Concepts

Technical

Trading Systems

New Concepts in Technical Trading Systems

Image summary: This is a portrait photograph. The image depicts a middle aged man wearing glasses, a dress shirt, a tie, and a suit jacket. The man has a neutral expression and is looking directly at the camera, suggesting a formal or professional setting for the photograph.

Welles Wilder is known world-wide for his Innovative and original concepts for technical trading systems. His revolutionary book, New Concepts in Technical Trading Ststems is legendary, In technical circles. Forbes Magazine (Oct. '80) singled Mr. Wilder out as 'The premier technical trader publishing his work today.' Forbes goes on to say, 'For those of you who have seen all the conventional systems, this book is the place to start.'

Wilder's "Relative Strength Index" (R.S.I) is monitored daily by many big brokerage firms and Is charted by most chart services for each commodity. His "Directional Movement" system and "Parabolic lime/Price" system have become bywords to technical traders world-wide. Most computer trading systems in use today utilize some of Wilder's originally published concepts.

Mr. Wilder is an active trader and advisor on technical trading systems and methods. He has authored many articles on trading techniques and makes appearances on radio and television programs. Around the world, there are probably more traders using Mr. Wilder's systems and methods than any other single discipline.

Mr. Wilder has presented his methods and systems at technical trading seminars in Asia, Australia, Canada, the U.S. and the capitals of Europe. Mr. Wilder's company, Trend Research, Ltd., McLeansville, N.C. develops computer trading programs and computer software, and distributes his book.

new Concepts

In Technical Trading Systems

J. Welles Wilder Junior.

Audio by Paper2Audio.

Acknowledgments

I wish to express sincere appreciation to my associates who have helped to make this book possible.

To Richard C. Meekins who devoted many hours to the perfection of the graphs, work sheets and diagrams presented in the book.

To my “Gal Friday”, Carol Lawson, who kept the coffee hot and battled pages of manuscript to the final draft.

Chart in Section 6 reprinted by permission of Commodity Perspective, 327 S. LaSalle, Chicago, Illinois 60604.

Printed in the United States of America by Hunter Publishing Company, Winston-Salem, North Carolina. I.S.B.N 0-89459-027-8 Library of Congress Card Catalog No. 78 to 60759 © 1978 by J. Welles Wilder, Junior.

Introduction

The concepts, methods and systems presented in this book are the result of many years of study and research in the market. The approach is strictly technical and the results are definitive. The purpose of this book is not to entertain, but rather to equip the reader with specific concepts, tools and indexes to use in trading the markets.

Nothing in this book has been taken from a previous author's work. What you are about to read is original. I have tried to present the material in such a way that it will be readily understandable to the beginning trader as well as the seasoned professional who is familiar with systems technology. This is a difficult task. I realize that the beginner may find himself reading through the text several times in order to completely comprehend the material and the computer whiz kids will find the information overly simplified; however, I think the average trader will find the material set out in a way that is reasonably easy to follow.

The programmable calculator, due to its relatively inexpensive cost, is readily becoming an indispensable tool for the technical trader. All of the systems and indexes in this book can be programmed on most of the programmable calculators now on the market. Usually the dealer who sells programmable calculators also has personnel capable of writing programs to be used in the calculator and it should be easy for this person to program your calculator for any or all systems in this book.

Following any of these systems with a programmable calculator is extremely simple. Just punch in the latest price data, push the compute key and the answer will appear either on a register or on a printout in less than a second.

Most programmable calculators also have the capacity to store a particular program and data on a magnetic card; thus, by changing magnetic cards, you can go from one system to another in a matter of a few seconds.

The systems in this book have been programmed for the Hewlett Packard hand-held programmable calculator, H.P-41 C.V, the Apple 2 (+ & E) computers and the I.B.M-P.C computer. A brochure is available upon request describing the new Concepts software package for each of these computers from Trend Research, Ltd. P.O. Box 128, McLeansville, N.C. 27301. Telephone (919) 698 to 0500.

Division of Concepts

This book is divided into ten different sections. The reason for this division is that each section can be studied independently of any previous or following section, except for Section 1.

Section 1 should be read first, as it pertains to certain basic tools and definitions which apply to all following sections. For instance, if your initial interest is in directional movement, you may read Section 1 first and then skip to Section 4 without having to first read Sections 2 and 3.

However, before beginning to trade any of these systems, be sure to read Sections 9 and X. The Table of Contents classifies the sections as described above.

Work Sheets

For each index and system presented in this book, a daily work sheet has been developed to facilitate following the method on a daily basis.

With the exception of the Relative Strength Index, which is a chart interpretation technique, all other indexes and systems can be followed using only the daily work sheets. It is not necessary to construct charts, although some traders may want to use charts as visual aids.

At the end of each section, an example of the index or system is worked out using the daily work sheet. If reading through the text does not give you an immediate grasp of the method, then it will fall into place when you follow the example on the daily work sheet.

A blank copy of each work sheet is provided in the Appendix so it can be reproduced on any standard office copier and used in following the particular system on a daily basis.

Charts

Although it is not necessary to construct charts to follow the systems in this book, most technical traders subscribe to a good chart service.

I prefer the Commodity Perspective charts because each commodity and currency is printed on a separate sheet 13 inches high and 10 inches wide. Ample space is provided after the last price bar to update the chart for the following week. These charts are received each Monday morning and are updated through the previous Friday.

An example of the Commodity Perspective chart is presented with the Relative Strength Index in Section 6. If interested in using this type of chart, a subscription is available from:

Investor Publishing, Inc. 327 South La Salle Chicago, Illinois 60604

Parameter Ranges (An Infinite Number of Systems)

One of the problems in presenting a definitive technical system to a number of traders is the fear of the trader that others are trading the same system, causing a concentration of orders at the exact same point; thereby resulting in bad fills. This problem has been alleviated where possible by giving a range of parameters. Each trader can choose his own parameters and constants to use with the system within the range given. The differences in the end result will be insignificant.

For an example of this, suppose that a parameter for a hypothetical system states that a Long trade is to be exited on a 30% retracement from a new High to point P. The constant is then 0.30. In other words, measure the vertical distance from hypothetical point P to the highest point reached while in the Long trade. By taking 30% of that distance and subtracting it from the highest point, the stop price is determined.

How did the author of this system determine 30% to be the absolute best distance to use? If he determined the constant using only eight trades on one particular commodity or stock, he would have found that varying the distance just slightly could result in one bad trade and his overall result would be decreased significantly. However, if he determined this constant using 400 trades on each of 20 different commodities, he would have found that the results would be virtually the same if he had used 29% or 31%. There would be very little variation if he had used 28.4% or 31.6%. By using 27% or 33%, he would begin to see a small decrease in the overall profit. By using 20% or 40%, he might see a drastic reduction in his profit.

The results of this hypothetical situation can be compared to a 'bell curve.'

Image summary: This figure is a line chart depicting a bell-shaped curve. The chart illustrates the range of constants, specifically highlighting a segment between two points labeled A and B at the peak of the curve. The figure indicates that the most frequent or central values of the constants are concentrated within the narrow interval between point A and point B, suggesting a normal distribution where the majority of the data falls near the center.

Point A represents the lower end of the range at 28%; Point B represents the higher end of the range at 32%. As long as the trader uses a constant between 28% and 32%, the results over the long run will be about the same.

The 'bell curve' analogy would be applicable to the range of constants given (where possible) for the systems in this book.

Table Of Contents

Basic Tools

Section 1

Basics

The following bar will quickly be recognized by most traders as that period of time representing one trading day.

High The top of the bar represents the highest price at which the stock or commodity was traded during the day. The low extreme of the bar represents the lowest price at which the stock or commodity was traded during the day. The hash mark on the left side of the bar represents the opening price; the hash mark on the right side represents the closing price.

Reference will be made throughout the book to what is called a lop and a hip. lop is an abbreviation used for low Point. A lop is any time bar which has a time bar immediately before it, and immediately after it with a higher low.

A hip signifies a high Point and is defined as any time bar which has a time bar immediately before it, and immediately after it, with a lower high.

Another configuration which will be used constantly is a Significant Point which is abbreviated sip. A sip must be defined as either a hi sip or a lo sip. The hi sip is defined as being the highest price reached while in a Long trade. The lo sip is defined as the lowest price reached while in a Short trade.

sic is the abbreviation for Significant Close. The sic is defined as the extreme favorable Close made while in the trade. If Long the sic is the high sic which is the highest close made while in the trade. If Short, the low sic is the lowest close made while in the trade.

S.A.R stands for Stop and Reverse. This is the point at which a Long trade is exited and a Short trade is entered, or vice versa. These basic configurations will be referred to repeatedly in the text that follows.

Figure 1.1 summary: This figure is a schematic diagram. It illustrates the components of a financial candlestick or bar chart element, labeling the vertical line to indicate the highest and lowest price points reached during a specific period. The horizontal ticks on the line represent the opening and closing prices. Based on the arrangement of the labels, the figure demonstrates a scenario where the closing price is higher than the opening price, and the price peaked above the close and dipped below the open.

Figure 1.2 summary: This figure is a schematic diagram. It depicts three separate sets of vertical line segments, each labeled as LOP. Within each set, the line segments vary in length and vertical positioning. The figure illustrates a pattern of variation in the length and alignment of these segments across the three different groups, suggesting a comparison of relative positions and sizes.

Figure 1.3 summary: This figure consists of a series of schematic diagrams. The content displays three separate groups of vertical lines, each labeled as HIP, where each group contains three lines of varying lengths. Based on the arrangement, it can be inferred that the figure illustrates variations in relative magnitude or duration across different samples or conditions within the HIP category.

Figure 1.4 summary: This figure is a schematic diagram. It illustrates the relationship between different operational states and entry conditions, specifically highlighting the transitions between low and high signal intensity levels. The diagram indicates that entering a state with a shorter duration leads toward a lower signal intensity point, while entering with a longer duration leads toward a higher signal intensity point. It can be inferred that the system exhibits a cyclical or wave-like behavior where the duration of entry determines whether the system trends toward a peak or a trough in signal intensity.

The Missing Part of Most Technical Trading Plans

Most technical trading plans have two parts:

A technical trading system

A capital management technique

Most technical trading systems are trend-following systems. I believe a trend-following method is the most profitable method to use in trending markets. However, a trend-following method invariably gives back a good part of its profit when the market changes to non-directional sideways movement.

An anti-trend, congestion phase system is profitable in a sideways, non-trending market. However, the profits are smaller, the trades are more frequent and the commissions become a significant factor. When the market changes to a trending mode, the anti-trend system tends to become unprofitable.

In all the years I have spent developing and analyzing technical trading methods, I have yet to see any one system that is consistently profitable in all markets.

The answer then is to devise a rating scale upon which all commodities of interest to the trader can be rated as to whether trending or non-trending. This concept is explained in Section 4 entitled the Directional Movement Index.

There are several other things to consider also. The most profitable trending markets are usually the volatile trending markets; that is, the markets that are moving the fastest. This concept is explained in Section 3 entitled the Volatility Index.

Also, margin requirements and commission charges are factors to be considered.

All four of these factors are appropriately weighted and combined in the Commodity Selection Index (C.S.I) explained in Section 9. The highest commodities on the C.S.I scale will be those which:

Are high in directional movement.

Are high in volatility,

Have reasonable margin requirements relative to volatility and directional movement, and

Have reasonable commission rates.

The missing part of most technical trading plans then, is a method for evaluating and determining which commodities to trade when. The answer presented in this book is the Commodity Selection Index.

Before we take up some of the heavier concepts such as Directional Movement, Volatility, Momentum, etcetera, I want to present a relatively simple system which is also very profitable when used in a moving market. It is one of my favorite systems because it squeezes more profit out of an intermediate move (which lasts for two or three weeks) than any method I know. I call it the Parabolic Time/Price System.

Section 2

The Parabolic Time/Price System

The Parabolic Time/Price System derives its name from the fact that when charted, the pattern formed by the stops resembles a parabola, or if you will, a French Curve. The system allows room for the market to react for the first few days after a trade is initiated and then the stop begins to move more rapidly. The stop is not only a function of price, but is also a function of time. The stop never backs up. It moves an incremental amount every day, only in the direction in which the trade has been initiated.

For example, if you are Long, the stop will move up every day regardless of the direction the price is moving. This is the Time function. The stop is also a function of Price because the distance the stop moves up is relative to the favorable distance the price has moved . . . specifically, the most favorable price reached since the trade was initiated. This Time/Price concept is most intriguing. In effect, it allows just so much time for the price to move favorably.

If the move does not materialize or goes the other way, the stop reverses the position and a new time period begins. This concept is illustrated in the hypothetical illustration. figure 2.1.

Figure 2.1 summary: This figure is a line graph featuring a series of vertical bars. The chart plots a progression of values over a sequence of intervals, highlighting a series of new highs. The vertical bars represent specific peak values achieved at each step, while the line connects a set of lower baseline points. The data indicates a consistent upward trend, where both the baseline and the peak values increase steadily over time. It can be inferred that there is a positive correlation between the sequence of intervals and the magnitude of the highs, showing a continuous growth pattern.

Notice that the price is moving up exactly the same amount each day. Notice also the pattern formed by the stops. The stop accelerates gradually at first, but then begins to move up rapidly. On the 10th day, the stop is no longer accelerating but becomes a function of price only.

First let's look at the concept of this system by learning how the stops were calculated in the illustration. Let's say that we entered this Long trade on Day 4. The stop for the first day in the trade, Day 4, is the sip. (We have previously defined the sip as the extreme price point reached while in the previous trade.) Let's assume that our previous trade was Short and we are now reversing to Long on Day 4. The stop, then, is 50.00 for the day of entry.

This system is a true reversal system; that is, every stop point is also a reverse point. We will therefore call each stop point a S.A.R, which stands for Stop and Reverse. On the first day of entry, our S.A.R is the sip. We are now ready to calculate the S.A.R for Day 5.

Take the highest price reached on Day 4, subtract from this price the S.A.R for Day 4 and multiply this distance by the acceleration factor, 0.02, and then add this amount back to the S.A.R for Day 4. The result becomes the S.A.R for Day 5. The equation is as follows:

Math summary: This computation calculates the stop and reverse value for the fifth day. It takes the difference between the fourth day high price and the fourth day stop and reverse value, multiplies that difference by an acceleration factor, and adds the result to the fourth day stop and reverse value.

Substituting in the above equation:

Math summary: This computation calculates a stop and reverse value by adding a scaled difference to a base value. The process subtracts the base value from a current high to find the difference, multiplies that result by an acceleration factor, and adds the product back to the base value to produce the final output.

The S.A.R for Day 5 then, is 50.05. The acceleration Factor (A.F) is one of a progression of numbers beginning at 0.02 and ending at 0.20. The A.F is increased by 0.02 each day that a new high is made. In this example, a new high is made every day; therefore the A.F is increased by 0.02 every day. The S.A.R for Day 6 would be calculated as follows:

Math summary: This computation calculates the stop and reverse value for the next day. It adds a scaling factor multiplied by the difference between the previous high and the previous stop value to the current stop value.

The general equation, then, is as follows:

Math summary: This formula calculates the updated stop loss value for tomorrow. It takes the current stop loss and adds a scaling factor multiplied by the difference between the extreme price point and the current stop loss.

Where A.F begins at 0.02 and is increased by 0.02 until a value of 0.20 is reached; E.P Trade equals Extreme Price Point for the trade made so far (If Long, E.P is the extreme high price for the trade; if Short, E.P is the extreme low price for the trade.)

The equations for the S.A.R for Days 7 through 12 on the chart are as follows:

Math summary: This process calculates a sequence of stop and reverse values using an iterative weighted average. Each new output is determined by adding a scaling factor multiplied by the difference between a target price and the previous output.

Now that we understand the concept upon which this system is based, let's state the rules to be used in trading the system.

Entry:

Rules Parabolic Time/Price System

A position is entered when a price penetrates the S.A.R.

Stop and Reverse (S.A.R):

A. For the first day of entry, the S.A.R is the previous sip (Significant Point).

1. If entered Long the sip is the lowest price reached while in the previous Short trade

2. If entered Short, the sip is the highest price reached while in the previous Long trade

B. For the second day and thereafter, the S.A.R is calculated as follows:

1. If long:

a. Find the difference between the highest price made while in the trade and the S.A.R for today. Multiply the difference by the A.F and add the result to the S.A.R today to obtain the S.A.R for tomorrow.

b. Use 0.02 for the first A.F and increase its value by 0.02 on every day that a new high for the trade is made. If a new high is not made, continue to use the A.F as last increased do not Increase the A.F above 0.20.

2. If Short

a. Find the difference between the lowest price made while in the trade and the S.A.R for today. Multiply the difference by the A.F and subtract the result from the S.A.R today to obtain the S.A.R for tomorrow.

b. Use 0.02 for the first A.F and increase its value by 0.02 on every day that a new low for the trade is made. If a new low is not made, continue to use the A.F as last increased do not Increase the A.F above 0.20.

C. Never move the S.A.R into the previous day's range or today's range.

1. If Long, never move the S.A.R for tomorrow above the previous day's low or today's low. If the S.A.R is calculated to be above the previous day's low or today's low, then use the lower low between today and the previous day as the new S.A.R. Make the next day's calculations based upon this S.A.R.

2. If Short, never move the S.A.R for tomorrow below the previous day's high or today's high. If the S.A.R is calculated to be below the previous day's high or today's high, then use the higher high between today and the previous day as the new S.A.R. Make the next day's calculations based upon this S.A.R.

Now let's look at a hypothetical example on the work sheet which is illustrated on the following chart figure 2.2. For this example, we will assume that we were reversed from a Short position to a Long position on Day 4. On the initial day of entry, we can give our broker the S.A.R without making any calculations because we know the lowest point reached while in the previous Short trade was 50.00 (which was the low sip). We are now ready to calculate the S.A.R for the following day.

Figure 2.2 summary: This figure is a line chart representing price movements over time. The chart displays a series of price fluctuations that initially trend upward, reaching a peak, and then trend downward. It specifically highlights periods of new highs and new lows, with a designated entry point for a long position at the beginning of an uptrend. The data indicates a cyclical pattern where the asset experiences a sustained period of growth followed by a steady decline, suggesting a transition from a bullish to a bearish market phase.

On the worksheet, we have filled out only the High and Low columns for simplicity. In actually following the system, you would want to fill in the Open and Close columns also.

On Day 4, we insert the high of 52.35 and the low of 51.50. Under Column #1, we insert the S A.R for today, which, for the first day in the trade is always the previous sip, so we put 50.00 in Column #1.

Our Extreme Price for the first day in the trade is the high made during that day, and we put 52.35 in Column #2 under E.P (Extreme Price.) We then take the difference between 50.00 and 52.35 (i.e., the difference between Column #1 and Column #2) and insert this value, 2.35, in Column #3.

Table summary: The table records a single entry price point with no corresponding exit, profit and loss data, or associated actions and orders.

Our first acceleration factor is always 0.02 and we insert this in Column #4. We now multiply 0.02 times the difference, 2.35 (Column #3) and obtain 0.05 to place in Column #5.

Now we are ready to calculate the S.A.R for tomorrow. Add Column #5 to Column #1 and obtain 50.05. Put this number in Column #1 for the next day. This is the S.A.R for Day 5. Now let's see what happened on Day 5.

The high was 52.10, and the low was 51.00. A new high was not made for the trade, so we continue to use the same A.F, which is 0.02. Notice in Column #2, we always put the Extreme Price which, so far, is 52.35. We take the difference between Column #1 and Column #2 and insert 2.30 in Column #3. Multiply Column #3 by Column #4 and obtain 0.05. We then add this to the S.A.R for the day, 50.05, and obtain 50.10 as the S.A.R for tomorrow, Day 6.

Now let's skip to Day 8. On this day, we have a new high of 52.50. We therefore increase our A.F for that day by 0.02 and insert the new A.F, 0.04, in Column #4. We take the extreme high price for the trade, E.P, which is 52.50, and subtract our S.A.R for that day, 50.19. We multiply the difference, 2.31 by 0.04 and obtain 0.09. We add this to 50.19 and obtain the S.A.R for tomorrow, 50.28.

Now skip to Day 16 and let's calculate the S.A.R for Day 17. The high is 53.50 and the low is 52.10. We take the difference between the E.P, 54.20 and the S.A.R, 51.96 and obtain 2.24. We multiply 2.24 times the A.F of 0.12 and get 0.27. Add 0.27 to the S.A.R of 51.96 and we get 52.23. However, the low for Day 16 is 52.10. Since we cannot move the S.A.R for tomorrow into yesterday's range or today's range, we must back up the S.A.R to today's low which is 52.10. We put 52.10 in Column #1 and use this S.A.R for tomorrow's calculations.

On the following day, Day 17, we must still hold the S.A.R at 52.10 because we cannot move the S.A.R higher than either today's range or yesterday's range.

Every day that we have a new high, we will increase the A.F by 0.02 until we get to an A.F of 0.20, at which point we stop increasing the A.F. No matter how many new highs are made thereafter, we do not increase the Acceleration Factor beyond 0.20. Notice on Day 20 the A.F reaches 0.20 which is maintained for the duration of the trade.

Now let's look at what happens when we are reversed to Short. On Day 26, our S.A.R is penetrated and we reverse to Short at 56.62. We know that on the day we are reversed, our S.A.R is the previous high sip which is the highest point reached while in the Long trade.

