Market Technician No 49

5/26/2018 Market Technician No 49

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As this journal goes to press, stock markets are cautiously marking the

first anniversary of the nadir of the bear market. At the March monthly

meeting Nicola Merrell was relatively upbeat about the long term

outlook for equities,although she did note that many indices (such as the

Russell 2000) were approaching significant resistant levels.

The emphasis of this issue is on candlestick charts and this seems to

reflect a growing interest in the technique generally amongst traders.

For example, STA chairman Adam Sorab is a recent convert to

candlesticks having found them particularly effective in predicting the

recent gyrations in the euro/dollar rate.

The Barbican Library has also repor ted a growing interest in candlestick

charts and that books on the subject are always out on loan, with waiting

lists starting to appear. Our librarian, Michael Feeny, has thereforestocked up on this subject with another two or three copies of the

following titles:

Japanese Candlestick Charting Techniques A Contemporary Guide

to the Ancient Investment Techniques of the Far East

by Steve Nison published by NYIF ISBN: 0735201811, 2001

Beyond Candlesticks, New Charting Methods Revealed

by Steve Nison published by John Wiley & Sons ISBN: 047100720X, 1994

The Candlestick Course

by Steve Nison published by Marketplace Books (Wiley)

ISBN: 0471227285, 2003

Candlestick Charting Explained, Timeless Techniques for Trading

Stocks and Futuresby Gregory Morris published by Probus Publishing ISBN:1557388911

Candlesticks Explained

by Martin Pring published by McGraw-Hill ISBN: 0071384014, 2002

Profitable Candlestick Trading Pinpointing Market Opportunities

to Maximise Profits

by Stephen Bigalow published by John Wiley & Sons ISBN: 047102466X, 2002

The two Nison books (1994 and 2001) are considered the core textbooks

on Candlesticks and he brought out a new one last year (2003). Morris

(1995) is popular and,according to the Global Investor Bookshop, it is the

most popular of the candle books.

Pring (2002) and Bigalow (2002) are perhaps a little less well-known so far.

STA Members who visit the Barbican Library may like to know that our

liaison man there, Mr Jonathan Gibbs,is taking over systems

development within the Library and our new contact person is Miss

Sibhe Lynch. (Her first name rhymes with jive). Members will find her

very helpful. Her telephone number is 020 7638 0569,e-mail

[email protected]. We would remind Members that you can

reserve and renew books by telephone or e-mail, and can even receive

books by mail, in which case the library pays the postage to you and you

pay the postage back to the Library.

Membership of the library is renewable every three years: the simplest

way to re-register is to e-mail Miss Lynch to confirm your details.

If you have any requests for books to be added to our library,please

contact Michael Feeny.

It is good to see to see some new names amongst the contributors to

this issue and we would like to encourage other members to think about

writing an article for the Journal. Articles should be double-spaced with

wide margins and should initially be submitted in hard copy format.

Once they have been accepted for publication,they will be processed

electronically.

The STA website (www.sta-uk.org) saw over 15,000 hits in February, a

continued pickup in interest and in a short month as well. We had

requests from over 120 different linked sites, many of them from sister

IFTA societies as well as search engines and trading software sites. On a

Google search the STA website is quite far down the list when searching

for technical analysis, but is the third technical analysis society listed after

the Australian and Canadian societies. There are a lot of sites out there

peddling books, tip sheets and trading models as well as courses around

the world. However, the STA website comes in 1st in a Google search of

technical analysis UK which is helpful (ignoring sponsored links) for us in

trying to increase our exposure in the investment community in the UK.

COPY DEADLINE FOR THE NEXT ISSUE

31st May 2004

PUBLICATION OF THE NEXT ISSUE

July 2004

IN THIS ISSUED.Watts Bytes and Pieces . . . . . . . . . . . . . . . . . 2

D.Watts Software Review . . . . . . . . . . . . . . . . . 3

G. Rowe Trading the Bearish

Engulfing Pattern . . . . . . . . . . . . . . . . . 4

A. Whitby The Euro a Top or the Top? . . . . . . 9

C. Lambert Candlestick Reversals . . . . . . . . . . . . 10

E. Miller The Case for a Base in

Coffee Futures . . . . . . . . . . . . . . . . . . . 11

M. Gunn Integrating Technical Analysis

into an Investment Process . . . . . . 12

D.Valcu Trending with Heikin-Ashi . . . . . . . 14

H. Calder The Resurgence of China and

South East Asian Stock Markets . . . 16

April 2004 The Journal of the STA

Issue No. 49 www.sta-uk.org

MARKET TECHNICIAN

FOR YOUR DIARY

14th April Optimisation From a

Technical Analysts Point of View

J. du Plessis FSTA, Head of Technical Analysis, Updata

12th May Swing Trading

Marc Rivalland

N.B.The monthly meetings will take place at the

Institute of Marine Engineering, Science and Technology

80 Coleman Street, London EC2 at 6.00 p.m.


2/16

MARKET TECHNICIAN Issue 49 April 20042

A number of new programs have been released since the last journal.

Some of these are from smaller developers but they are worthy of

consideration as often they are designed to meet a specific need. As

always you should ensure that the program meets your needs and the

level of support required. Most have free trials but smaller independent

companies normally only supply web-based support, so it often takessome time to get an answer. However often they are more responsive to

requests by users for improvements to their products.

Another Chart Pattern Finder

Patterns Ascending triangles, symmetrical triangles, descending

triangles, pennants, head-and-shoulders, flags,wedges, double tops and

double bottoms and more can all be found via a new software release

called Chart Pattern Finder. With an EOD product released and a real-

time product under development those Edwards & Magee addicts may

find it of interest.A windows program, its someway to go for support as it

was developed in Australia, priced at $279.

See http://www.cpFinder.com

For the Quants

QuantStudio is a new release from the UK based company a .NET

framework for building trading systems. If you are looking to develop a

quantitative trading strategy for a Fund then its worthy of consideration.

There is a non-time limited demo available for those able to wait for a

40mb download. Suitable for Quants, Programmers,Math wizards,etc. the

range of frames includes portfolio and risk management.Support in this

case is only a walk away at Cannon Street for London-based traders.

http://www.smartquant.com

World-wide Stock Data

I have become increasing impressed by the range and quality of the freeservice Yahoo provide for EOD stock data. Most world stock exchanges

are now covered, with the data being released midnight local time for

the exchange concerned.Yahoo data is adjusted for scripts and dividends

and, for the most part,appears reasonably clean.There are a number of

download interface programs available, but few have the ability of

MLdownloader with an excellent directory structure set-up for easy

downloading.

See MLdownloader at http://www.trading-tools.com/mld.htm for a

free trial.

Trendline Trader?

For fans of trendlines a new program called Ramp released by

Newdawn can provide hours of fun. One of the few independentprograms that can scan a database for trendline breaks, its ideal for the

Fund Manager/Technical Trader. The free stock trader videos provide a

structured approach to trendline trading.The cost is $350.

See http://www.nebadawn.com/

SpySweeper

The Trojans and Spy wear war appears to be increasingly dangerous with

numerous new viruses being released and web pages often able to load

new bugs via Java and other browser based languages. One new

program that I have found to be particularly effective and worthy of the

free trial is Spysweeper from webroot.Their website offers a free security

check, worth ten minutes of your time the results may surprise you.

See http://www.webroot.com

David Watts

CHAIRMAN

Adam Sorab,

Deutsche Asset Management,

1 Appold Street, London EC2A 2UU

TREASURERSimon Warren. Tel: 020-7656 2212

PROGRAMME ORGANISATION

Mark Tennyson d'Eyncourt.

Tel: 020-8995 5998 (eves)

LIBRARY AND LIAISON

Michael Feeny. Tel: 020-7786 1322

The Barbican library contains our collection. Michael buys new books for it

where appropriate.Any suggestions for new books should be made to him.

