Getting Started in Technical Analysis (Jack D. Schwager, 1999)

Charts

1. 1. Charts provide a concise price history—an essential item of information for any trader. 
2. Charts can provide the trader with a good sense of the market's volatility—an important consideration in assessing risk. 
3. Charts are a very useful tool to the fundamental analyst. Long­term price charts enable the fundamentalist to isolate quickly the periods of major price moves. By determining the fundamental conditions or events that were peculiar to those periods, the fundamentalist can identify the key price­influencing factors. This information can then be used to construct a price behavior model. 
4. Charts can be used as a timing tool, even by traders who formulate their trading decisions on the basis of other information (e.g., fundamentals).
5. Charts can be used as a money management tool by helping to define meaningful and realistic stop points. 
6. Charts reflect market behavior that is subject to certain repetitive patterns. Given sufficient experience, some traders will uncover an innate ability to use charts successfully as a method of anticipating price moves. 
7. An understanding of chart concepts is probably an essential prerequisite for developing profitable technical trading systems. 
8. Cynics take notice: Under specific circumstances, a contrarian approach to classical chart signals can lead to very profitable trading opportunities.

Conventional Trend Lines

Spike High

1. A wide difference between the spike high and the highs of the preceding and succeeding days.
2. A close near the low of the day's range.
3. A substantive price advance preceding the spike's formation.

Spike Low

1. A wide difference between the lows of the preceding and succeeding days and the spike low. 
2. A close near the high of the day's range. 
3. A substantive price decline preceding the spike's formation.

Rules

Entering trades

1. Differentiate between major position trades and short­term trades. The average risk allocated to short­term trades (as implied by the number of shares or contracts in the position and the stop point) should be significantly smaller. Also, the speculator should focus on major position trades, since these are usually far more critical to trading success. A mistake made by many traders is that they become so involved in trying to catch the minor market swings (generating lots of commissions and slippage in the process) that they miss the major price moves. 
2. If you believe a major trading opportunity exists, don't be greedy in trying to get a slightly better entry price. The lost profit potential of one missed price move can offset the savings from 50 slightly better execution prices. 
3. Entry into any major position should be planned and carefully thought out—never an intraday impulse. 
4.  Find a chart pattern that says the timing is right—now. Don't initiate a trade without such a confirming pattern. (Occasionally, one might consider a trade without such a pattern if there is a convergence of many measured moves and support/resistance points at a given price area and there is a well­defined stop point that does not imply much risk.) 
5. Place orders determined by daily analysis. If the market is not close to the desired entry level, record the trade idea and review it each day until either the trade is entered or the trade idea is no longer deemed attractive. Failure to adhere to this rule can result in missing good trades. One common occurrence is that a trade idea is recalled once the market has moved beyond the intended entry, and it is then difficult to do the same trade at a worse price. 
6. When looking for a major reversal in a trend, it is usually wiser to wait for some pattern that suggests that the timing is right rather than fading the trend at projected objectives and support/resistance points. This rule is particularly important in the case of a market in which the trend has carried prices to longterm highs or lows (e.g., highs or lows beyond a prior 100­day range). Remember, in most cases of an extended trend, the market will not form V­type reversals. Instead, prices will normally pull back to test highs and lows—often a number of times. Thus, waiting for a top or bottom to form can prevent getting chopped to pieces during the topping or bottoming process—not to mention the losses that can occur if you are highly premature in picking the top or bottom. Even if the market does form a major V top or V bottom, subsequent consolidations (e.g., flags) can allow favorable reward/risk entries. 
7. If you have an immediate instinctive impression when looking at a chart (particularly if you are not conscious about which market you are looking at), go with that feeling. 
8. Don't let the fact that you missed the first major portion of a new trend keep you from trading with that trend (as long as you can define a reasonable stoploss point). 
9. Don't fade recent price failure patterns (e.g., bull or bear traps) when implementing trades, even if there are many other reasons for the trade. 
10. Never fade the first gap of a price move! For example, if you are waiting to enter a trade on a correction, and the correction is then formed on a price gap, don't enter the trade. 
11. In most cases, use market orders rather than limit orders. This is especially important when liquidating a losing position or entering a perceived major trading opportunity—situations in which traders are apt to be greatly concerned about the market getting away from them. Although limit orders will provide slightly better fills for a large majority of trades, this benefit will usually be more than offset by the substantially poorer fills, or missed profit potential, in those cases in which the initial limit order is not filled. 
12. Never double up near the original trade entry point after having been ahead. Often, the fact that the market has completely re­traced is a negative sign for the trade. Even if the trade is still good, doubling up in this manner will jeopardize holding power due to overtrading.
    
