Discussion 14 : Trade on the Gambling Table!

Great day ahead!

Due to recent feedbacks that I've gotten from my readers who repeatedly question the success of technical trading, I consider myself to have an obligation to share this discussion with all my readers.

Before we begin, I apologize if I ever hinted a guaranteed success trading with Technical Analysis (TA). TA, in no way, guarantees absolute profitability to its practitioners. TA's role is merely to enhance the probabilities of you guessing the right market direction.

Therefore, TA alone, is not sufficient in making you a successful trader.


THEN WHAT MAKES A SUCCESSFUL TRADER?
When I ask most average traders whether they realise that there are risks in trading, all of them would say "YES". But when the stock price fell, they hold onto their stocks, hoping that the prices would go up. From a trader, they suddenly became an investor! Obviously, they understand only the English Language of 'risk', but not the Financial Literacy of 'risk'.

The key to making yourself a successful technical trader is not so much on the extent of the Technical Analysis that you practise or what Technical Indicators you use, but very much dependent on the way you manage your risks with each trades, and the discipline to follow through your strategy, enduring losses as they happen!


MAKING A SENSIBLE TRADE
You give a million dollars of cash to an average gambler, and you see your money got wiped out in a few hours.

A professional gambler, on the other hand, is able to make a lot of money on the casino table, with just very little initial capital.

Being a trader is akin to being a gambler. Being an ignorant trader is equivalent of being an ignorant gambler who will get wiped out, regardless of how much money he brought along into the casino. A professional trader, would be able to make a fortune with very little initial capital.

A professional gambler makes money on the table due to a few factors:

1. The probabilities of winning is higher than the probabilities of losing.
2. The rewards of winning is higher than the costs of losing.
3. The risks of his gambling capital to be wiped out after a streak of consecutive losses are low.

THE USE OF TECHNICAL ANALYSIS
Professional gamblers are masters of probabilities. They are aware of their odds of winning and losing and are able to brilliantly keep up with their odds on the trading table after each cards are dealt from the deck. When the odds of winning is with the gambler, he may either raise or call, but when things turn bad, he would know when to fold the hand, taking the loss of the initial 'table money'.

Same goes to trading. As a trade turns bad, traders cut their losses (fold). When the trade goes in their favour, they may consider buying/shorting more (raise), or wait and let the profits run (call). TA is an indicator of probabilites that would help a trader to keep track of their odds in the environment of the market (trading table) after each trading period (cards dealt from deck).

Since TA enhances the probability of winning, it is undeniably a good component to include in devising your trading strategy. You need not win each and every of your trades, but if you are able to minimize your losses (cut losses) and letting your profits run when it happens, and the probability of you making profits is higher than the probability of you making losses, you are doing fine.

Think. Why gamble when the odds are not with you (going against the trend)? Will you even consider gambling when you are unaware of your odds of winning (trade without TA)?


RISK AND REWARD RATIO (RRR)
If I were to buy a stock at RM1.00, and am prepared to cut loss at RM0.80, with a profit target in mind of RM1.60, it can be translated (in terms of gambling) to "I am putting RM0.20 as a 'bet' for a winning reward of RM0.60". In other words, my RRR is RM0.20 : RM0.60, which is 1 : 3.

If I were to buy a stock at RM1.00, and am prepared to cut loss at RM0.80, with RM1.10 in mind as profit target, my RRR is RM0.20 : RM0.10, which is 1 : 0.5.

Which of the two trades above is a more sensible one? I believe the first one would be. It does not make sense if you traded for an expected gain of half the amount of the money you wagered on the 'bet'. No professional gamblers would gamble on such terms, unless the odds of winning is significantly higher than the odds of losing.

I always avoid involvements in trades that have RRRs that are lower than 1 : 2. To most traders, the RRR would have to be at least 1 : 3 before they find that the trade is sensible. Some traders might even accept a trading RRR of as low as 1 : 1.5! Determination of which RRRs are acceptable to you generally depends on how good and reliable the odds of winning are in your trading strategy.


RISK OF RUIN
The Risk of Ruin is a term that is often used in gambling. It is the risk of you losing a substantial amount of capital due to a streak of successive losses to render it unwise or unprofitable to continue gambling.

Since professional gambling is a business of odds, there are times when a gambler would experience a streak of consecutive losses. No matter how good a trading strategy is, as long as it is subjected to odds, he would not make money if he loses all of his capital before his streak of consecutive losses ends.

All traders face this problem. In the game of probabilities, you may lose all your earned money in a blink due to a streak of successive losses. That is why risk management is so crucial if you intend to be a successful technical trader. This problem is more apparent during the initial stages when traders just started off their trading careers. This is due to them having small portfolios and their inexperience in trading that make them more susceptible to successive losses that wipe them out before even making a penny of profit.


EXAMPLE OF RISK OF RUIN
Adapting an illustration from The Edge, I would use the FKLI contracts as an example. You opened an account with RM7,700, keeping in mind that margin required for FKLI is RM2,700, so your risk capital would be RM5,000 (RM7,700 - RM2,700). Assume that you trade 1 contract and stopping out after 2 points of losses (which is RM125, including commissions).

This way, you can afford to lose 40 consecutive trades before raising the white flag (liquidating your account). In the event that things work well, and let's say that you have managed to accumulate RM22,000 in your account, and you are now trading 3 contracts (assuming you raise a contract after every RM7,500), your losses would now be RM375 a trade.

You can then afford to lose 19 consecutive trades before reducing your account balance to RM14,875. This time, you reduce your trading contracts to 2 (RM250). Now, you can afford to make another 30 consecutive losing trades before your account balance reduces to RM7,375. You'll then lower your trading contracts to 1 (RM125) and can afford to lose another 38 consecutive trades before turning your account balance to RM2,625, which you will then declare your account as 'ruined'.

From here, we can see that to be ruined from RM22,000 to RM2,625, requires a consecutive loss of 87 (19 + 30 + 38) trades, giving you ample opportunities to remain in-play. The 'Risk of Ruin' concept is widely practised by Turtle Traders in managing their risks.