EDUCATION

John Cameron. Tel: 01981-510210

George Maclean. Tel: 020-7312 7000

EXTERNAL RELATIONS

Axel Rudolph. Tel: 020-7842 9494

IFTA

Anne Whitby. Tel: 020-7636 6533

MARKETING

Gerry Celaya. Tel: 01561 340358

Simon Warren. Tel: 020-7656 2212

Kevan Conlon. Tel: 020-7329 6333

Barry Tarr. Tel: 020-7522 3626

Richard Raymar. Tel: 07890 821619

MEMBERSHIP


REGIONAL CHAPTERS

Robert Newgrosh. Tel: 0161-428 1069

Murray Gunn. Tel: 0131-245 7885

SECRETARY

Mark Tennyson dEyncourt. Tel: 020-8995 5998 (eves)

STA JOURNAL

Editor,Deborah Owen. Tel: 020-7278 4605

WEBSITE

Gerry Celaya. Tel: 01561 340358


Deborah Owen. Tel: 020-7278 4605

Please keep the articles coming in the success of the Journal depends

on its authors, and we would like to thank all those who have supported

us with their high standard of work.The aim is to make the Journal a

valuable showcase for members research as well as to inform and

entertain readers.

The Society is not resp onsible for any material published in The Market

Technician and publication of any material or expression of opinions

does not necessarily imply that the Society agrees with them. The

Society is not authorised to conduct investment business and does not

provide investment advice or recommendations.

Articles are published without responsibility on the part of the Society,

the editor or authors for loss occasioned by any person acting or

refraining from action as a result of any view expressed therein.

NetworkingWHO TO CONTACT ON YOUR COMMITTEE

Bytes and Pieces


3/16

Issue 49 April 2004 MARKET TECHNICIAN 3

Updata Technical AnalystVersion 2.13.

Summary: A fully featured TA charting

program for Windows, great P&F charts.

Data: EOD and Real-timeSupport: UK phone or Web based.

Website: http://www.update.co.uk

Telephone: 0845 129 4884

Updatas Technical Analyst program (TA) is a comprehensive technical

toolbox for the discerning technical analyst. TA offers the promise of

Indexias proven technology with reliable accurate charting. Now with

version two released,the program appear robust, but does it deliver?

This is a substantial program that installs within some 76 MB of disc space.

A ten-minute install gets the program running with a further call needed

to the web to verify the installation key and update the database. What is

immediately apparent is the taskbar icon that acts as the quick access

route to the programs main features. Right clicking the icon gives you a

menu from Run Technical Analyst to Real-time feeds. Its a uniquefeature that makes the program easy to access.

Data handling is another strength of TA; the web acts as an interactive

source of data, so if in need of more data one click and you have

extended the history of any chart under analysis. This I found to be a really

handy feature but it points to one vital thing to get the most of this

program, fast Internet access is a must you need broadband or better.

Waiting around for data on download speeds of 56k would not be my

idea of fun and, unless you are in need of plenty of tea breaks, I would not

run this program with anything less than broadband.

Real-time and EOD data is available via the web and with excellent data

handling there were no data issues.Seamless integration with the

database was apparent. An extensive international database is available

via Updatas database which is a re-packaged Xpressfeed supplied byStandard & Poors Comstock.The LSE database appeared clean and

without the data errors so often apparent with UK data. What also

impressed me was the flexibility of the program to read either Metastock

or CSI data, a vital addition for the commodity trader. This is ideal for the

commodity trader/analyst as the CSI is an extensive and accurate

commodity database. For the equity analyst the standard datafeed will

prove adequate with the worldwide stock markets listed.

TA may front end a professional data feed via the Dynamic Data Exchange

(DDE) link. Professional-looking charts can quickly and easily be copied for

inclusion into text, allowing images to be captured for sending to a client.

The front end interface window is chock full of toolb ars, and upon

opening presents a number of standard charts. In the right hand corner

are four templates that allow you to run through some standard analysis

which has been previously set-up. Clicking the indicator windows gives a

long list of the standard indicators and shows

how many tools are supplied.This is not a

program that you are going to master in a

couple of days, but within a few weeks you

should become a competent TA operator.

In many respects this program is a

comprehensive toolbox with a wide range of

standard chart types and technical indicators.

Chart types include line,bar, candle,

equivolume, candle volume and wave.

Extensive technical indicators are available and

there are some that deserve special mention

Indexias moving averages,the market tracker

and noise filters that are unique. I particularly

liked the chart inversion tool and biorhythm

charts! Then there is the market scanner here

named Highlighter for quickly finding stocks

that meet certain criteria such as head and

shoulders tops and bottoms and P&F breakouts. A moving average andindicator optimiser is available for finding best fitvalues but beware,

without walk forward testing, optimisation can be a trap for the unwary.

Add the portfolio manager and the quote screen and its a pretty

crammed-full top menu. The only thing that TA lacks is the extensive self-

programming system testing apparent amongst some of its competitors.

It is evident that this program has been given the user-friendly treatment

with one click trend-lines, right click undo and the easy click toolbars. I

particularly liked the easy to use scroll bar beneath the charts, the

templates, the easy to use data handling and the clear and accurate charts

provided. This all goes to make standard analysis fast and effective, just

what I like.The program has the best P&F charts, I have seen for some

time, making this one of the best programs for those who use P&F.

Another special feature is that a P&F count ruler is provided for quickly

measuring counts.

The program comes with an extensive manual and help is availab le on

line.Updata provides online support, via the web and the forum. Updates

to the program are also available, with pdf files of the manual and support

information. The example Historical Charts of the Day and emailed alerts

are a useful addition which will help the novice analyst/trader.The user

also gets access to the newsletter and training sessions (at extra cost) on

the program and TA in general. Comprehensive UK support is available,

which is rare given the many imported programs. Cost details can be

found via the web site.

Yes,Updatas TA does deliver. I found TA to be an accurate and

comprehensive product you can trust, I particularly liked the clear P&F

charts. Verdict: An effective choice for the discerning TA professional or

amateur User.Why not give it a whirl?

Software ReviewBy David Watts

Feature: Rating:

Flexibility * * * * *

Features/Charts * * * *

Accuracy * * * * *

Support * * * * *

Overall * * * * *


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Introduction

This article aims to analyse the profitabil ity and practical application

of a trading system based upon candlestick charting. The system uses

the bearish engulfing candlestick pattern as a signal to initiate a

short salein Microsoft Corporation (MSFT). Following the

appearance of the bearish engulfing pattern, the stock price isexpected to decline enabling the short seller to profit from the short

sale. The system is tested on MSFTs daily historical share price data

for the five-year period 2nd January 1997 to 2nd January 2002. The

results are analysed and conclusions drawn.

The overall aim of the investigation is to: -

Determine whether the system generates positive returns that aresuperior to a conventional buy and hold strategy on MSFT shares.

Determine whether any trading system return exceeds the buy andhold return on MSFT shares, which is over and above the average

risk free rate for the five-year period studied.

The main objective of this investigation is to: -

Determine whether the system has any practical application for theindividual buy and hold investor.

A brief history of candlestick charting

Technical analysis evolved in the 18th century when a Japanese rice

trader by the name of Homma developed the principles of Japanese

candlestick analysis (Nison 1991). In candlestick analysis or

candlestick charting, as it is more commonly known, price movements

for a particular financial instrument (e.g. a share) are plotted on a

chart where the y-axis represents price and the x-axis represents time.

Figure 1 shows a candlestick chart with the daily price movements for

MSFT shares.

In Figure 1, one candlerepresents the price movements for a given

time period. The price movements shown are for one trading day.

Therefore each candle represents the full range of one days price

movement.

A candle is constructed by plotting the opening price, the highest

price,the lowest price and the closing price for the trading day. This is

shown in Figure 2.

A white candle illustrates that the closing price was higher than the

opening price for the day. Conversely, a black candle shows that the

closing price for the session was lower than the opening price.

The Japanese place great emphasis on the relationship between the

opening and closing prices. Elder (1993) explains this relationship by

describing how the opening price usually reflects the amateurs

opinion of value for the stock. Elder also notes that closing prices

tend to reflect the actions of professional market traders. He explains

that amateur traders tend to commit funds to the market after

analysing overnight news reports. The amateur will also trade the

market open because other commitments, i.e. work duties, will

prevent him from trading during the day or at the market close.

Conversely, the professional trader will be active at the close in order

to avoid carrying positions overnight. Squaring positions at the end

of the trading session allows the professional trader to eliminate risk

from overnight price movements. If trading on margin, the traderwill also avoid paying variation margin and overnight financing

charges to his broker. Marginis a deposit, which must be paid to a

broker in order to maintain a position in a financial instrument e.g. a

share or futures contract.

