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msg #48340
Ignore TheRumpledOne
12/2/2006 7:31:04 PM

Homework Perspectives for the week ending December 1, 2006

Each week in this newsletter I discuss some aspect of trading. How to read charts, the psychological side of trading, the importance of managing risk; if you have been reading Perspectives for long enough you will have seen me repeat a number of basic principles over and over in the commentary. This week, I want you to do some work. It is time to see the value of the analytical concepts that form the Stockscores Approach.

Here is what I want you to do. Print out the one year charts of 10 stocks, any 10 stocks. I only ask that the stocks you choose be fairly actively traded, don't pick stocks that trade by appointment. You will get more out of this if you choose some stocks that have made some sort of trend, either up or down, in the last year.

Here are your instructions:

First, circle the five trading days in the last year that had the most noticeably higher trading volumes than the days prior. Look for the big spikes up in volume.

Now, we are going to eliminate some of these days. Here is what to do next:

If the stock was up on the day of the big volume spike, draw a line across the tops of the chart leading in to that day. If the move to the upside does not break through the line, cross that day out.

If the stock was down on the day of the big volume spike, draw a line across the bottoms of the price chart leading in to that day. If the move to the downside does not break through the line, cross the day out.

For the days that remain, look at the price activity before the big volume day. If the stock had not been trading sideways for at least a week, cross out the day.

Now, consider the chart like a photograph of some mountains. Draw a horizontal line across the top of each peak, spanning the width of the whole page. Draw a horizontal line across the bottom of each valley.

Let's do an example together by printing out a chart of T.SXR. The best way to print out the chart is to first bring it up on Stockscores in large chart view, make sure you set it as a one year chart and then click on the Print Chart link below the chart. This will bring the chart up in a separate window. Then, right click on the chart with your mouse and select Print.

With your printed chart, circle the high volume days, remember this is relative to what was before it. I circled the following:

Day 1 - about March 3
Day 2 - last week of March
Day 3 - middle of June
Day 4 - third week of August
Day 5 - third week of October

Since Day 1 was a down day, I draw a line across the bottoms leading in to that down day. Since the down day broke through the line and the stock had been trading sideways in the day prior to Day 1, I keep it circled.

Day 2 was an up day so I draw a line across the tops leading in to the up day and find that it breaks through the line on Day 2 and the stock was sideways in the days prior. Day 2 stays.

Day 3 was an up day, so I draw a line sloping downward from the peak early in May, across the peak at the start of June. The stock did not break through this line, so I cross out Day 3.

Day 4 is virtually the same, the line should be drawn from the peak at the first week in July and cutting across the very small peak in the third week of July. The line was not broken so we cross out Day 4.

Day 5 stays because the stock break through the line drawn across the tops from early in July and early in September. It was also trading sideways prior to the abnormal day.

Now, I have to draw my horizontal lines at the peaks and valleys and carry them to the right of the peak, forward in time. The peaks that stand out are the one at the first week of February, the early part of May, the end of May, the middle of July, the start of September and the last week of November.

The valleys that stand out are the middle of February, the start of March, the middle of May, the middle of June, the middle of August and the first week of October.

Here is what should stand out:

Day 1 was a false signal. We would expect the stock to go down from here and it did not.
Day 2 was a good buy signal. We would expect the stock to up from here and it did.
Day 5 was a good buy signal. We would expect the stock to up from here and it did.

Believe it or not, this exercise encapsulates almost all that you need to know about technical analysis.

The first step was looking for abnormal activity. Abnormal activity is the first clue that the market is trading on significant new information that can drive a trend. The Stockscores Approach focuses on abnormal activity.

The second step was a very basic way to look for good chart patterns. If the stock was not breaking through support or resistance it was not worth considering. Notice that Day 3 and Day 4, the days that we crossed out, did not lead to good trends.

The drawing of horizontal lines at the peaks and valleys shows how the market has memory. Notice how often stocks stall when they come up to a line of resistance at a previous peak. The same happens when they fall to a floor price. How many times did this stock bounce off the floor at $7.50?

Now, try this on other stocks, do at least 10. It will not work all of the time but the more times you do it the more you will see how well this simple exercise really does work for predicting share price change. Some charts will have no valid days, be sure to rule out days if they do not meet the criteria of the rules.

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