On Day 26, we write down our high of 57.00 and low of 56.30. Under Column #1, we put our sip which is 58.00. Now, since we are Short, we are looking for the Extreme Low Price (E.P) while in the Short trade. For the first day, the E.P would be the low for the day, so we put 56.30 in Column #2. As before, we take the difference between Column #1 and Column #2 and insert this value, 1.70, in Column #3. We now start over again with the A.F at 0.02. Multiply 0.02 times the difference, which is 1.70, and obtain 0.03. We now subtract 0.03 from our S.A.R for today, 58.00 and obtain a S.A.R for tomorrow of 57.97.

On Day 27, we have a new low for the trade, 56.20. We take the difference between this E.P, which we enter in Column #2, and the previous S.A.R of 57.97 and obtain 1.77. This is the second new low for the trade, so our A.F has now jumped to 0.04. We multiply 0.04 times 1.77 and obtain 0.07. We then subtract 0.07 from our S.A.R that day of 57.97 and obtain a S.A.R for tomorrow of 57.90. Again, we never increase our A.F beyond 0.20.

One last thing to consider . . . where do we begin trading in this system. Since each entry point is a reverse from a previous trade, where does the first trade start?

If the market is in a general up trend, go back several weeks to a hi sip on your chart and make a paper trade Short entry on the most significant down day within three or four days after the hi sip. Follow this trade on the chart until you are reversed to a Long trade. Make the first market entry at this point, which will usually be in the direction of the general trend.

If the market is in a general down trend, then pick the lo sip several weeks back and follow the same procedure as above for a Long paper trade so that your first market entry will be the next Short trade in the direction of the trend.

An alternate way to trade this system is in accordance with the Directional Movement Index explained in Section 4. If directional movement is up, take only the Long trades. If directional movement is down, take only the Short trades.

In essence, that is the system. It is very simple to calculate the S.A.R (stop and reverse point) and it is very easy to follow. Notice that the number used for the A.F is always the number of new highs (or new lows, if Short) multiplied by two. For instance, on the sixth new high, the Acceleration Factor is 0.12; on the eighth new high, the A.F is 0.16, etcetera

Although this system is very simple, it is an extremely profitable system in a moving market. Technicians have spent many hours devising moving average systems which would make allowance for reactions at the beginning of the move but would accelerate as the move began to top out. This system does just that. By moving the initial stop back to the sip when a trade is initiated, the system prevents being whipsawed until the price begins to move directionally.

Study the following charts and you will get a good feel for the way this system handles a volatile market. Notice especially the pattern made by the S.A.R's.

I have tried many different acceleration factors on this system and have found that a consistent increase of 0.02 works best overall; however, if you desire to individualize this system in order to vary the stop points from what others may be using, the range for the incremental increase is between 0.018 and 0.021. Any constant increase within this range will work well. Use the number of increases it takes to reach at least 0.20, but do not exceed 0.22.

This system should be used primarily in a directional market which can be determined by using the Directional Movement Index or the Commodity Selection Index explained in other sections in the book.

Image summary: This figure is a line chart combined with a data table. The chart tracks the price movements of Chicago Wheat from April to September, featuring a price line and a parabolic system indicator, while the table lists specific trade details including dates, positions, prices, and cumulative profit and loss. The data shows that the wheat price experienced a general downward trend for several months, reaching its lowest point in August before beginning a recovery toward the end of the period. The trading strategy successfully captured these price swings, resulting in a positive cumulative gain by the final trade.

Image summary: This figure is a line chart. It displays a time series of data points recorded from October through March, with various points of interest labeled numerically. The data exhibits a fluctuating trend, characterized by several peaks and troughs over the six-month period. The overall pattern shows an initial increase toward a peak in late autumn, followed by a gradual decline through winter, and a sharp increase toward the end of the observed period.

Image summary: This figure is a candlestick chart. It displays the price fluctuations of a financial asset over several months, specifically from June through October of nineteen seventy five, with various long and short trading positions marked. The data indicates a strong overall upward trend over the period, characterized by several peaks and troughs. It can be inferred that the asset experienced significant growth, reaching its highest point in late September before undergoing a sharp decline and subsequent partial recovery in October.

Table summary: The table tracks a series of long and short trades for February 1976 Pork Bellies using a Parabolic System, showing that while individual trades fluctuated between gains and losses, the overall accumulated profit increased over time.

Section 3

Volatility

The Volatility Index

What is volatility? Most traders will define volatility in terms of market action. If a market is very active, it is volatile. If a market is inactive, it is considered non-volatile. It is easy enough to look at a chart and point out a very volatile market or a very non-volatile market, but how does the trader get a handle on volatility? How can volatility be defined?

The one thing that is directly proportional to volatility is range. Range can be defined as the distance the price moves per increment of time.

In the time bar figure 3.1, it is obvious that the range is simply the distance from the highest point to the lowest point of the bar.

Figure 3.1 summary: This figure is a schematic diagram. It illustrates the concept of range by showing a vertical distance between a top boundary and a bottom boundary, indicated by a double-headed arrow. The diagram demonstrates that the range represents the total span or difference between the maximum and minimum extents of a given set of data or a physical dimension.

Suppose, however, that as in time bar figure 3.2, the price is limit; that is, either limit up or limit down. In this case, all trades for the day, if any, were made at one price. Would the range then, for a limit day, be zero? Obviously not. If the price has moved as far as it can move in a time period, it certainly would not have a value of zero. The real price range is, in this case, the distance from the previous close to the limit price. By using this distance, we have given the range for time bar figure 3.2 the largest value it could have, which is appropriate. It follows then, that the True Range to use in describing volatility is the maximum range that the price moved — either during the day or from yesterday's close to the extreme point reached during the day. Therefore, the True Range is defined as the greatest of the following:

Figure 3.2 summary: This figure is a schematic diagram. It illustrates the concept of range by showing the distance between two parallel horizontal lines, indicated by a double-headed vertical arrow. The diagram demonstrates that the range represents the total span or difference between the maximum and minimum values of a given set.

The distance from today's high to today's low.

The distance from yesterday's close to today's high, or

The distance from yesterday's close to today's low.

In order for range to be a meaningful tool as a measure of volatility, more than one day's range must be considered. The answer is to consider an average of the true range made per day over a number of days. A volatility indicator will be fast or slow, depending on the number of days used to obtain the average daily true range. How many days should be used to obtain the average daily true range? After extensive testing, I have found that about 14 days gives the best indicator of volatility to use for the Volatility Index.

The Volatility Index (6) is used along with the Directional Movement Index to compute the Commodity Selection Index.

The equation for the Volatility Index is:

Math summary: This expression calculates the current volatility index as a weighted average. It multiplies the previous volatility index by thirteen, adds the current true range, and divides the total by fourteen.

Where T.R 1 is today's true range The numerator in this equation is also used in the Directional Movement Index and the same equation with different constants is explained in the Volatility System which follows.

In the Volatility System, we use a seven day true range average (rather than a 14-day true range average) because this system needs a faster acting average true range than the Volatility Index. The procedure for solving this equation is the same regardless of the number of days used for the average. We will therefore explain in detail the procedure for solving the seven day equation in the next chapter.

The Volatility System is a trend-following system. It is also a true reversal system which means that the position is reversed at every stop. This system is extremely simple to follow.

Before we discuss the mechanics of the Volatility System, we must learn to calculate the Average True Range. The A.T.R is the basic unit of measurement for the system. The A.T.R is based upon seven day's True ranges. We learned how to obtain the True Range for one day ( T.R 1 ) in the previous chapter. We will now learn how to calculate the Average True Range (A.T.R.)

The equation for the Average True Range is as follows:

Math summary: This formula calculates a weighted average of the true range to determine the latest average true range value. It multiplies the previous average by six, adds the current day's true range, and divides the total by seven.

or

Math summary: This computation calculates the current average true range. It takes six times the previous average true range, divides that result by seven, and adds the current day's true range.

To get the A.T.R initially, add the true range, as defined, for the past seven days and divide by seven. The answer from this will be used as the A.T.R _{p} in the equation for the next day. The following table will illustrate how to calculate the A.T.R on a daily basis:

Starting Initially, we add the True Ranges for the first seven days and obtain a total of 10.00.

9.90 divided by 7 equals 1.43 which is the A.T.R for day 1 slash 7 From now on, we use the A.T.R equation:

Math summary: This computation calculates a weighted average of the average true range. It multiplies the previous average true range by six, adds the current day true range, and divides the total by seven to produce the new average true range.

At the end of Day 1/8, the previous A.T.R is 1.41; therefore:

Math summary: This computation calculates a weighted average for the average true range. It multiplies a constant by a scaling factor, adds a current value, and divides the total by seven to produce the final result.

Now let's review the procedure for calculating the A.T.R (Average True Range) on a daily basis. Initially, the A.T.R is obtained by taking the sum of the ranges for the first seven days and dividing this entire quantity by seven. This gives the A.T.R for the seventh day. For the eighth day; and thereafter, simply use the A.T.R for the previous day, multiply it by six, add the true range for the latest day and divide this quantity by seven. By obtaining the A.T.R is this manner, we only have to keep up with data for the previous day.

Now that we know how to obtain the A.T.R, there is one thing left to do to make this quantity usable in the Volatility System, and this is to multiply the A.T.R by a constant (C).

I have found that the multiplier that works best is about 3.0. The range for this constant is 2.8 to 3.1. If you wish to individualize this system (as set out in the Introduction) any constant within this range will work quite well. By multiplying this constant, 3.00, times the A.T.R, we obtain a number which we will call the arc (Average Range times Constant). Note that the arc is directly proportional to the A.T.R and therefore is directly proportional to volatility. As volatility increases, the arc increases, and as volatility decreases, the arc decreases.

In Table 3.4, the open price was listed with the high, low and close prices; however, it was not used in any of the calculations. In following the system on a daily basis, it will be helpful to tabulate the open price which may be pertinent in the case of a gap opening.

Table 3.4 summary: The data shows a general upward trend in opening and closing prices during the first week of January, followed by a slight decline toward the end of the period. Daily price ranges remained relatively stable, with the average true range showing minor fluctuations.

Now let's define the Volatility System:

A position is exited and reversed at a distance of one arc from the sic (extreme favorable Close reached while in a trade.)

In figure 3.5, the price is going up and making new highs almost every day. We obtain for the previous seven days, the high, low and close prices for the particular contract we want to follow. With this information, the arc is calculated for the seventh day. Next we take the high Close for the seven day period, the sic, and subtract from it the numerical value of the arc for that day.

Figure 3.5 summary: This figure is a schematic diagram representing a sequence of events or states. The content illustrates a series of vertical markers across a horizontal axis, with specific annotations such as SIC, SAR, and ARC, along with a note regarding a short on close. The diagram indicates that as the sequence progresses, there is a transition from simple markers to more complex interactions involving directional arrows and specific state labels. It can be inferred that the process evolves from initial stages toward a more complex set of conditions, where the latter stages involve cyclical or reciprocal relationships between different states.

This will be the S.A.R (Stop and Reverse point) to use for the eighth day. Let's say that on the ninth day, the price retraces and closes below the S.A.R, reversing us to a Short position. We add the arc distance to the close price (as it is the lowest close since entering the trade) and obtain the S.A.R for the Short trade for the tenth day.

Now let's assume that the Short trade moves in our favor and the price continues to go down. We continue to use the arc distance from the lowest close made while in the trade as the S.A.R until we are stopped and reversed on the first close above the arc distance point (S.A.R).

Suppose the volatility increases and we are not stopped out of the trade. The arc distance could increase more than the previous day's arc distance and push the stop further away from the price. This is okay — when the volatility increases, the system automatically compensates and pushes the stop further away from the extreme favorable close point.

This is the nice thing about this system — it is relative both to the extreme close price reached while in the trade and also relative to volatility. If the price becomes very volatile, the S.A.R compensates by lengthening relative to the increased volatility, yet it remains a function of the most extreme close price reached while in the trade. Conversely, when the market cools down, the volatility decreases and the stop moves closer to the trading price.

To continue with the Short trade, let's say the price moves favorably for two or three weeks and then closes above the arc distance S.A.R. The new S.A.R for the Long position for the next day is then the arc distance below the most favorable close ... in this case, the close at which we reversed.

In trading this system on a daily basis, it is not necessary to draw charts. All the information needed is on the work sheet. I find it helpful to put parenthesis around the Significant Closes S.I.C's as a point of reference.

That's all there is to the Volatility System. However, don't let the simplicity of the system fool you. The key point, which is the S.A.R (Stop and Reverse) is relative to the extreme close price and also relative to volatility. It compensates automatically when the price slows down or speeds up. The Constant, C, multiplier of the Average True Range, A.T.R, is gauged to keep the trader in the trade as long as the trend is intact. It allows for retracements or reactions but it is also gauged to reverse the position when the price has reacted enough to indicate a change in direction of the major trend. If the trend should resume in the same direction, the trader is automatically reversed at the arc S.A.R and put right back in the direction of the trend.

Following are the rules set out for quick reference. An example worked out on the work sheet and a corresponding chart are also included. By following the work sheet and chart, a complete understanding of the system should be grasped very quickly.

Definitions:

- True Range is the greatest of the following A. Today's high to today's low. B. Today's high to yesterday's close, or C. Today's low to yesterday's close.

Figure 3.3 summary: This figure is a technical diagram. It illustrates a series of vertical distance measurements, labeled as D1, D2, and D3, between different structural or positional markers. The diagram shows that the distances vary across the three examples, with the first distance being the largest, the second being intermediate, and the third being the smallest. It can be inferred that the figure is intended to demonstrate a trend of decreasing distance or displacement across the sequenced measurements.

2. A.T.R-Average True Range

A. Initially obtained by adding the true ranges for seven days and dividing by seven B. The latest A.T.R is obtained by multiplying the previous A.T.R by six, adding today's true range and then dividing the total by seven.

C — Constant Any number between 2.80 and 3.10.

arc-The A.T.R multiplied by the Constant C

sic — The Significant Close; the extreme favorable close price reached while in a trade. S.A.R — The Stop and Reverse point; a point defined by the arc distance from the sic.

Rules

- Entry is made on the Close when the price closes contrary to the S.A.R.

Stop and Reverse (S.A.R)

A. From Long to Short: on the Close when the close is below the arc distance point from the highest close made while in the trade. That is, when the close is below the S.A.R. B. From Short to Long: On the Close when the close is above the arc distance point from the lowest close made while in the trade. That is, when the close is above the S.A.R.

Commodity Volatility System

Table summary: The data tracks daily price movements and technical indicators over time, showing an initial period of gradual decline followed by a significant uptrend that peaks before stabilizing and eventually decreasing. The volatility, as measured by the average true range, increases during the sharpest price rise and remains higher during the subsequent peak and decline compared to the starting period. A long position was initiated during a price recovery and closed when the price trend reversed downward.

Image summary: This figure is a scatter plot with vertical error bars plotted on a grid. The plot displays a series of data points and associated variability across a sequence of intervals. The data shows a general upward trend, starting from lower values on the left and increasing toward the right, although there are significant fluctuations and a notable dip in the early stages. The vertical lines indicate a range of variation for each point, suggesting that the measurement uncertainty or spread increases as the overall values rise.

Work Sheet Example

Table summary: The table provides a step-by-step walkthrough of calculating and applying Stop and Reverse values over several days, illustrating how the SAR is adjusted based on volatility and price trends to determine entry points for long and short positions and to manage trade reversals.

On the following pages are charts showing this system in actual markets. This system does not make as many trades as the other systems in this book. The Volatility System is designed to pick up and hold on to the long-term moves.

It should be traded in those markets that are high on the Commodity Selection Index (Explained in Section 9).

Image summary: This figure is a line chart. It displays a time series of data points plotted over several months, spanning from December through April. The data shows a general upward trend from the beginning of the period until it reaches a peak in early March, followed by a decline towards the end of April. The overall pattern indicates a gradual increase in values during the winter months, reaching a maximum point before decreasing as spring begins.

Image summary: This figure is a line chart combined with a data table. The chart tracks the price fluctuations of April 1978 Live Cattle over several months, while the table lists specific trade entries, positions, prices, and profit and loss outcomes. The data shows a general downward trend in cattle prices from April through September, with several short-term fluctuations. Based on the trade table and chart markers, the volatility system successfully captured gains by alternating between short and long positions, ultimately resulting in an overall accumulated profit by the time the trade was exited.

Image summary: This figure is a line chart. It displays the fluctuation of a specific value over a period of time spanning from October to March. The chart includes a primary fluctuating line and a secondary smoother trend line. The data shows a general upward trajectory over the observed months, with the value increasing more rapidly toward the end of the period. It can be inferred that there is a strong positive growth trend, characterized by increasing volatility and a sharp acceleration in value during the final month.

Figure 1 summary: This figure consists of a price chart combined with a data table. The chart displays the price movements of Comex Gold over several months, featuring price bars and a dotted line representing a stop-loss level, while the table lists specific trade details including dates, positions, prices, and accumulated profit and loss. The data indicates that the volatility system successfully captured gains through a series of long and short positions, with the stop-loss line dynamically adjusting its distance from the price based on market volatility to protect capital and lock in profits.

Section 4

Directional Movement

Directional movement is the most fascinating concept I have studied. Defining it is a little like chasing the end of a rainbow . . . you can see it, you know it's there, but the closer you get to it the more elusive it becomes. I have probably spent more time studying directional movement than any other concept. Certainly one of my most satisfying achievements was the day I was actually able to reduce this concept to an absolute mathematical equation.

Think of the implications of being able to rate the directional movement of any or all commodities or stocks on a scale of zero to one hundred. If you use a trend-following method, you would trade only those commodities that are in the upper end of the scale. If you are using a system that capitalizes on choppy or non-trending markets, then you would trade only those commodities at the lower end of the scale. Consider also, being able to define an equilibrium point where directional movement up is in equilibrium with directional movement down.

Much work has been done in defining technical trading systems, but very little work has been done in the area of defining market's relative to technical trading systems. Now let's look at how this can be done.

We will start with the smallest increment of directional movement. In figure 4.1, movement is obviously in the up direction. The magnitude of this up movement is the difference between points C and A. In effect, this is the high today minus the high yesterday. We will call this distance plus D.M (+D.M). Because the movement is up we consider only the highs.

Figure 4.1 summary: This figure consists of schematic diagrams illustrating spatial relationships and displacements. The diagrams depict vertical segments labeled with letters, showing a reference length and a corresponding shifted length denoted by a displacement variable. The comparison between the diagrams indicates that the displacement can occur in opposite directions, resulting in either a positive or negative change in the relative position of the segments.

We disregard the distance between the lows; that is, points B and D.

In figure 4.2, the directional movement is obviously down. The directional distance is the difference between points B and D. This distance is considered to be a minus distance and is the difference between the low today and the low yesterday. Since the direction is obviously down, we are concerned only with the lows.

We disregard the distance between the highs. We will call the difference between the lows, minus D.M (—D.M).

Now, how do we handle an outside day? Look at figure 4.3. In this case, the directional movement is up because +D.M is greater than -D.M. Directional movement must be either up or down — it cannot be a combination of both. We therefore consider the larger D.M for an outside day and disregard the smaller D.M. Here, the D.M is the distance between C and A and is plus.

In figure 4.4, only —D.M is considered because it is larger than +D.M.

Figure 4.4 summary: This figure is a schematic diagram. It illustrates two vertical line segments of different lengths, labeled with endpoints A, B and C, D, alongside a measurement indicator denoted as DM. The diagram shows that the segment CD is longer than segment AB, with the difference in their lengths represented by the distance DM. It can be inferred that the figure is intended to visually define a delta or a difference in magnitude between two linear dimensions.

How about an inside day? (Fig. 4.5) In this case, directional movement is zero. In figure 4.6, the directional movement is also zero.

Figure 4.5 summary: This figure is a schematic diagram. It illustrates a comparison between two vertical line segments, one defined by points A and B and a shorter one defined by points C and D, associated with a zero difference measurement. The diagram indicates that the distance between points C and D is less than the distance between points A and B, leading to the conclusion that there is a measurable discrepancy in length between the two segments.

On a limit up day (Fig. 4.7), the +D.M is C minus A. On a limit down day, (Fig. 4.8), the -D.M is D minus B. These illustrations take into consideration every possible configuration that could occur between two days relative to directional movement. To sum the preceding in one sentence, we could say that the basic increment of directional movement is:

Figure 4.7 summary: This figure is a schematic diagram illustrating energy level transitions. It depicts two separate scenarios showing the relationship between different energy states labeled A, B, C, and D. In the first scenario, a positive change in the dipole moment is associated with a transition to a higher energy state. In the second scenario, a negative change in the dipole moment corresponds to a transition to a lower energy state. The figure demonstrates that the direction and sign of the dipole moment change are inversely related to the relative energy positions of the states in these two compared cases.

The Largest Part of Today's Range That Is Outside Yesterday's Range.

If the largest part of today's range is above yesterday's range, the D.M is plus. If the largest part of today's range is below yesterday's range, the D.M is minus.

To be meaningful, D.M must be expressed as a function of range; that is, it must be relative to range. The range increment is today's True Range ( T.R 1 ). This is the same true range we have used in previous chapters. It is the largest of the following:

The distance between today's high and today's low.

The distance between today's high and yesterday's close, or

The distance between today's low and yesterday's close.

True range is always considered to be a positive number.

To make directional movement relative to range, we simply divide directional movement by the true range. This will give us what we will call the Directional Indicator (D.I). The +D.I and -D.I equations below each express the Directional Indicator for one day which is indicated by the subscript {}_{1} .

