Channel Surfing: Riding the Waves of Channels to Profitable Trading

Channel Surfing Riding the Waves of Channels to Profitable Trading

by Michael J. Parsons

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1663 £tHER7Y DRIVE, SUITE 200 BLOOMINGTON, INDIANA 47403 (800) 839-8640 wwW.AUTHORHouSE.COM

© 2005 Michael J. Parsons. All Rights Reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted by any means without the written permission of the author.

First published by AuthorHouse 03/16/05

ISBN: 1-4208-3312-X (sc)

Printed in the United States of America Bloomington, Indiana

This book is printed on acid-free paper.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi­ cally disclaim any implied warranties of merchantability orfitness for a particular pur­ pose. No warranty may be created or extended by sales representatives or wrillen sales materials. The advice and strategies contained herein may not be suitable for your situ­ ation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. It should not be assumed that the methods, techniques, or indicators presented in this book will be profitable or that they will not result in losses. Past results are not neces­ sarily indicative of future results. Examples in this book are for educational purposes only. This is not a solicitation of any order to buy or sell. The National Futures Association (NFA) requires us to state that "Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under or over compensat­ ed for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve proi f ts or losses similar to these shown."

To my mother Peggy whose legacy still impacts this world for good more than a quarter of a century after she left it and my wife Ruth who stood by me through all the good, the bad and the ugly this world had to offer.

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Table of Contents 1.

Channel Surfing - The Basic Concept . .

2.

Break ing Waves

3.

Kiss of the Channel Line

4.

Major Price Levels

5.

Determining Balance Of Power

6.

Doing the Math - Setting Stops and Calculating the Waves

7.

Multiple Time Frames

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II. Putting It All Together

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True Support and Resistance

]0. Trading Options

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8. The Repeating Channel and Trend Angle 9.

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1 05 121 131 1 55 181

Introduction Trading is a blessing and a curse. It is a blessing in that no other occupation can be more exciting and rewarding than trading. You literally can become a mill ionaire overnight or at least in a very short period of time. On the other hand, trading is a curse because it is more likely that you will make someone else rich long before you have any real success. It is without a doubt the most expensive education you can obtain. In the process of educating yourself it can destroy your marriage, your retirement, your home ownership and many other things that take a lifetime to acquire. Poor money management, inability to control one's emotions and a clueless approach to trading leads many down the road to the poor house paved in fool's gold. It may look great to walk on, but who really wants to go there? My own introduction to this blessing and curse came from a man in a cowboy hat that made trading sound like child's play. Very quickly I realized that I was in over my head and that this man probably would have sold me the Brooklyn Bridge if given half a chance. Since then I have hit rock bottom twice while trading. (A nice way of saying I lost it all) After my last fiasco, I decided since I couldn't find any method that worked to my satisfaction, that is a method that actually made money, I would discover one for myself. This lead to a number of observations and discoveries of how the market works, why it behaves the way it does and more importantly, several methods that actually work that are based on the geometry of the market. Channel Surfing is one of those methods, providing an in-depth understanding of the markets that you will rarely find elsewhere. As you read this book you can expect to learn the following: The basic concepts of Channel Surfing, presented i n a way that is easy to understand and easy to apply. 2. Why channels are a natural phenomenon and how to take full advantage of this. 3. How to take the basic concepts of Channel Surfing and catapult it into an even more powerful method of trading using advanced techniques. 4. Additional tricks to reading the geometry of the market that add to your success. 1.

IX

While there exists an endless array of indicators available to use in this day and age, most have one common fail ing; they fail to adapt to changing market conditions. Channel Surfing succeeds in adapting to market conditions because channels are actually weaved by the market itself. Price rarely moves in a straight line, therefore channels provide the ultimate momentum indicator. Despite its adaptability, Channel Surfing continues to outperform many of the most popular indicators in use today, time and time again. The beauty of it is that it doesn't require you to suffer through large drawdowns in order to realize a profit. I n fact, it is so effective that it is probably the very best approach for beginning traders and those with very little capital. So just imagine what an experienced and well-funded trader can do with it! Although a parallel is made with actual surfing, this is a methodology that is about something very serious, trading profitably. But obviously the more success you have and the greater your confidence in your ability to extract a profit, the more pleasurable it becomes. Success and confidence are directly influenced by your ability to understand the market that you are trading. To that end each chapter of this book will take you step by step through the process of reading the language of the markets. Put into practice an individual can look at a market and recognize how it is likely to behave and react to the various situations that arise, a skill that often takes decades for a person to develop. Chapter one begins by covering the basic concepts of Channel Surfing, with nineteen illustrations that make it easy to comprehend. Five different entry methods are covered, along with two exits. These basic concepts alone can dramatically improve a person's trading success, but this is only the begi oning. Chapter two describes several specific entry methods that enhance the basics and provides more opportunities to enter a market with low risk. Chapter three delves into an important price phenomenon that can be exploited for profit. It also takes a closer look at the psychological aspects of trading and how they impact success. Chapter four examines major price levels, which include much more than just support and resistance. M ajor Price levels impact how trading decisions are made and can even contradict normal guidelines, so they are discussed in detail.

x

In chapter five the balance of power is discussed. What is the secret to knowing the bias of a market? The answer is detailed here from the most subtle indications on up to the larger and stronger signals. The math of Channel Surfing is covered in chapter six. Calculations are a requirement if you want to provide specific entry and exit numbers to a broker, but they also provide several other advantages as welL. Chapter sevcn elevates Channel Surfing to another level by using multiple time frames as a basis for trading decisions. This one technique will dramatically increase the odds of success in any trade you consider. Chapter eight brings a series of additional techniques to the table that enhances trading even further. Simple and effective, they provide additional tools to your trading arsenal that will cut down to size any market that is stubborn ly refusing to be analyzed. Chapter ninc is a real eyc opener and after reading it you will never look at a chart the same way again. True support and resistance flies in the face of traditional technical analysis, but it has proven itself time after time. Practically every consolidation pattern, reversal and acceleration can be understood and even predicted by using this invaluable method of reading a market. In chapter ten options are discussed. Options offer a great opportunity for profit if you can accurately identify where a market will go and when it will be therc. How to determine these key factors are outl ined. Chapter eleven brings everything together providing several trading examples that show how to effectively use these methods. A sobering look at the reality of trading is discussed, as well as some additional factors that will impact trading success. The techniques and methods discussed in this book provide a complete trading plan that improves as the skill of the user improves. More than what is needed is discussed so that an individual can adopt what fits their particular style of trading. But initial ly the most conservative techniques should be utilized. For example, some entries described in this book can be very aggressive and have been identified as such. While such high-risk entries are at times discussed, several that are low-risk are emphasized throughout this entire book that will provide plenty of profitable trades without the need of such aggressive tactics. So initially focusing on the conservative techniques is strongly encouraged. Xl

Channel Surfing is a solid foundation for understanding the language of the markets. Even though my research has led to other advanced and powerful trading techniques, I still return to Channel Surfing whenever I first look at a chart. I am convinced that it will become your first and favorite choice when you look at a chart as well. For all its simplicity it remains an exceptionally powerful technique because it keeps losses low and profits high. I wouldn't trade without it. Besides, what could be more fun than surfing? Especially when it is profitable!

Xli

Chapter One

Channel Surfing - The Basic Concept A surfer surfing a wave, a sailboat sai ling with the wind and a glider soaring an updraft all have one thing in common. They catch and ride natural forces in motion. Yet, a surfer has no more control over a wave than a sailboat can direct the wind. They simply take advantage of forces that already exist for their benefit. It is no different for a trader. During the course of a long and successful career in trading an individual will weather many storms and lulls in the markets and face many updrafts and down drafts. No one can dictate how the market will act, but that doesn't mean that we can't learn how to take advantage of the forces that develop. Have you ever seen what a surfer does when a storm brews? As a storm hits a coastal area most beachcombers wil l avoid the beach. But a surfer sees this as an opportunity and they will come out in droves l ike sharks circling bait in hope of surfing larger and better waves. In a sense, trading is the same because a market storm can result in some wild swings and potential ly offer an exceptional ly high return. For an inexperienced surfer, such a storm could mean a wipe�)Ut just as surely as a stormy market often does for an inexperienced trader. In contrast, a storm for an experienced surfer can mean the ride of his life, just as a wild market can mean a windfall for an experienced trader. In many ways the market behaves just like the waves of an ocean, so forming a parallel between a surfer and a trader is as natural as a wave breaking along a beach. The similarities between surfers and traders are

Michael 1. Parsons

uncanny. A surfer will wait until he finds the best wave, time his entry, ride that wave as long as he can balance on it and then go back out to catch another wave. Guess what a successfu l trader does? He waits for and chooses the best market, times his entry, rides that market as far as he can manage and when the ride is over he starts the whole process all over agam. Throughout this book you find many references to the simi larities that exist between surfing and trading. But in all seriousness this book is about a trading method that actually works and has proven to be one of the easiest to learn, easiest to apply and easiest to fol low. Particularly if you are a beginning trader or have a very limited budget you will appreciate how this method overcomes your limitations by providing you with low risk and high return. The analogy to surfing serves to give you a visual aid to understanding what it takes to be successful in trading. But where a surfer surfs the waves strictly for fun, you will be surfing the market for both fun and profit. So how do you surf the markets? Visualize for a moment a surfer surfing a wave. He rides a flat board that he balances on the cascade of a breaking wave. I nitially, he sets up where waves first break at what is known as the impact zone and makes a wave (catches a ride), and balances for as long as he can until the wave finally collapses on itself just shy of the beach. Once the wave dies and slips away from under the surfboard, the ride is over and its time to set up for the next wave. Channel lines act as your surfboard and price your wave. As long as your surfboard rides the price wave, then you just have to keep your balance and enjoy the ride. When price slips away from your channels then the ride is over and it is time to set up for your next wave. In other words, Channel Surfing uses channels to set the parameters for price movement. For those of us that are mathematically impaired, this is a graphical way to determine what the market can be expected to do and not do. The value of this is that if it exceeds these parameters then you are alerted to a change in a market's condition and the need to make a change in your trading. Here is how it works: Once a market is moving, you draw a trend line fol lowing the edges ofthe price bars using the highs or lows as your gauge. Normally, you will need to have at least two highs or two lows to draw your l ine from and the more highs or lows to work with, the better. But it 2

Channel Surfing

is not a matter ofjust finding the most bars, but rather the bars that outl ine the extreme of price activity. So there may only be a few bars to work with, particularly when a trend is new. However, as a rule the greater the number of bars that support a trend l ine, the stronger these l ines will be. On the other side of the price movement you also draw a simi lar trend li ne and thereby, create a channel . In effect, you put a fence around the price movement and provide a visual range parameter. Each price bar that fol lows should be within that channel and whenever you see a price bar exceed one of those channel l i nes then you know it is time to take action. The highs and lows you draw to create a channel should enclose all the price movement, so you are looking for the extreme highs and lows that fol low a singular direction. For the length of this book I will be differentiating between these two l ines by referring to them as an outside l ine or inside line. By definition, the inside line is the channel line that is always to your right, whether the trend is up or down. The outside line is the channel line that is always to your left. So if you have an up trend, the inside line is the supporting line, while the outside line is the resistance line. In a downtrend, the roles are reversed and the inside line is now resistance whi le the outside l ine is support. Notice in Figure 1 - 1 how the channel is drawn and that there is an inside and outside line that will reverse roles depending on whether you are in a bull or bear market (up trend or down trend)

The extreme swings of a trend are used to define a channel

3

Michael 1. Parsons

What if the market happens to be i n a sideways pattern? The principles are the same with one exception; channel l ines are drawn horizontally rather than diagonally. When the channel lines are horizontal there isn't any inside or outside l ines. So i n this case the channel lines are simply referred to as the upper and lower channel l ine. Figure 1 -2 demonstrates how this is done.

Lower Channel Line

QQQ 1 Minute

Exiting with channels

So now that we have a basic concept as to how to draw our channel, how do we use it? Success in trading depends on putting the odds i n our favor. By this I mean that we want the odds favoring that the market will go in the direction of our trade. But we also want the odds favoring profit over loss; that is we want our losses to be small and our profits h igh. As in any game you might play success in trading isn't about making all the points but winning more points than you lose, or in real life terms, winning more dollars than you lose. Putting the odds in your favor is not a matter of luck, but a matter of evaluating the risks, determining what the odds favor and then taking the position that is favored to win. The channel is our guide for evaluating our risk, a basis for making our trading decisions and for weighing the odds of any trade. As long as price remains within a channel and moving our way, then the odds are in our 4

Channel Surfing

favor. But as soon as price extends outside a channel the situation has changed and so have the odds. It is now time to exit. Exiting is a key component of Channel Surfing and it happens to also be a key component of successful trading. Initially, most traders want to focus on their entries, thinking that if they enter well then they are bound to make a profit. While it is true that entries can make a substantial impact on any trade the reality is that exits have an even greater impact. An entry only deals with one thing in your trade, the starting point. But exits incorporate two elements, the avoidance of unnecessary losses and the locking in of profits. Just consider one exit fault that can sabotage your success; exiti ng too soon. I f you exit too early such as just before a market starts to move in your favor, then it doesn't matter how great of an entry you make because you stiII take a loss. I n l i ke manner, if you exit before a trend has a chance to finish its run then you miss out on a large part of the profits. A bad entry can mean a small loss, but a bad exit can mean a financial disaster. So if exits arc one of the most important aspects of trading then it is essential that we understand how to determine our exits properly and when to exit. So for the next few moments we will be examining how Channel Surfing determines exits. Trends tend to offer some of the best tradi ng opportunities in trading, so we will look at one in our first example. I magine that you have shorted or sold a market that is in a downward trend. The trend has established a wel l formed channel that the market is fol lowing perfectly. Suddenly the market slows down and extends through the inside channel Line and price bars start to close beyond it, breaking the channel. When this happens the first rule of Channel Surfing is to get out as soon as possible because this signals that the market has changed and likely will extend into a sideways pattern or possibly reverse direction entirely. Take a look at Figure 1 -3. In this chart example I have entered a trade by shorting (selling) a contract at the point it breaks a support l ine. As it drops, channel lines are drawn. Later, the market extends beyond the inside channel line and an exit is signaled.

5

A4ichael J Parsons

An exit is signaled when the market breaks out of the channel - Its time to lock in the profits!

A short is taken when the market breaks an inside channel line and holds

Hewlett Packard

The signal is relatively simple, break the l ine and you exit. To clarify this a l ittle, you are looking for an actual break and not j ust a touching of the line. Price is expected to have contact with the line, but an actual break where price extends beyond it is another story. This is particu larly true if price not only breaks the l i ne, but price bars actually close beyond it. But in Channel Surfing we use two l ines, not just one. So what if price exceeds the opposite line? The answer again is to exit. Even though it may look like the market is accelerating in your favor, when this line is broken it usually develops into a reversal. So despite the apparent good fortune, an exit is still called for. Notice Figure 1-4 and what happens. Odds are that by exiting when a channel line is exceeded you are locking in the highest amount of profit. This is particularly true when an outside l ine is broken because an accelerated move usually ends in a spike before reversing direction. This phenomenon occurs because price hits a critical level and the market over-extends itself. For many unskil led traders this is a temptation they can't resist, a move that appears to be rocketing out of control. Only they are in for a surprise because a rocket out of control usually comes crashing down to the ground. By over-extending itself a market has in essence doomed itself to col lapse.

6

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Since we are using two channel lines that require an exit if broken, then two stop orders would be needed instead of just the usually one stop limit. Additional ly, should either exit order be activated, the remaining order would then need to be cancel led at the same time. Such requirements in your orders can be placed with a broker, but might be diffic ult with some on-line order systems. But aside from these additional requirements, the method is relatively simply to apply. Stop l imit orders are placed just outside, but close to the channel l ines. They cannot be equal to them because the market is expected to actually reach them and you would be forced out of the market needlessly. I f you are trading daily charts and are able to watch the markets during the day, then do not exit immediately when an outside channel line is broken. The reason is that a break of an outside channel l ine often leads to a price spike and a market will tend to move some distance before actually reversing direction. So sometimes it works to your advantage to wait a little longer while it extends as far as it will go before exiting your position and thereby capture more profit. Simply establ ish a new channel line at the accelerated rate and fol low price until this new and tighter channel line is broken. Whether you diligently watch the markets through the day, set a stop based on a recent high or low, adjust your stop at different intervals as the day progresses, or simply have an alert that notifies you when price exceeds a parameter, the idea is to take advantage of the continued move 7

Michael 1. Parsons

fol lowing a channel break until the trend falters. But even if you take the easy way out and place a stop j ust outside the two channel l ines, the key is to keep oneself protected from any undue risk. Just make sure your broker u nderstands that if one order is fi l led that in turn, the other is canceled or you will end up entering a market unexpectedly. There are times when "flipping" your position may be something you would want to do, but usually this is inadvisable. From an emotionally standpoint, exiting out of a market when it appears to be rocketing in your favor is a l ittle hard to accept. After all, the market is accelerating and most traders would think that this is very positive, not something negative. So why would you want to exit at this point? Won't you miss a lot of profit? There are times when you will miss a profit, but look at this realistically; what usually happens when price exceeds the outside channel? Usually it turns around and reverses direction. I f you tried to hold onto your position in the hope that it will continue accelerating, then you will most likely lose a portion of that profit. The loss will frequently exceed any profit you might have gotten by chasing after the market. So unless you are able to closely monitor the move as it is developing, it is best to leave it alone and gracefu l ly bow out. There is an exception to this rule that we will cover much later, but for now the rule is: Exit whenever a channel line is broken, plain and simple. A word of caution is in order here. When a strong trending market exceeds the outside channel it is a sign for exiting your position, not reversing it. I f the market should continue and gap the result could b e a substantial loss. Discretion is the better part of valor here. When a trend initially begins and the first line of support or resistance establishes itself there will be a question as to where to draw an outside channel line, which is used to determine the limit of how far the market is expected to travel. As this point, simply create a line that is at the same angle as your first channel line and place this on the solitary high or low that currently exists on the opposing side. I f you have a charting program that allows it, just duplicate the l ine and move it into place. As a trend develops, channel l ines tend to run parallel to one another and so either l ine can be used to as a gauge for the other. This enables you to establish the channel parameters very quickly and later on you can adjust it as necessary to the actual market when the trend becomes fully 8

Channel Surfing

established. Often there will be a slight variation, but as a rule they will generally be very close in angle to one another, if not exactly the same. The exception is ifthere is an imbalance of power, which will be discussed in a later chapter. In Figure 1 -5, the channel line created by the supporting trend line is dupl icated and then moved with the same exact angle to new high. This completes the channel and provides a starting point to work with. As other highs are established an adjustment of the channel line can be made accordingly.

Resulting i n an exit near the top

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Because this is only an estimated and temporary channel line rather than an actual one, there will be a need to allow some leeway as price approaches it. Price may either fai l to reach it or actually exceed it by a small amount. In either case, price should draw close to the estimated l ine. If not, then it could indicate a problem with any trend development. Additionally, while the line may be broken there should be no substantial move beyond it and any break should only be short-term. Any excessive break or delay in reversing would indicate that your parameters are off. Fortunately, you usually do not have to wait long before you know exactly where a market permanently sets the outside line. From a trading standpoint, the advantage of having an estimated channel l ine is that you know approximately how far price should move. When price backs away after reaching this l ine it wi ll not come as a surprise and create a panic. But there are other reasons for using an estimated channel l ine. 9

Michael J. Parsons

I f price fails to reach this level it would be an early sign that the trend is too weak, giving you an opportunity to exit before it falls back into a losing position. Additionally it can help you to avoid excessive draw down and open up the opportunity to profit twice, taking advantage of multiple moves covering the same territory. I f the distance between the two channel lines is great enough, then it may be more profitable to exit near the opposing channel line (even if it is an estimated one) and reenter when price comes back to your original channel l ine. Because Channel Surfing is so flexible, you can adapt it to all markets, time frames, and market conditions. Figure 1-6 demonstrates how Channel Surfing can be adjusted for a market that is accelerating. This is an important aspect of Channel Surfing because it allows you to always be one step ahead of the market.

Inside c:hannel lines narrow as a market accelerates, tightening your stops and protect your profits Clta.rt

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Initially, a trend can develop a wide channel that narrows down as it accelerates. This acceleration will draw price away from the inside line, diminishing the value of that l ine. This in turn will require an adjustment of the inside line to match the new parameters, even ifprice shows no signs of altering the outside line. An adjustment is made by drawing a new line to replace the outdated one. So as a market narrows, you in turn narrow down your channel line to match it and repeat this as often as necessary. Because trends have a habit of repeating this process several times before the trend actually ends, you frequently end up with a fan l ike pattern. The adjustment of a channel l ine is a one-way affair that continually tightens yoUl stops as the market accelerates. Each new fan line becomes the only 10

Channel Surfing

inside channel line you are concerned with because as soon as the tightest angle is violated, you exit. Handling market acceleration this way allows you to closely monitor your trading and protect your profits. To summarize what we have covered so far; two l ines are drawn to enclose price activity and when price violates either of these l ines you exit your trade. In market acceleration, draw additional new channel lines that form a fan pattern and exit when the tightest of these lines is violated. These rules for exiting will help you to trade more successfully. But for these rules to be of any value, we sti l l need a way to enter a market in the first place. So this is the next area that we will consider.

Entries using channels

Because a wide variety of market conditions can arise, there is in turn a wide variation of entries that can be chosen. The approach you take will depend to a large degree on your risk tolerance. So one determining factor is how aggressive or conservative of a trader you happen to be. Aggressive trading would be viewed as trading with greater risk in the hope of more robust profits, whi le conservative trading would be viewed as exposing yourself to much less risk, but in turn, accepting lower profits. Despite the impl ications, don't automatically assume that aggressive trading is always more profitable or that conservative trading always has less risk. The approach one takes should be based on the conditions of the market that is he or she is trading just as much as one's own trading style and risk tolerance. So the first step is to evaluate whether or not the risk is acceptable to you. This leads to an important question that needs to be answered before entering into any trade; what is the potential return as compared to the risk? This is known as the risk/reward ratio and is a simple mathematical calculation where you divide the potential reward by the potential risk. Ideal ly, you would want a ratio of four to one. In other words, a trade should have a potential profit that is four times greater than the risk that is being taken. Now at this juncture you may be asking, how am I supposed to know what the potential profit will be? Don't worry; you don't have to be a psychic here. We are not talking about predicting the future, just estimating the potential move.

11

Michael 1. Parsons

There are two factors to determine here. First, you are determining where you would exit or place your stop. The difference between this figure and your entry is the risk of your trade. Second, you are determining the likely move of the market and the difference between this and your entry provide your potential reward. This last figure is based on a market's previous action, any channels that develop, and the current trend. Support and resistance levels and recent swings provide a gauge of previous market activity. A larger channel than you are currently trading provides a gauge of possible price movement and this will be covered in more detail later. Additionally, channels provide key information about potential trends and what can be expected. For example, an up trend that has an average move of ten points each day and today happens to have an expected range from 100 to 110. If we are able to enter below 102 and thereby only risk two points while having the remaining potential of an 8 point move, then you would have met the criteria of an acceptable risk/reward ratio. Why would determining a risk/reward ratio be critical? There are two important reasons why, money management and controlling the emotional aspects of trading. These two also happen to be top of the list for destroying trading success. For example, often a trader will attempt to jump into a market when it appears to be building momentum and speed. But commonly this is exactly where a trend will come to an end and reverse direction. But because the trader entered so far beyond any stop that he will set, he has to allow a greater amount of risk and when wrong, accept a much greater loss. Even ifthe market goes your way you can still lose money if the risk/reward isn't reasonable. Slippage alone can eat away at your profit. Imagine the frustration you would have if you tried to buy at 1000 and actually get filled at 1002 and then turned around to sell at 1003 only to be filled at 1001.5. You may have been right about the market and what it would do, but you still lost money because of slippage. Breaking even on a trade is still a loss because you have to pay your broker. Remember that you are trading to make yourself rich, not your broker. Determining your risk/reward ratio helps to put the money in your pocket rather than someone else. The first approach to determining the risk/reward ratio is to simply calculate the trend average and find an entry that is on the favorable side of the trend. What this means is that for you to enter on a four to one ratio you would need to enter within the best quarter of that range. Subtract the low from the high of a channel to determine a trend average and then divide this number by four. Add to or subtract from your inside channel 12

Channel Surfing

line and you know the ideal zone to enter. Ideal is not always practical and there will be times when a trend will not cooperate with this ratio of entry, such as during times of a trend acceleration. In such cases you may have to accept a greater risk, perhaps attempting to enter when you have a two to one ratio. Even though this may be required from time to time, most trends will work with a four to one ratio and an adjustment will not be necessary. Don't allow a trend that is simply uncooperative for a few days allow you to fal l into the bad habit of chasing a market. I n any event and regardless of the trade situation, you should always have a greater potential reward than any risk. If you have an equal risk/reward ratio then it is no better than just flipping a coin. Once you have an acceptable risk/reward ratio, the next step is to enter. There are five specific entries that we will be focusing on in this chapter. There is an aggressive and conservative entry, each with its own specific rules. Additionally, there is an inside entry that borrows from both of these entries. Finally, there arc two other entries called the rebound entry (sometimes referred as the "kiss entry" for short) and the trend entry, which is used for entering after a trend has been established. Initial ly, the focus should be on the conservative entry and the last two entries (kiss and trend entries) because they provide the least amount of risk. So these three entries should be learned first, even though two are actual ly l isted last. In the fol lowing chapter some additional entries will be expanded on that are designed to adapt to breakout situations that frequently arise.

Conservative Entry

The rule for a conservative entry is as follows: Enter when an inside channel l ine is broken and price bars close beyond that line. Waiting for price to close beyond a channel l ine ensures that a break isn't just a rogue spike. Further, it usually doesn't hurt to wait for multiple closes either. A bar close is simply a term that defines where price settled in a given time period. So the issue here is not whether or not price extended into an area, but if it stayed there until the next time period began. Whi le there is a risk of a market rocketing off and leaving you behind as you wait for the confirmation of a bar close, odds are that it won't. In fact, a market will usually pull back toward the prior channel l ine before 13

Michael 1. Parsons

continuing with a new trend. I n the early stages of trend formation there is a strong possibility that a market will give you a false signal. I f this were the case, a premature entry would put you on the wrong side of the market. So this is a good low-risk rule of entry. To illustrate, if you had been in a downtrend and the inside channel line (the one acting as resistance) was broken by price fol lowed by price bars closing beyond that line you would then buy or enter long. In the opposite scenario of an up trend you would then go short after the inside channel line were broken and price bars closed beyond the line. If the market had been in a trading range or sideways pattern and both your channel l ines are horizontal then you would enter when either of these l ines is broken and price closes beyond that line. Figure 1-7 provides an example of a conservative entry.

Enter on the

Crude

all

Ckart

The previous inside channel l i ne now becomes your initially stop. So the rule then would be that if price exceeds an inside channel line and then returns back within the prior channel, then your trade is a bust and you need to exit. A prior channel usual ly works wel l as a temporary stop, but there is a problem that can sometimes arise when using this method. The prior channel line is al ready headed in the opposite direction of your trade and so the stop limit wil l natura l ly increase with time, increasing risk right along with it. Obviously then, an additional limit on your trade is needed. If a new channel has

14

Channel Surfing

al ready begun to form in the direction of your trade, even if it is only partially formed, you can use this to l i m it the risk. However, if there were no clear indication of where to place a stop then a temporary substitute would be necessary. This can be a prior low or a certain limit based on bar movement, such as a maximum of three bars against your trade. For example, if you had entered long and each succeeding bar crept lower, then when a third bar made an additional low you would then exit. Most brief pul lbacks will be three bars or less. A maximum bar limit is comparable to another version ofa temporary stop, the time limit. As mentioned earlier, if price lingers excessively without reversing direction it can be an indication of a consolidation pattern rather than a reversal. Sometimes when this happens it is simply better to get out of a trade when it is convenient. Later, if it does start to go your way you can look to enter again.

Aggressive Entry

The rule for an aggressive entry is as fol lows: Enter when the outside channel line is broken and the developing secondary channel breaks. Remember when I said earlier that a spike that extends beyond the outside channel will often signal a reversal? An aggressive entry takes advantage of this. In this case you are not waiting for any close, but for a spike beyond the outside channel l ine to lose momentum and reverse. This approach has much higher risks and is not for the faint of heart, but if done properly can result in profiting l iterally from one end of a move to the other. There are times when this trade should never be attempted, such as when the market breaks a major high or low or when a report is fueling the move. A market should have already demonstrated that it is a strong candidate for this type of entry even before considering it. If a market is prone to wide swings and sharp reversals then it is worth considering, but if it instead tends to be a slow moving market or one that has had a strong trend that just won't quit then it is inadvisable to attempt this entry. Here is how it works; as a market accelerates it w i l l develop a series of inside channel lines that fan the market tighter and tighter. Earl ier we discussed this phenomenon and used it to signal an exit for locking in higher profits. The difference here is that we are now using it to signal 15

A1ichae/ J Parsons

an entry in the opposite direction of the prevailing trend. To do th is requires that a trading position be very closely monitored, but because we have a break in the larger outside channel there is already a strong indication that a reversal can be expected, even if we initially do not know exactly when this will take place. It is a way of day trading a market even if you normally do not day trade or an aggressive way to extract extra profits if you do. This doesn't mean that you have to suddenly drop everything that you are doing in order to watch the markets. You are simply l ooking for an indication that the market has reversed off the new high or low. Periodically checking a market, having an alert sent to you, placing an order to enter if the market moves off a new high or low by a certain amount, or half a dozen other methods can have you in the market where you need to be. Figure 1 - 8 illustrates how this is done.

When the outside channel line (Line "A'� breaks. enter as the accelerated secondary channel line (Line "B'� breaks

CIw1

.rMetaSiock

A word of caution, if you arbitrarily use this entry you wil l end up being fooled by false signals and take frequent losses. So there are a few qualifying factors to look for. First, the channel line should have been part of a solid trend that had previously held back numerous price bars. You need to have a trend that would naturally elicit a strong reaction when it is broken, so we are not talking about a newly formed trend here. Second, the characteristic spike that shows up as the outside channel line is broken should be an excessively long bar compared to the normal pace of the market. There should be no question that this bar broke the channel 16

Channel Surfing

because it should stand out like a sore thumb. It should also show clear signs of reversing off its extreme high or low. The bar must indicate that it wants to retrace the entire move made by this spike. So you want to see some type of smaller reversal develop that indicates the extreme move is over. In any event, be cautious of any prior highs or lows set earlier by a market. I f this bar breaks a major high or low it can have a tendency to continue the move rather than reverse off of it. So never attempt this at major resistance or support zones. Third, price should reverse immediately off of this bar. This entry should have no delay and each succeeding bar should exhibit a clear change in direction. Aside from the possibility of a spike that is composed of two bars rather than one, no other bar should be equal to, much less exceed it. Any questionable action on the part of price should have you exiting in post haste. Because it requires the abi lity to recognize a number of factors, beginners should avoid this entry altogether. It should only be attempted by experienced traders who understand the subtleties of market action. Normally you should avoid high-risk trades, but if done right th is particular entry can offer some powerful returns.

Inside Entry

An inside entry takes something from both of the previous entries. Like the conservative approach, the entry is signaled with the break of the inside channel line. But like the aggressive approach, you are entering as soon as the break occurs rather than waiting for price bars to close beyond that line. The rule for an inside entry is as fol lows: Enter as soon as an inside channel line is broken. So as soon as the inside channel line is broken you enter in the direction of the break. I sometimes refer to this as a passively aggressive entry, which fits very well but is a term too lengthy to use often. Figure 1-9 shows how the entry is signaled.

17

A{ichae/J. Parsons

at the break of the inside line without waitin g for price to close beyond it

In my own personal trading I tend to favor this approach, but it does require you to be very alert of any sign of fai lure. Just as it is true with the aggressive approach, an inside entry can frequently lead to false signals if you arbitrarily use it. Many ofthe qualifying factors to look for are similar to the aggressive approach, but with a few minor differences. You still want to see that the channel l ine was part of a solid trend and it certainly doesn't hurt to see a spike of the outside channel either. But a spike is not necessary to actually take this trade. However, it does provide an added basis for confidence. Either way, this entry stil l requires you to be nimble and exit at the first sign of trouble. The difference between this entry and the other two has to do with how the market may develop fol lowing the signal . A spike should reverse very quickly, but a break of the inside channel line may take time to develop. Price should fol low through within a reasonable amount of time, but remember that it often requires a l ittle time to build a base to launch from. So the issue is not whether price l ingers, but if it lingers excessively. If what you thought was a reversal turns out to be just a trading range (which can be a waste of time to trade) or worse, a pause in the market that leads to a continuation of the trend, then an exit is cal led for. But obviously, if you jump ship too early you could miss out on a boatload of profits. So anything that happens after the break must be weighed as it develops. What then is a reasonable amount of time? This is a judgment call based on market conditions and how a particular market normal ly behaves, so 18

Channel Surfing

it helps to be wel l acquainted with the characteristics of the market you are trading. But there are two characteristics that may develop that will be important signs. The first is if a market returns to the same high and low price more than two times. In other words, you should see succeeding highs or lows, not a return to the same price level repeatedly even if it isn't the highest high or lowest low. Failure to make progress implies a trading range. The second is if price returns to the actual previous high or low that the market reversed off of in the first place. Neither of these signs is encouraging. When a trade starts to become questionable it is often best to look for a convenient exit. Entries always have risk associated with them and that includes these three. Even the conservative entry is not always low risk, but these entries are designed to get you into a market early enough to benefit ful ly from a new trend. However, a trend can stil l fal l apart and drop into a trading range or revert to its previous direction. Therefore, you need to always determine what your exit will be BEFORE you enter any market. This point is extremely important. If you trade like a cowboy who is shooting from the hip, then you are likely to be gunned down. Know what your escape route is before you are caught in the crossfire. Entries are just one aspect of the trading equation. When market conditions make these entries too risky, then a more conservative approach is needed. The next two methods of entry provide this and are the two that I recommend that you start with, adding the rest later on as your experience grows. So in essence, I have saved the best for last. They are the rebound entry and the trend entry.

Rebound Entry

The rule for a rebound entry is as fol lows: Enter at the break of the secondary channel that rebounds toward the previous inside channel line, as long as it does not exceed the prior high or low. This initially sounds a l ittle confusing, but basically what the rule is saying is that you are waiting for a break of an inside channel that is fol lowed by the development of a smaller channel that rebounds back toward this previous inside channel. As long as price does not exceed the prior channel high or low, enter when this smaller secondary channel breaks.

19

Michael J. Parsons

The theory behind this entry is based on the tendency of price to return to kiss the previous channel good-bye. Most of the time price will never actually reach a previous channel l ine, but it will often make a great effort to do so. As a result, a smaller channel will develop that will angle toward the previous trend. The outside line of this smaller channel will often be a l ittle hazy, but the inside line (which is the line we are most concerned with) will usually be quite easy to define with a simple trend line. When this smaller channel l ine is broken you then enter in the direction of the break or opposite of the previous trend. Figures 1-10 and 1 - 1 1 illustrate tbis entry.

