yed to achieve
these objectives:
 1. Percent retracement. this approach attempts to capitalize on the natural tendency of a
market to partially retrace prior price swings. generally speaking, one might initiate the
position anytime the market retraces a given percentage of the price swing from the last
relative low or relative high. A reasonable choice for this percentage would be a fi gure in the
35 to 65 percent range. Figure 12.3 illustrates the entry points using this approach, assuming
a 50 percent retracement criterion. Notice two of these retracements are based on rallies
(A–d and C–d, respectively) that are defi ned by the same relative high but diff erent rela-
tive lows. the main advantage of this method is that it is capable of providing superior entry
points. however, it is also subject to a major disadvantage: frequently, the necessary retrace-
ment condition may not be fulfi lled until the trend has carried much further, or possibly even
reversed.
 2. reversal of minor reaction. this approach is based on waiting for a minor reaction to mate-
rialize and then entering on the fi rst signs of a resumption of the major trend. of course,
the precise method would depend on how a reaction and trend resumption were defi ned. the
choices are virtually limitless. For illustration purposes, we will provide one possible set of
defi nitions.
 A “reaction” is identifi ed whenever the reaction count reaches 4. the reaction count is initially
set to 0. in a rising market, the count would be raised to 1 any day in which the high and low were
equal or lower than the corresponding points on the day on which the high of the move was set.
the count would be increased by 1 each day the high and low are equal to or lower than the high
 FIGURE /uni00A012.3 Buy signals on 50 Percent retracements (E-Mini s&P MidCap 400
Continuous Futures)
Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved.
180A CoMPlEtE gUidE to thE FUtUrEs MArKEt
and low of the most recent day on which the count was increased. the count would be reset to 0
anytime the market moved to new highs. Analogous conditions would apply to a declining market.
 the resumption of the major trend would be indicated whenever the thrust count reached 3.
the thrust count would initially be set to 0 and would begin being monitored after a reaction
was defi ned. in the case of a reaction in a rising market, the thrust count would increase by 1
on each upthrust day and would be reset to 0 anytime the reaction low was penetrated. (thrust
days were defi ned in Chapter 9.) once a signal was received, the reaction low could be used as
a stop-loss reference point. For example, the position might be liquidated anytime the market
closed below the reaction low . once again, an analogous set of conditions could be used for
defi ning a resumption of the trend in a declining market.
 Figure 12.4 illustrates the reversal of minor reaction approach using the specifi c defi nitions
just detailed. the points at which reactions are defi ned are denoted by the symbol RD, with the
numbers prior to these points indicating the reaction count values. Buy signals are indicated at
the points at which the thrust count equals 3, with the letters prior to these points indicating
the thrust count values. For any given entry point, stop-loss liquidation would be signaled by a
close below the most recent stop level, which in this case is the lowest relative low between the
identifi cation of the reaction and the completion of the thrust count.
 3. Continuation pattern and trading range breakouts. the use of continuation pat-
terns and trading ranges for entry signals was discussed in Chapter 9 . since to some extent
chart patterns are in the eye of the beholder, this approach will reflect a degree of subjec-
tivity. Figure 12.5 offers one interpretation of continuation patterns (implicit assumption:
 FIGURE /uni00A012.4 reversal of Minor reaction (Australian dollar Continuous Futures)
Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved.

181
MidtrENd ENtry ANd PyrAMidiNg
at least five trading days are required to form a continuation pattern), and the correspond-
ing sell points reflect closes below these consolidations. it should be noted, however, that
once a trend is considered established, it is not absolutely necessary to wait for penetra-
tions of continuation patterns as confirmation of trade entry signals. By definition, these
patterns are expected to be resolved by price swings in the same direction as the price
moves that preceded their formation. thus, for example, in a downtrend, short positions
could be established within consolidation patterns based on an expectation of an eventual
downside breakout. the high prices in the patterns depicted in Figure 12.5 could be used
as reference points for the placement of protective stops (as marked on the chart) follow-
ing the downside breakouts of these patterns.
 4. reaction to long-term moving average. Price retracements to a moving average of the
price series can be viewed as signals that the reaction to the main trend is near an end. specifi -
cally, if a trader believed that an uptrend was in place, long positions could be entered anytime
prices declined to below a specifi ed moving average. similarly, if a downtrend were believed
to be in eff ect, short positions could be initiated on rallies above the moving average. Figure
 12.6 , which superimposes a 40-day moving average over continuous E-mini s&P 500 futures,
provides an illustration of this approach. For example, traders who were bullish on the stock
market during the period depicted and looking to enter on a correction could have used price
pullbacks below the 40-day moving average as entry signals for long positions. the arrows in
Figure 12.6 indicate potential buy entry levels based on this approach.
 FIGURE/uni00A012.5 Continuation


futures,
provides an illustration of this approach. For example, traders who were bullish on the stock
market during the period depicted and looking to enter on a correction could have used price
pullbacks below the 40-day moving average as entry signals for long positions. the arrows in
Figure 12.6 indicate potential buy entry levels based on this approach.
 FIGURE/uni00A012.5 Continuation Pattern Breakouts as Entry signals (February Wti Crude oil)
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182A CoMPlEtE gUidE to thE FUtUrEs MArKEt
 FIGURE /uni00A012.6 reaction to long- t erm Moving Average (E-Mini s&P 500 Futures)
 Note: /uni2191 = buy entry signal based on a reaction to below the 40-day moving average.
Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved.
 Chapter 16 illustrates how crossovers of moving averages can be used as trend-reversal signals. in the
application just described, we have used moving average crossover points to signal countertrend trade
entry signals. there is no contradiction. When moving average crossovers are employed for generat-
ing trend reversal signals, typically, two moving averages are used so that the smoothing of both data
series will reduce false trend-reversal signals. in the method just detailed, we deliberately defi ned
crossover points based on the price series itself, which is more sensitive than a moving average since
it contains no smoothing of the data, and one moving average. in other words, we would use more
sensitive defi nitions of moving average crossovers for countertrend applications than we would for
trend-identifi cation applications.
 it should be noted that the problem of midtrend entry is identical to the problem of pyramiding ,
which is the implementation of additional units to an existing position. Both transactions involve
implementing a position after the market has already witnessed a substantial move in a given direc-
tion. Consequently, the strategies discussed in this chapter for a midtrend entry could also be applied
to the timing of pyramid positions.
 A few additional guidelines are necessary for pyramiding. First, one should not add to any existing
position unless the last unit placed shows a profi t. second, one should not add to an existing position
if the intended stop point would imply a net loss for the entire position. third, pyramid units should
be no greater than the base (initial) position size.
183
It was the same with all. They would not take a small loss at first but had held on,
in the hope of a recovery that would “let them out even. ” And prices had sunk and
sunk until the loss was so great that it seemed only proper to hold on, if need be a year,
for sooner or later prices must come back. But the break “shook them out, ” and prices just
went so much lower because so many people had to sell, whether they would or not.
—Edwin Lefèvre
T
he success of chart-oriented trading is critically dependent on the effective control of losses.
A precise stop-loss liquidation point should be determined before initiating a trade. The most
disciplined approach would be to enter a good-till-canceled (GTC) stop order at the same time
the trade is implemented. However, if the trader knows he can trust himself, he could predeter-
mine the stop point and then enter a day order at any time this price is within the permissible
daily limit.
How should stop points be determined? A basic principle is that the position should be liquidated
at or before the point at which price movement causes a transition in the technical picture. For exam-
ple, assume a trader decides to sell September natural gas after the mid-October downside breakout
has remained intact for five days (see Figure 13.1). In this case, the protective buy stop should be
placed no higher than the upper boundary of the July–October trading range, since the realization of
such a price would totally transform the chart picture. Some of the technical reference points com-
monly used for placing protective stops include:
 1. Trend lines. A sell stop can be placed below an uptrend line; a buy stop can be placed above
a downtrend line. One advantage of this approach is that the penetration of a trend line will
Choosing
Stop-Loss Points
Chap T er 13
184A COMPLETE GUIDE TO THE FUTURES MARKET
usually be one of the fi rst technical signals in a trend reversal. Thus, this type of stop point
will strongly limit the magnitude of the loss or the surrendered open profi t. However, this
attribute comes at a steep price: trend line penetrations are prone to false signals. As dis-
cussed in Chapter 6 , it is common for trend lines to be redefi ned in the course of a bull or
bear market.
 2. Trading range. As illustrated in the preceding natural gas example, the opposite side of a
trading range can be used as a stop point. Frequently, the stop can be placed closer (particu-
larly in the case of broader trading ranges) because if the breakout is a valid signal, prices
should not retreat too deeply into the range. Thus, the stop might be placed somewhere in
the zone between the midpoint and the more distant boundary of the range. The near end of
the trading range, however, would not be a meaningful stop point. In fact, retracements to
this area are so common that many traders prefer to wait for such a reaction before initiating
a position. (The advisability of this delayed entry strategy following breakouts is a matter of
personal choice. In many instances it will provide better fi lls, but it will also cause the trader
to miss some major moves.)
 3. Flags and pennants. After a breakout in one direction of a fl ag or pennant formation, the
return to the opposite end (or some point beyond) can be used as a signal of a price reversal, and
by implication a point for placing stops. For example, in Figure 13.2 the downside penetration
of a fl ag pattern in m

eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf


rovide better fi lls, but it will also cause the trader
to miss some major moves.)
 3. Flags and pennants. After a breakout in one direction of a fl ag or pennant formation, the
return to the opposite end (or some point beyond) can be used as a signal of a price reversal, and
by implication a point for placing stops. For example, in Figure 13.2 the downside penetration
of a fl ag pattern in mid-August was quickly followed by a rebound above the same formation.
This price action proved to be a precursor of a signifi cant price advance.
 FIGURE /uni00A013.1 Stop Placement Following Trading Range Breakout: September
2015 Natural Gas
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185
CHOOSING STOP-LOSS POINTS
 4. Wide-ranging days. Similar to fl ags and pennants, after a breakout in one direction, the
return to the opposite end can be used as a signal of a price reversal, and hence a point for plac-
ing stops. For example, in Figure 13.3 note how the return of prices back above the true high of
the wide-ranging down day that formed in mid-March (after initially trading below this pattern)
led to a strong rally.
 5. relative highs and relative lows. If the implied risk is not too great, the most recent relative
high or relative low can be used as a stop point.
1 For example, assume a trader initiated a long
position in December corn in response to the breakout above resistance in June (see Figure 13.4 ).
In this case, the sell stop could be placed below either the May low or the June low .
 Sometimes the risk implied by even the closest technically signifi cant points may be excessive. In
this case, the trader may decide to use a money stop— that is, a protective stop-loss point with no tech-
nical signifi cance that is determined by the desired dollar risk level. For example, consider the plight
of a trader in July 2008 who after the swift, steep (nearly $18/barrel) price break during the week
ending July 18 is convinced the crude oil market has put in a major top (see Figure 13.5 ). The closest
 1 The specifi c defi nition of a relative low or relative high is somewhat arbitrary. (The following description is in
terms of the relative low , but analogous commentary would apply to the relative high.) The general defi nition of
a relative low is a day whose low is below the lows of the preceding and succeeding N days. The specifi c defi nition
of a relative low will depend on the choice of N . A reasonable range for N is 5 to 15.
 FIGURE /uni00A013.2 Stop Placement Following Flag Pattern Breakout: December 2010 RBOB
Gasoline
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186A COMPLETE GUIDE TO THE FUTURES MARKET
 FIGURE /uni00A013.3 Stop Placement Following Wide-Ranging Day Breakout: June 2012 10- Y ear T -Note
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE /uni00A013.4 Stop Placement at Relative Lows: December 2012 Corn
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187
CHOOSING STOP-LOSS POINTS
 FIGURE /uni00A013.5 Example of Market Where Money Stop Is Appropriate: December
2008 WTI Crude Oil
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
meaningful stop point—the contract high (which is the nearest relative high)—would imply a risk
of $17,850 per contract (assuming entry at the July 18 closing price)! Although risk can sometimes
be reduced if the trader waits for a reaction before entering the market, such a retracement may not
occur until the market moves substantially lower. Thus, in a situation in which the nearest meaningful
stop point implies a very large risk, a market order accompanied by a money stop may represent the
most viable trading approach.
 Stops should be used not only to limit losses but also to protect profi ts. In the case of a long posi-
tion, the stop should be raised intermittently as the market rises. Similarly, in a declining market, the
stop should be lowered as the market declines. This type of stop is called a trailing stop.
 Figure 13.6 illustrates the use of a trailing stop. Assume a trader implements a long position on
the breakout above the upper boundary of the trading range, with a stop-loss liquidation plan keyed
to relative lows. Specifi cally, the trader plans to liquidate the long position following a close below the
most recent relative low with the reference point being revised each time the market moves to new
high ground. (Of course, the stop condition may often be more restrictive. For example, the trader
might require a specifi ed number of closes below a previous low , or a minimum penetration of that
low to activate the stop.) The initial stop-loss point would be a close below Stop 1, which is set at a
level in the lower half of the trading range—a point that represents less risk than a stop at the more
distant March 2009 relative low . Following the early June 2009 advance to new highs, the stop-loss
reference point would be raised to the May low (Stop 2). Similarly, the stop reference points would
be raised successively to the levels indicated by Stops 3 to 11. The position would have been stopped
out on the decline below Stop 11 in March 2010.
188A COMPLETE GUIDE TO THE FUTURES MARKET
 As a general rule, stops should be changed only to reduce risk. Some traders who can’t stand the
thought of getting stopped out at the bottom of a move (top if short) may be diligent in placing a GTC
stop order upon initiating the position, but then cancel the order when the market gets within range.
This type of order has been derisively, albeit appropriately, referred to as a CIC (cancel if close) order.
Revising the stop to allow greater risk defeats the entire purpose of the stop.
 FIGURE /uni00A013.6 Trailing Stop: E-Mini Nasdaq 100 Continuous Futures
Chart created using TradeStation.


stop order upon initiating the position, but then cancel the order when the market gets within range.
This type of order has been derisively, albeit appropriately, referred to as a CIC (cancel if close) order.
Revising the stop to allow greater risk defeats the entire purpose of the stop.
 FIGURE /uni00A013.6 Trailing Stop: E-Mini Nasdaq 100 Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

189
It never was my thinking that made the big money for me. It was always my sitting.
Got that? My sitting tight! It is no trick at all to be right on the market.
—Edwin Lefèvre
A
trade is like the army—getting in is a lot easier than getting out. Provided the trader is adhering
to money management principles, a losing trade presents little ambiguity; that is, liquidation
would be indicated by a predetermined stop point. However, the profitable trade presents a problem
(albeit a desirable one). How should the trader decide when to take profits? Myriad solutions have
been proposed to this dilemma. The following sections explore some of the primary approaches.
 ■ Chart-Based Objectives
Many chart patterns are believed to provide clues regarding the magnitude of the potential price
move. For example, conventional chart wisdom suggests that once prices penetrate the neckline of
a head-and-shoulders formation, the ensuing price move will at least equal the distance from the top
(or bottom) of the head to the neckline. As another example, many point-and-figure chartists claim
that the number of columns that compose a trading range provides an indication of the potential num-
ber of boxes in a subsequent trend. (See discussion in Chapter 4 for an explanation of point-and-figure
charting.) Generally speaking, chart patterns are probably considerably less reliable as indicators of
price objectives than as trade signals.
Setting Objectives
and Other Position
Exit Criteria
Chapter 14
190A COMPLETE GUidE TO THE FUTUrES MArKET
 ■ Measured Move
 This method is the essence of simplicity. The underlying premise is that markets will move in approxi-
mately equal-size price swings. Thus, if a market rallies 30 cents and then reacts, the implication is
that the rally from the reaction low will approximate 30 cents. Although the measured move concept
is so simple that it strains credibility, the approach off ers reasonable guidelines more frequently than
one might expect. When two or more of these objectives nearly coincide, it tends to enhance the reli-
ability of the price area as an important objective zone.
 Since price swings often span several contracts, it is useful to apply the measured move technique
to longer-term price charts that link several contracts. Generally speaking, continuous futures charts
are more appropriate than nearest futures charts for measured move analysis because, as was noted
in Chapter 4 and further detailed in Chapter 5 , continuous futures accurately refl ect price swings,
whereas nearest futures do not.
 in Figure 14.1 , the measured move objective that was fulfi lled in july 2012 was the result of
adding the amount of the december 2011–May 2012 rally (404.75¢) to the early june 2012 low of
667.25¢. Figure 14.2 shows two measured moves on a weekly chart. The fi rst measured move target
at 0.2711 (MM1), which was very close to the March 2015 relative low , was derived by subtract-
ing the june–december 2014 decline of 0.0752 from the january 2015 high of 0.3462. The second
measured move objective at 0.2297 (MM2), which was fairly close to the September 2015 low ,
was obtained by subtracting the january–March 2015 decline of 0.0818 from the late April high of
 FIGURE  14.1 Measured Move: Soybean Continuous Futures
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191
SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA
0.3115. Figure 14.3 shows four measured move targets, three of which (MM1, MM3, and MM4)
implied targets very near swing point highs.
 Figure 14.4 illustrates a series of reasonably accurate measured move targets in frozen orange
juice futures from mid-2012 to late 2013. Price didn’t reach three of the targets (MM2, MM6, and
MM9, represented by dashed lines), but missed only MM2 by a notable margin. Of the other six
targets, all but MM4 represented quite advantageous exit points. Also, note that MM3 and MM5
signaled exit points at around the same level, reinforcing the target objective in that price vicinity.
 Figure 14.5 provides another example of successive reasonably accurate measured move targets over
a roughly two-year period. Note that the same price point can serve as the terminus of two diff erent
price swings (see October 2014 high with stacked 8 and 4), which can lead to two diff erent measured
move objectives based on that point (MM4 and MM8). This chart also provides an example of coincident
measured move objectives: MM6, which is a projection based on the january–March 2014 upswing off
the May low , occurred one tick away from MM8, which was the result of adding the june–October 2013
rally to the November low . MM4 and MM5 also signaled exits at approximately the same price level.
 As Figures 14.4 and 14.5 illustrate, when there is more than one relevant price swing for deriv-
ing a measured move objective, there will be more than one measured move objective for the same
projected low or high. When two or more of these objectives nearly coincide, it tends to enhance
the reliability of the projected price area as an important target zone. Figure 14.6 provides a perfect
example of two coinciding measured move price targets. The measured move objectives implied by
the july 2014–March 2015 decline (MM5) and the May–October 2015 decline (MM6) coincided just
above the actual market bottom formed in january 2016.
 FIGURE  14.2 Measured Moves: brazilian real Continuous Futures
Chart created using TradeStation. ©Trad


