AlBrooks Reading Price Charts PDF

Preface I M y goals in writing this book are to describe my understanding of why the trades in Figure P.I offer great risk-reward ratios, and to present ways to profit from setups like these in bo...

Preface I M y goals in writing this book are to describe my understanding of why the trades in Figure P.I offer great risk-reward ratios, and to present ways to profit from setups like these in both stocks and futures trading. The most important message that I can deliver is to focus on the absolute best trades, avoid the absolute worst setups, and work on increasing the number of shares that you are trading. I freely recognize that every one of my reasons behind each setup is just my opinion and my reasoning about why a trade works might be completely wrong. However, that is irrelevant. What is important is that reading price action is a very I have thought a lot about why certain things effective way to trade, and I am comfortable with my explanations, and happen the way that they do. they give me confidence when I place a trade, but they are irrelevant to !tMO ",00 FIGURE P. 1 AAPL, Daily Chart through J u n e 1 0, 2 0 0 8 (Th is chart with trend l in e s added is a l s o i n the final chapter, a l o n g w i t h the explanations behind each trade. ) xiii  xlv PREFACE my placing trades, so it is not important to me that they are right. Just as I can reverse my opinion about the direction of the market in an instant, I. can also reverse my opinion about why a particular pattern works if I come across a reason that is more logical or if I discover a flaw in my logic. I am providing the opinions because they appear to make sense, and they may help readers become more comfortable trading certain setups and because they may be intellectually stimulating, but they are not needed for any price action trades. The book is a comprehensive guide to understanding price action and is directed toward sophisticated traders and market professionals. How­ ever, the concepts are useful to traders at all levels. It uses many of the standard techniques described by Edwards and Magee and many others, but will focus more on individual bars to demonstrate how the informa­ tion they provide can significantly enhance the risk-reward ratio of trading. Most books point out three or four trades on a chart, which implies that ev­ erything else on the chart is incomprehensible, meaningless, or risky. I be­ lieve that there is something to be learned from every tick that takes place during the day and that there are far more great trades on every chart than just the few obvious ones, but to see them, you have to understand price action, and you cannot dismiss any bars as unimportant. I learned from performing thousands of operations through a microscope that some of the most important things can be very small. I read charts bar by bar and look for any information that each bar is telling me. They are all important. At the end of every bar, most traders ask themselves, "What just took place?" With most bars, they conclude that it is just too confusing to understand and choose to wait for a pattern that they recognize. It is as if they believe that the bar did not exist, or they dismiss it as just institutional program activity that is not tradable by an individual trader. They do not feel as though they are part of the market at these times, but these times constitute the vast majority of the day. Yet, if they look at the volume, all of those bars that they are ignoring have as much volume as the bars they are using for the bases for their trades. Clearly, a lot of trading is taking place, but they don't understand how that can be, and essentially they pretend that it does not exist. But that is denying reality. There is always trading taking place, and as a trader you owe it to yourself to understand why it's taking place and to figure out a way to make money off it. Learning what the market is telling you is very time consuming and difficult, but it gives you the foundation that you need to be a successful trader. Unlike most books on candle charts where the majority of readers feel compelled to memorize patterns, this book will provide a rationale for why particular patterns are reliable setups for traders. Some of the terms used have specific meaning to market technicians but different meanings Preface xv to traders and I am writing this entirely from a trader's perspective. I ;;un certain tp.at many traders already understand everything in this book, but likely wouldn't describe price action in the same way that I do. There are no secrets among successful traders, and they all know common setups, and many have their own names for each one. All of them are buying and sell­ ing pretty much at the same time, catching the same swings, and each has his own reasons for getting into a trade. Many trade price action intuitively without ever feeling a need to articulate why a certain setup works. I hope that they enjoy reading my understanding of and perspective on price ac­ tion and that this gives them some insights that will improve their already successful trading. The goal for most traders is to maximize trading profits through a style that is compatible with their personalities. Without that compatibility, I believe that it is virtually impossible to trade profitably long term. Many traders wonder how long it will take them to be successful and are will­ ing to lose money for some period of time, even a few years. However, it took me over 10 years to be able to trade successfully. Each of us has many considerations and distractions, so the time will vary, but a