You may not be win while you remain in-play, but you lose once you've lost your ability to play.


CONCLUSION
Being a successful trader requires you to

1. Maximize your probabilities of winning;
2. Given the maximized probabilities of winning, make a sensible trade;
3. While making a sensible trade, be aware of the Risk of Ruin; and
4. The Discipline to go through tough times of consecutive losses.

Always remember, it is very often NOT the knowledge that makes you a successful trader, it's the DISCIPLINE and SMART APPLICATION of knowledge that makes you one.


Thank you for reading, and have a profitable week ahead! =)

Discussion 13 : Trend Following With Moving Average Convergence/Divergence (MACD)

Hello and a very good day to you! 

While viewing the charts that I have included in my previous Discussions, you guys might have seen some Momentum Indicators (MI) and Momentum Oscillators (MO) being plotted to enhance the reliability of signals generated. These Western technical tools are generally used to gauge the force behind a price trend or movement, and very often, are used to generate entry and exit signals for technical traders.

MOs, such as Stochastic and RSI, are leading indicators of a price movement. Oscillators would make use of two lines to gauge an overbought and oversold region. It is generally understood that one should sell when the price is in the overbought region, and buy when it is in the oversold region.

MIs, such as Moving Averages (MAs) and MACD, are lagging indicators. They will urge you to chase the boats that you have missed! Despite the fact that MIs often give signals late, causing you a late entry to an already established trend, it is many times more reliable than MOs, which are renowned for their high frequencies of emiting False Signals.


INTRODUCTION
Moving Average Convergence/Divergence (MACD) is a Momentum Indicator created by Gerald Apple in the late 1970s, and futher improved by Thomas Aspray in 1986. MACD, pronounced as "mack-dee" by technicians around the world, appears in chartists' toolbox as a deadly trend following indicator. It generates entry and exit signals for long term trend tradings, and is also often used to enhance reliability of signals generated by Candlestick Patterns.


SETUP OF MACD
MACD indicator is generally comprised of 3 components:

1. MACD Line - 12 days EMA of stock price minus 26 days EMA of stock price.
2. Signal Line - 9 days EMA of MACD Line.
3. MACD Histogram - Difference between MACD Line and Signal Line.

Note that in MACD, EMAs are used in favour of SMAs. Exponential Moving Averages (EMA) put a higher weighting on the more recent stock price against the older ones. This is essential due to the principle that the latest stock prices would logically 'spearhead' the upcoming/existing trend.


ZERO LINE CROSSOVERS
Principles:
Buy Signal - When MACD Line crosses over Zero Line from the bottom.
Sell Signal - When MACD Line crosses over Zero Line from the top.

The zero line acts as a 'realm divider' between an uptrend and a downtrend. According to the MACD, an uptrend is confirmed when the MACD Line crosses above the Zero line (positive region), and a downtrend is confirmed when the MACD Line drops below the Zero line (negative region). Illustration (i) shows FBMKLCI daily chart of year 2008 and year 2009, with the Zero Line and MACD Line clearly separating the two trends.

Illustration (i) : FBMKLCI - MACD & Identification of Trend

MACD Line takes the difference between a faster EMA (12 days) and a slower EMA (26 days). As the differences increase, the MACD Line will sway further away from the Zero Line, be it in positive or negative regions. As the differences decrease (happens when stock prices consolidate), the MACD Line moves closer to Zero Line. A crossover happens when there is a change in polarity from negative region to positive region, and vice versa (happens when consolidation is over, i.e. consolidation breakout!). See illustration (ii).

Illustration (ii) : FBMKLCI - MACD & Consolidation Breakout Play

However, caution should be taken while implementing this strategy. A Zero Line Crossover could happen in an instant due to a sudden change of price momentum from upwards to downwards, or vice versa. In that case, the crossover is no longer due to a consolidation breakout, and chasing such trend could be dangerous, as the trend might have already been exhausted by the time it crosses the Zero Line.


MACD CROSSOVERS (SINGLE LINE CROSSOVERS)
Principles:
Buy Signal - When MACD Line crosses over Signal Line from the bottom (Bullish MACD Crossover).
Sell Signal - When MACD Line crosses over Signal Line from the top (Bearish MACD Crossover).

Signal Line is the 9 day EMA of the MACD Line. This acts to 'smoothen' and 'average out' the MACD Line. As the MACD Line crosses over the Signal Line, it means a change in momentum is under way. Buy and sell decisions based on MACD Crossovers should therefore be more profitable, compared to Zero Line Crossovers, as MACD Crossovers give an indication of a change in momentum, which is a necessary build-up to a change of polarity.

Illustration (iii) shows how KFC fares using the MACD Crossover strategy.

Illustration (iii) : KFC - MACD Crossovers

Traders should be careful when practising this approach as it tends to give quite a number of False Signals, particularly when MACD Line and Signal Line braid themselves during short term consolidations. Traders should make use of other predictive indicators such as Candlestick Patterns, as they could give an early psychological indication of a potential momentum outbreak.


MACD HISTOGRAM
The improvement made by Thomas Aspray on the MACD system is the introduction of MACD Histogram. MACD Histogram measures the difference between the MACD Line and Signal Line and present them in the form of histogram.

Principle:
Buy Signal - MACD Histogram reduces in length and formed below the Zero Line.
Sell Signal - MACD Histogram reduces in length and formed above the Zero Line.

When MACD Crossovers give a buying or selling signal, they are very often a late entry and exit signal. This is due to the lagging nature of Moving Averages (which is the heart of MACD system). Thomas Aspray then came up with an idea that entries and exits should not be based on MACD Crossovers, but should be triggered when the differences between MACD Line and Signal Line reduce. That is the earliest possible entry and exit points that would yield maximum profits.

Compare illustration (iv) with illustration (iii). Both charts represent KFC in the same exact situation. See the differences in profits if MACD Histogram is heeded ahead of MACD Crossover!

