit is to be given to Equis International whose Metastock software is very useful for profit analysis This book did not happen overnight either It took the efforts of many individuals from different backgrounds and parts of the world whom I have come to know as friends over the years I thank Dr Noor Azlinna Azizan for going through this book I thank Christopher Cudmore, my commissioning editor, for publishing this book and all the team at Pearson Education I thank all my friends, my colleagues, clients and readers whose support make my books bestsellers I thank all my family, especially my parents, Chan Kok Heong and Yap Chin Tuck for their love and support Lastly and most importantly, I thank God for all these wonderful family, friends, colleagues, clients, editors and the great teachers of technical analysis who contribute to the success of this book Jacinta Chan Publisher’s acknowledgements We are grateful to the following for permission to reproduce copyright material: The Financial Times Figure 1.0 from FTSE100, http://markets.ft.com/markets/interactive-Chart.asp; Figure 1.1 from FTSE100, http://markets.ft.com/markets/interactiveChart.asp; Figure 1.3 from FTSE100, http://markets.ft.com/markets/interactiveChart.asp; Figure 1.5 from FTSE100, http://markets.ft.com/markets/interactiveChart.asp; Figure 1.10 from FTSE100, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.1 from Nikkei 225 http://markets.ft.com/markets/interactiveChart.asp; Figure 2.2 from DJIA, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.3 from SSE, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.4 from ASX 200 http://markets.ft.com/markets/interactiveChart.asp; Figure 2.5 from ASX200, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.6 from ASX, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.7 from http://markets.ft.com/markets/interactiveChart.asp; Figure 2.8 from Hang Seng http://markets.ft.com/markets/interactiveChart.asp; Figure 2.9 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.10 from ASX200, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.11 from http://markets.ft.com/markets/interactiveChart.asp; Figure 2.12 from DAX, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.13 from CAC40, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.14 from Nasdaq, http://markets.ft.com/markets/interactiveChart.asp; Figure 2.15 from Eurofirst300 http://markets.ft.com/markets/interactiveChart.asp; Figure 2.16 from Dax, http://markets.ft.com/markets/interactiveChart.asp; Figure 3.1 from Hang Seng, http://markets.ft.com/markets/interactiveChart.asp; Figure 3.2 from Hang Seng, http://markets.ft.com/markets/interactiveChart.asp; Figure 3.3 from Hang Seng, http://markets.ft.com/markets/interactiveChart.asp; Figure 3.4 from Hang Seng, http://markets.ft.com/markets/interactiveChart.asp; Figure 3.5 from Hang Seng, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.1 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.2 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.3 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.4 from Nikkei 225 using Moving Aver, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.5 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.6 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.7 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 4.8 from Nikkei 225, http://markets.ft.com/markets/interactiveChart.asp; Figure 5.1 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 5.2 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 5.3 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 6.1 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 6.2 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 6.3 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 6.4 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 6.5 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 6.6 from S&P 500, http://markets.ft.com/markets/interactiveChart.asp; Figure 7.1 from FTSE 100 http://markets.ft.com/markets/interactiveChart.asp; Figure 7.2 from FTSE 100 http://markets.ft.com/markets/interactiveChart.asp; Figure 7.4 from FTSE 100 http://markets.ft.com/markets/interactiveChart.asp; Figure 9.1 from FTSE 100 http://markets.ft.com/markets/interactiveChart.asp In some instances we have been unable to trace the owners of