On the world's financial markets and stock exchanges. Part 5
1. Dow Theory
1.1 History of technical analysis.
The beginnings of technical analysis were preceded by observations of price changes in financial markets over the centuries. The oldest tool in the arsenal of technical analysis is the "Japanese candlestick" chart, developed by Japanese rice traders in the XVII-XVIII centuries.
However, in 1900-1902, The Wall Street Journal published a series of relatively obscure articles on the mechanism of stock price movements. The author was the paper's founder and editor-in-chief, Charles Henry Dow, who, in addition to the paper, founded the famous Dow Jones financial news service.
Dow's successor as editor, William Peter Hamilton, described him as "ultra-conservative", a cool, knowledgeable and intelligent man who "knew his business" and did not allow himself to be annoyed by anything. At some period of his career he had his own seat on the New York Stock Exchange, for his good practical mind allowed him to penetrate the very essence of securities trading. Unfortunately, he died in 1902 at the age of only 52, so he did not publish anything from his research, except for selected material in newspaper articles. However, these observations were later synthesised into what we now call the "Dow Theory".
Initially, the principles outlined in Charles Dow were used to analyse the American indices he created, the industrial and railway indices. But most of Dow's analytical conclusions can just as well be applied to financial markets.
The development of computer technology in the second half of the 20th century led to improvements in analysis tools and methods, as well as the emergence of new methods that exploited the power of computer technology.
1.3 Fundamentals of Technical Analysis Theory
Technical analysis does not take into account why prices change direction (for example because of poor returns on stocks or changes in other prices), but only the fact that prices are already moving in a certain direction. From an analyst's point of view, profits can be made in any market if you correctly guess the trend and then close the trade on time. For example, if the price has dropped to the low side, you should take the chance and buy, and if it has risen to the high side, you should take the chance and sell without covering.
Also, in technical analysis we check the so-called patterns - the patterns that appear on the charts. For example, we know from history that the price rises in many cases continuously, and then falls in jumps (this happens due to the closing of short positions). Such observations can be used in order to open and close a trading position in time.
Conclusions drawn from technical analysis may be inconsistent with those drawn from fundamental analysis. Basically, fundamental analysis is based on the fact that the value of a security differs from its market price, i.e. it is over- or under-valued. If it is possible to calculate the "right" price, it is possible to assume that the market will "correct" to the necessary level (the correction can be up or down). Therefore fundamental analysis can recommend to open a long position, while technical analysis will recommend to go short.
Criticism of Technical Analysis Although many "chartists" believe that their technique gives them an advantage over other traders, not all researchers share this belief. Technical analysis of price charts in the past does not allow us to guess the "reversal points" of prices in the future, and when prices develop in an already known direction, thechanalysis provides a simple "buy and hold" strategy. Among the critics of thechanalysis there are quite a few successful investors. Warren Buffett says the following: "I realised technical analysis didn't work when I turned the price charts upside down and got the same result." Peter Lynch gives an even sharper assessment: "The price charts are great for predicting the past". In defence of technical analysis, the goal of many traders is to recognise the direction in which the market is moving. George Lane, a technical analyst, became famous for his phrase: "The trend is your friend! The trend is your friend! You need a tool to recognise a trend. And the same tool should be used in order to exit a trading position on time. Technical analysis helps to do this (although it cannot predict anything accurately). Many market participants act on the basis of their experience, believing that "success lies on the far side of error" (Thomas Watson Sr., founder of IBM). Studying prices and trading volumes is necessary to gain experience in making trades in the stock market. Can I use technical analysis today? Before the advent of on-line trading, technical analysis was only of interest to a narrow circle of specialists. Now textbooks on technical analysis are available in many shops. Thus, knowledge of technical analysis is available to almost anyone.
1.4 Postulates of the Dow Theory.
1. There are three types of trends in the market. In an uptrend, every subsequent peak and every subsequent decline is higher than the previous one. In case of descending trend, each subsequent peak and declining trend is lower than the previous one. In a horizontal trend, every subsequent peak and decline is at about the same level as the previous ones. Dow also distinguished three categories of trends: primary, secondary and minor. He gave most importance to the primary or main trend which lasts more than a year, and sometimes several years. A secondary or intermediate trend is a correction to the main trend and usually lasts from three weeks to three months. Such intermediate corrections amount to one to two thirds (very often half) of the distance travelled by prices during the previous (main) trend. Small or short term trends last no longer than three weeks and are short term fluctuations of the intermediate trend.
2. The main trend has three phases. Phase one, or the accumulation phase, is when the most astute and informed investors start buying as all adverse economic information has already been taken into account by the market. The second phase occurs when those who use technical methods to follow trends come into play. The economic information becomes more and more optimistic. The trend enters its third or final phase when the general public enters the game and media-fueled excitement begins in the market. Economic forecasts are full of optimism. The volume of speculation increases. It is at this point that the knowledgeable investors who had been "hoarding" during the previous trend, when no one wanted to "hoard", begin to "spread". The trend comes to an end.
3. indices take into account everything. According to Dow Theory, any factor that can affect supply or demand in one way or another will invariably find its reflection in the index dynamics. Of course, these events are not predictable, but nevertheless they are instantly considered by the market and are reflected in index dynamics.
4. The indices should confirm each other. Dow was referring to the industry and railway indices. He believed that any important upward or downward signal in the market should pass in the values of both indices.
5. Trading volume must confirm the nature of the trend. Volume should rise in the direction of the main trend.
6. The trend is in effect until it gives clear signals that it has changed. Or in other words - the trend is more likely to continue than to change. A very important rule! It will help you choose the right direction to enter the market.