    Exiting Trades and Risk Control (Money Management)
    
    
13. Decide on a specific protective stop point at the time of trade entry. 
14. Exit any trade if newly developing patterns or market action are contrary to trade—even if stop point has not been reached. Ask yourself, "If I had to have a position in this market, which way would it be?" If the answer is not the position you hold, get out! In fact, if contradictory indications are strong enough, reverse the position. 
15. Always get out immediately once the original premise for a trade is violated. 
16. If you are dramatically wrong the first day a trade is on, abandon the trade immediately—especially if the market gaps against you. 
17. In the event of a major breakout counter to the position held, either liquidate immediately or use a very close stop. In the event of a gap breakout, always liquidate immediately. 
18. If a given stock or futures market suddenly trades far in excess of its recent volatility in a direction opposite to the position held, liquidate your position immediately. For example, if a market that has been trading in approximate 50­point daily ranges opens 100 to 150 points higher, cover immediately if you are short. 
19. If selling into resistance or buying into support and the market consolidates instead of reversing, get out. 
20. For analysts and market advisers: If your gut feeling is that a recent recommendation, hot line broadcast, trade, or written report of yours is wrong, reverse your opinion! 
21. If you're unable to watch markets for a period of time (e.g., when traveling), either liquidate all positions or be sure to have GTC stop orders on all open positions. (Also, in such situations, limit orders can be used to ensure getting into the market on planned buys at lower prices or planned sells at higher prices.)
22. Do not get complacent about an open position. Always know where you are getting out even if the point is far removed from the current price. Also, an evolving pattern contrary to the trade may suggest the desirability of an earlier­than­intended exit. 
23. Fight the desire to immediately get back into the market following a stopped­out trade. Getting back in will usually supplement the original loss with additional losses. The only reason to get back in on a stopped­out trade is if the timing seems appropriate based on evolving price patterns—that is, only if all the conditions and justifications of any new trade are met.
    
    Other Risk­Control (Money Management) Rules
    
    
24. . When trading is going badly: (a) reduce position size (keep in mind that positions in strongly correlated markets are similar to one larger position); (b) use tight stop­loss points; (c) slow up in taking new trades. 
25. When trading is going badly, reduce risk exposure by liquidating losing trades, not winning trades. This observation was memorably related by Edwin Lefèvre in Reminiscences of a Stock Operator: "I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit." 
26. Be extremely careful not to change trading patterns after making a profit:
1. Do not initiate any trades that would have been deemed too risky at the start of the trading program. 
2. Do not suddenly increase the number of shares or contracts in a typical trade. (However, a gradual increase as equity grows is okay.)
27. Treat small positions with the same common sense as large positions. Never say, "It's only 50 shares," or "It's only one or two contracts." 
28. Avoid holding very large positions into major reports or the release of important government statistics.
29. Futures traders: Apply the same money management principles to spreads as to outright positions. It is easy to be lulled into thinking that spreads move gradually enough so that it is not necessary to worry about stop­loss protection. 
30. Don't buy options without planning at what outright price the trade is to be liquidated.
    