�Secondary Channel that rebounds back toward the original channel

Original channel CIw1

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Enter at the break of � 'h'"" "

I

Secondary Channel rebounds back toward the original channel

Ford

20

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Channel Surfing

A word of caution when using this entry; ifprice in the secondary channel exceeds the previous high or low established by the prior trend, then the risk is dramatical ly increased and the trade should be avoided. At times price will exceed this prior level and the trade stil l goes on to be successful, but the odds in favor of this are greatly reduced. Additionally, if a market goes into a trading range it is more likely to continue the prior trend. In either of these cases it is best to look for a point to exit. If the trade unfolds the way as it is suppose to, then you have reason for additional confidence in the trade. First, you already have a break in the original channel, indicating a trend change. Second, you also have the break of the additional channel , giving more strength and weight to the trade. But there is an added bonus here. Often a smal ler secondary channel will set up the second point from which an inside channel l ine for the entire new trend will be drawn off of. So entering at the break of this channel will usually be very close to an optimal entry. So this particular entry offers one of the best approaches to entering a new trend. While there is stil l no guarantee that the trade will be successful, this entry offers some extra bonuses that put more ofthe odds in your favor which is what trading is all about. Of all the entries that we have discussed so far, this is the most important one to learn. This is the preferred entry when first starting out and the one that I encourage you to use the most. The prior entries depend on the ski l l that you develop and are used primarily with markets that frequently swing. The negative aspect of this trade is that you will miss a few trades that fai l to return to kiss the channel good­ bye. If this should happen, then you need an alternative entry. If you miss your queue on any of the previous entries and a new trend has al ready establ ished itself, another approach will be needed that al lows you to enter a trend in progress. Additional ly, it is not uncommon to find long established trends that almost a guarantee a profit if you just enter. Whether you are dealing with long established trends or short-term swings, it is always important to enter when there is a low amount of risk. Even long-term trends come to an end eventual ly. A lthough the trend entry sti l l has risk associated with it, i t i s perhaps the most conservative and safest entry of the group.

21

Michael J. Parsons

Trend Entry

The rule for a trend entry is as fol lows: Enter an established trend within one-third nearest to an inside channel l ine. What this means is that once the channel lines are established, the average range is then determined. Entry is then set at a price level that is one-third or less than that range and nearest to the i nside channel line. If a market is accelerating at a rapid pace, this ratio wil l tend to be too conservative. In such a case an alternative would be to use a one-half ratio, entering whi le in the better half. The actual calculations will be covered in more detail later, but for now simply focus on mentally gauging this ratio by visualizing the channel split into thirds and in halves. You don't have to be perfect, just close. Despite any apparent strength of a trend, you can never be sure when it will stop and reverse. Because of this possibil ity we always want to limit our risk and look to enter when price is closest to our stop. Since stops are placed just beyond an inside channel line, the closer we enter to this line the less risk we take on. It requires patience to wait for a market to come to you, but the results are much better than chasing after it. There is no way to avoid losses all together when trading, but there are ways to keep losses from putting you on the road to the poor house. So keeping losses to a minimum is a priority. A football team can have a great offense and rack up score after score, but if the defense can't stop the other team from scoring more points then they will sti l l lose the game. So the more you l im it what the market is able to take from you, the greater the odds you will come out the winner. At times this rule of waiting for the market to trade on your terms will mean that you will m iss out on some very rewarding moves, but a market that suddenly rockets w i l l also usually burn out very quickly. Figure 1 - 1 2 shows how a trend entry is made.

22

Channel Surfing ".)1

Enter when price is closer to the inside channel line of an established trend

Channel

Avoid entering when price is near this channel line Manugistics

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G• •• " H •• o. " " " .0 1@ 1$ 11 ,. TS " ., " " 1' • •9 •• " ,. ,; .< 03 " " •• I• . ,' " .. .. " n

Trend entries are an excel lent way to start out when first learning to trade. It follows the wel l known rule to trade with the trend. You are not attempting to buy a bottom or sell a top, but instead taking advantage of a prevailing move. So this entry method is one that you should learn well because it will serve you well . The negative aspect of this entry is that markets frequently swing up and down rather than move in a steady trend. So using just this method will mean that there are fewer trades to take. It also means that you will miss a good portion of any trend, at least the initial portion. But the trade-off will be that more of your trades will end up being successful. It will also go a long way to build up your confidence and skill. As you skills improve you can add the other methods of entry that fit your style of trading. Just bear in mind that with any entry you use, the key is to always enter when you have the least amount of risk. So to summarize, the entries are as fol lows: For a conservative entry, enter when an inside channel l ine is broken and price closes beyond that l ine. 2. For an aggressive entry, enter when the outside channel l ine is broken. 3. For an inside entry, enter as soon as your inside channel line is broken. 4. For a rebound entry, enter after the break of a secondary channel that returns to kiss the previous channel good-bye. 5. For a trend entry, enter an established trend closest to the inside channel line. 1.

23

A1ichael J Parsons

The fol lowing chart examples should help to strengthen your understanding of these entries. As you review them, look for ways that you can apply these principles to current markets.

Notiee how the market dropped after breaking the inside ehannel line

Chart

priee breaks the outside ehannel line----... An even better exit is signaled when

Exiting with this signal loeks in even more profit

24

Channel Surfing

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Michael J. Parsons

Conse'rvative

Trend Entry

Long from here Gold

Despite my initial recommendations, eventually you will be faced with the question as to which entries are best for you. The answer would depend on your own trading style and the amount of risk you are will ing to accept. Only you can make this decision. You may decide to use all of them or favor just one or two. There is no right or wrong answer here. But start by focusing on the two recommended methods of entries and you can expand later as you become more proficient in using Channel Surfing. The rebound entry and the trend entry tend to be the most conservative and least l i kely to cause confusion. The other entry methods can be added later as you become more comfortable with the mechanics of how they develop. As the expression goes, "the devil is in the details" and so it is true in trading. There will be many times when you will come across similar trading set ups where one will have success written all over it while the other will reek of fai lure. An inexperienced trader will look at both and see no difference between the two. An experienced trader will recognize right away that there is a distinct difference between them even ifhe can't quite put his fi nger on what that difference is. The answer will be in the subtleties that only experience teaches. So take the time needed to gain experience in using the entries discussed here and it will increase your odds of success. One example where the subtleties will make a substantial difference is in how you interpret a channel. Remember, the ideal channel will have two lines that run in parallel to one another, both set at the same angle. 26

Channel Surfing

But there are times when it is necessary to fan a channel, such as when a market accelerates. The first and foremost use of fanning is for exiting. It can be used for entering, but caution needs to be considered when doing so. You see, there is stil l likely to be an existing paral lel channel l ine even if you cannot detect it yet. An invisible channel l ine can occur with either side of a channel, but when it is an inside line it will often become a problem just when the market seemed like it had already confirmed a reversal. Often, price will just bounce off this hidden l ine and resume the prior trend. To "see" where this channel line is hiding is a simple process of duplicating the outside channel line and placing it on the inside channel point that is extended the furthest out of range. This point is usually easy to identify because it would have been the main culprit in "distorting" the inside channel l ine originally. Figure 1 - 1 8 shows an example of a hidden channel l ine.

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Channel Surfing sum mary

Before I cover any new ground on this subject, it would be appropriate to review some key points already discussed. 1.

Channel Surfing involves the drawing of two trend l ines referred to as channel l ines to encompass price movement either in a trend or in a sideways pattern. 27

Michael 1. Parsons

2.

A channel l ine is drawn off a series of highs or a series of lows. 3. The channel l ine to the right is referred to as an inside channel l ine and the channel l ine to the left is referred to as the outside channel l ine 4. Channel l ines behave as a fence and direct price in a particular direction whether this is up, down, or in the case of a trading range, sideways. 5. I f either channel l i ne is broken, than open positions would be closed. 6. There are five methods ofentry and they include; conservative, aggressive, inside, rebound, and trend.

As a reminder, a key component of Channel Surfing is exiting whenever either channel line is broken. Any open position would be closed or exited from even if it happens to be the outside channel l ine that was exceeded. This exit rule would apply to all styles of trading no matter how aggressive or conservative the approach may be. Exits can be set up by placing orders just outside the existing channel lines so that an open position would be closed if either is reached. When one order is fil led then the remaining order would then be canceled. In the case of an aggressive trader, an entry can be made when an outside channel l ine is broken as long as the situation implies that a reversal is imminent and certain requirements are met first. A passively aggressive trader would enter upon the break of the inside channel line and this is known as an inside entry. I n contrast, a conservative trader would wait until price bars actually close beyond the inside channel line before entering. A n even more conservative method is the rebound entry which is signaled by the break of a smaller secondary channel. Finally, a trend entry would be made after a trend has established itself and within one­ third of the trend range, closest to the inside channel. Before continuing, it would be good to clarify a few aspects related to developing your own style of trading. Just as a surfer can choose from among a variety of surfboards, beaches and waves, you too have a variety of choices when it comes to the markets and time frames that can be traded. The choice you make can make the difference between a profitable trade and a losing one despite the strength of any trading method you possess. In real life no one is going to buy an Enron when it is clear it's headed for bankruptcy, so don't trade a dead horse. Slippage will create problems if you 28

Channel Surfing

are trading shrimp so avoid shrimp sized markets. There is no money to be made if a stock has stayed at the same exact price for twenty years and looks to remain that way for the next twenty, so avoid sticks in the mud. Once you have a decided on a market that suits you, the next choice will be the time frame that is best for you to trade. This is not a simple decision. Too large of a time frame and the draw down will be murder. If you do not have the capital to handle larger time frames, then just a couple of bad trades wiII deplete your account in a very short period of ti me. Too small of a time frame and you will never see a profit. After all, how can you trade intra-day channels if you only check charts at the end of the day? Or how can you make any money trading minute by minute if the market barely moves at that level? Choose the wrong time frame and your trading will cause you undue frustration and losses. Your choice of a time frame is not based solely on your convenience. Just because you may l ike to trade five minute charts doesn't mean that you should. There is a balance that will be based on what a market allows and what fits your comfort level. For example, many new traders first start out trading daily charts. This can be an excellent time frame to start with unless the market gaps excessively. During times of high volatility, a market may be prone to very fast and wide swings. Trading these swings may require much larger channels that bring with them much greater risk. A single loss at this extreme size would be a huge blow to most small traders. But if you use too small of a channel then it can nickel and dime you to death. A proper channel will al low enough breathing room to allow a market to move while keeping the draw down tolerable. The benefit of Channel Surfing is that it is fle xible with many choices. If you cannot tolerate larger draw downs then it wil l just mean you will have to monitor the market more closely using smaller channels. If you have a budget that allows more room for draw down then by using larger channels you have the opportunity for greater profit with less effort. It comes down to this; your choice isn't about choosing between the largest time frame and the smallest that is to your l iking, but a compromise between the two that fits your trading style, risk tolerance, and patience wh ile providing clearly defined channels to trade off of. It is more the size of the channel itself rather than a specific time frame.

29

Michael 1. Parsons

In a later chapter we will discuss the use of multiple time frames so that you can get the best of both worlds. There is a great deal of value in using multiple time frames, but for now it is important to be able to identify which channel and time frame is right for you to trade. Figure 1 - 1 9 shows how Channel Surfing can be implemented different situations that can develop.

ill

the

What you have seen applied here with this daily chart will work in whatever time frame you are using. If you were trading intra-day, then you would use the same exact rules and techniques whether you were looking at a 30-minute chart or a 5-minute chart. The rules do not change. Trade the same way you have learned here and keep the rules simple and they will serve you well. The rest of this book will be devoted to expanding these basic concepts with advanced techniques that will drastically improve the success of this method. For this reason I would suggest that you hold off trading until you have had a chance to read what these techniques are. A lthough it is true that even without the rest of the book you would have a measure of success, the difference can be as vast as a beginning surfer trying to compete with a professional. There is no dispute that the professional will come out as the winner. Even so, what you have learned so far will serve you better than most methods that are currently used today to trade the markets and this will give you a decisive edge. While they are struggling to keep their heads above water, you will be surfing above them all and making money, and that is always fun. But then again, surfing always is. 30

Chapter TwQ

Breaking Waves To get the most from a wave a surfer attempts to catch it just as it begins to break. The area where waves start to break is known as the impact zone and this is where you will see surfers' congregate, waiting for their turn to catch a wave. Channel Surfing works in a similar way because most ofthe entries are based on the break of a channel line. But a breaking wave can at times be hard to predict. While we may already have several choices for entering a market, all of them are based on a clear and distinct channel that is either fully or partially developed. Unfortunately, some markets can be very uncooperative about revealing a channels form, making it very difficult to pinpoint a low risk entry. So a modified entry is necessary in order to get around this problem. One case in point involves the early stages of a trend before any channel is well defined. Price may be breaking higher or lower and giving clear indications that there is a valid trend in there somewhere, but you can't seem to put your finger on any specific point of entry until after it has jumped to a high-risk area. A market that repeatedly gaps and then pauses is a prime example and can be very tempting to trade because the jumps in price tend to be very quick and large moves. The problem is that every time it does pause it just lingers there without any indication of the direction the next break will be in. This can leave you very nervous about attempting any trade. So the profit potential is there, but you just don't have the confidence to trade it. Because a market like this tends to jump so radically, a low risk entry is essential in case you are wrong about the direction of the market. What this all boils down to is that you need a simple way of determining 31

Michael 1. Parsons

which direction the market is leaning toward before the move jumps into high gear. Without some sort of early entry method you can easily find that the profit opportunity is all over before you even have a chance to enter. The way around this is through a few modified rules for Channel Surfing that focuses on specific situations related to breakouts. A breakout entry is designed to take advantage of a modified channel signal. It takes a little more effort to construct, but is much easier and effective to enter when the situation calls for it. Breakout entries are not a new concept. In fact, many trading systems are totally depended upon them. The theory is that once you exceed a certain level then the market should continue in the direction of the break for some time, allowing a person to make a profit. This method has proven itself many times over. It fol lows a very simple and basic law of physics; once an object is set in motion it will continue in motion. Only in this case we are talking about price. To be a true breakout entry price has to breakout ofsomething. It isn't enough to have prices rising or dropping in the normal course of a trend, but rather price had in a sense run into a brick wall and then had to develop enough force to break through. If something has enough force to break through a brick wall it isn't likely to be stopped anytime soon. So the obvious first step to finding a breakout trade is to find the proverbial brick wall. Of course, there are no literal brick walls in the market, but support and resistance levels behave similarly. Support and resistance levels are simply price levels that the market reached but couldn't exceed. In essence, they are horizontal fences that price is likely to bounce off of because it did so in the past. Find a place where price set a new high or low and then fel l away from it and you have one of these fences. The more times that price bounces off support or resistance, the more solid that support or resistance is. It's as if each bounce is another brick that is added to the wall. So ideally you want to look for levels that price had bounced off of several times in the past, because once price does break through and holds it should continue for some while.

Trading range breakouts

An ideal example of this would be a trading range. A trading range locks price within a high and low boundary. Sometimes they can run for 32

Channel Surfing

extended periods of time with price continually bouncing from side to side. But watch out when it final ly breaks out of that range! Take a look at figure 2-1 for an example. 11Q1 1101)

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It is important to emphasize here that a trading range involves multiple hits against the high and low boundaries. One or two do not make for a solid range and in turn, leave any breakout weak at best. The more hits at the high and low ranges, the more reliable the breakout is likely to be. Trading range breakouts tend to be solid trades as long as you allow the market to confirm the breakout. However, caution needs to be exercised because even in this situation you will commonly have false breakouts. False breakouts occur when a market exceeds a level but fails to sustain it. Instead price returns back within the zone prior to the breakout. Fortunately, there are two reliable ways that a market will confirm a breakout. Either one can be used as a basis for entering with confidence. The first confirmation is the close beyond the breakout. For example, if you break to the upside the previous resistance line should now act as support. Rather than falling back below this l ine you should see price bars closing above it. It is preferred that at least two closes occur beyond a breakout line before entering a trade; the breakout bar and a secondary price bar. AdditionaLLy, you should see momentum start to pick up withi n a short period o f time away from the breakout leveL. This entry is similar to the conservative entry that was discussed in the first chapter. Figure 2-2 demonstrates how it works. 33

Michael 1. Parsons

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The secondary confirmation is a panic bar. This occurs when price exceeds the range and the price bar explodes like a rocket and never looks back. Momentum picks up and continues to increase. How far does a bar need to extend before it is considered a panic bar? There is no exact answer to this, but the key to determining this is found in the action of previous bars. Look before the trading range and compare the pace that price set with in the market. A panic bar will often extend twice the length as normal and stand out as significant. A market is also likely to have other examples of panic bars to compare with, such as when a major reversal occurred. Markets tend to be prone to panics so it would be unusual to have just one showing on any chart. The problem that you can have with panic bars is that you can place an order early on just as the move gets started and still not have it filled until it comes to an end, leaving you exposed to higher risk. Fortunately panic buying usually begets panic buying so it is still likely to be a solid trade as long as the market doesn't take a break. Beware of holding a position based on a panic that extends through a weekend or holiday. Breaks in trading will take the steam out of panics and they will lose their momentum. Figure 2-3 shows an example of a panic bar. The goal of confirmation is to provide some sort of indication that a breakout is for real and not a trap. I f a market exceeds a trading range and then returns back into that range, you are not likely to see it break out in the same direction again for a while. In fact, a false breakout often signals that the market will move in the opposite direction. So beware of any time you see a market return back within a prior range. 34

Channel Surfing

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One other factor that adds to a confirmation is an increase in volume or the number of trades. We are talking about a substantial increase, not just a minor one. Greed and panic should be motivating the market during these times, resulting in a flock of traders scampering to get in or out. I f there is no serious increase in the amount of trades, then the market i s not responding positively to the breakout and may fail to sustain it and is in danger of failing. These confirmation techniques can be used for practically any type of breakout trade you are considering. There are a number of patterns where you can readily apply them, such as with triangle and wedge patterns. But some breakout trades will require a more aggressive approach by entering at the break. Of course, these trades will also include more risk, but the pay-off can be more frequent trades and greater rewards. However, it must be understood that the breakout trades that we are about to discuss are not of the same caliper as trading range breakouts. There are usually no multiple hits against support or resistance and you are not likely to see any substanti.al increase in volume when they break. Earlier, we discussed an entry based on the break of a secondary channel called a rebound entry. The signal required a previous break off of a larger channel before a set up was in place. I n effect, the two channels acted as a form of confirmation because of a repeated break. Now we are returning to this same basic concept, but with a twist.

35

Adichael J Parsons

Mini channel breakout

When a market is unclear about a channel parameter you will often have instead smaller channels that develop somewhat like stair steps. Obviously, there is a trend in there somewhere, but it is difficult to put your finger on its limits. By using a similar approach as we did with the rebound entry we stil l have the ability to trade such an obscure trend. The difference here is that rather than based on the break of a larger channel you are simply looking for smaller channels to repeat a break in the same direction. So in a sense this entry is based on what could be referred to as mini-channel breaks. The basic concept fol lows these steps: A market breaks a channel, whether large or small, and then forms a mini-channel. If the mini-channel breaks in the same direction as before and continues the trend direction you then enter at the break. A stop is set just before the mini-channel zone that was used to signal the entry. Figure 2-4 demonstrates the technique.

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This method of entry has a higher risk associated with it as part of the deal, but it does resolve a few scenarios where entering would normally be a real problem. Just remember, you are looking for a secondary break in the same direction, one right after the other. If you have a market that breaks a mini channel in the opposite direction in-between the two then this approach will not work. To be valid you must have a market stepping either up or down, not both ways. 36

Channel Surfing

This entry is particularly valuable when trading a market that frequently gaps. If you day trade, then you know that this is a real problem when starting any trading day. When a market opens with a gap because of overnight trading it frequently attempts to close that gap before doing anything else. But this is in opposition to the established trend. With no activity to really base a channel on you could be left out of a good part of trading while you wait for some parameters to be established. This method allows you to overcome this lack and enter more quickly. Using a mini-channel break to enter a market works with another type of confirmation. Rather than a prior channel break, the next entry simply uses a prior trend to confirm the mini-channel break's validity. Throughout any chart you are likely to see trends that pause from time to time as if they ran out of steam and needed to stop and take a breather. It isn't that the trend has really finished its run, but simply that it needs to regroup before going further. These pauses will often form mini-channels. One of the many examples avai lable is the flag pattern. Flags are short lived and will often exhibit a tendency to drift in the opposite direction of the market trend, thereby creating a mini-channel. Usually this mini­ channel will lead to a continuation of the prior trend. Unfortunately, a trend can also have a dying top where it slowly drifts into a reversal and will exhibit similar characteristics, so it usually best to wait for the market to tip its hand before committing to a trade. This tip or signal to enter is found in the break of the mini-channel. A lthough no prior channel breaks exist that you would normally use as confirmation, the prior trend itself serves the same purpose. The only requirement is that both the prior trend and the mini-channel break be in the same direction. An example can be seen in figure 2-5. It doesn't matter whether we are talking about a channel break or a trend, for a mini-channel break to be valid they must both be in the same direction. If the market was in an up trend j ust prior to the flag and then the flag broke downward, then this would not qualify as a valid signal. It is possible for such a move to qualify under the normal entry rules, but that would then depend on a larger channel and the overall trend. Do not confuse the two methods of entry. Aside from this and the added risk, you will certainly find plenty of opportunity to use mini-channels in your trading. They frequently show up within any market providing some great trading opportunities.

37

Michael 1. Parsons

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Trading false breakouts

In real life, trading a breakout is not always as simple as we would hope. There are a host of reasons why a market may muster enough strength to break through a wall and stil l falter and return to the prior side of that wall . A failure is referred to as a false breakout, a term that is very fitting. Synonyms for the word false include terms such as misleading, deceptive, wrong, fabricated and deceitful. All of them apply well in describing what a false breakout means for a trader. This is why there is a need to look for confirmation on any breakout trade you are considering. Unfortunately, false breakouts are a frequent occurrence and are very effective in trapping traders on the wrong side of a trade. So what do you do if you entered a trade only to discover that it was just a false breakout? The first step is to get out of your trade as soon as possible. As simple as this statement may seem to be, when dealing with breakout trades this is an extremely important point to understand. False breakouts have a nasty habit of moving in the opposite direction and sometimes this turns out to be a considerable move. In other words, if you bought on a breakout to the upside and it turned out to be a false, then price may not only drop back within the pre-breakout zone but continue to fall much lower. If you fai led to exit at the first sign of trouble you could be looking at a substantial loss. 38

Channel Surfing

Despite the prevalence of false breakouts, there are times when a market will seem to fail to follow through and drift back into the previous zone, only to reestablish a channel that carries it back in the direction of the original breakout and beyond. So a return to a prior zone does not guarantee that your trade has gone wrong. A saving grace will often be the channel that forms just before a breakout occurs and this can be used to judge the progress of any breakout. If this channel holds despite returning within the prior zone then there is a possibility of a successful trade. If it fails then the odds of success dramatically drop with it and you need to exit. An example of a channel that brings a false breakout back to life can be seen in fig ure 2-6. - . 11 .

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So a fai lure can still become a success as long as a channel manages to hold. Even if it did turn out to be a bad trade, you may still be able to take advantage of the signal in another way. A fai lure has the tendency to carry a market a considerable distance in the opposite direction, so reversing your position can turn out to be a very profitable trade. This is particularly true when it involved a break of a major brick wall of support or resistance and failed to follow through. Remember, if it took a considerable amount offorce to break through it once, it takes a similar force to break through it a second time. In essence, it is a breakout trade that breaks out again, only this time in the opposite direction. Don't take this move lightly because the market will not. It is the nature of the market to implode on itself when there is a failure and this tendency offers one more opportunity for profit from a breakout or in this case, a failed breakout. 39

Michael 1. Parsons

False breakouts have an added force hidden within them. It is called limit orders and they can be found sitting at predictable levels within a market, especially just beyond breakouts. Traders who themselves are trying to take advantage of a breakout trade as a market hits new levels will place standing limit orders just beyond the breakout. As I mentioned earlier, breakout trades are nothing new and used quite frequently by other methods of trading. So as price hits these levels a flood of orders is activated. This initially adds strength to the conclusion that a breakout is valid, so often others will jump on board as wel l . But if this demand is not enough to sustain the move then the market quickly returns back into its previous zone. Now all these traders who had their l imit orders activated have a problem, they are sitting on the wrong side of the market and in a loss. So many of them start to scramble to get out of the trade and this pushes the market further away from the original breakout, fueling even more orders. As fear picks up, the market is often pushed beyond any range that was established and panic ensues, driving the market even further away. So if you can correctly identify that a false breakout is occurring early enough then you are in a prime position to make a very nice profit. The key to this trade is to expect certain requirements to be met. Otherwise the move will tend to be very weak. The main requirement boils down to whether the breakout was a substantial one or not. There are two ways a breakout will establish itself as significant before it occurs and if either are present then it would certainly qualify for reversing positions when a failure does happen. Repeated attempts at breaking through a barrier would certainly qualify. This is in essence what happens with a trading range. So a well defined trading range where a fai led breakout occurs is an example of a good candidate. The second way would be when the market set a prior high or low and significant time has passed before attempting to break it again. In this instance, it is the time factor that makes it significant. It took a considerable effort for the market to return to that same level again. I f price now breaks this high or low but still fails to sustain it, the market will likely react by moving in the opposite direction, just as it did before. This second version can seem a little difficult to interpret. The question that invariably arises here is; how much time is considered enough of a time elapse between a prior high/low and the one that breaks it? The answer is simply; enough time to establish that any break is a serious 40

Channel Surfing

accomplishment by the market. This is usually a judgment call based on how the market develops, but it can be based on a more restrictive and defined rule such as a set period of time. For example, you could require that any breakout fai lure be at least twenty days from the prior high or low it exceeds before considering a trade. This way, there are no questions as to whether enough time has passed. Some trading methods use this exact same rule. But this is only a hypothetical rule and what you use should be in line with how a particular market has responded to false breakouts in the past. The important issue is that the high or low stand out so that any break will catch the interest of other traders. It is additional traders that fuel these moves. If it isn't a breakout that stands out in your mind, odds are it will not be outstanding to others who are trading the market. If you see it as significant, odds are that others will too. Figure 2-7 demonstrates how significant this can be.

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Breakout entries have their inherent risks, but utilizing these set ups can also provide a wealth of profitable trading opportunities. At times you may even find yourself dependant on them to make a large portion of your trades. Some markets are best traded using breakout entries while others will tend to slap anyone that tries to trade this way. It will take some perception on your part to know which the market you are trading favors. In any case, it is important to realize that breakout entries are simply an addition to the original Channel Surfing rules and not a replacement. A ny market you are trading still requires you to establish the parameters and risk as best as you can before even considering a trade. It also pays to be 41

Afichael J Parsons

n imble, particularly if any sign of trouble exists. Breakouts tend to move very fast, even if they fail. But on a positive note, breakouts tend to work out well in a large percentage of trades. So don't forget to use this entry as you become more proficient in using Channel Surfing. Just set up in the impact zone and hit those breakers !

42

Chapter Three

Kiss of the Channel Line While the title of this chapter may conjure up thoughts of a romantic interlude while surfing channels, the kiss of the channel line has nothing to do with us personally. The love of its life is price and understanding the choreography between the two elements allows us to exploit the attraction between the two for profit, not love. There is a lesson to be learned here from a movie entitled "Kiss of the Spider Woman". Technically, it was a movie about two prisoners and how one uses a Nazi propaganda movie he once saw about the unlikely love affair between a French chanteuse caught up in the Resistance and the chief of German counter-intelligence for occupied France to manipulate a fellow prisoner into accepting a homosexual relationship that he would otherwise have viewed as repulsive. In the end he succeeds. So the movie is really about the process of weaving a web of emotion around an extreme point of view in order to manipulate a person to accept it, even though he would normally be repelled by such an action. The lesson here is a psychological one, having to do with taking one relationship and using it to manipulate another. So it is true when it comes to learning how to trade. We have to take certain aspects of the relationship between price and channels and weave them together in order to extract a profit. As in this movie, you are in essence playing off the psychological extremes of other traders while they are manipulated into accepting what they would normally be repel led by, taking a loss.

43

Michael 1. Parsons

The point here is that whi le Channel Surfing is a technical trading method, its success is rooted in crowd psychology. It is important that you understand this concept because the market is designed to play on one's emotions and does so in extremes. Emotionally you want to sell when you need to buy and buy when you need to sell . For most, emotion will overrule logic. Our heart can make even the most foolish act look l ike a good idea. Ask anyone who has fallen in love with the wrong person and they will agree. This is why understanding what makes channels tick and how markets really operate is so very important. Otherwise, you we will be caught up in the emotional roller coaster that will have you manipulated into doing what you would never want to do, take a loss. Here lies one of the hardest lessons for traders to learn; despite all that you learn the market will still find ways to have you doing what it wants you to do. It is for this reason that some people wil l never succeed in trading. When the market starts rocketing higher, it screams at you to buy as greed takes hold. The temptation becomes unbearable and you can hardly restrain yourself, but restrain yourself you must because the turn­ around is imminent. Or immediately after you have bought price spikes lower and fear grabs hold of you. Seconds seem to last hours as panic sets in. The market screams at you to sell and you can hardly contain yourself, but contain yourself you must because as soon as you exit you do so at a loss and usual ly just before the market finally moves your way. All the profit that would have been made has passed you by. Can you fight and control these emotions? There is absolutely no avoiding them. You will have to face this battle and only you can conquer them. I f you cannot d o so, then nothing in this book o r any other will help you to trade successfully. Fear and greed will warp your senses into believing you see things that are simply not there. Only by detaching yourself emotionally from your trading will you be able to trade logically and perceive what is really happening. A market is a living organism with a will and personality of its own. Like a wild animal it cannot be trusted. But it can be managed, at least in regard to specific situations. However, even in controlled situations you cannot let your guard down, particularly when you are dealing with a predator that will chew you up and spit you out. Our greatest vulnerability to this beast is our emotions. Many forms of spider venom attack the nervous system, rendering a victim helpless and unable to move. The market's venom also attacks the nervous system, but instead causes erratic and uncontrollable movement. Beware the kiss of the spider. 44

Channel Surfing

Despite this reality, the way a market unfolds with channels and their subsequent dividing lines is a beautiful process to behold. The intricate design of these lines will often literally reflect that of a spider web. But if we have a spider web then we have a spider. For most smal l creatures being caught in a spider's web means a death sentence. For man, the kiss ofthe spider is a painful one, but that has not prevented man from profiting from the use of spider webs as well. For example, primitive people in New Guinea have used spider webs as fishing nets, while others have used spider webs to make clothing and thread. The difference is in who is exploiting the web, the spider or man. In order to exploit the web the user has to understand it. The same is true in regard to the markets. But while a web is designed to remain stable, markets are not. They are ever changing l ike that of an ocean. Yet, even an ocean has a "web" of interconnected I imits that it weaves throughout itself. Understanding how those limits are set will increase your understanding of how a market weaves its own web as well. Despite appearing chaotic, the waves of an ocean are still built upon the laws of physics. Obviously, an ocean is not built in the same manner as you would build a house. A bouse is rigid and unchangeable, an ocean is not. But an ocean is subject to some very specific limitations, making certain actions predictable. A wave will not raise above its shoreline limits, only an additional influence such as a storm or tidal wave can do this. It has to instead settle on a very narrow range of shoreline determined by the tide and wave strength. Additionally, a wave will not break in the direction away from the shoreline. It must always break toward the shore and do so continual ly. These simple limitations enable a surfer to take advantage of an ocean and its waves. Still, a few l imitations are not enough to allow a surfer to surf. A surfer also needs to understand the subtleties of how these limitations work. There are no surfers out on their boards using a slide rule or calculator. They use their experience and knowledge to judge what will unfold. So too, more is needed than just simple rules to trade successfully. One also needs to understand the how and why. Perception is a required ski l l i n this business. Just consider a few o f the rules that we bave covered so far and you will find that in real life applications there are a few situations where they appear confusing and even contradictory. The rules are solid, but you have to apply them to something that is not. Markets are ever changing and require greater perception than any simple entry and exit rules can provide. 45

Michael 1. Parsons

Channel lines provide a means of gauging price, allowing us to perceive what its l imits are. However, channels never dictate to price, price instead dictates to channels. This is the relationship between price and channels. Channels are created by price action, not the other way around. A surfer may expertly surf a wave, but he can never control it. There is nothing he can do to alter when a wave comes in, how it will break, how large it will be or anything else that a wave may possibly do. He is only a rider of that wave and nothing more. Since a channel line is nothing more than a surfboard enabling us to ride a market wave, there is nothing we can do to control price either. Channel lines work because they identify and follow a natural phenomenon of price action, just as a surfer is able to surf a wave because of a natural phenomenon. While it may be beyond our abil ity to control this natural phenomenon, it does tend to reoccur often enough to allow us to take advantage of it. Waves will repeat over and over in a series where one fol lows another even if none are exactly the same. So a surfer knows that if he misses a wave he doesn't have to worry because another will fol low shortly. Market waves will often do something similar and have a series of channels that form one after another, often overlapping each other. They demonstrate in various ways that they are interconnected even though each is a distinct wave. Even within the channels themselves price will swing in a repeating fashion with similar breath, length and angle. Repetition demonstrates that each part is interconnected with that of the whole. Like a web, each strand is connected in such a way that if one is touched it vibrates the entire lot. A pattern is established that will set the pace and personality of all that fol lows.

Changing of the guard

A n example of such interconnected phenomena can be seen in a trend shift. Trend shifts occur when a price trend develops a fault line and shifts a channel, only to resume the trend as if nothing out of the ordinary ever happened. Channel lines will usually switch roles when a trend shift occurs and what was once support suddenly becomes resistance or what was once resistance suddenly becomes support. One can interchange with another and revert back again. The interchange extends further in cases where a channel l ine becomes the launching pad for a new trend as a market changes direction. Price has a habit of kissing its former lover or channel 46

Channel Surfing

good-bye. This habit works to our benefit, allowing us an opportunity to exploit the changing of the guard. There are three primary ways in which a changing of the guard takes place. l . When a trend reverses direction 2 . When the trend continues after pausing 3. Changes in momentum and trend shifts Each of these events will tend to exceed a channel line and normally require us to exit a market. But under these special circumstances it may actually be more appropriate to either stay in a market or even enter. While we have already explored some of these entries, the key here is to understand the actual mechanics behind these changes and the subtleties that make or break a trade.

