The New Science of Technical Analysis by Thomas R. DeMark

Contents  ˅

Introduction 1) Trendlines 2) Retracements 3) Overbought/Oversoid 4) Wave Analysis 5) Accumulation/Distribution 6) Moving Averages 7) Sequential™ 8) Gaps 9) Daily Range Projections 10) Rate of Change 11) Equities 12) Options 13) "Waldo"-Patterns Conclusion Trademarks

Tom DeMark divides traders who use charts, into three categories. The first type relies on gut feel to analyze trades. This type of trader lacks objectivity and the method used amounts to guesswork. Operating off of feelings requires no great effort, which is a reason most traders follow this path. These traders don't see a need to do the work required to validate how they trade.

The second type of trader usually depends on indicators to identify overbought/oversold price areas. Unfortunately, the level of their effort stops after they have chosen which indicators to use. Their use of a tool separates them from the first group, but not from all those who use the same indicators. This group doesn't try to improve the indicators or come up with something new. Also, there is often the belief if an indicator is popular, it must be effective. Yet they are not aware of the indicator's limitations.

The third trader category consists of those who make the effort to develop trading systems. It is Tom DeMark's goal to teach traders from the first two groups how to make it to the third. Not with subjective methods or common technical tools, but with tested systems and techniques. He calls this going from chart artist (chartist) to chart scientist.

This book is a guide to successful trading. But DeMark doesn't want you to accept the information as is. Instead, make it your own. Choose the most suitable parts and improve them when you can. The techniques have a record of success, yet that doesn't mean they can't be improved. These trading tools are simple because simple is more reliable and works as well or better than complex. With the knowledge provided, you can assume complete responsibility for your trading and not have to rely on untested methods.

Trendlines are one of the many subjective technical trading tools. There are no common objective standards for how to draw them. As a result, traders don't agree on trendline placement. Unless they can be drawn in a consistent way, they are a shaky foundation to rely on.

Creating a trendline, like any line, requires two points of reference. The problem with trendlines has been deciding which two points to connect. TD Points™ answer that question. In discussing TD Points use, the context will be daily charts, but they are valid for any time frame.

The significant price points on a chart are those where price reverses direction. These are known as pivot points. A pivot point high is a day's high price which is above the high of the day immediately before and after it. Likewise, a pivot point low is the low of a day which is less than the low of the day which precedes it and the day which follows it. These pivot points are TD Points

Trendlines are usually drawn from some point on the left hand side of a chart to another point on the right hand side. Drawing them this way makes older prices as meaningful as recent prices. DeMark thinks this is incorrect and trendlines should only be drawn using the two most recent TD Points.

A line connecting two descending TD Point highs is called the TD Supply Line™. The TD Demand Line™ is the line connecting two ascending TD Point lows.

TD Lines™ are dynamic and change when new TD Points are created. As supply and demand changes, so do the TD Lines. Because TD Lines use the two most recent significant price points, the TD Points, the trendline stays close to the most recent price action.

When choosing TD Points, there are two optional adjustments. The first occurs when there's a price gap for the day immediately preceding the TD Point high or low. For a TD Point high, if the preceding day gaps down from the prior day's close, this gap disguises the day's true range. So in this case, the pivot point high should also be above the close two days before it, to qualify as a TD Point.

The same qualification applies to a TD Point low. If the day preceding the pivot point low gaps up, the pivot point low must also be below the close two days before it, to qualify as a TD Point.

The second optional adjustment relates to the close of the day Immediately after the TD Point. Once the two most recent TD Point highs are found, you can draw a TD Line. If the close of the day just after the most recent TD Point high is above the trendline, this makes the TD Line suspect. Similarly, when the TD Line is connecting two TD Point lows, if the close of the day right after the most recent TD Point low is below the trendline, it makes the TD Line somewhat less reliable.

An important question when a trendline is broken, is how far prices are likely to go. TD Lines give you three ways to calculate a price target after a trendline break. The methods differ in their simplicity and accuracy. For just a rough price target, the first method is enough. For a more conservative price estimate, use one of the other two price projectors. To improve the accuracy of any of the methods, it's highly recommended to reduce the price projection by two ticks.

When making price projections, there are three situations which negate the forecast. The most obvious is when prices reverse before reaching the target price. The reversal is indicated if prices break through a new TD Line in the opposite direction. Sometimes one of the more conservative price targets is hit first which negates the more distant objective.

Lastly, projections are canceled when there's a TD Line false breakout or a reaction to an unexpected news event. Either case is indicated by a close back through the TD Line opposite to the breakout direction.

