The Law of Charts

At Trading Educators we only use Price and Volume Charts to identify high probability trades. The Law of Charts™ describes only four chart formations on the price charts which present trading opportunities, then specifies entry and exit targets based upon those four chart formations. In the following we will present you these four major chart formations and how to trade them.

Please note: The Law of Charts™ is not a trading method, nor is it a trading system. It serves to identify the chart formations that form as a result of human behavior in the markets. These chart formations give the trader an indication of when, at what price target, and how (long or short) to enter the market.

The Laws of Charts

1-2-3 HIGHS AND LOWS

The Breakout of a 1-2-3 High Or Low

Let's illustrate what a 1-2-3 is:



Sell a breakout of the # 2 point of a 1-2-3 high

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Buy a breakout of the # 2 point of a 1-2-3 low

 

The next price bar makes an unusual close. We must do all we can to protect profits. There is apt to be further correction on the next price bar.

We protect profits by moving our stop one tick above the high of any bar that closes very close to the high when we feel that prices should be continuing to move down.

 

 

The correction comes intraday, creating an intraday hook situation. Day traders may have been able to scalp a few ticks of profit here.

Day traders may have been able to profit by selling under the low of the previous day. Any day trader at any time should consider a breakout of the low of the previous day a strong reason to sell short.

 

 

The correction by prices on the last bar shown gives us another Rh.

 

 

As prices correct, we try to sell a breakout of the low of the correcting bar.

The following comments apply to the chart above and the one below. We may want to put on our entire position but we have only two opportunities. It may be best to put on 2/3 of the position at the higher of the two entry points, and only 1/3 at the hook, if we are given the choice. Once prices start back down, we try for 2/3 immediately. If we still cannot get our position on, then we will have to place the entire position on at the hook. You may recall in a similar situation we looked at the 3x3 moving average of the close and considered it a filter for the trade because the 3x3 was running through a five bar consolidation. In this instance, the 3x3 moving average was still displaying containment of the downtrend.

 

 

A trade at the low is missed because of the gap opening. We then try to sell a breakout of the next low, as well as the Rh.

 

 

Our position is filled at both entry points.

The following comments apply to the chart above and the chart below: As we take profits out of the market, we come to a point where we have accumulated sufficient profits that if we wish to risk those profits, we can begin to keep our stop further away from the price action.

If we don’t want to take additional risk, then it’s best to trail a 50% stop as the market moves down, and pull stops even tighter on reversal bars, or any indication that something is amiss.

 

 

Because of the reversal bar, we tighten stops. We don’t want a win to turn into a loss.

 

 

Another intraday correction gives day traders an opportunity to sell short.

 

 

All traders can jump in front of the market and get filled as the low is taken out.

 

 

Prices break nicely to the downside.

 

 

The downtrend is fully intact. If we are willing to take more risk, we can allow our stop to lag further back.

 

 

Here we see the value in keeping our trailing stop a bit further away, once we have established acceptable profits.

 

 

In any case, we would place a sell stop below the Rh and the next correction bar, in effect opting for the Trader’s Trick.

 

 

We now have three possible selling points. Whenever we get 3 bars of correction, we move our lagging stop (if we have one) to one tick above the high of the third correction bar. This is because, if we were to get more than three correcting bars, we would have to assume that the trend is at least temporarily over, and prices may now move higher, or at the very least move into a congestion phase.

 

 

The gap open misses our highest entry point. Because it does, it would cause us to try to fill 2/3rds of our position on a breakout of the low of the gap down bar.

 

 

Once again the entry point was missed on the gap opening. We will try again for entry on the next price bar.

 

 

This bar brings a fill near the close.

 

 

At this point our entire position should be in place.

 

 

We do not need a sell order below the Rh if our entire position is in place.

Note with regard to the last four charts: An adequate trailing stop would have kept us in the market throughout the four days show on these charts. We would have been able to build a position by adding contracts.

But keep in mind that adding contracts also adds all new risk. Furthermore, the risk which is incurred may be greater in nature than the risk originally accepted. Why? Because each time we add to our position, we are closer in time to the end of the move being made.

