Stops, targets, and risk control

Using protective stops is essential for your survival and long-term success. One of the main reasons so many traders lose and wash out of the markets is that they don’t use stops. We like thinking about profits, but you’ve got to know what is the maximum amount you can lose in a trade. Without that limit, you can irreparably damage your account.
People don’t use stops for three reasons: ignorance, wanting to hang on to hope, and the trouble with whipsaws.

As you approach the end of this book, ignorance should no longer be an issue. You know better than to waste money hoping that a sinking stock will miraculously reverse and rally. Whipsaws, on the other hand, are a real problem.
A whipsaw means that you buy a stock, set a stop underneath, the stock declines and hits it; you exit with a loss, only to see your stock reverse and rally just as you originally expected. After several whipsaws many folks give up using stops. But trading without stops is a recipe for a disaster because sooner or later, one of your ‘stopless’ stocks will get caught in a major downdraft and deliver a ‘shark bite’ to your account. Even though we can never completely eliminate whipsaws, we do have ways of reducing their occurrences.

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Trading with fundamentals and technicals

At the time of this writing Philip is the top-performing Spiker (an elite-level member) of SpikeTrade.com. Both trades shown below come from his “How I Won My Gold” posts. Each weekend the Spiker who wins our trading competition during the previous week posts his “Gold”
report (you can read those reports even as a non-member – they’re open to guests).
Philip selects his trades on the basis of fundamental news items that are getting a lot of play in the media. He zooms in on specific stocks using a few technical tools, and backs all his trades with ironclad risk management.

On October 18, 2014 Philip posted a report titled “Managing an Ebola trade with a protective stop – Long TKMR.” He wrote: “Tekmira Pharmaceuticals Corporation (TKMR) is a biopharmaceutical company focused on advancing novel therapeutics. It provides leading lipid nanoparticle delivery technology to pharmaceutical partners. Over the past weekend there was significant news coverage of the Ebola crisis. I decided to pick a drug stock in this area to
leverage on this news event which could send prices higher. Canada-based Tekmira Pharmaceuticals was said to be furthest along among the companies working on Ebola treatment. Technicals showed TKMR price as oversold, near a support level, and on a rising channel. I chose TKMR as my Spike pick.

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Trading Systems

The trades to avoid (the Impulse system)

Before we build a trading system let’s set up a censorship system. The Impulse system will keep us out of trouble by showing when not to trade. As Jesse Livermore, one of the great speculators of the 20th century, said to an interviewer: “There’s a time to be long, a time to be short, and a time to go fishing.”

The Impulse System applies a pair of indicators to any trading vehicle or an index: a fast exponential moving average and MACD-Histogram. The slope of the EMA reflects the direction of the market’s inertia. The slope of the last two bars of MACD-Histogram shows the direction of market power. Their combination colors every bar: green if both are rising, red if both are falling, and blue if they move in the opposite directions. When both the inertia and the power are pointing against your planned trade, you shouldn’t be getting into it.

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May the force be with you (Force Index)

The power of bulls and bears (MACD indicator)

Our indicators should be simple and robust. Simple because they track only a few basic numbers: opening, high, low and closing prices, plus volume. It doesn’t pay to overcomplicate your analysis. Brian Monieson, a professional trader in Chicago, once said: “I have a PhD in mathematics, I specialized in cybernetics, but I was able to overcome those disadvantages and make money.” Good indicators are not only simple but also robust, meaning that small changes of their parameters don’t change their bullish or bearish messages.

MACD stands for Moving Average Convergence-Divergence. We can plot it as two lines or a histogram. You can study MACD in the StockCharts’ free ChartSchool as well as in all of my books.
Figure 14. AMZN daily, 26- and 13-bar EMAs, MACD Lines and MACD-Histogram (12, 26, 9).
The original indicator, invented by Gerald Appel, was MACD Lines. The Fast line of MACD tracks a short-term consensus of value, while the Slow line tracks long-term consensus of value. In pre-computer days Appel calculated them by hand and used their crossovers as buy and sell signals. Waiting for MACD Lines to cross leads to missing the most dynamic early part of a trend; by the time those lines intersect, half of the price move is history.

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Dressing a naked chart: a pair of moving averages

Computerized technical analysis is more objective than classical charting. When an indicator is up, it’s up, and when it’s down, it’s down. There’s no fiddling with the angle of a ruler.
Technical analysis software contains a wealth of indicators, but you aren’t going to use all of them. Compare this to sitting down in a restaurant and picking up a menu. You’re not going to order every item on the list, only select an appetizer, a main course, and a dessert. In trading, we need to select just a handful of indicators and learn to use them.

A perfect indicator doesn’t exist. Markets are complex; you cannot win using a single tool. Some indicators work best during trends, others in trading ranges. Trends and ranges are easy to recognize in the middle of a chart, but the closer we get to the right edge, the foggier they become. That’s why we need to combine trend-following indicators, which are good for trends, with oscillators, which work better in trading ranges. Let’s begin by selecting several indicators, and in later chapters we’ll combine them into trading systems.

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It All Starts with a ‘Campaign’

The business of accumulating a stock is like any other campaign. To buy stock in very large amounts
without putting the price up against your own buying requires planning, good judgement, effort,
concentration, trading skill and money. As a basic guide, you will notice that the stock is very reluctant to react when the Index itself is falling. This is because the professionals are buying most of the sell orders coming into the market and certainly not selling. On any sort of rally, there is usually very low volume associated with a stock under accumulation. This is because they are not chasing the higher prices (indicated by the low volume up-moves). On these low volume rallies you will often see a sudden increase in volume on an up-day – the stock is being hit hard and fast by just enough selling to knock it back down again, which prevents any sort of rally to start. This results in more stock being bought than sold. These are the classic signs of accumulation. You should anticipate a test, or a shake-out (on bad news) near, or at the end of an accumulation zone, just before a genuine bull move in the stock is about to start.

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The Anatomy of Bull & Bear Markets

What Starts a Bull Market?

The following describes how bull markets come into being: To start the bull market process, an Index (or the stocks it represents) starts to fall in price day after day, week after week, punctuated with small up-moves with lower tops, as seen in a bear market. There will be a level reached at some time where weak holders will start to panic (known as ‘the herd’) and will tend to sell their stock holdings all at the same time. These weak holders will not be able to stand any more losses, and will be fearful of even further losses (the news will be bad). As these traders sell, professional money will step in and start buying, because in their view, the stock can now be sold at a higher price at some point in the future. The panic selling has also given professional money the opportunity to buy without
putting the price up against their own buying (accumulation).

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Trend Scaling

Trends have the awkward property of being fractal in nature, or scale-free. What we mean by this is that their scale is dependent upon the point of observation. If you look at the coast of Britain, you can see that it is jagged. We cannot apply a scale to measure the degree of jaggedness unless we fix the point of observation. The entire coastline is jagged when viewed from a weather satellite, the coast is still jagged when viewed from an aircraft and it is equally jagged if viewed when standing on the shoreline.

Jaggedness is a scale-free description.

When we look at trends, they are often classified as;
• long-term (major)
• intermediate
• short-term (minor).

It is the intermediate trend that is of the greatest use when combined with VSA charting techniques, but what exactly is an intermediate trend? We cannot apply a scale because the height and width of an
intermediate trend varies, even on a single chart. To add to the confusion, a short-term trend on a weekly chart would be an intermediate trend on a daily chart and long-term on an hourly one.
All we can do to place a trend into some sort of classification is to base the classification on the timeframe over which the trend remains useful. If the trend channel is narrow, steep, or broken by a counter-trend in the short-term, then it is a short-term trend. If it exhibits resistance characteristics in the medium-term, it is an intermediate trend and so on.