In the light of these factors, the closing price is psychologically

influential on all market participants. It is the benchmark by which

margin calculations are made. It is also the price that is reported in

television and newspaper reports.

The relationship, therefore, between the opening and closing prices is

a significant principle upon which candlestick analysis is founded.

Bigalow (2002) describes the psychological importance of the

opening and closing numbers as a graphic depiction of overall

market sentiment. Thus, the candlestick chart is not only anillustration of price movement resulting from changes in the forces of

supply and demand, but it is also a graphic illustration of changes in

market sentiment whether bullish,bearish or neutral.

Candlestick patterns and signals may be derived from the price action

for a single trading day or for a series of trading sessions. This analysis

however, will be concerned with a two-candle or two-day pattern called

the bearish engulfing. This pattern represents two successive trading

days. An illustration of the bearish engulfing is shown in Figure 3.

In order to identify a bearish engulfing,the first candle must be white

i.e. the closing price is higher than the opening price for the session.

The second candles opening price must also exceed the closing price

of the first candle. Finally, the closing price of the second candle must

be below that of the opening price of the first candle. As illustrated in

Figure 3, one observes that the second black candle is seen to envelop

or engulf the previous white candle. Once completed, this pattern is a

signal of a potential reversal in price and prices are expected to

decline thereafter (Nison 1991). Figure 4 demonstrates the effect of a

bearish engulfing on Microsoft Corporations share price.

Trading the Bearish Engulfing PatternBy George Rowe

Figure 1 Daily Candlestick Chart of Microsoft Corporation

Figure 2 Construction of a Candle

High

Closing price

Opening price

Low

High

Opening price

Closing price

Low

Figure 3 The Bearish Engulfing Pattern

H

C

O

L

H

O

C

L

O = Opening price

H = Highest price

L = Lowest price

C = Closing price


5/16


Figure 4 shows that a bearish engulfing pattern is completed on Day

10. Following the pattern, the share price declines from

approximately $66 to a low of $63. MSFT shares lose approximately

4.5% of their value in eight trading days.

The bearish engulfing indicates that prices will decline. This article

will therefore seek to test the profitability of a trading system, which

uses the bearish engulfing as a signal to transact a short sale in the

share concerned. Edwards and McGee (1992) describe a short sale

as a transaction where the entry position is to sell a stock or

commodity first and then repurchase it (hopefully at a lower price) at

a later date. The project adopts a short selling strategy based on

empirical and authoritative evidence that stock prices tend to fall

faster than they rise (Edwards and McGee 1992). As a result of this

tendency, Edwards and McGee (1992, p.393) state that,profits can be

made faster on the downside of the market than on the upside.

The profitability of the short selling trading system is tested on

MSFTs daily historical share price data for the five-year period 2ndJanuary 1997 to 2nd January 2002.

The operation of the short selling system

MSFT was chosen for this investigation due to its high level of

liquidity, its wide ownership by traders, private investors and

institutions and its membership of the Dow Jones Industrial Average

(DJIA), the Standard and Poors 500 Index (S&P 500) and the Nasdaq

Composite Index.

Highly liquid stocks usually bear lower transaction costs than illiquid

stocks. The low cost associated with trading MSFT refers to its dealing

spread and not the broker commissions associated with buying and

selling. The dealing spread is the difference between the sell price

and the buy price. The typical market spread on MSFT will be around2 cents or 0.04% of the stock price, e.g.44.10 (sell) - 44.12 (buy). A

high level of liquidity infers a high level of price certainty i.e. the

investor knows with a degree of certainty at which price he is able to

enter and exit a trade. Given this observation,the results gathered

should have a more practical application. It should be noted

however, that the system assumes that there are no transaction costs.

For the period 2nd January 1997 to 2nd January 2002, daily historical

share price data for MSFT was downloaded to a Microsoft Excel

spreadsheet from a Bloomberg data terminal. Bloomberg is a

provider of news and data to large City institutions. The data it

supplies is therefore highly reliable and accurate.

Using the open, high, low and closing price data for MSFT, a

candlestick chart was constructed in the spreadsheet. A formula waswritten in the spreadsheet to identify a bearish engulfing. For a

bearish engulfing to be identified three criteria must be met:-

1. The first candle must be white i.e. the closing price must be higher

than the opening price.

2. The opening price of the second candle must be greater than or

equal to the closing price of the first candle.

3. The closing price of the second candle must be less than the

opening price of the first white candle.

The above criteria for a bearish engulfing differ from the descr iption

given earlier in Figure 3. Figure 5 illustrates Figure 3s definition and

the definition that will be used for this article.

In Figure 5, Definition A illustrates that the opening price of the

second candle is higher than the close of the first white candle.

Definition B shows the opening price of the second candle may be

greater than or equal to the close of the first white candle. N.B. for

clarity, the high and low prices have not been marked in Figure 5.

Nison (1994) explains that stocks tend to open relatively unchanged

from the close of the previous day and thus there should be more

flexibility in defining an engulfing pattern. It is for this reason that

Definition B is adopted.

Having identified a bearish engulfing in the spreadsheet and having

verified this on a candlestick chart of the share price, one share is sold

short at the closing price of the second candle that makes up the

bearish engulfing pattern. The buy and hold investor is assumed to

hold one share in MSFT. By selling one share short against his one share

holding, the buy and hold investor is conducting a perfect hedge.

A perfect hedge eliminates risk (Arnold 1998, p.1022). By conducting

a perfect hedge, any loss made on the short sale will be equally offset

by the gain made on the investors share holding. Similarly, any loss in

value in the share holding is equally offset by the profit made on the

short sale.

At the same time that the short sale is made, a limit order to buy the

stock back is placed at a 1% limit order level. This means that, if the

price declines and the stock loses 1% of its value,the limit order will

be triggered and a profit will be registered for the trade. The profit on

the trade is the entry price minus the exit price.

At the same time that the short sale is made, a buy stop order is

placed on any close equal to,or above the high of the second candle

that makes up the bearish engulfing. The stop order is placed to

guard against potentially unlimited losses should the share price

advance after the short sale. According to Nison (1994), the high of

the bearish engulfing is usually an area of resistance on a closing

basis, i.e. a level that acts as a ceiling to any advance in price. It is for

this reason that the stop is placed on any close equal to or above the

high of the bearish engulfing. Furthermore, with the stop at this level

the investor knows that, should the price move through this level

during the session, but fail to close above it, he will not be unduly

forced to close his position and suffer a loss. Any loss on the trade is

calculated by subtracting the exit price from the entry price.

By inspecting the stocks candlestick chart in Microsoft Excel, the

author identified whether the limit order was triggered before the

stop. If this occurred the exit price was entered in the spreadsheet

and the profit calculated. However, if the stop was triggered before

the limit order, the exit price was recorded in the spreadsheet and the

resultant loss automatically calculated. Figure 6 shows how a trade

was made in MSFT with a 5% limit order.

Figure 4 Microsoft Corporations Share Price Following theBearish Englufing

Figure 5 An Illustration of Bearish Engulfing Definitions

C

O

O

C

C

O

O

or O

C

O = Opening price

C = Closing price

Definition A.

Conventional definition

Also shown in Figure 3.

Definition B.

Definition used for

this report


6/16


In Figure 6, a bearish engulfing labelled BE occurs on Day 13. A short

sale is entered at the close on the BE day at a price of 23.69. This is

labelled point E. A limit order to take a profit on the short position is

placed at a level 5% lower than the entry price. This level is 22.50 and

labelled point L. The 5% limit order price is calculated by multiplying

the entry price,23.69,by 0.95. The buy stop order,point S, is placed on

any close equal to or above this level of 24.94. The buy stop order at

point S to close out the short position is an arbitrary level. It is only

triggered if the price settles above point S at the market close. Also

note that if the buy stop is triggered, the limit order is cancelled and

vice versa. One observes that following the bearish engulfing; the stock

fails to decline in value leaving the limit order unfilled. Instead,the

share price advances and closes above point S at point S*. The trade is

exited at point S* at a price of 25.28 and a loss of $1.59 is recorded.

Ten different limit orders were tested for MSFT ranging from 1% to

10% inclusive. This was carried out to analyse the effect of moving

the level of the limit order downwards, thereby increasing the

potential profit on the short sale. The hypothesis derived from this is

that the higher the limit order percentage, the further the share must

decline in order for the limit order to be triggered and a profit made.

