Head & Shoulders: a Close-up

A Cinderella among the Nobles

Trading methods are not only different and, most of the time, personalized ways of looking at the market or the developments that take place on it. In most cases, they turn into a sort of living entities that have their own histories and lives. Unlike some of the famous methods, shrouded in myths and invented by some celebrated, charismatic, and enigmatic personalities to whom they owe their popularity, the well-known Head & Shoulders method was neither concocted by any controversial trading guru nor is it promoted by the less lucky in trading offspring of the latter, who opted for the marketing of their great grandfather's dubious legacy having considered the other option of setting up a diners for the local townies round the corner. And this is what gives another reason to look more closely at why the technique is so popular with so many traders.

How It Works, or You Still Need a Head on Those Shoulders

Basically, the head & shoulders technique is rather simple as compared to most other methods. You don't need to painstakingly select any inputs to train your software, measure the planetary influence of Saturn or count the number of successful UFO landings on it. It's all pretty much down to earth, and, probably, this is one the method's major merits: you can clearly see the advantages and disadvantages of what you entrust your hard-earned bucks to.

The Head & Shoulders pattern is comprised of four equally important parts: the left shoulder, the head, the right shoulder and the neckline. The starting point for the formation of the figure on the whole, and the left shoulder in particular, becomes a sharp rise in the trend-line followed by a fall, a downward advance, and the largest volume in the pattern. The peak volume is accounted for by the growing number of buyers, joining in as the upward move continues.

Now we have the left shoulder. The head is formed by an upward and shorter advance toward the highest peak in the formation, a fall, and a peak volume for this part of the figure. The right shoulder starts with a high-volume sell-off and an upward trend. This upward trend breaks lower than the head peak to cause the volume to fall to the lowest point in the pattern as the public starts awakening to the reversal in the making. The main element in the pattern is the neckline, drawn between the lowermost points of the shoulders. The pattern is complete when the neckline, being a support line, is pierced by the right shoulder. The "lifespan" of the pattern is normally from several weeks to several months, and it's unlikely to be suitable for use over the longer haul. One the face of it, getting the hang of the whole thing is like a cinch: definitely no nerdy background is a requirement. But as a thinking trader you are aware that everything can be so simple only in that software with the one magic button, fools spend their whole lives looking for. Therefore, what are the pitfalls and how to avoid them?

Identifying the Familiar Silhouette

A really big problem about the Head & Shoulders method is that if you really want that to happen, you'll see signs of the pattern occurring everywhere. A sign of a true occurrence of the pattern is a very sharp rise in the price and a distinctly large volume this rise is accompanied with.

Also, one should always bear it in mind that for this specific pattern volume is of greatest importance. A very low volume on the right shoulder means that a reversal is happening. A true reversal is also accompanied by the price falling far enough below the neck-line. The market tries to overcome the previous high, fails to do so, and, thus, experiences the deepest drop for the entire pattern. Most probably, it is largely this simple, "trustworthy", and entirely logical explanation that the technique owes the trust many traders put in it to. Please note, that if the price trend-line is simply bobbing along the neckline, you may well expect an upward move.

Another helpful sign is that the peaks of the two shoulders should take roughly the same amount of time to develop and be roughly of the same height.

Overall, one can say that the possibility of error while recognizing the true occurrences of the pattern, especially with novice or less experienced traders, is pretty high. The chances can be approximately estimated as 50/50. That is why, to reduce the related risks, it would be expedient to use this method as an "auxiliary" method along with the other methods you use until you feel more confident about your pattern recognition ability. In any case, another result that coincides with the result of your forecasting results will not do any harm.

Can Moving Averages Be Used to Forecast Price Direction?

In a single word: No.

I often hear of or read the comment that analysts use moving averages to predict price direction and even the next close. I started my career as a technical analyst way back when I was working in Hong Kong and my treasurer sent me on a technical analysis seminar where I learned about golden crosses and dead crosses. In particular, stated the presenter, use a 20 days and 60 average to represent a 1 month and 3 month average.

"Great!" thought I, "this is going to make my life easier. I can't wait to get back into the dealing room to try this out."