Illustration (iv) : MACD Histogram



MACD DIVERGENCE
This is by far the most powerful signal that any MI or MO can give. A divergence means that the price actions (price movements) are inconsistent with signals generated from the MI or MO. Divergences occur in MACD as well.

The general rule for divergences in any MI or MO is, the price action would ultimately follow the direction signalled by the MI or MO.

Study OSK's daily chart in illustration (v) and see for yourself!

Illustration (v) : OSK - MACD Divergence

CONCLUSION
MACD is a useful indicator for intermediate term swing traders and position traders, as trend following is the core concept of this system.

Shorter term traders such as day traders and short term swing traders may make use of this indicator to confirm the direction of the prevalent trend, on multiple time-frame charts. Scalpers may want to scalp only in a long position on 5-minute chart if the MACD on hourly chart shows upwards momentum. The risk of losing is then highly minimized.

There are many further information and knowledge that revolves around this topic, which I couldn't finish discussing even with another 10 similar articles! MACD is a system that looks simple, but contains highly sophisticated trading disciplines that could greatly enhance trading precision and winning probabilities, particularly for a long term position trader.

The best way to learn a technique is to learn it from its creator. I highly recommend these 2 books for my readers who are interested in perfecting this technique. One of them is written by Gerald Appel in 1985, entitled "The Moving Average Convergence - Divergence Trading Method (Advanced Version)". Another would be "Understanding MACD", a book he co-authored with Edward Dobson in 2008. These 2 books, together with other MACD materials, are now available at TLSBookstore.com.

So, ride the trend for the week ahead with MACD! I'll see you again next week~! = )


The Moving Average Convergence-Divergence Trading Method (Advanced Version)

Discussion 12 : Head and Shoulders

Greetings! Made any profits last week? = )


INTRODUCTION
Head and Shoulders (H&S) is a chart pattern which is extremely reliable in identifying an end of an uptrend and gives birth to a new downtrend, and is very commonly seen on daily charts, as well as intra-day charts. The silhouette of H&S pattern resembles a human with one head and two shoulders.

The reverse of this chart pattern is known as Inverted Head and Shoulder Pattern (IH&S), which I regard as rather rare in KLSE, and is comparatively less reliable than H&S. IH&S is a bullish reversal chart pattern which is seen at the bottom of a downtrend.

The heart of Discussion 12 is H&S, which is a bearish reversal chart pattern.

CHART PATTERN OF HEAD AND SHOULDERS
H&S is basically identified by its pattern of having three consecutive tops, with the middle top higher than the tops on the left and right side. A neckline is drawn from the low of the retracement of the left top, to the low of the retracement of the middle top, projecting it further to gauge the retracement low of the right top. Refer illustration (i).

Illustration (i) : KNM - H&S and Neckline

BREAKING THE NECKLINE
The H&S pattern is complete when the price breaks the neckline on the right. Then, the stock price would have effectively fallen out of the prevalent trend. If the neckline at the right shoulder is not broken, then there is a possibility of it being a false signal. The high of the right shoulder should not be broken if the signal is to remain valid. After breaking the neckline, the neckline support now turns into neckline resistance. Refer illustration (ii).

Illustration (ii) : KNM - Breaking the Neckline

PREDICTIVE NATURE OF HEAD AND SHOULDERS PATTERN
The distance between the head and neckline would be taken as a guideline to gauge how far will the price drop after breaking the neckline. There is a rather complicated rationale behind this technique, which I would not explain further as at now. Having said so, I find that the gauge is rather accurate when practised in KLSE. Refer illustration (iii).

Illustration (iii) : KNM - Predictive Nature of H&S

THE ROLE OF VOLUME IN HEAD AND SHOULDERS PATTERN
Ideally, we would want to see higher volume on the build-up of the left shoulder (preferably a volume blowoff at the left shoulder top) compared to the build-up of the head. This means there are declining interests in the build-up towards the top of the head. The descent from the top of the right shoulder that breaks the neckline should be accompanied by increasing volume. Refer illustration (iv).

Illustration (iv) : KNM - Volume in H&S

OTHER CONFIRMATIONS
It is crucial that any TA techniques not to be used in isolation. Traders/technicians must seek confirmation(s) or convergence(s)/divergence(s) of other technical indicators to further enhance the signal emitted by any one indicator.

In explaining the the above theories, I have made use of KNM as an illustrative example. Keep in mind that you might have already seen this chart in Discussion 11 (Part 1) : Playing the Gap (Basic Hand). Aside from Gap Analysis and H&S Pattern, many other indicators can be used to further confirm this signal. For instance, Volume Analysis (as detailed above), Stochastic Divergence, and Moving Average. Refer illustration (v).

Illustration (v) : KNM - Stochastic Divergence / Moving Average Convergence

ANOTHER EXAMPLE
Please see the below chart for another illustration of H&S Pattern in WCT (illustration (vi)).

Illustration (vi) : WCT - Head and Shoulders Pattern

CONCLUSION
With the recent KLCI moving upwards after a few successive declines, it is imperative to deduce that the index is currently in a downward momentum. With this upward movement seen as a temporary pullback (in my opinion), I would be expecting to see more downward movements in the near future, and I mean real near future. >.<

I hope that by sharing this bearish reversal chart pattern would help serve my readers to as an early indication of any possible trend reversals that might unfold. Capital preservation is number one priority in stock trading. Therefore, remember,

"Cut your losses short, let your profits run!"

Happy trading for the coming week ahead~!   = )

Robert Kiyosaki's Talk on Financial IQ

Dear Readers,


Robert Kiyosaki is one of the investment gurus that I have always looked up to. I have learned a great deal of Personal Finance from his talks and best-selling books, "Rich Dad, Poor Dad" series. Up to today, I am still re-reading his books as if it is my 'Financial Bible'! = ) His knowledge would undeniably pave marble steps on the stairs to Financial Independence.

I came across this clip while surfing in Youtube and felt a sudden urge to share it with you. It was one of his talks on Financial IQ, in which he very quickly review the definition of assets and liabilities, and a brief discussion on the Cashflow Quadrant.