The method of trade management that we have been showing you in this entire series of charts is here is to demonstrate to you an alternative method of trade management. It is up to the trader to decide how to manage his/her own positions. In our minds there are two basic approaches, both of which may be acceptable to some.

The first is that of putting on the entire position upon the initial entry and then liquidating portions of that position to cover costs, take a small profit, and finally to ride the trade as far as it will go with what remains of the position after partial liquidation.

The converse of this method is to build the position by entering a portion of it to test the waters. If the initial portion becomes profitable, you then add to the position by adding contractss in stages until you have put on the entire position.

Much of any acceptability depends upon your personal comfort level in handling risk, and your financial capacity for handling risk.

We’ll look at two more charts now. In actuality, the market continued downward for quite some time after the last chart below.

Here we see a reversal day. By now you should know that it usually means some sort of correction is due.

Sure enough, prices correct. We would start by trying to sell a breakout of the correction low. We would also place a sell stop below the Rh for part of our position.

Remember, it is up to you to decide how much of your position you want to place at any given level. It is a matter of comfort and style. Where do you feel best about placing your entry orders?

THE TRADER'S TRICK ONE MORE TIME

The purpose of the Trader's Trick entry (TTE) is to get us into a trade prior to entry by other traders.

Let's be realistic. Trading is a business in which the more knowledgeable have the advantage over the less knowledgeable. It's a shame that most traders end up spending countless hours and dollars searching for and acquiring the wrong kind of knowledge. Unfortunately, there is a ton of misinformation out there and it is heavily promoted. What we are trying to avoid here is the damage that can be done by a false breakout.

Typically, there will be many orders bunched just beyond the point of a Ross Hook. This is also true of the number two point of a 1-2-3 formation. The insiders are very much aware of the bunching of orders at those points, and if they can make it happen, they will move prices to where they see the orders bunched together, and then a little past that point in order to liquidate as much of their own position as possible. This action by the insiders is called “stop running.”

Unless the pressure from the outsiders (us) is sufficient to carry the market to a new level, the breakout will prove to be false.

The Trader's Trick is designed to beat the insiders at their own game, or at the very least to create a level playing field on which we can trade. WHEN TRADING HOOKS, WE WANT TO GET IN AHEAD OF THE ACTUAL BREAKOUT OF THE POINT OF THE HOOK. IF THE BREAKOUT IS NOT FALSE, THE RESULT WILL BE SIGNIFICANT PROFITS. IF THE BREAKOUT IS FALSE, WE WILL HAVE AT LEAST COVERED OUR COSTS AND TAKEN SOME PROFIT FOR OUR EFFORT.

Insiders will often engineer moves aimed at precisely those points where they realize orders are bunched. It is exactly that kind of engineering that makes the Trader's Trick possible.

The best way to explain the engineering by the insiders is to give an example. Ask the following question: If we were large operators down on the floor, and we wanted to make the market move sufficiently for us to take a fat profit out of the market, and know that we could liquidate easily at a higher level than where the market now is because of the orders bunched there, how would we engineer such a move?



We would begin by bidding slightly above the market.



By bidding a large number of contracts above the market, prices would quickly move up to our price level.



Once again by bidding a large number of contracts at a higher level, prices would move up to that next level.



The sudden movement up by prices, to meet our large-order overpriced-bid, will cause others to take notice. The others are day traders trading from a screen, and even insiders.

Their buy orders will help in moving the market upward towards where the stops are bunched. It doesn't matter whether this is a daily chart or a five minute chart, the principle is the same.

In order to maintain the momentum, we may have to place a few more buy orders above the market, but we don't mind. We know there are plenty of orders bunched above the high point. These buy orders will help us fill our liquidating sell orders when it's time for us to make a hasty exit.

Who has placed the buy orders above the market? The outsiders, of course. They are made up of two groups. One group are those who went short sometime after the high was made, and feel that above the high point is all they are willing to risk. The other group are those outsiders who feel that if the market takes out that high, they want to be long.