trader has to work though most obstacles before becoming consistently profitable. I had several major problems that had to be corrected, including raising three wonderful daughters who always filled my mind with thoughts of them and what I needed to be doing as their father. That was solved as they got older and more independent. Then it took me a long time to accept many per­ sonality traits as real and unchangeable (or at least I concluded that I was unwilling to change them). And finally there was the issue of confidence. I have always been confident to the point of arrogant in so many things that those who know me would be surprised that this was difficult for me. How­ ever, deep inside I believed that I really would never come up with a con­ sistently profitable approach that I would enjoy employing for many years. Instead, I bought many systems, wrote and tested countless indicators and systems, read many books and magazines, went to seminars, hired tutors, joined chat rooms, and talked with people who presented themselves as successful traders, but I never saw their account statements and suspect that most could teach but few if any could trade. Usually in trading, those who know don't talk, and those who talk don't know. This was all extremely helpful because it showed all of the things that I needed to avoid before becoming successful. Any nontrader who looks at a chart will invariably conclude that trading has to be extremely easy, and that is part of the appeal. At the end of the day, anyone can look at any chart and see very clear entry and exit points. However, it is much more difficult to do in real time. There is a natural tendency to want to buy the exact low and never have the trade come back. If it does, a novice will take the loss to avoid a bigger loss, resulting in a series of losing trades that will xvi PREFACE ultimately bust his account. Using wide stops solves that to some extent, but invariably a trader will soon hit a few big losses that will put him into the red and make him too scared to continue using that approach. Why do so many business schools continue to recommend Edwards and Magee when their book is essentially simplistic, largely using trend­ lines, breakouts, and pullbacks as the basis for trading? They do so be­ cause the system works, and it always has, and it always will. Now that just about all traders have computers with access to intraday data, many of those techniques can be adapted to day trading. Also, candle charts give additional information about who is controlling the market, which results in a more timely entry with smaller risk. Edwards and Magee's focus is on the overall trend. I use those same basic techniques but pay much closer attention to the individual bars on the chart to improve the risk-reward ratio, and I devote considerable attention to intraday charts. It seemed obvious to me that if one could simply read the charts well enough to be able to enter at the exact times that the move would take off and not come back, then that trader would have a huge advantage. He would have a high winning percentage and the few losses would be small. I decided that this would be my starting point, and what I discovered was that nothing had to be added. In fact, any additions are distractions that re­ sult in lower profitability. This sounds so obvious and easy that it is difficult for most people to believe. I am a day trader who relies entirely on price action on the intra­ day Emini S&P 500 Futures (the "Emini") charts, and I believe that read­ ing price action well is an invaluable skill for all traders. Beginners often instead have a deep-seated belief that something more is required, that maybe some complex mathematical formula that very few use would give them just the edge that they need. Goldman Sachs is so rich and sophis­ ticated that they must have a supercomputer and high-powered software that gives them an advantage that insures that all the individual traders are doomed to failure. They start looking at all kinds of indicators and playing with the inputs to customize the indicators to make them just right. Every indicator works some of the time, but for me, they obfuscate instead of elu­ cidate. In fact, without even looking at a chart, you can place a buy order and have a 50 percent chance of being right! I am not dismissing indicators and systems out of ignorance of their subtleties. I have spent over 10,000 hours writing and testing indicators and systems over the years, and that probably is far more experience than most. This extensive experience with indicators and systems was an essen­ tial part of my becoming a successful trader. Indicators work well for many traders, but the best success comes once a trader finds an approach that is compatible with his personality. My single biggest problem with indica­ tors and systems is that I never fully trusted them. At every setup, I saw Preface xvii exceptions that needed to be tested. I always wanted every last penny out of the market and was never satisfied with a return from a system if I could incorporate a new twist that would make it better. I am simply too control­ ling, compulsive, restless, observant, and untrusting to make money long term off indicators or automated systems, but I am at the extreme in many ways, and most people don't have these same issues. Many traders, especially beginners, are drawn to indicators, hoping that an indicator will show them when to enter a trade. What they don't realize is that the vast majority of indicators are based on simple price ac­ tion, and when I am placing trades, I simply cannot think fast enough to process