Ladies and gentlemen, I present to you, Mr Robert Kiyosaki!!

Discussion 11 (Part 2) : Playing the Gap (Professional Hand)

Hello there~!

KLCI took a beating last week as a result of most stock prices succumbed to series of bad news. We have seen China reporting its largest traded deficit in 7 years in February, crude oil price continuing its ascent due to growing unrest in Libya, contraction in Japan's 4Q2010 GDP, Moody's downgrade of Spain's government bonds rating, and also not forgetting the unfortunate natural calamity that hit Japan last Friday.

While all these adversely affect regional stock market, we as distinguished traders/investors know well that stock prices are now retreating to possible lows. For those who have lost a fortune last week, reflect on your losses, then wipe your tears right now! Opportunities tend to show itself during unexpectedly bad situations! Remember,

"From the ashes of defeat, burns the fire to success!"


INTRODUCTION

In Part 1, we have discussed on the basic strategies that most traders practise, which could be summarized as follows:

1. "Go (trade) in the direction of Window" (Window as Continuation Pattern)
2. Empty vacuum as Support & Resistance, confirmed by volume (Gap Breakout Play)

Western Technical Analysts enhanced the use of Windows (Gap, in Western term) by further classifying Gaps into four categories - Common, Breakaway, Runaway, and Exhaustion.


COMMON GAP (CG)
As the name suggests, CGs are commonly seen on charts. They often appear on shorter time frame charts, such as 1 and 5 minute charts, but may also appear on daily charts in numerous occassions. CG happened due to short temporary differences in pricing psychology, which don't really play a significant influence on the price trend.

Therefore, CGs usually appear together with low volume confirmation, and the vacuum area would be relatively smaller compared to other types of Gaps. Traders will expect that CGs would be filled rather quickly, perhaps within a few minutes (intra-day chart) or days (daily chart), before continuing the prevalent trend.


BREAKAWAY GAP (BG)
BG usually appears in two situations where:

1. A prevalent trend has been established, and the stock price has been moving along the trend, and hesitated at the top or the bottom.
2. The prevalent trend has ended, and the stock price has moved into a consolidation in a box range.

BG usually gives birth to a new trend. The term "Break-away" here means the trend has broken, and is now moving away from the prevalent trend. Usually BG will come together with high volume and has a significantly huge empty vacuum in between.

Traders will generally wait for the break to extend for a moment and will expect the stock price to make a retracement back to the Gap Support or Resistance. Only then, they will buy, or short stocks accordingly.

In KLSE, the probability of a downtrend BG to make a pull back to its resistance is a lot lower compared to an uptrend BG. This is because this retracement happens due to profit takings. As KLSE discourages shorting of stocks (policy wise), and if a downtrend BG were to occur, those caught in the wrong position will frantically sell to cut loss. This action will further increase the already strong downward force! Dumb Money (DM), in this sense, will start cannibalizing among themselves. >.<


RUNAWAY GAP (RG)
RG appears in the middle of an trend. Sometimes RG is called a Continuation Gap, which literally means a continuation of prevalent trend. A RG normally comes together with a huge volume and an empty vacuum usually smaller than BG, but bigger than a CG.

RG occurs due to renewed interests in the stock. This may happen following a reported increase/decrease in corporate earnings during a price uptrend/downtrend. Investors' confidence are greatly enhanced/reduced by this, causing the eventual Gap Up/Down.


EXHAUSTION GAP (EG)
EG usually shows itself at the end of the prevalent trend. EG comes with a small volume, and has a huge empty vacuum. The term "Exhaustion" here means that the prevalent trend is over-extended, and is currently exhausted. The trend has come to an end.

Having said so, traders should expect to see a sharp trend reversal after the new high/low is hit.


PUTTING IT ALL TOGETHER
Let's study AFFIN's chart between late October 2009 to mid April 2010.



Illustration (i) : Playing the Gap - AFFIN


At A, a Common Gap is seen, which has a small empty vacuum in between accompanied by low volume. It has an insignificant effect on the trend, and was therefore instinctively filled on the next day.

At B, we could see a Runaway Gap. Although the empty vacuum is small, the gap is formed after an uptrend is established. In addition to that, the volume that come together with the gap is not massive enough to be considered as a Breakaway Gap.

After two days, an Exhaustion Gap is seen at C. This is evidenced by a significantly massive volume, pushing the stock price up to a ridiculous high, causing the trend to over-extend. A very useful indicator to use while detecting overextended trends is the Bollinger Band. You can see that the White Candle at C is trading outside the Upper Bollinger Band, which is a very strong evidence that the trend had over-extended, which you would then expect a trend reversal to follow.

Soon, the price kissed the Gap Support twice, and then made a bounce to test the prior resistance made by the high at C. Failing to break through the resistance up north (as expected), the price then made its way south to break the Gap Support.

The supposedly downward trending technical outlook took a complete turn when the candles made a Breakaway Gap at D. This is a Breakaway Gap due to the high volume which accompanied the Gap Up. With the Gap unlikely to fill itself, the price went all the way up from mid December 2009 to mid April 2010, when the price again over-extended itself when it formed a White Candle outside of the Upper Bollinger Band.

Assuming that you took a long position after the Breakaway Gap on 14/12, and closed your position just after the confirmation on 12/04, you would have made a 31.3% profit in just a little under 4 months, which is already well above the average performance of most, if not all, mutual funds in Malaysia. All these profits could have been yours, if you have been competently playing well with the Gap. ^_^

CONCLUSION
The Window classifications made by Western traders are very useful indication of whether the Gap will fill itself or otherwise in near future, thereby allowing traders to position themselves for better entries. Below table shows a summary of the four Gaps.


