Joe Ross' Spread Scan Newsletter

Joe's Trading Tidbit

TRADE WHAT YOU SEE

I am a firm believer in trading what you see, and not what you think. The two must be divorced.

Trading what you see can be applied to every aspect of trading, even classical technical analysis. I was taught classical analysis at the beginning of my career.
I still use it when I have the time to do the work.

Years ago I taught the following lesson to some of my students:

Notice the weekly wheat chart. Wheat had been in a long term downtrend
when I came across a beautiful case of classical technical analysis.

The situation I'm referring to occurred in the December 1991 Wheat contract.

It involved what has come to be known as a "Head-and-Shoulders" formation, along with a second formation known as a "Megaphone Top," (Lines: AB and CD.

The combination of these two technical patterns suggested that the price of wheat would see a significant downside erosion before bottoming out.

The head-and-shoulders reversal formation is perhaps the most well-known of all technical patterns. Though usually found at the end of major up or down trends, it also can occur at the end of medium-term trends.

A head-and-shoulders bottom is a graphic representation of accumulation by investors, while a head-and-shoulders top is a graphic representation of distribution by investors. Since I will be discussing the head-and-shoulders top on the wheat chart, I will limit my remarks to the mechanics of the head-and-shoulders top.

First, an extensive rally ends on heavy volume as investors take profits in what they consider to be an overvalued situation. The decline is halted at the low of what will be the end of the left shoulder, prior to rising to the top. At this point, volume drops off and buyers enter to take advantage of the perceived bargain opportunity.

Next, demand is sufficient to take prices to new highs at the top of the head of the head-and-shoulders formation. However, typically this advance will take place on less volume than the advance that created the top of the left shoulder.

Looking at price alone, you would see no indication that the trend is over, but the alert trader will have noticed the decline in volume on the rally to the top of the head.

Next, profit takers sell into the strength of the rally to the top of the head, pushing prices back down to what is to become the base for the rise to the top of the right shoulder. Prices may even descend to break the support line from the rise to the previous high.

Then the remaining bulls step in again to push up to the top of the right shoulder. Usually volume is thin compared with the previous rallies.

Finally, one last sell-off follows on very heavy volume, pushing price down through the neckline. The neckline is a trend line drawn to connect the low at the end of the left shoulder to the low at the beginning of the right shoulder.

Estimating The Fall

The question becomes, "How far will prices fall?"

The way I was taught to figure this from the head-and-shoulders formation, is to measure the distance from the top of the head straight down to the neckline. This distance is the amount that prices are supposed to move downward from the point at which prices penetrate the neckline to the downside. I've shown this objective on the chart. Note that time is not a factor here. It is not known how long prices will take to make their plunge.

Megaphone Tops

A megaphone top is also known as a broadening top. Similar to the head-and-shoulders, it consists of five stages. The broadening top in wheat occurred as part of the right shoulder. It, too, is found at the end of a major advance.

Trader's perceptions of value continually fluctuate in response to rumors and unexpected news releases.

This uncertainty causes prices to move from a low to new highs.

Shortly, prices move back to new lows, only to be followed by new highs. The final push to new highs warns the trader to prepare for a strong sell-off, which will take prices to new lows and complete the megaphone top.

In the case of December wheat, the highs tended to be rather flat, but the lows were continually lower.

On the chart, I've labeled the top of the megaphone A-B, and the bottom, C-D.

Once the trader has seen the five stages take place, i.e. the swings from low to high and back again, he determines the objective of the megaphone top by measuring the distance from the highest high of the megaphone, straight down to the point at which prices break through the lower line of the megaphone. This distance is then marked downward from the point of the breakthrough. I've shown this as the Megaphone Top Objective.

Those objectives were based upon what, until that point, could be been seen on the chart. Calling those objectives was an example of trading what you see.

As you can see, prices went directly down to the objective area and then bounced.

“How Much Lower?”

The downside objectives of both the head-and-shoulders top and the megaphone top, based on the methods previously described, are shown on the chart. On July 8, 1991, the December wheat contract set a low that was between the two objectives.