When a trend reverses direction

Trends reverse direction all the time. It is not a question of "if" a trend will reverse, but when. When a price spike breaks an outside channel line it frequently serves as an early warning that a reversal is imminent. Unfortunately, a spike is not always present during a reversal. On the other hand, a reversal always breaks the inside channel l ine because there is simply no way to avoid it. But just because our inside channel line has been broken doesn't necessarily mean that price is completely done with it. You see, price created this channel line in the first place because it was naturally attracted to a certain l ine of progression. Even though the trend is over, the attraction is not. Frequently you will see price attempt to return to this l ine as if to kiss it goodbye. This doesn't happen all the time, but enough to give you a trading opportunity if you miss the initial channel break. There are also times when it would be helpful to have more confidence that a reversal has actually occurred, particularly if a trend has had a habit of false reverses in the past. Or you may have missed the initial break of the channel line and don't want to risk chasing the market. In either case, price's kiss goodbye may be the solution you have been looking for. Catching this initial pullback at its zenith can provide you with a low risk, high profit opportunity. I f you are wrong you risk only the difference 47

Michael J. Parsons

between your entry and the reversal's extreme price. Figure 3 - 1 shows how good of an entry this can be.

Although price breaks through the channel line. it still tries to return and kiss it good-bye

Chart courtesy ofMetaS1Dck

British Pound

While price doesn't always kiss the channel line goodbye it happens frequent enough to look for it. Failure to do so usually means that the new trend will move very rapidly and far. I f this is the case, then getting i n at the best price doesn't really matter as long as you do get in quickly because you are stil l likely to make money. However, if you hesitate and miss getting in on such a fast-mover, it is best left alone. Quick moves have a habit of springing back and catchi ng any Johnny-corne-lately for a quick loss. I f a market happens to gap away twice from the prior inside channel line, then there is a good chance it will continue. Two gaps in a row tend to show strength in any new trend. I n any event, vigilance is needed because volatile moves tend to swing both ways. Trading fast-movers is as much an art as it is a skill. Because a fast-mover is frequently difficult to judge, our focus is better served on the pullback toward the previous channel line rather than the runaway market. When price attempts to kiss this channel line good-bye, a small trend will form that signals an entry when broken. That is as long as this pullback doesn't exceed the prior high or low that ended the previous trend. The reason that this works is because the prior channel line still acts as an attraction and part of the inherent geometry of the market. When you build a house you butt the end of one wall against another. When bees build a nest, they join one honeycomb cell to another. When you write a letter, you fol low each word in sequence. When multiple parts are joined 48

Channel Surfing

as one, they make the whole stronger. In like manner, price will naturally attempt to connect to itself in some form or fashion. Entering as price draws near to a prior channel line is often an ideal entry because the risk is small and the profit potential high. But this stil l doesn't guarantee a profitable trade. Unfortunately, it is also not uncommon for a market to excessively drift, paralleling a prior channel line for quite some time before actually breaking in the direction of the new trend. This is one of the quandaries of trading that despite breaking a channel, price can still exceed a prior high or low and continue in its prior trend's direction, resulting in a loss. Only after a new trend is clearly established do you know for sure whether an entry was good or bad. Obviously, you want to get in at the very best possible price, which requires an early entry. But you also don't want to take a heavy loss or do the opposite, get too nervous and jump out too soon, missing the trade entirely. So how do you know when a drift is just a minor delay in a new trend or a failed break that threatens a major loss? While it is possible for a market to develop a double top or bottom or even slightly exceed prior highs or lows and still reverse, the odds change dramaticall y when it does. It is better to take a small loss than to risk a large one. Once a market breaks a prior high or low, the move can be extremely fast. The slippage can be very large if you hesitate too long. H is a sickening feeling to have the points rack up against you whi le you desperately try to get out, but are unable to find someone to take the other side of your trade. If there is no indication of a channel that will provide support or resistance in close proximity of the previous high or low, then the high or low has to act as your limit. Multiple attempts at this level or actually exceeding it will require an immediate exit. This possibility emphasizes that the best approach for a beginner is usually to wait until the small channel is actually broken before entering. But entering is often a matter of taking stabs at a market, getting out of the ones that become questionable and sticking with the trades that show signs of paying off. A prior channel line acts as an indicator of what will unfold. Even at the expense of exceeding a prior high or low, this channel line will normally be the limit of price's progression and once it is reached price should show clear signs ofreversing direction. If price reaches this point and fails to reverse quickly, the trade's success quickly fades with it. An important early warning that a reversal may fai l can be seen in the price action immediately fol lowing the break of the prior channel l ine. 49

Michael 1. Parsons

The two most common fai lures are trading ranges and pullbacks and in both, price will usually stall . New trends tend to form very quickly and even though it is common for price to kiss the channel line goodbye, any excessive delay makes the new trend suspect. This leads us to the second way the changing of the guard takes place.

When the trend continues after pausing

A fai led reversal usually translates into a continuation of the current trend fol lowing a brief pause, such as a consolidation pattern. Pauses act as a breather and after the market is refreshed it trends to pick up where it left off. They come in various forms that you can literally spend a lifetime learning to identify and analyze. But there is no need to do all of that. They fol low the same principles of Channel Surfing as you have already learned. Most pauses have too little movement to make the actual pattern worthwhile to trade, but they stil l offer a great trading opportunity for two other reasons. 1. 2.

They predict the next leg of the trend. They offer a low risk entry.

Although they are too narrow to trade, the real value of pauses is derived by what they can tell you about any upcoming move. I f you look closely at most charts you will notice that pauses are general ly found at the center of trends. I n other words, they tend to be the halfway point of trends. So once a trend resumes, you can normally expect it to go approximately the same distance as it did in the first leg of the trend. Translated, this means that if you have a trend that started at 900 and it then paused at 950 then it is l i kely to go on to 1 000. Markets are more likely to continue than reverse direction and pauses offer a way of taking advantage of this phenomenon. But it gets better than this. Not only do you know where the market is l i kely to go, but market pauses also provide a low risk entry. Since they are generally narrow patterns to start with you will in turn have a narrow or close stop attached to your entry. A low risk entry with a defined high reward makes this pattern a favorite of many professional traders today. It is easy to see why when you look at figure 3-2.

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While these patterns can be great to trade, there are a couple of issues that need to be clarified. Pauses can end up reversing the trend after all , so there are n o guarantees here. There are also times when a pause will become a larger consolidation pattern and develop wide swings. If it is wide enough then you may be able to trade the actual pattern itself. But even if you decide not to, a much wider pattern can actually provide a better signal to enter a trade for the upcoming move. In essence, you are trading the pattern for the purpose of trading the trend. Exploiting the range is illustrated in figure 3-3.

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Another important point worth remembering is that a trend can actually be much larger than the chart shows. It is easy to miss the fact that a wide consolidation pattern may actually be a mid-point for a much larger move than you realize. Take a look at a higher time frame whenever you see a wide pattern develop. This offers an i nsight that you may otherwise miss. It is not uncommon to have what appears to be just a pattern for a small move on a daily chart turn out to be a huge move on a weekly chart. Figures 3 -4 and 3 -5 demonstrate this vividly.

Although this tradi n g range lasts for n early two days, it is also an integral part of a larger trend, implying both a breakout direetion and extent of the following move

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52

Channel Surfing

Learning how to trade pauses can reward you with a very nice income. Although there are many types of consolidation patterns and market pauses, they all follow the same rules. So there are no complexities here. But it does add to your trading success if you can identify them early, which is a skill that has to be developed. Even so, if you do have problems identifying them you can always trade the breakout of the pattern as it exceeds the prior high or low. Even if you should miss out on the breakout you may still get one final shot at it when it comes back to k iss the former channel line goodbye. So pauses really give you a lot of breaks in trading. A few of these breaks are shown in figure 3-6. " .. 19 7. " ,. IS "

Does a breakout make you a little too nervous to actually take the trade?

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Pauses can provide you with advance knowledge regarding possible moves within a trend and offer a great low risk entry position to boot. So a pause in the market can truly be the pause that refreshes, your bank account that IS.

Changes in mo mentum and trend shifts

A change in the market's momentum is another way that price will flip sides on a channel line or have a changing of the guard. Throughout a chart you will notice that price often changes its momentum by increasing or decreasing a trends progression. Although these changes in momentum will often start entirely new channel l ines at times they will simply "borrow", even if only temporarily, a previous channel line. This phenomenon provides a key point that you can use for gauging a market's 53

Michael J. Parsons

future price action and serves to provide a stop in case the market should snap back against you. Changes in momentum are usually handled by way of "fanning" channel lines, so any prior channel line would only be used for setting a stop, at least until a new trend was established. But there are times when a market accelerates simply by jumping over a prior outside channel line, resulting in the need for a new outside channel line rather than inside channel lines. Figure 3-7 provides an example of this phenomenon.

This channel line that once acted as resistance now becomes support

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Changes in momentum can occur for a number of reasons, but they generally involve two elements or the lack of them, greed and fear. These elements will increase or decrease participation, impact the overall bias of a market, and affect whether individual traders remain settled with their trades or choose to trade often. Just as trends tend to continue in their chosen direction, changes in momentum tend to beget similar changes in momentum. If a market is accelerating, it is l ikely to continue to accelerate. If it is slowing down, then it is likely to continue to slow down. Even with this tendency it is good to remember that highly accelerated moves tend to be short lived, burning out in a blaze of glory. If momentum changes are short l ived, they are usual ly replaced with trend shifts. The difference between the two is that whi l e a change in momentum will use a prior channel l ine momentarily and then later develop its own, a trend shift is more likely to continue using a prior channel line or at least parallel it for quite some time. 54

Channel Surfing

There are two reoccurring versions of trend shifts. I n one, the market accelerates and jumps across a channel l ine and then simply settles back into a similar angle of progression as it had before. In this version the shift crosses the outside channel l ine. The second version crosses the inside channel l ine creating something that at first looks like a pullback, but in this case the move extends further than normal and actually "shifts" the entire price channel. Sometimes this shift moves well beyond any current channel line and an entirely new channel has to be drawn, even though in most cases it will sti l l paral lel it. But often you will just simply see price "flip" sides and continue to use the prior inside channel line as its new outside channel line. Despite the extreme price offset, the market will frequently fight to reach the original outside channel l ine. If it does succeed, it usually signals the end of the trend and that a reversal is imminent, such as can be seen in figure 3-8. Later, the market returns to the After developing a channel, the market shifts over to form a new one at the same angle

prior outside channel and the market soon reverses d i rection

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With one side of your channel already wel l established all you have to do is duplicate that l ine and move it into place, adjusting later as the channel warrants it. Even if price moves too far from previous channel lines to actual use what was originally drawn, usually you will find that price sti l l progresses at the very same angle. S o a l l you have to d o is to draw two parallel l ines at the previous channel's angle to create your channel. Price tends to want to establish a channel where the l ines are parallel whenever possible. Equilibrium is at stake, so the average progression of highs and lows need to fol low a similar pace. When channel l ines are not 55

Michael 1. Parsons

parallel, then something is unequal and the bias indicates that a change is just around the corner. Just as we are creatures of habit, so is the market. It does not like change. So do not be fooled by any sporadic price bars that spike abnormally. Find the channel line that holds up for the long term and you have found the correct placement of your line. Occasional ly, there will be multiple channel lines that create duel outside or inside lines. Both will be valid, but there will be differences based on any changes i n volatility. If you have a very active day, then the lines further out may be required to limit how far price will extend. On slower days the narrower l ines will usually contain price. The secret to trading duel channel lines is to let the market reveal what it wants to favor. Draw both sets oflines and observe what develops when each is reached. Despite the presence of secondary lines, both comparable inside and outside lines should be parallel to one another. Rarely will you have a distortion of the angle between them. Keep this in mind and it will help to prevent incorrect placement of your l ines and the confusion that would cause. Figure 3-9 shows an example of duel channel lines. When trading, use caution when the narrower lines are reached and in all cases the wider lines remain the very limit of your trades. View the duel l ines as a trading zone similar to the way support and resistance bands are traded, which is detai led in chapter four.

Channels can have a duel effect in other ways too. Just as a spider web will have strands that extend outward while still impacting the whole web, so too channel lines have a habit of resurfacing later to impact the market 56

Channel Surfing

all over again. Even though price may have long ago left off from using a specific channel line that doesn't mean that the love affair is over. You may be surprised to discover how many times they will come back again and again. So it pays not to forget your old friends, the channel lines. A key element of channels is that price continues to fol low them either in part or in whole. The attraction and dance continues until the party is over and they have drifted too far apart. If price can find its way back to a channel line, it will. So whether you are dealing with trend shifts or acceleration, each succeeding point and line will be the foundation of another. In fact, you will often begin new channel l ines directly off of prior highs, lows and channels. This is where the intricate dance between price and channels and the web they weave exists. What we have discussed so far is only the beginning. This dance extends further to include special support and resistance lines, which we will cover in more detail later. But for now, the glimpse inside the web of channel lines has provided us with a little more insight as to how they work and why. If we understand this web, then we can use it to make a profit. Otherwise, we may have to endure the kiss of the spider and find ourselves manipulated like the majority of traders into taking a loss. The difference is in who is exploiting the web, the market or you.

57

Chapter Four

Major Price Levels In the beginning, there was light. COh sorry, wrong book) Actually, in the beginning I wrote, "Exit whenever a channel line is broken". Did I mention that my words were not set in a stone? Rules are made to be broken or at least to be bent every once in a while, and so it is true with this rule. When an outside channel line is broken it usually signals an impending reversal and normally is a good time to exit. That is unless it happens to occur at a major price level. Major Price levels are support and resistance areas where price has reached in the past but was unable to exceed. Particularly if you should see that a specific support or resistance level is showing up in a higher time frame than you are currently trading would you consider it as major. For example, if you were trading a one minute chart and come across a level where even the hourly chart has had trouble exceeding, then you know you have a major price level, at least for trading a one minute chart. When a market breaks both an outside channel l ine and a major price level at the exact same time, it is a major undertaking and requires a substantial amount of force to do so. So rather than reversing direction, price will often continue to move onward and frequently at a more rapid pace. So if you were to exit at this point then you would miss out on a very quick move that would have brought in a very nice profit. As the market breaks a major price level fear and greed take over and traders become very anxious to trade. The resulting orders come in like a tsunami and price movement accelerates, breaking channel lines in the 59

Michael J. Parsons

process. This explains why the break occurred in the first place and in turn, why it fails to reverse direction after having done so. To some extent we covered changes in momentum in the preceding chapter, so what makes this different? This particular movement tends to be extreme, fast and powerful. Trade it right and you walk away feeling as exh ilarated as a surfer that catches the extreme rogue wave of the day. You walk away on cloud nine, which is an expression of great elation. Get wiped out by it and you will be very depressed for quite some time. So, what will differentiate this trade from just the normal changes in momentum are the size, power and speed of the move. Obviously then you don't want to miss out on this trade when it comes along. So when price breaks a major price level and a channel line at the same time don't exit right away. Instead, hang on for a wild ride and some quick profits. A prime example of a major price level break can be seen on figure 4-1.

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Shortly after price breaks the previous high it exceeds an outside channel Major Price level acts as resistance

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This scenario makes for some very nice trades, so why didn't I tell you about this before? I n order to be able to trade this set up you have to be able to determine major price levels. Without that skill this trading opportunity is meaningless. You just can't take any high or low and label it a major price level. I f you do you will stay in when you should be getting out and suffer losses. So what do you look for that identifies a major price level?

60

Channel Surfing

Here are a few characteristics to look for in identifying a major price level. 1. 2. 3. 4. 5.

6. 7. 8.

The more times that a level has acted as support and/or resistance in the past the more i mportant it becomes. The higher the time frame that a price level has acted as support and/or resistance the stronger that price level will be. The very top or bottom of a market will always be a major price level as long as some time has passed since they were set. Intermediate highs and lows can act as major price levels if a substantial amount of time that has passed since they were set. Somewhere within the center of the entire price movement (50% level) is a major price level. Several points of support and/or resistance will usually develop that help to identify where it is. The top of a large ascending triangle or the bottom of a large descending triangle covering a substantial amount of time. Major round numbers such as 50, 1 00, 1000, etc. Long term moving averages that are commonly used by market participants.

These are just some examples of where you will find major support and resistance levels or as I have termed it here, major price levels. Unlike some patterns and situations that you may encounter when trading, major price levels are never shrouded in mystery because the market clearly indicates where they are. However, if you still have trouble determining these levels I would suggest further study. More information can be found in various publications dealing with basic technical analysis and this specific subject is covered quite frequently. I f you run into a situation where you are not sure whether you are dealing with a major price level or not, the safest course would be to fol low our original rule and get out of the market as soon as a channel line is broken. It is better to miss out on a quick profit than to take a quick and substantial loss.

Not all major price levels are h ighs and lows

It definitely pays to be cognizant of any major price levels within a market. There a number of traders who will trade solely on them, including professionals. Copying their method is a relatively simple process that only requires you to scan for markets that have reached new highs or lows, 61

Michael J. Parsons

which would naturally be major price levels. An added filter on any scan would be to limit the amount of time covered. It is not necessary that a h igh or low be the greatest since the first trading day of that particular market, but only that enough time has passed so that any break would be viewed as a major accompl ishment. But you should also be aware that major price levels are not always a high or low. There are three in particular that relate to crowd perception and have l ittle to do with any h igh or low that is set within a market. They are the fifty percent level, long term moving averages and round numbers. Within crowd psychology there exist certain perceptions regarding any market. At what point does the majority change their belief that the market is no longer rising, but fal ling? A number of common elements overlap to create the general consensus of market bias. For example, fund managers will often use sixty day moving averages as a determining factor. But whatever method may be used, at some point the majority will change their view of the overall market direction within close proximity to one another. When the consensus changes so does the position of the larger percentage of traders. The result can be as powerful as any major price level break. Perception is the name of the game. Discover what will change the perception of others and you will know where the turning point will be.

Critical moving averages

One of the simplest and most common methods used to determine market bias are moving averages, particularly larger samplings. The critical ones will encompass ranges such as forty-five, sixty, eighty or a hundred and twenty just to name a few. Obviously, major critical moving averages are not of short-term duration. Markets will differ as to which duration is favored, but it doesn't take a great deal of effort to determine what they are. Most markets will have pullbacks that line up very well with their favorite durations. Experiment with a few settings and observe which ones price bounces off of and you will know the favorites. When a critical moving average is violated then a change in the consensus can be expected. Figure 4-2 shows the power of a favorite moving average in Coffee.

62

Channel Surfing

The halfway point

When you look at half a glass of water do you see it as half full or half empty? We all recognize what half is, but what if something is slightly higher or lower than half? Mentally, if something is less than half then it is mostly gone. Never mind that the amount below hal f is very m inimal. If there is more than half, then it is mostly full. It is a perception game played on us by our minds. This perception game fol lows us when we enter into the world of trading. Take any chart and find a defined high and low and the halfway point between them. If price is currently lower than that halfway point then you most likely see this market as bearish and will be more inclined to sell. If price is higher then you probably see it as bullish and will be more inclined to buy. Where price sits in relation to recent activity goes a long way in formulating our belief about market bias. This is why the halfway point or fifty percent level of market activity behaves much like a major price level. In actual trading it isn't necessary to measure an exact halfway point between the highs and lows. It is more a matter of recognizing the market's perception of where the halfway point sits. These levels will generally have highs and lows that buffer them and set them apart. Take a look at figure 4-3 and see how greatly halfway points impact a market. 63

Michael 1. Parsons

This h alfway point acts as resistance twice

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Big fat round numbers

Another major price level that is not always obvious is that of round numbers. We all tend to get hung up on numbers. It is another game that our minds play on us. Advertisers know this all too well . When you go to buy something that costs around three dollars you will often see the price l isted as $2.95 or $2.99. Why the odd number? Because a whole number changes our perspective and a slightly lower price fools us into bel ieving we are getting more for less, even if the difference it is negligible. This makes us more receptive to spending our hard earned cash. Price a product at $3.05 and all of a sudden there is more reluctance to buy. Six cents is hardly worth any concern, but mentally we see it as another dollar. The same principle applies to round numbers within a market. Certain numbers change the view of market bias. If a market exceeds a round number and the market is able to sustain it, then it is likely to continue in the current direction. Often, it will do so at a more rapid pace. I f a market reaches a round number and fails to hold, then it is likely to reverse in a dramatic way. Take a look back at the major US indexes and you will see how this has proved true. I n figure 4-4 the NASDAQ i llustrates this point very well when it hit 5000 early in the year 2000, but was unable to sustain this level. It then promptly dropped for the next couple of years losing more than three quarters of its value. But this was not the only round number 64

Channef Surjing

that this market responded to. In 1998 it rose to 2000 and then fell for the next three months, dropping more than 500 points. Toward the end of 1999 it broke 3000 and then dramatically increased its pace moving over 2000 points within a five-month period alone. When the market started to drop in the year 2000 it reacted again to the price level of 3000 by halting and promptly rising back up 1 000 points. When it finally succeeded in breaking below 3000 it did so with a vengeance and from then on it was painfully clear to investors that the bull market was over. The S&P and Dow have shown similar reactions at round numbers as well.

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3000 level is broken

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1500 level

So round numbers will often act as major price levels even if they have never been reached before. The human tendency to focus on round numbers is undeniable and shows even in the markets. Whether you are dealing with critical moving averages, halfway levels, round numbers or established major highs and lows, it always pays to be aware of them and to take them in consideration when making your trading decisions. The market certainly does.

When a break of a major price level fails

Although breaking through a maj or price level w i l l usually result in a continued move, not all do. So what bappens if a market breaks a major price level but then stalls? A fai lure fol lowing a break is a common occurrence. I mentioned earlier how some traders will push a market 65

A4ichael J Parsons

in order to h it stops even though there really wasn't any momentum to sustain the move. This can happen even with major price levels. No support or resistance break is guaranteed to succeed. It is stil l a matter of perception by the majority w ithin a market. If a market stalls and particularly if it retreats off of a break, the first order is to exit from your trade. A market that returns back across a line that it just broke is not to be trusted. This is a breakout failure and it changes your entire analysis. Even if price just l ingers near the breakout l ine, hugging it j ust on the breakout side, it is sti l l not to be trusted. Just as in the case of when you are deal i ng with a reversal , price should start t o move fairly quickly into new territory. The only exception would be a characteristic brief kiss goodbye of the major price level. The second order when dealing with a fai lure is to take the opposite trade. Remember that it takes a considerable amount of force to break major price levels. If that force is exhausted in crossing a line then the opposing force takes over, usually with a vengeance. This is where you w i l l see volume pick up drastically and a flood of orders rush in. In essence, a market has gotten all dressed up with volume and is determine to go somewhere. I f one side won't take it out on the town then it will go with the other. It has no conscience. The other side of the trade simply fol lows the rules that you would use when trading any other reversal. Enter on a channel line break and then establish a set of channel l i nes to act as your running stop. It may not have gone far i nto new territory on the break, but watch it do someth ing now on the return. I n figure 4-5 Oracle fails to sustain a break above $ 1 5.00 a share and with in two months price falls below $ 1 1 .50 a share. Major Price levels equate with major paychecks if you know how to recognize them and how to use them. People tend to get excited when they see such levels broken and the resulting influx of orders often explodes with large and quick moves. Often, this is in the direction of the current trend but even if it does reverse direction you still may have an opportunity for a nice profit simply by reversing positions. So a major concern for your trading should be major price levels.

66

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Price Bands and Price Zones

If you have read any of the more common publications on technical analysis you have already recognized major price levels as an equivalent to major support and resistance. The concept of support and resistance is simple; the levels at which price stopped in the past will tend to halt price again in the future. Some of the things that we have already discussed are simply an application of these widely known concepts. But our emphasis here has been on major price levels that elicit a strong reaction from the market rather than those that have only a momentary reaction. Support and resistance theory has certain inherent fail ings when applied in real life. Even when dealing with major price levels support and resistance can at times be very frustrating. They are even more so when these levels are only minor. I n a later chapter we will discuss how to overcome these shortcomings, but for now we just can't ignore the subject of support and resistance entirely. I f you have used these levels in the past then you know that the market will often react to them even if they are not really "major". But more often than ·not price will play with them, dancing on both sides before actually making any substantial move. So they do have value, just frequently are hard to predict. When using standard support and resistance levels it is often best to interpret them based on bands rather than a thin l ine of price. Additionally, price activity in general will often congregate into wider zones, which is of itself an extension of this concept of support and resistance. Price bands 67

Michael J. Parsons

and price zones are particularly evident when a market has been in any long term trading range. What this means is that price will bounce back and forth between ranges that are fairly wide, with support and resistance levels loosely overlapping these zones in narrow bands. So there are two aspects here to consider; the narrow band that is identified as support and resistance and the wider zone containing most of the price activity. Since we started our discussion with support and resistance, we will address support and resistance bands first. Price will frequently jump back and forth over a specific level normally identified as support and resistance. It is obvious that these levels have significance, but actually defining a specific number on this significance is another story. It is much better to define support and resistance as a narrow band. The negative aspect of handling it this way is that you are allowing much more room for error and so a larger stop loss is required. But on a positive note you are less likely to have an activated stop force you out of a market just prior to a substantial move. Figure 4-6 illustrates an example of a support and resistance band.

These narrow support and resistance bands will have a center point that will equate with a set price. A band can be extremely narrow but usually there will be a small but definite range extending on either side of the center point. Even though a market may have identified a support and resistance level of 1 00, it may not actually consider this specific price as a number to meet or beat. That is, price may rise to 1 02 only to fall off from this high into a downtrend. Or instead, price may fall down to 98 only to 68

Channel Surfing

rise back up into an uptrend. So rather than 1 00 being the deciding factor it was actually the move beyond the range of 98 through 1 02 that was. Further, these bands can work both ways. Price may rise up to 98 but not quite make it to 1 00. Or it may descend down to 1 02, but fail to reach the actual support number. It is because of these characteristics that you are often better off looking at support and resistance as a band rather than a specific price. That is not to say that the market will never react sharply to a specific price, just that it will often require more latitude than this. Of course, the problem with defining it this way is that you now have to deal with a range rather than a set price, making any decision about what to do more difficult. Fortunately, price tends to fol low certain habits, giving you at least some indication of what is likely to be the outcome. The first habit has to do with the speed of attack. The market will naturally see these levels as important. So if price blows by them as if there is nothing there then it is likely to keep on going and never look back, at least not until much later. So look at the speed and force of any break in support and resistance. It is not uncommon to see a market gap pass these points, or at least to have an unusually fast move through them. In contrast, if price lingers around support and resistance levels then a bounce usually will occur. This tends to happen even if price does manage to actually break the level, but still lingers. Failure to fol low through is never a good sign. This does not guarantee that price will return to a prior side of these levels, but only that it is likely to. In fact, a l ingering price will often dance on both sides of a support and resistance l ine in order to fool traders. An exception to this would be when price lingers on the breakout side for a lengthy period without ever returning back to the prior side. This would show up as a trading range and would have the market building a foundation or ceiling that will act as a launching pad to the next level. So a return back to the prior side is a critical indicator of a bounce or reversal. While this is an obvious fact required by any reversal, the issue is more of the dance rather than the act. If price is not swinging its partner then it will tend to go to the next level to find a better one to dance with. Of course, the real question is "how do you trade this?" The first step is to define the band and its width. Look at previous encounters with the support and resistance level and determine how far the market stopped short or exceeded it. What you are looking for is a measure of how far the market ends a swing beyond a specific price. Remember, these are narrow bands, so you are looking for points where price was very close to this line. Ignore 69

Michael 1. Parsons

swings where price came within the general area but was still a considerable distance from it. Once you have found suitable samplings of price against that level, measure how far price strayed from it. The distance you measure would then be used in the future to provide a range and would apply to both sides evenly. For example, if the support and resistance line was at 100 and you measure a Y4 point sway on either side, then you would use a range that ran from 99.75 ( Y4 less than 1 00) to 1 00.25 (% more than 1 00) as your band. It doesn't really matter that you never found an instance where price actually dropped down to 99.75 previously. If price went up to 1 00.25, then a Y4 point would be used in both directions. Once you have established your support and resistance band then you would enter the market just as you would any trading range, at the breakout of that range. So if price went to 1 00.5 you would then go long or buy. A stop would then be placed below the lower range of the band at 99.5. Shorting would be done in the opposite manner. The value of handling it this way is that you are less likely to be fooled by the market and avoid over-trading. Figure 4-7 demonstrates how a support and resistance band is used.

- - -

T

- - - -

The market spikes and is

Later the market extends this

stopped by this extended level

range further and this level has a repeat performance

Arden

One of the best methods oftrading support and resistance is simply to enter on a breakout, anticipating that the market will extend from extremes of a range or price zone to the other. Support and resistance levels act as a sort of pivot system. I n a sense it works in a similar way as an elevator does. It only wants to go up or go down, not in both directions. If you press a call button for an elevator to come to your floor you may observe that it still travels further away from you even though you may be just one floor away. 70

Channel Surfing

This is because an elevator is programmed to respond to all requests in one direction first before it reverses direction. So an elevator that is headed down will continue to move lower until no lower floors are requesting service, which is usually the first floor. After this it will then proceed to higher floors until no higher floor are requested. It doesn't zigzag up and down randomly. In similar fashion price really wants to move from one end of a zone to the other. Of course price zigzags along its way from one extreme to the other, so it doesn't work exactly like an elevator. But overall it does have the tendency to follow the same principle. This means that if you can identify a zone then you can profit from it. So next we will consider the second aspect of support and resistance, price zones. Price zones are ranges that a market tends to l inger within. They can be rather wide, but generally are limited to common price levels that act as support and resistance. Price has a habit of moving in stages that are evenly spaced apart. The spacing is commonly based on certain price integrals that it fits loosely within. When a zone starts to build a clearly defined trading range then price tends to move into another zone, thereby blurring what is really happening to the average trader. But ranges are a way of life for most market conditions and even in strong trends a stair-step effect is often created that demonstrates the zone effect in the pullback and consolidation patterns that form. What blurs zones even further is that price frequently jumps into a higher or lower zone for a whi le, only to return to a previous zone later on. Jumps give the false impression that all the price activity is grouped together and is the same, despite having shifted through several different price zones. Zones are really not that hard to recognize if you look for them. There are actually a number of things that characteristically point to them within a market. However, we will only focus on the two most common markers. First and most obvious is the support and resistance levels that define their ranges, marked by highs and lows. However, not all support and resistance levels will actually be price zone limits. So by itself support and resistance levels really don't confirm price zones. Many support and resistance levels have nothing to do with price zones and are instead caused by other factors. But price zones will almost always have support and resistance levels outlining them, so it is a marker that can identify where they are likely to be. Secondly, price zones are usually spaced evenly apart by reoccurring price integrals, although this will vary from time to time. For example, you may have a spacing of 20 points where a market starts a zone at 1 200 and ends a zone at 1220. The next zone will end at 1240 and so on. The problem with this 71

Michael J. Parsons

concept is that price integrals do not always remain consistent. Sometimes a price integral will split into two or more segments and have a clear definition between each of them. Or price may only loosely follow price integrals and have an occasional wide variant. The integral can become wider in a strong bul l market or adapt to higher numbers by increasing their range. I f the exceptions here make defining price zones seem rather vague, don't let this discourage you. At times they will be easy to determine, but this is not an exact science. It is largely an art, but an art that is rather simple in practice. It serves as an added tool for analyzing a market when it is available, not a basis for a complete trading system. Figure 4-8 shows how straightforward and simple price zones can be in real life. .

.

In this market zones are divided by $3.00 each, placing the end of each range

at 9, 12, 15, 18, 21, and 24 respectively

��--�-4���

Arden

The real value derived from the use of price zones is that price is more likely to stay within a zone than to exit it. This means that you can trade a zone just as you normally would any wide trading range, from top to bottom and back again. The bonus over normal trading ranges is that they are already built into the market and yet, are rarely recognize by the general trading public until it is too late to take advantage of them. So detecting price zones early can be a nice l ittle edge over other traders. Additionally, price has a habit of returning to previous zones, enabling you to take advantage of already well-defined limits. Zones usually remain intact for very long periods of time. The deciding point of any zone will be the far reaches of that zone. While it is always preferable that channels be used in any trading, playing off of these zones can work exceedingly well in most trading environments. 72

Channel Surfing

They work because of a certain perception related to these levels. To understand this perception, it helps to visualize price zones as rooms and support and resistance levels as doors. If you have ever had a family pet such as a cat within your home then you can appreciate how this works. A pet that wanders freely through a house may choose to wander into any room that has an open door. The only way to be certain that it will not go into a particular room is to keep the room's door closed. Even though a cat may have this freedom, that does not mean it will wander constantly from room to room. Rather, it will usually settle into a favorite room where it will spend most of its time. No animal really wants to just keep walking back and forth through doorways. Often they only move from room to room for some purpose, such as when they are bored or hungry. While cats can be unpredictable, the odds are that if it enters a room it is there to stay, at least for a while. Markets are similar in that they will tend to l inger within a zone for extended periods of time. They may wander throughout that zone, but they do not leave it indiscriminately. Once it passes through the doorway of support and resistance it will tend to want to stay in the new zone for a while and will likely search out the other side of the "room" or zone. What all this leads to is that when price leaves a support and resistance band it is likely to move toward the other side of a price zone, offering the opportunity for a short term trade. Playing the market off each side of a zone is another way to exploit the market, as i l lustrated in figure 4-9. .

�

.

-----.-----t-

.

Always wait for a secondary

Sell

bounce once a market enters a new zone before entering

'"

1' 0 ns

. ,, . "

)'0 - 1t 5

III'

Elizabeth Arden

Buy

Buy

-,

--------'

"' Exit

----

Chart cour1osy ofMeiaStoek

73

m IT •

Michael 1. Parsons

Support and resistance offers a wealth of opportunities in trading, but they do require an understanding of what is relevant and what is not. There are many publications that place support and resistance on a pedestal, but in real life it will have many shortcomings. I n spite of this, there is a clear value to understanding and using these concepts. Later on we will cover what true support and resistance actually is and how it differs from that what we have already discussed. Until then, these concepts should prove very supportive of your profit margin and resistant to any losses.

74

Chapter five

Determining Balance Of Power There is no question that surfing requires balance. Without it, it is simply not possible to surf. Unless you master this skill you certainly cannot hope to do any stunts where the real fun is. A Hang Ten maneuver is a prime example. This is a stunt where the surfer stands as far forward on a board as possible while riding a wave. It is hard enough for most people to stand up in the center of a board, let alone at one end of it. But this maneuver pushes the front of a board down, catching more of the wave and providing greater speed. Because you are so far forward on the board you have the illusion that you are literally walking on water, a very surreal effect. But you just don't get on a board for the very first time and do this trick. Even for the most experienced surfers it takes considerable practice and skill. Just as balance is essential for a surfer, so too is balance necessary for a trader. You can study and master all the patterns you like, but if you don't understand how balance works within a market then you will stil l have trouble riding any move for a profit. Every buyer needs a seller and every seller needs a buyer. If you have more buyers than sellers, then the price will rise. More sellers than buyers, then the price will fall. This is simply known as supply and demand and it is a basic principle of market value. W hichever way the buyer/seller balance is biased, it is a sure bet that the market will fol low. Traders spend fortunes betting on which way they think the bias is leaning. Many will simply use reports and gut feelings to make that decision, but the balance of power is

75

Michael J. Parsons

already revealed in a subtle way by price action. Learn to see the subtleties that reveal it and you have the edge that everyone is looking for. When a channel develops you will usually have both lines running parallel to one other, maintaining the same distance and the same angle during the course of the trend. This is a balanced trend. But when it comes to the battle between buyers and seller, balance is never permanent. So there are many times when channels do not follow the normal same distance/same angle course. These distorted channels are what reveal bias within the balance of power. I n fact, anytime you see that both channel lines are not in agreement then an imbalance exists. I f you have studied basic technical analysis before then you are already familiar with a host of patterns that have non-parallel channel lines. One such example would be that of the triangle pattern which has both lines angled toward one another. Depending on how the triangle forms, standard technical analysis tells you something of the bias in the market based on the pattern's shape or the angle of its l ines. A n ascending triangle has an upward bias, a descending triangle a downward bias and a symmetrical triangle has no bias until it makes a commitment one way or the other. The view of each of these patterns and their bias is based on past experience alone, but in reality the very shape and angle of the channels that actually form them already tel ls you what to expect. When you understand how to read the bias of channel lines patterns start to make a great deal more sense. Further, you are then able to apply these same principles to a much larger portion of price activity, far beyond that ofjust mere patterns. When the balance of power is extreme as you find during a strong trend, then it is easy to determine what that bias is. But when it is subtle as it is during consolidation patterns then it is a much more difficult task to determine. Yet, it's during the subtle times that knowing the bias would be of the most benefit. So what is the secret to determining the bias in the balance of power?