what several indicators might be telling me. Also, oscillators tend to make traders look for reversals and focus less on price charts. These can be effective tools on most days when the market has two or three re­ versals lasting an hour or more. The problem comes when the market is trending strongly. If you focus too much on your indicators, you will see that they are forming divergences all day long, and you may find yourself repeatedly entering Countertrend and losing money. By the time you come to accept that the market is trending, you will not have enough time left in the day to recoup your losses. Instead, if you were simply looking at a bar or candle chart, you would see that the market is clearly trending, and you would not be tempted by indicators to look for trend reversals. The most common successful reversals first break a trendline with strong mo­ mentum and then pullback to test the extreme, and if a trader focuses too much on divergences, she will often overlook this fundamental fact. A di­ vergence in the absence of a Countertrend momentum surge that breaks a trendline is a losing strategy. Wait for the trendline break, and then see if the test of the old extreme reverses or if the old trend resumes. You do not need an indicator to tell you that a strong reversal here is a high-probability trade, at least for a scalp, and there will almost certainly be a divergence, so why complicate your thinking by adding the indicator to your calculus? Some pundits recommend a combination of time frames, indicators, wave counting, and Fibonacci retracements and extensions, but when it comes time to place the trade, they will only do it if there is a good price action setup. Also, when they see a good price action setup, they start look­ ing for indicators that show divergences or different time frames for mov­ ing average tests or wave counts or Fibonacci setups to confirm what is in front of them. In reality, they are price action traders who are trading exclusively off price action on only one chart but don't feel comfortable admitting it. They are complicating their trading to the point that they cer­ tainly are missing many, many trades because their overanalysis takes too much time to place their orders, and they are forced to wait for the next setup. The logic just isn't there for making the simple so complicated. Ob­ viously adding any information can lead to better decision making, and xviii PREFACE many people may be able to process lots of inputs when deciding whether to place a trade. Ignoring data because of a simplistic ideology alone is foolish. The goal is to make money, and a trader should do everything he can to maximize his profits. I simply cannot process multiple indicators and time frames well in the time needed to place my orders accurately, and I find that carefully reading a single chart is far more profitable for me. Also, if I rely on indicators, I find that I get lazy in my price action reading and often miss the obvious. Price action is far more important than any other information, and if you sacrifice some of what it is telling you to gain information from something else, you are likely making a bad decision. There are countless ways to make money trading stocks and Erninis, but all require movement (well, except for shorting options). If you learn to read the charts, you will catch a great number of these profitable trades every day without ever knowing why some institution started the trend and without ever knowing what any indicator is showing. You don't need their software or analysts because they will show you what they are doing. All you have to do is piggy-back onto their trades, and you will make a profit. Price action will tell you what they are doing and allow you an early entry with a tight stop. I have found that I consistently make far more money by minimizing what I have to consider when placing a trade. All I need is a single chart on my laptop computer with no indicators except a 20-bar exponential moving average, which does not require too much analysis and clarifies many good setups each day. I sometimes trade even without the moving average, but it provides enough setups that it is usually worth having on the chart. Volume on I-minute charts is also sometimes minimally useful when looking for a sign that a trend reversal might be imminent, but I never look at it because I trade mostly offthe 5-minute chart (rarely I will take an early 5-minute With , Trend entry off the I-minute chart). An unusually large I-minute volume spike often comes near the end of a bear trend, and the next new swing low or two often provide profitable long scalps. However, this is simply an observation; it is far too unreliable to be a part of your trading and should be ignored. Volume spikes also sometimes occur on daily charts when a selloff is overdone. Even traders who base their trades on a collection of indicators routinely look at price action when placing their entries and exits. Who wouldn't feel better about buying a divergence if there was also a strong reversal bar at the low? However, charts provide far more information about who is in control of the market than most traders realize. Almost every bar offers important clues as to where the market is going, and a trader who dismisses any activity as noise is passing up many profitable trades each day, As a trader, I see everything in shades of gray and am constantly think­ ing in terms of probabilities, If a pattern is setting up and it is not perfect Preface xix but it is reasonably similar to a reliable setup, it will likely behave similarly as well. Close is usually close