Thus, the greater the profit made on each successful trade, the greater

the overall profitability of the system.

It should be noted that the system takes account of price gaps. A

gap is a price area between one days closing price and the

following days opening price where no trades take place. Gaps occur

when prices move sharply in response to a sudden imbalance of buy

or sell orders (Elder 1993, p.95). An example of a gap and its effect onthe execution of the limit order is shown in Figure 7.

In Figure 7, one sees that the bearish engulfing, BE, is completed on

Day 3. The entry level for the short position, E, is made at the market

closing price of 57.25. A buy stop order to close the short position is

placed on any close above 60.50, which is point S. The 6% limit order

to buy at 53.81 marked L, is not triggered because MSFT did not trade

at this price. As a result, the limit order is filled at 51.05, marked L*.

This is the opening price of the stock for the following trading day. If

the stock had traded at the limit order of 53.81,a profit of $3.44 would

have been registered. Due to the formation of the gap,the order was

filled at a lower and more favourable price. As a result, a profit of $6.20

was recorded. Thus,an extra $2.76 was made on the trade.

As Figure 7 demonstrates, a gap changes the level at which the limit

order is executed, which in turn leads to a greater profit on the short

sale than had previously been anticipated. Gaps are a natural

phenomenon in the stock market and they have been incorporated into

this study to ensure the results generated are as realistic as possible.

Having carried out the trading method described earlier, the

profitability of the system using each limit order from 1% to 10% was

analysed and comparisons made. Profitability was measured by

multiplying the buy and hold dollar return on MSFT by the average

risk free rate. This was carried out to observe whether any short

selling returns exceeded the return that could be earned without

assuming any risk. The average risk free rate adopted was 5.19%. This

figure represents the average Fed funds rate published by the US

Federal Reserve Bank during the period studied.

The author would have preferred to have tested the profitability of

the system over a ten-year period,however due to time constraints

and the large volume of data created, this would have been infeasible.

Results and analysis

The profitability of the short selling strategy on MSFT is analysed by

comparing the risk free adjusted percentage return (RFA%R) to the

conventional buy and hold return over the five-year period. The

author also analyses the changes in profitability for each limit order.

Figure 6 A Trade in MSFT with a 5% Limit Order Figure 7 Example of a Gap in MSFT with a 6% Limit Order

Figure 8 Histogram Showing the Risk Free Adjusted Percentage

Return (RFA%R) over a Buy and Hold Strategy on MSFT


7/16


The overall buy and hold return on MSFT for the period studied was

$46.26 per share as the share price rose from $20.78 to $67.04. 58

short sales were initiated. Figure 8 shows the percentage return of

the strategy over and above the average risk free rate. One observes

from Figure 8 that the system is only profitable over the period

studied when a limit order of 6% to 10% is applied. Limit orders 1%

to 5% show negative returns. This indicates that when these limit

orders are employed; the losses on each trade exceed the profit made

on each trade. Figure 8 shows that as the limit order percentage

increases, the RFA%R over the buy and hold strategy also increases.

This is most apparent when comparing the 6% and 10% limit orders.

The 10% limit order, for example, generates around 3.5 times the

return of the 6% limit order whilst the difference between the two

limit order percentages is only 4%. By allowing the price to fall by

10% after each bearish engulfing, the RFA%R over the buy and hold

strategy is an impressive 65%. On the other hand, by allowing the

price to fall 6% after the bearish engulfing, the return is a much lower

22%. To understand the difference in return between the limit orders,

one should observe Figure 9. Figure 9 shows the percentage of

winning trades for each limit order.

Figure 9 illustrates that 1% to 5% limit orders display negative returns,

however the percentage of winning trades remains relatively high

compared to the 6% to 10% limit orders. This is most apparent in the

1% and 2% limit orders where there is a negative RFA%R of -35% and

-42% respectively. Winning trades for these limit orders are 71% and

59%. This indicates that for the 1% and 2% limit orders, although the

percentage of winning trades was high, the profits made on winning

trades were not great enough to offset losses made on losing

positions. Thus the general observation made from Figure 9 is that

the percentage of winning trades declines as the limit order

percentage increases. One may infer from this observation that the

further the limit order is from the entry price, the greater the

probability that the limit order will not be executed and, as a direct

result, the greater the probability that the stop will be hit instead.

However,the further the limit order is from the entry price, the

greater the profit generated on winning trades compared to losing

trades. In the case of the positive return bars in Figure 9, it can be

concluded, that as the limit order increases,fewer winning trades areaccounting for a large proportion of profits.

Given this analysis, one must decipher whether the combination of a

low winning trade percentage and a substantial RFA%R is desirable

for the buy and hold investor. By analysing the maximum dollar

drawdown and the overall dollar return for each limit order, one may

find a solution to this question. Drawdown is defined as the

maximum dollar loss that the system records during the period

studied. Figure 10 shows the drawdown for the 6% to 10% limit

orders. Limit orders 1% to 5% have been ruled out of this analysis as

their RFA%Rs compared to a buy and hold strategy are negative.

The limit orders 6% to 10% marked on the right hand side in Figure

10 all show positive dollar returns for the period studied. However,

these returns are generated with a certain degree of risk or

drawdown. Clayburg (2001) recommends that for a system to be

considered, return should be at least 3 to 1 over drawdown. In Figure

10, the return to drawdown ratio for the 6% limit order for MSFT is

0.78. This means that the overall dollar return is actually less than the

drawdown of the system during the five-year period. In this instance,

the trade-off between drawdown and return is undesirable as the

amount of drawdown exceeds overall return. However,the

drawdown to return ratio is more favourable for the 9% and 7% limitorders. The ratios for these limit orders are 1.63 and 1.96 respectively

and represent the two greatest return to drawdown ratios for the

limit orders studied. However,these ratios are significantly less than

Clayburgs (2001) minimum desired return to drawdown ratio of 3 to

1. Even though the 9% and 7% limit orders do not meet the desired

ratio, the likelihood of the system generating profitable returns over

time can be analysed by observing the equity curves. Equity curves

show the change in profit and loss for each limit order and are shown

in Figure 11.

Figure 9 Histogram Showing the Risk Free Adjusted Percentage

Return (RFA%R) over a Buy and Hold Strategy on MSFT

Shares and the Percentage of Winning Trades for Each

Limit Order

Figure 10 Graph Showing the Dollar Drawdown and Return for MSFT

Figure 11 Equity Curves for MSFT with 7% and 9% Limit Orders


8/16


Figure 11 illustrates that the 7% limit order has less volatility around

the zero line on the drawdown and return axis. The 9% limit order

produces more erratic price movements between positive and

negative territory. Clayburg (2001) advises that the equity curves

should exhibit a steady progression from the beginning to the end

of the test period. Given this advice, it may be considered that the

7% limit order is most suitable even though its dollar return is

slightly less than the 9% limit order. However, it should be noted

that for both limit orders, the majority of the systems returns are

generated from day 758 onwards where the share price of MSFT

made its all-time high. As one would suspect, this demonstrates that

short selling following a bearish engulfing is most profitable when ashare is declining in value for a prolonged period. The advantages of

the 7% limit order are that the dollar returns on MSFT are positive

and the RFA%R over the buy and hold strategy is an impressive 52%.

However, the combination of a poor return to drawdown ratio, a low

percentage of winning trades and the observation of erratic equity

curves make the long-term application of the short selling system on

MSFT shares difficult to justify. Should MSFT shares reverse their

current downtrend and begin a prolonged advance, the current level

of profitability performance for the 7% limit order as well as the

other limit orders is at risk. A study of the system for a 5-year period

from when the test period ended would enable the buy and hold

investor to observe the systems performance in both bull and bear

market phases.

Conclusions

With MSFT, there is evidence to suggest that increasing the limit order

percentage reduces the percentage of winning trades. It is also clear

that setting a low limit order, perhaps 1%, does not necessarily equate

to long term system profitability. This is because, because the fact

that there are numerous small profit trades, the resultant losing

trades although few in number are big enough loss makers to more

than wipe out any profit. One may deduce, therefore, that the current

stop loss rule is not an adequate risk management tool.