The two factors that determine balance of power

There are two factors to consider when reading market bias, the overall direction of the channel and any distortion between the angles that form the two channel lines.

76

Channel Surfing

The first factor is easy to understand. The overall direction of the channel indicates market bias. This means that if both channel lines are rising, then the market bias is upward fol lowing the direction of the channel. It is as simple as up is up and down is down. When you have a trading range with two horizontal lines bordering price activity then the bias is neutral. So whatever direction the channel is facing indicates the bias of the market. The second factor requires a little more effort to understand. Any distortion from a parallel angle between the two channel l ines indicates bias in the balance of power. This means that if the two lines are drawing closer to one another then there is a bias indicated. If they are drifting further away, then again, there is a bias indicated. In addition, how the altered channel l ines are directed in relation to the market further dictates how this bias would be interpreted. What this means is that both the angle and direction are important in determining market bias. So there are a series of configurations that we need to consider and although there are a number of them, they all fol low similar principles. The series is shown in figures 5-1and 5-2. Channels are horizontal The balance of power is equal

____ ____ ----

____ _____ ____

---_____

No bias is indicated

WillfU'

Channels are both dropping Bears are in control and Bulls are in agreement Bias is downward and stable Channels are both rising Bulls are in control and Bears are in agreement Indicated bias Is upward and stable Channels are directed toward one another Both Bulls and Bears are advancing and pressure is building No bias indicated, but the winner will likely reap a big reward Channels are directed away from one another Both Bulls and Bears are retreating and pressure Is dropping No bias indicated and the winner will reap a small reward Both channels are falling, but the lower one is moving at a faster pace Bears have the power, but are getitng too greedy Bias i s currently bearish, but it i s about to change to bullish

77

Michael 1. Parsons

Both channels are dropping, but not e qually

-------

�

Bears have more power, but bulls are fighting back

W""i"

Bias is changing and indicates the bulls are about to take power

- - - - - - - - - - - - - - - - - - - - - - - - - - ,

____

Both channels are rising, but not equally Bulls have more power, but bears are fighting back Bias Is changing and Indicates the bears are about to take power Upper channel is dropping while the lower channel is holding fast Bears have the power, but bulls have taken a firm stand Bias is bearish and pressure is building for a downward move

----

lower channel is rising while the upper channel is holding fast Bulls have the power, but bears have taken a firm stand Bias is bullish and pressure is building for an upward move Both channels are rising, but the upper one i s moving at a faster pace Bulls have the power, but are getitng too greedy Bias i s currently bullish, but it is about to change to bearish

As you look at this series, some of the configurations and bias indications may seem at first contradictory. For example, if the upper line rises slower than the lower line, why does this indicate a bearish move when both are sti l l rising? Now compare this to the pattern where a horizontal line stopped prices from advancing any higher while the lower line continues to ascend, why is this bul lish? Both of these examples fit descriptions of a wedge and an ascending triangle and their indications are probably already familiar to you, but the real question here is why do they indicate what they do? Understanding the why and how would give you the opportunity to apply these same principles to other situations other than a few well­ known patterns. The answer to why and how is inseparably connected to crowd psychology. There is a battle going on between buyers and sellers. The upper line represents the battle line of the buyers, while the lower line represents the battle line of the sellers. Remember, a buyer is looking to purchase at the very best possible price and may have previously sold short. So it is not in his best i nterest to have prices rise higher, at least not until he has actually bought. On the other hand, a seller is looking to sell at the very best price that he can obtain. Here again, he may have already bought or is simply looking to sell short. Either way, he does not want price to drop further, at least not until he has actually sold. It is those who accept the offers that change the value of a market and these are the ones looking to buy or sell, not those who already hold positions. In actual trading there is a bid price and an ask price where buyers and sellers make offers to the other 78

Channel Surfing

side. The bid price is what the buyers are offering and is natural ly lower than the ask price, which happens to be what sellers are offering. Each is offering what they think they can get from the other side. The battle between buyers and sellers through the bid/ask spread is nothing more than the balance of power at work and the principles of this struggle extend to a greater level far beyond this momentary spread. The bid/ask action gives us our first glimpse as to who has the upper hand. But unless you are a floor trader exploiting the bid/ask spread, it really is of l ittle use for determining which way a market is leaning. The spread is j ust too narrow and short I ived for most trading. So our view of this battle has to extend to higher ground, the battle lines of channel lines. In any advancement, up or down, it is the line that is pushing the market (the inside channel line) that is key to the trends design and survival. This is why an exit is always called for when the inside l ine is broken, while in contrast the outside line has some exceptions. When there is a distortion in the parallel of the two lines the culprit is usually the outside channel line because this is the variable in the equation. But even variables have l imitations. If the outside line advances too fast for the inside line to keep up then the market will exhaust itself. The inside line's help is needed to sustain any move. Such an advance in an uptrend would demonstrate that the sellers are over inflating the value by demanding more and that a few buyers are even giving into those demands. But not everyone is so willing, shown by the fact that the inside l ine continues to hold its position. Buyers who give in so willingly are usually just desperate and eventually these desperate buyers will dry up, ending the over-inflated run. When the outside line begins to snap back the gap alone between the two lines will create a sellers panic and cause prices to tumble down in haste. As it is true with the bid/ask spread, the alignment of these two lines define who has the upper hand in a market, the buyers or the sellers. In fact, it is actually an extension of the bid/ask spread itself and so contains the extremes of what each believes they can get from the other. The advantage of channel lines is that they show greater depth of the battle between both sides and aren't limited to just a few minutes sampling of trading. So a history of the battle develops and the battle plan becomes obvious. The key to this battle is the inside I ine because it is the base that everything works off of. When the outside line begins to accelerate the important factor will be in how the inside line chooses to respond. If it fails to accelerate as fast as the outside line then the move has a serious problem and an i mbalance between the buyers and sellers exists. The common theme throughout all 79

Michael 1. Parsons

the configurations i l lustrated is that if both are not in unison, then a battle is taking place. To get a better idea of how this battle relates to the action of channel l ines consider the example of a few patterns that you are already probably familiar with, triangles. There are three basic types of triangles; symmetrical, ascending and descending. The l ines that are drawn to outline a triangle are in fact nothing more than channel lines, although they are non-parallel. As the l ines draw closer to one another, pressure builds up to a point where it is finally forced to break, usually resulting in a substantial move. But before this happens, the bias of that break or balance of power may already be indicated by the way the l ines have formed. In an ascending triangle the outside line comes to a complete stop and is seen as a horizontal l ine, all the while the inside line continues to advance toward it. The very fact that an inside line is rising tells you that the bias is toward higher prices and that the power belongs to the sellers. What makes this different than a wedge pattern is that the buyers have entrenched themselves and are refusing to budge at all, yet they are still losing ground. So not enough buyers are settling up and a point of buyer desperation is just around the corner. The buyers may be attempting to hold a battle line, but they can't stop the progression entirely and in time that battle line is likely to collapse and give way to higher prices. Because triangles are so well documented in technical analysis publ ications you may already have a good handle on how to trade them. But there are times when they do not fol low their indicated bias or are subject to false breakouts. Using channel lines to make an analysis of a pattern can offer a critical insight as to who has the balance of power and which way a pattern is likely to break. Sometimes the balance of power will be indicated by the entire pattern. Other times you will have to look at individual pieces of the pattern as it develops. Either way, the bias is usually somewhere to be found in the pattern itself. Obviously, a large cross-section of a pattern will provide you with the strongest indications of bias. But the advantage of small cross-sections is that they often provide the earliest indication of bias. The earliest warning can at times be the most critical when entering and exiting, so there is a great value in being able to interpret the balance of power with just the most subtle variations in channel lines that occur. The more subtle configurations that you can accurately read and interpret, the quicker you can respond. This in turn allows you to be able to enter or exit at better prices and greater profit. 80

Channel Surfing

Often, the initial indication of bias rests in a single bar that doesn't quite reach as far as other highs or lows within a pattern. The signal may be subtle, but it is the first warning to where the balance of power is leaning and of course, where price is likely to be headed in the near future. Since price frequently moves rapidly after leaving any consolidation pattern, understanding these subtle signals can make the difference between making a quick profit and taking a quick loss. These subtle indications can be seen in a series found in figures 5-3 and 5-4.

Bar Indicated Bias During Trading Ranges

-----· ---·--

niiiiiiii i il i

.'111,,1

If the high, low o r close are all equal, no bias is indicated

If the high, low or close is nearer to the upper channel line without actually exceeding it, then the bias is bullish

If the high, low or close is nearer to the lower channel line without actually exceeding it, then the bias is bearish

__.__....__ . . .. __ .. _.._----------_... _--

Bar Indicated Bias During Trends Ifthe high low or closes are all equal in their location in the trend, n o bias is indicated

Ifthe high, low o r close is nearer to the upper channel line without actually exceeding it, then the bias is bullish

If the high, low or close is nearer to the lower channel line without actually exceeding it, then the bias is bearish

81

Michael 1. Parsons

As we go through the next few charts found (Figures 5-5, 5-6, 5-7, 5-8) see if you can identify the subtle indications that tell s you who is winning in the battle over the balance of power.

Bar has low close

82

Channel Surfing

Another high close occurs just before the bullish move Although bars are low within the channel, high closes implv pending bullish move

of MetaStock

z· .

So it is to your advantage to look beyond patterns and see what is actually happening within the action ofprice itself. It is fine to understand triangles, flags, wedges and so on, but the real signals are contained within the channels that actually form them. Besides, it is much easier to memorize the few channel patterns than all the hundreds of patterns that can develop on a chart. This holds true in regard to using candlestick charts as well. Candlestick charts consider a much greater price bar detail than bar charts, but there are literally hundreds of candlestick patterns that you can spend a lifetime trying to master. On the other hand, Channel Surfing accurately 83

A1ichael J Parsons

determ ines the balance of power and is much easier to learn, to interpret, and implement. Particularly when you see non-parallel channel l ines will there be subtle indications of a bias in the balance of power. While momentary bias doesn't guarantee that a market is headed in any specific direction, it does provide you with an early warning and will usually be the precursor to the market's direction when it finally commits to one. Any early indication in the balance of power can provide you with an edge, allowing you to have more success with your trading. I f, like a surfer, you get a handle on balance then you are bound to succeed in riding the waves of profit. Master the balance and you will master the market.

84

Chapter Six

Doing the Math - Setting stops and Calculating the Waves Surfboards don't have brakes and neither do markets. But Surfboards do have safety lines that surfers strap to their ankles called leashes to prevent them from losing their surfboard on a wipeout. We can't put the brakes on the market anymore than we can put the brakes on a wave, but we can use a safety line to keep us from losing everything in the event of a wipeout as well. In trading, these safety lines are called stops. Basically, a trader places an order to exit at a specific price limit that he is willing to risk so that if the market goes against him he is automatically out, so the theory goes. Stops are a necessary evil. I say evil because as every trader knows stops have a habit of getting hit just before the market goes your way. The result is that despite being right about the market you are knocked out of it tor a loss and miss the move that would have been so profitable for you. No one likes to use stops to begin with and they tend to bite the hand that sets them. Stops are mean, spiteful and downright ugly animals. Unfortunately, there is one thing even uglier than stops and that is the animal that shows up when you fail to use them. Have the market go against you just one time without a stop and you will agree that this animal is not only ugly, but it makes Jurassic Park look like a petting zoo. This monster will have you shaking all night long like a child with a monster hiding under his bed. So stops are literally the lesser of two evils, or should I say, the least ugly of two monsters. What makes stops so ugly is the challenge in setting them. You don't want to give away the store so you have to set your stops reasonably close. But if you 85

Michael 1. Parsons

don't allow enough room for your stops then they will get hit every single time and it will nickel and dime you to death. To top it all off, once you start using stops you will swear that someone is broadcasting them to the world because the market always seems to reach just far enough to gobble them up. Although no one is really looking over your shoulder or setting up a news wire to broadcast your stops, there is some truth that the market knows where they are at and is deliberately reaching for them. There may be no X-Files here, but there is a psychology at work. The problem is that people are so predictable with their stops that the odds are that you are just as predictable right along with them.

Mr. Floor Trader and your stops

I magine for a moment M r. Floor Trader who works on the floor of an exchange. He routinely buys thousands of stock shares trying to extract a quarter of a point from the lot of them. He is not looking for a big move, just any move his way. This type of trading is known as scalping and it is basically reserved for floor traders. So today M r. Floor Trader decides to buy a thousand shares of X YZ Company at 99.75. To make a profit he needs to sell them at a higher price than what he originally paid for them. Only problem is that he can't dump the entire 1 000 XYZ shares at once or the price will drop with such a large sale and in turn he will lose money. On top of that, XYZ hasn't traded above 100 all day, so it will be tough to extract a profit. It just doesn't look like it will go much higher, let alone stay there long enough to unload a thousand shares. So what does Mr. F loor Trader do? Rather than sell his shares at a loss he buys one at 1 00.25. Buy, you ask? Yes, buy at an even higher price than it is currently selling for. He hasn't lost his mind, he is just betting on the psychology of the crowd. When he buys at this price all of a sudden everyone that is short or had sold X YZ now panics because they were only anticipating at worse a high of 1 00. So stops are then activated and in come a rush of buy orders. At the same time X YZ suddenly catches the interest of traders who hadn't given it the time of day before. "There must be something happening with X YZ". So this brings in even more orders. Our floor trader leisurely sells his thousand shares of X YZ at an average of 1 00.50 and makes a very nice profit. But he hasn't finished with his little ploy yet because he also sells another thousand X YZ stocks knowing that as soon as everybody figures 86

Channel Surfing

out that there was really nothing to move price in the first place it will then just fall right back down to where it was before. So he profits both ways and this happens all too often. But how did he know that all those stops were there? Elementary, my dear Watson! He knew that the high of XYZ was at 1 00. The stops would be just above this number at 100.25, which is why he bought one share at this price. Actually, most of the stops were probably at 100 because people love to use round numbers, but he wasn't taking any chances. By taking a loss on one share, he makes a killing on a thousand. In order for Mr. Floor Trader to be successful in creating a momentary panic a number of factors have to l ine up. There are limitations on any manipulation that one person can do, so don't think that there is a huge conspiracy here. Traders who take advantage of these tricks are just opportunists, but the tricks are many and the opportunities present themselves far more often than anyone would care to admit. Most of these tricks are simply based on the psychology of the crowd, which is why it is important to understand that when it comes to trading you simply cannot fit in. The lesson here is that if you don't want to have your stop hit, know where everyone else is setting theirs and avoid those prices like the plague. Otherwise Mr. Floor Trader will come looking for it every time he needs to. Either understand how to set your stops or you will be eaten up alive, one stop at a time.

Setting and forgetting stops

Another psychological minefield that traders walk into is the bad habit of "setting" a stop and then "forgetting it" only later to be burnt. There is no such thing as "set it and forget it" in trading. But people seem to envision their stop as a sign planted in a concrete roadway and think that moving it would be breaking the law. When asked about a specific market I am quite often asked, "Where would you set your stop?" Personally, I cringe when I am asked this question. Of course, I have a specific stop in mind and rules for determining where I will set them, but people tend to get hung up on numbers that are quoted while the market itself is in constant change. How do you explain to the average trader that a stop set today will not be the same tomorrow? The concept of a variable stop seems to go against the grain of what most are taught in this business. The rule is to set a stop, lock it up and throw away 87

Michael J. Parsons

the key. Maybe later when the market establishes a new prominent high or low you can then consider a change, but otherwise it is off-limits. The reality is that setting stops this way is just asking for trouble. Sometime ago I bought a rotisserie (a rotating cooking appliance) that was heavily advertised on television. The catch phrase that was used over and over was to, "Set it and forget it". People must love this type of convenience because it had some incredible sales figures and continued to be sold for a number of years. Even I fel l victim to this advertising campaign and bought one. To be honest, the only person for whom this was truly a "Set it and forget it" appliance was my wife who refused to learn how to use it and so all she had to do was to "set me up" to using it and then she could "forget it". I think the catch phrase should have been "Set up your husband to cook the meals and you can forget about dinner and relax". That would have been a more honest advertising campaign and probably would have had all the wives in every major country buying one for their husbands to use as well. The truth is that if you did "set it and forget it" then your food had a tendency to do some wild and crazy things. For example, a roaster chicken might have a wing pop loose as it continually rotated within the appliance creating havoc with the burner and singeing it. Similarly, traders have the tendency to do the same thing by placing stops at obvious locations and then leaving them there. Floor traders know where these obvious places are because people are so predictable, so setting and forgetting your stops is often a huge mistake. You can't prevent the market from popping out somewhere you didn't expect and playing havoc on your account. You are sure to end up getting burnt from time and time, or at least singed pretty badly. But even if you never have to worry about Mr. Floor Trader there is still another reason for never setting and forgetting your stops. A market is in constant change and fai lure to adjust to market conditions leaves you vulnerable to those changes. For example, what happens when volatility increases? Any stop that you may have set is no longer able to accommodate the wider swings and you will end up taking a loss when your stop is hit. Even if a trend does go your way you are stil l guaranteed a loss if for any reason a stop is reached. Stops are initially set at a loss and if out of habit you never change it then your set it and forget it will mean a loss every time a market retreats back to the stop's price level. The only time you would actually make a profit is when you manually exit from the market. Think about this for a minute, 88

Channel Surfing

what happens when something just l ies around too long as ifit were dead? The vultures come along and chew it up. What makes you think it will be any different for your stop if you set it and forget it? So just setting your stops based on prominent highs and lows and then ignoring them is just asking for trouble, which is exactly what it will bring. But how else can you approach the placement and movement of stops? Here again, Channel Surfing comes to the rescue because it automatically sets and adjusts them for you. As you will recall, whenever your channel l ines are broken you exit, so in essence you are setting a variable stop that fol lows the market. Using channel lines in this way forces you to change your stops regularly with every new data bar. So when trading daily charts your stop is automatically adjusted each day as long as the market continues to move in a trend. Of course, you are actually using two channel l ines and therefore setting two stops, not just one. But even with both sides considered the process is extremely easy to apply because it is done graphically. You simply set your stops just outside of your channel lines and when it crosses either of them you exit. But what is done graphically can also be done mathematically and there are reasons why you may need or want to do it this way.

Calculating stops mathematically

I f you were day trading and using a five minute chart t track your trades then it would be redundant to send your broker a stop every five minutes. It would become obsolete within minutes of submitting your order. So a day trader is better offjust watching the channel lines and using them as "stop lines", exiting whenever the market exceeds them. However, if your trading style requires that you submit a stop order then you will need to calculate your stops mathematically. I magine calling your broker and tel ling h im to get you out of the market when it exceeds a channel l ine. You would be the joke of the day in his office. If you want to submit a stop order you have to provide it in the form of a specific price. Position or short-term traders usually have to submit their stop orders in this way. Fortunately, figuring out a specific price is a simple mathematical calculation that can be done either by hand or more conveniently, by using a spreadsheet. Throughout this chapter there will be examples where daily charts are used to determine the placement of a stop, but the principles are the same for any time frame that you may be considering. 89

A1ichael J Parsons

The first task is to draw channel l ines and determine the date (or time) of the highs and lows that generate those lines and their prices. Figure 6-1 provides our first example chart and shows a trend where the Channel lines are already drawn. I have taken the liberty of writing the highs and lows ( H=high & L=low), as well as the dates (month & day), of the bars that are touching either channel line. For our purposes there is no need to worry about any highs or lows that are not actual ly touching a channel line.

To determine trading days. Include both bars that establish your highs or lows in your count.

Once we have the prices and dates (or times) of our highs and lows, our next step is to determine the average price change of the channel line each day (or data bar). This figure is then added (or subtracted) against the current value of the channel line to give us the channel's limit for each succeeding day. For example, in the case of a supporting channel l ine in an up trend we would take the lows that have touched the line and calculate the difference between the low and the date. The elements of the calculation are: A = 1 st low price B = 2nd low price X 1 st low date Y = 2nd low date Z Average price move per data bar for the channel =

=

Based on these elements, the calculation is: Z = (B-A) / (Y-X) 90

Channel Surfing

In other words, the 1 st low price would be subtracted from the second low price, giving the total price difference between the two. Subtracting the 1 st low date from the second low date would provide the total difference in days between the two lows. Remember to subtract any non-trading days from this calculation since you are only interested i n the actual trading day difference. Then divide the price difference by the number of days and you come up with the average daily price move that needs to be added or subtracted from each day to continue the channel 1ine. The upper channel line would be calculated in similar fashion, only the highs that touched the upper channel would be used. Of course, if you were dealing with a channel that was bearish then the calculation would be in reverse order. The calculation would look l ike this: Z

=

(A-B) / (X-Y).

So the only difference would be that the order of A and B which would be switched, as well as the order of X and Y. Or so it is easily remembered, you always subtract the lower number from the higher number to get the difference. Having established the calculation of the channel lines and using the highs, the lows and the dates from our previous chart (Figure 6-1), let us determine what the stops will be for the next several days. Starting with our inside channel l ine (Supporting trend line), we have the following: 33.39 - 3 l .00 2.39 (2nd L) - ( l st L) Price Difference =

=

December 3 1 't - November l JIh

=

33 trading days

Take out any non-traded days such as weekends and holidays. Here, Christmas and Thanksgiving [USA holidays] and several weekend days require 1 6 days to be subtracted from the actual total of 49 calendar days. The easiest method for determining trading days is to simply count the actual bars, starting with and including the first low/high and each bar up to and including your last low/high bar. 2.39 / 33

=

.0724 (Average Price Difference)

Based on these calculations, you would add .0724 to each succeeding day to determine where the price level of the Channel l ine would be for that day. 91

Michael 1. Parsons

So the next trading day fol lowing your last date of December 3 1 '1 should have no lower low than 33.4646 33.39 + .0724

=

33.4624.

You can then add .0724 to any calculated day to find the next day's low. For example, the next few days will follow a sequence of33.5348, 33.6072, 33.6796 and 33.7520. Simply set a stop just below the expected low (never place a stop at the actual calculated number since this is what price is allowed to reach) and fol low it with a new calculated stop for each succeeding day. Calculating the upper channel line is just as easy. 38.2 1 5 - 35.25 2.965 (Price Difference) January 2 1SI - November 22nd 39 (Trading Day Difference) 2.965 / 39 .076 (Average Price Difference) =

=

=

Based on these calculations, add .076 to each day to calculate this channel l ine. The day fol lowing your last date (January 2 1 SI) should have no higher high than 38.29 1 . 38.21 5

+

.076

=

38.291

Simply add .076 for each succeeding trading day that fol lows to calculate the maximum high for each day. The next few days to follow will calculate as: 38.367, 38.443, 38. 5 1 9 and 38.595. In this particular case, you will notice that the average price difference is slightly different between the two channel lines. This is not unusual. Although channel l ines are parallel, they are often not perfectly aligned. You will need to recalculate from time to time because the market has a way of compensating for these differences and does so quite often. Now that we know how to calculate the numbers for our channel, we need to determine our stops. Why couldn't we simply use the numbers we have already calculated? Because these numbers are the limits of the channel lines and so price is expected to actually reach them. Therefore, it will naturally hit these numbers regularly. Price has to actually break a channel line (or exceed our numbers) to signal a change in trend. So how much breathing room do we allow? 92

Channel Surfing

This depends on how aggressive you want to trade. You can set your numbers at the very minimum price movement above or below your channel lines. In the T-Bond for example, the minimum price movement allowed is 1 /32 ofa point. So if you have a supporting channel line number at 36 7/32 then you could set a stop at 1 /32 less than this number, which would be 36 3/16. In the case of a market that has a tendency to become volatile, you may want to al low a little extra breathing room. For example, with the S&P it may be necessary to allow a ful l point or more above or below your channel numbers to compensate for any wild swings that may occur. Another approach and one that I prefer is to set stops at the previous day or following day channel line numbers, depending on whether an up trend or down trend exists and of course, which channel l ine you are looking at. Then an adjustment is made as needed. So that you are not confused by the way that I just explained this, lets look at the numbers based on our previous calculation. The next day's low for our inside channel l ine is 33.4624. This was based on our calculation of 33.39 + .0724. Based on this, our stop could be set at the previous day's low which just happens to be, you guessed it, 33.39. It can't get any simpler than that. Just remember, this would be the calculated low for the channel line and not necessarily the actual low price set by the market. Of course, Channel Surfing uses two stops, so we need to calculate that as well. The calculation for the opposite stop is just as simple as the prior stop. 38.21 5

+

.076

=

38.291

For our outside channel line, we simply take our calculation 38.21 5 + .076 38.291 and add for the next day .076. So the calculation becomes: 38.291 + .076 38.367. So the channel l ine price level for tomorrow (38.367) will serve as our other stop. Now that wasn't too hard, was it?

=

=

Just to make sure we have the right idea, let's go through another example. In figure 6-2 we have a trend moving in the opposite direction, so the calculation sequence is slightly different.

93

Michael J. Parsons

Low

1 � �}�i r 1 13.38�J1fl

Feb.

24

1� J�lt�l-l

12.92�

Low Mar. 11

Ford

tI

I tt t

}1

The inside or upper channel l ine has its first high at 14.77 and the second high at 14.26. They are l7 days apart. 14.77 - 14.26 . 5 1 .51 / 17 days .03 =

=

So the next days high should he no higher than 14.23. ( 14.26 - .03 14.23)

=

To determine the current high limit, simply add the number of days from the last high to the calculation. The last bar on the chart is 17 days from the last high. Multiply 17 by the average price difference and subtract this from the last channel l ine high, which will give you a limit of 13.75. 17 x .03 . 5 1 (Total Accumulated Price Difference) 14.26 - . 5 1 1 3 .75 (Current High Price Limit) =

=

The lows are just as easy to determine. The outside or lower channel l ine has as its first low 1 3.385 and its second low is 1 2.92. They are 13 days apart. 1 3.385 - 1 2 .92 .465 .465 / 1 3 days .0357 =

=

So the next day's low limit would be 1 2.8843. ( 1 2.92 - .0357 94

=

1 2.8843)

Channel Surfing

Multiplying the average price difference (.0357) by the current number of trading days from the last low touched by the channel line and then subtracting this total from that low ( 1 2.92) would provide you with the current price limit. Setting a stop just beyond these limits will provide you with a dynamic and self adjusting stop that moves with the market. This method of setting stops works well when a trend is well established, but what if you have just entered a market or a trend isn't fully discernable yet?

Calculating stops for breakout trades

A trend that hasn't shown its hand is a difficult one to judge. There are often signs of what will act as support and resistance within a market, but until a trend actually gets under way you will have to make a judgment call. A market may break a trend line according to the rules but still drift a considerable way into enemy territory. Obviously, you have to put some limit any move against you or the losses will mount up. Resorting to using a prior high or low is one way to handle this. The problem is that this is a very common method of setting stops and the market has a habit of taking out these highs and lows just before the move gets under way. So caution needs to be used when taking this approach. A minor break may not negate a trade and so some d iscretion needs to be used when these prior levels are reached. A simple three break rule can also be used. It works like this; if you have three bars that are exceeded against your trade, then an exit is called for. In other words, if! am long and the bar I entered on has a low of99 and the next bar has a lower low of 98, followed by another bar that is even lower at 97, and finally a third bar exceeds even this low and reaches 96, then an exit is called for. Three new lows exceeding each other will signal an exit. On the opposite side of the coin, three new h ighs exceeding each other would signal an exit from any short that you would have taken. Figure 6-3 demonstrates this method.

95

Michael J. Parsons

The low of this bar was

12.45 and is the first

break of the entry bar '

If this bar had been exceeded, then it second lower low

would be a third lower low and signaled an exit. In this case it was not exceeded and the long was held.

Ford

Cltart

If you choose to use the three break stop, there is a word of caution. There are times when individual bars will have very strong and excessive moves. If you have a bar that moves against you in such a fashion then waiting until three bars are exceeded can lead to a very substantial loss. So discretion is needed when it comes to real application of this method. An excessively strong move against you is not a welcomed sign with any method of stop. Strong moves tend to beget strong moves. So as a backup to this three break stop method you may want to adopt an average expected range within the equation. I f you determine that a market normally averages only one point per day and the market moves three points against you, then you may choose to use this as an indication is get out of that market rather than wait for an additional two days to call it quits. However, this alternative should be the exception and not the rule. Many pullbacks are three days long and a premature exit based on a momentary panic can become a habit that will sabotage your trading success. Of any stop method that you can use nothing wiII match the level of channel lines. So the preferred approach will always be the use of any prior or existing channel lines to identify support or resistance. Although a new channel may not be clear enough to work with, a prior channel line will be. Despite how far back they may originate price will dance with a prior channel line just as if she is an old flame that it still longs for. If an old channel line extends within the range of an entry point it will often act as the critical indicator of any failed move. The only drawback to this method is that they can be very subtle at times or simply not apply at the 96

Channel Surfing

moment, so a back up plan for setting stops is sometimes needed. This is of course the reason we discussed the other methods. In any event, once a channel gets under way then the channel is used to set the stop. A l l other methods for setting a stop are abandoned from that point on. Figure 6-4 illustrates this point very well.

A long position I s taken when price exceeds and holds above a previous high

Setting your stops by means of a channel l ine is always the preferred method, whether that channel line is old or new. So whenever possible, use them as much as possible. They are a great way to start out on any trade and their adaptability allows you to gauge a market as it develops and make any needed adj ustments as well. Just remember that adjustments are necessary from time to time and never think that any particular way of setting stops is written in stone. Stops require diligence because the market is dynamic. Unless your stops are dynamic as well you are l ikely to find their lag dragging you, along with your margin account. You will also need to consider the ever changing market conditions and your risk tolerance when deciding how to set them and how to adjust them. Out of the hundreds of methods that I have explored, using channel l ines to set stops remains one ofthe very best techniques that I ever seen. I am sure that the more you use them the more you will agree. Stops are an integral part of money management and money management is well recognized as an essential key to trading success. Unfortunately, money management is also one of the most neglected parts of trading that is taught as well. But this comes as no surprise since most teachers don't have a clue how to properly set stops anyway. Except for the overused method of using prior 97

Michael 1. Parsons

highs and lows there are few choices that are even mentioned. The focus is usually on how to enter, not how to exit. If the majority of teachers have no clue to how to set stops then it is understandable why the majority of traders do not know either. For this reason it is to your advantage to learn this method of setting stops well since it will give you a substantial edge over this poorly taught majority. It is amazing how well you can do simply by setting your stops properly, even if you are wrong in other areas of your trading. Channel Surfing allows you to use the market to dictate where your stops will be and this takes the guesswork out of the equation. So even if you can't put the brakes on the market you can still keep the market from wiping you out. Learn how to set your stops right and you will go far in your trading.

Calculating entries mathematically

There is another aspect of trading that the calculations we have discussed prove invaluable for; the entry. A bad entry can turn a good trade into a losing one. A lion knows that a running gazelle is a very tough hunt. Rather than exhausting itself trying to chase an animal designed for running, lions will use a trick where they will roar and scare the gazelle into the clutches of other lions that are waiting in ambush. So in reality, lions wait for the gazelle to come to them, rather than chase after the gazelle. What the lion has known for thousands of years is a lesson that traders do well to learn as well. It isn't prudent or healthy for your bank account to chase after markets, no matter how fast they may run. But how do you wait for the market to come to you, particularly when it is running in a trend? Every market has an up and down motion. Sometimes it is very pronounced as it is with trading ranges. Other times you will be hard pressed to find that motion such as when a market is in a runaway trend. Even so, it will always be there in one way or another. Channel Surfing enables you to identify a market's up and down motion and enter when the price comes to you. If you are looking to enter during a trend then the range will be outlined for you by a channel. By using the very same calculations that you did when determining your stops you can also determine the very best point of entry. The ideal entry will always be closest to where your stop will be set, which is of course next to an inside channel line. There is one problem with this concept; price will usually only touch a channel line on occasion so it is unrealistic to expect that price will come 98

Channel Surfing

down to the lowest low or up to the highest high on any range calculation. Therefore, don't expect to enter at these extreme price levels. But what you can expect to do is to enter within the best portion of that range and thereby, reduce your risk exposure. How do you determine the best portion of a range? The simplest way is to use a one-third rule. Determine the range for the next trading day and divide that range by three. Then enter the market only if it is within the better third of that range. The formula works l ike this: [(H L) / 3] + L H - [(H L) / 3] -

-

=

=

Up Trend Range Down Trend Range

So in an up trend, we would take the Lower third of the range and enter long when it drops within this range. On a downtrend, we would use the upper third of the range to enter short. This is of course closest to what we identify as the inside channel line, whichever direction the market is gomg. I fwe go back to an earlier example offigure 6-1, we can use the calculations we had made to go a step further and determine where exactly the upper and lower third of the range is at any given time. But it will take a few extra steps because we need to coordinate the high and low ranges. I n other words, we just can't take the high and low prices we have because they do not occur on the same exact day. We must first adjust one of the highs or Lows to match the same day as the opposite channel line's high or low. The last high that the channel line connects outer channel line touches is 38.215. The last low that the inside channel l ine touches is 33.39. The problem is that these two numbers are 14 days apart. So we need to make an adjustment. In this case we will take the low and adjust it to match the high. Because there is often a variation between the angle of the two channel lines, it is best to make this adjustment as close to the current price activity as possible. The average price difference for the lower channel line calculated to be .0724. Multiplying this by 14 (the day difference) we have a total difference of 1 .0 1 36. This is then added to the low we are using (33.39) and the adjusted price becomes 34.4036. 99

Michael J. Parsons

14 x .0724 = 1 .0136 33.39 + 1 .0136 34.4036 =

With the adjusted low determined, we now subtract this from the high and find our total range, 3.81 14. 38.215 - 34.4036

=

3.81 14

We then divide this number by three resulting in 1 .2704. 3.81 14 / 3

=

1.2704

When the third of the range is determined, you then simply add or subtract from the inside channel, or whichever would be the better side ofthe range. Since this example was in an up trend and we want to go long we would enter closest to the supporting channel l ine and therefore, add to that line's number. Adding 1 .2704 to the adjusted low of 34.4036 we derive 35.674. 34.4036 + 1.2704

=

35.674

If price fel l below 35.674 we could then enter long. But our entry is not really based on a specific price, but rather on a zone. If you can enter at a better price than 35.974, then by all means do so. Nothing in this equation prevents you from i mproving your entry if at all possible. As long as it is within the range from 35.674 down to the inside channel line, any price will do. Often, it would simply depend on what price was reached first. That is unless a stop was exceeded, which would negate any trade. Since our stop would be just outside of the 34.4036 price level, perhaps at 34.2, the risk would only be about 1.5 if entered at the maximum allowed price. 35.674 - 34.2

=

1 .474 (Rounded out at 1 .5)

This risk is substantially lower than ifwe just entered haphazardly, perhaps at the high end of range which may have exposed us to a risk higher than 4.0. 38.2 1 5 - 34.2 = 4.015 Risking less than 1 .5 is a whole lot better than risking over 4.0, wouldn't you agree? But what i f it never comes within one-third ofthe range? This will happen often, so don't be alarmed by this and panic. While it is true that you may miss out on a trade and have to wait for another day to try again, the 100

Channel Surfing

alternative is enter haphazardly and put yourself at greater risk. I f you want to succeed in trading you have to succeed in keeping your exposure low on each trade. Losing trades are inevitable, but big losses are not. They are a matter of poor trading and that makes a trader poor. If you are repeatedly faced with missed trades while using the one-third ratio then there are two other approaches that can be taken to deal with them. The first is simply to wait until it fi nally does meet the one-third level criteria. You will miss part of the move, but you don't have to have it all to make a profit. There is always a trade-off when it comes to risk/ reward ratios. While you can do some things to control your risk and improve your reward, risk cannot be totally eliminated. So there are times when you have to be willing to make a trade-off. Accepting bigger risks for bigger rewards is one of them. An alternative that involves a bigger risk is adjusting the ratio from one­ third to one-half. When a market trend is rapidly accelerating the one-third rule will not work because each day that passes draws more of a crowd and causes the market to jump a little faster than it did the day before. As a result, you could end up watching the entire trend run its course without ever retracing to the better one-third range of the channel. Adjusting the ratio to one-half will often compensate for an accelerating trend and enable you to enter a runaway market. As with the one-third rule, you are simply dividing the days range by two and using the better half for entry. Of course, this means that you are also accepting a higher risk, so this ratio adjustment is not recommended unless market conditions warrant it. Most trends will never require a ratio adjustment at all. But there are times when a supply and demand issue has fueled a major move and it is clear that the run will be a dramatic one. As a rule, be cautious about chasing runaway markets because they will usually leave you exhausted and broke.