enough. If something resembles a textbook setup, the trade will likely unfold similarly to the trade from the textbook setup. This is the art of trading, and it takes years to become good at trad­ ing in the gray zone. Everyone wants concrete, clear rules, or indicators, and chat rooms, newsletters, hotlines, or tutors that will tell them when exactly to get in to minimize risk and maximize profit, but none of it works in the long run. You have to take responsibility for your decisions, but you first have to learn how to make them, and that means that you have to get used to operating in the gray fog. Nothing is ever as clear as black and white, and I have been doing this long enough to appreciate that anything, no matter how unlikely, can and will happen. It's like quantum physics. Ev­ ery conceivable event has a probability, and so do events that you have yet to consider. It is not emotional, and the reasons why something happens are irrelevant. Watching to see if the Feds cut rates today is a waste of time because there is both a bullish and bearish interpretation of anything that they do. What is key is to see what the market does, not what the Fed does. Never watch the news during the trading day. If you want to know what a news event means, the chart in front of you will tell you. If a pundit on CNBC announces that a report was bearish and the market goes up, are you going to look to short? Only look at the chart, and it will tell you what you need to know. The chart is what will give you money or take money from you, so it is the only thing that you should ever consider when trad­ ing. If you are on the floor, you can't even trust what your best friend is doing. He might be offering a lot of orange juice calls but secretly having a broker looking to buy 10 times as many below the market. Your friend is just trying to create a panic to drive the market down so he can load up through a surrogate at a much better price. There is one other problem with the news. Invariably when the mar­ ket makes a huge move, the reporters will find some confident, convincing expert who predicted it and interview him, leading the viewers to believe that this pundit has an uncanny ability to predict the market, despite the untold reality that this same pundit has been wrong in his last 10 predic­ tions. The pundit then makes some future prediction, and the naive viewer will attach significance to it and let it affect his trading. What the viewer may not realize is that some pundits are bullish 100 percent of the time and others are bearish 100 percent of the time, and still others just swing for the fences all of the time and make outrageous predictions. The reporter just rushes to the one who is consistent with the day's news, which is to­ tally useless to a trader. In fact it is destructive because it can influence his trading and make him question and deviate from his own methods. So, if you really must watch TV during the trading day, I recommend cartoons or foreign language shows, so there will be no chance that the show will influence your trading. xx PREFACE Friends and colleagues freely offer opinions for you to ignore. Occa­ sionally traders will tell me that they have a great setup and want to dis­ cuss it with me. I invariably get them angry at me when I tell them that I am not interested. They immediately perceive me as selfish, stubborn, and close-minded, and when it comes to trading, I am all of that and probably much more. The skills that make you money are generally seen as flaws to the lay person. Why do I no longer read books or articles about trading, or talk to other traders about their ideas? As I said, the chart tells me all that I need to know, and any other information is a distraction. Several people have been offended by my attitude, but I think it in part comes from me turning down what they are presenting as something helpful to me when in reality they are making an offering, hoping that I will reciprocate with some tutoring. They become frustrated and angry when I tell them that I don't want to hear about anyone else's trading techniques. I tell them that I haven't even mastered my own and probably never will, but I am confident that I will make far more money perfecting what I already know than trying to incorporate non-price action approaches into my trading. I ask them if James Galway offered a beautiful flute to Yo Yo Mah and insisted that Yo Yo start learning the flute because Galway makes so much money by play­ ing his flute, should Mah accept the offer? Clearly not. Mah should continue to become better and better at the cello and by doing so he will make far more money than if he also started playing the flute. I am no Galway or Mah, but the concept is the same. Price action is the only instrument that I want to play and I strongly believe that I will make far more money by mastering it than by incorporating ideas from other successful traders. Yesterday, Costco's earnings were up 32 percent on the quarter and above analysts' expectations. It gapped up on the open, tested the gap on the first bar and then ran up over a dollar in twenty minutes. (See Fig­ ure P.2.) It then drifted down to test yesterday's close. It had two rallies that broke bear trendlines, and both failed. This created a Double Top (Bars 2 and 3) Bear Flag or Triple Top (Bars 1, 2, and 3) and the market then plunged three dollars, below the prior day's low. If you were unaware of the report, you would have shorted at the failed bear trendline breaks at Bars 2 and 3 and you would have sold more on the Breakout Pullback at Bar 4. You would have reversed to long on the Bar 5 big reversal bar, which was the second attempt to reverse the breakout below yesterday's low and a climactic reversal of the breakout of the bottom of the steep bear trend channel line. Alternatively, you could have bought the open because of the bullish report, and then worried about why the stock was collapsing instead of soaring the way that TV analysts predicted, and you likely would have sold out your long on the second plunge down to Bar 5. Any trend that covers a lot of points in very few bars, meaning that there is some combination of large bars and bars with very little overlap, Preface xxi ,... 