Math summary: This computation calculates the directional indicator by dividing the directional movement by the true range. The process takes the positive or negative directional movement as the input and uses the true range as a scaling factor to determine the percentage of movement for the day.

If the day were an up day, the +D.I equation would be applicable; if the day were a down day, the minus D.I 1 equation would be applicable. We cannot have both directional movement up and directional movement down on the same day. Today is either up or it is down. In effect, the +D.I is an expression of the percent of the true range that is up for the day; the -D.I is an expression of the percent of the true range that is down for the day.

To make the Directional Indicator (D.I) a useable tool, we must obtain the sum of the Dls for a period of time. We use 14 days because that is an average half-cycle period. This can be done by reviewing the preceding 14 days and determining the Directional Movement (D.M₁) for each day. We also determine the True Range for each day. First, we add together all of the True Ranges for the 14 days. We will designate the sum of the 14 day's ranges as T.R₁₄. Next, add together all of the Plus D.M's (+D.M₁) for the 14 days and call the sum +D.M₁₄. Now go back and add all the Minus D.M's (-D.M₁) for the previous 14 days and call the sum -D.M₁₄.

The equations for plus D I 14 and minus D I 14 are as follows:

Math summary: This computation calculates the directional indicators by dividing the positive and negative movement values by the true range. The process takes the movement inputs as the numerator and the range as the scaling factor to produce the final directional outputs.

(The definition “minus D.M” is a description of downward movement. It is not treated as a minus number in the equation.)

Once we have determined the first plus D.M 14 and the first minus D.M 14, it is no longer necessary to keep up with 14 day's back data to determine the plus D.M 14 and minus D.M 14 for the following day. We use the previous day's data and an accumulation technique in this determination. The advantage to using the accumulation technique is:

It eliminates the necessity of keeping up with 14 day's previous data.

It incorporates a smoothing effect on the D.M.

To obtain the new plus D.M 14 using the accumulation technique, take yesterday's plus D.M 14, divide it by 14 and subtract this amount from yesterday's plus D.M 14. Next, add back the plus D.M 1 for today, if any. The result is the plus D.M 14 for today.

Math summary: This computation calculates the current accumulated positive directional movement. It subtracts a fourteenth of the previous accumulated value from that same previous value and then adds the current day's positive movement to reach the final result.

We do the same thing with the minus D M 14. We subtract 1/14th of yesterday's minus D M 14 and add back the minus D M 1 today, if any.

Math summary: This computation updates a running total by subtracting a scaling factor of one fourteenth from the previous total. It then adds the current day's input value to produce the new output total.

Each day we will be taking away 1/14th of the +D.M and 1/14th of the —D.M. If the D.M₁ (today) is minus, we will add its value back to the —D.M₁₄. If the D.M₁ (today) is plus, we will add it back to the +D.M₁₄.

The same procedure is used on the True Range. We reduce T.R 14 by 1 fourteenth and add back to it the True Range for today (T.R 1). The result is our new T.R 14.

Math summary: This expression calculates the current fourteen day true range. It subtracts one fourteenth of the previous fourteen day true range from that previous value and then adds the most recent single day true range.

The plus D.I 14 is an indication of the percent of the total true range of the last 14 days which was up. The minus D.I 14 is an indication of the percent of the total true range of the last 14 days which was down. Both the plus D.I 14 and the minus D.I 14 are positive numbers.

If you are a little confused at this point, don't worry. We will stop here and go through an example step by step of everything discussed to this point. We will then show how to utilize the +D.I _{14} and the -D.I _{14} and then go on to the derivation of the Directional Movement Index which is the difference between +D.I _{14} and -D.I _{14} converted into a value that always falls between 0 and 100. First, though, let's look at an example on the following work sheet.

On the work sheet, we are following March '78 Chicago Wheat. Let's begin by looking at the first 14 days.

Columns #1 through #5 are self-explanatory. Column #6 is the True Range for the day. Column #7 is the plus D.M (+D.M₁) for today. Column #8 is the minus D.M (−D.M₁) for today.

Note on 6/7/77 that both the +D.M₁ and the —D.M₁ are zero. This is an inside day. Also, 6/16/77 is an inside day. For the first 14 days, we only fill in Columns #6, #7, and #8. At the end of 14 days, we obtain the total of Columns #6, #7 and #8.

At the end of 14 days, the total True Range, T.R 14 obtained from adding together each of the 14 day's true ranges (T.R 1) is 41.00. The total plus D.M 14 obtained from adding together all of the numbers in Column #7 is 9.50. The total minus D.M 14 obtaining by summing the numbers in Column #8 is 14.00.

We are now, at Day 15, (6/21/77) ready to determine T.R 14 for today, plus D.M 14 for today and minus D.M 14 for today. The mathematics for obtaining T.R 14 for today are as follows:

Math summary: This computation calculates a smoothed average range for the current day. It takes the previous average, subtracts a scaling factor equal to one fourteenth of that previous value, and adds the current day's range to produce the updated output.

The mathematics for obtaining +D.M _{14} are as follows: (in these equations, +D.M is written 'plus' and -D.M is written 'minus' so as not to be confused with + and - as mathematical operators).

Math summary: This computation calculates the updated positive directional movement over a fourteen day period. It takes the previous total, subtracts a scaling factor equal to one fourteenth of that total, and adds the current day's positive movement to produce the final output.

The mathematics for determining — D.M 14 are as follows:

Math summary: This calculation determines the Minus DM value for the current day. It takes the previous Minus DM value, subtracts one fourteenth of that value, and then adds the current day's Minus DM input.

Note that in each case above, we decrease the previous total by 1/14th and then add back the applicable D.M₁ for the day. For the True Range Column, we always have a number to add back for the day; however, for the +D.M there was nothing to add back because +D.M on the 15th day was zero. For the -D.M on the 15th day, we have 2.75 to add back.

In Column #9, insert T.R 14, which is 43.32.

In Column #10, insert the +D.M 14 which is 8.82.

In Column #11, insert the —D.M 14 which is 15.75.

Now divide plus D.M 14 (in Column #10) by T.R 14 (in Column #9) as follows:

Math summary: This computation calculates the plus directional indicator by dividing the positive directional movement by the true range. The resulting quotient is then multiplied by a scaling factor of one hundred to produce a percentage value.

We multiply the answer by 100 (or simply drop the decimal point) and put this number in Column #12. This number, 20, is the plus Directional Indicator (+D.I). In effect, it implies that 20% of the True Range for the previous 14 days was up.

Math summary: This computation calculates the minus directional indicator by dividing the negative directional movement by the true range. The resulting quotient is then multiplied by a scaling factor of one hundred to produce a percentage value.

Now we take our -D.M 14 in Column #11 and divide it by the same T.R _{14} in Column #9 and obtain 0.36. This is the minus Directional Indicator (-D.I). Again, we either multiply by 100 or simply drop the decimal point and insert 36 in Column #13. In effect, this tells us that 36% of the True Range for the past 14 days was down.

Now let's analyze what we have here. If 20% of the True Range for the past 14 days was up and 36% of the True Range for the past 14 days was down, then we add these two figures together and determine that 56% of the True Range was directional — either up or down; therefore, 44% of the True Range was non-directional.

Here is the real breakthrough — True Directional Movement is the Difference between plus D.I 14 and minus D.I 14. This is the important concept. The more directional the movement of a commodity or stock, the greater will be the difference between plus D.I 14 and minus D.I 14. Each day that we have a plus directional movement, we are adding to plus D.I 14. At the same time, we are subtracting from minus D.I 14. If the direction were up for 14 or more consecutive days, the plus D.I 14 would have a large value and the minus D.I 14 would approach zero. Therefore, the difference between the two would be very large.

Conversely, if the price were to go down for 14 or more consecutive days, giving us a minus D.M for every day, we are adding to the minus D.I 14 and subtracting from the plus D.I 14, thereby increasing the difference between plus D.I 14 and minus D.I 14.

If the price were meandering in a sideways direction, then the difference between +D.I 14 and -D.I 14 would be very small. This tells us the price is moving non-directionally. Notice also that we can have a high directional movement value in a very slow moving market because directional movement is a function of daily range. Conversely we can have a low directional movement value in a very volatile market.

Now let's go back to our work sheet. We take the difference between plus D I 14 and minus D I 14 (i.e., the difference of the numbers in Column #12 and #13) and put this value in Column #14.

Column #14 is the D.I Difference.

In this case, the D.I Difference is 16.

We stated previously that the sum of the plus directional movement and the minus directional movement (+D.I 14 added to -D.I 14) represents the total amount of the past 14 day's ranges that moved directionally... either plus or minus. We put this number in Column #15.

Column #15 is the sum of Columns #12 and #13.

In this case, 20 plus 36 equals 56.

We are now ready to fill in Column #16, which is our Directional Movement Index (D.X). This is obtained by dividing the difference between plus D.I 14 and minus D.I 14 by the sum of plus D.I 14 and minus D.I 14.

We divide 16 by 56 and either multiply by 100 or drop the decimal point and we have 29, the D.X for today.

This equation results in a D.X that must always be between 0 and 100. The higher the D.X, the more directional the movement; the lower the D.X, the less directional the movement. Notice that whether the price movement is up or down, it makes no difference relative to the value of the D.X.

Suppose that the price goes straight up for 14 days or more and then turns around and goes straight down for 14 days or more. The D.X will decrease as the price tops out and starts down, and it will increase again as the price continues down. Both the up move and the down move represent good directional movement. As the price tops out and starts down, the difference between the +D.I 14 and -D.I 14 will decrease, go to zero and then increase.

That is, as the price is going up, plus D.I 14 will be a large number and minus D.I 14 will be a small number. As the price tops out and goes down, the equilibrium point will be reached, then the minus D.I 14 will increase and the plus D.I 14 will decrease and therefore the difference will again increase.

In order to smooth out this action relative to D.X, and make D.X indicative of both extreme up and down price movement, the period for determining D.X must be twice the period for determining +D.I _{14} and -D.I _{14} . This can be accomplished simply by using a 14 day average of D.X. We compute the D.X for 14 days and then at that time begin determining the Average Directional Movement Index (A.D.X) from the previous day's A.D.X.

At this point you have probably already figured out that you go Long when +D.I _{14} crosses over -D.I _{14} and you go Short when -D.I _{14} crosses over +D.I _{14} and that you only trade the top five or six commodities that are highest on the A.D.X Scale. If so, you have a good understanding of the text so far, but there is a little more to it than that. Before we take up the last part of this concept, let's review the above discussion by picking up at Day 16 (6/22/77) on the work sheet.

Table summary: The data tracks price movements and directional movement indicators over time, showing a general downward trend in closing prices. The directional indicators demonstrate a shift where negative directional movement consistently outweighs positive directional movement, leading to an increasing difference in the directional index that favors a bearish trend.

Commodity Chicago West Contract Month March 1918 K

Table summary: The provided table contains headers for various technical analysis indicators and trading actions, but it contains no data to analyze.

Directional Movement — Work Sheet Explanation

Day 16: We put in the high, low and close and then determine the True Range to be 2.75. The +D.M is 0 and the —D.M is 1.75. To determine T.R _{14} for Column #9, we make the following calculation:

Math summary: This computation calculates the average true range by updating a previous average with a new value. It subtracts one fourteenth of the previous average from that total and then adds the current true range as a scaling factor to produce the final output.

To determine the plus D.M 14 for Column #10, we make the following calculation:

Math summary: This computation calculates a directional movement value by subtracting a scaled factor from an initial input. The process divides the input value by fourteen and subtracts that result from the original input to produce the final output.

To determine the negative D M 14 for Column #11, we make the following calculation:

Math summary: This computation determines a specific directional movement value through a series of additions and subtractions. It starts with a base value, subtracts a calculated adjustment factor, and adds a final scaling constant to produce the output.

Now divide Column #10 by Column #9, drop the decimal point and obtain 19 for +D.I _{14} which goes in Column #12:

Column #12:

Math summary: This computation calculates a percentage by dividing a specific value by a larger base value. The resulting decimal is then multiplied by a scaling factor of one hundred to produce the final whole number output.

Now divide Column #11 by Column #9, drop the decimal and obtain 38 for —D.I _{14} which goes in Column #13 Column #13:

Math summary: This computation calculates a final value by multiplying a decimal input by a scaling factor of one hundred. The process converts zero point three eight into the output value of thirty eight.

Now take the difference between Column #12 and Column #13 and put the D.I Difference in Column #14.

Column #14:

Math summary: This computation performs a subtraction to find the difference between two numbers. It takes thirty eight as the input and subtracts nineteen to produce the final output.

Now take the sum of Column #12 and Column #13 and put the result in Column #15.

Column #15:

Math summary: This computation performs a simple addition of two whole numbers. It takes thirty nine and nineteen as input values to produce a total output of fifty seven.

Now divide Column #14 by Column #15, drop the decimal and put the result in Column #16.

Column #16:

Math summary: This computation performs a division of a dividend by a divisor. The process divides thirty three by fifty seven to produce a quotient of zero and a remainder of thirty three.

This is the D.X.

Follow this procedure for the next 14 days and you will have the routine firmly in mind. On the 28th day, 7/11/77, we have enough previous information to calculate the first Average Directional Movement Index (A.D.X).

We obtain the A.D.X on Day 28 by adding together the 14 previous numbers in Column #16 and dividing this total by 14. The result, 16, is the A.D.X for Day 28 (7/11/77). To obtain the A.D.X for the 29th day, 7/12/77, we use the moving average equation because now we are dealing with averages instead of totals. We multiply yesterday's A.D.X by 13, add today's D.X and divide the total by 14. The procedure is as follows:

Image summary: This figure is a mathematical equation. It displays the step by step calculation for determining the current Average Directional Index by using a formula that incorporates the previous index value and the current directional index. The process demonstrates that the current value is derived by weighting the previous value and adding the most recent data point, then dividing the sum by a constant. The calculation shows that the current index value is slightly higher than the previous index value.

We put the result of this calculation, 17, in Column #17. The calculations are relatively simple and will become second nature very quickly to those who follow this method. The nice thing about this method is that once you obtain your first A.D.X you no longer have to look at previous data beyond yesterday. It takes only a minute or two a day to write down the information and run through the calculations on a small electronic calculator. You'll be surprised at how easy it is to follow once you have done it for a week or so.

This is all the information we need to follow the Directional Movement Index. However, there are three columns left on the work sheet which are:

A.D.X.R — Average Directional Movement Index Rating

Math summary: This process calculates the Commodity Selection Index by subtracting the fourteen day average true range from a baseline value. The output provides a standardized index used to evaluate commodity selection.

These three entities pertain to the Commodity Selection Index (C.S.I) which is explained in Section 9. These columns have been added to the work sheet because this work sheet contains most of the information used to calculate the C.S.I.

At this point we will discuss the A.D.X.R and the A.T.R _{14} . The A.D.X.R is the final number which is used to rate all of the commodities, currencies, stocks, etcetera, on a rating scale which is indicative of directional movement. The A.D.X.R is simply the A.D.X today plus the A.D.X 14 days ago divided by 2.

Math summary: This computation calculates the average directional movement index rating. It adds the current input value to the value from fourteen days ago and divides the sum by a scaling factor of two.

Since the A.D.X.R is used only as a rating of directional movement, it must be indicative of directional movement but at the same time must have a minimum fluctuation when directional movement changes direction.

The A.D.X, when plotted, tends to form a sine curve on the A.D.X scale.

The amplitude of the curve is measured from the zero line. The peaks and valleys of the A.D.X curve indicate a change of direction. If the major trend is down, the peaks would be low price points and the valleys would be high price points. If the major trend is up, the peaks would be high price points and the valleys would be low price points.

The higher the amplitude, the higher is the directional movement in one direction, either up or down, which is indicative of the major trend. The greater the distance between the peaks and valleys, the greater are the reactions to the trend. If the reactions are of significant duration and distance, the trend-following system will be profitable in both directions.

The A.D.X.R must be indicative of good directional movement, but it must not overly fluctuate at equilibrium points. This is achieved by taking the average of a 14 day differential of the A.D.X.

The directional movement concept is not the easiest concept to grasp quickly.

Good directional movement is not simply straight up or straight down movement. It is also good up and down movement in excess of the equilibrium point. This, in effect, is what the A.D.X measures. The equilibrium point is reached when +D.I 14 equals -D.I 14.

In figure 4.11, the A.D.X will have a low value. The swings in the following illustration represent Price Swings.

Figure 4.11 summary: This figure is a line chart depicting a fluctuating path. The chart illustrates a series of peaks and valleys with several marked equilibrium points located along the slopes of the line. The diagram highlights the distance between these equilibrium points and the surrounding local maxima and minima. It can be inferred that the equilibrium points represent intermediate states between the highest and lowest points of the fluctuations, indicating a relationship between the stability of these points and their relative distance from the extremes.

The distance between the equilibrium points is relatively small.

In figure 4.12, the A.D.X will be higher because the distance between the equilibrium points is larger.

Figure 4.12 summary: This figure is a line chart showing a periodic, zigzagging waveform. The chart displays a series of peaks and troughs with specific points identified as equilibrium points, and the vertical distance between these points is labeled as D. The data indicates a consistent oscillatory pattern where the system fluctuates between high and low values, maintaining a stable amplitude represented by the distance D between the equilibrium points.

In figure 4.13, the A.D.X will have a higher value yet, because the equilibrium point was only reached one time, which was the turn down.

Figure 4.13 summary: This figure is a line chart. It displays a fluctuating data trend over time or a sequence, with specific data points identified as equilibrium points. These equilibrium points are marked as individual dots positioned near the peaks and troughs of the line. The chart indicates that while the overall trend experiences significant volatility and reaches a peak, there are several stable or balanced states where the system tends to settle, suggesting that the equilibrium points occur at various levels of the observed variable throughout its progression.

The distance between equilibrium point B and C is 0. If we had bought at B and sold at C, we would have broken even. Suppose we had sold at E and bought at F. We would have had a loss. There is some directional movement because there is some distance between E and F.

This is indicative of market action when the A.D.X.R is less than 20. When the A.D.X.R is above 25, then the equilibrium points widen out. When directional movement is high relative to a 14 day period, then the equilibrium points come immediately after the turn rather than halfway up the next swing as happened at points B, D and F.

Much can be learned from an intensive study of this concept and the interactions of the lines made by +D.I 14 and -D.I 14 and A.D.X when charted. We will touch on some of the more obvious ones after we discuss the Directional Movement System.

On the work sheet, the first A.D.X.R number of 22 on Day 41 was obtained by adding the A.D.X of 27 to the A.D.X 14 days ago, which was 16, and dividing the sum by 2:

Math summary: This computation calculates the average directional movement index rating. It adds the current input value to a previous input value and divides the sum by a scaling factor of two to produce a rounded final output.

A.T.R 14 is simply the Average T.R 14 which is obtained by dividing T.R 14 by 14.

Math summary: This computation calculates the average true range over a fourteen day period. It divides the total input value by a scaling factor of fourteen to produce the final average output.

The C.S.I and the constant K are explained in Section 9.

Figure 4.10 summary: This figure is a line chart featuring a solid line and a dashed line. The chart illustrates the relationship between a fluctuating signal and its smoothed version, highlighting specific measurement points such as amplitude, ADX, and ADXR. The solid line exhibits significant peaks and valleys, while the dashed line represents a trend or average over time. It can be inferred that the amplitude is measured as the distance from a baseline to a peak, and the ADX and ADXR indicators identify specific points of intersection or relative positioning between the volatile signal and the smoothed trend line.

Figure 4.14 summary: This figure is a line chart depicting a series of fluctuations over time or across a sequence. The chart shows a jagged path with several peaks and troughs, with specific points labeled from A through G along the line. The data exhibits a volatile pattern of alternating increases and decreases, suggesting a cyclical or oscillating trend where the values rise and fall repeatedly across the observed interval.

Directional Movement System

The system itself is extremely simple. When plus D.I 14 crosses above minus D.I 14, a Long position is taken. The position is reversed when minus D.I 14 crosses above plus D.I 14. For best results, the system should be traded on markets which are high on the C.S.I scale.

As a rule of thumb, the system will be profitable on commodities that have an A.D.X.R value above 25. When the A.D.X.R drops below 20, then do not use a trend-following system. There are two systems in the book that can be used in a market with an A.D.X.R less than 20 to 25. They are the Trend Balance Point System and the Reaction Trend System.

There is one more rule to following the Directional Movement System, and that is, the Extreme Point Rule.

On the day that plus D.I 14 and minus D.I 14 cross, use the extreme price made that day as the reverse point.

If you are Long the reverse point is the low made on the day of crossing. If you are Short, the reverse point is the high made on the day of crossing. Stay with this point, if not stopped out, even if the indexes stay crossed contrary to your position for several days.

I have noticed that the equilibrium point made by the Directional Movement System seems to be a critical point regardless of whether or not a market is going to turn around. Often the extreme price point made on the day that the indexes cross will not be penetrated again and the market will turn back in the direction of the open position.

The entry and reverse rules are so simple that it is not necessary to go through a worksheet example. Instead, we will discuss some significant interaction between lines made by +D.I _{14} and —D.I _{14} and the A.D.X when plotted on a bar chart.

For an example, we have used the bar chart of March 1978 Wheat. In July and August, the trend is down. The -D.I 14 line is above the +D.I 14 line and the D.I Difference is relatively large. The A.D.X line is increasing. When the A.D.X line goes above the -D.I 14 line, a turning point is indicated. The reason is that -D.I 14 is beginning to wane but the A.D.X is still increasing because +D.I 14 is still decreasing; therefore, the D.I Difference is still large. The turning point often occurs concurrent with the first down turn of the A.D.X line after the A.D.X has crossed above both the D.I 14 lines.