A trend is a definite price movement in one direction or another. In real life, no market moves in any direction in a straight line. The market dynamics is a series of zigzags: up and down and up and down. It is the direction of the dynamics of these ups and downs that forms the market trend.
The basic rule is: "The trend is your friend". Consequence: "Don't work against the trend"!
1.5 Support and resistance lines
Support lines connect important market lows and occur when sellers are no longer able or willing to sell at lower prices. At this price level, the desire to buy is strong enough to resist selling pressure. The fall stops, and prices start moving up again.
Resistance lines connect important highs (tops) in the market, and occur when buyers are no longer able or willing to buy the commodity at higher prices. Seller pressure outweighs buyer pressure, and as a result the rise stops and gives way to a fall.
If we break the support line downwards, it turns into resistance. When you break up the resistance line, it turns into support.
Charles Dow's original principles were used to analyze the U.S. indices which he created, the Industrial Average and the Railroad Index. But most of Dow's analytical conclusions can just as well be applied to financial markets.
In financial markets, prices can be figuratively thought of as the outcome of a bout between a bull (buyer) and a bear (seller). Bulls push prices up and bears push prices down. In fact, the direction of price movement shows whose take is up.
Drawing on this figurative comparison, let's take a look at Phillip Morris' share price performance. Notice how whenever the prices during the analysis period fell to the level of $45.50, the bulls (i.e. the buyers) took the initiative to prevent further price declines. It means that at the price of $45.50 buyers considered it profitable to buy securities of this company (and sellers did not want to sell at the price lower than $45.50). This price situation is called support, because buyers are supporting the price of $45.50.
Similar to a support level, resistance is a level where sellers control prices, preventing them from rising further. Consider the following figure. Notice how whenever prices approached $51.50, the sellers outnumbered the buyers, preventing prices from rising.
The price at which the deal is made is a price which satisfies both the bull and the bear. It reflects the coincidence of their expectations. Bulls expect prices to rise and bears expect prices to fall.
Support levels indicate a price at which most investors expect it to rise; resistance levels indicate a price at which most investors believe it will fall.
But investors' expectations change over time! For example, for a long time investors thought the Dow Jones Industrial Average would not go above 1,000 (as indicated by the strong resistance at 1,000 in the following figure). But as the years have gone by, they are no longer surprised by an index close to 2500.
When investors' expectations change, it is often quite dramatic. Look at how decisively prices have crossed the resistance level on the share price chart of Hasbro Inc. Also note that when that level was breached, trading volume increased significantly.
Once market participants realized that Hasbro stock could be worth more than $20.00, the number of investors willing to buy it at a higher price also increased (leading to an increase in both price and volume). By the same token, the bears, who would have previously started selling as prices approached $20.00, also believed that prices would rise further and gave up selling.
The formation of support and resistance levels is perhaps the most visible and recurring phenomenon on price charts. A breakout of support/resistance levels can be due to fundamental changes that exceed or fall short of investors' expectations (e.g., changes in earnings, management, competition, etc.) or due to a self-fulfilling prophecy (investors buying as they see prices going up). The cause is less significant than the effect: new expectations lead to new price levels.
The following figure shows a breakout due to fundamental reasons. It occurred when Snapple released a higher-than-expected earnings report. How do you see that they are higher? By the price movements that followed the publication of the report!
There are also support/resistance levels which are more related to emotion. For example, the Dow Jones Industrials could not break through 3000 for a long time, because investors were not psychologically prepared for it.
1.6 The strength of the support and resistance levels
The area of consolidation, which was struck by several trends, is like a battlefield full of craters. Its defenders have plenty of cover, and attackers will probably have to slow down. The longer prices stay in a consolidation area, the stronger the emotional commitment of bulls and bears to that area.
The strength of each support or resistance area is determined by three factors: its duration, height and the volume of trades that were concluded in it. These factors can be thought of as the length, width and depth of a consolidation zone. We can identify the main characteristics of the strength of the support and resistance lines:
The longer the consolidation zone, in time or in terms of the number of touches it has sustained, the stronger it is. Support and resistance, like good wine, get better with age. In two weeks of trading, the nearest support and resistance form, in two months people get used to them and support or resistance becomes of medium strength, and in two years an actual standard forms, providing very strong support and resistance. As support and resistance levels age, they weaken. Losers leave the market and are replaced by newcomers who have no emotional connection to the old price levels. Those who have just lost money remember very well what happened to them. They are probably still in the market, with their pain or regret, and are seeking to rectify the situation. Those who made bad decisions a few years ago are probably already out of the market and their feelings mean less. The strength of support and resistance increases every time prices reach that level. When players see prices turning around at a certain level, they will expect them to turn around the next time too.
The larger the range of prices in the resistance and support area, the stronger it is. A consolidation with a large break price range is like a high fence around valuable property. A consolidation area equal to 1 per cent of the current price level (4 points with the S&P 500 at 400) gives only marginal support or resistance. A price area equal to 3 per cent gives average support or resistance, and a price area equal to 7 per cent or more can halt a very strong trend.
The higher the volume of trades in a support or resistance area' the stronger it is. High volume in a consolidation area shows the involvement of many players and indicates strong emotions. Low volume indicates that players don't care about crossing that level and is a sign of weak support or resistance.
As soon as the trend on which you are trading approaches support or resistance, tighten your precautions. Precautionary measures are an instruction to sell below the existing price level if you have a buy position open or an instruction to close a sell position above the existing price level. Such an instruction will protect you from large losses if the trend changes. The trend shows the strength of the market when prices reach support and resistance levels. If they are strong enough to overcome them, the trend will accelerate and your precautionary measure will not be triggered. If the trend reveals weakness, then prices bounce off support or resistance. In this case, the precautionary measure saves most of the profit.