Because of the action of our above-the-market bidding, accompanied by the action of other inside traders and day traders, the market begins to make a strong move up. The move up attracts the attention of others, and the market begins to move up even more because of new buying coming into the market.



This kind of move has nothing whatsoever to do with supply and demand. It is purely contrived and engineered.



Once the market nears the high, practically everyone wants in on this “miraculous” move in the market. Unless there is strong buying by the outsiders, the market will fail at or shortly after reaching the high. This is known as a buying climax.



What will cause this failure? Selling. By whom? By us as big operators, and all the other insiders who are anxious to take profits. At the very least, the market will make some sort of intraday hesitation shortly after the high is reached.



If there is enough buying to overcome all the selling, the market will continue up. If not, the insiders will have a wonderful time selling the market short, especially those who know this was an engineered move. NOTE: DON’T THINK FOR ONE MOMENT THAT THERE IS NOT COLLUSION BY INSIDERS TO MANIPULATE PRICES.

What will happen is that not only will selling be done for purposes of liquidation, but also for purposes of reversing position and going short. This means the selling at the buying climax may be close to triple the amount it would normally be if there were only profit taking.

Why triple? Because if prices were engineered upward by a large operator whose real intention is to sell, he will need to sell one set of contracts to liquidate all of his buying, and perhaps double that number in order to get short the amount of contracts he originally intended to sell. The buying from the outsiders will have to overcome that additional selling.

Because of that fact, the charts will attest to a false breakout. Of course, the reverse scenario is true of a downside engineered move resulting in a false breakout to the downside.

WARNING: MOVING THE MARKET AS SHOWN IN THE PREVIOUS EXAMPLE IS NOT SOMETHING THE AVERAGE TRADER SHOULD ATTEMPT!

It is very important to realize what may be happening when a market approaches a Ross Hook after having been in a congestion area for awhile. The prior pages have illustrated this concept.

With the preceding information in mind, let's see how to accomplish the Trader's Trick.



On the chart above the Rh is the high. There were two price bars following the high: one is the bar whose failure to move higher created the Hook, and the other is one that simply furthered the depth of the correction.

Let’s look at that again by breaking it down in detail in an example.



Following the high is a bar that fails to have a higher high. This failure creates the Ross Hook, and is the first bar of correction. If there is sufficient room to cover costs and take a small profit in the distance between the high of the correcting bar and the point of the Hook, we attempt to buy a breakout of the high of the bar that created the Hook, i.e., the first bar of correction. If the high of the first bar of correction is not taken out, i.e., violated, we wait for a second bar of correction.

Once the second bar of correction is in place, we attempt to buy a violation of its high, again provided that there is sufficient room to cover costs and take a profit based on the distance prices have to travel between our entry point and the point of the Hook.

If the high of the second bar of correction is not violated, we will attempt to buy a violation the high of a third bar of correction provided there is sufficient room to cover costs and take a profit based on the distance prices have to move between our entry point and the point of the Hook. Beyond three bars in the correction, we will cease in our attempt to buy a breakout of the correction highs.



What if the fourth bar did as pictured on the left? As long as prices are moving back up in the direction of the trend that created the Ross Hook, and as long as there is sufficient room for us to cover costs and take a profit, we will buy a breakout of the high of any of the three previous correction bars. In the example, if we were able to enter before prices violated the high of the second bar of correction, we would enter on a violation of the high of the second correcting price bar. If not, and there is still room to cover and profit from a violation of the first correcting price bar, we would enter there.

Additionally, we could choose to enter on a takeout of the high of the latest price bar as shown by the double arrow, even if it gaps past one of the correction bar highs.

REMINDER: ONCE THERE ARE MORE THAN THREE BARS OF CORRECTION, WE NO LONGER ATTEMPT TO ENTER A TRADE. THE MARKET MUST BEGIN TO MOVE TOWARD THE HOOK AT THE TIME OF OR BEFORE A FOURTH BAR IS MADE.

Although not shown, the exact same concept applies to Ross Hooks formed at the end of a down move.