6 , oo...00 5 f1:30 12:00 12:30 1:00 1:;)(1 ,:00 ':30 ';00 ,:30 10;00 1(k30 11:00 11:30 12:00 12:30 7:00 7:30.:00 ':30 ':00 1:30 FIGURE P.2 Shou l d You Buy Based on a G reat Earn i n g s Report or Short Based on Price Action? will eventually have a pullback. These trends have such strong momentum that the odds favor a test of the trend's extreme after the pullback and usu­ ally the extreme will be exceeded, as long as the pullback does not become a new trend and extend beyond the start of the prior trend. In general, the odds that a pullback will get back to the prior trend's extreme fall substan­ tially if the pullback retraces 75 percent or more. For a pullback in a bear, at that point, a trader is better to think of the pullback as a new bull trend rather than a pullback in an old bear. Bar 6 was about a 70 percent pull­ back and then the market tested the climactic bear low on the open of the next day. The only thing that is as it seems is the chart. If you cannot figure out what it is telling you, do not trade. Wait for clarity. It will always come. But once it is there, you must place the trade and assume the risk and follow your plan. Do not dial down to a I-minute chart and tighten your stop because you will lose. The problem with the I-minute chart is that it tempts you by offering lots of entries. However, you will not be able to take them all and you will instead cherry-pick, which will lead to the death of your account; you will invariably pick too many bad cherries. The best trades often happen too fast for you to place your orders and that means you will be choosing among the less desirable trades and will lose more often. When you enter on a 5-minute chart, your trade is based on your analysis of the 5-minute chart without any idea of what the I-minute looks like. You must therefore rely on your 5-minute stops and targets, and just accept the reality that the I-minute chart will move against you and hit a I-minute stop frequently. If you watch the I-minute chart, you will xxii PREFACE not be devoting your full attention to the 5-minute chart and I will take your money from your account and put it in my account. If you want to compete, you must minimize all distractions and all inputs other than what is on the chart in front of you, and trust that if you do, you will make a lot of money. It will seem unreal but it is very real. Never question it. Just keep things simple and follow your simple rules. It is extremely difficult to consistently do something simple, but in my opinion, it is the best way to trade. Ultimately, as a trader understands price action better and better, trading becomes much less stressful and actually pretty boring, but much more profitable. Although I never gamble because the odds are against me and I never want to bet against math, there are some similarities with gambling, espe­ cially in the minds of those who don't trade. For example, some traders use simple game theory and increase the size of a trade after one or more losing trades. Blackjack card counters are very similar to trading range traders. The card counter is trying to determine when the math has gone too far in one direction. In particular, he wants to know then the remaining cards in the deck are likely overweighed with face cards. When his count indicates that this is likely, he places a trade (bet) based on the probability that a dis­ proportionate number of face cards will be coming up, increasing his odds of winning. A trading range trader is looking for times when he thinks the market has gone too far in one direction and then he places his trade in the opposite direction (a fade). One unfortunate reality is that there are aspects of trading that are very similar to gambling-the most important one is that many losing games win often enough to make you believe that you will be able to find a way to win at them in the long run. You are fighting relentless, unstoppable math and you will go broke trying to beat it. The most obvious example is trading off the I-minute chart. Since it looks the same as the 5-minute and since you can make many winning trades day trading it, it is logical to conclude that you can use it as your primary chart. However, too many of the best trades happen too fast to catch and you will find yourself left with the second-tier trades. Over time, you will either go broke or make substantially less than you would off the 5-minute chart. One unfortunate comparison is from non-traders who assume that all day traders, and all market traders for that matter, are addicted gamblers and therefore have a mental illness. I suspect that many are in that they are doing it more for excitement than for profit and are willing to make low probability bets and lose large sums of money because of the huge rush they feel when they occasionally win. However, most successful traders are essentially investors, just like an investor who buys commercial real estate or a small business. The only real differences from any other type of investing are that the time frame