Illustration (ii) : Summary - Type of Gaps


There is saying like this among Western Traders, "Gaps will be filled". Basing on this belief, many traders go against the Gap, hoping the Gap will be filled. Well, I have no idea how true this saying is. But as far as I'm concerned, I play the Gaps professionally, according to the strategies I've detailed above. I may not win all the time, but the probability of winning is greatly enhanced, and that's what Technical Analysis all about. :D


tlsinvestor.blogspot.com prays for the unfortunate victims of recent earthquake and tsunami in Japan. I urge all readers to join us for a moment of silence right now... May the streak of calamities end soon...

Discussion 11 (Part 1) : Playing the Gap (Basic Hand)

Coming from an accountancy background, it is only natural that most of my friends come from that field as well. However, being accountants and auditors don't necessarily mean that we possess above average financial knowledge. I had this conversation with my friend, who has read Discussion 9, and asked me this,

"How could Gaps happen? Isn't the opening balance of the next day equal to the closing of previous day?"

My response to her was,
"We are not preparing accounts!"

A few days later, another friend of mine asked me the same question after reading Discussion 9, and again, I told her the same thing. After hearing that, she exclaimed that investing is risky. Stock trading is risky. You could lose hundreds or thousands in just a morning due to a Gap. She then went on to close her mind on the subject matter.

I did not respond further. Sometimes, I feel that if I were to gather a group of 10 accountants or auditors, I will get 9 paradoxically formed animals. Like an eagle, they proudly perform risk assessments and majestically criticize others' risk management policies, but they immediately turned into a scaredy-cat when they assess and manage their own financial risks!

In fact, I very much agree with my friend on the risks that are present due to a Gap movement. However, rather than turning away from the stock market, I seek a way to bend that risk into a weapon of financial wealth! Let me now share with you some fundamental knowledge on how to play the Gap in our favour.


CONVERGING EASTERN AND WESTERN TERMINOLOGIES
In Japanese terminology, a Western "Gap" is called a "Window". In my Discussions, I will use Gaps and Windows interchangeably, as they essentially mean the same thing.

A Western "Gap Up", is a Japanese "Rising Window", while a Western "Gap Down", is a Japanese "Falling Window".


IDENTIFYING WINDOWS


Illustration (i) : Window

Windows are identified as an empty vacuum between two candlesticks. In other words, it means, there must be a 'gap' between the first candle's high/low and second candle's low/high.

Know that the key here is the candles' high and low, not the real body. If the shadows of the candles exist in the empty space, then there is no empty vacuum, and therefore, no Window. See illustration (i).


WINDOW AS A CONTINUATION PATTERN



Illustration (ii) : Rising & Falling Window

Most of the time, we see a Window as a continuation of the prevalent trend. As the Japanese saying goes, "Go in the direction of the Window". This is the very basic that you must have in mind when playing a gap.

If a Rising Window is formed in an uptrend, then traders/investors may seek to buy when the price takes a retracement. If a Falling Window is formed in a downtrend, then you may seek to sell when a rebound occurs. Refer illustration (ii).


WINDOW AS SUPPORT & RESISTANCE



Illustration (iii) : Support & Resistance Area

Japanese says, "Corrections stop at the Window". Windows act as a support or resistance of price movements.

In a Rising Window, the area between the low of the second candle and the high of the first candle would act as a support area, with the high of the first candle being he last line of support.

In a Falling Window, the area between the high of the second candle and the low of the first candle would act as a resistance area, with the low of the second candle being the last line of resistance.

The volume on the gapping day would serve to tell the strength of the resistance or support. Higher volume means stronger resistance or support, and vice versa.



Illustration (iv) : Gap Breakout Play

Traders may time for a breakout play this way. A breakout is usually confirmed by a close above the resistance or below a support. Merely having a shadow peeking above a resistance or below a support doesn't confirm that the resistance or support is broken. The general rule is to enter into the play after a breakout is confirmed, as seen in illustration (iv).

However, a handful of competent traders trade on breakout strategies during the formation of the candle itself. If there is a high volume during the intra-day, and the trader is confident that the price would close above the resistance or below the support, he may make an early entry to maximize profits.


PUTTING IT ALL TOGETHER
Let's study KNM. Refer Illustration (v).



Illustration (v) : Gap Analysis - KNM

Three Rising Windows (RW) are seen in KNM daily chart. Notice that in all three RW days, the volume is considerably enormous compared to others. This shows the strength of the support areas, as well as the strength of the trend.

An ideal entry would be after the retracement following the first RW on 06/12, when the price closes on the support of MA50d. Coincidently, that was the time when MA50d crosses over MA100d, giving a bullish signal as well. The stock price then rallied to make another two RW.

After the third RW, the stock retraced to test the support area of RM2.80 - RM 2.81, before making another higher low. A stop loss should be adjusted to just below the higher low, at approximately RM3.00. The reason for this is that in an uptrend, the stock price should make a higher high and a higher low. The trend was then broken on 21/01 when it is unable to make another higher low.

After tested the third RW's support area for a number of times, the support was finally broken on 23/02. The Bullish Counterattack Pattern wasn't good enough to sustain the support area, due to poor volume. On 24/02, the stock price plummetted down to the next support area formed on the previous RW, at RM2.34 - RM2.37.

On 03/03, a Bullish Hammer was formed at support area. Together with the black candle on 02/03, these two candles complete the Bullish Harami Pattern.

A RW was seen the next day on 04/03, with its lower shadow resting on its support of MA100d, accompanied by healthy volume. All these lead to a bullish signal, with the immediate resistance area of RM2.80 - RM2.81 (support turned resistance). This bullish attempt is confirmed to be a failure when the price closes below RM2.29 (the low of previous Bullish Hammer).


This concludes the first instalment of Playing the Gap. It is reminded that trading at the gap is arguably a risky strategy to trade. However, competent traders usually make use of more advanced strategies to ensure that their 'bet' at the gap has a higher winning probability. This, I will address in Discussion 11 (Part 2) : Playing the Gap (Professional Hand).

Happy trading on the fruitful week ahead!