copyright material, and we would appreciate any information that would enable us to so Doesn’t’, Journal of Derivatives, 1, 39–44 Simon, D and Wiggins, R (2001), ‘S & P Futures Returns and Contrary Sentiment Indicators’, The Journal of Futures Markets, 21, 5, 447–462 Smidt, S (1965), ‘A Test of the Serial Independence of Price Changes in Soybean Futures’, Food Research Institute Studies, 5, 117–136 Sweeny, R (1986), ‘Beating the Foreign Exchange Market’, Journal of Finance, 41, 163–182 Sweeny, R (1988), ‘Some New Filter Rule Tests: Methods and Results’, Journal of Financial and Quantitative Analysis, 23, 285– 300 Szakmary, A and Mathur, I (1997), ‘Central Bank Intervention and Trading Rule Profits in Foreign Exchange Markets’, Journal of International Money and Finance, 16, 513–535 Taylor, M and Allen, H (1992), ‘The Use of Technical Analysis in the Foreign Exchange Market’, Journal of International Money and Finance, 11, 3, 304–314 Taylor, S (1986), Modelling Financial Time Series, John Wiley & Sons Taylor, S (1992), ‘Rewards Available to Currency Futures Speculators: Compensation for Risk or Evidence of Inefficient Pricing’, Economic Record, 68, 105–116 Taylor, S (1994), ‘Trading Futures Using A Channel Rule: A Study of The Predictive Power of Technical Analysis With Currency Examples’, Journal of Futures Markets, 14, 215–235 Taylor, S (2000), ‘Stock Index and Price Dynamics in the UK and the US: New Evidence for a Trading Rule and Statistical Analysis’, European Journal of Finance, 6, 39–69 Taylor, S and Tari, A (1989), ‘Further Evidence Against the Efficiency of Futures Markets’, in R.M.C Guimaraes et al (ed.) A Reappraisal of the Efficiency of Financial Markets, pp 557–601, Springer-Verlag Thompson, S and Waller, M (1987), ‘The Execution Cost of Trading in Commodity Futures Markets’, Food Research Institute Studies, 20, 141–163 Valcu, V (2002), ‘Z-Score Indicator’, Working Money Wilder, W (1978), ‘New Concepts in Technical Trading Systems’, Trend Research, New York Williams, L (1970) The Definitive Guide to Futures Trading (Volume I), Windsor Books Williams, L (1989) The Definitive Guide to Futures Trading (Volume II),Windsor Books Recommended websites www.bollingerband.com www.traders.com www.tradingtech.com www.turtletrader.com http://klme2.tripod.com www.workingmoney.com Index absolute range breakout 2nd, accumulation phase adjustable bands Z-test statistic (ABZ) algorithm trading systems, 2nd, 3rd, 4th, 5th design optimisation, 2nd, 2nd, 3rd parameters, 2nd, 3rd, 4th professional trading desks risk to reward ratio, 2nd, 3rd, 4th, 5th, 6th robustness, 2nd, 3rd slippage, 2nd, 3rd system improvements transaction costs, 2nd unexpected losses whipsaws, 2nd, 3rd, 4th, 5th, 6th arrogance ascending triangles ask prices attitude average directional index backtesting, 2nd, 3rd, 4th bar charts Bband Z-test statistics (BBZ), 2nd, 3rd, 4th, 5th formulas trading rules bearish engulfing sign bearish primary market movements, 2nd, 3rd behavioural finance, 2nd bid prices black box Bollinger bands, 2nd, 3rd breakaway gap, 2nd breakout see range breakout bullish engulfing sign bullish primary market movements, 2nd, 3rd buy signals directional movement (DM) exponential moving averages (EMA) moving average convergence and divergence (MACD) relative strength index (RSI) simple moving averages, 2nd stochastics buy-and-hold returns candlestick charts capital preservation capital requirements, 2nd Chande, T., 2nd channels charts ,2nd bar candlestick constructing equivolume with closing prices kagi line OHLC point and figure and risk management volume classical technical analysis closing prices, 2nd commodity markets common gap consecutive losses, 2nd constructing a chart contemporary technical analysis continuation patterns flags, 2nd pennants rectangles triangles currency markets cutting losses, 2nd data analysis day traders descending triangles designing a system directional movement (DM) buy signals sell signals discipline, 2nd distribution phase, 2nd doji sign double/triple tops and bottoms Dow, Charles Dow theory, 2nd, 3rd, 4th accumulation phase distribution phase, 2nd downtrend phase primary market movements, 2nd, 3rd risk to reward ratio, 2nd uptrend phase downtrends, 2nd, 3rd, 4th, 5th on balance volume (OBV) channels downward impulse waves