With the exception of MSFTs 1% to 5% limit orders,it may be stated

that short selling following a bearish engulfing is a profitable

hedging strategy for the buy and hold investor. However, the period

studied was only five years, where the last two years of the study saw

a bear market in MSFT shares. By studying a longer time frame e.g.

10 years, a greater degree of accuracy in the results could be

obtained. In turn, this would give a better indication of the long-

term viability of the system. This is important as it may be

considered that most rational investors will only consider a system

that performs over the long term.

Considering the analysis of the short selling strategy on MSFT, does

the strategy have any practical application for the buy and hold

investor? There is a possibility that the system could be used for MSFT

with a 7% limit order but, given the fact that the system performed

poorly for the first three years,there is no guarantee that positive

dollar returns would be sustainable. This may be especially true if

MSFT ended its current bear phase and began a new bull market leg.

Moreover, if an investor had followed the system, would he be able toexecute the trades with trying to second guess the signals?

In light of the positive returns obtained on MSFT for varying limit

orders, the question arises, what is the implication of a profitable

system based on technical analysis on the weak form of the efficient

market hypothesis? The bearish engulfing pattern has been shown to

repeat itself over time and using certain filter rules does produce a

superior return to the conventional buy and hold strategy. This

implies that to a certain extent and certainly for MSFT, that the

application of a form of technical analysis does work in practice. On

the other hand of course, the returns may be put down to chance. In

order to prove this point a more comprehensive study would be

warranted. This study would have to include at least ten years of daily

historical price data on a variety of financial instruments and not just

US stocks. This would ensure that the system is robust and can beapplied to any financial instrument.

There are some apparent limitat ions with the system. The exit rule for

stops does appear, in hindsight, to be flawed somewhat. This is

discussed further in the recommendations section.

Recommendations

Before exploring the practicalities of using this system, a discussion

should be made on the flaws of the system and the changes that can

be made to improve overall performance.

Although the criterion for closing a trade at a loss is adequately

defined, the rationale behind placing the buy stop order is flawed

somewhat. Under the systems rules, the buy stop is triggered and the

position is closed if the closing price of the stock is equal to or above

the high of the second candle of the bearish engulfing pattern. The

drawback of this exit rule is that the closing price can be significantly

higher than the high of the second candle that makes up the bearishengulfing. The stop order is designed to limit risk. However,when the

short sale is initiated it is impossible to define the risk level assumed

for the trade. This is because the stop may be executed at any price

higher than the minimum stop level. By employing this exit rule,risk

is technically unlimited. This rule is therefore undesirable for risk

management purposes. The benefit of the exit rule however, is that it

provides clear confirmation that the price has completed a reaction

and is resuming an advance. The investor knows that he should

therefore accept a loss. A possible solution to this problem may be to

set the stop level at a pre-defined distance above the high of the

second candle of the bearish engulfing. This stop would be a trading

stop, meaning it could be triggered during the trading session and

not just at the market close. If the stop was triggered during the

session and the price continued higher, a smaller loss would be made

compared to the market on close exit rule.

One other flaw of the system is the market on close rule for both trade

entry and trade exit by being stopped out. The assumption is that the

last traded price equates to the entry or exit price. In reality, it may be

difficult to achieve this price, as the investor has to decide whether a

bearish engulfing has occurred. He then has to make sure that he

initiates his short position and places his stop and limit orders before

the market closes. In reality therefore,the entry or exit price may be

slightly different from the closing price on the bearish engulfing day.

One final drawback is that the system is not fully automated. As

Schwager (1996) emphasises, the benefit of a mechanical trading

system is to eliminate emotional decision-making from trading. The

investor must follow the rules of the system in order to maintain a

consistent approach. Because of the human decision making

involved in making trades, there is a risk that in reality, the investor

may decide to ignore the systems trade signals. Given this risk, the

investor may decide to pass up certain trades as he considers that his

judgement is superior to that of the system. Granting the freedom to

make trading decisions to a nave or inexperienced investor could be

detrimental to the financial standing of the individual.

In order for the system to be implemented in a practical sense, the

investor must consider which financial instruments to employ so that

transaction costs are minimised and returns are maximised. One

option is physical stock trading on the stock exchange. There are

noticeable transaction costs however. Broker commissions, the size of

the bid offer spread and the potential for slippage would contribute to

a reduction in overall returns. Furthermore, there are certain exchangerules which apply to short sales. On US stock exchanges,short selling is

only allowed on an uptick(SEC 1934). This means that the short sale is

only allowed if the last price traded higher (on an uptick) than the

previous price. Because of this rule,short selling at the market close

may be difficult, especially if the price continues to trade on a downtick.

These rules can be avoided by trading a contract for difference (CFD).

Trading a CFD equates exactly to trading the underlying stock, the

only difference being that the investor is not conducting a deal on an

exchange. By trading a CFD, the investor is able to trade on a

downtick. CFDs are also margined trading instruments, which enables

the investor to benefit from gearing. Any returns made on capital will

be augmented by the gearing effect. Furthermore, the CFD price will

have the same bid offer spread as the underlying stock. CFD trading

houses also accept market or close orders. Finally, there are minimaltransaction costs when trading a CFD.

Having considered these factors, short selling using CFDs is a serious

consideration for any investor willing to adopt this trading system. Of

course, further research is required before this strategy can be


9/16


There is no doubt that the February peak in the Euro showed some

worrying technical action. Firstly,we saw key reversals on both the daily

and weekly charts. Secondly, momentum indicators were high or

overbought, and divergent, in daily,weekly and monthly time frames.

Thirdly, the currency had already seen an approximate 50% rise against

the US Dollar. Finally,as if any more were needed,we were bumping into

heavy historic resistance (though based on synthetic rates) in the 1.30

area. All quite alarming stuff,and certainly enough to inspire the thought

that perhaps the Euro bull run was at an end.

While that may indeed prove to be the case, there are reasons for viewing

the activity so far this year as another consolidation rather than the finaltop. An aging bull almost certainly,but probably not quite a dead one

yet.What supports this argument?

Apart from its second half 2002 consolidation of the break up from its

base, the Euro had only seen one major pause in its rise until this year.

From that point of view,and given the overhead congestion resistance, it

was likely that gains would slow overall and become subject to another

longer reaction and consolidation phase. To date, there is no indication

that the January/April action is any different in character from that of

May/September 2003, and on that basis a further downside move, which

I would expect, would not alter the conclusion that the current pause istemporary. The June to early September drop was about 9% and if we

see a similar reaction from the February peak, it could bring us back to

1.17/16. This is an area of congestion and a retracement of some 61.8%

of the September/February rise. Such a further decline should act to fully

correct the overbought position of weekly indicators, and bring monthly

ones back to a more positive level. Daily indicators have already been on

the low side of the spectrum for over a month.

In addition the large 2000/02 base,together with the second half of 2002

extension of that formation,looks capable of supporting some further

advance for the Euro against the US Dollar. The overall range from May to

November last year offers further support for some additional gains. Both

these areas give higher counts on the point and figure chart. Also, looking

at the weekly bar chart, it can be seen that on the bigger swings up in

April/May 2003,down in May/September 2003, up in September 2003 to

January 2003, down in February/March 2003 the angles of ascent are

steeper than the angles of descent. In other words, the Euro moves withmore dynamism in its up phases than it does in its down phases.

Clearly there is at present a large area of resistance up to about1.25.

Later clearance of this is expected and would signal that demand was

increasing again. A retest of the1.29 peak area would be expected to

follow. Once this and1.30 are decisively broken, higher targets will

open up at 1.3310/35,1.3460 and 1.3610. (These mark, respectively,

a projection and the midpoint of the 1995 top,a second projection, and

the October 1995 high.) Beyond is the1.40 area, which looks harder to

reach,let alone clear. The early 1995 synthetic peak is around1.45.

In conclusion, I would argue that the overall pattern remains consistent

with an ongoing, though mature, bull market, which is undergoing a

multi-week reaction and consolidation prior to what will probably be its

final run up before a top really does start to develop.