There's no way to prevent adverse news, but there are three qualifiers to help avoid the false breakouts. Only one qualifier is required to validate a breakout.

TD Points require a day's high or low price which exceeds the high or low of both adjacent days. This minimum requirement qualifies most pivot points and so creates short-term TD Lines. Tom DeMark decided to sometimes make identifying TD Points more restrictive. This leads to fewer pivot points and makes the resulting TD Lines reflect longer-term trends.

The only change to identifying a TD Point is how many adjacent price days must be exceeded. The original TD Point definition required only one day to either side of the TD Point. This is called a level 1 TD Point. The level number indicates the number of days to either side of the TD Point which are exceeded. A level 2 TD Point requires a high or low above or below the previous two days' highs or lows and the two following days' highs or lows.

The higher level TD Points and the resulting TD Lines function in the same way as level 1, but DeMark usually prefers to stick with level 1. He likes level 1 TD Lines because they give more trade opportunities and are more likely to meet their target price. Higher level TD Lines don't reach their price objective as frequently as level 1. This is usually due to a level 1 TD Line signaling a trade counter to the higher level trendline. DeMark does sometimes use a higher level TD Line to confirm a level 1's direction.

Probably the most popular method to estimate trend retracements is to use Fibonacci ratios. These ratios are derived from the Fibonacci number sequence. The numbers in the sequence are the sum of the two previous numbers. Starting with 0 and 1, the Fibonacci numbers are 0, 1, 1, 2, 3, 5, 8, 13, 21, 34,… and so on indefinitely.

The Fibonacci ratios are derived by dividing one number by one of the other numbers (34 / 55 = 0.618, 34 / 89 = 0.382, 55 / 34 = 1.618, 89 / 34 = 2.618). The ratios can be added to each other to form additional reference numbers. Tom DeMark uses the following for estimating retracements: 0.382, 0.618, "magnet price" (the high or low day's close), 1.382, 1.618, 2.236, 2.618, and 3.618.

Once one or more retracement levels are chosen, the next step is to decide what price to use for creating the projection. After price makes a significant low or high, find the last time there was the same low or high price. The highest price between the two same level lows and the lowest price between the two same level highs is called the "critical price". The retracement levels are applied to the difference between the low or high and the critical price.

Typically prices will retrace 0.382 or 0.618 of the recent price move. If prices exceed 0.618, the next level is what Tom DeMark calls, the "magnet price". The magnet price is the critical price's close. It's commonly thought the low of a critical price low is an important support level and the high of a critical price high is an important resistance level. But DeMark says his research shows, it's the critical price's close which is the more important support or resistance level.

When prices make an all-time new high, a critical price can't be found because there's no previous price at the same level. In this case, two good retracement levels can be found by multiplying the high by 0.382 and 0.618.

Normal retracement estimates project price, but not time. TD Retracement Arcs™ supply price estimates that vary with time. To draw an TD Retracement Arc, first draw a line from the recent high or low to the critical price. Then find the 0.382 and 0.618 retracement levels on that line. Using the recent high or low as the center of the arc, the two retracement levels are projected forward to create two arcs. When prices close beyond the 0.382 arc, expect a move to the 0.618 arc.

TD Lines have three qualifiers for a valid breakout. These same qualifiers can be applied to validate prices breaking through a retracement level.

When price exceeds one retracement level and is a qualified breakout, it's normally expected prices will continue to the next retracement level. There's a modification to this concept. If the day price exceeds a retracement level and doesn't also close beyond that level, the next price objective is changed. The new retracement level is half way between the level just passed through and the usual next level. If price had failed to close beyond the 0.382 level, the new expected retracement level would be half way to 0.618, which is 0.500.

In addition to price retracements, you can also calculate time retracements. Count the number of days between the recent low or high and the critical price. Multiply the number by a retracement ratio, such as 0.382 or 0.5 and when added to the low or high, gives an estimated retracement completion date.

Trend Factors™
Tom DeMark thinks increased market volatility has made describing price moves in terms of time alone, an outdated concept. The price moves which once took weeks, can now happen in days. So instead of defining short, intermediate, and long term as so much time, DeMark uses percentage price changes. For him, short term is a change less then 5 percent. Intermediate is 5 to 15 percent and long term is a price move more than 15 percent.

Trend Factors are a set of ratios used to determine the extent of intermediate and long-term price trends. A qualified high or low price is multiplied by these ratios to project likely support or resistance levels.

The first step in using Trend Factors is to locate a reference high or low price. In order to qualify as a reference high or low, prices must have a minimum move from a previous reference close. Since the smallest Trend Factor ratio is 0.0556, a reference low price must have declined to at least 0.9444 of a qualified high close. A reference high must have advanced at least 1.0556 from a reference low close.