Support and resistance are more important on long-term charts than short-term charts. Weekly charts are more important than daily charts. A good trader sees several time scales and is guided by the longer one. If you are moving through the free zone on the weekly chart, then touching the resistance line on the daily chart is not as important. When you get close to resistance or support on the weekly chart, you need to be more ready for action.
Support and resistance levels are good for giving guidance on avoiding losses and preserving profits. The minimum of a consolidation area always coincides with the lowest support point. If you buy by placing your stop level below this low, the uptrend has plenty of room to manoeuvre. More cautious players buy after the upper boundary is crossed and place a safety measure in the middle of it. With a true breakout of resistance, it is unlikely that prices will move back into this range just as it is unlikely that the rocket will return to the launch pad immediately after liftoff. In a downtrend, mirror this procedure.
Many players avoid setting the stop level at round numbers. This prejudice goes back to the wise advice of Edwards and Magee to avoid setting a stop on a round figure because "everybody sets it there. In other words, if a player buys copper at 92, he sets the stop at 89.75, not 90. When he sells off a stock at 76, the precautionary measure is set at 80.25, not 80. But today, fewer stops are set on round numbers than on fractional numbers. So it is better to set the stop at a reasonable level, whether the number is round or not.
1.7 Actual and false breakouts
The market spends more time in a certain price corridor than in a trend. Most breakouts outside the price corridor are false. They are just in time to pull in the players who follow the trend before prices return to normal. False breakouts are the bane of amateurs, while professionals love them.
Professionals expect prices to fluctuate most of the time, without much deviation from the norm. They wait for the upside breakout to reach its final highs and, on the downside breakout, for prices to finally stop falling. They then play against the breakout by placing precautions on the last high or low in prices. This is a very tight stop and their risk is low, while there is an opportunity to make large profits if prices return to their range. The risk/reward ratio is so good that a professional can be wrong half the time and still make a profit.
The optimum play when opening a buy position is when a breakout to the upside on the daily chart is accompanied by technical indicators of a new uptrend forming on the weekly chart. Valid breakouts are accompanied by high volume, while false ones usually have low volume. True breakouts are confirmed when technical indicators reach new highs or lows in the direction of the trend and false breakouts are often indicated by divergence between prices and indicators.
2 Trends and Channels
2.1 Trend lines
The graphs show the "bulls" and "bears" actions. At the lows the bears are losing and the bulls are gaining control of the market. The highs indicate when the bulls have exhausted their resources and the initiative has been taken by the bears. The line connecting the two nearest lows gives the lowest total power divider for the bulls. A line connecting two adjacent highs gives the lowest total divisor of bearish strength. These lines are called trendlines. Players use them to identify the trend.
When prices are rising, draw an uptrend line through the lows. When prices are falling, draw a downtrend line through the highs. Projecting these lines into the future will help identify sell and buy points.
The most important characteristic of a trendline is its slope, because it determines the dominant force in the market. When the trend line is pointing upwards, it indicates that the bulls are in control. In that case it is wise to buy with caution below the trend line. When the trend line is pointing downward, it indicates that the bears are in control. In this case, it is wise to sell off and defend your position by stopping above the trend line.
A channel is formed by two parallel lines between which prices are traded. If you draw an uptrend line through the lows of declines, you should draw a channel line parallel to it through the highs of rises. If you draw a downtrend line through the highs of rises, draw a channel line through the lows of falls.
Channels, like trend lines, should be drawn through the boundaries of areas of price consolidation, discarding extreme lows and highs. The existence of channels adds to the reliability of the trend line. The reliability of channels is determined by the number of touches.
Channels reflect the maximum strength of the "bulls" in an uptrend and the maximum strength of the "bears" in a downtrend. The wider the channel, the stronger the trend. It is wise to trade in the direction the channel slopes, buying in the lower quarter or half of the uptrend channel and selling in the upper half or quarter of the downtrend channel. You should make profit on the other side of the channel.
2.3 Peculiarities of trading in the trend and in the channel
Traders try to profit from price fluctuations: buy low and sell high, or sell when prices are high and close a buy position when prices are falling. Even a quick glance at the charts shows that the market is in a price corridor most of the time. Much less time is spent on trends.
A trend occurs when prices are rising or falling all the time. In an uptrend (Uptrend) each rise reaches a higher value than the previous one and each fall stops at a higher level than the previous one. In a Downtrend, each downtrend reaches a deeper low than the previous one, and each rise stops at a lower level than the previous one. In a price corridor, in other words - in a flat (Trading Range, Trendless Market) all rises stop at approximately the same maximum level, and all falls reach approximately the same minimum.
A trader should distinguish a trend and a price corridor (channel). It is easier to trade during a trend. When prices are constant, it is harder to make money unless you trade options, which requires special skills.
Trading in a trend and in a price corridor requires different tactics. When you buy during an uptrend or sell during a downtrend, you have to give the trend the presumption of innocence and not let it easily derail you, beneficially strap in and hold as long as the trend lasts. When you are playing in a price corridor, you need to be sensitive and close your position at the first sign of change.
Another difference between trading in a trend and in a price corridor is your approach to the ups and downs of the market. In a trend, you follow the market - buy on the upside and sell on the downside. If prices are in a corridor, you should buy on the downside and sell on the upside.
An uptrend occurs when the bulls are stronger than the bears and their purchases push prices up. If the 'bears' manage to bring prices down, the 'bulls' come back in to play with renewed vigour, reversing the decline and pushing prices to a new high. A downtrend occurs when the bears are stronger and their selling pushes prices down. When an influx of buyers brings prices back up, the bears take the opportunity to sell again, knocking the rise down and pushing prices to a new low.