dynamic volatility indicator Elliott wave theory, 2nd downward impulse waves Fibonacci ratios stop loss orders upward impulse waves entry and exit trading rules envelopes see standard deviation bands equity markets equivolume charts with closing prices evaluation journal exhaustion gaps exponential moving averages (EMA) buy signals sell signals eyeballing falling wedge falling window Fama, E., 2nd fast trading systems fat tails, 2nd Fibonacci numbers, 2nd Fibonacci ratios fill fixed percentage band breakout flags, 2nd formulas fractal geometry, 2nd FTSE 100 futures contract fundamental analysis, 2nd, 3rd futures markets, 2nd, 3rd Gandolfi, R gaps breakaway, 2nd common exhaustion island gap reversal runaway Gartley, Harold Gaussian distribution, 2nd good-till-cancel (GTC) orders, 2nd, 3rd head and shoulders herd mentality highest prices, 2nd Hudson, R indicators see technical indicators intrinsic value inverse head and shoulders Irwin, S., 2nd island gap reversal journals see record keeping kagi charts lagging indicators leading indicators, 2nd average directional index on balance volume (OBV), 2nd directional movement (DM) momentum, 2nd parabolic stop and reverse, 2nd relative strength index (RSI), 2nd stochastics, 2nd leverage, 2nd limit orders line charts linear trading, 2nd, 3rd liquid markets live testing long positions parabolic stop and reverse long white/black candlestick losing trade ratio loss aversion losses, 2nd, 3rd consecutive, 2nd cutting, 2nd evaluation journal maximum probability of losing, 2nd see also stop loss orders lowest prices, 2nd Mandelbrot, B margin payments, 2nd, 3rd, 4th market characteristics mathematical formulas maximum losses mechanical trading, 2nd, 3rd, 4th, 5th model trading see algorithm trading systems momentum, 2nd moving averages, ,2nd, 3rd, 4th, 5th buy signals, 2nd, 3rd choosing number of days convergence and divergence (MACD), 2nd exponential (EMA) range breakout, 2nd sell signals, 2nd, 3rd trading rules narrow shapes neckline noise OHLC charts on balance volume (OBV), 2nd, 3rd open interest, 2nd opening prices, 2nd optimisation, 2nd, 3rd, 4th Bband Z-test statistics (BBZ) oscillators, 2nd overconfidence oversquare shapes overtrading parabolic stop and reverse, 2nd parameters, 2nd, 3rd changing Park, C.-H., 2nd patterns, 2nd, 3rd continuation patterns double/triple tops and bottoms flags, 2nd head and shoulders pennants rectangles reversal patterns, 2nd rounded tops and bottoms triangles V spike tops and bottoms wedge reversals pennants perfect trading systems planning, 2nd, 3rd capital requirements, 2nd components entry and exit trading rules following a plan linear trading, 2nd, 3rd overtrading pyramiding risk to reward ratio, 2nd, 3rd, 4th, 5th, 6th strategies, 2nd writing a plan point and figure charts post-mortem evaluations power law power shapes price envelopes, 2nd, 3rd see also standard deviation bands price patterns see patterns primary market movements, 2nd, 3rd probability of winning/losing, 2nd products professional traders professional trading desks profit analysis, 2nd evaluation journal probability of winning, 2nd Profits in the Stock Market Profits in Volume: Equivolume Charting psychology pyramiding Quinn, Edward S random walk theory, 2nd range breakout, 2nd, 3rd, 4th, 5th absolute range breakout, 2nd Bollinger bands, 2nd, 3rd fixed percentage band breakout price envelopes volatility breakout, 2nd range trading, 2nd, 2nd, 3rd, 4th data analysis price envelope bands, 2nd resistance, 2nd support, 2nd volatility whipsaws record keeping actual and permissible losses actual and projected profit post-mortem evaluations rectangles relative strength index (RSI), 2nd buy signals sell signals research, 2nd, 3rd data analysis market characteristics products resistance 2nd, reversal patterns, 2nd double/triple tops and bottoms head and shoulders rounded tops and bottoms V spike tops and bottoms wedge reversals rising wedge rising window risk management see also stop loss orders risk to reward ratio, 2nd, 3rd, 4th, 5th, 6th robustness, 2nd, 3rd rollover, 2nd rounded tops and bottoms runaway gap scalpers, 2nd, 3rd secondary corrections, 2nd sell signals directional movement (DM) exponential moving averages (EMA) moving average convergence and divergence (MACD) relative strength index (RSI) simple