Risk management is based upon the expectation that prices will go up to at least test the point of the Hook. At that time, we will take, or already have taken some profit and have covered costs.

We are now prepared to exit at breakeven, at the very worst, on the remaining contracts. Barring any horrible slippage, the worst we can do is having to exit the trade with some sort of profit for our efforts.

We usually limit the Trader's Trick to no more than three bars of correction following the high of the bar that is the point of the Hook. However, there is an important exception to this rule. The next chart shows the use of double or triple support and resistance areas for implementing the Trader's Trick.

Please realize that “support” and “resistance” on an intraday chart does not have the usual meaning of those terms when applied to the overall supply and demand in the market place. What is referred to here is given in the following four examples:





Any time a business can consistently make profits, that business is going to prosper. Add to that profit the huge amount of money made on the trades that take off and never look back, and it’s readily apparent that enormous profits are available from trading. The management method we use shows why it is so important to be properly capitalized. Size in trading helps enormously.

The method also shows why, if we are undercapitalized (most traders are), we must be patient and gradually build our account by taking profits quickly when they are there.

If you are not able to tend to your own orders intraday electronically or on the Internet, it may be well worth your while to negotiate with a broker who will execute your trading plan for you. There are brokers who will do this, and you may be surprised to find that there are some who will perform such service at reasonable prices if you trade regularly. When we are trading using the Trader’s Trick, we don’t want to be filled on a gap opening beyond our desired entry price unless there is sufficient room for us to still cover costs and take a profit. Can you grasp the logic of that? The reason is that we have no way of knowing whether a move toward a breakout is real or not. If it is engineered, the market will move forward to the point of taking out the order accumulations and perhaps a few ticks more. Then the market will reverse with no follow through in the direction of the breakout. As long as we have left enough room between our entry point and the point where orders are accumulated to take care of costs and a profit, we will do no worse than breakeven.

Usually, we will also have a profit to show for any remaining contracts, however small. If the move proves to be real (not engineered), then the market will give us a huge reward relative to our risk and costs. Remember, commission and time are our only real investment in the trade if it goes our way.

The important understanding that we need to have about the Trader’s Trick is that by taking entry into a market at the correct point, we can neutralize the action by the insiders. We can be right and earn something for our efforts should the breakout prove to be false.

Some breakouts will be real. The fundamentals of the market ensure that. When those breakouts happen, we will be happy, richer traders.

With proper money management, we can earn something for our efforts even if the breakout proves to be false.

IDENTIFYING CONGESTION

One of the concepts every trader must learn is how to know when prices are in congestion. There are a few rules for the early discovery of this ever important price action, and they are explained in detail in this chapter.

RULE: ANY TIME PRICES OPEN OR CLOSE ON FOUR CONSECUTIVE BARS, WITHIN THE CONFINES OF THE RANGE OF A “MEASURING BAR,” YOU HAVE CONGESTION. THIS IS REGARDLESS OF WHERE THE HIGHS AND LOWS MAY BE LOCATED. A “MEASURING BAR” BECOMES SUCH BY VIRTUE OF ITS PRICE RANGE CONTAINING THE OPENS OR CLOSES OF AT LEAST 3 OF 4 SUBSEQUENT PRICE BARS.



Closely and carefully study this chart again. Congestion can be very subtle in appearance. Often the difference between congestion or trend is the positioning of a single open or close.



To further demonstrate this concept, let’s first look at the combination of points “K” through “M” on the chart below. Even though “M” closed below the range of the measuring bar “J,” the fact that “L” made a new high and then closed, dropping back into the Trading Range of “J”, tells us that prices are still in congestion. This will be explained on the following pages. In addition, we now have congestion by virtue of alternating bars, which will also be discussed next.



ANY TIME PRICES ARE NOT MAKING HIGHER HIGHS AND HIGHER LOWS, OR LOWER HIGHS AND LOWER LOWS, AND WE CAN SEE FOUR ALTERNATING BARS, AT TIMES COUPLED WITH INSIDE BARS AND AT TIMES COUPLED WITH DOJIS, WE HAVE CONGESTION.