Calculating breakout entries

But what if you need an entry price for a trend that you are only anticipating? Several entries that have been discussed in this book use the break of a channel l ine to signal an entry rather than a bounce, so obviously a means for calculating these entries is also needed. Actually, these entries are even easier to calculate. You are in essence using the same process as you would in setting a stop, only what you 101

Michael J. Parsons

calculate will be used for an entry instead. Take the existing channel and calculate the range. In the direction of the trade you are anticipating, determine a price that is clearly outside the current channel range, but still very close to it. So the same exact method of setting a stop is what will in turn set your entry price. You can even still use the one-third rule, only in this case you are looking for this to be a minimum to signal an entry rather than a maximum. For example, if you have a potential breakout entry setting up and are considering going long off of a downward trend whi Ie the current expected maximum high is 1 104 and the expected low is 1 1 01 , then a long entry would obviously be made above 1 104, but the question is how far above it? To include the one-third rule, you simple determine the range, which in this case would be 3 points ( 1 1 04 - 1 104 3), and divide this by three, which gives you one (3 / 3 1). Now take the maximum high and add this number to find the minimum, which would make 1 105 your entry price. ( 1 1 04 + 1 1 105) =

=

=

Looking at an actual example in figure 6-5 you can see how this process is done. While many of these trades fall into place like clockwork, this example is actually one that had a problem and still turned out profitable.

L t�

Price slightlv exceeds the breakout price and a

�

Low 29.047 Sep. 22 Starcraft

Low 27 oct.

1 .8342 is added to the channel line to form a breakout line Total Range = 5.5028 5.5028 1 3 = 1.8342 Clw1

The first step is to calculate the channel lines. The inside channel line has two highs (35.9905 and 33.8095) separated by 9 days. Subtracting the lower high from the higher high we end up with 2. 1 8 1 . This is then divided by 9 days to provide the average price difference of .2423. 102

Channel Surfing

35.9905 - 33.8095 2 . 1 8 1 / 9 = .2423

=

2.181

We then need to adjust a high to match the same date as a low. The low occurs 5 days later, so we multiply .2423 by 5 days and then subtract this from our high. This provides the matching high to the low. . 2423 x 5 = 1 .2 1 1 5 33.8095 - 1 .2 1 1 5 = 32.598 The low is then subtracted from the high and we determine that the range is 5.5028 and then divide this by 3 for the one-third range, which turns out to be 1 .8342. 32.598 - 27.0952 5.5028 5.5028 / 3 1 . 8342 =

=

So 1 .8342 is what we would add to the current high, translating this specific date's breakout price into 34.4322. 32.598

+

1 . 8342

=

34.4322

To calculate future breakout prices, you simply adjust the breakout price just as you would the inside channel l ine, by subtracting or adding the average price difference. In this case you would subtract .2423 for each day. So the very next day's breakout price would be 34. 1 899. 34.4322 - .2423

=

34. 1 899

The days fol lowing would have a sequence of 33.9476, 33.7053, and 33.4630. It just so happens that on the fourth day price reaches a h igh of 33.5238, exceeding the breakout entry level for that day of 33.4630. The value of requiring a certain amount of fol low through when a breakout occurs will help prevent you from fal l ing victim to false breakouts that happen so often while sti l l providing an early entry that stil l takes ful l advantage of any changes in trend direction. Particularly when you are faced with a market that has a tendency to make frequent trend changes this entry can be just the ticket to get in early and make a profit. While most of us may be adverse to math, successful trading requires it. A short term or position trader can't avoid math and even if you day trade I guarantee that there will be many times when you won't be able to avoid 1 03

A1ichael J Parsons

it either. We all need to know how to make the necessary calculations. If you are confused by any part of this chapter then for your own benefit reread it again. Practice on a number of charts until these calculations become second nature to you. Become proficient at your trading math and the money in your bank account will really start to add up for you. And tabulating up all your profits will be the one calculation you will take great pleasure in. You can count on it.

1 04

Chapter Seven

Multiple Time Frames Many years ago I took my wife and daughter of three hiking down a path in the Skyline Mountains in the eastern part of the United States to see a waterfall. At the time it seemed like a good idea. The path was nearly three miles long, but was an easy walk. Of course, the wal k to the falls happened to be all downhill and so when we attempted to return the walk became an uphill climb and a much more difficult task, especially with an exhausted three year old who had to be carried. The real problem arose when the sun started to set and darkness started to cloak the markers that marked the path we were walking on. There was stil l some l ight in the sky, but the denseness of the forest kept most of that light from illuminating the trail making the path impossible to fol low. Even the trees became a blur of shadows. All we could do was to keep walking and hope we were going in the right direction, extending our hands out to prevent us from walking into a tree. Fortunately for us we managed to find a fire road (a pathway cut through the forest to limit fires and to allow access for equipment) and we were then able to find our way back to the main road where we were parked. Because of the width of this access road there was no mistaking where we needed to go and without trees to block the sunlight we were able to see our way easily. However, I shutter to think what would have happened if we hadn't come across this access road. The point is that we can sometimes be too close to the trees to see the forest or in th is case, too deep in the trees to see our way out of a dimly lit forest. Sometimes our path can be too small and too unclear to be of use. Step back and look at a situation from a bird's eye view or find a much 1 05

Michael J. Parsons

larger path and your direction becomes much clearer. This is the benefit that larger time frames can bring to the table of trading and can very well be the difference between knowing where the market is going and being lost in the woods. The big picture reveals what is actually happening within a market, and of course, the strongest forces influencing it. But imagine trying to trade a market using only charts based on weeks, months or even years. The draw down would be so immense that it would make trading unrealistic for most traders, particularly for those with very limited capital. There are times when we need to see what is far ahead in the distance, but who of us can keep ourselves from stumbling when we can't see what is directly under our feet? We would be stumbled by everything in our path. So too, smaller time frames are a necessity if we want to control our risk. Does it really make that much difference to look at multiple time frames? Well, would you like to know when a trend will stop, a top or bottom form, or when a market will take off? Higher time frames can actually help you determine when such occurrences will happen and knowing this in advance will make trading much easier and more profitable. Naturally, we would l ike each and every one of our trades to be a guaranteed success, but realistically that isn't possible. No matter how good a sports team might be no one wins every single point in every game. A team becomes a champion, not by winning every single point, but by winning the most games. If you won more trades than you lost then that would be great, wouldn't it? What if you also won more money on each winning trade than you lost on any losing trade? When you add both positive elements together in your trading and are able to repeat this process consistently, the results are substantial profits. This is the ideal that you are after in trading, plain and simple. For this scenario to be a reality you need to consistently find low risk and high return trades where the odds are substantially in your favor. Most think this is an elusive dream, but I am about to show you how to actually do this. By applying multiple time frames to Channel Surfing the trades are dramatically improved with lower risk and higher return. Trades are not only more frequent winners, but winning trades will have much greater profits and losing trades will have much lower losses. The profit/loss ratio widens and even gaps in your favor. Multiple time frames are a primary factor that elevates Channel Surfing to a whole new level, the level you want to be at. 106

Channel Surfing

Before we go any further I need to clarify a term I am using here. Although I use the term multiple time frame, the more accurate term is actually multiple time span. A time span is simply defined as a period of time or data. A chart may have several usable time spans showing on the same chart. What is of importance are the patterns that develop and define the specific channels, whether you are looking at a single chart or charts derived from various time frames. For example, if I were looking at a daily chart that has a channel covering a one-week period then this would be one time span. I might also notice a channel that covers a period of one to two months and overlaps my one-week channel, which would be an example of a higher time span. Both of these channels may be visible on the same chart and time frame, but they are still distinctly different views of market activity. A weekly chart, which would be an entirely different chart, may show a channel covering a six-month period that encompasses the other two channels. This would be an example of using multiple time frames to accomplish the same thing as we did with the two time spans found on a single chart. The important factor is that a larger channel is found that encompasses the smaller channel and this is used in our analysis of a market. Even though the terms multiple time frames and multiple time spans apply, the term multiple time frames will be used interchangeably for both. So don't be surprised or confused by the use of this term even though we may actually be dealing with two separate channels that appear on the same chart. Although a different time frame will be used through most of this chapter to prevent confusion it is not necessary that you actually have a different time frame to accomplish what is being demonstrated. As a general rule, the larger the channel the greater the impact it will have on a market. But in using multiple time frames you are not looking for the largest channel available. Rather, you are looking for a larger channel that encompasses your smaller channel and can be used for setting some parameters. This is usually the next higher channel available. Once you determine a larger channel that meets your requirements it is then used in conjunction with the smaller channel which will be providing that actual signals for any entry or exit.

Trading multiple time frames

The concept of using multiple time frames is relatively simple. You determine a time frame or time span that you want to trade and find a 1 07

Michael 1. Parsons

prevailing channel to set up your entry and exit points. At the same time you set up a channel in a larger time frame or time span that encompasses the smaller channel to determine the trades with the lowest risk and highest profit potential. Normally this larger channel will be the very next in l ine above the smaller channel, but the essential factor is that both channels be well defined, not next in line. Once both channels are defined you are then looking for trades that are only in the same direction as the larger channel, not against it. The smaller channel will be used to narrow down your entries and exits in the direction of the larger one. What this means is that you are only trading when both channels are moving in the same direction. If one channel is up while the other is down, then no trade will take place. I n essence, you are requiring both channels to work for you, not against you. By waiting for both channels to line up together you increase the odds that a trade will fol low through with a move in your favor. Additionally, there still is one other requirement that must be met before a trade is taken. This requirement has to do with the position of price within the larger channel. Earlier, we covered the specifics of how a trend entry was to be made and the requirement of price to be within one-third of the inside channel. I f a market accelerated rapidly then this percentage could be adjusted to one-half. This requirement allowed more room for a profitable move. The same principle is carried over to trading multiple time frames. However, in this case we are focusing on the position of price in relation to the larger channel. The minimum that price should be is within the one-half range closest to the larger inside channel l ine. But this rule is for an entry only. I f a position has already been taken then you can maintain it until a smaller channel signals an exit. The position of price within a larger channel has no bearing on the decision to exit, unless of course you have reach the larger outside channel line. But once you have exited any position then it is best to wait until price has again returned within the one-half range of the larger inside channel l ine before considering another entry. Figure 7-1 demonstrates this principle. One of the major objections to these requirements is that there will be no available trade for a large portion of time. While this may be true, the trade-off is that there will be more successful trades, the method wil l be simpler and the rewards more robust then if you just attempted to trade continuously. Remember, there are always plenty of markets available to trade and if one no longer fits the requirements then there will be others to take its place. Of course, you can still return to using just the basic 108

Channel Surfing

Channel Surfing techniques so that you will have more trades, but multiple time frame setups are the most desirable and should always be your first focus when scanning for new trading opportunities.

Only trade in the direction that the larger channel I S biased toward

In this case. the bias is bullish. so only a long position is taken

The reality is that markets swing both ways. Naturally, we would all l i ke to start every trade with the least amount of risk. By approaching each trade with this double requirement you have two channels, not just one, working in your favor. While this stil l does not guarantee a profit, multiple channels will multiply your chances of success. To summarize, the larger channel is used to reduce the risk of any trade. It has the stronger influence on the market and biases the market in your favor. The smaller channel is used to signal the actual entry and exit of your trades. For any entry, two requirements must be met. First, the entry must be in the direction of the larger channel which means that both channels must be in unison. Secondly, price must be within one-half of the larger channel range, closest to the inside l ine. Exits are determined by the smaller channel only. Aside from these specific rules everything else would be handled just as you have already learned. But this simple addition to the basic techniques brings with it a big impact on the results. Before I go into any further detail s about this process, consider the reasoni ng behind this approach. We have all heard of the expression. "The trend is your friend". There is a lot of truth to this expression. By using a larger and stronger trend price tends to move in our favor. This is the part that creates the low risk for our trades. At the same time, none 1 09

Michael 1. Parsons

of us really want to endure the extensive drawdown that accompanies the use of larger trends. So to solve this problem we use a smaller trend to limit the drawdown and refine our entries and exits. Remember this expression, "Follow the shadow of the big while walking in the footsteps of the small." At this point you may be a little confused about this larger/smal ler channel combination. Relax, because I am going to walk you through a couple of trades. Since there are two types of market conditions to consider, trending and trading, we will approach each separately and discuss how each is best traded.

Trending markets and multiple time frames

Of the two, multiple time frames are easiest to apply to trending markets. I n order to make a profit we need to have price moving up or down in our favor. Trending markets have already shown their bias and so determining the direction of your trade is made that much easier. Despite this, the first order of business is to determine the time frame that you prefer to trade. I f you are looking for trades that last for six months or more, then there is no need for you to look at channels that appear on an hourly chart. So this determination is based on what your goals and preferences are. For demonstration purposes, we will consider trades that run from a couple of days on up to several weeks in length. However, the time frame choice is irrelevant when using these techniques. If you prefer a longer trade that lasts several months or just the opposite, trades that last but a few minutes, the methods are applied in the very same manner. In any time frame you settle on you will start by choosing a channel that will fit your preference and be used to signal your entries and exits. Because this first channel is the foundation of all that follows, making a good choice is essential. A lso, while it doesn't have to be perfect, your time level preference does need to have a habit of forming wel l defined channels. There is a delicate balance here. The average movement in price has to be enough to cover any slippage and transaction costs, so a minimum size is required. But at the same time the channel has to be small enough to keep drawdown tolerable, so there is a maximum to the size you choose. Look at recent trends to find what fits your trading requirements. Once you have found a channel that fits your requirements you then locate a channel on a higher time frame that encompasses the smaller channel. 1 10

Channel Surfing

This will be used to determine certain risk parameters, so obviously this channel must be well defined as welL Again, you are not looking for perfection here, just the ability to easily determine what the limits are. As you search through the available larger channels you will usually run across more than one to choose from. Each additional channel will offer something more when analyzing the market, so they are worth reviewing. But for our purposes we are most concerned with using the next available larger channel that is well defined. This will be our main focus, even though you should never entirely ignore these other channels. Remember that the larger the channel the greater the impact on the market. So they will be of particularly importance whenever price draws near to one of these other channel lines. One question that often arises at this point has to do with the use of the term "well defined". Whenever you have a new trend that is just forming a channel will usually be unclear to some degree. Even larger channels turn at some point. There are of course other situations when finding a well defined channel can be tricky as welL Sometimes it is necessary to step up to the next available channel to find one that is well defined. But usually it just depends on how a person actually looks at a market and how much data they include. A channel that is clear with three months of data may be lost if you only have two months of data. So if you don't see a channel that can be easily drawn, then it is likely that you just don't have enough data showing on your chart and need to go to a higher time frame. A channel requires a minimum of two h ighs and two lows and it should stand out clearly, not be questionable. The key here is not to overcomplicate this by trying to make a channel appear where none exists or where it isn't well defined. You either see one or you don't. There are a few shortcuts to establishing a channel that we discussed earlier, but because a larger channel is used to limit risk it is always best to have the points already established, not estimated. As long as you have enough data there will always be a channel on a higher time frame somewhere. If you don't see one then it is just a matter of finding it. If you do have problems defining your channels or if there appears to be too many choices for you to narrow them down, then avoid that particular market until you gain more experience in using this method or until that particular market becomes easier to define. These requirements can at times mean that a substantial part of a market's activity is off limits, but again the key here is to keep your risk low. As you develop your skill in using these methods you can adjust your trading to match your risk tolerance. 111

Michael 1. Parsons

Defining your entries and exits using multiple time frames

So now that you have determined both your smaller and larger channels, what then? In a trending market the larger channel dictates the direction of your trades. I f the larger channel is up then you are only going to buy. I f the larger channel is down then you are only going to sell. Additionally, the larger channel is divided into two halves and a trade would be executed only when price is in the one-half range closest to the inside channel. Aside from these requirements, you would simply take your entry and exit signals off of the smaller channel. It is as simple as it is shown in figure 7-2.

Exit ----F� Oats

Trending market summary

Using multiple time frames with trends will dramatically increase the odds of success on each trade. The process is relatively simple, but to further clarify these methods there are five summary points that we will review. These summary points are to serve as a guide when you are considering any trade. Although this guide is not written in stone, you should have some very good reasons before violating any rule and be prepared to accept the additional risk of such action. The five summary points are: 1 12

Channel Surfing

1. 2.

Enter within the half closest to the large inside channel. Enter only when both channels are trending in the same direction. 3. Enter within a third of the smaller channel range, closest to the inside channel l ine. 4. Set a stop just outside the smaller channel range, avoiding round and obvious numbers. 5. Set a target price just outside the smaller channel range for an exit. Before covering some examples of entries and exits, let's review a few summary points in more detail by way of a few questions. The answers to these questions tend to put a market in focus and require you justify any trade that you are considering. This demands that you have logical reasons for taking any action, which in turn will help you avoid the emotional illusions that tend to sink many a trader. Which way is the larger channel trending? Are you closest to the inside line or outside line? Look for trades that are closer to your inside l ine. The greater the distance to meet the opposing channel l ine, the lower the risk and higher the reward. Only buy when the larger channel is in an up trend and only sell when it is in a downtrend. Avoid entering in the opposing direction. Which direction is your smaller channel trending? It is required to be trending in the same direction as the larger channel. It is more likely to move further in the trending direction than in the opposing direction. A good entry would be just as the smaller channel breaks and starts to trend in the direction of the larger channel. What is the lowest risk point for an entry in the current trend? Even though a market may appear to be in a solid trend you stil l want to enter with the least amount of risk. As mentioned in an earlier chapter, using the one­ third rule for entering is best. Simply determine the range for the next day using the upper and lower channels and divide this by three. I n an up trend, buy when the market drops into the lower third of this range. On a downtrend, buy when it rises into the upper third of this range. If market conditions are too volatile for this rule then an adjustment can be made by using one-half of the range instead. What is your stop? Determine your channel and place your stops just beyond the inside channel line, avoiding obvious and round numbers. 1 13

AJichael J Parsons

Remember, as a trend progresses a stop will have to be adjusted with each new data bar. What is your target price? Channel Surfing has a unique element attached to its trading methodology, an exit price. Again, determine your channel and place your exit target just beyond the outside channel l i ne. Whenever price moves too fast it is usually an early warning of an impending reversal and time to consider a possible exit. The exception here would be if price also broke a major high or low at the same time because this is where you will often see a market accelerate. I f price continues to accelerate without slowing, simply hang on and enjoy the ride. I f it fails to sustain the new high or low, then get out. Figure 7-3 provides several examples of this method in action. Remember, it is not essential to always be right. The important issue is a matter of entering when risk exposure is low and reward high, while exiting quickly when the market becomes questionable. You don't have to predict the future of any market. You just have to enter when it meets your requirements and exit when it doesn't. That is called predictive reaction. Every market offers you an opportunity to profit from predictive reaction. Don't try to force or rush a set up. Sometimes the best position in the market is no position at all . But when the set up comes then you must act upon it. The market will not wait for anyone and doesn't like providing second chances. T o enter long. all breaks of the smaller channel must be below the one-half level

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1 14

Channel Surfing

Multiple time frames and trading ranges

When there is a trend present then using multiple time frames is a much easier process. But not every market will be in a trend. Often, you will find a market locked in a trading range where it just continues to bounce between similar high and low zones. A channel exists, but it is neither trending up nor down. It is only running sideways. Since one of the main rules of using multiple time frames is to trade only in the direction of the larger channel, this situation creates a dilemma. Obviously, trading ranges are still tradable markets. But they do require some adjustment to our original rules in order to allow us to trade them. Fortunately, this adjustment requires only a minor modification and most of the rules remain intact. The main difference between trending and trading ranges is that in trading ranges the larger channel is now sideways. There is no distinct indication of any upward or downward bias. Rather than eliminating all possible trades because of a lack in bias this situation actually allows us to trade more often and in both directions. That is as long as one additional risk requirement is met. When a market is in a trading range the profit potential is limited to the extent of that range. This is the distance between the high and the low. I f a market breaks out of its range then you would change gears and trade it as a trending market. But until that actually happens all you can expect is a move back and forth from one end of the range to the other, nothing more. Since we only have this range to work with we need to establish whether or not there is exists enough of a spread between the upper and lower channel l ines to justify the risk. Keep in mind that when entering or exiting any market you will rarely get the very best price that is traded. As a result, slippage can make or break you here. You may be right as to when to place your orders, but slippage alone can rob you of any profit and even put you in a loss. So how do you know if there is enough spread to trade a range? This is done by determining the spread ratio. Basically, the spread ratio will tell you how many bars you can expect the market to move before hitting against one of the larger channel l ines. You will need two figures; the total spread between the larger channel l ines and the average daily range or data bar you are working with. The simplest way to determine this ratio is to divide your total range by the daily range. us

Michael J. Parsons

The greater the number the better it is for trading. I recommend a spread ratio of at least eight. Less than this is usually not a good candidate for trading. Why eight? Slippage will usually cost you as much as two bar ranges offboth sides of your trade. In other words, you will come out short on an average of four bar ranges for each round turn you make. This leaves a potential four bar range to realistically work with and this in turn, would be the acceptable risk/reward ratio of four to one. To calculate these two numbers you are simply taking the two larger channel l ines and subtracting the lower from the higher to obtain the total spread. The average daily or data bar range comes from your smaller channel and it is the difference between the two channel lines, a process we discussed earlier. The formula written in long hand looks like this: Large Channel H igh - Large Channel Low Spread Smaller Channel H igh - Smaller Channel Low Range Spread / Range Spread Ratio =

=

=

I f the ratio is eight or higher then enough spread ratio exists to consider trading the range. Once you have determined that you have enough of a spread ratio to work with the process is very similar to trading a trend, with but one exception. Since the market has no bias at this point you are allowed to trade in both directions. When you are at the higher channel line then you can sell when the smaller channel breaks downward. When you are near the lower channel l ine then you can buy as the smaller channel breaks upward. Just as we did when entering a trending market, our entries here will only be made when price is within the more favorable half of the larger channel range. An initial stop will be set just beyond either of the two larger channel lines or outside of the calculated range. Figure 7-4 demonstrates this procedure. A word of caution here; do not be surprised if price slightly breaks either channel line before reversing. Most traders will set their stops just beyond the high and low of the range and they become targets for floor traders. The real concern is whether price shows signs of staying beyond either channel line. That is why it is to your advantage to wait until the smaller channel actually breaks before entering your trade. Similarly, it is usually better to wait until either smal ler channel line is broken before exiting as 1 16

Channel Surfing

well . Remember, sooner or later a market wil l break out of its sideways pattern and when it does it is likely to make a substantial move. These larger channel lines act as major price levels, so any break that holds beyond the channel lines should not be ignored. This can very wel l be one of those "just hold on and enjoy the ride" trades.

Short on the break of the smaller trend line if

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Even so, if you happen to be a conservative trader who would rather just trade the current trading range and anticipate a change in trend rather than the breakout, then you can exit anytime that price draws near to the opposite channel line in order to lock in the most profit. This means that you are not actually waiting for a channel l ine to break, but are looking for a price that is reasonably close to the larger channel l ine. This will avoid the drawdown that can occur when waiting for the inside channel l ine to break. If price has exceeded the trading range then it is best to avoid entering a trade until price is clearly back within that trading range, even if the smaller channel breaks before then. For the requirements of a low risk trade to be met you will need the larger channel acting as a border to price. It is no longer doi ng this if price has m igrated to another zone. Wait until price has both established a smaller channel break in the correct direction and is within the borders of the larger channel before entering. When everything finally does l ine up, an entry must be made on queue. If an entry is not made at the initial break of the smal ler channel then the trade is a bust. It is inadvisable to attempt a later entry, even if there is a 1 17

Michael J. Parsons

secondary bounce. Once the first bounce has occurred, each succeeding bounce against that channel line before moving to the opposite side increases the odds of actually breaking through. So if you miss out on a trade then you are better off waiting for the next set up. One final refinement that should be addressed when dealing with trading ranges has to do with entries that are very close to the center of the trading range. Earlier we discussed a rebound entry. A rebound entry takes advantage of the fact that if a market has already been moving in a certain direction, a break that continues that same direction will usually follow through. Price has a habit of l ingering around center lines and trading ranges are no exception. So you can have several swings around a center line that have a very narrow range and if traded would result in poor results. Even though price may be on the correct side of the center l ine for an entry, if a smaller channel break is against a prior move without having established itself seriously within the lower risk range, then an entry is best avoided. I n other words, if price just bounced off of the upper larger channel line and then it falls just below the center of the range, a long entry off of the break of the smaller channel l ine is not recommended. You need to see price establish more than a foot in the door within this lower range before attempting a long. Reaching within � of the range closest to the larger channel line is preferred. There is one negative that will come from cautiously avoiding an entry close to the center l ine. Often a market will bounce off the center line when it is about to break out of the trading range and begin to trend. An early entry at this point makes for a very nice trade. The problem is that unless you have some sort of indication that a break out is about to occur then it is more likely that any attempt to trade this scenario will work against you. I f you have strong reason to believe that a break out is about to happen then you may want to risk the entry. Otherwise, it is better to wait until price has clearly broken out of the range to actually trade the trend.

1 18

Channel Surfing

Trading range sum mary

To sum up the process of trading a trading range: Determine i f there is enough of a spread ratio between the larger channel lines to justify a trade taking the distance between the two lines and dividing it by the average data bar range derived from the smaller channel, with eight as your minImum. 2. Enter as close to one of the larger channel lines as possible and while sti l l within the range just as price breaks a smal ler channel in the direction of the opposing larger channel l ine. 3. Beware of any sustained break of a larger channel line. A sustained break wil l usually signal the start of a trend and a change in your trading approach. l.

Figures 7-5 and 7-6 provide several examples of a trading range and how to handle trading them. 'It 1es, !IS it' m ,e.� ,e, '" :�1 Hit} 'II Wit lIS 's'

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Whether your chosen market happens to be i n a trading range or moving briskly along in a trend, Channel Surfing offers a powerful way of exploiting it. It doesn't matter whether a market is rising or fal ling, only that it is moving. When you approach trading using the advantage of multiple time frames you take this method to a higher level of accuracy. While this won't guarantee success it does make success much easier to reach. So I invite you to explore the advantages of using multiple time frames. It will definitely multiply your profits.

1 20

Chapter Eight

The Repeating Channel and Trend Angle Years before the advent of computer trading a great deal of research went into the geometric patterns of the entire market. Back then the focus was to understand the markets based on principles that were well understood, such as mathematics and natural phenomena. Ideas of chaos, short-term patterns, over-bought and over-sold, and many other terms and concepts that we commonly use today were foreign. The researcher looked at the markets as a living breathing organism and worked to define it as a whole. In retrospect, while we today seem to be focused on individual trees they were focused on the entire forest. Th is unique approach to market analysis led to some very interesting and powerful views of how the market behaved that many today religiously follow. Have you ever heard of Gann or Elliot? Gann's research began over a hundred years ago during a time of enlightenment shortly after Einstein wrote his famous theory of relativity and the Wright brothers flew their very first plane. It was a very exciting time of discovery, both for the markets and in other sciences as well. Unique approaches to market research continued up until the seventies when computers came along and changed the focus by ushering in indicators and programmed systems. While there have been some great advances that have come from this age of computers, many of these older remarkable concepts were lost in the process. While some of that research has stil l survived until today and is used by a few technicians, so much more has long been forgotten. Many know the names of Gann, Elliott, and Wyckoff, but how many have 121

A1ichael J Parsons

any idea who Richard Ney, James West, J. M . Hurst, J. D. Hamon, Dr. Andrews or a host of others who have come and gone through the years, much less the contributions that they made to trading. Incredibly, some ofthese contributions still prove just as effective in today's markets as they did when they were first introduced. In spite of this, only a few scraps of these wonderful techniques are even known today, much less used in actual trading. I n many cases you will be hard pressed to even find any reference material on such older work. What a shame when so many offered an insight into market analysis that is beyond many of today's methods. I n a world where the majority of traders are using very similar means to analyze the markets, anything that works and is different in its approach can often provide a substantial trading edge. What were some of these great contributions? One example comes from Richard Ney who made the observation that trend lines tended to repeat at the same angle, axis and spacing. To some degree his work was an extension of Gann's. Like Gann, he recognized that the market had a geometry that repeated itself. This wasn't just a linear repetition either. Often this repetition shows up as diagonal patterns where channels crisscrossed one another from two equal directions. Whi le it is not necessary to point out what made Ney's work different from Gann's, it is well worth pointing out a few key points that both researchers revealed. Today, some charting programs contain an indicator called a Gann grid. If you should happen to have one of these programs then I would encourage you to experiment with it. By adjusting the angles of this grid you are likely to see what Ney and Gann did. In the markets there exists a tendency for channels to repeat. Take a look at one example of a Gann grid in use in figure 8- 1 . If you look closely at this chart, you will see numerous places where price either followed or bounced off of channels that are in reality no more than duplicates of one another. This phenomenon of repeating angles and spacing provides another valuable tool that is derived from the use of channels and for this reason is of interest to us. While there is a definite advantage to having a "Gann grid", it is no more than a repeating set of channels that can be drawn by hand or by using tools that are already available in most charting programs.

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Channel Surfing

We have already discussed at least one way to use repeating channels and that had to do with setting up a temporary channel as a new trend first began. But repeating channels offer much more to trading than just that. They actually have forecasting abilities and will often tell you when a trend will end and a new one will begin in advance. Even so, they should never be used as a solitary method of trading. Rather, their purpose is to offer some additional insight that will enhance the use of Channel Surfing as a whole. Repeating channels will always be diagonal , never horizontal or vertical . Horizontal zones are what support and resistance is all about and is a different subject all together. There are two varieties; an upward diagonal channel and a downward diagonal channel, so the direction will either continually rise or fal l . As these lines repeat themselves they will d o so i n one of two ways. Either they will be evenly spaced apart or they will vary in their distance. In both cases, they will tend to retain the same exact angle. The angle can and will change from time to time, but once an angle is set in motion it will usually last for extended periods oftime. This is one of the reasons they have predictive qualities. Obviously, the preferred repeating channel will always be the one with channels that are evenly spaced apart or what I refer to as regular channel spacing. This makes your trading decisions much easier and more reliable. You can literally draw line after line with the same exact angle and spacing and price will follow them in amazing rhythm. Figure 8-2 provides a fine example of this phenomenon. 1 23

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Surprisingly, this symmetry occurs more commonly than you might think. Taking advantage of this phenomenon simply requires you to draw a line, copy it, and then place copies at the appropriate location. The question is of course, how do you determine the appropriate location? Simply draw a horizontal line which will act as a foundation for all the succeeding lines you draw and count the days (or bars) between each line. Once the count is known then you simply place a copied channel line at equal intervals or counts. The same process can be employed with the opposing lines. Figure 8-3 details this process.

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Channel Surfing

While a regular pattern does show up quite often, the irregular version will be more frequently encountered. In this version price advances at the same repeating angle, but the spacing or distance between the l ines vary. While this presents some challenges in determining how to anticipate the future price action it sti l l adds an important edge that will help you to make more profitable decisions. As with the regular version we are looking for sim ilar angles in price movement. Even though they may not be the same distance apart the mere fact that they are at the same angle gives you a leading indicator for future channel l ines and of course, your entries and exits. Once a channel angle is established it tends to remain in force for some time throughout a market, repeating again and again just as it does in Figure 8-4.

While it may be evident that repeating channels do occur, the real question is "how do you take advantage of them in your trading?" The first use of repeating channels comes into play as soon as a market changes direction. In the second chapter of this book we discussed how channels reverse position and how to take advantage of that. Adding to this, we now have repeating channels that make the initial parameter of a new trend easier to define and trade. This means that you can gauge where you can enter at a better price. Frequently, this will be much earlier than a trend entry would even be considered, allowing you to profit from much more of a trend and stil l have the security of a conservative entry. Figure 8-5 shows the benefit of this in real trading. l 25

Michael J. Parsons

Initially. this channel angle is established by the market and IS used as a model for future channel lines

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The second use of repeating channels is in gauging how far your trend is likely to move. The advantage ofknowing this bit of information is that it allows you to estimate when the optimum time of exiting will occur. One of the most difficult parts of trading is in knowing when to exit. Too soon and you will miss a portion of the profits. Too late and your profits will be eaten up as the market retraces against you. Both translate into one thing, missed profits. Since repeating channels extend in both diagonal directions, they create a series of fences that guide and direct the market. Knowing where the fence line sits will put you in a better position to identify when price will reverse direction. Such a use of repeating angles provides an ideal exit in figure 8-6.