rtant target zone. Figure 14.6 provides a perfect
example of two coinciding measured move price targets. The measured move objectives implied by
the july 2014–March 2015 decline (MM5) and the May–October 2015 decline (MM6) coincided just
above the actual market bottom formed in january 2016.
 FIGURE  14.2 Measured Moves: brazilian real Continuous Futures
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192A COMPLETE GUidE TO THE FUTUrES MArKET
 FIGURE  14.3 Measured Moves: Soymeal Continuous Futures
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 FIGURE  14.4 Measured Moves: Orange juice Continuous Futures
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193
SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA
 FIGURE  14.5 Concentration of Measured Move Targets: Cocoa Continuous Futures
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 FIGURE  14.6 Concentration of Measured Move Targets: Canadian dollar Continuous Futures
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194A COMPLETE GUidE TO THE FUTUrES MArKET
 ■ Rule of Seven
 This method of setting objectives is an interesting and easy-to-use approach detailed in T echniques of a
Professional Commodity Chart Analyst by Arthur Sklarew (Windsor books, 1980). The rule of seven refers
to a common set of multipliers used to determine objectives, which are derived by dividing 7 by 5, 4, 3,
and 2, respectively. Thus, the multipliers are: 7 ÷ 5 = 1.4, 7 ÷ 4 = 1.75, 7 ÷ 3 = 2.33, and
7 ÷ 2 = 3.5. The products of each of these multipliers and the magnitude of the fi rst price swing in
a bull market are added to the low to obtain a set of price objectives. in a bear market, the products
are subtracted from the high.
 Sklarew suggests using the latter three multipliers (1.75, 2.33, and 3.5) for fi nding objectives in bull
markets and the fi rst three multipliers (1.4, 1.75, and 2.33) for deriving objectives in a bear market.
in addition, he indicates objectives based on the lower multipliers are more meaningful if the reference
price move (the price swing multiplied by the multipliers) is of extended duration (i.e., several months)
and objectives based on the higher multipliers are more signifi cant if a short-term price swing is used in
the calculations. Of course, there will be some degree of subjectivity in this approach, since the percep-
tion of what constitutes the fi rst price swing in a trend could vary from trader to trader.
 The rule of seven is illustrated in Figure 14.7 . (Note that this is the same chart that was used as
Figure 14.3 to illustrate measured move objectives. readers may fi nd it instructive to compare the
 FIGURE  14.7 rule of Seven: Soymeal Continuous Futures
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195
SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA
implications of these two approaches.) The fi rst wave of the bull market that began in April 2013
was 94.30 points, measured from the April low to the june high. Following Sklarew’s guidelines,
because this is a bull market, we skip the fi rst objective and use the second through fourth objec-
tives, obtained using the multipliers 1.75, 2.33, and 3.5. The April 11 low , which is used to cal-
culate all the objectives, was 123.90. The second objective is 288.90 [123.90 + (1.75 × 94.30)].
The third objective is 343.60 [123.90 + (2.33 × 94.30)]. The fourth objective is 454 [123.90 +
(3.5 × 94.30)]. Note that objective 2 was just below the december 2013 relative high of 294.80,
while objective 3 was just below the February 27 relative high of 346.10. The market failed to
reach objective 4.
 Figure 14.8 (which repeats Figure 14.6 ) illustrates the rule of seven for an extended bear market
in Canadian dollar continuous futures. The chart intentionally shows two sets of objectives based
on using diff erent lows (A and b) to defi ne the initial leg of the downtrend. in both cases, the Sep-
tember 2012 high was used as the initial high reference price. The fi rst wave of this bear market
using low A in March 2013 was 0.0674 points, while using low b in March 2014 the fi rst wave was
0.1407 points. Following Sklarew’s guidelines, since this is a bear market, we use the fi rst through
third objectives (obtained using the multipliers 1.4, 1.75, and 2.33). The products of these three
multipliers and the two initial price swings are subtracted from the high of the move to obtain the
two sets of downside objectives. Of the three objectives that referenced low A, only Objective 2 was
 FIGURE  14.8 rule of Seven: Canadian dollar Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved.

196A COMPLETE GUidE TO THE FUTUrES MArKET
fairly close to a relative low (during the january–March 2014 consolidation). Among the objectives
using low b, Objective 2 was just below the March 2015 relative low , while Objective 3 was just
above the january 2016 low .
 ■ Support and Resistance Levels
 Points near support levels provide a reasonable choice for setting initial objectives on short positions.
For example, the indicated objective zone in Figure 14.9 is based on support anticipated in the area
of two prior relative lows. Similarly, prices near resistance levels can be used for setting initial objec-
tives on long positions. For example, the indicated objective in Figure 14.10 is based on resistance
implied by the two previous highs in late 2009 and early 2010. in Figure 14.11 , an upside objective
for british pound prices after the early 2009 bottom was implied by the late 2005 relative low , a level
that continued to function as a ceiling for prices over the next several years (a case of former support
becoming resistance, as discussed in Chap


tive in Figure 14.10 is based on resistance
implied by the two previous highs in late 2009 and early 2010. in Figure 14.11 , an upside objective
for british pound prices after the early 2009 bottom was implied by the late 2005 relative low , a level
that continued to function as a ceiling for prices over the next several years (a case of former support
becoming resistance, as discussed in Chapter 8 ).
 Generally speaking, support and resistance levels usually represent only temporary rather than
major objectives. Consequently, in using this approach, it is advisable to seek to reenter the position
at a better price if a reaction does develop.
 FIGURE  14.9 downside Objective at Support Zone: Australian dollar Continuous Futures
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197
SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA
 FIGURE  14.10 Upside Objective at resistance Level: Cocoa Nearest Futures
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 FIGURE  14.11 Upside Objective at Former Support Turned resistance: british Pound Nearest Futures
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198A COMPLETE GUidE TO THE FUTUrES MArKET
 ■ Overbought/Oversold Indicators
 Overbought/oversold indicators are technical measures intended to refl ect when prices have risen or
fallen too sharply and are thus vulnerable to a reaction. Figure 14.12 illustrates the relative strength
index (rSi), which provides an example of an overbought/oversold indicator.
1 The rSi has a range
of values between 0 and 100. based on the standard interpretation, levels above 70 suggest an over-
bought condition, while levels below 30 suggest an oversold condition.
 The choice of specifi c overbought/oversold boundaries is a subjective one. For example, instead
of 70 and 30, one might use 75 and 25, or 80 and 20. The more extreme the selected threshold lev-
els, the closer the overbought/oversold signals will be to market turning points, but the greater the
number of such points that will be missed.
 The buy (up) arrows in Figure 14.12 denote points at which the rSi crosses below 30—that
is, reaches an oversold condition that can be viewed as a signal to liquidate short positions. The sell
(down) arrows denote points at which the rSi crosses above 70—that is, reaches an overbought con-
dition that can be viewed as a signal to liquidate long positions.
 Although the overbought/oversold signals in Figure 14.12 provide some reasonably good position
liquidation signals in the latter half of the chart (mid-April 2015 forward), the signals before that
 FIGURE  14.12 relative Strength index in Trend and Trading range Conditions: U.S. dollar index
Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved.
 1 The rSi was originally introduced in j. W elles Wilder, jr., New Concepts in T echnical T rading Systems (Winston-
Salem, NC: Hunter Publishing, 1978).
199
SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA
point—when the market was in a strong uptrend—were almost all terrible. The 27 percent rally off
the july 2014 low that ultimately extended into March 2015 generated 10 overbought signals, four
of which occurred in rapid succession in the first two months of the rally. Only the final two signals
during this period, in late
january and early March 2015, could be considered relatively timely. This
example hints at both the benefits and drawbacks of using overbought/oversold indicators as liquida-
tion signals. The approach will usually work well when the market is in a trading range, but will fail
miserably during strong trending phases.
The derivation and interpretation of various technical indicators are discussed in detail in
Chapter 11.
 ■ DeMark Sequential
As discussed in Chapter 11, all the popular overbought/oversold indicators (e.g., rSi, moving aver-
age convergence-divergence [MACd], stochastic) are very highly correlated with each other. T om
deMark’s sequential, which is intended to signal points where the market is fully extended and vul-
nerable to a major trend reversal, represents a completely different and original overbought/oversold
indicator. The sequential methodology falls within the domain of pattern recognition. The sequential
is fully described in a 48-page chapter in T om
deMark’s book The New Science of T echnical Analysis (john
Wiley & Sons, 1994). The following brief summary of the technique is intended to give a general
sense of the approach.
readers interested in a fully detailed explanation of the sequential, which
includes several additional qualifying conditions and a discussion of various alternative trade entry
and exit rules, are referred to
deMark’s text.
The fulfillment of the sequential buy condition involves three basic stages:
 1. Setup. The setup requires nine or more consecutive closes that are lower than the correspond-
ing closes four trading days earlier.
 2. Intersection. This condition requires that the high of any day on or after the eighth day of the
setup exceed the low of any day three or more trading days earlier. Essentially, this is a minimal
qualifying condition that ensures that the buy setup will not be deemed complete in a “waterfall”
price slide.
 3. Countdown. The countdown stage begins once the previous two conditions have been ful-
filled. Starting from 0, the countdown increases by one on each day with a close lower than the
low two days earlier. A sequential buy signal is generated once the countdown reaches 13.
in
contrast to the setup stage, countdown days do not need to be consecutive. The countdown is
canceled if any of the following three conditions arise:
a.
 There is a close that exceeds the highest intraday high during the setup stage.
b. A sell setup occurs (i.e., nine consecutive closes above the corresponding closes four d