On this chart, notice that the A.D.X line turned down (after crossing above both D.I lines) two days after the bottom. The next A.D.X turn down (after crossing above both D.I lines) was three days after the first intermediate top made on October 4, 1977. The next turn down (again, after crossing above both D.I lines) was one day after the top made on November 21, 1977.

Notice that this indicator can only occur at favorable points in the direction of the major trend. When this occurs, it is seldom a bad time to take some profits. If you want to stay with the major trend, you will usually get a better buy point than the point at which you took profits. There is nothing wrong with exiting the system trade when this occurs and reentering in the direction of the next crossing of the D.I lines or reentering if the A.D.X line again turns up.

Sometimes in a rip-roaring bull market approaching a blow-off stage, the A.D.X will turn up again after turning down while above both D.I lines. In this situation, you may want to wait for the crossing; however, if you are trading several contracts, it is still a good time to pocket some profit at the first down turn of the A.D.X if it is above both D.I lines.

Another interesting thing is that when the A.D.X line goes below both of the D.I lines, then it is time to stop trading . . . at least, stop trading a trend-following system.

Now let's look at some examples of the Extreme Point Rule. On October 13, the +D.I _{14} line crossed below the —D.I _{14} line, giving a signal to reverse our Long position. We put our stop at the low of the day at 251.50, but this stop was never touched. On October 21, +D.I _{14} equaled —D.I _{14} but did not cross, so no action was indicated.

Again, on January 23, the +D.I _{14} line crossed above the —D.I _{14} line; however, we maintained the Short position because the high point made on January 23 was never penetrated.

Study the other chart in light of the discussion of the Wheat chart. Notice how this system follows the big moves and at times takes significant reactions without reversing. Notice also how quickly the position is reversed back in the direction of the major trend if the major trend continues.

I know that for many, the Directional Movement concept and its implications have not been easy to comprehend; however, those who pursue it will be rewarded for their effort. Here is a system that gives you a definitive entry and exit point in the market and at the same time tells you whether or not you should be trading that particular market.

Another way that the +D.I _{14} and —D.I _{14} indicators can be used is as a backup on whatever system you may prefer to use and also as an early indicator of bottoms and tops when the A.D.X line goes above both D.I lines and then turns down. Suppose, for instance, as a long-term trader you have been watching a commodity go down for several months and are looking for a buy point. This system usually gives an early indication of the bottom by a turn down of the A.D.X and a confirmation when +D.I goes above —D.I _{14} .

Another alternative is to use the A.D.X as a trend indicator for the other systems in this book . . . or any system you wish to use. When plus D.I 14 crosses above minus D.I 14, take only the Long trades; when minus D.I 14 crosses above plus D.I 14, take only the Short trades.

I'm not going to rate the systems in this book because one trader's cup of tea may be another's nemesis. However, suffice it to say, for the serious trader who is interested in making profits, this chapter alone is worth many times the cost of this book.

Since this section is closely related to the Commodity Selection Index, it may be a good idea to skip to Section 9 when finished with this section.

Image summary: This figure is a combined financial chart featuring a price line graph and technical indicator plots. The top section displays the price movements of Chicago Wheat using a directional movement system, accompanied by a data table detailing specific trades, positions, and profit and loss. The bottom section contains the Directional Movement Index and the Average Directional Index. The price trend shows a period of volatility with a significant decline followed by a gradual recovery. The technical indicators fluctuate, reflecting changes in trend strength and direction, with the ADX peaking during strong price movements. It can be inferred that the trading strategy utilized the directional movement system to enter and exit positions, resulting in an overall accumulated profit over the specified timeframe.

Image summary: This figure consists of two synchronized line charts sharing a common horizontal time axis. The top chart tracks a high-value variable over several months, while the bottom chart tracks a lower-value variable over the same period. The upper trend shows significant volatility with a general downward trajectory toward the end of the period, characterized by several sharp peaks and troughs. The lower trend exhibits more frequent, smaller fluctuations and remains relatively stable compared to the upper chart. It can be inferred that while both variables experience periodic changes, the upper variable is subject to more drastic declines over time, whereas the lower variable maintains a more consistent range.

Image summary: This figure is a line chart. It displays the price fluctuations of July soybeans over a period of time, accompanied by a data table detailing specific trades including dates, positions, prices, and profit and loss. The chart indicates a period of significant volatility with a sharp increase in price followed by a steep decline and subsequent recovery. It can be inferred that the trading system described in the text was designed to manage risk during extreme price movements, as the accompanying notes highlight the system's ability to avoid being whipsawed during blow-off tops.

Image summary: This is a line chart. The figure displays multiple fluctuating data series plotted over a time period spanning from late October to July. The horizontal axis represents the timeline, while the vertical axis indicates numerical values. The chart shows several lines with varying degrees of volatility, tracking trends and intersections over several months. One series shows a significant peak followed by a steady decline and a subsequent recovery, while other series exhibit more frequent and smaller oscillations. The data suggests a period of high volatility and divergent trends among the measured variables, with some lines converging and others diverging sharply during the spring months.

Section 5

The Momentum Concept

One of the most useful concepts in technical trading is that of momentum; yet, for many traders, momentum is also one of the hardest concepts to understand. Momentum can be thought of as acceleration and deceleration.

In this discussion, upward momentum (acceleration) will be considered as 'plus' and downward momentum (deceleration) will be considered as 'minus'. Let's look at an example illustrating momentum.

Suppose that Pork Bellies closes one cent above the previous close for five consecutive days. The acceleration is zero. Conversely, if Bellies closes down one cent from the previous close for five consecutive days, the deceleration would also be zero. Now let's go back to the case where Bellies closes up one cent from the previous close for five consecutive days.

For the momentum factor to be above zero, it would be necessary for the price to close up more than one cent, so let's say that on the sixth day, the price closed up one and a half cents from the previous close. Now we have a plus momentum factor which is acceleration for the sixth day. On the seventh day, for the momentum to stay positive, the price must close up more than one and a half cents from the previous close.

If the close on the seventh day were exactly one and a half cents more than the previous close, the momentum factor would again be zero. Now suppose that on the following day, Bellies closed up only one and a quarter cents more than the previous close. We would now have deceleration, or a minus momentum factor.

In figure 5.1, each point on the curve represents the closing price of a stock or commodity. Notice that from Days 1 through 9, each close is not only higher than the previous close, it is higher than the previous close by an ever In- increasing amount. Therefore, the price from Day 1 through 9 is accelerating and has a plus momentum factor. On Days 10 through 12, there is no acceleration or deceleration because the curve becomes a straight line. The price closed up exactly the same amount for each of these days, making a zero momentum factor for Days 9 through 12.

Figure 5.1 summary: This figure is a scatter plot with horizontal lines. It illustrates the relationship between a vertical scale and a horizontal scale, depicting the movement of points over time or sequence. The plot is divided into two primary phases, labeled as acceleration and deceleration. In the lower section, the points shift progressively toward the right as the vertical value increases, indicating a period of acceleration. In the upper section, the points shift back toward the left as the vertical value continues to rise, indicating a period of deceleration. The overall pattern shows that the horizontal position first increases and then decreases, suggesting a cycle of increasing and then decreasing velocity or displacement relative to the vertical axis.

On Days 13 through 20, the price is closing up from the previous close; however, each close is a smaller distance up from the previous close and the price is beginning to decelerate and the momentum factors are minus.

The Trend Balance Point System

The momentum system set forth here utilizes this concept in a most unique way. This system will satisfy traders and brokers who like a lot of action. It will usually make three to five trades a week. It takes small consistent profits and therefore the percentage of correct trades will be quite high compared to most technical systems.

In this system we use only close prices to compute the momentum factor. The system is not a true reversal system because profits are taken at a target. The indicator that tells whether the trade should be Long or Short in the market is the Momentum Factor.

Now let's see how this momentum factor is calculated. The momentum factor is the difference between the close price today and the close price two days ago. It is important to note that we always take today's close first and subtract from it the close two days ago. This means that the difference may then be either 'plus' or 'minus'.

Table summary: The data shows an initial upward trend in closing prices and positive momentum, followed by a peak and a subsequent decline in both price and momentum towards the end of the period.

In this example, the first momentum factor (M.F) was obtained by subtracting 49.25 (Day 1) from 50.25 (Day 3). The second M.F was obtained by subtracting Day 2 from Day 4. The third was obtained by subtracting Day 3 from Day 5.

Now let's look at Day 7. We subtract 51.10 from 51.00 and get a minus 0.10 (-.10). Whenever we subtract a larger number from a smaller number, we always use the sign of the number being subtracted. In this case, it is the sign of the larger number. On Day 9,49.25 minus 51.00 gives a difference of -1.75.

Below is a graphic example of the procedure:

Now that we know how to determine the momentum factor on a daily basis, at this point we will outline the overall concept of the trading procedure and then take it step by step.

Figure 5.2 summary: This figure is a schematic diagram. It depicts a series of horizontal levels with vertical arrows labeled as MF, representing the distance or gap between different stages of acceleration. The diagram shows a progression of these gaps across multiple levels. It can be inferred that the acceleration process involves varying magnitudes of change, with some stages showing larger gaps and others showing smaller gaps, indicating a non-uniform rate of acceleration across the different levels.

Figure 5.3 summary: This figure is a schematic diagram. It depicts a series of horizontal lines with associated vertical distance markers, labeled as various MF values, alongside a set of points that follow a descending path from right to left. The diagram illustrates the concept of deceleration by showing a progressive increase in the vertical spacing between the markers as the sequence advances. It can be inferred that the increasing magnitude of the MF intervals represents a slowing rate of change or a decrease in velocity over the observed sequence.

Basic Procedure

Go Long on the close today when the momentum factor today is a higher number than the momentum factor for either of the previous two days.

Go Short on the close today when today's momentum factor is a lower number than the momentum factor for both of the previous two days.

Take profits at the target. Do not reverse.

Exit the market at the Stop. Do not reverse.

When out of the market, either at the target or at the stop, reenter on the close under the first or second procedure as applicable.

Let's look again at our example:

Table summary: The data shows a closing price that initially increases, peaks, and then declines before a slight recovery, with corresponding momentum factor fluctuations and the execution of short and long positions at the price peaks and troughs.

We went Short on the close on Day 5 because the M.F of +.85 was a lower number than both of the two previous momentum factors. If the M.F on Day 5 had been lower than only one of the two previous M.F's, we would not have had a signal. It must be lower than both of the two previous M.F's to have a valid signal. Once we are Short, we then calculate the target at which point we will take profits. But before we take up the target, let's continue the discussion of the entry point.

Now let's go back to Day 5. If you have followed the discussion to this point, you have one big question in mind. You have looked at the example and wondered, "If I have to know the close price before I can determine the momentum factor, how am I going to enter the market Short on the close at 51.10?" That's a good question. The answer is that we can determine before the close — in fact, even before the open on Day 5 — exactly what price will be necessary to produce a momentum factor of less than 1.00. This brings us to the Trend Balance Point.

Since we are going to subtract Day 3 from Day 5 to obtain the momentum factor for Day 5, we can see very quickly that the close price of 51.25 on Day 5 will give an M.F of +1.00. If the close is less than 51.25, the M.F will be less than +1.00. If the close is higher than 51.25, we know the M.F will be higher than +1.00. If the close is exactly 51.25, then the M.F today will be equal to +1.00; therefore, 51.25 is a very crucial point. We call this point the Trend Balance Point (T.B.P). If we are Long in the market, the T.B.P is defined as:

The point the price must close below in order to reverse our position to Short. If we are Short in the market, the T.B.P is defined as:

The point the price must close above in order to reverse our position to Long.

Here is our example again, with the Trend Balance Points indicated:

Table summary: The data tracks daily closing prices alongside trading signals and positions, showing an initial upward trend in price followed by a decline, with a short position taken at a peak and a long position established after a subsequent price drop.

On Day 5, the T.B.P was 51.25; therefore, we went Short on the close at 51.10. As soon as the market closes on Day 5, we can calculate the T.B.P for the following day. The question is, how high can the market close the following day and not produce an M.F which will be higher than 1.00? Since the M.F must be higher than both of the two previous momentum factors, obviously we pick the higher of the two previous momentum factors. In this case, they are +1.00 and +85. The higher of the two is +1.00. Since we are Short we pick the higher M.F and add this number to the close on Day 4 and obtain a T.B.P of 51.95 to be used for Day 6. On Day 6, our previous two momentum factors are +.85 and 0. We pick the higher of these two, +.85, and add this number to the close on Day 5 and obtain a T.B.P of 51.95 to be used for Day 7. On Day 7, we look at the two previous momentum factors, which are 0 and -10. The higher of these two is 0; therefore, we add 0 to the close on Day 6 and obtain a T.B.P of 50.75 to be used for Day 8. On Day 8, the higher of the two previous momentum factors is -10. We add -10 to the close on Day 7 and obtain a T.B.P of 50.90 to be used for Day 9.

Remember, if we add a minus number to a plus number, the answer is the difference between the two numbers.

Now suppose we had taken profits at the Short trade target on Day 10. How would we reenter the market on the close of Day 10 — Long or Short? Since we had already calculated the T.B.P to be 48.75, we will go Long if the close is above 48.75 and Short if the close is at or below 48.75. Since we were Short, we would not change direction if the close were exactly 48.75. Whenever the close is exactly equal to the T.B.P, we continue to trade in the same direction.

Notice that -0.25 is a higher number than the two previous momentum factors which are -1.00 and -1.75. (If operating with minus numbers is a little confusing at first, think of it this way; minus 25 degrees is a higher temperature than minus 100 degrees or minus 175 degrees.)

Now that we are Long, to obtain the Trend Balance Point, the question is, what close price will produce an M.F lower than the two previous momentum factors? Now we take the lower of the two previous momentum factors and add this number to the close two days ago in order to obtain the T.B.P for the following day.

On Day 11, the two previous momentum factors are —1.75 and —.25. The lower of these two is —1.75; therefore, we add —1.75 to 49.25 and obtain a T.B.P of 47.50. So, at the end of trading on Day 10, we know that on Day 11 we will maintain our Long position unless the close that day is lower than 47.50, at which point we will reverse to Short.

Now let's review the procedure for obtaining the Trend Balance Point (T.B.P):

To obtain the T.B.P for tomorrow if Long, select the lower of the two previous momentum factors and add this number to yesterday's close.

To obtain the T.B.P for tomorrow if Short, select the higher of the two previous momentum factors and add this number to yesterday's close.

Note: the two previous momentum factors are the M.F for today and the M.F for yesterday.

When stated in this manner it becomes a very simple procedure.

Remember, when we add a minus number to a plus number, we take the difference and use the sign of the larger number. For instance, if we add an M.F of -1.75 to a close price of 49.25, our answer will be 47.50.

Protective Stop

At this point, we know when to enter and when to exit the market. Since we enter on the close, we need a protective stop for the next day in case of an extreme move and in case the price should close limit against us and lock us in the market. Our stop must also be relative to the momentum concept upon which the system is based.

The stop for this system is a function of the True Range (T.R) and the Average Price X bar. The equation for the stop is X bar plus or minus T.R. If we are Long, the equation is X bar minus T.R. If we are Short, the equation is X bar plus T.R. X bar is a simple average of the high, low and close price. It is obtained by adding the high, low and close and dividing by three.

The True Range, T.R, is the same one-day True Range used in other systems in this book. To recap briefly, it is the largest of the following three possibilities:

The distance between the high and low made during the day.

The distance between today's high and yesterday's close, or

The distance between today's low and yesterday's close.

Let's look at an example. Suppose the following prices are for the last two days of trading:

Table summary: The daily stock prices show a general upward trend across the high, low, and closing values from the first day to the second day.

High to low = 0.80 Previous close to today's high = 1.10 Previous close to today's low = 0.30 True Range = 1.10

Math summary: This computation calculates the average of three input values. It sums the three values and then divides that total by three to produce the final average output.

If Long, the stop is x bar minus T.R.

Math summary: This computation calculates a stop price by subtracting a range value from an average price. The process takes the average input and subtracts a scaling factor to produce the final output value.

If Short, the stop is X bar plus T.R.

Math summary: This computation calculates the sum of two values to determine a final stop price. It adds a scaling factor to an input value to produce the total output.

The stop is calculated after the market closes, using the most recent high, low and close price, and is then for use on the following day.

Target

The Target for this system is a function of the Average Price, x bar and the extreme price made for the day. If we are Long, the equation for the Target is 2 times x bar minus L. If we are Short, the equation for the Target is 2 times x bar minus H. For example, suppose the following prices are for the last two days of trading:

Table summary: The daily price data shows a general upward trend across the high, low, and closing values from the first day to the second day.

In the above example, if we were Long, the target for Day 3 would be:

Math summary: This computation calculates a target value by doubling a mean input value. The process takes the average input and applies a scaling factor of two to produce the final output.

If we were Short, the target for Day 3 would be:

Math summary: This computation determines a target value by doubling the average input price and subtracting a specific offset. The process multiplies the average price by a scaling factor of two and then subtracts the closing price to produce the final result.

The target is calculated after the market closes, using the most recent high, low and close price, and is then for use on the following day.

We always put the Target, the Stop and the Trend Balance Point (T.B.P) on the line on the work sheet for the following day because they apply to the following day.

To recap briefly, a position is entered only on the close in accordance with the momentum factor. A position is exited at the target, but not reversed. If a position is exited during the day at the target, then the position is reinstated on the close as indicated by the Trend Balance Point. The T.B.P also determines whether an existing position should be held or reversed on the close.

If the position has been stopped out by the stop during the day, no reversal is made at the stop. The position is reinstated on the close in accordance with the Trend Balance Point.

Following are the definitions and rules of the Trend Balance Point System.

Definitions — Trend Balance Point System

- True Range: the greatest of: (1) The distance between today's high and low. The distance between today's high and yesterday's close, or The distance between today's low and yesterday's close.

- Momentum Factor Today's close minus the close the day before yesterday

- Bar Today's high, low and close, added together and divided by three.

- Trend Balance Point: If Long, the price at which the close must be below to reverse to Short. If Short, the price at which the close must be above to reverse to Long.

- Stop (Non-Reversing) It Long, Stop is X minus True Range. It Short, Stop is X plus True Range.

- Target Target (Exit only --Non-Reversing) If Long, target is 2 X --L If Short, target is 2 X --H

Initial Entry:

Rules — Trend Balance Point System

Enter Long on close when close is above the Trend Balance Point. Enter Short on close when close is below the Trend Balance Point. Reverse Entry (if Target or Stop not touched):

Reverse on close from Short to Long when close is above the Trend Balance Point. Reverse on close from Long to Short when close is below the Trend Balance Point. Exit:

Exit position at Target. Do not reverse. Exit position at Stop. Do not reverse.

Re-Entry:

Re-enter on close as dictated by the Trend Balance Point after exiting at Stop or at Target. Determination of Trend Balance Point for Tomorrow:

If Long select the lower of the two previous momentum factors and add this number to yesterday's close. If Short select the higher of the two previous momentum factors and add the number to yesterday's close.

An optional way to trade this system is to reinstate the position on the open the following day rather than on the close the previous day. Although I have obtained better overall results in trading this system by reinstating a position on the close, some traders may prefer to eliminate the risk of an overnight position and also obtain the reduced day trading commission by reinstating on the open. If this option makes you feel more comfortable, then by all means, tailor the system to suit your trading disposition. I would certainly recommend taking this option on any day that a significant F.D.A or other major report is coming out on the commodity you are following.

Now let's look quickly at some peculiarities of this system. Compared to the stop, the target is relatively close. This is just the opposite of most systems which have a close stop and a long target.

This concept is probably contrary to anything you have read, yet when you think it through, this concept becomes very interesting. First of all, the momentum factor keeps the trader in the market in the direction of the momentum so you have a definite edge in the direction you are trading; therefore the chances of reaching a relatively close target before reacting to a longer stop are decidedly in the trader's favor. The Trend Balance Point also acts as a stop. If the trade is not going in your direction the position will usually be reversed on the close in accordance with the T.B.P long before the stop is touched. Most traders have experienced the frustration of using very close stops and being continually stopped out.

They then realize that all these small losses often consume — and sometimes exceed — the occasional large profit. It's not unusual for this system to show between 70% and 80% profit trades.

I know traders who can never seem to hang on and follow a good system because of a compulsive need for action. I know other traders who have a greater need to be right most of the time than they have a need for the money they can make. So, if you have a method that makes money over a long term and has proved itself successful for you, then stay with it. But, in the meantime, if you need action and are not trying to make a killing on every trade, this little system could be beneficial in more ways than one.

The trader does not have to be overly concerned about how many others are trading this system. Most of the time the price will hit the target. If there are a large number of orders at this point and the market “runs” these stops, then any slippage will be in the trader's favor.

There is always a large volume of 'on close only' orders in the market, so a few more will make relatively little difference.

The stop is seldom touched; however, to ensure that a number of stop orders do not accumulate at one price, the trader can use a constant multiplier between 0.90 and 1.00 of the True Range and use this new value for the True Range in calculating the Stop.

Following is a work sheet example of this system on March 1978 Plywood.

Work Sheet Explanation

Table summary: The table details a series of trading actions where positions are opened, held, or reversed based on whether the closing price is above or below the Trend Break Point, resulting in multiple successful profit-taking events for both short and long positions.

