The next week, I and Bob went to Master Wong's house to meet him.
After lunch, we went to his study room.
Master Wong: As I told you last time, as long as a stock has a higher high, it is in an uptrend.
If a stock makes a lower low, it is in a downtrend.
So, suppose there is a stock making a series of higher high and then it makes a lower high. Can you tell what does it imply?
Bob: It means that the stock has changed direction from uptrend to downtrend. Correct?
Master Wong: Not exactly..The answer is..Maybe the stock has changed trend..It may go sideways or it may go up again, but it is not behaving in the ideal manner. The ideal uptrend is a stock making a higher high and a higher low.
If the stock betrays the trend by making a lower high and a lower low, we can no longer trust the stock and should watch it carefully.
Bob: What do you mean watch it carefully?
Master Wong: By that I means that I would either stay away from such a stock or if I want to short it, I would risk very little. For example, if I normally buy 100 or 200 shares, I would buy just 25 to 30 shares just to test the market.
There is nothing wrong in using small quantities of shares to test the market and monitor it. In fact, the famous speculator, Jesse Livermore used to test the market by trading small quantities and when he was confident that the trend is intact, he used to trade thousands of shares.
Master Wong took a chalk and went to the blackboard.
Here is what he drew.
[[fig 3.1]]
Master Wong: See the figure. The stock was in an uptrend and was making a higher high and higher low. Then it made a lower low. This immediately indicates that the uptrend may be over and there is a possibility of Downtrend.
This is a bearish sign.
Modern day technical analysts call this pattern Head and Shoulders pattern, but you can now find this pattern just by looking if the chart makes a lower high and lower low.
Bob: You said that this MAY means that the stock is in a downturn. When could you be completely certain that the stock is in a downtrend.
Master Wong: Why? I had taught you that principle. It is very simple. If the 20 days moving average goes BELOW the 50 days moving average, then and only then the trend changes to a downtrend.
[[fig 3.2]]
So, after the downtrend is confirmed (when 20 days moving average moves below the 50 days moving average), you can short the full quantity of shares instead of just shorting 25 to 30 shares.
Bob: So, when do we short if we know that the market is not in an uptrend.
Master Wong: You should short at the next lower peak. If you want, you can add to your position at each of the lower peaks.
[[fig 3.3]]
Bob: OK! What happens if after a series of higher highs and higher lows, we get a lower high but a HIGHER low? Or if we get equal highs and equal lows?
Master Wong: Relax! You are jumping ahead. There are other patterns I have to teach you. This session is only to master how to analyze the market structure.
Bob: Fine! Let me bring up the chart of Dow Jones Industrial Average and let us try to analyze it.
Bob prints out a chart of the Dow Jones Industrial Average and begins to draw a line connecting the peaks and valleys of the chart.
Master Wong: Bob, why don't you try analyzing the market structure of the chart?
Bob: Sure! Before point A on the chart, the market was not going in any specific pattern. It is neither making a higher high nor a higher low. I do not know what this pattern is.
Master Wong: Relax! Just ignore this for now and continue. I will teach other profit producing patterns later on.
[[fig 3.4]] CLICK TO ENLARGE
Bob: OK! At point A it made a lower low. So, it is not in an uptrend. It may go in a downtrend. However, as the 20 days moving average is still above the 50 days moving average the downtrend is not confirmed. I should risk a very little amount if I want to short..Correct?
Master Wong: I prefer to stay away from market whose structure is unpredictable. If you can not resist staying away from the market, just risk a small token amount..say 25 shares or so..
Bob: OK After point A, the 20 days moving average went below the 50 days moving average. So, the DOWNTREND WAS CONFIRMED!!.
Master Wong: Yes! Now we can short higher quantity at B because we are now confident the trend is definitely down.
Bob: Then, C, D and E are lower highs and lower low. These are perfect places to add to your short position. That is, you can short more stocks at these points.
Then, at E, F and G and H, the market makes higher high. This means that the trend is no longer in a downtrend. The uptrend was confirmed at point H, because the 20 days moving average goes above the 50 days moving average.
Master Wong: Yes! That means that you can be confident and go long.
Bob: Yes, but unfortunately, that uptrend does not last and you get a downtrend again.
Master Wong: If you had placed a stop loss, you would have been stopped out.Always place stop losses to control your risk At any time, do not risk more than 2 percent of your total capital on any trade.
Bob:At I, J and K we had a lower low and the downtrend is confirmed.
Master Wong: So, we can go short at these points with confidence.
Bob: Then we had a higher high at L and M.
Master Wong: What does this mean?
Bob: This means I would get out of all my short positions and stay out of the market.
Master Wong: Correct! Also, if your are adventurous, you can buy just really very very small quantities of shares around L and M because they are making higher high. However, the Uptrend is NOT CONFIRMED till the 20 days moving average goes ABOVE the 50 days moving average. Till that time, we are just guessing that the trend may go up.
The only thing we are sure is that the trend is no longer the ideal downtrend and is not making lower highs and lower lows.
So, the behavior of the market has changed. If you want my advice, I would prefer to stay away from such markets where I can not guess the behavior.
Bob: This was great! Now, i really understood how to analyze the market structure.
Master Wong: I am glad that this session is useful to you. Let us meet next week and discuss further.
Bob and Sanjoy: Thanks Master Wong. See you next week.