In those days the fashion was to draw your own charts to get a better "feel" for the market and thus I used to draw the averages on large charts stuck to the wall.

What a waste of time…

Every time the 20 days average crossed above the 60 days average price reversed lower.

OK. Then throw average out of the window… Since that time I have never used averages in my analysis again.

That was around 1989-1990 just as real time technical analysis systems started appearing in trading rooms. Over the 1990's I became interested in building systems and it was around the mid 90's that I kept hearing this statement about how moving averages predict price.

Well, using a programmable technical analysis software I set up the software to write a report for me that summarized the close to close profit or loss generated from using the underlying moving average direction. Hence, when the moving average was rising I would then measure the profit or loss generated from close to close over the next day, and vice versa when the average was declining. Which average did I use? For the sake of simplicity I used the market favorite, the 20 period moving average used by the fund management industry.

The following are the results for six currency pairs showing the average profit & loss and the percentage of winning trades:

	USDJPY	EURUSD	USDCHF	GBPUSD	GBPJPY	AUDUSD
% Winning Trades	50.06	49.55	48.42	48.93	48.64	49.13
Average Profit	0.62	0.0053	0.0079	0.0066	1.01	0.0035
Average Loss	0.60	0.0050	0.0072	0.0062	1.06	0.0033

Note that in all cases the average profit is not any higher than the bid-ask spread and mostly lower. This doesn't really give me any confidence in using a moving average to predict the next day's close to close movement.

The moral of the story? Don't expect too much from your indicators. There is nothing magic about any of them in providing anything but circumstantial supporting evidence of a trade. All indicators, whatever the creator's claim, are lagging indicators since they are based off historic prices and therefore reflect what has been and not what will be. They can provide you with information about the general characteristic of price action at that time but the real information you require is all in price and it is in the understanding of price and trading mentality that will help you pick better trades.

Andrews's Pitchfork: Thinking Approach

Trading approaches are much like people: some aren't worth a dime but have a lot going for them: their genius creator's legendary bios, intricate, if bizarre, theories behind them, commercial websites, full of promotional puffery, and hordes of steadfast followers, who keep the former afloat. Others are rather modest but talented and really able to help trade profitably. No doubt, one of such talentedly developed methods was invented by Dr. Alan Andrews in the beginning of the 1960-s to become one of the simplest, most efficient and reliable technical analysis techniques. So what makes Andrew's Pitchfork a valuable analysis technical tool and what are the benefits and risks one should be aware of while applying this method?

As we have already mentioned, the method is quite simple. It shows the areas of resistance and support using three lines: a median, starting from the most recent contract's low or high, and two more lines, being the "tines" of the pitchfork. The upper "tine" originates from the peak of the first upward move. The lower "tine" originates from the low of the downward move that follows the first upward move. The pattern looks like a triangle. The idea is to buy at lows and sell at highs. Simple, isn't it?

You may ask: "And what's the big deal? Does this give a better guarantee than the other commonly used methods?" The answer is "No". Andrews's Pitchfork is about as precise as most other methods (our estimate would be around 60%). But the precision level, ensured by Andrews's Pitchfork, is, actually, not the reason for which the method is valued so highly or should be used. What makes the method a great trading tool is the inestimable possibility of being able to analyze one part of the pattern using the other parts. In other words, you can analyze the different trends that make up the pattern as parts of the same figure, for example, you can most effectively and very easily forecast the size of the second bullish trend based on the length of the first bullish trend.

We will agree with those who will say that Andrew's Pitchfork should not probably be used as the bulk, determining method of your trading combination. However, its importance as that of an extremely valuable "tactical" method should not be overlooked.

Gann Studies: Reality Behind Legend

A Live Legend of All Times

Even in the boisterous world of finance, where there never seems to be a dearth of men of renown, it is rather seldom that figures of this size and reputation appear: Mr. William Gann has been referred to as a trading legend and the most successful trader since the early 1920-s. For the sake of justice, one should mention that probably since about the same time he has been called none other than a lucky marketer of ideas by some others. In any event, his unique predictive abilities and the forecasts he made on both trading and non-trading issues are still well-remembered and beyond any doubt. The somewhat mystical air that the alleged use of astrological concepts in his predictions made Gann an all the more mysterious figure and his theory more attractive to many.