Table summary: The data tracks daily price movements and technical indicators for a security using the Trend Balance Point system. The closing prices exhibit significant volatility, characterized by periods of steady growth followed by sharp declines and subsequent recoveries. The MF and TR columns show fluctuating daily changes, while the TBP and LG STOP columns provide shifting support and resistance levels that adjust in response to the overall price trend.

Table summary: The table tracks a series of trading activities, including entry and exit points, with a majority of the recorded trades resulting in positive gains, though a few experienced losses.

Section 6

The Relative Strength Index

The Relative Strength Index, R.S.I, is a tool which can add a new dimension to chart interpretation when plotted in conjunction with a daily bar chart. Some of these interpretive factors are:

Tops and Bottoms are indicated when the R.S.I goes above 70 or drops below 30.

Chart Formations which often show up graphically on the R.S.I may not be apparent on the bar chart.

Failure Swings above 70 or below 30 on the R.S.I scale are strong indications of market reversals.

Support and Resistance often show up clearly on the R.S.I before becoming apparent on the bar chart.

Divergence between the R.S.I and price action on the chart is a very strong indication that a market turning point is imminent.

Before taking up the equation for calculating the Relative Strength Index, let's examine briefly the momentum concept upon which the R.S.I is based.

The Momentum Oscillator Concept

One of the most useful tools employed by many technicians is the momentum oscillator. The momentum oscillator measures the velocity of directional price movement. When the price moves up very rapidly, at some point it is considered to be overbought; when it moves down very rapidly, at some point it is considered to be oversold. In either case, a reaction or reversal is imminent. The slope of the momentum oscillator is directly proportional to the velocity of the move. The distance traveled up or down by the momentum oscillator is proportional to the magnitude of the move.

The momentum oscillator is usually characterized by a line on a chart drawn in two dimensions. The 'Y' axis (vertical) represents magnitude or distance the indicator moves; the 'X' axis (horizontal) represents time. The momentum oscillator drawn in this manner is characterized by the fact that it moves very rapidly at market turning points and tends to slow down as the market continues the directional move.

Suppose we are using the close price to calculate the oscillator and the price is moving up daily by exactly the same increment from close to close. At some point, the oscillator begins to flatten out and eventually becomes a horizontal line. When this occurs, if the price begins to level out, the oscillator will begin to descend.

Let's look at this concept using a simple oscillator expressed in terms of the price today minus the price 'x' number of days ago. In this example, we will use the price today minus the price ten days ago. The oscillator is measured from a zero line. If the price ten days ago were higher than the price today, then the oscillator value is minus; conversely, if today's price were higher than the price ten days ago, then the oscillator value is plus.

The easiest way to illustrate the interaction between price movement and oscillator movement is to take a straight line-price relationship and plot the oscillator points based on this relationship.

In figure 6.1, we begin on Day 10 when the close price is 48.50. The price ten days ago, on Day 1, is 50.75. Utilizing a ten day oscillator, we take today's price of 48.50, subtract the price ten days ago, 50.75, and the result, -2.25, is the oscillator value. This oscillator value of -2.25 is plotted below the zero line. By following this procedure for each day, we develop the oscillator curve.

Figure 6.1 summary: This figure consists of two line charts plotted against a common horizontal axis. The top chart displays an oscillator curve relative to a zero baseline, while the bottom chart displays a price curve. The price curve shows a downward trend that reaches a minimum before recovering and trending upward. The oscillator curve remains at a low constant level during the initial decline of the price, then begins to rise and crosses the zero line shortly after the price curve hits its lowest point. The oscillator curve reaches its peak and begins to decline while the price curve is still ascending. This suggests that the oscillator serves as a leading indicator, signaling a trend reversal in price before the price curve itself reaches its peak.

The oscillator curve developed in this hypothetical situation is very interesting. As the price moves down by the same increment each day between Days 10 and 14, the oscillator curve is a horizontal line. On Day 15, the price turns up by 25 points yet the oscillator turns up by 50 points. The oscillator is increasing twice as fast as the price. The oscillator continues this rate of movement until Day 23 when its value becomes a constant although the price continues to move up at the same rate.

On Day 29, another very interesting thing happens. The price levels out at 51.00, yet the oscillator begins to go down. If the price continues to move horizontally, the oscillator will continue to descend until the tenth day at which time both the oscillator and the price will be moving horizontally.

Note the interaction of the oscillator curve and the price curve. The oscillator appears to be one step ahead of the price; the reason being that the oscillator, in effect, is measuring the rate of change of price movement. Between Days 14 and 23, the oscillator shows that the price rate of change is very fast because the direction of the price is changing from down to up. Once the price of ten days ago has bottomed out and started up, then the rate of change slows down because the increments of change are measured in one direction only.

The oscillator can be an excellent technical tool for the trader who understands its inherent characteristics; however, there are three problems encountered in developing a meaningful oscillator.

The first problem is erratic movement within the general oscillator configuration. As an example of this, using a ten day oscillator, suppose that ten days ago the price moved limit down from the previous day. Now, suppose that today, the price closed the same as yesterday. When we subtract the price ten days ago from the price today, we will get an erroneously high value for the oscillator today. To overcome this problem, there must be some way to dampen or smooth out the extreme points used to calculate the oscillator.

The second problem characteristic of oscillators is the scale to use for the 'Y' axis. In other words, how high is high and how low is low? The scale will also change with each commodity being charted. To overcome this problem, there must be some common denominator to apply to all commodities so the amplitude of the oscillator is relative and meaningful.

The third problem is the necessity of having to keep up with enormous amounts of data. This is the least of the three problems; however, it can become burdensome to the trader who is following several commodities with an oscillator technique.

The solution to these three problems is incorporated in the indicator which we will call the Relative Strength Index.

The Relative Strength Index Equation

The equation for the Relative Strength Index, R.S.I, is:

Math summary: This computation calculates the Relative Strength Index to determine price momentum. It takes the relative strength value, adds one to it as a denominator for one hundred, and subtracts that result from one hundred to produce the final output.

R.S equals the average of 14 day's closes up divided by the average of 14 day's closes down For the first calculation of the Relative Strength Index, R.S.I, we need the previous 14 day's close prices. From then on, we need only the previous day's data. The initial R.S.I is calculated as follows:

Obtain the sum of the up closes for the previous 14 days and divide this sum by 14. This is the average up close.

Obtain the sum of the down closes for the previous 14 days and divide this sum by 14. This is the average down close.

Divide the average up close by the average down close. This is the Relative Strength (R.S).

Add 1.00 to the R.S.

Divide the result obtained in Step 4 into 100.

Subtract the result obtained in Step 5 from 100. This is the first R.S.I.

From this point on, it is only necessary to use the previous average up close and the previous average down close in the calculation of the next R.S.I. This procedure, which incorporates the dampening or smoothing factor into the equation, is as follows:

To obtain the next average up close: Multiply the previous average up close by 13, add to this amount today's up close (if any) and divide the total by 14.

To obtain the next average down close:

Multiply the previous average down close by 13, add to this amount today's down close (if any) and divide the total by 14.

Steps,, (5) and (6) are the same as for the initial R.S.I.

An easy way to keep up with the R.S.I on a daily basis is to use a ten column worksheet, figure 6.2.

Figure 6.2 summary: The table tracks the Relative Strength Index over time, showing that the closing price initially trends upward before experiencing a period of volatility and a subsequent gradual decline. The calculated strength indicators show a general decrease in relative strength over the observed period, with the final values indicating a shift toward a weaker trend compared to the earlier peak.

Column #1 is the date.

Column #2 is the close price for the day.

Column #3 is the amount the price closed up from the previous day. (For example, on Day 2, the price closed up 2.00 from Day 1. Entry is made in Column #3 only if the price closed up from the previous day.)

Column #4 is the amount the price closed down from the previous day. (For example, on Day 8, the price closed down 1.57 from the close on Day 7. Entry is made in column #4 only of the price closed down from the previous day.)

Column #5 is the value of the average up close. (On Day 15, we have the necessary information to begin calculating the R.S.I. We add all the values in Column #3 and obtain a sum of 11.80. We then divide this sum by 14 to obtain the average up close for the 14-day period. This value of 0.84 is put in Column #5.)

Column #6 is the value of the average down close. (Sum the down closes in Column #4 and obtain 4.10. Divide this figure by 14 and obtain the average down close and put this value of 0.29 in Column #6.)

Column #7 is the result of dividing the number in Column #5 by the number in Column #6. 0.84 divided by 0.29 equals 2.90 Column #8 is the result of adding 1.00 to the number in Column #7. 290 plus 100 equals 390

Math summary: This computation performs a simple addition. It adds a constant value to the input value to produce a final sum.

Column #9 is the result of dividing 100 by the number in Column #8. 100 divided by 3.90 equals 25.64 Column #10 is the value of the Relative Strength Index and is derived by subtracting the number in Column #9 from 100. (100 — 25.64 = 74.36)

On Day 16 and thereafter, we are no longer concerned with data for the previous 14 days. The R.S.I is calculated using only the previous day's average up close and average down close. The procedure for obtaining the average up and down closes is as follows:

On Day 16, take the previous average up close in Column #5, which is 0.84 and multiply it by 13. Add to this the up close for the day (in Column #3) and divide the total by 14.

Math summary: This process calculates a new average by multiplying the previous average value by thirteen and adding the current day's input value. The resulting sum is then divided by a scaling factor of fourteen to produce the final output.

The result, 0.79, is the new average Up close and is placed in Column #5.

Since the price on Day 16 closed up, the value of the average down close must decrease relative to the 14 day average. However, the procedure is the same. Take the average down close in Column #6, which is 0.29, multiply this by 13. Since the down close on Day 16 was zero, there is nothing to add back. Now divide the total by 14.

Math summary: This computation calculates a new average by multiplying the previous average down close by thirteen and adding zero. The resulting total is then divided by fourteen to produce the final output value.

Columns #7 through #10 are filled in as explained previously.

Now that we know how to obtain the Relative Strength Index number for each day, let's discuss briefly the peculiarities of the R.S.I in light of the three problems inherent to most oscillators:

Erroneous erratic movement is eliminated by the averaging technique. However, the R.S.I is amply responsive to price movement because an increase of the average close up is automatically coordinated with a decrease in the average close down and vice versa.

The question of 'how high is high and how low is low' is answered because the R.S.I value must always fall between 0 and 100. Therefore, the daily momentum of any number of commodities can be measured on the same scale for comparison to each other and to previous highs and lows within the same commodity. The most active commodities are those in which the R.S.I is showing the greatest vertical movement — either up or down.

The problem of having to keep up with mountains of previous data is also solved. After calculating the initial R.S.I, only the previous day's data is required for the next calculation.

Learning to use this index is a lot like learning to read a chart. The more a trader studies the interaction between chart movement and the Relative Strength Index, the more revealing the R.S.I will become. If used properly, the R.S.I can be a very valuable tool in interpreting chart movement. The R.S.I points are plotted daily on a bar chart and when connected, form the R.S.I line.

Now let's look at the different things this index can tell us; first, the Index itself indicates:

Tops and Bottoms: These are indicated when the Index goes above 70 or below 30. The Index will usually top out or bottom out before the actual market top or bottom, giving an indication that a reversal or at least a significant reaction is imminent.

Chart Formations: The Index will display graphic chart formations which may not be obvious on a corresponding bar chart. For instance, head and shoulders tops or bottoms, pennants or triangles often show up on the Index to indicate breakouts and buy and sell points.

Failure Swings: Failure swings above 70 or below 30 are very strong indications of a market reversal. (See figure 6.3 and figure 6.4.)

Figure 6.3 summary: This figure is a line chart depicting a price movement pattern. The chart illustrates a sequence of peaks and troughs, specifically highlighting a failure swing pattern where an initial peak is followed by a lower peak. Key markers identify the fail point at a local minimum and the failure swing point at a subsequent lower minimum, which leads to a designated sell point. The data indicates that when a previous high is not exceeded, it signals a failure swing, suggesting a reversal in trend from upward to downward movement.

Figure 6.4 summary: This figure is a line chart. It depicts a price movement pattern over time, identifying specific technical markers such as the bottom, fail point, failure swing point, and buy point. The chart illustrates a scenario where a price decline reaches a low point, attempts a recovery, dips again without dropping below the previous low, and then rises. The primary inference is that when a previous low is not exceeded during a secondary dip, it creates a failure swing, which serves as a bullish signal indicating a potential buy point as the price trends upward.

Second, the Index, in conjunction with the bar chart, defines these interactions:

Support and Resistance: Areas of support and resistance often show up clearly on the Index before becoming apparent on the bar chart. In fact, support and resistance lines drawn using Index points are often analogous to trend lines drawn using bar chart points.

Divergence: Divergence between price action and the R.S.I is a very strong indicator of a market turning point. Divergence occurs when the R.S.I is increasing and the price movement is either flat or decreasing. Conversely, divergence occurs when the R.S.I is decreasing and price movement is either flat or increasing. (Note on the June Silver chart, figure 6.5, that there was divergence between the bar chart and the R.S.I at every major turning point.)

Figure 6.5 summary: This figure consists of two aligned line charts showing price movements over time. The top chart displays the price fluctuations of Chicago Silver, while the bottom chart shows a related technical indicator tracking divergences. The data spans several months from July through March. The price of silver exhibits a general upward trend characterized by significant volatility, with several peaks and troughs. The lower chart identifies specific points of divergence, labeled as D, which correspond to shifts in the price momentum. It can be inferred that the silver market experienced a period of overall growth with periodic corrections, and the identified divergences served as indicators for potential trend reversals or continuations.

In view of these five interpretive factors of the R.S.I, let's examine the bar chart of June 1978 Chicago Silver.

Tops and bottoms: The major bottom of August 15 was accompanied by an R.S.I value below 30. During the next few days, a turning point was indicated by divergence between the R.S.I and price action. The major top of November 9 was preceded by an R.S.I value above 70. The top made on January 24 was preceded by an R.S.I value of less than 70. This would indicate that this top is less significant than the previous one and that either a higher top is in the making or that the long-term up trend is running out of steam.

Chart Formation: Note the pennant formed on the R.S.I line during October that is not evident on the bar chart. A breakout of this triangle indicates an intermediate move in the direction of the breakout. Note also the long-term pennant with the large number of supporting points on the R.S.I line. A significant breakout of this triangle should be indicative of the next long-term trend.

Failure Swings: Failure swings made by this Index are most significant after an R.S.I high in the area of 70 or low in the area of 30. Note that when the R.S.I reached 70, the immediate down swing carried to 58. It is not un-

usual for the following up swing to be composed of several small swings as long as the high and low of the main swing are not penetrated. When the low point of 58 was penetrated, the failure swing was completed. On the low of August 15, the failure swing carried up to 41 on the R.S.I scale. After several small down swings, this point was penetrated on the up side on August 26.

Support and Resistance: Trend lines on the bar chart often show up as support lines on the R.S.I. Notice the support lines made by the low swing points during October and part of November could be used to confirm trend lines drawn on the chart. Depending upon who is drawing the trend line, a breaking of the trend line could have occurred on November 4; however, this was not confirmed on the support line drawn on the R.S.I.

Divergence: Although divergence does not occur at every turning point, it does occur at most significant turning points. When divergence

begins to show up after a good directional move, this is a very strong indication that a turning point is near. Divergence is the single most indicative characteristic of the Relative Strength Index. Note that the top made on November 9 was Indicated by an R.S.I value above 70 and divergence. It was confirmed by the failure swing, breaking out of the pennant formation and breaking the support line.

The Relative Strength Index, used in conjunction with a bar chart, can provide a new dimension of interpretation for the chart reader. No single tool, method or system is going to produce the right answers 100% of the time. A successful trader utilizes several different kinds of input into his decisions.

Often the problem is in narrowing this input down to two or three things that work best for him. In this context, the Relative Strength Index can be a valuable input into this decision-making process.

Section 7

The Reaction Trend System is just what the name implies — it is both an anti-trend system and a trend system. The normal mode of operation is the Reaction Mode (anti-trend). In the Reaction Mode, we buy on weakness and sell on strength. The anti-trend mode reverses at each buy point and most sell points. The Trend Mode of the system does not reverse, but exits the market at a trailing stop.

This system provides plenty of action. It will average making a trade about every two or three days. This system capitalizes on the kind of market most systems perform very poorly in; that is, those exasperating markets which have periods of non-directional congestion-type action and suddenly spurt to new highs or new lows. These markets will show up on the lower end of the Directional Movement Index scale.

Characteristically, this system makes money in a non-directional market; however, when the market suddenly becomes directional and moves rapidly, it will automatically go into its Trend Mode and follow the move. When the trend halts, the system reverts to the anti-trend or Reaction Mode.

Before we get into the rules for trading, let's look at the geometry of the system in order to understand the concept upon which the price action points are based. The high, low and close prices for each day generate Four Price Action Points for the following day. These points are good for the following day only. The four price action points are all based on the average of the high, low and close price for the day which is designated X.

Math summary: This computation calculates the average price of a trading day. It sums the high, low, and closing input values and divides that total by a scaling factor of three to produce the final average price.

The four price action points are:

B 1 (Buy Point) equals 2 times X bar minus H

S 1 (Sell Point) equals 2 times X bar minus L

H B O.P (High Break Out Point) equals 2 times X minus 2 times L plus H

L.B.O.P (Low Break Out Point) equals 2 times X bar minus 2 H plus L

The geometry for these points is diagrammed in figure 7.1 All of the points are generated by three distances, D 1, D 2 and D 3.

Figure 7.1 summary: This figure is a schematic diagram illustrating mathematical relationships and operational modes. It depicts the calculation of various boundary points and thresholds based on variables representing high, low, and center values, specifically defining the transition between a reaction mode and a trend mode. The diagram shows how the average value serves as a central reference point from which deviations are measured to determine specific limits. It can be inferred that the system uses these calculated thresholds to distinguish between stable reaction states and trending states, where the reaction mode is bounded by upper and lower operational limits derived from the spread of the underlying data.

D 1 is the distance from X bar to the high price of the day. The Buy Point, B 1, is obtained by swinging D 1 through an 180 degree arc below X bar.

D 2 is the distance between X bar and the low price of the day. The Sell Point, S 1, is obtained by swinging D 2 through an 180 degrees above X bar.

D 3 is the distance between the high and low of the day. The high Break Out Point, H.B.O.P, is the distance D 3 plus D 2 above X bar.

The low Break Out Point, L.B.O.P, is the distance D 3 plus D 1 below X bar. The X bar is the base point for derivation of the equation of each of the four price action points which are shown in figure 7.1 Before we discuss when to take a position, let's look at the price action relative to the four price action points. We stated that the normal mode of operation for the Reaction Trend system is the Reaction mode. We also said that the four price action points generated on one day are good for the following day only. We are in the normal Reaction mode when the prices for the next day stay within the bounds of the H.B.O.P and the L.B.O.P. In this mode, we buy at point B 1 and sell at point S 1 .

Math summary: This computation determines the high and low break out prices to trigger a trend mode. The process calculates these thresholds by subtracting the sum of the price range and the distance from the average to the extremes from the average price.

If the price for the next day should go through the H.B.O.P or the L.B.O.P, the system is then automatically in Trend mode. Once in this mode, the stop becomes the most distant price of the previous two days. (If the price should go through the H.B.O.P, the trailing stop is the lowest low made for the previous two days. If the price should go through the L.B.O.P, the trailing stop is the highest high made for the previous two days.) We follow the price in the direction of the breakout with the trailing stop. When the price reacts enough after the breakout to trigger the trailing stop, we exit the market at the trailing stop. We then go back into the Reaction mode and remain until another breakout occurs.

This system is based on what appears to be a repetitious peculiarity of random price movement. This is the three-day-up-two-day-down phenomenon. This phenomenon is most prevalent in a non-directional market or a lazily trending market. For some reason, random price movement appears to take longer to increase than it does to decrease. This appears to be indicative of most price action; that is, the down moves are more severe and of shorter duration than the up moves. Often a good directional move starts with a significant increase in range on the first day of the move. When this happens, the breakout points will be exceeded and the system will go into Trend mode and follow the move until the first reaction occurs — at which time the system automatically reverts to the Reaction mode.

Now let's discuss the question of when to enter the market. We look back over the price action for the last two or three weeks and select the significantly lowest price (Fig. 7.2).

Figure 7.2 summary: This figure is a bar chart. It displays a series of vertical bars of varying lengths arranged sequentially, with several bars specifically labeled as BOS. The length of the bars fluctuates across the sequence, reaching a minimum point at one of the BOS markers before generally increasing again. It can be inferred that the BOS markers coincide with significant troughs or shifts in the measured value, suggesting that these specific points represent local minima or transition states within the dataset.

We place a “B” under that day.

We place an “O” under the following day.

We place an "S" under the next day.

We designate all following days in the sequence, "B", "O", "S", "B", "O", "S", "B", "O", "S". (This represents nine days of the sequence.) We continue to designate all of the days in this sequence until we get to today.

If the market is in a general down trend, we can pick out the significantly highest price for the last two or three weeks and label the high point "S". The next day of the sequence would be "B", the following day, "O", etcetera

An alternate method to begin the “B”, “O”, “S” sequence would be at a Phasing change or confirmation (after a breakout) which we will explain later.

Following are the basic principles for trading the Reaction Trend System.

For trading the Reaction Mode:

Long (Buy) positions are initiated only on a “B” day.

Short (Sell) positions are initiated only on an “S” day.

no positions are initiated on an"O" day except those initiated by the breakout points, H.B.O.P or L.B.O.P.