Anne Whitby is Vice Chairman of the Society

implemented. The author also tested the system using Genaral

Electric (GE) and 3M. Results varied between all three stocks with 3M

performing better than MSFT. In fact, 9 of the 10 limit orders for 3M

generated positive returns with 6 limit orders producing risk free

adjusted returns of 70% or more. This is of course compared to a

conventional buy and hold strategy. By contrast,GEs results were

extremely poor with negative returns across all limit orders except

the 6% order. Without a more detailed analysis of GE it is diffcult to

account for the huge discrepancy in results. However,it is clear that

with this stock the systems rules were not suitable and too much risk

was borne. As it stands, the system certainly has some promise with

3M and to a lesser extent with MSFT. It is the authors view that there

is considerable scope for the buy and hold investor in 3M stock to

earn abnormal returns.

References

ARNOLD,G., 1998. Corporate Financial Management. London:

Financial Times Prentice Hall.

BIGALOW, S.W., 2002.Profitable Candlestick Trading: Pinpointing Market

Opportunities to Maximise Profits. New York: John Wiley & Sons.

CLAYBURG, J. F., 2001. Four steps to trading success: using everyday

indicators to achieve extraordinary profits. New York: John Wiley

& Sons.

ELDER, A., 1993. Trading for a living: psychology, trading tactics, money

management. New York: John Wiley & Sons.

NISON, S., 1991. Japanese candlestick charting techniques: a contemporary

guide to the ancient investment techniques of the Far East. New York:

New York Institute of Finance.

NISON, S., 1994. Beyond candlesticks: new Japanese chartingtechniques revealed. New York: John Wiley & Sons.

SCHWAGER,J. D.,1996. Schwager on futures: technical analysis. New

York: John Wiley & Sons.

SECURITIES AND EXCHANGE COMMISSION. (1934) Rule 10a-1 - Short

Sales [online]. Cincinnati, University of Cincinnati. Available from:

http://www.law.uc.edu/CCL/34ActRls/rule10a-1.html [Accessed 8

August 2002]

The Euro a Top or the Top?By Anne Whitby


10/16


On February 11th 2004 I presented a talk entitled Candlestick Reversals

Patterns and Applications for Long Term to Intra-day Charts. In the wake

of this I received a number of e-mails and I thought I could answer the

points raised in an article as a kind of open forum. At the meeting I

went through some of the more common candlestick patterns,

highlighting the psychology behind the patterns by talking through theprice action that led to their formation. For the benefit of those who

couldnt make it to the meeting I have given a brief prcis of the patterns.

Bullish Engulfing PatternA two-day pattern. The first day

is bearish in line with the trend. On the second day we

open below the previous days close, but then rally sharply

to close above the first days open: Quite a change over a

two-day period!

Bullish Engulfing Patterns. Do you require confirmation before

placing a trade on an engulfing pattern? I find doing so reduces

whipsaws but also causes one to sometimes enter too far into the

move because engulfing patterns can foretell immediate and

significant reversals?

The Bullish Engulfing Pattern is one of the strongest and most reliable

patterns in the book so acting upon one should give you extra

conviction for your trade. One rule I like on trading candle patterns on a

daily chart is to wait for the pattern to form (rather than pre-empting its

possible formation), then look at where the market opens the next day. If

we open higher then the chances are the late buying from the previous

day is not merely a fluke. Often a stronger open the next day would also

leave a gap/window which could be a good place to put a stop below.

So you get extra confirmation plus a solid price level to get out. But with

any candle pattern I always look for confirmation from another form of

analysis. I do not recommend using one form of analysis in isolation,

whatever it is. If you have a candle pattern, as well as a trend break,and a

divergence on a commonly used indicator, then your conviction will be

strong (and therefore your target may be higher,which in turn should

allow you a bigger stop in line with basic risk/reward ratio theory. This issomething I am very keen on).

Exiting. Once in a trade, what do you do if after one,two or a few

more bars you get a reversal pattern? Do you exit,move your stop to

the low of the reversal bar or continue with the trade? For example,

you go long on a bullish engulfing pattern and two bars later a

shooting star appears. The shooting star is not at the top of a long

trend but it may be foretelling an imminent change in sentiment

and,therefore,time to exit.

Again confirmation is the key here and the next days open would give a

good idea as to whether, using the example you cited, the Shooting Star

was a reversal,albeit reversing a very short term move, or merely the

result of a bit of closing shenanigans.

Shooting Star: A single candle pattern, which suggests a

reversal when seen in an uptrend. It has a large upper

shadow. To get the long upper shadow the market has to

rally strongly then fail and give back all of the earlier gains

to close pretty much back where it started,near the low of

the day. So the bears took hold of the baton at some point

over the session.

Stop Placement. Where do you place your stop-loss upon entering

on a candlestick pattern?

The text-book answer is to put a stop below the lower shadow of the

reversal candle/candles,but in practice this could present large draw-

downs. This is one of the toughest conundrums for me and something

that I have to admit I have always had trouble with when trading themarkets using candle patterns. Moving a stop higher in line with a rising

market is still,for me, the best way to go on this one, plus always being

prepared to re-enter the trade if you feel youve been stopped out too

early, as long as the reversal characteristics are still in place. This is why

the textbook definition is useful and sensible. For example with a

Hammer pattern: If the market goes on to make a new low then the

Hammer is effectively negated.

Hammer: The opposite to a Shooting Star; therefore

appears in a downtrend. This is a session where the early

price action is bearish but we bounce from a low and the

buying continues to the end of the session where we close

strongly, suggesting a surge of buying that may well have

spelt the end of the downtrend

Diminishment of the Edge. Do you think that too many people do,or

in the future will, use candlestick patterns on US markets to the

point where the significant edge they provide will disappear?

There is no doubt that the more and more peop le that look at a

particular study, or the study of technical analysis as a whole, the more

effect it will have on the market. But whether this is bad for the

technician or not is I think arguable. The NASDAQ, for me,is one of the

best-behaved markets from a technical point of view (you only have to

look at how many dayshighs or lows are gap fills to realise this), and this

can only be because of the number of people looking at it that are using

technical analysis. The Bund Futures is one of my old favourites.In this

market the localslook for the stops below a gap but, as long as you are

aware of this, you can adjust your trading style accordingly.

In saying this Ive always said that the market is way too big for one

particular type of analysis (or sub-group thereof) to have an absolute

effect on its direction.

Defining Small Shadows. For the hammer,shooting stars and similar

patterns, the body is supposed to have a long shadow for a tail and

the other end of the body has no shadow or a small shadow. How

large can the small shadow be? One book I read recommended no

more than 10% of the total range of the price bar but that can cause

one to miss some good trades.

I dont subscribe to putting a percentage value on this. Textbooksprobably feel the need to adopt a quantative approach so that the

academics dont give them a hard time, but I think a commonsense

approach is more effective. Once youve been looking at candle patterns

for some time you will make the decision that something may not qualify

to be a Hammer in the true text-bookdefinition but, as a trader youre

not going to ignore a small bodied candle at a bottom, especially if the

lower shadow is long. It may not be a Hammerper-se, but itd probably

bang a nail in if need be!

Candlestick Patterns in stocks. Do you find that you can trade candle

patterns on stocks and disregard the effect of the trend of the

overall market (i.e.taking long positions when the market trend is

down or vice-a-versa)? If not, what do you use to determine the

trend of the overall market for trading candlestick patterns on

stocks in the direction of such trend?

I prefer to use candle patterns in cahoots with the overall trend of the

market. The Trend is your Friend may be the oldest adage in the book, but

my experience is that its also the most relevant! I like using candle

patterns to buy stocks when the market is in an uptrend. One of the best

times to buy is on a pullback/retracement. One of the best times to buy

during a retracement is if the market has got to key support levels, either

old highs or lows, trend support lines, a reliable moving average, or a

Fibonacci retracement level (long or short term), and if at the same time

you get a bullish candle pattern.

Doji: A single candlestick that signals a reversal if seen in an

uptrend or a downtrend.It has one simple rule: No real body.

This means we open and close at the same level, the

psychology behind this being that if you have been in a solidtrend then suddenly post a day where the market opened

and closed at the same level this means the buyers and

sellers were perfectly matched over the session as a whole.

Continues on page 13

Candlestick ReversalsBy Clive Lambert


11/16


Background and market fundamentals:

Coffee is traded on the futures markets at both LIFFE and at the Coffee

Sugar Cocoa Exchange (CSCE, now part of the NYBOT). While the contract

specifications are different between LIFFE and the CSCE,the broad

market trends are the same. We will concentrate on the US market.