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Manipulation of the Markets

A large percentage of people are surprised to learn that the markets can be manipulated in the ways that we have described. Almost all traders are labouring under various misconceptions.
There are all sorts of professional interests in the world's financial markets: brokers, dealers, banks, trading syndicates, market-makers, and traders with personal interests. Some traders have a strong capital base, some are trading on behalf of others as investment fund managers, pension fund managers, insurance companies and trade union funds, to name but a few.

As in all professions, these professionals operate with varying degrees of competence. We do not have to be concerned by all these activities, or what the news happens to be, because all the trading movements from around the world are funnelled down to a limited number of major players known as market-makers, pit traders or specialist (collectively know as the ‘smart money’ or ‘professional money’). These traders, by law, have to create a market. They are able to see all the sell orders as they arrive, and they can also see all the buy orders as they come in. They may also be filling large blocks of buy or sell orders (with special trading techniques to prevent putting the price up against themselves or their clients).

These traders have the significant advantage of being able to see all the stop-loss orders on their screens. They are also aware of ‘inside information’, which they use to trade their own accounts! Despite ‘insider dealing’ being illegal, privileged information is used all the time in direct and indirect means to make huge sums of money.

To put it simply, a professional trader can see the balance of supply and demand far better than anyone else can. This information is dominating their trading activity. Their trading will then create an ongoing price auction.

Floor traders usually complain bitterly if they are asked to modernise, which usually means leaving the floor to trade on computer screens. They will have lost the feel and help of the floor! "I am all in favour of progress, as long as I do not have to change the way I do things", was a passing comment from one London floor trader as he was forced off the trading floor.

Professionals trade in many different ways, ranging from scalping (that is buying the bid and selling the offer) to the long-term accumulation and distribution of stock. You need not be concerned too much with the activity of individuals, or groups of professional traders, because the result of all their trading is shown in the volume and the price spread. Firstly, the volume is telling you how much trading activity there has been. Secondly, the spread or price action is telling you the position the specialists are happy with on this activity (which is why the price spread is so important). All the buying and selling activity from around the world has been averaged down into a 'view' taken by the specialists or market-makers – a view from those traders who have to create a market, can see both sides of the order book, and who trade their own accounts.

However, you do need to recognise that professional traders can do a number of things to better their
trading positions: Gapping up or gapping down, shake-outs, testing, and up-thrusts are all moneymaking manoeuvres helping the market-makers to trade successfully, at your expense – it matters not to them, as they do not even know you.

This brings us to the "smoke-filled room syndrome”. Some people may think that when we talk about a moneymaking manoeuvre, some sort of cartel gathers in a smoke-filled room. "OK chaps, we are going to have a test of supply today. Let's drive the prices down on a few strategic stocks and see if any bears come out of the closet”. In practice, it does not usually work like that. This sort of thing was much more common many decades ago, before the exchanges were built, and the volume of trading was such, that markets were much easier to manipulate. Now, no single trader, or group of traders, has sufficient financial power to control a market for any significant length of time. True, a large trader buying 200 contracts in a futures market would cause prices to rise for a short time, but unless other buyers joined in, creating a following, the move could not be sustained. If you are trading futures related to the stock market, any move has to have the backing of the underlying stocks; otherwise, your contracts are quickly arbitraged, bringing the price back in line with
the cash market.

If we take the example of the 'test of supply', what actually happens is something like this:
Groups of syndicate dealers have been accumulating stock, anticipating higher prices in the future. They may have launched their accumulation campaigns independently. Other traders and specialists note the accumulation and also start buying. Before any substantial up-move can take place they have to be sure that the potential supply (resistance) is out of the market. To do this they can use the ‘test‘. Usually they need a window of opportunity in which to act. They do not collude in the test action directly; they simply have the same aims and objectives and are presented with the same opportunity at the same time. Market-makers can see windows of opportunity better than most other traders.

Good or bad news is an opportunity, so is a lull in trading activity. Late in the trading day, just before a holiday, is often used and so on. As they take these opportunities, reduced effort is required to mark the prices down (this is now cost effective), the market automatically tells them a story. If most of the floating supply has been removed, then the volume will be low (little or no selling). If the floating supply has not been removed, then the volume will be high (somebody is trading actively on the mark-down which means supply is present). If most of the floating supply had been removed from the market, how can you have active trading or high volume? (This point refers specifically to cash markets). Professional interests frequently band together. Lloyds of London, for example, have trading syndicates, or trading rings, to trade insurance contracts, making their group effort more powerful while spreading the risk. You accept this without question – you know about them because they are well known and have much publicity; you read about them, they are on television, they want the publicity and they want the business.

Similar things go on in the stock market. However, you hear little of these activities, because these traders shun publicity. The last thing they want is for you or anybody else to know that a stock is under accumulation or distribution. They have to keep their activities as secret as possible. They have been known to go to the extremes, producing false rumours (which is far more common than you would perhaps believe), as well as actively selling the stock in the open, but secretly buying it all back, and more, via other routes.

From a practical point of view, professional money consists of a mass of trades, which if large enough, will change the trend of the market. However, this takes time. Their lack of participation is always as important as their active participation. When these traders are not interested in any up-move, you will see low volume, which is known as ‘no demand‘. This is a sure sign that the rally will not last long. It is the activity of the professional traders that causes noticeable changes in volume – not the trading activity of individuals such as you or me.
Top professional traders understand how to read the interrelationship between volume and price action. They also understand human psychology. They know most traders are controlled in varying degrees by the TWO FEARS: The fear of missing out and the fear of losses.

Frequently, they will use good or bad news to better their trading position and to capitalise on known
human weaknesses. If the news is bad and if, at that moment, it is to their advantage, the market can be marked down rapidly by the specialist, or market-makers. Weak holders are liable to be shaken out at lower prices (this is very effective if the news appears to be really bad). Stop-loss orders can be triggered, allowing stock to be bought at lower prices. Many traders, who short the market on the bad news, can be locked-in by a rapid recovery. They then have to cover their position, forcing them to buy, helping the professional money, which has been long all the time. In other words, many traders are liable to fall for 'the sting’.

Market-makers in England are allowed to withhold information on large deals for ninety minutes. Even this lengthy period is likely to be extended. Each stock has an average deal size traded and, on any deal, which is three times the average, they can withhold information for ninety minutes. If for example, trading in ICI, the average is 100,000 shares and 300,000 are traded, they can withhold this information for ninety minutes. Their popular explanation for this incredible advantage is that they have to have an edge over all other traders to make a profit large enough to warrant their huge exposure. As these late trades are reported, this not only corrupts the data on one bar, but two bars. To add insult to injury, you are expected to pay exchange fees for deliberate incorrect data. In practice, the TradeGuider software ignores all late trades.

So professional traders can withhold the price at which they are trading at for ninety minutes or longer, if it suits them. However, the main thing they want to hide from you is not the price, but the VOLUME.Seeing the price will give you either fear or hope, but knowing the volume will give you the facts. In trading other markets around the world, you may not have the same rules, but if the volume is so important in London, it will be just as important in any other market. Markets may differ in some details but all free markets around the world work the same way.

As these market-makers trade their own accounts, what is stopping them trading the futures markets or option markets just before they buy or sell huge blocks of stocks in the cash markets? Is this why the future always appears to move first? Similar things happen in other markets – however, the more liquid or heavily traded a market is, the more difficult it will be to manipulate.
You will frequently see market manipulation and you must expect it. Be on your guard looking for
manipulation and be ready to act. The TradeGuider system will be an invaluable tool in helping you to achieve this. Market-makers cannot just mark the price up or down at will, as this is only possible in a thinly traded market – most of the time, this will be too costly a manoeuvre. As we have already pointed out, windows of opportunity are needed; a temporary thinning out of trading orders on their books, or taking full advantage of news items (good or bad).