[Disclaimer: The only reason I made use of KNM in this Discussion as my example is that it illustrates Gap Analysis closer to current date. It certainly does not constitute to a suggestion or recommendation to buy or sell KNM shares. >.<]

Discussion 10: Volume Sparks Interests

As most of us know, technical traders do not rely solely on Candlestick Patterns. Usually, there are more than candlesticks that are plotted on the charts. In my previous Discussions, I have repeatedly stressed the importance of Volume in confirming Candlestick Patterns.

Volume is the number of transactions that took place during the day. It should not be confused with Open Interests (which applies only to futures and options). A transaction involves a buyer and a seller. One buy and one sell, in this sense, constitutes to one volume.

So, why is volume so important? Volume shows the amount of interests in a certain movement. In other words, increases in volume means traders/investors are agreeing to the stock price, and therefore, they are more interested to transact at that price. Interests start to decline when traders/investors think the stock price is no longer attractive. At that time, volume starts to decrease.


VOLUME AND PRICE TREND

Volume Divergence

In a price uptrend, if the Volume does not increase with the Price (we say Price Action is inconsistent with Volume, or sometimes, Volume Divergence), then most likely the movement lacks interests from the traders/investors. In this sense, as smart traders, we will begin to tighten our stop losses, and take partial or all profits.

This is also true during a price decline. Theoretically, if Volume does not increase during a price drop, then the drop are lacking interests from the traders/investors, and very likely, a reversal would be taking place soon. However, due to fear prevails over greed, prices fall of its own weight! Established traders/investors would therefore pay more attention to volume decline at the top, and volume increase at the bottom, of a prevalent trend.

The table below shows different convergence and divergence combinations of Volume and Price:

Price	Volume	Remarks
Increase	Increase	Trending, with Conviction
Increase	Decrease	Trending, but losing Momentum
Decrease	Increase	Trending, with Conviction
Decrease	Decrease	Trending, but losing Momentum



Illustration (i) : TCHONG - Volume Divergence


Volume Behaviour in Trending Market
In an uptrend, prices tend to move up and then retraces to its support before making another leg of ascent. The reverse is true for a downtrend. Volume tends to make a hike when the price is trending, and then reduced when the prices consolidated or retraced to its support/resistance, and then makes another hike when the price continues its trend. A trend is usually broken when volume made consecutive highs in a retracement, and the price unable to make another higher low.

Illustration (ii) : KNM - Trend Broken

In illustration (ii), KNM was in an uptrend since end of November 2010. We can see that with each retracement, volume decreases. Volume then increased when the price trend resumed upwards.

In an uptrend, the tendency is to have the price making a higher high and higher low. Therefore, on 11/01, the new low created at RM3.01 was a support that KNM was expected to rebound off, if the uptrend were to continue. Unfortunately, on 21/01, the support was broken on a Gap Down, coupled with successive higher volume. Unable to make another higher low, the uptrend is confirmed to have been broken.

The price then hovered within the box, with the previous support of RM2.80 (created by the previous retracement low) and resistance of RM3.01 (support turned resistance). Both support and resistance were tested on numerous occasions, before the support was broken on 23/02. The drop on 24/02 in high volume was halted by the prior support of RM2.37 (created in previous Gap Up).

Taking a step back, you could already have seen this coming way back on 23/12. Since then, the volume has been making consecutive lower highs, while prices making higher highs. This constituted to a Volume Divergence, which signals the end of the uptrend is imminent, before it took place on 21/01 (approximately a month before it happened!)


VOLUME AND CANDLESTICK PATTERNS

Candlestick Patterns can be a Reversal, or Continuation Pattern. Volume plays an important role in further strengthening the signals derived from Candlestick Patterns. In seeking a volume confirmation, we always expect to see a convergence of Price Action and Volume.

For Candlestick Reversal Patterns, Volume on the candle itself or the next few candles is crucial to confirm the strength of the signal. We tend to look for high volumes in Candlestick Patterns as a strong signal confirmation. Subsequent price movements will most likely follow the direction of what traders/investors are more interested in. If the reversal candles receive more interest than the prior candles (high volume), then most likely, the bullish or bearish reversal signals generated are genuine ones.

Illustration (iii) : WCT - High Volume Confirmation

For Candlestick Continuation Patterns, Volume is almost associated with breakouts. Upon breakouts, high volume would confirm the success of the signal, with very little chances of the price falling back to the support/resistance.

[Note: We will discuss more on Candlestick Continuation Patterns in future Discussions]


VOLUME AND SUPPORT & RESISTANCE

As the price approaches support and resistance, most trader/investors will buy, or sell the stocks accordingly. While prices tend to range within the support and resistance, there are instances where such supports and resistances are broken, and the price then goes on a rally or dip. Volume acts as a useful indicator to hint such potential breakouts.

Due to the fact that support and resistance are hard to break, it is understandable that in order to break them, huge convictions must be in place. When a lot of traders/investors are interested in a price surge or dip, the probabilities of such support and resistance of being broken are greatly enhanced.

Illustration (iv) : WCT - High Volume Resistance Breakout

VOLUME AS CRYSTAL BALL

Volume, being magical as it is, may bring early signals of an imminent huge movement. This is particularly important when it happens on the intra-day chart. When traders/investors see a sudden volume spike in the charts (be it intra-day or daily chart), and there are no significant Price Actions on that candle, then traders/investors must be prepared for a potential big movement. It could mean that someone could be accumulating at that point of time, knowing that the price may surge or decline soon.

As the saying goes, "Volume Precedes Price".

Illustration (v) : FKLI 5-minute - 23/02

Illustration (vi) : FKLI 5-minute - 24/02

Illustration (v) and (vi) shows FKLI futures 5-minute intraday chart. The futures index made a sideway move. A significant spike in volume occurred but there were no significant Price Actions (candlesticks showed a doji). This gave a signal that the sideway trend was about to be broken and a huge movement is following up soon. True enough, FKLI futures made a breakout in the next few candles. This indication showed us a signal minutes before the breakout happened.


VOLUME BLOWOFF!

In a trending market, a sudden spike of volume may not necessarily signal trend continuation. Most of the time, when the volume spikes to an extreme high, accompanied by significant Price Actions, it may signal the end of the trend. Let me show you an example. Study the illustration below.