William Delbert Gann was born to the family of a cotton rancher on a Texas farm June 6, 1878. Being obliged to provide for his numerous younger brothers and sisters, he had never attended grammar or high school. Having moved to NY at the age of 25, he set up a brokerage of his own called W.D. Gann & Co. Gann's major predictions include the end of WW1 in 1918, the end of the Great Depression in the States in 1932 and Perl Harbor. He is the author of 8 books and one of the most popular trading theories ever.

William Gann's ascension to the heights of the world of finance began in 1908 when he invented a theory called "the market time factor." By using his newly invented trading approach, he was able to make several tens of thousand dollars using two accounts that contained a total of just USD 450. A true Wall Street celebrity, Gann was a tremendous success as a commodities trader.

The Technology behind the Legend

The basis of Gann's theory was formed by the following three maxims:

1. There is nothing else to take into consideration besides price, time and range;
2. The markets move through certain cycles;
3. The markets are geometric in nature.

The theory could be used for three major types of predictions: price, time and pattern forecasts. To make a forecast, you first need to select a time period (normally an intermediate or short-term time period) and choose the high and low that will become the starting points for the Gann lines. Normally, the high and low are determined by employing some other technical analysis method. When the high and low are determined, a 1x1 or 1x2 pattern is applied, the difference being in the angle of the line being drawn. After the pattern or 'cycle" is completed by linking the two points, similar 'cycles" down the trend-line are searched for. Probably, this is what has been so fascinating about the Gann method - seemingly, it's like falling off a log, just tack a crack, and you are a success. But when you come to grips with the technique, all the ease is gone. To locate the low and high, Gann used some mathematical methods, including and similar to Fibonacci. His amazing command of those and, as is surmised now, some other clandestine methods, is what is responsible for most of his financial success.

During his life, Gann kept secret the astrological methods he used for predicting stock market actions. It is now said that all the astrological work for Gann was performed by two outstanding Canadian astrologists of the time - Lorne Edward Johndro and Kenneth Brown. All this says that there is a lot more to the Gann theory than what the average trader knows and can apply. Consequently, the average trader is highly unlikely to be able to hone the technique to the point when it starts bringing in the kind of profit it earned for its inventor. Most likely, the technique will serve him as just another method that allows drawing support and resistance lines. And unless you are prepared to spend years on research and mastering the technique, it is best to use the Gann studies as just another method in your combination that will help you prove a decision made by applying the whole of the combination. Or, better still, avoid using the method altogether.

Counting on the Waves: A New Look on the Celebrated Trading Method

The Elliott Wave theory has been a major thing in trading for decades now and, undoubtedly, Mr. Ralph Nelson Elliott should be held in high esteem by all those who trade the markets these days. However, while some steadfast followers consider his theory to be a highly effective pattern recognition technique able to help predict market developments, others are prone to regard Elliott's creation as a commonly used methodology, a brilliantly created means of seeing the recent past of the market, rendering this past with stunning clarity. Who's right and who's wrong?

The Elliott approach construes market actions as recurrent phases, comprised of two major moves: a five-wave advance and a three- wave decline, customarily referred to as the Impulse Wave and Corrective Wave. According to the Elliott theory, the market phases are scalable and the same market actions can constitute the same but larger or smaller phases and be considered over time periods that differ in duration significantly. By identifying the current position in the phase, it is possible to predict the kind of market action that will follow. This is made easier by the following interpretation rules for the counting of the waves:

1. Wave 2 should not end below the beginning of Wave 1;
2. Wave 3 should not be the shortest wave among Wave 1, 3 and 5;
3. Wave 4 should not overlap with Wave 1, except for wave 1, 5, a or c of a higher degree;
4. Rule of Alternation: Wave 2 and 4 should unfurl in two different wave forms.