It is no coincidence that market probes are often seen early in the mornings or very late in the day's trading. There are fewer traders around at these times. Fund managers and traders working for large institutions (we shall refer to these people as ‘non-professional’ to distinguish them from market-makers et al) like to work so called 'normal hours' – they like to settle down, have a cup of coffee, or hold meetings before concentrating on market action. Many traders who are trading other people's money, or who are on salaries, do not have the dedication to be alert very early in the morning. Similarly, by late afternoon, many are tired of trading and want to get home to their families.

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Markets Can be Marked Up (or Down)

You cannot help notice how major moves from one price level to another usually happen quickly. This rapid movement from one price level to another is not by chance – it is designed for you to lose money. You can be suddenly locked-into a poor trading position, or locked out of a potentially good trade by one or two days (or bars) of rapid price movement: The Index or stock usually then rests and starts to go sideways.If you have been locked-into a poor trade, you may regain hope, and so will not cover a potentially dangerous position. The next sudden move against you does exactly the same thing, so the process continues.

Conversely, if you are not in the market and have been hesitating or waiting to trade, sudden upmoves
will catch you unawares; you are then reluctant to buy into a market where, yesterday, you could
have bought cheaper. Eventually a price is reached where you cannot stand the increases in prices any
more and you buy, usually at the top!

Market-makers, specialists and other professional traders, are not controlling the market, but simply taking full advantage of market conditions to improve their trading positions. However, they can and will, if market conditions are right, mark the market up or down, if only temporarily, to catch stops and generally put many traders on the wrong side of the market. The volume will usually tell you if this is going on, as it will be low in any mark-up that is not genuine. Yes, they are marking the market either up or down, but if the volume is low, it is telling you that there is reduced trading. If there is no trading going on in one direction, the path of least resistance is generally in the opposite direction!

Volume Surges in Related Markets

If you are an experienced market-maker or floor trader, you can read the market as it flows along fairly well. As soon as you see either strength or weakness appearing in the cash markets you are immediately thinking of trading in the option markets to improve your trading position.
As this activity is recorded as total option volume, we have something to work with. We will know that with a sudden high option volume day, professional money is certainly active. If they are active, then they will have a good reason.

Using Different timeframes By analysing a daily chart, we may say to ourselves, "Well, there is nothing very much I can read into today's action“. The indications may not be very clear. However, looking at the same day on an intraday chart will give you the missing information you require. For instance, by looking at the intraday price action from yesterday, you will have a much clearer view of whether the next day’s trading will be bullish or bearish.

In the same way, a weekly chart may provide you with insights not immediately apparent in the daily chart. This is very clear when you start to look at individual stocks, which generally make far more sense viewed on a weekly chart. Intraday traders mostly stick to hourly or shorter time frames, rarely looking at the larger picture, whilst position traders would consider hourly charts of little value to them. Both attitudes are counter-productive. Intraday charts are useful to position traders, as they often highlight indications of strength or weakness, marking the day as a bullish or bearish day, which then gives a very strong indication of how to trade the following day. In turn, intraday traders can benefit significantly from the wider picture offered by daily or

The Relationship Between the Cash and the Futures Price

Futures will fluctuate above or below the cash price, but the cash price sets the limits of any move in the futures market, because large dealing houses with low dealing costs will have an established arbitrage channel and their actions will bring the future back in line with the cash. This process keeps the price movements between the cash and futures markets largely similar.

Sudden movements away from the cash price are usually caused by the activities of the specialists or
market-makers. These professionals are trading their own accounts and can see both sides of the market (i.e. the buy and sell orders). If syndicates are in the process of selling or buying large blocks of shares, they know these large transactions will have an immediate effect on the market, so they will also trade the futures and option contracts in order to offset or lower risk. This is why the future often seems to move before the cash.

Technicians watch for price clues that can alert them about a shift in market psychology and trend. Reversal patterns are these technical clues. ‘Western reversal indicators include double tops and bottoms. reversal days. head and shoulders. and island tops and bottoms. 

Yet the term “reversal pattern” is somewhat c a misnomer. Hearing that term may lead you to think at an old trend ending abruptly and then reversing to a new trend. This rarely happens. Trend reversals usually occur slowly, in stages as the underlying psychology shifts gears.
A trend reversal signal implies that the prior trend is likely to change. but not necessarily reverse. 

This is very important to understand. Cornp are an uptrend to a car travelling forward at 30 m.p.h. The carts red brake lights go on and the cal’ stops. The brake light was the reversal indicator showing that the prior trend (that is. the car moving forward) was about to end. But now that the car is stationary will the driver then decide to put the car in reverse’? Will he remained stopped? Will lie decide to go forward again? Without more cities we do not know. 

Exhibits 4.1 through 4.3 are some examples c what can happen after a top reversal signal appears. The prior uptrend, for instance. could con-veil into a period 1 sideways price action. Then a new and opposite trend lower could start. (See Exhibit 4. 1.) Exhibit 4.2 shows how an old uptrend can resume. Exhibit 4.3 illustrates how an uptrend can abruptly reverse into a downtrend.

It is prudent to think of reversal patterns as trend change patterns. I was tempted to use the term “trend change patterns” instead of “reversal patterns” in this book. However, to keep consistent with other technical analysis literature. I decided to use the term reversal patterns. Remember that when I say “reversal pattern” it means only that the prior trend should change but not necessarily reverse. 

Recognising the emergence of reversal patterns can be a valuable skill. Successful trading entails having both the trend and probability on your side. The reversal indicators are the market’s way of providing a road sign. such as “Caution—Trend in Process of Change.” In other words. the market’s psychology is in transformation. You should adjust your trading style to reflect the new market environment. There are many ways to trade in and out of positions with reversal indicators. We shall discuss them throughout the book. 

An important principle is to place a new position (based on a revers al signal) only that signal is in the direction of the major trend. Let us say. for example. that in a bull market, a top reversal pattern appears. This bearish signal would not warrant a short sale. This is because the major trend is still lip. It would. however. signal a liquidation of longs. U’ there was a prevailing downtrend, this same top reversal formation could be used to place short sales. 

I have gone into detail about the subject of reversal patterns because most of the candlestick indicators are reversals. Now, let us turn our attention to the first group of these candlestick reversal indicators, the hammer and hanging-man lines.

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Pushing Up Through Supply

Let us return to look more closely at what happens when professional money pushes up through a potential area of supply. Old trading ranges form resistance areas, because it is a known supply level. Human behaviour will never change and the actions of the herd are well documented. Of the traders that had been buying into the market within the old trading area, many are still in there and have been locked-in by a down-move – the chart below illustrates this. The main concern for these locked-in traders is to sell and recover as much as they can, hopefully without losses. As such, they represent potential supply (resistance) to the market.

The market-makers know exactly where these resistance areas are. If they are bullish, and higher prices are anticipated, the market-maker will certainly want a rally. The problem now is how to avoid being forced to buy stock from these locked-in traders at what, to them, may appear to be high prices.
Any supply area can be compared to the frequent and hated toll gates placed across roads in olden days.

Your progress was constantly impeded by having to stop and pay your toll fee if you wanted to go further.In the stock market, higher prices are frequently blocked by a variety of traders who already hold poor trading positions and want to sell. If the specialists or market-makers are expecting higher prices they will have to pay their toll by absorbing any selling from these traders, but they will try and avoid or limit this toll fee by all means.

So how do the market-makers cope with this problem?

A rapid, wide spread, or gapping, up through an old area of supply as quickly as possible, is an old and trusted method. To the informed trader, we now have a clear sign of strength. The stock specialist does not want to have to buy stock at high prices. He has already bought his main holding at lower levels.