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Channel Surfing

It can be amazing how well repeating channels define a market i n advance. But not every market will react as perfectly as corn does in Figure 8-6. Their usefulness will often depend on a person's skill. Learning to use repeating channels correctly will take some practice. While the concept is simple, application is not always easy and requires experience in order to master their use. Just remember it is a tool and not a decision maker. They can perform so admirably that the temptation can be very strong to use them as a sole means for determining a trade. Unfortunately, the spacing of a repeating channel line can be off, resulting in a costly mistake. If you misplace a channel line then you can actually be fooled into trading a market in the wrong direction. Repeating channels are a very n ice tool to add to your trading arsenal. There will be many times when you will be faced with a market that is difficult to read. Repeating channels may just be the means to decipher it, determine what the next move will be and actually make the trade that you otherwise would have missed.

Repeating trend angles

The phenomenon of repeating channels can be useful in other ways too. They also produce repeating trend angles that can be useful in gauging market reversals and future trends. While this too should only be used as an indicator in conjunction with the other methods, they can provide key signals that will help you during critical junctures of trading. The advantage of trend angles is that they can be calculated much qu icker than repeating channels since fewer lines are drawn and smaller data samplings are needed. In a pinch it can work wonders. Repeating angles really find their best application with trends that have frequent pullbacks. A longer term trend may have several instances where it simply goes against the grain. Pullbacks will break smaller and tighter channels. As a result, an exit will be signaled and in turn, taken. This may lock in the profits, but a pullback is only that and will eventually come to an end when the trend resumes. While a break of a smaller channel back into the direction of the prevailing trend can be used to signal an entry it would add confidence to a trade if some other indication of support or resistance existed, particularly if all previous channel l ines had already been broken.

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Michael 1. Parsons

Angles are so frequently repetitive that a prior trend can actually be used to determine the most likely starting point of the very next trend. The beginning and ending high and low of a trend's inside channel line is used to create a trend angle that will be applied elsewhere. Obviously, you will need some sort of starting point to place this angle and this is determined by intersecting two lines created off of the beginning and end of the prior trend. Draw a vertical line directly off the high or low that ends the trend and then draw a horizontal line from the extreme high or low that started the original trend. Where these two l ines intersect is the starting point for the trend angle. This will establish the most likely progression of the upcoming trend. When price reaches this line you will usually see a reaction. The reaction may be very slight or not at all, but quite often price will dramatically reverse off of this line, following it at the very same angle. I n essence, it will often serve as an inside channel line just as it did for the prior trend. I n figure 8-7 the method of creating trend angles is shown.

A lthough price generally reacts to a trend angle set off of the first prominent high or low, in some cases an adj ustment will be necessary because a trading range or a set of multiple highs or lows develop. If a market fai ls to react to the first prominent high or low then find the center of the top and use it for your vertical line. The simplest approach is to count the bars between the two h ighs or lows and divide the total. It helps to remember that what you are really looking for is the point that the market views as

1 28

Channel Surfing

the center of its top, not necessarily what appears as the highest high or lowest low. [ f these trend angles are exceeded by the market it usual ly indicates a trend change. In Figure 8-7 you will see an example of just sucb a trend change occur following the top established at the end of 2004. At that time the trend angle was exceeded in the downtrend and price reacted to it as if it were an outside channel line. When price final ly touches tbis line again the market promptly reverses direction and doesn't look back. So the use of trend angles can really help you to make more competent trading decisions. Just as a trend angle can substitute initially for an inside channel line, so too can it substitute for an outside channel line. An adjustment is of course required and is a simple matter of determining the distance between the prior channel lines and using this distance to set a secondary trend angle just prior to the one you initially set up. It is possible to have an entire channel outl ined even before the trend has changed. No doubt, this certainly would make trading much easier. As fascinating as this technique is it still has a few negatives. As markets go through various changes trend angles will often change with them. So there wi ll be times when this technique will simply not work. This is why you should never use it as a sole method of trading. It tends to work wel l in persistent trading ranges or persistent trends. But when there is a transition from one to the other then you will tend to see more frequent errors in the angle and placement of your lines. Some markets will have a tendency to only loosely fol low the angles. Instead of having a channel that price runs through perfectly you may discover that the trend angle acts more l ike the center of a trend or as a regression line. A linear regression line is used frequently in mathematics. On a chart it places a l ine at the very center of activity to the finest degree possible for a straight l ine. In similar fashion, there will be times when a trend angle will fol low the center of price activity rather than its border. Price will bounce around this line as if it is playing fol low the leader. A trend angle that has price fol lowing as a regression l ine will be common, so don't be disappointed if this is the case with any market you are analyzing. Unlike normal channel l ines where a break would signal some specific action, minor infractions of trend angles are largely ignored. The issue is the overall reaction price has wben it meets up witb trend angles rather than how it reacts to the definitive line itself. 1 29

Michael 1. Parsons

Still, even with some vanatlon in actual use it is obvious that this phenomenon is a very useful tool. Remember, the purpose of trend angles is simply to give you a starting point to work with. Once a trend establishes itself your focus then is on the actual channel lines, not the trend angle. In addition to repeating channels and trend angles, there are many other older methods that are worth investigating. The use of Andrews pitchfork, Hurst's cycles and a large variety of other techniques can enhance your trading in ways you never imagined. Education is a never-ending process and this is especially true in trading. Just because it is old doesn't mean it isn't gold. Sometimes you can obtain some of original publications when someone decides to clean out their library. I have obtained some of this gold from auction houses such as eBay. Other times you may be able to obtain copies that have been reproduced. Either way, you will find that they not only add to your library but to your trading arsenal as well. So whether you are using repeating channels or trend angles, there is a definite advantage to having a repeat performance, which provides predictability to your trading. Ifwe could see tomorrow's newspaper today then it would be easy to make money tomorrow. While there are no time machine plans in this book, repeating channels and trend angles prove reliable enough to at least give you a glimpse of the future. Combined with the other techniques in this book they will provide you with a substantial edge that can translate into substantial profits. And that is an encore performance worth cheering about.

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Chapter Nine

True Support and Resistance During the American Revolutionary war Patrick Henry uttered his famous request, "Give me liberty or give me death". Of course, life only guarantees two things, death and taxes. In the end Patrick Henry got the only one that he could count on, death. Perhaps Patrick Henry should have instead demanded, "Give me life or give me death". It wouldn't have been so inspiring or memorable, but he might have actually survived his capture by the British. The fact is that while not all choices are equal, all choices do have an equal counterpart. The British obviously did not see the choices provided by Patrick Henry as being equal. What Patrick Henry failed to comprehend about choices is something that we do well to learn ourselves; all things of great importance come in comparable twos. There is a husband and a wife, night and day, a yin and a yang, a left and a right, and an endless array of other two's that are interconnected, whether they happen to be balancing choices or opposing forces. So it shouldn't come as any surprise to learn that there are also two great opposing forces in trading, support and resistance Support and resistance levels are one of the basic tenants of technical analysis. In many books and courses it is among the very first lesson taught because so much is based on its foundation. The concept of support and resistance focuses on price levels that prior market activity couldn't exceed and so these levels are expected to put up a roadblock whenever price approaches them again. If they are exceeded then it is considered a strong sign that price will continue for some time and that the former 131

Michael J. Parsons

support or resistance will act as a guard preventing price from retreating out of its new territory. It is as if price has a fence that isn't easily crossed. If price manages to cross it then it is with great effort and will in turn require greater effort to jump back to its former side. Therefore, it isn't hard to realize the importance of understanding support and resistance when it comes to trading. There is only one problem with this concept. Support and resistance will frequently fail and cause many a trader to take a substantial loss. For example, one very common trap is called a "false breakout" and this is where a market will exceed the resistance or support level just enough to fool traders into thinking that the market is about to make a substantial move. So they jump in only to have price promptly return to its former side, which guarantees a loss for every trader fooled by the move. It is not that the concept of support and resistance is flawed, but rather the problem lies in the method for determining support and resistance. How so? The method of determining support and resistance is based on a horizontal view. That is, wherever price set a high or low and then reversed in the past this is the price level that you would use as support and resistance in the future. It remains at that same level throughout all future price activity. For example, let us say that a market reached 1 00 and promptly reversed direction, establishing a major high. Two months later when price reaches this level again the normal method of determining support and resistance would dictate that 100 should stop any further progression of price. I f price rises to 1 0 1 then it would b e expected to continue higher with the former resistance level of 100 now becoming support. Sounds logical and at times it would be correct, but surprisingly the use of horizontal levels for determining support and resistance is often just plain wrong. Considering how pervasive the belief is that support and resistance is set on a horizontal plain I have no doubt that this statement comes as a bit offensive to some. But the reality is that horizontal levels are static in nature and the markets are anything but static. So if horizontal levels do not accurately represent true support and resistance, what does?

Defining true support and resistance

True support and resistance is more accurately defined as, "Levels that have established themselves within the flow of a market by mUltiple limits on price action." 1 32

Channel Surfing

This means that a true support and resistance level will have mUltiple highs and lows establ ishing a line of support and/or resistance. You will rarely find multiple support and/or resistance points at the same exact price level. It does happen, but usually they are offset to some degree. What will be the normal course of discovery is that these l ines will be diagonal in nature similar to what we have already seen with channel lines, only these l ines are used in a slightly different way. To emphasize this point, while support and resistance will from time to time establish themselves horizontally most true support and resistance levels are actual ly diagonal and inclined either upward or downward. This distinctly different definition is an important basis for understanding why a market will tend to exceed some levels and still fai l to sustain that move or why a market appears to lunge early in a large move even before it actual ly breaks a prior high or low. When you redefine support and resistance levels beyond the traditional view it becomes clear why certain events happen the way they do and the true deciding moment. To help clarify this definition and what we are actually talking about here let's look at few examples found in figures 9-1 and 9-2. .

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The majority of true support and resistance exhibit themselves diagonally with either an upward or downward incline. This means that they are constantly changing their actual price limit. They intertwine throughout price action, impeding price whenever it approaches. There are times when price will shoot through or even gap pass these lines with great power, but that is to be expected in order to break through a brick wall. Other times price will break through, but has difficulty letting go and will linger for a whi le. However they choose to exhibit themselves, they will continue to reassert their power time and time again. They will even traverse huge voids of a chart and sti l l reestablish their force at a later date. Like a spiders web, the intertwining of true support and resistance can be quite extensive and as numerous as the strands of a well-spun web. At other times there may only be a few "strands". Many are very subtle so it takes an eye for detail and a patient individual to find them. There is no rushing this process. A quick glance at a chart will almost certainly guarantee that you will miss some key support or resistance level. Find them and the rewards can be fantastic. To appreciate the benefits of patiently looking for these subtle l ines let's take a closer look at a few examples and notice the impact that they had in figures 9-3, 9-4 and 9-5.

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This line has four points of support and/or resistance extending over a substantial distance

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The subtlety of true support and resistance will make identification a l ittle more difficult than that of traditional support and resistance levels, but they are well worth the extra effort. Mastering this skil l will take some practice because it doesn't come automatically. But there is a real benefit in that it gives you the ability to recognize what is really happening in a market showing you where price is likely to stop and reverse or even gap. I n fact, gaps will often be the first clue as to where many of these lines are actually located.

Characteristics of true support and resistance

There are a number of unique characteristics that are associated with true support and resistance. One such example can be seen when two or more of these l ines intersect and cross one another. The market tends to have a strong reaction that starts with attraction. Price will strive to reach an intersecting point even if it is against a current trend. But at the same time these intersecting points are also taboo for price and it will normally avoid actually touching them. Most of the time the market will stop short and pull away, but occasionally it will choose to gap over it instead. Obviously, this tendency is one worth remembering. I f a trend is approaching an intersecting point then it is quite likely that a pullback will occur just before it actually touches it, delaying a trend and possibly reversing direction. So when price hesitates you will already know why l36

Channel Surfing

and will have been expecting it. Of course, there also is the possibil ity of price actually gapping over this point, or at least making a quick move through it. This is not as common, but does happen frequent enough. Knowing this helps you to understand why a gap may appear out of the blue for no apparent reason. Usually this type of gap is not worth getting overly excited about because the market is only trying to deal with a point that is too hot to handle, but the ability to recognize the reason and difference can be of great value. Another characteristic involves trends that are actually headed away from an intersecting point and how they react to the time of that intersection. Just before reaching the specific time of an intersection a trend will often come to a complete halt and reverse direction in an attempt to reach it, even though it is much too far to actually do so. Sometimes this will result in a complete reversal, but more commonly it will only create a pul lback that ends as soon as the intersecting point passes. What this means is that this knowledge can provide a key entry or exit point based on time that you would otherwise not have. In the case of a trend that forms a pul lback, the intersecting point may very wel l be the ideal time to enter a prevailing trend. There are always exceptions to any rule but the attraction that price has for intersecting points is unmistakable. A few very pronounced examples of this phenomenon can be seen in figures 9-6 and 9-7.

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A1ichael J Parsons

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One of the most powerful reactions related to intersecting true support and resistance levels occurs when price is caught between the converging l ines. As they come together they create a powerful force that "squeezes" price as they converge closer and closer together. As the distance narrows pressure builds up until price finally succeeds in exploding through one of the l i nes. This is a great set up for an option trader who is looking for a low volatility straddle trade. I n a straddle the trader buys cal l and put options and will profit as long as the market moves sufficiently in either direction. I f the market fails to move enough, then a loss will be taken. So this situation meets the criteria that a successful straddle requires. Taking a look at a pattern we have used in the past as an example, the triangle displays the characteristic narrowing of support and resistance levels and usually results in a price explosion from the built up pressure. This provides an easy model for us to appreciate how this effect works. But what we are really describing here goes much further than just a simple pattern and is actually drawn on support and resistance levels that many would assume had lost their influence on a market long ago. This insight of market behavior is what creates a profitable trading opportunity that will normally leave other traders dazed and confused. Anytime that you find true support and resistance levels putting the "squeeze" on price then you are l ikely to find an opportunity for a quick profit when it finally breaks. And you don't have to be an option trader to take advantage of this either. By looking at the overall trend and determining which direction the odds favor for the market to move, a trader can enter while a market 1 38

Channel Surfing

is calm and exit after it has exploded and run its heart out. Notice how in Figure 9-8 a wedge pattern was already outlined by true support and resistance lines even before price was trapped by them. The squeeze could only result in one thing, price rocketing toward new highs.

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The converging of support and resistance levels offers some very nice profit opportunities. But what if you are dealing with only one l ine? Do singular levels of support and resistance offer any trades? The answer is a resounding yes. Singular support and resistance levels are by themselves a source of strength to price movement and price will use them as a resting place, a springboard and as a home to return to. One line by itself cannot guarantee that it will stop or support a trend, but the odds favor that it will. The key to gauging the strength of a particular l ine can be found in what it has demonstrated in the past. The more a l i ne has provided support or resistance as price touched it the more powerful the move will have to be in order to actually break through. So what you can count on with support or resistance levels is that they will either continue to support or resist price, acting like a brick wall, or when they actually do fai l then price is l i kely to make a substantial move. So trading becomes a simple matter of taking action based on what price does at these pivotal junctures. If a line has supported price several times in the past, then buying as price reaches this line once again would be the logical step to take. If you buy and it stil l breaks through the line then 1 39

Michael 1. Parsons

you simply reverse positions and sell, expecting the price to drop even further. While it is best to use the overall situation to judge a trade, the basic concept boils down to this simple rule; you use what happens at the support or resistance level to determine the trade you will take. Assume it will bounce off a support or resistance line, but if it doesn't then accept the small loss and reverse positions. This approach is basically the same strategy that we discussed earlier when using channels to make our trading decisions. The difference here is that you are now looking at the internal interweaving of support and resistance that flows through the market to gain an additional edge. In the majority of cases you will find that every pullback, reversal and pause in the market can be predicted based on these lines. New support and resistance levels will appear and old ones fade away, but rarely wi 11 you find price that is not guided by these lines in some way. Figure 9-9 provides numerous examples of just how much each swing in GE is guided by these lines.

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Support and resistance levels habitually stop the advancement of price like a brick wall. In spite of this aversion for crossing them, price does seem to be a glutton for punishment and will butt up against them every chance it gets. These lines act like magnets and will draw price like a moth to the flame. The stronger a line resists price the stronger the attraction seems to be. Even if price wanders a considerable distance, just give it half a chance and it will come running right back again. This is one of the reasons it is important to keep track of true support and resistance levels even if they haven't been used for quite a while. They are likely to resurface and 140

Channel Surfing

become support or resistance again. As it is true in the case of channels, it pays to monitor larger time frames because older and stronger support and resistance levels will be easier to find this way. This is another way that multiple time frames will add to your trading success. The difference in perspective can be considerable as figures 9-10 and 9-1 1 show. .

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Michael 1. Parsons

and numerous, most every reversal, pause and gap can be explained by means of them. They have a predictive quality that can provide an edge that is simply not possible with most forms of chart analysis. Additionally, certain lines can even be more definitively classified and attributed with specific characteristics that can refine market analysis even further. One example is that of the center line.

Center lines, the magnetic center of trends

Most l ines repel price, which is why the concept of support and resistance works in the first place. Still, price is a glutton for punishment and will run its head against a brick wall of a support or resistance line every chance it gets, so an undeniable attraction exists as well. This appears to be a bit of a contradiction, but isn't that true of many aspects in life? A man and woman may fal l in love, get married, and raise children that they both absolutely adore, yet repeatedly fight and argue with one another, make up, and a few days later fight like cats and dogs all over again throughout the life of their marriage. There are more than a few marriages that repeat this type of cycle over and over again, where mates will butt their heads against one another constantly. Similarly, price will keep butting its head up against any line that develops as well. But there is an exception to the norm, a line that price is very attracted to but would rather dance with than fight. This l ine isn't really a brick wall, but rather just a magnet. This attractive line is known as the center line. Unlike other lines a center line runs through the center of a trend and price will freely jump from side to side, a practice that price normally has an aversion to with lines. Sti ll, it does retain one characteristic that other lines have; price normally considers it taboo to actually step on the line. So price will dance around both sides jumping back and forth at will while endeavoring not to step on its toes. It will from time to time still manage to misstep and land on the line, but it repeatedly demonstrates that it is trying very hard not to. As if a constant magnetic force were present, price has difficulty wandering too far. Unless price latches onto another center line and adopts it as its center you can usually count on price returning to a center line over and over again. Center lines can be rather subtle and hard to see, but they are always there and can be found with just a little patience. What identifies a center line is that price will border it providing highs and lows that project a subtle thin line through the trend. As its name implies, center l ines sit in the m iddle of a trend so knowing where to look 142

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is the easiest part in the identification process. I f for some reason you still have trouble determining where they are at, it is usual ly just a matter of too little data showing on your chart. Most center lines actually originate from a high or low just prior to the trend reversal, so this is often the best place to start your search. But be aware that not every center line will be connected to a prior high or low, so the center ofthe trend sti l l remains the confirmation of where it exists. Figure 9- 1 2 shows a very prominent center line in the NASDAQ. - x .

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A long term trend wiII have one main center line, but there will be instances when you will have multiple center l ines to contend with. The difference will depend on the amount of data you are looking at. Portions of a trend can be made up of several smaller trends that each contains their own center l ine for their specific section. Overall, larger center l ines will win out over smal ler ones, just as it is true with other support and resistance lines. But smal ler center lines can often provide the means to determine swing extremes or key support and resistance levels, so they should not be ignored. Figure 9-13 shows two center lines in Express Scripts and by utilizing them both a trader is able to analyze a market much easier.

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Center lines don't produce any trading signals by themselves, but they do act as a gauge in two important ways. The first relates to the end of a trend and the changing of the guard. In an earlier chapter we discussed how channel l ines will reverse roles as they flip-flop from support to resistance or from resistance to support. You may have already noticed that there are times when price will extend much further than just the prior inside channel line, but a reversal still occurs nonetheless. Take another look at any chart where this occurred and you are l i kely to find that price was actually reaching for the center line rather than the inside channel l ine. This happens quite often, so knowing how to identify the center line can at times be a valuable skill. The second gauge is of even greater importance and relates to how far price will swing from one extreme to the other. The mere fact that we call this line a center line tell s you that price will swing on both sides, using the line as a center. Swings will often extend an equal distance on both sides of the center line during the life of a trend. The minimum swing that you can normally expect out of price is a trip back to the original center line itself. K nowing this proves invaluable because it provides a basis for determining whether the reward/risk ratio is favorable for certain trades. It is one of the few indicators with an actual predictive quality. You can see how evident this tendency for an equal swing repeatedly occurs in figure 9-14.

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The further price extends away from a center l ine, the more the center line tugs on it. Eventual ly it will take its tol l and pull price back home and sometimes beyond. Like a rubber band that is stretched too far, the further price moves away the more the force is exerted on it. The result will be an equal reaction to the action. The returning move will often force price to swing to an equal distance on the opposite side of the center l ine. Knowing this can happen will make trading against the trend very tempting, but caution is in order here. An equal distance against the trend does not necessarily mean a similar price move. The l ine is usually diagonal and its axis will constantly reduce the avai lable price movement. In other words, you have to look at the move based on the angle of the center line and not from the perspective of actual price, unless the market has reversed direction. So any move against the trend is unlikely to turn out to be as great as a move with the trend. If you happen to be deal ing with an exceptional large trend that collapses into a consol idation pattern then potentially a trade against the trend could be worth the risk. But to even consider such a trade there should be a substantial move just to return to the center line since this could potentially stop any further advancement. Even so, if the distance is substantial then the trade agai nst the trend can be one of the quickest and most rewarding trades to take. The advantage of center line trades is that they have a built-in target. They provide a way of taking advantage of a pattern trade without having any 145

Aiichael J Parsons

discernable pattern. All you need is any consolidation pattern or extreme move that has wandered too far from its center point. It is a trade that capitalizes on an imbalance in the balance of power. The one area where you need to be cautious of relates to any time price manages to latch onto or create a new center line. Since any trade you take will be based on reacting to a break of a channel line this should normally not be a concern. Previous center lines will generally be easy enough to notice, so it is the new ones that you have to watch out for. But most center lines originate with a prior high or low of a trend reversal, so often you will have an easy reference point to start with. So any time price starts to set a lower high than two previous highs or set a higher low than two previous lows then a new center line may be forming. This price movement would be comparable to the well known head and shoulders pattern. Confirmation of a new center line requires an actual trend to develop, not just a sideways pattern. Aside from this caution the only real qualifying factors are that price move has wandered a considerable distance from the center line and that a channel break has occurred in the direction of your trade. This first factor obviously implies that the trade is in the direction toward the center l ine and not away from it. There is an extension of this trade that does take advantage of the continued move extending pass the center line and this will be covered shortly, but for now we will simply focus on the easier of the two to determine, the move back to the center line The obvious first step is to determine the center line. This is accomplished by using a high or low prior to a reversal and the natural flow of the trend's center as outlined by price bars. The prior high or low will not always present, but if it is then it is usually a great starting point for locating the center line. Once you have located the center line a judgment call will need to be made as whether any move is extensive enough to warrant the risk. There is no pure mathematical formula for determining this. It is solely based on what you would consider an appealing trade to take and more a matter of common sense than anything else. For example, in most trends you will see some type of consolidation pattern and these usually offer the potential for a center line trade. But smaller trends will have a very limited profit potential because of so little extension away from the center line. So common sense dictates that a larger trend would be preferred because then you will have a greater distance between each extreme, allowing for a much better risk/reward 1 46

Channel Surfing

ratio. The identification of a larger trend would be based on its width and not its length and really judged by how far price wanders away from the center line. The rule of thumb here would be that the greater the distance from the center line, the more appealing the trade. If this extended move is the result of the market acceleration then you wi ll likely have a signal generated by price when it exceeds the outside channel line. A lthough an aggressive entry can be taken at this point it is not necessary to take such an extreme risk in order to take advantage of a center line move of this size. A n accelerated move will result in a fanning of the channel lines and so you simply enter when price breaks the one of these "fanned" lines. A stop would then be placed just beyond the high or low that ended the accelerated move. Entering off the break of a fanned channel line isn't without its risk. A small flag pattern can develop and result in a continued move away from the center line in spite of the fact that some of them are broken. In order to reduce false signals it is better and more conservative to enter on the break of the second tightest channel line that breaks, rather than the absolute tightest. Doing so will reduce some of the available profit, but the risk is dramatically reduced as wel l. A secondary break adds confirmation to any trade. The target of this trade will be the center line itself. Once you reach the target you would then exit under normal circumstances. Price will tend to avoid actually touching this l ine if at all possible and will either bounce off of this line or shoot very quickly right through it. Since there is a distinct possibility of an equal swing opposite the center line you may wish to risk holding your position until a channel breaks against your trade. But this trade has a number of subtleties that you will need to recognize and so a swing through to the opposing side isn't recommended for beginners. Figure 9- 1 5 shows how a center line trade works. Another example of a center Iine trade develops with many trading ranges that form a trend shift. A trend shift of this nature usually turns into a continuation pattern and so it would normally be traded with the trend anyway. But incorporating the aspects of a center l ine trade will provide you with a target for exiting as an added bonus.

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Trading ranges are often best traded using a breakout entry. That is, when price exceeds the range a position is then taken. However, not all continuation patterns are trading ranges. Sti l l, some type of channel will always form that can be used for an entry signal. Two trading ranges are shown in figure 9-16 that provide excellent opportunities for a quick profit utilizing center l ine trades.

Some pullbacks can have rather extensive moves without actually reversing a trend. A return off of such an extensive move can add up to an extremely attractive short term trade. However, many large pullbacks 148

Channel Surfing

will also develop into a trend shift and fail to ever reach the original center l ine, settling instead on just the former inside line or less. Although there are two possibil ities here, trend shifts will develop a separate center line that encompasses a much larger trend and so with a little ski l l you will be able to determine which situation you are dealing long before a move begins. Remember too that channels are always the overruling factor and the basis for any decision whether you are dealing with a center line trade or not. Extensive pul lbacks and trend shifts usually set up repeating trends early on or instead, work off of preexisting channels. Particularly if a channel line itself brings a pullback to a screeching halt will a move back to the center line be likely. If price hits a brick wal l then it is much more likely to run back home with its tail between its legs and its home is the center line. A center line trade would sti ll be signaled with a channel l ine break, so this aspect of entering remains the same. Most center line trades tend to be quick with a substantial return for the time invested in a trade. It also has the added benefit of a targeted exit as well . The minimum that you should be able to expect would be a move back to the center l ine, with the potential of price extending an equal distance on the opposite side of the center line. Simply put, the greater the distance that price pulls away from the center line, the greater the profit you are likely to wal k away with on the return move. Figure 9-17 i llustrates wel l the potential a center line trade has.

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So far we have discussed trades based on a return move back towards the center line, but often a market will simply not stop there. Many will actually travel to an equal distance on the opposite side. This means that there is the potential of profiting twice as much from a single trade, you just need to know when to hold them and when to fold them. A move away from a center line is a l ittle more risky to trade simply because there is a strong attraction between price and the center l ine. Price will have a tendency to either bounce off this line or linger, dancing from side to side. Even so, an overshoot is not uncommon because of the sheer force behind the move that brought price back to the center l ine to begin with. While the first target will always be the center line itself, if price continues past the center line then a continuation equal in distance as that required to reach the line in the first place is likely. What price does when it meets up with the center line will usually tell you whether it will continue or not. If price fails to break through this line, then the move is in doubt. If it l ingers excessively hugging the line as if it is a long lost friend, then a continued move is also unlikely. Most continued moves are very quick to break through a center l ine and will only hesitate for a short period of time, if at all . If you see more than three bars lingering at the center l ine then you are better off exiting any position. Those that hesitate tend to retrace part of the original center line move even if they eventually do break through later on. If you want to enter later you can do so when price finally breaks and holds past the center line, but otherwise when in doubt you need to get out. Several examples of determining when and when not to stay in for a continued move off the center line is shown in figure 9-18. While price can extend a considerable distance away from the center l ine, there is a limit based on the strength of the overall trend. There are a number of factors that go into that determination based on the angle and size ofthe trend, but they can be rather difficult to interpret by the average person. In the interest of simplicity just bear in mind that the greater the angle that price breaks away from a trend, the greater distance possible from the center l ine. In other words, if a market has been in a very slow progressing trend and then suddenly breaks away into a dramatically accelerated state, then this would be a good candidate for an extreme move away from the center l ine. This is an overly simplistic definition because in reality it is not the angle, but the angle in relation to the original trend that is at issue. But it is usually safe to say that the more vertical a move, the stronger the move will be.

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There is another factor that comes into play here that will impact how far price will be able to extend beyond the center line; support and resistance levels. As a rule, when price travels away from it's center l i ne it uses up energy and either has to find a support or resistance level for strength or it will be forced to return back to its center l ine. Price tends to regain its strength whenever it rests on support and resistance, sort of pausing to catch its breath. In reality, it is the traders within a market that have to catch their breath. If a market moves too rapidly it will eventually run low on buyers or sellers, resulting i n a drop in participation. After all, if a market were climbing l ike a rocket how inclined would you be to sell it? Bring a halt to a market's momentum for a time and suddenly an equal number of buyers to sellers will reappear. This is what most consolidation patterns are all about. When the market pauses traders begin to see stabil ity in the market and return to trading both sides. Consolidation patterns will pivot around or off of true support and resistance lines, so these patterns are clear indications that the l ines are present. Without pauses a trend cannot sustain itself for long and pauses need support and resistance lines to form, so the two work together. Price will latch onto any support or resistance line that it can find in order to refortify itself, so be aware of any that may be present in the vicinity of price. The further price extends away from the center l ine, the greater the pull. This is why you will often see a stair step effect near the end of a trend as it requires more and more resting places to sustain its high-energy move against that pull . Support and resistance l ines will be a valuable key 151

Michael J. Parsons

to determining how long a move can last beyond a center line. However, these lines will not automatically provide support for a trend and in fact, will often be the very thing that brings it to an end. So the reaction to these l ines is sti l l in question until after they have actually met up with one another. But reactions tend to be repeat performances and so you can usually count on something similar to what has already occurred in the past. If price jumped over a support or resistance line before then it is more l i kely a strong trend will use them as secondary launching pads. If price has repeatedly failed to exceed them in the past then odds are it will be halted when the two meet once again. At the heart of the issue will be whether or not these lines act as a secondary launching pad. As long as price can continue to find a resting place it will continue in an accelerated state. When price finally runs out of steam and out of support and resistance levels it has no choice but to plummet or rocket back to the center line. So knowing where these lines are, or more specifically when they run out, will be an important indicator as to when price will be forced to make a return run back to the center line. Additionally, there is a limit to how long these support and resistance levels can sustain price as well. Unless some fundamental reason exists in the supply and demand providing an actual or perceived basis for a move, support and resistance levels will only provide limited help. This is one area where understanding fundamental aspects of trading is a benefit. Support and resistance levels need to draw their strength from something and since they are born out of crowd perception, they must be strengthened by that perception as well . Once a trend runs out o f support and resistance levels there are only two options avai lable for price. Break away into a new trend by adopting a new center line or return to the original center line. To adopt a new center line requires that a new trend develop whether that means a trend shift, trading range or reversal. This is a change in the geometry of the market and is usually influenced by higher time frames. Such changes in the market geometry happen often, but also tend to have many signs along the way. They also tend to be very forgiving to center l ine trades and will usually provide a reprieve, allowing a person to exit with very little to no loss. But there is another bonus when making a center line trade. Odds are that you will actually see a return back to the original center line long before a market actually makes a trend change. So once a line is established it represents an important gauge throughout the life of that trend. 1 52

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Wh ile the center l ine doesn't provide any reliable trading signals of its own, it is an important indicator. Its value is found in the unique insight into market geometry that al lows you to use other signals more effectively. If you understand the language of the market it will talk to you and tell you what it wants to do. That is why Channel Surfing is such a great simple way of determining entries and exits. Price just naturally follows trend lines, support and resistance lines and center lines. This tendency is a very predictable characteristic of price movement. When price breaks through any of these lines, somcthing has drastically changed. Each of these lines provide an early warning signal of what the market intends to do, enabling you to handle each trcnd, trading range and trend changes more effectively. The more you use Channel Surfing and the better you become at it, the more you will see true support and resistance l ines and effectively use them as well. The two go hand in hand and are really extensions of the same thing. True support and resistance will take more skill to master because of the subtlety that is associated with these lines, but the market itself will tcl l you where they are at if you just exercise a little patience. Once you find them do not forget about them. It is not uncommon for a support or resistance line to influence a market and then disappear for a long time only to resume a powerful impact later on. They can travel for quite some distance through "empty space" and still stop the market dead in its tracks when they meet up again. Note how effective they do so with the NASDAQ in figure 9-19. Nasdaq

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Michael J. Parsons

While identifying true support and resistance lines will require patience and diligence on your part, their influence is clearly very powerful. It will astound you how significantly these lines will continually impact a market and their reliability opposed to "normal" support and resistance lines. The hardest part is simply being able to spot them. But aside for the need to have a detail-oriented eye and patience, the method is relatively simple. Fortunately, you will tend to find that your skill naturally develops the more that you use these techniques, so the process becomes easier each time you attempt it. Once you master this process you will no longer look at support and resistance in the same way again. And that is one skill that everyone, including famous statesmen, will be envious of.

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Chapter Ten

Trading Options Trading options has grown in popularity over the years because of the appeal of limited risk associatcd with them. Unlike buying a stock or contract where the losses have no limit and can quickly mount up, buying an option limits the risk to only the cost of the option. This is called the prcm ium. The greatest fear of most traders is that the market will have some disaster and go against them so fast and furious that it puts them into bankruptcy. So rather than bet the farm an option trader can trade the market with a sense of security. Of course, there is a cost associated with acquiring a sense of security. The purchase price of the option or premium is non-refundable. Whether you win, lose or draw, you are never refunded this investment. At best, you can recoup your investment if your winnings are great enough to cover it. Despite this fact, if you are right about an option trade then you can actually profit more than if you traded a contract or stock outright. This is because an option investment is generally much lower than the margin required to trade a contract or stock, allowing you to trade much more with the capital you al ready have. The more instruments you are trading on a profitable trade, the more profit you actually make. So the benefit is not only more security, but more money as well . That is of course if you can call the market right. This is the trick that eludes most option traders. The cost of an option depends on three issues; the time left before expiration, the strike price in comparison to the current price and the implied volatil ity. The way these are determined can be very complex, 1 55

Michael J. Parsons

but the price is calculated by set rules and all you normally have to do is to look at readily available quotes to know what an option is currently going for. The rules are not stacked in an option buyer's favor because the option writer or seller doesn't have the same benefit of security as the buyer. It is the sellers of options who are given an edge when it comes to trading options, just as any casino would have over a gambler who walks in through its doors. Writers are in essence "the H ouse". If this leaves you with the impression that the writers (sellers) of options are generally the winners in this market then you are absolutely correct. This makes the selling of options the more profitable venture, as long as a market doesn't explode against you unexpectedly. The problem with writing options is that you have the same risk as when you buy a stock or commodity outright. So if you are an option writer and the market suddenly explodes against you, you have a real problem. So despite having an edge, option writers still have inherent risks associated with their mode of trading. So there are advantages and disadvantages to both sides when it comes to trading options. Even so, options do offer an excellent trading vehicle and although they are a bit more complicated than buying or selling stocks and commodities outright, sources of information about how they work are plentiful. In fact, some of the best information is available for free from the exchanges and brokers who handle options. Since this is the case, it is not the purpose of this book to explain what a butterfly is or the difference between a call and put. The option trading process is something that can be learned by multiple sources elsewhere. But what this chapter will address is how Channel Surfing can be used to determine option trades that are potentially profitable, whether you are buying or selling them. Before we discuss either venues of trading options, it is important that you understand something about option value. Profit or loss is not really based on the strike price of an option, but rather on the value it accumulates. If you are a buyer, the true value of an option must exceed the cost of the premium that you paid or no profit is actually realized. So the strike price isn't the real issue here when it comes to determining what is in a safe zone and what is not. You must add the premium cost to the strike price in order to ascertain the actual breakeven point. For the moment, just bear this point in m ind and later on this issue will be discussed in more detail. For now, we will consider the two distinct modes of option trading, buying and writing.