. A sequential buy signal is generated once the countdown reaches 13.
in
contrast to the setup stage, countdown days do not need to be consecutive. The countdown is
canceled if any of the following three conditions arise:
a.
 There is a close that exceeds the highest intraday high during the setup stage.
b. A sell setup occurs (i.e., nine consecutive closes above the corresponding closes four days
earlier).
c. Another buy setup occurs before the buy countdown is complete. in this situation, the new
buy setup takes precedence, and the countdown restarts from 0 once the intersection condi-
tion is met.
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A Complete Guide to the Futures mArket
The fulfillment of the sequential sell conditions are analogous:
 1. Setup. The setup requires nine or more consecutive closes that are higher than the correspond-
ing closes four trading day earlier.
 2. Intersection. This condition requires that the low of any day on or after the eighth day of the
setup is lower than the high of any day three or more trading days earlier. Essentially, this is a
minimal qualifying condition that ensures that the sell setup will not be deemed complete in a
“runaway” rally.
 3. Countdown. The countdown stage begins once the previous two conditions have been ful-
filled. Starting from 0, the countdown increases by one on each day with a close higher than the
high two days earlier. A sequential sell signal is generated once the countdown reaches 13.
in
contrast to the setup stage, countdown days do not need to be consecutive. The countdown is
canceled if any of the following three conditions arise:
a.
 There is a close that is below the lowest intraday low during the setup stage.
b. A buy setup occurs (i.e., nine consecutive closes below the corresponding closes four days
earlier).
c. Another sell setup occurs before the sell countdown is complete. in this situation, the new
sell setup takes precedence, and the countdown restarts from 0 once the intersection condi-
tion is met.
Figures 14.13 through 14.17 provide illustrations of markets that fulfilled the complete sequential
process.
in each case, the setup, intersection, and countdown stages are marked on the charts; the
final bar of the setup stage is highlighted with a boldfaced 9, while the final bar of the countdown
phase is marked with a boldfaced 13. The preceding description will be clearer if read in conjunction
with an examination of these charts.
Figure 14.13 provides an illustration of a sequential sell signal in
june 2016 10-year T -note futures.
Note that in this case, the first day of the countdown stage (which occurred three days after the end
of the setup stage) also fulfilled the intersection requirement (a bar with a low below the high of a day
three or more days earlier). The countdown phase completed on February 11, the day that marked the
highest high and close of the upmove. Figure 14.14, which shows the
june 2016 gold contract, pro-
vides an example of a sequential buy. As was the case in Figure 14.13, the first day of the countdown
stage also marked the fulfillment of the intersection requirement. The completion of the countdown
stage coincided with the mid-
december 2015 low .
Figure 14.15 provides another example of a sequential buy, this time in the May 2016 soybean
contract. in this case the intersection requirement occurred on the eighth bar of the setup phase,
while the countdown phase didn’t begin until nine days after the end of the setup phase. The count-
down completed in early March 2016, the day with the lowest low of the move and one day after the
lowest close. (Note: Figures 14.14 and 14.15 reflect day-session-only data.)
The sequential rules can also be applied to bar charts for time periods other than daily. Figure 14.16
illustrates a sequential sell on a monthly copper continuous futures chart. Here, the end of the setup
stage, the beginning of the countdown stage, and the fulfillment of the intersection requirement all
occur on the same bar (month). The market peaked at month 11 of the countdown phase, but the real
201
SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA
 FIGURE  14.13 deMark Sequential: june 2016 10- Y ear T -Note Continuous Futures
 Source for sequential signals: deMark Analytics ( www .demark.com )
Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved.
 deMark Sequential: june 2016 10- Y ear T -Note Continuous Futures
 FIGURE  14.14 deMark Sequential: june 2016 Gold
 Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com
Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics.
Countdown begins/
Intersection fulfilled
Setup complete Countdown complete
12000
11800
11600
11400
11200
11000
10800
10600
10400
10200
01
Feb
04 11 19 25
2016
2801 07 14 21
Dec
02 26 09 16 23
Nov
13
9
12
1110
98
6
7
54
32
187
65
4
3
2
1
June 2016 gold (GCM16), daily (day-session)
202A COMPLETE GUidE TO THE FUTUrES MArKET
Countdown begins
Setup complete Countdown complete
9400
9300
9200
9100
9000
8900
8800
8700
8600
8400
8500
11
Apr
14 21 28 01
Mar
0708 16 22 01
Feb
0421 28 11 19 0125
2016
Intersection
fulfilled
32
1
13
9
1211109
8
6
7 1
5
4
3
2
1
8
76
54
May 2016 soybeans (SK16), daily (day-session)
 FIGURE  14.15 deMark Sequential: May 2016 Soybeans
 Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com
Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics.
Copper continuous futures (HG), monthly
Setup complete/
Countdown begins
Countdown complete
47500
42500
45000
37500
35000
30000
40000
32500
27500
25000
22500
20000
17500
15000
2016
JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul Jan
12500
20152012 2013 201420112009 20 10
Intersection fulfilled
3
21
13
9
12
11109
8
6
7
5
4
32
1
876
54
 FIGURE  14.16 deMark Sequential: Copper Continuous Futures
 Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com
Chart from CQG,


500
45000
37500
35000
30000
40000
32500
27500
25000
22500
20000
17500
15000
2016
JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul Jan
12500
20152012 2013 201420112009 20 10
Intersection fulfilled
3
21
13
9
12
11109
8
6
7
5
4
32
1
876
54
 FIGURE  14.16 deMark Sequential: Copper Continuous Futures
 Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com
Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics.
203
SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA
 FIGURE  14.17 deMark Sequential: june 2016 E-Mini Nasdaq 100
 Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com
Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics.
reversal did not occur until after the completion of countdown six months later. Figure 14.17 shows
completed sequential sell and buy setups on an intraday chart (15-minute bars). The sell setup com-
pleted during a consolidation near the top of the rally, while the buy setup completed a bit above the
low of the subsequent decline, but right at the start of the fi rst extended rally after the low .
 The preceding examples were obviously selected with hindsight to illustrate the methodology. Of
course, in real-life trading, the accuracy of the deMark sequential approach will not approach the
uniformly near-perfect signals provided by the previous set of examples. if it did, all anyone would
need to do would be to trade all sequential signals and retire a multimillionaire. Nevertheless, these
examples should demonstrate that sequential can be a very powerful tool, with the capability of pro-
viding extraordinary timing signals. Sequential also has the advantage of being inversely correlated to
trend-following approaches that typically dominate the technical tool bag. For these reasons, many
traders might fi nd deMark’s sequential a very useful addition to their overall trading methodology.
 ■ Contrary Opinion
 The theory of contrary opinion suggests that whenever a large majority of speculators are bullish,
those who want to be long are already long. Consequently, there will be a paucity of potential new
buyers, and the market will be vulnerable to a downside reaction. An analogous interpretation would
apply when the majority of traders are bearish. Contrary opinion measures are based on either surveys
204
A Complete Guide to the Futures mArket
of market advisory recommendations or surveys of traders and implicitly assume these opinions rep-
resent a reasonable proxy for overall market sentiment. The overbought and oversold thresholds in
contrary opinion indexes will vary with the source.
Although contrary opinion is undoubtedly a sound theoretical concept, the Achilles’ heel of this
approach is the difficulty of measuring market sentiment accurately. Contrary opinion measures pro-
vided by existing services have frequently signaled major turning points. On the other hand, it is also
not unusual for a contrary opinion index to stay high while the market continues to climb, or to stay
low as the market continues to slide. On balance, this method provides useful information as long as
it is not used as the sole trading guideline.
 ■ Trailing Stops
The use of trailing stops may be among the least glamorous, but most sensible, methods of determin-
ing a trade exit point. Although one will never sell the high or buy the low using this method, the
approach comes closest to the ideal of permitting a profitable trade to run its course. Trailing stops
were detailed in Chapter 13.
 ■ Change of Market Opinion
This method of exiting trades represents another approach with very little flash, but lots of common
sense.
in this case, the trader sets no predetermined objectives at all, but rather maintains the position
until her market opinion changes to at least neutral.
205
Chapter 15
The Most Important
Rule in Chart Analysis
The market is like a flu virus—as soon as you think you have it pegged, it mutates into
something else.
—Wayne H. Wagner
 ■ Failed Signals
A failed signal is among the most reliable of all chart signals. When a market fails to follow through
in the direction of a chart signal, it very strongly suggests the possibility of a significant move in the
opposite direction. For example, in Figure 15.1 note how the market abruptly reversed course after
breaking out above the high of the July–August 2013 consolidation in WTI crude oil. If the upside
penetration signal were valid, the market should not have retreated back to the lower portion of the
consolidation and certainly not below its lower boundary. The fact that such a retracement occurs
almost immediately following the breakout strongly suggests a “bull trap.” Such price action is con-
sistent with the market’s rising just enough to activate stop orders lying beyond the boundary of the
range, but uncovering no additional buying support after the breakout—an indication of a very weak
underlying technical picture. In effect, the immediate failure of the apparent buy signal can be viewed
as a strong indication the market should be sold.
Now that we have established the critical importance of failed signals, the following sections detail
various types of failed signals, along with guidelines as to their interpretation and trading implications.
 ■ Bull and Bear Traps
Bull and bear traps are major breakouts that are soon followed by abrupt, sharp price reversals, in stark
contrast to the price follow-through that is expected to follow breakouts. In my experience, this type
of counter-to-anticipated price action is among the most reliable indicators of major tops and bottoms.
206A CoMPleTe GuIDe To THe FuTuReS MARKeT
 An example of a bull trap was provided in the previous section (Figure 15.1 ). Another instance of
a bull trap was the June 2015 peak in RBoB gasoline (see Figure 15.2 ). After rallying from January to
May 2015, the market consolidated fo