Once price qualifies with this minimum advance or decline, the specific reference price is determined by the price behavior preceding and following the high or low day. For a qualified low, the reference price is either the day's low or the close. The reference day's low price is the reference price if three conditions are met. First, the low day's close is below the prior day's close. Second, the prior day's close is below the previous day's close. Last, the day following the low day must be a higher close.

If the low day's close or the prior day's close was an up or unchanged close, then the low day's close is the reference price. But the close is used to find only the first resistance level. The higher resistance levels use the reference day's low price as the reference price.

An exception to using the low or close of the low day happens if the day following the low day gaps up. This makes this day's low above the low day's close. In this case, the reference price for calculating the first resistance level is this gap day's close. The reference price for the higher resistance levels reverts back to the low of the reference low day.

To determine the expected resistance levels off a qualified low, the reference price is multiplied by the Trend Factors, 1.0556, 1.112, 1.14.

The process for finding the reference price of a qualified high is similar. The high price of qualified high is the reference price if it meets two conditions. The first condition is the high day's close is above the prior day's close. And the prior day's close must be above the previous day's close.

The close of the high day is the reference price, if either the reference day's close or the prior day's close is a down close. As with reference lows, the close is used for only the first support level. The other two support levels use the high of the reference day.

If the day following the reference high gaps down, its close is made the reference price for projecting the first price support level. The remaining support levels use the reference day's high as the reference price.

The first support level is found by multiplying the reference high by 0.9444. The first support level price is multiplied by 0.9444 to determine the next support level. The third support level is found by multiplying the second level price by 0.9722.

Usually the first support or resistance level is easily exceeded. But sometimes on the day prices exceed the first level, the close is above the support level or below the resistance level. When this happens, reduce the next level projection factor by 50 percent. The new second level factors are 0.9722, and 1.0834.

One final adjustment applies to currencies and other markets which are quoted only in decimals and without whole numbers. For those markets, change 0.9444 to 0.99444 and 1.0556 to 1.00556.

A common trader's tool is an indicator which identifies extreme price levels, overbought and oversold. Most traders interpret the indicator's signals in the same way. Prices are considered either overbought or oversold when the indicator moves to extreme levels. Tom DeMark thinks this simplistic indicator usage doesn't reflect the reality of price behavior. He thinks true overbought/oversold prices are more a function of time and not just price.

A common example of a false overbought or oversold indicator reading happens when prices break out of a sideways price range. The supply-demand situation has suddenly changed and it takes time to find a new price equilibrium level.

Instead of looking to sell or buy what looks like an overbought/oversold situation, it's usually better to do the opposite. Prices may quickly consolidate after a rapid price move, but it takes time for the trend to reverse direction.

DeMark rates overbought/oversold indicator signals as either mild or extreme. Mild readings are overbought/oversold indicator levels which last for no more than five days. If the overbought/oversold signals last more than five days, the condition is considered extreme.

It's the mild indicator periods which are most likely to signal an imminent price reversal. There's a rare exception when indicator readings are at their most extreme level for an extended period. This is the one case when a period longer than five days usually leads to a reversal.

To properly use overbought/oversold indicators, align their signals with the long-term trend. If the trend is up, wait for mild oversold signals to buy. And sell a mild overbought signal when in a downtrend.

Two indicators were created to identify trend reversals following price exhaustion. The first is the Range Expansion Index (REI)™. To calculate the REI, subtract the daily high from two days ago from today's high. Also subtract the low from two days ago from today's low. Add the two differences to come up with a single positive or negative number.

There are some qualifications to be met before recording the day's REI number. The daily high price of two days ago must be greater than or equal to the close of seven or eight days ago. Or today's high is greater than or equal to the low of 5 or 6 days ago.

Additionally, either the daily low two days ago is less than or equal to the close seven or eight days ago. Or today's low is less than or equal to the daily low five or six days ago.

These qualifications prevent buying or selling extreme price moves. If these two restrictions are not met, the day's REI is assigned a zero. The final calculation step is to add the last eight daily REI numbers and divide that total by the absolute price change over the eight days. The indicator has a maximum range of -100 to +100. Price weakness is signaled if REI rises above 60 and then falls below it. Price strength is indicated if REI drops below -60 and then moves above -60.

The second price exhaustion tool is the DeMarker Indicator™. To calculate the indicator, record the difference between today's high and the previous day's high, but only if today's high is higher. Otherwise, record a zero. The difference of today's low subtracted from yesterday's low is recorded only if yesterday's low is above todays low. If not, then a zero is recorded.