    Holding and Exiting Winning Trades
    
    
31. Do not take small, quick profits in major position trades. In particular, if you are dramatically right on a trade, never, never take profits on the first day. 
32. Don't be too hasty to get out of a trade with a gap in your direction. Use the gap as initial stop; then bring in stop in trailing fashion. 
33. Try to use trailing stops, supplemented by developing market action, instead of objectives as a means of getting out of profitable trades. Using objectives will often work against fully realizing the potential of major trends. Remember, you need the occasional big winners to offset losers.
34. The preceding rule notwithstanding, it is still useful to set an initial objective at the time of trade entry to allow the application of the following rule: If a very large portion of an objective is realized very quickly (e.g., 50–60% in one week or 75–80% in two or three weeks), take partial profits, with the idea of reinstating liquidated shares or contracts on a reaction. The idea is that it is okay to take a quick sizable profit. Although this rule may often result in missing the remainder of the move on the liquidated portion of the position, holding the entire position, in such a case, can frequently lead to nervous liquidation on the first sharp retracement. 
35. If an objective is reached, but you still like the trade, stay with it using a trailing stop. This rule is important in order to be able to ride a major trend. Remember, patience is important not only in waiting for the right trades, but also in staying with trades that are working. The failure to adequately profit from correct trades is a key profit­limiting factor. 
36. One partial exception to the previous rule is that if you are heavily positioned and equity is surging straight up, consider taking scale­up profits. Corollary rule: When things look too good to be true—watch out! If everything is going right, it is probably a good time to begin taking scale­up (or scale­down) profits and using close trailing stops on a portion of your positions. 
37. If taking profits on a trade that is believed to still have long­term potential (but is presumably vulnerable to a near­term correction), have a game plan for reentering position. If the market doesn't retrace sufficiently to allow for reentry, be cognizant of patterns that can be used for timing a reentry. Don't let the fact that the reentry point would be worse than the exit point keep you from getting back into a trade in which the perception of both the long­term trend and current timing suggest reentering. Inability to enter at a worse price can often lead to missing major portions of large trends. 
38. If trading larger positions, avoid the emotional trap of wanting to be 100% right. In other words, take only partial profits. Always try to keep at least a partial position for the duration of the move—until the market forms a convincing reversal pattern or reaches a meaningful stop­loss point.
    
    Miscellaneous Principles and Rules
    
    
39. Always pay more attention to market action and evolving patterns than to objectives and support/resistance areas. The latter can often cause you to reverse a correct market bias very prematurely. 
40. When you feel action should be taken either entering or exiting a position—act, don't procrastinate. 
41. Never go counter to your own opinion of the long­term trend of the market. In other words, don't try to dance between the raindrops. 
42. Winning trades tend to be ahead right from the start. 
43. Correct timing of entry and exit (e.g., timing entry on a reliable pattern, getting out immediately on the first sign of trade failure) can often keep a loss small even if the trade is dead wrong. 
44. Intraday decisions are almost always losers. Keep screen off intraday. 
45. Be sure to check markets before the close on Friday. Often the situation is clearer at the end of the week. In such cases, a better entry or exit can usually be obtained on Friday near the close than on the following Monday opening. This rule is particularly important if you are holding a significant position. 
46. Act on market dreams (that are recalled unambiguously). Such dreams are often right because they represent your subconscious market knowledge attempting to break through the barriers established by the conscious mind (e.g., "How can I buy here when I could have gone long $2,000 lower last week?") 
47. You are never immune to bad trading habits—the best you can do is to keep them latent. As soon as you get lazy or sloppy, they will return.
    