A pattern of consecutive lows and highs indicates a downtrend. Soybeans have fallen in price from November to mid-January. The low 4 is lower than the low 2 and the high 3 is lower than the high 1. A break of the downtrend line at 5 indicates the end of the downtrend. A breach of the line defining the downtrend may indicate a market reversal in the opposite direction or that prices will stop falling and fluctuate within a certain corridor.
The November-January downtrend moved into the price corridor defined by horizontal lines drawn through lows 4 and highs 3 and 6. When the decline from high 6 stopped at low 7 before reaching the bottom of the range, a tentative uptrend line could already be drawn. A breakout from the corridor at 8 confirms the start of a new uptrend.
At the right edge of the chart prices stopped just above the trend line. Since the trend is upward, this is a buying opportunity. The risk, in the case of a downward move, can be limited by placing the stop either below the last low or below the trend line. Note that the daily price intervals (distances from highs to lows) are relatively short. This is typical of a strong trend. A trend often ends after a few days with a wide price band indicating feverish activity.
When the bulls and bears are roughly equal in strength, prices remain within the price corridor. When the bulls manage to lift prices, the bears start selling and stop the fall. The profit hunters step in and interrupt the decline. "Bears" close the selling positions, which causes prices to rise, and the cycle repeats.
The price corridor is like a battle between two equally strong gangs. They are pushing each other back and forth on the street corner, but no one can master the position. The trend is like a fight in which one gang chases the other along the street. Every now and then, the weaker gang stops and tries to fight back, but then they still have to keep running.
There is no price movement in the price corridor, nor does the crowd spend most of their time aimlessly swarming around. The market spends more time in the price corridor than in the trend, simply because inactivity is more natural for people than meaningful activity. When the crowd gets excited, it looks for and creates a trend. The crowd doesn't stay excited for long, it goes back to its fluctuations. Professionals usually assume that there is a price corridor.
Identifying a trend or price corridor is the most difficult task of technical analysis. They are easy to identify in the middle of the chart, but the closer you get to the right-hand edge, the more difficult your task becomes.
There is no universal simple method for identifying the trend and price corridor. There are several methods, and it is wise to combine them. If they confirm each other's results, there is more confidence in that result. If they contradict each other, it is better not to trade and wait for certainty.
Having determined the boundaries of the trend, it is equally important to decide when to enter the market. If you have detected an uptrend, you will have to decide whether to buy immediately or wait until the local low. If you buy immediately, you will go along with the trend, but your precautionary measure is likely to be set far enough and your risk will be greater.
The most important indicator of a trend line is its slope. If the slope is up, then trade to the upside. If it is sloping downwards, then trade downwards.
An ascending line connecting lows 1 and 2 indicates an uptrend. Note that prices sometimes break through the trend line downwards, but then rise back up to it (3). This provides an excellent opportunity to sell. The same happens again at point 7, where prices return to the trend line after falling below it.
When you trade in the direction of the trend line, you usually act in the direction of the market tide. At the right edge of the chart, you should look for a selling opportunity as the trend is going down. Do not sell immediately, prices are too far below the trend line and even when you enter the game, insurance measures will not be able to reduce your losses. It is important to wait for a trade with a good profit to risk ratio. Patience is a trader's virtue.
If you wait until the low side, your risk will be less, but you will acquire competitors of four varieties: position holders who want to add to the position, players who want to close the position, players who have not yet bought, and players who sold too early and are now looking to buy, the waiting room is quite full for a price decline! The market is not exactly renowned for being charitable and a deep downturn could well mean the beginning of a change in trend direction. This reasoning also holds true in a downtrend. Waiting for a pullback when the trend is gaining momentum is for amateurs.
If the market is in a price corridor, in a flat, and you are waiting for a breakout, then you have to decide whether to buy in anticipation of a breakout, or during a breakout, or during a pullback after an actual breakout. If you are working with multiple positions, you can buy a third in anticipation of a breakout, a third during a breakout and a third during a pullback.
Whichever decision you make, one money management rule will always keep you out of the riskiest trades. The recommended distance from the entry point to your precautionary measure should be no more than 2 per cent of your capital. No matter how profitable a trade appears to be, skip it if it requires a more distant precautionary measure.
During a trend, money management tactics should be different than during a price corridor. During a trend, it is wise to make a smaller position volume and place precautions farther away. Then you will have less chance of being affected by market fluctuations, and the risk will still be under control.
During a price corridor it is very important to get the timing of your entry into the market right. Accuracy is important here, as there are few opportunities to profit. The trend is forgiving for a lagged entry, as long as you continue to act in the direction of the trend. Old gamblers advise: "Don't break your head in a bull market. If you are unsure whether the market is in a price corridor or trending, remember that professionals assume the existence of a price corridor until proven otherwise. If you are still in doubt, step aside.
Professionals love the price corridor because they can buy and dump positions with little or no risk of being taken over by a trend. Because they pay low or no commissions and do not suffer from price differentials, playing in a slightly fluctuating market is profitable for them. For those of us who play outside the trading room, it is better to wait for a trend to emerge. During a trend, you can trade less frequently, and your account will suffer less from commissions and price differences.
2.4 Conflicting time scales of trends
Most traders do not realize that the market is usually in a trend and price corridor at the same time! They choose one time frame, for example daily or hourly, and look for profitable deals on daily charts. When their attention is fixed on the daily or hourly chart, trends on other time frames, for example weekly or 10 minute charts, take them by surprise and upset their plans.
The market exists on all timeframes at the same time. It may be shown on the 10-minute, hourly, daily, weekly or any other chart. A daily chart may show a buy signal and a weekly chart may show a sell signal, and vice versa. Signals on different timeframes often contradict each other. Which of them should you follow?
If you have doubts about the existence of a trend, consider a larger timescale chart.