Therefore, the locked-in traders must be encouraged not to sell. As the market approaches the area at
which the locked-in traders could sell out without a loss, the price rockets, gapping up, or shooting up on a wide spread. This phenomenon can be seen on the previous chart.

The locked-in traders who have been concerned over potential losses will now suddenly be showing a
profit and will be tempted not to sell as the stress of a potential loss now turns to elation. As these traders allowed themselves to be trapped in the first place, it is liable to happen to them again at even higher prices.

Gapping up and through resistance on wide spreads is a tried and tested manoeuvre by market-makers and specialists to limit the amount of stock having to be bought to keep the rally going – a way of avoiding the toll gates. The example on the above chart is on a daily timeframe, but these principles will appear on any chart because this is the way professional traders behave.

If you observe high volume accompanying wide spreads up, this shows that the professional money was prepared to absorb any selling from those locked-in traders who decided to sell – this is known as absorption volume. In this situation, the market-makers anticipate higher prices and are bullish. They know that a breakout above an old trading area will create a new wave of buying. In addition, those traders who have shorted the market will now be forced to cover their poor positions by buying as well.

Furthermore, traders that are looking for breakouts will buy. Finally, all those traders not in the market may feel they are missing out and will be encouraged to start buying. This all adds to the professional bullish positions. If you see any testing or down-bars on low volume after this event, it is a very strong buy signal.

High Volume on Market Tops

Many newspaper journalists and television reporters assume that when the market hits new highs on high volume, that this is buying and a continuation of the up-move (the news is ‘good’ and everybody is bullish). This is a very dangerous assumption. As we have already touched upon during this text, high volume on its own is not enough. If the market is already in a rally and high volume suddenly appears during an up-day (or bar) and immediately the market starts to move sideways or even falls next day, then this is a key indicator of a potential end to the rally. If the higher volume shows an increased effort to go up, we would expect the extra effort to result in higher prices. If it does not, then there must have been something wrong. This principle is known as effort versus results and we will cover this in more detail later.

A high volume up-day into new high ground with the next day level or down is an indication of weakness. If the high volume had shown professional buying, how can the prices not go on up? This action shows that buying has come into the market, but be warned that the buying has most likely come from potential weak holders who are being sucked into a rally top! It happens all the time.

Effort versus Results

Effort to go up is usually seen as a wide spread up-bar, closing on the highs, with increased volume – this is bullish. The volume should not be excessive, as this will show that there is also supply involved in the move (markets do not like very high volume on up-bars).

Conversely, a wide spread down-bar, closing on the lows, on increased volume is bearish, and represents effort to go down. However, to read these bars on your chart, common sense must also be applied, because if there has been an effort to move, then there should be a result. The result of effort can be a positive one or a negative one. For example, on Chart 7 (pushing up through supply), we saw an effort to go up and through resistance to the left. The result of this effort was positive, because the effort to rise was successful – this demonstrates that professional money is not selling.

If the additional effort implied in the higher volume and wide spreads upwards had not resulted in higher prices, we can draw only one conclusion: The high volume seen must have contained more selling than buying. Supply on the opposite side of the market has been swamped by demand from new buyers and slowed or stopped the move. This has now turned into a sign of weakness. Moreover, this sign of weakness does not just simply disappear; it will affect the market for some time.

Markets will frequently have to rest and go sideways after any high volume up-days, because the selling has to disappear before any further up-moves can take place. Remember, selling is resistance to higher prices! The best way for professional traders to find out if the selling has disappeared is to ‘test’ the market – that is, to drive the market down during the day (or other timeframe) to flush out any sellers. If the activity and the volume are low on any drive down in price, the professional traders will immediately know that the selling has dried-up. This now becomes a very strong buy signal for them.

Frequently, you will see effort with no result. For instance, you may observe a bullish rally in progress with sudden high volume appearing – news at this time will almost certainly be ‘good’. However, the next day is down, or has only gone up on a narrow spread, closing in the middle or even the lows. This is an indication of weakness – the market must be weak because if the high activity (high volume) had been bullish, why is the market now reluctant to go up? When reading the market, try to see things in context. If you base your analysis on an effort versus results basis, you will be taking a very sensible and logical approach that detaches you from outside influences, such as ‘news’ items, which are often unwittingly inaccurate with regards to the true reasons for a move.

Remember, markets move because of the effects of professional accumulation or distribution. If a market is not supported by professional activity, it will not go very far. It is true that the news will often act as a catalyst for a move (often short-lived), but always keep in mind that it is the underlying activity of ‘smart money’ that provides the effort and the result for any sustained price movement.

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How to Identify Buying & Selling

For a market to move up you need buying, which is generally seen on an up-bar (i.e. the present bar closes higher than the previous bar). The amount of volume attached to the up-bar should be increasing in volume. However, this increase in volume should not be excessive, as this is indicative of supply in the background that is swamping the demand.

If you observe that the volume is low as the market moves up, you know this has to be a false picture. This low volume is caused by the professional money refusing to participate in the up-move, usually because they know the market is weak. The market may be moving up, but it does not have the participation of the traders that matter. Unless the ‘smart money’ is interested in the move, it is certainly not going to rise very far.

During a bear market, you will frequently see temporary up-moves on low volume. The reason for the upmove is of no concern to us, but we see a market that is bearish going up on low volume. This can only happen because the professional money is not interested in higher prices and is not participating, hence the low volume. The professionals are bearish and have no intention of buying into a weak market just because it happens to be going up. If this action is seen with a trading range to the left, at the same price level, this becomes a very strong indication of lower prices to follow.

The opposite is also true for down-moves. So, for a legitimate down-move you would need to witness
evidence of selling, which would reveal itself as increased volume on down-bars (i.e. the present bar closes lower than the previous bar). If you see an increase in volume that is excessive, then you should be wary, as this may indicate that demand is in the background.

If you begin to notice the volume drying up on down-bars, this is evidence that the amount of selling
pressure is reducing. The market may continue to fall, but be aware that it could quickly turn and rise
momentarily, due to the lack of supply. A decreasing amount of volume on any down-bar indicates that there is no professional interest to the downside.


How to Identify Lack of Demand

‘Lack of demand’ is one of the most common indications you will see and it is pretty easy to pick out.
Basically, you will be watching out for a low volume up-bar, on a narrow spread, such as the one identified by Trade Guider in the chart below.

If, over the next few bars or more, the price closes down, on declining volume, with narrow spreads, then this indicates that there is no selling pressure. In this case, we have observed some temporary weakness, which has now been overcome – the up-move may now continue.
Whilst reading a chart, try to keep in mind that most people fail to link human behaviour (in this case, of professional traders) with the price spreads and the volume, but would rather believe the mass of incoming 'news', which inevitably differs from what supply and demand is telling you.
It is the lack of demand from professional money that causes a market to roll over at the tops, resulting in the characteristic mushroom shape. You will not notice this weakness because the news will still be good.

The chart above shows a market that is completely devoid of professional support. All the Xs on the chart show narrow spread bars that are closing higher than the previous bar, on low volume. There is absolutely no way a market can rally up through an old trading top, and into fresh new ground on this lack of demand. Do not view lack of demand in isolation – try to take a holistic view when reading the market. You should always look to the background. What are the previous bars telling you? If you have the TradeGuider software, this will help you to become a better trader by teaching you how to read the markets. In time, you will become more proficient at market analysis, such that you may even decide to trade ‘blind’, to test your skills without the supply and demand indicators built into the software.

For now, remember that we need confirmation before shorting the market following any sign of no
demand. There are many confirming indicators built into the software, but suffice to say that this
sometimes appears as a narrow spread up-bar on greatly increased volume. In this instance, professional traders have started to transfer stock to eager uninformed (or misinformed!) buyers. Prices are being kept low to encourage buying, which accounts for the narrow spread. These traders are completely unaware of the implications of volume activity and are probably buying on repeated ‘good news‘.

