Most of the formations important to bar charting can be traded using a penetration of one of the support or resistance lines as a signal. The most interesting and potentially profitable trades occur on breakouts from major top or bottom formations. The simplest of all bottom formations, as well as one that offers great opportunities, is the extended rectangle at contract lows. Fortunes have been made by applying patience, some available capital, and the following plan:
1. Find a market with a long consolidating base and low volatility (with futures it should also have increasing open interest). When evaluating interest rates, use the yield rather than the price, and avoid currencies that have no base price; that is, they have no level considered low, but instead have a point of equilibrium.
2. Buy whenever there is a test of its major support level, placing a stop-loss to liquidate all positions on a new, low price.
3. After the initial breakout, buy again when prices pull back to the original resistance line (now a support level). Close out all positions if prices penetrate back into the consolidation area, and start again at step 2.
4. Buy whenever there is a major price adjustment in the bull move. These adjustments, or pullbacks, will become shorter and less frequent as the move develops. They will usually be proportional to current volatility or the size of the price as measured from the original breakout.
5. Liquidate all positions at a prior major resistance point, a top formation, or the breaking of a major bullish support line.
Building positions in this way can be done with a relatively small amount of capital and risk. The closer the price comes to major support, the shorter the distance from the stop loss; however, fewer positions can be placed. In his book, The Professional Commodity Trader (Harper & Row), Stanley Kroll discussed “The Copper Caper-How We’re Going to Make a Million,” using a similar technique for building positions. It can be done, but it requires patience, planning, and capital. The opportunities continue to be there.
This example of patiently building a large position does not usually apply to bear markets. Although there is a great deal of money to be made on the short side of the market, prices move faster and may not permit the accumulation of a large position. There is also exceptionally high risk and the increased risk of false signals caused by greater volatility. Within consolidation areas at low levels, there is an underlying demand for a product, the cost of production, government price support (for agricultural products), and low volatility. There is also a well-defined trendline that may have been tested many times. A careful trader will not enter a large short-sale position at an anticipated top, but will join the buyers who contribute to the growing volume and open interest at a well-defined major support level.