Long positions may be closed out on an “O” day or reversed on an “S” day.

Short positions are reversed on a"B" day.

The target and reverse point for a position initiated at B 1 is always S 1.

The target and reverse point for a position initiated at S 1 is always B 1.

For Trading the Trend Mode:

Breakout points, H.B.O.P and L.B.O.P, are stop and reversal points for open positions in the Reaction Mode. They are also entry points for a new position. Any position initiated at H.B.O.P or L.B.O.P is taken on any day it occurs.

The stop for any Trend Mode position is always the trailing stop. This Trailing Stop is not a reverse.

Now let's discuss how these rules are used. Assuming that we have designated our previous days as either "B", "O", or "S", we are ready to begin trading the Reaction Mode of this system. Suppose, however, that tomorrow is an "O" day. We cannot initiate a position on an "O" day, so we calculate the four price action points for the following "S" day. On the following "S" day, we can only go Short, and then only if the price touches the S 1 sell point. Assume that the price touched S 1 and we go Short (Fig. 7.3), Day 2.

Figure 7.3 summary: This figure is a series of schematic diagrams representing various signal patterns across twelve distinct cases. Each case illustrates the relative positioning and duration of high-band and low-band operational peaks, alongside specific transition markers and signal labels. The diagrams demonstrate a variety of signal configurations, showing differences in the timing and sequence of operational peaks. It can be inferred that the different cases represent a range of operational scenarios, where the relationship between high and low operational peaks varies from simple offsets to more complex overlapping or sequential patterns.

On Day 2, the price went down and penetrated the B 1 target; however, we do not take profits on day of entry. We must wait for the following “B” day to take profits and reverse at B 1 .

On Day 3, a “B” day, the price came down, touched the B 1 buy point and we reversed to Long because we can only buy on a “B” day.

On Day 4, the price continued up, went through the S 1 point and we took profits at S 1 because S 1 is a target only on an “O” day. We cannot reverse and/or initiate a new position on an “O” day while in the Reaction Mode.

On Day 5, an “S” day, we go Short at S 1 On Day 6, a "B" day, the B 1 price is not touched; therefore we exit the market on the close of Day 6.

On Day 7, an “O” day, we cannot initiate a new position unless the price penetrates one of the breakout points; in which case, we would initiate a position, enacting the Trend Mode and using the trailing stop. This did not occur; therefore, we continue in the Reaction Mode.

On Day 8, an “S” day, the price opened above the 1 dollar point, so we went Short on the open. The price then went directly down through the 1 dollar point and closed on the low. Since we do not exit a trade on the day it is initiated (unless the price penetrates one of the breakout points), we remain in the trade on Day 8.

On Day 9, the price opens below B 1 ; therefore, we went Long on the open, reversing the previous Short position. The price continues to drop, goes through the L.B.O.P and we go Short. We are now in Trend Mode and will follow this Short trade with the trailing stop.

On the day of the breakout, we use the highest high of the two previous days as the trailing stop. After the market closes, we compare the high made today and the high made yesterday. The higher of the two will be the trailing stop to use for tomorrow.

On Day 10 and Day 11, we remain in the Short trade. The trailing stop was not touched.

On Day 12, the price reacts and we exit the market at the trailing stop (which was the high made on Day 11). We do not reverse. We are now back in the Reaction Mode (Anti-trend).

Phasing Technique

(For use only after a Trend Mode Trade)

Now we come to a very important part of this system which has not yet been explained. This part is the Phasing Technique, and here is the rule:

The day on which the lowest price was reached while in a Short Trend Mode trade (initiated by L.B.O.P) is designated as a"B" day; or

The day on which the highest price was reached while in a Long Trend Mode trade (initiated by H.B.O.P) is designated as an “S” day.

Notice that the lowest price reached while in the Short Trend Mode trade was made on Day 10; therefore, Day 10 (which was previously an “O” day) is redesignated as a “B” day. Maintaining the same sequence, Day 11 is then designated as an “O” day, etcetera

Here is another important point. Suppose on Day 11 the price had continued to go up and had broken through the H.B.O.P. In this case, we would have gone Long at the H.B.O.P which would have put us in the Trend Mode. Our trailing stop for Day 11 would have been the low on Day 10. It is therefore possible to go from the Short Trend Mode to the Long Trend Mode and vice versa without initiating a trade in the Reaction Mode.

Day 12 is an “S” day. We go Short at S 1 ; however, the price continued to go against our position and broke through the H.B.O.P. We reversed and went Long at the H.B.O.P. We are now back in Trend Mode and following the price up with the trailing stop.

Let's say that the price continues to go up for two more days, reacts, and we exit the market at the trailing stop. We are now back in the Reaction Mode. We must, at this point, ascertain that our phasing is correct. The day upon which the highest price was reached will be an "S" day. If it happens to be an "S" day under the previous phasing, then no change is made; however, if it is not an "S" day under the previous phasing, then it must be designated as an "S" day and the phasing continued in the sequence "B", "O", "S", "B", "O", "S", etcetera

One other important thing. Can a Reaction Mode trade be initiated on the same day that a Trend Mode is stopped out? The answer is Yes . . . if there is at least one day between the lowest or highest day, and the day the Reaction Mode trade is initiated.

If we are stopped out of a Short Trend Mode trade, the lowest day will be a “B” day and the following day must be an “O” day, which means that a Reaction Mode trade cannot be initiated until the following “S” day. Conversely, if we are stopped out of a Long Trend Mode trade, the highest day will be an “S” day and the following day will be a “B” day. However, no position can be taken on the “B” day because it cannot be ascertained until the close that the previous day was, in fact, the highest day.

Now that we have a basic understanding of the system, we will set out the complete rules. Study these rules in light of the previous discussion and then we will recap the procedure, cover the mathematics and work through an example on the work sheet.

General:

Reaction Trend Rules

Begin trading in Reaction Mode. Switch to Trend Mode on any day that the price crosses a breakout point, H.B.O.P or L.B.O.P. Stay in Trend Mode until stopped out at the trailing stop. Do not reverse at the trailing stop. Adjust Phasing if necessary and resume trading in the Reaction Mode.

Reaction Mode:

Phasing:

Find a significant low point two to three weeks prior to initiating the first trade. Designate the day of this low point as a"B" day. Designate all following days in sequence,"O","S","B","O","S", etcetera

If a previous high point is most significant, then designate that day as an"S" day and continue the sequence"B","O","S", etcetera The initial phasing may also be determined by the following Rule.

Whenever the price penetrates a breakout point, H.B.O.P or L.B.O.P, adjust, if necessary, the phasing as follows:

Entry:

(A) Designate the highest day while in a Long Trend Mode trade as an "S" day and continue the sequence, "B", "O", "S", etcetera

(B) Designate the lowest day while in a Short Trend Mode trade as a "B" day and continue the sequence, "O", "S", "B", etcetera

Long at B, on a"B" day only

Short at S, on an"S" day only.

Exit: (non-reversing)

From a long position

(A) At S, on an "O" day. (B) At Close on an "S" day if S, (reverse point) is not touched. (C) Do not exit on day of entry except at L.B.O.P which is a reverse on any day.

(A) At Close on a "B" day if B, (reverse point) is not touched. (B) Do not exit on day of entry except at H.B.O.P which is a reverse on any day.

Reverse

From a Long position: (A) At S.1 on an"S" day. (B) At L.B.O.P on any day.

From a Short position (A) At B.1 on a"B" day (B) At H.B.O.P on any day.

Trend Mode

Entry

Long at H.B.O.P on any day. Short at L.B.O.P on any day.

From a Long position at the trailing stop. (The lower of the two previous day's lows.) This is a stop only — not a reverse. From a Short position at the trailing stop. (The higher of the two previous day's highs.) This is a stop only — not a reverse.

Reverse:

None in Trend Mode Before we explain the mathematics for this system, let's review the options we have for each day:

On the “B” day, let's assume we went Long at B₁. On this day, we do not exit at the S₁ price action point. We will exit on the “B” day only if the price goes against us enough to cross the L.B.O.P, at which point we will reverse to Short. Let's say that the price moved in our favor on the “B” day. When the market closes, we take the high, low and close price and generate the price action points for the following day, which is an “O” day.

On the “O” day, we have two options. If the price moves far enough in our favor to touch S 1 we will take our profits and get out of the market — we will not reverse. If the price goes through a breakout point, we will enter the Trend Mode and follow the price with the trailing stop. If the price does not reach S 1 on the “O” day nor does it go through a breakout point, then no action is taken on the “O” day. When the market closes, we calculate the price action points for the following “S” day.

On the “S” day, we must exit the Long position one way or another. On the “S” day, there are three options available to us. If the price continues to go in our favor and touches the S 1 sell point, we will reverse our position at that point. If the price crosses a breakout point, we will follow the Trend Mode. If the price does neither of these, we will exit on the close, but will not reverse. In this case, we will plan to go Long the following “B” day at B 1 . (If the price does not go down enough on the “B” day to trigger B 1 , we will stay out of the market.)

Now let's say that on the "S" day we are reversed at S 1 . As soon as we are reversed, our stop is the H.B.O.P which is a reverse to put us Long in the Trend Mode. If the price drops down and crosses B 1 on the "S" day, we do not exit but stay with the position. Let's say that when the market closes on the "S" day, we are still Short. We calculate the price action points for the following "B" day.

On the “B” day we must exit the Short position one way or the other. If, on the “B” day, the price goes down and touches B 1 , we will reverse from Short to Long. If this happens, the stop will be the L.B.O.P which is also a reverse to put us in the Trend Mode with a Short position. However, if the price on the “B” day does not go low enough to reverse our open Short position at B 1 and does not go high enough to reverse into the Trend Mode at H.B.O.P, then we will exit the market on the close. If this happens, we could not take a new position on the following “O” day but would wait and try to take a Short position on the “S” day at S 1 . If the price never reaches S 1 on the “S” day, we will still be out of the market and would attempt to enter Long at B 1 on the following “B” day.

On any day that the price crosses either the H.B.O.P or the L.B.O.P, we are automatically in Trend Mode and follow only the Trend Mode rules until stopped out by the trailing stop.

Normally, we would enter Trend Mode on a reversal or new entry from the Reaction Mode trade; however, it is possible, if we are not in the market while the system is in Reaction Mode, that the price could open above the H.B.O.P or below the L.B.O.P. In this case, we would enter either Long or Short as applicable. This is the only way we could enter the Trend Mode without reversing from the Reaction Mode if we were not in an open position.

Now let's look at a hypothetical example illustrated on the following chart and work sheet.

The prices for Day 1 are as follows:

High: 51.50

Math summary: This expression identifies the lowest price value recorded for the first day. This input value is used as a baseline to calculate price action points for the following day.

The prices for Day 1 are used to calculate the price action points for Day 2.

Close: 50.50

Table summary: The table tracks the Reaction Trend System over a period of time, showing that the calculated support and resistance levels generally follow the fluctuations of the closing prices, with a period of volatility followed by a phase of price stabilization.

Table summary: The table tracks a series of trading activities, showing that the majority of closed positions resulted in gains, leading to a generally increasing cumulative profit over time, despite a few minor losses.

Math summary: This process calculates a typical price by averaging the high, low, and closing values. It then uses this average and a scaling factor of two to determine the upper and lower boundary levels by adding or subtracting the high and low input values.

Now that we have calculated the four price action points for Day 2, we insert them in the appropriate columns on the line for Day 2. For this example, we will assume we have determined that Day 1 is an “S” day and therefore, Day 2 is a “B” day.

Since Day 2 is a “B” day, we are concerned with only three of the four price action points; that is, B 1 , L.B.O.P, and H.B.O.P. On the following “B” day, we will attempt to go Long at 50.16. The stop and reverse is the L.B.O.P at 49.16 On Day 2, the price touches B 1 and we go Long in the market at 50.16. After the market closes this day, we calculate the four price action points for Day 3, which is an "O" day. On the "O" day, we will attempt to exit the market at S 1 if reached.

On Day 3, the high was 51.20 so we did not reach the S _{1} target of 51.34. We calculate the four price action points for Day 4 and note that the S _{1} for Day 4 is 51.30.

On Day 4, the price hit S 1 and we reversed our position to Short at 51.30. We also gave the broker our stop and reverse point, the H.B.O.P at 52.00.

Day 5 is a “B” day and we reverse the Short position to Long at B 1 , 50.16. The stop and reverse point after taking the Long position is the L.B.O.P at 49.16.

On Day 6, the price falls out of bed and dives through the L.B.O.P at 49.50. We go Short at this point and are now in Trend Mode. We immediately give the broker the stop for today of 51.50, which is the higher high of the two previous days.

Our trailing stop for Day 7 is 51.00.

On Day 8, the trailing stop is 50.50. On Day 9, the trailing stop is 49.50. On Day 10, we are stopped out at the trailing stop at 48.50. Since this is a Trend Mode trade, we do not reverse but simply exit the market at the stop. The first thing we must do after being stopped out of a Trend Mode trade is to check the phasing to see if it needs to be adjusted. The lowest day while in the Trend Mode trade was Day 9, which was an "O" day according to the original phasing. After the market closed on Day 10, we can recognize Day 9 as being the lowest day while in the Short Trend Mode trade. We therefore designate Day 9 as a "B" day, Day 10 as an "O" day, and Day 11 as an "S" day, etcetera

Having just exited the Trend Mode, we are automatically back in Reaction Mode. Day 10 is an “O” day; therefore, we initiate no trades on the “O” day unless, of course, the price penetrates the H.B.O.P or L.B.O.P.

On Day 11, the price hits S 1 at 50.10 and we go Short at this price.

Day 12 is a “B” day and we want to cover the Short position at B 1 , which is 48.64. However, the price does not get that low, so we exit the market on the close that day. We do not take a Long position unless the B 1 price is touched.

Day 13 is an “O” day and since we are not in the market, we must remain neutral until the following “S” day unless the price goes through the H.B.O.P or L.B.O.P.

On Day 14, we go Short at S 1 at 50.64.

On Day 15, the following “B” day, we reverse our Short position at B _{1} and go Long at 49.34.

Day 16 is an “O” day and we hold our position because the S 1 target was not reached. (Notice that S 1 for Day 17, the “S” day, is lower than for Day 16. This is because the move on Day 16 did not carry through and therefore produced a lower target for Day 17.)

The price on Day 17 still did not hit the reduced target, so we exited on the close that day.

On Day 18, a “B” day, the price touches B _{1} and we go Long.

On Day 19, the following “O” day, the S 1 target of 49.64 is reached and we exit the market at that point. We do not reverse.

On Day 20, we go Short at S 1 at 49.66.

On Day 21, the B 1 of 48.84 is not reached, so we exit the Short position on the close at 49.20. Notice that this system often produces a profit even when the B 1 or S 1 points are not reached.

Day 22 is an “O” day, so no new positions are initiated since the price did not cross the H.B.O.P or L.B.O.P.

Now, just for fun, let's see what happens when we have an absolute sideways market; that is, the high, low and close price for each day is identical. Since Day 22 is an "O" day, the first position we can take is on Day 23.

We go Short at S 1 at 50.00. The following day, we reverse at B 1 at 49.00. On Day 25, an “O” day, we take our profits at 50.00 and are out of the market. On Day 26, an “S” day, we go Short at 50.00. On Day 27, we go Long at B 1 , 49.00. On Day 28, an “O” day, we exit the market at 50.00, which is S 1 . This hypothetical example shows the inherent characteristics of this system which enable it to be profitable in a very low directional non-trending type of market. Often this type of market is the “lull before the storm,” that is, it precedes a dramatic breakout one way or the other. If you are in the market with the system when the breakout does occur, there is no way you can miss it.

For simplicity in the preceding example, we entered the market at the breakout price and exited at the trailing stop price. However, when trading this system in the actual market, always Increase the distance of these points by several ticks. These points are:

H.B.O.P

L.B.O.P

Trailing Stop

Even though it may take several readings, I hope this System has been presented so it is understandable to the reader.

Following is a chart of May 1977 Soybean Meal which shows the system trading in this type of market. I think you will agree that this system is worth the effort it may take to master it.

Table summary: The table tracks a series of trading sequences, showing that while there are frequent small losses and gains, the overall cumulative profit trend is positive, driven by several significant winning trades that outweigh the smaller losses.

Open Close Recap: Reaction Trend System (May 77 Soybean Meal)

Table summary: The table tracks a series of trading activities, showing that while individual trades result in both gains and losses, the overall accumulated profit remains consistently positive and generally increases over the sequence of trades.

Trades: 36 profit (64%) 20 loss (36%) 56 total Profits: 174.70 points profit 75.50 points loss 99.20 points total profit

Image summary: This figure is a line chart representing price movements over time. The chart tracks the price of May 77 Soybean Meal from November through March, featuring numerous annotated points that mark specific reactions and trends within the market. The data shows a general upward trajectory characterized by frequent fluctuations and short-term reversals. It can be inferred that while the overall market trend is bullish, the price action is volatile, creating a whipsaw effect that the Reaction Trend System is designed to navigate.

Section 8

The Swing Index

One of the smartest technicians I know put me on the trail of this method with the following statement:

"Somewhere amidst the maze of Open, High, Low and Close prices is a phantom line that is the Real market. This line is also indicative of the Real swings the market is making."

After some study, I concluded that if each day's action could be evaluated definitively, within constant parameters, the phantom line could be revealed. The problem was to compare each day's action within the day and with that of the previous day and relate this action to an absolute.

The problem is compounded by the fact that there are no less than 28 points of evaluation within a two day period. The 16 following points can be compared between the two days. The subscript “1” is for the first day, the subscript “2” is for the second day:

Table summary: The table displays a balanced distribution of various combinations of high, low, oxygen, and carbon elements across its rows and columns.

The following six points can be compared within each day:

Math summary: This expression organizes a set of comparative data points into a grid. It maps specific combinations of high, low, and control variables across two different daily observation groups.

After devising and testing innumerable approaches, the following factors were isolated as the most indicative:

For an up day, the most indicative plus factors are as follows:

Close today above previous close.

Close today above open today.

High today above previous close.

Low today above previous close.

Previous close above previous open.

For a down day, these same factors would have a minus value.

These factors were then weighted and evaluated relative to the highest or lowest possible value and defined on a scale with absolute limits.

The highest value for a day would be Limit up from a Limit up day.

The lowest value for a day would be Limit down from a Limit down day.

A zero value would be a no Change day from a no Change day.

The absolute limits would be +100 and -100.

The following equation was derived to satisfy these prerequisites:

Math summary: This expression calculates a stability index by combining differences between various concentration and oxygen values. The process sums these weighted differences, divides them by a reference value, and then multiplies the result by a scaling factor based on the ratio of constants.

Now, before we take up the mathematics for this equation, let's look at how the equation evaluates certain plus and minus factors relative to two day's action. Assume the value of a Limit move is 3.00.

(2) (3) (4) (5) (6) (7)

At first glance, the above values may seem contradictory. The highs and lows for every two days are the same, yet the value for the days varies from -10 to +32. However, when each example is evaluated in light of the five plus factors as set out previously, then the values fall into place. Example 7 had the most weighted plus factors and closed up the highest from the previous day.

In examples 5 and 8, the minus factors outweighted the plus factors and each also closed down from the previous day. In fact, most technicians would call both of these days "Key Reversal" days because the second day

Opened higher

Had a higher high

Closed lower

than the first day.

Take a few minutes and study these first eight examples in light of the five plus factors.

Now let's look at a few more examples. Assume the same 3.00 limit as the maximum allowable move in either direction from the previous day's close.

(11) (13) (15)

- Example 9 The configuration is the same as Example 2; however, the index value is higher because the price moved farther compared to the value of a limit move.

- Example 10 The index value is higher than Example 9 because of the higher close compared to the previous day.

- Example 11 The opens and closes are identical to Example 10; however, Example 11 has a higher index value because of the Gap caused by the low of Day 2 being above the close of Day 1. (In the equation, Gaps are measured between L 2 and C 1, not L 2 and H 1 as is the common practice.)

- Example 12 The close for Day 2 is Limit up; yet the index value is 72, not 100.

- Example 13 The close for Day 2 here is also Limit up; yet there was trading below the limit. This larger gap indicates a stronger index value than Example 12.

- Example 14 Here the price is locked Limit for Day 2 and the index value is greater than the previous Limit day which had a trading range.

Example 15 Here is Locked Limit from a Locked Limit day and the equation gives the highest possible value of 100 because there was no trading range for either day.

Now that we have an insight into the rating characteristics of the equation relative to the index value, let's look at another important feature of the Swing Index equation, that of identifying swings:

In figure 8.3, most technicians would have readily identified the short-term swing as shown. The Swing Index also identified the swing, figure 8.4. This was done by simply accumulating the index value of each day and graphing the results.

Figure 8.3 summary: This figure is a line chart featuring error bars at each data point. The chart illustrates the fluctuation of a measured value across a sequence of observations. The data shows an initial sharp increase, followed by a moderate decline, and concludes with a final upward trend to reach the highest observed value. Based on the trends and the overlap of the error bars, it can be inferred that while there is overall growth over the sequence, the variations between consecutive points are partially offset by the uncertainty of the measurements.

Figure 8.4 summary: This figure is a line chart. It displays a sequence of data points plotted across six ordered categories on the horizontal axis, showing the fluctuations of a specific value over these categories. The data shows an initial sharp increase reaching a peak at the third category, followed by a decline through the fourth and fifth categories, and ending with a steep rise to the highest overall value at the final category.