Testing Supply

Testing is by far the most important of the low volume buy signals. As we shall refer to the subject many times, in what follows, it will be worthwhile to digress here for a moment and look at the subject in detail. What is a "test" and why do we place such importance on this action?
A large trader who has been accumulating an individual stock or a section of the market can mark prices down with some confidence, but he cannot mark prices up when others are selling into the same market without losing money. To attempt to mark prices up into selling is extremely poor business, so poor in fact, it will lead to bankruptcy if one persists.

The danger to any professional operator who is bullish, is supply coming into his market (selling), because on any rally, selling on the opposite side of the market will act as resistance to the rally and may even swamp his buying. Bullish professionals will have to absorb this selling if they want higher prices to be maintained. If they are forced to absorb selling at higher levels (by more buying), the selling may become so great that prices are forced down. They will have been forced to buy stock at an unacceptably high level and will lose money if the market falls.

Rallies in any stock-based indices are usually short-lived after you have seen supply in the background. The professional trader knows that given enough time (with bad news, persistent down-moves, even time itself with nothing much happening) the floating supply can be removed from the market, but he has to be sure the supply has been completely removed before trying to trade up his holding. The best way to find out is to rapidly mark the prices down. This challenges any bears around to come out into the open and show their hand.

The amount of volume (activity) of trading as the market is marked down will tell the professional how much selling there is. Low volume, or low trading activity, shows there is little selling on the mark-down . This will also catch any stops below the market, which is a way of buying at still lower prices. (This action is sometimes known as a springboard) High volume, or high activity, shows that there is in fact selling (supply) on the mark-down . This process is known as testing. You can have successful tests on low volume and other types of tests on high volume, usually on ‘bad news‘.

This not only catches stops, but shakes the market out as well, making the way easier for higher prices. Testing is a good sign of strength (as long as you have strength in the background). Usually, a successful test (on low volume) tells you that the market is ready to rise immediately, whilst a higher volume test usually results in a temporary up-move, and will be subject to are-test of the same price area again at a later time. This action sometimes results in a “W” shape.

This pattern is sometimes referred to as a “dead cat bounce” or a “double bottom”. The “W” shape results from the action of re-testing an area that had too much supply before.

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How to Tell if a Market is Weak or Strong

Buy and sell orders from traders around the world are generally processed and matched up by market makers.

It is their job to create a market. In order to create a market they must have large blocks of stocks
to trade with. If they do not have sufficient quantities on their books to trade at the current price level, they will have to move quickly to another price level where they do have a holding, or call on other market makers for assistance. All market-makers are in competition with each other for your business, so their response to your buy or sell order has to be realistic and responsive to market conditions.

If the market has been in a bull-move and you place a buy order into a rising market, you may receive what appears to be a good price from the floor of the exchange. Why are you receiving a good price? Have these hard-nosed professionals decided that they like you and have decided to be generous giving away some of their profits to you? Or have they now decided to start switching positions, taking a bearish or negative view of the market, because their books have started to show large sell orders to dispose of? Their perceived value of the market or stock may be lower than yours because they expect prices to fall or at best go sideways.

Such action, repeated many times across the floor, will tend to keep the spread of the day narrow, by limiting the upper end of the price spread, because they are not only giving you what appears to be a good price, but also every other buyer. If, on the other hand, the market-maker has a bullish view, because he does not have large sell orders on his books, he will mark-up the price on your buy order, giving you what appears to be a poor price. This,repeated, makes the spread wider as the price is constantly marked up during the day.

So by simple observation of the spread of the bar, we can read the sentiment of the market-makers; the opinion of those who can see both sides of the market.

Frequently, you will find that there are days where the market gaps up on weakness. This gapping up is far different from a wide spread up, where the market-makers are marking the prices up against buying. The gapping up is done rapidly, usually very early in the day's trading, and will certainly have emotional impact. This price action is usually designed to try to suck you into a potentially weak market and into a poor trade, catching stop-losses on the short side, and generally panicking traders to do the wrong thing. You will find that weak gap-ups are always into regions of new highs, when news is good and the bull market looks as though it will last forever.

You can observe similar types of gapping-up action in strong markets too, but in this second case you will have an old (sideways) trading area to the left. Traders who have become trapped within the channel(sometimes referred to as a ‘trading range’), either buying at the top and hoping for a rise, or buying at the bottom and not seeing any significant upwards price action, will become demoralised at the lack of profit. These locked-in traders want only one thing – to get out of the market at a similar price to the one they first started with. Professional traders that are still bullish know this. To encourage these old locked-in traders not to sell, professional traders will mark-up , or gap up the market, through these potential resistance areas as quickly as possible.

Here you can see that prices have been rapidly marked up by professional traders, whose view of the
market at that moment is bullish. We know this because the volume has increased, substantially backing up the move. It cannot be a trap up-move, because the volume is supporting the move. Wide spreads up are designed to lock you out of the market rather than attempting to suck you in. This will tend to put you off buying, as it goes against human nature to buy something today that you could have bought cheaper yesterday, or even a few hours earlier. This also panics those traders that shorted the market on the last low, usually encouraged by the timely release of ‘bad news’, which always seems to appear on, or near, the lows. These traders now have to cover their short position (buying), adding to the demand.

Note from the above chart that the volume shows a substantial and healthy increase – this is bullish volume. Excessive volume, however, is never a good sign; this indicates ‘supply’ in the market, which is liable to be swamping the demand. However, low volume warns you of a trap up-move (which is indicative of a lack of demand in the market).

If you take the rapid up-move in isolation, all it shows is a market that is going up. What brings it to life is the trading range directly to the left. You now know why it is being rapidly marked up, or even gapped-up. Also note that any low volume down-bars which appear after the prices have rallied and cleared the resistance to the left, is an indication of strength and higher prices to come.
Specialists and market-makers base their bids and offers on information you are not privileged to see.

They know of big blocks of buy or sell orders on their books at particular price levels and they are also fully in tune with the general flow of the market. These wholesalers of stocks also trade their own accounts. It would be naïve to think they are not capable of temporarily marking the market up or down as the opportunity presents itself, trading in the futures or options markets at the same time. They can easily mark the market up or down on good or bad news, or any other pretence. They are not under the severe trading pressures of normal traders, because they are aware of the real picture, and in the most part, it is they who are doing all the manipulating. This is good news for us because we can see them doing this, in most cases fairly clearly, and can catch a good trade if we are paying attention.

Why play around with the prices? Well, the market-makers want to trap as many traders as possible into poor positions. An extra bonus for them includes catching stop-loss orders, which is a lucrative business in itself. Owing to the huge volume of trading in the markets, it will take professional buying or selling to make a difference that is large enough for us to observe. This fact alone tells us that there are professionals working in all the markets. These traders, by their very nature, will have little interest in your financial well-being. In fact, given the slightest opportunity, the ‘smart money’ can be regarded as predators looking to catch your stops and mislead you into a poor trade.

                                                                                                                                                                    

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Supply & Demand

We can learn a great deal from observing the professional market operators. If you watch a top professional trading and he is not on the floor, he will most likely be looking at a trading screen, or a live chart on a computer screen. On the face of it, his resources are no different from any other
trader. However, he does have information on the screen you are not privileged to see. He knows where all the stops are, he knows who the large traders are and whether they are buying or selling. He has low dealing costs compared to you. He is well practised in the art of trading and money management.

What does he see? How does he manage to get a good position when, by the time you get to the market, prices always seem to be against your interests? How does such a trader know when the market is going to move up or down? Well, he understands the market and uses his knowledge of volume and price action as his primary cues to enter (or exit) the market.