, this type
of counter-to-anticipated price action is among the most reliable indicators of major tops and bottoms.
206A CoMPleTe GuIDe To THe FuTuReS MARKeT
 An example of a bull trap was provided in the previous section (Figure 15.1 ). Another instance of
a bull trap was the June 2015 peak in RBoB gasoline (see Figure 15.2 ). After rallying from January to
May 2015, the market consolidated for roughly one month before breaking out to new highs in mid-
June. However, the market quickly reversed back into the trading range, and by mid-July prices had
broken below the range’s lower boundary, setting the stage for a multimonth downtrend.
 Analogous to the bull trap, in the case of a bear trap, the market falls just enough to trigger resting
stops below the low end of a trading range, but fails to uncover any additional selling pressure after
the breakout—an indication of substantial underlying strength. In eff ect, the immediate failure of a
sell signal can be viewed as a signal the market should be bought.
 Figure 15.3 shows a bear trap that marked the 2014 low in u.S. Dollar Index futures. In May the
market broke below the lower boundary of a long-standing trading range but reversed two days later
to close back above that threshold. This price action proved to be the beginning of the market’s largest
rally in more than a decade.
 Figure 15.4 provides another example of a bear trap. Corn prices, which had been trending lower
since late summer 2012, entered a trading range in November–December 2013. The market broke
below the downside of the range in early January 2014, falling more than 2 percent over the next two
days before reversing sharply and returning to the midpoint of the range. May corn futures subse-
quently surged approximately 25 percent over the next three months.
 FIGURE  15.1 Bull Trap: WTI Crude oil Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
207
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.2 Bull Trap: RBoB Gasoline Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.3 Bear Trap: u.S. Dollar Index Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

208A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.4 Bear Trap: May 2014 Corn Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 How much of a pullback is required to indicate a bull or bear trap has occurred? The following are
several possible confi rmation conditions:
Initial price confi rmation. A price retracement to the midpoint of the consolidation that
preceded the breakout.
Strong price confi rmation. A price retracement to the more distant boundary (lower for bull
trap; upper for bear trap) of the consolidation that preceded the breakout.
time confi rmation. The failure of the market to return to the extreme price witnessed follow-
ing the breakout within a specifi ed amount of time (e.g., four weeks).
 The trade-off between initial and strong price confi rmations is that the former will provide better
entry levels in trading bull and bear traps, whereas the latter will provide more reliable signals. The
time confi rmation condition can be used on its own or in conjunction with the two price confi rma-
tion conditions. Figures 15.5 through 15.8 repeat Figures 15.1 through 15.4 , adding each of the
three confi rmation conditions (using four weeks for the time confi rmation condition). Note the time
confi rmation can occur before both price confi rmation conditions, after both price confi rmation
conditions (as is the case in Figures 15.6 and 15.8 ), or between the price confi rmations (Figures 15.5
and 15.7 ).
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THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.5 Bull Trap Confi rmation Conditions: WTI Crude oil Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.6 Bull Trap Confi rmation Conditions: RBoB Gasoline Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

210A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.7 Bear Trap Confi rmation Conditions: u.S. Dollar Index Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.8 Bear Trap Confi rmation Conditions: May 2014 Corn Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

211
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
A bull trap signal would be invalidated if the market returned to the breakout high. Similarly,
a bear trap signal would be invalidated if the market returned to the breakout low . More sensitive
 conditions could be used to invalidate bull or bear trap signals once the market has moved sufficiently
in the direction of the signal or a specified amount of time has elapsed. An example of such a condition
would be the return of prices to the opposite boundary of a consolidation once a strong price confir-
mation signal was received (e.g., in the case of a bull trap, a return to the top of the consolidation after
prices broke to below the low end of the consolidation). An example of a more sensitive combined
price/time invalidation signal would be the return of prices to the median of a consolidation (i.e.,
the initial price confirmation point for bull and bear trap signals) at any time four or more weeks after
a strong price confirmation was received. The more sensitive the selected invalidation condition, the
smaller the loss on an incorrect call of a bull or bear trap, but the greater the chance that a correct
trade will be abandoned prematurely.
If the selected invalidation condition does not occur, a trade implemented on a bull or bear trap
signal would be held until a price objective or other trade liquidation condition was met or until the


more sensitive the selected invalidation condition, the
smaller the loss on an incorrect call of a bull or bear trap, but the greater the chance that a correct
trade will be abandoned prematurely.
If the selected invalidation condition does not occur, a trade implemented on a bull or bear trap
signal would be held until a price objective or other trade liquidation condition was met or until there
was evidence of an opposite direction trend reversal.
 ■ False Trend Line Breakouts
As discussed in Chapter 6, trend lines are particularly prone to false breakouts. Such false break-
outs can be used as signals for trading in the direction opposite to the breakout. In fact, in my
opinion, false trend line breakout signals are considerably more reliable than conventional trend
line breakout signals. In the case of a downtrend, a false trend line breakout would be confirmed
if the market closed below the trend line a specified number of times (e.g., two, three) follow-
ing an upside breakout. Similarly, in the case of an uptrend, a false trend line breakout would
be confirmed if the market closed above the trend line a specified number of times following a
downside breakout.
Figure 15.9 provides an example of a false breakout of an uptrend line in 10-year T -note
futures. The September downside breakout of the uptrend line was soon followed by a break
above the line. The indicated failure signal is based on an assumed requirement of two closes
above the line for confirmation. Figure 15.10 provides a similar example in the
e-mini Nasdaq
100 futures.
It is quite possible for a chart to yield multiple successive false trend breakout signals in the
process of a trend line being redefined. In Figure 15.11 the initial upside penetration of the prevail -
ing downtrend line occurred in mid-March. Prices quickly retreated back below the line, with the
indicated failure signal assumed to be triggered by the second close below the line. Another false
breakout occurred about a month later based on the redefined trend line using the March relative
high. Prices retreated below this downtrend line several days later, yielding another false trend
breakout signal.
212A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.10 False Breakout of uptrend line: e-Mini Nasdaq Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.9 False Breakout of uptrend line: 10- y ear T -Note Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

213
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.11 Multiple False Breakouts of Downtrend lines: euro Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 ■ Return to Spike Extremes
 As was detailed in Chapter 9 , price spikes frequently occur at important price reversals. Conse-
quently, the return of prices to a prior spike extreme can be viewed as transforming the original spike
into a failed signal. The more extreme the spike (i.e., the greater the magnitude by which the spike
high or low exceeds the highs or lows on the prior and subsequent days), the more signifi cant its pen-
etration. The signifi cance of such failed signals is also enhanced if at least several weeks, and preferably
several months, have elapsed since the original spike.
 In Figure 15.12 , the January 2016 return to both the August and october 2015 spike highs was
followed by a sharp rally well above the prior spike highs. In Figure 15.13, the october 2010 penetra-
tion of the early 2008 spike high was followed by a sharp rally. Figures 15.14 and 15.15 provide two
illustrations of downside penetrations of spike lows being followed by steep sell-off s.
214A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.12 Penetration of Spike Highs: 30- y ear T -Bond Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.13 Penetration of Spike High: Cotton Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

215
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.14 Penetration of Spike Highs: Soybean oil Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.15 Penetration of Spike low: Australian Dollar Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