The final step is to add up thirteen days of the daily high differences and divide that total by the sum of thirteen days of the daily high and low differences. This results in an indicator with a range of 0 to 100. A potential bottom is signaled with a reading below 30 and a potential top when the indicator is above 70.

It's suggested you experiment with different parameters to make the indicators more effective for different time frames. By varying the parameters you can create both short and long-term indicators. You could then use the short-term indicator to time a trade when it was aligned with the long-term indicator.

Tom DeMark has no patience for subjective methods like Elliott wave analysis. He wants a method which gives the same results for anyone who uses it. To make that happen, DeMark created D-Wave™ analysis which is an objective interpretation of price waves.

D-Wave focuses on price moves alone without regard to how long it takes for them to complete. This represents DeMark's belief trade holding periods should be defined by the size of price moves, not the amount of time. D-Wave uses Fibonacci numbers to create a consistent structure of price highs and lows.

The first step to identify a D-Wave is to find a close which is the lowest close for at least the previous 21 days. From this low close, the first of three waves is defined. The high of the first wave is the highest close for the previous 13 days. After the 13-day high close, the low of this wave is the lowest close in 8 days. These three price points identify the first wave.

The second wave is started when the highest close in 21 days is reached. After this high close, the second wave is completed when a 13-day lowest close is created.

The third wave consists of a 34-day highest price (daily high, not only the close) followed by a 21-day low price.

There is nothing special about the Fibonacci numbers used. You're encouraged to try others. For a longer-term perspective, you might use a sequence starting with a 21-day highest close instead of 13 days. The three wave highs would be 21, 34, and 55. With the objective wave formation D-Wave provides, it's easier to also objectively project price targets with Fibonacci ratios.

It takes money to move markets and no one has more money than the financial institutions. Even when their analysis of the market direction is wrong, the size of their buy and sell orders makes opposing them a losing game.

Institutions don't want their actions easily known which makes uncovering them a challenge. But if you can accurately measure when informed money is buying or selling, you can make trades in line with theirs. The concept of volume preceding price is the reason to analyze price changes along with volume.

Most measures of accumulation/distribution use the price change from one close to the next close. Larry Williams convinced Tom DeMark the important reference price was the day's open. A news event overnight can result in prices opening sharply higher or lower than the previous close. Even if the day closes above the previous close, if the close is below the open, it makes any apparent accumulation suspect.

Relating the open to the day's range and volume results in a basic accumulation/distribution formula which can be plotted as a cumulated total on a price chart:

[(Close - Open) / (High - Low)] X Volume

An adjustment to the formula is made if the opening price is eight percent or more above the previous day's close:

{[(High₁ - Close₀ + Close₁ - Low₁) - (High₁ - Low₁)] / (High₁ - Close₀)} x Volume₁

This type of adjustment is also applied for an open eight percent or more below the previous close:

{[(Close₀ - Low₁ + High₁ - Close₁) - (Close₁ - Low₁)] / (Close₀ - Low₁)} x Volume₁

High₁ = Today's high
Low₁ = Today's low
Close₁ = Today's close
Volume₁ = Today's volume
Close₀ = Previous close

One further refinement is to measure accumulation/distribution over various periods. It's suggested to use Fibonacci numbers from 5 to 377.

For each period, add up all the daily positive values. This sum represents the total buying pressure for the period. Then add up all the daily negative values. This sum represents the total selling pressure over the period.

Finally, divide the buying pressure total by the sum of the buying pressure total and the absolute value of the selling pressure total. This ratio measures the buying pressure as a percentage of the total buying and selling activity. When multiplied by 100, the indicator ranges from 0 to 100.

There are two suggested ways to use this formula. You can use the indicator as is, and compare over the different time periods to spot subtle changes.

DeMark's preference is to plot the accumulation/distribution formula as a rate of change indicator. To do this, divide the daily percentage by the daily percentage from X days ago. He compares the daily percentage for a given period (usually a Fibonacci number) to the daily percentage four Fibonacci levels below the period. If the period was 144 days, then the comparison would be between today and 21 days ago.

The use of a rate of change indicator provides a uniform way to rate different stocks or futures for trade opportunities. When using the formula with futures, it's suggested you make one modification to compensate for limit moves. In the formula, treat consecutive limit moves as if they occurred on one day. The first day's open, the last day's close, the low and high of the entire sequence, and the total sequence's volume, are all recorded as if it was a single day.