The conflict between signals from different time scales coming from the same market is one of the great mysteries of market analysis. What appears to be a trend on a daily chart may turn out to be a slight bounce on a perfectly straight weekly chart. What looks like a normal price corridor on the daily chart reveals a wealth of upward and downward trends on the hourly chart, and so on. When professionals are in doubt, they look at the bigger picture, while amateurs focus on the smaller scale charts.
On the weekly chart, the Eurodollars show a pronounced A-B uptrend. At the same time, the daily chart shows that an X-Y downtrend is starting. Which one will you follow? The contradiction between signals of different time scales in the same market is one of the most frequent and most unpleasant dilemmas a player faces. You need to follow the market on several time scales and know how to react to contradictions between them.
2.5 How to draw a trend line
Most traders draw trend lines through the highest and lowest price levels, but it is better to draw them through the boundaries of price consolidation areas (fig b). These boundaries show where most players have changed direction. Technical analysis is a kind of public opinion poll, and in such a poll we are interested in the opinion of the masses, not a few extremists. Drawing trend lines across the boundaries of consolidation areas is somewhat subjective. You will have to fight the temptation to skew the ruler.
Panic selling of "bulls" and panic buying of "bears" create extremes, which look like "tails" on the chart. You may prefer to draw trend lines through consolidation areas rather than through extremes, also because the latter only tell you about the crowd that it is prone to panic.
Extreme points are very important, but not for drawing trend lines. The market usually recovers after such values, providing good opportunities for short-term play.
Draw trend lines through areas of price consolidation and leave out price extremes. "Tails" are high dashes at the end of the trend and they jump out of consolidation areas. The market moves away from the 'tails', offering good opportunities to play in the opposite direction.
Notice how persistently the angles of the trend lines are repeated month after month. If you know them, it will be easier for you to draw preliminary trend lines. At the right edge of the chart, prices touch trend lines. Buy as soon as you see that the next line has not made a new high.
The markets are constantly oscillating in search of the area where the trading volume will be highest. Tails indicate that a given price has been rejected by the market. This usually leads to a rush in the opposite direction. Once you spot a tail, play against it. Place your safety stop in the middle of the tail. If the market starts to 'chew its tail', it's time to exit the trade.
Victor Sperandeo gives another method of depicting trend lines in his book The Vic Player. His technique helps identify the reversal of a well-established trend.
Sperandeo draws an uptrend line through the lowest low of the entire trend and through the highest local low preceding the highest high. Such a line may not touch prices between these two points. The crossing of this line by prices gives the first signal that the trend is changing. The next signal is triggered when prices reach the previous maximum and move downward from it. The third signal is triggered when prices fall below the previous low. It confirms that the uptrend has changed direction. This procedure is mirrored in a downtrend.
2.6 Classification of trend lines
The main and most important characteristic of a trendline is its slope angle. When the trend line is sloping upwards, the bulls are in control and you should look for buying opportunities. When it is sloping downward, the bears are in control and we should be looking for a way to sell. You can classify trend lines according to their importance using five indicators: time scale, duration, number of times prices have touched the trend line, slope angle and volume of trades.
The basic rules for trendline evaluation:
The greater the time scale, the more important the trend line. The trend line on the weekly chart shows a more significant trend than on the daily chart. The trend line on the daily chart is more important than on the hourly chart, and so on.
The longer the trendline, the more reliable it is. A short trend line reflects the behaviour of the masses over a short time interval. A longer line reflects their behaviour over a longer period of time. The longer the trend line lasts, the greater its inertia. A serious bull market can follow its trend for several years.
The greater the number of price contacts with the trend line, the more reliable it is. In an uptrend, a return to the line means a rebellion among the "bears". In a downtrend, a price surge to the trend line indicates a bullish rebound. When prices reach the trend line and then move back up, you know that the dominant group in the market has won the rebellion. The preliminary trend line is drawn through only two points. A third contact point makes it more reliable. Four or five points of contact show that the market-dominating crowd is firmly in the grains of power.
The angle between the trend line and the horizontal reflects the intensity of emotions among the dominant market crowd. A steep trend line shows that the dominating crowd is dynamic. A relatively flat trend line indicates that the dominant crowd is turning slowly. A flat trend line usually lasts longer, similar to a competition between a turtle and a deer.
A comparison of the angles of the trend lines shows whether the dominant crowd is leaning more towards the "bulls" or the "bears". It is striking how often the trend lines go with the same slope in a given market. Perhaps this is because the key participants rarely change.
Often prices move away from the trend line faster. In this case you can draw a different, steeper trend line. This shows that the trend line is accelerating, becoming unstable (Figure 8). Having drawn a steeper trendline, you should harden your precautions by placing a stop immediately behind the previous trendline and adjust the stop after each new price bar appears on the chart. Breaking a steep trend is usually accompanied by a sharp rush in the opposite direction.
In an uptrend, the volume of trades usually increases when prices move up and decreases when they move down. This suggests that uptrends attract players and downtrends leave them indifferent. In a downtrend, the opposite happens: volume increases when there are declines and decreases when there are rises. A pullback in high volume threatens the trend because it shows a rebellious crowd rising.
If volume increases when prices move in the direction of the trend, it confirms the trend. If volume decreases when prices move against the trend, it also confirms the trend. If volume increases when prices return to the trend line, it indicates an opportunity for change. When volume decreases when prices move away from the trend line, the trend is in trouble.
2.6.1 Trend reversal
Figure 7. A simple method for trend reversal detection
Draw a trend line from the absolute maximum (A) to the lowest local maximum (B) preceding the absolute minimum (C), so that it does not cross the prices between A and B. A break through this trend line (1) gives the first signal that the trend is changing. A return to the previous low (2) gives the second signal that the trend is changing. This is a good time to start buying. When prices pass the local maximum (3), it will confirm that the trend has reversed. With this method, described by Victor Spirandeo, it is easier to catch major turns rather than short-term fluctuations.