CSCE Coffee futures have been trending lower since May 1997, from a

peak of $3.18/lb to a trough of 41.90c/lb in December 2001 on futures

continuation charts. The decline was due for the most part to the

establishment of new plantations in the worlds leading coffee supplier

Brazil and runner-up Vietnam, in the face of fairly steady demand.

However,s ince the end of 2001, the market has been shuffling higher as

production has eased and producers have shifted from arabica to robusta

production (moving up the quality scale). The market should find some

additional support this year as the Brazilian

crop shrinks due to the biennial nature of the

coffee crop. (Coffee harvests tend to be heavy

in one year and not so high in the next). The

International Coffee Organisation (ICO)

estimates that total production in the 2003/04

crop year will be 101.31 million 60-kg bags, a

fall of 15.3% compared to the 2002/03 crop

year and total production of arabica beans is

expected to fall 22%.

Technical outlook

While the long term trend is bearish,the

market has been correcting higher since the

41.90c/lb trough at the end of 2001. Bear in

mind that the market has only probed below

50c three times, once in April 1975,once in

August 1992 and the somewhat lengthier

September 2001-August 2002 period. The

market does not seem comfortable on probesbelow 50c and a correction back towards

more normal levels looks underway. The

recovery through the old support line from

the January 1996 and September 1999 lows,

which had marked the neckline of a large and

sloppy top, helped trigger a supportive cup

and handlepattern breakout on weekly

charts a bullish pattern. That move has seen

the 13-week (quarterly) moving average

regained, confirming a bullish crossover in the

13- and 60-week moving averages

Daily charts show a large triangle continuation

pattern,which in turn seems to be part of a

bull flag on weekly charts. The triangleparameters on the front month CSCE May 04

contract are noted at 70.95c and 79.05c

currently. The weekly moving averages have

seen a bullish crossover in the 13-week

(quarterly) and 50-week (annual) moving

averages and the price rebound through the

13-week moving average is encouraging. The

250-week moving average (5-year average)

offers strong support now near 69c and is key

to hold to keep the overall bias on gains. For

choice,a push towards the 79.05c triangle

resistance line looks on the cards. Ability to

clear that line, then the key 80.60/81.00c zone

(late January 2004 peak and 38.2%

retracement of the decline from the March

1999 $1.45 peak to the 41.50c December 2001

low) would trigger the large bull flag for a

target to $1.07 over the coming weeks. Along

the way, the 93.25c level marks the 50%

retracement of the same move, while the 61.8% retracement comes in

near $1.055.

The 70.95c and 69c levels offer key support on dai ly charts. The latter is

key to hold to not only retain the bullish patterns currently apparent on

the charts but also to retain bullish Elliott wave counts as a breach therewould invalidate a potential wave 4correction unfolding here. If seen,

such a break would leave the 61.75c contract low vulnerable to approach

again (tested last November, as well as the previous August in thin

trading). While the long term trend is bearish,the basing pattern that has

been building since the end of 2001 dominates the charts and an

extension higher is favoured over the coming months through the

80.60/81c region towards the 93.25c retracement initially.

Elizabeth Miller,Head of Research, Redtower Research

The Case for a Base in Coffee FuturesBy Elizabeth Miller

CSCE May 04 Coffee futures daily chart , with 20-day and 60-day moving averages and a triangle

pattern.

CSCE Coffee futures weekly chart, with 13-week and 50-week moving averages.


12/16


To buy and hold blindly on the basis that it is a great company, or a strong

industry,or the economys general health is, to me, the equivalent of stock-

market suicide. Jesse Livermore

As most market practitioners believe, be they fundamentally or technically

biased, price trends exist due to the inefficiency of financial markets to

digest information in a timely manner.This is due to the fact that p rice

sensitive information is used in different ways, over different time scales

by many different market players thus confining the efficient market

hypothesis to the ivory towers of academia. A logical extension from this

is that a mix of diversified investment processes are required in order to

make markets inefficient and for trends to exist.

An investment process will be dictated by the bias of the practitioner (a

macro economist will be biased towards using a fundamental investment

process) and by the relevant customer base (a retail oriented fund will

generally find it easier to talk in the language that they believe their retailcustomers understand). Also, different markets will require different

investment processes. A small companies investor/trader will be better

following a fundamental investment process whereas a currency

investor/trader would be more suited to a process mixed between

fundamental and technical analysis.

Technical analysis really only works and has any theoretical credibility in

deep, liquid markets because there has to be a reasonable crowd in order

for there to be crowd psychology at work. However,technical market

analysis is the oldest form of market analysis. It pre-dates modern

fundamental analysis by decades if not centuries yet the modern

assumption is that fundamental analysis is the most appropriate method

on which to base investment decisions. This is due to the natural human

desire to understand and explain WHY events happen or WHY markets

move. Lets face it, what fund manager you know would want to be honestenough to tell you that he doesnt know why prices are moving or why

some trends exist?

So why integrate technical analysis into an investment process? Well, for

technical analysts the why markets moveis not important, they are only

interested in the HOW markets move. Also, fundamental analysis is

broadly subjective whereas technical analysis is broadly objective.

Therefore, integrating technical analysis into an investment process allows

it to act as a REALITY CHECK on subjective decisions.

Technical analysis acts as a tremendous risk management tool as it tells

the trader or fund manager when they are wrong.This acts as a great

defence against a fund managers worst enemy their EGO and as such

it prevents crippling losses occurring from a badly positioned portfolio. As

the old market adage says the market is never wrong: opinions often are.By integrating technical analysis,losing positions will never be held on to

for too long and indeed by using trend following techniques the market

practitioner can be guaranteed to be on the right side (or, at least, not on

the wrong side) of a large sustained market move.This is a huge benefit in

preservation of capital.

The elements of good trading are: 1. Cutting losses, 2. Cutting losses, and 3.

Cutting losses.If you can follow these three rules, you may have a chance.

Ed Seykota

So what form of technical analysis should be integrated into a process?

Although technical analysis is broadly split between trend following and

contrary thinking both can be used together.However, generally one form

will dominate the other depending on the bias of the practitioner.For

most practitioners trend identification is the bedrock of what technicalanalysis is all about and is certainly the area of technical analysis most

suited to limiting the risk of holding on to losing positions for too long.

There are three broad methods of integrating technical analysis into an

investment process.

1. Full Integration

2. Position Management

3. Style Diversification

The objective of each method is to reach overweight (buy), underweight

(sell) or neutral (stand aside) decisions.The examples used here are based

on Currency Management (Overlay) but the methodology can easily be

transferred to other liquid asset classes. Fundamental drivers will differ

between asset classes and the technical analysis may have to be tweaked

slightly trend following works in most asset classes over the long term

but some asset classes (or sub sectors) may be more suited to oscillators

or contrary opinion.As always, flexibility is the key.

Full integration

In this method we include technical analysis as part of the overall process in

order to reach one single decision (i.e:overweight, underweight or neutral).

The spreadsheet shows various drivers of currencies each with a

hypothetical score ranging from -5 to +5. A score of -3 in the Growth

Expectations field for EUR/USD means that this driver is negative for

EUR/USD and a score of +4 in the trend field indicates that this driver (the

trend) is positive for EUR/USD. The overall decision is reached by simply

adding the scores of each driver together. Thus we get a small

underweight position in EUR/USD. Note that we are assuming an equal

weight given to each driver here but they could be weighted according to

their importance for the currency pair.

The advantages of full integration are that it can be seen to take all

relevant drivers into account to reach one simple decision and that it

controls risk (limits the downside) by having a weighting given to

technical analysis.

The disadvantages are that p ositions taken away from the benchmark (or

neutral) may be very infrequent due to the often conflicting messages

from fundamental and technical analysis.The technicals could be a

screaming buy but if the fundamentals are poor then only a neutral

position would result.There is therefore a very high risk of opportunity

loss using the full integration method.

Position managementIn this method we include technical analysis as a filter in order to decide

the size of the position that will be taken.

Integrating Technical Analysis into anInvestment Process

By Murray Gunn

Vs USD Value Growth Money Sentiment Trend Position

(PPP, FEERS) Expectations Supply Growth

EUR 1 -3 0 -3 4 Underweight

JPY 0 -4 -1 2 3 neutral

STRATEGIC PROCESS

PRICEACTIONFILTER

Neutral

Smallest o/w

Overweight

Currency

Underweight

Currency

Neutral

Smallest u/w


13/16


The method makes use of two processes. A Strategic Process

(fundamental analysis) decides the direction of the position whilst a Price

Action Filter (technical analysis) decides the size and timing of the

position.