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Option buying

In the option world time is truly money and the longer the time until the option expires the more expensive the option will be. As time runs low the cost of the option is reduced. Another factor affecting the price of the option is the strike price. This is the price where the option starts to have value. The closer the strike price to the current market price the more expensive it is. In-the-money options, which are those that already have value, are among the most expensive to purchase. Both of these factors are pretty straightforward in how they work. Simply put, the more time and value you have in the option the more expensive it is. It is the third factor called implied volatility that is the most complicated and variable. This is also the area where we are most concerned with when it comes to options. Basically, implied volatility relates to how much movement is expected out of a market. This is strictly based on what the market has been doing recently so it will vary from market condition to market condition. So if a market has been dead with very little movement for the past few weeks then the implied volatility will be low and so will the price of the option. I f you can buy an option just before it rockets off again you stand a good chance to make money with options. The trick then is to buy an option during passive or dead times all the whi le knowing which direction it will go and when it will get there. Before you say, "that would be some trick", there are actually a number of ways to do this with Channel Surfing. Channels facilitate the ability to determine the likely progression of a market. Enhance this by using multiple time frames, true support and resistance l ines, and repeating channels and you can develop a pretty good picture of how the market will unfold. This means that you can make a fair estimate of whether or not an option has any chance of becoming profitable based on the market's own geometry. For example, a market in a downtrend will eventually find support and reverse direction. No market can stay in the same direction forever. The likely spot where this will occur will be at the bottom of a larger channel. So find the larger channel on a higher time frame and you will know where the odds favor such a bounce. But the benefit goes further because a bounce of such a magnitude will translate into a substantial reversal on the smaller time frame that you are trading. Additionally, a larger channel provides a target for the current move and the succeeding one. This succeeding move would be the other side of the larger channel. Take 1 57

Michael 1. Parsons

the previous up trend and calculate the likely angle of progression and you have the factor needed to determine how much time to allow price to reach that point. Time is a key element to trading options because even if you are right about where the market will go it is of l ittle value if you don't make it there in time. If you purchase an option just as it approaches this "bounce point" and allow sufficient time for the move to make it to the opposing channel the odds are you will have a profitable trade on your hands. In figure 10-1 these elements are combined to calculate a reasonable expectation for an option trade. A lthough a smaller channel in a downtrend is currently the main focus, a larger channel is dictating that a bounce is likely to occur very soon. On top of this, a true support and resistance l ine appears to be stopping price even sooner than this. So this is a good area to consider buying a call option. The recent trend angles have lasted just under 2 Yz months long, from low to high. The average move has been about 12.5 cents. Since this is early September, this move would require more time than the current contract of September will allow. The next available contract month for the British Pound is December, which would be long enough for the needed 2 Yz months. So a call option is purchased with a strike price of $ 1 .58 slightly above the current closing price.

Within the expected 2 Yz months price shoots up to $ 1 .70 for a very nice profit. This is how an option trade is supposed to work, but for most traders this type of result is very elusive. The reason is that there are generally two mindsets when it comes to buying options. In one case you have the approach that both a call and a put option should be bought while option 158

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cost is low, which is called a straddle. The focus of this strategy is an attempt to exploit an increase in volatility which will eventually follow, but no one knows exactly when. The problem with this is that you spend twice as much in order to set up a straddle and unless volatility picks up dramatically both options expire worthless, or at least fail to generate enough profit to cover the cost of both options. The second approach is to buy options as a hedge or to take advantage of a trend. Both of these will often rcsult in the transaction taking place when the price of an option is high. In addition, most traders fail to balance the cost of an option against the needed time for a reasonable profit. The tendency in each of these is for an option that is either so expensive that you are never able to recoup your investment or one that expires worthless because there wasn't enough time to generate a profit. Determining what options have any real potential of becoming profitable is a balance between the time required to reach a profitable target and the prem ium or purchase price of an option. Obviously, this means that you first have to be able to determine the amount of time needed to reach a profitable target. So how do you determine the time needed for price to reach a target or as I term it, "an option profit zone"? The time factor is built into the smaller channel itself. The inside channel is the minimum movement expected out of price. So once a channel gets under way all you have to do is look at the inside line and see where price will be at any given time in the future. If the strike price and expiration fal l outside of this range then you will have a problem pulling in a profit. I f your targeted profit zone is crossed by the inside line before the expiration date then a profit is likely, with all other factors in your favor. Even though you can pul l in a profit with just the outside line crossing your profit zone, a trade based solely on this line is very risky. It would depend on the market maintaining the necessary volatility and this is a variable in the life of a trend. In contrast, unless something changes within the market geometry you can count on the inside line fol lowing through. Although this technique will dramatical ly add to your assessment of any option trade, there is a fly in the ointment here. It is important to understand something about the characteristics of trends. Markets wil l zigzag as they move. Any trend that develops is more aptly described as higher h ighs and higher lows or lower lows and lower highs. Rarely will you see a straight line anywhere on a chart. It does happen occasionally such as when a market explodes during some earth-shattering event, but usually it will 1 59

Michael J. Parsons

just zigzag along until it reaches its destination. Sort of l ike a river flowing through a countryside and weaving across the landscape. This is why we look at the market based on channels that provide an expected range rather than in straight lines. It is a river nourishing the land rather then a rigid road paved in gold. Trends not only zigzag within a channel, but they also from time to time zigzag out of a channel. While this is not true of every trend most will have a point somewhere in the middle where the market extends beyond the normal range, breaking channel lines along the way. This excessively wide zigzag often turns out to be what was earlier described as a trend shift. Not all result in an actual trend shift, but many do. But whether you have a trend shift or not, you will generally have some type of zigzag motion that splits a trend in half. Because this zigzag has a habit of occurring right at the center of a trend or at its mid-point it is in turn a gift to you when you are attempting to project how far the trend will go. However, this habit is really a two-edge sword. The positive aspect is that the mid-point will l ikely be just that, a halfway point of the trend. You simply double the prior distance and you are likely to be close to where a trend will end. The negative aspect is that the shift itself creates a delay of unknown length making it difficult to know when it will actually get there. Figure 10-2 demonstrates the characteristics of zigzags and their impact on a trend.

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A mid-point zigzag occurs quite frequently. Some trends will bypass this step all together, but this is the exception rather than the rule. Look for it in every trend that appears no matter what time frame you are looking at and it will give you one more trick to deciphering a market. But th is brings us back to the negative aspect of a zigzag. When calculating the time needed for a price target to be met you have to take in consideration any delay that might develop as well. Odds are that a delay such as a trend shift wi ll occur. So how much time should you allow to compensate for such delays? This can vary widely and I do mean widely, but a trend will generally shift no more than three times its width. So this is the maximum that would be expected. Even so, three times its width can still translate into a considerable delay. Fortunately, markets have a habit of repeating themselves and a past trend shift is a good starting point for determining how much time to allow. Most will be very simi lar in length and breadth across each trend. So in reviewing one you are Iikely to have a fair estimate of another. But this is not the only way to narrow down your estimate. A trend will operate within a channel with a set width and this width can be used to measure the likely delay. A trend shift will usually last on average from one to two widths of the channel, with three as its maximum. In other words, to calculate the time that you need to allow for a trend shift you would simply measure the time between the two channels and use this as your basis for estimating the maximum. Realistically, most trend shi fts will last no longer than a double channel width, but a trio estimate will allow you to cover most worst-case scenarios. I n spite of this, there will still be times when even three widths are exceeded such as when a trading range develops, but this will be the exception rather than the rule. In figure 1 0-2 the trend ends up shifting two additional channel widths, which is very common. The width of the channel in this example is approximately 1 % months and the actual shift lasts a total of 3 Yz months from the point that the shift begins until it finally resumes the up trend. Not every trend shift will work out this well, but many do. A llowing for these delays when purchasing an option will reduce those that eventually meet your price, just never in time to make a profit. While you can never be sure if a market will develop a trend shift or even its smaller counterpart the zigzag, the odds favor some type of delay will occur. If you fai l to take this into consideration then you will delay 161

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achieving the profit that you had hoped for as well. Old habits are hard to break and a market will tend to repeat them quite often, but so do traders who take shortcuts and think that this time it will be different, fai ling to consider the possibility of a delay in their option trades. While trend shifts can be unpredictable in general, they do have one tendency that is predictable; they often repeat and maintain the same angle. This enables you to make a reasonable judgment as to when a trend will resume. By using the technique of trend angles discussed in an earlier chapter, the resumption of the trend can often be determined in advance. When it comes to buying options, time is the enemy. If you cannot conquer it, it will conquer you. Therefore, it is imperative that you understand how to make a time calculation if you want to trade options. While it is not the only factor, time alone will kill hordes of your option trades. Trend shifts are just one of the factors that are commonly overlooked by option buyers. While you may be right about a particular market and even have the price target reached, if it is not within the required time it is to no avail that you have made the trade. Therefore, you must understand how trend shifts alter the time factor or it will shift you into a losing trend. Once you understand the concept of trend shifts along with the other idiosyncrasies of the markets, the process of time calculations becomes simple. The amount of time for any movement can be reasonably estimated based on the ranges of channels. Take a look at some daily charts and find the channels that develop. Now drop down to a ten-minute chart and you will see that this single channel breaks down into several smaller channels and trends. Go up to a monthly chart and the daily channel is nothing more than part of a bar on a much wider channel. So what does this have to do with projecting targets? When we calculate an expected range for a particular day in order to set our stops we are actually determining targets. The only difference is that we neither care which target is hit first, nor how soon it arrives. Our only interest l ies in whether or not it exceeds those targets, which in turn would signal an exit. With time calculations we take this a step further and actually use the range to determine when price will reach those targets. Channel limits are determined by calculating a range that we would expect price to remain in. If a channel were trending up or down, then time would constantly alter that price limit. So unless a trend changes a channel wil l project where price will be at any given time and i n turn, how long it 1 62

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needs to arrive at a certain price. Within this basic concept is the formula to determine whether an option has the potential of becoming profitable or not. By projecting a smaller channel within the larger channel you are actually making a time calculation. Start by drawing a smaller channel and extend it until it hits the larger channel. The answer to the question here is just a matter of looking at when the smaller inside channel meets up with the larger channel line. You now have the expected limit on price and the time when it should arrive, barring any delays. But wait a mi nute, how do you do this when the trend hasn't even begun yet? By using a previous channel's angle and size and using it as a basis to create a projected channel. Start this projected channel at the point where the current trend is expected to meet the larger channel, which is also a projected target. Remember, this is a projected channel and not a measured one. To do this mathematically you will need the trend ratio. This is calculated by taking two lows or two highs within a prior trend and subtracting the lower number from the higher. This gives you the difference between the two numbers, which is then divided by the amount of days or time periods between them to provide the trend ratio. This process was discussed in detail earlier in chapter six. Determine the minimum amount that price will need to move in order for an option to become profitable and divide this by the trend ratio to find the number of days or time periods needed, barring any delays. If an option's expiration is due before this date then the odds are against the trade ever earning a profit. Of course, you also need to add in any expected delays such as trend shifts for a more accurate calculation, but a trend ratio can tel l you very quickly whether an option has any chance or if it is instead doomed to expire worthless. At this point all of this may sound a bit confusing, but it just takes a few simple steps shown in figure 10-3. There are a number of factors being considered here in figure 1 0-3, but the basic concept of projecting a trend isn't a difficult one to understand. A larger channel is set up to provide the potential target. In this example the larger lower channel was already establ ished, but the upper channel l ine was not yet complete. So a dupl icate was made of the lower channel line and placed on the available high to form a temporary upper channel line. While this market is technically in an up trend this incline is only slight, 1 63

Michael J. Parsons

almost to the point of being viewed as a trading range. Additionally, with such a wide range between the channel l ines the potential profit from a short is substantial and an option provides risk control that is normally not available with a futures position. Therefore, this set up has definite potential for an option trade.

of the lower channel line and slmplv placed on the high

l"v""

!J

r

.tI

. }

I""'� Y

1 00

As price approaches the temporary upper channel line in June of 2004 and starts to break the smaller inside channel line, it begins to drift into a small wedge pattern. The indication is that price considers the temporary larger channel line as resistance and that it is likely to decline from here. As a bonus, the trend has almost come to a halt and reduced its volatility making the cost of an option low. But before jumping into an option trade there are a few questions that must be answered. How much time is needed to allow an option to become profitable? How far can this market be expected to move? The answers to both of these questions will allow you to answer the third and most important question, does this option have any real chance of becoming profitable or not? Ideally we would like to see price move down to the larger lower channel l ine and many times it will. Unfortunately, there is no guarantee that this will actually happen and price may be considerably short of that goal. So any required expectation must be lower. If in the end it actually does reach that far, then that is even better. But never trade an option that requires the ideal in order to be profitable because as soon as you do it will come up 1 64

Channel Surfing

short every time. So what can be reasonable expected? Halfway between the upper and lower larger channel l ines or what is referred to as the center line. Remember that price is attracted to this l ine l ike a magnet and every trend has one. The current value of the market we are looking at has a high of approximately 1 1 5 and a low of about 83. Halfway would then be around 99 at this time. While the actual center line may not match this precisely, this simple math does put us within the ballpark and enable us to go on to the next step. By using the prior down trend as a model for the projected trend a trend ratio can be calculated using the previous trend's highs. These points are circled on the chart. The first point had a high of 1 1 0. 175 and the second had a high of 1 02.45, with 35 trading days between them. 1 10.175 - 1 02.45 7.425 / 35

=

=

7.425

.2121

So the trend ratio is .21 2 1 and price should drop a minimum of this much each day unti l a delay or reversal occurs. In real life there will be days that drop much faster than this, but we are concerned with the overal l average and not accelerated days. S o if price i s currently at I ] 5 and we can reasonable expect it to drop at least down to 99, then nearly 76 trading days would be required to reach the target. 115

-

99

=

16 / .2]21

16

=

75.4361 Trading days

76 trading days would be nearly four months. For a move down to the lower larger channel l ine this potentially would be doubled. Fortunately, a trend will often meet the ideal within the shorter time period because it usually ends by touching the outside channel l ine, which is far in advance of the inside channel line. But the inside channel line is the minimum that price should move and so for an option calculation this is what must be used. So if you strongly believe that the ideal target will be met and you want an option that covers this, then you wil l need an option that has twice the expiration time, in this case 8 months. The one thing that has not been discussed so far is any delay. Since we used the prior trend as a model and it incorporates a delay the projected trend already has it figured into the equation. However, i f no delays are

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evident within a model trend then it will be necessary to add time to cover any potential delay. The date is currently near the end of August and the next available option that would allow four months will be the January contract, since no contract is available for December. January's contract price is currently at a lower price and trading at 109, but when doing an analysis it is best to use the most active contract. A January put option with a strike price of 109 costs $2,400.00. Therefore, Feeder Cattle will need to drop to 1 04.20 just to cover the premium costs. While we are expecting price to drop down to 99, an exit should be a l ittle conservative. So an exit of 100 or higher is determined, which would have a potential gain of $4,500.00. So any costs associated with this trade would be more than adequately covered as long as the trade turns out successful. Obviously, the answer to the most i mportant question regarding this potential trade is a resounding yes. It indeed has the potential of becoming a profitable option trade. The profit on this one is nothing exceptional, especially when you take out the premium costs. But as far as option trades go this one if successful will still result in a very nice profit. $4,500.00 - $2,400.00

=

$2,100.00

On November 22nd January Feeder Cattle traded as low as 99.4 and remained below 100 for most of the day. Amazingly, price bounced right off this target level and the trade worked out perfectly. Amazing, but not surprising. If the market shows any signs of dropping further down to the ideal, then the profit minus premium costs would be around $9,600.00. So the potential is even greater and sometimes a market will actually cooperate with you. But taking a conservative approach enables you to profit without demanding the ideal out of any market. Using Channel Surfing to set up your option trades will make repeating this example in real life very possible. The benefit of calculating the potential of an option is that it will prevent you from trading those that are obvious losers. Generally it isn't an issue of whether price will ever reach a certain price level, but rather that it fails to do so within the allotted time before an option expires. Time, trend shifts and other delays are not your only enemy when it comes to option buying. There is one other factor called volatility. One of the factors affecting the purchase price of options is implied volatility, but 1 66

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this is not what is being referred to here. Implied volatility is a method of pricing an option based on recent price activity and movement. I f price has had wider swings then the price of the option will be higher. Smaller swings and tight trading ranges will mean an option will be cheaper. The volatil ity we are referring to here is the real or actual volatil ity that devclops within the market. After you purchase an option any actual volatil ity changes will impact the rate at which a market progresses. Volatil ity is a variable and always remains so. While there are differences in opinion about how to define volatility, here it is defined as; the amount of price swing within a given period of time as compared to simi lar time periods. So what will determine the level of volatility are the differences between the highs and lows set as compared to other similar periods of time. For our purposes, as little as a single data bar wil l do for comparison, although larger sampl ings can be use as wel l . If this week each day has an average range of 10 points while prior weeks averaged only 8 points, then volatil ity has increased this week over previous weeks. As volatil ity increases so does the speed of movement. This means that if you are expecting price to reach a certain level by next week and volatil ity has dropped off considerably your prior calculations will be off and you may have a problem. Changes in volatility are often subtle and a trader has to be alert to any variation in order to exploit a market ful ly. It is one of the factors that are often overlooked when trading. For example, if you are day trading and you see signs of low volatility then it might be better to take a break from trading that day. Price has to move a certain amount in order to make a profit. Unless you are positioning yourself for an upcoming move, trading during times of low volati lity are often more frustrating than they are worth. After an option has been purchased low volatility proves even more frustrating because it causes the trade to fal l apart. Get caught behind a person driving wel l below the posted speed l imit and you have a similar frustration, particularly if you are late for work. When the market is slow, the profits will forgo. Volatil ity will be affected by many factors such as participation, supply and demand concerns, reports, and so on. The impact of these factors will be seen in the swings of the price bars. By comparing the average high and low set in any given time period you can reasonably make a judgment as to whether volati lity is changing and how these changes are likely to affect 1 67

Michael 1. Parsons

a market. I n figure 1 0-4 there are a number of volatility changes over a brief two month period and the impact is rather obvious.

Obviously the preferred volatility after purchasing an option is increasing volatility. If instead you find that volatility is dropping off with no signs of improving its pace later on, then it may be time to consider selling the option. Remember that time is your enemy here so don't waste it on an option that is screaming that the trade is a bust. The more time you have left on an option, then the more you will recoup by selling it. If it has moved at all in your direction then you might even come out with a profit. But in order to recoup any money from an option trade that is quickly fading you need to sell it while time is still on your side. Being aware of the impact that volatility has and any subtle changes is another aspect of option trading that plays a vital role in success. Understanding how time works and how a market progresses is essential when it comes to trading options. Any delay can translate into losses. This is why it is so important to comprehend the concepts of trend ratios, trend shifts, volatility and any other factor that influences the rate of price progression. Master time and you will master options.

Option writing

Option writers have the odds stacked in their favor. The rules are set this way because ifan option writer loses they do not have the benefit of limited 168

Channel Surfing

risk like the option buyer. This can translate into substantial losses for the writer of an option if he doesn't maintain a proactive defense against such loses. There is a long list of failed option writers who were wiped out by a market that exploded against them. In spite of this, option writers still tend to come out the overall winner in option trading. So writing options, which is what selling options is called, is a good way to start out. Of course, the trick in option writing is to know where a market will not go and when it will not be there. Naturally if we can determine where a market will go and when it will be there, we can also determine where it will not go and when it will not be there. Successful option writing isn't about finding levels where the market will never reach, but finding levels that a market will not reach in the allotted time or by the expiration date. This is the key element that success or failure in option writing pivots on. So all you have to do is determine what is outside of the expiration range and use these levels and dates for writing options. Because option writing requires the opposite approach that is employed in buying options, you are looking for levels that sit outside of channels rather than any that are within. You are still combining price, time and volatility within the equation in a way very similar to when we bought options. So much of the calculations will be similar, with the focus on options that will fail to achieve value. There is one major difference between the two forms of trading that has to do with volatility and the way it impacts option writing. H igher volatil ity increases the cost of an option and in turn, requires greater price movement to reach a break-even point for a buyer. This means that high volatility options represent greater profit for the writer while demanding more of the market, so these are the preferred ones to write. So the focus as an option writer is opposite of what is recommended when buying option. So that leads to a question, if you are taking an opposite view of when it is best to trade options then how likely are you to find an option buyer? Many option traders have been taught to look for low volatile situations before buying options and are simply looking to exploit changes in volatil ity, hoping an increase will push the option into profitable territory. These traders will not be i nterested i n what you are selling. Don't let that discourage you because there are just as many who are looking to buy for completely different reasons and are more willing to consider higher priced 169

Michael J. Parsons

options. As with anything else, the ideal time to sell is when everyone wants to buy. When a market is moving briskly along you can guarantee that there are plenty who want to be in on the action. But a wild market will also make traders nervous about owning a stock or contract, so many will be looking at options to control their risk. By the time that it becomes evident that a market has potential for a substantial move it has already priced options accordingly. So you will still have a ready and willing market. Still, while these are the preferred options to write there are plenty of low volatile options that can and will be profitable for a writer. So don't refuse to write an option simply because it isn't at its highest price. It is more important that an option meets the criteria required rather than an issue of high volatility. A n example of exploiting higher volatility while writing options can be found when a market reaches a limit such as a channel line. Similar to the approach we used when buying a put option in figure 10-3, a larger channel is used to determine the limit of the market. Only in this case you are writing an option near or beyond that limit, usually just as the market approaches that l ine. This provides the highest price available for an option with l ittle to no chance of making a profit for its buyer. That is of course as long as the market responds as expected. To protect yourself in case a market decides to change its geometry and move beyond its limits you would stand ready to purchase a stock or contract or a similar option as it exceeds the expected parameter. Barring any need to cover your exposure, you will make a hefty profit. When you do have to cover, taking action at the first sign of trouble should keep the losses down to a bare minimum and allow your profitable trades to more than adequately generate a profit. Knowing the limit of the market using Channel Surfing enables you to judge not only the extent of any move, but the timing of that move as well. Dissecting this process we start by defining the necessary channels. This is the same exact process used when buying options. Once those limits have been determined you then look for what options are already being written at and choose one that meets your criteria. The necessary criterion is that a breakeven price will still be outside of the channels at the time of expiration. Sources of option quotes that are sel ling are readily available through many web sites and financial newspapers, so there is no need to complicate this process. You are simply looking for the options that are already selling, preferably with the most bid/ask and settlement activity. I f an option is generating interest then it is fair game for writing l70

Channel Surfing

consideration. But out of al l the most popular options it is those that offer the highest potential return with the least amount of risk that will be of greatest interest to you. There will be three key pieces of information that you will need from a quote source; the strike price, the expiration of the option and the premium or current purchase price of the option. This is the same information we needed for purchasing an option earlier, so there is nothing new here. Much of this process is the same and it is a matter of how we are using this information rather than the mathematical results.

Figure 10-5 shows Gold early in M ay of 2004. Gold has been in a bull trend that started back in 200 1 , so this trend has lasted a couple of years and is likely to continue for quite a whi le. An earlier channel line covering a shorter period of time was broken back in the beginning of the year, but a larger outside channel line established itself prior to the trend change, indicating that a wider range existed for this trend. This is the focus of our trade. The outside line is duplicated and placed on the low that is furthest out and extends the channel in proportion. Currently price is touching this line and shows signs of gaining support from it. Price is closing just above 375, wh ich is a strike price that is currently attracting a lot of attention and so this is the option we will consider for writing. The prior uptrend lasted over ten months and so if the channel line holds it is likely that it will be some time before price returns. This allows the consideration of a longer term option, wh ich has greater profit potential as 171

Michael J. Parsons

well . Six months is well within the length of time allowed by the previous bull trend, so this means that an option for October 2004 will fit well within the parameters of a safe zone. A put option is currently selling for $20.50, which translates into a $2,050.00 premium. This means that price would have to drop down to $354.50 in order for it to reach a break-even point for a buyer. Price does indeed bounce off of this channel line and the trade becomes a profitable one. In this case price never even comes close to a breakeven point before expiration and so the option writer profits from the entire premium, less commissions and fees. But what if the channel line had fai led to hold? Because the break-even point would have required such an extensive move you would have plenty of opportunity to protect yourself from loss. Taking a short position if price dropped to $370.00 would have hedged against losses and reduced them down to $ 1 ,550.00, which would still provide a profit of $500.00 from the trade. By using channels you can calculate how the market will progress over the next week, month, or year and then find what remains outside of that projected area. This will of course be the majority of price levels on any given chart, so locating a "safe zone" is an easy process. The trick is to determine what others are willing to buy that fit within that "safe zone". Remember, when selling anything you want a ready market willing to grab up what you are offering. So don't try to sell refrigerators to Eskimos. The options that are the most popular will be in-the-money options, which mean that they already have value. This will be fol lowed by at-the-money options that sit right at or very close to the current price, although not yet having value. You can tel l which are attracting attention because there will be bid and offer activity. Because the most desirable options will always be closest to the current price, writing your options as price approaches a "safe zone" can be the most profitable. I f all goes according to plan the option will sell very quickly and price quickly bounces off of a channel "limit", resulting in the option fai ling to generate value before it expires. Realistically, there is no such thing as a totally "safe zone" and any market can and will from time to time exceed its "limits". So you need to have a backup plan that would be implemented whenever a market does go against you. Channel Surfing will normally alert you wel l in advance if any parameters have changed and there is a threat of having your option exercised. In most cases this will enable you to match the best approach with your budget while avoiding the pressures of a panic situation. This 172

Channel Surfing

is not to say that if a trade goes bad you will be able to avoid all losses, but rather that most losses can be controlled and kept minimal. If handled properly you may even be able to wal k away with a l ittle profit. But no matter what the outcome of an individual trade may be, if you manage to keep your losses infrequent and small, then your profits from successful trades will more than compensate for those that bl indside you. So how do you create a backup plan? The foremost key is to remain alert of any changes in the market geometry and take immediate action as soon as these changes become evident. When the market breaks a channel then you know that something has changed. In most cases you will stil l be able to gauge where the market is likely to move and approximately when it will arrive there. At the point of a channel break you are stil l l i kely to have some profit, particularly if any time has elapsed since you originally wrote the option. Of course, you also have the profit generated from the sale of the option to help offset any losses. So a loss is not a certainty at this point, unless you faiI to take action. Limiting your losses can be accomplished through one of several approaches. One approach is to buy or sell the stock or future that you had previously written an option for. If you wrote a call option and the market goes against you then buying a stock or contract protects you from further losses that would otherwise mount up against you. As the option increases i n value against you so does the stock or contract that you now own. The drawback to this approach is that if the market moves back into your favor then you start to accumulate losses on the stock or contract you purchased for protection. So you must be alert to l iquidate any stock or contract position when its usefulness has ended. In this situation you are trading so as to protect yourself from a loss and not with the goal of generating a profit. This is called hedging. The difference is substantial because you don't have the l iberty of waiting for the perfect set up. Often you must accept whatever the market deals you at the time and stick with it until the market shows clear signs that the option is out of danger. If you are determined to try and make a profit then it can cause you to repeatedly buy and sell as a market dances around a l imit area. The result would be mounting losses just from overtrading alone. This is why it helps to remember that the goal here is to l imit losses, not to make a profit. A different goal and approach than you would have with other forms of trading.

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A second approach is to use an option to protect an option. There are two versions of this approach. I n the first version you purchase an option at the same exact time as when you write one. The difference here between the two options will be the strike price, with the one you purchase much further out than the one you are writing. If the option you wrote is ever exercised then it is likely you will take some loss, but the option you purchased will protect you from a catastrophic loss that would occur if a market exploded against you. I n this case the profit that you would make will be based on the difference between the prices of the two options. Your profit is lower, but your losses are limited as well. Just remember that options are worthless unless they are exercised. The purpose ofthis option serves as protection, not as a profit generator. So it is best to exercise it when the option you wrote is exercised, if at all possible. The second version involves purchasing an option at the first sign oftrouble, similar to using a stock or contract for protection as mentioned earlier. In this approach you are not indiscriminately buying options and will profit ful ly from any you write if protection is never needed. But due diligence is required here because you are also fully exposed to unlimited losses. Further, this will often result in some of those protection options costing you hefty premium, sometimes more than the option you actually wrote. But when the parameters of a market changes and a "safe zone" is no longer safe then the appropriate action still needs to be taken immediately, so there will be little choice here. When a market starts to work against you and you need to consider protection the first step is to determine what your exposure actually is. Exposure is the amount of potential losses that could accumulate against you. Sometimes exposure is so minimal that if an option were ever exercised the loss would never justify the cost of the protection. In such a case it may be better not to acquire protection. For example, when options are purchased for protection then obviously additional funds will be required. This cost must be weighed against potential losses and if your exposure is too high and warrants the purchase of an option then you will need to calculate two numbers to determine the best approach. The further out a strike price is the greater the loss before it starts to protect you. So the difference in value between the two strike prices is the first consideration. The second has to do with the cost of the option itself Both of these numbers must be added together in order determine the total estimated cost or loss. 174

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This step is necessary because you may find that a "cheaper" option with a further out strike price may end up costing you much more than a more expensive option with a closer strike price. It will vary considerably, so weigh these two costs carefu l ly when determining what option to purchase. Discrepancies between different strike prices will occur regularly with options as well. In a free market options will tend to have price variances that are disproportional, cven though they all for the same market and the same month. So don't assume that everything is equal on an option quote list. Do your homework and find the best one that matches your needs. An example of this can be seen with January 2005 Orange Juice. In December 2004 when Orange Juice settled for 80.75 you had a choice of purchasing a call option with a strike price of either 80 or 85. The first was obviously already in the money and one would assume that th is would prove the more costly of the two. The premium initially looks that way because the 80 option was quoted at $367.50, whi le the 85 option was quoted at $ 1 50.00. But what real ly is the breakeven point for either of these options? The breakeven point for the 80 option turns out to be 82.45, whi le the 85 option is 86. That means that by the time you are just hitting the strike price for the 85 option you have already profited $382.50 with the 80 option. To be fair, in the case of the 80 option you are risking more cash and i f price had fai led to reach the strike price then you would have lost more money. Sti ll, it is hard to ignore the discrepancy between the two options. This discrepancy is actual ly common with options because of the view that the more you spend, the more you risk. But who really is risking more between these two options? I f you are hedging against an option you wrote that continues to mount up losses against you, which would you prefer to be holding? If this market goes to 90, which option would you have preferred to have bought? Of course, if the option expires worthless then we would prefer the cheaper one, but most of us are not trading with the intent to pick losers even if most end up doing so anyway. The point is that option trading is not always about deciding how much option we can afford. It is often deciding how much option we can afford to be without. If Orange Juice only goes to 84 then the more expensive option is the only one that will be profitable. So it becomes necessary to weigh the real value of an option in line with specific trading goals. 1 75

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The extra effort to determine which option works best is an essential part of good money management for your option business. Losses are a problem for any business. All successful businesses must take steps to control losses or failure is l i kely. A person who owns a shop or store will always have times when product will not sell or simply goes bad. Of course, there is also theft that plagues shop owners as wel l. These occurrences are just viewed as the cost of doing business. But no shop owner will last long if he doesn't take steps to reduce and control those losses. But a shop owner cannot point a rifle at every customer who walks in through his door. However, he can install a camera or security device to discourage potential criminals from stealing his wares. In a similar light, while you will never be able to eliminate losses entirely, you must still endeavor control them. It is a matter of survival. If enough time has passed since you wrote an option it may sti ll be possible to come out of a bad situation with a profit. Time decay alone will reduce the cost of purchasing an option as protection. But as it is true with trading actual stocks or futures, what is more important is the overall result. If, because of the shear number of wins, the profits more than overshadow any losses then those losses are tolerable and simply just the cost of doing business.