Moving averages are a standard tool of many traders and yet they have a number of faults. The most common of these is a tendency for whipsaws when a market is moving sideways. Tom DeMark came up with some ways to address this problem.

One way to avoid common problems, is to do the uncommon. In this case, offset the moving average into the future, instead of plotting it to coincide with the most recent price. This idea can be applied when using two moving averages of different lengths. Buy and sell signals occur when the projected short-period moving average rises above or falls below the projected longer-period moving average.

Two good periods to use for the moving averages are 5 and 21 days. The prices which are averaged consist of the sum of the daily open, high, low, and close divided by 4. The 5-day average is offset 3 days into the future. The 21-day average is offset 13 days.

When the 5-day projected moving average moves above the projected 21-day moving average, it's a buy signal. A sell signal happens when the 5-day projected moving average falls below the 21-day projected moving average.

An added twist is to require both averages to exceed a specific high or low price to validate a trade signal. For instance, require both averages to be above the average of the highs of the last two days for a buy signal. And for a sell signal, both averages must be below the average of the lows of the last two days. It also helps if both moving averages are rising or declining at the same time.

Since whipsaw trades occur in sideways markets, avoiding these trades requires a method to help identify trending markets. For a rising market, such an indicator is a low which is the highest low of the last 13 days. An indication of a declining market is a high which is the lowest high over the last 13 days.

In a rising market, when there's a low which is the highest low of the last 13 days, a 3-day moving average of the daily lows is created. The 3-day moving average is followed for 4 trading days to provide a sell signal. The 3-day moving average is only active as long as a new 13-day highest low has been set in the previous 4 trading days.

A similar process is used for declining markets. A 3-day daily high moving average is created when a high is the lowest high for the last 13 days. The 3-day average provides buy signals and is only active when a new 13-day lowest high is recorded in the previous 4 trading days.

Requiring prices to move a certain amount before a signal is generated can also be accomplished with the use of trading bands. The upper band is the daily low multiplied by 1.1. The lower band is the daily high multiplied by 0.9. For smoother bands, use a 3-day average of the daily lows and highs and multiply the lows average by 1.15 and the highs average by 0.85. Prices outside the bands is a sign of an overbought or oversold condition.

In the simplest terms, price highs and lows are the result of an exhausted supply of buyers or sellers. When no buyer is willing to buy at a certain price, sellers will lower their offering price and a top is formed. Likewise, a price low is the result of no seller is willing to accept the current price and buyers raise their bid price in response. The trick is to identify this exhausted buyer or seller supply and demand, as it occurs. Identifying these exhaustion points is what Sequential™ is designed to do.

Setup
Sequential, as its name implies, has a series of stages. The first of these is the setup. A buy setup requires at least 9 consecutive closes below the close 4 trading days earlier. A sell setup requires at least 9 consecutive closes above the close 4 trading days earlier. Although the setup is not the complete Sequential process, it often does coincide with a short-term high or low. Note the requirement of consecutive closes. If during the count, a close doesn't meet the required relationship to the close 4 trading days earlier, the count is started over.

Intersection
The consecutive 9 or more closes completes a setup, but there's one qualification used to avoid a setup off an extreme market move. Intersection requires the daily price range of the eighth or ninth setup day to overlap part of the daily range of a setup day, at least three days earlier. The intersection qualification is also met if the overlap happens for any day following the ninth day, even if not a continuation of the count.

Setup Cancellation
A setup is canceled when one of two situations takes place. The first is if a new setup completes before the next Sequential step (countdown) generates a buy or sell signal. The setup is also canceled when there's a significant contrary price move after the setup, and before a buy or sell signal is given.

For a buy setup, a contrary move occurs if following setup completion, a close exceeds the highest intraday price of the setup. For a sell setup, it's a close lower than the lowest intraday price in the setup. When the setup is canceled, a new setup count must be started.

Countdown
The countdown for a buy signal is a total of 13 closes which are less than the daily low 2 days earlier. For a sell signal, the 13 closes are above the daily high 2 days earlier. The closes don't have to be consecutive and the count can only start once intersection has occurred, but no earlier than the ninth day of the setup. Usually the countdown will take 15 to 30 days to get the total of 13 qualifying closes.

Canceling the Countdown
There are two circumstances when a countdown is canceled. In both cases, it's due to a new setup taking place. When the new setup is in the opposite direction to the first setup, both the initial setup and the countdown are canceled.

If the new setup is in the same direction as the first setup, and occurs during the countdown, the countdown and first setup are canceled. But the new countdown doesn't have to wait to start after the new setup completes. This setup process is called recycling. The new countdown can start simultaneously with the new setup.