    Market Patterns
    
    
48. If the market sets new historical highs and holds, the odds strongly favor a move very far beyond the old highs. Selling a market at new record highs is probably one of the amateur trader's worst mistakes. 
49. Narrow market consolidations near the upper end of broader trading ranges are bullish patterns. Similarly, narrow consolidations near the low end of trading ranges are bearish.
50. Play the breakout from an extended, narrow range with a stop against the other side of the range. 
51. Breakouts from trading ranges that hold for one to two weeks, or longer, are among the most reliable technical indicators of impending trends. 
52. A common and particularly useful form of the above rule is: Flags or pennants forming right above or below prior extended and broad trading ranges tend to be fairly reliable continuation patterns. 
53. Trade in the direction of wide gaps. 
54. Gaps out of congestion patterns, particularly one­to­two­month trading ranges, are often excellent signals. (This pattern works especially well in bear markets.) 
55. If a "breakaway gap" is not filled during the first week, it should be viewed as a particularly reliable signal. 
56. A breakout to new highs or lows followed within the next week or two by a gap (particularly a wide gap) back into the range is a particularly reliable form of a bull trap or bear trap.
57. If the market breaks out to a new high or low and then pulls back to form a flag or pennant in the prebreakout trading range, assume that a top or bottom is in place. A position can be taken using a protective stop beyond the flag or pennant consolidation. 
58. A breakout from a trading range followed by a pullback deep into the range (e.g., three­quarters of the way back into the range or more) is yet another significant bull or bear trap formation. 
59. If an apparent V bottom is followed by a nearby congestion pattern, it may represent a bottom pattern. However, if this consolidation is then broken on the downside and the V bottom is approached, the market action can be read as a sign of an impending move to new lows. In the latter case, short positions could be implemented using protective stops near the top of the consolidation. Analogous comments would apply to V tops followed by nearby consolidations. 
60. V tops and V bottoms followed by multimonth consolidations that form in close proximity to the reversal point tend to be major top or bottom formations. 
61. Tight flag and pennant consolidations tend to be reliable continuation patterns and allow entry into an existing trend, with a reasonably close, yet meaningful, stop point. 
62. If a tight flag or pennant consolidation leads to a breakout in the wrong direction (i.e., a reversal instead of a continuation), expect the move to continue in the direction of the breakout. 
63. Curved consolidations tend to suggest an accelerated move in the direction of the curve. 
64. The breaking of a short­term curved consolidation (see Chapter 11) in the direction opposite of the curve pathway tends to be a good trend reversal signal. 
65. Wide­ranging days (i.e., days with a range far exceeding the recent average range) with a close counter to the main trend usually tend to provide a reliable early signal of a trend change—particularly if they also trigger a reversal signal (e.g., filling of a runaway gap, complete penetration of prior consolidation). 
66. Near­vertical, large price moves over a period of two to four days (coming off a relative high or low) tend to be extended in the following weeks.
67. Spikes are good short­term reversal signals. The extreme of the spike can be used as a stop point. 
68. In spike situations, look at chart both ways—with and without spike. For example, if when a spike is removed a flag is evident, a penetration of that flag is a meaningful signal. 
69. The filling­in of a runaway gap can be viewed as evidence of a possible trend reversal.
70. An island reversal followed shortly thereafter with a pullback into the most recent trading range or consolidation pattern represents a possible major top (or bottom) signal.
71. The ability of a stock or future to hold relatively firm when other related markets are under significant pressure can be viewed as a sign of intrinsic strength. Similarly, a market acting weak when related markets are strong can be viewed as a bearish sign. 
72. If a market trades consistently higher for most of the daily trading session, anticipate a close in the same direction. 
73. Two successive flags with little separation can be viewed as a probable continuation pattern. 
74. View a curved bottom, followed by a shallower, same­direction curved consolidation near the top of this pattern, as a bullish formation ("cup­and­handle"). A similar pattern would apply to market tops. 
75. Moderate sentiment in a market that is strongly trending may be a more reliable indicator of a probable continuation of the price move than a high or low sentiment reading is of a reversal. In other words, extreme sentiment readings can often occur in the absence of major tops and bottoms, but major tops and bottoms rarely occur in the absence of extreme sentiment readings (current or recent). 
76. A failed signal is more reliable than the original signal. Go the other way, using the high (or low) before the failed signal as a stop. Some examples of such failure patterns are rule numbers 56, 57, 58, 62, 64, and 69. 
77. The failure of a market to follow through on significant bullish or bearish news (e.g., an important earnings reporter or a major U.S. Department of Agriculture report) is often a harbinger of an imminent trend reversal. Pay particular attention to such a development if you have an existing position.
    
    Analysis and Review
    
    
78. Review charts every day—especially if you're too busy.
79. Periodically review long­term charts (e.g., every two to four weeks). 
80. Religiously maintain a trader's diary, including a chart for each trade taken and noting the following: reasons for trade; intended stop and objective (if any); follow up at a later point indicating how the trade turned out; observations and lessons (mistakes, things done right, or noteworthy patterns); and net profit or loss. It is important that the trade sheet be filled out when the trade is entered so that the reasons for the trade accurately reflect your actual thinking rather than a reconstruction. 
81. Maintain a patterns chart book whenever you notice a market pattern that is interesting and you want to note how you think it will turn out, or you want to record how that pattern is eventually resolved (in the case where you don't have any bias concerning the correct interpretation). Be sure to follow each chart up at a later date to see the actual outcome. Over time, this process may improve skills in chart interpretation by providing some statistical evidence of the forecasting reliability of various chart patterns (as recognized in real time). 
82. Review and update trading rules, trader's diary, and patterns chart book on a regular schedule (e.g., three­month rotation for the three items). Of course, any of these items can be reviewed more frequently, whenever it is felt such a review would be useful.