True option value

So far, the focus of our option writing discussion has been centered on options that are within "safe zones" or outside of the defined channels. However, there is a fine l ine between what is considered a safe zone and what is not. It starts to become blurred when you consider in-the­ money options because these options already have value attached to them. Technically, as soon as they are sold a person could conceivably cash them in and money would be drawn from your "account" to settle the difference between the option and the current price. Of course, you would have originally been paid much more than this settlement amount by the option buyer so there is really no threat of a loss at this stage. But naturally this means that the option's strike price was never in a "safe zone" to begin with. So why would we even consider selling them? I n-the-money options offer the highest premium and are often sold the fastest. Buyers have the illusion of profit because the option already has met its strike price. Despite having intrinsic value, unless the market moves enough to overcome the cost of the premium you are stiII guaranteed 1 76

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to make a profit as an option writer. And because these are among the most expensive options to purchase price needs to move a considerable distance in order for a buyer to even recoup the premium he invested. So realistical ly, it is the break-even point of the option rather than the strike price that is at issue. This means that an in-thc-money option is technical ly sti ll within a safe zone despite its strike price having already been reached. In fact, on rarc occasions the market may even price in-the­ money options so high that their break-even point or "safe zone" extends beyond that of the nearest out-of-the-money option. So when it comcs to trading options you have to look beyond the i l lusion of profit created by a strike price quote. This i llusion tends to fool traders on both sides, so no matter how you are using options you sti l l need to calculate the true value of any you are considering. Quote boards do not make this distinction. They just tell you the strike price, expiration date and the premium. So the only way for you to really know is by calculating this yoursclf. There are a number of software programs available that will make the calculations automatically for you, but many stil l require you to input the numbers. So some understanding of the calculation is stil l required on your part. Fortunately, the process involves just a few simple steps. In essence, you are determining at what price the market needs to be in order to bring the intrinsic value of the option up to an equal value of the cost of the premium. For simplicity sake we will ignore the commission cost associated with option transactions in our discussion and focus just on the intrinsic value. The process will require three numbers; the cost or premium of the option, the value of each trading increment in the market you are trading and the strike price. The cost of the premium for the option is determined by the market and is avai lable from the exchanges themselves. Quotes are given in their basic format and require that you multiply the premium quote against the basic value of the market you arc trading. For example, corn may have a quote of $ .34 premium for a cal l option. Since corn is traded in 5,000 bushel lots the $.34 would be multipl ied by 5,000 to determine the actual option cost or total premium. This would mean that the option premium would be $ 1 ,700.00. (.34 x 5,000 $ 1 ,700.00) Because of the way it is quoted the amount of move necessary for the option to meet a break-even value is already given to you. To equal the $ 1 ,700.00 cost for the premium you would need to have the market move at least $ 1 ,700.00. This just happens =

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to be $.34 which is the premium quote that we started with in the first place. This makes it simple, doesn't it? A n important note to remember here is that the value of the option is calculated from the strike price and not the current price. If the current price is $2.60 while the strike price is at $2.70 then you must add the premium value to $2.70 and not the lower number. This would mean that price needs to rise to $3.04 ($2.70 + .34 $3.04) before it is equal to your premium cost rather than the lower price of $2.94. ($2.60 + .34 $2.94) =

=

So, with the exception of any commission paid for the option transaction, as long as price never reaches $3.04 then an option writer will make money. Realistically, if an option develops any value it is possible for an option buyer to either exercise it or sell the option to recoup a portion of his investment. But in either case he will not be able to recoup all of the premium and it is possible that none of it will come from the option writer. A buyer of this corn option needs price to exceed $3.04 or the option can be considered a loss. So what we need to know as an option writer is whether our channels indicated that $3.04 is within a "safe zone" for the duration of a specific option's life. This would be the true determining factor as to whether we would consider writing this option. The original strike price of $2.70 is not the issue, but only the starting point. This changes dramatically how we look at an option. There is some clarification is in order here. Just because the break-even point has not been reached does not automatically mean that you will obtain the full premium as a writer of an option. If the strike price has been exceeded at all then the option could be exercised and some of the premium lost. But as long as the break-even point has not been exceeded then you are likely to walk away with some profit, even if it isn't the maXImum. Depending on the time left an option buyer may also choose to take another route. He can sell the option that he bought to someone else and recoup some of h is investment. The new option owner will usually end up with a greater break-even point than the original owner and so the further down the line an option goes the less likely it will be exercised. There are exceptions depending on how market conditions develop, but you will never have any greater risk than with the original buyer. Risk can be the same, but it will never increase based on who owns the option. Only the market can do that. 178

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Loss on ly occurs when an option you write is actually exercised. Some options with intrinsic value are never exercised because of their value is just too low to make it worth it. There is a cost associated with exercising an option and this can exceed whatever value may exist. Depending on how option transactions are handled by the buyer's broker, a buyer may view it too costly to actually exercise an option and instead just let it expire. So it is possible for an option writer to still come out of the deal with the entire premium despite a gain in the intrinsic value. Another frequent scenario with simi lar results is when an option develops intrinsic value but later loses it as price reverts to prior levels. So an option buyer's poor timing can also turn a potential loss into a profit. On the other side of the coin, these principles need to be understood by an option buyer as well . Unless price reaches a break-even point you will not profit from an option, period. If the strike price has been exceeded then you can exercise the option to recoup some of your losses. Needless to say, thcrc wi ll still be some loss. You can also take another route and sell your option to recoup a portion of your losses. But obviously you will need to be vigilant about your purchased option. Once you have reason to believe that an option is destined never to reach a break-even point then time is of the essence. It is time for damage control because an option loses value the closer it draws to the expiration date. Further, an option that reaches profit status is not guaranteed to stay there. Options are not causal trading instruments. They just provide a more predictable risk. Options literally offer you a world of options in trading. Some option strategies can be rather complex, but they all pivot on one simple question; wi ll an option have intrinsic value before it expires? Whether you are writing or buying options this is the key that makes or breaks any option trade. Channel Surfing offers you the advantage of determining the odds of price actually reaching a break-even point and provides a great tool that can help you to come off as a consistent winner, enabling you to l iterally write your own check with options. And this makes trading options a rather attractive option.

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Chapter Eleven

Putting It All Together Trading is a zero sum game. This means that there will always be a winner and there will always be a loser. There is no such thing as a win-win situation in trading. Technically, there is one person that will always be a winner and that is the broker who will get his commission from you whether you win, lose or draw. The exchanges are the same way. But you and 1 simply do not have that luxury. What this means is that when you win you are banking someone else's money. When you lose someone is pocketing yours. But this fact does have one positive twist to it. It means that all you have to do is beat the next trader and not some huge corporation, brokerage or exchange. While we can't choose who will be on the other side of our trade, if we are more ski l l ful and educated than our competition then the odds are that we will make money. When put in this perspective it is easy to see why some traders are consistently profitable. Most of the profit will go to the few traders who have educated themselves and developed their skill. Not because they are such great traders, but because of the overwhelming lack of skil l and education of the majority. Most traders are simply out of their league and can't hope to compete. This disparity is largely a choice. Most simply fail to put in the necessary effort to go beyond anything but a very basic comprehension of trading. The result is that they make the wrong choices by approaching their trades haphazardly, taking them based on assumptions and uneducated guesses, all the while using methods that they do not fully understand. In the end they al low the emotional roller coaster to sway them rather than using it to their advantage. With the 181

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constant influx of new traders attracted to the i llusion of quick money one can make a very long career out of trading. New traders tend to repeat the same mistakes of their predecessors. Most are only sold the sizzle and never the steak. Without any real trading techniques they are easy targets for those with real experience and solid trading methods. Trading is in reality one of the most expensive educations you can obtain and most do not have the staying power to stick through the hard times until their efforts finally bear fruit. Does it bother you that you are taking money from inexperienced traders who are in essence sheep led to the slaughter? Just remember that they freely chose to trade and would have lost their money anyway. In fact, many do so despite countless recommendations against it from the people that they trust. There is no h ighway robbery here, although after losing their hard-earned cash they might think so. If you didn't take the other side of their trade then they would simply have found someone else, anyone else that would. These people are not exactly being taken for a ride. In fact, they are the ones that actually drove themselves onto this road paved in fool's gold. Here is the harsh reality about the majority of your competition; most traders are uneducated greedy fools who are willing to throw their hard­ earned cash at an industry that they know nothing about. The crazy thing about all of this is that many actually believe that trading is as simple as 1 23 and that the market is just one big cash giveaway ripe for the picking. A fool and their money are soon parted. While I am sure that to some degree this statement is upsetting to you, it is unfortunately the reality. This harsh reality should serve as a wakeup call regarding your own trading habits and expectations. Practically all of us come to this business uneducated. There is no license requirement, educational degree or experience minimum in order to trade. On top of this, everyone is programmed to think that this is the last gold rush and so greed and unreasonable expectations are rampant. It is not surprising then that most are doomed to lose huge sums of money right from the starting gate. It is not until you realize that this is a very serious game and begin to educate yourself with something more than parlor tricks that you understand what you need to do and how to succeed. Just as an alcoholic must stop all consumption of alcohol in order to break free from his pain, we must also make harsh changes in our personality, our approach and our 1 82

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view of trading. Successful traders do not do what is natural because the market naturally motivates you to do what is wrong. There is an intuition to successful trading, but it sti l l must be void of all emotion. As in a poker game you need to be able to read when the other side is bluffing and know when they are not. It is a game of logic and a battle of wits. Melting intuition and logic together is no simple or easy task. The question then is a matter of where do you stand in this battle of intuition and wits. Do you think you can beat the uneducated greedy masses and become a winner in this zero-sum game? Despite what I just said, it isn't as impossible as you might imagine. But it does take hard work. How much effort will this require? That will depend much on you, your background and your personality. The education that you have gained through this book will take you a long way. That is as long as you really understand what you have learned. There is no getting around the need to practice and gain experience and let me emphasize this point, a great deal of practice and experience. But even with this, there wil l stil l be times when the market will make no sense at all and play you for a fool. For me, it took six years just to make sense of the market. After that it sti ll took another eight years to develop my skills using the knowledge that I had gained and to learn to control my emotions which proved to be the toughest part. Of course, I didn't have what you have in your hands right now. No one was teaching this method back then. I had to figure that part out all by myself. After all, that is why I wrote this book in the first place. You on the other hand have this advantage over me. Even so, the reality is that reading a book is one thing, developing the skill to use what you have learned is another. This book is but a foundation for you to build on. In your quest for success there will be battles related to the emotional issues of trading that will take time to master and control. There wil l be times when you make a serious m istake and i n hindsight see so clearly what you did wrong. The lessons will be useful for future trades, but of little consolation for the loss that you had to take. There will be an emotional roller coaster ride that takes you from great elation to deep depression. You will need patience which many lack. You will need focus and concentration which is beyond many. You will need the abi l ity to make sound decisions during pressure situations which is something that most find impossible to do even in everyday life. And we are just talking about the emotional side of trading here. If this gives you the impression that trading is not a casual affair then welcome to the reality of trading. I personally do not know of any traders 1 83

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that are sitting on some sun drenched beach while calling their brokers to place their orders between cocktails. Despite the illusion created by many in this industry, this is a business, not a vacation. Never treat your business of trading in a casual manner. I f you came to the world of trading expecting to have an easy time of it, then think again. Swimming is a pleasurable experience, but if you are in the water with a school of sharks in a feeding frenzy then the experience is anything but pleasurable. I f you want a serious income from your trading then you have to take your trading very seriously. Part of this seriousness is putting forth earnest effort to master the skills and methods that you have learned. To actually be able to use them successfully will require good old fashioned hard work and practice, practice, practice. As you come to a finish in this book I would love to be able to tell you that you will be a resounding success from now on, but I simply can't do that. The only thing that I can promise you is that somewhere along the line in reading this book you probably have missed key points that you will need to know in the future. Whether this is due to overlooking something, failure to clearly understand a point, or simply that you just forgot some part in the time it took to read this far it will be well worth your effort to reread this entire book again, particularly as you first begin to experiment with these methods. So keep this book handy and refer to it often. Channel Surfing is very powerful, but success depends much on the individual and how they use the information they have learned. What you have here is a great foundation from which to start. Instead of being equipped with just a couple of situations that may or may not develop favorably, you now have a way to enter any market with low risk and high profit potential, along with an exit method that will protect you time after time. That doesn't mean that it will always work flawlessly, but if you follow the rules and learn to adapt to any changing condition then I am sure you will have the success that you desire. To help put all this together we will review a few specific situations and the process that went into making each decision, starting with figure 1 1 - 1 .

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A well established channel is broken and sets up a short entry

A couple of refinements in defining a channel are addressed in figure 1 1 - 1 . A s price reaches a channel line i t w i l l often spike, a reaction common to reversals. Each time this happens a channel needs to be reevaluated and adjusted. Experience teaches that this is not always the best route to take and despite a spike a channel sometimes remains unaltered. There are a couple of characteristics that identify that the original channel should continue to be used instead of an adjusted one. Notice in this chart the numerous bars that ride against the inside channel l ine. There is one bar that spikes beyond this line, but overal l there are nearly a dozen bars that ali i i ned up with one another. Obviously a trader would not have the benefit of knowing this very early on with this trend, but even the first two lows established four bars that were all aligned with one other, a commonality that is hard to ignore. So don't ignore this unity when you see it. Also, both channel lines normally progress at very similar rates, meaning that you should have a parallel between the two l ines unless the bias is distorted. This is why you can so easily duplicate one l ine to use as a temporary line for the opposing side. So as much as possible keep the l i nes that you draw in formation. At the same time, do not ignore distortions when they do occur. If there is a choice that is unclear then define both and let the markets reaction to the lines decide your position for you. But general ly speaking, the market will fol low wel l defined parallel channels whenever possible.

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Figure 1 1 - 1 also shows a classic example of a rebound entry, one of the best entries to start with. While this market also had the benefit of forming a double top that allows you to draw a horizontal resistance line to limit price, this entry is easy enough to fol low here and is exactly what you will look for when a market reverses direction. In this instance there were a number of factors that lined up beautifully to set a short in motion, a strong resistance line shown by the double top, an attempt to kiss the channel line good-bye, and a rebound break that were all well defined. Additionally, there was a false breakout that gave another indication that a drop in price was imminent. For the next nine months Intel continued to drop until it fel l below $20.00 a share. A short off ofthis set up would have potentially resulted in a $ 1 3.50 gain per share.

Another stock example is that of Lucent which is shown in figure 1 1 -2, only in this case the set up is a buy. Technically a triangle pattern has formed here, but off of a channel line that has been giving support for months. As price draws close to the channel l ine it allows an entry that is low risk. A failure of the channel line would indicate a change in the markets direction, but currently the odds favor this line holding and in turn, the trend continuing. An additional signal is that of the triangle itself which begins to narrow before the breakout. If the inside channel line holds while the triangle resistance line breaks to the upside, then the two act as confirmation for the trade. The breakout is dramatic when it occurs and actually results in price j umping up to $5.00 a share in less than a month. 1 86

Channel Surfing

Set ups as we see in figures 1 1 -1 and 1 1 -2 are great examples, but not every situation will be so easy to identify. So in the next series of charts we will look at trading through a blow by blow account, starting off with a continuation of the previous chart for Lucent in figure 1 1 -3. " .. .. •• " .. " " .) " " ., ,.

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Figure 1 1 -3 picks up where figure 1 1 -2 ends, at the buy signal. I - Here the buy was signaled and a stop was initially placed using the prior channel line, which cannot be seen on this chart view. The stop never even came close to being activated before the market exploded upward. 2 - A new channel line develops and is then used as a stop. This channel ends up lasting the life of this rocketing trend and will later be used to signal an exit. 3 - The outsidc channel l ine is initially hard to define. The highs run a very narrow range above the lows, which means that an early exit is questionable. I f an exit is taken too early then an entry back into the trend will probably result in missed profits. Since it is so narrow, l ittle would be lost if the inside line is used solely as an exit signal. When a single prominent high finally appears, a duplicate of the inside channel l ine is placed upon it to act as an exit signal. This l ine is what will later be broken and signal an exit. 4 - The outside channel line is broken and an exit is taken.

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5 A rebound entry sets up for a short and taken as the rebound channel l ine is broken. There actually is an earlier channel line that could have been used for a rebound entry, but the advancement was too fast back then and the entry missed. Therefore a second one had to be found and this one turns out to be very well defined. -

6 A break of the inside channel line occurs. As a rule, I look at what type of break occurs with the inside channel l ine to determine whether I want to exit or not. Obviously if you had placed a stop limit order with your broker then an exit would have occurred here, but if you are able to review your trades during the day then some liberties can be taken as in this instance. Remember that a break of a channel line often signals a reversal. If a break has strength or bars begin to close beyond the channel line then an exit is clearly called for. Momentary breaks of an inside channel line often work i n our favor, but altering the plan here will require common sense and diligence to prevent a bad decision from getting out of hand. Obviously, this is a consideration that must be made when placing a stop limit order with a broker as well. I n this example the reward actually outweighs the risk and so no exit is necessary. If it is taken, than a day or so later you can reenter again using the trend entry method. -

7

-

Price breaks the outside channel l ine and an exit is taken.

8 After breaking the inside line, a rebound entry sets up for a buy. When the rebound channel l ine is broken a long position is taken. -

9 Here is another example of an inside channel l ine break. This one is much stronger than the one before and therefore an exit is taken. While it isn't really the end of the trend, two days later it is clear that the trend is now in trouble. -

10 Price begins to make it perfectly clear that the up trend is over and shortly afterward a downward channel forms. -

11

-

A rebound entry sets up and signals a short.

1 2 The trend begins an accelerated descent and a fanned channel line has to be drawn. -

13

-

Price breaks the outside channel line and an exit is signaled.

14 Although the downward inside channel l ine is initially broken, price establishes a lower low and reveals that the trend is still headed downward. -

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A new channel establishes itself, although it is not as accelerated as it was previously. 1 5 A short entry is signaled in two ways; a rebound entry and a trend entry. A nice gap follows, resulting in a quick profit. -

Being aware of subtle detai Is is essential when it comes to trading and th is is demonstrated in figure 1 1 -4. Since each aspect of a market is interrelated, a missed relationship can result in a missed trade. Particularly when you are deal ing with true support and resistance l ines do you want to take special note. But remember that channel lines are also true support and resistance lines as well.

Silver continued t o climb for six months, until i t reached $8.00

.0 IS

Silver

1 An inside channel line forms a clearly established line, even though price eventually does move to higher ground. -

2

-

The outside channel line also clearly develops.

3 Later on after dropping off of its high the downward trend is halted when it enters the channel that established itself much earlier. This prior channel sets up predetermined limits, allowing for a quick trade set up. -

4 A rebound entry is set up with the additional benefit of a channel already in place. -

5 Because a channel is so wel l defined and at such a low incline that it could even be considered a trading range, a short can be taken as soon as -

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Michael J. Parsons

the upper line is reached. Of course, a short can also be taken with the break of the smaller channel line as well, or this can simply be used as confirmation. 6 Similarly, a long can be taken as the lower channel line is reached. Again, another development that can be used for confirmation is the descending channel line that forms off of the major high and the more recent lower high. Whichever way price breaks here should result in a strong price move. -

You can count on some of these subtle details impacting price at some point and time, usually when you have a trade in place. However, even if you miss any of them as long as you think through your trades and keep focused you will do just fi ne. There will be the occasional out of character move and it does help to be able to identify them as just that, out of place events. Doing so will prevent you from exiting sooner than you should or entering when you should not. So as much as you possibly can, learn to find and identify any subtle details in the market you are trading. Some markets are prone to these events and may be a challenge to trade, but all markets can successfully be defined and traded. The T-bond is an example of a market that many find difficult to trade, particularly on a short term basis. Figure 1 1 -5 demonstrates that despite its reputation it stil l responds well to Channel Surfing.

1

-

A rebound entry sets up and a long position is signaled. 1 90

Channel Surfing

2 3

-

A well defined cbannel develops that lasts for nearly a month. Price spikes out of the outside channel and an exit is signaled.

-

4 An entry back into the market is signaled by the break of a small downward channel line and occurs near the well defined upward inside channel line. -

5 The following day the market gaps above the outside channel l ine. An exit would occur here if a limit order were already placed with a broker, but a position could be held since the market fails to drop back below the inside channel line. I f an exit were taken then a trend entry could be made a day or so later when it became clear that the prior outside channel line was providing support. -

6 A break of the outside channel line signals an exit and profits are locked in. -

7 A channel develops that is not as steep as previously, but a couple of price bars clearly establish it as valid. A long is signaled at the break of a smaller bearish channel line, but because it had al ready broken a prior larger inside channel l ine tbe trade would be risky and most conservative traders would not trade it. -

8 If this trade were taken and outlasts the slight break of the inner channel line occurring three days earlier, then an exit would be taken here at the break of the outside channel line. -

9 At this point it is clear that the trend has changed direction and a short is set up by a rebound entry, wh ich is signaled by the break of tbe smaller bul lish channel line. -

JO The outside channel line is broken and an exit is called for. H owever, price initial ly holds beyond the channel line and a short could be maintained. -

1 1 If an exit had been taken previously then at this point it would now be evident tbat the trend is ongoing. A breakout entry would be the cboice here and once price drops a new channel line will automatical ly form that will be used for setting a stop. -

1 2 The prior fanned inside cbannel line now serves as an outside channel line. An exit is signaled here when it is broken. -

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1 3 Another prior inside channel l ine comes back into play and stops the pullback. A short would be taken at the break of the smaller inside channel line. However, the break actually occurs when the market gaps and this places an entry deep within the channel. If this trade were to be manually entered it should be weighed against the increased risk. Even so, it is a valid short. -

14 Price's action here leaves a lot of uncertainly as to what it will do next. In one case you have broken an inside channel line. On the other hand it has gapped lower making it appear to be a strong short and even set a new low. Now price approaches a prior inside channel line and the move is in question. -

1 5 Price returns to finally break the prior major inside channel line and it becomes clear that the trend has changed. An exit would also be signaled, which creates the first loss even if it is a very small one. Following this, a trading range develops and provides the set up for the next trade. -

1 6 The trading range can be traded in both directions if it is wide enough. This specific range would normally be out of the question for a short term trader because it is far too narrow. So an entry would be signaled by means of a breakout. This trading range also sets up a secondary low that establishes a new inside channel line that will be critical for any future trading decisions. -

17 A secondary high is established and the outside channel line can be accurately defined. This l ine is almost a perfect match for the inside channel line, which is not surprising but does confirm that the trend parameters are accurate. I f for some reason a long entry wasn't made when price broke out of the trading range, then a long can now be made whenever price returns back to the inside channel line. -

18

-

Price spikes through the outside channel line and an exit is signaled.

19 The inside channel line is broken and price starts to close beyond it, signaling an exit. The trend has again changed. -

A lthough a market can be a challenge to trade, Channel Surfing will stil l cut that challenge down to size. These series of trades can b e repeated over and over in any market you wish to trade simply by applying common sense and the methods that you have learned in this book. Yes my friend, trading success is indeed possible ! What I have done here you can do just as wel l yoursel f. 1 92

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A few closing thoughts

Now that we have comc full circle, you may be wondering what kind of success you can expect while trading these methods. This is always a difficult question to answer because everyone is so different. Obviously, those in the right place at the right time will fair much better than those in the wrong place at the wrong time. But who can predict these events? Nevertheless, there are a few things that you can do to change the type of "luck" you have. If you trade markets that have very little movement then obviously you will not do as well as someone that happens to pick the next 1 979 gold market. But then again, a slow mover is better than getting stuck in a market that is exploding against you, particularly if you are unable to get out. I magine owning Enron stock and watching it plummet while you desperately try to find a buyer. No one is buying when everyone knows that the company is doomed. These things do happen and are part ofthe opportunity and risk oftrading. Even so, both of these examples had plenty of signs along the way so perception and common sense will go a long way in impacting your success. Realistically, trading success has as much to do with money management and controlling one's emotions as it does with a method. A method alone can not guarantee your success. Fortunately, many of these aspects are already built into the rules of Channel Surfing. Stil l , there are others that are not addressed and you will need to find a way to control them. So I encourage you to educate yourself in these areas before trading. Trading brings with it an incredible opportunity, but also an ever-present risk. A year of hard work can literally make you a m i l lionaire many times over. But then again, a week of bad trading can take it al l back. Successful traders strive to be consistent and therefore are alert to when they need to take a break from trading. Burn out is common in this industry and it is often necessary to take time to benefit from the fruits of your labor and to regroup. Bad trading usual ly begets bad trading. Sometimes it is better to walk away than to fight. The income derived from trading can exceed your wildest dreams, but there is a self-limiting effect in trading. As long as you are consistently winning, you can give yoursel f a raise at any time by simply trading more stocks, contracts or options. But as trading quantity increases so does the delay in any buying and sel ling. One contract of the S&P 500 will move in a heartbeat, but one thousand will take quite a bit longer. So while you

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have the opportunity to become very wealthy by trading you will never rule the world by means of it. Another limiting factor has to do with the method itself. If you incorporate all the trading principles that we have covered in this book then you will fi nd that most markets can only be traded less than half the time. But on the positive side the results can and will be rather robust. So don't let this concern you. There are always plenty of markets to choose from. Beware of becoming greedy or chasing after markets when you have already missed the set up. It is not uncommon for someone to make a steady profit and build up a substantial account only to blow it all on a couple of sloppy trades where they just had to get in on a runaway market or they decided to try something new. Stick with what you know works and keep greed in check. Additionally, the type of market you trade can be limiting as well. Trading stocks by buying and selling them outright will offer much less of a return than trading futures that are traded on margin. The more power your money has then the greater you can profit from it. If you do trade stocks, keep an eye out for the big gainers and losers and then keep track of them. The best markets are the ones that will have the greatest movement associated with them. Many charting programs and web sites will provide scans of stocks that meet this criterion. Simply find a larger channel that the stock is fol lowing and set an alert for whenever price draws near to its inside channel line. A smaller channel would then be used to set up the trade. Right now all ofthis is new to you so keep your expectations low at first. It is unreasonable for a beginner to expect the same results as an experienced trader. Even though you may follow the same rules nothing teaches like experience. There are many subtleties of trading that no book or class will ever teach you, only experience can. The positive note here is that you will improve as you gain more experience, so trading will only get better with time. With this point in mind I would recommend paper trading until you thoroughly understand the process and how to deal with situations that develop before devoting any real money to this method. Paper trading is defined as recording your entries and exits as if you were really trading, but doing so without the transaction of real monies. At the same time, paper trading will never replace actual trading. When your money is on the line then your emotions will step out of line. No amount of paper trading will make you a real trader. Emotions can be the biggest obstacle 1 94

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to trading success. So the next step would be to trade with a control led and limited account in order to get a handle on your emotions. While a larger account does allow more room to trade under pressure and should be the norm for anyone seriously trading the markets, caution needs to be applied here particularly when you first start out. A runner doesn't throw everything to the wind at the starting gate. Start with an easy steady pace until your understanding and confidence has grown to a comfortable level. I f you start with too large of an account you could allow the false security of a large bank rol l to allow you to get too comfortable with a lackluster performance. A larger account can also place a larger emotional strain on your trading as wel l. An even worse emotional strain occurs when you use money that you should never touch. I f you are depositing your life's savings or your children's college fund in a margin account then you are setting yourself up for fai lure. Trading with money that you can't afford to lose is a sure guarantee that you will lose it. Emotions are that devious when it comes to trading. If you are fol lowing the rules of Channel Surfing properly then you should see a consistent profit. I f losses start to dramatical ly shrink your account then something is wrong and the culprit is probably your emotions. Of course, there will be times when you will stil l have losses, such as when a market gaps unexpectedly against you. But this should be the exception and not the rule. The problem with emotions is that they will cause you to chase after markets, rush entries, stay in a losing trade, choose dead markets, take bigger risks than you need to, take smaller profits than you could have, and see things that are not really there. There is a long list of other fatal faults that can sabotage your best efforts as well . Learning to detach ourselves from our money and trade based on logic is one of the hardest aspects of learning to trade. Don't underestimate the power of emotion. That is why it is essential to only use money that you can afford to lose. Otherwise, your fear of losing it w i l l be devastating to your trading success. The same principle applies in regard to any reliance on trading for your livelihood. If you wake up one morning and decide that you are going to become a day trader and th is will be your only source of income and yet, you haven't mastered trading, then I guarantee you that you are setting yourself up for failure. In order to succeed you cannot have the emotional baggage that comes from a do-or-die situation. Take trading one step at 1 95

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a time and your success will come as your experience grows. Because learning to trade is the most expensive education you can obtain it is best to let your trading fund it and not your bank account. If day trading is your goal then let the transition occur because trading success demands it, not because you do. There is a great deal of subtle aspects to learn about trading that cannot be accomplished overnight. Learning them will require practice, practice, and practice. Did I mention that you need to practice? Of course, this goes against the grain of what everyone wants trading to be. Why do we all get into trading in the first place? We are attracted by the thought of easy money that requires very little work and offers a great deal of excitement. One could say that all losing traders are greedy lazy thrill seekers. But oddly enough just replace the word lazy with hardworking and you have a fitting description of a successful trader. Success comes to the trader who puts in the necessary work to ensure that the odds are in his or her favor. So never forget to take lazy out of your description and replace it with good old fashion hard work. Despite what you have been told hard work comes with the territory. We are creatures that habitually choose the easy route whenever we can. After all, many of today's inventions were thought up as a way to reduce labor and make life more convenient. To become a doctor a person has to attend an educational institution for nearly a decade. This is followed up by a couple of additional years of internship where they practice their skills under the supervision of another doctor. Then finally a doctor can be allowed to "practice" on his own. Even after this a doctor must add to his education every year or he will not be allowed to continue to practice. I n comparison, trading offers an income that is even greater than that of a doctor. Is it reasonable then to conclude that you wiII succeed with little or no work? The reality is that you must work hard in order to become more skillful than your opponent and then continually work hard to remain one step ahead of your competition. What you have embarked on is a never­ ending battle of supremacy. To l ive like a king means that you have to conquer like a king. The day that you take the easy route is the day that you are conquered, even if just for that day. Shortcuts translate into losses. Unless it is your intent to be a loser, do not take shortcuts. Throughout this chapter, you have no doubt noticed that I have focused highly on emotions and the development of your skiII, even to the point of repeating myself a number of times. From experience I recognize how important these issues are to trading success and know that you need 1 96

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to understand what you are truly up against. We can do more damage to ourselves than aU the surprises that a market can throw against us combined. While the focus throughout this book as a whole has been on a trading method, no method can keep you from beating yoursel f if that is your determination. Your emotions are determined to beat you and the market is geared to exploit this tendency to the ful l . I cannot overemphasize this point; you must learn to control your emotions. Remember these three goals before taking any trade and your odds of success will be multiplied. ]. Trade in the direction the market is biased toward. 2. Enter when you risk the least. 3. Trade when the profit potential is high, preferably with a minimum 4 to 1 ratio. Trading that follows the direction of market bias is a simple matter of knowing which direction the trend is in. Channels will tel l you this, particularly when you use multiple time frames. When two channels line up in the same direction then you have a market biased toward one direction, the direction of your trade. Entering with the least amount of risk means that you are waiting for the market to come to you, not chasing after it. However, don't get unreasonable about this. You are not going to buy the bottom or sel l the top. You just want to negotiate a better price and plaee your entry as close to your stop as reasonable. The market itself will dictate where your stop will be plaeed and an exit would be taken at the first sign of trouble. I f the trade goes wrong then your loss will be small . It is mueh easier to recoup a small loss then it is a large one. Trade when the profit potential is high. This requires some type of price projection and a larger channel wil l usual ly suffice in giving you some indication of the potential move. Even if you have two channels line up in the same direction, ifprice is already close to the larger channel's limit then the profit potential is relatively small. It is much better to enter when you are further away. A four to one ratio means you are risking one point for a potential four-point or greater profit. While this may be an unreasonable ratio at times and need to be adjusted, the key point will always be to only take trades that have a higher profit potential than risk.

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Experience will allow you to adjust your risk level, enabling you to take more frequent trades. One benefit from success is an increasing account size that will automatically open up more trading opportunities for you as well. An example of a higher risk trade would be trading in the opposite direction of a larger channel, a contradiction to one of the basic rules. But sometimes the right situation develops and this can be a very profitable trade. However, this should only be done when there is a clear indication of a substantial move such as you would see with a center Iine swing. It should also only be attempted by an individual who has a considerable amount of trading experience. H igher risk trades are not recommended for beginners because you have to be able to recognize when this is appropriate and when it is not. The point is that although your trades may be very limited at fi rst as your experience grows so will your trading opportunities. Channel Surfing has proven itselfin a wide array ofmarkets, from stocks to futures and from funds to the Forex. 1t is strategically effective in defining any market's bias. No, it will not always work flawlessly. But aside from Enron scandals, unexpected disasters or trading channels so small that slippage alone puts you in the red, it will prove to be a very reliable and profitable method that will rival any other that you can possibly use. On top of this, the technique is simple to learn, easy to apply and adapts to any market condition. It is a solid foundation for success, leaving the rest up to you. It is my hope that you will richly benefit from what you have learned here and find the success you desire. Success means different things to different people. Perhaps your desire is to simply have more free time to spend with your family, better and longer vacations, an oceanfront dream home, put your kids through college, improve your family's health, or travel to distant places. Perhaps it is all of these and more. It is amazing what you can do when you have money. Most people work their lives away just dreaming of the life they desire. With Channel Surfing you can actually live the dream. So ride the waves of channels to profitable trading. It will be the ride of your life ! Surf's up!

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Glossary Aggressive Entry - An cntry signal generated when an outside channel l ine is broken. Average Price Differencc - The average variation of price within certain period of time. Balancc of Power - Term that refers to the battIe between buyers and sellers and who has control of market direction. Breakout -When price exceeds a range, high or low that it previously could not exceed. Center line - The center of a trend that is identifiable by a series of subtle highs and lows that split that trend into two. Changing of the guard - A term uscd to described the phenomenon of channcl lines or support and resistance lines that reverse roles. Channcl Surfing - A trading methodology that uti lizes channels to control risk, signal entries and exits, and analyze markets. Conservative Entry - An entry signal generated by price bars closing beyond an insidc channel line. Current Price Limit - The maximum current l imit of price based on a channel calculation. False Breakout - A break of support or resistance that fails to hold, often resulting in a move in the opposite direction of the breakout. Inside Channel li ne - A trend line that provides either support or resistance and is to the right of price activity. Inside Entry - An entry signal generated by when an inside channel line is broken. Lower Channel Line - A trend line that acts as support for a trading range. Major Price Levels - Refers to major support and resistance levels whether static or dynamic that el icits a strong reaction from a market when broken. 1 99

Mini Channel - A very small channel that is hard to completely outline but can be used for a break out entry signal. Multiple Time Span - Two different samplings of data ranges that form channels with one usually larger than the other and encompassing the smaller range. Outside Channel Line - A trend line that provides either support or resistance and is to the left of price activity. Panic Bar - An unusually extensive price bar created by crowd anxiety. Predictive Reaction: Taking an action in response to an event because of the future implications of that event. Price Band - A thin band surrounding a specific price level that acts as support and resistance. Price Zone - Ranges that price lingers and bordered by highs and lows. Pullback - A contrary move against the prevailing trend. Rebound Entry - An entry signal generated by the break of a secondary channel that rebounds toward the previous inside channel l ine, as long as it does not exceed the prior high or low. Repeating Channel - Channels that follow a similar angle as a previous channel. Risk/Reward Ratio - A ratio of risk in relation to potential profit. Safe Zone - Price levels beyond the ability of price to reach within the required time period. Stops - An order that exits a trade when a predetermined pnce reached.

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Total Accumulated Price Difference - Total difference in price between two different price levels. Trend Angle - An angle used to gauge trends that fol low at a similar angle. Trend Entry - An entry signal that occurs price is closest to the inside channel line of a prevailing trend. 200

Truc Option Value - Actual current value of an option once all costs are factored in. True Support and Resistance -Price levels that have established themselves within the flow of a market by multiple l imits on price action. Upper Channel Line - A trend line that acts as resistance for a trading range. Volatil ity - A comparison of the degree of movement within simi lar periods of time for increase or decrease. Zigzag - Refers to a form of pul lback or price pattern that forms a contrary move against itself.

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About The Author Michacl 1. Parsons started tradi ng in 1 987 and fol lowing a series of losses embarked on ajourney of research that has led to the development of several trading techniques based on a unique approach. By utilizing aspects of wave science he first developed what would later be cal led Reversal Magic, a time based method for predicting reversals. The accuracy and success of this method was astounding, but even astounding methods need some form of money management, resulting i n the birth of Channel Surfing. He has continued to develop an emerging science of technical analysis with a price targeting method cal led Balance Magic. Today he continues to write about and research new methods of trading and maintains a web site at www.tradingcafc.com. Additional information on the various publications he has written can be seen at www.reversalmagic.com.