His primary concern is the state of supply and demand of those instruments in which he has an interest. One way or another, the answers lie in some form of analysis of trading volume, price action and price spreads. Here at TradeGuider Systems Ltd, we have developed a methodology called Volume Spread Analysis (abbreviated to VSA), which has been built into the computer model that is utilised in the TradeGuider software.

Learning which questions to ask and how to obtain the answers requires us to look more deeply into the markets. The stock market becomes far more interesting if you have some idea what is going on and what is causing it to go up or down. A completely new and exciting world can open up for you.
Nearly all traders use computers and many of these traders are using Technical Analysis packages.

They will have learned how to use well-known indicators, like RSI and Stochastics, which are mathematical formulae based on a historical study of price. Some packages have over 100 indicators and other tools that measure cycles, angles, or retracements. There is even software that analyses the effects of tidal forces, astrological, planetary, and galactic influences. To many traders, these methods will have a place in their trading decisions, because they will be familiar with their use. However, it can become a very frustrating business being placed outside of the market looking in, using these tools, trying to decide if the market is likely to go up or down.

The fact is, these tools never tell you why the market is moving either up or down – that, in most cases remains a complete mystery. People, unless they are naturally well disciplined, are extremely open to suggestion! Folks like to be given tips, listen to the news stories, seek out rumours in internet chat rooms, or maybe subscribe to secret information leaked from unknown sources.

For the most part, professional floor traders, syndicate traders, and the specialists, do not look at these
things. They simply do not have the time. Professionals have to act swiftly, as soon as market conditions change, because they are up against other professionals who will act immediately against their interests if they are too slow in reacting to the market. The only way they can respond that fast is to understand and react, almost instinctively, to what the market is telling them. They read the market through volume and its relationship to price action. You, too, can read the market just as effectively, but you have to know what you are looking at, and what you are looking for.

The Basics of Market Reading

Before you can start your analysis, you will need to see all the relevant price action, going back over the past few months. We recommend using the Trade Guider software, by Trade Guider Systems Ltd
(www.TradeGuider.com), since using this software will give you a significant advantage over standard charting software, as you will also be able to see our proprietary VSA indicators. There are around 400 indicators built into Trade Guider, which utilize all the introductory principles in this brief book, plus the many other advanced VSA indicators that we have developed and researched over the course of the last 15 years.

Volume is usually shown as a histogram on the bottom of the chart. We recommend that you don’t use the open interest volume, since this can be misleading. However, for real-time charts, tick volume may be used where no transaction volume is available.
At this point, it is important to note that volume gives us an indication of the amount of activity that has taken place during whichever time frame is being monitored.

All markets move in ‘phases’; we can observe the market building a cause for the next move. These phases vary – some last only a few days, some several weeks. The longer phases give rise to large moves, and the shorter phases result in smaller moves.

The amount of volume taken in isolation means little – it is the relative volume we are interested in. The chart below shows the relative volume indicator that is unique to Trade Guider. It is showing that there is considerably more bearish volume in the market, which is why the prices decline on this chart. Once you have established the relative volume of business, you must consider how the market responds to this activity.

The spread is the range from the high to the low of the price bar. We are particularly interested in whether the spread is abnormally wide, narrow, or just average. The Trade Guider software interprets the spread size, and all other relevant information for you, so there is no need to establish anything by eye (which can be difficult at times). The graphic below shows how Trade Guider reports all the required information with easily comprehensible English words, rather than arbitrary numerical values.

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Accumulation & Distribution

Syndicate traders are very good at deciding which of the listed shares are worth buying, and which are best left alone. If they decide to buy into a stock, they are not going to go about it in a haphazard or half-hearted fashion. They will first plan and then launch, with military precision, a co-ordinated campaign to acquire the stock – this is referred to as accumulation. Similarly, a co-ordinated approach to selling stock is referred to as distribution.

Accumulation

To accumulate means to buy as much of the stock as possible, without significantly putting the price
up against your own buying, until there are few, or no more shares available at the price level you have been buying at. This buying usually happens after a bear move has taken place in the stock market (which will be reflected by looking at the Index).

To the syndicate trader, the lower prices now look attractive. Not all of the issued stock can be
accumulated straight away, since most of the stock is tied up. For example, banks retain stock to cover loans, and directors retain stock to keep control in their company. It is the floating supply that the syndicate traders are after.

Once most of the stock has been removed from the hands of other traders (ordinary private
individuals), there will be little, or no stock left to sell into a mark-up in price (which would normally
cause the price to drop). At this point of ‘critical mass’, the resistance to higher prices has been
removed from the market. If accumulation has taken place in lots of other stocks, by many other
professionals, at a similar time (because market conditions are right), we have the makings of a bull
market. Once a bullish move starts, it will continue without resistance, as the supply has now been
removed from the market.

Distribution

At the potential top of a bull market, many professional traders will be looking to sell stock bought at lower levels to take profits. Most of these traders will place large orders to sell, not at the current price available, but at a specified price range. Any selling has to be absorbed by the market-makers, who have to create a 'market’. Some sell orders will be filled immediately, some go, figuratively, 'onto the books‘. The market makers in turn have to resell, which has to be accomplished without putting the price down against their own, or other traders’ selling. This process is known as distribution, and it will normally take some time for the process to complete.

In the early stages of distribution, if the selling is so great that prices are forced down, the selling will stop and the price will be supported, which gives the market-maker, and other traders, the chance to sell more stock on the next wave up. Once the professionals have sold most of their holdings, a bear market starts, because markets tend to fall without professional support.

Strong & Weak Holders

The stock market revolves around the simple principles of accumulation and distribution, which are
processes that are not well known to most traders.
Perhaps you can now appreciate the unique position that the market-makers, syndicate traders, and other specialist traders are in – they can see both sides of the market at the same time, which represents a significant advantage over the ordinary trader. It is now time to refine your understanding of the stock market, by introducing the concept of ‘Strong and Weak Holders.’

Strong Holders

Strong holders are usually those traders who have not allowed themselves to be trapped into a poor trading situation. They are happy with their position, and they will not be shaken out on sudden down-moves, or sucked into the market at or near the top. Strong holders are strong because they are trading on the right side of the market. Their capital base is usually large, and they can normally read the market with a high degree of competence. Despite their proficiency, strong holders will still take losses frequently, but the losses will be minimal, because they have learnt to close out losing trades quickly. A succession of small losses is looked upon in the same way as a business expense. Strong holders may even have more losing trades than winning trades, but overall, the profitability of the winning trades will far outweigh the combined effect of the losing trades.

Weak Holders

Most traders who are new to the markets will very easily become Weak Holders. These people are usually under-capitalised and cannot readily cope with losses, especially if most of their capital is rapidly disappearing, which will undoubtedly result in emotional decision-making. Weak holders are on a learning curve and tend to execute their trades on ‘instinct’. Weak holders are those traders who have allowed themselves to be 'locked-in' as the market moves against them, and are hoping and praying that the market will soon move back to their price level. These traders are liable to be 'shaken out' on any sudden moves or bad news.

Generally, weak holders will find that they are trading on the wrong side of the market, and are therefore immediately under pressure if prices turn against them.
If we combine the concepts of strong holders accumulating stock from weak holders prior to a bull move, and distributing stock to potential weak holders prior to a bear move, then in this context:

• A Bull Market occurs when there has been a substantial transfer of stock from Weak
Holders to Strong Holders, generally, at a loss to Weak Holders.

• A Bear Market occurs when there has been a substantial transfer of stock from Strong
Holders to Weak Holders, generally at a profit to the Strong Holders.

The following events will always occur when markets move from one major trending state to another:

The Buying Climax

Brief Definition: An imbalance of supply and demand causing a bull market to transform into a bear
market.