The result is the Accumulative Swing Index (A.S.I). It is obtained by adding or subtracting (as indicated by the sign + or —) each day's value from the previous total value.

In figure 8.4, we start at 0, add to this the value for the second day of +19 and the A.S.I for Day 2 is +19. On Day 3, the S.I is 26. Add this to +19 and the A.S.I for Day 3 is 45. On Day 4, the S.I is -7. Subtract this from 45 and the A.S.I for Day 4 is 38, etcetera

Now look at figure 8.5, which is identical to figure 8.3 except for the high on Day 3 and the low on Day 5. Most technicians would not have identified this swing; however, by evaluating each day's action, the A.S.I picks up the swing.

Figure 8.5 summary: This figure is a line chart featuring error bars at each data point. The chart displays a series of values plotted over a sequence of intervals, with the horizontal axis indicating the change between consecutive points. The trend shows an overall increase in values from the start to the end of the sequence, despite some fluctuations. It can be inferred that the values generally trend upward, with the most significant increases occurring at the beginning and end of the observed period, while moderate decreases occur in the middle.

I realize that there are few, if any, definitive rules accepted by every technician for positively identifying swings. In fact, there are probably as many different rules for identifying swings as there are swing systems. Add to these the practitioners of the Elliott Wave Theory and it is obvious that the value of an equation which will identify the short-term swings mathematically without any rules is certainly a significant concept.

The implications for being able to plug the four daily prices into an equation which will give a one number relative value for the day's trading and also identify precisely all short term swings are far reaching indeed. Those readers who like to use their own creative ability and ingenuity to devise workable systems will have a field day with this concept.

I wanted to take the time to show the reader the value and the results of this equation before explaining it. The reason is that this equation is not overly simple for the non-mathematically inclined; however, solving the equation is only a matter of adding, subtracting, multiplying and dividing.

In the S.I equation, use the Absolute Value of all terms except those in the numerator inside the brackets. The numerator is all terms on the line above R inside the brackets.

Figure 7.4 summary: This figure is a line chart with error bars. It displays measurements taken over a period of several days, tracking a specific value across multiple daily observations. The data points show fluctuations in the measured value, with vertical bars indicating the variability or uncertainty associated with each reading. The overall trend indicates that the values remain relatively stable over time, though they exhibit minor oscillations around a central mean. It can be inferred that the process being monitored is under control, as the measurements consistently stay within a narrow range despite small daily variations.

Chart 85 summary: This is a line chart depicting price fluctuations over a period of several months. The horizontal axis represents time from May through October, while the vertical axis tracks a numerical value. The data shows a sharp upward trend starting in May, reaching a peak in July, followed by a period of significant volatility with several peaks and troughs through August and September, before ending with a general decline and stabilization in October. The overall trend indicates that the value increased substantially in the early summer before entering a volatile phase and eventually decreasing toward the end of the period.

Figure 8.1 summary: This figure is a plot displaying vertical segments across several different categories. Each category is represented by a pair of vertical lines that indicate a range of values relative to a vertical axis. The data shows that the ranges vary in both their vertical position and their overall span across the different categories. It can be inferred that some categories exhibit a narrow range centered around a specific value, while others show a broader range that shifts upward or downward, indicating variability in the measured parameters across the tested conditions.

Figure 8.2 summary: This figure is a plot featuring vertical line segments representing data ranges across several categories. The horizontal axis displays a series of increasing positive values, while the vertical axis indicates a numerical scale. The vertical segments vary in length and position, showing the distribution or spread of values for each corresponding category on the horizontal axis. It can be inferred that as the values on the horizontal axis increase, there is a general upward shift in the range of the data, with some categories exhibiting significantly wider spreads than others, particularly toward the middle and later stages of the sequence.

Swing Index Equation (S.I)

Math summary: This expression calculates a stability index by combining differences between closing and opening prices. It sums these price differences, divides the result by a range value, and then applies a scaling factor of fifty and a ratio of constants.

Where K = the largest of:

(1)

Math summary: This computation calculates the difference between two specific values. It subtracts a constant value from both a high value and a limit move value to determine the remaining distance.

and L = Value of a limit move in one direction.

To obtain "R", first determine the largest of:

(1) H 2 minus C 1

(2) L 2 minus C 1

(3) H 2 minus L 2

If (1) is the largest, R equals open parenthesis H 2 minus C 1 close parenthesis minus 0.5 times open parenthesis L 2 minus C 1 close parenthesis plus 0.25 times open parenthesis C 1 minus O 1 close parenthesis If (2) is the largest, R equals open parenthesis L 2 minus C 1 close parenthesis minus 0.5 times open parenthesis H 2 minus C 1 close parenthesis plus 0.25 times open parenthesis C 1 minus O 1 close parenthesis If (3) is the largest, R equals H 2 minus L 2 plus 0.25 times the quantity C 1 minus O 1 Where:

Math summary: This computation organizes various stock price data points into a structured list. It takes the opening, high, low, and closing prices from yesterday and today to produce a final vector of values called Frouncers.

Now let's work out an example using the following prices:

Table summary: The data shows a general increase in the opening, high, low, and closing prices from the first day to the second day.

First we will obtain the numerator: (N)

Table summary: The table demonstrates a step-by-step calculation to determine the value of N by substituting specific constants into a linear formula, resulting in a final positive value.

We will put the numerical equivalents in the S.I Equation as they are obtained. We will assume the Limit (50) is 3.00. So far: or:

Image summary: This figure is a mathematical equation. It presents a calculation for a variable termed SI, which is derived by multiplying a constant by two separate fractional terms. The equation indicates that the final value is determined by the product of a coefficient and the ratio of two different numerical values.

K = the greater of:

H 2 minus C 1: substituting 53.00 minus 51.50 equals 1.50

L 2 minus C 1 : substituting 51.30 minus 51.50 equals point 20 (A.B.S)

K therefore is 1.50.

Image summary: This figure is a mathematical equation. It shows the calculation for a variable labeled as SI, which is determined by multiplying a constant by the product of two fractions. The equation indicates that the final value of SI is derived from a scaling factor applied to the ratio of two sets of numerical values.

To obtain R, first determine the largest of:

1.50

L 2 minus C 1 : substituting 51.30 minus 51.50 equals point 20 (A.B.S)

H 2 minus L 2 : substituting 53.00 minus 51.30 equals 1.70

Since (3) above is the largest, we will find R by substituting in R (3) equation.

Math summary: This computation calculates a final result by adding the difference between two high and low values to a scaled difference of two other values. The process subtracts the second set of inputs, multiplies that result by a scaling factor of zero point two five, and adds it to the first difference to produce the output.

Now we have all of the terms for the S.I equation.

Math summary: This computation calculates a final index value by multiplying a constant scaling factor by two separate ratios. The process divides the first set of input values and the second set of input values before multiplying those results by fifty to produce the final output.

First divide the numbers inside the brackets

Math summary: This computation calculates the product of three specific values. The process multiplies a base value of fifty by a scaling factor of one point zero five and a final multiplier of zero point five zero.

Now multiply the three numbers together:

Math summary: This computation calculates the simple interest by multiplying three specific values together. The process takes a principal amount, a rate, and a time period as inputs to produce a final scaled output.

And round off to the nearest whole number: S.I = 26 There are some short cuts that can be taken. For instance, when we determined the value for K we used these same values in addition to H 2 - L 2 to determine which of the three equations to use for R. Also the 0.25 ( C 1 - O 1 ) term in the R equation had already been obtained as one of the terms in the numerator.

Now let's use these short cuts and find the S.I for a down day:

Table summary: The table shows a general decrease in the open, high, low, and closing prices from the first day to the second day.

First, obtain the numerator: (N)

Math summary: This computation calculates a weighted sum of three different differences between pairs of values. The process subtracts a first set of values, then adds a second difference scaled by a factor of zero point five and a third difference scaled by a factor of zero point two five to produce the final result.

Note the term 51.00 — 52.50 is —1.50. Also, a plus number times a minus number gives a minus number as an answer.

Math summary: This computation calculates the product of a scaling factor and a negative value. The process multiplies zero point five by negative one to produce a final output of negative zero point five.

So far, our S.I Equation is:

Math summary: This computation calculates a final value by multiplying a constant scaling factor of fifty by two separate ratios. The process divides a negative input value by a reference value and then multiplies that result by a second ratio of inputs.

The numerator is the only term in which we do not use absolute values. (Remember from previous chapters, the absolute value of a plus (+) number being subtracted from a minus (-) number is the difference with the sign of the larger number.)

K = the largest of:

H 2 minus C 1: substituting 52.00 minus 52.50 equals point 50 (A.B.S)

L 2 minus C 1: substituting 51.00 minus 52.50 equals 1.50 (A.B.S)

K = 1.50 (the largest absolute value)

To find the equation to use for R, first determine the largest of:

Math summary: This process calculates the difference between various height and length measurements and a previously determined constant. The final step subtracts a lower length value from a higher height value to produce a numerical result.

The largest value is in (2) above, so we use the R equation to find R.

Math summary: This computation calculates a final result by combining three separate differences. It subtracts half of the difference between the second height and first center from the difference between the second length and first center, then adds one quarter of the difference between the first center and first offset.

We found in obtaining the numerator that 0.25 (C 1 minus O 1) was -.25. The absolute value is 0.25 therefore:

Math summary: This computation calculates a final result by combining differences between input values and a constant. The process subtracts a weighted difference from an initial difference and adds a scaling factor to reach the final output.

therefore:

Math summary: This computation calculates a final index value by multiplying a base constant by two separate scaling factors. The process divides a negative numerator by a denominator and multiplies the result by a second ratio to produce the final negative output.

Note that the sign (+ or —) of the S.I is determined by the numerator. If the numerator has a —sign, the index will be minus. If the numerator has a +sign, the index will be plus.

Now for the benefit of those who find the mathematics of the equation a bit tedious, let's look at the work sheet with a set of "cook book" instructions which will work this equation. The headings on the work sheet indicate when to use the absolute value A.B.S (when to drop the minus sign) and when to use the + or - value (when to keep the minus sign). The following is for the second day on the work sheet.

Use Absolute Values

Math summary: This process calculates the differences between specific measurement values to populate four separate columns. It subtracts one input value from another for each column to produce a final numerical result.

- Put C 2 minus C 1 in Column #5 Put C 2 minus O 2 in Column #6 Put C 1 minus O 1 in Column #7

Math summary: This computation calculates a weighted sum of three specific column values to determine a final result. The process adds the first column value to half of the second column value and one quarter of the third column value.

Put N in Column #8.

Find the largest number in Column #1 or Column #2.

Put this in Column #9 (2.50).

Find the largest number in Columns #1, #2, or #3 Since the largest number is in Column #1, we substitute in the R 1 equation.

Code summary: This algorithm calculates a result based on the active category. It takes multiple column values as input and applies different weighted combinations of those values depending on the selected category to produce a final output.

Code summary: This logic calculates the difference between pairs of values to determine the remaining amount. It takes a set of numerical pairs as input and outputs the resulting subtraction for each pair.

Math summary: This computation calculates a final result by subtracting and adding weighted values to a starting constant. The process takes a base value of two point five zero, subtracts a scaled input of zero point two five, and then adds another scaling factor of zero point two five to return the original value.

Put R in Column #10 (2.50).

Put the Limit in Column #11 (3.00).

Math summary: This computation calculates a final score by multiplying a base scaling factor of fifty by two separate ratios. The process divides specific column values to find two decimal proportions, then multiplies those proportions by the scaling factor to produce the result.

Round off to the nearest whole number:

Now let's follow the procedure on the work sheet for a down day. Day 2 (today) is the third day on the work sheet; Day 1 (yesterday) is the second day on the work sheet.

Use Absolute Values

Code summary: This algorithm calculates the differences between various price points and assigns the resulting values to specific columns. It takes a set of high, low, close, and open price values as input and outputs a series of calculated spreads.

Math summary: This process calculates the absolute value of a given number. It converts any negative input value into a positive output value.

Code summary: This algorithm calculates the differences between various paired values and assigns the resulting values to specific columns. It takes a set of numerical constants as input and outputs the calculated variance for each pair.

Math summary: This computation calculates a weighted sum to determine a final area value. It adds the fifth column value to half of the sixth column value and one quarter of the seventh column value.

Put N in Column #8 (-1.15).

Find the largest of Column #1 or Column #2 (1.50).

Put K in Column #9 (1.50).

Use R (3) equation because Column #3 is the largest of Columns #1, #2, or #3.

Math summary: This computation calculates a final result by adding a primary input value to a scaled secondary value. The process takes the value from column three and adds it to one quarter of the value from column four to produce the output.

Put R in column #10 (2.25).

Put the Limit in Column #11 (in this example, 3.00)

Math summary: This computation calculates a stability index by multiplying a scaling factor of fifty by two separate ratios. The process divides the eighth column by the tenth column and the ninth column by the eleventh column, then multiplies these results together with the scaling factor to produce a final rounded whole number.

The A.S.I is the Accumulative Swing Index which is obtained by accumulating each day's S.I as indicated by the sign (+ or —) of the latest S.I. The accumulative index may be either minus or plus. If the long-term trend is up, the accumulative index will be a plus. If the long-term trend is down the accumulative index will be a minus. If the long-term trend is non-directional, the A.S.I will fluctuate from plus to minus.

In the work sheet example, the A.S.I is the same as the S.I on the first day. On the second day, the S.I of -13 subtracted from the previous A.S.I of 37 makes the A.S.I 24 for the second day, etcetera

At the top of the work sheet are brief instructions for obtaining the S.I and the A.S.I using only the work sheet with the column headings and the open, high, low and close prices for the day. By using the work sheet in this manner, even the non-mathematically inclined should have little problem in obtaining the S.I and A.S.I for each trading day. It's like "cook book" engineering. Simply fill in the columns, follow the instructions and it all falls into place.

On the work sheet, the columns have been left blank for days 4 through 8 for those who would like to stop at this point and solve the equation for those five days. The correct answers for each day are filled in under the S.I and A.S.I columns. As with all systems and indexes in this book, there is a blank work sheet for this system in the Appendix. This work sheet can be removed and reproduced on a copier for following the markets on a daily basis.

Let's pause for a minute at this point and consider the significance of the Swing Index. The Swing Index gives us a numerical value for each day's trading which will always fall between 0 and +100 or 0 and -100. Second, the Swing Index gives us definitive short-term swing points. Third, the Swing Index gives us a line which cuts through the maze of high, low and close prices and indicates the real strength and direction of the market. Many good systems and methods could be devised based on one or a combination of these indicators. Those who already use a good swing method or wave method can use this index as an additional tool to indicate by simple mathematics the short-term swings without spending a lot of time with the rules trying to figure out whether a swing is a swing or not. The Swing Index can also be used supplementary to other methods as a breakout indicator. A breakout is indicated when the value of the A.S.I exceeds the A.S.I value on the day when a previous significant high Swing Point was made. A downside breakout would be indicated when the value of the A.S.I drops below the A.S.I value on a day when a previous significant low Swing Point was made.

When the Swing Index is plotted on the same chart as the daily bar chart, trend lines drawn on the A.S.I can be compared to trend lines drawn on the bar chart. For those who know how to draw meaningful trend lines, the A.S.I can be a good tool to confirm trend-line breakouts. Often erroneous breaking of trend lines drawn on bar charts will not be confirmed by the trend lines drawn on the A.S.I. Since the A.S.I is heavily weighted in favor of the close price, a quick run up or down during a day's trading does not adversely affect the index.

The system I have devised using the Accumulative Swing Index is a very simple swing system. The swing points are the high Swing Points and low Swing Points as indicated by the A.S.I.

Swing Index System

Initially, the market is entered on a breakout. For instance, we would go Long (Fig. 8.6) the next day when the value of the A.S.I exceeded the value posted on the day of a previous significant high Swing Point; or go Short (Fig. 8.7) the next day when the A.S.I dropped below the A.S.I on a day that a previous significant low Swing Point was made.

Figure 8.6 summary: This figure is a line chart depicting a price movement pattern. The chart illustrates a price trend that reaches a peak at a significant high swing point, declines to a significant low swing point, and then recovers. It highlights a specific entry point for a long position when the price returns to the level of the previous high swing point, coinciding with a stop and reverse indicator. The figure suggests that a bullish trend reversal is confirmed when the price breaks above a prior significant high, signaling a strategic point for investors to enter the market.

Figure 8.7 summary: This figure is a line chart representing price movement over time. The chart illustrates a price trend that reaches a peak at a significant high swing point before declining to a significant low swing point. Following this low, the price undergoes a series of smaller fluctuations, reaching a secondary peak labeled as the stop and reverse point, before falling again. The figure indicates a trading strategy where a short position is entered when the price drops back down to the level of the previous significant low swing point, suggesting a bearish continuation or a breakdown of a support level.

Once in the market, we use the previous swing point as the Index Stop and Reverse (S.A.R). If Long, the Index S.A.R is the previous low Swing Point. If Short, the Index S.A.R is the previous high Swing Point. In addition, we use an Index S.A.R trailing stop which is 60 points on the A.S.I from the extreme favorable A.S.I high (if Long) and from the extreme favorable A.S.I low (if Short). This 60 point trailing S.A.R is 60 points on the Accumulative Swing Index. The 60 points are not in terms of the Price of the commodity being followed.

We go Long initially (Fig. 8.8) when the A.S.I exceeds the A.S.I at the significant high Swing Point (A). The Index S.A.R is point (C) since this is a closer stop than the 60 point trailing Index S.A.R. When point (D) is formed, the Index S.A.R becomes point (D).

Figure 8.8 summary: This figure consists of two aligned time-series charts. The top chart displays daily price movements using a candlestick-style format, while the bottom chart illustrates the corresponding Adaptive Swing Index and a trailing stop-loss mechanism. The figure depicts the relationship between actual market prices and a technical indicator used for trade execution. It marks specific points for entering a long position when the trend shifts upward and reversing to a short position when the trend peaks and begins to decline. The lower chart shows the fluctuations of the indicator and a trailing stop line that follows the price action. It can be inferred that the indicator is designed to filter out minor price noise and identify major trend reversals. The alignment between the two charts demonstrates that the trailing index provides a systematic method for timing entries and exits, allowing a trader to capture a significant portion of an upward move before exiting as the trend reverses.

There is one more important rule which must be followed in order to cut down the whip-saws when the market stalls; if we are in a Long trade, as in the example, use the first low Swing Point after a new high Swing Point as the Index S.A.R. Then keep the Index S.A.R at this point until the A.S.I makes a new high. After the new high is made, then the first low Swing Point formed after the new high becomes the new Index S.A.R.

In figure 8.8, after the A.S.I made a new high at (E), the first low Swing Point was formed at (F). We moved the Index S.A.R to (F) as soon as this point was defined and left it there until the A.S.I made a new high at point (J) and then reacted to point (K). Notice that the 60 point trailing Index S.A.R levels out after every new high Swing Point is made because the trailing stop is always measured from the most favorable A.S.I point. The 60 point trailing Index S.A.R is always a Stop and Reverse.

Point (K) is the first low Swing Point after making a new high Swing Point. The A.S.I then moves up to (50), making a classic failure swing and then breaks below the Index S.A.R at (K) where we reverse and go Short. After going Short, the Index S.A.R is the previous high Swing Point at (50) because it is closer than the 60 point trailing Index S.A.R.

Now let's pick up the Short trade on figure 8.9. The A.S.I made a new low Swing Point at (A). The first high Swing Point after making the new low is point (B), which becomes the S.A.R. Now watch what happens here. The A.S.I drops to point (D) then forms the first high Swing Point at (E). The A.S.I then drops straight down to point (F) and reacts straight up. Since no swing points were formed between (E) and (F), the 60 point A.S.I trailing stop becomes the closest Index S.A.R. We reverse to Long at the trailing stop.

Figure 8.9 summary: This figure is a line chart representing price movements over time, incorporating technical analysis markers. The chart displays a series of price fluctuations with specific labels identifying trading signals such as short positions and reversals to long positions, alongside a trailing index stop and reverse indicator. The data shows a significant downward trend followed by a sharp recovery, with markers indicating the precise points where a trader would shift their market position from bearish to bullish. It can be inferred that the trailing index serves as a mechanism to lock in gains or limit losses, triggering a position reversal once the price action crosses the indicator threshold, thereby signaling a change in the overall market trend.

After making the new high for the trade at point (G), the first low Swing Point is (H) which remains the Index S.A.R until the A.S.I makes a new high Swing Point and then the first low Swing Point is formed. The Index S.A.R is then the first low Swing Point after the new high Swing Point is made.

I have explained this system by referring to low Swing Points and high Swing Points for simplicity. All of the swing points are made by the Accumulative Swing Index (A.S.I). In the following this system on the work sheet, I have used the abbreviation L.S.P for low Swing Point and H.S.P for high Swing Point. This abbreviation is put in the S.I column beside the swing index value for the day the L.S.P and H.S.P is made. Of course, the swing point cannot be determined until the next day after it occurs.

Now that you understand the concept of this system, there is one thing left to define; that is, the relationship of the H.S.P, L.S.P and the Index S.A.R (made by the Swing Index) to the actual H.I.P's and L.O.P's (made by the price). We have to know which price points correspond to H.S.P's and L.S.P's and Index S.A.R's in order to ascertain the exact market price to enter and exit the trade.

In effect, what we are really doing is trading the line which is made by connecting the Accumulative Swing Index points for each day. The Entry, Exit and Reverse signals do not come from price points directly; the signals come from the Swing Index points generated by the S.I equation.