Illustration (vii) : OSK - Volume Blowoff

OSK made a sudden high on 06/01 with and unexpected surge of volume. Following that, the price went on a downtrend. This is due to the fact that during the extreme volume hike, those who wanted to buy the stock have already done so, now leaving only the sellers. Therefore, with supply more than demand, the price fell off its balance and made its way south.


In addition to candlesticks, traders/investors must also utilize Volume to assess the reliability of signals disseminated from the candlesticks. Volume, on its own, may not tell us much. Candlesticks, on the other hand, lack reliability. Combining volume and candlesticks would complement both tools' weaknesses, and at the same time, forging yourself a strong weapon for your trading success.

Happy Charting for the week ahead! Thank you for patronizing tlsinvestor.blogspot.com!

C.ky Series 4 : Proof of the Pudding is in the Eating

Proof of the pudding is in the eating. This idiom means that something can only be judged when it is tested or by seeing its results. So I am going to share with readers one of the successful fundamental techniques in investing used widely by many well-informed, professional investors.

There are many methodologies one can use to pick stocks. One of the methods that I am using is called the Top-Down Approach.

This method believes that the economic environment and industry performance influence the share price and its return. So, in picking shares, we first analyze the economy, then choose the industry and finally, select the company.

In October 2010, emerging markets were recovering well after the world’s economy was battered by the subprime loan crisis originated from US. As the economies in East Asia were recovering faster, it was a good time to invest in those countries. During this period of time, I had some funds to be invested. I started to analyze which industries will perform better with the economy cycle on the upswing in Malaysia. I narrowed down the industries into a few and one of them was the oil and gas sector.

 

The oil price dropped sharply (from the high of U$145 per barrel to US$30.28) during the economic crisis and investment activities in this sector also slowed down. However, when the economy picks up, the demand of oil and gas will rise and the price of oil will start to rise too. Companies will invest more in oil exploration activities as it’s more profitable to do so as compared to when the oil price was lower. These investments will create multiplier effects and benefit oil and gas related companies that provide support services.

 

There is a number of oil and gas related companies in Malaysia. I did some analysis and finally picked the Dialog Group Bhd, one of the leading specialist technical services providers to the oil, gas and petrochemical industry. I invested in the shares at RM1.20 in October 2010. I hold some shares for long term investment and some shares for short term trading purpose.

 

Why did I pick the Dialog Group Bhd? The main reasons are:

1. It is not a neglected stock (It’s popular with analysts and fund managers). Neglected stocks are good companies that are not in the radar of most investors thus it’s harder for the price to move up.
2. Excellent past management track record. 
3. Good financial results, these include good ROE for the past 3 years (2008: 19.9.3%, 2009: 20.87%, 2010: 24.42%), high Altman’s Z-Score, reasonable gearing (low financial risk) and good liquidity, amongst many other indicators)

So, with economy improving, the rising oil price, increasing investment in the oil and gas industry, and a slew of positive news and contracts awarded, it’s not surprising that Dialog Group Bhd share price increased almost 100% in just four months. I made some handsome realized gain and substantial unrealised profit in the past 4 months. (The price on 18 Feb 2011 was RM2.31)

 

This company is one of my most successful stock picks in recent months based on the Top Down Approach. Though the price has almost doubled, I am still holding some of the stocks as I think there is further upside potential.

 

 

[Disclaimer: This article serves an educational purpose and in no way, constitutes to a recommendation to buy Dialog Group Bhd shares.]

Discussion 9 : Engulf the Trends!

Have you ever heard of this man named Munehisa Homma? Allow me to briefly introduce him to my readers in these opening few paragraphs of this Discussion.

If we study the history of Japanese revolutions, we would definitely come across writings relating to a 100 year which the revolutionists and historians call the "Sengoku Jidai", which literally means, "Age of Country at War". Unifications of over 60 provinces under one power (government) took place during that time (years 1500 - 1600).

After the "Sengoku Jidai", Japan is under the rule of Tokugawa Shogun. The country, at this time, is said to be in the Tokugawa era. With the centralization of feudal systems led by Tokugawa, Japan gained economic stability and had then resulted in growth of the agrarian economy, as well as improving ease of domestic trades. This introduction forms a national marketplace and, by the 17th century, replaced the conventional isolated and local marketplace concept.

As there was no currency standards in place at that time, rice became the de facto medium of exchange. The Dojima Rice Exchange was institutionalized in late 1600s in Osaka. The exchange deals with actual rice until 1710. After 1710, rice coupons were issued by rice warehouses. Since then, rice coupons were used as medium of transactions. Later, rice coupons were raised for crops that weren't even harvested yet! This, somehow, became the first kinds of "futures contracts" in the world!

In 1724, Homma was born to a wealthy family in Sakata, and inherited his family business in 1750. It was during that time that he developed a technique to trade in the local rice exchange, and subsequently amassed a huge fortune enough to trade "rice futures" in the Dojima Rice Exchange in Osaka. Using the same technique, he then moved on to conquer the regional exchange in Edo (now Tokyo). After making 100 consecutive successful trades, he retired and joined the government as a financial consultant. He was then later honoured with the title of 'samurai' before passing on his life in 1803.

The technique Homma used to achieve this huge financial success is none other than the Candlesticks that we use in Technical Analysis (TA) nowadays. Up to approximately 25 years ago, this technique was unknown to the western hemisphere until Steve Nison, the father of Candlesticks, wrote the book "Japanese Candlestick Charting Techniques".



ENGULFING SET
One of the candlestick patterns that I introduced to my readers in Discussion 4 (Part 2) is the Engulfing Set. As we know, the Engulfing Set consists of Bullish Engulfing and Bearish Engulfing. They are illustrated as one candle eclipses or engulfs the previous day's candle in opposite colour. Please see illustration (i).