Entry
There are three suggested methods for a Sequential trade entry. The first is to buy or sell on the countdown completion day's close. This entry is both the highest risk and highest reward of the three. It's the best price, but also subject to a setup recycle which negates the signal.

To avoid a recycle, the second entry technique requires a close higher or lower than the close 4 days before. For a buy entry, it's the first close after countdown completion which is above the 4-day earlier close. The sell entry takes place with the first close after countdown completion which is below the close 4 days back.

The third entry method, like the second, waits for an indication prices have reversed. Instead of the 4 day earlier close, the reference price is the high or low of the day 2 days prior. A buy entry occurs after the countdown completes on the first close which is higher than the high price of 2 days earlier. The entry for selling is the first close after countdown completion which is below the low price of the day 2 days before.

Exit
It's suggested to exit a Sequential trade in one of two ways. Both cases compare the current setup with the most recent inactive setup. Exit the trade, if when the current setup completes, it doesn't exceed the price extreme of the inactive setup. The other exit method takes place on a reversal signal if the current setup does exceed the price extreme of the inactive setup.

Stop Loss
The daily range of the extreme price recorded during the setup and countdown is used to determine a stop loss. For a buy trade, find the lowest price and subtract the low from the day's high, or from the previous day's close if higher. Subtracting that value from the same day's low is the stop loss. The stop loss for a sell trade uses the highest daily price minus the day's low or the previous day's close if lower. Adding this value to the day's high is the stop loss. The trade is exited on a close which exceeds the stop loss

An alternative stop loss uses the same extreme price for a buy or sell, but a different value combined with the price. A buy stop loss takes the difference between the close of the lowest day and the day's low and subtracts that amount from the low. The sell stop loss subtracts the close of the highest day from the day's high and adds it to the high.

Unlike most of the other techniques in this book, it's recommended to use Sequential only with daily charts. It can work with other time frames, but its purpose is to identify points of price exhaustion, which are more evident on a daily basis. And when used with daily charts, it works in all markets.

There are two types of price gaps. If a price bar's high or low overlaps part of the previous price bar range, but not the close, it's called a lap. If neither of a price bar's high or low overlaps the previous bar's range, it's called a gap. However, in this discussion, both laps and gaps are referred to as gaps.

Most gaps are filled within a few days, but which ones will fill is the question. Tom DeMark's research shows a gap caused by a minor news event is usually filled as soon as the same day. Gaps following major unexpected news, or even no news, tend to stay unfilled for a significant period of time.

An important factor in creating gaps is the emotion behind them. The significance of a gap depends on the degree of emotion involved. Several circumstances indicate when there is little or no emotion powering a gap:

• If a news event happens over a weekend, people have time to analyze the situation. If there's a Monday gap, it would usually be based more on the facts of the situation than an emotional response.
• A gap in the opposite direction to what was expected following a news report, is a clear sign of no emotional response. It also usually indicates the news was already discounted.
• A significant gap is shown if a gap remains unfilled for more than 11 days, and the eighth, ninth, or tenth close is the most extreme price since the gap. Prices are likely to continue in the gap direction.
• When the gap volume is light, it's another sign of little emotion involved in creating the gap. This in turn implies, there is some undisclosed factor causing the gap.

Emotionally charged gaps are usually filled quickly and are good for only short-term trades. But those which have more substance to them, can offer the basis for longer-term trades.

Tom DeMark created a simple formula for estimating the next day's price range. There are three variations to cover the three possible open and close relationships used in the calculation.

If today's close is below today's open, the formula is:
(H₀ + L₀ + C₀ + L₀) / 2 = X
H₁ = X - L₀
L₁ = X - H₀

If today's close is above today's open, the formula is:
(H₀ + L₀ + C₀ + H₀) / 2 = X
H₁ = X - L₀
L₁ = X - H₀

If today's close equals today's open, the formula is:
(H₀ + L₀ + C₀ + C₀) / 2 = X
H₁ = X - L₀
L₁ = X - H₀

H₀ = Today's high
L₀ = Today's low
C₀ = Today's close
H₁ = Tomorrow's projected high
L₁ = Tomorrow's projected low

It's recommended to use the projected range in relation to how prices open. If the open is within the projected range, then during the day, look for support at the projected low and resistance at the projected high. If the open is outside the projected range, expect prices to continue in the direction of the opening breakout.

If there is a breakout, you can either ignore the projection or shift the projected range in the direction of the breakout. An upside breakout would move the projected range higher, with the old high, now the new projected low. A breakout to the downside would shift the range down, so the old projected low would be the new projected high.