Explanation: If the volume is seen to be exceptionally high, accompanied by narrow spreads into new high ground, you can be assured that this is a ‘buying climax’.
It is called a buying climax because to create this phenomenon there has to be a huge demand for buying from the public, fund managers, banks and so on. It is into this buying frenzy, that syndicate traders and market-makers will dump their holdings, to such an extent that higher prices are now impossible. In the last phase of the buying climax, the market will be seen to close in the middle or high of the bar.

The Selling Climax

Brief Definition: An imbalance of supply and demand causing a bear market to transform into a bull
market.

Explanation: This is the exact opposite of a buying climax. The volume will be extremely high on
down-moves, accompanied by narrow spreads, with the price entering fresh low ground.
The only difference is that on the lows, just before the market begins to turn, the price
will be seen to close in the middle or low of the bar.

To create this phenomenon requires a huge amount of selling, such as that witnessed following the tragic events of the terrorist attacks on the World Trade Centre in New York on September the 11th 2001.
Note that the above principles seem to go against your natural thinking (i.e. market strength actually
appears on down-bars and weakness, in reality, appears on up-bars). Once you have learned to grasp this concept, you will be on your way to thinking much more like a professional trader.

Resistance & Crowd Behaviour

We have all heard of the term ‘resistance’, but what exactly is meant by this loosely used term? Well, in the context of market mechanics, resistance to any up-move is caused by somebody selling the stock as soon as a rally starts. In this case, the floating supply has not yet been removed. The act of selling into a rally is bad news for higher prices. This is why the supply (resistance) has to be removed before a stock can rally (rise in price).

Once an up-move does take place, then like sheep, all other traders will be inclined to follow. This concept is normally referred to as ‘herd instinct’ (or crowd behaviour). As human beings, we are free to act however we see fit, but when presented with danger or opportunity, most people act with surprising predictability. It is this knowledge of crowd behaviour that helps the professional syndicate traders to choose their moment to make a large profit. Make no mistake – professional traders are predatory beasts and uninformed traders represent the symbolic ‘lamb to the slaughter’.

We shall return to the concept of ‘herd instinct’ again, but for now, consider the importance of this
phenomenon, and what it means to you as a trader. Unless the laws of human behaviour change, this
process will always be present in the financial markets. You must always try to be aware of ‘Herd
Instinct’.

There are only two main principles at work in the stock market, which will cause a market to turn. Both of these principles will arrive in varying intensities producing larger or smaller moves:

1. The ‘herd’ will panic after observing substantial falls in a market (usually on bad news) and will
usually follow its instinct to sell. As a trader who is aware of crowd psychology, you must ask
yourself, “Are the trading syndicates and market-makers prepared to absorb the panic selling at these
price levels?” If they are, then this is a good sign that indicates market strength.

2. After substantial rises, the ‘herd’ will become annoyed at missing the up-move, and will rush in and buy, usually on good news. This includes traders who already have long positions, and want more. At this stage, you need to ask yourself, “Are the trading syndicates selling into the buying?” If so, then this is a severe sign of weakness.

Does this mean that the dice is always loaded against you when you enter the market? Are you destined always to be manipulated? Well, yes and no.

A professional trader isolates himself from the ‘herd’ and becomes a predator rather than a victim. He
understands and recognizes the principles that drive the markets and refuses to be misled by good or bad news, tips, advice, brokers, or well-meaning friends. When the market is being shaken-out on bad news, he is in there buying. When the ‘herd’ is buying and the news is good, he is looking to sell.

Master the Markets 

You are entering a business that has attracted some of the sharpest minds around. All you have to do is to join them. Trading with the ‘strong holders’ requires a means to determine the balance of supply and demand for an instrument, in terms of professional interest, or lack of interest, in it. If you can buy when the professionals are buying (accumulating or re-accumulating) and sell when the professionals are selling (distributing or re-distributing) and you do not try to buck the system you are following, you can be as successful as anybody else can in the market. Indeed, you stand the chance of being considerably moresuccessful than most!

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A Special Word About Market-Makers

It is important to understand that the market-makers do not control the market. They are responding to market conditions and taking advantage of opportunities presented to them. Where there is a window of opportunity provided by market conditions – panic selling or thin trading – they may see the potential to increase profits through price manipulation, but they can only do so if the market allows them to.

 You must not therefore assume that market-makers control the markets. No individual trader or organisation can control any but the most thinly traded of markets for any substantial period of time.
Market-makers are fully aware of the activities of trading syndicates and other professional operators that place substantial orders. It therefore makes sense that they will take whatever opportunity is available to better their own accounts accordingly.

Volume – The Key to the Truth

Volume is the major indicator for the professional trader.

You have to ask yourself why the members of the self-regulated Exchanges around the world like to keep true volume information away from you as far as possible. The reason is because they know how important it is in analysing a market!

The significance and importance of volume appears little understood by most non-professional traders. Perhaps this is because there is very little information and limited teaching available on this vital part of technical analysis. To use a chart without volume data is similar to buying an automobile without a gasoline tank.

Where volume is dealt with in other forms of technical analysis, it is often viewed in isolation, or averaged in some way across an extended timeframe. Analysing volume, or price for that matter, is something that cannot be broken down into simple mathematical formulae. This is one of the reasons why there are so many technical indicators – some formulas work best for cyclic markets, some formulas are better for volatile situations, whilst others are better when prices are trending.

Some technical indicators attempt to combine volume and price movements together. This is a better way,but rest assured that this approach has its limitations too, because at times the market will go up on high volume, but can do exactly the same thing on low volume. Prices can suddenly go sideways, or even fall off, on exactly the same volume! So, there are obviously other factors at work.
Price and volume are intimately linked, and the interrelationship is a complex one, which is the reason.TradeGuider was developed in the first place. The system is capable of analysing the markets in real-time (or at the end of the day), and displaying any one of 400 indicators on the screen to show imbalances of supply and demand.

Urban Myths You Should Ignore

There are frequent quotes on supply and demand seen in magazines and newspapers, many of which are unintentionally misleading. Two common ones run along these lines.

• "For every buyer there has to be a seller"

• "All that is needed to make a market is two traders willing to trade at the correct price"

These statements sound so logical and straightforward that you might read them and accept them
immediately at face value, without ever thinking about the logical implications! You are left with the
impression that the market is a very straightforward affair, like a genuine open auction at Sotheby's
perhaps. However, these are in fact very misleading statements.

Yes, you may be buying today and somebody may be willing to sell to you. However, you might be buying only a small part of large blocks of sell orders that may have been on the market-makers' books, sitting there, well before you arrived on the scene. These sell orders are stock waiting to be distributed at certain price levels and not lower.

The market will be supported until these sell orders are exercised, which once sold will weaken the market, or even turn it into a bear market. So, at important points in the market the truth may be that for every share you buy, there may be ten thousand shares to sell at or near the current price level, waiting to be distributed. The market does not work like a balanced weighing scale, where adding a little to one scale tips the other side up and taking some away lets the other side fall. It is not nearly so simple and straightforward.

You frequently hear of large blocks of stock being traded between professionals, bypassing what appears to be the usual routes. My broker, who is supposedly "in the know", once told me to ignore the very high volume seen in the market that day, because most of the volume was only market-makers trading amongst themselves. These professionals trade to make money and while there may be many reasons for these transactions, whatever is going on, you can be assured one thing: It is not designed for your benefit.

Youshould certainly never ignore any abnormal volume in the market.
In fact, you should also watch closely for volume surges in other markets that are related to that which you are trading. For example, there may be sudden high volume in the options market, or the futures market.Volume is activity! You have to ask yourself, why is the ‘smart money’ active right now?