moving averages, 2nd stochastics short positions parabolic stop and reverse slippage, 2nd, 3rd slow trading systems spreadsheets square shapes standard deviation bands 2nd, 2nd, 3rd, 4th, 5th, 6th, 7th adjustable formulas trading rules see also price envelopes stochastics, 2nd buy signals sell signals stock markets stop loss orders, 2nd, 3rd, 4th, 5th, 6th, 7th good-till-cancel (GTC), 2nd, 3rd revealing to others trailing stops, 2nd strategies, 2nd support 2nd, symmetrical triangles system improvements technical analysis, 2nd definitions technical indicators 2nd, 2nd average directional index on balance volume (OBV), 2nd Bband Z-test statistics (BBZ) 2nd, 2nd, 3rd, 4th directional movement (DM) exponential moving averages (EMA) lagging indicators leading indicators, 2nd momentum, 2nd moving averages 2nd, 3rd, 4th, 5th convergence and divergence 2nd, parabolic stop and reverse, 2nd relative strength index (RSI), 2nd stochastics, 2nd test results, 2nd backtesting, 2nd, 3rd, 4th live testing theories Dow theory, 2nd, 3rd, 4th Elliott wave theory, 2nd, fractal geometry random walk theory, 2nd tipsters, 2nd trade evaluations trading plans see planning trading psychology trading range see range trading trading rules, 2nd Bband Z test statistics (BBZ) entry and exit trading rules moving averages trading strategies trading terms trailing stops, 2nd transaction costs, 2nd trend trading, 2nd, 3rd, 4th on balance volume (OBV) channels data analysis downtrends, 2nd, 3rd, 4th, 5th fast trading systems mechanical systems, 2nd, 3rd problems with slow trading systems standard deviation bands, 2nd, 3rd, 4th uptrends, 2nd, 3rd, 4th, 5th volatility, 2nd, 3rd, 4th whipsaws, 2nd, 3rd, 4th, 5th, 6th triangles triple tops and bottoms unexpected losses uptrends, 2nd, 3rd, 4th, 5th on balance volume (OBV) channels upward impulse waves V spike tops and bottoms variance volatility, 2nd, 3rd, 4th dynamic volatility indicator volatility breakout, 2nd volume, 2nd, 3rd on balance volume (OBV), 2nd equivolume charts Wall Street Journal wave theory see Elliott wave theory wedge reversals whipsaws, 2nd, 3rd, 4th, 5th, 6th winning psychology winning trade ratio writing a plan Z-test statistic adjustable bands Bband (BBZ) 2nd, 2nd, 3rd, 4th, 5th PEARSON EDUCATION LIMITED Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearson.com/uk First published in Great Britain in 2011 Electronic edition published 2012 © Pearson Education Limited 2011 (print) © Pearson Education Limited 2012 (electronic) The right of Jacinta Chan to be identified as author of this work has been asserted by her in accordance with the Copyright, Designs and Patents Act 1988 Pearson Education is not responsible for the content of third-party internet sites ISBN: 978-0-273-75133-5 (print) 978-0-273-75175-5 (ePub) 978-0-273-75174-8 (PDF) British Library Cataloguing-in-Publication Data A catalogue record for the print edition is available from the British Library This product is copyright material and must not be copied, reproduced, transferred, distributed, leased, licensed or publicly performed or used in any way except as specifically permitted in writing by the publishers, as allowed under the terms and conditions under which it was purchased or as strictly permitted by applicable copyright law Any unauthorised distribution or use of this text may be a direct infringement of the author's and the publishers' rights and those responsible may be liable in law accordingly All trademarks used herein are the property of their respective owners The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners 10 Front cover image © Brad Rickerby/Getty Images NOTE THAT ANY PAGE CROSS REFERENCES REFER TO THE PRINT EDITION ... Technical analysis includes a variety of techniques such as chart analysis, pattern recognition, seasonality and cycle analysis, and algorithm technical trading systems Chart analysis Chart A. .. Professional traders are market technicians who are financial experts in the practical science of trading Today’s market technicians usually use technical analysis to trade in the financial markets... trader needs to make it as a professional Anyone can be a trader but only those who have undergone and passed professional technical training and are trading seriously can be a professional trader