When is a market over-priced, and when is it cheap? A simple rate of change indicator can show when prices are relatively high or low.

A rate-of-change indicator can cover any period, but it's suggested to start with one year. This period works best with commodities and indexes. The indicator is today's price divided by the price a year ago. The purpose of this rate of change indicator is to spot long-term overbought/oversold areas. So the indicator need not be updated daily, only weekly or monthly.

By charting this rate-of-change indicator, not only does it help identify the high and low price levels, but also how price reacts at those levels. Once the long-term overbought/oversold areas are found, a short-term entry technique can be used to make a trade.

The basic trading techniques in the other chapters can be applied to any market, but there are some situations unique to stocks and the stock market.

Initial Public Offerings (IPOs)
New issues often show a specific price pattern starting on the first few days of their offering. Prices either move up slightly or sideways for the first two or three days. Then for the next two to four weeks, prices usually decline slightly or move sideways. It's during this time, the initial interest in the stock has faded, and the underwriter is no longer supporting the price.

This lull in interest is followed by new buying demand in three to five weeks after the initial offering day. To help anticipate this round of buying, find the number of shares offered. Then see if you can determine who may have bought a substantial portion of the shares. Often the underwriter will try to place the stock with institutions as a long-term investment. The rule of thumb is, once the initial stock volume held by the stock offering syndicate is turned over two times, the stock is ready to move higher.

Buy-Outs
The methods from the accumulation/distribution and Sequential chapters both can indicate when a company is subject to a buy-out. A stock's volume can also indicate a possible buy-out. A company will start buying the stock of the company it wants to acquire before making the announcement. The Securities and Exchange Commission requires any shareholder who holds more than 5 percent of a company's shares to reveal their ownership.

What this means is, if no announcement is made of a 5 percent acquired interest, it's likely there's no buy-out. To determine when the 5 percent level is reached, first assume 20 percent of the daily volume is the acquisition company's buying. If after 25 percent of the outstanding shares have been traded, the 5 percent should have been obtained.

Exchange and Index Listings
Stocks new to an exchange or index usually get a boost of buying from index funds and others. The opposite also happens when a stock is delisted from an exchange or removed from an index. Stocks which fall below $10 are subject to more selling pressure from institutions which aren't allowed to own stocks under $10.

New High-New Lows
Stocks which hit new 52-week highs tend to be leaders on the upside, while those making 52-week lows are the weakest in downtrends. You can anticipate these new highs or lows with the TD New High/Low Index™.

The index has a 10 point scale with each point representing 10 percent of the 52-week price range. A rating of 10 is within 10 percent of the 52-week high and a 1 is a price more than 90 percent off the high. The index is plotted as a cumulative value on a price chart and is used to help verify the strength of price trends.

Advances-Declines
Tracking daily advancing and declining stocks can give an overall check of market strength. To do this requires calculating two moving averages of 5 days and 13 days for various measures of advancing and declining stocks.

Start with keeping a 5-day moving average and a 13-day moving average of the daily advances minus the declines. Expect overbought/oversold extremes of +450 and -450 for the 5-day value and +250 and -250 extremes for the 13-day number.

Using the same two periods, calculate the moving averages for daily advances divided by the declines. The 5-day readings of 1.95 and 0.65 and the 13-day readings of 1.70 and 0.96 indicate overbought/oversold.

Two more moving averages are created for the daily ratio of advances divided by the total stocks traded. Overbought/oversold ratings are 50 and 30 for the 5-day moving average and 45 and 35 for the 13-day moving average.

Next, make two moving averages for the Dow Jones Industrial Average (DJIA) daily advancing and declining stocks and the trend index (TRIN). The TRIN is the ratio of advances to declines divided by the ratio of upside to downside volume.

Overbought/oversold ratings for the DJIA are 14 and -14 for the 5-day moving average and 5 and -5 for the 13-day moving average. The TRIN averages show overbought/oversold values of 1.35 and 0.75 for the 5-day moving average and 1.20 and 0.85 for the 13-day moving average.

The final calculation is the current day's DJIA close divided by its close 55 trading days before. The overbought and oversold numbers are 1.13 and 0.89. This rating when combined with the others gives a indication of the underlying strength or weakness of the market.

Trading options may seem no more difficult than stocks, yet over 80 percent of option traders lose money. To avoid the same fate, buy call options when the market is down and buy puts when the market is up. Specifically, buy a call only when the call is down, the call's industry group is down, and the overall market is down on the day. Buy put options on days when the option security, industry group, and overall market are all up.