Once the signal has been made by the A.S.I, it is then necessary to translate the signal points into price action points.

The price action points which correspond to the H.S.P's and L.S.P's on the Swing Index are the H.I.P's and L.O.P's (as previously defined) which are made by the daily prices.

Remember, a hip is a daily high price with a lower daily high price the day before it and the day after it. A lop is a daily low price with a higher daily low price the day before it and the day after it.

Usually the hip will occur on the same day as the H.S.P. In this case, the hip is the S.A.R and is simply the highest price made on that day. If the lowest price occurs on the same day as the L.S.P, then the lowest price made that day, the lop, is the S.A.R.

In figure 8.10, the H.S.P occurred on Day 5; however, the hip was made on Day 6. Although the price was higher on Day 6 than on Day 5, Day 6 will show up on the Swing Index as a minus (—) value . . . which it should . . . because it opened high, closed low, and also closed significantly lower than the previous day's close.

Figure 8.10 summary: This figure is a combined line graph and a series of vertical markers. The content illustrates the relationship between a fluctuating index, labeled as index HSP, and various points labeled as ASI and HIP across a sequence of numbered intervals. The line graph shows a peak and trough pattern, while the vertical markers indicate specific ranges or positions for each interval. It can be inferred that there is a correlation between the peaks of the index and the positioning of the HIP markers, suggesting that the index HSP reaches its maximum value when the HIP marker is at its highest relative position.

In figure 8.10, if we were Short, it is obvious that we would want to use the hip on Day 6 as our S.A.R rather than the High on Day 5 which corresponds with the H.S.P.

In figure 8.11, the lop is made on Day 6, but the L.S.P is made on Day 5. It is not unusual for the H.S.P and L.S.P to precede the hip and lop (made by the price) by one day.

Figure 8.11 summary: This figure is a combination plot featuring a line graph and a series of vertical error-like bars. The content illustrates the relationship between a sequence of indices and two different metrics, identified as ASI and INDEX LSP, while the vertical bars represent LOP across the same sequence. The line graph shows an initial upward trend that peaks and then dips before rising again, while the vertical bars generally shift upward in position as the index increases, though they vary in length. It can be inferred that as the index progresses, there is a general increase in the LOP values, and the ASI and INDEX LSP metrics exhibit a fluctuating but overall positive correlation with the index sequence.

In figure 8.11, if we were Long, we would want to use the lop made on Day 6 as our S.A.R even though the L.S.P occurred on Day 5.

As long as the hip made by the price occurs on the same day as the H.S.P, then both the hip and the H.S.P are recognized the next day after the high is made. However, suppose we are Short as in figure 8.10, and the market has closed on Day 6. The index H.S.P has formed, but we do not have a corresponding hip. What S.A.R do we give our broker for Day 7? The answer is that we give him the high price made on Day 6. We must assume that the H.S.P has preceded the hip by one day.

If we were Long, as in figure 8.11, the same reasoning would apply to the lop as shown. The S.A.R is the low price made on Day 6.

Now suppose our closest S.A.R is determined by the 60 point trailing Index S.A.R. Let's say that the market has closed and we calculate the A.S.I for the day and find that since the A.S.I high point was made, we have accumulated —65 points against the Long position as illustrated in figure 8.12. What do we do? We do not reverse on the open the next day. We use the lowest price made since we began counting the 60 point drop on the A.S.I as our S.A.R. As will usually be the case, the S.A.R is the low made today.

Figure 8.12 summary: This figure is a line chart combined with a series of vertical markers representing price action. The chart illustrates the movement of an asset over time, featuring a price trend line and a corresponding trailing stop line indicated by a series of dots. The figure highlights the gap between the current price level and the trailing stop level at a specific point in time. The visualization demonstrates how a trailing stop follows the upward movement of a price trend to protect gains, and concludes that a price drop below the trailing stop threshold triggers an exit, resulting in a specific point loss from the peak.

In using this system, I have found that many times the price will turn around the next day and go to new highs without going through the low made on the day that -60 or more points was calculated. Also, I refrain from placing my order the next day until about five minutes after the open, if the price action is near my order. The first and last five minutes of trading are the most likely times for meaningless wide swings to pick off a stop order. Personally, I just don't like to give them something to "shoot at" on the open if my order is near the price action. Sometimes I even change a regular "stop" order to a "Stop on Close Only" order about 15 minutes before the close if the market action is near my order.

On the following pages are the definitions and rules for the Swing Index System, which will be followed by a work sheet example and explanation.

Table summary: This table provides a glossary of definitions for technical trading terms, specifically detailing the components and calculations for the Accumulative Swing Index, high and low swing points, and the application of Stop and Reverse points for both the index and price, including trailing parameters.

Initial Entry

Index

Rules Swing Index System

A. Enter Long when the A.S.I crosses above the previous significant H.S.P.

B. Enter Short when the A.S.I crosses below the previous significant L.S.P.

Stop and Reverse (S.A.R)

A. Long: Immediately after being reversed to Long the S.A.R is the previous L.S.P

Thereafter, the S.A.R is the first L.S.P after a new H.S.P is made for the trade.

B. Short. Immediately after being reversed to Short, the S.A.R is the previous H.S.P.

Thereafter, the S.A.R is the first H.S.P after a new L.S.P is made for the trade.

Index

The S.A.R is the lowest daily low made between the highest H.S.P and the close of the day on which the A.S.I decreased 60 points or more.

B. Short: The S.A.R is the highest daily high made between the lowest L.S.P and the close of the day on which the A.S.I increased 60 points or more.

Note: The Rules are given in accordance with the Accumulative Swing Index only, and must be correlated with the Price Action Points as explained in the text.

Swing Index System — Work Sheet Example

Table summary: The table provides a chronological log of trading activity, detailing how specific indicator signals and price movements trigger entries, exits, and adjustments to stop-and-reverse levels over a period of several weeks.

Image summary: This figure is a combination line and scatter plot overlaid on a grid. The chart displays two distinct sets of data over a sequence of intervals, featuring a lower series of connected points with associated markers and an upper series of vertical lines with specific value labels. The lower data series shows an overall upward trend with significant fluctuations, reaching its peak in the middle of the sequence before declining and stabilizing. The upper data series exhibits higher values than the lower series and shows a general increase followed by a gradual decrease toward the end of the sequence.

Table summary: The table tracks daily stock price movements, including open, high, low, and close values, alongside various calculated absolute and relative differences. Over the observed period, the closing price shows an overall upward trend with significant volatility, peaking mid-period before experiencing several fluctuations and a partial decline toward the end.

If (1) largest col 10 equals negative one half times 2 plus one fourth times 4 if largest col 10 equals negative one half times one plus one fourth times four if largest col 10 equals plus one fourth times four Col 2 = limit Col 12 equals 50 times divided by times divided by Contract Month _ _ Day 42 The A.S.I at 296 goes above the previous H.S.P of 289. However, we do not take action until or if the A.S.I breaks the first upswing after the 257 low which is 310.

Table summary: The table presents a series of financial or trading records tracking various metrics across multiple columns, showing fluctuating values for several indicators. The data indicates a general upward trend in the ASI column over the first half of the entries before experiencing volatility and a subsequent decline in the latter portion of the records.

Day 45 The A.S.I made a new low for the trade of 254 on Day 43. The first upswing after the new low is confirmed on Day 45. The S.A.R is the hip on Day 44 of 52.50.

Day 46 We went Long at 52.55. The new S.A.R is the lop of 49.00 corresponding to the previous L.S.P made on Day 45.

This system performs best on those entities which are high on the Average Directional Movement Index Rating (A.D.X.R). One option that can be used with this system is to simply stop trading after two consecutive loss trades and then use the initial entry procedure for the next trade.

The following chart shows the system trading Cocoa for one full year.

Image summary: This figure consists of a data table and a corresponding line chart. The table lists trading activity for cocoa futures, including trade numbers, dates, positions, prices, and accumulated profit and loss. The chart displays the price movement of cocoa over several months, with markers indicating specific trade entries and exits. The data indicates that the swing system strategy resulted in a consistent increase in accumulated profits over time. The chart demonstrates that the trading strategy successfully captured upward price trends while utilizing a trailing stop to limit losses during volatile periods.

Image summary: This figure is a line chart with vertical error bars and annotated data points. The chart tracks a value over time, spanning from June through November, with specific dates and months marked on the horizontal axis and numerical values on the vertical axis. The data shows a consistent upward trend over the observed period, characterized by steady growth punctuated by occasional fluctuations. The final readings are significantly higher than the initial measurements, indicating a substantial overall increase in the measured variable over the several months.

Section 9

The Commodity Selection Index

From Section 3, we learned how to rate the commodities or stocks being followed as to which are the most Volatile.

In Section 4, we learned how to rate the same entities relative to their Directional Movement.

Volatility is also an indicator of movement. The paradox is that volatility is always accompanied by movement, but movement is not always accompanied by volatility. A commodity can move up very slowly and be high on the Average Directional Movement Index Rating (A.D.X.R) but still be low on the Volatility Index.

For this reason, the most important index to use for a trend-following system is the A.D.X.R; however, generally the most money is made in the shortest period of time when the stock or commodity is volatile. For those who don't like the risk associated with volatile markets, they should stay with the A.D.X.R and trade the commodities on the higher end of the scale which suit their inclinations and pocketbooks.

For those who have the capital and are looking for the best overall situation, then the Commodity Selection Index (C.S.I) equation takes in all of the following factors:

Directional Movement

Volatility

Margin Requirement

Commission costs

The factors are individually weighted in the order listed above. Here is the Commodity Selection Index Equation.

Math summary: This expression calculates the Commodity Selection Index by multiplying the average directional movement index rating by the fourteen day average true range. This result is then multiplied by a scaling factor derived from the ratio of the move value over the square root of the margin requirement, adjusted for commissions and scaled by one hundred.

Note: the result of the term 1 divided by the quantity 150 plus C must be carried to four decimal places Now let's look at an example. Suppose the factors for two commodities are as follows:

Table summary: The table compares trading parameters across different commodities, showing that soybeans have a higher average directional index and average true range compared to pork bellies, while pork bellies exhibit higher values for the C and V metrics.

Substituting in the equation for Soybeans:

Math summary: This computation calculates a specific index value by multiplying a quantity and a price by a scaling factor. The process divides a constant by the square root of a value, multiplies it by the inverse of a sum, and applies a final percentage multiplier to produce the result.

Substituting in the equation for Pork Bellies:

Math summary: This computation calculates a specific rating for pork bellies using a series of multiplications. It multiplies a base value by a scaling factor, then multiplies that result by the ratio of a constant to the square root of a value, a reciprocal of a combined sum, and a final multiplier of one hundred.

Therefore, Soybeans has the higher rating of the two.

Now let's look again at the C.S.I equation and point out a short cut that can be used:

All the values inside the brackets are constant as long as the margin requirement and the commission cost do not change. The 100 is also a constant.

The equation then, can be rewritten so that “K” represents all of the constants:

Math summary: This computation calculates the commodity stop index. It multiplies the average directional movement index, the average true range over fourteen periods, and a constant scaling factor to produce the final output.

We can therefore calculate “K” one time for each commodity being followed and use that value every day multiplied times the A.D.X.R and the A.T.R _{14} to obtain the C.S.I for that day. We only have to recalculate K when and if either the margin requirement changes or the commission rate changes.

In the previous C.S.I equation for Soybeans:

Math summary: This calculation determines the crop seed index by multiplying a base constant by a scaling factor. The process divides a fixed value by the square root of a total and then multiplies that result by the inverse of the sum of two specific constants.

Therefore, C.S.I For Bellies:

Therefore, C.S.I

Math summary: This process calculates a scaling factor by multiplying a ratio of a constant over a square root by a secondary ratio and a scaling constant. The final output is then computed by multiplying the average directional index and the average true range by this scaling factor.

The last three columns on the Directional Movement Index work sheet are entitled A.D.X.R, A.T.R _{14} and C.S.I. Just above the three columns is a space for K. The C.S.I can be calculated daily by using K and the values already obtained for the Directional Movement Index work sheet.

The A.D.X.R is the latest A.D.X plus the A.D.X 14 days ago, divided by 2, as explained in the section on Directional Movement.

The A.T.R 14 is the value in the A.T.R column divided by 14.

To obtain the C.S.I for each day, simply multiply A.D.X.R x A.T.R _{14} x K and insert the value in the C.S.I column.

Now let's look at an extreme example. Suppose Coffee is highest on the A.D.X.R at 70 and the Volatility Index shows that its Average True Range (A.T.R _{14} ) is 3.75.

At 375.00 for a 1¢ move, the average dollar movement per day is 3.75 times 375 = \1,406.25 . Sounds good so far, but if the margin requirement is 9,000 per contract and the commission is 85.00, then how does Coffee compare with trading Soybeans in the previous example? The factors are as follows:

Table summary: The data compares trading parameters for Soybeans and Coffee, showing that Coffee has higher values across all listed metrics, including the average true range, trend strength, and volume indicators, compared to Soybeans.

For Coffee:

Math summary: This computation calculates a cost stability index by multiplying a base value by a scaling factor and two ratios. The process takes the initial input, multiplies it by a constant and a weight derived from a square root, and then scales the result by a combined total to produce a final value.

The C.S.I for Soybeans was 348; therefore, Soybeans is the better overall deal. Now let's analyze the Soybean situation:

The Average True Range (A.T.R 14) is 15 phi times 50.00 equals 750 average dollar movement per day. This is only about half that of Coffee, and in addition, Soybeans has less directional movement than Coffee.

To give you an idea of what the C.S.I equation does, let's make two general suppositions; let's say that we traded both Coffee and Soybeans:

Suppose we got 70% of the move in Coffee since A.D.X.R for Coffee was 70, the same reasoning would give us 50% of the Soybean move.

Suppose we are in each trade for ten days, so that our money is tied up for the same period of time.

For Coffee:

For Soybeans:

Math summary: This computation calculates the total profit by multiplying a daily rate by the number of days and a percentage scaling factor. The process then subtracts a commission fee from that result to determine the final profit output.

However, due to the difference in margin requirement, we could have traded three contracts of Soybeans for each contract of Coffee; therefore, 3 times 3,705 equals 11,115.

The profit on Soybeans was The profit on Coffee was The Commodity Selection Index for Soybeans was 348 The Commodity Selection Index for Coffee was 318

Math summary: This calculation determines the percentage relationship between two commodity indices. It divides the first index value by the second index value to produce a result of nine percent.

The A.D.X.R indicated that Soybeans was a 9% better deal than Coffee. Actually, in the example Soybeans was a 13.9% better deal than Coffee.

11,115 dollars and 0 cents minus 9,758 dollars and 75 cents 1,356 dollars and 25 cents divided by 9,758 dollars and 75 cents equals 13.9 percent I realize that what we are dealing with here is not an exact science. The margin requirements will not be set, nor could they be set to maintain a constant relationship with volatility or directional movement, nor any other variable, for that matter. There is, however, a direct — though not constant — relationship between margin requirement, volatility and directional movement. The C.S.I equation constantly analyzes all of these factors and points out the most advantageous situations.

As a rule, margin requirements lag market action. They are slow to go up and slow to go down. The Commodity Selection Index also enables the trader to take advantage of this lag to obtain the best return on invested capital.

Most technical systems are trend-following systems; however, most commodities are in a good trending mode (high directional movement) only about 30% of the time. If the trader follows the same commodities or stocks all of the time, then his system has to be good enough to make more money 30% of the time than it will give back 70% of the time. Compare that approach to trading only the top five or six commodities on the C.S.I scale. This is the underlying concept ... the reason this book was written.

Section 10

Capital Management

The message of this book is that there are three parts to a good technical trading plan:

Using a good technical system.

Using the system on the right market (s) at the right time.

Using a good money management technique.

Of these three, the third is the most important, the easiest to learn ... and the hardest to do.

It is the hardest to do because at one time or another, most of us have put all our marbles in one basket, timed it just right, and made a tremendous profit. When this happens, the results are usually two-fold. One, it boosts our ego and confidence to the point that we think we can do it at least one more time; second, the profit was made so quickly that we don't consider it in the same light as if it took us several years to earn it.

One of the smartest businessmen I know started out with a horse, a homemade sawmill and a fourth grade education. Over the years, he became a multimillionaire, dealing in land and timber. He made a statement that I have never forgotten.

He said, "Boys, when you really make a big profit fast, you have got to get used to having it. Don't do anything with it for six months. By that time, you will be used to having it and you will treat it prudently."

This man had learned something that many of us never learn.

I can sum up my concept of money management in two sentences:

Don't margin more than 15% of total capital on any one commodity.

Don't margin more than 60% of total capital at any one time.

These are the limits. I prefer to trade the six top commodities on the C.S.I scale with not over 10% of total capital on any one commodity. I use this criteria on my own account and on the accounts which I manage.

There is one more concept I would like to leave with you. This is not new — it was old when the Phoenicians were trading with the Romans and the Greek Philosophers cornered the olive oil market. The concept is this . . .

The percent gain it takes to recover a loss increases geometrically with the loss. For example, if we lose 15% of our capital, we have to make 17.6% gain on the balance to get even. However, if we lose 30% of our capital, it will take 42.9% gain on the balance we have left to get even; and if we lose 50% of our capital, it will take 100% gain on the balance to get even.

This concept is set out in the little table which follows. I have a copy of this table posted on the wall near my desk as a reminder of the importance of capital management.

Table summary: As the percentage of initial capital loss increases, the gain required to recover those losses grows at an accelerating rate, demonstrating that larger losses necessitate disproportionately larger gains to return to the original balance.

Conclusion

At the beginning of this book, I made the statement that I had never seen a technical trading system that consistently makes profits in all markets. Trend-following systems can make consistent profits in a directional market and consistent losses in a non-directional market. The answer, therefore, is to discover a way to define directional movement and translate this definition to a rating scale within known parameters.

The Directional Movement Index (Average Directional Movement Index Rating A.D.X.R) is my answer to this problem. The A.D.X.R may not be the best answer, nor may it be the final answer; but to my knowledge, it is the first truly definitive answer.

Several times in the past, I have come to the conclusion after perfecting and testing a system that it was the 'ultimate' method. I would decide to stop searching and researching and be content to just trade the system . . . and then . . . as I did this morning, I will awake about 3 o'clock a.m., with another new concept to explore. It seems to be a never-ending search.

Perhaps if the early morning Revelations continue, someday there will be new Concepts in Technical Trading Systems — Book 2.

Good luck and good trading.

Glossary of Terms and Abbreviations

- A.B.S Absolute value A.D.X Average Directional Movement Index A.D.X.R Average Directional Movement Index Rating A.F Acceleration Factor arc Average Range times Constant A.T.R Average True Range B 1 Buy Point C Close C.S.I Commodity Selection Index diff Difference between two prices +D.I₁ up directional indicator for one day -D.I₁ down directional indicator for one day +D.I₁₄ Sum of +D.I₁ for 14 days -D.I₁₄ Sum of -D.I₁ for 14 days +D.M₁ up directional movement for one day -D.M₁ down directional movement for one day +D.M₁₄ Sum of +D.M₁ for 14 days -D.M₁₄ Sum of -D.M₁ for 14 days D.X Directional Movement Index E.P Extreme Price H High H.B.O.P High Break Out Point hip High Point hi sip Significant High Point H.S.P High Swing Point K Constant L Low L.B.O.P Low Break Out Point lop Low Point lo sip Significant Low Point L.S.P Low Swing Point M.F Momentum Factor O Open R.S Relative Strength R.S.I Relative Strength Index S₁ Sell Point S.A.R Stop and Reverse Point S.I Swing Index sic Significant Close sip Significant Point T.B.P Trend Balance Point T.R₁ Today's True Range T.R₁₄ Sum of T.R₁ for 14 days V.I Volatility Index X Average of the High, Low and Close Price for all

Table summary: The provided table contains headers for financial tracking data, including price movements and technical indicators, but contains no data entries to analyze.

Table summary: The table is empty and contains no data regarding entries, exits, profit and loss, or order actions.

Table summary: The table provides a structured log of daily financial market data, tracking price movements and technical indicators to determine specific trading actions and orders.

Contract Month Commodity _ _ Contract Month _ _ K _ _ |f | largest col 10 equals minus one half plus one fourth |f | largest col 10 equals minus one half plus one fourth |f | largest col 10 equals plus one fourth times four Col 11 = limit Col 12 equals 50 times divided by times divided by Contract Month _ _

Table summary: The table provides a structural framework for calculating the Relative Strength Index, outlining the sequential steps to derive the index from closing prices, including the determination of average gains and losses.

Table summary: The provided table contains headers for financial and technical analysis indicators, including date, price points, and directional movement indices, but contains no data.

Table summary: The table contains headers for various technical analysis indicators and trading actions, but it contains no data.

Table summary: The provided table contains a header for the Trend Balance Point system with columns for date, price movements, and various technical indicators, but it contains no data.

Table summary: The provided table contains structural headers for trading parameters such as targets, stops, and entry and exit points, but it contains no data values to analyze.

Table summary: The provided table contains a structural framework for a reaction trend system, outlining headers for price data and technical indicators, but it contains no numerical data to analyze.

Table summary: The provided table is empty and contains no data regarding entries, exits, profit and loss, or actions and orders.

Table summary: The table provides a framework for tracking daily price movements, including open, high, low, and close values, along with various calculated absolute and relative differences between these price points.

Table summary: The provided table contains column headers for various categories and actions but contains no data in the rows.

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