2.6.2 Breakout of a trend
A breakout of an established trend shows that the dominant group in the market has lost its power. You need to be careful not to wait for signals to enter the game, most people lose money trying to ride the core out of the cannon.
The trend line is not a glass floor beneath the market, a single crack is enough to shatter it. Rather, it is a fence on which "bulls" and "bears" can lean. They can even move it slightly without destroying it. The trend is indeed broken when prices touch it from the other side. Some punters argue that a trend can only be considered broken when prices move away from it by two or three percentage points.
After breaking a steep uptrend, prices often jump back up, pass through the previous high and touch the old trendline from below (Figures 4 and 8). When that happens, you have an almost perfect opportunity to sell: a combination of a double high, a touch of the old trendline and possibly a bearish divergence in the indicators. Again the mirror image applies to downtrends.
Figure 8. The trend is accelerating
The stock market has been rising slowly and steadily since the low of 1987. You could buy whenever prices touched the flat trend line (1). The trend accelerated in 1988 and a new trend line (2) should be drawn at point A. When the new steeper line was broken, it signalled the end of the bull period. The market provided, as is often the case, a great opportunity to play down at point B when prices rose to the old trendline before the collapse.
Rules for using trends:
Trade in the direction of the slope of the trend line. If it goes up, look for buying opportunities and refrain from selling. If it slopes downwards, sell and avoid buying.
The trend line provides support or resistance. If prices are rising, place an order on the trend line and take precautions below it. When prices fall, do the opposite.
Steep trends precede sharp changes in direction. If the trend line is steeper than 45 degrees, place precautions on the trend line and adjust it daily.
Prices often return to the previous extreme price after they have broken a steep trendline. A rise to an old high with falling trading volume and divergence with the indicators provides an excellent opportunity to sell. A fall to the previous low after a break in the downtrend provides a low-risk buying opportunity.
Draw a range line, a channel parallel to the trend line and use it to identify when to take profits.
2.7 A preliminary trend line
Usually a trend line passes through at least two points on a chart. But there is a little known method of drawing a preliminary trend line through only one point (Figure 9).
If prices have broken through a downtrend and risen above it, you can assume that the downtrend has ended and a new uptrend has begun. Connect the last two highs and this will be the channel line for the new rise. Draw a line parallel to it through the last low. This preliminary trend line, parallel to the channel line, will show you where to expect the next low. It often indicates an excellent buying opportunity. This method works somewhat better on lows than on highs.
Figure 9. Channels and preliminary trend lines
The downward trend line 1, drawn through the highs of rises, characterizes a bearish market in corn. Line 2 is drawn through the lows parallel to the trend line. It tracks maximum bearish strength in a downtrend. The best opportunities to sell are in the upper half of the falling channel and to buy are in the lower half of the rising channel.
When prices break up through a downtrend line, the channel can help you draw a preliminary uptrend line. First draw a new channel line 3 connecting the two uptrend tops. Then draw a line parallel to it through the last low. This will be the provisional new trend line.
On the right edge of the chart, the corn is selling high. It is at the upper edge of the channel. If you want to play up, place a buy order near the new trend line 4.
If prices have broken the uptrend, measure the vertical distance from the trend line to the last high and set it aside from the breakout point downwards. If the crowd can be optimistic enough to push prices that many dollars above the trendline, they can probably also be pessimistic enough to push prices the same amount below the trendline. For a downtrend, apply this procedure in reverse. This method gives you a minimum estimate of the value of the next market movement, which is usually larger.
Trend lines can be applied to both volume and indicators. The slope of the trend line for volume shows whether there is more or less interest in the market. A rising trend in volume confirms an active trend. Falling volume indicates that the market crowd refuses to follow the trend. Of all the technical indicators, the Relative Strength Index-RSI is the most suitable for trendline analysis. Its trend lines often break earlier than trend lines on price charts, giving early warning of a change in market direction.
A gap is a configuration of adjacent features on a price chart where the bottom of the first feature is higher than the top of the next (fig. 10). It suggests that no deals were made at a certain price, and deals were made only at higher and lower prices.
Gaps occur when prices jump when there is a sudden imbalance between buy and sell orders. Important news often leads to gaps. Gaps on the daily chart reflect reactions to events which came to light overnight, when trading was closed. If the news had been known during trading, the gaps would have only been on the smaller charts and the price spread would probably have been larger during the day.
For example, a strike at a large copper mine would benefit the bulls. If the news comes in the evening, the bears will get scared and want to close the position. They will flood the room with buy orders before the opening of trading. Traders in the room will react with a starting price of copper above the previous day's high. The smart trader prefers to trade when the market is quiet, while amateurs tend to react impulsively to news.
Gaps indicate that the market crowd is agitated, that the losers are in pain for their positions. When you know whether "bulls" or "bears" are hurting, you can predict what they will do next and act accordingly.
Figure 10. Breaks
Let's take a closer look at this movement. To do this, cover this chart with a piece of paper and slowly slide it from left to right.
А. Breakout Breakout. Trade downwards with a stop above the upper edge of the gap.
В. Gap depletion, prices are back up the next day. The downtrend has ended. Close the position immediately.
С. Another depletion gap, marked by no new highs afterwards. A few days are offered to trade down with a stop above the high.
D. A continuation gap during the downtrend. Trade down with a stop above the upper edge of the gap. Prices will activate a stop after a few days, as there is no method insured against failure.
Е. Exhaustion gap closing in a few days. Close the position immediately.