One of the sub-waves 1, 3, 5 of the Impulsive Wave is supposed to be an extended wave. For a better understanding of the Corrective Wave phase, the Elliott theory delineates the following types of sub-waves that can make up the Corrective Wave: Zig-Zag, Flat, Irregular, Horizontal Triangle, Double Three, Triple Three. This stringently ordered, if a bit complicated in places, and revered by many theory seems to provide an effective means of analyzing market developments and only God knows what would happen if it worked completely as stated. Basically, all you have to do is determine which of the itemized wave forms is going to arise next. And here is where the pitfalls start. And God forbid we call into question the accuracy of Mr. Ellliott's concept, Fibonacci's Golden Ratio it is based on, or the laws of the Universe the latter claims to explain. The problems are a lot more trivial. How will you determine the starting point for your count of the waves? Out of five people who will look at the same chart two will most probably see the starting point differently. Right from the outset, the ticket for your journey to success seems to be hard to get hold of.

However, if you've been able to identify the starting point correctly, you will very soon understand that identifying waves as they are occurring is something altogether different from identifying waves when they have already occurred. And this is the second and biggest disadvantage of the Elliott theory. Unfortunately, there are several more. Is there going to be the fifth wave? Will the correction be flat or zigzag? Which of the waves will have the extension? All these are questions Elliott's theory has difficulty answering.

It is true that many experienced traders who have extensively dealt with the "bugs" the theory contains use the Elliott method as a predictive technique. However, all the above has caused many thinking traders to form a vision of the Elliott theory as of a methodology, rather than a predictive technique. In their opinion, this methodology has been extremely helpful in naming and identifying different states of the market: strong and week trends, complex and simple corrections. This can help gainfully use the other methods in your combination at the opportune time.

This view on the Elliott theory and the approach on which some of the thinking traders base their use of Elliott waves seems to be quite correct: the main value of the method is the possibility of determining the phase the market is currently in. And this is too valuable an addition to any thinking trader's arsenal to overlook or underestimate.

Candlesticks Technique: A Panacea Or A Big Frog In A Small Pond?

Just like a vast number of mind-boggling and revolutionary inventions, Candlesticks originate from Japan, where they were initially used by rice traders yet in the 17-th century. This gives the technique an air of Oriental charm, invoking associations with precision, technical eminence, and some innate, hidden ancient wisdom, which, of course, can never fail. Candlesticks were first introduced as a technical analysis technique by Steven Nison in his acclaimed book Japanese Candlestick Charting Techniques. Did the guy do the right thing? - new version - as a technical analysis technique by the esteemed Steven Nison in his acclaimed book Japanese Candlestick Charting Techniques. Did the man do the right thing? We think he did, but let's try to answer this question at a greater depth.

To create a candlestick pattern, you need a data set that will contain an open, a high, a low, and a close. A candlestick is formed by a "body" and two "tails" that grow out of this body. The four milestone points, passed by every trade, are located as follows:

In this pattern, the tails represent the whole range of prices, used during the trade, whilst the body represents the opening and closing prices for the selected period. If the closing price is higher than the opening one, the body will be colored blue or green; when the opposite is the case, the body will be colored red.

Basically, the Candlesticks pattern provides exactly the kind of information that you can observe on about any other kind of chart. The thing is definitely a lot more pleasant to look at than most of the other types of charts, but what's the big deal in terms of its usefulness?

The most powerful advantage that this technique can give is, undoubtedly, the easily discernible respective relationship between the four points that make up the pattern. One look is enough to size up the underlying price action in terms of the two key relationships.

But, the most important advantage, offered by Candlesticks, is that there are a number of sure (well, most of the time, you know) signs of a market development occurring that no other technique can offer. So what is this bag of tricks?

For example, if the body of your candlestick is green and rather prolonged, this means that buyers are very active - a definitely bullish sign. Conversely, a long red candlestick body will be a sure bearish sign.

Another useful sign, offered by the Candlesticks technique is Doji - the situation, when the opening and closing prices coincide. The so called Dragonfly variation of Doji, whereby the prices coincide at the top of the trading range, serves as a sign of trend reversal and a forthcoming upward advance.

An equally useful sign is the so called Piercing Line, whereby the closing price point of the green bar is just slightly higher than the middle of the preceding red candlestick. This situation signals a forthcoming reversal of a downward trend.