216A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.16 Spike Penetration Signals Negated: 5- y ear T -Note Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 Generally speaking, a close beyond the opposite extreme of the spike can be viewed as negat-
ing the failed signal. For example, in Figure 15.16 the price briefl y exceeded the August spike high,
forming a second spike high in early october, but then immediately retreated, falling below the low
of the August spike day—a failed failed signal, so to speak. This pattern repeated itself in early 2016
when the market penetrated the october spike, rallied for about a week (forming a spike high in the
process), but then reversed to close below the low of the october spike day in early March.
 ■ Return to Wide-Ranging Day Extremes
 As explained in Chapter 9 , wide-ranging days (WRDs) with particularly strong or weak closes tend to
lead to price extensions in the same direction. Consequently, a close above the high price of a downside
WRD or below the low price of an upside WRD can be viewed as confi rming such days as failed signals.
 In Figure 15.17 the WRD that formed in mid-April 2015 is penetrated to the downside about 10
weeks later, leading to a signifi cant decline. In Figure 15.18 a huge WRD formed in early July 2013
in the vicinity of the May swing high. Three days later, the uptrend was reversed by


of a downside
WRD or below the low price of an upside WRD can be viewed as confi rming such days as failed signals.
 In Figure 15.17 the WRD that formed in mid-April 2015 is penetrated to the downside about 10
weeks later, leading to a signifi cant decline. In Figure 15.18 a huge WRD formed in early July 2013
in the vicinity of the May swing high. Three days later, the uptrend was reversed by a downside WRD,
which was followed three days later by a close below the low of the fi rst WRD, confi rming a failed
signal and leading to an extended market slide.
 Figure 15.19 shows an example of an up-closing WRD in late April that was reversed by a down-
closing WRD 12 days later. A closing penetration of the April WRD occurred four days later and was
followed by a large, sustained downtrend. Figure 15.20 shows a massive down-closing WRD that was
eclipsed to the upside a little more than a month later and followed by a strong rally to new high ground.
217
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.17 Penetration of upside Wide-Ranging Day: Canadian Dollar Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.18 Penetration of upside Wide-Ranging Day: u.S. Dollar Index Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

218A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.19 Penetration of upside Wide-Ranging Day: Copper Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.20 Penetration of Downside Wide-Ranging Day: Bund Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

219
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 ■ Counter-to-Anticipated Breakout of Flag or Pennant
 As was explained in Chapter 9 , typically, fl ag or pennant consolidations tend to be followed by price
swings in the same direction as the price swings that preceded their formation. Therefore, if a fl ag or
pennant formation is followed by a breakout in the opposite direction of the preceding price swing, it
would qualify the pattern as a failed signal.
 In Figure 15.21 , just as would have been implied by the chart interpretation guidelines presented in
Chapter 9 , the fl ag formations that evolved during the 2014 downtrend in soybean prices were generally
followed by downswings. The one exception, however, was the fl ag that formed in late September and
early october. In this instance, the fl ag was followed by an upside breakout. This counter-to-anticipated
price action was followed by a rally of more than 13 percent to the mid-November high. Figures 15.22 ,
 15.23 , and 15.24 provide three examples where counter-to-anticipated downside breakouts of fl ag pat-
terns signaled major trend reversals. Note that Figure 15.24 is, in fact, the same reversal depicted in
Figure 15.19 , which focused on the downside penetration of the strong-closing WRD that immediately
preceded the fl ag. In Figure 15.25 heating oil prices rallied more than 33 percent in one month after the
counter-to-anticipated upside breakout of the fl ag that formed in early 2015.
 A counter-to-anticipated breakout does not need to be followed by an immediate extension of
the price move in order to be a valid confi rmation of a failed signal. How much of a retracement can
be allowed before the interpretation of a failed signal is abandoned? one reasonable approach is to
 FIGURE  15.21 Counter-to-Anticipated Breakout of Flag Pattern: Soybean Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

220A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.22 Counter-to-Anticipated Breakout of Flag Pattern: Canadian Dollar Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.23 Counter-to-Anticipated Breakout of Flag Pattern: orange Juice Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

221
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.24 Counter-to-Anticipated Breakout of Flag Pattern: Copper Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.25 Counter-to-Anticipated Breakout of Flag Pattern: Heating oil Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

222A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.26 Counter-to-Anticipated Flag Breakout and opposite Direction Flag Breakout
Following Normal Breakout: Cocoa Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 consider the confi rmation of a failed signal in force as long as prices do not close beyond the oppo-
site end of the relevant fl ag or pennant. The retracement in Figure 15.21 provides a good example:
after the breakout above the top of the September–october fl ag, prices pulled back but held at the
approximate midpoint of the fl ag before pushing higher, thereby leaving the failed signal intact.
 Figure 15.26 highlights two fl ag patterns. The fi rst formed in July when prices were rallying and
was followed by a sharp sell-off after a counter-to-anticipated breakout to the downside. The second
fl ag occurred in September when the market was rebounding. The market initially broke out of this
fl ag in the expected direction—to the upside—but after a few days prices dropped back into the fl ag’s
range and, eventually, penetrated the bottom of the fl ag, confi rming a failed signal pattern. The mar-
ket subsequently dropped more than 5 percent over the next two weeks. This type of reversal after a
normal breakout is the subject of the next section.
 ■ Opposite Direction Breakout of Flag or Pennant Following
a Normal Breakout
 In some cases


few days prices dropped back into the fl ag’s
range and, eventually, penetrated the bottom of the fl ag, confi rming a failed signal pattern. The mar-
ket subsequently dropped more than 5 percent over the next two weeks. This type of reversal after a
normal breakout is the subject of the next section.
 ■ Opposite Direction Breakout of Flag or Pennant Following
a Normal Breakout
 In some cases, fl ags and pennants are followed by breakouts in the anticipated direction, but prices
then reverse to close beyond the opposite extreme of the fl ag or pennant, as was the case with the
September 2015 pattern in Figure 15.26 . This combined price action provides another example of
223
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.27 opposite Direction Breakout of Flag Following Normal Breakout: Platinum
Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
a failed signal, since the anticipated breakout of the fl ag or pennant is followed by a price reversal
instead of a price follow-through. Note that a close beyond the opposite end of the fl ag or pennant
is required to confi rm a failed signal, rather than a mere intraday penetration. Although this more
restrictive condition will yield slightly less timely confi rmations of failed signals in cases when such a
conclusion proves valid, it will reduce the number of inaccurate calls of failed signals.
 In Figure 15.27 the fl ag consolidation that formed in January–February 2013 after an upswing off
support near the November–December lows was followed by an upside breakout, as might have been
anticipated. Instead of witnessing a further sustained advance, however, prices moved higher for only
two days, and less than two weeks later the market had retreated to below the low end of the fl ag
consolidation. This price action qualifi ed the earlier upside breakout above the fl ag pattern as a failed
signal. (Note this type of signal could also be termed a bull or bear trap if it occurs at a major high
or low .) In April a counter-to-anticipated upside breakout of a pennant formation was followed by a
sharp bounce and consolidation before the market dropped to new lows in June.
 In Figure 15.28 the fl ag that formed during an upswing in natural gas prices was also followed by
an upside breakout and then a retreat below the low end of the fl ag. In this instance, the market pushed
back into the fl ag’s range several days later but did not reach the pattern’s upper boundary, leaving the
failed signal confi rmation intact.
 Figure 15.29 illustrates a fl ag pattern that formed during an extended downtrend in sugar futures.
The market fi rst broke out of the fl ag in the anticipated direction but reversed in a few days after
224A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.28 opposite Direction Breakout of Flag Following Normal Breakout: April 2016 Natural Gas
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.29 opposite Direction Breakout of Flag Following Normal Breakout: Sugar
 Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

225
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 FIGURE  15.30 opposite Direction Breakout of Flag Following Normal Breakout: euro Continuous
Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
forming a spike low . The subsequent upside penetration of the fl ag confi rmed the failed signal. After
a partial pullback toward the middle of this upward-sloping fl ag, prices staged a huge upmove. Note
this failed signal is also a perfect example of a bear trap bottom.
 In Figure 15.30 an expected downside breakout of the fl ag was followed by an upswing above its
upper boundary, confi rming a failed fl ag signal that was followed by a brisk rally.
 ■ Penetration of Top and Bottom Formations
 The penetration of patterns that are normally associated with major tops and bottoms represents
another important type of failed signal. For example, Figure 15.31 illustrates the double top
that formed in u.S. 30-year T -bond futures in late 2010 and the penetration of this top several
months later. The monthly chart inset shows the extent of the market’s subsequent rally. Pen-
etrations of double tops and double bottoms can be significant failure signals even if the top or
bottom formation is not confirmed. For example, Figure 15.32 shows the downside penetration
of an unconfirmed double bottom—that is, prices did not exceed the pattern’s october 2013
intermediate high. Nonetheless, penetration of the pattern’s July 2013 and January 2014 lows
represented the violation of an important support level, as evidenced by the continued sell-off
that followed.
226A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.31 Penetration of Double T op: 30- y ear u.S. T -Bond Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.32 Penetration of Double Bottom: Australian Dollar Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

227
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 Penetrations of double-top and double-bottom patterns provide good signals but are rela-
tively rare. Failed signals involving head-and-shoulders patterns are more common and often
provide excellent trading indicators. Although the choice of what condition constitutes a confi r-
mation of a failed head-and-shoulders pattern is somewhat arbitrary, I would use the criterion of
prices exceeding the most recent shoulder. For example, in Figure 15.33 the rebound above the
shoulder that peaked at the beginning of November 2012 would represent a confi rmation of a
failed head-and-shoulders top pattern. Sometimes prices will fi rst dip back after penetrating the
shoulder, even when a substantial advance ultimately


attern is somewhat arbitrary, I would use the criterion of
prices exceeding the most recent shoulder. For example, in Figure 15.33 the rebound above the
shoulder that peaked at the beginning of November 2012 would represent a confi rmation of a
failed head-and-shoulders top pattern. Sometimes prices will fi rst dip back after penetrating the
shoulder, even when a substantial advance ultimately ensues, as is the case in Figure 15.34 , which
shows a long-term example on a weekly chart of the e-mini S&P 500 futures. As long as prices
don’t close below the relative low formed between the head and right shoulder, the failed signal
would remain intact. Figure 15.35 provides another example of a strong rally following a failed
head-and-shoulders top.
 Figure 15.36 illustrates a failed head-and-shoulders bottom pattern. In analogous fashion to the
head-and-shoulders top case, the downside penetration of the more recent shoulder is used as the
confi rmation condition of a failed signal.
 The trader may often benefi t by waiting for a retracement before implementing a position based
on the confi rmation of a failed head-and-shoulders pattern, as illustrated by Figure 15.34 . The trade-
off is that such a strategy will result in missing very profi table trades in those cases where there is no
retracement or only a very modest retracement (e.g., Figures 15.35 and 15.36 ).
 FIGURE  15.33 Failed Head-and-Shoulders T op Pattern: Soymeal Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