F. Normal gap in the price stop area. No action is recommended.
G. Breakout Gap. Play up with a stop just below the lower edge of the gap.
Н. Continuation Gap. Add more to the open position and place the stop just below the lower edge of the gap. The gap at the right edge of the chart will be either a continuation gap or an exhaustion gap. Relatively low volume hints at a continuation. If you will be buying, place a stop below the lower edge of this gap.
Some gaps are real and others are imaginary. A real gap occurs when the market misses some price corridor. An imaginary gap occurs when the trading takes place in another market while this market is closed. For example, the daily charts of the Chicago Futures Exchange are full of imaginary gaps. Currencies are traded in Tokyo, London and elsewhere when the Chicago exchange is closed. When the exchange opens, prices reflect the results of trading across the ocean.
All gaps can be divided into four main groups: normal, breakout, continuation and depletion. You need to be able to differentiate between them, as each tells a different story and requires a different tactic in the game.
3.1 Common Gaps
Common Gaps close quickly in a few days and prices return to their corridor. Common Gaps often occur in quiet markets without trends. They are common in futures markets with far-off closing dates and low-volume bottom lines, when all possible sell positions are already open.
Normal gaps have no continuation: new highs after an upward gap and new lows after a downward gap. Volume may increase slightly on the day of a regular gap, but it returns to its average values on the following days. The lack of new highs and lows, as well as constant volume, show that neither the bulls nor the bears have developed strong feelings about this market. Of all the gaps, regular gaps are the least useful for a trader.
Regular gaps occur more often than the others. In a stagnant market they occur very easily. A big trader once told how he could move gold up or down two dollars on a quiet day. He usually traded big contracts and if he bid for 20 contracts at once, other players would take notice, thinking that he knew something. Gold jumped up and his job was to sell before the gap closed.
The gap after a stock dividend occurs on the stock market on the day of the dividend and it is a normal gap. For example, if the dividend is 50 cents, each share becomes 50 cents cheaper after the dividend is paid. This is similar to how the price of a cow drops after she gives birth to a calf. After the cow gives birth, the price of the cow falls by the price of the calf, as it no longer comes with the cow. Previously, postpartum gaps were common. Now the daily range of the dividend-paying stock price is larger than that of the dividend, and post-dividend price movements rarely result in a gap.
Breakaway Gaps occur when prices leave a consolidation area with a high volume of trades and start a new trend, Breakaway Gaps can remain open for weeks and months or sometimes years. The longer the period of the price corridor that preceded the breakout, the longer the new trend will last.
An upward breakout is usually followed by a new high over the next few days and a downward breakout by a series of new lows. On the day of the breakout, there is a sharp increase in transaction volume, which persists for several days afterwards. On the day of the breakout, volume may be double the average of the previous few days.
The breakout shows a significant change in the mentality of the masses and reveals the presence of a lot of pressure supporting the new trend. The sooner you join the new trend, the better.
Most breakouts are common and close quickly. Professional players love them and play against the gap on the rebound. You need to be careful because if you do it mechanically, sooner or later the breakout will come back at you. You need to have deep pockets to hold a losing position for months, waiting for the gap to close.
3.3 Continuation Gaps
A Continuation Gap occurs in the middle of a strong trend which keeps making new highs or lows without closing the gap. It is similar to a breakout, but occurs in the middle of a trend, not at the very beginning. It means a rush of new strength to the dominant market group. There were many such gaps during the inflationary bull market in the commodity markets of the 1970s.
The continuation gap helps you estimate how long a trend can last. Measure the vertical distance from the beginning of the trend to the gap and set it off from the gap in the direction of the trend. When the market approaches this mark, you should consider taking profits.
Volume confirms the presence of a continuation gap if it increases by at least 50 per cent compared to the average level of the past few days. If prices do not make new highs or lows for several days after the gap, then you are probably dealing with a treacherous attrition gap.
3.4 Exhaustion Gap
The Exhaustion Gap is not accompanied by new highs or lows for several days after the gap. Prices stop and then go backwards to close the gap. Exhaustion Gaps occur at the end of a trend. Prices rise or fall for weeks or months and then jump in the direction of the trend. At first, the depletion gap looks like a continuation gap - jumping in the direction of the trend with high volume. But if prices fail to make new highs or lows over the next few days, it is probably a depletion gap.
That it is a depletion gap is only confirmed when prices move in the opposite direction and close it. This gap is like the last throw of a tired athlete. He lunges forward but cannot keep up the pace. If others catch up with him, he can be considered to have lost.
3.5 Island Rebound
An Island Reversal is formed by a combination of a continuation gap and a break in the opposite direction. The island gap looks like an island separated from the other prices by a strait with no trades. It starts as a continuation gap followed by a limited period of high volume trading. Prices then jump in the opposite direction, leaving a price island behind. This pattern forms very rarely, but it marks a fundamental change in trend direction. Play against the trend preceding the island.
It makes sense to look for gaps in similar markets. If gold gives a breakout, but platinum and silver do not, then you have an opportunity to make a "preemptive move" in a market, which has not yet moved.
Gaps can act as support and resistance levels. If more volume was seen upwards after the gap, it serves as an indication of strong support. If greater volume was observed before the gap upwards, then support is less strong.
Recommendations for trading using gaps:
Regular gaps do not provide good opportunities for traders, but if you are forced to trade, trade against them. If prices are up, sell as soon as the market stops making new highs and put a caution over the highs of the past few days. Close the position to the downside and take profits on the lower edge of the gap. If prices have jumped down, buy as soon as the market stops making new lows and place a caution below the lows of the past few days. Give an instruction to sell and take profits at the upper edge of the gap.