A common measure of market sentiment divides put option volume by call option volume. However, this ratio treats all options the same without regard to their price. To correct for this, the TD Dollar-Weighted Option Ratio™ multiplies an option's volume by its price. This modified ratio is analyzed in the same manner as the conventional version. Excessive put buying (pessimism) or call buying (optimism) levels are an indication the market is oversold or overbought.

Another option indicator can be derived by dividing the option volume by the open interest. This ratio can indicate a change in market conditions when the volume is a large percentage of the open interest. It shows a substantial shift of ownership and market sentiment.

Institutions can affect the best time to buy or sell options as they do with stocks. The option models they use are typically updated over the weekend. This often leads to a significant drop in the option price between Friday and the following Monday. The shorter the time until expiration, the greater this drop is.

"Waldo" patterns are formations which, like their namesake, are obscured by the surrounding prices.

• It's commonly believed increasing volume is necessary to validate price moves higher. But Tom DeMark prefers light volume off a bottom as it indicates a limited supply. A similar situation occurs just before price returns to a previous high. The volume should be light before reaching the peak indicating little supply. Once the peak is exceeded, volume should increase due to short covering and trend traders buying the breakout.
• A sign of a price bottom occurs when price makes a new low but closes above the previous 4 closes. Tops are signaled by a new high and a close below the prior 4 closes.
• If a day's range is more than 2 times the previous day's range, it's a sign consolidation will follow. This is especially so after a market which had been trending for some time.
• Watch the price action if a major low or high was formed more than 9 days ago. If there are 2 consecutive days which exceed that low or high, it's likely forming a bottom or top.
• When price closes unchanged after a day which had closed up, expect prices to move higher. If the day before the unchanged day was down, expect price to go lower.
• When a short-term low occurs, subtract the day's low from the close. Compare that value to the difference between the prior day's close and its low. If the low day's difference is greater, then the day after the low day is likely to move higher, if a new low is not made first. Finding a reversal off a high follows the same process using the difference between the high and close.
• A bottom is signaled if an open or close is above the high price set 4 days before the most recent TD Point Low. This is only valid within 4 days after the TD Point Low. The signal is suspect if there were two price gaps on two days up to and including the signal day's close. A top is signaled in a reverse manner off a TD Point High.
• A short-term bottom is created if today's close is less than the lowest price of the previous 7 days, but not the lowest price of the previous 11 days. The close 1 day ago must also be above the close 5 days ago. A short-term top is made in the reverse manner.
• Look for a change in price behavior if there's a day with an historically significant volume to open interest percentage.
• Most trend followers buy or sell when prices exceed a set number of highs or lows. For a typical period of 40 days, a trader buys when price exceeds the 40-day high and reverses the position when price drops below the 40-day low. Some traders prefer to close out a position earlier, for instance the 20-day high or low, and remain neutral until the next signal.
• Seasonal trends are a common characteristic of commodities. But some stocks also show seasonal effects which are not commonly recognized.
• Despite the difference in the indicator's behavior, most traders apply the same rules for overbought/oversold decisions in both up and down trends. In uptrends, overbought signals last longer than oversold signals and the opposite is true for downtrends. The prevailing trend should be a factor in determining overbought/oversold levels.
• An alternative for selling a trendline breakout is to wait for a reaction after the breakout. For an up trendline, after the breakout, wait for a low which is followed by a rally. A sell signal is given once price then breaks this low. For a downtrend trendline, the process is reversed.
• Support and resistance levels exist with stocks, but because of their high turnover, the same doesn't apply for futures.
• Market timing should include the day of the week, month, and year as a relevant factor since external circumstances can influence the supply/demand balance.

No method is foolproof, and some of the worst losses happen when a trade looks perfect. To avoid catastrophic losses, it's recommended to always use sound money management when trading. It's also suggested, you make a list of your strengths and weaknesses. This trading personality profile can offer a guide for which trades to take and which to avoid. Knowing your strengths and weaknesses can also help you plan how best to deal with losses when they occur.

The following are trademarks held by Thomas R. DeMark:
Countdown
D-Wave
Daily Range Projections
DeMarker
Magnet Price
Price Countdown
Price Intersector
Price Setup
Range Expansion Breakout
Range Expansion Index (REI)
REBO
Sequential
Setup
TD Breakout Qualifiers
TD Channel
TD Demand Line
TD Dollar Rated Option Ratio
TD Line Breakout
TD Line Value
TD Lines
TD New High-New Low Index
TD Points
TD Price Points
TD Price Projector
TD Rate of Change
TD Retracement Arc
TD Retracement Qualifier
TD Supply Line
TD Supply Points
Trend Factors

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