The technique offers several more eloquently referred to pattern variations, whose names sound like the names of some mortally dangerous jab or a bizarre and potentially lethal posture from an Oriental martial system. But are these tricks really as dependable as the great ancient fighting legacy of the Orient?

Of course, the technique is not infallible and just like any other trading method is a bit on the dodgy side. One of the main drawbacks of the technique is that despite it clearly shows the relationship between the opening and closing prices, it does not allow seeing how volatile the price action actually was during the different stages of the trade. Actually, some significantly different scenarios can be possible.

All told, a great many traders reckon candlesticks to be the primary trading method in technical analysis. Our opinion would be that although Candlesticks are, certainly, a lot more reliable than most of the other technical analysis methods, one shouldn't still rely entirely on this single method.

Are There Optimum Indicator Parameters?

A question asked by both professional and private traders alike

I have been training traders for around 15 years and perhaps the most frequently asked question of all goes something like: "What parameters do you use for your moving averages?"

My sincere and honest response is that I don't use any in my analysis and if I did there is no such thing as an optimum parameter … except in hindsight. However, hindsight is not much worth to us right now.

Is there any such thing as an optimum parameter for any indicator? Not as far as I am aware.

Are there any mystical powers about indicators which make them predict the market? No.

Let's get this straight. All indicators are lagging. This is intrinsically so since they are all calculated from historic prices and there is categorically no argument to say that price develops in a linear fashion that implies indicators can be used to forecast price. I have not found one that predicts the market.

Let's take an RSI. The default in most platforms is 14. This is because it was considered by Welles Wilder who created RSI that there is a common 28 day cycle in the market and thus an indicator length of half the cycle length is a broad yardstick to use.

If you look back at price history and apply several different length RSIs over that history, at times you will find that (for example) an 8 period will work well during sharper oscillating markets while during broad swinging markets a 14 period may work better.

Well, now we have a game plan. We can use an 8 period RSI when the market is choppy and a 14 period when it's not... Now look at your chart and decide what will happen from now. There is always an element of judgment involved and no way of saying for certain which length you should use.

The next argument is to optimize the RSI and choose the most profitable periods. Well, it can be done but having written systems I have never found a parameter that works without substantial a drawdown, certainly not one I would care to trade through. In addition, developing a system is not as straightforward as it seems. What if the optimum period is 14 with a profit of 100 but parameters of 12, 13, 15 and 16 only have profits of 25? (This is not an uncommon occurrence.) Would you feel confident that the optimum period was not just an aberration? (In all probability it is.)

So after all that it seems that there is no safe parameter to use for indicators. Frankly I use the default in most cases - at least for momentum indicators - but the bigger issue here is not the indicator but how you use it.

Again let's take an RSI. Broadly it is commonly used as an overbought/oversold indicator. This is only true during consolidating markets and not trending. You should never use these types of signals from momentum indicators while a trend is in place. Does this mean it is right that, as soon as RSI moves above 70 it is time to sell and below 30 is a time to buy?

No. Definitely not… Here is one of the best bits of advice I can give.

Never take a trade taking a signal from only one form of analysis.

The biggest piece of the puzzle that many (and probably most) traders fail to understand is price. For instance, why take a sell signal because RSI is above 70 but has not moved back below a strategic low. It could be beginning an uptrend and the lows and highs are still moving higher. It could be pausing in a flag formation which is a strong continuation pattern. Remember that many of the best profits come from long positions when momentum indicators are overbought (and short positions when momentum indicators are oversold.)

Always make sure that price is doing something to confirm your trade…

Maybe you see daily RSI above 70. Fine, move down into the hourly charts and see if:

• There is a price/momentum divergence, or
• A reversal pattern is developing - then confirmed, or
• A trend support has been broken.

If any of these occur then your short trade because daily RSI is overbought stands a much greater chance of success.

But what has this got to do with the parameter you choose for the RSI?

Nothing really, but as long as you are using one that is not an extreme and follows the market on the majority of occasions the actual parameter is not important - the combination of the RSI and price should be enough for the majority of trades in this way. Just understand that indicators have their limitations and do not expect them to magically tell you what trade to take. Study price. Understand price. Combine it with indicators and you will have taken a step forward to better profits.