The diagram shows how the strategic process (the fundamentals)

interacts with the price action filter (the technical analysis). If the

fundamentals are positive and the technicals are positive then an

overweight currency position will exist. If the fundamentals are negative

but the technicals are positive then we have a neutral or very small

underweight position.

The advantages of using technical analysis as part of a process in this

way is that it combines fundamental and technical analysis but for

separate purposes. The technical analysis is acting as a controller of how

much risk to place on a given fundamental view. It therefore contains risk

and limits the downside.

The disadvantage of this method is that a very high risk of opportunity

loss still exists.The Yen could be on a strong upward trend but if the

fundamental view was for Yen weakness then only a neutral position (or

even the smallest underweight position) would exist. A large move in the

market in the opposite direction of the strategic process would NOT be

captured.

Perhaps a better way to use this process would be to flip it around so

that the technical analysis decides the direction and timing of the

position and the fundamentals decide the size of the position. This would

avoid the opportunity loss problem as trend following (if that is the

technical analysis utilised) is guaranteed to be the right side of a large,

sustained market move.

Style diversification

In this method we include technical analysis as part of a diversified

portfolio of management styles. We take the maximum position (or risk)

that can be taken and divide it up into sub-positions with each one

managing a portion of risk according to a separate management style.

For example, suppose we are managing the Japanese Yen risk in a

portfolio. Assume that the benchmark weighting is 20% for Yen but we,

as the managers,are allowed to vary the exposure between 10% and

30%.The 10% differential from the index is the maximum position size.

If we were to utilise the style diversification method here then we may

have something that looks like this.

The spreadsheet shows that we are employing four separate styles of

management, fundamentals, cost of carry, contrary opinion and trend

following.We have allocated a percentage to each one and this refers to

the amount of risk that each style will manage. For example, we haveallocated 40% to trend following which means that 4% (40% of 10%) of

the portfolio will trade the Yen based on trend following techniques.

Assuming a portfolio value of USD100m then the trend following position

can go up to USD4m long of Yen or USD4m short of Yen.In the above

example the trend following style is showing an overweight position in

Yen so the position would be USD4m long of Yen.

Each sub-position should not be heavily correlated with any other and

each will have its own independent designation for performance

attribution purposes.The size of the sub-positions will vary according to

what is working well and what is not. This is process known as risk

budgeting and means that more risk can be allocated to the styles that

are working well and less risk can be allocated to the styles that are not

working well.

Note also that the sub-positions could be further sub-divided. For

instance, the USD4m allocated to trend following could be further split

into USD1m for a moving average crossover system, USD1m for a MACD

system, USD1m for a breakout system and USD1m for discretionary

pattern recognition.

The main advantage of using the style diversification method as a way of

integrating technical analysis in to an investment process is that it reduces

risk,especially of opportunity loss.It also optimises returns,it is

transparent and very flexible.

The disadvantage is that it can be administratively cumbersome

depending on how many different styles will be used.

Conclusion

Technical analysis should be an integral part of an investment process, if

only for risk control purposes. There are various methods of integration

but the danger of opportunity loss exists in most. However,stylediversification is probably the best method as it goes a long way to

eliminating the opportunity loss and it is extremely transparent.

Few, if any, have the ability to view their portfolios as a whole and even fewer

are able to optimise capital usage.Traders and investors must move from a

defensive or reactive view of risk in which they measure risk to avoid losses, to

an offensive or proactive posture in which risks are actively managed for a

more efficient use of capital.

Turtle Trader

Continued from page 10

Candlestick Reversals

Defining Doji. How large can the body of a bar be before it goes

from a Doji to a Spinning Top? The book referenced above says the

body can be up to 3% of the entire range of the price-bar?

The 3% rule is most l ikely derived from a computerised study of these

sorts of patterns in a wide range of different markets where the

computer plays around with different percentages and finds the most

optimal. But there are so many different markets and so many different

time frames that can be applied to each market, that this sort of figure is

too much of a generalisation, admirable though its intent may be.

Hard work is the only answer to this conundrum; knowing your market

and your time frame, combined with knowing your risk profile. The

market is a bunch of individuals acting as a whole. No one person has all

the answers. To be a successful trader or analyst you need to work out

what works best for your market and time frame and this is a long hard

slog. There is no other way.

But if it came down to whats the difference between a Doji and

Spinning TopI would say theres not too much to choose between them

if the next day confirms. Whats in a name?!

Defining Long Candles. How long must it be? The books tend to

suggest that long candle should be at least 130% of the average

body size of the prior 10 trading sessions

Again I wouldnt put a figure on it but prefer to think of it this way: If

the prior 10 sessions had seen the market posting a range of 100 points,

all with red/filled candles, then the market posts a Hammer with a 100

point lower shadow, then the market has actually moved over 200

points that day. The first 100 points were much the same as the

previous sessions, but the second 100 points, i.e. the subsequent intra-

day rally, was quite different to anything seen previously. This is the key

to this pattern.

As you may have gathered Im not a huge fan of quantifying patterns

with percentages that need to be stuck to rigidly. I prefer to look at

candlestick analysis as a strong guide to market psychology rather than a

set of rules that must be rigidly applied to in order to present clear cuttrading signals. Use the candles to light your way in coming to trading

decisions, not to give you outright signals.

Clive Lambert writes a subscription daily technical analysis service on

European and US Financial Futures Markets. [email protected]

Vs USD Fundament al s Cost of Carry Cont rary O pi ni on Trend Foll owing

20% 20% 20% 40%

EUR Underweight Overweight Underweight Overweight

JPY Underweight Underweight Neutral Overweight


14/16


ABSTRACT.The article introduces an almost unknown Japanese trend

technique, Heikin-ashi, which is based on modified open-high-low-close

values and is displayed using candlesticks. It is a visual instrument which

assesses the current trend and its strength. The Heikin-ashi technique,

also known as modified candles, takes the noise out from the price and

displays a smoother evolution of the stock price or index value. Thistechnique is mainly used as a visual way to assess the trend, but it can

also be quantified with indicators.It can be applied successfully to all

instruments with open-high-low-close values (stocks, options,

commodities, futures). Heikin-ashi charts and related indicators are easy

to generate by most of the technical analysis software packages available

on the market. They can also be produced using common spreadsheet

software available on all personal computers. The article will also discuss

how this technique may apply to UK stock market.

WHAT IS HEIKIN-ASHI? Last summer, while researching for Ichimoku

charts material, I came across a very rare way to look at trends: Heikin-

ashi or modified candlesticks. At that time there was only one English-

language site which displayed charts built using this technique. Now

there are a number of sites and discussion forums which focus on this

form of analysis. However, it is still very difficult to trace its origin due tothe lack of available literature in English. I could only obtain the way the

modified OHLC values are computed from a Japanese trader. From there,

interpretation and quantification as technical indicators came as logical

steps. Lets start with the definitions of modified values and continue

with discussions about use of this technique:

COMPUTATION OF HEIKIN-ASHI VALUES

CASE STUDIES:The best way to understand Heikin-ashi is to apply it to

familiar instruments. For example, lets apply the code to display Heikin-

ashi / modified candlesticks (see box on next page) to the FTSE-100 index:

The periods associated with ascending trends are shown as sequences of

continuous white candles, while descending trends are displayed as black

filled candles. A trend may be strong, weak, or ready to change. A strong

uptrend appears as a sequence of long white candles with no lower

shadows. A strong downtrend is associated with a sequence of long

black candles with no higher shadows. The reduction in size for the

candles during a trend may signal a weakening of the current trend.

Periods of consolidations are associated with Heikin-ashi candles having

small bodies, but longer upper and lower shadows. And finally,possible

trend changes are identified by a candle with a small body having both

high upper- and lower shadow.

The table below summarizes these b asic rules to identify and assess the

strength of any trend using the Heikin-ashi technique:

Taking into account the findings in the previous table and looking at the

second subchart,we can see some obvious trends.

The main advantage of Heikin-ashi technique is that the modified OHLC

values are displayed as Japanese candlesticks. Th

Market Technician No 49

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Transcript of Market Technician No 49