228A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.34 Failed Head-and-Shoulders T op Pattern: e-Mini S&P 500 Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.35 Failed Head-and-Shoulders T op Pattern: Nikkei 225 Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

229
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
 ■ Breaking of Curvature
 As was discussed in Chapter 9 , rounding patterns often provide very reliable trading signals. In this
sense, the breaking of a curved price pattern can be viewed as transforming the pattern into a failed
signal. Figure 15.37 actually contains two examples where the breaking of the curvature of what had
been an apparent rounding-top pattern represented a bullish signal. In Figure 15.38 , the breaking of
the curvature of an apparent rounding-bottom pattern led to a steep decline in corn prices in 2014.
Note the downthrust in January 2014 (the low of the curved pattern) was the bear trap illustrated in
Figures 15.4 and 15.8 . So, in eff ect, this chart illustrates two successive failure patterns, the fi rst sig-
naling a near-two-month rebound, and the second the subsequent reversal into a major downtrend.
 ■ The Future Reliability of Failed Signals
 There is an inverse relationship between the popularity of an indicator and its effi ciency. For example,
decades ago, when technical analysis was used by fewer market practitioners, chart breakouts (price
moves above or below prior trading ranges) tended to work relatively well, providing many excellent
signals without an abundance of false signals. In my observation, as technical analysis became increasingly
popular and breakouts a commonly used tool, the effi ciency of this pattern seemed to deteriorate. In
fact, it now seems that price reversals following breakouts may more often be the rule than the exception.
 FIGURE  15.36 Failed Head-and-Shoulders Bottom Pattern: Sugar Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

230A CoMPleTe GuIDe To THe FuTuReS MARKeT
 FIGURE  15.37 Breaking of Curvature: e-Mini Nasdaq 100 Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  15.38 Breaking of Curvature: Corn Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

231
THe MoST IMPoRTANT Rule IN CHART ANAlySIS
As stated earlier, I find failed signals considerably more reliable than conventional chart patterns.
Although the concept of failed signals is certainly not new , I don’t believe its usage is widely empha-
sized. If the use of failed signals were to become significantly more widespread, however, their long-
term reliability could be adversely affected.
As a final comment, it should be emphasized that the concept of failed signals in this chapter has
been presented in the context of conventional chart analysis as it exists today. In the future—particu-
larly the distant future—what passes for popular chart interpretation may well change. The concept
of failed signals, however, can be made dynamic by pegging it to the conventional wisdom. In other
words, if a new chart pattern became popular as a technical signal in the future (e.g., in the way
breakouts are widely used today), a failure of the pattern could be viewed as more significant than the
pattern itself. In this more general sense, the concept of failed signals could prove timeless.
 ■ Conclusion
The novice trader will ignore a failed signal, riding a position into a large loss while hoping for the
best. More experienced traders, having learned the importance of money management, will exit
quickly once it is apparent they have made a bad trade. However, the truly skilled trader will be able
to do a 180-degree turn, reversing a position at a loss if market behavior (e.g., confirmation of a failed
signal) points to such a course of action. In other words, it takes great discipline to capitalize on failed
signals, but such flexibility is essential to the effective synthesis of chart analysis and trading.

TraDing SySTeMS
anD PerforMance
MeaSureMenT
Part IV

235
Cha P ter 16
There are only two types of trend-following systems: fast and slow.
—Jim orcutt
B
e forewarned. if you are expe


led
signal) points to such a course of action. In other words, it takes great discipline to capitalize on failed
signals, but such flexibility is essential to the effective synthesis of chart analysis and trading.

TraDing SySTeMS
anD PerforMance
MeaSureMenT
Part IV

235
Cha P ter 16
There are only two types of trend-following systems: fast and slow.
—Jim orcutt
B
e forewarned. if you are expecting to find the blueprint for a heretofore secret trading system
that consistently makes 100 percent plus per year in real-life trading with minimal risk, you’ll
have to look elsewhere. for one thing, i have not yet discovered such a “sure thing” money machine.
But, in a sense, that is beside the point. Quite frankly, i have always been somewhat puzzled by
advertisements for books or computer software promising to reveal the secrets of systems that
make 100 percent, 200 percent, and more! Why are they selling such valuable information for $99,
or even $2,999?
The primary goal of this chapter is to provide readers with the background knowledge necessary
to develop their own trading systems. The discussion focuses on the following five areas:
 1. a n overview of some basic trend-following systems
 2. The key weaknesses of these systems
 3. g uidelines for transforming “generic” systems into more powerful systems
 4. c ountertrend systems
 5. Diversification as a means of improving performance
chapter 17 provides additional examples of trading systems, using original systems as illustra-
tions. The essential issues of appropriate data selection, system testing procedures, and performance
measurement are discussed in
chapters 18, 19, and 20.
T echnical
Trading Systems:
Structure and Design
236
A Complete Guide to the Futures mArket
 ■ The Benefits of a Mechanical Trading System
is paper trading easier than real trading? Most speculators would answer yes, even though both tasks
require an equivalent decision process. This difference is explained by a single factor: emotion. over-
trading, premature liquidation of good positions because of rumors, jumping the gun on market entry
to get a better price, riding a losing position—these are but a few of the negative manifestations of
emotion in actual trading. Perhaps the greatest value of a mechanical system is that it eliminates emo-
tion from trading.
in so doing, it allows the speculator to avoid many of the common errors that often
impede trading performance. furthermore, removing the implied need for constant decision making
substantially reduces trading-related stress and anxiety.
another benefit of a mechanical system is that it ensures a consistent approach—that is, the trader
follows all signals indicated by a common set of conditions. This is important, since even profitable
trading strategies can lose money if applied selectively. T o illustrate this point, consider the example
of a market advisory whose recommendations yield a net profit over the long run (after allowances for
commissions and poor executions). Will the advisory’s subscribers make money if they only imple-
ment trades in line with its recommendations?
not necessarily. Some people will pick and choose
trades, invariably missing some of the biggest winners. others will stop following the recommenda-
tions after the advisor has a losing streak, and as a result may miss a string of profitable trades. The
point is that a good trading strategy is not sufficient; success also depends on consistency.
a third advantage of mechanical trading systems is they normally provide the trader with a method
for controlling risk. Money management is an essential ingredient of trading success. Without a plan
for limiting losses, a single bad trade can lead to disaster.
any properly constructed mechanical system
will either contain explicit stop-loss rules or specify conditions for reversing a position given a sufficient
adverse price move.
as a result, following signals generated by a mechanical trading system will nor-
mally prevent the possibility of huge losses on individual trades (except in extreme circumstances when
one is unable to liquidate a position because the market is in the midst of a string of locked-limit moves).
Thus, the speculator using a mechanical system may end up losing money due to the cumulative effect
of a number of negative trades, but at least his account will not be decimated by one or two bad trades.
of course, money management does not necessarily require the use of a trading system. risk control
can also be achieved by initiating a good-till-canceled stop order whenever a new position is taken, or by
predetermining the exit point upon entering a trade and sticking to that decision. However, many trad-
ers lack sufficient discipline and will be tempted to give the market just a little more time once too often.
 ■ Three Basic Types of Systems
The categories used to classify trading systems are completely arbitrary. The following three-division
classification is intended to emphasize a subjective interpretation of the key conceptual differences in
possible trading approaches:
trend-following. a trend-following system waits for a specified price move and then initiates
a position in the same direction based on the implicit assumption that the trend will continue.
Countertrend. a countertrend system waits for a significant price move and then initiates a
position in the opposite direction on the assumption that the market is due for a correction.
237
Technical Trading SySTemS: STrucTure and deSign
Pattern recognition. in a sense, all systems can be classified as pattern recognition systems.
after all, the conditions that signal a trend or a countertrend trade are a type of pattern (e.g.,
close beyond the 20-day high or low). However, the implication here is that the chosen patterns
are not based primarily on directional moves, as is the case in trend-following and counter-
trend systems.
for example, a pattern-recognition syste