ALTERNATING BARS ARE ONES WHERE PRICES OPEN LOWER AND CLOSE HIGHER ON ONE BAR, AND OPEN HIGHER AND CLOSE LOWER ON THE NEXT.

Inside bars look like this:



Doji Bars look like this:



Below are more Doji bars. The open and close are at the same price or very near to the same price, yielding a bar that looks like this:



A combination of alternate close-high-open-low, close-low-open-high pairs is congestion.

“Pointy” places made when the market is in congestion are not Ross Hooks. If a trend has been defined within congestion, you now have a trend, and any subsequent pointy place is a Ross Hook.

The first bar of the congestion may very well be the last bar of what had been a trend. A congestion may look similar to any of the following, as long as it consists of four or more bars. Study these formations carefully:

Frequently congestion will start or end with a doji. Frequently congestion will begin or end with a long bar move, or a gap.

Another way to identify congestion is when you see // or // on the chart.

The smallest possible number of bars that can make up this formation is four. Let’s see how this can be done.



In reality, we may get something that looks more like the following:



If we were to get a formation that looked like the following, the Ross Hook would be as marked. If that Hook is taken out, we would want to be long prior to the violation. Notice that the bar that created the Ross Hook was the last bar of the trend and the first bar of the congestion.



Now, let’s see if you’re really getting this. Assume that an established trend is in effect, with prices having trended up from much lower. We’ve changed the chart a bit, so pay attention.

The Ross Hook is as marked below.





Note: A 1-2-3 FOLLOWED BY A BREAKOUT OF THE #2 POINT THAT SUBSEQUENTLY RESULTS IN A ROSS HOOK, SUPERCEDES ANY CONGESTION OR PREVIOUS ROSS HOOK. QUITE OFTEN, SUCH A SERIES OF PRICE BAR OCCURRENCES WILL BE THE WAY PRICES EXIT A CONGESTION AREA, I.E, A 1-2-3 FORMATION WITHIN A CONGESTION AREA, A BREAKOUT OF THE #2 POINT, FOLLOWED BY A ROSS HOOK .

The price bar labeled “b” made a new local low. The take out by prices of the local double resistance, “a” and “b,” is a significant event. “a” and “b”, together, constitute the number two point of a 1-2-3 low occurring in congestion. The low of bar “b” is also a #3 point, and two bars later we get the highest high of the congestion, which is also an Rh.

The new Ross Hook represents an even more significant breakout point. Combined with the old Rh, there is significant resistance. Within a few ticks of each other, the two constitute a double top. If prices take them both out, we would normally expect a relatively longer term, strong move up.

We use the term “relatively” here, because the intensity and the duration of the move would be relative to the time frame in which the price bars were made.

Obviously such a move on a one minute chart would hardly compare with an equivalent move on a daily chart. While we are looking at the chart, there is something else of importance to notice. Prices retreated from the resistance point, thereby creating the second Ross Hook. This represented a failure to break out. This failure is why Reverse Ross hooks are important. When prices retreat from a resistance point and move towards a RRh, it may indicate that the only reason the resistance point was challenged or even violated was because prices were “engineered” in that direction by some party or parties capable of moving prices for their own benefit. The anticipation is that prices next may move in the opposite direction toward a violation of the RRh.

Now, go through a brief review of the various congestions. All of the three following conditions that define congestion must occur without consistently making higher highs or lower lows.

Congestion by Opens/Closes: Four consecutive closes or opens within the range of a measuring bar. If opens are used, there can be no correcting bars before or coincident with the bar in which the open is used.

Congestion by Combination: A series of four consecutive dojis, or at least one doji and any three alternating bars. The doji is a wild card and can be used to alternate with any other bar. If there are three non-doji bars, one of them must alternate high-to-low with the other two non-doji bars.

Congestion by Alternation: A series of four consecutive alternating open high - close low, open low - close high bars in any sequence. This definition includes Congestion by High/Low pairs.