Illustration (i) : Engulfing Patterns



PSYCHOLOGY
Consider the example below:

Illustration (ii) : Bearish Engulfing - John

John bought a stock at RM0.70. The price then went on an uptrend. On the 4th day, the price opened at RM0.90 and closed at RM0.95. On the 5th day, the stock price opened at RM1.10 (this is what we call a price Gap Up). Then, he sold his house and car and buy more into this stock, thinking that it is bullish. At the end of the day, the stock price closed at RM0.85. This completed the Bearish Engulfing Pattern.







Illustration (iii) : Bullish Engulfing - John

For the next 4 days, the price came tumbling down. On the 9th day, the price opened at RM0.60 and closed at RM0.55. On the 10th day, the price opened at RM0.40 (price Gap Down). John could no longer contain the fear inside him, and he sold off his entire holding at RM0.35 (bid price). He then jumped off the building on the same day at 5pm, after seeing the price closed at RM0.65. This completed the Bullish Engulfing Pattern.

(Note: Gaps are strong bullish or bearish signal, depending on the prevalent trend.)

Notice that in the event above, as the price rode up the trend, buyers were euphoric. The filling of the Gap Up, which subsequently went on to form the second black candle in Bearish Engulfing Pattern, tells us that the S&B Money considered the price was at the top, and that they greedily took profits. Seeing that the price moved so low to fully discount the profits earned on the first day, uncertainties strike investors.

(Note: "Filling of Gap" means the gap is closed by subsequent price movements during the day. For instance, the price closes on Monday at RM1.00 and opens at RM1.20 On Tuesday (Gap Up). During the day, the price then traded lower from RM1.20 back to RM1.00. The Gap is now filled.)

As the stock moved down, other investors started to sell in panic. As the price moved to a ridiculous low, even the most stubborn investors, such as John, began to feel defeated and started to sell in distress. The S&B Money then came back to grab at the low. This was signaled by a ridiculously high buying sentiment, moving the price higher to make up the previous day's losses (Bulling Engulfing Pattern).



ENGULFING - HOW TO USE
They are rather easily recognizable. One candle must eclipses or engulfs the candle of the previous day with an opposite colour.


What is the Trend?
Again, you must identify that the Engulfing Pattern in play is a Bullish or Bearish one. Remember that Bullish Engulfing appears only at the BOTTOM of a downtrend, while Bearish Engulfing appears only at the TOP of an uptrend.


Seek Confirmations
Most of the time, the second candle would have already acted as a signal confirmation. The first candle will most of the time be a single candlestick reversal pattern such as Hammer or Doji, or part of a three candles reversal pattern such as Three Black Crows or Three White Soldiers.

The question here is how strong the confirmation is. I usually look at three things : Volume, Support & Resistance, and Momentum Indicators (MIs).

Volume: Preferably high, but volume may not be high for Bearish Engulfing.
Support & Resistance: Engulfing Pattern should form at or near, Support or Resistance.
MIs: Prices should preferably be trading in overbought or oversold region.

What if the confirmations of the second candle aren't convincing? Wait for another day then!


Illustration (iv) : GAMUDA



Illustration (v) : SALCON



Illustration (vi) : MAYBANK

Illustration (iv) and (v) show recent movements in GAMUDA and SALCON that featured the Bearish Engulfing Pattern.

Illustration (vi) backdates MAYBANK to late May and mid August 2010 which showed a requirement for another day of confirmation due to the lack of strength of second candle.


Ignore Shadows in Recognition



Illustration (vii) : Western Bar vs Japanese Candles

Perhaps one of the most difficult recognition issues of Engulfing patterns is its shadows. Many Western traders recognize Engulfing when the body of the second candle engulfs the high and low of the previous day. This is due to the fact that this candlestick pattern is very similar to the "Outside Reversal Day" pattern in western bar charts that Western traders relied on prior to the introduction of Candlesticks some 25 years ago.

In Japanese Candlestick patterns, the requirement for it to qualify as an Engulfing pattern is the body of the second day engulfs the body of the first day. This makes most trend reversals to be identified quicker and timelier compared to the conventional "Outside Reversal Day" pattern. Study illustration (vii).


Gap Means Strength!


Illustration (viii) : Gap Engulfing

Some books write on Engulfing patterns to involve a Gap Up or Gap Down in price when the day opens. In my opinion, such gaps are essential to measure the reliability of a reversal signal. When a Gap occurs, it shows that the market sentiment is either very bullish or bearish, depending on the prevalent trend. When such gap is filled and then subsequently closed lower/higher than the previous day's close/open, it sends out an even stronger sentiment that trend reversal is now taking place with conviction.

However, this doesn't mean that a Gap is a must! An Engulfing Pattern is formed when the second candle fully eclipses or engulfs the body of the previous candle with opposite body colour. A Gap only strengthens the signal further!

(Note: We will cover more on Gap Analysis in future Discussions.)


Engulfing Support (ES) and Engulfing Resistance (ER)
Engulfing Patterns could give birth to a strong Support or Resistance, depending on the prevalent trend. The general rule is, the longer of the shadow or body (if the Engulfing Pattern doesn't have shadows) of the two candles would be the trend's Support or Resistance.


Illustration (ix) : MAYBANK - Support & Resistance



Illustration (x) : 1 minute FKLI

Illustration (ix) shows ES and ER that occured in MAYBANK that was backdated to late October and Early November of 2010.

Illustration (x) shows the FKLI futures 1 minute intra-day chart which took place this afternoon (11 February 2011).

Although this is commonly seen in the US market, ES and ER don't seem to work very well in KLSE. They are rarely tested and are rather easily broken by price surge. Having said so, traders should nonetheless be aware that Engulfing Patterns are extremely reliable in identifying trend reversals, although they defend their Support and Resistance levels poorly.



A smart trader would always trade when the stock price is trending. Therefore, knowing how to use reversal patterns would further enhance the chances of betting on the right animal. As the legendary trader Jesse Livermore says,

"There is only one side to the market... not the bull side nor the bear side, but the right side!"

My appreciations to my readers for your attentions. May the new Rabbit year leaps your wealth higher in the stock market!

Happy Charting!