If the market has jumped out of the long-term price corridor at the peak in transaction volume and continues to give new highs and lows for several days, then you are probably facing a breakout. If prices have moved up, then buy by putting precautions on the lower edge of the gap. A true breakout gap almost never closes. In a downtrend, use the reverse procedure. Waiting for a pullback when a new trend has just begun can leave you on the sidelines.
Playing after a continuation breakout is similar to playing after a breakout breakout. Buy immediately and set up precautions at the lower edge of the breakout. On a downtrend, use the reverse procedure. Tighten your stop when the trend approaches the target level indicated by the continuation gap.
A true continuation or breakout gap should be confirmed by a series of new highs or lows. If this is not the case, then you may be facing a depletion gap. If the market refuses to make new lows or highs in the direction of the gap, then get out and re-evaluate the market, looking from the outside.
Exhaustion gaps offer attractive trading opportunities, as they are often followed by a swift reversal. If you find an upward depletion gap, sell by setting precautions above the last high. When prices start to fall, the weakest 'bulls' will start to dump. Sell while prices are still hitting new lows and return yours the next day after prices have failed to make a new low. In a downtrend, do the opposite.
Technical indicators can help identify the type of gap. The Force Index is based on price and volume. If the Force Index has changed little on the day of the gap, it is likely to be a normal gap. If the Force Index reaches a record high or low in several weeks, it confirms that a continuation or breakout is true.
Charts with a time scale of less than 1 year show many opening gaps when the opening price lies outside the previous day's price corridor. If there is an imbalance between buy and sell orders before the opening, hall traders open the market lower or higher. If outsiders want to buy, hall traders sell to them at a price that will allow them to earn at the slightest drop in price. If customers want to sell, the goods are snatched out of their hands and paid enough to make money at the slightest price rise. Professionals play it cool: they know that the crowd rarely stays excited for long, and prices usually return to yesterday's corridor. They sell above or buy below that corridor, expecting that when prices level off, they will regain their position and make a profit.
4. Figures (patterns)
A pattern is a recognisable pattern of price changes. The patterns you see on the charts or computer screen are the traces left by "bulls" and "bears". The analyst is a hunter, looking for the faint traces, visible only to those who know where to look. Figures can help you decide whether a trend will continue or not.
There are two main groups of shapes: continuation and reversal. Continuation patterns include flags (Flags) and pennants (Pennants). They tell us to trade in the direction of the current trend. Turning patterns include Head and Shoulders, Reverse Head and Shoulders, Double Bottom and Double Top. They tell you that it's time to take profits from your existing positions. Some figures may be continuation figures as well as reversal figures. Triangles and rectangles are known to play such double role.
When several figures on the chart point in the same direction their signals are mutually reinforcing. For example, when there is an uptrend line crossing and a "head" and "shoulders" formation is completed, both facts indicate that the uptrend is ending. When different figures give contradictory signals, their effects cancel each other out and it is better to refrain from trading.
4.1 Trend reversal patterns
4.1.1 Head & Shoulders
Confirms a trend reversal. Peculiarities of the figure:
if "Head & Shoulders" figure appears on a bearish trend, the higher second shoulder
strengthens its signal;
if the second shoulder of "head and shoulders" figure is lower than the first one on the bull trend, it also strengthens the signal;
to identify a "head and shoulders" pattern, you should compare it with the volumes;
a false (failed) figure is possible.
There is a good sell position on the left and a good buy position on the right.
4.1.2 Triple and double bottom tops
Confirms trend reversal. This is a good position to open downwards
and this is a good position to open up
it is a good position to open down after receiving the confirmation
and this is a good position to open up after a confirmation
Among triple tops and especially among double tops there are many false signals going into the channel, which are eliminated by parallel analysis of convergence/divergence using oscillators and volume indicators.
4.1.3 V-shaped top and base ("spike")
The pattern is formed as a rule after a rapid previous trend. There are many gaps in the chart and practically no resistance/support levels. A trend break is formed as a key day, or as an island break.
The only signal for the trader may be a break of a very steep trend line.
Diamond or diamond is the rarest reversal pattern. It appears when two "triangles" - convergent and divergent - meet.
4.2 Trend continuation patterns
General rules of triangle analysis:
in a classic triangle there should be five lines from the moment the triangle enters (three down and two up or vice versa)
if price enters from above, the stronger position for a downward continuation of price
if price enters from below, then the stronger position for the upside continuation
If the angle of the triangle is upwards, price is more likely to go up
Price is more likely to go down when the triangle angle is directed downwards
the more lines in the triangle and the closer to the top the exit, the stronger and more significant the price movement will be on the way out,
but if the exit occurs in the last quarter, the subsequent move is likely to be sluggish and unstable and the breakout is likely to be between 1/2 and 3/4, the apex of the triangle and will act as support-resistance level in the future;
volume declines as the triangle forms, rising sharply after the breakout, price will travel in the direction of the breakout at least as far as the triangle's highest point
A "flag" is usually formed after a precipitous previous trend. It looks like a rectangle against the direction of the trend. The "flag" is usually formed in the middle of the movement. As the "flag" is forming, the volume decreases, and rises sharply after breaking through. The formation takes from 5 to 15 bars.
The "Pennant" is very similar to a small symmetrical triangle. The volume, as the "pennant" is formed, decreases, rising sharply after the breakout.
4.2.4 A wedge
A wedge is a pattern of a small triangle sloping against the direction of the trend. If the slope is in the direction of the trend, a trend break is most likely. A breakout usually occurs between 2/3 to 1.
A rectangle is very similar to a triple top. Oscillatory and volume analysis is used to determine the type of pattern formed. After the breakout the price will pass in the direction of the breakout a distance, not less than the rectangle height. The borders of the rectangle in the future will serve as good resistance - support levels.