is shorter and the leverage is greater. Preface xxiii One final point about gambling. Monte Carlo techniques work well in theory but not in practice because of the conflict between math and emo­ tion. If you double (or even triple) your position size and reverse at each loss, you will theoretically make money. Although four losers in a row is rare on the 5-minute Emini chart (especially if you avoid trading in small sideways trading ranges in the middle of the day's range), they will happen, and so will six, seven, or more, even though I can't remember ever seeing that. In any case, if you are comfortable trading ten contracts and you de­ cide to double and reverse with each loser, but begin with one contract, four consecutive losers would require sixteen contracts and it is unlikely that you would place a trade that is larger than your comfort zone following four losers. Also, if you like trading ten contracts, you will not be satisfied with the profit from trading one contract, which is what you would end up trading most of the time. Lay people are also concerned about the risk of crashes and because of that risk, they again associate trading with gambling. Crashes are very rare on daily charts (but common on intraday charts). They are afraid of their inability to function effectively during extremely emotional events. Although the term "crash" is generally reserved for daily charts and applied to bear markets of about 20 percent or more happening in a short time frame, like in 1927 and 1987, it is more useful to think of it as just a simple and common chart pattern because that removes the emotion and helps a trader follow his rules. If you remove the time and price axes from a chart and focus simply on the price action, there are market movements that occur on intraday charts that are indistinguishable from the patterns in a classic crash. If you can get passed the emotion, you can make money off crashes because with all charts, they display tradable price action. Figure P.3 (from TradeStation) shows how markets can crash in any timeframe. The one on the left is a daily chart of GE during the 1987 crash, the middle is a 5-minute chart of COST after a very strong earnings re­ port, and the one on the right is a I-minute Emini chart. Although the term "crash" is used almost exclusively to refer to a 20 percent or more selloff over a short time on a daily chart and was widely used only twice in past hundred years, a price action trader looks for shape and the same crash pattern is common on intraday charts. Since crashes are so common intra­ day, there is no need to apply the term because from a trading perspective, they are just a bear swing with tradable price action. Most traders only consider price action when trading divergences and trend pullbacks. They like to see a strong close on a large reversal bar, but in reality this is a fairly rare occurrence. The most useful tools for under­ standing price action are trendlines and trend channel lines, prior highs and lows, breakouts and failed breakouts, the size of bodies and tails on can­ dles, and relationships between the current bar to the prior several bars. In xxiv PREFACE FIGURE ".3 Market Crashes Look the Same on All Timeframes particular, how the open, high, low, and close of the current bar compare to the action of the prior several bars tells a lot about what will happen next. Most of the observations in this book are directly related to placing trades, but a few have to do with simple curious price action tendencies without sufficient dependability to be the basis for a trade. I personally rely mainly on candle charts for Emini trading and bar charts for stock trading, but most signals are also visible on any type of chart and many are even evident on simple line charts. I will focus pri­ marily on 5-minute candle charts to illustrate basic principles but will also thoroughly discuss daily and weekly charts as well. Additionally, I place in­ traday swing trades on several stocks each day and make occasional option purchases based on daily charts, and will discuss how using price action alone can be the basis for this type of trading. Most of the charts in the book demonstrate many different concepts and I indicated key price action observations on most. Because of this, almost any chart could be on any page, but I placed them in the sec­ tion where I thought they best illustrated a point. Many charts reference setups that are described later in the book, but when they are clear exam­ ples of important setups, I point them out, which should be helpful on a sec­ ond read through the book. Also, almost every pattern that you see during the day can be placed into several categories in this book. Don't waste time deciding if a reversal is unfolding as a Double Bottom Pullback or a Spike and Trading Range low or a simple Higher Low. You are a trader, not a file clerk. When you see a reversal pattern, just take the trade and don't labor over which name most accurately applies. Also, not all chap­ ters are created equal. Some are essential to your success whereas others are included for completeness. If you are a beginner, focus on Chapter 15 Preface because it describes the best trades, and then refer back to the appropri­ ate earlier chapters to learn more. Don't spend a lot of time on concepts like Magnets and Measured Moves, because that is not where the money is. They are included simply because they demonstrate aspects of price action, but do not offer reliable trading patterns. Since I trade in California, allof the charts are in Pacific Standard Time. Allof the charts were created with TradeStation.