ms can be classified as pattern recognition systems.
after all, the conditions that signal a trend or a countertrend trade are a type of pattern (e.g.,
close beyond the 20-day high or low). However, the implication here is that the chosen patterns
are not based primarily on directional moves, as is the case in trend-following and counter-
trend systems.
for example, a pattern-recognition system might generate signals on the basis
of “spike days” (see chapter 9). in this case, the key consideration is the pattern itself (e.g.,
spike) rather than the extent of any preceding price move. of course, this example is overly
simplistic. in practice, the patterns used for determining trading signals will be more complex,
and several patterns may be incorporated into a single system.
Systems of this type may sometimes employ probability models in making trading decisions.
in this case the researcher would try to identify patterns that appeared to act as precursors of
price advances or declines in the past. an underlying assumption in this approach is that such
past behavioral patterns can be used to estimate current probabilities for rising or declining
markets given certain specified conditions. This chapter does not elaborate on this approach of
trading system design since it lies beyond the scope of the overall discussion.
it should be emphasized that the lines dividing the preceding categories are not always clear-cut.
as modifications are incorporated, a system of one type may begin to more closely approximate the
behavioral pattern of a different system category.
 ■ Trend-Following Systems
By definition, trend-following systems never sell near the high or buy near the low , because a meaningful
opposite price move is required to signal a trade. Thus, in using this type of system, the trader will always
miss the first part of a price move and may surrender a significant portion of profits before an opposite
signal is received (assuming the system is always in the market). There is a basic trade-off involved in
the choice of the sensitivity, or speed, of a trend-following system.
a sensitive system, which responds
quickly to signs of a trend reversal, will tend to maximize profits on valid signals, but it will also gener-
ate far more false signals. a nonsensitive, or slow , system will reflect the reverse set of characteristics.
Many traders become obsessed with trying to catch every market wiggle. Such a predilection leads
them toward faster and faster trend-following systems. although in some markets fast systems con-
sistently outperform slow systems, in most markets the reverse is true, as the minimization of losing
trades and commission costs in slow systems more than offsets the reduced profits in the good trades.
This observation is only intended as a cautionary note against the natural tendency toward seeking
out more sensitive systems. However, in all cases, the choice between fast and slow systems must be
determined on the basis of empirical observation and the trader’s subjective preferences.
There is a wide variety of possible approaches in constructing a trend-following system.
in this
chapter we focus on two of the most basic methods: moving average systems and breakout systems.
Moving average Systems
The moving average for a given day is equal to the average of that day’s closing price and the closing
prices on the preceding N − 1 days, where N is equal to the number of days in the moving average.
238
A Complete Guide to the Futures mArket
for example, in a 10-day moving average, the appropriate value for a given day would be the average
of the 10 closing prices culminating with that day. The term moving average refers to the fact that the
set of numbers being averaged is continuously moving through time.
Because the moving average is based on past prices, in a rising market the moving average will be
below the price, while in a declining market the moving average will be above the price. Thus, when
a price trend reverses from up to down, prices must cross the moving average from above. Similarly,
when the trend reverses from down to up, prices must cross the moving average from below .
in the
most basic type of moving average system, these crossover points are viewed as trade signals: a buy
signal is indicated when prices cross the moving average from below; a sell signal is indicated when
prices cross the moving average from above. The crossover should be determined based on closing
prices. Table 16.1 illustrates the calculation of a 10-day simple moving average and indicates the cor-
responding crossover signal points.
table 16.1 Calculating a Moving average
Day Closing Price 10-Day Moving average Crossover Signal
1 80.50
2 81.00
3 81.90
4 81.40
5 83.10
6 82.60
7 82.20
8 83.10
9 84.40
10 85.20 82.54
11 84.60 82.95
12 83.90 83.24
13 84.40 83.49
14 85.20 83.87
15 86.10 84.17
16 85.40 84.45
17 84.10 84.64 Sell
18 83.50 84.68
19 83.90 84.63
20 83.10 84.42
21 82.50 84.21
22 81.90 84.01
23 81.20 83.69
24 81.60 83.33
25 82.20 82.94
26 82.80 82.68 Buy
27 83.40 82.61
28 83.80 82.64
29 83.90 82.64
30 83.50 82.68
239
TecHnicaL TraDing SySTeMS: STrucTure anD DeSign
 figure 16.1 shows the June 2015 WTi crude oil contract with a 35-day moving average. The non-
circled buy and sell signals on the chart are based on the simple moving average system just described.
(for now ignore the circled signals; they are explained later.) note that although the system catches
the major downtrend, it also generates several false signals. of course, this problem can be mitigated
by increasing the length of the moving average, but the tendency toward excessive false signals is a
characteristic of the simple moving average system. The reason for this is that temporary, sharp price
fl uctuations, suffi cient to trigger trade signals, are commonplace events in futures markets.
 one school of thought suggests the problem with the simple moving average system is th


itigated
by increasing the length of the moving average, but the tendency toward excessive false signals is a
characteristic of the simple moving average system. The reason for this is that temporary, sharp price
fl uctuations, suffi cient to trigger trade signals, are commonplace events in futures markets.
 one school of thought suggests the problem with the simple moving average system is that it
weights all days equally, whereas more recent days are more important and hence should be weighted
more heavily. Many diff erent weighting schemes have been proposed for constructing moving aver-
ages. Two of the most common weighting approaches are the linearly weighted moving average (LWMa)
and the exponentially weighted moving average (eWMa).
1
 The LWMa assigns the oldest price in the moving average a weight of 1, the second oldest price
a weight of 2, and so on. The weight of the most recent price would be equal to the number of days
 FIGURE  16.1 June 2015 WTi crude oil and 35-Day Moving average
 Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell
signal: prices cross moving average from above and close below line; = buy signal not
eliminated by fi lter; = sell signal not eliminated by fi lter.
chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved.
 1 The following two sources were used as reference for the remainder of this section: (1) Perry Kaufman, T rading
Systems and Methods (Hoboken, nJ: John Wiley & Sons, 2013), and (2) T echnical Analysis of Stocks & Commodities,
bonus issue 1995, sidebar, page 66.
240
A Complete Guide to the Futures mArket
in the moving average. The LWMa is equal to the sum of the weighted prices divided by the sum of
the weights:
LWMA =
Pt
t
t
t
n
t
n
⋅
=
=
∑
∑
1
1
where t = time indicator (oldest day = 1, second oldest = 2, etc.)
Pt = price at time t
n = number of days in moving average
for example, for a 10-day LWM a, the price of 10 days ago would be multiplied by 1, the
price of 9 days ago by 2, and so on through the most recent price, which would be multiplied by
10. The sum of these weighted prices would then be divided by 55 (the sum of 1 through 10) to
obtain the LWM
a.
The eWMa is calculated as the sum of the current price multiplied by a smoothing constant between
0 and 1, denoted by the symbol a, and the previous day’s eWMa multiplied by 1 − a:
EWMA EWMAtt taP a=+ − −()1 1
This linked calculation wherein each day’s value of the eWMa is based on the previous day’s value
means that all prior prices will have some weight, but the weight of each day drops exponentially the
further back in time it is. The weight of any individual day would be:
aa k()1 −
where k = number of days prior to current day (for current day, k = 0 and term reduces to a).
Since a is a value between 0 and 1, the weight of each given day drops sharply moving back in time.
for example, if a = 0.1, yesterday’s price would have a weight of 0.09, the price two days ago would
have a weight of 0.081, the price 10 days ago would have a weight of 0.035, and the price 30 days ago
would have a weight of 0.004.
an eWMa with a smoothing constant, a, corresponds roughly to a simple moving average of
length n, where a and n are related by the following formula:
an=+21/( )
or
na a=−() / 2
Thus, for example, an eWMa with a smoothing constant equal to 0.1 would correspond roughly
to a 19-day simple moving average. as another example, a 40-day simple moving average would cor-
respond roughly to an eWMa with a smoothing constant equal to 0.04878.
241
TecHnicaL TraDing SySTeMS: STrucTure anD DeSign
 in my view , there is no strong empirical evidence to support the idea that linearly or exponentially
weighted moving averages provide a substantive and consistent improvement over simple moving
averages. Sometimes weighted moving averages will do better; sometimes simple moving averages
will do better. (See chapter 11 for an illustration of this point.) The question of which method will
yield better results will be entirely dependent on the markets and time periods selected, with no rea-
son to assume that past relative superiority will be indicative of the probable future pattern. in short,
experimentation with diff erent weighted moving averages probably does not represent a particularly
fruitful path for trying to improve the simple moving average system.
 a far more meaningful improvement is provided by the crossover moving average approach. in this
system, trade signals are based on the interaction of two moving averages, as opposed to the interaction
between a single moving average and price. The trading rules are very similar to those of the simple
moving average system: a buy signal is generated when the shorter moving average crosses above the
longer moving average; a sell signal is generated when the shorter moving average crosses below the lon-
ger moving average. (in a sense, the simple moving average system can be thought of as a special case of
the crossover moving average system, in which the short-term moving average is equal to 1.) Because
trade signals for the crossover system are based upon two smoothed series (as opposed to one smoothed
series and price), the number of false signals is substantially reduced. figures 16.2 , 16.3 , and 16.4
compare trade signals generated by a simple 12-day moving average system, a simple 48-day moving
average system, and the crossover system based on these two averages. generally speaking, the crossover
moving average system is far superior to the simple moving average. (However, it should be noted that
 FIGURE  16.2 e-Mini nasdaq 100 continuous futures with 12-Day Moving average
 Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell
signal: prices cross moving average from above and close below line.
chart created using TradeStation. ©TradeStation T echnologies, inc.