Further Understanding Volume

Volume is not difficult to understand once the basic principles of supply and demand are understood. This requires you to relate the volume with price action. Volume is the powerhouse of the stock market. Start to understand volume and you will start to trade on facts (not on ‘news’). Your trading will become exciting as you start to realise that you can read the market – a very precious skill that only a few people share.

To say that the market will go up when there is more buying (demand) than selling – and go down when there is more selling (supply) than buying may seem like an obvious statement. However, to understand this statement you need to look at the principles involved. To understand what the volume is saying to you, you have to ask yourself again, “What has the price done on this volume”?

The price spread is the difference between the highest and lowest trading points reached during the
timeframe you are looking at, which may be weekly, daily, hourly, or whatever other timeframe you
choose. Volume shows the activity of trading during a specific period. If the volume is taken in isolation it means very little – volume should be looked at in relative terms. Therefore, if you compare today's volume with volume during the previous thirty days (or bars) it is easy to see if today's volume is high, low or average compared to the volume seen in the past.

If you stand thirty people in a line, it is easy for you to see who the tall ones are, compared to the others. This is a skill of human observation, so you will have no problems identifying whether the volume is relatively high, low or average.

Compare this volume information with the price spread and you will then know how bullish or bearish the professional wholesalers really are. The more practice you have, by taking this professional approach, the better you will become.To make it easier for you to understand volume, compare it to the accelerator of your automobile. Think about the results you would expect from pressing the accelerator when approaching ‘resistance’, such as a hill. Imagine you are an engineer monitoring a car's performance by remote control.

Your instruments only allow you to see the power applied to the accelerator pedal (volume) and a second engineer is looking at the cars actual motion (price movement). The second engineer informs you that the car is moving forward uphill; however, this uphill movement is not in keeping with your observation of power to the accelerator pedal, which you observe is very low. You would naturally be somewhat sceptical, as you know a car cannot go uphill without sufficient power being applied.

You may conclude that this movement uphill could not possibly be a genuine lasting movement, and that it is probably caused by some reason other than power application. You may even disbelieve what your instruments are telling you, as it is obvious that cars cannot travel uphill unless power is applied to the accelerator pedal. Now you are thinking more like a professional trader!

Many traders are mystified if the same thing happens in the stock market. Remember, any market, just like an automobile, has ‘momentum’ that will cause movement even when the power has been turned off. This example explains why markets can momentarily rise on a low volume up-move. However, all moves with differing types of volume activity can be explained using the “accelerator pedal” analogy.

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Importance of Dark Cloud Cover Pattern

Our next reversal pattern is the dark-cloud cover (see below image). It is a two candlestick pattern that is a top reversal after a uptrend or. at times. at the top of a congestion band. The first day of this two candlestick pattern is a strong white real body. The second clay’s price opens above the prior session’s high (that is. above the top ‘ the upper shadow). 

However, by the end the second day’s session. the market closes near the low of the day and well within the prior day’s white body. The greater the degree of penetration into the white real body the more likely a top will occur. Some Japanese technicians require more than a 50% penetration of the black session’s close into the white real body. fi’ the black candlestick does not close below the halfway point of the white candles tick it may be best to wait for more bearish confirmation following the dark cloud cover. 

The rationale behind this bearish pattern is readily explained. The market is in an uptrend. A strong white candlestick is followed by a gap higher on the next session’s opening. Thus far the bulls are in complete control. But then no continuation of the rally occurs! In fact, the market closes at or near the lows of the day moving well within the prior day’s real body. In such a scenario the longs will have second thoughts about their position. Those who were waiting for selling short now have a benchmark to place a stop—at the new high of the second day of the dark-cloud cover pattern.

The following is a list of some factors that intensify the importance of dark-cloud covers:

1. The greater the degree of penetration the black real body’s close into (lie prior white real body. the greater the chance for a top. If (lie black real body covers the prior clay’s entire white body. a bearish engulfing pattern would occur. The dark-cloud cover’s black real body only gets partially into the white body. Think (lie dark-cloud cover as a partial solar eclipse blocking out part. The bearish engulfing pattern can be viewed as a total solar eclipse blocking out (lie entire sun (that is. covers (lie entire white body). A bearish engulfing pattern. consequently. is a more meaningful top reversal. If a long, white real body closes above the highs ‘ (lie dark-cloud cover, or the bearish engulfing pattern, it could presage another rally.

 2. During a prolonged uptrend, there is a strong white clay which opens on its low (that is a shaven bottom) and closes on its high (that is. a shaven head) and the next day reveals a long black real body day. opening on its high and closing on its low, then a shaven head and shaven bottom black day have occurred. 

3. the second body (that is the black body) of the dark-cloud cover opens above a major resistance level and then fails, it would prove the bulls were unable to take control of the market. 

4. It on the opening of the second day there is very heavy volume, a buying blow off could have occurred. For example. heavy volume at a new opening high could mean that many new buyers have decided to jump aboard ship. Then the market sells offs. It probably won’t be too long before this multitude of new longs (and old longs who have ridden the uptrend) realise that the ship they jumped onto is the Titanic. For futures traders. very high opening interest can be another warning.

HAMMER AND HANGING-MAN LINES

Figure shows candlesticks with long lower shadows and small real bodies. The real bodies are near the top 1 the daily range. The variety ± candlestick lines shown in the exhibit are fascinating iii that either line can be bullish or bearish depending on where they appear in a trend. if either of these lines emerges during a downtrend it is a signal that the downtrend should end. In such a scenario. this line is labelled a hammer.

as in “the market is hammering out” a base. See Exhibit 4.5. Interestingly. the accrual Japanese word for this line is takuri. This word means something to the affect Cf “trying to gauge the depth Cf the water by feeling for its bottom.”
if either Cf the lines in Exhibit 4.4 emerge after a rally it tells you that the prior move may be ending. Such a line is ominously called a hanging man (see Exhibit 4.6). The name hanging man is derived from the fact that it looks like a hanging man with dangling legs.

It may seem unusual that the same candlestick line can be both bullish and bearish. Yet. for those familiar with Western island tops and island bottoms you will recognise that the identical idea applies here. The island formation is either bullish or bearish depending on where it is in a trend. An island after a prolonged uptrend is bearish, while the same island pattern after a downtrend is bullish.

The hammer and hanging man can be recognised by three criteria:

1. The real body is at the upper end of the trading range. The colour Cf the real body is not important.
2. A long lower shadow should be twice the height Cf the real body
3. It should have no. or a very short. upper shadow.

The longer the lower shadow. the shorter the upper shadow and the smaller the real body the more meaningful the bullish hammer or bearish hanging man. Although the real body the hammer or hanging man can be white or black. it is slightly more bullish if the real body c the hammer is white. and slightly more bearish if the real body c( the hanging man is black. if’ a hammer has a white real body it means the market sold off sharply during the session and then bounced back to close at. or near. the session’s high. This could have bullish ramifications if’ a hanging man has a black real body. it shows that the close could not get back to the opening price level. This could have potentially bearish implications. 

It is especially important that you wait for bearish confirmation with the hanging man. The logic for this has to do with how the hanging-man line is generated. Usually in this kind of scenario the market is full of bullish energy. Then the hanging man appears. On the hanging-man day. the market opens at or near the highs. then sharply sells off and then rallies to close at or near the highs. This might not be the type of price action that would let you think the hanging man could be a top reversal. But this type of price action now shows once the market starts to sell off. it has become vulnerable to a fast break. 

the market opens lower the next day. those who bought on the open or close of the hanging—man day are now left “hanging” with a losing position. Thus the general principle for the hanging man: the greater the down gap between the real body of the hanging-man day and the opening the next day the more likely the hanging man will be a top. Another bearish verification could be a black real body session with a lower close than the hanging-man sessions close.

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